Analyst Amit Daryanani published a research note (via Barron's) in which he points out that chip maker Broadcom (NASDAQ:AVGO) recently signed a three-year agreement with smartphone giant Apple (NASDAQ:AAPL) for the supply of "RF components and modules."
This deal, Daryanani says, should be a "positive" for investors in the chipmaker. Let's take a closer look at the reasoning behind this conclusion.
Cutting to the chase
On Broadcom's earnings calls (and formerly Avago's), management had expressed significant confidence around its ability to gain content share in Apple's latest smartphones. As Apple increases the wireless capabilities of its iPhones, Broadcom's RF content (through its "Classic Avago" business) should continue to improve.
Separately, Broadcom's "Classic Broadcom" business, which has typically supplied Apple with mobile Wi-Fi chips, should also benefit as Apple increases the Wi-Fi capabilities of its phones each year as well.
What the news of this agreement tells us is that, as long as Avago can deliver products to Apple on time and in the right quantities, it seems to have this business locked down.
"We think FBAR revenues as AVGO should sustain 20%+ growth over the next 2-3 years agnostic to [iPhone] unit growth/decline," the analyst writes.
Digging deeper into the implications
The analysts also say they spoke with Broadcom's management, presumably to get additional clarity around this deal, and came to four key takeaways.
The first is that Broadcom now has a "clear roadmap on their share within RF bands," which "takes away any noise around share loss until theoretical iPhone 8S." The next is that Broadcom now has "clarity to ramp production and commit manufacturing capacity for FBAR filters."
Beyond that, the analysts say this deal "locks in certain pricing schedules that [aren't] volume centric" and should make it "difficult for peers like Qualcomm (NASDAQ:QCOM)/TDK, Qorvo (NASDAQ:QRVO), and Skyworks Solutions (NASDAQ:SWKS)" to gain share from Apple at Avago's expense.
The analysts do point out some potential negatives here, though.
First, they note that the pricing schedule here isn't dependent on volume, "so the ability to use pricing to offset volume concerns doesn't exist." In other words, if Apple sees demand come in materially weaker than it expects, Avago presumably winds up seeing a margin-per-unit decline as under-utilized manufacturing facilities raise the effective cost per unit.
The next is that the agreement apparently says "Apple intends, but is not required, to source fixed and substantial percentages of its RF front end component and module needs from [Broadcom]." This intention is "provided that [Broadcom is] able to meet certain development, supply, and quality commitments."
Thirdly, the analyst thinks this agreement "reduces [Broadcom's] ability to "pivot content to other smartphone manufacturers." As the analyst points out, what if, say, Xiaomi or some other smartphone vendor starts taking high-end share away from Apple?
Finally, the analyst says this contract "reduces the incremental profit contribution from RF sales." In other words, since Apple buys these RF components in very high volumes, it probably commands materially lower revenue per unit compared to sales to another vendor.
As long as Avago can deliver, and iPhone sales don't fall off a cliff, shareholders rejoice
Apple drives its suppliers hard and tends to have quite a lot of power over said suppliers because of the sheer volumes it brings to the table. As long as Broadcom can deliver for Apple, and as long as Apple provides generally accurate demand forecasts to Broadcom, I agree that this deal is a "win" for the chip maker.
Broadcom's execution has traditionally been quite strong, so shareholders probably shouldn't worry too much about that. The big variable here will ultimately be the trend in unit demand for iPhones in the coming years. That being said, as the analyst points out, Broadcom should grow its content share so revenue growth can be achieved independently of fluctuations in unit demand.