Two ways of looking at the same thing
On 24th September, the world’s largest chip manufacturing equipment maker U.S. based Applied Materials (AMAT) announced its intention to merge with world number three Tokyo Electron, resulting in a company which will be twice the size of its next rival.
AMAT’s executive chairman Mike Splinter commented on CNBC that he believed “the regulators will look closely at this deal” but concluded that he is “confident it will get approved”. Not so according to the same CNBC’s Jim Cramer who declared “This deal will not go through. It will absolutely not go through”. There is only one absolute certainty: one of these two gentlemen is right!
Market dominance: the helicopter view vs. the microscope
In his categorical prediction, Jim Cramer also refers to some of the U.S. Regulators’ recent decision, particularly their opposition to mega mergers in the airline industry (see American Airlines – US Airways article on this blog site), which follows years of relative leniency during which industry consolidation was seen as a necessary evil to remain competitive in global markets. The question, really, is to define the point at which a company becomes so competitive that it effectively crushes its rivals and erects barriers to the entry of newcomers. In other words: market dominance.
Opponents to the merger will be quick to point out that the resulting merged company would achieve a worldwide market share of over 25% of all chip manufacturing equipment, whereas the number 2 would struggle to maintain 13%, particularly as AMAT’s executive chairman states that beyond generating costs savings, the merger would enable the combined entity to gain a few points in market share.
AMAT and Tokyo Electron will therefore need to “educate” all the regulatory bodies consulted in this matter to demonstrate that although there is some overlap in their products, most of them actually complement each other in the end-to-end process of chip manufacturing, because that process involves a number of different tasks performed by different machines. Seen from that angle (if they can persuade the regulators to adopt that view), the merger closes gaps and does not result in a simple addition of the two players’ current market shares.
The outcome of a debate between helicopter view and deep-dive into the segmentation of a market is quite uncertain. Back in 1997 when Guinness and Grand Met merged to become Diageo, competitors and customers were argued that owning Gordon’s, Tanqueray, Booths and Bombay Sapphire would give Diageo complete dominance of the gin market. Diageo, on the other hand, contended that those brands’ market shares should be considered within the broader context of white spirits (which include vodka, white rum, cachaça), so that even by including Smirnoff vodka into that calculation, Diageo would only be a relatively modest player in an enormous market. In that instance, the Regulators did not quite buy into Diageo’s argumentation, forced the group to dispose of Bombay Sapphire, and whilst looking at the white spirits category as a whole, also forced Diageo to sell rum-based brand Malibu.
Supplier vs. customer power
It would be wrong, however, to compare the Regulators’ conditional acceptance of the Diageo merger and refusal of the American Airlines – US Airways merger to the proposal which is being put forward by AMAT and Tokyo Electron. The regulators’ main focus is the impact on the end-consumer rather than what happens upstream in the value chain. Allowing a consolidated supplier to dictate prices in an unchallenged manner to an atomized set of customers inflates prices and is therefore detrimental to the end-consumer. But AMAT and Tokyo Electron’s main customers are a industry giants such as Intel Corporation, Samsung Electronics or Taiwan Semiconductor Manufacturing Company: the very companies that have continuously exerted extreme pressure on their suppliers to reduce their costs whilst at the same time requiring the development of ever increasingly sophisticated equipment to match the exponential complexity and miniaturisation of micro-processor chips.
Seen from that angle, the Regulators might view the AMAT – Tokyo Electron merger as restoring the balance between a supplier and its dominant customers rather than upsetting the balance within the pool of suppliers. Even if that merger allows the future company to gain a few points in terms of gross margin, this will be achieved through savings and improved efficiencies rather than through increases in selling prices which will be contained by the group’s giant customers. It is therefore unlikely to cause a perceptible impact on the end consumer price of a large screen TV, tablet, smartphone or laptop computer.
As a final consideration, the consolidation of R&D capability could ultimately benefit the end-consumer by allowing an acceleration of the pace at which the performance of microprocessors improves.
So all things considered, if AMAT and Tokyo Electron construct a cogent argumentation, it is quite possible they will get their way. That certainly seems to be the view of both companies’ shareholders, judging by the stock market reaction to the merger announcement.
Konichiwa ? Ugh, not that well actually!
The biggest hurdle ahead for AMAT and Tokyo Electron will probably not be the regulators’ verdict, but what will ensue. Whilst Tokyo Electron may well be considered as one of Japan’s most “westernised” companies, it is not a Japanese subsidiary of a western company and this is important, because the combined business culture and ways of working will need to be redefined.
Already now, both sides are trying to emit the right sound-bytes in an attempt to pave a smooth way towards a harmonious integration; but anyone with some experience of post-merger integrations can see through that smoke-screen. “A merger of equals” is the official version, though it will in fact be a 68% AMAT / 32% Tokyo Electron balance. To restore some sense of equilibrium, AMAT’s recently appointed CEO will move to Tokyo and run the combined business from there. It remains to be seen whether the Japanese language has an equivalent for the idiom of “the tail wagging the dog”.
More significant even than the challenge presented by the business culture integration is the fact that both AMAT and Tokyo Electron are operating in a highly cyclical and very tough market. AMAT’s net income fell to $168 million in its most recent quarterly results, compared to $218 million the previous year. In Japan, things do not look rosy either as the semiconductor industry is living through difficult times, with important players filing for bankruptcy or being bailed out by the Japanese government, leading to diminished demand for Tokyo Electron’s products in their key home market.
The relative uncertainty and more importantly the likely duration of the regulatory process may cause some instability in both companies at a time when they need to focus on surviving through these difficult times, and the integration that lies ahead will be a huge distraction.
And the end result is …
If the AMAT – Tokyo Electron merger goes ahead – which I think is likely, contrary to Jim Cramer’s confident statement – the price of our smartphones, tablets, large screen TVs and laptops will not jump, but that merger may have a domino effect in the industry, as the world’s number two ASML will seek alliances and acquisitions to avoid being dwarfed.
Consolidation is the almost inevitable evolution of a maturing industry.