Semtech: Chronically Undervalued And Highly Specialized (NASDAQ:SMTC)

Alongside other fabless chipmakers, Semtech (NASDAQ:SMTC) has borne the brunt of broader market headwinds, thus exposing its vulnerability to market swings. I will argue that Semtech’s subsequent undervaluation is unfair, due to its unique product segmentation and ability to capture industry growth.

Investment Thesis

Semtech’s long-term bull case is three-fold:

1. The company is undervalued – not just in regards to financials, but also their forward operational strategies.
2. The company is in a superior position to innovate and expand with their wider.
3. Their products and services integration is relatively irreplaceable due to in-house network effects.

In the midst of the pullback in the semiconductor industry, Semtech has doubled down on long-term investments and partnerships across its supply chain, with Semtech’s 6.4x capex (with the information technology industry average being ~3.0) coverage ratio, indicating yet a greater ability to invest in R&D despite significant spending in the area of ~20% of net sales, or $150mn over the past year.

While the short-term prospects of the company are subject to volatile circumstances, Semtech’s willingness to invest during a contractionary period, alongside their expanded TAM and role in engaging unfulfilled market niches is why I maintain that Semtech’s long-term future remains a positive one.

Introduction

Semtech is a leading global supplier of high-performance analog and mixed-signal semiconductors and advanced algorithms.

Incorporated in Delaware in 1960, Semtech is segmented into three primary product divisions; Signal Integrity- involving the end-to-end procurement of optical data communications and video transport products, Wireless and Sensing- which includes radio frequency products and IoT, and Protection devices such as transient voltage suppressors.

The company sustains a diverse revenue stream set, with 50% of customers being highly fragmented and the geographic sales breaking down to North America 14%, Europe 12%, APAC 72%, and Other 2%.

Valuation & Financials

General Overview

Trailing both the broader market and industry, Semtech has faced a 63% price decline in the past year, versus a 27% price depreciation for semiconductor ETF, SMH, and a 16% decline for the wider market.

This exposes one of Semtech’s structural risks; its dependence on APAC, rather China specifically, on both the demand and supply sides. The geopolitical risk associated with the nation thus magnifies and attaches a greater risk premium to events such as supply chain difficulty or geopolitical perils.

Yet, even though these concerns, SMTC posted a profit margin of ~13% at their lowest point in Q3 2022, sustaining a debt-assets ratio of <50%, and over $70mn in free cash flow.

Comparable Companies

Due to the high levels of specialization the semiconductor industry, and Semtech, in particular, sustains- designing and delivering chips for niche IoT projects- Semtech has no direct competitors. I have thus gathered similar-sized companies, each of whom operates in one or more of Semtech’s distinct segments; Marvell Technology (MRVL) focuses on data infrastructure, similar to Semtech’s LoRa line of products while Monolithic Power Systems (MPWR) focuses on power regulation products and On Semiconductor (ON) designs intelligent sensing semiconductors.

Above, I have demonstrated Semtech’s undervaluation by effectively contrasting their multiples with that of competitors; the company consistently demonstrates a superior proposition.

While the company’s EPS was lacklustre in its most recent quarter due to its aforementioned dependency on an APAC region with slower growth, Semtech presents itself as the best option of the four companies in terms of trailing and forward P/E, P/S, and P/CF ratios. While there is a significant sector-wide compression occurring, the reasons behind Semtech’s even greater relative price reduction beyond APAC dependency likely boil to investor uncertainty surrounding the $1.2bn Sierra Wireless Acquisition and capital-intensive R&D with comes with this broadened set of products.

In spite of Semtech’s superior multiples, though, Semtech’s stock has performed fairly poorly in the past year.

As such, Semtech presents itself as the best value case in the mid-cap semiconductor market.

Valuation

According to my unlevered DCF model, Semtech is undervalued by ~18%, worth $38.59 at its base case. The model assumes a discount rate of 8%, over a forecast period of 5 years with an operating margin of ~27% and further calculates cash flow and NOPAT by adjusting for taxes and net CAPEX.

Walking through my model, it uses a discount rate of 8%, which is essentially Semtech’s WACC of ~10% adjusted for Semtech’s ability to generate significant cash flows in spite of macroeconomic volatility and concentrated risks to their core businesses in China.

I furthermore projected an operating margin of 27% to calculate cash flows, in line with the smoothed-out mean of the historic margins (EBITDA and net income) of the company and projected margins of the industry over the coming years.

On a larger scale, using a multiples-based relative value analysis through AlphaSpread (which applies P/S, P/E, P/B, etc.) Semtech is undervalued by nearly 53%, with an estimated fair value of $66.54. However, unlike my DCF, the relative value model does not assess intangible or future risks in the same way.

Thus, using a weighted mean between the two models, Semtech is fundamentally worth $47.91 or has approximately 35% upside.

Corporate Strategy

Acquisition Driven Growth

The company has zeroed in on accelerating its IoT-centric businesses, as it represents the avenue of greatest growth. Alongside their previous acquisitions of companies like EnVerv and AptoVision, Semtech’s $1.2bn acquisition of Sierra Wireless is expected to 10x their IoT SAM, double company revenue, and generate $40mn in synergies, largely by streamlining marketing and sales expenses. Additionally IoT revenues- which operate at a superior margin to other segments- are expected to grow from 21% of the business to 54% in the coming years.

With Sierra Wireless, not only does the company grow its ability to provide across different bandwidths and power consumptions, but also diminishes a risk core to the business- dependency on APAC; Chinese revenues will decline from 34% to 21% with this acquisition.

The companies value chain only then strengthens to produce subsequent organic growth- syndicated sales, greater pricing power in this already highly specialized field, the ability to leverage their pre-existing relationships, vertical integration in every arena outside manufacturing of their chips, and their superior financial position will only be bolstered by Sierra Wireless.

Continued Innovation & Revenue Diversity

While the company may not sustain significant geographic diversity in terms of sales- though they are improving via the Sierra Wireless acquisition, as noted in the previous section- Semtech, due to their highly specialized and niche role, services a versatile range of consumers and producers.

Nearly half the company’s revenue comes from a highly fragmented market.

with the other 50% split between 4 companies; Trend-tek, CEAC International, Frontek, and Arrow Electronics. End-markets also vary, with 36% represented by industrial uses, 36% by infrastructure, and 28% by high-end consumer products.

With these dynamics and Semtech’s exclusive dominion over many of its products, such as LoRa, the company has many opportunities for margin expansion. The aforementioned focus on higher profit IoT products, as well as their ability to expand direct sales- which currently account for approximately 20% of revenues- will only produce greater profits and increase supplier power for the company.

Wall Street Consensus

Analysts echo my positive sentiment on the company, who forecast an average one-year price increase to $41.71, up 32% from today.

The minimum price increase is still positive (1.23%)- a highly promising sign considering the implied volatility of the stock and the broader IoT market in a time of heightened economic uncertainty.

Risks

Dependency on APAC

As I’ve previously discussed, the company is highly dependent on APAC, specifically China, for both the production and the demand for its chip products, leading to heightened regulatory and geopolitical risk. The company has already encountered the consequences of this risk over the past few years, with compressed margins and greater debt as a result. As such, Semtech has moved towards diversification, both with their Sierra Wireless acquisition and by leveraging government supports such as the CHIPS Act in the US.

Unsustainable R&D

The additional competition from established and rapidly growing IoT, cloud, and wireless services providers will not only lead to additional competition in a niche dominated by Semtech but may thus lead to greater price competition, margin compression, and a greater need and requirement for R&D-centric competitiveness, which in itself may prove a drain on resources.

IP Security & Talent Retention

The number of qualified engineers and integrated circuit designers will lag the extreme growth that the IoT and semiconductors will continue to undergo. Recognizing the exclusivity of talent, and how it may pose a structural risk to the businesses’ long-term ability to innovate, Semtech has invested $147.9mn to boost talent retention via human resources. Additionally, Semtech has invested and has accelerated its geographic shift to promote the security of its IP.

Conclusion

From geography to consumers to products, Semtech is driven by distinct and secular growth trends, further buoyed by their expansion in IoT through their Sierra Wireless acquisition.

Thus, in the short-term, I believe that Semtech will revert to the mean and revalue to at least the level of peers, while in the long-term, Semtech’s ability to identify and address risks while investing in platforms for the future only bolsters my belief in the company.