When looking at Broadcom's (BRCM) one-year chart (below), you will notice the plunge in Broadcom's share price in July 2013 that erased nearly 19% of Broadcom's market capitalization. Reason was that the company issued new revenue guidance for the third quarter of 2013 which came in below analyst estimates: Analysts expected average revenues of $2.25 billion vs. a new guidance range of $2.05-2.20 billion. Q3 2013 revenues eventually stood at $2.15 billion.
I have previously asserted that hefty share price declines based on singular, independent events are often an opportunity for contrarian investors. Market panic offers investors the chance to pick up first class businesses at bargain prices. Oftentimes, the market overshoots and reacts irrationally to news. Specifically, in the case of Broadcom, I do not think that lower revenues in the amount of $100 million would justify a $3.5 billion reduction in market capitalization. Not surprisingly, the market slowly recovered from its hiccough and readjusted its pricing and Broadcom's shares are steadily edging higher ever since September.
Another company that bounced back nicely after its Q4 2012 guidance adjustment caused a hysteric sell-off, is Cisco which was similarly thrown under the bus. Other high-conviction, contrarian investments of mine are Potash Corp. (POT) and Mosaic (MOS) whose charts also depict forceful sell-offs driven by fear and panic. It is my estimate that those companies will equally recover from negative sentiment and quote substantially higher one or two years from now (I am long both companies and the theses for Potash Corp. and Mosaic can be found here and here).
Broadcom is slowly recovering from its mindless sell-off and shares are now trading at $29.29. Broadcom has lost 11.80% over the last year which is mainly due to the correction described above.
Other companies in the semiconductor sector have done much better than Broadcom. Given the downward adjustment of revenue expectations, the return differential between Broadcom and other peers is quite striking. Broadcom's underperformance is almost entirely attributable to the July 2013 correction even though shares have managed to reclaim part of its lost territory. Peer companies include Analog Devices (ADI) which gained 42%, Semiconductor Manufacturing International (SMI) 60%, Skyworks Solutions (SWKS) 72% and Xilinx (XLNX) 41%.
Broadcom's intrinsic value estimate
I believe Broadcom can achieve operating cash flows similar to 2011 and 2012 levels in both 2013 and 2014. Projected increases in OCF are mostly moderate with growth rates of 4% to 5%. With both investing cash flows and net borrowings in line with historical averages, I estimate that Broadcom can book a free cash flow to equity of around $1.6 billion or $2.78 per share in 2014. This translates to an outstanding 9.5% free cash flow yield and a low 10.54x forward P/FCFE multiple; thanks to the sell-off in July.
Applying a discounted free cash flow model (equity capital cost of 10%, terminal growth rate of 3%), yields an intrinsic value estimate of $40.22 per Broadcom share. Considering that shares of Broadcom currently trade at $29.29, the model implies about 37% upside potential to its intrinsic value.
Peer group comparison
Bringing in market-related multiples confirms the picture from above: Broadcom is cheap. The company trades at just 11.76x forward earnings which is way below the peer group average ratio of 15.24. Only Skyworks Solutions is cheaper at 9.94 times forward earnings. In terms of P/S sales ratios (second chart below), Broadcom trades at about 2x sales which seems to be fairly reasonable considering the dispersion of ratios for other integrated circuit companies in the sector.
The summary table below compares Broadcom to its peers in the semiconductor industry and displays discounts to peer group average P/E, P/S and D/P ratios.
Although Broadcom has recovered quite a bit, the company still trades significantly below its true value. Broadcom was sold-off amid fears of revenue contraction and I don't see anything on the horizon that would justify an ongoing depressed valuation of the company. The free cash flow valuation from above is conservative in my opinion, yet implies 37% upside potential for shares of Broadcom. An investment in Broadcom is contrarian in nature and I expect the trend of recovery to continue. The high implied free cash flow yield and low earnings multiple suggest that the company has decent upside potential. Long-term BUY.