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Stock Analyst Update

Broadcom Makes a Shrewd Deal to Acquire Brocade

We’re raising our fair value estimate for Broadcom following the firm’s move into the fibre channel storage business.

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We applaud  Broadcom’s (AVGO) acquisition of  Brocade (BRCD) for $5.9 billion or $12.75 per share, as we've viewed Brocade’s fibre channel, or FC, storage business as an undervalued asset. We were initially surprised that Broadcom would venture into moving further up the value chain into FC storage equipment, but we also see the strategic alignment, given Broadcom's expertise in other storage products. We're further encouraged that Broadcom will spin off Brocade's IP networking business, in order to avoid potential conflict with Broadcom's networking chip customers such as Cisco, Arista, and others. Based on the announcement, as well as Broadcom's revised revenue guidance to the high end of its prior range for its fiscal fourth quarter, we will be raising our fair value estimate to $176 per share from $165 and maintain our narrow-moat rating for the firm. We think there is a high likelihood that the deal would receive regulatory approval. However, we also see a chance that another bidder could emerge for Brocade.

Broadcom expects the deal to be accretive to adjusted gross margins and operating margins. Brocade’s FC storage area network, or SAN, business is highly profitable as the legacy connectivity standard of choice in enterprise storage systems. Although this business is in secular decline, we calculate that Broadcom is paying less than 7 times adjusted EBITDA for a business that won’t go away anytime soon. Brocade in total was running at high 60% adjusted gross margins and mid-20% operating margins prior to its acquisition of Ruckus Wireless. However, under Broadcom, the firm expects to run the FC SAN business at 77% gross margins and 58% adjusted operating margins as it strips out Brocade’s lower-margin IP networking business and also likely extracts other cost synergies out of FC SAN. In turn, Brocade is expected to deliver $900 million of adjusted EBITDA to Broadcom, which we view as an achievable target.

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Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.