Efficiency Trumping Growth At Microsemi For Now

| About: Microsemi Corporation (MSCC)
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Microsemi's revenue growth performance isn't jumping out amidst a slow stretch for the industry, but management has been making notable progress in reducing operating costs after the PMC-Sierra deal.

Shrinking the cost base should leave the company well-placed to enjoy meaningful margin leverage as opportunities in aerospace, communications and data center kick in over the next 12-18 months.

The shares look fairly valued today, though even more progress on margin improvement and/or stronger revenue growth would drive a higher fair value.

As the larger semiconductor industry continues to bump along with little-to-no organic growth, Microsemi (NASDAQ:MSCC) too has found its organic growth opportunities somewhat limited in the near term. The good news, though, is that the company has been making real progress with cost-cutting and debt repayment, putting it in a good position to reap meaningful operating leverage and profit growth when underlying demand improves.

Microsemi's quarter was pretty nearly on target with my model, so my post-earnings changes aren't significant. The shares have done alright over the last year, matching the SOX index and beating the major indices, but I don't see major upside left based on the fundamentals. I do think there is a possibility that the growth outlook improves toward the end of the year (and higher revenue drives a higher fair value), but with a 25% move since my last article, I regard this more as a "quality hold" to buy on pullbacks than a must-buy at today's price.

Murky Underlying Growth Trends, But Generally Positive

Unfortunately Microsemi elects not to report organic revenue growth figures that would adjust for the impact of the PMC-Sierra acquisition and the recent divestitures. Consequently, the reported 36% growth in revenue from last year is most definitely not an accurate reflection of underlying business momentum, but then neither is the 3% sequential decline.

Based on what I know about the divested businesses, I think Microsemi grew around 2% to 3% on a sequential basis. That's not up to the level of NXP (NASDAQ:NXPI) or Integrated Device Technology (NASDAQ:IDTI), but it's better than the nearly flat overall semiconductor industry average and it is not a bad result for a company with low exposure to the fast-growing auto market (fast-growing for chip companies, that is).

Looking further, the 15% sequential decline in the aero/defense business seems to be largely due to the company's sale of the board-level systems and packaging business to Mercury Systems (NASDAQ:MRCY) earlier this year. Aero was reportedly up 13% and the company reported strong satellite bookings that should ship later this calendar year.

The Comm business was up just a bit sequentially (up 1%) despite good results in optical and Ethernet. Data center was up 8% and management sounded bullish on 12G SAS, while Industrial was down 3% sequentially due in part to the Mercury sale but also ongoing weakness in oil/gas and industrial automation. Medical was strong for the company, but again I'll mention that the company lacks that auto driver that has pushed growth for many chip companies like NXP in recent quarters.

Delivering On Execution

A major component of the PMC-Sierra deal was the notion that Microsemi management would effectively cut costs, drive synergy and generate meaningful leverage on the back of PMC-Sierra's superior revenue growth prospects (off a smaller base, but heading into major product ramps) and strong gross margins.

So far, so good.

Gross margin improved almost eight points from last year on a GAAP basis (close to five points on a non-GAAP basis), and was about two points higher sequentially on a non-GAAP basis. I was impressed with the $11 million sequential decline in reported SG&A expenses, as well as the $5 million decline in R&D expense, and management's target of $100 million (or more) in long-term operating synergies seems to be drifting in the direction of "or more."

It's not just about going hack-and-slash to PMC-Sierra's cost structure, though. Microsemi seems focused on maintaining R&D spending at a "mid-high" teens percentage of revenue (or however you'd refer to 17%) and the company now outsources around 90% of its manufacturing. Prioritizing Arrow as a distributor should streamline the sales effort to some extent, and I believe this is establishing a lean operating structure that will be able to translate future revenue growth into stronger profit growth.

What Will Drive The Next Leg Of The Journey?

Management has talked about future organic revenue growth potential in the mid-to-high single-digit range. That's an aggressive target given the pronounced overall (and ongoing) slowdown in the chip space, but I believe management has a credible chance of attaining that goal.

Defense and security is still a promising market, with information assurance, anti-counterfeiting and anti-tamper all key growth areas that Microsemi can address. Aerospace continues to offer above-average growth, as the company's content has grown with both Airbus (OTCPK:EADSY) and Boeing (NYSE:BA), with nearly $300,000 in content per plane for the A380 and 787 programs, and ongoing growth with engine supplier Rolls Royce (OTCPK:RYCEY).

On the communications side, the company has done well with Cisco (NASDAQ:CSCO) and Ericsson (NASDAQ:ERIC), with the latter incorporating more Microsemi content (particularly in timing products) into base station and backhaul equipment. Looking not all that far ahead, ongoing 4G deployments and data demand growth should be meaningful tailwinds for the company's communications and data center businesses. I think it's worth mentioning that IDT is a pretty formidable rival in timing, at least in terms of market share, and Silicon Laboratories (NASDAQ:SLAB) has also targeted this market as a growth opportunity.

Industrial is more "meh" at this point. The company does have some exposure to electrification of transportation and has been building up its offerings for industrial automation, but neither that market, oil/gas, nor medical seems poised to deliver exciting growth in the next year or two.

Putting It Together

As I said before, not much in this quarter was different than I'd expected, so there's not much to change in the model. I was a little concerned about the sub-1.0 book-to-bill, but "concerned" is not the same as surprised. After some adjustments, I'm still looking for roughly 9% long-term revenue growth, or around 6% adjusting for the turbulence created by the recent deals. I continue to believe that Microsemi will hit its margin targets and that that can support significantly higher free cash flow margins (in the 20%s) in the coming years.

Discounted back, my cash flow-based fair value is around $37. The other method that I use, a margin-based EV/revenue approach, gives me a fair value of almost $39.50 on the basis of a 3.55x multiple to 12-month revenue. In this model, a quarter-point of better operating margin would support a 0.1x improvement to the multiple, or about $1.50/share in upside, so further improvements in the cost structure can definitely drive value (not to mention higher revenue estimates).

The Bottom Line

Management was pretty clear that further M&A is off the table until they've paid down more of the PMC-Sierra debt, and I believe that is a good move at this point. Looking ahead, I would think management would like to increase its exposure to the auto sector and M&A could be one way to achieve that. That said, it sounds like industrial IoT is a bigger near-term priority and I can't argue with that.

With the move in the shares, I'm back to a footing where I like the company more than the stock. I'm going to continue holding, but I think it would take either a sell-off back into the mid-$30s or a stronger near-term growth outlook for me to argue that this is a good buy for new investors. Still, there are worse things than holding a well-run company with both organic growth and margin leverage potential near at hand.

Disclosure: I am/we are 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.