4 Reasons Broadcom's $18.9B CA Technologies Buy Makes No Sense

SAN JOSE, CA - JUNE 07: Signage is displayed outside the Broadcom offices on June 7, 2018 in San Jose, California. Broadcom is expected to report second-quarter earnings today after the closing bell. (Photo by Justin Sullivan/Getty Images)

More than half of mergers fail. And it's no wonder -- since there are so many things that can go wrong with them.

And that certainly comes to mind in considering San Jose, Calif. (by way of Singapore)-based chip-maker Broadcom's $18.9 billion cash deal, a 20% premium over its pre-deal price, to acquire Manhattan-based mainframe software maker CA Technologies. (I have no financial interest in the securities mentioned here).

Broadcom -- a maker of chips for smartphones and network equipment whose shares have lost 4% in 2018 -- has been growing rapidly and boosting profits. In the last five years, revenues have grown at a 49% average rate to $17.6 billion in 2017 while free cash flow soared at a 64% compound annual growth rate to $3.6 billion during that time, according to Morningstar.

CA, whose stock has gained 13.3% through July 11 -- has been shrinking and suffering from declining profits. In the last five years, revenues have fallen at a 1.2% average rate to $4.2 billion in 2017 while net income crept down at a 12.4% compound annual growth rate to $470 million during that time, according to Morningstar.

CEOs of both companies are thrilled with this deal. In a statement. Hock Tan, Broadcom CEO said, "CA will add to our portfolio of mission critical technology businesses." and Mike Gregoire, CA's CEO, noted, "This combination aligns our expertise in software with Broadcom's leadership in the semiconductor industry."

I am not sure what he means by "align" but one thing is for sure -- if this deal goes through, it will give a definitive answer to a question I asked in 2014 in my post "Will CA Survive the Decade?".

Before getting into why this deal does not make sense, let's revisit why I questioned its ability to survive and why this deal would be a pretty good outcome for CA shareholders. In 2014, I suggested that the way companies were buying software was changing.

It used to be that enterprise software sales people would play golf with corporate executives -- including the chief information officer (CIO) who buy from the company sponsoring the golf. The software did not work very well so the companies had to spend even more money hiring consultants to install it in the company.

But then startups came along and made products that were much easier to use and less expensive. They gave away a basic version of the software to the company's software developers who got hooked. They recommended the software to their bosses who recognized its superiority and paid for the full-featured version.

The golf-sponsoring incumbents -- with their 2,000-person salesforce -- would recognize that the startups -- with, say, 50 salespeople -- were starting to pose a threat. So they would acquire the startup, cut R&D, and give that startup's product to its sales force to push onto customers.

The engineers in the startup would leave and the resulting lack of innovation would make the formerly cutting edge startup's product obsolete.

So what's not to like about this deal? After all, Tan probably thinks that this one is less likely to be blocked by the U.S. government which put the kibosh a few months ago on its $117 billion-plus hostile bid for Qualcomm, according to the Wall Street Journal. Plus he can cut costs at CA, which already has a 27% operating margin -- well-above Broadcom's 15%.

Here are four reasons this deal defies logic.

1. Unattractive industry

One reason acquisitions fail is that the target company participates in a poorly-performing industry.

The mainframe software industry from which CA derives 90% of its profits is hardly booming. If there is any good news about the industry in which CA competes -- it is that Gartner estimates that enterprise software market -- which includes mainframe code -- will grow at 11.1% in 2018 to $351 billion.

But since CA is the leader in mainframe software and its revenues have been falling -- albeit with a 5% upward move in the 2017 due mostly to the acquisition of Veracode -- that does not bode well for CA's ability to contribute to Broadcom's top-line growth.

2. Combined companies worse off

Another reason that deals tank is that the combined companies are weaker than they were apart.

Broadcom has no knowledge of the mainframe software industry and will therefore be unable to do anything to improve the already weak performance of CA's management team.

CA has plenty of experience in acquiring software companies. After all, under Charles Wang, it bought mainframe software companies -- but then it came to light that CA had accounting problems which wiped out its top management and forced it to pay $500 million in fines, according to the New York Times.

After Wang, CA kept acquiring and cutting costs from its newly bought prizes. Its greatest asset is clearly not product innovation, but it does have some skills in getting enterprises to buy mainframe software.

Of course that will not help Broadcom sell more chips -- since those are bought by makers of smartphones and network equipment. Nor will Broadcom's sales people be able to hawk CA's mainframe software to the hardware makers it knows so well.

Bernstein analyst Stacy Rasgon, told the Journal, “Mainframe software is sticky and profitable. But enterprise software is not something Broadcom does, so it’s less clear how CA fits into their portfolio versus prior acquisitions.”

3. Broadcom overpaid

Deals can also founder when the acquirer overpays.

With its shrinking revenues and net income and a P/E of about 33, it is safe to say that investors were not under-valuing CA prior to the announcement of this deal. To be sure, a 20% premium over the market price -- paid in cash -- is a fine deal for CA which probably would have been happy to take Broadcom's stock if its board thought the combined deal made strategic sense.

I am confident that Broadcom will cut cost from CA once the deal closes. But I do not see how this deal could boost Broadcom's revenue growth rate -- beyond the $4 billion bump Broadcom will get on its top line after the deal closes.

4. Inability to integrate

A final reason deals disintegrate is that the two companies do not work well together after the deal closes. Bloomberg Intelligence analyst Anand Srinivasan, said, “Legacy software assets are highly tangential to Broadcom’s core data-center and smartphone chip businesses. Integration here would likely be harder and customer bases have little overlap.”

I am not sure who will be running CA should it become part of Broadcom -- but I do not see much evidence that either company has great expertise in leading an enterprise software company.

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