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Here’s How Broadcom Stock Fell Back into Favor with Investors

James Brumley

It would be an understatement to say Broadcom (NASDAQ:AVGO) shareholders were less than thrilled with the July 11, post-close announcement that the company would be acquiring business software outfit CA (NASDAQ:CA). They were outright worried. The evidence? The fact that Broadcom stock plunged nearly 14% on July 12.

Investors simply didn’t see how the hardware giant would fare better with exposure to the software market.

Those investors had a chance and reason to rethink things late last week though. And they did. Along with a commendable fiscal Q3 report, the chipmaker further explained its rationale for the CA deal, sending Broadcom stock higher by nearly 8% and kick-starting an uptrend that’s not yet slowed down.

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Truth be told though, we don’t know a lot more about the impending pairing than we did before. On the other hand, we don’t really have to know more to like Broadcom stock.

Paradigm Shift

For the quarter ending in July, Broadcom’s top line grew more than 13% year-over-year to $5.1 billion, just edging out revenue estimates. Earnings of $4.98 per share of Broadcom stock, however, decidedly beat estimates of $4.83, up more than 21% from the year-earlier bottom line.

Data center revenue has become the big growth engine for Broadcom, though the acquisition of Brocade late last year gave that arm a bit of a bonus push.

The very fact that the term ‘data center’ is front and center of the Broadcom discussion is not only unfamiliar to long-term owners of Broadcom stock, it’s the crux of the case for purchasing CA.

Broadcom is (or was, anyway) best known as a maker of networking and connectivity components, particularly for wirelessly connected mobile devices. Apple (NASDAQ:AAPL), for instance, has historically utilized several pieces of Broadcom’s tech in most iterations of its iPhones.

The advent of cloud computing and the normalization of software as an alternative to hardware, however, has blurred lines for all companies. New uses and applications of technology, code as well as hardware, has allowed organizations to develop all sorts of efficient and effective solutions that were unthinkable just a few years ago.

Enter CA.

Sometimes called CA Technologies but previously known as Computer Associates International, CA CA caters to the business market, developing mainframe systems that (among other things) lend themselves to the development of apps.

It’s a far cry from the hardware world where Broadcom stock owners expected the company to focus its future. CA CEO Mike Gregoire explained of the acquisition in July, “This combination aligns our expertise in software with Broadcom’s leadership in the semiconductor industry,” but the message fell on deaf ears.

Those ears weren’t deaf to the buying company’s follow-up explanation last week.

Broadcom Gets Another Look

Perhaps the market just needed to hear a little more on the matter from someone else. Namely, investors may have been waiting on to Broadcom CEO Hock Tan to explain last week:

“Through CA, we believe we have a big doorway to engage strategically with these customers and provide them direct access at very compelling economics to the same leading-edge networking, storage, and computer technology that are used to enable the cloud service providers today.”

Then in response to an analyst’s question during the earnings call, Tan went on to say “Some of the big operators now are starting to… build their own data centers. And some of them have come to us and asked us to enable that.”

And with that simple acknowledgement, everything changed for the better.

Intellectually honest investors who read, critically, Tan’s statement for a second time will realize he didn’t actually tell investors anything they couldn’t have deduced for themselves. In fact, the direction described is not only an obvious one for a CA/Broadcom merger, it was the only path the combined duo could have feasibly taken.

Investors just needed to hear in the right context.

Looking Ahead for Broadcom Stock

It’s still too soon for the so-far-incomplete purchase of CA to boost Broadcom’s top and bottom lines, but it’s coming. A July presentation explaining the rationale for the deal suggested the company’s EBITDA margins will rise from 48% to 55% with CA under the Broadcom umbrella. Baird analyst Tristan Gerra expects the deal to improve the company’s per-share profits by 20%.

The market may not have believed it before. With some time to take a step back and realize hardware is better when developed with software in mind and vice-versa, however, investors have good reason to wonder if they’ve underestimated this company’s potential. The forward-looking P/E of 11.6 says they have.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.

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