June 17, 2008

Mentor says Cadence offer too low

Fraught with regulatory issues

By Bolaji Ojo

Michael J. Fister of Cadence Design Systems Inc. wants to buy Mentor Graphics Corp. Badly. However, industry observers believe Fister is unlikely to get Walden C. Rhines' company on his current terms notwithstanding the double-digit premium Cadence is willing to pay for Mentor.

In order to close this deal, the largest in recent years for the beleaguered EDA market, Cadence would either have to increase its price — a scenario industry observers consider unlikely but which Mentor Graphics appears to be suggesting — or offer significant concessions to Rhines, chairman and CEO at Oregon-based Mentor Graphics.

In a statement Rhines said Mentor Graphics considered Cadence's proposal and rejected it initially because the company was also concerned regulators might not approve the transaction.

"As we recently indicated to Cadence, we reviewed Cadence's proposal and analyzed both the price proposed and the risks associated with obtaining antitrust approval for a combination between the companies," Rhines said. "We concluded that not only was the price insufficient to support a transaction but that the risks of not gaining regulatory approval were sufficiently high that the ability of the parties to consummate the transaction would be in jeopardy."

Observers have long called for increased consolidation in the EDA market on the contention that the sector was fast losing pricing leverage with customers while the absence of a large start-up base was starving the industry of venture capital and equity shareholder interest.

The proposed $1.6 billion Cadence-Mentor Graphics deal wasn't expected, though.

Many assumed Cadence, which in the last few quarters seemed to desperately need to reinvigorate its weakening sales, would go after much smaller Magma Design Automation Inc.

Apparently Magma wasn't big enough for Fister who is instead going after a much bigger target with a potentially bigger payoff if the two companies could agree on a deal and successfully pull off what analysts contend might be a difficult integration of very different corporate cultures.

"A combination [of Cadence and Mentor Graphics] would result in an EDA powerhouse, one that would offer serious competitive threat to Synpsys," said Mahech Sanganeria, an analyst at RBC Capital Markets in a research report.

Sanganeria, like many other analysts including Gary Smith of market research firm Gary Smith EDA, expects Mentor Graphics to fight the deal. (see: Analyst: Cadence/Mentor merger "a bad idea")

Sanganeria believes Synopsys could even make a counter offer for Mentor Graphics because a successful conclusion of the Cadence-Mentor Graphics merger could pose a major challenge to Synopsys. "We will not be surprised if Synopys offers a counter bid," Sanganeria said. "We expect Mentor's management to fight the offer. This could get real ugly."

Cadence was then forced to take the now hostile offer public, according to Fister during a conference call.

"The valuation is full and fair and we feel it's a shareholder friendly proposal," Fister said. "It is beneficial to shareholders and customers. It is very financially beneficial for us as well."

A successful acquisition of Mentor Graphics would reenergize Cadence at a time its revenue growth was just beginning to decline. The company is forecast to report lower sales in 2008 versus the prior year as competition heats up and as average selling prices drop off in its market.

"Cadence is in big trouble and the only way to save the company now is through an acquisition," Smith said. "They created a bubble in their billing and they are dropping behind in technology especially on the IC side."

Smith believes Cadence offered to acquire Mentor Graphics because it is the company's best option to avoid even faster revenue decline although he believes Magma would have been the better choice. "The synergy would be better with Magma," Smith said. "Cadence has the front end covered. Magma would bring in the back end."

Analysts said the main attraction of Mentor Graphics for Cadence is Caliber, Mentor Graphics' physical verification business, which RBC Capital Markets' Sanganeria believes has over 60 percent of the market. "Neither Cadence nor Synopsys has anything close," he said.

Mentor Graphics is not going to fold easily, though.

Analysts said the company, though struggling, is one of the better managed in the EDA market and its savvy sales force is reputedly an attraction to rivals.

Yet Mentor Graphics has been rewarded with lukewarm valuation by investors. Prior to Cadence's public offer, Mentor Graphics stock price had only recently begun recovering after slumping to a 52-week low $7.52. Cadence's $16 per share offer is closer to the 12-month high of $16.50.

Industry observers said they expect Mentor Graphics to fight the offer because chairman and CEO Rhines believes the company is better off as an independent entity. Nevertheless, the huge premium Cadence is willing to pay, combined with the industry-s push for consolidation may make it difficult for Mentor Graphics to remain independent.

"Whether Wally Rhines likes it or not, Mentor shareholders have just been given a nice opportunity to cash out," said Sramana Mitra, an industry consultant and entrepreneur. "EDA should not have so many players and this incessant price-war."

While financial analysts applaud this transaction, there are huge obstacles lurking ahead, however. Sources point to the different corporate cultures at the two companies that might make integration a headache for the combined entity.

Additionally, Cadence will be taking on new debts totaling $1.1 billion to close the acquisition. Combined with its current debt load of $500 million, the company that emerges from this transaction could end up with long-term debt as high as $1.6 billion, a hefty burden for a company operating in a sector that requires high marketing and R&D costs.