Volatility And A Murky Near-Term Outlook Hammer Renesas Electronics

Summary

• Renesas beat second quarter expectations, but results were not particularly strong and the beat was driven by delayed inventory corrections.
• Management now expects bigger inventory corrections in the auto business in Q3, while the outlook for the industrial business is deteriorating quickly on weakening Chinese automation orders.
• Renesas shares appear to have attractive long-term potential, but the short-term outlook is still quite rocky and uncertain.

I had previously said that I thought this year could be a little shaky for Japan’s Renesas Electronics (OTCPK:RNECY) (6723.T), the global leader in microcontrollers (or MCUs) and one of the leaders in semiconductors for autos, but I didn’t expect the sharp declines in the stock since July, nor the significant underperformance to peers like ON Semiconductor (ON), Infineon (OTCQX:IFNNY), or STMicroelectronics (STM) in what has admittedly been a weakening market for many chip companies.

Between inventory corrections in the auto channel, a much weaker outlook for industrial automation in China, and less near-term leverage to strong auto segments, the next few quarters could still be rough for Renesas. The long-term outlook remains favorable for the company, though, and the market seems to be pricing in an ugly correction. It may take a little while for this stock to shake off these worries, but the potential value makes this a name worth watching.

Readers should note that Renesas’s ADRs are not particularly liquid.

A Better Second Quarter, But Not Necessary For The Right Reasons

Renesas did beat expectations by a significant margin in the second quarter, but the reasons for that outperformance don’t really build any particular confidence in the near-term outlook. Likewise, with weaker guidance for the third quarter and weaker implied guidance beyond that, the second quarter’s better-than-expected numbers are little more than just kicking the can down the road a bit.

Revenue rose 3% in the second quarter, with semiconductor revenue up 3% year-over-year and 9% quarter-over-quarter. That was around 4% better than expected, with all segments showing growth in the quarter. Auto sales were up 2% (and up 15% qoq), while Industrial was up 6% (up 1% qoq), and “Broadbased” was up 2% (up 7% qoq).

Gross margin declined slightly from the year-ago level on a non-GAAP basis, but closer to three points on a sequential basis as the company’s capacity utilization has contracted. Operating income rose 17% from the year-ago level (again on a non-GAAP basis) and reported operating income was almost one-third higher than expected.

Inventory levels were mixed, with finished goods inventory shrinking 5% sequentially and semi-finished increased 3%, with the latter likely driven mostly by 40nm MCU products expected to ship next year.

Messy Results And A Murky Outlook

Renesas saw better results from areas like infotainment within Auto, but the reality is that the biggest contributor to the performance was a delayed impact of an expected inventory correction. Management’s guidance after the first quarter results was a little strange (or rather, the explanation seemed quite awkward), and once again the guidance was not nearly as clear as you might like.

What is clear is that third quarter earnings guidance was substantially lower than the prior expectations, with Renesas giving back pretty much all of the second quarter operating income outperformance. With inventory corrections expected in auto and industrial, revenue is expected to be down 10% year-over year and 13% sequentially, and capacity utilization will likely be poor again.

The auto situation should resolve itself over the next couple of quarters, and management continues to expect improving results in 2019 as new 40nm MCU design wins from 2016 and 2017 start shipping. In addition to content growth, these 40nm MCU products will offer better gross margins for the company.

On the other hand, the industrial business, which contributes around 30% of revenue, is likely to be weaker for a while longer. Although demand in areas like HVAC and industrial automation was strong this past quarter, management expects a sharp decline in the third quarter, particularly in industrial automation in China. That largely echoes what Fanuc (OTCPK:FANUY) and Yaskawa (OTCPK:YASKY) have said recently, and Renesas management cited the ongoing trade issues between the U.S. and China as a prime contributor to the weakening spending / capital investment environment among Chinese industrial companies.

Controlling Costs, But What About The Auto Mix?

Renesas management continues to try to control what they can control with respect to margins and costs. The company recently announced that it was going to close its Yamaguchi factory and consolidate its Shiga factory. Although this will likely take two to three years, it will take out more than 15% of Renesas’s capacity, and primarily older 200mm capacity. Renesas has always been uncommonly willing (for a Japanese company at least) to adjust capacity as needed, and this seems like a good long-term move. What’s more, I’d note that Renesas is increasingly turning to Taiwan Semiconductor (TSM) for its more advanced production needs, including its MCUs at 40nm and below. There are always trade-offs in doing this, but I believe it will support a less volatile margin profile and a less capital-intensive model in the future.

On the other hand, there are still some valid concerns about Renesas’s mix and leverage to future growth trends, and particularly in the auto space.

Renesas clearly underperformed ON Semiconductor this quarter (where auto revenue improved 10% yoy), as ON benefited from its strong position in ADAS image sensors and power management products. Silicon Labs (SLAB), too, saw some solid demand from EV customers for its isolator products. None of this helps Renesas, which has a very strong position in MCUs in the auto market, but very little in the way of imaging, sensing, or power management. As a significant portion of the auto content growth in EVs is tied to power management chips and a significant portion of auto content growth in conventional passenger vehicles today is tied to ADAS and sensing, Renesas is comparatively less exposed to the healthiest parts of the auto cycle.

I believe this is largely a transitional issue. Although the company is under-leveraged to power management (it has some power management know-how, it just hasn’t really moved it into the auto space yet) and sensing, there is still growing demand for MCUs across car designs (powertrain, control, instruments, etc.) that will benefit Renesas in 2019 and beyond. Likewise, while Level 2 ADAS system content is largely driven by camera and sensing modules (which is good for ON today), Level 3 systems offer considerably more MCU/SoC content potential to Renesas and should start scaling up in 2020.

The Opportunity

I’m cutting back my expectations for Renesas in 2018 and 2019, but my numbers beyond that don’t change all that much, as I continue to believe that Renesas remains well-placed within the growing auto semiconductor market. I’m still looking for long-term revenue growth in the neighborhood of 4%, with mid-teens annualized FCF growth. I’d also note that Renesas is likely to look for additional M&A opportunities in the future, and I wouldn’t be surprised if power management, sensing, and/or wireless communication were areas of focus.

The Bottom Line

Renesas looks undervalued below the $4.50 to $5 range (for the ADRs), but investors should be aware of the risk that things get worse before they get better. Recent 40nm MCU auto wins give me confidence that the company will continue to benefit from chip content growth in autos, but inventory corrections can be ugly in the short term and high lead times are a risk for companies like Renesas and ON. I can understand staying away from this name for now, but I’d argue that the valuation and the level of expectations make it a name to watch as (or if) the business stabilizes later this year.

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Analyst’s Disclosure: I/we 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.