Broadcom Stock: Time To Take Some Profit

seekingalpha05-03

Broadcom Inc. is currently priced for perfection, leading little margin of safety.For investors truly committed to the long term, there is plenty to like, such as its focus on enterprise ...

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周佐舜
05-07
周佐舜
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Sundry Photography AVGO stock: high P/E and high EPS growth expectations My thesis for this article is that Broadcom Inc. (NASDAQ:AVGO) stock is currently priced for perfection. As a result, I rate the stock as a HOLD. I think it is prudent for existing investors to take some profit (unless you are truly committed to the long term) and for potential investors to stay on the sideline for now. The stock is currently expensively valued even on a non-GAAP basis and by the FAAMNG standard as seen in the chart below. Trading at 28.96x of non-GAAP earnings (on a TTM basis), AVGO is more expensively priced than all the other companies listed here except for (Microsoft) and Netflix (NFLX).   Seeking Alpha The market certainly has a good reason for such an elevated P/E ratio. It expects the EPS growth to quickly catch up and compress the P/E as you can see from the chart next, which describes consensus EPS estimates for AVGO stock in the five few years. Based on the chart, analysts expect that AVGO’s EPS will grow significantly over the next few years and the implied P/E would shrink rapidly in tandem. To wit, its FY 2024 EPS is estimated to be $47.3, translating into a YOY growth rate of almost 12%. Its FY 2025 EPS growth is expected to be even higher at more than 22%. All told, the CAGR for the next 5 years is about 16%. At such growth rates, its implied FWD P/E would drop to below 20x in FY 2026 and to only 13.2x in 5 years. In the next section, I will explain why such a growth projection is overly optimistic in my view.   Seeking Alpha AVGO stock: My growth projections Firstly, I need to acknowledge that there are good reasons behind the above aggressive growth expectations. Unlike many tech companies focused on consumer products or software-as-a-service (“SaaS”), AVGO’s business model offers a few key differentiators in my view. The top one is its specialization in semiconductor and infrastructure software solutions. This niche targets the building blocks of technology, making its products essential for various industries like data centers, telecom, and enterprise computing. Second, AVGO is also savvy at making strategic acquisitions of complementary businesses to expand its product portfolio and market reach. A recent example is VMWare. Although VMWare is no longer the dominant high-growth virtualization software company, I anticipate a trend to more private clouds in the coming years, which would help VMWare’s efforts to sell virtualization to on-premises customers. Finally, the company invests aggressively in new products. The chart below shows AVGO's R&D expenses (top panel) and its CFO (cash from operations, bottom panel) recently. As seen, AVGO's R&D expenses have been increasing significantly. In 2022, the company's R&D expense was a humongous $4.9 billion already. This figure then increased to $5.25 billion in 2023. To better contextualize things, the company's CFO is currently $18.09B. Thus, a $5.25B R&D budget represents almost 30% (29.0% to be exact) of its CFO. With the burgeoning AI applications, such aggressive investments position AVGO well for this nonlinear growth area.   Seeking Alpha Analyzing its R&D expenses as a percentage of its CFO is important because my method for estimating long-term growth involves reinvestment rates. The method is detailed in my other articles and I will just quote the results here for AVGO: The method involves the return on capital employed (“ROCE”) and the reinvestment rate (“RR”). The ROCE for AVGO has reached a peak of around 25% recently as seen in the chart below. Its RR is about 35% considering the above R&D investments and growth CAPEX expenditures. With these inputs, AVGO’s organic growth rate would be ~8.75% (25.7% ROCE x 35% RR =8.8%). Note this number is the real growth rate without inflation. To obtain a notional growth rate, one would need to add an inflation escalator. Assuming an average inflation of 2.5% would bring the notional growth rate to 11.3%.   Seeking Alpha Hence, my estimate, although not as high as consensus expectations, also points to double-digit annual growth. However, there are two key assumptions in my above estimation. First, I assumed its ROCE would remain at the recent peak level of 25.7%, which is an aggressive but justifiable assumption in my mind. A key consideration here is the synergist benefit on the cost reduction front regarding the VMWare acquisition. CEO Hock Tan has a stellar track record of reducing costs at prior software acquisitions, and I see no reason this won’t be repeated with the VMWare integration. Second, I assume an RR of 35%. This is simply too aggressive and unsustainable eventually. AVGO may be able to sustain it for a few years (say the next 5 as consensus estimates imply). But the average RR among mature large tech firms is around 5%. As business expands, there are simply fewer and fewer growth areas to invest in that can move the needle – even if the business has the cash to reinvest. Next, I will explore the implications of these assumptions for the stock’s return projections. AVGO stock’s future return projections Here, I will apply a discounted FCF (free cash flow) model to assess AVGO’s fair price. More specifically, I will apply the following 2-stage discounted FCF model: There are a total of 3 key parameters in the 2-stage discounted FCF model: the discount rate, the growth rate in stage 1, and the terminal growth rate. For the discount rate, I relied on the so-called WACC, the weighted average cost of the capital model. The discount rate for AVGO is about 9.5% on average in recent years following this model.  For the growth rate in the 1st stage, I will assume AVGO can maintain an RR of 10% (i.e., about 2x of the average) for the next 10 years at a ROCE of 25.7% based on the discussions we just had above. These assumptions lead to a real growth rate of 2.57%. Adding an average inflation of 2.5% results in a nominal growth rate of 5.07% in this stage. For the terminal growth rates in stage 2, I will assume AVGO’s ROCE to remain at 25.7% but its RR to drop to the 5% average. These assumptions, again with a 2.5% inflation factor, lead to a terminal growth rate of 3.78%. With these parameters, the table below shows the fair price based on the discounted FCF model. Note that these calculations used its FY1 FCF of $47.46 per share, which was inferred from its 3.77% FCF yield on FY1 basis (see the second chart below). My analysis of its fair price ended up being around $986, about 20% below its market price of $1240 as of this writing.   Author  Seeking Alpha Summary To conclude, Broadcom Inc. presents a mix of factors under current conditions, and thus I rate it as HOLD. To reiterate, my thesis is largely oriented to the near- or medium term (say the next 1~2 years). For investors truly committed to the long term, I am optimistic about its business model, which offers several key differentiation factors through its focus on enterprise infrastructure, strategic M&A, and cost-efficiency.  As mentioned earlier, these factors position Broadcom Inc. well to capitalize on the nonlinear growth curve of AI demand – but again, my view is that these are futuristic opportunities and I see more downside uncertainties than upside potentials in the near term. 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