PMC-Sierra Inc. / (PMCS-NASDAQ) / $8.32

Note: This report contains substantially new material. Subsequent reports will have changes highlighted.

Reason for Report: 2Q07 Results Prev. Ed.: June 26, 2007.

Recent Events: Summary

July 19: PMCS reported 2Q07 Earnings Results.

March 29: PMCS announced corporate restructuring.

For more details, and more recent events of importance, please see further on in this report, after “Overview”, below.

Overview

PMC-Sierra (PMCS or the Company) designs, develops, markets, and supports high-speed broadband communications, storage semiconductors, and MIPS-based processors for service providers, enterprise, storage, and wireless networking equipment.

Key investment considerations as identified by analysts are as follows:

Key Positive Arguments / Key Negative Arguments
Good precedence: The Company has a strong track record of analog, digital, mixed signal, and microprocessor expertise, and is able to integrate many functions and protocols into complex devices. / Weak financial condition: PMCS is subject to rapid changes in demand because of inventory levels, production schedules, and fluctuations in demand for networking equipment and customer concentration, which could affect its business, financial condition, or operating results.
Inventory depletion: Analysts expect benefits to flow from inventory depletion at telecom and networking OEMs over the coming years. / Adverse operating results: Business strategy involves acquisitions of other companies or technologies, which could affect operating performance because of inherent integration risks.
Position strengthened: PMCS has strengthened its position in the service provider market and broadened its business in the enterprise and storage markets. / Customer dependence: The Company relies on a few customers for a major portion of sales; analysts believe any change in ordering patterns could hurt results.
Passave acquisition: PMCS has made an accretive deal with Passave; analysts expect the deal to result in increased revenue. / Declining margins: The Company’s strategy of expansion in new markets may cause profit margins to decline.
Revenue volatility: Telecom order patterns tend to be inconsistent and PMCS can therefore be subject to revenue volatility.

PMCS develops Application Specific Standard Products (ASSPs) that are used in equipment based on Asynchronous Transfer Mode (ATM), Synchronized Optical Network (SONET), Synchronized Digital Hierarchy (SDH), T1/E1/J1 and T3/E3/J2, and Ethernet protocols. PMC-Sierra has more than 180 different semiconductor devices that are sold to equipment manufacturers, who in turn supply their equipment principally to communications network service providers and enterprises. The Company sells its networking products primarily to Access, Enterprise/Storage, and Consumer-related markets.

Additional information is available at the Company website: www.pmc-sierra.com

Note: The Company’s fiscal year coincides with the calendar year.

Recent Events: Details

On July 19, 2007, PMCS reported 2Q07 Earnings Results. Highlights are:

·  Total revenue was $104.7 million versus $103.7 million in 1Q07

·  Non-GAAP net income was $7.4 million versus $4.4 million in 1Q07

·  Non-GAAP EPS was $0.03 versus $0.02 million in 1Q07

On March 29, 2007, PMCS announced the implementation of a corporate restructuring that it expects will reduce ongoing annualized operating expenses by an estimated $20.0–$24.0 million per year. According to analysts, the Company's decision to initiate cost reduction activities is part of an ongoing endeavor to improve its corporate operating performance and boost productivity across the organization.

Revenue

Total average revenue in 2Q07 as compiled by Zacks Digest was $104.7 million (in line with the Company’s results), down 11.9% y/y but up 1.0% sequentially, versus $103.7 million in 1Q07. However, the results exclude deferred revenue of $4.2 million, following the announcement by management in 1Q that the Company would recognize revenue from Avnet, its largest distributor, as product was sold to the end customer rather than into Avnet inventory. The Company saw broad-based improvement across the telecommunications and enterprise storage end markets.

Without the adjustment, revenues were $108.9 million and came in at the upper end of guidance of $106.0–$109.0 million. The book-to-bill for the quarter was greater than 1. Cisco and EMC were the only customers that accounted for over 10.0% of revenues. The September quarter guidance is for revenues of $112.0 to $115.0 million.

Revenue Analysis by Segment

Enterprise Storage

Revenue for the Enterprise division (includes Avago) improved 11% sequentially. The Enterprise Storage business also improved 16% sequentially. PMCS cited a strong rebound in orders and backlog in 2Q07 as an indication of healthy demand trends, combined with strong design wins, which is expected to impact revenues positively in the next several quarters. Enterprise networking and laser printing experienced strength in the quarter and management expects these segments to continue to grow in 3Q07.

Telecommunications

Revenues for the Telecommunications division ticked up a modest 2.0% sequentially. PMCS believes the business to be stabilizing as supply chain inventories have leveled. It sees its position being strengthened as components suppliers consolidate. Management claimed that this business segment will be more profitable through a moderation of R&D spending going forward and through benefits of recent design wins with OEMs.

FTTH

Revenues for the FTTH division improved 16.0% sequentially. The Company is encouraged by its prospects within the FTTH market, as it sees this segment picking up after a dip earlier in the quarter. Developments in this category are focused primarily in Asia. PMCS expects to benefit through Korea Telecom’s rollout of an estimated 800K GPON subscriber lines. Also, NTT in Japan announced its intention to add 3.4 million EPON lines over the next four quarters. In China, PMCS claims it introduced the first EPON product that adheres to China Telecom standards and is working with an OEM with hopes that its product will be brought to field trials later this year.

Microprocessors business

Revenues for the Microprocessors business division declined 9.0% sequentially. The analyst (Merrill) believes MIPS will be an overall flattish business, with growth from printing design wins, largely offsetting stand-alone network processors.

Turns and Bookings

The Company needs to achieve a similar level of turns business in 3Q07 in order to meet the midpoint of its guidance range of $112.0–$115.0 million.

The MIPS processor business was described as particularly strong, driven by strong laser printer demand at HP and Japanese customers. PMCS’ telecom business showed signs of life as inventory adjustments in that market were also terminated. Enterprise Storage improved 11.0% sequentially due to the segments strong design with momentum, with SAS loop switches beginning in 2Q07 and SAS controllers likely contributing in 2Q08. PMCS also expects positive sequential growth in FTTx and Telecom ICs.

On a geographical basis, 2Q07 revenue can be broken down as follows: Asia 62.0%, North America 27.0%, Europe 7.0%, and Other 4.0%. The two customers, which accounted for more than 10.0% of revenue was Cisco and EMC.

Outlook

The Company expects 3Q07 revenue in the range of $112.0 million to $115.0 million. The Company expects growth in 3Q07 to emanate from enterprise storage segment and communications, driven by strength in Chinese, Asian, and North American markets as they upgrade their network. The Company also expects FTTH to improve and the microprocessor business to remain flattish sequentially. Communications demand is expected to increase as service providers continue to upgrade the edge access and metro portions of their network. Furthermore, the Company expects the microprocessor business to slow slightly in 3Q07.

The Company tweaked up its FY07 estimates modestly, largely to reflect the Company’s accounting adjustment. For FY07, the Company now expects revenue of $442.1 million and EPS of $0.19 versus a prior $445.0 million and EPS of $0.18. FY08 estimates for revenue of $515.0 million and EPS of $0.35 remains unchanged.

FTTH, SAS, and China 3G are still in their early stages and will be joined by RAID-on-Chip in 2008.

Provided below is a summary of revenue estimates as compiled by the Zacks Research Digest:

Total Revenue ($M) / 2006A / 1Q07A / 2Q07A / 3Q07E / 4Q07E / 2007E / 2008E
Digest High / $425.0 / $104.0 / $105.0 / $114.0 / $122.7 / $445.0 / $548.7
Digest Low / $425.0 / $103.7 / $104.5 / $111.9 / $116.0 / $436.3 / $500.0
Digest Average / $425.0 / $103.7 / $104.7 / $113.4 / $119.7 / $441.6 / $517.2
Digest Average Y/Y Growth / 45.8% / 18.1% / -11.9% / -2.7% / 17.4% / 3.9% / 17.1%
Quarterly Growth / 1.8% / 1.0% / 8.3% / 5.6%

Highlights from the chart are as follows:

• 2007 forecasts (13 analysts) range from $436.3 million to $445.0 million; the average is $441.6 million.

• 2008 forecasts (13 analysts) range from $500.0 million to $548.7 million; the average is $517.2 million.

Please refer to the Zacks Research Digest spreadsheet on PMCS for more details on revenue.

Margins

Average 2Q07 gross margin as compiled by Zacks Digest was 64.7% versus 64.1% in 1Q07. Operating margin in 2Q07 was 7.4% versus 4.1% in 1Q07. Total pre-tax margin and net margin was 9.8% and 7.1%, respectively. Total R&D expense in 2Q07 was $38.3 million, up 1.1% y/y and down 6.8% sequentially, versus $41.1 million in 1Q07. Total SG&A expense in 2Q07 was $23.5 million, up 0.8% y/y and 1.3% sequentially, versus $23.3 million in 1Q07.

Outlook

According to management, non-GAAP gross margin is expected to stay around 65.0%. Operating expense is expected to be approximately $62.0 million. Interest income should be about $3 million and the effective tax rate between 24.2% and 30.0%.

Provided below is a summary of margins as compiled by Zacks Research Digest:

Margins / 2006A / 1Q07A / 2Q07A / 3Q07E / 4Q07E / 2007E / 2008E
Gross / 67.9% / 64.1% / 64.7% / 64.7% / 64.9% / 64.6% / 64.9%
Operating / 15.3% / 4.1% / 7.4% / 13.5% / 17.2% / 10.8% / 19.6%
Pre-Tax / 16.5% / 5.7% / 9.8% / 15.2% / 19.0% / 12.7% / 21.4%
Net / 13.6% / 4.2% / 7.1% / 11.1% / 13.9% / 9.3% / 15.7%

Please refer to the Zacks Research Digest spreadsheet on PMCS for more details on margin estimates.

Earnings per Share

Total non-GAAP EPS in 2Q07 as compiled by Zacks Digest was $0.03 (modestly in line with the Company’s results). Total GAAP EPS in 2Q07 as compiled by Zacks Digest was ($0.09) (in line with the Company’s results).

PMCS reported net loss in the quarter on a GAAP basis of $22.3 million (GAAP diluted loss per share of $0.10) versus a GAAP net loss in the first quarter of 2007 of $15.8 million (GAAP loss per share of $0.07). Non-GAAP net income was $7.4 million (non-GAAP diluted earnings per share of $0.03) versus non-GAAP net income of $4.4 million (non-GAAP diluted earnings per share of $0.02) in the first quarter of 2007.

Non-GAAP net income in the second quarter of 2007 excludes the following items: (i) $9.6 million in stock-based compensation expense; (ii) $2.2 million reversal of a payroll tax accrual in a foreign jurisdiction; (iii) $9.8 million in amortization of purchased intangible assets; (iv) $3.8 million in costs and charges related to the Company’s corporate restructuring announced March 29th, 2007; (v) $8.3 million foreign exchange loss on foreign denominated FIN 48 liabilities, and (vi) $0.3 million income tax effect relating to these non-GAAP adjustments.

Outlook

In light of strong performance by the Company, most analysts (Pacific Crest; AG Edwards; CIBC; Lehman; MorganStanley; and Stifel Nicolaus) raised their respective EPS estimates.

Provided below is a summary of EPS estimates as compiled by Zacks Research Digest:

Pro forma EPS / 2006A / 1Q07A / 2Q07A / 3Q07E / 4Q07E / 2007E / 2008E
Digest Avg. / $0.28 / $0.02 / $0.03 / $0.06 / $0.08 / $0.19 / $0.36
Digest High / $0.29 / $0.02 / $0.04 / $0.07 / $0.08 / $0.21 / $0.44
Digest Low / $0.26 / $0.02 / $0.03 / $0.05 / $0.07 / $0.17 / $0.31
Digest Average Y/Y Growth / 39.1% / -75.0% / -65.8% / -25.7% / 279.5% / -32.0% / 92.2%
Quarterly Growth / 0.0% / 53.8% / 93.3% / 27.7%
Zacks Consensus / $0.01 / $0.04 / $0.01 / $0.19

Highlights from the chart are as follows:

• 2007 forecasts (13 analysts) range from $0.17 to $0.21; the average is $0.19.

• 2008 forecasts (13 analysts) range from $0.31 to $0.44; the average is $0.36.

Please refer to the Zacks Research Digest spreadsheet on PMCS for more extensive EPS figures.

Target Price/Valuation

Target prices for PMCS range from a low of $8.00 (Stanford and Lehman) to a high of $11.00 (Stifel Nicolaus and UnionBankSwitz.), with an average of $9.38 ( $0.65 from the previous Zacks Digest report of $8.72).

Provided below is a summary of valuation and ratings as compiled by Zacks Research Digest:

Rating Distribution
Positive / 30.8%
Neutral / 69.2%
Negative / 0.0%
Average target price / $9.38
Digest High / $11.00
Digest Low / $8.00

General risks to analyst target prices include a weakening in end demand for telecommunications equipment or a slowdown in telecom carrier spending; delay in the rollout of 3G infrastructure in Asia, US, and Europe; inventory overhangs in the sales channel, which could make revenue uneven and also adversely affect pricing; a slowdown in IT spending which could affect demand for enterprise and storage products; and quicker-than-expected transition away from ATM to Ethernet-based transport protocols, according to analysts.

Metrics detailing current management effectiveness are as follows:

Metric (TTM) / Company / Industry / S&P 500
Return on Assets (ROA) / -11.22% / 11.56% / 8.38%
Return on Equity (ROE) / -21.51% / 15.31% / 20.84%
Return on Invested Capital (ROIC) / -13.45% / 14.05% / 12.37%

Please refer to the Zacks Research Digest spreadsheet on PMCS for further details on valuation.

Capital Structure/Solvency/Cash Flow/Governance/Other

Cash and Cash equivalents