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Based in Camarillo, CA, Semtech Corporation (SMTC) is a fabless original equipment manufacturer (OEM) of a broad range of analog and mixed-signal semiconductor devices for several communications, computing and industrial applications. In fiscal year 2007, communications generated 37% of total revenue (down -14.7% from 2006 levels), computing generated 24% (down -16.1%) and industrial/other 39% (up 70.6%). Computer applications include notebooks, desktops, servers, computer graphics and gaming systems, and personal digital assistants (PDAs). Communications market devices are contained within wireless handsets, wireless base stations and wireline networking gear. Industrial applications include automated test equipment, factory automation systems and medical devices. The 2007 sales performance by specific application was handsets 20% of total revenue (down -21.9%), wireless infrastructure 17% (down -5.6%), desktop PCs/servers 9% (-20.9%), notebooks/PDAs 15% (-12.1%), test & measurement 7% (84.6%) and industrial/military/medical 32% (up 68.8%).

Semiconductor devices are broadly divided into three categories analog, digital and radio frequency (RF). Analog semiconductors condition and regulate real world information such as light, temperature, speed, pressure, power and electrical currents. Digital logic semiconductors process information in only two states. Mixed-signal semiconductors combine both analog and digital technology into a single device. Typically, an analog sensor samples real world information, and then converts the input into an electronic analog signal, which is converted into a digital format for further digital processing. The analog and mixed-signal markets tend to be more varied and specialized, with customized products that have longer life cycles than those in the digital industry segment. There is an ongoing drive to decrease the number of discrete devices, lessen power requirements and shrink the size of the existing devices, which correspondingly increase performance and reliability. Consequently, a greater amount of functionality is being consolidated into increasingly smaller devices. According to the SIA, total microchip sales are expected to grow at a compound annual growth rate of 9% from 2006-2009. The analog component, driven by industrial, wireless and portable electronic applications, is projected to grow at a

compound annual growth rate of 11% during the same period. We expect a larger number of players in the space and a more competitive landscape.

Semtech's area of focus is defined under five broad heads power management, protection, advanced communications, test and measurement, and wireless and sensing. Its power management ICs control, alter, regulate and condition electrical pulses in electronic devices. The product line includes switching regulators, charge pumps, LED drivers, linear regulators, MOSFET drivers, battery chargers and hot-swap controllers. Protection products are transient voltage suppressors, or TVS, that provide protection for electronic systems where voltage spikes, such as electrostatic discharge generated by the human body, can permanently damage voltage-sensitive components. The product line includes electrostatic discharge (ESD) protection devices, ESD/EMI filter and termination devices, high-power surge devices, low capacitance devices and low-voltage devices that are generally sold as a complement to TVS devices. The advanced communications product line includes timing synchronization products, power controllers, power regulators, transient voltage suppressors, high-speed line drivers and ECL clock/logic devices that are mainly used in optical communications networks. The communications ICs are referred to as Station Equipment Timing Synchronization, or SETS. These chips impart timing and synchronization in high-speed networks, such as metropolitan area networks (MANs), wide area networks (WANs) and wireless networks. Test and measurement products include pin electronics, timing, clock distribution, parametric measurement, and clock ICs in ATE, workstations and communication infrastructure equipment. The Wireless and Sensing product line came with the June 2005 acquisition of XEMICS. XEMICS is a fabless supplier of ultra-low power analog and RF ICs. The primary technology focus is on sensor interfaces, 8-bit RISC (reduced instruction set controllers) microcontrollers, RF transceivers and audio codecs. The product line comprises ultra-low-power low-voltage devices that transmit voice, pressure, temperature, acceleration, time, position, speed and other analog inputs in personal area and home and building automation networks. The areas of application include home automation, remote metering and control, GPS positioning and asset tracking, hearing aids and wireless headsets.

The company operates in two business segments Standard Semiconductor Products, which generated 96% of its revenue in fiscal 2006, and Rectifier, Assembly & Other Products, which generated the remaining 4%. The Standard Semiconductor Products segment includes power management, protection, test and measurement, advanced communications and wireless and sensing product lines. The Rectifier, Assembly & Other Products segment consists of the company's legacy rectifier devices, assemblies of rectifiers and other miscellaneous products.


Being a fabless company, Semtech outsources most of the wafer fabrication to semiconductor manufacturing foundries. The company uses a Chinese foundry for 43% of its total wafer requirements, a German foundry for another 12% and several other foundries for 39%. Fabrication of the remaining 6%, mainly consisting of legacy products, is done in-house at its Reynosa, Mexico facility. SMTC outsources the test and assembly of products to third party contractors located in Malaysia, the Philippines and China.

The company caters to the top companies in the computing, communications and industrial/other end markets. Important customers in the computing market include Apple, Dell, Hewlett-Packard, Intel and LG Electronics. Its customers in the communications space include Alcatel, Motorola, Nortel, Samsung and Sony. Industrial and other customers include Credence, LTX, Rockwell, Siemens and Phonak. The company had one 10% customer in 2007. For fiscal year 2007, North America contributed 23% of the company's revenue (up 33.1%), Europe 15% (up 36.6%) and Asia 62% (down -6.6%).

Analog products do not require leading edge manufacturing process

In general, digital semiconductor OEMs' products are differentiated on cost of production rather than application. Therefore, digital semiconductor OEMs usually utilize leading edge manufacturing equipment, with correspondingly higher embedded capital equipment costs. This results in higher depreciation expenses and higher foundry utilization requirements in order to recover the capital equipment investments. Being a fabless analog company, Semtech has to spend relatively smaller amounts on capital equipment. Moreover, a large portion of the manufacturing is contracted to outside foundries, which further reduces costs for SMTC.

Analog products possess longer life cycles that support higher margins

Analog and mixed signal products tend to be more customized, with relatively longer life cycles than digital components. Analog and mixed signal OEMs differentiate their product lines based on specific applications or vertical end markets. Consistent with industry-wide trends, Semtech's analog offerings have transitioned from being generic to more application specific. The large upfront design costs embedded in these customized devices act as a barrier to entry for competitors, making it harder to compete successfully with firms such as Semtech. Consequently, its older analog products can keep contributing to revenue for longer periods of time and generate higher margins (due to pricing power) than corresponding digital products.

Revenue growth is always an area of concern for analog companies

While the business model supports outstanding margins, revenue growth, by its very nature, is always an area of concern for analog companies. The long lead times for customized devices require a relatively longer sales cycle than a digital semiconductor company. Management has been focused on identifying customer requirements and defining products to suit these requirements. This is expected to bring faster adoption, driving sales growth in the next few quarters.

New products, especially in power management, are likely to play a key role

The company continues to build research and development (R&D) resources (it has set up a new design and engineering unit in England) to maintain growth levels and further build its portfolio of new products. Semtech introduced 17 new products in the last quarter, compared to 36 introduced in the preceding quarter. Management is particularly optimistic about the new power management products, since they are of better quality and differentiation. These products are expected to generate revenue in the current fiscal year. Design win momentum continues to be very strong, with the company recording 789 new design wins in Q3, up from 775 in the July quarter. Most of the wins were for protection and power management products in handheld, consumer, communications and industrial applications. Both revenue and gross margin are expected to look up in 2009, as these new products gain traction.

The power management turnaround is here, with significant revenue growth expected in the next few quarters

In August 2006, the new CEO Mohan Maheswaran stated that the power management product line would require a turnaround period of around 18 months. Now, after a year, it looks as if the company is making significant progress. The new management has redefined product strategies, carrying out more critical analysis before developing products. It has also been studying the market to acquire the necessary technical information to ensure the success of new products. Customer relationship-building is another focus area. In order to execute the above, SMTC hired a new product definition manager specifically to define and single out more competitive power management products. The company also appointed a new SVP, and changed several other key positions. Last quarter, power management revenue was up around 25%, and we think the company may be gaining back some market share. This was the third sequential revenue increase in around three years. The strength in the last quarter came from the computing, handhelds and general consumer markets.

Protection products set to take off very strongly

The protection business continues to do well, generating around 47% of total revenue in the last quarter. The segment was up 23% sequentially, driven by the handheld, computing and industrial markets. Management expressed satisfaction at the rate of design win momentum at important customers, and stated that penetration at new customers was also going up. The company has a very wide reach in the area handhelds, LCD TVs, set top boxes, DVRs, consumer equipment, communications and industrial protection, Ethernet ports and security devices, to name a few. Semtech's specialized product set and customer response to recent product releases indicate that this business is likely to experience strong growth.

Portables up strongly handsets, desktops and industrial witness modest increase networking and test sluggish

The company had been losing share in both the handset and notebook markets. The share loss was attributed to poor execution in power management products. The handset and portable segments were down around -20% and -19%, respectively, in fiscal 2006 and down -22% and -12%, respectively, in 2007. The notebook market was up over 40% in Q2, and Santa Rosa is likely to have had a small positive influence on revenue. Penetration of the company's power management products is taking hold. The handset market was up double-digits in the last quarter, and management indicated that there would be further upside when new products gained traction. Management intends to use the protection customer base to expand the power management business, as it is expected that many customers currently using protection products will also take the new power management offerings. The computing business increased for the second consecutive quarter, although demand is expected to soften in the seasonally softer January quarter.

The high-margin test & measurement business declined from 3% to 1% of total revenue. Although the company continues to see design wins for its new pin drive cobalt platform, these wins are not likely to convert to revenue until fiscal year 2009.

Investment Summary

Improvements in semiconductor supply chain management have caused smaller and quicker corrections to under or oversupply conditions. The last revenue trough occurred in the fourth quarter of fiscal 2007, while the previous two troughs occurred in the first quarters of fiscal year 2004 and 2006. The power management business is well on the recovery path, although gross margins are still below the corporate average. Both protection and power management product revenue increased in the last quarter, and management appears confident that new products will generate significantly higher revenue and accelerate margin expansion. Advanced communications is another area with good growth potential. The company has a number of important design wins, and expects to play in the emerging femtocell area (wireless in the home without the wireless LAN infrastructure). However, its position on the computing market, which makes a sizeable contribution to revenue is not so positive. While the new products are expected to improve results in this market as well, management stated that the computing market tended towards commodtization within a shorter timeframe. Semtech has always played in the higher-ASP specialized area, which enabled it to generate solid margins year upon year. The current nature of the computing business is, therefore, a walk away from this goal. Management is unlikely to disturb production patterns considering the production machinery currently in place.

Historically, Semtech has had a lean operating structure, and margins have responded quickly to a pick-up in revenue. The company introduced 72 new products in fiscal 2007 and continued to secure a large number of design wins (2,530 in fiscal 2007). This momentum continued in Q1, with the company adding 36 new products and securing 775 design wins. The normal lag time for completing the design process and beginning the production cycle is about 12 months. Some of the new designs are expected to take 18 months to get to the revenue generating stage. Management contends that a larger percentage of current design wins are likely to be converted to revenue, since there is now a system in place for clearer identification of customer requirements, better product definition and timely product launches. The new CEO projected a turnaround period of 18 months, and the progress in the business seems to indicate that this is going per schedule. The stock had been trading due to a number of reasons. However, the fundamentals continue to improve, which makes us optimistic about the stock.




References

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