Cypress Semiconductor (CY +0.00%) rallied 36% this year, which trailed the Philadelphia Semiconductor Index's 41% gain but beat the NASDAQ's 30% return. But looking further ahead, where will Cypress head over the next five years? Let's examine several of its long-term catalysts to decide.
Cypress 3.0
Cypress, through its "Cypress 3.0" initiative, wants to become a "one-stop embedded solutions provider" for the IoT (Internet of Things) market. It expanded heavily into that market via its acquisition of Broadcom's (AVGO +0.52%) wireless IoT business last year.
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That purchase added Broadcom's Wi-Fi, Bluetooth and Zigbee IoT product lines, its WICED brand and developer community, and all of its related intellectual property to Cypress' own analog and memory chips. Cypress is selling those bundles to a wide range of customers across the automotive, industrial, and consumer markets.
Cypress also expects its content share in those markets to rise. For example, BMW's 7 Series contained $23 worth of Cypress chips in 2010. In the 2016 model, that figure had more than tripled to $79.
Cypress expects the growth of these markets to significantly outpace the 3%-4% compound annual growth rate of the overall semiconductor industry from 2016 to 2021. Cypress isn't the only company which is bullish on the IoT market -- networking giant Cisco expects the number of connected devices worldwide to double from 25 billion in 2015 to 50 billion in 2020.
More acquisitions... or a potential takeover
Cypress already expanded significantly with its merger with Spansion in 2015 and its acquisition of Broadcom's IoT business. However, Cypress might acquire other smaller players in the analog, embedded, and wireless markets to expand its Cypress 3.0 strategy.
With an enterprise value of $6 billion, Cypress also remains a lucrative buyout target for bigger chipmakers or companies. Last year, multiple reports indicated that the Chinese firm Summitville Capital, TPG Capital, and other firms wanted to buy Cypress.
However, Cypress reportedly rejected those offers. Therefore, Cypress could either keep expanding inorganically or be absorbed by a larger company over the next five years.
The rising adoption of USB-C
Another major growth opportunity for Cypress is the USB-C standard. Cypress is a leading manufacturer of USB-C charging platforms, but the adoption rate remains slow across the personal computing and mobile industries.
For now, the use of USB-C remains restricted to higher-end devices from companies like Apple, Samsung, and Alphabet's Google. But over the next few years, other companies will likely adopt USB-C as the all-in-one standard for fast charging and data transfers.
Cypress' USB-C revenues only accounted for less than 5% of its top line last quarter, but that percentage will likely rise to become a major revenue stream for the chipmaker.
Expanding gross margins
Over the past two years, Cypress pivoted its memory business away from lower-margin commoditized markets toward higher-end markets. These "sticky" markets, according to CEO Hassane El-Khoury, have more customers who "value quality, reliability, and longevity" above cheaper prices.
As a result, Cypress' gross margin of 43% during the third quarter (up from 40.5% a year earlier) actually met the company's target one quarter ahead of schedule. Cypress attributes that margin expansion to several big moves.
First, it increased its utilization of Fab 25, which it acquired via the Spansion merger, from the low-50% range in early 2016 to 78% last quarter. Boosting its utilization at Fab 25 lowers its wafer costs by 15% to 20%. It also divested its Minnesota Fab to cut costs, shifted toward higher-margin products and end markets, rebalanced pricing across its portfolio, and capitalized on favorable pricing trends in flash memory.
It focused on the "higher density and more predictable" segments of the NOR and NAND flash markets, which are less commoditized, and shifted its customers toward longer-term pricing contracts to offset volatile market prices.
Cypress expects its gross margin to dip slightly to "roughly 40%" during the current quarter on "seasonal declines, product mix and the roll-off of the $6.25 million pre-merger licensing revenue," but that dip will be partly offset by higher utilization rates. The company also noted that it was still on track to hit its gross margin target of 47.9% by the end of 2018.
Therefore, Cypress' earnings growth should improve on these long-term trends over the next few years. Analysts expect the company's earnings to grow 76% this year and 38% next year, which are impressive growth rates for a stock that trades at just 13 times forward earnings.
The key takeaways
Cypress is a unique chipmaker with plenty of irons in the fire, a low valuation, and a forward dividend yield of 2.9%. That's why I recently started a position in the stock, and why I believe investors could be well-rewarded over the next five years as its growth catalysts kick in.
