Introduction
Broadcom (NASDAQ:AVGO$Broadcom(AVGO)$ ) might be one of the most impressive companies from the last decade while at the same time being very much underappreciated by investors. Broadcom is a semiconductor and software giant with a focus on connectivitytechnology. This includes connectivity semiconductors like Wi-Fi/Bluetooth chips and enterprise software like cybersecurity. The company once started as a semiconductor company but has been heavily investing in software over the last decade with the acquisition of several software companies of which the pending acquisition of VMware (VMW) should become its latest addition. Broadcom currently derives most of its revenues from semiconductors still, with about 80% of revenue coming from this product segment, but once the VMware acquisition is completed, this should come in closer to a 60/40 split.
As a result of the many acquisitions conducted by Broadcom, it has beenable to see very solid revenue growth over the last decade as well, with revenue growing at a CAGR of close to 12%, as can be seen below. Today, Broadcom has a market cap of close to $250 billion and is a serious free cash flow machine with free cash flows that approach 50% of revenue, which is simply stellar. With more revenue expected to come from software products over the next several years and solid growth expectations from its excellent exposure, this FCF margin should be able to go up even more with software generally sporting the highest margins. Investors are poised to benefit from this growth in free cash flow as Broadcom targets to return 50% of free cash flow to shareholders in the form of both dividends and share buybacks.
Due to Broadcom being primarily exposed to enterprise clients (with Apple (AAPL) being the largest customer) and not directly to consumer spending, it has been able to keep growing revenue over 2022, with its 4Q22 even putting in a new record high. Yet, despite continued strong financial results, the company was dragged down by general weakness in the financial markets, with its share price flat over the past year. As a result, Broadcom is far from expensive as it has been for quite a while now.
I lastcovered Broadcomin December, following its 4Q22 results, and called the company a buy as it was trading at a discount. Broadcom has returned 17% since this article, easily outperforming the 3% performance from the SP500. This is what I concluded back then:
Broadcom continued to outperform expectations and report incredible growth, despite a difficult economy. I'm very impressed by the business and continue to see Broadcom as a high conviction pick for long-term growth and strong shareholder returns. My long-term thesis has not changed, but I have become more convinced.
Last week Broadcom released its1Q23 earningsand managed to beat both top and bottom-line estimates by Wall Street analysts. EPS outperformed expectations by $0.17, or 1.6%. Revenue beat by $20 million. This showed a strong continued performance from Broadcom which is seeing falling growth rates but is performing much better compared to semiconductor peers that are reporting negative growth rates across the board. With growth rates remaining in the double digits, I don't think investors have much to complain about.
Following these results, I will update my investment thesis and rating on the company by going through the latest financial results, happenings, outlook, and check out its valuation after the increase in share price over the last quarter. Does Broadcom continue to be buy and a no-brainer investment?
Let's dive in!
Quarterly review
For its first quarter of fiscal FY23 Broadcom reported revenue of $8.9 billion which was up 16% YoY. Driving this growth was once again the larger semiconductor product segment which increased revenue by 21% YoY and reported revenue of $7.1 billion, now accounting for almost 80% of revenue. That the semiconductor segment increased its share in revenue is primarily due to a somewhat weaker performance in software revenues which fell by 1% YoY to $1.8 billion (VMware revenues of $3.71 billion, reported on the same day, would bring up the software segment to 44% of revenue). Despite, this drop in enterprise software revenue, the overall top-line growth of Broadcom continues to be very impressive, growing by double digits. Yet, it was down slightly from last quarter as Broadcom is also starting to feel the deterioration of the economy.
Broadcom saw continued growth in infrastructure spending during the first quarter. Demand for infrastructure technology is still strong with double-digit growth for 9 consecutive quarters now. This high demand is reflected in the backlog of Broadcom as visibility on semiconductors remains largely at 50 weeks, meaning Broadcom continues to be booked for all of FY23. This illustrates that demand for Broadcom products is very strong still, and the company is struggling to bring down lead times which, in this case, I will see as a positive. Falling demand has caused a lot of pain across the semiconductor industry, but so far Broadcom looks like it remains largely untouched, at least for its semiconductor products.
Now, focusing on the end markets of Broadcom, CEO Hock Tan reported that networking is still experiencing strong growth, growing 20% YoY. With $2.3 billion in revenue, this end market represents 32% of semiconductor revenue for Broadcom. The networking segment is a very interesting one and should see strong sustained growth for the rest of the decade as well, driven by fast growth among hyperscalers. According to Research and Market, the hyperscaler market should see very impressive growth at aCAGR of 25.37%until 2026. Networking semiconductors are a crucial component for hyperscalers as these are responsible for managing the flow of data between servers, storage devices, and networking equipment. Hyperscalers rely on high-performance networking hardware to enable fast and reliable communication between their servers, which is essential for running their complex workloads. With Broadcom being the frontrunner in high-end networking semiconductors, this positions them favorably.
Maybe the most important factor for hyperscaler growth over the next decade is the rise and importance of AI. This is whatHock Tan saidregarding the impact of AI on Broadcom:
Keep in mind that at hyperscalers, a growing portion of our switches have been deployed within their AI networks, which are separate from the traditional x86 CPU scale outrunning existing workloads.
Now this is today. Tomorrow, we generated AI using large scale -- large language, I should say, models with billions of parameters, we have to run thousands of AI engines in tower enabling large and synchronized bus of data at speeds of 400 gig and 800 gig. The network to support this massive processor density is critical and it's important SDAI engines.
So, Broadcom's networking products will play a very important role in realizing the expected growth in AI. Networking semiconductors are crucial for AI applications as they enable the fast and efficient communication that is necessary for processing large amounts of data quickly and accurately. Without networking semiconductors, AI systems would not be able to achieve the high levels of performance that are required for many real-world applications. And with the AI market projected to grow at a37.3% CAGRuntil 2029, Broadcom looks poised to benefit. Broadcom even estimates that over 2022, about $200 million worth of its products were already deployed in AI as indicated by Hock Tan during the earnings call:
Such networks have to be lossless, low latency and be able to scale. So as you know, such AI networks are already been deployed at certain hyperscalers through our Jericho 2 switches and Ramon Fabric. In fact, in 2022, we estimated our Ethernet switch shipments deployed in AI was over $200 million.
Broadcom is an understated beneficiary of these growing markets and forecasts that in 2023 the worth of Broadcom products deployed in AI will reach $800 million, which is 4x the amount of 2022, illustrating the sheer amount of growth ahead for Broadcom in this segment. In fact, I believe that the networking product segment for Broadcom will continue to see growth of above 20% in the near future and accelerate again once economic worries disappear. As a result, it will increase its share of total revenue as well, driving growth for Broadcom as a whole. To maximize its share in AI networking, Broadcom has been heavily investing in a new generation of this lossless low latency Ethernet fabric, designed specifically to handle such data and compute-intensive AI workloads. As a result, Broadcom itself also projects this segment to report growth of 20% YoY for FY23, despite the fair share of economic headwinds, tailwinds seem stronger for this specific segment.
Moving on to the server storage connectivity segment. This segment saw revenue of a record $1.3 billion last quarter as it grew 57% YoY and accounted for 18% of semiconductor revenue. Management said that the rapid growth for this segment was the result of the rapid transition to next-generation megawatt solutions but expects this transition to be largely complete now and growth to moderate to 20% for next quarter.
The broadband product segment also delivered impressive growth of 34% YoY and revenue of $1.2 billion, representing 17% of semiconductor revenue. Growth for this segment is expected to remain solid driven by new product releases and the high attach rates seen for the new Wi-Fi 6 and 6E. Growth for this segment should come in at around 10% for the next quarter.
Next, we have the wireless product segment. This one saw revenue of $2.1 billion, representing growth of 4% YoY and 29% of semiconductor revenue. The little bit of growth remaining for this segment came from new product releases and demand from North American customers. Due to some seasonality, Broadcom predicts this segment to be down by high single digits YoY in the second fiscal quarter.
As I mentioned earlier, growth in software was not as good with a 1% decline in revenue. Core software did increase by 5% YoY, but this is still not overly impressive in any way. Broadcom did achieve a 119% renewal rate, meaning that it is able to up and cross-sell to existing customers, driving up revenue per customer. Also, over 90% of renewal value consisted of recurring revenue which is good to see. This makes the company less sensitive to possible downturns and creates higher customer loyalty. ARR (annual recurring revenue) now totals $5.3 billion but was up only 3% YoY. Finally, regarding the acquisition of VMware, Hock Tan said the following during the earnings call:
As we stated on our last earnings call, we continue to anticipate that the time line for the review process will be extended in other key regions, especially given the size of this transaction. Having said that, we continue to expect the transaction to close within our fiscal 2023.
Moving on to the bottom line and we can see that Broadcom reported a gross margin of 74% which continues to be very impressive and slightly higher than anticipated. Semiconductor solutions saw its gross margin come in at a very impressive 69% and quite a bit higher than any of its peers. Enterprise software saw a gross margin of 91%. Broadcom has been focused on efficiency and as a result, both operating expenses and R&D were down 1% YoY. Broadcom continues to increase its headcount and invest in future growth.
Free cash flow for 1Q23 was $3.9 billion and increased by 16% YoY. This represented 44% of revenues, which is incredibly impressive and in line with the same quarter last year, Yet down from the previous quarter.
Balance sheet & dividend
Broadcom ended the first quarter of its fiscal 2023 with $12.6 billion in total cash and $39.3 billion in total debt, of which $1.1 billion is short-term debt. This balance sheet might not look overly attractive, even more so considering the fact that Broadcom also plans to acquire VMware for a total of $69 billion. Yet, we must also consider the amount of free cash flow this business is able to generate yearly. For FY22, Broadcom generated a massive $16.3 billion. Even if Broadcom were to, indeed, return 50% of this to shareholders, Broadcom would still generate $8 billion in remaining FCF to pay off debt and strengthen its balance sheet. Broadcom has shown in the past that it is very well capable of integrating new businesses and making them cash flow machines and I expect Hock Tan to do this again with VMware. Therefore, I do not think the current balance sheet should be of any worry.
That Broadcom has an excellent shareholder return policy will be clear by now, and it illustrated this again during the latest quarter. Broadcom paid $1.9 billion in dividends and repurchased $1.2 billion worth of its own shares. Broadcom still has $11.8 billion remaining under its current share repurchase program, so investors should continue to see plenty of repurchases over the following 12 months as well.
Broadcom shares currently yield an excellent 3.07%, which does not leave much to be desired, honestly. The payout ratio is safe at a 45% payout ratio while also seeing a 5-year dividend growth rate of over 28%. With a big acquisition pending and growth expected to moderate over the next couple of years, I am not expecting the dividend growth to remain this high, but investors should still expect dividend growth of high single digits at the bare minimum, in line with free cash flow growth. Overall, the dividend is safe, strong, and leaves plenty of room for growth, making this an excellent dividend pick. The Seeking Alpha dividend grades paint a similar picture as can be seen below.
Conclusion
Broadcom delivered an excellent quarter with growth that outperforms many of its semiconductor and software peers. It is its networking product segment in particular that should see very impressive growth for the next couple of years as this is seeing significant tailwinds from secular growth drivers like AI and cloud computing. Broadcom looks well positioned to benefit here and might be overlooked as a solid beneficiary. Also, while software growth was not as good as the semiconductor solutions, I do expect this to play an important part for Broadcom to make the business less sensitive to cyclical semiconductor downturns and significantly increase its margins as well, as shown by the over 90% gross margins currently achieved by the software segment. The VMware acquisition could play an important role here as this would boost software revenue to over 40% of total revenue. Also, a higher percentage of software revenue would increase the ARR, making cash flows even more predictable.
Overall, Broadcom remains a top pick for me as the long-term outlook is incredibly strong, while the short-term performance is impressive. The company remains resilient despite it earning 80% of its revenues from the historically cyclical semiconductor industry. And while the growth outlook according to analysts isn't overly strong for the period until 2026, I am expecting Broadcom to show us much stronger growth after a slight slowdown in 2023. And despite the impressive performance delivered by the company in combination with very strong shareholder returns and a 44% free cash flow margin, the company seems to be somewhat disliked by the market and deserves a much higher valuation. Despite this, I went with a conservative 16x P/E for the company and calculated a target price of $729 per share, leaving investors with approximately a 15% upside. While this is not a great margin of safety, I feel like the current EPS estimates by analysts are still somewhat conservative and the company could deserve a valuation that is closer to 20x. Therefore, I believe downside protection is still sufficient at this price point. Of course, there still exists a risk of losing Apple as a customer, but this does not worry me all that much as Apple's share of revenue is decreasing and the company has enough other growth levers. Of course, it could cause a short-term dip in revenue, but would not damage the long-term growth story.
The strong quarter delivered by Broadcom overall and in line with my estimates makes that I see no reason to change my expectations. Therefore, I rate Broadcom a buy at a share price below $660 per share. This is in line with my estimates made following the 4Q22 results from Broadcom:
I believe the fair value for Broadcom to be closer to $650-$700 per share and think the company is a solid buy on current prices and remains to be inexpensive.
Source: seeking alpha
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