There has been speculation lately that Motley Fool Stock Advisor recommendation Silicon Labs (NASDAQ:SLAB) may be an attractive acquisition candidate, and recently that was proven to be true, at least in part. Management announced that it has decided to sell most of its wireless business to NXP Semiconductors for $285 million in cash, plus an additional $65 million over three years if certain performance targets are met.

The pieces that Silabs is jettisoning account for roughly a third of revenues. They include its cell phone on a chip, named AeroFONE; the Aero transceiver; and its power amplifier line. The AeroFONE appears to be a competitive product and is aimed at the low-cost handset market, where it competes with products from much larger competitors -- including a Texas Instruments (NYSE:TXN) offering creatively named LoCosto. One of the problems with the AeroFONE, from Silabs' point of view, is that it has lower gross margins than the rest of the company's products.

Exiting the wireless business is probably a good move. Roughly a billion handsets are sold per year, and most of the growth will likely come at the low end. To make a good living selling inexpensive chips, you have to sell them in huge numbers, and Silicon Labs' much larger competitors are in a stronger position to do that. Another reason to exit the cell phone chip business is that manufacturers like Motorola (NYSE:MOT), Nokia (NYSE:NOK), and Samsung are demanding ever-more-complex chips that integrate numerous functions in order to reduce costs. It's possible that the Apple (NASDAQ:AAPL) iPhone will pressure these companies even further. Integrating additional functionality on a single chip is easier for a large company like TI, which can afford to acquire or develop the necessary technology.

The new Silicon Labs
The question for investors is: What will Silicon Labs look like now? From information given in the press release and the conference call, we can stitch together some tentative 2006 financials for Silabs' remaining business. Here is the relevant information:

  • The divested business accounted for $176 million of revenue during 2006 (from the NXP release).
  • The retained businesses have greater than 60% gross margins.
  • 20% of operating expenses of $227 million during 2006 were associated with the divested business.

Using this information, we can make an educated guess as to what the financials for the "new Silabs" look like. The table below shows the result, assuming a 62% gross margin. As you can see, it isn't exactly pretty (shield your eyes if you must).

Old Silabs

Wireless Unit

New Silabs

Revenue

$465

$176

$289

Gross profit

$257

$77.8

$179.2

Operating expenses

$227

$45.4

$181.6

Operating profit

$30

$32.4

($2.4)

Operating margin

6.5%

18.4%

(0.8%)
Dollars in millions.

It looks like all of the operating profits were generated by the business that is being shown the door. Despite this apparent poor performance, Silabs has stated that it plans to achieve 25% operating margins by the end of 2007 without reducing R&D costs.

A reasonable question to ask might be "Huh?"

Since my computer didn't respond to that, I decided to contact Silicon Labs for clarification. There are two items of note.

1. The 25% target for operating margin excludes stock compensation.
2. Certain operating expenses during 2006 skewed the percentage, meaning that the wireless business would normally account for greater than 20% of operating expenses.

It looks to me like the expenses that skewed the percentage during 2006 totaled no more than around $6 million, but we'll deduct them, along with the 2006 stock compensation of $39.4 million. This helps out a lot, as the table below shows, although more than half of operating profits still appear to have been generated by the wireless business during 2006.

Old Silabs

Wireless Unit

New Silabs

Revenue

$465

$176

$289

Gross profit

$257

$77.8

$179.2

Operating expenses minus stock comp.

$181.6

$36.3

$145.3

Operating profit

$75.4

$41.5

$33.9

Operating margin

16.2%

23.6%

11.7%
Dollars in millions.

Despite the fact that the divested business appears to have been more profitable during 2006, I believe the sale was the right action to take. What matters now is the future performance of the two businesses, and Silabs' management has decided to focus on those parts of its business where it feels it can afford the R&D costs and compete most effectively.

What about the future?
While an 11.7% operating margin is a lot higher than the negative operating margin you get without deducting stock compensation, it is still a long way from the 25% target. Management expects growth over the long term to be in the range of 10% to 15%. Let's see what effect 20% year-over-year growth during next year's Q4 could have. The table below shows tentative financials for the continuing business for Q4 2006 and 2007, assuming what I believe is a best-case scenario -- 20% year-over-year growth in revenue, 62% gross margins, and flat operating expenses (again, ignoring stock compensation).

Q4 06

Q4 07

Revenue

$74.4

$89.2

Gross profit

$46.1

$55.3

Operating expenses

$37.4

$37.4

Operating profit

$8.7

$17.9

Operating margin

11.7%

20.0%
Dollars in millions.

As you can see, the result is still short of the 25%-operating-margin target. If Silicon Labs can continue growing, it may reach its target in 2008.

Is the stock cheap?
Well, it is not obviously cheap -- to me, anyway. Remember that the 20% operating margin was generated using favorable assumptions, and it doesn't include stock compensation expenses.

Yahoo! Finance reports that Silicon Labs' forward P/E ratio based on 2008 earnings is 21, but I would not put a lot of stock in the earnings estimates that were used to calculate that number. This multiple implies 2008 earnings of $82 million, which I believe is possible, but come on -- we don't even know what the earnings will look like later this year. Management does intend to provide more financial information during a conference call in April, and if you own these shares, I would recommend listening to the call.

On the other hand, Silicon Labs will have around $600 million in cash after the transaction closes, which totals more than one-third of its current $1.7 billion market cap. With this kind of financial firepower, management may be able to make an acquisition or two that will significantly strengthen its business -- and it has indicated that it is on the prowl for acquisitions. If Silabs makes good use of its cash hoard and is able to generate growth, current shareholders should do just fine. If not, there may be more tough times ahead.

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Fool contributor Dan Bloom doesn't own shares in any of the companies mentioned in this article. If you feel the arguments he has presented here are wrong, he would love to hear your point of view. The Fool's disclosure policy is wireless and hands-free.