How Cypress Semiconductor Overcame a Weak Smartphone Market

Cypress Semiconductor (NASDAQ: CY  ) released its second quarter results last week, beating estimates on the bottom line and meeting them on revenue. For the quarter, Cypress reported earnings of $0.16 per share on revenue of $183.6 million. Analysts had been expecting just $0.12 per share and $184 million in revenue.

Looking past the top and bottom lines, investors will find a few important details in the report. Most notably, Cypress saw weakness in the handset market last quarter, which doesn't bode well for rival Synaptics (NASDAQ: SYNA  ) . Here's how Cypress overcame that headwind, and what investors can expect going forward.

A look at product mix
Cypress Semiconductor is well known for its touchscreens on smartphones, tablets, and now smartwatches, which are part of its programmable systems division. What many investors ignore, however, is the company's automotive and industrial segment, which is in the same division.

Last quarter, the automotive and industrial segment generated more than twice the revenue of the touchscreen business. More importantly, the automotive and industrial segment products carry higher gross margin than Cypress's TrueTouch products.

Management was keen to point out that the slowing in the smartphone market was not due to a lack of design wins, but from lower unit volumes overall. Whether this was just an issue with Cypress's biggest customers or the market as a whole is unclear.

If it's an issue with the market, rival Synaptics will have a hard time meeting earnings expectations considering that it's more heavily reliant on smartphone and tablet sales. Last quarter, the touchscreen maker brought in 74% of revenue from mobile devices.

Booming gross margin
The shift in product mix led to a significant improvement in gross margin at Cypress. The company posted gross margin of 54%. That's 210 basis points above the same period last year and a 370 basis point improvement from the prior quarter.

Management doesn't see that huge improvement lasting through the current quarter, however, as smartphone sales bounce back. The company forecast for gross margin to move back down to 53% next quarter as the product mix shifts back to mobile.

The company's long-term goal for gross margin is 55%, and despite moving in the wrong direction in the third quarter, it may be closer than investors realize. The biggest drag on gross margin is the Emerging Technologies division. In fact, the division currently operates at negative gross margin because it has yet to ramp up production. The good news is that the division is expected to be break even as soon as the first quarter of next year.

With the rest of the company posting a gross margin of 55.8% last quarter and the Emerging Technologies division being so small ($5 million last quarter), 55% is well within reach.

Reducing operating expenditures to boost the bottom line
Improving gross margin is only half of the equation for overcoming the weak smartphone market and demolishing earnings expectations. The other half is Cypress's focus on reducing its operating expenses. Overall, Cypress reduced operating expenses by 14.8% year over year.

One way it's done that is by increasing its direct sales in relation to distribution channels. SG&A expenses declined 12.5% year over year. Reducing OpEx also meant reducing spending on R&D, though, which saw a 16.1% decrease year over year.

Going forward, the company doesn't expect much more reduction in its operating expenses. Instead, it's just a matter of reallocating OpEx dollars to where they'll create the biggest impact.

CEO T.J. Rodgers said on the conference call that he doesn't intend to add anything to R&D or sales until the company hits $200 million in sales per quarter. It may be another year before Cypress starts to invest in making new products faster. In the meantime, investors should expect OpEx to remain flat going forward.

Still hard to find significant upside
Cypress did more than survive a weak consumer electronics environment in the second quarter -- it thrived. Still, revenue growth isn't there and the leverage that OpEx afforded the company is just about depleted. Going forward, Cypress will depend on improving its gross margin for upside. While the Emerging Tech division should stop dragging earnings down starting next year, it's unlikely that Cypress will see significant earnings or revenue growth without sacrificing margin somewhere, especially with its SRAM business continuing to decline.

On the flip side, the company's stock still yields 4% with its dividend. It has also proven quite resilient on several occasions.

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