This Stock Is on Sale, Don’t Miss It

Harsh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Chipmaker Cavium (NASDAQ: CAVM) was supposed to be one of my better picks for 2013, but I have to admit that I have been wrong so far. Shares have underperformed the NASDAQ Composite index by a wide margin so far, appreciating less than 15%, and as I write this, the stock is down around 5%.

The year had begun on a promising note, but dropped off after fears of a slowdown in infrastructure spending after F5 Networks’ terrible report in April. However, Cavium rescued its stock after a solid quarterly report in May, but it looks like the latest second-quarter report has failed to strike a chord with investors who are selling the stock as I write this.

Surprising!

So, what went wrong in the report? Revenue came in at $74.2 million, which was an impressive increase of 34% from the year-ago period and was marginally ahead of the consensus estimate. Similarly, non-GAAP net income jumped considerable to $12.6 million, or $0.23 per share, from $3.5 million, or $0.07 per share, last year. Earnings were on par with the consensus estimate, as well.

On outlook as well, Cavium didn’t disappoint, as it expects revenue between $77.5 million and $80 million, ahead of the $78.6 million consensus at the mid-point. The expected earnings of $0.26 to $0.27 per share are also ahead of the $0.26 consensus estimate at the higher end. A look at the gross margin makes me more confident that I wasn’t wrong about Cavium’s business doing well this year, as non-GAAP gross margin jumped to 65.8% in the quarter from 60.6% last year.

So, I still do not see any reason why investors should be dumping the stock given that it performed well in the quarter and the outlook issued is also decent. Hence, with the stock being beaten down right now, why not consider buying some of it? While the company might have underperformed the market so far, the business is doing well, and that’s what we should ideally look at, a good business.

No dearth of opportunity

My opinion on the company remains unchanged, as I believe a company that provides chips for networking and communication equipment and has some solid clients should do well on the back higher infrastructure spending going forward. Cloud computing is expected to be the fastest-growing category according to the Telecommunications Industry Association, and Cavium is in the right spot to benefit from this growth.

Cavium has witnessed solid progress in its enterprise and data center business, which is not surprising when considering that networking bellwether Cisco (NASDAQ: CSCO) is its major customer and accounted for 18% of revenue in the previous quarter. Going forward, Cavium expects growth in cloud infrastructure on the back of software-defined networking (SDN).

Cavium is counting on the need for more efficient and denser data center processors to drive performance, and the moves by its largest customer should also enable it to perform well. Cisco is looking to grab a greater share of SDN technology, although through a new architecture strategy. Cisco’s Application-Centric Infrastructure looks to integrate data center management and cloud computing, and the company believes that it is better than SDN.

Cisco will start deploying this architecture later this year. In addition, the company projects data center traffic to grow at a CAGR of 33% till 2015, clocking an annual run rate of 4.8 zettabytes. So, given Cisco’s predominant position in cloud computing and the rapid growth rate that it expects, I believe that Cavium is positioned to do better as Cisco goes about its cloud strategy.

Beyond Cisco

Apart from Cisco, Cavium had also landed contract wins at various other Tier 1 players earlier in the year, such as Nokia Siemens, Samsung, Alcatel-Lucent, and Huawei. These should bring diversification to the table, and it looks like the positive effects of these customer wins is already showing. On a sequential basis, revenue from Cisco was flat for Cavium, but even then, the company managed to grow revenue almost 7%.

Apart from enterprise and data center, Cavium is also well-positioned to benefit from growth of wired and wireless infrastructure markets. The company cites strength in 3G/4G equipment sales. I believe that its content in 4G base stations will be another reason why revenue should get better in the future, along with margins, as the more complex the technology, the higher the margin it commands.

Also, there is the probability that Cavium might benefit from the roll out of TD-LTE by China Mobile (NYSE: CHL) in the Middle Kingdom. CEO Syed Ali stated on the conference call that Cavium does have a customer who might participate in China Mobile’s initiative, leading to an improved backlog later this year.

Now, considering that Huawei enjoys a strong relationship with China Mobile, and Cavium had landed a design win earlier this year, I believe that the company might benefit from LTE deployment in the region.

China Mobile had launched a huge LTE tender in June, which, according to China Daily, is its largest to date. The tender is for supply of equipment for 207,000 base stations in 31 provinces as China Mobile aggressively moves to deploy TD-LTE, and an expected jump of 50% in capital expenditure to $30 billion this year indicates that there is a lot of opportunity for players such as Cavium to grow revenue.

The takeaway

Cavium is expecting improvements across the board in the third quarter, and this reinforces the fact that the company’s business is on a roll. Moreover, analysts are expecting earnings to grow at a robust 21.5% per year for the next five years and an impressive 38% next year, which makes the forward P/E of 26 times appear fairly reasonable.

So, investors shouldn’t be scared to scoop up more shares as the stock tanks since Cavium has a lot of firepower to grow in the future.

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Harsh Chauhan has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of China Mobile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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