SSNLF - Qorvo Export Controls And Huawei: Possible Ramifications

2023-07-19 03:55:28 ET

Summary

• Qorvo has seen earnings shrink, but the market has looked past it in anticipation of a recovery in the near future.
• The trajectory of the recovery could be influenced by a couple of wildcards, although it remains to be seen what, if any, impact there will be.
• The potential impact could range from nothing much to severe disruptions in the supply chain and a long-term impact on QRVO’s competitive positioning.
• The stock can continue to rise, provided no new headwinds pop up because the recovery will be impacted if there are new ones.

Qorvo ( QRVO ) has seen its earnings shrink in recent quarters due to a number of headwinds, including weak demand for RFFE modules used in the mobile market. Yet the stock has done fairly well in comparison as the market has been trying to look past the present with an eye towards the future. However, QRVO got a jolt in early July when China announced export controls on gallium and germanium. These are needed for compound semiconductors like silicon germanium or SiGe, gallium arsenide or GaAs and gallium nitride or GaN, all used by QRVO in its various products like power amplifiers. In addition, there are reports Huawei intends to make a comeback in the 5G market for smartphones. These developments come at a time when QRVO is trying to get back on its feet, but they have the potential to affect the recovery for QRVO. Why will be covered next.

QRVO is in a downturn, but the market is betting on a rebound

It's fair to say business is not so good for QRVO. In the recently concluded FY2023, revenue declined by 23.2% YoY from $4,645.7M to $3,569.4M. FY2023 EPS fell to $1.00 in terms of GAAP and to $5.92 in terms of non-GAAP, down from $9.26 and $12.35, respectively, in FY2022, even though 8.7M shares were bought back to boost EPS.

The decline can be attributed to various factors, including weak demand in end markets in combination with excess inventories. Weakness in demand has been more pronounced in the consumer segment, especially the smartphone market. For instance, IDC is forecasting a 3.2% YoY decrease in smartphone shipments to 1.17B units in 2023.

This affects QRVO because the need for RFFE modules for mobile communications is huge due to the size of the market. QRVO is trying to mitigate the impact with higher chip content, but unit shipments will always be a factor. What goes on in the smartphone market matters a lot, even though QRVO produces a range of other products for various markets.

It's not without reason that Apple ( AAPL ) and Samsung ( OTCPK:SSNLF ), the two leading manufacturers of smartphones, were QRVO's top customers at 37% and 12% respectively in FY2023. Keep in mind that the last two quarters were much weaker than the two that preceded it. QRVO earned $4.91 in H1 FY2023, but just $1.01 in H2 FY2023.

Q4 FY2023 non-GAAP EPS hit a multi-year low at $0.26, much less than Q4 FY2022's $3.12. Yet, the stock has actually done better with the weaker numbers than with the stronger numbers. The chart below show how QRVO has done relatively well in recent quarters terms of the stock's performance, especially after accounting for the prevailing headwinds. The stock is up 18.5% YTD.

Why the market is looking past the weak results at QRVO

QRVO actually disappointed with the most recent quarterly guidance $0.03 below expectations at $0.15 and revenue of $620-660M in Q1 FY2024. However, QRVO was able to counter soft guidance with an outlook that called for a rebound in the following quarters. For instance, QRVO suggested in the earnings call a 50% sequential increase in Q2 FY2024 revenue with seasonality turning in its favor.

This implies at least a ten-fold sequential increase in EPS from $0.15 to around $1.50-1.60 in Q2. FY2024 revenue is expected to be better than FY2023 with non-GAAP gross margin of 44%. Based on these data points, QRVO is estimated to earn around $5.00 on revenue of $3.6B by the end of FY2024. From the Q4 FY2023 earnings call:

For the full year fiscal '24, we forecast revenue will be above fiscal '23 and expect to benefit from strong dollar content growth at our largest customers. For the full year, fiscal '24 non-GAAP gross margin is expected to be approximately 44%, with variability on a quarterly basis, primarily tracking utilization and mix."

A transcript of the Q4 FY2023 earnings call can be found here .

The recovery is based on several premises. Excess inventories have gone down and will continue to go down. Seasonality will come into force later in the year. Leading customers are expected to outperform in the smartphone market. The smartphone market is expected to grow again next year. QRVO is thus getting a lift from the belief the recovery is about to start, if it hasn't already.

What could affect the recovery at QRVO

A closer look at the previous chart shows how the stock took a dip after July 3, although it did manage to recover. It's probably no coincidence this date coincided with China announcing export controls on germanium and gallium, which could have an impact as China is the largest supplier of both. China was reportedly the source for 98% of the 550K kilograms of low-purity gallium produced in 2022, on top of having 86% of the global gallium production capacity. China is also the leading exporter of germanium, but not to the same extent as gallium.

Note that export controls do not mean export is prohibited. Export requires permission and China's Ministry of Commerce has said permission will be granted as long as applicants comply with relevant regulations. Still, there is the possibility the worldwide supply of germanium and gallium could be reduced to a lesser or greater degree, depending on how export controls are implemented by China. Less supply implies higher prices, depending on the extent of the shortage, if any.

However, a total ban on exports seems unlikely in light of the above. On the other hand, QRVO might be more vulnerable than other companies to disruptions in its supply chain due to the fact that it is a supplier to defense contractors like Raytheon ( RTX ) and Lockheed Martin ( LMT ) for things like radar systems that depend on GaN. Keep in mind China put both companies on its own version of the U.S. Entity List earlier in the year.

More worrying is that China reportedly did so "to prevent the use of Chinese products in their military businesses." One could therefore surmise China may seek to ensure its gallium and germanium does not wind up at these customers of QRVO. QRVO might see some disruptions to its supply chain due to this. Keep in mind that the export controls require companies to inform China what the gallium is to be used for and to whom it is destined for. Companies can go for alternatives, but this becomes harder if there is a global shortage.

It's probably too early to say what, if any, impact there will be from China's export controls. As long as supply is not reduced by too much, the impact could be manageable. There are alternatives to China being prepared, but this will take time. So whether supply chains are impacted depends on how the export controls are enforced by China.

How Huawei's return could impact the market for radio frequency chips and QRVO

China's export controls could be a problem in the near term, but it is something that will be resolved one way or the other in the long run, whether it is because China relents or because alternative supplies are brought online. A more lasting issue could be the possible return of Huawei as a supplier of 5G smartphones.

Huawei used to be one of the three largest manufacturers of smartphones, but its share has gone down ever since it was put on the U.S. Entity list, which reduced the supply of semiconductor chips severely or entirely, depending on the type. This basically prevented Huawei from making smartphones that are 5G capable.

Huawei had its own SoC with a build-in 5G modem and it had designed a number of RF parts like the low noise amplifiers, RF switches, power amplifiers and transceivers. However, what Huawei did not have were the filters. Huawei used BAW filters from QRVO, although it seemed to prefer using SAW filters from Skyworks ( SWKS ). Murata ( OTCPK:MRAAY ) used to be another supplier of filters to Huawei besides QRVO and SWKS.

Huawei's inability to source filters were confirmed when it released smartphones that came equipped with a SoC that was 5G capable, but which still did not support 5G because they lacked the 5G RFFE modules to go along with the modem. However, it appears Huawei may have found a solution to this problem, which could allow it to re-enter the market for 5G smartphones.

According to recent reports , Huawei intends to release smartphones that support 5G later this year. Note that this has not been officially confirmed, but these reports are consistent with earlier reports from China that suggest a number of companies in China have begun mass producing filters that support the frequencies needed for 5G functionality.

Remember Huawei is still under U.S. sanctions. If Huawei is able to release 5G phones, then this implies at least one company in China has succeeded in making the necessary BAW filters, something China was not capable of before. This could have several ramifications for QRVO. First, the absence of Huawei made it easier for its competitors, AAPL in particular.

AAPL was able to outperform in the last few years, which is reflected in AAPL's share of QRVO's revenue going from 33% in FY2022 to 37% in FY2023. But if Huawei returns in a big way, AAPL could see some or all of that tailwind disappear. This would in turn affect QRVO if demand from its number one customer goes down. More competition in the smartphone market with a Huawei return could make life harder for all players. Remember that smartphone demand is currently weak and more competitors will magnify the fallout.

Furthermore, QRVO will be affected by the emergence of an alternative supplier of RFFE modules that compete with what are arguably the most important product line at QRVO, although it remains to be seen how they perform versus the established players. If Huawei gains market share with RFFE modules using its own design or that of some other Chinese company, then that's no good for QRVO, or AAPL, SWKS and so on for that matter. The anticipated recovery at QRVO could be slowed down and the earnings slump at QRVO could have more legs to it than anticipated.

Investor takeaways

QRVO remains in a downturn due to weak demand, but the market has looked the other way based on the assumption that a recovery is on the horizon. The stock has moved off the lows based on this anticipated recovery in earnings. However, two recent development have the potential to change the trajectory of the recovery.

It depends on how China proceeds with its export controls, but on paper, China could drastically reduce the amount of germanium and gallium the world has access to, the latter in particular. This could disrupt supply chains for anyone whose products require gallium or germanium, including QRVO. Prices would go up, depending on the extent of the shortage. Bringing new supplies online can be done, but not quickly, especially not in the amounts China produces. QRVO could see its bottom line affected by these export controls, but it depends on how the export controls are implemented.

Another potential headwind could come later this year if or when Huawei re-enters the 5G smartphone market as recent reports suggest it will. The impact may not be all that much in the short term as Huawei and others will likely need time to ramp up production, but the impact could be substantial in the long run as more production enters the market.

QRVO could be impacted in several ways. If its top customers lose sales due to competition from Huawei, then that will translate into reduced demand from these customers. QRVO will also have to contend with new alternatives to its products, which could pressure margins and put more pressure on the bottom line.

Keep in mind that neither of these potential headwinds are definite. China may elect not to restrict supplies in a substantial way. The return of Huawei has not been officially confirmed by the company. It's possible QRVO may not see any real impact, which would help clear the way for a sustained recovery. Still, it's possible one or two headwinds may pop up in the near future for QRVO.

Bottom line, there is a reason why the stock has risen since the October 2022 lows. The situation is improving, if only slowly. QRVO has a good shot at reclaiming some of the ground it has lost since the stock peaked in the summer of 2021, provided the two previously mentioned issues remain under control. If they do, then the stock can continue to rise. If they don't, then all bets are off.

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