Summary
- GlobalFoundries has enjoyed double-digit revenue growth due to high demand amid a low supply of the less advanced chips.
- Comparison with Taiwanese UMC shows that subsidies through the CHIPS act can improve the company's gross margins, with GFS having the ability to add capacity faster than its giant peer.
- On the other hand, higher labor costs could impact operating margins, but these have already been considered in the first quarter 2022 guidance.
- GFS is a buy due to its cash-generating capability and its low price to cash flow multiple, and its stock could move higher following updates on subsidies.
PhonlamaiPhoto/iStock via Getty Images
GlobalFoundries Inc.'s (NASDAQ: GFS) share price as shown in the orange chart below fell by more than 40% from March 25, but on a year-to-date basis, it suffered less than the iShares Semiconductor ETF (SOXX), which represents the wider sector. The same is the case with giant chip manufacturer Intel (INTC), as shown by the purple chart.
Charts comparison (www.seekingalpha.com)
These two U.S.-based companies have suffered relatively less, and this may be linked to the fact that they produce a significant quantity of their semiconductors domestically and are also likely to benefit from the$52 billion CHIPS act following a vote by the Senate Committee meeting on March 28, as I will elaborate in this thesis.
The aim is also to make an investment case for GFS in view of the company reporting financial results on May 10, and I start by elaborating on how the law of supply and demand is favoring this foundry play.
Increasing revenues and profitability
As seen by the supply crunch which impacted large automakers like Ford (F), which had to cut production in several plants during the recent months, the U.S. remains behind when it comes to chip production. Scarcity has resulted in the global automotive industry suffering from over $200 billionin losses.
Talking economics, the laws of demand and supply have favored producers like GFS which have inked strategic partnerships with clients covering 3-4 years. Higher demand ensures sustainable growth in sales, while pricing power improves profitability. This makes recouping the$4.5 billionof capital expenditures to be made in 2022 easier. This amount is up by 150% on the $1.8 billion spent in 2021.
Going into details, except for the second part of 2020, when Covid-induced social distancing measures impacted production, the company has been incrementing sales sustainably. The fourth quarter of 2021 delivered revenues of $1.85 billion, or a74% y-o-y growth. Now, given that 2020 was a low year, the more meaningful sequential improvement of 9% (chart below) from Q3 to Q4 shows that the company has the necessaryinventoryof raw materials. Also, revenues beat analysts' expectations by$40 million.
Quarterly revenue trend and gross margins (www.seekingalpha.com)
Next is the gross margin, as per the chart above, which is an important metric for fabs as it considers both the production efficiency and ability of the company to manage supply chains related costs. For Q4, adjusted gross margins were 21.5% which represents a 3.46% increase over Q3. This was achieved primarily on the back of higher pricing, improved product mix, and better absorption of fixed costs, with factories operating at 100% of capacity compared to only 80% in 2020.
Full-year 2021 gross margins (adjusted) were up approximately 21.5%, but this is lower than the 38% delivered by peer United Microelectronics (UMC) which is also a smaller third-party foundry play based in Taiwan.
The competition
UMC, just like GFS, made the decision not to invest in the single-digit nanometer (or nm) newer technology back in 2018 and instead focus on the less capital-intensive double-digit nm like 300 nm. Now, these are precisely the type of chips that are facing supply constraints since last year rather than the more advanced ones.
Thus, driven by high volumes of orders, both GFS and UMC are benefiting from higher factory utilization rates, in turn ensuring that more output is derived from the same fixed costs. This results in higher profitability. In these circumstances, UMC's gross margins outpacing its U.S. peer by as much as 16.5% (38 - 21.5) can only be explained by other factors, like subsidies.
In response, the U.S. has moved a step closer to boosting domestic production through subsidies as part of the CHIPS act. The aim is to increase the country's share of global chip production and, in practice, this should be done by funneling money into building U.S.-based foundries, in addition to funding chip design and research.
Compared to Intel, which is having to build factories from the ground up in Ohio, GFS just needs to add capacity in terms of additional factory space and tooling in existing locations. This, according to its CEO, is much faster, by as much as 12 to 18 months, than actually constructing a new greenfield site where new equipment has to be installed. In other words, as soon as Congress passes the CHIPS act (also referred to as the USICA legislation), GFS is likely to move swiftly, while the attention is on giant Intel.
For people who doubt the ability of a small U.S. foundry to compete on a global basis, check the operating expenses. Here, I noted that both SG&A (sales and admin) and R&D (research) expenses as a percentage of total revenues are in the 6% to 10% range for UMC and GFS, as shown in the chart below.
Chart built by the author using data from (www.seekingalpha.com)
Relative expenses are slightly higher for GFS due to higher labor costs in the U.S., but, this could change with Federal support to boost production volume, resulting in higher sales and margins. Moreover, as the semiconductor ecosystem, especially the fab part, expands, the talent pool in advanced manufacturing should follow.
However, in the meantime, as shown by the upward movement of GFS's blue and red charts in the December quarter, costs are on the rise. Thus, even if the CHIPS act is converted to law, a tight labor market, especially for specialized skills like wafer fabrication, may restrain foundries' ability to expand production profitably in the short term.
Valuations and key takeaways
Thus, it is important to watch out for the evolution of operating expenses when the company reports financial results on Tuesday next week. For this purpose, it expects an operating profit margin of 6.5% (mid-point) in Q1-2022 as per the table below, compared to 8% in Q4-2021.
Company presentation (www.seekingalpha.com)
Also, the adjusted EBITDA margin of 31.6% should be slightly less than 32% obtained in the previous quarter. On the other hand, GFS generated a strong free cash flow of$423.9 millionin Q4 despite high capital expenses. This translated into FCF margins (FCF divided by sales) of 23%, which is excellent. Thus, valuing the company according to its trailing price to cash flow multiple of10.15x, it is undervalued with respect to the IT sector by 49%. Adjusting accordingly, I obtain a target of around $80 based on the current share price of $54.
This target may seem high, but is justified considering GFS has a disciplined approach to using capital to sustainably grow its business, with one example being the $4.5 billion Capex, including about $3.2 billion of customer funding. It deserves a higher valuation with respect to UMC thanks to its presence in Germany, Singapore, and the U.S..
Pursuing further, and to be realistic, with the economy having shrunk in Q1-2022, and uncertainty caused by the Fed hiking interest rates, there are recessionary fears in case inflation cannot be brought under control. There have also been some concerns raised about the supply of neon gas, which is used for certain chip-making applications due to Ukraine, which is a major supplier being in turmoil. Larger foundry plays like Intel may have a diversified supply of the gas, but the impact on small plays like GFS still needs to be ascertained.
On the other hand, with low debt and strong operating cash flow, GFS has the financial means to weather temporary supply chain-related cost increases and adverse economic conditions. It can also rely on its differentiated SOI (silicon-on-insulator) technology which leads to the production of low-power and cost-effective chips for military applications. This strength translated into a$117 millioncontract with the Department of Defense only a few days ago, with the chips to be shipped from next year.
Consequently, with guaranteed orders till 2023 and beyond, smaller and nimbler GFS is likely to benefit more rapidly from U.S. government subsidies than its larger peer. Also, with less than 10% of revenue exposure to China, where Covid is playing havoc with the supply chain, GFS could be impacted, but the degree of impact should be less than others which depend heavily on the Chinese market. Finally, there should also be news-induced momentum around subsidies which could also propel the stock higher.
Source: Seeking Alpha
Comments
πππ