Description

Introduction

RF Micro Devices (“RFMD”) is a special situations investment that entails a transformative acquisition with Triquint (“TQNT”) that that could drive a paradigm shift in its industry resulting in a 50-90% upside in the stock.

My target price for RFMD is $12 - $15 for the following key reasons:

1)      Industry consolidation to 3 players will lead to capacity reductions, improved pricing, higher margins and multiples.

2)      Management’s synergy estimates of $150M are extremely conservative and will ultimately reach $250M or more.

3)      Growing industry led by various large demand drivers should enable 10%+ revenue growth.

4)      Perceived technology risk from QCOM and other CMOS-based suppliers is a red herring.

5)      Combined company will generate nearly $1.00/sh in pro forma cash earnings or 20-30% earnings accretion.

6)      The investment has good risk/reward as upside in the stock is 50-90% to $12-15 while downside is 15% to $7.00. Newco’s cash, downside earnings and non-core assets provide a margin of safety with a number of catalysts to unlock value.

Thesis

The radio frequency components industry (“RF Market”) is characterized as one with little differentiation, relentless pricing pressure, and low gross margins.  The stocks in the sector have become  trading vehicles for Apple and Samsung new phone launches – investors bought them a few months prior to a product launch if they gained a new design win and sold them six months after the handset launch.   These were stocks you rented, but never owned.

As we have seen in other low margin, technology component markets, when an industry consolidates down to 3 large players, a more rational approach to market share, capacity and pricing has followed.  This had led to improved profitability and revenue sustainability for the surviving suppliers enabling investor’s to eventually increase earnings multiples that they ascribe on these businesses rather than valuing them as they were in terminal decline.   A strategy of capacity reductions to improve the industry’s margin structure as part of a consolidation transaction first happened in the hard disk drive (“HDD”) market in 2011 (e.g. Seagate/Samsung HDD and Western Digital/Hitachi HDD transaction where multiples went from 3x to 6x EV/EBITDA) and then more recently in the Memory sector in 2013 (e.g. Micron/Elpida transaction where the multiple went from 1.0x Price/Tangible Book to 10.0x P/E).  Historically, both RFMD and TQNT have been valued at 1.0-1.5x EV/Revenue as margins and profits were never sustainable and even harder to project.

I believe a similar paradigm shift will materialize in the RF Market as Skyworks (“SWKS”), Avago (“AVGO”) and RFMD/TQNT (“NewCo”) will be the remaining major players.  NewCo management is expected to lead a drive to removing excess front-end manufacturing capacity, insource products and services where they have additional capacity, and cut overlapping R&D and SG&A without sacrificing its competitive position and technology advantage.  This cost cutting plan should enable the combined entity to raise its margin structure closer to that of the other players in the market (SWKS and AVGO).  NewCo will also be well positioned in various mobile, aerospace, defense, networking and home appliance markets to capture the next wave of growth in these end markets.

Though both RFMD and TQNT equity will be exchanged into NewCo stock upon the deal closing, I believe a long position in RFMD’s stock provides a better relative value opportunity as TQNT trades above the merger ratio on expectations of a potential over-the-top bid even though the deal was announced over a month ago.  I don’t believe a topping bid will materialize as there are only a limited number of buyers of these assets while anti-trust, valuation and business model issues make TQNT unattractive to potential US buyers. Foreign investment approval requirements for TQNT’s defense electronics segment make it less likely that a foreign buyer will emerge.  Further, the industrial logic, synergies, and that only the merger of these two entities would pass anti-trust approval in a 3 player market make it a very high likelihood of this merger transaction closing.  This investment also includes a free option on a potential second step value unlocking event to drive additional future value where NewCo would spin-off or sell a smaller, non-core business that its under the radar of the investment community.

I am assuming NewCo can realize $250M of synergies on combined Street revenues estimates of $2.325B (which I believe is conservative) for CY15 to achieve $750M of EBITDA and almost $1.00 of pro forma cash earnings.  Newco is currently trading at 6x EBITDA and 8x P/E multiple which is a 30-40% discount to SWKS’ multiples.  As NewCo transforms it margin structure and profit potential, I believe it would be appropriate to apply a 9x-10x EBITDA and 12x-15x P/E multiple to this level of earnings which would be in line with those of its competitors.  My target price does not even factor in the net cash, free cash flow generation and leverage potential of NewCo to enhance equity value.   As a result, my target price for RFMD is $12-15 or 50-90% from the current price.

My downside case assumes that the entity only realizes $150M in synergies on $2.150B of revenues (assuming 7.5% of negative revenue synergies) translating into $.65/sh in CY15 earnings or $565M in EBITDA.  Applying a 12x P/E multiple to this depressed earnings levels, leads me to believe the downside here is $7.00 in the stock or less than 15%.  Newco’s cash and value of its non-core assets are alone worth $3.00/sh.

Background on the Transaction

On February 24, 2014, RFMD and TQNT announced a merger of equals transaction that would combine the 2^nd and 4^th largest players in the RF Market.  The merger transaction is structured as a tax-free reorganization, where RFMD shareholders will receive 1 share of NewCo and TQNT shareholders will receive 1.675 shares of NewCo.  As a result, each group of shareholders, will own 50% of NewCo.  At the closing of the transaction, NewCo will execute a 1-for-4 reverse stock split that will result in up to 145M fully diluted shares outstanding.   To make the pre and post earnings per share calculations easier, I believe it’s best to use RFMD’s fully diluted shares plus 1.675 x TQNT’s fully diluted shares outstanding to understand the earnings accretion relative to RFMD’s and TQNT’s stand-alone earnings power.

The new management team will consist of TQNT’s CEO becoming Non-Executive Chairman, RFMD’s CEO becoming the NewCo’s CEO, TQNT’ CFO becoming the NewCo’s CFO, and RFMD’s CFO becoming NewCo’s VP of Administration responsible for integration and synergy value creation. The transaction is expected to close in the 2H-14, most likely at the end of Q3-14 or early Q4-14 once regulatory and shareholder approvals are received.

Products and Technology

RFMD and TQNT both supply high-performance front-end radio frequency (“RF”) and analog semiconductor components to mobile handset vendors that enable communications across various spectrums (eg. 2G, 3G, LTE), connectivity protocols (e.g Wifi, Bluetooth) and support advanced functionality, power management and improved performance on smartphones.  Their core products includes power amplifiers (“PAs”) and  multi-mode power amplifiers (“MMPAs”)that boost RF signals, switches that direct the path of those signals, and filters that block unwanted noise.  Related products include antennae switch modules and tuners that improve battery performance.  The most advanced products include envelope tracking, carrier aggregation, and transmit MIMO to enable multi-tasking across various bands. 

The RF vendors have historically used Gallium Arsenide (“GaAs”) technology to manufacture their products though recently they have been threatened by silicon-based technology known as CMOS that is used to construct integrated circuits.   Silicon-based handset component vendors like Qualcomm (“QCOM”) have periodically talked about CMOS displacing GaAs-based RF components. This worry became an overhang on the RF stocks in early 2013.   Though GaAs based crystals and resulting wafers are more expensive to produce, GaAs’ electronic properties are vastly superior to those of silicon. GaAs wafers function at higher frequencies, higher temperatures, transmit less noise, and require smaller die sizes compared to silicon wafers.  Overall, GaAs-based PAs deliver high level of efficiency which is the key to long battery life in small form factors. Silicon-based CMOS PAs which are now standard in 2G feature phones sacrifice performance and battery life but enable better component integration helping handset vendors to reduce the total bill of materials.  Recently, these two technologies have come together in the development of MMPAs that include high-performance GaAs based PAs with a CMOS controller and silicon switches.   MMPAs have been well received in 3G and 4G/LTE phones enabling OEMs to lower the total number components and costs. 

However, the rapidly increasing number of frequency bands deployed on these global smartphones to manage the interference between congested RF spectrum alongside various wireless protocols requires the use of one GaAs-based filter per band.  The GaAs-based filter market is a subset and one of fastest growing parts of the RF Market.  TQNT and AVGO are the primary two vendors that develop discrete premium filters using various electromechanical technologies. TQNT’s has developed technologies known as SAW, TC-SAW and BAW while AVGO uses technology known as FBAR.

The development of integrated PA modules using both GaAs and CMOS based technology is a recent product design development that should ensure the longer-term survival of the traditional RF vendors.  The threat of CMOS technology completely displacing high-performance GaAs is a red herring that investors need to understand but look past.

Market Size and Growth Drivers

Both RFMD and TQNT sell discrete components and integrated systems to the various parts of the smartphone and feature phone market.  To understand the current and potential size of this market, one needs to understand the annual volume and pricing dynamics.

(1)     Based on TQNT, RFMD and SWKS investor presentations.

(2)     IDC Mobile Handset Market

The RF Market for mobile handsets was a $6B+ market in 2013.  This calculation is derived from the fact that over 1 billion mobile 3G + 4G/LTE smartphones were sold in 2013 with the average RF dollar content per device of approximately $6.00. The average number of PAs in a handset expanded 5.6 in 2013 from 4.9 in 2012 and is expected to continue to increase.  The 4G/LTE smartphone market is growing the fastest and should help to drive the market size for the RF Market to grow at 10-15% for the next several years.   For high-end handsets, each band on average requires a separate filter.  For example, the recent iPhone 5S device supports up to 13 different bands which has enabled its primary filter vendor, TQNT, to capture up to $6.50 of dollar content on these devices.    The filter market alone is expected to grow to a $2B opportunity in the next few years as more high-end 4G/LTE phones proliferate which is expected to drive the overall growth of the RF Market to $7.5B over the next 2 years.

The top four vendors (SWKS, RFMD, AVGO and TQNT) are capturing approximately 65-75% of the growth in this market and are expected to increase their market share as only these four vendors have the necessary IP, engineering resources and products to serve the complexities and performance requirements of the large handset OEM vendors.    Historically, pricing and costs have declined by 10-15% per year in the industry though I believe an improved supply environment as a result of this merger and subsequent supply capacity removal has the potential to alleviate some of the historical pricing pressure.  The limited size of the RF Market driven by niche GaAs technology is expected to make large integrated semiconductor players like Intel and Samsung reluctant to enter into this market in the future.       

Both RFMD and TQNT also have separate business segments (representing 20-30% of total revenues) where they apply their engineering expertise and products to the defense, aerospace, and networking communications markets.  The TAM for these applications is also a multi-billion dollar opportunity but it is much more fragmented both from a supplier and customer perspective.  RFMD groups this segment as multi-market products group (“MPG”) while TQNT has a separate Networks and Defense segments (N&D).  The RF products into these end markets are highly sophisticated and are used in optical transport networks, cellular base stations, small-scale networks, home and metro WiFi, CableTV, and military airborne radar.  These products are difficult to design and manufacturer, with RFMD and TQNT often the sole sourced vendor for these long products cycle products.  Customers are often willing to pay a premium for these high performance and reliability components which in turn carry higher than average corporate gross margins of 50% or more. 

Further, these non-mobile businesses have very good growth characteristics as more and more consumer devices and appliances such as TVs, watches, home appliances, security systems, thermostats, and automobiles become connected to the Internet. This huge emerging growth theme is known as the Internet of Things (“IoT”).  All of these connected devices require embedded RF components to wirelessly connect to the Internet while preserving battery life and minimizing footprint.  Though the market for these types of devices is currently nascent, it is expected to eventually include billions of connected devices each requiring multiple RF components.   The leading RF players have already started winning references designs and even begun to ship their components on first generation IoT products like smart thermostats and wearable devices where unit volumes are ramping off a low base.  Industry analysts’ expect the RF Market from the IoT related opportunity could grow to be as large as the mobile handset market over the next five to ten years.

RFMD Stand-alone model

RFMD is generating 80% of its revenues from its Cellular Products Group (“CPG”) with revenues expected to grow nearly 20% year-over-year for its fiscal year ending March 31, 2014 (FY14).  The MPG segment accounts for the remaining 20% of revenues.   Samsung (22% or rev) and Apple (8% of rev) are its largest customers in CY13.  RFMD is also a leading supplier of both CMOS and GaAs products into the China whitebox handset market selling to several OEM vendors. This China market represents approximately 20% of revenues.  Over the next two calendar years, the Street is only expecting 5-6% annualized growth on expectations of slowing unit volumes sales from high-end smartphone launches from Samsung and Apple.  RFMD management believes they can grow revenues by 10%+ over this period as a result of the mix shift to 4G/LTE devices and growth in the MPG segment.

 RFMD has done a good job recently of improving its gross margins from 35% last year to a 40% run-rate through reducing excess fab capacity while developing a flexible sourcing strategy and lowering its back-end test and packaging costs.   The company has recently discussed several process improvement steps it is taking to continue to increase its gross margins which are expected to increase at least another 200-300bps on a stand-alone basis over the next two years.  In terms of mix, I believe the MPG segment is currently operating at nearly 50% gross margins while the CPG segment gross margins are approximately 37.5%.  If management can increase the CPG margins to 40%, its overall margins should improve to approximately 42% given the product mix.

Its cash operating expenses are running at $75M/qtr (R&D at $48M and SG&A is at $27M) or 25% of LTM revenues.  For the first 9mo of the fiscal year, the company has averaged $300M/qtr of revenues which are expected to grow to $325M/qtr over the next year which at a 42% gross margin (with D&A averaging 3% of revenues), implies that RFMD’s stand-alone EBIT margin will be 19% and EBITDA margin will be 22%.  The Company has a 10% cash tax rate as a result of its $140M in Federal Net Operating Losses (“NOLs”).  Using the Street revenues expectations for CY15 of $1.3B, implies that RFMD’s stand-alone model would translate into a 17% cash earnings margin or normalized earnings power of approximately $.78/sh assuming 285M fully diluted shares.

RFMD has $205M in cash and $88M in short-term debt.  Its cash generation prior to the deal closing should enable its net cash position to reach nearly $150M. 

TQNT stand-alone model

TQNT generated 67% of its revenues from its Handsets Group (which is the equivalent to RFMD’s CPG group) for its fiscal year ended December 31, 2013 (FY13). The N&D segments generated 33% of revenues.   Foxconn, Apple’s contract manufacturer, accounted for nearly 33% of revenues while Samsung represented 7% of revenues in FY13.  Total revenues grew by 7% in FY13 with the handset segment growing by 10%.

Gross margins in 2013 were at 33% for the entire year, but the company has been able to raise them to an average of 37.5% over the last 2 quarters as a result of reducing manufacturing capacity in its Oregon plant recently.  TQNT management has recently discussed plans to improve gross margins to 40% in 2014 as a result of improved product mix, revenue growth and cost reductions.

Its cash operating expenses averaged $70M/qtr (R&D of $46M and SG&A of $24M) or 31% of revenues.  Revenues in 2013 averaged $225M/qtr and are expected to grow to $255M/qtr over the next year.  Assuming TQNT can get is gross margins to 40%, then its normalized EBIT margin would be 13% and EBITDA margin would be 23%.  The Company has a 5% cash tax rate as it has $112M of Federal NOLs.  Using Street revenue estimates of $1.025B in CY15 (implies 7% annual growth), I expect that TQNT’s stand-alone model would translate into a 12% cash earnings margin or normalized earnings of approximately $.72/sh on 174M of fully diluted shares.

TQNT ended the year with $79M of cash and no debt with management guiding cash growing to $150M by end of Q1-14.  I expect that TQNT will have at least this amount and maybe more cash upon closing.

NewCo

Though both RFMD and TQNT are competitors, over the last few years they have gravitated to different parts of the RF Market to fit their core strengths which has made their product portfolios fairly complimentary.   For instance, RFMD’s revenue growth (35% in the last twelve months) has come from its systems and integrated switching portfolio that include Antenna Control Solutions (“ACS”).  As for TQNT, most of it growth has come from focusing on selling discrete and integrated premium filters into the growing high-end smartphone market.  NewCo’s combined mobile handset business is expected to generate $1.8B in revenues by CY15 with the potential to grow at low double digit rates.

RFMD and TQNT will also be combining their MPG and N&D segments into a $500M revenue segment that I will refer to as NewCo’s MPG segment.  This segment is expected to generate 50%+ gross margins and close to 30% EBITDA margins but revenue growth is expected to be single digits until the IoT opportunity materializes. 

Combining both companies CY15 stand-alone financial models but assuming no synergies, the 50/50 stock deal implies a $.60/sh cash earnings potential for the combined entity.   Synergies are clearly a big part of the story to get NewCo’s earnings power to nearly $1.00/sh.

Manufacturing and Industry Capacity

Both entities own and operate their own manufacturing fabs and both have had capacity under-utilization problems in the past leading them to generate below industry average gross and operating margins for the last several years.  In contrast, both SWKS and AVGO employ a flexible manufacturing strategy using both its internal capacity and that of WIN Semi, the leading third party GaAs foundry based in Taiwan.  This strategy has enabled them to generate superior margins relative to RFMD and TQNT.  For instance, SWKS’ gross and operating margins were 43% and 26% in 2013, respectively, while AVGO’s gross and operating margins were 51% and 29%. 

RFMD has proactively taken steps to reduce its GaAs capacity by selling its 50k square foot UK GaAs fab and shifting all of its front-end production to its North Carolina facility while reducing its annual operating costs by $20M.  After this capacity reduction event, RFMD qualified Win Semi to to serve as a partner for when surge capacity is needed.

On the other hand, TQNT spent over $200M in capex in 2010 and 2011 to increase its PA capacity in both of its Oregon and Texas fabs while using extra capacity to provide third party GaAs foundry services.  When growth didn’t materialize and utilization levels dipped below 50% in its Oregon facility, TQNT was forced to take write-offs in 2013 and shut down it foundry business.  Though TQNT has discussed moving to a hybrid manufacturing model, management has been worried about the risk of disruption from qualifying a new contract manufacturer as only new design wins can be moved to a third party fab.  This merger creates an elegant solution for NewCo to both reduce GaAs capacity by shutting down TQNT’s Oregon fab completely over the next 18-24mo, moving new premium PA design wins to RFMD’s North Carolina fab while moving the more commodity oriented lower margin product designs to WIN Semi. 

The recent shutdown of RFMD’s UK GaAs fab along with the expected shut down of the TQNT’s Oregon GaAs fab could result in at least 15-25% capacity reduction in the worldwide GaAs monthly wafer supply (“wpm”).  TQNT’s Oregon fab today has approximately 10K wpm of supply.  TQNT, as recently as 2008, had 40% market share of the global GaAs wafer supply market after which point WIN Semi became the market share leader in GaAs supply. Based on data from WIN Semi, its GaAs monthly wafer capacity is 24K wpm as of 2013, representing 60% or approximately 40K wpm of global capacity.  WIN Semi recently announced that it plans to stop capacity expansions in 2014. GaAs demand in 2013 was 25K wpm (implying a worldwide capacity utilization rate of 62%).  Industry analysts’ expect demand to increase to 35M wpm by 2015 and to 40M wpm by 2017.  If NewCo is able to reduce worldwide capacity by 6-10K wpm by 2015 taking total global capacity to 30M-35M, the market would all of a sudden reach a supply/demand balance or even be in a state of shortage enabling a better pricing environment for all remaining GaAs-based suppliers.  The technology market saw this same situation play out in the HDD and Memory markets over the last few years as component prices in fact increased after several years of declines once supply fell below demand. 

Synergies

At the time of the deal’s announcement, the combined management team committed to generating at least $150M in cost synergies with a majority coming from COGS.  They expected $75M to materialize in the first 6-12 months and another $75M materializing in 12-24 months.  As a result of achieving these synergies, they also guided to a target financial model of 45% gross margins and 25% operating margins.

Based on conversations that I have had with management and RF industry experts who have worked in the industry, I estimate that Newco can achieve up to $250M of synergies as follows:

1)      Closure of the TQNT fab in Oregon – since TQNT owns the land and the building for this fab, I believe they will be able to generate $75M-$115M of on-going COGS savings from selling the facility or shutting it down and moving the equipment to TQNT’s Texas fab or RFMD’s North Carolina fab.  Further, NewCo should be able to generate significant cash from the sale or partial sale-leaseback of the land and the entire 260k sq ft building that is listed at cost on its balance sheet of $150M.  Since TQNT did nearly $900M in revenues in 2013, I would assume their average front-end manufacturing costs are 45-50% of revenue or $400M-450M across three of its fabs with the Oregon fab being the oldest.  The company should be able to save 20-30% of their total front-end costs from this fab shut down.  This synergy estimate assumes no improvement in long-term industry pricing dynamics.

2)      TQNT insourcing back-end PA test & packaging from RFMD’s facility - TQNT currently uses a large Taiwanese based test and packaging provider with facilities in Singapore to provide contract back-end services for its discrete and integrated PA modules.  TQNT owns its own back-end filter test & packaging facility that is based in Costa Rica.  Post-closing, one of management’s first priorities is to move the Singapore service provider in-house to RFMD’s back-end facility in Beijing, China that currently has excess packaging capacity.   To optimize its tax structure, I believe TQNT setup a Singapore subsidiary to take delivery of the finished products and sell it out of this subsidiary,  thus enabling it to recognize revenues and income in a 10% corporate income tax jurisdiction.  In 2013, TQNT generated $393M of revenues but had $42M in losses (-11% margin) from operations out of its Singapore subsidiary.  In effect, TQNT’s inefficient, high-cost back-end test and packaging services contract is causing it to sell finished product below cost.  By insourcing the portion of products that are finished in Singapore to the Beijing facility, NewCo should be able to reduce TQNT’s Singapore operations losses by 50-100%.  Hence, I calculate the back-end savings to be approximately $20-40M. 

3)      RFMD insourcing filter supply from TQNT – On RFMD’s last earnings call on 1/28/14 prior to the deal announcement, management spent a significant amount of time discussing how they made a multi-million dollar capital investment to secure access to third party SAW, TC-SAW and BAW filters.  As TQNT is the only qualified vendor that sells these specific types of filters, I believe RFMD spent at least $10-30M just in the March 2014 quarter and maybe more to secure this filter capacity for its integrated PA products.  This seems to be annual rather than a one-time occurrence for RFMD. Over the March and June 2013 quarters, RFMD disclosed that it made $12M of capital investments with a third party to secure SAW and BAW duplexer filter capacity to support its 2013 build plans.  Interestingly, TQNT management on their 2/5/14 earnings call mentioned that their cash in Q1-14 is expected to grow by $80M to $150M. Historically, TQNT has never generated more than $20M of free cash flow in its seasonally weak Q1 quarter.  Many of the integrated high-end RF modules that RFMD is shipping currently include these premium filters that carry approximately 50% gross margins.  Post-merger, RFMD would be able to source these filters from TQNT without having to make a special capital investment to secure capacity at a much lower gross margin rate.  I assume RFMD will be able save at least $10-20M and potentially a lot more from insourcing TQNT’s premium filters out of the Texas fab. 

4)      R&D integration – both companies have a number of R&D centers where they are working on similar product development projects where duplicative efforts could be eliminated including duplicative design centers. For instance, both companies’ have engineering design centers in the Research Triangle Park in North Carolina.  In 2013, TQNT employed 519 engineers and spent $180M in Non-GAAP R&D costs (excluding stock comp) or approximately $350k/employee.   In comparison, RFMD spent $190M in Non-GAAP R&D costs for what I would expect would be a similar size R&D organization.  I believe the NewCo can reduce its R&D costs by 5-10% or $20-35M.

5)      SG&A consolidation – NewCo will easily be able to eliminate a number of public company costs such as (two boards, two accountings firms, two listings, etc.) along with a number of overlapping back-office G&A functions.  Further, since both companies sell to many of the same large handset OEMs, I expect management should be able to consolidate a number of the overlapping sales & marketing functions as well.  In 2013, TQNT employed 408 SG&A related- employees and spent $97M in Non-GAAP SG&A costs or approximately $237k/employee.  In comparison, RFMD spent $107M in Non-GAAP SG&A costs.  I believe NewCo should be able to reduce its combined SG&A costs by 10-20% or $25-40M.

As the table below shows, management’s commitment to a minimum of $150M of costs savings is extremely conservative.   I believe they can easily get to $200M of post-closing synergies once detailed integration plans have been put together but should be able to achieve at least $250M in less than two years of closing with potentially more once all fab consolidations and excess GaAs capacity has been removed as part of an ultimate move to a hybrid manufacturing model.  As outlined in my financial model, I believe that NewCo can approach nearly $750M in EBITDA and $1.00 in cash pro forma earnings by CY15 making the deal extremely accretive to shareholders.

Table of Synergy Estimates

Catalyst