One of my favorite sectors in 2021 was the semiconductor sector. Advances in technology have pushed demand up and supply chain challenges have made it harder for companies to acquire all the quantities needed, resulting in a shortage that has driven up prices. I own stocks in most major manufacturers, including Texas Instruments (TXN) and Qualcomm (QCOM).
In this article, I will discuss Broadcom (AVGO) in more detail. The company saw its stock price hit an all-time high in 2021, and as we speak, it’s down 20% from the peak. In this article, I intend to review the company and try to determine if it is a good addition to dividend growth portfolios after the recent decline.
I will analyze the company using the chart below, which represents my methodology for analyzing dividend growth stocks. I use the same methodology to facilitate the comparison of the stocks analyzed. I will examine the fundamentals, valuation, growth opportunities and risks of the business. I will then try to determine if it is a good investment.
According to Seeking Alpha’s company overview, Broadcom designs, develops and delivers semiconductor infrastructure software solutions. It offers semiconductor devices focused on complex mixed-signal and digital complementary metal oxide semiconductor devices and III-V-based analog products worldwide.
Revenues have increased significantly over the past five years. The company combines organic and inorganic growth as a strategy. During this period, the company acquired three companies to diversify its offer, while continuing to develop its basic offer. Going forward, and without taking into account any additional acquisitions, analysts believe that Broadcom will continue to grow at a mid-single-digit growth rate according to Seeking Alpha.
During the same period, EPS grew much faster due to revenue growth, margin expansion and synergies with acquired companies. Broadcom has become a cash cow, its free cash flow skyrocketing nearly 300% in five years. The ability to grow EPS and produce significant FCF is crucial for Broadcom to become a future dividend aristocrat. Going forward, analyst consensus, as seen on Seeking Alpha, expects Broadcom to post a CAGR EPS in the high single-digit area.
Broadcom has been paying and increasing its dividend since its inception 11 years ago. The latest increase was a generous 14% in December. The current yield is attractive at close to 3%, and investors can feel safer since, despite the 92% payout ratio using GAAP figures, the company only pays about 50% of its non-GAAP EPS and of its free cash flow. Management constantly reiterates how crucial the dividend is to the company’s capital allocation strategy, which is a good sign for investors in long-term dividend growth.
The second form by which a company can return money to shareholders is through buyouts. Historically, Broadcom focused on the dividend and used the rest of its FCF for acquisitions to grow the business. Therefore, as shown in the chart below, the number of shares in the company remained roughly the same. The lack of good acquisition opportunities launched a $10 billion buyback program, which equates to almost 5% of the number of shares. This in itself will have a positive effect on the EPS.
Broadcom’s current valuation is attractive. The company sells for 16.5x forecast 2022 earnings. The company is a little more expensive than Intel (INTC), but Intel is suffering from a declining EPS due to its attempted transformation. Other peers like Nvidia (NVDA) and AMD (AMD) are much more expensive but offer higher growth with this higher risk. Broadcom is at the sweet spot of decent growth and decent valuation.
The chart below from Fastgraphs shows the decline in the stock price over the past few weeks. The company is growing more slowly than in the past and its valuation is higher. However, I think the current valuation is warranted as the company is a much more stable company, with less fundamental risk. Shareholders set the price because Broadcom attracts income and dividend growth investors. To be in line with the average valuation, the share price will have to fall by another 10% bringing the yield to 3%.
To conclude, Broadcom is a great semiconductor manufacturer. The company is enjoying both organic and inorganic revenue growth. This translates into EPS growth and FCF growth that fuels dividend growth that far outpaces inflation. Additionally, the company is launching a buyback program that will increase EPS. This package comes at a rating which I think is decent.
The first opportunity is that of acquisitions. The company is known for its growth through acquisitions. Smart acquisitions that complemented the company’s portfolio and strengthened it. The current valuation makes it much more difficult for companies to grow through acquisition. Still, the company is smart, and when there is no acquisition opportunity, excess cash is earmarked for buyouts. There is no forced acquisition. The current expected growth rate does not take into account acquisitions, and this is a clear future benefit as Broadcom is looking for a target.
We have always said that we would return capital to shareholders if we did not announce a merger and acquisition by December. And so that fits with what we said and we plan to follow through. The $10 billion authorization will be executed according to a business plan and it will be thoughtful and consistent with what we said we would do.
(Kirsten Spears, CFO, Q4 Earnings Call)
The shortage of semiconductors is not going away anytime soon. Companies are still seeing strong demand for chips. This happens due to several trends. The IoT trend makes most electronic devices require chips, and as more of us own more and more devices, we consume more semiconductors. Companies in the sector are seeing strong demand that they are struggling to meet, which is reflected in price increases. Broadcom’s CEO has repeatedly emphasized the strength of demand, and this will be a major opportunity in the short to medium term.
We continue to see strong demand bookings from the semiconductor side. But a lot of that and the demand and a growing part of that demand now comes from business spending, which translates into end markets tend to drive a lot of our broadband to continue to drive broadband , which has been strong for most of 2021 continues to lead the enterprise portion of our networking business. And, of course, server and industrial storage is just very, very strong.
(Hock Tan, CEO, fourth quarter earnings call)
Another opportunity for investors is the margin of safety. The company is trading for a decent valuation relative to its peers and relative to the broader market. Moreover, the company is increasing its turnover and results at a decent rate. Therefore, while we continue to see a correction in the market, it will be more limited with Broadcom as the stock price is already trading for a more attractive valuation.
Market sentiment toward the technology is another risk. Since the start of 2022, tech companies have been the worst-performing sector in the S&P 500. Sentiment may be a short-term risk for investors selling tech-company ETFs, with the aim of shifting into higher-performing sectors. performing this year. This sentiment may hurt Broadcom as its shares will be sold, and it will have nothing to do with fundamentals or growth prospects. As investors flee a sector, even well-priced stocks suffer.
In addition, the company also evolves in a very competitive field. Right now we are seeing a shortage of semiconductors, but when supply meets demand and the global supply chain balances out, we will again see a much tougher competitive landscape where Broadcom will be in competition with other powers. Additionally, some technology companies like Apple (AAPL) are developing their product-specific semiconductors, which may affect the size of the total addressable market.
Broadcom uses acquisitions as an integral part of its growth strategy. The company is constantly on the lookout for opportunities. However, interest rates will slowly climb over the next two years as the Federal Reserve fights inflation. The company carries almost $40 billion in debt on its balance sheet, and a higher rate will mean higher interest charges and more difficult acquisitions in the future.
To put it into perspective, Broadcom is simply a good company at a good price. In a stock market where everyone is trying to be sophisticated, sometimes it’s best to stick with the fundamentals. Top line growth, bottom line growth and management that puts shareholders first with buyouts and dividends.
These strong fundamentals come with several decent growth opportunities going forward, and what I consider to be limited risk. Moreover, I also find the current valuation decent. If an investor thinks the stock will continue to decline shortly, they should take a small position in Broadcom and add dips. In the meantime, investors should take advantage of this dividend of almost 3% which should continue to grow by around 10% per year.