Broadcom: Upside Potential Suggests A Buy

| About: Broadcom Limited (AVGO)

Shares of Broadcom Corporation (BRCM) have declined 8.1% over the past 12 months. At $31.45, the stock has dropped by 15% from its three-month high at $37 achieved in September. I believe the recent plunge presents a valuable buying opportunity for investors based on the following four reasons:

1. BRCM's valuations are cheap based on the company's solid financial performance relative to its peers' (see comparable analysis table below). Analysts on average predict BRCM's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 10.1%, 34.0%, and -2.3% over the current and next fiscal years. Those estimates are considerably better than the average projections of 0.8%, 3.5%, and -7.5% for a peer group consisting of some primary players in the semiconductor sector.

In addition, BRCM's EBITDA margin is forecasted to expand significantly by 7.4%, compared to the peer average of just 0.5%. On the profit side, BRCM's profitability and capital return performance is fairly in line with the peer average. Although some of the metrics are below the peer averages, the company's net profit margin and ROE ratio are above the par. BRCM has a comparable financial leverage as reflected by the firm's higher debt to capitalization ratio, but lower debt to EBITDA rate.

In terms of liquidity, the company's trailing free cash flow margin of 16.4% is far above the peer average at 10.3%. Despite being below the par, BRCM's interest coverage ratio is still within a safe range. Both BRCM's current and quick ratios are in line with the peer averages, reflecting a healthy balance sheet.

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To summarize the financial comparisons, given the in-line profitability and liquidity performance, BRCM's robust growth prospects and free cash flow generating capability should warrant a premium stock valuation over the peer-average level. Nevertheless, the current stock valuations at 9.5x forward EV/EBITDA, 11.2x forward P/E, and 0.78x PEG represent an average valuation discount of 5.7% to the peer-average trading multiples, suggesting an undervaluation (see comparable analysis table above).

2. BRCM's forward P/E multiple has underperformed the same valuation multiple of the S&P 500 Index over the past 12 months and is currently trading at a 17.1% discount (see chart below). I believe BRCM's below-market valuation is exaggerated given that: (1) the company's estimated long-term earnings growth of 14.4% is substantially higher than the average estimate of 7.9% for the S&P 500 companies; and (2) according to Thomson One, BRCM has beaten both the consensus revenue and EPS estimates over the past four consecutive quarters.

3. BRCM's trailing EV/sales multiple has been trading at a smaller premium over the same multiple of the PHLX Semiconductor Index since 2008 (see chart below). I believe BRCM should command a higher premium EV/sales multiple over the index level as the aforementioned financial comparisons suggest a superior top-line growth potential for BRCM.

4. Analysts are very bullish on the stock and have a high average target price. According to Thomson One, of the 48 analyst ratings, there are 15 strong buys, 25 buys, 6 holds, and only 2 underperforms. The mean target price of $40.32 represents a 28% upside. Wedbush's research analyst, Betsy Van Hees, wrote in the recent research note:

"BRCM remains our top defensive play in an especially tough semi tape as we believe it is (1) levered to the mobile market with considerable market share (75+%) in connectivity chips, (2) a solid derivative play to Apple, and (3) end to end solutions in 10Gigabit and KBPs will benefit when wireline/wireless infrastructure growth resumes. With the stock having declined -10% since mid-Sept vs. the S&P 500's -3%, we think the pull back has created an attractive entry point and recommend investors buy shares."

Bottom line, investors should enjoy a solid margin of safety on BRCM due to the stock's cheap valuation and high growth potential. Assuming a forward P/E ratio at 13.5x, which is consistent with the average P/E multiple of the peer group and the P/E multiple of the S&P 500 Index, and supposing that BRCM's EPS would rise to the analysts' average estimated level at $3.21 by FY2014, this base-case scenario implies a 1-year target price of $43, which is 38% above the current market price. In the light of the ample upside potential, I strongly recommend acquiring the shares now.

Comparable analysis table is created by author, all other charts are sourced from Capital IQ, and all financial data is sourced from Capital IQ and Thomson One.

Disclosure: I am long BRCM, INTC, QCOM. 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.