the announcement

Last Thursday INTC issued a press release and held a web news conference announcing that it had reached an agreement with the board of directors and top management of McAfee to acquire MFE for $48 per share in cash.  This would be a total of about $7.7 billion, or $6.8 billion after subtracting the cash MFE has on its balance sheet.

Assuming regulatory and shareholder approval, the merger could be completed before the end of this year.  Presumably, the two firms are aiming to have this happen, to save the effort and expense of producing a superfluous, pre-merger set of audited accounts.  Senior management of MFE have agreed to stay on at INTC for an unspecified period of time–probably at least a couple of years–operating as a more or less autonomous unit and reporting to one of INTC’s division heads.

the numbers

MFE rose almost 60% on the news, to $47 a share.  INTC fell about 3%.  To me, this looks like ordinary risk arbitrage activity, making a statement that no other bidder is going to emerge (I can’t imagine who would) and that the deal will face no real obstacles to completion.

Over the past five years, cash generation at MFE has been growing at about a 15% annual pace and now stands at a what I estimate to be a touch over $3 a share annually.  There are enough unusual non-cash expenses charged against operations that net income is only about 40% of that.  But because earnings are so unreflective of cash flow, I think they shouldn’t be the standard used in evaluating whether the acquisition makes financial sense.

MFE has no debt and about $2 a share in working capital, a quarter of that in cash.  Net of cash, the acquisition cost is $46 a share.

INTC says that, ex unusual items, MFE will be accretive to INTC earnings immediately.  This is at least in part due to the fact that MFE’s profits will replace interest income on the cash deposits INTC will use to pay for the MFE shares.  At today’s rates, that income has to be very close to zero, so being accretive right away isn’t saying much.

Let’s assume I’m correct that current MFE cash generation is about $3 a share and is growing at a 10% annual rate (given competition in the internet security business, that may be high).  Let’s also say that the appropriate rate to discount MFE’s future cash flows back into the present is 5% (that’s probably too low, but its halfway between the zero INTC is earning on its cash and the 10% it would cost the company to issue new stock).  On these assumptions, it takes MFE about ten years to pay for itself.

That’s a long time.  So the rationale for the acquisition can’t be that MFE stock is really cheap.

INTC’s reasoning

The company points to the rapid increase in size and sophistication of cybercrime in recent years.  It argues that by putting MFE security software directly onto INTC silicon, the result will be a defense against viruses, malware…that is more hackproof than a purely software solution and that lets a computer to run faster.  By owning MFE, INTC will have complete control over any products of this type that the two develop.

I’m sure that INTC wouldn’t put it this way, but it also sees the rapid proliferation of non-traditional mobile computing devices–namely, smartphones and tablets.  Although INTC dominates the netbook arena, it has virtually no other presence in mobile.  Cellphone developers regard INTC microprocessors as too big, too clunky and not customizable enough.  As I wrote about earlier this year, for example, an INTC-TSMC joint venture to customize Atom chips was put on hold.  Why?  –no takers.

But what if security became the same sort of all-important issue for cellphone-like devices that it is for traditional computers?  A software-only defense solution is likely to use a lot of valuable storage space and processor time that a hardware solution on a much more powerful chip (no one disputes the superior processing ability of INTC mobile chips) could look very attractive.  So INTC could have a second lease on mobile life.

who thought this up, engineers or marketers?

Marketing firms find out what people want and then figure out how to make it.  Engineers, on the other hand, tend to first make devices that are great achievements of applied science and then go out to try to find people who will buy them.  The first kind of firm (think:  AAPL) is typically very successful.  The second (think, unfortunately:  MSFT or INTC), not so much.

If this were ten years ago, it would be easy to convince me that the INTC engineers were the motive force behind the MFE idea.  With the much stronger management in charge today, I’m not so sure.  INTC may be ahead of the consensus this time.

arguably MFE makes INTC more attractive, not less

Also, INTC is currently generating about $500 million a month above its capital spending and dividend needs.  So MFE amounts to less than a year and a half’s free cash flow.  Even in the highly unlikely event that MFE ends up a total writeoff, the after-tax loss to INTC would be about $4.5 billion, equal to the cash it takes in three or four months.  The point is:  by almost any measure MFE is very small relative to INTC.

In short:  I think the downside to INTC from acquiring MFE is small.  Although I have no sense of how probable, the upside from playing a key role in the next generation of mobile computer/cellphone devices is large.  So I can’t fault INT for taking the chance.