Description

Investment thesis

We are presenting a merger arbitrage opportunity for those with excess cash in their portfolios. Due to low trading volume this $146 million deal is only viable for smaller accounts as only 40-60k shares trade daily. O2Micro (OIIM) is going private in a management-led buyout for $4.93 per ADS after fees. EGM is scheduled for January 31 and the company expects the transaction to close this quarter. The current price is $4.48, which represents a potential 10% upside to the net offer price. The discount can possibly be attributed to regulatory intervention concerns.

Business description and deal background

O2Micro designs, develops and manufactures analog and mixed-signal backlighting and power management chips for a wide range of applications, such as LCD/LED screens, phones, tablets, power tools, vacuum cleaners and electric vehicles. It does not work with the most advanced chips that come in tiny sizes of 0.04 micron or smaller. Its power management chips are larger, having feature sizes of 0.18 micron and 0.5 micron or greater. The company is part of electronics and industrial supply chains and the vast majority of its sales are in China. O2Micro is largely based in China with two facilities in Taiwan and one in California (with only 17 employees). Management is Taiwanese.

O2Micro’s stock has been incredibly volatile over its history. It listed at $9 per ADS in the year 2000 and has lost money since then, significantly underperforming its peers and the S&P500 over any selected long or medium term. For some of the period it traded at a negative enterprise value. An activist got involved in 2014 but failed to have an impact. Capital return policy has mostly benefited exiting shareholders with $102.2 million spent on share repurchases since 2002 at an average of around $5 per ADS.

Management followed the typical playbook that the Chinese use to take US-listed companies private. A preliminary non-binding proposal at $5.50 per ADS was submitted in March 2022. In June, management, while actively bidding on the company, provided financial projections to the board for evaluating its own bid. In July, following a weak quarterly earnings report, management updated its projections downward. In September, management revised its non-binding bid downward to $4.90 citing deteriorated performance and finally agreed to $5.00 which the board accepted.

The spread started wide at 16.5% on the date of the announcement and has been declining as expected. Some risks are also now lower as the closing date approaches.

The private equity sponsor is Forebright Capital Management, owned by Cheng Liu and Kun Wan Ip. It was formed as a result of a 2014 spin-off of Hong Kong-listed Chinese SOE financial group China Everbright. It is a very experienced investor in the Chinese markets. Forebright has been successful at taking US-listed Chinese companies private and relisting them in China where they trade at higher multiples. In 2016 it took Jinpan Tech private for $97 million and relisted it in Mainland China in 2021 where it currently has a market cap of $2.7 billion.

Regulatory approval

Obtaining required approvals is a condition of the transaction. The company claims that the only approvals necessary are those required under the federal securities laws and applicable listing rules of NASDAQ, as well as filing documents with the Cayman Registrar. It decided not to notify Cfius.

Cfius has become increasingly focused on semiconductors, whether for military or consumer electronics applications. Further, Chinese buyers would likely receive the highest amount of scrutiny in any transaction. So on the surface it may look like O2Micro, with 564 patents issued in the United States and 18 more applications pending, as well as a facility in California with 17 staff, and Chinese capital being part of the buyer group, may be at risk. Cfius has also been increasing its jurisdiction, especially after the implementation of the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”), where “but only to the extent of its activities in interstate commerce” was removed from the definition of “U.S. business”. The block of the attempted 2021 acquisition by Chinese private equity of Magnachip Semiconductor, a Korean semiconductor company with hardly any nexus to the US, demonstrated the increasingly long reach of Cfius. There is some concern about O2Micro being subjected to the same.

While Cfius can assert that O2Micro has some US IP due to R&D conducted in the US over the years, it relied on Magnachip’s top-level Delaware holding company to demonstrate “U.S. business”. O2Micro has a different organizational structure: while it has a U.S. subsidiary (O2Micro, Inc.), its holding company is Cayman-based. Further, Magnachip is run by Korean staff from Korean facilities from where it exports to other countries, including China. O2Micro, on the other hand, has already transferred a large part of its operations to China since the mid-2000s where it employs the majority of its staff. Even if Cfius were to identify a risk, there is not much further IP transfer that it can prevent by restricting ownership to the current shareholders.

Cfius is good at noticing non-notified transactions (i.e. transactions within the jurisdiction of Cfius that were not notified to Cfius). In 2021, Cfius identified and reviewed 135 of such transactions but only decided to request notices to be filed for 8 of those transactions (6%). Cfius contacted Magnachip within 2 months of the definitive merger agreement date. Currently O2Micro hasn’t heard anything from Cfius at the 3.5-month mark. It is likely that Cfius has already reviewed the transaction and if it were interested it would have contacted by now and the company would have had to put out a disclosure.

Shareholder approval

Two-thirds of voting power among voting shareholders must be in favor to approve the deal. The buyer group and rollover shareholders have 16.9%. The stock has kept disappointing its long-term holders, many of who will welcome a cash-out. There is no opposition campaign against the buyout. A condition for the transaction is that “the holders of no more than 10% of the Shares shall have validly served and not validly withdrawn a notice of dissent under Section 238(5) of the Cayman Islands Companies Act”. It is unlikely that appraisal arbitrageurs have entered the stock because relatively few ADS have been transacted after the definitive merger agreement date, under the 10% threshold.

Export controls

The US has been tightening China’s access to chip-making technology. A sweeping set of export controls were announced late last year after the merger agreement was signed. These controls don’t affect anywhere near the larger chip sizes that O2Micro deals with. Further, O2Micro mostly produces in China. We don’t see this hurting O2Micro’s business or constituting a Material Adverse Effect. However, it will increase the amount of investment and enthusiasm shown by the Chinese for semiconductor companies in an attempt to dominate the older technologies that they still have access to. O2Micro would likely benefit from a potential listing in China in this environment.

Financing

The sponsor is putting up $45 million in equity and Credit Suisse Singapore is lending $80 million for a total of the $125 million needed to buy the company. Of the $80 million of debt $40 million is a five-year term loan and $40 million is a cash bridge facility. As of Q3 2022 the company had $50.3 million in unrestricted cash and term deposits or $1.72 per outstanding ADS. Considering this the transaction is not that highly leveraged and we are not overly concerned about Credit Suisse’s ability to come through with the loan. Financing is not a condition to the merger.

Downside

O2Micro has been very volatile in terms of both operational performance and stock price. Stifel Nicolaus had a $3.50 price target on the stock. It closed at $3.25 on the day before the merger agreement was signed and the 90-day volume-weighted average price was $3.62. The large net cash balance should act as a cushion. Downside in case the deal breaks is likely 20-30%.

Catalyst

Deal closing.