What: Shares of NXP Semiconductors (NASDAQ:NXPI), a company that provides semiconductor solutions for the automotive and mobile industries, jumped $6.08 -- better than 6% -- on Friday to close at an all-time record high of$104.67 after Wall Street research firm Needham & Co. initiated coverage on the company.
So what: According to Rajvindra Gill, the covering analyst for Needham & Co., the recent merger announcement between NXP Semiconductor and Freescale Semiconductor (UNKNOWN:FSL.DL) will create a semiconductor powerhouse. In case you missed that deal announcement on March 1, Freescale shareholders will be receiving $6.25 in cash and 0.3521 shares of NXP common stock for each share of Freescale that they own.(UNKNOWN:FSL.DL)
Based on Gill's assessment, the merger transforms NXP/Freescale into the fourth-largest semiconductor company (if you exclude memory developers), the leading supplier of semiconductor solutions to the automotive industry, the leading global provider of general purpose microcontroller products, the leader in mobile payment-based semiconductor solutions, and an Internet of Things powerhouse. Needham anticipates its market-leading positions will result in unparalleled leverage and substantial profits that it believes could top $9 in EPS within the next several years.
Taking this into consideration, Needham & Co. initiated coverage with a "strong buy" rating and a price target of $140, or 34% higher than where NXP closed on Friday.
Now what: The real question that investors have to ask here is whether this merger and NXP's leading position as a semiconductor solutions provider for all things interconnected is worth $140.
On one hand, we have two big concerns. First, NXP's valuation is beginning to head into the stratosphere. If the company were growing its top line at a double-digit rate over the long term that would be one thing, but go beyond 2015 and its top-line growth is projected to slow to the high single digits. Based on its forward P/E of 18 we're approaching a PEG ratio of two, which is sometimes a good point to sell a stock. Also, the technology sector is cyclical, and with six years of low lending rates and the Federal Reserve likely to begin hiking its federal funds target rate, investors have to be thinking a sizable correction is coming sooner rather than later.
But we also have a company that's set to completely revolutionize how devices connect with one another. From our cars to thermostats and refrigerators in our homes, NXP's solutions could be the catalyst for much of that change. It's also not hurting that Apple Pay is showing signs of early strength and finally providing credence to the near-field communications chips supplied by NXP. Even the valuation isn't too far-fetched as long as its long-term growth prospects remain in the high single digits.
Ultimately, I do believe $140 is achievable, as NXP's importance in connectivity continues to grow right alongside its margins. However, I also wouldn't be surprised to see traders push this back below $100 over the short term as they try and get a grip on what this merger will mean for shareholders and the company's long-term profitability, as well as whether NXP deserves the premium it's currently carrying.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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