AVGO: Delivers Strong Guidance on Upcoming Smartphone Builds (AVGO: BUY, $43 PT)

Avago delivered April results ahead of expectations and gave guidance above the Street. Guidance implies roughly $0.70 in EPS (non-GAAP, ex-SBC) for this quarter which is close to our prior of $0.71 and above Street at $0.68. We are reiterating our BUY and $43 price target.

• Wireless results and outlook came in roughly where we expected as Apple builds declined, but Samsung picked up (Samsung was a 10%+ customer for first time last quarter) as did HTC (although HTC is suffering from component shortages – see prior post). China Mobile’s eventual move into 4G/LTE has apparently prompted orders for Avago components and the management noted that the interference caused by the proximity of the LTE band to the WiFi band calls for FBAR filtering. Our checks show that Apple and China Mobile remain in negotiations regarding their arrangement, but this may not stop Apple from moving forward on the product line. Also, we suspect Huawei as a customer for Avago for 4G models  and one with greater visibility toward the 4G/LTE rollout likely coming in 2H13.

• Industrial was better than expected – in line with our checks about 2 months ago, but Avago was being cautious even when I spoke with them at that time. Discussions with management last night revealed that Avago had begun to see improvement in the middle of the quarter, as we noted, and the trend firmed as the quarter progressed. Looks like Industrial continues to build from here. Resales out of distributors and sell-in were both up 3-4% Q/Q last quarter and the strength is global. Japan was held back by the yen last quarter, but newly aggressive monetary policy there is likely to stabilize the yen-dollar rate and allow changes in demand to flow through to industrial suppliers. We have been looking for the recovery of Industrial to be an important margin driver for Avago and we saw some of that boost last quarter; look for a bit more help going forward (but note that Wireless will be growing faster).
• Wired infrastructure is also strengthening—both last quarter and this—on data center build-outs and move to parallel optics from AVGO. This seems to be driven both by product cycle upgrades (from 10G to 40G) and by the pressures on data centers to expand capacity. Traditional enterprise customers remain largely in a holding pattern on IT spending.

Gross margin moved higher than expected on the strength of industrial. Also, mix within wireless is improving as FBAR contributes increasingly to that segments sales. These two factors are likely to push GM higher again this Q and for several more Qs.

Final Analysis: The AVGO story is holding together well – results and outlook should boost investor confidence. And we expect October, as noted yesterday, to be up very strongly on Apple and Samsung ramps (and HTC and others) and continued recovery of Industrial and Wired. We expect valuation to be driven by upward revisions to estimates which we expect to follow this guidancev and as additional information confirms the upcoming ramps for China Mobile.

Avago Estimates:

• F3Q13 (July 2013): expecting Avago to deliver revenues of $607M, and non-GAAP EPS (ex SBC) of $0.70 (vs. $0.68, consensus).
• FY13E: $2.77 (up from $2.72 prior on stronger GM) on sales of $2.40B; FY14: $3.22 on sales of $2.75B.

Avago Investment Thesis:

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 12.4x 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 13.1x 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.).