Infineon Remains a Powerhouse

Infineon Technologies IFNNY/IFX is a leading broad-based European chipmaker with nice exposure to secular growth drivers in the industrial and automotive chip sectors. However, like most chipmakers, its business remains highly cyclical as demand ebbs and flows in line with the health of its various end markets.

Looking at the automotive chip market, vehicles with advanced powertrain technology and safety systems require a variety of sensors and power management chips supplied by companies like Infineon. Similarly, the company’s exposure to power management circuits positions it to benefit from trends in the electronics industry toward power conservation, not only in more efficient devices like industrial drives, but also in green energy solutions like solar panels. Infineon is also a leader in chip card and security products, such as chips for chip-and-pin credit cards. We think limiting exposure to challenging markets is just as important as increasing exposure to promising markets, and Infineon has done a good job of eliminating unattractive business segments in recent years, such as its spin-off of its wireless baseband chip business to Intel.

Despite the recent changes, Infineon’s product lines still face formidable competition. Many other large semiconductor companies also focus on power semiconductors and have similar products. Further, Infineon focuses on discrete power products rather than analog power management integrated circuits. While the former products are valuable to customers, the latter of which we view as more complex products that allow leading analog companies (such as several wide-moat names we cover) to enjoy stronger pricing power and relatively higher returns on invested capital. Infineon also has hefty manufacturing capacity for its products, which may lead to a higher fixed-cost structure and may cause significant margin compression when supply far exceeds demand.

We are generally in favor of Infineon’s recent bid to acquire Cypress Semiconductor CY in a EUR 9 billion deal (as measured by enterprise value). We don’t view the deal as value-destructive, as the strategic rationale makes sense for Infineon to strive to cross-sell its automotive products with Cypress’ solutions. Infineon remains quite strong in semis used in the power train and active safety systems of the car with close ties to the European automotive supply chain, while Cypress’ emerging automotive chip business is targeted at the infotainment system (where Infineon has no presence) and to Japanese car original-equipment manufacturers (thanks to Cypress’ ownership of Fujitsu’s microcontroller products).

One of the Largest Chipmakers in Europe We assign Infineon a narrow economic moat, as we think it is more likely than not that the company will be able to earn excess returns on capital over the next decade. We think the company's automotive chip business (which was over 40% of revenue and 30% of EBIT in fiscal 2018) benefits from intangible assets around proprietary chip designs as well as high switching costs once its products are designed into automotive programs. We believe that the company's power chip business (almost 50% of revenue between industrial and power management products and excluding the portion of power semis also in automotive) also benefits from intangible assets around design expertise for high-voltage products. We see the power business benefiting from a cost advantage, as size and scale give Infineon a leg up over other entrants and enable the company to spread its research and development over a large enough customer base and broad enough product portfolio to generate excess returns on capital over time.

Infineon is one of the largest chipmakers in Europe, selling thousands of products to tens of thousands of customers, especially into the industrial and automotive end markets. In power, the company specializes in discrete power semiconductors like insulated-gate bipolar transistors and metal-oxide-semiconductor field-effect transistors. These essentially act as a switch to turn electric signals on and off. We view these power products as commoditylike in nature, but note that Infineon has particular expertise in high-voltage power applications, which we think is harder to do and allows the company to extract a modest pricing premium from customers. Outside of power, Infineon’s largest end market is the automotive sector, where the company sells power products as well as sensors and microcontrollers.

Among broad-based chipmakers like Infineon, we tend to find moats across two sources: intangible assets and customer switching costs. Intangible assets stem from decades of chip design and manufacturing expertise across a broad portfolio of products. Typically, we see wider moats among pure-play analog chipmakers, as development of these products is as much an art as a science, while precision and accuracy in capturing real world signals and regulating voltage is valued by customers. Wide-moat U.S.-based analog leaders like Texas Instruments TXN and Analog Devices ADI earn well over 60% gross margins and 30%-plus operating margins and enjoy healthy excess returns on capital.

Infineon has limited analog expertise and has relatively greater exposure to more commoditylike power products, which we think is evidenced by its gross margins in the high 30s rather than the 60s seen in high-performance analog. That said, we do believe that the company has proprietary design and manufacturing expertise in power products. Furthermore, automotive semiconductors have stringent quality requirements, so Infineon’s expertise in automotive chip manufacturing would be difficult for newcomers to replicate.

Broad-based chipmakers tend to benefit from customer switching costs. Analog and power semis tend to make up only a small portion of a product’s bill of materials, so purchasing decisions tend to be based on performance rather than price, helping companies to retain pricing power. Automotive, industrial, and communications infrastructure customers, in particular, are unlikely to choose an inferior chip in order to save $0.20 on the cost of a piece of equipment worth tens of thousands of dollars. Thus, once an electronics device maker selects an analog or power chip, it tends to stick with it for the life of the device. Chipmakers prosper even more when they have greater exposure to products and industries where product lives are measured in decades (cars, heavy machinery, and so on) rather than years (smartphones, PCs). We believe that Infineon benefits from such switching costs in both automotive and power products.

Intangible assets and customer switching costs enable companies like Infineon to benefit from long useful lives associated with certain chip products, which leads to lower ongoing R&D and capital expenditures. In turn, these companies are able to generate attractive excess returns on capital. We foresee Infineon’s mid- to high-teens adjusted operating margins and mid-teens returns on capital as sustainable, more likely than not, over the next decade.

Finally, as a leader in power products with 3 times the market share of its next-closest competitor, Infineon benefits from a cost advantage in power semiconductors, in our view. A startup would need to invest in a multi-billion-dollar fab and hundreds of millions of dollars in R&D to build a power product lineup comparable with Infineon’s, and would it then have to find tens of thousands of customers to consume such products. All the while, prices of transistors can be as low as a few cents, so any upstart or challenger would struggle to undercut Infineon on price while still generating an adequate return on investment. This last point is probably why a company with significant excess capacity, like Texas Instruments, is likely to stay out of this market. Instead, startups and other chipmakers would find a quicker return on investment in other types of digital products like processors or networking chips. We continue to see consolidation and fab closures throughout the industry, making it less likely that hefty investments will be made in the power semiconductor arena.

Chip Industry Is Cyclical Given the cyclical nature of the chip industry, our fair value uncertainty rating for Infineon is high. Infineon's biggest risk is exposure to the cyclical chip industry. Most of Infineon's chip manufacturing is performed in-house, and when the company has excess manufacturing capacity or chip demand fails to live up to expectations, it is on the hook for the high fixed costs associated with running these facilities. After its recent spin-offs, Infineon is now more closely tied to the health of the automotive industry, and weakness in this end market could spell trouble for the company. Infineon also has significant exposure to customers in Europe, which may provide headwinds if the region's economic turmoil continues. Finally, the analog industry is increasingly fragmented and specialized, and the company faces stout competition from large, diversified chipmakers such as NXP NXPI and Texas Instruments.