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Broadcom Is Proving the Bears Wrong

Daniel Sparks, The Motley Fool

Shares of semiconductor company Broadcom (NASDAQ: AVGO) surged on Friday, following the company's third-quarter earnings release. The stock's jump comes amid a rough period as shares fell more than 21% in the 10 months leading up to the company's just-released quarterly update. The decline was partly fueled by Broadcom's drawn-out attempt to acquire Qualcomm (which eventually was blocked by an executive order by President Trump) and concerns about the company's pending acquisition of CA Technologies (NASDAQ: CA).

The stock's sell-off, however, has pushed shares to arguably undervalued levels. This is why stronger-than-expected results and optimistic commentary from management this week sent shares higher on Friday.

Put another way, Broadcom is proving the bears wrong.

A bull in fighting stance

Image source: Getty Images.

Strong results

In Broadcom's third quarter, revenue increased 13% year over year to $5.06 billion. Non-GAAP EPS increased 21% year over year to $4.98. Though revenue was just shy of the consensus analyst estimate for $5.07 billion, non-GAAP EPS easily beat an average forecast for $4.83. 

Free cash flow, or cash from operations less capital expenditures, was $2.1 billion during the quarter, accounting for an impressive 42% of revenue. This cold, hard cash was up 52% from the year-ago period. More importantly, Broadcom's free cash flow as a percentage of revenue has increased substantially. In the year-ago quarter, free cash flow accounted for only 31% of free cash flow.

Maximizing free cash flow and deploying it effectively is a key part of management's strategy to build shareholder value. It's management's policy to return half of its prior fiscal-year free cash flow to shareholders in the form of dividends while using the remaining balance to give the company flexibility to fund share repurchases and acquisitions that would be accretive to earnings.

To ensure management was ready to take advantage of opportunistic buyback opportunities, Broadcom's board approved up to $12 billion for share repurchases earlier this year. The repurchase program has proven to be timely, as shares have fallen since the authorization and management has already spent $5.4 billion repurchasing 24 million shares.

Looking beyond the quarter, the company offered strong guidance. Management forecast fourth-quarter revenue of $5.4 billion -- above a consensus forecast for $5.35 billion.

Why buying CA makes sense

Broadcom management also used its third-quarter earnings call to address concerns about its pending acquisition of CA Technologies. Broadcom stock's decline after the acquisition was announced suggested that Wall Street had concerns about Broadcom's ability to achieve synergies to support the deal's $18.9 billion all-cash price tag.

But management believes the acquisition is a big opportunity. Acquiring CA, said Broadcom CEO Hock Tan, is all about CA's long list of large, entrenched customers.

Tan explained:

CA sells mission-critical software to virtually all of the world's largest enterprises. ... And CA does it at a scale fairly unique to the infrastructures of web space. This can only come from long-standing relationships with these customers that spend several decades. In other words, these guys are deeply embedded.

The plan, therefore, is for Broadcom to take advantage of these customer relationships and get these companies on board with other products and services, Tan said.

Through CA, we believe we have a big doorway to engage strategically with these customers and provide them direct access at very compelling economics to the same leading-edge networking, storage, and computer technology that are used to enable the cloud service providers today.

Overall, the quarter's results and management's pitch for its pending acquisition of CA are making Broadcom's conservative valuation look like a compelling entry point for investors.

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Daniel Sparks owns shares of Broadcom Ltd. The Motley Fool owns shares of Qualcomm. The Motley Fool recommends Broadcom Ltd. The Motley Fool has a disclosure policy.