Execution And Opportunity Continue To Drive Broadcom

| About: Broadcom Limited (AVGO)

Summary

Broadcom saw meaningful content growth in the new iPhone and ongoing adoption of LTE phones continues to drive demand for components like filters.

Broadcom's opportunities in networking seem to be less well appreciated, as a leading position in switching silicon and other components can support high single-digit growth in large addressable markets.

Absent more value-accretive M&A, Broadcom shares look undervalued with a more aggressive valuation methodology supporting a fair value above $200.

Broadcom's (NASDAQ:AVGO) recent stock market performance hasn't been all that special. Since my last update on this leading chip company, the shares have done a little better than the NASDAQ, but have lagged the SOX pretty meaningfully, not to mention lagging other notables like Qualcomm (NASDAQ:QCOM), Texas Instruments (NYSE:TXN), and Intel (NASDAQ:INTC).

I'm not worried. Sure, as a Broadcom shareholder I'd love to see the stock performing better, but the company's financial reports have been positive and I believe there are strong tailwinds for both the wireless and wired businesses. Uncertainty around M&A is a risk factor, as are general market/economic conditions and competition, but I believe Broadcom has the quality to be a long-term holding and the valuation today isn't bad.

Wireless Set For More Growth

Broadcom was expected to be a winner with the new Apple (NASDAQ:AAPL) iPhone 7, and that has proven to be the case. The company continues to leverage its strong positions in areas like filters and connectivity, but also gained some content on the power amplifier side. All told, it looks like Broadcom gained roughly 30% more content value with this new generation, and the recent problems at Samsung are likely to help Apple at least a little in terms of unit sales.

Taking a step back and looking more at the big picture, I think Broadcom (as well as Qorvo (NASDAQ:QRVO) and Skyworks (NASDAQ:SWKS)) are in a position to benefit from ongoing adoption of LTE phones around the world. These more sophisticated phones use considerably more components like filters, switches, power amplifiers, and so on, and while I'm sure Qorvo, Murata, and others will benefit as Chinese OEMs look to control component costs, I believe there will be sufficient demand for high-end filters to benefit Broadcom as well, not to mention demand for connectivity combo chips.

Greater competition seems inevitable given the potential revenue up for grabs. Both Skyworks and Qualcomm have made it clear that they want to be players in filters, including the BAW filters that are so important to Broadcom (Broadcom's version being the Film Bulk Acoustic Resonator, or FBAR). While some have suggested that Broadcom's reluctance to spend on R&D creates an exploitable opportunity, I think that's actually a bad read of the situation - Broadcom management (formerly Avago management) is quite willing to spend on R&D that supports its market share in attractive markets; it's speculative R&D and/or re-investing in R&D in declining markets that Broadcom avoids. So while I don't rule out the threat that Qorvo, Qualcomm, and/or Skyworks can build BAW filter businesses over time, I think Broadcom's position on the high end is secure for at least the near future.

Wired Is No Slouch

Broadcom's wireless business is strong and an important driver of the business, but it sometimes seems to me that the wired infrastructure business gets less attention than it should. This is the largest segment of the company's business (generating over half of its revenue in the last quarter), and the growth outlook here is also attractive. This is a diverse collection of businesses, with strong positions in areas like set-top boxes, switching chips, and processors, and the company is in the early stages of what should be a mulityear ramp driving by demand in market segments like data centers.

Up-and-comers like Cavium (NASDAQ:CAVM) and Mellanox (NASDAQ:MLNX) have made a lot of noise in the Ethernet switch space, but Broadcom's Tomahawk is a very strong platform in its own right and they will have their work cut out to take away major market share. On the routing side, Broadcom is also leveraging its Jericho and Qumran families quite effectively.

Broadcom is already ramping its 25GbE Tomahawk switch silicon with vendors like Cisco (NASDAQ:CSCO), Dell, and Hewlett Packard Enterprise (NYSE:HPE), while Jericho and Qumran are ramping in high/low-end edge routers as well. The Tomahawk 2 should maintain that momentum into 50GbE a little further down the line (doubling the per-chip port density and port speed), and help the company continue to exploit the demand created by greater adoption of cloud services. All told, Broadcom should be in place to leverage/exploit a target market worth close to $6 billion a year and growing at a high single-digit to low double-digit rate over the next three to five years.

While not exclusive to wired infrastructure, I would also argue that Broadcom's custom ASIC business is overlooked. On the networking side, Broadcom's IP in areas like SerDes, PHY, and memory is hard to engineer around and the company's technology is in the new Cisco Cloud Scale custom ASIC switch. Likewise, Apple uses Broadcom technology for touch controllers. Overall this business is probably around 10% of Broadcom's business and it is an attractive one - while rivals like Cavium can play here as well, few customers have the resources to develop the technology and chips on their own, so Broadcom benefits from either off-the-shelf purchases or custom silicon partnerships.

M&A A Known Unknown

Broadcom is a company that has been built through repeated successful M&A, and I see no reason to expect that to change. I expect the company will continue to look for opportunities where the target company has good market share (and relatively few competitors) in a business with stable revenue growth potential, as well as post-close margin improvement potential. Revenue diversification is a "nice to have", but I don't believe it will come at the expense of margins and defensible market share.

Given those requirements, I think Xilinx (NASDAQ:XLNX), Skyworks, Maxim (NASDAQ:MXIM), Cavium, Mellanox, Power Integrations (NASDAQ:POWI), and Integrated Device Technology (NASDAQ:IDTI) could all be options.

Xilinx's FPGA technology makes it a scarce asset, and cross-selling those chips into wired infrastructure markets seems like a natural fit; Xilinx also has relatively attractive gross margins but high operating expenses which is a set-up Broadcom has done well with in the past (cutting opex post-deal). Skyworks would further solidify the company's position in RF front-end components, but antitrust could be a problem and management may not want to tie itself that much more to the fortunes of the smart phone market. Maxim would significantly diversify Broadcom's business (and definitely add exposure to areas like auto and industrial), but the analog chip space is a lot more competitive than Broadcom typically likes. Integrated Device would overlap pretty smoothly with Broadcom and Broadcom's CEO used to run IDTI, but it may be too small to be worth the bother, and so too with Power Integrations. As for Cavium and Mellanox, while the IP and growth potential are attractive, the deal multiples are less so and the ongoing R&D needs may limit the margin improvement potential.

I also wonder if Broadcom has put a call into NXP (NASDAQ:NXPI) now that there are rumors that NXP and Qualcomm are talking merger. There has been speculation in the past about Broadcom's interest in NXP, and there are some attractive aspects to such a deal (market/industry diversification, technologies like NFC, adding MCU capabilities/IP), but I'm not sure the competitive moats are deep/wide enough, it would be a big deal to digest, and any sort of bidding war could push valuations beyond a point that would work for Broadcom.

The Opportunity

I still believe that Broadcom can generate long-term revenue growth in mid single-digits with strong margin leverage driving FCF growth into the mid-to-high single-digit range on an annualized basis. That works back to a fair value of around $173 on a DCF basis, while the combined operating margin and revenue growth potential support a higher EV/revenue-based fair value of over $200. A further slowdown in smartphone sales would be a notable threat to those projections, as would a slower pace of adoption of higher-speed switches by data centers (not to mention greater competition/market share losses).

The Bottom Line

Although the shares have been a little sluggish over the last six months, Broadcom is still pretty popular with most sell-side analysts and institutional investors. Even so, while the valuation isn't a table-pounding bargain, it's good enough that I think it's still a worthwhile buy-and-hold name. I expect the next 12 to 24 months to really underline the growth potential of the wired business, and that should support some better returns for the stock.

Disclosure: I am/we are long AVGO.

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.