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Based in Sunnyvale, CA, Maxim Integrated Products, Inc., (NASDAQ:MXIM), is an original equipment manufacturer [OEM] of semiconductor analog and mixed signal integrated circuits [ICs]. The company has a broad product portfolio that includes analog-to-digital converters, amplifiers and comparators, communications devices, data converters, filters, interface and interconnect devices, power supplies and management components, sensors, timing and wireless products.

Management has been revising its long-term strategy, moving into several lower-margin areas that have strong growth potential. Management remains committed to being the lowest cost producer of any product that Maxim invents. Semiconductor devices are broadly divided into three categories analog, digital and radio frequency [RF]. Analog semiconductors condition and regulate real world information such as light, temperature, speed, pressure, power and electrical currents. Digital logic semiconductors process information in only two states. Mixed-signal semiconductors combine both analog and digital technology into a single device.

Typically, an analog sensor samples real world information, and then converts the input into an electronic analog signal, which is converted into a digital format for further digital processing. The analog and mixed-signal markets tend to be more varied and specialized, with customized products that have longer life cycles than the digital industry segment. There is an ongoing drive to decrease the number of discrete devices, lessen power requirements and shrink the size of the existing devices, which correspondingly increase performance and reliability. Consequently, a greater amount of functionality is being consolidated into increasingly smaller devices.

Gartner expects that the total semiconductor chip market increased 10.6% to a $259.5 billion market in 2006. The latest SIA forecast pegs it at $248.8 billion (up 9.4% over 2005 (the analog component is expected to grow 16.8% to a $37.3 billion market).

The bulk of the wafer manufacturing is carried out at MXIM's four fabrication facilities, although the company outsources a small portion to outside foundries. Previously, more than half the processed wafers were shipped to Asian subcontractors for sorting and packaging. The company has been investing in new equipment to expand capacity at the Philippine facility, and recently finished a new Thai facility that is now operational. The two manufacturing plants, with backend-of-the-line testing capabilities, can now process 735 million units per quarter.

Maxim serves the automotive, communications, consumer, data processing, industrial control, instrumentation and medical markets. The company has 74 different product lines. Its products have very wide-ranging application in various communications gear and networking equipment; consumer goods like cordless phones, digital cameras, DVD players and PDAs; data processing equipment like computers, printers and workstations; industrial products like temperature, pressure, velocity, and/or flow controllers and robotics products; instrumentation products like automatic test equipment, analyzers, testers and measuring equipment; and medical instruments like blood glucose meters, blood oximetry and imaging instruments.

The company operates in the Asia/Pacific region, which generated 52.0% of revenue in 2005, the U.S. generated 26.4%, Europe 18.9% and other regions 2.7%. Products are distributed in the U.S. and Canada through a direct sales force and support system. MXIM also has 25 sales offices, 29 distributors and a sales representative for distributing its products in other countries. The company has over 15,000 customers worldwide.

Attractive business model
Maxim has had one of the most efficient business models in the technology sector, offering 70%+ gross margins in four consecutive fiscal years. The corporate strategy had been focused on pursuing highmargin business, which limited expansion into high-growth markets. Management recently revised this strategy, entering several high-volume markets such as the digital camera and display markets.

Since these markets allow less attractive gross margins, the corporate average has dropped to the 65% range. Management stated that despite the significant drop in gross margins, the bottom line impact would be mitigated by continued operating expense reductions. Opex declined in four out of the last five reported quarters (as a percentage of sales), and barring the September quarter, yielded very stable operating margins of around 44%.

Management expects some of the gross margin pressure to be alleviated once the transition at one of the fabs (from six inch to eight inch wafers) is completed and some of the negative gross margin products transition to new platforms. The attractive margins, absence of long-term debt and consistent free cash flow are evidence of management s efficient execution.

Differentiated engineering design team
Maxim s design team is another strength, and a competitive differentiator. Unlike digital design, analog design requires a greater amount of customization. It takes a long period of time to assemble an experienced analog design engineering team such as Maxim s. The customization aspect enables the company s products to command a higher price, thus making it a very lucrative business.

However, the attractive margins of the high-performance analog market are attracting more players. This is worsening
the competitive climate and increasing demand for engineering staff. In view of the changing scenario and in-line with its long-range plans, management has been making additions to its engineering staff. Although there has been some turnover over the last few months, this is an insignificant number (1-2% of the total workforce).

Analog products do not require leading edge manufacturing process
In general, digital semiconductor OEMs products are differentiated on a cost of production basis rather than application. Therefore, digital semiconductor OEMs usually utilize leading edge manufacturing equipment with correspondingly higher embedded capital equipment costs. This results in higher depreciation expenses and higher foundry utilization requirements in order to recover the capital equipment investments. Analog products are less capital intensive.

Analog products possess longer life cycles that support higher margins
Analog and mixed signal products tend to be more customized, with relatively longer life cycles than digital components. Analog and mixed signal OEMs differentiate their product lines based on specific applications or vertical end markets. Consistent with industry-wide trends, Maxim's analog offerings have transitioned from being generic to more application specific. The large upfront design costs embedded in the customized devices act as a barrier to entry for competitors. Consequently, older analog products can keep contributing to revenue for longer periods of time and generate higher margins (due to pricing power) than corresponding digital products.

Revenue growth is always an area of concern for Analog companies
While the business model supports outstanding margins, revenue growth, by its very nature, is always an area of concern for analog companies. The long lead times for customized devices require a relatively longer sales cycle than digital products. Management is addressing the need for growth by targeting some lower-margin higher-volume business. This could change the gross margin profile of the company. Management appears optimistic about leverage in the operating model, but we are unable to comment since September quarter profits declined and the company only reported partial results for the fourth quarter. Management guided to lower revenue in the current quarter, which could increase margin pressures due to lower cost absorption.

Capacity is being expanded as the company nears the $2 billion annual revenue run rate
Management had previously stated that existing facilities would support $3 billion in wafer shipments and that test capacity would have to be expanded when revenue reached the $2 billion annual run rate. With annual revenue close to the $2 billion mark, management is looking at expansion opportunities. The company is building a new manufacturing facility in the Philippines to bring the production of some modules in-house. The test capacity in Thailand is being doubled. The company is also building a large facility in India, and has plans of building or purchasing another facility in Arizona.

End customer shift from industrial to consumer markets
Management acknowledged that there has been a subtle shift in the end customer base from industrial markets such as process control, instrumentation and information technology to consumer markets. High end consumer goods (mainly digital cameras, notebook computers, cell phones, cable and satellite television boxes, PDAs, PS systems, automobiles, MP3 players, home security and network consumer video transmission) now generate a significant chunk of revenue. This sector is typically driven by the quick ramp of new products or innovations and is also given to rapid declines.

A company serving the consumer market would have to gauge future demand, or maintain a more sizeable inventory, failing
which it would be prone to losing business. Since Maxim is starting out in this area, management is facing some execution issues. However the company has made good progress on the learning curve, and management expects strong growth through calendar 2007.

Consumer OEMs are more sensitive to stock-outs than an inventory glut

According to management, OEM customers in the consumer markets are more sensitive to having an inadequate supply of the end product than excess component inventory. This is a consequence of the importance that consumer OEMs place on product branding. This causes periods of oversupply, since consumer markets are notoriously fickle and unpredictable.

Investment Summary
The major near-term concern for Maxim continues to be revenue growth. Orders and revenue grew every quarter since June 2005, before declining in the first and second quarters of fiscal 2007. We had previously expressed our concern regarding the composition of the die bank. In the fourth quarter of fiscal 2006, management stated that the company would have shipped a larger percentage of turns if the composition of the die bank had permitted. But because of the relatively short lead times and the anticipation of required inventory falling out a bit, revenue fell short of expectations. As anticipated, this situation continued into the first and second quarters of fiscal 2007.

Management guided to another sharper decline in Q3, so it is hard to determine the trough. Maxim continues to introduce products into a large number of growing markets such as the automotive, industrial, instrumentation and measurement markets. The company has been taking share in these relatively nascent markets, along with other analog companies such as Linear Technology. It is solidly positioned with several design wins in the telecom and computing segments and is the leading supplier in the notebook area.

ISIL continues to grow in the consumer segment as well. Maxim tests new products onshore and gradually transfers the testing offshore, as the product life cycle advances. This lowers production costs substantially. Since recent introductions targeted at the high-volume markets are in the initial stages of production and many new products started to ramp before related costs could be brought down to desired levels, the negative impact on margins appears to be more. We cannot say with confidence that this situation will not continue, as these markets are characterized by rapid ramp of new products and short product life cycles. Therefore, while we expect the unfavorable mix to continue per management's new plan, the impact is likely to be mitigated by improving operating performance. MXIM continues to generate significant cash from operations, its solid debt-free balance sheet and strong liquidity position providing financial flexibility.

INDUSTRY OUTLOOK - POSITIVE

We believe that the semiconductor industry is a positive story in 2007, as demand continues to strengthen. The Semiconductor Industry Association [SIA] released its annual forecast for 2006-2009, with record 2005 sales of $227.5 billion rising 9.4% to $248.8 billion in 2006. The forecast projects that sales will grow at a compound annual growth rate of 9% to $321 billion in 2009. According to the SIA, expected areas of application strength include cell phones (up 20%), digital cameras (up 11%), MP3
players (up 35%), digital TVs (up 56%) and PCs (up 10%).

The fundamental shift in the semiconductor industry from corporate IT to consumer demand is becoming increasingly apparent. This shift will continue in the years ahead, as consumers all over the world are captivated by the richness and portability of digital media. Advances in computing, digital media processing and wireless technology are enabling the industry to create lifestyle-changing devices and gadgets that could only be imagined a few years ago. The changing nature of customers will affect every aspect of the business, from product design to marketing to demand forecasting.

INDUSTRY POSITION

Maxim has a long list of competitors including Altera, Anadigics, Analog Devices, Applied Micro, Conexant, Exar, Fairchild, Infineon, Level One (an Intel subsidiary), Intersil, Linear Technology, Lucent, Micrel, Microchip, Mitsubishi, Monolithic Power Systems, Motorola, National Semiconductor, ON Semiconductor, Philips, PMC-Sierra, RF Micro, Ricoh, Seiko, Semtech, STMicroelectronics, Silicon Laboratories, Texas Instruments, Vitesse Semiconductor, Volterra Semiconductor and others.

However, Texas Instruments, Analog Devices and Linear Technology are the most direct competitors or peer group, with products that overlap the largest number of end applications. According to IC Insights, the worldwide rankings of the company's peer group are Texas Instruments (3rd ranked), Analog Devices (23rd ranked), Maxim Integrated Products (34th ranked) and then Linear Technology, just missing the top fifty ranking.

RECENT NEWS

On February 7 2007, Maxim announced partial results for the second quarter of fiscal year 2007 ending December 2006. The top line was in-line with consensus estimates. Revenue for the period was $497 million, down -1.1% sequentially and up 11.5% year-over-year. Revenue was in-line with consensus estimates (exceeding by 1.0%), and was within management s guidance of 1-4% decline.

Last quarter management estimated that orders to the tune of $47 million were pushed from the first quarter into the second. Despite this push-in, net orders were down -1.4% to $500 million. Management reclassified its end markets under four heads. Accordingly, orders from the computing market increased, offsetting the decline in high-end consumer. The other two end markets, communications and industrial had flattish order growth. Management noted that the decreasing customer lead-time trend was stabilizing, as it was 10 weeks for the fourth consecutive quarter. Maxim's gradually increasing exposure to consumer driven markets has been one major factor behind its need for quicker order fulfillment. The company has been successful at meeting this demand and also building its die bank.


The percentage of turns shipped was down slightly at 59.5%, compared to 59.7% in the September quarter. Turns orders added an incremental $90 million to the backlog. The total backlog declined -2.9% in the second quarter. This was the second consecutive quarter that backlog declined in the -3% range. The book-to-bill was flattish at 1.01.

Management expects a -3% to -6% revenue decline in Q2. The turns ship rate declined in five of the last six quarters, and was flat in the one remaining quarter. This means that the company is retaining a larger percentage of orders in backlog than it did previously, probably a reflection of the inadequate inventory that is leading to a stretching of lead times (10 weeks in the last quarter). We estimate that if the turns business is flat sequentially, the company would require a 59.3% ship rate to meet the guidance for the third quarter. ISIL has had a 59%+ ship rate in the last eight quarters, and we do not expect it to fall short of this in the third quarter. However, the company has a very broad product range, therefore it has to anticipate demand in a large number of markets and build inventory accordingly. If there is a discrepancy between the composition of inventory and actual demand, shipments will fall below expectations.

First quarter highlights
The first quarter was the last reported quarter. The results are summarized here. The pro forma gross margin for the first quarter was 66.1%, down -199 basis points [bps] from the previous quarter s 68.1%. This was the fifth consecutive quarter of decline in gross margins. Including the impact of -$11.2 million in stock compensation expenses, the gross margin was 63.9%, or down 240 bps sequentially. The gross margin decline in the last quarter was attributed partly to product mix, as a result of the execution of management s new growth strategy and partly, to other factors. The operating expenses of $130.4 million were higher than the previous quarter's $123.0 million. Approximately $3 million was spent on the review of the company s stock option practices, and $3 million for additional R&D headcount and expenses. The operating margin was down sharply to 40.2%. The cash (earnings before interest, taxes, depreciation & amortization or EBITDA) margin was 54.8%, down -364 bps from the prior quarter s 58.5%. The expensing of stock options had a 1016 bp impact on the cash margin in the last quarter.


On a pro forma basis, MXIM had a net income of $158.6 million, or a 31.5% net income margin, compared to $175.6 million, or 34.4% in the previous quarter and $133.6 million or a 31.5% net income margin in the prior-year quarter. Fully diluted pro forma earnings per share [EPS] was $0.48, compared to $0.53 in the June quarter and $0.39 in the first quarter of fiscal 2006. On a fully diluted GAAP basis, the company recorded a net profit of $107.5 million ($0.33 per share) compared to $124.3 million ($0.37 per share) in the previous quarter and a net profit of $105.4 million ($0.31 per share) in the prior-year quarter. The GAAP EPS of $0.33 was in-line with the consensus pro forma EPS estimate of $0.33.

Inventories rose 5.1% to $218 million, yielding annualized inventory turns of 3.1x. DSOs were up from 52 to 53 days in the last quarter. Maxim ended with a cash and investments balance of $1.394 billion, as cash from operations was $214 million. The uses of cash include $60.8 million for the repurchase of 2.1 million shares and $50 million for the payment of quarterly dividend. Capital expenditures were $94.9 million in the last quarter. MXIM has no long-term debt and $87.1 million in long-term liabilities.

The quarterly dividend was raised to $0.156 per share. There is very little risk of the dividend stream being interrupted.

Third quarter guidance
Management's revenue guidance was for a -3 to -6% sequential decrease. The company did not provide further color on its expected performance in the third quarter. Management had previously stated that it expects to spend $185 million in capex in fiscal 2007 ($80 million of which was to be spent on front-end expansion, $50 million on back-end and test, $15-20 million on buildings, and $15 million on software, CAD and other non-technical expenses). Around $95 million of this was spent in Q1, while the balance was expected to be split at $20-30 million a quarter for the next three quarters.

The company has received another delisting notice from NASDAQ due to the continued delay in filing its financial reports. The Nasdaq Listing Qualifications Panel has granted the company an extension until March 26 to file the necessary forms, information about its stock option review and required restatements.

VALUATION
MXIM shares are currently trading at a 25.9x multiple of our 2007 EPS estimate [P/E]. The company operates in an attractive segment that until recently was a fast-growing market. Management s disciplined execution and cost-cutting initiatives lay the foundation for steady controlled growth, without margin erosion. However, the new growth strategy involves a lower-gross margin, offset by lower operating expenses. Both orders and backlog declined again in the last quarter. The turns business continues to be impacted by a mismatch between existing inventories and market demand.

Our ROE analysis is based on data available up to the last reported quarter. The TTM ROE was 17.0%. This number has been on a decline, although it has been edging up slightly over the last few quarters. On splitting the ROE into its three components net margin, asset turnover and equity multiplier we were able to determine the reason for the decline. The company is facing gross margin issues (outlined above), which is the reason for the declining net margin. Revenue growth (other than in the September quarter) has been steady, driven by strength in its end markets.

This is outpacing the growth in assets, indicating that the company is efficient in converting assets to revenue. Maxim has no long-term debt, which makes it a lower-risk investment. Since management will only invest in business that is in-line with its long-term margin goals, this cash rich company continues to return cash to investors in the form of dividends. Maxim raised the quarterly dividend in the June quarter, and investors can now earn $0.125 per quarter on each MXIM share owned. We continue to be very positive on this stock and believe it is under-valued.

We expect the stock to trade higher as the margin issues are resolved and the general market environment improves. Consequently, we are maintaining our Buy rating on MXIM shares and target price of $35.00, which corresponds to a 29.4x P/E multiple.

RISKS

  • Order fulfillment could be difficult, as management remains unsuccessful at aligning inventory with
    end market demand.
  • The exposure to the consumer end market has been increasing, and this is increasing the volatility
    of ordering patterns.
  • The negative impact of the new lower-margin business is likely to continue.
  • INSIDER TRADING AND OWNERSHIP
    The top five institutional holders of the stock are Capital Research & Management Co. (with 17.5% of total shares), Fidelity Management & Research (11.6%), Wellington Management Company (9.6%), T. Rowe Price Associates (8.6%) and Barclays Global Investors (3.2%). All the major holders except Fidelity increased their positions in the quarter. Fidelity liquidated 10.0% of its holdings. Insiders hold 4.4% of the total shares and were net sellers of the stock since January 2005.

    SUMMARY
    Maxim is an OEM of semiconductor analog and mixed signal ICs. December quarter revenue was in-line with consensus estimates. Both bookings and backlog were down again last quarter, pushing up turns requirements for the fiscal third quarter. Management did not announce further details on the quarter, and expects to restate results from 2000 through 2006 pursuant to the stock option issue. We expect a softer quarter, as management adjusts to the changing profile of business. Additional capacity and a more suitable die bank should support growth in fiscal 2007. The stock is trading at two-year lows, indicating strong upside potential when these issues are resolved. Consequently, we reiterate our Buy rating on MXIM shares.

    KEY POINTS

  • Maxim has not provided detailed numbers for the December quarter, citing the stock option issue. Management will be restating results from 2000 to 2005 and for the interim period through March 2006.
  • The business model continues to look attractive, as even with the new strategy the company last reported gross margins of nearly 70%, operating margins in the 40 50% range and net margins in the 25 34% range.
  • Revenues were well within the guidance range after two quarters of misses, indicating that management may be getting a handle on the changing mix of the business.
  • Backlog declined for the second consecutive time in six quarters.
  • Management indicated a change in end market classifications, broadly dividing the business under the high-end consumer, computing, communications and industrial heads. Strength in computing offset weakness in consumer in Q4, while communications and industrial bookings were relatively flat sequentially.
  • Semiconductor analog and mixed signal product segments have longer product cycles and are less likely to become commoditized.
  • We are unable to comment on the cash position, but the company continues to boast a debt-free balance sheet and generate strong cash flow.
  • The semiconductor industry is expected to have grown at well over 9% in 2006, and the SIA forecasts a CAGR of at least 9% through 2009. The analog component is expected to grow in low double-digits.
  • MXIM 1-yr chart:

    Source: Maxim Integrated: Good Entry Point, Strong Upside Potential