Broadcom's Margin Warning Spooked Wall Street-But Cash Flow Could Still Win

Investors are feeling more uncertainty around semiconductor giant Broadcom (NASDAQ: AVGO) than they have in quite a while.

Shares are down nearly 14% since the company reported its fiscal Q4 2025 earnings report on Dec. 11.

Broadcom’s post-earnings sell-off is really a debate over one question: will the company’s fast-growing AI “system” revenue dilute margins—or expand operating profit and free cash flow anyway?

The answer could determine whether the sell-off is a short-term sentiment hit or a broader reassessment of Broadcom’s longer-term earnings power.

Gross Margin Concerns Weigh on AVGO Stock

The primary issue plaguing Broadcom shares after earnings was management's gross margin outlook.

Next quarter, Broadcom expects its gross margin to fall 100 basis points due to a higher mix of artificial intelligence (AI) revenue. With a 78% gross margin last quarter, management signaled that margins may continue trending lower throughout 2026 as Broadcom increases AI system shipments.

Instead of simply selling its chips, Broadcom is combining them with third-party components, such as memory and delivering them to customers as systems. This strategy increases total revenue but lowers overall margins because those third-party components add costs that Broadcom passes on to customers.

It also leads to concerns about the profitability of Broadcom’s $73 billion AI backlog, which it expects to convert into revenue over the next 18 months. Analysts believe Broadcom’s orders from Anthropic, totaling $21 billion, are system sales. That is certainly a significant portion of the company’s AI backlog, adding weight to margin-related concerns.

However, Broadcom emphasized that while gross margins will deteriorate, operating margins will only come down slightly in 2026 because the company can spread its higher revenues over a larger base of fixed costs. Ultimately, operating margin is more important than gross margin, as it correlates much more closely with free cash flow (FCF) generation. Thus, it is a very positive sign that Broadcom believes it can protect its operating margin.

Lower Margins Can Still Mean Higher Profits

Until recently, Broadcom had not engaged in system sales on a large scale. Although investors typically dislike margin deterioration, companies will often pursue new lines of business that have this effect. Entering lower-margin markets often drives revenue growth that offsets thinner margins—a tradeoff that Broadcom believes will play out in 2026.

There are also clear reasons why, in the case of Anthropic, it would make sense for Broadcom to pursue system sales. Broadcom is not developing a specific chip for Anthropic. Instead, Anthropic will use tensor processing units (TPUs), which Broadcom originally developed for Alphabet (NASDAQ: GOOGL). Broadcom’s deep experience with TPUs positions it to deliver ready-made AI systems faster than Anthropic could build them independently.

By providing turnkey systems, Broadcom captures billions in new revenue opportunities and strengthens relationships in the fast-growing AI infrastructure market. Still, investors should monitor whether system sales become a long-term structural shift or remain a short-term growth lever. Overextending into lower-margin segments could pressure profitability if not managed carefully.

Despite Uncertainty, the Long-Term Case Remains Strong

Ultimately, the disappointment in Broadcom’s earnings release stems from one key dynamic: the introduction of uncertainty.

In not knowing how far Broadcom's gross margins could fall, markets ran for cover.

However, what investors do know is that Broadcom’s demonstrated success in the AI chip design space is second only to NVIDIA (NASDAQ: NVDA).

They also know Alphabet solely used TPUs to develop its highly advanced Gemini 3 model, and that analysts still see big-time upside in this stock.

Amid the uncertainty, these factors support the continued bullish outlook on Broadcom shares.

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The article "Broadcom’s Margin Warning Spooked Wall Street—But Cash Flow Could Still Win" first appeared on MarketBeat.