Excellence Rewarded With Avago

| About: Broadcom Limited (AVGO)

Summary

The new Broadcom is well-placed to leverage its exceptional market share in growing markets in wireless and wired communications to generate 30%-plus operating margins and strong cash flows.

Broadcom isn't going to spend billions looking for uncertain growth and will instead focus on maximizing the value of existing businesses with competitive advantages and pursuing opportunistic M&A.

Long-term revenue growth of 5% and GAAP operating margins in the 30%s can support a fair value in the neighborhood of $170.

I've been pretty bullish on both Avago and Broadcom (NASDAQ:AVGO) over the years and now that the merger is completed, nothing about this combination has really changed my mind. If anything, watching Avago's management more closely has led me to a greater appreciation of how they see the semiconductor world differently than most and how that informs their management choices. At an overly simplified level, this isn't a company that believes that success will come from pursuing growth for its own sake, but rather that strong margins generated by businesses with meaningful competitive advantages is the real key.

I continue to believe that fair value for the new Broadcom is in the neighborhood of $170, but that there could be some upside to the long-term underlying growth rate of around 5%. As a diversified chip company with tremendous scale and 40%-plus market share in multiple markets, I think Broadcom can still be thought of as a core tech holding, but it may be better to try to add shares when the enthusiasm cools a bit.

Wireless Can Still Drive A Lot Of Growth

It is true that growth in the smartphone/handset sector has slowed, but that doesn't mean that suppliers like Qorvo (NASDAQ:QRVO) and Broadcom have seen their growth opportunities dry up. Phones designed for 4G have considerably greater component needs in terms of filters, switches and amplifiers, with Qorvo having previously laid out an estimate of five to six times more RF content between 3G and 4G phones. Add in increased adoption of carrier aggregation (driving data through previously unused bands to maximize carrier spectrum), and even more multiplexers and filters are required.

Broadcom is a strong player in the overall front-end module space, and holds a commanding lead in BAW filters with its Film Bulk Acoustic Resonator (or FBAR) technology. Qorvo and Broadcom are pretty much the only game in BAW filters, but Broadcom's FBAR filters still have 70% to 75% market share. While older SAW filters are cheaper, BAW filters offer better power handling, better reception and can operate at a much wider range of frequencies. Insofar as the BAW filters go, Broadcom's FBAR technology has shown superior frequency response (keeping more of what's wanted and less of what's unwanted), less interference with WiFi and better power use.

With the acquisition, the company also benefits from the former Broadcom's strong position in combo connectivity and the wireless business will be a little more than a third of the company's revenue. There's some risk that Qualcomm (NASDAQ:QCOM) or others could disrupt the company's strong market share, but it will be difficult to break in at the high end of the market. To that end, I'd note that the company recently announced a three-year supply agreement with Apple (NASDAQ:AAPL) - a deal that is somewhat informal (there are no volume obligations), but would seem to reflect Apple's need to ensure supply of high-end components.

Penetration of 4G phones should include in the coming years and the higher content in these phones can support several years of double-digit revenue growth for Broadcom. Even though wireless sales were down 15% qoq in Avago's fiscal first quarter on what looked like a 20%-plus decline in FBAR sales to Apple, segment profit margin still came in at over 45%.

Networking Another Source Of Strength

There's room to argue how much or how well Broadcom complements Avago in wireless, as some would have had Broadcom sell the connectivity business some time ago. What's less arguable in my opinion is the strong synergy that the two companies will have in the wired communications space - a business that will be around 45% of combined revenue.

Between them, Avago and Broadcom had strong positions across the networking space, with switches, controllers, transceivers and processors. Importantly, the two companies have complementary strengths in both ASICs and merchant silicon and over 50% share in multiple market segments within wired communications. The launch of the Tomahawk is a significant opportunity to benefit from the adoption of 25G/50G Ethernet in data centers. Cavium (NASDAQ:CAVM) is coming after some of Broadcom's business with its Xpliant programmable switch silicon, but I don't believe any company has the breadth of offerings for the data center that the new Broadcom has.

Broadcom also has an underappreciated (in my view) position in physical layer (or PHY), with new PHY chips coming that can reportedly support 40/100/200G data rates over copper with the new PAM4 signal modulation. Likewise, I don't think the old Broadcom ever got much respect for its position in broadband access and leverage to 4K video and DOCSIS 3.0 adoption.

Cash Has Its Value Too

Broadcom holds strong share in its Enterprise Storage businesses (HDD controllers, SAS/RAID controllers and NICs) and in Industrial market segments like optocouplers, motion encoders and industrial fiber. These are not likely to be major growth drivers for Broadcom, but the margins are good (45%-plus in the first quarter) and the businesses generate good cash flow. I don't know whether Broadcom will look to augment the growth potential of the Industrial segment through M&A, but I would note that the connectivity assets of the former Broadcom could play a meaningful role in industrial Internet of Things applications.

Build It … Now Drive It

Key to the success of the combination will be leveraging product/market synergy opportunities like those available in wired communications, as well as cost synergies. Management should be able to wring more than $750 million in expenses from the deal, and has already identified about $300 million in low-margin business from the former Broadcom to divest.

I'm looking for long-term revenue growth in the neighborhood of 5%, with wireless holding significantly more potential than that over the next five years (maybe double or more) and wired communications likewise having upside above 5%. I still believe that the combined companies can generate GAAP margins into the thirties in a couple of year, with strong cash flows to follow.

More importantly, I think Broadcom's management (largely former Avago management) has the right outlook for success in the semiconductor industry. Instead of investing billions of dollars trying to create growth by greenfield expansion into new markets (often against established competitors), Avago is looking to play to its existing strengths and leverage its 40%, 50% and 60% or higher market shares in its core markets to drive exceptional margins and cash flow. Yes, this does mean that Broadcom is less likely to invent/develop the next disruptive technology, but management's view is that they can wait and buy the disruptors once they emerge.

Given the upward spiral in development costs and the lower incremental revenue generated by next-gen products in the semiconductor space, I think this is the right approach. Many companies have squandered billions trying in vain to compete with the likes of Intel (NASDAQ:INTC), Qualcomm and Broadcom (including, ironically enough, Intel, Qualcomm and the old Broadcom) and I think Avago's approach is more in tune with how top industrials/conglomerates like Honeywell (NYSE:HON) and 3M (NYSE:MMM) operate.

The Bottom Line

Whether by discounting back the cash flows in my model or using the "fair" EV/revenue multiple suggested by Broadcom's operating margins, I arrive at a fair value around $170 ($169 to $175). That doesn't offer a lot of upside from today's price, and the possibility of better than 5% revenue growth has to be set against the risks that smartphone volumes and/or data center upgrades will underwhelm, competition will intensify and take away share and so on. I do believe Broadcom is a good core holding, though, and one that could be built on periodic pullbacks.

Disclosure: I am/we are long AVGO, MMM.

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.