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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