Here's Why Marvell's Pending Purchase of Cavium Networks Looks Brilliant

Over the last several years, there has been a flurry of merger and acquisition activity in the chip industry. Last year, one of the more notable announced deals was Marvell's (NASDAQ: MRVL) planned acquisition of specialty data-center chip maker Cavium Networks (NASDAQ: CAVM) in a combination cash and stock deal that valued Cavium at $6 billion.

When the two companies announced this business combination in November, Marvell spent a great deal of time explaining to investors why the acquisition is in the best interests of both Marvell and Cavium stockholders.

The deal is expected to close in the middle of calendar year 2018 and so far there haven't been any obvious regulatory hurdles to the deal closing. So it looks like the deal will go through and here's why it makes sense to stay invested in Marvell after the deal closes.

Complementing Marvell's product portfolio

Marvell sells chips into the storage, networking, and wireless connectivity markets. Cavium sells products into the computing, networking, storage connectivity, and security markets. While both Marvell and Cavium offer products to the storage and networking markets, keep in mind that those markets are vast and the two companies focus on different areas within those markets, meaning that their respective storage and networking businesses should be quite complementary.

Additionally, by scooping up Cavium, Marvell will get access to the data-center processor market as well as the security processor market.

Marvell estimates that its served addressable market, excluding Cavium, is about $8 billion (and growing), and that Cavium's served addressable market is also $8 billion. So that gives the combined entities a combined revenue opportunity of at least $16 billion.

That's not to say that they'll be successful in capturing all of it; competition across all of these markets is fierce. But ideally, the greater financial might and scale of the combined entities will make revenue-share gains across the board easier to achieve.

A compelling financial argument

Marvell argued that the combined entity will have a "best-in-class financial model." Although Cavium generates less revenue than Marvell, Cavium's gross profit margin is higher, as is its EBITDA (earnings before interest, taxes, depreciation, and amortization) margin.

Without any cost synergies -- such as eliminating redundant positions, or combining marketing and engineering efforts where possible -- the combined entity would enjoy higher gross profit margin and higher EBITDA margin (though operating income margin would be slightly down, as Cavium's is 100 basis points lower than Marvell's).

However, Marvell thinks that it can realize between $150 million and $175 million in cost synergies within 18 months following the close of the deal. Looking out longer term, Marvell says that it hopes that the combined entity will enjoy 6% to 8% compounded annual revenue growth, with gross profit margin expansion to around 65% (up from 61%) and operating income margin of around 35% (up from around 26%).

In other words, not only will bringing Cavium into the fold allow Marvell to enjoy better long-term revenue growth prospects, but both companies together could be substantially more profitable than either would be as a stand-alone entity.

This looks like a good deal for both

As the chip industry matures, it's only natural that smaller companies like Marvell and Cavium would want to combine to form a larger, more powerful entity. Scale is a critical competitive advantage in the chip industry, and the ability to offer a wider portfolio of products to potential customers (Marvell and Cavium sell to many of the same customers) can be the difference between closing the deal and not.

Marvell's acquisition of Cavium should clearly accelerate Marvell's revenue and profit growth in the years ahead.

For Cavium stockholders, this deal looks pretty good, too. The deal consists of $40 per share in cash, as well as 2.1757 shares of Marvell stock for each share of Cavium stock. This gives Cavium stockholders more for their shares than the stock ever traded for before the deal was announced, and it allows them to remain significantly invested in the combined company.

Both Marvell and Cavium stockholders should be happy with this deal.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.