As The Share Price Climbs, Broadcom Remains Undervalued

Apr. 6.14 | About: Broadcom Limited (AVGO)

Summary

Broadcom is 87% undervalued.

The firm is forecasted to generate substantial cash flows.

The technicals are bullish.

Broadcom Corporation (BRCM) is an innovator and provider of semiconductors for wired and wireless communications. Shares of the firm have continued to climb following a steep decline emanating from the NetLogic impairment charge.

While management is forecasting roughly flat first quarter revenues, a key risk Broadcom investors face is that the company may lose the battle to be #2 in baseband LTE. This is almost a make or break year for the company in the cellular market, and the second half is the period when news of design wins will begin to trickle into the market.

With that said, I view Broadcom as being able to grow in the mid- to high-single digits and view the firm as 87% undervalued. The substantial undervaluation stems from the NetLogic write down.

Recent Developments

  1. Piper Jaffray downgraded Broadcom from "overweight" to "neutral."
  2. Broadcom announced the industry's first 5G Wi-Fi system-on-chip to deliver pinpoint indoor position technology.
  3. Inspur Group selected Broadcom's SoC to enable deployment of cable services to millions of China cable subscribers.
  4. QLogic Corporation (NASDAQ:QLGC) purchased Ethernet controller-related assets for approximately $147 million in cash.

Business Summary

Broadcom is the market share leader in providing chips for technologies such as enterprise networking, set-top boxes, and mobile connectivity functions. BRCM has an extensive R&D staff, as the majority of its employees work in R&D. This impressive human capital should help the firm develop and integrate new technologies.

From the industry perspective, the competitive landscape is likely to weigh on future average selling prices. But unit sales growth in 5G Wi-Fi, 3G basebands, 4G chips, GPS, and near field communication solutions is expected to counteract declining prices, resulting in industry net sales growth. The product lifecycle dynamics in both emerging and developed markets should contribute to strong industry performance in the coming years.

For a few reasons, one of which is niceness, I will call this a general "Wall Street " perspective. So, the thought is that investors shouldn't be long Broadcom because of deteriorating net income and return on equity. We are talking about company with less than $10B of annual revenue, which is like a young adult. That is the company life-cycle stage. Consequently, management is heavily reinvesting revenue into research and development in order to drive revenues significantly higher. In other words, create shareholder value. The general perspective is slipshod and is part of the reason that I am substantially "green" on my Broadcom holding.

For the year ending (in millions of dollars except per share data):

2011-12

2012-12

2013-12

2014-12E

2015-12E

Revenues

$7,389

$8,006

$8,305

$8,803

$9,331

Adjusted operating income

$953

$676

$892

$880

$1,026

Adjusted net income

$927

$719

$827

$836

$933

Diluted EPS

$1.65

$1.25

$1.42

$1.39

$1.52

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The first half of 2014 is expected to start slowly, but the forecast is for full-year revenues growth of 6%. Management is likely to continue to reinvest revenues into research and development, which will adversely impact the return on capital. Adjusted diluted EPS is forecasted to decline by 2% in 2014.

 

2011-12

2012-12

2013-12

2014-12E

2015-12E

Asset turnover

0.82

0.71

0.72

0.73

0.72

Ending financial leverage

1.39

1.43

1.37

1.4

1.4

Debt-to-capital

0.18

0.22

0.17

0.17

0.20

Cash ratio

4.12

1.41

1.63

1.7

1.75

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The liquidity is ample and the solvency position appears solid. I think management will both increase liquidity and increase debt in the coming fiscal years. Overall, the balance sheet is strong.

For the year ending (in millions of dollars):

2011-12

2012-12

2013-12

2014-12E

2015-12E

Cash provided by operations

$1,838

$1,931

$1,785

$2,201

$2,333

Capex

$163

$244

$228

$250

$300

FCFF

$1,680

$1,716

$1,586

$1,980

$2,067

FCFE

$2,169

$2,179

$1,257

$1,951

$2,233

Stock repurchases

$670

$33

$597

$600

$700

Dividends

$194

$224

$254

$279

$307

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I think that we continue to see strong cash flow from operations with 2014's CFO increasing 23%. Capital expenditure is anticipated to remain modest. Free cash flow to the firm could reach $2B annually in the coming fiscal years with roughly 50% of that capital being returned to shareholders in the form of dividends and share repurchases.

The Trident 2 Ethernet switch, wireless connectivity, cellular SoCs, and set-top boxes should drive fiscal 2014's return on equity. Also, there is substantial potential in 5G Wi-Fi, HEVC, and Ultra HD, but these opportunities may not be fully realized until the second half of the decade. Overall, the outlook for Broadcom is bullish. But there is the risk that the firm loses the battle to be #2 in baseband LTE.

Risks

  1. The share price is likely to remain volatile and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in BRCM in light of their own unique circumstances.
  3. A decline in the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
  4. The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
  5. Competition in product development and pricing could adversely impact performance.
  6. Incorrect forecasts of customer demand could adversely impact the results of operations.
  7. Higher interest rates may reduce demand for BRCM's offerings and negatively impact the results of operations and the share price.

This section does not discuss all risks related to an investment in BRCM.

Portfolio & Valuation

Click to enlarge

Broadcom is in a bull market of intermediate and primary degree. But the bearish divergences forming on the MACD suggest a correction is becoming more likely. For now, the market for shares of Broadcom remains bullish.

Monthly expected return

Quarterly expected return

Quarterly standard deviation of returns

1.2%

3.58%

15.7%

Click to enlarge
 

Intrinsic value estimates

Forward multiplier model valuations based on base case intrinsic value

Optimistic

$78.84

P/E: 41.25

Base case

$57.34

P/S: 3.92

Pessimistic

$28.67

P/BV: 4.00

   

P/CFO: 15.67

Click to enlarge

The intrinsic value estimates are based on fundamental factors that are adjusted for the company's lifecycle stage. Based on the estimates, Broadcom is 87% undervalued. With the exception of the price/earnings ratio, the multiplier model valuations are above the 5-years average valuations. Consequently, while I am confident that Broadcom will converge to my intrinsic value estimate, the convergence may be a multiyear process of intermediate bull and bear markets.

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.