Modest Expectations Still Working in Broadcom Corporation's Favor

Owning a stock market darling is a blast, but sometimes you have to turn to the ugly ducklings to find value. Such is the case with Broadcom (NASDAQ: BRCM  ) , where the market seems certain that the company can't win much baseband, can't keep its connectivity business, and doesn't deserve to be owned on the basis of its strength in networking or broadband. It is up to Broadcom management to prove that the market is too skeptical, but investors who own Broadcom today should be in position to benefit from stronger results later this year.

The wild, wild, wireless
Even though Broadcom has built exceptionally strong market share in 3G and 4G combo connectivity (with market share north of 70% by most estimates), and has won 5G slots at Samsung and Apple, both the handset OEM market and the stock market are "what have you done for me lately?" places.

The most important question is whether or not the company can build up real share in LTE baseband. Qualcomm (NASDAQ: QCOM  ) has long dominated this market, while Broadcom has historically struggled to beat out Intel (NASDAQ: INTC  ) or Mediatek for the No. 2 slot, let alone even challenge Qualcomm's 50%-plus market share.

Broadcom's acquisition of LTE assets from Renesas gave this business a real shot in the arm, confirmed with a subsequent win at Samsung. It is going to make much more than that to convince the market. Marvell (NASDAQ: MRVL  ) , Mediatek, and Intel are all pushing hard and that is rarely good for margins. But if Broadcom can follow up with subsequent LTE wins and start leveraging years of spending in this space, the benefits to revenue and margins could be well in excess of today's low expectations.

Importantly, if the boasts of Broadcom's management as to the size and power consumption benefits of the new chips prove true, not to mention features like voice-over-LTE support, Qualcomm just may have a new rival. Broadcom is also licensing ARMv7 and v8 technology, indicating that it may be looking to challenge Qualcomm here (as well as compete more effectively with Intel and Marvell).

Getting stronger (and maybe smarter) in Infrastructure
I do believe that Broadcom's strength in Infrastructure, where it designs and sells chips for applications like Ethernet switches, is an overlooked factor in the company's favor. The company has leading share in many switch and controller applications (over 50% in some cases), and the new Trident II product should be a winner. Supporting over 100 10G ports, customers like Cisco, Juniper, and Huawei have already launched switches with Trident II.

Even with competition from Marvell and Intel (and emerging competition from companies like Cavium), this business should do well in 2014. Data center demand should be solid, particularly with 10GbE switches. It's also worth noting that Broadcom should start shipping product to BMW for the auto connectivity market, a market that management believes could ultimately be worth $1 billion or more.

Broadcom is also actively managing this business. The company just agreed to sell its 10/40/100G Ethernet controller business to QLogic for $147 million and license some fibre channel IP for an additional $62 million. Importantly, the agreement calls for Broadcom to supply ASICs for QLogic's NetXtreme II controllers, giving the company exposure to market growth potential in 10G to 100G without heavy ongoing R&D burdens.

Even modest growth looks like enough
Expectations on Broadcom appear to be at a point where even just holding serve should lead to upside in the shares. I'm expecting to see momentum in 5G WiFi combo later this year from Samsung and Apple, as well as more design wins for LTE, while also looking for businesses like Broadband to benefit from product cycles like high-efficiency video codecs, ultra HD, and PON upgrades.

Longer term, I do expect Qualcomm to remain a ferocious rival, and I believe Marvell and Intel will not let up either. With that, I'm only looking for long-term revenue growth on the order of 4%. I likewise believe that the relentless cycle of competition in Broadcom's markets is going to limit margin potential; I don't see Broadcom returning to free cash flow margins above 20%, but I do believe they can stay in the high teens, allowing for FCF growth of around 4%.

The bottom line
Even with an elevated discount rate to account for the risk of competing with Qualcomm and Intel (not to mention lower-cost suppliers in Asia), 4% FCF growth supports a fair value today of $35. Looking at valuation a little differently, using sector comps to value the parts, I calculate an implied value of only about $2 to $3 per share for the wireless business (a business that supplies almost half of revenue). That tells me that the Street is very down on this business and additional design wins in LTE could lead to meaningful upside. Broadcom is not going to be the easiest stock to own, but I do believe the potential rewards make it worth a careful look.

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