MACOM Technology Solutions Holdings, Inc. annual report, FY2015

Business context and reporting period

M/A-COM Technology Solutions Holdings, Inc. filed this Form 10-K for the 52-week fiscal year ended October 2, 2015. The company designs and sells high-performance analog semiconductors and modules for Networks, Aerospace and Defense (A&D), and Multi-market applications. Fiscal 2014 had 53 weeks, so the year-over-year comparison is not exactly like-for-like. The company reports one operating segment.

Financial results and liquidity

FY2015 basic and diluted earnings per share were $0.95, including $1.06 per share from discontinued operations; continuing-operations loss per share was $0.11. The annual net profit therefore does not represent profit from continuing operations. Fourth-quarter revenue was $112.6 million, gross profit $57.0 million, continuing-operations income $13.8 million, and discontinued-operations income $40.6 million.

• Operating cash flow rose to $33.7 million. Investing activities used $207.4 million, including $208.4 million of net acquisition spending, partly offset by $81.2 million of divestiture proceeds. Financing activities provided $122.4 million.
• At year-end, cash and cash equivalents were $122.3 million and short-term investments were $39.6 million. Working capital was $312.7 million.
• Debt principal outstanding was $345.6 million, largely under variable-rate term loans due in 2021; the company had $130.0 million of available revolving capacity and reported covenant compliance. The debt is secured by a first-priority lien on substantially all company assets.
• Research and development expense was $82.2 million (19.5% of revenue); selling, general and administrative expense was $110.0 million (26.2%).

Material changes versus the prior comparable period

• Revenue increased 24.0%, principally reflecting the BinOptics acquisition and a full year of Mindspeed contribution. Networks revenue grew 49.4% to $273.9 million; A&D declined 4.9% to $83.3 million and Multi-market declined 7.2% to $63.4 million.
• Gross margin increased 6.8 percentage points to 48.4%, which management attributed largely to favorable product mix, including acquired and legacy products. Higher acquired-intangible amortization partly offset the improvement.
• Operating results improved from a loss to income as higher revenue and gross profit more than offset increased operating expenses. Interest expense rose to $18.4 million from $12.4 million, reflecting acquisition-related borrowing and higher rates.
• The company acquired BinOptics for approximately $208.4 million in cash in December 2014, adding InP laser and photonics products. In August 2015 it sold its Automotive business to Autoliv, which management said was no longer aligned with its growth and profitability priorities.

Outlook, commentary, risks and unusual items

• Management expects growth opportunities in Networks from communications infrastructure upgrades, cloud and data-center demand, and optical links; A&D opportunities from radar and battlefield communications modernization; and Multi-market demand from catalog products. The filing does not provide quantified revenue or earnings guidance.
• The change to recognizing eligible distributor revenue at shipment rather than resale increased FY2015 revenue by $17.4 million and net income by $7.7 million (about $0.15 per share). The company established a $6.0 million reserve for future distributor credits and returns. This accounting estimate is a significant factor in evaluating reported growth and earnings.
• The Automotive sale generated a reported pretax gain of $61.8 million. Consideration included $82.1 million paid at closing, $18.0 million payable after 18 months subject to contingencies, and potential earnout payments up to $30.0 million through 2019. A consulting agreement could provide up to $15.0 million over two years. Further amounts are contingent and not assured.
• Key risks include customer and distributor concentration (the ten largest customers represented 57% of revenue; two customers individually accounted for at least 10%), order cancellations and limited backlog visibility, semiconductor cyclicality, pricing and product-mix pressure, and reliance on some sole-source suppliers and external foundries. International customers generated 63.6% of revenue.
• GaN manufacturing transfer and qualification require continued investment; management cautioned that timing, customer adoption, and expected returns are uncertain. Variable-rate debt exposes the company to interest-rate changes; a 1% rate change was estimated to change annual interest expense by about $3.5 million at year-end debt levels.
• Management and the auditor identified a material weakness in IT general controls involving user access and program change management. The auditor gave an adverse opinion on internal control over financial reporting, while issuing an unqualified opinion on the financial statements. Management planned remediation during fiscal 2016; effectiveness had not yet been established.
• The company disclosed an employment lawsuit alleging employee misclassification; class claims were to be dismissed under an agreement, while an individual claim and Private Attorneys’ General Act claims remained. The company disputed the allegations and could not reasonably estimate potential loss. In November 2015, it also agreed to acquire Japan-based FiBest for approximately $60 million, subject to closing conditions.

Important facts for investors to verify

• How much reported growth and profitability is sustainable after separating acquisition contributions, the distributor-revenue estimate change, and discontinued-operation gains?
• Whether distributor credits, returns, and the $6.0 million reserve adequately reflect actual future claims.
• Progress on remediation and independent testing of the IT-control material weakness in fiscal 2016.
• Debt repayment capacity, variable-rate exposure, and the use of Automotive-sale proceeds, including contingent consideration.
• FiBest transaction completion and price, plus the execution, qualification, and customer-adoption milestones for GaN and acquired optical products.