Description

Broadcom, formerly known as Avago, designs, develops, and supplies a broad range of specialized semiconductors for connectivity solutions, and outsources its manufacturing to third-party foundries.

AVGO is a diversified, high-quality business with excellent management and an attractive valuation, assuming organic growth alone. However, the company is a proven acquisition platform as well, which provides additional upside. We believe it has at least 20% upside as-is, and over 30% assuming future potential acquisitions.

Background:

AVGO today is the result of years of effective and disciplined acquisitions of various specialized semiconductor companies. Initially, Avago was a part of the Agilent spinout from Hewlett-Packard. KKR and Silver Lake purchased the Avago division from Agilent and took Avago public in 2009. Since going public, management has focused on acquiring a portfolio of highly-defensible semiconductor franchises that fit a set of attractive criteria we will highlight below. Any acquired business lines that didn't fit these criteria have been divested, leaving the company with a lean and coherent business. The company's biggest acquisition to date was of Broadcom, in February of this year, at which time Avago took the Broadcom name but kept its ticker. The acquisition added 7 new business lines to the company, for a total of 19 franchises in 4 segments.

AVGO's segments are Wired Infrastructure, Wireless Communications, Enterprise Storage, and Industrial. A very brief description of each segment follows.

Wired Infrastructure, which contributes 58% of company revenues (now, post-Broadcom acquisition), makes chips for set-top boxes, cable modems, routers, and ethernet switches for cloud-scale networking. AVGO is deeply entrenched with its customers in this category (similar to the whole business), which include Cisco, Alcatel-Lucent, Juniper, HP, and Arista. Co-development of products often takes several years, an indication of how sticky customers are likely to be. AVGO has #1 market share in most applications in this segment, including set-top boxes (>60%) and enterprise ethernet switching. This segment (and industry) is growing in the low-to-mid single digits and should continue to do so.

Wireless Communications, which contributes 22% of revenues, makes chips for smartphones, primarily radio-frequency filters for Apple and Samsung. While global smartphone growth is slowing from double-digit to single-digit rates, with projections of a 5-6% cagr over the next 5 years,* demand for the RF filters that

AVGO makes is growing much faster, as content is increasing in phones to enable rapidly increasing data demand and frequency congestion. Estimates from Qorvo, a competitor to AVGO, call for 15% annual growth through 2018 in the RF filter market due to content growth and mix-shift toward premium phones. AVGO itself is seeing 20% content growth extending for the next couple years. Also within the segment, AVGO makes chips for WiFi, Bluetooth, and GPS applications. Demand growth for these applications is lower than for the RF filters, leading to segment growth rates in the high-single digits.

Enterprise Storage, which contributes 15% of revenues, makes chips for reading and controlling hard-disk drives, solid-state drives, and connecting with and controlling large storage arrays. Because of well-known declines in hard-disk drive shipments,** offset somewhat by growth in solid-state drives, this segment is expected to decline in the low-single digits.

Industrial & Other, which contributes 5% of revenues, makes chips for a variety of factory automation, automotive, power generation, and other applications. The segment also includes revenues from IP licensing, which tends to be lumpy. Growth in some applications has been offset by declines in others, leading to roughly flat growth trends in this segment.

Combined, AVGO guides to long-term topline growth of >5%.

Quality company:

The quality of the business is evident qualitatively and quantitatively.

AVGO management has stated many times the characteristics it seeks in any line of business it enters or acquires. These are:

1) Sustainability. As the CFO said in the Q2 2016 earnings call, "The most important element of our model is sustainability of the franchise, as we invest in it over the long term." AVGO seeks businesses in which it can partner with customers and invest for the long-term on co-development of products, leading to high stickiness and visibility. The CEO added, "We go 100% in for the customer, and we invest to develop those [differentiated] products. In return, we ask for certainty, we ask for partnership and we tend to enter into long-term strategic partnerships with the customers where they will continue to use us for future generations of products."  

2) Market leadership. The CEO said at the SIG tech conference in March of this year, "We are the leader... the incumbent... in most of the product lines we're in. Our key strategy is to be very focused in each of these businesses and continue to ensure we remain number one."

3) High barriers entry. AVGO seeks businesses "built on the back of proprietary and highly defensible technologies" (Q2 '16 call).

4) Pricing power. The CEO said in the Q3 2011 call, "As I said, our long-term business model is to provide products that have a price differentiation." And again in the CyOptics acquisition call in April of 2013: "Our business model is very simple, premium products sold at premium prices... All our product lines... have the ability to leverage on this simple edict, which is, we can develop products at a totally differentiated high performance, and we'll do it provided we can sell it at a premium price to the right customers." Barron's has an article from Aug 9 highlighting this strength of AVGO with regard to pricing pressure from Apple.***

The company has been consistent in driving toward these objectives. At the SIG conference the CEO emphasized, "It's a business model I would say that hasn't changed over the last five years, six years, seven years." The company's financial metrics, operating history, and historical comments confirm this statement.

From a quantitative standpoint, the quality of the business is equally apparent. The company is running very close to its current long-term financial targets, which are:

• Gross margins: >60% -- last quarter at 60% (non-gaap, company-reported for all)

• R&D as a % of revenue: >16% -- last quarter at 19%

• SG&A as a % of revenue: 4% -- last quarter at 4%

• Operating margins: >40% -- last quarter at 37%
  
  

With targets like these and an asset-light manufacturing model, returns on invested capital have been and should continue to be very high. Last year, ROIC was 18%, and with the exception of 2014 when AVGO made two big acquisitions, ROIC has ranged from 20% to 30% over the prior five years (Bloomberg stats).

In addition, the positive trend in the company's financial targets over time, and its success in meeting and exceeding these targets is a strong indication of the quality of the business. Let's trace the company's steadily increasing financial targets since it went public:

• In Q4 of 2009, the company's target gross margin was 45%, and operating margin, 18%.

• At Analyst Day in Sept of 2010, the company's target gross margin was increased to 50-53%.

• Also in Sept of 2010 at a DB tech conference, the CEO commented, "We have a model of expanding gross margin and expanding operating margin."

• In Q1 of 2012 they commented, "Year on year, we tend to improve our gross margin 100, 150 basis points... And we still maintain that model, 100, 150."

• By Q3 2012, the company's implied operating margin target was 29-32%, a number they were already achieving.

• In April of 2013 they commented, regarding their acquisition of CyOptics, "We are not changing our long-term Avago model as a result of this transaction. To remind you, our long-term model is to... achieve gross margins north of 50% and operating margins around 30%... By the time we exit fiscal 2014 we expect to have significantly improved CyOptics' gross margin and drive its operating margin to Avago's target model."

• In Q1 of 2014 they said, "We successfully improved the gross margin of the CyOptics business to our targeted level... three quarters ahead of our original plan."

• By Q1 of 2016 they had increased their target gross and operating margins to present levels of >60% and >40%, respectively.
  
  

Another indication of the quality of the business and its management is the company's history of meeting the cost savings targets it has projected for acquisitions:

• The $400 mm acquisition of CyOptics. Cost savings were achieved three quarters ahead of schedule, as noted above.

• The $6.6 bn acquisition of LSI in May of 2014. The company projected $200 mm in cost savings would be achieved by the end of fiscal 2015. By Dec of 2014 the company commented, "We're running ahead of our financials, achieving financial synergies." By December of 2015 the company said, "We drove... the full achievement of LSI acquisition cost synergies to deliver operating margins over 40%. In other words, mission accomplished."

• The $606 mm acquisition of Emulex in May of 2015. By Q3 of 2015 the company commented, "Total operating expenses [were $5 mm below guidance]... because of cost synergies from the Emulex transaction being realized faster than expectations.
  
  

And so far, the company is on track with its Broadcom acquisition as well, which has a target of $750 mm of cost savings. In the Q2 2016 call the company reported, "Earnings came in significantly above expectations, enabled by delivering gross margin at the high end of guidance and driving faster-than-expected realization of acquisition-related cost synergies."

There isn’t a single example in AVGO's history as a public company of management guiding to cost savings or synergies and not meeting or exceeding those targets.

Valuation:

AVGO currently trades at 14.2x ntm consensus earnings, 11.5x ntm cash flow, and 11.6x ntm ebitda. The street expects earnings to grow 22% this fiscal year, 18% next year, and 7.5% the following.

The company seeks mid-to-high single-digit long-term revenue growth, before acquisitions, and with that topline growth, expects double-digit earnings growth.

At a high level, we think a business of this quality and earnings growth power should have a higher multiple -- at least a market-level one! In fact, despite growing earnings 4x over the past 5 years, and 2.5x in the last 2, its multiple has barely budged, and actually declined in the last couple years as seen in the following chart:

In our proprietary valuation model, which projects earnings six years forward and applies a discounted market-level multiple to those earnings, we see a base case fair value of $205, or ~20% upside. Additional upside is likely both from current operations and potential acquisitions.

The company hints at the potential for additional synergies from current operations in transcripts. In the Q1 2016 call they said, "We continue to expect we will achieve the $750 million target in annualized cost synergies over the next six fiscal quarters, and we think we might be able to even beat that." They emphasized that there are additional cost savings that will come from discontinuing and divesting certain parts of the Broadcom business, but that they do not count these in their $750 mm target. Hence these would also provide additional upside.

The company's history in constantly exceeding prior guidance gives weight to these hints. RBC had a recent research report with the amusing headline, "Even Interest Expense Can't Escape THE HOCKATHON," referring to Hock Tan, the company's CEO since 2006. The report describes a recent debt refinancing that should reduce annual interest expense by $100 mm and add a couple percent to eps.

The likelihood of additional upside from future acquisitions is clear from the CFO’s comments in the recent Q2 2016 earnings call: "Going forward, we believe acquisition opportunities will continue to present themselves... As a result, we currently intend to limit the paydown of our expanding term loans until our gross debt is approximately two times ebitda, at which time we intend to start pooling excess cash for the purposes of M&A."  The CEO added, "We think there are opportunities out there that are very interesting. And opportunistically and cared properly, carefully, we will keep pursuing that strategy."

Sellside analysts have identified a healthy group of small-to-large-cap candidates that would meet AVGO's target criteria and could each provide mid-single to low-double digit earnings accretion.

Should AVGO find attractive candidates, we are inclined to believe the company will execute as it has done in the past, and extend the dramatic earnings growth trend of the past few years.

In our valuation model, one additional mid-cap and one additional large-cap acquisition that together provide 15% earnings accretion (in the next three years) results in a fair value target of $225, or ~30% upside.

Conclusion:

AVGO has proven itself to be an extremely high-quality and well-run business. It has material upside to fair value as-is, but there is a high probability for additional organic and acquisition-related upside as the company continues doing what it has done since it went public.

Key risks:

• Company fails to achieve targeted synergies in the Broadcom acquisition, which is roughly 5x bigger than its previous biggest acquisition.

• Company suffers from customer concentration, with 20-30% of sales at Apple and Samsung, and 46% of sales from the top 5 customers. Note, concentration is down post the Broadcom acquisition, with top-5 concentration at 65% in fiscal 2013 (RBC analysis). Also, note the Barron’s article which highlights AVGO’s strong position vis-a-vis Apple.
  
  

Citations:

*http://www.idc.com/getdoc.jsp?containerId=prUS41061616

**http://www.anandtech.com/show/10315/market-views-hdd-shipments-down-q1-2016

***http://blogs.barrons.com/techtraderdaily/2016/08/09/apple-likely-pressuring-suppliers-on-price-says-rbc-broadcom-adi-best-positioned/

Catalyst

Potential near-term catalysts:

• Better-than-expected Apple iPhone sales combined with substantially higher AVGO content, as detailed by AVGO CEO in the Q2 2016 call.
• Better-than-expected hard disk drive trends (which Seagate and Western Digital have been indicating), which could reduce or reverse declines in the Enterprise Storage segment.
• Alleviation of a production bottleneck in the Wired segment which the company reported in the Q2 call, and said progress was being made rapidly to fix the issue.

Medium-term catalysts:

• Full realization of expected Broadcom synergies. The company expects to end this fiscal year (in October) slightly ahead of plan on achieving the Broadcom synergies, with full realization coming in the first half of fiscal 2017.
• Realization of additional suggested synergies.
• New accretive deal announcements.