Summary
I previously gave Cohu (NASDAQ:COHU) stock a buy rating given the robust demand and higher mature gross margin. However, I am now downgrading to hold as valuation is now at 18x NTM PE which is 1 standard deviation above COHU historical average. Note that this downgrade is purely on a valuation basis as I am not a fan of multiple compression risk. However, the company’s performance is promising. Management’s tone on 2H23 was also encouraging, with comments essentially aligned with what they had provided three months ago, and gross margin continues to track forecasts, with improvement to 48%. Importantly, COHU keeps racking up design wins, especially in the contactor industry, and making strides toward better contactor profitability thanks to a manufacturing ramp in the Philippines. However, given the stock’s 10+% gain since my last report and its consequently high valuation, I advise scaling back existing holdings. The cyclical nature of the Automotive and Industrial end-markets is still a threat to which COHU is vulnerable.
Growth supported by new capacity
Management’s emphasis on COHU’s having manufactured 80% of its contactors in Asia by 1Q23 is encouraging, as it shows that growth in contactors continues to underpin expansion elsewhere in the business. The new building will be completely operational by the middle of 2024, and its extra 20% capacity will be able to handle contactors with annual sales of around $200 million. To give perspective, the $200 million annual revenue is around 25% of 1Q23 LTM revenue. As COHU increases its utilization of this new capacity, I anticipate a corresponding improvement in gross margin expansion. This ought to aid in keeping the gross margin up around the 40% mark. In my perspective, the primary gross margin drivers of the future will be the scaling of capacity and the persistent focus of in-sourcing contactors.
Weakness in certain verticals
I think the biggest concern investors have today is the weakness that COHU will see in the Automotive and Industrial end-markets. The normalization of production of devices that had been in short supply due to difficulties in the supply chain raises this legitimate fear that the demand environment in Automotive and Industrial may soften or drop in the coming quarters. Such examples are microcontrollers and analog semiconductors. Indeed, Microchip MCHP, another major participant in the market, has reported an increase in push-out requests from clients, which suggests to me that demand is slowing. Customers who were previously in a rush to stock up on goods are now taking their time. MCHP management also revised their CAPEX plans in order to align with this demand environment. However, COHU management has taken note that handler lead-times continue to be prolonged at over 22 weeks, which is well over the 15-week target set for the medium term. On one hand, longer lead times improve visibility in demand; on the other, they motivate customers to place orders in excess of actual demand. Therefore, it does not provide a reliable depiction of true demand. The best course of action here, in my opinion, is to wait for more proof that trends have steadied, as I do not believe it is practically viable for investors to access the uncertainties and risk here.
Valuation
COHU valuation is no longer cheap, like when I wrote about it previously. In my previous post, the stock traded at 15x NTM earnings which is its average, right now, it is at 18x NTM earnings. Historically, COHU has never sustained valuation at these levels for more than a quarter except during covid periods. Which means there is a very high chance that COHU will face a compression in multiples. Interesting, every multiples compression will dip below the average line before recovering, this translates to around 40% downside (from 18x to 10x earnings).
Conclusion
While COHU shows promising performance and growth potential, I am downgrading my rating to hold due to its high valuation at 18x NTM PE, above historical averages. The company’s focus on expanding capacity and in-sourcing contactors is encouraging, but weakness in the Automotive and Industrial end-markets raises concerns about future demand. Additionally, COHU’s current valuation suggests a potential for multiple compression, which could result in a significant downside. Therefore, I recommend scaling back existing holdings and monitoring the situation closely.
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