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Orcs march on Qualcomm – Are there dark powers behind them?

From the point of view of Faultline Online reporter coverage – i.e. video delivery – the potential takeover by Broadcom of Qualcomm, in a $100 billion plus bid announced this week, seems relatively unimportant.

On the one hand Broadcom is dominant in both WiFi and set top chips, as well as strong in full band capture, and these are, for the most part, alongside important future broadband delivery technologies such as G.fast, as the chip areas which define video performance globally. 5G may yet become one such technology, but Broadcom has no presence here.

There are a few other areas – Smart TV chips, which MediaTek’s MStar dominates; CCAP components where companies like MaxLinear have a good showing, and to a lesser extent broadcast specific components such as ATSC 3.0 chips. But is that truly where the industry continues to be headed?

We would suggest that most video chips will shrink in complexity as the cloud becomes more important, and that workflow, video editing, encoding and playout, as well as ABR packaging, CDNs and analytics – all shift from hardware to software. So the Broadcom hegemony of video chips could be all but over. Marvell is better placed for the smaller future set top boxes that run Android or which are simply media adapters, than say Broadcom.

Qualcomm is historically strongest in cellular chips, both baseband and application processors, and retains a continued lead over Samsung and MediaTek here – just. Of course Qualcomm is a maverick with its double dipping IP charges, but these have been tried and tested in US courts and these habits will likely survive the challenge from Apple. Just because Apple does not like a law, does not mean that anyone can change it. And whatever Donald Trump thinks, you cannot have the US Trade Commission blessing a practice (IPR double dipping) in one era and casting it aside when one of its favorites sons (Apple) requests it. It has a duty to be consistent.

It is one thing as an analyst to know that Qualcomm will surmount the Apple challenge or at the very least, meet Apple half way, and quite another if you are an investor, having witnessed the fall from grace that the Qualcomm profit performance has been through these past 3 years, and fear the way vultures are circling. There are no doubt many who will be content to take the Broadcom $70 offer and run. But will there be enough?

Qualcomm for its part has the remnants of Atheros, plus its own WiFi expertise in handsets, strength in Bluetooth chips, and devices which are perfectly capable of harnessing HEVC in a 4K environment and Snapdragon – all chips which might have some say in how video is delivered or processed both in the network and certainly on the handset. It has viable set top and smart TV chips which can adequately run Android. In other worlds, Qualcomm is not dominant in many of the areas which touch video, but it has competitive capability against Broadcom.

But the crux of the matter is the influence that 5G will have on future chip markets and the way that Qualcomm dominates those markets today. Investors seem unable to see this clearly. Perhaps investors are right and Qualcomm won’t dominate in 5G the way it has in LTE, but we think it is highly likely. This alone will force Apple to run back into its open arms and bury the hatchet, if not this year, then next. All investors have to do is wait and the heady days of Qualcomm may come back. And with that the share price would go way up past $70 and continue to rise. We probably agree that there is a genuine value on the innovative nature of Qualcomm culture versus what has become a cost timid, percentage play at Broadcom.

Combine Broadcom with Qualcomm and it will never speculatively enter a new chip space again. Instead it will opportunistically acquire new skills, in much the same way that it is opportunistically trying to acquire Qualcomm at a time when its revenue and profits are arbitrarily depressed.

There is nothing, in principle, against running a chip firm like Cisco has been run this last 20 years – where M&A replaces the R&D department. The alternative is that the maverick that is Qualcomm, rarely loved, sometimes feared, but innovative as hell, and a home for the best silicon engineers on the planet, which continues to be slightly unpredictable and surly around the market. It is Marmite, you either love it or you can’t stand it.

This is simply an innovative culture versus a capital returns culture. Ask any ex-employee of Broadcom if the place has gone to the dogs since the new management took over and you will hear a unanimous “yes.” But ask any investor if they like the rise from a valuation of $55 billion when the merger with Avago was complete to the $116.7 billion it is today, and they will tell you they love this business.

But the truth lies somewhere in-between. Innovators attract one type of investor and do well in early markets, acquirers do better in later markets, tidying up inefficiencies that have been inherited.

Here is something to consider – Broadcom in our view will likely become cumbersome and unable to react. It will certainly sell off any overlaps parts of Qualcomm (think Atheros and Cambridge Silicon Radio), and anything that does not bring in a large enough margin. The result will be ejecting hundreds, if not 1,000s of silicon engineers onto the market, an outcome that will result in many of them taking the VC shilling, and going back in to compete with Broadcom.

The merger will drop the Qualcomm element from being genuinely a leader in 5G, to a mere part player. That will drive down its share price eventually, but automatically. Investors should ponder that before remaining in the chip sector.

The question now to ask is whether existing Qualcomm investors will fall for the Broadcom logic and the rise in the Qualcomm share price overnight suggests some will, but the fact that the share price has risen nowhere near the offer price suggests that either there are recalcitrant shareholders who do not believe in the Broadcom approach, or that they are at least holding out for a higher offer.

At Faultline, we suspect that there will be no higher offer forthcoming, unless there are shadows operating behind this deal. The chain of events is likely to be that the Qualcomm board will consider the offer and reject it. But this is not the board which created Qualcomm, as it has been infiltrated by outsiders who have transformed it – negatively in our view – into a less aggressive, less exciting company. It may endorse the deal, but it could only do so after asking for a higher price. This offer certainly undervalues it, almost as much as the current share price overvalues Broadcom, which has a massive multiple as of now that seems bizarre.

The initial offer talks of Bank of America Merrill Lynch, Citi, Deutsche Bank, J.P. Morgan and Morgan Stanley who are advising Broadcom, saying they can arrange the necessary debt financing. That shows how opportunistic this offer is – there is no source, as of yet, arranged for the debt funding, which is $60 of the price to be paid, just some reassurances that it can be done.

Only Silver Lake Partners, which has served as a strategic partner to Broadcom in prior transactions, has provided Broadcom with a commitment letter for $5 billion of convertible debt.

So why are the others so confident that the money can be raised. Is there perhaps another shadowy figure behind such a deal, someone like Apple, for instance, telling those bankers that it would take on much of the debt through its own cash mountain. Would that even be legal?

We think it would need a “settlement in principle” with Apple to allow this deal to go any higher, so that at the very least Broadcom may have had initial discussions with Apple about the terms under which Apple might settle litigation with Qualcomm, if acquired, and continue to use its chips. Something like that would give Broadcom the confidence to make this offer in the first place. Perhaps Apple may have even put them up to it.

We are not saying we know that this is the case, only that, if legal, it would be highly likely that such re-assuring conversations had taken place. However if such a conversation had ever taken place and it came to light, a lot of angry shareholders and some anti-trust officials from the Justice Department, would all be seeking brutal conversations with Apple’s CEO.

But such a solution might solve the Apple issue about margins overnight, although not permanently. Apple has had declining margins since it launched its first iPhone, and it sees Qualcomm as the best chip maker, but the one which charges it the most. If it gets a privileged deal from Qualcomm, either by becoming friends with its new owner, or by bullying Qualcomm directly, then a similar advantageous deal could soon be in place with other handset vendors, bringing margin pressure back on Apple. In other words all that Apple will ever get from its current annoyance with Qualcomm is “temporary” market relief, at best.

We have to remember that many US pension funds and the like cannot even invest in Avago-Broadcom, because it is resident outside of the US. Which is why it has overnight redomiciled in the US, a purely paper exercise, which does affect taxation, putting the US “powers that be” onside.

Intel got into cellular chips by acquiring an arm of Infineon, after two failed attempts to build its way in. Now Broadcom, after multiple similar failed attempts is hoping to go the same route straight to market leader at a time when margin pressures are being applied to smartphones for the first time. Our instincts say that enough investors will see this coming and break the bank by asking for far more cash. But if Apple resuming chip purchases from Qualcomm is any part of the background to such a deal, Broadcom could comfortably afford to go higher.

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