Broadcom: AI exposure expected to grow rapidly (NASDAQ:AVGO)

Investment thesis

Broadcom Inc. (NASDAQ: AVGO) is a supporter who has the price of a supporter. Expectations are pretty low, as the stock is priced at 19 times this year’s free cash flows. And this fiscal year ends for Broadcom in 4 months.

Here I explain why an investment in Broadcom and why now. Beyond its economic valuation, I’m drawn to this business because of its rapidly growing exposure to the demand for artificial intelligence.

Simply put, I want to participate in the need for AI infrastructure and energy efficiency provided by Broadcom chips. But I don’t want to pay a foolish multiple to invest in the semiconductor industry.

This is a balanced approach to investing in what is undoubtedly the fastest growing sector of the market.

Why Broadcom? What time?

Broadcom is a semiconductor company. Broadcom supplies specialized hardware components, such as processors and chips, optimized for artificial intelligence applications. These components deliver the higher performance, power efficiency, and compute capabilities required for AI workloads.

As compute, storage, and communication workloads become more complex due to artificial intelligence, so does the need for workload-optimized silicon designs.

For Broadcom, AI, and cloud hyperscaler customers like Alphabet (GOOG), Meta (META), Microsoft (MSFT), and Amazon (AMZN), the key chips they need are better performance, lower power consumption, and overall operating costs. lower silicon.

This means, as I have long argued, that a key limiting factor for AI computing will be access to very cheap energy, as chips are extremely power hungry.

Working with Broadcom and Marvell Technology (MRVL), these titans source and develop Application Specific Integrated Circuits (“ASICs”). These chips end up being cheaper than standard commercial chips.

Don’t be put off by unfamiliar terms, just understand that ASICs improve the performance, speed and efficiency of AI applications.

During its earnings call, Broadcom said AI will account for 15% of semiconductor revenues this fiscal year (ends October), up from 10% last year, and could approach $1 billion in the current quarter. , with revenues expected to increase by 100%. y/y within the fourth quarter of fiscal 2023.

Looking ahead to next year, Broadcom believes its exposure to AI will account for about 25% of its semiconductor revenues. This means that around 20% of its total revenues next year will be exposed to the rapidly growing AI sector.

So why didn’t the stock take off?

Messaging from Broadcom was consistent with the prior quarter. After Nvidia’s (NVDA) and Marvell Technology’s earnings, investors wanted more.

But as you know from my thesis, while I’m trying to take advantage of companies that reduce the energy needed to drive AI applications and companies that are exposed to AI, I don’t want to pay for something that would be too ‘jazz’. ”

I was more than willing to get something less subdued, with fewer pros, but also fewer cons. Not because I’m looking for the best edge. But because I want stocks that will allow me to stay sane in the midst of all this market volatility.

Revenue growth rates are not accelerating

Investors were hoping to be dazzled by Broadcom’s third-quarter 2023 fiscal guidance. Instead, the guide points to revenue growth rates of 5% year-over-year.

That said, consider the following:

Currently, analysts expect very low single-digit growth rates coming from Broadcom. As a result, if Broadcom can continue to increase its exposure to AI at a rapid pace, this will over time allow its overall revenues to increase.

Incidentally, this was also my thoughts behind Palo Alto Networks (PANW), and why I recommended that stock in the first place. I wanted a stock that wasn’t too buoyant and had a part of their rapidly growing business (Next Generation Security of Palo Alto).

Impressive cash flows

Broadcom reported free cash flow of $4.4 billion and indicates it expects its free cash flows to remain solid in the coming quarter.

Above we can see that Broadcom has a very high EBITDA to free cash flow conversion rate. In the second quarter of 2023, more than 75% of Broadcom’s EBITDA became free and clean cash flow. That was 400 basis points less than a year earlier, and no doubt investors wouldn’t have seemed too enthused about this free cash flow margin contraction.

The other issues that would have partially weighed on the stock would have been that Broadcom’s gross margin profile contracted approximately 100% basis points year over year.

Objectively, these two issues taken together imply that Broadcom’s overall profitability in the quarter will weaken. And if we were to continue to weaken going forward, investors would be paying a smaller (or multiple) premium for AVGO’s stock.

For now, if we include Broadcom’s fiscal 2023 guidance and assume that Broadcom’s free cash flow conversion returns slightly higher, that would leave Broadcom on a path to approximately $17.5 billion in free cash flow. this year.

This figure would be about 14% lower than my previous forecast and something I will be extremely careful about.

That said, that would leave Broadcom priced at 19 times this year’s free cash flow. But as I mentioned last week, Broadcom is already in fiscal Q3 2023. That means this year effectively ends in October 2023.

Thus reinforcing that investors aren’t really paying a significant multiple for a company that has a significant chance of rekindling its growth rates by supplying customers with custom-designed chips.

The bottom line

Broadcom Inc. has rapidly increased its exposure to demand for AI infrastructure.

What weighed on the stock was that investors were hoping for higher revenue growth rates and were concerned about shrinking margins.

I highly recommend looking at this stock on a time horizon slightly longer than 1 quarter. There is an attractive upside opportunity over the next twelve months as Broadcom’s AI exposure continues to grow 100% year over year and could reach around 20% of total sales next year.