Broadcom Inc (AVGO) — Q1 2019 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 first quarter of fiscal year 2019. If you did not receive a copy, you may obtain the information from the Investors section of Broadcom's website at Broadcom.com. This conference call is being broadcast 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 2019 results, guidance for fiscal year 2019, and commentary regarding the business environment. We will take questions after the end of our prepared comments. 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. 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 table attached to today's press release. Comments made during today's call will primarily refer to our non-GAAP financial results. So with that, I'll turn the call over to Hock.

Thank you, Bea, and thank you everyone for joining us today. We had a good start to fiscal 2019, growing 9% in our first fiscal quarter compared to the same period a year ago. The strength of our business model delivered another quarter of sustained revenues, strong earnings, and an extremely strong free cash flow. Our semiconductor business helped us relatively well. Not surprisingly, our wireless business was down sharply and our storage business underperformed somewhat. However, these challenges were more than mitigated by our networking business, which grew double digits year-over-year. In addition, we were very pleased to see that the broadband business has started to recover and stabilize in the quarter. In fact, putting it all together, the semiconductor segment was actually up year-over-year in the first quarter, if you exclude the expected sharp decline in wireless. Turning to infrastructure, this business which includes SAN switching, mainframe, and enterprise software delivered solid top line results, benefiting from a very robust enterprise spending environment. The integration of CA onto the Broadcom platform is very well underway, and we are confident that we can meet, if not exceed, the long-term revenue and profitability target that we laid out for CA to you last year. In fact, renewals in our CA business have been strong this past quarter, and we believe the dollar commitments from our core customers will continue to grow. Many of our peers have commented that they are seeing a softening demand environment, especially out of China. While we are experiencing the same demand dynamics, we have factored in much of this macroeconomic backdrop when we provided fiscal 2019 guidance last quarter. As a result, after a solid start to the year, we are reaffirming our fiscal 2019 revenue guidance of $24.5 billion. Having said that, we expect our semiconductor business to bottom in the second fiscal quarter, driven almost entirely by the seasonal drop in wireless. But looking to the second half, we are confident that the semiconductor business will resume very meaningful growth. This will be driven by strong product cycles in both wireless and networking, coupled with a recovery in broadband. Infrastructure software, on the other hand, is expected to sustain throughout the year. So in summary, our diversification strategy is working, and we are effectively managing the decline in wireless as well as in the broader semiconductor industry headwinds. Now, let me turn over to Tom to provide you with more color in Q1.

Thank you, Hock. Consolidated net revenue for the first quarter was $5.8 billion, a 9% increase from a year ago. And EPS came in at $5.55, an 8% increase from a year ago off of a $441 million weighted average fully diluted share count. In addition, free cash flow was $2.03 billion or 35% of revenue. I would highlight that free cash flow grew 39% year-over-year. The Semiconductor Solutions segment revenue was $4.4 billion and represented 76% of our total revenue this quarter. This was down 12% year-on-year on a comparable basis. But as Hock explained, the semiconductor segment was actually up slightly year-over-year in the first quarter, excluding wireless. Let me now turn to our Infrastructure Software segment. Revenue was $1.4 billion and represented 24% of revenue. SAN switching continues to perform extremely well. And as Hock mentioned, mainframe enterprise software is off to a good start. Let me now provide additional detail on our financial performance. Operating expenses were $1.08 billion. Operating income from continuing operations was $3.05 billion and represented 52.7% of net revenue. Adjusted EBITDA was $3.24 billion and represented 55.9% of net revenue. This figure excludes $143 million of depreciation. Inventory decreased $50 million from the prior quarter. Similarly, semiconductor receivables were actually down, which is typical for Q1, even though receivables increased $352 million overall due to the CA acquisition. Total current liabilities excluding debt increased $2.5 billion due to CA. However, excluding CA, total current liabilities excluding debt decreased meaningfully more than receivables, primarily due to the payment of our annual performance bonus in Q1. In addition, we spent $99 million on capital expenditures. As a result, we had record Q1 free cash flow from operations at $2.03 billion, or 35% of revenue. This represents 39% growth in free cash flow from operations compared to Q1 of 2018. I would note a couple of things. One, fiscal Q1 is typically our seasonally weakest cash flow quarter due to the annual performance bonus payment we make to our employees in the quarter that we accrue throughout the prior fiscal year. In Q1, we paid approximately $530 million in APB cash bonuses to our employees. And second, I would also note that we accrued $723 million of restructuring integration expenses, of which that includes $363 million of cash payments in the quarter. In Q1, we returned $4.6 billion to stockholders consisting of $1.1 billion in the form of cash dividends and $3.5 billion for the repurchase and elimination of 14.2 million shares. We ended the quarter with $5.1 billion of cash, $37.6 billion of total debt, 396 million outstanding shares, and 451 million fully diluted shares outstanding. Turning to our fiscal year 2019 guidance, as Hock discussed, we are reaffirming our full-year revenue guidance of approximately $24.5 billion, including approximately $19.5 billion from semiconductor solutions and approximately $5 billion from infrastructure software. IP licensing is not expected to generate a material amount of revenue. On a non-GAAP basis, operating margins are expected to be approximately 51%. Net interest expense and other is expected to be approximately $1.25 billion. We do not contemplate any debt pay down in fiscal year 2019. The tax rate is forecasted to be approximately 11%. Depreciation is expected to be approximately $600 million. CapEx is expected to be approximately $550 million. And as a result, free cash flow from continuing operations is expected to be approximately $10 billion. And finally, stock-based compensation expense is expected to be approximately $2 billion. As we outlined last quarter, we granted approximately 31 million of restricted and performance stock units as part of the multi-year grant that will vest over the next seven years. As a result, for modeling purposes, we expect the fully diluted share count in the second quarter to be approximately 450 million. This excludes any stock repurchases. Similarly, for modeling purposes, we expect stock-based compensation expense to be approximately $530 million in Q2. Looking forward beyond Q2, we expect the share count excluding any stock repurchases and eliminations to remain relatively unchanged, and the quarterly stock-based compensation in the second half of 2019 to start to decrease slightly each quarter. We expect stock-based compensation to level out at approximately $1.5 billion in 2021. Now onto capital allocation. Our capital allocation strategy remains the same. We plan to maintain the current quarterly dividend payout of $2.65 per share throughout the year, subject to quarterly Board approval, which means we plan to pay out over $4 billion in cash dividends in fiscal 2019. In addition, we remain committed to buying back and eliminating a total of $8 billion of stock in fiscal 2019. That concludes my prepared remarks. During the Q&A portion of today's call, please limit yourselves to one question each, so we can accommodate as many analysts as possible. Operator, please open up the call for questions.

Good afternoon and congratulations on the solid quarterly execution. Hock, on the strong double-digits year-over-year momentum in your data center network compute acceleration segment, you've been shipping your new Tomahawk 3 switching platform now since the second half of last year. I think Google's using it for 200-gig. We hear Amazon is going to transition to 400. We're hearing good things from Baidu, Tencent, and all of the cloud guys. Additionally, you're ramping compute acceleration ASIC into some of the big cloud guys as well. The question is, do you anticipate continued double-digits year-over-year growth for the full year here for the networking business as the pipeline here appears fairly strong?

That's a great question, Harlan. You've sparked a lot of thoughts. In networking, our focus extends beyond just data centers. Specifically regarding data centers, Tomahawk 3, which is our 12.8 terabit top of the rack switch, has just begun production shipments. We anticipate that the ramp-up of Tomahawk 3 will align with the broader data center expansion that incorporates 400 gig pipes, and we expect this to start around now. Our growth will be notable in Q2 and will continue through the end of the year as more cloud companies expand and upgrade their data centers. Increasing the capacity of data centers and their connection speeds is the most effective way to alleviate congestion in large data centers. There is a significant effort to refresh and upgrade data centers among these cloud providers. Tomahawk 3 shipments have just begun this quarter in substantial volumes. Additionally, while it may not be immediately apparent, to support 400 gigabit per second throughput, specialized fiber optic interconnects are necessary. These high-tech products are an area where we are heavily involved, significantly enhancing our presence in the data center space. As the top of the rack switch expands, there is also a need for DCI interconnectivity to link data centers. We are actively working with multiple OEMs to support cloud providers using coherent fiber optic connections at 400 gig. We believe we are leading in this sector as well. The product cycles we are witnessing continue to drive double-digit growth in networking. This growth extends to routing, where we plan to launch and ramp up our new generation router, Jericho 2, likely in the third quarter of our fiscal year. This will cater to Edge routing, especially among telecom service providers, and we are starting to see preparations for that. Overall, we feel very optimistic about networking and our capacity to maintain the impressive growth we have experienced.

Thank you, Hock.

Hi guys. Wanted to echo my congratulations. Sticking on the wired category, Hock, you mentioned that the broadband space had stabilized and recovered. Can you talk a little bit about the product cycles that will be driving demand in that segment? Any geographic or product cycle color would be helpful?

Sure. Sure, Ross. Yes. In broadband, I’m happy to say finally, the thing has recovered. A big part of driving the recovery is cable modem video delivery, DOCSIS 3.1. We've seen implementations across multiple carriers and service providers of DOCSIS 3.1, so that's very good. What we're also seeing is in gateway access, which is a big part of broadband, among many carriers is the newer generation of DSL, digital subscriber line as they need to expand capacity and throughput, going through what they’re calling the next-generation G.fast or 35b, and we’re seeing a lot of that in Europe, some in North American carriers. But what's also equally interesting is as they go to the last mile into households, we are seeing the adoption of wireless connectivity or what we all call Wi-Fi. As we see these wired gateways, whether it's cable modem DOCSIS 3.1 or digital subscriber line, we see, especially in the back half of the year, enterprises and more service providers, telecoms, start to attach the next-generation Wi-Fi, Wi-Fi 6 to those gateways. I'm very pleased to note that we are very much in the lead in having developed and productized a whole suite of products that perfectly address these enterprise and service provider needs. However, most of that will only be shipping, we believe, in the second half of the year, both fiscal and calendar. We're looking forward to seeing that happen, but it's a very nice product cycle that will push the recovery of our broadband business.

Thank you.

Thank you. Hock, I'm wondering how you view Huawei. I believe that they're a mid-single-digit customer right now. We're hearing a lot of evidence that they may be double ordering in response to possible sanctions. I'm wondering how you think of that and how you handicap that for the full-year guidance. Thank you.

I probably know as much as you do, honestly, in terms of what's available publicly and the concerns and the issues surrounding high-tech companies like Huawei from China. They're a good customer, and they buy products which obviously helps their products in a competitive global export market. I hope they continue to do so. But the overhang of that is something we are closely monitoring and are very concerned about. As far as specifics go regarding what you mentioned, I'm not able to comment simply because I don't know.

Okay, Hock. Thanks so much.

Thanks for taking my question. Actually, a quick clarification on a question. I believe Hock, you mentioned software could sustain throughout the year. That suggests annualized closer to $6 million rather than the $5 million you mentioned before. If that is the case, shouldn't profit margins be better than what you had anticipated? Then my question is there has been some more consolidation in semiconductors, NVIDIA acquiring Mellanox. We're curious how you think there might be an impact on Broadcom. Even if there isn't, how do you view the M&A environment in semiconductors? Thank you.

Okay. You asked two questions here, very clever. Let me start with the second one. I mean, we have done quite a bit of acquisitions in very strong assets in the semiconductor space. It's obviously something we continue to look at because semiconductor is a core area for us. But you also know we're not necessarily limiting ourselves to that. We'll look towards broader areas of technology, software, and appliances as well. We'll continue to be very thoughtful and timely in terms of any acquisitions we make. We have observed our behavior over the last several years and we tend to do it in a measured pace because it's critical for any acquisition we make to be able to integrate it well. We’re right in the thick of it with CA currently while being very mindful. To your first question, yes, the software segment appears to be performing well.

Yeah. Good afternoon, guys. Thanks for letting me ask the question. I'll echo my congratulations on the results. Hock, relative to the full-year guide, it does imply like many of your semi-peers, some pretty meaningfully above seasonal growth half on half on the semi-solutions business. I think you did a good job on some prior questions specific to data center and broadband access. I would be curious if you could give insight into how wireless progresses throughout the year and how we should be thinking about your content this year versus units within the wireless segment.

Somehow I knew this was going to come up. The product cycle in wireless is, in our view, predictable. We will see that happen in our Q3 and Q4 of fiscal 2019. We are already starting production in this area, which has a long product cycle on FBAR and some of our products. We will see, for lack of a better term, a nice bounce-back due to seasonal effects and our confidence in our full-year guidance is something that is very simple. In the second half, we will see meaningful growth in the semiconductor segment of our business. As I mentioned in previous questions, data center, especially networking, will generate a large part of that double-digit growth. So will our view of wireless. I would expect that to happen quickly. This particular year, perhaps the difference between 2019 and 2018 is we're likely to gain better share and secondly, see an overall increase in content, especially in Wi-Fi. Wi-Fi 6 will not just be limited to enterprise and access gateways but is increasingly being adopted within handheld devices. This will drive a strong increase in content as the number of bands continue to expand. So, all of that is going to drive a bounce back from what we expect.

That’s helpful. Thanks a lot.

Hi, guys. Thanks for taking my question. So understanding the confidence in the semiconductor ramp, your guidance also implies the infrastructure software business has to decelerate pretty significantly as we progress through the year. It seems that the CA business may have already been hitting close to a $3.5 billion annualized run rate in Q1. What drove the strength of CA in Q1? And why does that business have to decelerate so markedly in order to fit into the guidance provided?

Stacy, it's Tom. I think one element is we don't want to get into the details between CA and SAN switching, but we're taking a conservative approach. It's just the first quarter out of the gate. We've got three quarters to go. As Hock mentioned, we are actually pretty pleasantly surprised with the number of ELA and PLA opportunities that we see in the pipeline. A lot of our success in growing the dollars of each of these accounts will be driven by our ability to convert those into wins. But for now, given that we're only one quarter into the year, we feel very comfortable reaffirming guidance on the top line. Of course, we feel comfortable with operating profit as well as cash flow expectations going forward.

But you said CA would sustain through the rest of the year, right? So does that mean Brocade has to come down a lot? Or is it just overall conservatism in the numbers?

No. Stacy, what we said is that the software, the infrastructure software segment would continue to sustain throughout the year. That's our expectation, but we are taking a conservative approach relative to the overall outlook for the business.

If it sustains wouldn't you be at $5.6 billion for the year instead of $5 billion?

I'll leave that to you, Stacy, to figure out.

Okay. Thank you, guys.

Thank you for taking the question. Hock, I had a question on 5G as it relates to your wireless business. Based on preliminary discussions with your customers, what sort of content uplift are you expecting in your wireless business as 5G is introduced moving forward? From a timing perspective, do you think it's more of a 2020 dynamic when 5G starts to affect results, or is it 2020 and beyond? Thank you.

It's a very interesting question. You're asking in an area of great uncertainty here. My sense is you'll start to see a tiny bit of it in 2020, but it will only be a small part. I think 5G will really begin to impact content in components, particularly in high-end smartphones, beyond 2020. While 2020 will see some starts, the impact will not be significant. However, beyond 2020, as 5G is deployed, the content uplift, particularly for RS analog FBAR, will be quite significant, but not so much in 2020.

Thank you.

Yes. Thank you. Just a question for Tom. On the back of the strong gross margin upside in the quarter, can you talk about trends you're seeing in gross margin for the core semiconductor business and then software, just how we should think about expectations through the year?

Sure, Craig. Well you can see that the gross margins are exceptional. They're all over 70% in the quarter. A lot of that is driven by including CA in the business. But you're right, the semiconductor business continues to increase from a gross margin perspective. Product mix helps. As wireless comes down, we benefit from the rest of the portfolio in semis being at or above the corporate average. Looking long-term, we do continue to see the opportunity to improve gross margins and apply that directly to operating margins and free cash flow conversion, so we see that continuing.

Got it. Thanks.

Yeah. Hey guys. First of all congratulations on the exceptional execution. I wanted to follow up on the gross margin question, maybe for Tom. They stepped up quite dramatically. On one of the field trips, I think you mentioned that it really takes an acquisition about a year to start yielding results. So my question is, did you capture the vast majority of CA benefits very quickly in Q1? Or is the best yet to come from CA later on?

No. I think as you look through the numbers, we're still not fully optimized around CA. We're only one quarter in. You've seen some meaningful improvement in profitability for the company that includes CA. But when you look specifically at gross margins, it’s a number of elements within the CA business that tie to gross margins primarily services as well as support. We have taken some actions to improve gross margins and the P&L in general. One in particular is we announced a deal with HCL to outsource a lot of our service activity to them going forward for the CA business. As we continue to work through our model, which is really driving these PLAs, we see the opportunity to get better returns on our investment, including improvements in our gross margins going forward. We would expect them to continue to improve not just this year, but really over the long-term.

If I could add on CA, we continue to go through transitions. You’re right; it takes at least a year for us to ramp up. In the case of software companies, I believe it may take longer, closer to two years because of contractual commitments. However, it will get there. A significant part of the improvement we expect here is the combination of software and hardware, particularly in the CA segment. We're right into it managing it as indicated by our numbers.

Thank you very much. Hock, I want to touch on wireless again. The rebound you’re predicting for the second half of the year seems to be a much stronger recovery than usual based solely on content. Please correct me if I'm mistaken, but you are focusing on three major areas in handsets, including your standard business for the 2.4-gig spectrum, additional products in areas with antenna congestion, which is becoming increasingly critical, especially for 5G. Moreover, the Wi-Fi 802.11ax is gaining traction, and it seems you have a significant advantage over your close competitor, Qualcomm. Should we anticipate a more substantial rebound just from content? Additionally, do you believe this trend will continue more strongly than we might expect as we move into next year?

Ed, we appreciate your comments, but I want to emphasize it's a normal rebound. Yes, we see a rebound with an easier comparison from last year. So, we will definitely have a rebound; this will be a good one, but it will not be extraordinary. I'd want to emphasize that. Just your normal rebound against last year, specifically in the second half of fiscal 2019. We will also see a main improvement.

Yeah. Thanks for taking the question, and congratulations on the quarter. A lot of questions on wired and wireless have been asked, but I wanted to ask about the storage business. The storage business, I think you mentioned, was up. What should we be focused on in that piece of the business over the next couple of quarters? How do you assume that can go through the course of this year? Thank you.

In storage, we have a mixed bag here. Much of it relates to hard disk drives. Hard disk drives are not performing well, and we see that no different from the industry overall. Our mitigating factor is that most of our hard disk drive component sales go to near-line storage or data centers. We don't do a lot in PC desktops or mobile. We do see the impact, but not as extreme as the rest of the industry. Where we hope to see a new product cycle coming in is with Flash SSDs, especially PCI Express. We anticipate a strong push in the marketplace on PCI Express Gen 4, and we're well-positioned for it. We see a lot of interesting opportunities related to Gen 4, not just in storage, but also in offload computing from the viewpoint of machine learning and GPU-to-GPU connectivity. This push for PCI Gen 4 is particularly interesting in storage over the course of the year, especially in the second half.

Thank you.

Thanks for taking my question. Hock, if you look at the business geographically instead of by end markets, I know that shifting to one region might not reflect consumption, especially since China's a major export economy. Can you discuss the pace of demand in China, particularly in relation to inventories there? Thank you.

Good question. No surprise that China is the weakest region as far as we can sense. We all see that. Domestic demand is weak, which also has collateral impacts we see to some extent on certain sectors in Japan and in Europe, but not as much in the U.S. However, North America continues to be quite decent, which helps us mitigate the overall macroeconomic saturation.