NDCVF - Synaptics Shares Have Snapped Back In Anticipation That The Worst Is In Sight

Summary

• Synaptics missed December quarter expectations, with a sharp sequential decline in the IoT business and sequential growth in Mobile that isn't sustainable.
• Inventories remain too high among PC, smart home, and other consumer product customers, driving weaker guidance and an expected 8% revenue decline in March.
• The Street may be too confident that Synaptics won't see another weak guide for June, as inventories still look high relative to demand, but management is handling this downturn well.
• I have broader concerns that the semiconductor rally has come too far too fast, but Synaptics still offers relative value and attractive long-term drivers.

I liked Synaptics ( SYNA ) for its turnaround potential when I wrote about the shares in November, but I underestimated just how quickly the market was going to shift to looking past this correction phase of the cycle. Although chip stock guidance was generally quite weak for March, the market is increasingly of the opinion that that’s pretty much the end of it; March will be weak and June will be weak relative to the prior year but resume sequential growth.

Up about 40% since my last update , Synaptics has outperformed other IoT-sensitive names like NXP Semiconductors ( NXPI ) and Nordic Semiconductor ( OTCPK:NRSDY ), but underperformed Silicon Labs ( SLAB ), and I think the latter can be explained at least in part by very different end-market mixes. In any case, I do see a risk that the market’s assumption that consumer will be the “first in, first out” leader of the cycle will prove too optimistic and that there could still be another quarter (and maybe two) of miss-and-lower performance. On the other hand, valuation still isn’t all that demanding and I believe Synaptics will reemerge with a better-than-average growth and margin profile on the other side of this correction.

A Miss All Around In The December Quarter

There weren’t many positives about Synaptics’s fiscal second quarter (the December quarter) other than that it is over with and puts the company another quarter closer to the recovery phase.

Revenue fell 16% year over year and 21% quarter over quarter, missing expectations by 3%. The IoT business grew 8% yoy but shrank 30% sequentially on well-known weakness across consumer IoT this quarter, including smart home gaming. Interestingly, management called out weakness on the processor side but not in connectivity, even though the commentary from Nordic, NXP, and Silicon Labs would all suggest that connectivity has an inventory problem as well.

Looking at the other segments, Mobile declined 25% yoy, but rebounded 43% qoq; I believe this is an anomaly driven by phone OEMs choosing to build lower-cost inventory before year end. Revenue in the PC business declined 32% yoy and 13% qoq, with well-reported weakness in PC volumes across the market.

Gross margin improved 30bp from the year-ago level but declined almost three points sequentially to 59.8%. This was a miss (the size varies by reporting source, but somewhere between half a point and 130bp), but I’d note that Synaptics has good gross margins (only a bit below Silicon Labs and a bit better than NXP) and they’re holding up so far. Operating income declined 28% yoy and 38% qoq, with margin down 520bp yoy and 830bp qoq to 31.9%. While that’s a steep drop, bottoming out in the high-20%’s to low-30%’s is still quite good relative to the broader group.

Not surprisingly, inventory days grew sequentially (up about 16 days qoq by my math), though with inventory days below 100, here again Synaptics stacks up pretty well against many of its rivals. One of the challenges going forward for a few more quarters will be driving a customer/channel destocking process without losing too much margin leverage by under-producing.

Is This The Last Big Cut?

Like most other chip companies, Synaptics guided below expectations for the March quarter. Management is looking for an 8% qoq decline, driving a number 7% below prior Street expectations. Readers may remember from my prior article that I thought the Street was too optimistic about the magnitude of the correction awaiting Synaptics’s consumer-heavy business, and that appears to be playing out.

Even so, while Synpatics’s sequential guide was weaker than Silicon Labs (in terms of the percentage sequential decline), it was actually better than NXP’s guidance, as well as the guidance from MaxLinear ( MXL ) and Qorvo ( QRVO ) (both of which have meaningful consumer exposure).

Management believes that they’re undershipping demand in computing, and I agree that that end-market will likely bottom in the March quarter. I’m less confident about the smartphone business, though, as I think unit volumes could still disappoint in CY’23, leading to a prolonged destocking cycle. Likewise, I expect connected/smart home customers to be a little more cautious about rebuilding inventory into what could be another weak holiday season if the economy continues to slow.

Auto should be a bright spot, but it’s only about 10% to 15% of revenue. U.S. build rates should be okay in 2023, and Synaptics has been logging some TDDI wins that should help augment underlying volume improvements.

While this is absolutely not a one-quarter project, I would like to see the company do more to leverage its core technologies into markets beyond consumer and auto. Edge IoT with artificial intelligence has a lot of potential applications in industrial markets, as does wireless connectivity, and I believe that those assets/capabilities of Synaptics that are relevant to VR can be applied to industrial markets – most directly augmented reality, but likely machine vision and edge sensing/monitoring as well.

The Outlook

I was well below the Street for my FY’23 revenue estimate, and that still feels like the right place to be. I’ve nudged my estimate a bit higher (by about 1%), but the bigger swing is to my FY’24 estimate, which I’ve increased close to 10%. Given how aggressively the IoT space seems to be working down inventory, it feels like the right move, though I’m still concerned about a longer hangover for consumer electronics and smartphones. Longer term, my 5% revenue growth expectation hasn’t really changed.

I do think my earlier margin assumptions may have been too draconian. While I do think quarterly operating margin is going to break 30% before the recovery begins in earnest, I think my former 31% operating margin estimate may be too low. I am still worried about how pricing will impact gross margin in FY’23/24 (pricing was a big driver for semiconductor industry revenue in CY’23), but I think bottoming out in the low-30%’s is looking more likely, with 34% operating margin in FY’25 a possibility.

Longer term, I’m still looking for adjusted free cash flow margins in the low-20%’s, driving high single-digit FCF growth.

Discounted cash flow still suggests relative undervaluation for Synaptics, and likewise with my margin-based EV/revenue approach. The market has quickly moved from valuing the sector on trough multiples to mid-cycle multiples. Even if I give Synpatics only “half-credit” (halfway between the trough and mid-cycle multiple), its margins should support a 4.25x multiple and a $146 fair value on 12-month forward revenue.

The Bottom Line

I do have real concerns that the entire semiconductor rally has come too far too fast, as I still think June numbers carry some risk. Even so, Synaptics still offers better upside than many other names. The company’s heavy consumer exposure is a risk now, but if consumer spending rebounds more quickly (and/or more strongly), they’ll certainly benefit. For now, in a sector where a lot of names have run beyond what I think is a fair price, Synaptics still offers some value on its future recovery cycle and long-term leverage to consumer IoT.

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