By David Sterman
When Apple's (AAPL) engineers first dreamed up the concept of the iPad -- perhaps the most important computer product in a decade -- they had to rethink every aspect of its design.
To make a very thin, lightweight, powerful device would have been hard to pull off if it were stuffed with a number of distinct semiconductors handling tasks such as WiFi, Bluetooth and network communications. Luckily for Apple, Broadcom (BRCM) already had a solution at hand. The chip maker managed to combine a number of discrete functions on just one semiconductor -- known as systems-on-a-chip (SOC).
Broadcom's SOCs can now be found in a number of Apple products, and if you would consider Broadcom as an investment idea, then you need not be concerned that Google's (GOOG) Android system could take market share from Apple: A range of Android phones also use Broadcom's SOCs.
You actually come across Broadcom's chips every day: Wireless base stations that direct cell phone traffic rely on Broadcom's communications chips; Amazon.com's (AMZN) data centers use Broadcom chips to direct traffic when you make online purchases; and when you get home at night, that set-top box sitting on your TV may also use Broadcom chips.
It's no coincidence. Management has been steadily expanding the company's reach into new niches after it realized that communications, video and computing were all converging into one eco-sphere. So Broadcom has poured prodigious amounts of research and development (R&D) --$1.8 billion in 2010 alone and $4.8 billion during the past three years -- and has, arguably, the broadest lineup of chips among industry players, including venerable names such as Qualcomm (QCOM) and Texas Instruments (TXN).
When Broadcom finds a hole in its product lineup, it's not afraid to spend liberally to bring in the expertise. For example, it paid nearly $4 billion this past September to acquire Netlogic Microsystems (NETL), a maker of specialized high-capacity communications chips (the deal should close this spring). Some say Broadcom overpaid, seeing as how NetLogic has only $400 million in annual sales. But Netlogic's reputation among wireless-service operators, network-security specialists and major systems OEMs (original equipment manufacturers) is stellar. As a result, Broadcom should soon be able to penetrate its existing customer base more deeply with Netlogic's cutting-edge chips. The long-term plan is to integrate the two firms' technology on one platform, taking the whole SOC concept to a whole new level.
OK, so why am I only now writing about this great company now? Because short-sighted investors, focused on an expected subpar December quarter, have been dumping the stock.
But this is the kind of company investors should be seeking out in the current market environment. Great track records, bright futures and myopic selling are a great recipe when looking for an entry point. The key is to wait until shares have found a bottom with downside support in place, and with catalysts for fresh upside in coming quarters. And you even want to see the beginnings of a rebound (Shares hit a 52-week low on Monday, Dec. 19, closing at $27.74 and then received fresh support on Tuesday, Dec. 20, rallying 4%) .
Where's the downside support? Well, shares now support a free cash flow yield in excess of 10%, based on 2011 projections. It's rare to find such a high number for a tech stock. Robust ongoing free cash flow explains why Merrill Lynch says Broadcom's cash balance could rise from a current $2.5 billion to $4.3 billion by the end of 2013.
What are the upside catalysts? Broadcom is on the cusp of a major refresh cycle for a number of its chips in the first half of 2012. As just one example, Wi-Fi networks are slated to move to a new standard next summer known as 802.11ac. The protocol, which supports high-speed transmission of high-definition video across greater distances (three times faster than current Wi-Fi) should lead many hardware makers to offer new models -- many of which will carry Broadcom's chips. In fact, Broadcom's 802.11ac chip will be the first to hit the market, according to management.
Broadcom held its annual Analyst Day on Dec. 14 and laid out a technology roadmap, which management says will lead to market share gains in every niche in which the company operates. Few doubt such a boast. As Needham's analysts point out, "Broadcom's strategy has enabled the company to outgrow the broader semiconductor market in 15 of the past 16 years." Much of the company's future growth is expected to come from the BRIC countries (Brazil, Russia, India and China), which need to make ample investments to support such systems as high-speed wireless video streaming.
Risks to Consider: A tepid fourth-quarter outlook is the key reason behind the stock's recent downward move, and first-quarter results may also be restrained due to the lingering effects of flooding in Thailand, which is the supplier of the about 40% of the world's hard-disk parts, and an ongoing correction in chip inventories. Broadcom is unlikely to benefit from the projected upgrade cycle for many of its chips until the second quarter of 2012.
The recent sell-off has turned Broadcom into a bargain at around 10 times projected 2011 profits. Back out the hefty $3.5 billion net cash balance and this multiple drops below nine. Shares have historically traded for between 10 and 20 times forward earnings, and a rebound just up to a multiple of 13 times projected 2012 profits (when cash is excluded) yields a $40 price target , which is more than 30% above current levels. By the time Broadcom is in the sweet spot of its product upgrade cycle four to six quarters from now, shares could easily revisit that its 52-week high of $47 . At that price, investors would be looking at roughly 60% upside.
Disclosure: Neither D. Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.