AVGO's Selloff: Is the Margin Panic Already Priced In?

The market's reaction to Broadcom's December report is a classic case of expectations versus reality. The company delivered a clear beat, with revenue of $18.02 billion and adjusted EPS of $1.95 that topped estimates. Yet shares plunged, sinking nearly 14% since the Dec. 11 report. The disconnect is stark: the beat was overshadowed by management's warnings of a near-term margin squeeze and 2026 tax headwinds. This is the core conflict.

The stock's decline reflects a rational reassessment of near-term profitability. Management explicitly guided for a gross margin to fall 100 basis points next quarter, citing a higher mix of AI system revenue. This shift-from selling discrete chips to integrating them into systems with third-party components-boosts top-line growth but compresses gross margins. The market is pricing in this trade-off, viewing it as a tangible near-term cost to the AI-driven expansion story.

The debate now centers on whether this is an overreaction or a justified recalibration. On one side, the bull case argues that AI demand is structurally powerful, with a $50 billion custom AI chip revenue target for 2026 and a massive backlog. On the other, the bear case highlights that the company's elevated valuation (PE ratio of ~85) leaves little room for error, and the margin pressure is a real headwind. The selloff suggests investors are leaning toward the latter view, at least for the near term.

The key question is the asymmetry of risk. The market has already priced in significant margin pressure for Q1 and 2026. If Broadcom's operating margins hold up as management expects-because higher revenues spread over fixed costs-then the worst may be over. But if the margin compression proves deeper or more prolonged, the current price may still be too high. For now, the sentiment gap is wide, and the stock's path hinges on whether the AI growth narrative can quickly reassert itself above the noise of near-term profitability concerns.

Margin Reality: Pressure vs. Pricing Power

The market's margin panic is focused on a specific, near-term shift. Broadcom's full-year 2025 gross margin expanded to around 77.3%, a testament to its pricing power and operational excellence. Yet management's guidance for the first quarter points to compression, with the gross margin expected to fall 100 basis points from the recent 76-77% range. The primary driver is a change in revenue mix. The company is increasingly selling AI "systems"-combining its high-margin chips with third-party components like memory-rather than just discrete silicon. This strategy boosts total revenue but lowers the overall gross margin because those external components add cost. The key question is whether this is a temporary mix shift or a sign of structural weakness. The evidence leans heavily toward the former. Management explicitly states that while gross margins will deteriorate, operating margins will only come down slightly in 2026. This is because the company's operating leverage is extreme. In the last quarter, quarterly operating income reached about $7.7 billion, up more than 50% year-over-year. This means the massive increase in AI system revenue is still flowing through to the bottom line, as higher revenues spread over a large base of fixed costs. The market is pricing in the gross margin hit, but the operating margin guidance suggests the core profitability engine remains intact.

Furthermore, the AI segment itself is a high-margin powerhouse. At its reported gross margin of close to 78%, the $8.2 billion in AI semiconductor revenue expected for Q1 alone could generate roughly $4 billion in operating income per quarter. This creates a powerful earnings floor that can offset any dilution from the system sales mix. The demand for this custom AI silicon is also highly visible, backed by a committed, contracted backlog that stretches into 2026. This isn't speculative growth; it's revenue already on the books.

In reality, the margin pressure is a trade-off for scale. Broadcom is choosing to capture more of the AI infrastructure value chain, even if it means a lower gross margin percentage. The market's selloff suggests investors are overly focused on the headline gross margin number, missing the more important operating margin and cash flow picture. The company's proven track record of cost control and its ability to protect operating leverage indicate this is a managed transition, not a breakdown. The risk is that the mix shift accelerates faster than expected, but for now, the operating leverage story provides a strong buffer.

Valuation and the Priced-In Asymmetry

The current valuation tells a clear story: the market is pricing in a flawless execution of the AI growth plan. Broadcom trades at roughly 33 times this year's expected earnings and 16 times expected sales. This premium is not a bet on the present-it is a bet on the future. It assumes that the company will navigate the near-term margin mix shift without a lasting hit to profitability and that its $50 billion custom AI chip revenue target for 2026 materializes as forecast. The selloff has brought the stock down from its highs, but it has not reset the valuation to a level that discounts significant risk.

Analyst sentiment provides a crucial counterpoint to the market's panic. In the week following the earnings report, seven firms raised price targets, with no downgrades. This is a powerful signal that the consensus view sees the selloff as a temporary margin reset, not a fundamental breakdown. The raised targets, with the median near $450, imply substantial upside from current levels. This bullish stance is rooted in the structural AI thesis: the company's locked-in supply deals, massive backlog, and hyperscaler relationships are seen as durable growth drivers that outweigh near-term noise.

The key risk/reward asymmetry is now defined by this valuation. The risk is that the margin pressure persists longer than expected or deepens, forcing a re-rating of the growth premium. This could be triggered by a slowdown in AI infrastructure spending, competitive erosion in custom chips, or the geopolitical headwinds highlighted by the recent stock slide. The reward, conversely, hinges entirely on the AI revenue scaling as forecast. If Broadcom can demonstrate that its operating leverage holds and that the system revenue mix is a temporary, high-margin growth phase, the current price may look cheap in hindsight.

In practice, the market has already priced in the near-term margin squeeze. The stock's decline has compressed its valuation, but it remains a premium multiple. The asymmetry favors the bulls if execution is good, but the bears have a clear path to disappointment if it falters. For now, the priced-in view is one of cautious optimism, waiting for the company to prove that the AI growth story can overcome its own profitability trade-offs.

Catalysts and What to Watch

The path forward for Broadcom hinges on a few clear catalysts. The immediate test is the first-quarter report, expected in late March. Investors will be watching for two key metrics: the actual gross margin performance against the guided 100 basis point compression, and the trajectory of AI system revenue. The company has a custom AI chip revenue target of $50 billion for 2026, and the Q1 results will show whether that growth is accelerating as forecast. Any deviation from this plan would directly challenge the bullish thesis that the margin pressure is a temporary mix shift.

Beyond the quarterly numbers, the health of Broadcom's backlog and its relationships with hyperscalers are critical. The company has locked in supply deals, like Samsung's HBM supply for Google AI chips, and is in discussions with Microsoft on custom AI designs. Updates on the size and visibility of this backlog, and any new announcements of hyperscaler partnerships, will provide concrete evidence of sustained demand. The market is pricing in these relationships as a given; any sign of strain would be a major red flag.

Geopolitical developments, particularly China's stance on U.S. semiconductors, represent a broader, external catalyst. The stock recently fell on news that China may not be taking Nvidia's H200 chips, a move that could signal a broader cooling in AI infrastructure spending in the region. Since Broadcom's connectivity chips are vital for linking AI processors, this creates a direct headwind. The resolution of this uncertainty-whether China's restrictions ease or tighten-could provide a significant tailwind or headwind for the entire AI infrastructure narrative.

In summary, the near-term catalysts are binary. The Q1 results will confirm if the margin squeeze is contained and AI growth is on track. Backlog and hyperscaler news will validate the demand story. And geopolitical clarity on China will remove a major overhang. For now, the market has priced in the near-term noise. The next move will be driven by whether the company's execution can prove the consensus view right.