Silicon Labs Executing On Its IoT Opportunity, With Infrastructure Likely To Get Better In 2020

Summary

• IoT continues to drive Silicon Labs' growth, and particularly its strong wireless portfolio, which saw better than 20% growth in the third quarter.
• Infrastructure is being held back by weakness in the timing business, but the isolation business is doing well and Silicon Labs has attractive long-term opportunities in 5G and auto timing.
• Silicon Labs shares still seem to be embedding a takeover premium in the valuation, as the shares have outpaced what the company's growth and margins could otherwise seem to support.

Maybe valuation does matter, at least a little. When I last wrote about Silicon Labs (SLAB) I wrote that I’d at least somewhat thrown in the towel on valuation where this stock was concerned – investors prize the company for its focus on IoT and likely for its M&A takeout as well – but the shares have since underperformed the broader semiconductor space by about 10%. Then again, it could just be a reallocation of some resources in the sector, with other chip companies stumbling (if not crawling) toward the end of their correction cycle and investors wanting to establish positions for the broader recovery.

Whatever the case may be, the shares are still richly-valued, even on a hybrid EV/sales approach that factors in a takeout premium (based upon what companies like Infineon (OTCQX:IFNNY), NXP Semiconductors (NXPI), and ON Semiconductor (ON) have paid for wireless assets). I do believe Silicon Labs is still well-placed for above-average growth, particularly when the timing business recovers and as opportunities in auto mature, but paying premium prices for growth is not really my favored investment strategy.

Differentiated IoT Exposure Continues To Help

One of the prominent positive features of Silicon Labs remains its above-average exposure to IoT, with that business now generating about 60% of overall revenue. Silicon Labs isn’t literally a pure-play on IoT, and there are smaller companies with an even greater revenue skew toward IoT, but among larger companies (say, those above $2.5 billion in market cap), this is as about as close as you get.

Silicon Labs is also at least somewhat differentiated with its end-market exposures within IoT. Home automation/networking has had a mixed (at best) track record so far, but Cypress (CY) (which Infineon is acquiring) and Silicon Labs are among those that have nevertheless made the market work for them, with home automation helping drive above-average growth in the third quarter. Smart metering also remains a critical market for Silicon Labs, with the company holding close to 90% share in the U.K. and getting around 10% of its segment revenue from this market.

A major driver of Silicon Labs’ IoT success remains its strong and differentiated wireless portfolio, with a particular strength in mesh networking (ZigBee, Bluetooth, Z-Wave). While mesh networking isn’t the right solution for all applications (cost and complexity can be issues), it has a lot of significant advantages in its favor. In any case, Silicon Labs remains one of the strongest independent wireless plays, with wireless IoT sales up more than 20% in the third quarter, offsetting double-digit weakness in its MCU portfolio.

Looking at some of the company’s comparables, that differentiation showed through in the third quarter. Where Silicon Labs reported 3% yoy growth in its IoT business, Texas Instruments (TXN) reported a 19% decline in Embedded Processing and NXP reported a 14% decline, while STMicro (STM) reported a 4% decline in its MCU-driven MDG segment. These are apples-to-oranges comparisons at best (particularly in the case of STMicro), but at least for the time being, Silicon Labs’ strong leverage to wireless relative to MCUs is benefiting the company.

Infrastructure – Isolation Doing Its Part, And Waiting On Timing

Infrastructure, which includes timing products used primarily in networking (as well as auto and other markets to some extent) and isolation products used in a range of electrical applications, saw a 14% revenue decline in the third quarter with weak results in the timing business.

As has been seen at other chip companies, networking and 5G-driven sales are hard to predict right now and are highly customer-dependent. Ongoing uncertainty regarding the long-term prospects of doing business with Huawei isn’t helping Silicon Labs, but spending should improve in 2020 and the company has a longer-term opportunity in autos as well.

Isolation is an interesting business right now. While there’s a significant long-term opportunity in more legacy applications like power supplies and electric motors (where Analog Devices (ADI), Broadcom (AVGO), and NXP are stronger), Silicon Labs seems to be benefiting from its lower exposure to those markets (which are seeing weaker macro conditions) and greater exposure to markets like electric vehicles and solar inverters. Trade policy remains a risk here, particularly given the significant role of Chinese companies in the solar inverter market, but so far it has not been a major issue.

The Outlook

M&A remains a key unknown in the Silicon Labs story. SLAB itself has been a pretty willing acquirer over the years, and recently tucked in Qulsar’s IEEE 1588 precision time protocol software and modules (including PTP masters, gateways, boundary and slave clocks). Focused on precise synchronization for 5G and smart auto applications, this acquisition fills some gaps in Silicon Labs’ portfolio and improves its long-term growth outlook (particularly timing in advanced autos). As far as Silicon Labs as a target goes, I believe the valuation would be an issue for companies like STMicro that could arguably use better IoT wireless assets, but need could trump price discipline as the number of worthwhile acquirable assets has shrunk meaningfully.

As far as the near-term outlook goes, management acknowledged a “cloudy” macro environment, but pointed to steady order rates in the business. I’d also note that inventory levels have continued to improve, with a 12-day qoq improvement this quarter leaving the company in an historically good place with respect to its inventory levels.

Silicon Labs is looking pretty good with respect to gross margins and I’m getting a little more bullish on the prospects for better-than-expected long-term gross margins (maybe in the low-to-mid-60%’s). I’m still looking for long-term annualized revenue growth in the high single digits and adjusted FCF margins in the 20%’s, but none of that supports the share price on a DCF basis. Silicon Labs is likewise pricey on traditional norms for its margins (both present-day and likely margins over the next 12-24 months), though I believe there’s an M&A and growth scarcity premium in play.

The Bottom Line

I can’t argue for Silicon Labs on a valuation basis, and I won’t try to, other than to say that I’ve seen deals for lesser assets go off at even higher premiums. I rarely buy stocks on the basis of their takeover potential, though, and I think the market is already wiling to pay a pretty hefty premium for the company’s growth and margins. Still, for investors who like to buy growth and are more insensitive to price/valuation, this could still be a name to watch.

Disclosure: I am/we are long AVGO. 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.