“No place for beginners or sensitive hearts / When sentiment is left to chance” Sade, Smooth Operator

As the high-performance logic segment of the semiconductor space continues to face challenges regarding end-user demand, inventory levels, and the timing of end-market re-acceleration, NXP Semiconductors (NASDAQ:NXPI) continues to burnish its reputation as a smooth operator with a good grasp of how to manage the cycles. NXP moved faster than most of its peers to correct inventory levels in 2023 and with healthy pricing and content wins, could outperform in the second half of 2024 despite a challenging macro outlook.

NXPI shares are up about 40% since my last update, outperforming a host of peers including Texas Instruments (TXN) (up 10%), Microchip (MCHP) (up 7%), Infineon (OTCQX:IFNNY) (down 3%), onsemi (ON) (down 17%), and STMicro (STM) (down 20%). While NXPI has lagged the SOX over that period, I attribute that to NXPI’s perceived lack of AI exposure (and indeed, it doesn’t really have meaningful direct data center exposure).

I’m torn on the recommendation now. I only see about 10% upside now, and while I do think there’s a credible case for ongoing outperformance in the second half, and I like the company’s longer-term leverage to EV adoption and intelligent devices, I’m concerned about what ongoing weakness in EV demand could do to sales growth expectations over the next few years.

Engineering A Soft Landing

I think NXP management deserves a lot of credit for seeing early warning signs in 2023 across many markets and adjusting inventories accordingly. The company moved faster than most to de-risk its mobile, IoT, and industrial businesses, and has been tightly managing distributor inventories (onsemi has done relatively well there too).

Typically NXP and its distributors want around 2.5 months of inventory on hand. NXP has been below that for some time now, with the last few quarters in the 1.6 month range (Q1’24 ticked up to 1.7 months). That has helped cap the peak-to-trough revenue decline to under 10% where many comparables have seen 30% or greater declines and far larger hits to margins and profitability.

NXP’s landing has also been softened by factors that I think have longer legs. Pricing has held up better here, and I think that’s due in part to a mix shift toward higher-value chips; NXP has a sizable presence in 32-bit microcontrollers (or MCUs), for instance, but not much exposure to 8-bit. Likewise, the company has been seeing good content growth in areas like comprehensive battery management, radar and ADAS.

Autos – EV Adoption Matters A Lot, But It’s Not The Only Factor

The biggest risk I see to NXP over the next couple of years is the weaker than expected pace of EV adoption, particularly among consumers in Western markets. Across battery management, motor control, and other EV systems, NXP has won a lot of high-value content with its MCUs, MPUs, sensors, controllers, and so on. If EV adoption stalls out, that’s going to rob NXP of at least some of its projected growth.

There is a “but” that mitigates this to some extent – weak battery electric vehicle (or BEV) adoption could lead OEMs to reconsider their plans with hybrids and bring more plug-in hybrids into the mix. That could actually be a net positive for NXP, as the company has products that address opportunities like hybrid control units and 48V systems, and it is at least plausible to me that a shift toward hybrids could be positive or net-neutral. Of course, the bigger risk is that PHEVs fare no better than BEVs and the mix is just higher toward conventional internal combustion powertrains for a longer period.

Another significant “but” is that NXP is far more than an electrification play. The company is a top player for radar transceivers and ADAS components, and newer models have significantly higher content here irrespective of their powertrains. Likewise with UWB connectivity (smart access products for autos).

There’s a shift underway with auto design that is seeing a significant shift toward “software-defined” vehicles where there is zonal computing that is basically run by high-performance MCUs. NXP was an early mover here, working with auto OEMs as early as 2013-2014 I believe, to start developing MCU families like the S32 and G3, the latter of which can handle even more centralized compute functions.

This shift will mean fewer MCUs overall in future models, but more value for the MCUs that are used and I think the pyramid will narrow in terms of who can supply the market – auto OEMs and suppliers currently source MCUs from multiple vendors (sometimes six or more), but not all companies are making the same investments into MCU development and companies like Microchip and Texas Instruments could find themselves on the outside.

I do want to note, though, that the most recent MCU market share update from Gartner showed a significant shift in auto MCU share in 2023. Infineon gained a whopping 1,000bp of share, becoming the #1 player at nearly 29%, while Renesas (OTCPK:RNECY) and NXP fell by 610bp and 310bp, respectively. I think the Renesas shift had at least something to do with forex and inventory management, and I’m sure inventory management impacted NXP, but this is something to monitor, as it seems that Infineon has really boosted its MCU business with its new AURIX line (including design wins totaling around EUR 19B).

The Outlook

I do have my concerns about the health of NXP’s major end-markets for the remainder of 2024. Auto demand has clearly slowed, with the S&P recently revising its outlook for auto production to negative 1% and EV penetration coming in short of expectations. NXP can offset that with content/platform wins and well-managed inventory, but it’s an area to watch.

Communications and industrial demand is likewise looking pretty rough in the meantime, but NXP has controlled its inventory well, and I see near-term opportunities like RFID and medium-to-longer-term opportunities like increasing its participation in 32-bit MCUs for industrial markets and benefiting from edge AI. Given the company’s strong presence in MCUs and connectivity, I think NXP has underrated/overlooked potential to benefit from AI-enabled edge devices, but this market will take years to develop.

NXP did better than I expected in 2023, but it looks like that mostly just changed the timing on the adjustment I saw, as my 2024 numbers are a fair bit lower now. I’m looking for a slight decline this year (about 1%), making two straight years of basically no growth, but I expect improvement in FY’25 and FY’26. I do see some risk that that 2025 recovery could get pushed in to 2026/2027 depending upon what happens with auto/EV demand, but channel inventories should be supportive as auto OEMs don’t want a repeat of when they couldn’t get chips at any price. Long term, I’m looking for around 6% annualized growth from NXP.

On the margin side, gross margins have been remarkably stable, and I expect GMs to stay in the mid-58%’s for a few more years. I expect flattish operating margin in FY’24 (around 35%), improving to 36% over two years. Free cash flow margin should move into the low-20%’s over the next couple of years and then improve toward the mid-20%’s, driving 10% FCF growth.

As far as valuation goes, NXP doesn’t look that cheap on discounted cash flow, but oftentimes it’s difficult to find growing semiconductor companies trading at attractive DCF-based fair values (it typically requires either a major downturn/investor pessimism or really low discount rates). I also favor a margin-driven EV/revenue and EV/EBITDA approach, and those lead me to multiples of 5.95x and 14.85x respectively and a fair value in the $290’s.

The Bottom Line

There’s certainly a risk that NXP’s carefully-managed downturn could be upset by even greater erosion in end-market demand, but even then I think the company is better-placed than many competitors. I also see a risk that EV sales expectations for 2024-2027 could still be too high. On the other hand, between the company’s strength in areas like MCUs, its opportunities in auto electrification, edge compute, and industrial automation, I do still like the long-term outlook, and management has proven itself on execution.

I may regret taking a neutral stance today, and I do still see room for the shares to move above $290, but I think the risk/return right now is just not the best. Call this a very grudging “hold” call, as I’d like the excuse to be more bullish.

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