Factors That Can Significantly Increase Our Valuation For Broadcom

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Broadcom

A leading semiconductor provider for wired and wireless communications, Broadcom (NASDAQ:BRCM) has seen continuous top line growth in the last five years, though its bottom line (net income) shrank from $1.08 billion in 2010 to $424 million in 2013, as its operating expenses grew at a much faster rate. The company announced its decision to exit the cellular baseband business in Q2 2014 on account of intense competition in the market, allowing it to eliminate the ongoing losses from the business and shift its focus to its core strengths in other segments. The strategy seems to have worked well, as Broadcom’s net income increased from $424 million in 2013 to $652 million in 2014 (54% growth), even though its revenue base remained relatively flat during the same period.

In the last one year, Broadcom’s stock price has increased by over 50%. We believe that Broadcom’s operating performance will continue to strengthen on a tight operating expense discipline and strong margins, consistent with the company’s objective of driving profitable growth. We believe the business will see strong growth in the future driven by product cycles and new launches from key customers.

Our price estimate of $44 for Broadcom is marginally below the current market price. In this article, we list down certain factors that can lead to a significant upside in our valuation for the company.

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See Our Complete Analysis for Broadcom Here

Broadcom’s Wireless Connectivity Market Share Increases to 40%  (~10% Upside)

A quarter or two back, Broadcom expected its connectivity business to decline in 2015. However, the company now claims that its overall connectivity portfolio is definitely strengthening, and expects the business to probably be flat or even up on a year on year basis this year. Broadcom claims that a lot of concerns that it had about the loss of business on exiting basebands have not materialized and the company does not expect them to at this point. Broadcom expected that its exit from the baseband business would negatively impact the low-end of its connectivity business. However, the company has in fact gained share in the low-end of the market in the last few quarters. Some of Broadcom’s partners are gaining share in the baseband space, which helps Brodcom’s penetration in the market.

New phone launches, rising consumer adoption of new high end phones, growing penetration of new technologies (such as 802.11ac and 2×2), and the ramp of new highly integrated products such as the location hub that all direct higher ASPs, are driving demand for Broadcom’s connectivity business. The company claims to be seeing significant customer interest in its latest 5G Wi-Fi chip that offers an industry first real simultaneous dual band or RSDB. This technology, which allows a smartphone or tablet to transfer data across two bands, is expected to ship later this year. It also at the same time enables new applications and increases the performance of existing applications.

In addition to smartphones and tablets, Broadcom sees new growth potential in emerging markets, including the Internet-of-Things (IoT), automotive electronics, wearable devices and small cell technology. The company continues to drive leading-edge features so as to maintain its strength in high end smartphones and tablets. It is strengthening and diversifying its portfolio with new low power connectivity solutions for the IoT and the support of iBeacon and HomeKit. The registrations for Broadcom’s WICED IoT platform have grown significantly, from 2,000 at the beginning of 2014 to over 8,000 at present. The company has announced the expansion of its distribution channel with over 40 new partners to expand its sales reach to IoT customers.

We currently forecast Broadcom’s share in the wireless connectivity market to remain at the current level for the rest of our review period. IoT is still at a nascent stage and is widely expected to be the next big wave in computing, after smartphones and tablets. It is likely that we are currently underestimating Broadcom’s potential in the wireless connectivity market. If the company continues to gain additional share in the low-end of the smartphone market, and becomes a significant player in the fast expanding IoT space (Broadcom is the No.1 player in smartphones connectivity so it can easily be expected to be an important player in IoT as well), then its market share in wireless connectivity could increase in the future. If Broadcom’s wireless connectivity market share rises to 40% by the end of our review period, then there will be a 10% increase in our valuation for the company.

Infrastructure & Networking Market Increases to $20 Billion (>10% Upside)

The infrastructure & networking market has grown from $2.5 billion in 2008 to around $7.5 billion in 2014, growing at a CAGR of 20%. Given the strong growth rate the business has seen in the past few years, we expect the growth to slow going forward. We forecast the infrastructure & networking market to increase to $13 billion by the end of our review period, growing at a CAGR of 7%.

Long-term growth drivers for Broadcom’s infrastructure business include: 1) new build-outs and expansions of data centers; 2)  increasing data traffic at faster speeds; 3)  ASIC conversions to merchant solutions; and, 4) overall enterprise network upgrades as people move to higher speeds. Broadcom expects double-digit growth in its infrastructure business for the next few years. Though Broadcom admits that the infrastructure business remains lumpy in the short term, the company believes it will benefit from new product launches and capabilities rolling out in the near future. We expect the overall infrastructure & networking market to grow in double digits for the next two years, and forecast the growth rate to taper off thereon.

It is possible that we are being less optimistic and not accounting for the full potential of the infrastructure & networking market. If the market grows faster than we expect, reaching $20 billion in the next 5 – 6 years, there will be a more than 10% upside in our valuation for Broadcom.

SG&A Expenses As A Percentage of Gross Profit Remains At The Current Level (>10% Upside)

Broadcom’s selling, general and administrative expenses (SG&A), adjusted for stock-based compensation, as a % its gross profit has averaged around 13% in the last three years. We currently forecast the ratio to increase in the next two years and remain stable thereon for the rest of our review period, as we expect Broadcom to incur additional SG&A costs to market its new products and technologies. If SG&A costs as % of gross profit remains around the current level of 13%, then there will be a more than 10% increase in our valuation for Broadcom.

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