Skyworks Has Bright Prospects on the Horizon

Revenue in the September quarter was $1.01 billion, up 13% sequentially and 2% year over year. Sales were ahead of Street estimates and at the high end of the company's prior guidance. For the December quarter, Skyworks expects flattish revenue, which would represent a 4% year-over-year decline, again attributed to soft unit demand for the iPhone and smartphones sold in China. The company hinted at another year-over-year decline in the March quarter with typical seasonal weakness, but it anticipates a return to year-over-year growth in the second half of fiscal 2019, delivering full-year growth despite a slow start. Although these fiscal 2019 expectations are below our prior estimates, we remain bullish on Skyworks' content gains and pricing power on 5G RF content in the years ahead.

In the September quarter, broad-market chip sales rose 10%-plus on a year-over-year basis, thanks to rising connectivity in nonsmartphone applications and Internet of Things devices. Higher sales levels enabled adjusted gross margins to rise 30 basis points sequentially to 51.2%. Skyworks also fared well on the operating expense front as adjusted operating margins rose 130 basis points sequentially to 37.6%.

Skyworks incorporates BAW filters into its integrated products today, but outsources them from discrete filter manufacturers. Its newfound BAW capabilities are likely to reduce the importance of its BAW partnerships over time, although the shift won't be sudden as the company won't rip out the third-party BAW filters used in existing products. We note that Skyworks partnered with discrete surface acoustic wave manufacturers for many years before acquiring Panasonic's SAW filter business and focusing on temperature-controlled SAW products. Skyworks now outsources only a minority of its SAW filter needs while building the rest in house, and it is likely to use even more in-house temperature-controlled SAW filters over time.

RF Expertise Is Competitive Advantage We believe Skyworks has a narrow economic moat based on intangible assets around the design, manufacturing, and packaging of a variety of nonsilicon radio frequency products, including SAW filters, power amplifiers, and integrated front-end modules used in many 4G-enabled smartphones.

RF leaders like Skyworks have years, if not decades, of RF expertise, both in design and, perhaps more important, in chip manufacturing, packaging, and testing, which we view as especially valuable since most RF products are based on more specialized materials, rather than the traditional silicon used in most digital processors. Skyworks' ability to integrate a variety of RF parts into a single package, like its SkyOne suite of products, has been difficult for many others to replicate, and the company has reaped the rewards with healthy profitability and earnings growth.

As wireless networks upgrade to 5G technologies, RF designs should only grow in complexity, making RF leaders even more valuable suppliers into smartphones and other device makers than they are today. We believe this complexity in 4G today and 5G tomorrow enables a company like Skyworks to benefit from its integration capabilities, packing more and more content into its devices. In turn, the value added by this integration should help the company fend off pricing pressure.

We think that Skyworks has some stickier design wins in a host of nonsmartphone applications. The company is a leading RF supplier into a wider array of other industries, such as industrial, medical, and networking and wireless infrastructure equipment. In these industries, Skyworks appears to be profiting from longer product life cycles and steadier pricing as a result of fewer volume discounts.

A constant concern in the RF industry is the threat of pricing pressure, as Skyworks and others rely on a handful of smartphone leaders for the bulk of their revenue. Similarly, product life cycles in the smartphone industry are exceptionally short, so hard-fought design wins one year might not translate to a steady revenue stream in the long term. These dynamics prevent us from assigning a wide economic moat rating to Skyworks or other RF players.

To that end, we are modestly concerned about the customer concentration with Apple, which made up 39% of Skyworks' revenue in fiscal 2017. While business with Apple remains strong and is still a large chunk of revenue, we estimate that it is still more likely than not that Skyworks could earn excess returns on capital over the next decade even if it were to lose all of its business with Apple over the next couple of years (although we don't see this doomsday scenario playing out).

Nonetheless, Skyworks' supplier relationship with Apple appears secure, if not strengthening, to us. We doubt that Apple or others would run the risk of poor connectivity within its smartphones just to save a few pennies on a lesser filter, or by taking a chance on a startup without the size and scale to manufacture and supply hundreds of millions of filters for its marquee device launch.

We think Skyworks' sustainable competitive advantage lies in its expertise in RF integration, design, packaging, and other RF parts like power amplifiers. Ultimately, we view Skyworks as one of a small number of companies that can supply the necessary volume of increasingly valuable RF parts to smartphone makers, all while generating excess returns on capital over the next decade.