Broadcom's (UNKNOWN:BRCM.DL) long, frustrating dalliance with baseband wireless is now at an end, with the company winding down the business after investing hundreds of millions of dollars (if not billions) over the years, but failing to find a buyer. Broadcom remains a strong player in network infrastructure and broadband, and perhaps an underrated player in the emerging "Internet of Things" market, but investors are right to question how mobile connectivity will fare in the coming years, as well as whether management may fritter away cash on further value-eroding deals.
A first look at a higher-margin Broadcom
While Broadcom has not been investing resources into mobile to the same extent as Intel, it was, nevertheless, compressing margins and the second quarter (and third-quarter guidance) give insight into how margins can evolve with the closure of the baseband ops.
Revenue fell 2% year over year this quarter (and rose 3% sequentially), which came in slightly weaker than expected. Broadband rose 10% year over year and 12% quarter over quarter (about 4% better than expected), while infrastructure rose 24% and 10%, respectively (almost 3% better than expected). Mobile and wireless revenue fell 19% and 8%, respectively, missing estimates by nearly 6%, as connectivity sales declined 2% sequentially, and legacy baseband plunged about 40%.
Gross margin jumped almost three points from the year-ago and quarter-ago levels, beating expectations by more than a point due to the elimination of the money-losing baseband sales. Operating income was still down 7% YoY (and up 26% sequentially), but more than 7% better than expected due to the elimination of the baseband spending.
Looking ahead, Broadcom management produced a vision for the next quarter with slightly lower revenue and meaningfully higher margins. The midpoint of the $2.1 billion-$2.25 billion revenue guide was just barely below the prior average estimate ($2.18 billion), but the midpoint of the gross margin guidance range (54.25%-55.75%) was well ahead of the 53.1% average estimate.
Can Connectivity survive without baseband?
Investors and analysts have generally cheered Broadcom's decision to exit the baseband business. The company was spending hundreds of millions of dollars, but making no real gains on Qualcomm (NASDAQ:QCOM) in the high end of the market. Although Intel remains committed to spending what it must to become a legitimate rival to Qualcomm, Broadcom management saw the writing on the wall (including a faster-than-expected erosion in 4G profitability) and decided to pack it up.
Some may be disappointed that Broadcom is winding down instead of selling, but the business appeared to be well behind Qualcomm, and uncompetitive with respect to features like carrier aggregation and envelope tracking. With that, any buyer was still looking at extensive investments just to make it competitive. This decision is also a net positive for Qualcomm and Intel, as it eliminates the possibility of a major customer like Apple, Samsung, or Huawei buying baseband assets and potentially going in-house in the future (though, don't rule out Broadcom looking to sell/license IP in the future).
The decision to get out of baseband seems universally praised, but there are ongoing worries about Broadcom's position in connectivity. Qualcomm has been upping its efforts here, particularly on the high end, and this is still a pretty significant business for Broadcom. While the low-end business (an estimated 20% of segment profits) is at risk, Broadcom's 5G MiMO combo connectivity should keep the company very competitive with Qualcomm and Intel in the short term.
Can the Internet of Things fill the gap?
Where will Broadcom go for growth now? The company should have significant revenue opportunities in networking, particularly centered around ongoing network virtualization, and broadband looks like a growth market as well with next-gen set-top boxes, Ultra HD, and more high-speed broadband initiatives targeting the consumer market.
Beyond these, the growing Internet of Things opportunity could give a new growth platform for connectivity. Broadcom has already introduced its WICED Direct platform, next-gen NFC controllers, and the first global location SoC for wearables. Intel, Qualcomm, Texas Instruments, and Microchip Technology have all pointed to wearables and the IoT as a growth opportunity, but Broadcom has staked out valuable early mover leadership. It will also be interesting to see what the company may be able to do in machine-to-machine communication, an area that Linear Technology has staked out as a significant future growth opportunity.
What comes next is a major question for Broadcom investors. The company has ample cash and will be generating significantly more free cash flow now that baseband is done, but there's a not-so-good history here of frittering away capital on ill-conceived acquisitions.
On its own merits, the stock seems to be pricing in mid-single-digit long-term free cash flow growth, which may be too low, given the opportunities in networking, broadband, and wearables/IoT. Shares appear undervalued by EV/revenue on the basis of its new margin potential, but management may have to convince the Street of its staying power in connectivity and overall growth potential before reaping the full benefits of the new and improved margins.
Stephen D. Simpson, CFA owns shares of Broadcom. The Motley Fool recommends Apple and Intel. The Motley Fool owns shares of Apple, Intel, 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.