Broadcom's Software Push Will Drive Margin Expansion

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Before technology stalwart Broadcom (NASDAQ: AVGO) began its push into infrastructure software and was simply a chipmaker, it enjoyed best-in-class gross margins. In fact, in the company's fourth quarter of its fiscal year 2018 -- the last quarter that didn't include results from its acquisition of mainframe software specialist CA Technologies -- it enjoyed a non-GAAP gross margin of 68.4%. But that might not be the best it gets.

Software inherently carries higher gross margin than hardware, since producing hardware requires significant materials and manufacturing costs that software distribution simply doesn't. Here's why I think that Broadcom's software efforts -- which will fall under the company's infrastructure software reporting segment -- will have the effect of boosting Broadcom's gross and net profit margins.

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The gross margin impact isn't over yet

Broadcom enjoyed a huge spike in its gross margin in the first quarter of its fiscal 2019, to 71.4%, something that's undoubtedly due to the mix-in of the CA Technologies business during the quarter. It's also worth noting, though, that CFO Tom Krause said that the increase was partially due to a shift in the mix toward the non-wireless parts of its semiconductor business.

While the integration of the CA Technologies business should lead to a structurally improved gross margin for the company, I don't think that the increase in that percentage stops here. It'll certainly take some time for Broadcom to fully digest its acquisition of CA Technologies. For instance, Broadcom plans to dramatically reduce the operating expenses associated with the business to juice its overall profitability. But I don't think it'll be too long before we see Broadcom augment its infrastructure software business with additional acquisitions.

Remember that back on the company's earnings call in December, Broadcom CEO Hock Tan said the following: "With the acquisition of CA, we will grow this revenue stream and build upon it through acquisitions consistent with our business model."

What I expect to see is that, over time, the company's CA Technologies business will deliver growth -- after whatever reset Broadcom's restructuring of the business causes for its revenue -- and that CA Technologies will be augmented with other related software acquisitions. This should have the effect of increasing Broadcom's revenue from software as a percentage of its total revenue, giving its gross margin a lift.

Boosting the bottom line

One thing you need to remember is that a company's overall profitability isn't just a function of gross margin; it's a function of operating expenses, too. If a company has extremely high gross margins but spends too much of that gross profit paying for product development (research and development) and things like marketing, then it can still have weak or even negative profitability.

Broadcom made it clear that it plans to significantly slash CA Technologies' marketing, general, and administrative costs to improve the overall profitability of the business. I expect that when Broadcom gets around to making additional acquisitions in support of its infrastructure software business, it'll take similar actions to right-size its cost structures, too.

Indeed, on the company's March earnings call, Krause said that, "[We] continue to see the opportunity to improve gross margins, which directly translates of course into our operating margins and our free cash flow conversion."

What does this mean for shareholders? Growing free cash flow, which should ultimately mean dividend increases. This is something that should be very attractive to many long-term investors.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool recommends Broadcom Ltd. The Motley Fool has a disclosure policy.