Is Broadcom Getting Desperate?

About: Broadcom Limited (AVGO), Includes: CA
by: Nicholas Ward

Broadcom made headlines with news breaking of an $18 billion offer to acquire CA Technologies.

This horizontal move is a far cry from the company's recent big to acquire Qualcomm.

Personally, I don't like the move, but I'm not selling my shares in response. Instead, I'm trusting in management to make this deal work out.

For a while now, Broadcom (NASDAQ:AVGO) has been a controversial holding in my DGI portfolio. I’ve heard certain investors say that they wouldn’t touch it with a 10-foot pole because it appears to be a classic roll-up type operation and those tend to end badly. Others absolutely love the stock because of its low multiple, strong growth, solid yield, and absolutely fantastic dividend growth. I think I’m somewhere in the middle.

I own AVGO, but I do have my reservations. The stock is volatile, yet I don’t often feel compelled to buy it on the dips because my position is already full and I’m afraid to go overweight this one. So, with news breaking after-hours of AVGO’s most recent acquisition attempt, an $18 billion deal for CA Technologies (NASDAQ:CA), I’m stuck in a bit of a conundrum again. As of right now, AVGO is down more than 5% after-hours. The stock has fallen below $230 again, and while many metrics point to this being one heck of a bargain, I still have my concerns.

So, before we get into AVGO, let’s take a look at CA. Admittedly, CA wasn’t previously on my radar. This company pays a dividend but isn’t a reliable dividend grower, and this evening is the first time that I’ve ever done due diligence on the stock. With that said, after a quick glance at the company’s balance sheet and operations, I’m not overly impressed.

CA is well known for its mainframe software operations. These services provide solid cash flows, yet their legacy nature leaves the company at risk of secular headwinds as more and more customers switch to the cloud. CA’s sales have been fairly stagnant over the last 5 years. In 2013 it produced $4.64 billion in sales, and during the trailing 12 months, CA has only produced $4.16 billion on the top line. Frankly put, I’m rarely interested in owning a stock that hasn’t shown top line growth over a 5-year period of time. I imagine that AVGO sees synergies somewhere along the line, though I can’t help but imagine that there isn’t a more productive use of $18 billion elsewhere in the market.

CA’s EPS, cash flows, and free cash flows per share are also trending downward looking at the past 5 years. The business is still profitable, though it appears that the headwinds likely to affect its legacy segments are picking up again, making it tough for this company to produce.

I will say that CA has done a fairly nice job of managing its debt load. The company’s debt/equity ratio is fine. It has also significantly reduced its share count during the past 5 years, which is also something that I like to see as a buyer. CA maintains high gross margins at ~85%, but its net margins aren’t nearly as impressive at ~20% (during the trailing twelve months, the company’s net margin is only 10.1%, but over the prior 5 years, it hovered between 20.3% and 18.8%).

CA has made investments to revolutionize the services that it offers, and is still considered a leader in its industry. It’s worth noting that AVGO didn’t pay a huge premium for this company; CA shares closed the trading at ~$37, and AVGO is offering $44.50. $44.50 still represents a ~16x forward multiple on CA shares. Looking at the F.A.S.T. Graph below, you’ll see that CA’s “normal” P/E ratio over the past decade or so is ~13x. It appears to me that AVGO is overpaying a bit for what is likely to result in reliable cash flows but minimal (if not negative) growth.

(Source: F.A.S.T. Graphs)

AVGO obviously feels compelled to spend its cash somewhere. At the end of its most recent quarter, AVGO had ~$8.2 billion in cash/cash equivalents. The company has made a habit of making acquisitions, and apparently that $8.2 billion is burning a hole in CEO Hock Tan’s pocket. I really liked AVGO’s attempt at purchasing Qualcomm (NASDAQ:QCOM). Actually, I’m a bit surprised to see Mr. Tan pursue a name outside of AVGO’s core company of semi-conductors. I’m sure that Mr. Tan has a vision for integrating CA’s services into AVGO’s current operational environment, but as a shareholder, I would have rather seen AVGO try to broaden its moat a bit in the highly competitive semiconductor space rather than move into legacy software services.

I’m also a bit concerned that this deal will have a hard time being approved. AVGO has had issues with this lately, though I’m not sure if there will be national security-type concerns related to the CA deal. In an environment where vertical deals are questioned by the DOJ, I can’t help but feel as though a horizontal deal is at even more risk. I suppose one could make the argument that CA is shrinking and needs to diversify itself to remain relevant over the long term. Horizontal M&A certainly achieves that goal, but in a political environment that is so focused on job creation, a company famous for cost cutting roll-ups will probably have a hard time receiving political favor (which might be necessary for approval, whether that’s right or wrong).

But with all of my negatives on the CA purchase aside, let’s take a look at AVGO. Even if the deal is a bad one, ~$18 billion isn’t going to break the bank for a company like AVGO that has generated nearly $6 billion in free cash flow during the trailing 12 months. If other analysts (whose opinions are much more important than my own, and much more likely to move the stock) come out with bearish reports on the deal, the share price could be unjustly punished.

AT ~$230/share, there is certainly a large amount of pessimism in this stock. Analysts expect AVGO to post $20 of EPS in 2018, meaning that shares are trading at only 11.5x this year’s earnings. This $20 figure represents ~25% growth yoy from 2017’s $16.01 figure. It’s rare to find a company growing at ~20% and only trading for 11.5x.

However, it’s important to note that because of AVGO’s growth via its acquisition strategy, there is typically a large gap between its reported earnings and GAAP earnings. For instance, in 2015, the company posted $8.98 in non-GAAP earnings but only $4.85 in GAAP. In 2016, the gap was even worse, with AVGO posting $11.45 in non-GAAP earnings and -$4.86 in GAAP. In 2017, GAAP earnings turned positive again, but there was still a large divergence between reported and GAAP earnings, which came in at $16.01 and $4.27, respectively. I suspect that we’ll see more of the same moving forward, so if you’re a strict GAAP accounting investor, then AVGO is probably not the stock for you.

It’s also worth noting that analysts expect AVGO’s growth to hit a major speed bump in 2019, where it’s only expected to grow ~3%. The consensus estimate for 2019 EPS currently sits at $20.63/share. Looing out to 2020, analysts are expecting to see slightly better growth (8% yoy) with the consensus sitting at $22.36/share. Looking out a couple of years, we’re staring down at a single-digit forward P/E. Oftentimes this results in solid long-term total returns, but looking at this M&A news, which doesn’t quite reek but does hint of desperation, I can’t help but worry that AVGO management is worried that without some sort of move the company's results will fall short of expected growth targets.

I’m a fairly conservative investor, and I admit that AVGO’s gap between GAAP and non-GAAP accounting figures have me concerned - as does the roll-up strategy in general. I’ve seen this fall apart more than once, and when it does it happens fast and investors get hurt. With all of this being said, you might be wondering why I own AVGO stock in the first place. Well, the answer is plain and simple: its dividend.

AVGO’s annual dividend currently sits at $7.00/share. At $230, it yields 3.04%. While there is nothing particularly special about a 3% yield, there is something special about a company whose last two dividend increases were 100% and 75%. In 2010, when AVGO initiated its dividend, the payment was $0.07/quarterly. Flash forward less than a decade and we’re looking at $1.75 quarterly, or an increase of 25x.

Obviously, near-triple digit increases aren’t sustainable over the long term. With that being said, AVGO’s payout ratio is still relatively low looking at its 2018 non-GAAP EPS estimates. Assuming the company hits that $20 target, we’re talking about a 35% forward payout ratio. Because of the low payout ratio, management continues to raise the dividend at a faster rate than EPS growth. That really all depends on the R&D, M&A, and shareholder return plans.

I wouldn’t be surprised in the least to see AVGO increase its dividend to $2.00/share or more in December of this year, when it’s due to declare the next increase. I think a ~40% payout ratio makes sense. With that said, I’ve been surprised by the size of the last two increases as well, and for all I know, management could increase the payment to $10.00 or more annually, which would still represent a fairly conservative non-GAAP payout ratio.

Looking forward a year, an $8.00 dividend equates to a 3.5% yield at $230 and a $10.00 dividend represents a potential forward yield north of 4.3%.

Granted, it’s also worth noting that management could simply cut the dividend at any time. It’s risky to look ahead in terms of dividends because they’re not guaranteed. Nothing in the market, though I suspect that AVGO wants to maintain its shareholder-friendly outlook, because without the dividend, I think this stock would be even more volatile.

Frankly put, the more and more I think about this, the more I just wish that Tan and Co. would have simply used the ~$8 billion of cash on the balance sheet to buy back stock. AVGO has produced better growth than CA. CA does have higher margins, but that’s not an apple to apples comparison, being that the two companies operate in totally different industries.

Maybe I’m being totally off base here, and hopefully Tan and Co. are right (admittedly, they’re in a much better place to make any sort of judgment on this deal than I am). I’ll find out with time, I suppose. I don’t think I’ll be adding here around $230, but I don’t have any plans to sell either. AVGO is my 17th largest holding, making up 1.48% of my portfolio; that weighting is essentially full. Should shares fall below $200, I’ll start thinking about going overweight, but because of the volatile earnings and expectations of slowing growth, I’m going to want to see a wide margin of safety before I allocate more funds to AVGO.

Disclosure: I am/we are long QCOM, AVGO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.