Description

Zarlink Semiconductors

Zarlink Semiconductors (ZL on TSX) is an interesting risk/reward arbitrage situation (please note that numbers are in Canadian dollars unless otherwise stated).  Currently, there is a hostile offer at $3.35 cash and ZL is trading at $3.65 per share (ZL's market cap is roughly $600 million Canadian including converts which are now in the money).  The acquirer is Microsemi Corporation (MSCC on NASDAQ), a provider of semiconductor solutions, that is publicly traded with a market capitalization of approximately $1.8 billion (US$).

Company Description

Zarlink delivers world-leading, mixed-signal chip technology for a broad range of communications and medical applications.  Zarlink is focused on 3 main markets:  line circuits, network timing and medical wireless.  The revenue breakdown is as follows:

Description of the Acquirer

Microsemi Corp. is a provider of semiconductor solutions differentiated by power, security, reliability and performance.  Microsemi offers a comprehensive portfolio of semiconductor solutions for:  aerospace, defense and security; enterprise and commercial; and industrial and alternative energy markets.  Microsemi is an experienced acquirer and is prepared to go hostile.

Strategic Rationale for the Deal

There is very sound strategic rationale for the deal which increases the probability of a transaction happening.  Microsemi outlined 4 reasons in their recent presentation:

• 1) Strengthens their position in high-value, high barrier-to-entry markets - fortifies their leading medical position and continues to build their strong position in communications
• 2) Expands mixed-signal product portfolio and design capabilities - bolsters their existing portfolio with complementary medical wireless and communications product families
• 3) Drives revenue growth by building on existing product strategies and overlapping customers - ZL's communications products build on MSCC's offerings in enterprise and communications
• 4) Financially attractive - ZL adds meaningful scale and the deal is immediately accretive to EPS ($0.20 accretive in year one) before synergies

Deal Background

Between January and April 2011, Microsemi expressed an interest in exploring a strategic transaction with ZL to ZL's former CEO.  In May, 2011, Microsemi re-expressed their interest and submitted an indication of interest to acquire ZL for $3.00 per share.  In June, 2011, ZL's board rejected the proposal.  Microsemi submitted a revised indication for between $3.25 and $3.55 per share (due diligence was required to achieve the $3.55 price).  ZL's board once again rejected the proposal.

Recent Trading Activity

Zarlink has roughly 120 million shares outstanding of which 55 million traded on July 20 (the day the transaction was announced) indicating that arbitrage players are accumulating positions and will be supportive of a transaction.  Furthermore, given this dynamic, there is a lower probability of success of a just say no defense.

Other Competitive Bidders

The strategic rationale that MSCC has outlined can also be applied to many players in the semiconductor space.  As such, there are many potential acquirers who could look at this situation, especially given the small market capitalization of ZL.

Valuation

Using MSCC's own EV/Sales multiple (2.1x) results in a price of $4.00 per share.  ZL has responded that the current $3.35 MSCC proposal "significantly undervalues the Company" and that they are expecting significant growth in their medical business.  ZL is also willing to consider all appropriate alternatives which capture the true value of the Company.

Investment Case

There is always a probability of no deal happening (although the odds may be small).  In that case, ZL may fall back to its pre-deal price of $2.40 for a loss of roughly 33%.  The most likely scenario is a deal happening but the real question is price.  By buying at $3.65, and assuming no other acquirer appears and MSCC pays $3.55, there is roughly 3% downside.  However, assuming that a competitive auction takes place, $4.00 may be a more appropriate valuation, giving potential upside of roughly 10%.  In other words, 3% down, 10% up with a potential deal closing by the end of 2011 (5 month time horizon).

Catalyst