The semiconductor space that Skyworks (NASDAQ:SWKS) operates in can be tricky to investors unfamiliar with the industry, as well as the overall tech market. Similar to an industry such as cloud computing, there is no concrete definition of the industry, and it can be extremely tricky to decipher exactly what a given company produces. Skyworks describes itself as a company that supports a multitude of industries ranging from mobile devices to medical and military equipment by leveraging core technologies to produce high performance analog semiconductors.
Now, many investors could care less about what exactly a high performance analog semiconductor is or how core technology is leveraged, as long as management is able to consistently grow earnings year over year. However, in order to gauge the company's future earnings prospects, it is crucial to understand the products it currently markets and the various spaces that management is attempting to guide the company into.
The Mobile Market
The first space I will discuss is one that has garnered a lot of publicity both here on Seeking Alpha and other forums: the mobile market. Future earnings growth within the mobile market will come from a specific area: the growth of LTE enabled devices (phones and tablets) in international markets, specifically China and India. Within the United States, and much of Europe, the market is already saturated with smart phones and tablets. While these two markets will continue providing revenue as consumers upgrade their devices every 1-2 years, it is not necessarily a growth opportunity. One favorable trend, albeit a small one, that could help grow revenue is recently announced cell phone plans that enable the user to upgrade every 6 months through T-Mobile (NASDAQ:TMUS). If this trend were to catch on with carriers such as AT&T (NYSE:T) or Verizon (NYSE:VZ) it could create substantial growth domestically.
A telling statistic that should prove favorable for SWKS is that a majority of phones currently in China are not LTE-enabled. As devices such as the iPhone and Galaxy become more accessible to the average Chinese consumer, Skyworks will benefit heavily from its partnerships with both Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) to provide semiconductors which provide connectivity support or in simpler terms, the ability to connect to the internet over 4G and Wi-Fi. Apple's recent partnership with China Mobile reveals how the company is targeting the Asian Pacific market.
India also has the ability to provide a huge source of revenue as a market that has low mobile device penetration. India is expected to grow the number of data users rapidly at 20%-25% per year through FY2018. This would result in an increase of over 200 million new users to the smartphone and tablet market. The chart below shows the growth expectations by geography. It is clear that the trends favor the Asia Pacific region as a whole, and Skyworks has the capability and business relationships to capitalize within this space.
Perhaps Skyworks' biggest asset is its pre-existing partnerships with both Apple and Samsung. Skyworks is able to hedge against user preference risk in foreign markets by having the ability to profit from both the company's products which are currently the clear leaders in the smartphone space. One obvious risk is the possibility of Apple or Samsung dropping Skyworks as their provider, but there is no reason to believe this would ever come to fruition, considering there have been no conflicts in the past and no other chip provider has a distinct advantage over Skyworks.
A direct catalyst that has caused major stock appreciation YTD is anticipation before the release of the iPhone 6 and Galaxy S6 later this fiscal year. Both phones are expected to have near record sales both domestically and abroad following the lackluster device evolution in recent releases. When I initiated my position in early February, it was with this short-term catalyst in mind as strong sales for either or both of these phones will boost the stock price.
In addition to major smartphone releases, the trend towards cheaper LTE enabled tablets and the increase in "phablets" will also prove fruitful for Skyworks as it provides connectivity support for these devices as well. The tablet market is not quite as saturated in the western states compared to smartphones, and more consumers are opting for tablet type laptops to replace the traditional PCs, especially young adults and college students. This trend is favorable because of Skyworks' market share in tablets versus PCs and traditional computing devices.
The Internet of Things
The Internet of Things (IoT) is in effect a buzz word. However, this buzz word is the long-term catalyst that can sustain Skyworks' growth for years to come, and is the reason I plan to hold this stock long past the device releases later this fiscal year (in contrast to my original investment thesis). Name an object you see in your home or walking down the street, and I guarantee you it could benefit from internet connectivity. The Internet of Things is just what it sounds like, a network of everyday objects that can connect to the Internet and communicate with each other. As consumers demand internet access at any time of the day, anywhere on Earth, Skyworks will capitalize by providing chips that can do just that.
In the years to come, your thermostat will connect to the internet (if it doesn't already), your car will have in-vehicle Wi-Fi and will speak to other cars on the road as you drive, the surgery equipment used on you at the hospital will be connected, and the list goes on and on. As of ten years ago, a thermostat that downloaded local weather reports to maximize energy efficiency in conjunction with homeowner preference would have seemed illogical and unnecessary. Nest, the maker of that exact thermostat, was purchased by Google for $3.2 billion. A recent fad, Fit Bit, enables users to track physical activity throughout the day and transmits the data over Wi-Fi to the user's phone or computer. Much speculation revolves around Apple and the potential iWatch, which will undoubtedly have internet connectivity. A watch connected to Wi-Fi -- why not? All of these products sport Skyworks chips. The same can be said for high-end televisions, sensor-laden cars, etc. The possibilities are quite literally endless.
While Skyworks is solely a semiconductor company, it offers diversification across market segments including military contracts, the future prospects in wearable technology which is estimated to be huge, healthcare, smartphones, home appliances, automobiles, and more. The graph below displays the market size for wearable technology which Skyworks is expected to capitalize on in the long term. However, it represents just one of the many markets that are expected to grow at this pace through FY2018.
The number of devices with internet capability could reach 75 billion by 2020 according to analysts, and there is absolutely no reason to think that this trend would stagnate or that Skyworks should not be able to capitalize given its strong track record and fantastic position within the industry.
The qualitative aspects surrounding Skyworks seem very strong, but valuation is equally as important. When I first valued Skyworks back in February, I ran into trouble valuing the Internet of Things aspect of the company considering the endless possibilities and no clear guidance from management on how it will play out in the next 2-4 years. Since my initial thesis was to hold solely through the upcoming phone releases, I decided to ignore these potential sources of revenue altogether. I updated my old model with recent guidance from management but kept most major assumptions the same. My DCF analysis assumed revenue growth of 13% in FY2014 (in line with historical averages and Bloomberg reports) with slight decreases in each subsequent year to err on the side of caution.
Projecting out five years with a WACC (discount rate) of 10.5% and applying an EV/EBITDA multiple of 15 to the terminal value, the result was a price target between $45-$49 on the sensitivity analysis. At current price levels, this means that the market has priced in earnings from upcoming device releases, but has entirely mispriced the future earnings possible from the Internet of Things.
If Skyworks can even capitalize on one segment of the future prospects (i.e., just automobiles or just wearables), it becomes an immediate buy with a DCF target price in the mid-$50 range. The ultra-bullish scenario is that Skyworks becomes the dominant player in the industry and is able to capitalize on a large range of segments resulting in huge upside growth for the stock, which is not improbable considering their market position currently. This scenario would result in annual revenue growth around 20%-22% and a price target in the $70-$75 range. Due to the range of assumptions, it is somewhat difficult to estimate an exact target price for a given time frame. Rather, I will continue adding to my position on major dips and evaluate Skyworks after each earnings release to ensure my investment thesis of a long-term hold due to the IoT catalyst is still intact.
In addition, Skyworks financials look to be very strong. While SWKS may seem overvalued when comparing against its peer group average, it has the lowest trailing PEG ratio at approximately .818, which is a much better indicator of the stock price given the growth expectations of the industry as a whole.
The chart below shows the forward P/E ratio of 18.5 vs. the trailing P/E of 28.76. While the trailing P/E has jumped up in recent months, the forward P/E has increased at a constant rate, which is expected due to increased guidance being the cause of the jump in price.
With a current ratio of almost 7 as of the latest 10-Q and almost $1B cash on hand, Skyworks has the ability to raise financing and acquire a competitor or patents if there is a suitable opportunity. This flexibility cannot be overstated in an ever-changing market such as semiconductors. Purchasing patents and investing in R&D are the keys to sustainable long-term growth in this sector, and management seems to understand this quite well when comparing financials to its peer group.
There are risks associated with Skyworks. The first being lackluster smartphone sales towards the end of FY2014, which would most likely lead to a drop in the stock price. Other developments that could hurt Skyworks are the pace of the semiconductor industry as a whole where technology is constantly evolving. Despite R&D higher than peers, it is entirely possible that another company develops a product in the long run with a significant competitive advantage over Skyworks' products.
As I noted earlier, I believe the appropriate plan of action for Skyworks is to purchase at current price levels, buy on any future dips, and evaluate quarterly reports and guidance from management to ensure the ability to capitalize on the Internet of Things trend. I will hold through FY2014, even if the revenue from Apple or Samsung releases are sub-par.
Disclosure: The author is long SWKS, AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.