Broadcom Stock Is Overvalued

Summary

• Broadcom has a good growth history, especially supported by acquisitions.
• Even though it has diversified its product portfolio and is exposed to several secular growth trends, its growth prospects aren’t impressive.
• Its shares are currently overvalued, based on relative and absolute basis, so this is a stock to avoid.

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I invest in several secular growth trends, such as semiconductors or 5G, and decided to take a look at Broadcom (NASDAQ:AVGO) as an alternative to other stocks that I own. However, I’m not impressed by its growth prospects, its balance sheet and dividend sustainability could be better, and its valuation is expensive.

Business Overview

Broadcom is a technology company offering semiconductor and infrastructure solutions, including various wireless communication applications. It currently has a market capitalization of about $217 billion and trades on the NASDAQ, being one of the largest companies in the semiconductor industry by this measure.

It has about 21,000 employees, of which some 63% are in research & development (R&D) activities. This high weight of staff in R&D is explained by its fabless business model, which means that it outsources production of its products to third parties, such as Taiwan Semiconductor Manufacturing Company (TSM).

Broadcom’s technologies and products are quite diverse and mainly for wireless applications, including radio-frequency filters, wi-fi, storage adapters, beyond others. Its business is split into two segments, namely Infrastructure Software and Semiconductor Solutions. In the last fiscal year, the vast majority of its sales were generated by the Semiconductor segment, while Infrastructure was responsible for a much smaller part.

Broadcom has a relatively concentrated customer base, with Apple (AAPL) being its largest client accounting for some 15-20% of its annual revenue. This is a similar weight compared to QUALCOMM (QCOM), but it is lower than for other Apple suppliers like Qorvo (QRVO) or Skyworks Solutions (SWKS) that have a higher reliance on Apple.

Growth

As I’ve discussed several times in previous articles, I invest mainly in secular growth companies in a few investing themes, namely semiconductors, electric vehicles, digital payments, 5G and big data.

In the 5G theme, I currently own Skyworks Solutions and have recently covered Qualcomm, while Broadcom is generally also exposed to semiconductors beyond 5G and IoT technologies. However, I see Broadcom mainly a play on the 5G theme, as within the semiconductor industry that seems to be a better play, such as ASML (ASML), NVIDIA (NVDA) or AMD (AMD).

Nevertheless, these secular growth trends are a strong tailwind for all companies in these industries, as modern technology is constantly changing and new developments are constantly pushing for new applications and devices. The volume of data is expected to grow strongly over the coming years, through technological advances like 5G.

5G is the next generation mobile network that should enable the connection of pretty much everything, including machines, objects and devices increasing the total addressable market for wireless applications. For instance, the rise of artificial intelligence and the internet of things (IoT) should become more intertwined, facilitated by 5G.

Broadcom is one of the companies that is well positioned to benefit from secular growth trends of 5G, IoT, and cloud computing as the company has adapted its product portfolio for the expected increased demand for wireless technologies and infrastructure over the next few years. Indeed, this is already clear in the premium smartphone market with the vast majority of devices sold over the past few quarters already offering 5G capabilities.

Source: Counterpoint.

Even though Broadcom should benefit from 5G, both through increased spending in handsets but also in infrastructure, the company’s product portfolio is exposed to several growth sources, including industrial automation, increasing spending in data centers, beyond other industries.

Additionally, Broadcom has also grown historically through acquisitions, a strategy that is not expected to change in the future, particularly to further diversify its product portfolio. For instance, Broadcom has bought Symantec in 2019 for more than $10 billion, expanding its business into the cybersecurity segment within the infrastructure segment.

Financial Overview

Regarding its financial performance, Broadcom’s history is quite positive as the company reported over the past few years growing revenues, margins and earnings. Indeed, over the past five fiscal years (it fiscal year - FY- ends in November), its annual revenues have increased from $13.2 billion to $23.9 billion, including acquisitions. Its gross margin has improved significantly during this period, from 60.5% to 73.5% in the last fiscal year.

Source: Broadcom.

In FY 2020, revenues amounted to $23.9 billion (-3.1% YoY), while its net income increased 18% YoY to $5.2 billion. During the first nine months of fiscal year 2021 (FY 2021), Broadcom has maintained a positive operating momentum supported by secular growth drivers of 5G, cloud, and wireless infrastructure. In the third quarter of FY 2021, its revenues increased by 16% YoY to nearly $6.8 billion. Its operating income was up by 24% YoY and its adjusted EBITDA margin achieved a new record at 61%.

Free cash flow was $3.4 billion, or about 50% of its revenue, showing that Broadcom has a very good cash generation capacity.

Going forward, Broadcom expects Q4 revenue of around $7.35 billion, representing an increase of 14% YoY, and an adjusted EBITDA margin near 61%. This outlook is supported by strong demand among phone makers, telecoms and cloud providers that is not expected to slow down in the coming quarters, even though supply constraints may add some uncertainty to these forecasts.

Over the coming years, Broadcom is not expected to grow its revenues and earnings by much, at least without considering potential acquisitions. Its revenues are estimated to be above $34 billion by fiscal year 2025, which implies a relatively weak compounded annual growth rate of 5.5% during the next four years.

Regarding its balance sheet, Broadcom has a weaker position than most technology companies due to its acquisition history, even though its financial leverage is still at an acceptable level. At the end of the last fiscal quarter, Broadcom’s net debt position amounted to about $29 billion, representing a net debt leverage ratio of 2.1x (net debt-to-EBITDA ratio) considering earnings over the last 12 months.

This is a weaker position than most peers given that most technology companies don’t hold much debt, while other peers such as Qualcomm or Skyworks have leverage ratios lower than 1x. I don’t think this higher financial leverage is an issue in the short term, but it may cause Broadcom to underperform during a period of rising interest rates, something that may occur in late 2022 or 2023, thus this is a risk that investors should not overlook in the medium term.

Moreover, this relatively weaker balance sheet position may put some pressure on the company’s medium-term ability to return profits to shareholders, especially considering potential share buybacks. Broadcom has a good dividend history and a growing dividend path seems to be a strategic goal for its management, therefore it is likely that dividends will be the preferred way to reward shareholders in the future while share buybacks will only be performed if financial momentum remains in a positive trend.

Source: Broadcom

Broadcom’s latest quarterly dividend was $3.60 per share, or $14.40 annualized, which means that at its current share price Broadcom offers a dividend yield of about 2.70%. This is a higher yield than compared to most of its technology peers, but its indebtedness is also higher, thus I don’t see this yield as high enough to be a key factor of Broadcom’s investment case.

Moreover, considering that its EPS during the first three quarters of FY 2021 was $11.06 and for the full year EPS is projected to be slightly higher than $15 per share, this means Broadcom’s dividend payout ratio is close to 94%. This is a very high dividend payout ratio, which means that Broadcom’s dividend sustainability is not fantastic and if earnings suffer a slight drop, the dividend payout can easily be above 100%.

Taking this into consideration, for income investors there are certainly other stocks with higher dividend yields that are more attractive from a sustainability standpoint, thus Broadcom does not appear to be particularly attractive from an income perspective.

Bottom Line

Broadcom is exposed to several secular growth trends that should support its business over the coming years, but its growth prospects aren’t impressive and its balance sheet is weaker than compared to most peers.

Moreover, Broadcom is currently trading at close to 19x its forward earnings, a premium valuation to peers Qualcomm or Skyworks. Also, taking an absolute valuation approach, my price target for year-end 2024 is about $340 per share, assuming a multiple of 14.7x and GAAP EPS estimate for FY 2025 of $23.12.

This implies that Broadcom is overvalued right now by more than 35%, and therefore it is not a great play at its current share price to ride secular growth waves of 5G or cloud computing.

If you are a long-term investor and want to be exposed to several secular growth trends, I’m planning to soon launch a marketplace service focused on different secular growth themes, namely: Digital Payments/FinTech, Semiconductors, 5G/IoT/Big Data, Electric Vehicles, and the Metaverse. If this is something that you may be interested or have any questions, feel free to send me a direct message.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SWKS, ASML, NVDA, AMD either through stock ownership, options, or other derivatives. 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.