Broadcom Inc (AVGO) — Q1 2018 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 the market closed today, Broadcom distributed a press release and financial tables describing our financial performance for the first quarter of fiscal year 2018. 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 first quarter fiscal year 2018 results, guidance for our second quarter of fiscal year 2018, 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. We really had a very good start to our fiscal year 2018 with first quarter revenue and earnings towards the upper end of our guidance. First quarter revenue of $5.33 billion grew 28% year-on-year and 10% sequentially. On the income front, earnings per share were $5.12, which grew 41% year-on-year and 12% sequentially. However, please don’t get too excited by this as Q1 was actually a 14-week quarter and did include a partial quarter contribution from Brocade, which we closed during the quarter. Having said this, we do expect business conditions to remain favorable in our second quarter as well. Although the revenue mix by segment will be quite dramatically different. First quarter revenue, after adjusting for Brocade contribution, was driven by wireless growth. We expect the second quarter to be driven by double-digit growth from our other three segments, offsetting a sharp seasonal decline in wireless. As a result, thanks to diversification, second quarter top-line stability is expected. Let's dive deeper into performance by segment. Starting with wired infrastructure. In the first quarter, wired revenue was $1.88 billion, declining 10% year-on-year and 13% sequentially, representing 35% of our total revenue. As expected, first quarter wired results reflected the bottom of the seasonal decline in demand for both our set-top box and broadband carrier access products. The known weakness in optical access and metro end markets impacted us this quarter. However, demand was strong from datacenters, and cloud shipments remained stable. Turning to the second quarter outlook for fiscal 2018, we have a different picture, as demand in this wired segment returns with a vengeance. We project strong double-digit sequential revenue growth. This growth is driven by a very strong increase in demand for networking products from cloud and data centers, as well as a weighted seasonal recovery in broadband carrier access. Set-top boxes remain flat. Now, the situation in wired is in sharp contrast to wireless. In the first quarter, wireless revenue was $2.2 billion, growing 88% year-on-year and 23% sequentially. The wireless segment represented 41% of total revenue. First quarter 2018 wireless revenue growth was driven by the ramp of the next-generation platform from a large North American smartphone customer, which had been pushed into the first quarter from the fourth quarter as compared to prior years. This push-out, coupled with a significant increase in our content for this new platform, drove the substantial year-on-year growth in revenue in the first quarter. However, as we look into the second quarter of fiscal '18, we expect a larger than typical seasonal decline in wireless revenue, as shipments to our North American smartphone customer will trend down sharply from the exaggerated first quarter. We expect to partially offset this decline with an increase in product shipments to support the ramp of the next-generation flagship phone at a large Korean smartphone customer. Notwithstanding such volatile seasonality, year-on-year revenue growth for Q2 in this segment will still be in the double digits. Turning to enterprise storage. In the first quarter of 2018, enterprise storage revenue was $991 million, which included approximately $330 million in partial quarter contribution from the recently acquired Brocade Fibre Channel switch business. Enterprise storage segment revenue grew 40% year-on-year and 54% sequentially. Without Brocade's contribution, however, first quarter enterprise storage revenue would have resulted in flat but still stable performance sequentially. This segment represented 19% of our total revenue for the first quarter. The Brocade revenue in the quarter was actually higher than our prior expectation of $250 million, driven by stronger than expected demand for Fibre Channel SAN switches. Our server and storage connectivity products also had a strong quarter with a substantial increase in revenue driven by a ramp in Purley generation server shipments, although this growth was partially offset by a decline in our hard disk drive business as demand bottomed out during the quarter. Into the second quarter of fiscal '18, we expect strong double-digit sequential growth in revenue in enterprise storage, driven by robust demand from both enterprise and datacenters. Finally, in the industrial segment, first quarter revenue was $251 million, representing 5% of total revenue. Industrial product revenue remained robust, growing by over 20% year-on-year, with resales also growing by 20% year-on-year and trending up 7% sequentially. Looking into the second quarter, we expect strong double-digit sequential growth in industrial product revenue, and we continue to expect resale to trend up by the same amount. In summary, we delivered very strong financial results for the first quarter and completed the acquisition of Brocade during that period. Our second quarter fiscal 2018 revenue outlook reflects the benefit of a well-diversified product portfolio. We expect to fully offset the impact of a much higher than normal seasonal decline in wireless revenue with strong increases in our wired, storage, and industrial segments. As a result, we expect second quarter revenue to be sequentially flat at $5 billion on a normalized 13-week basis for the quarter. However, the change in product mix will have a dramatic impact on second quarter gross margin, which we expect to expand sequentially by 100 to 150 basis points. Tom will provide more color during his earnings guidance commentary on the impact this will have on our Q2 profitability. With that, let me turn the call over to Tom for a more detailed review.

Thank you, Hock, and 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 in the earnings release issued today and is also available on our website at www.broadcom.com. Let me quickly summarize the results for the first quarter of fiscal ’18, focusing primarily on balance sheet and cash flow items. We delivered strong financial results for the first quarter, starting with revenue of $5.33 billion, which was at the upper end of guidance. Our first quarter gross margin from continuing operations was 64.8%, 80 basis points above the midpoint of guidance as we benefited from a more favorable product mix in the quarter, driven by higher than expected revenue from the Brocade fiber channel SAN switches. Operating income from continuing operations for the quarter was $2.6 billion and represented 48.2% of net revenue. EBITDA from continuing operations for the quarter was approximately $2.7 billion, representing 50.6% of net revenue. Our day sales outstanding are running on target at 45 days, a one-day decrease from the prior quarter. Our inventory at the end of the first quarter was $1.3 billion, a decrease of $156 million from the prior quarter as we depleted wireless inventory built up to support the large ramp in first quarter shipments. We are pleased with this level of inventory going into the second quarter. We generated $1.7 billion in operational cash flow, which reflected the impact in the first quarter of approximately $460 million in payments of annual employee bonuses for fiscal year '17, $240 million of cash expended primarily on Brocade restructuring acquisition-related activities, and an additional $129 million payment to fund the legacy pension plan. Capital expenditure in the first quarter was $220 million or 4.1% of net revenue. Our free cash flow defined as operating cash flow less CapEx in the first quarter was $1.5 billion or 27.5% of net revenue. Without those one-off items, I would note, free cash flow as a percentage of net revenue would have been 43%. As a housekeeping matter, CapEx was $94 million higher than depreciation in the quarter. We expect CapEx to continue to trend down and approach our long-term target of 3% of net revenue in the second half of fiscal '18. We also continue to make significant progress in increasing our free cash flow per share. For the first quarter of fiscal '18, free cash flow per share was $3.39, based on 410 million outstanding ordinary shares and 22 million LP Units. More importantly, on a trailing 12-month basis, free cash flow per share for the period ending Q1 '18 was $13.79, an increase of 71% compared to the trailing 12-month period ended Q1 '17. Now, let me turn to our non-GAAP guidance for the second quarter of fiscal year '18. 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 $5 billion, plus or minus $75 million. Gross margin is expected to be 66%, plus or minus 1 percentage point. Operating expenses are estimated to be approximately $890 million. Tax provision is forecasted to be approximately $103 million. Net interest expense and other is expected to be approximately $114 million. The diluted share count forecast is for 461 million shares. Share-based compensation expense will be approximately $305 million. CapEx will be approximately $190 million. Our second quarter gross margin guidance anticipates a very favorable revenue mix, driven by strong high-margin networking and enterprise storage product sales and a more than seasonal decline in relatively lower margin wireless product sales. Our guidance for second quarter operating expenses includes a full quarter of Brocade expenses and anticipates our typical increase in employee payroll taxes from the annual vesting of RSUs in the quarter. Please note that after we complete our readjustments on affiliations in the United States, we expect our effective cash tax rate to be approximately 10%. We expect to start reflecting this new rate in our non-GAAP results starting with the third fiscal quarter of 2018. In the second quarter, we are anticipating healthy free cash flow and expect to deliver results above our target model of 40% of revenue. Before we open the call for questions, I would like to briefly address this week’s events. Yesterday, we announced that we have withdrawn and terminated our offer to acquire Qualcomm. We've also withdrawn our slate of independent director nominees for Qualcomm's 2018 annual meeting of stockholders. Although we are disappointed with this outcome, we will comply with the order issued on Monday March 12, 2018 regarding the proposed transaction. Importantly, we appreciate the overwhelming support we received from Qualcomm and Broadcom stockholders throughout these past few months. We have to say that we are touched by the ISS report issued just last night that continues to recommend the Broadcom independent nominees and by our understanding that, based on the vote tally as of today, the 11 Qualcomm nominees are only garnering between 15% to 16% of the outstanding shares. In any event, back to Broadcom. Consistent with our announcement in November to redomicile the Company, we continue to believe the U.S. represents the best location from which to pursue our strategy going forward, and we don’t see this week’s events putting any constraints on our ability to pursue acquisitions more broadly. Therefore, we continue to move forward with our redomiciliation to the U.S. and now expect to complete this process after the close of the market on April 4th. This timing will allow us to hold our annual meeting of shareholders on April 4th as presently scheduled. Our special meeting for stockholders to vote on redominciliation will still be held on March 23rd. With this, we know many of you are asking what’s next. Hock and I have had the last couple of days to reflect on this. First and most importantly, we remain focused on delivering superior returns for our shareholders. Broadcom benefits from a long history of technology innovation, engineering excellence, and product leadership across our 20 franchise businesses. We believe this will allow us to sustain mid-single digit revenue growth and increasing operating and free cash flow margins. To reflect our confidence in the sustainability of the current business, we will continue targeting aggregate dividends of approximately 50% of free cash flow. This should afford us the opportunity to provide material dividend increases in the future. The allocation of the remaining 50% of free cash flow is governed by the returns we believe we can drive via acquisitions versus buying AVGO stock and/or paying down debt. As you all know, Hock and I are quite familiar with the industry landscape. Sitting here today, we see potential targets that are consistent with our proven business model and that can drive returns well in excess of what we would otherwise achieve by buying our own stock and/or paying down debt. If this view changes, rest assured, we will not hesitate to change our approach. Providing superior returns for shareholders has been and always will be our focus. One final point I want to make. Qualcomm was a unique and large acquisition opportunity. Given the maturity of the industry, the consolidation it has seen, and our relative size now, our future acquisitions are likely to be funded with cash available on our balance sheet without the need to stretch our balance sheet much beyond our current financial policy of two times net leverage. I would like to remind you that the purpose of today’s call is to discuss our quarterly earnings. Consistent with our previous call, please keep your questions focused on today’s financial results. We will not be commenting in Q&A on this week’s events. That concludes my prepared remarks. Operator, please open up the call for questions.

Yes, thank you. Hock, can you talk about the strong rebound expected in the wired segment? I know you mentioned datacenter continues to be strong. Also, anything around traditional enterprise? We are seeing some rebound in enterprise IT spending, and how much of that helps the segment a bit?

We’ve seen strength and we saw it obviously in bookings in Q1 for shipments in Q2. We saw a lot of strength in both enterprise as well as cloud datacenters in both respects. It’s just strong across the full range of our networking products that I commented on. We also saw strong bookings which will translate into revenues obviously in Q2, a very strong revenue recovery in our broadband carrier access, which reflects DSL, digital subscriber line, PON, and attached enterprise and carrier Wi-Fi. That’s typically seasonality, and it came back very, very strongly. What we don’t see a sharp recovery in is fiber optics in networking, though fiber optics out of datacenters continued to show renewed strength. Basically, both datacenter and cloud are showing strength, as well as enterprise, to offset what I call, metro networks, and in our case, still continued flatness in set-top box.

Got it, thanks for all the color there. And then just a quick follow-up for Tom just on Brocade, the integration. Now that you have the business, how do you see it performing? And is there anything we should be aware of just from a margin perspective as you take some cost out?

Yes. We’ve been really pleased with Brocade. Obviously, that’s something that’s been in the works for some time. The business we targeted there was the SAN switching business. It’s continued to be as we envisioned throughout not only the close period but has a very good start as part of Broadcom going forward. Clearly, it’s a unique asset from a financial standpoint as well; it’s margin accretive to the Company. We see that continue to contribute positively to earnings and free cash flow. It echoes some of the comments I made in the prepared remarks, reflecting the kind of transactions we’re looking to target going forward.

Hock, I just want to talk about the wireless business. I think everybody is pretty up-to-date on why the volatility both to the upside and then to the downside in the April quarter, given what your largest customer is doing. I want to think a little bit longer term. As we think about the rest of this year and next year, can you talk about what you see from a content perspective across the two components of your wireless business as well as from a market share perspective?

Let’s talk about content first. On a sustained basis, I’ll put it over the next five years, across multiple sockets, we have been positioned to see double-digit growth. We do not see a change in that trend. We have the technology and market share where we continue to invest significant amounts of money for further innovation. The bottom line is that in those businesses, what we worry about are the ankle-biters. To be honest, their biggest problem is that they cannot bite above the ankle.

How about on the share side of things?

In terms of market share, we have positioned the business to lead in all core areas.

Okay. And I guess as my follow-up question, one for you, Tom. You made it pretty clear about the use of cash flow on the dividend side, the 50-50 split. But your commentary about what you may do with the other 50%, give a little more detail than we’ve heard in the past. You included the phrase about paying down debt and share repurchases. Was that meant to signal something increased probability or are you just stating the obvious as far as potential uses of the other 50%?

What it’s trying to reinforce is that Hock and I are focused on doing what’s in the best interest of shareholders. We had the opportunity to reflect after this week’s event on the forward capital allocation strategy. We feel looking at the landscape, that the strategy we’ve had in place here for quite some time remains the value to drive returns. So, we want to maintain that focus on shareholder returns. If that strategy no longer presents these types of returns, we will focus elsewhere.

Hi, guys. Thanks for taking my questions. First, given the gross margin upside in Q2 on the heavy mix shift of the businesses, how should we be thinking about the drivers of gross margin into the second half of the year?

There are a couple of things going on, both short-term and long-term. Short-term, when you look at the seasonality in the business over the fiscal year, the second half of the year is typically more wireless-weighted. Wireless tends to carry slightly lower gross margins. I wouldn’t get too excited in terms of where gross margins go from here through the end of this fiscal year. Long-term, consistent with the driving model, we continue to see content gains and strong product leadership across our businesses. We continue to add unique capabilities that should help sustain the gross margin expansion trend.

My follow-up question is about the sustainability of the storage segment. We’ve seen some upside; Brocade was stronger than you had expected. How should we think about the sustainability of that growth?

In enterprise storage, we have strong positions in the LSI businesses and SaaS connectivity, which can have a cyclical move. The HDD market is in structural decline but we still have good positions with those product lines. The Brocade acquisition is expected to be quite stable, and we think overall should provide low single-digit growth in revenue as we consider annual performance.

The only volatile part is the hard disk drive business. The other components in enterprise storage are very stable, growing low single digits. Even with recent fluctuations, we see the enterprise storage business remaining quite stable and profitable.

Yes. Good afternoon, guys. Congratulations on the strong results. Hock, my first question goes back to the wired segment in the January quarter. I’m still trying to figure out that business being down 10% year-on-year, and you characterized it as a seasonal low. But I would assume the year-over-year compare would touch that. As you think about long-term growth in this business, how does this business fit in? This is likely to be one of the businesses investors may pay a higher multiple on. Can you provide clarification?

To try and answer technically, first, year-on-year comparisons were impacted by exceptional items a year ago related to asset sales during integration. The wired business has two parts—datacenters and service provider—only half is stable, while the other half is volatile, reflecting seasonality. We see significant potential for growth in enterprise and datacenters, especially related to bandwidth needs. The April strength demonstrates this.

That’s helpful, Hock. And then, Tom, for my follow-up, regarding OpEx trends going from April to the second half of the year?

You have the payroll uptick from RSUs and other Brocade-related costs, but we expect OpEx to trend slightly down moving into the second half of the year. We are mindful of these ongoing dynamics.

Thanks for taking my question and congratulations on continued strong execution. For the first one, Hock, I wanted to ask about the wired segment again. Setting aside the seasonal aspects, what is the right way to think about a two to three-year growth rate for the wired business? Is the set-top box going to be a long-term headwind?

On average over a five-year period, I would say it will run at mid-single digits overall. For wired infrastructure, enterprise datacenters are growing fast while the service provider portion is more seasonal and flat. The growth in enterprise and cloud products will sustain that average.

I appreciate that you want to talk about earnings, but acquisitions have been key to your strategy long-term. Most of your targets have been digital and logic companies. Are you open to also looking at analog or microcontroller assets?

We’re open to any acquisitions that align with our business model and provide returns exceeding alternatives. Brocade was an example of that and will remain part of our strategy going forward.

On the wireless side, Hock, you talked about mid-teens content growth. Is pricing dynamics expected to change due to some of your larger competitors struggling to drive growth?

The dynamics at the high end of the market suggest that flagship manufacturers must innovate and drive features forward. Components such as RF front ends and connectivity win in the high-bandwidth ecosystems of 5G. The need for these fundamental components ensures that we will see growth.

Tom, can I ask about the convergence of net income margins and free cash flow margins? When do you see both aligning without the one-time items?

These two metrics are converging now. We expect the adjustments for the one-off items to reveal operating performance better aligned with our net income. So, as we progress into Q2, that should become more apparent.

Thank you for taking my question and great to see the diversification in the business. Hock, you provided a longer-term view on wired, more near-term. Do you expect your wired business to grow in fiscal 2018 compared to fiscal 2017?

Yes, for sure. Our fiscal '18 is projected to grow compared to fiscal '17, driven by the continued strength in the datacenter and networking products, addressing bandwidth needs.

The strength in your ASIC business is impressive. Can you talk about the differentiators you bring to the mixed signal analog ASICs, keeping your pipeline strong?

Our mixed signal capabilities, particularly in analog-to-digital conversion, give us a leading edge in creating unique solutions. The return on investment for these projects ensures that we remain disciplined, driving further innovation without unnecessary risk.