Broadcom Inc (AVGO) — Q3 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 third 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 third 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 US 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. I'll now turn the call over to Hock.

Thank you, Bea. Good afternoon everyone and thank you for joining us today. In the third quarter, consolidated net revenue was $5.5 billion, reflecting a 9% increase from the previous year. Revenue from semiconductor solutions totaled $4.4 billion, which is a 5% decrease year-on-year but a 6% increase quarter-over-quarter. Networking continued to do well, fueled by strong demand for our merchant switching and routing platforms, and as expected, shipments of custom silicon solutions for AI, SmartNIC, and video transcoding to cloud datacenters were robust. We are also beginning to see a typical seasonal uptick in wireless, along with initial positive impacts from increased content. However, this was somewhat countered by decreased demand in storage and broadband. Revenue from infrastructure software reached $1.1 billion. The CA business is performing above our expectations, benefiting from ongoing enterprise demand for our mainframe and distributed software. Nevertheless, SAN switching demand has stalled due to supply chain constraints for our partner OEMs during these uncertain times. Now, regarding the current environment and outlook, enterprise and mainframe software demand remains stable, particularly in North America and Western Europe. SAN switching demand is likely to decline for another quarter while inventory in OEM channels is managed. In terms of semiconductors, despite the ongoing US-China trade conflict, we have not experienced any further decline in our business, whether in China or globally. As a result, we continue to project over $22.5 billion in revenue for fiscal 2019, with $17.5 billion coming from semiconductor solutions and $5 billion from infrastructure software. Looking ahead to next year, infrastructure software remains stable as renewals among our core customers are solid. However, visibility on semiconductors is limited. Therefore, we are managing the business with the expectation of continuing to operate in a low-growth, uncertain macroeconomic environment for the foreseeable future. Fortunately, the fundamentals of our semiconductor business are strong. Our focus is on connectivity—from CPUs to memory in data centers, core to edge in networks, and from central offices to client devices in distributed systems. This positions us well to benefit from the growing need for increased bandwidth. In data centers, Tomahawk switching has advanced from 3.2 terabits per second three years ago to 12.8 terabits per second today. In cloud computing, as limitations of Moore's Law impact CPU and GPU performance, the connections between computing cycles, networks, and storage continue to evolve. PCI Express Gen 4 is currently at 16G and is replacing Gen 3 with next-generation Rome CPUs. Legacy network interface controllers are evolving into SmartNICs, which accelerate workloads offloading from non-optimized CPUs. In SAN, Fibre Channel is advancing its bandwidth from 32 gigabits per second in Generation 6 to 64 gigabits per second in Generation 7 next year to fully utilize all-flash arrays in enterprise storage. We are also seeing a shift from direct-attach copper to fiber optics, with 100 G channels moving to 400 G as our hypercloud customers scale out data centers with Tomahawk 3. Regarding telco networks, call routing performance has improved from 1.6 terabits per second a few years ago to 9.6 terabits with our Jericho 2 router today. In broadband, DOCSIS 3.0 cable modems currently provide 1 gigabit, but we expect to upgrade to DOCSIS 4.0 at 10 gigabits in the coming years to compete with 5G networks. Likewise, DSL will increase from 500 megabits per second to over 1 gigabit in G.Fast, and we are gearing up to launch mass markets with 10G xPON. Wireless connectivity has also been significant. In enterprise access gateways, the protocol has shifted from 802.11ac to the new OFDMA-enabled 802.11ax, also known as Wi-Fi 6, with cellular communications transitioning from 4G to 5G in radio access networks and smartphones. We are capitalizing on these key market trends, which gives us confidence in our ability to sustain and grow our semiconductor business over the long haul. Moving on to software, particularly CA, we are focusing on the largest 500 enterprises worldwide, who are the biggest users of our infrastructure software. Based on our experience in the third quarter, we anticipate growth in our core customer business due for renewal in fiscal 2019 to exceed 20%. However, we expect the attrition rate from our smaller customers to be over 10% in fiscal 2019. We still have over two years to renew CA customer contracts, but given the renewal growth trends from our core clientele, we are optimistic about meeting or exceeding our long-term revenue and profitability targets for CA that we discussed last year when we acquired that business. Most of our integration work is nearly complete, with operating expenses for CA approaching our target levels. Lastly, I would like to take a moment to discuss our planned acquisition of Symantec's Enterprise business as announced in August. This acquisition enhances our strategy to build a leading infrastructure technology platform and adds a $160 billion cybersecurity market to Broadcom's addressable total addressable market. We will gain critical security solutions that are well-integrated with our core customers, presenting substantial cross-selling opportunities with Brocade and CA solutions. We believe this acquisition will allow Broadcom to capture a larger share of wallet among these core clients. We expect the transaction to contribute more than $2 billion in sustainable run rate revenue, in addition to achieving over $1 billion in run rate cost synergies within 12 months post-completion. Importantly, this transaction supports our ongoing financial goal of double-digit cash on cash returns. Our integration planning is underway, and as announced, we cleared the HSR process last week. We remain on track to close this transaction in the first quarter of fiscal 2020, pending antitrust approvals in the European Union and Japan, along with customary closing conditions. In summary, our broad and increasingly diverse portfolio of leading technology franchises has enabled us to maintain revenue and enhance cash flow, even in a challenging market environment.

Thank you, Hock. Consolidated net revenue for the third quarter was $5.5 billion, a 9% increase from a year ago. The Semiconductor Solutions segment revenue was $4.4 billion and represented 79% of our total revenue this quarter. This was down 5% year-on-year on a comparable basis. Our Infrastructure Software segment revenue was $1.1 billion and represented 21% of revenue. Free cash flow was 42% of revenue or $2.31 billion and grew 8.5% year-over-year. Let me now provide additional detail on our financial performance. Operating expenses were $1.01 billion, driven by further reductions from CA-related activities. Operating income from continuing operations was $2.91 billion and represented 52.8% of net revenue. Adjusted EBITDA was $3.06 billion and represented 55.6% of net revenue. This figure excludes $141 million of depreciation. In terms of working capital, our payables increase of $237 million was somewhat offset by receivables increase of $55 million, and an inventory increase of $57 million from the prior quarter. I would also note that we accrued $110 million of restructuring and integration expenses and made $164 million of cash restructuring and integration payments in the quarter. Finally, we spent $112 million on capital expenditures. In the third quarter, we returned $2 billion to stockholders, consisting of $1.1 billion in the form of cash dividends and $977 million for the repurchase and elimination of 3.5 million AVGO shares. We ended the quarter with $5.5 billion of cash, $37.6 billion of total debt, 398 million outstanding shares, and had 442 million fully diluted shares for the quarter. Turning to our fiscal year 2019 guidance. As Hock discussed, we are maintaining our full-year revenue guidance of $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%. Net interest expense and other is expected to be approximately $1.3 billion. 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 does take into account projected restructuring and integration charges of approximately $1.1 billion. Note, as of the end of the third quarter, $6.9 billion of free cash flow has been generated and includes $969 million of restructuring and integration charges. Stock-based compensation expense is expected to be approximately $2.2 billion, and finally, we expect average diluted share count to be 440 million for Q4 and this excludes any impact from share buybacks and eliminations. Now on the capital allocation. As many of you know, Broadcom has a business model that generates a very healthy amount of free cash flow across an increasingly diverse and stable set of mainly infrastructure technology franchises. Over the last few years, we have worked to create a more transparent and balanced capital allocation policy. First and foremost, we have committed to return half of our free cash flow to shareholders each year in the form of cash dividends. In essence, this allows the AVGO stockholder to decide how best to reinvest 50% of the free cash flow that we generate. In return, we have, in effect, as the Broadcom struggled to put trust and management to optimally reinvest the remainder of the free cash flow after the dividend is distributed. Fundamentally, we think that we have a unique M&A strategy that allows us to consistently reinvest these excess cash flows that will drive returns well above our free cash flow yields. Over the past few years, we have developed a roadmap primarily around Infrastructure Software starting with Brocade, and then with CA and now Symantec that will allow us to continue to execute on the strategy for many years to come. So going forward, our plan is to use this excess cash for acquisitions and/or to pay down the debt that we borrowed to make these acquisitions. Now over the last years, we have bought back a lot of stock. We had an opportunity to buy stock at depressed prices following the CA announcement. We also want to limit the dilution from the one-time multi-year grant we did earlier this year. In all, we have invested $13.1 billion to repurchase or eliminate a total of 54.5 million shares at an average price of approximately $240 per share over the last 16 months through the end of our fiscal Q3 '19. So in summary, we think this decision made a lot of sense. That being said, maintaining our core capital allocation strategy of dividends and M&A while pursuing meaningful buybacks in parallel has caused us to increase our leverage and leverage multiples pretty substantially. Especially in light of the weak macro environment we are seeing today, we're conscious of the risks that a more levered balance sheet creates and are very focused on managing those risks. As a result, we have started to transition our focus to deleveraging the balance sheet following the recent Symantec acquisition announcement. That concludes my prepared remarks. During the Q&A portion of today's call, please limit yourselves to one question each, so we’re going to accommodate as many analysts as possible.

Good afternoon and thanks for taking my question. Good to see the business bottoming here in the second half of the year. Hock, you know we continue to hear that Tomahawk 3, Jericho 2 are seeing strong demand for the 200 gig and 400 gig cloud networking adoption, also your revenue and design win pipeline on compute networking and security off-load acceleration ASICs is pretty strong with guys like Google, Facebook, Microsoft, etcetera. Last earnings call, you had anticipated full-year double-digits growth in your datacenter networking, compute off-load businesses. Question is, are you still tracking to that and despite the muted growth outlook for the overall business looking into next year, given your design win pipeline, do you expect continued double-digits growth in the datacenter networking and compute off-load looking into next year as well?

Our outlook, which we shared with you earlier, has not changed significantly. We continue to see improvements, including an increase in ship deliveries into hypercloud, as well as gains in networking and computing off-load silicon. This has provided a substantial buffer in what is currently a fairly uncertain and challenging market.

Thanks for taking my question. Hock, you started mentioning something about next year and I just wanted to flesh that out. I know you're not giving next year guidance per se, but on the positive side, you're saying business is bottoming, you outlined the number of product cycles or so, but then you sound a little bit cautious on just the environment. So, I was curious how you were thinking conceptually about next year, pluses and minuses. And then as part of that, if you could also give us some indication of how Huawei figures into that both kind of in the near-term Q4 and next year? Thank you.

You have essentially answered my question in several respects. The US-China trade dispute appears to be evolving into a prolonged situation filled with complexities and uncertainties. We are assuming that the conditions and the environment will remain consistent with what we are currently experiencing. If we maintain that assumption for next year, it seems likely that 2020 will be quite uncertain. At this moment, we may still need about three months before we can provide clearer guidance for 2020. However, as we look at the rest of this calendar year, or perhaps this fiscal year, it appears we have reached a low point in the semiconductor solutions segment. We are optimistic as we anticipate some improvement, particularly as we expect increased activity from our large North American OEM customers in handsets over the coming months. Overall, we appear to be remaining at this low level.

Good afternoon, everyone. Thank you for allowing me to ask a question. Hock, I understand you're avoiding providing specific guidance by business line, but I am curious about your comments regarding the wireless segment of the Semiconductor business. How should we view this build cycle for this year compared to previous years? There's a perspective that you're increasing content in the RF sector, and with Wi-Fi 6, your largest customer is not staggering their phone launches this year. They are also facing tariff challenges that may prompt them to accelerate some builds. Considering the July quarter results were up sequentially in the mid-teens, how should we approach the outlook for October? How long will this build last, and what's the seasonal forecast looking into January? Any additional insights would be appreciated.

It's always challenging to predict how far we can go given the limited visibility our customers provide. Specifically regarding wireless, as we've consistently observed in prior years, we anticipate an increase in seasonality in the third quarter, which corresponds to July, and we expect to see even more in our final fiscal quarter in October. This is as far as we can project typically, as it ultimately relies on adjustments from our OEM customers. However, this year seems consistent with past trends, and year-on-year, the patterns appear quite predictable. That said, our company encompasses much more than just wireless. In our Semiconductor Solutions segment, we engage in various areas with several factors influencing performance. While we continue to see strong demand in networking and computing offload within data centers, we are experiencing some declines in storage and broadband. It’s possible that conditions for wireless may improve in the next quarter, but there could be other areas that may weaken concurrently. Overall, given our extensive portfolio and strength across different areas, the semiconductor macro market reflects that we are not as robust now compared to the same time last year. Based on our data year-to-date, we are likely down around 8% year-on-year on average, which aligns with the broader market trends we perceive, excluding memory. Although we saw greater declines in the first and second quarters of this fiscal year, we expect less decline in the second half. This does not necessarily indicate that we've hit the bottom or are on the verge of recovery. Our statement reflects our confidence that we are at the lowest point, but there remains limited clarity or certainty about a significant recovery in the near future.

Hey, thanks guys. Hey Hock, can you talk about the expected timing of the 5G ramp, especially for your ASIC and ASSP business? When do you think that starts? Has this been pushed out at all? Is it about as good as you thought it would be three or six months ago or has the forecast changed and how much?

That's a difficult question because, honestly, we don't have much involvement in the 5G ramp in radio access from a broad perspective. We thought we had some impact at the handset level related to radio access, but we believe our main influence is more on backhaul and networks. Each segment will likely ramp up 5G at different times. Our understanding of the size of that ramp at any given moment also varies, as different operators in various countries may choose to ramp up at different times and in different parts of the network, whether it's front-side or backhaul. My guess is that we won't see much movement until later this year or early next year, particularly in the backhaul area, which affects our results.

Hi guys. Thanks for taking my question. I wanted to know, you've had a growth target for semis of mid-single digits, and obviously we're in an uncertain environment. But you also talked a lot about, I guess, company-specific drivers and product cycles that fundamentally can still drive. So I guess, are those fundamental drivers enough to keep the semi business growing at least somewhere in the ballpark of that sort of mid-single-digit long-term guidance even in an environment of uncertainty? I guess, maybe even put a different way, could you maybe talk about specifically some of the product cycles and trajectories that are unique to Broadcom that you see kind of ramping next year and maybe compare with what we had this year across your different businesses?

When I discussed the various trends influencing our product lines and semiconductor business, I wasn't considering just one year. This reflects our ongoing trend. I provided examples because these are relevant today, in the recent past, and into the future. My observation is that in areas where we participate, such as networking in data centers, routing in core and metro networks, and cable and broadband, it is clear that there is a continuous evolution in technology, specifically semiconductor technology. We see a constant demand for improved performance and increased bandwidth, which is central to our connectivity solutions. Depending on the application, some transitions may take a year or three years, but they do occur and contribute to sustained demand for our technology and products. This underpins our long-term growth forecast in semiconductors at a mid-single-digit rate. I am not referring to one year or even two or three years, but over the next five to ten years. For example, in the fiscal year 2018, our semiconductor business grew 12% organically from 2017, which was over 16% in 2017 when adjusted for acquisitions. I do not expect that high double-digit growth to continue indefinitely, as we cover a broad area. Therefore, in 2019, we anticipate a decline from a strong 2018, likely in the mid to high-single digits, which is not unexpected. However, over multiple years, we believe we can achieve that mid-single-digit compounded annual growth rate, although it won’t manifest every year.

Thanks. Tom, I had one for you on the capital return side of things. In the past, that 50% dividend policy you have, it's very clear, but the free cash flow that generates that at times has been a little more subjective due to one-time charges finishing the classic Broadcom campus, etc. So how do restructuring charges, how do they fit into the math of free cash flow? And then the investment-grade target where you want to keep it there, what sort of leverage target should we think about with you guys more aggressively paying down debt as opposed to repurchasing shares in the near future?

Yeah, I think on the cash flow side, Ross, what we've tried to do is create somewhat of a formula, because we do typically have acquisitions and we do have investments we make to get to the synergy targets. In fact, what we're trying to do is deliver the benefits to the stockholders the year with which we are able to achieve those synergies. So what we've done, as we said, look, what would be free cash flow from operations, which obviously includes restructuring charges and we want to add back those for the purposes of calculating the dividend. So when we get to the end of the year, we will take the cash flow from operations, we will add back the restructuring and integration charges, and in fact will divide by 2 to get to the number that we use to calculate the dividend. This year we don't have any specific one-time large campus initiatives of things like that that we would also want to back out. So that should be a fairly good proxy for how we think about the dividend and the recommendation of the Board at the end of this year. In terms of investment grade, I think we've talked about this before, but maintaining investment grade similar to the dividend policy is a core principle here, and I think the reason for that, Mark and I discussed it many times internally is, it provides maximum flexibility for us to continue to pursue our strategy. It's always been very important. Over time, we had this one-time event. We bought back a bunch of stock as I talked about in the prepared remarks, that's pushed leverage up more so than we normally would. We think based on the economics and the results so far that was the right decision, but we're really looking forward to going back to the playbook we pursued in the past, which is following the distribution of the dividend. Now we still have a lot of cash flow and that cash flow we think based on our strategy is best used for M&A because that's where the returns are most optimal. As part of that, we often borrow money to finance those acquisitions, and then we go and pay that debt down. So I think we're going back to a more traditional playbook and as part of that given the size and the scale and the increasing diversity of the business and the share profitability and the cash flows, we're very much an investment-grade company and we're going to be very focused on maintaining that investment-grade status going forward.

Hey guys, thanks for your question. Tom for you, just on the annual guidance for operating margin would suggest a tick down into October, I just want to make sure how literally to take that, and if so, can you talk about any drivers as to why profitability to be coming down in October? Thanks.

Yeah, it's a good point, and maybe we're a bit conservative to be honest, when I think the reality as you see the mix shift in the second half of the year. We've got a couple things going on. One with wireless ramping seasonally as Hock discussed, those margins are not as high as the rest of the portfolio. And then on top of that, we are giving back some on the SAN switching side in the back half which is fairly high margin product. So we thought it made sense given the mix to stick to that number and that's why we're staying there.

Hi, everyone. Thank you for the question. Hock, could you provide more insight into the hyperscale cloud environment? Several of your competitors have mentioned early signs of recovery for the latter half of the year and possibly into 2024 after a long period of decline. I understand your company has specific factors at play, but what is your perspective on customer sentiment regarding spending and capacity expansion? Thank you.

It's a very interesting question. I can address it in two ways. First, regarding cloud spending, we are seeing some common trends with what many others are reporting, particularly an improvement in cloud spending across various areas, especially in the expansion of new generation datacenters. This expansion benefits our switching and routing business, as well as some of our specific custom off-load programs in AI and SmartNICs. However, cloud spending has become somewhat unpredictable, resembling telco spending in its lumpiness. On the other side of our infrastructure business, we are observing enterprises and end users—particularly our largest core customers—continuing to spend aggressively. Their IT budgets remain strong as they pursue digital transformation amid decent business performance. This consistent spending is why our infrastructure software business's renewals are growing positively. However, there is a noticeable difference when selling components to OEMs, who then produce systems for these same end users. In this case, we are witnessing some slowdown, as all our partners are tightening their supply chains due to the prevailing uncertainty in the environment. This tightening has resulted in reduced orders and what seems to be diminished demand. While our direct sales to large enterprises are holding steady, selling components through partners has slowed down, which is clearly reflected in our current numbers and the outlook we are sharing.

Yes, thank you. Hock, switching gears to CA in the software side. Can you talk about just some of the efforts around portfolio license agreements, specifically what kind of sales efforts you have in place there and what this could mean for the business over the next couple of years as you try to gear it that way?

Yes. The portfolio licensing arrangements are key to our infrastructure software business, which currently includes CA. It has been less than a year since we launched this, and the progress we've seen since taking over CA last November has been positive. We're focused on our largest 500 to 600 customers, where we have significant potential for large contracts. As we approach renewals, our ability to offer portfolio-wide licensing arrangements across a wide range of products, from mainframe to distributed software, is appealing and cost-effective for large enterprises that utilize our infrastructure software. We have completed multiple deals and renewals and remain actively engaged with these companies. By concentrating on these major customers, where there is substantial existing usage and room for more, we believe we can effectively enhance our sales strategy. This emphasis helps us avoid spreading ourselves too thin with smaller, non-core customers. Our focus on larger clients enables us to secure renewals for larger contracts under portfolio licensing agreements at an annual rate exceeding 20%. In contrast, our smaller, non-core customer base is attriting at around 10%. These core customers contribute 80% of our total revenue, while the long tail accounts for only 20%. Consequently, after almost a year, we expect to demonstrate a net gain of over 10%. If we maintain this trajectory, we could see a significant increase in our revenues from this business, potentially achieving double-digit growth in three years as we reach the average term of our contracts.