Investors in semiconductor stocks have been waiting for almost two years for signs of sustained (or sustainable) improvements in the industry. Companies as varied as ON Semiconductor (Nasdaq:ONNN), Analog Devices (NYSE:ADI), and International Rectifier (NYSE:IRF) have been showing some signs of progress, though it seems like every quarter's guidance is fraught with uncertainty. While International Rectifier reported a quarter with strong sequential revenue growth and better margins, additional margin and cash flow generation improvement is necessary if this stock is going to continue its recovery.
Closing The Fiscal Year On A High Note
For International Rectifier's fiscal fourth quarter, revenue rose almost 3% from the year-ago level and about 23% from the prior quarter on a reported basis. There was a calendar anomaly playing into this, though, and adjusted performance was more on the order of down 4%/up 15% for the respective periods. Either way, though, that's still about 6% better than the Street was expecting – one of the better beats in the chip sector in recent history.
SEE: Industry Handbook: Semiconductors
Perhaps just as encouraging, the performance was consistent across the segments. Enterprise power, power management, and energy savings were all particularly strong (with double-digit sequential growth on an adjusted basis), but auto and high reliability also delivered solid single digit sequential growth.
International Rectifier also came through with better margins. Gross margin of 30.2% (non-GAAP) improved almost five points from the year-ago quarter (and six points sequentially) and came in a full point ahead of expectations. Operating expenses were more or less in line, but that still allowed for nearly $5 million non-GAAP operating profit for the quarter.
The Beat Blurs Guidance, But Other Indicators Are Positive
All told, I believe International Rectifier gave pretty good guidance for the next quarter. The projected sequential growth rate was lower than the Street's prior target (0.1%), but in absolute dollars management did raise the goal. Just as important to me, though, was the guidance of 33% to 34% gross margin – well above prior expectations around 30.5%.
I think it's also worth noting that some of the non-financial indicators were also positive. Like ON Semiconductor, International Rectifier management pointed to lower channel inventories and shorter lead times – both of which are typically indicators of improving demand. On the other hand, distributors are apparently being more cautious with their restocking orders and TSMC (NYSE:TSM) has been cautious on demand going into the year on mobile device inventory corrections.
SEE: A Look At Corporate Profit Margins
The Opportunities Are There, Now Management Needs To Execute
International Rectifier is a solid player in the power management chip space – the fifth-largest company and holding about 5% share (after Infineon (Nasdaq:IFNNY), Mitsubishi, Toshiba, and STMicroelectronics (NYSE:STM)) and the #1 company in power MOSFETs. What's more, not only is the overall opportunity is quite large ($40 billion a year, according to iSuppli), but there are segments of the market that should also offer meaningful growth.
Once such segment is insulated-gate bipolar transistors (IGBT), a type of power management chip that combines the features of MOSFETs and bipolar transistors. With high efficiency and fast switching, IGBTs are important in a host of applications like wind power and trains (where a single module can sell for more than $1,000) and very important in applications like electric/hybrid cars. Although companies like Infineon and Mitsubishi lead the market at present (Infineon believes it has 24% share of the discrete IGBT market), this could be a growth opportunity for International Rectifier in the coming years.
While the opportunity to grow revenue should be improved by a recovery in chip demand, management has to drive better margins to fully exploit it. IRF has never been particularly good at converting revenue into free cash flow, with a trailing 10-year average of just barely more than 1%. The extent to which management can drive better utilization, wafer sourcing, and operating efficiency will go a long way towards determining how much the company can reap from the next up cycle in the sector.
The Bottom Line
International Rectifier really doesn't work as a stock from a DCF perspective unless you believe that management can drive free cash flow margins closer to industry norms in the high single digits and low teens. On the other hand, relative to historical multiples to EBITDA, sales, and book value, the shares look as though they could still have a worthwhile amount of room to run. So on balance, while I the company's past margin and cash flow efficiency challenges may be a concern to some investors, I'm not sure I'd be in a big rush to sell a company that is already starting to enjoy some of the benefits of a turnaround in its core markets.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.