Broadcom's (AVGO 3.84%) stock price declined in 2022 due to various factors, including the Federal Reserve's interest rate hikes and inflation, which led investors to assign lower valuations to stocks.
But concerns about a slowdown in chip demand also played a part, as most analysts believed the chip industry ended its boom cycle in 2021. Also, Broadcom's pending acquisition of VMware (VMW) was a factor, as many investors were concerned about the deal falling through.
Broadcom's stock returns this year through May showed only a slight increase compared to the returns of the S&P 500. However, on May 19, there was some great news when VMware's management notified the Securities and Exchange Commission that both companies agreed to extend a May 26 deadline for completing their deal to Aug. 26. In addition, the deadline can be extended to Nov. 26, if necessary.
These extensions should give the companies time to complete regulatory approvals to close the transaction. This is a positive sign, as it indicates that both companies are confident they can obtain all the necessary approvals. Investors reacted by bidding the stock price up by 29% between May 19 and June 30, putting its stock's returns well ahead of the S&P 500's year-to-date returns.
The stock price reaction suggests that investors are also optimistic about the deal closing, which many expect to create a leading provider of cloud infrastructure software.
Despite the good news, some investors may dislike the company's relatively high price-to-earnings (P/E) ratio of 27.48, now above the S&P 500's P/E ratio of 25.79.
Moreover, the risk is high that the U.S. economy could still tank, resulting in the stock selling off. Nevertheless, it may still be worth investing in Broadcom at its current valuation. Here's why.
Acquisition of VMware is a significant strategic move
Broadcom, a company known for producing semiconductor chips, recently diversified its business by venturing into software offerings. Acquiring VMware would significantly boost its software portfolio, particularly in virtualization software, which could help it compete against established software companies like Microsoft (NASDAQ: MSFT).
The acquisition of VMware would also give Broadcom a significant foothold in the cloud computing market. VMware is a leader in cloud computing infrastructure, and has strategic relationships with many of the world's largest cloud providers. Furthermore, the addition is a solid move to expand its presence and competitiveness in the software application market.
Image source: Broadcom.
Investors want this deal to close due to management's proven success in acquiring strategically aligned, successful companies, improving those companies' financials, and extracting value from the acquisitions. The company has been able to do this by several means, including:
- Synergies: Broadcom often finds ways to combine the operations of its acquired businesses with its own, resulting in cost savings and revenue growth.
- Growth: Broadcom also looks for acquisitions that will help it grow into new markets or expand its existing businesses. For example, when Broadcom acquired Symantec in 2019, it enabled Broadcom to provide a wider variety of products and services to its customers, and it also helped the company gain a significant share of the cybersecurity market.
- Innovation: Broadcom also looks for acquisitions to help it innovate. For example, when Broadcom acquired Brocade Communications Systems in 2017, it gained access to Brocade's switching technology, which helped Broadcom develop new networking products.
As a result of these strategies, Broadcom improved the profitability of the companies it acquires. It already has plans to enhance the profitability of VMWare significantly.
Image source: Broadcom.
Furthermore, the company has a strong track record of exceptional performance following acquisitions.
Image Source: Broadcom.
So, investors have many reasons to like this acquisition. However, the big question is: Will the deal go through?
There is a significant risk the deal will fail to close
While management is optimistic the deal will get done, several obstacles could prevent the acquisition from closing, the most prominent being regulatory scrutiny.
Regulators in the U.S., Europe, and China have yet to rule on the deal and whether they believe it would harm competition.
In particular, regulators in the U.S. and Europe are concerned that Broadcom's acquisition of VMware would give the company too much control over the market for server virtualization software.
VMware is the leading server virtualization software provider, and Broadcom is a primary server hardware component supplier. Regulators worry that if Broadcom were to acquire VMware, it could use its control of VMware's software to stifle competition in the server hardware market.
It is currently unknown whether regulators in China will investigate the Broadcom-VMware deal. However, China has a track record of blocking or delaying U.S. company mergers, which means it may do the same in this case.
Management likes its chances
Broadcom has a strong track record of completing acquisitions. The company has acquired 41 organizations, according to Crunchbase. Broadcom's team of experienced dealmakers are familiar with the regulatory process and have a good track record of working with regulators to get deals approved.
During the second-quarter 2023 earnings call, Broadcom CEO Hock Tan was optimistic the acquisition would be completed.
"We're making good progress with our various regulatory filings around the world, having received legal merger clearance in Australia, Brazil, Canada, South Africa, and Taiwan and foreign investment control clearance in all necessary jurisdictions," he said. "We still expect the transaction will close in Broadcom's fiscal 2023."
So, it is evident that the management of both companies believes the odds still favor the deal. If you're an aggressive growth investor and think the Broadcom and VMware acquisition has a high chance of closing this year, consider adding some shares to your portfolio.
