Avago Technologies Limited (NASDAQ:AVGO) is a world-class semiconductor company specializing in the design and development of a broad range of mixed-signal, analog, digital, and optoelectronic components and subsystems, offering world class products and services in 4 primary categories of revenue; wireless management, enterprise storage, wired infrastructure, and industrial/other. Together this mix in FY 2015 generated an incredible 95% increase Y/Y in net income, and a 99% increase in EPS, which derived from a 60% increase in revenue Y/Y, bringing the company to 40B in market cap, and a roughly 50% 1-year return, despite the worst secular decline since 2011. In May of 2015, Avago announced a game-changing merger with another semiconductor heavy weight, Broadcom Corporation (BRCM), that will create a powerhouse, and a world leader in both wired and wireless communication semiconductors. Broadcom also provides semiconductor solutions for wired and wireless communication. Their products offer voice, video, multimedia, and data connectivity in the home, office, and mobile markets. The combination will ensure investors a front-row seat for both the IoT ("Internet of things") revolution, as well as the ever-growing need in Data Center infrastructure to support the continued explosion of cloud, Data and enterprise services, as well as the continued transition in wireless infrastructure. The deal stands to close in the first half of next year.
The combination will create a $75B company with over $15B in annual revenues, $6-7B in FCF, and steady growth in the world's key technological areas such as IoT, cloud infrastructure, and mobile, while providing immense pricing, logistical, and technological leverage that will create huge barriers to entry. These barriers will make it even harder for smaller firms to compete in terms of scale and lack of in-house fabrication capabilities. Both companies serve leading OEMs, and together they will ensure continued design wins for key devices such as the iPhone and Galaxy lines, as well as the necessary infrastructure to sustain the massive shift to the cloud. In fact, data and cloud revenues have quickly become a very essential component to their growth with over a 35% Y/Y change (35% of total revenue). Despite mobile making up 37% of revenue (with only 10% Y/Y growth), data and cloud revenues will most likely surpass mobile as the key revenue driver in 2016, while still retaining essential design wins and growth in the smartphone and IOT space. The massively successful acquisitions of LSI Corporation, PLX Technologies, and Emulex Corporation have quickly propelled/transitioned Avago as a top player in cloud and enterprise storage infrastructure market, on multiple levels of server and storage connectivity. Their successful history of acquisitions only strengthens the bullish case for owning Avago (especially before their massive merger/acquisition of Broadcom).
Below we will see where and why they had such a successful year. We also will get to see how key information for many main steam high-growth names such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), and Amazon (NASDAQ:AMZN), can be discerned from Avago's financial results. As a major supplier for Apple, as well as a key player in the build out of cloud infrastructure, the main growth drivers for AAPL, MSFT, and AMZN can have key indicative data lurking in the financial results.
Avago's Results, Valuation, and Price Estimates
Annual Results and Highlights
Avago is a very large company already, generating just under $7B in standalone revenue, with a healthy mix of high growth revenue streams balancing macro risk, while maintaining key leadership positions in each area (especially in mobile chips and cloud and data infrastructure). They are also a major supplier for mobile phones (ex: Power Amplifier modules), with key OEM relationships with Apple, Samsung, and many others that make up almost 37% of the $7B. What really stood out to me was the double digit Y/Y growth of 10% while analyst fear of a saturated market, and a less than blow out quarter from Apple and iPhone sales. In my opinion, besides IoT, cloud storage is the most attractive, and hyper-growth area of the company. We saw the blow-out year Amazon had, and it's no secret their dominance in enterprise services on the cloud platform is driving the new levels of profitability, and optimism for the stock (a very similar success story for MSFT). Below we see the latest results, which drove $4B in market cap upon revelation (post earnings pop), bringing Avago very near both their 52-week and all-time high of $150.50 reached on June 1st, 2015.
|Fiscal Year 2015 Non-GAAP Results||Change|
|(Dollars in millions, except EPS)||2015||2014||Y/Y|
|Earnings Per Share - Diluted||$||8.98||$||4.90||+$||4.08|
As mentioned in the introduction, the above represents a historical year for the firm in terms of growth, as well as M&A. The last two years, Avago invested a net $7B into 3 different companies, and as a result has seen price appreciation of over 400%, with a 300% increase in revenues, alongside corresponding FCF growth, and massive increases in profitability as a direct result of healthy margin expansion (see "2-Year Chart Below"). This year was a statement that Avago through strategic vision and acquisitions has managed to position their revenue stream for serious participation in IoT, Mobile, and Cloud/Data connectivity and infrastructure. Below we see the massive growth in enterprise storage, as well as the respectable run rate in a capacity constrained wireless department.
|Percentage of Net Revenue*||Growth Rates|
|Net Revenue by Segment||Q4 15||Q3 15||Q4 14||Q/Q||Y/Y|
|Industrial & Other||8||10||10||-10||%||-7||%|
As we can see, there has been a dynamic shift, while keeping in mind the previous 3 acquisitions, and upcoming Broadcom merger, they are competitively positioned to maintain their dominance in semiconductor opportunities related to cloud storage, while growing sequentially 20% content growth in key mobile devices, making them incredibly profitable. The rapid expansion in revenue, and plans for more fabrication expansion are clear indication that companies like Apple, Microsoft and Amazon will continue to see heavy growth in 2016, mainly due to a continued demand for their enterprise cloud solutions as well as future iPhone releases. As we know capacity is constantly being ramped to meet the growing bandwidth demand, and data needs are growing by the day, making both mobile and cloud the company's brightest catalysts.
Valuation and Performance Analysis
Above we have a clear picture of just how valuable cloud, and the series acquisitions including LSI corp have had on the company. Until the additions, the metrics in terms of growth both in revenue and shareholder returns were flat compared to the clear inflection point of marginal benefits being realized as each of the 3 acquisitions closed, and the company gained significant scale and margin expansion. The majority of FCF, Revenue Growth, Gross Profit, and Operating growth have occurred specifically as a result of the strategic transition in core revenue targets achieved through the last 2 years of M&A. Going forward, the clear success above is very indicative of how effectively Avago will leverage Broadcom.
As we focus in on the future, we are seeing tremendous growth in key areas, and this is on a standalone basis (without the future consideration of Broadcom). The key item of focus is that margins have expanded tremendously while incurring significant leverage, integration costs, and stiff competition coupled with serious industry shifts. This is clear by the larger increases in GP, Op Income, and FCF, relative to Revenue. In fact the most impressive is the growth in FCF (59% larger than Revenue), which is key to managing capex, and debt servicing, while maintaining competitive leads in key design wins and expanding market share across segments.
It gets even better when we look at what this year's massive 30% 2H correction in the semiconductor space (especially Apple suppliers) has created a buying opportunity based on historically, and relatively cheap multiples, especially in consideration of performance. Essentially with an overall cyclical sector-related downturn, fear pounded Avago down to very attractive levels for their size and potential growth. In combination with Broadcom, we easily can see them grow together to over a 100B dollar company (25% higher than the projected EV of the combined companies on the date of the announced acquisition) by 2018.
Guidance And Price Estimates
Growth for all players in the sector next quarter is seasonally expected to be weaker, with no exception for Avago. According to their Conference Call, management didn't hold back from expressing extreme optimism, even if a tougher climate is expected. Here is a conference call clip of CEO Hock Tan:
"In summary therefore, after the strong close for fiscal 2015, we expect an approximate 4% sequential decline in consolidated first quarter 2016 revenue, driven primarily by seasonality in our Wireless and Industrial segments, offsetting projected sustained performance from our Wired and Enterprise Storage segments. With the LSI integration completed in fiscal 2015, we have created a very powerful business model that leverage our largest scale and increase diversity to deliver strong growth in earnings for the year. As Tony will provide more color on his - in his summary, we expect our earnings strength to carry over into the first fiscal quarter regardless of revenue seasonality. And as we go into the rest of fiscal 2016, we expect this earnings machine to further strengthen with the pending Broadcom acquisition."
As we can see, conservative guidance has been given, but if you consider the discussion by revenue segment breakdown, their belief in continued strength is strongly supported from a multi quarter perspective (especially considering the impact of Broadcom). Here are some key takeaways in terms of revenue growth:
- Wireless (37% of Revenue): Strong Y/Y growth in Q4, and overall on annual basis is expected to weaken with seasonality, as well as some capacity issues. For 2016 they are expanding their fabrication capabilities 50% (from 6-inch to 8-inch FBAR), while still running at near 100% capacity. This should allow them to achieve their projected dollar content per device 20% run rate target, especially considering Broadcom revenue hitting the bottom line by this time next year.
- Enterprise Storage (35% revenue): Here is where the incredible growth in profitability is truly being generated through sustained prices, healthy margins, and even more demand, surpassing their already explosive 38% Y/Y growth. Expectations remain solid for this trend to continue, and offset seasonality in other areas.
- Wired (20% revenue): In 2016 the company expects for an increase in revenue and strong growth in fiber optics to the home and routing (especially enterprise), which should sustain their 2015 performance. In Q4, we saw Y/Y growth of 7%, which is impressive considering the condition of the global economy, especially in China over the last year.
- Industrial and Other (8% of revenue): Since the segment has shrunk both sequentially and on a Y/Y basis, it's no surprise that their core shift in strategy has increasingly lowered both their reliance, and need for many of the ancillary products in the segment. Avago has been, and will remain prudent in terms of channel inventories, and expects the weakness to continue, with little to no material impact.
Quarterly Dividend Increases
Before I get to my price estimate and forecasts, I wanted to briefly point out the immense value of their capital return policy. For income loving investors, Avago is a golden opportunity. With their size, position, and market dominance, 5 years from now, the combined entity can easily translate into a $100B dividend champ. Avago has increased their dividend steadily every quarter since they initiated one 3 years ago. On an ongoing basis, there is nothing standing in the way of continuing to provide steady increases in their dividend. While the yield isn't anything to jump at yet, on a total return basis, you are getting in early on a firm that will surely be dominant as far as the eye can see, and eventually become more blue chip in nature with significant future dividend growth.
What is even more impressive than the quarterly increases in dividends, is the growth the price has seen, making the absolute return very attractive, especially for the size of the company. Realistically, post-merger with combined revenues of almost $15B, the "new Avago," most likely won't be appreciating in price as fast, which in turn will quickly increase the dividend yield. I expect by 2018 that the yield will have at least doubled based on the consistent quarterly increases in the dividend, and realistic price targets. This gives long-term investors, especially income investors, in the accumulation phase, a great opportunity to get in early on a future dividend dog.
Due to the fact that half of 2016 is completely in the air on account of the Broadcom merger, we will measure our price estimate on a pre-merger basis. Essentially, the price target is meant to reflect where we see the stock heading in 1H 2016. There is also data available for annual estimates, which in my opinion are very broad. According to Fidelity, here is a summary of their EPS and reporting record:
For Q1, analysts forecast a midpoint of adj EPS $2.35, which, looking out into Q2, would be reasonable to assume a similar price target. My logic behind my rolling EPS estimate out to into Q2 is based on both quarters being seasonally weaker, as well as relatively close to each other historically in sequential growth. With a significant seasonal ramp into the back half of the year, using $2.35 for the first two quarters, we arrive at a total of $9.45 rolling EPS. By using $2.35 as an estimate for both quarters, one can smooth out the difference, especially considering Avago has a large multi-year streak of beating estimates. With a conservative multiple of 20x, you can easily arrive at a $190 6-month price target, 25% upside from today. Broadcom is anticipated to close by the end of Q2. On a conservative note, incorporating both conservative growth, as well as minimal investor optimism, it is fair to say $180 is an achievable price target, which also reflects the slow, but certain cyclical turnaround I expect in the non-memory-related semiconductor industry as a whole for 2016. At this point pre-merger, I believe this form of analysis provides the most logical forward outlook. For these reasons, and many more, I rate Avago as a BUY, even trading at near all-time highs, with a price target of $180.
Before we move on, let's take a quick look at the trading levels, and decide if now is a good time to buy, or should one wait for the price to "pull back". Here is the reality of the situation; the price has already corrected the market discount created by the immense secular decline in the second half of 2015. Buying at today's prices means you are buying into more of the future, than any significant discount created by market inefficiencies. One key item to consider is that the 50- and 200-Day MA is about to make a "bullish cross," which will signal technical buyers to come in, add further price appreciation, and will most likely set a slightly higher 52-week high on any year-end strength.
I recommend buying 1/3 to 1/2 of a "full position," now as a way to avoid it running up any further, since all fundamental indicators are pointing to continued growth, and technical indicators, although showing over bought territories (mainly due to tight consolidation and a subsequent earnings pop), are also holding strong with a pending bullish crossover of the 50/200-day MA. With that in mind, investors should accumulate slowly as I am sure volatility will bring the price closer to the floor of the new gap, and eventually test the $142 level. Caution and patience are vital considerations that are to gain the best overall cost basis. With an over 10% pop after Q4 earnings, and a sustained price level considering all the volatility, both Avago, and the sector seemed poised to head north sooner rather than later. It would be prudent to buy with some dry powder on the side to bring your average cost down in case Santa brings the market a bag of coal instead of the usual year-end rally.
Considerations and Insight for Apple, Microsoft, and Amazon
We all remember the stir that Credit Suisse (NYSE:CS) caused in the Apple sphere by issuing a report that their channel checks indicate a weak and most likely disappointing iPhone sales figure. We already know that growth has been a bit difficult for all smartphone makers, even though Apple has continued to produce record results (how the street views them is a topic for a different article). The general consensus is mixed as usual, leaving investors checking under every floor board, and news headline for clues. Besides key retailers all indicating to Apple being the number one ticket item (iPhone, iPad Pro and iWatch), the numbers in key suppliers seem to indicate that the channel checks may not have represented accurately this seasons tidings related to Apple sales. From Avago's perspective, two items come to mind:
1) Avago had strong results for wireless in Q4, with a sequential increase of 10% (8% Y/Y) in revenue. The key data point is that the company admitted to flat dollar content per mobile devices this year.
2) Based on a similar dollar content, the significant increase in revenue most likely is directly related to strong iPhone sales, as their capacity is already constrained, admittedly turning away business as a result. This year they are expanding production by 50%, which reflects the continued design wins, which the company claims will create a 20% compounded growth rate in the category per device, especially in the high end like the iPhone and Galaxy lines.
Apple expects between $75.50B and $77.50B in revenue for the fourth quarter, and 39-40% gross margins, which would be another record, and is looking to be a pivotal point for the company and its stock. As the holiday season rolls on, and suppliers like Avago are showing strong signs of growth with flat Y/Y content per device, it offers some security behind Apple's guidance (not necessarily the street's expectations, but that itself is a different topic).
Microsoft and Amazon
The insight here is a lot more clear, and less speculative. Both companies have seen record prices for their stocks this year, driven by strong positions in enterprise solutions on the cloud. Microsoft has a close relationship with Avago, so the continued growth in the company's guidance indicates that 2016 should be much of the same for the two giants. On Avago's website, you can view this summary here related to their products for enterprise cloud, SaaS, and data storage center clients. Here is a clip related to Avago's key Syncro product line:
"We are pleased to continue collaboration with Avago to bring cost-effective, high-availability storage to a range of traditional and virtualized business environments," said Michael Leworthy, group manager, Enterprise Cloud, Microsoft.
At these kind of growth rates, and with the inclusion of Broadcom switches, Avago will be a key player for both Microsoft and Amazon, and I expect revenues in this area going forward to provide key insight into sustainable demand for Cloud Enterprise Services, which are now key revenue items for the two major players.
Even though I have generally been bullish about Avago personally, I am even more bullish about the whole sector, and believe Avago is well positioned. In particular, RF rival Skyworks Solutions (NASDAQ:SWKS) has been a well-covered topic for me on SA, as well as NFC pioneer NXP Semiconductor (NASDAQ:NXPI), and their own game changing merger with Freescale (NYSE:FSL), which just closed, and stands to be immediately accretive creating a combined $40B in market cap. Avago has now been positioned as a leader in the connectivity space not only because of their size and future scale-up, but for technologies that they will be able to use with the additional fab capacity (front-end modules, not just discrete components anymore). I remain bullish about all 3 companies, as there is plenty of growth in mobile and IoT to continue to fuel my bull theses on the competition. I welcome readers to read the above articles linked for Skyworks and NXP in conjunction with Avago, as these 3 players have dominated their niche markets with great success, and trade at very high correlations to each other. You really see a big picture in terms of Apple's ecosystem of key suppliers.
As the merger closes and the benefits become even more clear in early 2016, I will continue to provide close coverage, including a future analysis of purely just the post-merger entity that will be ran under Avago. The bull case is quite clear, and has been laid out in black and white above, especially when one considers the growth relative to size in relation to the company. On a technology level their switch to 8-inch FBAR fabrication will yield 50% greater capacity and drive 20% run rate on component dollar value growth per device. This of course will be more of a story in 2017 as additional capacity in Oregon is complete. It is clear Avago is here to stay. They are well diversified, quickly evolving with a clear plan of transition that we have seen the last 3 years, and will only grow more successful with Broadcom as an addition.
The valuation and multiples speak for themselves when considering a whopping near-$9 earnings per share. The debt loads pre- and post-merger will be significant but justifiable, as margin expansion and growth in FCF/earnings easily cover any concerns. With all the above in consideration, I feel comfortable giving Avago two thumbs up, a bravo, and a BUY rating.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AVGO, AAPL over the next 72 hours.
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.
Additional disclosure: We are also Long SWKS and NXPI
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.