Summary
- Broadcom reported strong quarterly results.
- AVGO stock beat estimates on both lines and showcased compelling business growth.
- The valuation is not demanding, and the dividend is attractive.
Article Thesis
Broadcom ( AVGO ) reported its first-quarter earnings results on March 2. The company easily beat estimates, and guidance for the current quarter indicates that growth will remain healthy going forward. With a reasonable valuation and an attractive dividend yield, AVGO looks like a better-than-average pick in the tech industry.
What Happened?
Broadcom reported its first-quarter earnings results on Thursday afternoon. The headline numbers can be seen here:
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The company was able to grow its revenue by 16%, which is quite strong in absolute terms, and which also beat the consensus estimate. This is not too surprising, however, as Broadcom has a very clear track record of outperforming expectations:
Over the last ten quarters, prior to the current report, Broadcom had beaten estimates on both lines. Wall Street thus seems to have a pretty pronounced tendency to underestimate Broadcom, which is why the current double beat is not really a surprise, I believe.
Nevertheless, the fact that Broadcom was able to beat results while also showcasing a compelling year-over-year performance is compelling, especially when we consider that the market for semiconductors isn't very strong any longer. Many other chip companies are reporting year-over-year declines, including major ones such as Intel ( INTC ) and NVIDIA ( NVDA ) - relative to them, Broadcom had an excellent quarter.
Broadcom's revenue growth was driven by several contributing factors. The company benefited from the fact that demand especially in the infrastructure business was strong. Customers were not reluctant to spend money on new equipment despite the ongoing economic slowdown, which can be attributed due to the fact that not all of Broadcom's businesses are consumer centric. Where Broadcom's products are mission-critical for businesses and other institutions, spending remains strong, no matter the strength of the economy. Broadcom also benefited from price increases which did not only contribute to revenue growth but which also bolstered Broadcom's already strong margins during the period. Looking at the income statement for the period, we see the following:
We see that the company's revenue growth of 16% was significantly higher than its cost of revenue growth of 9%. This resulted in an expansion of Broadcom's gross margin, which naturally is good for the company's profitability. Even better, Broadcom also benefited from operating leverage. As its research and development, SG&A, and other operating expenses were down marginally year over year - which is quite a feat in an environment where most things are becoming more expensive - the company saw its operating margin jump versus the previous year's quarter. This, in turn, is why net profits soared as well.
On an adjusted basis, Broadcom generated earnings per share of $10.33 during the quarter, or a little north of $41 annualized. Of course, there's no guarantee that the remainder of the year will be equally good, but since analysts are predicting earnings per share of $40.60 right now, and since they have a clear tendency of underestimating Broadcom, earnings per share of more than $40 wouldn't be too surprising, I believe.
Cash Flows And Shareholder Returns
Broadcom operates with a fabless business model, meaning the company does not operate its own manufacturing plants. Instead, the chips that it designs and sells are produced by foundries such as Taiwan Semiconductor Manufacturing ( TSM ). This means that Broadcom will always be reliant on other companies, but at the same time, the fabless business model means that Broadcom does not need to invest heavily in its operations, apart from R&D which is already accounted for in the income statement.
During the most recent quarter, Broadcom generated operating cash flows of slightly more than $4.0 billion. At the same time, capital expenditures totaled just above $100 million during the quarter, which is why free cash flows totaled $3.9 billion. In other words, Broadcom managed to turn around 98% of its operating cash flow into free cash flow, which is exceptional.
Free cash flows can, as the name suggests, be used freely. They can be spent on debt reduction, acquisitions, or shareholder returns via dividends and/or buybacks. Broadcom has been pursuing acquisitions aggressively in the past, but the company also has been very active when it comes to shareholder returns. Right now, the company is working on the acquisition of VMware ( VMW ), which is still pending. This deal is worth around $61 billion and thus pretty sizable, even for a company such as Broadcom. At the current run rate, the deal size is equal to around four years' worth of Broadcom's free cash flows. Whether the deal will close in the foreseeable future is not known, and it might even fall through altogether, although that's not very likely according to many analysts. Still, there's the possibility for this deal to fail, in which case Broadcom suddenly would have significantly larger available cash resources. This could result in another acquisition, but it might also allow Broadcom to pursue other things, such as debt reduction or more aggressive buyback spending. Since Broadcom is trading for less than 15x this year's expected net profit, buybacks would be quite accretive and would thus not be a bad idea.
For income investors, Broadcom remains attractive. At current prices, Broadcom's shares offer a dividend yield of 3.1%, which is close to twice as high as the broad market's yield. On top of that, Broadcom offers very reliable dividend growth at a hefty pace. While the company will not increase its dividend at an annual rate of 30% (which is the five-year average growth rate) in the future, investors can expect a meaningful dividend growth rate nevertheless. Analysts are predicting that Broadcom will deliver earnings per share growth in the 12%-13% range in the long run, thus a dividend growth rate in the mid-teens could be achievable for quite some time if analysts are right. After all, the current payout ratio of just 45% leaves considerable room for growth. If Broadcom were to grow its earnings per share by 12% per year over the next five years, while the dividend grows by 15% per year over the same time frame, the dividend payout ratio would rise moderately, to 52%. Of course, analysts could be too optimistic. But even if Broadcom's future earnings per share growth is just half as high as currently predicted, i.e. in the 6% range, Broadcom could easily offer a high single digit dividend growth rate going forward. In combination with a starting dividend yield of a little more than 3%, that's quite attractive for dividend growth investors, I believe.
Shares Are Up But Not Expensive
Last fall, when equity markets were especially jittery, Broadcom saw its shares slump to just above $400 - without there being a good reason for that share price decline. At that point, shares were very inexpensive and thus pretty attractive. Today, with AVGO trading at around $600 per share, they are more pricey and less attractive on a relative basis. But in absolute terms, Broadcom is still far from expensive, as shares are trading for just 14.5x this year's expected profits (and profit estimates might end up being too conservative again).
We can also look at Broadcom's enterprise value to EBITDA multiple, which accounts for changes in debt usage over time (e.g. due to AVGO's takeovers in the past):
We see that Broadcom isn't as inexpensive as it was last fall, but Broadcom still trades at a clear discount relative to the longer-term average valuation. The five-year and 10-year median EBITDA multiples are in the 16x range, thus Broadcom has an upside potential of around 30% relative to its historically normal valuation. Due to higher interest rates (and thus higher discount rates), one can argue that Broadcom's fair value is lower than its historically normal valuation. Still, with an EV/EBITDA multiple of 12, Broadcom is far from expensive even when we consider that the interest rate environment is different from a couple of years ago.
Takeaway
Broadcom had a pretty strong quarter. Revenues rose massively, and the company guides for revenue growth in the current quarter as well. This sets Broadcom apart from many other chip companies that suffer from declining sales in the current environment.
Margins are up, cash flows are strong, and the valuation is very reasonable. Depending on how the VMWare acquisition progresses, Broadcom's shares could be volatile. But I believe that dividend growth investors will ultimately be happy with their investment in the long run.
For further details see:
Broadcom: Strong Growth Continues