How Broadcom Keeps Its Edge

This article is part of our Rising Stars portfolio series.

Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get bull's-eyes on their backs, targeted by other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Even if a company continues to dominate its particular field, other changes in technology can shift spending away from its products. Think about how Microsoft still dominates PCs, but it's pressured by sales that are shifting to mobile devices such as smartphones and tablets.

With that in mind, today we're looking at how Broadcom (Nasdaq: BRCM  ) innovates. Technology companies can innovate either through acquisitions or by spending more on research and development. We'll compare Broadcom'sspending in these areas with that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, Broadcom has spent an average of 31% of revenues on R&D. Here's how that figure stacks up next to some of its rivals.

Company

2006

2007

2008

2009

2010

LTM

Broadcom

30%

36%

32%

36%

27%

26%

Qualcomm (Nasdaq: QCOM  )

20%

21%

20%

23%

23%

21%

Intel (Nasdaq: INTC  )

17%

15%

15%

16%

15%

15%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates represent calendar years; yearly totals are for company fiscal years closing in that period.

Broadcom's R&D expense as a percentage of sales has declined, but the company still spent an astonishing 31% of revenues on R&D over the past five years. What's especially stunning is that Broadcom spends 76% of revenues on cost of goods sold and R&D alone yet generates an impressive 16% profit margin. How does the company do that? Well, its income-tax situation doesn't hurt. Despite having $1.118 billion in pretax profits over the past 12 months, the company reported only $17.5 million in income-tax expense. Sorry, Uncle Sam.

Broadcom's not alone in this respect; many semiconductor companies that recorded crushing losses early last decade (and, in some cases, during the financial crisis) have managed to use operating losses to lessen future tax liabilities. Aside from that, many of these companies have optimized their organizational structures around paying little to no taxes. One of Broadcom's key competitors, Marvell (Nasdaq: MRVL  ) , has adeptly structured itself in low tax jurisdictions and actively seeks out new development in countries offering tax breaks for high-tech investments.

Acquisitions
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as hard drives and PCs while it focuses on acquiring additional services and software expertise that have transformed its business model.

However, on the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in research and development to the point that it has to overpay on acquisitions to catch up with its competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow. With that in mind, let's take a look at Broadcom's free cash flow over the past five years against cash spent on acquisitions.

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates represent calendar years; yearly totals are for company fiscal years closing in that period.

Broadcom isn't afraid to go the acquisition route to better compete in varying communications markets. Recently, the company made a splash by shelling out $316 million for Beceem, a company with particular strength in next-generation, or 4G, baseband chips.

Baseband is an important market right now. Companies are increasingly pairing communications chips with processors to offer smaller, more power-efficient, all-in-one solutions. The early leader in this market is Qualcomm, but like Broadcom, other companies are going shopping to catch up. Intel spent $1.4 billion to acquire Infineon's wireless unit last year. Just last month, NVIDIA (Nasdaq: NVDA  ) announced its largest acquisition ever -- a $367 million deal for baseband specialist Icera -- to better position itself in the connectivity market.

With all the added competition in the market, it wouldn't be surprising to see Broadcom make another acquisition of its own. Finding a company that could add processor-design expertise seems like a logical next move for the company.

Final thoughts
Broadcom is diversified across several communications markets and is the market-share leader in many. That's an enviable position, but as we've seen, the company must also spend heavily to defend its top-dog status.

As investors watch Broadcom over the next few years, they should keep an eye on its valuation. Although Broadcom has tremendous operating cash flow, if you factor in the cost of acquisitions and capital expenditures and subtract stock-based compensation from cash flows, the company has generated only about $1.1 billion in free cash flow over the past five years. Not exactly an impressive sum for a company worth nearly $16 billion.

Fortunately for Broadcom, Wall Street seems content to value the company around its reported earnings. However, the figure does raise a warning flag for investors that the company's ability to continually produce cash might not be as great as a glance at its impressive operating cash flows might indicate.

If you're looking to stay updated on Broadcom, or any other companies mentioned here, make sure to add them to our free watchlist service, My Watchlist. It's free, and it helps you constantly stay updated on news and analysis on your favorite companies.

Eric Bleeker owns shares of NVIDIA. The Motley Fool owns shares of Marvell Technology Group, Microsoft, IBM, Intel, and Qualcomm and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel, NVIDIA, and Microsoft, writing puts in NVIDIA, and creating diagonal call positions in Microsoft and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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