Qualcomm Inc (QCOM)

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Broadcom Before the Storm

By Nicole Ridgway Published: September 28, 2006

http://www.smartmoney.com/Techsmart/index.cfm?story=20060928

ONCE THE POSTER CHILD of the tech boom, Broadcom (BRCM: 30.66, +0.91, +3.1%) now finds itself emblematic of a much less heralded sign of the times. The chip maker is one of more than 100 companies embroiled in the stock options backdating fiasco, but it holds the singular distinction of racking up the largest amount of charges so far — more than $1.5 billion worth — as a result of its options-granting practices.

Like a true bubble-era wonder, Broadcom, which had yet to turn a profit when it went public in 1998, used options to lure new talent and retain its highly coveted execs. Now, with the company expected to pull in $3.7 billion in sales this year, the options craze has come back to haunt it. Broadcom's auditors discovered that a significant chunk of the options it granted employees between June 1998 and May 2003 was backdated.

Backdating occurs when the date an option was granted is changed to reflect a date when the stock was trading at a much lower price. So when an employee cashes in those options at the lower exercise price, they make a larger profit. In congressional testimony earlier this month, Lynn Turner, the managing director at investment research firm Glass Lewis & Co., likened the practice to betting on a race after the race is over.

Since Broadcom launched an internal review of its options practices in mid-May, its share have plunged 20% to around $30. (The 52-week high was $50). Investors have reason to be concerned about the Irvine, Calif., company, but I can't help wonder whether the selloff is too reactionary. Those option-related charges, while admittedly humongous, will be recorded as noncash, stock-based compensation charges that will be reflected in restated earnings statements that go back to 1998. The charges should be offset by the company's paid-in capital accounts. If you don't have an accounting degree, don't fret. The bottom line is the charges aren't expected to impact the company's cash position or shareholders' equity, begging the question of whether investors should run for the hills or take advantage of Broadcom's beaten-down shares.

For short-term investors, the what-ifs facing this company, including higher tax expenses and possible shareholder lawsuits, far outweigh the potential near-term payoff. Long-term investors, however, might find a golden opportunity to tap into some high-growth markets. Broadcom's market-leading integrated circuits are used in a whole slew of broadband and wireless communications products, as well as enterprise networking gear. According to Stifel Nicolaus analyst Cody Acree, Broadcom has outpaced its industry peers for at least four quarters now. "They will continue to outgrow the industry as they continue to gain net share," he says.

But investors will have to be patient. Pacific Crest Securities analyst Ruben Roy, whose firm makes a market in Broadcom's shares, predicts that the stock will be stuck in a tight trading range of $26 to $32 until 2007 when, hopefully, the stock options dust has settled.

Those willing to wait it out should keep in mind that this backdating business is complicated, right down to a debate on the legality of the whole thing. Some claim there was no law governing the practice at the time, therefore offenders shouldn't be criminally prosecuted. Others disagree. "It is patently against the law," declares H. Nejat Seyhun, a finance professor at the University of Michigan's Ross School of Business. "If someone tampers with corporate documents in order to increase their compensation, then that comes under corporate fraud laws."

Executives at Comverse Technology (CMVT: 21.30, -0.37, -1.7%) and Brocade Communication Systems (BRCD: 7.05, -0.05, -0.7%) are currently under criminal investigation by U.S. authorities for just that. The Securities and Exchange Commission is probing more than 100 companies and the Internal Revenue Service is also digging in its heels. The U.S. Attorney's Office in central California contacted Broadcom, asking it to voluntarily provide certain documents, but no criminal investigation is underway.

Road to Recovery
Broadcom Chief Financial Officer William Ruehle, who had been with the company since 1997, unexpectedly retired last week as a result of the company's options review. A highly regarded exec, Ruehle had signed off on the SEC documents during the time in question and some, like Jefferies analyst Adam Benjamin, believe his departure might help speed the review along. "We believe the certainty and potentially quicker timing of a resolution outweigh the change in management, and we would take advantage of any weakness," he wrote in a Sept. 20 research report.

Timing is a big issue. Broadcom has left us in the dark about when the review will be completed. Earlier this month, investors were shocked to hear that charges were expected to be more than twice as much as the $750 million the company had anticipated two months earlier and could climb significantly higher. Broadcom also said it would have to restate earnings from 1998 through the first quarter of 2006 (originally it was only going to be 2000-2003). As a result of the review, the company has delayed the filing of its earnings statements, and Nasdaq is threatening to delist its shares.

I find it highly doubtful it'll come to that, though. Broadcom spokesman William Blanning says the company has filed for an extension with Nasdaq and expects a decision within the next few weeks. "We hope to refile our restated financials and get back to compliance as quickly as possible," he wrote in an email.

There are other risks to keep in mind as the options saga unfolds. Broadcom could be facing a hefty tax bill. Companies used to be able to write off options that were granted as incentive income for execs. Should the options in question be deemed unworthy of those benefits, the company could owe Uncle Sam some serious back-taxes. It could also face shareholder lawsuits. Both lawyers and accountants will cost the company plenty of money.

There's also the psychological impact of an options-backdating investigation. University of Michigan's Seyhun and his colleagues conducted a study examining 88 companies and found that once a company discloses an options review its shares lose an average of 7.5% in value, lobbing off $415 million in market cap. Broadcom's stock has taken much more than a 7.5% hit, and that's exactly why I think it would do long-term investors well to invest in the stock once much of the results of the options review are revealed, which I believe will be in the next month or so.

In late July, the company said sales during the current third quarter would fall short of expectations due to slower-than-expected demand for digital subscriber line and Ethernet switching products. That inventory buildup might cause another hit to the stock, but it's widely expected to be resolved by the fourth quarter.

"Per our industry checks, our sense is that Broadcom's own visibility has improved going into 4Q," wrote BMO Capital Markets analyst Ambrish Srivastava in a research note Monday. Srivastava said sales should pick up on the release of Nintendo's Wii, the addition of new PC customers like Hewlett-Packard (HPQ: 35.73, +0.34, +1.0%) and Apple Computer (AAPL: 76.77, +0.36, +0.5%), increased wireless handset shipments and a faster-than-expected recovery in the DSL market. The analyst, who has an Outperform rating on the stock, ratcheted his 2006 earnings estimates up to $1.32 from $1.29 a share compared to last year's 98 cents.

"Longer term, we think Broadcom is one of the top three semiconductor companies," says Pacific Crest's Roy, who rates the company's shares Sector Perform. He thinks the company's set-top box, wireless local area network and Bluetooth businesses will be highfliers going forward.

Maybe in a few months Broadcom can concentrate on what it really should be known for: that "top three" semiconductor company status. Until that time, it's going to have to try its best to put this options debacle behind it.