3 Reasons Broadcom Is A Must Own Blue-Chip Dividend Stock

Mar. 26, 2019 12:28 AM ETBroadcom Inc. (AVGO)40 Comments


  • I'm a huge fan of Broadcom, one of my favorite high-yield tech dividend blue-chips.
  • That's because its quality management team is a master of sustaining strong growth through strategic M&A, resulting in some of the industry's most impressive dividend growth.
  • Broadcom is a 10/11 SWAN stock on my new Sensei Quality Score, which I use to rank every company on my watchlists.
  • From today's price (1% to 10% undervalued), Broadcom could deliver about 17% to 19% CAGR long-term total returns, more than double that of the S&P 500.
  • Investors need to be aware that a recession and bear market is possible next year, which could result in a big short-term decline.

(Source: imgflip)

While I'm a huge fan of buying quality blue-chips at deep discounts (and near 52-week lows) as I recently did for my retirement portfolio with AbbVie (ABBV) and Tanger (SKT), I'm not against recommending industry leading SWAN or sleep well at night stocks that are growing like weeds and soaring in price. The key is to always follow the Buffett rule of "it's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price."

I've been a big Broadcom (NASDAQ:AVGO) bull for over two years now, and the company's recent blowout earnings sent shares soaring to the delight of investors who were smart/brave enough to buy during December's correction.

(Source: Ycharts)

Well despite that impressive runup, I'm here to tell you that Broadcom remains a strong long-term buy today, for three important reasons. In fact, from today's valuation, I expect the company to deliver about 17% to 19% long-term total returns in the coming five years. That makes this level 10 SWAN stock (on my 11 point quality scale) a must-own dividend growth investment.

1. A Management Team That Knows How To Consistently Deliver Industry-Leading Growth

It's not hard to see why dividend growth investors might love Broadcom. The company has consistently delivered spectacular growth, in a highly cyclical and capital intensive industry no less.

(Source: investor presentation)

More importantly, free cash flow/share, what pays the dividends, has been growing like a weed over the last six years. And thanks to management's 50% FCF payout ratio target, so has the dividend.

(Source: investor presentation)

But past performance isn't necessarily a guarantee of future glory. Rather the reason I've been such a fan of Broadcom is that management's guidance for 2019 (and beyond) has been for impressive continued growth in its bottom line and dividend.

(Source: Broadcom CA Tech acquisition fact sheet)

For example, the 2018 $18.9 billion CA Tech acquisition, according to management, is supposed to drive long-term double-digit growth in earnings and free cash flow. For 2019 guidance was initially provided for results in line with that

  • 2019 Revenue Growth: 18%
  • 2019 Adjusted EPS growth: 13.6%

Even more impressive was what CFO Tom Krause told analysts at the Q4 conference call, about the company's expected growth in FCF and the dividend this year.

"So when you do that math, you are going to come up with a number that’s north of 20% in terms of potential for dividend growth (for 2019).... So I think we have a good setup to continue to be able to drive the dividend well into the double digits over the next several years." - CFO Tom Krause (emphasis added)

But wait it gets even better, according to Krause the company is planning to also buy back $8 billion in stock this year, bringing total capital returns to shareholders to $12 billion. All while rapidly deleveraging the balance sheet after the CA Tech Acquisition to maintain its investment-grade credit rating.

And to top it all off Krause also reiterated previous 2019 guidance for 18% top-line growth and nearly 14% earnings growth (and 20+% FCF/share growth) during the Q1 earnings call.

Ok, so rapid growth, a soaring dividend, and copious buybacks are all impressive but management can be as bullish as it wants. What matters is the ability to actually deliver on those rosy projections in the face of a downturn in the semiconductor industry and a rapidly slowing global economy.

  • Q1 revenue growth: 9%
  • Q1 semiconductor revenue growth: -12%

Here's what CEO Hock Tan told analysts about the most recent quarterly results.

"Similar to our peers, we see a slowdown in China impacting demand...However, much of this was factored into our original guidance and we are maintaining our full year fiscal 2019 business outlook." (emphasis added)

Indeed that slowdown in the industry is hurting Broadcom, who derives about 30% of sales from high-end smartphones. Longer industry refresh cycles, plus a slowing economy, have caused smartphone growth to slow to a crawl.

(Source: Statista)

But take a look at the blowout growth that Broadcom managed to deliver in Q1, especially where it matters most free cash flow.

"We generated over $2 billion in free cash flow in the quarter, which represented 39% growth on a year on year basis...Consistent with our capital return plan, we returned $4.6 billion to stockholders in the quarter including $1.1 billion of cash dividends and $3.5 billion of share repurchases and eliminations. We remain focused on returning approximately $12 billion to stockholders in fiscal 2019 via a combination of cash dividends and stock buybacks and eliminations, while maintaining our investment grade credit rating." - Tom Krause (emphasis added)

Accounting for buybacks (1.7% decrease in share count) Broadcom's FCF/share soared nearly 41% YOY in the last quarter. Now it's true that FCF can be very lumpy from quarter to quarter, as it depends on capex that isn't necessarily steady throughout the year.

But the point is that the CFO's 20+% FCF 2019 guidance from last quarter now appears to be a reasonable estimate of what the company can deliver this year.

That's especially true given that the CA Tech acquisition which increased the company's recurring subscription sales to about 20% of revenue, is likely to generate a lot of stable free cash flow.

(Source: investor presentation)

That's because last quarter CEO Hock Tan, who I consider one of the top CEOs in the industry (the Bezos of chip makers) announced that Broadcom was taking its brand new toy and improving upon it.

"We expect these changes to result in a dramatically more profitable revenue base which is more aligned to the rest of Broadcom and that we expect will grow. First and foremost, gone are the days of trying to land new products with new customers and I am referring to software, enterprise software. We are focusing all our attention on renewing existing products with existing mainframe-centric customers, customers that represent virtually all of the world’s largest enterprises and largest spenders on IT. We are also targeting expansion opportunities within this core mainframe customer base. The cost of running this renewed and expanded model will be substantially less than the legacy land-at-all-cost model and importantly renewing and expanding plays to CA’s strengths." Hock Tan (emphasis added)

The reason Broadcom bought CA Tech was that the mainframe software business while experiencing essentially no growth, is a highly stable and very cash-rich business. One that management plans to boost margins on by switching customers (corporate IT clients) to a subscription model vs the old perpetual licenses CA Tech used. Basically, it's what Microsoft (MSFT) did with Office and has resulted in a growing subscription business that has turned Microsoft's cash cow into an even better money minting machine. Broadcom plans to do something similar with CA Tech.

Which brings me to the biggest reason to like Broadcom and what makes it a must own SWAN stock in my opinion. That would be management's skill, led by Hock Tan (strong background in both finance and engineering) and how it's mastered the art of M&A that is so popular in the tech sector in generous and the semiconductor industry in particular.

According to the Harvard Business Review, 70% to 90% of mergers fail. That's because companies typically overpay, take on a lot of debt, and fail to achieve the synergies they expected (due to incompatible corporate cultures).

(Source: investor presentation)

Well just take a look at the bevy of M&A deals that have built Broadcom into its current empire. And mind you those are just the big ones.

From 2013 to 2015 Broadcom (at the time Avago) bought four companies for under $1 billion.

That's part of Broadcom's strategy of acquiring leading (#1 or #2 market share) companies, and then selling off all the low-margin/slow growing parts, while investing heavily into the most lucrative parts of the business. That's why Broadcom's profitability profile, a key sign of management quality, is so impressive.

(Source: Simply Safe Dividends)

Note that ROIC has taken a big hit due to the debt Broadcom has taken on as part of the CA Tech acquisition. In 2016 and 2017 you'll also note that ROIC (the best proxy for quality management) fell off a cliff due to the Broadcom/Avago merger and Brocade acquisitions. But ROIC then soared again in 2018 and I fully expect the CA Tech acquisition will pay off big starting this year, causing ROIC to climb steadily higher.

But notice how the company's operating margin is relatively stable at about 26% over time, far above the level that's considered the benchmark of quality in its industry. Most importantly of all, look at the sky-high free cash flow margin which has been climbing over time and last year was almost 10 times the level that's considered good for chip makers.

Broadcom's management is masterful at M&A (Hock Tan is chess master at strategic acquisitions and good capital allocation) which is why I rank Broadcom a 3/3 on management quality on my Sensei Quality Score. That's my new quality rubric which looks at three crucial characteristics of a company

  • dividend safety (1-5) - payout ratio, balance sheet, cash flow stability
  • business model risk (1-3) - moat, disruption risk
  • management quality (1-3) - long-term capital allocation track record/capital return policy (how supporting of stable and rising dividends over time)

Broadcom ranks a 4, 3, and 3 giving it a total score of 10/11. That makes it a solid SWAN stock (9+ on my scale). The only reason the dividend safety isn't higher is due to the current leverage ratio which I'll address in a moment.

But in case you don't want to take my word for how great Broadcom's management is here's Motley Fool's (where I used to be an analyst) Ashraf Eassa with his take on Tan and company

Broadcom is singularly adept at acquiring and integrating businesses in a way that undeniably creates shareholder value."

Basically, Broadcom's wheeling and dealing over the years have turned a leading semiconductor maker into a dominant chip maker with strong wireless, storage, and wired infrastructure franchises PLUS now a great high-margin infrastructure software business. That level of diversification is one that smaller rivals lack and smooths out cash flow nicely when wireless gets weak as it is now.

For example, according to Hock Tan, the networking business is thriving right now, posting double-digit revenue growth management expects to continue over the long-term. That's thanks to the launch of new router/Ethernet switching products.

And thanks to cutting costs by $1.4 billion at CA Tech (via the new shift to subscriptions vs perpetual licenses) Broadcom things it can increase CA Tech's operating profits by 127% in the coming years. That means that business's high FCF margins will get even better, driving overall improvements in Broadcom's profitability.

That translates into ongoing strong dividend growth for one of the best tech companies in the world, which should convert into some of the best total returns you can find from a high-yield SWAN stock.

2. Total Return Profile: One Of The Best SWAN Stocks You Can Own

What ultimately drives total returns, and thus my recommendations and portfolio buys, is a company's dividend profile. This is why I look at four things, yield, dividend safety, long-term growth potential, and valuation.

Company Yield TTM FCF Payout Ratio Simply Safe Dividend Safety Score (Out Of 100) Sensei Quality Score (Out Of 11) Projected 10 Year Dividend Growth (Analyst Consensus) 10 Year Potential Annual Total Return (No Valuation Change)

Valuation Adjusted 10 Year Return Potential

Broadcom 3.6% 42% 67 (Safe) 10 (SWAN) 13% to 14% 16.6% to 17.6% 16.7% to 18.7%
S&P 500 1.9% 38% NA NA 6.4% 8.3% 2% to 8%

(Sources: management guidance, Gurufocus, Fast Graphs, Simply Safe Dividends, Morningstar, BlackRock, Vanguard, Gordon Dividend Growth Model, Dividend Yield Theory, Multipl.com, Yardeni Research, moneychimp, analyst estimates)

Broadcom's yield has come down a lot but it still offers almost double the payout of the S&P 500. More importantly, that dividend is safe thanks to a low payout ratio and some of the most stable FCF in the industry.

But of course dividend safety is about more than just a well-covered payout, it also means a strong balance sheet.

Company Debt/EBITDA Interest Coverage Ratio S&P Credit Rating

Average Interest Cost

Return On Invested Capital

Broadcom 3.4 7.1 BBB- 5.0% 9%
Industry Average 1.7 57.8 NA NA NA

(Sources: Morningstar, Gurufocus, CSImarketing, Fastgraphs)

This is where some investors get nervous because the CA Tech acquisition meant taking on a lot of debt and at the end of the current economic cycle (the longest expansion in US history) no less.

Moody's has already downgraded Broadcom's credit rating to a stable BBB- equivalent over the increased leverage ratio. However, Moody's expects the company, despite its huge buybacks this year, to still deleverage quickly, with leverage falling into the low 3s within 12 to 18 months.

(Source: Simply Safe Dividends)

Analysts are also optimistic about the deleveraging efforts forecasting the net debt/EBITDA ratio will decline to 2.5 within the next 12 months. You'll notice how outside of large M&A Broadcom's leverage ratio has generally been very safe, typically well below the 1.5 level that's low-risk for the industry.

Basically, I'm not worried about Broadcom's debt because management has proven it knows what it's doing in terms of using cheap debt wisely and effectively, all while delivering safe and fast-growing dividends.

How fast can we expect Broadcom's dividend to grow? Well given the FCF payout ratio is right at management's long-term target, in-line with cash flow. Fortunately, management says that will be at a double-digit rate, and analysts expect 13% to 14% CAGR FCF/share growth over the next five years. I consider that a reasonable estimate given management's cost-cutting plans at CA Tech and its initial success in its long-term plan for that high margin business.

13% to 14% long-term FCF/share growth plus that 3.6% yield means investors can likely expect great total returns of about 17% to 19% when you factor in the current valuation.

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

For example, today Broadcom is trading at a trailing Adjusted PE of 13.4, and its long-term average is 13.8. Assuming the PE is just 13.5 in five years (still below its historical norm) the stock would deliver nearly 16% CAGR total returns. And if the stock hits a multiple of 15 (Chuck Carnevale's rule of thumb for quality companies) then 17.7% CAGR total returns would be expected.

In contrast, according to Morningstar most asset managers/analysts expect just 2% to 8% CAGR from the S&P 500 over the next five years. Which means that Broadcom today offers

  • double the market yield
  • a dividend growth rate that's likely double that of the S&P 500 (20-year median dividend growth 6.4%)
  • total return potential that's two to four times as great

Ok, so maybe Broadcom is a great blue-chip dividend growth stock. But with shares up almost 30% in the last few months how can it possibly be a strong buy today? Well, actually I consider Broadcom's valuation attractive and the third reason to consider buying the company today.

3. Valuation: Despite Strong Rally, Broadcom Is Still A Strong Buy

(Source: Ycharts)

It's been a great, though volatile year for Broadcom shareholders. But even with the stock up almost 25% in the past 12 months, I consider today a good long-term buying opportunity.

Forward PE 5-year average Forward PE Long-term Growth Rate Baked Into Price

Analyst Growth Consensus

12.6 12.3 2.7% 13% to 14%

(Sources: Simply Safe Dividends, Benjamin Graham, Fast Graphs)

Broadcom's forward PE is just 12.6 which is slightly above the five-year average. BUT that multiple is pricing in just 2.7% long-term cash flow growth, which a steadily more profitable business model will likely easily allow it to exceed.

This means Broadcom's future multiple is likely to be far higher and result in great total returns. To determine how much of a valuation boost investors can expect I turn to my favorite dividend stock valuation method, dividend yield theory or DYT.

This has proven highly effective since 1966 when asset manager/newsletter publisher Investment Quality Trends began exclusively using this valuation method to deliver decades of market-beating total returns.

(Source: Investment Quality Trends)

According to Hulbert Financial Digest, IQT's risk-adjusted returns are the best of any investing newsletter over the past 30 years and that's from using this one valuation approach for blue-chip stocks (based on six quality criteria). In other words, the approach I am using has a great historical track record.

DYT merely says that since dividends are paid out of cash flow, which is what a stock's long-term price is based on, the yield (a proxy for P/FCF) should cycle around a relatively fixed point over time approximating fair value.

Yield 5-Year Average Yield

Estimated Fair Value

Discount To Fair Value

3.6% 3.2% $331 10%

(Sources: Simply Safe Dividends, Gurufocus, Dividend Yield Theory)

Based on Broadcom's five-year average yield I estimate shares are fairly valued (and thus still worth buying) up to $331. That means the stock is about 10% undervalued and will likely provide a modest valuation boost over time.

Upside To Fair Value Long-Term (10 Year) Valuation Boost

Valuation Adjusted Total Return Potential

11% 1.1% CAGR 17.7% to 18.7%

(Sources: Dividend Yield Theory, moneychimp, Gordon Dividend Growth Model, Fast Graphs)

But given the fast growth rate and attractive yield (and thus strong total return potential) that 10% discount to fair value for a blue-chip of this caliber is still enough to rate a "strong buy" under my valuation scale.

But of course, I may be overly bullish so in case you don't quite trust DYT let's look at Morningstar's three-stage discounted cash flow model as well.

Morningstar Fair Value Discount To Fair Value Long-Term Valuation Boost

Total Return Potential

$300 1% 0.1% 16.7% to 17.7%

(Sources: Morningstar, Fast Graphs, Moneychimp, Gordon Dividend Growth Model)

Morningstar's analysts are famous for some of the most conservative growth assumptions on the Street, and so it's not surprising that Morningstar thinks Broadcom is less undervalued. But even it thinks Broadcom is trading at close to fair value which makes today a good time for long-term investors to consider adding this company to their diversified dividend growth portfolios.

Of course, that's only if you're comfortable with the risk profile.

Risks To Consider

While I consider Broadcom a low-risk SWAN stock that doesn't mean investors shouldn't be aware of things that could go wrong in the future that could hurt the investment thesis.

According to its 2018 annual Broadcom has a lot of customer concentration

  • Foxconn: 9% of sales
  • Apple: 25% of sales
  • Top 5 customers: 40% of sales

That amount of sales from just a handful of top clients could hurt profitability in the future, especially since in its 10-K Broadcom lists no less than 30 major rivals across its various business units.

While it's true that the company has 20,898 patents and 1,655 more pending (as of November 2018) the semiconductor industry is highly competitive and management will need to continue spending heavily but wisely on R&D to keep Broadcom a dominant industry leader.

And of course, there's the fact that Broadcom's heavy M&A strategy, which usually involves taking on a lot of debt to fund deals, comes with high execution risk. Hock Tan has proven a master at accretive deals and the company has been able to deleverage relatively quickly. BUT no one bats 1.000 and in a recession, credit markets will tighten up. Thus if the company's big bet on CA Tech doesn't work out (so far it's going very well) then Broadcom might be facing a credit downgrade to junk status which could significantly limit its future M&A abilities, at least for as long as a recession lasts.

Which brings me to the big short-term risk that most investors might care about, the recession we're likely facing in 2020.

As I write this the 10y-3m yield-curve, the most accurate recession predictor ever discovered according to a report by the San Francisco Federal Reserve, and what banks use to partially determine lending policies, has now inverted and sits at -1 basis points.

If we look at the last three recessions it's taken an average of 13 months from yield-curve inversion to the start of a recession. That means the next economic downturn is now looking likely to start between December 2019 to July 2020.

Now the good news is that while inversions signal a recession within 2 years 90% of the time, that doesn't necessarily mean that stocks immediately fall off a cliff. In fact, they typically keep going up for several months, sometimes by a large amount.

But this time might be different given that economic fundamentals now point to a recession starting relatively soon AND the fact that the media is hyperfocused on the yield-curve and thus stocks might start sliding much sooner.

Historical Average Correction/Bear Market Since 1926

If so then stocks could be in for a rough year, which is approximately how long the average slide to bottom takes (to a peak decline of 30% from all-time highs).

Now the thing to remember about historical averages is that they are just a very rough guide. In fact, every bear market is different, with declines ranging from -20% in 1990 to -57% during the Financial Crisis.

(Source: Moon Capital Management)

Where this applies to Broadcom is the fact that the semiconductor industry is both cyclical and highly economically sensitive. The good news is that over the past decade Broadcom has only been 82% as volatile as the S&P 500 (one of the lowest beta companies in its industry).

But that still means that shares might tumble significantly and any investor who will need cash to pay the bills over the next two to four years needs to make sure their overall asset allocation is set up to meet short to medium-term financial needs WITHOUT selling quality stocks at what might be incredibly undervalued prices.

That's why it's a good idea to have enough cash equivalents (like T-bills) or bonds (like long-term US treasuries) to be able to meet your expenses via the sale of appreciating income producing assets rather than potentially falling stocks.

My personal recommendations for cash and bonds are

  • cash equivalent: PIMCO Enhanced Short Maturity Active ETF (MINT) - 5 star Morningstar rated T-bill ETF (US and foreign sovereign bond ETF)
  • Long-bonds, average maturity 17 years (appreciate the most in a bear market): Vanguard Long-Term Treasury ETF (VGLT)

Don't get me wrong, I'm not trying to fear-monger anyone out of owning quality dividend growth blue-chips during a recession. My portfolio is both large ($243K) and 92% dividend stocks (I'm 8% in VGLT) and I have no intention of selling my holdings even if it's likely they are going to fall hard in the coming year. But my point is that anyone considering owning any stock, including Broadcom, needs to always do so as part of the equity portion of their portfolio and always keep total asset allocation and portfolio construction in mind.

Good risk management is the most important component of achieving your long-term financial goals.

Bottom Line: Broadcom Is A Must Own Dividend SWAN Stock

Don't get me wrong, I'm not saying that Broadcom is going to continue its torrid rise over the next few months. With economic fundamentals weakening and a recession possibly coming in 2020 anyone buying Broadcom needs to be aware of the volatile nature of its industry and the short-term pain that could impart on the share price.

But as far as high-quality SWAN stocks go, Broadcom is one of my favorite tech stocks. That's courtesy of a fantastic management team who consistently manages to deliver industry-leading growth rates, especially when it comes to free cash flow and dividends. That's courtesy of its CEO's masterful use of large scale M&A, which is among the best not just in the tech sector, but all of corporate America.

With a 10/11 quality score, I consider Broadcom one of the best dividend paying companies you can own, and despite that incredible run-up in recent months, I still think the company is 10% undervalued. Combined with a still attractive yield and mid-double digit long-term growth rate, that should translate into about 18% long-term total return potential.

Not just is that more than double what the S&P 500 is likely to deliver in the coming five years, but it's also one of the best return potentials of any blue-chip or SWAN stock you can find today.

This article was written by

Dividend Sensei profile picture
Maximize your income with the world’s highest-quality dividend investments

Adam Galas is a co-founder of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 5,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.

The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha).

I'm a proud Army veteran and have seven years of experience as an analyst/investment writer for Dividend Kings, iREIT, The Intelligent Dividend Investor, The Motley Fool, Simply Safe Dividends, Seeking Alpha, and the Adam Mesh Trading Group. I'm proud to be one of the founders of The Dividend Kings, joining forces with Brad Thomas, Chuck Carnevale, and other leading income writers to offer the best premium service on Seeking Alpha's Market Place.

My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives.

With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and safe and dependable income streams in all economic and market conditions.

Disclosure: I am/we are long AVGO, VGLT. 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.

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