Broadcom - Investors Applaud Potential Sale Of The Cellular Baseband Business, Sending Shares Up 25%

Jun. 9.14 | About: Broadcom Limited (AVGO)


Broadcom is potentially selling its huge yet unprofitable cellular baseband business.

Investors applaud the move, sending shares roughly 25% higher in the matter of weeks.

This jump already factors in the value-accretive move, and perhaps some more.

Investors in Broadcom (BRCM) have seen great momentum in recent weeks as shares have risen by more than a quarter.

This momentum has been fueled by the announcement that the company is exploring strategic alternatives for its cellular baseband business. An upbeat outlook for the current second quarter has been helpful as well.

Exploring Strategic Alternatives

On June the 2nd, Broadcom announced that it is exploring strategic alternatives for its cellular baseband business which could result in either a sale, or even a wind-down of the business if necessary.

Any potential decision would be a big move, as the unit generated 47% of total reported revenues of $8.31 billion over the past year. The business unit posted a $32 million operating loss in the first quarter, a quarter in which the overall company posted a $165 million profit.

Competition for the segment has been increasing a lot with Qualcomm (NASDAQ:QCOM) dominating the market. Broadcom is behind the curve and reckons that it might be hard to hit its targets, including that for $100 million in LTE revenues. The poor competitive position of the firm does not only put pressure on margins, sales in the first quarter were down by 15% to $846 million as well.

Investment bank J.P. Morgan is advising Broadcom on the strategic decisions.

If a sale or wind-down is established, Broadcom can reduce its GAAP research & development expenses, as well as selling, general and administrative expenses by $700 million. Of these cost savings, about a $100 million is based in stock-based compensation.

Broadcom recognizes that the company would incur potential impairment or restructuring charges when making such a move. The company has not specified how large these potential costs could be.

Updating The Outlook

For the quarter ending on June 30, Broadcom anticipates sales to come in between $2.0 and $2.1 billion. Both GAAP and non-GAAP gross margins are expected to come in at or above the high end of the previously issued range.

At the first quarter earnings release, Broadcom anticipated gross margin expansion of 75 to 175 basis points from the reported non-GAAP margins of 52.2% in the first quarter. As such, non-GAAP gross margins are expected to come in at roughly 54.0% of total sales, or even higher.

Valuing Broadcom

The company ended its first quarter with $2.9 billion in cash, equivalents and marketable securities. The company has $1.4 billion in debt outstanding, resulting in a solid net cash position.

Broadcom currently trades at $38 per share which values equity in the business at $22.2 billion. This values operating assets at $20.7 billion which values the company at 2.5 times last year's revenues of $8.3 billion. Given the reported earnings of just $424 million, equity is valued at roughly 50 times GAAP earnings.

Broadcom's quarterly dividend of $0.12 per share provides investors with a 1.3% dividend yield.

Implications For Broadcom

The implications for the company are huge with the business unit generating 47% of total revenues over the past year. Yet despite the huge relative size, the unit was unprofitable, posting a $32 million operating loss in the first quarter. This is as the overall company posted a $165 million net profit. This implies that all other operations earn about $200 million per quarter, or roughly $800 million per annum.

As a matter of fact, Broadcom posted a $424 million profit for the year of 2013, and $700 million in GAAP cost savings could push annual earnings towards $880 million assuming statutory taxes. Of course, revenues of the firm would be cut in half following a sale or the wind-down.

Implications For Investors

Investors are very happy with the decision made by the company, sending shares 10% higher on the day following the announcement, thereby adding more than $1.5 billion to the company's equity valuation. Shares have risen another 10% in the trading days following the announcements.

Over the past decade, Broadcom's shares have traded in a $15-$45 trading range, and the latest announcements have pushed the shares towards the higher end of that range.

The exit will undoubtedly result in various one-time charges, as a sale of the division appears to be not very likely. As a matter of fact, many other companies have exited the segment given the fierce competition. Assuming pro-forma earnings could indeed improve towards $900 million per annum, shares trade at roughly 22-23 times earnings, while the growth profile of the company has improved significantly.

This is still a rather steep valuation which shows that investors have already priced in all the good news and perhaps some more. I remain on the sidelines, but will eagerly watch the process in search for opportunities. If a potential buyer might step up, or a modest bidding war might be ignited, shares might see more upside potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.