Skyworks Solutions: An Undervalued Semiconductor Stock With Growth Prospects

Investment thesis

Skyworks Solutions Inc. (SWKS, Financial) has fallen 9.7% over the past 12 months. The company's growth prospects are attractive, but the stock is deeply undervalued because the market is failing to recognize its potential.

Company profile

The company is a global leader in providing wireless semiconductor technology solutions. It manufactures and sells front-end modules, radio frequency subsystems and semiconductor components to wireless handsets and infrastructure original equipment manufacturers. Its product portfolio includes multi-band amplifiers, attenuators, diodes, directional couplers, switches and synthesizers.

Industry analysis

The performance of the wireless communication semiconductor sector is influenced by trends in the general semiconductor industry, which is highly cyclical. In 2018, the Semiconductor Industry Association reported global chip sales grew 13.3% to $467.1 billion, though demand weakened in the second half of the year. The decline in demand has extended into 2019. For instance, sales in the first half of the year plunged 13.9% compared to the same period last year. The decline in demand was experienced across all the major markets. Sales in the Americas, for example, were $41 billion, down from $49 billion in the first half of 2018. SIA estimates the semiconductor industry's sales will fall by 11.8% in 2019.

Source: Data from World Semiconductor Trade Statistics.

The wireless semiconductor industry is also characterized by rapid technological changes and the evolution of technical standards. Currently, the industry is poised for the transition from 4G to 5G. The shift is set to cause exponential growth in the industry. According to an Ericsson research report, at the end of third-quarter 2018, there were 5.7 billion mobile broadband subscriptions. Both 3G and 4G connections were included in this number. Most of these subscriptions are likely to shift to 5G-enabled devices in the future. Data from Helpnet Security reveals there were more than 22 billion connected devices worldwide at the end of 2018, which is approximately three times the number of people on earth. By 2025, this number is expected to be around 40 billion.

Source: Helpnet Security.

Wireless handset original equipment manufacturers are the industry's largest customers. Consequently, the demand for smartphones and other mobile connectivity devices has a substantial impact on industry revenues. Smartphones account for the largest portion of new mobile phone shipments. For instance, Counterpoint Research reported 77% of phone shipments in the fourth quarter of 2018 were smartphones, compared to 23% for feature phones. The top smartphone original equipment manufacturers are Samsung (XKRX:005930, Financial), Huawei and Apple (AAPL, Financial). In the second quarter, these three companies accounted for 48% of all smartphone shipments. Year-over-year shipments for Samsung and Huawei grew by 7.1% and 4.6% during the quarter, while Apple’s year-over-year shipments declined 11%. Overall, global shipments decreased by 3% to 341 million in the second quarter.

The semiconductor industry’s performance has also been affected by the U.S. government’s ban on Huawei's networking equipment. According to the Semiconductor Industry Association, Huawei is the third-largest buyer of semiconductor components in the U.S. Skyworks Solutions serves all the major smartphone original equipment manufacturers, including Huawei. As a result, the company revised its revenue guidance for the third quarter from a range of $815 million to $835 million to $755 million to $775 million.

Financial performance and valuation assumptions

The trends in the most-important inputs to the discounted cash flow model are analyzed here. The results have been used in the model to calculate the intrinsic value.

Skyworks revenue has grown in each of the last five years. However, the company is expected to report lower revenue in 2019. The company’s revenue for the first nine months of the year was $2.5 billion, compared to $2.8 billion for the same period last year. Moreover, its third-quarter sales were down 14.23% from the prior-year quarter.

Source: Data from company filings.

Revenue by segment indicates the company's major customers have been shifting operations from the Asia Pacific region (China, Taiwan, South Korea) to the Americas. Revenue from the Americas, which now accounts for about 50% of Skyworks' sales, increased from $1.09 billion in 2015 to $1.95 billion in 2018. In contrast, revenue from China fell from $2.24 billion in 2015 to $982.8 million in 2018. Overall, sales from the Asia Pacific region declined from $3.1 billion to $1.77 billion over the same period.

Source: Data from company filings.

The gross profit margin has been stable since 2016, ranging between 50.4% and 50.6%. The 2019 margin is, however, expected to be lower relative to the last three years. For instance, the gross margin for the first nine months of 2019 was 46.98% and, in the third quarter, it declined further to 40%. Skyworks attributes most of this decline to non-recurring items. In the third quarter, margin deterioration was caused by a non-recurring charge of $67 million, mainly relating to inventory write-downs connected to the Huawei ban. Adjusted for this one-time item, the margin would come to 50.4%, which is consistent with the trend over the last three years. The company produces customized products for its customers. Therefore, the loss of key customers usually leads to material inventory write-downs.

Source: Data from company filings.

The company's operating margin followed the same trend as the gross margin over the last five years, indicating that operating expenses are highly stable. The margin declined to 21% in the third quarter, largely due to the expenses relating to the Huawei ban. The operating margin adjusted for non-recurring items was 33% in the same quarter.

Source: Data from company filings.

Due to low non-operating expenses, the company has a very high net income margin. The margin was highest in 2016 (30.26%) and lowest in 2014 (19.97%). Further, the margin has been on a downtrend in the last two financial years after peaking in 2016. The trend is, however, likely to reverse in 2019. According to Skyworks' third-quarter results, its net margin for the nine months ended June 30 was 22.22%, relative to 16.36% for the same period in 2018.

The company has low insolvency risk due to a lack of long-term debt. Although this characteristic has a negative effect on the value of the company by raising the cost of capital (because debt is cheaper than equity), it increases its ability to withstand economic slowdowns since it has no interest expenses to pay during such periods. Low leverage is vital for semiconductor companies because of the cyclical nature of the industry.

Source: Data from company filings.

Valuation

Skyworks had a compounded annual sales growth rate of 8.45% over the last two years and 11% over the last five years. Assuming the two-year growth rate can be maintained over the next five years, a DCF analysis yields a value per share of $111.54. In contrast, the intrinsic share price is $124.82 based on the last five years' CAGR. The current price of the stock is $79.27. Therefore, the company is undervalued by between $32.27 and $45.55 per share under the DCF approach.

Source: Inputs from company filings and the results of the DCF model.

Semiconductor stocks tend to be volatile due to the cyclicality of earnings. Therefore, concluding that Skyworks is undervalued using a DCF model alone seems risky, especially when there is a possibility that shares are trading at comparable multiples with the industry and its peers. Considering this, it’s safe to calculate the intrinsic value of Skyworks shares using earnings multiples as well to verify whether the result would be the same.

According to analyst estimates found on Reuters Eikon, the forward earnings per share for Skyworks is $6.17, whereas the forward industry price-earnings ratio is 17.76. Hence, the company’s value per share based on earnings multiples is $109.57. Accordingly, the stock is undervalued by $30.3 under this method.

Source: Estimates using consensus analyst expectations on Reuters Eikon.

Based on both techniques used, Skyworks shares are undervalued. This reflects the pessimistic sentiment of investors toward the semiconductor industry as well. The poor performance in 2019 is largely attributed to three factors. First, the sales trend in the industry has affected the company’s revenues. Second, the ban on Huawei has caused the company to forego a large portion of sales—Huawei accounted for 10% of the company’s revenue in 2018. Third, Apple, the company’s largest customer, recorded lower sales in the first half of 2019 compared to 2018. It accounted for about 47% of the company’s revenues in 2018, as per company filings.

Conclusion: multiple catalysts will drive Skyworks' shares higher

Over the last 10 years, Skyworks' sales have grown at a compounded annual rate of 17%. Even during the recession, the company only recorded a sales decline of 7%. As Barron’s projects, the transformation from 4G to 5G will result in higher demand for advanced chips due to the high technical requirements of 5G-enabled devices. This will act as a catalyst for Skyworks considering the existing partnerships the company has with leading mobile device manufacturers. The expected growth in the number of connected devices globally will also be a performance driver in the future.

The valuation methods used suggest these growth opportunities are not yet priced into the stock. Skyworks is a buy.

Disclosure: I do not own any stocks mentioned in the article.

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