After trying and failing to acquire mobile-chip giant Qualcomm, Broadcom (NASDAQ:AVGO) has turned its attention to other targets. The company announced on July 11 that it had agreed to pay $18.9 billion in cash for CA Technologies (NASDAQ:CA), a software company that derives about half its revenue and most of its profits from software and solutions for mainframe systems. Broadcom is making a very big bet on big iron.

The deal

Broadcom will pay CA shareholders $44.50 per share in cash, about 20% above the stock's closing price on July 11. The total equity value of the transaction is $18.9 billion, and the enterprise value is $18.4 billion. CA had a net cash position of roughly $500 million at the end of its latest quarter.

A drawing on a notepad page of a big fish eating a little fish.

Image source: Getty Images.

Broadcom will fund this acquisition with cash on hand and $18 billion in new debt. The company plans to pay down that debt quickly after the deal closes. Broadcom's total debt will balloon to around $35 billion as a result of this acquisition.

Broadcom expects the deal to push its long-term adjusted EBITDA margins above 55%, with an immediate benefit to non-GAAP EPS. The transaction is expected to close in the fourth quarter of 2018.

Not as strange as it seems

Broadcom is a chip company, so a massive acquisition of a software company is a little out of character. What's more, CA focuses on mainframe software, which is not exactly a growth area. CA's mainframe-related revenue, which accounts for 51% of total revenue, declined by 1% in fiscal 2018 adjusted for currency.

But the mainframe business is a cash cow. CA booked a mainframe-segment operating margin of 64% in fiscal 2018. The company's two other segments, enterprise solutions and services, managed operating margins of just 9% and 3%, respectively. The stickiness of mainframe systems, like those sold by IBM, makes selling software for those systems a lucrative business.

Broadcom expects this transaction to provide significant recurring revenue while expanding its total addressable market. CEO Hock Tan said that he is committed to growing both the mainframe and enterprise solutions businesses: "With its sizable installed base of customers, CA is uniquely positioned across the growing and fragmented infrastructure software market, and its mainframe and enterprise software franchises will add to our portfolio of mission-critical technology businesses. We intend to continue to strengthen these franchises to meet the growing demand for infrastructure software solutions."

CA produced free cash flow of $1.15 billion in fiscal 2018, putting the enterprise value of the deal at about 16 times that number. Buying CA is a relatively inexpensive way for Broadcom to boost its own free cash flow generation, and it will allow the company to continue to produce double-digit earnings growth.

Investors are not thrilled

Based on the performance of Broadcom's stock on the day following the announcement, the market very clearly doesn't like this deal. Shares of the chip company were down around 15% at midday, knocking around $15 billion off the company's market capitalization. A couple of analysts downgraded the stock on the news, adding fuel to the fire.

Wall Street may not like this deal, but Broadcom has managed to add a meaningful amount of revenue and free cash flow while paying a reasonable price. It's getting a portfolio of mission-critical software with ultra-high margins, and there may be room to boost those margins even further. The CA acquisition looks to me like a disciplined push into the software market.

The biggest risk for Broadcom is the possibility that CA's mainframe business continues to decline. But mainframe systems are certainly here to stay, and market leader IBM has been working to make the systems more attractive in the age of cloud computing. Most recently, IBM launched a version of its latest mainframe system in a form factor that can be put into any standard data center.

With any megadeal in the chip industry likely on ice thanks to the Qualcomm debacle, it makes sense for Broadcom to diversify into software. Instead of paying a crazy premium for some hyped-up software company, Broadcom has opted for an out-of-favor, reasonably priced software company with fat margins and products with meaningful switching costs. Once you get past the out-of-the-blue nature of this deal, I think it makes a lot of sense.

Timothy Green owns shares of IBM. The Motley Fool owns shares of Qualcomm. The Motley Fool recommends Broadcom Ltd. The Motley Fool has a disclosure policy.