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The Ratings Game: VMware stock rallies 25% on reports Broadcom is weighing its third software acquisition in four years

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VMware Inc. shares rallied Monday as Wall Street chimed in on reports that Broadcom Ltd. is once again looking for a threepeat when it comes to software acquisitions.

VMware
VMW,
+19.65%

shares surged nearly 22% to an intraday high of $116.46 for a market cap of $49 billion.

Late Sunday, several outlets reported that Broadcom
AVGO,
-4.29%

was in talks to acquire enterprise cloud-computing software company VMware for an undisclosed amount, although analysts on Monday were estimating the deal at around $50 billion.

While Broadcom shares fell as much as 5% Monday, speculation about the deal is being better received than previous ones, like when the company said it was acquiring Symantec’s enterprise security business in 2019, or CA Inc. back in 2018. The pursuit of VMware also follows Broadcom’s talks to buy software company SAS Institute Inc., which fell apart last summer.

KeyBanc Capital Markets analyst Thomas Blakey, who has an overweight rating and a $150 price target on VMware, touched upon Broadcom’s “long track record of diversifying its business model away from semiconductors toward software.”

“Broadcom has stated publicly over the years it’s interested in becoming an enterprise infrastructure provider, including software, where we believe VMware would be a strong fit in line with this longstanding strategy,” Blakey said.

Last year, Dell Technologies Inc. 
DELL,
+2.67%

finally spun off its majority stake in VMware, giving Michael Dell about 40% ownership of VMW shares and private-equity firm Silver Lake about a 10% stake.

If Dell and Silver Lake support the deal, then Blakey said it “should be relatively easy to close, barring regulatory approval, which we don’t see as an issue given past infrastructure software transactions at Broadcom.”

While he sees “the probability of another strategic suitor for VMware as unlikely,” Blakey said “a non-strategic competing bid could surface” given VMware’s relatively low valuation.

Read: The end of one-chip wonders: Why Nvidia, Intel and AMD’s valuations have experienced massive upheaval

Stifel analyst Brad Reback, who has a buy rating and a $135 price target on VMware, says he believes the deal “makes sense on many fronts as a Broadcom controlled VMware will likely be much more profitable, less dependent on top-line growth and have less pressure to accelerate its ongoing shift to a SaaS model.”

“We believe the hardest question is to what degree VMware shareholders will get credit for these synergies,” Reback said, adding he expects Dell “to drive a solid deal.”

On the Broadcom side, Evercore ISI analyst C.J. Muse, also said the VMware acquisition “makes sense,” as the deal would give Broadcom a hardware-software revenue mix approaching “almost 50/50.” Last earnings report, software sales made up 24% of Broadcom’s revenue. Muse has an outperform rating and a $700 price target on Broadcom.

“We believe Broadcom has long coveted the asset, but thinking was that Michael Dell was not an obvious seller,” Muse said. “We note that Broadcom does have a very strong relationship with private-equity firm Silver Lake Partners, which could help facilitate any such deal, and we believe the deal would be highly accretive at discussed pricing, particularly given room for meaningful synergies when considering a more bloated cost structure for VMware (~35% EBITDA margins) vs. Broadcom (60%+ EBITDA margins).”

Citi Research analyst Fatima Boolani, who has a neutral rating and a $130 price target, said the deal presents some over lap when it comes to endpoint cybersecurity, given Symantec’s business on the Broadcom side and Carbon Black’s on the VMware side.

“Net, while this combination could in aggregate prove advantageous for shoring up Broadcom’s overall cybersecurity market positioning, history would suggest this has potential to create distraction, customer attrition, and channel partner alienation that could benefit pure plays in the broader endpoint security market, where nimbler and agile dedicated vendors have shown to benefit from the aftermath of similar transaction outcomes,” Boolani said.

Citi Research analyst Christopher Danley, who has a buy rating and a $666 price target on Broadcom, said the deal would put pressure on Broadcom shares given VMware’s lower margins.

“While we believe Broadcom could be able to increase VMWare operating margins given company management’s stellar track record of raising margins of acquired companies, Broadcom has not acquired a company with operating margins roughly 30% below company average.”

Even with Monday’s stock moves, VMware shares are still 29% off their levels from 12 months ago, while Broadcom shares are 15% higher. In comparison, the S&P 500 index
SPX,
+1.74%

is down 5%, while the tech-heavy Nasdaq Composite Index
COMP,
+1.32%

is off 15%.

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