STM - Renesas Electronics Attractively Priced Despite An Ongoing Chip Correction Cycle

2023-09-25 18:03:28 ET

Summary

• Renesas Electronics has outperformed its competitors in the MCU semiconductor segment, though Renesas has not been immune to shrinking lead times and a weakening demand outlook.
• The company has regained its share in the auto MCU business and is diversifying its position into areas like high-performance computing and control and ADAS.
• AI-enabled edge processing could be a major growth opportunity for the non-auto MCU business, but the company has to step up its game and gain share in 32/64-bit MCUs.
• Despite the recent downturn in the semiconductor sector, Renesas is well-positioned for an eventual recovery and offers attractive growth opportunities in the industrial, infrastructure, and IoT markets.

Although the shares have retreated well off their midsummer highs, I still can’t complain too much about the performance of Renesas Electronics ( RNECY ) ( RNECF ) (6723.T) since my last update on this leading MCU semiconductor company. The local shares have more than doubled the return of the SOX since that March article (the ADRs have slightly underperformed), and the stock has performed considerably better than MCU competitors/peers like Infineon ( IFNNY ), Microchip ( MCHP ), and STMicroelectronics ( STM )) with arguably more evidence of stability in lead-times in recent weeks and months.

I remain bullish on Renesas. The company has regained share in its market-leading auto MCU business, and I like the company’s efforts to further diversify its position in autos by leveraging existing capabilities in areas like high-performance computing, control, and communications. I’m also bullish on the longer-term opportunities in higher-end industrial, infrastructure, and IoT MCU, particularly in areas like AI-enabled edge processing and combo (processing combined with analog, connectivity, and/or power) chips.

Mid-single-digit core growth and margins toward the lower end of management’s long-term targets (and below recent results) can support a fair value comfortably above today’s price, and I think this a name well worth considering for an eventual recovery in semiconductor stocks.

Lead-Times Continue To Shrink … But The Street Will Eventually Start Looking Ahead

Talking about “the semiconductor sector” can often be misleading, as it suggests that the companies all move together, and that’s just not the case. The SOX index, for instance, is up about 9% over the last six months, but large weightings to names like Broadcom ( AVGO ) and Nvidia ( NVDA ) (the latter of which in particular has been on a tear) have masked the weaker performance from MCU and analog chip companies like Analog Devices ( ADI ), Infineon, Microchip, STMicro, and so on.

In general terms, the sector is seeing weakness as the boom times are over – lead-times have meaningfully retreated from record highs, customers have started delaying/pushing out orders, and many companies have warned of weakening demand in the second half of 2023 and into 2024. Nothing about this is unusual, as the semiconductor industry has always been cyclical, and I would note again that stock market moves tend to anticipate underlying industry trends by around two quarters.

Specific to Renesas and its markets, MCU lead-times have shrunk considerably, with Susquehana’s Christopher Rolland noting another 6-day month-over-month decline in August. Since the peak in August 2022 (a peak considerably higher than past peaks), lead-times have dropped by 15.5 weeks (or almost 40%), though certain areas of the MCU market (like auto MCUs) are still relatively more constrained. While the corrections haven’t been as steep in other areas where Renesas competes (timing lead-times are down 8.4 weeks, or 25%), it has still been a significant reset and there is still a lot of uncertainty in company outlooks for the next 6 to 12 months, particularly given weakness across major global economies, weakness in China’s EV market, and the uncertainties around the UAW strike in the U.S..

For Renesas, this has been a good news/bad news sort of proposition. Lead-time shrinkage here has been greater than average (closer to 45% from the peaks), but lead-times have flattened more in recent months relative to peers. Moreover, management has been actively planning and managing for the downturn, including proactively reducing fab utilization and reducing the profit hit from these curtailments – while internal fab utilization will likely fall more than 10 points in CY’23 (from 90% in CY’22 to “the 70%’s”), each 10-point decline only means about 1% negative gross margin leverage today.

This correction was long in coming and much-needed, but chip demand and volumes will recover. Vehicle electrification is here to stay, and not only will that contribute to meaningful semiconductor growth, all models of cars today contain significantly more silicon than before. Likewise, the near-term outlook for industrial chip demand (automation, machinery, et al) is not great and nor is the outlook for wireless infrastructure or consumer IoT, but I expect recoveries in 2024/2025 and strong expansion beyond that.

Auto Performing Better

Renesas’s auto business has been doing relatively better of late (FQ2’24 revenue was up 3% yoy and almost 1% qoq), and more importantly to me, the company has been regaining share in auto MCUs where it has long enjoyed a leadership position (30% share, ahead of NXP Semiconductors ’ ( NXPI ) 25% and Infineon’s 18% share). A refreshed product line-up has helped including more focus on advanced computing and control capabilities, as has more proactive channel inventory management.

Long term I like the company’s leverage to ongoing auto MCU growth, as well as new socket opportunities. As I mentioned, the company is stepping up its capabilities in areas like control applications and gateways. The company is also investing in ADAS by enhancing its offerings in high-performing computing (MCUs can be thought of as “mini-computers”), radar, and AI, while also repurposing existing connectivity capabilities (BLE, NFC, UWB, and WiFi) into the auto space.

Renesas has also made a sizable commitment to getting into the silicon carbide (or SiC) auto power space, including IGBTs (which functions as an electrical switch in EVs). Earlier this year the company announced new SiC device lines at two of its existing fabs and then announced a 10-year supply agreement with Wolfspeed ( WOLF ) to get the SiC wafers it will need to produce those devices. Whether Wolfspeed can successfully ramp up wafer production is still a debatable point between bulls and bears, and likewise it is debatable as to how well Renesas will fare against more established players in auto SiC power like Infineon, O N Semi ( ON ), and STMicro, but Renesas’s long relationships with Japanese automakers and more recent relationships with emerging Chinese EV companies should help.

Attractive Opportunities In Industrial, But There’s Work To Be Done

I often think that the auto business dominates the conversations around Renesas a bit too much. Yes, the auto business is critical, but the Industrial, Infrastructure, and IoT (or 3-I) segment actually generates more operating income (59% of ’22 operating income) and has for some time. The auto business is absolutely important to the future of the company, but it’s not as if the 3-I business is just along for the ride.

Not unlike in the auto space, Renesas is focused on combining more capabilities into its chips to increase its wallet share with customers. With industrial that means adding more analog, connectivity, and power capabilities to its core MCU offerings, and I’d note too that SiC power isn’t just an auto opportunity – it will also feature prominently in industrial power applications, including robotics and renewable energy.

Management is also looking to step up its execution and product development for AI-enabled edge processing. I’ve written a lot about this opportunity in articles on companies like Lattice ( LSCC ), but the gist of it is that as IoT and AI capabilities expand, more and more tasks are going to be handled by edge devices rather than within a central cloud. Think of applications like process monitoring and quality control and inspection – smarter edge devices can use sensor inputs and onboard processing to measure, interpret, and respond, allowing for more accurate and responsive monitoring and control systems (the sooner you can detect a problem in a manufacturing line or at a refinery, the better).

As attractive as the opportunities here are, Renesas has work to do. While Renesas is a leading company in MCUs as a whole, the company’s share is much stronger in 16-bit (32%) than 32-bit (17%) or 64-bit (8%). I believe Renesas needs to step up its product development/capabilities in 32-bit and 64-bit to really maximize the opportunity, and I believe management is already at work here.

The Outlook

I was expecting 2023 to be a challenging year for companies in the analog and MCU space, and while it has been a better year than I’d expected, the signs of weakness are now evident. This rearranges some of my modeling estimates, but doesn’t really change the thesis – there will be a painful reset off of the 2022 peak, a working-out process, and then a resumption of growth underpinned by ongoing growth in electrification, processing power needs, and data traffic across a range of industries.

For Renesas, I think 4% to 5% long-term revenue growth is attainable, and I’m incrementally more bullish now that I think more conservatism has come into numbers. While overall auto market growth is likely to be soft in 2024 and 2025, and Renesas doesn’t have ideal leverage to EVs, the company’s efforts to regain share in core auto MCU, expand into more control/processing tasks, and build up its ADAS offerings will serve the company well over the long term. In the 3-I business, I like near-term leverage to Nvidia’s AI growth (second-source PMIC products, among others) and longer-term leverage to edge processing and industrial automation and IoT.

On the margin side, management’s long-term targets assume that the recent peak margins are not sustainable, and I think that’s prudent guidance. Gross margins in the low 50%’s, operating margins in the high-20%’s, and FCF margins in the 20%’s will be a step back from recent results, but still strong on a historical basis (helped by improved scale, more efficient manufacturing, and entry into higher-value/higher-margin businesses) and strong enough to support a healthy valuation.

On a discounted cash flow basis, long-term revenue growth around 5% with low-20%’s FCF margins (a long-term weighted average of 21%) gets me to a fair value about 30% higher than today’s price. Turning to margin-driven EV/revenue and EV/EBTIDA (semiconductor valuations have long shown high correlation between margins and multiples, a 25% operating margin (the low end of 2030 guidance) would support a 4x multiple and the company could certainly exceed that target (likewise with gross margin) and a 4x multiple today would support around 40% upside.

The Bottom Line

With the recent downturn in many chip names, there are certainly some buying opportunities to consider. I think Renesas is one of them – while companies like Infineon, Microchip, NXP, and STMicro are formidable rivals, I think Renesas has attractive growth opportunities in both its auto and non-auto businesses and I think today’s valuation does not assume particularly heroic growth or margin performance in the coming years.

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