STM - The Battle Between Bulls And Bears Over Wolfspeed Is Well Worth Watching

Summary

• Wolfspeed posted another quarter of disappointing results marked by ongoing operational and execution issues.
• The bulls may be overestimating future market share for Wolfspeed in SiC materials and power devices, but I expect Wolfspeed will be a player in these rapidly-growing markets.
• If Wolfspeed can reach $3B+ in revenue and 20%+ operating margins within five years, the shares look pretty interesting here, but this is a high-risk story.

As an investor grounded in value, I usually get a little suspicious when a pre-profit, pre-positive free cash flow growth story starts looking reasonably valued, but such is the case with Wolfspeed ( WOLF ). There's no shortage of bull-versus-bear debate over this name, with considerable disagreement on a range of topics including management's ability to execute, the company's ability to fund necessary capex, and what future market share and margins will look like given the gold rush that's underway in silicon carbide (or SiC) chip production.

I'm more with the bulls than I expected to be. I do think some of the five-year projections for market share and margins are too bullish, but I am a firm believer in the electrification trend in autos, industrial, and other markets, as well as the use-case arguments for SiC power devices. If Wolfspeed can deliver 25% compound revenue growth, 20%-plus operating margins, and 20%-plus future FCF margins, none of which are conservative assumptions, these shares have appeal today.

Another Quarter Highlighted By Operational Issues

Given how difficult managing growth can be, the ongoing operational issues at Wolfspeed don't add a lot of confidence to the story. By the same token, I'm not sure that Wolfspeed's challenges are so unique - it may well be that companies like onsemi ( ON ) and STMicroelectronics ( STM ) are having their own challenges, but they're blended into much larger, well-established operations.

In any case, revenue rose 25% year over year, but fell 10% sequentially in the December quarter, missing by 15% after a miss-and-lower quarter previously. Gross margin worsened by 180bp yoy and 200bp qoq to 33.6%, but that was actually good for a modest (40bp) beat. With the weaker top-line numbers, the operating loss of $25M was about $8M larger than the Street expected.

Management once again lowered forward expectations, targeting $210M to $230M in revenue for the next quarter versus a prior Street expectation of $248M.

Wolfspeed is seeing a host of operational challenges. Longer cycle times for longer SiC boules are impacting productivity, as are supply issues for replacement parts at the Durham fab. At the same time, the Mohawk Valley fab (or MVF) is ramping a little slower than expected (pushed out by a quarter), and the company is running into meaningful end-market headwinds, with a significant slowdown in developed market 5G spending driving weaker demand for GaN RF chips in the near term (I discussed the 5G issues here in a recent article on Ericsson ( ERIC )).

Building The Business Takes Time And Money, Lots Of Money. Lots And Lots Of Money

I don't actually care all that much about these near-term challenges. Component/supply issues are still an industry-wide phenomenon and while the issues with the new, longer SiC boules may be frustrating, the fact remains that producing SiC wafers is a very demanding task that Wolfspeed management has already demonstrated that they can handle. I view these issues, then, more as "growing pains" than worrisome signs for the future.

Still, there is a lot of work left to do to get this company where it needs to be to drive an attractive return for shareholders from here.

Capex is likely to run around $2B for several years, with the company ramping up MVF now, building a new facility in North Carolina (the Siler City plant), and possibly adding a new plant in Germany to the list. There were rumors going into the quarter that the company was planning to build a facility in Germany in partnership with ZF (a major auto supplier), and management didn't exactly quash those rumors in its comments during the call. Given that Wolfspeed has already won business with Mercedes-Benz ( MBGAF ) and has been targeting other automakers in the region, a plant in Germany would make plenty of sense.

Speaking of design wins, while the $1.5B of announced design-ins in this latest quarter do mark a significant slowdown from $3.5B in the prior quarter and $2.6B in the quarter before that, I don't think there's much to read into it at this point - Wolfspeed already has a large backlog of design wins on its plate and may well have taken the foot off the accelerator with respect to pursuing more margin design-in opportunities. I'd also note that about half of Wolfspeed's design-ins have led to actual design wins.

Still, serving all of this demand is going to require a lot of capex. The Siler City facility will cost $1.3B for the initial phase, and will expand capacity about 10x over the existing Durham facility, and will likely be expanded beyond 2024. A plant in Germany would likely cost a similar amount, and I think it's reasonable to expect hefty annual capex out through at least 2026/2027 to serve the anticipated demand.

Are Demand Expectations Reasonable? Yes, But…

Speaking of demand, Wolfspeed is heavily leveraged to the growth of battery electric vehicles (or BEVs) and increased adoption of SiC power devices for those vehicles. While many current EVs use IGBTs (a business where Infineon ( IFNNY ) is exceptionally strong), and SiC MOSFETs are about 3x more expensive, SiC MOSFETs are smaller, lighter, incur less switching loss, and produce less heat; even with their higher cost, they can save OEMs more than 10% per vehicle, particularly as they can reduce the amount/size of batteries needed.

Wolfspeed is pursuing a hybrid business model, providing SiC materials (wafers, et al.) to semiconductor companies like STMicro, but also producing their own power devices. At this point it remains to be seen how the in-source/out-source debate will resolve; companies like Infineon, onsemi, and STMicro have all turned to external suppliers like Wolfspeed and Coherent ( COHR ) to ensure adequate SiC supply in these early years, but many intend to build/maintain significant internal capacity (though Infineon is publicly skeptical about the benefits of extensive insourcing).

Right now Wolfspeed has over 50% share (likely close to 55%) of SiC materials, and management's projections for 2026/2027 have included an assumption of 50% share going forward. Given the "gold rush" into SiC, and considering precedent (say, the rush to add fiber optic capacity in the 1990s), I think that's overly optimistic. Making SiC wafers is very difficult, but that's typically true of all new technologies and over time more and more companies figure it out.

Likewise, I think Wolfspeed needs 20%-25% share of BEV power devices (particularly the higher-value SiC MOSFETs used in inverters) to reach its 2026/27 goals, and with companies like Infineon, onsemi, and STMicro all targeting the market, I won't call that a cautious or conservative assumption. Relationships with companies like BorgWarner ( BWA ), General Motors ( GM ), and Mercedes certainly help, but it's going to be a battle royale for BEV SiC MOSFET share over the next 5-10 years.

While I do see risk to the bull-side revenue projections, I do think that operating margin assumptions in the low-to-mid-20%s are pretty reasonable on $2.5B-plus of revenue. I'd also note that in all of the excitement over SiC power devices, the GaN business may be going somewhat overlooked - while this business doesn't have nearly the same potential as the SiC power device business, I do expect healthy above-average growth in the adoption of GaN-based RF chips over the next five-plus years.

The Outlook

I'm expecting revenue to ramp to around $3.2B to $3.3B in 2027, below management's target from the recent investor day (about $4B), and I'm modeling lower operating and FCF margins as well (though not dramatically lower, with an operating margin in the low-20%s and an FCF margin of 10%). Long term, I think Wolfspeed can generate around 20% annualized revenue growth, primarily on the back of demand for SiC power chips used in autos, but also in other markets like industrial automation/electrification and renewable energy. Over time, I believe FCF margins can get into the high-20%s, though capacity needs are a potential risk (in addition to more basic competition/market share and execution risks).

If all of this is plausible, I can argue for a fair value in the range of $75 to $85 today based upon discounted free cash flow and discounted forward EV/revenue (using a 6x multiple) based on future operating margins.

The Bottom Line

Of course, my projections could be wildly out of line - that's the nature of trying to model and invest in growth stories. That said, I'm a believer in the growth of electrification and the future demand for SiC MOSFETs in autos and other markets. I also believe that Wolfspeed has the potential to be a significant player here in the years to come and while this is a high-risk proposition, and one with significant near-term sentiment risks, the valuation is more reasonable than I expected.

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