NXP Semi: Making All The Right Moves

| About: NXP Semiconductors (NXPI)

Summary

NXP Semi reported second quarter earnings last Wednesday to shrugs.

Revenue and EPS beat consensus estimates and overall guidance was solid as well.

The Freescale merger is progressing smoothly and recent organic growth is showing strength.

NXPI looks like it will head higher.

This article will be provide an overview of NXP's Q2 earnings report and I will then provide an analysis of margins and then an analysis by business segment. If you know the basic details of the report, you can skip to the Margins section directly below the bullet points.

Introduction

NXP Semiconductors (NASDAQ:NXPI) reported Q2 results after the close Wednesday in what appeared to be a solid quarter, but the stock reacted negatively in trading Thursday. The stock had a strange day, first falling 4%, rebounding back to about even, and then ending the day down 3.5% as the market appeared unsure about what to make of the Q2 release. After reading the press release and conference call transcript, I'm ready to provide my take on earnings and how investors should react. Let's dive in.

NXPI Chart

NXPI data by YCharts

Here's a basic summary:

  • Beat on both the top and bottom lines by slight margins and provided (Non-GAAP) revenue guidance of between $2.41 billion and $2.51 billion, in line with consensus estimates.
  • Both overall gross margin and operating margin were very solid at 50% and 25.6% respectively.
  • Overall sequential revenue growth, was 6%, indicating strong recent organic growth.
  • Margin guidance was impressive with midpoint gross margin and midpoint operating margin at 50.2% and 27.5% respectively.
  • Estimating based upon guidance figures and using an estimated profit margin of 20%, EPS for Q3 2016 will be between $1.41 and $1.47 per share.

The two things I would like to focus on are gross and operating margins and the performance of NXP's various segments. Most of the information provided by management was given on the Q2 conference call, which I recommend readers take a look at.

Margins

First off, let's discuss margins. As I stated in the bullet points, NXP expects gross margin to increase by 20 bps and operating margin to increase by 190 bps in Q3. This second quarter marked the third straight quarter that the company reported non-GAAP gross margin of 50% or higher, and Q3 is expected to stretch that streak to four. In equally positive news, non-GAAP gross margin for the high performance mixed signal ("HPMS") segment, which comprises 87% of total product revenue, was 53.7%.

That gross margin figure will become the new normal after the sale of NXP's Standard Product unit goes through likely sometime in Q1 2017. The gross margin on the Standard Products business was 32.7% in the second quarter, which is one of the reasons NXP decided to sell it for $2.75 billion. Without Standard Products, the company will be able to focus on growing its HPMS business without the drag on overall gross and operating margins.

In addition to the margin increases that will result from the sale of the Standard Products unit, effective expense management and synergies created by the Freescale merger will further amplify the margin expansion. To get a feel for how effective cost cutting and merger synergies have been and will continue to be, Q3's expected operating margin of 27.5% is a 420 bps improvement over Q1 2016's margin. Management expects the combined effect of the sale of the Standard Products unit and merger synergies to result in an operating margin between 31% and 34% at the end of 2017, entering 2018. Color me impressed!

To give some numbers to what that would be mean for operating income, I will try and estimate some approximate figures for 2018. First, let's assume that NXP achieves the midpoint of its 2018 operating margin guidance of 32.5%, which with current improvements appears very reachable. Instead of trying to estimate a specific revenue figure out to 2018, I will provide a bunch of different scenarios based on compound annual growth rates and let readers make their own judgments.

First things first, let's make an estimate for full-year 2016 revenue. If we use the revenue from the first two quarters and the midpoint of Q3 guidance, we get about $7 billion. For Q4 we have no concrete estimates from management, but consensus analyst estimates put Q4 revenue at $2.42 billion, which would mean about flat sequential growth. I think this is a good figure for an approximation because management said on the conference call that the combined entity of NXP and Freescale will see a seasonally weak Q4 that is actually weaker than NXP would have experienced otherwise.

So let's say that our 2016 revenue estimate is about $9.4 billion, a 54% increase from 2015. The last step is to subtract expected revenue from the Standard Products segment, which will likely total around $1.2 billion. For the purpose of CAGR projection we will use the total estimated 2016 revenue minus $1.2 billion to yield $8.2 billion.

The following table displays my best estimates for what revenue growth will look like:

CAGR Projected 2018 Revenue Operating Margin 2018 Operating Income
3% $8.70 billion 32.5% $2.83 billion
4% $8.87 billion 32.5% $2.88 billion
5% $9.04 billion 32.5% $2.94 billion
6% $9.21 billion 32.5% $3.00 billion
7% $9.39 billion 32.5% $3.05 billion
Click to enlarge

These are obviously pretty rough estimates and not to be taken completely at face value. In my opinion, the scenario of 5% CAGR is the most realistic, which will yield $2.94 billion in operating income. Based on past financial statements, I think it's reasonable to assume a 20% reduction from operating income to net income, which would translate into $2.35 billion in net income for full-year 2018. Assuming the shares outstanding remains at 341.3 million, which it likely won't considering NXP has bought back $663 million worth of shares in the first half of 2016, that would translate into EPS of $6.89 and a forward 2018 P/E of about 12.

Take this information for what you will, but I think these estimates are conservative and that NXPI is undervalued based on future earnings growth and margin expansion.

Moving on to the performance prospects of NXP's different segments, I think Q2 provided much reason for investors to be excited.

Automotive

The automotive segment reported quarterly revenue of $853 million, which is a 177% year-over-year ("YoY") increase mainly due to the Freescale merger, but more importantly revenue was up 7% from Q1 2016, which of course included Freescale's revenue contribution. The automotive sector is where NXP-Freescale is a powerhouse, and so growth in this area is expected and encouraging. In some more good news, CEO Richard Clemmer had this to say regarding NXP's automotive radar solutions:

Additionally during the quarter, HELLA announced its plan to adopt NXP's next generation 77 gigahertz radar solution. We are now designed in with 9 of the top 10 tier 1 suppliers for the complete next generation radar solutions, both RF front end and the back end processing engines where we are already the market leader.

Yet more exciting news came in response to a question by SunTrust Robinson Humphrey analyst William Stein regarding advanced driver assistance systems ("ADAS") and autonomous driving technologies. Clemmer responded that NXP is focused on maintaining and growing its edge in vehicle-to-vehicle solutions, and that the company has, to this point, been the only one seeing design wins with this aspect of autonomous driving. Further, Clemmer stated:

If you look at the auto industry, there's really four levels of autonomous driving with only the last levels being fully autonomous. If you actually get through level three, which is a lot of safety features that assists the driving, we get about 80% of the revenue associated with it. The significant portions of that will be vehicle to vehicle, will include radar, and will include the processing associated with it.

It's an exciting time to be an NXPI investor. As auto manufacturers ramp up development, and soon production, of autonomous vehicle, NXP will be a significant beneficiary because of the technological lead it has in vehicle-to-vehicle, which is vital for the safety of autonomous driving. If you're wondering what kind of time frame over which this will develop, VP of Investor Relations Jeff Palmer stated that management expects ADAS to comprise about 10% of automotive revenue by 2019.

Secure Connected Devices ("SCD"), Secure Interface & Infrastructure (SI&I), Secure Identification Solutions ("SIS"), and Standard Products

Revenue in the Secure Connected Devices segment was up 9% sequentially to $514 million. NXP said the revenue increase was the result of strong demand across the board for its product in the segment, and for more details you can read the conference call transcript. SCD is expected to provide strong performance in Q3 with sequential revenue growth expected to be in the mid-teens to 20%.

SI&I was up 4% sequentially to $442 million. The company said the same seasonal factors (mentioned in the CC) that lifted SCD also contributed to the increase in SI&I revenue. Something I found interesting was the Clemmer found it relevant to state the following in the discussion of SI&I:

I'd like to reiterate that our largest handset customer, while still very important to NXP, only represents a mid single-digit percentage of the total company revenue.

The "largest handset customer" to which Clemmer is referring is very likely Apple (NASDAQ:AAPL), and he thought it important to emphasize that the reliance on Apple is perhaps not as significant as some assume it to be. I just thought that was an interesting tidbit that deserved mentioning. Management expects SI&I revenue to increase in the low to high single-digit range in Q3.

Third up is SIS, which has shown mixed performance recently. Quarterly revenue of $200 million is down 6% sequentially and 22% YoY, so at first glance things are not looking good in this segment. However, management provides a good reason for the weakness, which I appreciate as a shareholder. Essentially, the argument is that the non-China banking card market is too competitive and margins are too slim for NXP to invest the resources to grow revenue and market share. Specifically, Clemmer said:

This is an area where our participation has been quite selective given the aggressive pricing and margin pressure our competitor has taken who clearly has a much different profitability requirement.

I'm with management on this one. Keep overall margins healthy and don't burn resources pushing into a market that won't yield much in the way of profits or shareholder returns anyway. On the other hand, NXP said it is performing much better in China's banking card industry but the revenue there is lumpy and also not robust enough to generate any significant segment growth. Indicative of the market pressures, NXP expects revenue in SIS to decline by high single-digits to low double-digits in Q3.

Lastly, and least importantly because it will be gone in a few months, Standard Products reported revenue of $303 million, which was up 11% sequentially and down 6% YoY. Yay!

To sum it up, NXP's business segments have been experiencing some headwinds in recent quarters, but growth seems to be making a comeback and I expect NXPI stock to respond accordingly. The Freescale merger is progressing smoothly with cost synergies expected to boost NXP's operating margin significantly over the coming quarters and through 2017. I'm holding NXPI for the long haul.

If you want to stay up-to-date on my articles, you can Follow me by going to my author page or by clicking "Follow" at the top of this page.

Thanks for reading!

Disclosure: I am/we are long NXPI.

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.