Broadcom Inc (AVGO) — Q2 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. After the market closed today, Broadcom distributed a press release and financial tables describing our financial performance for the second 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 second quarter fiscal year 2018 results, guidance for our third 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, and good afternoon, everyone. I am very pleased with our execution in the second quarter of fiscal 2018. We drove gross margin to 66.6%, EBITDA to 52.3%, and free cash flow to 42.3% of revenue. All record achievements for us and a continued demonstration of our robust business model. We were also quite active in executing on our recently announced stock repurchase program. Since the announcement, over a six-week period through June 1, 2018, we have returned approximately $1.5 billion to stockholders by repurchasing more than 6.4 million shares. And we do intend to continue to be active. Consolidated net revenue for the second quarter was $5.02 billion, just above the midpoint of guidance, with strong wired and enterprise storage results offsetting weaker wireless revenue. As a reminder, before I go and give you more color into this quarter, the second quarter of fiscal 2018 was a 13-week quarter, while the prior quarter, Q1, was a 14-week quarter. Segment revenue comparisons reflect this as I discuss performance by segment. Starting with wired. In the second quarter, wired revenue was $2.3 billion, growing 9% year-on-year and 22% sequentially. The wired segment represented 46% of our total revenue. Second quarter wired results reflected a strong sequential increase in demand from cloud data centers and a seasonal recovery in broadband access. Solid year-on-year growth was driven by a robust increase in networking and compute offloading in cloud data centers and strong growth spending by enterprise IT. We also benefited from an increase in spending on broadband capacity expansion by service providers. In contrast, spending on video access and in the China optical markets remained sluggish. Turning to the third quarter fiscal '18, we expect growth in the wired revenue side to continue, notwithstanding the ban on shipments to ZTE. We expect demand to remain healthy from cloud data centers and enterprise IT, while broadband access remains robust. Moving on to wireless. In the second quarter, wireless revenue was $1.29 billion, growing 13% year-on-year but declining 41% sequentially. The wireless segment represented 26% of our total revenue. The second quarter sequential decline in wireless revenue was deeper than usual, as shipments to our North American smartphone customers reduced sharply from typically exaggerated first quarter. We did partially offset this decline with an increase in our product shipments to a large Korean smartphone customer as they supported their new product launch. Looking ahead to the third quarter, we expect to see the beginning of a seasonal second half ramp in demand from our large North American smartphone customer as they start to transition to their next-generation platform. However, we expect this strength to be offset by a decline in shipments to a large Korean customer. As a result, we are expecting our overall wireless revenue to be flat, maybe even slightly declining on a sequential basis for the third quarter. Let me now turn to enterprise storage. Second quarter 2018 enterprise storage revenue was $1.16 billion and represented 23% of our total revenue. This, of course, included a full quarter of contributions of over $400 million from the recently acquired Brocade Fiber Channel switch business. As you may recall, we completed the acquisition of this business early in our first quarter of fiscal 2018. And as reported, enterprise storage segment revenue grew 63% year-on-year and 17% sequentially. But if we exclude Brocade's contribution, second quarter enterprise storage revenue would have shown stable year-on-year performance with strong growth from enterprise server and storage markets, partially offset by softer demand from the hard disk drive market. For the second quarter, overall sequential revenue growth was driven by broad strength from the enterprise IT sector. Looking ahead to third quarter fiscal 2018, we expect continued spending in enterprise IT to drive sequential growth in enterprise storage, and growth in cloud storage capacity will lead to a recovery in hard disk drive demand. Finally, our last segment, industrial. In the second quarter, industrial segment revenue was $263 million, growing 17% year-on-year and 5% sequentially. The industrial segment represented 5% of our total revenue. Resales continued to remain very strong with 20% year-on-year growth. And we expect this momentum to continue into the third quarter. Notwithstanding the strength today, we expect annual industrial revenue growth, however, to be in the mid-single-digit range on a long-term basis. So, in summary, our overall business remains robust and stable. Our third quarter fiscal 2018 outlook reflects this with the consolidated revenue focus of $5.05 billion at the midpoint, as we experience continued strength in wired and enterprise storage, benefitting from a very robust cloud data center and enterprise IT spending environment. Year-on-year, our revenue growth has remained very sustainable. Even without contributions from Brocade, organic revenue growth for the second quarter would have been in the high single digits. And for the third quarter, we foresee this year-on-year organic revenue growth to modulate towards our long-term target of mid-single digits. We will continue to keep a consistent focus on improving margins and increasing free cash flow from our business. Our balance sheet continues to be strong with over $8 billion in cash at the end of the second quarter. We also have $10.5 billion remaining on our stock repurchase authorization as of June 1st, and reflecting the very strong free cash flow generation, we expect that during the balance of fiscal 2018, we plan to continue to aggressively repurchase our shares as long as we believe that we can generate superior returns in doing so. With that, let me turn the call over to Tom for a more detailed review of our second quarter financials and third quarter outlook.

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 broadcom.com. Let me quickly summarize our results for the second quarter of fiscal 2018. Second quarter net revenue was $5.02 billion, in line with guidance. Our second quarter gross margin from continuing operations was 66.6%, 60 basis points above the midpoint of guidance. We did benefit from a more favorable product mix in the quarter, driven by higher than expected revenue from our wired segment and lower than expected revenue from our wireless segment. Operating income from continuing operations for the quarter was $2.46 billion and represented 48.9% of revenue. Adjusted EBITDA for the quarter was $2.63 billion and represented 52.3% of revenue. Our days sales outstanding were 50 days, a 5-day increase from the prior quarter as we saw a reduction in linearity of revenue across the quarter. Our inventory at the end of the second quarter was $1.26 billion, a decrease of $56 million from the prior quarter. Days on hand remained flat from the prior quarter at 67 days. We generated $2.31 billion in operational cash flow, which reflected the impact of $117 million of cash expanded on acquisition and restructuring related activities including Qualcomm and Brocade. Please also note that we did not make any interest payments in the second quarter as these are made on a biannual basis in the first and third quarters of our fiscal year. Capital expenditure in the second quarter was $189 million or 3.8% of net revenue. As a housekeeping matter, I would also note that CapEx was $61 million higher than depreciation. Free cash flow, which is defined as operating cash flow less CapEx in the second quarter, was $2.12 billion or 42.3% of net revenue and reflects the impact of acquisition and restructuring expenses. On the buyback, just to give you some more clarity, in the second quarter, we spent $347 million on repurchasing 1.5 million shares. These repurchases took place over the last two weeks of the quarter. Over the first four weeks of the third quarter, we have spent an additional $1.16 billion, repurchasing 4.9 million shares. In addition, we returned $766 million in the form of dividends and distributions in the second quarter. Turning to our balance sheet, we increased our cash balance by $1.1 billion through the second quarter and ended the period with $8.2 billion in cash and $17.6 billion in total debt. Now, let me turn to our non-GAAP guidance for the third quarter of fiscal year 2018. 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 $5.05 billion, plus or minus $75 million. Gross margin is expected to be 66.5%, plus or minus 1 percentage point. Operating expenses are estimated to be approximately $882 million. The tax provision is forecasted to be approximately 7%. Net interest expense and other is expected to be approximately $115 million. The diluted share count forecast is for 457 million shares, and it does not include the impact from any share repurchases done after June 1, 2018. Stock-based compensation expense will be approximately $320 million. CapEx will be approximately $125 million. As you may recall, in connection with the redomiciling to the United States and as a result of the effects of U.S. corporate tax reform, we had initially expected our effective cash tax rate on a steady state basis to be in the range of 9% to 11% per year. Following the redomiciliation, we currently expect our cash tax rate for the balance of fiscal year '18 to be approximately 7%, and our long-term cash tax rate to remain in a 9% to 11% range. That concludes my prepared remarks. Operator, please open up the call for questions.

Hi, guys. Thanks a lot, and I have a few questions. I want to start off on the wired side. Last quarter, there was a lot of debate about why the year-over-year growth slowed so much, and you guided for confident sequential growth that you just delivered. Talk a little bit about the visibility going forward. What’s driving the slight growth that you’re guiding to in the fiscal third quarter? And can you still hit the mid-single-digit growth for the fiscal year in that wired segment?

The wired segment for us, especially the networking part of it, we have very good visibility right now, and it’s largely driven, as I indicated in my prepared remarks, from the cloud data center guys, the big cloud data center guys. What we also see, and that’s probably less visible, is very strong spending patterns at enterprise. I call that the enterprise IT environment, the more traditional enterprise. Those guys have also been spending. So, when you combine the two together, that portion of our wired infrastructure, as it relates to networking broadly as we describe it, is very strong. And of course, as an aside, a separate segment we call enterprise storage benefits along with that. So that’s why we see very strong business in what storage, I call near line or what I call data center storage business, very, very strong, in many of the situations because the cloud data center guys tend to spend in a fairly lumpy manner. So, you get that visibility as opposed to a more secular or trended manner as the enterprise IT guys are doing. So, to answer your question, bottom line, that will drive our wired business to hit our goal of mid-single-digit year-on-year for this year.

Perfect. Then, I guess, as my follow-up, switching gears onto the wireless side of things. It’s good to see that your big North American business is starting to turn up and that the business as a whole has stabilized. Can you just talk about whether via content or the unit side, how you think about seasonality in the back half of the year, given that there are so many different moving parts of content per SKU and what different customers are doing?

There are many factors to consider. It’s simpler to evaluate everything on a total and comprehensive basis, and there are some unusual elements that we anticipated. As we transition from the iPhone 8 to the iPhone 9 generation, we are being cautious about the build levels. However, we are also noticing that orders are coming in with what I would describe as a typical seasonal strength. Bookings from North American customers extend close to the end of this calendar year. This aligns with the normal patterns we discussed. The key difference lies in the ratio of new generation phones to legacy phones, which may introduce some uncertainty regarding potential changes or increases in content. Honestly, the outlook is a bit unclear because it’s challenging to forecast the mix between new generation and legacy phones.

Yes. Thank you. Hock, just more of a strategic question of how you view the business. So, some of the pushback on the company is that you’ve been so acquisitive that there is a feeling that there is a need to do more M&A. So, just a few things on that. Number one, with the current makeup of the business, can you talk about the long-term growth profile as you see it? And then the second part would be, now that you’re buying back stock, your view of the opportunities to do M&A versus return cash through buybacks?

That's a great question. Regarding the long-term growth of our Company and the various franchise businesses that make up our operations, we have consistently indicated that there is no reason to alter our long-term outlook, which suggests an average compounded growth rate in the mid-single digits over an extended period. Our business model continues to support this expectation, and we have no indications that would suggest otherwise. Year over year, you may see some fluctuations around that mid-single-digit growth. For instance, in 2017 compared to 2016, we experienced strong organic growth, excluding the impacts of acquisitions, with nearly mid-double-digit growth in 2017. Looking at 2018, I don’t anticipate that mid-teen growth rate to persist. While it's just one year of data, we expect growth in 2018 to remain above mid-single digits but moderate down to perhaps high single digits in a conservative estimate. This expectation aligns with the natural pace of our business, particularly within the connectivity solutions sector, which cannot outpace the overall growth of the semiconductor industry, excluding memory products. There's an inevitable modulation toward industry growth rates, and the variations we observe typically stem from the cycles characteristic of technology businesses. As each new generation of products emerges, there is variability in product life cycles. This can range from handsets with an 18-month cycle to storage solutions that may last 5 to 6 years or even longer in industrial applications. Each new generation does bring growth that can exceed GDP rates, which is why we still believe in that mid-single-digit growth trajectory on a global scale. Although short-term variations are evident, such as in 2017 and anticipated in 2018, over a long enough timeframe, we are confident this will trend back toward mid-single digits.

And then, just as a second part of that question around how you’re evaluating M&A opportunities versus the aggressive steps you’re taking on the buyback?

We can pursue both strategies since our decisions are based on return on investment as we generate cash. Our cash flow generation has been strong, as Tom mentioned, especially in the last quarter, which is consistent with our performance. Looking ahead, our cash flow generation remains robust, with over $2 billion in free cash flow last quarter. This is significantly influenced by the reduction in capital expenditures, which had consumed a large portion of our cash flow over the past two years due to investments in capacity and global campus expansions. Now that those programs are nearing completion, our capital expenditures have decreased considerably. As Tom indicated, we expect our capital expenditure levels to be much lower than in previous years and quarters. This substantial cash generation opens up more flexibility for us, allowing us to explore mergers and acquisitions while also investing in assets that generate strong returns, like our own shares, which have produced more than $8 billion, reflecting an 8% cash-on-cash return. We will continue to engage in share buybacks, especially given our strong cash generation. However, that doesn't mean we will stop pursuing M&A opportunities. We will continue to evaluate and act on potential M&A deals based on our cash criteria and expected returns.

This is Gabriel Ho calling in for Ambrish. Thank you for taking my question. I believe this question is for Hock. The guidance for wireless seems to suggest flat year-over-year growth for the fiscal third quarter. My understanding is that last year, the phone at your large smartphone OEM customer arrived later than usual. Why is wireless revenue not experiencing growth? Is it related to the content or is it more about the number of units?

It’s difficult to evaluate it on a quarterly basis for several reasons. In my comments, I was quite clear. At this time last year, in the third quarter, we had both the North American smartphone manufacturer and the Korean high-end phone manufacturer trending positively. While we still have a favorable outlook on the North American phone manufacturer, we are not experiencing similar strength with the Korean phone manufacturer. That is, as I mentioned in my prepared remarks, the main reason we are observing that discrepancy.

If I understood your question correctly, you’re inquiring about operating leverage and the model moving forward. Looking at the operating expenses, they have largely stabilized at these levels. We might see a slight decrease, especially as we approach 2019, but we don’t anticipate a significant increase from this point. We believe there is still considerable leverage available from a gross margin perspective. We have consistently observed the expansion of gross margins over the past several years, and we expect this trend to continue. Therefore, we are confident that we have ample capacity to enhance our operating margins. As Hock mentioned, capital expenditures are decreasing. This company is primarily fabless and has low capital expenditure needs based on its fundamentals. We are targeting capital expenditure around $100 million per quarter, which indicates that it will be closer to 2% of revenue. Consequently, our goal for free cash flow margins is 40%, and we believe there is potential for further improvement, likely exceeding 40% when considering these figures.

I want to ask about the guidance. It sounded like all the segments would be improving, but then you mentioned not to discuss ZTE. I'm curious about the impact of that. Additionally, regarding wireless, I’d like to understand the difficulty in determining content, as legacy is just one part, but there's also the share aspect. Can you provide insight into your visibility of your share with that North American customer? Thank you.

We don't want to discuss share because it doesn't significantly impact us. It may be important to others, but for us, we view our business through the lens of 20 product divisions across four segments. Some segments are performing better than others from quarter to quarter, but overall, we're very stable and sustainable. In response to the first part of your question about ZTE, we're aiming to take a high-level perspective. Until we are able to ship products to ZTE, we prefer not to comment on that situation. Currently, our products are not shipping, and that's our stance at this time.

Yes. Thanks for taking my questions. I just have two as well. First, just on capital allocation. Now, that buybacks are part of your broader capital allocation, does the bar for M&A for deals essentially become higher because plan B would be assuming to buy your own stock, buy something at an 8% cash yield with no integration issues? So, I’m curious, does the bar for deals become higher, or how do you look at the cash on cash targets today now that you have the option to do buybacks?

I think Hock said it well. I’ll just reiterate it, maybe with a little bit more color. But basically, it’s a returns-driven phenomenon. You can see our views on the returns of buying back our own stock based on our execution to buy back over the last month plus. So, I think that’s self-evident. Going forward, as Hock said, we always look to drive double-digit returns from an M&A standpoint. Obviously, we think we know how to do integration. And so, we’ll take a risk-adjusted view of it. But as long as we think we can find opportunities that are well in excess, we can buy our own stock at, we’ll obviously take a very close look at that. But without that in mind, obviously the stock over the last month plus is what we try to do based on the stock that we brought back and we continue to do so, as Hock said given the returns.

We do not provide forecasts beyond one quarter, let alone for the entire year. We have no intention of changing this practice because it would lead to excessive speculation in every earnings call. Instead, we will share a strategic overview, which remains unchanged. We hold strong positions in every segment, particularly in wireless. We do not discuss year-long projections.

Yes. Good afternoon, guys. Tom, congratulations on the strong quarter. Thanks for letting me ask the question. Hock, just maybe I’ll ask the wireless question a little bit differently. I understand the impact that the mix might have as far as your revenue growth in the back half of the year. But as you think sort of flagship to flagship at your North American customer, how should we think about content growth this time around? And perhaps differentiate between RF and other applications. And I guess, with the RF stack, we’ll start to see some initial 5G modems coming out at the end of this year, just wondering what kind of visibility you have for continued growth of RF as the world transitions from 4G to 5G?

Strategically, as we delve deeper into 5G, particularly in the ultra-high band frequency spectrum, which generally refers to anything at 3 gigahertz and beyond, we are moving towards more advanced systems that are well established and recognized. The timing and manner of 5G implementation are crucial, as the initial phones marketed as 5G may not truly meet the full standards of 5G, leading to less rigorous performance specifications. Manufacturers might opt for softer alternatives, especially in the lower-end models, to achieve acceptable performance without fully addressing the requirements. However, as we advance further into 5G, more sophisticated filters will be necessary for optimal functionality. Looking at the long-term, it is clear that content will increase, not only in the number of frequencies but also in those that will require higher capabilities. Beyond that, the future remains uncertain.

Thanks for the insight there, Hock. And then a question for Tom. You guys have a full quarter of Brocade under your wings. You were targeting $900 million in annualized EBITDA, post synergies, with 60% EBITDA margins. Just given the Company’s total margin profile that you’re driving right now, seems like you guys are kind of already there, but wanted to get your view. Can you just help us level set where you are relative to your target and how much more you think you can drive versus prior expectations?

Sure. Good question. At this point, we feel very positive about Brocade. Revenues are strong, which is well-known as a public company. A lot of this strength is seen in the storage business and its results. Regarding margins, this is a deal that enhances our margins. Most of the operating expenses have been addressed, with only a little left to tackle. Overall, this is a business that is meeting or even exceeding our expectations. I prefer not to go into further details.