Allegro MicroSystems: Good Prospects At A Price (NASDAQ:ALGM)

Allegro MicroSystems (NASDAQ:ALGM), a supplier of sensors and analog power ICs, is likely to end a difficult 2022 on a positive note. The stock has rallied in the fourth quarter for several reasons, including hopes for a less restrictive Fed, a strong earnings report and a raised outlook. This has resulted in a substantial reduction in losses for the year, putting ALGM in a good position heading into 2023 after having outperformed most semiconductor stocks. However, the stock has struggled in the closing days of 2022 for a couple of reasons. Why will be covered next.

ALGM came back strong

The stock has lost 17% of its value YTD with only a few days left to go in 2022. In comparison, the iShares PHLX Semiconductor ETF (SOXX) has lost 37% YTD. ALGM has outperformed most semiconductor stocks, but it’s worth noting that ALGM needed a strong fourth quarter rally to bring down losses. For instance, as recently as October 14, ALGM had lost as much as 44% of its value for the year. The stock has rallied since then to bring down losses for the year as shown in the chart below.

The stock gained an impressive 63% from October 14 to December 13, but the stock is now off the recent highs, having lost about 10% in recent weeks. This did not happen by accident. Most of the losses came on December 15 when the stock fell 6% in one day. The selloff coincided with weakness in the electrical vehicle or EV sector, which could be a problem for a stock like ALGM since the company derives most of its revenue from the automotive industry.

For instance, reports popped up on December 14 of Elon Musk selling large numbers of shares of Tesla (TSLA), which negatively affected investor sentiment towards TSLA and other EV names due to the insider selling, which had a spillover effect on suppliers like ALGM. If a high-profile name like TSLA keeps dropping like it has, buyers are likely to remain wary of a name like ALGM, its recent performance notwithstanding.

ALGM trades at a premium

The news of insider selling at the EV industry’s most high-profile name is one thing, but the fact that it came at a time when valuations for ALGM was getting up there is another thing. A stock may gain 63% in two months, but such a big rise in the price of the stock will also push up multiples in a hurry, which is likely to cause some to take a step back after a big rally in the stock.

For instance, ALGM trades at 35 times forward GAAP earnings with a trailing P/E of 49 after posting GAAP EPS of $0.62 in the last twelve months. In comparison, the median for the sector is 23x and 22x respectively. It’s true elevated multiples are not that uncommon for EV and related stocks, but not everyone is willing to pay a huge premium, no matter how much potential the EV industry has. The table below shows some of the multiples ALGM trades at.

	ALGM
Market cap	$5.79B
Enterprise value	$5.52B
Revenue (“ttm”)	$842.3M
EBITDA	$191.9M
Trailing GAAP P/E	48.77
Forward GAAP P/E	34.66
PEG ratio	0.31
P/S	6.84
P/B	7.10
EV/sales	6.56
Trailing EV/EBITDA	28.78
Forward EV/EBITDA	17.67

Click to enlarge

Source: Seeking Alpha

Earnings growth has held up at ALGM

Still, there is a reason why ALGM was able to go on a huge rally in the fourth quarter. For starters, semis have been weighed down by monetary tightening in 2022 and raised expectations of a Fed pivot have given semis a boost. In addition, it helped that ALGM’s latest report came in strong, way above expectations.

In fact, ALGM easily beat estimates for the top and the bottom line in its most recent report. Revenue increased by 22.8% YoY to $237.7M, a new record high. Automotive revenue contributed $157.4M. GAAP EPS increased by 52.9% YoY to $0.26 and non-GAAP EPS increased by 55% YoY to $0.31, which was $0.05 more than expected. Adjusted EBITDA was $78.4M in Q2 FY2023, up from $66.7M in Q1 FY2023 and $59M in Q2 FY2022.

The EPS gains are even more impressive once share dilution is accounted for. The GAAP weighted-average of shares outstanding rose to 192.64M in Q2 FY2023, up from 191.68M a year ago. At the same time, it’s worth mentioning that earnings growth got help in the form of a lower-than-expected tax rate of 10% and favorable exchange rates.

Note that GAAP earnings in Q1 FY2023 were negatively affected by a 67% YoY increase in operating expenses in that quarter, which was mostly the result of $32.2M in stock-compensation expense, up from just $3.6M a year ago. ALGM finished with cash and cash equivalents of $303M on its balance sheet. The table below shows the numbers for Q2 FY2023.

(GAAP)	Q2 FY2023	Q1 FY2023	Q2 FY2022	QoQ	YoY
Net sales	$237.666M	$217.753M	$193.610M	9.14%	22.76%
Gross margin	55.5%	54.4%	53.0%	110bps	250bps
Operating margin	25.1%	6.9%	19.9%	1820bps	520bps
Operating income	$59.838M	$14.737M	$38.554M	306.04%	55.21%
Net income	$50.648M	$10.283M	$33.223M	392.54%	52.45%
EPS	$0.26	$0.05	$0.17	420.00%	52.94%
(Non-GAAP)
Net sales	$237.666M	$217.753M	$193.610M	9.14%	22.76%
Gross margin	56.2%	54.9%	53.8%	130bps	240bps
Operating margin	27.9%	25.3%	24.1%	260bps	380bps
Operating income	$66.297M	$55.049M	$46.649M	20.43%	42.12%
Net income	$59.758M	$47.118M	$38.670M	26.83%	54.53%
EPS	$0.31	$0.24	$0.20	29.17%	55.00%

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Source: ALGM Form 8-K

Guidance was a pleasant surprise. Guidance calls for Q3 FY2023 revenue of $240-250M, an increase of 31.3% YoY at the midpoint. The forecast sees non-GAAP EPS of $0.31-0.33, an increase of 68.4% YoY at the midpoint. In contrast, consensus estimates expected revenue of $233M and non-GAAP EPS of $0.27 in Q3 FY2023.

	Q3 FY2023 (guidance)	Q3 FY2022	YoY (at the midpoint)
Revenue	$240-250M	$186.6M	31.30%
Non-GAAP gross margin	56.0%	54.8%	120bps
Non-GAAP EPS	$0.31-0.33	$0.19	68.42%

Click to enlarge

Last but not least, ALGM raised its growth outlook for FY2023. FY2023 revenue is now projected to grow by 24% YoY, an increase from the prior 20% and way more than the mid-teens expected at the start of FY2023. From the Q2 earnings call:

“Finally, turning to our Q3 outlook. We expect sales to be in the range of $240 million to $250 million. In Q3, we expect auto sales to grow slightly above the midpoint of that range. Industrial to be in line with the midpoint and sales through our other markets could be flat to down sequentially. We are also increasing our sales growth expectations for FY ’23 to approximately 24%, up from our previous guidance of 20%.”

A transcript of the Q2 FY2023 earnings call can be found here.

On the other hand, management did acknowledge some softening in demand in certain areas, although overall demand remains robust.

“We continue to see robust demand across our strategic focus areas within both, the automotive and industrial markets. We also once again ended Q2 with more than a year of backlog and extended visibility. While we expect our positive trajectory to continue, we do acknowledge, there is increasing uncertainty relating to the broader macroeconomic environment, including pervasive inflation and clear signs of slowing consumer demand. Similar to many peers, we have noted a softening of demand, specific to some of our computer and consumer applications.

However, I would like to emphasize that these end markets traditionally represent less than 50% of our total sales in any given quarter. That said, we continue to be very vigilant and proactively monitor a series of leading indicators for potential changes in demand and supply dynamics across each of our end markets.”

Nevertheless, the backlog remains high, which pretty much ensures the quarterly numbers will remain strong for at least the next several quarters.

Investor takeaways

There is certainly a case to be made in favor of long ALGM. ALGM is riding a wave higher due to fundamental changes taking place in the automotive industry, especially as it relates to the shift towards EVs. ALGM as a leading supplier of such components as ADAS has been able to take advantage of these secular trends taking place. This transition is not expected to be over anytime soon, which means ALGM has good prospects it can look forward to.

While other semis have reported declining earnings due to slumping demand, ALGM is still going strong on that front. ALGM is expected to finish with non-GAAP EPS of $1.19 on revenue of $953M in FY2023 at the halfway mark, which represent YoY increases of 53% and 24% respectively, which is very respectable compared to many other semis. The record backlog ensures the quarterly numbers are unlikely to see much of a decline in the near term. There is a reason after all why the stock has outperformed most semis in 2022.

I remain neutral on ALGM nonetheless as mentioned before in a previous article. While there are certainly arguments in favor of long ALGM, there are also arguments against it. The semiconductor market is slowing down, which is a cause for concern. It’s true demand remains mostly robust in the end markets served by ALGM, but there are no guarantees the weakness as seen in the memory market will not spread to other markets like say the automotive market which is still going strong. It may not happen anytime soon and the record backlog should ensure it will be a while before any weakness filters through to quarterly earnings, but a slowdown is not out of the question for ALGM. The reports of a softening in demand are not to be ignored.

A slowdown is not something ALGM can afford, especially not with multiples where they are. The stock is, for instance, currently valued at 7 times book value, which may not be an issue for some, but is unlikely to be acceptable to everyone. The premium can be justified as long as the EV market grows by leaps and bounds, but if this market slows down because of say falling consumer spending as a result of a global recession, something that could happen in 2023, then all bets are off.

Bottom line, the stock is on track to end the year 2022 with losses for a reason. There are headwinds out there and none of the issues that have contributed to the decline have really gone away. Whether it’s Fed policy or a slowing market for semiconductors, they are still there and with them the potential for a resumption in the stock’s decline. Staying on the sidelines is the way to go.