Small-cap value is a dicey proposition in technology, as investors are often more inclined to ignore valuation in the pursuit of disruptive technology and break-out growth stories. Unfortunately, while Microsemi's (MSCC) growth isn't bad by the depressed standards of today's semiconductor market, this is not a stock that's going to challenge names like Broadcom (BRCM) or Mellanox (MLNX) for growth leadership. What Microsemi does offer, though, is a business leveraged to operating improvements and built around markets where the company is often hard to dislodge.
A Fiscal Third Quarter Mostly On Target
From a high-level view, there wasn't much about Microsemi's fiscal third quarter that surprised investors.
Revenue rose 4% from the second quarter (up 20% from the year-ago level) and more or less in line with expectations. Interestingly, the company showed higher growth in industrial (up 8% sequentially) than many other large players like Texas Instruments (TXN), Maxim (MXIM), or Fairchild (FCS), while solid growth in commercial aerospace went along with what we've heard from large customers like Honeywell (HON) and General Electric (GE).
Margins continue to improve as the company absorbs and leverages the deals for Actel and Zarlink. Gross margin improved about three points sequentially (GAAP basis), while operating income nearly doubled. The company's progress was not so dramatic by non-GAAP adjusted accounting, but the company's ongoing margin improvement story is nonetheless intact.
Near-Term Looking Surprising Solid
Microsemi's management modestly increased guidance for the next quarter relative to sell-side expectations. Against soft guides from Texas Instruments and Fairchild, I find that encouraging. What's more, I find it interesting that the company's defense business is holding up as management suggested - with growth in the high single-digits to low teens. At a minimum, it would seem that Microsemi is benefiting from the long-term trend towards higher silicon content in munitions and systems even in a period of difficult budget constraints.
Can The Company Perform?
I'm not really that concerned about management's ability to execute on the synergy potential with the Zarlink deal; Microsemi's operating performance history is by no means flawless, but it's good enough that it's not my primary concern.
My primary concern is whether the company can take what it now has and continue to build from here. The company's acquisitions brought a lot of know-how and potential to the table, but the company will have to execute on that potential and keep up a steady flow from the lab to the market.
Microsemi may benefit from the fact that companies like Texas Instruments, Maxim, and Broadcom would rather bludgeon each other over market share and sockets in phones and tablets than move into markets like medical, satellite, and renewable power, but that won't last forever. So it is up to Microsemi management to demonstrate that they can simultaneously execute on the margin potential and grow their markets like medical and programmable logic devices.
The Bottom Line
I own Microsemi shares, and I do believe that they are undervalued on the basis of a fair value in the mid-$20s. I expect about half of the forward free cash flow growth to come from revenue growth, with the remainder from cash flow conversion (largely operating margin improvement).
That said, this is a somewhat low-conviction hold for me. While I do believe that Microsemi is undervalued, under-followed, and underestimated, it's difficult to ignore a name like Broadcom that is also undervalued and enjoys a well-earned reputation for execution. So long as management continues to deliver on margin improvements, I'm willing to stand by the stock … but a lot of my bullishness hinges on that improving operating leverage.