Broadcom's Outlook Falls Short

| About: Broadcom Limited (AVGO)

Telecom equipment maker Broadcom (BRCM) announced relatively decent second quarter results, but its outlook left much to be desired. Revenue increased 6% year-over-year to $2.09 billion, slightly below consensus estimates. Earnings, excluding a sizeable impairment attributable to its NetLogic acquisition, grew 8% year-over-year to $0.70 per share, modestly exceeding consensus expectations. Free cash flow was decent at $267 million, or 13% of revenue.

Broadcom acquired NetLogic for $3.7 billion in 2012, and as is often the case with acquisitions, it turns out Broadcom paid too much. NetLogic products help improve network performance for 3G and 4G devices, and at the time of the acquisition, Broadcom paid a 57% premium to acquire the firm. After reducing the long-term sales outlook, the firm took a $501 million charge, equal to $0.87 per share. Given what appears to be a bad decision at Broadcom, we've grown more cautious on the firm's capital-allocation decisions.

As for operational performance, Broadcom's gross margin declined 40 basis points year-over-year to 51.8%. Management noted that the gross margin outlook seems relatively stable, and we like some of the actions the firm is taking to bolster performance. CFO Eric Brandt added some specific commentary about how the firm uses its strong balance sheet to enhance gross margins, saying on the conference call:

"So to the extent that we can use our balance sheet to buy inventory which raises our gross margin, we'll do that. And so if you would have backed that out we would probably be up 45 or 50 basis points, in terms of turns in north of 7 which would be about where we expect it to be. But given that we have this opportunity to improve the gross margins and do a spot purchase, we took advantage of it."

From Brandt's commentary, we figure that the $90 million increase in inventory is nothing to worry about at this time. It also highlights the flexibility any company can achieve with an unlevered, stable capital structure. Still, cash flow remains the more important metric to evaluate, as it remains independent of the type of inventory accounting a firm uses (and any games the firm may play with earnings).

On a segment basis, Broadcom experienced strong results from its broadband segment where revenues grew 5% year-over-year to $568 million. The firm sees strong global satellite TV and set-top box growth as long-term catalysts going forward, though the company expects revenue to come in flat sequentially.

The market is more concerned about mobile revenue, which declined 3% sequentially (but is up 7% year-over-year) to $967 million. Fears of Qualcomm (NASDAQ:QCOM) and other competitors taking significant share in the connectivity combo space have weighed on shares, and management did little to temper these fears. CEO Scott McGregor pointed to several design wins, but the connectivity market is becoming increasingly more competitive.

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