Undervalued Dividend Growth Stock of the Week: Broadcom Inc. (AVGO)

As someone who takes both fitness and finance very seriously, I see a lot of commonalities.

For example, saving money requires spending less than you earn.

Likewise, losing weight requires burning more calories than you ingest.

I’m simplifying things here, but that’s the basic gist.

Well, fitness and finance have something else in common.

Just like many people fall for fad diets, many people also fall for get-rich-quick schemes.

Why is this? 

Well, I’d argue it comes down to many people lacking two attributes: discipline and patience.

But if you can master these two attributes for yourself, you can go on to do amazing things – across all aspects of your life.

In terms of finance, I’ve used both discipline and patience to my advantage.

The patience came in handy when I basically set aside six years of my life to dig myself out of debt, become financially independent, and retire early (FIRE).

I started out as 27 years old and broke in early 2010, and I ended as 33 years old and FIRE in early 2016.

That entire journey has been recounted in my Early Retirement Blueprint.

Six years might not seem like a long time. But it feels like a long time when you’re in the moment. I mean, we’re talking almost 2,200 days. That’s a lot of days!

But most great things in this life require time. Anything worth having is worth working and waiting for.

Meanwhile, I stayed disciplined by choosing what I determined would be the investment strategy to get me to FIRE – and sticking with it through thick and thin.

That strategy was dividend growth investing.

It essentially involves buying shares in high-quality businesses that reward their shareholders with reliable and rising cash dividend payments (funded by the growing profits the businesses are producing).

You hold for the long haul, collect (and reinvest) the growing passive dividend income, and eventually become quite wealthy and independent.

To see what I mean by dividend growth stocks, check out the Dividend Champions, Contenders, and Challengers list – a collection of almost 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

Dividend growth investing is a wonderful strategy for building serious wealth and passive income.

After all, the strategy basically limits one’s investment universe to some of the best companies in the world – evidenced by their ability to regularly pay out increasing cash dividend payments to shareholders.

These are often blue-chip stocks.

You can’t fake cash. And you certainly can’t fake ever-more cash. To be able to write those bigger and bigger checks to shareholders, a company must be simultaneously raking in the growing profit.

And those growing dividends make for the perfect source of passive income, upon which one can build the foundation for financial independence and (if they so choose) early retirement.

Jason Fieber's Dividend Growth PortfolioThis strategy is exactly what I used to build my FIRE Fund, which is my six-figure dividend growth stock portfolio that generates the five-figure and growing passive dividend income I need to pay my bills without having a job.

But as great as this strategy is, part of that aforementioned discipline is making sure you buy high-quality dividend growth stocks at the right valuations. 

Price only tells you how much money you’ll pay for a stock; value tells you what you’re actually getting for your money.

Value gives context to price; without knowing the former, the latter is practically useless information.

But what is the right valuation?

Well, it’s one where price is as far below estimated intrinsic value as possible.

When undervaluation is present, there are often huge advantages in place for the investor.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk. 

This is all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

The higher yield comes about due to the fact that price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

A higher yield is obviously beneficial in terms of short-term and long-term passive income, which provides additional reinvestment ammo for the duration of the investment.

And if your goal is to become financially independent as soon as possible (which, I believe, is every investor’s dream), more passive income will almost surely get you there faster.

But that higher yield also goes on to positively impact total return, as total return is comprised of investment income (via dividends or distributions) and capital gain.

Since you’re looking at more investment income with a higher yield, there’s greater long-term total return potential right off the bat.

That’s before even factoring in the possibility of additional capital gain, due to the “upside” that should be present when the price paid is well below intrinsic value.

While the stock market isn’t necessarily accurate with stock pricing over the short term, price and value do tend to more or less converge over the long run.

And this capital gain would be on top of whatever capital gain will organically manifest itself as a result of a company becoming more profitable (and thus worth more).

These dynamics should also go a long way toward reducing risk for the investor.

It’s obviously less risky to pay less money for the same exact asset.

It’d be like having a choice of paying $200,000 or $225,000 for a house. The former is obviously less risky, for you’re risking less capital and introducing a margin of safety (protecting yourself against future unknowns).

Fortunately, these favorable dynamics aren’t impossible to spot or take advantage of.

Fellow contributor Dave Van Knapp has made it much easier to spot undervalued dividend growth stocks by simplifying the entire valuation process.

That simplification is summed up in Lesson 11: Valuation, which is one of his “lessons” in an overarching series of articles designed to educate investors on the entire strategy of dividend growth investing.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Broadcom Inc. (AVGO)

Broadcom Inc. (AVGO) is a leading designer, developer, and supplier of analog and digital semiconductor devices.

The company’s technologies serve four primary markets that also make up its four individual business segments: Wired Infrastructure (48% of FY 2017 net revenue); Wireless Communications (31%); Enterprise Storage (16%); and Industrial & Other (5%).

So investing in Broadcom is basically investing in major technology themes across broadband, smartphones, accessibility, data, cloud computing, storage, and the very future of the Internet and how people communicate with each other.

Growing wired and wireless access to data and communications bodes well for Broadcom, since it manufactures devices that facilitate all of that. And then you have the data storage, too, which is becoming increasingly integral to modern computing.

Broadcom as it exists now has come about through a series of major mergers and acquisitions, with some of the more recent moves including the closing of Brocade for $5.5 billion in 2017 and the announcement (in the summer of 2018) of intent to acquire CA Technologies for $18.9 billion.

Because of the sheer number of deals, it’s difficult to get a feel for what kind of organic growth this $94 billion company (by market cap) is truly capable of moving forward; however, there’s no doubt that it’s now positioned as an absolute juggernaut in the semiconductor space.

And this should position it well in terms of paying out a large and growing dividend, too.

Indeed, the company has already increased its dividend for eight consecutive years.

While that track record might be relatively short, the dividend growth since the initiation of the dividend has been absolutely astounding.

The five-year dividend growth rate is 51.1%.

If you think that’s impressive, check this out: the most recent increase came in at a whopping 71.6%.

So there’s been no slipping or deceleration here.

However, it should be obvious that this kind of dividend growth cannot continue indefinitely. It’s just a situation where you the company had no dividend a decade ago, and they were able to ramp it up quickly from a 0% payout ratio. And that was combined with a fast-growing enterprise at the same time.

With the payout ratio now sitting at 40.6% (based on TTM EPS that factors out a one-time tax gain for Q1 FY 2018), it’s unlikely we’ll see those massive dividend increases continue.

That said, I don’t see any reason why the company couldn’t grow its dividend at a pace in the low double digits looking out over the foreseeable future.

That kind of expected dividend growth is on top of the stock’s current yield of 3.01%, which is a considerable combination of yield and dividend growth.

The stock’s yield, by the way, is twice as high as its five-year average.

I think it goes without saying that the dividend metrics are pretty impressive.

But in order to reasonably estimate the rate of future dividend increases, which will help us value the business as a whole, we must look at what kind of growth the company is producing across its top and bottom lines.

Since profit growth will ultimately fuel dividend growth, it’s imperative that we understand what kind of overall business growth Broadcom is capable of.

So we’ll look at the company’s revenue and earnings per share growth over the last decade, before comparing that to a near-term professional forecast for profit growth.

Blending known results and a forecast in this manner should give us a fairly accurate idea as to where this company is going.

Broadcom increased its revenue from $1.699 billion in FY 2008 to $17.636 billion in FY 2017. That’s a compound annual growth rate of 29.69%.

This is an incredible rate of top-line growth, although we have to keep in mind that the company has been particularly acquisitive over the last decade.

While it seems likely they’ll continue to seek out accretive deals (as highlighted by the aforementioned deal for CA Technologies), it’ll be harder to move the dial now that the company is so large.

Meanwhile, earnings per share grew from $0.38 to $4.27 over this same period, which is a CAGR of 30.84%.

The fact that bottom-line growth has kept pace with (and actually slightly exceeded) the top line (which was growing at a blistering rate) straight through a period that was very heavy with M&A activity is a wonderful sign, in my view.

This shows that management has been making the right moves on the acquisition side, and then they’ve properly integrated and taken advantage of synergies.

Looking out over the next three years, CFRA is predicting that Broadcom will compound its EPS at an annual rate of 11%.

CFRA notes data center demand growth (which should help drive the wired side of the business), the accretive nature of acquisitions (e.g., CA Technologies), and the potential for greater tech content per mobile device (which should help drive the wireless side of the business).

This kind of growth, if it were to materialize, would be well below what the company has produced over the last decade.

However, 30%+ annual growth isn’t sustainable over the long run. Furthermore, a 11% CAGR for the bottom line would be more than acceptable – and that should drive double-digit dividend growth moving forward.

Setting that up is that low payout ratio, which means dividend growth investors should be most pleased when dividend increases are announced from Broadcom (especially speaking in terms of the next 5-10 years).

With all of these deals, it shouldn’t be a surprise that the balance sheet has become a bit bloated in recent years.

Still, the long-term debt/equity ratio is at just 0.75. And the interest coverage ratio is a bit over 5.

These are acceptable numbers. Moreover, cash and cash equivalents offset more than 60% of the long-term debt.

However, the CA Technologies deal, if it closes, will certainly change these dynamics. And since CA shareholders just recently approved the deal, it seems likely that it will close.

Profitability is where this company really shines. While the M&A activity clouds things quite a bit, this is a highly-profitable business model at its core.

Over the last five years, the company has averaged annual net margin of 8.90% and annual return on equity of 7.11%.

The averages are heavily skewed by a number of recent adjustments, however. The Q3 numbers for FY 2018 (which aren’t so skewed) show gross margin of 51.7% and net margin 23.6%. That’s a more accurate picture of what this company is really doing.

Overall, there’s a lot to like about this company.

You have a large, diversified, and scaled business that is heavily exposed to some of the most exciting trends in all of technology.

If you think about where this world is going in terms of technology, Broadcom is one of the major players behind making sure that dream is realized.

And dividend growth investors have to love this big, growing, and sustainable dividend. There’s nothing to indicate that investors should expect anything less than double-digit dividend growth for the foreseeable future, which is on top of a heady 3% yield. This is partly why I decided to very recently initiate a position in this business for my own personal portfolio.

One should consider risks, though.

Namely, Broadcom is heavily exposed to a small handful of customers. Apple Inc. (AAPL), for example, accounted for more than 20% of Broadcom’s FY 2017 revenue; Broadcom’s top five customers accounted for more than 40% of their FY 2017 revenue.

In addition, many of their end markets (especially in the consumer electronics space) are cyclical, and any major economic downturn would almost certainly adversely affect demand for Broadcom’s chips.

Finally, the acquisitive nature of the company means that they have to continue making the right deals. They have to acquire the right companies, at the right valuations, at the right time.

But at the right price, this could be a fantastic long-term investment for dividend growth investors.

Well, the valuation appears to be pretty compelling right now…

The stock is trading hands for a P/E ratio of 13.44 (based on TTM EPS that factors out a one-time tax gain for Q1 FY 2018).

That’s extremely low in this market. And it compares to an industry average P/E ratio of 24.5.

The P/B ratio is almost 50% lower than its five-year average; the cash flow multiple of 13.0 significantly lower than the three-year average P/CF ratio of 20.6.

And the yield, as noted earlier, is twice as high as its recent historical average.

This stock looks plainly cheap here, but how cheap might it be? What might an estimate of the intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.

That long-term DGR is well below the demonstrated dividend growth thus far, and it’s quite conservative when lined up against the near-term forecast for EPS growth. Plus, the payout ratio is still moderate.

However, the company’s short track record for managing dividend growth is being considered. And the company’s likely going to rapidly decelerate into its more mature state, which should impact the dividend raises moving forward.

This is, in my view, a cautious valuation, but I do like to err on the side of caution.

The DDM analysis gives me a fair value of $301.00.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

Even a conservative look at the company’s future dividend growth shows a stock that’s substantially undervalued here, which shouldn’t be a surprise when you line up some of the basic valuation metrics against their recent historical averages.

Of course, my perspective is but one of many. So we’ll now compare where I came out to what professional stock analysis firms are valuing this stock at. This will add depth and a more well-rounded perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates AVGO as a 4-star stock, with a fair value estimate of $300.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates AVGO as a 5-star “STRONG BUY”, with a 12-month target price of $282.00.

A pretty tight consensus here. Averaging out the three numbers gives us a final valuation of $294.33, which would indicate the stock is potentially 27% undervalued.

Bottom line: Broadcom Inc. (AVGO) is a high-quality, large, diversified, and experienced semiconductor firm that has scaled itself into a juggernaut through smart and accretive deals. It’s now exposed to just about every exciting technology trend that one could possibly want to hitch a wagon to. With a 3% yield, a recent 75% dividend increase, expected dividend growth at well into the double digits, a moderate payout ratio, and the possibility that shares are 27% undervalued, dividend growth investors should take a good look at this stock.

-Jason Fieber

Note from DTA: How safe is AVGO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 87. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, AVGO’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.

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