Shares of Sierra Wireless (NASDAQ:SWIR), which makes embedded modules and gateways for M2M (machine-to-machine) communications, have rallied 85% this year. But at its current price, investors are paying a steep premium for Sierra at 65 times earnings, compared to the industry average P/E of 27 for communication equipment companies.

That multiple is also higher than Sierra's projected non-GAAP earnings growth rate of 53% this year. So why are investors paying that premium? Let's take a look at the four most common reasons.

A graphical depiction of cloud connectivity.

Source: Getty.

1. The Internet of Things hype

Sierra is often considered a "pure play" on the Internet of Things (IoT), which connects various devices to each other and the cloud. Consulting firm McKinsey & Co. expects the total size of the IoT market to grow from $900 million in 2015 to $3.7 billion in 2020. During that period, research firm IHS expects the number of IoT devices to surge from 15.4 billion to 30.7 billion.

If the IoT market really grows that quickly, sales of Sierra's M2M modules will likely soar. However, the rising number of hacks and data breaches might convince enterprise and mainstream consumers to think twice before connecting everything to the internet.

Moreover, the growth of many IoT sub-categories -- like wearables, drones, and home automation devices -- remains speculative. If those issues throttle the growth of the IoT market, investors might not be willing to pay a premium for Sierra anymore.

2. Its dominance of the M2M market

Investors also love Sierra because it's the biggest M2M module maker in the world. It controls 33% of that growing market, according to ABI Research. Sierra's closest competitors are Italian wireless equipment vendor Telit Communications and Dutch digital security firm Gemalto -- but neither stock trades on U.S. exchanges.

In the past, the bears claimed that Sierra would cede market share to cheaper M2M module makers in China. However, Sierra scaled up by acquiring a long list of wireless players, including AnyData, Maingate, Mobiquithings, GenX Mobile, and GlobalTop's GNSS assets.

It even bought Qualcomm's (NASDAQ:QCOM) CDMA module business, a deal which tethered it to the mobile chipmaker with a series of supply and licensing agreements. These moves enabled Sierra to boost its market share, scale up, lower production costs, and widen its competitive moat.

3. Its expanding margins

Sierra's inorganic growth helped it expand its gross margin over the past few years. That expansion, coupled with its accelerating sales growth over the past two quarters, convinced many investors that concerns about its Chinese rivals were overblown.

SWIR Gross Profit Margin (TTM) Chart

Source: YCharts

Back in May, Sierra also raised its guidance for the second quarter. It now expects 6%-12% year-over-year revenue growth, compared to analyst expectations for 5% growth.

Sierra expects its non-GAAP earnings to grow 20%-60% for the quarter, which also crushed analyst expectations for 5% growth. Sierra attributes that rosy forecast to gains from GlobalTop's GNSS assets, "solid demand from established customers," and contributions from "new programs and products."

4. The buyout possibilities

With a market cap of less than $900 million, a clean balance sheet, and a dominant position in M2M modules, Sierra seems like a great takeover target for other chipmakers. No serious offers have emerged yet, but I've long thought that Qualcomm would be a natural suitor since it's already expanding its IoT ecosystem with the purchases of CSR and NXP Semiconductors.

Sierra's M2M modules would complement Qualcomm's mobile chipsets, and both chipmakers have growing exposure to the connected car market. However, Qualcomm seems occupied with closing the NXP deal for now, and there are extra regulatory hurdles for an American chipmaker to buy a Canadian company like Sierra.

Should you pay a premium for Sierra Wireless?

I have mixed feelings about Sierra Wireless. On one hand, it's a market-leading play on the IoT market, it has accelerating sales growth and expanding margins, and it looks like a tempting buyout target.

But on the other hand, it's a richly valued stock in a frothy market, and analysts might be too bullish on the IoT market's growth potential. Sierra also stated that its margins would slightly decline in the second half of the year due to lower profits from next-gen automotive platforms -- indicating that the competition could be heating up again.

Therefore, I believe that Sierra could still climb higher over the next few years, but I'm not sure that the risks outweigh the rewards. I'll keep an eye on Sierra, but I won't be buying this stock anytime soon.

 

Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Sierra Wireless. The Motley Fool owns shares of Qualcomm. The Motley Fool recommends NXP Semiconductors. The Motley Fool has a disclosure policy.