Broadcom Still Undervalued, And With Cards To Play

Apr. 29, 2015 7:00 AM ETBroadcom Inc. (AVGO)QCOM, MRVL6 Comments
Stephen Simpson profile picture
Stephen Simpson
18.03K Followers

Summary

  • Broadcom reports good first quarter results and guidance, one of the relatively few chip companies to do so.
  • New product introductions in networking could offer more growth upside than presented believed, while IoT remains a long-term opportunity to offset share loss in connectivity.
  • Free cash flow and margins continue to support a fair value range from the mid-$40's to the low-$50's.

While it has not kept pace with Cavium (CAVM) or Avago (NASDAQ:AVGO) over the past year, Broadcom (BRCM) has still made a good showing with nearly 50% increase in the value of its stock price (considerably better than rivals like Qualcomm (QCOM), Intel (INTC), and STMicroelectronics (STM)). Better still for today's shareholders, the company has not gone as far as it can with its new focus on sustainable growth and lean operations.

The murky outlook for connectivity isn't going to resolve soon, as it's still unclear if growth in IoT applications like wearables and home automation will offset all but inevitable share loss in mobile handsets. On the other hand, Broadcom's opportunities in the networking space may yet be underestimated, particularly if new product introductions can coax more business out of Cisco (CSCO). With a fair value in the mid-$40's to low-$50's, Broadcom isn't a striking bargain but still offers enough upside to be worth buying and/or holding.

A Rare Positive Outlier

Along with Fairchild (FCS), Broadcom is one of the only chip companies to report so far and not leave bullish analysts reaching for explanations/excuses. The company posted a revenue number that was more than 2% ahead of the Street, as revenue rose almost 4% from last year and fell a similar percentage from the fourth quarter. Broadband and connectivity revenue rose 13%/fell 5%, while the networking business saw revenue rise 6% and 1%.

A higher than expected contribution from mobile drove gross margin a bit below management's guidance, but the 30bp qoq decline (and 250bp yoy improvement) in non-GAAP gross margin was still a respectable result and just 10bp below the average of sell-side estimates. R&D and SG&A were both a little better than the average expectations, and so too was the resulting operating margin. Operating income jumped significantly from the year-ago level (and fell 14% sequentially), and the non-GAAP operating margin of 19.6% was a few tenths of a point better than expected.

Building on first quarter results, Broadcom also laid out pretty good guidance. The midpoint of revenue guidance for the second quarter was more than 1% higher than the prior average, with a gross margin target more than a full point higher.

For Connectivity The Debate Stretches On...

Broadcom not only won the WiFi/Bluetooth combo chip slot in the Samsung Galaxy 6 phone, but it added the GPS/sensor hub as well - adding more than a dollar of per-phone content for the Connectivity business. Apple (AAPL)/Samsung revenue was weaker than the overall result, but stripping out the baseband business points to almost 18% yoy growth.

It still very much remains to be seen whether the company's 50%-plus market share in smartphone connectivity will hold up. The widespread assumption, which I basically share, is that the company won't be able to hold off companies like Qualcomm and Spreadtrum in the low-to-mid-range markets and that the high-end will erode as well over time.

The "but" is whether or not the company can offset those losses with gains in non-smartphone applications. Although the company has logged some wins in wearbles and IoT applications with Apple, Samsung, and Google (GOOG), it remains to be seen if the gains here can/will offset the probable future losses in phones. The company does offer a complete portfolio of technologies, but the market has no shortage of would-be competitors (including Silicon Labs (SLAB), NXP (NXPI), and Qualcomm).

Networking Still An Area Of Strength

Broadcom is looking to hold and build on its leadership position in switching chips, and new products like Tomahawk, Dune, and Trident II+ will have to come through. I'll be particularly interested to see how the new 25 Gb opportunity develops in 2015 and 2016. 25 Gb advocates, which very much includes Broadcom, argue that by taking advantage of 25GHz-plus SERDES, customers can acquire 2.5 times the speed of 10 Gb for only 1.5 times the cost (and with lower power requirements).

A little further off is the question of how Broadcom's Tomahawk will stack up against Cavium's Xpliant platform. One of the big positives for Xpliant is supposed to be its full programmability (with similar speed/cost), but Broadcom counters that the Tomahawk has enough programmability of its own and is better optimized for top performance at a more compelling price point. Even further down the line is the question of whether this latest generation of Broadcom products can sway Cisco to swap its own ASICs for Broadcom chips. Were Broadcom to make meaningful inroads with Cisco, that alone could drive a few additional percentage points of overall company revenue growth in the coming years.

Sticking To Its Knitting, And Improving The Stitches

Thus far, Broadcom does in fact seem committed to sticking to what it does well and using its market share and R&D knowhow to leverage itself into adjacent markets instead of chasing growth via M&A. To that end, the company has been pretty quiet on the M&A front while others seek to fill holes in their platform through acquisitions.

There is a credible case that Broadcom can offset risks to its mobile connectivity revenue with growing IoT applications. I also believe that the company can continue to drive good growth in networking even if Cavium becomes a more significant competitive factor. Last and not least is the set-top box market - where the company is not only looking to increase its per-box content as cable companies upgrade their service offerings to tempt cord-cutters, but also sell its chips into over-the-top alternatives to set-top boxes.

I'm not making major changes to my model at this point, and am still looking for long-term revenue growth in the 4% to 5% range. I'm also still looking for FCF margins to peak in the low 20%'s, supporting a FCF growth rate in the 5%'s. Discounted back, those cash flows are worth about $46.50. Using another metric I favor for chip companies (using GAAP operating margins to determine the "fair" EV/revenue multiple), I come up with a target closer to $52, but this approach typically skews to a higher valuation.

The Bottom Line

Broadcom has done well from the point where it reached "maximum pain" with the baseband business and where it decided that it needed to retrench around its core competencies. Those competencies are going to be under pretty much constant attack from companies like Qualcomm, Intel, and Cavium, but it is not as if Broadcom is helpless through this process. With Broadcom doing better than expected on revenue and laying out a path to better margins, I believe there are still opportunities to generate gains with these shares.

This article was written by

Stephen Simpson profile picture
18.03K Followers
Stephen Simpson is a freelance financial writer and investor. Spent close to 15 years on the Street (sell-side, buy-side, equities, bonds); now a semi-retired raccoon rancher. That last part isn't entirely true. Probably.

Disclosure: The author is long BRCM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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