These past few weeks, Seeking Alpha has been inundated with intense debate and new members sharing opinions regarding the rise of Tesla Motors (TSLA). Despite the difficulty in valuing the stock, the one clear fact is that electric vehicles are moving from niche to mainstream.
Why jump ahead and predict markets in 2030 when there is another quiet revolution that is changing the way we travel from A to B. I'm not even talking about self-driving cars, faster trains or teleportation; instead this article looks at the slow evolution of cars from mechanical beasts to smart machines. Take the S-Class Mercedes; far from being a motor with four seats, it exhibits 20 million lines of code and contains nearly as many ECU's (Electronic Control Units) than an Airbus A380!
The point I am trying to make is that as cars get more complex and premium technology diffuses into the mass market, the companies that make this technology possible will grow at a significant rate. According to IC Insights, the Automotive Semiconductor industry is currently worth $19.6bn growing to $27.3bn in just three years. Not enough for you? Let me add that electric vehicles are built with nearly 3x as many semiconductors as comparable combustion vehicles and IHS believes that by 2020, this segment of the market will add another $7bn of semiconductor demand.
As you can imagine, semiconductors in vehicles are different from those operating your mobile phone. For one, cars tend to be an awful lot bigger than mobile phones meaning that size isn't a problem. Producers don't need to invest in bank busting machinery such as the upcoming $130m EUV - lithography equipment. In fact, the smallest auto semiconductors are printed using 90nm technology as opposed to the 22nm we currently see with mobile processors. In the vehicular semiconductor market, production is both easier and cheaper and end users require partners to offer strong pricing, a complete range of offerings and the ability to supply through the 7-year vehicle cycle (from planning to selling). Of the stocks most set to benefit, there is one that sticks out like a sore thumb, Infineon (OTCPK:IFNNF).
Revenue is $m
Since last year, Infineon's share price has dropped from $9.50 to $8.50. FY12 revenues came in at only $5,075m with Free Cash Flow at -$325m compared with FY11's $5,196m and +$338m. The sharp drop in the bottom line comes from Infineon's well documented capacity issues. Despite a 51% growth in revenues between 2009 and 2010 and 21% between 2010 and 2011, the company hit a capacity wall. For almost 7 quarters extending either side of 2011, the operation was running at 100% utilization. In 2010, the decision was made to upgrade Infineon's capacity and so after spending $537m on Capital for that year, expenditures doubled to $2,275m over the next two years.
They say timing is everything and to be brutally honest, timing isn't Infineon's strong suit. 2012 revenues were in line with 2011 and this year isn't expected to be much better. Net income in 2012 nearly halved (from $968m to $561m) and is expected to half again, giving a 7-10% EBIT margin for FY13. Despite the company halting nearly $1.3bn of CapEx related to a new 300mm wafer plant (will allow a 30% reduction in cost per die), the company only utilizes 80% of current capacity meaning that they can cope with up to $8,004m of orders for any consequent financial year.
As a new investor, you have effectively allowed other investors to 'build the factory' while your equity is left to reap the benefits of any increase in orders. All the upgrades (bar the 300nm factory) have been completed and are currently depreciated on a straight line basis despite being idled. It is therefore unlikely that the firm will need to invest in capital in the mid-term meaning all that sweet free cash flow can flow straight to investors. Furthermore, because of capital intensive nature of the cost base, the firm has extremely high operating leverage meaning that 71% of additional revenue will flow down to the EBIT line!
Var Cost per Euro
**Financial reports in Euro's
The Tax Issue
Over the past few years, the company has been a poster child for inefficiency and strategic mistakes and between 2001 and 2009, the company was continually loss making (except for one year of +$53m). Still, as a new investor you effectively receive all the benefits without enduring the consistent underperformance. I know it's hard to consider that nine loss making year can lead to benefits but the company has managed to rack up nearly $3,900m of tax loss carry-forwards!
Consider 2012; the company owed $61m in tax (10% ETR) and ended up receiving $3m in cash! Of course, they cannot write off 100% of the tax bill every year (60% can be eliminated in normal operating years) but this treasure trove means that the company will not be paying standard taxation levels for the foreseeable future.
Once again, instead of taxes going to the tax-man, they will instead be flowing into the investor's pocket!
Using a blue-sky scenario, where the company can ride the complementary economic trends to full capacity, the Free Cash Flow for this semi-conductor company is quite unbelievable.
Tax @ 20%
Chg in NWC
Of course, the first year of full production will see investment in working capital but the following year FCF yield looks like one out of a Telco stock.
Being a market leading conglomerate that is finally finishing with a decade long restructuring with exposure to huge potential markets means that valuing Infineon is difficult. Let me further complicate things by adding that this is a cyclical stock with an unknown cycle length. I have therefore taken two approaches:
Approach one (Price Target $9.65) takes a three-year cycle and a cycle average as terminal value. DCF assumptions are a 10% WACC and a 3% long-term growth rate.
Approach two (Price Target $10.15) uses the three-year cycle and grows the free cash flow at 10% per cycle, using a mid-cycle average as terminal. It is worth noting that halving the cycle growth to 5% reduces the price target to $9.64.
|as % of Rev||22%||23%||24%||23%||21%||22%|
|Tax Actually Paid||-78||-13||-83.2||-83.2||-83.2||-83.2|
|Non Cash Adj|
|Share Based Payments||2.6||2.6||3.9||3.9||3.9||3.9|
Even with a 15% upside to the DCF target, there is an added bonus in the 300mm ramp up which allows the firm to produce 2.25x the number of chips under the same process, dropping the cost per chip by 30%. Looking at the top half of my DCF, you can see that revenue plateaus at $6,126 and this is because the 300mm facility requires nearly $1,300m of investment (giving roughly $1,620m of extra capacity). Because the fixed costs of this new facility are higher than other facilities using the cheaper 200mm wafer machines, utilizing only a small portion of this extra capacity will actually reduce segmental margin in the short term. It is therefore my assumption (which has been confirmed by the IR) that investment won't take place until they are certain this capacity can be used.
Too Long, Didn't Read
For those of you that enjoy your stock ideas in Summary format, let me round up why I think this stock is a must have for investors who are bullish on the economy over the next two years.
1. The company's main business is semiconductors for the automotive industry meaning that growing car ownership increases their market size, while growing semiconductor content in cars and increasing electric vehicle ownership provide added multiples for top line growth.
2. The company has already done all their capex and more meaning that FCF going forward will be given to shareholders.
3. The firm has a huge tax credit portfolio making sure they do not have to pay real rates of tax for the foreseeable future.
4. Extremely long product cycles make revenues more predictable.
5. 15% upside with added upside if the economy or underlying secular trends are stronger than expected.
I consider myself to be a skeptical person who enjoys playing devil's advocate and when looking into a stock I try to approach the same company as both a long and short. By spending adequate time thinking about what I hate about the company, it allows me to build a more balanced approach as confirmatory bias is a real problem for us humans so without further ado…
Japanese competition is by far my largest worry. It cannot be ignored that Abenomics have given an extremely large boost for Japanese exporters and YTD, the USDJPY has strengthened (JPY weakened) by 16%. Infineon currently operate on a 36% gross margin (the auto business will likely be slightly larger). By contrast, Renesas (the main Japanese player and world number 2) enjoys a 34% gross margin.
By keeping USD pricing the same, Renesas can improve their EBIT margin by 16% or compete more aggressively to tear market share away from Infineon, while also enjoying incremental improvements to margin.
This is a significant threat to operations, and having outlined these concerns with the company, it seems Infineon believe that their Japanese competitors will keep prices the same and absorb the currency effects into their financial performance. Why won't Renesas attempt to attack Infineon on price? Beyond the price war problem it seems that because of the Japanese earthquake and the long stagnation of the Japanese economy, Renesas hasn't seen a net profit since 2007. Furthermore, the money required to rebuild their operating facilities post the earthquake has led to a net debt-to-EBITDA of 148% (compared with Infineon's 3%). This means that FCF is likely to be used for paying down debt as opposed to paying out stockholders.
Moving away from the Auto Semi sector, the Industrial Power Control (IPC) sector (16% of revenue, negative margin) is a business line that is much more vulnerable to Japanese competition (Fuji Electric and Mitsubishi). Unlike Renesas, these firms are both sizeable and profitable and considering that the majority of IPC revenue comes from the renewable power industry (heavy presence in China) they also have a geographic advantage.
In this author's opinion, it is likely that Infineon will be pushed down the rankings in IPC but considering the business is currently loss making and the industry struggling, I do not believe that this sector adds much value to the business.
Aside from the Yen risk, we have to look at the risk to a downturn in the auto-industry as a whole. The current geographic trends consist of fast past growth in China (where only 1 in 10 own a car) and sluggish European demand (as shown by today's German Vehicle registration data, which dropped 9.9% year-over-year).
Looking at Daimler (OTCPK:DDAIY), 35% of sales come from Germany, while 21% are form Asia. It is also worth noting that Asia sales have increased 13.5% YoY compared to Western Europe which stayed relatively flat.
Despite luxury Marques expanding sales rapidly in Asia, the cold hard truth is that they still rely on Western Europe, which looks set to jump in and out of recession over the next few years. Closely following European registration and sales data is therefore vital.
When to Invest
Despite the recent equity market sell-off, Infineon has remained strong and is currently trading at $8.50 (current range is between $8.10 and $8.90). I would feel comfortable putting money at this level because outperformance during market correction is a good sign of institutional interest. Furthermore, the most recent quarter upgraded guidance at both the sales and segment level with other analysts seeing further upside.
If you require further evidence of resurgence, it is worth following the company's listed customers who are not the car manufacturers but the component manufacturers. I would recommend following the outlook and guidance of the company's stated customers (Autoliv, Delphi, Denso, Hella, Lear, TRW, Valeo) as well as ElringKlinger and Leoni.