Broadcom Inc (AVGO) — Q2 2021 Earnings Call Transcript

Thank you, operator, and good afternoon, everyone. Joining me on today's call are Hock Tan, President and CEO; Kirsten Spears, Chief Financial Officer; Tom Krause, President, Infrastructure Software Group; and Charlie Kawwas, Chief Operating Officer. Broadcom also distributed a press release and financial tables after the market closed, describing our financial performance for the second quarter of fiscal year 2021. 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, Hock and Kirsten will be providing details of our second quarter fiscal year 2021 results, guidance for our third quarter, as well as 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. I'll now turn the call over to Hock.

Thank you, Ji, and thank you, everyone, for joining us today. In Q2, semiconductor solutions revenue grew a strong 20% year-on-year to $4.8 billion, with infrastructure software revenue growing an expected 4% year-on-year to $1.8 billion. Consolidated net revenue was $6.6 billion, up 15% year-on-year. Now on the last earnings call we had – we talked about how strong broadband and networking bookings were from hypercloud and service providers, even as wireless was declining seasonally. In Q2, just passed, not only do we see broadband and networking sustaining, we now see a recovery of bookings from enterprise. And on the supply side, our lead times have now stabilized, but the volume of bookings we are experiencing today continues to grow. Now, we intend to meet such demand and in doing so we maintain our disciplined process of carefully reviewing our backlog, identifying real end user demand and delivering products accordingly. With that as context, let me provide you more color. Starting with broadband, which interestingly enough is going through somewhat of a renaissance. Revenue grew 28% year-on-year and represented 18% of semiconductor revenue. As discussed during our broadband teaching, the work, learn and play from home environment is driving global service providers to expand connectivity to the home. In our broadband carrier access business, PON fiber, or otherwise known as PON, grew over 40% year-on-year, mostly with existing generation 2.5G, but with next-generation 10G PON representing only 30% today. There is significant room for content growth as 10G PON deploys over the next few years. Not to be outdone by fiber, cable operators in the U.S. are driving deployments of DOCSIS 3.1 cable modems; we saw an 80% year-on-year growth and are planning to accelerate the upgrade to next-generation DOCSIS 4.0. Our broadband technologies, in fact, are enabling service providers to complement the 5G they delivered to deliver the best experience for consumers. Now overlaying all this last-mile broadband upgrades, we see a demand surge for the latest Wi-Fi 6 and 6E technology to enable the last 100 feet of connectivity in homes. Broadcom has emerged as the clear market and technology leader in Wi-Fi for access gateways to the home and into enterprises, with over 15 million parts shipped in Q2 alone, or a year-on-year revenue growth of some 30%. On the other hand, as we might expect, with a push into higher performance fiber, copper DSL, digital subscriber line deployments for wireline broadband declined 30% year-on-year, and with a lack of live events during the pandemic, video declined 20%. But with the onset of 5G, service providers are competing for subscribers, leading to technology upgrades globally in fiber, cable, and Wi-Fi connectivity. We're seeing this investment cycle in broadband extending into 2022. And so for Q3, we expect to sustain double-digit year-on-year revenue growth in this segment. Moving on to networking, networking grew 10% year-on-year and represented 32% of our semiconductor revenue. We experienced a tailwind from hypercloud and telcos, partially offset by headwinds from enterprise. Revenue for switching was up 30% year-on-year, primarily driven by the strong ramp of our Trident and Tomahawk 3 for over 400G platforms and hypercloud data centers. In the networks, service providers have been investing in 5G infrastructure worldwide, where the demand for Jericho 2 at the metro core and Qumran at the edge has been robust with revenue up 35% year-on-year. On the other hand, enterprise demand in networking has not yet recovered, still down double digits from a year ago. And as we go into the back half of the year, we expect to see hypercloud upgrading to a next-generation Trident Tomahawk 4 or over 800G switching platforms and sustained strength by service providers in network routing. Accordingly in Q3, we expect networking revenue to maintain the trend of low double-digit growth year-on-year, awaiting the complete recovery of enterprise demand. Speaking of enterprise, let's talk about service storage connectivity, which represented approximately 12% of semiconductor revenue. This end market is largely driven by enterprise and in line with our guidance, revenue was down 16% year-on-year. You may recall, however, in Q1, this was down 22%. As the economy starts to recover, we have seen an improving demand trajectory. In Q3, we expect service storage connectivity revenue to be down high single-digit percentage year-on-year. With the launch of Intel's Ice Lake, AMD's Milan as well as future ARM-based servers, this space is turning quite exciting and innovative for us, both in hardware and software. We will provide more color during our next teach-in in July on our server storage business. Moving on to wireless, Q2 revenue was down 16% sequentially, reflecting seasonality with wireless representing 34% of semiconductor revenue mix. Nonetheless, on a year-over-year basis, wireless revenue was up 48%, reflecting a very favorable comparison year-on-year, as well as content increases in FBAR and Wi-Fi. In Q2, we were able to ship more than we had originally planned. Accordingly, in Q3, we expect the growth trend in wireless revenue to sustain, but at over 30% year-on-year. Finally, industrial and other represented approximately 4% of Q2 semiconductor solutions revenue. Resales grew 34% year-over-year in Q2, driven by recovery in automotive and China. Inventory in the channel continues to deplete, as what we shipped to the distributors grew only 23%. Turning to Q3, we expect resales to continue to grow double-digit percentages on a year-on-year basis. In summary, Q2 semiconductor solutions segment was up 20% year-on-year, and in Q3, we expect revenue growth year-over-year to be of a similar amount. Turning to software, in Q2 infrastructure software produced another quarter of steady and predictable results, as revenue grew 4% year-on-year and represented 27% of total revenue. If we exclude professional services, our enterprise software revenue grew 7%, actually year-over-year, and as further indicator of the quality and sustainability of our products, over 90% of our software bookings represented recurring subscription and maintenance, with an average contract lifespan from core customers close to three years. We continue to believe our infrastructure software business is on track to grow at better than mid-single digit percentages year-over-year, which is again what we expect to see in Q3. Summarizing this, demand continues to be robust and so our Q2 consolidated net revenue grew 15% year-over-year. We expect the momentum to sustain in Q3 and total revenue to be at $6.75 billion or up 16% year-on-year. With that, let me now turn the call over to Kirsten.

Thank you, Hock. Let me now provide additional detail on our financial performance. Revenue was $6.6 billion for the quarter, up 15% from a year ago. Gross margins were a record 75% of revenue in the quarter, and up approximately 180 basis points year-on-year. Operating expenses were $1.2 billion, down 1% year-on-year, driven by lower SG&A offset in part by increased investment in R&D. Operating income for the quarter was $3.8 billion and was up 25% from a year ago. Operating margin was 58% of revenue, up approximately 470 basis points year-on-year. Adjusted EBITDA was $4 billion or 60% of revenue. This figure excludes $133 million of depreciation. Now, a review of the P&L for our two segments. Revenue for our semiconductor solution segment was $4.8 billion and represented 73% of total revenue in the quarter. This was up 20% year-on-year. Gross margins for our semiconductor solution segment were approximately 69%, up 290 basis points year-on-year, driven primarily by higher product margins. This margin improvement comes from content growth, as we deploy more next-generation products in broadband and networking end markets. Operating expenses were $795 million in Q2, up approximately 2% year-on-year as we invested in R&D and streamlined SG&A. R&D was $702 million in Q2, up approximately 6% year-on-year. Q2 operating margins increased to 53%, up 580 basis points year-on-year. While semiconductor revenue was up 20%, operating profit grew 35%. Moving to the P&L for our infrastructure software segment, revenue for infrastructure software was $1.8 billion and represented 27% of revenue. This was up 4% year-on-year. Gross margins for infrastructure software were 90% in the quarter, up 100 basis points year-over-year. Operating expenses were $355 million in the quarter, down 8% year-on-year, as we've completed the integration of Symantec. R&D spending at $228 million is up 1% year-over-year. Operating profit was up 10% year-on-year on top-line growth of 4%. Operating margin was 70% in Q2, up 360 basis points year-over-year. Moving to cash flow, free cash flow in the second quarter was $3.4 billion representing 52% of revenue. Day sales outstanding were 33 days in the second quarter compared to 51 days a year ago. We ended the second quarter with inventory of $1 billion, an increase of $52 million or 5% from the end of the prior quarter. We should also note, in Q2 we spent $126 million on capital expenditures. On the financing front, we extended our weighted average debt maturity to approximately 10 years from nine, by exchanging notes. Our weighted average coupon decreased about 5 basis points to 3.7%. During the quarter, we made $1.5 billion in payments on debt obligations, ending the quarter with $9.5 billion of cash and $40.4 billion of total debt, of which $278 million is short-term. Turning to capital allocation, in the quarter, we paid stockholders $1.6 billion of cash dividends. We also paid $461 million in withholding taxes due on vesting of employee equity, resulting in the elimination of approximately 1 million AVGO shares. We ended the quarter with $410 million outstanding common shares and $450 million diluted shares. Note that we expect the diluted share count to be $449 million in Q3. The Board of Directors has approved a quarterly cash dividend on our common stock of $3.60 per share in Q3. Based on current trends and conditions, our guidance for the third quarter of fiscal 2021 is for consolidated revenues to be $6.75 billion and adjusted EBITDA of approximately 60% of projected revenue. That concludes my prepared remarks. Operator, please open up the call for questions.

Yeah. Good afternoon, guys. Thanks for letting me ask a question. Hock, I've got two quick ones. First, within your wireless business, you've been able to sign long-term contracts with your key customer. And I'd argue that's benefited both you and them. It's given you the confidence to invest in the business properly, and then the confidence that you'll have supply for them when they need it. I'm just kind of curious, given how tight things are elsewhere in the semi business, have you been able to parlay this into any longer-term customer contracts? And what implication might that have as we all start to worry about the end of the cycle? And then secondly, just on your comments about enterprise recovery. Can you elaborate on that? Was that specifically a storage comment? Or is that also a networking comment?

Okay. Let me take the question one at a time. On arrangements with long-term agreements, John, this is something we have been thoughtfully and carefully putting in place with our core strategic customers. We just don't go do it as if it's commoditized. We're very thoughtful about doing it. We do it in very specific areas where technology is fairly, fairly difficult complex to manage, and which requires a substantial amount of R&D spending. We've been doing it for a while now. We've got strategic customers in core businesses. So we just don't do it across the board. What you pointed out is very correct. It's a structure and an agreement with mutual benefit. We have the confidence to invest in R&D to make CapEx capacity investments. In return, we offer the best leading-edge technology in specific areas in a timely manner to our critical customers. So yes, we have been doing it, and we will continue to thoughtfully do it in a very appropriate manner. On the second part, okay, if you could repeat the question, John, let me be sure I capture everything.

Yes. Can you just elaborate a little bit on your comments about an enterprise recovering brewing? Was that mostly within storage? Or was it networking? So I'm a little bit surprised, given some of Cisco's comments that you're not a little bit more positive on the enterprise network space.

It relates to enterprise spending, but I wouldn't say it's uniform across all sectors. We've categorized service providers and telecommunications companies separately from traditional enterprises. As I mentioned, telecom companies have made significant investments in broadband over the last year. On the other hand, traditional enterprises, such as banks, manufacturers, various retailers, and airlines, are still in recovery mode. As the pandemic eases in places like North America, we are seeing an uptick in spending, but it's not a dramatic increase. Certain sectors that depend on warehouses, Wi-Fi networks, and campus networking are experiencing improvements. However, I can't say that all enterprises are increasing their spending. We're still witnessing a year-on-year decline in servers and storage connectivity, which impacts both data centers and enterprise campus environments. Overall, we see a decline, rather than growth across the board.

Good afternoon. Great job on the quarterly execution, strong margins and free cash flow generation. Hock, I think as you mentioned, we're still in the early phases of the 400-gig networking upgrade cycle with your hyperscale and telco customers. I know two of your big cloud piping customers have already started the upgrade. Looks like there are another two more that are going to start the upgrade cycle here in the second half of this year, and quite a bit more next year. And then as you mentioned, you still have Tomahawk 4 ahead of you. So given the extended visibility that the team has with a strong backlog, do you see the cloud and telco upgrade cycle as an inevitable recovery in enterprise driving continued year-over-year growth in networking into next year?

I don’t – we don't really try to guide more than one quarter at a time, first of all, because we're not that smart to be able to do that. But on a broader trajectory, it does appear fairly much like the trend, that is, the hypercloud guys will push out in the second half as indicated on the data center sign on Tomahawk 4, the 800G platform. They have a substantial backlog for delivery in the back half of the year for Tomahawk 4. We see that going on. But—and you're right, we see the recovery step-by-step of their enterprise, though I do not see that really taking off to the level it was a year ago, probably until 2022. What we do not know for sure is whether that will give pause to hypercloud in their spending. We're not sure if hypercloud spending will necessarily continue into 2022. We sense it would and see some of the backlog, but as enterprise steps up, one really never knows if the economy starts to rebalance in that area. What we do see in broadband is service providers, particularly telcos, are for sure upgrading, and we see them upgrade with a longer upgrade cycle extending into 2022.

Hi, guys. Thanks for having me ask a question. Congrats on the strong results. Hock, I wanted to dive a little bit into the lead time commentary that you had with that stabilizing. Two quarters ago, you talked about the size of the book, the backlog you had. Last quarter, you talked about the year-over-year, and even in some instances, the sequential growth being so large in bookings. Now we're hearing that the lead times are stabilizing. People could interpret that in many different ways regarding demand or supply catching up. Or frankly, people are just ordering so far out that they're not willing to extend that any further. So, I was hoping to double-click on that lead time commentary and get your feelings as to why it's stabilizing. Do you take that as a positive or a negative?

I just made a comment to say we have stretched our lead time so far, Ross. Good point you bring up, and I'm glad you bring it up to give me a chance to clarify a quick comment I made in my opening remarks. We are comfortable at the lead times we are on. Our customers are comfortable seeing our lead time now. What we've found rather remarkable over the last quarter is that even if our lead times remain stable, consistent, the volume of bookings we receive every week continues to grow. I made that comment and I'm thankful for the opportunity to reiterate that point. Our lead times have been stable for the last three months, but the booking rate we are seeing every week continues to step up.

Thanks for taking my question. Hock, I had another one on the supply situation. If there were no supply constraints, how fast would your semiconductor business be growing? And what is driving the shortages for you right now? What are you doing to resolve it? And do you have any kind of gut feel on when the supply situation will become normal? Thank you.

Great. I'll answer the first and the last, and in between I'm not sure. On the first, we will not put ourselves in the situation nor should anyone do it, because there's also a certain amount you don't know we do not want our customers and I don't think any of our peers want to do that either to buy too hot to create buffers, to buy ahead of what they mean. So, we try to match and identify, as I said, go through a process of rigorously understanding through end demand. In other words, we look for drop date quantities, as the term is used in the industry. We ship to those drop date quantities and maybe a little more. What you see today is the true growth rate we are representing. We are not hiding what could have been. We've been shipping to what we believe our customers consider their true real demand. Having said that, we may be delivering during just-in-time, but nonetheless, we do try to fulfill what customers truly want just in a timely basis. From our perspective, the challenges we have in the supply chain is a constant side challenge to ensure that we get components, whether it's wafers, substrates, getting our products assembled, tested, and any other small components on a timely basis to keep this running. We look at the size of our inventory versus the size of our cost of goods sold, or revenue quarterly, and you can see we run close to just in time through our entire supply chain. We've been able to sustain that. The 20% year-on-year growth we are reporting on semiconductor components is, in our view, a decent reflection of true end demand needs.

Thanks a lot. Hock, I guess I wanted to ask you what you think the long-term growth rate is of your semiconductor business. You're trending to the high teens this year, but that's due to easy comps, the compressed iPhone launch, and the pull forward of some of these technologies due to the pandemic. Once this all sorts of normalizes, what do you think is the right long-term growth rate for the business? Are you still thinking 5%? Or do you think given the strength of the bookings recently that it could be better than that? Thanks.

That's a hell of a question. I'll tell you this, right now, we're in the midst of very strong demand. That has created, perhaps, as we all know, a severe imbalance within demand and supply, as supply works to catch up. The dynamics underlying the semiconductor industry hasn't yet changed. At least I haven't seen it change. So Tim, that's my best answer, which is I haven't changed my thinking about how this industry will behave over the next 10 years. It's a relatively matured industry, evolving, and disruption is less of an event. It's evolutionary. I have not seen anything that tells me there's a fundamental change.

Thanks. Hock, just given the ongoing strength in the free cash flow and improved balance sheet, can you just talk about your thoughts on the M&A environment? Also, buybacks, how you're thinking about cash deployment as you go forward?

Yeah, I'll take that one. This is Kirsten. Relative to capital allocation, first and foremost, we're dedicated to paying 50% of our free cash flows to our shareholders. That would be first. Secondly, M&A—if we can find accretive M&A—would be the second objective. Then thirdly, stock buybacks, and at the end, there would be debt repayments. That's how we're looking at capital allocation in that order. There isn't anything yet on the M&A front that I can talk about, but if anything does come up, we'll let you know.

Hey, good afternoon. Thanks for taking my question. Just curious, a little more detail on the gross margin—it's a record gross margin. Any color on product or segment? As you look forward here, if you could describe what you're still dealing with in terms of excess costs due to COVID? Should that be added to the gross margin?

I expect gross margin next quarter to be about the same as it was this quarter. At the end of the year, we're expecting wireless to come back in for the normal ramp that we have, and so the margins will come down a bit towards the end of the year. But at this point, I see us being able to sustain the margins that we experienced this quarter, mostly coming from networking and broadband.

Blayne, our gross margin has this natural trend of continuing to keep expanding year-on-year, not necessarily quarter-on-quarter, but sequentially as much as year-on-year, simply because we tend to have a chance to go to a new product, a new next-generation product across some of our franchise products. The natural growth of our gross margin for our business, especially in the semiconductor side, which I assume your question is related to, is as I've always said, we have a gross margin expansion range of 50 to 150 basis points year-on-year. This is an average across 20 or so different product lines, each with a different product lifecycle. Each going with new generation product each time. You should expect that year after year; you will see that 50 to 150 basis point improvement in gross margin on the semiconductor side.

Hi, guys. Thank you so much for taking my questions. I had two, actually, one on wireless and one on the cost side. Hock, in terms of wireless, the Q2 revenue came in better than expected. Was that primarily supply being better, or were there dynamics on the demand side that came in better than expected? Also, as you think about the next generation product cycle your largest customer, how are you thinking about the content opportunity at this point? If you can comment on RF and Wi-Fi, and compare and contrast this uplift in this cycle vis-à-vis past cycles that would be super helpful. On the cost side, can you speak to wafer pricing and substrates and what you're seeing from a cost perspective over the next year or so?

Alright, let's start with the first one. On wireless, you're right. Q2 wireless was higher than we had originally planned. It's all related to demand, of course. We will never ship just because we have the product; it is based on demand one thing, and we are happy to fulfill it. Part of the demand may actually come a bit from Q3. We aren’t sure, except we know we did pull in some from Q3 to Q2, not much, and that allows Q2 to perform 48% year-on-year growth which is great. Q3 will still be pretty good year-on-year as we fully expect. Related to content, I prefer at this point not to answer that question at all. No offense, please. But I'll be happy to take the third question. Yes, we have cost inflation in this environment, where the semiconductor supply chain is under severe constraints on its ability to provide. We are a very large and loyal customer to many of our suppliers. We believe we are treated very well. Where prices are concerned, of course, we see cost inflation. In this environment, we are open to talking to customers who are in turn very willing to address cost pressures with higher purchase prices. So we're good, which is why our margins have been stable.

Yeah. Good afternoon. Thank you for taking the question. Another question on the supply chain, and a bigger picture question, Hock. If you think about your increased lead times, you talked earlier to John's question about selective strategic agreements with key customers. At the same time, we're taking multiyear take or pay contracts with foundries. Curious if you see any structural changes to the semi-industry as we emerge post-pandemic?

My frank opinion is, I don't know that there should be any structural changes. The question that was asked is if I think the semiconductor industry over the next 10 to 20 years will grow any faster or slower. My view is, I don’t see any fundamental things that have changed. While we're in the flick of this storm, all hell breaks loose. But these are cycles we've seen many times in the semiconductor industry. This supply will stabilize at some point. Demand is always there because people need technology and the performance that we all offer in our products. We'll be competing the same way in the same manner. I do not see anything that changes that.

Hey, thanks, gang. There's a lot of talk, worries, speculation, I don’t know of old wives’ tales, whatever, about this big inventory build of handsets in China. Any thoughts there, Hock and team? What will be the potential impact for Broadcom?

Not directly. If there's such a big overhang sitting out there, not directly because our wireless business, as we have articulated, sells to two large customers primarily. We do not sell much, if any, to the chipset makers in China. We sell to two big customers: one in North America and one in Korea, high-end flagship phones. Indirectly, there could be some blowback, and I do recognize in certain markets, if there is excess inventory to sell out there. But on a direct basis, we do not expect to see anything.

Thank you, operator. In closing, please note that Hock will be presenting at the BOFA Securities Technology Conference on Tuesday, June 8. Following our networking and broadband teachings earlier this year, Broadcom and Bernstein will be hosting a teaching on our storage businesses on Wednesday, July 21 at 12 PM Eastern, 9 AM Pacific. Hock will be joined by Jas Tremblay, General Manager of our Server Storage Connectivity business, Jack Rondoni, General Manager of our thin business, and Dan Dolan, marketing head of our hard disk drive business. That will conclude our earnings call today. Thank you all for joining. Operator, you may end the call.