Tickers mentioned in this show: AVGO

Tidal River Investments positions the day after the first show airing:

Long: NFLX, ETSY, SPY, TDOC, U, Z, ZG, WK, ATVI, AVGO

Show Notes: Collected AVGO data spreadsheet

3Q2021 Earnings Call transcript

Photography from Tidal River Investments can be purchased at tidalriverinvestments.com

Script

Welcome to Fluctuating Tides, the Podcast, Episode 8. I’m your host, SomeCodingGuy, and let’s get right to it!

This week I’m going to be covering Broadcom Incorporated, ticker AVGO, a heavyweight in the semiconductor and Chip Fab industry currently with a market cap of about two hundred billion dollars. Broadcom has been making chips for a long time, and is well diversified across a variety of customer sectors, but let’s start off by talking about how we can check how well they manage the business.

For this week’s knowledge segment I’d like to talk about operational expenses, and one of the ways we can use to keep an eye on Management’s effectiveness. There’s a lot of different investor metrics available to get a handle on how management is handling their business, in particular looking at how money invested or reinvested from past operations is being used. While more broadly we could look at ratios such as return on invested capital, and return on equity, or even ROI, this week I want to focus in on expenses as they relate to their previous comments. Granted, during a given year, business can change quite a lot, and any large inflows or significant changes in the marketplace would cause any of these measures to fluctuate in the short run beyond their immediate control, but one way that I like to look at companies is to compare what management said expenses would look like versus what actually happened, to get a rough idea of how well they understand and can operate their business. With that in mind, let’s take a closer look at the OpEx charges that I usually track in the spreadsheets that accompany these episodes.

On the income statement, you will typically see 3 lines relating to operational expenses or OpEx - technology (also known as research and development on some balance sheets), sales and marketing, and general and administrative or G & A. depending on the business line of the company under analysis, some of these lines may or may not make sense, so the company may drop one of these, relabel Tech as R&D, or combine sales and marketing with General and administrative, and call it collectively “S, G, & A”, so there’s some art to finding the expense you may be interested in.

To figure out an operational expense ratio, all we do is we calculate what share the given expense is out of the revenue for a given period, So if we wanted to know Tech as a percentage of Revenue in a given quarter, we would take the OpEx tech line and divide it by revenue for that quarter. To take an example, in the most recent quarter, Broadcom spent about 1.2 billion on research and development, while earning about 6.8 billion in revenue over the same period, so tech represents about 18% of expenses. S,G & A, which they reported altogether in one line, came in at about 350 million, so using the same Revenue figure, S,G&A represents about 5% of expenses in that quarter. Now while we can compare these expense ratios across different companies in the same line of business, one of the more interesting comparisons I like to make is “how do these expenses relate to previous quarters”, and specifically against what management said they were going to do.

In the case of Broadcom specifically, management said that they were going to try to keep R&D expenses flat over the year, and looking over the previous quarters, it’s almost boring how much that number doesn’t change from quarter-to-quarter, and in this case boring is a very good thing. Expenses stayed flat at about 18% for the previous 12 months and are down a little bit from before that, so management is doing a really good job of sticking to what they said they were going to do.

As I mentioned briefly, short-term fluctuations in a given quarter could easily make this a very difficult task, and revenue over the same period was steadily rising, with some lumpiness baked in, so sticking to a solid number on this line is actually quite a feat. Incidentally, sales and the general staff needed to run the company has held steady over the previous 12 months, and is also down from the quarters before that, which usually indicates that the product is well known and may not require a lot of spend to promote. I’m not going to read too much into this given that the pandemic caused a large drop in sales and marketing expenses, but for the education segment, I thought it would be useful to break all of these numbers out in the spreadsheet included in the show notes.

Micro measures of management effectiveness aside, several things brought my attention to Broadcom for this week’s show. The well-publicized chip shortages and the increased demand conversations among some of my engineer friends brought my interest to the semiconductor industry in general. Unfortunately Wall Street had already priced in very large stock prices against earnings for most companies in this sector, so I did some more analysis before settling in on broadcom as an interesting play. Compared to the previous episodes, Broadcom is quite a lot larger than most of the stocks in the Tidal River portfolio, with a $200b market cap, and growth at that scale can be quite a bit more difficult than growth for smaller companies, with the advantage that these businesses are more mature and well-known, and tend to follow more predictable growth trajectories, even if the particular industry is a little bit cyclical in its buying patterns.

Broadcom, however, derives its revenue from a small number of very large customers, spread across a number of different Industries, including exposure to large-scale Cloud providers, fiber and Telecom Industrials, handset and smartphone providers (with Apple being a particularly large customer), as well as handling ASIC and custom chip design on behalf of a number of their larger clients. Broadcom’s primary fabrication facilities are located in Malaysia, with their R&D sales staff being spread around the world, and of concern in the most recent earnings call was their exposure to COVID might be at the Malaysian fabrication facilities. Management replied that 99% of their staff had already been vaccinated, and that they had a particular focus on health safety controls to make sure that their plants could remain operational during these difficult times, so it looks like it’s a non-event for the company.

Three of their largest broadband customers, namely AT&T, British Telecom, and Deutsche Telekom, have all begun large-scale deployment of fiber to homes, and given previous relationships and ordering patterns, management believes that there will continue to be healthy orders in this sector for years to come, above and beyond the short-term crunch in semiconductor supplies. They’re embracing the wave of the new Wi-Fi 6 standards being deployed, being a large Wi-Fi chipset provider, and they pointed out healthy growth in both their software services sector, in addition to their custom ASICs and chips for large-scale cloud customers, being involved in fabricating TPUs for Google as well as custom circuits for Amazon’s AWS, even if Amazon is building more of that capability in-house. That type of expertise is hard to come by, and as more of the industry moves towards power sensitivity and custom silicon, Broadcom appears to be one of the market leaders in being able to provide those services.

Broadcom also has an 11-year history of dividend increases, with management continuing to guide to a 50% payout ratio against free cash flow, a metric that we’ll cover in future shows, and appears to have no trouble covering both the steady-state, or providing for future increases given the current business pipeline. As of today, the dividend is holding at just under 3%, providing a nice side benefit to investors, with plenty of room for the company to reduce payouts under emergency circumstances if cash gets tight. Not that cash appears to be tight, with $11b on the balance sheet, and most of the debt set at long-term low rates, with plenty of evidence of competence with refinancing activities. They did mention a continued appetite for the mergers-and-acquisitions space, and have been careful about inventories, in particular holding off bulk wholesale purchasers that may be overstepping their inventories after the shortages from earlier in the year, to ensure that inventory is flowing through to customers as needed, showing a healthy conservative tilt, and quite a difference from other players in the sector based.

Given all this, Tidal River is going to take a position in Broadcom this week.

As usual, I’ve included the numbers from previous 10-Q and 10-K reports and the math I discussed earlier in the spreadsheet attached in the show notes.

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We’re here for learning, not advice, and I wish you the best on your financial journey, and remember, tides fluctuate!