After the worst December for stocks since 1931, investors have been relieved to see a strong recovery rally since the December 24th low.
Two main factors have driven that rally, one being the Federal Reserve announcing it was effectively done with monetary tightening. But most recently it's been a steady stream of positive trade news that's been boosting stocks, especially trade and economically sensitive names like semiconductor firms Broadcom (AVGO), Texas Instruments (TXN), and Lam Research (LRCX).
That's understandable given that tech companies, in particular, are the most trade sensitive, since they obtain 57% of revenue from overseas and thus have the most to gain from an end to the trade war.
In a recent article, I highlighted the best-undervalued dividend stocks to buy ahead of a trade deal, including plenty of firms that will benefit, directly or indirectly from a trade deal that now appears to be imminent. That's because President Trump, citing great progress on trade talks (including all six major points of contention), has delayed the March 1st tariff deadline and said he'd participate in a "signing Summit" with Chinese President Xi to end the trade war with a conclusive deal, possibly by late March.
I am a big fan of all three of these dividend-paying tech blue-chips, and my Deep Value Dividend Growth Portfolio (beating the market by over 9% over the first nine weeks) owns them all. However, as I explained in this week's top recommendation article, valuation is always important and with the strong trade induced rally, a lot of the potential upside is priced into many great dividend stocks.
So let's take a look at why Broadcom, Texas Instruments and Lam Research are all top quality tech dividend blue-chips and must own income growth investments, BUT only at the right price. More importantly, find out why, from today's prices Broadcom and Texas Instruments are still "buys" while Lam Research, despite its strengths, is a "hold".
Since its founding in the 1960s Broadcom has grown into one of the world's largest chip makes thanks to numerous strategic mergers.
What's especially impressive is that according to the Harvard Business Review, 70% to 90% of mergers fail. Yet Broadcom, which was created by the $37 billion merger of Broadcom and Avago (the biggest chip merger ever completed). That merger combined Avago's industry lead in radio frequency filters (for mobile chips), with Broadcom's dominance in networking, wireless connectively, and broadband chips.
The result of all this M&A has been able to generate some of the most impressive top and bottom line growth in the industry.
Broadcom's great M&A track record is courtesy of CEO Hock Tan, who has a strong background in both engineering and finance.
This explains why Avago under Tan was able to pull off such strong deals including the following acquisitions.
The company's M&A strategy is very focused, with Broadcom buying #1 or #2 market leaders, and then selling off commoditized and slower selling business units from acquired companies to keep its R&D highly focused and efficient. That is what has allowed AVGO to build up a patent portfolio of 25,000 current and pending patents that keeps its FCF margins among the highest in the industry.
Best of all Broadcom's dividend policy is among the most shareholder-friendly, specifically to pay out 50% of free cash flow as dividends, and also be generous with buybacks that help growth FCF/share (and thus drive future dividend hikes).
And unlike some chip makers, Broadcom is guiding for strong top and bottom line growth in 2019, including
That is largely due to the recently completed CA Tech acquisition which is greatly expanding the company's future total addressable market.
Now the CA Tech deal had many critics, including analysts who were shocked that hardware focused Broadcom would spend so much for a company specialized in mainframe software.
However, at the last conference call, Hock Tan announced that Broadcom was restructuring CA Tech's business from a focus on perpetual software licenses to a subscription-based model that would provide highly stable and higher margin revenue.
"We expect these changes to result in a dramatically more profitable revenue base which is more aligned to the rest of Broadcom and that we expect will grow." - CEO Hock Tan
That's why Broadcom is now guiding for about $12 billion in cash returns in 2019 and according to CFO Tom Krause, Broadcom's CA Tech plans could drive at least three more double-digit years of payout growth.
"So when you do that math, you are going to come up with a number that’s north of 20% in terms of potential for dividend growth (for 2019)... So I think we have a good setup to continue to be able to drive the dividend well into the double digits over the next several years." - Tom Krause (emphasis added).
The key to a semiconductor giant being able to safely achieve that kind of impressive payout growth is the fact that over 20% of Broadcom's revenue will now be from recurring subscription revenue, thanks to that controversial CA Tech acquisition.
What's going to drive Broadcom's growth other than cost-cutting and higher margin subscription revenue from CA Tech?
Well, 5G is going to be a major contributor. About 30% of total revenue is currently from smartphone chips, and 5G phones are just now starting to launch. 5G chipsets are more expensive and higher margin for Broadcom and that is expected to be a decade long secular trend.
But 5G isn't just about much faster phones it's about so much more. 5G will allow for 10 times lower latency (how fast mobile devices communicate with networks) which will enable the internet of things or IOT. IOT will connect hundreds of billions of devices to the internet (200 billion devices by 2020) which will enable real-time AI-driven data analysis for things like
Better yet, all that data is going to lead to a decades-long exponential growth in data centers and cloud computing, because the data that AI needs to maximize productivity (and corporate profitability) will need to be stored somewhere it can be quickly accessed.
5G is just now starting to roll out and yet global data continues to grow at a mindboggling rage.
Broadcom's empire, built up over decades of smart M&A as well as billions in focused R&D, has its finger in every piece of the future chip pie. That's why analysts currently agree with management's long-term double-digit EPS and FCF/share guidance which should make Broadcom a dividend growth dream stock for the foreseeable future.
But despite my bullishness on the company, there are some important risk factors to consider, including besides the cyclical nature of the overall industry.
Broadcom has done a masterful job of achieving very strong cash flow and dividend growth over the years thanks to one of the industry's best M&A track records.
|Company||TTM Net Debt/EBITDA||Interest Coverage Ratio||S&P Credit Rating||Average Interest Rate|
Return On Invested Capital
|Safe Levels||1.5 Or Less||8 Or Higher||NA||NA||NA|
However, the downside of that acquisition-fueled growth strategy is that it has much higher debt and the weakest balance sheet of these three tech companies. Management has said that maintaining an investment grade credit rating (BBB- or better) is a top priority.
But the CA Tech acquisition is going to require taking on $18.9 billion in debt. According to Moody's that is going to increase the company's total debt/EBITDA ratio from 2.0 to 3.7, which is why it downgraded the company to Baa2 (S&P BBB- equivalent).
This means that Broadcom has no room for error with CA Tech's integration, restructuring to its new business model, and needs to make deleveraging a top priority. That's because, with a recession possibly coming in 2020 or 2021 (more on this in a moment) credit markets could tighten in the coming years, especially for junk bond-rated corporate bonds.
Currently, the spread (difference) between junk and investment grade bonds isn't very high. But as you can see both the spread and corporate bond yields in general, can be highly volatile during periods of financial stress (which correlate with corrections and bear markets).
For example, during December's recession scare, all corporate bond yields went up, but junk bond yields soared to over 6%. As a result, that month saw zero US companies sell new junk bonds, which was the first such month since 2011 (when we had a severe correction over the US debt ceiling showdown).
During a recession/bear market bond yields, and bond spreads will increase significantly and stay elevated for a long time (since 1926 the average bear market lasts about 36 months).
This is why maintaining its IG credit rating and deleveraging rapidly is of paramount importance to Broadcom's long-term financial flexibility as well as dividend safety. The good news is that Broadcom's fast-growing river of free cash flow (nearly 40% FCF margin in fiscal 2018) will allow it to easily pay down debt.
Assuming that Broadcom is able to hit even 50% of its expected growth rate in 2019, then it should generate about $8.5 billion in FCF this year, with about $4.25 billion left over after paying the current dividend. Moody's doesn't expect the company to use all that retained FCF to pay down debt but within 12 to 18 months it does expect the total debt/EBITDA to fall into the low threes. Moody's says that once the leverage ratio falls under 3.0 (considered a safe level for most corporations) it will upgrade Broadcom's rating to the equivalent of BBB.
And Broadcom's large retained cash flow (assuming a constant payout ratio as is management's new policy) should allow the company to repay all CA Tech related debt within less than five years.
But investors have to remember that this rosy outlook for AVGO's balance sheet assumes several things
Founded in 1930 Texas Instruments is one of the oldest pioneers in computer chips with company engineer Jack Kilby literally inventing the integrated circuit in 1958. Today TXN is the world's largest maker of analog and embedded chips which convert physical data (like temp, sound, and pressure) into digital signals that can be read by electronics.
Nearly 90 years of dedication to smart and focused R&D has allowed the company to acquire over 45,000 patents covering more than 2,000 chips it sells to over 100,000 customers around the world.
Unlike many semiconductor makers, TXN is mostly focused on organic growth and R&D, with its last major acquisition being National Semi in 2011. Basically, Texas Instruments has managed to become famous for some of the industry's best capital allocation.
The importance of disciplined capital allocation can't be overstated because it's literally the only thing that allows for safe and steadily rising dividends in a cyclical and capital intensive industry. Texas Instruments has a long-term goal of delivering 30% FCF margins (among the highest in corporate America) and returning 100% of free cash flow to investors, either via dividends (50% payout ratio) or opportunistic buybacks.
Remember that FCF is what's left over after running the business and investing in future growth. TXN isn't afraid to spend freely when it believes it can make great returns on investment. That's why capex as a % of revenue is now going from 4% to 6% as the company pursues its top opportunities related to the 5G future.
And investors can have confidence that spending will likely pay off, given that Texas Instrument's ROIC has not just historically been among the highest in the entire tech sector, but among the best in all of corporate America.
The key to TXN's amazing success over the past decade is the smart focus on maximizing organic growth. The cash returns to shareholders have been weighted towards opportunistic buybacks made possibly by the inherently cyclical nature of the industry and a volatile share price. Acquisitions have been limited to small bolt-ons, forgoing riskier splashy deals like Broadcom prefers (and has proven a master of).
TXN's focus has been away from fast-changing industries (like phone chips) and towards segments like industrial and automotive, where chip designs last longer and development costs can be amortized for several years thus boosting profitability.
Better yet, those analog chips designed for industrial and automotive markets are mission critical, with safety and reliability taking precedence over price. Yet thanks to its economies of scale Texas Instruments is able to make 68% gross margins on those chips and still maintain industry-leading market share (wide moat).
The factories (which can cost $8 billion to construct) also create a competitive advantage since few smaller rivals can afford to invest such fortunes into high-tech manufacturing facilities that can take many years to scale up. For example, TXN's 300 mm wafer plants (that make the industrial and automotive chips) are scaling utilization at 10% per year and hit 60% in 2018. That's after being online for several years already, meaning that TXN's strong profitability should continue to increase as utilization keeps climbing.
TXN's analog chip sales have been growing at 8% annually over the past decade and gaining about 0.35% global market share each year, a trend it expects to continue.
That's what's likely to keep the company FCF/share growing at double-digits as it has since 2004 when it began its current capital allocation strategy.
That's the same capital allocation plan that has made TXN one of the most FCF rich companies in America and among the 3% most efficient in terms of returns on invested capital.
And while many companies buy back shares, TXN management has proven they know how to do so opportunistically which has resulted in a 45% reduction in share count over the last 14 years. That includes buying back almost 4% of shares in 2018, mostly during the two corrections when TXN was highly undervalued and the buybacks were most accretive to FCF/share.
That large reduction in shares has helped fuel that double-digit FCF/share growth which in turn has led to what income investors care about most, sensational and safe long-term dividend growth.
Since it started paying a dividend, Texas Instruments has raised its payout (for 15 straight years) at nearly 27% CAGR and 24% last year. While that torrid growth rate isn't sustainable forever, even if it grows just double-digits in the coming years that will be enough to richly reward long-term income investors.
But while TXN may be the ultimate SWAN dividend growth stock in this industry that doesn't mean that shareholders shouldn't be comfortable with extreme volatility like we saw in late 2018. That volatility will repeat itself in the future, especially during recessions.
Texas Instruments has proven itself a master of shareholder-friendly capital allocation and is a true SWAN stock. But while the dividend may survive and keep growing through a recession investors have to remember this company's free cash flow is highly cyclical and economically sensitive.
And while the risks of a recession beginning this year remain low, with about a 20% probability of a downturn beginning within the next nine months, current economic trends are pointing to a possible recession beginning in 2020 or 2021.
Specifically, certain key economic leading indicators have turned downwards to an extent that the New York Fed's real-time GDP growth model recently cut its Q1 growth forecast in half. Now it's important to not panic and remember Q1 is usually the slowest growth quarter of the year.
And most of the surveys these reports are based on cite trade uncertainty as the leading cause of slowing orders and investment. Thus a trade deal in March could easily help boost growth in Q2 and beyond, especially if China ends up rapidly ramping up US imports (they offered to import $1.2 trillion over several years).
However, when it comes to the most accurate recession predictor ever discovered, the 10y-3m yield curve (what banks use to predict recessions and set lending policies) the trend continues to point to bad news on the economic front.
The yield curve is currently at just 20.5 basis points, and if its long-term decline trend holds, then it will likely invert in six to seven months (July or August 2019).
Based on historical precedent that would mean a recession might begin in 15 to 19 months. What about a bear market, where high beta semiconductor stocks usually take it on the chin?
Well, the good news is that historically stocks, in general, keep rising even after an inversion, ignoring the economic warning signs and rising significantly higher. BUT we can't forget that this time might be different given that the yield curve is now much more famous than it was in the past and so the forward-looking stock market might peak a lot sooner after the "banker's yield curve" turns negative. After all, part of the reason for the December crash (a 17% collapse in three weeks) was the media hyping the meaningless inversion of insignificant yield curves like the 5y-3y and 3y-2y.
While I'm confident that all three of these companies will be able to maintain and possibly grow their dividends (slowly) during the next recession, conservative income investors need to keep bear markets in mind. That's especially true if you are relying on something like the 4% rule where you fund living expenses by selling shares each year.
Since 1926 the average bear market lasts about three years (from peak to peak) which means that it's a good idea to have three years worth of cash equivalents (like T-bills) to tide you over during bear markets. Bonds are a good thing to have as well, in case stocks take longer to recover (the record is 69 months post-1973 bear market).
As you can see cash equivalents and long-term US Treasuries do well during bear markets, which is why the right asset allocation (mix of stocks/bonds/cash) is crucial to a sleep well at night or SWAN retirement portfolio.
The last thing you want to do is be forced to sell great dividend stocks at rock bottom prices during a bear market. Which is why having sufficient cash and bonds (which appreciate during recessions due to falling interest rates and a flight to safety) is a great idea for most conservative income investors.
Founded in 1980 in California, Lam Research designs and manufactures, semiconductor processing equipment used in the fabrication of integrated circuits. The company specializes in high tech areas like nanoscale applications enablement, chemistry, plasma, and fluidics advanced systems engineering. and a broad range of operational disciplines.
These enable its customers to build smaller, faster, and better performing devices that are used in a variety of electronic products, including mobile phones, personal computers, servers, wearables, automotive devices, storage devices, and networking equipment.
Basically, Lam is a leader in chip fabrication tech, including in etching and deposition machines that are how modern computer chips are created. About 80% of its revenue is tied to memory chips (solid-state NAND and DRAM) but the company has been diversifying into other areas in the past decade. That includes via smart M&A deals like
Part of that diversification plan involves the Customer Support Business Group or CSBG. This provides annuity-like recurring cash flow from Lam servicing the equipment it makes and installs, and helps smooth out sales over time in an otherwise highly cyclical industry. CSBG also provides refurbished equipment for customers on a budget who don't need the latest and greatest tech (also a great business to have when industry capex budgets get squeezed).
Thanks to those well-executed acquisitions and steadily growing service installed base is why Lam Research has been able to grow its sales at 25% CAGR over the past five years, while a higher margin product mix and improved efficiencies allowed adjusted EPS to grow 50% CAGR.
The key to Lam's success has been heavy but focused investment in R&D (about 11% of revenue), including $4.7 billion worth over the past five years. That's helped maintain Lam's lead in this rapidly changing industry and post impressive 2018 results including:
Best of all, like many Semiconductor companies, Lam has become a dividend growth dream stock, with some of the fastest payout growth in corporate America.
That's part of management's "plan to return at least 50% of free cash flow to our stockholders over the next five years." Buybacks will be a big part of that cash return plan, with Lam recently authorizing a $5 billion buyback that was one of the big reasons its shares shot up after its latest earnings report beat low expectations (at the time it was enough to repurchase 20% of shares).
That shows the company's confidence in its strong balance sheet ($3.9 billion in cash which is enough to fund operating expenses for two years), that should allow this dividend growth blue-chip to ride out any inevitable future industry downturns.
Basically, Lam Research is one of the industry leaders that will help to power the tech-driven economy of the future. It's semiconductor manufacturing and service tech is going to allow for the advanced chips that will lead us into a 5G and data-centric world dominated by cloud computing, AI-based real-time data analysis, and the internet of things.
But just as with all semiconductor companies, there are plenty of risks to be aware of.
Because of Lam Research's niche, it's revenues and cash flow are not just cyclical and economically sensitive, but also highly focused among key customers. About 70% of total semiconductor equipment demand comes from just five key buyers and LRCX has to compete with major players like Applied Materials (AMAT), Hitachi (OTCPK:HTHIY) and Tokyo Electron (OTCPK:TOELF). Lam has five customers that each accounted for over 10% of 2018 sales:
Semiconductor capex is expected to decline in 2019, by the mid to high teens according to management's latest guidance. That is why analysts expect a 22% decline in adjusted EPS for LRCX in 2019. But while 2019 is likely to be a single bad year (Morningstar expects growth to resume in 2020) during recessions sales and earnings can fall off a cliff. While the company's fortress-like balance sheet will allow it to ride out such downturns, the share price is going to be highly volatile and crash hard and fast during such times.
And there is another big risk that's baked into the business model you should be aware of.
Lam Research Sales By Region
Of these three companies, LRCX has the most exposure to currency risk and tariffs, with China accounting for double the sales it generates in the US. In total 93% of sales are from outside the US which explains why Lam's share price has been booming so strongly as positive trade news has rolled in.
But that means that a stronger dollar can be a major short-term headwind for the company because it reduces US profits and cash flows. That hasn't stopped the company's dividend from growing like a weed BUT that's only because the payout ratio has been expanding off a very low base and eventually the cyclical nature of its industry when combined with currency fluctuations will require much slower dividend growth than in the past.
This is why it's so important to buy semiconductor companies at opportunistic times when their yields are high enough to lock in not just great income but likely market-beating total returns as well.
Ultimately what drives my investing recommendations and portfolio buys is a company's dividend profile which consists of yield, payout safety, and long-term growth potential. Combined with valuation this is what tends to determine total returns over time.
|Company||Yield||TTM FCF Payout Ratio||5 Year Forecast Cash Flow Growth||Expected Total Return (No Valuation Change)|
Valuation-Adjusted Total Return Potential
|Broadcom||3.8%||40%||10.1%||14.9%||15.7% to 16.7%|
|Texas Instruments||2.9%||42%||10.0%||12.9%||12.7% to 14.1%|
|S&P 500||1.9%||33%||6.4%||8.3%||3% to 8.3%|
Today all three semiconductor firms offer a superior yield to the S&P 500 but more importantly those dividends are safe. That's both due to safe payout ratios and good to great balance sheets which ensure low cost fixed rating borrowing costs far below their returns on invested capital.
But where these companies start to diverge is in expected long-term growth. Analysts currently expect TXN and AVGO to continue delivering double-digit cash flow growth while Lam's is expected to be just half as large.
That means that LRCX is going to have a hard time beating the market from current valuations while Texas Instruments and Broadcom should easily exceed the modest 3% to 8.3% most analysts expect the S&P 500 to deliver over the coming five years.
In fact, when we adjust for valuations TXN and AVGO are likely to double or even triple the market's probable future returns, all while delivering superior current yields as well. That makes them the clearly better buys.
While most stocks have had a strong run since the December lows, Lam Research has been on fire. That explains why I consider it a "hold" while AVGO and TXN are still "buys" today.
That's based on two valuation methods I typically use. The first is dividend yield theory or DYT. This was popularized by asset manager/newsletter publisher Investment Quality Trends in 1966 when that's the only approach it began using to recommend blue-chip dividend growth stocks.
After decades of beating the market (and with 10% lower volatility to boot), you can see why DYT is what I trust with my own money and with my reader recommendations.
DYT compares a stock's yield to its historical yield. As long as nothing drastic has changed, yields tend to mean revert around a relatively stable norm that approximates fair value.
|Company||Yield||5 Year Average Yield||Discount To Fair Value||Upside To Fair Value||Long-Term Valuation Boost|
At first glance, LRCX might appear the most undervalued stock of the three since its yield is 85% above its historical average. But remember that Lam Research hasn't been a dividend stock very long and that more than 100% dividend hike in 2018 is skewing those results. In contrast, Broadcom and Texas Instruments have long histories of rapid dividend growth that makes those fair value yields far more accurate.
To confirm this I also turn to Morningstar's three-stage discounted cash flow models, which use some of the most conservative growth estimates on Wall Street.
|Company||Morningstar Fair Value Estimate||Discount To Fair Value||Upside To Fair Value|
Long-Term Valuation Boost
Morningstar's valuation models typically show smaller margins of safety than DYT but the point is that Lam Research isn't nearly as undervalued as it appears using a historical yield analysis.
Rather it's about fairly valued, as is TXN according to Morningstar, with Broadcom being slightly undervalued. Given the industry-leading positions each company holds, and great long-term growth potential, I'm happy to recommend buying at fair value, at least for AVGO and TXN.
That's based on my personal valuation scale which lists Broadcom and TXN as buys when averaging their valuation estimates with Morningstar's. Lam Research, using just Morningstar's valuation estimate would be a buy EXCEPT that its slow medium-term growth outlook means it can't deliver the double-digit total return potential that I need to see before recommending an active buy.
Thus, from current prices, I consider Broadcom and Texas Instruments solid long-term buys but LRCX is best watchlisted to wait for a better price (I'm personally waiting for a 3% yield to buy more).
Semiconductor companies like Broadcom, Texas Instruments and Lam Research are all cyclical companies, who are especially sensitive to the economy and trade conditions. Thus it's no surprise that during December's recession scare, all three fell especially hard.
However, with the strong recovery rally we've seen, fueled in large part by what appears to be the imminent and permanent end to the US/China trade war, all three dividend blue-chips have stormed higher.
As a value-focused income growth investor, it's important to remember that patience and discipline are critical to achieving strong long-term returns. With the easy money now having been made, investors should put top quality tech dividend growth stocks like these on their watchlists but make sure to wait for the right price.
That means waiting for a point where a company's margin of safety is high enough to compensate for its short and long-term risk profile, AND likely to help generate the kind of total returns you're personally looking for. From today's prices, I can still recommend Broadcom and Texas Instruments as decent dividend growth "buys" but Lam Research is a "hold".
That's not because it's crazy expensive by any means, but about fairly valued. However, in terms of delivering the kinds of market-beating double-digit total return potential that I like to recommend for readers (and buy for my portfolios), Lam is currently out of active recommendation/buying range.
Texas Instruments and Broadcom are still solid choices for new money today but don't forget that they are still cyclical and economically sensitive companies, and a recession may be coming in 2020 or 2021. In other words, while you'll likely do well buying them today over the long-term, you still need to be prepared for high volatility in the coming years, as is the case with all semiconductor companies.
Don Kaufman delivers what readers are calling 'HIS BEST YET!' In this exclusive Guide, Don will give you ALL the secrets he's taught millions of other traders to help guide them along in their successful options trading journey...
Now, this is NOT for those who only want to make a HALF attempt...nope...this is ONLY for those serious about becoming a better trained, more profitable, and long term options trader!
If that's YOU...Download Your Copy below: