Financial results from Irvine, Calif.-based Broadcom Corp. (Nasdaq:BRCM) remain frustrating. While the company's networking business is performing exceptionally well and the broadband business is also quite solid, the company continues to pay the price for tilting at mobile windmills. Management may be reluctant to turn its back on what looks like potentially billions in mobile/wireless revenue, but ongoing losses from these efforts will likely continue to weigh on a fair value in the mid-$30s.
Reasonable Results For Q1, But With Caveats
All told, Broadcom delivered a pretty good quarter. Revenue was down 1% year over year and down 4% sequentially, but still a bit higher than the sell side expected. The devil is in the details, though, as mobile/wireless remains weak (down 15%/down10%) and weigh on good broadband results (up 4%/up 2%) and infrastructure (up 35%/up 1%).
Margins, too, were better than expected but on the back of good results outside of mobile. Gross margin improved 20 basis points from last year and declined 40 basis points sequentially, but came in about 30 basis points better than expected. Operating income fell by double-digits (down 19% year on year and down 14% quarter over quarter), but was about 14% better than expected. The problem here again was the mix; the margins in networking have become exceptional (around 35%) but the company continues to lose money on its mobile/wireless business.
Not surprisingly, guidance was also mixed. Revenue for the next quarter was trimmed slightly and margin expectations were raised, but management reduced and pushed out expectations for the mobile business.
Time To Hang Up On Mobile?
It is not hard to see why Broadcom's management is resisting the idea of abandoning its mobile ambitions. The company built itself into a leading connectivity chip supplier and the multi-billion-dollar potential in baseband, processors and combo chips is a very tempting pot of gold at the end of a long rainbow.
The problem, though, is that Qualcomm, Inc. (Nasdaq:QCOM) is a fierce rival at the high end and the low end simply isn't profitable enough to be viable for Broadcom. While Broadcom's acquisition of the baseband business (and designers of) Japan's Renesas Electronics Corp. was supposed to boost the company's long term evolution (LTE) baseband business, the company took a writedown this quarter and cut its LTE outlook below $100 million. At that level, the business isn't likely generating even 20% of its R&D budget.
Bulls will argue that Broadcom needs to push on through these growing pains. They will argue that Broadcom has the only viable 4G baseband rival to Qualcomm and phone OEMs almost certainly want at least two viable suppliers. Santa Clara, Calif.-based Intel Corp. (Nasdaq:INTC) continues to spin its wheels (and spend mind-boggling sums), and Santa Clara-based Marvell Technology Group Ltd. (Nasdaq:MRVL) and Taiwan's MediaTek Inc. both seem more interested in lower end China 4G opportunities.
Those arguments are fine to a point. The baseband opportunity is indeed large, but it's difficult to overstate how much further ahead Qualcomm is right now and how expensive it is to stay in the game at sub-scale levels. Were Broadcom to retrench around connectivity (conceding that Qualcomm is gaining share there too), the shares would likely rise simply on the basis of eliminating those R&D expenditures, which the market now widely regards as fruitless.
Networking And Broadband Looking Good
Broadcom arguably doesn't get enough credit for its very strong position in Ethernet switching, led by the Trident II. This is a competitive market, with San Jose, Calif.-based Cavium Inc. (Nasdaq:CAVM), a soon-to-be combined LSI Corp. (Nasdaq:LSI) and Avago Technologies Ltd. (Nasdaq:AVGO), Intel and Marvell all on the prowl. But Broadcom has staked out quite a bit of market share in a business that should benefit from growth in software-defined networking.
Broadband is another quality business and growth opportunity for Broadcom. Along with Geneva-based STMicroelectronics (NYSE:STM), Broadcom is basically a co-headliner in set-top boxes, as well as a major player in areas like “smart home” and ultra-HD television.
Broadcom should remain in mobile at least into 2015. If the company's 4G LTE efforts gain traction in the second half of 2014, it may be easier to make the case for staying in the business. Investors should look for long-term revenue growth of around 4%, with similar free cash flow growth. At this point, exiting mobile would likely be a net positive, though there remains a chance that Broadband can make this into a growth business.
On a free cash flow basis, Broadcom looks as though it should trade closer to $35. The company's operating margin would typically support an enterprise-value-to-revenue multiple closer to 2.75x or a fair value above $40.
The Bottom Line
Investors are clearly skeptical about not only the long-term health of the mobile/wireless market, but Broadcom's role in the market and its willingness to lose money in pursuit of market share. That is likely to limit the potential of Broadcom's shares in the near term. Over the long-term, however, those shares appear undervalued.
Disclosure: As of this writing, the author owned shares of Broadcom.
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