Renesas Electronics Finally Getting A Fairer Shake, But Not Yet Overvalued

When I last wrote about Renesas Electronics (OTCPK:RNECF), I thought this Japanese leader in microcontrollers (or MCUs) was undervalued on the basis of its strong leverage to supply-constrained auto MCUs, as well as longer-term opportunities in power management, precision analog, sensors and connectivity across auto, industrial, compute, and IoT markets. I didn't think, though, that the company was going to come in quite so strong on Q4'22 earnings and guidance, and the resulting 40%-plus move in the shares exceeded my expectations.

I'm still below-Street on my FY'23 and FY'24 numbers, and probably more cautious on the space overall than many analysts, but I still like Renesas for the longer term. Low-to-mid single-digit adjusted revenue and free cash flow growth is enough to support at least 20% more upside, and those estimates could well prove conservative if management's growth projects bear fruit. It's tough to buy in after such a big jump, but I do still see better upside here than at many peers/rivals.

Better Results On Healthy Auto

Renesas offered a relatively rare beat-and-raise for the December quarter, with the company benefiting from strength in its auto business, including an uptick in the ADAS/cockpit business.

Revenue rose more than 24% year over year and about 1% quarter over quarter, beating by around 2%. Auto revenue rose 29% yoy and close to 8% qoq, beating by close to 4%. Industrial, Infrastructure, and IoT was up 22% yoy, but down 4% qoq, and missed modestly. Investors who follow the space closely may not be surprised that weakness in Industrial and IoT was more evident in the fourth quarter results.

Peer-to-peer comparisons can be a little fraught because of differences in business structure and reporting, but Renesas did well. Chip companies with direct exposure to EV powertrains (like Infineon (OTCQX:IFNNY) and STMicro (STM)) did better than Renesas, but Renesas outperformed Microchip (MCHP) and NXP Semiconductors (NXPI) on the strength of its auto MCU business. Core industrial results also looked good, and it sounds as though Renesas saw less pressure in its IoT business (likely due to less leverage to consumer markets).

Gross margin improved 170bp yoy and declined 100bp qoq, with Auto down 110bp qoq to 48.2% and III down 20bp to 62.5%. Operating income rose 38% yoy and fell 5% qoq, an 8% beat, with margin up 330bp yoy and down 210bp qoq to 34.7%. Auto margin declined 50bp qoq to 31%, while III declined 360bp qoq to 36.7%.

Healthy Guidance For March Is A Good Start

Management also guided to better-than-expected March quarter results, though I think the bar was low going in after many chip companies lowered guidance. Management is looking for a sequential revenue decline of 9% in the next quarter, and while that's actually worse than its peer groups (Microchip - up 2.5% Infineon - flat, STMicro - down 5%, Texas Instruments (TXN) - down 7%) excluding NXP, it was still meaningfully better than expected. Likewise with the 150bp sequential hit to gross margin.

Renesas's auto business should remain healthy in 2023. Several companies have warned of weaker volume growth in the auto sector in FY'23 relative to sell-side expectations, but low single-digit global volume growth will translate into larger revenue growth for companies like Renesas as new models have increased chip content. What's more, auto MCUs remain capacity-constrained, with the market basically sold out for 2023.

At this point it is unclear to me how much chip availability may be constraining potential auto volume growth in 2023. I think that's a relevant question, because companies like Infineon and Renesas (and several others) are repurposing consumer and industrial MCU capacity toward auto MCU production, so if MCUs are an important constraining factor on auto volume growth in FY'23, there could be further upside here.

I also like the apparent wins that Renesas has been securing in areas like ADAS and with integrated solutions that combine MCUs with analog, power, sensor, and other chip components. These wins span ADAS, xEV power (though not core inverter power), motor control, communications/networking, body, and infotainment, and they're an important contributor to the story. With these wins, Renesas seems to have stemmed some recent MCU share loss trends, and I think Renesas may yet be underrated on the quality of its 32-bit MCU platform.

3I - Weaker For Now, But With Good Growth Opportunities

I'm not as bullish on the Industrial, Infrastructure, and IoT (or 3I) business in 2023. There's already evidence of slowing demand in industrial automation, drives, and machinery, and I believe this could still get worse from here. Renesas is also more leveraged to run-of-the-mill data center content that is more vulnerable to weaker near-term data center capex trends, and there is also exposure to PCs, consumer devices, and appliances that is not likely to perform well in the near future. Last and not least, I think wireless infrastructure could be a risk given weaker 5G deployments outside of India.

Longer term, though, I like Renesas's exposure to automation - both factory and building - and I think there is undervalued or underappreciated exposure here to areas like robotics and the growth of renewables. Renesas is also overlooked (at least in my opinion) on its leverage to industrial IoT, with that market likely to accelerate in 2024 and beyond.

The Outlook

Management continues to be smart with managing inventory, letting utilization slide a bit and cutting wafer starts (down 5% qoq) to limit inventory build. I'd also note that management felt comfortable enough with the near-term outlook to launch a JPY 50B buyback.

There are still areas where I'd like to see improvement. I think there's more that Renesas could do on the 3I side, and I think management may want to consider investing in advanced power capabilities (GaN and/or SiC), even if that comes at a high upfront cost. I don't need or particularly want to see Renesas try to compete head-to-head with Infineon and STMicro in areas like IGBTs for EVs, but I think there are attractive markets in areas like industrial (automation and electrification), renewables, and data center where this would be worthwhile, particularly considering the ability to further integrate that with other offerings like MCUs, sensors, and specialty analog.

In general, I've been more conservative than the Street on FY'23/FY'24 semiconductor revenue expectations, only to see guidance come in even lower. Renesas is a different case, and I'm reluctant to raise my numbers as much as initial guidance could suggest - it's not that I don't believe Renesas management or believe in the Renesas story, but I still see risks to semiconductor lead-times and pricing in 2023.

With that, I'm still looking for a roughly 7% revenue decline in 2023 and I'm basically now in line with the low on the Street. For FY'24 I expect 3% growth and am a bit below the Street; I'm probably being too conservative here. In any case, my longer-term estimates haven't changed that much, with my FY'32 revenue number about 2% higher now, with a long-term revenue growth rate around 3% to 4%. On the margin side, I expect a meaningful decline from the 37% operating margin and 25.5% FCF margin of 2023, with a low-30%'s operating margin in FY'23. Longer term, I'm modeling low-20%'s FCF margins, and that fuels mid-single-digit FCF growth.

I may well be underestimating the growth potential here on both the revenue and FCF lines, but even with these estimates, the shares end up looking about 20% undervalued today on cash flow, and even more undervalued on the basis of margin-driven EV/revenue and EV/EBITDA.

The Bottom Line

As a Japanese chip company, Renesas is probably off the radar for may American investors, but I think this company definitely merits a closer look. While sentiment has seen a big reset, and I do still see risks to the outlook in FY'23, the business still looks undervalued enough to merit a positive stance on the shares.

To read my recent articles on other companies mentioned, please click here (Infineon), here (Microchip), here (NXP Semiconductors), and here (STMicro).

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