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Given Broadcom’s (NASDAQ:AVGO) focus on margins and cash flows over growth, it’s never been altogether surprising to me that these shares often lag when the chip sector is very much in favor with the Street but outperform when the bloom comes off that particular rose. And so it seems to be today, with the shares having outperformed the SOX index by more than 16% since my last update on the company as semiconductor valuations come off their highs.
I don’t dismiss the risk that Broadcom shares can get caught up in broader declines for tech stocks (or chip stocks more specifically), but I believe this company is very well-positioned operationally for the next two years, given strong demand in networking (enterprise and service provider), broadband/connectivity, wireless, and data center storage. From here I can see upside toward the $650’s, and I believe the shares are priced for respectable long-term annualized total returns in the high single-digits.
The Year Of The Tiger Should Be A Chance For Broadcom To Roar
At this point, it’s hard to find markets that aren’t setting up well for Broadcom. Of course, with lead-times of almost a year, the immediate benefits to Broadcom may be more modest, but it should reduce downside risk and I expect the company to see strong order interest for 2023. Likewise, I believe recent reports across the company’s end-markets support a healthy outlook for the next quarter (to be reported in March).
Networking
Looking at 2022 and Broadcom’s next quarter, I’m seeing strength almost across the board. Arista (ANET) recently reported strong revenue (up 27% yoy in Q4) and guidance (up 31% in FY’22), and Cisco (CSCO) posted strong product orders in general (up 33%), with enterprise up 37%, service providers up 42%, and strong webscale demand overall. Likewise, while acknowledging some supply issues in the quarter, Ciena (CIEN) recently confirmed strong demand for networking equipment across its business, and Intel (INTC) is expecting strength in enterprise through the year.
Between its Jericho and Trident programs, that’s great news for Broadcom, and I expect this networking surge to last for at least 24 months as companies move from 200G/400G to 800G upgrade cycles in some cases. One item worth watching is whether Broadcom can gain traction on Marvell (MRVL) in PAM-4 with hyperscale customers.
Broadband/Connectivity
MaxLinear (MXL) has been doing a much better job in this segment of late, but there seems to be little falloff in demand for home broadband and connectivity, helped in part by the Wi-Fi 6 upgrade cycle. While CommScope’s (COMM) recent earnings report wasn’t universally positive, the takeaway for me with respect to Broadcom is that chip supply is a significant constraining factor in the market, suggesting that this demand cycle still has legs, as upgrades are being pushed out due to product availability issues.
Storage
Not unlike the situation in broadband/connectivity, I don’t think there’s any end-market demand issues for Broadcom in the storage space. The recent earnings reports/guidance from both Seagate (STX) and Western Digital (WDC) suggest strong ongoing enterprise and data center demand, with supply again being the limiting constraint.
Wireless
Apple’s (AAPL) recent quarter was better than expected from a unit volume standpoint, and there doesn’t seem to be anything in the wider smartphone space that would concern me that much about Broadcom’s wireless business. While Qorvo (QRVO) has made some inroads, Broadcom still looks to be on the leading edge of filters and I see no reason to expect that the trend of ever more intense filtering demand in new phone generations will change. Moreover, with ongoing 5G penetration growth, content per unit should be a positive tailwind for the business.
A Few Less-Positive Points To Ponder
I see no meaningful issues on the demand side for Broadcom, at least in the near term. I expect the networking cycle to last for at least two years, and I likewise expect ongoing investment in data center capacity, though probably with a lumpier trajectory in the future.
I also see ongoing growth potential for Broadcom’s custom ASIC business (and Marvell’s too), as major webscale customers will increasingly need custom compute workload acceleration capabilities. Broadcom should start shipping its 5nm chip to Google (GOOGL) later this year (a $1B-plus business), while also ramping new programs with Microsoft (MSFT) and Meta (FB); that Meta/Facebook would partner with Broadcom is interesting to me given it’s not exactly a secret that Meta/Facebook isn’t the biggest fan of Broadcom.
All of that said, there are some less positive points to watch.
R&D is likely going to be higher in the near term, with the company working on tape-outs for new Tomahawk, Trident, and Jericho chips, as well as a new 5G backhaul product, and preparing a broader launch of photonics products in FY’23/FY’24. Management has already guided for this, but the Street being what it is, the reality of higher opex could still create near-term sentiment challenges.
There are also ongoing supply challenges and risks. Broadcom doesn’t expect meaningful supply improvements in FY’22, and there could be some risks of demand destruction if the industry-wide supply shortages don’t ease up. Management has said that they’re not looking for other foundry partners beyond TSMC (TSM), but I suppose that’s an item to monitor.
Capital redeployment is another item to watch. Debt continues to shrink and management used its last quarter to boost the dividend 14% and launch a new $10B buyback. Still, Broadcom continues to generate substantial cash flows, and I believe management would like to do additional deals. Semiconductor deals are likely off the table, at least large ones, and the shares usually trade weaker when rumors start circulating about potential large software deals (even though I’d argue the diversification into software is working).
This risk could be exacerbated if Broadcom ever does decide to sell the wireless business. There have been rumors from time to time, and it wouldn’t be so surprising if Apple decided it also wanted to control that part of its content. Were that to happen, I’m sure there would be rampant debates about how Broadcom could best use the cash, with investors agitating for substantial returns through special dividends and/or buybacks.
The Outlook
My core outlook for Broadcom really hasn’t changed much; I’m still expecting mid-single-digit long-term revenue growth, and there could be upside here given the company’s growing custom ASIC business, opportunities in photonics, and the upgrade to growth guidance for the software business at the 2021 Software Day (where management gave a revenue growth target of 5%-plus for the software business). Still, Broadcom isn’t going to be a growth leader in the chip space and investors need to keep that in mind.
On the margin side, I have no concerns about near-term reinvestments in R&D; Broadcom has amply demonstrated that they can leverage R&D spending into long-term revenue growth. I’m still expecting core adjusted FCF margins to climb toward the mid-40%’s over the next five years, with more modest growth thereafter, while operating margins should hit 60% in FY’23.
The Bottom Line
Between discounted adjusted free cash flow and margin-driven EV/revenue and EV/EBITDA, I continue to believe that Broadcom shares are undervalued. On a multiples-based approach I can see a path to $650 or higher over the next six to 12 months, and free cash flow likewise supports the idea of a long-term total annualized return in the high single-digits. On its own merits, then, I continue to believe that Broadcom is a semiconductor and enterprise software company well worth consideration.