Broadcom In The Right Place At The Right Time

By Stephen D. Simpson, CFA | July 25, 2012 AAA

Broadcom (Nasdaq:BRCM) continues to deliver the goods. In a market rattled by bad tech earnings numbers, particularly in chips and communications, this leading communications chip company once again posted solid results and encouraging guidance. While the exceptional popularity of Broadcom concerns me, the numbers are what they are and Broadcom still looks like a good stock to own.

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Second Quarter Earnings
Broadcom did well across the board this quarter, even though Apple's (Nasdaq:AAPL) phone performance was a little soft.

Revenue rose 10% from last year and 8% from the first quarter, or 5% on an organic basis. This was only a small beat relative to expectations, but a beat all the same. Broadband revenue grew almost 10% sequentially, while mobile/wireless grew 3% and infrastructure rose 18%.

Margin performance was mixed - not great in absolute terms, but solid relative to expectations. Product gross margin fell three points from last year and a point and a half from the prior quarter. Operating income fell 11% from last year, but improved significantly on a sequential basis. Using the popular non-GAAP numbers, Broadcom posted a 1% annual decline in operating income and a slight (0.4%) improvement sequentially.

SEE: A Look At Corporate Profit Margins

Waiting for Apple and a Bigger Communications Recovery
Apple is a 10%+ customer for Broadcom, as is Samsung, so the company was likely able to play relative market strength in the latter against some weakness in the former. With the much-anticipated upcoming new iPhone launch, though, Apple revenue should be a bigger factor later this year, and management's solid guidance would seem to back that up.

It's not all about Apple or Samsung, nor other mobile devices like the Amazon's (Nasdaq:AMZN) Kindle Fire. There's a much bigger ecosystem of baseband, set-top boxes, networking, satellite and VoIP that Broadcom supplies, and a lot of these markets have been fairly stagnant of late. While market growth here may not revive this year, Broadcom would at least appear to be gaining share in many of these businesses with customers like Cisco (Nasdaq:CSCO).

SEE: Four Online Shopping Alternatives To Amazon

Is the Samsung Business at Risk?
The market did not like the news that Samsung had agreed to buy the connectivity chip business of CSR (Nasdaq:CSRE), and with good reason - connectivity chips are Broadcom's bread and butter in the mobile marketplace. The threat is clear - that Samsung will use its newly bought internal capabilities to design and build its own connectivity chips and cut Broadcom out of future designs.

This is a legitimate and real threat. Broadcom is ahead of CSR in terms of technology and product performance, but Samsung's large R&D capabilities could cut into that lead. If they cannot, it creates an interesting dilemma - to use an inferior chip (and "validate" the acquisition) and risk losing phone share on performance issues, or give up the margin advantage and continue using Broadcom.

For better or worse, this is just part of the business risk at Broadcom. Even if Samsung hadn't bought CSR, who's to say that Texas Instruments (NYSE:TXN) or Qualcomm (Nasdaq:QCOM) may not have won sockets in later phones anyway?

SEE: Cell Phone Evolution

The Bottom Line
Broadcom remains a strong and popular name in chips; perhaps too popular, given the 38 buy/strong buy ratings against seven holds and two underperforms. Nevertheless, if the company can continue to execute, the numbers will drive valuation higher.

I expect mid-single digit free cash flow growth over the next decade. While that may strike some as low, I would not ignore the ongoing competitive pressures in the business. In any case, that growth rate is sufficient to support a fair value in the mid-$40s and while I worry that the company may be too popular, value is value.

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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