Image Source: Broadcom Inc – IR Presentation
By Callum Turcan
Broadcom (AVGO) posted third quarter earnings for its fiscal 2019 on September 12. The semiconductor and enterprise software giant reported GAAP revenues of $5.5 billion (up 9% year-over-year) and non-GAAP diluted EPS of $5.16 (up 4% year-over-year). The initial reaction from Wall Street was pessimistic on September 13 but shares of AVGO climbed later in the trading session to recover some of those initial losses.
Reiterating FY2019 Outlook, FY2020 Outlook Uncertain
Right off the bat, one thing we think is very important is that Broadcom reaffirmed revenue guidance for FY2019 calling for $22.5 billion in net sales ($17.5 billion from semiconductor solutions and $5.0 billion from infrastructure software sales). However, please note that Broadcom’s revenue is expected to decline in FY2019 versus FY2018 levels on a pro forma basis, a point obfuscated by Broadcom’s purchase of CA Technologies that closed at the start of FY2019. Here’s what we said June 14 (additionally, please note Broadcom cut its guidance for expected FY2019 revenue several months ago):
Fast forward to the fiscal second quarter FY2019 (ended May 5, 2019), however, and things start to look a lot less rosy. Before getting into the guidance cut for FY2019, note that Broadcom generated $20.8 billion in GAAP revenue in FY2018 with an adjusted non-GAAP operating margin of 50.0%. After its latest earnings report, management now sees Broadcom’s FY2019 sales coming in at $22.5 billion, down $2.0 billion from its previous forecast.
However, note that the firm’s $18.9 billion all-cash purchase of CA Technologies closed during the first day of FY2019. At the time of closing, management stated in the press release:
“The transaction is expected to drive Broadcom’s long-term Adjusted EBITDA margins above 55% and be immediately accretive to Broadcom’s non-GAAP EPS. On a combined basis, Broadcom expects to have last twelve months non-GAAP revenues of approximately $23.9 billion and last twelve months non-GAAP Adjusted EBITDA of approximately $11.6 billion.”
Using that as a baseline for FY2018, Broadcom’s adjusted revenue is actually expected to decline in FY2019.
Broadcom wants to communicate that the business is stabilizing, but things aren’t going to get significantly better… yet. Initially, Broadcom was targeting $19.5 billion in semiconductor sales in FY2019, but trade wars and other exogenous shocks got in the way. Management, led by its larger than life CEO Hock Tan, has sought to offset these headwinds by moving into the software space. Part of that strategy involves Broadcom buying Symantec’s (SYMC) enterprise security business for $10.7 billion in cash, building on its $18.9 billion all-cash purchase of CA Technologies (which substantially grew Broadcom’s presence in the infrastructure software space). The Symantec deal was announced August 8, and is expected to close by Broadcom’s first quarter FY2020 subject to regulatory approvals.
As part of this strategy, Broadcom intends on using “excess” free cash flow after covering dividends to retire debt and improve its financial standing, instead of allocating large sums towards share buybacks. This is all about preserving its investment grade credit ratings. Broadcom had $5.5 billion in cash and cash equivalents on hand at the end of August 4, versus roughly $3.5 billion in short-term debt and $34.0 billion in long-term debt. While we think its free cash flows and decent cash position make its $32.1 billion net debt load manageable, Broadcom acknowledges the need to focus on debt reduction which we appreciate (in-between acquisitions, given the firm is a serial acquirer).
During the third quarter of FY2019, Broadcom generated $2.4 billion in net operating cash flow while spending $0.1 billion on capital expenditures, allowing for $2.3 billion in free cash flow that covered $1.1 billion in dividends, $1.0 billion in total share repurchases (through its repurchase program and for tax withholding purposes), and $0.2 billion in reductions in “other borrowings” highlighting the strength of Broadcom’s cash flow profile. Soon, Broadcom should be allocating greater amounts of its excess free cash flows towards delivering activities instead of share buybacks as mentioned previously. Here’s what Broadcom’s management team had to say during the company’s third quarter FY2019 conference call (emphasis added):
“Now let me address the current environment and outlook. Enterprise and mainframe software customer demand continues to remain stable, particularly in North America and Western Europe. SAN switching demand will likely continue to be down another quarter, while inventory in the OEM channels have been worked down. As it relates to semiconductors, although the US-China trade conflict continues, we have not seen further deterioration in our business, both specific to China as well as globally. Accordingly, we continue to expect to achieve over $22.5 billion of revenue in fiscal 2019, including $17.5 billion from semiconductor solutions and $5 billion from infrastructure software.
Looking into next year. Infrastructure software is stable as renewals among our core customer base continue to be very solid. However, visibility continues to be very limited on the semiconductor side. So we are managing the business with an expectation that we will continue to operate in a very low growth uncertain macro environment for the foreseeable future.
Fortunately, the fundamentals of our semiconductor business remain strong. As you know, our business is all about connectivity from CPUs to memory in data centers, core to edge in networks, central office to client devices in distributed systems, and here we continue to benefit from the underlying trend in the IT world and insatiable need for increasing bandwidth to connect things.”
Major investments in infrastructure software better allows for Broadcom to maintain its free cash flow profile in the face of weakness at its traditional semiconductor segment. It doesn’t look like the semiconductor space has turned a corner, but Broadcom reiterated that it’s optimistic long-term trends (Internet of Things, 5G, autonomous driving, greater need for data centers, etc.) will eventually revive growth in semiconductor demand.
Check out Broadcom’s 16-page Stock Report here —->>>>
Cree Battering Down the Hatches
Cree Inc (CREE) is an innovator of LED components, and semiconductor products for power and radio frequency applications. The company operates two segments: ‘Wolfspeed’ (silicon carbide and gallium nitride materials) and ‘LED Products.’ In May 2019, Cree completed the sale of its Lighting Products business unit which raised $225 million from an initial cash payment and management is targeting an additional $85 million via earn-out payments. We recently updated our valuation model for Cree, and we assign the company a fair value estimate of $50/share, and would like to note that shares of CREE could move to the upper end of our fair value estimate range ($35/share – $65/share) if the US-China trade war pans out more favorably than previously expected.
Check out Cree’s 16-page Stock Report here—->>>>
We noticed Cree’s fundamentals improved significantly during its fourth quarter FY2019 earnings report, released August 20, and we think that FY2020 turbulence aside, its free cash flow outlook looks bright. Cree’s management stated that:
“While the Huawei ban and softness in the LED market will continue to impact the sector in the short-term, our long-term outlook remains unchanged – there is a significant opportunity to help customers make the shift from silicon to silicon carbide solutions for their next generation applications.”
The optimism in Cree’s medium- and long-term outlook was reflected in Broadcom’s conference call as well. Before getting into that, please note Huawei represented a modest portion of Broadcom’s FY2018 revenue (just over 4%). That’s enough to create short-term headwinds, but not enough to stymie Broadcom’s growth trajectory as the secular trends create powerful tailwinds the company has historically done a good job at capitalizing on. Cree is also taking a hit from not being able to do business with Huawei, but has found ways to keep pushing forward.
One thing Cree and Broadcom both have in common is their newfound-focus on debt reduction. By the end of FY2019 (ended June 30), Cree removed the $0.3 billion long-term debt position from its balance sheet (as of the end of FY2018) in return for $0.5 billion in convertible notes (as of the end of FY2019) and grew its cash, cash equivalents, and short-term investment holdings from $0.4 billion (as of the end of FY2018) to $1.1 billion (as of the end of FY2019). This was made possible through positive free cash flows, divestment proceeds and by tapping capital markets to change its capital structure (a combination of common stock and convertible note issuances allowing Cree to both retire debt and bulk up its cash position).
However, we caution that Cree has been engaging in corporate maneuvers that appear defensive in nature, the kind that a company would pursue if they were worried about the future. We think Cree is more worried about short-term exogenous threats than anything else. Here’s what Cree’s management team had to say during its latest quarterly conference call (emphasis added):
“Turning to the outlook for the first quarter of 2020, we are targeting revenue in a range of $237 million to $243 million based on the following segment trends. Wolfspeed revenue is expected to be down slightly; approximately 5% to 7% due to the full quarter impact of the Huawei ban and software selling conditions in China, as it appears the Chinese government’s reduction and incentives is impacting electric vehicle sales. Regarding Huawei, we are not shipping product at this time, and we will continue to comply with US Federal Law. We have applied for licenses from the government to potentially resume certain shipments to our customer but have not yet received a response.
LED revenue is expected to be down approximately 2% to 4% sequentially due to continued market softness and tariff concerns that Gregg discussed earlier. We target Q1 non-GAAP gross margins from continuing operations at approximately 30.8% based on the following segment trends. Wolfspeed gross margin is targeted at approximately 46.3%, down from 50.2%. As a result of product mix shifts resulting from the Huawei ban. LED margin is targeted at approximately 17.5%, down from Q4, primarily driven by lower factory utilization and lower sales volume.
We are proactively managing the situation and taking a more conservative approach by lowering our factory utilization as well as lowering our inventory levels both internally and in the channel. We believe this will better align us with current market conditions.”
Cree is worried about the future and is planning accordingly by lowering factory utilization and working down inventory levels. That’s on top of strengthening its balance sheet and selling off non-core assets late in the broader business cycle. Broadcom is taking a different approach, utilizing its free cash flows to move aggressively into new markets, but both firms are aware that strengthening the balance sheet is needed when facing major exogenous headwinds.
Concluding Thoughts
We don’t include many semiconductors in our portfolios given how notoriously difficult the space is to play. As things stand today, Intel (INTC) is included in both our Dividend Growth Newsletter and Best Ideas Newsletter portfolios, and we continue to like INTC as our way to gain exposure to secular growth trends within the semiconductor space (at an attractive price, shares of Intel trade just above our fair value estimate as of this writing but well below the upper end of our fair value estimate range). While the free cash flow outlooks for AVGO and CREE are relatively strong, weakening business confidence and investment around the world and mounting geopolitical tensions between the US and China (short-term tariff reprieves aside) create monstrous headwinds that the semiconductor industry can only do so much to mitigate.
Broad Line Semiconductor Industry – AMD AVGO FSLR INTC TXN
Integrated Circuits Industry – ADI MCHP MRVL NVDA SWKS TSM XLNX
Software Security Industry – CHKP FEYE IMPV PANW PFPT SYMC VRSN
Related: SMH, QQQ
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Callum Turcan does not own shares in any of the securities mentioned above. Intel Corporation (INTC) is included in both Valuentum’s simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.