Shares of Broadcom (UNKNOWN:BRCM.DL), a leading manufacturer of semiconductors for wireless and broadband communications, have rallied nearly 40% in 2014. Let's look at how this stock climbed so quickly, and whether it still has room to run.
Dumping old businesses for new ones
Broadcom makes ICs for ethernet and wireless LANs, cable and DSL modems, servers, home networking devices, and cell phones. It also sells high-speed encryption co-processors, processors for digital set-top boxes, Bluetooth and Wi-Fi transceivers, and RF receivers for satellite television. In 2011, Broadcom shut down its digital TV and Blu-ray chip businesses.
Over the past few years, Broadcom has continuously lost market share in cellular baseband processors (which process the signals received from a cell phone's antenna) to Qualcomm (NASDAQ:QCOM). Other major competitors in the field -- including Texas Instruments (NASDAQ:TXN), STMicroelectronics, and Ericsson -- have since abandoned the business to Qualcomm, which has grown its market share from 52% in 2012 to 66% in 2014.
That's why it wasn't surprising when Broadcom declared in June that it would also exit the cellular baseband business. That was a smart move, since the segment had been a dead weight on its bottom line.
Revenue in the cellular baseband division, which accounted for 40% of Broadcom's top line, slumped 17% year over year to $1.63 billion for the first half of fiscal 2014. The segment also posted a six-month loss of $53 million, down from a profit of $219 million a year earlier. Broadcom expects to save $600 million (excluding a $100 million reduction in stock-based compensation) in research, development, and administrative costs annually by shedding the business. This decision led to the cut of 2,500 workers, or a fifth of its workforce, in late July.
An impressive third quarter keeps the rally going
Broadcom's exit from the cellular baseband business ignited the stock's big rally, but an impressive third-quarter earnings report on Oct. 21 helped it cruise back toward its 52-week high.
During the third quarter, Broadcom's revenue rose 5.3% year over year to $2.26 billion, topping the consensus estimate of $2.17 billion. Non-generally accepted accounting principles earnings climbed 20% to $0.91 per share, beating the estimate by $0.07. With cellular baseband eliminated, Broadcom only reported revenue in two business segments: broadband and connectivity and infrastructure and networking. Revenue from the former rose 7.8% to $1.5 billion, while revenue from the latter climbed 10.9% to $651 million. Operating income from both segments, excluding leftover cellular baseband sales, rose 15.3% to $611 million.
The company attributed its robust quarterly top-line performance to strong demand for broadband and connectivity chips in newer smartphones. Ironically, some of that revenue growth was also attributed to the cellular baseband business. Looking ahead, Broadcom expects fourth-quarter revenue to come in between $2 billion and $2.15 billion, which is in line with the average analyst estimate of $2.11 billion.
Valuation and growth potential
While things certainly look brighter for Broadcom, we should look at how its stock stacks up against rivals Qualcomm and Texas Instruments.
Qualcomm certainly looks like the best value based on these valuations, but investors should remember that smaller companies usually grow faster than massive ones. That's why Broadcom easily outperformed both stocks over the past year:
Although Broadcom trades at 55 times trailing earnings, it also trades at 12 times forward earnings. By comparison, Texas Instruments and Qualcomm trade at 17 and 14 times forward earnings, respectively. This means that if Broadcom can meet earnings estimates, its trailing P/E could easily cool off and reconcile with its soaring stock price.
The road ahead
Looking ahead, Broadcom's second-generation 2x2 MIMO 802.11ac combo chip enables higher Wi-Fi speeds and lower power usage on smartphones and tablets. Its new GPS sensor hub combo chip reduces power consumption in smartphones while enabling "always on" fitness tracking. Broadcom is also poised to profit from the growth of mobile payments with its support for Apple's iBeacon standard for Bluetooth low-energy payments.
All these new chips will help the company tap into the growth of the Internet of Things. Simply put, Broadcom is a solid bet on a more connected world, and in its newly slimmed-down form it's definitely a top stock to watch in the wireless and broadband market.