A value trap snaps shut.
The Tide is Ebbing
Over the last 2 years the investing landscape has been littered with value traps. Covid era supply / demand imbalances put many companies in the driver’s seat, able to charge high prices while they kept their expenses low. But supply chains are loosening up, shelves have been restocked, inventory levels need to be wrestled back down and companies are again having to offer discounts and promotions to get their stuff out the door. At the same time, inflationary cost pressures are cutting into the bottom line. Those covid era windfall profits are fading. The tide is going out and we are starting to get a sense of who was swimming naked.
I would love to smugly say that I was not so naïve as to get caught in any of these covid era value traps. But with Skyworks, I think that is exactly what happened.
Betting On 5G
My investment in Skyworks was basically part 2 of an investment thesis that began with the purchase of Qorvo in November of 2021. At the time, I was well aware of the distorting effects of covid. I remember talking about the “un-cession” that was unfolding. But I hadn’t lumped Qorvo (and later Skyworks) in with that crowd. I thought the recent success of Qorvo came from their leadership in 5G technology and the rollout of this new standard across the industry. I believed management when they talked about a multi-year runway of double-digit growth as 5G rolled out across the ecosystem.
Then, about 6 months later, covid hit China and the short-term outlook for Qorvo deteriorated. I switched horses at this point and moved my money into Skyworks which, being less exposed to the lower tier Chinese handset makers, appeared to offer more resiliency. This turned out to be spot on as Qorvo is now losing money while Skyworks continues to be solidly profitable. At the time, I was still optimistic that the long-term growth story for these 5G companies was largely intact. I viewed the Chinese issues as a temporary speed bump that would resolve once the covid storm had passed and Skyworks seemed like a good bet to weather the short-term storm with while still participating in the long-term growth.
A Deteriorating Outlook
However, with recent Q1 results and management guidance for the upcoming Q2, we see earnings continuing to deteriorate even as China opens back up. The entire semiconductor industry is following the same general playbook. A wave of covid era demand for electronic gadgets collided with a widespread chip shortage to produce record profits for everyone involved. But those profits are now fading as supply chains open up and consumers spend their inflation reduced dollars elsewhere.
What I thought was a company specific burst of growth caused by the transition to 5G is looking increasingly like it was simply part of the overall semiconductor boom and now bust. While 5G sounds very cool on paper, I’ve yet to see any evidence of truly groundbreaking new use cases for this technology. As with many new technologies, I suspect the hype may turn out to have been overdone.
What’s more, I am starting to have misgivings about the whole smartphone sector. I remember well when the personal computer industry hit an inflection point. Back in the late nineties, you’d assume that you’d need to get a new computer every few years (or at least the nerdier among us did). Every new Microsoft Windows release got the same sort of fanfare that new apple iPhone releases get now. Steadily improving technology drove a wave of continual upgrades. Then the growth stopped. Computers got as good as they were going to get, more or less. Newer and faster no longer produced much observable benefit. I have no idea what the current version of Windows is called. I can’t remember when I purchased the Dell laptop I’m typing this post on. It was easily over a decade ago and yet it still works just fine and handles all my sprawling spreadsheets without complaint.
I could see us getting to the same inflection point soon with smartphones. The newest and greatest Apple iPhone is not going to play Cwazy Cupcakes any better than your existing Apple iPhone. That could end up being a longer-term headwind for a company like Skyworks which still generates the bulk of its revenue and earnings from the Apple upgrade cycle.
And in the shorter term, we’ve got a sector-wide downturn to deal with, possibly exacerbated by a looming recession. A year or two ago, I was looking for future earnings of as much as $10 a share, and in my more optimistic moments, putting a higher growth p:e on those earnings to boot, to account for the vaunted wonders that the “internet of things” would produce.
Now, my mindset has shifted. Recent guidance for a further drop in sales and earnings next quarter, along with the more general deterioration in the semiconductor industry at large is the loud “snap” that tells me I’ve just been caught in a value trap. I’m lowering my future earnings expectations to the $6 mark and lowering my growth expectations as well. Putting both of those things together I come up with a fair value for this stock that is pretty close to where it trades now. Never one to overstay my welcome, I decided to sell Skyworks and move on.
This now leaves me with enough cash to buy 2 new full-sized positions, if I can find them, and that keeps me hungry. One would think that with the market down over 30% from its highs on an inflation adjusted basis there might be plenty of bottom fishing opportunities out there, but I’m really not seeing that. To a large extent, the decline in the market simply reflects the Skyworks experience writ large. Investors got duped by surging profits during covid and extrapolated these surging profits into the future. Now that the covid era profits are fading, prices and expectations are coming back down to earth. Will the pendulum swing too far back in the opposite direction? Will we stumble into a recession this fall? Or will we settle gently back down to an equilibrium glide path? Until we have more clarity on that, it is difficult to make accurate assessments and so I am still playing my cards fairly close to the chest.
I’ll be looking hard for one or two new replacements as I pour over Q1 results in the coming weeks but if I come up empty handed, I am happy to give my excess cash the summer off. Perhaps things will look clearer in the fall.
Full disclosure: I do not own shares in Skyworks Solutions or Qorvo Inc.