Yesterday, Broadcom officially made a record-breaking $130 billion acquisition offer to Qualcomm confirming media reports that emerged over the weekend. News of this significance certainly needs some time to digest. The semiconductor industry has been going through a period of extreme consolidation and the last two years have seen hundreds of billions of dollars spent on mergers and acquisitions. Qualcomm itself is in the process of acquiring NXP. In the wake of increased capital costs, semiconductor companies are engaged in consolidation to stabilize the pricing environment and to gain leverage over their shrinking customer base. Scale is often cited as a key rationale in semiconductor acquisitions and Broadcom’s offer for Qualcomm raises a key question: how much scale is enough for a semiconductor company.

Before getting into details, this takeover makes no sense to us for three reasons:

• Firstly, Qualcomm is an established company with a strong track record of execution and one would hardly expect it to be an acquisition target to a relatively smaller company. Still Broadcom dared to do this.
• Secondly, Broadcom’s opportunistic offer looks like it acquiring a distressed company. Qualcomm’s well-publicised legal battles with Apple and regulatory bodies in various geographies and its slow-moving NXP acquisition process have created a perfect storm and made Qualcomm look vulnerable. In reality we believe Qualcomm is not vulnerable as the company’s chip unit (QCT) has been performing well since Qualcomm’s strategic review on whether to split the chip unit and the licensing unit in 2015. QCT’s margins recovered well and its efforts to expand beyond smartphones have started to pay off. To further expand into non-smartphone markets and to further secure its future in the semiconductor industry, Qualcomm announced its intention to acquire NXP, which has a strong presence in security, IoT and automotive markets. This is on top of Qualcomm’s safe and secure baseband modem leadership and its pioneering 5G efforts. Let’s not forget that QCT’s efforts to capture more value per smartphone with its broad portfolio (modem, apps processor, connectivity, RF 360 JV, sensors, etc.) have also started showing fruitful results.
• Finally, a deal of this size will no doubt face intense scrutiny from regulators around the world, especially as Qualcomm is involved. The combined company will have an enviable share in smartphone chips including modem, processor, connectivity and RF. This could easily attract anti-trust organisations to demand concessions, which may include product divestitures, conditions on pricing and completive-friendly measures. Avago closed Broadcom’s acquisition in 8 months and is expecting any Qualcomm deal will close in 12 months. This is an aggressive target. Qualcomm’s in-progress acquisition of NXP has already taken more than 12 months and Qualcomm is still waiting to get approvals from China and the EU. Qualcomm has already made concessions to the EU to accelerate the NXP deal process.

Broadcom’s offer clearly undervalues Qualcomm as a company. In our view, once the NXP acquisition closes, Qualcomm’s chip unit could function more independently from QCT, the licensing arm with its increased non-smartphone revenue and profit streams. At the moment the success of Qualcomm’s chip unit is largely tied to its licensing unit, whose profits fund the chip unit’s R&D. In light of the licensing unit’s challenges and the chip unit’s need to expand beyond smartphones, Qualcomm is pressured to be less dependent on this interlinked business model.

What does Broadcom want from Qualcomm? One word. Modems! For a company like Broadcom, Qualcomm’s modem leadership completes the wireless picture. Please note that Avago acquired Broadcom one year after Broadcom’s exit from the baseband market and the company did not inherit modem products. At this point, only Qualcomm’s modems make sense as Intel, MediaTek and Spreadtrum are behind in terms of product strength. HiSilicon and Samsung LSI are vertically integrated and Broadcom cannot acquire them. Qualcomm’s success in 5G is all but assured at this point, thanks to its first-mover advantage. Can Broadcom develop a 5G baseband on its own? Yes, of course. But, it will take a huge R&D budget and multiple years to get customer acceptance and Broadcom’s lack of experience in 4G basebands further complicates the process as backward compatibility is a key requirement for network operators. So, the only option is to look for an acquisition to fill this gap and Qualcomm fits the bill perfectly.

This brings into question Broadcom’s commitment to Qualcomm’s ongoing NXP acquisition. If Broadcom wanted NXP, it would have directly acquired NXP by counter-bidding Qualcomm. But, that’s not the case. Broadcom only wants Qualcomm’s chip assets, to be more specific. This casts doubt on Broadcom’s commitment to Qualcomm’s licensing unit too. All in all, Broadcom’s announcement raises more questions than it answers.

Stepping back and looking at this from Qualcomm’s perspective, Qualcomm’s management has been saying that the resolution of its litigation battle with Apple and the closure of its acquisition of NXP will happen eventually, although these issues are taking time and testing investors’ patience. Qualcomm’s track record in resolving legal issues is in its favor and we have full confidence that Qualcomm will find a way to rest all its battles with Apple outside the courts. Also, the NXP acquisition should be closed with another 2-3 months. In addition, 5G will kick start in 2019, increasing Qualcomm’s opportunity. Once the NXP acquisition closes, Qualcomm’s chip unit will be less dependent on Apple and Samsung and will participate more aggressively in growth markets. Now, Broadcom’s offer disturbs this well thought-out organic growth plan and creates an unnecessary distraction. As mentioned earlier, the price and anti-trust hurdles should make Qualcomm think more than twice before accepting Broadcom’s offer. Broadcom and Qualcomm do not have much product overlap (except for RF filters, connectivity chips, and some networking products) and make a good match on paper. Broadcom’s presence in data-center and Qualcomm’s data-center ambitions also match well. But, ultimately we think Broadcom needs Qualcomm more than Qualcomm needs Broadcom. Qualcomm already has a clear path ahead and the last thing the company needs is another distraction.

If Qualcomm agrees to this takeover from Broadcom this will actually increase Qualcomm’s dependence on the smartphone market rather than reduce it. Clearly an uncomfortable position for both companies even with NXP in the mix as Broadcom is likely to focus on wireless.

As Qualcomm has already patiently worked for an extended period and is close to acquiring NXP to kick start its ambitious journey we weigh more towards a Qualcomm-NXP only combination rather than a Broadcom-NXP-Qualcomm or simply a Qualcomm-Broadcom combination. Integration with Broadcom means more delays and execution risks.

Sravan Kundojjala (@SKundojjala)