If the old adage is "Don't judge a book by its cover," then the parallel for stocks should be "Don't judge a company by its business description." Those that take a look at M/A-COM Technology Solutions Holdings (MTSI 1.89%) might be tempted to pass over it as soon as they read about analog semiconductors and radio microwaves. But doing so could be a mistake -- MACOM might look like a boring component maker, but the company's recent growth figures and performance are anything but.
Differentiation is key
Most investors get turned off by analog semiconductor manufacturers, and rightly so. These types of companies generally make commodity-like chips that go into everything from walkie-talkies to household appliances and automobiles. But MACOM has deliberately moved away from this kind of business and has ramped up R&D to focus on higher-complexity products and niche markets.
The company divides its revenue into three categories: Networks comprises 65% of sales and includes wired broadband, cellular infrastructure, and fiber optics. Aerospace and Defense, mainly radar and communication, is approximately 20% of sales. The defense business also has a comparative advantage, as the company's fabrication plants are located in the U.S. and certified as a "trusted foundry" by the Department of Defense. The rest is composed of "multi-market," a catch-all for everything from industrial and scientific measurement to even medical, such as CAT scanners.
MACOM has also replaced low-margin products with more specialized high-margin products. This has boosted its gross margin by five percentage points since 2011. Sales have also increased at double-digit growth rates for the past five quarters.
Growth drivers on the horizon include the continued build-out of cellular and high-speed networks, including fiber optic networks where MACOM is increasingly building expertise, most notably with its recent acquisition of FiBest Limited, a Japanese supplier of optic sub-assemblies.
In fact, management appears adept at finding small companies to buy at good prices. It most recently bought Aeroflex's diode business for $38 million in cash. The business had approximately $37 million in sales the year before, making the acquisition very modest, at a cost equivalent to sales.
Analysts expect the high margin and acquisition integration strategy to pay off in the coming quarters, estimating sales growth of 26% next year and EPS growth of 52%. However, with a small company like this, it should be taken with a grain of salt, as only four analysts cover the stock.
Never without risks
The advantage to some of these small-cap component makers for individual investors is they can be too small for big institutional investors to notice or care about. Of course, the flip side is elevated risk and volatility. MACOM rallied over 50% from late August to its recent high, but has been taking it on the chin along with the rest of the market lately. Partially dampening the volatility is the fact that chairman John Ocampo owns over 35% of the outstanding shares. This is the kind of alignment of interests you want to see.
Growth stocks are never cheap, and MACOM is no exception, with a current price-to-earnings ratio of nearly 41, and a forward ratio of 26. It has only been a few quarters where this kind of growth and performance has been demonstrated, so investors will largely be betting on it to continue. CEO John Croteau has also stated that the acquisition pace will slow in 2016, and the challenge will be to integrate those acquisitions.
To recap, MACOM has been turning things around by moving into more complex and specialized products and increasing R&D, which has boosted the company's gross margin. Sales growth has also increased with acquisitions. The company is a pure player in what appears to be a niche area, adding to its competitive positioning. These factors and the impressive performance so far may warrant a deeper dive for investors looking for the next small-cap tech winner.