Image Shown: Broadcom Inc is acquiring VMware Inc and the deal will significantly increase its enterprise software business. Image Source: Broadcom Inc and VMware Inc – May 2022 IR Presentation
By Callum Turcan
Continuing with its acquisitive streak, the semiconductor and enterprise software giant Broadcom Inc (AVGO) announced on May 26 that it would acquire hybrid cloud services provider VMware Inc (VMW) through a cash-and-stock deal that values VMware at ~$61 billion. Additionally, Broadcom will assume ~$8 billion in net debt from VMware. This follows in the footsteps of Broadcom’s $18.9 billion deal to acquire CA Technologies in 2018 and its $10.7 billion deal to acquire the enterprise security business of then-Symantec, now NortonLifeLock Inc (NLOK), in 2019.
Under the leadership of Hock Tan, Broadcom’s CEO since 2006, the company has built itself into a tech powerhouse through a series of acquisitions. In 2018, Broadcom formally ended its attempt to acquire Qualcomm Inc (QCOM) in the face of antitrust concerns and adjusted its strategy accordingly. By growing its enterprise software business, namely through acquisitions, Broadcom was largely able to avoid antitrust concerns. However, it remains to be seen if regulators will give their blessing to this pending acquisition.
Deal Overview
Shareholders of VMware have the option to receive either $142.50 in cash or 0.252 share of Broadcom for each share of VMware they own. Additionally, “the shareholder election will be subject to proration, resulting in approximately 50% of VMware’s shares being exchanged for cash consideration and 50% being exchanged for Broadcom common stock,” which effectively limits the total cash considerations of the deal. If the deal goes through as planned, Broadcom notes that existing AVGO shareholders will own ~88% of the combined company’s equity and VMW shareholders will own the remaining ~12%. The respective boards of directors of both companies have already unanimously approved the deal.
Here is some important background information. In November 2021, Dell Technologies Inc (DELL) completed the spinoff of its equity stake in VMware to its shareholders. This move is why Michael Dell (founder, CEO and Chairman of Dell Technologies) and Silver Lake (a private equity firm) own ~40% and ~10% of VMware’s outstanding equity, respectively. Silver Lake helped take Dell Technologies private in 2013 and also helped the firm acquire EMC Corp in 2016. It was Dell Technologies’ acquisition of EMC Corp that saw it obtain a roughly 81% equity stake in VMware. By late 2018, Dell Technologies had returned to public markets.
Given that Dell and Silver Lake together own over half of VMware’s outstanding equity and support Broadcom’s offer, before taking regulatory concerns into account, it seems quite likely that the deal will proceed as planned. There is a 40-day “go-shop” provision in the acquisition, so VMware could see another offer emerge. Broadcom is offering a ~44% premium to take over VMware based on where the company’s stock was trading at on May 20, before rumors of a potential deal emerged. This acquisition is expected to close in Broadcom’s fiscal 2023, with its fiscal 2022 expected to end either in late October or early November of this calendar year.
Additionally, this deal includes a $1.5 billion termination fee that could be paid by either Broadcom (should regulatory hurdles prevent the deal from proceeding, among other factors) or VMware (should a better offer materialize from a different party, among other factors), depending on the circumstances. The size of the termination fee also changes depending on when the deal is terminated, particularly as it concerns VMware’s potential termination fee.
Financial Considerations for Broadcom
On May 26, Broadcom reported second quarter earnings for fiscal 2022 (period ended May 1, 2022) that beat both consensus top- and bottom-line estimates. Its GAAP revenues grew 23% year-over-year last fiscal quarter to reach $8.1 billion as sales at its ‘semiconductor solutions’ segment rose 29% and sales at its ‘infrastructure software’ segment rose 5%. Broadcom posseses ample pricing power as its GAAP gross margin surged higher ~575 basis points year-over-year to hit 67.1% last fiscal quarter, while a modest decline in its operating expenses combined with gross margin expansion saw its GAAP operating margin grow by ~1,200 basis points to reach 41.9%.
The company’s GAAP diluted EPS grew 80% year-over-year to hit $5.93 in the fiscal second quarter due to net income growth and a modest reduction in its outstanding diluted share count. Broadcom runs an incredibly lucrative business, and its performance has been impressive of late.
Due to Broadcom’s asset-light business model, which requires relatively modest capital expenditures to maintain a given level of revenues, the firm is a free cash flow cow. Broadcom generated $7.5 billion in free cash flow during the first half of fiscal 2022 while spending $3.5 billion covering its dividend obligations and another $5.5 billion buying back its common stock through its repurchase program (exclusive of the $0.9 billion spent on ‘shares repurchased for tax withholdings on vesting of equity awards’). The firm also spent $0.2 billion on acquisitions during this period.
As of May 1, Broadcom had $9.0 billion in cash and cash equivalents on hand versus $0.3 billion in short-term debt and $39.2 billion in long-term debt. The company noted in the press release announcing its deal for VMware that it had “obtained commitments from a consortium of banks for $32 billion in new, fully committed debt financing” which signaled to the market the serious nature of its offer. Broadcom’s net debt load, which is quite substantial, is a product of its acquisitive past and its share repurchase programs.
In conjunction with the announcement of its deal for VMware, Broadcom noted that it had authorized an additional $10.0 billion in share buyback authority through the end of December 2023. That is on top of its existing share repurchase program, which had ~$3 billion in remaining buyback capacity as of late May.
As it concerns the firm’s dividend, management noted that “Broadcom expects to maintain its current dividend policy of delivering 50% of its prior fiscal year free cash flow to shareholders” and that “Broadcom expects to maintain an investment grade rating, given its strong cash flow generation and intention to rapidly de-lever.” We appreciate Broadcom’s plan to pay down debt as fast as possible, though that will be difficult to do while repurchasing large amounts of its stock.
Image Shown: Broadcom is a free cash flow cow with a stellar track-record of dividend growth. The company’s shareholder return policy calls for paying out half of its previous fiscal year’s free cash flows to investors as dividends. Image Source: Broadcom and VMware – May 2022 IR Presentation
The firm’s aggressive growth ambitions combined with its generous shareholder return programs and sizbale net debt load (which is about to get much bigger) are concerning. Beyond the debt required to fund the cash portion of the deal for VMware, the ~$8 billion in net debt it expects to take on from VMware will further bloat Broadcom’s balance sheet. When this deal closes, we expect Broadcom’s Dividend Cushion ratio will take a big hit. The firm aims to bring its total debt to adjusted EBITDA ratio down to 2.5x or lower within two years of the deal closing, and Broadcom will likely need to slow down the pace of its share repurchases, and dividend increases, in order to do so.
Broadcom sees the VMware deal adding ~$8.5 billion to its annualized non-GAAP EBITDA within three years of the acquisition closing. A combination of sales growth and cost cutting measures are expected to make that possible. Furthermore, the deal will see software revenue grow to around half of Broadcom’s company-wide revenues. Last fiscal quarter, its infrastructure software sales represented just under one quarter of its company-wide revenues, highlighting the transformative nature of this deal.
Image Shown: Within three years of the deal for VMware closing, Broadcom aims to substantially increase the annualized EBITDA from these operations by focusing on recurring revenues, optimizing R&D expenses, implementing new sales and marketing strategies, and cutting corporate overhead costs by rationalizing redundant back-office activities. Image Source: Broadcom and VMware – May 2022 IR Presentation
Operational Considerations for Broadcom
From an operational standpoint, this deal makes a lot of sense. Broadcom sees ample room for synergies across its portfolio by joining forces with VMware, and due to its expansive slate of offerings, we are inclined to agree. Historically, Broadcom has done a stellar job integrating new assets into its broader operations. We expect that will be the case for its pending VMware deal as well.
Image Shown: An overview of VMware’s operations. Image Source: Broadcom and VMware – May 2022 IR Presentation
Here is an excerpt from the acquisition press release detailing VMware’s operational focus and the reasoning behind Broadcom’s pending acquisition (emphasis added):
VMware, a leading provider of multi-cloud services for all apps, pioneered virtualization technology, an innovation that positively transformed x86 server-based computing. VMware then created the software-defined data center and played a leading role in virtualizing networking and storage, before evolving to become a hybrid cloud and digital workspace leader. Today, VMware’s multi-cloud portfolio, spanning application modernization, cloud management, cloud infrastructure, networking, security and anywhere workspaces, forms a flexible, consistent digital foundation on which the largest and most dynamic enterprises across industries build, run, manage, connect and protect their most important and complex workloads for the benefit of their customers.
Following the closing of the transaction, the Broadcom Software Group will rebrand and operate as VMware, incorporating Broadcom’s existing infrastructure and security software solutions as part of an expanded VMware portfolio.
By bringing together the complementary Broadcom Software portfolio with the leading VMware platform, the combined company will provide enterprise customers an expanded platform of critical infrastructure solutions to accelerate innovation and address the most complex information technology infrastructure needs. The combined solutions will enable customers, including leaders in all industry verticals, greater choice and flexibility to build, run, manage, connect and protect applications at scale across diversified, distributed environments, regardless of where they run: from the data center, to any cloud and to edge-computing. With the combined company’s shared focus on technology innovation and significant research and development expenditures, Broadcom will deliver compelling benefits for customers and partners.
Both Broadcom and VMware are targeting attractive opportunities that are supported by secular tailwinds. Growth in the utilization of private and public cloud computing operations, and growth in the utilization of hybrid cloud activities (using both private and public cloud services), is expected to remain robust going forward.
Image Shown: Acquiring VMware will further grow Broadcom’s exposure to secular tailwinds, which is already quite substantial. Image Source: Broadcom and VMware – May 2022 IR Presentation
As it concerns Broadcom’s semiconductor business there are numerous secular tailwinds to consider including the Internet of Things (‘IoT’) trend, growing demand from the automotive industry for additional computing power, the proliferation of cloud computing, growth in the volume of consumer electronics sales, the expansion of reliable electricity and internet services in emerging markets, and much more. Broadcom’s outlook is incredibly bright with or without VMware, though adding VMware to its portfolio would further solidify its promising growth runway.
Concluding Thoughts
Our fair value estimate for Broadcom sits at $502 per share and the top end of our fair value estimate range sits at $628 per share. As of this writing, Broadcom is trading in the upper half of our fair value estimate range, indicating its shares are fairly valued at this time. Shares of AVGO yield a nice ~3.0% as of this writing and its Dividend Cushion ratio sits just over parity at 1.1, earning Broadcom a “GOOD” Dividend Safety rating, though again we caution that its deal for VMware will likely see its dividend strength weaken until it is able to repair its balance sheet strength. We assign Broadcom an “EXCELLENT” Dividend Growth rating given its impressive free cash flow generating abilities and stellar dividend growth track-record.
Broadcom’s deal for VMware makes strategic sense, though the company is pushing its balance sheet to the limit in its “empire building” quest. We are keeping a close eye on the deal, and caution that it may run into headwinds over antitrust concerns now that Broadcom is a much bigger player in the enterprise software space. On a final note concerning Broadcom, the firm issued guidance for the current fiscal quarter during its latest earnings update that calls for approximately $8.4 billion in revenue (which if realized represents ~29% year-over-year growth) and for its non-GAAP adjusted EBITDA to equal around 63.5% of its forecasted revenues (which would come in around $5.3 billion if realized, representing ~29% year-over-year growth).
Our favorite ideas in this space are ASML Holding NV (ASML), the Dutch company that makes photolithography systems used to produce high end semiconductors, Qualcomm, which designs semiconductors used in a variety of applications, and Taiwan Semiconductor Manufacturing Company Limited (TSM), the largest semiconductor foundry which produces semiconductors designed by third-parties.
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Callum Turcan owns shares of DIS, FB, GOOG, VRTX, and XLE and is long DIS and FB call options. Apple Inc (AAPL), Cisco Systems Inc (CSCO) and Microsoft Corporation (MSFT) are all included in both Valuentum’s simulated Best Ideas Newsletter portfolio and simulated Dividend Growth Newsletter portfolio. Alphabet Inc (GOOG) Class C shares, Meta Platforms Inc (FB), Korn Ferry (KFY), PayPal Holdings Inc (PYPL) and Visa Inc (V) are all included in Valuentum’s simulated Best Ideas Newsletter portfolio. Oracle Corporation (ORCL) and Qualcomm Inc (QCOM) are both included in Valuentum’s simulated Dividend Growth Newsletter portfolio. ASML Holding NV (ASML), Meta Platforms, Oracle, and Taiwan Semiconductor Manufacturing Company Limited (TSM) are all included in Valuentum’s simulated ESG Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.