CSFB (on Epigram purchase two weeks ago): Broadcom Corporation (BRCM) - Buy Targets Next Broadband Opportunity—Home Networking
-Acquisition of Epigram allows BRCM to penetrate the nascent home
networking segment and gives it first mover advantage with significant
customers already in place. We believe the fit is terrific.
-Epigram's low cost silicon provides broadband transmission speeds
of >10 Mbps for home PCs and peripherals. Epigram has significant
endorsements from 3Com, Nortel, Cisco, Microsoft, Lucent, and Texas
Instruments.
-Epigram should benefit more from the upcoming home networking
standard than most competitors, as it was instrumental in its drafting.
-Shareholders should be able to tolerate early dilution (6 cents in 1999) from Epigram, as BRCM now has a strong chance of providing the
broadband pipe both to and within the home.
-Reducing 1999E EPS to $0.70-0.75 from $0.80; 2000E unchanged at
$1.00, but should have upside as home networking is embryonic and
BRCM expects Epigram to be accretive next year.
Summary and Investment Conclusion
Broadcom announced it would acquire the leading provider of silicon solutions for home networking —Epigram Inc.—in a stock transaction valued at $316 million.
This acquisition catapults BRCM to a leadership position in a nascent market and raises the barriers for competitors in BRCM's existing markets. Epigram has first mover advantage in its market and employs a low cost, simple yet powerful connectivity option for in-home networking over existing phone lines.
Our long-term view of BRCM is that it offers investors an unparalleled claim on the future of broadband access, high-speed data networking, and home/personal networking. Accordingly, we continue to recommend BRCM and reiterate our Buy rating and $90-95 price objective.
Home Networking Market Opportunity
Several key factors driving the anticipated demand for home networking include: the number of homes within the U.S. that are equipped with multiple PCs (Exhibit 1); the significant growth trends for Internet usage (which suggest that over 25% of all U.S. homes were on-line during 1998); and the aggressive rollout of broadband access into homes (via cable or DSL modems). Industry sources estimate that as much as 34% of U.S. PC-owning homes already have two or more computers. As broadband access catches on, we think consumers are going to demand the ability to connect their multiple PCs over existing phone lines, rather than installing additional lines and incurring additional monthly charges.
These trends suggest that a market is emerging that will create an opportunity for the PC vendors to introduce networking into homes. But before this can take place, a standard needs to be adopted. Currently, four major technologies exist— phoneline, powerline, wireless (or RF), and category-5 ethernet (10BaseT) all vying for adoption mainly by the PC OEMs. Epigram's silicon solution, which utilizes existing phoneline technology, appears to be at the forefront of obtaining the standards necessary for deployment (from the HPNA), as well as being a favorite
technology among the PC OEMs. The compelling factor that we believe will eventually lead to the adoption of the phoneline technology will be its low cost.
PC vendors anticipate that phoneline-based networking will be the clear winner. Recent market surveys indicate that over 80% of U.S. preinstalled networking nodes in 1999 will be based on phoneline technology (Exhibit 2), thereby creating a large installed base of network-ready systems in homes.
Epigram's iLine10 Chipsets have considerable momentum within the market and management is extremely optimistic that HPNA (standards body) will adopt Epigram's chipsets as the standard silicon solution for the home office. If HPNA accepts the chipsets, integrating them into broadband access devices such as cable modems, cable set top boxes, and DSL modems will significantly add to BRCM's market opportunity.
Epigram—Silicon for the Home
Epigram designs silicon products that allow broadband distribution of data, Internet access, video, and telephony within a home or small office. Epigram's iLine10 product supports speeds of 10 Mbps today, but will support 100 Mbps speeds in the future. The chips will be used in a wide range of devices from PCs and printers to DVD and VCR players to scanners and digital cameras. We almost think of this as the USB port for broadband communications—any home digital appliance would be a natural candidate for such silicon.
Epigram's silicon provides its customers with a means to distribute broadband capabilities within the home. Whereas Broadcom's silicon focuses on providing bandwidth for the conduits into the home or business (cable modems, Fast/Gigabit Ethernet, set top boxes), Epigram's mission is to make it possible to connect a billion appliances to the Internet over simple, easy-to-use phone wires.
Key Attributes
We believe the following are the key factors that BRCM considered in acquiring Epigram.
· Exciting new market and great backers. The home networking market is just emerging and will likely take several years to solidify. While there are risks of being too early, the market clearly perceives Epigram as the leader. The company has built an impressive list of customers/backers: 3Com and Panasonic have equity interests; Cisco is using Epigram across its full line of home networking products; and products stemming from the co-branded 3Com/Microsoft initiative will be based on Epigram. Additionally, Lucent and Texas Instrument, while both likely long-term competitors, have agreed to endorse Epigram's technology. Although not announced, we believe Epigram has significant working relationships with major consumer electronics and PC companies.
· Another high hurdle for existing competitors. Aside from the advantage of being early in a new market, acquiring this technology will make it more difficult for BRCM's existing competitors in the cable modem and set top box arena. Now that it is armed with formidable home networking technology, BRCM will most likely deploy the technology in cable modem and set top box designs (BRCM has over 80% share here). By embedding home networking technology within other broadband platforms, BRCM has added yet another arrow to its system-on-a-chip-technology quiver.
· Gaining first mover company. Epigram was a founding member of the Home Phoneline Networking Alliance (HPNA), the 70-member organization that is driving the creation of standards for interoperability among home networking devices. We believe that Epigram, with its reputation as one of the hottest startups in Silicon Valley, gives BRCM leadership technology in the home networking market. Consistent with past practices, BRCM is capturing the high ground by owning leadership technology, where it can exert significant influence on the final product through its work with the standards bodies or via key customer relationships.
· Standard for home networking coming. While the standard for home networking has yet to be ratified, we believe Epigram had a strong hand in drafting the specifications of version 2.0 of the standard. We expect ratification of the standard shortly with working, standards-compliant silicon from Epigram in the third or fourth quarter of 1999. Just as Broadcom was able to do with the DOCSIS cable modem standard, we think it can likely layer many proprietary extensions on top of the baseline standard that only Epigram can take advantage of, while still being fully compatible with all other vendors.
· Customer and cultural overlap is a positive. The networking customer overlap is obvious — Cisco, 3Com, and Nortel. Somewhat less obvious is that home networking will be a valuable technology in demand by BRCM's cable and set top box customers. This will be especially true as IP-voice begins to permeate the home. From a management style perspective, Broadcom and Epigram are led by aggressive, type-A personalities and both companies are highly engineering-driven organizations.
Financial Implications
Financially, BRCM is accepting about 2 cents per share per quarter in dilution. Epigram has only nominal revenues at this point and is incurring the expense of over 50 people. BRCM will issue 4.6 million shares to purchase Epigram. This transaction, combined with the earlier acquisition of Maveric (which will close this quarter), reduces our 1999E EPS to $0.70-0.75 from $0.80. (Note that following
last week's blowout earnings report, which was 35% ahead of expectations, we had raised estimates by 20 cents.) For 2000, we have not yet factored in the impact of Epigram, as we are still assessing the potential. We believe, however, that the revenue impact could ultimately be in the tens of millions, as conservative estimates for the 2000 home networking market range between 10 million and 15 million units. Since BRCM is likely to use an aggressive pricing strategy for home networking, just as it did for broadband and high speed networking, we believe Epigram's current ASPs are likely to decline rapidly from the $15-20 level. As was the case in networking, the more aggressive BRCM is with pricing, the more we expect its hegemony over this space to rise.
Conclusion
BRCM has made a significant attempt to gain entry into the home, completing the end-to-end solution for broadband—from the user, across the WAN, to the business. We expect broadband access capacity, coupled with the usefulness of the Internet in general and new potential wireless applications, to foster pervasive connectivity. In the future, we believe users—both business and consumer—will demand the any-to-any communications model—connect to any network (IP, ATM, WAN, LAN) over any medium (copper, fiber, air) to access any service (voice, data, video) irrespective of time and distance. Many of the solutions that Broadcom proposes would fulfill this model on an end-to-end basis, leading us to continue to recommend Broadcom as a core holding. |
