Ever since the European debt crisis entered a dangerous new phase in 2011, markets have been thrown into hysteria. Investors buy and sell stocks based on developments in Europe with seemingly little regard to underlying fundamentals. Companies that can succeed without Europe get sold off needlessly, just as companies facing structural challenges get bought on any whiff of a debt crisis resolution. With stock correlations at record highs, investors are forgetting that every company is different. We would like to remind investors of that by highlighting a company that stands above and beyond its peers.
Broadcom (BRCM) is a leader in the mobile semiconductor sector, and its products appear in a myriad of mobile devices, ranging from tablets to smart phones. Customers include Nokia (NOK), Samsung (OTC:SSNLF), and of course, Apple (AAPL). Over the past year, Broadcom has lost nearly 37% of its value, as the S&P 500 lost 2.39%. We think this decline is absurd given the robust fundamentals, balance sheet, and valuation of this company.
The semiconductor industry, as a whole, is a cyclical business, and it is impossible for most firms in it to escape the vagaries of the global economy. Profits rise and fall with economic growth, with a few exceptions. Intel (INTC) consistently grows profits, while AMD (AMD) languishes no matter what is occurring in the broader economy. Most of the other companies in this sector, however, depend on global growth for success, and we have seen just how true this is in the past week.
On Thursday, December 8, Altera (ALTR) a major semiconductor programmable logic solutions company cut guidance for the fourth quarter. Specifically, the company stated that "that fourth quarter revenue will be 13 to 16 percent lower than third quarter levels. Previous guidance was for a decline of 7 to 11 percent. The revenue outlook has deteriorated across all major vertical markets, including both large and small customers. With the exception of North America, which will benefit from rising military sales, all geographic regions will be weak. As the quarter has progressed, economic uncertainty, macroeconomic concerns, and, in some instances, lower than planned sales have resulted in customers reducing demand on Altera. Consistent with the third quarter, Altera believes it will continue to under ship customer end demand in the fourth quarter." We did not think much of Altera's guidance cut, for while we think the company has solid execution and a strong management team, its products have little going for them in terms of secular trends, such as smart phone adoption. The company sells logic chips to the industrial and electronic sectors, so it is very sensitive to economic changes. We have been long Broadcom for some time, adding to our position as it declined, for we think this company is in a class of its own in the semiconductor sector.
But then we received word of another guidance cut in the semiconductor sector, this time from Texas Instruments (TXN), a Broadcom competitor. TI, as it is more commonly known, cut its guidance for the third quarter in a row. The company now expects fourth quarter revenues to be $3.19-$3.33 billion and EPS of 21-25 cents/share, down from $3.26-$3.54 billion and 28-36 cents/share respectively. The company cited "broadly lower demand across a wide range of markets, customers and products, except for Wireless applications processors." Texas Instruments clearly has some company-specific issues, as its guidance has fallen for three straight quarters. It resembles the Cisco (CSCO) debacle, where investors looked to the company as a bellwether. The first time Cisco missed expectations and cut guidance, people feared for the health of the global economy. But then, investors started to see that the cuts at Cisco were symptomatic of company-specific issues, not a weak overall market.
On Tuesday, however, Intel, the king of the semiconductor industry, also cut guidance, taking the entire sector down with it, including Broadcom, which fell over 3%. Intel cut its fourth quarter revenue guidance by $1 billion, citing hard drive supply issues due to flooding in Thailand. There is no reason for Broadcom to have fallen on the back of this news, for Intel did not cite economic weakness, but rather supply chain issues as the reason for its cut, something that does not reflect the underlying fundamentals of Intel's market.
On Wednesday, December 14, Broadcom held its own analyst day, and unlike its peers, the company RAISED guidance for the fourth quarter. The company boosted revenue guidance to $1.8 billion, from a range of $1.7-$1.8 billion, and raised its margin outlook to the high range of its previous estimate, implying that margins should be around 49.5% in the fourth quarter. Broadcom CEO Scott McGregor stated that "Broadcom's Q4 is coming in stronger than expected driven by solid shipments and tight operational management." The company also signaled that its cash on the balance sheet will grow by $900 million this quarter, to $5.1 billion, up from $4.2 billion. How can this be? Shouldn't the European debt crisis be taking all companies down with it? Bears may think so. But that ignores the central tenet of investing in stocks. If investors do not believe that each company is different, there is no pointin picking stocks. Investors should instead buy and index fund or ETF. Broadcom, however, has a number of factors working in its favor that make it far more resilient than its peers.
The first is much larger exposure to Apple. Broadcom's chips appear in all of Apple's iDevices, and as such the company is able to ride the coattails of Apple. While Apple is notoriously secretive about its supply chain, data gathered by Bloomberg estimates that Apple accounts for 11% of Broadcom's sales making the company Broadcom's largest customer. Given the strength of Broadcom's technology, we do not think Apple will abandon the company. Broadcom has more than Apple to support it however, Samsung is the company's second largest customer, and Broadcom's focus on the smart phone sector makes it more resilient than its peers. In its guidance cut, Texas Instruments noted weakness in all areas except wireless chips. But the problem is that TI's wireless business is too small relative to the rest of the company to make up for weakness in other divisions. Broadcom's wireless division, however, is far larger relative to the rest of the company. Below is a breakdown of Broadcom's revenue by segment in the third quarter.
The Mobile & Wireless division contributed over 48% of Broadcom's revenue in the third quarter, making it the company's single largest and most profitable business segment. The quality of the company's products, as well as its platform agnosticism means that Broadcom will be able to ride the smart phone wave well into the future no matter who wins. As the company pointed out in its analyst day presentation, 4/4 of Gizmodo's top phones, 4/5 of CNET's and 9/10 of PC World's top phones all have one thing in common: Broadcom chips. Its chips are present in the iPhone, most Android phones, and most Windows phones.
In short, we think the opportunities for Broadcom are numerous, and are not currently reflected in its stock price. The company is a leader in its industry, and is projected to be the second largest in its sector by revenue in 2011. The acquisition of NetLogic (NETL) should only strengthen Broadcom's dominant position. Analysts agree. After the analyst day, Lazard reiterated its buy recommendation and $45 price target (58% upside), arguing that "the strength this quarter appears to be coming from “combo chips” shipping in Apple products, enterprise networking equipment shipments, and from consumer and broadband products, where expectations were low." Nomura also reiterated its buy target and $42 target (47.6% upside). The firm believes that upside is coming from the company's "strong position in the hottest gadgets." In addition, analyst Romit Shah thinks that at 1.8x enterprise value (a 35% discount to the semiconductor average), the stock is too cheap. He believes that the upside is being driven by Apple and Samsung, due to the fact that neither TI or Intel have had positive guidance announcements. Since neither of those companies have a meaningful presence with either company, Shah assume that what has allowed Broadcom to raise guidance is its relationship with the 2 leading smart phone manufacturers.
To be fair, RBC is more muted in its support of the stock, arguing that the only reason guidance was raised this quarter is because it was too low to begin with. RBC Capital's Doug Freedman thinks that the October forecast was $250 million short of where it should have been, and that this guidance raise makes it that much harder to beat the street's first quarter expectations. While we can see his arguments, we think the bullish side holds more merit. Factor in the company's $4.445 billion in net cash ($5.1 billion of cash from guidance and $700 million of debt) at the end of the fourth quarter and the bullish arguments grow even stronger.
Broadcom's valuation is currently far too low given its opportunities. It trades at 1.8x enterprise value, 16.95x earnings, and just 10.26x forward earnings, despite having a compound annual growth rate of 24.7% over the past 5 years, and earnings in 2011 that are projected to grow 38.4% from 2010, to $2.75/share. We think Broadcom will outperform in the months and years to come, and analysts agree. The Reuters average price target is currently $40.01, representing upside of 40.63%, and we think it will be raised in the days and weeks to come. Broadcom's slogan is "connecting everything," and investors looking for profits should connect with Broadcom.