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By Stephen D. Simpson, CFA

There's a quote out there, apocryphally quoted to former NFL player Randy White, that “potential is a fancy French word that means you haven't done anything yet”. Although that is arguably a harsh introduction to semiconductor company Microsemi (Nasdaq: MSCC), there is an element of truth to it – Microsemi could indeed be an attractive semiconductor stock to hold at these prices, but the company needs to begin delivering on the growth and margin potential that bulls have long seen in the name.

Come Hell Or High Water

There were multiples concerns that set these shares back in 2011, but it is worth noting that Microsemi's performance was not that bad in the context of a generally poor year for semiconductor stocks.

For starters, the near-constant wrangling over the federal budget and the concern over the government's debt and deficit situation has led investors to assume significant cutbacks in defense spending. With roughly one-third of Microsemi's business coming from selling to defense contractors like Lockheed (NYSE: LMT), Raytheon (NYSE: RTN), and L-3 (NYSE: LLL), that's no trivial concern. Fortunately for the company, the recent defense budget was not as bad as initially feared and the company stands to benefit from smart warefare retrofit projects (like GPS-equipped mortars).

Microsemi has also been impacted by the severe flooding in Thailand. While a great deal of attention has gone to disc drive makers like Western Digital (NYSE: WDC) and Seagate (NYSE: STX), this disaster was more broadly disruptive to electronics – and Microsemi has lost a few percentage points of organic growth because of it.

Last and not least, many of the secular growth stories that Microsemi bulls have been counting on have been slow to develop. Exposure to a quality medical device maker like Medtronic (NYSE: MDT) means much less when pacemaker and ICD sales are weak. Likewise, sales of products like notebooks and power-over-ethernet (PoE) systems have been soft.

A Business With Under-Appreciated Qualities

While 2011 was disappointing, it should be noted that Microsemi has once again proven that its bad cycles are relatively better than those of analog players like Linear Technology (Nasdaq: LLTC) or smaller ON Semiconductor (Nasdaq: ONNN).

Microsemi also arguably does not get enough credit for the barriers to entry in its core business. About 60% of the company's sales come from so-called high-reliability semiconductors. These products, which Microsemi sells to defense and satellite customers like Raytheon and Lockheed and aerospace contractors like Honeywell (NYSE: HON) and Goodrich (now owned by United Technologies (NYSE: UTX)), are often sole-sourced and can have qualification periods of three years or more. Couple this with relatively modest growth rates and few companies are eager to make the upfront investments to supplant Microsemi.

It's also worth noting that there should be some growth upside starting in 2012. In addition to the aforementioned defense upgrades, Boeing (NYSE: BA) and EADS have both pointed to a stronger commercial aerospace market. And though it may stretch beyond 2012, Microsemi longs can also look to increasing roll-outs of millimeter wave scanners, PoE systems, and a bottoming-out of the solar panel industry.

Cobbling Together Spare Parts

Microsemi has been an active acquirer, often targeting companies with low market capitalizations and relative low investor interest. In many cases, though, these are deals where Microsemi can theoretically reap significant synergies (often by implementing its fab-light model) as well as penetrate attractive markets. Actel, for example, should improve the company's programmable logic device business, while Zarlink should bring additional customers in the medical technology arena.

One of the big questions for Microsemi is whether it can deliver on those margin promises. Although Microsemi holds its own with smaller players like ON Semiconductor and Fairchild (NYSE: FCS), it just doesn't compare that well with the likes of Texas Instruments (NYSE: TXN) or Linear. The opportunity is there and there are no structural reasons why Microsemi can't get there, but investor frustration with the company's low returns on capital and slow margin progress is an issue.

The Bottom Line

If Microsemi can execute on its margin improvement potential, this is an intriguing semiconductor company that combines above-average growth prospects in markets like body scanners, medical devices, and PoE with well-protected core markets in areas like defense systems, aerospace, and satellites. Likewise, it is not too difficult to extrapolate that there could be many more higher-growth commercial opportunities for those core high-reliability capabilities.

Microsemi has delivered four straight years of double-digit free cash flow margin and a long-term revenue growth rate of over 16%. Even if future topline growth is less than half that rate, so long as the company can drive margins back to fiscal 2010 levels there is ample upside to this stock and fair value could lie close to $30 per share.

Disclosure: I am long MSCC.