Semtech Stock: A Challenging Task To Recover From Its Self-Inflicted Wound (NASDAQ:SMTC)

Investment Thesis

Before 2023, Semtech Corporation (NASDAQ:SMTC) performed reasonably with an average of 10% ROIC and 8% ROE from 2015 to 2022. All this changed with the USD 1.3 billion Sierra Wireless acquisition in 2023.

In 2024, the company had to write off almost USD 890 million of goodwill and assets, mainly related to this acquisition. There was also a reduction of its gross profit margins from an average of 63% for 2021 to 2023 to 49% in 2024. These resulted in a significant loss.

The company is undergoing a turnaround. I identified 2 paths for this, but both resulted in intrinsic values substantially lower than the current market price. This is not an investment opportunity.

Background

The company is a “leading supplier of analog and mixed-signal semiconductor products”. Most of these products are sold to the infrastructure, high-end consumer, and industrial end markets.

Semtech end-customers are “primarily original equipment manufacturers and their suppliers such as Cisco, Huawei, LG Electronics, Apple and Amazon”. As can be seen from Chart 1, the bulk of Semtech’s net sales came from the Asia Pacific region.

Unfortunately, I could not track the trends for the segments’ revenue. This was because the company differentiated between operating segments and reporting segments. Furthermore, there appears to be regular restructuring of operating and reporting segments:

• In 2015 there were 4 operating segments. 3 of them were aggregated and reported under the Semiconductor Products Group, while the other was reported under the “All others” category.
• In 2016 there were 5 operating segments. 4 of them were aggregated and reported under the Semiconductor Products Group.
• Following a divestment, there were 4 operating segments in 2017 under the Semiconductor Products Group.
• From 2019 to 2021, there were 3 operating segments that came under one reporting segment.
• In 2023, there were 4 operating segments with their reporting segments.

You can understand why it is difficult to track the segment trends. More disconcerting is that the frequent changes in the operating and reporting segments reflect frequent changes in market focus, divestments, and possibly shifts in company direction. It makes you wonder whether the company has a consistent long-term operating strategy.

Operating trends

When I tracked the performance over the past decade, I found that there was a deep performance dip in 2024.

Note: Semtech had its financial year-end on Jan. In my article, unless stated otherwise, the years refer to the financial years.

If you look at the left part of Chart 2, you can see that from 2015 to 2022, there seem to be some improving trends (albeit with some volatility) for the various metrics. But the profits in 2024 seemed to have fallen to a cliff, even though there was revenue growth. There were 2 main reasons for this:

• The average gross profit margin was 63% for 2021 to 2023, but it deteriorated to 49% in 2024. Refer to the right part of Chart 2. The company attributed this to “an unfavorable product mix driven by lower sales.”
• There was a write-off for goodwill of USD 756 million and asset write-down of USD 133 million. According to the company, the goodwill impairment was “primarily due to reduced earnings forecasts associated with the business acquired from Sierra Wireless and current macroeconomic conditions.”

Sierra Wireless was a USD 1.3 billion acquisition completed in 2023. About ¾ of this was for goodwill. In its 2023 Form 10k, the company stated that:

“…the acquisition… brought together the ultra-low power benefits of LoRa® with higher bandwidth capabilities of cellular to create a new Internet of things (“IoT”) Cloud-to-Chip system leader.”

“Sierra Wireless acquisition will result in certain benefits, including certain operational synergies and cost efficiencies, and drive product innovations…achieving these anticipated benefits will depend on successfully combining our and Sierra Wireless’ businesses…”

Sierra Wireless was the biggest M&A exercise undertaken by the company over the past decade. For management to have to write off more than half of the acquisition price within a year implies poor due diligence and/or acquisition assessment.

To give you some perspective, the goodwill written-off is more than the total PBT excluding unusual items achieved by the company from 2015 to 2023.

More troubling is that it is not clear how much of the reduction in the 2024 gross profit margin was due to the merger of the legacy business with that of Sierra Wireless. The troubling point was that:

• For the first half of FYE 2025, the gross profit margin remained low at about 50%.
• In its Q2 2025 presentation, there was not much change to the gross profit margin projected for the Q3 FYE 2025 gross profit margin.

Management does not seem to have explained this in either the 2024 Form 10k or the Q2 2025 investors’ presentation. As an investor, I would be interested to know whether this is a one-off blip that the company can recover from or whether there is some fundamental issue like changes in the product structure.

Turnaround

For the first half of FYE 2025, the company revenue declined by 11%. While there was a small operating profit compared to a loss for the same period FYE 2024, the company incurred a net loss. This was due to a USD 145 million “loss on extinguishment of debt.”

To get a better understanding of the key drivers, I modelled the operations as shown in the left part of Chart 3. In the chart, the gap between revenue and total costs (fixed + variable) represents the operating profit.

• Revenue and contribution margin for 2025 remained about the same as those for 2024.
• The fixed cost in 2025 had reduced compared to that for 2024 due to the reduction in Depreciation & Amortization. But it was still higher than those from 2015 to 2023.
• Operating profit margin for FYE 2025 was 7% compared to the average of 13% from 2015 to 2023.

It is obvious that to get back to the 13% operating profit margin, the company has to improve the contribution margin. There are 2 options for the company:

• Cut loss. Assuming that the drop in margin was due to the Sierra Wireless acquisition, the company could divest the business and revert to the previous product structure.
• Rebuild. If the loss in margin was due to the poor integration of the Sierra Wireless operations, the company could address this through cost reduction and/or other productivity improvement programmes.

If you look at the 2015 to 2023 performance, you can see that the contribution margin and fixed costs have been “stable” notwithstanding the increase in revenue. Refer to the left part of Chart 3. Thus, both options do not look impossible. There is a path back to profitability.

The other positive point is that the company seemed to be recovering its capital efficiency. Refer to the right part of Chart 3. This was technically an “accounting fix” as the assets and capital employed in 2024 were reduced significantly when the goodwill was written off.

Notes to Chart 3:

1) Op Profit Profile. I broke down the operating profits into fixed costs and variable costs.

• Fixed cost = SGA, Depreciation & Amortization and Others.
• Variable cost = Cost of Sales – Depreciation & Amortization.
• Contribution = Revenue – Variable Cost.
• Contribution margin = Contribution/Revenue.

2) The 2025 performance was projected based on the 1H FYE 2025 results for the costs. The 2025 revenue was based on the 1H FYE 2025 plus the Q3 FYE 2025 guidance provided by the company.

Valuation

In valuing Semtech, I considered the 2 turnaround paths. For both cases, I assumed the following:

• The base revenue would be the 2024 revenue growing at 4% CAGR in perpetuity.
• The company could get back the pre-2024 margin and capital efficiency and reduce the fixed costs to the pre-2024 levels.
• Scenario 1 – cut loss. I assumed that this would be undertaken immediately and that Sierra Wireless could be divested without any loss given the goodwill impairment and asset write-off.
• Scenario 2 – rebuild. I assumed that it would take 5 years for the company to get back to the pre-2024 performance from the margin and capital efficiency perspective.

Under Scenario 1, I obtained an intrinsic value of USD 27 per share. For Scenario 2, I obtained an intrinsic value of USD 24 per share. The market price of Semtech as of 10 Sep 2024 was USD 39 per share. The market has overpriced the company.

Valuation model – Scenario 1

I used a single-stage Free Cash Flow to the Firm (FCFF) model where the EBIT was determined based on the following:

FCFF = EBIT(1 – t) X (1 – Reinvestment rate) X (1 + g) / (WACC – g).

EBIT = Revenue X Contribution margin – Fixed cost. This was based on the operating model as shown in the left part of Chart 3.

Contribution margin and capital turnover were based on the average 2015 to 2022 values.

The reinvestment rate was derived from the fundamental growth equation of g = Return X Reinvestment rate.

Value of equity = Value of firm + Cash + Other investments – Debt – Minority interests + excess Total capital employed.

Table 1 illustrates the calculation for Scenario 1.

The WACC was determined from the first page results of a Google search for “Semtech WACC” as illustrated in Table 2.

Valuation model – Scenario 2.

This was based on a multi-stage growth model as shown in Table 3. The key assumptions used are stated in the accompanying notes.

Notes to Table 3:

a) Perpetual growth rate.

b) Starting revenue based on 2024 revenue. Pegged to growth rate.

c) Starting based on 2024 rate and improved to average 2015 to 2022 rate.

d) Starting based on the 2015 to 2022 average cost. Assumed growth at terminal rate.

e) Revenue X Net Margin and after accounting for Fixed costs.

f) Starting based on 2024 rate and improved to average 2015 to 2022 rate.

g) Revenue X (Revenue/TCE) ratio. TCE = total capital employed.

h) Based on growth equation.

i) FCFF for each year = e X (1-h).

j) Assumed constant D/E ratio. Refer to WACC table.

k) NPV for each year = (i X j).

l) Terminal for the year discounted at 4% growth rate.

m) 5 years NPV + terminal value.

n) Inclusive of any excess TCE. Non-operating assets, MI, and Debt were based on Jul 2024.

o) Based on Jul 2024 number of shares.

Risks and limitations

There are several issues to consider when looking at my valuation:

• Financial position.
• Tax loss.
• Fixed costs.
• No loss from divestment of Sierra Wireless under Scenario 1

The 2024 performance has put Semtech in a challenging financial position.

• As of Jul 2024, it had negative equity.
• It has a Debt Capital ratio of 113% as of Jul 2024. The company had USD 1.2 billion in total debts.
• For the first 6 months of FYE 2025, the company generated a negative cash flow from operations.

I assumed that if the company can show that it is turning around, it would be able to re-finance and/or restructure its loans. As such I did not consider the dire financial position in my valuation.

Secondly, the company would have about USD 1 billion in losses that could reduce its taxes for several years. I have not considered this. Assuming that it is spread over 10 years, this could be equal to about USD 7 to USD 10 per share in present value terms. Even if I accounted for this, there would still not be a margin of safety under both Scenarios.

I have taken an optimistic picture that the company would be able to reduce its fixed cost to the pre-2024 level. In my valuation I have assumed this to be USD 327 million for the base year compared to the 2025 projected fixed cost of USD 441 million. Despite this optimistic view, there is no margin of safety.

Finally, in my Scenario 1 valuation, I assumed that given the massive goodwill write-off, Sierra Wireless could be divested without any further loss to the company. Any loss would reduce the intrinsic value under Scenario 1.

Conclusion

Before the Sierra Wireless acquisition, the company did reasonably well. From 2015 to 2022, it delivered an average ROIC of 10% and an average ROE of 8%.

The company only got into trouble following the Sierra Wireless acquisition in 2023 for USD 1.3 billion. In 2024:

• It had to write off goodwill of USD 756 million.
• Its gross profit margin declined to 49% compared to the average gross profit margin of 63% for 2021 to 2023.

The company is undergoing a turnaround and I have suggested 2 paths to return to profitability. Based on these paths, I found that the intrinsic values are very much below the current market price.

Given this and the current weak financial position, I would avoid this stock.