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Microsemi (NASDAQ:MSCC)

Q2 2014 Earnings Call

April 24, 2014 4:45 pm ET

Executives

Terri Donnelly

John W. Hohener - Chief Financial Officer, Chief Accounting Officer, Executive Vice President, Treasurer and Secretary

James J. Peterson - Chairman, Chief Executive Officer and Chairman of Executive Committee

Paul H. Pickle - President and Chief Operating Officer

Steven G. Litchfield - Chief Strategy Officer and Executive Vice President

Analysts

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Harsh N. Kumar - Stephens Inc., Research Division

Jack Sheng - Goldman Sachs Group Inc., Research Division

Andrew Huang - Sterne Agee & Leach Inc., Research Division

Shawn Simmons - Oppenheimer & Co. Inc., Research Division

Operator

Good afternoon. My name is Hope, and I will be your conference operator today. At this time, I would like to welcome everyone to the Microsemi Fiscal Second Quarter 2014 Earnings Call. [Operator Instructions] Ms. Terri Donnelly, Conference Coordinator, you may begin your conference.

Terri Donnelly

Good afternoon, and welcome to Microsemi's Earnings Conference Call for the second quarter of fiscal year 2014. I am Terri Donnelly, coordinator of this call. In a few moments, you will hear from, and have an opportunity to ask questions of, Jim Peterson, our Chairman of the Board and Chief Executive Officer; of Paul Pickle, our President and Chief Operating Officer; of John Hohener, our Executive Vice President and Chief Financial Officer; and of Steve Litchfield, our Executive Vice President and Chief Strategy Officer. A recording of this conference call will be available on the Microsemi website under the Investors section. Our website is located at www.microsemi.com.

Microsemi issues guidance in the form of a limited business outlook on our expectations for the next quarter. This business outlook reflects our current expectations, and is continually subject to reassessment due to changing market conditions and/or other factors, therefore, must be considered only as management's present opinion.

Actual results may be materially different. However, management undertakes no obligation to update these or any forward-looking statements, whether as a result of new information, future events or otherwise.

If an update to our business outlook is provided, the information will be in the form of a news release.

We wish to caution you that all of our statements, except the company's past financial results, are just our current opinions, predictions and expectations. Actual future events or results may differ materially.

For a review of risk factors, please refer to Microsemi's report on Form 10-K for the fiscal year ended September 29, 2013, which was filed with the SEC on November 14, 2013, and our latest Form 10-Q, which was filed with the SEC on January 29, 2014.

With that said, I'm going to turn the call over to John to discuss our financial results, and then Jim will address our end markets and overall business strategy. Here's John Hohener.

John W. Hohener

Thank you, Terri. Net sales for our second fiscal quarter ended March 30, 2014 were $287 million, sequentially up 12.3% from the $255.6 million reported for the first quarter of 2014, and up 22% from the $235.3 million we reported in the year-ago second quarter. All of our end markets grew quarter-over-quarter.

For the first half of fiscal year 2014, net sales were $542.6 million compared to $482.9 million in the corresponding prior year period.

Bookings were consistent with our expectations and an improving macroeconomic environment accelerated throughout the quarter and we're especially strong in the last month of the quarter. As such, book-to-bill was solidly greater than 1:1. Given the nature of our generally longer cycle time product, much of these bookings were scheduled for shipments in our fiscal fourth quarter of 2014 and beyond.

Our GAAP gross margin, which includes the impact of $12.9 million in noncash purchase accounting adjustments, was with 50.7% compared to 54.1% in the prior quarter. Non-GAAP gross margin was 55.2% compared to 56% last quarter, reflecting the impact of product mix and the impact of a full quarter of revenue from Symmetricom, which we will now refer to as FTD or our Frequency and Timing Division. As mentioned last quarter, following an acquisition for GAAP presentation, we eliminate the profit and acquired inventory. This profit is effectively amortized over the turn of that inventory and we expect to record the last adjustment of $2.7 million in the third quarter.

Going forward, we expect non-GAAP gross margin to increase between 20 and 100 basis points next quarter. Non-selling -- non-GAAP selling, general and administrative expenses for the second quarter were $49.8 million or 17.3% of net sales, down from 17.5% of net sales -- percent of net sales in the prior quarter.

Research and development costs were $49.3 million or 17.2% of net sales, also down from 17.3% of net sales in the prior quarter.

For the third quarter of fiscal year 2014, we forecast that operating expenses, as a whole, will decrease between 90 basis points and 150 basis points as a percentage of sales, in line with our integration activities as previously discussed, along with some reductions in some nonstrategic areas.

We see expenses going up in the fourth quarter in an effort to support strategic development efforts of our FPGA timing and mixed-signal RF focus.

The overall percentage does continue to trend down as a percentage of revenue from our just completed second quarter.

Our non-GAAP operating income was $59.3 million or 20.7% of sales compared to $54.1 million or 21.2% of sales in the prior quarter, and $50 million or 21.2% of sales in the prior year second quarter. For the first half of fiscal year 2014, non-GAAP operating income was $113.4 million or 20.9% of net sales, compared to $106.7 million or 22.1% of sales in the prior year period. We reported $8 million in non-GAAP interest and other expense, the same as the prior quarter. We borrowed an incremental amount to finance the Symmetricom acquisition, but that was offset by a lower interest rate achieved on repricing a term loan tranche from 3.75% to 3.25%.

For the first half of fiscal year 2014, non-GAAP interest and other expense was $16 million compared to $16.5 million in the prior year period. Based on these improvements and early principal payments, we estimate that non-GAAP interest and other expense will decrease to approximately $6.8 million next quarter.

Our term loan now stands at $726 million with a pro forma debt-to-EBITDA of 2.8, down from 3.35 when we announced the transaction. We ended the quarter with a term loan balance of $796 million, a decrease of $30 million from last quarter. Subsequent to the end of the quarter, we completed additional principal payments of $70 million, meeting our stated $100 million goal for fiscal year 2014. While we have met our stated objective well ahead of schedule, in the near term, we continue to see debt paydown as one of Microsemi's best uses of cash.

Non-GAAP net income was $47.7 million or $0.51 per diluted share. Our non-GAAP effective tax rate for the quarter was 7%, the same as the prior quarter. We expect the same tax rate next quarter, but geographical mix of income is the largest determinant of rate.

For the second quarter, our GAAP results included noncash expenses of $24.3 million in amortization, $12.9 million in the aforementioned inventory-related purchase accounting adjustments and $11.4 million in stock-based compensation. We recorded $6.2 million in restructuring charges and other expenses, primarily related to severance and facilities shutdown cost, $400,000 in other acquisition-related expenses and $800,000 in financing charges, primarily related to the repricing of our credit facility.

We estimate the stock-based compensation expense for the third quarter of 2014 will be approximately $11.2 million. Capital spending was $8.8 million compared to a $12.1 million in the prior quarter, with current quarter amounts allocated to support new products, transition to lower cost manufacturing facilities and outbidding existing locations in support of facility consolidation. Next quarter, we expect capital spending to be approximately $9 million.

Depreciation and amortization expense was $39.2 million, compared to $29.5 million in the prior quarter, reflecting a full quarter of activity for FTD. We expect depreciation and amortization expenses next quarter to approximate the Q2 amount. Accounts receivable were $193.8 million compared to $174.9 million at the end of the prior quarter, with DSO of 59 days. Inventories were $202.1 million, down from $216.3 million at the end of the prior quarter, with days of inventory at 142 days. We ended the quarter with a cash balance of $205.2 million and our operating cash flow for the first half of 2014 was $92.7 million compared to $60 million in the first half of 2013. Operating cash flow for the quarter was $30.2 million and our free cash flow was $21.5 million.

In this quarter, our operating cash flow was impacted primarily by strong shipment activity late in the quarter resulting in the increase in accounts receivable as well as strong collections that occurred in the previous quarter. While cash flow can fluctuate from quarter-to-quarter, we stay committed to our goal of exiting the year at a free cash flow run rate exceeding $200 million.

Our best estimate of the end market percentage breakout of net sales for the second quarter was approximately, aerospace, 15%; communications, 35%; defense and security, 27%; and industrial, 23%.

Now for our business outlook. For the third quarter of fiscal year 2014, we expect our net sales will increase to between $287 million and $293 million sequentially. On a non-GAAP basis, we expect earnings for the third quarter of fiscal year 2014 to be $0.55 to $0.61 per diluted share.

With that, I'm going to turn the call over to Jim.

James J. Peterson

Okay. Thank you, John. As John mentioned, Microsemi's book-to-bill was solidly above 1:1 in the March quarter. We also saw improvement in absolute dollars at each of our end markets. Important to me is the fact that these bookings validate the strategic actions we have taken in transforming the company from an aerospace and defense-focused discrete supplier into a communications-focused company that boasts the most comprehensive product portfolio in the industry today.

Focus products including FPGAs, timing and mixing of RF are all showing significant design and booking activity and are the crux of our strength. Looking at our bookings last quarter, we also started to see the results as these translate into revenues. I am more confident ever in our future prospects.

With that, let me move to the end market commentary. Our communications end market grew 3% sequentially, reaching $100 million in sales for the quarter, a significant milestone for us here at Microsemi, given our strategic focus on this end market in recent years.

Timing remains the big story. Following a strong performance in December, Microsemi's timing business delivered a second consecutive record quarter, driven by packet timing and OTN sales in Asia, as always, market share gains for a new sapphire clock management product family.

In aggregate, Microsemi's timing component revenues have grown 35% year-over-year, validating our market leadership position and share gains. As we integrate Symmetricom, we are building one of the largest timing portfolios in the market today. It certainly is the broadest and Microsemi now stands alone as the industry's only end-to-end solution. From timing, origination and distribution to connectivity and interface, we believe this is a strong competitive advantage for Microsemi as it drives a deeper understanding of our customers' needs throughout the most critical layer of the infrastructure. Whether they are communications equipment manufacturers, such as Cisco or Huawei, or whether they are service providers, such as AT&T and Verizon, this is a tremendous competitive advantage for Microsemi. It is driving the most astute timing product road map in the industry, allowing us to better anticipate and serve customers' needs, while driving market share and revenue growth.

Defense and security rebounded nicely off a budget-driven seasonal low dip in December. In the March quarter, revenues grew 25% sequentially to almost $79 million. These results were aided by the inclusion of a full quarter of results from our acquisition. But it's important to note, that if we exclude the contributions of Symmetricom, our core defense and security end markets still grew 11% sequentially between December and March.

The mood of our customers has improved dramatically quarter-over-quarter, and we are seeing some purchase order activity from programs that had previously been delayed. To be clear, the market is still settling out and 2014 will move up and to the right across the board market. But as these results illustrate, the downside in December was artificially low, the market environment is improving, and we have good reason to remain optimistic about the long-term profit opportunity over Microsemi.

Aerospace also resumed growth in the March quarter, growing 8% sequentially to approximately $43 million or about 50% of revenues. In the mix, commercial air is the more significant near term driver. Fundamentals remain solid and Microsemi is benefiting from the content growth trends in more electronic-oriented aircrafts, such as the Boeing 787, Airbus A350 and A380. Our team has done a great job in driving our differentiated, high reliability and secure FPGA technology into these aircrafts. And we have high expectations in terms of building on this trend with our fourth generation SmartFusion and IGLOO devices.

Moving to satellite. Revenues here have bounced off the lows we saw in our December quarter. However, in aggregate, we expect to see softer satellite mix in the June and September quarters, with stronger shipments coming in the December quarter.

Industrial. We grew 17% sequentially to $65 million, accounting for 23% of our revenues. Strength in this end market is broadening against the backdrop of a slowly improving economy worldwide. Microsemi's ultra low power RF products remained a steady contributor in this market, having now delivered 5 consecutive quarters of record revenue, while growing 20% year-over-year.

Also noteworthy is the first full quarter of revenue contributions from our highly advanced chip scale atomic clock, or as we refer to it, CSAC products. These revolutionary components are the lowest power, smallest form factor clock solutions available today and enable highly precised timing solutions.

Okay. With that, I would like to thank you for your interest and support, and we'll now take questions from our analysts. [Operator Instructions] Hope?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Steve Smigie with Raymond James.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

I was wondering if you guys could talk a little bit about the cost cutting here. It seems like you had some decent improvement here in the margin, gross margin. Should we expect that cost cutting to continue? Or at least see gross margin expansion throughout the balance of the calendar year?

James J. Peterson

Yes. Just let -- let's work with Paul on that. Paul, you want to speak to it?

Paul H. Pickle

Yes. We've made some nice progress on some of our integration activities. And I'd say that we're on a life cycle of continual refinement. We do expect to continue to reduce us cost, leverage the scale and we'll steadily make progress.

Jonathan Steven Smigie - Raymond James & Associates, Inc., Research Division

Okay, great. And then, just in terms of overall product mix. It seems like the defense business is definitely performing much better at this point. Should we expect that to return to sort of the more historical positive growth patterns over the next year? It seems like you've got the good book-to-bill ratio there.

Paul H. Pickle

Yes. I think we saw the bottoming in the December quarter. I think one upside we'll see, as a global position, is foreign military sales are certainly increasing. Most of our larger end customers have shown strength in their bookings, which is good for us because they'll now feed down to the Microsemi suppliers and the like. I think we have nothing but upward and onward in the defense and the security markets.

Operator

Your next question comes from the line of Harsh Kumar with Stephens.

Harsh N. Kumar - Stephens Inc., Research Division

Jim, if I can ask you a question. Investors are -- obviously, were concerned last quarter about defense and aerospace. It's bounced back, so kudos to you guys. As you look at maybe, Jim, over the next, call it, 2, 3, 4 quarters, the midterm outlook, do you see those businesses just nicely kind of growing at a steady organic sort of growth rate?

James J. Peterson

Yes, what I'm seeing is historically, what had been program delays, most likely, because of sequestration. I see some of those deals actually being released. I could tell you that the customers, our end customers and their end customers, their moods improved dramatically. So I'm not claiming here your that you're going to see tremendous amount of growth over the next quarter or so, but I think you're going to see a steady influx in demand.

Harsh N. Kumar - Stephens Inc., Research Division

And another one for you. I think in your script, you guys mentioned that bookings were strong, picked up kind of very nicely towards the end of the quarter. Sometimes you rank order -- some of the calls you ranked order your growth prospects for the different businesses, Jim, and I was wondering if you could do that for us?

James J. Peterson

Yes. Or better yet, let me just tell you what I think is really the tipping point to our life cycle today. Our communications markets, our defense markets, our aerospace markets, including space, and our industrial, we've been gaining significant design wins in FPGAs, in our timing products and certainly in our mixed signal RF products, which is the focus for the company. That is the leading indicator, I think, that you really want to know about.

Harsh N. Kumar - Stephens Inc., Research Division

Okay. Now, that's very helpful. So it looks like -- I mean, just reading into what you're saying, things are good, and we should expect all the markets to be up in June.

James J. Peterson

Look, I don't know [indiscernible] we're not giving a real robust revenue number here for the next quarter, but I think going forward, you're going to see strength in our markets at Microsemi. Last quarter, we're a company, we do what we say and we say what we do. So I think you just stick hard to our number and our guide and understand that we're -- we might be an undervalued company on Wall Street, and we're in good position, and so will you as our analyst.

Operator

Your next question comes from the line of Mark Delaney with Goldman Sachs.

Jack Sheng - Goldman Sachs Group Inc., Research Division

This is Jack Sheng on behalf of Mark Delaney. Really quick, can you guys provide an update on your progress at reaching your 60% gross and 30% operating margin targets? And I guess maybe highlight at what revenue you guys expect to achieve this?

James J. Peterson

That's a great question. Litch, you want to answer that?

Steven G. Litchfield

Sure, sure. So I would just say that probably not a lot's changed there. We're making good progress. I think you could see from our guidance this quarter that we're headed up towards that 60-30, and we continue to make progress. We're focused in our product development efforts, and where we're spending our R&D dollars is very much focused around FPGAs, timing, mix signal RF in order to make more traction towards that target.

Jack Sheng - Goldman Sachs Group Inc., Research Division

Great. And as a quick follow-up, can you guys update us on how the FPGA business is progressing? I guess, maybe highlighting some of the effort you guys are taking to make progress in that area.

James J. Peterson

We certainly can. Paul, do you want to check on that?

Paul H. Pickle

Yes, so we've -- and you've probably seen this in some of the press releases, we've actually launched our fourth generation devices, which we've talked about today. We're in design on our fifth generation. We also talked a little bit in the past couple of quarters about our Intel Foundry partnership. And so we feel like we're making very, very good progress towards a strong robust road map. So for us, it's going quite nicely. And the design and acceptance has been quite strong as well.

Operator

Your next question comes from the line of Andrew Huang with Sterne Agee.

Andrew Huang - Sterne Agee & Leach Inc., Research Division

So I just had one big picture question. I was wondering if there are certain product families that you could potentially walk away from? And other product families to focus on that would help drive your gross margins up a little bit more quickly?

James J. Peterson

Yes, that's probably the key message we want to get across here at Microsemi. If you look at our focus for the last several quarters and most certainly going forward, track our press releases, it's kind of a plant corn, get corn project. We're focusing heavily on our FPGA programs. But in fact, I think everybody else out in the audience would be surprised to realize that only about 23% of our revenue is FPGAs. So FPGAs, timing and mixed signal RF products in all markets, communication, defense and aerospace, is the message going forward and it's the right message.

Andrew Huang - Sterne Agee & Leach Inc., Research Division

So actually that brings up a follow on question. So you're saying FPGA is already 22% of revenue. Can you give us a sense of how high the gross margins are for FPGA?

James J. Peterson

Yes, they're certainly within our targets and they're helping us get to our 60-30 platform, which actually fits in our long-term profitability targets. You know I'm not going to carve that out for you.

Operator

[Operator Instructions] Your next question comes from the line of Rick Schafer with Oppenheimer & Co.

Shawn Simmons - Oppenheimer & Co. Inc., Research Division

This is Shawn Simmons calling in for Rick. Just one quick question on the guidance, I mean, it seems a little bit less than some of your peers, but book-to-bill is solidly above 1. I mean, can you kind of just describe what's going on there? Is that some of the business that you're walking away from?

James J. Peterson

Yes. [indiscernible] Microsemi. We're not catalog products. We're not heavily into consumer market space. We are strengthening our markets, and we typically, if you're -- if you track Micro, historically and going forward, we kind of trail the gang, as you might call them, by a quarter or 2. And you wouldn't expect much different from our product mix. You realize our cycle time and a lot of our products are -- in commercial, into 12 weeks; defense, security, about 20 to 30 weeks; and satellite 36. So we -- you'll see as we're seeing here stronger bookings. And in the revenue, about a quarter or 2 behind the other peers appears and that's exactly what you want to see from Microsemi.

Shawn Simmons - Oppenheimer & Co. Inc., Research Division

Okay, great. And then going into the next quarter, are you still walking away from some of that Symmetricom business? Or has that more or less played itself out at this point?

James J. Peterson

We're 8 months into it. Symmetricom is Microsemi. So -- but Symmetricom as well as all our products, we're looking at where we really belong and where we really could generate our $200 million in cash and our 60-30. So it's an ongoing thing, but Symmetricom, we're about 90%, 95% there.

Shawn Simmons - Oppenheimer & Co. Inc., Research Division

Okay, great. And then, John, just one quick question for you. Do you have a turn sense for the second quarter and how would that compare to the last quarter or last few?

John W. Hohener

The turns number?

Shawn Simmons - Oppenheimer & Co. Inc., Research Division

Yes.

John W. Hohener

Approximately 35%, that's similar to what we had last quarter.

Operator

Your next question comes as a follow-up question from the line of Harsh Kumar with Stephens.

Harsh N. Kumar - Stephens Inc., Research Division

Jim, if I can ask you 2-strategy questions. On the FPGA side, it's a relatively new market. There's some heavyweight guys in there. When you guys look at this sort of business for yourself, how do you want to take it to market? In other words, are you angling for com? Are you angling for niche markets at first and maybe brought it later? Just any kind of color you want to give us on how the go-to market strategy and penetration strategy here.

James J. Peterson

Yes. Well, I remember last quarter when we talked about FPGA, we got to talk -- bold ambitions. Well, the fact of the matter is bold ambitions are true ambitions. In our FPGA market, we're focusing on security, high reliability and reliability...

Paul H. Pickle

Low power.

James J. Peterson

Oh, our low power, I forgot. We have the lowest power in the industry. Thanks, Paul. And we're taking market share where we want. We're not going to be the leader at the high-end consumer,lower-margin product. But certainly, in defense, in aerospace, satellite, higher margin industrial and communications markets, that's exactly were we're taking market share. We're a $1 billion to $1.2 billion company with 23% of our business in FPGAs. We just teamed up with the best of the best in distributors for demand creation in FPGAs worldwide. We're doing training seminars throughout the planet worldwide for FPGAs. If somebody believes that we're not convicted and we have the right product in FPGAs. I'm here to tell you you're absolutely incorrect. We're doing quite well. Thank you.

Harsh N. Kumar - Stephens Inc., Research Division

Okay. Yes, I know. And let me ask a philosophical question on expenses. We've heard a variety of semi companies talk about how they manage expenses. Some say they manage it at a percentage of revenues. Some say they manage it, revenues grow at x, expenses grow at half. Is there any such philosophy like that? Maybe a question for John, more appropriately.

John W. Hohener

Yes. Certainly, as we grow the top line, our ultimate goal is to decrease revenues as a percentage of revenue -- decrease costs as a percentage of revenue. And I think we've talked about even though our expenses may go up in the fourth quarter as a percentage of revenue, you're going to see that coming down.

Operator

[Operator Instructions] And there are no further questions at this time.

James J. Peterson

Okay. Thank you for joining us today, and have a great day.

Operator

Thank you. This does conclude that Microsemi fiscal second quarter 2014 earnings call. You may now disconnect.

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