Qorvo’s (NASDAQ:QRVO) shares have seen a 28% drawdown over the last 6 months, but our revisit highlights unrealistic market expectations for free cash flow generation into FY3/2023. The risk of normalizing tax rates remains and combined with earnings growth deceleration makes the shares unattractive. We stick with our sell rating.
Qorvo was formed via the merger of TriQuint Semiconductor and RF Micro Devices in January 2015. Headquartered in North Carolina, it is a specialist in wireless technologies for mobile devices, infrastructure, and defense applications.
Keen to expand from its core expertise in RF (radio frequency) solutions, Qorvo acquired United Silicon Carbide, a leading manufacturer of silicon carbide power semiconductors in November 2021 for USD234.2 million. This transaction expands Qorvo’s reach into the fast-growing infrastructure markets for electric vehicles, industrial power, circuit protection, renewables, and data center power.
Key financials including consensus forecasts
We analyzed the weakening tax shield impact (an allowable expense that reduces your tax bill enhancing cash generation) at Qorvo in our last piece in May 2021. This time we look into the following:
- whether our thesis panned out and to assess the outlook for future free cash flow generation.
- why Qorvo is positioning itself outside RF solutions with United Silicon Carbide (UnitedSic).
We will take each one in turn.
Tax shield disintegrating
We believed that Qorvo had structured its merger in 2015 carefully by creating a major tax shield and that this benefit would significantly fall in FY3/2022 reducing its ability to generate free cash flow.
We see from Refinitiv how the sell-side began to reduce its estimate for FY3/2022 free cash flow by 25% over the last 6 months. There is a similar move in the share price over the same period. Investors would take note that despite 15% topline growth and 17% growth in operating profit in FY3/2022, free cash flow is expected to fall by 13% YoY. Our view is that the market is paying closer attention to real value generation (free cash flow) declining as opposed to the positive earnings growth outlook on paper which can benefit from financial engineering.
FY3/2022 cash flow estimate change over the last 6 months, with corresponding share price chart
Results from FY2016 to FY2021 showed the company has benefited from escalated levels of amortization of intangibles as a tax shield (an allowable expense that reduces your tax bill enhancing cash generation). Q3 FY3/2022 results showed that intangible asset amortization expense declined by 48% YoY, in line with our expectations for the full year.
Full-year amortization expense – and estimated tax shield balance remaining
With the tax shield decline, we see an uptick in the effective income tax rate which is beginning to normalize. The Company’s effective tax rate was 23.6% for the quarter ended January 1st, 2022 (page 18 under Income Tax), versus 10.1% in the same period last year. Our thesis was therefore correct.
Current consensus forecasts (see Key financials table above) has Qorvo’s outlook for free cash flow being robust, growing 39% YoY for FY3/2023. This does not make sense to us for the following reasons: 1) consensus forecasts the effective income tax rate to remain at a startlingly low level of 9.1% when the January 1st, 2022 quarter was over double this level, and 2) the recent acquisition of United Silicon Carbide will contribute only USD11.5 million amortization expense from its technology, nowhere near to offset the overall decline in the tax shield. We surmise that consensus forecasts are once again overestimating free cash flow estimates.
Next, we look at the strategic reasoning for the acquisition of United Silicon Carbide.
With consensus estimating a decelerating sales growth profile, this implies a notable slowdown in Qorvo’s mainstay Mobile Products division in FY3/2023. We believe one key reason for this is the intense competition. Q3 FY3/2022 results highlight that the company has experienced its strongest sales growth in the ‘Other Asia’ region (excluding China) of 64% YoY; this illustrates that Qorvo’s current core demand driver is cheaper lower-end components, highlighting its relative lack of competitiveness for higher-end products for the US market. There are also singular challenges with Chinese manufacturers with the aim to source locally. With increasing discounting pressure as the 5G cycle matures, we believe Qorvo faces limited growth potential.
Expanding the Infrastructure and Defense Product segment makes sense to access less competitive markets for growth. Qorvo’s acquisition of UnitedSic bolsters its position as an industry leader in silicon carbide technologies, providing access to power factor devices (the ability to operate at higher voltages in various environments with low losses) being used in greater numbers due to electrification. Applications span from renewable power generation, electric vehicles, and data centers.
The impact on earnings in the short to medium term looks limited due to this small-sized acquisition. The accretive earnings impact does not look large from its purchase price, and addressable market growth will have limitations in longer-cycle capital goods.
Overall, we see the UnitedSic acquisition as being neutral.
On consensus forecasts, the shares are trading on a free cash flow yield of 10.1% for FY3/2023. This is a very attractive valuation but unfortunately, we believe consensus forecasts are too bullish. If the market is currently pricing in expectations at this level, we believe the shares are too expensive.
Upside risk comes from free cash flow generation making a major recovery YoY into FY3/2023. This could come from very effective working capital management and restricted capital expenditure. However, with continuing supply chain difficulties in the industry we believe working capital requirements are likely to remain at elevated levels.
A change in the shareholder returns policy will be positive, given Qorvo’s current position of not paying a dividend.
Downside risk comes from a continued decline in free cash flow generation given normalization of the income tax rate and increasing working capital needs.
A marked deceleration in organic growth would be negative for the earnings outlook, highlighting Qorvo’s greater reliance on acquisitive growth to generate positive growth optics.
Qorvo’s shares have seen a 28% drawdown over the last 6 months, but our revisit has highlighted that market expectations for free cash flow generation remain too high for FY3/2023. The risk of normalizing tax rates remains, and combined with growth deceleration makes the shares unattractive. We stick with our sell rating.