Another 'Is What It Is' Quarter From Microsemi

| About: Microsemi Corporation (MSCC)
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Microsemi hit its marks for the fiscal second quarter, but a small cut to revenue expectations for the next quarter matters more than a margin boost.

Synchronization/timing and FPGAs remain large addressable multiyear growth opportunities for Microsemi.

Microsemi looks undervalued on the basis of margins and FCF growth, but it's longer-cycle nature runs counter to what chip investors typically want.

Because Microsemi (NASDAQ:MSCC) zigs where most other chip companies zag, it never really seems to fit in with the general sentiment on chips. That's a plus when chip stocks go into the tank, but it can be frustrating when there's relatively more optimism about the semiconductor space. Given Microsemi's position in timing/synchronization and its growing FPGA business, I'm content to continue holding these undervalued shares, but I acknowledge that the company's erratic progress on revenue growth and margins will frustrate many investors.

In-Line For The Fiscal Second Quarter

Microsemi basically did what it said it would in the fiscal second quarter. Revenue rose 22% yoy and 12% sequentially, helped both by the Symmetricom acquisition in late 2013 and strong sequential improvements in aerospace, defense, and industrial end markets. Communications, the company's largest business, saw 3% sequential growth, while defense/security rose 25%, industrial rose 17%, and aerospace rose 8%.

Margins remain frustrating as the company continues to target 60%/30% levels for gross and operating margins, but makes erratic progress toward that goal. Gross margin (non-GAAP) fell a point and a half yoy and 80bp sequentially, but basically came in as expected by the Street. Operating income rose 19% yoy and 10%, with operating margin down a half-point on both a sequential and annual basis.

Guidance Doesn't Give The Street What It Really Wants

Although long-term performance in semiconductor stocks is typically driven by operating margins, near-term performance is much more sensitive to revenue growth. Microsemi revised its revenue target for the next quarter down by about 1.5%, while the guide for a sequential GM improvement of 20bp to 100bp was a little better than expected. The net result, lower revenue but better margins/earnings, isn't really what investors want and so I expect the shares will sell off on the news.

Underlying the near-term outlook, Microsemi's business appears to be in good shape. The company spoke a book-to-bill "solidly greater than 1", though management wouldn't quantify beyond that. The issue for Microsemi, as opposed to a chip company like Freescale (NYSE:FSL) or Linear (NASDAQ:LLTC), is that the company's business typically has substantially longer lead times. Consequently, a strong book in Q2 doesn't mean to Microsemi what it would mean to other chip stocks, as those orders will convert to revenue further down the line.

Good Potential In Timing And FPGAs

Nobody is going to confuse Microsemi for Altera (NASDAQ:ALTR) or Xilinx, but Microsemi's commitment to FPGAs is more significant than many investors seem to realize. As a very quick overview, FPGAs offer certain advantages over ASICs like faster time to market, lower design costs, and flexibility (field reprogramability). While the advantages and disadvantages of FPGAs versus ASICs is a topic for its own article, the more relevant point is that Altera and Xilinx basically dominate this market with over 80% share.

While Altera and Xilinx are significantly larger than Microsemi in FPGAs, Microsemi has grown its FPGA business to the point where it is nearly one-quarter of revenue. Microsemi has been focusing on the sort of low-power/high-reliability market segments that have served it well for many years, and Microsemi already counts Rolls Royce, Medtronic, and Ericsson among its FPGA customers, which tells you a little bit about the markets that Microsemi is addressing (aerospace, implanted devices, and networking/communications, respectively).

Microsemi's opportunity to leverage its Symmetricom acquisition may also still be underappreciated in the market. Timing and synchronization is vital in satellites and wireless networks and Microsemi is really the only end-to-end provider in the market. Microsemi does face competition from Frequency Electronics (NASDAQ:FEIM) in both satellites and communications, but most of Microsemi's competition is from internal sourcing or small businesses within larger enterprises and Microsemi should be able to exploit its wider portfolio and greater R&D and sales commitment to the space.

Undervalued For Growth And Margin Potential

Microsemi looks undervalued on both its long-term growth potential and its near-term margins. I model long-term revenue growth of 7% for Microsemi. That's a relatively high number for a chip company, but I believe the company can expand its opportunities in FPGAs and timing/synch to add growth. I'm also looking for Microsemi's 60/30 margin goals to lead to high teens/low 20%'s free cash flow margins, supporting double-digit long-term FCF growth.

Those cash flows discount back to a fair value of around $31, setting these shares up as a pretty undervalued opportunity in chips. I also believe the company's margins indicate that the company is undervalued. Looking at how the market typically prices semiconductor company operating margin, Microsemi should be trading at over three times revenue (EV/sales), or a fair value of $33.

The Bottom Line

In the near term, I won't be surprised if stocks like Freescale, Linear, or ON Semiconductor (ONNN) outperform Microsemi, but I continue to believe this is an overlooked, underestimate, and undervalued chip company. Admittedly, a downward revision in revenue growth and unsteady progress toward margin goals doesn't strengthen the case, but I continue to believe that Microsemi's different approach and business model will generate above-average long-term returns from today's level.

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.

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