Seeking Alpha "Seeking Alpha predicted stock returns... Home | My Portfolio | Breaking News | Latest Articles | StockTalk | ALERTS | PRO This article was sent to 638 people who get email alerts on .Which cover: new articles | breaking news | earnings results | dividend announcementsGet email alerts on »This article was sent to 451,144 people who get the Investing Ideas newsletter. (You’ll be notified by email with new articles from your favorite authors. Should Investors Buy PMC-Sierra Ahead Of Big Product Ramps? Apr. PMC-Sierra is looking to new storage products to drive significant incremental revenue growth. OTN and Mobile are more challenging markets where PMC-Sierra needs a bigger revenue base to drive better profits. The shares don't look cheap today, but nobody seems to be giving full credit to management's projections. Shares of storage and networking semiconductor company PMC-Sierra (PMCS) have done reasonably well since I last wrote about the company in October. Up around 20%, the company has lagged acquisition-assisted LSI (LSI), but matched Broadcom (BRCM) and outperformed Applied Micro (AMCC). Analysts, though, are a little worse than lukewarm on the shares, with four holds and two underperforms at present. In reading the sell-side research, it seems like analysts are concerned about going positive on PMC-Sierra ahead of meaningful ramps in PCIe flash controllers, 12G SAS, and OTN. While I find it odd that the normally overly-bullish sell-side is being cautious, investors don't seem to have the same issue. With the run in the shares over the past six months, PMC-Sierra's price seems more than fair relative to its long-term cash flow-based value and likewise quite reasonable relative to operating margins. Investors have become more concerned about the health of the enterprise storage market and the question of how companies like EMC (EMC) will fare as companies migrate to cloud solutions. When it comes to PMC-Sierra, though, it looks like the company's ability to ramp up business in data centers is offsetting that overall market sluggishness. Revenue was up more than 6% sequentially in the storage business when PMC-Sierra last reported, with the company highlighting a good ongoing launch of its PCIe flash controller products. The next big event may well be the transition to Intel (INTC) Grantley servers later this year. PMC-Sierra management believes that this will accelerate the 12G SAS adoption cycle, an area where they believe they have the best product and an opportunity to gain share from LSI. PMC-Sierra is one of the only companies to offer PCIe and SAS, but it remains to be seen if 12G SAS can live up to management's hopes of up to $100 million in incremental revenue. The company certainly has a good partner in EMC and over $250 million in incremental revenue (flash controllers and SAS) would be very significant for a company of this size. Competition here comes down to what you might expect - who can offer the best performance (speed, in particular), the least energy consumption, and the best overall improvements in operating performance and costs in the best cost-benefit package. PMC-Sierra did manage to build over 50% share in the 6G SAS space, but there are questions as to whether 12G SAS will be as competitive against PCIe. PMC-Sierra has been seeing weakness in its optical business (down 19% qoq in the last quarter), as a large PON deployment ended and SONET orders declined. Now the question is whether the company's single-chip SoC OTN processor will boost sales through the next couple of years. As SONET trails off and PON isn't expected to grow all that much, PMC-Sierra management is looking for the opportunity in OTN to nearly triple between 2012 and 2017. PMCS's new DIGI processors offer a lot of familiar selling points - a big reduction in power consumption (50%), reduced line card variants, and meaningful savings by consolidating multiple functions into that single chip. The question is whether PMC-Sierra can break into what has been a strong area for Cortina and Applied Micro. Management believes OTN switching could bring nearly $100 million in incremental revenue in 2015 and beyond and the company has referred to design wins with the three largest optical companies. Where PMC-Sierra doesn't look as strong or interesting in the short term is in mobile. Broadcom's offering has greater throughput and I'm not sure that the greater flexibility and customization features of the PMC-Sierra offering is enough to compensate. I also don't see the company having all that much leverage to LTE rollouts in China, which likely dims the near-term prospects. Longer term, the company's radio head solutions could be worth watching. One thing that concerns me about the PMC-Sierra model is something that also bothers me with Broadcom's mobile offerings - do these companies have the necessary revenue scale to continue funding the R&D needs to stay in all of these markets for the long term? The company is definitely competitive in the storage market, and I think there is good long-term opportunity there, but I wonder about the long-term returns on capital invested in R&D for the optical and mobile businesses. Right now it doesn't look like anybody is quite as bullish about PMC-Sierra's prospects as management. The company has talked about over $500 million in incremental annual revenue potential from flash controllers, 12G SAS, OTN, and so on, but it doesn't seem like anybody credits them for much more than half that amount. My base-case model calls for about 7% long-term revenue growth and FCF margins growing into the high teens, but a trajectory closer to management's expectations would add about three points to the revenue growth number and around $1.50 per share in fair value. My expectations are lower than management's, and a DCF-based valuation approach still suggests fair value around $7. An EV/revenue approach likewise suggests that the shares are pretty fairly valued today - there is a pretty tight correlation between operating margins and EV/revenue multiples in semiconductors, and PMC-Sierra's multiple seems fair today. The market is definitely suggesting that the sell-side is playing it too conservatively and that management will get closer to its own incremental revenue targets than the analysts believe. I don't have any particular problem with the idea that PMC-Sierra deserves more benefit of the doubt, but the company really needs to show some upside to revenue and/or margins to justify a substantially higher multiple. Disclosure: I am long BRCM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)Want more from this author? Follow and be the first to know when they publish. Stephen Simpson, CFA (2,399 followers) Long only, growth at reasonable price, value, research analyst(You’ll be notified by email with new articles from your favorite authors. Contact Me We only use your contact details to reply to your request for more information. We do not sell the personal contact data you submit to anyone else. We look forward to contacting you shortly for a conversation. 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