This commentary was originally sent to Action Alerts PLUS subscribers at 11:45 on Aug.9.
We wanted to address a recent Forum question in which a member asked for our view around NXP Semiconductors (NXPI) in light of potential macroeconomic slowdown and its sensitivity to global growth. We want to use the question as a platform to discuss our overarching thesis, views around recent price performance in light of its quarterly results as well as secular trends (in particular, lateral concerns around its exposure to the auto industry, which has come under scrutiny in light of recent sales results and forecasts).
We also had the opportunity to speak with CEO Rick Clemmer last week, in a conversation that validated our conviction in management and its ability to create long-term, sustainable shareholder value. While we approached our conversation and evaluation of second-quarter results through a cynical lens (in order to avoid confirmation bias), we emerged incrementally confident. We found Clemmer's straightforward, pragmatic nature refreshing amid the arena of defiant management teams who pride themselves on prior successes that they extrapolate into the future. Clemmer falls in the sweet spot of conveying confidence as well as transparency, and remaining audacious yet realistic. His strategic vision is firm from a high level yet fluid underneath, allowing room for the company to adjust in lockstep with the constantly evolving marketplace.
These traits have allowed him and the remarkable executive team around him to stay focused throughout the ups and downs inherent to its industry. They have created an ecosystem along the way that has diversified the company from a product, end-market, geographic and customer standpoint.
Before delving into why we reiterate our conviction in the NXP investment thesis, let's look at some timely context.
Six years ago nearly to the the day, NXP went public in an IPO that was met with utter apathy (if not outright dismissal) by the market at the time. In fact, demand was so tepid that bankers on the deal were forced to slash the offering price to $14 from $18-$21 in the days leading up to the offering. Headlines from the Financial Times -- "NXP Semiconductors Slashes IPO Price", or Bloomberg -- "KKR, Bain Sell NXP in IPO at 46% Discount to Buyout" -- sum up the market's disinterest.
The Bloomberg article noted that NXP, which "makes semiconductors used in everything from radars to hearing aids and pachinko machines, reported combined losses of $5.5 billion since the takeover. KKR, the leveraged buyout firm founded by billionaire investors Henry Kravis and George Roberts, said in May its stake in NXP was worth 40 cents on the dollar". The article also went on to cite a prominent Chief Investment Officer who proclaimed "This is an investment that went bad....The private equity investors are trying to cut their losses."
Lost amid the satirized headlines was the clear, focused strategy explicitly outlined by Clemmer: NXP would focus on areas where the company can hold a leadership position while growing at least 50% faster than its next largest competitor. This message was met with deaf ears; perhaps the very journalists and analysts lampooning a chipmaker which they (incorrectly) diminished to a "hearing aids" provider should have purchased a pair themselves. If so, perhaps they may have listened to the game-changing, albeit bold growth vision Clemmer unveiled.
To execute on his vision, Clemmer explained that NXP intended to leverage existing category leadership in (then-nascent) areas of security, mobility and digital processing, and focus investments in significant, fast-growing long-term opportunities: specifically connectivity, security and networking. The early investments took form through the creation of innovative products, two of which were truly transformational: near-field-communication (NFC) and secure identification (secure ID). NXP invented NFC technology, which facilitates contactless communication between devices (mobile payments like Apple Pay and Samsung Pay). The company also pioneered the development of the "secured element market", or a chip that keeps all of your information encrypted so that only you can access it (it is likely embedded on your credit card), a major selling point in terms of fraud prevention.
Growth is only as powerful as the underlying operational excellence, which NXP prioritized by streamlining operations, extracting operational efficiencies, and generating robust free cash flow. All retained earnings would, according to Clemmer, be rolled right back into the fastest-growing areas that positioned the company for the future.
Six years, $72 dollars in share price, $30 billion in value creation and 500%+ returns later, Clemmer's strategy has certainly been validated. Yet, this in and of itself does not sufficiently describe the depth of the story. As we take a step back in time and read through the company's pre-IPO prospectus, litany of conference calls/shareholder meetings, and analyst day presentations over the past six years, the one constant is consistency. Second, execution. Amid constant change across the chip industry, NXP has adapted, evolved and emerged stronger, selectively leveraging a carousel of opportunities at the right place and time.
We reiterate our conviction in our NXP investment from both valuation and fundamental standpoints. We view shares as incredibly undervalued -- trading at peer-low multiples, or 12x next year's earnings -- despite its track record of consistent execution, sales growth, earnings growth and strong visibility into future growth. These levers are fueled by enviable end-market exposure, diversification, operational excellence, and proven track record of creating shareholder value amid an industry vulnerable to cyclicality. The company has always delivered above and beyond its long-term sales/earnings growth algorithm across multiple analyst days and iterations. Management has a clear line of sight into its current vision: 5-7% sales and 15% earnings growth annually over the next three years which, paired with robust cash flow generation and an aggressive buyback program, is why the stock is our top-ranked name within our Value index.
We typically would not give a management team the benefit of the doubt around any form of longer-term growth guidance. NXP is a rare exception; the company has a proven track record of delivering on its long-term sales and earnings forecast, regardless of industry backdrop. Its business strategy dictates its financial strategy, which dictates its allocation of resources and strategic areas of focus. The result is delivering best-in-class products across an evolving range of high-growth, high-return, and highly enviable areas of interest. Or, as NXP says it, creating "secured devices in a connected world".
Its leading position as a chip provider for high-end smartphones (with its near-field-communication technology) and credit cards was locked in several years ago. Since then, the company has made a strategic shift (five years into the making) into the auto market, which it now dominates by a wide margin. As it continues to benefit from legacy investments in mobile payments, the next growth levers are both established and in their early innings. Its acquisition of Freescale last year catapulted the combined entity into a top-5 semiconductor company (NXP was 14th largest, Freescale 18th) overall and the number one auto semiconductor company (NXP/Freescale was 4th/5th prior to transaction).
We spoke with Clemmer within hours of the merger announcement in a conversation where he outlined the strategic rationale, noting that 27 of 28 auto companies use NXP as their technology of choice, while seven of those 28 companies use Freescale as their application processor. By bringing Freescale's processing onto NXP's platform, the end product is a total solution, making it easier to deal with the top tier 1 suppliers (original equipment manufacturers, OEMs in short). He viewed the deal as one that leveraged Freescale's leading computing platform with NXP's leading position in connectivity and security. Clemmer expressed confidence not only in remaining leader in the auto market but expanding the company's lead at least 50% faster than the industry average.
Looking forward, the combined entity would command thought leadership in ADAS (advanced driver assistance systems) by bringing a safer combination with RADAR in combination with vehicle-to- vehicle communication to make driving more efficient and safer. Cost synergies of $300 million were achievable. We tempered our excitement following the merger news, as we believed shares had run too far.
NXP represents true leadership. Fast forward 15 months and the vision is reality. NXP is not only the largest auto chipmaker by a country mile (15.5% market share vs. 10% for next-largest competitor) but growing relative share at a 50% pace. The company has visibility into its long-term growth, as it has secured 80% of design wins required to meet their 2019 autos sales goal, and is closing in on the final 20%. It is over three years ahead of schedule, with growth dictated not by the autos market but by increased chip content and their relative market share growth, which allow them to grow at a roughly 6% annual sales clip even if autos are in cyclical decline. Oh, and synergies have been raised from $300 million to $500 million.
Clemmer's strategy has played out. Within autos, the company's dominance is supported by its superior technology, which is unmatched in its ability to combine security and connectivity. This leadership has helped NXP land major design wins with nine out of the top nine (Tier 1) auto manufacturers. NXP is able to command a high price tag for its best-in-class, full-suite offering, with unmatched leadership in RADAR technology (for autonomous driving/crash prevention purposes), infotainment (the hardware/software audio/video entertainment systems in cars), vehicle-to-vehicle networking, in-vehicle networking/connected devices (the same chip that facilitates contactless mobile payment transactions is used for contactless keys) and most importantly secured connectivity, serving to help it literally drive away from the competition.
We cannot emphasize enough the importance of security. A chip's processing power, connectivity, networking and sophistication is worthless unless it is enveloped by a security solution that provides proven end-to-end encryption across hardware and software. NXP is the proven, trusted, and uncontested leader in security: the exact same technology which powers the embedded encryption across the entire payment industry (both plastic and mobile), along with the sheer dominance it holds over the global smartphone transit transaction market (85% share) is applied.
Existing relationships with the top auto manufacturers, in which NXP's technology has been successfully integrated into multiple generations of top-tier model designs, have been cemented and expanded upon (as the automakers roll out new models). Securing new relationships with top OEMs which are willing to pay a premium for NXP's proven, sophisticated, and full-suite technology has also driven outsized growth.
Bottom line: although shares trade at 12x earnings, what is clear is that the investment is in the company, its management team and the strategic focus that underpins each and every decision. It is an investment in a company that delivers near-term, medium-term and long-term, doing so by investing with the mindset of a chess grandmaster and not strapping itself to the price competition inherent to a cyclical industry, one that has seen its titans devolve into lumbering, antiquated, slow-growth entities. Five moves ahead, NXP no longer needs to grow through acquisition, burn cash through indiscriminate share buybacks or turn blinders on to the Internet of Things future.
Once the hearing aids are inserted, blinders erased, and sensors restored, the stark reality emerges: NXP is the future.