Broadcom (AVGO) has significantly increased its scale and almost doubled its revenue by adding seven businesses to its existing portfolio of 12 businesses. It is now acquiring Brocade Communications Systems (BRCD), as it has few competitors, stable revenue, high gross margins, similar end markets, and complementary products. The company has already secured regulatory approval from the European Union, Japan (EWJ), and China for the merger.
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While other companies are using M&A (mergers and acquisitions) to expand in fast-growing markets, Broadcom is acquiring Brocade to expand in the FC (fiber channel) market, which is shrinking as FC networks are replaced by Ethernet technology. This merger aims to squeeze out as much cash as possible from the FC business.
The Brocade deal would make Broadcom a leader in the FC SAN (storage area network) switch market, giving it pricing power. Rivals Cisco Systems (CSCO) and Cavium (CAVM) may not be keen to compete with Broadcom over pricing in a weakening market, allowing it to squeeze out maximum profit.
With the advent of the IoT (Internet of Things) and autonomous cars, the use of data centers should increase significantly. IDC Research estimates that data files could grow at a CAGR (compound annual growth rate) of 131% between 2014 and 2020. Broadcom stands to benefit from its broad portfolio of enterprise storage. Moreover, having both FC and Ethernet offerings could help Broadcom receive the greatest benefit from the fiber to Ethernet transition.
Brocade could help Broadcom achieve 5% organic revenue growth over the long term. The merger would be immediately accretive to Broadcom’s earnings and improve its margins. Brocade would add ~$900 million to Broadcom’s non-GAAP (generally accepted accounting principles) EBITDA (earnings before interest, tax, depreciation, and amortization), which may increase the combined company’s EBITDA margin to 45% in the short term and 48% in the long term.
However, for a merger to be successful, it is important to realize cost synergies. With high leverage and fast growth, there could be a significant execution risk. Broadcom faces several other legal challenges, which we’ll look at in the next part of this series.