3 Reasons Broadcom Corporation’s Stock Could Rise

Here's why shares of this chipmaker could be set to continue rising.

Aug 20, 2014 at 8:30AM

Shares of Broadcom (NASDAQ:BRCM) have performed exceptionally well following the company's divestiture of it its money-losing cellular chip business. While the company could have realized significant upside had it succeeded in this business, the harsh reality is that the market proved too brutal and the incumbents too powerful.

While Broadcom isn't going to find itself in the mobile chip spotlight that competitors Qualcomm and MediaTek enjoy, the remaining business is a cash-generating machine. Here are three reasons that -- even after a 28% rise year to date -- Broadcom's stock could continue upward.

Would you look at those infrastructure and networking profits?

One of Broadcom's more attractive businesses is its infrastructure and networking division. This operating segment, unfortunately, rarely gets much press because it's all "behind the scenes," so to speak. According to Broadcom's latest form 10-K, this business develops chips that power the backbone of the Internet (for example, Ethernet switches and wireless base stations).

As a result of the continued secular explosion of Internet traffic, Broadcom's infrastructure and networking business has grown rapidly. Last quarter, this operating segment saw sales jump 24.5% on a year-over-year basis, with operating profit up 67.5%

Naturally, this level of growth probably won't last forever. However, division General Manager Rajiv Ramaswami suggested in a presentation at the Cowen Technology, Media, & Telecom Conference that the business is set to grow revenue by double-digits over at least the next few years.

If Broadcom can sustain low double-digit growth in infrastructure and networking, along with operating margin between 35% and 40% (it did just shy of 40% in the most recent quarter), then this is a very attractive longer-term opportunity.

Cellular divestiture significantly improves Broadcom's profitability

Heavy investments in the cellular space have masked, if not completely wiped out, the profitability of Broadcom's connectivity chop business. In fact, Broadcom has noted that the total annual savings from exiting the cellular market would be about $600 million.

One of the main concerns among investors seems to be that exiting cellular would threaten Broadcom's connectivity business. It's true; without a complete cellular platform with which to attack the low end, Broadcom is likely to lose much of its lower-end connectivity business. Broadcom's management estimates that this "at risk" business is worth anywhere from $500 million to $800 million annually. 

The good news is that even if the worst-case materializes and Broadcom loses the full $800 million in low-end connectivity revenue, that revenue, at between 15% and 20% operating margin, is worth between $120 million and $160 million in operating profit. By cutting cellular loose, Broadcom potentially loses $160 million over time, but saves approximately $600 million in research and development spending (along with an additional $100 million in stock-based compensation).

Broadband is breaking out

Broadcom's final operating segment, broadband communications, also began showing significant strength in the company's most recent quarter. The division did $625 million in sales in the period, growing approximately 10% from the year-ago period and representing the highest revenue the segment has delivered on a quarterly basis in over two years.

More important, Broadcom guided this division to be "up slightly" in the current quarter. This is roughly in line with the trend seen in 2012 and an improvement from the third quarter of 2013, which was flat relative to the second quarter.

On top of the encouraging revenue growth, this operating segment also has a compelling (though not quite infrastructure and networking-level) operating margin, which came in at 28% in the most recent quarter.

Foolish takeaway

Even without a cellular-chip play, Broadcom's infrastructure and networking and broadband communications businesses are still incredibly robust cash-generating machines. Furthermore, Broadcom's most-visible business -- connectivity -- is set to see improved profitability as the operating expenses associated with the cellular business vanish.

Finally, the stock looks cheap, with sell-side consensus (per Yahoo! Finance) sitting at non-GAAP earnings per share of $3.26 (implying the stock is trading at under 12 times next year's earnings). Continued execution along this current trajectory could be enough to justify a far higher share price.

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Ashraf Eassa has no position in any stocks mentioned. The Motley Fool owns shares of Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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