SMTC - Semtech: Looking At Upcoming Earnings And The Sierra Wireless Acquisition

2023-06-06 15:30:51 ET

Summary

• Semtech Corporation's growth remains sluggish due to weak consumer demand and exposure to China's economy, causing the stock to underperform in the wider technology sector.
• The company has made progress with cost-cutting measures and integration synergies from the Sierra Wireless acquisition, potentially leading to an earnings beat.
• Despite challenges, Semtech saw growth in its LoRa-enabled revenues and these should gain additional traction with the Sierra Wireless acquisition.
• The stock should be on your watchlist.

Semtech Corporation (SMTC) is a semiconductor company specializing in analog devices and IoT (Internet of Things) with demand for some of its products remaining weak. On top, it has significant exposure to China, where the economy was in a frozen state for a long time followed by an uneven Covid recovery. On top, there are additional uncertainties due to the East Asian country's sour relationship with the U.S.

Thus, with growth remaining sluggish, the stock has significantly underperformed the wider technology sector as shown in the deep blue chart below.

However, the company has made progress with cost-cutting measures, plus the integration synergies out of the Sierra Wireless acquisition are materializing rapidly, as this thesis aims to elaborate upon. At the same time, since the company is reporting its fiscal first quarter 2024 (Q1FY’24) earnings on June 7 , I will assess the probability of an earnings or revenue beat.

I start with finances.

Revenue and Profitability

Going back to the end of March, when the fourth quarter of FY'23 (Q4FY'23) results was reported, the company delivered revenues of $167.5 million, which was down by 12% year-over-year and 6% sequentially despite the results including $15 million from the Sierra acquisition. Noteworthily, the stock slid by more than 15% at that time showing investors' disappointment despite the top line beating analyst estimates.

This quarterly sales regression was somewhat mitigated by results for the whole of FY'23, which ended in January when organic revenues grew by 2% over FY'22, to $742 million .

Still, looking across the industry, this represents an anemic growth compared with peers like Analog Devices ( ADI ), Silicon Laboratories ( SLAB ), Infineon Technologies ( OTCQX:IFNNY ), STMicroelectronics ( STM ), and NXP Semiconductors ( NXPI ) as illustrated in the table below. Thus Semtech faces strong competition both on technological grounds and the breadth of products offered and its lower EBIT margins of only 8% as per the table below shows that it is probably having to offer discounts in order to drive product sales.

There is also the China factor, with the lower-margin country consuming approximately 33% of its shipments in FY'23 compared to 27% in the Americas, and 22% in Europe. To address this, the Sierra acquisition is expected to balance out the geographical mix and, continuing on a positive note, in response to the challenging sales growth environment, the company reduced operating expenses (including headcount) in Q4, by 13% on a sequential basis to $59 million.

Looking at Consensus EPS

Now, this figure should rise to about $99 million in Q1FY’24 which comprises February to April, thereby reflecting a full quarter of Sierra’s merger as well as certain compensation-related expenses. This opEx figure already includes synergies worth about $40 million of the $50 million targeted, signifying that the integration process has been moving quite fast given the deal was finalized only on January 12. As a matter of fact, this $40 million of operational synergies were anticipated only within 12-18 months after closing the deal, signifying that the integration is being made at a rapid pace.

Moreover, according to the management, the rest of the synergies (about $10 million) will materialize in Q4FY'24, signifying that the Opex is likely to fall below the $99 million level, which augurs well for the profitability.

Looking at the bottom line as pictured below, EPS was $0.47 in Q4FY'23 and is expected to drop to $-0.08 in Q1FY'24 after being adversely impacted by acquisition-related expenses. With the synergies happening faster, the path to EPS recovery, or emerging from sub-zero could also be accelerated, which also hints at the possibility of the company beating estimates. For investors, while Semtech did beat revenue estimates in Q4, as I mentioned earlier, the EPS delivered was in line with consensus. To further support the possibility of an earnings beat, the company delivered more earnings beats than misses over the last two years.

On the other hand, there is less likelihood of a revenue beat, as demand for FY'24 has "started off weak ," with the company only expecting a recovery in the second half of its fiscal year. For investors, the acquisition is expected to nearly double Semtech's annual revenue and add approximately $100 million of recurring revenue to the high-margin cloud IoT services segment.

Leadership in Device-to-Cloud IoT Solutions

Detailing further, the company's LoRa (or long-range communication) business grew rapidly in FY '23 with the number of LoRaWAN network operators growing by about 12.5% from FY '22 with the number of endpoints growing by 25%. For investors, the LoRa infrastructure enables a broad range of emerging industry use cases which should gain more traction with the completion of the integration of Sierra Wireless.

Furthermore, LoRa is proprietary to and has been patented by Semtech and basically builds a layer of infrastructure for enabling long-range communication while using less power and involving fewer costs. Now, with Sierra Wireless's leadership position in IoT (Internet of Things), the merger should expand opportunities in this market by approximately tenfold to $10 billion by 2027.

In addition, since Semtech is also a supplier of analog and mixed semiconductors, there are opportunities in the device-to-Cloud portfolio which encompasses devices that connect directly to an internet service provider's network instead of requiring servers.

Thus, as per Mohan Maheswaran, Semtech’s president and CEO:

“Sierra Wireless brings nearly 30 years of leadership in cellular IoT and a strong and diverse device-to-Cloud IoT solutions portfolio. Combined with Semtech’s LoRa-enabled end nodes, we believe we are very well positioned to deliver a highly differentiated, end-to-end platform to enable the transformation to a smarter, more sustainable planet.”

Therefore, the company's positioning in the high-growth IoT segment is strengthened both in terms of product portfolio and service delivery, and as an end-to-end service provider, it can better compete too.

High Debts, but Profitable with Low Valuations

This potential improvement in the competitive position, which, will also depend on the execution, came at an acquisition cost of $1.2 billion, and, since this was an all-cash transaction, also saw a higher debt level. In this respect, the debt of $1.3 billion as pictured below is 3.4 times leverage on a net basis, and it is expected to increase further as less cash is generated because of the softer demand environment while more money has to be directed towards interest payments.

Now, such a leverage ratio while the company navigates a weaker demand environment can be viewed as a cause for concern, and the stock is rated as a Strong Sell by Quant Ratings. Thus, risk-averse investors are likely to stay away.

On the other hand, with a profitability score of B-, gross margins of 64% when compared to peers, and rapid execution on the acquisition, Semtech cannot be written off. Moreover, with sales likely to double from $756.5 million to roughly $1.5 billion in FY'24, the company could increase its gross margins significantly as it would have a higher revenue base on which to apply its fixed costs.

Furthermore, the company trades at a considerable discount, with a valuation grade of B- as shown below.

Thus, Semtech Corporation stock should be on your watchlist.

Semtech should be on Your Radar

In conclusion, with lackluster growth, significant exposure to the Chinese market, and being highly leveraged, it would seem prudent to shy away from Semtech. However, the company is trying to improve its competitive positioning and diversify its geographical mix, namely through the Sierra Wireless acquisition. Furthermore, with the soft demand experienced by both companies, revenue should not beat expectations. For this purpose, the management has guided $235 million of revenues (midpoint) including approximately $100 million from organic Semtech and $135 million from Sierra Wireless.

Still, with the ability to generate higher gross margins, and cost synergies kicking in rapidly, Semtech Corporation could deliver an earnings beat over the consensus of $-0.08. At the same time, it is important to look at what the executives say about product uptake from the combined entity. In this respect, one of the merits of this merger is that it simplifies the life of IoT developers by making possible a cloud-driven end-to-end services provider, and this by itself can encourage wider adoption of the technology. Finally, based on the progress made, Semtech Corporation stock could be a long-term buying opportunity.

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