Microsemi Not Quite To Plan, But Still Improving

| About: Microsemi Corporation (MSCC)
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Owning Microsemi (NASDAQ:MSCC) is an interesting experience. For a company that is pretty small and obscure by most standards, there's a surprising number of people who want to bash the company and claim that its success is only due to the fact that it is, in many cases, the only approved supplier of a particular component.

Let the haters hate - I'm firmly in the black with these shares and the trailing performance compares quite nicely with the semiconductor sector as a whole, not to mention individual rivals like Silicon Labs (NASDAQ:SLAB), Fairchild (FCS), and Semtech (NASDAQ:SMTC). What's more, the company is built upon a continuous flow of new products, coupled with moves to unlock more operating leverage from the operations. Although these shares are close to my fair value, and I have considered selling them in favor of owning a more undervalued chip stock, a recovery in multiple end-markets could drive higher performance from here.

Q3 Numbers Hit The Mark, If Not Quite According To Expectation

All in all, Microsemi had a decent quarter, with a more or less in-line quarter and consistent guidance. It wasn't a quarter to change hearts and minds about the company, but it was enough to maintain confidence in a slow-going recovery scenario.

Revenue fell 6% from the year-ago period, but rose 3% sequentially. Defense was surprisingly weak on a sequential basis (down 4% against an expectation of mid single-digit growth), but this business had outperformed for multiple quarters and it seems as though order timing played a significant role in the shortfall. Commercial aerospace was pretty soft (up 2% qoq), but communications revenue looked good (up 5%) and industrial revenue (up 13%) was surprisingly strong.

Margin performance was a little convoluted. Microsemi's gross margin improvement seems to have stalled out a bit, as it improved 120bp from last year, but only 30bp sequentially. Operating income was the more convoluted part - up 18% and 114% by GAAP standards (stronger than expected), or down 10%/up 10% by non-GAAP standards (basically in line) due to less stock option expense.

The Future Is Looking Good, But It Will Likely Be Volatile

Whether it's analog players like Analog Devices (NASDAQ:ADI) and Linear Technology (NASDAQ:LLTC) or an FPGA company like Altera (NASDAQ:ALTR), guidance and management's comments about the near future often count for more than reported results. To that end, Microsemi's guidance seemed basically okay.

Microsemi's book-to-bill was over 1.0 for the quarter and management maintained its guidance for the next quarter (2% to 4% sequential revenue growth). That said, I'd be very surprised if the company managed to repeat the strength in Industrial, which was helped by strong orders tied to Medtronic (NYSE:MDT) ICDs and MRIs (likely either General Electric (NYSE:GE) or Siemens (SI)), as the underlying growth in ICDs and medical "big iron" is not that strong at present.

On the other hand, the company announced a new government contract for a complex SoC that will deliver $75 million in revenue over the next two years, starting next quarter (though with more of the revenue weighted into 2014). Elsewhere, Agilent (NYSE:A) reported strong test & measurement demand in the satellite space, which could mean that these programs are getting closer to deployment. With Microsemi seeing its content increasing by about 50% to $3 million per satellite, that would be a welcome development.

Growth Won't Save The Story, But Leverage Might

Microsemi is never going to offer the sort of growth investors expect from the more exciting stories in semiconductors - that's just not the model here. Now, that's not to say that improvements in industrial, communications, and aerospace chip demand can't or won't help; I do believe an overall recovery in chip demand could see Microsemi delivering double-digit revenue growth for a period of time.

What Microsemi can do, though, is continue to produce better operating leverage. Gross margins of 57% already put the company on the stronger end of the industry spectrum, and management believes they can still hit 60% (though I think it'll take a little longer...). Moreover, the company's operations are relatively R&D-intensive, which does force competitors to invest resources as well if they want to try to compete in the same markets (not to mention qualification periods that can run three years or longer). All told, I believe Microsemi can hit its goal of 60% gross margin and 30% operating margin - a development that will flow strongly to the bottom line and into free cash flow.

The Bottom Line

I believe that demand for new scanners, power over Ethernet, high-end FPGAs (on a very limited basis), tamper-proof products in defense/security, satellites, and maybe even a solar recovery can lead to a revenue growth recovery at Microsemi. With that, I'm looking for long-term growth of about 6%, with a somewhat higher growth rate over the next five years. I'm also maintaining my expectation for operating leverage and better free cash flow margins, leading to a low-to-mid teens free cash flow growth rate.

On the basis of those assumptions, I'm comfortable with a price target in the high $20s, though you may be able to get to $30 if you're willing to use a lower discount rate due to the barriers to entry in many of Microsemi's markets/sockets. Although that's above today's price, it doesn't scream "bargain" to me, and it does leave the risks of Microsemi facing more competition and/or failing to achieve its operating leverage goals. With that, I may be tempted to switch to a stock like Broadcom (BRCM) or LSI (NYSE:LSI), but I'm not in a big hurry to sell so long as the company continues to show improvement.

Disclosure: I am long MSCC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.