Generative AI’s spending boom has not only driven increased demand for data centers as hyperscalers work to expand capacity, but also is driving a surge in optic connections. This is due to the heavy data requirements needed to support genAI services and connections needed to link GPUs together in the clusters. Optical transceivers are becoming increasingly important in addressing bandwidth, a primary bottleneck in large-scale data centers, which refers to the speed of data transfer in the data center.

Corning is a centuries-old bellwether for materials such as advanced optics. The management team recently explained in its Q2 earnings call that “traditional data centers contain a network of interconnected switches and CPUs. GenAI requires a second network within data centers to connect every GPU to every other GPU in the cluster, creating a neural network. Now because GPUs have more processing capacity than CPUs, they need higher bandwidth links connecting them. The result is about 10 times the number of fiber [optic] connections in this new network versus a traditional data center.”

We’ve previously discussed memory bandwidth as a primary bottleneck at the GPU level, but scaling from singular GPUs to hyperscale data centers featuring hundreds of thousands of GPUs sees bandwidth arise as a primary bottleneck due to the immense data transfer requirements of AI training and inference.

GenAI to Drive Optical Growth

AI requires interconnected processors, to where thousands or tens of thousands of processors are connected. In turn, connectivity is needed for accelerated compute, which includes an increased number of switches, NICs, ports and also port speed.

For example, Chat-GPT was trained on a 25,000-accelerator cluster with roughly 75,000 optical interconnects. Increasingly powerful AI models, with escalating data and compute demands, are making bandwidth, data speeds and latency critical factors for future data centers to address.

Copper had long been standard for data center interconnects, but it cannot support network speeds of 800 gigabits (800G) to 1.6 terabits (1.6T) over long distances due to substantial signal loss. This isn’t to say copper is dead – Nvidia’s GB200 NVL72 utilized copper over optics (with more than 2 miles of copper cabling in the rack) to reduce power consumption by 20 kw (the system still draws 120kw of power). According to a representative from Marvell’s Cloud Optics division, “optical is the only technology that can give you the bandwidth and reach needed to connect hundreds and thousands and tens of thousands of servers across the whole data center.”

Optical transceivers are crucial in enabling high-speed data transfer, by transmitting and receiving data from optical (light) signals to electrical signals. In data centers, optical interconnects and transceivers are becoming the de facto standard to handle AI workloads, since they can function at significantly higher speeds than copper (currently  at 800G+ speeds and moving quickly to 1.6T), with longer range, higher data capacity, and lower latency with minimal signal loss. One drawback, however, is that due to the electronic complexity of optical products, costs are higher as well as power consumption versus copper.

800G transceivers are a driver of growth industry-wide at the moment, with Marvell, Lumentum, Coherent, Mitsubishi Electric, Broadcom, Nvidia and others all shipping 800G transceivers and seeing high growth and demand. Coherent forecast in 2023 that the datacom transceiver market would more than double to $11.4 billion by 2028, with 800G transceivers taking more than 50% market share, up from the mid-teens in 2023, with the majority of that growth arising through 2026.

Source: Coherent

Mitsubishi Electric sees much more market share growth ahead for high-speed transceivers, forecasting the optical transceiver market to nearly triple from just over $4 billion in 2023 to $12 billion by 2029, with 800G and 1.6T transceivers accounting for more than 80% of the market.

Source: Mitsubishi Electric

Other industry forecasts suggest the broader optical transceiver market (including other end markets in industrial and telecom) will nearly double from $13.3 billion in 2024 to $24.7 billion by 2027.

Industry Executives See Strong Growth in Optics

Management teams from companies in the optical transceiver industry remain quite bullish about growth prospects in the future, catalyzed by AI data center demand.

Mitsubishi Electric, which reportedly commands nearly 50% market share in optical transmission devices for data centers, per Bloomberg, is rapidly expanding capacity to meet demand. Mitsubishi is “ramping up production capacity for optical devices to a level 50% above last year’s,” though CEO Masayoshi Takemi said that “won’t be enough to meet the strong level of inquiries we’re getting, [and] we may need double what we’ll have in September.”

Coherent CEO Jim Anderson similarly sees strong growth ahead for transceivers: “one of the most exciting growth opportunities is our optical transceiver technology, which underpins and drives the high-speed connectivity required by new AI data centers.” He added that the company “saw strong sequential growth in our 800G datacom transceiver revenue in Q4 and [is] also seeing increasing orders in backlog for the current and future quarters. We also delivered initial samples of our 1.6T datacom transceivers, which we expect to begin ramping in calendar 2025.”

Barclays analyst Tom O’Malley asked Anderson about the trajectory of the “big growth engine” for Coherent, the ramp of 800G and soon 1.6T transceivers, with Anderson saying that “It's stronger than what I had thought. And we've seen, just over the last, I would say, gosh, four to six weeks as I've spent a lot of time with our top customers across the – across all of our different product lines, but especially in our datacom business, I've gotten a much better sense for the opportunity that's in front of us, and I would say it's a very strong opportunity. And we continue to see demand strengthening, forecast strengthening, billings, backlog.”

Optics has also been a primary growth driver so far this year for Marvell, with electro-optics revenue exceeding expectations in Q2 and expected to grow in each quarter of this fiscal year. To note, Marvell is targeting to exceed its $1.5 billion AI revenue target this year, with optics contributing $1 billion or more of that sum.

Marvell CEO Matt Murphy explained in Q2’s earnings call that “demand has been extremely strong in the AI business, as we mentioned, both in custom and in our optics business. And that's the 800G products as well as traditional cloud, as well as DCI [data center interconnects]. So that's all going extremely well. And for next year, that should absolutely ripple through. We see continued strength next year above what we had communicated relative to the target for next year both in custom and in optics and the broader portfolio. … Demand has been strong. Bookings momentum has been extremely strong.”

Marvell’s management also noted in Q1 that its 800G PAM4 modules are currently the “primary interconnect enabler for state-of-the–art AI deployments,” while qualifications have begun for its 1.6T modules, which it expects will enable the next generation of AI chips. Marvell added in Q2 that “strong bookings continue for our market leading 800G PAM products and 400ZR data center interconnect, or DCI products,” while its 1.6T DSPs (digital signal processors) would begin shipments in Q3.

Marvell has the advantage of scale over its competitors. Per a Marvell spokesperson in June, “every single large language model today runs on compute clusters that are enabled by Marvell’s connectivity silicon.”

Lumentum is expecting the optical opportunity to quickly drive quarterly revenues to $500 million by the end of 2025, up 60% from last quarter’s $308 million, with management saying that transceivers will be the “number one growth area,” with EML chips and optical switching other growth drivers as the company works to rapidly boost transceiver capacity in Thailand. You can access our previous Lumentum deep dive here.

In terms of optics (and/or networking revenue), Marvell likely leads the three, with Coherent close behind. Marvell’s data center optics segment alone contributed more than $1 billion in revenue in fiscal 2024, and in Q2 FY25, optics and networking and switches likely accounted for revenue in the mid-$600 million range, given management’s comments that suggested between $200 million to $250 million stemmed from ASICs and storage. For FY25, Marvell’s optics, networking/switches and enterprise networking revenue could reach approximately $3 billion annualized (~54% of FY25 revenue estimate of $5.54 billion), with more than $1 billion in AI revenue (mgmt’s $1.5 billion AI revenue target has 2/3 coming from optics).

Coherent reported approximately $2.3 billion in networking revenue in the twelve months ending in June, or ~49% of overall revenue; Coherent has not provided an AI revenue target, but noted that datacom revenue rose 16% QoQ and 58% YoY due to AI demand. Lumentum reported $1.08 billion in cloud & networking revenue in FY24 (~80% of revenue), down 18% YoY, with management eyeing AI to drive revenue to a $2 billion-plus run rate by the end of calendar 2025.

Interestingly, it was announced on September 5 that Marvell, Lumentum and Coherent have demonstrated the industry’s first 800G ZR/ZR+ pluggable modules for 500 kilometer data center interconnects (an industry first distance for 800G modules). Utilizing Marvell’s Orion 800G DSPs, modules from the three are now interoperable, allowing regional data centers to take advantage of a multi-vendor solution and minimize vendor lock-in risk by having the ability to link together transceivers from different companies in a cost-effective and power-efficient manner.

Blackwell in Focus

Nvidia’s Blackwell is a force of its own, and with initial shipments expected to begin in Q4 this year (which ends in January), but will ship in volume come     Q1 (ending in April), analysts are working to identify which companies will be primary suppliers on the optics side as Blackwell brings an enormous revenue opportunity for Nvidia and its suppliers.

Broadcom was the latest to field questions from analysts about optics tie-ins to Broadcom, though Marvell, Lumentum and Coherent all have been questioned as well – the common denominator is that the management teams are not commenting on individual customer engagements.

Interestingly, a Broadcom announcement from March 2024 noted that “Google and Nvidia will be the first adopters of 200G per lane optics for interconnecting GPUs and TPUs in AI Clusters” as 1.6T shipments begin by the end of the year (aligning with Blackwell). Broadcom also continued its partnerships with Innolight and Eoptolink in optics; this cross-checks with a report from SemiAnalysis on GB200 component suppliers, saying that “while Marvell was 100% share on Nvidia last generation with H100. This generation, Broadcom comes in a big way. We see both Innolight and Eoptolink looking to be adding Broadcom in volume for the DSP.”

Notably, in the most recent earnings report, the CEO stated he was not “directly” in the market of supplying Blackwell, so we will see if Broadcom is downstream or not come next year. Per the CEO of Broadcom: “We’re happy to be part of that ecosystem as I said. But directly, we’re not in that [Blackwell] market as you know.”

Marvell:Marvell:

Question (Atif Malik, Citi): “Curious when are you thinking about the volume adoption of 1.6T and what is holding that if it's not the DSPs. Are the lasers not ready? Or is it just waiting for the Blackwell?”

Answer (CEO Matt Murphy): “I think the way to think about it is just timing relative to the system builds our customers call, schedule their ramp, et cetera. … I remember all these issues in the past, right. There's a green laser problem. There's this problem or that. There's always some issue in this optical space, but this time it's really, everyone's going a million miles an hour trying to get their products ramped. Our module partners are ramping up with our solution. Our end customers that are driving this are going as fast as they can.

So it's just more of a timing issue that we need to intercept the platforms as they're ramping and we're doing that. So think of that as sort of shipments in the back half, but really contributing much more meaningfully next year on the 1.6T transition. But it's definitely underway, and we see a clear path to help enable right, this part of this next generation of accelerators to be able to ship in volume with the latest optical standards. And we're at the forefront and in the lead in that regard. So yes, it will be later this year and then more volume next year and it will — I think be a big product cycle for us.”

Quick Note on CXL: About two years ago, our firm covered Marvell’s CXL memory catalyst. Compute Express Link (CXL) improves how data centers add memory by offering a new switch that offers “cache coherent” memory pooling. Essentially, this means offering a new architecture that boosts memory bandwidth and helps to enable memory pooling through partially-disaggregated racks.

The new fabric required for disaggregated memory from the CPU is based on PAM electro-optics that Marvell specializes in. In July, new CXL memory-expansion controllers were announced called Structera with partners AMD, Intel, Micron and Arm participating in the press release.  Custom CXL silicon is expected to sample in the fourth quarter and will represent an expansion to Marvell’s TAM assuming all goes well.

Lumentum:Lumentum:

Question (George Notters, Jefferies): “I'm just curious if you guys have an Nvidia qualification on this 800 gig single mode transceiver?”

Answer (CEO Alan Lowe): “Yes, we're not going to comment on who the customer is, George. I would say that — as I said before, most customers are working with us on products they don't already have. And so, for instance, we are designing 1.6T transceivers, and the performance is quite good. We plan on sampling customers this quarter on 1.6T. So, there's a few leaders that would be consuming that. And so, you can imply what you want from that, but we're not going to speak specifically about any individual customer.”

Coherent:Coherent:

Question (Vivek Arya, Bank of America): “Are you seeing any impact at all, positive or negative, because of changes in Nvidia’s product schedule or does that have no impact?”

Answer (CEO Jim Anderson): “On the first part, on the part that was about the order book, yes, we continue to see the order book strengthen. I think you asked about a particular customer. I can't comment on that particular customer, or really any particular customer. But I can say that in aggregate, we're continuing to see, again, the order book strengthen and demand growing, which is good.”

Margins May Determine the Winners

Given that optics is a fairly fragmented market with four major firms vying for market share in 800G and soon 1.6T transceivers, margins may ultimately determine the winners. This view is shared by Coherent, with management stating that on pricing and gross margins, “in general, what we would usually see in the transceiver market is the newer speed grades like 800G and then soon to be 1.6T generally carry higher gross margins than the older speed grades, right? The older speed grades are usually become commoditized over time.”

Based on Coherent and Mitsubishi Electric’s forecasts, shipment growth in 800G is expected through 2026 before shifting to 1.6T, leaving four to six quarters for these companies to drive shipments and revenues before commoditization potentially occurs with product margins shrinking.

Of the trio, Marvell has the best gross margin profile, at 46.2% last quarter, compared to 32.9% for Coherent and 16.6% for Lumentum. Marvell is expecting gross margin to expand to 47.2% next quarter, while Coherent guided flat QoQ and Lumentum guiding for some sequential improvement in future quarters.

Moving down the line, Coherent is the only one of the three with a positive operating margin, reporting a ~300 bp sequential expansion to a 4.8% margin last quarter. Marvell reported a (7.9%) operating margin, while Lumentum reported a (43.3%) operating margin.

With Marvell’s success likely equally tied to the ramp of ASICs in the coming quarters, and Lumentum deep in the red, Coherent is better positioned with a stronger bottom line profile to be able to withstand pricing competition, should the manufacturers prioritize capacity expansion. In this case, Coherent has leverage to boost market share gains by undercutting on price. Coherent also is showing slightly better sequential growth than Marvell, reporting ~10% QoQ growth in networking revenue to $680 million, while Marvell reported 8% QoQ growth in data center to $881 million (though Marvell is seeing growth arise from ASICs as well); Lumentum, on the other hand, reported an (11%) YoY decline as it struggles with weaker end market demand from telecom.

One primary theme evident in Big Tech’s recent earnings reports was the need for continual investments in AI infrastructure and physical data centers, with management teams positive on the long-term potential of generative AI products and services. Lead Tech Analyst Beth Kindig spoke with Yahoo Finance following Nvidia’s Q2 earnings report last month, saying that Big Tech is “in a race toward preventing extinction,” in that whichever company succeeds in AI first “could completely dominate to a level” to where competitors’ businesses will decline substantially. This is a view shared by Alphabet CEO Sundar Pichai: “the risk of under-investing is dramatically greater than the risk of over-investing.”

We’re seeing clear growth in Big Tech’s capex with no slowdown in sight – Bank of America is estimating that the Big 4 (Microsoft, Meta, Alphabet, and Amazon) will spend a combined total of $700 billion through the end of 2026. While a majority of AI capex is expected to flow to Nvidia and other AI accelerator beneficiaries including AMD and Broadcom, physical data center construction is surging, and outfitting new data centers requires AI server racks, cooling infrastructure, power systems, connectivity and other components. One component subsegment where we’re currently seeing growth arise, with positive forward-looking commentary from executives, is optical transceivers, with Marvell, Lumentum, and Coherent among the leading manufacturers we’re currently tracking.

Big Tech’s AI Spending, Physical Data Center Construction Surging

As we explained in our free newsletter in early August, “Big Tech Battles on AI: Here’s the Winner,” Big Tech’s capex spending is surging. Microsoft, Meta, Alphabet and Amazon committed more than $104 billion in the first half of 2024, up 47% YoY, with the four well on the way to spending more than $210 billion in capex for the year.

Spending is not expected to slow any time soon – UBS expects capex from the four to rise 25% YoY in 2025, well ahead of the current consensus estimates for 10% to 15% YoY growth, as AI demand still outpaces capacity as management teams push AI investments to the forefront.

The weight of four Big Tech CEOs speaking in unison on this topic (risking overinvesting and building AI capacity before it’s needed) is either a staggering coincidence — or they have important insights that are leading to the same conclusion, which is that AI’s primary risk is for those companies that are not early enough to capture it.

For a deeper understanding of Big Tech’s AI capex spending and outlook, and crucial comments on AI capacity and ROI, read our August newsletter here.here.

Stemming from this prioritization of expanding AI capacity comes a rapid uptick in physical data center construction, along with other signs that data center demand is rapidly increasing.

In North America, data center capacity under construction has soared more than 70% YoY to 3.87 GW through the end of June – for comparison, construction in all of 2023 totaled less than 3.1 GW. Preleased capacity surpassed 3 GW, with Big Tech and GPU renting startups such as CoreWeave accounting for more than 80% of this upcoming capacity.

In addition to this surge in construction activity, data from CBRE points to asking rental rates also rising, driven by tight existing supply and strong demand. Asking rental rates have increased 6.5% to $174 per kw/month this year, following an 18.6% rise in 2023 and a 14.5% increase in 2022. To put it a different way, asking rental rates have jumped 45% since 2021 (as construction began to accelerate), from ~$120 per kw/month to $174 per kw/month.

Building and optimizing these new data centers to meet the increasing performance and efficiency demands of Nvidia’s and AMD’s next-generation GPUs is placing more emphasis on fiber optics and optical transceivers for high-speed and high-capacity data transmission. 

The I/O Fund strongly believes investors should look for demand signals for AI, which is why we steered away from best-of-breed software companies where AI revenue was entirely speculative and became a trap for investors, such as MongoDB or Snowflake. Big Tech does not use these software platforms, and therefore, the demand equation had not been solved. Instead, we focused tracking capex as it relates to AI semis and data center buildouts over the past 3 years, and that remains our strategy until we see capex contracts – with optics fitting well within this strategy.

Conclusion

As the industry gears up for Blackwell’s imminent ramp into 2025, we’ll be closely monitoring sequential growth in data center and networking segments, along with management commentary about the growth trajectories in optics as it unfolds. Optical transceivers and interconnects are becoming a key component in AI data centers due to transfer speed and other benefits, with the industry set to more than double over the next few years as data center construction surges along with hyperscaler AI capex.

Our Advanced members have received technical analysis updates and a possible buy plan for one of these optics stocks, as well as a handful of other AI stocks in explosive growth trends such as AI PCs.

Damien Robbins, Equity Analyst for the I/O Fund, contributed to this analysis.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

• Broadcom Fiscal Q3: AI Revenue Outlook Raised, but Valuation is Stretched
• Broadcom’s AI Revenue Surge Continues: FQ3 Earnings Preview
• Marvell FQ2 Earnings: Rebound in the cards
• Nvidia Q2: Blackwell Shipments to Begin in Q4

Generative AI’s spending boom has not only driven increased demand for data centers as hyperscalers work to expand capacity, but also is driving a surge in optic connections. This is due to the heavy data requirements needed to support genAI services and connections needed to link GPUs together in the clusters. Optical transceivers are becoming increasingly important in addressing bandwidth, a primary bottleneck in large-scale data centers, which refers to the speed of data transfer in the data center.

Corning is a centuries-old bellwether for materials such as advanced optics. The management team recently explained in its Q2 earnings call that “traditional data centers contain a network of interconnected switches and CPUs. GenAI requires a second network within data centers to connect every GPU to every other GPU in the cluster, creating a neural network. Now because GPUs have more processing capacity than CPUs, they need higher bandwidth links connecting them. The result is about 10 times the number of fiber [optic] connections in this new network versus a traditional data center.”

We’ve previously discussed memory bandwidth as a primary bottleneck at the GPU level, but scaling from singular GPUs to hyperscale data centers featuring hundreds of thousands of GPUs sees bandwidth arise as a primary bottleneck due to the immense data transfer requirements of AI training and inference.

GenAI to Drive Optical Growth

AI requires interconnected processors, to where thousands or tens of thousands of processors are connected. In turn, connectivity is needed for accelerated compute, which includes an increased number of switches, NICs, ports and also port speed.

For example, Chat-GPT was trained on a 25,000-accelerator cluster with roughly 75,000 optical interconnects. Increasingly powerful AI models, with escalating data and compute demands, are making bandwidth, data speeds and latency critical factors for future data centers to address.

Copper had long been standard for data center interconnects, but it cannot support network speeds of 800 gigabits (800G) to 1.6 terabits (1.6T) over long distances due to substantial signal loss. This isn’t to say copper is dead – Nvidia’s GB200 NVL72 utilized copper over optics (with more than 2 miles of copper cabling in the rack) to reduce power consumption by 20 kw (the system still draws 120kw of power). According to a representative from Marvell’s Cloud Optics division, “optical is the only technology that can give you the bandwidth and reach needed to connect hundreds and thousands and tens of thousands of servers across the whole data center.”

Optical transceivers are crucial in enabling high-speed data transfer, by transmitting and receiving data from optical (light) signals to electrical signals. In data centers, optical interconnects and transceivers are becoming the de facto standard to handle AI workloads, since they can function at significantly higher speeds than copper (currently  at 800G+ speeds and moving quickly to 1.6T), with longer range, higher data capacity, and lower latency with minimal signal loss. One drawback, however, is that due to the electronic complexity of optical products, costs are higher as well as power consumption versus copper.

800G transceivers are a driver of growth industry-wide at the moment, with Marvell, Lumentum, Coherent, Mitsubishi Electric, Broadcom, Nvidia and others all shipping 800G transceivers and seeing high growth and demand. Coherent forecast in 2023 that the datacom transceiver market would more than double to $11.4 billion by 2028, with 800G transceivers taking more than 50% market share, up from the mid-teens in 2023, with the majority of that growth arising through 2026.

Source: Coherent

Mitsubishi Electric sees much more market share growth ahead for high-speed transceivers, forecasting the optical transceiver market to nearly triple from just over $4 billion in 2023 to $12 billion by 2029, with 800G and 1.6T transceivers accounting for more than 80% of the market.

Source: Mitsubishi Electric

Other industry forecasts suggest the broader optical transceiver market (including other end markets in industrial and telecom) will nearly double from $13.3 billion in 2024 to $24.7 billion by 2027.

Industry Executives See Strong Growth in Optics

Management teams from companies in the optical transceiver industry remain quite bullish about growth prospects in the future, catalyzed by AI data center demand.

Mitsubishi Electric, which reportedly commands nearly 50% market share in optical transmission devices for data centers, per Bloomberg, is rapidly expanding capacity to meet demand. Mitsubishi is “ramping up production capacity for optical devices to a level 50% above last year’s,” though CEO Masayoshi Takemi said that “won’t be enough to meet the strong level of inquiries we’re getting, [and] we may need double what we’ll have in September.”

Coherent CEO Jim Anderson similarly sees strong growth ahead for transceivers: “one of the most exciting growth opportunities is our optical transceiver technology, which underpins and drives the high-speed connectivity required by new AI data centers.” He added that the company “saw strong sequential growth in our 800G datacom transceiver revenue in Q4 and [is] also seeing increasing orders in backlog for the current and future quarters. We also delivered initial samples of our 1.6T datacom transceivers, which we expect to begin ramping in calendar 2025.”

Barclays analyst Tom O’Malley asked Anderson about the trajectory of the “big growth engine” for Coherent, the ramp of 800G and soon 1.6T transceivers, with Anderson saying that “It's stronger than what I had thought. And we've seen, just over the last, I would say, gosh, four to six weeks as I've spent a lot of time with our top customers across the – across all of our different product lines, but especially in our datacom business, I've gotten a much better sense for the opportunity that's in front of us, and I would say it's a very strong opportunity. And we continue to see demand strengthening, forecast strengthening, billings, backlog.”

Optics has also been a primary growth driver so far this year for Marvell, with electro-optics revenue exceeding expectations in Q2 and expected to grow in each quarter of this fiscal year. To note, Marvell is targeting to exceed its $1.5 billion AI revenue target this year, with optics contributing $1 billion or more of that sum.

Marvell CEO Matt Murphy explained in Q2’s earnings call that “demand has been extremely strong in the AI business, as we mentioned, both in custom and in our optics business. And that's the 800G products as well as traditional cloud, as well as DCI [data center interconnects]. So that's all going extremely well. And for next year, that should absolutely ripple through. We see continued strength next year above what we had communicated relative to the target for next year both in custom and in optics and the broader portfolio. … Demand has been strong. Bookings momentum has been extremely strong.”

Marvell’s management also noted in Q1 that its 800G PAM4 modules are currently the “primary interconnect enabler for state-of-the–art AI deployments,” while qualifications have begun for its 1.6T modules, which it expects will enable the next generation of AI chips. Marvell added in Q2 that “strong bookings continue for our market leading 800G PAM products and 400ZR data center interconnect, or DCI products,” while its 1.6T DSPs (digital signal processors) would begin shipments in Q3.

Marvell has the advantage of scale over its competitors. Per a Marvell spokesperson in June, “every single large language model today runs on compute clusters that are enabled by Marvell’s connectivity silicon.”

Lumentum is expecting the optical opportunity to quickly drive quarterly revenues to $500 million by the end of 2025, up 60% from last quarter’s $308 million, with management saying that transceivers will be the “number one growth area,” with EML chips and optical switching other growth drivers as the company works to rapidly boost transceiver capacity in Thailand. You can access our previous Lumentum deep dive here.

In terms of optics (and/or networking revenue), Marvell likely leads the three, with Coherent close behind. Marvell’s data center optics segment alone contributed more than $1 billion in revenue in fiscal 2024, and in Q2 FY25, optics and networking and switches likely accounted for revenue in the mid-$600 million range, given management’s comments that suggested between $200 million to $250 million stemmed from ASICs and storage. For FY25, Marvell’s optics, networking/switches and enterprise networking revenue could reach approximately $3 billion annualized (~54% of FY25 revenue estimate of $5.54 billion), with more than $1 billion in AI revenue (mgmt’s $1.5 billion AI revenue target has 2/3 coming from optics).

Coherent reported approximately $2.3 billion in networking revenue in the twelve months ending in June, or ~49% of overall revenue; Coherent has not provided an AI revenue target, but noted that datacom revenue rose 16% QoQ and 58% YoY due to AI demand. Lumentum reported $1.08 billion in cloud & networking revenue in FY24 (~80% of revenue), down 18% YoY, with management eyeing AI to drive revenue to a $2 billion-plus run rate by the end of calendar 2025.

Interestingly, it was announced on September 5 that Marvell, Lumentum and Coherent have demonstrated the industry’s first 800G ZR/ZR+ pluggable modules for 500 kilometer data center interconnects (an industry first distance for 800G modules). Utilizing Marvell’s Orion 800G DSPs, modules from the three are now interoperable, allowing regional data centers to take advantage of a multi-vendor solution and minimize vendor lock-in risk by having the ability to link together transceivers from different companies in a cost-effective and power-efficient manner.

Blackwell in Focus

Nvidia’s Blackwell is a force of its own, and with initial shipments expected to begin in Q4 this year (which ends in January), but will ship in volume come     Q1 (ending in April), analysts are working to identify which companies will be primary suppliers on the optics side as Blackwell brings an enormous revenue opportunity for Nvidia and its suppliers.

Broadcom was the latest to field questions from analysts about optics tie-ins to Broadcom, though Marvell, Lumentum and Coherent all have been questioned as well – the common denominator is that the management teams are not commenting on individual customer engagements.

Interestingly, a Broadcom announcement from March 2024 noted that “Google and Nvidia will be the first adopters of 200G per lane optics for interconnecting GPUs and TPUs in AI Clusters” as 1.6T shipments begin by the end of the year (aligning with Blackwell). Broadcom also continued its partnerships with Innolight and Eoptolink in optics; this cross-checks with a report from SemiAnalysis on GB200 component suppliers, saying that “while Marvell was 100% share on Nvidia last generation with H100. This generation, Broadcom comes in a big way. We see both Innolight and Eoptolink looking to be adding Broadcom in volume for the DSP.”

Notably, in the most recent earnings report, the CEO stated he was not “directly” in the market of supplying Blackwell, so we will see if Broadcom is downstream or not come next year. Per the CEO of Broadcom: “We’re happy to be part of that ecosystem as I said. But directly, we’re not in that [Blackwell] market as you know.”

Marvell:Marvell:

Question (Atif Malik, Citi): “Curious when are you thinking about the volume adoption of 1.6T and what is holding that if it's not the DSPs. Are the lasers not ready? Or is it just waiting for the Blackwell?”

Answer (CEO Matt Murphy): “I think the way to think about it is just timing relative to the system builds our customers call, schedule their ramp, et cetera. … I remember all these issues in the past, right. There's a green laser problem. There's this problem or that. There's always some issue in this optical space, but this time it's really, everyone's going a million miles an hour trying to get their products ramped. Our module partners are ramping up with our solution. Our end customers that are driving this are going as fast as they can.

So it's just more of a timing issue that we need to intercept the platforms as they're ramping and we're doing that. So think of that as sort of shipments in the back half, but really contributing much more meaningfully next year on the 1.6T transition. But it's definitely underway, and we see a clear path to help enable right, this part of this next generation of accelerators to be able to ship in volume with the latest optical standards. And we're at the forefront and in the lead in that regard. So yes, it will be later this year and then more volume next year and it will — I think be a big product cycle for us.”

Quick Note on CXL: About two years ago, our firm covered Marvell’s CXL memory catalyst. Compute Express Link (CXL) improves how data centers add memory by offering a new switch that offers “cache coherent” memory pooling. Essentially, this means offering a new architecture that boosts memory bandwidth and helps to enable memory pooling through partially-disaggregated racks.

The new fabric required for disaggregated memory from the CPU is based on PAM electro-optics that Marvell specializes in. In July, new CXL memory-expansion controllers were announced called Structera with partners AMD, Intel, Micron and Arm participating in the press release.  Custom CXL silicon is expected to sample in the fourth quarter and will represent an expansion to Marvell’s TAM assuming all goes well.

Lumentum:Lumentum:

Question (George Notters, Jefferies): “I'm just curious if you guys have an Nvidia qualification on this 800 gig single mode transceiver?”

Answer (CEO Alan Lowe): “Yes, we're not going to comment on who the customer is, George. I would say that — as I said before, most customers are working with us on products they don't already have. And so, for instance, we are designing 1.6T transceivers, and the performance is quite good. We plan on sampling customers this quarter on 1.6T. So, there's a few leaders that would be consuming that. And so, you can imply what you want from that, but we're not going to speak specifically about any individual customer.”

Coherent:Coherent:

Question (Vivek Arya, Bank of America): “Are you seeing any impact at all, positive or negative, because of changes in Nvidia’s product schedule or does that have no impact?”

Answer (CEO Jim Anderson): “On the first part, on the part that was about the order book, yes, we continue to see the order book strengthen. I think you asked about a particular customer. I can't comment on that particular customer, or really any particular customer. But I can say that in aggregate, we're continuing to see, again, the order book strengthen and demand growing, which is good.”

Margins May Determine the Winners

Given that optics is a fairly fragmented market with four major firms vying for market share in 800G and soon 1.6T transceivers, margins may ultimately determine the winners. This view is shared by Coherent, with management stating that on pricing and gross margins, “in general, what we would usually see in the transceiver market is the newer speed grades like 800G and then soon to be 1.6T generally carry higher gross margins than the older speed grades, right? The older speed grades are usually become commoditized over time.”

Based on Coherent and Mitsubishi Electric’s forecasts, shipment growth in 800G is expected through 2026 before shifting to 1.6T, leaving four to six quarters for these companies to drive shipments and revenues before commoditization potentially occurs with product margins shrinking.

Of the trio, Marvell has the best gross margin profile, at 46.2% last quarter, compared to 32.9% for Coherent and 16.6% for Lumentum. Marvell is expecting gross margin to expand to 47.2% next quarter, while Coherent guided flat QoQ and Lumentum guiding for some sequential improvement in future quarters.

Moving down the line, Coherent is the only one of the three with a positive operating margin, reporting a ~300 bp sequential expansion to a 4.8% margin last quarter. Marvell reported a (7.9%) operating margin, while Lumentum reported a (43.3%) operating margin.

With Marvell’s success likely equally tied to the ramp of ASICs in the coming quarters, and Lumentum deep in the red, Coherent is better positioned with a stronger bottom line profile to be able to withstand pricing competition, should the manufacturers prioritize capacity expansion. In this case, Coherent has leverage to boost market share gains by undercutting on price. Coherent also is showing slightly better sequential growth than Marvell, reporting ~10% QoQ growth in networking revenue to $680 million, while Marvell reported 8% QoQ growth in data center to $881 million (though Marvell is seeing growth arise from ASICs as well); Lumentum, on the other hand, reported an (11%) YoY decline as it struggles with weaker end market demand from telecom.

One primary theme evident in Big Tech’s recent earnings reports was the need for continual investments in AI infrastructure and physical data centers, with management teams positive on the long-term potential of generative AI products and services. Lead Tech Analyst Beth Kindig spoke with Yahoo Finance following Nvidia’s Q2 earnings report last month, saying that Big Tech is “in a race toward preventing extinction,” in that whichever company succeeds in AI first “could completely dominate to a level” to where competitors’ businesses will decline substantially. This is a view shared by Alphabet CEO Sundar Pichai: “the risk of under-investing is dramatically greater than the risk of over-investing.”

We’re seeing clear growth in Big Tech’s capex with no slowdown in sight – Bank of America is estimating that the Big 4 (Microsoft, Meta, Alphabet, and Amazon) will spend a combined total of $700 billion through the end of 2026. While a majority of AI capex is expected to flow to Nvidia and other AI accelerator beneficiaries including AMD and Broadcom, physical data center construction is surging, and outfitting new data centers requires AI server racks, cooling infrastructure, power systems, connectivity and other components. One component subsegment where we’re currently seeing growth arise, with positive forward-looking commentary from executives, is optical transceivers, with Marvell, Lumentum, and Coherent among the leading manufacturers we’re currently tracking.

Big Tech’s AI Spending, Physical Data Center Construction Surging

As we explained in our free newsletter in early August, “Big Tech Battles on AI: Here’s the Winner,” Big Tech’s capex spending is surging. Microsoft, Meta, Alphabet and Amazon committed more than $104 billion in the first half of 2024, up 47% YoY, with the four well on the way to spending more than $210 billion in capex for the year.

Spending is not expected to slow any time soon – UBS expects capex from the four to rise 25% YoY in 2025, well ahead of the current consensus estimates for 10% to 15% YoY growth, as AI demand still outpaces capacity as management teams push AI investments to the forefront.

The weight of four Big Tech CEOs speaking in unison on this topic (risking overinvesting and building AI capacity before it’s needed) is either a staggering coincidence — or they have important insights that are leading to the same conclusion, which is that AI’s primary risk is for those companies that are not early enough to capture it.

For a deeper understanding of Big Tech’s AI capex spending and outlook, and crucial comments on AI capacity and ROI, read our August newsletter here.here.

Stemming from this prioritization of expanding AI capacity comes a rapid uptick in physical data center construction, along with other signs that data center demand is rapidly increasing.

In North America, data center capacity under construction has soared more than 70% YoY to 3.87 GW through the end of June – for comparison, construction in all of 2023 totaled less than 3.1 GW. Preleased capacity surpassed 3 GW, with Big Tech and GPU renting startups such as CoreWeave accounting for more than 80% of this upcoming capacity.

In addition to this surge in construction activity, data from CBRE points to asking rental rates also rising, driven by tight existing supply and strong demand. Asking rental rates have increased 6.5% to $174 per kw/month this year, following an 18.6% rise in 2023 and a 14.5% increase in 2022. To put it a different way, asking rental rates have jumped 45% since 2021 (as construction began to accelerate), from ~$120 per kw/month to $174 per kw/month.

Building and optimizing these new data centers to meet the increasing performance and efficiency demands of Nvidia’s and AMD’s next-generation GPUs is placing more emphasis on fiber optics and optical transceivers for high-speed and high-capacity data transmission. 

The I/O Fund strongly believes investors should look for demand signals for AI, which is why we steered away from best-of-breed software companies where AI revenue was entirely speculative and became a trap for investors, such as MongoDB or Snowflake. Big Tech does not use these software platforms, and therefore, the demand equation had not been solved. Instead, we focused tracking capex as it relates to AI semis and data center buildouts over the past 3 years, and that remains our strategy until we see capex contracts – with optics fitting well within this strategy.

Conclusion

As the industry gears up for Blackwell’s imminent ramp into 2025, we’ll be closely monitoring sequential growth in data center and networking segments, along with management commentary about the growth trajectories in optics as it unfolds. Optical transceivers and interconnects are becoming a key component in AI data centers due to transfer speed and other benefits, with the industry set to more than double over the next few years as data center construction surges along with hyperscaler AI capex.

Our Advanced members have received technical analysis updates and a possible buy plan for one of these optics stocks, as well as a handful of other AI stocks in explosive growth trends such as AI PCs.

Damien Robbins, Equity Analyst for the I/O Fund, contributed to this analysis.

Recommended Reading:

• Broadcom Fiscal Q3: AI Revenue Outlook Raised, but Valuation is Stretched
• Broadcom’s AI Revenue Surge Continues: FQ3 Earnings Preview
• Marvell FQ2 Earnings: Rebound in the cards
• Nvidia Q2: Blackwell Shipments to Begin in Q4

Broadcom boosted AI revenue outlook for the year from $11 billion to $12 billion. Based on the forecasted $51.5 billion in revenue in fiscal 2024, AI is expected to contribute more than 23% of Broadcom’s revenue this year.

During the CEO’s opening remarks, more information about Q3’s AI revenue and Q4’s AI revenue was provided: “AI demand remains strong and we expect, in Q4, AI revenue to grow sequentially 10% to over $3.5 billion. This will translate to AI revenue of $12 billion for fiscal '24, up from our prior guidance of over $11 billion.” The issue is that AI revenue was flat QoQ compared to being up 35% QoQ last quarter.

Overall, Q3 did beat yet Q4’s guide was a bit light, with Broadcom forecasting revenue of $14 billion next quarter versus consensus for $14.04 billion. Semiconductor solutions revenue growth also missed growth forecasts with YoY growth of 5%, while estimates from Oppenheimer expected 7% growth.

The stock is priced to perfection, and we do not think this earnings report is not enough to sustain the valuation. We discuss this and more below.

Revenue

Broadcom beat Q3’s revenue estimates marginally and was one percent ahead of consensus estimates, compared to a nearly 4% beat last quarter. Q4 was also guided slightly below analyst estimates. 

• Q3 revenue was $13.07 billion for YoY growth of 47.3%, accelerating 430 bp from 43% YoY growth in Q2. Excluding VMWare’s contribution, YoY growth was 4%.
• For Q4, management guided for $14 billion in revenue, for YoY growth of 50.6%, marking another 330 bp acceleration, but short of the 51% growth estimate from analysts.

• For FY24, management did not provide an updated revenue guide, with the previous guidance provided of $51 billion. However, given Q4’s guide, revenue for FY24 is projected to be $51.5 billion.

As probably the most-closely watched (and most anticipated) figure, AI revenue for FQ3 was $3.1 billion, flat QoQ. Through Q3, AI revenue totaled $8.5 billion. For fiscal 2024, Broadcom increased its AI revenue outlook to $12 billion, a 20% increase from $10 billion in Q1 and another $1 billion increase from last quarter’s view for $11 billion. The increased outlook is driven by strong growth for Ethernet and ASICs, and implies Q4 AI revenue of $3.5 billion, up nearly 13% QoQ.

The issue that remains is, will this AI revenue be enough to justify the valuation (in the near term)?

Key Segments

Semiconductor solutions revenue was $7.27 billion, increasing 5% YoY and 1% QoQ. This was a 100 bp deceleration from 6% YoY growth last quarter, while also falling short of estimates, with some analysts expecting growth of ~7% YoY and 2% QoQ.

• Networking grew 43% YoY to $4 billion. Ethernet switching, driven by Tomahawk 5 and Jericho3-AI grew over 4x year-on-year. We’ve covered these products here. Within networking, lasers and dies used in optical interconnects grew 3X, PCI Express switches grew 2X and Broadcom is shipping 5nm 400GB NICs and 800GB DSPs.
• The CEO stated non-AI networking bottomed in Q2 and was up 17% QoQ yet down (-41%) YoY
• The CEO stated custom AI accelerators grew 3.5X year-over-year. Notably, we did not get a QoQ number which is where the weak metric was at $3.1B AI revenue flat QoQ.

Infrastructure solutions revenue was $5.80 billion, accelerating to 200% YoY growth from 175% YoY in the prior quarter. The segment was up 9.7% QoQ and this segment also grew QoQ last quarter, which helps to illustrate the acceleration from VMWare.

• VMWare contributed $3.8 billion with the acquisition helping to drive the strong YoY growth.
• VMWare’s annualized booking value (ABV) was up 32% QoQ to $2.5 billion, and is shaping up to be a major piece to Broadcom’s story. You can read more about this here. Two quarters ago, the ABV for VMWare was $1.2 billion, proving there has been a sudden acceleration underway. The VMWare segment is expected to be quite profitable, achieving adjusted EBITDA of $8.5 billion by next fiscal year. During the Q&A portion, it was discussed the overall software margin will remain between 80% and 90%.

Aligned with the commentary that the non-AI segments have bottomed (with the exception of Broadband), the remaining revenue segments reported QoQ growth despite being down double digits YoY.

• Server storage connectivity revenue was $861 million, up 5% QoQ yet down (-25%) YoY. Server storage is expected to grow QoQ yet will be down YoY
• Wireless revenue of $1.7 billion grew 1% YoY and is expected to grow 20% QoQ next quarter.
• Broadband revenue declined 49% YoY and is expected to bottom in the beginning of 2025.

On the call, an analyst asked if these segments will return to prior levels, to which the CEO stated they would and he cited bookings as an indication the bottom is likely behind them.

Hock Tan:

“As you all know, we've gone through your typical down cycle of semiconductors. And I'm referring particularly to non-AI, and we have talked about that before many times. We've gone through a down cycle as the ecosystem, as many of our customers, but the broad ecosystems, work on an adjustment in inventory levels in all stages in the supply chain. And we're not immune from it, obviously as we try to insulate ourselves from it as much as possible. We've gone through it. And the signs on the indications we have seen very clearly is we have, in fact, passed through the bottom. The best indicator is the bookings we are receiving. In non-AI, our bookings in Q3 of non-AI semiconductor demand is up 20%. And so that tells us we are well on the way to recovery.”

Margins

As outlined in our pre-earnings analysis, the VMWare merger integration has weighed on margins so far in fiscal 2024, though Q3 showed more positive signs on margin recoveries. Adjusted margins strengthened sequentially across the board, with larger growth visible down the line.

• Gross margin was 63.9% in Q3, down from 69.5% in the year ago quarter but up from 62.3% in Q2. Adjusted gross margin was 77.4%, up from 75.1% last year and 76.2% last quarter.
• Operating margin was 29.0% in Q3, up from 23.7% last quarter and a remarkable increase from 17.3% in Q1; however, Q3’s margin remained much lower on a YoY basis, down from 43.4% last year. Adjusted operating margin was 60.8%, up from 57.2% last quarter but decreasing from 62.4% last year.
• Net margin was (14.4%) for Q3, due to a one-time non-cash tax provision of $4.5 billion in the quarter. Adjusted net margin was 46.8%, up from 43.2% last quarter but down from 51.8% last year.

Regarding the tax liability, there was a question in the Q&A session if it was related to selling assets, to which the CFO responded that it was not due to a sale of assets, rather: “It's just we relocated the IP and that caused the $4 billion charge. The offset to that is a deferred tax liability. So think of that as noncash, very little cash impact to that.”

EPS

GAAP EPS was ($0.40), not comparable to estimates for $0.55 due to the $4.5 billion tax provision in the quarter. Adjusted EPS was $1.24, beating estimates by $0.04, and representing YoY growth of 18% and QoQ growth of nearly 13%.

Adjusted EPS growth is currently estimated to accelerate to nearly 24% YoY in Q4, and to the low-30% range for the first half of fiscal 2025. Given the sequential rebound in margins (partially due to better controlled costs at VMWare) and adjusted EPS beat in Q3, these growth projects may get revised higher in the coming days.

Q3’s adjusted EBITDA was 62.9%, with growth of 42% YoY to $8.22 billion. This was a solid improvement from 59.5% in Q2. Management guided for a 64% adjusted EBITDA margin in Q4, with the sequential improvement being driven by the integration of VMWare as Broadcom charts a path to pre-acquisition EBITDA margins.

Cash Flows and Balance Sheet

Cash flows and cash flow margins improved sequentially, while total debt took a step lower this quarter.

• Operating cash flow was $4.96 billion, increasing more than 5% YoY and 8% QoQ. Operating cash flow margin as 38.0%, improving from 36.7% last quarter, though this is lower than pre-acquisition margins of 53.2% in the year ago quarter.
• Free cash flow was $4.79 billion, rising more than 4% YoY and nearly 8% QoQ. Free cash flow margin was 36.7%, increasing from 35.6% last quarter but also lower than the 51.8% margin in the year ago quarter.
• Cash, equivalents and investments totaled $9.95 billion.
• Total debt was $69.96 billion at the end of Q3, down from $74.02 billion in Q2, with Broadcom repaying more than $9.2 billion of debt in the quarter, offset by nearly $5 billion in proceeds from long-term borrowings.

Valuation:

Broadcom is priced for perfection at 32 forward PE Ratio and 14 forward PS Ratio. We’ve covered semis since 2018 and a quality semiconductor stock rarely trades at these levels, it’s normally in the 6-8 forward PS range.

The 3-year median is only available on current PE Ratio, but I have a 3-year PE ratio of 28.5 compared to the current PE ratio of 65.8. The 5-year median is at 39.5.

Earnings Call:

Analysts asked in various ways what growth rate they could expect on AI revenue moving forward, but to no avail on any specific numbers. Here was the first question on the call:

Question
Vivek Arya (Analysts)

Just a clarification, Hock, and then the question. So I think AI revenue roughly $3.1-ish billion in Q3, flattish sequentially. What was the mix in terms of compute versus networking? And the $3.5 billion for Q4, what do you see of that mix? And then as we get into fiscal '25, I realize you're not guiding overall AI, but just how is your general kind of confidence and visibility? Do you think that Broadcom can kind of grow in line or better than the overall AI silicon industry in fiscal '25?

Answer
Kirsten Spears (Executives)

Yes. Well, as we indicated in the last earnings call, for this past quarter, I think we're talking about 2/3 in compute and 1/3 in networking. And we kind of expect Q4 to run the similar trend. And to answer your second part, no, we don't guide yet for fiscal '25, but we do expect fiscal '25 to continue to be strong, to show strong growth on our AI revenue.

-End Quote

There was a more tempered tone in terms of timing. For example, when asked where custom silicon is in the adoption curve, it was stated it will take some time.

Question
Edward Snyder (Analysts)

Right. That basically suggests that you're on the early part of your curve where I'm not trying to call the GPUs whatever, but you could be getting to something closer to the peak of the GPU market just because everything, right, beside the cost expense and as you're spending all this money and you're paying all this money for power, the ASICs become more and more attractive. So the curves are going to look different, right?

Answer
Hock Tan (Executives)

It's an accelerating curve. It may take longer than we all want it to happen but definitely accelerating because the size of the demand from those hyperscalers will totally rival that in the enterprise.

-End Quote

Conclusion:

Given AI growth has plateaued this quarter from its rapid growth, there will likely be a re-rating of Broadcom’s valuation sometime in the next 1-2 quarters. Our goal is to trim this position and buy back at lower levels. This strategy requires remaining steadfast to the bigger picture as this company is setting up to be a clear winner over the next decade. We want to do our best at actively managing the position while not losing sight of the bigger picture. With that said, valuation is a common pitfall for tech investors, who grow complacent with their positions. Our firm works to avoid valuation traps, and thus we plan to follow our disciplined process, which is to actively manage stocks that are richly valued.  

Damien Robbins, I/O Fund Equity Analyst, contributed to this analysis

Recommended Reading:

• Broadcom’s AI Revenue Surge Continues: FQ3 Earnings Preview
• Nvidia Q2: Blackwell Shipments to Begin in Q4
• Positions Update: Nvidia, Broadcom, and Bitcoin
• Microsoft Fiscal Q4 2024 Earnings: Capex Surges QoQ; Azure Remains Durable

Broadcom boosted AI revenue outlook for the year from $11 billion to $12 billion. Based on the forecasted $51.5 billion in revenue in fiscal 2024, AI is expected to contribute more than 23% of Broadcom’s revenue this year.

During the CEO’s opening remarks, more information about Q3’s AI revenue and Q4’s AI revenue was provided: “AI demand remains strong and we expect, in Q4, AI revenue to grow sequentially 10% to over $3.5 billion. This will translate to AI revenue of $12 billion for fiscal '24, up from our prior guidance of over $11 billion.” The issue is that AI revenue was flat QoQ compared to being up 35% QoQ last quarter.

Overall, Q3 did beat yet Q4’s guide was a bit light, with Broadcom forecasting revenue of $14 billion next quarter versus consensus for $14.04 billion. Semiconductor solutions revenue growth also missed growth forecasts with YoY growth of 5%, while estimates from Oppenheimer expected 7% growth.

The stock is priced to perfection, and we do not think this earnings report is not enough to sustain the valuation. We discuss this and more below.

Revenue

Broadcom beat Q3’s revenue estimates marginally and was one percent ahead of consensus estimates, compared to a nearly 4% beat last quarter. Q4 was also guided slightly below analyst estimates. 

• Q3 revenue was $13.07 billion for YoY growth of 47.3%, accelerating 430 bp from 43% YoY growth in Q2. Excluding VMWare’s contribution, YoY growth was 4%.
• For Q4, management guided for $14 billion in revenue, for YoY growth of 50.6%, marking another 330 bp acceleration, but short of the 51% growth estimate from analysts.

• For FY24, management did not provide an updated revenue guide, with the previous guidance provided of $51 billion. However, given Q4’s guide, revenue for FY24 is projected to be $51.5 billion.

As probably the most-closely watched (and most anticipated) figure, AI revenue for FQ3 was $3.1 billion, flat QoQ. Through Q3, AI revenue totaled $8.5 billion. For fiscal 2024, Broadcom increased its AI revenue outlook to $12 billion, a 20% increase from $10 billion in Q1 and another $1 billion increase from last quarter’s view for $11 billion. The increased outlook is driven by strong growth for Ethernet and ASICs, and implies Q4 AI revenue of $3.5 billion, up nearly 13% QoQ.

The issue that remains is, will this AI revenue be enough to justify the valuation (in the near term)?

Key Segments

Semiconductor solutions revenue was $7.27 billion, increasing 5% YoY and 1% QoQ. This was a 100 bp deceleration from 6% YoY growth last quarter, while also falling short of estimates, with some analysts expecting growth of ~7% YoY and 2% QoQ.

• Networking grew 43% YoY to $4 billion. Ethernet switching, driven by Tomahawk 5 and Jericho3-AI grew over 4x year-on-year. We’ve covered these products here. Within networking, lasers and dies used in optical interconnects grew 3X, PCI Express switches grew 2X and Broadcom is shipping 5nm 400GB NICs and 800GB DSPs.
• The CEO stated non-AI networking bottomed in Q2 and was up 17% QoQ yet down (-41%) YoY
• The CEO stated custom AI accelerators grew 3.5X year-over-year. Notably, we did not get a QoQ number which is where the weak metric was at $3.1B AI revenue flat QoQ.

Infrastructure solutions revenue was $5.80 billion, accelerating to 200% YoY growth from 175% YoY in the prior quarter. The segment was up 9.7% QoQ and this segment also grew QoQ last quarter, which helps to illustrate the acceleration from VMWare.

• VMWare contributed $3.8 billion with the acquisition helping to drive the strong YoY growth.
• VMWare’s annualized booking value (ABV) was up 32% QoQ to $2.5 billion, and is shaping up to be a major piece to Broadcom’s story. You can read more about this here. Two quarters ago, the ABV for VMWare was $1.2 billion, proving there has been a sudden acceleration underway. The VMWare segment is expected to be quite profitable, achieving adjusted EBITDA of $8.5 billion by next fiscal year. During the Q&A portion, it was discussed the overall software margin will remain between 80% and 90%.

Aligned with the commentary that the non-AI segments have bottomed (with the exception of Broadband), the remaining revenue segments reported QoQ growth despite being down double digits YoY.

• Server storage connectivity revenue was $861 million, up 5% QoQ yet down (-25%) YoY. Server storage is expected to grow QoQ yet will be down YoY
• Wireless revenue of $1.7 billion grew 1% YoY and is expected to grow 20% QoQ next quarter.
• Broadband revenue declined 49% YoY and is expected to bottom in the beginning of 2025.

On the call, an analyst asked if these segments will return to prior levels, to which the CEO stated they would and he cited bookings as an indication the bottom is likely behind them.

Hock Tan:

“As you all know, we've gone through your typical down cycle of semiconductors. And I'm referring particularly to non-AI, and we have talked about that before many times. We've gone through a down cycle as the ecosystem, as many of our customers, but the broad ecosystems, work on an adjustment in inventory levels in all stages in the supply chain. And we're not immune from it, obviously as we try to insulate ourselves from it as much as possible. We've gone through it. And the signs on the indications we have seen very clearly is we have, in fact, passed through the bottom. The best indicator is the bookings we are receiving. In non-AI, our bookings in Q3 of non-AI semiconductor demand is up 20%. And so that tells us we are well on the way to recovery.”

Margins

As outlined in our pre-earnings analysis, the VMWare merger integration has weighed on margins so far in fiscal 2024, though Q3 showed more positive signs on margin recoveries. Adjusted margins strengthened sequentially across the board, with larger growth visible down the line.

• Gross margin was 63.9% in Q3, down from 69.5% in the year ago quarter but up from 62.3% in Q2. Adjusted gross margin was 77.4%, up from 75.1% last year and 76.2% last quarter.
• Operating margin was 29.0% in Q3, up from 23.7% last quarter and a remarkable increase from 17.3% in Q1; however, Q3’s margin remained much lower on a YoY basis, down from 43.4% last year. Adjusted operating margin was 60.8%, up from 57.2% last quarter but decreasing from 62.4% last year.
• Net margin was (14.4%) for Q3, due to a one-time non-cash tax provision of $4.5 billion in the quarter. Adjusted net margin was 46.8%, up from 43.2% last quarter but down from 51.8% last year.

Regarding the tax liability, there was a question in the Q&A session if it was related to selling assets, to which the CFO responded that it was not due to a sale of assets, rather: “It's just we relocated the IP and that caused the $4 billion charge. The offset to that is a deferred tax liability. So think of that as noncash, very little cash impact to that.”

EPS

GAAP EPS was ($0.40), not comparable to estimates for $0.55 due to the $4.5 billion tax provision in the quarter. Adjusted EPS was $1.24, beating estimates by $0.04, and representing YoY growth of 18% and QoQ growth of nearly 13%.

Adjusted EPS growth is currently estimated to accelerate to nearly 24% YoY in Q4, and to the low-30% range for the first half of fiscal 2025. Given the sequential rebound in margins (partially due to better controlled costs at VMWare) and adjusted EPS beat in Q3, these growth projects may get revised higher in the coming days.

Q3’s adjusted EBITDA was 62.9%, with growth of 42% YoY to $8.22 billion. This was a solid improvement from 59.5% in Q2. Management guided for a 64% adjusted EBITDA margin in Q4, with the sequential improvement being driven by the integration of VMWare as Broadcom charts a path to pre-acquisition EBITDA margins.

Cash Flows and Balance Sheet

Cash flows and cash flow margins improved sequentially, while total debt took a step lower this quarter.

• Operating cash flow was $4.96 billion, increasing more than 5% YoY and 8% QoQ. Operating cash flow margin as 38.0%, improving from 36.7% last quarter, though this is lower than pre-acquisition margins of 53.2% in the year ago quarter.
• Free cash flow was $4.79 billion, rising more than 4% YoY and nearly 8% QoQ. Free cash flow margin was 36.7%, increasing from 35.6% last quarter but also lower than the 51.8% margin in the year ago quarter.
• Cash, equivalents and investments totaled $9.95 billion.
• Total debt was $69.96 billion at the end of Q3, down from $74.02 billion in Q2, with Broadcom repaying more than $9.2 billion of debt in the quarter, offset by nearly $5 billion in proceeds from long-term borrowings.

Valuation:

Broadcom is priced for perfection at 32 forward PE Ratio and 14 forward PS Ratio. We’ve covered semis since 2018 and a quality semiconductor stock rarely trades at these levels, it’s normally in the 6-8 forward PS range.

The 3-year median is only available on current PE Ratio, but I have a 3-year PE ratio of 28.5 compared to the current PE ratio of 65.8. The 5-year median is at 39.5.

Earnings Call:

Analysts asked in various ways what growth rate they could expect on AI revenue moving forward, but to no avail on any specific numbers. Here was the first question on the call:

Question
Vivek Arya (Analysts)

Just a clarification, Hock, and then the question. So I think AI revenue roughly $3.1-ish billion in Q3, flattish sequentially. What was the mix in terms of compute versus networking? And the $3.5 billion for Q4, what do you see of that mix? And then as we get into fiscal '25, I realize you're not guiding overall AI, but just how is your general kind of confidence and visibility? Do you think that Broadcom can kind of grow in line or better than the overall AI silicon industry in fiscal '25?

Answer
Kirsten Spears (Executives)

Yes. Well, as we indicated in the last earnings call, for this past quarter, I think we're talking about 2/3 in compute and 1/3 in networking. And we kind of expect Q4 to run the similar trend. And to answer your second part, no, we don't guide yet for fiscal '25, but we do expect fiscal '25 to continue to be strong, to show strong growth on our AI revenue.

-End Quote

There was a more tempered tone in terms of timing. For example, when asked where custom silicon is in the adoption curve, it was stated it will take some time.

Question
Edward Snyder (Analysts)

Right. That basically suggests that you're on the early part of your curve where I'm not trying to call the GPUs whatever, but you could be getting to something closer to the peak of the GPU market just because everything, right, beside the cost expense and as you're spending all this money and you're paying all this money for power, the ASICs become more and more attractive. So the curves are going to look different, right?

Answer
Hock Tan (Executives)

It's an accelerating curve. It may take longer than we all want it to happen but definitely accelerating because the size of the demand from those hyperscalers will totally rival that in the enterprise.

-End Quote

Conclusion:

Given AI growth has plateaued this quarter from its rapid growth, there will likely be a re-rating of Broadcom’s valuation sometime in the next 1-2 quarters. Our goal is to trim this position and buy back at lower levels. This strategy requires remaining steadfast to the bigger picture as this company is setting up to be a clear winner over the next decade. We want to do our best at actively managing the position while not losing sight of the bigger picture. With that said, valuation is a common pitfall for tech investors, who grow complacent with their positions. Our firm works to avoid valuation traps, and thus we plan to follow our disciplined process, which is to actively manage stocks that are richly valued.  

Damien Robbins, I/O Fund Equity Analyst, contributed to this analysis

Recommended Reading:

• Broadcom’s AI Revenue Surge Continues: FQ3 Earnings Preview
• Marvell FQ2 Earnings: Rebound in the cards
• Nvidia Q2: Blackwell Shipments to Begin in Q4
• Super Micro FQ4 Preview: High Anticipation for Blackwell & DLC Commentary

Broadcom will release its Q3 FY2024 results after market close today. Investors will be closely watching the AI revenue updates for the ASIC market leader. Broadcom has the potential to grab the attention after Nvidia due to the company’s unique position in the AI Infrastructure space. Recently Citi Analyst also highlighted that the company is catching up on Nvidia as the top holding as it adds more AI customers and accretion from VMware. In addition, it could benefit from investor fatigue with Nvidia, which aligns with our thoughts that we have highlighted here.

The main highlight in the last earnings call was the AI revenue FY2024 guide increase from over $10 billion to over $11 billion. The company beat the top-line and bottom-line estimates and also raised the full-year revenue guidance to $51 billion from the earlier $50 billion. Analysts believe the guide was conservative due to the company ramping up new ASIC customers, the potential bottoming of non-AI networking markets, and VMware integration progressing well. The company also raised the FY2024 adjusted EBITDA guide from 60% to 61%, which is positive as margin recovery post-VMware integration is also important for the stock momentum to grind higher.

Revenue

• FQ2 revenue grew by 43% YoY to $12.49 billion, up from 34.2% growth in FQ1. Next quarter, revenue is going to accelerate to 46% YoY growth to $12.96 billion and further accelerate to 51% growth in FQ4.
• FQ2 was the first full quarter with a contribution from VMware, and organically, it grew by 12%. Revenue beat estimates by 4.0% and was primarily helped by the strong 280% YoY growth in AI revenue of $3.1 billion, offset by cyclical weakness in enterprises and telcos. Management hinted that non-AI semiconductor revenue had bottomed out in Q2 and was likely to have a modest recovery in the second half of the year.

• Management increased the FY2024 revenue guide from $50 billion to $51 billion Analysts expect FY2024 revenue to grow 43.8% YoY to $51.51 billion, organic growth is about 10%.
• Analysts expect FY2025 revenue to grow 16.8% YoY to $60.15 billion and FY2026 revenue to grow 11.6% to $67.13 billion.

Ji Yoo, Head of Investor Relations, said in the earnings call, “For fiscal '24, we expect revenue from AI to be much stronger at over $11 billion. Non-AI semiconductor revenue has bottomed in Q2 and is likely to recover modestly for the second half of fiscal '24.

On infrastructure software, we're making very strong progress in integrating VMware and accelerating its growth. Pulling all these three key factors together, we are raising our fiscal '24 revenue guidance to $51 billion.”

Margins

The merger integration process will initially drag the margins in FY2024 due to transition costs and VMware’s lower margin profile. However, cost cutting and merger synergies are anticipated to improve margins in the long term.

• The FQ2 gross margin was 62.3%, down from 70% in the same period last year and up from 61.7% in the previous quarter. Adjusted gross margin was 76.2%, down from 75.6% last year and up from 75.4% in the previous quarter.
• Operating margin was 23.7%, down from 45.9% last year and up from 17.4% in the previous quarter. The operating margin was mainly lower from last year due to the increase in amortization of acquisition-related intangible assets, restructuring charges, and stock-based compensation.
• The adjusted operating margin was 57.2%, down from 62% last year and up marginally from 57.1% in the previous quarter. Excluding transition costs, the adjusted operating margin was 59% and remained the same as in the previous quarter.
• Net income was $2.1 billion or 17% of revenue compared to $3.48 billion or 39.9% of revenue in the same period last year. The lower net income was mainly due to the points discussed in the above paragraphs and higher interest expenses this year. The adjusted net income was $5.39 billion or 43.2% of revenue compared to $4.49 billion or 51.4% of revenue last year.

EPS

GAAP EPS was $0.44 compared to $0.82 in the same period last year. The adjusted EPS grew by 6.2% YoY to $1.096 and beat estimates by 1.1%, helped by cost savings. The company has been able to reduce VMware spending to $1.6 billion from the previous $2.3 billion pre-acquisition. Management expects to exit Q4 with a spending of $1.3 billion run rate, better than the previous plan of $1.4 billion. It is further expected to stabilize at $1.2 billion post-integration.

• Analysts expect adjusted EPS to accelerate to 14.3% YoY growth to $1.20 in FQ3 and to 23.7% YoY growth to $1.37 in FQ4.

• Analysts expect FY2024 adjusted EPS to grow 12.4% YoY to $4.75 and accelerate to 27.7% growth to $6.06 in FY2025.

FQ2 adjusted EBITDA was 59.5%, compared to 65.1% in the same period last year and 59.8% in the previous quarter. The drop is mainly due to VMware's lower margin. The post-integration is progressing well, and management also raised the FY2024 adjusted EBITDA guide from 60% to 61%. They also expect VMware's adjusted operating margin to match Broadcom’s software margin by FY2025.

Cash Flow and Balance Sheet

The company has high debt as it has been growing through successful acquisitions. While high debt is a concern, the company is focusing on repaying medium-term debt and has strong cash flows. Also, the company’s debt prior to the VMware acquisition has long maturities.

• Operating cash flow was $4.58 billion or 36.7% of revenue compared to $4.5 billion or 51.6% of revenue in the same period last year and 40.3% in the previous quarter.
• Free cash flow was $4.45 billion or 35.6% of revenue compared to $4.38 billion or 50.2% of revenue last year and 39.2% in the previous quarter. Free cash flow excluding cash used for restructuring and integration was $5.3 billion or 42% of revenue. Free cash flow as a percentage of revenue declined from last year due to higher interest expenses related to debt for VMware acquisition and “higher cash taxes due to a higher mix of US income and the delay in the reenactment of Section 174.”
• Cash was $9.81 billion and debt of $74.02 billion compared to $11.9 billion and $75.9 billion in the previous quarter. The weighted average coupon rate and term to maturity of $48 billion fixed rate debt is 3.5% and 8.2 years, respectively. The weighted average coupon rate and term to maturity of floating rate debt are 6.6% and 2.8 years, respectively. The company repaid $2 billion of floating rate debt in FQ2 and plans to maintain this quarterly repayment throughout FY2024.
• The company paid $2.4 billion in dividends and $1.5 billion in withholding taxes due to the vesting of employee equity, eliminating 1.2 million shares.
• Inventory was $1.84 billion compared to $1.92 billion in the previous quarter.
• The company’s shares started trading on a 10-for-1 stock split basis on July 15, 2024 and also filed a mixed shelf offering on July 08.

Segments

Infrastructure Software

Infrastructure Software revenue grew by 175% YoY to $5.29 billion, primarily due to the contribution of VMware, accelerating from 153% growth in the previous quarter. Organically it grew by 35% YoY. The segment’s adjusted gross margins were 88% compared to 92% in the same period last year. The adjusted operating margin was 60% and excluding transition costs was 64% compared to 73% in the same period last year. The drop in margins was primarily due to VMware’s lower margin profile.

Management provided a key update on VMware in FQ2. “VMware revenue in Q1 was $2.1 billion, grew to $2.7 billion in Q2 and will accelerate towards a $4 billion per quarter run rate. We therefore expect operating margins for VMware to begin to converge towards that of classic Broadcom software by fiscal 2025.”

To illustrate VMware’s successful integration, management highlighted the streamlining of product SKUs from over 8,000 disparate SKUs to 4 core product offerings, thereby eliminating massive channel conflicts.

The company is also transitioning all VMware products to a subscription licensing model. “We are making good progress in transitioning all VMware products to a subscription licensing model. And since closing the deal, we have actually signed up close to 3,000 of our largest 10,000 customers to enable them to build a self-service virtual private cloud on-prem. Each of these customers typically sign up to a multiyear contract, which we normalize into an annual measure known as annualized booking value or ABV. This metric, ABV, for VMware products accelerated from $1.2 billion in Q1 to $1.9 billion in Q2. For a reference, for the consolidated Broadcom software portfolio, ABV grew from $1.9 billion in Q1 to $2.8 billion over the same period in Q2.”

Semiconductor Solutions

Semiconductor Solutions revenue grew by 6% YoY to $7.20 billion, accelerating from 4% in the previous quarter. The segment’s adjusted gross margins were 67%, down 370 basis points YoY, primarily due to a higher mix of custom AI accelerators. The adjusted operating margin was 55% compared to 59% in the same period last year. According to Oppenheimer, Semiconductor revenue is expected to grow 7% YoY and 2% sequentially in FQ3.

• Networking revenue grew by 44% YoY to $3.8 billion, representing 53% of semiconductor revenue, led by strong demand from hyperscalers for AI networking and custom accelerators. According to Oppenheimer, Networking revenue is expected to grow 43% YoY and 5% QoQ in FQ3.
• The company doubled the number of switches sold YoY, particularly the PAM-5 and Jericho3. It also benefits from the rapid transition of optical interconnects in AI data centers to 800 gigabit bandwidth.  

CEO Hock Tan said in the earnings call. “Next year, we expect all mega-scale GPU deployments to be on Ethernet. We expect the strength in AI to continue, and because of that, we now expect networking revenue to grow 40% year-on-year compared to our prior guidance of over 35% growth.”

• Server storage revenue declined by (-27%) YoY to $824 million. Management believes Q2 was the bottom in server storage and expects a modest recovery in the second half of the year. They expect server storage revenue to decline around 20% YoY range for FY2024 from the earlier mid-20 percentage range.
• Broadband revenue declined by (-39%) YoY to $730 million due to the continued slowdown in telco spending. Management expects Broadband to bottom in the second half of the year with a recovery in 2025. They expect Broadband to decline to a high 30s percentage from the prior guide of just over 30% YoY decline.
• Wireless revenue grew 2% YoY and down seasonally (-19%) sequentially to $1.6 billion. Management reiterated the previous guidance of flat YoY wireless revenue for FY2024.
• Industrial resale revenue declined by (-10%) YoY to $234 million. They expect to be down double-digit YoY from the prior guide of high single-digit decline.

AI Revenue

AI revenue grew by 280% YoY and 35% sequentially to $3.1 billion. Management has increased the FY2024 revenue guide from over $10 billion to over $11 billion. J.P. Morgan analyst Harlan Sur is bullish on the AI opportunity and estimates about $12 billion in AI revenue this year and more than $16 billion next year. He also highlighted that Broadcom has recently won OpenAI’s first and second generation AI ASIC orders, making OpenAI the fourth major AI ASIC customer for the company.

The company highlighted their expertise in Ethernet and the opportunity, as they expect all mega GPU deployments to be on Ethernet. “Talking of AI accelerators, you may know our hyperscale customers are accelerating their investments to scale up the performance of these clusters. And to that end, we have just been awarded the next generation custom AI accelerators for these hyperscale customers of ours. Networking these AI accelerators is very challenging, but the technology does exist today. In Broadcom, with the deepest and broadest understanding of what it takes for complex, large workloads to be scaled out in an AI fabric. Proof in point, seven of the largest eight AI clusters in deployment today use Broadcom Ethernet solutions.”

Valuation

The company trades at a P/E ratio of 65.8 and a forward P/E ratio of 32.2, higher than the 5-year average of 41.1. Similarly, it trades at a P/S ratio of 16.1 and a forward P/S ratio of 13.8, higher than the average of 8.6. Valuation is a concern for all semiconductor stocks. At the same time, the market is rewarding the company with a premium valuation due to its transition from a value stock to an AI growth stock.

Conclusion

Strong AI growth, merger synergies, and the Ethernet opportunity make Broadcom a leading AI juggernaut second only to Nvidia. We will look toward the report to confirm our understanding that the fundamentals are on track due to ASICs growth, the acceleration in the VMWare software opportunity and networking. 

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

Recommended Readings:

• Nvidia Q2: Blackwell Shipments to Begin in Q4
• Nvidia Q2 Pre-Earnings: Hopper Thrives Yet Valuation is High
• Broadcom Q2 Post-Earnings: “We are not Standing Still”
• Broadcom Q2 FY2024 Earnings Preview: AI Networking and Early to AI Software

Broadcom will release its Q3 FY2024 results after market close today. Investors will be closely watching the AI revenue updates for the ASIC market leader. Broadcom has the potential to grab the attention after Nvidia due to the company’s unique position in the AI Infrastructure space. Recently Citi Analyst also highlighted that the company is catching up on Nvidia as the top holding as it adds more AI customers and accretion from VMware. In addition, it could benefit from investor fatigue with Nvidia, which aligns with our thoughts that we have highlighted here.

The main highlight in the last earnings call was the AI revenue FY2024 guide increase from over $10 billion to over $11 billion. The company beat the top-line and bottom-line estimates and also raised the full-year revenue guidance to $51 billion from the earlier $50 billion. Analysts believe the guide was conservative due to the company ramping up new ASIC customers, the potential bottoming of non-AI networking markets, and VMware integration progressing well. The company also raised the FY2024 adjusted EBITDA guide from 60% to 61%, which is positive as margin recovery post-VMware integration is also important for the stock momentum to grind higher.

Revenue

• FQ2 revenue grew by 43% YoY to $12.49 billion, up from 34.2% growth in FQ1. Next quarter, revenue is going to accelerate to 46% YoY growth to $12.96 billion and further accelerate to 51% growth in FQ4.
• FQ2 was the first full quarter with a contribution from VMware, and organically, it grew by 12%. Revenue beat estimates by 4.0% and was primarily helped by the strong 280% YoY growth in AI revenue of $3.1 billion, offset by cyclical weakness in enterprises and telcos. Management hinted that non-AI semiconductor revenue had bottomed out in Q2 and was likely to have a modest recovery in the second half of the year.

• Management increased the FY2024 revenue guide from $50 billion to $51 billion Analysts expect FY2024 revenue to grow 43.8% YoY to $51.51 billion, organic growth is about 10%.
• Analysts expect FY2025 revenue to grow 16.8% YoY to $60.15 billion and FY2026 revenue to grow 11.6% to $67.13 billion.

Ji Yoo, Head of Investor Relations, said in the earnings call, “For fiscal '24, we expect revenue from AI to be much stronger at over $11 billion. Non-AI semiconductor revenue has bottomed in Q2 and is likely to recover modestly for the second half of fiscal '24.

On infrastructure software, we're making very strong progress in integrating VMware and accelerating its growth. Pulling all these three key factors together, we are raising our fiscal '24 revenue guidance to $51 billion.”

Margins

The merger integration process will initially drag the margins in FY2024 due to transition costs and VMware’s lower margin profile. However, cost cutting and merger synergies are anticipated to improve margins in the long term.

• The FQ2 gross margin was 62.3%, down from 70% in the same period last year and up from 61.7% in the previous quarter. Adjusted gross margin was 76.2%, down from 75.6% last year and up from 75.4% in the previous quarter.
• Operating margin was 23.7%, down from 45.9% last year and up from 17.4% in the previous quarter. The operating margin was mainly lower from last year due to the increase in amortization of acquisition-related intangible assets, restructuring charges, and stock-based compensation.
• The adjusted operating margin was 57.2%, down from 62% last year and up marginally from 57.1% in the previous quarter. Excluding transition costs, the adjusted operating margin was 59% and remained the same as in the previous quarter.
• Net income was $2.1 billion or 17% of revenue compared to $3.48 billion or 39.9% of revenue in the same period last year. The lower net income was mainly due to the points discussed in the above paragraphs and higher interest expenses this year. The adjusted net income was $5.39 billion or 43.2% of revenue compared to $4.49 billion or 51.4% of revenue last year.

EPS

GAAP EPS was $0.44 compared to $0.82 in the same period last year. The adjusted EPS grew by 6.2% YoY to $1.096 and beat estimates by 1.1%, helped by cost savings. The company has been able to reduce VMware spending to $1.6 billion from the previous $2.3 billion pre-acquisition. Management expects to exit Q4 with a spending of $1.3 billion run rate, better than the previous plan of $1.4 billion. It is further expected to stabilize at $1.2 billion post-integration.

• Analysts expect adjusted EPS to accelerate to 14.3% YoY growth to $1.20 in FQ3 and to 23.7% YoY growth to $1.37 in FQ4.

• Analysts expect FY2024 adjusted EPS to grow 12.4% YoY to $4.75 and accelerate to 27.7% growth to $6.06 in FY2025.

FQ2 adjusted EBITDA was 59.5%, compared to 65.1% in the same period last year and 59.8% in the previous quarter. The drop is mainly due to VMware's lower margin. The post-integration is progressing well, and management also raised the FY2024 adjusted EBITDA guide from 60% to 61%. They also expect VMware's adjusted operating margin to match Broadcom’s software margin by FY2025.

Cash Flow and Balance Sheet

The company has high debt as it has been growing through successful acquisitions. While high debt is a concern, the company is focusing on repaying medium-term debt and has strong cash flows. Also, the company’s debt prior to the VMware acquisition has long maturities.

• Operating cash flow was $4.58 billion or 36.7% of revenue compared to $4.5 billion or 51.6% of revenue in the same period last year and 40.3% in the previous quarter.
• Free cash flow was $4.45 billion or 35.6% of revenue compared to $4.38 billion or 50.2% of revenue last year and 39.2% in the previous quarter. Free cash flow excluding cash used for restructuring and integration was $5.3 billion or 42% of revenue. Free cash flow as a percentage of revenue declined from last year due to higher interest expenses related to debt for VMware acquisition and “higher cash taxes due to a higher mix of US income and the delay in the reenactment of Section 174.”
• Cash was $9.81 billion and debt of $74.02 billion compared to $11.9 billion and $75.9 billion in the previous quarter. The weighted average coupon rate and term to maturity of $48 billion fixed rate debt is 3.5% and 8.2 years, respectively. The weighted average coupon rate and term to maturity of floating rate debt are 6.6% and 2.8 years, respectively. The company repaid $2 billion of floating rate debt in FQ2 and plans to maintain this quarterly repayment throughout FY2024.
• The company paid $2.4 billion in dividends and $1.5 billion in withholding taxes due to the vesting of employee equity, eliminating 1.2 million shares.
• Inventory was $1.84 billion compared to $1.92 billion in the previous quarter.
• The company’s shares started trading on a 10-for-1 stock split basis on July 15, 2024 and also filed a mixed shelf offering on July 08.

Segments

Infrastructure Software

Infrastructure Software revenue grew by 175% YoY to $5.29 billion, primarily due to the contribution of VMware, accelerating from 153% growth in the previous quarter. Organically it grew by 35% YoY. The segment’s adjusted gross margins were 88% compared to 92% in the same period last year. The adjusted operating margin was 60% and excluding transition costs was 64% compared to 73% in the same period last year. The drop in margins was primarily due to VMware’s lower margin profile.

Management provided a key update on VMware in FQ2. “VMware revenue in Q1 was $2.1 billion, grew to $2.7 billion in Q2 and will accelerate towards a $4 billion per quarter run rate. We therefore expect operating margins for VMware to begin to converge towards that of classic Broadcom software by fiscal 2025.”

To illustrate VMware’s successful integration, management highlighted the streamlining of product SKUs from over 8,000 disparate SKUs to 4 core product offerings, thereby eliminating massive channel conflicts.

The company is also transitioning all VMware products to a subscription licensing model. “We are making good progress in transitioning all VMware products to a subscription licensing model. And since closing the deal, we have actually signed up close to 3,000 of our largest 10,000 customers to enable them to build a self-service virtual private cloud on-prem. Each of these customers typically sign up to a multiyear contract, which we normalize into an annual measure known as annualized booking value or ABV. This metric, ABV, for VMware products accelerated from $1.2 billion in Q1 to $1.9 billion in Q2. For a reference, for the consolidated Broadcom software portfolio, ABV grew from $1.9 billion in Q1 to $2.8 billion over the same period in Q2.”

Semiconductor Solutions

Semiconductor Solutions revenue grew by 6% YoY to $7.20 billion, accelerating from 4% in the previous quarter. The segment’s adjusted gross margins were 67%, down 370 basis points YoY, primarily due to a higher mix of custom AI accelerators. The adjusted operating margin was 55% compared to 59% in the same period last year. According to Oppenheimer, Semiconductor revenue is expected to grow 7% YoY and 2% sequentially in FQ3.

• Networking revenue grew by 44% YoY to $3.8 billion, representing 53% of semiconductor revenue, led by strong demand from hyperscalers for AI networking and custom accelerators. According to Oppenheimer, Networking revenue is expected to grow 43% YoY and 5% QoQ in FQ3.
• The company doubled the number of switches sold YoY, particularly the PAM-5 and Jericho3. It also benefits from the rapid transition of optical interconnects in AI data centers to 800 gigabit bandwidth.  

CEO Hock Tan said in the earnings call. “Next year, we expect all mega-scale GPU deployments to be on Ethernet. We expect the strength in AI to continue, and because of that, we now expect networking revenue to grow 40% year-on-year compared to our prior guidance of over 35% growth.”

• Server storage revenue declined by (-27%) YoY to $824 million. Management believes Q2 was the bottom in server storage and expects a modest recovery in the second half of the year. They expect server storage revenue to decline around 20% YoY range for FY2024 from the earlier mid-20 percentage range.
• Broadband revenue declined by (-39%) YoY to $730 million due to the continued slowdown in telco spending. Management expects Broadband to bottom in the second half of the year with a recovery in 2025. They expect Broadband to decline to a high 30s percentage from the prior guide of just over 30% YoY decline.
• Wireless revenue grew 2% YoY and down seasonally (-19%) sequentially to $1.6 billion. Management reiterated the previous guidance of flat YoY wireless revenue for FY2024.
• Industrial resale revenue declined by (-10%) YoY to $234 million. They expect to be down double-digit YoY from the prior guide of high single-digit decline.

AI Revenue

AI revenue grew by 280% YoY and 35% sequentially to $3.1 billion. Management has increased the FY2024 revenue guide from over $10 billion to over $11 billion. J.P. Morgan analyst Harlan Sur is bullish on the AI opportunity and estimates about $12 billion in AI revenue this year and more than $16 billion next year. He also highlighted that Broadcom has recently won OpenAI’s first and second generation AI ASIC orders, making OpenAI the fourth major AI ASIC customer for the company.

The company highlighted their expertise in Ethernet and the opportunity, as they expect all mega GPU deployments to be on Ethernet. “Talking of AI accelerators, you may know our hyperscale customers are accelerating their investments to scale up the performance of these clusters. And to that end, we have just been awarded the next generation custom AI accelerators for these hyperscale customers of ours. Networking these AI accelerators is very challenging, but the technology does exist today. In Broadcom, with the deepest and broadest understanding of what it takes for complex, large workloads to be scaled out in an AI fabric. Proof in point, seven of the largest eight AI clusters in deployment today use Broadcom Ethernet solutions.”

Valuation

The company trades at a P/E ratio of 65.8 and a forward P/E ratio of 32.2, higher than the 5-year average of 41.1. Similarly, it trades at a P/S ratio of 16.1 and a forward P/S ratio of 13.8, higher than the average of 8.6. Valuation is a concern for all semiconductor stocks. At the same time, the market is rewarding the company with a premium valuation due to its transition from a value stock to an AI growth stock.

Conclusion

Strong AI growth, merger synergies, and the Ethernet opportunity make Broadcom a leading AI juggernaut second only to Nvidia. We will look toward the report to confirm our understanding that the fundamentals are on track due to ASICs growth, the acceleration in the VMWare software opportunity and networking. 

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

Recommended Reading:

• Marvell FQ2 Earnings: Rebound in the cards
• Dell Q2: AI Server Shipments Rise 82% QoQ; Pipeline Preparing for Blackwell
• Nvidia Q2: Blackwell Shipments to Begin in Q4
• Super Micro FQ4 Preview: High Anticipation for Blackwell & DLC Commentary