NXP Semiconductors (NXPI) – Merger Arbitrage – 19% Upside

Current Price – $107.37

Merger Consideration – $127.5

Upside – 19%

Expiration Date – Q3 2018

This idea was shared by Max.

 

Qualcomm announced its bid for NXP Semiconductors on Oct 26, 2016. From the get go, this was expectedly a contentious deal as it involved the semiconductors business – an sector highly scrutinized by governmental regulatory bodies because of its implications in national security. From a regulatory stance, the completion of the NXPI/QCOM deal depended on the approval from various countries, including Korea, Japan, Taiwan, Russia, Philippines, EU, Mexico, US and last but certainly not least, China.

After obtaining regulatory approvals from all non-Chinese government – including that of the US government – one last hurdle to deal completion remains outstanding. That last hurdle is the currently pending approval of NXPI/QCOM from China. This has created an opportunity from which NXPI is trading at a ~19% gross spread to its QCOM’s cash offer price of US$127.50/sh. I believe the current discount will close contingent on the receipt of the Chinese approval, which has been intentionally withheld by China. Ultimately, I believe that the approval will be granted by China and that the NXPI/QCOM deal will close.

Based on 1) NXPI’s Jul 9, 2018 closing price of US$107.37/sh; 2) NXPI pre deal-rumor price of US$82.24/sh on Sep 28, 2016; and 3) QCOM cash bid of US$127.50/sh; the gross return of going long NXPI is 18.7%, with a 23.1% downside. This represents an implied odds of deal break of 45%, which is too high in my opinion.

Hence, I am long NXPI with the expectation of NXPI/QCOM close following the receipt of Chinese merger approval.

 

Why Chinese approval still hasn’t been granted

Ordinarily, in evaluating a merger transaction, a government regulatory body considers the after-effects of the merger from an anti-trust/competitive standpoint, and from a national security standpoint if the merger deals with sensitive technologies that may pose threat to national security.

In the present case of the NXPI/QCOM merger, Chinese considerations have extended beyond the concerns national security and anti-trust. In actuality, the Chinese approval of NXPI/QCOM is withheld more-so as a bargaining chip with the US in the interest of reviving ZTE (expanded on below) and negotiations on US-Sino trades relations.

The spread has fluctuated especially widely since the second quarter of this year following the onset of the tumultuous political developments on US-SINO relations, relating to both trade war concerns and the fate of ZTE.

Of the two concerns, I believe the approval of NXPI/QCOM from the Chinese side will be more-so hinged on US’s cooperation on the ZTE issue than on the broader development on US-Sino trade war. In a nutshell, I believe that ultimately, US will cooperate with China on getting ZTE back into business by lifting the severe US-side 7 year suppliers ban, which previously forbade US suppliers from exporting their technologies (micro-processors, etc.) to ZTE. The restriction since then has fatally debilitated the Chinese company from its normal course of operations and has put ZTE in a more-or-less limbo state, with its ultimate fate unclear. US’s cooperation on ZTE will ultimately lead to Chinese reciprocity and approval of NXPI/QCOM, culminating into a deal completion after almost two years of waiting period.

 

The importance of ZTE to China

To understand why Chinese approval of the NXPI/QCOM deal is predicated on the survival of ZTE, we need to understand why ZTE is so important to China, and, in turn, to the NXPI/QCOM deal.

ZTE is a Chinese MNC telecom company and one of the pre-eminent giants of Chinese smartphone makers and Chinese corporation. Not only does the company generates US$16bn+ in revenue as of FY2017 (selling 16+mm phones in US) and employs 75,000 people, mostly in China, ZTE also holds significance in China’s attempt to get ahead in the global race of 5G. ZTE is known for its close relations to the Chinese government. Because of the nature of ZTE’s business, which deals with cellular networks, China deems ZTE’s importance beyond just the commercial aspect but also in terms of national security and geopolitics as China hopes to wean off reliance on foreign technologies in communications.

 

What exactly happened to ZTE?

Historically, ZTE has caused its consternations with the US government. In March 2017, US trade/enforcement bodies raised concerns on ZTE violating US sanctions by selling/exporting crucial US technologies to North Korea and Iran. After paying US$890mm in penalties last year and staking another US$300mm in escrow as collateral for future violations, ZTE claimed to have reprimanded the internal personnel complicit in violating US sanctions.

However, ZTE’s compliance and action in disciplining itself was ostensible at best, claimed by the US. In an April 15, 2018 Denial Order, the US Commerce of Export Enforcement stated that ZTE’s repeated – and continuing – violations of re- selling US imported technologies to US designated Group D countries (North Korea, Iran, Syria among a few) had started as early as 2012 and that ZTE’s top management has been willfully complicit in its misconduct by NOT reprimanding internal personnel accountable for sanctioned transactions and even by constructing internal department specifically purposed to obstruct transaction evidences implicating ZTE involvement in the violations.

As a result of the Commerce of Export Enforcement’s 2018 evaluation of ZTE’s behavior, the US issued a Denial Order on April 15 2018, which forbade US from exporting mission critical technologies to ZTE. The supplier ban has a duration in effect of 7 years, expiring April 15, 2025.

https://www.commerce.gov/sites/commerce.gov/files/zte_denial_order.pdf

Because a material portion (estimated to be >25%) of the inputs needed for ZTE equipment/phone production are irreplaceable US technologies, ZTE found itself unable to conduct normal operations as it lacked the necessary components for its smartphones and equipment production. The crippling effect was immediate and the Chinese company halted operations in May 2018. Since then, ZTE has been eager to resume operations and the Chinese government, recognizing the critical importance of ZTE, has stepped into revive the company by raising the issue with the Trump Administration.

 

ZTE already complying with US government demands

From the negotiations ensued, deals were struck and ZTE has worked to comply with US requests and managed to execute a series of initiatives purposed to lifting the US ban. Earlier this week, ZTE announced via a Chinese public filing that the smartphone giant has completely replaced its corporate leadership, replacing its CEO, CFO and CTO. This move comes after June’s sacking of the entire ZTE board. Additionally, ZTE has agreed to paying US$1.4bn in penalties, consisting of US$1bn of cash penalties and US$400mm of escrow set aside in case of future violation. This penalty is on top of the ~US$1,190mm already paid by ZTE last year. Furthermore, ZTE has agreed to subjecting itself to US regulatory inspections by providing unfettered access to US personnel and funding US efforts to do so.

These compliant gestures have already shown fruition as US has just granted ZTE temporary relief from the export ban, allowing ZTE to resume limited operations from July 2 to Aug 1, 2018. Such progressive turn of events cannot and should not be understated when anticipating the eventuality of the ZTE fiasco.

 

Ban on ZTE and US-Sino trade war should be delineated as two separate issues

Because the ZTE ban happened amidst US-Sino trade war, which is the larger and more pressing issue, I believe that some have viewed the ZTE ban with the same lenses. But this isn’t correct. ZTE’s ban was led by US Commerce for Export Enforcement’s strident opposition to China leaking US technologies to North Korea and Iran, whereas the trade war and tariff issue was almost solely championed by the Trump Administration, in the interest of, first and foremost, reducing US trade deficit with China.

Because the cause of the two conflicts are of different concerns, the solutions to the two problems are also different. In the case of ZTE ban, the US’s actual request is for China to stop leaking US technologies to North Korea and Iran; and if China is willing to comply on these requests, the ban should be lifted.

There is the logic that China complying with US sanctions won’t be enough and that US will continue upholding the ban to press for leverage on the separate issue of trade. This is certainly a justified view given the Trump Administration’s negotiation style. However, how valid does such a view hold when the Trump Administration – the one most likely to use the ZTE ban as a negotiation tool – has already taken the stance to ease restriction on ZTE? I argue that the White House’s most recent attitude on ZTE indicate that ZTE’s current compliance and whatever other deals struck between China and US are sufficient for the lift on ZTE ban.

 

Help from the White House

Subsequent to the April implementation of the ZTE export ban, negotiations ensued between the Chinese government and the Trump Administration. Deals were then struck to penalize ZTE for previous violations. Then, the White House sought to ease restriction on ZTE , with Trump personally becoming a vocal proponent of helping ZTE getting back into business. This gesture from the White House has been attributed to Trump’s motivation to foster personal good will and relationship with Xi. Of course the ease of restriction on ZTE also came at some costs to the Chinese side. Among the more transparent deals terms, ZTE will be fined up to US$1.4bn for its violations.

A temporary relief order came into effect following the May negotiations and US granted a reprieve order, allowing the resumption of US suppliers transacting with ZTE so that the latter may operate from July 2 to Aug 1, 2018.

 

Next catalyst on the ZTE issue will happen within the next two months

There is a concern that the ban on ZTE won’t be permanently lifted based on the most recent actions of the US Senate. On June 18, 2018, the US Senate included the sanction/ZTE ban as part of the FY19 National Defense Authorization Act. This act is a MUST PASS defense bill that has to be signed by the US president. Including the ZTE sanction in the final NDAA means that ZTE ban will be upheld. This would in turn imply that China will likely react negatively, issuing denies and exhibit uncooperative behaviors, such as denying the NXPI/QCOM merger.

Yet the Trump Administration had sought to ease restriction on the ZTE ban, and the US House of Representative’s May version of NDAA did NOT include the ZTE sanction as part of the bill. This means that the US Senate and the House Representatives will have to reconcile the two version to decide whether or not to include the ZTE ban in the finalized version of the NDAA, which MUST pass.

This reconciliation will likely take until the end of this month if not into the next month. The result of this reconciliation shall constitute the next catalyst on the ZTE issue. Later this month or sometimes next month, the finalized NDAA shall be set, and the language within the Act will indicate whether the ZTE ban will be lifted.

From the sources, news and interviews that I’ve processed, the US Senate’s May/June adamancy on upholding the ZTE ban has waned in the presence of the Trump Administrations support of lifting the ban and from ZTE’s even more recent compliance on paying US$1.4bn in fines, sacking senior corporate leadership, and granting unfettered access to US officials verifying ZTE operations relating to North Korea and Iran sanctions. Moreover, even from a political standpoint, the US Senate is somewhat discouraged to drive a wedge between the House and Senate as such would further complicate the Republican party lines on issues that are more pressing, such as trade, where Republicans usually finds cohesion and need such to be effective.

In my most formulated opinion, I believe that a permanent ZTE ban (remember, ZTE ban has already been temporarily lifted from July 2 to Aug 1 while a more permanent decision is in the making) will be lifted in the coming months. The revival of ZTE will be a strong driving force in China approving the NXPI/QCOM deal.

 

NXPI/QCOM denial in light of a lift on ZTE ban is small

The market is worried that NXPI/QCOM won’t be approved because of the ZTE ban and because of the ongoing trade wars between US and China, which is just starting after the first US$34bn US tariff came into effect this weekend.

When considering how China will react to the NXPI/QCOM merger, we need to understand how China is and has been responding to US’s more proactive/offensive actions. China is fundamentally adopting a defensive strategy of tit-for-tat punishment with the US. The core tension has and still revolves around trade-war, to which China’s strategy has been to re-levy tariff proportional to the amount levied by US.

With a concession from the US to ease restriction on ZTE, China – adopting a quid pro quo strategy – will likely reciprocate by giving the US something back. And the NXPI/QCOM approval will likely be a good point to return concession for a couple of reasons. First, the acquirer of NXPI is QCOM, which actually supplies ZTE with vital components needed for ZTE’s production. It would be imprudent (and somewhat awkward) if US lifted restriction on ZTE, only to have China slap the ZTE partner – QCOM – on the face by denying QCOM to acquire NXPI. Second, China has already shown its was willing to speed up its review (and approve) of the NXPI/QCOM deal when the White House’s attitude on ZTE eased in May. A definitive lift on the ZTE ban will only put China’s support for NXPI/QCOM back on track, as substantiated by the Chinese government’s previous reaction in late May 2018.

https://www.wsj.com/articles/china-set-to-approve-qualcomm-purchase-of-nxp-semiconductors-1527333552

Third, shortly after the April 15, 2018 ZTE ban, China seemed to have made a small subtle concession which went unnoticed by the market. In early May 2018, QCOM actually received Chinese antitrust approval for JV with Chinese companies. And unlike conventional JV, which only allowed foreign companies a 49% share in the JV, China recently allowed foreign companies to hold 51% interest in Chinese JVs. This marks a lax of Chinese control on JVs, a positive development for foreign companies doing business in China.

 

Would China block NXPI/QCOM for actual anti-trust or national security concerns

Not likely. This is important to address because there is always the scenario that China genuinely wants to block the deal for non-political reasons related to actual anti-trust and national security concerns.

Addressing this concern, I argue that a NXPI/QCOM merger is unlikely to pose threats to China’s competitive landscape in the demand for semiconductors. This is because of the estimated ~US$210bn Chinese demand for semi-conductors in 2018, NXPI’s market share will amount to <2.5% (based on NXPI’s 2017 Chinese revenue of US$3.6bn). Such slight market share should not constitute a concern for China from anti-trust or national security standpoint.

 

Conclusion

The NXPI/QCOM deal has been outstanding for almost two years and it is drawing to a close. The completion of this deal is hinged on the last regulatory approval, needed from China. The Chinese approval of NXPI/QCOM has been withheld not by anti-trust / national security concerns (which are normally the considerations contemplated by regulatory bodies), but by the recent current political transgressions between US and China. Specifically, China is withholding NXPI/QCOM as a leverage to press for US to lift its suppliers ban on ZTE, a Chinese national jewel that is not only a commercial success but also crucial instrument in China’s advancement in telecom technology and the race of 5G. I believe that the US will ultimately cooperate with China on lifting the ban on ZTE. This is for three reasons. First, US has an interest in incentivizing China to cooperate on larger trade issues (and on getting China to approve NXPI/QCOM, which benefits QCOM, a US company developing 5G for US). Second, recent ZTE compliance of firing the entire board of directors, CEO, CFO and CTO, as well as paying an additional US$1.4bn, plus agreeing to US inspection is undoubtedly cooperative behaviors that the US likes to see. Third, in light of compliance and May/Jun negotiations between China and the Trump Administration, which led to Chinese’s cooperative behavior, Trump Administration became vocal in actually supporting the ease on ZTE. This is a strong indicator that ZTE will be OK.

Upon the lifting of ZTE ban, I expect NXPI/QCOM approval from China to follow suit. The gross spread of ~19% should shrink accordingly, yielding a nice return for those willing to bear the political risk to invest now.