Broadcom Inc (AVGO) — Q2 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 table describing our financial performance for the second 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 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 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 tables 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 in today. Let me touch on the second quarter results after which I will update you on the current environment and our outlook for the second half of the year. Looking at the second quarter just passed, it really went as planned. Networking continued to perform very well, and our broadband business started to recover. This was offset by the anticipated sharp decline in wireless and the ongoing softness in storage. On the other hand, the infrastructure software business delivered solid top-line results, benefiting from sustained enterprise demand for our mainframe and distributed software as well as SAN switching products. The integration of CA is progressing well. Just last week, we reached a major milestone with day two, which is the integration of the CA business processes onto Broadcom's IP platform. We remain confident that we can meet, if not exceed, the long-term revenue and profitability targets that we laid out for CA to you last year. Renewals in our CA business are strong, and the dollar commitments from our core customers continue to grow. Now, let me address the current business environment and our outlook for the remainder of the year. We have, as I indicated, performed very much to plan in the first half of fiscal 2019. And in the second half, we had expected a recovery. However, while enterprise and mainframe software demand remained stable, particularly in North America and Europe, with respect to semiconductors, it is clear that the U.S./China trade conflict, including the Huawei export ban, is creating economic and political uncertainty and reducing visibility for our global OEM customers. As a result, demand volatility has increased and our customers are actively reducing inventory levels to manage risks. This leads us to believe the second half of 2019 will be more in line with the first half as opposed to the previously expected recovery. We now anticipate fiscal 2019 semiconductor solutions segment revenue of $17.5 billion, which translates into a year-over-year decline in the high single digits. CA software continues to perform above our original expectations while SAN switching is slowing down after a very strong first half. As a result, we are maintaining our fiscal 2019 infrastructure software outlook at $5 billion. While this scenario has been playing out, I should emphasize the fundamentals of our business remain very much intact. We continue to execute on the very rich roadmap for next-generation network switching and routing in the cloud and enterprises, including the leading-edge Trident 4 software-defined network switch just recently announced this week. We've also secured the next two generations of RF front-end at a large North American OEM, which positions us very well for the transition into 5G. We continue to win increasing numbers of compute off-load accelerators in the hypercloud operators across AI, video transcoding, encryption, and networking. We are pleased with the ramp of our new-generation Wi-Fi 802.11ax, otherwise called Wi-Fi 6, in enterprise gateways and carrier access. All this leaves us confident that we will be able to continue to drive sustained long-term revenue growth and increasing free cash flow. Let me now turn it over to Tom who will provide you with more color.

Thank you, Hock. Consolidated net revenue for the second quarter was $5.5 billion, a 10% increase from a year ago, and EPS came in at $5.21, a 7% increase from a year ago off of a 448 million weighted average fully diluted share count. In addition, we have record free cash flow of $2.54 billion or 46% of revenue. Free cash flow grew 20% year-over-year. The semiconductor solutions segment revenue was $4.1 billion and represented 74% of our total revenue this quarter, which was down 10% as expected year-on-year on a comparable basis. Our infrastructure software segment revenue was $1.4 billion and represented 26% of revenue. Let me now provide additional detail on our financial performance. Operating expenses were $1.02 billion. Operating income from continuing operations was $2.95 billion and represented 53.5% of net revenue. Adjusted EBITDA was $3.11 billion and represented 56.4% of net revenue. This figure excludes $142 million of depreciation. Receivables in the quarter decreased $193 million, and inventory decreased $40 million from the prior quarter. I would also note that we accrued $136 million of restructuring and integration expenses and made $218 million of cash restructuring and integration payments in the quarter. Finally, we spent $125 million on capital expenditures. In the second quarter, we returned $2.4 billion to stockholders consisting of $1.1 billion in the form of cash dividends and $1.3 billion for the repurchase and elimination of 4.7 million AVGO shares. We ended the quarter with $5.3 billion of cash, $37.5 billion of total debt, 399 million outstanding shares, and 447 million fully diluted shares outstanding. We also refinanced our $18 billion of term loans that we put in place at the beginning of fiscal 2019 to finance the CA acquisition. Via a combination of $11 billion of investment-grade bonds and a new term loan, we're able to extend our average debt maturity to approximately five years and substantially reduce the quantum of debt due in any one year. As of today, our average cost of borrowing stands at approximately 3.7%. Turning to our fiscal year 2019 guidance, as Hock discussed, we are updating our full year revenue guidance to $22.5 billion, including approximately $17.5 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 52.5%, an increase of approximately 150 basis points from our prior guidance. Net interest expense and others are expected to be approximately $1.3 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 $500 million. As a result, free cash flow is expected to be approximately $9 billion, which takes into account projected restructuring and integration charges of approximately $1.1 billion. Stock-based compensation expense is expected to be approximately $2.2 billion. And finally, we expect weighted average diluted share count to be 444 million for Q3 and 443 million for Q4, and this excludes any impacts from share buybacks and eliminations. Now, on to 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. In the first half of the fiscal year, we have spent $4.8 billion for the repurchase and elimination of shares. 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.

Thanks for taking my question. Hock, in the $2 billion or so reduction in the semiconductor outlook for the next two quarters, can you give us some sense of how much of that is Huawei, how much is outside of Huawei and just any segment level impact so we can calibrate our models? Thank you.

Well, it's an interesting way to figure that out because in terms of full disclosure, Huawei represented last year about $900 million of revenues for this company by itself. But the other part of the picture I should add is that guide down that we're providing, as you put it, of $2 billion obviously extends beyond just one particular customer. We're talking about uncertainty in our marketplace, uncertainty because of the demand in the form of order reduction as the supply chain out there contricts, so to speak. And because we do see, to some extent, end users in the U.S., particularly North America and Europe, continuing to be there. But what we do see in between is the uncertainty of the environment has put in place a concern about placing additional orders and actively a reduction of inventory out there. Basically, compression of the supply chain is what's driving this reduction more than anything else, and it's broad-based.

Hey guys, thanks for taking my question. Maybe I could just follow-up on that question, Hock. Just kind of curious, as you look, I mean I think markets were soft and you saw a lot of revisions last quarter. You guys kind of maintained your forecast. I'm kind of just trying to figure out when you saw this slowdown, if you can give us any idea of that. And then if there's just any more color you can add for end markets, is there any end markets that you're not seeing this weakness? And if you can point to any particular product, that would be helpful.

Well, we started seeing this softness basically at the beginning of this quarter, like Q3, very much so a dramatic reduction, and it particularly accelerated with the order denials imposed on Huawei.

Good afternoon. Thanks for taking my question. On the networking side specifically, that's been a strong area for the team, growing double digits year-over-year for the past few quarters. And it's an area where you guys actually do have some pretty strong product cycles like Tomahawk 3, Jericho 2, some of the compute offload ASICs. In the revised outlook ex-Huawei, how is the macro uncertainty impacting this segment and some of these programs? And again, ex-Huawei, would you expect the networking business to grow second half over first half?

Harlan, very good question. Our networking business, which I think is what you're referring to, continues to be a very strong business. Year-on-year, we expect our total networking business to grow double digits year-on-year. It's strong, particularly with new product ramps and new product cycles that we've seen both in switching and routing related to that. It is one of the brightest areas in our portfolio in this environment and continues to be strong notwithstanding the export ban on Huawei.

Hi Hock, thank you for the opportunity to ask my question. I wanted to discuss the wireless segment. I understand you recently signed a supply agreement with a major North American customer, who generally experiences positive seasonality in the second half of the year. Many of us believe you are gaining market share. Considering this, along with your statement about networking growing in double digits, how do you expect the second half to remain relatively flat compared to the first half? Are there offsets in other areas, or do we have some incorrect assumptions about the wireless side?

Well, I don't know what the assumptions are, Ross, on wireless. But networking is really the only area of strength in this current environment, and that's because it coincides with very strong product cycles we are seeing. In just about broadly any of the end market segments, we do not see, in terms of year-on-year, improvement from 2018.

Hi. Hock, I actually just had a question about the competitive environment for your RF front-end business as we kind of move into 5G and particularly around a large modem maker now that's talking about having a complete RF package and sort of being able to sweep that in with their modem. So, can you kind of talk about the competitive environment and your position as you can get into 5G? Thanks.

That's a very interesting question. We continue to believe we are very, very strongly positioned. And it's in many ways validated by some of the data points I just mentioned. We have, by far, the best technology and products out there in RF front-end components. They're typically the filters and the integrated front-end modules. We are, by far, the furthest ahead technology-wise and in terms of capabilities. And we continue to believe we are still very much in front. And as I said, it's been validated and continues to be validated by the value we give to our very critical customers and the fact that they continue to be very supportive of our business.

Hi guys. Thanks for taking the question. I had a question on RF as well. Hock, can you remind us what kind of content growth you are expecting or assuming into the back half, both on the RF side as well as the Wi-Fi side of your business within wireless? And then you also talked about 5G or rather how the recent win positions you well into 5G. As of today, what do you know based on what you heard from your customers, what kind of content growth on the RF side are you expecting as we transition to 5G over the next couple of years? Thank you.

Thank you. Well, asking year-on-year is actually very difficult, so I appreciate you asking me what do I see over the next two to three years on content growth. And I mean the best way to describe content growth in RF, and we have seen that and we have empirical evidence of that for the last five years, even longer and not the same every year, is that, annually, we probably see in the 5% to 10% range content growth in terms of the products we ship. Now, for the entire, I guess, our further available market, it's probably a smaller growth percentage.

Yes, good afternoon guys. Hock, I just want to go back to Ross' question about the wireless guide for the balance of the year. I'm just curious, relative to 90 days ago when you guys were kind of guiding the overall semi business well above normal seasonality for the balance of the year, now you're talking about a flat half-to-half. To what extent did your content expectations come down to the back half of the year versus just this really being a unit issue on the wireless side of the business?

Well, that's an interesting question that lays out that – keep in mind; we're taking a very conservative stance here. And very frankly, even as we see the ramp-up and we do see the ramp-up, we have also been forecasting a fairly dramatic set of numbers before. And that is more than offset by the fact that for the rest of the broader markets, we're just seeing a demand environment that is extremely uncertain.

Yes, thanks. Hock, I’d like to revisit the compute offload you mentioned in relation to hyperscale. Some time ago, you discussed initial progress with ASICs. I’m looking for an update on the extent of that hyperscale and whether you are expanding this to multiple customers moving forward.

I have mentioned in previous calls our focus on increasing traction in what we refer to as compute offload engines or compute offload accelerators in areas such as AI, virtualization, and orchestration from compute servers, and now expanding to include video transcoding and encryption. We view this as an emerging space which is steadily growing and trending significantly upwards. We believe that within three to five years, this could represent a substantial portion of total compute spending in large-scale data centers, potentially reaching as high as 25% or more of total computing expenditures in a cloud data center.

Hey, thanks guys. Just looking at the overall environment, Hock, do you think your guidance incorporates the proposed next round of $300 billion in tariffs, i.e., if that thing does go through, do you still feel good about your guidance? Or do you think there could be more downside if that does go through?

I believe we are trying to capture everything, including the potential next round of tariffs. The current environment feels very tense, which is reflected in the significant and quick reduction of supply chain activities and orders from our customers, particularly global OEM customers, although we haven't seen a decline in end demand in North America and Europe. There is a reactive sentiment at play, influenced by the possibility of these $300 billion in tariffs being implemented. Additionally, I want to highlight that the Huawei ban has a significant impact on our ability to sell components and technology. In the short term, we will experience a sharp decline because purchases are not allowed, and there are no immediate substitutes from other OEMs to meet that end demand. However, if those demands persist over the next few months, other OEMs may qualify to fill that gap and continue purchasing our products, leading to a rebalancing and adjustment in demand from our side. But for the short term, we do not anticipate that happening.

Great. Thanks for taking my question. On a brighter note, I'd like to ask about CA a little bit. Last quarter, Hock, I think you talked about at least one proof point with regard to sort of deeper engagements with CIOs around a deal that might involve both sides of the business. Anything similar to that? Were you seeing more proof points around traction in sort of the strategic approach in that acquisition? Thank you.

One of the things we are focusing on is core accounts, which are the largest enterprises in the world that purchase significant amounts of software infrastructure. CA has a broad portfolio of products that we can offer, especially given that these major companies often utilize a considerable amount of mainframe capacity and distributed software infrastructure. Our ability to present this as a comprehensive enterprise solution has led to considerable success in securing enterprise-wide contracts, resulting in a notable increase in booking dollars through larger renewals. Currently, we have over 20 large accounts we’ve engaged with in the six months since we took over, and we expect that number to grow even higher in the next six months. This strategy is proving effective, and we feel positive about how the CA business is trending. Overall, the amount of dollar commitments we've secured compared to what is expiring has risen significantly.

Thank you very much. Good afternoon. Hock, I wanted to ask about the M&A environment as you see it. We've discussed the demand and trade environment, but I'm curious about mergers and acquisitions, especially since CA has steered the company in a different direction. We've recently seen some semiconductor mergers announced. Could you provide your insights on the current M&A landscape in the semiconductor sector? Thank you.

Yes, I understand your question about the M&A environment in the semiconductor sector. I perceive the activity you're noticing, which appears to be encouraging. It's interesting to see that our strategic approach resonates with many of our industry peers. We appreciate this trend, and as I have mentioned in prior earnings calls, our focus is on identifying actionable opportunities that align with our sustainable business model and that we can potentially acquire. Currently, we observe considerable movement in the market, and we remain keen on exploring any opportunities that may arise, continuing to assess them actively.

Yes, thank you. Hock, I just wanted to return to some of your comments regarding inventory, and you talked about the customers reducing inventory. Do you think that the inventory levels at the customers were elevated coming into the quarter or is this just a situation where the customers are reducing inventory proactively because of the uncertainty? I guess the question is how much of the weakness you see here is driven by inventory reduction as opposed to demand.

I think what we are observing is that overall demand weakness or uncertainty likely began before this quarter. The sharp decline in demand is primarily due to customers aggressively trying to reduce their inventory. A significant portion of this refers to customer inventory. Our balance sheet indicates that we have managed our inventory effectively, maintaining it consistently around 65 days. Therefore, this reduction is largely influenced by the actions of end users in the supply chain, which in turn affects our direct customers who are experiencing a notable decrease in inventory levels. Is this significant? Yes, it certainly is, and we expect this trend to continue. This expectation is reflected in our updated guidance for the upcoming six months. Beyond that timeframe, it's uncertain.