Earlier this month, Avago closed its $37 billion merger with fellow chipmaker Broadcom and renamed itself Broadcom Limited (NASDAQ:AVGO). The "new" Broadcom now sells a broad portfolio of analog and mixed signal chips, wireless radios, custom networking chips, and data center networking chips to a wide range of industries
However, investors might be wondering if this new company is a riskier bet than the smaller version of Avago. To find out, we should highlight the three biggest risks which Avago mentioned in the "risk factors" section of its most recent 10-K filing.
1. Its exposure to Apple
Avago admits that "aggregate sales to Apple (NASDAQ:AAPL) accounted for more than 20%" of its 2015 sales. Meanwhile, Broadcom depended on Apple for 14% of its 2014 sales. Therefore, merging with Broadcom won't really diversify Avago's business away from Apple. Last quarter, Apple's iPhone shipments only rose 0.4% annually, iPad shipments plunged 25%, and the company warned that its second quarter sales could fall as much as 14%. Those bleak numbers dragged down many of Apple's top suppliers.
For the iPhone and iPad, Avago supplies power amplifier modules, and Broadcom supplies touchscreen controllers and combo radios. Now that those components are being produced by a single company, Avago can lower production costs by eliminating redundancies and relying on economies of scale. It might also gain more clout in price negotiations with Apple. However, it's unclear if those benefits can offset the headwinds facing Apple's phone and tablet businesses. In regards to Apple and other top customers, Avago notes that "a reduction in demand or loss of one or more of our significant customers may adversely affect our business."
2. A small number of competitive markets
Avago also admits that the company is "dependent on a small number of markets, and dynamics in these markets could negatively impact our business or results of operations." Avago states that "a substantial portion of our revenue is generated from sales of products for use in mobile handsets, particularly our FBAR (film bulk acoustic resonator) filter products, the market for which is growing and becoming increasingly competitive and volatile."
Avago's main competitor in FBAR filters is Qorvo (NASDAQ:QRVO), a smaller chipmaker formed from the 2015 merger of TriQuint Semiconductor and RF Micro Devices. Apple currently installs power amplifier modules from both Avago and Qorvo in the iPhone 6s.
Avago notes that wireless communications revenue accounted for 37% of its 2015 sales. It also warns that its success is dependent on mobile handsets which gain "broad commercial acceptance," but there's no guarantee that its chips will be designed into "the next generation(s) of a particular handset." If the new Broadcom loses crucial design to rivals like Qorvo, the company warns that those losses could "result in a sharp decrease" in revenues.
3. Its inorganic growth strategy might backfire
Inorganic growth is one of Avago's core strategies. Over the past three years, it acquired disk controller company LSI for $6.6 billion, PCI Express chip and switch maker PLX Technology for $309 million, and Fibre Channel and Ethernet adapter maker Emulex for $606 million. Those acquisitions all strengthened its enterprise storage business, which posted 38% sales growth last quarter and accounted for 35% of its top line. By merging with Broadcom for $37 billion, it adds the chipmaker's data center chips and custom networking chips to that growing portfolio.
In its 10-K filing, Avago clearly warns that the company "may pursue acquisitions, dispositions, investments and joint ventures, which could adversely affect our results of operations." While that disclaimer is common for companies pursuing inorganic growth, investors should keep an eye on Avago's rising debt. To fund the acquisition of Broadcom, Avago took on $9 billion in new debt, which gives the new company $14.2 billion in debt and boosts its leverage to 2.5 times EBITDA. By comparison, Avago's analog chip rival Texas Instruments has a trailing debt to EBITDA ratio of just 0.8.
Both Avago's management and ratings agency Moody's have expressed confidence that improved cash flows should reduce the new Broadcom's leverage by the end of the year. However, problems at Apple or a loss of major customers might dampen those rosy forecasts.
So how risky is the "new" Broadcom?
Despite these risks, I personally don't think the new Broadcom is a "risky" stock. Avago and Broadcom both have "best in breed" reputations among smartphone makers, and their combined production capabilities should boost margins -- a win-win situation for both Broadcom and its OEMs.
Avago's inorganic growth strategy has also paid off before -- its trailing 12-month FCF has soared over 200% over the past five years, giving it the cash to pursue bigger acquisitions like Broadcom. However, investors should still keep these three risks in mind and carefully weigh the chipmaker's strengths and weaknesses before picking up any shares. Broadcom Limited is scheduled to report its first quarter earnings on March 3.
Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool recommends Moody's. 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.