Why Broadcom Is Appealing

| About: Broadcom Limited (AVGO)

The share price of Broadcom Corporation (BRCM) has experienced a flat performance over the past 3 months. At $33.80, the stock is trading at the mid-point of its 52-week price band from $28.60 and $39.66 and offers a 1.3% dividend yield. Investors should consider buying the shares at this price level based on the following 4 compelling reasons:

1. From a relative valuation perspective, Broadcom shares are cheap based on the company's solid financials relative to its peers' (see chart below). Consensus estimates on average predict the firm's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 9.4%, 35.2%, and 21.8%, respectively. Those figures considerably outperform the averages of 9.4%, 13.2%, and 5.6%, respectively, for a group consisting of Broadcom's primary peers in the semiconductor device sector. Similarly, Broadcom's long-term earnings growth rate is forecasted to be 15.0%, slightly above the peer average at 14.4%. On the profit side, however, the company's performance is below par as reflected by the below-average profitability margins and capital return metrics. In terms of liquidity, Broadcom's free cash flow margin is only slightly below the peer average. Although both the firm's current and quick ratios are below the group averages, they remain at a healthy level on an absolute basis.

(Click to enlarge)

To summarize, Broadcom's relatively weaker profitability and capital return performance would likely be the primary drag on the stock valuation. However, given the company's superior growth potential, I believe the stock's fair value should trade at only a modest discount to the peer-average valuation level. Nevertheless, the current valuations at 9.5x forward EBITDA (next 12 months) and 12.1x forward EPS (next 12 months) together represent a significant discount of 39.2% to the same peer-average trading multiples, suggesting that the stock is modestly undervalued on a relative basis (see chart above). Further, after accounting for Broadcom's better EPS growth estimate, the stock's PEG ratio of 0.8x is still at a substantial discount of 50.3% below the peer average at 1.6x, again indicating an undervaluation.

2. Broadcom's forward P/E multiple is trading at a 17.4% discount to the same multiple of the S&P 500 Index, which stands at 14.6x now (see chart below). In my view, this presents a great buying opportunity as Broadcom shares should reasonably trade on par with the market provided that 1) the stock traded on par with the market in late 2011 and early 2012 and the market discount averaged at just 11.6% in the past 12 months; 2) Broadcom's long-term EPS growth at 15.0% is almost twice of the average estimate of only 8.2% for the S&P 500 companies; 3) the company is a strong cash flow generator and approximately 12.6% of the current market cap is in cash; and 4) the stock also offers a 1.3% dividend yield.

(Click to enlarge)

3. Further, Broadcom's trailing EV/EBITDA multiple of 15.7x is currently trading in line with its 2-year historical average (see chart below). This suggests an attractive valuation level given the facts that:

(Click to enlarge)

1) Broadcom has been able to sustain steady profitability margins and gradually improve the free cash flow margin over the past 2 years (see chart below); and

(Click to enlarge)

2) The company has significantly recovered from a negative growth state in early 2012 and market's consensus revenue and EBITDA estimates reveal a somewhat steady growth trajectory over 2013 and 2014 (see chart below).

(Click to enlarge)

4. Broadcom has beaten the consensus revenue and EPS estimates over the past 6 consecutive quarters. According to Thomson One, sell-side analysts appear to be very bullish on the stock. Of the total 47 ratings, there are 15 strong buys and 25 buys. On February 21, 2013, Auguste Gus Richard at Piper Jaffray initiated his research coverage for the stock with an overweight rating and a $50 target price. The analyst elaborated on the following investment thesis which I tend to agree on (sourced from Thomson One, Equity Research):

"We believe Broadcom is particularly well positioned ahead of a number of strong product cycles that will drive communication semiconductor demand. In addition, the company is poised to grow its market share in mobile with its new LTE and other platforms that will likely drive content higher. We believe Apple will be a lead customer for the recently announced LTE baseband, though revenue would be a 2014 event. We think BRCM's large R&D investments of the past few years, market leadership in a wide range of communication markets and increasing content per unit is going to start to drive top line growth and financial leverage. We initiate coverage with consensus estimates but, based on our checks, we could see upside to our forecast based on secular momentum and diminishing macro headwinds."

Bottom line, in light of Broadcom's solid growth prospects and cheap valuation, the shares should deserve a buy rating and be worth your consideration.

All charts are created by the author and all financial data used in the article and the charts are sourced from Capital IQ unless otherwise specified.

Disclosure: I am long BRCM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.