Broadcom Inc. AVGO recently entered into a definitive agreement to acquire CA, Inc CA for $18.9 billion in cash. The chipmaker intends to enhance its long-term margins with the buyout of CA, a leading IT management software provider. The buyout is subject to CA shareholder nod and other customary regulatory approvals from Japan, European Union and the United States.

Broadcom’s move of shifting headquarters to San Jose, CA from Singapore, will aid it to pursue the acquisition of Islandia, NY-based CA. The base-shift is anticipated to make the regulatory environment less complicated for Broadcom. Moreover, the company can reap the benefits of cost reduction as well as lessened competition. However, the Qualcomm QCOM deal still hasn’t materialized despite re-domiciliation. The issue remains a concern even for the ongoing CA agreement.

Nevertheless, after fulfilling the regulatory approvals, Broadcom expects the deal to close in fourth quarter of 2018. Following the buyout, chipmaker anticipates the buyout to boost long-term adjusted EBITDA margins by more than 55%. The company envisionsthe acquisition to be immediately accretive, enabling it to continue earnings in double digit CAGR.

Moreover, on a combined basis, the company expects non-GAAP revenues to be roughly $23.9 billion in the last 12 months and adjusted EBITDA to be approximately $11.6 billion

Following the news, Broadcom’s shares were down almost 9% in pre-market trade, while that of CA went up approximately 18%. Shares of Broadcom were down owing to high debt level which the company will incur in regard to the acquisition. Moreover, its shares have returned just 0.9% in the past year underperforming the industry’s rally of 1.8%.

How Will Broadcom Pay $18.9 Billion in Cash?

Broadcom will incur a new committed debt to finance $18 billion while the remaining will be paid from cash on hand. Consequently, CA shareholders will obtain $44.50 per share in cash, approximately 19.6% premium over the $37.21 price on Jul 11, 2018 after market close.

Notably, as on May 6, 2018, cash & cash equivalents of Broadcom were $8.2 billion compared with $7.1 billion in the previous quarter. Long-term debt was $17.5 billion at the end of the second quarter, which was flat compared with the preceding quarter level.

What Prompted The Chipmaker to Bid For a Software Company?

The increasing demand of IT management software solutions persuaded Broadcom to pick CA. This out-of-the-box move from the chipmaker took the shareholders, investors and analysts by surprise. Broadcom’s CEO and president Hock Tan said, “This transaction represents an important building block as we create one of the world’s leading infrastructure technology companies.”

CA has been benefiting from higher Mainframe new sales as well as solid demand for its recently launched Trusted Access Manager for Z, a Mainframe solution. The previous buyouts have enhanced the software providers’ IT management, software and services portfolio. Moreover, the depth of its product portfolio and the increased efficiency offered by it has witnessed solid adoption, strengthening its business model.

CA’s substantial customer base will enable Broadcom to explore the infrastructure software market and expand its TAM. The company attempts to expand mission critical technology solutions portfolio on the heels of CA’s mainframe and enterprise software businesses.

Our Take

Considering its business line, we are of the opinion that Broadcom is foraying into unfamiliar territory with this buyout. We remain inquisitive as to how it will integrate CA’s software business with the chipmaker’s methodologies. The move is in contrast with Broadcom’s previous acquisitions and it will be interesting to observe its strategy to capitalize on the potential of growing software business.

However, diversification of end market and customer base bodes well for the long haul. This is anticipated to add resilience to Broadcom’s current business model.

Zacks Rank & Key Pick

Broadcom carriesa Zacks Rank #3 (Hold).

You may consider Mellanox Technologies MLNX, sporting a Zacks Rank #1 (Strong Buy), from the same industry. The company has a long-term EPS growth rate of 15%. You can see the complete list of today’s Zacks #1 Rank stocks here.

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