Why Is Avago Technologies Ltd. Paying $37 Billion for Broadcom Corporation?

I was wrong. Avago Technologies really is buying semiconductor design rival Broadcom , right after I said this would be a "surprising" choice.

So why is Avago ponying up $17 billion in cash and another $20 billion of freshly printed Avago shares for Broadcom? Let's have a look.

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The basics Technically, Avago is acquiring Broadcom, but this is really a marriage of equals. In some ways, Avago is the smaller partner in this combination.

Data from Yahoo! Finance.

Press materials say the new company will use the Broadcom brand but Avago's senior leadership. It should have an enterprise value of $77 billion on closing, which is expected to happen in the first quarter of 2016.

You'll notice that the $77 billion enterprise value target is significantly higher than the total value of the two original companies. That's because Avago must take on a large amount of new debt to finance the $17 billion cash portion of the transaction.

Avago only has $2.6 billion of cash on hand today, and Broadcom adds just $3 billion. Both balance sheets also hold smallish amounts of long-term debt, which will skyrocket when this merger closes. The companies plan to add $9 billion of fresh debt papers and an undisclosed amount of share sales in a secondary offering.

Broadcom and Avago expect to reap annual cost-saving synergies of at least $750 million within the first 18 months. Since the two product portfolios hardly overlap at all, these savings will fall mostly in the combined sales and administration structure. Avago's leaders hope to bring Broadcom's lagging profit margin up to Avago's higher levels.

Together, Broadcom and Avago should produce somewhere around $15 billion in annual sales. That would be the third-richest revenue flow in the semiconductor industry, behind Qualcomm's $27.5 billion and Intel at $55.9 billion.

For those keeping score at home, both Intel and Qualcomm also command far higher profit margins than Avago. These giants enjoy generous economies of scale, and this merger seems designed to copy that blueprint.

Image source: Avago.

What's wrong with this picture? All of this looks kosher on paper, and the semiconductor industry is about to get a third giant that can stand shoulder-to-shoulder with Qualcomm and Intel. So why did I expect Avago to settle for a smaller deal?

Well, I'm all for cost synergies unlocking additional market value. But paying back Avago's new debt will soak up the upgraded annual earnings from this combination for a decade or more.

The merger between radio specialist Avago and networking titan Broadcom creates a smaller version of Qualcomm, which already covers both of these markets. That's not a bad role model, given Qualcomm's track record of profitable growth, but I'm not sure Avago should be setting itself up for head-to-head comparisons with that particular juggernaut. If nothing else, the merged company will need a couple of years to prove the former Broadcom and Avago components work together just as well as the integrated Qualcomm portfolio does.

The companies held a conference call with analysts to explain the merger. In it, Avago CEO Hock Tan admitted that "we are not as familiar as we should be with Broadcom's various businesses."

Therefore, he couldn't provide a detailed analysis of the expected long-term cost savings, or offer any insight on how the two product portfolios might work together. Sounds like someone forgot to do their homework before spending billions of borrowed dollars.

For these reasons, I don't expect the merger to reach the sales levels of today's individual companies, which will hurt the promised cost savings for a while.

Image source: Broadcom.

Patience, young grasshopper The deal could indeed work out in the very long term. But I expect at least two or three years of integration pains along the way, damaging both sales and profits. The negative effect might be temporary, but we'll have to see how the integration works out in reality.

If the early going is good, Avago might reap shareholder value from this combination. But even so, I expect investors to suffer through a few lean years.

In other words, keep an eye on Avago/Broadcom. Be prepared to pounce on whatever good news shows up, probably at lower buy-in prices. Today does not look like a good time to buy either one of these stocks.

The article Why Is Avago Technologies Ltd. Paying $37 Billion for Broadcom Corporation? originally appeared on Fool.com.

Anders Bylund owns shares of Intel. The Motley Fool recommends Apple and Intel. The Motley Fool owns shares of Apple and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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