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The last few months have not been easy ones for Semtech (NASDAQ:SMTC). A collapse in the value of Helium HNT cryptocurrency (down 95% over the past year) threatens one of the recent sources of momentum in the key LoRa business, while the acquisition of Sierra Wireless (SWIR) looks questionable at best. If that weren’t enough, handset volumes are weak, and it looks like PON, data center, and 5G deployments are slowing.
Should the Sierra Wireless deal go forward, I think it will ultimately destroy value for shareholders. That’s offset by good long-term trends and opportunities in home broadband and data center, not to mention the longer-term potential of LoRa in the IoT space. The valuation does look too low now, but it’s hard for me to recommend a stock where I disagree with management’s strategic priorities, and that’s the case for me now with Semtech.
Moving Forward, For Now, With Sierra Wireless
Semtech announced the Sierra Wireless deal back in August of this year, and while the initial reaction to the deal wasn’t all that bad, the shares have been sliding ever since and took another kick with weak guidance with fiscal second quarter earnings at the end of August.
Semtech is proposing to acquire Sierra Wireless for $1.2 billion, and I don’t like the deal. Management has made its case that the deal will significantly expand the company’s addressable market (which is true) and give the company improved scale and leverage to the growing IoT market (I disagree).
Sierra Wireless is primarily a manufacturer of modules and gateways for cellular IoT connectivity. While cellular IoT is a very viable option for creating IoT networks that have to cover a lot of distance (remotely placed sensors, for instance), the reality is that carriers drive the ecosystem and the cellular IoT connectivity device market is generally a low-margin opportunity (relatively speaking) – Sierra’s gross margins are around half that of Semtech’s.
Owning a module-maker could make some sense long term as a way to control the quality of LoRa modules, and maybe there’s technology here that could enhance the long-term performance of LoRa modules, but that’s a high price to pay for limited gain. Conversely, maybe Semtech thinks they can harness their own technology to make differentiated cellular IoT products that stand out better from the crowd.
More significantly, Semtech management has claimed that LoRa customers want added cellular IoT functionality, as many LoRa users turn to cellular networks for data traffic backhaul. I can certainly think of examples where you’d want LoRa functionality for basic low-power “passive” monitoring but also cellular IoT capabilities for high-bandwidth, low-latency transmission.
Basically, LoRa could handle a fleet of low-power, low-bandwidth remote field devices while the cellular side would handle higher-payload data communications aggregated from those field devices (sort of a hub-and-spoke system). I would also think that you could combine the two in monitoring/response systems – the LoRa side monitors assets, but the cellular IoT network’s greater capacity and lower latency are brought in when the monitoring triggers/demands an active response (like activating shut-off valves, opening gates, et al.).
All of that is fair enough, but I think this is an expensive way to add cellular IoT functionality to the LoRa platform. I can understand wanting to assemble a broader range of connectivity technologies (like Nordic Semiconductor (OTCPK:NRSDY) and Silicon Labs (SLAB) have done), but there had to have been more cost-effective ways for Semtech to acquire cellular IoT capabilities.
Sierra investors have approved the deal and Semtech has issued convertible debt to fund it, but the final approvals are not yet in, and the companies got a second request from the DOJ about a month ago. I expect this deal to go through, but it’s clearly not a done deal at this point.
A Speed Bump On The Road To Growth
Semtech’s business had been progressing well, with strong demand for 10G PON products used in home broadband (particularly in China), data center products like the Tri-Edge PAM4 CDR (used for signal integrity in interconnect), and LoRa gateways, particularly for the Helium Network (a dedicated wireless IoT network tied to the Helium Network Token (or HNT) cryptocurrency. That changed with the last earnings report.
The 3.5% sequential revenue growth wasn’t that bad, and the company saw growth in the aforementioned areas like PON, data center, 5G, and LoRa, but guidance was the issue. Management guided to flattish demand for PON products in the next quarter (consistent with reports from MaxLinear (MXL) of slowing home broadband), as well as flat performance in data center, while 5G was guided down on slower deployments (base stations include Semtech CDRs, among other components).
A pause in home broadband, 5G, and data center deployments isn’t a big deal. In the latter case, I’ve been expecting some “digestion” of past data center investments and more capex-consciousness on the part of enterprise data center operators, but I still see strong demand for 400G and 800G products in 2023, and I’m bullish on the potential of Semtech’s new Active Electrical Cable product (the CopperEdge PAM4 linear equalizer).
LoRa is the bigger issue. Helium-related hotspots grew at the slowest rate so far in the last quarter, and the value of the HNT cryptocurrency has cratered. While Semtech’s revenue exposure to Helium may be overstated (I’m assuming around $5 to $15 of content on those nearly one million hotspots), management guided for a major deceleration in the overall business, with gateway deployments falling from 800K in the last quarter to 250K in the next two quarters.
The Outlook
I believe home broadband demand could be weak for a year or so, but I do expect attractive long-term growth, including an acceleration in U.S. deployments in the future. I’m likewise bullish on long-term data center growth tied to 200G-800G adoption, and I think the 5G market is still a worthwhile growth opportunity. Semtech’s proximity and protection businesses are less exciting, but I like the efforts to diversify proximity products beyond mobile and into auto and industrial markets.
I’m more concerned about LoRa. Helium provided a big boost to the technology, but it’s also true that there are now more than 4.2M LoRa gateways, 256M nodes, and 170 LoRa network operators around the world and interest continues to grow for smart metering, smart city, and network/asset monitoring applications. This sharp revision in guidance is concerning, though I’d note that other players in the IoT space (generally more focused on shorter-range technologies) have also reported a significant slowdown in deployments.
Excluding Sierra, I’m expecting long-term revenue growth from Semtech on the high end of the mid-single digits (around 6%); while businesses like PON, PAM-4 CDRs, and LoRa should outgrow that (significantly, in the case of LoRa), a significant part of the business is still centered in slower-growing, more commoditized products. I’m also expecting Semtech to leverage the higher margins available from its growth drivers; as broadband, data center, and IoT grow, I expect adjusted free cash flow margins to move toward the high-teens and 20%’s, driving high single-digit FCF growth.
Discounted cash flow suggests a double-digit total annualized potential return. Using my near-term margin estimates for Semtech to drive EV/revenue, I believe a 3.75x multiple is fair, supporting a $45 fair value on my twelve-month revenue estimate.
The Bottom Line
I don’t like the Sierra Wireless deal; I think I understand the rationale behind it, but I think Semtech is paying a lot for what it’s getting. That concern mitigates the value I see in the shares. While LoRa adoption has always been lumpy, I’m still a long-term believer in the opportunity, as well as the growth potential in other end-markets like home broadband and data center.
Ultimately, though, management drives value and I can’t see myself investing in a company where I don’t see eye-to-eye on major strategic moves. I could easily be very wrong about the value Sierra brings to Semtech, and I’ll happily write the mea culpa piece in the future if it’s warranted, but for now, I can’t see myself buying Semtech shares despite the apparent undervaluation.
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