Broadcom can avoid the conglomerate curse

Broadcom will look like a very different company next year. The trick will be to make sure the good stuff stays the same.

VMware’s $61 billion acquisition unveiled last week puts the chipmaker on the path to becoming a new kind of tech conglomerate. After the deal closes — currently expected in Broadcom’s fiscal year ending October 2023 — about half of the company’s total revenue will come from software. This mix could tip even further if the current chip shortage eases and the semiconductor industry returns to its cyclical nature. Global chip sales have fallen in six of the past 20 years, according to data from the Semiconductor Industry Association.

Another fall does not seem imminent. Average lead times for chipmakers rose slightly again in May to a record 27.1 weeks, Susquehanna Research reported Tuesday. And Broadcom’s chip business isn’t lagging behind: The company is thought to have secured design wins on Facebook’s parent platforms that will be worth $1 billion a year in custom data center chips, wrote JPMorgan analysts on Tuesday.

While VMware isn’t immediately needed as a hedge against future chip cycles, the deal shows that Broadcom is swimming strongly against the recent wave of giant tech companies unraveling some of their empires. The company formerly known as Hewlett-Packard split in two in 2015, while International Business Machines spun off its IT services arm into a new company called Kyndryl last year. VMware itself was recently unbundled when Dell sold its majority stake in the company in November.

These movements are often motivated by the notion of “value release”. Conglomerates often struggle with relatively low valuations, are perceived as difficult to manage, or are weighed down by mature companies in decline. Some analysts are concerned because there are few precedents for a hybrid chip/software company.

“If the market doesn’t reward the multiple, we wouldn’t be surprised to see the company eventually split into two parts at some point in the future to unlock value,” Raymond James’ Chris Caso wrote in a memo to clients.

To avoid the conglomerate curse, Broadcom will need to show that it can apply the successful M&A playbook it has used thus far.

The company has completed five other major transactions valued at over $1 billion over the past seven years. These remade a business initially focused primarily on radio frequency chips used in wireless devices; Broadcom’s revenue of $27.5 billion in its last fiscal year is four times what it generated in fiscal 2015, when the company was called Avago. Annual free cash flow – Broadcom’s true North Star – increased nearly eightfold to $13.3 billion during this period.

However, buying VMware represents a new type of bet. With nearly $13 billion in annual revenue, VMware’s business is more than three times the size of CA Technologies when Broadcom bought the mainframe software provider in 2018. It’s also much more widely used, as companies in the around the world use VMware applications to run their data centers and cloud-based offerings more efficiently.

This requires a large business footprint. VMware’s sales and marketing spend now exceeds $4 billion annually, more than three times what Broadcom has spent on the same in the past four quarters despite a revenue base more than twice as large .

Broadcom’s deal is based on the idea that it can do more with less. By disclosing the transaction, the company set a goal of increasing VMware’s annual pre-tax profits by 80%. Broadcom software president Tom Krause told analysts on a call last week that the company has “several buttons we can push on profitability,” which includes “efficiencies” in sales and marketing. Karl Keirstead of UBS also wrote to clients that “there is significant margin upside potential at VMware”, including the possibility of divesting “non-core businesses”.

Wall Street jumped on board. Broadcom’s share price, which fell 3% on initial reports of the deal, has since rallied, closing Monday with a 9% gain in three days since the official announcement. At around 15 times forward earnings, Broadcom’s multiple is well ahead of the single-digit valuations that HP and Dell had in their conglomerate days. But it’s also well below the current average for chip and software peers, giving Broadcom upside potential once it proves it can effectively straddle both worlds.

This story was published from a news agency feed with no text edits

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