Keep These Automotive Chip Makers on Your Radar
Autos remain a key growth opportunity for many chipmakers, but investors should wait for a pullback in prices before diving in.
We believe the automotive end market remains the most attractive growth opportunity for broad-based analog and microcontroller chipmakers. While global automobile production is expected to rise at a 1%-3% average annual pace, we foresee far greater auto-related analog chip growth thanks to increased content per vehicle. We think the firms we cover can increase their auto chip revenue at an 8% average annual pace, ahead of the chip industry as a whole as well as industry analyst expectations for the overall auto semiconductor market.
Nonetheless, we fear that valuations are stretched. While the analog leaders in our coverage universe are well managed and offer attractive capital-allocation policies in the form of rising dividends and buybacks, we think some investors, perhaps in search of yield, are being lulled into a false sense of security, believing that the industry is no longer cyclical. We think cycles still exist, though the analog cycle is more related to GDP than the supply-chain inefficiencies in PCs and cell phones that drove cycles in years past. We’re still enthusiastic buyers of these high-quality names when adequate margins of safety arise, but we would stress patience at current valuations.
Long Design and Product Lifecycles
One of the primary reasons we remain optimistic about automotive chip demand is the timeline associated with new programs and design cycles. Unlike smartphones, which can be designed in a matter of months and antiquated just as quickly, automotive programs take years to ramp up. We think that analog firms (and auto suppliers in general) have excellent visibility into new car models (and, more important, the advanced electronics inside of such cars).
Our automotive team has noted that some original-equipment manufacturers are seeking faster lifecycles, or more rapid refreshes, associated with their vehicles. We view any acceleration of this cycle as a positive for chipmakers. We doubt such acceleration will lead to cars being designed as rapidly as consumer devices, so visibility into future design wins should remain relatively clear. More important is that car OEMs are seeking these refreshes precisely so they can add more electronics content per car, thus speeding up the implementation of the newest features with chip content. Given the stringent quality controls throughout the automotive supply chain, a speedier car refresh probably won’t lead to incumbent chip providers getting forced out of the car anytime soon.
Government mandates are another main driver of analog chip demand, as car manufacturers need to hit certain fuel economy and safety metrics and are increasingly relying on electronics, rather than mechanical parts, to get there. One of the most important ones for advanced driver-assistance systems relates to Europe’s New Car Assessment Programme, where advanced driver-assistance systems are required to achieve 5-star safety ratings today and 4-star ratings in 2017. Although we have not seen any new regulations over the past year that will significantly alter the design and content of new vehicles, we remain confident that, if a new mandate were to arise, auto-parts makers will rely on electronics and semiconductor content, rather than mechanical parts, to address such directives.
Higher-Priced, More-Advanced Automotive Parts Going Into Cars
Another key growth driver for electronics demand is that auto-parts makers are clearly profiting from the rise of increased electronics content per car. Continental, for example, recognized a 45% increase in ADAS unit sales in the first half of 2016 versus the same period a year ago, along with 58% growth in fiscal 2015 and 47% in fiscal 2014. On a revenue basis, Continental’s entire chassis and safety segment grew more than 12% in 2015, likely because of ADAS expansion. Similarly, Magna International’s ADAS revenue rose at a 51% compound annual growth rate from 2010 to 2015, and the firm foresees a 15%-17% CAGR through 2020. ADAS unit sales are expected to rise at Magna from 15 million in 2013-15 to 25 million in 2016-18. Another prominent beneficiary, in our view, is Autoliv. The auto-parts firm continues to profit from the rising tide of more-advanced safety systems per car, while its larger legacy safety businesses (airbags, seatbelts) grow at a far more modest pace.
Consumer Interest in Advanced Technology in Cars Is Growing
Anecdotally, in the United States, a host of car commercials over the past year suggest that car OEMs continue to use safety features as differentiators, and customers are increasingly desiring these features.
Several data points suggest a growing shift toward safety and infotainment features in the car versus prior selling points (brand, horsepower, body style, and so on). A 2016 automotive study of U.S. drivers from Autotrader and Kelley Blue Book (performed by Cox Automotive) showed that 65% of customers would switch to another brand if the first brand they were considering did not offer their desired technology features (up 9% from the same study a year ago). Similarly, 77% of customers said that a car that has all their desired technology is more important than the color of the vehicle (up 8% year over year).
The same study shows that 57% of Generation X customers (ages 35-50) view it as important that their car syncs with all other technology in their lives. Although they aren’t car buyers today, Generation Z customers (ages 0-17) view safety features as even more important than infotainment (43% versus 35%) and many more place an emphasis on safety in the long run than prior generations (43% deem safety as an important feature versus 25% of millennials, 11% of Gen X, and 9% of baby boomers).
New Features and Fragmentation Open Opportunities to All Chip Suppliers
Growth rates throughout the analog industry (particularly at Linear Technology (LLTC) and Maxim Integrated Products (MXIM)) suggest that all of these newfound chip opportunities aren’t merely going to legacy vendors. Instead, other high-quality chipmakers that lacked significant Tier 1 and car OEM relationships in the past are beginning to gain share at the expense of incumbents. A teardown of the BMW i3, performed by teardown.com, points to $4,000 of semiconductor content inside the vehicle, supplied by a wide variety of automotive chip leaders. The i3 serves as a clear example to us that the car won’t be winner-take-all for a single firm, but a rising tide that benefits all players.
Valuations Have Grown Less Attractive
Perhaps the biggest change in our analog coverage list over the past year has been valuation. While firms like Analog Devices (ADI), Microchip Technology (MCHP), Maxim Integrated, Infineon Technologies (IFNNY), and Texas Instruments (TXN) remain high-quality businesses, valuations have flipped from offering modest margins of safety a year ago to being overvalued, in our view.
We believe that part of the disconnect with recent stock prices is based on the cyclicality of these businesses. Growth has rarely occurred in a straight line in these names over the years, but demand has steadily increased since the financial crisis. Any sort of macroeconomic shock could spur a cyclical dip in demand. Analog chipmakers often suffer from the bullwhip effect: Small cuts in production lead to heftier inventory cuts and even fewer reorders at distributors, all of which lead to outsize reductions in chip orders and near-term sales. Given the fixed-cost nature of analog chip manufacturing and research and development, soft revenue translates to a dip in operating margins. Usually around the same time, multiples tend to compress and analog stocks tend to sell off on such sour news.
Typically, we’ve been enthusiastic buyers on these types of dips, as the high-quality firms under our coverage are well versed in these downturns and have come out stronger on the other side. Now is not that time, however. We think we’re seeing the opposite, where production has been stable, operating margins have been healthy, and multiples have expanded. Also, while we’re optimistic about automotive chip revenue, the near-term growth picture across some other end markets is less rosy, and most revenue across the chipmakers we cover comes from nonautomotive end markets.
Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.