It seems fair to say Broadcom (AVGO:NASDAQ) is one of the unsung heroes of the modern technological revolution. A couple of years back, the Silicon Valley semiconductor and infrastructure software business had a market valuation of about $220 billion based on a share price of around $44.

As the AI (artificial intelligence) investment story emerged, talk in investment circles was all about OpenAI, lifting Nvidia (NVDA:NASDAQ), Advanced Micro Devices (AMD:NASDAQ), Microsoft (MSFT:NASDAQ) and a handful of others.

Broadcom barely got mention, which was odd considering how crucial the firm’s kit is to the modern world: an estimated 99% of all internet traffic passes across its chips, which means the company touches pretty much every major tech theme from AI to automation, cloud computing to cybersecurity and much else besides.

Shares has written about Broadcom’s emerging revenues and earnings story as far back as May 2022 in the wake of its shock $69 billion acquisition of VMware, yet the wider investment community largely ignored the promising signs and its stock only really started motoring over the past year, up 60%.

That means Broadcom shares will now cost you around $140 (after July’s 10-for-one stock split) and its market cap of $732 billion puts in with a reasonable chance of becoming the next member of the exclusive trillion-dollar club. It currently sits as the S&P 500’s ninth biggest company, if we combine Alphabet’s (GOOG:NASDAQ) Class A and C shares.

UNDERSTANDING BROADCOM

San Jose, California-based Broadcom today operates across two primary segments - Semiconductor Solutions and Infrastructure Software. The former designs chips for networking, server storage, broadband, wireless communication and industrial applications, the traditional knitting of the business.

This part of the business is also one of the world’s leading custom silicon developers, working closely with customers like Alphabet, for example, to create application-specific chips or ASICs (application-specific integrated circuits), which deliver superior performance and energy efficiency at lower cost for targeted workloads.

Infrastructure Software was traditionally the smaller part of the business, although not so much following the acquisition of VMware which completed in November 2023. A leader in cloud computing and virtualisation, VMware brought its software solutions into Broadcom’s portfolio, substantially diversifying its revenue and propelling the segment’s contribution massively, as the bar chart shows.

Broadcom shuns the growth-at-any-cost approach and, according to Blue Whale Growth’s (BD6PG78) Stephen Yiu, chooses to work with its largest 600 to 700 customers to expand their use of its software, resulting in a highly attractive margin profile.

Gross margins ran above 62% in the most recent second quarter earnings to 5 May (announced 12 Jun), with operating and net profit margins coming in at 24% and 17% respectively.

One-time items hurt margins year-on-year, primarily due to expenses related to the VMware integration including the amortisation of intangible assets, but analysts see margins stabilising towards past levels of close to 70% (gross) in future, with operating margins returning towards 40% as structural tailwinds behind the sector combine with the firm’s pragmatic business approach which has led to years of superior investment returns.

AI has been a significant growth driver, with $3.1 billion in Q2 revenue coming from AI products or roughly 26% of overall income. Based on the 280% growth discussed by management during the earnings call, AI alone contributed to a $2.2 billion revenue increase year-on-year offsetting cyclical weakness in semiconductor revenue from enterprises and telcos.

WHAT TO WATCH

The equity market’s sharp shock is creating increased volatility at the moment, which may continue in the short-term, but beyond that Broadcom’s AI kit is driving significant growth. Maintaining momentum here will be crucial to keeping the share price rising.

Investors also need to watch for next-generation product releases from its large R&D investment, which reached $2.4 billion in Q2. The recent launches of its Tomahawk and Jericho switching products will be vital to maintaining its leadership in networking, for example.

The return of the inflation monster and any supply chain trips could undermine the stock, while there will always be regulatory scrutiny, and the European Commission is investigating the VMware acquisition, which could lead to fines or other penalties.

A final fact to consider is Broadcom’s balance sheet. With its history of jumbo acquisitions, Broadcom doesn’t look like the rest of the big tech universe which typically enjoys large cash piles.

By contrast, Broadcom needs to service gigantic net debt of around $62 billion, yet equally it throws off enormous amounts of cash every year, $18 billion over the past 12 months alone, demonstrating its ability to handle its financial obligations and invest in future growth.

In short, Broadcom provides crucial kit right across the tech sphere, presenting decent defensive moats to its revenues. It is also enjoying strong AI momentum but from a diversified portfolio.

Analysts see fiscal 2023 revenues of around $35 billion close to doubling to more than $67 billion by 2026 based on Koyfin consensus, implying EPS (earnings per share) of about $7 versus $4.22 last year.

This makes its three-year average forward PE (price to earnings) multiple of less than 25 times look attractive in our view, while it needs its share price to reach roughly $196 to hit the trillion-dollar market cap mark. 

DISCLAIMER: Steven Frazer owns a personal stake in Blue Whale Growth.

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