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A year ago, NXP Semiconductors (NASDAQ:NXPI) was a consummate example of “love the company, don’t love the stock (or the valuation, more precisely)”. Since my last update on the company, the shares have fallen about 18%, underperforming the SOX by around 17%, while names I preferred like onsemi (ON) and STMicro (STM) have done notably better. While nothing is fundamentally wrong with NXP, I think the weakness can be tied to limited margin upside over the next few years, as well as risk/vulnerability in the coming normalization (if not down-cycle).
I think a lot of the correction may already be in the shares and I’m increasingly intrigued by the value I see here. Although there are better plays to leverage auto electrification, NXP will generate growth here, and I like the company’s leverage to industrial automation, edge intelligence, and what I’d call “non-traditional” mobile (UWB in particular). I certainly acknowledge a risk that I may be underestimating the downside if the cycle really corrects sharply, but I still think NXP is set for high single-digit revenue growth and strong margins that can fuel an attractive long-term return from today’s price.
Capped Upside On Supply Challenges
If forced to find criticisms about management or their strategy over the last year or so, I suppose I could quibble with the company underinvesting in capacity, and particularly internal capacity. The relatively weak sequential growth outlook for NXP in this first quarter (flat qoq performance in autos and industrial/IoT) is largely down to capped supply, and I believe companies like Texas Instruments (TXN) may be able to pick up some incremental business from this situation over time as they prioritize more internal capacity.
This leaves price as a revenue driver, and that’s a tough spot. Prices have undoubtedly gone up over the past year, but no company wants to admit that they’re being opportunistic here … and yet, overall non-memory chip prices are up double-digits over the past year. I don’t see NXP as standing out as an aggressive price-taker at this point, and I think doing so would risk alienating customers when the inevitable correction in orders comes.
I also believe that, between limited capacity and the likelihood of softening lead-times on more robust customer inventories, margin leverage is likely capped in the near term. NXP produced 57.3% gross margin in Q4’21 and 34.9% operating margin, compared to the company’s three-year guide (from its late 2021 Investor Day) 56.5% and 34%. It’s certainly possible that management guided to a beatable bar, but I do think this underlines limited margin leverage in the near term, and perhaps more margin risk in ’23 than commonly believed as the cycle corrects.
One opportunity that I haven’t heard management discuss, nor have I seen discussed by sell-side analysts, is the prospect of product-pruning. I have to think that there are some non-strategic (or at least less-strategic) products with lagging margins within the overall mix, and deprioritizing those could be an option to consider while capacity remains constrained, though here again there is the need to balance profit maximization with customer relationships.
When, Rather Than If, On The Cycle
Like seemingly every other chip company, NXP has pointed to a growing backlog of non-cancellable orders as a shield against likely double-ordering today and the risk of order cancellation as customer inventories build. I’m still at least somewhat skeptical as to how much this will insulate the sector.
It’s not that I don’t believe these management teams, it’s just that I’ve seen supposedly non-cancellable orders cancelled in past cycles, and I don’t think many chip companies will be willing to permanently blackball customers who try to revise their orders. As customer inventories build (it’s hard to find an industrial or tech company that hasn’t been building inventories to mitigate supply challenges) and demand slows later this year, we’ll see how these order books hold up.
If I haven’t been clear enough on this point, let me reiterate – this is NOT an NXP-specific problem, and I don’t think they’ll fare any worse. If anything, given the company’s strong share in auto MCUs, radar transceivers, and BMS-related chips, I think NXP will probably see its order book hold up better than most.
Content Growth On Top Of Market Growth
Management has guided to 9% to 14% multiyear growth in the auto sector, or around 1.2x the market growth rate. Indeed, I do expect that companies like onsemi and STMicro will outgrow NXP in autos, partly due to the fact that NXP is already so significantly exposed to autos and also due to its relatively lower leverage to higher-end power components (SiC MOSFETs, IGBTs, et al).
That’s not to say that there aren’t content growth opportunities here, though. NXP is still the leader in auto MCUs, and while I’m sure Renesas (OTCPK:RNECY) wants the crown back, and both TI and STMicro are targeting this as a growth market, NXP’s new S32 portfolio will be hard to make inroads against. Elsewhere, I see growth opportunities in ADAS (radar components for ADAS L2+) and electrification, with NXP winning slots in battery management and inverters. Underlining the content growth opportunity, I would note that NXPI’s auto revenue grew 30% from 2019 to 2021, while global auto production declined 14%, making for a 51% increase in content per vehicle.
I also expect meaningful content and market growth in the Industrial & IoT and Mobile segments. I’ve talked at length about my convictions regarding a long-term growth cycle in industrial automation, and with partnerships with the likes of Schneider (OTCPK:SBGSY), I think NXP is well-placed with its MCUs, application processors, driver ICs, connectivity and so on. Likewise in intelligent edge IoT; I believe there’s going to be exceptional growth in intelligent edge IoT in the coming five years, with companies using this technology for functions like remote monitoring and asset tracking.
Within Mobile, I like the company’s leverage to UWB and the ongoing opportunity to benefit from more and more functions going digital – digital wallets, digital keys, and so on.
The Outlook
I do see some risk to my ‘23/’24 numbers if there’s a sharper cyclical correction, but I expect NXP to generate long-term revenue growth in roughly the same 7% to 8% range I expect from Microchip (MCHP), onsemi, STMicro, TI, and so on, with NXP having attractive leverage to autos and industrials. Better leverage to data center, enterprise networking, and/or sensing would be nice, but no company has everything.
Although I do see margins as relatively capped in the near term, and I have sector-wide concerns about higher long-term capital intensity, I still believe NXP can push its adjusted FCF margins into the high 20%’s over time, leveraging that high single-digit revenue growth into low double-digit FCF growth.
The Bottom Line
Between discounted cash flow and margin-driven EV/revenue and EV/EBITDA, I believe NXP shares are undervalued today. Discounted cash flow with the aforementioned assumptions supports a double-digit long-term annualized return, while mid-30%’s OPM and mid-to-high-50%’s GPM supports a fair value in the $220’s. Even if the market were to return to trough valuation multiples (relative to margins), NXP would still be modestly undervalued.
I don’t think current undervaluation in the semiconductor sector is “free money”; I do see legitimate risks regarding revenue and margins over ’23 to ’24 and I won’t rule out the possibility of both trough multiples and lower revenue/margin estimates (which would drive a fair value below today’s price). These are typical risks for cyclical companies, though, but I think the long-term opportunity and quality at NXP make it a risk increasingly worth taking.
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