April - 1999 - issue > Business

The Internet sector has been the best performing asset class in the last two years, returning over 200 percent annually on average. Several Internet related stocks like Yahoo and Amazon appreciated over 500 percent in 1998. An amount of $10,000 invested in the Cisco stock in early 1991, would be worth around $2.9 million today (after they went public), showing an annual growth rate of 103 percent.

Looking for Another Cisco

If investors can spot a trend early enough, they can gain an advantage by investing in companies that may benefit from the trend. Cisco benefited from the growing use of the Internet — and may still continue to do so for several years. It is likely, though, at some point its growth rate will slow down from its present 35 percent rate. A slower growth rate may mean a lower return for investors from the historical returns of over 100 percent annually. The key is to spot a trend early on and benefit from it. The high-speed transmission of data, voice and video is transforming the way we live and work.

Faster Internet, More Bandwidth

The two conspicuous trends are the need for a faster Internet access speeds (faster than the current standard 56K dial-up modem or ISDN connection) for users and more bandwidth needed by suppliers so they can club more data, voice and video in the same wire into the homes and offices of Internet users. It can be frustrating for Internet users to wait for several seconds — and sometimes up to a minute — for picture frames to load up on the screen because of a slow download.
There are a few solutions available to users asking for faster Internet access speed. Among these, ISDN, xDSL (Digital Subscriber Line) and cable modem are the leading ones. More and more, the telephone access offered through ISDN or 56K dial up is losing the battle to cable and xDSL technologies. Broadcom is revolutionizing high-speed digital transmission, as an equipment solutions provider for faster Internet.

History And Products

Broadcom manufactures chips and integrated circuits, which enable broadband digital data transmission to the home and business, regardless of the type of technology used. It dominates its market, holding more than 90 percent of the market share. The company’s products are used in cable modems, cable set-top boxes, high-speed Ethernet networking, digital broadcast satellite, high definition TVs and xDSL technologies. Its customers include 3Com, Bay Networks, Cisco Systems, General Instrument, Motorola and Scientific Atlanta.

Broadcom is a major beneficiary of the convergence of television, computers, telephones and the Internet. Broadcom’s co-chairman, president, and CEO Henry Nicholas and co-chairman, VP, and chief technical officer Henry Samueli each control 28 percent of Broadcom. General Instrument, Intel, and Scientific-Atlanta also own small stakes. Intel recently purchased a 3.9 percent stake in the company. Samueli and Nicholas began their partnership at UCLA as professor and student, respectively, though the two had earlier worked together as product designers for technology specialist TRW. In 1988, Samueli helped found copper line-based data transmission firm PairGain Technologies as its director of microelectronics. In 1991, the pair left the company to found Broadcom, convinced that the speediest microchip would own the burgeoning market for the devices combining computers, TVs and telephones. By choosing to accept no venture capital, the duo hoped to be able to offer heady stock options to potential employees. Two years later, Broadcom introduced an advanced chip for cable boxes chosen for Time Warner’s pioneering interactive cable TV trials. Refer to Table 1 for information about the major product milestones achieved by the company’s engineers.

Financial Data

Broadcom went public in 1998 in an IPO that made more than 200 of its employees millionaires. In 1999, it made plans for its first acquisition, offering $104 million for Maverick Networks, a maker of chips that enable high-speed voice, data, and video networking. The company has shown sales growth of over 500 percent in 1998 over 1997. It maintains a high gross margin of over 35 percent and net margins of 18 percent. In the fourth quarter of 1998, sales grew 35percent to $70 million over the third quarter of 1998. Broadcom’s sales are evidently gaining momentum, which is in line with the accelerating trend of Internet users switching to faster modes of accessing the Internet. Its return on equity was over 26 percent in 1998.

Figure 1 shows the rising trend in net income of the company. For 1998, Broadcom had sales of over $200 million and became profitable for the first time making $36 million in net profit (versus a net loss of $1.2 million in 1997), which resulted in an EPS of $0.40 on total outstanding shares of 89.2 million. The company declared its first two for one stock split after going public in February 1999. The balance sheet, at the end of 1998, has approximately $50 million in cash and no debt.
The fast growth rates in sales and earnings have rewarded shareholders with a rising stock price. Figure 2, shows the performance of the Broadcom stock since February 1999.

Valuation and Outlook

Out of the seven analysts who follow the company, the average estimate for 1999 EPS is $0.57 per share, which implies a 1999 P/E of 105 at the current price of $54. In the past four quarters, the company has surprised analysts by exceeding their EPS expectations. For the first and second quarters in 1999, the analysts are expecting $0.14 per share in EPS, an easily achievable goal.

Table 2 highlights some of the valuation measures for Broadcom. At a current P/E of 145 and 1999 P/E of 105, the company is not exactly cheap. But then again, finding a profit-making company in the Internet sector at a low valuation is more difficult these days than looking for a needle in a haystack.
The company should grow at least 35 to 40 percent internally in sales and earnings in 1999. If it makes acquisitions, the growth could be much faster.

It’s likely that the company will have accelerating sales and earnings and will positively surprise the analysts. Its 90 percent-plus market dominance makes it a near monopoly, like Intel and Microsoft. According to fund manager Peter Lynch, monopolies and duopolies do extremely well. Broadcom certainly fits the definition of a monopoly. Investors need to decide how much they want to pay up for a company that dominates its market.

Five years ago, Cisco, Microsoft, Intel and America Online had high P/Es and valuations, which was understood by only a chosen few. Yet all these companies did extremely well for the investors who were willing to pay up for their brand name and market dominance. Broadcom is currently in a similar position. The trend for high-speed Internet is conspicuous — but the beauty lies in the eyes of the beholder. Not everyone may be willing to pay up for the company. The biggest risk with this investment will be due to other companies deciding to enter the market for Broadcom’s products and cutting into their margins.

This is not a recommendation or a solicitation to buy. All investment decisions should be made after consulting with an investment adviser based upon an investor’s investment objectives. This is not a guarantee of performance and the views are solely that of the author.