Market Reacts With Cynicism as Broadcom Beats the Street

Broadcom Inc. (AVGO, Financial), the provider of digital and analog semiconductors for connectivity devices, reported the results of its second quarter after the bell yesterday, beating the top-line and bottom-line estimates.

The company reported revenue of $5.01 billion during the quarter, up 19.6% year over year. Analysts were modeling for revenue of $5 billion. Earnings per share grew 32% to reach $4.88. Analysts’ consensus stood at $4.76. Broadcom also repurchased 1.5 million of its shares, returning a cumulative $347 million to the shareholders.

“Our business continues to be very robust and sustainable. This is validated through our strong execution in the second quarter which drove gross margin to a record 66.6% and free cash flow to 42.3% of net revenue,” Hock Tan, president and CEO of Broadcom, said in the press release.

For the third quarter, the company is guiding for mid-point revenue of $5.05 billion compared to the Street’s consensus of $5.06 billion. Non-GAAP EPS is expected to reach $4.80, above the analyst consensus of $4.57. Despite stellar results and strong guidance, the market was unimpressed as the stock lost roughly 1.96% of its market cap in after-hours trading on Thursday.

Performance insights

Although revenue increased from the previous year, Broadcom reported a 5.9% decline in sequential revenue due to headwinds in the wireless segment.

Wired infrastructure and enterprise storage drove top line growth

Growth was led by enterprise storage, a segment that is involved in the provision of storage connectivity solutions, posting an astonishing 63% year-over-year growth. However, the rise primarily came from the acquisition of Brocade – a company that specializes in data and storage networking products. Brocade Fiber Channel's switch business contributed $400 million towards the revenue of Broadcom’s enterprise storage segment. Nonetheless, the enterprise storage segment registered 17% growth sequentially, indicating that organic growth is still intact.

The wired infrastructure segment posted 9% year-over-year growth while registering 22% sequential growth during the quarter. Demand from cloud data centers, enterprise IT and growth of infrastructure-as-a-service (IaaS) boosted wired infrastructure revenue. Note that Broadcom generated around 50% of its revenue from this segment during the quarter ended in April.

For the third quarter, Broadcom expects the growth in wired infrastructure to continue despite the ban on shipments to the Chinese telecom player ZTE. However, note that the U.S. has entered into a deal with ZTE to end the sanctions for $1 billion in fines and reorganization of the board. For the full year, Broadcom is set to hit mid-single digit growth in the segment.

Wireless business is facing headwinds

The wireless communication segment, which provides RF front-end and wireless connectivity solutions, weighed on top-line growth as the segment shed 41% of the revenue compared to the previous quarter. The sequential decline in wireless revenue was related to reduced-shipments to Apple (AAPL, Financial), noted the management of Broadcom on an earnings call. The management expects the wireless revenue to remain flat, or slightly decline, during the third quarter of 2018 on a year-over-year basis.

From earnings calls commentary, it seems like that content-per-device growth is coming from legacy rather than high-end phones, hence the flat forecast. “The mix of legacy phones customers increasing dramatically … the legacy phones may increase in percentage, which then dilutes any increase in content,” said Tan in response to a question regarding wireless content-per-device on the earnings call. In short, revenue from wireless communication is expected to decline a bit during the next quarter or so.

The industrial segment contributed $263 million towards the revenue of Broadcom, up 17% year over year and 5% sequentially. However, the industrial segment makes up only 5% of Broadcom’s total revenue.

What’s the outlook for growth?

The proliferation of connected devices has been the enabler of secular growth for several technology companies. However, integrated circuit providers like Broadcom are benefiting from growth in every area of cloud data centers including networking and storage.

According to a rather rosy research report, the global data center networking market is set to grow at 15% per year from 2017 to 2025. But a report from Research&Markets forecasts that the data center networks market will grow at 5.23% between 2017 and 2025. Another report from Global Market Insights estimates that the data center infrastructure market will reach $77.9 billion by 2020, translating into a CAGR of 10% from 2018 to 2024. As Broadcom serves the networking market, it’s set to benefit from the growth of data center networking.

On the surface, the enterprise storage seems to be doing great also. But Broadcom registered only 7% year-over-year growth in the segment, after excluding the acquisition of Brocade. It is worth mentioning that Dell’Oro Group – the authoritative source for telecommunications, networks and data center research – forecasts that the storage systems market will decline for three years before returning to growth. Although internal storage revenue is expected to rise at CAGR of 3% during the next five years, external storage revenue will decline at 3% per year between 2017 and 2020.

Moreover, Broadcom notes the following in one of its quarterly reports: “As cloud-based IT solutions become more prevalent, our results of operations will suffer if we are unable to increase sales of our products to cloud-based data center providers.”

Broadcom’s management also said the following on its earnings call yesterday:Â “We expect continued spend in enterprise IT to drive sequential growth in enterprise storage, and growth in cloud storage capacity will lead to a recovery in hard disk drive demand."

Although the company sees a recovery in hard disk drive demand, Dell’Oro Group thinks that the growth of all-flash array will cannibalize the sales of all-disk and hybrid storage systems.

The point is that the enterprise segment might not support high growth in upcoming quarters as is evident from the forecast of Dell’Oro Group and Broadcom’s unimpressive organic growth in enterprise storage segment. The wireless segment is also expected to stay flat, at least in the short run. But the company expects the industrial segment to maintain mid-single digit growth in the long run.

What about valuation?

One way to derive Broadcom’s valuation is to use the weighted average of the expected growth in each segment and use it to project earnings.

Notes to the table: Growth of each segment is based on industry forecast or Broadcom guidance.

Focus Equity estimates

Despite using a low enterprise storage forecast, the valuation reveals an upside of 15%. Moreover, the stock yields around 3% in annual dividends. Note that it is assumed that dividends will grow in line with earnings for the purpose of valuation.

Takeaways

• Broadcom is a diversified semiconductor company with exposure to growth markets like data centers networking and storage. Although data center storage might come under pressure, the company will probably maintain its strong performance amid extensive diversification.
• Enterprise storage and wireless communication will grow slower than expected. A shift to software defined storage and rise network function virtualization might also take a toll on the company’s enterprise storage segment. Given the maturing smartphones market, growth will be hard to come by
• Nonetheless, Broadcom remains a good candidate for an investor's portfolio amid diverse operations, reasonable valuation and a decent dividend yield.

Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.