AMD is in pursuit of Xilinx in a deal with a rumored value of $30 billion.
The rich valuation of Xilinx approaching 10x sales makes the deal difficult to become accretive.
AMD currently has faster growth than Xilinx, making the premium valuation difficult to swallow.
The numbers aren’t supportive for a deal, but investors should prepare to listen to AMD CEO Lisa Su before dumping the stock on an announced deal.
The news of Advanced Micro Devices (AMD) looking to buy Xilinx (XLNX) has its stock down 4% to end the week. At a list price of $30 billion, Xilinx wouldn’t be easy for AMD to swallow considering the likely need to utilize debt. My investment thesis remains bullish on the stock due to CEO Lisa Su, but the devil will be in the details of any agreed upon merger.
Xilinx Isn’t Cheap
The biggest issues with a deal for Xilinx is that the semiconductor stock isn’t even cheap, nor have results been very spectacular. AMD would need to either take on substantial debt or get Xilinx shareholders to accept AMD as currency in the deal.
Xilinx produces chips used in data centers and 5G communications base stations. The FPGA [field programmable gate array] circuits offer the customer the ability to optimize the workload.
The stock tumbled during 2019 after trade tensions with China limited shipments from Chinese tech giant Huawei. The Chinese firm accounted for up to 8% of Xilinx’s revenue in 2019, leading to the company reporting a revenue decline for the year.
In fact, the interactive revenue chart from WSJ shows Xilinx hasn’t had a ton of revenue growth in the last decade. The company generated revenues of $2.4 billion all the way back in 2011 and only recently topped $3.0 billion before running into issues with Chinese customers.
AMD is the company growing at 30% rates now, not Xilinx. AMD possibly sees the potential to join forces with Xilinx to increase market share in 5G base stations or capture more data center sales. Potentially, customers are driving this move with requests for new chips combining technologies of the two companies. Unfortunately though, analysts are adamant that the Intel (INTC) acquisition of Altera was a failure due to limited synergies.
Xilinx really isn’t expensive in comparison with AMD trading at a higher forward P/S multiple. The deal wouldn’t necessarily be dilutive depending on the cash/stock portions.
For FY20 ending March, Xilinx had operating margins of 27.5% based on gross margins of 67.7%. The company has far higher margins than AMD, which only recently started generating consistent profits.
Xilinx has about $370 million in annual SG&A expenses that could partially be cut in cost synergies from a deal. The business units don’t overlap, so the combined company can’t cut a lot of operating expenses.
Long-Term Dilutive Potential
A debt-fueled deal isn’t likely very accretive unless AMD pays close to a $30 billion valuation. The combined company could end up with $20+ billion in net debt on a cash/stock deal tilted heavily towards debt.
Xilinx has about 244 million shares outstanding and based on $3.50 EPS targets for FY22, the company is on pace to generate $854 million of net income. Even with low interest rates, the deal hardly provides much in the way of additional income due to the valuation tag. A $30-billion debt deal at 3% interest rates would add $900 million in interest expenses. The new entity would need some solid synergies in order to generate accretive earnings as the cost exceeds $30 billion.
A stock deal could dilute future profits as AMD was on pace for a $4.50 EPS target in a few years. At a $4.50 EPS, AMD generates $5.4 billion in profits in a few years. Xilinx is only at $0.85 billion in 18 months. The Xilinx business has to generate $1.6 billion in annual profits to not dilute future EPS potential of AMD considering somewhere up to 360 million shares issued for the $30-billion deal. At a $35 billion valuation, the deal issues 422 million shares at the current price of $83 and would require $1.9 billion in annual income.
So clearly, a debt deal places AMD back into a stressed balance sheet the company has dug out of over the last 5 years. In addition, the high interest costs reduce the accretive nature of the deal. While a stock deal is potentially dilutive to the long-term earnings potential of the current AMD, where the chip company takes 30% of the current CPU/GPU markets.
The risk here is that AMD justifies a deal based on current analyst EPS targets barely topping $2 in 2022. In such a case, buying Xilinx could appear accretive in the short term.
When a stock trades at nearly 10x sales, the accretive potential of any deal becomes very stretched. Especially considering analysts aren’t forecasting much more than 10% revenue growth for the acquisition target.
The key investor takeaway is that an investment in AMD is based on the strong management team. One has to trust CEO Lisa Su to make a deal that rewards shareholders considering the massive addressable markets and low market shares of both chip companies. Regardless, the devil is in the details on growth prospects for this deal to really reward shareholders once the deal value tops $30 billion and approaches $35 billion. A good business combination from a technology viewpoint might not work from a financial point of view.
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Originally published on Seeking Alpha