STMEF - Deep Dive Into Automotive Semiconductor: Top Picks To Rev Up Your Portfolio

2023-07-20 10:57:16 ET

Summary

• The automotive semi is expected to experience significant growth due to the rise of electrification, autonomous driving, and e-mobility technologies.
• The demand for automotive semiconductors has become less correlated with car production, with sales increasing by 47% from 2019 to 2022 despite a 7% decline in car production due to the pandemic and supply chain constraints.
• ON Semiconductor and Infineon Technologies are the top picks due to their high exposure in the automotive, market leader positions, strategic focus, and early investments in silicon carbide.

The automotive semiconductor market is experiencing several megatrends that are shaping the future of the industry. Electrification, ADAS, autonomous driving and e-mobility technologies are creating a growing demand for microcontrollers, sensors, and processors. I think in the next decade, the strongest-growing segment among global semiconductors is likely to be automotive. After going through the major automotive semiconductor companies, I choose ON Semiconductor (ON), and Infineon (IFNNY) as my top picks.

Potential Market Size

According to McKinsey the semiconductor decade: A trillion-dollar industry Report , the global semiconductor market is projected to surpass $1 trillion by 2030. The automotive sector is expected to experience the most significant growth, potentially tripling its demand due to the rise of electrification, autonomous driving, and e-mobility technologies. Analysts forecast that the automotive semiconductor market will reach $150 billion by 2030, indicating an annual compound growth rate of 13% from 2021 onwards.

Automotive Semiconductor Demand Has Become Uncorrelated with Car Production

For automotive-related investments, a general risk has been the volatility of car production. When a company's sales are tied to car production volume to some extent, their earnings can become highly cyclical. However, it seems that the demand for automotive semiconductors has become less correlated with car production.

An example of this decoupling can be seen during the period from 2019 to 2022, where car production declined by 7% due to the pandemic and supply chain constraints, but automotive semiconductor sales actually increased by 47% during the same period.

In the past, auto makers didn't prioritize semiconductor companies as important partners, leading them to not build up their chips inventory. Instead, they would place orders for chips when they needed to manufacture their cars. However, the dynamics have shifted with the increasing penetration of electric vehicles and the impact of the pandemic.

The importance of automotive semiconductors has emerged prominently now, as these chips are critical components for electrification, ADAS, autonomous driving, and e-mobility technologies. Without an adequate supply of chips, auto makers face difficulties in delivering cars, which underscores the crucial role of semiconductor companies in the automotive industry's future.

Semiconductor Content Per Car Growth

According to McKinsey Winning share in automotive semiconductor report , the average automobile currently contains approximately $350 worth of semiconductor content, with nearly 80% of that attributed to microcontroller units, analog, and power components. However, the semiconductor content nearly doubles in hybrid vehicles, reaching around $1,000 in luxury vehicles. Therefore, considering the increasing penetration of electric vehicles, it is reasonable to assume that the semiconductor content per car will experience accelerated growth over the next decade.

In Infineon Automotive Conference Call on October 4, 2022, Infineon expects electric vehicle semiconductor content to grow from $1,000 today to $1,500 by 2027. As a result, electric vehicles present a unique opportunity for semiconductor companies, and the chips will be broadly used in various aspects such as chassis, powertrain, infotainment, networking, safety and control, autonomy, and electronic systems.

Automotive Semiconductor Universe

I only include US and European companies in this analysis, considering that most readers here are US-focused. Among US-listed companies, ON Semiconductor ( ON ) and NXP Semiconductor ( NXPI ) have high exposure in the automotive semiconductor space. In Europe, STMicroelectronics ( STM ) and Infineon ( IFNNY ) are the two key players.

As I point out in ON Semiconductor: Multi-Decade Growth In Silicon Carbide And Electrification , I believe silicon carbide will experience remarkable growth in the next decade compared to traditional silicon technology and IGBT. Silicon carbide offers an extended range for EVs, although it currently comes with a higher cost. In the silicon carbide market, ON Semiconductor, STMicroelectronics, Infineon, and ROHM (a Japanese company) are the major players.

It's important to note that Wolfspeed (WOLF) is a major wafer provider for silicon carbide. However, it has a capital-intensive business model and a weak balance sheet, which is why I haven't included this company in my analysis.

Top Pick #1: On Semiconductor

On Semiconductor has 47% exposure in the automotive end-market, and their management has actively optimized their portfolio by divesting non-core businesses and focusing on high-growth end-markets in the automotive and industrial sectors. They are well-positioned in the sweet spot of electrification and silicon carbide, two key areas driving innovation and growth in the semiconductor industry. ON is targeting three times the market growth from 2022 to 2027, implying a sales compound annual growth rate of 10-12%.

In addition, ON Semiconductor is actively ramping up their silicon carbide business and expects to accelerate sales to reach $1 billion by the end of the year. In the last quarter, they have already secured $17.6 billion worth of long-term supply agreements, paving the way for ON's future growth.

On July 18, 2023, ON Semiconductor announced an expansion of their silicon carbide collaboration with BorgWarner ( BWA ) , which is worth over $1 billion in lifetime value. Given ON's consistent investments in the automotive semiconductor sector, it is expected that they will continue to gain more market share in the future.

ON is scheduled to announce their Q2 results on July 31. They anticipate Q2 revenue to be in the range of $1.975 billion to $2.075 billion, remaining roughly flat year over year. More specifically, they expect growth in the automotive and industrial sectors, while other markets may experience flat to down performance as ON plans further exits in their non-strategic end markets. They aim to exit $400 million of non-core, low-margin business, having already exited around $47 million in Q1, slightly below their expectation. The plan is to exit $85 million in Q2, with the remainder planned for the second half of this year. This indicates a ramp-up in the second half of the year.

Considering ON Semiconductor's Q2 guidance, it sets up a weak growth expectation, and I don't anticipate they will deliver a weaker result than the guidance.

For more detailed analysis and valuation model, please refer to my recent article: ON Semiconductor: Multi-Decade Growth In Silicon Carbide And Electrification . I maintain my valuation at $124 per share.

Top Pick #2: Infineon Technologies

If you want to include a European company in your portfolio, I'd pick Infineon Technologies. It is one of the leading semiconductor companies for automotive, renewable energy, data center, and IoT applications, with automotive representing 45% of their group sales. As previously mentioned, Infineon is also one of the key players in the silicon carbide industry.

Infineon is a truly global player, ranking #1 in power semiconductors and #5 in the overall microcontroller market. Their undisputed power system leadership encompasses all three key materials: silicon, silicon carbide, and gallium nitride.

Infineon's growth rate has accelerated in recent years, and I expect them to deliver above 10% of annual sales growth in the future.

Financial Outlook: Infineon is scheduled to report their Q3 earnings on August 3rd. They expect to generate revenue of around €4 billion in Q3 FY23, indicating 10.5% year-over-year growth, or remaining flat compared to the previous quarter. For the full year, they anticipate €3 billion of capital spending.

Infineon expects strong growth in the automotive and industrial sectors, particularly in e-mobility and renewables, which are expected to remain robust. However, consumer-facing markets and spending on IT infrastructure are still sluggish, with no immediate improvement in sight. The end-market outlook aligns with the high inflation, putting significant pressure on consumers, and enterprises are delaying their IT infrastructure spending to prepare for a potential recession.

Key Risks : First, the key risk is the cyclicality of their business, given that they are a semiconductor company. However, it is important to acknowledge that they have a well-diversified range of end-markets, with 13% of sales from auto body power, 8% from IoT, 6% from data centers, 5% from ADAS, 6% from renewables, 10% from e-mobility, 7% from classic powertrain, and more. This diversification across end-markets could help offset some of the cyclicality that affects their business.

Secondly, Infineon operates on a capital-intensive business model, building some of their chip manufacturing facilities internally. In FY22, they spent more than 14% of their sales on capital expenditures, and I expect their capex spending to remain at a high level in the coming years.

Lastly, for those investing in US ADRs, it's essential to consider the foreign exchange rate of EUR/USD, as it could have an impact on capital gains when dealing with Infineon's stock, which is denominated in Euros.

Valuation : In the DCF model, I assume Infineon can grow above 10% in the next 5 years, then the growth rate starts to moderate to 8.1% in FY32. Due to the operating leverage and silicon carbide products, the operating margin is assumed to expand to 21.5% in FY32 in my model.

The model assumes 10% of WACC, 4% of terminal growth rate, and 17.5% of tax rate. With these assumptions, the free cash flow conversion is estimated to reach 17.2% in FY32 in my model. The present values of FCFF over the next 10 years and terminal are estimated to be €17 billion and 43 billion. Adjusting the cash and debt, the fair value is estimated to be €46 per share, as per my estimates. If you are investing in US ADRs, the fair value is USD $51 per share.

Conclusion

I think it is reasonable to include automotive semiconductor companies in my portfolio, as the automotive semiconductor industry is expected to experience structural growth in the next decade. In particular, ON Semiconductor and Infineon appear to be the two best players in the automotive semiconductor space due to their high exposure in the automotive end markets, market leader positions, strategic focus, and early investments in silicon carbide.

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