People contemplate 5G in terms of what it may enable in the future -- virtual and augmented reality, automated factories and farms, and perhaps a replacement for broadband. Brand new applications are also likely to be invented when the capability of 5G is fully implemented.
But which stocks will benefit the most from 5G? It may not be the phone companies or carriers, but rather the key semiconductor companies that power this new platform. That's because 5G requires more radios, data centers, and fiber linkages closer and closer to customers, in addition to more advanced smartphones.
So not only will a greater quantity of chips will be required, but 5G will also need more specialized, high-margin chips to handle all that speed and data traffic in an efficient way.
With the 5G ecosystem touching so many devices, from phones to radios to data center servers, semiconductor companies with broad exposure, such as Broadcom (AVGO -1.39%) and Lam Research (LRCX 0.27%), are likely to benefit handsomely in the 5G era. What's even better? Both stocks pay growing dividends, so investors are paid to wait for more 5G-powered growth.
Broadcom: One of the cheapest 5G stocks around
Last week, Broadcom reported its fiscal third quarter earnings. Revenue was up a solid 16% to $6.78 billion, and adjusted (non-GAAP) earnings per share of $6.96 were up 28.9%. Both figures beat analyst expectations.
Broadcom has a notable growth-via-acquisition strategy, conceived by visionary CEO Hock Tan. Broadcom typically targets competitively advantaged, profitable chip or software companies, uses debt to buy them, and then wrings out more profits by cutting overhead. As a result of this strategy, Broadcom now has a very diverse portfolio of chips that go into phones, data centers, and general communications equipment -- all of which are used in 5G.
Last quarter's results showed Tan's strategy working like a charm: Gross margin increased 85 basis points to 75%, yet overall operating expenses were flat year over year. The result is a cash gusher, with Broadcom minting $3.43 billion in free cash flow on revenue of just $6.78 billion, good for a free cash flow margin of more than 50%.
Broadcom pays a 2.9% dividend at today's stock price, and that payout is likely to be raised again soon. Broadcom's strategy is to return half of free cash flow as dividends, with the other 50% reserved for either for acquisitions, buybacks, or debt paydown.
Broadcom's cash on the balance sheet also swelled to $11 billion against $40 billion in debt, and cash should grow to $13 billion by the end of this quarter. Given its highly profitable business, Tan said on the conference call with analysts that that level of cash is $6 billion to $8 billion above where he'd like it to be. That means if the company doesn't execute an acquisition soon, it could institute a share repurchase program in addition to its dividend. Either one of those scenarios would be great news for shareholders.
Despite solid growth and more cash than it needs, Broadcom's stock trades at only 16.5 times next year's earnings estimates, below the multiple of the overall market. That seems too cheap for a company exposed to many tech megatrends, including 5G.
Lam Research: Making everybody's best chips
Like Broadcom, the stock of semiconductor equipment provider Lam Research has been relatively quiet over the past six months, which means it could be a great time to pick up shares. In fact, in a relatively quiet August for the company, Lam quietly announced a 15% increase in its quarterly dividend to $1.50 per share. That's a 400% increase in the dividend over just the past five years.
The reason Lam has done so well, and should continue to do exceedingly well in the age of 5G, is its lead in etch and deposition machines crucial to producing the most advanced leading-edge logic chips and most densely stacked NAND flash chips. 5G will generally require leading-edge chips in high-end smartphones, radios, and edge data centers, so Lam's equipment should be in high demand as long as that's the case.
Lam also gets a larger-than-normal portion of revenue from its services segment, which made up one-third of revenue last quarter. Services generally grow with its installed base every year, even as equipment sales can be uneven. But equipment sales are also booming, up a whopping 48% year over year last quarter.
In response to the well-documented chip shortage, the world's largest foundries have announced big, multiyear spending plans to meet demand and remain competitive. Last month, key customer Samsung announced a big increase to its spending plans over the next three years. That means Lam has great visibility into equipment sales growth for the next couple years at least.
Semiconductor equipment stocks spiked toward the end of 2020 and early 2021, yet after such a hot start to the year, Lam's stock has trailed the market over the past six months. I'd chalk that up to mere profit-taking, and a healthy consolidation before the next leg higher. Lam trades at only 22 times trailing earnings and 17 times next year's earnings estimates, which seems too cheap for a stock bound to benefit over the duration of the 5G era.