KN - ams-OSRAM Continues To Lag On Lackluster Performance

Summary

• Despite lower expectations, ams-OSRAM has continued to disappoint, including recent large cuts to guidance for Q1'23 and an early cut to 2024 guidance.
• The company's leverage to Apple (vs Android) smartphones has helped, but weaker Apple volumes are a risk in 2023, as is the company's skew to lower-value slots.
• Auto build rates should be positive in 2023, but the European market will likely be relatively weak and ams-OSRAM hasn't made the hoped-for progress in more advanced sensing-driven auto products.
• The microLED opportunity remains a significant one, and if ams-OSRAM can build an edge in assembly, it could establish valuable cost leadership.
• A new CEO could be the right medicine for this long-ailing company, and the expectations are low, but it will take time to rebuild the growth story.

For a little while there my "it's bad, but it's not that bad " call on ams-OSRAM (AMSSY) seemed to be working, as the shares were up about 25% relative to my last article going into the fourth quarter earnings. If you've followed ams-OSRAM for any length of time, you can probably guess what comes next - a weak report and ugly guidance, as the company continues to underperform a challenging smartphone market, but also continues to fail to distinguish itself in other markets. With that, the shares are down another 10% or so and have continued to lag the SOX index, as well as other smartphone-driven names like Knowles ( KN ) and Qorvo ( QRVO ), to say nothing of auto plays like NXP Semiconductors ( NXPI ).

I've said before that stocks don't outperform just because they're seemingly cheap, and ams-OSRAM is a case in point, as the market really doesn't have a place for a low-growth, low-margin semiconductor and LED company that has failed to show it can establish (and hold) meaningful traction in growth markets.

Low expectations (low single-digit revenue growth and mid-to-high single-digit free cash flow margins) can support a fair value of around $5 for the ADRs, and I do see potential catalysts with the new CEO and the eventual ramp of microLEDs. By the same token, Apple ( AAPL ) units could be vulnerable in 2023 and ams-OSRAM has a lot of work ahead to rebuild credibility with shareholders.

Weak Earnings And Very Weak Guidance

Miss-and-lower quarters weren't all that uncommon for the fourth quarter reporting cycle, but ams-OSRAM still delivered a pretty ugly combination, particularly on the guidance side.

Revenue declined 4% year over year and 3% quarter over quarter, missing by 1%. Core semiconductor sales were down 6% sequentially, while lamps and systems saw 3% sequential growth. Gross margin declined about five points from the prior year and 20bp from the prior quarter to 28.5%, while operating income fell 27% yoy and almost 6% qoq, missing by about 2%, with margin down 230bp yoy and 20bp qoq to 7.3%. Profits in the semiconductor business fell 26% qoq, with margin down 160bp to 5.9%, while lamps/systems rose 40% with margin up 270bp to 10.2%.

Like other companies with significant exposure to smartphones (companies like Knowles and Qorvo), ams-OSRAM slashed guidance for the first quarter of 2023. Management guided to 19% sequential decline at the midpoint, more than 10% below sell-side expectations, but in line with the 17% to 25% declines forecast by Knowles and Qorvo. Not surprisingly, margin guidance was also weak (with operating income down about 18% relative to analyst expectations).

Making matters worse, management also talked down 2024 guidance, with management projecting revenue on the lower end of its prior EUR 4,400M to EUR 5,000M range and operating margin on the lower end of its 12%-14% range. The main driver here seems to be a delay in the commercial ramp of microLED products, and we'll come back to this.

Autos Should Keep The Lights On

As far as good news goes, I do think that 2023 will be a respectable year for auto builds. I do have some concerns about weakening demand in Europe and ongoing issues in China, but I do think there will at least be net growth in auto production volumes, and I think ams-OSRAM should benefit from increasing penetration of LED lighting (more new models containing LED products relative to older models).

At the same time, the shares really need to see the company secure meaningful wins for more advanced products. Part of the "logic" of the OSRAM acquisition was integrating ams's expertise in areas like imaging and sensing to develop more sophisticated in-cabin components like condition monitoring and gesture tracking. While adoption here has been challenging for many companies ( Alps Alpine (APELY) has had its issues as well), at this point it's hard to really argue that OSRAM is showing itself to be much more than a run-of-the-mill lighting supplier, and that's just not good enough.

Smartphones Likely To Remain Under Pressure

Given its greater leverage to Apple, ams-OSRAM has thus far bypassed some of the worst of the smartphone volume weakness, but that may not be the case much longer. Apple volumes have held up relatively well compared to Android, but I do believe Apple smartphone volumes could be weak in 2023 - something on the order of a mid-to-high single-digit decline. That's a headwind that ams-OSRAM really doesn't need.

I'd also note that the company has really lost momentum in what were supposed to be higher-value growth drivers. The company seems to have lost a lot of momentum in areas like 3D sensing to STMicro ( STM ) and likewise in VCSELs to vendors like Coherent ( COHR ). Management has been refocusing around areas like camera enhancement (color sensing and folded path optics) and ambient light sensors, but those are lower-margin opportunities and I expect more significant price pressure here in the coming years.

There are still opportunities for this business to grow. Vital signs monitoring via wearables looks like a growth opportunity, as does sensing/imaging technology for VR/AR, and I like the longer-term opportunity to leverage the core sensing technology here into machine vision and industrial IIoT markets. Unfortunately, these are all small markets today and I have real concerns about how ams-OSRAM will perform once larger players start addressing them more directly.

The Wait Goes On For microLED

The opportunity to leverage a multibillion-dollar opportunity in microLEDs, including the integration of OSRAM LED technology with ams sensors and controllers was touted as one of the main value-creation opportunities from the ams-OSRAM deal, but it has been slow to develop, and now management says there won't be a real commercial ramp until 2025.

Maybe good things will come to those who wait, but this is an important market opportunity. This technology is alternative to OLED and is supposed to offer numerous advantages like improved contrast, true blacks, and off-angle viewing without issues like burn-in or decay. It's not unusual for new technologies to see delays in reaching the market, but ams-OSRAM really needs this market to pan out for them.

One of the biggest issues to adoption today is the high cost, which is a byproduct of how challenging it is to assemble microLED displays - you're basically putting together millions of elements the size of a grain of pollen and there can't be any errors in the positioning. If ams-OSRAM can establish leadership here (more efficient assembly, leading to lower costs), it could be a major catalyst for a longer-term recovery.

The Outlook

This company will soon have a new CEO, with Alexander Everke stepping aside and Aldo Kamper becoming the new CEO in April. I haven't been all that impressed with Everke, and Kamper used to run the Opto Semiconductors business at ams, back when that was a growth-driving part of the business. To be fair to Everke, perhaps he realized that early success in 3D sensing for smartphone applications wasn't sustainable and that the business would need something else to offset its eventual deterioration, but I have disagreed with the OSRAM deal pretty much from day one and have viewed it as a value-destroying move.

Looking at ams-OSRAM now, I'm still only expecting low single-digit revenue growth. Opportunities to do better are plentiful, but the company's execution has been poor and I need to see more "addressable market" revenue translate into actual revenue before getting more aggressive with my modeling. Likewise on margins, where I do think double-digit operating margin in 2024 may yet prove too optimistic if the smartphone business deteriorates further (not just in volume terms, but in pricing/margin as well).

At this point, then, I'm only modeling around 2% to 4% revenue growth (2% if you start from FY'22, 4% if you start from my FY'23 estimate, which I believe will be a new low/base), and I'm only expecting FCF margins to get into the 7%'s (versus a long-term trailing average of around 5%). Success in 3D sensing, behind-OLED sensing, machine vision, medical/vital signs monitoring, in-cabin gesture sensing/condition monitoring, and micro-LED could all support better revenue and margins, but ams-OSRAM has to earn some benefit of the doubt.

Even on those lowered assumptions I get a fair value of around $5, and likewise with my near-term margin assumptions for gross margin and operating margin (margins correlate relatively well to EV/revenue and EV/EBTIDA multiples for chip stocks).

The Bottom Line

On one hand, ams-OSRAM is already beaten down to a point where it takes very little in the way of growth assumptions to drive a higher fair value. On the other hand, the smartphone business could erode further, auto volumes could disappoint, and the company may not gain any meaningful traction in potential growth markets like microLEDs. I do think the risk/reward still skews toward the stock as a worthwhile speculation, but it's hard for me to advocate strongly for a stock where I have a lot of ongoing concerns about the base business.

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