Broadcom: Strong AI Growth Overshadowed By Disappointing 4Q Revenue Outlook (NASDAQ:AVGO)

What Happened in 3Q FY2024

Broadcom’s (NASDAQ:AVGO) stock dropped 10% following its 3Q FY2024 earnings report. Despite strong growth in the Infrastructure Software segment, much of it was driven by VMware, while AVGO’s core software business saw a sharp deceleration, growing only 3.3% compared to 34% YoY in the previous quarter. However, AI-related revenue continued its robust growth, implying at least a 174% YoY increase in 3Q, and the company raised its AI revenue outlook for 4Q. Meanwhile, the Semiconductor Solutions segment, which accounts for 55% of total revenue, posted only mid-single-digit growth.

In my last coverage, I issued a hold rating on the stock due to concerns about potential growth deterioration excluding VMware’s contribution. Since then, the stock has underperformed iShares Semiconductor ETF (NASDAQ:SOXX) by 1%. While costs related to the VMware acquisition led to a negative EPS on a GAAP basis in 3Q, the company’s margins are showing signs of gradual recovery. Given the disappointing 4Q revenue guidance, I’m reiterating my hold rating, as the stock is still trading at 13.5x EV/Sales fwd.

VMware Continues Driving Strong Growth

AVGO’s top-line growth is largely driven by VMware. The company topped both revenue and non-GAAP EPS estimates for 3Q FY2024, with the Infrastructure Software segment growing 200% YoY, up from 175% in the previous quarter. However, this YoY growth isn’t directly comparable, as VMware’s revenue was not included in last year’s results.

During the 3Q FY2024 earnings call, the management highlighted that VMware generated $3.8 billion in revenue, reflecting a QoQ growth acceleration to 40.7%, compared to 28.6% in 2Q due to strong bookings. Particularly, VMware Cloud Foundation (VCF) showed strong growth, with its annualized booking value reaching $2.5 billion in 3Q, representing a 32% QoQ increase. However, excluding VMware, AVGO’s core software business experienced a significant QoQ slowdown.

As previously mentioned, on a GAAP basis, EPS fell to -$0.40 per share, the first negative result since FY2016. Management attributed this decline to higher taxes, restructuring, and integration costs related to the VMware acquisition. While these costs are non-recurring, investors should carefully consider both the costs and benefits of VMware’s contribution.

Despite overall revenue growing 47.3% YoY in 3Q FY2024, excluding VMware, AVGO’s growth was just 4% YoY, marking a growth slowdown from the 4.9% growth in 3Q FY2023. Although VMware’s business model transformation has been successful, AVGO’s triple-digit overall growth momentum does not reflect its organic performance. Management acknowledged concerns about the slowdown in AVGO’s core business and indicated that non-VMware software revenue has now stabilized, expecting mid-single-digit growth moving forward.

Raising AI-Related Revenue Outlook in FY2024

The management also mentioned that AI revenue in 4Q FY2024 is expected to grow 10% QoQ to $3.5 billion. This implied that 3Q FY2024 AI revenue to be $3.15 billion, growing roughly 178.8% YoY, which was in-line with the management’s expectations. The total AI revenue in FY2024 will be around $12 billion, which is higher than the company’s previous guidance of $11billion. The CEO Hock Tan believes that the AI revenue growth trend will continue to be strong in FY2025, supported by its existing backlogs.

4Q FY2024 Total Revenue Missed Estimates

Despite the positive AI outlook, AVGO’s 4Q revenue guidance missed market expectations. The implied 4Q revenue of $14 billion suggests continued growth acceleration to 51% YoY, driven primarily by VMware and AI-related revenue. Management expects VMware to generate roughly $4 billion in revenue for 4Q FY2024, representing mid-single-digit QoQ growth. They also believe the strong bookings trend will persist into FY2025.

Management also noted that non-AI markets have likely bottomed and expect a gradual recovery in the coming quarters, with Semiconductor Solutions revenue forecasted to grow 9% YoY in 4Q FY2024, up from 4.8% in 3Q.

Margin Pressure and Recovery

Due to the VMware integration, the company has faced margin pressure, with its adjusted EBITDA margin dropping significantly in 1H FY2024. However, the company is guiding for a 64% margin in 4Q FY2024, indicating that a continued recovery remains on track, as acquisition-related cost reductions have been better than expected. The company reduced VMware spendings to $1.3 billion in 3Q, down from $1.6 billion in the previous quarter. Lastly, VMware is expected to generate $8.5 billion in adjusted EBITDA within three years of the acquisition, and according to management’s comments, the company may achieve this target ahead of schedule by FY2025.

Valuation

Despite a significant reacceleration in revenue growth over the past four quarters, AVGO’s stock remains expensive, trading at 14.9x EV/Sales TTM. While its strong growth justifies a higher valuation, I believe the stock is fairly valued given its 51% YoY revenue growth guidance for 4Q. Growth is likely to normalize in FY2025, with the EV/Sales fwd sitting at 13.5x, which is 52% above its 5-year average, according to Seeking Alpha. Meanwhile, AVGO’s non-GAAP P/E fwd is 28.3x, roughly in line with the Nasdaq 100’s P/E.

With the equity market beginning to price in a potential economic slowdown, as indicated by a recent broad-based index pullback, it’s prudent to be cautious with this high-multiple stock. However, I believe AVGO’s risk-reward profile will become more attractive if its EV/Sales fwd approaching to 10x.

Conclusion

In conclusion, AVGO 3Q FY2024 results showed strong growth, primarily driven by VMware, while its core Broadcom Software business experienced significant deceleration and Semiconductor Solutions posted only mid-single-digit growth. Management believes the non-AI business has bottomed out, and indicates AI-related revenue continues to expand, with a positive outlook for 4Q and FY2025. However, the stock remains expensive at 13.5x EV/Sales fwd, justifying its current growth momentum. Given the disappointing 4Q revenue guidance, I remain cautious. However, I believe a more attractive entry point may arise around 10x EV/Sales fwd, so I’m maintaining a hold rating on the stock.