Even differentiated growth stories are often bounded by the performance of the underlying markets they serve, and so it seems with Power Integrations (NASDAQ:POWI). After a soft third quarter that saw 13% sequential revenue contraction, management guided to even weaker fourth quarter results and the company is likely to see a year-over-year decline in 2023 as the company sees inventory corrections across much of its business.
Even so, the shares have held up pretty well, only declining about 7% over the past year and outperforming the semiconductor industry index (the SOX) by more than 20%. Performance compared to other power-heavy semiconductor stocks has been more mixed, with onsemi (ON) and Analog Devices (ADI) outperforming and Infineon (OTCQX:IFNNY) underperforming. Pull the comparison out to three years and Power Integrations has done a little better than the SOX, a little worse than Analog and Infineon, and nowhere near as well as onsemi, which I attribute at least in part to POWI’s robust valuation in years past.
Looking at the investment case, I see some similarities with names like Lattice (LSCC) and Silicon Labs (SLAB) where valuations have gotten a little less demanding but where it’s still hard to call them conventional bargains. I’m not a big believer in “ignore valuation and just buy”, but if you want a solid multiyear growth semiconductor story this is a name to look at today.
Like most other semiconductor companies, Power Integrations over-earned in this recent boom period as capacity shortages across the industry and demand for more capable power conversion products gave the company strong pricing power and margin leverage. These situations don’t last, though, and by virtue of power products being toward the front of the production cycle, POWI is seeing its reckoning come on a little faster than other chip companies.
Revenue declined 13% sequentially (and 9% year over year) in the third quarter and management guided to a 22% sequential decline in Q4 (down about 28% yoy at the midpoint). The current average sell-side estimate is in line with that midpoint, but I do see some downside (maybe 3% to 5%) in the coming report, as underlying markets like smartphones, appliances, computing, and industrial have continued to weaken.
Power Integrations is in the midst of a painful inventory correction process. Early in the cycle POWI management chose to use supply to gain share (a strategy that Texas Instruments (TXN) also used to good effect), but inventories have been ramping up. By my calculations, inventory days have jumped from around 112-114 days at the start of 2022 (Q4’21 and Q1’22) to almost 150 days in the third quarter. Management has acknowledged as much, noting customers needing to work down inventories across its end-markets, but with demand starting to taper off more strongly (particularly in industrial markets), that inventory work-down process could be a little sharper in the next couple of quarters.
The good news is that I think this is a “first in, first out” sort of situation and that POWI is likely to see the bottom and recovery before the wider semiconductor group. I think we’re close to the end of the downcycle in smartphones and I likewise think the PC/consumer electronics end-markets are pretty close to washed out – I’m not looking for a strong rebound in 2023, but I don’t think there’s another leg down.
Other consumer devices, appliances in particular, could need a little more time to correct, and likewise with industrial markets. I’ll be very interested to see what companies like Eaton (ETN) and Schneider (OTCPK:SBGSY) have to say this quarter with respect to electrical product demand and the demand for factory automation.
I believe Power Integrations will emerge from this correction in strong shape, and with strong growth in FY’25-FY’28 on the back of growing demand for high-power power conversion products and growing penetration of GaN chips in power switches.
POWI’s gate driver business is a good play on the ongoing growth of automation and electrification in factories, commercial buildings, and warehouses, as automation systems generally have more demanding power requirements. On top of that is ongoing growth in areas like solar power generation, medical equipment, and EV charging, as well as longer-term growth in areas like industrial microgrids.
I’m also bullish on the motor driver business, including the company’s BridgeSwitch motor control products. Smart motor control is going to become increasingly significant in a range of served markets (including consumer appliances and industrial equipment), and appliances alone could be a $100M business for POWI in 2027 (that is, in smart motor control chips for consumer appliances).
POWI also has a strong play on the growth of EVs. The IGBTs manufactured by companies like Infineon for electric cars need gate drivers to provide the control logic, and the company is well-placed here. This is still a small business today (EVs are still a small percentage of overall auto production), but the demand for higher-voltage power conversion in EVs could push the company’s addressable content in cars from around $75 to $175 over the next five years.
In terms of more traditional power modules, POWI is still in place to benefit from companies like Dialog (now part of Renesas Electronics (OTCPK:RNECY)) and onsemi walking away from what is, for them, lower-margin and less attractive business.
It’s not inherently bad business, though, and POWI has shown that it can earn decent returns here – management’s overall margin guidance is still below the 60%-65%/30% “sweet spot” for semiconductors (gross margin and operating margin), but it’s not too far off and growth in businesses like GaN (which could grow from a high single-digit percentage of revenue to 20% over the next five years) could offer some upside.
In addition to a slightly weaker outlook for the fourth quarter, my 2023 revenue expectation is below the Street average (around $605M versus $622M). I may be too bearish on the outlooks for appliances, enterprise computing, and industrial end-markets, but we’ll see what fourth quarter earnings reports hold in terms of guidance for 2023 for these end-markets. I expect a sharp rebound in 2024, though, and long-term (10-year) annualized revenue growth in the high single-digits.
I do expect margins to erode more in 2023, but I think operating margin will get back into the high-20%’s in FY25 and I think 30% is a fair target over the longer term (and perhaps higher if the business mix shifts). I’m expecting long-term free cash flow margins in the low-to-mid-20%’s, and that will fuel healthy double-digit FCF growth. Given a clean balance sheet and good FCF growth potential, I do wonder if POWI might get more active on M&A during the downturn.
Unfortunately, none of this drives particularly compelling fair values by my discounted cash flow and margin-driven multiple-based valuation approaches. Discounted cash flow suggests an annualized long-term total return potential in the high single-digits, which actually isn’t too bad, but even if I give the benefit of the doubt with respect to margins, revenue growth, and sentiment (EV/revenue and EV/EBITDA multiples expand and contract over the cycle), it’s tough to get a price where the shares look cheap.
I’m not surprised that POWI doesn’t screen out as cheap, particularly given the company’s leverage (and leadership) to longer-term secular growth in building/factory automation, energy efficiency, vehicle electrification, and so on. This is typically the way it goes with growth stories and investors have to make their peace with it. While I’m not going to advocate for “just ignore the valuation and buy”, investors who are less sensitive to valuation concerns and more confident in the company’s ability to “grow into” the valuation should definitely take a closer look.
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