Koichi Kamoshida
Renesas Electronics (OTCPK:RNECF) (OTCPK:RNECY) has been actively restructuring the business over the last five years, driving substantially better margins and cash flow, but investors continue to treat this company like a sluggish legacy vendor of commoditized semiconductors. While I do see risk from competitors like Infineon (OTCQX:IFNNY), onsemi (ON), NXP Semiconductors (NXPI), and STMicroelectronics (STM), I think it’s overly conservative to assume that Renesas is nothing more than a share-donor at this point, and I think the market is undervaluing both the revenue growth potential and the margin/profit/cash flow value of that revenue growth.
Since my last article, the shares (the U.S. dollar-denominated ADRs) have done a little better than the SOX, and I think today’s valuation is attractive. The biggest caveat now is the upcoming downturn or at least “adjustment process” in the semiconductor sector, as inventories are catching up and order cancellations are starting to appeal. That could make for a turbulent 12-24 month period (which arguably started eight months ago), but I think patient investors will like what Renesas does over time.
Autos – Cautious Today, But Undervalued Opportunities Further Down The Road
Renesas’s valuation suggests a view that the company is basically a last-gen supplier of increasingly commoditized semiconductors for autos that is doomed to be supplanted by newer technologies from those aforementioned chip companies and others. While I do think that Renesas has historically been more cyclical than semiconductor investors typically prefer, I think this is an excessively bleak view.
First, there isn’t much evidence that I can find that Renesas is losing meaningful share in its core auto MCU or SoC businesses. MCUs are still core components across autos (powertrain, chassis, door/seats, cockpit, info/ADAS), and the company has been seeing good growth from recently-introduced next-gen products like RH850 (a MCU manufactured with a 40nm process) and Gen 3 R-Car SoCs (16nm process).
It’s possible that Renesas could lose some share to rivals who can bundle powertrain MCUs/SoCs with advanced electrification components (IGBTs, et al) in new EVs, but Renesas has been developing its own products for these markets.
Moreover, Renesas was certainly not an early mover in advanced power (IGBTs and SiC MOSFETs), but the company is stepping up now – announcing back in May that it would retrofit its Kofu plant to produce IGBTs and power MOSFETs on 300mm wafers (doubling capacity). While there will be significant competition in EV power from Infineon, onsemi, and STMicro (as well as others), I do think Renesas can leverage its deep and long-standing relationships with Japanese OEMs and Tier 1 suppliers, who generally prefer to stick with Japanese suppliers when possible.
Renesas’s growth focus in auto consists largely of three strategies – grow business with new customers, particularly in emerging markets (like a partnership with Tata Motors (TTM)); build out emerging applications like xEV and ADAS; and drive increased penetration with newer analog and power offerings, including PMICs and SiC power products. The company has introduced new MMICs for radar and a central SoC for camera/radar fusion, giving the company a new platform offering for advanced ADAS, and the company is likewise pursuing platform EV solutions that offer complete chipsets for functions like inverters, onboard charging, and battery management.
In the short term, though, management is being more cautious. Due in part to sourcing challenges beyond Renesas, Japanese OEM build rates are still pressured, and with channel inventories approaching 12 weeks, management is easing off on shipments. Likewise, I do see some risk of Renesas being supplanted in new EV models outside of Japan where rivals can offer more compelling bundles – as I said above, I think Renesas is moving to remain competitive in EVs (which are still below 10% of global production), but there could be a gap.
The Three I’s Should Get More Attention
Renesas is still thought of largely as an auto chips supplier, but multiple acquisitions and diversification efforts have lowered the weighting of the auto business to the low 40%’s. In addition to that diversification, I believe the opportunities in Industrial, Infrastructure and IoT (or 3I, as I’ll call it) are being overlooked.
About 30% of the segment (or around 15% of total sales) is Industrial, which serves markets like utility meters, building automation, printers, and industrial automation. The latter is already 6% of total sales (so, around 40% of sub-segment sales), and Renesas is a leader in MCUs for motor control with a customer base that includes Rockwell (ROK), Emerson (EMR), Siemens (OTCPK:SIEGY), and Schneider (OTCPK:SBGSY). Renesas is already leveraging its acquisitions to round its offerings, adding value-added PMIC, timing, and sensor offerings to core MCU/ASIC offerings to increase share-of-wallet with customers, and the Celeno deal also brings valuable connectivity assets into play as well.
In IoT, which is about half of 3I sales and around 30% of total company revenue, Renesas targets a range of markets including PCs, handsets, appliances, and industrial IoT with a range of MCU and analog products (timing, PMICs, sensors, connectivity). Where Silicon Labs (SLAB) has built a fast-growing IoT business by focusing on excellent connectivity options (and adequate MCUs), Renesas leads with strong 32-bit MCU capabilities that enable more sophisticated edge IoT functionality.
Last and by no means least is Infrastructure, which accounts for around 20% of segment sales and 10% of total sales. The main markets here are data centers and wireless; the slow growth of millimeter wave adoption has been a headwind, but the company has benefited from healthy data center demand. In the near term, though, the company is seeing some headwinds from the slower adoption of DDR5 and its inability to fully satisfy demand for DDR4 PMICs.
I think there are multiple reasons for investors to pay more attention to this business. First, I see meaningful growth opportunities in areas like industrial and building automation, mass market IoT, data centers, wireless infrastructure, and industrial IoT. Second, I still see ongoing opportunities to increase share of wallet with bundled offerings that combine Renesas’s leading 32-bit (and future 64-bit MCUs) with analog components like PMICs, sensors, and connectivity. Third, this is already a business with good margins, with segment gross margin in the last quarter of 64% versus 52% in auto and operating margin of 40.1% versus 36.3% (Renesas continues to invest meaningfully into R&D and SG&A to build out the 3I business).
The Outlook
The possibility of recession in 2023 shouldn’t be ignored, and that would likely hit consumer demand for autos at the same time that considerable new capacity is going to come online. Likewise, I think the near-term outlook for appliances, PCs, smartphones, and appliances is weaker, and I believe data center spending growth is likely to slow some in 2023 as SaaS companies pay more attention to profitability and cash flow. I also see an ongoing risk to sentiment from further M&A – I think Renesas has actually done a good job with its M&A program, but it’s a topic that often makes analysts and investors nervous, and I could see some more expensive deals for assets in connectivity or SiC/GaN.
I do expect a correction in the semiconductor market, and I’m looking for Renesas to see a 4% revenue decline in FY’23. Beyond that, though, I expect mid-single-digit revenue growth from the company, and I think there could be upside to that growth rate if Renesas eventually captures more share in EV powertrains (IGBT/MOSFET) and/or advanced ADAS. I expect Renesas to maintain FCF margins in the 20%’s, driving mid-single-digit FCF growth, with upside to the high single-digits if the company outperforms on revenue (better operating leverage).
The Bottom Line
Discounted cash flow suggest long-term annualized total return potential in the low teens, and the shares are likewise quite cheap-looking on margin-driven EV/revenue and EV/EBTIDA. The margins that Renesas generates would normally drive a forward EV/revenue multiple in the 4x’s, and even factoring in the likely lower operating margin next year and the shift in sentiment across the chip space, I think a forward EV/revenue multiple of 2.2x is just too low.
There are legitimate risks here to consider. Renesas may lose more ground in its auto business than I expect and may not be able to compete effectively in areas like SiC power. Likewise, the 3I business may not develop as I expect. It’s also possible that the downturn in the semiconductor space could be worse than I expect, and it’s tricky to buy in ahead of the actual downturn (the market is already starting to price in the downturn, but reported results haven’t turned yet). Even with those risks in place, I think the shares are undervalued and that investors should give this one a closer look.
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