When chip giant Broadcom (NASDAQ: AVGO) announced in July that it planned to pay $18.9 billion in cash to acquire CA Technologies (NASDAQ: CA), the reaction from analysts was far from positive.
"Lots of explanation (is) needed," wrote RBC Capital Markets analyst Amit Daryanani in a note to clients, as reported by Reuters.
"We believe this planned acquisition definitely will create some uneasiness among its current investor base," KinNgai Chan, analyst for Summit Insights Group, told Reuters.
Broadcom has built itself into a chip juggernaut by making acquisitions, but CA doesn't fit the mold of a typical Broadcom buy. CA is a software company that derives the bulk of its revenue and almost all its profit from solutions for mainframe systems. Mainframe systems have been around for decades, and they're still used for mission-critical workloads in certain industries. But it's not exactly a growth business -- CA's mainframe solutions revenue was flat in fiscal 2018.
So why did Broadcom hurl nearly $20 billion at a mainframe software company? CEO Hock Tan answered that question during Broadcom's latest earnings call.
"These guys are deeply embedded"
Tan admitted during the call that the company's strategy with the CA acquisition wasn't clear: "The No. 1 question we get with CA is, why did we choose to buy?"
Tan believes CA's mainframe solutions business is attractive: "Mainframes remain the backbone of the enterprise computing environment and are relied on to run mission-critical applications. ... Given mainframes are the most important parts of large enterprises, we believe this will remain a strong and stable market opportunity for us for long term."
But that stable mainframe business isn't what Broadcom is ultimately after. Instead, Broadcom wants access to CA's base of longtime customers. CA's software is entrenched in industries like financial services, insurance, and healthcare that are heavy users of mainframe systems. Companies in those industries rely on CA's software for mission-critical workloads. Switching costs are high for both the software and the underlying mainframe systems.
International Business Machines, the market leader in mainframe systems, is having its strongest mainframe product cycle in years. There's no denying that the mainframe is about as sticky as it gets when it comes to enterprise hardware.
Broadcom wants to use CA's deeply embedded status to cross-sell other products to CA's customers. Tan explained: "Just as we have done with hyper cloud players, we believe we can bring our compute offload solutions, our Tomahawk switches, Jericho routers, fiber optics and our server storage connectivity portfolio directly to these same large enterprises that are buying CA software."
So while Broadcom views CA's core mainframe business positively, its strategy is to leverage CA's deep customer relationships to boost sales across its portfolio of products.
That plan makes sense, especially considering the price Broadcom paid for CA. The $18.9 billion price tag values CA at just about 16 times free cash flow. That might seem a bit high if only CA's growth prospects as an independent company are considered. But tack on the potential to sell other products to CA's customer base, and it's not hard to see the financial logic of this deal.
The data center market was Broadcom's growth engine during the third quarter, driving double-digit growth in revenue and profit. The CA deal opens up a new set of customers to Broadcom, potentially driving growth for years to come.
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