This has been a strange quarter for many tech stocks, as investors seem relatively willing to give a pass to unimpressive guidance for the first calendar quarter of 2013. That's fortunate for Microsemi (MSCC) shareholders, as this company not only posted a small miss and weak bookings for its quarter, but offered weak guidance for the next. Microsemi can be a maddening and frustrating stock to own, but if management stays on target with cost reductions and new product introductions, the long-term rewards could be well worth some white knuckles in the meantime.
A Tough Quarter Was Not Unexpected, But The Components Were A Little Strange
That Microsemi was going to have a challenging quarter was not really in much doubt - after all, the company gets about half of its revenue from communications and industrial verticals, and neither of those were looking strong at the end of 2012. Likewise, quarterly commentary from large players like Linear Technology (LLTC) and Texas Instruments (TXN) already confirmed that those markets were soft.
What Microsemi actually reported was 3% year-on-year growth and a 6% sequential decline - a bit below the average of analyst estimates, but not materially so. That said, the composition of revenue was surprising. Given all of the nervousness around the fiscal cliff, defense was supposed to weaken, but Microsemi saw 9% and 3% growth here. Communications was soft as expected (up 2%, down 5%), but aerospace (down 14% sequentially) and industrial (also down 14% sequentially) were surprisingly bad.
On a more encouraging note, management is making progress with its cost control/margin improvement initiatives. Gross margin improved about three points from last year and nearly half a point sequentially. While operating income was flat from last year and down a bit sequentially (and operating margins correspondingly improved/worsened), the company salvaged a decent overall result.
Investors Are Giving A Pass On The Guidance
Reading management's guidance last night, I figured that the stock was going to get smacked today (and it was down in the after hours market), but I think management's comments on the call eased some of the worries.
The sequential decline in revenue is frustrating, with the midpoint of management's guidance about 9% below the prior average analyst estimate, and gross margins retreating back to the 56% level. It sounds like there are some timing issues here, though, that could salvage the full year. Not unlike many of the industrials that have reported so far this quarter, Microsemi management appears to expect conditions to get better as the year goes along, with the book-to-bill going positive again next quarter. With other chip companies that serve some of the same markets (including Fairchild (FCS) and Maxim (MXIM)) seeing some of the same trends, that seems to have taken some of the sting out of the guidance.
So far, defense is holding up pretty well, though I think body scanners orders could be vulnerable. Design wins at companies like Cisco (CSCO) and Juniper (JNPR) and new clock synthesis products should give the company a boost if carrier spending recovers as expected. Aerospace sounds pretty iffy for the near-term, even despite relatively good news from Honeywell (HON) and United Technologies (UTX) regarding order trends. On the other hand, satellite programs from the EU (Galileo) and Iridium's (IRDM) Iridium NEXT should start to ramp up later this year, and Microsemi should be positioned for roughly 50% higher content per satellite.
Still Substantial Opportunities For Margin, Cash Flow Leverage
The Microsemi story really isn't about robust long-term revenue growth potential. Leveraging the programmable logic device technology it got with the Actel deal is certainly an opportunity, as is expanding its business in markets like healthcare and industrial automation. Even so, I'm looking for a long-term growth rate of about 5% or so on the top line.
Where Microsemi works (or not) as a stock is through operating leverage and free cash flow. Doing some regression analysis on the operating margins and looking into the cash flow components suggests the potential to generate free cash flow margins in the low 20%s. Potential is a dangerous word, but management's progress with gross margins has been somewhat encouraging, and there are long-term opportunities here from improving mix, better fixed cost leverage, and fully integrating past acquisitions. All told, then, I believe Microsemi can grow its free cash at a rate in the low teens.
The Bottom Line
This is a multi-year improvement story, and I see fair value for Microsemi around $25 today. There is potential up into the low $30s, but getting there will require an accelerated path to those margin and cash flow improvements, and/or some positive surprises with design wins and end market growth. At a minimum, I would encourage investors to keep a close eye on the company's progress with incremental margins, working capital, and free cash flow over the next year or two to see whether that best-case scenario is likely.
As I said in the open, owning Microsemi can try your nerves and test your patience, but there is meaningful upside in the shares if the company can hit its marks. While chip stocks with more mobile exposure are likely to outperform in the near term, Microsemi could ultimately prove to be the tortoise to those hares.