STMicroelectronics: Apple Is This Semiconductor Maker's Largest Customer

Summary

• Last year, Apple accounted for ~24% of STM's total revenue.
• However, that may not be such a great thing considering STM's margins are unusually low for a semiconductor company.
• That said, STM has a very strong automotive business and is guiding for FY21 revenue growth of ~18.4%.
• Meantime, the company plans to spend $2 billion this year on capacity expansions to meet strong growth.

Photo by Nikola Ilic/E+ via Getty Images

In my first Seeking Alpha article on semiconductor maker ST Microelectronics (NYSE:STM), the stock had been moving higher and I touted its supply-chain link to major and fast-growing customers Apple (AAPL) and Tesla (TSLA). Indeed, according to STM's FY2020 Annual Report, Apple was STM's largest customer and accounted for 23.9% of total revenue. However, the company's margins were weak so I gave it a "Neutral" rating. Sure enough, shortly thereafter the stock dropped on an earnings report disappointment. Last week, the company's Q1 EPS report met expectations, but margins were still unusually low for a semiconductor company. Perhaps having Apple as its #1 company isn't such a good thing after all.

Investment Thesis

As I wrote in my recent Seeking Alpha article Semiconductors Rule!,

The semiconductor industry used to be fairly cyclical and very dependent on the fortunes of the PC and automotive markets. Today, semiconductors are needed in a plethora of old and emerging markets: 5G infrastructure, networking, smartphones, cloud computing, PCs, mobile devices, automotive/EVs, IoT, data centers, graphics, and AI/ML accelerators - just to name a few.

As I have been saying for a few years now, "Data Is The New Oil". Indeed, the following graphic displays that important inflection point was reached in 2018:

Source: Applied Materials 2021 Investor Meeting

As can be seen, 2018 was the year when machines began generating more data than humans. That, combined with low-latency and higher bandwidth 5G and networking infrastructure, will lead to exponential growth in the amount of global data being generated - the majority of growth being in the IoT industrial sector. For more on that trend, see my Seeking Alpha article Aspen Tech's "AIoT Hub" Could Lead To Self-Optimizing Plants. Indeed, the amount of data generated in 2025 is estimated to be over 20x that generated last year.

But the more important point is this: all that data will be generated by devices (EVs, IoT, etc.) that will be driven by semiconductors. And semiconductors are needed by the internet and networks required to get the data to/from the cloud. Then, optimized ML/AI algorithms will need specially designed hardware accelerators (i.e. semiconductors) to process all this megadata in order to optimize processes, gain insights, and ultimately to improve companies' efficiencies and cash flow.

Is STM a good semiconductor company to cash-in on these long-term trends that will drive global semiconductor growth?

Earnings

STM's Q1 EPS report was strong. Highlights included:

• Revenue of $3.0 billion was up 35.2% yoy.
• Net income of $364 million ($0.39/share) was up 89.6% yoy.
• Operating margin of 14.6% was up a whopping 420 basis points yoy.
• Q1 free-cash-flow was $261 million.

At first glance, that appears like a very solid report - and it was (for STM). The results were driven by strong revenue growth in the Automotive & Discrete ("ADG") segment:

Source: STM Q1 Presentation

However, at 8.2% note, the ADG segment has the company's lowest operating margin. Meantime, revenue fell ~24% sequentially in the AMS segment (17.2% operating margin) and was relatively flat in the Microcontroller & Digital IC segment ("MDG") where operating margins actually fell qoq to 19.4%.

No Margin For Error

Overall, for Q1 STM reported:

• Gross Margin: 39.0%
• Operating Margin: 14.6%

While both were improvements as compared to the year-ago Q1, let's compare them with Texas Instruments' (TXN) Q1 results:

• Gross Margin: 64.6%
• Operating Margin: 45.2%

That is huge difference as compared to STM's margins. Consider that TXN's operating margin is higher than STM's gross margin. As a result, TXN generated $1.54 billion in FCF during the quarter or ~36% of Q1 revenue. That compares to FCF/revenue of ~8.7% for STM.

The bottom line: there are a number of reasons that STM has lower margins than TXN, one being its connection with the French government which likely influences wages over profitability. The other just might be that having such a large percentage of revenue coming from Apple may not be all it's cracked up to be. I say that because Apple is getting its high margin silicon (i.e. M1 processors) from Taiwan Semiconductor Corp (TSM). That means many of what I would characterize as second-tier silicon solutions (i.e. discrete, sensors, Bluetooth micro-controllers, etc.) are coming from STM, and Apple no-doubt squeezes them on margins.

Performance

As a result, STM isn't performing as well as some of the other semiconductor companies like TI and TSMC, although it has done better than Intel (INTC), but what company hasn't?

Data by YCharts

Going Forward

Meanwhile, STM guidance for Q2 shows minimal margin improvement going forward:

Source: STM Q1 Presentation

While expectations for revenue growth of 39% yoy is excellent, the 39.5% expected gross margin is up only 0.5% sequentially over Q1.

At the midpoint of FY21 guidance, STM expects revenue to grow 18.4% yoy. The company also expects to invest $2 billion into additional capacity to meet strong demand. That all sounds great, but the question for investors is simple: why not invest in a semiconductor company that will achieve a higher return on investment capital?

Summary & Conclusion

As my followers know, it is my belief that the fundamental global growth story driving the semiconductor sector makes it an ideal long-term holding, with a full allocation, in any well-diversified portfolio. And STM will likely be a decent market performer over the coming years simply due to the strength of the semiconductor market. However, it won't be a leader because its margins are substantially lower than the competition. That being the case, I would advise investors to stick with the best: companies like TSMC, Broadcom (AVGO), or even TI. For those who want a diversified semiconductor fund, I continue to recommend the VanEck Semiconductor ETF (SMH) - which has excellent exposure to the semiconductor equipment makers, which should thrive over the next few years as more global capacity gets built out.

I'll end with a three-year total-return comparison of STM to AVGO and SMH:

Data by YCharts

Analyst’s Disclosure: I am/we are long AVGO, SMH. 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.

I am an electronics engineer, not a CFA. The information and data presented in this article were obtained from company documents and/or sources believed to be reliable, but have not been independently verified. Therefore, the author cannot guarantee their accuracy. Please do your own research and contact a qualified investment advisor. I am not responsible for the investment decisions you make.