NXP Semiconductors: Automotive, And Industrial And IoT Drive Future Growth

NXP Semiconductors (NASDAQ:NXPI) offer processing chips, analog, and RF products to automotive, industrial, mobile, and communication markets. I favor their automotive and industrial semiconductor exposure for long-term growth prospects. The stock appears undervalued at the current price, and I assign a 'Buy' rating to NXP.

NXP Growth in Automotive Chips

NXP produces ADAS, Electrification, eCockpit, and Powertrain chips for automotive OEMs. The automotive end-market accounts for more than half of NXP's total revenue and has been a significant growth driver over the past few years due to the increasing adoption of EVs and autonomous driving. The revenue contribution from automotive markets increased from 38.8% of total revenue in FY16 to 52.1% in FY22, driven by outsized growth.

As indicated by their management team, the average traditional ICE car has approximately $500 worth of semiconductor content, while EVs double that to $1,000 per car. Therefore, as the entire automotive industry shifts toward EVs, the automotive semiconductor industry is booming. I believe that the EV market is poised for structural growth over the next decade, and NXP’s automotive chip business will continue to drive the company's top-line and bottom-line growth. According to GlobalNewswire, the global EV semiconductor market is expected to experience an approximate 32.1% compound annual growth rate from 2021 to 2026. I believe this growth is driven by the increasing penetration of EVs as well as the growth in semiconductor content per car.

Industrial & IoT

The Industrial & IoT end-market accounts for approximately 20% of the total revenue. NXP’s products are used in factory automation, smart home appliances, home entertainment, and the power/energy industries. With the growing number of connected devices, there is an increasing demand for semiconductors in these types of equipment.

Over the past few years, NXP has actively expanded its processors and analog solutions attached to IoT, covering both connectivity and network security. I believe NXP's industrial and IoT products are well-positioned in the field of connectivity, and their leading processor and analog chips enable traditional industries to achieve factory automation and connectivity via Wi-Fi or Bluetooth.

Pricing Power

NXP has successfully passed along any inflationary input costs to its end customers, with the target of maintaining the same gross margin. Therefore, inflation has a positive impact on the dollar amount of their gross profits even if they keep the margin flat. Additionally, according to their management, 60% of their revenues are sourced externally from foundries like TSMC (TSM), and 40% are sourced internally. This split enables them to better control input cost inflation. Recently, TSMC, Bosch, Infineon (OTCQX:IFNNY), and NXP established a joint venture to produce chips for Europe. This activity proves that NXP continues to gain more direct control over the manufacturing process and enhance its capability to control input costs over time.

Key Issues

Mobile Business: Mobile business accounts for approximately 12% of the group's revenue, and the end-market has been highly volatile over the past few years, worsened by the pandemic. Currently, they are facing numerous challenges in the Android smartphone industry, similar to other players. The mobile business revenue declined by 26.8% in Q2 FY23 and 35.2% in Q1 FY23. It is difficult to determine when the Android smartphone market will start to turn around; however, NXP is taking actions to tightly control their distribution channel. Distributors contribute more than half of NXP’s group revenue, and NXP usually maintains a 2.5-month inventory level at the distribution level. Right now, they have reduced it to only a 1.6-month level.

Weak Growth in China: Mainland China and Hong Kong represent 35% of the group's revenue, and the smartphone business there is currently very weak. NXP’s management doesn’t expect a turnaround anytime soon. In their Q2 FY23 earnings call, it appears that their management lacks insights or visibility into the market environment there.

Financials and Outlook

I admire NXP’s growth playbook, which targets 8-12% revenue growth and a 25% free cash flow margin during the period from FY21 to FY24. I believe their growth profile is reasonable and achievable, primarily due to the growth in the automotive and industrial end-markets. NXP’s pricing power enables them to maintain a decent gross margin, and their operating margin could be further expanded through operating leverage.

In Q2 FY23, the revenue was down 0.4% year over year, and the operating margin dropped by 100 basis points compared to Q2 FY22. Their industrial and mobile segments declined by 18.9% and 26.8%, respectively. Their management team guided the industrial and IoT business to decline in the mid-teen percentage range in Q3 but expected it to rebound by a low-single-digit percentage sequentially. On the other hand, the Mobile business is expected to decline in the mid-teen percentage range in Q3 but to rebound by a mid-20% range sequentially.

On the balance sheet, they hold $11.17 billion in debt, and the net debt leverage is approximately 1.3 times. Therefore, I believe their balance sheet is manageable, although I wish their debt level could be lower than the current level.

During Q2, they repurchased $302 million of their own shares and paid $264 million in dividends. On a trailing 12-month basis, their free cash flow margin is around 20%, and they are still on the way to achieve their 25% target.

Valuation

For revenue growth, I forecast that NXP will decline by 1% in FY23 and then rebound to 10% in FY24. I don't anticipate their Industrial and Mobile businesses rebounding anytime soon this year, and they will face weak comparable in FY24. In my model, I assume that NXP will allocate 3% of their revenue for acquisitions to broaden their semiconductor product spectrum. As a result, acquisitions are expected to contribute 1% to their top-line growth in my model.

I model their free cash flow margin gradually reaching more than 25% over the next ten years, and these assumptions are largely in line with their long-term playbook.

After applying a 10% discount rate, a 4% terminal growth rate, and a 17% tax rate, the discounted free cash flow from the firm is estimated to be a total of $72 billion. Deducting the net debt balance, I estimate the fair value of their stock price to be $257 per share, which suggests that their current stock price is significantly undervalued.

End Notes

I expect the automotive and industrial end-markets will continue to witness structural growth in semiconductor demands. NXP’s product portfolio is well positioned to embrace the structural growth, and their stock price is undervalued. I assign a “Buy” rating to NXP.