LRCX Lam Research Corporation

Lam Research Corp (LRCX) will be buying Novellus Systems Inc (NVLS) for $3.3 billion in exchange for its shares. Specifically, Novellus shareholders will get 1.125 shares of Lam stock for each Novellus share, or roughly a 28.0% premium based on Lam’s closing prices yesterday.

The agreement gives Lam shareholders a 59% share of the combined entity, which will continue to be called Lam Research Corp. The remaining 41% will go to Novellus shareholders.

Lam will also spend around $1.6 billion for share repurchases over the next year utilizing the existing domestic cash balances of both companies. This system is more beneficial for Novellus shareholders, as it makes the distribution tax-free. It is also positive for Lam, since it would not have to fork out any cash right away (as could have been the case if it was a cash-and-stock purchase).

The financial advisors for Lam and Novellus were Goldman Sachs (GS) and Bank of America Corp (BAC), respectively.

Why It Makes Sense

The transaction, which is expected to close in the second quarter of 2012 subject to statutory closing conditions and shareholder approval of both companies, is a no-brainer, since the companies complement each other in many respects.

Most importantly, they sell complementary front-end equipment. Novellus specializes in thin-film deposition and surface preparation equipment, while Lam is a leading provider of etching and cleaning equipment.

Semiconductor manufacturing refers to the deposition of several layers of materials on a silicon wafer in specific patterns using photomasks, or reticles (held down like a stencil).  However, after the deposition of each layer, the excess material deposited is etched (or “cleaned”) away and the remaining material is exposed in a manner that changes the chemical properties of the wafer.

Therefore, after the merger, Lam’s product line would be considerably broader, taking care of a greater portion of key semiconductor manufacturing processes.

Combining resources would also be beneficial for the R&D teams, which could put their heads together to develop solutions for 450mm wafers and three dimensional chip architectures. A focus on advanced technologies is a must in the current environment, where newer generations of computing devices and phones are increasing chip complexities, while growing demand from emerging countries is a constant pressure to lower costs. 

Naturally, the combination would also enable significant cross-selling opportunities for both Novellus and Lam sales teams, helping to drive penetration at existing customer accounts.

In addition to these advantages, the merged company would be able to eliminate $100 million in costs a year (starting from the fourth quarter of 2013). The companies have also stated that the transaction would be accretive to non GAAP earnings within the first year after the deal closes.

Lam’s competitive position also improves, with the company now moving to the fourth spot among semi equipment makers, behind Applied Materials (AMAT), Tokyo Electron and ASML Holding NV (ASML).

Consolidations Galore

There have been a number of big consolidations in the semiconductor sector in recent times and we are reminded of Applied Material’s acquisition of Varian Semiconductor and Texas Instruments’ (TXN) takeover of National Semiconductor.

We think that the primary concern for semiconductor companies is the uncertain economic climate and weak consumer spending that has increased the need for cost control. For example, in the last reported quarter, Lam and Novellus saw their profits shrinking 63% and 30%, respectively. The fact that this concern has also kept a lid on prices is a bonus, because it means that acquiring companies have to pay relatively less.

For equipment makers, the outlook is decidedly murky, with Gartner projecting a 23% decline in wafer fabrication equipment in 2012, following an expected 10% increase this year.

To Summarize

Lam and Novellus have entered into a mutually beneficial agreement in particularly trying times. We believe that the deal makes sense because synergies look significant right now. Also, considering the fact that the premium is not too high, Lam shareholders are likely to approve.

The fact that it is a tax-free distribution is likely to appeal to Novellus shareholders. Since the combined entity strengthens competition, legal hurdles are also likely to be limited. Therefore, the deal should go through smoothly.

Both Lam Research and Novellus have a Zacks rank of #3, translating into a Hold rating in the near term (1-3 months).

 
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