The news exploded across the interwebs last night: Qualcomm (NASDAQ: QCOM) is in talks to buy NXP Semiconductors (NASDAQ: NXPI) -- and Wall Street loves the idea.
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As reported this morning in the The Wall Street Journal, investors pushed NXP stock 17% higher yesterday in response to rumors of a deal between the two companies. In an unusual move, the acquiring stock (which must usually overcome a presumption of overpaying in such deals) benefited as well; Qualcomm stock was up more than 6%. Echoing this confidence, analysts at Mizuho Securities raised their rating on Qualcomm stock to "buy" this morning, and increased their price target to $75.
According to the Journal, the reason for all this optimism about both NXP stock, and Qualcomm stock as well, is that it makes a lot of sense for Qualcomm to diversify its business away from the smartphone market, and expand its automotive semiconductor chips business with an acquisition of NXP, which owns significant market share in the space. But does this deal make sense for Qualcomm investors?
Here are three things you need to know.
Investors are taking a close look at a possible Qualcomm-NXP merger. Image source: Getty Images.
1. "The first end-to-end semiconductor auto supplier"
As explained today in a write-up on StreetInsider.com, Mizuho likes the idea of a Qualcomm-NXP merger because it will diversify Qualcomm away from the maturing smartphone market. Already, Qualcomm "dominates automotive telematics," says the analyst. By buying NXP, the company would acquire "in-cockpit market share, powertrain, safety, and an automotive processor portfolio." This, says, Mizuho, would create "the first end-to-end semiconductor auto supplier of the future."
That all sounds pretty good. But what does it mean in dollars and cents?
2. Revenue and profits
According to data from S&P Global Market Intelligence, Qualcomm recorded $22.8 billion in revenue over the past year, and NXP Semiconductors $7.7 billion. A combined company would therefore boast annual revenue of $30.5 billion. The profitability of the two companies' revenues, however, couldn't be more different.
Over the past 12 months, Qualcomm has averaged operating profit margins of 27.4% on its products, yielding $6.25 billion in operating profit. NXP has reaped just 7.4% operating margins, however, resulting in operating profit of only $572 million. Absent significant synergies from a merger, therefore, investors can expect that combining Qualcomm stock with NXP stock will yield a company earning only about $6.8 billion annually in operating profit -- not much different from Qualcomm's profits on its own.
3. The bottom line
Granted, a cursory glance at the companies' income statements gives a slightly different picture. Over the past year, Qualcomm recorded net profits of $5.2 billion, and NXP $922 million. That implies $6.1 billion in net income for the combined company.
What may not be immediately evident from these numbers is that NXP depended on gains from an asset sale for $1.3 billion in profit last year (which is more than the company's total net profit for the year). Those gains will not be repeated in future years. On the other hand, NXP also incurred significant restructuring charges during the period, which partially offset its merger-related gains -- and which will also not be repeated. Taken all together, it's apparent that NXP's level of operating profitability is significantly lower than the company's 11.9% net profit margin would imply.
That's something worth keeping in mind.
The most important thing: Valuation
So what does all of this work out to, in dollars and cents? Combining Qualcomm stock with NXP would create a smartphones-and-automotive semiconductor behemoth, boasting $30.5 billion in annual revenue, operating profits of $6.8 billion, and net profits of something less than $6.1 billion -- probably in the neighborhood of $5.8 billion.
As for what it will cost to own these revenue and profit streams, currently investors are valuing Qualcomm stock at roughly $98 billion, considering the company's market capitalization, minus its cash, and plus its debt. TheJournal reports that a buyout would probably value NXP "in excess of $30 billion," so let's call the enterprise value of the combined company $130 billion.
That all works out to a debt-adjusted valuation of about 4.3 times sales on the putative combined company, versus its current price-to-sales ratio of 4.5, and a debt-adjusted price-to-earnings ratio of perhaps 22.4, versus the company's current P/E ratio of 20.5. It implies that "the first end-to-end semiconductor auto supplier" would actually be cheaper than the current Qualcomm when valued on sales, and only slightly more expensive when valued on earnings -- earnings that could boom as Qualcomm works to gradually bring NXP's profit margins up to par with its own.
So in the end, are investors right to be bidding up Qualcomm stock in response to this week's merger news? And is Mizuho right to recommend buying Qualcomm stock?
Yes. I believe they both are right.
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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 284 out of more than 75,000 rated members.
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