We Like Analog Devices' Deal for Linear Technology
The reasonably priced merger will create an analog powerhouse.
We like the strategic rationale behind Analog Devices’ (ADI) acquisition of Linear Technology (LLTC) for approximately $60 per share, composed of $46 per share in cash and 0.2321 share of ADI stock. We believe the merger will create an analog powerhouse that will rival industry leader Texas Instruments (TXN), as ADI’s strength in data converters and signal processing should pair well with Linear’s focus on power management chips. Given the fragmented nature of the analog industry, we would expect this deal to clear any regulatory hurdles. We wouldn’t rule out another bid for Linear (TI appears best equipped to be a bidder, given its size in the industry), but with the $60 deal price representing a 30% premium to our $46 stand-alone fair value estimate for Linear, we would err on the side of locking in gains now. We have raised our Linear fair value estimate to $60 per share and are maintaining our $61 ADI fair value estimate, as future operating expense synergies should more than offset the quite reasonable 24% premium paid for a high-quality analog leader. We are maintaining our wide economic moat ratings for both firms.
Analog Devices will issue about 58 million new shares to fund the deal as well as take on $7.3 billion of new long-term debt to help pay for the cash portion. ADI expects to maintain an investment-grade rating on its debt, while interest rates on the bonds should hover around 3%. Although ADI-Linear will fall into a net debt position, we foresee strong free cash flow generation over time that should allow ADI to service the debt as well as maintain its current dividend policy (ADI did indicate that stock buybacks are likely to be suspended for a while).
ADI is targeting $150 million of annual synergies after 18 months. We think such a target is reasonable and, once achieved, will justify the 24% premium paid. Management cited cost savings in manufacturing, research and development, and selling, general, and administrative costs, but we think the last will be the source of the heftiest cuts. We don’t foresee tremendous top-line synergies, but management was optimistic about cross-selling some of Linear’s products into ADI’s entrenched customers in the wireless infrastructure space in particular, as well as automotive advanced driver-assistance systems.
We had thought this combination was one of the few large deals in the analog chip industry that would make sense, given a relative lack of product overlap. Our wide-moat theses for TI, ADI, Linear, and Maxim Integrated Products (MXIM) are all based in part on customer switching costs, where we think it is rarely worth it for most customers to expend the time and effort to redesign an electrical board in order to switch to another vendor, just to save a few cents on the cost of an analog chip. For this reason, analog M&A has been historically rare to begin with (although M&A has clearly heated up over the past couple of years) because an acquirer cannot simply streamline the acquiree’s product portfolio, cut out redundant or overlapping products, and switch customers over to the larger firm’s product. Furthermore, R&D staff needs to be maintained in order to support products from both firms. Even shifting manufacturing to the acquirer’s fabrication plants takes time and effort. Thus, we often see little synergies in the cost of goods sold or R&D lines to justify many deals. ADI cited potential for some improvements in revenue and manufacturing synergies from the deal, but we are only cautiously optimistic on this front.
This merger also raises the question as to the fate of Maxim Integrated; both TI and ADI were rumored to be negotiating with Maxim last year, but no deal came to fruition. We can certainly see a scenario where TI-Maxim talks are rekindled, and it might be incrementally harder for Maxim to capture new business now that customers have two larger, high-quality firms from which to choose. However, we think Maxim can continue to do quite well on a stand-alone basis and it doesn’t explicitly need to roll up other smaller (and perhaps less profitable) analog firms in order to remain relevant and profitable.
In addition to announcing the merger, ADI raised its revenue and earnings per share guidance for its fiscal third quarter ending in July. It now expects revenue of $865 million, ahead of the $800 million-$840 million forecast it gave in May. The firm also foresees adjusted EPS of $0.77-$0.78 versus prior guidance of $0.66-$0.74. We suspect that the upside relates to ADI’s business with Apple, a tech leader that is notoriously secretive about its future buying volume. It appears that Apple may have placed orders with ADI either ahead of schedule or in greater volume than previously estimated.
Also, Linear Technology reported fiscal fourth-quarter results that were squarely in line with our expectations. Revenue of $374 million was down 1.5% year over year but up 3.5% sequentially and at the midpoint of management’s guidance of 2%-5% growth given in April. Revenue from the industrial sector held up well, while the firm saw a nice boost in revenue from its smaller computer and high-end consumer segments. Transportation and telecom chip demand was down slightly, but not by a worrisome amount. Gross margins and operating margins remained peerless at 76% and 46% in the quarter, respectively, up 20 basis points and 90 basis points from the prior quarter. As a result of the pending merger, Linear will no longer provide forecasts to investors.
Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.