Summary
- Broadcom remains as one of the best-positioned semiconductors stocks, but lower topline growth is to be expected going forward.
- Contrary to other peers, Broadcom has so far done a great job at expanding its product and service offerings through M&A deals.
- However, there are major risks associated with this strategy that will become more evident, if the VMware deal goes through.
Broadcom Inc. ( AVGO ) has just reported yet another strong fiscal Q1 2023 quarter , marked by high top and bottom line growth. Quarterly results are rarely a good indication about the future and often contain lots of noise, however, they also give us useful context for evaluating the success of long-term strategies.
That is why we will first have a closer look at Broadcom's latest quarterly results. From there, we will proceed to evaluating the company's long-term strategy and all the risks associated with it.
The Most Recent Quarter
Even though performance across business segments was mixed and gross margins noted a decline, Broadcom stock's earnings per share exceeded expectations , both on a GAAP and Non-GAAP basis.
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Consolidated net revenue improved 16% year-on-year, entirely driven by Semiconductor Solutions, which increased by 21%. Infrastructure Software, however, fell by 1%, largely driven by softness in Brocade - a business acquired only a couple of years ago in 2017.
In Q1, Infrastructure Software revenue of $1.8 billion declined 1% year-on-year and represented 20% of total revenue. While core software revenue grew 5% year-on-year, the Brocade business declined because of lumpiness in enterprise consumption in this very narrow vertical of SAN storage.
Source: Broadcom Q1 2023 Earnings Call Transcript (emphasis added)
Going forward, however, the weakness in Brocade business is expected to be offset by higher growth in Broadcom's core software business, resulting in low-to-mid single-digit growth.
Overall, of the three largest business segments (marked in red below), networking remains the main growth driver as demand for Broadcom's switchers by hyperscalers remains robust, especially with the generative AI deployment across major data centers.
Prepared by the author, using data from AVGO earnings transcript
Although the 57% growth in server/storage connectivity is also drawing attention during the quarter, growth in this segment is expected to decline going forward.
the rapid transition to next-generation megawatt solutions drove this substantial year-on-year content increase. (...) we expect that in Q2 on a year-on-year basis server storage connectivity revenue will moderate towards 20% year-on-year growth.
Source: Broadcom Q1 2023 Earnings Transcript (emphasis added)
In a nutshell, it appears that until the pending VMware ( VMW ) transaction is complete, AVGO's topline growth is expected to be largely driven by its Semiconductor Solutions division and would likely slow down through the rest of 2023.
Q1 Semiconductor Solutions revenue was up 21% year-on-year and in Q2 we expect semiconductor revenue growth of high-single-digit percentage year-on-year
(...) So, in summary, we are guiding consolidated Q2 revenue for the company to be $8.7 billion, up 8% year-on-year.
Source: Broadcom Q1 2023 Earnings Transcript (emphasis added).
A forward revenue growth of 10% is still impressive but is well below the historical average for Broadcom.
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In terms of gross profitability, Broadcom is currently among the highest gross margin semiconductor companies. At the same time, the business is among the least capital-intensive within the broader peer group.
I have recently outlined the importance of gross margins within the semiconductors space and how we could use them in conjunction with other metrics in order to identify the best-performing stocks. Based on this framework, I have identified two of the best-positioned stocks from the peer group above (see here and here ).
In the case of Broadcom, the company has achieved this largely through its recent acquisitions and a stronger focus on software. Although I personally, favor the more capital-intensive peers within the semiconductors space, Broadcom's management has done a very good job historically at both selecting its targets and integrating them within its long-term strategy.
Successful Transitioning
Post the Broadcom - Avago Technologies deal, the company was all about wired infrastructure. Focusing exclusively on deals within this space made perfect sense and was also associated with significant synergies.
Even one of its latest deals for Brocade, which is currently within the Infrastructure Software business segment, was a very good fit from a product point of view.
Over the more recent periods, Broadcom has slowly begun to expand in adjacent areas of security software, IT management software, and most recently with the VMware deal into multi-cloud solutions, such as server virtualization and unified endpoint management.
In spite of its long history of acquisitions and high topline growth, Broadcom's management has kept its stock-based compensation under control, which is in stark contrast to other semiconductor stocks .
Prepared by the author, using data from Seeking Alpha and SEC Filings
* Note: Nvidia fiscal year 2023 is plotted against Broadcom fiscal year 2022 due to differences in fiscal year end.
The level of stock-based compensation is often ignored as an item that is having only accounting-related implications. The truth, however, is that at too extreme levels it raises major red flags for shareholders.
Every major deal that Broadcom has made over the past decade also had an important role to play in reducing the company's capital intensity (measured by the property, plant & equipment-to-sales ratio) and moving the business to higher gross margin categories.
Prepared by the author, using data from Seeking Alpha and SEC Filings
Initially, this was bringing huge incremental increases in profitability, with huge leaps in gross margins from 2014 to 2015 period and then once more in 2017, following the acquisition of Broadcom.
Not surprisingly, the VMware deal will also be accretive for AVGO's gross margins.
The strategy of both improving gross profitability, capitalizing on synergies, and cross-selling opportunities has played a central role in AVGO's strong share price performance over the years.
Nevertheless, in recent years it has become more expensive to rely on outside deals, and AVGO is also pushing the limits in terms of the size of target companies. Moreover, as we saw above, margin improvements have also slowed down and all that has resulted in Broadcom's share price largely trailing the semiconductors sector in the past few years.
This brings us to some of the risks associated with Broadcom's aggressive acquisition-led strategy and some important considerations for the future.
The Risks Associated With This Strategy
When it comes to M&A deals, intangible assets are almost always the most important assets within the balance sheet. That is why investors should always pay close attention to purchase price allocations within the SEC filings.
On the surface, the split between goodwill and identified intangible assets offers investors a glimpse into the rationale for each deal. Deals where intangible assets are identified and split individually usually offer greater transparency and are associated with better planning.
On the other hand, deals where goodwill is the only major intangible recognized on the balance sheet are a sign of either an inferior reporting process or the target purchase price being way too high. Such deals would also require significantly higher synergies in order to justify the large amount of goodwill recorded on the acquirer's balance sheet.
Having said all that, over the past 10 years, AVGO's split between individual intangible assets and goodwill has gradually shifted towards the latter, thus significantly increasing the risk of the company overpaying for its targets.
Prepared by the author, using data from Seeking Alpha and SEC Filings
The lack of annual amortization of goodwill contributes to the dynamic we see above. However, recent acquisitions of Broadcom, Brocade, CA Technologies, and Symantec's enterprise security business were by far the biggest drivers.
Within the other intangibles category, technology-related assets are the most important ones for semiconductor companies. Thus, the level of research & development expenses is crucial for sustaining their quality over time.
In that regard, we often witness a large jump in Broadcom's R&D Expense to Sales ratio following an acquisition. The increase is then followed by a gradual decline in R&D relative to sales.
Prepared by the author, using data from Seeking Alpha and SEC Filings
Large synergies in R&D spend could explain this trend. However, the company's R&D to Sales ratio now sits at one of its lowest levels, which could be a sign of too-extreme cost-cutting measures.
The ever-growing size of M&A deals also significantly increases the risks of Broadcom significantly overpaying for its targets and the successful business integration.
Such is the case for the $61bn deal for VMware, which undoubtedly will bring significant cross-selling opportunities between VMware and Broadcom software. Broadcom's bargaining power with customers will also improve as it significantly expands its service offerings for large enterprises, hyperscalers, and hybrid cloud vendors.
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The acquisition, however, holds much higher risk when compared to Broadcom's prior deals. Apart from its enormous size, it will also shift focus away from Broadcom's legacy business in semiconductors.
Indeed, Broadcom has a long history of deleveraging post its acquisitions (see the graph below), but:
- most of the past deals were in highly complementary areas within the semiconductors segment, and thus synergies were easier to achieve;
- the deals shown below were also relatively smaller in size and were also done during a period of rapid growth and extremely low interest rates.
With the sharp increase in interest rates over the past year and the heightened risk of an economic slowdown, Broadcom's management will find it much harder to deleverage as rapidly this time around.
The pressure to deleverage, however, will be even higher this time around due to the enormous debt load relative to Broadcom's current net debt figure (see below).
Investor Takeaway
Broadcom Inc.'s Q1 2023 results were yet another testament that the acquisition-led strategy is working. By focusing on low capital intensity and high gross margin areas that were also highly complementary with Broadcom's legacy business, the company was able to sustain both high topline growth and industry-leading margins. All that resulted in outstanding shareholder returns, high dividend increases, and a premium valuation .
However, organic growth is slowing down, and Broadcom Inc.'s more aggressive movement into infrastructure software also holds a number of risks. These risks were not as pronounced in the company's prior deals. Thus, investors should not rely so heavily on Broadcom Inc.'s prior success. Although I see Broadcom Inc. as one of the best-positioned semiconductors stocks, I have a hard time turning bullish on the stock.
For further details see:
Broadcom's Strong Quarterly Results In The Light Of Its Acquisition-Led Strategy