Broadcom Q3: VMware Integration Likely Not Successful (NASDAQ:AVGO)

I presented my “Sell” thesis on Broadcom Inc. (NASDAQ:AVGO) in my previous article from June 2024, noting that aside from AI and VMware, Broadcom’s traditional businesses saw revenue decline by 15%. Broadcom released its Q3 report result on September 5 after market close, forecasting $12 billion in AI revenue for fiscal 2024. While I am bullish on their custom ASCI and AI networking business, I remain concerned about their legacy software portfolio as well as their VMware integration. I maintain a “Sell” rating with a fair value of $120 per share.

VMware integration will probably not be successful

Since Broadcom completed its acquisition of VMware last November, Broadcom has begun integrating the VMware business and making controversial changes. I do not believe Broadcom can successfully integrate the VMware business for the following reasons:

• Broadcom Ends VMware Perpetual License Model to Promote VMware software subscription model. The termination could potentially force their partners to distribute VMware’s competitor products, such as those from Microsoft Corporation (MSFT) and Nutanix, Inc. (NTNX), which can offer customers cheaper solutions. For example, at the recent Nutanix event telephone conversation regarding financial resultsThe company indicated that it managed to sign several major deals thanks to the Broadcom-VMware integration.
• Broadcom is currently reportedly only selling bundled products, which has led to price increases of 500-600% in extreme cases. I think the change in business model could benefit Broadcom’s growth in the short term, but partners and customers may look for cheaper alternatives in the future.
• In August 2024, VMware announced the new VMware Cloud Foundation 9 (VCF 9), a cloud-based platform that consolidates all third-party applications and software. While I believe VCF 9 is a better fit for Broadcom’s business AI solutions, it is unlikely to help VMware gain any competitive advantage. As shown in the slide below, VCF 9 provides solutions for compute, storage, and networking layers. However, VMware’s core strength lies primarily in their vSphere solutions in the compute layer, and VCF 9 must rely on partners to deliver a holistic cloud platform.

• Dell Technologies Inc. (DELL) has already exited its VMware reseller business in 2024, according to a Jan. 30, 2024 SEC filing. Additionally, Cisco Systems, Inc. (CSCO) announced a global strategic partnership with Nutanix to provide customers with a complete hybrid cloud solution. It’s clear that VMware is losing some key partners as a result of the Broadcom integration.

Custom AI ASIC and AI Network

I think both custom AI ASCI and networking chips are key growth drivers for Broadcom. The company is targeting $12 billion in AI revenue in fiscal 2024, more than 20% of total revenue.

As I noted in my previous report, both Broadcom and Marvell Technology, Inc. (MRVL) are leaders in custom AI ASIC technology, delivering customized accelerators in partnership with major hyperscalers and internet operators such as Alphabet Inc. (GOOG), (GOOGL), Microsoft Corporation (MSFT), Meta Platforms, Inc. (META), Amazon.com, Inc. (AMZN), and ByteDance. As previously reported, Broadcom successfully secured 3nm AI ASIC deals with Alphabet and Meta.

Broadcom has invested significantly in 3nm and 2nm ASIC technology over the past five years, positioning it well to benefit from the growing demand for custom accelerators. Management also points out that custom ASIC is a high-margin business with longer R&D cycles.

Broadcom also offers networking chips for switch manufacturers such as Arista Networks, Inc. (ANET), Dell, Juniper Networks, Inc. (JNPR) and Super Micro Computer, Inc. (SMCI). Broadcom is poised for rapid growth in its networking business in the near future, driven by data center expansion and growing demand for network connectivity. In their latest quarterly earnings, major Ethernet AI companies reported strong growth in the data center market. For example, Dell reported 80% year-over-year growth in its Server and Networking business in Q2.

As such, I support Broadcom’s leadership position in AI ASICs and AI networking solutions, which will continue to be a key growth driver for the company.

Outlook and valuation

Broadcom saw revenue grow 47% in Q3 and adjusted operating profit jump 43.6%. Semiconductor grew just 5% year over year, while Infrastructure Software grew 200%, mostly due to the consolidation of VMware. Excluding VMware, Broadcom grew revenue just 4% in the quarter, which is not impressive.

Since the company has already reported three quarters of results, I do not expect any major surprises in the FY24 financials. For the normalized growth rate from FY25, I consider the following factors:

• Semiconductor Solutions: As mentioned earlier, custom ASICs and AI networks will be key growth drivers for their semiconductor solutions business. During Marvell’s Q2 earnings conference call, their management indicated that the overall custom ASIC market will accelerate in the second half of fiscal 2024 as most hyperscalers ramp up custom ASIC accelerator production. I think Broadcom’s 2nm and 3nm ASIC technology could significantly boost their semiconductor solutions growth in fiscal 2025. I estimate that the semiconductor solutions business will grow at 10% per year from fiscal 2025.
• Infrastructure Software: My primary concern for Broadcom is the infrastructure software segment. As I mentioned in my previous article, Broadcom has acquired several legacy software companies in the past, such as CA and Symantec. Broadcom is unlikely to grow revenue in the mainframe segment, which is a dying industry. Additionally, Symantec is facing increasing competition from other security companies, such as Palo Alto Networks, Inc. (PANW), CrowdStrike Holdings, Inc. (CRWD), and Zscaler, Inc. (ZS). As a result, I am assuming only 2% organic revenue growth in the infrastructure software segment.

Overall, I calculate Broadcom to grow its revenue by 8.3% annually from FY25. Given that custom ASICs and AI networks have higher gross margins, I project Broadcom to deliver 10 basis points of gross margin expansion on a favorable revenue mix. With these parameters, the DCF summary can be found as follows:

The weighted average cost of capital (WACC) is calculated at 12%, assuming a risk-free rate of 3.7%, a beta of 1.36, an equity risk premium of 7%, a cost of debt of 7%, equity of $717 billion, debt of $74 billion, and a tax rate of 10%. The fair value of Broadcom stock is calculated at $120 per share.

Growth Risk

In giving Broadcom a Sell rating, I consider factors that could cause my rating to change:

Infrastructure software will be less than 20% of total revenue by the end of fiscal 2024. It is entirely possible that Broadcom will spin off its software business into a standalone company in the future. If that happens, I think it could be very positive for Broadcom’s share price, and such a spin-off could unlock value for shareholders. It is clear that the software and semiconductor businesses are very different in nature, with no clear synergies between them.

Furthermore, if hyperscalers accelerate custom ASIC production in 2024, Broadcom could see higher AI revenue in FY24, exceeding $12 billion. In that case, it could lead to an overly optimistic market outlook for custom ASIC growth in FY25, which would significantly boost the stock price. It is worth noting that Broadcom increased its AI revenue forecast from $11 billion to $12 billion this quarter.

Application

I am not comfortable with Broadcom’s acquisition strategy in the software market and doubt the company will be able to successfully integrate VMware in the near future. I reiterate my Sell rating with a fair value of $120 per share.