Capuski
“Buy the dip” is a piece of advice that can make investors a lot of money over time, but it’s also difficult advice to follow. Every once in a while there’s a market, sector, or stock-specific “freak out”, but more often than not, meaningful dips come with scarier changes in the near-term outlook. The Street being what it is, it’s not uncommon for those near-term changes to lead to big swings in long-term outlooks, estimates, and target prices, as many analysts seem to forget that cyclical stocks/industries cycle in both directions.
Since my last update, Silicon Labs (NASDAQ:SLAB) has outperformed the broader semiconductor space by about 15%, as the company has continued to post strong growth from its IoT-focused business. While there is growing evidence of an impending slowdown (echoed by other players in IoT), this hasn’t been outside of my expectations. I do see elevated risk to sentiment and near-term estimates, but I also think Silicon Labs is trading at a pretty attractive valuation relative to how growth semiconductor stocks typically trade.
Conditions Continue To Erode
Evidence continues to mount that the semiconductor sector is already in the early stages of a cyclical correction that will lead to weaker volumes, revenue, and margins over the next year or so. Lead-times are still well above pre-pandemic norms, but dropped by almost a week in October (a large month-to-month drop by normal standards) and companies are openly acknowledging order/delivery pushouts from customers as inventories mount.
For Silicon Labs’ part, lead-times fell to around 26 weeks with the third quarter report, a significant move from the “26-52 week” lead-times reported earlier in the year, and management noted more volatility in orders. Along similar lines, company inventory rose another 20% qoq in the third quarter, with inventory days up 9 to 76 (versus 55 days in the fourth quarter of 2021), and distributor inventory days are now around 60 (above the high end of the company’s target range).
Peer reports likewise reflect more challenging operating conditions. NXP Semiconductor (NXPI), Semtech (SMTC), STMicro (STM), and Texas Instruments (TXN) have all mentioned weakness in their IoT businesses, particularly consumer-related IoT, while companies outside of the IoT space like ON Semi (ON) have likewise pointed to noticeably weaker trends in consumer markets and initial signs of weakening industrial demand. Nordic Semiconductor (OTCPK:NRSDY), a good comp for Silicon Labs in the IoT wireless space, likewise openly acknowledged order cancellations and guided toward a possible sequential decline in revenue.
I don’t believe there’s anything fundamentally wrong with IoT – the market is not broken – but there are multiple dynamics working against companies in the short term. First, the pandemic pulled forward demand for many IoT products in the consumer, commercial, and industrial markets as companies accelerated their automation and remote monitoring plans (in response to social distancing needs and labor challenges), while consumers spent considerable sums on improving their home quality of life.
At the same time, semiconductor supply shortages pushed many customers to over-order in an attempt to secure necessary components and many companies built inventories to guard against further production disruptions. With inventories now at more robust levels and demand starting to fall off, those customers are readdressing their own supply needs – while customers still appeal reluctant to defy non-cancellable orders, multiple semiconductor companies have mentioned increasing pushouts, as customers try to better manage their inventory needs.
Long-Term Trends Still Favor Edge IoT
In the short term, business is going to get more challenging for Silicon Labs. The IoT market continues to grow, and I expect Silicon Labs to do better than most where volumes are concerned, but the company has been leveraging strong pricing and I think that will fall off more significantly in the coming quarters as supply shortages vanish. Moreover, while I do think the overall market will continue to grow as new use-cases come on board, established IoT markets like metering and smart/connected home are likely to see some meaningful weakness.
Longer term, I’m not concerned about Silicon Labs’ markets. Smart/connected home adoption is still in its infancy, and I expected adoption/use-case arguments to get stronger as connected home offerings make life easier for home owners and start offering more meaningful benefits like lower energy consumption. I likewise expect more personal device IoT adoption for applications like health and wellness (there are hearing aids now can track heart rate and/or steps, and automatically feed that information to tracking apps) and with smart/connected appliances.
Outside of personal/home use, I expect more municipal use of IoT. Cities can use IoT to monitor traffic and street lights and respond in real-time – adjusting traffic lights and street lights in response to demand/need. IoT also provides cost-effective asset security and monitoring options, a need underlined by a recent attack on electric substations in Oregon, North Carolina, and Washington – guarding substations is impractical, but remote monitoring aided by IoT is a cost-effective option. Likewise with many industrial applications, including wearables, asset tracking, and sensors for predictive maintenance and diagnostics – for instance, IoT-enabled smart monitoring/diagnostics can allow elevator technicians to diagnose and fix certain mechanical issues without having to make a service call.
Silicon Labs continues to offer the broadest set of wireless communication capabilities for IoT, while both Nordic and Semtech are more tied to specific technologies. I’ve said before that I think Silicon Labs could benefit from improving its MCU portfolio, and I still believe that, but customers have proven willing to cobble together best-of-breed components to achieve the performance characteristics they need and want, so I don’t think Silicon Labs’ relative deficiencies in microcontrollers limit the opportunity yet.
The Outlook
The next quarter is likely to see the first sequential revenue decline in quite some time (and a painful year-over-year decline), and I do see a risk of a year-over-year revenue decline for the full 2023. I still believe, though, that mid-teens revenue growth should be achievable over 2021-2026, and I’m still expecting low double-digit long-term revenue growth as IoT adoption grows in multiple end-markets and use-cases.
With Silicon Labs enjoying strong pricing leverage in 2022, I do believe that 2022 is likely to be a multiyear peak for gross and operation margins. Even so, high-teens operating margin (non-GAAP) in 2024-2025 is hardly poor, and I do expect healthy margin and free cash flow leverage over time, with long-term adjusted FCF margin in the high-teens to low-20%’s in the 2030’s.
Discounted cash flow suggests a high single-digit total potential annualized return, which isn’t bad for a growth semiconductor stock. Likewise, margin-driven EV/revenue suggests a fair value in the $140’s if I use my 2024 margin assumption (which I believe is more representative of long-term “run-rate” performance than 2023 is likely to be).
Certainly there are issues with all of these approaches. Results in 2023 could be weaker than I expect and could linger on into 2024. Likewise, if near-term results are weaker than expected, it wouldn’t be at all surprising for the Street to refuse to look beyond the near-term weakness when it comes to valuation (this has happened many times in the past). On the other hand, while I don’t think Silicon Labs is an imminent M&A target, I do think there is an M&A backstop here and if near-term results/valuation weaken too much, I believe a deal could happen.
The Bottom Line
Silicon Labs isn’t “can’t miss” cheap, but growth semiconductor stories don’t often get to that level unless market conditions get truly ugly. I’m not ruling that out as a possibility or risk factor, and I can certainly understand readers choosing to hold off in anticipation of further cuts to guidance/expectations.
That said, the shares are likely to bottom out and rebound ahead of actual reported financial improvements and I think these shares could get more attention in 2023 as the Street starts thinking about the names it wants to own after the semiconductor correction cycle is over.
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