Broadcom (AVGO 1.63%) shares have fallen about 18% from recent highs, with much of that decline coming when the semiconductor and data-center networking specialist reported fiscal fourth-quarter results and issued guidance for the current quarter.
Interestingly, the drop was not sparked by weak sales. In fact, sales soared during the quarter. So what caused the stock to get hammered? It boiled down to what management said about profitability as AI revenue becomes a larger slice of the business. In short, management said in its fiscal fourth-quarter earnings call that it expects sales of its AI (artificial intelligence)-related products to be dilutive to its gross profit margin.
But is the market overreacting? After all, management stated that since its AI business is growing so rapidly, it should eventually lead to operating margin leverage as the business scales -- even if the overall company operates at a lower gross profit margin.
Let's take a look.
Image source: Getty Images.
A lower-margin AI business
Broadcom's fiscal fourth-quarter results were strong. Revenue rose 28% from the year-ago period to just over $18 billion, with semiconductor solutions revenue up 35% and infrastructure software revenue up 19%.
Within semiconductors, the AI line keeps getting bigger. Management said AI semiconductor revenue rose 74% year over year in the quarter. Even more impressive, Broadcom said in its fiscal fourth-quarter earnings call that it expects AI semiconductor revenue growth to accelerate in fiscal Q1. Specifically, management forecast AI semiconductor revenue to double year over year to $8.2 billion in the first quarter of fiscal 2026.
That growth is why investors have treated Broadcom as a direct play on cloud computing AI spending.
Yet the company also said its fiscal first quarter should bring a hit to gross margin of about one percentage point compared with the prior quarter, mainly because AI revenue will be a larger part of total revenue. Similarly, adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) is guided to about 67% of revenue for the quarter, down from 68% in fiscal Q4.
In plain terms, Broadcom is shipping more of the products cloud customers want most as its AI business booms, but some of those AI products carry lower margins than other parts of its business.
Also worth noting, management said non-AI semiconductor revenue is expected to be roughly flat from a year ago in the current quarter. That means a lot of the near-term growth is coming from AI chips and software, which puts even more weight on those two areas to keep delivering.
NASDAQ: AVGO
Key Data Points
A lofty valuation
Bolstering the bull case for the stock, Broadcom generates huge sums of cash and returns a lot of it to shareholders. In fiscal 2025, it produced $26.9 billion of free cash flow and returned $17.5 billion to shareholders, including $11.1 billion in dividends and $6.4 billion in share repurchases. It also recently raised its quarterly dividend 10% to $0.65 per share.
These are great figures in absolute terms. But in the context of the company's market capitalization of $1.6 trillion, they're less impressive.
With the stock trading around $340 per share as of this writing, Broadcom has a forward price-to-earnings ratio of about 36. A valuation like this would be easier to justify if the tech company could maintain its gross margin as its AI business continues growing rapidly. But with management indicating that it expects gross margin pressure, a valuation like this may be too high.
In short, even after the stock's recent decline, the current price still leaves little room for disappointment. A better entry point would likely require either a materially lower valuation or several quarters of results coming in ahead of expectations (combined with a reasonable valuation).
