Summary
- Broadcom's FQ3 earnings release highlighted the execution prowess of CEO Hock Tan and team, as it delivered another robust performance, despite worsening macro headwinds.
- Therefore, we are not surprised that AVGO has outperformed its broad semi peers YTD, as represented by the SOXX ETF, coupled with its more reasonable valuation.
- But, we surmise that Broadcom's near-term growth could have peaked in FQ3 and could slow markedly through FY23. Therefore, investors need to assess whether it has been factored in.
- Its deal to acquire VMware could also face significant execution risks, which might not have been adequately de-risked, given its lower profitability profile against Broadcom's corporate average.
- We discuss why we revise our rating from Buy to Hold.
Thesis
Broadcom Inc.'s ( AVGO ) FQ3 earnings release was the sole bright spot in a punishing week for semi stocks, as Nvidia ( NVDA ) stock revisited its July lows. Notwithstanding, AVGO's relief was temporary, as it has given back all its gains from August and more than 50% of its July recovery.
Notwithstanding, AVGO's resilience against its broad semi peers is a testament to the market's confidence in CEO Hock Tan and team. Notably, AVGO posted a YTD return of -23.7% against the iShares Semiconductor ETF's ( SOXX ) 33.6% YTD decline. We believe Broadcom's lower exposure to the end-consumer segment (about 25%) has helped it mitigate the weakness seen in that segment. Coupled with the reacceleration in its enterprise/telco/hyperscaler segment, it has lifted Broadcom's semiconductor solutions growth cadence markedly in FQ3.
However, we need to remind investors that Tan remains steadfast that the elevated growth in the semiconductor industry would normalize over time, including Broadcom's. Therefore, given Broadcom's market leadership, we believe it's prudent for investors not to expect Broadcom to continue posting such remarkable growth rates, given tougher comps and growth normalization moving ahead.
Our valuation analysis indicates that AVGO's valuation seems well-balanced in the context of potentially slowing growth through FY23. Also, investors need to consider the execution issues of its proposed VMware ( VMW ) acquisition, which Broadcom expects to close fully by FY23.
While we remain confident of Broadcom's profitability drivers, and execution prowess in integrating VMware, we believe a deeper pullback of AVGO could still be possible. Also, it could help de-risk some of its execution risks and the deceleration headwinds we discussed earlier.
As a result, we rate AVGO as a Hold for now .
Don't Expect Broadcom To Post Such Remarkable Growth Rates Through FY23
It was another robust performance by Hock Tan and Co. in FQ3 as Broadcom posted revenue growth of 24.9% YoY, up from Q2's 22.6%. Notably, semiconductor solutions continue to spur Broadcom's upward momentum, as it delivered an increase of 31.9%, well above Q2's 29.2%. In addition, it's the third consecutive quarter of accelerating growth cadence, as Broadcom leveraged its robust and diversified semi portfolio, coupled with the reopening momentum.
What's even more impressive was the company's ability to deliver such remarkable underlying metrics, despite the worsening macroeconomic headwinds impacting the semi industry in general. In addition, Broadcom has also not experienced any potential weakness that could capsize its growth cadence, as Hock Tan articulated:
We scrap to our backlog thoughtfully, carefully before we deliver products to customers, that's true end demand. You see the numbers that we're presenting and the strength of the numbers, if I could say so myself, it's true end demand what we're seeing with respect to the various end markets. Now we also have a ton of backlog, and our lead time continues unchanged at 50 weeks. As far as what we reported in Q3 and expect to see in Q4, we believe and we're pretty clear about that to be true end demand and consumption by our customers. ( Broadcom FQ3'22 earnings call )
However, we urge investors to consider the potential that Broadcom's FQ3 could also be its near-term peak quarter, as its Q4 guidance suggests a marked slowdown from Q3's metrics.
Management guided to a 25% YoY revenue increase for semiconductor solutions in FQ4 while keeping the guidance for software around an average of 5% growth, in line with FQ3. Accordingly, its overall revenue growth cadence should moderate to 20% for FQ4, down from FQ3's 24.9% uptick. Therefore, we posit that Broadcom's near-term peak growth could have occurred in Q3. Of course, the critical question is whether the market has priced that in, given the battering from its highs in December 2021.
Broadcom revenue change % and adjusted EBITDA change % consensus estimates (S&P Cap IQ)
Furthermore, the consensus estimates (very bullish) suggest that Broadcom's revenue and adjusted EBITDA growth could slow markedly through FY23. Therefore, we deduce the potential deceleration needs to be factored into investors' valuation models to assess whether AVGO's valuations have de-risked the possible marked slowdown moving ahead.
Also, we urge investors not to consider the acquisition of VMware as a bed of roses. Given VMware's much lower profitability profile than Broadcom's corporate average, Broadcom is expected to dissect VMware's business to maximize its operational efficiencies, to reduce the dilution of its organic margins profile.
While VMware's organic topline growth should be accretive to its software segment, we postulate it's insufficient to mitigate the potential sharp slowdown in its semi solutions segment. Furthermore, investors need to consider the execution risks of integrating VMware's business as no mean feat.
Insider detailed in a series of reports that AWS ( AMZN ) and Google Cloud ( GOOGL ) ( GOOG ) have been aggressively recruiting VMware's employees ahead of the expected deal completion, leading to an " exodus " in VMware's ranks. Furthermore, the company has also been slowing down the closure of new deals as customers' inquiries surged, given their worries of a marked price increase after Broadcom acquires VMware.
In addition, the internal sentiments over the acquisition by Broadcom have been mixed, as customers and partners remain concerned over Broadcom's past integration approach. Insider reported:
Many VMware employees fear the Broadcom acquisition will ruin what made the company special: its transparent communication from leadership, flexible work policies, and huge investment on open source. "Broadcom is where good software goes to die," an employee from a VMware partner told Insider. VMware helps companies "lift and shift" their services to the cloud, but at some point, these companies will want to be cloud-native and then won't need VMware's services anymore, he said. He's doubtful Broadcom will be the one to help VMware through this period. ( Insider )
AVGO's Valuation Remains Well-Balanced
Broadcom adjusted gross margins % and adjusted EBITDA margins % consensus estimates (S&P Cap IQ)
Broadcom's robust profitability profile has been instrumental in helping undergird AVGO's valuations. Moreover, management is confident of continuing to lift its gross margins over time through its superior tech portfolio.
Notwithstanding, we assessed that AVGO's valuation seems well-balanced, even as it has fallen markedly from its overvalued zones in late 2021. While it last traded close to its 10Y mean, we don't consider it as undervalued.
It still remains well above the two standard deviation zone below its 10Y mean, which we believe offers a more considerable margin of safety, given Broadcom's potential growth deceleration and execution risks. Therefore, we deduce that these headwinds have not been adequately de-risked.
Is AVGO Stock A Buy, Sell, Or Hold?
AVGO is a strong stock, as we can glean its secular medium-term uptrend from the chart above.
However, AVGO appeared to have met stiff selling pressure at its August highs, even though we observed a strong support zone at its July lows.
Given the extent of the selldown, it's possible that AVGO could form a bottom near its July lows, rejecting further selling downside. Therefore, we must emphasize that we are not bearish on AVGO but remain concerned that its valuation might not have reflected the headwinds discussed earlier.
Therefore, we revise our rating on AVGO from Buy to Hold as we await the possible re-test of its July lows.
For further details see:
Broadcom Q3: Solid Performance No Doubt, But Prepare For A Slowdown