Broadcom Should Outperform the SOX in 2007

| About: Broadcom Limited (AVGO)

Wedbush Morgan analyst Craig Berger sent a note to clients in which he gave his reasons for upgrading Broadcom Corporation (BRCM) from Buy to Strong Buy. Excerpts follow:

Upgrading BRCM from BUY to STRONG BUY given 1) we think the firm has won more Bluetooth designs for 2H with Nokia (NYSE:NOK) than most anticipate, 2) we expect chip stocks to appreciate in 2007 with BRCM outperforming most peers given its diverse product offering and technology leadership, 3) we believe the firm’s very heavy investments in 65nm products are likely to pay off in 2008, and 4) new product launches at 3GSM increase the likelihood of a 2008 cellular product cycle with Nokia and/or Samsung.

Bluetooth wins at Nokia could contribute more than many anticipate. We believe Broadcom has won a number of significant Bluetooth design wins into Nokia’s handsets and headsets, possibly contributing more in 2H:07 than many investors anticipate. These wins, some of which are for discrete Bluetooth solutions and some of which are for integrated FM Tuner/Bluetooth chips, could continue the firm’s growth in this segment at the expense of Cambridge Silicon Radio. In addition to Bluetooth, we think Broadcom still has ramping product cycles into 1) Wi-Fi 802.11n, 2) gigabit Ethernet into switches, 3) high definition set top boxes, 4) cellular handsets (in 2008), 4) voice functionality into cable modems, and 5) mobile multimedia into the Apple iPod and/or the iPhone.

Aggressive transition to 65nm chips could pay off in 2008, making BRCM a core semiconductor holding for investors with a 1-2 year investment horizon. Broadcom is transitioning its chips aggressively from 130nm to 65nm process technology, nearly bypassing 90nm altogether in a move that lowers costs, improves thermal and electrical chip performance, and allows for greater integration. The firm’s goal is to have 20 chips on 65nm soon, which should extend its product lead against many smaller or less aggressive competitors. Given the depth of its product offering, its aggressive pace of 65nm product introduction, and improving chip industry dynamics, we think BRCM should be a core holding for chip investors with a 1-2 year investment horizon.

New product launches at 3GSM increase likelihood of 2008 cellular product cycle; Samsung EDGE design wins secured, though Nokia remains elusive thus far. Broadcom announced various chips at, or just before, the 3GSM Congress recently that increase its chances of benefiting from a 2008 cellular product cycle. In fact, our contacts suggest that Broadcom already has single-chip EDGE design wins with Samsung, and that Nokia is closely evaluating its offering, though no purchase order has yet been signed with the European handset giant. We do not believe discussions with Motorola or LG are ongoing at this time. The most important chips Broadcom announced at 3GSM are: 1) a 65nm EDGE transceiver, 2) a 65nm EDGE baseband/transceiver/applications processor (single-chip), 3) a 65nm 3G HSDPA baseband/applications processor, and 4) a 65nm single-chip WiFi/Bluetooth/FM Tuner.

BRCM should outperform the SOX in 2007 given its diverse product offering and technology leadership, as next semiconductor upcycle is likely to arrive sometime in 2H:07. Several broadline firms have called Q1 the cyclical and seasonal trough for the semiconductor industry, including ON Semi, Microsemi, and International Rectifier. Further, this cycle has played out nearly two years after the prior semiconductor cycle, which means chip stocks could heat up in 2H:07, with chip stocks likely to cyclically peak by March 2008. As such, we believe the SOX semiconductor index could increase in 2007 after declining in 2006, and that BRCM should outperform the index and many peers given its diverse product portfolio, technology leadership, and execution track record. • Increase 2007 EPS estimate from $1.25 to $1.27, 2008 EPS estimate from $1.60 to $1.65, price target from $42 to $44, and rating from BUY to STRONG BUY. Our price target is based on a 30x multiple of our forward EPS estimate (2H’07 and 1H’08), in line with the firm’s four-year historical median forward P/E multiple. Our price target is also based on a 5.9x enterprise value-to-sales multiple (2007), generally in line with the firm’s four year historical median multiple.

Risks to attainment of our share price target include: options backdating related risks, litigation risks with QUALCOMM, customer concentration risks, a cyclical or end demand slowdown in the semiconductor industry or macroeconomic environment, market share losses in key markets, technological difficulty in moving its chips aggressively to 65nm, worse than expected chip pricing pressure, or weaker than expected margins.

Strong Bluetooth Run Still Has Legs with Nokia

We believe Broadcom has locked in some significant design wins with Nokia for its 2H:07 handsets and headsets. We expect the firm will ship both discrete Bluetooth chips and integrated FM Tuner/Bluetooth chips, with business likely coming at the expense of Cambridge Silicon Radio.

Figure 1. Broadcom’s Bluetooth Revenue Growth Likely to Continue into 2008
brcm 1

Mega-integration trends to continue, favoring BRCM, TXN, QCOM, MRVL, IFX, NXP, STM, and Freescale. We continue to expect the secular trend towards mega-integration to continue with multimedia and wireless chips including any combination of the following features: Bluetooth, WiFi, FM Tuner, GPS, Mobile TV, Cellular baseband, cellular applications processor, power management, VoIP processors, security, and others. This trend stands to directly benefit Broadcom, and other large chip firms that have all of these functional IP blocks in house. Texas Instruments, QUALCOMM, Marvell, Infineon, NXP, STMicro, Freescale, and possibly Atheros are the only firms that we believe have or will soon have enough critical mass of these components to be significant competitors in three to five years.

Cellular Update: Broadcom Likely Has 65nm EDGE Wins at Samsung, Still Working on Nokia

Broadcom likely has cellular design wins with Samsung; still working on Nokia. Our checks suggest Broadcom has made meaningful progress in its efforts to ramp up its cellular business in 2008, though we continue to heavily discount the firm’s 10% baseband market share goal for 2H:08. Specifically, our contacts said that Broadcom has won some 65nm single-chip designs with Samsung, though that volumes remain very low. With Broadcom servicing archrival Samsung, its prospects of penetrating LG are slim. We also heard that Nokia is very closely evaluating Broadcom’s 65nm cellular product offering and would like to use these or other non-Texas Instruments products in order to further diversify its supplier base (it just announced Infineon as a new baseband supplier). At this point in time, however, Nokia has not signed any purchase orders and has not indicated when it may do so. Finally, with respect to Motorola, we do not believe any significant discussions are taking place, with the U.S. cellular giant continuing to use chips from Freescale and others.

Impressive 65nm cellular product offering increases prospects for 2H:08 ramp; Barcelona 3GSM Congress product recap. Broadcom’s management did a lot of chest thumping about its new cellular products, reference designs, and customer design wins just before and during the 3GSM Congress in Barcelona.

Here is a brief summary of the firm’s important announcements:

• 65nm EDGE single-chip baseband/transceiver/applications processor. Broadcom announced a 65nm EDGE single chip that integrates the RF transceiver, digital and analog baseband, and multimedia functionalities. It is focused on low cost handsets that require low power consumption. Management claims this is the most feature rich processor solution available with 3 megapixel camera support, 30 frames per second video streaming at QVGA resolution (H.264), USB2.0, and can be paired with its WiFi/Bluetooth/FM Tuner discrete or integrated solutions.

• 65nm EDGE transceiver. Broadcom announced a 65nm EDGE transceiver that integrates the transceiver and analog baseband functionality, driving lower power, lower cost, high integration, and a small footprint. Management claims this is the smallest EDGE transceiver solution in the world and the only one currently available for samples on 65nm.

• 65nm 3G HSDPA baseband/applications processor. Broadcom announced a 65nm 3G HSDPA processor that integrates an HSDPA baseband modem with a multimedia processor. Management claims it provides 3G connectivity for advanced applications at lower prices than competing two-chip solutions.

• 65nm single-chip WiFi/Bluetooth/FM Tuner. Broadcom announced a 65nm single-chip solution that combines Wi-Fi, Bluetooth, and an FM tuner. It provides significant cost, footprint size, and power consumption benefits versus discrete solutions.

• 3G HSDPA reference design. Broadcom announced a new High-Speed Downlink Packet Access [HSDPA] compliant reference design allowing for new features and better connectivity.

• Mobile TV handset reference design. Broadcom introduced a mobile TV reference design and software that handset makers can use to integrate mobile TV into their handsets. The platform includes Broadcom’s VideoCore mobile multimedia processor, its GPRS baseband processor and a Bluetooth radio.

• Linux support for CellAirity reference designs. Broadcom announced a new reference design that can run applications on the Linux operating system, providing software support for Bluetooth, Wi-Fi, and multimedia processors, polyphonic ringtones, and integrated audio amplifiers.

• TCL and Asustek adopt Bluetooth in handsets; Lenovo adopts GPRS baseband processor. Broadcom announced several new design wins at the 3GSM Congress including new Bluetooth handset wins with Asustek and TCL, and a GPRS baseband (CellAirity platform) win with Lenovo at the 3GSM Congress. We expect its newly launched handset chips could begin to drive meaningful revenues one year from now.

As Cycle Heats Up EPS Upside Surprises Will Make BRCM a More Attractively Valued Stock

As the semiconductor cycle heats up, likely in late 2007 or early 2008, Broadcom could post topline growth materially better than analysts estimates in at least one quarter (historically it has done it more frequently than that). Below we take a look at an upside EPS case, a downside EPS case, and a downside EPS case with a downside target multiple.

• 5% revenue upside surprise in Q3 or Q4 could drive $55 target on BRCM at 30x, $46 target at 25x. In our scenario analysis, if revenues come in 5% stronger than currently expected in either Q3 or Q4 2007, our 2008 EPS estimate would increase from $1.65 to $1.82 (we will be looking at 2008 estimates by 2H:07). With a 30x multiple on BRCM shares could be worth $55. With a lower 25x forward multiple, shares could be worth $45-46.

• 5% revenue downside surprise in extended downcycle scenario for either Q1 or Q2 could drive a $38 target at 30x, $32 target at 25x. In our scenario analysis, if the semiconductor downcycle surprises us and stays weak in either Q1 or Q2, thus causing revenues to come in 5% worse than currently expected for either quarter, then our forward EPS estimate (2H:07 and 1H:08) could decrease from $1.45 to $1.27. With a 30x multiple on BRCM shares could be worth $38. With a lower 25x forward multiple, shares could be worth $32.

• Risk/Reward attractive. Per our EPS sensitivity and forward multiple sensitivity above, we see downside risk in BRCM to $32 and upside opportunity in Broadcom to $45-55, depending on what an investor is willing to pay for the stock. As such, we do see favorable risk/reward in the shares and recommend investors build positions for better industry conditions in 2H:07 and 2008.