Broadcom's Set-Top Issues Are Overshadowing a Big iPhone 7 Ramp

With the help of Apple's (AAPL) iPhone 7 ramp and a big increase in the amount of revenue the company will get from each iPhone, Broadcom's (AVGO)  results and guidance were a little better than analysts forecast. But with shares up 22% on the year going into earnings and near their highs, markets wanted better numbers still, and a hiccup at a less flashy business got in the way.

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On Thursday, Broadcom, the company that resulted from the Broadcom-Avago merger that closed in early February, reported fiscal third-quarter revenue of $3.8 billion and adjusted EPS of $2.89, topping consensus analyst estimates of $3.76 billion and $2.77. The company also guided for fiscal fourth-quarter revenue of $4.1 billion, plus or minus $75 million. That's above a consensus estimate of $4.06 billion. Nonetheless, shares are down nearly 2% after hours.

The third-quarter beat was partly driven in by better-than-expected sales within Broadcom's enterprise storage unit, which stems from the LSI and Emulex acquisitions and has been pressured by soft end-market demand. Strength in the company's "industrial and other," which benefited from strong inventory replenishment, also helped out.

Also playing a role: Slightly stronger than expected sales within Broadcom's wireless chip unit, which accounted for 27% of revenue and saw sales rise 27% sequentially to $1.01 billion. A production ramp at a big North American phone OEM (clearly Apple) contributed, as did strong demand from a big Asian client (believed to be Samsung, which just launched the Note 7). Broadcom is a big supplier of RF chips and Bluetooth/Wi-Fi combo chips to both Apple and Samsung.

On its earnings call, the company forecast wireless sales will rise over 30% sequentially in the fourth quarter, with the North American ramp offsetting a seasonal decline in shipments to the Asian client. Notably, Broadcom suggested it doesn't expect this year's iPhone builds to be too different in size from a year ago -- iPhone 7 estimates have been subdued for some time -- but due to a "substantial increase" in content per device, as the growing RF complexity of smartphones drives greater demand for chips and modules containing Broadcom's FBAR filters.

RBC analyst Amit Daryanani estimates an increase of $8 to $9 per iPhone due to this phenomenon. Broadcom doesn't expect a big increase in combo chip content relative to last year. But it does expect a larger increases next year and sees adoption of the high-speed 802.11ax Wi-Fi standard as a future growth driver.

But while things look good on the wireless front, Broadcom's wired infrastructure chip unit, which accounted for 54% of third-quarter revenue, posted roughly flat sales growth, missing a forecast for low-single digit growth. In addition, the segment's revenue is expected to be flat in the seasonally strong fourth quarter.

Broadcom blames "supply constraints" for its large set-top chip business, while insisting they should be mostly resolved by the end of the fourth quarter. It also claims demand remains strong in other wired infrastructure segments, such as chips used in fiber-to-the-home (FTTH) deployments and Ethernet switching chips going into enterprise and cloud data centers.

Analysts pressed the company for more clarity, but Broadcom declined to give a specific number for the impact its supply constraints are having.

Meanwhile, the financial execution of Broadcom's management, which features much of the old Avago's management team, remains superb. Adjusted gross margin rose by 40 basis points sequentially to 60.4%, topping a guidance midpoint of 60%, and is forecast to be in a range of 59.5% to 61.5% in the fourth quarter.

Adjusted operating expenses fell slightly, and -- even though revenue is expected to rise by about $300 million -- are expected to be flat in the fourth quarter at $808 million. Broadcom also paid down $1.3 billion in long-term debt, and refinanced term loans at "substantially lower rates."

There's a lot to like in Broadcom's numbers and commentary. But markets were looking for something close to perfection. If shares were still trading at the levels they were at going into Avago's April quarter report, chances are the market's reaction would be much more positive.

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