Qorvo: Market expectations remain at unrealistic levels for free cash flow

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Investment thesis

from Qorvo (NASDAQ: QRVO) stocks are down 28% in the past 6 months, but our review highlights unrealistic market expectations for free cash flow generation in fiscal year 3/2023. The risk of normalization of tax rates remains and combined with decelerating earnings growth makes stocks unattractive. We stick to our sell rating.

quick primer

Qorvo was born from the merger of TriQuint Semiconductor and RF Micro Devices in January 2015. Based in North Carolina, it specializes in wireless technologies for mobile devices, infrastructure and defense applications.

Eager to expand 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 $234.2 million. This transaction expands Qorvo’s reach into the fast-growing infrastructure markets for electric vehicles, industrial energy, circuit protection, renewable energy and data center power.

Key financial data, including consensus forecasts

Key financial data, including consensus forecasts

Key financial data, including consensus forecasts (Enterprise, Refinitiv)

Our goals

We analyzed the impact of weakening the tax shield (a permitted expense that lowers your tax bill by improving cash generation) at Qorvo in our last article in May 2021. This time we look at the following:

  • whether our thesis has proven successful and to assess the prospects for future generation of free cash flow.
  • why Qorvo is positioning itself outside of RF solutions with United Silicon Carbide (UnitedSic).

We will take each in turn.

The tax shield is disintegrating

We believed that Qorvo had carefully structured its merger in 2015 by creating a major tax shield and that this advantage would diminish significantly in FY3/2022, reducing its ability to generate free cash flow.

We see from Refinitiv how the sell side has started to cut its free cash flow estimate for FY 3/2022 by 25% in the last 6 months. There is a similar movement in the stock price over the same period. Investors will note that despite 15% revenue growth and 17% operating profit growth in FY3/2022, free cash flow is expected to fall 13% year-on-year . We believe the market is paying more attention to the decline in real value generation (free cash flow) as opposed to the positive earnings growth outlook on paper which can benefit from financial engineering.

Change in FY 3/2022 cash flow estimate over the past 6 months, with corresponding stock price chart

Change in consensus estimate of free cash flow over the past 6 months, with corresponding stock price chart

Change in consensus estimate of free cash flow over the past 6 months, with corresponding stock price chart (Refinitive)

Results from fiscal year 2016 to fiscal year 2021 showed the business benefited from increased levels of amortization of intangible assets as a tax shield (an allowable expense that lowers your tax bill and improves cash generation) . Results for the third quarter of FY3/2022 showed that intangible asset amortization expense decreased 48% year-on-year, in line with our expectations for the full year.

Depreciation expense for the full year – and estimated remaining tax shield balance

Estimated depreciation expense - remaining tax shield

Estimated depreciation expense – remaining tax shield (Company, Karreta Advisors)

With the fall in the tax shield, we are witnessing a rise in the effective income tax rate, which is starting to normalize. The Company’s effective tax rate was 23.6% for the quarter ended January 1, 2022 (page 18 under Income Tax), compared to 10.1% for the same period last year. Our thesis was therefore correct.

Current consensus forecasts (see Financial Highlights table above) indicate that Qorvo’s free cash flow outlook is strong, growing 39% year-over-year for FY 3/2023. This doesn’t make sense to us for the following reasons: 1) the consensus expects the effective tax rate to remain at a surprisingly low 9.1% as the January 1, 2022 quarter exceeded double that level, and 2) the recent acquisition of United Silicon Carbide will contribute only $11.5 million to the amortization of its technology, far from offsetting the overall drop in the tax shield. We assume that the consensus forecast once again overestimates the free cash flow estimates.

Next, we examine the strategic rationale for the acquisition of United Silicon Carbide.

Changing focus

With consensus estimating a decelerating sales growth profile, this implies a noticeable slowdown in Qorvo’s core mobile products division in fiscal year 3/2023. We believe that one of the main reasons for this is the intensity of competition. FY3/2022 third quarter results show the company saw its strongest sales growth in the “Other Asia” region (excluding China) of 64% year-over-year; this shows that the main driver of Qorvo’s current demand is cheaper low-end components, highlighting its relative lack of competitiveness for high-end products aimed at the US market. There are also unique challenges with Chinese manufacturers in an effort to source locally. With increasing pressure on discounts as the 5G cycle matures, we believe Qorvo faces limited growth potential.

Expanding the infrastructure and defense products segment makes sense to access less competitive markets for growth. Qorvo’s acquisition of UnitedSic strengthens 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 ) used in greater numbers due to electrification. Applications cover renewable energy generation, electric vehicles and data centers.

The impact on earnings in the short and medium term seems limited due to this small acquisition. The accretive impact on earnings does not appear significant given its purchase price, and addressable market growth will have limits in longer-cycle capital goods.

Overall, we view the acquisition of UnitedSic as neutral.

Evaluation

According to the consensus forecast, stocks are trading on a free cash flow yield of 10.1% for fiscal year 3/2023. This is a very attractive valuation but unfortunately we think the consensus forecast is too bullish. If the market is currently pricing in expectations at this level, we believe stocks are overpriced.

Risks

The upside risk comes from free cash flow generation making a major year-over-year recovery in fiscal year 3/2023. This could be due to very efficient working capital management and limited investments. However, with ongoing supply chain challenges in the industry, we believe working capital requirements are likely to remain at elevated levels.

A change in the shareholder return policy will be positive, given Qorvo’s current stance of not paying a dividend.

The downside risk comes from a continued decline in free cash flow generation given the normalization of the tax rate and increased working capital requirements.

A marked deceleration in organic growth would be negative for the earnings outlook, underscoring Qorvo’s greater reliance on growth through acquisitions to generate a positive growth outlook.

Conclusion

Qorvo shares are down 28% in the past 6 months, but our review 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 slowing growth, makes equities unattractive. We stick to our sell rating.

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