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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Though relatively small, Thoma Bravo’s Mediware buy signals larger trends

Contact: Ben Kolada

Although Thoma Bravo’s $195m reach for Mediware Information Systems isn’t exactly a market-moving acquisition, tech dealmakers will note that the transaction underscores a pair of larger trends in tech M&A. The deal continues the consolidation in the medical-focused IT vertical, as well as hints at the reemergence of buyout shops as volume acquirers.

Thoma Bravo is handing over $22 in cash for each share of Mediware’s stock, a 40% premium to the day-prior closing price, and the highest price Mediware’s shares have ever seen. The transaction values Mediware’s equity at $195m. However, the medical management software vendor’s $40m in cash holdings, and no debt, reduces its net cost to $155m. Using that enterprise value figure, Mediware is valued at 2.4 times trailing revenue and 8.8x trailing EBITDA.

Mediware’s sale is the latest acquisition in the rapidly consolidating medical-focused IT vertical. In July, Huntsman Gay Global Capital sold Sunquest Information Systems to Roper Industries for $1.4bn, or about 10x projected EBITDA, and One Equity Partners acquired M*Modal for an enterprise value of $1.1bn, or 2.4x trailing sales. We’ve recently noted that medical speech recognition and transcription companies in particular seem to be receiving considerable buyout interest.

While the Mediware acquisition shows the health of medical-focused tech M&A, it also points at somewhat of a reemergence of private equity firms as volume acquirers. Thoma Bravo, including its portfolio companies LANDesk and PLATO Learning, has already announced five acquisitions this year. PE firms were also especially active in August, with Carlyle Group shelling out $3.3bn for Getty Images.

PE activity also comes while some strategics are sitting on the sidelines. For instance, CA Technologies, which has historically announced about four acquisitions per year, has only announced one this year – the purchase of process automation software veteran Paragon Global Technology. The deal, announced this week, is CA’s first disclosed transaction in more than a year. Also, Symantec has been out of the market since March.

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Mirror moves at CA and Compuware

Contact: Brenon Daly, Dennis Callaghan

Both Compuware and CA Technologies recently announced deals for application development and the related field of performance monitoring in which the transactions themselves shared more than a few similarities. The two acquisitions saw the old-line companies, with their corporate roots in the mainframe era, paying nearly double-digit multiples for startups that have been doubling sales each year. Further, each buyer was adding the acquired technology to an existing management platform that has largely been shaped by earlier M&A.

In the first transaction, CA Technologies announced that it will hand over $330m in cash for ITKO, which adds testing capabilities to CA’s management portfolio as well as makes the company more of a player in ‘devops’ as cloud adoption blurs the roles between development and operations in IT departments. The following week, Compuware paid $256m in cash for dynaTrace Software to bolster its business transaction management offering, particularly in the area of pre-deployment performance monitoring, which goes hand-in-hand with testing. The two deals mean that the companies will be competing hard against each other in distributed systems performance testing and monitoring, especially around Java applications.

For the targets in the purchases, though ITKO and dynaTrace were focused on slightly different markets, the two startups had a number of traits in common. Both were founded far from Silicon Valley and went on to be parsimonious fundraisers, each drawing in only about $20m. (In other words, an exit price that was 10 times greater than the money that went into the company.) Both startups had more than 100 employees and were tracking to top $50m in sales next year. And finally, both startups went with boutiques to advise them on the sales, with ITKO tapping Qatalyst Partners and dynaTrace working with Pacific Crest Securities.