Description

Investment Thesis

SWKS is a play on data connectivity.  It is a business with a rare combination of competitive moat and secular tailwind - 5G and Internet-of-Things (IoT) - that can reasonably be expected to last multi-decades; if history is any guide, 6G should launch in some time around 2030 and will be a secular growth driver then, and so on.  

In addition, SWKS is in a net cash position, consistently generates 15-20% return on invested capital, and has a target of returning 60 - 75% of (company-defined) free cash flow through dividends and share repurchase.  A long position at $67.5 should provide at least 30% upside under conservative assumptions.

Why Does This Opportunity Exists?

The short life cycle of radio frequency (RF) products, especially smartphones, means trends in revenue and earnings are volatile.  This cyclicality creates an attractive entry point from time to time.

Recently there were a clutch of negative news.  First, SWKS provided weak guidance in CQ-3Q18, citing weakness in high-end phones.  Second, Apple, which is the biggest customer of SWKS, stopped reporting iPhone sales numbers.  Third, there are reports that suppliers of Apple are cutting outputs.

Combined together, the reasoning goes, consumers are buying less smartphones, or at least high-end phones which have more RF content.  Therefore, the weakening fundamentals and the broader retreat of tech stocks drove SWKS stock to its 52 week low and created this opportunity.  

Business Overview

SWKS designs, develops and manufactures semiconductors focused on RF which is vital for connectivity.  It is a premier supplier of highly-integrated RF solutions to smartphone makers and other electronics manufacturers.  Its portfolio is extensive and includes amplifiers, converters, diversity receive and front-end modules, power management, and antenna solutions.  

Demand Drivers

Wireless network and demand for connectivity is driving demand for RF solutions in a number of ways.

First, more devices (including phones and non-phones) have connectivity built-in as a basic feature, and each device requires RF components for connectivity.

Second, the increasing complexity of connectivity infrastructure (for example, from 3G to 4G, the latter uses a wider variety of spectrum and frequency bands) increases RF content per device.  As complexity intensifies, devices need to connect across various communication protocols, thus driving the number of RF content per device, and the need for higher-end, more expensive RF modules.  

Third, the demand for faster network speed is another driver.  Faster speed can be achieved in two ways: 1) buy more spectrum and network equipment, which is expensive; or 2) utilize existing spectrum efficiently.  Carrier aggregation, which combines (more like mix and match) multiple frequency bands into a larger data pipeline, utilizes the second approach. To achieve carrier aggregation, more bands per device are required, and additional filters per device are needed to eliminate the interferences that accompany multiple bands usage.

Furthermore, SWKS is expanding its solutions beyond smartphones and into additional end markets and customers including automotive, home and factory automation, infrastructure, medical, smart energy, and wireless networking.

Secular Growth Opportunity: 5G and IoT

5G is the next generation of wireless network that has been launched in several countries, including by Verizon in the US, albeit in a smaller scale.  With data speed that is 10 - 100x faster than 4G, and much higher connection density – 1 million device per square kilometer vs 2000 device per square kilometer with 4G - it is indeed a game changer, similar to how smartphones impacted the TMT vertical.

Internet of things, or IoT, is the interconnection of previously unconnected devices (beyond PC, laptops, tablets, smartphones) through the internet, to systems and applications that facilitate the exchange, and analytics of data.  5G will accelerate the growth of IoT by providing the data speed and connection density at levels that allow IoT to thrive. Devices that are already or expected to be connected include cars, factory equipments, wearable tech, home appliances and more.

Besides being a secular tailwind for RF content in the next 8 to 10 years, 5G and IoT also reinforce the competitive strength of SWKS.  As the architectural design of 5G-connected devices becomes more complex, the value of an efficient RF front-end increases, which in turn makes SWKS’ expertise even more valuable to device makers.

For reference, during 4G adoption (4G was launched in 2010), the revenue CAGR for SWKS was 16%, adjusted for acquisitions (but not adjusted for currency impact).  While it is impossible to quantify the revenue impact of 5G and IoT, it is reasonable to assume revenue CAGR to be higher going forward than 4G because: 1) the sheer volume of connected devices and use cases in 5G, especially for non-phone devices, is well beyond 4G, and will require a vast range of modules to accommodate different use cases and functions; 2) the RF semiconductor industry has consolidated considerably (Murata bought Peregrine, RFMD and TriQuint merged to form Qorvo) and thus relatively less competitive than before.

That said, I am only assuming 10% normalized earning growth for margin of safety.

Competitive Moat:

The increasing complexity in architecture design acts as a barrier to entry; new entrants have to come up with superior RF content with a constantly evolving performance target.  What’s more, product life cycle is notoriously short, which means design wins do not translate into steady revenue.  Even if new entrants can secure a design win, they would be uncompetitive due to inferior production yield.

Another competitive advantage is in the form of intangible assets: patents, experience and technical know-how; SWKS has years of experience in design, testing, quality control and manufacturing.  SWKS ability to integrate a wide range of functions and RF content into a single product has been difficult for others to replicate.

The value-add of an efficient RF front-end exceeds its cost to OEMs and to some extent insulate SWKS from pricing pressure; the end-products sell for hundreds of dollars (i.e. wearable tech and phones) to hundreds of thousands of dollars (cars, medical devices).  It would be irrational for OEMs to sacrifice performance and reliability for savings of a few dollars per device. This is not to say there is no pricing pressure, but the pressure is less intense than a typical commoditized business.

Why is weakening iPhone sales and Apple revenue concentration not a concern?

Because any resulting weakness from Apple is only transitory.  First, SWKS has existing business with Apple’s competitors. OEMs that take market share from Apple are an offset to revenue lost to Apple.  It is important to recognize causation - SWKS solid market share in high-end phones is a testament to its product capabilities. Those same capabilities is also attractive to other OEMs (e.g. Oppo, Huawei, Xiaomi) and allow SWKS to prepare for any market share changes in smartphones.

Lastly, In the long term, reliance on phones will decrease as non-phone revenue should grow at a faster pace due to IoT.

Risks

1. Revenue and earnings are more volatile due to short design cycles and high customer concentration.

2. Fundamentals would inevitably turn, but can get much worse before it does.

Valuation Math

I use a normalized earnings approach to analyze SWKS due to its cyclicality.  Given its strong balance sheet, competitive position, and the secular earnings growth opportunity (10% per year) from 5G and IoT, I believe a multiple of 20 - 25x of my normalized earnings ($4.38) is warranted.  At 20x normalized EPS or $88 per share, this implies a 30% upside to current stock price. For context, consensus FY 19 EPS is $7.36. $88 implies 12x P/2019 E, which is at the lower end of its P/E NTM range of 9.5x - 20.5x in the last 5 years.

Key Definition

• Invested Capital = Interest bearing debt + Adjusted Equity + Operating lease capitalized at 8 times minus Cash.

• Average Invested capital is the average of the latest 5 quarters.  For example, FY 2017 invested capital is the average of 4Q16, 1Q17, 2Q17, 3Q17 and 4Q17.

• Operating earnings = Gross Profit – SG&A expense – R&D expense – Restructuring charge – acquisition related expense – R&D and capex + Depreciation and Amortization + stock-based comp + operating lease

• R&D and capex = R&D expense + capex + purchase of intangibles + acquisition; the latter two are treated as another form of R&D expense

• Adjusted earnings = Operating earnings – operating lease – interest expense – cash tax

Adjustments made to Earnings

• Add back stock-based compensation to earnings, and include non-vested shares and options to shares outstanding.  This is better because GAAP stock-based compensation crystallizes the cost but fails to capture the true cost of dilution.

• Treat operating lease as financing costs by adding back operating lease expense to operating earnings and deduct the expense as interest expense.

• Adjust for cash tax by adding back GAAP tax expense and deduct cash tax paid.

Adjustments made to Equity for Invested Capital

• Write-off deferred tax assets against equity

• Adjust for Gross Property and Equipment by crediting accumulated depreciation to equity

Key Assumptions

1. Assume EBITDAR margins would mean-revert to FY 2011 - 18 average, despite EBITDAR margins has improved to low 50 percentage points post 2015, primarily as a result of industry consolidation.

2. Assume R&D and capex, as a percentage of revenue, would mean-revert to FY 2011 - 18 dollar weighted average.

Catalyst

Roll out of 5G should translate to meaningful demand in 2H19