2023-12-06 11:27:20 ET
Summary
- Allegro Microsystems' stock is currently flagged as high risk and has been on a downturn since July.
- The company's growth outlook is gloomy, with expected YoY growth of just 2.5% in FQ3 and a decline of 4.76% in FQ4.
- Despite the downside, Allegro's healthy balance sheet and profitability make it a long-term opportunity, but investors should wait for a potential bottom around $19-$21.
- This will also depend on how the Crocus acquisition works out.
Trading at around $27 at the time of writing, Allegro MicroSystems, Inc.'s ( ALGM ) stock has been on a downturn since the end of July and is currently flagged as having a high risk of performing badly. A comparison with the iShares Semiconductor ETF ( SOXX ) in the orange chart below provides an idea about the extent to which it has suffered during the last year.
Quant ratings also point to a Sell, which means the stock could drop further. However, with a profitability grade of A- and exhibiting a healthy balance sheet even after the Crocus acquisition, this fabless chip designer could be a long-term opportunity. From this perspective, this thesis aims to identify a potential bottom for new investors and for those pursuing a dollar cost-averaging strategy.
First, I highlight the reasons why this company which sells its products to automotive and industrial companies is not a Buy despite its forward Non-GAAP P/E currently trading at a discount of over 11% relative to the IT sector.
The Growth Picture Looks Gloomy
Diving into the second quarter of fiscal year 2024 (FQ2) which ended in September, revenue was up nearly 16% YoY, a double-digit figure for sure but considerably lower than the 28% achieved in FQ1. When the financial results were announced on November 2, topline expectations were beaten by $0.52 million , and the stock gained around $2 to $3 in the immediate aftermath. This upside was also helped by its non-GAAP earnings per share of $0.4 not only beating expectations by $0.03 but also surging by 29% YoY.
However, it does not look like the upside will be sustained because the superior revenue growth narrative that has characterized this stock's past financial performance now appears at risk.
Thus, looking at the third quarter of 2024 (FQ3) which ends this month, $255 million (midpoint) of sales are expected which would result in a YoY growth of just 2.5%, or down by more than 7% sequentially, but, worse, for FQ4 which ends in March next year, analysts expect a decline of 4.76%. Plotting a chart of historical and forecasted revenue growth as pictured below, it is found that the deterioration had already started from the March 2023 quarter with the dotted portion putting into perspective as to how bad things are likely to become. Consequently, going ahead, the company's current C+ growth grade could be at risk.
Now, Allegro held its Analyst Day back on March 14 where it had stated its strategy for a high-growth market with secular trends in both automotive and industrial, with themes like e-mobility, clean energy, and automation being put forward. More importantly, at that time the company was enjoying quarterly growth of above 30% driven by xEV (plug-in hybrid EVs and fuel cell EVs) and ADAS (advanced driver-assistance system).
Noteworthily, the management targeted 25% CAGR for xEVs for FY-23 to FY-28, and 18% CAGR for Clean Energy and Automation.
Stock Downside should Continue
However, in contrast, the $1.06 billion of revenues expected by analysts for fiscal year (FY-24) which ends in March next year would constitute only a 9.23% YoY increase. An even worse outlook is envisaged for FY-25 with only 3.6% YoY growth. Thus, things have not turned out as expected, due to a variety of reasons including macroeconomic concerns in Greater China as from FQ1, a region that constituted 23.7% of overall sales for the six months ending in September (table below).
Elsewhere, the company faces weakness in the industrial segment which accounted for 21.4% of sales (table below) as its clients have slowed production and are carefully managing cash and inventories in the face of slowing consumer demand. As for the automotive segment which made up 79.6% of sales, it is facing some near-term headwinds with the United Auto Workers or UAW strike , but the management still expects growth in FQ3.
However, this growth which is expected to be less than 3% by analysts, pales in comparison with historical performance. Furthermore, while the stock could gain by a few dollars in case of a topline beat around January 30 when FQ3's results are announced, as was the case with the second quarter's results, the downtrend should continue. This pessimistic outlook is justified by the momentum grade of D whereby the price performance has considerably lagged relative to the IT sector. There is also the fact that the current share price of $27.28 is below the 100-day and 200-day moving averages which indicates a longer-term downside.
Thus, the stock could drop to its support level of $19-$21, last reached in July and October 2022 which coincided with the YoY quarterly revenue growth dropping to below 15% from above 40%.
At this point, it could constitute a long-term buy, thanks mostly to its healthy balance sheet as well as margin gains made possible by the Crocus acquisition.
Assessing Balance Sheet Strength and Profitability
The acquisition which closed on October 31, will contribute two months of sales to FQ3 or $5 million already included in the guidance. However, $3.5 million will have to be disbursed for interest payments. In this respect, the buyout came at a price tag of $420 million in cash, and, since Allegro only had $370 million at the end of September, it contracted $250 million of loans. As a result, it was left with approximately $200 million of cash, plus the $46 million in debt that was already there.
Now, given the company will report an estimated $296 million (250 + 46) in debt at the end of FQ3 with the total equity valued at $1.1 billion, the leverage (debt-to-equity ratio) comes to around 27% which is still relatively low. Moreover, this is a cash-generating business with $193.2 million generated in FY-23 and its credit rating has been upgraded to Ba3 by credit rating agency Moody's.
Continuing with Crocus, it is a leading specialist in advanced Tunnel Magnetoresistance ("TMR") sensor technology which should help Allegro to further refine its portfolio of products in its e-mobility, Clean Energy, and Automation businesses. To be more specific, the company already derives 63.4% of its sales from the magnetic sensing market, which is expected to increase to over $5 billion in size by 2030, driven by TMR. However, there are also other players including Infineon Technologies AG ( IFNNY ), and TDK Corporation ( TTDKY ) which means that Allegro's ability to gain market share depends on how it positions itself.
In this respect, it can take advantage of its exposure to the automotive industry to scale Crocus' technology since the latter mostly serves industrial customers. Here, Allegro's team does not have to look for new customers to propose to them a new technology which takes relatively more time and is costlier in terms of marketing hours. Instead, with TMR, it is more about upselling opportunities to the existing customer base as the demand for a more comprehensive magnetic sensing portfolio is already present.
Thus, squeezing more sales out of the same customer base creates margin gain opportunities. Two other areas that could enhance profitability are firstly, scaling of Crocus which will mean a larger revenue base on which to spread fixed costs. Second, cost synergies are also expected, namely by factoring in economies of scale across the supply chain and logistics.
A Buy in the $19-$21 Range
This rationale for an improvement in profitability is also aligned with the estimates by analysts, but, is expected to happen in FY-26, when EPS should surge by 23% YoY. This is two and a half more years from now, and, till then, there should be a deterioration as shown in the table below namely in FY-25 where a decline in EPS is expected.
This gloomy outlook is explained by the adverse effect of the acquisition on the bottom line starting with the gross margin for FQ3 now expected at 54%, down from the 55.5% to 57.9% achieved in the five previous quarters. This margin decrease also reflects a deterioration in the product mix with earning projections for FY-24 slashed from $1.47 to $1.36 on November 3, or by 7.5% just one day after the earnings call.
Therefore, going forward a lot will depend on how Crocus is integrated into Allegro's business, and to this end, it is important to stay tuned on the integration process and how cost synergies accrue to the income statement. Also, having in mind the balance sheet, the long-term thesis depends on whether Allegro sustains its cash generation capacity.
In conclusion, this thesis has shown that despite its attractive valuations after the decline, Allegro is not an opportunistic buy. Also, given that both topline and bottom lines are likely to face headwinds for fiscal years 2024 and 2025 respectively, the stock may continue to remain volatile with a risk of gradually descending to the $19-$21 range, unless cost synergies are achieved faster than expected or Crocus rapidly scales under the Allegro brand.
For further details see:
Allegro MicroSystems: Expect Further Downside With A Buying Opportunity Around $19-$21