Broadcom Inc (AVGO) — Q1 2017 Earnings Call Transcript

Thank you, Operator, and good afternoon, everyone. Joining me today are Hock Tan, President and CEO; and Tom Krause, Chief Financial Officer of Broadcom Limited. After market close today, Broadcom distributed a press release and financial tables describing our financial performance for the first quarter of fiscal year 2017. If you did not receive a copy, you may obtain the information from the Investor section of Broadcom’s website at www.broadcom.com. This conference call is being webcast live, and a recording will be made available via telephone playback for one week. It will also be archived in the Investor section of our website at Broadcom.com. During the prepared comments section of this call, Hock and Tom will be providing details of our first quarter year 2017 results, background to our second quarter fiscal year 2017 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 financial results for the first quarter with revenue of $41.5 billion and gross margin at 62.4%, both at the very top end of our guidance. Earnings per share of $3.63 grew by 5% sequentially, while net revenue was essentially flat. Revenue was better than expected in all four segments. The benefits we achieved through business diversification clearly came through this quarter with growth in Wired, Enterprise Storage, and Industrial completely offsetting the typical negative seasonality from Wireless. The integration of classic Broadcom has gone very well and is now mostly complete. We remain focused on driving financial performance towards our long-term operating margin and free cash flow targets. Let me now turn to a discussion of our segment results, starting with Wired, our largest segment. In the first quarter, Wired revenue came in at $2.09 billion better than expected and represented 50% of our total revenue. Revenue for this segment was up slightly on a sequential basis, benefiting from strong demand for Ethernet Switching and Routing products from cloud data center operators. This growth was partially offset by the continuing seasonal decline in demand for our broadband carrier access and set-top box products, which we expect to bottom in this first quarter. Turning to the second fiscal quarter, we forecast Wired revenue to experience sequential growth a little bit stronger than what we saw in the prior quarter. We expect the momentum from cloud data center demand to sustain and expect a seasonal increase in demand for our broadband access and set-top box products. Now moving on to Wireless. In the first quarter, Wireless revenue came in at about $1.18 billion, better than expected, and the Wireless segment represented 28% of our total revenues. Revenue for this core segment was down 13% sequentially, driven by the expected seasonal decline in demand from a major North American customer. Turning now to our projection for the second quarter fiscal of 2017, we expect to hit the bottom of the annual product cycle transition at a major North American customer. However, we expect to offset a significant portion of this decline in Wireless from a ramp of the next generation phone from our large Korean smartphone customer. This phone comes with an increase in Broadcom's RF and Wi-Fi connectivity content. As a result, we expect our Wireless revenue in the second quarter of fiscal 2017 to be still sequentially down, but in the high single-digits better than the more typical double-digit declines we have experienced in prior years. Let me now turn to Enterprise Storage, which continues to be strong. In the first quarter, Enterprise Storage revenue came in at $707 million and this segment represented 17% of our total revenue. Segment revenue grew 26% sequentially, gaining better than expected, driven by stronger shipments of SAS, RAID, and Fiber Channel products. As we foresaw, our hard disk drive and custom solid state drive controllers also had a very strong quarter. And looking into the second quarter, however, we believe this resurgence of Enterprise Storage has to taper off and hence flatten out. Having said that, the backlog for Enterprise Storage products continues to be very strong. But we foresee seasonality to start slowing demand in the third quarter, if not late in the second quarter. Finally, turning to our last segment, Industrial. In the first quarter, Industrial revenue came in at $180 million, up 11% sequentially, better than expected as we rebuild depleted channel inventory consistent with stronger product resales. The industrial segment represented 5% of our total revenue and as we look into the second quarter, we are anticipating industrial activity to continue to improve seasonally and accordingly, we are expecting industrial segment revenue to increase by high single-digits sequentially. With all that to sum up, this second quarter was strong, revenue flat from the seasonally high fourth quarter of the preceding year. As we now look into the second quarter, we expect this demand environment for our products to continue to be very healthy and our outlook for this quarter's revenue to be virtually flat to that of the prior quarter. It is becoming evident that our broader and more diversified product portfolio has largely mitigated seasonal impacts to consolidated revenue during the first half of the year. This is certainly an intrinsic goal of our business model that we did not expect to achieve so soon. The integration of classic Broadcom is clearly going well and we continue to invest across all our franchise products. We are sustaining our technology leadership and our products are very well received by our customers. Our revenue trajectory from the first half of fiscal 2017 could possibly extend into the second half. Nonetheless, we do not expect that the approximate 15% level of year-on-year growth we are guiding for the second quarter to really be sustainable in the long term. Our long-term operating model will continue to assume mid-single-digit annual revenue growth for the consolidated business. With that, let me now turn the call over to Tom for a detailed review of our first quarter fiscal 2017 financials.

Thank you, Hock, good afternoon everyone. My comments today will focus primarily on our non-GAAP results from continuing operations unless otherwise specifically noted. A reconciliation of our GAAP and non-GAAP data is included with the earnings release issued today that is available on our website at Broadcom.com. Let me first start out by saying that we are very pleased with the execution this quarter and specifically the progress we've made towards our long-term target model, which remains an operating margin target of 45% of net revenue and a free cash flow margin above 35% of net revenue. Further to what Hock was saying, we also believe that we can achieve these long-term operating targets based on a sustainable long-term revenue growth rate of mid-single-digits. Now, let me review the Q1 results. Revenue for the quarter came in at $4.15 billion, approximately flat sequentially. Foxconn was a greater than 10% direct customer in the first fiscal quarter. Our first quarter gross margin from continuing operations was 62.4%, about 90 basis points above the midpoint of guidance, primarily due to revenue at the top end of guidance and a slightly better product mix. This quarter's gross margin also benefited from the impact of approximately $60 million of revenue related to the assignment of certain manufacturing rights to a customer in our Wired segment, which is included in our original guidance. Turning to OpEx, R&D expenses were $664 million and SG&A expenses were $120 million. This resulted in total operating expenses for the first quarter of $784 million, or 18.9% of net revenue. As Hock mentioned, we have now largely completed the integration of classic Broadcom and I would reiterate that we feel comfortable at this level of operating expenses relative to net revenue. Operating income from continuing operations for the quarter was $1.8 billion and represented 43.5% of net revenue. Provision for taxes came in at $77 million, slightly above our guidance. This was primarily due to higher than expected net income. First quarter interest expense of $110 million and other income net was $8 million. First quarter net income was $1.63 billion and earnings per diluted share were $3.63. Our share-based compensation expense in the first quarter was $201 million. Moving on to the balance sheet, our days sales outstanding were 43 days, a decrease of five days from the prior quarter due to better linearity of revenue in the quarter. Our inventory ended at $1.34 billion, a decrease of $64 million from the beginning of the quarter. We generated $1.35 billion in operational cash flow, which reflected the impact of approximately $313 million for annual employee bonus payments for fiscal year 2016 and approximately $80 million of cash expended on classic Broadcom restructuring integration activities, including discontinued operations. I'm very pleased that in the first quarter, the business already demonstrated the ability to generate free cash flow close to our long-term target model of 35%, while free cash flow in the first quarter was $1 billion, approximately or only 25% of net revenue. This does include, I want to highlight, the impact from the annual employee cash bonus payment, as well as cash restructuring expenses and capital expenditures that, as we discussed before, are running higher than our long-term targets. Looking forward, we expect classic Broadcom related restructuring expenses to continue to decrease as we finish this integration. Capital expenditure in the first quarter was $325 million, or 7.8% of net revenue. However, we expect long-term CapEx largely for a fabless semiconductor company to run at about 3% of net revenue consistent with that fabless business model. As a reminder for the full fiscal year 2017, we expect CapEx to run at an elevated level of approximately $1.2 billion. This includes about $500 million towards campus construction, primarily at our Irvine and San Jose locations, and about $200 million towards purchasing of testing equipment at our contract manufacturers. A total of $431 million in cash was spent on company dividend and partnership distribution payments in the first quarter. We ended the first quarter with a cash balance of approximately $3.5 billion. Now let me turn to non-GAAP guidance for the second quarter of fiscal year 2017. This guidance reflects our current assessment of business conditions and we do not intend to update this guidance. This guidance is for results from continuing operations only. Net revenue is expected to be $4.1 billion plus or minus $75 million. Gross margin is expected to be 62%, plus or minus 1 percentage point. Operating expenses are estimated to be approximately $789 million. Tax provision is forecasted to be approximately $74 million. Net interest expense and other is expected to be approximately $106 million. The diluted share count forecast is for 452 million shares. Share-based compensation expense will be approximately $223 million. CapEx will be approximately $290 million. And as you have seen, our Board has declared a dividend of $1.02 per share to be paid later in the second fiscal quarter. We're also looking forward to completing the acquisition of Brocade, which is proceeding as planned and we presently expect to close this transaction in our third quarter of fiscal 2017. I'm pleased that we're able to reach an agreement with ARRIS earlier this quarter for the sale of Brocade's network edge business for $800 million in cash, plus the additional cost of unvested employee stock awards. Following Brocade's recent results, we continue to feel very comfortable that Brocade's Fiber Channel San Switching business, the key business that we're focused on, will generate approximately $900 million of EBITDA in fiscal 2018. That concludes my prepared remarks. Operator, please open the call for questions.

Hey guys. Thanks for letting me ask a question. I guess Hock, the first question is on the Wireless side. It's good to see the content rising at other customers besides just your big North American customer; can you talk a little bit more detail about what's driving that content up? Is there anything unique, or is it basically the same goodness that you've seen in the North America side? And any more color about that goodness continuing on the North America side into the second half of this year would also be helpful. Thanks.

Yes, Ross, thanks for the question. Yes, it's, in fact, a phenomenon we have been indicating to you guys for the last several years, which is over the medium term, long-term, I would say, our strength of franchise in cellular and our RF cellular analog, the front end cellular analog, which includes FBAR and power amplifiers and all the circuitry and components that go in front of the transceiver in the handset for cellular. That's one area, and the other area in Wi-Fi Bluetooth connectivity. Those two functionalities, those two features in phones continue to evolve and with each generation. And as each generation evolves, what involves is, in the case of RF cellular it is two-fold. One is basically more bands as we gradually move from what used to be much lower bandwidth in Wi-Fi to today's AC. As we move from a single user to multiple users and as we move to AX and further. Obviously, the difficulty of doing those products in smartphones becomes correspondingly more difficult, content increases and we benefit from basically content increase. It's a normal phenomenon; we expect to see that continuing into the medium term.

Great, that's helpful. I guess for my one follow-up, both you and Tom, Hock, mentioned about the 15% growth not being your long-term assumption. Just wondering why you are bringing that up? Is there something you're seeing now that gives you pause that things are going to slow down, or is this just a reminder that the level we are now is not the base assumption in your business model?

I think the fairest way to answer that is we have articulated last fiscal year very clearly and even a year ago when we acquired Broadcom, as long as a year ago, that we were scaled and we were diversification of product portfolio. Our long-term model, out five years, 10 years is a compounded annual growth of 5%. Not every year necessarily, but long-term 5%. And why we feel the need to mention it is obviously you saw the numbers we were guiding for Q2 on the top line and they're showing 15% year-on-year from a year ago. That's just one quarter and obviously just one fiscal year, one point in time. So, we felt it necessary to just mention it that do not just take it and extrapolate it to say that we have moved away from our broad model on guidance of 5% compounded annual growth in the long term to a 15%, far from it.

And Ross, I want to reiterate that we don't think we need to achieve accelerated revenue growth to meet our financial targets, which we are focused on, particularly the free cash flow margins at 35%. We feel confident in reaching those results based on a more normalized long-term compound annual growth rate of mid-single digits.

Hey guys, thanks for taking my question and congrats on the great results. Just following-up on the Wireless guide, you've talked in the past sometimes it can be seasonal down 15%, 20% to the high single-digits. Just curious between contents and the units, what are you seeing with your two large customers in terms of the seasonality and the timing of the ramp magnitude versus the content gains you're seeing?

To be clear, I don't have specific data to accurately break it out between units and content, but off the cuff, my sense is it's largely content.

You mentioned the strength in switching, and I was curious about your thoughts. Looking at the full year, you noted some businesses may be weak in the second half. With the significant upgrade cycle for 2500G, how do you see the switch business performing for the rest of the year?

That's an interesting question. Focusing on the switching aspect, which is part of our larger Wired segment, we are observing consistent strength in our switching and routing sectors, particularly in data center networking. This robustness is largely attributed to strong data center demand driven by cloud operators. We expect this trend to continue, especially as we introduce new generations of our Tomahawks and Tridents, and later in the year with our DMX router and aggregation switches. The momentum appears to be positive, fueled by the ongoing expansion of data centers, particularly in the cloud, and the launch of several key new products this year.

Good afternoon and thank you for taking my question, and it's great to see the diversity in the business playing out here. On the strong growth in the storage business, I’m assuming some of this is your SSD product lines; I believe you guys are supplying Enterprise SSD controllers into the top two enterprise cloud SSD suppliers. And I think your top customer here just grew their Enterprise SSD business I think 20% sequentially and 20% year-over-year in the December quarter. Wondering if you guys are seeing similar growth trends? And do you expect double-digit growth in the SSD segment for the full year?

I'll be honest: our visibility in the SSDs is not as good as perhaps our customers are. A big part of it is there are three parts to our Enterprise Storage: three broad parts, one is very related to storage server connectivity, that's the RAID part and the Fiber Channel whole part side. Then there are the components we ship into hard disk drives. And hard disk drives have experienced, as you well know, a strong surge over the last several months probably because flash has been in short supply. And the last and smallest part of our business in Enterprise Storage is really related to Enterprise flash controllers for SSD. And that's really a small part. So, we don't get that broad visibility into this SSD market as a lot of other people would. But you're right, right now, it's very, very strong and especially in SAS.

Great. Thanks for the insights there. And then off of the success of Tomahawks and I also hear that your prior generation Trident is still very strong as well and the team is ramping into this upgrade cycle, but you started sampling Tomahawk II, I think it was second half of last year. Can you just give us an update on the qualification, customer feedback, and when should we see the adoption curve for T2 starting to ramp, is that going to be kind of the 2018 timeframe?

For competitive reasons, I prefer not to provide specifics. However, I can say that the response has been very positive. Our entire switch portfolio is experiencing significant momentum. It's important to note that Tomahawk does not completely replace Trident, as Trident serves a different market segment, and both are performing well, along with the Jericho products, which focus on aggregation switching and routing. Overall, our portfolio, from high-end products down to lower-range campus switching solutions, is doing very well. I believe this success is largely driven by the ongoing strength in data center spending, especially as we are seeing a strong transition of enterprises to the cloud.

Great. Thanks so much for taking my question and congrats on the very strong results and outlook. I wanted to address the free cash flow margin trajectory. Tom, I think you referred to some of this in your prepared remarks, but I'd like you to maybe highlight what, aside from the restructuring expenses that are still being paid and the temporarily higher CapEx that you are experiencing, what are the other drivers to get you to the 35% free cash flow margin? And what sort of timing should we think about for that?

William, good question, and I think that's sort of the point of the prepared remarks. If you look at where we are from an operating margin perspective, you look at the fact we restructured the balance sheet around now fixed-rate debt. If you look at our sustainable tax rate of 4.5% and cash taxes of approximately $100 million a quarter, and you take out the restructuring costs, which are bleeding off here pretty quickly, you take out the one-time campus initiative, the one-time tester initiative this year which will sort of play itself out over the next couple of quarters. Frankly, we're largely there. And that's probably the real takeaway, and of course, that doesn't take into account what we would expect to be the second half seasonally uptrends from a revenue perspective.

It's helpful, thank you. One more thing to address is the change in capital allocation strategy that was mentioned last quarter. Could you share your plans for mergers and acquisitions moving forward? With the significantly higher free cash flow expected after the temporary expenses decrease, it seems there will be good support for M&A activities. Could you elaborate on that for us, please?

Yes, I mean there's no real uptick there other than we outlined very clearly that we're going to continue to give back 50% of free cash flows to investors in the form of dividends, which, of course, at these levels would imply that we're going to have the ability to continue to increase the dividend pretty meaningfully here over the next couple of years, certainly. Beyond that, we've used M&A to drive returns, obviously, over the last several years pretty effectively. We continue to see opportunities to do that. Brocade is the latest example of being able to put capital work and an interesting opportunity that drives better returns than our alternative. So, we're going to continue to do that, but given our scale, we have the opportunity to do that mostly off the balance sheet, particularly with smaller opportunities that arise.

Hello, this is Vinay Jaising calling in for Craig. Thanks for giving the opportunity to ask the question. So, I wanted to touch upon carrier aggregation; this is one of the key growth drivers for the RF business. Hock, can you provide us an update on the trends you're seeing by geography for that? And what that means for your portfolio?

Carrier aggregation is particularly advantageous for operators with multiple spectrum bands, as it helps reduce capital expenditure on infrastructure. This capability allows those bands to combine and increase overall capacity and throughput, impacting both the infrastructure and mobile devices. We are among the leading enablers of this technology in mobile devices, thanks to our architectural design and the performance of FBAR filters, which have been effectively integrated into modules that facilitate the combination and separation of various spectral bands. This process has been actively taking place in China and is also progressing rapidly in the U.S. These are the primary regions witnessing this growth, having started with downlink capabilities last year and now advancing into uplink capabilities as well. This contributes to the rising demand for cellular RF technology. We are optimistic about the continued growth and expansion of this phenomenon into other global markets. It's a very interesting point. If we look back to a year ago when we closed the Broadcom transaction, we have been able to expand our gross margin by approximately 40 to 50 basis points each quarter since then. A significant part of this is due to settling down the portfolio, benefiting from larger scale in purchasing materials, and specific actions such as bringing testing in-house and consigning testers to contract manufacturers instead of leasing test time for our high volume of semiconductor chips. Much of this gross margin expansion comes from scale and the ability to leverage direct materials. Additionally, as we transition from one generation to the next, our product margin continues to improve due to a better mix. These two factors contribute to our success. As for where we go from here, honestly, I’m not sure. The best indicator may be to look at our historical performance.

Hi guys, thanks for taking my questions. For my first one, you've talked a lot about free cash flow margins, but I wanted to dig a little bit into the payout ratio. You are paying out right now about a little over 30%, target is 50%. Should we think about that sort of level going up to 50% in line with the margins going up to 35% or more? Or how should we think about the trajectory of reaching your target on the payout ratio that seems like something that's more in your control maybe even quicker than the margins themselves?

Well, they are closely connected, Stacy. What we plan to do, as I've mentioned before, is at the end of the fiscal year, we will review the free cash flow trends and margins from the past year. We will assess the business, with a strong emphasis on sustainability. Our intention is to pay out 50%. You can see that we are gradually improving from where we finished last year to our current position at the end of Q1 and our guidance for Q2. As you pointed out, in line with our policy, we will meet our expectations by the end of the year and should be in a position to increase that dividend to 50% on a trailing twelve-month basis.

Great question. I appreciate the chance to elaborate a bit more. As we have mentioned, we are the technology and market leader in our franchise products. These are significant niche markets, and we achieve our position through substantial investment. We have consistently invested in these areas and develop our products ahead of competitors, which allows us to maintain strong margins. Our offerings help customers differentiate and innovate themselves. Our total investment in research and development is $2.7 billion annually, ensuring we have the best engineers and products in these sectors. This is how we sustain our leadership in our existing franchise products. Regarding certain speculative ventures mentioned earlier, I’m not ruling anything out. If opportunities arise, particularly those that face challenges, we are prepared to consider acquiring successful companies. Thank you.

Great. Thanks for taking my question and congrats on the strong quarter. I had one short-term question and then another longer-term question. On the short-term question, with regards to Wireless, you talked about trends at your Korean customer offsetting the seasonal trends at your North American customer, and therefore you are guiding Q2 to be down only high single-digits relative to history being down about 15%, I recall. Is the upside versus historical seasonality, is that all coming from dynamics at your Korean customer or dynamics in terms of units or content at your North American customer trending better than history as well?

You are really trying to pass the data, aren't you? It's all a combination really. You know that it’s also about the timing of some of the shipments and purchases by our two largest customers. There are several factors at play here. One of which is the differences in timing this quarter. The Korean customer is coming in aggressively to try to recover market share. We are also seeing content increases with each new generation, and this applies to both the Korean customer and the major North American customer. It’s a mix of all these factors. Have I broken it down in detail? No. We don’t analyze it to that extent, but these multiple factors suggest that the downward seasonality we experienced a year ago is perhaps less pronounced this year. There are opportunities for us in China, and the focus of our success and our product success in Wireless, especially with content increases year-on-year, is that we push the cutting edge on technology. Whether it's wireless Wi-Fi connectivity or RF cellular, we push the envelope, primarily for flagship class phones. This is where a significant portion of our business comes from our major North American and Korean customers, along with a few others. That's where our strength lies, as well as where the demand and value for our products can be seen. As China evolves, there is an opportunity for them to transition from feature phones to low-end smartphones and now to premium phones. We're starting to gain traction with those premium phones as long as the brands in China adopt it, which is why we need to provide the technological engineering edge in our products. Until they require more advanced technology, they mostly need the basics. There are exceptions, like carrier aggregation, where we are clearly the leader in providing discrete solutions. However, in integrated smartphones, it's still primarily flagship phones and increasingly premium phones that drive demand. This transition is happening in China, albeit slowly, but we are patient and willing to wait for it.

Yes, good afternoon, guys. Thanks for sneaking me in and congratulations. Hock, my first question is kind of a follow-up on the Enterprise Storage side. You rightfully pointed out that today the SSD controller business is the smallest part of that business. I'm curious as you look out over time, do you see that market developing similar and potentially getting to be the size of the HDD controller market? Or is there something inherent about the growing complexity of raw NAND itself, which means there will always be a large portion of that controller market which is insourced, the guys building NAND actually building their own controllers? Do you think eventually you will end up in a situation where it's all outsourced?

That's a very insightful question. We anticipate that a significant portion of the SSD controllers for Enterprise will be outsourced. The reason for this is that certain intellectual property involved in those Enterprise flash controllers is quite complex and challenging to develop. This situation is somewhat similar to what we see in the hard disk drive channel. The nature of this technology is not overly complex, and the required IP is not excessively advanced, which makes it less likely to provide significant opportunities for us, although it's hard to predict. However, we see a strong demand in the Enterprise sector, where we focus, for specific intellectual property blocks and features that only a handful of companies can effectively provide, and we are among those capable of doing it very well.

That's helpful. And then, Hock, as my follow-up, I think a lot of us in the investment community understand the Wireless, both on the RF and on the connectivity side, the content ASP story. I'm wondering if you could talk a little bit about that same dynamic in your Wired business. And maybe differentiate between switching and routing versus set-top box and broadband access? How do we think about the ASP trends in those two segments over time? Or just your content going into the CapEx dollars being spent in the Wired market?

When discussing switching and routing, it's about more than just chips; it's about the underlying architecture, particularly in high-end data center environments. Our approach extends beyond merely selling silicon; we also offer substantial firmware and software that facilitate the integration of these chips with various OEM customers. This is a distinctive aspect of our business. The driving factor in this sector is the increasing demand for higher throughput, especially in data centers from the top of the rack to the spine. We hold significant advantages due to our robust intellectual property, which allows us to create complex engineering and high-speed interfaces. We are committed to this development, having progressed from 10-gigabit solutions to quickly advancing towards 25 and 100 gigabits. Our investments are aimed at ensuring we lead in producing these advanced products efficiently. As we enhance our features, we also see growth in the value we offer to customers, as moving from 10-gigabit to 100 gigabit is substantial. In broadband, while there are parallels, the market evolves more slowly due to its stability. For example, the transition to 4K and eventually 8K video delivery is evolving, although the acceptance of 8K might be limited by human perception. However, it's a demand we can meet. Broadband development is steadier, even amidst the excitement around OTT platforms, which we are involved in. In data centers, the influx of data due to expanding social media demands more robust solutions, which is reflected in the recent strong demand for switching and routing technologies.