August 15th was not supposed to turn out the way it did, if you were a member of the Mentor Graphics executive team. Ever since Cadence public offer to acquire it for $16.00/share, Mentor had been busy doing due diligence and building a constructive response to the unsolicited offer. At the end of June it retained both Goldman Sachs and Merrill Lynch to advise them on financial matters. Then it did what any rational company would do: it made sure that its key employees would have financial security in case of a takeover and re-organization (read layoffs). And when it thought it was ready, it told Cadence it was ready for those face-to-face talks that Cadence executives desired.
The first direct discussion between Cadence and Mentor on the subject of the proposed acquisition was scheduled for August 15th.
Instead, Cadence issued a press release stating that it was abandoning the effort to acquire Mentor Graphics. So much for all the work. That Mentor was taken by surprise and that it was somewhat disappointed by the news can be seen in the following sentence taken directly from their press release "Mentor Graphics notes that this withdrawal is inconsistent with both Cadence's recent public statements and recent communications between Mentor Graphics and Cadence." But, should a new suitor materialize, Mentor is ready and the bottom offering price will have to be $16.00/share, so not all is lost.
What Cadence said and did
The public trip from "we want you because it makes sense," to "we are not interested," required very little time. In fact, things went very wrong for Cadence in the last sixty days.
On June 17th, the day after the public announcement, I wrote that there would be significant anti-trust issues raised about the proposed acquisition. During the ensuing weeks Cadence continued to say that it was working with the Federal Trade Commission (FTC) and that it expected a quick approval since it saw no "restrain of trade" issues in its plan.
Cadence also stated that it had lined up financing sources for the deal and that the deal itself was not dependent on obtaining said financing. I always found the two statements a bit puzzling. On the one hand you are working to obtain financing before you finalize the deal, but on the other hand you do not need such financing. What the second statement really meant was: we believe we can obtain financing for the deal on terms that are favorable to Cadence, and thus the deal makes sense from a financial point of view.
Finally, I have also learned that the acquisition was not, as I first assumed, Mike Fister's idea. I am thus offering my apologies to Mr. Fister for defining the proposed deal as his Napoleonic gamble. In fact the Board of Directors of Cadence instructed Mr. Fister to go make the deal happen. This is a problem because there is no single champion for the deal that is so passionate to perform miracles to see his or her idea come to a positive conclusion.
Reality did not collaborate. First of all Mentor did not think the deal was so sweet to rush into acceptance. This Cadence must have expected. You offer 16, they want 23, you offer financial security to key executives and raise the bid to 17, they come back with 20: you get my drift. It turns out that all this probably went on, and this part of the negotiations was progressing according to expectations, since they had agreed to meet and talk directly on Friday August 15th.
But on July 23rd Cadence reported Q2 revenue that showed a 92% plunge in second quarter profit from the previous year, forecast a significant third quarter loss, and halved its 2008 operating cash flow to $175 million. It also issued an outlook for fiscal 2008 revenue that was well below its 2007 results, by about $500 millions in fact. This was a very big problem with securing the financing of the acquisition. The company lost over a third of its equity value almost overnight, and its near term financial health outlook took a decisive turn for the worst. The result was that financing became much more expensive than had been planned. By the time the new numbers were used, the cost of the acquisition became a real challenge.
Just like any individual, companies looking to borrow money are assigned a credit rating, usually based on the exotic sounding "debt-to-EBIDA ratio". EBIDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization" and is a fairly accurate measure of the ability of a company to repay its debt on time. It works inversely of your credit score. The higher your score the easier to obtain a loan and the lower the interest you will have to pay. Companies want a low debt-to-EBIDA number. According to an article by Gerald E. McCormick of Reuters, a score of 2 or 3 is considered safe. But Cadence number is close to 4 and is likely to go higher.
To complicate matters another reality hit Cadence square in the face. The FTC, as most EDA analysts had predicted, decided that the transaction required a second look and an analysis that would stretch into many months. The outlook for the EDA industry and for Cadence for next few months is not positive, the general economic picture worldwide is sluggish, and that includes semiconductors sales.
In a couple of days, on August 20 to be precise, Mentor is due to report its financial condition. I suspect it will show to be in a better position than Cadence. Thus its contribution to the combined company would be more substantial than what Cadence had valued when it offered $16/share. This explains Mentor's eagerness to enter in direct negotiations after having been so reticent (before Cadence announced its fiscal results). Given the new conditions Cadence would have to raise its offer and negotiate from a much weaker position. And so Cadence gave up the quest before Mentor had the opportunity to humiliate it by arranging a merger on its terms.