Broadcom Has To Play Offense And Defense

By Stephen D. Simpson, CFA | May 07, 2013 AAA

Once a darling of the floundering chip space, smartphone chip stocks have had a rather rough time of it over the past year or so. Avago (Nasdaq:AVGO), Skyworks (Nasdaq:SWKS), Qualcomm (Nasdaq:QCOM), and Broadcom (Nasdaq:BRCM) have all notably lagged the market over the past year. While it's true that these one-time market-beaters may have overshot the mark and been due for a retrenchment, investors have nevertheless been worried about the pace of high-end smartphone demand and the risk of increased price-based competition from Asian suppliers.

Though I'd be very careful about simply plugging my ears and ignoring the threats to Broadcom's business, this stock continues to look like a solid name for the long term. That said, with the stock close to a 52-week high, the potential here isn't quite what it once was.

SEE: Market Breadth: 52-Week Highs/Lows

First Quarter Numbers Give A Sigh Of Relief
To the extent that investors feared that a sales slowdown at Apple (Nasdaq:AAPL) would spill over into Broadcom, first quarter results were a welcome relief. Revenue rose 10% from the year-ago period (and down 4% sequentially) and beat estimates by about 5%. Mobile/wireless sales were the strongest, up 14% and down 2%, due in part to strong dual-core baseband sales to Samsung – a good reminder that Broadcom is not “all Apple, all the time”.

Margins were also pretty solid. Gross margins were pretty much flat both annually and sequentially, and that may disappoint some given the year over year increase in revenue. Nevertheless, gross margin was in line with expectation, and operating income beat the average estimate by nearly 20% (up 3% on a non-GAAP basis).

The Good – New Cycles And New Opportunities
Broadcom has invested a lot of time, money, and effort into its next-gen LTE platform, and that business could be getting near a point where it makes a real splash. Some analysts have speculated that the 4G baseband modem market could quadruple to around $7 billion in 2015. While Broadcom's software-defined approach is new and may encounter some resistance, it could be the key in breaking what has very nearly been a stranglehold by Qualcomm.

Other opportunities like 5G WiFi and near field communication (NFC) should also not be overlooked by investors. More and more of these features will become must-haves on new smartphones, and that should help Broadcom maintain a feature/value edge on rivals even with stronger ASPs.

SEE: A Primer On Investing In The Tech Industry

The Bad – Competition, Particularly In Connectivity
While Broadcom absolutely has opportunities to continue growing, these are opportunities and not guarantees. In particular, competition is a very real threat to what Broadcom has already established, let alone what it hopes to gain with new products and new cycles.

In the case of baseband, for instance, Broadcom has the not-inconsiderable task of taking on Qualcomm – the 800-pound gorilla of the space. Qualcomm has maintained better than 50% share of the 3G baseband market (and Broadcom has fought hard to get to around 10%), and both Intel (Nasdaq:INTC) and MediaTek will be formidable competitors.

Broadcom will also have to fight to keep what it has. Broadcom has more than 70% share in the combo connectivity segment, and while the company continues to innovate, Qualcomm, MediaTek, and Spreadtrum (Nasdaq:SPRD) are threatening this market share with integrated connectivity and baseband products. Making matters worse, this competition is coming from both directions – Qualcomm certainly has the capability of competing on performance and functionality, while Broadcom's Asian rivals offer meaningful price competition on lower-function chips for cheaper phones.

SEE: Which Is Better: Dominance Or Innovation?

The Bottom Line
I don't believe that Broadcom is the “next Qualcomm”, but I also don't believe it has to be. I do believe that investments in areas like 5G WiFi and 4G LTE will start paying dividends relatively soon, and I likewise believe that the broadband and infrastructure segments are due for improvements. Provided that phone designers continue to look for new features and functions to validate a high-end segment, I believe Broadcom can do well.
My expectations for Broadcom are not all that strenuous. I look for the company to post long-term revenue growth of around 5%, with similar growth in free cash flow (FCF). With that growth, a fair value of $42 looks reasonable today – making Broadcom undervalued today, but perhaps not enough to entice investors to make a big commitment heading into the summer doldrums.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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