Broadcom’s stock price (NASDAQ: AVGO) was in the process of breaking resistance before third-quarter results were released last week. The results were slightly better than expected but still put the brakes on the potential for a breakout. However, regardless of the short-term price action, upside may be limited over the next few quarters.
Quarterly revenue at $ 5.5 billion was up 9.1% for the year and in-line. Non-GAAP EPS of $5.16 were marginally ahead of estimates. Diluted GAAP EPS of $1.71 were $0.41 better than estimates, but 36% down from a year earlier. On a year-on-year basis, the gross margin rose from 66 to 70%, while the operating margin fell to 16.6%, down from 26.8%. Free cash flow increased 8% to $2.3 billion, allowing the company to repurchase $977 million worth of shares.
Semiconductor solutions revenue fell 5% to $4.35 billion but still contributes 80% of revenue. Infrastructure software revenue grew 132% to $1.14 billion primarily as a result of the CA Technologies acquisition.
The Outlook Remains Uncertain for Semiconductor Sales
The company’s management team is sticking to their forecasts of $22.5 billion in revenue for the full year. They expect to earn $17.5 billion from semiconductor solutions and $5 billion from infrastructure software. Based on the current profit margin, the company’s outlook puts the stock on a forward PE north of 35, which is fairly high given the current growth trajectory.
Perhaps the most valuable takeaway was CEO Hock Tan saying that while semiconductor sales may have bottomed the outlook remains uncertain. He also indicated that the company would look to deleverage its balance sheet.
Broadcom is building a strong portfolio of businesses with the acquisition of CA Technologies and Symantec. These additions bring synergies to the company and will make it a formidable player in the infrastructure software industry. However, it will take time for these segments to contribute meaningfully to top-line growth.
In the interim, earnings growth will be driven by buybacks and expense management. The average analyst target for the stock is $322, and even the most bullish analysts are only looking for $345.
Limited Upside Doesn’t Justify Downside Risks
Those targets imply upside of 12 to 20%, which ties in with analyst forecasts for annual earnings growth of 16% over the next five years. That’s not much upside when one considers risks facing the global economy, the tech sector, and the semiconductor industry.
The stock price has been consolidating within a triangle pattern since May and was tentatively breaking to the upside before the results were released. A break above the high of the failed breakout at $301 would probably lead to a rally to the previous high at $320. For the stock to trade higher than that would require a change in the macro-environment.
Unless a trade deal between China and the U.S. is signed soon, it is more likely that the stock will drift lower. There is little reason to chase the stock, and investors may even be able to buy it below $260, where it will offer a much better reward to risk ratio.
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