Broadcom: Stock Price Has Reached Peak Valuation (NASDAQ:AVGO)

In our prior analysis of Broadcom Inc. (NASDAQ:AVGO), we focused on its semiconductor business segment, emphasizing its robust growth propelled by Networking, driven by swift product development in the realm of AI. Additionally, we highlighted positive trends in other segments such as Storage, Wireless, and Broadband, all benefiting from the deployment of 5G and advancements in Wi-Fi technologies.

In this re-evaluation, we reassess the company’s performance to determine if it merits a higher price target, considering our initial target of $1,083 was achieved. Despite a revenue growth slowdown in 2023 and a slight underperformance relative to our previous projections, we delve into the growth prospects for Broadcom in 2024 and beyond, focusing on both its semiconductor and software segments. For the semiconductor segment, we conduct a thorough analysis of its performance, aiming to identify any specific segments that may counterbalance its overall strong growth. In the software segment, we investigate the outlook post-completion of the VMWare acquisition. Lastly, we projected the company’s margins, comparing them with our initial forecast and updating them to account for the impact of the VMWare acquisition.

Strong Growth in Networking Mitigated by Weakness in Other Semicon Segments

In this point, we focused on its semicon business which comprised 79% of the company’s revenues in FY2023 to determine what its forward growth will be. We examine its segment performance and determine whether any semicon segments are slowing down its growth.

Click to enlarge

Source: Company Data, Khaveen Investments

Based on the table above, Broadcom’s actual 2023 semicon revenue growth was 7.4% lower than our previous revenue growth forecast. The largest difference was due to the Broadband revenue growth difference of 10.9%. In the latest earnings briefing, management highlighted the slowdown attributed to the cyclical weakness of its service provider customers. Similarly, the Storage segment’s actual revenue growth was lower than our forecast because of the cyclical downturn that began in late 2023. On the other hand, the growth rate of the Networking sub-segment aligned with our previous forecast and contributed mainly to 2023 revenue growth, driven by strong demand from AI accelerators and data centers.

Furthermore, management guided “semiconductor solutions revenue to be up mid- to high-single-digit percent year-on-year” in FY2024, which is also lower than our forecast for the company’s semicon growth of 16.9% in 2024. Thus, we reexamine its growth outlook for each segment.

Networking

Following this robust growth, the company guided the sub-segment to grow 30% in FY2024 “driven by accelerating deployment of networking connectivity and expansion of AI accelerators in hyperscalers”. This is as the company disclosed that its AI-related revenues reached 20% of the total semicon segment. Interestingly, its AI revenue is driven by networking products such as ethernet and custom AI accelerators (ASICs). Based on this, we calculated its AI represents half of its Networking sub-segment revenue.

Click to enlarge

Source: Company Data, Khaveen Investments

Furthermore, the company highlighted an opportunity for accelerating growth attributed to AI. For example, management highlighted the increasing compute requirements for LLM models, benefiting demand for AI accelerators which had previously been highlighted in our previous analysis. In relation, Broadcom’s CEO also highlighted in its latest earnings briefing he expects related revenue to double by 2024 worth $4 bln due to the strong demand for AI.

It is accelerating as fast as our AI accelerators, the compute engines are growing. And we see that growing hand in hand and particularly so as training — continuous training of very large language models with very different and very large parameters keep going on and things keep changing. So we’re seeing no slowdown, in fact, in the update on building out this AI networks. If anything else on average, we are seeing a doubling on size of those networks across the board. – Hock Tan, President and CEO

In addition, since our previous analysis, Broadcom also launched several new products for the networking sub-segment including its Trident 5, which offers a more powerful chip with higher specs in terms of using a 100-G PAM4 SERDES core compared to the 50-G PAM4 core of the Trident 4. Trident 5 also uses a more advanced 5nm process compared to Trident 4 (7nm). The company also released its new PAM-4 DSP PHY targeted for data centers which we had highlighted previously as important infrastructure needed to support AI inferencing and training and hosting large LLMs such as Microsoft’s (MSFT) exclusive partnership with OpenAI as their exclusive cloud provider.

Overall, we expect the company’s Networking sub-segment growth could accelerate higher than our previous growth forecast following the strong guidance of management for demand related to its AI chips as well as the launch of its new products. Based on our updated projections, we assumed its AI-related product category revenues including ethernet, silicon photonics, and custom ASICs to double based on management guidance that it expects $4 bln in networking AI revenues to double in 2024. Assuming the revenue is spread evenly, we estimated each sub-segment’s share of AI revenue at 48.8% and assumed the growth of its non-AI exposure for each sub-segment based on our previous forecast CAGR.

Click to enlarge

Source: Company Data, Khaveen Investments

Based on management’s guidance of $4 bln in Networking segment revenues to double in FY2024 while non-AI revenues remain flat compared to 2023, we derived an estimated growth of 46.6%. The segment’s ethernet subsegment revenue is the highest, followed by custom ASICs, which is positive for its growth related to its AI exposure, in addition to the silicon photonics segment.

Storage

In our previous analysis, we projected the sub-segment growth by deriving a weighted average market forecast CAGR of 18.15% based on its products, which is fairly in line with the company’s past 4 years average growth rate of 20%. However, the company’s Storage revenue growth had slowed down in 2023 with a growth rate of 11%, driven by cyclical weakness and also guided FY2024 growth to be impacted and “expect server storage revenue to decline mid- to high-teens percentage year-on-year, driven by the cyclical weakness that began late ‘23”. Therefore, we believe that the company’s negative Storage sub-segment outlook in 2024 is primarily affected by market weakness and the memory chip market is highly volatile. However, as the memory market is forecasted to rise by over 40% by WSTS in 2024, we believe this may support the segment’s growth recovery. Thus, we believe the negative growth outlook for the company is only a short-term headwind and its growth outlook could recover beyond 2024. Beyond 2025, we continue to forecast it with our updated long-term weighted CAGR from our previous analysis.

Broadband

In our previous analysis, we derived a weighted average market forecast CAGR of 10.31% for the Broadband sub-segment based on its products. In 2023, the company’s revenue growth slowed down to only 8%. Similarly, the company highlighted cyclical weakness affecting its customers in 2023 and “expect broadband revenue to be down low- to mid-teens percentage year-on-year and reflecting, again, the further slowdown as the cyclical weakness at service providers that began in late ‘23 continues into fiscal ‘24”. Furthermore, according to Dell’Oro Group, broadband equipment is forecasted to decrease by 5% YoY in 2024, highlighting the market weakness. Therefore, we believe the company’s sub-segment outlook in 2024 is weighted down primarily due to the market weakness as a short-term headwind and could recover beyond 2024. Thus, we based our updated sub-segment projection on our previous analysis for its Broadband segment.

Wireless

The company’s Wireless sub-segment growth was muted in 2023 in line with our previous forecasts based on prorated Q1 and Q2 results as we highlighted the smartphone market which was forecasted to decline by 3% in 2023 affecting RF suppliers in our analysis of Qorvo (QRVO). However, the company management highlighted that it “expects wireless revenue to again remain stable year-on-year,” in comparison to our previous analysis, we derived a weighted average market CAGR of 14.1% for the company’s Wireless sub-segment based on its products. Also, the company’s 4-year sub-segment growth of 8%.

Based on our estimated TAM breakdown for its Wireless segment, RF represented the largest product market at 37% of total with a market forecast CAGR of 14%. While we expected the smartphone market to continue maturing and forecasted a decline of 2.7% in shipments in 2024 as smartphone replacement rates decline as consumers hold onto their phones longer due to less attractive upgrades and longer software support, we expect the continued rising adoption of 5G to support RF growth. The penetration rate of 5G is projected to increase to 83% by 2027 from 61% in 2023, a CAGR of 8%. However, the share of mobile subscribers with 5G plans still lags behind 5G smartphone adoption and is only projected to reach 58% by 2028 according to Ericsson (ERIC). Below, we updated our forecast of the RF market to compare with the previous market forecast CAGR based on our estimated increase in 5G adoption rate, 5G content increase factor (2.2x), and our smartphone market shipment projections.

Click to enlarge

*c = [(1+a) x (1 +b)] – 1

Source: Company Data, IDC, Khaveen Investments

As seen, we forecasted the total RF growth at a forward average of 3.6% which is lower compared to the market forecast CAGR of 14% we used previously.

Furthermore, in May 2023, Broadcom announced a new multiyear deal with its largest customer Apple for RF filters, thus we believe this supports the case for management’s stable outlook for the Wireless segment, following our previous expectations of Apple to switch to in-house RF chips which signals it has been delayed.

Outlook

Source: Company Data, Khaveen Investments

Overall, we expect Broadcom’s semicon growth outlook to remain positive. In particular, we see its Networking sub-segment growth being a key driver for its growth as it has exposure to AI through its ethernet and ASIC accelerator chips with the launch of its new next-gen chips further supporting its growth. Furthermore, the company sees a significant growth opportunity in AI, which represents approximately 51.5% of the Networking sub-segment revenue. With the assumption that revenues from AI-related product categories such as ethernet, silicon photonics, and custom ASICs to double, the Networking sub-segment is expected to grow significantly, reaching 46.6% in FY2024. Thus, we believe management’s focus on R&D in Networking is justifiable.

Comparing our forecasted average growth rates with the historical averages from 2019 to 2023, the Networking segment’s growth rate is higher with its average (22.5% vs 16.3%) whereas the Wireless sub-segment (6.9% vs 8.4%) is fairly in line. However, the Storage and Broadband segments’ forward averages are lower than their past average, due to the lower growth expectations in 2024 weighing down on their averages. Thus, we believe this further highlights the strength and importance of its Networking segment.

Software Growth and VMWare Acquisition Completion

In this point, we examined its software segment (21% of revenue in 2023) growth outlook following the acquisition of its VMWare (VMW) acquisition which we had previously covered. In 2023, Broadcom’s software segment grew at 3.4% YoY which was below our expectations with a forecast of 7.87%.

Based on its annual report, the company’s existing software revenues in FY2023 are broken down into 5 categories which are mainframe software, distributed software, Symantec cyber security, FC SAN management, and payment security. Furthermore, following its acquisition of VMWare, we also included that as a separate category.

VMWare (Virtualization)

In November 2023, the company completed its acquisition of VMWare. The company guided VMWare to contribute $12 bln in revenues for 2024. Previously, when we covered VMWare, ex expected the acquisition to be completed by FY2023 and accounted for the full-year revenues in FY2023 at a forecast of $16 bln. As expected, Broadcom has started pursuing its restructuring of VMware as it had done with its past track record of acquisitions, mainly to divest non-core business segments and focus on large enterprise customers.

For example, following its acquisition, Broadcom announced that it is divesting non-core businesses within VMWare including its end-user computing and Carbon Black businesses which have a revenue of $2 bln according to the company. Furthermore, the company also highlighted that it is going forward with its plans to convert perpetual license customers to subscription-based licenses and expects revenue growth to accelerate going forward.

We are also converting an installed base of licenses that is over 60% perpetual today to one that will be mostly subscription by the end of fiscal 2024. Offsetting these, our new strategy for VMware will accelerate revenue growth over the next three years. – Kirsten Spears, CFO

Additionally, the company also announced that it is enhancing its virtualization stack and expects revenue growth to accelerate, which is in line with our previous analysis that we forecasted its growth to accelerate (17% in 2 years post-acquisition).

We’re probably seeing a double-digit growth for the next three years, just by the sheer math of selling that higher value virtualization stack. – Hock Tan, President and CEO

Click to enlarge

Source: Company Data, Khaveen Investments

Furthermore, including the revenue contribution of VMWare, we see its revenues rising by 166% to $20.3 bln in FY2024, which is in line with management guidance of $20 bln for the total combined software revenues. Beyond 2024, we forecast its growth rate at 32%, higher than our projections for core software revenue growth, driven by higher growth of VMWare and revenue synergies.

Mainframe & Distributed Software and Payment Security (CA Technologies)

Broadcom’s Infrastructure Software segment consists of its CA and Symantec acquisitions which include products under its Mainframe Software, Distributed Software, and Payment Security categories. We derived a breakdown of the market forecast CAGR for each of its respective categories. For its Mainframe Software and Payment Security, we based this on the Systems Infrastructure software market growth forecast. Its Distributed software includes Broadcom’s suite of Enterprise software solutions spanning DevOps, AIOps, and ValueOps.

Click to enlarge

Source: Statista, Khaveen Investments

Based on the table, we derived a total weighted average CAGR of 4.89%. The Distributed Software sub-segment represents the largest accounting for 65% of total weight and has a higher growth compared to Mainframe Software and Payment Security due to the higher market forecast growth of Enterprise software driven by enterprise IT spending (6.8% in 2024).

Cybersecurity (Symantec)

Furthermore, we based its Symantec Cybersecurity category on our compiled cybersecurity market forecast CAGR of 15.4% from our previous analysis of Palo Alto (PANW) as it covers a broad range of areas such as endpoint, network, information, and identity security. In 2023, Broadcom announced that it is partnering with Google Cloud (GOOG) to introduce generative AI into its Symantec platform with several advantages for enhanced threat protection according to Broadcom.

Fiber Channel SAN (Brocade)

In 2023, Broadcom’s annual report stated that its revenue grew “primarily due to increases in sales from our mainframe solutions, partially offset by lower demand for our FC SAN products”. Furthermore, in its previous earnings briefing, management highlighted that the Brocade business declined due to cyclical weakness. Nonetheless, the company highlighted that it expects the business to rebound and the total software segment growth to be in the high single digits compared to 3% in 2023. Management emphasized the long-term outlook for mid-single-digit growth for the total core infrastructure software segment.

Then we overlay on it a business that is software, but also very appliance different, the fiber channel SAN business of Brocade. And that’s very enterprise-driven, very, very much so. Only used by enterprises, obviously, and large enterprises at that. And it is a fairly cyclical business. And last year was a very strong up cycle. And this year, not surprisingly, the cycles are not as strong, especially compared year-on-year to the very strong numbers last year. So, that’s — well, this is the phenomenon — the outcome of the combining the two is what we’re seeing today. But given another — my view next year, the cycle could turn around and Brocade would go on. And then instead of a 3% year-on-year growth in this whole segment, we could end up with high single digits year-on-year growth rate because the core software revenue, as I’ve always indicated to you guys, you want to plan long term on mid-single-digit year-on-year growth rate. – Hock Tan, President and CEO

Outlook

Overall, we revised our revenue projections for Broadcom’s Infrastructure Software segment below based on our breakdown by its product categories as well as its VMWare revenue contribution. For its core Software segments, we based its growth on market forecast CAGR whereas for VMWare, we factored in management guidance of $12 revenue contribution (11 months) in 2024 following its completion and excluding $2 bln in revenues that the company plans to divest. Furthermore, we forecasted its growth in 2025 based on our previous updated revenue growth forecasts for VMWare as well as updated revenue synergies estimates.

Click to enlarge

Source: Company Data, Khaveen Investments

Based on our projections for Broadcom’s core Infrastructure Software revenues, we derived a stable average growth rate of 8.7% through 2026. Based on our core software projections, we believe the key growth driver is its Cybersecurity product category which is its Symantec acquisition as it has the higher market forecast CAGR of 15.4%, compared to the FC SAN CAGR of 5.8% and weighted average CAGR of Mainframe & Distributed Software and Payment Security of 4.9%. Additionally, we see the % share of its cybersecurity revenue increasing and becoming the largest sub-segment by 2025, which could bode well for its growth outlook of the total core Software revenue growth.

Including VMWare’s revenue, we anticipate a 166% increase to $20.3 bln in FY2024, in line with management’s total combined software revenue guidance of $20 bln. Post-2024, we project a 32% growth rate, surpassing our core software revenue projections, driven by VMWare’s accelerated growth and revenue synergies. According to management, the company highlighted the company’s strategy that it sees VMWare revenue growth accelerating as it converts its installed base of perpetual licenses to subscription licenses.

Profitability Outlook

In this point, we examined the company’s profitability performance in 2023 as well as revised our projections factoring in VMWare acquisition.

In 2023, the company’s profitability improved in terms of its net margin, rising by 4.7% to 39.3% but its gross margins remained relatively stable compared to the previous year with a 1% decline.

Expense Analysis

Click to enlarge

Source: Company Data, Khaveen Investments

Comparing our previous expense assumptions for the company, the expenses that had the most significant difference were SG&A expenses. Furthermore, R&D and COGS were significant expenses that were different from our forecasts. Thus, we examined each in further detail below.

COGS

The company’s COGS % of revenue was higher than our previous forecast of 9.9% which was previously based on its 2022 COGS % of revenue. This is as the company’s gross margin declined by 1% from 74.1% from 75.1% in the previous year. One of the reasons for the decrease in margin is the lower segment margin of its semiconductor business compared to its software business as seen below.

Click to enlarge

Source: Company Data, Khaveen Investments

Broadcom’s Net Operating Income (EBIT) and its margins have been increasing significantly over the past 5 years. In FY2023, the Semiconductor Solutions and Infrastructure Software segments’ EBIT margins stand at 42% and 57.3% respectively, which are 30.6% and 29.1% higher than their EBIT margins in 2019. Additionally, the Semiconductor Solutions segment consistently has a lower operating margin compared to the Infrastructure Software segment. Though, as we projected the software segment growth to accelerate going forward with the inclusion of VMWare, we believe this could benefit Broadcom’s gross margins and we forecasted COGS % of revenue going forward to remain stable based on its 3-year average.

SG&A

The company’s SG&A expenses as a % of revenue were only 4.4%, compared to our forecasts of 17.5% for 2023. This was as we had accounted for the VMWare acquisition for the full year of FY2023. VMWare’s margins are lower compared to Broadcom as analyzed in our previous analysis. However, we also expected Broadcom to streamline the business and reduce costs. This has already been seen starting to take place. After acquiring VMware, Broadcom is now implementing a series of strategic changes in order to reduce costs, including job cuts and the termination of VMware’s Partner Program. In December, Broadcom announced the layoffs of at least 2,800 VMware employees in December, impacting about 7% of the total number of employees, which we believe is positive for the company to reduce costs. Furthermore, during the same month, Broadcom revealed the ending of the ongoing VMware Partner Program, effective February 2024, and its transition to the invitation-only Broadcom Advantage Partner Program, thus highlighting it is streamlining its distribution network and leveraging Broadcom’s own salesforce and could lead to higher efficiencies.

Therefore, we updated our projection for its SG&A % of revenue based on a weighted average of Broadcom and VMWare SG&A % of revenue. Additionally, we continue to expect the company to achieve cost savings from its integration plans and continue to assume VMWare’s SG&A decreases by 5% per year through 2027, 3 years post-acquisition as stated previously.

Click to enlarge

Source: Company Data, Khaveen Investments

R&D

Furthermore, in terms of R&D, the company’s actual R&D spending was lower compared to our forecast as we previously derived it based on a weighted average including VMWare which has a higher R&D spending % of revenue as highlighted in our previous analysis. Going forward, the company highlighted in its latest earnings briefing that the company will continue to invest and focus on R&D for VMWare with “a rich catalog of microservices tools” to create a “higher-value software stack” to meet its enterprise customer demands.

And so, we’re now going to invest and focus our sales and R&D on those core areas of VMware Cloud Foundation. – Hock Tan, President and CEO

Therefore, we expect the company to continue maintaining its R&D % of revenue and we updated our projections for a weighted average R&D and SG&A % of revenue with a constant R&D spending % of revenue for Broadcom and VMware through 2028.

Click to enlarge

Source: Company Data, Khaveen Investments

Outlook

Click to enlarge

Source: Company Data, Khaveen Investments

Overall, we updated our assumptions for the combined company and modeled its margins as seen above. We see the company’s net margins decreasing as expected following its VMWare acquisition to 26.6% in 2024 from 39.3% in 2023. However, we see its net margins improving through 2028 driven mainly by its integration plans underway and cost-cutting efforts which we believe benefit it through lower SG&A % of revenue as mentioned above.

Risk: VMWare Integration

Broadcom highlighted its integration strategy for VMWare which includes ending VMWare’s partner program. However, this move has raised concern among VMware’s current partners, as around 2,000 of them could be affected. Additionally, some partners criticized Broadcom for prioritizing only major customers who earn more than $500,000 annually to gain more profit, leaving other partners facing the challenges of not being invited to join the program. Therefore, smaller customers may be sidelined by Broadcom and could benefit competitors such as Nutanix (NTNX). However, this is unsurprising as Broadcom has done this before with its Symantec acquisition to consolidate its customer base and focus on core enterprise customers, which benefitted its margins growth.

Valuation

Based on a discount rate of 10%, we derived an upside of -2.3% for the company, with the terminal value based on a 5-year average chipmaker average EV/EBITDA of 18.71x.

Verdict

All in all, we believe Broadcom’s growth outlook in 2024 and beyond remains very positive, with its semiconductor growth driven by the Networking segment’s key role in AI development and we updated our projection for its revenue growth at almost 10% in 2024 despite cyclical weakness in some market segments and a forward average of 13.1%. For core Infrastructure Software revenues, we projected a stable average growth rate of 8.7% through 2026. We believe its Cybersecurity, particularly the Symantec acquisition, is the primary growth driver, with a forecasted CAGR of 15.4%. This shift is anticipated to make the cybersecurity segment the largest contributor by 2025, positively impacting overall software revenue. Including VMWare’s contribution, we expect Broadcom’s revenues to rise by 166% to $20.3 bln in FY2024, which is also in line with management guidance. Beyond 2024, a 32% growth rate is projected, driven by VMWare and revenue synergies, as Broadcom pursues its growth acceleration such as by converting perpetual licenses customers to subscription licenses. In terms of profitability, while we modeled Broadcom’s combined net margins to decrease to 26.6% in 2024 following the VMWare acquisition, we anticipate improvement through 2028 as Broadcom undergoes its integration plans and cost-cutting efforts.

Notwithstanding these factors, our updated valuation indicates that it does not deserve a higher price target, as we derived an updated price target of $1,177.36 ($1,082 previously) with a higher EV/EBITDA average (18.71x). Based on its limited upside of -2.3% following its strong run up by 31.25% since our last coverage, we downgrade the company to a Hold rating.