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By Stephen D. Simpson

Small-cap semiconductor company Microsemi (NASDAQ:MSCC) and I go back a ways. I've owned this stock at various points over the last 16 years and have always managed to make money doing so. I suspect a fair bit of those profits have come from appreciating the company's qualities and prospects at times when the Street was entranced by sexier growth names and then selling as the optimism built.

It's a little hard to really feel good about the December results that Microsemi just posted. Sure, there are good reasons that results were just in-line and that guidance was a little soft, but I hold these shares for performance and not to hear good reasons for underperformance. So, what's a Microsemi investor to do?

A Good Enough Q4

Don't get the idea that Microsemi had a bad quarter; the company did what management basically said it would. Revenue rose 31% from last year and 6% sequentially, boosted in large part by the communications sales that came with the acquisition of Zarlink. Shipments in commercial aerospace and defense were both down double digits, while the industrial/energy business was mixed.

This later point is not so shocking - sentiment on chip stocks may be improving, but earnings reports and guidance from the likes of Texas Instruments (NASDAQ:TXN) and Freescale (NYSE:FSL) serve as reminders that that things aren't great yet.

Margins were something of a disappointment. I suspect that I underestimated the cost ramifications of bringing in Zarlink, the disruptions in Thailand, and the impact of utilization. Nevertheless, gross margin slipped about five points sequentially on a GAAP basis. Microsemi reported a GAAP operating loss, while "adjusted" income fell 13% sequentially.

Better Margins Are Going To Take Longer To Achieve

Odds are that the biggest disappointment on the Street is going to be with Microsemi's guidance. Defense orders are shaky right now as customers like Raytheon (NYSE:RTN) and Lockheed (NYSE:LMT) try to figure out the new realities of federal funding. At the same time, it seems like the immediate potential of Zarlink to contribute to revenue is a little less than previously thought.

On a more positive note, millimeter wave scanner shipments should be on the way up in 2012 and it seems as though the company may pick up Cisco (NASDAQ:CSCO) as a power over ethernet customer. It's also important to recognize that book-to-bill was above 1.0, and that's usually been a good predictor of better sales growth on the way at Microsemi.

On the margin side, the company has to absorb some consolidation expenses and still deal with utilization and production rates that are fairly close to trough levels. Management didn't back away from rather encouraging long-term targets; they just believe it will take a few quarters longer to get there.

Microsemi's Best Attributes May Not Be In Vogue Now

Compare Microsemi's peak-to-trough performance in sales and margins to the likes of Texas Instruments, Linear Technology (NASDAQ:LLTC), and even Analog Devices (NASDAQ:ADI) and Microsemi holds up quite well. Unfortunately, steadiness is rarely priced among tech investors.

What investors seem to want today (and most days in tech) is strong growth and product cycle stories. Broadcom (NASDAQ:BRCM) has the strength of mobile devices to build around, Silicon Labs (NASDAQ:SLAB) has a strong organic growth story in touch controllers and TV tuners, and Atmel (NASDAQ:ATML) has its microcontroller and maXTouch touch controller business to stoke expectations for 2012.

Now Microsemi isn't bereft of growth opportunities. It's just that body scanners, power over ethernet, and wireless LAN are more "on the come" and management's trimming of guidance isn't going to get investors excited about the story. By the same token, Microsemi spends quite a lot on R&D (more than 16% in this quarter), so it's not like bulls don't have some reason for optimism about internal product development fueling future growth.

The Bottom Line

So, what to do with Microsemi's stock? Looking at alternate chip stock ideas like Atmel, Broadcom, and Silicon Labs, the expectations for Microsemi do seem relatively conservative. Bears will say that's richly deserved, as the company's largest markets (defense and aerospace) don't have the same end-market growth. That's true, but it also overlooks the company's growth prospects in communications, industrial, and medical applications.

For investors who believe Microsemi management can deliver on their long-term gross and operating margin targets, these shares are worth something in the mid-$20s today. That's less than the target I offered a few weeks ago, but I'm taking a much more conservative growth outlook now. Although I get the appeal of more dynamic near-term growth stories, history suggests that the right time to buy Microsemi is when the Street is downcast on the company's growth prospects.

Source: Microsemi's Frustrating But Ultimately Undervalued Story