This Is the Best-Performing Chip Stock. Why It’s Still a Buy

While the semiconductor scarcity has been detrimental to consumers and businesses of all types, it has been a clear benefit to chip investors. Since the start of 2020, chip stocks have increased by 82 percent, considerably outpacing the Nasdaq Composite's 54 percent rise. While well-known chipmakers such as Advanced Micro Devices and Nvidia have garnered the most attention, a lesser-known chipmaker has beaten them all: San Jose, Calif.–based Synaptics.

Originally a low-profile manufacturer of processors for PC touchpads, mobile phone screens, and fingerprint scanners, Synaptics (SYNA) has rebranded itself as an Internet of Things company focused on bridging the physical and digital worlds.

Synaptics currently manufactures details for virtual reality headsets, security cameras, automobile displays, and voice-recognition systems, among other uses. The business got rid of its low-margin display semiconductors for LCD phones and reduced its workforce by around 30%.

The transformation began in August 2019 with the entrance of CEO Michael Hurlston. Synaptics shares have surged 560 percent since then, reaching a recent $212, an average increase of approximately one percentage point every trading day.

In August 2020, when the stock was trading at $80, Barron's published a positive story on Synaptics. Synaptics, on the other hand, has been caught up in the larger tech selloff in recent months, with shares down 28 percent from their December high. The retreat provides an excellent entry time for those who were unable to participate in the first rally.

"Demand is extraordinarily high, and supply is really constrained," Hurlston explains. Synaptics' fiscal year-end sales are expected to increase by 29% to $1.73 billion. And it may have been much better had chip shortages not occurred. According to Hurlston, revenue was held back in the most recent quarter by capacity issues at the company's foundry partners, especially Taiwan Semiconductor Manufacturing (TSM), the world's largest semiconductor maker.

Hurlston explains that prior to the shortages, Synaptics normally began each quarter with around 70% of their demand booked. Now, he adds, the firm has nearly a year's worth of orders in its backlog, with wait times surpassing 12 months for some goods.

Synaptics completed its third significant purchase during the Hurlston period in December, spending $550 million in cash for chipmaker DSP Group. DSP is an abbreviation for "digital signal processing," a semiconductor technology that connects the physical world of sound and visuals to the digital realm—another way of thinking about the Internet of Things, or IoT. DSP Group's portfolio integrated seamlessly with the rest of Synaptics', and the transaction immediately boosted earnings.

Synaptics recently purchased DisplayLink for $444 million under Hurlston, a Palo Alto, Calif.-based firm that controls the market for components used in PC docking stations. Furthermore, the corporation invested $250 million in Broadcom's (AVGO) wireless Internet of Things division, which includes Wi-Fi, Bluetooth, and GPS technology. Hurlston formerly led the company as a senior executive at Broadcom.

Synaptics today generates more than 60% of income from the Internet of Things, with an annual run rate of more than $1 billion. While the firm continues to manufacture components for PCs and smartphones, they are becoming less significant to the story. Only a few years ago, Synaptics produced 80 percent of sales from touch-screen components for handsets—and at one time, Synaptics owed more than half of its income to Apple (AAPL), alarmingly high reliance on a single client.

Synaptics is also becoming increasingly profitable. In the most recent quarter, the company's adjusted gross margin increased to 59.5 percent, up from 46.9 percent just six quarters prior. The business anticipates a tick up to 60% in the March quarter. For the current fiscal year, Wall Street anticipates earnings to climb 57 percent, to about $13 per share, once certain one-time charges are included.

When we last wrote about the stock, Paul Wick, the long-time manager of the Columbia Seligman Technology & Information fund, was optimistic about it, and it remains a top ten position in the fund. Shekhar Pramanick, Wick's colleague who covers chip companies for the fund, believes the business is on track to achieve annual earnings of $15 per share. If a ratio of 20 times earnings is used, which is about in line with the norm for semiconductor stocks, Synaptics shares may rebound to $300.

Susquehanna Financial Group analyst Christopher Rolland recently stated in a note that the company's IoT business gained more than 70% year over year for the sixth straight quarter—and he anticipates a rise above 100% growth in that area in the March quarter, with more increases to follow. He believes the company's 2020 acquisition of Broadcom's wireless IoT business "will serve as a growth engine for years to come, multiplying in size many times over." Barron's talked with Hurlston the day after the business posted better-than-expected quarterly revenue of $421 million, an increase of 18 percent. For the current March quarter, the business anticipates sales of $450 million to $480 million, far higher than Wall Street's previous forecast of $410 million.

The CEO was enraged by investors' lack of interest in the report. "We achieved record gross margin and earnings per share, yet the stock is flat," he says.

That is unlikely to continue.