Broadcom Stands Out In A Weak Crowd

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

Against the host of weak sisters that make up most of the semiconductor space today, Broadcom's (Nasdaq:BRCM) product cycle-driven strength really pops out. And yet, the stock really hasn't done all that well over the past year. While I do worry that going long on Broadcom is a crowded trade, it's tough to argue with one of the strongest chip stories available today.

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Another Solid Quarter at Broadcom
Due at least in part to ongoing success with Apple (Nasdaq:AAPL), Broadcom delivered another solid quarter. Revenue rose 9% from last year as reported, and about 8% over the second quarter with organic growth of 4% and 8%, respectively. Growth was driven by the large mobile/wireless business (up 14% sequentially), but all units were up for the quarter.

Profitability was a little more complicated, as it often seems to be for tech companies. On a GAAP basis, gross margin declined about a point from last year and rose almost two points from June, while non-GAAP product gross margin actually improved over a point from last year and stayed basically flat sequentially. GAAP operating income declined more than 20% from last year, but rose 39% sequentially. On a non-GAAP basis, income improved over both time periods, though the non-GAAP margin declined a bit from last year.

SEE: Analyzing Operating Margins

Guidance Is Still a Relative Thing
Broadcom management revised its guidance down by about 4% relative to the prior consensus. Relative to the wider universe of chip stocks that have reported so far, including names such as Intel (Nasdaq:INTC), Linear (Nasdaq:LLTC) and Texas Instruments (NYSE:TXN), that revision isn't bad (nor is the full year 2012 growth rate). What's more, it makes sense given season trends at major customers such as Apple, Samsung, Amazon (Nasdaq:AMZN) and Google (Nasdaq:GOOG). Nevertheless, it's a negative revision and investors seldom welcome that.

SEE: Revenue Projections Show Profit Potential

Widening the Gap in Connectivity, While Trying to Improve Infrastructure
Broadcom does exceptionally well in connectivity, with what looks like more than two-thirds share of the combo connectivity chip market. Although some analysts and investors worry that Qualcomm (Nasdaq:QCOM) and Samsung are going to chew into that lead, a new chip that will ship into first half 2013 launches looks like it should only increase the technological gap.

Elsewhere, the company is also trying to improve its standing in areas such as networking (part of its Infrastructure segment). A new Ethernet chipset (Trident II 10G) should launch next year with top-tier customers Cisco (Nasdaq:CSCO), Juniper (Nasdaq:JNPR) and Huawei. Although this sounds like a good product for Broadcom, I'm still a little nervous about the overall outlook for networking product demand in 2013.

Where Do You Go from the Top?
Much as I like Broadcom, I do have my concerns. With so much share of the connectivity combo chip market, how much longer can Broadcom significantly outgrow its markets? Along similar lines, can the company maintain both share and margins over time? They're different companies serving different markets, but companies such as Analog Devices (NYSE:ADI) and Linear have in the past been forced to choose between the two, as rivals step up their capabilities over time in particular markets/products.

Along the same lines, it seems like almost everybody likes Broadcom and many analysts have it tagged as their top pick. A few analysts may talk about worries tied to competitors like Qualcomm, limited operating leverage and/or a lack of capabilities/leverage in areas such as baseband and 4G LTE, but there's already a lot of people out there flogging positive calls on this stock.

The Bottom Line
Other chip names such as Qualcomm, Fairchild (NYSE:FCS) and ON Semiconductor (Nasdaq:ONNN) may all be worth a look today, but it's hard to say that Broadcom doesn't continue to look like an interesting name in the space. At a minimum, the company still has the support of leading consumer companies such as Apple, Google and Amazon.

Assuming that Broadcom can successfully aspire to free cash flow margins on par with Analog or Maxim (Nasdaq:MXIM), Broadcom should be able to support long-term free cash flow growth, at least in the mid-single digits. That rate of growth suggests a fair value in the low $40s, though the dynamics of the chip industry argue against a steady step-wise year-on-year improvement. As a result, I'd still be favorably inclined towards adding shares of Broadcom, even if it does seem a little too popular with the sell-side.

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

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