Broadcom Limited (AVGO 1.80%) recently announced the sale of its wireless Internet of Things (IoT) business to Cypress Semiconductor (CY) for $550 million in cash. The sale, which is expected to close in the third quarter of this year, will include Broadcom's Wi-Fi, Bluetooth and Zigbee IoT product lines, its WICED brand and developer community, and all related intellectual property.

Broadcom's retreat from the IoT market was surprising, since many chipmakers have been expanding their IoT presence. Intel (INTC 3.56%), which formed a dedicated IoT unit in 2013, estimates that the number of connected devices worldwide could soar from 15 billion in 2015 to 200 billion by 2020. Qualcomm (QCOM 0.46%) acquired CSR last year to accelerate its growth in IoT chips, and is expanding into connected cameras, drones, and cars.

The WICED Sense development kit. Image source: Broadcom.

Cypress, which sells programmable chips, memory, and other solutions for automotive, industrial, and networking purposes, expects the acquisition to become accretive within a year of closing and improve its gross margin, earnings, and long-term revenue growth potential. If that's true, why did Broadcom part with this potentially high-growth business?

How much revenue is Broadcom giving up?
Broadcom claims that its IoT business generated $189 million in revenue over the past year. That's a tiny amount compared to the $13.1 billion which Broadcom is expected to generate this year. It's also much lower than the $2.3 billion in sales that Intel's IoT unit generated last year. Qualcomm doesn't disclose how much IoT revenue it generates on a regular basis, but it claims that sales crossed the $1 billion mark in 2014. Its subsequent acquisition of CSR, which generated $774 million in sales in 2014, likely boosted that figure significantly.

To generate meaningful revenue and profits from sales of IoT chips, which often cost less than a dollar, companies need to sell a lot of them to take advantage of economies of scale. If they can't scale up, they will be marginalized by rivals which can manufacture chips for less. Profit growth in IoT chips even remains tough for the market leaders -- Intel's IoT operating margins fell from 27.2% to 22.4% between fiscal 2014 and 2015.

A Broadcom adapter for the Raspberry Pi. Image source: Broadcom.

Cypress' main presence in the IoT market consists of ultra-low-power programmable SoCs. The company previously only paired those SoCs with generic radios, but CEO T.J. Rodgers believes that pairing those SoCs with Broadcom's IoT devices could turn the company "into a force in IoT" by creating an "easy-to-use programmable embedded system solution" for its 30,000 customers worldwide.

Simply put, companies like Cypress and Intel, which have significant stakes in programmable chips, see synergies in expanding into the IoT market. Companies like Broadcom, which don't, could fail to effectively scale stand-alone IoT businesses. Therefore, selling the IoT business to pay off debt and streamline its operations is a reasonable move for Broadcom.

Choosing its battles carefully
Broadcom (formerly known as Avago) expressed interest in acquiring programmable chip maker Xilinx last year, but Avago's $37 billion purchase of Broadcom has made it tough to consider buying Xilinx, which has an enterprise value of nearly $10 billion.

Exiting IoT also shows that the "new" Broadcom has learned the lessons of the "old" one. The "old" Broadcom and Texas Instruments previously fought a long and costly battle against Qualcomm in the mobile chipset market. Qualcomm crushed both by scaling up faster, forcing TI to exit the business in 2012 and Broadcom to retreat in 2014. Both companies pivoted toward analog and embedded chips, which had higher margins and were less capital intensive.

Selling the IoT business to Cypress shows that the "new" Broadcom plans to avoid margin-bruising battles against big chipmakers like Intel and Qualcomm in widely hyped markets. Instead, Broadcom plans to focus on big and boring businesses like data center solutions, which it expanded through its acquisitions of LSI, PLX Technology, and Emulex. The company will also integrate that business with its dominant share in data center switch chips.

A shrewd and disciplined move
Broadcom investors shouldn't worry about the company's exit from the wireless IoT business. Instead, they should applaud it as a smart way to drop a small business which can't scale up effectively to compete against larger rivals. If Avago had bought both Broadcom and Xilinx last year, it might have a reason to retain the IoT business, but it didn't, so Cypress can proably do more with it than Broadcom ever could.