Growth In Broadband & Infrastructure To Offset Decline In Broadcom’s Wireless Revenue In Q2’14

Leading semiconductor provider for wired and wireless communications Broadcom (NASDAQ:BRCM) will announce its Q2 2014 earnings on July 22. Despite a marginal decline (4% sequential and 1% annual) in its Q1 2014 revenue, we believe the company performed well in a seasonally down quarter. While Broadcom witnessed strong growth in its broadband and infrastructure business segments, it reported a steep decline (10% sequential decline) in its connectivity business. Last month, it announced its decision to exit the cellular baseband business on account of intense competition in the market. The company intends to instead increase its focus and competitiveness in the broadband, infrastructure and connectivity businesses.

Broadcom expects its wireless business to decline in Q2 2014 but anticipates revenue to increase by 3% (at the mid-point of its guided range), driven by continued strength in its broadband and infrastructure business. Additionally, the company believes that a favorable mix and improvements in certain non-standard, non-recurring costs will help improve its gross margin in the quarter. Margins have been under pressure due to increased price competition in the 3G chipset market and higher-than-expected levels of excess and obsolete inventory.

Broadcom’s stock price has increased by approximately 20% after the company declared its intent to exit the cellular baseband market. Our price estimate of $38 for Broadcom is now in line with the current market price. We will update our valuation after the Q2 2014 earnings release.

See Our Complete Analysis for Broadcom Here

Broadcom Exits The Baseband Market; Remains A Leader In Connectivity Solutions

Broadcom’s mobile and wireless business can be split into two parts: connectivity solutions and baseband solutions. With a 33% market share, Broadcom has been the leader in connectivity solutions for many years and, despite losing some low-cost smartphone sockets to Qualcomm (NASDAQ:QCOM), Broadcom claims that its market share in the segment remains stable. On the other hand, Broadcom accounts for less than 3% of the mobile baseband and application processor market.

The company has engaged investment bank JP Morgan to explore strategic alternatives for its cellular baseband business, including a potential sale or wind-down. The company expects the sale or wind-down of its cellular baseband business to result in a $700 million reduction in annualized GAAP research and development (R&D) and selling, general and administrative (SG&A) expenses, including $100 million in estimated reductions in stock-based compensation. Broadcom plans to originally reinvest around $50 million of these savings on an annualized basis into projects in the broadband, infrastructure and connectivity businesses.

A substantial increase in R&D expenses for developing cellular baseband products has lowered Broadcom’s mobile and wireless operating income in the last two years. The baseband market is quite R&D intensive, and Broadcom has spent over $3 billion on cellular baseband related R&D since 2007 without earning any profit. ^[1] (Read: Rising Competition Forces Broadcom To Exit The Baseband Market)

Data center remains a strong growth driver for Broadcom, with its leadership in high density Ethernet switches a key driver. Broadcom’s infrastructure and networking revenue was above the company’s expectation in Q1 2014 and grew 1% sequentially and 35% year on year.

Strength in the quarter was driven by continued growth in Broadcom’s switching business, particularly in the service provider and data center markets. It continued to see strong demand from service providers for a broad range of switch and processor solutions that power base stations, back haul and the core of the network. The service provider market growth was mainly driven by LTE build-outs in China, while data center growth was driven by the transition to public cloud and broad adoption of Broadcom’s leading merchant platforms.

We expect the company to benefit from the ongoing transition to 4G LTE in China, where it has secured wins for switches, processors, the back haul and other technologies. Currently, only China Mobile is aggressively building out its TD-LTE network, but we expect the other carriers to join the fray soon as FDD-LTE licenses are rolled out in the coming years.

Broadcom continues to deliver innovative solutions that set the stage for an industry transition to more virtualized scalable data center architectures. Its next generation Trident II is now in volume production and Broadcom expects the same to contribute to its growth momentum in networking through 2014.

Broadband Business To Be Driven By The Set-Top Market & Access Business

Broadcom is seeing strong momentum in its VDSL and PON sales due to share gains, increased operator spending and new operator service launches. Its access business grew in Q1 2014 as operators continued to deploy the latest technologies including VDSL upgrades to power faster connections in the home. Additionally, the company gained share in PON globally and saw continued unit growth driven principally by China.

The set-top market is another important growth driver for Broadcom. Driven primarily by rising demand from emerging markets, the global set-top box shipments are forecast to grow at a CAGR of 9.7% through 2016. Broadcom claims that in Q1 2014 it gained share in international markets on account of rising digital penetration and new designs which came to market in Russia, Europe, Central and South America.  In developed countries, the industry is transitioning to ultra HD along with HEVC, which will drive richer content in the set top box for years to come, a trend that will benefit Broadcom.

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1. Intense 3G Price Competition and 4G LTE R&D Took Toll On Broadcom Baseband Business, Strategy Analytics, June 2, 2014 [↩]