ST wants to jack up annual revenue within the next several years by more than 20%, above its projected 2020 sales. But is ST chasing the wrong financial target and ignoring a different metric preferred by investors and shareholders?
STMicroelectronics N.V. wants to jack up annual revenue within the next several years by more than $2 billion, or 20 percent, above its projected 2020 sales. But is ST, one of the semiconductor industry’s leading suppliers, chasing the wrong financial target and ignoring a different metric preferred by investors and shareholders?
This year, ST expects revenue to be in the range of $9.25 billion to $9.65 billion, according to Jean-Marc Chery, CEO of the Switzerland-based chipmaker. Analysts see it coming in somewhere between those numbers at around $9.4 billion, based on the consensus forecasts compiled by Yahoo! That would be slightly below the $9.6 billion reported in 2019. Gross profit margins, too, are expected to decline, falling several percentage points and exacerbating concerns about the company’s ability to improve profits on a longer-term basis.
ST needs to improve its operating metrics. And the integrated device manufacturer – one of a dwindling group of chipmakers that still operate their own semiconductor fabs – has indeed tried to improve both sales and profits. But it may have to plunge deeper into the fabless world having failed for more than one decade to post sustainable gross profit margins comparable to the best-in-class semiconductor suppliers. As ST’s leadership baton has passed from one CEO to another, the company faced the perennial problem of figuring out how to boost margins and sales on a consistent basis.
To improve valuation and enhance acquisition prospects, ST should focus temporarily on margin improvements and defend sales in markets where it has a leading position. The company is seen closing this decade with sales of approximately $9.4 billion, down slightly from $9.6 billion in 2019, but well below the $9.7 billion and $10.4 billion reported in 2011 and 2010, respectively. The same struggles to improve financial performance are obvious in the company’s gross profit margins (GPM). In 2019, it reported GPM of 38.7 percent, similar to the 38.8 percent recorded in 2010 but better than the low of 30.9 percent from 2009. This year, ST’s gross profit margins will drop from the 2019 level, down to somewhere between 36 percent and 37 percent, depending on fourth quarter sales performance.
Gross profit margins are important in the capital intensive and R&D-driven semiconductor industry. They impact what companies can spend money on, how much they can spend and the size of enterprise profits. Investors pay close attention to the numbers, poring over it for information about a business’ fiscal health and using it to determine market valuations. While ST executives understand the significance of strong profits, they have chosen a rather curious strategy for improving the company’s overall financial position. By pushing for higher sales, they expect to gain productivity improvements that would trickle down and help improve gross profit margins and operating margins. That is why the company has set a goal of increasing sales to $12 billion by 2022 to 2023.
“We are working on [the $12 billion sales target] and we rework and update this every year,” Chery, the CEO, said during a conference call to discuss second quarter financial results. “$12 billion will be achieved within the next 3 years.”
Hitting that sales growth by 2022 or 2023 will be difficult. ST is projected to hit sales of $10.78 billion in 2021, a sharp increase on the $9.4 billion predicted for 2020. If achieved, this should move the company closer to its stated goal and add momentum towards other objectives. But there are many unknowns on the way. ST was expected to grow in 2020 until the Covid-19 pandemic sideswiped the key automotive market. Any other negative incidents in the rest of this year or in 2021 could further hurt sales and push out the achievement of the $12 billion revenue objective.
Large Acquisitions for Higher Sales or Margin Improvement?
Hitting $12 billion in revenue could be easily achieved by ST if it were to follow the traditional mergers and acquisition path. The company is not averse to making acquisitions; it makes regular strategic deals. However, it has avoided large acquisitions over the years and has been less active than similar-sized enterprises as the industry went through a vigorous consolidation period starting in 2015.
ST has, instead, focused on organic growth. The company knows scale is important, hence the lofty goal of growing sales within a few years by more than $2 billion. But this quest may be clashing against a more pressing need: a more than one decade-long push to raise gross profit margins to match its best-in-class semiconductor competitors.
Nobody is really betting against ST achieving its sales target. Analysts raise the topic only occasionally, perhaps because they are interested in a different financial metric — gross profit margins. ST, and fellow European chipmaker Infineon Technologies A.G., have amongst the lowest gross profit margins in the semiconductor world. The two companies’ gross profit margins are not horrible; they are just not stellar.
ST wants better gross profit margins and it has certainly worked on improving these over the last decade. But the results are mixed. ST’s GPM have over the last decade been as high as 40 percent (2018) and as low as 32.3 percent (2013). Like a pendulum, the company’s gross profit margins have swung back and forth, propelled negatively and positively by market developments, much of which it has been minimal influenced. Two years after hitting the decade-high level of 40 percent in 2018, the GPM are trending down again.
But even at their peak, ST’s gross profit margins were multiple percentage points below those of the industry’s top companies. Let us review the numbers.
Observers measure ST against a basket of companies – about 10 of them. These include direct competitors and others in the semiconductor sector, including Texas Instruments, Infineon, NXP, Xilinx, Nvidia, Microchip, Analog Devices, Advanced Micro Devices, Micron, and Qualcomm. In this group, ST and Infineon in 2019 reported GPM of 38.7 percent and 38 percent, respectively.
No other company in the above group had gross profit margins below 40 percent. The comparisons are not similar – because not all these companies play in the same markets or report calendar year results – but the trends are instructive. The breakout in their fiscal or calendar year, as applicable, is as follows: TI, which plays primarily in the analog semiconductor market, reported gross profit margins of 64 percent; Microchip (62 percent); Analog Devices (67 percent); NXP (52 percent); Xilinx (67 percent); AMD (43 percent); Micron (46 percent); Nvidia (62 percent) and; Qualcomm (65 percent).
Gross profit margin results have implications for market valuation. Just look at ST’s market capitalization, juxtaposed against companies with comparable sales. Nvidia in fiscal 2019 reported sales of $10.9 billion and market capitalization – as of Friday July 31, 2020 – of $261.1 billion, compared with $24.6 billion for ST and $26.3 billion for Infineon, which in fiscal 2019 reported revenue of $8 billion. Analog Devices, with revenue of $6 billion in fiscal 2019 – below those of both ST and Infineon – had capitalization of $42.4 billion at the end of July. AMD’s market value during the same period was much higher at $91 billion, despite reporting gross profit margins below industry average. The company’s valuation is reflective of investor belief about AMD’s prospects. Texas Instruments’ sales are about $5 billion above ST’s on an annual basis, but the disparity in the two companies’ market value is huge and in favor of the Dallas analog giant. It was valued last week Friday at $116.8 billion.
Numbers matter. To be attractive to investors, a company must have not only strong growth prospects, it must also demonstrate strong operating margins. Investors pay a premium for companies they believe demonstrate efficient use of resources and market penetration. ST has scored numerous design wins at OEMs and has remained competitive despite setbacks years ago in the cellular handset market and today in the legacy automotive sector, but the company’s gross profit margins remain problematic, hence the lower valuation.
The company’s options are clear: it can rapidly increase sales or make operations more efficient to improve margins. Doing the two simultaneously has proven challenging. So far, ST’s management have chosen a hybrid strategy. They have tried sales growth and pushed for lower expenses, as Chery noted in his presentation.
“We are maintaining strict discipline on expense control, while protecting our energy, sales and marketing transformation initiatives,” he said.
These actions are good. But they are not enough. Merely squeezing costs out of operations while boosting sales have left ST at a standstill. It may be time to implement a more aggressive strategy. This should include a drastic reduction in internal manufacturing and back-end services to reduce costs and benefit from the fabless system adopted by many of ST’s rivals.
That process is in progress. In 2019, ST increased foundry purchases to “18 percent of the value of our total silicon production,” from 11 percent in 2018, and said it plans “to continue sourcing silicon from external foundries to give us flexibility in supporting our growth.”
If ST is to emerge from the decade-long margins and sales slump it would have to take drastic actions that could include greater use of foundries.
This article was first published on EE Times Europe