KLAC & LRCX – Fall Out from the deal Falling Apart (1 of 3)

“A quagmire wrapped up inside an enigma” – LRCX & KLAC’s merger is the talk of the town, both in the semiconductor equipment industry as well as DOJ watchers in Washington DC. The opaque process of the DOJ and the surprising complexity of what might have otherwise should have been an easy deal has created a stir and a lot of speculation. The only thing clear about the deal is that it has taken far too long and that the odds of a successful outcome are likely falling by the day.

Although we just started out last October by being just skeptical and assuming the deal would take longer than the company had suggested we have now transitioned through dubious and into doubtful, now viewing the deal as have only a 30 to 40% chance of success at best. As the clock ticks down to October 20th, investors need to prepare.

Words you don’t want to hear in a hospital: “Yours is an interesting case”……..
You also don’t want the DOJ to use your merger as a poster child to set policy or precedent. You just want to be a run of the mill merger with no HSR issues that just sails through. There is much speculation that the deal is different than normal and that it may be related to precedent or policy setting. Being an oddball case in the DOJ is clearly not good…..

Vertical & Horizontal…
Most merger concerns revolve around horizontal problems, product overlap, that hit the HSR 40% tripwire. Less popular forms of concern are vertical, those with overlapping customer base. Since KLA & Lam are vertical it already puts it into a class that has been historically harder for the DOJ to prosecute. It seems to suggest that the deal is outside of normal bell curve in terms of DOJ interest making the delay curious.

Death by Delay…
Even if the DOJ doesn’t want to set policy or precedent but doesn’t like the deal, they can always kill anything they don’t want by “delaying it to death”. This allows them a way to get rid of it without seeming to act by actually acting by “failure to act”. Its a convenient “alibi” for the DOJ, by burying a deal in the normal Washington bureaucracy. In the case of KLA & Lam the DOJ is surely aware of the Oct 20th timeout.

Did a balloon pop?
In the AMAT TEL merger, the DOJ sent around to interested parties, a proposed consent decree settlement trial balloon that apparently did not go over very well. Given that its likely that the same people at DOJ are looking at this proposed merger as well, perhaps they sent out a similar trial balloon to interested parties, maybe with similar results. hard to tell, but could be an explanation for the sudden change……

The timing looks very difficult…and long
We think whatever remedy is being sought or negotiated has to be something more substantial than just a behavioral remedy. As we have previously said, if this were just a behavioral remedy revolving around “firewalling” data it would have been done a long time ago as KLA already has been doing it for years ( protecting sensitive customer data). If it is a divestiture or licensing or similar, it will likely take time. It took Fairchild and On semiconductor 5 months to get rid of a dinky $25M IGBT business before they got the green light from the DOJ after a deal to sell it to Littlfuse, and they were very forthcoming and admitted the problem of overlap way up front. Lam was probably not as accommodating. How long would it take for Lam/KLA to sell or license off thin film or critical dimension business? Probably at least 3-6 months in a fire sale.

Given that the deal appears to be stuck in the DOJ, that suggests we still need Korea, Japan & China regulators to approve the deal. They are likely waiting on the DOJ remedy before their figure out what they want which will be at least as much as the DOJ if not more. This will likely mean several more months assuming that foreign regulators go along with whatever the DOJ got….if not…it will take even longer.

Taken together, this suggests that even if we had an approved remedy we are probably talking about another 6 months to get the deal done which would make it equal to the length of the AMAT TEL deal before it fell apart.

Deal “Certainty & Uncertainty”….
One of the very significant parameters that a board has to consider in an M&A transaction is certainty of the deal. An deal that is less certain should have a higher price premium or a higher break up fee to make up for the added risk of the acquisition not going through. In the case of KLA and Lam the deal seems a lot less certain than it did a year ago, which would imply that KLA’s board could ask for a significant break up fee or higher value of both. When you add to this the view that lam is now getting KLA at a discount price given the outperformance over the past year it seems to underscore the need for a different deal.

The problem is that if its a deal at a different price or break up do we have to go back to square one for approval further delaying things.

The other issue is should KLA extend the deal no matter how much Lam is willing to pay. Maybe the risk is too high and the odds now too low that any amount of money would not offset the risk and increased valuation that KLA sees. Customers and employees of KLA have been left in the lurch for almost a year and another 6 months of waiting could do very serious , irreparable, damage. On the other side , would Lam want to pay a much higher price or a high breakup and risk getting a damaged KLA or not getting a deal and being out a lot of money (plus the $50M to $100M in interest on the debt raised already for the deal).

Plus theres the fact that AMAT continues to gain ground while KLA and Lam are in limbo. We find this an amazing case of “trading places” as it was Lam who a few short years ago was gaining share while AMAT was engaged to TEL. The shoe is now on the other foot…

We had been saying that KLA was so important to Lam and Lam’s management that they would do anything or pay any amount of money to get the deal done. We are not so sure now…..even though this is the one and only last chance to catch up to Applied, Lam has no other alternatives, they may have to let it go as it has gone beyond a recoverable point. Even if Lam wants to pay stupid money or commit stupid acts to get the deal done its not really their choice any more as KLA’s board can just walk away on Oct 20th

Extending the play clock beyond Oct 20th does not look very enticing to anyone…except perhaps to AMAT

October 21st 2016…the morning after…
If we try to figure out the aftermath on Oct 21st, we have seen this movie before. When the AMAT TEL deal broke, it took quite a while for both parties to get their act back together and figure out where they were going, perhaps at least a year with AMAT and more with TEL.

KLA would emerge in better shape than Lam as much of Lam’s valuation and future is tied up with the acquisition of KLA. Lam has made public statements about how it needs to integrate yield management with process for the good of customers and used that statement as the centerpiece of support of the deal. Now they won’t have it but AMAT does.

Lam needs “something more” because dep and etch are becoming more commoditized and thus price sensitive as time goes by. Multi patterning has been great but that will slow sooner or later as EUV finally kicks in. The lack of node/geometry progress in dep and etch has allowed competitors to catch up and make more of the steps competitive and subject to price competition. We have seen this happen at customers such as Toshiba who split up the commodity tools and left the remaining critical tools to Lam out of the 20 some odd etch steps. Lam needs differentiation….

KLA on the other hand didn’t need the merger (other than for a pay day) and likely emerges in better shape though perhaps a bit of wear and tear for being distracted for a year.
Business has been very good for everybody

One thing that may mask the damage and fall out is the fact that business is very , very good for everyone in the industry right now. We expect both Lam and KLA will have bang up September quarters as the second half looks a lot better than previously thought. We have already heard how great things are at the recent Applied lovefest. This tone of strong business may soften the blow of a busted deal.

The Stocks.. Buy on the Barf
One of the potential stock reactions is that the arbs who have replaced fundamental investors in the stock of KLA will “puke up the stock” when the deal fails and drive the price down as they exit stage left. However fundamental investors who haven’t paid attention to KLAC in the last year will likely recognize that the stock is currently trading in the range of a roughly 12 P/E when it should be trading closer to its historical 14 to 15 times (which has always been higher than Lam’s valuation). The fundamental guys will likely push it back up after the arbs exit and may start buying in before they exit thus minimizing the downside.

Fundamental guys run little risk as even if the deal does go through they still get rewarded by a nice upside given the wide spread due to the uncertainty.

Basically, if you are a fundamental investors, just go out and buy KLAC now as you have little to lose if you are willing to wait till the dust settles.

LAM = Life After Merger?
What to do? Lam has had a great run and stalled out in the low 90’s as we had previously suggested it would. Lam is already fully valued and has the benefit of the merger priced in so there is likely more downside than upside in Lam. Its hard to call it a short as fundamental business remains strong and can potentially soften a break up. We do however see downside risk into the 80’s and potentially continued weak behavior in the weeks and months following until they come up with a new story and new direction and get their act together again. Its likely going to be tougher on lam as a lot was pinned on the acquisition so coming up with an alternate story will be tougher as compared to KLA who will just carry on as they were before the deal.

Right now we see more risk than reward in owning Lam especially going into Oct 20th. Depending on the outcome we may be tempted to get back in if the deal and the stock fall apart.