Renesas Electronics Corp. (TYO: 6723) – market cap as of 17/09/2018: ¥1.21tn
Integrated Device Technology Inc. (NASDAQ: IDTI) – market cap as of 17/09/2018: $6.05bn
Exchange rate: 1 JPY (¥) = 0.0089 USD ($)
Introduction
On September 11, 2018, Japanese Renesas Electronics Corp. (“Renesas Electronics”), a global player in the field of advanced semiconductor solutions, acquired US chipmaker and rival Integrated Device Technology Inc. (“IDT”), a specialized provider of analog mixed-signal products. The deal, the size of which was in the region of $7.2bn, seals the comeback of M&A activity in the lately beleaguered semiconductor industry. Renesas’ move is in line with its corporate strategy, aimed at positioning the company in the front row in the race towards the attractive field of profitable automotive chips and self-driving car applications.
About Renesas Electronics
Renesas Electronics started its operations in 2010, as a result of the business combination between NEC Electronics Corp. and Renesas Technology Corp. After the losses reported in the first two years of operations, Renesas planned a strategic repositioning. Innovation Network Corp. of Japan – a public-private venture involving the Japanese government – provided the company with the $1.5bn bailout needed in order to carry out the restructuring plan, which was completed in 2013. Since the bailout, Innovation Network Corp. has been Renesas’ major shareholder, with a 33.4% stake in the company’s equity. A major turnaround in 2013 gave the company a new strategic direction. In Q1 2017, The New Renesas completed the acquisition of Intersil Corp for a value of $3.2bn, thereby acquiring a leading position in the field of power management and precision analog capabilities. This strategic move turned Renesas into a profit-generating company and today it is recognized as a primary supplier of complete semiconductor solutions.
Headquartered in Tokyo and listed on the TSE (Tokyo Stock Exchange), the company is a specialized provider of platforms, development kits and product solutions aimed at creating smarter endpoints. It operates along two main business lines: Automotive and Industrial & Broad-based. The automotive sector collects the most successful applications of the company’s semiconductor solutions, generating about half of its consolidated revenues. In 2016, Renesas recorded worldwide aggregate shipments of approximately 1bn units for its microcontrollers and system-on-chip technologies for the automotive segment, reporting an extremely low failure rate of 0.1 Parts Per Million. Renesas’ best in quality automotive semiconductors are used in electric vehicles and interconnected cars production processes and in the increasingly attractive market for autonomous driving. On the other hand, Industrial & Broad-based solutions focus on the design of fully comprehensive and integrated platforms for embedded Artificial Intelligence (“e-AI”) real time applications, as well as energy consumption optimization systems. These platforms integrate the construction process of smart homes, factories and infrastructures, making them more comfortable, safer and more flexible.
Renesas’ key consolidated financials for the year ended in December 2017 highlight net sales amounting to $6.7bn, Operating Income of $672m – corresponding to a 10% operating margin – and a $661.7m net income. Due to changes in the fiscal term implemented by the Group in 2016, a YoY comparison is not readily observable.
About Integrated Device Technologies
Founded in 1980, IDT has always played the role of a pioneer in the market for computer components, starting from memories and flow control management devices. In 1993, the company entered the PC clock market and in the early 2000s it presented the first integrated microprocessor. A strategic repositioning affecting the previously entered PC clock market was carried out by the American chipmaker, as more recent applications such as new-generation desktops, notebooks and server platforms emerged. This was carried out through an external growth strategy that led IDT to enter new markets, such as the serial switching industry, as well as strengthen its position in already penetrated markets.
Headquartered in San Jose, California, and listed on the NASDAQ, IDT is a globally recognized developer of system-level solutions thought for the optimization of Clients’ existing applications. In particular, its product portfolio currently involves radio frequency, high performance timing, real-time interconnectivity, wireless power and smart sensors applications. The width and breath of its products allow IDT to play the role of market leader in the field of complete mixed-signal solutions for the communications, computing, consumer, automotive and industrial segments.
IDT’s key consolidated financials for the year ended in April 2017 highlight increasing revenues amounting to $728.2m (+4.4% YoY), an operating income of $110.3m reporting a decrease (-19.2% YoY) with respect to previous year’s results mainly due to soaring R&D expenses (+$16.6m YoY). Similarly, 2017 Net Income ($110.5m) replicated the same trend as the one followed by Operating Income, falling 43.3% YoY.
Industry Overview
For most of the semiconductor industry’s life, the famous Moore’s Law held true. Today it no longer appears to be the case. In 1965, Gordon Moore theorized that the number of transistors in an integrated circuit would double every year. This extraordinary growth made possible frequent technological breakthroughs, which often meant higher returns to the companies in the sector. Recently, however, merely increasing the transistor density by reducing their size has become increasingly difficult and this has brought a slower pace of technological advancement. Companies have seen decreasing returns on R&D despite a record aggregate investment of more than $23bn in 2017. This applies negative pressure to the returns on capital, which adds up to the highly cyclical nature of the industry, generating a widespread negative trend.
Nonetheless, the rise of autonomous cars has increased demand and sustained the most recent growth in revenues. Companies have shifted their attention to this growing market as choosing the correct market amounts to as much as 70% of the growth of semiconductor producers, according to McKinsey. This has been yet another phase of the rise of the Internet of Things, a trend which has increased the demand for chips beyond the traditional PC manufacturing industry. However, the fundamental technological barriers to innovation have started to threaten the confidence of investors in the industry. The expected growth in revenues for 2019, for example, is 4.4%, while a 12.4% growth rate was observed last year.
As technological breakthroughs become less frequent, it is expected that successful products will have to change in nature. The industry, which is dominated by products that can be used for multiple purposes, is expected to shift to the development of more tailored products. Such development could provide new players with an opportunity to emerge in specialized markets at the expense of incumbents, who might struggle to adapt. Such scenario is even more likely with the Chinese industrial policy aimed at reshaping the market by providing government funding.
Deal Structure
On September 11, Renesas announced that it will buy IDT in a deal worth $7.2bn, recognizing an implied equity value of $6.7bn. Renesas will pay $49.00 per share, which represents a 29.5% premium over the target unaffected share price measured on August 30th. The consideration is to be paid in cash. To fund the transaction, Renesas will raise approximately ¥679bn ($6.1bn) in debt, and the remainder will be financed with existing cash on its balance sheet, so no new Renesas shares will be issued.
Deal rationale
From Renesas’ point of view, the deal, although backed by a strong strategic rationale, poses some financial questions.
From a strategic standpoint, through the acquisition Renesas would at once tackle one of the weaknesses of its automotive segment and diversify away from it. Indeed, Renesas lacks expertise in analog chips, through which signals from e.g. sound and light are processed into data, and which are crucial in autonomous driving applications. Renesas could therefore solidify its competitive position in the attractive $38bn market for connected car technologies. At the same time, the company would gain a valuable exposure to fast growing complementary segments, such as data centres and communication infrastructure. This is good news for Renesas shareholders, considering that the company currently derives from Japan and the auto sector respectively 60% and 50% of its revenues.
Financially speaking, Renesas expects the deal to be EPS accretive by 1.8% right after closing and to derive $250m run rate synergies. Because of limited overlap in product portfolios and comparatively higher cross selling opportunities, two thirds are forecasted to be revenue synergies. The fact that such a dominant percentage is made up of revenue synergies is troubling, because unlike cost synergies they are significantly harder to both quantify and achieve. In addition to this, given the all cash nature of this deal, the combined company would have to lever significantly – net debt / EBITDA would exceed 3x. Given that business cycle in semiconductor has shown signs of turning, the financial strain might be too cumbersome. If we also consider that S&P has warned that if acquisition is finalised, it will downgrade Renesas by one or even two notches, the synergistic benefit might get completely overturned by higher interest expense.
Finally, governments have put cross border deals in sensitive industries such as semiconductors under an increasing amount of scrutiny, recently blocking the acquisition of Qualcomm by Broadcom and that of NXP Semiconductors by Qualcomm, hence it is not clear whether the deal will gain approval from the Committee on Foreign Investment in the United States.
Market reaction
Information about the acquisition was welcomed by initial optimism on trading floors in both New York and Tokyo. On the back of the announcement, Renesas stock price gained 4.4%, its highest increase after a long series of declines starting that brought the stock price from ¥1488 in November 2017 to its current level of just above ¥725. IDT stockholders may have some reasons for optimism since the announcement brought the price to the new highs, reaching $47 on Monday, 17th September, an increase of more than 25% since the end of August.
Financial advisors
Morgan Stanley, BofA Merrill Lynch and Mizuho Securities acted as financial advisors to Renesas; Morrison & Foerster LLP, and Covington & Burling LLP and Nagashima Ohno & Tsunematsu acted as Renesas’ legal counsel. J.P. Morgan acted as exclusive financial advisor to IDT; Latham & Watkins LLP acted as IDT’s legal counsel.
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