SMTC - Semtech Corp. - Initiating With Buy: Inventory Correction Is Over

2023-10-12 18:40:01 ET

Summary

• We’re initiating Semtech Corporation with a buy rating. We think the macro weakness has been priced into the stock and its near-term outlook.
• We now believe the inventory correction for Semtech Corporation’s IoT products, accounting for ~50% of sales, will be completed in 2H23, and expect the recovery in 1HCY24 to drive top line growth.
• Additionally, we think the Signal Integrity and Protection inventory correction is now behind us, with the segments growing 35% and 12% QoQ, respectively, this quarter, accounting for 40% of sales.
• We expect financial outperformance over the next few quarters driven by demand recovery.
• We recommend investors initiate a position in Semtech Corporation shares at current levels.

We're initiating Semtech Corporation ( SMTC ) with a buy rating. We believe end demand will pick back up in 2024, and think the inventory correction weighing on STMC's top line growth is now behind us. We now see more balanced demand-supply dynamics for SMTC's core markets into 2024. Hence, we expect SMTC shares to exhibit financial outperformance over the next few quarters and recommend investors initiate a position at current levels.

SMTC is a semiconductor company specializing in developing and producing analog and mixed-signal semiconductors; the company's products are used in various applications across a wide range of industries, including communication, consumer, computing, and industrial applications. The key areas of focus for SMTC range from wireless and RF technology, protection and signal integrity, high-performance analog, power management, and IoT. Our buy rating is based on our belief that the core markets to which SMTC is most exposed are at the end of their inventory correction cycle and will experience a demand recovery in 2024.

The following chart outlines SMTC's net sales by end market.

SMTC stock underperforms the S&P 500 (SP500) by 36%, 4%, and 2% on YTD, six-month, and one-month timeframes, respectively. We believe the macro weakness has been priced into the stock and near-term outlook. We recommend our readers tip their toes into SMTC around current levels and add opportunistically on any future pullbacks, as we expect financial outperformance towards 2H24.

The below outlines SMTC's stock performance against the S&P 500 over the past six months.

Shifting to demand recovery post-correction

In the July quarter , SMTC reported sales of $248.4M, in line with estimates of $237.4M; the market clearly liked fiscal Q2 2024 earnings results, with the stock trading 10% higher post-earnings. We think this quarter's Signal Integrity and Protection results reflect that inventory correction is behind us. Notably, sales in the Protection and Sensing segment experienced a robust 35% QoQ growth to $48.5M, which we believe was driven by shipments to Apple ( AAPL ) in preparation for the iPhone 15 ramp, compensating for the ongoing weakness in the Android market. The Signal Integrity Group also showed a positive trend with 12% QoQ growth to $46.5M, which we attribute to recovering demand in data centers fueled by A.I., actively counteracting the weaker China infrastructure market. Consistent with management's expectations, we see both segments growing QoQ into next year.

IoT system sales, accounting for ~50% of total sales, fell 11% QoQ to $119.5M; we believe the decline was due to slow router demand, while IoT services held steady at $24M. IoT-related sales are projected to decline due to the inventory correction in the OEM module business; we think we're in the last leg of the correction. Looking to Q3 2023, total sales are expected to decline 12-20% QoQ to $190M to $210, way below the $248.8M consensus. We think next quarter will be the bottom for IoT sales, and recommend investors fish at the bottom to ride the demand recovery in 2024.

Valuation

SMTC is currently trading at 3x on an EV/Sales ratio CY23, while the peer group average is trading at a multiple of 5.5. We believe the stock should be valued on an EV/Sales ratio and believe SMTC is currently undervalued on this metric. We see attractive entry points at current valuation levels for investors to ride the recovery into CY24. The below outlines SMTC's valuation against the peer group made using Refinitiv data.

Word on Wall Street

Wall Street shares our bullish sentiment. More than nine sell-side analysts recommend investors start a position at current levels, while none recommend selling the stock, and five recommend investors stay on the sideline. SMTC is currently trading at $22 per share. Using the median price target of $31, we calculate an upside of 40% and a 58% upside using the mean price target of $35. The below charts outline Wall Street's sentiment on the stock more fully.

What to do with the stock

We are initiating Semtech Corporation with a buy rating, considering the macro challenges have been factored into both the stock and near-term outlook. We see a positive shift on the horizon due to the completion of inventory correction of SMTC's IoT products, constituting ~50% of total sales, by the end of 2H23. We expect the completed correction to drive top line growth in the 1H24. Additionally, the correction in the signal integrity and protection segments that account for 40% of total sales is behind us now. We expect outperformance over the next few quarters and recommend investors initiate a position in Semtech Corporation at current levels.

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