When I was an electrical engineering student in the late 90s/early 2000s, Broadcom Inc. (NASDAQ: AVGO) was known as an advanced semiconductor company, especially in wired and wireless networking equipment, one of the hottest areas in the early 2000s.
I lost track of the company after changing careers and it wasn’t until 2016 when Avago acquired Broadcom that I saw the company again. At the time of the acquisition, Broadcom was one of the world’s 10 largest semiconductor companies by revenue, while the acquirer, Avago, was No. 11, but growing rapidly (Figure 1).
Who was Avago, I wondered? I had never heard of the company during my undergraduate studies.
Avago applies the private equity model to public markets
Avago was the private equity-backed spin-out of the semiconductor business of Hewlett Packard (“Agilent’s Semiconductor Products Group”) that went public in 2009. Applying a private equity business model to the semiconductor industry, Avago consolidated the semiconductor business, culminating in the 2016 merger with Broadcom (Figure 2). The company retained the Broadcom name after the merger.
Avago/Broadcom’s basic model was to acquire a business, improve margins, pay off debt, and start over. However, the model hit physical/competitive constraints in 2017 when its proposed acquisition of Qualcomm Incorporated (QCOM) stalled on national security grounds. Around the same time, the company was also under investigation by the FTC and the European Commission for anti-competitive practices.
As the roll-up strategy in semiconductors became more difficult, Broadcom shifted gears and began acquiring infrastructure software companies, such as CA Technologies in 2018 and Symantec in 2019. Recently, Broadcom has announced its most ambitious acquisition to date, the $69 billion (cash, stock and debt) pending acquisition of VMWare.
The main premise behind the VMWare acquisition is a repeat of the same PE model – acquiring a mature, cash-flow-generating business, improving margins (Figure 3), and paying down debt (Figure 4).
With pro forma revenues of over $40 billion, the addition of VMWare is expected to bring Broadcom’s revenue split closer to 50/50 between semiconductor solutions and infrastructure software, compared to 2021 (Figure 5).
Hard to argue with Broadcom’s business model
It’s hard to argue against Broadcom PE’s business model, as it has generated consistent revenue growth and improved margins, while generating large amounts of free cash flow. Free cash flow in 2021 was $13.3 billion, 80% of adjusted EBITDA and 48% of revenue (Figure 6).
Investors were well rewarded as Broadcom increased the common stock dividend at a CAGR of 43% to an expected $16.40/share, an increase of 8.5x from $1.94 in 2016 (Figure 7).
Meanwhile, Broadcom has generated a total return of 275% since 2016, outperforming the Nasdaq index and the S&P 500 index, and trailing only the best performing stocks like Nvidia (NVDA), Apple (AAPL) and Microsoft. (MSFT) (Figure 8).
Slightly Expensive Pro-Forma Valuation
Although the addition of VMWare will add over $32 billion in debt to the balance sheet (bringing pro forma net debt to over $62 billion), it adds nearly $5 billion in EBITDA to the 16, AVGO’s $6 billion in Adjusted EBITDA (2021). Once the synergies are realised, EBITDA could exceed $25 billion. With a pro forma enterprise value of over $320B (currently $255B + $69B for VMWare), this values the resulting AVGO at ~13x EV/EBITDA, assuming synergies are carried out. Before synergies, the Broadcom pro forma is valued at 14.8 EV/EBITDA. This is a slight premium to the industry median of 13.4x (Figure 9).
On a historical basis, 13x forward EV/EBITDA is also costly, especially since the synergies have not been realized. AVGO’s multiple has traded between 8x and 16x over the past few years, with 12x near the peak before the post-COVID market euphoria (Figure 10).
At current valuations, AVGO is slightly expensive. I’d be a long Broadcom buyer if it were to trade at 11-12x pro forma EV/EBITDA or $420-$470 per share (note that the stock recently bottomed in June at $464/share).
Risks for Avago
The biggest risk for AVGO is the imminent acquisition of VMWare. While it shouldn’t attract the same level of regulatory scrutiny as the Qualcomm acquisition a few years ago, because Broadcom isn’t dominant in software as it was in semiconductors, the agreement is currently undergoing regulatory review by European, US and Chinese authorities.
Another risk is that after VMWare, the number of potential acquisition targets that move the needle for Broadcom will decrease further, as Broadcom will be a $300 billion tech giant. Will AVGO make a run for IBM (IBM) or Intel (INTC) and, more importantly, will regulators allow it?
Finally, Broadcom is taking on an additional $32 billion in debt in the face of the global economic slowdown. With a pro forma net debt of over $62 billion (~3x Net Debt/EBITDA pre-synergies), this will make Avago one of the most indebted technology companies.
Techniques in the Consolidation Model
Technically, Broadcom has been in a consolidation pattern since late 2021. Broadcom is in a multi-year uptrend and recently bounced off the lower end of the uptrend around $460/share.
Broadcom’s recently announced acquisition of VMWare appears to be the latest chapter in its PE-like business model. On a pro forma basis, the stock looks rich at current valuations. However, I would be a buyer at around 12x pro forma EV/EBITDA, or ~$470/share, as the company, led by CEO Hock Tan, has a history of generating shareholder value through acquisitions.