Silicon Motion Technology Corporation: Looking For A Fresh Start

The year 2023 can be said to have been an eventful year for Silicon Motion Technology Corporation (NASDAQ:SIMO) with a couple of weeks left. SIMO went into 2023 intent on concluding the proposed merger with MaxLinear (MXL). This merger hogged the limelight for much of the year and for a brief moment appeared to be heading to the finishing line, only to fall apart at the last moment after MXL terminated the agreement. SIMO has to face the NAND memory market by itself, a market that has fallen into a deep slump, in contrast to when the merger was proposed in May 2022. This market remains fraught with uncertainty, but there are some green shoots to be spotted. Why will be covered next.

SIMO soars and then falls due to MXL

A past article from June 2022, written not long after the merger between SIMO and MXL was proposed, concluded that even though the former had seen its stock price soar in the wake of the proposal, there was reason to believe the proposed merger was not a done deal with hurdles in the way, which is why the article urged locking in profits to at least some extent since the stock price was likely to decline once opposition to the merger appeared.

For instance, China was identified as a likely hurdle to the merger, which turned out to be very true. A follow-up article from September 2022, written after China made it clear getting approval would not be so straightforward, theorized why China could let the merger go through despite objections, provided conditions were right, including on the political side.

Nonetheless, the article concluded that the odds of a successful merger had become less and the more time passed, the less likely the merger was to go through. Not because of China, but because MXL could be forced to walk away from SIMO due to changing conditions in the NAND market, which would make a merger between the two less desirable and thus less likely to proceed. Another article went into further detail as to why MXL could be better off by not going through with the SIMO acquisition.

All the above turned out to be prescient because MXL opted to terminate the merger with SIMO in July, shortly after SIMO announced it had received approval for the merger from the Chinese government. SIMO for its part has decided to continue as an independent entity and to pursue arbitration for monetary compensation from MXL.

Why SIMO shareholder could regret the merger between SIMO and MXL not going through for quite some time

It’s clear SIMO lost out when the deal fell through. The failed merger proposal offered $93.54 in cash and 0.388 share of MXL stock for each ADS from SIMO. In contrast, SIMO closed at $58.17 on December 20 with the stock down 10.5% YTD, giving SIMO a market cap of $1.94B. The chart below shows how the stock briefly spiked in July, only to collapse when the merger was called off.

SIMO is valued much less than under the merger proposal. Furthermore, the semiconductor market, and the NAND market in particular, has deteriorated significantly compared to May 2022 when the merger was proposed, which SIMO will now have to contend with on its own. In the most recent earnings report, for instance, revenue shrank by 31.3% YoY to $172.3M and non-GAAP EPADS fell by 58.8% YoY to $0.63. The table below shows the numbers for Q3 FY2023.

Click to enlarge

Source: SIMO Form 6-K

However, the numbers improved QoQ in Q3, just as they did in the preceding quarter, which suggests the worst has passed. In addition, guidance as shown below calls for Q4 FY2023 revenue of $190-198M, a decline of 3.4% YoY, which, if achieved, would represent the third consecutive sequential increase in quarterly revenue.

With these guidelines, SIMO is estimated to post non-GAAP EPS of $0.72 in Q4 FY2023. This represents a QoQ increase of $0.09, although still below last year’s $1.22. FY2023 non-GAAP EPS is projected to be $2.06. In comparison, SIMO earned $6.36 in FY2022 and $6.21 in FY2021.

Click to enlarge

Source: SIMO Form 6-K

SIMO is priced for a rebound in earnings

In addition, the outlook calls for the recent strengthening in end-market demand to continue in 2024. From the Q3 earnings call:

“By end market standpoint excess inventory in the PC and smartphone markets have plagued the industry since late 2022 when the global economy weakened and demand lowered. It has taken nearly a year, but we believe the inventory level in both the PC and smartphone markets are normalizing.

We are seeing more consistent order patterns from our customers and better visibility that are more closely aligned with end market demand. We are optimistic that this trend will continue and that the industry is well positioned to return to growth in 2024.”

A transcript of the Q3 FY2023 earnings call can be found here.

Earnings are expected to increase and this is reflected in how multiples have expanded. The table below shows how multiples are higher than they have been on average in recent years. For instance, EV/EBITDA is about double the average. Multiples for SIMO are also higher in general than the median in the sector.

Click to enlarge

Source: SeekingAlpha

Is there too much optimism around for 2024?

The market for semiconductor chips, and memory chips in particular, has struggled since the latter part of 2022. Demand has dropped and the semiconductor market is expected to show contraction for the first time in years by the time 2023 is over. However, demand is expected to rebound in 2024. Most industry estimates predict the market will expand in the low teens in 2024.

The memory market is expected to show even faster growth. For instance, a recent report from WSTS predicts the memory market will grow by 44.8% YoY in 2024 after shrinking by 31% in 2023. A number of industry players concur with this upbeat assessment. Micron (MU), for instance, the leading customer of SIMO, predicts it will get out of the red in 2024 as demand rebounds.

Still, there is a risk forward projections may be overestimating the degree to which demand will increase in the coming quarters. True, the numbers have improved sequentially, including at SIMO, but keep in mind the memory market benefits from seasonality due to, for example, the release of flagship smartphones for the holiday season.

A look at 10 Wall Street price targets for SIMO shows a range of $54-100 and the average is $74.50, well above the current price, which is consistent with the general expectation of increased earnings. If the argument is made that fair value for SIMO is in the low seventies even though SIMO has a P/E ratio in the high twenties with FY2023 non-GAAP EPS of $2.06 and a stock price of $58.17, then for this to be justified SIMO would need to grow earnings in the thirty to forty percent range on average per year.

Granted, SIMO did just exactly that as recently as FY2019-2022 when EPS grew at a CAGR of 34.7%. If we extrapolate this number and assuming FY2023 EPS is $2.06, then fair value would be around $71.48. So from that standpoint, a price target in the seventies is justified. Keep in mind though that SIMO’s growth rate in recent years got a boost from stimulus due to COVID-19. The earnings achieved in FY2021-2022 are very much the exception. Ignore those years and earnings growth at SIMO is much less.

Without this stimulus, it’s unlikely EPS would have grown from $2.60 in FY2019, and before COVID-19, to a record $6.36 in FY2022. For instance, the CAGR for EPS in FY2017-2022 is about half that of FY2019-2022 at 17.7%. If EPS grows at a CAGR of 17.7% instead of the mid thirties, then fair value would be more like $36.46, which is below the current stock price.

In other words, SIMO is expected to grow at a pace that may not be realistic. SIMO has historically grown at a pace that is significantly slower that what was achieved during the COVID-19 years, yet the forward estimates appear to assume SIMO will come close to matching those highs. It’s possible SIMO will get there once more, but it is definitely not a sure thing, especially not with the NAND market still dealing with sluggish demand.

Investor takeaways

SIMO headed into 2023 looking to complete the merger with MXL, but it will head into 2024 with a different future. Plans have changed and SIMO has to make the best of it on its own and without MXL. SIMO faces a weak NAND market that is projected to cause FY2023 non-GAAP EPS to shrink to just about a third of what it was in FY2022 and FY2021. This would give SIMO a P/E ratio close to 30, which some may argue is too high for their liking.

However, the quarterly results have improved from what may have been the low in Q1 and the outlook expects that improvement to continue in 2024. The general expectation is that the memory market will return in growth in 2024, which will drive demand at SIMO. The stock too has been on the rise. SIMO has appreciated by close to a fifth since entering the fourth quarter.

There is certainly reason to be long SIMO and I have been long SIMO in the past, but I am nonetheless neutral on SIMO at this time. Expectations may be too high. All signs point to a better 2024 than 2023 for the NAND market, if only because the NAND market has experienced what may have been the worst downturn ever, which should result in higher earnings in 2024, but the market may be overestimating the degree to which demand will increase. It may be way too early to say the NAND market has recovered.

While the QoQ increase in quarterly results has been better than that based on seasonality, the recent improvement may still be mostly due to seasonal fluctuations. Forward projections that call for 40+% growth in the memory market in 2024, for instance, may be getting ahead of themselves. It is very possible, if not likely, that the market may be overestimating the degree to which the numbers will rebound in the coming quarters.

Some expect earning to get back to $6+, similar to what was achieved in FY2021-2022, but those numbers were achieved under conditions that no longer apply. If growth is much less than expected, the stock may have further to fall. If, for instance, earnings growth is more like in FY2017-2022 and less like FY2019-2022, which some appear to be leaning towards, then the stock may have to get back to the thirties, like it did in 2019 before COVID-19 started to distort everything.

Bottom line, the NAND market has been absolutely horrible in the last 12 months with record low prices, so some sort of improvement is to be expected, but the degree to which it will improve may not be what most expect it to be. SIMO and its stock have been bid up in anticipation of a return to growth, but disappointment may be looming ahead. The possibility of a decline in the stock price is not to be dismissed.