San Jose-based semiconductor design tool market leader Cadence Design Systems disclosed yesterday that it has been in discussions with Mentor Graphics for two months regarding a possible acquisition by Cadence. It has submitted a proposal to Mentor's board of directors for $16 per share in cash for a total enterprise value of $1.6 billion on a fully diluted basis, which reflects Mentor's net debt of $69 million.

Cadence stressed during a conference call yesterday morning that its all-cash proposal represents a 30% premium over the $12.33 closing price of Mentor's stock on June 16, the last trading day prior to public disclosure of Cadence's proposal; a 59% premium over the $10.04 closing price of its stock on May 2, which is when Cadence said it first presented the terms of the proposal to Mentor; and a 46% premium over Mentor Graphics' average closing price for the past 30 trading days.

"A combined Cadence-Mentor will offer customers a broader and more fully integrated product and technology portfolio in a timeframe that better enables them to address urgent and complex challenges associated with their next-generation product development," Michael J. Fister, president and CEO of Cadence, said on the conference call.

"Together, we will accelerate the rate and efficiency of customers' innovation by making it possible for them to develop products that better meet end user needs," he added.

Cadence's proposal is subject to the negotiation of a mutually agreeable merger agreement, the completion of certain limited and confirmatory due diligence, and the satisfaction of other customary conditions, including receipt of regulatory approvals. However, Fister noted that Mentor informed Cadence at the end of May that it is not interested in continuing discussions and wishes to remain independent.

Fister reiterated that Cadence's goal in the market is to provide a complete front to back design flow, while Mentor focuses on specific best in class tools. For this reason, Cadence believes there are huge gains to be had by acquiring Mentor as Mentor's tools would bolster Cadence's market position.

Kevin Palatnik, senior VP and CFO of Cadence noted that "We believe the combination of Cadence and Mentor Graphics delivers significant benefits to both companies' shareholders that are simply too compelling to ignore. Our $16 per share all-cash proposal provides Mentor Graphics shareholders with a substantial cash premium for their investment in Mentor Graphics. It remains our strong preference to work cooperatively with Mentor Graphics, and to immediately commence discussions with Mentor Graphics regarding our proposal."

Signed by Fister, Mentor was sent a letter with the proposal to Mentor's board in care of Walden C. Rhines, chairman and CEO of Mentor, the text of which follows:

 Dear Wally:

 Over the last two months, we have sought to engage you and your Board of Directors in discussions regarding our proposal to combine Cadence Design Systems, Inc. and Mentor Graphics Corporation. We are disappointed that, despite our best efforts, you have thus far been unwilling to meaningfully participate in such discussions.

 As you will recall, you and I first spoke about combining Cadence and Mentor Graphics on April 16, 2008. On May 2, 2008, Bill Porter and I met with you and Greg Hinckley in Portland where we presented the terms of our proposal to acquire Mentor Graphics for $16.00 per share in cash.

 Following the May 2nd meeting, we repeatedly attempted to bring the Cadence and Mentor Graphics leadership teams together to discuss our proposal. On May 23, 2008, however, you informed us that, even without any substantive discussion with us or negotiation of our proposal, Mentor Graphics concluded that it did not wish to pursue discussions with us given Mentor Graphics' desire to stay independent.

 It remains our preference to bring Cadence and Mentor Graphics together through a negotiated transaction. However, given Mentor Graphics' refusal to engage in substantive discussions with us concerning our all-cash premium acquisition proposal and the importance of this transaction to both companies' respective shareholders, we have decided to publicly disclose our proposal. We believe there are clear and compelling advantages to a combination of Cadence and Mentor Graphics.

 As Bill and I explained to you on May 2, based upon our knowledge of Mentor Graphics from currently available public information, Cadence is prepared to acquire Mentor Graphics for $16.00 per share in cash. Our proposal is not subject to any financing condition. This proposal is a full and fair price and provides an attractive opportunity for your shareholders to realize, with certainty, significant value for their investment in Mentor Graphics. This price represents a 30% premium over the closing price of Mentor Graphics common stock on June 16, 2008, the last trading day prior to public disclosure of our proposal, a 59% premium over the closing price of Mentor Graphics common stock on May 2, when we presented the terms of our proposal, and a 46% premium over Mentor Graphics' average closing price for the past 30 trading days.

 We believe that a combined Cadence-Mentor will provide customers a broader and more fully integrated product and technology portfolio in a timeframe that better enables them to address urgent and complex challenges associated with their next-generation product development. From increasing complexity to stringent cost targets, developers must optimise and prioritise their efforts across the entire spectrum of specification, architecture, design, implementation, verification, and manufacturing.

 Combining Cadence and Mentor Graphics and aligning the creative talents of our respective hard-working and innovative employees will deliver more comprehensive cutting-edge solutions and an entirely new level of customer experience and satisfaction. Together we can accelerate the rate and efficiency of customers' innovation by making it possible for them to develop products that better meet end user needs.

 Our proposal is subject to the negotiation of a mutually acceptable merger agreement and completion of certain limited and confirmatory due diligence, which we believe we will be able to complete expeditiously, as well as satisfaction of other customary conditions, including receipt of regulatory approvals. We and our advisors have carefully analysed the combination of Cadence and Mentor Graphics and are confident that the proposed transaction will receive the necessary regulatory approvals.

 We strongly believe that a combination of Cadence and Mentor Graphics will create significant value for both companies' respective shareholders and customers. Our leadership team and advisors remain prepared to meet with you and your advisors at your earliest convenience to conduct the necessary due diligence and negotiate a merger agreement. I am confident that the Cadence and Mentor Graphics teams working together can make this transaction a success.

 The Board of Directors of Cadence unanimously supports this proposal and the combination of Cadence and Mentor Graphics. We expect you and the Mentor Graphics Board to give this proposal serious consideration. I look forward to hearing from you soon.

While there will surely be some overlapping product areas including verification, physical implementation, DFM, emulation and logic simulation, it remains to be seen how those products would be dealt with and Cadence did not speculate on possible scenarios given that Mentor has not yet replied to the letter.

A merger of this magnitude in the EDA industry has been anticipated for some time, and in terms of timing, Fister said, "Customers are facing unprecedented challenges. I don't know that there is ever a perfect time, but the value we can demonstrate to customers and the value we can demonstrate is impressive," Fister noted.

While the tone of the Cadence executives was friendly, Fister added, "We are committed to doing whatever it takes to get this done."

Commenting on the news, RBC Capital Markets Corp analyst Mahesh Sanganeria said in a report, "At this offer, we believe Cadence shareholders should get behind this deal. We note that the key product from Mentor is complementary to Cadence portfolio. As such, we do not believe the deal would face regulatory push back. A combination would result in an EDA powerhouse, one that would offer serious competitive threat to Synopsys. We will not be surprised if Synopsys offers a counter bid. We expect Mentor management to fight the offer. This could get real ugly, real soon."

In terms of products, RBC sees synergies in three out of four of Mentor's product segments.

First, in Mentor's IC design to system segment, which is 36% of Mentor's revenue, the flagship product is Calibre, the industry standard for physical verification with more than 60% market share. "Neither Cadence nor Synopsys has anything close.

The addition of the recently acquired Olympus product for physical implementation strengthens the segment. Starting out from a very small base ($20M in FY08), Mentor has had ambitious plans for Olympus to take share. Calibre continues to grow at single digits," Sanganeria said.

Second, in the verification segment, which is 24% of Mentor's revenue, RBC does not see synergy in this area as it overlaps with Cadence's tool portfolio. "We expect cost savings through rationalisation," he commented.

Next, in terms of integrated system design tools, which are 21% of Mentor's revenue, since this segment contains PCB design and FPGA synthesis tools, these are complementary to Cadence. "PCB design has locked in customers in military/aerospace. Stable and mature segment. Cash cow," Sanganeria asserted.

Finally, in the new and emerging tool segment, which comprises 15% of Mentor's revenue, Sanganeria pointed out that this is a "grab bag" of assorted products with TestKompress and the automotive products will be complementary to Cadence and the rest could be rationalized away.

Sanganeria also noted that Mentor's chief problem has been its low operating margins, which have been in the low teens, and this will be a key area where cost-focused Cadence will be looking to make improvements. Comparatively, Cadence has operating margins in the high 20s, he said.

Finally, in terms of integrating Mentor into Cadence, there would be a clashing of cultures as Mentor is an engineering driven company whereas Cadence is sales driven and integrating cultures will likely be a challenge, Sanganeria concluded.

EDA analyst Gary Smith, founder and chief analyst of Gary Smith EDA said the motivation behind Cadence's moves is to make up for a predicted serious drop in revenue, which he noted has been pegged at 4% by Cadence, but as much as 27% by financial analysts.

Smith also believes this merger will significantly hurt the semiconductor design tool industry. "Mentor is doing everything right, right now. Cadence is in trouble. They've got a debt problem, and if they pay $1.6 billion for Mentor, who is going to do the R&D?"

The EDA industry is currently in the middle of retooling for 32nm and creating the physical implementation tools that will allow 32nm designs to be manufactured, Smith reminded. "If this acquisition happens, Cadence/Mentor would be a non-factor for 32nm, so would it be a Synopsys Magma world?" he asked.

While Smith said this acquisition makes no sense at all, he recognises that it fills in Cadence's biggest hole - the entire back-end of the design flow.

In a statement, Mentor's Rhines said, "As we recently indicated to Cadence, we reviewed Cadence's proposal and analysed both the price proposed and the risks associated with obtaining antitrust approval for a combination between the companies. Following this review, we concluded that not only was the price insufficient to support a transaction but that the risks of not gaining regulatory approval were sufficiently high that the ability of the parties to consummate the transaction would be in jeopardy. For these and other reasons, our Board unanimously rejected the proposal."

By Ann Steffora Mutschler, Senior Editor - Electronic News