RNECY - STMicroelectronics Q1 Preview: Near-Term Industrial Demand Worries But Long-Term Value Appealing

2023-04-25 13:09:33 ET

Summary

• Weaker consumer and industrial markets are likely to drive STMicro's revenue down about 5% from the prior quarter, but the Street expects a modest sequential improvement in Q2.
• Declining lead-times across the semiconductor remain a risk, but STMicro has positive leverage to supply-constrained markets like SiC power and auto MCUs.
• The depth and breadth of an industrial slowdown remains a key unknown for the chip sector, though STMicro has relatively attractive leverage to advanced power, IoT, and MCUs.
• Weaker Q2 guidance is a very real near-term risk for the stock price, but I believe the shares are undervalued on a longer-term basis.

Semiconductor stocks have recovered so far in 2023, with the SOX index up about 16% year-to-date, as investors seem relatively comfortable that the worst is over in markets like handsets, PCs, and consumer devices, that autos will continue to grow, and that the industrial downturn won't be too severe or prolonged. That said, stocks have weakened some recently as there's still a lot of nervousness in the market and concerns about whether guidance for Q2'23 will support this generally positive outlook.

Specific to STMicroelectronics (STM) ("STMicro"), the shares have done so-so since my last update , declining slightly and more or less tracking the broader semiconductor market and largely tracking peers/rivals like Infineon ( IFNNY ), Microchip ( MCHP ), and onsemi ( ON ), while Renesas ( RNECY ) has done noticeably better. While the Street outlook for STMicro is a little stronger than for other broad-based chip companies, I do still see meaningful risk to demand in the industrial business, though this is offset by growth opportunities (share gains, new products, et al) tied to strength in power and MCUs.

I do see near-term risk from a weaker Q2 guide, but so far the relatively limited data points from industrial companies have been positive. I think investors can make money from STMicro shares at this level over the years to come, but I would definitely watch this name for possible post-earnings weakness tied to softer near-term guidance.

Q1 Expectations Look Achievable, But Sequential Growth in Q2 And 2H'23 Is The Bigger Question

Street expectations (Bloomberg and Visible Alpha) are calling for a 5% sequential decline in revenue for STMicro's first quarter, with likely softness in consumer/PC, industrial, and smartphone markets on customer destocking. While auto could well be soft overall in volume terms, the growing EV mix should more than offset this for STMicro (as well as other EV-leveraged names like Infineon and onsemi). Should STMicro meet or beat the $4.2 billion target, the company will likely outperform the average broad-based chip company this quarter (the average sequential decline will likely be closer to 8%).

As far as margins go, I expect modest sequential improvement on mix and capacity utilization, but I do think operating margin is likely to decline sequentially, in part due to higher R&D spending (with the company investing in areas like GaN).

Guidance for the next quarter typically plays a bigger role in post-earnings stock price moves in this space, and I don't see why this quarter will be different. Right now the sell-side is expecting a little less than 1% sequential growth into the second quarter, and I'm a little below that (I'm more bearish generally on industrial end-markets), and the overall expectation for the majority of broad-based chip companies is that Q2'23 earnings will see a return to sequential growth.

As I said in my preview of Texas Instruments ( TXN ) earnings, I do see mixed trends behind this outlook. On the positive side, auto MCUs remain sold out for the year (STMicro has around 9% to 10% share) and companies are reallocating MCU capacity from consumer and industrial customers to meet auto demand. Silicon carbide (or SiC) is also capacity-constrained for both auto and industrial customers.

In the auto market, I do think low single-digit build growth is a reasonable expectation, but STMicro remains positively leveraged to ongoing growth in EVs as a percentage of overall builds. STMicro has been gaining share in auto MCUs, but I do see some risk from weaker macro trends (weaker auto lending, high prices, declining consumer confidence). In the near term, I'm not concerned about onsemi's recent announcement of winning some Tesla ( TSLA ) SiC business (this was already assumed in my model), nor reports of Tesla using less SiC in future models.

Looking at consumer, PC, and smartphone markets, I think the worst is over for STMicro as far as orders go. I do still some risk to Apple ( AAPL ) iPhone volumes in FY'23, but my base-case assumptions for the year have been below Street averages. Apple is incrementally less important to STMicro than a year ago (FY'22 revenue from Apple was 17% of total revenue versus almost 21% in FY'21), and I do expect the company do see some mix shift away from lower-margin imaging products.

Industrial end-markets concern me more. Seven straight months of sub-50 PMI readings reflects ongoing weakness, and I will be very curious to see what companies have to say about the possibility of a further slowdown into the fall of this year (guidance from the relatively few companies that have reported hasn't been too bad). I expect weaker demand in a wide range of markets/machinery types, but I do expect relative strength in areas like automation, electrification, and renewables - all of which should help STMicro's MCU and power businesses. I'd also note that STMicro has been a strong share-gainer recently in industrial MCUs (32-bit in particular).

The Outlook

STMicro benefited from exceptionally strong pricing in 2022 (up 18% to 40% across its businesses), and weakening lead-times and increasing cancellations/push-outs do point to risks on the pricing side. Likewise, with STMicro looking to continue adding capacity, I do see some pressure on margins over the next few years relative to the exceptional operating environment in FY'22. Mix shift to higher-value products like SiC components can help offset that, but I think it'll be tough to top FY'22 margins until FY'25.

Long term, I'm still looking for around 7% annualized revenue growth, with STMicro poised to benefit from long-term secular growth trends tied to electrification (in cars, buildings, factories, et al), renewable power, automation, and so on. I believe the company's opportunities in GaN power chips may be somewhat underappreciated, and likewise its opportunities in imaging and IoT.

I still expect free cash flow margins to improve from the high single digits to the mid-teens over time (supporting mid-teens FCF growth), but I think double-digit FCF margins will take a few years given ongoing capacity investment plans (in both MCUs and SiC).

Discounting my modeled cash flows, I believe STMicro is priced for slightly better than 10% annualized returns. On a margin-driven EV/EBITDA and EV/revenue basis I likewise believe the shares are undervalued below the mid-$60s and as semiconductor valuations recover again, there's upside into the $70s (provided guidance doesn't decline substantially for revenue/EBITDA over the next 12 months).

The Bottom Line

I continue to be bullish on the long-term prospects for STMicro, and I believe the valuation overly discounts the company's leverage to chip content growth in a variety of end-markets where STMicro already has a strong presence. I do see near-term risks, though, as industrial markets could weaken further, consumer and PC markets could see a longer recovery cycle, and even autos could disappoint. Should the shares sell off on softer Q2 guidance (or a larger downturn in chip stocks), this would definitely be a name to consider.

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