Month: September 2024

Broadcom Fiscal Q3: AI Revenue Outlook Raised, but Valuation is Stretched

Posted on by io-fund

Broadcom boosted AI revenue outlook for the year from $11 billion to $12 billion. Based on the forecasted $51.5 billion in revenue in fiscal 2024, AI is expected to contribute more than 23% of Broadcom’s revenue this year.

During the CEO’s opening remarks, more information about Q3’s AI revenue and Q4’s AI revenue was provided: “AI demand remains strong and we expect, in Q4, AI revenue to grow sequentially 10% to over $3.5 billion. This will translate to AI revenue of $12 billion for fiscal '24, up from our prior guidance of over $11 billion.” The issue is that AI revenue was flat QoQ compared to being up 35% QoQ last quarter.

Overall, Q3 did beat yet Q4’s guide was a bit light, with Broadcom forecasting revenue of $14 billion next quarter versus consensus for $14.04 billion. Semiconductor solutions revenue growth also missed growth forecasts with YoY growth of 5%, while estimates from Oppenheimer expected 7% growth.

The stock is priced to perfection, and we do not think this earnings report is not enough to sustain the valuation. We discuss this and more below.

Revenue

Broadcom beat Q3’s revenue estimates marginally and was one percent ahead of consensus estimates, compared to a nearly 4% beat last quarter. Q4 was also guided slightly below analyst estimates. 

  • Q3 revenue was $13.07 billion for YoY growth of 47.3%, accelerating 430 bp from 43% YoY growth in Q2. Excluding VMWare’s contribution, YoY growth was 4%.
  • For Q4, management guided for $14 billion in revenue, for YoY growth of 50.6%, marking another 330 bp acceleration, but short of the 51% growth estimate from analysts.
  • For FY24, management did not provide an updated revenue guide, with the previous guidance provided of $51 billion. However, given Q4’s guide, revenue for FY24 is projected to be $51.5 billion.

As probably the most-closely watched (and most anticipated) figure, AI revenue for FQ3 was $3.1 billion, flat QoQ. Through Q3, AI revenue totaled $8.5 billion. For fiscal 2024, Broadcom increased its AI revenue outlook to $12 billion, a 20% increase from $10 billion in Q1 and another $1 billion increase from last quarter’s view for $11 billion. The increased outlook is driven by strong growth for Ethernet and ASICs, and implies Q4 AI revenue of $3.5 billion, up nearly 13% QoQ.

The issue that remains is, will this AI revenue be enough to justify the valuation (in the near term)?

Key Segments

Semiconductor solutions revenue was $7.27 billion, increasing 5% YoY and 1% QoQ. This was a 100 bp deceleration from 6% YoY growth last quarter, while also falling short of estimates, with some analysts expecting growth of ~7% YoY and 2% QoQ.

  • Networking grew 43% YoY to $4 billion. Ethernet switching, driven by Tomahawk 5 and Jericho3-AI grew over 4x year-on-year. We’ve covered these products here. Within networking, lasers and dies used in optical interconnects grew 3X, PCI Express switches grew 2X and Broadcom is shipping 5nm 400GB NICs and 800GB DSPs.
  • The CEO stated non-AI networking bottomed in Q2 and was up 17% QoQ yet down (-41%) YoY
  • The CEO stated custom AI accelerators grew 3.5X year-over-year. Notably, we did not get a QoQ number which is where the weak metric was at $3.1B AI revenue flat QoQ.

Infrastructure solutions revenue was $5.80 billion, accelerating to 200% YoY growth from 175% YoY in the prior quarter. The segment was up 9.7% QoQ and this segment also grew QoQ last quarter, which helps to illustrate the acceleration from VMWare.

  • VMWare contributed $3.8 billion with the acquisition helping to drive the strong YoY growth.
  • VMWare’s annualized booking value (ABV) was up 32% QoQ to $2.5 billion, and is shaping up to be a major piece to Broadcom’s story. You can read more about this here. Two quarters ago, the ABV for VMWare was $1.2 billion, proving there has been a sudden acceleration underway. The VMWare segment is expected to be quite profitable, achieving adjusted EBITDA of $8.5 billion by next fiscal year. During the Q&A portion, it was discussed the overall software margin will remain between 80% and 90%.

Aligned with the commentary that the non-AI segments have bottomed (with the exception of Broadband), the remaining revenue segments reported QoQ growth despite being down double digits YoY.

  • Server storage connectivity revenue was $861 million, up 5% QoQ yet down (-25%) YoY. Server storage is expected to grow QoQ yet will be down YoY
  • Wireless revenue of $1.7 billion grew 1% YoY and is expected to grow 20% QoQ next quarter.
  • Broadband revenue declined 49% YoY and is expected to bottom in the beginning of 2025.

On the call, an analyst asked if these segments will return to prior levels, to which the CEO stated they would and he cited bookings as an indication the bottom is likely behind them.

Hock Tan:

“As you all know, we've gone through your typical down cycle of semiconductors. And I'm referring particularly to non-AI, and we have talked about that before many times. We've gone through a down cycle as the ecosystem, as many of our customers, but the broad ecosystems, work on an adjustment in inventory levels in all stages in the supply chain. And we're not immune from it, obviously as we try to insulate ourselves from it as much as possible. We've gone through it. And the signs on the indications we have seen very clearly is we have, in fact, passed through the bottom. The best indicator is the bookings we are receiving. In non-AI, our bookings in Q3 of non-AI semiconductor demand is up 20%. And so that tells us we are well on the way to recovery.”

Margins

As outlined in our pre-earnings analysis, the VMWare merger integration has weighed on margins so far in fiscal 2024, though Q3 showed more positive signs on margin recoveries. Adjusted margins strengthened sequentially across the board, with larger growth visible down the line.

  • Gross margin was 63.9% in Q3, down from 69.5% in the year ago quarter but up from 62.3% in Q2. Adjusted gross margin was 77.4%, up from 75.1% last year and 76.2% last quarter.
  • Operating margin was 29.0% in Q3, up from 23.7% last quarter and a remarkable increase from 17.3% in Q1; however, Q3’s margin remained much lower on a YoY basis, down from 43.4% last year. Adjusted operating margin was 60.8%, up from 57.2% last quarter but decreasing from 62.4% last year.
  • Net margin was (14.4%) for Q3, due to a one-time non-cash tax provision of $4.5 billion in the quarter. Adjusted net margin was 46.8%, up from 43.2% last quarter but down from 51.8% last year.

Regarding the tax liability, there was a question in the Q&A session if it was related to selling assets, to which the CFO responded that it was not due to a sale of assets, rather: “It's just we relocated the IP and that caused the $4 billion charge. The offset to that is a deferred tax liability. So think of that as noncash, very little cash impact to that.”

EPS

GAAP EPS was ($0.40), not comparable to estimates for $0.55 due to the $4.5 billion tax provision in the quarter. Adjusted EPS was $1.24, beating estimates by $0.04, and representing YoY growth of 18% and QoQ growth of nearly 13%.

Adjusted EPS growth is currently estimated to accelerate to nearly 24% YoY in Q4, and to the low-30% range for the first half of fiscal 2025. Given the sequential rebound in margins (partially due to better controlled costs at VMWare) and adjusted EPS beat in Q3, these growth projects may get revised higher in the coming days.

Q3’s adjusted EBITDA was 62.9%, with growth of 42% YoY to $8.22 billion. This was a solid improvement from 59.5% in Q2. Management guided for a 64% adjusted EBITDA margin in Q4, with the sequential improvement being driven by the integration of VMWare as Broadcom charts a path to pre-acquisition EBITDA margins.

Cash Flows and Balance Sheet

Cash flows and cash flow margins improved sequentially, while total debt took a step lower this quarter.

  • Operating cash flow was $4.96 billion, increasing more than 5% YoY and 8% QoQ. Operating cash flow margin as 38.0%, improving from 36.7% last quarter, though this is lower than pre-acquisition margins of 53.2% in the year ago quarter.
  • Free cash flow was $4.79 billion, rising more than 4% YoY and nearly 8% QoQ. Free cash flow margin was 36.7%, increasing from 35.6% last quarter but also lower than the 51.8% margin in the year ago quarter.
  • Cash, equivalents and investments totaled $9.95 billion.
  • Total debt was $69.96 billion at the end of Q3, down from $74.02 billion in Q2, with Broadcom repaying more than $9.2 billion of debt in the quarter, offset by nearly $5 billion in proceeds from long-term borrowings.

Valuation:

Broadcom is priced for perfection at 32 forward PE Ratio and 14 forward PS Ratio. We’ve covered semis since 2018 and a quality semiconductor stock rarely trades at these levels, it’s normally in the 6-8 forward PS range.

The 3-year median is only available on current PE Ratio, but I have a 3-year PE ratio of 28.5 compared to the current PE ratio of 65.8. The 5-year median is at 39.5.

Earnings Call:

Analysts asked in various ways what growth rate they could expect on AI revenue moving forward, but to no avail on any specific numbers. Here was the first question on the call:

Question
Vivek Arya (Analysts)

Just a clarification, Hock, and then the question. So I think AI revenue roughly $3.1-ish billion in Q3, flattish sequentially. What was the mix in terms of compute versus networking? And the $3.5 billion for Q4, what do you see of that mix? And then as we get into fiscal '25, I realize you're not guiding overall AI, but just how is your general kind of confidence and visibility? Do you think that Broadcom can kind of grow in line or better than the overall AI silicon industry in fiscal '25?

Answer
Kirsten Spears (Executives)

Yes. Well, as we indicated in the last earnings call, for this past quarter, I think we're talking about 2/3 in compute and 1/3 in networking. And we kind of expect Q4 to run the similar trend. And to answer your second part, no, we don't guide yet for fiscal '25, but we do expect fiscal '25 to continue to be strong, to show strong growth on our AI revenue.

-End Quote

There was a more tempered tone in terms of timing. For example, when asked where custom silicon is in the adoption curve, it was stated it will take some time.

Question
Edward Snyder (Analysts)

Right. That basically suggests that you're on the early part of your curve where I'm not trying to call the GPUs whatever, but you could be getting to something closer to the peak of the GPU market just because everything, right, beside the cost expense and as you're spending all this money and you're paying all this money for power, the ASICs become more and more attractive. So the curves are going to look different, right?

Answer
Hock Tan (Executives)

It's an accelerating curve. It may take longer than we all want it to happen but definitely accelerating because the size of the demand from those hyperscalers will totally rival that in the enterprise.

-End Quote

Conclusion:

Given AI growth has plateaued this quarter from its rapid growth, there will likely be a re-rating of Broadcom’s valuation sometime in the next 1-2 quarters. Our goal is to trim this position and buy back at lower levels. This strategy requires remaining steadfast to the bigger picture as this company is setting up to be a clear winner over the next decade. We want to do our best at actively managing the position while not losing sight of the bigger picture. With that said, valuation is a common pitfall for tech investors, who grow complacent with their positions. Our firm works to avoid valuation traps, and thus we plan to follow our disciplined process, which is to actively manage stocks that are richly valued.  

Damien Robbins, I/O Fund Equity Analyst, contributed to this analysis

Recommended Reading:

Broadcom’s AI Revenue Surge Continues: FQ3 Earnings Preview

Posted on by io-fund

Broadcom will release its Q3 FY2024 results after market close today. Investors will be closely watching the AI revenue updates for the ASIC market leader. Broadcom has the potential to grab the attention after Nvidia due to the company’s unique position in the AI Infrastructure space. Recently Citi Analyst also highlighted that the company is catching up on Nvidia as the top holding as it adds more AI customers and accretion from VMware. In addition, it could benefit from investor fatigue with Nvidia, which aligns with our thoughts that we have highlighted here.

The main highlight in the last earnings call was the AI revenue FY2024 guide increase from over $10 billion to over $11 billion. The company beat the top-line and bottom-line estimates and also raised the full-year revenue guidance to $51 billion from the earlier $50 billion. Analysts believe the guide was conservative due to the company ramping up new ASIC customers, the potential bottoming of non-AI networking markets, and VMware integration progressing well. The company also raised the FY2024 adjusted EBITDA guide from 60% to 61%, which is positive as margin recovery post-VMware integration is also important for the stock momentum to grind higher.

Revenue

  • FQ2 revenue grew by 43% YoY to $12.49 billion, up from 34.2% growth in FQ1. Next quarter, revenue is going to accelerate to 46% YoY growth to $12.96 billion and further accelerate to 51% growth in FQ4.
  • FQ2 was the first full quarter with a contribution from VMware, and organically, it grew by 12%. Revenue beat estimates by 4.0% and was primarily helped by the strong 280% YoY growth in AI revenue of $3.1 billion, offset by cyclical weakness in enterprises and telcos. Management hinted that non-AI semiconductor revenue had bottomed out in Q2 and was likely to have a modest recovery in the second half of the year.
  • Management increased the FY2024 revenue guide from $50 billion to $51 billion Analysts expect FY2024 revenue to grow 43.8% YoY to $51.51 billion, organic growth is about 10%.
  • Analysts expect FY2025 revenue to grow 16.8% YoY to $60.15 billion and FY2026 revenue to grow 11.6% to $67.13 billion.

Ji Yoo, Head of Investor Relations, said in the earnings call, “For fiscal '24, we expect revenue from AI to be much stronger at over $11 billion. Non-AI semiconductor revenue has bottomed in Q2 and is likely to recover modestly for the second half of fiscal '24.

On infrastructure software, we're making very strong progress in integrating VMware and accelerating its growth. Pulling all these three key factors together, we are raising our fiscal '24 revenue guidance to $51 billion.”

Margins

The merger integration process will initially drag the margins in FY2024 due to transition costs and VMware’s lower margin profile. However, cost cutting and merger synergies are anticipated to improve margins in the long term.

  • The FQ2 gross margin was 62.3%, down from 70% in the same period last year and up from 61.7% in the previous quarter. Adjusted gross margin was 76.2%, down from 75.6% last year and up from 75.4% in the previous quarter.
  • Operating margin was 23.7%, down from 45.9% last year and up from 17.4% in the previous quarter. The operating margin was mainly lower from last year due to the increase in amortization of acquisition-related intangible assets, restructuring charges, and stock-based compensation.
  • The adjusted operating margin was 57.2%, down from 62% last year and up marginally from 57.1% in the previous quarter. Excluding transition costs, the adjusted operating margin was 59% and remained the same as in the previous quarter.
  • Net income was $2.1 billion or 17% of revenue compared to $3.48 billion or 39.9% of revenue in the same period last year. The lower net income was mainly due to the points discussed in the above paragraphs and higher interest expenses this year. The adjusted net income was $5.39 billion or 43.2% of revenue compared to $4.49 billion or 51.4% of revenue last year.

EPS

GAAP EPS was $0.44 compared to $0.82 in the same period last year. The adjusted EPS grew by 6.2% YoY to $1.096 and beat estimates by 1.1%, helped by cost savings. The company has been able to reduce VMware spending to $1.6 billion from the previous $2.3 billion pre-acquisition. Management expects to exit Q4 with a spending of $1.3 billion run rate, better than the previous plan of $1.4 billion. It is further expected to stabilize at $1.2 billion post-integration.

  • Analysts expect adjusted EPS to accelerate to 14.3% YoY growth to $1.20 in FQ3 and to 23.7% YoY growth to $1.37 in FQ4.
  • Analysts expect FY2024 adjusted EPS to grow 12.4% YoY to $4.75 and accelerate to 27.7% growth to $6.06 in FY2025.

FQ2 adjusted EBITDA was 59.5%, compared to 65.1% in the same period last year and 59.8% in the previous quarter. The drop is mainly due to VMware's lower margin. The post-integration is progressing well, and management also raised the FY2024 adjusted EBITDA guide from 60% to 61%. They also expect VMware's adjusted operating margin to match Broadcom’s software margin by FY2025.

Cash Flow and Balance Sheet

The company has high debt as it has been growing through successful acquisitions. While high debt is a concern, the company is focusing on repaying medium-term debt and has strong cash flows. Also, the company’s debt prior to the VMware acquisition has long maturities.

  • Operating cash flow was $4.58 billion or 36.7% of revenue compared to $4.5 billion or 51.6% of revenue in the same period last year and 40.3% in the previous quarter.
  • Free cash flow was $4.45 billion or 35.6% of revenue compared to $4.38 billion or 50.2% of revenue last year and 39.2% in the previous quarter. Free cash flow excluding cash used for restructuring and integration was $5.3 billion or 42% of revenue. Free cash flow as a percentage of revenue declined from last year due to higher interest expenses related to debt for VMware acquisition and “higher cash taxes due to a higher mix of US income and the delay in the reenactment of Section 174.”
  • Cash was $9.81 billion and debt of $74.02 billion compared to $11.9 billion and $75.9 billion in the previous quarter. The weighted average coupon rate and term to maturity of $48 billion fixed rate debt is 3.5% and 8.2 years, respectively. The weighted average coupon rate and term to maturity of floating rate debt are 6.6% and 2.8 years, respectively. The company repaid $2 billion of floating rate debt in FQ2 and plans to maintain this quarterly repayment throughout FY2024.
  • The company paid $2.4 billion in dividends and $1.5 billion in withholding taxes due to the vesting of employee equity, eliminating 1.2 million shares.
  • Inventory was $1.84 billion compared to $1.92 billion in the previous quarter.
  • The company’s shares started trading on a 10-for-1 stock split basis on July 15, 2024 and also filed a mixed shelf offering on July 08.

Segments

Infrastructure Software

Infrastructure Software revenue grew by 175% YoY to $5.29 billion, primarily due to the contribution of VMware, accelerating from 153% growth in the previous quarter. Organically it grew by 35% YoY. The segment’s adjusted gross margins were 88% compared to 92% in the same period last year. The adjusted operating margin was 60% and excluding transition costs was 64% compared to 73% in the same period last year. The drop in margins was primarily due to VMware’s lower margin profile.

Management provided a key update on VMware in FQ2. “VMware revenue in Q1 was $2.1 billion, grew to $2.7 billion in Q2 and will accelerate towards a $4 billion per quarter run rate. We therefore expect operating margins for VMware to begin to converge towards that of classic Broadcom software by fiscal 2025.”

To illustrate VMware’s successful integration, management highlighted the streamlining of product SKUs from over 8,000 disparate SKUs to 4 core product offerings, thereby eliminating massive channel conflicts.

The company is also transitioning all VMware products to a subscription licensing model. “We are making good progress in transitioning all VMware products to a subscription licensing model. And since closing the deal, we have actually signed up close to 3,000 of our largest 10,000 customers to enable them to build a self-service virtual private cloud on-prem. Each of these customers typically sign up to a multiyear contract, which we normalize into an annual measure known as annualized booking value or ABV. This metric, ABV, for VMware products accelerated from $1.2 billion in Q1 to $1.9 billion in Q2. For a reference, for the consolidated Broadcom software portfolio, ABV grew from $1.9 billion in Q1 to $2.8 billion over the same period in Q2.”

Semiconductor Solutions

Semiconductor Solutions revenue grew by 6% YoY to $7.20 billion, accelerating from 4% in the previous quarter. The segment’s adjusted gross margins were 67%, down 370 basis points YoY, primarily due to a higher mix of custom AI accelerators. The adjusted operating margin was 55% compared to 59% in the same period last year. According to Oppenheimer, Semiconductor revenue is expected to grow 7% YoY and 2% sequentially in FQ3.

  • Networking revenue grew by 44% YoY to $3.8 billion, representing 53% of semiconductor revenue, led by strong demand from hyperscalers for AI networking and custom accelerators. According to Oppenheimer, Networking revenue is expected to grow 43% YoY and 5% QoQ in FQ3.
  • The company doubled the number of switches sold YoY, particularly the PAM-5 and Jericho3. It also benefits from the rapid transition of optical interconnects in AI data centers to 800 gigabit bandwidth.  

CEO Hock Tan said in the earnings call. “Next year, we expect all mega-scale GPU deployments to be on Ethernet. We expect the strength in AI to continue, and because of that, we now expect networking revenue to grow 40% year-on-year compared to our prior guidance of over 35% growth.”

  • Server storage revenue declined by (-27%) YoY to $824 million. Management believes Q2 was the bottom in server storage and expects a modest recovery in the second half of the year. They expect server storage revenue to decline around 20% YoY range for FY2024 from the earlier mid-20 percentage range.
  • Broadband revenue declined by (-39%) YoY to $730 million due to the continued slowdown in telco spending. Management expects Broadband to bottom in the second half of the year with a recovery in 2025. They expect Broadband to decline to a high 30s percentage from the prior guide of just over 30% YoY decline.
  • Wireless revenue grew 2% YoY and down seasonally (-19%) sequentially to $1.6 billion. Management reiterated the previous guidance of flat YoY wireless revenue for FY2024.
  • Industrial resale revenue declined by (-10%) YoY to $234 million. They expect to be down double-digit YoY from the prior guide of high single-digit decline.

AI Revenue

AI revenue grew by 280% YoY and 35% sequentially to $3.1 billion. Management has increased the FY2024 revenue guide from over $10 billion to over $11 billion. J.P. Morgan analyst Harlan Sur is bullish on the AI opportunity and estimates about $12 billion in AI revenue this year and more than $16 billion next year. He also highlighted that Broadcom has recently won OpenAI’s first and second generation AI ASIC orders, making OpenAI the fourth major AI ASIC customer for the company.

The company highlighted their expertise in Ethernet and the opportunity, as they expect all mega GPU deployments to be on Ethernet. “Talking of AI accelerators, you may know our hyperscale customers are accelerating their investments to scale up the performance of these clusters. And to that end, we have just been awarded the next generation custom AI accelerators for these hyperscale customers of ours. Networking these AI accelerators is very challenging, but the technology does exist today. In Broadcom, with the deepest and broadest understanding of what it takes for complex, large workloads to be scaled out in an AI fabric. Proof in point, seven of the largest eight AI clusters in deployment today use Broadcom Ethernet solutions.”

Valuation

The company trades at a P/E ratio of 65.8 and a forward P/E ratio of 32.2, higher than the 5-year average of 41.1. Similarly, it trades at a P/S ratio of 16.1 and a forward P/S ratio of 13.8, higher than the average of 8.6. Valuation is a concern for all semiconductor stocks. At the same time, the market is rewarding the company with a premium valuation due to its transition from a value stock to an AI growth stock.

Conclusion

Strong AI growth, merger synergies, and the Ethernet opportunity make Broadcom a leading AI juggernaut second only to Nvidia. We will look toward the report to confirm our understanding that the fundamentals are on track due to ASICs growth, the acceleration in the VMWare software opportunity and networking. 

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

Recommended Readings:

Broadcom’s AI Revenue Surge Continues: FQ3 Earnings Preview

Posted on by io-fund

Broadcom will release its Q3 FY2024 results after market close today. Investors will be closely watching the AI revenue updates for the ASIC market leader. Broadcom has the potential to grab the attention after Nvidia due to the company’s unique position in the AI Infrastructure space. Recently Citi Analyst also highlighted that the company is catching up on Nvidia as the top holding as it adds more AI customers and accretion from VMware. In addition, it could benefit from investor fatigue with Nvidia, which aligns with our thoughts that we have highlighted here.

The main highlight in the last earnings call was the AI revenue FY2024 guide increase from over $10 billion to over $11 billion. The company beat the top-line and bottom-line estimates and also raised the full-year revenue guidance to $51 billion from the earlier $50 billion. Analysts believe the guide was conservative due to the company ramping up new ASIC customers, the potential bottoming of non-AI networking markets, and VMware integration progressing well. The company also raised the FY2024 adjusted EBITDA guide from 60% to 61%, which is positive as margin recovery post-VMware integration is also important for the stock momentum to grind higher.

Revenue

  • FQ2 revenue grew by 43% YoY to $12.49 billion, up from 34.2% growth in FQ1. Next quarter, revenue is going to accelerate to 46% YoY growth to $12.96 billion and further accelerate to 51% growth in FQ4.
  • FQ2 was the first full quarter with a contribution from VMware, and organically, it grew by 12%. Revenue beat estimates by 4.0% and was primarily helped by the strong 280% YoY growth in AI revenue of $3.1 billion, offset by cyclical weakness in enterprises and telcos. Management hinted that non-AI semiconductor revenue had bottomed out in Q2 and was likely to have a modest recovery in the second half of the year.
  • Management increased the FY2024 revenue guide from $50 billion to $51 billion Analysts expect FY2024 revenue to grow 43.8% YoY to $51.51 billion, organic growth is about 10%.
  • Analysts expect FY2025 revenue to grow 16.8% YoY to $60.15 billion and FY2026 revenue to grow 11.6% to $67.13 billion.

Ji Yoo, Head of Investor Relations, said in the earnings call, “For fiscal '24, we expect revenue from AI to be much stronger at over $11 billion. Non-AI semiconductor revenue has bottomed in Q2 and is likely to recover modestly for the second half of fiscal '24.

On infrastructure software, we're making very strong progress in integrating VMware and accelerating its growth. Pulling all these three key factors together, we are raising our fiscal '24 revenue guidance to $51 billion.”

Margins

The merger integration process will initially drag the margins in FY2024 due to transition costs and VMware’s lower margin profile. However, cost cutting and merger synergies are anticipated to improve margins in the long term.

  • The FQ2 gross margin was 62.3%, down from 70% in the same period last year and up from 61.7% in the previous quarter. Adjusted gross margin was 76.2%, down from 75.6% last year and up from 75.4% in the previous quarter.
  • Operating margin was 23.7%, down from 45.9% last year and up from 17.4% in the previous quarter. The operating margin was mainly lower from last year due to the increase in amortization of acquisition-related intangible assets, restructuring charges, and stock-based compensation.
  • The adjusted operating margin was 57.2%, down from 62% last year and up marginally from 57.1% in the previous quarter. Excluding transition costs, the adjusted operating margin was 59% and remained the same as in the previous quarter.
  • Net income was $2.1 billion or 17% of revenue compared to $3.48 billion or 39.9% of revenue in the same period last year. The lower net income was mainly due to the points discussed in the above paragraphs and higher interest expenses this year. The adjusted net income was $5.39 billion or 43.2% of revenue compared to $4.49 billion or 51.4% of revenue last year.

EPS

GAAP EPS was $0.44 compared to $0.82 in the same period last year. The adjusted EPS grew by 6.2% YoY to $1.096 and beat estimates by 1.1%, helped by cost savings. The company has been able to reduce VMware spending to $1.6 billion from the previous $2.3 billion pre-acquisition. Management expects to exit Q4 with a spending of $1.3 billion run rate, better than the previous plan of $1.4 billion. It is further expected to stabilize at $1.2 billion post-integration.

  • Analysts expect adjusted EPS to accelerate to 14.3% YoY growth to $1.20 in FQ3 and to 23.7% YoY growth to $1.37 in FQ4.
  • Analysts expect FY2024 adjusted EPS to grow 12.4% YoY to $4.75 and accelerate to 27.7% growth to $6.06 in FY2025.

FQ2 adjusted EBITDA was 59.5%, compared to 65.1% in the same period last year and 59.8% in the previous quarter. The drop is mainly due to VMware's lower margin. The post-integration is progressing well, and management also raised the FY2024 adjusted EBITDA guide from 60% to 61%. They also expect VMware's adjusted operating margin to match Broadcom’s software margin by FY2025.

Cash Flow and Balance Sheet

The company has high debt as it has been growing through successful acquisitions. While high debt is a concern, the company is focusing on repaying medium-term debt and has strong cash flows. Also, the company’s debt prior to the VMware acquisition has long maturities.

  • Operating cash flow was $4.58 billion or 36.7% of revenue compared to $4.5 billion or 51.6% of revenue in the same period last year and 40.3% in the previous quarter.
  • Free cash flow was $4.45 billion or 35.6% of revenue compared to $4.38 billion or 50.2% of revenue last year and 39.2% in the previous quarter. Free cash flow excluding cash used for restructuring and integration was $5.3 billion or 42% of revenue. Free cash flow as a percentage of revenue declined from last year due to higher interest expenses related to debt for VMware acquisition and “higher cash taxes due to a higher mix of US income and the delay in the reenactment of Section 174.”
  • Cash was $9.81 billion and debt of $74.02 billion compared to $11.9 billion and $75.9 billion in the previous quarter. The weighted average coupon rate and term to maturity of $48 billion fixed rate debt is 3.5% and 8.2 years, respectively. The weighted average coupon rate and term to maturity of floating rate debt are 6.6% and 2.8 years, respectively. The company repaid $2 billion of floating rate debt in FQ2 and plans to maintain this quarterly repayment throughout FY2024.
  • The company paid $2.4 billion in dividends and $1.5 billion in withholding taxes due to the vesting of employee equity, eliminating 1.2 million shares.
  • Inventory was $1.84 billion compared to $1.92 billion in the previous quarter.
  • The company’s shares started trading on a 10-for-1 stock split basis on July 15, 2024 and also filed a mixed shelf offering on July 08.

Segments

Infrastructure Software

Infrastructure Software revenue grew by 175% YoY to $5.29 billion, primarily due to the contribution of VMware, accelerating from 153% growth in the previous quarter. Organically it grew by 35% YoY. The segment’s adjusted gross margins were 88% compared to 92% in the same period last year. The adjusted operating margin was 60% and excluding transition costs was 64% compared to 73% in the same period last year. The drop in margins was primarily due to VMware’s lower margin profile.

Management provided a key update on VMware in FQ2. “VMware revenue in Q1 was $2.1 billion, grew to $2.7 billion in Q2 and will accelerate towards a $4 billion per quarter run rate. We therefore expect operating margins for VMware to begin to converge towards that of classic Broadcom software by fiscal 2025.”

To illustrate VMware’s successful integration, management highlighted the streamlining of product SKUs from over 8,000 disparate SKUs to 4 core product offerings, thereby eliminating massive channel conflicts.

The company is also transitioning all VMware products to a subscription licensing model. “We are making good progress in transitioning all VMware products to a subscription licensing model. And since closing the deal, we have actually signed up close to 3,000 of our largest 10,000 customers to enable them to build a self-service virtual private cloud on-prem. Each of these customers typically sign up to a multiyear contract, which we normalize into an annual measure known as annualized booking value or ABV. This metric, ABV, for VMware products accelerated from $1.2 billion in Q1 to $1.9 billion in Q2. For a reference, for the consolidated Broadcom software portfolio, ABV grew from $1.9 billion in Q1 to $2.8 billion over the same period in Q2.”

Semiconductor Solutions

Semiconductor Solutions revenue grew by 6% YoY to $7.20 billion, accelerating from 4% in the previous quarter. The segment’s adjusted gross margins were 67%, down 370 basis points YoY, primarily due to a higher mix of custom AI accelerators. The adjusted operating margin was 55% compared to 59% in the same period last year. According to Oppenheimer, Semiconductor revenue is expected to grow 7% YoY and 2% sequentially in FQ3.

  • Networking revenue grew by 44% YoY to $3.8 billion, representing 53% of semiconductor revenue, led by strong demand from hyperscalers for AI networking and custom accelerators. According to Oppenheimer, Networking revenue is expected to grow 43% YoY and 5% QoQ in FQ3.
  • The company doubled the number of switches sold YoY, particularly the PAM-5 and Jericho3. It also benefits from the rapid transition of optical interconnects in AI data centers to 800 gigabit bandwidth.  

CEO Hock Tan said in the earnings call. “Next year, we expect all mega-scale GPU deployments to be on Ethernet. We expect the strength in AI to continue, and because of that, we now expect networking revenue to grow 40% year-on-year compared to our prior guidance of over 35% growth.”

  • Server storage revenue declined by (-27%) YoY to $824 million. Management believes Q2 was the bottom in server storage and expects a modest recovery in the second half of the year. They expect server storage revenue to decline around 20% YoY range for FY2024 from the earlier mid-20 percentage range.
  • Broadband revenue declined by (-39%) YoY to $730 million due to the continued slowdown in telco spending. Management expects Broadband to bottom in the second half of the year with a recovery in 2025. They expect Broadband to decline to a high 30s percentage from the prior guide of just over 30% YoY decline.
  • Wireless revenue grew 2% YoY and down seasonally (-19%) sequentially to $1.6 billion. Management reiterated the previous guidance of flat YoY wireless revenue for FY2024.
  • Industrial resale revenue declined by (-10%) YoY to $234 million. They expect to be down double-digit YoY from the prior guide of high single-digit decline.

AI Revenue

AI revenue grew by 280% YoY and 35% sequentially to $3.1 billion. Management has increased the FY2024 revenue guide from over $10 billion to over $11 billion. J.P. Morgan analyst Harlan Sur is bullish on the AI opportunity and estimates about $12 billion in AI revenue this year and more than $16 billion next year. He also highlighted that Broadcom has recently won OpenAI’s first and second generation AI ASIC orders, making OpenAI the fourth major AI ASIC customer for the company.

The company highlighted their expertise in Ethernet and the opportunity, as they expect all mega GPU deployments to be on Ethernet. “Talking of AI accelerators, you may know our hyperscale customers are accelerating their investments to scale up the performance of these clusters. And to that end, we have just been awarded the next generation custom AI accelerators for these hyperscale customers of ours. Networking these AI accelerators is very challenging, but the technology does exist today. In Broadcom, with the deepest and broadest understanding of what it takes for complex, large workloads to be scaled out in an AI fabric. Proof in point, seven of the largest eight AI clusters in deployment today use Broadcom Ethernet solutions.”

Valuation

The company trades at a P/E ratio of 65.8 and a forward P/E ratio of 32.2, higher than the 5-year average of 41.1. Similarly, it trades at a P/S ratio of 16.1 and a forward P/S ratio of 13.8, higher than the average of 8.6. Valuation is a concern for all semiconductor stocks. At the same time, the market is rewarding the company with a premium valuation due to its transition from a value stock to an AI growth stock.

Conclusion

Strong AI growth, merger synergies, and the Ethernet opportunity make Broadcom a leading AI juggernaut second only to Nvidia. We will look toward the report to confirm our understanding that the fundamentals are on track due to ASICs growth, the acceleration in the VMWare software opportunity and networking. 

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

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Nvidia Stock Is Selling Off: It’s Not Because Of Blackwell

Posted on by io-fund

This article was originally published on Forbes on Updated Aug 30, 2024, 08:59am EDTForbesForbes on Updated Aug 30, 2024, 08:59am EDT

Our firm extrapolated supply chain data to conclude that Blackwell is in production at TSM and SMCI last week in the analysis: Nvidia Stock: Blackwell Suppliers Shrug Off Delay. The media was making much ado about nothing (and astonishingly, still is) despite crystal clear confirmation from Nvidia’s management team that all is well.

Given these delay rumors, it was widely expected that Nvidia’s management would provide some transparency in Q2 as to the status of Blackwell. I joined ‘Making Money’ on Fox Business Network shortly before Nvidia’s report, telling host Charles Payne that “we are getting bullish signals from the supply chain,” such as TSM’s HPC growth and Super Micro’s liquid cooling growth, and that I “fully expect Nvidia’s management team to calm any concerns about the outlook for Blackwell.”

Direct liquid cooling doesn’t lie as it’s intricately linked to the Blackwell launch, implying that Blackwell would indeed ship by Q4 – and Nvidia just confirmed that (multiple times) in Q2’s release:

“Blackwell production ramp is scheduled to begin in the fourth quarter and continue into fiscal 2026. In the fourth quarter, we expect to ship several billion dollars in Blackwell revenue.”

Later in the call, Jensen Huang stated: “There were no functional changes necessary. And so we're sampling functional samples of Blackwell — Grace Blackwell in a variety of system configurations as we speak. There are something like 100 different types of Blackwell-based systems that are built that were shown at Computex. And we're enabling our ecosystem to start sampling those. The functionality of Blackwell is as it is, and we expect to start production in Q4.”

We had published for our free readers going into the print that the valuation was stretched, and it would require fiscal year revisions to create room in the valuation. As you’ll see below, we got a few revisions today, which is paramount for the stock price. Will these upward revisions be enough to sustain the price? We look at this and more below.

Q2 Revenue Beats Estimates

Q2’s revenue of $30.04 billion increased 122% YoY and 15% QoQ, with management pointing out that “customers continue to accelerate their Hopper architecture purchases while gearing up to adopt Blackwell.” This marked a $1.3 billion beat to the consensus estimate for $28.75 billion. It also was a deceleration from 262% YoY growth in Q1, as Nvidia is now facing tougher comps against the vertical ramp of Hopper last year. GAAP EPS of $0.67 beat estimates by $0.03, and represented YoY growth of 168% and QoQ growth of 12%.

Nvidia guided for Q3 revenue of $32.5 billion, once again above consensus estimates, though it was only $700 million higher than the $31.77 billion estimate at the midpoint. This represents growth of 79.4% YoY at midpoint, compared to the estimate for 75.3% growth next quarter. Despite this being one of the ‘smaller’ beats in recent quarters, it’s a testament to the strength of Nvidia’s demand to guide for $2.5 billion sequential growth primarily based on Hopper demand with no contribution from Blackwell.

Revenue Growth

Source: I/O Fund

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Data Center Strength Visible with Blackwell on Tap

Data center revenue surpassed a $105 billion annualized run rate this quarter, up from $90 billion annualized last quarter, as Nvidia reported $26.27 billion in data center revenue, up 152% YoY and 16% QoQ. Nvidia said that “Hopper demand is strong, and shipments are expected to increase in the second half of fiscal 2025,” while Blackwell is on track to ramp in Q4 with “several” billions in revenue expected that quarter.

Notably, purchase commitments and obligations for inventory and capacity rose nearly 48% QoQ to $27.8 billion, including “new commitments for Blackwell capacity and components,” another signal that Nvidia is prepared to ramp in full-force come Q4.

In the segment, compute revenue was $22.6 billion, up 162% YoY, while networking revenue was $3.67 billion, up 114% YoY. In networking, Nvidia noted that InfiniBand and Ethernet drove growth in the quarter, and the 16% QoQ growth included “a doubling of Ethernet for AI revenue.”

Data Center Revenue

Source: I/O Fund

Nvidia’s Q3 revenue guide implies data center revenue above $28 billion to $28.5 billion, which we had modeled in our pre-earnings analysis earlier this week.

Delay Concerns Cleared, But Valuation Looks Stretched

Nvidia cleared the delay concerns for Blackwell, saying that they “shipped customer samples of our Blackwell architecture in the second quarter. We executed a change to the Blackwell GPU mask to improve production yield. Blackwell production ramp is scheduled to begin in the fourth quarter and continue into fiscal 2026,” with several billion in Blackwell revenue expected in Q4. Purchase commitments reiterated that Nvidia is serious about launching on schedule, and lining up the capacity and components to launch in full-force by the end of the year.

I spoke with Yahoo Finance on Thursday morning following the report, reemphasizing that the delay concerns were “completely thrown off the table last night. … Wall Street obviously is very closely tied to estimates, and we never saw revisions downward based on the so-called delay. … Nvidia beat, and they’re saying Blackwell is basically on time,” which is “not a concern — if anything, it’s extremely bullish.”

However, I cautioned on the valuation: “When you have a high-flyer like Nvidia, you get stretched at times. Going into the print, we warned our members that this valuation is looking a little toppy. What we need is for the fiscal year estimates next year to go up, so we’re in a waiting game for analysts to revise their estimates upward, which eventually they will, but until then the valuation is stretched.”

This morning, while I was being interviewed by Yahoo, we’ve already seen analyst estimates for Nvidia’s revenue revised higher following the report:

  • Fiscal 2025 revenue is now estimated at $124.8 billion, up 3.9% from the $120.1 billion estimate prior to Q2’s report.
  • Fiscal 2026 revenue is now estimated at $172.1 billion, up 5.2% from the $163.6 billion estimate prior to the report.

However, the true impact of Blackwell is yet to be seen in these estimates, with the only clues right now being Q3’s $32.5 billion guide and expectations for several billion in Blackwell revenue in Q4. From a long-term perspective, I explained on Yahoo Finance that the first “pathway for growth is to pay very close attention to Nvidia around the fiscal year guide,” while the “second-biggest moment of the year will be when Blackwell is shipping in volume. This will be the Q2 report, but we’ll get some signs in Q1 with that forward guide.” I believe that “early next year will be fireworks” for Nvidia, similar to Hopper’s moment in the fiscal Q1 report in May 2023.

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Eyes on Margins as Blackwell Ramps

Margins remained strong in Q2, with Nvidia reporting gross and operating margins at the high end and above its guided ranges. However, management guided for Q3 margins to contract slightly QoQ, suggesting that Q1 was the peak for both gross and operating margins with some pressure ahead as Blackwell gears up to launch in Q4.

  • GAAP gross margin was 75.1% in Q2, ahead of management’s guide for 74.8%. Adjusted gross margin was 75.7%, ahead of guidance for 75.5%. Per the CFO: “As our Data Center mix continues to shift to new products, we expect this trend to continue into the fourth quarter of fiscal 2025.” It’s likely she is referring to the higher cost of memory components, which we outlined in our pre-earnings analysis.
  • GAAP operating margin was 62.1%, ahead of the implied guide for 60.5%, indicative of the operating leverage power that Nvidia still commands in mid-launch cycle for Hopper with the H200s shipping now. Adjusted operating margin was 66.4%, ahead of the implied guide of 65.5%.
  • GAAP net margin was 55.3% down from 57.1% last quarter. This represents profits of $16.6 billion, up over $2 billion. This was a very large beat compared to the $14.3 billion guided.
Nvidia GAAP Margins

Source: I/O Fund

The chart above shows Nvidia’s margins, with the slight sequential contraction this quarter and next quarter visible. It’s no small feat to maintain GAAP operating margin >60% for four consecutive quarters while simultaneously undergoing the semiconductor industry’s most advanced and most rapid product release cycle. However, with management guiding for full-year gross margins to be in the mid-70% range, we’ll be keeping a close eye on how margins trend in Q3 heading into Q4 as Blackwell ramps — where the market is a tad concerned is gross margins, which peaked at 78.4% and will exit the year in the mid-70% range.

Conclusion

Our pre-earnings writeup expressed concerns about the valuation going into the print, and I think the selling on Thursday reflects the valuation. Our firm stuck our neck out over the past few weeks to bring quality information to our readers on how the supply chain for Blackwell is ramping. We were the first and only firm that I’m aware of to present actionable data that countered what other media outlets were reporting. To refresh your memory, media outlets stated Blackwell was delayed into Q1: “If the upcoming AI chips, known as the B100, B200 and GB200, are delayed three months or more, it may prevent some customers from operating large clusters of the chips in their data centers in the first quarter of 2025, as they had planned.”

In contrast, my analysis stated: “From the horse’s mouth, Nvidia’s own management team, it was stated during the GTC Financial Analyst Day in March that the very first systems will ship in Q4, but to expect constraints.”

Well, we have our answer – Blackwell is, in fact, shipping in Q4 and ramping in Q1. Purchase commitments up 48% QoQ help to reflect how serious the company is when it comes to the speed of ramping shipments.

Earnings reports are truly 50/50 – nobody can tell you what the market will do following a report. For example, we had high confidence Nvidia would beat, but there’s much more to consider than a beat. What’s important is to have a strategy. Our firm champions actively managing tech positions rather than buy-and-hold. Our plan is to trim Nvidia at key levels and attempt to buy lower. This is due to valuation concerns, but also importantly, many AI stocks are trading at stretched valuations. We’ve stated publicly a few times that Nvidia is a buy on dips, implying investors who are patient will find entries at lower prices.

Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund own shares in NVDA at the time of writing and may own stocks pictured in the charts.

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