Broadcom Still A Relative Bargain In Semis
- Broadcom did a little better than expected in fiscal Q2, helped by ongoing strength in the data center.
- The future of the wireless business may still be in question, but Apple should drive some incremental growth late in FY'20, and I believe Broadcom has secured its margins.
- Wired markets like data centers remain a key growth opportunity, with Broadcom looking to extend its leadership in switch silicon and continuing growing its custom ASIC business.
- Mid-single-digit revenue growth and high single-digit FCF growth still support relatively attractive returns from these shares.
Likely due in part to its “neither fish nor fowl” mix of semiconductor and software businesses, Broadcom (NASDAQ:AVGO) continues to trade at a discount to my estimate of fair value. Broadcom’s diverse business has held up relatively well, but the shares have nevertheless continued to modestly lag large comps like Texas Instruments (TXN) and the broader chip sector.
The biggest concern I have with Broadcom is that the company’s decision to view itself (and operate) as a more diverse enterprise technology company will continue to drive a discount to fair value relative to what discounted cash flow and margins would otherwise support. That’s an “is what it is” risk with this name now, but one that I believe is offset by a leading market position in almost a dozen sizable markets, as well as excellent margins and the prospect of double-digit dividend growth in the coming years.
Modest Outperformance In Fiscal Q2
Relative to revised expectations, Broadcom’s fiscal second quarter was a little better than expected. Revenue was almost 1% better, with both semiconductors and software outperforming. Margins were also a little better, with a small beat at the gross margin line and a roughly 40bp beat at the operating margin line.
Revenue rose 4% from the prior year and fell 2% from the prior quarter, with the core semiconductor business (70% of revenue) seeing a 2% yoy and 4% qoq decline. While networking remained strong (up 11% qoq) and the industrial business was stronger than many peers (up 13% qoq), server/storage/connectivity and wireless both saw mid-teens declines on various headwinds in those businesses. Infrastructure (software, mostly) was up 21% yoy and 3% qoq, with the Brocade business up 11% qoq and double-digit growth in core account bookings.
Gross margin improved over a point from the prior year and 10bp sequentially, beating expectations by about 10bp. Operating income rose 3% yoy and declined 2% qoq, with operating margin down 70bp yoy and up 20bp qoq, beating expectations by 40bp.
Guidance for the fiscal third quarter was basically consistent with Street expectations, but management noted improving momentum in several markets, including cloud, telecom, and enterprise customers. That largely corroborates what has been a broader trend of healthy spending on cloud infrastructure, and positive (if lumpy) outlooks for 5G-related telecom spending. Management did point to a double-digit decline in wireless in the third quarter, with Apple-driven (AAPL) revenue ramps pushed out about a quarter.
Is An RF Sale Still On The Table?
One of the biggest unknowns around Broadcom remains the fate and future of the company’s wireless business. While management never explicitly said it was looking to sell the business, which holds leading share in areas like filters and connectivity, that was the broadly-accepted implication of management announcing after fiscal Q4’19 earnings that they were changing their view of that business toward it being a financial, not strategic, asset.
Roughly a month later, the company announced two new statements of work with Apple that would cover approximately $15 billion in revenue over the next three and a half years. While the announcements of these agreements are always short on specifics, I would assume this deal secured Broadcom’s business with Apple and paved the way for content gains in 5G (perhaps 30% or more).
As many companies could attest, Apple can be a difficult customer to deal with, and I wouldn’t be surprised in the least if Broadcom used that prior announcement as a bargaining chip to secure a “floor” for this business. Given the challenging relationship between Apple and Qualcomm (QCOM), seeing Qualcomm buy that business would have been a bad outcome for Apple, and Apple has enjoyed a long-lasting, productive, and extensive relationship with Broadcom’s wireless business (Broadcom has made up about $20 of the bill of materials for recent iPhones).
I have no idea whether the statements of work with Apple include change-in-control provisions, but it wouldn’t surprise me if they do. While that may limit Broadcom’s flexibility on divesting the business, it comes with more margin insurance/assurance with Apple business relationship. This business may still be sold at some point down the road (with Apple possibly buying it), but it isn’t an urgent issue for Broadcom.
Wired Businesses Offer Attractive Opportunities
Whatever the future of the wireless business, Broadcom still has some exciting opportunities in “wired” markets like the data center. The Tomahawk 3 and Trident 3 are both ramping now, as well as the Jericho 2 portfolio for telco customers, and I see little to worry about in the Ethernet switch market, even with the progress made by rivals like Mellanox (now owned by Nvidia (NVDA)). I likewise remain quite bullish on the company’s custom ASIC business, a still-underappreciated business that has seen substantial growth (to “several hundred millions of dollars”) over the last few years with customers like Google, and could grow further with expansion into areas like basestation processors.
I also like the ongoing opportunities from an expanded photonics business. There are sound arguments for integrating switch silicon and photonics on the same die, and doing so would put Broadcom further ahead many of its would-be competitors. Inphi (IPHI) is definitely outperforming Broadcom today in PAM4, and the COVID-19 outbreak has complicated/delayed the qualification/validation process for alternative suppliers, but I believe Broadcom can start closing this gap later in 2020 and into 2021.
Further expansion of the software business remains more of a threat to valuation than long-term business performance; it’s unclear that Broadcom will be allowed to make meaningful additional semiconductor acquisitions, and management clearly sees enterprise software as a worthwhile target market given high margins and cash flow generation. In the meantime, I believe Broadcom has a valuable and under-valued semiconductor business with leadership in attractive end-markets like data centers and telecom. While Broadcom’s leadership in broadband (set-top boxes and so on) isn’t as attractive given lower growth rates, the profitability and cash flow production make it an underrated business as well.
Although the COVID-19 outbreak has clearly created some near-term challenges, my long-term view of the company really hasn’t changed much. With strong exposure to the data center (including switching silicon, ASICs, and photonics) and profitable exposure to markets like broadband, I believe Broadcom can credibly generate long-term annualized revenue growth of around 5%. I likewise still see room for further expansion in what are already extremely high gross, operating, and adjusted free cash flow margins, driving high single-digit long-term FCF growth.
The Bottom Line
Between discounted cash flow and margin-driven EV/revenue and EV/EBITDA valuation approaches, I believe Broadcom is priced for an annualized return in the high single digits to low double digits. Although that’s not really breathtaking upside, Broadcom is one of the very few quality semiconductor names that I see trading at any real discount to fair value. With that, I still see a good argument for holding these shares, even if the company’s business mix and strategic plan is no longer in sync with what many tech investors would prefer.
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