Apple Vs. Samsung - Avago Wins Either Way

| About: Broadcom Limited (AVGO)
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Although many investors, analysts, and writers are deeply invested in the "Apple (NASDAQ:AAPL) versus Samsung (OTC:SSNLF)/the field" battle, I really don't care who wins. Instead, I try to find companies that can prosper from the overall growth in next-gen wireless devices, and Avago (NASDAQ:AVGO) looks like a good candidate. While Apple certainly matters to Avago, I like the company's broader exposure to the handset market, not to mention what I believe to be undervalued opportunities in wired infrastructure and industrial/automotive markets.

A Familiar Story To Start The Fiscal Year

For investors who follow chip stocks, particularly the wireless group, Avago's results are going to look very familiar.

Revenue rose 2% overall, but fell about 7% sequentially, putting the company pretty much squarely between Broadcom (BRCM) and Analog Devices (NASDAQ:ADI) in terms of performance - which feels about right given the business mix. Wireless revenue rose 21% and fell 2% for the respective periods, which was quite similar to Broadcom's wireless performance, though not as good as Qualcomm (NASDAQ:QCOM). Wired revenue fell 12% and 10%, while industrial/automotive was up 9% and down 5%, respectively.

Although volumes did weaken for Avago, the change in utilization didn't hurt margins all that much. Gross margin fell very slightly on a GAAP basis from last year, and about a half-point from the prior quarter (non-GAAP results were broadly similar). Operating income fell 6% and 24%, though, and the operating margin did shrink about two points from last year - the non-GAAP performance wasn't quite as bad (down 1%, and down 19%), but not exactly strong either.

Guidance Reset Was Disappointing, But Not Tragic

Also not unlike Broadcom, and frankly the large majority of chip companies, Avago revised its guidance down again. Against an average sell-side guess of 1% sequential growth, management guided to a 3.5% decline. As you might imagine, bullish analysts waved it off as no big deal, while the couple of very scarce bearish analysts would have you think it was a serious revision.

I'm not bothered by the wireless side of it. A product transition at Apple seems like a cogent explanation, though I'm a little disappointed that a corresponding ramp at Samsung isn't offsetting it better.

Where I'm more troubled is on the industrial side. Not only were many chip companies with large industrial businesses (Analog Devices, Linear Technology (NASDAQ:LLTC), and Microchip (NASDAQ:MCHP)) more optimistic, but key customers like ABB (NYSE:ABB) were pretty positive on the discrete/factory automation market. I don't know if this is a transient "wrong place, wrong time" issue or incremental share loss, but it bears watching.

Using Proprietary Technology To Take Mobile Share

The key to the Avago story right now is the company's strong wireless business, particularly its suite of handset RF products. Handset RF is about one-third of the company's overall business, where it has gained significant share with its FBAR filters and integrated front-end modules and Apple, Samsung, LG, and other handset/tablet makers.

Avago has grabbed about 70% share in the FBAR market due in large part to the benefits its FBAR filters provide overall traditional SAW filters. As the image suggests, FBAR provides "sharper" filtering, which leads to less interference (less crosstalk and fewer dropped calls), better coexistence with adjacent bands, and longer battery life due to lower insertion loss. These advantages are significant enough that Avago has been gaining sockets even though its chips cost between two and four times as much as traditional SAW filters.

FBAR Filter Advantages

Source: Avago Technologies

As the transition to 4G LTE continues, better filtering is going to be a requirement and that suggests a sizable opportunity for Avago. In particular, I think the biggest catalyst is likely not to be ongoing growth at the high end of the market (where growth seems to be slowing), but rather in increasing filter content in lower-end handsets and smartphones. That scenario probably means lower market share and lower ASPs for Avago in the coming years, but significantly better volume.

Of course there will be competition. TriQuint (TQNT) is already the second-largest FBAR player (and they effectively control the market together), but Skyworks (NASDAQ:SWKS) has significant share in the overall RF component space. Qualcomm, too, is entering the space. The company recently introduced the RF360 RF front end solution, and though its lack of filters and duplexers suggests it's more of a threat to Avago's power amplifier business, few chip companies are going to say "Oh good, Qualcomm's here now too."

Switches And Datacenter Could Offer Life To Wireline

I realize that a lot of analysts and investors are down on the potential of telecom and networking equipment, but Avago could still have some life here. Avago has been winning the lion's share of new sockets with customers like Cisco (NASDAQ:CSCO), Hewlett-Packard (NYSE:HPQ), and Juniper (NYSE:JNPR), in part due to its proprietary SerDes cores. These chips offer better power efficiency, lower error rates, and overall superior performance, and have helped the company gain share with key vendors. I do have some concerns about LSI (NASDAQ:LSI-OLD) becoming a more formidable competitor in this market as well, though, and there may not be enough market growth for both to reach their goals.

Solid Growth, Underpinned By Strong Technology

If the popularity and technical demands of LTE ultimately do open up the broader handset market to Avago's FBAR filters, the growth potential is meaningful. Likewise, I do believe that growing share with higher-ASP products will make the networking/wired infrastructure a source of growth. Last and not least, Avago's industrial/auto business should benefit not only from rebounds in both of those markets, but generally positive long-term trends - the level of chip content in cars continues to grow, while the growth of distributed control within factory automation seems to fit Avago's capabilities nicely.

All in all, I see Avago producing long-term revenue growth of more than 6%, with more upside if the company can maintain more share (and/or higher pricing) in FBAR than I currently expect.

On the margin side, I've seen some analysts criticize Avago for having less incremental margin potential as volumes improve. Given that Avago's margins are actually pretty good as is, that seems a little perverse to me - almost as though it's better to hire a less-knowledgeable job candidate because you can teach him more. In any case, while Avago may not have huge gross margin leverage potential, I think the company has strong operating margin potential, and could drive higher free cash flow margins in the coming years. In all, I think Avago could grow its free cash flow at a long-term rate around 10-12%.

The Bottom Line

As 2012 showed so clearly, the cycles in the chip industry can be not only hard to predict in terms of timing, but also magnitude. Moreover, investors have to consider the risks that go with serving a demanding customer like Apple and competing with the likes of Qualcomm. Last and not least, it's worth noting that the company's CFO left to join Lam Research (NASDAQ:LRCX) - a company in the even more cyclical semi equipment space.

With that aforementioned 11% growth assumption, I estimate a fair value of $42.50 for Avago shares. At today's prices, that makes them about as undervalued as both Broadcom and Qualcomm, so that sets up an interesting set of choices for investors. I happen to like all three companies (though I don't own any of them yet), but I think Avago just may be the relative underdog given the quality of its proprietary technologies and its lack of "household name" status for many investors.

Disclosure: I am long ABB. 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.