Broadcom can’t get there from here

by Brenon Daly

CA Technologies just reported what’s likely to be its next-to-last financial results as a public company, and the numbers don’t add up. We’re not referring to anything about the specific bookkeeping at CA, which has long since distanced itself from the time when the ‘CA’ was said to stand for ‘Creative Accounting,’ with ’35-day months’ and the like.

Instead, our assessment of CA’s financial performance is based on the targets that its soon-to-be owner Broadcom has set for the combined company once the largest-ever software transaction closes later this year. In fact, it looks increasingly inescapable that the only way they get there from here is to shed a bunch of CA’s businesses.

Recall that the chip giant (rather inexplicably) turned its consolidation machine to the software industry, paying $19bn for CA in mid-July. As part of that blockbuster purchase, Broadcom laid out the goal of ‘long-term adjusted EBITDA margins’ above 55% for the combined company. Of course, the phrasing gives Broadcom plenty of wiggle room. ‘Long-term’ can mean a wide range of time, while ‘adjusted EBITDA’ is basically a fictitious financial measure that excludes many of the true costs of doing business.

But even setting aside our unfashionable quibbles around accounting, Broadcom’s margin goal looks like a stretch for CA, at least in its current form. On Monday, the company reported its overall financial performance for its just-completed quarter, and it’s pretty clear there are businesses inside of CA that will appeal to Broadcom and those that may not make the cut. CA’s financial results highlight the vast financial differences between its mature, cash-rich mainframe business and the other lines of more growth-oriented software that it has picked up over the course of a roughly 30-year M&A career.

CA’s two main businesses are nearly the same size, but the mainframe division runs at a 67% operating margin – more than 4x the operating margin posted by its enterprise software division. For the company’s full fiscal year, which ended in March, the enterprise software unit put up $1.7bn in revenue but only $151m in operating income. The tiny margin in CA’s enterprise software business, which contrasts with its richly profitable mainframe division, won’t help Broadcom hit its projected EBITDA targets, no matter how many ‘adjustments’ are made. In fact, the division stands in the way.

That reality won’t be lost on Broadcom, which had collected a bullish following on Wall Street for its reputation as a sharp financial operator. Nor will the fact that most other hardware vendors (including HPE, Dell and fellow chipmaker Intel) that have acquired their way into the software industry have eventually unwound many of their purchases. CA’s enterprise software division sells software in numerous markets, including identity and access management, application development, and security and IT operations management. For Broadcom to reestablish credibility among skeptical investors and hit the targets for the combined company, it is almost certain to divest some of those CA units.

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Two great tastes that taste great together

Chips and salsa? Sure. Chips and software? Not so much. Broadcom’s risky plan to pay $19bn for CA Technologies in an effort to become a software vendor left Wall Street puzzled, even mildly derisive. And when investors talk like that about a company, it’s almost invariably because they’re dumping it.

That’s certainly the case with shares of Broadcom, which plummeted 15% after the deal was announced. The decline slashed $15bn from Broadcom’s market value, almost equal to the amount of cash it is handing over for CA in the largest-ever purchase of a software provider. Weighing on the minds of investors is the tattered history of other hardware vendors that stumbled when they stepped into the enterprise software business.

The multibillion-dollar selloff is significant for two reasons – one that’s specific to acquiring a semiconductor firm and one that might have broader implications for large-scale tech M&A. For Broadcom, the reaction of Wall Street appears to be a penalty for it straying from a plan that had made it a favorite name among investors, who had doubled the value of the company since the start of 2016.

Much of that bullishness stemmed from the fact that Broadcom had been a disciplined financial operator, posting some of the healthiest margins in the semiconductor industry. (Recently, the company has been humming along with gross margins in the high-60% range and operating margins in the high-30% range.) It had a similarly disciplined approach to M&A, focusing on consolidating the mature semiconductor industry. That restrained strategy went out the window as it strayed into the unrelated field of enterprise software with CA.

More broadly, Wall Street’s stern reaction to Broadcom’s big bet reverses the support that investors have typically extended to acquirers in many of the tech industry’s largest transactions. In recent years, shares of buyers have largely been unmoved in the wake of blockbuster deal announcements, despite the dilution that can come with the acquisition as well as the possible integration difficulties.

But investors didn’t extend that confidence to Broadcom. In their view, the move from semiconductor giant to software provider is a step too far. 451 Research subscribers can view our full report on the massive transaction.

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Braving the IPO market

Contact: Thejeswi Venkatesh

While the IPO pipeline is getting drier, GCT Semiconductor has taken the contrarian route, filing paperwork for its proposed $100m offering. The company, a fabless designer and supplier of 4G mobile system-on-a-chip semiconductor solutions, has seen revenue triple from 2009 to $68.64m. With the mobile industry transitioning to 4G to handle the increase in rich media content, GCT thinks it could be on the verge of seeing sustained growth.

Clearly, that growth is what GCT will be selling on Wall Street. The planned offering resembles the Sequans Communications IPO, with the business profiles and financials of the two companies lining up similarly. For instance, both firms had nearly identical revenue at the time of filing and neither had an operating profit. Sequans came to market in April at 5 times trailing sales, a valuation we suspect GCT would be delighted with, since Sequans is currently trading at 2-3x trailing sales.

Across the tech sector, vendors planning to go public have instead ended up inside companies that are already public. In June, ANSYS pulled Apache Design Solutions from its IPO track and acquired it for $335m. Similarly, SiGe Semiconductor accepted a bid from Skyworks Solutions in May. With Qualcomm, Intel and Broadcom investing heavily in 4G solutions, we wouldn’t be surprised if one of these well-funded players snared GCT.

The ball is rolling in semiconductor networking M&A

Contact: Ben Kolada, Thejeswi Venkatesh

In announcing its largest-ever deal, and paying a princely price at the same time, Broadcom is keeping the ball rolling in semiconductor networking M&A. The company’s nearly $4bn pickup of NetLogic Microsystems comes less than two months after rival Intel announced a smaller strategic play of its own, and it likely won’t be the last transaction before the buyout curtain closes.

After a dearth of big-ticket semiconductor networking acquisitions, such vendors are now becoming hot properties. Before announcing its landmark NetLogic purchase, Broadcom itself bought networking provider Teknovus in February 2010 for $123m (in an earnings call, Broadcom mentioned that Teknovus generated revenue in the single digits of millions, which implies a price-to-sales valuation far north of 10x). And in July, Intel announced that it was acquiring Fulcrum Microsystems for a price we hear was in the ballpark of $175m, or about 13x trailing sales.

Broadcom’s richly priced offer for NetLogic, which values the target at 9.2x trailing sales, likely won’t be the last deal in this sector. If you ask The Street, the next companies to get scooped up could be Cavium Networks or EZchip Technologies. Shares of both firms surged following Broadcom’s announcement. As for likely acquirers, we could point to deep-pocketed vendors Qualcomm and Marvell Technology. With $10.7bn and $2.4bn of cash in their coffers, respectively, either company could easily digest Cavium, which currently sports a market cap of roughly $1.7bn.

Intel buys Fulcrum to further datacenter product push

Contact: Thejeswi Venkatesh, Ben Kolada

In a move that further boosts its 10-Gigabit Ethernet push, Intel has announced that it will acquire Fulcrum Microsystems, a fabless semiconductor company that developed the fully integrated FocalPoint family of 10Gb and 40Gb Ethernet switch chips. The acquisition advances Intel’s desire to transform itself into a comprehensive datacenter provider that offers computing, storage and networking building blocks.

Terms of the deal were not disclosed, though we estimate that Fulcrum generated about $13m in revenue in the 12 months before its sale. For a comparable transaction, we could look to Broadcom’s November 2009 acquisition of Dune Networks for about 3 times trailing sales, or twice the median for all semiconductor design deals announced so far this year. However, given Fulcrum’s strategic importance to Intel, we wouldn’t be surprised if its valuation is not only higher than the median, but also surpasses Dune’s. We would also note that Intel already had an insider’s view into Fulcrum – its venture investment arm, Intel Capital, provided mezzanine financing to Fulcrum in 2010.

Connecting thousands of nodes at maximum bandwidth is the holy grail of datacenter networking. Fulcrum’s FocalPoint portfolio provides high-performance, low-latency network switches to support evolving cloud architectures and the growth of converged networks in the enterprise. Intel’s earlier foray on this front was with InfiniBand, which it supported for many years before finally being squeezed out by faster, ultra-low-latency architectures like AMD’s HyperTransport consortium on the one end and on the other end by cheaper but slightly slower 10GigE. Intel has been supportive of 10Gb architecture and this acquisition further enhances that strategy. More importantly, 10GigE makes more sense for Intel if it is looking for a common single interconnect architecture for datacenters, since all applications run on it anyway.

Tech buyers shop locally

-by Yulitza Peraza, Brenon Daly

Although the Delaware Court of Chancery was slated to rule this week on Emulex’s poison pill, the court punted on the decision. In postponing the ruling on the poison pill, which has been a key part of Emulex’s defense against the unwanted advances of Broadcom, the judge indicated that the two sides may well be able to work out a deal over the next week. Broadcom, which took its bid public on April 21, recently extended the deadline of its tender offer until July 14. The extension came as Broadcom also raised its bid to $11 per share for Emulex, up from $9.25. That added about $150m to the price of Emulex, which is currently valued at some $912m. As we noted earlier, Broadcom’s initial offer essentially valued Emulex where it was trading last October.

Unsolicited offers for tech companies, while increasing, are still relatively rare. However, in one regard, Broadcom’s bid for Emulex is rather typical. Scouring our data, we noticed a significant trend among California tech vendors: they tend to shop locally. That’s certainly true for these two southern California firms, which are only about 10 miles from one another. In the last seven years, about half of total tech M&A spending by California-based buyers went toward acquiring other Golden State tech companies. We would add that the ‘shop local’ trend isn’t limited to California, which stands as the most-developed tech region in the world. It’s also true on the other side of the country, where tech vendors based on the East Coast have spent more on acquiring neighboring tech firms than they have on companies from anywhere else.

There are a number of reasons for this trend, both formal and informal. For starters, the two sides are more likely to have a number of connections, sharing financial backers or board members, for instance. Additionally, executives at the companies may belong to the same local tech organizations or business groups. (Or, more informally, they may frequent the same restaurants or belong to the same clubs.) In some ways, our finding flies in the face of the oft-repeated notion that the world is flat, with business flowing around the globe without regard to borders or geography. That may well be true in some aspects. But when it comes to M&A, business is still largely done locally.

Geographic tech M&A, 2002-2009

Acquirer state/region Target Number of deals Percentage of total deals Total value Percentage of total value
California All 2,389 100% $247bn 100%
California California 879 37% $126bn 51%
East Coast All 2,391 100% $282bn 100%
East Coast East Coast 758 32% $83bn 30%

Semi trouble

-Contact Thomas Rasmussen, Greg Quick

There are bargains aplenty in the semiconductor sector. From Integrated Device Technology’s $20m tuck-in of Silicon Optix last month to Sun Microsystems’ takeover last April of Montalvo Systems for an estimated $25m, we’ve seen a flurry of lowball purchases of semiconductor startups over the past year. The reason? These companies tend to have a high burn rate, without much revenue to offset that. (For instance, we estimate that Silicon Optix generated just $4m in sales in the year leading up to its acquisition, while Montalvo was still a pre-revenue company.)

Of course, the semiconductor industry has been slumping for several years, with a sharp decline in valuations. While the number of deals has been tracking steadily at around 180 per year recently (147 so far this year), the amount spent on deals – a far more important figure – is down almost 40% from last year, and close to 80% from 2006. Things are not getting any better, either, at least according to our recent Tech Banking Outlook Survey. Bankers rated the semiconductor industry the lowest in terms of anticipated M&A spending for next year.

This dour outlook is likely to have an extremely negative impact on the semiconductor startups still out there trying to make it. And there are a lot of companies, backed by a lot of venture capital, trying to crack into markets that have taken much longer to materialize than ever imagined. For example, in the promising category of 10Gbase-T physical layer technology, we wonder about the outlook for Teranetics and Solarflare Communications. Also, we recently wrote about the troubles in the highly crowded and fragmented 10-Gigabit Ethernet controller space. Although Intel, Broadcom and the overall market are starting to show signs of life, the situation for the many startups in the sector is not looking any better. In fact, we heard recently that Neterion’s president might have thrown in the towel and that the company could be on the block. Having wagered in the vicinity of $100m, investors will undoubtedly take a bath on this one.

Net effect from Intel’s buy

-by Thomas Rasmussen

It’s a somber 10-year anniversary for 10-Gigabit Ethernet vendor NetEffect. The company was picked up by Intel in a bankruptcy asset sale last week for a bargain $8m. Its technology, along with 30 of its engineers, will be rolled into Intel’s LAN Access Division. NetEffect has burned through some $50m in funding since recapitalizing in 2004. The company, which we once heralded as an innovator and potential leader in 10GigE technology, simply ran out of cash.

One reason for NetEffect’s scrap sale might be the increased competition. Big players like Intel, with its own organic offerings and its tuck-in of NetEffect, and Broadcom, with its $77m acquisition of Siliquent Technologies in 2005, have been crowding an already teeming market. This, coupled with scarce funding and lack of widespread adoption of the technology, makes us wonder what will happen to NetEffect’s surviving former rival startups still trying to stay afloat.

Venture capitalists have thrown hundreds of millions of dollars at 10GigE companies, with little to no payoff. We suspect the wind-down of NetEffect is an indication that VCs have had enough. Tehuti Networks, iVivity, Myricom, Neterion Technologies and Alacritech are some of the many startups in this sector that could potentially feel the net effect from this. In fact, iVivity seems to have quietly hit the switch already; its website is down and its phones are off the hook. Firms that will benefit from this include IBM, Hewlett-Packard, Dell and Hitachi, which are likely to follow Intel’s lead and peruse the bargain bin.

Known funding of select 10GigE players

Company Total funding Last round Status
Chelsio Communications $100m $25m series E (2008) Active
iVivity $60m $10m series D (2006) Missing in action
NetEffect $47m $25m series B (2006) Acquired by Intel for $8m
Siliquent Technologies $40m $21m (2004) Acquired by Broadcom in 2005 for $77m
Silverback Systems $51m $16m series D (2006) Acquired by Brocade Communications in 2007 for less than $10m*
Tehuti Networks Unknown Series B (2008) Active

Source: The 451 M&A KnowledgeBase *Official 451 Group estimate

Corporate castoffs

Look who’s hitting the corporate garage sales these days – other corporations. While divestitures used to go most often straight to private equity shops, more than a few castoff businesses are now finding homes inside new companies. The latest example: AMD’s sale of its digital TV chip division Monday to Broadcom for $193m.

Given AMD’s struggles, as well as the fact that rival Intel has shed a number of businesses in recent years, the divestiture wasn’t a surprise. In fact, my colleague Greg Quick noted two weeks ago that AMD was likely to dump its TV chip business, naming Broadcom as one of the likely acquirers.

On the buy side, Broadcom joins fellow publicly traded companies Overland Storage, L-1 Identity Solutions and Software AG, among others, that picked up properties from other listed companies this year. That’s not to say that buyout firms have been knocked out of the market, despite the tight credit conditions. PE shops Vector Capital, Thoma Cressey Bravo and Battery Ventures have all taken businesses off the books of publicly traded companies in 2008.

Still, the activity by the corporate shoppers is noteworthy. And the list is likely to grow as more companies look to clean up their operations during the lingering bear market. The next name we may well add to the list is Rackable Systems, which said earlier this month that it is looking to shed its RapidScale business. (The divestiture would effectively unwind its acquisition two years ago of Terrascale Technologies, and comes after a gadfly investor buzzed Rackable for much of the year.)

As to who might be eyeing the assets, we doubt there are many hardware vendors interested in RapidScale, because they have either made acquisitions (Sun’s purchase of Cluster File Systems, for instance) or have partnerships (both EMC and Dell partner with Ibrix). However, a service provider could use the technology to enhance its storage-as-a-service offering. In a similar move, we’ve seen telecom giants like BT and Verizon pick up security vendors to offer that as a service. And finally, we’d throw out a dark horse: Amazon, which is one of Rackable’s largest customers, could use RapidScale’s clustered storage technology to bolster its S3 offering.