2023-09-01 04:21:22 ET
Summary
- Alpha and Omega Semiconductor Limited is a smaller player in the semiconductor industry with a market cap of around $850 million.
- The company's margins are decreasing and it is heavily reliant on the Chinese market for revenue, which poses risks.
- AOSL's cash position is decreasing and it has been unable to pass on material cost increases to customers, making me conclude that it is a risky investment.
The semiconductor industry has been a hot topic for years now as large companies like Advanced Micro Devices Inc ( AMD ) caught the industry momentum very well and have managed to grow their top line by nearly 17% annually in the last 10 years. With a market cap of over $170 billion, it seems that AMD is priced to perfection given the sheer size and coverage it gets.
That's why I think sometimes we need to look at smaller players in the industry, like Alpha and Omega Semiconductor Limited ( AOSL ). The company has a market cap around the $850 million mark. However, when we dive deeper into the earnings, it seems that margins are hard to retain for the company and charts are indicating we are heading lower. The worries of decreasing margins and slowing revenues for electric consumables are warranted as the company's lack of ability to capitalize on cyclical demand for semiconductors is creating a scenario where risks outweigh the potential in my opinion. For these reasons, I am rating them a Sell.
Operational Overview
The operations entail both designing and developing power semiconductor products. These products are then used for computing and consumer electronics. In this day and age, almost all electric devices have some sort of connection to the semiconductor industry. So seeing strong demand in the semiconductor industry can often be correlated to strong consumer spending as well. As a lot of people were anticipating a recession for the US economy this year, the spending and willingness for companies to build up inventory levels decreased because of the shifting consumer sentiment. This hurt earnings for AOSL and they are quite far off from where they were in 2022 when the EPS came in at $4.56 per share. The last earnings report for example showcased revenues going from $194 million in FY2022 to $161 million in FY2023. The softer demand and worse pricing environment seem to have been aiding this development. On A QoQ basis though the gross margins have increased from 23.2% to 27.6% which makes me somewhat optimistic about the coming report for AOSL. What keeps me to the Sell rating though is the cyclical nature of the industry and we might very well have just seen a slight bump in revenues, as opposed to an increase that is significant and sustained as well.
The company has a varied set of products in its portfolio that are divided among low voltage, mid voltage, and high voltage + IGBT. Despite the broad product portfolio, they are all more or less dependent on strong consumer spending as that is the end market where the products that AOSL makes ultimately end up. Higher interest rates create less spending power and this of course affects the operations of AOSL as productions may have to be slowed down to not build up too large of an inventory level and have it rather be a liability than an asset. The vast majority of the revenues for the company come from sales in China and Hong Kong. In 2022 for example the yearly revenues were made up of over 90% coming from those regions. This means that AOSL is largely dependent on the landscape in China to grow its revenues. As fears of lockdowns continue in 2022, the revenues and demand fell off for AOSL and resulted in poor sentiment around the company and a falling share price followed too. But as China has dropped all Covid-19 restrictions the hopes are that AOSL will be able to recover its earnings. So far we have not seen that though as the last report showcased the difficulty for the company to retain its margins.
Gross margins have been in a steady decline since last year as the cost of goods is increasing quickly. Inflation has helped push up the prices of materials which is something that ultimately dictates the earnings potential of AOSL a fair bit. I think that AOSL has also proven to be unable to pass on material increases such as this onto their final products. The semiconductor industry is very competitive and sometimes price hikes will leave you without any customers as the cheaper companies take market share instead. This creates a situation for AOSL where I think the risks presented are too high and introducing that into a portfolio right now seems unnecessary and quite frankly harmful.
Management Comments
I am quite pessimistic about the future performance of an investment in AOSL given the lack of margin retention and reliance on Chinese market conditions the company has. But getting some comments from the management I think is only fair to balance out the article. The CEO Stephen Chang had some valuable comments from the last earnings call on August 9 .
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"Recall from our prior quarter call, we said our calendar Q1 results reflected our efforts to bring customer inventory levels back into balance as quickly as possible. We were confident then that due to our resilient fundamentals, we would see a swift recovery in Q2 and continued recovery in Q3 as we go into our peak season. I'm happy to report that it is playing out in line with our expectations".
While it's true that AOSL managed to grow gross margins on a QoQ basis, the recovery has not been quick enough in my opinion. The "resilient fundamentals" that are hinted at as well I don't think are that impressive either, unfortunately.
The margins continue downwards historically and the bottom line is barely above a positive level. Besides that, the cash position for the company has been decreasing since the last of December 2022 and it sits below $200 million right now. Based on fundamentals in terms of growing its asset base the company has also done poorly as a near 10% YoY decrease is visible. The long-term debts are at $38 million right now and it's comforting at least the company has a cash position to sufficiently pay it down. The net capital expenditures for the company are quite high right now though; the TTM figure is $131 million, which if kept up might start to drain the cash position and put AOSL in a less stronger financial position.
Contributing to this seems to be a decreasing cash position and a decrease in equity method investments. Even with a relatively low long-term debt position of just $38 million, the company has still seen it as necessary to dilute shares over the years. I don't see this stopping anytime soon as long as margins remain in a downward spiral and the company continues to rely heavily on positive Chinese market sentiments and demand to support growth. The CEO had this to say in the last call.
As for the broader market, end consumer demand continues to be soft; however, we are optimistic that the worst phase of this cycle is behind us. We anticipate further recovery in our September quarter, which seasonally has been our strongest quarter, driven by fall smartphone launches and back-to-school. While we remain cautious, we expect to navigate the current environment better than the broader market that we serve, thanks to our robust Tier 1 customer partnerships, leading market share.
I thought it was necessary to include this comment as well as I think it highlights some of the risks that the company still. A recovery is normally never in just a straight line up, it often comes with hurdles along the way, but AOSL still sees the coming months having solid demand. When Apple (AAPL) last reported earnings, it was clear that smartphone sales were slowing down at a noticeable rate. If the coming announcements of smartphone launches are exciting, a lack of orders or demand will quickly send the share price down for AOSL I think. Apple still has a lot of production and manufacturing in China for smartphones and if sales decline, the demand for products and services from AOSL will go down and the company will look even more pricey. This further contributes to my Sell rating for the company.
AOSL Valuation
Valuation wise the company does look expensive based on certain metrics, but rather fair on others. Looking at the earnings multiple for AOSL it's at 26 right now on a forward basis, a premium of 15% to the sector. For a company that is experiencing contracting margins, I find it likely we might see the forward P/E move upwards still if smartphones among other electric consumable sales decline and material expenses remain at current levels.
Which metrics AOSL does look appealing on are EV/EBITDA which has bounced off the lows of around 4 back in late 2022. Historically the company has traded above these levels a fair bit, currently, it has a discount of 58% to its 5-year average EV/EBITDA ratio of 14.7. On a book value as well, AOSL is trading below it. The FWD p/b is 0.97 right now, well below the sector's average of 2.89. Ultimately though, I think these metrics are a little misleading just looking at them like this. The company is faced with a lot of challenges still and the reliance on one market makes the discounted metrics make more sense. The company doesn't deserve a higher premium when they are operating like this in my opinion. Where I would like to see AOSL raise my rating would be an earnings multiple of around 15 and a net margin of at least 10%. This would introduce more stability to investment and also bring the company closer in line with the sector. The company is in an industry where there are a lot of high-growth companies and if one can't keep up then a discount should be applied. A p/e of 15 is nearly 50% below the rest of the sector on a forward basis and at that point, I think the fundamental long-term demand for the industry would make AOSL at least a decent buy. As for the p/s of the company, it's at 1.2 on an FWD basis, which I find fair given the lack of revenue growth the company has had recently. Perhaps a higher multiple is justified if the company can continue to grow revenues on a sequential basis, but it's not a bet I am willing to make. Further on, on a p/FCF the company is trading at a multiple of over 40x, which is a massive premium of 123% to the sector and in my mind puts AOSL at an unreasonable price level currently.
The semiconductor industry is known to be cyclical and I think the recent years were the runup and now we are still in the consolidation phase where margin preservation is incredibly important and the ones that do it best often turn out to be the best investment in the end. With AOSL not ticking this box the company becomes a sell for me.
Looking at the chart above here it further highlights some of the poor metrics that are applicable with AOSL right now. The company has a lower p/e perhaps than AMD but lacks the EPS growth that it has been able to display. Without any historical growth to the bottom line for AOSL, I think there is less of a possibility of them performing very well in the coming years. The industry had a massive boom and AOSL managed to miss capitalizing on it. Looking at Himax Technologies Inc ( HIMX ) as well the valuation seems more reasonable here in comparison to AOSL. The company has been able to grow the bottom line quickly and efficiently and hasn't been valued as richly as AOSL still. All in all, I find the poor historical performance and the premium applicable to AOSL right now to make it one of the worst options in the semiconductor space.
What I Am Looking For
I have covered throughout the article some of the risks that I see with the company, like potentially slowing smartphone sales as consumers are cutting back on excess spending. Buying the latest smartphone might not be a priority for all and that ultimately hurts demand for AOSL. But they aren't reliant on just selling smartphone components, the company also manufactures components for computers, electric machinery, and fridges. As I said, almost all electric machines have some sort of connection to the semiconductor market.
What I am looking particularly for AOSL to focus on in the coming quarters is for the company to move away from electric consumables like gaming, and graphic card-related products and more into the industrial sector instead. I think the prospects of growth are better here as revenues and demand are more resilient and predictable. Diverting and aiming to serve a more international market as well would further make the company appealing. Power tools for example are used in many areas and with a growing global industrial market it further boosts demand. Tapping into this market presents them with a TAM of $545 billion, which if they just capture a small part would ensure the company had exponential growth going forward in my opinion.
Thesis Recap
The challenges that are facing AOSL seem hard to face as the trend for slowing smartphone sales has already begun as the recent earnings season began. The company is trading at a discount based on both EV/EBITDA and p/b in comparison to the sector but it seems warranted as the company has over 90% of its revenues coming from China. This overreliance seems risky and opens up the possibility of significant earnings swings depending on the political landscape in the country. Margin preservation has been difficult for the company as passing on costs to customers seems improbable. Lacking the capability to do so showcases that AOSL also lacks a dominant position in the market. What makes my assessment of the company different from the sentiment on Seeking Alpha currently comes down to the cyclical nature of the industry and I think the current sequential increase is short-lived and coming quarters might very well display a lower set of revenues. That would lead to a decrease in the company's share price and also result in a poor ROI. On some valuation metrics as well the company looks expensive and I fear multiples are only going to go up, giving less of a margin of safety. Large amounts of revenues from a somewhat unstable geopolitical region further add to the risks. This ultimately leads me to rate AOSL a Sell right now.
For further details see:
Alpha and Omega Semiconductor: Cyclical Earnings Without Sustainability