There aren't too many beat-and-raise earnings stories in the semiconductor space these days, so Avago's (Nasdaq:AVGO) fiscal second quarter report is all the more impressive. Better still, the company not only has a strong position in next-gen smartphones (through its dominance of the FBAR market), but can look forward to recoveries in networking and industrial demand over the coming year. While Avago isn't a shockingly cheap stock today, it looks like a good mix of growth, quality, and value.
Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.
A Strong Fiscal Second Quarter
One of the best aspects of Avago to me is that it's relatively “platform neutral” when it comes to smartphones; Apple (Nasdaq:AAPL) and Samsung definitely matter, but the company isn't so reliant on one or the other that the business can be thrown off stride mid-cycle. That balance appeared to help this time around.
Revenue fell 3% from last year and 2% from the prior quarter, but was still slightly better than the sell-side expected. Wireless revenue rose 11% (and fell 9%) as the company was able to offset some Apple weakness with new ramps at Samsung. Wired revenue was the opposite, as revenue fell 9% from last year and rose 6% from the prior quarter. Industrial and auto revenue was up 2% and 3%.
Avago also outperformed on the income statement line items. Gross margin actually improved slightly from the year-ago period (up 10bp) and about a half a point from the prior quarter, beating expectations by almost half a point. Operating income fell 8% and 3%, but that was better than expected and operating margin came in 60bp better than the average of sell-side estimates.
SEE: Understanding The Income Statement
Spending On Technology And Expanding Its Wired Business
Since the last quarter, Avago has announced two significant acquisitions – one aimed primarily at expanding the business and the other aimed at enhancing the company's IP.
SEE: Analyzing An Acquisition Announcement
Avago paid $400 million for CyOptics to expand its offerings in wired/networking, particularly InP components and assemblies for products like transceivers and transponders in markets like 40G/100G. Although this business has lower margins than Avago (which is probably why Avago was able to pay less than 2.0x sales), management seems to think they can improve those margins in time.
Avago also acquired Javelin Semiconductor for an undisclosed amount. Javelin is a developer of CMOS power amplifiers for mobile devices. The appeal here would be to leverage Javelin's IP to improve Avago's own GaA power amplifier offerings and/or integrate it with the FBAR filters to create unique front-end module (FEM) offerings for the mobile/wireless space.
Neither of these deals transform the business in the short run. Even so, I think they're smart deals. I realize the wired market is not so appealing now, but Avago has built strong market share in the datacenter market with its SerDes chips, and I believe there is still growth to be had with major customers like Cisco (Nasdaq:CSCO). What's more, improving the company's wireless IP could serve to maintain the company's share and momentum in the face of rivals like Triquint (Nasdaq:TQNT) and Qualcomm (Nasdaq:QCOM).
The Bottom Line
Not unlike Broadcom (Nasdaq:BRCM) and Qualcomm in the wireless space, Avago has the challenge of maintaining strong market share – the company has about 70% of the FBAR market, and even more of the market in 4G. While I think Avago is less vulnerable to low-end competition, the company still needs a healthy demand environment for smartphones to prosper. Likewise, the company really could use a recovery/rebound in the wired and industrial markets to head higher from here.
I continue to like Avago shares. I expect long-term revenue growth in the neighborhood of 6% to 7%, with free cash flow growth of about 10% to 11%. That suggests a fair value in the low $40s, which doesn't make Avago substantially cheaper than Broadcom or Qualcomm, but I do think the company's more diverse end-market mix adds appeal.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.