Here's Why ON Semiconductor Just Bought Quantenna

On March 27, ON Semiconductor (NASDAQ: ON) announced that it planned to scoop up a relatively small wireless chipmaker known as Quantenna Communications (NASDAQ: QTNA) for $1.07 billion, or $24.50 per share.

Here I'd like to go over why ON Semiconductor wants to buy Quantenna and how the deal will affect ON Semiconductor once it has closed.

Broadening ON Semiconductor's horizons

ON Semiconductor explained in a presentation going over the details of this deal that Quantenna's Wi-Fi chip expertise and software chops would serve to complement the former's preexisting Bluetooth and power management products. Put simply, ON Semiconductor expects that the addition of Quantenna to its business portfolio will expand the former's served addressable market (SAM) by $4.3 billion by 2022.

And, to boot, ON Semiconductor claims that Quantenna's business has "minimal overlap in end-markets and consumers," so ON Semiconductor isn't really paying for much that it already had in house.

Now, to be fair, while ON Semiconductor talked up the large SAM expansion, keep in mind that Quantenna's revenue in 2018 was just shy of $221 million -- up 25% from the prior year. So while adding Quantenna to the portfolio allows ON Semiconductor to go after a much larger opportunity, it'll still need to work to capture a bigger slice of it.

For some context, ON Semiconductor itself generated $5.88 billion in revenue in 2018, so the addition of Quantenna's revenue isn't going to have a profound impact on ON Semiconductor's overall financial results in the near term.

Let's talk numbers

It's worth noting that although ON Semiconductor's and Quantenna's businesses don't really overlap, the former has signaled to investors that there will be some cost synergies associated with the transaction. In particular, ON Semiconductor says that there will be $26 million of "annual operational synergies run rate within one year of close" and that the source of those synergies will be in both cost of goods sold (COGS) and "general and administrative functions."

Considering that Quantenna's total operating expenses were about $106.6 million in 2018, that $26 million in "operational synergies" is actually quite significant and should dramatically increase the company's operating income, which was just $2.81 million in 2018.

And the good news is that the cost reductions don't appear to be affecting the company's research and development spending -- the fuel that powers the development of future technologies and products.

The deal, ON Semiconductor says, will be "immediately accretive to non-GAAP [generally accepted accounting principles] earnings and free cash flow." What this means is that once the deal has closed and Quantenna's financial results become part of ON Semiconductor's, the latter will see a boost in both non-GAAP earnings per share (EPS) and free cash flow.

Investor takeaway

Ultimately, ON Semiconductor's strategic rationale behind this deal looks sound. ON Semiconductor isn't getting a screaming bargain at the proposed purchase price, which is about 22 times what analysts expect Quantenna's EPS to be in 2020. However, if Quantenna continues to grow rapidly and if the cost synergies that ON Semiconductor expects to achieve actually happen, then the price ON Semiconductor is paying will probably, in hindsight, seem quite fair.

Now, one thing that might be frustrating to some Quantenna shareholders is that the company's shares, during their relatively brief time on the public markets (Quantenna's IPO happened in late 2016), actually traded briefly above the $24.50 purchase price about two years ago. So any shareholders who actually paid more than $24.50 for the stock and held on might not even walk away with a profit.

Nevertheless, with a price of $24.50, most shareholders are probably going to walk away with profits as a result of this acquisition, and those who bought at Quantenna's actual peak will see their losses minimized, so this looks like a pretty good deal all around.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool owns shares of Quantenna Communications. The Motley Fool has a disclosure policy.