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Morningstar | Infineon's Bid for Cypress Puts Automotive Business Into Overdrive; Maintain EUR 22 FVE

We're generally in favor of Infineon Technologies' plan to acquire Cypress Semiconductor for $23.85 per share, representing an enterprise value of EUR 9 billion ($10.1 billion). We will maintain our fair value estimates of EUR 22 and $25 per U.S. ADR for narrow-moat Infineon. The shares appeared cheap to us before the surprise announcement, as we think Infineon will weather the near-term industry slowdown, but with the 8% sell-off on June 3 after the news, we think they are even more attractively priced now.

The 46% premium that Infineon is paying for Cypress (based on its weighted average stock price before Cypress put itself up for sale) is a bit on the high side among recent semiconductor deals but isn't an outlandish overpayment. Infineon's plan to leverage up and issue equity to fund the deal is a bit surprising in light of sluggish near-term business conditions, although we like that the company is opportunistically investing during an industry downturn. More important, we think the strategic rationale makes sense as it expands Infineon's automotive exposure into infotainment systems, connectivity, and NOR flash parts used in autos and perhaps opens up cross-selling opportunities into the Japanese auto market, where Cypress has fared well thanks to its ownership of Fujitsu's microcontroller business. Given the long product lifecycles in automotive and Cypress' recent traction in the auto market, it's possible that Infineon is buying into some of Cypress' design wins before these sales drive future top-line growth. We also suspect that the firm's anticipated operating expense synergies might be conservative.

We don't foresee another bidder for Cypress at this point. On the downside, we have some trepidation that recent geopolitical concerns and trade wars might make it harder for a German company like Infineon to acquire a U.S.-based chipmaker.

From a product standpoint, Cypress will expand Infineon's automotive business into the infotainment system, an area where most other automotive chipmakers have exposure but where Infineon was lacking. Cypress' connectivity and NOR flash design wins into automotive may open up cross-selling opportunities for Infineon in these systems. Geographically, even though Infineon has fared relatively well as a foreign chipmaker selling into the Japanese automotive supply chain, Cypress' relationships within Japan may aid Infineon longer term; vice versa, Infineon's strength in Europe might be used to leverage some of Cypress' key products in the region.

Infineon expects EUR 1.0 billion of revenue synergies from the deal by 2025 and EUR 1.5 billion ($1.7 billion) by 2028, a striking assumption as compared to Cypress' total revenue of $2.5 billion earned in 2018. That said, we think Cypress has a nice growth runway in automotive and Internet of Things products in the years ahead, and the Cypress pipeline might already be robust. In IoT, Infineon's microcontrollers aren't necessarily geared toward these types of gadgets, but Cypress thinks it can expand its IoT business at a 12%-14% revenue rate, ahead of Infineon's prior target of 9% corporate revenue growth.

We also like the potential for Infineon to extract greater-than-expected cost synergies from the Cypress acquisition. The firm is modeling EUR 180 million (about $200 million) in calendar 2022, with maybe two thirds coming from operating expenses (rather than cost of goods sold). This operating expense synergy target strikes us as a bit low, in light of the $719 million we were forecasting for Cypress' total operating expenses in calendar 2019. We suspect that Infineon might be able to find more synergies upon completion of the deal, accelerating future operating leverage even further. Ultimately, the potential revenue and operating expense synergies in the deal more than make up for the relatively higher premium that Infineon will pay for Cypress, thus netting out and leading us to maintain our EUR 22 fair value estimate.

With the merger, Infineon is raising its long-term revenue growth target to "9%-plus" from 9% and its adjusted operating margin target to 19% from 17%, while reducing its investment/sales ratio to 13% from 15%. In terms of funding the deal, Infineon may fund up to 30% of the deal with equity, while debt financing has been secured but terms have not been disclosed. Infineon intends to maintain its investment-grade rating, current dividend payout plans, and goal of maintaining EUR 1 billion of cash on hand at any point in time. The company abandoned its prior target of leverage of less than 2 times EBITDA but thinks it can get back to these levels by the end of 2022, assuming the deal closes as planned in late 2019 or early 2020.

The market reaction to the merger has been negative, with Infineon's European shares down 8% on the day of the announcement. In addition to the deal price and leverage, we wonder whether investors are concerned about Infineon's re-entry into the memory chipmaking market. Cypress abandoned its NAND flash business, spinning it off into a joint venture with SK Hynix, but retains its NOR flash and SRAM businesses. We think these businesses are higher-quality, cash-generating segments that are relatively safe for Infineon to own. However, Infineon was weighed down for years by ownership of its memory chipmaking business, Qimonda, which ultimately went bankrupt, perhaps unnerving any long-time investors. We also wonder whether there are current management concerns; Infineon CFO Sven Schneider has been in his role only since May 1, and some investors may be worried about such a large merger and integration for a new hire.