Broadcom Acquires VMware: Make Money Out Of It





Top view of business office workstation with M&A letters or merger and acquisition

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On May 25, Broadcom (NASDAQ:AVGO) confirmed the acquisition of VMware (NYSE:VMW) rumored earlier and the announcement has created an attractive opportunity for investors. While promising it is rather complex, open-ended, and full of moving parts. Does it make sense to act now, wait longer, or ignore it?

Basic facts

We will mostly follow Broadcom’s 8-K filing of May 26 which, besides other things, contains the text of the Merger Agreement.

Each share of VMW, at the election of the holder and subject to 50-50 proration, will be exchanged for either $142.50 or 0.2520 shares of AVGO. The agreement stipulates a “go-shop” period that ends on July 5, 2022.

Each party has certain termination rights. In particular, if VMW terminates the Merger Agreement before the end of July 5, 2022, due to receiving a superior proposal from a different party, it will have to pay Broadcom a termination fee of $750M. After this date, this fee becomes $1.5B.

In case parties cannot close the merger because certain regulatory clearances are not obtained, Broadcom will have to pay VMWare a termination fee of $1.5B.

In a separate presentation, Broadcom mentions that it expects to close the transaction in its fiscal 2023, i.e. before October 31, 2023. The Merger Agreement is more specific: it stipulates that each party can terminate the transaction on Feb 26, 2023, subject to three extensions of three months each at either Broadcom’s or VMware’s election.

The total consideration payable to VMW shareholders is approximately $61B, half in cash and half in AVGO shares; Broadcom will also assume $8B of VMware net debt. To finance the cash part, Broadcom entered into a commitment letter with a group of banks to provide a $32B senior unsecured bridge facility.

Broadcom also entered into voting agreements with Michael Dell (via Trust) and Silver Lake who control 40.2% and 10% of VMW shares respectively to vote all the shares held in favor of adopting the Merger Agreement as long as the Board does not propose a better option. These agreements secure the results of VMW shareholders’ voting if the transaction ever gets to this stage.

The consideration ultimately payable for one VMW share can be expressed with a simple formula:

VMW = $71.25 + 0.126*AVGO

Most of the time since the announcement, this consideration has been hovering at 10-13% higher than the actual VMW price, which implies an arbitrage opportunity. Before analyzing, it makes sense to register the stock prices on May 20 at the close, immediately before the deal was first rumored in public:

VMW = $95.71 ; AVGO = $543.19 ; SPY = $389.63

Will the regulators block the deal?

Arbitrage opportunities exist only if a deal is reasonably likely to clear regulatory and other hurdles.

The main actors in the deal are some of the most sophisticated M&A investors in the world – Broadcom with Hock Tan at the helm, Michael Dell, and Silver Lake. This fact alone makes the deal more probable than not. According to Tracxn, Broadcom has made 35 acquisitions and 4 investments. We are not aware of a single Broadcom acquisition that did not close upon reaching the definitive merger agreement. The notable attempt to acquire QUALCOMM (QCOM) was blocked in March 2018 by the Trump administration due to national security concerns. At that point, Broadcom was a foreign (Singaporean) company about to redomicile in the US. A couple of months earlier, the Committee on Foreign Investment in the US (CFIUS) got rather unexpectedly involved in reviewing this deal even though Broadcom’s intention to redomicile to the US was known. Per Broadcom, the decision by CFIUS to review the deal was the result of secret moves made by Qualcomm in January 2018 to encourage an investigation into the offer.

In this regard, the deal with VMW differs dramatically from the deal with QCOM. Broadcom is now domiciled in the US, the deal is friendly (vs. hostile in the case of QCOM, at least when CFIUS got involved first), the definitive agreement is signed, and upon consummation, big US investors (Mr. Dell and Silver Lake) will project strong influence on the combined company.

Materials presented by Broadcom barely mention any synergies to be realized in the merger. Broadcom and VMware are not competitors, and their businesses are not directly related to each other at all. These facts make antitrust arguments to block the deal rather weak and our sophisticated actors with superior expertise must agree. The only possible argument to block this deal is its size. Can this acquisition make Broadcom so powerful that it will threaten its competitors?

Broadcom is a rather unusual hi-tech company. While it technically belongs to the semiconductor industry, its biggest acquisitions were done in software. Its strengths seem to be more in business operations, squeezing out costs, and optimizing cash flows than in breakthrough R&D. Its financial prowess is indisputable and the language of adjusted EBITDA is more natural for Broadcom than for most of its peers. While Mr. Tan (of Malaysian Chinese origin, 70 years old) graduated from MIT, he held purely financial positions with General Motors (GM), PepsiCo (PEP), and Commodore International. The acquisition of VMW seems another step in the same direction – a cash flow motivated software acquisition. The financial nature of Broadcom’s motivations makes blocking the acquisition less likely.

There is one revealing piece in Broadcom’s filings: within 3 years after closing, Broadcom expects VMware adjusted EBITDA to jump from $4.7B in FY 22 (ended in January) to $8.5B. One cannot hope to reach it without massive cost-cutting, not unlike what Broadcom did with CA Technologies – its biggest software acquisition so far. And it confirms the financial nature of the acquisition.

I have read some posts comparing the Broadcom-VMware merger with the failed NVIDIA (NVDA)-Arm transaction. This comparison is based on the neutrality of both VMware and Arm which are supplying all competitors in their respective industries (they are both dubbed “Switzerland” of sorts). But this is where the analogy ends. Nvidia is one of Arm’s customers very much focused on R&D. The acquisition could have stifled competition in the industry and provided Nvidia with unfair advantages. FTC had material arguments to consider the transaction as a vertical deal and sue to block it. Broadcom operates in a different industry than VMW and we deem similar arguments far-fetched for the combination with VMW.

Summing up, we think that regulators are unlikely to intervene and the transaction has a high probability to close within the next 6-12 months unless another suitor shows up. The text of the Merger Agreement implies that the actors think it might be possible to close before February 2023.

Possible strategies

If one agrees that a takeover of VMware is imminent, there are two possible strategies to proceed with. One can either lock the spread by buying VMW and shorting a prorated number of AVGO shares or go long VMW only without shorting (or use long-term call options with the same objectives). We prefer the second strategy. While riskier, it does not forego potential upsides which, in our opinion, are attractive.

If a second suitor shows up, it will drive VMW higher. However, it does not seem very likely. Big Tech is probably out of the picture due to antitrust concerns. The size of the deal should make it challenging for private equity. Moreover, Mr. Dell is likely to prefer a strategic acquirer due to tax reasons. It still leaves some options and, for example, some posts mention Intel (INTC) as a possible suitor. It might happen but I am doubtful: if a second acquirer wants to take advantage of technology or market synergies, antitrust concerns should become material for a deal of this size. In terms of a purely financial acquisition, it is challenging to beat Broadcom with its high and growing market cap and financial prowess.

So, while a bidding war represents a possible upside, I would not suggest buying VMW because of it. Another source of upside seems more promising: appreciation of AVGO both organically and due to the benefits of the VMW acquisition. In this regard, buying VMW represents an opportunity to buy AVGO at a discount and with less risk. Strictly speaking, it is no longer arbitrage but rather taking advantage of the special situation.

Valuations

The success of this strategy depends on valuing Broadcom. At the time of writing, VMW is trading around $130 and via our formula in the beginning, it is equivalent to paying ~$462 for AVGO. This is significantly lower than AVGO’s price today or right before deal rumors became public. Just as a reminder: AVGO reached its high of ~$665 in December 2021 and has reported smashing quarters since.

While the detailed analysis of AVGO and VMW is beyond the scope of this post, it makes sense to calculate Pro Forma EV/EBITDA as it is today without accounting for any benefits from the merger:

Broadcom's pro forma valuations

Broadcom’s pro forma valuations (Company’s filings and author)

Buying VMW today is equivalent to paying a multiple of 12.5 for the combined company EV/EBITDA. Again: this is BEFORE Broadcom’s cost-cutting and other actions to increase VMW’s cash flows! As we know, Broadcom hopes to almost double VMW’s adjusted EBITDA in 3 years after the acquisition.

Increasing VMware cash flows

Company’s presentation

And this is in addition to growing AVGO’s cash flows organically. On the last earnings call, Mr. Tan was optimistic about 2022.

Let us now compare this figure with the regular Broadcom’s multiples:

Broadcom's historic valuations

Broadcom’s historic valuations (Company’s filings and author)

Most of the time, Broadcom is trading at higher valuations than we can achieve by buying VMW now!

This exercise illustrates that buying VMW today represents a rather attractive entry point for holding Broadcom. Moreover, buying VMW has also a margin of safety because AVGO shares have to come down to ~$462 to break even.

Risks and conclusion

Broadcom has been a remarkable performer. The slide below helps to appreciate it better:

Broadcom remarkable performance

Company’s presentation

And it pays a substantial and quickly growing dividend as well. Buying at $462 implies a 3.5% yield with another bump in half a year.

Due to strong cash flows, Broadcom should be able to reduce its leverage rather quickly. They have successfully done it several times in the past:

Broadcom is expected to delever

Company’s presentation

Taking a position in such a company at a discount seems attractive to us but it comes with risks. If no other acquirer emerges AND the acquisition is blocked by regulators, VMW may revisit its price of ~ $96 before the rumors with a loss of ~27%. It should be somewhat mitigated though by the reverse termination fee of $1.5B and understanding that VMware remains in play.

The strategy of going long VMW can be implemented in different ways. One can do it through either stocks or options, play it long-term or short-term, buy VMW now or later, and so on. For example, upon the expiration of the go-shop period but before HSR clearance, VMW may be trading lower than today. The situation remains dynamic. Our post attempts to present the idea and does not touch upon trading issues related to it.




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