Broadcom (AVGO 2.99%) is often considered a safe blue chip tech stock for conservative income investors. It produces a wide range of chips for the data center, networking, broadband, wireless, storage, and industrial markets, and it also sells infrastructure software through its CA Technologies and Symantec subsidiaries.
Its revenue has grown at a compound annual growth rate (CAGR) of 13% between fiscal 2017 and fiscal 2022 (which ended last October), as its adjusted earnings per share (EPS) rose at a CAGR of 19%. Its diversification shielded it from the PC market's post-pandemic slowdown, and its stock still looks cheap at 15 times forward earnings despite rallying nearly 170% over the past five years. It also pays a forward dividend yield of 3%, and that payout should consume less than half of its projected EPS this year.
Image source: Getty Images.
I've praised Broadcom's strengths in previous articles, but investors should also be aware of its less obvious weaknesses. So today, I'll dig deeper and focus on two of those challenges: its heavy dependence on Apple (AAPL 0.52%) and the regulatory headwinds for its planned takeover of the cloud software giant VMware (VMW).
Broadcom's relationship with Apple
Broadcom provides Wi-Fi, Bluetooth, GPS, wireless charging, and radio frequency chips for Apple's iPhones, iPads, Macs, and other devices. Apple accounted for 20% of Broadcom's revenue in fiscal 2022, making it the chipmaker's top customer. Back in early 2020, Broadcom secured several contracts with Apple, which were expected to pay out about $15 billion in revenue through 2023. However, there's no guarantee that Apple will renew those contracts once they expire.
Instead, several reports from earlier this year suggested that Apple could replace Broadcom's Wi-Fi and Bluetooth combo chips with its own first-party chips by 2025. That potential switch, along with the iPhone's slowing growth in recent years, indicates that Broadcom needs to proactively diversify its business away from Apple.
Broadcom isn't the only chipmaker that faces the potential loss of Apple as a top customer. Qualcomm, which Broadcom nearly acquired via a hostile takeover in 2018, also faces the looming replacement of its iPhone modems.
The VMware deal could be in trouble
To pivot away from Apple and other smartphone makers, Broadcom expanded into the infrastructure software market with its acquisitions of CA in 2018 and Symantec's enterprise security unit in 2019. But even after integrating both companies, Broadcom still only generated 29% of its revenue from infrastructure software in fiscal 2022.
To accelerate that expansion, Broadcom agreed to buy Vmware for $61 billion last year. At the time, it expected to close the deal in fiscal 2023. However, that acquisition has run into a gauntlet of regulatory challenges over the past year.
Antitrust regulators in the U.S., U.K., and Europe have all been closely scrutinizing the deal, and a recent decision by the Competition and Markets Authority (CMA) in the U.K. to block Microsoft's planned acquisition of Activision Blizzard raises some serious doubts about Broadcom's ability to seal the deal.
If Broadcom actually buys VMware, it expects to generate nearly half of its annual revenue from software and significantly reduce its dependence on chips. It also believes the acquisition will add roughly $8.5 billion in pro forma earnings before interest, taxes, depreciation, and amortization (EBITDA) to its bottom line within the first three years. By comparison, Broadcom generated an adjusted EBITDA of $21 billion on its own in fiscal 2022.
Do these risks make Broadcom a less attractive stock?
I believe Broadcom can weather the loss of Apple if it acquires VMware. But if antitrust regulators block the VMware deal, I'd avoid investing in Broadcom because it could suffer severe revenue declines in fiscal 2025 and beyond.
However, some of those doubts already seem to be priced into its low valuation -- and Broadcom could still take the cash and make smaller acquisitions or execute some big buybacks to appease investors if the deal falls through. Therefore, Broadcom isn't doomed yet, but investors who are concerned about Apple or VMware should probably stick with more conservative tech stocks until it resolves those near-term challenges.
