WOLF - MACOM Technology Solutions: Focusing On Just The Good Could Backfire

2023-08-24 22:18:20 ET

Summary

• The stock has appreciated by over 50% in the last three months by focusing on the positive and ignoring the negative at MTSI.
• MTSI continues to face soft demand, which led it to lower the outlook and refrain from calling the bottom in the current downturn.
• There are a couple of factors that could result in further downside for MTSI, which multiples have seemingly ignored.
• The trend is pointing to higher stock prices, but if the market is wrong in assuming the worst is over, a reckoning looms.

The market has taken a glass half full and not a glass half empty approach to MACOM Technology Solutions Holdings ( MTSI ). The stock has rallied in recent months, even though MTSI is still dealing with the effects of weak demand as shown in the most recent earnings report. It’s true MTSI showed signs growth may be starting to come back, but there is nonetheless a large amount of optimism directed towards MTSI considering the state it finds itself in. Some would say perhaps too much so. Why will be covered next.

The glass is half full for MTSI

Some might argue as to whether the worst has passed, but there is no denying MTSI has experienced a downturn that has caused revenue and earnings to contract. However, it’s worth noting that the decline has been uneven. Some end markets have stayed more resilient than others. Defense, for instance, has outperformed, offsetting weakness in the telecom segment to a certain extent. A previous article delves deeper into some of the challenges confronting MTSI, which include a book-to-bill of 0.5, a sign customers have become stingy when it comes to placing new orders.

Yet you wouldn’t be able to tell that MTSI is dealing with a range of issues if one were to look at how the stock has soared higher. The chart below shows how the stock has staged a turnaround in the last three months. The stock hit a 52-week and 2023 low of $48.53 on May 4 after the Q2 FY2023 report disappointed with guidance that was much weaker than expected. The drop brought YTD losses to 22.9% at that point. However, it's been quite the change in the three months since then.

The stock has gone on an uptrend that continues to this day. The stock went from a May 2023 low of $48.53 to an August 2023 high of $77.47, which occurred shortly after the Q3 FY2023 report, resulting in a gain of 59.6% to eliminate all losses for 2023. The stock has pulled back in recent days, but the move up in the last three months was enough to put the stock up 15% YTD.

The stock remains in an uptrend despite the recent pullback. It’s true trends come to an end eventually, but there’s also a saying that the trend is your friend. And as long as the trend is pointing up as in the case of MTSI, that is all some people need to be convinced that long MTSI is justified.

What could keep the rally going for MTSI

To be fair, it is possible for the rally to continue. The rally could get a new lease on life if more signs emerge the contraction in demand is over and MTSI is back to the consistent growth of the fairly recent past. As mentioned earlier, some business segments are doing better than others. Telecom is weak, but defense is doing very well. Furthermore, there is reason to think defense can keep giving MTSI a boost.

It should be noted that defense spending by governments tend to be much less affected by the highs and lows associated with the business cycle. While say, consumer spending tends to go down due to changes in macro-economic conditions, defense spending does not. On the contrary, defense spending in the U.S. is scheduled to go up to with the budget for the DoD set to as much as $842B in FY2024, which represents a $100B increase in the last two years. Other U.S. allies also intend to increase defense spending.

The need to increase U.S. defense spending is driven by the need to maintain a military advantage over a range of potential adversaries, Russia and China in particular. This is not likely to change anytime soon, which means defense spending is likely to remain high for the foreseeable future. Companies like MTSI could reap the benefits of this.

Note that MTSI is a supplier of a number of components for equipment that the U.S. DoD has singled out as needing an upgrade in capability. For instance, MMIC power amplifiers are needed in next-generation radar systems for ballistic missile defense to detect and counter missile threats from the likes of North Korea, a country which has devoted much of its resources on developing long-range ballistic missiles.

Datacenters could also provide upside, although maybe not as much as defense. Companies can increase datacenter spending, buy also decrease it, which is why this segment is more prone to fluctuations than the defense segment. However, there is no doubt there is a growing need for datacenters to facilitate high-speed data transfers. While datacenter may be down for now, it’s unlikely to stay down for too long.

Is the rally built on a solid foundation?

As mentioned before, the release of the most recent report helped push the stock to new highs for the year, including an 11% jump immediately after the report’s release. Based on this one might conclude that the Q3 FY2023 report was an outstanding one. However, while the latest updates from MTSI contained a number of encouraging signs, they also contained some less than encouraging ones.

The latter seems to have been overshadowed by the former based on how well the stock has done, but that does not mean the latter is not there. For instance, the market reacted well after MTSI reported a big improvement in book-to-bill. Recall how book-to-bill fell to just 0.5 in the Q2 FY2023 report, a major reason why the stock hit a 2023 low afterwards. But in the Q3 FY2023 report, book-to-bill rebounded to 0.9, which is still below one, but enough to cause some to think the worst is over and the recovery has begun.

On the other hand, MTSI had some less than encouraging news to share. MTSI actually lowered its outlook by stating that it was aiming for $1B in revenue by late FY2026/early FY2027, which is about 1-1.5 years longer than the timeframe proposed a year ago. This delay was in all likelihood the result of the downturn that has engulfed MTSI in recent quarters.

Recall how MTSI managed to increase quarterly revenue QoQ for an impressive 14 consecutive quarters, starting in Q4 FY2019 all the way to Q1 FY2023. However, the streak came to an end in Q2 FY2023 and the downturn continued in the most recent Q3 FY2023. The table below shows the numbers for Q3 FY2023, which were roughly in line with expectations and guidance from MTSI.

In terms of end markets, industrial and defense increased from $75.5M to $83.5M YoY, which is a new record high, but datacenter declined from $34.8M to $26.6M YoY and telecom declined from $62M to $36.3M YoY. Adjusted EBITDA fell to $42.8M, down from $60M a year ago. Cash, cash equivalents and short-term investments totaled $587.6M, partially offset by $446.8M of long-term debt.

Source: MTSI Form 8-K

However, the bulls had something else to focus on. Guidance calls for Q4 FY2023 revenue of $148-152M, a decline of 15.8% at the midpoint. The forecast expects non-GAAP EPS of $0.53-0.57, a decline of 28.6% YoY at the midpoint. MTSI is expecting a Q4 that is flat to slightly up compared to Q3, which is better than the double-digit sequential decline of before. This might cause one to conclude the bottom is in.

On the other hand, it’s worth mentioning that MTSI itself is not ready to call the bottom. From the Q3 FY2023 earnings call:

“So we try not to call the bottom, let's say, because we really don't know. And what we can say based on where we are today that for a year-over-year comparison, two of our three markets will be up, I&D will be up, Data Center will be up, and Telecom will be down somewhere between 20% and 25%.

And as I highlighted in my comments that the inbound new business, and has been quite weak this year, for Telecom. We do expect at some point that will turn. We see certainly great opportunities in the SATCOM market with the deployment of a wide range of different satellite platforms, which we believe can provide certainly near-term growth opportunities. But it's very difficult for us to say sort of where the bottom is and what might happen 3 or 6 months from now.”

A transcript of the Q3 FY2023 earnings call can be found here .

What could trigger additional downside

MTSI is leaving open the possibility of a further contraction in business. Telecom, for instance, has yet to show any signs of a recovery. On the contrary, it’s possible telecom could see more declines. Several companies active in the sector like Lumentum ( LITE ) acknowledged weakness in demand and the existence of excess inventories that needs to be absorbed. Another factor is China where customers are pulling back. Revenue from China as a share of total revenue at MTSI went from the low twenties in Q1 to the mid teens in Q3. China could thus be a driver of further contraction.

However, there is one other factor out there that could shake things up and may not have received as much attention as it maybe should have. As shown earlier, defense has given MTSI a lift, negating some of the headwinds elsewhere to a certain extent. Demand from this segment is powered by, among other things, the need for gallium nitride or GaN and galium arsenide or GaAs, which can be used to enhance performance in a number of military applications.

“And in terms of the products its certainly many of the products that we've talked about in the past, a lot of our MMIC products, a lot of our high-end GaAs and GaN products for military applications, there's a wide range of those really supporting the growth within the defense sector.

When we think about 2024, the growth drivers from a product set point of view would certainly be GaN. GaN is -- we think 2024 will be a great year for us.”

In fact, MTSI views GaN as a growth driver in 2024 and beyond. Keep in mind products like MMIC utilizing GaN come with some of the highest margins at MTSI, if not the highest. However, while MTSI is banking on GaN, it’s worth mentioning that China has recently imposed export controls on the export of gallium, which is needed for GaN.

Starting in August the export of gallium out of China requires government permission. The significance of this is that China is the source of most of the global supply of gallium. According to the USGS , for instance, China accounted for 98% of the production of primary low-purity gallium in the world, in addition to being home to 86% of the global production capacity in 2022.

China could therefore exert much influence on the price and the amount of gallium available to markets. It depends on how the export controls are implemented in practice, but in theory, China could cause a global shortage of gallium and prices to spike for whatever is available. This could make its way back to MTSI.

Note that MTSI has recently doubled down on GaN with the acquisition of Wolfspeed’s ( WOLF ) RF business for $125M, which includes Wolfspeed’s GaN production facility and related patents. It’s interesting to note that Wolfspeed has stated that China’s export controls on gallium will have no impact on its GaN unit.

This may be correct, but not everyone is convinced there is nothing to be concerned about. Wolfspeed’s decision to dispose of the GaN unit is likely to strengthen these beliefs. One could surmise that Wolfspeed may have had some doubts about the potential risk to the GaN unit due to export controls and that by disposing of the GaN unit Wolfspeed has removed a potential source of problems for itself.

It should be noted that export controls do not forbid the export of gallium. Alternative sources of gallium can be developed, but this takes time. Various companies have submitted an application to the Chinese government and the wait is on for approval. The consensus is that China will not reduce the supply of gallium to a great extent because doing so could negatively impact its own companies since they too need products that are made with gallium. This is just an assumption, though.

However, if gallium supply does become an issue, MTSI could be affected since it produces a range of products that require access to gallium. If business contracts because of supply chain problems, it would come at an inconvenient time for MTSI. Keep in mind multiples have been expanding as the stock has risen while earnings have fallen, based on the apparent assumption that the worst is over and growth will soon return.

Source: SeekingAlpha

The table above shows how multiples for MTSI are significantly higher than the median in the sector. This is not so unusual since multiples tend to expand when the market expects revenue and earnings to grow significantly in the near term and this is then priced into the stock. However, if it turns out the market was too optimistic in assuming the worst is over and the downturn has ways to go, the stock could be in for a correction, especially after it has rallied as much as it has in the last three months. This happened even though MTSI itself is not sure the bottom has been reached during the current downturn.

Investor takeaways

The market has definitely taken a glass half full approach to MTSI. The stock has appreciated by more than half in the last three months, including an 11% jump after a Q3 report that came in mixed at best. While the Q3 report featured a number of positive indicators, including an improvement in book-to-bill to 0.9, the latest report was arguably not deserving of a double-digit increase in the stock as the report was not that good.

The outlook, for instance, was lowered with MTSI delaying the timeframe it expects to reach $1B in revenue. While some end markets are doing well, others remain weak, as shown by a book-to-bill that remains below one. The way the stock moved one could be mistaken for thinking the bottom is in, but management left open the possibility of further downside by declining to say the bottom is in.

The downside could be triggered by a number of factors. The telecom market remains weak, as acknowledged by MTSI and other relevant players. China has yet to show signs of stabilizing. MTSI is counting on the defense sector to keep providing a lift, but there is a possibility the supply chain could be in for some turmoil if gallium becomes scarce due to export controls in China.

While some may decide to go for long MTSI, especially with the stock in an uptrend, I am neutral on MTSI. The market has decided to focus on the positive, while essentially ignoring the negative. This has allowed the stock to soar higher to the point that MTSI trades at multiples that are higher than most semis, all the while having its top and bottom line contract.

This may prove to be warranted if MTSI continues to improve in the coming quarters, but if the anticipated recovery stays away, or worse, the downturn continues, the stock looks in prime position for a haircut. Focusing on just the good and ignoring the bad can backfire. It’s perfectly okay to be optimistic, but one has to be careful to not go overboard with optimism to the point that one ignores problems that are right in front of you. Otherwise a reckoning could be just a matter of time.

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