This is $500 week, but you'll have to wait until the end of tonight's column to learn who gets my nomination for our April investment. First, I thought it would be interesting to discuss a company that appears to be an emerging Rule Maker -- Broadcom (Nasdaq: BRCM). It's also a company that recently found its way into my investment club's portfolio as well as my own.

Let's start with a little background on what this company does. Broadcom designs and develops integrated circuits for the broadband communications market. There's something very important about what I haven't said in that last statement. If you go back and reread it, you'll see that a word is missing. You see, Broadcom does not manufacture these chips. It's fabless -- that is, it doesn't manufacture chips. In my view, this is a key determinant of why its margins are far better than those of the two companies it competes with across the most product lines -- Conexant Systems (Nasdaq: CNXT) and LSI Logic (NYSE: LSI).

While there are risks in not manufacturing your own chips, there are also compelling advantages. Although Broadcom won't earn the full profit realized from the sale of its chips, the company doesn't have to expend significant amounts of capital to build chip fabrication facilities. This gives it a much lighter business model than its competitors. It should also be noted that the company's reliance on contract manufacturers to make its chips adds some additional risk to the business model.

Broadcom's Markets
Broadcom's business can be broken down into three segments: cable modems, networking, and cable set-top boxes. The link is that these businesses are all directed toward increasing the rate at which data can be transmitted. The chips it designs are sold into six high-growth niche markets: chips for digital set-top boxes, cable modems, digital broadcast satellite (DBS) technology, digital subscriber line (xDSL) technology, home networking, and high-speed networking. What follows is a brief overview of these markets and the related products.

Cable set-top boxes are used to facilitate high-speed digital communications between the cable network and the cable subscriber's television set. Cable modems are used to connect PCs to the cable network and allow for downstream transmission speeds that can be 1000 times faster than those for the analog modem by which the majority of users connect to the Internet.

DBS can be used to transmit information at speeds of up to 90 Mbps (megabits per second) and can actually be used to provide television programming in areas where no cable infrastructure is in place. xDSL, which can be offered by your local phone company, enables transmission speeds that range from 128 kbps (kilobits per second) to 52 Mbps depending upon how far from the central office the subscriber is located.

Broadcom's efforts in the high-speed networking area are focused on faster local area networks (LANs) based on Gigabit Ethernet, which it believes will become the predominant technology for backbone infrastructures that support LANs. Broadcom currently holds a 63% share in the high-end networking market.

Rule Maker Criteria
Let's move on to the numbers and see how Broadcom holds up to the quantitative Rule Maker criteria.

One item that looks unusual is the deferred taxes line of the cash flow statement. I'll try to be careful here as I don't want to start speaking all kinds of mumbo jumbo describing a subject that is so near and dear to my heart (OUCH! I've got to remove my tongue from where it's currently planted -- my cheek). Which reminds me, what possessed me to specialize in taxes anyway? OK. Ready or not, here goes.

Making Sense of Deferred Taxes
Basically deferred taxes are used to reflect the income tax impact of differences between income reported under GAAP (Generally Accepted Accounting Principles) and that reported on a tax return. These differences are called "temporary differences," as they will reverse in the future. There are also "permanent differences," which means that the difference between the amount for GAAP and the amount for tax won't ever change. Since permanent items are not part of deferred taxes, I won't say another word about them here.

Here's an example of how a temporary difference might arise: Say that Broadcom has set up a reserve for some type of future expense. Under GAAP, this amount is deducted currently. Under tax principles, the amount cannot be expensed until it has actually been paid. For other examples of items that can give rise to deferred taxes, you can check the footnotes of any company's financial statements.

When a GAAP expense is greater than a tax expense, a company has a deferred tax asset; i.e., a tax benefit that can be claimed in the future. If a tax expense is greater than a GAAP expense, then a company has a deferred tax liability, meaning that it will have to pay taxes on it in the future.

Assume that in the current period, we've expensed $10 million for a reserve. However, for tax purposes, all that we can expense so far is $2 million. So, we have a future tax deduction of $8 million. Next assume that the combined federal and state tax rate is 40%. If we multiply the $8 million by 40%, then we're left with a deferred tax asset of $3.2 million on the balance sheet. In this example, the company has advanced $3.2 million to the government that it should be able to get back in the future. (One caveat: This assumes that the estimated reserve ends up being expensed fully. On a number of occasions companies have been accused of overbooking reserves, reflecting them as one-time items in the financial statements and then releasing some of the reserves back into income in the future. This would cause the deferred tax benefit to be reversed as well.)

From a cash flow perspective, though, a deferred tax asset is not a good thing. The company has paid the cash now, but it won't get the deduction until some point in the future (if it's a current deferred tax asset, then that means within the next year). From what I read in Broadcom's footnotes, it appears that its acquisitions have wreaked havoc on the deferred tax balance.

As for the $500 selection, I'll go with American Express (NYSE: AXP) again this month. My rationale remains the same as last month.

That's all we have time for tonight. If you'd like to see a full Rule Maker Ranker for Broadcom, you can check this post on the Rule Maker Companies message board. And, if you have any questions, please ask them on one of our Rule Maker boards.

Phil (TMFGrape on the boards)