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Did PMC-Sierra Overpay?

There is some discussion that PMC-Sierra (PMCS) may have overpaid KKR for the storage semiconductor portion of the Agilent business.

We think PMC-Sierra did indeed overpay. Here’s a generous financial picture of the storage division.

Revenue 112M
Gross Profit 78.4M     70% Margins
R&D 22.4M 20% Typically
SG&A 16.8M 15% Typically
EBITDA 39.2M Conclusion: PMCS paid 11x Pretax Earnings

Some have drawn the conclusion that this is a positive deal because it is accretive to earnings, while ignoring the erosion of stockholder equity. Others draw conclusions by comparing this deal to the Qlogic deal or Adaptec deal. We don’t think that’s important. What is important is what will need to happen for shareholders to realize a decent ROI on a 425M cash investment.

These are the real questions:

  1. Will the unit volume grow?
  2. Are the margins defensible?
  3. Does the product line have a compelling roadmap?

1. HP and IBM are moving away from Fibre Channel. Their roadmaps are pointed at SAS and SATA arrays. Outside of EMC there has been a wholesale shift from Fibre Channel to SAS as a technology. PMC-Sierra has made a big investment in this area but emerged with only one big win- you guessed it – EMC. It is safe to assume that EMC is expected to provide the bulk of the top line growth for the Tachyon products.

2. Today, nearly 1/2 of the Agilent Fibre Channel revenue comes from EMC. EMC as a supplier isn’t going to be thrilled by the prospect of paying 70% margins long term on $50MM of annual sourcing business. Even if the margins are at this level we don’t expect them to stay there long. Since most of the top line growth going forward is likely to be EMC, expect the margins on this business to drop into a range of 30-50% more common with mature boutique product technology cycles

3. We have some serious concerns here. It is known that Sierra Logic was founded by the team that built the original HP/Agilent Tachyon products. Agilent has been slow to migrate their products away from Fibre Channel and ceded the new SAS market to companies like VTSS and PMCS. PMCS already has a running start in SAS/SATA, so why do they need Agilent? Also, it’s impossible that this was a cash flow harvesting move by PMC-Sierra since they would be terminating the product roadmap for their #1 storage customer.

PMC-Sierra is a well managed company but we don’t see the logic in this acquisition. “There is what we see and what we do not see” (Bastait) and it is what we do not see that may be most interesting. Some enlightenment from management on what we do not see would be most welcome.