The Clouds Are Parting for Skyworks

Skyworks Solutions (SWKS) has been punished in 2011, but a longer-term secular shift and favorable margin sturdiness have me looking past an uncertain near-term outlook and ready to buy. Shares of RF semiconductor company Skyworks Solutions have fallen about 60% over the past eight months and have underperformed the S&P 500 by nearly 50% in that time. While there has been some concern of late over the supply chain for connected devices (mobile phones, smartphones, tablets e-readers, etc.), Skyworks has continued to execute in 2011 and is on track for 35% earnings growth on 27% revenue growth this calendar year. Earnings growing faster than revenues signals margin expansion, which I like to see -- especially in a company in an exploding market such as connected devices. The Street is getting hung up on Skyworks' outlook for 2012. Some analysts worry about excess industry capacity for RF components and pockets of softness in the smartphone space. But this scenario is expected and reflects the logical cycle of what I have been calling the smartphone bloodbath: As the smartphone market began to take off, too many companies decided to bring a smartphone to market, and now companies are exiting the space as customers vote with their wallets. A previous example of this phenomenon is Palm's smartphone products; a more current one is Research In Motion (RIMM) and its BlackBerry offering. Looking past these original equipment share shifts, the question to ponder is what will happen if connected device shipments in aggregate are flat in 2012. The kneejerk reaction would be that revenues and earnings will be flat to down. But that misses the ongoing transitions in the connected device space that are revenue-favorable for RF semiconductor companies like Skyworks and others. These transitions include the ongoing industry migration to 3G WCDMA from 2G GPRS/EDGE; the deployment of next-generation 4G LTE-powered devices, which is in its early stages; the growing shift to smartphones from basic mobile phones and messaging phones; and the adoption of non-handset devices that have cellular and other connectivity. All of these shifts have greater RF content per device than basic mobile phones, and as such a high-tier smartphone brings close to $9 per device to Skyworks while a low-tier smartphone is closer to $3 per device. (The good news is this is well above the $1 that Skyworks was making on low-end 2G devices.) According to ABI Research, smartphones accounted for 29% of overall mobile phone shipments in the September 2011 quarter, and with manufacturers bringing smartphones to low- and middle-tier price points, smartphone penetration will continue to grow in the coming quarters. And the device makers that took market share in the September quarter -- Samsung, ZTE and Apple (AAPL) for example -- are all customers of Skyworks, as are other smartphone manufacturers including Motorola Mobility, Nokia (NOK), Sony Ericsson (SNE), RIM and HTC. This diverse customer base should help Skyworks weather share shifts on a short-term basis while the industry migrates to offerings with more RF content -- and that's before we factor in the impact from tablets, pads and e-readers. I see two major areas of concern. The first is industry pricing for RF components; excess industry manufacturing capacity could hit pricing and margins. While there will be some pricing pressure, Skyworks has historically generated favorable incremental operating margins on additional revenue, which should help stem margin pressure. And as mobile devices have become more complex with greater functionality and therefore more components, the degree to which competitors could supply competing parts has fallen, further limiting overall pricing and margin pressure. The second area of concern is the mobile infrastructure market, which has been challenged recently despite the buildout of 4G LTE networks. Mobile infrastructure growth has always been lumpy, and that is especially true during technology transitions like the current one from 3G WCDMA to 4G LTE. While 2011 has been a lull, analysts at TeleGeography expect LTE deployment to grow globally in 2012 and beyond. This idea is supported by leading mobile infrastructure vendor Ericsson (ERIC), which recently said it expects LTE penetration to grow to 35% of the world's population by the end of 2016 from just 2% today. Given broadly favorable prospects and modest risk, SWKS shares at $14.50 -- now trading at 7.4x calendar 2011 and 2012 earnings, not to mention a balance sheet that has roughly $2 a share in net cash -- offer a very favorable reward-to-risk profile. Do I see SWKS shares rebounding to highs earlier this year near $38? No, but investors could see some very nice returns even if shares don't approach that lofty level in the next 12 months. Modest multiple expansion on current earnings expectations can get SWKS shares back to $20, which offers far more upside than the downside at current levels. The current reward-to-risk profile looks very similar to that of January 2009 and January 2010, which were very good times to get long SWKS shares. If SWKS approaches $12, I will get far more aggressive in the shares. In terms of risks to watch for, I would keep my eyes on mobile phone and smartphone inventory levels as we exit the holiday season, as higher-than-expected inventories after Chinese New Year could lead to RF component order push-outs.

The Clouds Are Parting for Skyworks

A broad shift toward more RF components in connected devices could mean a bright future for this beaten-down tech play.

Columnist Conversation

This Weekend on Real Money

Wednesday on Real Money Pro

Pretty Incredible + Hard to Believe

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.