This week’s Focus Stock is Broadcom Ltd. (AVGO) which carries CFRA’s highest investment recommendation of 5-STARS, or Strong Buy. AVGO is a leading designer, developer, and global supplier of a broad range of analog semiconductor devices, with a focus on radio frequency, or RF. AVGO generates 70% to 75% of its revenue within the Semiconductor Solutions segment while the other 25% to 30% comes from the Infrastructure Software segment. Within Semiconductor Solutions, AVGO sells a range of products used in end devices like smartphones, hard disk drives, computer servers, consumer appliances, data networking and telecommunications equipment, enterprise storage and servers, as well as factory automation and industrial equipment. Our Strong Buy recommendation reflects our views about valuation and attractive growth prospects over the next 12 months. We expect AVGO to benefit from favorable trends in the data center space as well as a new iPhone cycle in the second half of the calendar year. We also think robust free cash flow generation will allow AVGO to significantly return cash to shareholders.

We see upside in AVGO given our view of attractive valuation and potential earnings/free cash flow leverage. We are encouraged by AVGO’s increasing shift to its higher-margin infrastructure software business, which is more recurring and offers diversity from semiconductors. AVGO will likely benefit from improving networking demand for its switching and routing platforms as well as for its custom ASIC solutions in cloud, in our view. We have high confidence in management execution and expect AVGO to benefit from higher spending from cloud customers and telecom providers that are looking to upgrade their infrastructure and networks. We think end-market visibility remains extremely high through the rest of the calendar year across all core end-markets.

We forecast sales increasing about 5% in FY 22 (Oct.) after our outlook for a 14% rise in FY 21. Sales rose 15% in the most recently reported April quarter, with Semiconductor Solutions up 20% and Infrastructure Software increasing 4%. AVGO is benefiting from elevated broadband and network growth while wireless (up 48% in the Apr-Q and 34% of semiconductor revenue) sees easy comparisons from 5G content gains related to FBAR and WiFi. We think smartphone replacement cycles have stabilized in 2021 after extending for the last four years while the company has also been benefiting from content gains as customers shift to 5G devices. We think content gains for 5G devices are 30% to 40% higher than 4G phones as it pertains to AVGO’s offerings. Infrastructure Software revenue is very predictable, with over 90% of bookings recurring and average contract term length at three years.

We believe AVGO’s broadband business is going through a resurgence (18% of semiconductor sales), as the work, learn, and play from home environment is driving global service providers to expand connectivity to the home. On the broadband carrier access side, AVGO’s passive optical network (PON) business will see significant content growth as 10G PON deploys over the next few years and cable operators in the U.S. drive deployment of DOCSIS 3.1 cable modems, with plans to accelerate the upgrade to next-generation DOCSIS 4.0. In addition, we see broadband upgrades supported by higher demand WiFi 6 and 6E technology to enable the last 100 feet of connectivity in homes. We see this investment cycle in broadband being sustained in 2022.

In networking (up 10% in the Apr-Q and 32% of semiconductor revenue), we see tailwinds from hyper cloud and telecom customers. Revenue for switching is witnessing a strong ramp for AVGO’s Trident and Tomahawk 3 offerings for over 400G platforms and from hyper cloud data centers. In the network, service providers have been investing in 5G infrastructure worldwide and we expect enterprise demand in networking to recover in the coming quarter. In addition, server storage connectivity, which has been weak (down 16% in the Apr-Q and 12% of semiconductor revenue), should also recover as the enterprise trajectory improves (this segment is largely enterprise driven). Industrial and other represents about 4% of semiconductor solutions revenue.

We see AVGO’s annual gross margin widening to 74% in FY 21 and FY 22. Semiconductor Solutions gross margin stands at 69% (up 290 basis points in the April quarter) and software at 90% (up 100 basis points). We remain optimistic about operating margin expansion ahead, led by higher volume as well as improving mix towards higher margin offerings.

We like free cash flow potential (52% of April quarter sales), which we see at $12.5 billion in FY 21 and $13.1 billion in FY 22 (vs. $11.6 billion in FY 20). We expect excess cash to support dividend hikes (we project a 10%-15% boost in December) and potentially a return to acquisitions.

We project EPS of $27.24 in FY 21 (Oct.) and $29.12 in FY 22. We believe Apple’s shift towards 5G, among other hardware manufacturers, has permanently shifted AVGO’s wireless revenue higher, largely driven by greater content per device. Although much of the smartphone benefits related to 5G has been realized, we see additional upside on the wireless infrastructure side as well as an expanding addressable market over time. The software business continues to offer a stable and highly recurring revenue stream, supporting EPS across volatile semiconductor cycles better than its peers.

Our 12-month target price of $510 is based on a P/E of 17.5x our FY 22 EPS estimate of $29.12, above AVGO’s 5-year historical forward average of 13.3x but below chip peers to reflect its more leveraged balance sheet. We view AVGO’s 3% plus yield as among the most attractive and sustainable within the semiconductor industry.

Risks to our recommendation and target price include slower-than-expected consumer demand for devices that use AVGO’s products, greater than projected pricing pressure, more competitive pressures, and inability to find strategic deals.