NXP Semiconductors Indicates the Chip Industry Is Still Very Healthy

The stock market is in a bear market in 2022. With investors increasingly worried about a recession, cyclical manufacturing companies have been punished. Chips are building blocks of tech, but they are manufactured products, so many of these companies' stocks have taken a sizable hit.

Automotive chip designer and manufacturer NXP Semiconductors (NXPI 4.18%) hasn't been spared. Shares are down 22% so far this year. But the company's second-quarter earnings update and outlook paint a very different picture than what the market is saying.

Chip fabs are still scrambling to keep up with demand

First, an update on NXP's Q2 earnings. In a nutshell, they were very good as the company's fabrication facilities churn out chips to circuitry-hungry customers.

Data source: NXP Semiconductors. YOY = year-over-year. pp = percentage points.  

Despite the strong growth figures, NXP's customer demand for new chips is still reportedly higher than the company's ability to produce. NXP is nonetheless making incremental improvements in production from its fabs. As has been the case for the last year or two during the present chip shortage, the automotive industry is particularly behind the curve in obtaining the semiconductors it needs. The modern auto needs a lot more silicon than ever before, and consumers are buying up cars and trucks quicker than they can be pulled onto the lot.  

Something similar is going on in industrial Internet of Things (IoT), where industrial equipment and other hardware is being hooked up to a mobile network to infuse it with greater "intelligence." This is all particularly good news for NXP, since the automotive industry and industrial IoT are its two largest end-markets. Autos make up about half of NXP's revenue, and IoT about 22%.

So why the gloomy mood on Wall Street? As with all things manufacturing, chips are cyclical. Skyrocketing demand this year could give way to stagnating growth -- or even decline -- next year. NXP itself acknowledges this, saying it's experiencing "waves" of growth during its Q2 earnings presentation. Spending on consumer electronics (which NXP has minimal exposure to at this point, with revenue from mobile accounting for just 13% of revenue) already seems to have hit the skids and is headed for a cool off in the second half of this year. Industrial markets could be next as we get closer to 2023, or at least that's the fear among some investors.

A long ramp-up for auto and industrial tech lies ahead

Let's assume the current market sentiment is correct and NXP and other chip stocks with outsized exposure to enterprise and industrial spending are headed for a big slowdown next year. NXP itself has some of this expectation baked into its own forecasts. Based on the outlook through 2024, management expects average annual revenue growth in the 8% to 12% range. That's far lower than the figure posted in Q2, lower than even the Q3 2022 outlook for 17% to 22% year-over-year revenue growth.

Indeed, at some point NXP will catch up with customer demand and sales growth will normalize. That being said, the nearly three-quarters of total sales coming from autos and IoT are expected to expand well above the average, at a 9% to 14% rate over the next few years. And along the way, NXP expects to maintain its high adjusted operating profit margins of between 32% and 36%.

In other words, I think the market is underestimating NXP's potential (and other chip stocks' potential, for that matter). After the recent update, NXP shares trade for 22 times trailing-12-month free cash flow, but only 12.4 times 2024 expected free cash flow. This valuation assumes NXP grows at the midpoint of revenue guidance from 2021 to 2024 at an average 10% per year, and generates an expected free cash flow margin of 25% at that time.

If you're looking for a gradual growth story and some dividend income along the way, NXP deserves some attention. Either way, NXP's earnings update paints a rosy outlook for chip stocks over the next few years. After the market has sent top semiconductor businesses to the doghouse in the first half of 2022, now looks like the time to start accumulating shares.