Here's Why Broadcom's Acquisition of CA Technologies Creates a Buying Opportunity

Broadcom (AVGO, Financial), the provider of digital and analog semiconductors for connectivity devices, has agreed to acquire CA Technologies (CA, Financial) – the company known for its mainframe and enterprise software solutions – in a surprise move yesterday.

“With its sizable installed base of customers, CA is uniquely positioned across the growing and fragmented infrastructure software market, and its mainframe and enterprise software franchises will add to our portfolio of mission critical technology businesses,” said the Hock Tan, president and CEO of Broadcom, in a press release.

The market quickly adjusted the price of CA technologies as the stock gained 18% during the afterhours trading on Wednesday. Broadcom investors are not taking the news well as the stock has declined 17% in the pre-market trading today, translating into a market cap loss of $17 billion in under 24 hours.

What’s the deal?

Shareholders of CA Technologies are set to receive $44.50 per share in cash, a premium of 20% on Wednesday’s closing price. Broadcom, in effect, is expected to pay $18.4 billion in cash to acquire all the outstanding shares of the IT management software company. Broadcom is set to finance the transaction using a mix of cash on hand and $18 billion in new debt financing, taking the total debt to $35.6 billion. The transaction is expected to close by the end of 2018.

The acquisition will expose the company to the growth prospects of infrastructure software market, the management of Broadcom said. It will also allow Broadcom to sustain double-digit earnings growth going forward. The acquisition will potentially add more than $4 billion to the top line of the California-based semiconductor company.

Why did the market react negatively?

The market is punishing Broadcom’s stock as it is unclear where this acquisition fits in strategically. Broadcom is a semiconductor company involved in the provision of chips for networking devices, smartphones and cloud storage while CA technologies is a completely different player with involvement in provision of IT infrastructure software. This strategic disconnect between the businesses has made analysts and investors uncomfortable. Several investment banks including Evercore ISI and RBC have downgraded Broadcom, cutting their price targets in the aftermath of acquisition news.

Is the reaction justified?

The technology sector is used to consolidations, making this acquisition difficult to swallow for investors. However, the acquisition makes sense from both a business and a financial perspective.

Strategic rationale

As Broadcom is facing slowing growth in the wireless connectivity market – especially due to the reduction of orders from Apple (AAPL, Financial) – and slowdown in growth in the hard disk storage market, acquisition of a company in another line of business increases diversification and reduces the overall risks facing Broadcom.

CA Technologies operates in the technology infrastructure software market, which is expected to grow going forward. According to Gartner, enterprise infrastructure market is set to grow at CAGR of 5.6% during 2016 tpo 2022. The global mainframe market is expected to grow at 2.5% during the next four years, another report forecasted. In short, Broadcom not only diversified into software, it acquired a company with mid-single digit growth prospects.

Furthermore, the market is not taking into account the rise of software defined networking (SDN) and network function virtualization (NFV). As more hardware functions shift toward software, the demand for specialized ICs from Broadcom for networking or storage will go down going forward.

“In 2021, 49% of the NFV revenue will be new revenue from software and outsourced services, and 8% will be displaced revenue spent on NFVI server/storage/switch hardware purchased instead of purpose-built network appliances,” noted IHS Markit in a network function virtualization forecast.

Acquiring a software company gives Broadcom a shot at the growth of SDN and NFV while offsetting the risk from loss of IC demand. The bottom line is that acquisition of CA Technologies complements Broadcom’s semiconductor business as it can act as a hedge against the rise of SDN and NFV in coming years. To review the strategic side of the acquisition, Broadcom is expected to benefit from diversification into infrastructure software that will help the company against the threat of SDN and NFV.

Financial rationale

From a financial perspective, the deal also looks reasonable. Broadcom is paying around four times 2018 sales of CA technologies. On a price-earnings basis, Broadcom is paying just 16 times forward earnings to acquire CA Technologies. Economic value added (EVA) valuation also reveals that Broadcom is paying a reasonable amount for acquiring CA Technologies.

Based on analysts’ earnings consensus and growth forecast for the next five years, CA Technologies is valued at $41.9, slightly below the $44 a share price being offered by Broadcom. Acquisitions usually carry hefty premiums; Broadcom is paying just around 5% over the fair value of CA Technologies. In short, the deal seems reasonable.

Bottom line

As the market turned against Broadcom after the deal was announced, the decline in stock price creates a decent buying opportunity. Broadcom was already trading at a discount to its fair value before the acquisition of CA Technologies, EVA price target at $300. The 15-20% decline in the stock price in reaction to the acquisition news puts the California-based semiconductor company in a value territory.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.