Grab a Seat for the Broadcom-Qualcomm Battle

Bluechip

By: R. Scott Raynovich

Get ready for the Battle of the Comms, which may determine the trajectory for the communications chip market for a decade to come. Broadcom, the ruler of networking equipment "merchant silicon" as well as many specialty mobile device chips, is trying to take over Qualcomm, the king of radio frequency (RF) intellectual property. And Qualcomm wants none of it.

After Qualcomm's board on Monday ejected chip rival Broadcom's $70-per-share bid for its company, it's becoming more evident that Broadcom will likely have to sustain a projected battle, including a much higher bid and possible proxy battle, to acquire Qualcomm. And many analysts and pundits see the stakes rising and the bid price going much higher.

It's a classic shareholder value debate: Qualcomm says it's doing a fine job, while Broadcom's offer to shareholders could pay them premium value and potential upside in a merger.

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Qualcomm's executive chairman, Paul Jacobs: "It is the board's unanimous belief that Broadcom’s proposal significantly undervalues Qualcomm relative to the company's leadership position in mobile technology and our future growth prospects."

There is some irony in Qualcomm's board rejecting the $70-per share, or $105 billion net of debt, as "undervalued." A month earlier, Qualcomm's share price had sunk to a 52-week low of $50 following threats by Apple (AAPL) that it would be seeking alternative suppliers for Qualcomm's chips.

Hock Tan vs. the Qualcomm braintrust

There is a lot at stake. San Diego-based Qualcomm is an iconic American technology company, one of the pioneers in wireless technology that holds thousands of patents and retains a steel grip on the mobile phone industry with its ubiquitous RF modem chips for which it extracts healthy licensing revenues, the source of the aforementioned remorse at Apple.

Qualcomm is also in the midst of remaking itself with a crucial $47 billion merger with NXP Semiconductor (NXPI), which has emerged as dominant in the attractive automotive chip sector. Is this maybe what the Broadcom battle is all about? It's a big part of it. Qualcomm says that NXP will grow Qualcomm's addressable market to $138 billion by 2020. That's pretty big. (Check out our Ultimate Industrial Internet of Things [IIoT] report for more on this.)

The two company cultures could not be any more different. On Wall St., Qualcomm has long been thought of as a solid cash cow, generating steady royalties on licensing revenue while selling billions in chips as well. In 2016, Qualcomm made $6.5 billion of pretax profit on $7.6 billion of revenue from licensing. Its chip business was a mere $1.8 billion of pretax profit on $15.4 billion of sales. The company has 25% operating margin and is paying a 4% dividend at the current stock price.

Qualcomm's culture is engineering driven, focused on long-term intellectual property -- and of course protecting the royalty stream. It's also become risk-averse in recent years, as indicated by Qualcomm's stagnant revenue growth. That's a big reason for the NXP deal -- the company is in search of big new markets to take it to the next level.

Some critics believe that over time, Qualcomm has depended too much on its licensing business, which is a cash cow but may not provide enough motivation to develop new products.

Enter Broadcom's CEO Hock Tan, an aggressive master of the deal who has transformed Broadcom from a sleepy networking chip company into an industry goliath with a couple swooshes of the pen. Tan for many years was the CEO of Avago, the Singapore-based company that acquired Broadcom in 2015 in the biggest tech merger ever, then took its name. Tan is in the midst of moving Broadcom/Avago to the United States from its current base of Singapore.

It worked once, why not do it again? Only this time the deal will be much larger. Broadcom's bid is a compelling catalyst to change Qualcomm and alter its business model away from technology royalties and into growth. Tan is brilliant in that he pounced at exactly the right time -- when Qualcomm was weakened by its share price and the growing threats by Apple, including its alliance with Intel as a alternative source.

Many pundits and analysts predict that Broadcom will up its bid from $70 per share price -- possibly as high as $80 per share. Qualcomm recently sat around $66, not quite reaching Broadcom's first $70-per share bid but much higher than the $52 it was trading at the day before the bid last week. Analysts predict a higher price to get the deal done. For example, RBC says Broadcom will need to go to $80/share, though this might require a formal proxy battle to gain the side of Qualcomm shareholders. Canaccord analysts recently upped their price target for Qualcomm to $83 from $76 a share.

But Qualcomm executives hate this deal. Of course they do. Nobody likes to lose control.

What's next?

The growing consensus on Wall St. is that Tan is hungry for this deal and is willing to go higher. But at what price does the Qualcomm board or shareholders cave? Many analysts and pundits are calling for $80 a share.

I will give you a price right now: $85 a share. That seems like a good number to turn the corner. But it's not going to be easy -- and it could get even more complicated. Consider the following scenarios:

  • Broadcom ups the price and eventually succeeds at acquiring Qualcomm. Qualcomm shareholders would have a hard time rejecting any price at $80 or higher.
  • Broadcom succeeds in a takeover bid but the US department of commerce takes issue with the size of the Broadcom-Qualcomm-NXP combination and requests some kind of scaled back marger or divestitures.
  • Qualcomm succeeds in rebuffing Broadcom, which doesn't go high enough. It merges with NXP, and embarks on its new journey.

Broadcom's Tan says that his company would prefer that Qualcomm "engage cooperatively with Qualcomm's Board of Directors and management team." In other words, he wants a friendly takeover, not a hostile one, but it's clear he's sending the signal that he could get down and dirty, and we know that he will.

The reason this scenario has set up is a numbers game: Qualcomm's stock had fallen too low, the NXP deal is taking forever because of the complexity and regulatory review, and Broadcom saw an opportunity in classic merger synergies.

Resultant merger to rule phones, cars

Once merged, Broadcom believes an acquisition of Qualcomm and NXP would result in sales of $51 billion a year and some $23 billion in adjusted EBITDA, according to public statements. That would make the newly formed mega-chip company third in size to Samsung (SSNLF) and Intel (INTC), which have about $60 billion in sales. The company would have a dominant position in mobile device chips, and a significant lead in the growing and attractive automotive chip segment.

NXP and Qualcomm would add $32 billion to Broadcom's $19 billion in sales. Even though Broadcom has a smaller revenue number, its valuation is much higher, at a premium 7X sales multiple, giving it the equity to make the deal. Broadcom is valued at 18 times cashflow. Qualcomm is trading at about 12 times cashflow. So if you average the two out and subtract the estimated $3 billion in cost savings, what you get at the end of the deal is Broadcom with a cheaper valuation and earnings leverage, giving Tan the money to work with.

Given that Broadcom is smaller, how would it make this work? Debt -- of course -- the source of all leveraged buyouts. At the current low rates, borrowing is attractive, especially if Broadcom considers the savings it could garner from the "synergies" of combining the companies (layoff OS core functions).

In the end, the stage is set for a classic hostile takeover battle. Tan, the global maverick, versus conservative, suit-wearing engineers in San Diego. Grab some popcorn.

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