No Surprises In MACOM's (NASDAQ:MTSI) Q3 Sales Numbers, Next Quarter Growth Looks Optimistic

Network chips maker MACOM Technology Solutions (NASDAQ: MTSI) reported results in line with analysts' expectations in Q3 FY2023, with revenue down 13.8% year on year to $148.5 million. Guidance for next quarter's revenue was also better than expected $150 million at the midpoint, 1.26% above analysts' estimates. MACOM made a GAAP profit of $11.9 million, down from its profit of $32.2 million in the same quarter last year.

Founded in the 1950s as Microwave Associates, a communications supplier to the US Army Signal Corp, today MACOM Technology Solutions (NASDAQ: MTSI) is a provider of analog chips used in optical, wireless, and satellite networks.

Analog Semiconductors

Longer manufacturing duration allows analog chip makers to generate greater efficiencies, leading to structurally higher gross margins than their fabless digital peers. The downside of vertical integration is that cyclicality can be more pronounced for analog chipmakers, as capacity utilization upsides work in reverse during down periods. Read More The semiconductor industry is broadly divided into analog and digital semiconductors. Digital chips are what most people think of as the brains of almost every electronic device. Their primary purpose is to either store (memory chips) or process (CPUs/GPUs) data. By comparison, analog chips regulate real world signals, such as temperature, speed, sound, or electrical current, converting them into a stream of digital data that can be processed by digital semiconductors. Analog semiconductors are also used to manage power in any electronic device; they convert, store and distribute the electrical energy that comes from a battery or wall plug. Analog chips are found everywhere from household appliances like refrigerators or washing machines, to smartphones, cars and factory production lines.

Sales Growth

MACOM's revenue growth over the last three years has been unremarkable, averaging 11.5% annually. This quarter, its revenue declined from $172.3 million in the same quarter last year to $148.5 million. Semiconductors are a cyclical industry, and long-term investors should be prepared for periods of high growth followed by periods of revenue contractions (which can sometimes offer opportune times to buy).

Even though MACOM surpassed analysts' revenue estimates, this was a slow quarter for the company as its revenue dropped 13.8% year on year.

MACOM's revenue inverted from positive to negative growth this quarter, which was unfortunate to see. Looking ahead to the next quarter, the company's management team forecasts a 15.8% year-on-year revenue decline. Analysts seem to agree that the poor performance will continue, as their average revenue growth estimates for the next 12 months are -5.54%.

Product Demand & Outstanding Inventory

Days Inventory Outstanding (DIO) is an important metric for chipmakers, as it reflects a business' capital intensity and the cyclical nature of semiconductor supply and demand. In a tight supply environment, inventories tend to be stable, allowing chipmakers to exert pricing power. Steadily increasing DIO can be a warning sign that demand is weak, and if inventories continue to rise, the company may have to downsize production.

This quarter, MACOM's DIO came in at 203, which is 60 days above its five-year average, suggesting that the company's inventory has grown to higher levels than we've seen in the past.

Pricing Power

In the semiconductor industry, a company's gross profit margin is a critical metric to track because it sheds light on its pricing power, complexity of products, and ability to procure raw materials, equipment, and labor. MACOM's gross profit margin, which shows how much money the company gets to keep after paying key materials, input, and manufacturing costs, came in at 58% in Q3, down 2.7 percentage points year on year.

Over the past year, MACOM has seen its already robust gross margins rise, averaging 60.2%. These attractive unit economics are indicative of its potent and competitive product offering, pricing power, and efficient inventory management.

Profitability

MACOM reported an operating margin of 24.9% in Q3, down 6.5 percentage points year on year. Operating margins are one of the best measures of profitability because they tell us how much money a company takes home after manufacturing its products, marketing and selling them, and, importantly, keeping them relevant through research and development.

MACOM's operating margins have been trending up over the last year, averaging 29.5%. On top of that, the company's margins are around the midpoint for the semiconductor industry, suggesting that its cost structure is appropriately managed.

Earnings, Cash & Competitive Moat

Wall Street expects earnings per share to decline 12.6% over the next 12 months, although estimates will likely change after earnings.

Although earnings are important, we believe cash is king because you can't use accounting profits to pay the bills. MACOM's free cash flow came in at $42.5 million in Q3, up 26% year on year.

As you can see above, MACOM produced $150 million in free cash flow over the last 12 months, an impressive 22.4% of revenue. This is a strong result; MACOM's free cash flow conversion was higher than most semiconductor companies, and if it can maintain this level of cash generation, it can invest in plenty of new and existing products to ride out cyclical downturns more easily.

Over the last five years, MACOM has reported an average return on invested capital (ROIC) of just 11.4%. This suggests it struggled to find compelling reinvestment opportunities within the business.

Key Takeaways from MACOM's Q3 Results

With a market capitalization of $4.77 billion, MACOM is among smaller companies, but its $587.6 million cash balance and positive free cash flow over the last 12 months give us confidence that it has the resources needed to pursue a high-growth business strategy.

This was a very "middle of the fairway" quarter. Revenue beat slightly and EPS was relatively in line with expectations. Revenue guidance for next quarter beat and EPS guidance for that same period was slightly ahead. Although gross margin missed this quarter, the company's guidance for next quarter's gross margin was in line with Wall Street analyst expectations. Operating margins decline year on year and inventory levels increased, which we don't like seeing. Overall, this was a quarter with no major surprises. The CEO remarked that “Although the markets are currently weak, we believe our long-term growth drivers remain intact.” The stock is flat after reporting and currently trades at $67.26 per share.

Is Now The Time?

When considering an investment in MACOM, investors should take into account its valuation and business qualities as well as what's happened in the latest quarter. We cheer for everyone who's making the lives of others easier through technology but in the case of MACOM, we'll be cheering from the sidelines. Its revenue growth has been mediocre, and analysts expect growth rates to deteriorate from there. And while its strong free cash generation allows it to sustainably invest in growth initiatives, unfortunately its relatively low ROIC suggests suboptimal growth prospects.

MACOM's price-to-earnings ratio based on the next 12 months is 27.6x. While we have no doubt one can find things to like about the company, and the price is not completely unreasonable, we think that at the moment there might be better opportunities in the market.

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