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Previous articles on Broadcom’s attempts to acquire Qualcomm:  Why Broadcom’s offer to buy Qualcomm is a terrible idea and Why Broadcom’s offer to buy Qualcomm is still a terrible idea.

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When I first learned of Broadcom’s bid to acquire Qualcomm, my first reflex was to ask three simple questions:

1. How might the future of wireless technology (and consequently of the tech ecosystem as a whole) be impacted by a hypothetical acquisition of Qualcomm by Broadcom?
2. Given the impending commercialization of 5G, and Broadcom/Avago’s tendency to divest itself of critical business units that aren’t immediately profitable, how would a hypothetical acquisition of Qualcomm by Broadcom potentially impact stock value for shareholders and investors  in the mid-to-long long term? Especially knowing how important 5G (and whatever comes next) is likely to be to the company’s long term success.
3. How might the United States’ ability to maintain its technological and economic superiority well into the mid-century be affected by a hypothetical acquisition of Qualcomm by Broadcom – just as rival (and possibly hostile) foreign actors are working to gain an advantage (both economic and strategic) in the technology space?

I already addressed the first two questions a few months ago. (See links provided above.) Given the sudden interest CFIUS (The U.S. government’s Committee on Foreign Investment in the United States) has taken in Broadcom’s bid, the time may have come to start talking about the third.

Note: Why are we talking about Foreign Investment when Broadcom is technically a US company? For starters, because Avago/Broadcom is headquartered in Singapore. To its credit, Broadcom is trying to address this issue by moving its HQ to the US, but the timing of that move has raised questions about Avago/Broadcom’s decision to relocate. Some analysts I have spoken with on the matter feel that Broadcom’s relocation to the US is, at best, its way of checking a necessary box with regard to US regulators, and at worst, outright suspect. (I am of the opinion that one does not preclude the other.) The point being that even with a newly relocated HQ in the US, it may not be wise to think of Avago/Broadcom as a US company. At the very least, we can probably agree that the move is unlikely to have been motivated by any sense of patriotism, economic or otherwise, on the part of Avago/Broadcom. And while normally, patriotism would not be a relevant topic in a mergers & acquisition discussion, we are talking about National Security, after all.

Let’s jump into that discussion then.

Quick recap: 

• January 28, 2018: Qualcomm files a notice with CFIUS “seeking review of Broadcom’s solicitation of proxies for the purpose of electing a majority of the directors of Qualcomm.”
• March 4, 2018: CFIUS issues an interim order to Qualcomm, directing the San Diego company to postpone its annual stockholders meeting and election of directors by 30 days, to afford CFIUS the ability to look more closely into Broadcom’s proposed acquisition.
• March 5, 2018: Aimen Mir, Deputy Assistant Secretary for Investment Security at the US Department of Treasury, drafts a letter explaining CFIUS’ position: Between Jan 29 and March 2, CFIUS, having considered its first round of communications with both parties and weeks of due diligence on the matter, came to the following conclusion:

“Broadcom’s successful hostile takeover attempt of Qualcomm, including the related stock purchase, proxy contest for the election of six directors to Qualcomm’s Board as proposed and selected by Broadcom, Proposed Agreement and Plan of Merger, and any other potential merger between Broadcom and Qualcomm could pose a risk to the national security of the United States.”

This is an extraordinary statement from CFIUS, and one that should raise alarm bells everywhere.

 

Timing is everything: Why the sudden urgency?

The letter, which you can read here in its entirety, doesn’t stop there. It goes on for 4 pages, outlining the importance to the United States of Qualcomm’s leadership in technology and standard setting, national security risks associated with a weakening of Qualcomm’s technological leadership, and the danger of potential “disruptions” in the relationship between the Department of Defense and one of its key technology suppliers: Qualcomm.

We will eventually come back to that relationship later in the series, but first, I want to point to something that caught my eye in the section of the letter I just shared: CFIUS isn’t just calling attention to the threat of an eventual merger between Broadcom and Qualcomm, which, assuming a successful bid, would be unlikely to be finalized for some time. CFIUS is also warning against the immediate threat of the possible election of six new Broadcom-friendly directors to Qualcomm’s Board. (Directors “proposed and selected by Broadcom” to presumably facilitate its takeover of Qualcomm.)

The timing of the interim order filed by CFIUS, just days before Qualcomm’s scheduled vote, is unlikely to be coincidental: It wouldn’t be a stretch to suggest that CFIUS, in considering a plausible sequence of events in which Broadcom’s bid to successfully acquire Qualcomm might succeed, would see the appointment of these six directors as the tripping of the first domino in a chain reaction ultimately leading to Broadcom getting its way. Here are three quick points to consider:

1. Having a majority of directors on the board could enable Broadcom to influence and/or affect Qualcomm’s operations even before Broadcom/Avago reaches agreement to buy the company.
2. It could then also enable Broadcom to influence Qualcomm’s operations during the interim period (say, 12-18 months) between an offer being accepted and regulatory approvals being obtained. (Both companies would have to, by law, continue to operate as separate companies, but this is a way of circumventing that somewhat.) Note that Avago/Broadcom has already expressed its intent to make changes to Qualcomm’s licensing business even before a hypothetical deal closes.
3. In addition to the previous two points, it would enable Broadcom to maintain some influence over Qualcomm even if regulators ultimately block the acquisition – as the board members would remain. From where I sit, that doesn’t seem like a healthy or productive outcome for Qualcomm. Fellow analysts I have discussed this with have expressed concerns about the possibility of lingering conflicts of interest potentially poisoning Qualcomm’s operations should the acquisition be blocked. I agree with them.

The 30-day delay imposed by CFIUS seems a logical step in maintaining the status-quo between Qualcomm and Broadcom – a way to freeze time, so to speak – while the probe deepens, and all national security concerns surrounding the case are properly examined.

 

Uncovering Two Distinct Categories of Threats to US National Security: The Rise of China as a Technology Superpower, and Hostile Third Party Entities

Another aspect of the letter I find interesting is its specific mention of Huawei (which, last I checked, was not a subsidiary of Broadcom/Avago). See page 2:

“Given well known US National Security concerns about Huawei and other Chinese telecommunications companies, a shift to Chinese dominance in 5G would have substantial negative national security consequences for the United States.”

Since we are talking about about Huawei, note that with regard to 5G standards, Qualcomm’s loss is Huawei’s gain: Huawei has been vying for greater influence (read: control) of the 3GPP standards process, and has gone to extraordinary lengths to chair committees and working groups (thereby significantly growing the number of its contributions and participants) in an effort to increase the likelihood that more Huawei designs will become part of the standard. If Broadcom reduces Qualcomm’s involvement in 3GPP, Huawei will be happy to fill the void.

Although CFIUS takes makes a compelling (and accurate) case for the importance of ensuring that US companies remain competitive (in a leadership role) with regard to 5G, I feel that the subtext here is less about R&D investments, essential IP, and standard setting, than it is about the risk of handing over vital 5G, wireless, and semiconductor-related IP to China.

This may be a good time to note that China and the United States are not technically “enemies.” China and the United States are trade partners, diplomatic partners, and are generally open to pursuing mutually-beneficial common interests. But the United States and China are also simultaneously rivals. Among many points of friction between both countries, China still engages in a fairly consistent campaign of corporate espionage and IP theft. China’s aggressive expansionism in the Asia-Pacific region, as evidenced by the recent militarization of natural and artificial islands in the South China Sea, is also a policy which the US isn’t particularly happy about. Although not exactly a technical term, perhaps the simplest way to describe the complicated relationship between the US and China is to refer to both countries as frenemies.

Now that we have gotten that out of the way, I know what you’re thinking: “But… Avago/Broadcom isn’t Huawei, and it isn’t a Chinese company!” You’re right. Avago/Broadcom is (or was, if you are reading this after April 3, 2018) incorporated in Singapore, and Singapore is not China. Furthermore, while China and Singapore enjoy what Asia-Pacific experts might call a “close and prioritized” relationship, it would be a stretch to imply that a Singapore-based company would be inclined to act as a proxy for Chinese interests based on the general nature of that relationship alone. And yet, the main focus of CFIUS’ concern is clearly China: a rising rival with growing political, military, economic, and technological influence not only in the Asia-Pacific region but around the world.

The obvious question: If the subject of CFIUS scrutiny is Avago/Broadcom (which is not a Chinese company), why are we talking about China?

There are two ways to answer that question (and they are not mutually-exclusive):

1. No direct connection: short-term business thinking will give China the advantage it needs to overtake the US in the tech race – To Aimen Mir’s point (and echoing concerns already raised here months ago), Broadcom’s MO (and stated intent) is to take what one might call a “private equity” approach to the management of Qualcomm. This means aggressive cost-cutting across the organization and the prioritization of short-term profitability over long-term investments. Translation: A deprioritization of certain types of R&D (fundamental and long term), which, as we all know, are Qualcomm’s lifeblood, and among the core engines of its success.

In sharp contrast to Qualcomm’s model, Avago/Broadcom’s model appears to boil down to spending roughly 6x more on acquisitions than on R&D, while generally cutting fundamental R&D spending of companies it acquires. While this probably doesn’t impact Broadcom’s short-term product R&D programs, which are less risky and yield near-immediate results, this model appears to undermine its ability to drive long term and fundamental technology innovation.

Consider the impact of even a 5% reduction in fundamental R&D spending at Qualcomm at a time when Chinese technology companies are making significant forward leaps, especially in the 5G space. Now imagine the impact of a 10% cut. Now push that to 20%. Consider the ripple effects of these decisions as we move towards 2020, 2025, and 2030.

The math here is simple: Under Broadcom management, the expectation among serious technology analysts is that Qualcomm’s competitiveness would be weakened by the likely ensuing deprioritization of R&D funding. Consequently, just as Chinese technology companies (like Huawei), with the full support of the Chinese government, work to gain ground, improve their ability to innovate and compete, and work to gain more control over international technology standards, Qualcomm would find its ability to compete weakened by its new management regime.

In this model, we get the following scorecard:

• China: +
• US: –

In addition, Broadcom CEO Hock Tan has indicated an interest in making significant changes to Qualcomm’s technology licensing model. Three points here:

1. Qualcomm’s QTL business generates roughly two thirds of Qualcomm’s profits, which in turn fund a significant portion of Qualcomm’s wireless R&D. Disrupting Qualcomm’s licensing revenue stream would likely disrupt its wireless R&D funding. 
2. Deep cuts in fundamental R&D funding would likely trigger an exodus of key technology talent from Qualcomm. Best case scenario: they would be hired by US companies. Worst case scenario, they could be hired by foreign actors (like Chinese companies), thereby accelerating the dissemination of the inner-workings of important technology and security mechanisms.
3. Lastly, Broadcom, like Apple, has a tendency to be a captive, even protective IP vendor (the exact opposite of Qualcomm). Should Broadcom decide to take a wrecking ball to an open model that, thus far, has been a key component of America’s dominance in wireless technology innovation, the US could conceivably find itself at best losing its current competitive advantage, and at worst soon unable to compete against faster-moving Chinese tech companies (within 5 to 10 years).

Given how profitable to Qualcomm, equitable to the technology ecosystem at large, and available to the US government Qualcomm’s licensing model is, the sort of (yet undefined) disruption already suggested by Hock Tan doesn’t bode well for anyone currently benefiting from it.

In this scenario, the danger is that the US could lose its ability to compete against a significant geostrategic rival like China, not because of any nefarious intent or activity on the part of any company or country, but simply as a result of allowing short-term, “private-equity” business thinking to interfere with critical long-term technology innovation that the US needs to:

• drive job growth in an increasingly digital economy
• maintain its leadership position in global technology innovation, and
• provide the US and her allies with critical high-tech security and defense capabilities.

2. Indirect-Direct Connection: third party entities hostile to the US could gain access to sensitive IP as a result of this transaction –   The second and potentially far more nefarious scenario is one in which the US, having lost control of Qualcomm to Singapore-based Avago/Broadcom, might hypothetically see a portion, or even all of Qualcomm’s deep portfolio of IP, R&D, and trade secrets relating to chipsets, software, wireless technologies, edge computing, IoT, and security become more broadly available to hostile foreign actors (either directly or by way of corporate proxies).

In spite of the CFIUS letter’s emphasis on China, it stands to reason that China is not the only country the US should be concerned about. Hypothetically, should Qualcomm fall under “foreign management,” where else might Qualcomm’s most sensitive IP end up?

While this type of hypothetical exercise may seem paranoid to some, it is a legitimate concern for members of the intelligence and defense communities, as well it should be. If nothing else, consider the potential vulnerabilities relating to cyber-threats that are likely to emerge as 5G becomes embedded in (or connected to) every aspect of US (and Western society): Our communications infrastructure. Our power grids. Our nuclear power plants. Our missile defense systems. Our water treatment plants. Our transportation infrastructure. Airline traffic control. Our banking system. Food production and safety. Environmental control and safety. Our electoral system’s infrastructure. Government databases. And on, and on, and on.

Consider the growing importance of wireless connectivity, the IoT, cloud and edge computing (critical to IoT security) to every system and infrastructure layer we depend on. Now consider the need to ensure that we not only create impenetrable security layers to defend all of it from attacks by hostile actors, but that we remain 2-3 years ahead of our most technologically-savvy enemies at all times.

What would happen if a company critical to maintaining that advantage, a company like Qualcomm, suddenly fell into the hands of a foreign power, or in the hands of a conglomerate open to making some of its critical IP available (knowingly or not) to proxies of hostile foreign actors. This is also the scenario currently giving security folks in Washington (and in the EU) cold sweats.

And to be clear, no one is suggesting that Broadcom/Avago is a hostile actor, or an accomplice to hostile actors. The fear among defense, intelligence, and national security experts, as it pertains to this scenario, is simply that hostile actors could try to take advantage of Avago/Broadcom’s acquisition of Qualcomm to gain access to technologies they want and need to:

• upgrade their intelligence-gathering and spying capabilities, and/or
• potentially carry out cyber warfare operations against the United States and her allies.

Per the Treasury Department’s letter (emphasis mine), top of page 2:

“This analysis includes an assessment of the intent and capability the acquirer, including by an actor through the acquirer, to cause harm (the “threat”) and the nature of the US business and susceptibility of impairment of US national security (the “vulnerability”) should exploitation or compromise occur.”

Additionally (emphasis mine), also at the top of page 2:

“To the extent that some of the potential national security concerns can be described in an unclassified manner, CFIUS notes that they relate to the risks associated with Broadcom’s relationships with third party foreign entities and the national security effects of Broadcom’s business intentions with respect to Qualcomm.”

So there you have it. While the letter later mentions Huawei by name and suggests that other unnamed Chinese telecommunications companies have been acting against US national security interests, in this particular section, Deputy Assistant Secretary Aimen Mir provides three fascinating pieces of the investigation’s larger puzzle:

1. Additional third party foreign entities with a known relationship with Avago/Broadcom present a threat to US national security.
2. The identity of those third party foreign entities is significant enough to warrant that they remain classified for now.
3. Third party foreign entities may be attempting to exploit Avago/Broadcom’s possible acquisition of Qualcomm to compromise US national security.

 

One additional point of note regarding the second scenario is the massive $106 BILLION in US-based and foreign-based debt financing that Broadcom has had to line up in order to secure its bid to acquire Qualcomm. This is, as the letter points out, the largest corporate acquisition loan in history. So:

Adding to the growing list of concerns regarding the Singapore-based company’s potential vulnerability to exploitation and/or compromise by hostile third party foreign actors, a $106 Billion debt package opens the door to significant leverage against the debtor (in this case Avago/Broadcom) either by parties holding that debt, or (and here is the real danger) by third parties able to provide relief from it, should Avago/Broadcom become at risk of defaulting on the loan. 

As debt is a common lever pulled by hostile actors to compromise high value targets and, through them, gain access to sensitive national security assets, the amount of debt being incurred in this potential transaction more than likely presents its own layer of red flags for CFIUS. It certainly caught my attention.

More on this subject as our series continues.

In Part 2, we will cross the Atlantic to see how these latest developments are being received in the EU, and discuss how Broadcom’s hostile bid to acquire Qualcomm threatens the future of Europe’s thriving technology sector, could very well cost Europe tens of thousands of high-paying technology jobs, and might, just like with the United States, end up compromising the region’s ability to defend itself from hostile actors.

UPDATE: Several hours after we published this piece, the White House issued an executive order permanently blocking Broacom from acquiring Qualcomm. You can read the EO here.

The part that we find particularly interesting is Section 1.  Findings. (a). It states:

“There is credible evidence that leads me to believe that Broadcom Limited, a limited company organized under the laws of Singapore (Broadcom), along with its partners, subsidiaries, or affiliates, including Broadcom Corporation, a California corporation, and Broadcom Cayman L.P., a Cayman Islands limited partnership, and their partners, subsidiaries, or affiliates (together, the Purchaser), through exercising control of Qualcomm Incorporated (Qualcomm), a Delaware corporation, might take action that threatens to impair the national security of the United States;”

We will provide follow-ups as needed, but as of March 12, 2018, the Broadcom acquisition of Qualcomm appears to have become a smoldering heap of “not gonna happen.”

Cheers,

Olivier

Final Update: 14 March 2018 – Broadcom has announced that it will comply with the presidential EO preventing it from pursuing the acquisition of Qualcomm. “Although we are disappointed with this outcome, Broadcom will comply with the order,” Broadcom confirmed in a statement.