Broadcom (NASDAQ:AVGO) has never been a company content to just sit still and play the hand it holds. Instead, management has always looked to maximize what it sees as the best long-term opportunities – exiting businesses with suboptimal return prospects (or high R&D requirements), and recently diversifying into the high-margin infrastructure software segment. Now it looks like further transformation is on the way, with management possibly looking to exit close to 40% of its semiconductor business while targeting new opportunities like silicon photonics and further infrastructure software bundling options.
Moving another year to the right does shift my fair value range higher for Broadcom, and I believe the semiconductor sector is bottoming out. What’s more, I believe that Broadcom remains a leader in several key businesses, including networking silicon, and I like the growth prospects of new ventures in photonics and base stations. Broadcom has clearly put itself in a different category relative to how many chip companies run themselves, but I continue to believe this is a case of “different is better” and that Broadcom is still a strong core holding candidate.
Broadcom’s fiscal fourth quarter was nothing particularly special, particularly with lackluster results in the semiconductor business, but it also wasn’t thesis-changing from a negative perspective. I can understand why investors looking for a beat-and-raise quarter may have been disappointed, but I look at it as a pretty much “steady as she goes” result.
Revenue rose about 6%, driven by inclusion of CA in the results. Semiconductor revenue fell 7% with weakness in most areas apart from networking, though revenue did improve more than 4% on a sequential basis and it does look like most of Broadcom’s core markets have bottomed. Infrastructure revenue rose 5% sequentially, with healthy growth in CA offsetting ongoing weakness in storage area networking.
Gross margin was a little better than expected (20bp beat), helped by a higher-than-expected mix of software revenue, as infrastructure revenue came in 12% better than expected, offsetting a 3% miss in the chip business. Operating expenses were a little lower than expected (about 2%), helping drive a 110bp non-GAAP operating margin beat.
With the quarterly results, Broadcom announced a 23% hike in the dividend, and the recent convertible preferred offering helped improve its liquidity/leverage, though at the cost of some dilution to common equity investors – basically paying to secure a better credit rating and maintain some flexibility with respect to M&A.
It’s difficult to compare Broadcom’s FY 2020 guidance to published estimates, as some analysts didn’t have Symantec in the model yet, but relative to those who did, the guidance was okay but not particularly exciting. Within the semiconductor business, management expects the RF business up high single digits on some content wins at Apple (AAPL), WiFi down low single digits, and networking/infrastructure up around 7% on good core networking/data center growth.
Broadcom has never been a company to rest on its laurels; when a business no longer meets management’s long-term goals/requirements, the company has often moved promptly to either dispose of the business or shift toward maximizing the cash flow of the operation. With this quarterly update, management announced some significant strategic shifts.
The biggest shift is the recharacterization of the Wireless business as a financial, not strategic, asset. This business represents about 33% of semi revenue and Broadcom has long enjoyed leadership in FBAR filters and wireless connectivity, as well as respectable share in other segments like power amps. Although this announcement has been met with some surprise, it wasn’t so long ago that many analysts and investors were pressuring the company to exit wireless on the assumption that it would no longer be a growth business due to slowing handset volume growth and increasing pushback from OEMs like Apple (AAPL).
I don’t get the sense that Broadcom is desperate to sell out of this business, and the company’s strong IP position should allow it to hold good market share for some time. Still, management could likely find strategic buyers for the FBAR business (including Qualcomm (QCOM), SkyWorks (SWKS), and Murata), and maybe a strategic buyer for the mobile WLAN business.
Management also announced that it regards its Industrial business as non-strategic, but that strikes me more as an acknowledgement of what’s been readily apparent for some time, as the company hasn’t really been reinvesting or looking to grow here. Broadcom has enjoyed leadership (#1/#2) in areas like motion encoders , industrial fiber, and optocouplers, but I’m not sure what any of this might fetch in a sale, particularly as optocouplers are under competitive pressure from isolators from companies like Silicon Labs (SLAB).
On the flip side, Broadcom is returning to some older businesses to target new growth opportunities. Having reacquired the optical transceiver assets that Avago sold to Foxconn shortly before Avago acquired Broadcom, the company is now ready to make a push into silicon photonics, where its very strong position in switch silicon could make it a serious threat. Management also announced its intention to compete in basestation processors now that its standstill with Intel (INTC) tied to the Axxia sale is over. Given Broadcom’s overall capabilities in SoCs, this could be an attractive long-term opportunity as well. With these moves, Broadcom will be increasing its R&D spending by hundreds of millions, but the long-term opportunity is measured in the multiple billions of dollars, so I’d argue it’s worthwhile.
While not a strategic shift per se, Broadcom also acknowledged the evolution of Cisco (CSCO) from customer to direct competitor. Cisco is launching a switching/routing silicon product that will compete with Broadcom’s Tomahawk/Jericho platform, and given the various investments Cisco has been making, including the acquisition of Acacia, this can’t be considered a surprise. Still, I think Cisco has its work cut out – Cisco has had its own internal silicon effort for some time, but has had to rely on Broadcom, including using the Tomahawk/Jericho products and Broadcom’s custom silicon capabilities (which Acacia has also had to use). With Broadcom achieving 2x performance jumps every two years (the recently-sampled 7nm Tomahawk 4 doubles the Tomahawk 3’s 25.6 Tb/sec throughput), Cisco has a high bar to surmount.
While there is risk in shifting focus away from the Wireless business, I’ve been regarding the Wired business and the company’s custom ASIC capabilities as far more significant to the long-term outlook for some time now. Should the company sell those assets, I’ll be curious to see if the company can once again return to chip M&A (assuming management sees worthwhile opportunities).
Shifting my model another year forward doesn’t change all that much, though it does bring another year of potentially high-margin revenue into the mix. I’m still expecting around 5% long-term revenue growth and high single-digit FCF growth, though I’ve trimmed back my near-term margin assumptions a bit in the expectation of higher growth-enabling R&D, though cost savings from Symantec will offset that a bit.
Between discounted cash flow and margin-driven valuation metrics, my fair value range for Broadcom moves from $300 to $320 to $320 to $345, and I’d note that Broadcom trades below where many other high-margin chip companies trade (due, I’m sure, to the higher debt and operational risks of the software business). I also note that I treat the recent preferred offering as equity (upping the share count) instead of debt.
Broadcom is still at least in part a bet on the management prowess of CEO Hock Tan, particularly with the moves into infrastructure software and the decision to recharacterize the wireless and industrial chip businesses. That’s a bet I’m still comfortable making, and I still regard Broadcom as a solid core tech holding.
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Disclosure: I am/we are long 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.