Quick Thoughts: Broadcom Offer is Another Twist in the Qualcomm Soap Opera

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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November 4, 2017

Quick Thoughts: Broadcom Offer is Another Twist in the Qualcomm Soap Opera

  • A combination of AVGO and QCOM would be a powerhouse in wireless chips, dominating SoCs, modems, RF and patents. This would draw significant antitrust scrutiny.
  • QCOM believes that it is badly undervalued due to the unresolved legal conflict with AAPL. We would not expect an amicable agreement without a very significant premium.
  • QCOM’s deal for NXP complicates negotiations with AVGO, adding ~$37B to a $90B+ market cap and modest overlaps in product lines – if it goes through.
  • AVGO is validating QCOM’s confidence in a winning settlement w AAPL. The potential for a deal sets a new floor for QCOM shares as we await resolution to spark a re-rating.

We have been expecting consolidation in the chip industry (http://www.ssrllc.com/publication/the-cloudai-era-a-perspective-on-the-next-decade-of-tmt-investing-2/) and Friday’s newswires brought rumors of the biggest proposed semiconductor deal yet. Bloomberg reports that serial acquirer Broadcom has set its sights on its oft rival Qualcomm and is said to be preparing an unsolicited offer for the company. Qualcomm management, which is grinding to complete its own deal for NXP semiconductors amidst an acrimonious legal battle with Apple, would likely view the approach as opportunistic and unwelcome, and almost certainly demand a substantial premium in any deal. Including NXP in the mix, for which Qualcomm has agreed to pay $39B, could make the price tag far north of $100B that has been floated, including the assumed debt – a substantial stretch for Broadcom and its own $120Bish market cap.

A Qualcomm/Broadcom tie-up has merit, whether it would end as 2-way or a 3-way combination. Qualcomm generally rules the roost in the wireless chip market, but it has a few holes in its portfolio. Broadcom is strong where Qualcomm is weak, in the RF, power management, antennas and other components that make up the increasingly complex front end of wireless devices and infrastructure. Broadcom also brings strength in chips for optical communications and datacenter communications that could be synergistic with Qualcomm’s ambitions to take its processors and modems to new markets. There would also be the normal synergies that come from any combination of big companies competing in the same businesses – entrée to customers, lower expenses, yada, yada, yada.

Still, there are many things that could trip up this proposition. First, regulators – already on edge over Qualcomm’s royalty program – would conceivably object to adding Broadcom’s IPR (reputedly, the 9th largest portfolio amongst chip vendors) into the licensing mix. They would also be squeamish about adding to Broadcom’s leadership in Wi-Fi and Bluetooth chips (Qualcomm is #2 in both categories) and could demand divestiture of this and other businesses as a condition of approval. Next, Qualcomm is hustling to complete an acquisition of its own, looking to add automotive chip leader NXP for ~$39B in cash. Adding debt to complete the NXP transaction would raise the price for Broadcom, which would be assuming the debt in any subsequent deal.

The price is another issue. Qualcomm management has been steadfast in its confidence that its patent licensing program – which affixes a single royalty rate covering all its IP to percentage of its licensees’ products (subject to hard caps that limit payments for higher priced devices) – will withstand its current legal challenges, led by Apple. This approach has been accepted by device makers worldwide for nearly 25 years, a chain of precedence that has protected it through litigation and regulatory scrutiny in the US, the EU, China, South Korea, Japan and other jurisdictions. The current share price may be 37.4x trailing earnings, but those earnings have been badly depressed by Apple’s refusal to allow its OEMs to pay Qualcomm. If Apple had been paying, revenues would have been more than $1.5B higher over the past two quarters and profits would have more than doubled. Qualcomm management believes that it will recoup these payments when it, inevitably, reaches resolution with Apple. In that context, the trailing P/E is 26 times, the forward PE is 15 times and a 10% premium (even after today’s 14% spike) is unlikely to bring management to their side. We believe a friendly deal is very unlikely at prices below $80/share.

The ongoing Apple drama also raises in interesting wrinkle. We believe Qualcomm is confident in resolving the dispute and preserving its lucrative royalty program, and we presume that Broadcom, in making this move, is also comfortable that the downside on royalty rates is limited. Still, Qualcomm has far more information about the status of its negotiations than does outsider Broadcom – if things were going badly, it would be more likely to accept a deal, and to oppose it if they are as confident as we suspect. Watching the dance between these two chip giants may give us more insight into these dynamics.

Ultimately, Qualcomm’s decision on a Broadcom tender will belong with the investors and management will have to convince them that the future remains bright, particularly on the patent licensing front. To date, Qualcomm has been able to placate a handful of activist firms that have taken stakes and moved to pressure change. Convincing them to turn down a premium from Broadcom may require more decisive answers about the perceived threats.

Exh 1: QCOM Valuation Summary

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