Broadcom Tanks After $18.9 Billion CA Purchase Puzzles Market

Ian King (Bloomberg) -- Broadcom Inc. shares suffered their biggest drop ever Thursday after the company said it will buy software maker CA Technologies for $18.9 billion, a deal that flummoxed many analysts who failed to see its strategic or financial rationale.

“We are getting investor pushback with an unexpected surprise at a big software acquisition as it potentially strays from AVGO’s hardware focus,” Mizuho Securities analyst Vijay Rakesh wrote in a note.

The stock fell as much as 19 percent to $197.46 in New York, the lowest price in 18 months.

After almost a decade of deals that have been lauded by the market, Broadcom Chief Executive Officer Hock Tan has some explaining to do about his latest target. The CA purchase represents a leap into a completely different area of electronics with no significant overlap with the semiconductor industry Tan has so successfully reshaped.

Tan’s previous acquisitions have resulted in analyst notes with titles like “In Hock We Trust,” and pushed up Broadcom’s stock price to more than $280 last year from less than $20 in 2009. While Tan’s deal-making prowess built the company into one of the largest in the $400 billion chip industry and his strategy has earned rave reviews, the announcement of the CA purchase prompted analysts to react with lists of questions rather than the usual praise.

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“It’s the lack of obvious connection between the two businesses,” said Cody Acree, an analyst at Loop Capital Markets. “What does Broadcom know about improving CA’s efficiencies? It is hard to bet against the guy in the long term.”

Traditionally, companies make acquisitions in areas that give them the capability to improve what they’re already good at or provide access to new markets for their existing products. Tan and his team are asking investors to look beyond that framework, arguing that their ability to squeeze value from unloved assets is applicable across a broader chunk of the technology industry.

“We are applying the model that’s created so much value,” Chief Financial Officer Tom Krause said. “Our model is to find value in the public markets where the existing investors don’t see it. This is something that we had been thinking about for a while.”

Krause said software is less cyclical than semiconductors, provides high-margin recurring revenue and, because the two companies have no overlap, won’t face the kind of regulatory scrutiny that has delayed or scuttled chip-related deals.

The CA purchase follows on the heels of a rare defeat for Tan. Last year, the CEO launched an ambitious attempt to grow bigger through the purchase of rival mobile-chip maker Qualcomm Inc. That hostile takeover bid was halted in March by the U.S government on national-security grounds. After the rejection of the Qualcomm bid, the San Jose, California-based company -- which relocated its headquarters to the U.S. from Singapore earlier this year -- had said it would probably avoid large purchases and concentrate on returning cash to shareholders in the form of stock buybacks and dividends.

Tan has built Broadcom by acquiring what he calls franchises. He looks at targets and identifies units and businesses inside those companies that he believes have a sustainable advantage, makes an acquisition, then spins off or shutters everything else. The strategy has widened Broadcom’s profit margins by more than 20 percentage points since 2009 and earned him praise from the market. CA Technologies, incorporated as CA Inc., has even better profitability. Broadcom’s gross margin, or percentage of sales remaining after deducting the cost of production, was 67 percent in its most recent quarter. CA was at 86 percent.

Broadcom will pay $44.50 per share, a 20 percent premium to New York-based CA’s closing price on Wednesday, the companies said in a statement. The deal will immediately add to earnings once completed, which is expected in the fourth quarter. Broadcom plans to pay for the purchase with cash on hand plus $18 billion in new debt financing. The company said it expects its debt rating to remain at investment grade.

Broadcom is a provider of components for computers, smartphones and networking equipment. CA’s software and services don’t directly overlap in any way, but diverging so far in terms of products may help the transaction avoid the same level of regulatory scrutiny that the Qualcomm bid did. CA makes software to manage IT operations, digital security and project management and for developing applications. The company traditionally made products that run on mainframe computers, but in recent years has entered the cloud-computing market. The software maker is cutting 800 jobs, it said in a regulatory filing in May, putting it in line with the cost-reduction measures that Tan usually employs.

Tan, in the statement, implied he will make even more deals.

“This transaction represents an important building block as we create one of the world’s leading infrastructure technology companies,” he said. “We intend to continue to strengthen these franchises to meet the growing demand for infrastructure software solutions.”

While investors may scratch their heads in the short term, Tan and his team are firing up a playbook that has delivered: earnings growth through acquisitions. Convincing investors to trust him to pull it off again in a new industry again may be a bigger challenge than executing on his plan.

“That’s going to be the battle, to convince portfolio managers that it’s OK to replicate a good model in semiconductor in software,” said Pierre Ferragu an analyst at New Street Research LLP. “The initial reaction of the Street is going to be negative, but the company is going to deliver.”