Deep Dive $BRCM – 1 Major Concern, and 2 Reasons for Optimism

by Enis December 12, 2013 12:22 pm • Commentary

Dan had a good call about the potential for a bounce in BRCM after their analyst day in his Name That Trade post on Tuesday.  The stock’s breakout to a 4 month high caught our attention, especially given the better-than-expected news.

I wanted to take a more in depth look at the company’s fundamental situation.  Broadcom is a chip company that primarily supplies circuits for cable set-top boxes, cable modems, direct satellite and digital broadcasts, and digital subscriber lines.  The company offers 600 products grouped into 60 different product lines.  The company is split into 3 main reporting segments, each with about an equal share of profits.  From the company’s 10-Q:

Broadband Communications (Solutions for the Home) — Complete solutions for cable, xDSL, fiber, satellite and IP broadband networks to enable the connected home, including set-top-boxes and media servers, residential modems and gateways, small and residential cells and wired home networking solutions.

Mobile and Wireless (Solutions for the Hand) — Low-power, high-performance and highly integrated solutions powering the mobile and wireless ecosystem, including Wi-Fi and Bluetooth, cellular SoCs, global positioning, near field communications (NFC), Voice over IP (VoIP), and mobile power management solutions.

Infrastructure and Networking (Solutions for Infrastructure) — Highly integrated solutions for carriers, service providers, enterprises, small-to-medium businesses and data centers for network infrastructure needs, including Ethernet switches, physical layer devices (PHYs), multicore embedded processors, knowledge-based processors (KBP), switch fabric solutions, high-speed Ethernet controllers and microwave backhaul devices.

In short, Broadcom is an extremely diversified company, with exposure to various end-markets.  But with a strong market backdrop in 2013, why is the stock down 15.5% this year? Well… 

The stock took a big hit on its July earnings report, when it reported a major impairment in one of its businesses:

In the three months ended June 30, 2013 we recorded impairment charges of $501 million, of which $461 million related to our acquisition of NetLogic. The remaining $40 millionof the impairment is primarily related to our acquisition of Provigent, Inc. Both of these acquisitions are included in our Infrastructure and Networking reportable segment. Based on our impairment analysis, as further detailed below, we impaired $358 million of completed technology, $91 million of IPR&D, $50 million of customer relationships, and $2 million of other purchased intangible assets.
During the six months ended June 30, 2013 we had a steady reduction in near-term sales forecasts for NetLogic products sold into the service provider market, which caused us to review our long-term forecasts. In addition, we downwardly revised our longer-term expectations of the size of the addressable market for these products. As a result of these triggering events, we performed a detailed impairment analysis of the long-lived assets associated with these products during the three months ended June 30, 2013. Based on our analysis, we determined certain assets acquired from NetLogic were not recoverable and impaired, requiring us to reduce the associated carrying value to fair value. Specifically, we impaired $238 million of completed technology, $88 million of IPR&D and $48 million of customer relationships related to our embedded and knowledge-based processor products. We also impaired$87 million of completed technology related to our DFE processor products. For DFE, one of our smaller product lines, our customers indicated that they prefer custom solutions as opposed to standard merchant solutions. In response, we have decided to redirect our efforts by focusing on developing customized solutions, and have consequently fully impaired the assets related to the acquired DFE merchant product line.
Even the explanation is concerning, with management only now figuring out that customers preferred “custom solutions as opposed to standard merchant solutions.”  Maybe they should have figured that out before purchasing NetLogic back in early 2012.
The write-down was an accounting entry and did not affect the company’s operating cash flow going forward, but it was a serious signal of reduced operating performance for the NetLogic segment going forward.  More concerning to me is the lack of strategic foresight by management, displayed as much by the language of the disclosure and the timing (less than a year and a half after the acquisition), as by the write-down itself.
Traders reacted aggressively, taking the stock below the crucial $30 support level from the past few years (blue candle through the red line in July):
[caption id="attachment_33678" align="alignnone" width="600"]BRCM weekly, Courtesy of Bloomberg BRCM weekly, Courtesy of Bloomberg[/caption]
While the stock bounced a bit on better than expected guidance earlier this week, it has given back most of those gains today.  The more important longer-term question is whether BRCM’s businesses are perennial laggards, or whether its poorly thought-out purchase of NetLogic and some one-time weakness this year will be remedied going forward.
Two reasons for optimism:
1)  Valuation.  BRCM has grown sales in every year in the past decade, except for 2009.  The company has doubled sales since 2007, and earnings next year will also be more than double 6 years ago.  But the stock has stagnated as investors worry about future growth.
Here are Dan’s thoughts on valuation from Tuesday’s post:

Valuation & Balance Sheet:

The stock is sorta of cheap, trading at 11.5x next years expected earnings, which are supposed to be down 9% year over year, on sales that are only expected to grow for the second consecutive year at low single digits percent.  This is in comparison to INTC and QCOM that both trade a tad above 13x earnings.  Relative to INTC it looks cheap as analysts expect no growth in earnings or sales in 2014.  Compared to QCOM not so much as the company is one of the few large cap semiconductor companies that the street sees earnings growing double digits and sales high single digits.

BRCM has a very strong balance sheet with 27% of their market cap ($4.3 billion) in cash, or about 17% net of their debt.  The company has committed to returning more than 60% of their free cash flow back to shareholders, paying a dividend that yields 1.59% and have a multi-billion share repurchase agreement in place.

2)  The management missteps in the past couple years are substantial.  However, one reason for optimism is that Henry Samueli, Chairman and CTO, is a Co-Founder of the company, while Scott McGregor has been CEO since 2005, and has vast experience in the industry.  They are no slouches, and BRCM is still a major player ($16 billion market cap) with financial firepower to compete going forward.

Those 2 points are enough reason for me to keep an eye on BRCM stock, but not enough to consider it as a potential long opportunity (except for maybe a technical trade) at any point in the near future.  The company has to show that its business write-offs are behind it, with a clean slate and innovation ahead of it.