Comm Semi Update: Checks Show Continued Samsung Strength, Apple Inventory Clearing Ahead of New Model Launches (AVGO, SWKS, RFMD, TQNT)

Recent discussions with smartphone component suppliers indicate that 2Q shipments are likely to rise 5-10% Q/Q, in line with previous expectations, on new model launches. Shipments in 3Q are expected to pick up further momentum (up 15%+) as Samsung follows the S4 with more varied model launches and as low-cost iPhone builds commence.  Smartphone growth for 2013 is expected to reach 30%, led by emerging market demand for low- to mid-range models.

Our checks suggest that companies disproportionately exposed to Apple face downside risk to June quarter results, but increasing diversification protects key component suppliers such as BUY-rated AVGO, SWKS, RFMD, and TQNT. Also, ramp of Samsung models is proceeding in line with expectations and September quarter looks to combine strength in additional Samsung ramp with new Apple models.

Avago appears likely to turn in a slightly weaker-than-expected April quarter when it reports this evening, but we see guidance ahead of expectations on our checks showing strong mid-year smartphone component demand from Samsung and late-quarter iPhone initial builds. The pace of shipments should pick up further in Avago’s October quarter when ongoing Samsung builds coincide more fully with iPhone ramps. Also, while Wireline component orders remained cautious for the April quarter, the gradual return of spending signaled by Cisco and several analog providers suggest Wired and Industrial growth in July and October quarters. We are reiterating our BUY and $43 price target.

Asia Smartphone Checks & Avago Preview:

Smartphone component outlook

• 2Q smartphone component shipments and builds are likely to rise 5-10% Q/Q, in line with previous expectations as new model launches spur component demand. Apple build estimates have deteriorated further, and Samsung builds appear slightly weaker on slower-than-expected non-S4 demand. China-branded handsets are seeing stronger momentum in 2Q and are likely up 20% Q/Q following a strong start to the year. Huawei and whitebox vendors are continuing to launch new models.
• 3Q smartphone component shipments are expected to grow 15-20% Q/Q and reach a peak for the year to support new models debuting at the end of 3Q. Contacts report good visibility.
• Total smartphone growth in 2013 now projected at 30% which is down from early 2013 checks showing 40% projected annual growth. We have been modeling 25% unit growth and continue to do so. White-box and low-end handsets are likely to grow ~40% while higher-end units grow ~15%.

OEM-Specific Highlights

• Apple: 2Q iPhone shipments remain weak and are likely to be down 30% Q/Q, worse than prior expectations of down 15%. Apple is clearing inventory ahead of new model launches. Contacts expect 2Q to mark the bottom for component orders and expect a low-end model to be announced in 3Q. Supply chain expects component orders for this model to appear at the end of June. Look for component orders to rise 20% Q/Q in 3Q.
• Apple and China Mobile: Our discussions indicate that the two parties yet to come to agreement on the revenue split for new contracts involving iPhones. Contacts note that Apple will likely wait for China Mobile’s 4G (TD-SCDMA) deployment rather than releasing a model for the 3G-TD-SCDMA network. No firm word on when 4G will be deployed so it appears that Apple has a long wait before being able to take advantage of China Mobile’s subscriber base.
• Samsung: S4 shipments are likely to hit ~20M units in 2Q and to reach 20M again in 3Q (in line with prior expectations) even as non-S4 model builds see some weakness this quarter. Contacts report ample supply of the S4 with no component shortages.
• HTC: At HTC, by contrast, the HTC One continues to be plagued by shortages arising from a lack of certain camera parts associated with low yields. Yields are improving, but no word yet on when supplies will recover sufficiently to meet handset demand.
• LG: Contacts note that LG handsets are likely to see a 20% Q/Q increase in builds on new model launches targeted at the mid-range of the market.

Avago Outlook:  F2Q results and F3Q Guidance

Slightly weak results expected for F2Q:

• Additional weakness in iPhone builds in advance of new model launches.
• Weakness in Cisco core router shipments.
• Overall weakness in Industrial.

Longer-term Outlook:

• Checks indicate strong acceleration in OCtober quarter smartphone builds on low-cost iPhone and follow-on to Samsung’s S4 and additional models.
• Cisco outlook indicates gradual pick-up in Wired components demand; Core routing investments typically follow Edge investments, so while Core spending remains weak, we expect infrastructure spending to move in that direction of the next 2-3 quarters.
• Recovery in Industrial continuing, with positive guidance from several analog providers.
• C2H13 and CY14 gross margin expansion on rising FBAR penetration as new capacity comes on line.

Note on CyOptics Acquisition:

The CyOptics acquisition is expected to close during AVGO’s F3Q13; with quarterly revenue run-rate of ~$47M, but weaker gross margin than AVGO’s own Wired division, we would expect accretion of ~$0.01, but for this to rise in subsequent quarters as Avago cuts away low-margin products and generally improves efficiencies.  We do not expect the impact of CyOptics to be included in guidance for the July quarter.

We are positive on this acquisition since it complements Avago’s current offerings of perpendicular lasers with edge-based lasers and enables the company to address growing demand from infrastructure investments for metro and telecom customers. Gross margin will initially take a hit, but Avago has extensive experience in culling less profitable product lines and expanding more proprietary (and higher-margin) alternatives.

Avago Estimates:

• F2Q13 (April 2013): expecting Avago to report in-line revenues of $558M, but slightly low non-GAAP EPS (ex SBC) of $0.58 (vs. $0.59, consensus).
• F3Q Guidance: We expect the mid-point of revenue guidance at ~$608M (vs. $600M, consensus), non-GAAP gross margin of 51-52%, flat operating expenses, and non-GAAP EPS (ex SBC) of $0.69 (vs. $0.68, consensus).
• FY13E: $2.72 on sales of $2.40B; FY14: $3.19 on sales of $2.75B.

Avago Investment Thesis, Valuation, and Risks:

We see Avago (AVGO) as a leading opportunity among semi stocks at this point in the cycle and are reiterating our BUY rating and $43 12-month target price. Avago is highly leveraged to smartphone growth, and we expect further dollar content gains to enable it to grow faster than other suppliers. Handsets account for over 50% of Avago’s revenues, but optical components and ASICs should also provide above-sector growth. Also, AVGO’s limited consumer exposure leaves it better insulated than others during this uneven recovery.

Valuation: AVGO is trading at 12.5x 2013 consensus estimates, 10.8x 2014E consensus estimates, and at an EV/Sales of 3.0 for 2013, and at 2.7 for 2014E. Our 12-month price target of $43 implies a 2014E P/E of 13.2x and an EV/Sales of 3.5.

Risks: Potential risks to our investment thesis, rating, 12-month target price, and estimates include, but are not limited to, changing global economic conditions, failure of Avago to maintain our assumed pace of innovation, an unexpected degree of price competition from other companies, customer decisions to switch to other suppliers, and its own and the semiconductor and electronics supply chain’s disruptions from global physical, political, and economic shocks (earthquakes, hurricanes, floods, revolutions, etc.).