Broadcom Inc. (AVGO) Q2 2020 earnings call dated Jun. 04, 2020
Beatrice F. Russotto — Investor Relations
Hock E. Tan — President and Chief Executive Officer
Tom Krause — Chief Financial Officer
Vivek Arya — Bank of America — Analyst
Craig Hettenbach — Morgan Stanley — Analyst
John Pitzer — Credit Suisse — Analyst
Ross Seymore — Deutsche Bank — Analyst
Harlan Sur — JPMorgan — Analyst
Stacy Rasgon — Bernstein Research — Analyst
Blayne Curtis — Barclays — Analyst
Timothy Arcuri — UBS — Analyst
Pierre Ferragu — New Street — Analyst
Chris Danely — Citigroup — Analyst
Welcome to Broadcom, Inc’s Second Quarter Fiscal Year 2020 Financial Results Conference Call. At this time for opening remarks and introductions, I would like to turn the call over to Beatrice Russotto, Director of Investor Relations of Broadcom, Inc. Please go ahead ma’am.
Beatrice F. Russotto — Investor Relations
Thank you, operator, and good afternoon everyone. Joining me on today’s call are Hock Tan, President and CEO and Tom Krause, Chief Financial Officer of Broadcom. After the market closed, Broadcom distributed a press release and financial tables describing our financial performance for the second quarter of fiscal year 2020. If you did not receive a copy, you may obtain the information from the Investors section of Broadcom’s website at broadcom.com. This conference call is being webcast live and a recording will be available via telephone playback for one week. It will also be archived in the Investors section of our website at broadcom.com.
During the prepared comments, Hock and Tom will be providing details of our second quarter fiscal year 2020 results, guidance for our third quarter as well as commentary regarding the business environment. We’ll take questions after the end of our prepared comments. Please refer to our press release today and our recent filings with the SEC for information on the specific risk factors that could cause our actual results to differ materially from the forward-looking statements made on this call.
In addition to US GAAP reporting, Broadcom reports certain financial measures on a non-GAAP basis. A reconciliation between GAAP and non-GAAP measures is included in the tables attached to today’s press release. Comments made during today’s call will primarily refer to our non-GAAP financial results.
So with that, I’ll now turn the call over to Hock.
Hock E. Tan — President and Chief Executive Officer
All right. Thank you, Bea and thank you everyone for joining us today. Before I provide our quarterly results, I do want to take a moment to acknowledge and thank all of the healthcare professionals and essential workers on the front lines who are showing incredible courage during this unprecedented times. I speak for all of Broadcom when I say we are very grateful for their work.
I also especially want to thank our team of more than 20,000 employees working all over the world to keep our business running. I’m proud of their tireless efforts to preserve and protect our enterprise. Now, more than ever, our customers and communities are counting on us to continue to deliver the essential technologies that enable the continuity of functions critical to daily life.
So now let me turn to our second quarter results and our outlook for the third quarter. We delivered second quarter net revenue of $5.7 billion, very much in line with our guidance, down 2% sequentially, up 4% year-on-year. Semiconductor solutions revenue was $4 billion, declining 2% year-on-year. Infrastructure software revenue was $1.7 billion, up 21% year-on-year, which of course includes contribution from Symantec. On a sequential basis, semiconductors were down 4% while software was up 3%.
So on to more colors, starting with semiconductors. We face a very interesting demand environment in the midst of a challenging supply chain ecosystem. Let me provide more color on various semiconductor end markets, beginning with networking. Q2 reflected an expected recovery and was up 11% sequentially. Demand was healthy as we began to ramp our next generation Tomahawk 3 and Trident 3 switch products at our various cloud customers and in network routing Jericho 2 at our telco customers. This steady recovery which we saw in Q2 is now turning into a demand surge in Q3 as we are seeing strength for existing generation products in addition to these next generation ramps.
We are also seeing a strong uplift in demand from the ramp of next-generation deep learning inference chips for our lead cloud customers. In server storage connectivity we note a similar situation. From a 14% sequential revenue decline in Q2, demand in Q3 has turned around and is accelerating. Demand from enterprise customers for our RAID data protection controllers has recovered and is showing considerable strength. Demand from cloud service providers for our PCI Express Switches that drive solid state memory and AI applications has been particularly strong.
Turning onto broadband which was flat sequentially in Q2. We expect approximately 10% revenue growth quarter-over-quarter in Q3 driven by strong adoption of Wi-Fi 6 in next generation Access Gateways, not only from enterprises, but also from telcos and other service providers. We’re also seeing increased demand for broadband DSL and PON and next generation cable DOCSIS 3.1. That being said, we expect this to be partially offset by a sharp decline in video, particularly in satellite set-top boxes, given the current constraints on live sporting events.
Then moving on to wireless. Wireless saw typical seasonality in Q2, was down 14% sequentially much like last year. In Q3 we would normally expect to see a double-digit sequential uplift in revenue from the ramp of next-generation phone at our large North American mobile phone customer. However, this year we do not expect to see this uptick in revenue until our fourth fiscal quarter. So accordingly, we expect our wireless revenue in Q3 would be down sequentially as it was down in Q2.
Turning last to industrial. We began to see recovery in Q2 and revenue was up 13% sequentially, consistent with recovery in resales to end market. Even as we expect resales in Q3 to be flat, given the current market uncertainty arising from the current — the COVID-19 pandemic, we are aggressively moving to bring down channel inventory globally, especially in Europe and Japan. As a result, we expect a double-digit sequential decline in recognized shipping revenue in the third quarter. I would note resales in Asia-Pacific, in particular China, are expected to be up quarter-over-quarter, while other regions — all other regions are expected to be down. So that’s the demand picture.
Now on the supply chain side, we have experienced and continue to do so, some challenges, some of which are unique to us. Lead times, especially in leading edge processes, have extended and are running at historical highs. Coupled with this, we have significant test capacity — we’ve positioned [Phonetic] significant test capacity in Malaysia, where we also have a central — centralized warehouse. And this is a location which has experienced intermittent COVID-19 lockdowns and significant logistical delays. Bottom line, in Q3, we really have much more demand than we can supply and this may very well continue beyond Q3.
In summary, we clearly see significant puts and takes. On the positive side, a surge of demand in networking, storage and broadband; on the negative side, supply chain constraints and the product cycle delay in wireless. Therefore, we forecast our semiconductor solution revenue to be up 3% sequentially but only down 5% year-on-year for the third quarter despite the major product cycle delay in wireless.
Right, now turning to software. CA was up 2% year-on-year and flat sequentially. Bookings in our core accounts grew double digits annually, which was offset by the expected reduction in services revenue. Symantec grew 2% sequentially and contributed over $400 million in the quarter. After two quarters, we have successfully integrated Symantec onto the Broadcom platform and have largely contributed — completed the transition. As mentioned, bookings in our core accounts are growing and more than offsetting the transition out of smaller commercial accounts as we continue to rationalize the business. While Brocade was down 21% year-on-year, it was up 11% sequentially in Q2 and was the — and that was the third quarter in a row of sequential growth for Brocade following the Q3 bottom last year.
Looking ahead to next quarter, we expect revenues from CA and Symantec, of course, to sustain on a sequential basis. However, very consistent with our distribution strategy in semiconductors, we are reducing channel inventories significantly for Brocade and expect Brocade revenue will be down significantly quarter-on-quarter in Q3. So as a result, we expect revenue from the software segment to be down approximately 7% sequentially in the third quarter.
So in sum, we expect our consolidated third quarter net revenue to be $5.75 billion, roughly flat from Q2. This reflects a 3% sequential projected revenue increase in semiconductors and a 7% sequential expected revenue decline in software.
With that, I’ll turn it over to Tom.
Tom Krause — Chief Financial Officer
Thank you, Hock. Let me now provide additional detail on our financial performance. First on the P&L. Gross margins were 73% of revenue in the quarter and relatively flat with Q1, but up approximately 100 basis points year-on-year. The increase in software as a percentage of our overall revenue drove the increase.
Operating income from continuing operations was $3 billion and represented 53% of net revenue. Operating margins were effectively flat quarter-over-quarter, but down year-on-year by approximately 70 basis points, primarily due to the stranded costs for Symantec we carried in the quarter. In fact, operating expenses were $1.2 billion, which was down $28 million compared to Q1, but still included approximately $35 million of Symantec related expenses that we expect to go away over the remainder of the year. Adjusted EBITDA was $3.2 billion and represented 56% of net revenue. This figure excludes $147 million of depreciation.
Looking at cash flow, we had record quarterly free cash flow of $3.1 billion representing 53% of revenue. This is up a little more than 20% year-on-year. Collections were quite strong and it’s worth noting that our software businesses are seasonal with December and, to a lesser extent, March, being particularly strong bookings months. As a result, our fiscal Q2 is the peak collections period for software.
In addition, we strictly managed working capital to improve liquidity, but also out of an abundance of caution given the continuing lack of visibility. Notably, we moved most of our business to billed order during the quarter and are continuing to operate this way. However, the downside to our conservative approach is our ability to respond to short lead time orders is very limited. Overall, we are going to continue to operate and plan for challenging conditions going forward given the uncertain environment.
Turning to capital allocation. In the quarter, we paid our common stockholders $1.3 billion of cash dividends. We also paid $219 million in withholding taxes due to — on vesting of employee equity, resulting in the elimination of approximately 900,000 AVGO shares. We ended the quarter with 402 million outstanding common shares and 452 million fully diluted shares. Note that we expect the fully diluted share count to stay at 452 million in Q3.
On the financing and investing front, we derisked our balance sheet with over $18 billion of debt refinancing, including $2 billion of commercial paper. This allowed us to push out average debt maturities to six years from four years while our average cost of debt increased by just about 50 basis points. Note these figures are inclusive of the $8 billion financing and $3.9 billion exchange offering that we executed in the first month of our third fiscal quarter.
All told, we ended the quarter with $9.2 billion of cash and currently have $14.2 billion of liquidity, including our $5 billion revolver. Note, we did draw down $3 billion on our revolver earlier in the quarter, all of which we have repaid as part of our refinancing activity. We ended the quarter with $45.8 billion of total debt, of which approximately $800 million is short term.
In closing, given our strong free cash flow generation, healthy balance sheet and enhanced liquidity position, we remain committed to maintaining our dividend while we navigate this uncertain environment.
That concludes my prepared remarks. During the Q&A portion of today’s call, please limit yourselves to one question each so we can accommodate as many analysts as possible. Operator, please open the call for questions.
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