Fitch Affirms Avago Technologies Ratings at 'BBB-' on Acquisition of Brocade; Outlook Stable

CHICAGO--()--Fitch Ratings has affirmed the ratings for Broadcom Limited's (Broadcom) wholly-owned subsidiary, Avago Technologies Cayman Finance Limited (Avago Technologies) at 'BBB-' on news Broadcom will buy Brocade Communications Systems, Inc. (Brocade). The Rating Outlook is Stable. Fitch's actions affect as much as $14.2 billion of total debt (pro forma for the transaction, as much as $20.1 billion if Broadcom funds the deal entirely with debt), including the undrawn $500 million revolving credit facility (RCF). A full list of ratings follows at the end of this release.

Brocade is the market leader in fibre channel storage area network (FC SAN) switching and internet protocol (IP) networking. Broadcom will retain the FC SAN switching business and divest the IP networking business, including assets from Brocade's recent acquisition of Ruckus Wireless. Fitch believes the acquisition of Brocade strengthens Broadcom's enterprise storage portfolio by connecting its leading positions in fibre channel integrated circuits (IC) and fibre channel host bus adapters (HBA), providing opportunities for increased penetration from significant customer overlap.

Brocade's FC SAN business adds $1.4 billion of highly profitable annual revenue. Despite mid-single digit negative growth for the FC SAN switching market from workload migration to the public cloud, higher average selling prices (ASP) from storage upgrades to support customers' mission-critical data will offset lower unit demand. More fully integrated component platforms also should drive increased customer penetration for Broadcom. As a result, Fitch expects at least low-single digit organic growth for Broadcom through the intermediate-term.

Brocade should be immediately accretive to Broadcom's profitability, given Brocade's more than 70% gross profit margins, versus Fitch's estimate of gross profit margins (adjusted for the impact of purchase price accounting, restructuring and stock-based compensation) in the mid-50s for Broadcom. Fitch expects Broadcom's profitability will continue expanding from incremental cost savings from ongoing acquisition-related restructuring. Brocade could add as much as $900 million of operating EBITDA (upon divestiture of the IP networking business), resulting in a Fitch estimated $7.6 billion of combined operating EBITDA at closing.

Fitch expects Broadcom will remain on track to achieve its long-term total leverage (total debt to operating EBITDA) target of 2x, despite incremental debt to fund the Brocade and potentially additional acquisitions. Fitch expects significant annual free cash flow (FCF) and mandatory amortization and cash flow sweeps related to the term loans could reduce debt to below $18 billion, resulting in a Fitch estimated total leverage of 2.4x, pro forma for the acquisition (assuming the deal is 100% debt-funded) in the second half of fiscal 2017.

KEY RATING DRIVERS

Solid FCF Profile: The acquisition strengthens Broadcom's FCF profile, and Fitch expects $3 billion to $4 billion of annual FCF through the intermediate term. Solid profitability should strengthen from up to $750 million of run rate cost synergies 18 months following the acquisition's close and from the company's fab-light manufacturing model.

End Market Diversification: Fitch expects increased revenue diversification away from wireless will reduce longer-term operating volatility. Fitch expects Broadcom will continue to benefit from technology leadership in the Bulk Acoustic Airwave market for smart phones with its premium FBAR filter. However, increased sales from longer-cycle products, including broadband and set-top boxes will reduce volatility associated with handset product cycles or model ramps, although Broadcom also continues diversifying wireless customers as well. As a result of the Brocade acquisition, enterprise storage revenue will increase to more than 20% of total revenue from mid-teens currently, modestly diversifying significant wired infrastructure and wireless communications exposure.

Acquisition Risk: Fitch expects Broadcom will remain acquisitive through the intermediate-term, potentially delaying debt reduction and increasing integration risks. However, fewer large targets within the semiconductor space exist after the latest wave of industry consolidation. In addition, Broadcom's growing scale and ability to potentially fund smaller deals with FCF partially mitigate Fitch's concerns around integration risk.

Strong Market Positions: Fitch expects Broadcom's #1 market positions in FBAR filters for handsets, and wired infrastructure markets, including ethernet switching, fibre optic components and set-top boxes, will drive less volatile operating results. With the Brocade acquisition, Broadcom also gains the leading and most comprehensive platform of components for enterprise storage.

Debt Reduction Focus: Fitch expects Broadcom will remain focused on debt reduction, in the absence of significant acquisition activity. The company repaid $1.3 billion of term loans during the fiscal quarter ended July 31, 2016 with a combination of FCF and $630 million of net proceeds from the completion of previously announced divestitures. Fitch anticipates Broadcom will use net proceeds from the divestiture of Brocade's IP networking business for debt reduction, in addition to a percentage of FCF over the intermediate-term and until total leverage of below 2x.

Credible Cost Reduction Roadmap: Fitch expects Broadcom will drive profit margin expansion with top line growth but also lower fixed costs from acquisition related cost synergies. Fitch expects operating EBITDA margins in the mid-30s to low-40s through a normalized semiconductor cycle, driven in part by up to $750 million of annual cost savings associated with the acquisition of legacy Broadcom, which the company expects to achieve on a run rate basis 18 months following the acquisition's close. Fitch expects more modest cost synergies for the Brocade deal, particularly given the more complementary nature of Brocade's product offerings.

KEY ASSUMPTIONS

--Broadcom continues more than low-digit organic revenue growth through the intermediate-term, driven by broad-based demand across its franchises.

--Broadcom closes the Brocade acquisition and enters into an agreement to divest the IP Switching and associated Services business during fiscal 2017 and both close at the end of fiscal 2017.

--Brocade's revenue growth is flat with higher ASPs from product upgrades offsetting lower unit volume from workload migration.

--Broadcom continues using annual FCF for debt reduction, resulting in total leverage below 2.5x in fiscal 2018.

--Fitch expects operating EBITDA margin in the low 40x, with ongoing benefits from acquisition related restructuring offset by modestly net dilutive profit margins from future acquisitions.

--Fitch assumes 10% annual dividend growth and no meaningful share repurchases beyond offsetting dilution over the intermediate-term.

--Annual FCF (includes dividends) of $3 billion to $4 billion through the intermediate-term with potential upside from acquisitions.

RATING SENSITIVITIES

Positive rating action could occur if:

--Broadcom replaces its secured debt with an unsecured capital structure more consistent with an investment grade rating and Fitch believes the company will manage debt levels to maintain total leverage below 2.5x; and

--Fitch expects Broadcom will sustain operating EBITDA margins in the high 30s to low 40s through a normalized semiconductor cycle, resulting in annual FCF structurally above $3 billion.

Negative rating actions could occur if:

--Fitch expects total leverage to remain above 3x from serial debt financed acquisitions or the initiation of more aggressive shareholder returns prior to anticipated debt reduction; or

--Material share losses resulting in negative revenue growth and lower operating EBITDA margin sustained below 30%, resulting in annual FCF insufficient to achieve targeted debt reduction.

LIQUIDITY

Fitch believes Broadcom's liquidity was solid at July 31, 2016 and supported by:

--$2 billion of cash and cash equivalents, all of which was readily available given the company's offshore incorporation; and

--An undrawn $500 million senior secured revolving credit facility expiring Feb. 1, 2021.

Fitch's expectation for annual FCF for $3 billion to $4 billion in the intermediate term also supports liquidity.

Total debt was $13.9 billion ($13.7 billion less unaccreted and unamortized debt issuance costs associated with the term loans) at July 31, 2016 and consisted primarily of:

--$4.7 billion of Senior Secured Term Loan A due Feb. 1, 2021;

--$9.1 billion of Senior Secured Term Loan B-1 due Feb. 1, 2023; and

--$139 million of legacy Broadcom senior unsecured notes with various maturities.

Broadcom announced it entered into a definitive agreement to acquire Brocade in an all cash deal for $5.9 billion ($12.75 per share), including $400 million of Brocade's existing net debt. Broadcom will finance the deal with a mix of new debt and available cash. The company expects the deal will close in the second half of fiscal 2017 (ending Oct. 31, 2017), pending approval by Brocade's shareholders and subject to certain regulatory approvals and customary closing conditions.

In connection with the acquisition, Broadcom will seek to divest Brocade's internet protocol (IP) switching and related services businesses, which Fitch estimates represents roughly a third of Brocade's $2.3 billion of total revenue for the latest 12 months (LTM) ended July 30, 2016. The IP networking business is growing in the low single digits on an organic basis with Fitch estimated gross profit margins of roughly 50%.

The IP switching business does not fit with Broadcom's high value components strategy and, otherwise, would result in Broadcom competing with its systems provider customers. Fitch believes net proceeds for the divestiture could be in the $1.2 to $1.4 billion range based upon an assumed 2x revenue multiple, which Fitch believes Broadcom would use for acquisitions or debt reduction.

FULL LIST OF RATING ACTIONS

Avago Technologies Cayman Finance Limited:

--Long-Term Issuer-Default Rating (IDR) 'BBB-';

--Senior Secured Revolving Credit Facility (RCF) 'BBB';

--Senior Secured Term Loan A 'BBB';

--Senior Secured Term Loan B-1 'BBB';

--Senior Secured Term Loan B-3 'BBB'.

Date of Relevant Rating Committee: Nov. 3, 2016

Summary of Financial Statement Adjustments - Fitch made no financial statement adjustments that depart materially from those contained in the published financial statements of Broadcom Limited.

Additional information is available on www.fitchratings.com.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

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Senior Director
70 West Madison Street
Chicago, IL 60602
+1-312-368-3210
or
Secondary Analyst
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+1-312-368-3177
or
Committee Chairperson
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or
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Contacts

Fitch Ratings
Primary Analyst
Jason Pompeii
Senior Director
70 West Madison Street
Chicago, IL 60602
+1-312-368-3210
or
Secondary Analyst
David Peterson
Senior Director
+1-312-368-3177
or
Committee Chairperson
John C. Culver
Senior Director
+1-312-368-3216
or
Media Relations
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com