The Nvidia-Mellanox Deal: Expected Annualized Return Of 21.06%

Nvidia is buying Mellanox in an all-cash deal.

The spread is very wide as the market expects Chinese regulators to block or delay this deal.

Weighing the relevant variables I've allocated some money here.

Nvidia (NVDA) is buying Mellanox (MLNX) but the market doesn't like this transaction as indicated by the wide spread on this cash deal. Most likely because Chinese regulators need to sign off on it. They never did with the widely-followed Qualcomm (QCOM) and NXP (NXPI) deal which caught a lot of arbs off guard. I also lost money on that potential deal. I think this recent historic event explains most of the fear around this deal.

In this case, the downside is interesting as well. Although there were other interested parties for Mellanox, just like in the Roche (OTCQX:RHHBY) and Spark (ONCE) deal, in this instance, a break is much more unfavorable if based on Chinese objection. The problem being trade tensions and regulatory approval will also become an objection to other bidders. I've taken the break price down to $72 to reflect this. I believe most arbs use a higher number and I could be way conservative.

Nvidia's CEO talked to Jim Cramer in the clip at the end of this article. Skip to the 5:07 mark when Cramer asks him about the merger with Mellanox. He says "I think China is going to love it." Then proceeds to say absolutely nothing. He just blabbers about a box, which really reminded me of Gavin Belson in the TV-show Silicon Valley.

I did not find his comment particularly reassuring nor the recent Nvidia earnings call where an exchange went like this:

Analyst

Got it. This is a quick follow-up. I just wanted to ask about the regulatory around Mellanox in the context of what we're seeing out of China now. How do we sort of gauge the risk of potential further deterioration in relationship sort of spilling over on the regulatory front around deal. I we've seen that obviously with some of the other large deals in the space. What are your thoughts on that?

Jen-Hsun Huang

Well, on first principles. The acquisition is going to enable data centers around the world whether it's U.S. or elsewhere China to be able to advance much, much more quickly. Now we're going to invest and building infrastructure technology and as a combined company, we'll be able to do that much better. And so, this is good for customers and it's great for customers in China.

The two matters whether it's -- the two matters that we're talking about just are different. One is related to competition in a -- with respect to our acquisition to competition in the market. And the other is related to trade. And so, the two matters are just different. And in our particular case, we bring so much value to the marketplace in China. I mean I'm confident that the market will see that.

Weighting upside, downside, and probabilities of closing, I think the spread is now so wide at 11.69% gross, I should allocate some money here. There are two ways to win: 1) If fears subside ahead of the actual go-ahead or 2) if the deal is closed.

If it breaks there is quite a bit of downside though. If China wants to use this deal as leverage I expect it won't reject outright but just keep delaying approval for a long time. That's much more effective because by keeping the deal in Limbo it will retain the leverage.

Taking into account the expected closing date, estimated break price and my estimated closing probability, I think the expected annualized return is over 21.06% here. I calculate expected annualized returns for every deal I'm interested in the M&A Dashboard. The expected annualized return isn't just the return in case of success but includes the failures as well. It is a higher bar compared to just the annualized return if the spread is closed.

Some of the important and subjective estimates that go into it are the probability of closing which I put at 92.5%. That's a low closing probability among the universe of deals but it is high compared to real tough cases like Sprint (S) T-mobile (TMUS) and Oceanwide/Genworth (GNW). The break price is another subjective estimate that I put at $72 but I've heard many arbs use a higher number. As a closing date I'm working with 12/1/2019 but one of the major fears here are endless delays.

Conclusion

These China deals don't feel good to invest in. However, if I look at the cold hard numbers and try to weigh the probability of a block as objectively as possible, the spreads are irresistible. There are even better opportunities than Nvidia/Mellanox but an expected annualized return of 21.06% is nothing to sneeze at and I've added it to my portfolio mindful that it adds the same risk included in other China-related merger deals.

Disclosure: I am/we are long MLNX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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