Broadcom: Chip Demand Has Bottomed Out and Might Stay Low for Awhile

You wouldn't know it from checking stock prices, but 2019 hasn't been so kind to chipmakers.

The U.S.-China trade war, the resulting tariffs, and softening demand for some semiconductor categories (like digital memory, well documented by Micron lovers and haters alike) have all taken a toll on the Silicon Valley-centric industry. As measured by the PHLX Semiconductor Index, chip stocks are up 19% over the trailing 12 months and up 39% year-to-date after recovering from the Q4 2018 market meltdown.

The rally has taken place in spite of the news, as investors have been anticipating a rebound in chip demand. Plus, plenty of chipmakers have rounded out their businesses with more stable and higher-margin software products. Broadcom's (AVGO -4.31%) advance this year is due to both reasons -- although an anticipated halt in the semiconductor demand slide doesn't necessarily mean a big rebound is coming soon.

Image source: Getty Images.

Three quarters down, one to go

During the third quarter, Broadcom said its sales increased 9% from a year ago -- mostly due to its acquisition of infrastructure software company CA Technologies last year, as well as its other nonsemiconductor business.

As for semiconductors themselves, revenue from Broadcom's largest segment was up 6% from Q2 -- due to seasonal factors as manufacturing activity ramped up during the summer -- but was down 5% from Q3 2018. CEO Hock Tan said that demand for chips and other equipment has stabilized, but it's difficult to say it's a rebound given the political uncertainty at the moment. Nevertheless, the full-year outlook for $22.5 billion in total revenue was reiterated, with $17.5 billion coming from semiconductors and $5 billion from infrastructure software.

All told, although Broadcom's bread-and-butter revenue driver has been in a slide this year, the CA Technologies takeover has paid off thus far. It has pushed gross profit margins higher and increased free cash flow (basic profits, measured by subtracting cash operating expenses and capital expenditures from total sales).

Pp = percentage points. Data source: Broadcom.

Embracing the OK

The moderating environment for chips is all investors want at this point; hence the rally in Broadcom stock. It would certainly be nice to see a robust uptick in demand, but that might not be in the cards for a while because the trade war is weighing on business sentiment.

In the meantime, Broadcom is squeezing synergy out of its recent acquisition of CA Technology to make up the difference. In fact, the cross-selling between the hardware and software sides of the business has been going so well that the company is looking for a repeat with its recent purchase of Symantec's (GEN 0.59%) enterprise cybersecurity software unit. Tan expounded on the plan during the Q3 earnings call:

[The Symantec acquisition] is the logical next step in Broadcom's infrastructure software strategy, and adds a $160 billion cyber security market to our [total addressable market]. We will gain a portfolio of mission-critical security solutions that are deeply embedded among our core customers. There will be meaningful cross-selling opportunities with Brocade and CA solutions, and we believe this acquisition will enable Broadcom to gain a larger share of the wallet of these core customers and we expect this transaction to add more than $2 billion of sustainable run rate revenue with this leading franchise in cyber security, and we also expect to achieve in excess of $1 billion in run rate cost synergies within 12 months post-close.

Put another way, once Broadcom integrates the enterprise cybersecurity software unit into the fold, it will have a three-pronged solution for its customers' connectivity needs, from hardware to the software that governs it to security to keep the final system safe. More stable growth and higher margins than what chipmaking alone can offer is the reasoning here. The growing demand for cybersecurity solutions is likely to move the needle in the years ahead -- although the industry has become crowded and highly competitive lately.

A slow-and-steady bet

After seeing Broadcom's third-quarter report, it's clear now is certainly not a golden investment opportunity. Chip rebound or not, though, the stock looks like a slow-and-steady bet for investors looking for semiconductor exposure in their portfolio, and it's paying a solid 3.7% annual dividend yield. Investors looking to add could certainly do a lot worse.