Wedbush Morgan analyst Craig Berger recently sent a note to clients on why he believes Microsemi Corporation (MSCC), a high-performance analog and mixed-signal integrated circuits and semiconductor device manufacturer, continues to be a safe haven among chip stocks, despite posting lower net for 3Q06. The note follows:
• Microsemi delivered another quarter of solid execution and financial results, reinforcing our view that it is a compelling investment with significant growth opportunities, consolidation benefits, and factory efficiency benefits still left to reap; we also believe the firm’s unique characteristics provide chip investors with a relative safe-haven in times of a weak semiconductor tape, as well as capital appreciation opportunities during a stronger tape.
• Microsemi reported June revenues and EPS slightly above consensus estimates, but in line with our estimates; management commented that demand remains strong with a 1.07 book-to-bill ratio, the 15th consecutive quarter of positive book to bill performance. Microsemi recorded revenues of $100.2 million (+18% QoQ, +33% YoY) and pro forma EPS of $0.28, about in-line with our $100.7 million revenue forecast and our EPS estimate. Pro forma gross margins of 50.3% fell -80bps QoQ as the APT business is integrated into Microsemi’s operations. Operating margins of 30.0% fell -70bps QoQ on the APT acquisition impacts but rose an impressive +900bps YoY, reflecting strong the firm’s strong 30% operating margins.
• Management guided Q4’06 revenues to grow by +7-9% QoQ with EPS of $0.29 to $0.31, both inline with consensus estimates. Management will continue to focus on integrating the APT business (acquired 4/28) into its own operations, both from a manufacturing and sales personnel perspective. We do believe the APT acquisition is a big strategic positive that will drive the next leg of consolidation and growth for Microsemi.
• Satellite and commercial air businesses were strong while the medical business was expectedly slower; Microsemi saw additional strength in notebooks, LCD TVs, wireless LAN business with positive book-to-bill across all businesses. The defense and satellite businesses were again the strongest segments this quarter, a positive given that these segments have the highest margins and longest product leadtimes, thus driving enhanced demand visibility. We do believe that select ‘price positioning’ will again occur on some parts sold to the U.S. military in 2H’06, a positive for margin growth prospects in 1H’07.
• Maintain BUY rating, calendar 2006 and 2007 EPS estimates of $1.17 and $1.47, respectively, and lowering target to $32 to reflect lower industry multiples. Our $32 price target is based on a 22x multiple of our calendar 2007 EPS estimate. Historically Microsemi has traded within a wide range of 11x to 55x its forward 12-month EPS estimates, with a median forward multiple of 31x. Our 22x price target multiple is a discount to the stock’s historical median to reflect the firm’s already completed consolidation efforts and larger size, and is appropriate given its growing end-markets, margin expansion headroom, track record of facility consolidation, and expected 2007 EPS growth.
• Risks to attainment of our share price target include: weakness in the defense or medical markets, greater than expected chip pricing pressure, weaker than expected demand in 2H’06, greater than expected inventory, and weaker than expected gross margins.
June’06 Positives & Negatives
• Orders and product demand remain strong with the firm’s book to bill ratio at 1.07.
• Management reached targeted 30% operating margin two quarters early.
• Satellite, defense, commercial air businesses remain robust, and ICD business may increase in 2H’06.
• September revenue and EPS guidance was ‘only’ in-line with consensus estimates, a possible perceived shortcoming given Microsemi’s track record of guiding above consensus.
• Inventories increased by +13 days to 145 days, and by $21 million QoQ (though much of the increase was driven by the APT acquisition).
Background: Medical Device Market Weakness Could Drive about $0.05 of Risk to c’2007 EPS
Recent commentary from the implantable defibrillator market continues to be weak. The ICD market continues to be weak with Boston Scientific’s (BSX) recent recall of 100ku defibrillator adding to the negative press in this segment. It will likely take at least a couple more quarters for that end-market to return to its more normalized unit growth rates of +20% per year. On the other hand, a potential positive could be looming with Medicare potentially deciding to postpone the ICD reimbursement rate cuts it previously announced. Last week Reuters reported that:
“Senator Charles Grassley, Republican chair of the Senate Finance Committee and Max Baucus, the panel's ranking Democrat, asked the U.S. Centers for Medicare and Medicaid Services (CMS) to delay implementation of a rule rejiggering payments under Medicare. The proposed rules, which would cover in-patient hospital stays in 2007 and 2008, proposed more draconian cuts than expected for makers of coronary stent devices and cardiac rhythm management procedures.”
A current check on Microsemi’s ICD customers indicate the following:
• St. Jude’s (STJ) revenues expected to grow +4% QoQ – Defibrillator customer St. Jude did no pre-announce results for Q2 as it previously did for Q1, when it citied weaker than expected sales. Consensus estimates forecast the firm’s Q2 revenues to grow +4% QoQ, though some of this could be recapturing recent share gains from Boston Scientific or Medtronic. As a reminder, Microsemi says it will grow its silicon content per device from $62 to $100 over the next 18 months.
• Guidant acquisition driving less transparency and contributing to information vacuum – Boston Scientific’s recent acquisition of Guidant means that the firm’s implantable defibrillator shipments are no longer broken out as a separate line item, leading to less visibility and possibly increased concern among investors. The firm’s recent recall of an additional 100ku of Guidant ICDs will likely continue to strain the industry and possibly pressure growth rates.
• Medtronic’s (MDT) recent management comments suggest some strength in its international ICD customers. At a recent investor conference a Medtronic executive suggested that the U.S. ICD market was somewhat weak, though the international ICD market was relatively stronger, potentially offsetting some domestic weakness. The firm’s July’06 revenues are expected to decline by –2.8% QoQ, though the firm sells many types of medical devices, not just ICDs.
Background: APT Acquisition a Positive, Driving Revenue Growth and Cost Synergies
Conclusion – Advanced Power Technology Acquisition Provides an Opportunity for Further Cost Synergies: On Nov. 2, 2005, Microsemi announced its intention to acquire Advanced Power Technology (OTC:APTI) for $156 million or $14.40 per share ($2 per share in cash plus 0.435 Microsemi shares for each APTI share). Management estimates that the acquisition would add 20% ($70-78 million) in incremental revenue during calendar 2006, and that the acquisition will be accretive by Jun’06 (and neutral in Mar’06). APT currently has two manufacturing facilities: a 4-inch wafer fab in Bend, Oregon for the fabrication of high power chips, and a 4-inch fab in Santa Clara, CA for the manufacture of high-end RF chips. Microsemi management is likely to consolidate several aspects of the combined entity’s operations, including manufacturing sites (likely reducing the total number of post-acquisition manufacturing facilities from six to four or five), sales force headcount (many of Microsemi’s and APT’s customers are the same), and administrative costs (about one third of APT’s existing SG&A costs are attributed to public company reporting).
Conclusion – Advanced Power Technology Acquisition Provides an Opportunity for Microsemi to Grow Revenues Faster in its Core Markets of Defense/Aerospace and Medical: APT’s existing revenue base overlaps heavily with that of Microsemi’s revenue base. APT has 32% of revenues coming from commercial aerospace and defense, 29% from medical and industrial, 22% from data communications, and 15% from semiconductor capital equipment. The company specializes in RF (radio frequency) analog devices, as well as in very high power analog chips used in radar and other power management systems. APT has a significant research effort in silicon carbide (SiC) technology, which management hopes to develop into products to be introduced in 2006 or 2007. Silicon carbide is a still developing technology used to channel very large amounts of energy in high power electronics. We believe that Microsemi will also expend efforts to get APT chips qualified for government defense contracts, thus expanding the reach of complementary APT chips into the military/defense/aero/satellite markets.
MSCC Investment Thesis and Valuation Analysis
Microsemi Investment Thesis: We rate Microsemi a Buy with a $32 target price. We are positive on MSCC given its acquisition of APTI on 4/28, its ramping LCD TV and WiFi chip orders, its pricing benefits from military customers, and its growth and stability dynamics. We also like the firm’s topline growth opportunities, consolidation benefits, and factory efficiency benefits still left to realize. In sum, MSCC is a high quality company (as its 30% operating margins demonstrate), and could benefit from some investors’ ‘flight to quality’ mentality if the current semiconductor market weakness persists, in our view.
Microsemi Valuation Methodology: Our $32 price target is based upon a 22x multiple of our c’2007 EPS estimate. Historically Microsemi has traded within a very wide range of 11x to 55x its forward 12-month EPS estimates, with a median forward multiple of 31x. Our 22x price target multiple is a discount to the stock’s historical median to reflect the firm’s already completed consolidation efforts and larger size, and is appropriate given its growing end-markets, margin expansion headroom, track record of facility consolidation, and expected 2007 EPS growth.
• Cyclical Market Risk – Like all semiconductor companies, Microsemi faces the risk of a general industry downturn that could materially weaken end market demand over several consecutive quarters. Such a downturn could also lead to price declines and an inventory build. As a maker of analog products, Microsemi is exposed to macroeconomic driven end markets such as industrial capital equipment – thereby making cyclical capital spending an additional issue.
• Price Declines — Given the historical precedent of same-part price declines in the analog semiconductor market, steep ASP erosion would negatively affect Microsemi’s financial performance. ASP declines in excess of –15% per year will have negative ramifications on Microsemi’s earnings power.
• Competition — The consumer analog product market is increasingly competitive and litigious, with smaller players O2Micro and Monolithic Power aggressively trying to take market share in the display backlighting market. Microsemi will need to innovate rapidly and litigate successfully to match the agility of these smaller firms.
• Factory Capacity Utilization — Because it operates its own manufacturing facilities, Microsemi has substantial fixed operating expenses. If demand drops or product mix shifts between non-fungible manufacturing assets, Microsemi’s product margins and profitability may be adversely affected.
• Loss of Customer Design Wins – Given its exposure to proprietary and sole-source customers in the medical and defense markets, a significant portion of Microsemi’s revenues depends on the company’s ability to win future designs. If the company fails to win new designs then its revenue and profitability could be materially affected for some time.
• Technology Innovation Risk — If Microsemi is unable to sustain its current level of technology and product innovation, it may lose future, higher-margin analog designs in the end markets it serves.
MSCC 1-yr chart: