Second chances to buy strong growth stocks are always worth a look, particularly if there doesn't seem to be anything broken with the fundamental growth story. Such would seem to be the case at Silicon Labs (NASDAQ:SLAB). I can understand some disappointment with management not guiding to stronger longer-term profitability at the recent Analyst Day, but the core IoT growth story (driven by strong wireless capabilities at SLAB) is still very much intact.
Clearly, there are a lot of factors beyond Silicon Labs to consider now. The market is clearly not as interested in growth stocks now, and the semiconductor sector has weakened in light of the increasing likelihood that peak growth and margins have been seen (or are in sight) for the cycle. It will take time for those issues to work themselves out, but I still see Silicon Labs as a double-digit grower and that makes the stock valuation today considerably more interesting.
The Analyst Day that Silicon Labs hosted on March 1 gave investors a lot of arguments for why IoT will remain a significant growth category within semiconductors, as well as arguments for why and how Silicon Labs will continue to leverage that growth through its strong presence in wireless technologies.
The problem with that, if you want to call it that, is that it's not as if the market has been blind to the growth opportunities in IoT. Opportunities like smart grids, smart buildings, smart factories, and smart homes have all been understood for a while now, with IoT representing key enabling technology in a lot of these categories. So while management's projection of over $17B in addressable edge IoT revenue in 2025 underlines the strong growth potential of the market, I'd argue it's not really a new development.
At the same time, I think the Street was disappointed that management didn't raise the long-term financial guidance, reiterating a mid-50%s gross margin target and low-to-mid-20%s operating margin target. That's arguably more frustrating in the context of management's assertion of their advantages over large analog companies like NXP Semiconductors (NXPI), STMicro (STM), and Texas Instruments (TXN) in being able to lead from a strong position in wireless (claiming that integrating/adding wireless into compute functions (microcontrollers or MCUs) is harder than the other way around).
Likewise, I believe the Street wanted to hear more about management's plans for deploying the considerable cash it still has on the balance sheet after selling its non-IoT businesses to Skyworks (SWKS) last year. Management has already been active on the buyback front but ended the last quarter with over $2B in cash still on the books. Given management's commitment to remaining a pure-play on IoT, and given its strong existing platform in wireless tech, I would expect some M&A interest on the software side, and perhaps some interest in compute if the right deals were to appear.
Having addressed what Silicon Labs didn't offer up in the Analyst Day, I think reiterating some of the growth opportunities is still worthwhile.
Management is looking for 15% growth through 2025 in what it calls "Industrial and Commercial", a market that includes end-market use-cases like smart metering, renewables (helping better-positioned wind turbines and solar panels), EV charging, precision agriculture, remote monitoring/maintenance, industrial wearables (like mine safety), retail, and smart buildings (helping control lighting, HVAC, et al).
This business currently generates a little over half of revenue, and I believe this is a market where SLAB's recent focus on security can pay off. That said, and at the risk of harping on something I've mentioned in prior pieces, I do wonder if SLAB's relatively weaker positioning in areas like sensing and compute will be a limiting factor. Customers can, do, and will assemble "best of breed" components as needed, and SLAB has a strong wireless core franchise, but it's something that does concern me.
Management is also looking for around 12% growth in its "Home and Life" markets, which includes a range of smart home functionality like HVAC, security, lighting and so on, as well as a range of other indications like entertainment, wearables, and medical. On that latter point, I see significant ongoing opportunities in healthcare, particularly in remote monitoring and tracking. Given the ongoing shortages of skilled medical workers, the more patient monitoring that can be done remotely, the better, and likewise with ensuring patient safety by remotely monitoring their location and behavior (alerting nurse stations if patients get out of bed, etc.).
All told, I think Silicon Labs can generate low double-digit growth over the next decade on the back of significantly increased penetration of IoT devices across these end-markets. There will certainly be competition, but thus far, SLAB has been able to stand out on the strength of its wireless capabilities.
I would have liked a better explanation for why Silicon Labs won't see better margin leverage on what has been an upgraded revenue outlook. I do think reinvestment into the business is meaningful (R&D for software development especially), but I wonder if management is anticipating more vigorous competition in the future, particularly on price. Insofar as the gross margin is concerned, I don't see a lot of manufacturing cost risk - SLAB's chips don't require leading-edge nodes and can take advantage of cheaper, less sophisticated production processes.
In the near term, I am concerned about peak margin risk. While management guided to very strong gross margin in the next quarter (around 63%) on very strong pricing, that margin will shrink as the company builds up higher-cost inventory, and then drift down toward that mid-50%s longer-term target. In general, chip stocks do well on both strong revenue growth and expanding margins, and it looks like expanding margins will be off the table for some time.
Longer term, though, I do still like the potential here for well above-average revenue growth coupled with improving FCF margins over time. Provided that there is upside to low-to-mid-20%s operating margins further down the line (beyond 2025), and I believe there is, I think SLAB can get to 20%+ adjusted free cash flow margins and generate robust free cash flow growth.
Discounted cash flow now suggests a total annualized potential long-term return in the low double-digits, provided again that low double-digit revenue growth and long-term FCF margins in the low 20%s are both achievable targets. The near-term valuation gets tricky; typically, I would use the expected margin over the next 12 months, but given that Silicon Labs is coming off a peak, I'm still using a longer-term approach (estimated margins in 2024/25), discounted back to the present day. Doing so gives me a margin-based fair value in the $160s.
Silicon Labs shares shot up about a third after my last piece before beginning a steep slide that now has the shares about 15% below the price when I last wrote about the stock. Apart from some disappointment that 2025 margin targets weren't raised and some near-term concerns about customers rebuilding inventory (taking away pricing power) and lower margins, I don't think the story has gotten that much worse.
There is definitely a "falling knife" aspect to this stock now, and I don't pretend to know how much weaker the market will get before investors are willing to buy riskier growth stocks again. I am confident, however, that IoT remains an attractive growth market and that Silicon Labs is well-leveraged to that opportunity. With that, and a more interesting valuation, this stock is worth a look.
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