Potential Annualized Return of 9.32% Through Marvell's Acquisition of Inphi

Marvell Technology Group Ltd. (MRVL, Financial) has agreed to acquire Inphi Corp. (IPHI, Financial) through a combination of equity and cash.

According to the terms of the agreement, Inphi shareholders will receive 2.323 shares of Marvell Technologies as well as $66 in cash per each share held.

Marvell develops integrated circuits and offers a portfolio of ethernet solutions. The company's technologies are key to a future of data centers as well as 5G. In comparison, Inphi designs semiconductor solutions for the communications and cloud markets. Its semiconductor's strengths are in reducing system power consumption and in data centers. Both companies are headquartered in Santa Clara, California.

The rationale behind the deal is that the companies together have a highly comprehensive offer to large data centers. In addition, there are also some modest deal synergies. But the key point is that both sales forces can cross-sell each other's products. That way, both companies' growth can accelerate beyond what they would be able to achieve going at it alone.

I was initially confused by the wording the company used in its press release and filings with the Securities and Exchange Commission - more on that later. Once I felt I had a sufficient understanding of the deal, I modeled the expected return through an algorithm that factors in lots of small things that I expect to influence the deal outcome. I often manually adjust inputs when I know the company will struggle or miss something. Below are the results:

Table: Estimates used by author.

I've assumed 266 days until close. This is what my algorithm estimates based on the locations of the companies, industries in which they operate, type of deal, financing, how the deal is structured, size of the companies involved and many other factors. I've adjusted it downward because I think my algorithm doesn't fully account for the risk that this is going to take a long time. The Chinese regulator can be notoriously difficult regarding semiconductor deals. Which is why I'm not comfortable putting in 200 days or less.

The estimated closing probability is set at 89%. I've adjusted it downward a little bit because a conservative estimate seems best for a deal like this. The number is based on the average rate that merger and acquisition deals successfully close, but adjusted for many properties that are specific to this deal like the size of the companies, the regulatory process, the industries they operate in, the way the deal is structured, whether it is a cross border deal, whether shareholders are on board and whether there is a break fee and the size of the break fee.

This is a pretty complex deal to figure out. Because of the awkward wording in the press release and in the 8-K, I was initially on the wrong track. Here is an excerpt from the announcement:

"Under the terms of the definitive agreement, the transaction consideration will consist of $66 in cash and 2.323 shares of stock of the combined company for each Inphi share. Upon closing of the transaction, Marvell shareholders will own approximately 83% of the combined company and Inphi stockholders will own approximately 17% of the combined company."

The conference presentation used the same wording:

However, in the actual conference call, management stated the following:

"Now, moving to slide 17. As you'll read in the press release, Marvell will acquire all outstanding Inphi shares for $66 per share in cash and a fixed exchange ratio of 2.323 Marvell shares for every Inphi share. On closing, Marvell shareholders will own approximately 83% of the combined company and the Inphi shareholders will own approximately 17% of the combined company on a fully diluted share base."

Clearly, the latter deal is less interesting, but then again a 9.32% annualized expected return isn't bad. The gross spread is a 9.15% return until the close. That's simply the difference between the bid and the market price without any of my adjustments.

I get to 9.32% annualized by running my M&A algorithm, putting the outputs in a simple model and adjusting numbers where I think the algorithm is likely to be off because it doesn't yet account for all the strange properties of M&A deals. Since the deal is part equity, anyone who buys Inphi should hedge out Marvell to "lock" in that return. The formula is to short 2.323 Marvell shares per Inphi shares. When the deal closes, you have $66 and your short position is cancelled out. The positive about an equity M&A deal is that it is less vulnerable to market gyrations. If the market is volatile, it affects both legs in the opposite direction.

The way I like to compare mergers and acquisitions is on expected annualized return. I don't just take the spread, or the difference between the bid and the market price, and turn that into an annualized figure. I also take into account the odds of deal failure and the break price to factor in the results when the deal doesn't successfully close.

I think the spread is going to narrow from here, but not a lot in the short term. People have pretty much figured out the deal.

The deal has some negatives to it, but management put on a really good conference call. A 9% annualized is also really good, especially in a deal that you can hedge in part.

I think analysts will be writing positive things on the acquisition. I also suspect that if they model the deal out it will look really good for both parties, but especially Inphi. Marvell could recover a little bit as well and that would help both parties.

Disclosure: Author is long Inphi and short Marvell.

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