Semtech Corporation action: awareness (early but costly) of an irreversible error

Acquiring a company and entering the big leagues through inorganic growth is always fascinating until the post-acquisition truths begin to crystallize. It usually takes a few years for management to realize (and admit) that they probably overpaid and now need to note some of the goodwill and intangible assets. Interestingly, Semtech (NASDAQ:SMTC) management understood this relatively quickly (in less than a year) during the acquisition of Sierra Wireless. Unfortunately, it seems a little too late.

Hopes and dreams

It was probably anticipated that the acquisition would propel the company into a completely different area of ​​business when it paid $1.3 billion for net tangible assets of just $94.6 million. Even though the multiple was much higher than we would be comfortable with for an acquisition, management had to have their analysis done and develop the potential business plans that supported the project. decision at that time.

The frantic efforts to save the ship

The decision to write down a large part of the goodwill and intangible assets so early would also have been based on certain knowledge acquired over the past year. The company recorded a total of $755.6 million in non-cash pretax goodwill impairment for fiscal 2024, citing reduced earnings guidance for the acquired business (specifically, IoT connected services, IoT systems – IoT modules and systems – routers). shares), current macroeconomic conditions, including interest rates.

What we find more interesting is that impairments were recorded in several tests during the year, which increases the possibility of additional impairments in the coming year. It does not reassure us to repeat here that the company has not ruled out this possibility either.

Chained to dead weight, missing the promised fuel tank

The company would now be listed on the balance sheet for a much lower fraction of the initial investment. However, the debt taken out to finance the acquisition would still be there and would continue to bleed the company even further while it is already struggling to improve its margins, which would result in an unimpressive trend in earnings. net profit.

Average revenue growth since 2015 has been 5% per year, with gross profit growth even slower at 2.6% per year. It could be argued that profitability growth could return to the levels achieved by the company before the acquisition. This is a plausible argument because gross, operating and net profits grew at an annual rate of 4.8%, 10.6% and 10.4% during the period 2015-2022.

However, lower post-acquisition margins and higher interest expenses (on an absolute and relative basis) are now the differentiator, as we have seen in recent quarters. The results were rather disappointing and we believe that the optimism reflected in the stock price since December 2023 is most likely based on technical analysis which showed the shares to be oversold.

Growing debt problems

As of the last reporting date, the Company’s outstanding term loans amounted to $622.6 million. The outstanding amount of the revolving credit facility is $215.0 million and available undrawn borrowing capacity is $282.2 million, but there is $162.5 million of borrowing capacity on this facility is scheduled to mature on November 7, 2024 and $337.5 million is scheduled to mature on January 12. , 2028.

From the company the credit agreement has been subject to at least three modifications since January 2023 with discussions around increase in the covenant relating to the maximum consolidated leverage ratio, reduce the minimum clause of the consolidated interest coverage ratio And change the price among others. An overview of these covenants is given below and we would like to highlight the fact that the book value has become negative from the last reporting period. It is therefore likely that lenders will need to be contacted again (if they have not already done so) in case the liquidity situation does not improve.

It is also important to mention that SMTC’s loan is based on a variable rate plus a margin (different for each type of facility), priced at the upper end of the agreed range if the company chooses to roll over its interest payments. This differentiates the company from a number of other listed companies which have managed to secure medium-term loans at a comparatively lower fixed rate during the 2020-2022 period and obviously places it in a much more difficult position.

Assessment

The company ranks poorly in SA valuation metrics and it is very difficult to use DDM or FCFE projections to value the company until we have some visibility into the future outlook. We may be tempted to develop all kinds of growth scenarios, but these would be speculative and unfair in our opinion as long as there is no more recently established reference based on published figures.

Upward risk

Obviously, all is not lost and it is possible that management will now be able to better focus on growing the business after overcoming post-acquisition business alignment challenges. An improvement or return to previous profitability margin levels would certainly increase the availability of liquidity. One thing worth mentioning here is that these liquidity and profitability issues make SMTC a decent acquisition target, especially now that it owns its own intellectual property and was acquired via the purchase of Sierra Wireless.

Conclusion

We look forward to management’s plans on how they plan to effectively manage the current situation. If the next earnings announcement does not show a credible turnaround, we expect the price decline from current levels to be very sharp and persistent. We prefer to park on the side of the road and wait for this curtain of fog to lift a little before embarking on SMTC’s shareholding.