Analysis on Broadcom's acquisition of Brocade: Optical fiber communication market will usher in a new pattern

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Broadcom will use Brocade's Fibre Channel switches to complete its storage networking business and will sell the latter's Ethernet business for an estimated $1 billion to $2 billion...

Broadcom CEO Hock Tan is once again using his semiconductor executive's private-equity acquisition skills to build a splashy new company -- his planned $5.9 billion purchase of networking equipment maker Brocade is likely to inspire more similar deals that break down the lines between semiconductor suppliers and system makers, extend the life of the mature Fibre Channel market, raise its prices and turn around the Ethernet market.

According to the agreement between the two parties, Broadcom will use Brocade's Fiber Channel switches to make its storage network business more complete, and will sell the latter's Ethernet business for an estimated US$1 billion to US$2 billion; system-level switches are expected to add nearly US$1 billion in annual revenue to Broadcom and will increase its overall profit margin by 5%.

Broadcom has been in the Ethernet and Fibre Channel server card business for some time. The acquisition of Brocade will give Broadcom its first foray into the systems market, complete with services and support. Businesses such as cards, systems and services are attractive because they can bring better profit margins than chips.

Tan said in a conference call with financial analysts that the acquisition would only result in a little competition with original equipment manufacturers such as Cisco. Cisco is the only other large Fibre Channel switch manufacturer in the market and mainly sells its products directly to end users, while Brocade's customers are usually system manufacturers such as Dell and HP Enterprise. According to a Cisco engineer, the company develops its own Fibre Channel chips, but also sells a small amount to system manufacturers.

"We consider our original equipment manufacturers customers to be strategic partners, and we do not want to compete with them." In addition, Tan said in the conference call that he will work with Brocade to immediately start the process of selling its Ethernet business unit.

Although Brocade and Cisco both sell Fibre Channel switches to value-added resellers, Alan Weckel, vice president of market research firm Dell'Oro Group, said there is little overlap between the two markets. There aren't many new users in the market, and existing users are usually loyal customers of either Cisco or Brocade, and these two vendors account for most of the market share. Weckel said: "It's not like Broadcom is going to attack Cisco's foundation-this is not the way the Fibre Channel market has behaved since 2008." The bad news for Fibre Channel users is that Broadcom may find innovative ways to package existing optical communication modules, server boards and new generation switches together to increase prices, just as Avago did when it acquired network card maker Emulex for $606 million last year.

Other suppliers that will face pressure from Broadcom's acquisition of Brocade include Cavium, which acquired QLogic's storage networking business but lacks Fibre Channel switch products, and smaller Atto Technologies. Brocade's Fibre Channel switches will add a system product line to Broadcom's storage chips and boards (Source: Broadcom)

Is a new wave of mergers coming soon?

Weckel said that according to Dell'Oro's estimates, Fibre Channel unit sales will peak at 12 million ports this year and then decline 5-10% a year later, but prices will rise slightly, so that the overall market size will remain flat and the gross profit margin will be slightly higher than the typical performance of Broadcom's chip business.

Tan pointed out that in the next five years, when users upgrade from the current 16 Gbit/second Fibre Channel to the 32G version, prices may also rise; the T11 standards organization is defining specifications for single-channel 64G speed and quad-channel 256G speed, and single-channel 128G and 256G specifications are also in the plan blueprint.

Dell'Oro expects the Fibre Channel market to be worth $10 billion, with peak shipments of around 12.5 million ports per year (Source: FCIA)

Weckel also pointed out that several companies would be interested in acquiring Brocade's Ethernet business, mainly focusing on the company's business with the U.S. government and the campus Wi-Fi equipment business acquired through the acquisition of Ruckus; potential buyers include Dell, Juniper, Extreme Networks, and a private equity firm interested in further transforming the business.

And Weckel said that if Brocade's Ethernet business is acquired, the buyer will obviously become the third largest supplier of wired and wireless Ethernet systems after Cisco and HP, changing the balance of the market and possibly triggering other changes.

The Brocade acquisition is the latest in a string of bold moves by Tan, who completed the $37 billion merger of Avago and Broadcom in March and announced $300 million in cost savings.

The acquisition of Brocade also fills a missing piece in Broadcom's (Avago) recent M&A activities in the storage product business. Avago acquired LSI for $6.6 billion in 2013, retaining most of the latter's storage business, but sold its flash memory division to Seagate in June 2014, and two months later (August 2014) sold a communications SoC business group to Intel, with a total sales amount of approximately $1.1 billion.

During the period of the above transactions, Avago also acquired PCI Express switch and bridge manufacturer PLX for US$309 million (June 2014); six months later (February 2015), Avago acquired network communication chip manufacturer Emulex. Ironically, its acquisition price was much lower than the price that Broadcom had previously bid for the same company in 2009.

Tan said his boldest move so far, the integration of Avago and Broadcom, was progressing "better than planned," making it very easy for the management team to acquire Brocade; he also did not rule out more acquisitions in the future: "We are not at a point where we can say we are done yet, and there are still many opportunities in this market segment.

Weckel said Tan is "very, very good at acquisitions and has an almost perfect, essentially private equity-style, record."

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