Earnings Call: Q2 2019

Jun 13, 2019

Good day, ladies and gentlemen, and welcome to the Q2 2019 Broadcom Earnings Conference Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time. As a reminder, this conference is being recorded. I would now like to introduce your host for today's call, Ms. Beatrice Russotto, Director, Investor Relations. Ms. Russotto, you may begin. Thank you, operator, and good afternoon, everyone. Joining me today are Hock Tan, President and CEO and Tom Krause, Chief Financial Officer of Broadcom. After the market closed today, Broadcom distributed a press release and financial tables describing our financial performance for the Q2 of fiscal year 2019. If you did not receive a copy, you may obtain the information from the Investors section of Broadcom's website at broadcom.com. This conference call is being webcast live and a recording will be available via telephone playback for 1 week. It will also be archived in the Investors section of our website atbroadcom.com. During the prepared comments section of this call, Hock and Tom will be providing details of our Q2 fiscal year 2019 results, guidance for fiscal year 2019 and commentary regarding the business environment. We will take questions after the end of our prepared comments. Please refer to our press release today and our recent filings with the SEC for information on the specific risk factors that could cause our actual results to differ materially from the forward looking statements made on this call. In addition to U. S. GAAP reporting, Broadcom reports certain financial measures on a non GAAP basis. A reconciliation between GAAP and non GAAP measures is included in the tables attached to today's press release. Comments made during today's call will primarily refer to our non GAAP financial results. So with that, I'll now turn the call over to Hock. Thank you, Bea, and thank you, everyone, for joining in today. Let me touch on the 2nd quarter results, after which I will update you on the current environment and our outlook for the second half of the year. Looking at the Q2 just passed, it really went as planned. Networking continued to perform very well and our broadband business started to recover. This was offset by the anticipated sharp decline in wireless and the ongoing softness in storage. On the other hand, the infrastructure software business delivered solid top line results, benefiting from sustained enterprise demand for our mainframe and distributed software as well as SAN switching products. The integration of CA is progressing well. Just last week, we reached a major milestone with day 2, which is the integration of the CA's business processes onto Broadcom's IT platform. We remain confident that we can meet, if not exceed, the long term revenue and profitability targets that we laid out for CA to you last year. Renewals in our CA business are strong and the dollar commitments from our core customers continue to grow. Now let me address the current business environment and our outlook for the remainder of the year. We have, as I indicated, performed very much to plan in the first half of fiscal 2019. And in the second half, we had expected a recovery. However, while enterprise and mainframe software demand remains stable, North America and Europe. With respect to semiconductors, it is clear that the U. S.-China trade conflict, including the Huawei export ban, is creating economic and political uncertainty and reducing visibility for our global OEM customers. As a result, demand volatility has increased and our customers are are actively reducing inventory levels to manage risk. This leads us to believe the second half of twenty nineteen will be more in line with the first half as opposed to the previously expected recovery. We now anticipate fiscal 2019 into a year over year decline in the high single digits. CA software continues to perform above our original expectations, while SAN switching is slowing down after a very strong first half. As a result, we are maintaining our fiscal 2019 infrastructure software outlook at $5,000,000,000 While this scenario has been playing out, I should emphasize the fundamentals of our business remains very much intact. We continue to execute on a very rich roadmap for next generation network switching and routing in the cloud and enterprises, including the leading edge Trident 4 software defined network switch just recently announced this week. We have also secured the next two generations of RF front end and our large North American OEM, which positions us very well for the transition into 5 gs. We continue to win increasing numbers of compute offload accelerators in the hypercloud operators across AI, video transcoding, encryption and networking. We are pleased with the ramp of our new generation Wi Fi 802.11ax, otherwise called Wi Fi 6, in enterprise gateways and carrier access points. All this leaves us confident that we will be able to continue to drive sustained long term revenue growth and increasing free cash flow. Let me now turn it over to Tom, who will provide you with more color. Thank you, Hock. Consolidated net revenue for the Q2 was $5,500,000,000 a 10% increase from a year ago and EPS came in at $5.21 a 7% increase from a year ago off of a 448,000,000 weighted average fully diluted share count. In addition, we had record free cash flow of $2,540,000,000 or 46 percent of revenue. Free cash flow grew 20% year over year. The Semiconductor Solutions segment revenue was 4 point $1,000,000,000 and represented 74% of our total revenue this quarter. This was down 10% as expected year on year on a comparable basis. Our Infrastructure Software segment revenue was $1,400,000,000 and represented 26% of revenue. Let me now provide additional detail on our financial performance. Operating expenses were 1,020,000,000 Operating income from continuing operations was $2,950,000,000 and represented 53.5 percent of net revenue. Adjusted EBITDA was $3,110,000,000 and represented 56.4 percent of net revenue. This figure excludes $142,000,000 of depreciation. Receivables in the quarter decreased $193,000,000 and inventory decreased $40,000,000 from the prior quarter. I would also note that we accrued $136,000,000 of restructuring integration expenses and made $218,000,000 of cash restructuring and integration payments in the quarter. Finally, we spent $125,000,000 on capital expenditures. In the Q2, we returned $2,400,000,000 to stockholders consisting of $1,100,000,000 in the form of cash dividends and $1,300,000,000 for the repurchase and elimination of 4,700,000 AVGO shares. We ended the quarter with $5,300,000,000 of cash, $37,500,000,000 of total debt, $399,000,000 outstanding shares and $447,000,000 fully diluted shares outstanding. We also refinanced our $18,000,000,000 of term loans that we put in place at the beginning of fiscal 2019 to finance the CA acquisition. Via a combination of $11,000,000,000 of investment grade bonds and a new term loan, we're able to extend our average debt maturity to approximately 5 years and substantially reduce the cornwood debt due in any 1 year. As of today, our average cost of borrowing stands at approximately 3.7%. Turning to our fiscal year 2019 guidance. As Hock discussed, we are updating our full year revenue guidance to $22,500,000,000 including approximately $17,500,000,000 from semiconductor solutions and approximately $5,000,000,000 from infrastructure software. IP Licensing is not expected to generate a material amount of revenue. On a non GAAP basis, operating margins are expected to be approximately 52.5%, an increase of approximately 150 basis points from our prior guidance. Net interest expense and others expected to be approximately $1,300,000,000 We do not contemplate any debt pay down in fiscal year 2019. The tax rate is forecast to be approximately 11%. Depreciation is expected to be approximately $600,000,000 CapEx is expected to be approximately $500,000,000 As a result, free cash flow is expected to be approximately $9,000,000,000 which takes into account projected restructuring and integration charges of approximately 1,100,000,000 dollars Stock based compensation expense is expected to be approximately $2,200,000,000 And finally, we expect weighted average diluted share count to be $444,000,000 for Q3 $443,000,000 for Q4 and this excludes any impact from share buybacks and eliminations. Now on to capital allocation. Our capital allocation strategy remains the same. We plan to maintain the current quarterly dividend payout of $2.65 per share throughout the year, subject to quarterly Board approval, which means we plan to pay out over $4,000,000,000 in cash dividends in fiscal 2019. In addition, we remain committed to buying back and eliminating a total of 8,000,000,000 of stock in fiscal 2019. In the first half of the fiscal year, we have spent $4,800,000,000 for the repurchase and elimination of shares. That concludes my prepared remarks. During the Q and A portion of today's call, please limit yourself to 1 question each, so we can accommodate as many analysts as possible. Operator, please open up the call for questions. Thank Our first question comes from Vivek Arya with Bank of America. Thanks for taking my question. Hawke, in the $2,000,000,000 or so reduction in the semiconductor outlook for the next two quarters, Can you give us some sense how much of that is Huawei? How much is outside of Huawei? And just any segment level impact so we can calibrate our models? Well, it's an interesting way to figure that out because in terms of full disclosure, Huawei represented last year about $900,000,000 of revenues for this company by itself. But the other side of the picture I should add is that guide down that we're providing, as you put it, of $2,000,000,000 obviously extends beyond just one particular customer. We're talking about uncertainty in our marketplace, uncertainty because of that of demand in the form of order reduction as the supply chain out there constricts compress, so to speak. And because we do see, to some extent, end user in the U. S, particularly in North America and Europe, continuing to be there. But what we do see in between is the uncertainty of the environment has put in place concern about placing additional orders and actively a reduction of inventory out there, basically a compression of supply chain, is what's driving this reduction more than anything else, and it's broad based. Thank you. Our next question comes from Blayne Curtis with Barclays. Hey, guys. Thanks for my question. Maybe I guess follow-up on the next question. Hock, just kind of curious as you look, I mean, I think markets were soft and you saw a lot of revisions last quarter. You guys kind of maintain your forecast. Kind of just trying to figure out when you saw this slowdown, if you can give us any idea of that? And then is there just any more color you can add per end market? Is there any end markets that you're not seeing this weakness? And if you can point to any particular products, that would be helpful. Well, we've started seeing this softness right as we basically at the beginning of this quarter, right in Q3, very much so, and dramatic reduction and it particularly accelerated with the denial order that was imposed on Huawei. Thank you. Our next question comes from Harlan Sur with JPMorgan. Good afternoon. Thanks for taking my question. On the networking side specifically, that's been a strong area for the team, growing double digits year over year for the past few quarters. And it's an area where you guys actually do have some pretty strong product cycles like Tomahawk 3, Jericho 2, some of your compute offload ASICs. In your revised outlook ex Huawei, how is the macro uncertainty impacting this segment and some of these programs? And again, ex Huawei, would you expect the networking business to grow second half over first half? Arnold, a very good question. Our networking business, which I think is what you're referring to, continues to be a very strong business. Year on year, we expect our networking total networking business to grow double digits year on year. It's strong, particularly with new product ramps and new product cycles that we're seeing both in switching, routing. Related to It's it is one of the brightest areas in our portfolio in this environment and continues to be strong, notwithstanding the export ban on Huawei. Our next question comes from Ross Seymore with Deutsche Bank. Hi, thanks for letting me ask the question. I wanted to go into the wireless side. I know you just signed a supply agreement with a large North American customer. They typically have positive second half seasonality and most of us believe you actually were regaining some share. So I put that all into the mix. How are you getting especially given what you just said in networking growing double digits, how are you getting the second half to be relatively flat with the first half? Is there some offsets in other areas? Or are some of our assumptions in wireless incorrect? Well, I don't know what the assumptions are also on wireless, but networking is about really varies is about the only area of strength in this current environment. And that's because it coincides with very strong product cycles we're seeing. In just about broadly any of the end market segments, we do not see in terms of year on year improvement from 2018. Our next question comes from Timothy Arcuri with UBS. Hock, I just had a question about competitive environment for your RF front end business as we kind of move into 5 gs and particularly around a large modem maker now that's talking about having a complete RF package and sort of being able to sweep that in with their modem. So can you kind of talk about the competitive environment and your position as you kind of get into 5 gs? Thanks. That's a very interesting question. We continue to believe we are very, very strongly positioned and it's in many ways validated by some of the data points I just mentioned. We are by far the best technology and products out there in RF front end components, particularly the filters and the integrated front end modules. We are by far the furthest ahead technology wise and in terms of capabilities. And we continue to believe we are still very much in front. And as I said, it's been validated and continues to be validated by the value we give to our very critical customers and the fact that they continue to be very supportive of our business. Thank you. Our next question comes from Toshiya Hari with Goldman Sachs. Hi, guys. Thanks for taking the question. I had a question on RF as well. Todd, can you remind us what kind of content growth are you expecting or assuming into the back half, both on the RF side as well as the WiFi side of your business within wireless? And then you also talked about 5 gs or rather how the recent win positions you well into 5 gs. As of today, what you know based on what you've heard from your customers, what kind of content growth on the RF side are you expecting as we transition to 5 gs over the next couple of years? Thank you. Thank you. Well, asking year on year is actually very difficult. So I appreciate you asking me what do I see over the next 2, 3 years on content growth. And I mean, the best way to describe content growth in RF and we've seen that we have empirical evidence of that for the last 5 years, even longer and not the same every year is that annually, we probably see in the 5% to 10% range content growth. And with in terms of the products, we should. Now for the entire, I guess, our serve available market or yes, to serve available market, it's probably a smaller growth percentage. Thank you. Our next question comes from John Pitzer with Credit Suisse. Yes. Good afternoon, guys. Hock, I just want to go back to Ross' question about the wireless guide for the balance of the year. I'm just curious relative to 90 days ago, when you guys were guiding the overall semi business well above normal seasonality for the balance of the year. Now you're talking about a flat half to half. To what extent did your content expectations come down for the back half of the year versus just this really being a unit issue on the wireless side of the business? Well, that's an interesting question that lays out that way. It's keep in mind, we're taking a very conservative stance here. And very frankly, even as we see the ramp up and we do see the ramp up, we have also been forecasting a fairly dramatic set of numbers before. And when you come and that is more than offset by the fact that for the rest of the broader markets, we're just seeing a demand environment that is extremely uncertain. Thank you. Our next question comes from Craig Hettenbach with Morgan Stanley. Yes, thanks. Hock, just coming back to the compute offload, you talked about it at hyperscale. I know a little while back, you guys talked about some initial traction ASICs. Just wanted to get an update in terms of the breadth of that particular hyperscale is and how to the extent that you're extending that to multiple customers as we look forward? Well, I have mentioned before in previous calls, earnings calls, about our focus and increasing traction in what we call compute offload engines or I call it compute offload accelerators in multiple areas, including AI, of course, and virtualization, orchestration from the compute servers and expanding that now to video encryption. And we continue to see that. And it is an emerging space as from our perspective, but nonetheless, it's a space that seems to be growing very steadily and continuing to trend up very significantly. And this is a space we believe at the end of in a matter of 3 to 5 years could be a significant percentage of a total compute spend within any large scale data center. And we're talking about potentially getting to perhaps even as high as 25% or more of total spend in the computing environment of a large scale cloud data center. Thank you. Our next question comes from Chris Danely with Citi. Hey, thanks guys. Just looking at the overall environment, do you think your guidance incorporates the proposed next round of 300,000,000,000 dollars in tariffs, I. E, if that thing does go through, do you still feel good about your guidance? Or do you think there could be more downside if it does go through? I think at this point, we try to capture everything, including that proposed next round into the picture. We have to believe that things are environment is very, very nervous. And that's why we see a very, very sharp and rapid contraction of supply chain and orders out there from our customers, especially our global OEM customers. Even as we believe, as I mentioned in North America and Europe, end demand hasn't reflected there. So we are seeing a very reactive mode here. And so I got to believe that includes the sense that this $300,000,000,000 of next round potential tariffs could be in place. Also keep in mind something I should add is that even as we see some there are 2 parts to this. One part is what's the impact of the Huawei ban on a company like us selling components and technology. While short term, keep in mind, we'll see a very sharp impact simply because there are no purchase of a lot and there's no obvious substitution in place from other OEMs replace taking over end demand, which may exist which may continue to exist. Give it a few months, give it 6 months. If those end demand still remains out there, we'll see other OEMs qualified to take over those to replace Huawei on those demand. And other OEMs will come in and those OEMs will continue to buy our products. And so we have a rebalancing and readjustment in demand from our side. But short term, we do not expect to see that. Thank you. Our next question comes from William Stein with SunTrust. Great. Thanks for taking my question. On a brighter note, I'd like to ask about CA a little bit. Last quarter, Hock, I think you talked about at least one proof point with regard to sort of deeper engagements with CIOs around a deal that might involve both sides of the business. Anything similar to that where you see more proof of points around traction in sort of the strategic approach in that acquisition? Thank you. Well, yes, one of the things we are doing is, as we said last time, is as we focus on core accounts, as I said, these are the largest enterprises in the world who buys a lot of software infrastructure and infrastructure software. And given the broad portfolio of product CA has that we bring to bear between mainframes and these largest companies mostly runs a lot of mainframe capacity and distributed software in infrastructure and our ability to offer this as an enterprise and portfolio wide transaction. We've been very, very successful in securing such enterprise wide contracts with significant uplift in booking dollars on the form of larger amount of renewals with, right now, over 20 large accounts in the 6 months since we've taken over and closed on this transaction. And we foresee that rate being even higher over the next 6 months. So that's working, and that's working very well, which gives which allows us to give you a fairly positive tone to how the CA business has been trending as far as we're concerned. Putting in a nutshell, and I said that earlier, the amount of dollar commitments we've been able to achieve compared to what expires has increased quite significantly. Thank you. Our next question comes from Matt Ramsay with Cowen. Thank you very much. Good afternoon. Hock, I wanted to ask a little bit about obviously, we talked about the demand environment and the trade environment a bit, but I wanted to ask a little bit about the M and A environment as you see it. Obviously, CA took the company in a little bit of a different direction, but we've seen some semiconductor mergers announced here very recently. And I wonder if you might give us a little bit of a view on the M and A environment as you see it right now on the semiconductor side. You're saying the M and A environment in the semiconductor space. Yes, I see what you see there, which is some level of activity that seems to go on. And it's quite interesting in a way, quite encouraging for us to see that the direction we're picking a large part of this industry seems to be making sense to a lot of our peers, too. And from our point of view, we welcome it. And we as I've indicated before in previous earnings call, for us, it's what makes sense, what's actionable in terms of businesses that are franchises that we see as very sustainable and that we are able to acquire. But right now, we see a lot of movement. But we and we are very we continue to be very interested in opportunities that may present themselves, and we continue to be very active in assessing those opportunities. Thank you. And our final question will come from Chris Caso with Raymond James. Hock, I just wanted to return to some of your questions some of your comments rather regarding inventory and you talked about the customers reducing inventory. Do you think that the inventory levels at the customers were elevated coming into the quarter? Or is this just a situation where the customers are reducing inventory proactively because of the uncertainty. I guess question is how much of the weakness you see here is driven by inventory reductions as opposed to demand? I think what we're seeing a lot here because overall demand weakness or uncertainty probably started even before this quarter began. But the sharpness in terms of demand contraction demand reduction, I should say, is coming from the fact that customers are even more aggressively now trying to reduce inventory out there. And a lot of it is customer inventory that we're talking about directly. As you notice in our on our balance sheet, our inventory has been very well managed, tightly managed and we continue to be very, very consistent through all this in the range of 60, 65 days of inventory. So this reduction is very much action of the supply chain of the end user, which really reflects on our direct customers where there's been a sharp reduction of inventory out there. And are we talking significant? Yes. We believe it is what we've seen is very significant and we anticipate that to continue, which reflects in our revised guidance for the rest of this year, which is the next less than 6 months out there. Beyond that, who knows?