Summary
- Broadcom is one of very few effective acquirers in the market.
- Hock Tan has successfully driven significant earnings and margin growth off previous acquisitions, and will likely do the same if the VMware acquisition closes.
- Even if it doesn't, Broadcom isn't trading like a company that grew revenues 21% last year and drove 50% of it to free cash flow.
- Broadcom is a strong buy here.
I've long admired Broadcom (AVGO) from afar, but haven't opened a position. I think that's going to change here in the near future. The more I dig into the company, the more I like it. There aren't many companies that can pull off the string of acquisitions Hock Tan has over the years successfully without burning the shareholders. There is a rare breed of company like Constellation Software (CSU:CA) and Roper Technologies (ROP) that manages to be a top compounder while continuously buying and integrating companies.
Broadcom is in that group. The company is a $250B market cap behemoth today, and is an amalgamation of multiple business lines purchased over time. The Broadcom you bought 15 years ago isn't the same company today, by a long shot. The company derives the majority of its revenues (~70%) currently from semiconductors, with a significant portion of that derived from Apple (NYSE: AAPL ) (~20%) in its wireless line. The company's networking expertise has a few mega macro trends behind it. Smartphones have only grown more complex, and Broadcom's chips are more necessary than ever in 5G phones, although competition among the chipmakers is fierce.
The company's semiconductors are used across the spectrum, with significant R&D spend behind chip design to help maintain the company's market position. One only has to look as far as Intel (NYSE: INTC ) to see the dangers in latching on to some tech companies and what happens when they lose their advantage. As companies move to the cloud and further digitize, Broadcom's networking expertise should keep their chips in demand in both cloud and on-premises servers.
Infrastructure software represents around 30% of the business, and is growing relatively slowly, coming in at 4% on the most recent quarter. However, operating at a 72% margin, it's significant for the company's bottom line, and provides a solid base of cash flows.
Apple as a key customer is somewhat concerning over the long-term. It doesn't appear Apple has any real need to try and replace Broadcom's chips, and is likely to resign a supply deal in the near term. However, these types of deals can change and requires investors to pay attention. For now, Broadcom has the lead in RF and WiFi/Bluetooth connectivity, and there isn't any reason to think they won't maintain it over the medium term.
However, Broadcom's story isn't just as another chipmaker. The company is looking to dole out ~$60B this year for VMware (NYSE: VMW ), the data center virtualization company. This would bring software revenues up from around 30% to around 50% of revenues. Management is projecting $8.5B in accretive EBITDA, and it's likely Broadcom will cut costs, improve margins, and continue to shift VMware to more subscription-based. The company is among the best at integrating tech companies, after all.
Looking at the operating history of VMW, earnings have grown well over time, and the company isn't overly expensive. Broadcom is offering $142.50 a share, so a pretty substantial premium from the current share price. The market is pricing in a failed acquisition currently, or at least a substantial amount of skepticism. It's not unheard of, Broadcom was shot down on its bid to acquire Qualcomm (NYSE: QCOM ) not long ago, but for different reasons. Management remains optimistic on their chances, but regulators have cited concerns Broadcom could reduce interoperability of VMware's virtualization software with rival's hardware, ultimately harming customers. With big tech in the spotlight, it's anybody's guess whether this thing closes.
I'd like to see it close. I typically abhor large acquisitions, and historically they are value destructive for companies. Broadcom is an exception. Looking above, it's amazing what Hock Tan and his team have done for the company's operating metrics over time. They've slashed costs while improving sales growth and overall driving more and more profits to the bottom line. The company likes to advertise 80%+ of the workforce is in R&D and operations, with 14% of revenues spent on research and development.
If the deal doesn't close, it isn't the end of the world. Broadcom will maintain a higher revenue mix in semiconductors, and won't be quite as attractive to me. I like the moves the company is making into software and in diversifying its revenue lines. It makes for a more attractive long-term investment. However, if the deal doesn't close they will continue to return significant capital to shareholders, generate growing free cash flow, and likely start eyeing their next target for acquisition.
The CEO and management team are laser focused on managing costs and margins. Hock Tan is a master operator when it comes to eyeing value and integrating tech companies. When he's gone, it's tough to say I'll be as bullish on Broadcom.
Look at Broadcom's operating margin. It's uncommon to see a company this size driving margin expansion like this. However, the even crazier thing is the market hasn't really rewarded the company for it.
Returns on invested capital are solid and trending up over time. Again, this is uncommon for companies that acquire the way Broadcom does. Even with the relatively larger debt load, the company is generating significant shareholder value and the money they deploy is filtering through to the bottom line.
As far as the balance sheet, there's room for improvement. Short-term debt is sitting at $440M, which is easily serviceable. The company has $39.5B in total debt, and generated $16.31B in free cash flow this past year. What's impressive here is the company is turning 50% of revenues into free cash flow, which grew 25% yoy in the most recent quarter. Management is targeting a payout of 50% of the preceding year's cash flows to shareholders in the form of dividends and buybacks.
Broadcom has hiked the dividend every year since 2011, and most recently authorized a 12% increase. On top of that, the company repurchased $8.5B in shares this past year and still has $13B remaining on the current authorization. I'd like to see the company pay down some debt, and debt likely won't be getting any better with the ~$60B VMware acquisition (some stock and some cash). However, with the cash cow Broadcom is, I do anticipate seeing the company capably delever post-acquisition.
Looking at the long-term earnings graph, you'll see what I mean by the market failing to reward the company for its success. Since going public, Broadcom has compounded earnings growth at ~30% per year . However, it's still trading for ~15X earnings and a 3% dividend yield. These types of numbers are almost kind of shocking, and what I'd expect to find in a no-growth type business, not one that just grew revenues 21% last year.
Based on analyst estimates for earnings growth, and maintaining the current valuation, an investment in Broadcom today would yield around 9% annualized total returns.
Not bad, but I think there's plenty of room here for multiple expansion. The most likely issue is uncertainty.
Look at this cash cow. Broadcom has compounded its free cash flow 29% per year since going public. These graphs are the type I remember seeing when Apple was trading at around $90 pre-split in 2016. Before you start typing your angry comment, I'm not directly comparing the businesses. However, companies generating cash like this, with no foreseeable negative event preventing future growth don't deserve this multiple. Broadcom could easily expand from here and still have a very justifiable valuation.
Based on FCF multiples and analyst estimates, an investment today could yield around 12% annualized. That's at current multiples, not the average multiple, which would be substantially more.
The market doesn't like uncertainty. Neither do I, but money can be made off of it. Broadcom has its warts, certainly. Overall, however, I'll throw my hat in with Hock Tan continuing to guide the business towards margin and earnings-accretive acquisitions and shrewd cost management. Broadcom is throwing off tons of cash, growing cash flows, and then returning it to shareholders. That's what the game is all about. Broadcom is a strong buy here.
For further details see:
Broadcom: Cash Cow Unloved By The Market