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Don't Invest in Cypress Semiconductor Before Understanding These 3 Risks

Ashraf Eassa, The Motley Fool

Cypress Semiconductor (NASDAQ: CY) pitches itself these days as a maker of chips for two broad segments: automotive and the Internet of Things (IoT). At its recent analyst day, the company outlined its ambition to grow revenue at a sustained 7% to 9% rate, driven by strong growth in those two aforementioned markets but being partially offset by a decline in its so-called "legacy" product lines.

While the long-term strategy seems credible and the stock not particularly expensive, no investment is without risk. To that end, here are three potential risks to Cypress' business that prospective and current investors should be mindful of.

A logic board with a large chip being removed by a pair of pliers.

Image source: Getty Images.

What if automotive growth isn't as fast as expected?

At its analyst day, Cypress laid out a compelling case for why its automotive revenues will continue to grow in the coming years. The company is well-positioned to provide components that will be critical to the cars of tomorrow, including wireless and wired connectivity, as well as chips to handle some processing functions like its micro-controller chips. Cypress is also a key supplier of NOR flash memory, which the company says is critical to advanced driver-assistance systems (ADAS).

These opportunities are, in aggregate, exciting, and Cypress' product portfolio and bigger-picture strategy appear to be quite sound. 

In a nutshell, Cypress is betting that, as cars become smarter and more complex, it'll benefit from the increasing demand for chips to enable that transformation. For example, Cypress indicated that the amount of dollar content that it could sell into a typical ADAS in 2018 was $21, but that content will grow to $45 by 2023. Cypress is also banking on cars increasingly requiring wireless and even wired connectivity -- something that it can enable with its portfolio of products. 

While all of this sounds great, there are risks. What if ADAS isn't adopted as quickly as many are hoping? What if the company's estimates are off regarding the dollar content increases that it'll enjoy in future cars?

Make no mistake: The long-term trends really seem to favor Cypress, and I think the opportunities here are real and Cypress' read on the situation is credible. But as with anything in investing, there's always risk that things don't play out as hoped.

Will IoT growth be as rapid as Cypress hopes?

According to Cypress' analyst day materials, the company expects its revenue from IoT to grow more quickly than revenue from any other segment. And by 2023, the company's expectation is that its IoT revenue will be significantly larger than its automotive revenue. 

Again, it's not hard to see that Cypress is making a compelling case here. Devices are becoming increasingly smart and connected and Cypress' technology can certainly enable that functionality. The company is also pitching a smart-platform approach that incorporates integrated chips, software, and even services to make them relatively sticky. 

However, there are risks again. What if the market doesn't grow as quickly as Cypress expects? Additionally, Cypress seems to be banking on continued share gains against the competition. At its analyst day, it said it outgrew the overall 32-bit micro-controller market by a factor of five and that this is "continuing." While I'm confident that the company wouldn't make that statement without visibility into its future prospects, there's still a chance that those continued share gains (or at the very least, the rapid pace of those gains) might not pan out. 

IoT is hugely important to Cypress today and it's a segment that the company is betting big on for the future. If that opportunity isn't as lucrative as expected or it materializes more slowly than hoped for, it could be a risk to Cypress' long-term business performance and, ultimately, the stock.

What if the legacy business declines faster than expected?

Cypress' long-term financial model calls for 7%-9% compound annual revenue growth, driven by compound annual revenue growth rates of 12%-14% in its IoT business, 8%-12% in its automotive business, and negative growth of 2%-4% in its so-called legacy business. The latter segment still makes up a significant chunk of the company's overall revenue today, although it's smaller than either IoT or automotive. 

A potential risk to Cypress' long-term model is that this legacy business could decline faster than the company expects. If that's the case, even if Cypress hits its long-term growth targets in both IoT and automotive, those faster-than-feared declines could prove a drag on the company's overall growth rate.

On the bright side, the fact that this segment is in decline means that with each passing year, it becomes less influential on the overall business. Moreover, even in the case where this segment does deteriorate more rapidly than expected, investors might be willing to overlook that as long as the company's core growth segments are still delivering.

Investor takeaway

No investment is without risk, and Cypress is certainly no exception. While I really like the opportunities ahead of the company and think it will do well in capitalizing on them, things sometimes might not go as planned. The markets that Cypress participates in might not grow as quickly -- or in the case of its legacy business, decline as slowly -- as the company expects, or the company might not be able to gain share at the pace that it hopes to. If those risks materialize, the stock could face a setback.

Investors who are interested in Cypress should keep a close eye on the company's financial results as they come out each quarter and make sure that things are playing out as expected.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool recommends Cypress Semiconductor. The Motley Fool has a disclosure policy.