- Weakness in military spending has been overshadowing Hittite Microwave's potential in LTE.
- Look for margins to return to historical levels later this year and early 2015.
- Shares remain cheap and trade at only 19 times next year's earnings.
- The downside risk is mitigated by the company's pristine balance sheet and $472 million, or $15.41 a share in cash.
- Using its historical P/E multiple, the price target is $68.
The semiconductor space is riddled with promising companies, most of which have nothing to do with the computer industry. Hittite Microwave (HITT) happens to be one. Hittite is a compelling small cap play in the semiconductor space. Even for a sub $2 billion market cap company, Hittite operates globally and services a variety of industries.
Hittite managed to post 4Q revenue that was slightly above expectations, with EPS missing by 5%. Revenue for the quarter was actually only up marginally year-over-year and sequentially. Its gross margin came in at an impressive 67%, but this is at the low-end of its historical range. Investors appear to have mixed feels over Hittite's ability to record its low 70s gross margin and ability to grow its top line while military spending remains in question.
Weakness in military spending sends investors for cover
Its military, microwave and millimeterwave communications and cellular markets drive 75% of its revenues. Thus, with the government shutdown, it's no surprise that revenues came in light. The military side of the business was hurt by the shutdown, and the division may well be strained through 1Q as well.
What's more is that the military division was also the chief cause of the company's compressed gross margin. While part of the margin compression was related to a shift in mix, the other part was lower-margin military development contracts.
On the plus side, there is traction in other markets
Despite the slowdown from the military division, Hittite is finally gaining traction in other segments. Picking up the slack in revenue growth for the fourth quarter was the auto, space, cellular and microwave communications segments.
It also looks like the company managed to grow its microwave communication business double digits in 4Q Y/Y. This comes as the company snatched up market share from peers thanks to new product launches. Along those lines, it looks like the company has a suite of product launches set for 2014. These "new" products generally carry higher prices, thus are higher margin.
Hittite also has exposure to the LTE market, which has proved to be big, and will prove to even bigger in emerging markets. The top market being China and its 1.35 billion people. 1Q will mark further rollout of LTE in China for Hittite.
One of the big things is that Hittite is still getting 60% of revenues internationally. While domestic revenues were down 6.4% Y/Y during 4Q, international was up 5.7%. While international as a whole was up, Europe was actually down. As Europe strengthens, which appears to be pushed out to the latter part of 2014, Hittite should see another boost in international revenues.
Eventual margin improvement and pickup in weak segments is an overlooked earnings driver
As mentioned, Hittite is turning out a gross margin in the high 60s, however, there's room for improvement here. That gross margin is actually on the low-end of its historical range given the poor mix of revenues.
Hittite snatched up lower-margin military deployment contracts last year, a long-term investment the company made, one that some investors aren't quite sure how to digest. However, the fact remains that it gives the company an opportunity to capture higher-margin, higher-revenue, projects in the future. Worth noting is that it may well take a year or so before the programs ramp up and we see the impact on the margin side.
Long-term, gross margins should return to the low 70s. It's been awhile since its gross margin has been down to 68%, but that's the low end of their range, with the potential to hit 73% over the next couple years.
Commitment to shareholders and high cash flow means long-term potential
Any conversation of Hittite would be suspect if I didn't mention the company's brand new dividend. Come March, the company will be paying out $0.15 quarterly, a forward dividend yield of 1%. Other major IC company, Linear Technology, is already paying out 60% of its earnings via dividends. I don't look for that sort of payout anytime soon for Hittite, but theoretically it would put the company's yield up to 2.5%, compared to its current 1% forward yield.
The path to better margins is already paved, which should only further boost its already robust free cash flow margin. Assuming the company can maintain its 20% plus free cash flow margins, which it has a history of doing, I believe the stock is below fair value. Using its historical price-to-earnings multiple on 2015 earnings yields a price target of $68.
The opportunity for investors is now as the company resumes its growth trajectory next year. While the company earned $2.28 a share last year and this year will likely earn $2.31 a share, next year is when earnings take off again. This will come as further rollout of LTE occurs in China and emerging markets where Hittite is now well-positioned.
The consensus is for the company to earn $2.71 a share in 2015, with estimates as high as $3.08 a share. I see the company posting EPS of $3 a share and that puts its forward P/E at 19x 2015 earnings, which is below the industry average P/E multiple of 33.
The key is that the gross margin contraction doesn't appear to be a long-term issue, rather a cyclical one. High growth periods should yield gross margins of upwards of 73%. Low growth periods appear to yield gross margins of 68%. I believe we're in the trough of the cycle and expect margins to get closer to the mid-70s region in 2015.
Hittite has historically been a resilient company when it comes to market fluctuations, however, the military segment has had a greater than expected impact when it comes to revenues and margins. Even still, the company remains an international operator with other growth avenues that will support the company in the meantime.
Hittite is still a solid company going through a minor setback related to a slowdown in military spending. Mr. Market appears to have overreacted to its recent setback, setting Hittite up for a year that could beat estimates. I believe it will be a year of earnings beats for Hittite and investors can rest comfortably knowing that the company has over $472 million in cash, or $15.41 per share, on the balance sheet and no debt.