Description

Summary

Let me start out with what this idea is not before even getting into the thesis itself.

1. This is not a roll-up pitch, where I depend on more deals getting done at attractive prices with significant accretion
2. This not an “AVGO will/won’t buy QCOM and therefore…” pitch
3. This is not a “Hock Tan is a brilliant capital allocator and I’d trust him to watch my kids” pitch
4. This is not a faux “me against the world” contrarian pitch - AVGO has a plethora of sell-side coverage, nearly all of which is buy-equivalent rated.

Admittedly, I tend to search for (and prefer) ideas where I see a significant mis-pricing and thus an opportunity for outsized returns based on a fairly visible “monetization path” within a fairly visible timeframe (what some may call “contrarian” calls). Like I said, this is not one of those ideas. Rather, plain and simple, I think AVGO is a high-quality business with a strong mgmt team at a good price. A “long-term compounder” style idea, whose success is too often solely attributed to being a roll-up, which I think unfairly characterizes the true quality of the underlying business and mgmt team (i.e., their earnings growth/success isn’t only due to unsustainable financial engineering).

AVGO can be purchased today at an attractive valuation both on an absolute basis and relative to peers. While AVGO’s valuation has never been all that expensive, I find the combination of 1) undemanding absolute valuation; 2) excellent relative valuation; and 3) the prospect of rising rates taking a bite out of market valuations (thus favoring ideas that have both 1 and 2 above) providing a nice opportunity to own a quality name at a good price.

Company Description and History

(In their 2016 merger, Avago and Broadcom decided to compromise on company name / ticker by calling the combined co. Broadcom but using the ticker AVGO - just an FYI to avoid any potential reader confusion.)

AVGO is a mostly fabless semiconductor company, focused on all of digital, analog, and mixed signal devices, and diversified across multiple end-markets and product lines.

Unlike most “diversified” semis players, AVGO is not a broadline provider. In other words, as opposed to TXN, ADI, MCHP, MXIM and others, AVGO doesn’t make a gazillion different products, many at low-ASPs, that go into everything from toasters to supercomputers. While AVGO does have many products, the portfolio can be more appropriately characterized as several specific product “franchises” that are complex, have clear secular growth drivers, and face minimal competition (either due to high barriers to entry or a consolidated, duopolistic market niche, sometimes both). This differentiates AVGO in multiple ways: 1) AVGO is less cyclically-driven than other, diversified peers (the broadline guys in particular); 2) AVGO faces far less price / commoditization risk than other semis players; and 3) AVGO enjoys high(er) returns on capital.

AVGO has a long, interesting history that bears relevance to understanding the company today. AVGO was originally the semis division of HP and was originally focused on LEDs, fiber-optic transmitters, and optical mouse sensors. In 1999, HP spun off Agilent Technologies, which was mostly focused on test and measurement equipment (and also included what is today KEYS), but which also included HP’s semis division. In 2005, Agilent sold the semis division to private equity - led by Silver Lake and KKR - for $2.7B, making AVGO a pure-play semis company, albeit private, until IPO-ing the unit in 2009.

After acquiring AVGO from Agilent, Silver Lake / KKR installed Hock Tan as CEO. Tan came to AVGO from IDTI/ICSI, where he was chairman of IDTI after running ICSI (Pres and CEO) and selling the company to IDTI. Interestingly, Tan was never an R&D runt who rose the ranks, but rather a Harvard MBA who worked in financial-focused mgmt roles at Commodore, Pepsi, GM, and in venture capital before moving into the semis world.

Back to AVGO. Even before Hock was appointed CEO (in the few months between the Silver Lake acq closing in Dec 2005 and his appointment in April 2006), but certainly continuing under his leadership, AVGO has been very active in asset mgmt, not just on buying assets, but discarding those that didn’t meet specific parameters, regardless of their general quality (those parameters generally being high barriers to entry, minimal competition, strong market position, and complex/high-value-add). At the time of the Silver Lake deal, AVGO’s primary franchises were LEDs, optical components, and wireless filters (known as FBAR - chips that filter RF frequencies; the better the filter, the higher quality of wireless connectivity. These chips are a basic building block of wireless connectivity - particularly in smartphones - and increasingly important with every cellular technology advancement).

Following Tan’s arrival, AVGO made a few smaller moves from 2006-2012, before starting a string of meaningful acquisitions. In 2013, AVGO acquired CyOptics ($400M) and LSI ($6.6B), boosting AVGO’s networking franchise and re-starting the storage franchise (AVGO had previously exited storage in 2006, selling their prior storage business to PMC Sierra - now part of MSCC). In 2014, AVGO bought PLX for $300M (networking), and in 2015, AVGO took down ELX for $600M (storage). Finally, the Big Kahuna, AVGO merged w/ BRCM in a $37B deal in 2016, which was a leader in networking and connectivity. Since the BRCM deal, AVGO recently acquired the storage networking business of BRCD for $5.5B (though they jettisoned the ethernet and wireless networking pieces to EXTR and ARRS), in a deal that recently closed at the end of 2017.

What we are left with today is 4 primary franchises: wired (45% of rev; connectivity, networking), wireless (31% of rev; connectivity, mobile), storage (20% of rev), and industrials/other (5% of rev), with leading positions in high-end switching/routing ASICs/ASSPs (e.g., what ANET standardizes on), SoCs for cable/telco access equipment, wireless connectivity (bluetooth, WiFi, GPS, and wireless front-end/filters), server-storage connectivity, and HDD and SSD controllers, among others. More-or-less, high-end datacenter equipment is rife with AVGO products.

Financially, AVGO is a ~$19B company w/ industry-leading margins (GM% ~64%, EBITDA% in the high-40s, and net income margin in the low-40s) and a strong dividend (2.8%) with a >GDP LT rev growth profile.

Recent History / QCOM

Late in 2017, AVGO went hostile on QCOM, first offering $70/share ($60 cash / $10 in stock) and its now up to $82 ($60 cash / $22 in stock). I don’t want to re-hash the entire saga and certainly there is enough literature on it, given its become a public soap opera. A shareholder vote on AVGO’s nominated slate (for which Glass Lewis is in full favor of and ISS is in partial favor of) was supposed to be March 6, but has since been delayed 30 days or so by CFIUS looking into everything.

Bottom line is the following:

1. AVGO shares appear to be moving somewhat poorly with the news, with the idea that the best-and-final offer of $82 has a large stock component and QCOM’s goal of getting >$90/share would obviously require significantly more equity to make it work
2. My thesis doesn’t depend on QCOM whatsoever
3. If a deal for QCOM does happen, I think its a significant bonus/positive for AVGO and will be a source of significant value creation, so I’m perfectly comfortable in keeping my QCOM comments to this section and keeping the possibility of a deal as gravy.

Let me start by saying that I don’t think NXPI - even if QCOM can close that deal - ever becomes a meaningful part of AVGO. Hock has implied as much and, though a good company, doesn’t fit AVGO’s acq criteria or mold (they are broad-line guys). Thus, I’m going to focus on only QCOM, not NXPI. If AVGO does take down the whole 9 yards, my guess is they divest a significant portion of the NXPI assets.

QCOM fits the AVGO mold quite well - strong secular drivers, duopolistic market niche, and clear market leader. Further, for the most part, I agree w/ AVGO’s assessment that QCOM has been managed far too liberally for far too long (likely due to the rich licensing cash flow stream) and could really use a new look. Other than the very public issues on the licensing front, QCOM’s chip biz does $17B in rev, good for 3rd-largest after INTC and AVGO (among non-memory guys),  and yet carries segment EBT margin <20% and implied GM% of <47% (assuming licensing rev is 100% GM% and costs are all allocated to opex line).

Both metrics are troubling - application processors are pretty value-added devices, especially given that all smartphones run on them and smartphones have overtaken PCs as the connected device of choice. Secondly, QCOM has far and away the market-leading product - multiple media reports of AAPL throttling performance on INTC-based phones punctuated this point.

How are the GM% so low? I think its both due to mismanagement AND pricing games played in conjunction w/ the licensing biz. I think the argument of AVGO being able to negotiate lower licensing rates is a good one, not because QCOM can’t do it, but because AVGO would have a better negotiating position to jack prices on the processors. As a thought exercise - if QCOM slashed its licensing biz by 30%, to make up the difference, GM% on chips would have to be ~59%. That doesn’t seem all that ambitious. At a 50% cut, chip GM% would have to be ~69%, which even though pretty high, doesn’t seem all that crazy to me either.

More importantly, the opex intensity of QCOM’s chip business is ~29%:

• LTM chip revs = $17B
• LTM chip GP = $7.95B (46.7%)
  • Total GP = $13.88B
  • Licensing revs = $5.93B @ 100% GM%
  • = chip GP of $7.95B
• LTM chip EBT = $2.98B
• = chip opex of $4.97B (29%)

By contrast, AVGO is at ~17% opex intensity. Obviously, the opportunity would be for AVGO to bring the chip biz opex intensity to AVGO levels (from a combo of synergies and scale), which should be entirely possible unless there is some structural factor of QCOM’s chip biz opex that makes it more intensive. While there could be a reason why QCOM’s chip biz is more opex intensive (certainly if there is funny business in the R&D accounting between the chip and licensing segments), anecdotally QCOM has long been known for being liberal on spending. Ultimately, that potential opportunity is quite large - closing that 12% gap on $17B of rev = $2B.

Of course the other aspect would be getting back all the lost licensing revs, or at least a portion of it, that is currently going unpaid by AAPL. Using the low-end of QCOM’s estimates ($1.50-2.25/share, not including catch-up payments) on what a future relationship would look like, would yield another $2.2B. Together, that’s $4.2B (it could potentially be even higher, plus catch-up payments), which would even make a $90/share (with $30 of that in stock) deal accretive, with accretion growing as debt is paid down.

This all says nothing of the value of QCOM long-term based on its growth prospects and the quality of its offerings. Bottom line, I think a deal for QCOM would add an entire other leg to the story from which to extract value over many years, but which the thesis is not dependent on.

Thesis / Investment Positives

In order to properly set the stage for the thesis, I wanted to put the comp table upfront, given my view is more-or-less predicated on the idea that AVGO is one of the highest quality companies in semis (and in general), making the valuation compelling.

• Strong, secularly-aligned growth profile
  • AVGO mgmt has consistently described its growth target to be a 5% CAGR over time
    • On an organic basis, AVGO has been significantly exceeding this target
  • AVGO has generally sought to align itself with growth in datacenters and connectivity
    • Wired business benefits from demand for high-speed data connectivity both at the access layer (e.g., fiber/optical networking) and in the datacenter (e.g., AVGO’s ASIC products are the gold standard for merchant-silicon networking equipment, such as what ANET offers and what is increasingly in high-demand)
    • Storage business benefits from insatiable demand for datacenter storage capacity
    • Wireless business benefits from high-speed and general connectivity demand, whether cellular (RF front-end integral for smartphones, fixed wireless, etc.) or in general (WiFi, bluetooth, GPS, etc.).
  • This is a “deeper” level of structural growth than many diversified peers
    • Most have been seeking growth via preferred end-markets (auto/industrial)
    • AVGO’s drivers based on product differentiation more than end-market exposure
    • Large swaths of peers portfolios are commoditized or face significant competition
  • Ultimately, AVGO’s growth has a different flavor than most of its peers
    • Other than INTC, MRVL, SWKS, and QRVO in the table above, AVGO’s peers are all riding a strong up-cycle in general semis demand
    • By contrast, AVGO is riding very specific secular themes that have long-tails with no end in sight
      • For example, saturation of electronics in auto/industrial is much easier to see than the point at which demand for bandwidth/connectivity and storage slows down (let alone becomes saturated)

• Highly-Resilient
  • One of the negative points against AVGO is the appearance of not being all that diversified, given exposure to smartphones, and AAPL in particular is a very large slug of revs (wireless is largely smartphone today and AAPL exposure is ~20%)
  • Nevertheless, AVGO’s continued share and content gains, in addition to other legs of growth in other areas of the business, has already shielded the company from 2 iPhone dud cycles (late-2015/early-2016 and late-2017/early-2018)
    • Both periods, ironically enough, were during qtrs w/ clean comps vis-a-vis acqs
    • In terms of the current period, AVGO pre-announced the Jan-18 qtr and Apr-18 guidance to calm fears over the latest dud
    • Both times, organic growth remained strong - well above 5% target rate for both wireless segment and company overall
  • The resiliency is a testament to the quality of AVGO’s portfolio (i.e. ability to continue gaining share/content) and the strong growth profiles of all franchises that can offset dry spells in any particular area
• Excellent margins
  • Through a combo of tight cost controls (I know its a vague, generic term used too often, but proof is in the pudding I guess) and cost synergies from multiple deals, AVGO has the strongest EBIT%/EBITDA% margins in all of semis, based on a combo of:
    • Tremendous rev scale (2nd-largest among semis)
    • Strong GM% (based on unique product differentiation, roughly in-line w/ TXN and INTC and behind only MXIM and ADI on a meaningful basis)
    • Low opex-intensity (at 17% of rev, well below other large peers and behind only SWKS, who’s a pure-play with significant customer concentration limiting opex intensity)
  • Further, as opposed to broad-line players, AVGO carries far less inventory and thus has a better CCC and better returns on capital
  • As far as returns on capital, given the plethora of calculations, I’ll just leave it at this - AVGO’s tangible book is negative and the Greenblatt ROIC calc is anywhere from >50% to >100% depending on your definition of “excess cash”
    • Greenblatt ROIC being EBIT / (PPE + Net WC - “excess cash”)
  • Even if including intangibles under the idea that AVGO’s intangibles balance represents invested capital given its acquisitive nature (i.e., acquired IP), the metric still regularly yields >25%
• Solid capital allocation policy
  • Dividend is 50% of LTM FCF, w/ the base metric reset at the end of the FY
  • AVGO has never done buybacks given the preference to use M&A as a better form of capital allocation
  • From my perspective, this is fine - either accretive M&A opportunities continue to abound or buybacks will become more attractive
  • Either way, half of the FCF comes back into my pocket, which means it will grow with earnings/FCF and currently represents oa 2.8% yield, tops in the semis group and strong overall
  • Hard to argue w/ mgmt’s track record on putting non-dividend capital to use up until now
• Aligned interests
  • Vast majority of NEO total comp is share based and tied to TSR, both relative and absolute
  • Hock has a separate LTIP with more TSR levels/thresholds

Variant Perception / Bear Case / Things I Don’t Like

• “AVGO is a roll-up”
  • I think AVGO gets too often lumped into the “roll-up” category in the negative sense of they either need deals to grow earnings (which is unsustainable) or the company’s success has been a a product of financial engineering aided by historically cheap debt (also unsustainable)
  • First off, the organic growth has been strong and there have been several pockets of time in the last few years where the comps were clean - either for the entire company or for individual segments.
    • While one could still argue that the organic growth rates shown in those periods would be short-lived, AVGO has never claimed to be anything other than a 5% grower long-term
  • Secondly, look at the deals they’ve done - unlike other roll-ups, AVGO has been more of an asset cherry-picker than a broad consolidator.
    • The BRCM deal was obviously a huge one, but none of the other deals were all that large.
    • Even the BRCD deal was deceiving, given that they only wanted the storage networking piece and offloaded more than half of BRCD in subsequent deals.
    • Point being, the idea that Hock “never met a deal he didn’t like” is a misnomer and rather he has taken the opportunity to consolidate several related technologies and products w/ highly-favorable characteristics onto one platform. AVGO’s deal criteria has been extremely consistent and disciplined.
    • More importantly, Hock has built a sustainable organic earnings grower even when there aren’t further deals to do
• Underspend on R&D
  • I’ve heard the argument that AVGO underspends on R&D and it will come back to bite them
  • I don’t know if this is a real argument, but it seems pretty ridiculous to me - the $3.3B they spent last year is far and away the highest of any semis player not named INTC (who spends an absurd amount on process technology and isn’t competing w/ AVGO anyway) or QCOM (who has little overlap w/ AVGO).
  • Regardless, the plethora of recent share gains would seem to argue different (fast-charging was certainly an interesting one)
• Tapped-out / nowhere to go
  • A potential negative to AVGO could be that there is nowhere to go from here:
    • Margins are already best-in-class (potentially maxed out)
    • The semis space is largely consolidated and AVGO’s size makes future deals of smaller players insignificant anyway
    • Growth is more likely to decelerate than accelerate given strength up until now
  • I still see multiple avenues / levers for AVGO to grow earnings faster than rev, driving >10% earnings growth annually
    • General operating leverage on a mostly fixed cost base provides something at least over above straight rev growth
    • Further, there actually is more room on margins - by segment, wireless is actually a meaningful drag, with segment margins in the high-30s, vs. the other segments in the mid-40s to mid-50s; mix shift alone could improve margins, in addition to further improvements in wireless GM% as demand spreads from 5G applications and isn’t concentrated in the hands of AAPL and Samsung
    • Capital allocation has, thus far, been only divs and M&A, if shifted to debt reduction and buybacks, that’s another ~3% yield coming back to shareholders in other forms
    • Smaller M&A deals, though not game-changing, can add a few percentage points
  • Bottom line - if AVGO can continue growing at least 5% on the rev line, HSD/LDD earnings growth shouldn’t be a stretch
• High AAPL / smartphone exposure
  • As noted above - certainly a concern but AVGO has weathered this storm quite well already and the wireless business should actually become less concentrated (as it has been) over time
• One-sided trade
  • Using sell-side as a gauge, not many disagree with the general view of AVGO as a good company with strong prospects, which I don’t like
  • That said, I see value without building in multiple expansion (which I find is usually the benefits accrued from having a contrarian view on something)
• Potential leverage from QCOM deal
  • If they do the QCOM deal and NXPI is included, the leverage could get pretty high to start, but I don’t see this is a real concern

Risks

• Trouble in smartphone land
  • I don’t really see this as a sustainable problem, but rather something that could cause a hiccup in a given quarter or 2
• Competition
  • AVGO is typically the clear leader in the areas in which it plays, with minimal competitive threats
  • That said, there is some competition in RF front-end (QRVO, SKWS), networking ASICs (MRVL-CAVM), and storage (MRVL-CAVM)
  • I’m not really worried about it near/medium-term, but obviously something always to watch out for
• A dumb, large deal that goes south
  • Also, not too worried about this, but worth throwing out there
  • I’d be particularly concerned if they abandon their strict approach to deals, such as if they bought a broadline player or memory guy, as has been rumored at alternate times in the past, but I question whether truly accurate or just nonsense media speculation
• Exposure to some growth-challenged storage assets
  • AVGO has a large HDD controller business, as well as a the FC Switching business from BRCD, both of which are not considered to be structurally high-growers over the long-term; neither are large enough to ultimately be crippling, though also bears watching
  • I think AVGO ultimately makes some smaller deals in both spaces to counteract those threats (e.g. buying SIMO to bolster SSD controller biz)
• Key Man risk
  • While I said at the top that this isn’t an idea predicated on Hock Tan being invincible always, I’d still argue that he has been a top-notch manager and capital allocator and I would feel incrementally negative on the company’s long-term prospects if he weren’t there.

Estimates / Valuation

This is a tricky one too, given the style of the idea. I tend to look at these types of idea through the lense of multiple more than anything else. Meaning, instead of trying to call a given earnings number (and thus significant near/medium-term price appreciation as that number becomes reality), I will own  as long as the value prop is good at current valuations. Put another way, as long as I feel good about AVGO’s ability to grow rev ~5% and earnings/FCF ~10% annually, an ~8% earnings yield and ~3% div yield look good to me, particularly in light of the peers and the market.

Thus, valuation is a moving target - at a discount or in-line with both peers and the market, I’m staying put, possibly buying more; at a premium to both I may trim; at a large premium to both I may sell. It all depends on where things are in both the semis and broader markets.

Ultimately, I can make the case that Street numbers are too low and that EPS will be >$20/share this year (w/o QCOM), with 5-year earnings power >$25/share, but I don’t own it because I think everyone is so way off, so its not my primary focus. Put another way, the crux of this idea isn’t that the Street is way off.

Catalysts

1. Resolution of QCOM situation
2. Further improvements in FCF as acq-related expenses roll-off and temporarily-elevated capex comes down
3. Continued increases in the dividend
4. Diversification of wireless rev (intro of 5G should help there)

Accelerators

1. Further asset management (both acqs and divestitures)
   
   
   

Catalyst

1. Resolution of QCOM situation
2. Further improvements in FCF as acq-related expenses roll-off and temporarily-elevated capex comes down
3. Continued increases in the dividend
4. Diversification of wireless rev (intro of 5G should help there)