Tower Semiconductor, As Chip Manufacturing Gets Rerated

Tower Semiconductor Limited (NASDAQ: TSEM), an independent foundry services provider, is ready for a rerating with favorable industry tailwinds and significantly improved fundamentals. Now that the market has woken up to the potential offered by third-party semiconductor manufacturing service providers, as evident from the performance of Taiwan Semiconductor (NYSE: TSM) and United Microelectronics (NYSE: UMC), Tower should be next.    

Source: Tower Semi

Even though its hard to quantify the full impact, most industry observers and companies in the space agree that trade restrictions on Chinese state-owned or backed entities have led to non-Chinese customers diversifying away from the Chinese foundries that led to improved demand for companies like Tower Semi, besides Taiwan Semi and United Microelectronics.

Sales growth201720182019Latest Qtr.
Tower Semi11.0%-6.0%-5.4%1.3%
Taiwan Semi3.1%5.5%3.7%31.3%
United Micro1.0%1.3%-2.0%22.0%

When the global economy was experiencing one of the worst downturns, some of the major foundries experienced solid demand. The industry dynamics are much different from what they were just a few years ago. Utilization is high with major running out of capacity that is leading to improved pricing and better profitability.

The bears on the names might be worried about the expected increase in capital expenditure given the capacity shortages, but the market is smart enough to understand that valuations and cash flows do look worse when the revenues are ramping up for these businesses.

Tower Semi is set to announce quarterly results this week. The risk/reward tradeoff seems such that all the company needs to do is to inspire confidence among investors that that momentum, in terms of revenue growth and utilization rates, is sustainable which might be enough for the stock to close the gap with Taiwan Semi and United Micro.

 Next Yr. PEP/ SalesSales growth next yr. (Est.)Enterprise Value ($B)EV/ next yr. sales
Tower Semi 17 2.07% $2 1.7
Taiwan Semi 25 10.912% $397 8.7
United Micro 13 2.35% $12 2.0

What’s working for the company and why the momentum may continue?

The fab business model, with mostly fixed expense structure, is such that gross margins have the highest bearing on the earnings potential of the company and capital expenditure is a key element in the cash flow potential of the business.

Gross margins

Gross Margin2016201720182019Latest Qtr.
Tower Semi24.3%25.5%22.5%18.6%18.6%
Taiwan Semi50.1%50.6%48.3%46.0%53.4%
United Micro20.5%18.1%15.1%14.4%21.2%

Unlike Taiwan Semi and United Micro, Tower Semi focuses mainly on the lagging edge, which lacks both gross margins and the sex appeal associated with the leading edge nodes, but given the current capacity shortages, the company is well-positioned to monetize the favorable industry trends.

Gross margins are highly correlated with utilization trends and topline growth, both of which are improving with the potential for further improvement on the way.

Till the previous quarter, the utilization rate for most of the company fabs was hovering around 60-75%. Utilization for 300 millimeter was 85%, even after the increased capacity. Yes, not very high utilization rates compared to other players, which is why I am bullish on the gross margins trends moving forward, like the other two majors.

Growth

Revenue is expected to increase 5% during the third quarter, a significant improvement from trends seen over the past few years and there is enough data to suggest that the positive trend will carry forward. Mobile business, with market share gains, should act as a major contributor to the organic growth of the business while power discrete and sensor products should benefit from the economy opening up as well as the launch of new products.

Source: Tower Semi

Mobile is beneficiary of 5G deployments and data center growth

The mobile business of Tower Semiconductor will be a major beneficiary of the adoption of 5G technologies and the growth of data centers. The company has a high market share of the high-end SiGe products, which should benefit from the growth of data centers and deployment of 5G infrastructure. At the same time, the RF business should see increased demand from the rollout of 5G handsets.

Indeed, the mobile market is expected to shrink 15-20% due to Covid-19 related slowdown while Tower Semi is expected to grow its mobile business by 10-15% during the current quarter. Mostly due to fast-growing end markets, increasing content in 5G products, and gaining market share.

Power and sensor business

Both power and sensor businesses are largely driven by the broader economic trends and suffered during the past few months but now that the vaccine is here, these businesses should also turn the corner.

Over the past few months, Tower Semi has already launched a few new products catered to the power IC customers, which should further help the company increase its market share.  

Right now, the sensor business is heavily dependent upon products like dental x-ray and industrial sensors, markets that were largely shut down due to Covid-19 and stand to benefit significantly from the economy opening up. 

Besides the economy opening up, the ramp of new products like fingerprint sensors, non-imaging sensors, and MEMS microphone products over the coming quarters should also help the sensor business.

Cash flows

Source:Tower semi

Most investors will notice Street’s uneasiness related to the capital expenditure trends at the major foundries during the current earnings season, mostly due to rising demand and utilization rates. Yes, a good problem to have but a drag on the free cash flows nonetheless.  

For Tower Semi, capital expenditure will be less of an issue given there is still some extra capacity available for the company to boost production, other than 300 millimeters by the end of next year or early 2022. Indeed, capital expenditure for the company continues to be less than the cash flows generated from operations.

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