Broadcom Q3: VMware Integration Unlikely to Succeed (NASDAQ:AVGO)

I presented my “Sales” thesis Broadcom Inc. (NASDAQ:AVGO) in my previous article scope Broadcom’s legacy businesses, excluding AI and VMware, are expected to see revenue decline by 15% in June 2024, Broadcom said. S3 After the market close on September 5, the result projects $12 billion in AI revenue for FY24. While I am bullish on the dedicated ASCI and AI networking businesses, I am concerned about the legacy software portfolio and the integration of VMware. I maintain a “Sell” rating with a fair value of $120 per share.

VMware’s Integration Unlikely to Succeed

Since Broadcom complete With the acquisition of VMware last November, Broadcom began integrating VMware’s business and making controversial changes. I do not believe Broadcom can successfully integrate the VMware business for the following reasons:

• Broadcom ends VMware’s perpetual license model to promote VMware software subscription model. Termination could potentially push partners to distribute VMware’s competing products, such as those from Microsoft Corporation (MSFT) and Nutanix, Inc. (NTNX) can offer cheaper solutions for customers. For example, Nutanix’s latest earnings callThe company said it has secured some major deals thanks to the Broadcom-VMware integration.
• Reportedly mediaBroadcom now only sells product bundles, which has led to price increases of 500%-600% in some extreme cases. I think the business model change could benefit Broadcom’s growth in the short term, but partners and customers may look for more affordable alternatives in the future.
• VMware in August 2024 It was announced The new VMware Cloud Foundation 9 (VCF 9) is a cloud-based platform that unifies all applications and third-party software. While I think VCF 9 is better aligned with Broadcom’s AI business solutions, it’s unlikely to help VMware gain any competitive advantage. As shown in the slide below, VCF 9 offers solutions for the compute, storage, and network layers. However, VMware’s core strength lies primarily in its vSphere solutions at the Compute layer, and VCF 9 must rely on partners to deliver a holistic cloud platform.

• Dell Technologies Inc. (DELL) VMware ended its dealership business in 2024, SEC filing On January 30, 2024. Additionally, Cisco Systems, Inc. (CSCO) announced a global strategic partnership with Nutanix to provide a complete hybrid cloud solution to its customers. It is clear that VMware has lost some important partners as a result of the integration of Broadcom.

Custom AI ASIC Chip and AI Networks

I think both custom AI ASCI and networking chips are key growth drivers for Broadcom. The company is targeting $12 billion in AI revenue in FY24, representing more than 20% of total revenues.

As I noted in my previous report, both Broadcom and Marvell Technology, Inc. (MRVL) is a leader in custom AI ASIC chip technology and offers custom accelerators through partnerships with major hyperscalers and internet operators such as Alphabet Inc. (Google), (Google), Microsoft Corporation (MSFT), Meta Platforms, Inc. (META), Amazon.com, Inc. (AMZN) and ByteDance. As reported by mediaSuccessfully secured 3nm AI ASIC chip deals with Broadcom, Alphabet, and Meta.

Broadcom has made significant investments in 3nm and 2nm ASIC technology over the past five years, which has positioned them well to benefit from the growing demand for custom accelerators. Management also notes that custom ASIC is a high-margin business with longer R&D development cycles.

Broadcom also supplies network chips for switch manufacturers such as Arista Networks, Inc.ANET), Dell, Juniper Networks, Inc. (JNPR) and Super Micro Computer, Inc. (SMCIBroadcom is set to grow its networking business rapidly in the near future, driven by the increasing demands for data center construction and network connectivity. During its last quarter earnings, major AI Ethernet networking companies reported strong growth in the data center market. For example, Dell achieved 80% annual growth in its Server and Networking business 2nd Quarter.

In this context, I support Broadcom’s leadership position in the AI ​​ASIC chip and AI network markets, and this will continue to be the company’s primary growth driver.

Outlook and Valuation

In the 3rd quarterBroadcom grew revenue 47% and adjusted operating profit 43.6%. Its semiconductor segment grew just 5% YoY, and infrastructure software grew 200%, primarily driven by VMware’s consolidation. Excluding VMware, Broadcom grew revenue just 4% in the quarter, which isn’t impressive.

Since the company has already reported three quarters, I do not expect any major surprises for the FY24 financial results. For the normalized growth rate from FY25, I consider the following factors:

• Semiconductor solutions: As mentioned earlier, custom ASIC and AI networks will be key growth drivers for Semiconductor solutions businesses. Marvell 2nd Quarter In the earnings call, management noted that the overall custom ASIC market will accelerate in the second half of FY24 as most hyperscalers ramp up their custom ASIC accelerator production. I think Broadcom’s 2nm and 3nm ASIC technology could significantly drive Semiconductor solutions growth in FY25. I forecast the Semiconductor solutions business to grow 10% annually from FY25.
• Infrastructure software: My main concern with Broadcom lies in its Infrastructure software segment. As I mentioned in my previous article, Broadcom has acquired several legacy software companies in the past, such as CA and Symantec. Broadcom is unlikely to grow revenue in the mainframe business, a declining sector. Symantec also acquired Palo Alto Networks, Inc. (PANW), CrowdStrike Holdings, Inc. (CRWD) and Zscaler, Inc. (ZSTherefore, I assume only 2% organic revenue growth in the infrastructure software segment.

Overall, I estimate Broadcom will grow its revenue by 8.3% annually from FY25. I estimate Broadcom will generate 10bps of margin expansion from gross margins due to a favorable revenue mix, as its specialty ASIC and AI networking businesses carry higher gross margins. With these parameters, the DCF summary can be found as follows:

WACC is calculated as 12% assuming a risk-free rate of 3.7%, a beta of 1.36, an equity risk premium of 7%, a cost of debt of 7%, equity of $717 billion, debt of $74 billion, and a tax rate of 10%. The fair value of Broadcom’s stock price is calculated as $120 per share.

Upside Risks

While I give Broadcom a “Sell” rating, I consider the following factors that could lead to a change in my rating:

Infrastructure Software will account for less than 20% of total revenue by the end of FY24. It is quite possible that Broadcom will separate its software into a standalone company in the future. If that is the case, I think that could be very positive for Broadcom’s stock price and that such a separation could unlock shareholder value. It is clear that the software and semiconductor businesses are completely different in nature and there is no obvious synergy between them.

Additionally, if hyperscalers ramp up custom ASIC production in 2024, Broadcom could see even higher revenues from AI in excess of $12 billion in FY24. In that case, this could lead to an overly optimistic market outlook for custom ASIC growth in FY25 and could send the stock price much higher. It’s worth noting that Broadcom raised its AI revenue guidance from $11 billion to $12 billion this quarter.

Solution

I am not happy with Broadcom’s acquisition strategy in the software market and I doubt the company will be able to effectively integrate VMware in the near future. I reiterate my “Sell” rating at a fair value of $120 per share.