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Why Broadcom’s offer to buy Qualcomm is still a terrible idea
by Olivier Blanchard | December 13, 2017

A few weeks ago, I shared some of my reservations regarding the proposed “purchase” of Qualcomm by rival chip-maker Broadcom. If you haven’t read it, or did but can’t remember all of the details, now may be a good time to get caught up. You might also want to read this piece on the consolidation of the innovation ecosystem, because it touches on some tangential but important aspects of this proposed acquisition.

Today, I want to outline a few more pretty big reasons why I still think it’s a terrible idea for Broadcom to acquire Qualcomm. Let’s just use my original post as an introduction and jump right to it.

1. Given what is just over the horizon for Qualcomm with 5G, investors should see Broadcom’s offer for the financial absurdity it is.

You don’t need to be a financial analyst to see how ridiculous it is for Broadcom to offer a measly $105B, or about $70 per share, to acquire a company poised to start raking in significant amounts of revenue from the commercialization of 5G in just 18-24 months, to say nothing of what Qualcomm’s acquisition of NXP brings to the equation. (Consensus among analysts and observers of the NXP acquisition estimate that Qualcomm’s serviceable addressable market [SAM] would grow to $138B by 2020 and boost annual revenues to $30B.)

In my earlier post, I mentioned that unlike Broadcom, Qualcomm makes big bets. Long bets. Industry-changing bets tan can take 7-10 years to pay off. Bets like 3G, 4G, and now 5G. Bets with long runways but huge payoffs. Qualcomm’s investments in 5G have been massive and well coordinated and a long time coming, and those investments are about to start paying off. Even based on conservative estimates, the company’s annual revenues from the commercialization of 5G (slated to begin in 2019) and from its acquisition of NXP should make Broadcom’s offer seem grossly off-target. It is no surprise that it was promptly rejected by Qualcomm.

Broadcom isn’t likely to give up, however, so let’s keep going.

2. The impact of Qualcomm’s dispute with Apple is being overplayed.

You don’t invest in companies based on the value they deliver today. You invest in companies based on the value you believe they will deliver in the future. Broadcom’s offer makes sense from the perspective of a buyer trying to make an advantageous purchase just before a company’s market value starts going up.

My guess is that Broadcom is probably hoping that investors will see Qualcomm’s value as fixed in time and space, particularly as it pertains to its ongoing dispute with Apple. If you haven’t been following that dispute, part of it involves Apple and its contract manufacturers refusing to pay licensing fees owed to Qualcomm, pending the outcome of their dispute in court. (A decision is likely to come as early as Q4 2018.) Some observers have suggested that Apple may be engaging in a form of patent holdout strategy in order to pressure Qualcomm to agree to a renegotiation of their licensing terms (fees).

Two quick points:

  1. While it is true that Apple’s strategy has temporarily impacted Qualcomm’s revenue targets, the dispute (and specifically the hold on payments caused by Qualcomm’s dispute with Apple for perhaps another year), is a red herring when it comes to Qualcomm’s health, market potential, and profitability in coming years, especially on the eve of the commercialization of 5G and the completion of Qualcomm’s NXP acquisition.
  2. One way or the other, the Apple-Qualcomm dispute will be resolved, and there is no indication that Apple is likely to win. If anything, recent statements made by the US Department of Justice and the European Commission suggest a shift towards a tougher stance both in the US and in Europe against companies engaging in patent holdout strategies to either get out of their IP licensing commitments or force their supply chain partners to agree to disadvantageous terms. (I encourage you to read Assistant Attorney General Makan Delrahim’s illuminating 10 Nov 2017 speech on the subject.)

Let me elaborate on Point 1: While everyone (Qualcomm and Apple included) would benefit from both companies working out their differences amicably, Qualcomm’s roadmap to growth and profitability in the next decade isn’t dependent on Apple. As big a fish and as important a mobile ecosystem partner Apple may be, especially in the eyes of consumers, Qualcomm’s revenue flag is as firmly planted in the Android space as it is in the iOS space, to say nothing of Qualcomm’s ambitious plays in other areas like the IoT, mobile PCs (read up on the Snapdragon 835 mobile PC platform), and other 5G-related sectors.

Now, don’t get me wrong: I don’t want to minimize the importance of Apple in Qualcomm’s revenue ecosystem, at least until now. It isn’t negligible. But it is also important to acknowledge just how small Apple already is compared to the rest of the mobile ecosystem. To illustrate my point, compare the install base for Android and iOS, courtesy of this chart from Statista:

 

Note that while the Android ecosystem is growing, Apple’s iOS install base remains flat, with signs of light erosion. However you may feel about Apple, the iOS install base is no longer keeping up with Android’s growth. Following its current trajectory, Apple’s relevance to Qualcomm’s bottom-line appears to be decreasing rather than increasing. In addition to what I have already brought up, eyes are beginning to turn to China with regard to Qualcomm’s growth trajectory, especially given its FY17 25% YoY growth in QCT revenue and MSM shipments to Chinese OEMs, and the company’s newly minted MOUs with Chinese manufacturers Xiaomi, OPPO, and Vivo, worth $12B. It is worth noting that while Apple appears to have decided not to make good on its contract with Qualcomm, over 300 other licensees have not gone down that path. Quite the contrary. Ergo:  Qualcomm’s Technology Licensing model (QTL for short) doesn’t appear to be the problem here.

I have heard it argued more than once in recent months that Apple’s focus on suing Qualcomm rather than on leveraging the healthy partnership Apple and Qualcomm once enjoyed may even have contributed to Apple’s recent inability to keep up with the pace of innovation. Something about that rings true.

One last observation before we move on: As informative as the above graph is, it doesn’t take into account Qualcomm’s growing footprint. Gauging the company’s value barely 24 months from 2020 based on its recent squabbles with Apple is to completely miss the big picture.

3. Poorly researched journalism is breathing life into false narratives.

Despite the fairly obvious points I just outlined, the myth that Qualcomm’s dispute with Apple somehow threatens the future of Qualcomm (or Qualcomm’s ability to create value for the market and investors) persists. Here’s an example of the kind of reporting that helps perpetuate that dubious line of thinking, courtesy of Seeking Alpha‘s Javier Rojas:

Despite the ongoing legal battle between Qualcomm (NASDAQ:QCOM) and Apple (NASDAQ:AAPL) and the regulatory hurdles obstructing Qualcomm’s acquisition of NXP, Qualcomm is a strong acquisition target for Broadcom, and I expect Broadcom to return with a second offer next spring. Qualcomm is indeed undervalued at the $70 per share offered in early November, and Broadcom’s second offer will likely be in the $80 – $90 range, presenting investors with a short term consolidation play.

Qualcomm’s current legal predicament could serve as a catalyst for acquisition. […] The suit will serve as a strong indicator to the health of the company long term for two primary reasons: roughly 35% of Qualcomm’s total revenues come from licensing fees and Apple commands the second largest global market share in smartphones. Losing Apple as a customer would inevitably reduce mobile chip profitability, let alone the damaging legal expenses involved in a lawsuit of this magnitude. This is all the more reason for Qualcomm to find it advantageous to seek an exit opportunity, particularly with Broadcom, which is already a major beneficiary in Apple’s supply chain.

Let’s quickly unpack that last paragraph:

“Qualcomm’s current legal predicament could serve as a catalyst for acquisition.”

For starters, calling it a “predicament” may be overselling Apple’s case. We’ll find out in about a year the extent to which the “predicament” may actually be Apple’s rather than Qualcomm’s. Second, lawsuits happen. Companies run into legal challenges and regulatory hurdles on a regular basis, and they rarely serve as catalysts for acquisition.

“Roughly 35% of Qualcomm’s total revenues come from licensing fees and Apple commands the second largest global market share in smartphones.”

Let’s start with the obvious: Those licensing fees aren’t limited to the smartphone market. (Qualcomm’s revenue outside of smartphones was up $3B in 2017, more than 25% YOY. Four markets to keep an eye on are mobile (always connected) PCsdata centers, IOT, and automotive.)

Second, we’ve already established where Apple stands with regard to Android’s dominance in the mobile industry. Third, the first half of that sentence and the second half of that sentence have nothing to do with each other. If Javier was trying to suggest something about Apple’s share of Qualcomm’s licensing revenues, this is not the way to do it.

“Losing Apple as a customer would inevitably reduce mobile chip profitability, let alone the damaging legal expenses involved in a lawsuit of this magnitude.” 

No. First, losing Apple as a customer would not “inevitably” anything.

Second, losing Apple as a customer would have no impact on mobile chip profitability. It would only impact mobile chip revenue. Revenue and profitability are not the same thing.

Third, Apple doesn’t just buy chips from Qualcomm. Apple also licenses critical IP from Qualcomm, independent of its chip purchases. This means that even if Apple decides to never buy chips from Qualcomm again (which remains to be seen), Apple (or Apple’s contract manufacturers) will still be a Qualcomm licensee(s), which means continued revenues for Qualcomm. (That is, not unless Apple decides to no longer make its iPhones 4G LTE compatible, and/or decides to ignore 5G altogether. Fat chance of that happening unless Apple plans to get out of mobile altogether.)

Lastly, as there is no indication whatsoever that Qualcomm is likely to lose in court against Apple, assuming any “damaging legal expenses” is a hell of a stretch at this juncture.

“This is all the more reason for Qualcomm to find it advantageous to seek an exit opportunity, particularly with Broadcom, which is already a major beneficiary in Apple’s supply chain.”

Again, no.

Why on Earth would Qualcomm find it “advantageous” to seek “a exit opportunity” when 1) Qualcomm has a fairly strong case against Apple, which it looks forward to arguing in court in the coming months, 2) as I have already pointed out, Qualcomm’s investments in 5G and other technologies and markets are about to start paying off on such a scale that its dispute with Apple will soon be all but irrelevant, and 3) regardless of where Apple ultimately decides to buy its chips, a chunk of the licensing fees it owes Qualcomm has nothing to do with Qualcomm’s chip business?

Moreover, not only is there zero reason whatsoever for Qualcomm to “seek an exit opportunity” from its dispute with Apple (or from anything, really), Broadcom is such a horrible match for Qualcomm that the use of the term “particularly” in that article seems especially inadequate.

Lastly, I doubt that I am the only person who finds the following phrase problematic, if not outright suspect: “particularly with Broadcom, which is already a major beneficiary in Apple’s supply chain.” What in the world does Broadcom being “a major beneficiary in Apple’s supply chain” have to do with its ability to make Qualcomm’s dispute with Apple go away, should an acquisition occur? Take as long as you need.

For the record, I don’t mean to pick on Javier or single him out. His article was just a good example of the sort of bizarre coverage about this proposed acquisition that I routinely run into, and which deserves properly-sourced pushback.

4. Investors should also see right through Broadcom’s likely attempt to reshape Qualcomm’s Board of Directors.

As reported by the New York Times on December 4, 2017, Broadcom has proposed to replace Qualcomm’s entire board of directors with a slate of 11 new Directors who, presumably, would be in favor of the acquisition. It’s a bold move, and a clever one to a certain degree, but here are a few quick observations about that idea that jump out at me:

First, a board of directors designed to facilitate and manage an acquisition isn’t necessarily the board of directors you want to actually help run a company, especially one with with Qualcomm’s unique business model. Qualcomm’s current board is already world class (and equally important, independent), with 4 new directors added in the last 3 years, and impressive results already. If logic dictates that there is no need to fix a board that isn’t broken, experience tells us that there is no upside whatsoever to replacing a board that is already delivering increasingly impressive results.

Second, given all the ways that a Broadcom acquisition of Qualcomm could potentially disrupt the commercialization of 5G, shareholders who agree to this option run the risk of sabotaging their own investment in the company. From where I stand no one in their right minds should even consider rocking the boat this close to 2019, especially when Broadcom and Qualcomm are so obviously mismatched.

Third, Broadcom is already signaling that it plans to throw a wrench in Qualcomm’s lucrative licensing model. This should send chills up investors’ spines, not just with regard to Qualcomm’s long term revenue prospects but because of the impact such a change could possibly have on the health of the technology ecosystem as a whole. (Note that Qualcomm recently announced its 5G rates, and even those were universally well received.)

Fourth, consider the negative impact this could have on Qualcomm’s acquisition of NXP. I covered this in my earlier piece.

Fifth, unless Broadcom and Apple have agreed to some kind of deal that no one knows about, Broadcom taking over Qualcomm’s board of directors should have no impact on Qualcomm’s dispute with Apple. Moreover, by the time an hypothetical acquisition were to be finalized, the licensing dispute between Qualcomm and Apple would have likely run its course anyway.

Lastly, given Broadcom’s aggressive cost-cutting business practices, it is likely that the future of Qualcomm as an R&D powerhouse for the tech industry would be jeopardized by such an acquisition, which means that a Broadcom-controlled Qualcomm’s ability to generate revenue from long R&D bets is likely to find itself compromised in the future.

A question that keeps popping up in my discussions with fellow analysts is this: Why is Broadcom in such a hurry to pressure Qualcomm shareholders to rush through decisions about a transaction that isn’t only a year away but also fraught with financial, regulatory, and even redomiciling uncertainty?

Conclusion: Where does that leave us?

Qualcomm’s next shereholder meeting is scheduled for March 6, 2018. That’s the obvious save-the-date milestone for Broadcom’s next acquisition attempt. I imagine that between now and then, Broadcom is likely increase its original offer of $70 per share to something a little more palatable to shareholders. It’s difficult to gauge what Broadcom’s next offer would need to look like in order to make shareholders even consider it, but my guess is that it will need to be at least $95 per share. Even that figure seems short-sighted, given not only Qualcomm’s new growth trajectory, but the extent to which Broadcom might ultimately fail to properly capitalize on the commercialization of 5G.

The gamble here doesn’t seem to have much of an upside for anyone outside of Broadcom, and perhaps Apple. No matter how many ways I look at this, Broadcom acquiring Qualcomm now, in the final stretch just before the start of the commercialization of 5G, would seriously shortchange Qualcomm shareholders, to say nothing of the potential havoc such an acquisition could wreak on the tech industry.

From a purely Machiavellian perspective though, I can’t help but appreciate what Broadcom is trying to pull off: Swooping in with an unsolicited low-ball bid just a few short months after Apple decides to stop paying Qualcomm for the use of its IP? Brilliant timing. And managing to do so just in time to hopefully reap the benefits of the impending commercialization of 5G without incurring the years of costs and risk that Qualcomm took on to get here? Genius. You kind of have to admire the boldness and timing of it. The problem though, at least for me, is that no matter how clever and opportunistic it all is, it would still be a lousy, short-sighted, and ultimately toxic deal.

 

 

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