Where To Go With Semtech After The Disappointing Quarter

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 |  About: Semtech Corporation (SMTC)
by: Darspal S Mann

Thesis

Semtech Corporation (NASDAQ:SMTC) came out with disappointing quarterly results. The company blamed the poor results on temporary inventory issues at its biggest customer but a closer look reveals that issues are deeper than that. The company is challenged by a weak organic growth rate thus calling for a renewed push for investments in acquisitions and new product development.

This established mid-cap analog semiconductor stock has been outperforming the semiconductor sector in general, partly because of the strong revenue growth rate. But how to approach the stock in light of these developments is the key question.

Problems include losing sockets to competitors, inventory issues at its biggest customers and pricing pressures. Balance sheet, weakened by the loan undertaken in completing the Gennum acquisition, will make things difficult for the company to come out of this lull. Fending off these issues may take more than a few quarters.

Semtech yesterday and today

Semtech is a supplier of analog and mixed-signal semiconductor devices (Integrated circuits or ICs) used in a wide variety of electronics including computer, communication and industrial applications. The company outsources most of its manufacturing to third-party wafer foundries and sub-contractors. Due to the outsourcing, the company does not see huge gross margin swings associated with the production utilization rates of a typical semiconductor company.

Semtech was incorporated in 1960 and went public in 1967. The company was originally focused on serving the military and aerospace markets but transitioned to the commercial markets in the early 90s. Currently, the company focuses on 4 end markets - Enterprise Computing, Communications, High-end Consumer and Industrial. Revenues associated with each are as follows:

Revenues:

2013

2012

Enterprise Computing

15%

9%

Communications

31%

39%

High-end Consumer

29%

35%

Industrial and other

25%

17%

Click to enlarge

Even though Samsung and Huawei each represent more than 10% of revenue, revenue concentration of a single product is low as is typical of an analog semiconductor supplier.

Smartphone business is suffering

The company blamed the weakness in revenues, for the current quarter, to an inventory builds issue at its leading customer (read Samsung), but on closer look, the issues seem deeper than a small quarterly one.

Total exposure to handheld business is close to 17% of the total revenue of the company. For the older models, there is excess inventory so there's limited opportunity to catch up this year. Currently, lead times (time between order and scheduled delivery) for smartphones is fewer than four weeks and low lead times are a big sign of low visibility in the business. For the models, which are ramping up now, the company seems to have lost sockets in the new models and since design cycle is usually six to 12 months, it will be a while to see this business growing back to normal levels.

A lost year

As per Mohan Maheswaran, CEO, smartphone inventory cleanup is to take at least two quarters. Comments from most recent conference call,

Our customers have -- and specifically, one or two of the major ones have told us that actually they had anticipated much stronger demand for some of the new phones and demand just didn't come in, and we really did over ship, I think, in those quarters. So how quickly that inventory is going to bleed off, I think it will take at least Q3, and maybe some of Q4.

But the problem is, after two quarters, seasonal weakness will take over and keep things under pressure for few quarters after that. So net-net, at least a year is lost for the company.

Facing pricing pressures

The company is also facing pricing pressures. For example, with customers adopting 100G technologies, the average selling price [ASP] for the older 40G technology is going down. Faster adoption by customers is accelerating this downward ASP pressure. Revenue mix has moved from 50% of revenue from 40G and the rest from 100G to 70% from 100G. Chief Executive Officer said the following in the most recent conference call about ASP pressures,

I think the other thing is the 40G ASP erosion is probably a little bit more aggressive than we had built into the plans. So with the 40G transitioning to 100G, obviously that helps us from an ASP standpoint, but then you get the offsetting 40G price erosion.

Smartphones are facing these ASP pressure issues too. Revenue opportunity from some high-end phones can be as high as 40 cents and for low-end smartphones, it can be as low as 2 cents. Shift to these low-end smartphones is causing trouble.

Usually, pricing pressure is due to poor design cycles and lack of proprietary business. Distribution business is 39% for the company, which highlights the weakness in the high-margin proprietary business.

Problems are deeper as the company acquires growth

Looking at the organic growth rates for the company for the last two years, it seems quite evident that the growth problems have been there for a while.

Growth rates without the Gennum acquisition

2013

2012

Advance Communication

-4%

25%

Wireless & Sensing

-12%

-3%

Power Management & High Reliability

-10%

-16%

Protection

-5%

7%

Gennum

Click to enlarge

Total revenue growth for 2013 was 20% and out of those total revenues, Gennum was 22%.

Last March, the company acquired Gennum Corporation, a supplier of optical, analog and mixed-signal products and IP used in video broadcast, networking, storage, telecommunications and consumer connectivity applications. For this acquisition, the company paid $506.5 million financed with cash and $347 million of five-year secured term loans.

Balance sheet is dented by the acquisition

2013

2012

2011

EBITDA

$64,781

$114,599

$95,246

EBITDA Margins

11%

24%

21%

Debt

$330,735

$-

$-

Debt/ EBITDA

5.1

Click to enlarge

Worksheet suggests, in its quest for revenue growth.

  1. The company's margins have suffered.
  2. The company is more levered thus limiting its ability to purchase growth any more.

Even with the problems, Semtech is outpacing the SOX index

Click to enlarge

Source Ycharts.com

After understanding Semtech's problems in detail, it's hard to believe that the company, for the last 5 years, is handily beating the PHLX Semiconductor Index (^SOX) in terms of stock performance. Part of this out-performance is due to decent revenue growth rates shown by the company over the last few years against both its peers and the semiconductor industry.

Click to enlarge

Source: Semtech Corporation presentation

But if the company's growth rates suffer, the stock might catch up with the rest of the index on its way down. As the above chart suggests, there can be more than 40% downside to the stock.

Valuation

Stock

$29.9

Market Cap ($B)

$2.0

Net Cash/ Share

$(1.3)

P/ Expected 2013 Earnings

16.9

P/ Book

$2.7

P/ Expected 2014 Earnings

14.3

P/ Sales

3.2

EV/ EBITDA TTM.

12

Rev growth FY 14

6%

Operating Margins

15%

Gross Margins

61%

Click to enlarge

Looking at various valuation metrics in the worksheet above, things worth noting are

  1. Gross margins are the peak level the company has achieved.
  2. Organic revenue growth rate expectations are higher than what the company has been able to deliver.

Conclusion

At best, the stock looks like "dead money" for the next few quarters but valuations are high. Better to sell at these levels and visit the stock in a year's time frame. Target is $20.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.