Broadcom Q3: Solid Progress in VMware Integration (NASDAQ:AVGO)

Investment thesis

Broadcom (NASDAQ:AVGO), a major supplier of integrated circuits to technology companies, released its fiscal third-quarter 2024 earnings report, showing that the San Jose, California-based integrated circuit supplier beat estimates in terms of revenue and profit.

The company has shown accelerating growth in its AI-focused business revenues, which continued their growth momentum in Q3. However, Broadcom’s non-AI revenues continued to weigh on its bottom line as sales continued to decline. Despite this, Broadcom CEO Hock Tan announced on the call that the decline in non-AI revenues had bottomed out.

Tan’s comments did little to bolster Broadcom’s stock, which fell 10% the day after it reported third-quarter earnings.

From my point of view, a more interesting perspective was the progress that has been made in terms of integration with VMware showed, which was in line with Tan’s previous guidance and a reflection of the CEO’s typical acquisition strategy in the past.

These results and comments confirm my bullish view of the company that I have expressed previously. I continue to believe that Broadcom stock is a strong buy at current price levels.

Q3 Recap: Strong AI Revenues, Favorable Tails from VMware Integration

In my previous article on Broadcom, I delved into the details of how the company is benefiting from GenAI technology, maintaining a dominant position in the custom AI IC market, which is boosting the company’s prospects with a favorable AI environment.

In my previous note, I highlighted the company’s sales forecast for its artificial intelligence business, which was expected to generate at least $11 billion in sales of integrated circuits, networking products and other components.

In the Q3 earnings report released late last week, Broadcom’s Tan announced that they now expect ~$12 billion in AI-focused sales, which is an improvement over management’s previous guidance for fiscal 2024 and higher than the $11.8 billion market consensus was expecting. Part of the reason for the increase was the benefit the company gained from its integration with VMware.

While Broadcom’s consolidated revenue in the third quarter grew 34% year over year to $12 billion, it was the company’s Infrastructure Solutions segment that really did most of the heavy lifting. Broadcom’s Infrastructure Solutions segment grew revenue nearly four times over the revenue reported in the same quarter a year ago to $5.8 billion. Integration of VMware solutions was the main driver of growth in the segment, accounting for $3.8 billion, or 66% of the $5.8 billion in Infrastructure Solutions.

During the Q3 earnings call, Tan mentioned that VMWare had set aside millions of dollars for VCF compute costs (VMware Cloud Foundation)the latest release of VMware’s full-stack server virtualization software, which delivered $2.5 billion in annualized bookings, up 32% sequentially. Tan also noted VMware’s integration progress on the EBITDA front, where it continues to rebuild VMware’s operations to align with Broadcom’s overall software operating framework, which continues to enable VMware to achieve its goals:

Meanwhile, we continue to reduce costs at VMware. We reduced VMware expenses to $1.3 million in Q3 from $1.6 million in Q2. And when we acquired VMware, our goal was to achieve $8.5 billion of adjusted EBITDA within three years of the acquisition. We are on track to meet or exceed that EBITDA goal in the next fiscal year, 2025.

In contrast to the continued success of its Infrastructure Solutions segment, Broadcom’s Semiconductor Solutions segment saw another decline in growth after showing early signs of renewed acceleration in the second quarter.

Q3 Semiconductor Solutions revenue fell 4.8% YoY to $7.3 billion. Strong demand from hyperscalers for both Broadcom’s AI networking and custom AI chip products drove Semiconductor Solutions’ Broadcom networking segment up 43% YoY.

This strength was offset by weakness in other non-AI product segments due to weak demand from enterprise customers in the semiconductor solutions segment. Revenue from non-AI networking, server storage, and wireless and Broadcom products was either flat or significantly down and will continue to be flat in the coming quarter, according to management’s guidance.

However, Tan repeatedly said during the call that he predicts revenue declines from the non-AI sector will bottom out:

In summary, here are the trends we are seeing in semiconductors. In total, we have bottomed out in our non-AI markets and expect a recovery in Q4. AI demand remains strong and we expect AI revenue to grow 10% sequentially in Q4 to over $3.5 billion. This would translate to AI revenue of $12 billion in fiscal 2024, compared to our prior guidance of over $11 billion.

Putting it all together with software, here’s our Q4 forecast. We expect Q4 semiconductor revenue to be around $8 billion, up 9% year over year. Infrastructure software, we expect revenue to be around $6 billion. So we’re forecasting consolidated Q4 revenue to be around $14 billion, up 51% year over year.

Margins look good as Broadcom exits Q3

While markets were expecting more secular force from Broadcom’s cyclical revenue slowdown in Q3, I believe the earnings report was a validation of the company’s profitable growth-based strategy. Exhibit C below shows how Tan and team steered the company toward Broadcom’s overall EBITDA margin goals after integrating VMware last year.

Broadcom’s margins accelerated impressively after absorbing VMware into its portfolio last year. While adjusted EBITDA margins increased by 62.9% in Q3, GAAP operating margins also continued to expand sequentially to 32.4%. As observed in Exhibit C, Infrastructure Solutions grew by a solid 700 bp sequentially, adding momentum to the overall margin profile, while margins in Semiconductor Solutions also increased by 80 bp.

The margin results allowed Broadcom to report adjusted earnings per share of $1.24, which topped the consensus estimate by 3 cents.

Broadcom ended Q3 with $10B in cash and $72B in debt, resulting in an annualized interest expense of ~$4B. After factoring in management’s Q4 estimate of a 64% EBITDA margin, I estimate Broadcom’s leverage ratio is ~2.3x on an adjusted basis, making it relatively safe from a debt leverage perspective. In my previous article, I also pointed out how Broadcom’s debt was raised a few months ago, indicating a strong capital structure.

Valuation indicates solid growth potential

Based on management’s updated Q4 guidance, the company is on track to grow revenue by ~44% to ~$52bn this year. My expectation of >20% revenue growth by FY26 is unchanged based on Q3 earnings report.

However, on the margin side, I believe Broadcom has more room to expand its adjusted EBITDA margins after solid results this quarter. I believe margins can expand by at least 100 bp by FY2026, implying a 22% increase by FY2026. This earnings growth should justify an earnings multiple in excess of 35x.

But after factoring in the $4 billion in annual interest expense I mentioned earlier, I think an earnings multiple of 23x to 24x is warranted. That’s a 29% increase from current levels after factoring in a 10.4% discount rate and a 4.7 billion share base.

The growth model above does not include potential dividends. At the time of writing, Broadcom yields 1.5% and consensus estimates are for earnings to grow to 2% by fiscal year 2026.

VMware Integration Risks and Other Factors to Consider

One risk I will highlight is that markets enter the typical seasonal patterns of a September depression, which will compress valuation multiples for now. In such situations, I believe markets would value Broadcom at a lower earnings multiple, closer to the S&P 500 long-term P/E of ~17-18x, as questions about revenue growth and subsequent EBITDA margin are compounded by seasonal pessimism. This would imply a price target of ~$125-$128, as noted in Appendix D in the previous section.

One reason for the revenue growth would be the integration with VMware, where questions have been raised about Broadcom imposing its own software operating model on VMware. This has led to some customers leaving VMware for competitors like Nutanix (NTNX), claiming benefits from any benefits of the VMware integration. In such moments of doubt, I would remind investors of Hock Tan’s approach to his acquisition-led growth strategy, which is all about acquiring companies, redistributing resources, and offering customized solutions that can then be sold to large enterprises and hyperscalers.

This has served Broadcom well throughout its many acquisitions, allowing Tan’s team to set value-based pricing and maintain a margin expansion strategy. One commentator on the public forum, who apparently used to be a VMware salesman, said they would likely have to “we advise our (their) clients to do the same, as most of them are small and medium-sized enterprises” which proves Tan is right to eliminate SMBs and other small customers that are not Broadcom’s primary focus.

Still, media reports of VMware integration instability could pose some headwinds to Broadcom sentiment for now, prompting pullbacks. Such pullbacks would only create buying opportunities.

To go

Contrary to what most publications would report, I believe Broadcom had a solid earnings report to end Q3. The company continues to be a strong beneficiary of AI tailwinds, despite weakness evident in its non-AI business lines, which should reach cyclical lows by year-end, if not as early as Q3.

I am still confident that I can confirm my strong buy recommendation for Broadcom shares.