Broadcom (BRCM) is a leading designer of semiconductors used in networking, broadband, and mobile devices. The company's main competitors include Qualcomm (QCOM) and Texas Instruments (TXN). One of their more prominent products are chips which combine various communications standards such as bluetooth, WiFi, and GPS.
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* Full presentation here (PDF FILE)
Broadcom chips are used in a plethora of devices, as seen in the above graphic, leading to nearly all data traffic crossing a Broadcom chip. And the rise of mobile devices such as smartphones and tablets along with the subsequent increase in total internet traffic should be a boon for the company.
Shares of Broadcom currently trade for $34.38, down from the high 40's at the beginning of 2011. Here's the 5-year financial performance:
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Revenue | $3,776 | $4,658 | $4,490 | $6,818 | $7,389 |
| Operating Cash Flow | $825 | $919 | $986 | $1,371 | $1,838 |
| Capital Expenditure | $-151 | $-83 | $-67 | $-109 | $-163 |
| Free Cash Flow | $674 | $836 | $920 | $1,262 | $1,675 |
Revenue as well as free cash flow has grown at a breakneck pace since 2007, with revenue doubling and free cash flow nearly tripling.
Owner Earnings
Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:
These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.
I'll calculate Owner earnings by taking the Net Income and adding back various non-cash items, such as depreciation, and then subtracting the 5-year average Capital Expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Net income | $213 | $214 | $65 | $1,082 | $927 |
| Depreciation & amortization | $78 | $97 | $105 | $138 | $192 |
| Investment/asset impairment charges | $0 | $171 | $18 | $19 | $92 |
| Stock based compensation | $0 | $509 | $496 | $121 | $119 |
| Other non-cash items | $538 | $45 | $-2 | $360 | $381 |
| Interest Payments | $0 | $0 | $0 | $0 | $0 |
| Avg Capital Expenditure | $-115 | $-115 | $-115 | $-115 | $-115 |
| Owner Earnings | $715 | $923 | $568 | $1,605 | $1,596 |
Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Broadcom's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.
| (In Million $) | 2007 | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|---|
| Owner Earnings | $715 | $923 | $568 | $1,605 | $1,596 |
| Invested Capital | $4,838 | $4,393 | $5,127 | $7,944 | $9,040 |
| CROIC | 14.79% | 21.03% | 11.09% | 20.2% | 17.65% |
Broadcom's CROIC was 17.65% in 2011, which means that the company is capable of reinvesting retained earnings at that rate. Another positive is that 21.5% of revenue is turned into owner earnings. Clearly, Broadcom is a highly efficient company which excels at generating cash. Let's take a look at the most recent balance sheet.
| Cash and Cash Equivalents | $1,675 |
|---|---|
| Investments | $388 |
| Debt | $1,196 |
| Pension Obligations | $0 |
| Minority Interest | $0 |
| Net Cash (Debt) | $867 |
| Diluted Float | 558 |
| Cash/Share | $1.55 |
Broadcom has a strong balance sheet, with more cash than debt and net cash of $1.55 per share. This represents about 4.5% of the current market capitalization. Broadcom's cash-on-hand has decreased significantly since the end of 2011 due to some acquisitions, namely the $3.7 billion purchase of NetLogic Microsystems in February. At the end of 2011 Broadcom had $5.92 per share in net cash.
Valuation
I use a discounted cash flow analysis to estimate the fair value of a company. I will use a discount rate of both 12% and 15% and use these values to define a fair value range. I will assume that the owner earnings will grow at 9% next year and that the growth rate will decay to a perpetual rate of 3% over the next 20 years, as per the growth table below.
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| % | 9% | 8.7% | 8.4% | 8.1% | 7.8% | 7.5% | 7.2% | 6.9% | 6.6% | 6.3% |
| Year | 11 | 12 | 13 | 14 | 15 | 16 | 17 | 18 | 19 | 20 |
| % | 6% | 5.7% | 5.4% | 5.1% | 4.8% | 4.5% | 4.2% | 3.9% | 3.6% | 3.3% |
For reference, the average analyst estimate for 5-year earnings growth is 14.72%. Using the above parameters I arrive at a fair value estimate of $36.56 - $50.25 per share.
Conclusion
Broadcom currently trades at a 6% discount to the lower bound of my fair value range. With an extremely high CROIC and future growth prospects looking bright, Broadcom offers tremendous value at the current price point.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
