Broadcom Acquisition Is Avago’s Game Changer

 

Avago Technologies Ltd. (AVGO) announced today that it will purchase Broadcom Corporation (BRCM) for $37 billion. The purchase will be financed by $17 billion in cash-on-hand and $20 billion in equity value, which includes $9 billion of bank-approved new debt. The transaction has been unanimously approved by the boards of directors of both companies.

Standard & Poor’s reports that “BRCM investors will receive $54.50 in cash, AVGO shares, or a combination.”

Both companies are semi-conductor chipmakers. Broadcom achieved $8.4 billion in 2014 sales, and Avago reached $4.2 billion in 2014 sales.

Avago’s president and CEO, Mr. Hock Tan, will continue to serve in that capacity over the combined company, which will be called Broadcom Limited. 

Standard & Poor’s says that Broadcom “offers AVGO significant scale, greater earnings leverage, and further diversifies AVGO’s business.” Morgan Stanley commented, “we would see strong synergies for growth in networking, with both companies already well positioned in the data center.”

In additional news today, Avago reported second quarter earnings per share (EPS) of $2.13, beating the consensus estimate of $2.01.

As investors decide whether to own shares of Avago going forward, it’s important to remember that, over the medium- and longer-terms, stock price growth hinges upon EPS growth.  Wall Street has forecasted that both Avago and Broadcom are expected to grow EPS 4-8% per year in 2016 & ’17.

Those growth expectations are not strong enough to attract growth stock investors, including any growth stock mutual fund with strict fundamental selection criteria. Therefore, while there may be some near-term excitement over the merger, investors need to maintain reasonable expectations for the future of Avago’s stock price vs. their overall investment strategies.

 

AVAGO TECHNOLOGIES: HOLD

(AVGO, $140.88, down $0.61 midday)

It will be many months before Wall Street analysts get a firm grasp on Avago’s post-merger earnings outlook.

In a speculative research article dated May 27th, Morgan Stanley anticipated that an Avago-Broadcom merger would add $1.10-$2.20 to Avago’s 2016 earnings per share (EPS). The expected EPS increase would include cost synergies associated with combining two similar companies. The acquisition is also expected to immediately add to Avago’s cash flow.

Avago’s 2014 long-term debt-to-capitalization ratio was 62%, which was one of the red flags that I mentioned in my May 20th article. The Broadcom acquisition adds $9 billion to those debt levels.

  • It’s worth noting that Avago’s long-term debt ratio was 0% in 2013. It was the 2014 LSI Corp. (LSI) acquisition that incurred the current debt load. The 2015 Emulex Corp. (ELX) acquisition, announced in February, was a cash transaction, and thus should not affect the debt ratio.

Conversely, Broadcom’s 2014 long-term debt-to-capitalization ratio was only 15%.

 

Has Avago bit off more than it can chew?

Avago purchased LSI Corp. in 2014; additionally purchased Emulex Corp. this year; and is now acquiring Broadcom Corp.

Avago’s CEO will need to have a clear vision, a firm hand, and a workable plan, to successfully combine all those businesses.

 

Technical Chart

Avago shares reached all-time highs in March. At the time of my May 20th article, despite the modest earnings outlook, the chart appeared bullish. At that time, I said, “the chart might be signalling a near-term upside breakout.”

The stock proceeded to achieve an upside breakout on this week’s merger news.

 

Recent recommendations:

  • The stock price rose as much as 28.7% after January 13th, when I said, “Current shareholders should expect additional capital gains.  Momentum investors should jump in now…”

  • Then on February 26th, I encouraged buy-and-hold shareholders to continue to hold their shares.

  • On May 20th, I said, “AVGO shares do not qualify for a Goodfellow LLC buy rating due to slow 2016 & ’17 EPS growth, comparatively high 2016 & ’17 PE’s, and a high debt ratio.”

 

How to Proceed with Avago Shares

The Broadcom acquisition positively influences Avago’s earnings outlook, price/earnings ratio (PE), and possibly its debt ratio. Therefore, I’m changing my recommendation on AVGO from sell to hold.

 

Goodfellow LLC Rating:  Hold, Public. (05-28-15)

Avago Technologies purchased Emulex Corp. (ELX) on May 5, 2015; and also purchased LSI Corp. (LSI) in 2014.  AVGO was added to the S&P 500 index on May 7, 2014.

See my recent articles, AVAGO TECHNOLOGIES: DEVELOP AN EXIT STRATEGY and Avago Technologies Announces Strong Earnings Beat, and Emulex Acquisition.

AVGO6mosMay28

Chart courtesy of StockCharts.com.

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BROADCOM: SELL

(BRCM, $55.68, down $1.47 midday)

Broadcom’s stock price shot up yesterday, during the acquisition rumor phase, and has pulled back a bit, today.

Considering that the acquisition value is approximately $54.50, I would sell my shares now, while the price is above $54.50. I would then reinvest my capital into an undervalued growth stock, to increase the chances that my capital will continuing growing in the near-term.

 

Goodfellow LLC Rating:  Sell, Public. (05-28-15)

Broadcom Corp. (BRCM)   three-month chart   05-28-15

Broadcom Corp. (BRCM) three-month chart 05-28-15

Chart courtesy of StockCharts.com.

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