Broadcom: A FCF Machine, But Shares Near Fair Value Into Earnings, Momentum Weakens (2024)

Sometimes it pays to take a step back to view just how far we have come during bull markets. It's a useful exercise for two reasons. First, as part of any good analyst's toolkit, insights can be gleaned from seeing what booms and busts have looked like during previous regimes. Second, opening the aperture helps to avoid nitpicking small corrective moves in an industry or theme.

For the S&P 500 Semiconductors industry, the once-small niche of the US stock market is now larger than the Software group for the biggest subcomponent of the SPX. Its price-to-earnings ratio has jumped to 32x, compared to just 11x as recently as 2019. But the dot-com boom proved that valuations can grow to seemingly unimaginable heights.

For now, I am downgrading shares of Broadcom (NASDAQ:AVGO) from a buy to a hold. The valuation has turned stretched versus history, while the stock's momentum has slowed significantly.

S&P Semiconductor Industry P/E High Vs. History

Chips > Software

According to Bank of America Global Research, Broadcom has an extensive semiconductor product portfolio, which addresses applications within the wired infrastructure, wireless communications, enterprise storage, and industrial end markets. Applications for Broadcom's products in these end markets include data center networking, home connectivity, broadband access, telecommunications equipment, smartphones, base stations, servers, storage, factory automation, power generation, alternative energy systems, and displays.

Back in March, Broadcom reported a strong set of quarterly results. Q1 non-GAAP EPS of $10.99 beat the Wall Street consensus estimate of $10.42 while gangbuster revenue of $12.0 billion, up 34% from year-ago levels, was a strong $240 million beat. The firm recorded free cash flow of $4.7 billion, a high 39% of total revenue. Adjusted EBITDA of $7.2 billion was 60% of revenue, suggesting very strong margins and operating leverage. The management team was busy buying back shares during the quarter, and a quarterly dividend of $5.25 was paid.

Massive AI-Related Revenue, Record Adjusted EBITDA

It's expected that a second-half acceleration in both the top and bottom lines will occur, driven by high growth in the AI space and healthy performance from VMWare, which Broadcom acquired. The firm also reiterated its outlook for about $50 billion in FY 2024 revenue, with AI-related net sales coming in at $10 billion.

Bearish risks include margins reverting to long-term averages and new entrants in the chip space, increasing competition. Moreover, a slowdown in the macroeconomy and the ongoing risk of enterprise spending on AI and semiconductors being too aggressive, which could result in over-ordering this year, is something the AVGO bears often call out. Exposure to China is also a potential concern as US-Sino tensions remain firmly in place. But with a strong customer base that includes Google and Meta, there are clear fundamental tailwinds for AVGO.

Ahead of earnings due out on June 12, the options market has priced in a 5.7% stock price swing when pricing the at-the-money straddle expiring soonest after the report - shares fell 7% in the session after the March profit report, according to data from Option Research & Technology Services (ORATS). The EPS estimate per Seeking Alpha is $10.84.

On valuation, analysts at BofA see earnings rising from about $47 this year to nearly $60 in the out year. Operating EPS is then expected to rise at a rate above 10% by 2026. The Seeking Alpha consensus forecast is about on par with what BofA projects, while Broadcom's top line is seen surging 40% this year, rising another 14% in 2025, then easing to just 10% by 2026.

Dividends, meanwhile, are material with AVGO, with total payouts potentially hitting $25 per share looking ahead to a handful of quarters. But with a mid-20s P/E and an EV/EBITDA ratio that is now significantly above that of the S&P 500, AVGO's value case has lost some luster in my view. Of course, the company remains a free cash flow machine.

Broadcom: Earnings, Valuation, Dividend Yield, Free Cash Flow Forecasts

When I reviewed the stock last year, shares traded with a 23x forward non-GAAP P/E multiple. Today, that earnings multiple is five turns more expensive, though the PEG ratio is close to unchanged, under 2. So, AVGO is by no means at nosebleed valuation levels. In fact, it could still be considered a GARP play. But with most valuation metrics notably above their respective 5-year averages, Broadcom must continue to post impressive quarterly numbers to justify today's valuation.

If we assume $53 of next-12-month operating EPS and apply a 25 P/E, then shares should trade near $1325, making the stock near fair value today, though that is a substantial increase from my intrinsic value estimate from Q4 2023. A market multiple using 2026 EPS would be appropriate too given the growth rate - that would be a valuation of $1365.

Broadcom: Somewhat Bearish Valuation Metrics

Compared to its peers, Broadcom features a weak valuation rating - not surprising when considering the chart at the top of the article. But AVGO's growth situation is very impressive, nearly the best in the industry, while profitability is really where the company shines given the massive $43.43 of per-share trailing-12-month free cash flow generation.

Share-price momentum is marked with an "A" grade, but I take issue with that and will highlight key price levels on the chart to monitor later in this analysis. Finally, sellside EPS revisions in the past 90 days have been to the good side, but there have been 11 earnings downgrades.

Competitor Analysis

Looking ahead, corporate event data provided by Wall Street Horizon shows a confirmed Q2 2024 earnings date of Wednesday, June 12 AMC with a conference call immediately after the numbers cross the wires. You can listen live here. No other volatility catalysts are seen on the calendar.

Corporate Event Risk Calendar

The Technical Take

With shares nearly what I consider to be fair value, AVGO's technical view is likewise mixed. Notice in the chart below that shares have met selling pressure in the $1430 to $1450 range. The recent rally has also come alongside weakening RSI momentum, suggesting that there's downside risk in the weeks and months ahead. I see key support near $1200. A bearish breakdown under that level, based on the $250 range, would result in a downside price target to near $950. On the flip side, if we see a bullish breakout above the high from May, then an upside target to near $1700 would be triggered. So, heading into earnings, we have defined price points to monitor.

Bigger picture, AVGO's long-term 200-day moving average remains positively sloped, suggesting that the bulls are in control of the primary trend. There should also be healthy support in the $800 to $925 range, based on that being a previous consolidation zone.

Overall, AVGO's chart is strong from a long-term perspective, but there are near-term caution signs that investors should heed heading into what is sometimes a dicey part of the year for this chip stock, according to Seeking Alpha's seasonality data.

AVGO: Shares Consolidating, Bearish Momentum Trends, Bullish Long-Term 200dma

The Bottom Line

I am downgrading shares of Broadcom from a buy to a hold. With a near-fair valuation and a mixed technical view, the risk/reward on this high-flying semiconductor stock has turned less appealing ahead of Q2 earnings next week.

Mike Zaccardi, CFA, CMT