Should Oracle or Alphabet buy VMware instead of Broadcom?

As expected, the Broadcom-VMware deal is a go. The chip giant intends to snap up the virtualization software company for $61 billion in cash and stock, along with taking on $8 billion in VMware debt.

It’s not an inexpensive transaction, but thanks to a “go-shop” provision that gives VMware 40 days to “solicit, receive, evaluate and potentially enter negotiations with parties that offer alternative proposals,” there’s market speculation that another bidder could enter the fray.

After chewing through analyst notes on the deal, Ron and Alex wound up on opposite sides regarding whether a higher price or another bidder would make sense. Ron’s view is that the company’s value is higher than its recent financial results may imply, while Alex feels the company is not sufficiently performative to deserve a higher price.

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We’ve long speculated who might buy VMware, and after Dell spun out the company, TechCrunch listed Amazon, Alphabet, Oracle, Microsoft and IBM as potential acquirers. The fact that we did not foresee Broadcom as a potential suitor underscores our view that we don’t fully grok if it’s the correct buyer for VMware.

So let’s talk about the pros and cons of the matter, ask what VMware is worth, and how it may have value over and above its recent quarterly results. Ron is taking point!

Ron’s take:

With $61 billion on the table, it’s hard to imagine anyone paying more, and research firm Bernstein agrees with the perspective. Before we put the idea to bed, though, it’s worth taking a moment to think about the value of VMware.

VMware’s value goes beyond what its balance sheet or its profit and loss statement tells us at the moment. While the company might not have had a perfect first quarter, it has a particular set of skills that could fit nicely with any of the big cloud infrastructure providers.

In fact, cloud infrastructure-as-a-service exists today only because the early crew at VMware figured out virtualization at scale in the early 2000s. Until then, people used servers, and if a server was underutilized, well, too bad. Virtualization lets you divide a computer into multiple virtual machines, paving the way for cloud computing as we know it today.

While cloud computing has changed some since its early days, virtualization remains a core tenet of the market. Imagine for a moment if one of the three or four cloud vendors — think Amazon, Microsoft, Google or even IBM (although this deal is a bit rich for its blood) — brought VMware into its fold.

VMware brings more to the table than virtualization, of course. Over the years, it has gained various capabilities by acquiring companies like Heptio, a containerization startup launched by Craig McLuckie and Joe Beda, two of the people who helped create Kubernetes.

The company also paid $2.7 billion for Pivotal, which helps enterprises move to modern computing approaches like the cloud, containerization and micro services. VMware has also bought security companies like Carbon Black and AirWatch.

Gartner analyst Andrew Lerner says it well: “VMware has strong financials, a large and loyal installed base, and a diverse product portfolio. They have a huge installed base (500,000+) of enterprise customers using their products within their data centers. Thus, they’re deeply embedded and ‘sticky’ to customers.”

When you add all these factors together, you’re getting a lot for your money, in addition to the reputation VMware has with IT professionals. That would fit nicely into any of the companies above — and you could probably add Oracle to that list.

Much like IBM’s purchase of Red Hat, betting on VMware has high stakes, but the diversification and the prestige it brings would make it a welcome addition. However, not all are prepared to pay that kind of money right now, no matter how prestigious it may be to own VMware.

Microsoft just spent $61 billion on Activision Blizzard, Oracle spent $28 billion on Cerner, IBM cashed out $34 billion for Red Hat and Amazon doesn’t usually spend that kind of money on acquisitions. What’s more, as the market leader, Amazon doesn’t have to do something bold.

That would leave Google, which does, in fact, need to do something bold. While its public cloud performance has certainly improved under the leadership of Thomas Kurian, buying VMware would give it a lift with the enterprise customers it desperately needs, and it would change how Google is perceived in the market.

With VMware in the fold, as long as Google leaves it independent and lets it operate with any cloud or company, Google Cloud could be transformed into a player to be reckoned with.

Alphabet has $134 billion in cash and equivalents at the moment and can easily afford it. The company is unlikely to make such a move, but if it did, it would get ready entry into the enterprise, making this likely the best $70 billion (or whatever it takes to get it done) it ever spent.

Alex’s take:

From a pure monetary perspective, the core of the Broadcom pitch is not hard to understand. As the companies’ joint release states, the “transaction is expected to add approximately $8.5 billion of pro forma EBITDA from the acquisition within three years post-closing. Pro forma for each company’s fiscal year 2021, software revenue is expected to account for approximately 49% of total Broadcom revenue.”

Simply put, Broadcom expects to rip piles of adjusted profit out of the deal and also shake up its overall revenue mix to be more software forward. Both results would make Broadcom a more attractive company to investors, despite it taking on a bunch of debt: Broadcom said it has received “commitments from a consortium of banks for $32 billion in new, fully committed debt financing.”

How does Broadcom expect to drive so much profit from VMware? Per a deck about the deal, the chipmaker expects recurring revenue growth (high-margin, we presume), “focused” research and development spend (which we expect means staffing cuts) and profits squeezed from cuts to sales and marketing, and general and administrative line items.

Yes, those are the three main categories of operating expenses. Well spotted.

All this is to say that the deal makes some financial sense if you believe there are savings to be found, and that investors will like Broadcom more once it has a greater share of software revenue.

But I ask if the price is reasonable, because if it is, then it’s less likely that another company will jump in and try to snag VMware away. If the price is unreasonably low, then, well, the chances go up.

VMware’s most recent quarterly results were weak at the top-line level, but it got more encouraging when we dug into the numbers. At a high level, revenue rose just 3% to $3.09 billion, which is a number very near to stagnation and makes the overall 5x run-rate multiple that Broadcom is offering for the company feel reasonable.

If you want to take a more bullish angle, you could note that VMware’s subscription and SaaS efforts grew 21% year over year in Q1. Why didn’t that convert to a higher increase in total revenue? Because, per the company, “license revenue was impacted by the transition to subscription and SaaS.”

More simply, VMware is cannibalizing its old work to build its new business. Moving from license revenues to SaaS revenues always involves a period where you trade one kind of revenue for another and can lead to slower aggregate growth for a period.

Does that fact make the offer’s 5x run-rate multiple seem low? From my perspective, no.

“Subscription and SaaS” accounted for 29% of VMware’s revenues in Q1, meaning the company still has to convert most of its revenues. That could limit growth for years, depending on how quickly the exchange occurs.

Limited growth means that SaaS or not, VMware is mostly a cash machine for now. The company kicked off free cash flow of $899 million in the first quarter, and if it continues to do so, it should more than cover the debt payments that the deal engenders for Broadcom. But with net income of only $242 million in Q1 (down 43% from a year earlier), VMware is only bringing so much black ink to the table.

Gut-checking the numbers against the market gives me the material sense that Broadcom is not underpaying for the smaller company. Broadcom says the price “represents a 44% premium to the closing price of VMware” before news of the deal broke. So, for price reasons, I don’t see another suitor flying in to snag a potentially cheap purchase.

If another company could benefit more from buying VMware, then it could perhaps warrant a higher price. But the value of software revenues is down from recent highs, even for quickly growing, all-recurring-revenue companies. VMware is no such concern. So while I echo Ron by saying I cannot quite see the real value of the two companies tying up, I do expect the deal to close.