2023-03-24 01:40:56 ET
Summary
- In a high inflation environment where liquidity cracks have also started to appear amid tighter monetary policy in the western world, it is important to recalibrate our perception of risks in East Asia.
- I illustrate this recalibration using Taiwan's Silicon Motion which is subject to acquisition interest by U.S.-based MaxLinear, with Chinese regulators currently assessing the deal.
- In this way, a price target of $72 can be justified, supported by other metrics like profitability, and valuations.
- However, this positive outlook may become tainted in case of slack demand pickup after China's Covid recovery exacerbated by a recession in the United States.
Risk-averse investors may opt to stay away from the banking world where despite the government backstopping banks, uncertainty still reigns with the Financial Select Sector SPDR ETF ( XLF ) barely managing to recover its losses in the past five days. In contrast, Taiwan-headquartered Silicon Motion Technology ( SIMO ) gained 8.71% in the same period, as shown in the blue chart below. This is a significant gain and is certainly positive in a market where uncertainty prevails.
However, at around $65.5, the stock is well below its mid-2022 high of $95.15 when U.S.-based MaxLinear (NASDAQ: MXL ) made a bid to acquire it to the tune of $3.8 billion. The deal currently being reviewed by China's SAMR or State Administration for Market Regulation remains on track to be closed by mid-year, as I will elaborate upon later.
However, my objective with this thesis is to show that even if the deal is not approved due to an escalation of geopolitical tensions between the United States and China, this is a company worth considering, not only because it has managed to outpace growth in the PCs, tablets, and mobile phones market, but also due to inflation in the western world likely to remain high.
I start by providing more detailed insights into the products.
The attractiveness of SIMO
The company was founded in 1995 in San Jose, California, and has expertise in developing integrated circuits, more specifically, microcontrollers for NAND flash memory storage devices, and specialty RF (radio frequency) for mobile devices. These are purchased by the big NAND flash memory manufacturers like Samsung ( SSNLF ), SanDisk, Toshiba ( TOSYY ), and Micron ( MU ), as for their memories to function in a PC or server located in a data center, Silicon Motion's microcontrollers are required.
For this purpose, with over 20 years of experience, the Taiwanese company is "a global leader" in supplying NAND flash controllers for solid-state storage devices and SSD controllers. Its products are used in many of the major smartphones and other mobile devices available today.
It faces competition from Semtech ( SMTC ), Phison Electronics, etc., and large memory manufacturers wanting to integrate along the semiconductor supply chain vertically. In this respect, its profitability grade of "B" achieved despite average gross profit margins of C+, shows that despite facing supply chain-related overheads, it has been able to reduce costs considerably. This is further evidenced by its EBIT margin of 23.5% which is more than 400% than the sector median suggesting a solid operating cost structure.
Profitability Grade (seekingalpha.com)
Therefore, with a pickup in activities in the memories for PC, tablets, and smartphones, implying more sales, the company could see even higher profit margins.
Sales Resiliency amid Competition
In this respect, Silicon Motion reported full-year 2022 financial results on February 7 when sales grew by 3% despite challenging end-market conditions where worldwide shipments of PCs, tablets, and smartphones declined by 11.9% according to Gartner.
Therefore, by posting a 3% increment in sales, it significantly outperformed the PC and smartphone markets, as well as the competition. Interestingly, sales of SSD (Solid State Devices) controllers decreased by 5-10% for the year, but this comes amid a market that shrank in 2022 as server OEMs (Original Equipment Manufacturers), especially the ones from China bought fewer components from in the second half of last year. For investors, OEMs refer to pc laptops or smartphone makers which buy components like memories, controllers, or processors from different suppliers and assemble them to produce equipment to sell to end users like you and me.
/news-releases/news-release-details/silicoResults-period-ended-december-31-2022 (siliconmotiontechnologycorporation.gcs-web.com)
Thinking aloud, with China reopening after the Covid freeze, the management expects some rebound in the demand for SSDs as well as higher prices for NAND memory. There is another cause for optimism with the progress made to penetrate the OEM market with its PCIe Gen 4 SSD controllers, which constituted two-thirds of sales in 2022, compared to less than half in 2021. This figure should improve further thanks to technology upgrades carried out to enhance SSD efficiency as part of the technology refresh cycle.
Consequently, despite unfavorable market conditions, Silicon Motion is able to improve its sales figures, namely by offering a large degree of product differentiation. Also, the company had cash amounting to $232.2 million as of the end of 2022 and zero debt, which signifies that it does not need an infusion of liquidity from an acquirer to boost its competitive positioning. For this matter, capital expenses were $32.8 million last year, and given that it is profitable, it means that there is a sufficient amount of money to invest in growth.
Therefore, while forming part of MaxLinear after a potential acquisition would have undoubtedly brought more scale and expanded the base of operations, it is not a necessity for Silicon Motion. This is what the market must have sensed as, after falling more than 40% since the acquisition talks as shown by the blue chart below, its stock is now evolving more in line with the chips sector, represented here by the iShares Semiconductor ETF (NASDAQ: SOXX ).
Valuing by Considering Inflation Vs. Geopolitics
This signifies that valuations have come down, and as pictured below they are primarily green, implying undervaluation. Adopting a moderate stance and considering the trailing Price to Sales of 2.3x , this is undervalued with respect to the sector by 13.2%. Adjusting for a 10% increase, I come up with a target of $72 (65.45 x 1.1), which remains lower than the price of $93.54 which MaxLinear is ready to disburse for each share.
SIMO Valuations (seekingalpha.com)
Pursuing further, there were indications by MaxLinear in January of this year that the Chinese regulator may consider the deal favorably. The same type of optimism was voiced by Silicon Motion's management in February, and they expect a final determination by SAMR in the " second or third quarter of 2023, or even later." However, one must be realistic that given the level of tension between the U.S. and China, simply being bullish on regulatory grounds is pure speculation at this stage.
On the other hand, cracks are appearing along the liquidity front, both in Europe and the U.S., which the authorities are trying to plug by orchestrating capital injection measures and even mergers. Given that these geographies also face high inflation problems, the task of balancing price and financial stability may prove to be difficult, as I recently explained. Now, financial stability is intricately connected to the health of the banking system, while price stability is about combating high inflation. In this case, with central banks likely to prioritize the health of the financial industry, less effort is likely to be made to combat inflation which is likely to stay high in the western world, compared to Asia where Silicon Motion has its facilities .
Conclusion
This should favor companies that manufacture in Asia and do not produce advanced processors like Taiwan Semiconductor Company ( TSM ) which are subject to export restrictions. For this matter, memory and related controllers are more passive components when compared to NVIDIA ( NVDA ) GPUs.
Hence, it is likely that, except for periods of volatility which are likely to persist as further liquidity cracks appear in an environment of sustained monetary tightening, Silicon Motion's stock may move higher as it grinds away competitors' market share. Here, investors will note that I have a moderately bullish position with a $72 price target in view of the PC, tablet, and smartphone markets likely to be pressured this year. Finally, sales conditions may become exacerbated in case of a recession in the U.S. reducing demand for the company's product, which is not offset by the pickup in economic activities in China which absorbs a significant quantity of its products, following the Covid reopening.
For further details see:
Silicon Motion Technology: High Inflation Risks Now Outpace Geopolitical Tensions