DIOD - Vishay Making Big Strategic Pushes While Inventory Corrects And Lead-Times Remain High

Summary

• Vishay missed fourth quarter revenue and margin expectations and guided down for the first quarter as the industry-wide inventory correction cycle continues.
• Lead-times remain elevated across Vishay's product categories, particularly in MOSFETs, but higher chip content would argue against a return to historical norms.
• Vishay's new CEO is looking to pursue multiple potentially transformative strategies, including meaningful capacity growth, higher R&D spending, and enhanced go-to-market strategies.
• It remains to be seen if Vishay can meaningfully improve its revenue growth, margins, and cash flow generation, but the current valuation is not demanding amidst elevated operating risk.

It would seem that the new CEO at Vishay Intertechnology ( VSH ) is taking the saying, “when the going gets tough, the tough get going” pretty seriously. While book-to-bill has slipped below 1.0 and lead-times are shrinking (but still very elevated on an historical basis), creating more uncertainty about near-term revenue and margins, management is launching an aggressive capacity expansion plan, while also creating new go-to-market strategies for key products and looking to energize its R&D and solutions capabilities.

I do believe that high lead-times remain a significant risk factor, but I also believe that with the increased chip content across a wide-range of end-markets (most dramatically, but not exclusively, in autos), the old rules about lead-times may not be as relevant. I fundamentally like the approach Vishay’s new CEO is taking with the business, and while I do see elevated operating risk over the next 12-18 months, I believe VSH stock's valuation is nevertheless good enough to merit closer consideration.

The Cyclical Correction Is Starting To Bite

The semiconductor industry is well into a cyclical correction driven in large part by customer inventory destocking, as customers over-ordered to get what they needed during a supply-constrained 2021 and 2022 and now face weakening demand and overstocked inventories. As a supplier of a broad range of discrete and passive components that effectively “ride along” with a wide range of applications across auto, industrial, and other end-markets, there’s little Vishay can do to offset this corrective cycle.

Revenue rose about 1% year over year in the fourth quarter and declined about 8% from the prior quarter, missing by about 3%. Volume drove all of the sequential weakness, with management pointing to stable pricing. By end-market, autos declined more than 6% qoq, while industrial declined about 10%, and these markets account for close to 70% of Vishay’s revenue.

Gross margin improved nearly two points from the year-ago level but declined more than two points sequentially to 29.1%, also coming in weaker than Street expectations. Operating income rose 11% yoy and fell 26%, with margin up 140bp yoy and down 400bp qoq to 15.8%.

Book to bill was once again below 1.0, coming in at 0.94 versus 1.09 last year and 0.88 in the third quarter. Like most companies, Vishay is building inventory, though the 3-day increase to 93 isn’t actually that bad relatively speaking ( Diodes ( DIOD ) saw a 4-day increase to 117 days).

It’s the very rare semiconductor company that hasn’t guided down with fourth quarter results, and Vishay was no exception. While the 1% sequential revenue decline is quite a bit milder than many chip companies are expecting, it was nevertheless below Street expectations by about 3%, and gross margin was likewise guided down more than a point relative to expectations.

Lead-Times Make For Challenging Forecasting

After reaching unprecedented heights in the summer of 2022, lead-times have started to correct across the semiconductor space. The bad news is that they’re still quite high on an historical basis, suggesting the potential for substantial downside risk despite most companies suggesting that the correction will be relatively short-lived (around two quarters of sequential revenue declines and a full year 2023 down versus 2022 but recovering in 2024).

On the other hand, a lot of components are still capacity-constrained – MOSFET lead-times have fallen about six weeks from their all-time high, but are still at more than half a year (35 weeks), and you basically can’t get a Vishay MOSFET until May. What’s more, the end-markets have changed. Chip content has soared in autos relative to just five years ago, and that’s not just from the growth of EVs, as auto companies have increasingly designed out mechanical systems in favor of electrical alternatives and have added a range of new features that require semiconductors (in-car charging, in-car navigation, sensing, lighting, adaptive cruise control, et al).

Arguably the most dangerous words in investing are “it’s different this time”, but I don’t think we’ll see a correction back to prior norms for lead-times. That’s not to say that there isn’t more downside risk in discretes, passives, and opto, which are about 6 weeks, 3.5 weeks, and 3.5 weeks off their all time highs and still about 40% to 60% above prior norms.

Strategic Pivots Make Sense, But Will Have A Cost

Vishay’s new CEO is not stepping lightly in his initial months at the head of the company. As the aforementioned comment on MOSFET availability would suggest, capacity is an issue and one of Joel Smejkal’s first projects is a significant capacity expansion that will see the company spend $1.2 billion over the next three years to add capacity across the business including higher-value power products (SiC MOSFETs, SiC diodes, power inductors, et al), polymer tantalum capacitors, optocouplers, and so on.

At the same time the company will look to ease capacity issues in commodity passive components by turning to subcontractors. As a rule, I’m a fan of farming out lower-value production and prioritizing in-house capacity for higher-value products.

Management will also be working on enhanced go-to-market strategies for 30 key product lines, including much of what I previously mentioned (SiC MOSFETs, polymer tantalum capacitors, et al). As part of this, I expect to see the company put more emphasis on custom solution packages for clients in the auto and industrial spaces, and particularly in areas related to power management and sensing.

Increased R&D is another part of this strategy. Vishay is looking to sample new 600V and 1200V SiC MOSFETs later this year and there are significant opportunities in power management and sensing for its core auto and industrial markets given trends like automation, advanced driver assistance, electrification, and renewables.

The Outlook

How much management can change through these strategies remains to be seen. A lot of what Vishay produces is low-ASP and low-margin, where customer product selection is often based on price and/or availability, and with little meaningful performance distinction between one company’s products and another’s. This is reflected in the company’s margins, as it took an unprecedented period of component scarcity and pricing strength to drive company gross margin above 30%.

The flip side, though, is that success in driving more non-commodity/custom business can have a disproportionate impact on margins, and I believe there are opportunities to differentiate in power (particularly SiC components), sensing, and higher-end capacitors. I also volume growth and enhanced scale as a positive tailwind – chip content growth isn’t slowing down and that’s particularly true for higher-value power and sensing components.

I’m expecting around 4% to 5% long-term revenue growth from Vishay, which should be roughly in line with underlying volume growth, giving the company some potential to outperform if it can successfully migrate toward higher-margin, higher-specification products.

On the margin side, I expect a significant step back from the high-teens operating margin of last year and the mid-teens margin of the year prior. I think it will likely be 2025 or 2026 before a return to mid-teens margins is possible, and even then I’m not treating it as a certainty. I expect elevated capex and R&D to push free cash flow margins below the long-term average for the next three years, and my long-term target is an improvement back to the levels seen in the pandemic (where scarcity drove pricing and margins) but played out over a decade. On a weighted average basis, I’m not really looking for any FCF margin improvement.

Discounted cash flow suggests over 10% annualized total return potential, while a margin-based EV/revenue and EV/EBITDA approach gives me a fair value in $23 to $24 range using depressed multiples (semiconductor stock multiples correlate to margins, but will expand and contract at the highs and lows of sentiment; I’m using multiples close to the low end).

One non-quantitative factor to consider is that Vishay has a dual-class share structure and the founding family controls around 43% of the voting power. I’d also note that the chairman of the board (part of the founding family) is exceptionally well-paid, and it is not unreasonable to criticize the level of compensation that has gone to the members of the founding family over the years while long-term share price performance has been subpar (a long-term annualized return of around 6%).

The Bottom Line

Bullishness on Vishay rests on a few basic notions – that lead-times are not going to correct all the way back to former norms, that chip content continues to grow in key markets like aero/defense, auto, industrial, and medical, and that the new CEO’s plans will drive a lasting improvement in the revenue, margin, and FCF profile of the company. None of these are certain, but if they were I’d expect the shares to trade at a significantly higher multiple. Clearly this is a name with elevated risk, but I do think there are worthwhile potential returns to compensate for that risk.

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