Broadcom pursues software's stability with $61B VMware deal

Broadcom Inc.'s deal to acquire VMware Inc. will allow the chipmaker to diversify its core business of producing and selling semiconductors by aggressively moving into the lucrative enterprise software space.

In the cash-and-stock deal, which values VMware at $61 billion, Broadcom will almost triple the current size of its software business, making it the fifth-largest software provider in the world, according to S&P Capital IQ. The enterprise software business also typically reports higher margins and more stable recurring revenue than Broadcom's historic semiconductor business, analysts noted.

"Broadcom is trying to minimize the cyclicality of their business by engaging in areas that have much smoother and more consistent growth," said Dan Morgan, vice president and senior portfolio manager at Synovus Trust.

Broadcom's stock has grown in the past year, with its primary semiconductor business benefiting from a surge in demand. Meanwhile, VMware's shares declined as the company underperformed competing players in the cloud and software space.

Software's revenue stream

Broadcom, which is known for supplying chips for data centers and consumer devices such as Apple Inc.'s iPhones, among other products, began its turn toward the software sector in 2018. That is when it bought enterprise software firm CA Technologies for $21.78 billion, including debt. A year later, Broadcom expanded its software foothold when it acquired cybersecurity company Symantec for $10.70 billion.

In the second quarter of its fiscal 2022, ended May 1, Broadcom's infrastructure software segment reported revenue of $1.87 billion, up 5% year over year. The software segment made up 23% of the company's total revenue of $8.10 billion.

The VMware deal would be one of the largest technology acquisitions of all time, behind Microsoft Corp.'s pending $74.01 billion acquisition of gaming company Activision Blizzard Inc. and Dell Inc.'s purchase of EMC Corp., now Dell EMC, for $63.1 billion. EMC at the time included VMware, which Dell's parent Dell Technologies Inc. spun off in 2021.

If the VMware deal closes, software will make up about half of Broadcom's total revenue, helping to cushion the company from the more erratic chip business.

"The 50/50 split in hardware and software ... could actually be a blueprint for others going forward," Morgan said. "Other chipmakers such as NVIDIA and Intel already dabble in software, and seeing how much money is on the table could push them to invest further in this space."

Broadcom is also likely to strip out "significant costs and operating expenses" from VMware to improve its overall financial position and value to shareholders, said Angelo Zino, a senior industry analyst at CFRA Research.

Broadcom's software group will rebrand as VMware after the transaction closes. This will position VMware as the company's flagship software offering while maintaining the unit's identity, said John Abbott, principal research analyst at 451 Research.

"That way it will be able to keep up its wide-ranging relationships across the industry, including all the cloud hyperscalers and chip companies that might see Broadcom as a rival," Abbott said.

Potential regulatory scrutiny

The VMware deal comes at a time when U.S. regulators have demonstrated greater scrutiny of large tech deals. The U.S. Federal Trade Commission blocked the proposed $40 billion acquisition of chipmaker Arm Ltd. by NVIDIA in December 2021. NVIDIA paid a $1.35 billion termination charge for the abandoned deal. As part of the VMware deal, Broadcom agreed to pay a termination fee of up to $1.5 billion if the transaction does not close.

Broadcom's last major acquisition attempt, the $117 billion takeover bid of mobile chipmaker QUALCOMM Inc., was blocked in 2018 by then-U.S. President Donald Trump over national security concerns. Broadcom has since re-domiciled its business in the U.S. in hopes of allaying such concerns. It was previously based in Singapore.

Unlike some of its tech peers, Broadcom is not facing any current antitrust investigations, though analysts remained divided as to the VMware deal's chances of approval.

"In our opinion, we do not see antitrust issues and there are few companies capable of offering a competing bid as hyperscalers likely focus on public cloud and face regulatory risk," said Piper Sandler analyst James Fish.

Still, Broadcom does have a dominant market share in certain equipment categories such as router switches, while VMware's virtualization software is utilized in a large number of data centers around the globe as well as in router switches, noted CFRA's Zino.

"As both companies have very dominant market share positions in the segments they operate in, I wouldn't be surprised if regulators are wary about Broadcom leveraging that power to its advantage with methods such as exclusivity agreements that bundle both hardware and software offerings," Zino said.

Competing bids

The merger agreement between Broadcom and VMware includes a "go-shop" provision that allows VMware to actively solicit competing offers during a 40-day period ending July 5. Should VMware choose another offer, it agreed to pay Broadcom a termination fee of $750 million before July 5 or $1.5 billion after.

There are a number of other large tech players that may emerge with competitive bids for VMware in the period, said 451's Abbott.

"HPE is a possibility, except that it only fairly recently divested itself of major software assets, and its ownership would put VMware back in the very same awkward relationship it had with Dell," said Abbott.

Similarly Intel, which has former VMware CEO Pat Gelsinger at its helm, might consider an acquisition, while Oracle Corp. could be a potential buyer due to its renewed focus on cloud infrastructure, Abbott said.

Cisco Systems Inc., which is at its lowest leverage ratio in over a decade and seems eager to buy a software company right now, is the vendor that makes the most sense for a competing bid, said Piper Sandler's Fish.

Despite potential alternative buyers, it is unlikely that a new bid will emerge, said Oppenheimer analyst Ittai Kidron.

"While we believe VMware could be an attractive option for Cisco or HPE from a product and end-market standpoint, we don't believe those companies have the capacity to acquire a company of VMware's size," Kidron said.

451 Research is part of S&P Global Market Intelligence.