Fear Dominating The Broadcom Story

By Stephen D. Simpson, CFA | July 29, 2013 AAA

A lot of what has worried Broadcom (Nasdaq:BRCM) analysts and investors appeared to come home to roost with the company's latest earnings report. Weak guidance has investors fearing that the company is losing more and more share to Qualcomm (Nasdaq:QCOM), with an overall stagnation in high-end devices leading to fears that ASPs and margins are in danger.

I can understand these fears, but I think there are still some positives to this story. The company's NFC business appears to be doing pretty well, and the higher-margin broadband and networking businesses are likewise more than just afterthoughts. I'd be nervous making a long-term commitment to any mobile chip company right now, but Broadcom could work as a rebound trade for aggressive investors.

Q2's Results Weren't That Bad...
Broadcom reported revenue growth of 6% (year-on-year) and 4% (sequential) for the June quarter, slightly below the average sell-side estimate. While broadband (up 5% and 6%) and infrastructure (up 7% and 19%) were stronger than expected, the mobile/wireless business (up 7% and down 3%) was almost 10% below expectations.

While the growth (or lack thereof) of the mobile business pretty much dominates the discussion around Broadcom, the company's other units are actually more profitable, and the company benefited from that mix shift. Gross margin declined 40bp from last year and rose 20bp sequentially. Operating income was up 3% and 10%, though, which was slightly better than expected despite very weak margins in the wireless business.

SEE: Analyzing Operating Margins

But Guidance Was That Bad
Broadcom shares almost certainly weren't going to outperform on the basis of the reported results, but management's guidance and comments on the call seriously spooked the market. Management gave a range of revenue estimates for the third quarter with the midpoint about 5% below the prior sell-side estimate. Even worse, they pushed back the commercialization target for the LTE products by about six months – a significant delay in what many analysts have marked as a key driver of the company's near-term growth prospects.

What's Really Going On With Sockets And Shares?
A lot has been made of Broadcom losing connectivity slots in recent Samsung devices to Qualcomm as proof that Broadcom's mobile business is about to face serious trouble. To be sure, I do see some risk that Samsung shifts more business to Qualcomm or Marvell (Nasdaq: MRVL) in the future and/or leverages its purchase of assets from CSR to cut Broadcom out of future designs. Likewise, the announcement of Texas Instruments (NYSE: TXN) selling its connectivity assets to an unnamed buyer (speculation has centered on Apple (Nasdaq: AAPL)) has bears projecting significant share, ASP, and margin losses into the future.

That may be premature. It is true that Qualcomm has been winning sockets that were formerly Broadcom's, but it's also true that Broadcom has been winning baseband business elsewhere and this can actually be more lucrative. What's more, Broadcom has been beating NXP Semiconductors (Nasdaq: NXPI) and gaining some share in the NFC chip market.

It's also worth noting that Broadcom's non-mobile/wireless businesses aren't exactly chopped liver. Although the company wrote down the NetLogic deal by $501 million, the new Trident II networking chip is ramping with customers like Cisco (Nasdaq: CSCO) and Huawei, and these business can still drive worthwhile higher-margin growth.

The Bottom Line
At today's price, I think there's a great deal of bearishness on the company's future in wireless baked into the shares, bearishness that may well overlook the company's strong IP position in system-on-a-chip technologies. While I would not be cavalier about the threat of competition from Qualcomm or Intel (Nasdaq:INTC), nor the risk of “home-grown” solutions from Samsung and/or Apple, I think a lot of the downside may already be in the market.

Just 2% long-term annual free cash flow growth would suggest that Broadcom shares should trade closer to $33 or $34, while I think a worst-case scenario would fall around $27 or $28 per share. There are certainly risks tied to shrinking market growth, shrinking margins, and increasing competition, and these are not shares for investors who don't like or tolerate risk. Even so, while I don't think its appropriate to approach Broadcom with a buy-and-forget mentality, I do believe the shares are too cheap below $28.

Disclosure – At the time of writing, the author owned no shares of companies mentioned in this article.

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