Advanced Micro Devices Inc. is in advanced talks to buy rival chip maker Xilinx Inc., according to people familiar with the matter, in a deal that could be valued at more than $30 billion and mark the latest big tie-up in the rapidly consolidating semiconductor industry.
Source: Wall Street Journal
The Wall Street Journal has a very high accuracy on such reporting, and while the deal could fall apart, we have no doubt that one is being talked about today. The markets have rapidly moved to adjust as well.
We look at the deal from three angles and suggest investors use this opportunity to hedge.
Who Would Be Better Off?
Assuming the acquisition goes through both stocks would benefit. XLNX’s Aerospace and Defense presence alongside its foothold in telecommunications would expand AMD’s reach.
AMD on the other hand has stuck a sweet spot where it’s finally delivering the revenue growth it promised for more than five years. The revenue chart actually looks like a “Cup and Handle” breakout.
While XLNX has the ability to diversify AMD’s revenue base, it has hit a rough spot and recent quarters showed revenue declines. This though is predominantly a pandemic impact and XLNX should be able to get back to a 7-10% revenue growth rate very quickly.
Our verdict here is that the companies would likely be much stronger together with synergies in the data center division.
Price Of The Deal
The big issue for investors is that both stocks are trading at extremely expensive multiples. AMD is trading at over 13X revenues while XLNX is bordering on 10X.
These are not points from which investors have made money in general multiple years out. XLNX makes a great example of that. It traded over 10X revenues on three occasions in the past.
What were the returns?
If you bought at about 10X revenues you broke even after 16, 14 and 11 years, respectively.
Paying those revenue multiples can seem fun in the short term, and 1999 stands out as a stellar example of the “madness of crowds,” but longer term returns will be abysmal. Even if you ignore revenue multiples (which you should never do) both stocks are trading at over 45X earnings. Multiples that again suggest caution for a longer term outlook.
Nvidia’s (NVDA) foray into the M&A world by agreeing to acquire privately-held ARM Holdings from Softbank (OTCPK:SFTBY) is likely to get a very long and thorough review from antitrust authorities in many countries. XLNX and AMD will likely have almost none of these issues due to both their individual sizes and lack of domination of their sectors. ARM Holdings’ patents also are likely to be a very interesting issue for regulatory authorities to resolve and again AMD and XLNX will bypass that threat.
Terms Of The Deal
Before we get how to play the stocks, we want to bring one thing to your attention. AMD recently (less than one month back) got a big boost to its credit rating.
Shares of Advanced Micro Devices Inc rose 1.3% in premarket trading Friday, after its credit rating got a 3-notch boost at Moody’s Investors Service, to lift the rating out of “junk” territory. Moody’s raised AMD’s senior unsecured rating to Baa3, which is the credit rating agency’s lowest investment-grade rating, from Ba3. The outlook was revised to stable from positive. Moody’s said the new credit profile reflects the chip maker’s strong performance and outlook, driven by continued design wins, market share gains and an expanded set of product offerings and customers. In addition, Moody’s said the investment grade rating reflects the release of security on AMD’s previously secured $500 million credit facility. “With recent new product launches, we expect strong revenue growth in 2020 driven by new desktop, mobile, server, and graphics chips, and the launch of semi-custom revenue related to game consoles in the second half of 2020,” Moody’s said.
At last check S&P still had AMD at a “junk” rating but was scheduled to review for an upgrade soon. With these developments in play, expect very little in the way of cash from AMD. This will be an all-stock or a predominantly “all-stock” deal. What this means is that beyond a point, the more AMD tries to pay for XLNX, the lower its own stock will go, offsetting benefits for XLNX shareholders.
How To Play If You Are Long AMD
We are leaving our personal bearish thoughts aside, but the best thing for AMD shareholders would be to hedge this outcome by selling near-term $100 calls. These calls would buffer downside in case AMD gets incredibly enthusiastic in how much it agrees to pay.
Source: Interactive Brokers
In the case of XLNX, we would go closer to the money and consider selling the $125 calls. If the acquisition does not go through, you could offset half the share price gains you see today via the call option.
Source: Interactive Brokers
We could see AMD bid as high as $145 for XLNX, but when paid in AMD shares (which have dropped and will drop more), the value would be substantially lesser. The key risk in this action is if another white knight emerges and tries to get XLNX. Investors worried about this outcome could sell further out of the money call options.
AMD and XLNX’s marriage will likely benefit both companies and allow them to compete better against rivals like Intel (INTC). That said, the revenue multiples today are only justified though if you believe that this time is really, really different. Extremely high implied volatility should be used to the investors’ advantage. As we have recently shown, this is the single best method to keep returns the same while decreasing risk.
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Disclosure: I am/we are short NVDA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Originally published on Seeking Alpha