If Stabilizing Yields and Peak Inflation ...Post Q1 Earnings, Semiconductors are Worth a Look
Updated: Jun 12, 2022
Since posting our last update on the semiconductor space (posted on February 6, 2020), clearly much has changed in the landscape as inflation recently peaked to +8.5% y/y, yields on the 10-year treasury spiked to just over 3.0% and geopolitical tensions ratcheted up with Russia invading Ukraine. All that said, markets took a pronounced turn lower in April and May with the tech sector leading the way in terms of negative performance. Post-Q1/2022 earnings, no better time to revisit the beaten down semiconductor space.
As markets retraced by -14.25% on the S&P, -23.70% on the Nasdaq and -22.85% YTD on the PHLX Semiconductor Index (SOX), yields on the 10-year Treasury seem to have stabilized at approximately 2.9% since May 1st, after peaking at 3.07% just earlier in May. Though WTI remains stubbornly high, quarterly earnings were better than expected, the availability of jobs permeates through the economy, the peak inflation narrative seems is taking place, action from the Fed is finally understood (and largely priced in) and lastly, re-opening trends in China add to market optimism.
Since our previous update on February 6, 2022 (coincidentally, a day before Nvidia and SoftBank officially announced the termination to Nvidia’s attempted blockbuster acquisition of Arm Limited), valuation compression can be seen to date with semiconductor peers dropping 24.3% on an EV/EBITDA metric (since February 6th), going from a peer average of 29.1x to 20.5x at present. Moreover, forward P/Es have also dropped by 21.7%, going from 21.9x to 16.7% at present, while the average P/B also fell by approximately 24.6%, going from an average of 10.4x to 7.1x at present. Most telling was that heavyweight Nvidia underperformed the peer group the most as it lost -30.2% in Mcap, compared to the average for the peer group at -14.1%, while its Forward P/E also dropping -36.4%, compared to the peer group average dropping the aforementioned, -21.7%.
Broadcom (AVGO): The big news was the May 26 announcement in which Broadcom bid to takeover VMware (VMW) in a $61.0B transaction. The bid for the enterprise software company focusing on multi-cloud services was for either $142.50 in cash or 0.2520 shares of Broadcom common stock for each VMware share, representing a 32% premium to the previous 30 day VWAP. Subject to regulatory approval, the deal is expected to close sometime in 2023. The deal is expected to be immediately accretive and add approximately $8.5B in pro-forma EBITDA within three years post close. Strategically, the deal diversifies and complements Broadcom’s infrastructure software and semiconductor business as it adds capabilities to capture expanding trends towards the cloud/hybrid multi-cloud. Earnings from both companies were obviously secondary in importance to the takeover news but in any case, it was a quite the contrast versus expectations. Broadcom announced fiscal Q2/2022 financial results with revenues of $8.10B, adjusted EBITDA of $5.11B and adjusted EPS of $9.07, all of which beat expectations of $7.91B, $4.88B and $8.72 respectively. Moreover, operating margins, gross margins and FCF also came in ahead of expectations. VMware on the other hand announced revenues of $3.09B along with adjusted EPS of $1.28, both missing expectations calling for $3.19B and $1.56 respectively. The weak quarterly numbers from VMware coupled with the lack of anti-trust issues, along with Michael Dell and Silver Lake’s support of the deal likely point to a higher likelihood that the deal will close.
Nvidia (NVDA): Nvidia stock was one of the hardest to fall since February 6, not only due to a slowdown in gaming and bitcoin prices, but also due to the aborted acquisition of Arm Holding, as announced on February 7, 2022. Given a 30%+ stock price decline since the deal termination was announced, we think the steep multiple compression was unjustified given that Nvidia remains the pre-eminent growth name with dominant and differentiated cloud AI/ML offerings, along with a leading position in High Performance Compute (HPC) and in Gaming. The company just recently started to leverage its industry leadership in Deep Learning/AI to expand its offerings beyond semiconductors and now into software as well. Inroads have been made into data centers and into the automotive segment as well, which should equate to superior economics when compared to a standalone semiconductor company. There was quite a bit of worry ahead of the quarterly earnings, the fear being that given the collapse in bitcoin prices, the impact would be directly felt in lower shipments in graphical processors. Note that some estimates have Nvidia’s crypto mining processors contributing as much as $850M/quarter to total graphics revenue. Luckily, the quarterly numbers were much better than fears as Q1/2022 revenues came in at $8.29B while adjusted EPS amounted to $1.36, both topping estimates calling for $8.12B and $1.30 respectively. Gross margins of 67.1% alto topped expectations of 66.8%. Of note, the much dreaded gaming number contributed $3.62B to revenues, exceeding consensus estimates looking for $3.46B. Enterprise and Data Center remains strong, due to Nvidia’s dominant market positioning, management noted significant growth in hyperscale and public cloud customers. Also of note was that $2.1B was committed to share repurchases in Q1 with the BOD recently increasing and extending the repurchase program to encompass $15.0B and extending it until December 2023.
Advanced Micro Devices (AMD): Much like Nvidia, AMD’s quarterly numbers were also above consensus with Q1/2022 revenues amounting to $5.89B and adjusted EPS totaling $1.13, both beating expectations calling for $4.98B and $0.91 respectively. The quarter highlighted AMD’s two key segments as revenues from Enterprise/Data Centers and Computing/Graphics both proved to be stronger than expected. Highlighting this strength, FY/2022 top line guidance was increased to the mid-30% range. The Xilinx acquisition appears to be making immediate contributions with three quarters of 20%+ growth (quarterly run rate of approximately $1.0B) while broadening AMD’s processing and networking portfolio/customer base. AMD’s product suite for enterprise, data centers and gaming is pretty much the only viable competition to Nvidia, while it keeps taking market share from Intel (INTC). With solid cashflow generation and the inclusion of a significant number of shares given the Xilinx acquisition dampening EPS, look to the June 9 analyst day for any word on share buybacks or capital returns.
Marvell Technology (MRVL): Continuing the theme of strong Data Center results, Marvell reported an in-line Q1/2022 with revenues amounting to $1.45B and adjusted EPS totaling $0.52, pretty much in tandem with expectations calling for $1.43B and $0.51 respectively. That said, on the earnings call on May 26, management reiterated expectations for revenue growth in 2H/2022 with an expected ramp in cloud ethernet switches and other cloud custom design solutions. Recall that Marvell is the leading provider for high performance analog, mixed signal and digital processing technologies. The company’s strong product portfolio encompasses PC connectivity, storage, power management, networking, 5G carrier infrastructure along with semiconductor offerings used in cloud, enterprise, consumer or automotive applications. Ultimately, strong demand was seen in all end markets excluding Consumer. Though supply constraints continue to pressure all segments, additional capacity is expected to come online throughout this year. With revenue growth expected to be just over 40% y/y in Q2 (on a nearly all organic basis) Marvell is expected to be one of the fastest growing semiconductor companies with notable scale.
The obvious outlier in the above correlation matrix is Intel (INTC). Intel has hit hard times and continues to lose market share as it has struggled over the last few years to make 5nm chipsets (similarly to AMD’s Ryzen 7000 chips or TSMC’s N5 node). Though much has been said about the company’s massive $36.0B investment into and R&D and manufacturing campus in the EU and $20.0B to build two new manufacturing facilities in the mid-west, the company remains a “show me” story following consecutive quarters of product rollout and financial disappointment.
Though the old adage states that "no one can time markets, so don't try", what one can do is recognize discounted valuations, appreciate changing investment landscapes and try to buy quality companies with dominant market positions.