Current Price: $24.45
Offer Price: $29.00
Expected Closing: H2 2021
This idea was shared by Alan.
This is one of the most interesting merger arbitrage situations currently on the market, offering substantial short-term upside and downside protected by fundamentals.
On the 26th of March, the second-largest display chip (semiconductor) producer in the world, Magnachip Semiconductors announced a takeover by Chinese PE firm Wise Road Capital at $29/share in cash. The transaction is subject to approval by the majority of MX shareholders and several regulatory consents – China, South Korea and the U.S. Closing is expected in H2 2021. Shareholder meeting date hasn’t been announced yet.
Shareholder approval shouldn’t be an issue. The offer is priced at 15.5x TTM adj.EBITDA and at an all-time high share price. Management owns 3.6%. 5 major shareholders (mostly large asset managers) have a combined stake of around 27%. In two months since the announcement, none of them have opposed the transaction, and, in fact, all of them have recently slightly trimmed their stakes below the offer price. Given these facts shareholders are unlikely to oppose the takeover at $29/share.
The biggest issue and the reason for the spread is the regulatory hurdle and more specifically – the approval by Korean foreign investment regulator. MX keeps most of its operations, IP and cash in South Korea. The Korean government is currently in the process of deciding whether OLED chip technology (including MX’s IP) should be considered as a core national technology. The verdict is expected to be made by the end of this month. A decision that the MX IP is strategically critical would allow the regulators to put a probe on the takeover and in turn, this would significantly increase the chances of the transaction getting blocked. I am examining the Korean regulatory aspect in more detail below. And while this adds significant risk to the situation, the chances of consent still seem quite decent and definitely tolerable given the wide spread. Approvals from the U.S. and China regulators should not be an issue.
Importantly, at the current prices, the downside seems to be fully protected. MX has recently sold its foundry business and transitioned closer to a pure-play chip design company (the company retained a small foundry for its own products and transitional services). Going forward, the company expects significantly improved top-line growth and margins. The effects are already somewhat visible in the performance over the last two quarters. MX has around $10.30/share in cash (inc. break fee) and no debt. Excluding cash, the operating business now trades at 9.7x normalized TTM adj. EBITDA (vs peer multiple of 13.5x EV/TTM adj. EBITDA). So in the worst case, even if the merger breaks, the share price drop should be limited. Pre-announcement price stands at $20.41/share, but might no longer be applicable due to positive Q1’21 results announced recently.
MX sale process was highly competitive with bids from multiple interested parties including a few strategic buyers. The offered prices were above current levels. The second and third highest bids were $26.50/share and a range of $25-$29/share. One strategic buyer came late into the process and had no time to make an offer at all.
The company designs and supplies analog and mixed-signal semiconductors. Until recently it also provided foundry (i.e. chip manufacturing) services for third-party semiconductor companies (used to be c. 40% of revenues). Foundry business was capital intensive and lower margin – it was sold together with the manufacturing facility (Fab 4) in Sep’20 for $350m. With that, MX transitioned closer to a pure-play chip designer/supplier and part of the proceeds were used to eliminate debt. At the time, management commented:
We will run lean and mean. As a streamlined standard product company, we will rightsize OpEx and exercise financial discipline. Operating income targeted to double from current levels. Our longer term goal is for adjusted operating income, which excludes stock-based comp to double to above 10% in the next few years. […] Adjusted EBITDA margin percentage to increase. This goal will be made more achievable without the foundry business and Fab 4.
According to the sale agreement, MX will continue to provide transitional foundry services to the buyer for up to five years.
Current segments are standard products and transitional third-party foundry services:
Standard products (92% rev):
- Display solutions – comprises of display solutions and power solutions divisions. Display solutions provides products to major suppliers of mobiles, automotives, notebook PCs, LCDs, OLEDs, micro-LEDs, etc. MX is the largest OLED panel chip producer, after Samsung Electronics. OLED division generates around 17% of total revenues and is a high growth industry with positive tailwinds from 5G smarthphones sector.
- Power solutions – offers power management products and services. Products include metal exide semiconductor field effect transistors (MOSFETs), gate bipolar transistors (IGBTs), AC-DC converters, DC-DC converters, LED drivers etc.
Transitional Fab 3 services (8% rev) – uses the remaining MX’s manufacturing facility (Fab 3) to perform foundry services to the buyer of foundry services business/Fab 4.
Most of Magnachip’s operations, the design center, all of the IP and inventory are located in South Korea. 97% of cash is also held by the Korean subsidiary. The remaining Fab 3 foundry facility (used for 8-inch wafer manufacturing, 3x smaller than the one that was sold last year) is also located in Korea. OLED product manufacturing is outsourced to external 12-inch foundries. Assembly, test and packaging operations are also outsourced mostly to China.
56% of standard product sales are generated by the two largest customers – Samsung and LG, which are both South Korean companies. However, from the geographical standpoint, a majority of the company’s revenue is generated in China:
- Asia Pacific 75% (China is 61% of total)
- Korea – 22.9%
- Europe – 4.3%
- United States – 1.1%
- Others – 0.4%
The takeover requires consent from the Chinese antitrust watchdog and also regulatory approvals from the U.S. and South Korea. The merger background part of the proxy details that MX put very high importance to the regulatory concents and potential break-fee provision related to that. The negotiations with all bidders were led around it. Merger agreement included high break fees (usually these are around 3%) if the transaction is blocked by regulators – the very fact that the buyer has agreed to such high termination fees clearly indicates that it expected the deal to be approved eventually.
- U.S. – $70m or 5% of total consideration;
- South Korea – $84.3m or 6%;
- China – $105.3m or 7.5%.
Given that the company has no assets in the U.S. and generates only 1% of revenues in the states, no regulatory hurdles were/are expected there. The buyer is a Chinese PE firm, so a block from China is also unlikely.
MX management seemed confident about the South Korean approval as well, mainly due to buyer’s intentions to keep the MX technology, IP and remaining manufacturing operations in the country. MX management will also remain unchanged after the takeover – Wise Road was/is positioned as a purely financial buyer. From proxy:
Our Board considered that, although there is an antitrust filing that will be required to be made in the PRC, there are not likely to be significant antitrust or other regulatory impediments to closing, including none expected in the United States or in the Republic of Korea. <…> With respect to Korean regulatory approvals, our Board considered (1) the fact that no assets of MSK, including the technologies and the intellectual property rights as well as the manufacturing equipment and facilities held by MSK, will be transferred out of South Korea in connection with or as a result of the transaction, (2) the understanding that Parent does not intend to transfer any assets, including to the extent that MSK currently possesses or in the future may possess any National Core Technology (as defined in Article 2(2) of the Act on Prevention of Divulgence and Protection of Industrial Technology of Korea, as amended), outside of South Korea after the transaction closes, and (3) the understanding that the Company and Parent are committed to taking all necessary measures to continue to comply with the laws and regulations governing National Core Technology in connection with, as well as after, the transaction.
Despite assurances from management, the approval by South Korean authorities remains a major risk. Apparently, the country’s government fears that this transaction might result in a similar outcome as did the takeover of Hydis, an LCD company that was sold to a Chinese buyer in 2002. Hydis had its IP stolen and later on sold to Taiwanese companies. BOE, in turn, became the largest LCD company in the world.
Recent events on the regulatory front as highlighted by a few Korean media articles:
- March 30 – Korean government requested data to determine if MX has the “national core technology”. If it is decided that MX technology is critical, the government will review the takeover in detail and could potentially block it due to national security reasons.
- May 12 – government initiated a procedure to decide if OLED chip technology is a national core technology. It was reported that the Minisitry of Trade, Industry and Energy “recently held a display expert committee and decided to propose an agenda to designate OLED driving chip-related technology as a national core technology”. Spread widened from 20% to 30% upon this news, but has narrowed down again recently.
- May 17 – it was reported that the government should reach a decision by the end of this month.
- May 18 – another report came out stating that the government is “unlikely to intervene with the merger”.
At the moment it’s quite difficult to handicap what decision will be made, however, it is important to note that even if the OLED gets designated as a critical technology, it doesn’t automatically mean that the deal will get blocked (although the chances of that happening would become substantially higher).
Unlike OLED, LCD technology is already considered as critical in South Korea. Despite this status, the government approved Samsung’s LCD plant sale to Chinese buyer at $1.1bn a few months ago. LCD is a less valuable (i.e. old) technology and the mentioned plant is located in China, not Korea.
Magnachip is putting significant efforts into convincing regulators to approve the merger. Recently (May 20th) the company released a PR that outlines company’s intentions to significantly increase its investment in South Korea which will mostly be financed by the buyer. The announcement reads like a purely promotional move to appease regulators. Apparently, the company intends to invest nearly $2bn in its Korean R&D centers, manufacturing, workforce etc. and even mentioned that the consideration for the takeover will be paid by offshore (non-Chinese) funds. A few quotes:
We will support everything we can, to assist Magnachip in strengthening manufacturing and R&D capabilities in Korea, pursuant to this announcement on future growth goals and the investment plan. We expect to retain the existing management and we guarantee that employees, factory and IPs will stay in Korea, and the Company will continue to acquire the best talents and reinforce manufacturing and R&D capabilities in Korea, while also contributing to Korean regional economic development and vitalization.
As mentioned in Magnachip’s proxy statement filed with the U.S. Securities and Exchange Commission, Wise Road Capital expects the share transaction involving the U.S. parent company, Magnachip Semiconductor Corporation, to be funded by offshore funds outside of China.
We consider this announcement to be a positive factor to the labor union’s continued demand and priority for employment stability, improvement in treatment, retention of manufacturing facilities and increased investment, and vitalization of Gumi regional economy.
After completing investment processes, Wise Road Capital has supported its portfolio companies in expanding manufacturing facilities and increasing investments in R&D. Particularly, Wise Road Capital has, as a matter of principle, played the role of a pure financial investor and supported its portfolio companies to become global companies, by enabling their pre-existing headquarters, manufacturing facilities, R&D centers and other facilities to continue to operate, retaining the existing management team and employees, and avoiding intervening with ordinary business operations.
Reportedly, some analysts think the deal is unlikely to get blocked as MX’s OLED technology is not considered to be an advanced high-tech. This was apparently, confirmed by LG, which previously reviewed a possibility of acquiring MX: “LG Group considered that it did not possess advanced technology even after reviewing the acquisition of Magnachip”.
Peer comparison is quite tricky here as MX doesn’t have any direct competitors. The company is not entirely fabless (without foundry), which impacts its margins – the latest gross margins were 28% and adj. operating margins – 8%, whereas most fabless semiconductor companies operate at around 50% gross margins and close to 20% operating margins. Nonetheless, now that the company has sold its capital-intensive foundry services business, management expects to significantly increase operational efficiency in the upcoming years. The most recent investor presentation includes a 2020-2023 Plan to reach double digit revenue CAGR, above 30% gross margins and reduce operating expenses by 40%. In comparison, the company also expects OLED market to grow 12.7% from 2020 to 2023 and power semiconductor market by 4.3%.
A somewhat similar peer could be OSIS – it produces semiconductor products for security systems and healthcare monitoring and has its own manufacturing facility (not fabless). OSIS has $1.7bn market cap, $2bn EV and operates with 37% gross and 12% adj. operating margins. OSIS currently trades at 13.5x TTM adjusted EBITDA vs 15.5x offer price for MX.
In the deal breaks, downside seems to be well protected. MX currently trades at 11.5x adj. TTM EBITDA (including break fee cash). However, the company is still in the process of transition into a pure-play standard products business. Assuming the company manages to reach 10% adj. operating margins (shouldn’t be difficult given that Q4 was at 11% and Q1’21 at 8%) and keeping revenues at current levels, MX trades 9.7x forward EBITDA.
The company had multiple potential suitors:
- Party A – strategic, likely a company from the U.S. as negotiations mostly turned around the break fee from U.S. regulatory condition. The latest price offered was $26.50/share. Negotiations have lasted for over 1 year, so it seems that the buyer was really interested in MX.
- Party B – offered $21.50/share and later turned to bid for the power supply business only.
- Party C – offered $24.04/share.
- Party D – stated that it won’t have any problems with Chinese regulatory approvals and even agreed to an 8% termination fee. The latest price offered was $23.50/share.
- Party F – offered a range of $25-$29/share.
- Party G – a strategic buyer, joined the process a week before MX signed the merger agreement, had no time to put in the bid.
Wise Road Capital
Wise Road is a Chinese PE firm focused on investments in semiconductors and other high-tech industries. The company has recently made two similar acquisitions: