Macom Technology: Is the Growth Story Intact?

MACOM Technology (MTSI, Financial) has been on a decline, shedding 38% of its market share since July. Stifel’s downgrade further shattered investors’ confidence as the firm cited weakness in China as worrisome for MACOM.

Negative sentiment is fueled by the slowdown in growth, acquisition costs and integration challenges related to newly acquired businesses like AppliedMicro.

Nonetheless, long-term prospects remain positive. The industry is set to grow, thanks to the exponential growth of cloud data centers and upcoming switch to 5G in the telecom industry. Recent weakness in growth and margin is a short-term headwind. MACOM continues to post double-digit revenue growth. Negative sentiment is overstated. Let’s dive into details.

What does the company do?

MACOM Technology is an analog semiconductor play that is involved in the provision of RF, microwave, millimeter wave and light wave spectrum semiconductor components for networking and defense use cases. Products of the company include radio frequency power products, optoelectronics and photonic solutions.

MACOM serves markets like carrier and enterprise infrastructure, wired broadband and cellular backhaul, cellular infrastructure, photonic solutions and fiber optics. The company is exposed to the growth of cloud data centers, point-to-point wireless backhaul radio and high dense networks through its semiconductor components. Further, the company is a provider of semiconductor components for 100G+ transceivers, which is a high-growth market.

Here’s what you need to know about the company’s revenue growth

MACOM technology witnessed year-over-year revenue growth of more than 36% during the nine months ended in June.

Thanks to its acquisitive strategy, MACOM witnessed revenue growth across all its reportable segments. Revenue from networks grew ~40% during the nine months ended in June. A&D and multimarket revenue grew more than 20% during the same period.

It is important to note that network segment revenue growth was primarily supported by the acquisition of AppliedMicro. Growth in A&D revenue materialized because of Metelics’ acquisition. See the charts below:

The chart above depicts that revenue for the nine months ending in June would have been around $453.9 million without including AppliedMicro’s result. On the flip side, revenue in the preceding period can be made comparable by including Applied Micro’s revenue.

It can be seen that organic growth was almost half compared to growth through acquisition. See the chart below:

Analysts and markets aren’t taking this positively, and the stock has been trending downward. They are ignoring the fact that the company managed to post double-digit growth, which is expected to continue amid positive industry outlook. The company itself acknowledges that in its SEC filings.

“While sales in any or all of our primary markets may slow or decline from period to period, over the long term we generally expect to benefit from strength in these markets.”

It is important to note that revenue growth removing acquisition effect is relevant for forward looking analysis.

Bottom line remains challenged

Gross margin declined from 51% to 44% during the nine months ended in June compared to the same period last year. The company was unable to manage operating expenses efficiently as the expenses rose around 30% during the same period. Increase in operating expenses mostly relates to the acquisition of Applied Micro’s business. According to the SEC filings of MACOM:

“Gross profit during the three and nine months ended June 30 was negatively impacted by higher intangibles amortization and amortization of inventory step-up associated with the AppliedMicro Acquisition during the fiscal 2017 periods.”

Overall, the market is unsure about MACOM due to recent slowdown in growth and poor management of expense. Long-term growth prospects remain intact, and acquisition costs aren’t a recurring problem as detailed below.

Industry prospects

The need of data storage and processing is driving the growth of cloud data centers. The amount of connected devices, and data creation, is rising at an exponential rate. This is enabling the continued growth of cloud data centers.

Deloitte’s 2017 Telecommunications Outlook notes the following:

“The growth in smartphone usage signals continuing opportunity for all telecom subsectors, including wireless and wireline/broadband carriers,network equipment/infrastructure companies and device manufacturers.

“Total spending on IT infrastructure products (server, enterprise storage and Ethernet switches) for deployment in cloud environments will increase 15.3% year over year in 2017 to $41.7 billion,” says the IDC.

The 100G+ network port market is set to reach around 850,000 units by calendar year 2020, a CAGR of 34% during 2017-2020.

Dell’Oro group predicts that the market for microwave transmission and mobile backhaul will remain sluggish during 2018 before resuming growth in 2019. The group further notes that small cell deployments require a higher share of fiber and copper links. This can further boost the growth of Ethernet switches and 100G+ ports.

Regarding RF power semiconductors, the market is set to grow at CAGR of 15.4% to reach $31.26 billion by 2022, according to a report by MarketsandMarkets. "APAC market for RF power semiconductor will grow at the highest rate," says the report.

Micro mobile data centers, which include high density networks, will be worth around $8.47 billion by 2022, according to a report from MarketsandMarkets. Out of the segments of Micro mobile data centers, high density network application will grow at the highest rate.

Moreover, the global silicon photonics market is expected to grow at a rapid growth rate of 20.34% during 2016-2022. Intel (INTC, Financial), Cisco Systems (CSCO, Financial), IBM Corp. (IBM, Financial) and Juniper Networks (JNPR, Financial) are investing extensively in the silicon photonics market. In terms of product segments, transceivers have the highest market share in silicon photonics.

IHS Markit believes that $5.1 billion will be spent on outdoor small cell backhaul equipment by 2020. The number of small cell connections will grow from 109,000 in 2016 to reach 693,000 by 2020.

Source: IHS Markit

MarketsandMarkets forecasts the small cell backhaul market to grow at a CAGR of 28.8% during 2014-2019.

What’s the point of mentioning all these industry forecasts?

MACOM serves almost every end market mentioned in the industry prospects above. The company has several semiconductor products for 100G port market including modules, integrated TIAs and drivers. The company enabled 2.6 million 100G ports to date, establishing pre-eminent market share. Key customers for the company for transceiver use case include Cisco, Huawei and Arista Networks (ANET, Financial).

Macom is one of the key players in the RF power semiconductor market, as noted above. Other key companies include Broadcom Ltd. (AVGO, Financial), Infineon Technologies AG (IFNNY, Financial) and NXP Semiconductors (NXP, Financial).

MACOM also offers semiconductor products for wired and wireless mobile backhaul market. The company is also involved in the provision of semiconductor solutions for high density networks.

The point is that MACOM is exposed to double-digit growth across its whole product line, and there’s no indication of potential secular decline in growth for MACOM over the long term.

Industry growth estimates for MACOM’s networking semiconductor products range from 15% to 30%. Growth is expected to slow down in some segments, according to a few reports. But the long-term growth trend seems intact. Despite slowdown in growth, the company posted a 15% revenue growth. Let’s analyze the valuation of MACOM using a base case growth of 15%.

Relative measures reveal undervaluation

MACOM is priced moderately compared to its peers. In terms of forward P/E, the company is trading at a discount of 14% in contrast to its direct competitor, Analog Devices (ADI, Financial). Forward P/E is also below the industry average.

The growth is also cheaply priced. MACOM is trading at a PEG of 0.83 as compared to 1.08 for its direct counterpart, Analog Devices. Its growth is also cheaply priced than Inphi Corp. (IPHI), which competes with MACOM for data center transceiver market.

What’s interesting to note is that the company’s sales are the most cheaply priced in its peer group. This is driven by a recent downward pressure on the stock amid sales growth fears. Moreover, acquisition costs are also taking a toll out of operating margin. Therefore, the market is not pricing MACOM’s sales favorably.

To sum up, the company is trading on a low side when it comes to relative valuation.

Short-term pressure on growth and increase in acquisition cost is an opportunity as there’s a long-term growth trend in the industry, and integration benefits will appear sooner or later (think elimination of duplication and related cost savings).

Economic value added approach reveals upside

EVA-based valuation also reveals upside for MACOM technology. Assumptions for the valuation include the following:

Earnings are expected to grow at 15% p.a. during 2019 to 2022; 1% earnings growth is assumed in perpetuity. Analyst consensus earnings are used for 2017 and 2018. Cost of equity is expected to grow in line with earnings growth. CAPM is used to calculate the cost of equity.

EVA valuation reveals an upside of around 25% for MACOM. Note that the valuation is based on consensus analyst estimates for earnings, and base line growth forecast for the industry. If MACOM achieves an earnings growth of more than 15% p.a. during the next five years, which is quite possible, the stock should be priced higher.

Final thoughts

The market is reacting to short-term integration headwinds and a slowdown in growth. It's ignoring the fact that acquisition-related costs are a short-term headwind; integration benefits will follow. Further, industry analysts have a consensus on growth. Only some predict the slowdown to persist, but that’s also for a year. Over the long run, the stock is poised to benefit from industry growth. MACOM seems to offer some value in a stock market that’s flooded with overpriced momentum stocks.

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