Above Average Opportunities Largely In The NXP Semiconductors Price

By Stephen D. Simpson, CFA | June 24, 2013 AAA

There are still bargains to be found here and there in the chip space, but many of these stocks have already rallied over the past year on expectations of improving fundamentals in the second half of this year. With the stock NXP Semidconductors (Nasdaq:NXPI) up about 50% over the past year, these shares appear to be among that group. The company's high performance mixed signal business is attractive, as is the company's leading share across multiple product categories and above-average potential margin leverage, but a lot those positives appear to be factored into today's share price.

SEE: 3 ETFs To Play The Semiconductor Rally

Cars Will Be Back, And ID Keeps Growing
With NXPI getting more than 30% of its revenue from the auto sector, the sector-wide slowdown is certainly a threat to the company, even as per-vehicle chip content increases. This is definitely a strong segment for the company, as it leads the market in car access, infotainment, and in-vehicle networking, and rivals like STMicroelectronics (NYSE:STM) are not going to kill their own margins to compete on price.

While the growth opportunity in auto largely revolves around increased vehicle content (as build rates will likely continue to grow through difficult-to-predict cycles), the ID market is more of a pure growth opportunity. NXPI has built itself into a dominant provider of silicon products for ePassorts, near-field communications (NFC), RFID, smart cards, and other products for applications like public transport cards. NXPI won't win/keep every slot (they lost the NFC socket in the Galaxy S4 phone to Broadcom (Nasdaq:BRCM), but they still have a major role in the sector and ongoing worries about security and tamper-resistant identification are likely to lead to more and more conversions from traditional documents (identification, passes, etc.) to chip-enhanced products.

A Solid Model For The Long-Term
One of the positives to the NXPI story is that this is not an easy company for a start-up to challenge, at least not on a company-wide basis. The company employs over 2,500 engineers in its high-performance mixed signal business, which puts it in the same tier of Texas Instruments (NYSE:TXN), Analog Devices (NYSE:ADI), and STMicrolectronics in terms of IP estates and technological capabilities.

Other positives include the nature of the high-performance market. These products often have long product cycles and don't necessarily require the most cutting-edge manufacturing capabilities. That allows for solid marketing leverage across the full cycle. In fact, margin leverage is a key talking point right now, as the company is about 7% to 8% below its long-term targets for gross margin and operating margin. Some of that can be blamed on product mix, but utilization and recent issues at a fab in Malaysia are playing a negative role as well. Assuming management can get this worked out promptly, there could be meaningful earnings growth here over the next couple of years.

Competition And Ownership Could Offer Some Downside
While I previously made the case that NXPI's IP and engineering capabilities make it a difficult company to compete with, I can still see potential long-term competitive challenges. Japan's Renesas is already a credible rival, and I believe it will only be a matter of time before China sees a couple of its own Texas Instruments/Analog Devices companies emerge.

It's also worth noting that NXPI's own history does work against it to some point. Spun out from Philips (NYSE:PHG) some time ago, a significant portion of the shares are still owned by Philips (or rather, its pension trustees) and private equity owners. This company also has an above-average debt load, though servicing that debt has not been a serious issue.

The Bottom Line
As a play on an auto sector recovery and/or the ongoing growth of semiconductor-enhanced ID products, NXP Semiconductors seems like a fine idea. Likewise, I do believe the company can significantly improve its margins and report much better earnings growth in the coming years.

The only problem is that a lot of that appears to already be baked into the price. Even if the company sees substantial free cash flow improvement (with margins approaching 20% and long-term growth topping 10%), the shares seem, at best, 10% undervalued today. While companies like NXP can certainly over-shoot when investors get bullish on a sector again, I think there are better bargains to be found in the chip sector.

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