Once upon a time, being an Apple supplier meant that as the Apple beats (no pun intended) kept on coming, your stock would be on the way up, too. Broadcom (UNKNOWN:BRCM.DL), which is quite diversified and has plenty of non-mobile businesses, became well known as the connectivity chip supplier to the Apple's iconic devices (as well as Apple archrival Samsung's). However, as Broadcom has expanded its mobile ambitions, it may be investing too much for too little return.
Here's why Broadcom wants in on cellular
Broadcom has significantly stepped up its mobile-oriented research and development in recent years. While Broadcom has enjoyed a fairly lucrative position as the supplier of connectivity chips as well as touch controllers here and there, management realizes that it can drive a pretty significant uplift to its smartphone dollar content if it can provide the entire platform, top to bottom.
Now, this makes a lot of sense, right? What company that cares about its shareholders wouldn't want to increase its dollar content per smartphone by as much as 10 times? However, there's another -- perhaps darker -- reason at play here. While Broadcom has enjoyed immense success with discrete connectivity chips for high-end smartphones like the Samsung Galaxy S5 and the iPhone 5s, it hasn't fared as well in the relatively higher-volume, lower-end part of the market.
In the low end, you really need to sell a platform
At the high end of the smartphone market, companies such as Apple and Samsung very carefully pick and choose what components they design into their platforms. After all, when you're selling a premium device, you can afford to spend the R&D to put together a customized solution. However, most smartphones are low-cost, fairly commoditized products.
The vendors of these handsets have neither the budget nor the inclination to spend serious amounts of money to design their own platforms -- they want a turnkey solution to innovate on top of. These turnkey solutions usually come from the chip companies like Broadcom, MediaTek, and Qualcomm (NASDAQ:QCOM).
The good news for a company like Broadcom is that if it can win the entire platform, it not only wins the connectivity spot but the apps processor, power management IC, RF, and the like as well. The content share uplift per design win in the low end/mid-range is quite real, but it's much more of an "all or nothing" proposition.
Broadcom is investing to go up against the big boys
Broadcom has been investing quite heavily in mobile -- about $1 billion a year according to CEO Scott McGregor. The good news is that this shows that Broadcom is very serious about this market, but the bad news is the following:
- The majority of the merchant chip market is at the low end as the high end players (Apple, Samsung, and even LG) have shown an increasing interest in bringing as much of the content share as possible in-house
- The smartphone chip market has become commoditized given the ubiquity of the key graphics and CPU IPs available for licensing from the likes of ARM and Imagination Technologies. The differentiation is in the SoC surrounding these key IPs and the cellular/connectivity solution.
- This market is increasingly cost-sensitive given the long-term secular trends in the smartphone market (i.e., the volume growth is coming from the cheaper handsets).
Right now, Qualcomm is at an operating expense run rate of about $3.6 billion-$3.8 billion in mobile chips (most of this is R&D), and MediaTek's chip R&D worked out to about $876 million during 2013. Broadcom is certainly outspending MediaTek, but significantly lags Qualcomm. Intel(NASDAQ:INTC), too, is at a similar operating expense run rate as Qualcomm (but is coming from significantly behind) and is losing a hefty sum at this.
Broadcom has to go up essentially against Qualcomm, MediaTek, and Intel -- not at all an easy feat.
Broadcom doesn't need to do it, though
While Intel, Qualcomm, and MediaTek all rely on success in mobile to fuel their long-term ambitions in the chip space, Broadcom really doesn't need mobile to run a very successful business. It is a leader in the network infrastructure market and is currently a dominant force in anything and everything broadband. In fact, if we look at these two businesses and simply exclude mobile, we get a very healthy financial picture:
Broadcom's broadband and Infrastructure businesses combined generated $1.1 billion in operating income in 2013. The mobile and wireless business, on the other hand, has deteriorated and is now in negative operating margin territory. While it is understandable that Broadcom wants to grow mobile meaningfully and protect its current connectivity business, the investment may ultimately not prove worth it unless it can line up multiple big sockets and consistently win them year after year.
Foolish bottom line
Broadcom has a fantastic business ex-mobile and until recently its connectivity business had been wonderfully profitable. However, as the mobile apps processor market gets more intense, and as the amount of R&D required to support that business continues to grow, Broadcom may find it increasingly difficult to justify this investment in light of its many other great opportunities.
Ashraf Eassa owns shares of ARM Holdings and Intel. The Motley Fool recommends and owns shares of Apple and Intel. It owns shares of Imagination Technologies and 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.