Justin Sullivan/Getty Images News

Justin Sullivan/Getty Images News

While the market has definitely soured in the roughly two months since my last write-up on Broadcom (NASDAQ:AVGO ), not all that much has really changed in terms of performance trends or the long-term investment thesis for this leading semiconductor and enterprise software company. The acquisition of VMware ( VMW) is certainly material, but not any sort of departure from the company's stated M&A or capital allocation strategy, and I think VMware will prove to be another worthwhile "solid but not spectacular" type of deal for the company.

Broadcom shares are down about 9% since my last write-up (and down about 16% year-to-date), with the shares continuing to modestly outperform the SOX index (the outperformance is more significant on a year-to-date basis) and lag the S&P 500. As before, my concerns about Broadcom are almost solely macro-related (sentiment for stocks in general and tech stocks in particular), and I continue to believe that these shares offer attractive long-term total return potential, though I will note that there are individual semi stocks with more upside (and higher execution/end-market risk).

It's not strictly accurate to say that the fiscal second quarter was a carbon copy of the first quarter, but insofar as the major themes and drivers go, I'd call it close enough for jazz. Broadcom posted a somewhat larger revenue beat relative to sell-side expectations (over 2% versus around 1%), with upside driven by the semiconductor basis, and management guided to a stronger than expected fiscal third quarter, with revenue about 5% above expectations.

Overall revenue rose 23% year over year and 5% quarter over quarter, with the semiconductor business up 29% YoY and 6% QoQ. Software was up 5% and 2%, respectively. Gross margin improved 140bp YoY (and 80bp QoQ) to 76.3%, beating expectations by 70bp. Operating income rose 30% YoY and 6% QoQ, with operating margin up 350bp YoY and up 60bp QoQ to 61%, which was also good for a beat relative to sell-side expectations.

Within the semiconductor operations, the networking business grew 44% YoY, with strong merchant switching and routing demand, as well as strong demand for custom ASIC. These trends were broadly consistent with what Marvell (MRVL) reported (particularly with custom ASIC), though Marvell has continued to enjoy strength in PAM-4 that Broadcom hasn't been able to match.

Broadband remained surprisingly strong (up 24%) despite supply constraints at many set-top box customers, with the company continuing to benefit from a strong WiFi-6 and fiber/PON upgrade cycle. Wireless wasn't great, up 6% YoY, and the July quarter will likely see a small deceleration on a sequential basis, but content gains with Apple (AAPL) are still helping some. Storage was quite strong, up 66%, with ongoing strength in enterprise upgrade spending, including near-line HDDs.

Broadcom accelerated its earnings report by a few days to make the announcement in conjunction with the news that it had reached an agreement to acquire VMware in a $61B deal. VMware shareholders will have the choice of $142.50 in cash or 0.252 in Broadcom shares, subject to collars, and the deal includes both a go-shop period for VMware and a sizable termination fee ($1.5 billion) if Broadcom cannot complete the deal.

That Broadcom announced another M&A transaction, and that it was a software company, wasn't really that surprising. With robust free cash flow generation and steady progress in deleveraging, not to mention management commentary regarding their ongoing interest in expanding the enterprise software business, another sizable deal in the space was a "when, not if" question in my mind, particularly given the low likelihood that Broadcom would be allowed to make a meaningful acquisition in the semiconductor space.

I could maybe argue that Broadcom's rumored interest in SAS Institute a year ago was a better fit for the company's growing enterprise software business, but acquiring VMware is hardly "settling" and there have been rumors here and there for some time that VMware was high up on Broadcom's list of acquisition targets. VMware is a leader in private cloud infrastructure and virtualization, and while VMware is arguably not as entrenched with its customer base as former Broadcom targets CA and Symantec were/are, I also see more revenue growth potential from VMware than those two businesses.

Executing on that growth potential will be a challenge for Broadcom, particularly with VMware management already having its challenges in reaccelerating revenue growth to a target rate of 10%. Relative to the CA and Symantec deals, I think Broadcom has less to gain from deep cuts to SG&A and product development spending and refocusing around large core enterprise clients. Instead, I think management will have to navigate a trickier balance of reinvesting enough back into the business so as not to undermine the longer-term potential and competitiveness of VMware.

As far as the price Broadcom is paying, the deal is not that expensive on a trailing/prospective EV/revenue basis (less than 5x), but the 13x multiple to run-rate EBITDA is higher than what the company has paid in the past (8x to 11.5x). I attribute this to VMware reinvesting for growth (lower EBITDA margins), and the fact that it's at a different stage in its life-cycle than CA or Symantec, but I do think Broadcom can achieve double-digit (likely mid-teens) accretion in a couple of years without hamstringing VMware's growth potential.

Although a $61B deal is significant, the acquisition of VMware isn't really thesis-changing for me - due in no small part to the fact that I always expected additional very large software deals like this. In the meantime, the company continues to leverage hot data center and broadband market, with the company still well-placed to leverage both ongoing data center capacity growth and the 200G/400G/800G network upgrade cycle, as well as the growth potential of custom ASIC in networking and compute offload and growing opportunities in areas like 5G (due to the increasing complexity of massive MIMO radios).

Excluding the VMware deal, my modeling revisions aren't that significant, with my revenue growth estimate going from the mid-6%s closer to 7% and my FCF growth estimate now solidly above 8%. Likewise, I've made modest revisions to my near-term margin assumptions that support a higher fair value, but nothing that is thesis-changing.

I continue to believe that $700 is a pretty good near-term fair value target for Broadcom and that the shares are priced to generate a high single-digit long-term annualized total return for investors. The market sell-off has created other opportunities in the semi space with more upside, but I think Broadcom offers a reward-risk balance that is still quite compelling, particularly for investors looking for tech exposure that is more of the "buy and hold" variety and where execution/market growth is less at risk.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of AVGO, VMW either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.