Broadcom Q4: Continues To Outperform My Expectations (NASDAQ:AVGO)

Article Thesis

I maintain my Buy rating on Broadcom Inc. (NASDAQ:AVGO) and increase my price target from $975 to $1186 following the company’s strong fiscal Q4 results, the completion of the VMware acquisition, and slightly improved growth expectations driven by the effects of growing demand for AI.

Broadcom continues to demonstrate resilience in the software and semiconductor industry, reporting a solid Q4, surpassing the Wall Street consensus and my expectations. Notably, the company capitalizes on the demand for AI-related products, with revenue indirectly derived from Gen AI accounting for a substantial portion. In addition, the completion of the VMware acquisition significantly bolsters Broadcom’s software portfolio, enhancing its position in the cloud industry.

While facing cyclical weakness in certain segments, Broadcom’s networking and AI solutions drive substantial growth, especially with a projected 30% growth in FY24. The company’s financials showcase remarkable margins, making it a cash flow machine. Despite some headwinds, Broadcom’s FY23 free cash flow reached a staggering $17.6 billion, allowing for substantial returns to shareholders and continued dividend growth.

The stock’s valuation, trading at just below 20x FY24 EPS, is justified given the growth outlook and potential AI revenues. Despite economic uncertainties and AI demand unpredictability, a fair 21x multiple is reasonable, leading to a target price of $1186. With this positive outlook, Broadcom remains an attractive investment opportunity, and I maintain a Buy rating on the company.

Broadcom reports a solid fiscal Q4 as demand from hyperscalers offset cyclical weakness

Broadcom released its earnings report on December 7 aftermarket and beat both the Wall Street consensus and my own projections, although only slightly. The company reported revenue of $9.3 billion, up 4% YoY and roughly in line with the 5% growth reported in Q3. This brings the fiscal FY23 total to a record $35.8 billion, up 8% YoY.

I have said this many times before, but Broadcom remains a standout in the software and semiconductor industry with its revenues, while impacted by the downcycle, remaining really resilient as it continues to outperform the industry. For reference, the overall semiconductor industry is projected to be down double digits in 2023, while Broadcom has seen revenue grow 9% in its fiscal FY23 semiconductor segment.

While growth for Broadcom has definitely decelerated from prior years, and the company isn’t immune, it definitely deserves some credit for its resilience on both the top and bottom lines. Growth now seems to be stabilizing, and even as growth has slowed down, margins have stayed at staggering and industry-leading levels, and revenue growth remains positive, in large part supported by the company benefiting from investments made by hyperscalers as part of the enthusiasm and growing demand for AI.

Revenue derived indirectly from Gen AI, primarily through ethernet solutions and custom AI accelerators, now came in at $1.5 billion, or approximately 20% of semiconductor revenue, clearly illustrating how strong demand has been, remains to be, and has been able to offset weakness in other end-markets. Broadcom clearly can’t be ignored as a beneficiary of the growth in demand for AI. This is what I wrote in my last article on Broadcom regarding the company’s exposure to AI through its leading networking products:

Simply put, networking semiconductors are crucial for AI applications as they enable the fast and efficient communication that is necessary for processing large amounts of data quickly and accurately. In reality, without top-performance networking solutions, AI models with billions of parameters would not be able to work. And still, current advanced AI systems are limited by the available bandwidth.

Broadcom has been introducing AI-specific accelerators over the last few months, like its Jericho3-AI chip, capable of bringing together 32,000 GPUs while bringing down the completion time frame by 10%, allowing AI accelerators to run 10% more efficiently than any alternative. As a result of the strong demand for these networking products, revenue derived from AI was 15% of semiconductor revenue in fiscal FY23, and this should increase to 25% in fiscal FY24 as demand continues to grow and Broadcom introduces new AI-specific products.

The strong demand for AI-related networking products led to strong growth in Broadcom’s networking segment in Q4, with revenue up 23% YoY to $3.1 billion, accelerating from the 20% growth in Q3. Also, this specific sub-segment now accounts for 42% of semiconductor revenue and 33% of total revenues. Of course, with this being the company’s largest segment/end-market, it remains exceptionally well diversified, especially as this is also the fastest-growing one and is expected to keep showing accelerating growth.

For fiscal FY24, I earlier communicated that I expected growth to accelerate to the 25-30% range. Still, management topped this as it guides for growth of 30% in FY24, which is just incredible and highlights the strong continued and accelerating demand it sees for these specific products, driven by accelerating deployment of networking connectivity and expansion of AI accelerators in hyperscalers—plenty to be bullish about here.

Meanwhile, in Q4, this strong demand for AI-related products drove 3% growth in semiconductor revenue to $7.3 billion (78.5% of revenue), down from 5% growth in Q3, but still outperforming the industry even as it continues to face a cyclical demand slowdown at enterprises and telcos, offset by demand from hyperscalers. The remainder of semiconductor revenue is rather stable at around $6 billion.

Revenue derived from wireless was $2 billion in Q4, down 3% YoY. Overall demand remains steady and quite resilient, and as a result, management expects wireless revenues to remain stable in FY24 as well. However, in the server storage connectivity and broadband markets, Broadcom continues to face weakening cyclical demand, with revenues down 17% and 9% YoY in Q4, respectively. Moreover, this weakness should persist in FY24, leading to the expectation of a mid to high-teens percentage decline in server storage connectivity revenue and a low- to mid-teens percentage decline in broadband revenues, offsetting some of the AI strength.

Of course, as I have said many times before, these are simply cyclical effects, which means that growth in these segments should rebound once the economy does, leading to my expectation for improved growth in the second half of FY24 and FY25, assuming demand for the company’s networking and AI solutions remains strong as well.

Broadcom completes the acquisition of VMware

The company’s semiconductor segment obviously continues to be the leading part of the business, accounting for almost 80% of revenue and performing strongly. Meanwhile, growth in the infrastructure software operations remains stable as well, with growth up from 5% in Q3 to 7% in Q4, adding resilience to the Broadcom portfolio. This led to software revenue of $2 billion, which means software still only represents 21.5% of revenue. However, theoretically, including VMware revenues, this would increase to around 42%, making software operations a much more meaningful part of Broadcom.

However, the current performance of Broadcom’s Q4 software portfolio consisting of CA, Symantec, and Brocade also performed strongly with revenue of $2 billion and 119% consolidated renewal rates over expiring contracts and 130% in strategic accounts, which is excellent. Furthermore, management guides for this part of the software portfolio to grow revenues 4% YoY in fiscal FY24 to $8 billion as growth accelerates slightly from 3% in FY23.

I have never really been impressed by Broadcom’s software offering. Not necessarily in terms of financial data, but more focused on its offering, which seems largely inferior to more innovative peers in the software arena. However, I believe the VMware acquisition gives Broadcom a much stronger foothold in the software industry and greater cloud innovation, allowing it to compete much better. For reference and for those unfamiliar with the company, VMware is a company that provides virtualization and cloud computing software and services. Virtualization is a technology that allows you to run multiple operating systems or instances on a single physical machine, effectively creating virtual machines (VMs). These virtual machines operate independently of each other and can run different operating systems, allowing for increased flexibility, resource utilization, and cost efficiency.

Broadcom finally completed the acquisition of VMware on November 22. Broadcom wants to fully shift the VMware business’s focus back to its core business of creating private and hybrid cloud environments among large enterprises globally. Broadcom simply wants to focus this business on enabling global enterprises to run their applications across other data centers as well as on public clouds by consuming VMware’s higher-value software stack.

This means it plans to divest noncore assets like EUC and Carbon Black, including products like VMware Horizon and its endpoint security solutions. Excluding these operations, in fiscal FY24, based on 11 months of contribution, VMware is expected to contribute $12 billion in revenue, resulting in infrastructure revenue guidance of $20 billion or 40% of revenue.

This means the VMware acquisition meaningfully grows Broadcom’s software portfolio and level of software innovation through greater cloud exposure. I firmly believe that the VMware part of the business should grow solidly going forward, making it a worthy contribution to growth as well.

Still, a cash flow machine, even as it faces headwinds

Moving to the bottom line, Broadcom remains best in class, even as it is experiencing some cyclical weakness. The gross margin remained relatively steady at 74.3%, only down 40 basis points YoY and still industry-leading. This was driven by an improving gross margin in the infrastructure software segment of 92%, offset by a slightly lower gross margin in semiconductors of 70% following changes in the product mix and end-market demand.

Operating expenses were flat YoY at $1.2 billion with R&D of $940 million, also flat. This led to an operating income of $5.7 billion, up 4% YoY as revenue growth slightly outpaced expense growth, leading to a slight margin improvement to an operating margin of 62%. Furthermore, Broadcom reported an EBITDA of $6 billion or 65% of revenue. Finally, net income growth was 6% to $4.8 billion, translating into an EPS of 11.06, topping the consensus by a few cents. It is safe to say that across the board, the company’s margins are incredible, and it remains a cash flow machine despite some headwinds.

This is further highlighted by an FY23 FCF of a staggering $17.6 billion, up 8% YoY and representing an FCF margin of 49%. In Q4, the company generated $4.7 billion of FCF, representing a margin of 51%. Driven by this excellent FCF generation, the company remained able to return significant amounts of cash to shareholders as well, returning a total of $15.3 billion in the last four quarters, well covered by FCF.

The company remains committed to returning cash to its shareholders, highlighted by the company announcing another dividend increase of over 14%, in addition to the $7 billion in share repurchase authorization still outstanding. With the VMware acquisition now completed, Broadcom will resume its share repurchase program, although this will mainly be to offset the dilution from the VMware acquisition, which has led to a 15.7% increase in shares outstanding. With the current $7 billion authorized, Broadcom will be able to return just 2% of outstanding shares, so it will probably take some time to return to prior quarter levels.

However, I don’t believe investors need to worry about this as the VMware acquisition will significantly add to the company’s FCF generation. For reference, in recent years, VMware generated FCF of around $4 billion, and considering Broadcom and CEO Hock Tan’s proven ability to turn any business into a cash flow machine, I am confident this will reach even higher levels in the upcoming years, definitely making it a meaningful addition.

On top of this, shareholders are still looking at a very decent dividend with a current yield of around 2.3%, which few Broadcom peers can match. In addition, the company’s rapidly growing cash flows make it an ideal company for dividend growth investors. Broadcom has grown its dividend at a 5-year CAGR of over 21%, while the $8.8 billion in dividend obligations (based on next year’s payout) are easily covered by FCF. Also, based on the FY23 EPS, we are looking at a conservative payout ratio of below 50%. Therefore, and considering the significantly improved cash flows originating from the VMware acquisition, I continue to see plenty of room for double-digit dividend growth for at least another few years, even as it will be focused on paying down debt and buying back shares to offset dilution.

Outlook & Valuation – Is AVGO stock a Buy, Hold, or Sell?

Throughout the article, I have already pointed out management’s growth expectations by segment or sub-segment. Taking all this into consideration, management guides for fiscal FY24 revenue of $50 billion, including the contribution from VMware. With management guiding for $12 billion in VMware revenues, this means the ex-VMware business is projected to grow by 6.1% as the underlying operating environment remains challenging, but the growth slowdown stabilizes. This includes the expectation for mid to high-single-digit growth in the semiconductor segment, mainly driven, of course, by the networking subsegment. In addition, the legacy enterprise software portfolio is expected to grow 4% YoY and come in at $20 billion, including VMware.

Positively, even when including $1 billion in transition spending from the VMware integration, management expects to report an adjusted EBITDA of approximately 60% of revenue, down just 480 basis points YoY. Also, the business should be fully integrated by the end of the year.

Also worth noting is that the $12 billion of projected VMware revenues exclude the $2 billion generated by EUC and Carbon Black operations annually, as Broadcom plans to divest these operations. Also, management guides for VMware revenue growth to accelerate over the next three years, driven by its streamlining of the business.

Following this guidance from management, the completion and commentary of the VMware acquisition, and the solid Q4 results, I updated my financial outlook, now incorporating the VMware revenues and slightly improved financial targets for the ex-VMware business. This results in the following financial projections.

Based on these projections, shares now trade at just below 20x my FY24 EPS projection, which in no way can be seen as expensive or overly rich considering the company’s growth outlook and the upside surprise still present in my financial projections, driven by the VMware integration and the potential AI revenues. Yes, of course, shares now trade at quite a premium over the 5-year average P/E of 17x, but rightfully so, as the outlook is strong and risks not overly high.

There are, of course, the risks involved with a massive acquisition to take into consideration, as well as the higher share count and quite significant debt position, but we should not forget that Broadcom’s cash-generating abilities are out of this world and management has a lot of experience integrating new businesses into its portfolio. Therefore, I believe these potential risks are well under control, and considering the growth potential here, the company definitely deserves a premium.

However, considering the treacherous economic climate, the unpredictability of AI demand, and taking into account the risks discussed above, I believe a 21x multiple remains fair here, leaving plenty of room for margin expansion and downside protection. Based on this belief and my FY25 EPS multiple, I calculated a target price of $1186 (up from $975). This means that from a current share price of $950, investors are still poised for annual returns of close to 11%, or 13% including dividends.

Therefore, all things considered, I believe Broadcom shares present quite an attractive investment opportunity, which is why I maintain my Buy rating on the company.