Pros And Cons Of Investing In Broadcom In 2023 (NASDAQ:AVGO)

Broadcom Inc. (NASDAQ:AVGO) designs, develops, and supplies various semiconductor devices with a focus on complex digital and mixed signal complementary metal oxide semiconductor based devices and analog III-V based products worldwide. While the broader semiconductor industry (SMH) has lost 18% of its market value in the past 12 months, AVGO’s stock has gained about 4%.

Due to this outstanding performance in the past quarters we have decided to take a look at some of the pros and cons of investing in AVGO’s stock now.

Pros

Dividends

AVGO is currently paying a quarterly dividend of $4.6 per share, which is equivalent to an annual yield of 3.2%. For this reason, many dividend investors may get interested in this stock.

In fact, not only the current dividend is attractive, but the firm’s entire track record of dividend payments. AVGO has been returning value to its shareholders in the form of dividend payments since 2011, and they have managed to increase the amount in every single year.

Over the past 8 years, the growth has actually reach a CAGR of 38%, which we believe is outstanding.

The payments and the growth also appear to be safe and sustainable, for two reasons.

1.) While the payout ratios may compare unfavourably to the sector median, they are in line with the company’s 5Y average and they do not appear to be excessively high.

2.) Over the past 5 years, AVGO has demonstrated stable growth, both in terms of net revenue, gross margin, adjusted EBITDA and free cash flow. Even during the past year the firm has managed to improve its financial performance, despite the challenging macroeconomic environment.

In 2023, we believe that the macroeconomic environment is likely to improve, which could further fuel AVGO’s growth going forward.

For these reasons, we believe AVGO could be a great option for dividend and dividend growth investors.

Liquidity position

From a liquidity point of view, Broadcom’s balance sheet looks relatively strong. The firm’s current- and quick ratios are both well above 1, indicating that the current assets are more than enough to cover the current liabilities.

These ratios also compare favourably to those of Broadcom’s peers/competitors.

We believe in the current uncertain market environment a strong liquidity position could be a great advantage. It allows for financial flexibility and enables the firm to navigate through periods of downturns, if they were to happen in the near term.

Valuation

At the current price levels the valuation of the company also appears to be appealing. Broadcom’s current P/E ratio is 15.2x, indicating a discount compared to both the information technology sector median and the firm’s own 5Y average.

While uncertainties about the macroeconomic environment (and therefore about the demand for AVGO’s products) exist, we believe that the current stock price levels, these uncertainties are fully priced in. Also, the above-mentioned growth, dividend payments and strong liquidity position further indicate that there could be further upside potential from the current price levels.

One last factor to point out, which we believe makes the current valuation attractive is the development of the margins of the past years. The following chart depicts the quarterly gross-, operating, and profit margins. We can see that all three of these margins have been gradually increasing despite the challenging macroeconomic environment. While many firms have been struggling with contracting margins, AVGO has managed to keep expanding them.

Cons

Now let us take a look at the other side of the story, pointing out some of the risks and uncertainties that we have to take into account before establishing a rating on the firm’s stock.

Inventory levels

Over the past 2 years, AVGO has been building up its inventory in a rapid pace. At the same time, revenue has been growing at a significantly lower pace.

We believe that in this industry innovation is key. Products that may be valuable inventory today, may become quickly obsolete, if a new product hits the market. In case products become obsolete, write offs can have substantial impact on the firm’s balance sheet. If the company does not want to write off its inventory, it may try to sell it at steep discounts, which may result in a contraction of the margins. This thesis may become even more concerning as recently Apple (AAPL) has announced that it is looking to replace its Wi-Fi and Bluetooth chips (supplied by Broadcom) with its own chips starting from 2025. While it may not have an immediate impact on AVGO’s financial performance or inventory levels, it is worth keeping in mind, as Apple accounts for approximately 20% of AVGO’s revenue.

Wells Fargo analyst Aaron Rakers said:

From a Broadcom perspective, this likely creates an investor headwind given how significant Apple’s revenue contribution is to Broadcom, […]

Ideally, we would like to see the pace of the inventory build up to slow, before considering investing. While not directly related to inventory, we would also be keen to see new clients on the horizon, who could be replacing that potential revenue loss due to Apple’s planned move.

Investigation of the VMware acquisition

The European Union has announced that they are initiating an “in-depth” investigation of the $61B merger deal between the software company VMware (VMW) and Broadcom. The primary concern of the EU at this point is that if the deal goes through, the competition for certain hardware component may be restricted by Broadcom. The deadline for concluding the investigation has been set to 11th May, 2023.

An investigation about potential restriction of competition can often have a negative influence on the stock price, especially if the outcome is unfavourable. On the other hand, Broadcom has already received approval for the deal in several countries, including: Brazil, South Africa, and Canada, while it has also received foreign investment control clearance in Germany, France, Austria, and Italy. For these reasons, we believe that the outcome is less likely than not to be unfavourable for AVGO.

Further, the FTC is also reviewing the deal. The trade commission has its primary focus on the conglomerate effects of the deals.

Demand in consumer electronics is likely to remain low

In 2022, consumer confidence in the U.S. has hit historically low levels. While the sentiment has sharply improved in the past months, the reading continues to remain low. Poor consumer sentiment normally negative influences the consumer spending on durable, non-essential goods.

For this reason, we believe that the demand for consumer electronics is likely to remain low in 2023, which in turn is likely to have a negative impact on the demand for AVGO’s products. On the other hand, the slight improvement seen in the past months appears promising.

At the same time, analyst are expecting a “soft-landing” for chips. One of the reasons for the soft landing has been formulated by analysts John Vihn:

[…] consumer facing markets such as PCs, smartphones and others should continue to fall, but any decline is likely to be “partially” offset by growth in the cloud data center and vehicles.

For these reasons, we remain relatively cautious with our growth expectations for the coming quarters.

Important to also note that the reopening of China could also have positive impacts on the demand for consumer electronics, which may be able to fuel further growth in the quarters to come.