On April 17, 2008, Marty Dirks contemplated the financial statements of Cypress Semiconductor Corporation (Cypress) and SunPower Corporation (SunPower) (see Exhibit 1). Based on the expected long-term increases in energy prices and concerns about U.S. dependence on politically unstable or unfriendly countries for the import of oil, solar energy firms, such as SunPower, seemed to have a bright business outlook. That day, Cypress announced it received a favorable ruling from the IRS with respect to a potential taxfree distribution of its SunPower common shares. This could mean that Cypress would distribute its SunPower shares to its shareholders in a tax-free transaction. This should eliminate any tax-related discount that investors might attribute to Cypress ownership of SunPower. Dirks wondered if that might create some mispricing opportunity. Dirks had been a long/short equity analyst or portfolio manager for many years and was now investing his own capital. He liked to maintain his net long exposure at 20 to 30 per cent of equity, although at this time his portfolio was 60 per cent long and 20 per cent short, with a net long exposure of 40 per cent. CYPRESS SEMICONDUCTOR AND SUNPOWER Cypress Semiconductor designs and manufactures programmable system-on-chip (PSoC) products, capacitive sensing and touchscreen solutions, universal serial bus (USB) controllers, wireless USB, CyFi low-power radio frequency, programmable clocks, buffers and other semiconductor devices. SunPower Corporation designs and manufactures solar electric power technologies. Cypress made a significant investment in SunPower in 2002 and in November 2004 Cypress purchased the remainder of SunPower. In November 2005, Cypress sold approximately 13 per cent of SunPower to investors in an initial public offering. SunPowers stock increased 50 per cent in price the first day of trading. While SunPower was an exciting business, the stock was highly valued, with an enterprise value to trailing revenue multiple of more than five. SunPowers valuation seemed appropriate and Dirks concluded that it did not present an investment opportunity with which he was comfortable. However, Dirks heard from industry contacts that Cypress business was improving substantially. A simplified balance sheet for Cypress and SunPower is provided (see Exhibit 2). Exhibit 1 SELECTED DETAILS FROM FINANCIAL STATEMENTS On April 17, 2008: Cypress Semiconductor had a closing market price of $27.37 Cypress Semiconductor had 152.71 million shares outstanding SunPower had a closing market price of $86.80 SunPower had 84.39 million shares outstanding Cypress owned 44.5 million shares of SunPower Cypress consolidated revenues for the fiscal year ended December 30, 2007, in thousands: Consumer and Computation Division $357,671 Data Communications Division 117,755 Memory and Imaging Division 330,305 SunPower 774,790 Other 15,866 -------------------------------------------------------------------------------------- Total revenues $1,596,387 Cypress revenues excluding SunPower = 1,596 774 = $822 million Source: 10-K filings, Yahoo! Finance. Page 4 9B09N016 Exhibit 2 SIMPLIFIED BALANCE SHEET Cypress Semiconductor SunPower Cypress net of SunPower Consolidated Balance Sheet Items December 30, 2007 December 30, 2007 December 30, 2007 (In thousands) (In thousands) (In thousands) Assets Cash and equivalents 1,426,405 390,667 1,035,738 Other assets 2,299,544 1,263,071 1,036,473 Total Assets $ 3,725,949 $ 1,653,738 $ 2,072,211 Liabilities and Stockholders Equity Convertible debt 1,025,000 425,000 600,000 Other liabilities 602,117 364,648 237,469 Total liabilities 1,627,117 789,648 837,469 Minority interest 378,400 378,400 Total stockholders equity 1,720,432 864,090 856,342 Total Liabilities and Stockholders Equity $ 3,725,949 $ 1,653,738 $ 2,072,211 Consolidated Statements of Operations Revenues $ 1,596,387 $ 774,790 $ 821,597 CY/SPWR Questions: A) What is the market value of equity for Cypress (CY)? B) What is the market value of SunPower (SPWR) owned by CY? C) What is the market value of equity for CY excluding the SPWR business implied by the current market prices? D) What is the Enterprise Value implied by the current market prices for CY excluding the SPWR business? E) What value do the current market prices assign to each dollar of revenue for CYs business? (i.e. what is the revenue multiple for CY excluding the value of SPWR?) F) You determine from your research of comparable businesses and CYs historical valuation ranges that CY alone should be valued at 1.5 times its revenues. What stock price would that imply for CY? (This is the price CY stock actually should trade at in the market. This price would include the value of SPWR in the price of CY. Assume that SPWRs stock price does not change in value.) G) Do you see an investment opportunity here? If so, what? H) What circumstances could create an opportunity in a situation like this? Why could such an opportunity exist in what some academics say is a highly efficient market? I) If you decided you wanted to own CYs operating business, but not SPWR, how would you implement this in a portfolio? (i.e. how many shares of each company might you buy or sell if you wanted to have the position?) J) What are the issues to keep in mind when taking a position such as this? What could go wrong? K) If you were an analyst at a hedge fund, what would you say to your portfolio manager if she asked you to evaluate this position? (Should you take a position? If so, how large? Etc. What exactly would you say to her?) L) If your fund has $100 million in total assets under management, what size position would you recommend? M) Consider how this paired position fits with the rest of the portfolio. Would you expect the pairs profit or loss to be correlated with the market? N) Consider what would happen if Cypress did a stock spinoff/dividend of SunPower shares as a Class B stock which was not identical to the currently trading stock. The currently trading SunPower Class A stock would have less voting rights, but would be otherwise identical to the Class B stock spun out from Cypress. From a valuation point of view only, how should the Class A and Class B stock prices differ? From a market trading point of view only, how might the Class A and Class B stock prices differ? (Think of who owns what and how they would behave after a spinoff.) Considering both valuation and trading behavior factors, how would you predict SunPower Class A and Class B stock prices will differ after a spinoff? Why?