Most companies are founded with one or two employees. If they offer a good product or service at a competitive price, they expand, and grow their client numbers. As a result of more clients, businesses invest more money in hiring, training and developing new employees, and small businesses become medium sized enterprises of 50 – 500 people.
If the product or service has wide reach and customers, a small minority of firms have the option of growing beyond this medium-size to become large corporations. But once businesses become large corporations, their ability to grow naturally by selling more of the same product or service becomes limited. This natural growth is known as “organic growth”. Where organic growth stalls, shareholders, and options trading companies look to management to provide new avenues of growth. One of the major ways companies can accomplish this is through acquiring other companies and adding their products and services to their own.
Avago Technologies Ltd (NASDAQ:AVGO) has recently taken exactly this approach. Early indications are that the market likes the move, which has seen the stock price rise from below $70 late last year to recent highs above $140. So can Avago’s share price continue its upward march?
Understanding the Business
Avago Technologies is in the business of supplying the world with optoelectrics components to integrate into electronic devices. These components are often also known as semiconductors, and have the ability to transport information, light and data within devices and from one device to another. It helps to think of AVGO as the company that provides the raw material that helps built the “roads” that digital information travels on.
Avago began life as a spin off from its parent company, Hewlett Packard at the height of the dot com boom in 1999. The company’s largest transformative acquisition to date was the $6 billion plus purchase of LSI Corporation, which helped broaden the appeal of the company to other businesses that needed mass market solutions for their own devices.
Avago now earns the majority of its earnings from storage chips and interconnecting technology. A prime example of the kind of customer that has needs for large amounts of high quality material like this is the data centre industry, which is
growing exponentially as we create more and more data that needs to be securely stored.
Metrics and Measures
The first quarter results for Avago Technologies showed strong stable earnings from mature business divisions, which may have been one of the main reasons AVGO has recently announced another large scale acquisition. Revenue for the quarter was $1.61 billion, which was broadly in line with the $1.63 billion earned in the same quarter last year.
Encouragingly, the gross margins for the products sold by Avago increased by a percentage point to 52%, which equated to $846 million. This showed the market and options trading advisory services that Avago management was achieving success in streamlining their operations and controlling their costs without any negative effects on the sales levels.
The company also finished the quarter with an incredibly strong cash balance of $2.5 billion, which showed that free cash flow generation from sales after costs were removed was strong. Large cash balances give companies the option to invest in the business or purchase other businesses, which is exactly what Avago did.
The Investment Case
Using their strong cash in the bank position, Avago agreed to buy fellow semiconducting chip manufacturer, Broadcom (BRCM). This purchase once again substantially expands the potential customer base from Avago products.
Most notably, Broadcom supplies chips and technology to flagship Apple products like iPhones. With that company reporting strong sales and having a global user base, the prospects for those companies that supply them critical components is strong.
The purchase also allows Avago to compete better with giants of the industry like Intel and Qualcomm, while still being small and flexible enough to respond more quickly than these behemoths.
The investment case for Avago will depend on whether management can integrate the Broadcom services, products and research and development functions as successfully as they have with earlier acquisitions. If they can, the company can achieve stronger results through what are called “operational synergies” where more can be achieved with less money.
Avago operates in a global industry that has growing demand, which is a great business proposition for a growing company. If they can use the acquisition of Broadcom to increase their customer base and product range while maintaining their existing clients, their revenues and share price will likely experience healthy growth in the near future.
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