Mordechai Yavneh, founder and PM at Focus Capital, discusses his investment in Silicon Motion (SIMO) and why he thinks it's "merger arb for people who don't like merger arb."
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Andrew Walker: Hello and welcome to the Yet another Value podcast. I'm your host, Andrew Walker. If you like this podcast, it would mean a lot, if you could follow, rate, subscribe, and review it wherever you're watching or listening to it. With me today, I'm happy to have Mordechai Yavneh. Mordechai is the founder and portfolio manager of focus Capital Advisors. Mordechai, how's it going?
Mordechai Yavneh: Well, thank you for having me.
Andrew: Thanks fot coming on. I'm excited to have you on. I wish I could have met you. I kind of wish I'd had you on in the July timeframe, because I know what we would have been talking about then, but I think this is a good one too.
Before we get there, let me start this podcast the way I do every podcast. First, a disclaimer to remind everyone that nothing on this podcast is investing advice. That's always true, but we are talking about a company that's foreign domiciled, they trade under, they have an atheist, so they trade American, but they are a foreign company, probably as a little bit extra risk, you know. This is a merger-arm situation so adds a little risk there. Please consult a financial advisor. Do your advice this is investing advice. Second, with the pitch for you my guest, I mentioned the July timeframe because you were one of the few people who are riding hard to put me on the Twitter train. I know you saw on quite hard at Twitter but look, you run a concentrated, I'm going to call it event and event and quirky portfolio. I know you run concentrated. You do [crosstalk].
Mordechai: Mostly not of them is [crosstalk] difficult situation it comes up ahead. I have to hide it.
Andrew: But look, you weren't very concentrated. You do deep work; we were having fun Chinese before, so I'm excited to dive into this one. The company we're going to talk about today is silicon motion. The ticker there is S-I-M-O, you've got a deck on your website, which I'll link to in the show notes, anybody can check it out. I believe that the tagline board is merger Arbitrage for people who don't like merger Arbitrage, so, I'll just flip it over to you. What is silicon motion and why is it so interesting today?
Mordechai: Okay, so let's first, talk about what's bad about merger Arbitrage, to explain why this is different. Though the usual problem with merger arb is that most merger Arbitrages do their small spreads for companies that the market expects the merger to close and you're collecting your little spreads until one of the deals closed off unexpectedly and you lose a lot of money, kind of picking up nickels, dimes in front of the steamroller. That's not such an attractive project, especially for a concentrated portfolio like mine is maybe working some people have done work with that arb, especially the merger arb shops that have sometimes had success with that, but that's not going to work for my investment philosophy. The other type of merger arb is where you have a very large spread because a lot of people have looked and seen the risk of the merger arb closing. There are a lot of questions, usually about Regulators, sometimes about finances, whether the show proved it etcetera, etcetera. So, it's not clear if the merge is closed you have a large spread, but then you have a large risk as well, large reward large risk. That is the theory that can be attractive, but I'm not so attracted by risk I like large rewards, and low risk. So that's what I believe we have here was so much commotion in a Taiwanese company with as we said in AD arb U.S. it's being bought out by Max Lanier American company. And right now, they are trading full baths and six and seven dollars, and there being bought out for about 108 almost all of it. The vast majority that has cash is $92.24 cash and .388 of Max Lanier's shares come out to about 108 at the present prices. That is what we have here is a 60% spread on the merger, which is very large even for large. You know, you have a company with FTC's suing that Microsoft should not be able to take over activation and the spread is only about 30% and you have a 60% spread. So, I would say that the market is very negative about the merger closing.
Andrew: If I could just dive in when I was getting ready for this podcast, you know, is doing my standard, I'm sure you've got it, you've got you, hey, if you've got cash and stock, here's what everything's worth. And as you said, here's this bread I did it the first time and I forgot to drag my cells down to include the value of the share component. So, I only had the 90 plus dollars in stock and I was like, oh 40% spread, that's pretty big and then I was like, oh my gosh, I forgot about this extra 20 bucks and shit like it's big even if you ignore this year. So, you know, just neither here nor there just a funny story about me not being super confident and excelling.
Mordechai: Exactly when you forget part of the prices to level 40 cents back. Exactly. This bed here is out of the world and the reason is pretty obvious, I think for most market observers still commotion is a semiconductor company will get to discuss exactly what they do with their Semiconductor Company, a Taiwanese Semiconductor Company that has been bought by an American company and among all the approvals in the world which already has the one that has not yet received in Chinese approval. Given the call, the tensions between America and China now, about sudden conductor the America Banning China from buying many Advanced semiconductor technologies, etcetera, I'm sure the Chinese are not happy with the America that we talked about the other time. So, the question is whether they will allow an American company to purchase a Taiwanese company in the 7 conducted spaces when they have the right to deny approval. That seems to be, I mean the reason why most people expect that to, not to close. It's officially supposed to be reviewed by Chinese SAMR which is antitrust with you on antitrust bases is nothing to pick on in the case because Max Lanier and some commotion, don't have any overlap, both semiconductor companies but in different niches so there is no overlap, no antitrust risk at all. So, if they were following the rules is no way for them to deny approval. I don't think there's a reason to believe that China has to follow its own rules. So, we'll China approves or not approve, have no special insight, very well they may not probably the simplest thing for them to do is just drag their feet and not respond and not respond until they run the clock out, which I think is the preferred method of when they want to deny approval just [crosstalk] I get back to...
Andrew: And for anybody's done event, we are very familiar with this, you know, just this year, there was Roger's Dow, Dow or was Roger's upon one of the two. I will probably bring that up later the famous one, everyone remembers is an SPI Qualcomm back in 2016 or 2017. So, people are very familiar with China using SAMR to just drag out, drag-out, drag out until eventually, the company says all right, there's no way this merge was going to go through.
Mordechai: So okay, so this is the situation where I said the higher risk of not going through and a high spread and I just described that type of situation as being unattractive. So why do I say Silicon Motion is a merger arb for people who don't like merger arb the reason is that I haven't believed that Silicon Motion is worth much more alive than dead. I believe that if the merger doesn't go through, you'll make more money long-term as shareholders in a standalone Silicon Motion than we would buy it being purchased. Fun fact, when Silicon Motion announced a merger can be bought out for about $107 a share by Max Linear, I reached out for real advice to see if there was any way I could block the deal because I believe that $107 vastly under undervalued Silicon Motion as a company, turns out that Cayman Islands domicile, it was no real way to there's nothing to think the teeth into so we didn't have a way to try to block it but if this deal doesn't go through, I think that's great for the best. And so basically the way I view it is 60% of the deal goes through from the present price and even better if the deal doesn't go through. So really, although I call it a merger it's a fundamental devalue play on Silicon motion as a stand-alone company even though we have no opinion about the merger.
So, let me discuss why Silicon Motion what's so attractive, that's a little commotion in the company. So, I've said Silicon Motion has, I take try effect about I want to say 4 things quite effective, everything we could want in a company. One is highly profitable. Two, fast-growing. Three, low risk and diminishing competition, and fourth, super low valuation. You do not usually have all 4 of those at the same time, it's usually, you know, profit growth or cheap pick 2 or 3, open 1 of 3 sometimes, and this has all of them, highly profitable, fast-growing, low risk, and cheap valuation. So, realizing this if I can get 5 companies like this, for my friend, I'll go for it. No, I said mentioned that I run castrated fun so, I only invest in very high-conviction ideas with the support of 5 companies that's why it's going to be high conviction to slide into my, into my friend to begin with. And this is the highest conviction idea I've ever had we are holding about 35 cents and funds in Silicon Motion and the last long letter that we wrote about little car motions, all the moving parts we titled it, Pounding the table on Silicon Motion that the price was around here about six zeroes in 2 months ago. Near then 2021, before the merger was announced, it was trading around since the end we said that this is just not a price, its price did not make sense for the future of this company.
Andrew: Do you? It's called, I want to dive into a bunch of things you said but let's just start with one, you know it's common in a vet land where you'll see something that's got a rocky Arbitrage or even just a normal Arbitrage and people will say, look this thing is trading, this thing is trading discounted because no one wants to touch it, there's no natural by, right? The classic, I all the time, like a utility company agrees to sell for 10, 2 months, a year later the utility index has doubled and the stocks trading at 980 because there are questions over if the deal goes through or not and people say look this is because no utility funds or anyone who indexes to the utilities can buy this. After all, it's under arbitrage and no-arbitrage people want to underwrite the fundamentals because they want to get 10 or get out and so it's kind of broken that way. Do you think something similar is happening with Simon where It's hey if your fundamentals guy it's pretty obvious that the merger arbitrage here is Rocky and you don't want to step in front of a deal breaker? And then if you're a finance guy if you're a merger arb guy, it's pretty obvious the deals are rocky so you don't want to like a kind of underwrite too much in fundamental value. Do you think that's what's going on?
Mordechai: It might be a lesson, people ask me, I've been asked if the deal breaks, what will the stock drop them? So, I'm torn between thinking that the stock has already dropped. That this is the price that the market thinks it deserves, the deal breaks if the market isn't pricing in the deal. That's one way of looking, the question is the shareholder base now, is it most people who are believers in Silicon Motion and are waiting either for their $107, or for the company to continue as a standalone I know there are many shareholders like that in the base or has it mostly transferred to merger arb hands who are hoping to get the deal on the maybe they don't think it likely but it's enough of a spread to track them. Anyways, they figure that even if it breaks, it won't go down so much. But then, we'll be a lot of for selling if the deal breaks all the merger or people are going to leave and then they'll just be dumping it even doesn't make sense. I don't know. I can't tell you right now, what percent of the float is and merger arb hands which will dump it on a break, and what percentage of the funds are in index funds or in other long-term shareholders that are just going to keep going at it anyways. So, I don't know. I don't know if the merger breaks and starts dropping more or just gets more attractive, so there'd be a reason to buy more. I always feel that you know, trying to time, the same we can't time the markets as a whole, it's, you can't talk the time of companies. You can't say, this is a great company. It's worth double triple the price. But after 1/2 month and 3 hours, I mean, I can't tell you what they bought, I know that now the price is too attractive, so I think to go for it now, that's what I look at it.
Andrew: You know, I think we mentioned Twitter when I can't remember what I said explicitly or implicitly, but when I said, we had something talked about in July, I was referring to Twitter and one of the things, I mean, I don't think I swung as big as you, but I swung pretty big, but one of the things I regret is like if I started from the end and work backward, I was like Twitter is 95% to win this case and I always thought that every time, you know, and but I never quite so I certainly swung like I thought it was 95% because I would joke the people Kelly Criterion said you know if you think this is 95% you should sell your kidney, sell your house, sell your dog and put it all into Twitter, and I certainly didn't swim it, but I never swung quite as hard as of wanted to because I always like, I'll wait for the trial to get a little bit bigger. I'll wait for this event and then, you know, it just settled all the sudden out of nowhere you know what I've said, I throw in the towel I settle, and I kind of regret like if you're that convicted you start from the end work backward and say, take the position now and so it and that's obviously what you're doing your kind of like cutting out there is. But there are 2 things we need to talk about here, right? We need to talk about the merger arbitrage angle, which if it plays out, you might not be happy but I think a lot of people would be happy walking away with 100 in the near term. I think it's unlikely, people can see that from the share price, but we should discuss it and we should talk about the fundamental angle. So where do you think we should start?
Mordechai: I think we should start from the fundamental angle. I think [crosstalk] the base value of any company understands what the company does and why it's worth more if it is.
Andrew: Great. So, let's start with the fundamental angle. You mentioned a couple of things in there, you mentioned growth, I think the thing you've mentioned, and I've heard about you talk about it before, you kind of start alluding to it is that they are, I don't want to put words about but they're a little moti[?] and they're getting more moti[?] right? They're taking a little bit more share, they've got great partnerships, a lot of the competitors are exiting, so just if you can expand on that and we can use that as a jumping-off bullet point for fundamentals.
Mordechai: Let's first tell everybody what Silicon Motion does. They're probably waiting, I don't have my notes as well but that 15 minutes and we haven't said what they do with their semiconductor I mean, what do they do? So, Silicon Motion makes controllers for NAND flash. NAND flash is the memory that is ubiquitous in modern Computing, iPhones iPads smartphones, tablets, laptop, your computer, the data center anywhere that has storage used to be hard drives as all been transferred to flash memory, SSD etcetera, data center or Automotive in the Infotainment Center in the Telematics Center in the self-driving Internet things, if your toaster oven has some of them, you know as if the I don't know what they're putting it in nowadays but this okay that's a fact that those are important. But there is a growing internet thing you know the home video cameras, industrial lots of places with flash memory is going. Everywhere there's flash memory, there's a flash memory controller that runs the flash memory and it is important for we're leveling, it's important for garbage collection, prolonging the life of the memory Hardware-level encryption, and all the different things that depending on what the end case uses, and Market is what type of controller you need that only controls. Everywhere this flash is controlled.
Silicon Motion is the largest Merchant controller and largest Merchant provider of Flash control. What do I mean by Merchant provider? So flash is made up of 7 companies that make all the flash in the world. So that's Samsung and SK Hynix, our South Korean companies, then we have Kioxia, formerly known, as Toshiba, that's a Japanese Company. Then we have Micron Western Digital and Intel which were bought by SK Hynix most of them are American. And then we have YNTC, which is a new entry from China but has started to catch up a narrow already, I think they're ready at the commercial level of actually having customers. So those are 7 Flash makers in the world. The 7 Flash makers, can make their controls that's in-house control. And then a merchant controller is when the different company making the controller is being paired with the flash from these 7 Flash makers, either by the Flash maker themselves or by a third party called module makers. Module makers by Flash from the Flash controller from the Flash makers compare, combine it with a controller from Silicon Motion or someone else, and then put together the package and sell it at words the market.
So, silicon motions, customers are the flash makers themselves. These module makers and also in a large sense, the customers are their customers, the OEM, Dell, HP, the Apple, anything happens to a customer, but the OEMs who are making the products, they're highly involved in choosing who they want to be their provider for flash, they want you to vote for the controller, etcetera.
So those are the pretty overall overview of what the market looks like.
Andrew: Perfect.
Mordechai: Historically, the risk who I was going to start over, but we're talking about the, how the risk is diminishing, and competition is exciting. The biggest risk that has always faced Silicon Motion, at least the market fear has always been the in-house control of teams by the Flash makers that the Flash makers will take more of the market have been sold using arb, Silicon Motion and other merchants of merchant's controllers. With action to be happening at the opposite, over the years more and more, the Flash makers have been outsourcing, there's a controller needs to third parties like Silicon motion. Silicon Motion is the largest and the reason is simple. The Flash makers, their competitive advantage is knowing how to make Flash building the Fabs, bringing down the cost of the Fabs, and of course of the production, the manufacturing of the flash that's their competitive advantage, that's their secret sauce and that's where they have to go and compete in the market. Making a vote relatively small percent of the chip of the controller can be as little as 50 cents. It is not the critical component it needed but is not the majority of the package, the shape size, and form. And they can't amortize the cost of every new generation controller being more sophisticated and more expensive. They can't sell for the competitors Samsung's not going to be able to take control itself of SK Hynix if they are not doing business with Samsung. Their competitors and Flash can't buy controllers for each other so they're limited by amortizing the cost of development of control over their production only, Silicon Motion can amortize the cost control, of course, the entire ecosystem.
Andrew: So, Mordechai, if I wanted to just like dumb it down, and obviously, it's not quite this simple. But, you know, if I went back to the 90s and 2000s could Dell or could Dell and HP could, each of them has made their operating system and made their processing ship? I mean, technically yes, there are lots of network effects and everything that I don't think would apply here that would have applied to Microsoft and Intel. But, you know, especially on the process ship technically yes, they could have. But you know what? It was probably better for Intel to do all that RND, build the giant bath, and then sell to Dell, Microsoft Dell, HP, and Apple, all of them and amortize that cost over a much bigger base. So here I mean I'm not saying it's as Modi has Intel in the 90s but does it survive or spilled and all of them are saying hey, we're 1 of 6, 1 of 7, we have 20% market share if we give 100% to someone else or it's making this thing that you know is a reasonably small cost of the overall impact age. It makes more sense we'll get Dell, be able to amortize the RND, amortize upscale, they'll be able to produce it, bottom line cheaper than we could if everybody did this in-house, am I thinking about that correctly?
Mordechai: Absolutely. The Flash makers have to retain some control and talent in the house because as they're developing the next generation of flash, they have to be able to test it they have to be able to see how well it's working. So, they need some sort of, you know, in-house controller talent, and at the very high end where controllers are extremely expensive, I just got trolled on 27th of Chip, you can get controls for a few thousand dollars which at the very high end, that the very high, pretty high-end enterprise. So, that's of any more attractive, higher margin relatively for the Flash maker to compete in that market. They're still competing as a core competency, but the lower end and the mainstream, that's a living of Silicon Motion.
So, let's talk about all the various competitors over the years who have just fallen by the wayside. One of the big competitors will Marvel, Marvel was, let me first take a step back and break down the different divisions of the company.
Silicon Motion has 2 main divisions that cover most of the company and then, there are 3 main divisions that cover the company. The first main divisions are client SSD. That's the hard drive replacement that goes to computers and laptops. A low-end data center is also Enterprise SSD, which they are entering by have not entered yet until probably late next year. But client SSD would be in the said, computers, laptops, game consoles, and Low-end data centers. Then that's about 50% of the revenue, then there's eMMC and UFS. eMMC and UFS are a legacy in smartphone technology. It's still used a lot in low-end smartphones and internet things, but the successor technologies UFS that's been used on the premium end of smartphones and the mainstream as well nowadays. Probably, eventually, go down to the local level and at one point. That you have seen who has a business, is about 40% of the business, and then the rest of the Business Industrial and have a revision Shannon, which does Chinese hyper-scale data centers it's going to need a cell Tower of Babel the one customer Alibaba and Baidu, also a little bit of that hasn't been doing so well, that part of the businesspeople, small little sliver. I guess it's optionality that maybe they'll take off one day, but basically, right now we're looking at the client SSD and eMMC, UFS that 90% of it.
So, on the client SSD side Marvel used to be very big in hard drive controllers, so, as SSDs are taking over the market, they started doing SSD controllers as well. Marvel, of course, is a heavyweight much bigger than Silicon Motion. Marvel was not successful in competing with Silicon Motion. Marvel's and so their revenues and profits in that division kept on decreasing. They were asked on the conference calls you could read or listen to, that kind of calls where they were asked, point-blank whether competitors say that they're winning cheer, from them. And they wrestle Silicon Motion, nobody mentioned it by things, but Silicon Motion is making sure everyone knows when that time is it true. We're doing fine, we're doing great, we're doing great, there kept on saying to do great at doing great, doing great until they announce in 2018 that they're pivoting away from the client doesn't need space to focus on Enterprise SSD and that where they are, which is the major chunk of the business now. Enterprises as the brake lines that say neither abandoned because they were being unsuccessful, you are seeing, you could see for yourself as SSDs come at you see whose controllers are in them, and Marvel was having less, and less of the market and Silicon Motion, and a little advice on getting more and more the market, Marvel just being squeezed down. So that was the first note, a competitor that just exited stage left 2018-2019.
Kingston is technically a module maker. That is that they don't make any Flash to buy in the Flash of Flash makers and peering it together with controllers from third-party companies and selling on. But Kingston is almost a chair one company in terms of their almost as big as module makers. They are selling 10% or more of the world supply of SSD. So, Kingston's very big. Yeah, client and Enterprise. Kingston was a shareholder, a 7% shareholder in a competitor of Silicon Motion signs on. Joint venture [inaudible] and exclusively use 5 arms controllers, that was still 2018-2019. They started using Silicon Motion and they've been increasing in 2020, 2021, and 2022 they kept on increasing Silicon Motion share by Kingston. And that is quite an endorsement when you're the joint venture competitor coming to you for the controllers and moved away from the eyes on, just shows you that Silicon Motion was succeeding in execution and the RND and putting out the product at the price point that customer wanted and the winning market just then in 2020.
In 2020 they had 1, we had 1 client SSD customer that was direct Flash, one of the Flash maker customers that 1 in 2020, 2021 there's 2 in 2022 there's 7 which is all [crosstalk] it's on working with basic everybody. Not just module makers and their OEM business which is very important as 2 parts of the business, the module maker business, there are opportunities depending on the price of Flash, they get all occasionally need to get allocation when this tight supplier Flash in the market the module makers are last on the list again. When prices are high, the last on the list to want to buy because their margins are being crushed. So, they're more apt to see parties and want to buy more when prices are down with boy toys, then the module makers are coming in a buying Flash and therefore make controllers. When the prices are high supply tight module makers are not here as much. So, module makers in the business, they wanted, they just start that about 70% of the module makers, client, SSD degrees.
But the OEM market means Dell, the Hp's, the Apple who are long-term contracts, they need multi-year road maps, and they want to lock in their suppliers, know who they are using, and they want to make sure that they have that supply and even when prices go up, they still need to supply the thumping selling buying, buying flash, producing a product, and pushing into the market. So, they historically had maybe like 25% share of the alien market 2020 that went up, like 30, 2021, and 40%, and in this year 2022 they've won, 50% of the OEM slots as you see a lineup up to the right of growing that market share.
Andrew: Who's got the other 50% at this point?
Mordechai: So, some of that is going to be the Flash makers themselves.
Andrew: Yep. Okay. Just make a track. Yeah. That's who I thought [crosstalk]
Mordechai: COI[?] is probably the biggest competitor it's a COI[?] is the biggest competitor Bizon is somewhat a merged controller where they sell to a third party. It's a little bit also a captive producer for Kingston a little bit and Kioxia Toshiba who's also an investor who signs on. [crosstalk] call them virtual controllers you can look at that a little bit as a joint venture arb of Toshiba and Kingston.
Andrew: You've talked about how a lot of the potential competitors have come in and given up or lost a lot of shares, if I just said Mordechai of the controllers, of the Flash controllers out there, what percent of the outsource market do you think Silicon Motion owns and what percent of the overall controller market do you think is Silicon Motions ends? What would you say?
Mordechai: It's hard to give an exact number on that. The module makers, SSDs, have about 70% of the share [crosstalk]
Andrew: 70? Seven zero? Yeah.
Mordechai: Seven, zero on the module makers as a client SSD. OEM SSD there have around 50. So [crosstalk]
Andrew: That's overall, that's not outsourced. That's overall, also, including the stuff that the Flash makers are making into. So, they all the divisions they've got the majority. I mean, if you've got 70%, obviously your multiple is bigger than [crosstalk] competitor.
Mordechai: [inaudible] in OEM. So, I would say that they have [inaudible] of guess, 5% share of [inaudible]. And the eMMC, it's a little harder Fry's and I think is much larger than eMMC market than the client SSD market. I believe so, that the overall... the Silicon Motion has about, it's hard to say [crosstalk]
Andrew: It's fine. Let me just jump to a question that I think, look I'm a journalist, I think a lot of people who listen to this podcast are journalists, but not a lot of people are semiconductor experts, right? But I do think a lot of journalists were here to say oh this is a great story, right? You've got an itchy product; you've got a company that has the majority of the market share. We've already described how it's a growing market. We've already described how I mean, you've anybody who here is, hey, [crosstalk]
Mordechai: I think I misspoken when I said, and I was referring to the outsource market when I said those things.
Andrew: Okay.
Mordechai: [inaudible] outsource market. Samsung does all the clients as these almost all the kind that says he's our in-house by Samsung and that's about 34 inches in the market. If Samsung ever decides to outsource the client SSD, that will open another avenue of growth. [crosstalk] market probably will close to 40%, 30% of the entire market.
Andrew: Even there's that huge, tell me do they have a partnership with Samsung right? Like, Samsung has already worked with them, and I know in 2023, I think they got a partnership in [inaudible] Samsung work.
Mordechai: Yes. Samsung it also an eMMC there [crosstalk]
Andrew: But I guess you know if you're a journalist and you're hearing a lot of good sources here, but I think any journalist can hear oh they serve the Flash right market, and every journalist has seen Micron at one point. You know, when the stock is just for people who aren't on YouTube stock is a wave, right? You know, you're hitting a cycle and there's a bad flash cycle and prices go to hell. And, you know, it's oversupplied, and Micron stock is down 80% in a year and then 2 years later tight supply prices are going through the roof. Micron sucks a 5x inside a year you know like everybody has seen the Micron suck and I think people are going to bullet effect all the serious up here and say oh these guys are supplier flash; we've seen what happens to Micron stock. Why are these guys not going to be super cyclical yes, we're going to talk about the low-key as we talk about the growth story. But you know, everybody knows CMEs are getting crushed right now, why? When people look at these in their thinking the fundamentals story. Are we dancing? Oh, next year's going to be bad as oversupply flash polls back all that and I would add I guess all that stuff from the proxies in a second but I'll just I'll pause there on that question.
Mordechai: That's a great question and the great question to bring out why this has no similarity to Micron at all. Micron when Flash prices go down for its Micron consoles Flash and they end up selling negative margins and losing money. Well, Flash prices go down that does not hurt a Silicon Motions business at all that she hopes Silicon Motion visits. As Flashing prices go down, it's more attractive than the remaining hard drives or the main part of computers that are still using hard drives, flash drives become more attractive. They get used to more. They are, they are tied not to the price of Flash, but to the value of Flash. If the price of Flash goes down and its value comes up that helps the Silicon Motion story. Silicon Motion is selling the controller if the controllers are different businesses, the more Flashes sold, the more controllers are sold. If the Flash is used less that would hurt Silicon Motion. But in terms of the overall usage of Flash in the market, both a percentage of what's due to hard drives were through the Flash. I mean by now I mean they ready almost not 100% but it's getting pretty close to maybe 20% of the computers still using hard drives. I don't know exactly what the percentage is for our data centers. I might be even less depending on the type of things that they're the ones that need high performance, like Google now about of the world are all basically what is necessary. But now so, the value of this is just growing everywhere, Flash memory, besides the percentage, and the market share, the Flash memory has all of the memory of the storage space.
The storage space that's exploding data centers has been more and more, more memory, as an automotive, internet things everywhere Flash memory is being inserted. Flash memory could crater that helps a business nap. I want the one caveat on that to go back to the 2018-2019 cycle where the Flash memory crater hurt their business. Now I just said when Flash memory goes down that helps them. So, [crosstalk]
Andrew: You're cutting off my next question. Go ahead.
Mordechai: The answer is that in 2019, most of their business was still module makers. Module makers, although they benefit from a lower course as I said before, they don't benefit from a volatile market, then not only was Flash whoa cratering and the module makers were nervous about being stuck with inventory that was at the wrong price so they didn't want to make large purchases and then the price will go down and they would be stuck with him [inaudible]. The module makers pulled back to the local market and since a lot of the business module makers hurt their top Line secondly, they had their other division which the 10% parts at the time it was structured that they were buying Flash, packaging it, and selling it to Ali Baba. So that was fine and all but then they got some of the inventory risks and they had to take someone off right down on that. Now, all that is said and done, they will be highly profitable during the bad years in 2018 and 2019, their gross margins were close to 50% just like they always are there. Their skill went down a little bit, so the operating margin got hurt but their active margin. They were profitable to are always building up cash. Know that on the balance sheet, by the way constantly profitable even at the time that they were struggling because the module maker pulled back and they have to stop right there and there's still profitable everything said and done. But with the OEM Market multi-year sticky contracts. And by now about 50-60 percent of the businesses OEM Market, a lower, even a vowel comprised won't affect the OEM market. They're buying at high prices and low prices; they're going straight over session which hurts the end market. You know, down to Silicon Motion as well, they have no more visibility to the world economy than anybody else, but they're gaining their kind of double growth story. They're gaining a share in a growing market. It's a secular growth market, memory is a growing market, and Flash is gaining a share in the memory market and their gains share in the Flash which is gaining share. So far, I don't go triple growth if you want any share in a growing Market.
Andrew: Let me just, I hear you. So, this is I think we're sitting this long-term growth story is priced attractively whether you know as you said when the merger got an ouchy thought it was worth more than the merger price and it sounds like you still do. But I do just, I hate to dig into the next year is going to suck angle, but I do just want to dig into that a little bit more. You know, I look at so as part of the merger and we'll come back to the merger Arbitrage in a second, they polish a proxy, right? And I believe the pot proxy projections were made in late Q1 2022, right? So, they published proxy 2022. They say we're going to; we're projecting 1.15 billion in revenue with an ibadah of 366 million. Through the first, they are they're not going to do a billion of revenue this year, right? And ibadah I don't have the ibadah number, but they're going to come far short of that ibadah number. And, you know, you see that you see, gross margins in Q3 22 have cut. I think gross margins are coming down below 47% for the first time, you know, well, 50% for the first time in a while. Operating margins have come down to 25%, which is kind of where they were at the Navier in 2019, if I remember correctly, they were even lower in 2019.
Mordechai: Yes, actually in 2000, they entered 2021 with 20% operating margins, 2021 brought them up to 27% which dropped a bit down now to 25%, I think over the next few years, I'll be 30.
Andrew: Okay, yeah, because I'm looking at 2000, I was looking at 2019 overall, I was looking to queue for accidentally, but that was 24% for 2019, they did 21% but still, they're starting to get pretty low so I guess just, you know, I'm rambling here but it's easy to say, hey, look, long term, this is growing all this sort of stuff, but I think people are saying, oh, the cycle seems like it's turning, and it seems like it's turning pretty quickly when you're talking about in 5 months going from 1.15 billion projection to under a billion like it seems like it starting quickly and select like it could get ugly.
Mordechai: The projection was 1.2, wasn't it?
Andrew: It was 1.15 for 2020.
Mordechai: [inaudible] That's not, that's not such a huge difference. You said, 1.5.
Andrew: 1.15 under a billion is what they're going to do in 2022.
Mordechai: I have a 10% difference [crosstalk]
Andrew: In March that you're going to do 1.15, so you've already got 3 cores, you've already got 3 months in, and you've got, you've got some predictions on your [crosstalk]
Mordechai: They have no more visibility into all the kinds than anybody else. They can project the next quarter maybe, but not more than that, the rest is just for the customers who are buying them and the customers [inaudible] whether. So, right. What the world the customer will do to semi-conductor to stay, you know, goes up and down, up and down that's why. But you know, if you're going to be the big picture here, in 2018 or 2019, 2020 then draw back to $500 million revenue. 2021, and 2022, will be the step change. The step change occurs in the competitors exiting the market. Spoke back time [inaudible] think about eMMC also yet competitors exiting in the market, they got much more than market share in 2021, 2022 and the basic step change from 500 million in revenue to 1 billion revenues. I want to emphasize that step change was a permanent subject. It wasn't, you know, pandemic drawing in revenue that was [crosstalk]
Andrew: I think a lot of people probably do look at the growth in 22, and 21, and in 2021 and say, oh covid beneficiary, and what you're saying is no [crosstalk]
Mordechai: It was market share gains. The market as a whole didn't grow that much something out in 2022, but its market share gained. They rule out the market share, grew from 500 million in revenue to a billion, and took their operating margins from 20% to 25, 26 is whole now and 2023 this year already has been a year of a lot of suffering. 2021 had, 2020 the huge 20% to 2021 71% on that point. 2022 has been a hard year for the semiconductor industry. They're only going to grow by about 8%. That's bad news. Yeah. So, there are practices that they put out a mark she said don't use approximately we're going to for yourself. Yeah. Instead of growing, you know, 71% in 2021 which was a one-time step change, the growth of 8% is here, but their future growth both in their exiting the year was more OEM slots and they enter.
So, 2023 will probably have a higher market share overall than 2022 and they're starting to enter the Enterprise Market as well. They're sampling now and they're entering probably full-scale production towards the end of next year and that's a Greenfield Market for them. They haven't competed Enterprise Market as well, but they are competing in the client, and I can very well see them doing well in Enterprise Market as well. What would you be just adding growth on top of everything else, but even if they just stay at the 1 billion and then continue to grow as the market grows, and so expect 4, 10, 15, 5, 10% growth, you know, for a while, just in the markets that there right now investing in besides a party Market.
Andrew: So, I know you said, don't look at the proxy, I can't help but look at the proximity. Just want to ask you know you said when this deal was announced, I think they all ended at the time with the MXL price and everything, I think the price was around 110, 115 was the all-in value. Like how do you kind of look at the [crosstalk]
Mordechai: But as soon they announce the market when you drop that's what taking it a lot that grip, we're going to use that from the beginning.
Andrew: How do you look at the value? Because you did not want that price up, do you think it's worth more because when my dump model of it again, I looked at the proxy, even if you told me not to, I was kind of looking like, 2025 unlevered, free cash flow in the proxy is 363 million slaps at 10x multiple and that maybe that's too low, I'm not sure? That gives you to 3.6 and then after I assume they get the break the cash on the balance sheet that could you do about a 4 billion Enterprise Value, that would be about $120 per share price and then I guess I'll just call the cash, they generate till then versus the time, value money, fair value. So that would get me to about 120. Where would you disagree with those numbers?
Mordechai: So, well, first of all, the numbers on 2025 from the practice are made up. That's for sure.
Andrew: Yeah, yeah, I know you do, but management puts that projection out there and I can't help, but just kind of, [crosstalk]
Mordechai: They have no idea of the dancer of the outside that just pulled out of someone's butt. So, like this way, I look at it, is, we're dealing with 1 billion dollars in revenue about 25%, operating margin, there running about $200 million income net income which all falls down some cash $200 million of cashier and their company that I don't know whether they will, they do a presented to them going to approximately. I don't know how much they'll grow in 2023. Maybe, they'll be down, it's already been a year of a tough semiconductor market. A lot of people are thinking that's going to start turning back in 2023. In the first half and the second half, a lot of this has been inventory reduction, so it could start turning around, maybe we'll hit a recession. I don't know, by the end of 2023, I think we're probably most likely to be readily turning back up, but whether yes or not, I don't expect 2023. We're not looking at a 20% up anyway, shape, or margin.
At the most, I can imagine maybe attempting to thank God, I can easily hear temp sensor, even a 20% increase as well. In the long term, I see growing attempts here even if the Enterprise is not successful. If the Enterprise is successful, I can see the Enterprise being another 50% on top of the business that we have now. eMMC and client SSD are both growing, they occur in the end markets, it's a recession so that might fool them for a little bit but at the end of the day, the second growth market, and then I go anywhere, flash is going to use. So, I see it as a $20 million net income, I believe the operating margins can go up over time by 30% as they get more leverage on the operating expenses, as the revenue increases.
So, what are my students annually making the 3 years down the line? I've seen the making probably closer to about 300 million to 50 million. Let's say until 2024, that's the way I see it. And I think that a highly profitable fast road company should be used P of 15. I mean, I think that flow but let's give it a period 15, you know maybe the timing is discount, but you know, yes, I'm sees also Taiwanese company and they don't have a P of 9. Right now, Silicon Motion training is in a battle of and a half, and a quarter of the price is in cash, is in cash current assets, highly, highly liquid assets to be X that out. We're looking at the P of 8 in a half. Yeah, I think they can eat these are double that just to be maybe fairly valuable. Yeah, that's a price of about 130 and honestly even at that point you'd be getting a good company would be a fair price for a great company. Companies continue to grow and continue to be profitable, as I said before, even in downturns, they've been very profitable, and the margins have been pretty steady. The gross margins there, have gone down the path sometimes had years where they were down back when they had them out Jamaica and other issues, they were down, 25% revenue, and the gross margin will almost rack table. The gross margins go between 47, and 49 the margin grows depending on exactly what section of the business is selling what, it boils down to.
Andrew: I just want to point out. You made fun of me for using the proxy number and then your endgame. The earnings never you throughout were 350 millionaires, which is what I got from the proxy as well.
Mordechai: That proxy was in 2025, I believe that [crosstalk]
Andrew: That is true.
Mordechai: I have that a little bit earlier.
Andrew: I'm a little worried about time and people always laugh when I say, oh, our long podcast like we could go 2 hours on a lot of these names. But I want to turn over to the merger arb by starting with what I think is kind of important thing both for the fundamental and the merger arb case. And that is, why did MXL decide to buy Silicon Motion? Right? Because I think when you see that it helps, you think through both the merger Arbitrage case, and it helps you think through the fundamental case. So, I'll kind of flip it over to you on that.
Mordechai: Well, honestly, I think the reason is that XML, CL was bored and wanted to increase its system. Their serial acquires, they inquired other companies they take on allow desperately, I don't know whether it will turn out well. So maximum shareholders honestly, maximum shareholders didn't get to vote on it if they voted on it, it probably would have declined because of the lecture that if you get to vote on it because they were giving away enough shares is mostly a cash transaction, which is probably why they structured that way they can take on a lot of debt. That's going to be more expensive with the higher interest rate now, I wouldn't be a holder of Max Lanier firstly there, the voting into the loading, the loaded, to the help of debt, and they're adding more. But there, it's, just trying to become a bigger semiconductor business day. They, the way they say it is they want to have a larger kind of skill with the SMC and with their other semiconductor suppliers and manufacturers to be able to get better prices and better allocations etcetera. And maybe there's a grain of truth to that but immune light post at the end of the day, I think the CEO wants to be CEO of a larger company.
Andrew: So, look, I think you're probably right MXL stock drops 20% the day that they announced this deal. It is a big premium deal when they announced it. A lot of decades taken on not a lot of shares big dead, but so I think you're right there that does speak some concerns there, right? Like they say, hey, we're buying this company with a lot of debt for, let's call it. 110 per share whatever the number was like, if the market thought this stock was worth 150 per share, even if they were questioned, they be like, oh, you ride that with all debt. There are synergies here, the market, you know, goes to the roof.
Mordechai: I don't know how much its synergies are real onset I think that synergy is usually overwhelmed. They probably don't that manage synergy being that they're not in the same niches of the market. They can't ring the name. What's the name expensive Silicon Motion? The main expense of Silicon Motion is 1200 Engineers, and they have 1,400 employees, 1200 Engineers. They can't keep all those Engineers. Also, during the thorough engineering work, they not going anywhere. And then the next expense is the PayPal out and the paying TSMC they're not going to [inaudible] on that. TSMC is not going to go to Max Lanier, and say, oh, so now you're bringing me Max Lanier, Ansel commotion, business, will you give you 20% discount? I doubt it. I doubt that they're going to get much of a... This will give me time TSMC, and there's still going to be price takers on whatever TSMC, you know, charges that the customers. I don't think these synergies are that real. I think that is concerning but as you say, even before the merger was announced that the price was trading in the market for $70 and I think we're more. So yeah.
So, I think the market had a dim view of the fundamentals I think the market mostly is comparing it too much to Micron as I said before, not recognizing that they're not cyclical, like the Flash makers themselves are 2 are not attuned to how much of the competition has exited the market. We spoke on the client SSD side with Marvel exiting, Kingston something starting to use them instead of their joint venture, and the OEMs getting more and more shares going to 25, 30, 40, and 50% of OEM shares and more and more of the Flash makers, outsourcing their clients as these 2 Silicon Motion. If you talk about the eMMC, sorry to the equation, the eMMC is supposedly Legacy technology. Low-end smartphones, the higher-end smartphones are now using UFX, but the eMMC might be Legacy, but it's growing very quickly.
The low-end smartphone market still growing, and the Internet thing is being used then it's going very much there as well. And the eMMC market in 2021 Samsung decided to Texas, their Fab in Austin with a freeze there and abstract closed down to walk through start. Samsung decided that the eMMC market no longer care for them, they don't need to make those controllers. They're still making a Flash for controllers and they're going to make, they're going to answer the controllers to Silicon Motion. Among other Silicon Motion, the largest eMMC version controller out there, they're doing a lot, a lot of volume on the eMMC market.
You could look at the difference in the first half of 2021 before Samsung is in the market, they were growing their eMMC division by about 50%. In the third quarter of 2021, they quadrupled, and their growth went to quadruple, just get to the difference between in having to get better and not having a competitor. So, eMMC is that as hard they grow, and then you UFS which is the sequel know the high end and the mainstream of smartphones and tablets. They went from originally; they were the exclusive supplier to SK Hynix eMMC one of the things that when what wrong for them in 2018-2019, we spoke a little bit about what went wrong, and anything went wrong at the same. SK Hynix in their transition from eMMC to UFS decided not to use Silicon Motion of doing it in-house. Yeah. So, they lost over a few years. They lost a large chunk of that business and SK Hynix, eMMC business, turn to SK Hynix is UFS business which wasn't using them. So, they lost a good 23% of their revenue or so. So that was a large chunk. They made it up with eMMC to other customers and made up with UFS's other customers. They were the exclusive or are a supplier to Microns UFS, and they went from 1 UFS customer to 2 UFS customers in 2021, the 7 UFS customers in 2022.
Andrew: Just quick, the customer who decided to in-house, look, you're more familiar with them. When I do these podcasts, I generally look at the most recent, 12 months, and stuff. Could you just talk more about that? Because it does strike me like, we've pitched this. Hey, they're taking share, they are all these competitive, but you have 1 customer who decides at the time it sounds like they were 20% of the business and I do remember you mentioned this in the video. You did know that I kind of thinks back on it. But can you just mention why that customer made the decision? Why this, isn't as big a risk as people might say because I do think anybody's listening to it. Probably heard that it said, oh, somebody took 20% of the business way in-house in 2018 like there's a risk we haven't thought about so far.
Mordechai: Yes right. So, I cannot tell you exactly what was going through SK Hynix in minds, you know, they decided to take the position, so they thought they do well honestly, I think it ended up being too important for them. SK Hynix is not so large in the UFS business, and a major part of that is because Micron with Silicon Motions controller bit more of the business of the UFS Business Market away from SK Hynix. It's behind the, had not a lot but had a very large position in the eMMC Market. And when they transition to invest in their controller, they lost a large part of their position in the market, to competitors, who use Silicon Motion controllers, I don't think that works that well for them. They replace their UFS, they're non-existent USF as Skyonic they replace with Micron with other customers and tell other customers that are using that UFS and they replaced all that, you know, usually, you find a company to lose, 20% of the revenue that snap something that usually 2 carbons easy to recover from. But if you look at their revenue over the years, it's not so easy to pick out where that 20% of Wilson's, is because other parts of the business are growing in such a way to cover that up. They had that, and the module makes without the price volatility of module makers, and their rivals, those kinds of everything going wrong at the same time and still there were doing quite powerful and not growing, but 2019, 2018, and 2020, they were trading water as they turned over SK Hynix business to their other customers. But UFS has grown for them, posting 30% year-over-year nowadays. So, that's continuing to grow and basically, all parts of their business right now are in growth mode.
Andrew: That's perfect. I just want to come back wherein we're pretty lag. I just want to come back to the few things we mentioned why is MXL doing it? I do just want to, they say 100 million, and synergies, on the whole, the 2 combined companies would have liked 570 million in pre-synergies operating income. I'm with you, I think that's a high Synergy number these 2 businesses don't exactly fit hand in glove, but at the same time, if you go through the filings Max Linear, does kind of have a history or at least they say they've got a history of way exceeding, Synergy targets and mergers. So, I mean a hundred million on again, 570 million increase synergies, even that's a big number and maybe think they can exceed it. So maybe you give them some credit there. I want to just quickly, look at the merger, are it sounds to me, and I think you would agree you're playing this for the fundamental value.
If the Arb happens, I mean, you think is worth more long-term but if the Arbs happens great, it'll take the 60% pop in a day, I guess. I think you can tell me if you feel differently. I think it's a very not 0, but I think it's a very unlikely chance you know, just China has not approved semi-MNA[?] and a long time. And after what the Bidon[?] administration did to China semi-industry, a couple of months ago, I don't think they're approving any more going forward. You know, I do worry about people who listen to Rogers, and it was either [inaudible] I can never remember them too. They had a merger, it was trading very tight, Samir kind of walked it out, and then in early November Dow looked at Rogers at oh, this stock would have been worth 60% less than what we're paying for it. We're just going to walk because Samir didn't approve, and Roger's stock went from like 50 to 100 in three days. I do somewhat worried about that with SEMO, but the nice thing here is everybody knows that China is going to block it so it's not unexpected.
Mordechai: If the PE drops from 11 half to 3 I'm going to start my 11 by out to take over the company.
Andrew: I do just want to ask you then. So, let's say this most likes these icy most likely, not a guarantee but the most likely scenario, is Samir blocks this in August or so, or they just don't approve it and Max Lanier walks. So, PSI mode at that point is going to be a standalone company. They're going to get $160 million in break fee for Max Lanier, that's about $120 tax adjusted that's about $4 per share, they've got 250 million in cash on their balance sheet. You have to think, they'll probably generate a little bit more even if how [crosstalk] turned down in the near term, they'll generate more cash [crosstalk]
Mordechai: [inaudible] over the year.
Andrew: So, I just want to end capital allocation. And I know what they've done historically you know what they've done a story but what do you think they do? They emerge the thing breaks. What do you think they're looking at in Capital Allocation going forward? Kind of 2013 [crosstalk]
Mordechai: [inaudible] dividends. That falls for the merger dividends for the share come back maybe a larger, large amount that doing pretty good at increasing dividends over time. They've generally been conservative in terms of holding this amount of cash at a certain point, even they felt was ridiculous, and unlike most companies who buy back shares only when they're expensive. And then when the markets crash and things, get a little nervous, they pull back on buyback surprisingly, it has been above average in capital allocation and they have been buying back shares at loans at large buyback that they've done opportunistically in 2019, and earlier this year, before the merger was announced [crosstalk] low amounts and if the deal broke and the stock was still holding at 60, 65, I expect them to do a large, a large share buyback simply because of the be, a lot of cash would be close to 450, 500, 600 million of cash on the balance sheet. I would expect them to announce, a buyback immediately and either do it or not, depending on what starts, because they seem to be pretty good at buying back stock, is a stock as well, and buying back less stock [inaudible]. So, that's good.
Andrew: So, it just a couple of points on that dividend they used to pay I think it was 50 cents per share per quarter, is that right? About $2 per year? So, you think that's coming back, if, if the deal breaks?
Mordechai: Yeah, for sure, and that might come back at a higher now.
Andrew: That's about 50 million in cash per year, and then, as you said, they've historically been pretty good about buying back shares like look, I don't know many semiconductor companies, it's not like they went Whole Hog on it, but they bought back shares in 2020. They bought back shares when they were having the customer issues, we talked about earlier in 2019, and 2018 like these guys do return cash to shareholders. So, I would not be surprised if the deal breaks, and they get tax adjusted 120, 130 million coming in. They've already got the cash from that. I would be surprised if they did a tender for 10% of the shares. I wouldn't be surprised if they got pretty aggressive at taking shares out and, that speaks to a management team that sees value in their shares, rewards shareholders, both that in the dividend, all that sort of stuff, anything else on the capital allocation we should be talking about.
Mordechai: Nothing comes, nothing comes to mind straight down. That's it.
Andrew: Perfect. Hey Mordechai, the last question I've always asked we covered a lot here, we go, I do think we glossed over the MNA angle both for time reasons and because I think both of us think unlikely it would be bookish, but anything you think we kind of glossed over, or you wish we had hit harder or anything we didn't even touch on that you think people should be thinking about here.
Mordechai: Give me minutes to think about it... No, I think we cover all the bases. High-growth, profitable, lower risk of that competition with evaluation. That's why I have 5 companies like this. I beset; I'd be able to take a vacation.
Andrew: Well, hey, Mordechai I appreciate you coming on for people Mordechai. I'm going to include a link to Mordechai's deck on Simo in the show notes. So, go check that out. It's a 15-page death that nicely goes through everything we just spent an hour talking about, and here's the thing, you run 5 stalks, you and I had Twitter and comment earlier this year and I won't disclose them. But I know you and I have 2 other stocks in common right now, so we might have to have you back on the podcast. One of them would be very spicy in terms of the online Twitter outrage if we did it, we won't mention it here but Mordechai, I appreciate you coming on, I think this is great and we'll have to do it again in the near future.
Mordechai: Yeah, thank you for having me. Good stake with you.
Andrew: Thanks to you, man.
[END]
Thanks Andrew and Mordechai. This is now very topical. Wow.