With markets in a freefall, many investors are beginning to fear the United States entering a recession like never before. Indeed, the probability of a severe decline in quarterly GDP growth in the next couple of quarters is very real. However, if the U.S. follows the lead from China to contain the COVID-19 virus, the economy would be up and running in the latter half of this year. Therefore, it’s reasonable to assume that a recession, even if it occurs, would most likely be limited to its very definition: a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters. The downturn might go as soon as it arrived and empirical evidence suggests that pandemics are short-lived. This, however, is not an attempt to underestimate the economic impact of the novel coronavirus. For sure, some businesses will find it difficult to make ends meet and others would cut their capital budgets, dividends, and buybacks to stay afloat. Skyworks Solutions, Inc. (SWKS), in my opinion, falls into the category of stocks that have been punished because of the short-termism of market participants. No investment comes without constraints and risks, which is true of the opportunity that I see in Skyworks as well. These will be discussed along with my investment thesis.
The positive outlook for the industry is at the core of my thesis. As one of the leading manufacturers of semiconductors for use in radio frequency and mobile communication systems, the company is projected to benefit from the expected rollout of the 5G technology on a global scale. The business model of the company is hinged on the belief that technological advancements and the growth of concepts such as the Internet of Things (IoT) will create robust demand for chipmakers. The growth of the gig economy is another tailwind for the company as more professionals opting to work from home means network companies having to improve their services offering to match that of the demand from consumers for high-speed internet facilities. To do this, advanced chips would be required.
Research firm Gartner projects a year-over-year increase of 21% in the total number of IoT endpoints in 2020, which would bring the total number of connected devices to approximately 5.8 billion.
In this research report released in August 2019, Gartner analysts wrote:
“Electricity smart metering, both residential and commercial will boost the adoption of IoT among utilities. Physical security, where building intruder detection and indoor surveillance use cases will drive volume, will be the second-largest user of IoT endpoints in 2020.”
This is good news for chipmakers with a focus on mobile devices, such as Skyworks.
Based on all these developments, Skyworks expects stellar growth in the addressable market opportunity.
Source: Company presentation
Skyworks, evidently, is in a strong position to benefit from these industrywide tailwinds. The company has entered into strategic partnerships with some of the leading companies that operate in all these business segments. This is one thing that will work in the company’s favor in the next couple of years.
Skyworks is a supplier for many leading companies in the world
Source: Company presentation
The debt-free balance sheet of the company is also a positive as it would enable Skyworks to weather the current economic downturn. Regardless of whether the expected benefits from the rollout of the 5G technology will begin to materialize this year or not, the company is definitely ready for when the time comes.
The Apple problem
Most of the bear theses revolve around the company’s dependence on Apple. In its 2019 10-K filing, the following numbers were reported.
|Financial year||Apple’s contribution to Skyworks’ revenue|
Source: Form 10-K
This brings to light one of the primary risks of investing in Skyworks. Despite promising to diversify the business operations throughout the last couple of years, the management has not been able to find a solution to the dependency on Apple. In fact, the concentration of this single customer has increased steadily in this period. This, certainly, is not a positive development. As fellow contributor MarketGyrations correctly pointed out in a recent article, companies that relied heavily on Apple, including Dialog Semiconductor and Imagination Technologies, ended up in dire circumstances because of Apple’s bargaining power. As a billion-dollar company that has a dominant market share in the global smartphone industry, Apple is in a strong position to bargain for better prices from suppliers. In case such requests are not met, Apple could consider changing the suppliers they are working with. An analysis of Skyworks without factoring this risk would be grossly incomplete. In the valuation segment of this analysis, I will factor in a few different possible outcomes to determine the intrinsic value of Skyworks shares.
If Apple ceases to do business with Skyworks, we are looking at a massive hit of around 50% to company revenue. However, the most important question is, what is the probability of this happening? In my base case scenario, I have used a 20% probability of Skyworks losing the entire business with Apple. In the worst-case scenario, a 50% probability is used, and in the bullish scenario, I project no material change in the business relationship with Apple and its related parties.
The below table consists of the revenue growth assumptions used in the bullish scenario.
|Revenue (USD millions)||3370||3827||4282||4603||4764|
Source: Author’s estimates
Using an average EBITDA margin of 44.5%, a cost of equity of 9.5%, and a terminal growth rate of 2.5%, my intrinsic value estimate comes to $107, which represents an upside of 45% from the market price of $73.67 on Friday.
In comparison, the base case estimate comes to $93, which is still 26% higher than the current market price. However, in the worst-case scenario, the target price comes to just $54, which is 27% below the market price.
The risk-reward profile, in my opinion, is very attractive. The healthy balance sheet coupled with the positive outlook for the industry will help Skyworks report stellar numbers in the next couple of years unless otherwise the worst-case scenario materializes, which has a low probability as of writing this article.
I have been looking at Skyworks for quite some time. Shares had a nice run since September last year, which prompted me to stay away and wait for a better opportunity. The recent market decline is shaping up to be the exact type of opportunity that I was looking for.
Shares could remain volatile, especially until the COVID-19 fears are behind us, which could be less than 30 days or maybe even a couple of months from now. What I’m sure of is that this pandemic will be brought under control by the hardworking authorities around the globe, paving the way for Skyworks, among other companies, to prosper.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SWKS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.