Broadcom Inc (AVGO) — Q2 2016 Earnings Call Transcript

Thank you, operator, and good afternoon, everyone. Joining me today are Hock Tan, President and CEO, and Tom Krause, acting Chief Financial Officer of Broadcom Limited. After the market closed today, Broadcom distributed a press release and financial tables describing our financial performance for the second quarter of fiscal year 2016. If you did not receive a copy, you may obtain the information from the Investors section of Broadcom's website at www.broadcom.com. This conference call is being webcast live, and a recording will be available via telephone playback for one week. It will also be archived in the Investors section of our website at broadcom.com. During the prepared comments section of this call, Hock and Tom will be providing details of our second quarter fiscal year 2016 results, background to our third quarter fiscal year 2016 outlook and some commentary regarding the business environment. We will take questions after the end of our prepared comments. In addition to U.S. GAAP reporting, Broadcom reports certain financial measures on a non-GAAP basis. A reconciliation between GAAP and non-GAAP measures is included in the tables attached to today's press release. Comments made during today's call will primarily refer to our non-GAAP financial results. Please refer to our press release today and our recent filings with the SEC for information on the specific risk factors that could cause our actual results to differ materially from the forward-looking statements made on this call. At this time, I would like to turn the call over to Hock Tan. Hock?

Thank you, Ashish. Good afternoon, everyone. Well, we delivered strong results for the second fiscal quarter of 2016, the first quarter of operations as a combined company. Revenue of $3.56 billion came in just a shade above the midpoint of our guidance while earnings per share were significantly higher than guidance. As you all are well aware, demand for hard disk drives and premium smartphones was weak this quarter—Q2. However, we experience strong product cycles from switching and broadband in a wide segment enabling Company revenue to come in line with expectation. Our large scale and greater diversity enable consolidated results to be resilient, mitigating fluctuations in our individual end markets. Earnings came in significantly above expectations enabled by delivering gross margin at a high end of guidance and driving faster than expected ongoing realization of acquisition-related cost synergy. Let me now turn to a discussion of our second quarter segment results. Let's start with wired. In addition to classic Avago's custom networking ASIC and fiber optic products, the combination of classic Broadcom has added Ethernet switching and routing and routing ASSPs, physical layer, copper and optical products. In addition, this segment now includes classic Broadcom's broadband communication solutions for set-top boxes, cable modems, and carrier access. In the second quarter, wired revenue came in at $2.06 billion, which represents 58% of our total revenue. This is now obviously our largest segment and it performed better than we had expected in the second quarter. We saw strength across various product lines. We experienced robust demand in switching and routing, standard products including very strong traction for our new Tomahawk switching and Jericho routing platform, especially from the cloud and service provider customers. In fact, as some of you may know, a key customer today announced a new lead—universal lead switch and routing platform for next-generation data centers, which is based on the Jericho product platform. We also saw strong demand for broadband products from set-top box refreshes driven by the start-up adoption of 4K Video. Service providers continue to invest in broadband access infrastructure including ongoing fiber-to-the-home build-out in China, as well as DSL and cable modem build-out in Europe. As we look into the third quarter for our wired segment, we expect the strong demand to sustain from the prior quarter and project wired segment revenues to be up in the low single digits sequentially. We’re also working on resolving a few potential supply constraints in this particular segment. Moving onto wireless segment. In addition to Avago's FBAR filters and power amplifiers, our wireless segment now also includes classic Broadcom's wireless connectivity and custom analog handset solution. In this second quarter, wireless revenue came in at $792 million and the wireless segment represented 22% of our total revenue. As expected, we did see a decline in demand from our large North American smartphone customers, including the anticipated impact of seasonal product lifecycle related reduction in shipment. This was partially offset by an increasing shipment to a large Asian handset OEM. As we have said before, this second quarter was the trough for this segment for the rest of this fiscal year. Moving onto the third quarter, we’re expecting a very different picture for our wireless segment and expect strong sequential revenue growth in the mid-20% range. The expected growth is driven by the start of a ramp from a large North American smartphone customer as they transition to their next generation platform enhanced by a substantial increase in classic Avago's RF content in this new handset. Classic Broadcom's wireless connectivity content will also increase in this new handset. We anticipate our wireless connectivity business to continue to drive significant innovation for mobile Wi-Fi and Bluetooth applications and expect this product line to be a very key long-term contributor to our wireless segment. Let me now turn to enterprise storage. In the second quarter, enterprise storage revenue came in at $525 million, down 23% sequentially, enterprise storage represented 15% of total revenue. This segment experienced a sequential decline in revenue driven by large drop in hard disk drive unit TAM and seasonal weakness in the enterprise server storage connectivity market. Looking to the third quarter, lastly due to further hard disk drive unit TAM declines, we expect enterprise storage revenue to decline in the low single digits sequentially. We currently project the third quarter to be the trough for enterprise storage revenue this fiscal year. Regardless of fluctuations in unit TAM, we also expect to continue to gain share in our hard disk drive business. And let me now move to the last segment, industrial. As I mentioned previously, this segment does include our IP licensing business, but in the second quarter industrial segment revenue came in at $182 million, up 30% sequentially and represented 5% of our total revenue. Industrial resales grew sequentially mid-single digit and our revenue here increased as well by the same level as we replenish channel inventory to keep up with the seasonal increase. Looking at the third quarter, we expect the trend to sustain from the prior quarter and expect mid-single digit venture growth industrial product revenue driven by continuing high retail projection. However, in IP sales after strong and lumpy second quarter, we expect revenue to drop in the third quarter and as a result we expect revenue in the industrial segment to decline mid-single digit sequentially after a 30% increase in Q2. In summary therefore, what we expect for the third quarter is sustained performance from networking and broadband, a trough in enterprise storage but a strong seasonal ramp in wireless, driving sequential growth in consolidated revenue of over 5%. We expect earnings to grow even faster, and we are projecting earnings per share to grow sequentially and almost double the rate of revenue growth driven by lower operating and interest expense as a percentage of net revenue. This in a nutshell is the leverage and power of our business model. With that, let me now turn the call over to Tom for a more detailed review of our second quarter financials. Tom?

Thank you Hock, and good afternoon everyone. Before I start with my comments today, I will focus primarily on our non-GAAP results and continuing operations unless otherwise specifically noted. A reconciliation of our GAAP and our non-GAAP data is included with the earnings release issued today, and is also available on our website at broadcom.com. First, before I get into the second quarter results, I would like to take a few minutes to review the progress we're making towards our long-term financial model as we work through completing the integration of classic Broadcom. Fundamentally, just to review the financial model with the output of the business model that Hock is driving, the most important element of our model is sustainability of the franchise as we invest in over the long term. When we set out to acquire Broadcom, we recognized our collection of well-established businesses with leadership position. We believed that these franchises were critical to enabling rapidly evolving wireline and wireless ecosystems. While we only have one quarter under our belt, we think that this piece is very much intact. Another key element is discipline. We are actively managing the portfolio to stay focused on investing in the core franchises while monetizing businesses that do not have clear long-term sustainability. This is an ongoing process to continue to allow us to maximize returns on our R&D investment. Finally, we keep things simple and focus on critical business processes given our now larger economies of scale; we can be even more efficient across our global supply chain and sales platforms, as well as our general administrative function. This takes us to the three key elements in our financial model, starting with revenue. While we don't expect the broader semiconductor industry to grow much over the long term, we do believe that our franchises will benefit from some very positive trends, including what seems to be an ever-increasing demand for mobility, bandwidth, and storage. We believe that we have the right set of technologies for these needs which gives us confidence in our long-term annual revenue growth rate target of approximately 5%. On the gross margin front, given the market needs for our technology and the leadership positions we have, coupled with ongoing cost reductions in our supply chain, we see potential opportunities over time to push gross margins beyond 60%. We've already delivered this quarter. Turning to operating expense. We believe the completion of integration activities and our focus on return on investment will allow us to drive R&D expenses to 16% of net revenue within the next few quarters. Looking at the target portfolio in the set of core projects, we want to report—we feel 16% is currently the appropriate long-term target for R&D expenses. And finally on SG&A, we clearly see potential opportunities to drive these expenses below 4% of net revenue. In summary, as we look at the second half of fiscal 2016, we expect to see solid revenue growth from the second quarter, which we believe will help drive operating margins to 40% as we exit the year. As we work toward completing integration and the full achievement of cost synergies in fiscal '17, we think we can drive operating margins north of 40% and sustain those margins longer term. Let me turn to our capital allocation strategy moving forward. As many of you know, over the last several years we’ve focused on M&A and the returns have allowed us to drive significant value for shareholders. Going forward, we believe acquisition opportunities will continue to present themselves that under our business model will drive returns that far outweigh the alternative use for our capital. As a result, we currently intend to limit the paid down of outstanding term loan until our gross debt is approximately two times EBITDA, at which time we intend to start pulling excess cash with the purpose of M&A, as well as review our capital structure generally including our long-term debt alternative. As part of our capital allocation strategy, we plan to remain committed to our dividend program and are currently targeting an approximate 10% per year increase. However, as a reminder, our board reviews and determines our dividend policy on a quarterly basis, based on our financial performance and conditions and contractual provisions relating to outstanding indebtedness and other factors being relevant to our board. Now let me turn to a quick review of our results for the second quarter. Revenue for the second quarter came in at $3.56 billion, which we believe will be the trough for the rest of this fiscal year. Foxconn was greater than 10% direct customer in the second fiscal quarter. Our second quarter gross margin from continuing operations was 60%, which is at the upper end of our guidance range primarily due to better revenue mix with the stronger than expected wired segment and higher fab utilization as we pre-build filters to support the expected second half ramp in wireless revenues. Turning to operating expenses, R&D expenses were $663 million, and SG&A expenses were $146 million. This resulted in total operating expenses for the second quarter of $809 million, $23 million below guidance. This was largely due to faster than expected realization of acquisition-related cost synergies. On a percentage basis, for the second quarter total operating expenses were 23% of revenue, as a percentage of sales R&D was 19% and SG&A was 4% of net revenue. Operating income from continuing operations for the quarter was $1.3 billion and represented 37% of net revenue. Taxes came in at $53 million slightly above our guidance; this is primarily due to higher than expected net income. Second quarter net income was $1.1 billion, and earnings per diluted share were $2.53. Second quarter interest expense was $150 million and other expense net was $6 million. Our share-based compensation expense in the second quarter was $186 million, which included the impact from new grants issued to classic Broadcom employees approximately half-way through the quarter. In the third quarter of fiscal 2016, we anticipate share-based compensation expense will be approximately $221 million and this anticipates the full impact of the new grants for the quarter. This is a reminder that our definition of non-GAAP net income excludes share-based compensation expense. Moving on to the balance sheet, our days sales outstanding were 47 days reflecting the combined company. Our inventory ended at $1.47 billion and days on hand were 72 days, which includes the impact of an inventory build supporting the strong growth expected in our wireless business. We generated $622 million in operational cash flow, which reflected the impact of approximately $300 million of cash expended on restructuring activities. We ended the quarter with a cash balance of $2 billion. We believe that we currently need approximately $1.5 billion to operate the business. During the second quarter, we were paid approximately $565 million of outstanding term loans. We currently intend to repay approximately $1 billion in the third quarter, part of which we expect to fund using proceeds from the two previously announced divestitures which are expected to close in the third quarter. In the second quarter, we spent $158 million on capital expenditures. For the third quarter, we expect CapEx to be approximately $230 million, which includes approximately $75 million for ongoing capacity expansion for our manufacturing RF filters and $45 million for campus construction activity. We expect CapEx to run at an elevated level over the next several quarters driven by campus construction, our Irvine and San Jose locations, ongoing RF filter capacity expansion, and integration-related operations in IT investments. A total of $204 million of cash has been spent on the company's dividends and partnership distribution payments in the second quarter. As you've seen, our board has declared a dividend of $0.50 per share to be paid later in this third fiscal quarter. Finally, let me turn to our non-GAAP guidance for the third quarter of fiscal year 2016. This guidance reflects our current assessment of business conditions and we do not intend to update this guidance. This is guidance results from continuing operations only. Net revenue is expected to be $10.75 billion plus or minus $75 million. Gross margin is expected to be 60% plus or minus one percentage point. Operating expenses are estimated to be approximately $809 million. Taxes are forecasted to be approximately $59 million. Net interest expense and other is expected to be approximately $141 million. The diluted share count forecast is for 449 million shares. That concludes my prepared remarks. Operator, please open up the call for questions.

Good afternoon, guys. Hock, Tom, congratulations on the strong results and thanks for letting me ask a question. Hock, I guess my first question pertains to the wireless guidance for the July quarter. I'm kind of curious about a couple of things. Do both the North American and the Korean customers grow sequentially in July, or is it just mainly the North American customer? And when you look at that North American customer, does the July guidance reflect a four-quarter's worth of build benefit of their new high-end phone? Or is it only a partial benefit in the July quarter with really a full benefit coming in the next quarter?

All right. Are you getting very sticky and picky? But to answer your question, it's largely from the certain North American customer that's driving the bulk of the growth. Having said that, the Korean customers do show growth as well on its own, but obviously not to the extent the North American customer is doing because it’s a ramp. It’s the beginning, I could use the word, beginning of the ramp, for their next-generation phone, and tied to that is this July quarter, our two current quarter Q3, will not show them the full impact of an entire quarter of revenue ramp. It's just the beginning and very back-loaded.

Yes. Good question, John. It’s really the timing of the realization of synergies. Obviously, we did better than we thought we would do out of the gate first quarter, and you saw that in the results. A lot of the realization is tied to system integration and a lot of the back-office activities that's very much on target to be completed early in the first quarter of next year. So, I suggest we will see a bit of a pause here this quarter and perhaps a bit in the next, but as looking at the first half of next year, you'll see the full realization.

Hi guys, I will add my congrats as well. Just in wireless, can you talk about the connectivity business? There was some concern of share loss. You talked about content potentially going up. Can you just walk through where you see opportunities for content to go up and just the barriers around your mobile connectivity business?

Okay. You broke up every few seconds, but if I get it right, you're basically asking are we seeing content increase in our wireless revenue in terms of participation in all those premium handsets? And as I've always said, year-to-year generation, obviously there are fluctuations in the level of content increase, but over a period of time, we have experienced, we have seen and we'll continue to see a steady increase in content. And this is not just about FBAR front-end module content as more and more bands and carrier aggregation features come into high-end phones. Now that we have Wi-Fi, Bluetooth, and wireless connectivity, we are seeing the same phenomenon apply, exactly. I mean, the parallel between those two product lines is pretty amazing from our perspective, and it is not coincidental. It's part of the reason it attracts us to our acquisition of Broadcom is the fact that wireless—we see wireless connectivity as a very strategic product line in handsets, particularly in high-end handsets. For instance, fully 80% of data moves to Wi-Fi today in most handsets, not LTE but Wi-Fi, and so the importance of improved Wi-Fi connectivity performance, particularly in the form of capacity bandwidth, becomes more and more demanding. Improvement becomes more and more needed. And as each generation occurs, our belief is that increasing bandwidth capacity that increase in performance will follow for the same reasons that increased requirements for FBAR filters show the same kind of improvement. So we expect—I've seen FBAR filters that over the last few years content has grown by about 20% fairly steadily, and I might almost apply the same principles to wireless connectivity for Wi-Fi and Bluetooth.

We are experiencing very strong bookings and demand for our switching and routing product line, along with related products like PHY and Retimer, which are essential for connecting different parts of a data center. This creates a comprehensive set of offerings, particularly in switching and routing. The Tomahawk product was launched earlier than the new Jericho and is currently ramping up well, showing strong demand this quarter, especially for applications used in top-of-the-rack switching for data centers among cloud providers and services. Additionally, we’ve seen our advanced Jericho product line, which features routers that can also be described as deeply buffered switches, being utilized more frequently as the spine of data center architecture. Recently, we began seeing the launch of this same deeply buffered product on the leaf nodes of the data centers, contributing to an accelerated revenue ramp. We believe this is partly due to a product upgrade cycle, along with strong underlying demand in cloud computing data centers in North America, among hyper-scale data center operators, and in China.

Yes. Thank you. Just following up on wired and the comments of resolving some supply constraints, does that implication as you go out into kind of Q4 in terms of the ability to work through those and what type of visibility do you have there?

Yes. Visibility is increasing by leaps and bounds every day actually. Yes. There is a supply constraint in certain areas and that does extend our lead time somewhat, which we are working very hard to improve simply because we believe the demand is real out there. And yes, it does extend to Q4 and we are starting to have visibility on bookings and backlogs in Q4 as we sit here right now.

Thanks for taking my question. Hock, on wireless, you mentioned content growth has been around 20% or so a year for the last few years on your FBAR RF filters. As you look out the next few years, what kind of content growth opportunity do you see for the combined FBAR and connectivity portfolio that you have now?

Very good question and looking at what is always a very scary proposition, obviously, because I'm guessing and technology changes. I don’t call it disruption; I call it evolutionary even if very evolutionary DCs and we have a very clear roadmap all three years. And I won't even say we'll go beyond three years. It's still hard to predict, but my estimate and guess will be, we will continue to keep doing the same level on a combined basis for the next two to three years. Well, it’s a very good question and as Tom articulated, I think very, very anecdotally at the beginning of his remark. We've given it – we have been very thoughtful about this basic issue, I call it an issue, it's a bit of a high-class problem because we think there are still opportunities, significant opportunities out there for us in Broadcom limited to continue to pursue a strategy we've adopted over the last several years of creating shareholder value by acquisition in this space. And we believe that. Hence, as Tom articulated, we are positioning ourselves. We are creating a capital allocation strategy that will enable us to position us very well to do that. But to answer your question in one, yes, we think the opportunities are out there. They are very interesting and opportunistically and carefully we will keep pursuing that strategy.

Hock, I had one for you on the wired business that you mentioned, what was going on in a couple of the different areas, but you never mentioned what was happening on the traditional Avago ASIC business. So, I guess the first part of it in wire, what was going on in that and how do you see that going forward? And then as we look into the July quarter, the Broadband segment can you talk about the puts and takes within that sub-component of your wired business as well?

Sure. Thanks. Oh, no, on those traditional, you call it traditional, I call it a classic Broadcom networking ASIC and fiber optics business, is still charging along very nicely. And we're still seeing growth both on fiber optics as well as on traditional ASIC. The reason we don't say much about it is because what we are seeing in comparison to the standard switching product portfolio that we're seeing out of classic Broadcom is very strong by comparison in this area of standard switching and routing is extremely strong and probably, as I indicated, driven by data centers in the cloud guys who are speaking standard solutions versus the enterprise side which is more driven towards using ASIC-based solutions by the OEM. No, really isn’t. There isn’t. You know like moving from one to the other, no, I don't think so. We have not finished. I think it's still—they are firm factors that are strong now. I know you mentioned your asset question earlier about both the Broadband, set-top boxes, example of Carrier Access, and the areas we are seeing a lot of strength, one I mentioned is standard switching and routing. The other area we're seeing a lot of strength is Broadband Carrier Access, which is PON and DSL and associated with it enterprise, wireless access point, all those connected together in basically pushing into infrastructure to some extent as well as campus environment and we think it streams through in that area. Similar to what we're seeing the level of strength in standard switching and routing. So, I see more specific areas, specific segments or niches in the overall wide market, not all are growing at the same rate. Some are going to less as I indicated in net booking ASIC, or fiber optics interconnect, but in carrier access and standard switching and routing we think very strong demand.

Hi. Good afternoon and great job on the quarterly execution, we also heard demand is pretty high but Tomahawk and Jericho and then other product called Kumron. You talk about the supply constraint, and I just wanted to confirm, are the supply constraints associated with Tomahawk and Jericho and Kumron—are these little bottlenecks and when do you anticipate this situation to get better?

Yes. Well, we are working through it and a big part of it is lead time from the wafer fab has extended somewhat. And these products also take a more standard period of time to go through the manufacturing process front end and back end. And we are working to obviously accelerate, compress this cycle time and we believe we should be able to get there within a matter of a couple of months, maybe no more than three months, but again it is a process. And a big part of it is demand that came within the lead shorter than the lead times necessary to produce those products.

Thanks for squeezing me in guys. I guess two questions for me as well. On the wired segment, could you talk about how much incremental backlog is building or how much revenue did you leave on the table because of the supply constraints that you have in the segment? Certainly, get a sense of is there a potential to pick this back up in October quarter when things normalize?

This is a very hard question to answer. And the fact of the matter is, no we don’t know how to answer that question; I would be honest, because if you rather speculate and many of the designs are very full source designs for particular OEM, so obviously there is no switch around. Having said that, from the bigger microscopic system, doesn't mean that design opportunities disappear to somebody else who are able to find a different set of boxes as opposed to components. So if something we're not able to predict for them at the estimate.

Yes, thanks. I'm just trying to better understand how to think about wireless for the second half of the fiscal year and I believe it's unusual that the July period as it is this year is the big quarter for wireless. Even in fiscal 2014 where you had big content gains, it was October where you saw that was really the quarter we saw the big sequential growth. First question is I’m just curious why seasonality in wireless appears to be different this year? Why is July the big quarter instead of what's normally been October?

Okay. Romit, July has never been the big quarter; July in Q3 has never been the big quarter for us if you look back multiple years. Never has been. The big quarter has always been the October quarter, Q4, and never been July. Simply because July is the initial ramp up. Okay, and in the back half of the July quarter, precisely in the month of partially July, that we start to see shipment because of lead time taken to manufacturing—we shift to the old to the contract manufacturers, all our OEM at that time and so you see a small part of it in the July quarter. You see a full quarter of impact virtually in the October quarter and potentially if you look back two years ago, you will continue to see in the first quarter of fiscal 2017 that end January 2017 before it rolls over the typical seasonality rollover—where the trough will be the second fiscal quarter that we just finished. So no different we are seeing there now, one may however—you perhaps when you say wireless revenue ramping twenty odd percent in Q3 this year perhaps might be the best way to describe is for the various reasons I mention and you guys are very well aware of, Q2 this year for that particular generation of phone with something referred to has seen particular weakness known to everyone, and so you're stepping off from a bottom that is cheaper than Q2 last year or the audited for that matter. So when you come up for such a bottom to a new generation of phone, which is still having the ramp up in the same fashion with the same kind of profile to reach a certain level of the possibility of supply. So we suddenly see this big mid-20s ramp up. You're right, prior years Q2 to Q3 may not be that twenty odd percent; you'll take Q3 to Q4 to get that, but this year is really not Q3 that different perhaps Q2.

Thank you for participating in today's earnings call. We look forward to talking with you again when we report our third quarter fiscal year 2016 financial results.