RF Micro Devices: How To Play The Growing Telecom Market Of China

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We recommend investors to take a long position in RF Micro Devices (RFMD) as the company has significant growth potential due to its presence in the growing telecom market of China. Rising smartphone penetration and upgrades to the faster 3G and 4G technology by the telecom carriers should work in the favor of RFMD by increasing demand for its products and services. The stock is trading at cheap valuations and the current price of $4.45 could prove to be a good entry point for investors to take advantage of its future growth.

RF Micro Devices Inc. designs and manufactures high performance radio frequency components and semiconductor equipment for its customers, both domestically and internationally. The company's products enable mobility and connectivity in the mobile devices, wireless infrastructure, local area network, cable television, and aerospace and defense markets.

The company operates through three segments: Cellular product group, multi-market product group and compound semi conductor group. However, the compound semi conductor group is not one of the reportable segments. Cellular product group is the major revenue contributor for the company. In the quarter ended September 2012, the said segment accounted for almost 77% of RFMD's total revenue. Through its cellular product operations, the company supplies, globally, a wide range of cellular components for a variety of mobile phones, smartphones, notebooks, and tablets. The multi-market product group supplies equipments such as low noise amplifiers, transistors, switches and other military and space components that include radars as well as space equipments.

The company has been suffering from deterioration in its revenue stream in recent quarters, and the second quarter was no exception. Its quarterly revenue declined by 14% compared to the second quarter of the previous year due to the lower demand for its 2G products that are used in voice-only phones as well as lower demand for its various wireless infrastructure products. This drop in revenue was also reflected in its gross margin that shrunk to 31% by the end of the second quarter, from 37% in Q2 2011. If the results from its multi-market group are analyzed, the deterioration is visible there as well, with revenue dropping 7% in the quarter. The decrease, as previously mentioned, was largely due to weaker spending by various telecom carriers on wireless infrastructure equipment.

However, the factor offsetting the lower demand for its 2G products is the increased demand and sale of its 3G products, which we believe will bring staggering growth for the company. China, in particular, represents a tremendous growth opportunity for the company, where it already has a strong presence. China is still operating 2G technology. However, a few major telecom carriers are in the process of upgrading their networks, which would prove to be financially beneficial for the companies that supply the necessary equipment.

The Chinese Telecom Industry is dominated by a few players, which include China Mobile (NYSE:CHL), China Telecom (NYSE:CHA) and China Unicom (NYSE:CHU). All the telecom carriers are benefiting from a surge in mobile service revenues that have jumped up, and are now in the range of 20% to 35% in the first half of 2012, largely, due to demand for high speed 3G services. Net additions for the three key telecom players are also high and figures for 3G net additions are also impressive. With the passage of time, the 3G market share is expanding. A similar story can be observed for the country's biggest mobile operator, China Mobile, which is also in the process of launching the first 4G network in the country. Moreover, both China Unicom and China Telecom have made agreements with Apple (NASDAQ:AAPL) to sell the new iPhone 5, and it is very likely that China Mobile would soon follow suit. These developments are signaling towards RFMD's potential for a turnaround. As China upgrades its technology to 3G and 4G, the country's low smartphone penetration and huge potential for growth means chipmakers like RFMD stand to benefit.

Financial Position

The company has insignificant debt on its balance sheet, with a total debt to equity ratio of 12% as of the most recent quarter end. It also has a healthy interest coverage ratio of slightly over 7x, which indicates the company's ability to cover its interest payments with its operations. Moreover, RFMD has historically generated operating cash flows in excess of its capital expenditures.

2013 Guidance

The company is expecting strong growth in its 3G and 4G components in the third quarter across a wide range of products and customers. This has led the company's management to announce that its third quarter earnings will be about 6 cents per share on revenue of $245 million. Analysts were expecting the company to post earnings of 3 cents per share on revenue of $217 million.

RFMD is trading at 1.5 times its sales, which is a discount of 36% and 49% over the multiples of its rivals Broadcom Corp. (BRCM) and Skyworks Solutions Inc. (NASDAQ:SWKS), respectively. The stock is down 16% since the start of the year and is currently down 40% from its 52 week highs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Technology Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.