Baron Funds – Broadcom Inc.: Tailwinds Creating An Attractive Opportunity

Summary:

• We initiated a new position in Broadcom Inc.
• Over time, we believe that custom silicon solutions will obtain a noticeable market share of internal AI workloads, with Broadcom as the main beneficiary.
• We believe tailwinds would lead to strong earnings growth and a re-rating in the stock’s valuation, creating an attractive opportunity for long-term investors.

The following segment was excerpted from this fund letter.

Broadcom Inc. (NASDAQ:AVGO)

We also initiated a new position in Broadcom Inc., a global technology leader that designs, develops, and supplies a broad range of semiconductor and infrastructure software solutions. Its semiconductor solutions focus on complex digital, mixed signal, and analog products across a variety of end-markets while its software products help customers plan, develop, automate, manage, and secure applications across various platforms.

Historically, Broadcom’s semiconductor business has been a market-leading franchise with high margins and market-level growth, but the emergence of AI-related demand has spurred stronger growth across its portfolio, specifically in its Networking business unit. Broadcom’s AI-related revenue has grown from less than 5% of its semiconductor business to an expected 35% in its fiscal 2024 as its industry-leading Ethernet switch silicon business and, more importantly its custom silicon solutions, primarily the TPU for Google but with two additional customers ramping as well, have grown significantly.

While custom chips tend to be less versatile and flexible than GPUs, their adoption makes sense if customers have large scale workloads with algorithms that are relatively stable, as they allow hyperscale customers to save costs on both upfront capex as well as on energy consumption. Over time, we believe that custom silicon solutions will obtain a noticeable market share of internal AI workloads, with Broadcom as the main beneficiary given its 10-year history of working with its customers, leading to a higher proportion of sales related to AI and an above-market growth in the company’s semiconductor solutions business.

Its software business is also now a more significant portion of revenues with its recent acquisition of VMWare (40% of revenues in fiscal 2024). While Broadcom is implementing its usual strategy with software acquisitions in pursuing cost synergies, in VMWare’s case, the company is also investing in the product and reducing the hurdles for up-selling customers from the basic VSphere product (server virtualization) to the broader VMWare offering including networking, storage, and a management layer, while transitioning customers from license to subscription models. This, in our view, should drive noticeable growth for the software segment in the coming years.

These tailwinds would lead, in our view, to strong earnings growth and a re-rating in the stock’s valuation, creating an attractive opportunity for long-term investors. These tailwinds are supported by a growing stream of free cash flow, an increasing dividend, and a decline in the overall share count as Broadcom continues to repurchase its own stock.