Broadcom: An Undervalued Giant In The Rising AI Semiconductor Market (NASDAQ:AVGO)

AI is changing the face of technology, and Broadcom (NASDAQ:AVGO) is positioned to ride this wave. While many have been quick to point out the AI leadership of NVIDIA (NVDA), AVGO’s potential in this space remains largely underappreciated and undervalued. Our investment thesis argues that AVGO is well-positioned to benefit significantly from the rise in AI and stands as a potential leader, second only to Nvidia. This article will delve into AVGO’s recent strong quarterly performance, the escalating role of AI in its business, its partnership with Google, and how these factors collectively present a promising future for AVGO in the AI landscape.

FYQ2 Earnings: Another Strong Quarter, AI In Focus

AVGO’s recent FY Q2 earnings report was a reassuring reflection of its consistent performance, with the stock rising 2.8% following the announcement. In addition, FY Q3 revenue and earnings guidance also exceeded expectations. For the quarter, AVGO posted revenue of $8,733 million, representing a year-on-year growth of 7.8% and in line with consensus estimates. Encouragingly, the company’s gross margin stood at 75.6%, and an operating margin of 62.0%, a decent increase from 61.0% a year prior. The EPS for the quarter was reported at $10.32, up 14% year-on-year and outperforming consensus by 2%.

AVGO’s recent earnings call unveiled an exciting future driven by substantial AI opportunities. Today, AI-generated revenue constitutes approximately 15% of its semiconductor business, a significant leap from 10% in fiscal ’22. Management’s projection for fiscal ’24 estimates that AI could constitute over 25% of its semiconductor revenue (~$7.5 billion), indicating a substantial growth opportunity. Further, management anticipates that its revenue from AI will surpass $1 billion in Q3 of fiscal ’23, an indication of the booming potential of this sector.

We believe the company’s next-generation Ethernet switching portfolio, comprised of Tomahawk 5 and Jericho3 AI, presents a distinct competitive advantage. These industry-leading solutions offer superior performance fabric for extensive AI clusters, optimizing the use of costly and demanding AI resources. A considerable portion of AVGO’s AI growth stems from the networking components it supplies, facilitating the creation of an Ethernet fabric for AI clusters.

AVGO customers’ vigorous AI initiatives continue to generate robust orders and design activity for its networking and custom AI ASIC chips. By our calculation, we believe AI ASIC chips, driven by Google (GOOGL) (GOOG) demand, could reach $5-6 billion in FY24.

This growth trajectory could potentially establish Broadcom as the second-largest AI compute/networking semiconductor supplier, standing just behind NVIDIA but considerably ahead of Marvell (MRVL), Intel (INTC), AMD (AMD), and Amazon (AMZN). This would mark a considerable achievement for Broadcom and cement its place as a significant player in the rapidly evolving AI landscape.

Google Partnership: Opportunity and Risk

Recent reports suggest that AVGO and Google continue their collaborative efforts in creating the newest iteration of Google’s TPUs, or AI-specific ASICs, a partnership that has persisted across the last three generations. Analyzing AVGO’s latest earnings call suggests that its ASIC business, often referred to as the “offload” business, predominantly serves a single major customer and is projected to produce around $3.8 billion in revenue for FY23.

This development is seen as part of Google’s accelerated attempts to enhance its AI capabilities, a move likely triggered by competitive pressures from Microsoft (MSFT) and OpenAI. Furthermore, we anticipate that Google’s vigorous advancement in AI ASIC development could trigger Meta (META) to expedite its custom silicon chip production for AI. This could potentially position Meta as a significant AI ASIC client for AVGO.

Certainly, there is an inherent risk for AVGO due to its dependence on Google, which creates a concentration risk. Nonetheless, we are not overly worried, given the lack of apparent alternatives available to Google. This scenario illustrates AVGO’s robust competitive edge, and it explains why Google initially opted to collaborate with AVGO. The second risk lies in the highly dynamic nature of the AI market, which is susceptible to unforeseen developments. For instance, if Nvidia continues its current momentum and increases its competitive advantage, potential customers requiring AI ASICs might prefer to work with Nvidia instead.

Financial & Valuation

Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.

We’re pleased to note the steady growth trajectory AVGO is maintaining. Over the past three fiscal years, AVGO’s revenue grew at a compound annual growth rate (CAGR) of 13.7% and sell-side consensus predicts a continuation of this trend, with revenues expected to grow by 7.8% this fiscal year to $35.8 billion, and by 6.6% next fiscal year to $38.2 billion. It’s also heartening to see AVGO’s EBIT margin growing by 8.3% points over the past three fiscal years, to 61.1%, with consensus forecasting further expansion to 61.8% this fiscal year.

In terms of financial management, AVGO’s practices have been effective and investor-friendly. The company has been careful with its revenue, spending just 6.2% of it on share-based compensation (SBC) over the past three years. Though the diluted outstanding common shares did increase by 4.1% in the same period, EPS grew at an impressive CAGR of 20.9% over the past three fiscal years, significantly outpacing its revenue growth. The consensus forecasts EPS to rise further to $42.00 this fiscal year and $45.32 the following fiscal year.

Focusing on free cash flow (FCF), the company has been making tremendous strides. It’s projected to reach $18,245 million this fiscal year, marking a robust 51.0% FCF margin, a significant improvement from 41.0% four years ago. Over the past four fiscal years, AVGO maintained an average FCF margin of 47.2% while its capex, as a percentage of revenue, averaged a moderate 1.7%, attesting to its efficient business operations.

AVGO’s strong return on invested capital at 18.1%, coupled with a manageable net debt of $27.8 billion, demonstrates its financial stability. The company’s dividend yield of 2.3% is another attraction, comfortably exceeding the S&P 500’s yield by 76 basis points.

At its current share price of $812.00, AVGO’s market value stands at $338.5 billion and enterprise value at $366.3 billion. Despite trading at 12% below its 52-week high and at an EV/Sales premium of 329.2% relative to the S&P 500, AVGO’s outperformance of the S&P 500 by 41% points last year and its low short interest of 1.6% suggest sustained investor confidence.

Despite its excellent performance, AVGO offers a P/E premium of just 5.0% and an FCF discount of 16.4% when compared to the S&P 500. Furthermore, AVGO’s FY2 PEG ratio stands at 1.3, a noticeable discount of 19.9% compared to the S&P 500’s PEG ratio of 1.6.

From a historical valuation perspective, AVGO is trading at a forward 12-month P/E of 18.5, which is significantly higher than its 5-year mean of 13.5 and slightly above its 2-standard deviation range of 8.8 to 18.2. This implies that AVGO’s current valuation is historically high relative to its 5-year range, which could signal caution for some investors. However, we believe the company has been materially undervalued in the past and thus do not believe its historical valuation should serve as an anchor.

When compared to its industry peers, AVGO’s valuation appears more balanced. With AMD and MRVL trading at a forward 12-month P/E of 35.0 and 33.4, respectively, AVGO’s P/E ratio of 18.5 is substantially lower, while it is only slightly higher compared to ADI’s P/E of 17.5. This suggests that, relative to its competitors, AVGO is attractively valued.

Conclusion

AVGO is well-placed to exploit the burgeoning opportunities in the AI landscape. Its robust financial performance, consistent growth, and strategic partnership with Google set a firm foundation for AVGO’s future endeavors. The company’s noteworthy role in the AI semiconductor market and its competitive advantage in terms of AI ASICs production align it for potential market leadership.

While the dependency on Google does pose a concentration risk, the strength of AVGO’s offering and Google’s lack of clear alternatives significantly offset this concern. Additionally, the dynamic nature of the AI market opens the door for potential shifts in customer preferences, and while Nvidia’s rise is noteworthy, AVGO remains a solid contender in the space.

The underappreciation of AVGO in the AI landscape, combined with its undervaluation, makes it a compelling opportunity for investors seeking to tap into the growth of AI technology. Given these factors, we firmly believe that AVGO, while currently standing in Nvidia’s shadow, could soon emerge as a dominant force in the AI semiconductor market.