It's been a long, and sometimes strange, trip with Microsemi (NASDAQ:MSCC). It wasn't that long ago when writing positively about this semiconductor company generated a lot of negative feedback from the peanut gallery, but management has stuck to its plan and reshaped Microsemi into a diversified semiconductor company with multiple growth drivers and good margin leverage potential. The market has recognized this improvement too, with the shares up over 130% over the last three years and up more than 50% over the past twelve months.
Now Microsemi is a relatively popular name - it's on multiple sell-side "Top Pick" lists and the stock is in play as an M&A target. I do believe there is a credible case that Microsemi could be a target, if for no other reason than M&A is a reasonable way to drive earnings growth in the semi market today and the recent wave of consolidation has thinned the herd of eligible and worthwhile targets. Given the upside potential of a deal, I'm inclined to hold on to what I have but I will note that it's not really plausible (in my opinion, at least) to validate today's price on a standalone basis.
Still Growing And Improving
Microsemi's mid-November earnings report was fine. Revenue was up about 4% on a sequential basis and up 37% from the prior year, helped by the PMC-Sierra deal. All of the segments contributed to sequential growth, with Aero/Defense and Datacenter up in the low single digits, Communications up mid-single digits, and industrial up 8%.
While there are meaningful growth drivers here for the next few years, the margin leverage potential of the business has been the real attraction for some time. Gross margin improved by about 70 bps sequentially and closer to 10 points on a year-over-year basis. That more than flowed through to the operating line, as operating income rose 41% on a sequential basis, lifting the operating margin by about four points.
Digging a little deeper, the communications segment saw good growth in Ethernet, FPGAs, OTN, and timing products, although broadband was a little sluggish. Industrial was strong on good medical sales, while datacenter was a mix of decent growth in SAS and more disappointing performance in legacy products.
Looking ahead, management pointed to encouraging satellite bookings. While I do not question management's comments, the satellite business has been a frustrating one to track/predict. Aerospace is looking a little better and Microsemi management also noted that the new administration in Washington could lead to a doubling of their initial growth expectations for the defense business. Optical switching is looking healthy thanks to companies like AT&T and Verizon, while Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), and Microsoft (NASDAQ:MSFT) are helping the datacenter business outlook.
A Solid Outlook And Consistent Message
Microsemi hosted an analyst day back in September and it was remarkable mostly for not being remarkable. To management's credit, they've stayed consistent with the plan and the message for some time now, and they have largely been delivering on their stated objectives of margin leverage, debt reduction, and successful integration of the PMCS deal.
Management guided to 6% to 8% revenue growth, and pointed to some significant growth opportunities. The increased electrification of commercial aircraft could support an incremental $200 million in addressable revenue and defense could be a bigger contributor in the coming years with a Republican administration. The Grantley-Purley transition and the opportunity to gain as much as 10% market share in SAS/SATA could add $150 million from storage, and communications sub-markets like Ethernet switching, timing, and OTN could contribute over $300 million in incremental revenue.
Microsemi's management also reiterated that they are on the sidelines with respect to further M&A until they reduce leverage. Overstretching the balance sheet for yet another deal is arguably the largest potential bearish development, or at least within those that management can control.
Time For The Serial Buyer To Sell?
Microsemi's shares have been helped higher in recent weeks by rumors that this serial acquirer may itself by on the block. Rumors have indicated that Skyworks (NASDAQ:SWKS) has approached the company and sell-side analysts have added other names to the mix of potential buyers including Infineon, Marvell (NASDAQ:MRVL), STMicroelectronics (NYSE:STM), Maxim (NASDAQ:MXIM), Texas Instruments (NYSE:TXN), and Broadcom (NASDAQ:AVGO).
The appeal of Microsemi as a target is relatively straightforward. While the company does have a lot of debt, it also has strong market positions in attractive markets like timing/synch, power, and SAS controllers, as well as low-power FPGAs. Microsemi has historically been something of an odd duck with respect to its revenue cycle and the wider semiconductor market, so a buyer might find some appeal in that slight counter-cyclical aspect. Microsemi would also offer what drives so many semi deals these days - operating leverage. Microsemi's gross margins are pretty decent, but a lot of the operating expenses could be stripped out by a larger diversified chip company.
I don't think Broadcom is the most likely buyer; there would be some parts of Microsemi that they'd like and Broadcom management loves taking costs out of acquired companies, but I think they have their hands full already. For Skyworks, Maxim, Marvell, and TI, though, there could be 10% potential synergy to a deal if they can wring $100 million or more in cost savings from a deal and leverage the gross margin opportunity. It would be a big deal for Skyworks, but this company has made no secret of its desire to diversify its business and there aren't a lot of obviously better targets (and debt is still relatively cheap).
I would also note that the company has given the CEO restricted stock that is tied to the performance of the shares. Selling at a price of $60 to $70 would certainly be attractive from that standpoint, so I believe management will be receptive to a deal at the right price.
The Bottom Line
One of the most oft-repeated rules of investing from the greybeards is that you shouldn't buy stocks on the basis of M&A potential, and I largely agree with that. To that end, the 5% long-term revenue growth and 12%-plus FCF growth that I model isn't enough to support a price in the $50's, but I value Microsemi as a takeover target and work the cost savings into the valuation, the fair value goes above $60 pretty easily.
With that, I'm in no hurry to sell my Microsemi shares. They're stuck in that twilight zone between standalone value and a plausible takeout bid, but I'm willing to take the risk that the deal rumors fizzle in the hopes of getting that added value. Time will tell if that decision was greed or enlightened self-interest.
Disclosure: I am/we are long MSCC, AVGO.
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.