Semiconductors

Broadcom & Qualcomm: The Largest Deal in the History of Technology That Never Happened

One hundred and twenty one billion dollars; the number was staggering as it potentially represented the largest deal in the history of technology. While neither Broadcom nor Qualcomm are household names like Samsung or Intel, the combined company would have created the world’s third largest chip maker.

On November 2, 2017 Hock Tan, the chief executive of Broadcom, announced the company’s intent to redomicile its headquarters from Singapore to the United States. Mr. Tan made this announcement from the Oval Office while the current president of the United States looked on approvingly in the background.

Mr. Tan was effusive in his praise of America and its newly overhauled corporate tax rates. He preached that many of his direct managers and a majority of Broadcom’s board members and shareholders were also Americans. “America is once again the best place to lead a business with a global footprint” according to Mr. Tan. The ulterior motive of this patriotic show was revealed just four days later when Broadcom announced its intent to buy notably larger competitor Qualcomm for $105 billion dollars. The hostile takeover deal was eventually bumped up to $121 billion after being rebuffed by Qualcomm. Broadcom eventually retaliated by nominating its own directors to Qualcomm’s board to force a potential deal.

While calling the timing of the Qualcomm takeover announcement a “coincidence”, Broadcom was betting its chips (pun intended) that relocating to the U.S. would placate U.S. regulatory bodies and ingratiate itself with a protectionist American president who is averse to foreign competition. Furthermore, if Broadcom were classified as an American company, it could avoid the jurisdiction of the Committee on Foreign Investment in the United States (CFIS). CFIS has broad powers to review the national security implications of foreign investment in domestic companies.

Ultimately, the political maneuvering was all for naught as an executive order shut down the possibility of a merger on national security grounds. However, Broadcom has indicated that it still plans to redomicile to the U.S. from Singapore by April 2018; a move that could be advantageous in its hunt for future domestic acquisitions.

Broadcom’s Acquisition Mentality Starts at the Top

Broadcom’s CEO Hock Tan immigrated to the United States from Malaysia and eventually became a naturalized citizen in 1990. He earned both bachelor’s and master’s degrees in mechanical engineering from MIT and subsequently furthered his education with an MBA from Harvard’s much vaunted Business School.

It was in 2006 that he became the CEO of Broadcom’s predecessor Avago Technologies Ltd. which itself began as a division of Hewlett Packard. At the helm of Avago, Hock Tan has demonstrated remarkable expertise in deal making and value creation via acquisition. Mr. Tan (for better or worse) brings a private equity mentality to acquired companies. He targets businesses with high profit margins and then either significantly cuts or sells off the less successful parts of the business. Broadcom maintains a focus on its main customer bases of handset makers and data-center operators.

After bringing chip makers LSI and Emulex into the Avago portfolio, Tan’s crown jewel acquisition came about in 2015 when his company purchased the original Broadcom Corporation for $37 billion and renamed the merged company to Broadcom Limited. At the time of the merger, Broadcom Corporation’s revenues were twice the size of Avago’s.

“‘He ran through Broadcom with a machete,’ says Stacy Rasgon of Bernstein Research. According to Linley Gwennap of the Linley Group, a consultancy focused on semiconductors, Mr. Tan eliminated an entire layer of management at Broadcom and now has around 20 business units reporting directly to him.” – The Economist, Nov 9th 2017

Horizontal Integration Doesn’t Work, Until it Does

Although horizontal integration is frequently touted by firms as a way to create “synergies” and improve strategic positioning in their industries, I learned from noted Georgia Tech strategy Professor Frank Rothaermel that mergers and acquisitions, on average, destroy rather than create shareholder value as the anticipated synergies never materialize (see AOL-Time Warner, Daimler-Chrysler, HP-Compaq, etc). This happens due to the blending of disparate corporate cultures, high management turnover and a tendency to underestimate potential merger issues. However, if a firm can continue to successfully merge, acquire and integrate to its benefit, this can serve as a source of competitive advantage.

“Although there is strong evidence that mergers and acquisitions, on average, destroy rather than create shareholder value, it does not exclude the possibility that some firms are consistently able to identify, acquire, and integrate target companies to strengthen their competitive positions. Since it is valuable, rare, and difficult to imitate, a superior acquisition and integration capability, together with past experience, can lead to competitive advantage.” – Frank T. Rothaermel

With Hock Tan at the helm, Broadcom has flaunted a stellar acquisition and horizontal integration capability to become the world’s fifth largest semiconductor company. The company’s revenues continue to climb as a result of its deal making proficiencies. Even now Broadcom is seeking approval for a $5.9 billion acquisition of data and storage networking products company Brocade.

Broadcomm Revenues

In an apparent Russian nesting doll scenario, the Wall Street Journal reported that industry heavyweight Intel would have considered an offer for Broadcom if the Broadcom-Qualcomm merger was greenlit. Intel would have been trying to ingest Broadcom, which had tried to merge with Qualcomm, which is currently trying to acquire Dutch semiconductor company NXP.

The semiconductor industry continues to move towards an oligopolistic industry structure as firms look to lower their costs by gaining scale. Scale helps chip companies manage the capital intensive nature of their industry.

Research and Development: Show Me the Money

Broadcom and Qualcomm are similar in one respect; they are both fabless (i.e. fabrication-less) chip companies. They design and market processors while relying on an outsourced manufacturer for production. Despite never owning fabs (like Intel & Samsung), they both have become industry leaders. Outsourcing manufacturing allows firms to invest more capital into research and development and subsequent new products.

“In the absence of manufacturing differentiation, semiconductor players that design the most functionality and performance into their products in the shortest amount of time wield distinct competitive advantage. That puts product-development productivity at center stage.” – McKinsey&Company

Where Qualcomm differentiates itself from its peers is in the relative amount of dollars it invests in research and development. Aside from Intel, Qualcomm spends more on R&D than any other chipmaker ($5.15 billion in fiscal year 2016 and $40 billion over the past decade). To put these numbers in perspective, Qualcomm spends more on research and development than both Apple and Amazon.

This focus on research and development is in sharp contrast to Broadcom which operates with a private equity style philosophy that prioritizes cutting both jobs and research after acquisitions to boost short term profits. In theory, less money allocated for research and development leads to weaker products in the future which leads to a loss of competitive advantage. Broadcom tried to counter this criticism by announcing that they would increase Qualcomm’s research and development budget and create a $1.5 billion fund to train American engineers.

Qualcomm Makes Money Off of Every iPhone Sold! (In Theory)

Although Qualcomm may not be a household name, If you own a mobile phone, then most likely you are using Qualcomm’s patented technology. The company’s innovation bona fides were established by helping to bring about mobile standards like LTE. It is also the United States’ champion in the coming 5G revolution which is why it garnered so much political protection.

Qualcomm is a leader in processors that manage cellular communications in smartphones. It competes with Broadcom in the manufacturing of baseband processors that manage a device’s wireless connections. A combined Broadcom-Qualcomm with more market power in Wifi and baseband chips would not make buyers comfortable (see Porter’s Five Forces: Bargaining Power of Suppliers).

In accordance with Qualcomm’s high R&D spending, it owns a veritable trove of patents that are deemed essential to building cellular phones that adhere to wireless standards. The thousands of patents that the company owns allows it to engage in a unique business model that accounts for two thirds of its operating profits. Qualcomm charges device makers (e.g. Apple, its biggest customer) for use of its patents, it does not issue licenses on its patents to rival chipmakers.

These (device-makers) usually pay for the entire patent portfolio, rather than individual patents. And Qualcomm typically charges a percentage of the total selling price of a device—5%, according to insiders. – The Economist, Jan 28th, 2018

In case you missed that, Qualcomm makes money off of the total price of every iPhone sale.

Apple, among other things, claims that per-device royalties mean Qualcomm is taxing its innovation: it must pay up for new features, such as a new kind of camera, even if these are unrelated to Qualcomm’s patents. – The Economist, Jan 28th, 2018

Qualcomm’s Woes

Even though the takeover threat from Broadcom has dissipated, there are various storm clouds hanging over Qualcomm. As would be expected, Qualcomm is engaged in a protracted legal battle with Apple in regards to its business practices. As a result, Apple has withheld billions of dollars in royalty payments that have put downward pressure on Qualcomm’s stock price.

“Qualcomm’s 2019 forecast includes between $2.5 billion and $4 billion in payments it assumes would flow from resolving its customer disputes. It leaves out a further $5 billion to $7 billion in so-called catch-up payments that Qualcomm has said Apple and Huawei will owe by then for royalties they have withheld.” – Wall Street Journal, March 19, 2018

Qualcomm’s loss could be Intel’s gain as Apple has switched over to Intel chips for some of its devices and could completely cut Qualcomm out of the next cycle of iPhones. This scenario would play in Intel’s favor as it looks to diversify away from the PC market which has been in decline.

Qualcomm is also subjected to charges brought against it by the Federal Trade Commission for abusing its monopoly power on certain chips. Adding to its woes, Qualcomm is dealing with additional anti-trust reviews in Europe and Asia as a result of its patent and royalty-centric business model. The European Commission fined the company for $1.24 billion for abusing its position in regards to LTE baseband chips

China fined Qualcomm $975 million (the largest in China’s corporate history) and also forced the company to lower its patent royalty rates in 2015. Since roughly 65% of Qualcomm’s revenues originate from China and Hong Kong, the company had no choice but to comply.

As it fought off being acquired, Qualcomm was also playing the role of acquirer. The company is trying to complete a $47 billion dollar acquisition of Dutch semiconductor company NXP. On paper, the acquisition would bolster Qualcomm’s portfolio of intellectual property in chips for automotive and IoT devices. The deal was announced in 2016 but is currently held up in anti-trust review in China. The United States’ stifling of the Broadcom deal and current trade war tensions with China have not helped Qualcomm in gaining Chinese approval.

Last but not least, boardroom drama surfaced as Qualcomm recently removed its Chief Executive (scion of the company’s founder) from the board after he made public his desire to bid for the company.

Why the Deal Fell Through

Acquiring Qualcomm would have greatly expanded Broadcom’s position in smartphone and cellular communications chips. However, there is a technology arms race occurring between the United States and China over the future of 5G, and Qualcomm is the designated American champion in this race. America has held its own in 4G innovation but has fallen behind Asian countries in the application of 5G. 5G is touted as the fifth generation of mobile networking technology that will power a new wave of innovative services and applications; think self-driving cars and IoT devices. Although currently there is no defined standard for 5G, it promises to be a faster communications medium than current 4G technology.

The U.S. government and other Western industry CEOs fear that if China gains the lead in 5G technology, then China will gain a technology edge in the next wave of products that will take advantage of the faster speeds and interconnectivity; cyber-espionage tools included.

“China, under President Xi Jinping, has launched an ambitious plan to dominate mobile technology, supercomputers, artificial intelligence and other cutting-edge industries, putting huge resources behind an effort that it considers crucial to the country’s government, military and economy. Beijing wants to build its own technology champions and is encouraging companies to acquire the engineering, expertise and intellectual property from big rivals in the United States and elsewhere.” – New York Times. March 6, 2018

Although Broadcom has stated that it wouldn’t sell “any critical national security assets to any foreign companies”, its private equity reputation of cutting research and development to boost profitability caused more harm than good. The bottom line is that a takeover of an American firm by a perceived foreign competitor with a reputation for cutting research and development, risks strengthening Chinese competitors like Huawei and Xiaomi. The perceived political and national security ramifications of this scenario were deemed unacceptable.

It is for this reason that the biggest merger in the history of technology never happened.

References:

CNBC. March 1, 2018. Beware, Qualcomm: Broadcom is used to winning battles with hostility, as Amazon knows. https://www.cnbc.com/2018/03/01/broadcom-ceo-hock-tan-aggressive-negotiations-with-amazon-hpe-others.html

The Economist. Nov 9th 2017. Broadcom’s $130bn Qualcomm bid highlights a ruthless chip industry. https://www.economist.com/news/business/21731121-worlds-biggest-ever-technology-deal-would-face-antitrust-scrutiny-globally-broadcoms-130bn

The Economist. Jan 28th, 2017. Qualcomm is again under attack for living large off its patent portfolio. Its biggest customer, Apple, is suing it for $1bn. https://www.economist.com/news/business/21715705-its-biggest-customer-apple-suing-it-1bn-qualcomm-again-under-attack-living

McKinsey&Company. McKinsey on Semiconductors. Autumn 2013. https://www.mckinsey.com/client_service/semiconductors/~/media/32ae520663114c6eb1250bbdb92673c2.ashx

The Motley Fool. Feb 21,2017. Here’s Why Qualcomm, Inc.’s Research and Development Spending Dropped in 2016. https://www.fool.com/investing/2017/02/21/heres-why-qualcomm-incs-research-and-development-s.aspx

New York Times. March 6, 2018. The New U.S.-China Rivalry: A Technology Race. https://www.nytimes.com/2018/03/06/business/us-china-trade-technology-deals.html

New York Times. March 7, 2018. Broadcom’s Other Regulatory Hurdle: How It Treats Customers. https://www.nytimes.com/2018/03/07/technology/broadcom-qualcomm-customers.html

Rothaermel, Frank T. 2015. Strategic Management 2nd Edition. New York: McGrawHill, Irwin (2nd edition).

Wall Street Journal. March 6, 2018. Qualcomm’s Spending Buys the Right Friends. https://www.wsj.com/articles/qualcomms-spending-buys-the-right-friends-1520366524?tesla=y

Wall Street Journal. March 9th, 2018. Intel May Intervene in Broadcom’s Effort to Buy Qualcomm. https://www.wsj.com/articles/intel-considers-possible-bid-for-broadcom-1520633986

Wall Street Journal. March 19, 2018. Qualcomm Evaded Broadcom’s Bid; Now, CEO Has a Lot to Prove. Fending off Broadcom still leaves the chip giant with patent disputes and a takeover fight from within. https://www.wsj.com/articles/qualcomm-ceo-steve-mollenkopf-faces-fights-on-many-fronts-1521457200

Copyright: gmast3r / 123RF Stock Photo

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