Performance and Valuation Prime™ Chart
Microsemi Corporation (NASDAQ:MSCC) is a leading designer, manufacturer, and marketer of high-performance analog and mixed-signal semiconductor solutions, differentiated by power, security, reliability, and performance. Primarily in service of the aerospace and defense, communications, and industrial markets, MSCC appears well positioned to benefit from substantial tailwinds related to increased infrastructure and defense spending under President-elect Trump. Additionally, with industry-leading solutions in the cloud storage and fiber optic markets, MSCC stands to benefit from further tailwinds related to expanding cloud infrastructure, hyperscale data centers, and the continued transition from copper to optical networking.
Historically, MSCC has seen fairly volatile profitability, with Uniform Adjusted Financial Reporting Standards (UAFRS) based ROA typically ranging from 2x-3x cost-of-capital levels. While Adjusted ROA declined from 12% in 2001 to a low of -5% in 2003, it recovered to 17% in 2006, and ranged from 10-15% through 2010. In 2011, Adjusted ROA jumped to a new high of 25%, where it remained in 2012, before stabilizing around 17-19% levels from 2013-2016.
In FY 2016 MSCC also saw material Asset' growth, above their normal +10% rates from the last 7+ years, as Asset' growth was 45%. This was driven by the company's acquisition of PMC-Sierra. After adjusting for the acquisition, the company had relatively stable ROA' in 2016, but going forward this may change.
Analysts are forecasting that after the acquisition integration process and other positives for the company, Adjusted ROA will ramp towards historic peaks in 2017 and 2018. Analysts forecast Adjusted ROA to rise from 17% to 21% in 2017, and then to 22.4% in 2018, a substantial improvement thanks to tailwinds for the business.
For context, the PVP chart below reflects the real, economic performance and valuation measures of Microsemi Corporation after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
The four panels above explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.
Performance Drivers - Sales, Margins and Turns
It can be helpful to break down Adjusted ROA into its DuPont formula parts, UAFRS Earnings Margin and UAFRS Asset Turnover, which are cleaned up margins and turns metrics used to calculate Adjusted ROA. The chart below details both Adjusted Earnings Margin and Adjusted Asset Turns historically, to help us better understand the drivers of the firm's profitability and performance.
Trends in Adjusted ROA have been driven by trends in both UAFRS-based Earnings Margins and Asset Turns. While Adjusted Earnings Margins were fairly volatile from 2001-2010, they stabilized at 21-27% levels from 2011-2016. Meanwhile, Adjusted Asset Turns, which from 2001-2012 ranged from 0.8x-1.2x, fell to 0.7-0.8x levels from 2013-2016.
In 2015, MSCC acquired PMC-Sierra as part of the firm's strategic focus on market expansion, diversification, and cost synergy. As a result, analysts are projecting profitability to resume improvements once more, driven by a combination of expanded market reach and synergy savings.
Impact of Adjustments
This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.
The chart above highlights the impact UAFRS adjustments have on MSCC's asset base and earnings. The largest adjustment to the firm's Adjusted Net Asset base comes from UAFRS capitalization of R&D. MSCC has regular, and material investments in R&D each year that as-reported financial statements treat as expenses. This violates one of the core principles of accounting, which is that expenses should be recognized in the period when the related revenue is incurred. R&D investment is an investment in the long-term cash flow generation of the company. Because as-reported metrics treat R&D investment as an expense, as opposed to an investment, net income is artificially decreased.
In the same vein as R&D, MSCC's operating lease expense is somewhat material. However, the decision management makes between investing in capex and investing in a lease is not a decision between an expense and an investment, but rather a decision in how management wants to finance their investments. If they would rather spend cash up front for the asset, they will spend capex. However, if they want to spread the cost of the asset over several years, they will instead choose to lease the asset. That said, as-reported accounting statements treat one as an investment, and the other as an expense that does not impact the balance sheet. Because MSCC spends materially on operating leases, as-reported metrics like Total Assets and ROA materially overstate the firm's true profitability and capital efficiency versus UAFRS metrics.
MSCC also has material non-cash stock option expenses. This is treated as an expense to the company in accounting statements, when it is actually a way for the company to give employees an ownership stake in the company. As such, this non-cash expense should be treated as dilution to equity holders and another claim against the Enterprise Value of the firm, as opposed to it being treated as an annual expense. This is especially true as, unless the company uses cash to buy shares (to suppress dilution for equity holders from the option grants being exercised), there is no cash impact on the company.
These adjustments alone have a dramatic impact on MSCC's Adjusted Earnings, as the company actually has positive earnings, not the negative earnings as-reported distortions show.
Embedded Expectations Analysis
In addition to understanding the true profitability of the firm, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.
MSCC is currently trading at a 16.8x UAFRS-based P/E, which is near the high end of valuations since 2009. However, even at these levels, the market is pricing in expectations for declining Adjusted ROA, from 18% in 2016 to 12% in 2021, accompanied by 19% Adjusted Asset growth. With these expectations, it appears equity markets are expecting MSCC to fail to see any sustained benefit from the PMC-Sierra acquisition, despite analysts projecting otherwise. While the semiconductor market is highly cyclical and prone to volatility, expectations for MSCC to see Adjusted ROA fall back to levels not seen since 2010 appear overly bearish, especially in the context of analyst forecasts for improvements.
Peer Analysis - Valuations Relative to Profitability
A major benefit of adjusting as-reported financial statements is to clear away accounting distortions, to allow for more accurate peer-to-peer comparisons. To this end we have included a scatter chart below, that plots MSCC against its peers based on their Adjusted Price-to-Assets ratio (P/B) and Adjusted ROA.
Looking across industries, markets, and time, there has been a very strong relationship between a company's Adjusted ROA relative to the corporate average (6%) Adjusted ROA, and the multiple the market will pay above the value of the company's Adjusted Asset base, in terms of a UAFRS-based P/B (V/A') multiple. A company that generates a 6% Adjusted ROA will tend to trade at a 1.0x Adjusted P/B, and company that generates a 18% Adjusted ROA will trade at a 3.0x Adjusted P/B, etc.
Relative to its peers, MSCC appears somewhat undervalued with its 3.6x UAFRS-based P/B and 19% Adjusted ROA. While at first, the firm appears to be trading at valuations in line with peers relative to its current profitability, MSCC is projected to grow at a far greater rate than the other firms in the industry, with only SWKS expected to generate double-digit growth. Considering its substantially more robust growth profile, and robust, 3x cost of capital returns, MSCC deserves to be trading at a higher multiple.
Valuation Matrix - ROA' and Asset' Growth as Drivers of Valuation
When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for MSCC at various levels of profitability (in terms of Adjusted ROA) and growth (Adjusted Asset growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.
To justify current prices, MSCC would need to see Adjusted ROA fall by over a third, to levels not seen since 2010. Considering the robust macroeconomic tailwinds behind the firm, particularly those related to cloud storage, government spending, and fiber optic buildout, these expectations appear incredibly bearish. Moreover, analysts are projecting Adjusted ROA to improve toward previous highs on the back of market expansion and synergy savings from their acquisition of PMC-Sierra. Should the firm succeed in just sustaining Adjusted ROA at current levels, material equity upside would be warranted. Furthermore, if the firm can drive even more robust Adjusted Asset growth as the benefit from the aforementioned tailwinds, equity upside in excess of 100% would be justified.
Before concluding this article we would be remiss to fail to address the acquisition rumors swirling around MSCC in recent months. The past few years have seen a record-setting number of M&A transactions, with considerable consolidation within the semiconductor space. Just recently Skyworks (NASDAQ:SWKS) was reported to have been eyeing MSCC as a potential takeover target, having lost out to the firm last year in a bidding war for PMC-Sierra. Considering the low valuations at which MSCC is trading, despite its robust fundamentals and substantial macroeconomic tailwinds, the firm is a perfect takeover target. Should the firm find a suitable buyer willing to offer an appropriate premium, equity holders would likely be well rewarded.
To find out more about Microsemi Corporation and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.