Broadcom-Qualcomm: A Merger of Equals is Better

Qualcomm Inc. was right to turn down Broadcom Ltd.’s "final" purchase offer. It is bad for both companies. A better deal is a merger of equals that promises major tax benefits for shareholders, a lower debt burden and swift integration. A merger is what Broadcom and Qualcomm should be discussing rather than the likely fruitless conversation planned over the proposed $121 billion deal.

Investors must nudge them in this direction because neither company will voluntarily select the merger option. Hock E. Tan, president and CEO of Broadcom, wants to own Qualcomm, gobbling it up completely like he did Brocade Communications Systems last year. Qualcomm, too, prefers to continue operating as a standalone company, making occasional acquisitions like the pending purchase of NXP Semiconductors.

Buying NXP will not fundamentally alter Qualcomm’s prospects or help it ward off Chinese regulators and OEMs like Apple that are angling for lower royalties. Broadcom, on the other hand, has quadrupled sales over the past four years via acquisitions, and may be loath to alter what it considers a good growth model. Those acquisitions have boosted Broadcom’s sales but have also saddled it with a negative debt profile; long-term debts rose to $17.4 billion in fiscal 2017 from $4.5 billion three years earlier.

Broadcom has increased its offer for Qualcomm once and can be convinced to hike it again. It would be a mistake. Conservatively, its debt could surge above $40 billion if it succeeds in purchasing Qualcomm. Even Qualcomm’s cash hoard will not reduce the leverage because a large portion of it has been designated for the NXP transaction. Bankers want the deal but the loans they have agreed to provide would add to integration risks and force Broadcom to tamp down on future capital expenditure and R&D expenses.

A Mountain of Debts. So What?

Broadcom and Qualcomm do not seem worried about the debts. Qualcomm’s board of directors says the $82 per share proposal “materially undervalues” the company and is concerned about regulatory objections. It has demanded assurances of Qualcomm’s commitment to doing whatever it would take to guarantee a successful conclusion of the deal. Qualcomm said further, in a statement:

Your proposal ascribes no value to our accretive NXP acquisition, no value for the expected resolution of our current licensing disputes and no value for the significant opportunity in 5G. Your proposal is inferior relative to our prospects as an independent company and is significantly below both trading and transaction multiples in our sector.

The differences in our business models expose the Company to significant customer and licensee risk between signing and closing an agreement. It is indisputable that there are significant regulatory hurdles in your proposed transaction. It is also indisputable that if Qualcomm entered into a merger agreement and, after an extended regulatory review period the transaction did not close, Qualcomm would be enormously and irreparably damaged.

Qualcomm is right to be bothered about the value of the transaction. The company’s request to be shielded from any negative fallout is also a valid demand. However, the best way for Qualcomm to secure all of these demands is to engage in a merger with its suitor. Properly structured, the merger will help the companies achieve their growth objectives; bulk up to fend off competitors in the consolidating semiconductor market, and achieve higher returns on invested capital, all without piling on debts.

Shorn of the acrimony attendant to a hostile takeover effort, the companies can swiftly integrate operations, use cash more efficiently, engage regulators with a unified message, and develop a unified strategy for addressing political authorities in Asia, Europe and North America.

Very importantly, a merger would focus management's time and resources on explaining the transaction to customers, suppliers, employees and shareholders, and free them up to maintain operational efficiencies during the transition period. Rather than engage in a public spat, directors of the two companies should put their fiduciary duties first and engage in a merger discussion.

Equally Matched?

A cursory review of Broadcom’s and Qualcomm’s finances reveals both an oddity and strong reasons for a merger. Qualcomm appears slightly bigger and healthier than its pursuer. Qualcomm’s sales are higher ($22.3 billion versus $17.6 billion in fiscal 2017); its gross profit margin is more robust (58 percent versus 48 percent); and its cash, short- and long-term investments and other long-term assets are stronger ($45.6 billion compared with $11.7 billion for Broadcom.) However, Qualcomm has a higher load of “total long-term debt” – $21.9 billion as opposed to Broadcom’s $17.6 billion.

Source: Company Report

Broadcom has a more interesting longer term growth profile. Its sales have risen sharply on acquisitions and are forecast to jump to $21 billion in the current fiscal year from $17.6 billion in the fiscal year ended Oct. 29, 2017, and only $4.3 billion in fiscal 2014. The company is expected to maintain its strategy of growing through acquisitions.

Qualcomm has grown largely through organic expansion and has experienced severe downward sales pressure. The company is projected to report revenue of $22.2 billion for fiscal 2018, flat from the $22.3 billion posted in the fiscal year ended Sept. 24, 2017, but down from $26.5 billion in fiscal 2014. On a revenue basis, therefore, Qualcomm and Broadcom are evenly matched. They also have similar market capitalization: $97.1 billion for Qualcomm at the end of trading on Friday, Feb. 9, and $98.6 billion for Broadcom.

Odds are that Broadcom will eventually get Qualcomm. Tan has previously shown the flexibility required to secure regulatory approvals and sees no hurdles – financial, political or regulatory – that cannot be overcome with concessions. Qualcomm, on the other hand, has until recently been satisfied with a section of the semiconductor market, gingerly massaging its dominant IP for growth, and when startled by market turbulence willing to explore acquisitions.

Both strategies have their advantages and worked well separately until Tan decided the attainment of his long-term vision for Broadcom required adding Qualcomm to the company’s conquests. The clash is unnecessary; Broadcom and Qualcomm can see their dreams fulfilled in a union, but this should be through a merger. Neither company can afford the debt burden of an outright acquisition.

Bolaji Ojo is editor-at-large of EPSNews. The views expressed in this blog are those of the author alone who promises to base his sometimes biased, possibly ignorant, occasionally irrelevant but absolutely stimulating thoughts on the subjective interpretation of verifiable facts alone. Any comments should be sent to the author at bolaji.ojo@epsnewsonline.com.