Broadcom Inc. (AVGO, Financial) has been one of the best large-cap stocks to own over the past 10 years. It has returned more than 1,200% during this time.
Recently, however, the bull rally has seemed to have hit a wall as it trailed the S&P 500 Index over the past two years. To keep the momentum going, the semiconductor manufacterer acquired the enterprise security software division of Symantec for $10.7 billion last November.
So how does the future look like for the company? Is the growth it has been experiencing sustainable?
To answer that question, we have to understand the company's history and what's been triggering the growth.
Companies like Apple (AAPL, Financial) and Alphabet (GOOG, Financial)(GOOGL, Financial) have great teams of engineers and marketers that introduced stellar products which disrupted the market over and over again. But for Broadcom, the secret is in the management team led by CEO Tan Hock Eng, a self-made man who rose from poverty in Malaysia to building a reputable career out of his savvy deal-making skills.
Since 2013, he has been executing a series of successful mergers and acquisitions that created value for shareholders over and over again, which seems to have been triggered after experiencing stagnant organic growth.
As a result, the company had 30% market share in the chip industry in 2018, up from 4% in 2013.
Creating value through merger and acquisition deals is a very difficult thing to do, even for experienced deal makers. Numerous studies have proven how fatal the wrong deal can be. Just take a look at a recent $63 billion acquisition of Monsanto by Bayer (XTER:BAYN, Financial), which has proven to be a value-destructive deal for shareholders.
Not all are bad, however. Value-creating synergies can be achieved through the right combination of economies of scale, better value-chain control and functional integrations.
As a result, let's review some of Broadcom's biggest deals from the past several years.
The deals in chronological order:
As you can see, almost all the deals were paid for in cash at a relatively cheap price, buying businesses that had solid free cash flow and were experiencing growth stagnation or financial difficulty at the time of the acquisition.
Deals usually lead to lower margins, but cash-based deals lead to accretion in earnings per share and free cash flow. Broadcom hasalways proffered cash-based deals even when when they ran out of it by issuing debt.
Immediately after the deals closed, Broadcom would retain faster-growing areas while divesting of divisions with slower growth. From discontinued operating results, you can see that almost all divestitures have been recorded as gains, which means it got rid of operations that were incurring losses.
The deals were followed by large layoffs and other activities aimed at decreasing redundant expenditures. If you look at the revenue to employee ratio over the years, it becomes evident that the company laid off thousands of employees in a classic private equity style.Why is that? Because they are owned by one in Silver Lake and KKR & Co., who actively played an advisor role in the deals.
They also always seem to offer big incentives to the current management team of the target companies to get the deal done. The Emulex deal is being sued by its former shareholders partly because of that
The deals, until recently, always resulted in better financial synergies. That being said, it is really hard to track the synergy effect of net income simply because there were many acquisition-related, one-time costs, intangible amortization and goodwill write-downs.
Post-merger consolidated revenue has almost always been higher than the sum of the pre-merger revenues of each company until 2019.
The following tables summarizes the M&A deal for 2013:
Notice that post-merger revenue in first-quarter 2014 of $2,653 million is higher than the sum of pre-merger revenues of $2,362 million and $231 million by 2.3%.
2014
Avago adopted the name Broadcom after acquiring the company in January 2016.
Expected revenue by the second quarter of 2015 was $2.79 billion + $2.37 billion + 0.75 * 0.112+0. -0.113(Axxia)-0.12(Sandforce)+ $5.011 billion, while the actual second-quarter 2015 revenue was $6.1 billion.
So the post-merger revenue was much higher than the expected post-merger revenue.
2015
So the expected revenue by first-quarter 2016 was $6.11 billion + $0.48 billion*0.75 = $6.47 billion while the actual first-quarter 2016 revenue was $6.96 billion . Again, there's a revenue synergy.
2016
The expected revenue by first-quarter 2017 was $6,960 million + $8,428 million = $15,468 million, while the actual revenue was $15,610 million. There is a synergy here.
2018
Expected revenue by fourth-quarter 2018 was $1,760 million + $2,345 million = $19,985 million, while the actual revenue was $20,850 million. So there is a synergy here as well.
2019
Expected revenue by fourth-quarter 2019 was $20,850 million + $4,262 million = $25,112 million, while the actual revenue was $22,600 million. For some reason, revenue is falling behind badly, which is a red flag. So what does this mean for Broadcom shareholders?
Potential problems
There's no doubt Broadcom has an exceptional management team with a proven track record of creating shareholder value, but there are a few worrisome signs from a value investing perspective.
The buyback program that authorized the repurchase of up to $12 billion worth of its common stock ended on Nov. 3, 2019. There is no sign of extension of the program even though there is a high level of debt and goodwill. The long-term debt is now getting into dangerous territory of over $32 billion, which means its debt payment capacity and the ability to raise more capital will face more scrutiny.This could cap its acquisition-based growth despite its impressive free cash flow as an increase in leverage bears the risk of the credit market downgrading and a higher level of interest expense, while a high level of goodwill and intangibles will hurt net income through amortization and goodwill impairment
Intangibles are around $18 billion, which could mean yearly amortization between $3.55 billion and $5.21 billion. Goodwill is at $36 billion and is subject to annual impairment test, which means basically if the company performs poorly, there's $36 billion that could explode. Interest expense has jumped from $628 million to $1.44 billion. There was a sharp increase in contractual commitments (less than one year) to $6.5 billion.
In addition, after experiencing limited organic growth with the CA Tech acquisition, the company was forced to shop in a different industry. It ended up with NortonLifeLock, which is a cybersecurity software and services business. There are numerous examples of acquisitions going wrong when done outside your circle of competence.
We also can't forget that the law of diminishing return works even for successful and experienced deal makers. At one point, Cisco has become the largest company in the world through acquisitions. But regardless, as the company gets larger, there will be fewer bargain targets. Broadcom might be the next Cisco and in fact, the first signs of revenue growth deceleration are already present. Even worse, in the 1990s Cisco grew with much less level of debt.
Risks
There are several risks to Broadcom's operations as well.
First, the CEO payment structure has not been very clear since 2017. There's no indication that it wouldn't lead to increased risk-taking.
Second, there are dependency issues as over 20% of sales came from Apple and 50% are from China. Historically, a small number of customers or geographic locations have accounted for a significant portion of their net revenue. This exposure to China amid pandemic fear will take a noticeable chunk away from its fundamentals.
Finally, Broadcom is in an industry fraught with patents and litigations. You never know where the next lawsuit or regulation will come from.
Final thoughts
In conclusion, it is not a value stock even though the company is very good at generating synergies through acquisitions. There is a sign of deceleration of growth with the CA Tech deal. The stock is richly valued already and I don't see how Symantec is fitting into the core portfolio of chip-related businesses, not to mention the huge level of debt and goodwill amassed throughout the past five years. So I will be cautious of the stock.
Disclosure: I don't own any of the stocks mentioned and do not have intention to own in the near future.
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