INVESTMENT THESIS
BUY-rated Broadcom Inc. (NGS: AVGO) slipped 1% in a down market on 12/11/20 after the company exceeded consensus revenue and non-GAAP expectations for fiscal 4Q20. Both revenue and adjusted EPS grew at a double-digit pace for the first time in fiscal 2020.
Through most of FY20, growth in infrastructure software offset softness in the semiconductor business. The Infrastructure software business had a strong quarter, powered by the addition of Symantec’s enterprise security business.
Broadcom has announced executive transitions whereby current CFO Tom Krause will become head of the Infrastructure Software business. Head of Sales Charles Kawwas is moving into the role of Chief Operating Officer, with oversight for global operations and related tasks. Current corporate comptroller principal accounting officer Kristen Spears will succeed to the CFO role.
Broadcom’s board has announced an 11% increase in the quarterly dividend, to $3.60 per share. The company has deemphasized share buybacks since purchasing the Symantec enterprise security business, but we look for the company to continue to prioritize shareholder return via its dividend policy. AVGO trades at discounts to peers on most price-based metrics and is also attractive on discounted free cash flow valuation. Broadcom has a high degree of recurring revenue based on multiyear contracts, both in semiconductors and particularly in infrastructure software.
RECENT DEVELOPMENTS
AVGO rose 45% in 2017; peers advanced 35%, while the SOX rose 38%. AVGO shares rose 21% in 2016, compared to a 70% simple average gain for the peer group (market-cap weighted gain of 30%). AVGO rose 44% in 2015 and surged 90% in 2014.
For fiscal 4Q20 (ended 11/1/20), Broadcom reported revenue of $6.47 billion, which was up 12% year-over-year and 11% sequentially. Sales topped the $6.4 billion midpoint of Broadcom’s $6.25-$6.55 billion revenue guidance for 4Q20 and were slightly above the $6.43 billion consensus estimate. Non-GAAP earnings of $6.35 per diluted share were up 18% year-over-year and $0.95 on a sequential basis. Non-GAAP EPS topped the prereporting consensus forecast of $6.20.
Broadcom began its October 2020 fiscal year with top- and bottom-line challenges, but finished the year with low double-digit growth in both revenue and non-GAAP EPS for fiscal 4Q20. During the course of fiscal 2020, Broadcom acquired Symantec’s Enterprise security business, contributing to its Infrastructure software business and strengthening its ability to offer an integrated suite of solutions to enterprise and data center customers.
Concurrent with fiscal 4Q20 results report, the company announced executive changes for the year ahead. Current CFO Tom Krause will become head of the Infrastructure Software business. Head of Sales Charles Kawwas is moving into the role of Chief Operating Officer, with oversight for global operations. The new COO will maintain responsibility for corporate marketing company-wide, and for sales of the semiconductor Brocade storage network business and related tasks. Current corporate comptroller and principal accounting officer Kristen Spears will succeed to the CFO role.
The transitions are somewhat unusual in that executives typically move up the ranks through the financial, sales & marketing, or operations function and remain on that track. While new CFO Kristen Spears has reached the top of the finance track, COO Kawwas is becoming head of marketing while moving over from sales & marketing; and Tom Krause, in becoming president of Infrastructure Software, has moved from operations and off the finance track. We believe at the highest levels, these executives are deeply involved in company strategy, which should make the transitions smoother. The executive transitions appear orderly and unlikely to impact the stock performance.
Broadcom’s board has announced an 11% increase in the quarterly dividend, to $3.60 per share. The company has deemphasized share buybacks during the pandemic era and since purchasing the Symantec enterprise security business. We look for the company to continue to prioritize shareholder return via its dividend policy.
We also see the generous payout as a sound and affordable use of funds. During FY20, Broadcom paid out $5.53 billion in common dividends. Broadcom generated $12.06 billion in cash from operations for fiscal 2020, as well as free cash flow of about $11.5 billion. Cash flow from operations and free cash flow covered the cost of the dividend 2.2-times and 2.1-times, respectively. We look for CFO and FCF coverage to remain in the 2.2-2.5 area going forward.
CEO Hock Tan, referencing the senior leadership changes, wryly noted that ‘I’m not going anywhere.’ During fiscal 2020, total shareholder return (TSR) was 23.5%, according to the company, which noted that since IPO in 2009, TSR has averaged 34% annually. Broadcom capped off FY20 with record revenue and profitability in 4Q20 despite the ongoing pandemic and economic uncertainty. Semiconductor Solutions revenue of $4.82 billion increased 6%. Notably, Semiconductor Solutions returned to positive annual revenue growth in 4Q20 for the first time since FY18.
Within semiconductors, networking revenue was up 17% year-over-year, driven by cloud data center and telcos upgrading edge and core networks. Broadcom looks for networking demand strength to persist, despite softness in enterprise niches such as campus. Broadband was up 22%, driven by work-from-home and carrier upgrades to broadband connectivity. Broadcom is seeing strong adoption of WiFi 6 in next-generations access gateways. Additionally, strength in GPON and DSL offset weakness in video.
Wireless revenue was up 43% sequentially, reflecting more than normal seasonal strength. However, wireless was down 9% annually, principally reflecting the delayed launch at Apple. As a result of the iPhone 12 pushback, Broadcom now anticipates that fiscal 1Q21 will be the peak quarter of the seasonal ramp, and that revenue will compare ‘extremely favorably’ with the same quarter a year ago while rising 50% year-over-year.
Storage connectivity was down 9% year-over-year, reflecting as-anticipated softness in enterprise demand as offices remain just lightly staffed. This trend is expected to continue and, combined with a tough year-ago comp, could result in a 20% annual decline in fiscal 1Q21. Industrial shows signs of demand recovery, though at 3% of segment sales it does not much move the needle. Altogether, and reflecting the wireless ramp, total Semiconductor Solutions revenue is slated to rise in mid-teen-percentages year-over-year in fiscal 2021.
Infrastructure Software revenue of $1.63 billion was up 36% year-over-year, reflecting organic growth as well as the contribution from the Symantec acquisition. In terms of legacy businesses, CA grew 5% annually, while Brocade storage software was down in double digits. Although year-earlier comps are not visible, CEO Tan reported that Symantec grew in low double digits.
Broadcom has shifted its Infrastructure Software business model to focus only on the largest enterprise customers; about 90% of revenue is on a recurring subscription model. Brocade acquired Symantec’s enterprise security business in November 2019, so it will begin to lap that comparison in fiscal 1Q21 (the current quarter). For fiscal 1Q21, and reflecting continued pressure on Brocade storage software, Infrastructure Software is expected to be flat to up in single digits in fiscal 1Q21.
We believe that Broadcom is well positioned in key markets, which should drive revenue growth and margin expansion in the coming quarters and years.
We also look for a strong wireless ramp driven by 5G, steady growth in industrial led by IoT and automation, and recovery in the storage business as workers return to offices in a post-pandemic world.
EARNINGS & GROWTH ANALYSIS
Sales topped the $6.4 billion midpoint of Broadcom’s $6.25-$6.55 billion revenue guidance for 4Q20 and were slightly above the $6.43 billion consensus estimate.
The non-GAAP gross margin was 73.5% in 4Q20, vs. 74.2% in 3Q20 and 69.9% a year earlier. The higher gross margin reflects more software revenue, driven by enterprise security.
Non-GAAP earnings of $6.35 per diluted share were up 18% year-over-year and $0.95 on a sequential basis. Non-GAAP EPS topped the prereporting consensus forecast of $6.20.
For fiscal 1Q21, Broadcom forecast 1Q21 revenue of about $6.6 billion, which would be up 2% sequentially and 13% annually. Based on forecast adjusted EBITDA equal to 59% of revenue guidance, we believe AVGO can earn $6.15-$6.35 per diluted share in 1Q21, resulting in mid-20% annual EPS growth.
We are implementing a preliminary non-GAAP EPS forecast for FY22 of $29.79 per diluted share.
FINANCIAL STRENGTH & DIVIDEND
Broadcom Inc. is Medium-High. Broadcom issued $18 billion in debt to acquire CA Inc. in 2018. Broadcom acquired Symantec’s enterprise security business for about $11 billion late in 2019. The company has worked diligently to reduce debt and raise funds by selling non-core units acquired with major assets. Broadcom is a financially strong company that has increased the proportion of high-margined and recurring revenue via its infrastructure software business.
Total debt was $32.80 billion at the end of FY19. Prior to the CA acquisition, total debt was $17.5 billion.
Broadcom had previously planned to pay down $4 billion in debt in FY20, but paid down about $3 billion due to the pandemic.
Symantec de-risked its balance sheet in 2Q20 with more than $18 billion in debt refinancing. In the process, Broadcom pushed out its average maturities from four years to six years, while boosting the average cost of debt by just 50 basis points.
Cash flow from operations was $9.70 billion in FY19, $8.88 billion in FY18, $6.55 billion in FY17, and $3.54 billion in FY16.
Following the Symantec asset acquisition, we look for minimal share repurchase activity in FY20-FY21. In April 2018, Broadcom announced that it would repurchase up to $12 billion in common stock. Over the 16 months through August 2019, it spent $13.1 billion to purchase 54.5 million shares; that includes $4 billion spent to buy stock in FY18.
In December 2019, Broadcom hiked its quarterly dividend by 23%, to $3.25 per common share. In FY18, Broadcom increased its quarterly dividend by 51% to $2.65 per diluted share. We estimate that the annual dividend will cost the company $5.5 billion in FY20 and beyond. We expect cash flow to cover the dividend by a factor of 2.2-2.5 and free cash flow to cover the dividend by a factor of 2.0-2.3.
MANAGEMENT & RISKS
Avago’s CEO is Hock E. Tan. In December 2020, Broadcom announced that CFO Tom Krause would become head of the Infrastructure Software business. Head of Sales Charles Kawwas has shifted into the role of Chief Operating Officer, with oversight for global operations, global marketing, and other tasks. Current corporate comptroller and principal accounting officer Kristen Spears will succeed to the CFO role. The executive transitions appear orderly and unlikely to impact the stock performance. Operating in over 20 distinct end markets, Broadcom Inc. has 23 managers at the division level.
The loss of the Huawei business and related trade war impacts are obviously hurting Broadcom. However, this is a global matter being experienced by every semiconductor company. One consequence of the trade war is that the mix shift away from semis and to software is benefiting margins.
The announced acquisition of CA was poorly received by the market. Investors have warmed to the deal now that it is lifting margins. That led to a more favorable reception of the Symantec Enterprise Security acquisition.
The CA deal adds $18 billion in new debt, and Symantec added $11 billion. Broadcom Inc. has more debt than cash as a result of past acquisitions, but has shown diligence in paying it down.
The company was able to save face by being forced out of a deal, rather than having to walk away with its figurative tail between its legs. Buying Qualcomm would have doubled down on mobile devices just as that market was showing signs of saturation.
Broadcom Inc. is at risk from the diversity of its business lines, which increased further once Broadcom Corp. was acquired. Broadcom’s leadership and market share strength in Analog III-V and in mixed-signal CMOS enable the company to command premium prices for its products. The company has never hesitated to exit or sell unprofitable or low-return product lines, thus enabling it to maintain its profit margins.
COMPANY DESCRIPTION
Broadcom Inc. is a top-five global fabless semiconductor company with leading franchises in wired and wireless communications, enterprise data center and storage, and other end markets. The company has grown via acquisitions, including Agere, LSI Logic, Brocade and Emulex. In January 2016, the former Avago acquired Broadcom for $37 billion and changed its name to Broadcom Inc. The company acquired CA Inc. in November 2018 and Symantec’s enterprise security business in November 2019.
VALUATION
AVGO trades at 15.0-times average two-year-forward earnings, compared to an historical five-year (FY16-FY20) trailing P/E of 12.8. However, compared to the market, AVGO trades at a relative P/E of 0.71 on a two-year-forward basis, in line with its historical five-year trailing relative P/E of 0.70, even though growth is now accelerating. Fair value based on comparable historical multiples is in the upper $300s and in a rising trend, though below current prices.
Peer group analysis shows AVGO trading well below peers on forward P/E, price/sales, and EV/EBITDA. As such, peer indicated value is in the mid-$600s and well above current levels.
Discounted free cash flow analysis points to a value in the lowto mid- $600s, in a rising trend and above current levels. Cash flow generation should accelerate further as the company integrates high-margin assets and achieves volume leverage and greater synergies across its operations.
Our blended valuation analysis indicates a fair value for AVGO above $550 in a rising trend. Calculated fair value remains well above the current stock price.
Appreciation to our 12-month target of $460 (raised from $400) implies a potential risk-adjusted total return.
On December 11, BUY-rated AVGO closed at $405.82, down $4.22.
Source: Argus
