VMW - The Influence Of AI On Broadcom's Business Isn't Enough To Make It An AI Investment

2023-09-13 07:00:00 ET

Summary

• Not every company mentioning AI on its earnings call means it has a large AI business, worthy of calling it an AI investment.
• The only AI-related segment is networking, which is expected to carry all of Broadcom's semiconductor revenue growth and half of its overall revenue growth.
• Outside of networking's AI-related growth, all of Broadcom's semiconductor business segments are flat or declining, crowding out the AI benefits.
• Combined with the historically high valuation, Broadcom as an AI investment doesn't make sense.

If there's one thing I've noticed about the AI conversation, it's that it inevitably comes back to investors questioning why most companies are seeing a rally because of it - after all, just because a CEO says "AI" on their earnings call doesn't mean it has any AI business benefits. But inquisitive investors are dialing in this radar on some of the more "expected" AI-exposed companies and how AI isn't providing quite the Nvidia-like (NVDA) growth - or even near it. After Broadcom's (AVGO) earnings the other week, this typically praised AI company didn't have much to show for it outside of one of its segments. And if you're looking to invest in AI and use Broadcom as a proxy, when the rubber meets the road, it's not a highly exposed AI company. But that doesn't mean the stock has no place in your portfolio.

Finding The AI Growth

Broadcom has two main divisions: semiconductor and enterprise software. The Semiconductor division is where most of its AI-related business is found. That's not to say its Enterprise Software division doesn't deal with AI software at some level, but hardware is the leading component in the AI world; thus, its semiconductor business is my primary focus.

The problem is, semiconductor growth is slowing to near zero during one of the most significant boons to semiconductors in a generation due to AI. It makes one scratch their head, wondering where the growth is.

While Nvidia and other companies, like Dell (DELL) and Super Micro Computer (SMCI), are seeing meaningful increases in revenue growth due to AI, Broadcom's semiconductor growth has moderated quite a bit in the single digits after soaring this time last year.

While the company did telegraph this semiconductor slowdown a year ago - Hock Tan, the CEO, described it as a "soft landing" - the market is looking for something more "exciting" if it's positioned as an AI investment.

And the only exciting portion of Broadcom's business is its networking segment. This segment was 40% of semiconductor revenue and grew 20% year-over-year in FQ3. The CEO expects networking to carry the weight of its AI growth - and, really, all of its semiconductor growth - into FQ4 with revenue growth "in excess of 20% year-on-year" for the lone segment.

And that's the beginning and the end of the growth for semiconductors.

Its other segments, including wireless, server storage, and broadband, were flat year-over-year, with broadband the only one growing at 1%. With networking, these segments make up 97% of the semiconductor division. Industrial makes up the other 3%, which declined 3% year-over-year.

Don't get me wrong, networking is a place to invest in AI. I mean, I said it was one of my best AI ideas in Arista Networks (ANET) in August. The problem is networking made up only 31.4% of Broadcom's overall revenue. If roughly 30% of the company has influences from AI, it means 70% of the company is a headwind and an anchor to growth. And that's the case here.

But even this 20%-and-above growth in the reported and current quarters doesn't come unscathed. The problem is it's not coming with expanding margins. Semiconductor gross margins were 70% but down 160 basis points year-over-year due to what the CFO attributes as product mix. Instead, what most would expect would be higher gross margins related to AI were hampered by product mix within the segment and just as likely outside of it. Furthermore, the guide expects company-wide gross margins to be down 80 basis points sequentially into FQ4, also due to product mix.

So even the 20%+ growth coming from AI isn't helping the bottom line.

This isn't exactly the type of AI investment I want to make.

Not Exactly Friendly To Value Investors Here

Is the company still a cash machine? Absolutely. But with the additional debt of the VMware (VMW) deal about to take hold and the company's already massive net debt position - though at an attractive average 3.61% fixed interest rate - there's a lot of weight on the balance sheet. Unless there's more than single-digit growth, there's not much reason to be very bullish on the company at current prices .

Worse, the company's valuation has reached the highest levels in the last five years. While it's a cash flow machine, the rallying share price over the last year and the incremental revenue growth are expanding the price-to-free-cash-flow ratio to relative highs.

Broadcom is still a fantastic and well-run company. Still, there's a reason Hock Tan is positioning itself as a software-heavy conglomerate with its past enterprise software acquisitions and now the VMware deal. Much of it is due to the far less business cyclicality and volatility found in software. But this is offset by VMware's low 20% gross margin profile. Overall, this should increase visibility and reduce cyclicality but come at the cost of lower overall margins.

I Don't See The Wall Street Way

I'm not as bullish as Wall Street analysts , as they praise the company's AI future. When broken down, the numbers don't provide a serious AI investment case. While the VMware deal will expose them to other AI opportunities in server and enterprise software, the hardware side will be relegated to a small fraction of overall growth and unable to move company-wide revenue meaningfully. After the deal, the networking business will make up roughly 23% of revenue, diminishing AI-contributed revenue.

I find little value in pushing Broadcom as an AI play even though 30% of its revenue is from networking, a sector I like a lot for future AI growth. As other segments of the company flounder at flat growth, AI isn't doing more than providing a mid-single-digit growth profile to the company. If you're interested in Broadcom, you'll have to be looking for its other semiconductor segments to rise from their cyclical trough to bring the valuation into normal ranges. Add on top VMware and the shifts coming to company-wide revenue and margins, and it makes the AI side shrink to levels far below today's treading water.

Does this mean I'm abandoning ship? No, but I did trim when it was over $900 in my taxable account while continuing to hold steady in my IRA. At current prices, there's more than AI priced in, and much of it is the VMware deal settling into the market's expectations of a combined company. Analysts are too optimistic about its AI ventures, especially as the acquisition will further crowd out any upside. The bull case rests with the remaining 60% of the semiconductor business returning.

For further details see: