Broadcom: The Semiconductor Bellwether Is Trading Near Its Peak Valuations

Summary

• Broadcom is a very high-quality semiconductor company led by highly competent management.
• We have consistently looked at Broadcom when trying to understand the underlying drivers of the industry.
• We discuss whether it's a good time to add exposure as its stock nears its peak valuations.
• I do much more than just articles at Ultimate Growth Investing: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Investment Thesis

Broadcom Inc. (NASDAQ:AVGO) is a leading semiconductor company that has ridden the secular tailwinds underpinning the industry. Moreover, the company also holds a highly formidable patent portfolio exceeding 20K patents. Therefore, many astute semiconductor investors often look at Hock Tan & Co. to understand the underlying trends driving or affecting the industry.

Moreover, Broadcom is also a highly profitable company, with robust free cash flows. Consequently, we believe it is an appropriate anchor stock for many semiconductor investors' portfolios.

Given that the company is currently trading near its peak valuations, we discuss whether investors should add AVGO stock now.

AVGO Stock YTD Performance

AVGO stock YTD performance (as of 3 December'21).

AVGO stock has had a brilliant year so far. The stock has maintained its robust upward momentum throughout the year. In addition, the stock has also markedly outperformed the Invesco QQQ ETF (QQQ). Nevertheless, AVGO stock's YTD return of 27.1% has lagged behind VanEck Vectors Semiconductor ETF's (SMH) incredible YTD gain of 37.2%.

Broadcom is Riding the Mobile Device Upgrade Cycle

Some investors who are new to semiconductor stocks may not be aware of the scale of Broadcom's business. The company has exposure to the hardware and software side of the house. Apple (AAPL) is a significant customer, accounting for 20% of its FQ3'21 revenue. Therefore, AVGO has also benefited tremendously from the 5G iPhone upgrades that have driven iPhone sales in 2021, helping Apple reach record FY21 revenues. Within the 5G cycle, the company believes that the opportunity is still in the early innings. CEO Hock Tan emphasized (edited):

I think we've just seen the first two generations of the 5G phones. So I think we're still relatively early in that whole process because I would imagine 5G is going to run for five to seven years. If you look back at 4G. It ran for eight years. But, every year or every couple of years, we get more add-on features, but they all basically are 4G technology. And on 5G, we expect to see the same more bands, more capabilities, more features that are added on, and they'll all be derivatives of the underlying basic platform of 5G phones. And so I think we're still early in that whole 5G cycle. (from Citi 2021 Virtual Global Conference)

Therefore, we believe that Apple's success in its 5G series will continue to support Broadcom's mobile device connectivity revenue. In addition, Wedbush indicated that the demand for Apple's iPhone 13 is "much stronger than expected" and estimates more than 40M in sales over the holiday season. However, it also added that supply chain bottlenecks might continue to weigh on its sales. Nonetheless, these are likely ephemeral due to the potentially "massive product cycle playing out" across Apple's suite of products.

However, there may be reasons for investors to be cautious as well. For example, Bloomberg reported that Apple informed its component suppliers that "demand for the iPhone 13 lineup has weakened, signaling that some consumers have decided against trying to get the hard-to-find item." It also posited that consumers may be holding back purchases and waiting for the 2022 model, which is expected to introduce "bigger changes."

Tan also telegraphed that a decelerating smartphone growth might weigh on the company moving forward. Broadcom CEO articulated (edited):

So the question is what 2022 will bring. If 2022 reverts back to a normal pattern before COVID-19, then that's a headwind. If the number of phones continues pretty much in 2022 as it has run in 2021, then we have a continued, I would say, sustaining at a high level of growth. (from Citi Conference)

Moreover, Broadcom's key foundry partner, Taiwan Semiconductor (TSM), also telegraphed in its FQ3'21 earnings call that it observed "softness" in smartphones as well. TSMC CEO C.C. Wei emphasized (edited):

So far we observed some softness in smartphones and the PC market. But if you ask me to predict, I cannot give you a very accurate prediction. The demand does not only come from the unit growth but also the increasing silicon content in end devices. So even if you saw some smartphone units become soft or even decrease, that doesn't mean that our demand will fall. (from TSMC's FQ3'21 earnings call)

Therefore, we believe that investors need to carefully evaluate the demand and supply chain issues in the smartphone market. Broadcom is slated to report FY21 earnings on 9 December. Therefore, Tan might telegraph some meaningful insights for investors. Broadcom's CEO has previously cautioned that the current upcycle in the industry would likely revert to its pre-pandemic growth moving forward. We also discussed the matter in our previous article. Therefore, investors are reminded not to expect the "exaggerated up-cycle" to last "forever."

But, Broadcom Has a Tremendously Well-Diversified Portfolio

If Broadcom were exposed mainly to the end-consumer segment, we would be concerned. However, the company has an incredibly well-balanced portfolio that also benefits from the recovery in enterprise spending. The company emphasized that it has been observing a robust recovery cadence among its enterprise customers. Moreover, the underinvestment in previous years has also lent credence to the sustainability of the enterprise demand. Tan articulated (edited):

In 2019, we started back then at the bottom of a semiconductor down cycle. When COVID-19 hit, which obviously, with the lockdown environment, enterprise demand quietened down. And I would say enterprise did not spend much in 2020 and only started to step up in 2021. And I would even say really stepped up. It's only three months or so ago that enterprise started recovering in their spending and started placing large orders with us. And that's continuing on today. And we see revenue shipments, I would say, out of those demands will drive the back half of 2021 until 2022. (from Citi Conference)

Notably, AVGO's enterprise segment, excluding infrastructure software, accounts for 35% to 40% of the company's revenue. Therefore, AVGO is in an enviable position, as it benefits from various demand drivers. AVGO has demonstrated that the company has strong and growing enterprise demand to support continued growth. Despite the potential of a slowdown in the other segments, AVGO can rely on a solid portfolio to withstand a potential supply glut affecting some segments of its portfolio.

So, is AVGO Stock a Buy Now?

AVGO stock EV/NTM EBITDA 3Y mean.

Broadcom revenue and EBITDA mean consensus. Data source: S&P Capital IQ

Readers can quickly glean from the above charts showing that Broadcom's growth is estimated to decelerate over the next two years. Consensus estimates point to a 14.7% YoY revenue growth in FY21. However, AVGO's revenue is estimated to increase at a CAGR of just 5.8% from FY21 to FY23. In addition, its adjusted EBITDA is estimated to grow at a CAGR of just 4.7% over the same period.

Therefore, unless Hock Tan & Co. shows us otherwise, we think it's expensive to pay for the current premium asked in the market. AVGO stock is trading at an EV/NTM EBITDA of 14.7x, close to its 3Y high of 15.3x. It's also discernibly higher than its 3Y mean of 12.1x.

There is little doubt that AVGO is a very high-quality company. However, we encourage investors to wait for a meaningful retracement before considering adding the stock.

Consequently, we reiterate our Neutral rating on AVGO stock as it nears its peak valuations.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL, TSM 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.