Renesas Going Through A Rocky Patch, But The Future Prospects Look Undervalued

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About: Renesas Electronics Corp ADR (RNECY), Includes: IFNNY, MXIM, NXPI, ON
by: Stephen Simpson, CFA
Summary

Renesas shares have been sluggish of late on worries of inventory corrections and slower auto sales, but this is likely a relatively brief pause in a content growth story.

Renesas has leading share (30%) in auto MCUs and is poised to benefit from increasing chip content in the powertrain and growing ADAS adoption.

The auto space is attracting a lot of new competition, but Renesas looks undervalued on the basis of its growth and margin prospects.

"Buy the pullback" is one of the oft-used pieces of advice that is easier said than done but can nevertheless be profitable for patient investors. The semiconductor sector has certainly cooled, and Renesas Electronics (OTCPK:RNECY) is likely to see some weak reported results in the near-term, but this looks like a story that has some legs over the longer term.

Renesas is certainly looking at more competition in its core auto semiconductor market, but I wouldn't ignore the strong position it has built for itself in microcontrollers and SoCs, nor the opportunity to benefit from significant growth in semiconductor content in the auto sector. With mid-single-digit long-term revenue growth and low-to-mid teens operating margins, the stock looks undervalued enough today to merit a closer look.

Autos Will Continue To Drive The Story

Autos have become the hot segment within the semiconductor space over the last few years, as the increasing electrification of cars to support enhanced performance, safety, convenience, and driver/passenger enjoyment has led to significant content growth. As automakers look to squeeze even more performance out of internal combustion engines, improve safety even further, and transition toward electrified drivetrains and varying degrees of automation, that content is likely to increase significantly over the next 10 to 20 years.

Renesas is the second/third-largest player in the auto semiconductor space, with Renesas and Infineon (OTCQX:IFNNY) jockeying for position behind NXP Semiconductors (NXPI), each with around 9% share to NXPI's roughly 13% share. Renesas is a relatively focused player, specializing mostly in microcontrollers (or MCUs), where it holds almost one-third share in a $5 billion-plus market (with NXP's share closer to the mid-20%'s), and SoCs where it holds upwards of two-thirds share in SoCs for driver safety and infotainment. Renesas has a far smaller presence in analog, ASSPs, and logic - areas where rivals like NXP, Infineon, and Texas Instruments (TXN) hold meaningful share.

Auto semiconductors are a big part of what Renesas is today (over 50% of revenue), and that is likely to remain the case for the foreseeable future. Renesas MCUs are used everywhere - from safety/chassis applications, to powertrain, to cockpit/instrumentation (where it has nearly 50% share), and many of these applications are not going to go away even as auto makers turn toward hybrids and EVs.

Hybrids are actually a large opportunity for Renesas, as the cars have internal combustion drivetrains and electronic systems, and EVs aren't the threat to Renesas that they are to some auto component suppliers - the specific needs/applications of the chips are different, but the change in power source will, if anything, increase chip content. While some ICE-powered cars currently have over $300/unit in chip content, "light hybrids" will likely have upwards of $400, while HEVs and full electrics are likely to feature over $700/car in powertrain content.

Over the next few years, Advanced Driver Assistance Systems (or ADAS) are likely to be the most visible growth driver for Renesas. ADAS covers a lot of ground, including adaptive cruise control, automated braking, lane departure warnings, blind spot detection, and collision avoidance, but it means more imaging and more processing power on board the vehicle. While Renesas is not strong in imaging/sensing (an area where ON Semiconductor (ON) has done well), it does offer strong processing, control, and actuation capabilities with its MCUs and SoCs. All told, the transition toward Level 2 ADAS (some early Level 3) is likely to double the size of the ADAS market over the next five years, while the adoption of Level 3/Level 4 toward the end of the decade will likely expand the market by another 70%-plus.

All told, this can support full-cycle growth in the mid-to-high single-digits for the auto semi space. Now, Renesas won't get all of that. Companies like NXP are already fierce competitors, and the pending acquisition of NXP by Qualcomm (QCOM) could make them even stronger. Likewise, Renesas does not "cover the landscape" in terms of what it offers, meaning that it could lose some share to more integrated solutions. That's particularly true in the case of autonomous driving technology - Renesas believes they will have a strong presence, but companies like Intel (INTC) and NVIDIA (NVDA) are likely to be formidable challengers.

Industrial Opportunities Are Worthwhile, But Smaller

Auto applications tend to dominate the conversations around Renesas, but the company does generate more than 25% of its revenue from "industrial" applications like "smart infrastructure" and "smart factory". MCUs are the foundation of this business, and there are a wide range of applications where Renesas could grow. Robot adoption continues to grow outside its core market of auto OEMs, and more advanced industrial IoT adoption, including more automation on the factory floor and in warehousing, will demand more MCU-supplied processing power, particularly in critical areas like sensing and monitoring, power, and control.

Factory automation should grow at a mid-single-digit rate over the next decade (likely around double GDP growth), with some areas machine vision, human-machine interface, and robotics growing faster and more traditional drives growing slower. It's harder to filter out the specific content growth opportunities, but microcontrollers (and many types of analog chips) are ubiquitous in these applications, and I expect Renesas's addressable market growth to approximate that overall mid-single-digit growth rate.

M&A Likely To Be Significant

Renesas is a little unusual for a Japanese company in that it is quite willing to entertain M&A as a means toward growth and diversification. The company completed its acquisition of Intersil a little more than a year ago and has been tied to multiple other names as a rumored bidder/interested party since then, including Microsemi (MSCC) and Maxim (MXIM).

Management has talked about wanting more balance towards the analog side of the product line-up, and Maxim would certainly fit the bill, though they're basically even in terms of market cap. Although the name doesn't come up so often in M&A rumors, I think ON would also be a target of interest. ON would give Renesas a top-10 player in analog, as well as a company with strong capabilities in power management and sensing. ON is already a leader in ADAS-related sensing, and that should be a synergistic opportunity, to say nothing of the power management, ASIC, and sensor opportunities in areas like auto powertrain, auto body/interior, and industrial automation (power supplies/modules and brushless motors/motor controls). While ON would overlap and augment Renesas's existing auto and industrial exposure, but also give it some added exposure to areas like consumer and communications.

Of course, ON wouldn't exactly be a small deal either, and Renesas management may be reluctant to pursue such a large and potentially risky transaction. Accordingly, something more in the size range of Cypress (CY) or smaller could certainly make sense.

The Opportunity

I do not value or model Renesas today with any M&A included in the numbers. I expect about 80% of Renesas's addressable markets (by revenue) to grow around 5% to 7% over the next five to 10 years, but I'm modeling a little less than 5% long-term revenue growth for Renesas. The reason I see some gap between the addressable market growth and Renesas's growth is that not all of that addressable market is truly addressable - Renesas doesn't have competitive products for all of those opportunities (at least not today), and I believe there will be competition from newcomers like Qualcomm, Intel, and NVIDIA in ADAS/automation. Likewise, I expect fierce competition from the likes of NXP, Infineon, and others in the auto chip space.

I do believe that Renesas will see improving margins, though. The more advanced chips needed for higher-end auto and industrial applications carry higher margins and Renesas should also benefit from a shift to 40nm architectures and below in the coming years. I would also note that Renesas has been active in consolidating/closing its own capacity and shifting away from lower-margin business.

All told, I believe Renesas can and will build toward mid-to-high teens FCF margins over time, supporting double-digit cash flow growth. Those cash flows support a low-to-mid teens annualized return today, which I consider attractive. I'd also note that Renesas seems undervalued on a EV/revenue basis relative to its margins; I believe a forward multiple of 2.5x is more appropriate today (suggesting a fair value closer to $5.50/ADR), and a multiple of 3x should come into play as the operating margins move higher in the next few years.

I would note, though, that these ADRs aren't especially liquid, so investors should use some caution. I'd also note that the company recently filed for a large secondary offering. These are not new shares (so it's not a dilutive financing) and the reduced influence of the selling shareholder (Innovation Network Corporation of Japan) is a net positive, but this could still weigh on the shares. What's more, management previously warned that the first quarter's revenue will be weak as the company sees some inventory corrections (due in part to inventory adjustments after an earthquake in 2016).

The Bottom Line

I'm not overly concerned about the risk that the next quarter (or quarters) could be a little weak, but investors may want to hold off a bit to see how earnings and guidance play out for the first quarter. This is likely to be a somewhat sluggish period in the auto semiconductor space anyway, as build rates look a little soft. The longer-term opportunity in electrification and ADAS is real though, as is the opportunity to leverage M&A to broaden its product and market exposures. With what looks like a good risk/reward balance, this is a name that I'd take a closer look at today.

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Disclosure: I am/we are long MSCC. 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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