Please ensure Javascript is enabled for purposes of website accessibility

Broadcom Explains Its Surprising $18.9 Billion Acquisition

By Timothy Green – Updated Sep 10, 2018 at 6:09PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The deal made a lot more sense after Broadcom's CEO laid out the rationale.

When chip giant Broadcom (AVGO -0.70%) announced in July that it planned to pay $18.9 billion in cash to acquire CA Technologies (CA), the reaction from analysts was far from positive.

"Lots of explanation (is) needed," wrote RBC Capital Markets analyst Amit Daryanani in a note to clients, as reported by Reuters.

"We believe this planned acquisition definitely will create some uneasiness among its current investor base," KinNgai Chan, analyst for Summit Insights Group, told Reuters.

Broadcom has built itself into a chip juggernaut by making acquisitions, but CA doesn't fit the mold of a typical Broadcom buy. CA is a software company that derives the bulk of its revenue and almost all its profit from solutions for mainframe systems. Mainframe systems have been around for decades, and they're still used for mission-critical workloads in certain industries. But it's not exactly a growth business -- CA's mainframe solutions revenue was flat in fiscal 2018.

So why did Broadcom hurl nearly $20 billion at a mainframe software company? CEO Hock Tan answered that question during Broadcom's latest earnings call.

Servers in a data center.

Image source: Getty Images.

"These guys are deeply embedded"

Tan admitted during the call that the company's strategy with the CA acquisition wasn't clear: "The No. 1 question we get with CA is, why did we choose to buy?"

Tan believes CA's mainframe solutions business is attractive: "Mainframes remain the backbone of the enterprise computing environment and are relied on to run mission-critical applications. ... Given mainframes are the most important parts of large enterprises, we believe this will remain a strong and stable market opportunity for us for long term."

But that stable mainframe business isn't what Broadcom is ultimately after. Instead, Broadcom wants access to CA's base of longtime customers. CA's software is entrenched in industries like financial services, insurance, and healthcare that are heavy users of mainframe systems. Companies in those industries rely on CA's software for mission-critical workloads. Switching costs are high for both the software and the underlying mainframe systems.

International Business Machines, the market leader in mainframe systems, is having its strongest mainframe product cycle in years. There's no denying that the mainframe is about as sticky as it gets when it comes to enterprise hardware.

Broadcom wants to use CA's deeply embedded status to cross-sell other products to CA's customers. Tan explained: "Just as we have done with hyper cloud players, we believe we can bring our compute offload solutions, our Tomahawk switches, Jericho routers, fiber optics and our server storage connectivity portfolio directly to these same large enterprises that are buying CA software."

So while Broadcom views CA's core mainframe business positively, its strategy is to leverage CA's deep customer relationships to boost sales across its portfolio of products.

That plan makes sense, especially considering the price Broadcom paid for CA. The $18.9 billion price tag values CA at just about 16 times free cash flow. That might seem a bit high if only CA's growth prospects as an independent company are considered. But tack on the potential to sell other products to CA's customer base, and it's not hard to see the financial logic of this deal.

The data center market was Broadcom's growth engine during the third quarter, driving double-digit growth in revenue and profit. The CA deal opens up a new set of customers to Broadcom, potentially driving growth for years to come.

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

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

CA Technologies Stock Quote
CA Technologies
CA
Broadcom Ltd Stock Quote
Broadcom Ltd
AVGO
$529.91 (-0.70%) $-3.73

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
356%
 
S&P 500 Returns
118%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 11/27/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.