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Here's Broadcom's Plan to Boost Earnings

By Timothy Green - Dec 10, 2018 at 5:00PM

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Extreme cost-cutting at CA Technologies should do the trick.

Semiconductor supplier Broadcom ( AVGO 1.23% ) spent $18.9 billion earlier this year to acquire CA Technologies, a company that makes most of its money selling software for mainframe systems. The plan was to tap into CA's customer base, comprised of some of the largest companies and organizations in the world, and cross-sell products from Broadcom's portfolio.

Broadcom will also be making substantial changes to CA's business model, aimed at boosting profitability. Broadcom CEO Hock Tan laid out these adjustments during the fourth-quarter conference call, saying that the multiyear plan will raise CA's annual operating profits to more than $2.5 billion.

Scissors cutting paper that reads costs.

Image source: Getty Images.

No more chasing new customers

"Gone are the days of trying to land new products with new customers," according to Tan. CA's sole focus going forward will be on its existing base of mainframe-centric customers. The company will aim to renew existing products with existing customers while also trying to sell additional products to those customers.

The immediate benefit of this change will be far lower costs. "The cost of running this renewed and expanded model will be substantially less than the legacy land-at-all-cost model," Tan said. Broadcom is targeting annual spend of no more than $900 million at CA on roughly $3.5 billion of revenue. That would bring annual operating income for CA to around $2.5 billion, up from about $1.1 billion in fiscal 2018. CA's non-GAAP operating expenses for fiscal 2018 were $2.7 billion.

In other words, the cost-cutting will be extreme.

Broadcom's current customers "represent virtually all of the world's largest enterprises and largest spenders on IT," according to Tan. More than 70% of CA's revenue comes from its top 500 accounts, and many of those customers have been with CA for decades. Spending heavily to win new customers just doesn't make all that much sense.

Retaining existing customers shouldn't be all that hard, given that mainframe systems are extremely sticky. International Business Machines, the mainframe hardware market leader, has been selling mainframes for more than five decades, and is currently enjoying the strongest mainframe refresh cycle in years. Switching costs are extremely high, effectively locking in existing mainframe customers. It won't take much spending for Broadcom to hold onto CA's customer base.

Broadcom is also planning to shake up CA's licensing model in an effort to encourage customers to use more products. "So, moving forward, we are going to move away from the inflexible, perpetual license model for enterprise software to an enterprisewide, all-you-can-eat license for all of our core accounts. By doing this, we expect to remove the friction caused by selling expensive up-front perpetual licenses so that the incremental costs for our customers to expand the use of enterprise products will be highly competitive relative to [software-as-a-service]-based alternatives," Tan said.

A new source of profits

Tan believes this transition will take a couple of years, partly due to the timing of contract renewals. But the boost to earnings will be significant if Broadcom can pull it off. Broadcom is currently dealing with a slowdown in its wireless business, and weak demand for smartphones in general will make wireless growth a tough prospect going forward. The wireless segment suffered a 5% sales decline in the fourth quarter, although it would have been worse if not for stronger-than-expected sales of older iPhones.

Despite that slowdown, Broadcom still expects to grow per-share earnings at a double-digit rate in 2019. Even if the wireless business performs worse than the company is expecting, CA's improved profitability can keep Broadcom's bottom line moving in the right direction.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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