Broadcom Worth A Look

By Stephen D. Simpson, CFA | May 07, 2012 AAA

Investors canvassing the chip sector for ideas today have to make a tough choice - go with quality names like Broadcom (Nasdaq:BRCM) and Qualcomm (Nasdaq:QCOM) and pay premiums that may limit capital gains, or go with cheaper names like Silicon Labs (Nasdaq:SLAB) that have more questions and yellow flags. Broadcom remains a quality play on the mobile explosion (and combo chips in general), and still looks like a reasonable candidate for investors looking to add tech to their portfolio.

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Q1 Shows That Strength Is Always Relative
Investors who weren't aware of Wall Street expectations on Broadcom may well wonder why there seems to be a relatively positive buzz coming out of the chip company's quarter. After all, revenue was nearly flat both annually and sequentially, with not a lot of action (positive or negative) in broadband, wireless or networking.

Margins were a little soft as well. Gross margin dropped about a point sequentially and annually. While reported operating income plunged nearly 80% from last year's level, adjusted (non-GAAP) operating income shows a more moderate 4% annual and 6% sequential decline that is more in tune with the revenue and gross margin trends.

SEE: Understanding The Income Statement

Will the Noise Ever Stop?
One of the intrinsic parts of the Broadcom story is the near-constant buzzing over which company is threatening Broadcom's slot in this or that phone/manufacturer, and how the respective phones are all selling.

To be sure, this isn't all just noise - Broadcom's slot in Apple's (Nasdaq:AAPL) iPhone is important, as are its slots in Samsung's Galaxy line. But I do believe the constant pressure on sell side analysts to have something new (and "impactful") to tell their salesforce leads to a lot of hyperventilation and overreaction.

SEE: The Impact of Sell-Side Research

So, yes, there is a risk that production schedules at Apple will muck with Broadcom's sequential revenue numbers. And yes, there are risks that Intel (Nasdaq:INTC) may gain on Broadcom in baseband and/or that Broadcom may not close the gap with Qualcomm. And yes, there are risks that Texas Instruments (Nasdaq:TXN) or Marvell (Nasdaq:MRVL) catch a tailwind in connectivity. But Broadcom is a company that has won quite a few more battles than it has lost, and I would think these concerns often represent buying opportunities.

The Bottom Line
At this point, I expect Broadcom to deliver solid single-digit compound free cash flow growth over the next decade. That's going to strike many bulls as much too low, but I think the history of the semiconductor sector backs up a more conservative angle; price pressure will be constant and the growth leaders of one generation seldom transition to the same position in the next generation.

SEE: DCF Analysis: Forecasting Free Cash Flow

Fortunately, even a conservative projection points to a fair value in the $40s and enough undervaluation to make these shares worthy of consideration for investors looking for some tech exposure.

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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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