Broadcom's post-earnings pullback doesn't shift the fundamentals. It's a buying opportunity

Published Thu, Aug 31 20237:31 PM EDTUpdated Fri, Sep 1 20233:40 PM EDT

Semiconductor firm Broadcom (AVGO) reported better-than-expected fiscal third-quarter results Thursday, even as the stock came under pressure due to a miss on cash flow and in-line guidance. But we're unconcerned about the pullback and see this newest Club holding as clear beneficiary of the artificial-intelligence craze, with more room to run. Revenue for the three months ended July 30 increased 5% year-over-year, to $8.88 billion, exceeding analysts' forecasts of $8.86 billion, according to Refinitiv. Earnings-per-share (EPS) on the basis of non-generally accepted accounting principles (GAAP) climbed 8% on an annual basis, to $10.54, outpacing analysts' expectations of $10.42-per-share, Refinitiv data showed. Adjusted Earnings before interest, taxes, depreciation and amortization (EBITDA) of $5.8 billion also edged out the $5.7 billion Wall Street predicted. Shares of Broadcom tumbled roughly 4.75% in post-market trading, to around $879.13 apiece. Bottom line Though shares are lower in afterhours trading, we see no change to our investment thesis. And we would look to be buyers of this weakness. Guidance may not have been quite as strong as a stock at all-time highs might have demanded – so we understand the desire of some investors to book profits – but Broadcom management is notorious for under promising, only to over deliver when the actual results come through. In fact, management has exceeded its own sales guidance, even if by only a small amount, in every quarter going back through the first quarter of the company's fiscal year 2021. Our focus is not on the near term, but rather what's in store in 2024 and beyond. In addition to the expected integration of acquisition VMWare (VMW), we anticipate momentum around generative artificial intelligence to continue amid an overhaul of the world's data-center infrastructure. We also expect that the more-pressured areas of Broadcom's semiconductor business will bounce back as inventory levels outside of AI-related chips normalize and China's economy continues to rebound. As for VMWare, which also reported after the closing bell Thursday, sales came up a tad short even as earnings came in comfortably ahead of expectations. The acquisition should provide a boost to Broadcom's overall gross margin-profile given VMWare maintains a gross margin in the mid-80th percentile. That may be lower than the 92% gross margin we saw from Broadcom's infrastructure-software business in its fiscal third, but it's well ahead of the 70% gross margin the semiconductor solutions segment delivered. That unit comprises 78% of total company sales. VMWare's margin is also firmly above Broadcom's overall gross margin. In sum, we'll look to put some cash to work in this name in the coming days in an effort to build out the position before the VMWare acquisition is finalized. We continue to view Broadcom as a long-term beneficiary of the wave of money piling into artificial intelligence infrastructure — and that's precisely why we added the stock to the Club portfolio last week. Quarterly commentary Top-line weakness can be attributed to a slight miss at the semiconductor solutions segment. During the post-earnings conference call, management noted that sales to hyperscale customers — such as big cloud providers — remains resilient, advancing double digits on a percentage basis year-over-year, while enterprise spending moderated during the quarter. On the hyperscale front, Broadcom CEO Hock Tan attributed the strength to generative-AI initiatives, noting that the company supplies a "major hyperscale customer with custom AI compute engines." That customer is almost certainly fellow Club name Alphabet (GOOGL), which collaborates with Broadcom on on the design and manufacture of Google Tensor Processing Units (TPUs). Tan also said that sales related to generative AI are responsible for essentially all growth seen in the semiconductor business. Excluding these AI-related sales, semiconductor sales have largely stabilized around the $6 billion level and management continues to think that a "soft landing" is still in the cards. Moreover, generative AI is having a significant impact on the company's networking business, Tan explained. In fact, networking revenue was up 20% versus the year ago period and now represents 40% of revenue at the company's semiconductor segment. That's music to our ears because Broadcom's AI network solutions represent an important leg to our investment thesis. Looking ahead, Tan expects networking revenues to accelerate in the current quarter. "We are also supplying several hyperscalers a portfolio of networking technologies as they scale up and scale out their AI clusters within their datacenters," Tan said. Elsewhere within semiconductor solutions, wireless revenues (24% of segment revenue) were flat year-over-year, as was revenue for server storage connectivity (17% of segment revenue). Broadband sales (16% of segment revenue) moderated to 1% year-over-year growth following nine-consecutive quarters of double-digit growth. Industrial sales (about 3% of segment revenue) were down 3% year-over-year. Revenue at the segment is expected to be up by a low-to-mid-single-digit percentage year-over-year in the current quarter, in line with expectations. Consolidated renewal rates at the infrastructure software division averaged 117% in the core-software cohort and 127% in strategic accounts. Management expects infrastructure-software revenue to be up by a mid-single-digit percentage versus the year ago period, in line with expectations. Lastly, regarding the pending acquisition of VMWare, Tan said that Broadcom is "in the advanced stages of the process towards obtaining the remaining required regulatory approval" and continues to expect the deal to close on Oct. 30. Outlook Management expects fiscal fourth-quarter revenue to be approximately $9.27 billion, with adjusted EBITDA coming in at around 65% of that figure. The revenue projection is in line with what Wall Street was expecting, while the adjusted EBITDA margin target is ahead of the 64% the Street had been modeling into the print. (Jim Cramer's Charitable Trust is long AVGO, GOOGL. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. 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Hock Tan, CEO of Broadcom

Lucas Jackson | Reuters