2023-12-28 12:06:10 ET
Summary
- MACOM is ready to capitalize on better growth prospects, with improving demand in 70% of the current revenue mix and a potential bottom in the lagging telecom segment.
- An accelerated rate of new product launches is expected to fuel market share gains. Geographic diversification away from China and into new European accounts can improve the revenue profile.
- Inventory efficiencies can lead to superior cash flow conversion for the company as the recent acquisition of the Wolfspeed RF business scales up.
- It is trading at a premium to its historical trading range, however I think this is acceptable as I anticipate higher multiples in the next, potentially stronger semiconductor upcycle.
- Management has cautioned that there may still be gross margin pressures; this is a key risk to monitor.
Thesis
I am very bullish on MACOM Technology Solutions Holdings (MTSI) because:
- MACOM is ready to capitalize on better growth prospects
- New product expansion and geographic diversification improve the quality of revenues
- Inventory efficiencies can lead to superior cash flow conversion
MACOM is ready to capitalize on better growth prospects
Revenues (USD mn) (Company Filings, Author's AnalysisZ) Revenues YoY (Company Filings, Author's AnalysisZ)
2023 has been a tough year for MACOM as revenues have posted negative surprises even relative to management's own expectations. For example in Q2 FY23 , CEO Stephen Daly noted in the earnings call:
However, our actual bookings were approximately $40 million below our internal forecast.
This was due to excess inventory in the end markets, which hampered business order flow for MACOM.
A large contributor to the overall weakness in revenues was due to weak demand and de-growth from the Telecom segment, which has shrunk from making up a third of the revenues 5 quarters ago to 20% as of Q4 FY23:
Revenue Profile (Company Filings, Author's Analysis)
Familiar readers of my analysis may know that I generally like to see bottoming evidence in weak numbers first before joining in on a turnaround play. However, in this case, I am willing to play a growth turnaround without a clear sign of a quarterly bottoming out in the numbers because arguably reliable commentary inspires some confidence:
Compared to previous quarters, the Q4 FY23 earnings call started off on a more positive tone as the CEO noted that:
Q4 bookings improved across all 3 of our end markets... we see growing demand in data center, aerospace and defense as well as in satellite communication markets.
Data Center Revenues QoQ (Company Filings, Author's Analysis)
Data Center revenues in particular are expected to jump up 10% sequentially off a higher +52% base in Q4 FY23. This is driven by AI and hyper-scaler infrastructure demand. Management highlighted that they have visibility of this stronger demand until even FY25.
In the earnings call, it was discussed that the Industrial & Defense customer segment is also seeing budget increases and this is expected to continue. That translates to a bullish growth outlook for more than 70% of MACOM's business.
As for the Telecom segment, back in August 2023, the outlook was one of "broad-based weakness". But now, almost 4 months later, industry experts believe even this sector is poised to bottom as inventories in end markets ease out. If this is true and it materializes, it would be an added bonus wherein all major business segments are poised for growth.
Now, a lot of my reasons for being bullish on the Data Center and Industrial & Defense segments are based on management's commentary. So a reasonable question is how confident am I about the reliability of these signals?
Revenue Surprise vs Consensus (Capital IQ, Author's Analysis)
The answer is I am reasonably confident because management has generally communicated proactively and managed expectations well. They have generally beaten consensus expectations on revenues, and consecutively done so for the last 19 quarters of a weaker semiconductor cycle.
New product expansion and geographic diversification improves the quality of revenue
In FY23, MACOM had a 15% increase in the number of new products introduced. For FY24, the company is targeting another 50% increase in new product launches on top of that. I believe these efforts are likely to extend market share leadership in key categories such as radio frequency ((RF)) semiconductor chips, microwave applications and newer, more efficient transistor types such as gate-all-around ((GAA)) made from more resilient materials such as gallium nitride ((GaN)).
MACOM is also diversifying away from APAC and China reliance by expanding its sales footprint in Europe. The company intends to forge new customer relationships in this region, which not only opens up more growth avenues but also makes the revenue streams wider and more resilient.
Progress on this strategic initiative is ticking along well as MACOM has de-risked their reliance on China-based revenues from 40% 3 years ago to close to 20% as of the last quarter:
China Revenues Mix (Capital IQ, Author's Analysis)
The bulk of this revenue mix substitution is due to expansion in Europe:
Other countries (mostly Europe) revenues mix (Capital IQ, Author's Analysis)
I anticipate the European footprint to continue growing in revenue mix share and continuing the strong growth track seen in the last few quarters:
Other countries (mostly Europe) revenues YoY (Capital IQ, Author's Analysis)
Inventory efficiencies can lead to superior cash flow conversion
Over the last 1.5 years, MACOM's inventory days have crept up:
Inventory days on COGS (Company Filings, Author's Analysis)
This is mainly due to end-market inventory pile up, which is easing out even in the more constrained segments such as telecom. Also, a part of the uptick in inventory in FY23 is due to two acquired entities in the fiscal year - Wolfspeed's RF business and Linearizer . I anticipate that inventories will reduce going forward as the company completes post-acquisition integration and realizes synergies. This would help improve cash flow conversion.
Valuation
MACOM 1-yr fwd EV/EBITDA (Capital IQ, Author's Analysis)
The stock has been on a run recently and at 30.16x, it is currently trading at a 40.2% premium to the 3-yr median 1-yr fwd EV/EBITDA of 21.51x. However, this does not put me off a buy rating when I reason in the following way:
The last major semiconductor upcycle started in early 2020. The chart above shows peak multiples of around 28.0x for MACOM during this time. Now, as we potentially head towards a new upcycle, the question is whether this cycle would be stronger than the last one. I believe it would be due to the AI and cloud transition megatrends, which are playing out to a more powerful effect. Hence, I think it is reasonable to expect structural valuation multiple upgrades for the semiconductor businesses.
Key Risks
I am confident in the growth prospects of MACOM. However, I do perceive some risks to the margins. Gross margins have fallen around 300bps from their peak in recent quarters, mainly due to lower volumes :
Gross profit margins (Company Filings, Author's Analysis)
Management has cautioned that there would continue to be "modest" gross margin pressure as revenues from the acquired Wolfspeed RF business takes time to scale up.
I note that EBIT margin results have also missed consensus expectations for the last 3 quarters:
EBIT Margin Surprise vs Consensus (bps) (Capital IQ, Author's Analysis)
Overall, the margin movements are a key variable I am monitoring as they could suppress the bullish story in MACOM.
Takeaway
2023 has been a challenging year for MACOM, but I am anticipating a growth turnaround as management commentary - which I believe is reliable at least for the top-line outlook due to consistent, predictable execution on revenues - suggests order flow improvement in around 70% of the revenues mix. For the remaining 30%, more recent indications of a potential bottoming out in the telecom sector serve as bonus upside optionality for MACOM. Along with higher growth prospects, it is good to see an improvement in the quality and source of revenues as the company accelerates new product launches and geography expansion into Europe, opening new customer accounts. I believe we can also see more efficient inventory management as MACOM integrates recently acquired businesses, realizing synergies.
From a valuation perspective, MACOM is trading 40% higher than its 3-yr 1-yr fwd EV/EBITDA multiple. However, this does not sufficiently dampen my bullish view when I reason that the multiples in the next semiconductor upcycle are expected to be higher than in the last cycle because the demand drivers are more powerful courtesy of the AI and cloud migration trends. Risks wise, I have my eye on the gross margins, noting that management is cautioning for further temporary weakness in at least the quarter ahead.
Overall, as we enter 2024 with rate cut expectations fueling a risk-on sentiment, and considering this analysis on MACOM, I rate the stock a 'Strong Buy'.
How to interpret Hunting Alpha's ratings:
Strong Buy: Expect the company to outperform the S&P500 on a total shareholder return basis, with higher-than-usual confidence
Buy: Expect the company to outperform the S&P500 on a total shareholder return basis
Neutral/hold: Expect the company to perform in line with the S&P500 on a total shareholder return basis
Sell: Expect the company to underperform the S&P500 on a total shareholder return basis
Strong Sell: Expect the company to underperform the S&P500 on a total shareholder return basis, with higher than usual confidence
For further details see:
MACOM: Buy As Growth Turns Around