Broadcom: Worsening Geopolitical Environment (Rating Downgrade)
Contributor since 2023 / 2219 Followers
Summary:
- While Broadcom shares have performed well YTD (including going into a stock split), I believe shares have run up too much.
- Geopolitical tensions between the US, China, and Taiwan could impact Broadcom’s operations and revenue, with potential retaliatory measures affecting the semiconductor industry.
- TSMC’s plans to increase prices for clients like Broadcom, along with concerns about Broadcom’s high valuation and reliance on China, suggest a potential decline in the stock price.
- Their ROCE ratio shows that returns on capital are trailing the five-year average. If their ROCE is historically low during a strong AI boom, I expect returns to go even lower in the future.
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Investment Thesis
Broadcom Inc. (NASDAQ:AVGO) has had an impressive run for the first half of 2024 as investors have turned to the name as a way to play the custom AI chip game as companies like Alphabet Inc. (GOOG) (GOOGL) (and now OpenAI) turn to the chip company to make custom AI chips for their data centers. More recently, investors were excited at the prospect of the stock doing a 10:1 stock split that was meant to make each share more affordable for retail investors, further helping to drive the stock higher.
I believe this split (much like the Nvidia split earlier this year) was supposed to generate significant investor interest due to the company’s 43% revenue growth in 2Q that was fueled by the AI boom. Despite the expectation, the stock has not experienced the anticipated uptick.
As I mentioned above, Broadcom has had a good start to 2024, driven by a 43% surge in 2Q revenue and benefitting from the AI trend. Their stock has jumped by 33.72% YTD after taking the lead in the custom AI chip market.
However, recent developments suggest increasing downward pressure on their stock. Increasing pressure on China from both the Biden administration (likely to be transferred to the Harris administration if she wins) and the Trump campaign means that the regulatory and political climate for Broadcom going forward is likely to worsen regardless.
My previous sell decision, although poorly timed, now appears far more prescient given the current environment. Broadcom’s stock has shown signs of stagnation post-split, which is concerning for investors hoping for continued growth.
Given these factors, I am now a strong sell on Broadcom. The impressive gains seen earlier this year seem unsustainable, and the stock appears to have topped for 2024, in my opinion. The combination of mixed market reactions to the stock split, and now increased China risks, suggest that the company’s stock may likely encounter even stronger headwinds in the coming months, especially going into the election.
Background
Back in early May, I believed in selling Broadcom stock due to concerns about revenue risks from China. At that time, geopolitical tensions and potential trade restrictions posed significant threats to Broadcom’s business. Despite these concerns, the stock has since appreciated significantly, continuing to rise, and ending up approximately 50% year-to-date by the end of June.
For a while, my sell recommendation appeared to be incorrect, but I believe recent developments have validated my initial concerns.
The U.S. campaign trail and the upcoming presidential election have introduced new uncertainties. Both the Biden administration and potential candidates (Trump and Harris) have taken strong stances on China, which could impact Broadcom’s operations there if the Chinese government retaliates (like they have with other chipmakers).
Vice President Kamala Harris, the leading Democratic candidate, has emphasized a policy of “de-risking” rather than decoupling from China, highlighting the importance of protecting American interests while acknowledging China’s economic challenges.
This approach suggests that while the U.S. may not completely sever economic ties with China, there will be increased scrutiny and potentially stricter regulations on technology and trade.
The Biden administration has also bolstered security alliances in Asia to counter China’s assertiveness, particularly in the South China Sea. This geopolitical strategy could further complicate Broadcom’s business environment. Any escalation in tensions may likely lead to disruptions in the supply chain or market access.
The goal of this follow-up coverage is to talk about the US campaign trail and what this means for Broadcom.
US Politics Are Hurting Broadcom in China & Taiwan
In the past week, the Biden administration has taken actions affirming the US’ China stance with Taiwan that could lead to retribution from Beijing. President Joe Biden has emphasized strengthening alliances in the Indo-Pacific region, focusing on deterring Chinese aggression in Taiwan. This includes bolstering defense capabilities in Taiwan and reaffirming support for their government against potential Chinese military actions.
Moreover, Vice President Harris reiterated the U.S.’s commitment to preserving peace and stability across the Taiwan Strait during her recent interactions with international leaders. Harris has stressed that the U.S. would continue to oppose any unilateral actions by China that seek to alter the status quo in the region (this is moving away from the long-held ‘strategic ambiguity’ notions that the US has held as an official view). These statements support the broader U.S. policy of de-risking rather than decoupling from China to protect American interests while maintaining a strong stance on international norms and rules.
I think that such geopolitical actions could result in economic retribution from China, targeting U.S. companies with significant exposure to the Chinese market, including Broadcom. The semiconductor industry, already strained by supply chain disruptions and trade tensions, could face additional challenges if China imposes retaliatory measures. Broadcom, which has benefited immensely from the Chinese market, might experience adverse impacts on their revenue and operations due to these heightened geopolitical tensions.
Another issue is former President Donald Trump’s recent statements about Taiwan that emphasized the country must bear more of the financial burden for their defense against China. He claimed that the U.S. should act as a defense company that provides security in exchange for payments.
This is part of a pattern in Trump’s foreign policy, which prioritizes financial contributions from allies in exchange for U.S. military support. His comments suggest that Taiwan, despite their investments in purchasing U.S. military equipment, will need to increase their defense spending further if Trump returns to the presidency.
To clarify my perspective here, I do not anticipate an imminent invasion of Taiwan by China. Instead, but I believe Taiwan is being pressured to finance more of their military protection.
TSMC Is About To Get More Expensive, Hurting Margins
There’s no doubt that Taiwan Semiconductor Manufacturing Company Limited (TSM) is benefiting the most from the surge in demand for AI chips. The company recorded a strong 40% increase in revenue for the second quarter. This growth has prompted the company to raise their full-year revenue forecast to over 25%, which reflects the strong market demand for their advanced semiconductor technologies.
With this, TSMC has already announced plans to raise prices on companies Nvidia due to managing capacity bottlenecks and supporting the expansion of their advanced manufacturing capabilities.
This pricing adjustment will also likely be implemented for other major clients, including Broadcom, which relies heavily on TSMC for their cutting-edge semiconductor needs.
TSMC is a major contributor to Taiwan’s economy by helping finance their annual tax base (estimated at around 10%). As Taiwan grapples with potential financial burdens stemming from heightened defense commitments, particularly under a prospective Trump administration, I believe the ripple effects on TSMC and their customers are notable. Broadcom is set for a price increase, in my opinion, even if there is no geopolitical escalation. This escalation will make it worse.
Valuation
Broadcom’s forward non-GAAP P/E ratio is 31.43, which is 27.81% higher than the sector median of 24.59. As I said in my last piece, I believe this valuation raises concerns, particularly given the company’s heavy reliance on China for growth.
Broadcom, like many U.S. chipmakers, depends on the Chinese market for a huge portion of their revenue.
The concerns around the risk of being dependent on China, especially amid ongoing geopolitical tensions and potential trade restrictions, have already started to show within the semiconductor market. The market has already shed $480 billion in value due to fears of increased U.S.-China trade tensions and policy uncertainties under the current and prospective administrations.
Despite these risks, Wall Street analysts have recently raised their earnings and revenue estimates for Broadcom. For instance, consensus EPS estimates have been revised upwards 28 times, compared to 6 downward in the last 3 months. However, I believe this might be misplaced given the precarious geopolitical situation and Broadcom’s exposure to potential disruptions in China.
If Broadcom’s shares were to align with the forward sector median non-GAAP P/E ratio of 24.59, this would represent a significant downside (much like what I pointed out in early May). Given the current forward P/E ratio, convergence to the sector median implies a potential decline of approximately 21.8%.
Bull Thesis
While Broadcom is overvalued by traditional valuation metrics, it’s definitely an impressive growth story (no doubt).
The company’s gross profit margin stands at an impressive 74.24% which is 52.31% above the sector median of 48.75%.
On top of this, revenue growth has definitely been strong, coming in at a 529.01% premium to the sector median, or 21.62% YoY vs. 3.44%.
I think what is important to realize though is it’s very clear what has driven the stock up this year, when I am concerned about how this strong performance could revert as geopolitical tensions ramp up (along with scheduled price hikes from TSMC).
Take their gross profit margin. While this is well above the sector median, it’s only running 1.37% above their five-year average for gross profits. What this means is all the AI chip demand the company has experienced has not translated into significantly higher margins than what they saw before.
On this same note, their TTM return on common equity at 22.23% is actually below their five-year average of 29.95%. This means, despite an AI revolution causing chip demand to jump, they have not been able to capitalize on this to produce an above average return on capital.
Keep in mind, this is before any TSMC price hikes affect the stock or any geopolitical tension translates into actual impacts on the business. I believe we are early to the effects, and early to the market fully pricing this in.
Takeaway
While Broadcom remains a key player in the semiconductor industry, as proven by the company’s revenue growth driven by the industry-wide AI boom and strategic partnerships with major tech firms, I still think the stock is really overvalued.
To this point, geopolitical concerns have intensified (to a point even higher than where they were when I last wrote about them in May). Recent actions by the Biden administration, including heightened scrutiny and potential trade restrictions with China, pose risks to Broadcom, which heavily relies on the Chinese market for a huge portion of their revenue. Former President Trump’s rhetoric demanding increasing financial responsibility for Taiwan’s own defense further exacerbates the geopolitical tension. I just don’t see how this ends with Broadcom not having their costs go up from TSMC, or even worse, facing the wrath of geopolitical tensions.
Given these geopolitical risks and the inflated stock valuation, I now believe Broadcom is a strong sell. The combination of an overvalued stock and heightened geopolitical uncertainties creates an unfavorable investment scenario. Investors should be cautious, as the current setup does not support the optimistic projections reflected in the stock’s high price.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of TSLA, GOOGL either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Noah Cox (account author) is the managing partner of Noah’s Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk.
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