Infineon Technologies AG (OTCQX:IFNNY) (OTCQX:IFNNF) (FSE:IFX) is a prominent German semiconductor manufacturer emerged as a spin-off of Siemens (OTCPK:SIEGY). The company is a leader in the power discrete and module market, outstripping the market share of the runner-up (Mitsubishi (OTCPK:MSBHY)) almost three times. It also comes second in both automotive semiconductors and smart card ICs, swiftly catching up the leader NXP Semiconductors (NASDAQ:NXPI). The company's product portfolio is well diversified, ranging from cutting-edge sensors applied in Advanced Driver Assistance Systems (ADAS), robots and drones to market-leading IGBT modules for the renewable energy industry.
Putting it into perspective, the company's sales are comparable to those of Nvidia (NASDAQ:NVDA), STMicroelectronics (NYSE:STM) and Apple (NASDAQ:AAPL) (semiconductor operations). The lengthy list of customers comprises of Autoliv (NYSE:ALV), Bosch (OTC:BSWQY), Tesla (NASDAQ:TSLA), Airbus (OTCPK:EADSY), Dell, Samsung (OTC:SSNLF) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) to name a few. As of 31 September, 2016, Infineon employs more than 36,000 employees while holding 27,000 patents and patent applications worldwide.
The theme of the investment thesis is that Infineon is poised to take advantage of the adoption of autonomous vehicles, augmented reality, Internet of Things and gearing up across the renewable energy among others. The company is already benefiting from its economies of scale, global presence and ties with various industry leaders. Despite the 40% run in the share price over the past year, I believe Infineon is set for an exponential growth once the enormous potential starts to materialize. Although not thrifty cheap on both absolute and relative bases, the stellar fundamentals, proven track record and flawless management are justifying 20-25% upside in the short term.
The macroeconomics of the semiconductor industry
The semiconductor market is highly fragmented. The two largest players (Intel (NASDAQ:INTC) and Samsung) were the only ones with market share slightly north of 10% in 2015. The top 20 companies account for only 69.8% of the global revenues, with the remaining 30.2% spread over 2,000 vendors.
Despite the flushing headlines regarding groundbreaking innovation over the past 12 months (graphic cards for instance), the semiconductor revenues worldwide were virtually unchanged. Indeed, the statistics comes as a no surprise given the new gadget penetration was pretty much nonexistent. The bold statements that wearable equipment and 3D printing are the next big thing quickly perished, shifting the spotlight towards augmented reality and autonomous driving.
The steep increase in discrete semiconductors and sensor spaces proves electrification and automation aren't just a hype but an actual trend; that in my opinion is here to stay. As we shall see shortly, these are also the areas of strength for Infineon.
Logically, when extremely fragmented structure of the sector and sluggish revenue growth are combined, a certain degree of consolidation should take place. Qualcomm's (NASDAQ:QCOM) proposed takeover of NXP Semiconductors and ON Semiconductor's (NASDAQ:ON) acquisition of Fairchild are just a few examples. In my view, the M&A activities will continue in the foreseeable future. Considering Infineon's accommodative capital structure and leading market position, it should do well both as an acquirer and target.
First and foremost, Infineon is set to benefit from all stages of automation and electrification in the automotive industry. Several years ago, when Google's self-driving car project was revealed and Tesla emerged as the first mass all-electric vehicle producer, both sounded more like science fiction rather than viable businesses. In early 2017, however, the concepts are rather futuristic, but beloved by all dominant car manufacturers. And while various companies are taking different routes - from Audi's (OTCPK:VLKAY) slow introduction of autonomous systems to Ford's (NYSE:F) bold claims for fully-autonomous car by 2021 - the goal is clear. Moreover, the CO2 emission scandals erupting across the automotive industry should catalyze electrification. In fact, the environmental regulations are so shrewd, they can only be reached by substantially transforming the cars' internal infrastructure through efficient power controls and further electrification.
Infineon's unique advantage derives from the company's complete spectrum of solutions offered and forward-looking strategy. Before diving into the details, please familiarize with the SEA levels of automation system.
Currently, we are in between levels 1 and 2; cars are absorbing more and more electronics, yet generating limited income for the semiconductor industry per vehicle sold. Infineon is already capitalizing on the hybrid and electric markets by offering various power management, driving assistance and security systems.
As the rivalry for quicker commercial application of the new technology is getting more and more intense among car makers, the sole winner could only be the electronics suppliers. Moreover, as we progress through the levels of automation, the number of sensors required expand exponentially, adding to the bill-to-material per vehicle figure.
The question is how Infineon fits the whole picture? As the snapshot below illustrates, the company currently covers most of the automation domains while expanding and strengthening positions in the existing ones through both internal R&D and M&A activities:
The only "unexplored" subdomains are ultrasonic (which as the previous figure suggests are not making a big slice when it comes to revenue generation) and graphics processors (an area heavily occupied by Nvidia, Mobileye (NYSE:MBLY) and possible AMD (NASDAQ:AMD)). Nevertheless, even with a full coverage of products, Infineon is nowhere near Nvidia or Mobileye in terms of valuation. This might be partly explained by the advancement of the latter in the artificial intelligence field. An alternative thesis, however, might suggest market inefficiency caused by participants' inability to differentiate between "sexy" products and "money-generating" ones. After all, graphic card producers will be forced by buyers' bargaining power to depress their margins once the product hits mass production. At the same time, the competition among the semiconductor manufacturers has already driven the prices down to their equilibrium, implying limited downside.
What matters the most, however, is Infineon's forward-looking strategy. As widely discussed in The Economist's article, Infineon's recent acquisition of innovative MEMS LiDAR technology allows cutting the commercial cost more than 40 times to a mere $250. Apart from autonomous cars, the LiDARs are applied in drones and robots. If the LiDAR technology proves to be superior compared to sensors and other solutions, Infineon could become the only supplier of the viral equipment. In such case, cross-selling and margin expansion opportunities are unlimited.
Moving to renewable energy. During the past fiscal year, Infineon states that wind power turbines installed with its technology totaled a capacity of 23 gigawatts. To put it into perspective, a regular wind turbine has capacity of 2.5-3 megawatts, translating the company's market into roughly 8,000 units.
Also the leading manufacturers of photovoltaic inverters rely on our application understanding and our outstanding technologies. The strengths of power semiconductors based on silicon carbide (SiC) can be particularly well exploited in the market. Today we already offer SiC diodes and hybrid modules; we have also announced a SiC MOSFET. The planned acquisition of Wolfspeed will enable us to accelerate the trend towards SiC-based power semiconductors and will further strengthen our competitive position in the market.- Source: Infineon's 2016 Annual Report
Infineon's advantage in this field comes from innovative, more cost and electricity efficient substitutions of existing elements and technologies. The company is targeting niche particles that once the renewable industry unfolds could generate substantial revenues. The recent rally in the commodity markets could only support the renewable energy industry, letting it take a deep breath after the massacre over the past two years. As projected by EIA, the usage of both solar and wind power is expected to substantially increase over the next two years.
Infineon's REAL3™ Image Sensor chip is the company's route to augmented reality. The sensor is already integrated in Asus's (OTC:ASUUY) flagship Zenfone AR model. In addition, the company's recently released barometric pressure sensor could easily become part of the next-generation smartphones if a commercial application is found. Infineon is also positioned to benefit from the development of the next-generation cellular infrastructure (5G) through its radio-frequency components.
In the short term, Infineon's top and bottom lines will be supported by favorable developments in the FX markets. The strengthening of the US dollar against the euro will significantly improve the financial results of the group. Again quoting the annual report:
In terms of revenue, the impact of exchange rates is limited almost entirely to the euro/US dollar rate, where a deviation of 1% in the actual exchange rate compared to the forecast rate would have an impact on revenue of approximately 8 EUR million per quarter. Planning for the 2017 fiscal year is based on an assumed average exchange rate for the US dollar against the euro of US$1.10.
In other words, the recent drop in value of the euro alone amplifies company's top line by more than 2.5%. I believe the divergence of monetary policies between the eurozone and the Fed will persist, leading to further detrimental effects of the European currency.
Before jumping into company's financials and valuation, let's take a quick look at its competitors. The ones I find most relevant are NXP Semiconductors, ON Semiconductor, and STMicroelectronics.
NXP Semiconductors is by far the closest and most serious competitor. Following M&A activities, NXPI surpassed Infineon in several key domains, including automotive. More recently, the company has been targeted by Qualcomm for a strategic acquisition, an easy way the latter could break into the lucrative subdomains of automotive and power system semiconductors. While the deal could open doors for NXPI and cut administrative costs, a dose of skepticism concerning the scale of possible synergies is gaining traction among Seeking Alpha's community. Commonly, such deals are surrounded by lengthy restructuring processes and significant changes to long-term strategy. Considering the dynamics of the industry and NXPI's vulnerable position, this could be a nice opportunity for Infineon. Moreover, given the emerging tension between the US and China, the deal could turn into a tool for both governments to show muscles.
As evident from the company's recent financial performance, NXP Semiconductors is everything but a stellar investment. Revenues are inconsistent; bottom line swings from positive to negative; and depreciation figures are causing concerns. Moreover, the capital structure diverges from industry standards (too much debt). Hence if NXP Semiconductors is appealing to Qualcomm, appropriate premium should be added to Infineon's fair price.
NXP Semiconductors' financials:
Source: SEC filings and author's computations
ON Semiconductor is considerably smaller compared to the leading couple. Despite its ambitions to catch up through acquisitions, the only material effect has been more debt on its balance sheet. Revenue growth over the past two years is a mere single-digit figure, substantially below the industry averages. The company's R&D budget is a half of NXPI's and Infineon's. Automotive penetration is not just limited, but also shrinks over time. Gross and EBIT margins are below industry standards.
ON Semiconductor's financial information:
Source: SEC filings and author's computations
The French STMicroelectronics appear as a decent pick within the investment universe. It has good penetration in the booming markets and sizable portfolio of influential clients. The main problem I spot is R&D overspending leading to non-existent EBIT. Given the "burn rate," STM should either come up with a game-changing idea anytime soon or forget about its seat on the front row (can't afford to both overspend and participate in the consolidation as an acquirer). Moreover, due to the physical organization of the operations (concentrated in Europe), the company overspends for SG&A as well. Revenue growth is miserable. Here's the statistics:
Source: Company's financial reports and author's computations
Finally, for completeness, I present you Infineon's metrics and a table for quick comparison of useful figures among the four companies:
Source: Company's financial reports and author's computations
What I like the most is the gradual performance and steady growth the company had over the past two years. The financials are strictly reflecting management's strategy and vision (targeted R&D and CapEx spending, focus on organic growth as supplement to successful M&A activities, lack of dilution, limited debt with plenty of liquidity).
Source: Companies' financial reports and author's computations
A good starting point is the company's own projections:
Visibly, Infineon has been quite accurate in its 2016 estimates, hence the guidance is the basis of my DCF model.
Focusing on EBIT computation, all assumptions are bold and colored in red (other inputs are derived from them). Following the line of the report and the company's rhetoric, the Automotive segment is expected to grow the fastest (although the base case is conservative and does not account for substantial growth once level 4/5 of automation is reached in or before 2025). Industrial Power Control (driven by renewable energy) and Power Management (Internet of Things and mobile devices) are also expected to grow at reasonable levels. The Chip Card & Security division will quite likely face significant competition from emerging payment technologies and personal document security applications and is assumed to grow in line with the inflation expectations. Gross margin will slightly improve (resulting in higher EBIT); R&D expense growth will be a function of the revenue growth with minor inferences; and the company will benefit from economies of scale, which will slow down the pace in the SG&A line.
Other significant figures are plugged below. Capital expenditures are expected to grow aggressively due to the need for capacity expansion that will facilitate demand growth for the company's products. At first, depreciation will diverge from the trend swiftly to catch up with the end of the projected period. As the company expands, more working capital will be needed in the three years to come.
Finally, a DCF valuation is performed. Assumptions here are a constant capital structure including 10% debt, low bond yield of ~2.5% and slightly higher cost of capital of 7.5% (Damodaran suggests total risk premium for Germany of 5.76% while bund yields are still close to zero). Perpetual growth is set at 3% due to substantial opportunities expected after the end of the projected period.
Based on these assumptions, the fair value of the company is 23.4% above the current price. The valuation model alongside the company's financials is provided for the subscribed users.
It is prudent to provide a sensitivity analysis, varying the discount and perpetual growth rates:
Here's the place to address an important question - why is this opportunity presented at first place? The easy answer is the industry/company is flying below the radar. However, this is not necessary the case, as all competitors have added substantial value to their market capitalizations over the past 12 months. Indeed, the market has already priced in significant portion of the upside potential. Have we arrived late at the party? I don't think so. Especially if we are buying Infineon. The recent developments at both the company and macro levels are suggesting rapid improvement of Infineon's outlook. In my opinion, Infineon is the most stable and well-positioned participant in the industry and hence should trade at a premium.
Among the major risks I identify is the emergence of a new dominant player through vertical integration. In particular, companies that are riding the automation hype (namely AMD and NVDA) could easily purchase a smaller vendor and integrate their products to achieve complete coverage serving the automotive industry. Similarly, the auto manufacturers themselves could try to get their hands on the industry by developing in-house solutions and/or purchasing smaller vendors.
Given the bargaining power of the buyers and increasing spare capacity in the industry, a commonization of the products is possible, which will significantly hurt the company's margins.
Shared economy; many companies including Uber (Private:UBER) and Google's Waymo are pushing towards car sharing as against ownership. The model has numerous advantages, solving the parking space problem while employing significantly less resources, achieving the same results as the current system. Game theory suggests that if one is successful, rest should follow. Indeed, BMW (OTCPK:BMWYY) is already trying to get ahead of its likes. Such model, however, will be significantly detriment to the number of vehicles demanded, leading to volume cuts and ultimately bankruptcies.
Another risk could materialize if a superior technology or change in consumer sentiment appears. For example, Elon Musk has openly criticized the LiDAR technology while technical experts see particular limitations (don't work well in fog). If a better solution emerges, Infineon might be unable to tap the market due to licensing limitations.
In recent years, political uncertainties are driving the stock markets. Trump's protectionist policies might give advantage to NXP Semiconductors and ON Semiconductor due to their origin and location of administration. Although Infineon has sizable operations in the US, it is a German company that might be affected by the upcoming tax reforms.
Infineon's common equity presents compelling opportunity to tap into the various booming markets at a reasonable price. Although part of the potential is already priced in, I do believe the company's market value has more room to grow. I am confident Infineon will be one of the top performers over the coming calendar year (especially when one accounts for the limited downside).
Disclosure: I am/we are long XETRA:IFX.
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.
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