Fitch: Avago Technologies' Ratings Unaffected by Cash Settlement of $1B Convertible Notes
Pro forma for the conversion payment, Fitch believes liquidity remains solid and does not impact the company's ability to fund a portion of the recently announced Broadcom Corp. (Broadcom) acquisition with available cash, given Avago already received bank commitments to refinance all existing debt at both Avago and Broadcom in connection with the transaction.
Silver Lake Partners, sole holder of \\$1 billion of Avago's 2% convertible senior notes due 2021, exercised the option to convert the notes. Avago will repay the principal amount with available cash and the excess conversion value with ordinary shares.
Fitch believes the Broadcom acquisition will modestly strengthen Avago's operating profile with increased scale and diversification, despite operating profit margin dilution and integration risk associated with the deal.
Fitch believes the combined company will benefit from greater scale, given escalating investment intensity required to maintain technology leadership. Annual revenues more than double to \\$15.1 billion, versus Fitch's prior expectations for \\$6.6 billion of fiscal 2015 sales for Avago on a standalone basis. Combined annual free cash flow (FCF) should exceed \\$1 billion, supporting roughly \\$3 billion of research and development (R&D) and \\$1 billion of capital spending through the cycle.
The acquisition also diversifies revenues, reducing Avago's exposure to short-cycle products, including smart phones, which Fitch estimates currently represent 35% to 40% of total sales. The combination adds Broadcom's market leadership in infrastructure and networking and broadband and connectivity. Pro forma for the combination, the Wired Infrastructure segment should represent roughly 40% of total revenues, Wireless closer to 35%, Enterprise Storage roughly 10% and the remainder from Industrial & Other, which includes licensing.
Fitch expects operating EBITDA margin in the low 30s, pro forma for the transaction, down from the high 30s on a standalone basis. Fitch anticipates less volatile gross margins from increased diversification, although profitability will remain cyclical due to substantial fixed costs in the operating model. Over the intermediate term, Fitch expects \\$750 million of anticipated cost synergies the company expects to achieve within 18 months following the acquisition's close to drive mid-cycle operating EBITDA margin expansion.
Fitch believes there is meaningful integration risk associated with the transaction, given the deal is the largest ever in the semiconductor space. Fitch believes the company will need to bridge differing technology leadership requirements to maintain market share, given little minimal product overlap. Avago's R&D intensity (15% of sales) is lower than that of Broadcom (23%), and the company is targeting lowering combined R&D intensity (20%) to the mid-teens over the longer term, requiring substantial R&D rationalization.
The company has secured \\$15.5 billion of committed bank debt financing and will use \\$6.5 billion to refinance existing debt at both Avago and Broadcom and the remaining \\$9 billion to fund a portion of the transaction. Pro forma for the transaction, Fitch estimates total leverage (total debt to operating EBITDA) of 3.2 times (x), excluding anticipated cost synergies. Fitch expects total leverage will strengthen to below 3x from the company's use of FCF for debt reduction and profitability growth within 18 months following the acquisition's close.
Avago announced it will buy Broadcom for \\$37 billion and will be financed by 140 million of Avago shares and shares equivalents, \\$9 billion of incremental debt and \\$8 billion of available cash from both companies. The deal requires approval by both Avago and Broadcom shareholders, as well as certain regulatory approvals. Avago expects the deal to close in the first calendar quarter of calendar 2016.
Avago's ratings and Outlook reflect Fitch's expectations for solid operating performance from secular demand growth related to the LTE transition, datacentre spending, internet protocol (IP) traffic and connected home/internet of things (IoT). As a result, Fitch anticipates mid-single digit organic revenue growth (on a constant currency basis) through the intermediate term, in addition to inorganic growth from Broadcom and \\$250 million to \\$300 million of annual revenues from Emulex, which Avago closed in the current quarter.
Beyond debt reduction, Fitch expects Avago to remain acquisitive, although the company's capacity for large incremental acquisitions may be limited over at least the near term. Acquisitions primarily have been to diversify end market exposure, including increasing exposure from enterprise storage via the acquisitions of Emulex, PLX Technology and LSI.
KEY RATING DRIVERS
The ratings are supported by Avago's:
--Significant scale and strong positions in secular growth markets, driven by Avago's technology leadership in integrated high performance FBAR filters.
--Reduced but still strong profitability with expectations for margin expansion from anticipated cost synergies related to the acquisition.
--Consistent and solid annual mid-cycle FCF, providing ample financial flexibility for debt reduction and to organically fund smaller technology focused acquisitions.
Rating concerns center on:
--Expectations for ongoing and potentially significant debt financed acquisitions, as well as the attendant integration risks, given importance of research and development (R&D) investments.
--Expectations for operating volatility from short-cycle products, particularly smartphones, which require annual design socket wins and should represent lower but still substantial percentage of total sales. Fitch also anticipates additional volatility from uneven demand patterns in wireline infrastructure and enterprise and data center spending.
--Still substantial customer concentration, given wireless communications representing roughly a third of pro forma revenues and significant exposure to leading smart phone makers.
KEY ASSUMPTIONS
--Strong Wireless segment revenue growth, driven by smart phone model ramps in fiscal 2015. Fitch assumes more normalized mid-single digit growth beyond the near term.
--Enterprise segment revenue growth in the low- to mid-single digit, driven by solid enterprise and data center spend.
--Low single digit revenue growth for the Wireline segment, due to solid demand for ASIC and fiber optics.
--Low single digit revenue growth for Industrial, consistent with the broader market.
--Solid low- to mid-single digit revenue growth from Broadcom, driven by solid connectivity and broadband demand.
--Fitch assumes blended operating EBITDA margin in the low 30s, pro forma for the acquisition, and expands modestly from \\$750 million of cost synergies beginning 18 months following the transaction's close.
--R&D remains at \\$3 billion annually, while capital spending remains near \\$1 billion.
RATING SENSITIVITIES
Positive rating action could occur if Fitch expects:
--Total leverage will remain below 2.5x over the longer term, driven by voluntary debt reduction, structurally higher profitability or management's commitment to maintain financial policies consistent with investment grade; or
--Reduced debt-financed acquisition activity, driven by structurally higher FCF enabling Avago to fund deals without significant incremental debt.
Negative rating actions could result from:
--Market share erosion at leading customer or in aggregate, indicating an loss of technological advantage; or
--Fitch expects total leverage sustained above 3x from profitability and FCF degradation or diminished commitment to reduce debt from FCF.
LIQUIDITY
Pro forma for the conversion payment, Fitch believes liquidity as of May 3, 2015 is solid and consisted of:
--\\$1.5 billion of cash and cash equivalents, all of which is readily available due to the company's incorporation in Singapore;
--\\$500 million undrawn senior secured revolving credit facility (RCF) expiring 2019.
Fitch expects annual FCF of \\$500 million to \\$1 billion also supports liquidity.
Pro forma for the conversion payment, total debt as of May 3, 2015 is \\$3 billion and consists of \\$3 billion senior secured term loan B maturing in 2019.
The term loan B amortizes at \\$46 million (1%) annually until the bullet maturity in 2019.
FULL LIST OF RATINGS
Fitch currently rates Avago Technologies Finance Pte. Ltd. as follows:
--IDR at 'BB+';
--\\$4.6 billion senior secured term loan B at 'BBB-/RR1';
--\\$500 million senior secured RCF at 'BBB-/RR1'.
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