SKYT - SkyWater Technology: A Hold Until Uncertainty Over Short-Term Profitability Clears (Rating Downgrade)

2023-10-03 08:48:44 ET

Summary

• The downward revision in SkyWater Technology's consensus FY 2023 bottom line estimate is largely attributable to the increase in consulting fees and other investments relating to SKYT's business transformation.
• SKYT's shares have lost a third of their value in the last two months, and it is now trading at a price-to-revenue multiple of less than 1.
• I downgrade my investment rating for SKYT stock to a Hold, taking into consideration the company's near-term profitability outlook.

Elevator Pitch

My rating for SkyWater Technology, Inc. ( SKYT ) stock is a Hold. SKYT's ongoing investments in the company's transformation process has created uncertainty regarding its bottom line performance in the short term. But the valuation of SkyWater Technology's shares is pretty appealing, considering that its current market capitalization is below its expected revenue for the next twelve months. Therefore, I choose to lower my rating for SKYT from a Buy previously to a Hold now.

Price Correction Could Be Driven By Bottom Line Miss

Earlier, I did a preview of SkyWater Technology's financial performance for the second quarter of the current year in my prior July 25, 2023 write-up . SKYT's stock price has fallen by a substantial -33.6% (source: Seeking Alpha price data) after my previous update was published.

I had predicted that both SKYT's revenue and bottom line in Q2 2023 would have surpassed the Wall Street analysts' expectations, but I was only partially correct.

SkyWater Technology's top line jumped by +47% YoY to $69.8 million in the second quarter of this fiscal year, and the company delivered an impressive +9.4% revenue beat . At its Q2 2023 results briefing, SKYT emphasized that its "revenue growth is proving itself to be relatively decoupled from the macro weakness" thanks to "the U.S. government's continued commitment to" the company. This is aligned with my argument in the July 25, 2023 update that "the US government needs to maintain spending for such (aerospace and defense) programs at elevated levels in light of geopolitical tensions" which will benefit SKYT's top line.

On the flip side, SKYT's normalized net loss of per share amounting to -$0.14 for Q2 2023 was much wider than the market's consensus bottom line projection of -$0.11 per share. Higher than expected consulting fees paid to third parties led to SkyWater Technology's second quarter bottom line falling short of expectations. In its Q2 2023 results media release , SKYT disclosed that it incurred "$2.5 million of management consulting transformation fees related to long-term improvement in automation and operational efficiency and $1.3 million of specialist fees related to the CHIPS Act application process" in the recent quarter.

The bottom line miss for Q2 and the subsequent downward revision in profitability expectations (detailed in the next section) were the key factors that drove the massive drop in SkyWater's share price for the recent months.

Profitability Outlook Has Become More Uncertain Considering New Investments

SkyWater Technology's below-expectations Q2 2023 bottom line performance had a big impact on how analysts viewed the company's prospects for the full year.

In the last three months, all five of the sell-side analysts covering SKYT stock revised their FY 2023 revenue projections upwards. But all of these analysts also lowered their bottom line forecasts for SkyWater Technology in the same time period. Specifically, the consensus financial estimates (source: S&P Capital IQ ) point to SKYT's net loss widening from -$0.20 per share for 1H 2023 to -$0.25 per share in 2H 2023.

There is increased uncertainty regarding SkyWater Technology's future expenses and operating profitability, taking into account the potential consulting fees that the company might pay to external parties in the future and other related investments.

SKYT has guided that there won't be any fees associated with the CHIPS ("Creating Helpful Incentives to Produce Semiconductors") Act for Q3 2023, but noted that such fees might pop up again in the future in line with developments relating to the company's CHIPS Act application process.

On the other hand, SkyWater Technology expects the company to spend around a few million dollars on management consultation transformation fees in the third quarter similar to Q2, but it didn't provide specific guidance on such fees for the period beyond Q3 2023.

The company explained at its Q2 2023 results briefing that the $2.5 million of management consulting fees for the most recent quarter was pertaining to "investments related to long-term improvements in automation and operational efficiency to enable quicker execution on our ATS (Advanced Technology Services) programs."

As another indicator that SkyWater Technology is willing to spend more in the short term to boost its long term growth prospects, the company announced the appointment of "John Sakamoto as President and Chief Operating Officer" in the middle of last month. Considering that John Sakamoto comes with more two decades of experience at semiconductor businesses such as Intel ( INTC ) and Marvell ( MRVL ), it is reasonable to assume that his compensation package will be pretty competitive. In this announcement, SKYT highlighted that the addition of John Sakamoto to the company's ranks "would help accelerate the transformation process aimed at achieving greater levels of scale, revenue, and profitability."

In summary, it seems to be a classic case of short-term pain and long-term gain. There is a risk that SkyWater Technology's bottom line in the quarters ahead might potentially miss expectations, although that could possibly translate into an improvement in SKYT's financial performance for the medium to long term.

SKYT's Valuations Have Priced In Short-Term Negatives

The consensus target price for SkyWater Technology has remained relatively stable, although the analysts have revised their FY 2023 bottom line forecasts downwards as mentioned in an earlier section.

SKYT's consensus price target was increased slightly from $16.80 at the start of this year to $17.30 now, despite the fact that the company's shares have been down by -19.5% in 2023 thus far. This implies that the market still has confidence in SkyWater Technology's long-term prospects, and SKYT's valuations have become undemanding.

According to data taken from S&P Capital IQ , SKYT is currently trading at a consensus forward next twelve months' price-to-revenue multiple of below 1 times, or 0.97 times to be exact. As a comparison, the consensus FY 2023-2026 top line CAGR estimate for SkyWater Technology is a pretty decent +21.6%. It will be fair to say that the negatives relating to uncertainty over SKYT's short-term profitability have been factored into its price and valuations.

Concluding Thoughts

Taking into account SkyWater Technology's valuations and profitability expectations, I am of the view that a Hold rating for SKYT is fair. The outlook for SKYT's profitability in the short term has become more murky due to new investments, but this has already been priced in considering the stock's price-to-sales valuation metric.

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