NXP Semiconductors (NXPI 2.04%), a Dutch-American chipmaker that produces a wide range of automotive, secure identification, and digital networking chips, struggled this year as the COVID-19 crisis disrupted many of its core markets.

However, its stock still advanced about 30% over the past 12 months as investors looked toward its post-pandemic recovery. With NXP set to report its third-quarter numbers on Oct. 26, should investors share that optimism or stay more skeptical?

Chips being manufactured on a wafer.

Image source: Getty Images.

Understanding NXP's core business

NXP's takeover of Freescale in 2015 turned it into the world's largest producer of automotive chips. Qualcomm (QCOM 1.29%) agreed to buy NXP in 2016, but the deal collapsed due to resistance from NXP's investors and Chinese regulators.

NXP generated 47% of its revenue from automotive chips last year. Another 21% came from its communications infrastructure chips, 18% came from its industrial and Internet of Things (IoT) chips, and 13% came from its mobile chips.

NXP traditionally manufactures most of its chips with its own foundry, but it's outsourced some of that production to Taiwan Semiconductor Manufacturing (TSM 1.54%), the world's top contract chipmaker, in recent years.

NXP operates a joint venture fab with Taiwan Semiconductor in Singapore, and it's using Taiwan Semiconductor's 5nm process for its newest automotive chips. That relationship should help NXP meet the growing secular demand for its chips without overwhelming the capacity of its own plants.

How fast is NXP growing?

The COVID-19 crisis disrupted orders from many of NXP's top customers, but its automotive business suffered the most as automakers stopped producing new vehicles.

Its communication infrastructure revenue declined as carriers postponed their network upgrades, and its mobile revenue fell as smartphone sales slipped and the unit divested its voice and audio chip businesses. Those declines offset the growth of its industrial and IoT businesses.

Robotic arms in an assembly line.

Image source: Getty Images.

Aa s result, NXP's total revenue declined 11% year-over-year in the first half of the year, and it posted a net loss, compared to a slim profit a year ago. Its adjusted EBITDA declined 20%.

NXP's preliminary third-quarter results, which were released on Oct. 8, show its revenue stayed flat year over year and rose 25% sequentially. That rebound easily surpasses the midpoint of its prior guidance for a 12% year-over-year decline and 10% sequential growth.

NXP expects its gross and operating margins to expand sequentially (by both GAAP and non-GAAP measures), exceeding its prior expectations, and for its GAAP operating margin to turn positive again. NXP CEO Kurt Sievers attributed that acceleration to a "material improvement in demand across all end markets," with robust growth in the automotive and mobile markets.

NXP hinted at that recovery during the second-quarter conference call in July, since many automakers were coming back online and sales of 5G phones were expected to accelerate in the second half of the year. However, NXP's preliminary results indicate the worst is over and growth has stabilized again.

The valuations and dividends

Analysts currently expect NXP's revenue and earnings to decline 7% and 29%, respectively, for the full year. However, those estimates don't fully reflect NXP's rosy preliminary numbers for the third quarter, and will likely be raised after it posts its full earnings report.

Looking further ahead, Wall Street expects NXP's revenue and earnings to rise 13% and 36%, respectively, next year as its core markets warm up again. Those stable growth rates indicate the stock is reasonably valued at 19 times forward earnings.

By comparison, Texas Instruments (TXN 0.94%), which sells chips to many of the same industries as NXP, trades at 26 times forward earnings. TI's earnings are expected to dip 1% this year and grow 5% next year.

However, NXP's forward dividend yield of 1.1% is significantly lower than Texas Instruments' 2.7% yield and probably won't attract any serious income investors.

The verdict

NXP struggled in the first half of the year, but it will profit from several secular tailwinds. The auto market will require more chips per connected vehicle; the 5G market will boost its chip sales to both wireless carriers and handset makers; and the industrial and IoT markets will continue to expand as companies automate more tasks and accumulate more data.

Those catalysts, along with NXP's reasonable valuation, make it a compelling buy ahead of its third-quarter earnings.