Will clouds of consolidation rain on the semiconductor industry’s parade of innovation?
This past November Broadcom Limited submitted an unsolicited bid for rival semiconductor supplier Qualcomm in what would be the largest acquisition in semiconductor industry history. Broadcom offered to acquire Qualcomm for $70.00 per share, a 28% premium on top of the share price prior to the news of the offer, according to Broadcom. Qualcomm declined the offer and is making its own case for maintaining its independence. It cites insurmountable regulatory challenges standing in the way of a combined entity as well as many other benefits of remaining on its own, including projected future revenue growth rates of 6-8%, which is higher than Broadcom’s long-term consolidated revenue growth target of 5%. While there are many arguments each company can make for or against the proposed transaction, this article will focus on the potential impact of a Broadcom acquisition of Qualcomm on research and development and product innovation in the semiconductor industry.
Research and Development: The lifeblood of innovation
Broadcom Limited went by Avago Technologies before its acquisition of Broadcom Corp. closed in early 2016. The company is led by a management team that will spend what the company sees as required to maintain their leading market positions in the segments which they’ve chosen to focus. Management has shown a preference for markets where the company holds one of the top market share positions, and which have highly visible and well-known future growth trajectories. Also, Broadcom is well positioned in several markets where there are a few large customers dominating a large part of their respective markets. For example, Broadcom provides products including but not limited to, RF components, WLAN/Bluetooth combo ICs, and GPS ICs to the top three smartphone vendors, Samsung, Apple, and Huawei. According to the IHS Markit Smartphone Electronics Design Intelligence Service, those smartphone vendors accounted for over 46% of all smartphones shipped globally in Q3-2017. Broadcom capitalizes on these opportunities and establishes and maintains solid relationships with these leading companies as its customers. These tight relationships, coupled with its focus on markets with a relatively high degree of longer-term certainty help enable the company to spend less on their research and development activities as a percentage of sales. Below is a graph of R&D expense as a percentage of revenues. It demonstrates that (with the exception of Brocade) Broadcom/Avago has historically spent much less as a percentage of revenue compared to some of the major companies it has acquired going back to the LSI acquisition (in 2014). Combined, Qualcomm and Broadcom spent $8.7 billion on research and development activities during their respective 2017 fiscal years. This figure is larger than IHS Markit’s estimated revenue of the 9th largest semiconductor supplier in 2017. Qualcomm spent $5.5 billion on R&D while Broadcom spent $3.3 billion during their last fiscal year.
In the above graph, there are two Qualcomm measures, one is the R&D spend as a percentage of total revenue (including licensing revenue), and the other does not include licensing. Excluding licensing revenue shows that research and development costs account for about 33% of equipment and services revenue vs. 25% when licensing revenue is included. IHS Markit excluded Qualcomm’s revenue from licensing in one measure above to show a more consistent comparison to some of the other semiconductor companies. While Broadcom does have licensing revenue, it has not been a significant portion of sales as of yet. Broadcom’s licensing revenue is included in the company’s “Industrial and Other” market segment which was a total of $257 million in its last reported fiscal quarter. In comparison, Qualcomm’s licensing revenue during its fiscal fourth quarter of 2017 was over $1.2 billion.
Broadcom’s lower percentage of revenue spent on R&D is in part achieved by divesting the unattractive pieces of the companies that it acquires. From Broadcom’s presentation on the proposed acquisition of Qualcomm, the company called out Qualcomm’s cellular business as well as NXP’s MCU and automotive businesses which are pending acquisition by Qualcomm. This could indicate other parts of Qualcomm and NXP could be candidates for divestitures. For example, after the Broadcom Corp. acquisition closed Broadcom Limited management sold off the IoT centric wireless connectivity business to Cypress semiconductor. The large customer base with relatively small order sizes and a developer community which required support didn’t quite fit Broadcom’s business model. For now, the company has decided to focus wireless connectivity primarily on premium tier smartphones and tablets.
Merger aftermath could have implications on critical R&D during the early innings of 5G
While it’s not certain how a Broadcom buyout would shape Qualcomm’s existing employee base and operations, events following prior acquisitions by Broadcom could provide some insight on the potential impact of a deal. Generally, when major mergers and acquisitions take place some synergies are captured in removing overlapping or duplicate positions and roles, thus trimming the workforce. While these synergistic cuts typically impact support roles such as finance, accounting, and human resources, design and engineering staff aren’t immune from these adjustments either. The uncertainty which occurs between when a deal is announced and a transaction is closed could be enough for some employees to consider making a move voluntarily. The impact of downsizing can affect productivity throughout an organization including its research and development activities. By the time Brocade published its last quarterly report as a standalone company in July of last year, around 1 in 5 employees had been laid-off or voluntarily exited the company since the Broadcom acquisition was announced. Brocade had lost 1,360 employees in less than a year following the announcement of the acquisition.
While Broadcom management is confident that a deal could be closed within 12 months, Qualcomm suggests a deal could take 18 months or longer to gain approval from relevant regulatory bodies across the globe. Broadcom completed the acquisition of Brocade in November after announcing the deal in November of 2016, during this time the process was delayed by regulatory review. Qualcomm is itself in the midst of the acquisition of NXP, a process that began in October 2016 and has yet to finalize. The Broadcom-Qualcomm transaction would arguably be more complex than either of these; therefore a 12-18 month transaction approval window should be expected. This period of uncertainty would occur during the critical early stages of the commercial deployment of 5G wireless technologies, a critical time for Qualcomm to remain focused on its R&D activities in order to lay a foundation for future commercial product and licensing revenue.
Changes to the Qualcomm business model could cripple R&D abilities
The split licensing and chipset technologies model that Qualcomm runs has provided the company with the flexibility to use the high margin licensing (QTL) business to feed the R&D investment or other needs of the QCT (chipset) business as well as develop foundational technologies used in mobile devices including but not limited to 3G and 4G wireless communications. In the past, Qualcomm has been approached by investors such as Jana partners who wanted to officially split the businesses apart. At the time the Jana request was made public, IHS Markit took a position against splitting the business, in part because of the above advantage offered by the combined model.
Qualcomm is working through a variety of regulatory and litigation challenges related to its licensing business, however, the company in its current form could be in a better position to address these challenges as the uncertainty surrounding a combination with Broadcom may dis-incentivize agreements between Qualcomm and other parties.
At the time of this writing, Qualcomm has a market capitalization of over $100 billion and a share price of more than $68. From the standpoint of Broadcom’s management and shareholders, a successful acquisition of Qualcomm would be a boon, even if the offer amount had to be increased. However, if past acquisitions such as Brocade serve as a measuring stick the combined business could produce less benefit to the overall mobile ecosystem than the status quo, and add a level of uncertainty to the market which could strangle innovation in critical segments of the mobile ecosystem such as 5G technologies. Qualcomm has long served as a wireless technology leader by offering 3G and 4G solutions to the marketplace before the market needed it. In doing so, Qualcomm laid the foundation for its success in the run-up to the smartphone age. With 5G around the corner, a Broadcom - Qualcomm combined entity is unlikely to maintain the current R&D spend and pace of innovation. The direct result of which will have dire and lasting ramifications for the entire mobile electronics supply chain.