2023-11-19 11:13:54 ET
Summary
- Operations returned to reality in 2023 after two exceptionally strong years.
- The turnaround is expected to begin in 2024, but at a very slow pace.
- Profit and EBITDA margins remain very high, and the company is highly profitable.
- The balance sheet is very strong as it carries zero debt.
- The dividend is safe, but more moderate raises are to be expected over the next few years.
- The recent share price decline represents a good opportunity for long-term conservative dividend growth investors.
Investment thesis
Following a very strong 2021 and 2022, Power Integrations' ( POWI ) revenues are receiving a strong negative impact as customers are destocking their inventories in a macroeconomic landscape marked by weaker demand. Added to this is also a recent drop in profit margins (to normal levels) after two very profitable years, and although everything suggests that the fourth quarter will mark the bottom, no significant recovery is expected in 2024.
Fortunately, the balance sheet remains robust thanks to a zero debt policy and higher-than-usual inventories, but cash and equivalents have decreased significantly as the management decided to buy back shares in recent quarters due to the weak share price performance. Still, this is not a problem as short-term investments remain very high. Currently, the company is making a strong bet on the GaN (Gallium Nitride) technology and seeks to capitalize on its potential to eventually replace silicon carbide due to its lower manufacturing costs, better performance, and better sustainability for the environment, which should open the way to a long-term positive growth trend in the long run.
Nevertheless, current headwinds are reducing investors' expectations for the short and medium term, which has produced a 30% decline in the share price from all-time highs, which I consider a good opportunity for those long-term dividend growth investors with enough patience to wait for the current storm to subside as the company remains highly profitable and represents a good long-term holding for conservative investors. Still, a high P/S ratio suggests that averaging down should be a wise approach as pessimism could increase if revenues don't.
A brief overview of the company
Power Integrations is a global designer, developer, and marketer of analog and mixed-signal integrated circuits and other electronic components and circuitry used in high-voltage power conversion, and it also manufactures high-voltage LED drivers and high-voltage gate drivers. The company was founded in 1988 and its market cap currently stands at $4.19 billion as it employs almost 1,000 workers.
The company's products are used in power converters that convert electricity from a high-voltage source to the type of power required for a specified downstream use (mostly converting alternating current to direct current or vice versa, reducing or increasing the voltage, and regulating the output voltage and/or current). These products are used in mobile phones, computing and networking equipment, appliances, electronic utility meters, battery-powered tools, industrial controls and motors, solar and wind power systems, electric vehicles, and more. Since 2019, the company has been heavily investing in GaN transistors, and the management expects to keep launching GaN solutions with higher performance levels and better cost-effectiveness profiles compared to silicon carbide thanks to cheaper raw materials and lower energy usage during its manufacturing process.
Currently, shares are trading at $77.21, which represents a 30.23% decline from all-time highs of $110.66 reached in September 2021 as demand has moderated significantly at a time when customers are holding higher-than-usual inventories. For this reason, revenues significantly declined in recent quarters, and current headwinds suggest that the foreseeable future will not be as strong as the performance experienced in 2021 and 2022. For this reason, patience will be required for those long-term investors expecting significant dividend growth in the long run.
Revenues are declining as customers find themselves with high inventories in a lower-demand scenario
Thanks to great innovation efforts and increased average selling prices, the company has managed to increase its sales in recent years, and despite a sharp increase in revenues of $44% in 2021 (after a 16.08% increase in 2020), they decreased by 7.4% in 2022 and continued decreasing in 2023 as the current economic downturn has caught customers with high inventories.
In this regard, revenues declined by 41.64% year over year during the first quarter of 2023, by 33.03% year over year during the second quarter, and by 21.67% year over year during the third quarter, causing a significant decline in the trailing twelve months' revenue to $479.8 million (from $651.1 million in 2022). This decline has been caused by weaker demand (especially in the appliance and computer markets) and customer destocking as they accumulated inventory in the 2021-2022 period in order to avoid supply chain-related issues impacting their operations.
Sequentially, the company reported revenues of $106.3 million during the first quarter of 2023, but they improved to $123.2 million in the second quarter and $125.5 million in the third quarter. Still, the management expects quarterly revenues to decline to ~$90 million for the fourth quarter, which should mark the bottom. Now, the company won over a dozen smartphone and notebook GaN designs in the third quarter, and more designs were assigned for home automation, lighting, audio, and industrial controls, including a top European appliance OEM. In the long run, the GaN technology is expected to deliver very acceptable revenue growth rates as the global GaN power device market is expected to grow at a CAGR of 35.80% in the 2022-2030 period, and the company plans to double its addressable market by 2027 through new product launches, especially in the GaN, electric vehicles, motor drives, and renewable energy industries. Still, the short and medium-term outlook is not as promising as revenues are expected to decline by 31.63% to $445 million in 2023 and to increase by just 4.19% in 2024 as the management expects a (very mild) rebound to begin in the first quarter of 2024.
The company's revenue streams are well diversified by economic sectors as 32% of the company's revenue was generated in industrial markets during the third quarter of 2023, 32% in communication, 26% in consumer, and 10% in computer, but geographic diversification is more limited. In this regard, during the same quarter, 63.52% of the company's revenues took place in China and Hong Kong, and the list is followed by India, Western Europe, Germany, Taiwan, and Japan. Only 1.76% of revenues took place within the United States.
Besides, the recent decline in revenues coupled with a milder decline in the share price has caused a spike in the P/S ratio to 9.276, which means the company generates $0.11 for each dollar held in shares by investors, annually.
This ratio, despite representing a 22.96% decline from the 12.04 spike reached in 2021, is still 50.71% higher than the average of the past 10 years, which suggests that a longer-than-expected extension of the recovery could test investors' patience too much, which could lead to a further decline in the share price. It is also important to note that part of investors' hopes, which are holding the ratio at relatively high levels, are based (in my opinion) on three main factors: promising growth in the GaN industry, a zero-debt policy, and the fact that profit margins, despite a recent contraction to 'normal' levels, are still in the highest range of the pre-pandemic years.
Margins are back to 'usual' levels, but at the highest range
The company has been highly profitable in the past 10 years as the gross profit margin has typically remained in the ~50% range or higher, while the EBITDA margin has been close to 20%, and although these have fallen significantly in recent quarters, the main reason is unusually high margins in 2021 and 2022 (boosted by unusually high demand) as the trailing twelve months' gross profit margin currently stands at 52.13%, and the EBITDA margin at 19.67%.
Furthermore, the quarterly gross profit margin slightly improved in the third quarter of 2023 to 52.54%, and the EBITDA margin improvement was more pronounced as it increased to 21.45% as the company is temporarily decreasing its manufacturing capacity (by reducing staff hiring) while cutting expenses in order to adjust to a lower-volume scenario. A weaker yen also helped in margin improvement.
In this regard, I strongly believe this margin improvement is what actually helped to cushion part of the potential decline in the share price despite the recent decline in revenues. Furthermore, the lack of debt on the balance sheet means that the company should have no problem in continuing to generate positive cash from operations with which to continue investing in R&D in order to deploy its GaN technology, which means that, in the long run, sales should eventually return to a growth path once demand picks up. Therefore, despite the recent decline in revenues (and the subsequent increase in the price-to-sales ratio), many investors see significant limitations in potential further share price declines.
The balance sheet is very strong as the company is debt-free
The company has remained debt-free for many years, which is one of its most notable strengths (along with exceptionally high margins) as it allows the company to use all the cash generated through operations for capital expenditures, dividends, and share repurchases.
Recently, cash and equivalents declined from $343.3 million in the first quarter of 2021 to $94.74 million today as the company spent $73.9 million in 2021 and $311.1 million in 2022 in share repurchases, but inventories increased by $59.8 million since the beginning of 2020 to $150 million as the management is avoiding potential supply chain issues to impact its operations. Still, the recent reduction in production capacity aims to stop accumulating inventories in the immediate future, which should partially offset the recent decline in cash from operations. Also, the company has historically been increasing its short-term investments, which today stand at $261.9 million. In this regard, the balance sheet is very strong, so the company should not have any problem navigating the current complex macroeconomic context, and even a potential recession.
The fact that share buybacks have been higher than the decline in cash and equivalents while the company has continued to cover its dividend and capital expenditures while increasing inventories and generating excess cash demonstrates its exceptional performance in 2021 and 2022, but although the company continues to generate enough cash to cover all its expenses, excess cash is currently much more limited in comparison due to the recent decline in revenues and profit margins, and it seems that this will be the norm in the foreseeable future.
The dividend is safe, but growth will be more limited from now on
Without a doubt, the company has been a good holding for long-term dividend investors in recent years as the dividend increased by 300% in the past 10 years, and the latest raise was announced in November 2023 when it was raised by 5.3% to $0.20 per share and quarter.
This dividend growth has been possible thanks to a historically low cash payout ratio as the management has prioritized R&D efforts, capital expenditures, balance sheet improvements, and, when possible, share buybacks. Considering a $77.21 share price, the dividend yield currently stands at 1.04%, which, despite being low, is highly sustainable and should allow the company to continue generating excess cash in the long term, which should ultimately lead to sustained dividend raises. In the table below, I have calculated the cash payout ratio for recent years by calculating what percentage of the cash from operations has been allocated to cover the dividend.
Year | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
Cash from operations (in millions) | $85.6 | $92.2 | $97.9 | $82.0 | $84.0 | $224.5 | $125.6 | $230.9 | $215.3 |
Dividends paid (in millions) | $13.2 | $13.9 | $15.1 | $16.6 | $18.8 | $20.5 | $25.1 | $32.6 | $41.5 |
Cash payout ratio | 15% | 15% | 15% | 20% | 22% | 9% | 20% | 14% | 19% |
As one can see, the management has historically been very conservative when distributing dividends as the cash payout ratio has been very low, which explains the low dividend yield and the strength of the balance sheet. Still, the cash payout ratio has increased significantly in 2023 due to weaker operational performance.
During the third quarter of 2023, cash from operations was $26.7 million as inventories increased by $0.5 million, accounts receivable decreased by $3.6 million, but accounts payable decreased by $11.9 million, and the company reported positive net income of $19.8 million. In this regard, the trailing twelve months' cash payout ratio has increased to 58% as TTM cash from operations declined to $73.6 million while TTM dividends paid increased to $42.9 million (if we consider the company is expected to pay $45.9 million in annual dividends after the recent raise, the actual cash payout ratio is currently 62%). It should be said that this ratio is expected to moderate significantly as headwinds eventually ease. Until then, investors should not expect significant dividend raises, and that is why Power Integrations should be considered as a long-term dividend holding for patient and long-term-focused investors.
Thanks to excess cash, the company continually launches new solutions to the market in order to maintain its leading position in the industries where it operates. In September 2023, it launched the LinkSwitch-XT2SR family of off-line, constant-voltage, non-isolated flyback switcher integrated circuits for small open-frame power supplies, and in October 2023, the company also launched the world’s highest-voltage, single-switch, 1250-volt GaN power supply integrated circuit. In the near future, investors can expect the launch of higher voltage GaN products, which would expand the uses of the company's GaN technology. Currently, CapEX stands at $20.51 million, which should be easily covered with excess cash after covering the dividend.
Still, the company spent $7.5 million in capital expenditures during the third quarter of 2023, which would represent $30 million a year. Given what dividends paid and capital expenditures add up to in total, coupled with the recent deterioration in cash from operations, I believe that share buybacks will continue to be as limited as in the past few quarters at least until the excess cash generated is greater, but once headwinds ease, at least partially, excess cash should start widening.
Share buybacks will likely be frozen in the coming quarters
The company spent $73.9 million in share repurchases in 2021 and $311.1 million in 2022, and the number of shares outstanding declined by 6.26% as a result. Still, the pace of share buybacks has dramatically slowed down in recent quarters due to weaker operational performance. The company spent only $1.8 million in share repurchases during the third quarter of 2023, which is a marginal amount compared to 2021 and 2022. Sequentially, the decline was also significant as the company bought back $4.3 million worth of shares in the second quarter of 2023.
There is still $73 million remaining in the share buyback authorization, but in my opinion, these will most likely run very slowly due to the current economic downturn.
Risks worth mentioning
In the long term, I consider the risk of investing in Power Integrations to be very low because it operates in critical industries, its efforts to innovate are persistent, its profit margins are exceptional, and its balance sheet is debt-free. Still, there are certain risks that I would like to highlight, especially for the short and medium term.
- Much of the current optimism about the company's future lies in the significant demand growth expected for GaN products. Much more limited growth in demand for GaN products (than expected) or failure to penetrate the market would likely have a direct impact on the company's prospects.
- Recent interest rate hikes could trigger a potential recession, which would likely keep the current weak demand for much longer than expected.
- 76% of the company's revenues were provided by its top ten customers in 2022 (and 83% in the third quarter of 2023), which means that a significant reduction in orders from any of these customers would have a material impact on the company's operations.
- If revenues do not recover at a sufficient speed in 2024 and beyond, the management could decide to freeze the dividend and/or pause share buybacks in order to preserve as much cash as possible until the macroeconomic landscape improves.
- Due to the high volatility of recent times, the share price could experience significant changes in short periods of time. This is why I believe that averaging down should be considered as a way to cushion the potential impact of further share price declines as the P/S ratio is, despite recent weak share price performance, above the average of the last 10 years.
Conclusion
There is no doubt that the last few quarters have been difficult for Power Integrations, so it is not surprising that investors have lowered their expectations for the short and medium term, causing a 30% drop in the share price. Demand is expected to remain weak until at least the end of 2024, and profit margins, although high, have suffered a significant drop compared to 2021 and 2022. The company's operations have returned to reality in 2023 after two exceptionally strong years, confirming that the strong performance in 2021 and 2022 was actually temporary.
However, I consider that the moderation of investor expectations in the short and medium term represents a good opportunity for those conservative dividend growth investors with enough patience to wait for the company's prospects to improve in the long term. The company remains profitable, the balance sheet is very robust, and excess cash generation should increase as soon as consumer demand picks up again. Also, efforts to develop and deploy the company's GaN technology should pave the way for growth in the long run as the company expects to double the addressable market by 2027.
But despite this, I strongly recommend averaging down from current share prices in order to reduce the average share purchase price in case more declines occur since the current macroeconomic landscape is marked by strong volatility and a higher than average P/S ratio suggests that the share price still reflects significant optimism for the long term among investors.
For further details see:
Power Integrations: Time To Start Averaging Down