Let me start out by saying that I’m not nearly as upset with the results as I am with the press release presenting them. When there is a gain to be presented, management presents it, even if it is a stretch. If a gain can’t be found, there’s no mention of the decline. For example, this quarter’s revenue was $751.7 million, a 7% decline from last year’s third quarter and a 3% decline sequentially. The press release says, “Delivers Revenue of $751.7 Million” and “Revenue for the third fiscal quarter was $751.7 million, exceeding the Company’s guidance and First Call consensus estimates.” As I look back on old press releases, I see that this isn’t really a new tactic. But I don’t appreciate it, and the tactic jumped out at me this quarter because there were so many negative comparisons requiring omission or sugarcoating. So I start this analysis in a slightly foul mood because I realize that I’m not being told the whole story, only the good parts. I’ll have to figure out the bad parts on my own. And I’m also angry with myself for not realizing this sooner.
This is the first earnings conference call with Liam Griffin as Chief Executive Officer (CEO). I felt as if he comported himself well, if a little cautiously. I found it odd that only one of sixteen analysts congratulated him on the promotion. That one analyst was the twelfth of sixteen, so maybe the first eleven failures to congratulate were oversight, but I’m especially surprised that the last four didn’t follow suit (out of courtesy or obsequiousness).
Earnings Report Highlights
The earnings press release can be found here: http://investors.skyworksinc.com/releasedetail.cfm?ReleaseID… Seeking Alpha’s transcript of the conference call can be found here: http://seekingalpha.com/article/3990512-skyworks-solutions-s… (Thanks, Seeking Alpha.) Unless stated otherwise, all italicized quotations are from the Seeking Alpha transcript.
3Q16 Revenue: $751.7 million Revenue declined 7.2% from 3Q15, which isn’t too surprising given Skyworks’ continued reliance on Apple. The sequential 3% decline is a bit more disturbing, as 2Q results should typically be the seasonal low for the year. I can try to find positives by noting that this revenue result was expected, beating both guidance ($750 million) and Wall Street’s expectations ($750.2 million). Still, this is a difficult result. In a separate section, I’ll pick it apart by product segment.
I’m going to permanently add a table to this section showing several years of quarterly revenue results. I know I find such tables useful in other people’s posts, so I should do it too!
In millions. Note: These quarters are based on Skyworks’ fiscal year, which ends around Sept. 30. 1Q 2Q 3Q 4Q Comments 2012 393.7 364.7 389.0 421.1 2013 453.7 425.2 436.1 477.0 2014 505.2 481.0 587.1 718.2 3Q14 Panasonic JV 2015 805.5 762.1 810.0 880.8 2016 926.8 775.1 751.7 2Q+3Q16 Apple slowdown
3Q16 Gross Margin: 50.3% GAAP and 50.9% non-GAAP Although non-GAAP gross margin was up slightly on a sequential basis (and much improved over last year’s 49.0% result), management had guided 51% non-GAAP gross margin, so this is a slight miss.
3Q16 Operating Margin: 31.7% GAAP and 36.5% non-GAAP Operating Margin declined from 33.2% GAAP and 36.8% non-GAAP last quarter, but was close to the 32.0% GAAP and 36.5% non-GAAP registered in 3Q15. Management, anticipating the revenue decline, indicated they’d try to hold expenses roughly flat against 2Q16. I’ll devote a few paragraphs later to analyzing how they did with that (spoiler alert: um, not so good, in my opinion).
3Q16 Net Income: $185.0 million ($0.97 per diluted share; $1.24 non-GAAP) This is a big drop from last quarter’s $208.1 million ($1.08 per diluted share; $1.25 non-GAAP) and 3Q15’s $207.4 million ($1.06 per diluted share; $1.34 non-GAAP). Management had guided towards $1.21 in non-GAAP earnings per share, and Wall Street expected that same amount. I guess a small victory can be claimed there, but the first thing that strikes me is that revenue declined $23.4 million and net income declined by $23.1 million – almost 99% of the decline in revenue fell straight to the bottom line.
Earnings per Share (GAAP) 1Q 2Q 3Q 4Q Comments 2012 0.30 0.18 0.26 0.32 2013 0.34 0.32 0.34 0.44 2014 0.49 0.40 0.58 0.90 2015 1.01 0.85 1.06 1.18 2016 1.82 1.08 0.97 1Q16 incl PMCS fee ~$0.47 Earnings per Share (non-GAAP) 1Q 2Q 3Q 4Q Comments 2014 0.67 0.62 0.83 1.12 2015 1.26 1.15 1.34 1.52 2016 1.60 1.25 1.24
3Q16 Cash Flow From Operations (CFFO): $141 million; Capital Expenditures (CapEx): $57 million; Free Cash Flow (FCF): $84 million CapEx spending barely exceeded depreciation, indicating to me that the company is currently throttling spending to marshal cash. CFFO and FCF are subpar compared to the averages from recent years, but these are not horrible results.
4Q16 Guidance Management expects revenue to be $831 million and non-GAAP earnings to be $1.43 per share. Non-GAAP gross margin is expected to be 51%. Wall Street nailed the revenue estimate, guessing $831.15, and was very close on non-GAAP earnings, guessing $1.42. Although management talks about business picking up in the second half of the calendar year, you’ll no doubt have noted that this guidance predicts a year-over-year decline in both revenue and earnings. As a thought experiment, if I assume that 2015 was just an exceptional year and look at the compound annual growth rate (CAGR) over 4Q14, the guidance predicts a 7.5% revenue CAGR and a 13% non-GAAP earnings CAGR, which is better than a decline, but still pedestrian.
There was a limited amount of “further out” guidance in response to analysts’ questions. 1Q17 was predicted to be “up”, although management meant up from 4Q16, not up from 1Q16. CFO Palette went so far as to suggest to one analyst that he could use “historical growth opportunity of high single-digits” to model the quarter. It sounds as if Skyworks expects year-over-year growth to resume in 2Q17. I should hope so, since 2Q16 offers a low hurdle.
Cash, Cash Equivalents, and Investments: $974 million The company is currently debt free. The decline in cash from last quarter is largely due to share repurchases. Still, close to $1 billion is a healthy cash cushion. Recall that some cash will likely be spent in August buying the remainder of the Panasonic joint venture that Skyworks doesn’t already own. In their recent 10-K, they said unequivocally that they would do that (but there was no mention of it during the conference call). It is possible that I overstated how much they’d have to pay in my previous analysis (> $120 million). My best guess is that the investments they’ve been making in filter capacity have gone towards the joint venture. It is possible that the investments have increased Skyworks’ ownership stake, unless they were offset by investments made by Panasonic. But I have not seen confirmation of that – we’ll have to wait until next quarter’s 10-K is issued.
SWKS earnings day share price: $64.81 -8.62% (vs. S&P 500 +0.46%) A decline of this magnitude seems unusual when revenue, earnings, and guidance were all fairly well aligned with Wall Street expectations.
1000 Days of Ratios Analysis
The analysis is based on the July 22, 2016 closing price of $64.81.
Current Price to Earnings Ratio: 14.12x (best 5% – range is 12.38x to 35.23x)
Current Price to Sales Ratio: 3.77x (best 47% – range is 2.34x to 7.59x)
Current Price to Free Cash Flow Ratio: 27.31x (worst 18% – range is 12.69x to 34.84x)
25% P/E cut-off ratio is 18.54x. TTM earnings per share are $4.59. P/E-based target is $85.07.
25% P/Sales cut-off ratio is 2.80x. TTM sales per share are $17.21. P/Sales-based target is $48.20.
25% P/FCF cut-off ratio is 17.11x. TTM FCF per share is $2.37. P/FCF-based target is $40.61.
Suggested Attractive Price: $57.96
I remain of the opinion that this analysis is currently flawed due to the transformative nature of the Panasonic joint venture. This point is driven home to me by the widely disparate targets that each of the ratios suggest.
Product Mix Across Market Verticals
I’ve decided to present some tabular information here on an ongoing basis because I think it’s important to watch the growth of each vertical, especially Broad Markets. We want to see Skyworks’ dependence on the smartphone market in general – and Apple in particular – diminish over time. Including these tables should also reduce my word count, something you all probably will appreciate! I’ve gone as far back as the data I have access to was easily available. If you have data going further back, please feel free to post it and I’ll incorporate it into my analysis going forward.
Power Amplifiers ¶ – This set of products has the lowest gross margins (40-45%) and slowest long-term growth (~5%). I’m happy to see these numbers shrink, or at least grow more slowly than the company as a whole.
1Q 2Q 3Q 4Q Comments 2014 $258.6 (36%) 2015 $249.7 (31%) $236.3 (31%) $194.4 (24%) $176.2 (20%) 2016 $148.3 (16%) $131.8 (17%) $120.3 (16%) Year-over-Year Growth 1Q 2Q 3Q 4Q 2015 -32% 2016 -41% -44% -38%
Integrated Mobile Systems (IMS) – These “smart phone”-enabling products have better gross margins (~50%) and better long-term growth prospects (15-20%).
1Q 2Q 3Q 4Q Comments 2014 $280.1 (39%) 2015 $386.6 (48%) $358.2 (47%) $429.3 (53%) $519.7 (59%) 2016 $593.2 (64%) $449.6 (58%) $413.4 (55%) Year-over-Year Growth 1Q 2Q 3Q 4Q 2015 86% 2016 53% 26% -4%
Broad Markets – A catch-all category for the set of products that support set-top boxes and media gateways, fitness bands, smart-watches and other wearable technologies, automotive technologies, connected home technologies, and products that support the Internet of Things (IoT), with gross margins exceeding 50% and long-term growth rate exceeding 20%.
1Q 2Q 3Q 4Q Comments 2014 $179.6 (25%) 2015 $169.2 (21%) $167.7 (22%) $186.3 (23%) $193.8 (22%) 2016 $185.4 (20%) $193.8 (25%) $218.0 (29%) Year-over-Year Growth 1Q 2Q 3Q 4Q 2015 8% 2016 10% 16% 17%
It is nice to see an increasing growth rate for Broad Markets, and one that is starting to approach the expected long-term growth rate. The only concerning aspect of this is that, sequentially, PA fell 9%, IMS fell 8%, Broad Markets increased 12%, and gross margin only improved from 50.8% last quarter to 50.9% this quarter. With Broad Markets making a larger contribution, I’d have expected a better bump in gross margin. Actually, one of the analysts on the call had a very similar observation, but I feel as if CFO Palette’s answer dodged the issue. The CFO did express confidence though that Skyworks would achieve the intermediate-term target of 53% gross margin and said there weren’t any specific issues other than general revenue decline. I’ll elaborate on this point later.
Another observation is that we can’t place the revenue decline squarely on Apple’s doorstep, although Apple was likely the main factor. We also have to consider that Skyworks’ protracted exit from the legacy power amplifier business presents a strong headwind for both revenue and earnings growth. I’ll expand on this point, too.
Returning Money to Shareholders
It has long been Skyworks Solutions’ stated policy that they expect to return 40% of free cash flow (FCF) to shareholders via dividends and share repurchases. When asked about it this quarter, CFO Palette seemed to back away from 40% as a “policy”, saying, “We have been running a little higher than that. I think you use 50%, that’s kind of a good – that’s just as we are trying to model, I think that’s fair.”.
3Q16 FCF was $84 million. Skyworks probably paid $49 million in dividends last quarter, and they spent another $191 million or so buying roughly three million shares during the quarter. Obviously, “… running a little higher …” is a bit of an understatement. Still, CFO Palette’s answer seems a bit vague if 40% is still the stated policy.
On the same day earnings were announced, Skyworks also announced an increase in the dividend from $0.26 to $0.28 and a new $400 million share repurchase authorization. The new share repurchase authorization replaces the old one, which had about $73 million remaining.
Other Random Musings
The Big Apple, Amplified
No, not New York City. The other Apple. Skyworks’ management stated repeatedly (OK, twice) that their revenue would have been up 10-12% if you exclude the effects of their largest customer. By my calculations, using the simplifying assumption that Apple’s contribution to Skyworks’ revenue this quarter was zero (unlikely), Apple’s lost revenue contribution to 3Q16 was $133.8 million. The drop in Power Amplifier revenue from 3Q15 to 3Q16 was $74.1 million. So, yes, Apple’s contribution to revenue is important. But, as I mentioned earlier, the ongoing headwind from the declining Power Amplifier business is important too.
Several analysts on the call noted that Skyworks’ inventory line on the balance sheet had swelled. Obviously, this can be problematic if the inventory is obsolete products, so it was questioned, and rightly so. However, I was satisfied by the first answer, and I thought the emphasis placed by various analysts in subsequent lines of questioning was unwarranted. CEO Griffin indicated that this was work-in-progress inventory, largely “… filters that are designed into known programs with known ramps in the second half.” CFO Palette added, “there is essentially no risk with … this inventory.” I’m completely comfortable with that.
Oh! THAT Operating Expense
Part of last quarter’s guidance was that they’d try to keep operating expenses at Q2 levels during Q3. As I alluded to earlier, the lower operating margins indicate to me they didn’t do a great job. Still CEO Griffin cited “operating cost discipline” as a ”key element” of the quarter’s performance. Operating expenses were up $7 million, or 5.3%. R&D expenses are the largest component of operating expenses, which is as it should be at a technology company. This was the only operating expense category to decline (by $1.9 million) and, of course, it is the last one I’d want to see declining. Selling, General & Administrative was up $2.9 million, or almost 7%. Amortization of Intangibles – an expense over which management probably has little control – was up $1.4 million, or about 16%. The final category is Restructuring and other charges. This jumped from $0.3 million to $4.9 million. The earnings press release’s footnotes indicate that this is due to employee severance costs.
I think the disconnect between management declaring victory and my declaring failure is that management treats both amortization and restructuring costs as non-GAAP expenses. So non-GAAP operating expenses were only up by $1 million instead of the $7 million recorded under GAAP rules. One can probably make a case for excluding consideration of amortization of intangibles, but severance costs are cash that has left the building, and those costs are completely under management’s control. I think another aspect that bothers me here is that management never mentioned lay-offs during the conference call. In fact, they talked about hiring! CFO Palette said, “You can see during these last three quarters that with the backdrop we have been dealing with, we have done a good job of managing that number fairly flat during that timeframe. But going forward, we will be making investments and that will be primarily [engineering] headcount.” Again, I feel as if we’re only being told the pleasant parts of the story.
All that said, $7 million here or there is not hugely material to Skyworks’ results, and focusing so intently on one quarter’s operating expenses is clearly short-term thinking. I just got a little bent out of shape because management is giving themselves credit for achieving a goal that I think they didn’t meet cleanly. Enough on that point!
More Thoughts on Getting to 53% Gross Margin
Skyworks operates under what it calls a “hybrid model”. Some semiconductor companies do little more than design their chips, contracting with others to fabricate them. Others, like Intel, have made huge investments in manufacturing capability. Skyworks sits in the middle. It has a manufacturing facility in Mexicali, Mexico that seems to be fairly flexible in what it can produce. Also, by establishing the joint venture with Panasonic, Skyworks has become a significant manufacturer of filters. Through continued investment in the joint venture, Skyworks has become the number one manufacturer of temperature-controlled surface acoustic wave (TC-SAW) filters, tripling their previous capacity. But Skyworks also contracts out a fair amount of manufacturing. Management noted, in response to questions, that the Mexicali facility is not running at capacity. As the investments in filter capacity are relatively new, it is likely that they’re not running at full capacity yet either. CFO Palette envisions that gross margin gains can arise from running the manufacturing facilities closer to capacity. Further, he recognizes that Skyworks currently in-sources a significant number of filters. Some of these are surface acoustic wave (SAW) filters, which its facilities are easily capable of producing. Certain higher bandwidths require bulk acoustic wave (BAW) filters – a technology that Skyworks has yet to master, but one on which it has said it is working. BAW filters are more complicated and expensive to produce (and hence costlier, and probably higher-margined) than SAW or TC-SAW filters. Were Skyworks able to produce all the filters it needs – regardless of type – gross margin would likely improve. Skyworks had previously indicated that it would be able to produce BAW filters by 2017. Current management seems to have backed away from that a bit, stating, “… we are still looking into that as what is the right path to continue on that pace. And we absolutely plan to play in high-band. We are playing in it now. I talked about the Huawei platform and there are a few others. So, that’s something we will give you a little bit more color on perhaps in the next call, but it’s an area that we absolutely understand what’s needed to win. We are winning today with our current strategy and we will look at enhancing our strategy as we go forward.” Regardless of which types of filter Skyworks chooses to produce and in-source, the hybrid model has the nice attraction of limited overhead, but some unit cost advantage. When you own all your manufacturing capacity, you have to maintain that capacity, regardless of whether or not customers are buying your product. But your costs are generally lower when your capacity is adequately utilized. When you contract out all your manufacturing, your overhead is minimal, but your unit costs rise because they include the contractor’s profit margin. Hybrid is a very nice middle ground, as long as it is sized appropriately. So far, Skyworks has more demand than capacity, so its plants aren’t underutilized badly. But it sounds as if they could be running closer to capacity, and that should improve margins. Likewise, the ongoing shift in product mix towards IMS and broad markets and away from power amplifiers should provide a gross margin tailwind.
A Leading Online Retailer – Revisited
Last quarter, Saul (SaulR80683) caught an item in then-CEO Aldrich’s prepared remarks: “… we landed new opportunities which include … a new connected home hub for a leading online retailer …” and suggested that this might refer to Amazon’s Echo (see the Seeking Alpha 2Q16 earnings conference call transcript). This quarter, I think we’ve gotten near-certain confirmation that Saul’s observation was on-target, as Amazon has been confirmed as a customer, and the earnings press release’s business highlights section notes “Enabled connectivity within always-listening virtual assistant platforms”.
Although I started this analysis in a foul mood, my mood improved as I dug deeper. I still think that management’s tendency to accentuate the positive and bury the negative means that we, as investors, need to be more vigilant than usual. Apple’s ebbs and flows will add to the stock’s volatility (and perhaps our own personal volatility), but you already knew that from firsthand experience! The declining sales from the legacy power amplifier business is a cloud with a silver lining. The decline of that business is not new, and some of Skyworks’ best growth has occurred despite that headwind. Once the business is abandoned, or shrinks to the point that its results are no longer material, what growth rates are possible without that headwind?
Although I think I have to readjust it, I don’t think my investment thesis here is broken. I personally bought my shares in Nov. 2014 and Oct. 2015. If you have a mental image of the SWKS stock chart, you realize that those two holding have had fairly divergent results. The first holding made me feel like a genius for recognizing the company’s potential. The second made me feel like a lower-case-f fool for not accurately assessing the Panasonic deal’s impact on growth rates and confusing acquisition-fueled growth for sustainable growth, and for not appreciating the product-cycle lumpiness inherent in the kind of customer concentration Skyworks has. Regarding Panasonic, perhaps a more forthcoming management team would have presented organic growth rates separately. As usual, when presented with extremes, the truth lies somewhere in between (and thankfully my second purchase was well off all-time highs). Smartphones are still a growth market. Most of the world’s population currently doesn’t have one, but lower-cost models well-priced for emerging markets are gaining traction. From my analysis of other companies, I know that India is upgrading its wireless infrastructure. For higher-end phones, China is pushing its roll out of 3G and 4G technologies, while 5G in the U.S. is merely a handful of years away (the roll out is expected to start in 2020). Skyworks is quick to note that it gets more content into every phone with each successive generation due to increasing complexity (and backwards-compatibility requirements). I still believe that the trend towards connectivity of things is in its infancy, and today’s applications will likely look primitive a decade hence. Skyworks is already supporting today’s Internet of Things applications profitably, and I see no reason that they shouldn’t be able to grow that business. I have interest in other companies in this general space too, but I think Skyworks is as solid as any.
Thanks and best wishes,
TMFDatabaseBob (long: INTC, SWKS)
See my holdings here: http://my.fool.com/profile/TMFDatabasebob/info.aspx
Peace on Earth