You need a big stack of chips to play the Semiconductor Roulette

Most of the technological development over the last couple of decades has been driven by an industry driven by a very simple equation. Moores law states that the density of transistors in semiconductor chips doubles every two years. This means semiconductor companies deliver cheaper, faster and lower power consumption chips every year enabling other industries to grow.

The semiconductor industry itself is not growing significantly anymore even though the number of transistors it manufactures doubles every two years. It has reached a commodity equilibrium hard to break.

Just to stand still semiconductor companies need to invest massively in new technology and in acquiring competitors to get to a higher scale of economy that allows massive investments.

This is not an even race as can be seen in the chart. Three companies dominate the roulette table:

Top R&D Spenders 16Q3-01

 

A few companies dominate the race followed by a long string of companies that are struggling to handle the investments needed to participate in Moore's race. Although the technology is available through subcontractors, using it comes with a loss in the value chain that has an impact on costs and gross margins.

Moore's law is available only to a few companies

If you want to be in the semiconductor game you need to go big or go home. The R&D cost relative to sales is an average of 17.2% for the major semiconductor companies. This is significantly over what other industries normally invest in R&D and way above technologically (still) respected Apple Inc, that only invest 5.5% of sales into R&D.

Top R&D Spenders 16Q3 Share of Revenue

Investing too much into R&D makes you a target for acquisition. To buy a company you have to pay more than it is worth (many different measurements available). For an acquisition to make sense it has to either deliver revenue synergy, cost synergy or both. In the semiconductor industry, cost synergies dominate. This means a high R&D ratio gives an acquirer the opportunity to cut R&D spend with little immediate impact. Longer term there might be ramifications.

The industry is entering a new phase of uncertainty where M&A might not be the path to survival it has been for the last few years. What the Obama administration started the new Trump administration will continue, blocking foreign acquisitions of semiconductor companies. In return China and Europe are likely to block any intra-US mergers. Soon the industry will have to learn how to grow organically again.

Engagement Group is helping semiconductor and other hi-tech companies grow organically through social networks. We create new revenue from new customers.

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We transform your sales people from sellers to buying consultants attracting new customers and new orders.
We transform your advertising to content valued by the customer, at a fraction of the advertising cost.
Social Selling is so good it is irresponsible not to use it.
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What did Avago pay for?

I am certainly not a finance professional, nor do I have any personal or economic interest in talking the Avago-Broadcom merger up or down. When that is said, I am very interested in understanding the mechanics of semiconductor mergers. They have become the preferred way of growing in the semiconductor industry, but nobody knows if they create value for other stakeholders than the two management teams that get rewarded handsomely. Companies become larger than the were, but that is not the same as becoming better than they were. Size does not equal value for every stakeholder. 

M&A is the only game where the loser gets paid more than the winner

The only public information about a merger or acquisition is positive and talks about the upsides of the companies joining forces. Information about potential risks or losses is incomplete or omitted. If you ever have been part of a merger team, you will know how bloody and messy things can be on the inside at the same time as corporate communications send soothing music to the markets. 

When M&A becomes your main growth engine you have your back to your customers.

Most people in the industry seems to assume that the finance team have done the math and approved the merger from a financial perspective. It is safe to assume that there has been plenty analysis before signing the deal. Much more interesting is it to identify what the analysis is based upon. In the Due Diligence process, the buying entity is allowed to review all financial material, and everything else deemed material from the selling entity.

It is also safe to assume that the selling entity will make sure they get a good deal or they will have to answer to rebel investors and potential lawsuits. It is much more difficult for shareholders of the buying entity to understand if they are getting a good deal or not.

Where lawsuits from shareholders of the selling entity in an acquisition are quite common, you rarely see lawsuits from shareholders of the buying entity.

To buy a good company, you are likely to have to pay more than its is worth in the market. The deal can be attractive if the acquired company can be made worth more by joining the buying company than it could alone. Synergies can be created by expanding the offerings to customers or by lowering costs by economies of scales. The problem with synergies is that they are based on assumptions and expectations of the future and have a lot of risks associated.

The merger balance sheet.

A way of getting additional information about a merger is to take a look at the merger balance sheet. This information alone is not sufficient to establish if the merger makes sense or not, but it can be used to highlight issues and risks associated with the acquisition. The merger balance sheet is what entering the buying company's balance sheet in return for the purchase price creating a new balance. You can see what you paid for.

For a mega merger like Avago-Broadcom we are talking big numbers - we are certainly in the closed area of the casino - and as Avago was the smallest company the merger is going to change the balance sheet dramatically.

 

avago-balance-sheet

All figures are from AVGO balance sheet and in B$ 

Price of acquisition

The first element of the merger balance sheet is the acquisition price, in this case, shown less cash. You can view the transaction to include the acquired company's cash or exclude it as you immediately use the money to fund the transaction.

Working capital

The working capital involves the net value of all the assets that are in the cash cycle of the acquired company. This includes account receivables, account payables, and inventories. Also, assets held for sale and the short-term impact of debt is included. Working capital is a tangible asset, it has a very clear monetary value.

Property, Plant and Equipment

This asset group is also tangible. It is a group of physical assets with very clear accounting rules for establishing value. As Broadcom's business model was fabless, it is not surprising that this asset group is relatively modest in size.

Intangible assets

The next two asset groups are non-physical and much more complex to evaluate. The part that is possible to identify and assign a value to is called intangible assets. As can be seen from the chart, this includes trade names, customer backlog and contracts and technology plus in development technology. Although there are rules for how to establish the value, there is a lot of interpretation possible. The last and maybe most interesting element of the balance sheet is Goodwill. It represents the intangible value of unidentifiable assets. Goodwill also represents the price the buying company is willing to pay for above and beyond what can be specified in the balance sheet. The long-term liability element is predominantly deferred tax as a result of the write-up of Broadcom's assets.

So what?

When seeing the deal as expressed in its balance sheet components, it becomes clear that a semiconductor merger involves a lot of estimations, assumptions and expectations. In short, there is plenty of risks involved as well. Even thought M&A is the preferred growth strategy in the Semiconductor industry presently, it also represents a danger to the companies involved. Synergies will be harder to unlock as manufacturing costs are equalised and the market dominated by fewer larger companies with wider product portfolios. During the merger, companies need to reassign a lot of their people away from operations and into integration related activity. Companies risk forgetting the customer in this phase.

 

Engagement Group is helping semiconductor and other hi-tech companies grow organically through social networks. We create new revenue from new customers.

We make your organisation ready for the social network tsunami. You need to understand the social principles to survive and surf the wave.
We transform your sales people from sellers to buying consultants attracting new customers and new orders.
We transform your advertising to content valued by the customer, at a fraction of the advertising cost.
Social Selling is so good it is irresponsible not to use it.
Visit Engagement Group for more information or contact Claus Aasholm

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The buying hierarchy has been displaced by the buying networks

Pre-social selling methodologies operate with a model of the buying committee that mirrors the hierarchical structure of the buying organisation. The salesperson's job is to get to the decision maker in the top of the pyramid and convince this very important top officer to buy. Even though you also need to tick the boxes of the other participants in the buying hierarchy, this person calls the shots.

Unfortunately, the business world is not becoming simpler and nor is selling. In order to stay relevant salespeople need to rise above just being order takers. They need to become consultants that are able to create value for the buying organisation. In order to do so, the sales consultant has to understand the buying organisation in detail to be able to influence change.

Selling requires changing the buying organisation. If you are not changing it, then you are just taking orders.

 

The meteoric rise of social media has demonstrated that the world is not powered by hierarchies and nor are organisations. That certainly does not mean that hierarchies are irrelevant. They play an important role in any business.

The operational hierarchy and the creation network.

You don't need to spend many seconds in an organisation to identify the operational hierarchy. Employees and managers busy with processes, outcomes, KPI's and efficiencies. The machine room is important to the health of the company. It is, however, important to understand that this hierarchy with is very clear goals are not the best structure for creating new ideas, products, business models or strategies. They are far too busy with today to worry about tomorrow.

The operational hierachy fight change like the body fights an infection.

Senior managers are very aware of this and create separate groups of people to handle the creation of the future. These groups of people are pulled completely or partly out of the hierarchy to participate. This might be temporary project groups or more formal committees working across the organisation. This creation network holds the keys to the company's future and does not figure on any organisation charts. 

 

Order takers work the operational hierarchy, consultants work the creation network.

The individuals in the creation network are not chosen for their operational qualities. They are chosen for their creativity, expertise and the networks they are part of. They will typically be quite visible on LinkedIn as their orientation is outwards and towards the future. It is important for consultants to identify the changemakers of the organisation they want to create value for.

The changemakers of an organisation don't hold hierarchical power, they hold network power and as such are very important to the CEO. Whenever the organisation is in trouble they become very visible as the glue that holds the organisation together until the next steady state can be reached. They are masters at operating the 4 different but interconnecting networks that operate independently from the hierarchy in all organisations:

 

4-social-networks-01

The Trust network

Before being allowed to operate inside the customer's organisation a consultant needs to gain a level of trust. The trust network is very different from the other networks as it is not solely a professional network. People trust their spouse and family more than they do any expert, they trust a friend more than any salesperson. The trust network is of particular importance early in a professional relationship before the consultant has been able to prove her worth. Each of the members of the buying committee is in a trust network but also have their very personal trust networks that reach far beyond the borders of the buying company. This is a great entry point for a consultant.  To enter a person's trust network, you will need to get an endorsement from a member of the network. Social media makes this a lot easier than before.

  1. Family
  2. Friends
  3. Former Classmates
  4. Colleagues
  5. Organisation or clubs
  6. Competitors

 

The Expert network

As a consultant is interested in changing the customer, it is important to be connected to the expert network. This is where new products, solutions and business models are defined. For companies in the tech industry, this is mainly an engineering community. It is important to identify other experts also. Finance, legal and marketing experts carry decision weight and have a lot of veto power. To enter the network you do not necessarily have to be an expert in all disciplines but you have to have identified fields in which you excel. You will also be attractive to the expert network if you have access to valuable expert resource from your own organisation. 

 

The Power network

As most consultants have realised, just because the expert network is working on something does not mean it makes it to production. Every project has to pass several gates before it gets the green light and it can be stopped at any point in time by people in the power network. The power network is consisting of two main areas: Signature power and veto power. Signature power is held by high ranking people in the buying organisations that control budgets and can allocate resources. The veto power is held by staff functions like finance, legal, quality and reputational departments. Consultants will benefit from being well connected to the power network and understand the roadblocks for the changes that the consultant is bringing.

 

The Action network

The action network is tasked with executing the project or the decision. They might sound like a group without influences that only follow orders but it is important to be part of this network. Even if the decision has been made by people in power, the action network can decide that it is not possible to implement. They can also decide to fake participation and wait until the project slowly disappears again. Being well tapped into the action network will help move important projects through the maze.

As a sales consultant, it is vital to understand these networks and identify the key players. While order takers are busy hunting orders at the purchaser's desk, sales consultants are busy working with changemakers to define future order streams.

 

Engagement Group is helping semiconductor and other hi-tech companies grow organically through social networks. We create new revenue from new customers.

We make your organisation ready for the social network tsunami. You need to understand the social principles to survive and surf the wave.
We transform your sales people from sellers to buying consultants attracting new customers and new orders.
We transform your advertising to content valued by the customer, at a fraction of the advertising cost.
Social Selling is so good it is irresponsible not to use it.
Visit Engagement Group for more information or contact Claus Aasholm

Join our weekly Semiconductor Business Insights mailing list here.