One of the more common questions I get is “If you like 'X' so much, why don't you own it?” Sometimes the answer comes down to not wanting to sell stocks to raise cash, and sometimes it's a question of timing or portfolio allocation. In the case of Avago (Nasdaq:AVGO), a semiconductor stock I've liked for a little while now, it's a little bit of “all of the above”. In particular, though, the general malaise in anything tied to wireless had me cautious, as well as the company's high reliance on China for industrial segment growth.
As it turns out, I needn't have worried. Avago delivered another beat-and-raise quarter, which I argue once again highlights that the company's chips offer pretty compelling advantages that allow for market share gains even amidst challenging end-market conditions. Writing this in the pre-market hours, I don't know if the indicated gains will hold in the market, but while the stock is not the cheapest name around anymore, I think there's enough momentum and quality to the name to lean towards “benefit of the doubt” on value.
Another Strong Quarter
Amidst a still-challenging (or at least erratic) set of end-markets for chip companies, Avago came through once again.
Revenue rose 6% from the year-ago period and 15% sequentially, or 11% on a “core” or organic basis. That was good for a nearly 5% beat relative to the average sell-side estimate. Although weakness in wireless did materialize as feared, Avago still saw growth of 20% and 3%. Networking was strong, though, on 16%/32% (17% ex-CyOptics) growth, and industrial/auto revenue rose 3%/18% and was likewise stronger than expected.
Margin performance was not quite as robust. GAAP gross margin declined about 150bp from last year (and 120bp sequentially), though non-GAAP gross margin fell only 30bp and was 20bp ahead of expectations. GAAP operating income fell about 6% (and rose 19% sequentially), while the more commonly used non-GAAP figure rose 3% and 21%, beating the sell-side target by nearly 9%.
Even though wireless markets remain challenging in general and the industrial recovery is still uncertain, management laid out encouraging guidance. The new revenue midpoint was about 8% higher than the prior expectation, and while GM was tweaked down 30bp, operating income guidance was 9% higher.
Wireless – Some Share At Risk, But Fundamentals Favorable
Wireless chip stocks like Broadcom (Nasdaq:BRCM) and Qualcomm (Nasdaq:QCOM) have been under pressure on fears of slowing high-end handset demand and fears of market share loss (particularly for Broadcom). Although it does seem as though Avago lost some share in filters to Triquint (Nasdaq:TQNT), the company still enjoys strong overall share. What's more, even with high-end handset demand slowing, the need for next-gen phones (whether they're high-end or mid-range) to carry more precision filtering is a net positive for the company.
Strong Networking, But Will The Industrial Recovery Last?
Avago saw a strong quarter in networking, as shipments of a new Cisco (Nasdaq:CSCO) datacenter router with Avago chips helped to boost sales. With strong SerDes wins, this is another example of where Avago can likely continue to see revenue growth even in a relatively sluggish demand environment.
The industrial side of the business is less clear to me. It sounds like Avago got a boost from Chinese demand tied to high-speed rail and power gen, as well as from Japanese demand for servo drivers, but ordering patterns have been a little erratic in the past. Maybe this is looking a gift horse in the mouth, but I'd just be cautious in assuming that everything is fine in industrial once again.
The Bottom Line
On balance, I think I'm still relatively conservative with my Avago expectations. While the 7% long-term growth I'm looking for is pretty high by today's chip standards, I'm not as willing as some sell-side analysts to jack my free cash flow margin assumptions into the high 20%'s. Even so, I am still looking for almost 12% free cash flow growth, and that supports a fair value of almost $43.
A $43 price target doesn't make Avago the cheapest chip stock out there, but I don't really have a problem with paying more for a company with technology edges in multiple markets and that is seeing market share growth as a result.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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