kynny
It’s no secret that the U.S. semiconductor sector has been under pressure from supply chain issues and heavy reliance on foreign supply. It’s also no secret that the U.S. wants to reduce its exposure to overseas semiconductor suppliers and build up a robust domestic supply.
To that end, U.S.-based SkyWater Technology (NASDAQ:SKYT) has been working with a number of companies to develop solutions that will play a part in building up the U.S. semiconductor industry.
The unique business model of the company does mitigate some of the risk many of its peers face in the sector, but the market, overall, doesn’t seem to fully understand the what and why of it.
In this article we’ll dig into how the company differentiates itself, and how that is having an impact on the performance of SKYT.
How SKYT differentiates itself
Even though SKYT’s Wafer Services improved significantly year-over-year, the story of SkyWater will continue to be the growth of its Advanced Technology Services [ATS], which provides much higher margins, and will be the driver to profitability in the future.
What’s unique about SKYT in its ATS business is it generates revenue from the R&D budgets of its partners. How it generally works is, SKYT puts together teams with its customers, using its expertise to work on ways to improve efficiencies and cut costs.
This has been a winning strategy for the company, as in the third quarter revenue from the unit surpassed the revenue from its Wafer Services, even though that segment enjoyed solid year-over-year growth of 36 percent. ATS, on the other hand, had revenue growth of 57 percent during that same of time, up 18 percent sequentially.
Of the total $52 million in revenue from ATS in the third quarter, $35.2 million of that was from ATS, up 57 percent year-over-year, while revenue from Wafers was $17.2 million, up 36 percent year-over-year but down a little sequentially. Its ATS segment should continue to grow its percentage of overall revenue going forward, even if Wafers continue to grow.
The good news there is ATS commands much higher margin and is the driver of its earnings improvement.
While it includes all of the company, management has stated that approximately two-thirds of its budget comes from R&D budgets, and that helps shield it from the macroeconomic forces affecting the semiconductor industry at this time, as well as the boost in supply over the last couple of years, pointing to a probable decline in demand in the near term.
It’s true that this is a key differentiator for the company, but it also has its own inherent risks in that R&D budgets of some of its partners could be cut if the industry remains under pressure for a prolonged period of time.
For that reason, investors should continue to watch the strength of those partners and the potential for meaningful cuts in their R&D budgets if market conditions require it.
I do see that as a potential risk, but in comparison to others in the semiconductor sector, the risk is lower in my view.
Recent numbers
As mentioned above, overall revenue for the third quarter 2022 was $52.3 million, up 49 percent from the third quarter of 2021, and up 10 percent sequentially. The significance of its business model is reinforced by the ongoing increase in revenue as a percentage of its overall business in its ATS unit, which continues to be the main growth driver of the company. If it relied upon wafers as its growth engine, the performance of the company would be more unpredictable and uneven, underscored by the strong year-over-year performance of Wafer Services, but a weaker one as measured against the prior quarter. Also, Wafer Services offers little to the bottom line of the company.
At the same time, the company announced it has started “started several new products and designs with our 7 Wafer Services customers,” meaning it’s working from higher revenue base from which it can grow, even though it’ll have minimal impact on earnings.
Since ATS now accounts for about 67 percent of its revenue, the continued growth in ATS will continue to improve gross margins and earnings in the quarters ahead.
This is already being seen in its GAAP gross profit, which jumped in the third quarter to $8.3 million or 15.8 percent of revenues. On a non-GAAP basis, gross margin increased to 16.8 percent, exceeding company expectations. Going forward, the SKYT guided for non-GAAP gross margin to be at around 15.4 percent.
The improvement in gross margin came from the earlier-than-expected launch of Phase 2 of the Rad-Hard program, fab efficiency improvements, and the implementation of its cost-cutting plan.
Consequently, a better product mix with the increasing ATS wafer sales was the key contributor to the improvement of margin. On the improvement on efficiencies in its fab operations, that was attributed to increasing automation and tool availability, as well as headcount.
In regard to headcount, that also contributed to lowering costs because the company was able to cut back on spend for outside services. That, and lowering nitrogen expenses because its nitrogen plant, after being shuttered for upgrades, was fully operational in the reporting period. That should be a tailwind for the company as it boosts sales in its ATS segment. To give an example, gross margin improved from revenue growth above the mid-$40 million breakeven level by over 50 percent. Non-GAAP net loss in the third quarter was $5.1 million, or ($0.13) per share, a significant improvement over the net loss $11.5 million, or $(0.29) per share in the same reporting period of 2021.
Adjusted EBITDA in the quarter was $3.8 million, or 7.3 percent of revenue, up from the $(2.7) million or (7.7) percent of revenue year-over-year. Cash and cash equivalents were $9.3 million at the end of the third quarter, down from the $12.9 million at the beginning of calendar 2022. Total debt outstanding at the end of the reporting period was $77.8 million.
To align with its growth plans the company is raising capital to fund its growth opportunities.
Raising capital
In mid-November 2022 SKYT announced a proposed underwritten registered public offering of its common stock. Needham & Company, which is the sole book-running manager of the offering, is expected to be granted a 30-day option to acquire additional share.
SKYT said it will use the capital for general corporate purposes, which includes funding operations and working capital, among other potential uses.
The response of the market to dilution was predictable, as the share price of the company immediately dropped by about 7 percent on the news.
At the end of September 2022, the company also received additional funding from the U.S. Department of Defense of $99 million for the purpose of continuing to expand its “onshore production capabilities for strategic radiation-hardened (rad-hard) electronics.”
That followed previous funding of $170 million based upon the successful completion of its “base prototype project for its 90 nm rad-hard process (RH90).”
With the U.S. government considering the growth of the domestic semiconductor industry as vital to its interests, SKYT is positioned well to attract more funding as it proves it can complete the prototype projects it is working on.
Conclusion
SKYT has put forth some good numbers in 2022, but I don’t think the market has fully priced in its competitive advantage and differentiation in the business model that includes revenue growth from R&D revenue from its partners.
By far the most important segment to carefully watch is its ATS segment, which continues to grow, and as it grows and becomes a larger part of its product mix, it will further improve revenue, margins, and earnings.
As for guidance, SKYT sees improved but incremental growth in the fourth quarter of 2022, and the first quarter of 2023.
The company has endured some wild price swings in 2022, falling to a low of $4.43 on May 25, 2022, then soaring to its 52-week high of $20.95 on August 16, 2022, before falling back to approximately $6.25 on October 13, 2022. Since then, it started another upward run before pulling back to trade in a tight range between about $9.00 and $9.50.
Based upon its numbers and guidance, I tend to think the stock will probably trade in a tighter range in the next couple of quarters, bearing in mind it is a relatively small company, and can at times experience volatile price movement.
Part of that comes from short interest, which at this time stands at a little under 25 percent, as shorts like volatile stocks like SKYT to take positions in, especially after an increase in its share price.
Aside from short-term price fluctuations, I see it having more support than it has in the past based upon the increase in revenue from its higher-margin ATS business, while its more moderate Wafer Services continues to provide a revenue base to work from.
At this time, I think investors should consider SKYT to be a semiconductor company that will continue to grow incrementally in the near term, with the potential to take off further out as it lands more business with strong partners that are capable of continuing to throw R&D revenue its way.
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