Microsemi Delivering On Its Execution Promises

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About: Microsemi Corporation (MSCC)
by: Stephen Simpson, CFA
Summary

"Blocking and tackling" is boring, but ultimately important to long-term success, and Microsemi management has been executing well on its performance targets.

Growth is still a credible part of the story, with expanding share in aero/defense and market growth in optical and datacenter all on the table.

Microsemi's share price underperformance and solid margin performance have brought the shares back to slight undervaluation.

In my opinion, Microsemi (MSCC) is doing a good job of laying to rest whatever lingering arguments there were from bears that this company is/was “just” a serial acquisition story. Since the large PMCS deal, Microsemi has been executing on its synergy/cost-cutting targets, and the company continues to march toward its long-standing 65/35 gross margin and operating margin goals. What's more, the company is doing a decent job on revenue as well, with new products and market share gains helping to solidify the bull case

Microsemi shares haven't done very well since my last update (down about 7% and meaningfully underperforming SOX), but then, I did think the share price was demanding back in January and that buyout expectations were a big part of the story. While a buyout of Microsemi is still a possibility (and perhaps even likely depending on your time frame), the quarter-by-quarter execution story isn't going to be so exciting, and particularly so when the company isn't leveraged to buzzy areas of the chip sector today like autos and IoT. With the shares now offering a little upside relative to my fair value estimate, they could be worth a look and particularly so, if the market/shares were to sell off again.

Not A Perfect Fiscal Q3, But Solid

Microsemi reported revenue growth of 6% in the company's fiscal third quarter, with sequential revenue growth above 3%. The company's largest segment, communications, was down on weakness in legacy PMC products and broadband gateways (especially in China), but optical grew at a high teens rate over last year and the company continues to see the benefits of the ongoing market transition toward higher speed optical products.

The next-largest business, aerospace and defense, was up slightly, as the company continues to benefit from share gains and expanding share of wallet; sales of radiation-resistant FPGAs were up 20% sequentially and the company seems to be taking share from Xilinx (XLNX) in FPGAs and benefited from Intel's (INTC) refocusing of the Altera FPGA business toward higher-end opportunities (like datacenter).

Speaking of datacenter, this segment has nearly grown to the point of becoming Microsemi's second-largest business, with strong double-digit growth driven by its storage products and assisted by the Intel Purley ramp. Last and not least was industrial, which grew at a mid-teens rate on strong growth in medical (nearly one-third of the segment) and semiconductor capital equipment.

Although gross margin weakened slightly on a sequential basis, and likely will again in the next quarter, it still improved about two points from last year and the company is getting closer to its long-stated goal of 65% non-GAAP gross margins. Operating performance was stronger this quarter, with non-GAAP margin improving about four points from last year and more than a point sequentially.

Insofar as margins go, I expect that Microsemi will continue to see improvements, but at a slower pace. Winning more share of wallet with existing customers (especially in defense/aerospace) and seeing better demand in higher-margin areas like FPGA and satellites and aero/def will certainly help, as will growth in higher-margin PMC product lines, but a lot of the heavy lifting with the PMC integration has been done.

Making Plans For Cash Flow To Come

Microsemi took on quite a bit of debt to fund the PMC deal and management has made it a priority to steer the free cash flow toward working down that debt balance. Good progress has been made, and I don't think the target 3.0x EBITDA is too far away now (likely achievable within a year or so). With that, there has been some speculation over what management would do with the free cash flow, particularly as they have gone on the record in the past saying that they would continue to acquire until they themselves were acquired.

With the third quarter earnings report, management announced a $250 million buyback with a two-year authorization. Given that Microsemi's stock-based compensation has expanded pretty significantly, my enthusiasm is somewhat tempered here. Some may also regard this as a sort of commitment that big M&A is off the table, but I'd remind readers that share buybacks rarely come with any obligation to execute. In other words, if the right deal comes along, I have no doubt that Microsemi will consider going back to M&A.

As far as what the right deal would look like, I would think it would fit in with prior deal characteristics – a small chip company with a good product in a defensible niche that is sub-scale, if not struggling. I don't expect Microsemi to stretch too far for growth (at least not current growth), but complementary products in areas like datacenter, power management, or timing could hold some appeal.

Ongoing Opportunities To Grow

I continue to like Microsemi as an all-around strong execution story with some arguably under-appreciated growth opportunities. We'll have to wait and see if national defense budgets actually change all that much in the coming years, but Microsemi has meaningfully expanded its product array for the defense/aero market, and with that is coming increased share of wallet opportunities – management highlighted that the potential content available to the company on the F-35 program has grown to over $50,000 per plane, versus existing content of around $15,000 per plane.

I also see ongoing growth opportunities in optical, datacenter, and industrial. The transition in optical toward 25G-100G is real and happening (as seen by the results at companies like Ciena (CIEN)), and Microsemi should reap the benefits. So too with its storage controllers in the datacenter space. With industrial, I expect ongoing strength in semiconductor capital equipment and decent demand for medical products like imaging equipment, and the recovery in oil/gas could still offer some upside.

The only real negative “but” to this is that this has largely been in the background for my modeling assumptions. So, I'm still looking for mid-single-digit long-term revenue growth and low double-digit FCF growth; the only major change(s) relative to my last update are that the margin improvements are coming a little faster than I'd modeled. That is enough to boost my fair value range, with a target now from the high $40's to high $50's on the basis of DCF and revenue growth and margin-drive EV/revenue.

The Bottom Line

Microsemi isn't tremendously cheap on a standalone basis (though I still think a buyout would require a price of more than $60, if not close to $70), but there aren't a lot of cheap chip stocks out there, or at least not many without some real concerns around the business. That's not meant to be a “strong buy” case for Microsemi, but I do think these shares have some appeal now and would certainly be worth a look if/when the market cools.

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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.