Allegro MicroSystems Stock Is In A Tight Spot (NASDAQ:ALGM)

On paper, Allegro MicroSystems, Inc. (NASDAQ:ALGM) is in a good position. The company is well-positioned to reap the benefits from a couple of secular trends underway. Electrical vehicles, for instance, are on the rise, giving ALGM a powerful tailwind to fall back on as a supplier of related components. However, there are other factors to take into account before deciding whether ALGM is the right fit. The bull case for ALGM is not as clear-cut as it should be. Why will be covered next.

The trend may have shifted from neutral to bearish

It wasn’t that long ago that the way forward with ALGM was pretty clear. The chart below shows how the stock moved sideways in a horizontal channel with the lower and upper trendline running parallel to one another, the former being support and the latter being resistance. The stock would reverse course whenever it encountered the upper and lower trendline. This went on for months. People could use this to their advantage. The stock was a sell when it approached resistance and it became a buy when it approached support.

However, the charts have since undergone some changes as shown below. The stock is still unable to move past the area around $30, but support has buckled with the stock setting a series of lower lows. This price action suggests the bears have the upper hand over the bulls at this moment. On the other hand, the stock is currently closer to support provided by the lower trendline than it is to resistance. The stock may be able to rally in the short term. Still, the stock is down 31% YTD and the price action suggests lower prices are in store.

Growth is under pressure

ALGM is a supplier of power and sensing semiconductor solutions, especially to the automotive market, its largest market by far. The automobile market is increasingly transitioning towards electrical vehicles, which need, among other things, powertrains, ADAS and other solutions from suppliers like ALGM. The bull case for ALGM rests mostly on the premise that ALGM will be able to hitch a ride on the back of a growing market for electrical vehicles and the increased need for digitalization.

However, while demand is going up, ALGM’s ability to supply has been negatively affected by supply chain constraints, which have found their way into quarterly results. Quarterly revenue, for instance, declined QoQ for the first time in a while in Q3 FY2022, ending the streak of five consecutive sequential increases in quarterly revenue. The table below shows the numbers for Q3 FY2022.

On the other hand, ALGM was able to surpass both consensus estimates and its own guidance. Q3 FY2022 revenue increased by 13.4% YoY to $186.6M, even though it declined by 3.6% QoQ. Automotive revenue contributed around 70% or $130.8M. Non-GAAP EPS increased by 46.1% YoY to $0.19 and GAAP EPS ended up at $0.17, erasing the loss of $0.04 a year ago. Adjusted EBITDA was $54.9M in Q3 FY2022, up from $39.6M in Q3 FY2021. GAAP gross margin was 54.2%, a new record high.

(GAAP)	Q3 FY2022	Q2 FY2022	Q3 FY2021	QoQ	YoY
Net sales	$186.629M	$193.610M	$164.449M	(3.61%)	13.49%
Gross margin	54.2%	53.0%	45.3%	120bps	890bps
Operating margin	19.1%	19.9%	(14.7%)	(80bps)	–
Operating income (loss)	$35.605M	$38.554M	($24.224M)	(7.65%)	–
Net income (loss)	$32.936M	$33.223M	($5.060M)	(0.86%)	–
EPS	$0.17	$0.17	($0.04)	–	–
(Non-GAAP)
Net sales	$186.629M	$193.610M	$164.449M	(3.61%)	13.49%
Gross margin	54.8%	53.8%	49.6%	100bps	520bps
Operating margin	23.1%	24.1%	16.8%	(100bps)	630bps
Operating income (loss)	$43.091M	$46.649M	$27.707M	(7.63%)	55.52%
Net income (loss)	$36.091M	$38.670M	$22.980M	(6.67%)	57.05%
EPS	$0.19	$0.20	$0.13	(5.00%)	46.15%

Source: ALGM Form 8-K

ALGM may have found a solution to the supply problem, but there could be a catch

ALGM has been looking to ease supply constraints by roping in additional foundries for manufacturing. This is starting to bear fruit, which is part of the reason why ALGM expects to return to sequential growth after failing to do so in Q3. Guidance calls for Q4 FY2022 revenue of $193-197M, an increase of 4.5% QoQ at the midpoint. The forecast sees non-GAAP EPS of $0.20-0.21, a sequential increase of $0.01-0.02. From the Q3 earnings call:

“We anticipate a return to sequential growth, with revenue in the range of $193 million to $197 million to end fiscal ‘22 of approximately 29% year-over-year. For Q4, we expect both automotive and industrial to be off sequentially and other will be flat to down. We expect non-GAAP gross margin to be in the range of 54 to 55%. We anticipate non-GAAP earnings per share will be in the range of $0.20 to $0.21.”

A transcript of the Q3 FY2022 earnings call can be found here.

Finding alternative suppliers helped limit the impact of supply chain constraints. On the other hand, foundries are jacking up their price quotes to customers, which some may argue is justified due to market tightness. ALGM has countered the higher cost of supplies by passing it on to end customers, but there’s the risk that higher prices could lead to demand destruction if prices keep going up with no end in sight.

Why slower growth might be a problem for ALGM

Still, growth is slowing down at ALGM. This could be a problem since growth potential is what draws people to ALGM. Furthermore, valuations may be too high for some if growth is leveling off at ALGM. The table below shows the multiples ALGM trades at. In general, ALGM trades at a premium to most stocks.

	ALGM
Market cap	$4.63B
Enterprise value	$4.40B
Revenue (“ttm”)	$743.5M
EBITDA	$234.7M
Trailing P/E	46.42
Forward P/E	39.22
PEG ratio	0.21
P/S	6.37
P/B	6.82
EV/sales	5.92
Trailing EV/EBITDA	18.76
Forward EV/EBITDA	19.28

Source: Seeking Alpha

For instance, ALGM trades at 38 times forward earnings with a trailing P/E of 45. The stock is valued at close to 7 times book value, which is significantly higher than most. These multiples would look better if ALGM was growing at a fast pace, but that’s not the case right now.

Investor takeaways

The design wins keep on coming. ALGM is releasing new products. Margins are going higher. ALGM continues to benefit from several tailwinds. Strong demand in the electrical vehicle, Industry 4.0 and datacenter markets give every reason to believe that ALGM will remain a growth story for years to come. In the long run, ALGM looks to be in great shape.

However, the bull case for ALGM may be on more shaky ground in the short run. While it’s true supply chain constraints are having an adverse impact by limiting growth, growth is nevertheless slowing down. ALGM is supposed to be a growth story and it is falling short in that regard. ALGM is assigned multiples that are more in line with growth that is faster than what is found at ALGM. ALGM will have to step it up or multiples will have to come down to compensate for slower growth.

ALGM is facing headwinds on other fronts. While ALGM in active in several markets, the one that matters most is the automotive market, especially the market for electrical vehicles since that is where the most growth potential lies. Unfortunately for ALGM, many manufacturers of electrical vehicles have been hit by lockdowns in China due to outbreaks of COVID-19. This has greatly affected the stock of related companies.

For instance, Tesla (TSLA) is a customer of ALGM and it is one of the companies that has seen production disrupted. A halt in production has far-reaching consequences for automakers due to the size of the Chinese market, whether it is electrical vehicles or conventional ones with internal combustion engines.

According to one report, China represents 40% of the global battery electrical vehicle market. The market was valued at $124.2B in 2021 and it is expected to reach $799B in 2027 with a CAGR of 30%. Whatever happens in China is therefore important to makers of electrical vehicles, including suppliers like ALGM.

If vehicle production is reduced or halted, the need for related components goes down as well. If there’s less need for say powertrains and ADAS, then ALGM runs the risk of sales falling short of expectations. This risk remains as long as production has not been fully restored. At the moment, lockdowns continue to persist in China, which means that ALGM is likely to face continued pressure on this front.

ALGM may have a bright future further down the road as mentioned before in a previous article, but I am neutral on ALGM for now. ALGM is facing too many headwinds that have yet to be resolved. The supply chain constraints are still out there and could very well get worse. The COVID-19 situation could get worse in China, lowering vehicle production, which means demand for related parts could take a hit. ALGM stands to be affected due to its heavy reliance on the automobile market.

It’s not by accident that the stock has fallen more than most this year. It’s also slightly down on a 12-months basis, having lost all gains recently. While the long-term picture looks to be in good shape, the fact remains that ALGM is in a difficult spot in the short term. The chart patterns suggest that while a relief rally is possible, especially if electrical vehicle stocks manage to soothe existing concerns about China, the trend is for the stock to head lower. If this is the case, then staying on the sidelines is the way to go.