COHU - Cohu: Structurally Improved Gross Margin With Good Capital Allocation Policy

2023-03-16 03:52:47 ET

Summary

• 4Q22 adjusted EBITDA leans towards the higher end of guidance due to higher-than-expected revenue, strong gross margins, and reduced operating costs.
• Despite a weak macro backdrop, annual recurring revenue has increased for four consecutive quarters, and the company has made structural improvements to its gross margin profile.
• I expect management to continue returning at least 50% of its free cash flow to shareholders.

Summary

Cohu's ( COHU ) adjusted EBITDA for 4Q22 leans towards the higher end of guidance, thanks to higher-than-expected revenue, strong gross margins, and reduced operating costs. What is worth noting from this earnings is that I now have a deeper respect for the COHU ability to continue winning shares in Contactors and the resilience of Cohu's Recurring product offerings, despite the 800bps decrease in test cell utilization rates. In combination with the information provided below, I expect COHU to benefit from an up-cycle demand in 2024, and I believe COHU recent efforts to reduce costs will lead to a higher gross margin throughout the business cycle. Based on this, I recommend a buy rating for COHU.

Robust demand

Annual recurring revenue has increased for four consecutive quarters with revenue growing 3% to $86 million. Note that this is despite test cell utilization rates dropping to 79%. Management explained the discrepancy by saying that the interface business grew by 9% over last year as a result of numerous design wins by Contactor. As a result, the decline in Tester activity was cushioned somewhat by the increase in market share. What's more, it's important to note that COHU has proven particularly successful in boosting customer retention rates and encouraging a larger volume of new customers to sign up for the company's services. This is a huge step forward, as it helps with securing COHU market position by neutralizing the presence of competitive third-party suppliers. I find these outcomes encouraging because, other things being equal, a higher percentage of recurring revenue streams will result in a steadier top line and a more robust degree of free cash flow generation, both of which are important for the health of the balance sheet and the return to shareholders.

Gross margin

Non-GAAP gross margin for 4Q22 was 48.8%, an increase of 130bps from the previous quarter. Notably, COHU has increased its gross margins for the fifth consecutive quarter thanks to a combination of a better sales mix for its differentiated products and higher gross margins across the board. It is important for investors to know that COHU is still working through the last of its premium-priced IC component inventory, which is near-term headwind to margins right now. My calculations show that if this had been taken into account, non-GAAP gross margin would have been higher than the COHU target of 49% (the next mid-term gross margin target). Considering that the target margin was based on a revenue scale of $1 billion and the 4Q22 run-rate was $800 million, I think management deserves praise for this impressive achievement. Despite management's guidance that momentum will slow in the 1Q23 due to lower volume and unfavorable mix, I find it interesting that gross margin is similar to FY22 levels despite a ten percent decrease in annualized revenue. Therefore, I still maintain my belief that COHU has made structural improvements to its gross margin profile throughout its business cycle. Even though there may be a decrease in revenue, I anticipate that the non-GAAP gross margin will remain consistently stable in CY23.

Weak macro backdrop

This feeble macro assault does not spare COHU. Revenues are expected to fall by 10-15% in 2023, with the second quarter of that year being the low point, as management expects the recent softening in automotive and industrial end-market demand to deepen over the next few quarters. System sales would be hit the hardest, but consumer and mobility app sales would also be hit hard as those industries work through their stockpiles of unsold products. While bulls are fixated on the strong recovery story for 2H23, I like to remind investors that management has stated they anticipate a more gradual trajectory exiting 2Q23 due to the fact that longer lead times, especially for handlers, will slow the company's ability to respond quickly to a shift in demand.

Shareholder returns

During 4Q22, COHU bought back $12.6 million worth of shares and gave back almost half of its free cash flow to shareholders. This is the second consecutive quarter where the management has given back around 50% of FCF to shareholders. Looking forward, COHU still has approximately $80 million in authorization for share repurchases and I expect management to continue giving back at least 50% of FCF to shareholders over the next two years.

Conclusion

COHU 4Q22 earnings report highlights the company's ability to exceed guidance due to higher-than-expected revenue, strong gross margins, and reduced operating costs. Despite the challenging macro backdrop, Recurring product offerings have proven resilient, with annual recurring revenue increasing for four consecutive quarters, and customer retention rates improving. Furthermore, COHU has made structural improvements to its gross margin profile. All of these coupled with my expectations that management will continue to return at least 50% of FCF to shareholders, I believe that COHU is set up for success and deserves a buy rating.

For further details see: