Investors increasingly recognize Broadcom's (AVGO 3.84%) potential to enable generative AI. The company's second-quarter 2023 earnings report, released June 1, beat analysts' consensus estimates for revenue and earnings per share. Additionally, the forecast for third-quarter revenue exceeded analysts' expectations.
The stock reacted positively to this news, rising 3% on June 2 and ending the month of June up 10%. A significant chunk of the company's strong results was due to sales of products that enabled generative artificial intelligence (GenAI).
After the stock's huge run throughout May and June, it is now up 59% year to date. You might question whether investing in the company is viable today, since some analysts believe investors overvalue it and doubt the recent stock price rise's sustainability.
However, Broadcom may be worth its high valuation. Here's why.
Hardware companies are the biggest winners in the GenAI revolution
According to a recent Goldman Sachs Research analyst's report, enterprise software companies may take several years to benefit financially from GenAI. Although many people assumed that software companies with access to significant amounts of data, such as Microsoft and Alphabet, would benefit the most from GenAI, semiconductor companies are likely to be the primary beneficiaries.
Software companies train GenAI models using massive datasets that require substantial computing power. The models must efficiently process vast quantities of data and recognize patterns.
Semiconductor companies are the ones that manufacture the chips that power these models. As generative AI models become more complex and require more computing power, semiconductor companies must develop new chips to meet the demand. Moreover, semiconductor companies are also developing new technologies that can help to improve the efficiency of generative AI models, including new types of processors that can process data more efficiently.
As a result of these factors, semiconductor companies are positioned to benefit the most from the growth of generative AI. The company that develops the most powerful chips and the most efficient technologies will be the ones that reap the most significant rewards.
How its chips enable GenAI
Although Broadcom doesn't produce AI chips directly, it specializes in designing chips that facilitate communication between multiple AI chips using networking technology.
To process the massive datasets that GenAI requires, computer engineers discovered that they must connect and run graphics processing units (GPUs), tensor processing units (TPUs), or other AI hardware in parallel and in sync. In other words, engineers run GenAI hardware as a massive network.
This means the network's speed is one of the most significant limiting factors on how fast GenAI chatbots like ChatGPT or Bard can respond to an inquiry. Since Broadcom's networking chips are some of the best on the market, it should benefit significantly from the explosion in demand for GenAI.
Here are several Broadcom networking chips that benefit generative AI:
- Jericho3-AI: This new chip can wire together supercomputers for AI work by connecting up to 32,000 GPU chips, offering the industry's highest performance.
- 112G SerDes: This device provides high-speed data transmission and connectivity between AI accelerators and other hardware and software components. The company designed it to enable generative AI applications like OpenAI's ChatGPT.
- Tomahawk 5: This is a next-generation switch product that offers 51.2 terabits per second of Ethernet switching performance. It can deliver high capacity and quick response times, which are essential for generative AI applications.
The company is already seeing sales increase for these products. Here's what its CEO, Hock Tan, said on the company's second-quarter 2023 earnings call:
I know you all want to hear about how we are benefiting from this strong deployment of generative AI by our customers. Put this in perspective, our revenue today from this opportunity represents about 15% of [our] semiconductor business. Having said this, it was only 10% in fiscal '22. And we believe it could be over 25% of semiconductor revenue in fiscal '24. In fact, over the course of fiscal '23 that we're in, we are seeing a trajectory where our quarterly revenue entering the year doubles by the time we exit '23. And in fiscal third quarter '23, we expect this revenue to exceed a $1 billion in the quarter.
So business is booming in its networking segment as a direct result of the proliferation of GenAI. No wonder the stock rose after earnings.
The company has competition
Broadcom has two significant competitors in the market for AI networking chips.
The first is Nvidia, with its InfiniBand networking technology gained when it acquired Mellanox in 2019. InfiniBand is a high-speed networking interconnect technology for high-performance computing and artificial intelligence applications. Broadcom and Nvidia's products have different strengths and weaknesses. Whether a customer chooses Broadcom's or Nvidia's technology often comes down to trade-offs between performance, power consumption, and price.
The second competitor that could prove a thorn in its side is Cisco Systems. In June, the company released networking chips for AI supercomputers to compete with Broadcom's offering. It claimed that five major cloud providers are already testing these chips.
However, Broadcom is a strong company with a broad product portfolio and consistently invests in new technologies to remain competitive. As a result, Broadcom is likely to remain a significant player in the networking market.
Overall, the competition between Broadcom, Nvidia, Cisco, and others will likely remain intense in the coming years. The companies that can innovate the fastest, target the right customer segments, and navigate the regulatory environment are the most likely to succeed.
Is the stock overvalued or undervalued?
There are differing opinions on Broadcom's market value, with some thinking the market overvalues the company, while others believe Wall Street undervalues it. However, its low price/earnings-to-growth (PEG) ratio of 0.46 supports the case for an undervalued stock, as many believe a PEG ratio below 1 indicates an undervalued stock.
AVGO PEG Ratio data by YCharts
If you're considering investing in the rapidly growing GenAI trend, this giant in the networking industry should be on your radar.
