The following is a reprint of my January 8, 2008 RealMoney column.
In other articles, I have outlined the reasons why I think the semiconductor industry is poised for strong stock performance and why I think MEMC Electronic Materials (MEMC) is the best play on the sector.
But I also realize that a bullish semiconductor outlook right now involves making a grab at that falling knife. Therefore, I thought I should also let people know which semiconductor stock looks most vulnerable to a downturn.
I think that stock is Microsemi (MSCC).
Microsemi is a leading designer, manufacturer and marketer of high performance analog and mixed-signal integrated circuits and high-reliability semiconductors. Its products manage and control or regulate power, protect against transient voltage spikes and transmit, receive and amplify signals.
Microsemi has held up fairly well, handily beating the performance of the Semiconductor HOLDRs (SMH) over the last year. This may be due largely to its strong end markets, which include defense, commercial aerospace, industrial/semicap, medical, mobile connectivity and notebooks, monitors and LCD televisions.
More Questions Than Answers
To me, however, the strong end markets only raise questions concerning Microsemi’s fundamental performance. For example, with such strong end markets, why did its cash from operations fall by more than half in the year ended September 30, 2007, compared with the prior year? Why is its inventory rising faster than sales, and why is its gross margin slipping?
I turned to the company’s latest 10K in hope of finding answers.
To begin with, the area is highly competitive. According to the 10K (emphasis added), “some of our current major competitors are Freescale Semiconductor, Inc., National Semiconductor Corp. (NSM), Texas Instruments, Inc. (TXN - Annual Report), Koninklijke Philips Electronics (PHG), ON Semiconductor Corp. (ONNN), Fairchild Semiconductor International, Inc. (FCS), Micrel Incorporated (MCRL), International Rectifier Corp. (IRF), Semtech Corp. (SMTC), Linear Technology Corp. (LLTC), Maxim Integrated Products, Inc. (MXIM), Skyworks Solutions, Inc. (SWKS), Diodes, Inc. (DIOD - Annual Report), Vishay Intertechnology, Inc. (VSH), O2Micro International, Ltd. (OIIM) and Monolithic Power Systems, Inc. (MPWR).” Gosh, I wouldn’t want them to leave anyone out.
Yet competition is just the third risk factor among a list that runs more than 12 pages.
The company notes the decline in net income related to non-cash acquisition related charges, restructuring charges and other factors. Yet non-cash charges don’t quite explain the decline in cash flow from operating activity. Furthermore, with “non-recurring” charges being reported in each of the last three years I’m going to go out on a limb and say investors can probably expect more of them in the future.
A Questionable Acquisition
According to the 10K, the company completed a merger with PowerDsine on January 9, 2007 and subsequently renamed PowerDsine Ltd., Microsemi Corp. – Analog Mixed Signal Group, Ltd. (”AMSGL”). Later, it notes that it “provided a valuation allowance of approximately $9,534,000 as of September 30, 2007 on all of our net deferred tax assets related to AMSGL as we have determined that it was more likely than not that the deferred tax assets would not be realized.”
Deferred tax assets are realized when the company earns taxable income in future periods. I’m not a big fan of acquiring companies that will “more likely than not” fail to earn taxable income in the future. This was one of the contributors to the decline in cash flow.
Microsemi’s gross margin weakened in the latest quarter (see chart.)
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Source: Zacks Research Wizard, compiled by William A. Trent
I think there is additional margin risk stemming from burgeoning inventory levels.
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Source: Zacks Research Wizard, compiled by William A. Trent
Since a large percentage of costs at semiconductor companies is fixed, producing more units results in a lower cost per unit and higher profit margins. But many of the additional units Microsemi is producing are going into inventory rather than the hands of customers.
At some point, Microsemi is going to have to sell that inventory (by producing less than customers demand.) That will reverse the positive effect on future gross margins.
Valuation Too High
All this would matter less if the stock looked cheap. But on the basis of free cash flow yield, which is my favored metric, Microsemi looks more expensive than most of its peers.
Free cash flow in 2007 was less than $4 million. On an enterprise value of $1.56 billion, that amounts to a free cash flow yield of just 0.25%. The cash flow would have to grow 150-fold just to bring the yield on par with that of Treasury bonds.
Even using the company’s best cash flow on record ($36.5 million in 2006) the yield is just 2.35% – nearly a percentage point below that of Treasuries. If I thought the company could return to the 2006 cash flow level, then grow at the forecast rate, I would be willing to consider an investment.
But given the rising inventory, unprofitable acquisition and potential for further declines in gross margin, I won’t be holding my breath.
Disclosures: William Trent is long Semiconductor HOLDRS (SMH) and Maxim Integrated Products (MXIM). He holds put options against shares of Lam Research (LRCX).
William Trent currently owns put options against the shares of Lam Research (LRCX).