Why MaxLinear Could Be Better Off Not Acquiring Silicon Motion (MXL)

MaxLinear (NASDAQ:MXL), a supplier of analog, digital and mixed-signal integrated circuits, has not fared all that well since it announced its decision to acquire Silicon Motion (SIMO). The stock has lost around 32% of its value since the announcement on May 5, 2022. True, there were other factors at work that contributed to the decline, including declining earnings along with a weakening market for semiconductors, but it is safe to say that the proposed transaction has not been well-received for a multitude of reasons. MXL may want to take heed of these signals as it may be better off parting ways with SIMO. Why will be covered next.

The market gave the proposed acquisition a thumbs down right from the beginning

According to the proposal, SIMO shareholders are to receive $93.54 in cash and 0.388 share of MXL stock for each ADS they own. SIMO was thus assigned a valuation of $3.8B or $114.34 per ADS at that time. However, while the proposed transaction could turn out to be a positive for MXL in the long run, the reality is that the proposal has been seen as a negative for MXL pretty much right from the start.

The stock, for instance, fell 17% the day after the acquisition was announced, setting off a long decline from which it has yet to recover from. It paved the way for MXL to underperform in what was already a difficult year for semiconductor stocks. In all, MXL lost roughly half its value in 2022. In comparison, the iShares PHLX Semiconductor ETF (SOXX) lost 36% in 2022.

Granted, the year 2022 was a tough year for semis and stocks in general for a number of reasons, including tighter monetary policy, inflation and a weakening economy/consumer demand. Nevertheless, MXL has underperformed, having fallen more than most with most losses coming after the SIMO proposal. MXL has yet to recover as shown in the chart below.

The proposed transaction is currently in a state of limbo with China yet to grant regulatory approval after MXL and SIMO were required to refile their application. In addition, while China has yet to make a final decision, approval from China is not a sure thing with skepticism around as to whether the proposed acquisition will go through.

The market itself seems to be leaning towards the side of the doubters, which explains why SIMO is trading at $65.35 as of Jan 11, which is way below the proposed acquisition price. In fact, SIMO is below where it was shortly before the acquisition was announced. It’s fair to say that the proposed acquisition has not gotten a positive reception.

Why MXL may be better off not going through with the SIMO acquisition

There are a number of arguments as to why it may be better if the SIMO acquisition does not go through. For starters, the proposal may have come at a bad time. The proposal was contemplated at a time when the semiconductor market was riding high and prospects for the semiconductor industry looked better than ever. Expansions make sense under these conditions.

However, the market has since taken a turn for the worse with numerous companies reporting weakening demand for semiconductors. This has been especially true in the memory market, which includes DRAM, but also NAND memory chips. For instance, the memory market is projected to have contracted by 12.6% YoY in 2022 according to sources, way behind the 4.4% expansion for the overall semiconductor market. This is not good news for a company like SIMO, which is essentially a supplier of controllers for NAND memory chips.

The decline in end-user demand has consequences. For instance, Micron (MU), a supplier of NAND chips, saw its earnings collapse as demand got worse. MU reported GAAP EPS of $2 and quarterly revenue of $7.8B in early 2022, but by the end of 2022, this had turned into a GAAP loss of $0.18 with quarterly revenue of $4.1B.

MU has seen its earnings deteriorate in a hurry with prices for NAND memory chips falling due to a slump in demand, which does not bode well for SIMO, especially not with MU its number one customer. Keep in mind that MU is primarily a DRAM supplier and SIMO has other customers besides MU, but if SIMO sees a similar drop off in earnings as MU, SIMO can expect to see its value drop from where it is currently at.

SIMO and MXL have reported a gradual decrease in earnings in recent quarters, although nothing close to what happened to MU. There are, however, signs demand is getting worse, even if the headline numbers don’t look that bad. On the other hand, it’s worth mentioning that there are those who believe demand in the semiconductor market will start to improve in H2 2023. This includes a recent forecast from TSMC (TSM).

Why MXL could be overpaying to acquire SIMO

In fact, consensus estimates do not price in a major decline in earnings in the coming year, whether for SIMO or MXL. This may turn out to be correct, but it could also be way too optimistic, especially if the semiconductor market continues on the path it is on. If earnings do decline more than expected, valuations may have to be revised, especially in the case of SIMO. The table below shows the multiples for SIMO and MXL.

	MXL	SIMO
Market cap	$2.81B	$2.21B
Enterprise value	$2.81B	$2.01B
Revenue (“ttm”)	$1,077.6M	$1,009.5M
EBITDA	$248.4M	$277.3M
Trailing GAAP P/E	23.47	10.41
Forward GAAP P/E	21.65	10.67
PEG ratio	N/A	0.20
P/S	2.57	2.14
P/B	4.56	3.06
EV/sales	2.61	1.99
Trailing EV/EBITDA	11.33	7.25
Forward EV/EBITDA	6.61	6.74

Click to enlarge

Source: Seeking Alpha

Forward estimates do not expect much of a drop in earnings for SIMO, which looks like a tall order considering the state of the NAND market and the stress its number one customer is experiencing. It’s also worth mentioning that recent earnings at SIMO (and MXL for that matter) are way higher than usual, taking into account the long-term average.

SIMO has earned GAAP EPS of $6.32 on a TTM basis, but the average EPS in the last ten years is much less at $2.30. SIMO’s earnings have risen in recent years thanks to favorable market conditions, but if the market returns back to resembling the historical norm, EPS will likely be much less. It would also mean that SIMO would have to be assigned a much lower valuation than right now.

For example, an EPS of $2.30 and a P/E multiple of 10 implies a stock price of $23 for SIMO, far below the $65.35 it is going for at the moment. If earnings drop along with a slumping market for NAND chips and controllers by extension, MXL could be overpaying to acquire an asset that does not earn as much and is thus worth much less.

It’s also possible that EPS could be even less, especially since the market for controllers is crowded with many suppliers competing against SIMO. If the market remains in a state of glut, it becomes a buyers market, which often results in price wars and little to no profitability for those involved. MXL could come to regret paying a hefty sum for SIMO.

MXL may have to take on debt at a bad time

There is another reason why MXL may want to think twice about acquiring SIMO. MXL will have to leverage itself to get SIMO. This may not be so bad if the market remains as strong as it has been in the last couple of years, but MXL may be doing so when the business cycle is about to turn, if it hasn’t already.

Note that the cash portion of the proposed transaction with SIMO is worth $3.1B and MXL intends to finance this amount using cash from the combined entity and by taking on debt. MXL and SIMO have $400M in cash combined, which suggests MXL will have to add around $2.7B in debt to its balance sheet.

In addition, the interest to be paid on that debt is almost certain to be much higher than what MXL anticipated when it put together the acquisition of SIMO in late 2021/early 2022. Interest rates have soared higher since then, which means debt is a lot more expensive than it used to be during the days of zero interest rates.

Note that both SIMO and MXL have experienced years in which they did not earn a profit. If there’s a lot of interest expense to service a pile of debt at a time when demand is slumping for an asset that may not generate income as much as thought and could be worth less than what MXL paid for, then you begin to see why there are many out there who have given the merger between SIMO and MXL the thumbs down.

Investor takeaways

MXL management remains committed to the SIMO acquisition and it is optimistic the transaction will be completed as proposed. However, it seems to be in the minority in regard to its views on the SIMO and MXL combination. The market does not seem to believe the transaction will be completed with SIMO’s stock trading far below the proposed acquisition price.

MXL has not fared much better. The stock dropped after the proposal was made and it is now worth much less than before the proposal was made. Granted, the deterioration in the semiconductor market contributed to the decline, but I think the market has made it known that it does not see the SIMO acquisition as a positive for MXL.

On the contrary, MXL may be running the risk of getting into problems due to the acquisition. Whether it is taking on debt at a time when servicing debt is becoming harder due to higher interest rates or reduced earnings due to a weakening market for semiconductors. There is the risk that the SIMO acquisition will not pan out. Both MXL and SIMO have seen their GAAP earnings dip in recent quarters and this looks likely to continue, which is a bad sign of things to come.

The decline could be especially steep in the case of SIMO if recent quarterly results from MU are any indication. They suggests earnings at SIMO, which have risen in the last couple of years due to the semiconductor boom, are about to experience a steep decline, which has negative implications for valuations. MXL could be running the risk of paying too much to acquire an asset that is not worth as much.

Management may be optimistic, but it may want to take heed of the market’s reaction. It may want to consider if now is the right time to be spending heavily on acquiring an asset that could be worth much less in the near future. MXL could be better off waiting for a time when conditions are more favorable, acquisitions are less expensive and the risk of making an ill-timed acquisition is lower.

The proposed acquisition is currently on hold with China yet to grant regulatory approval. It’s not certain whether China will say yes or no to the proposal. However, if the price action from the point the proposal was made public is any indication, then the market seems of the opinion that the combination of MXL and SIMO is not a good idea and should not become a done deal. Odds are the market will be proven right in my view.