LSI Looks Too Cheap, But Only If You're A Believer

By Stephen D. Simpson, CFA | June 03, 2013 AAA

Investing nearly always calls for some leap of faith – Wall Street is a discounting mechanism, and that requires investors to try to peer into the future and see how industries, markets, and companies will look in a few years' time. If you wait too long, waiting for more certainty on developments, most of the gains will be gone by the time you decide to invest.

I mention this because I think it's a very relevant part of the LSI (NYSE:LSI) story today. As is, the company is not all that exciting. But if you believe that the company's flash technology will lead to share gains in this fast-growing (albeit small) market and that the company can benefit both from a recovery in network spending and increased share in network processors, the prospects for this stock look much more interesting.

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Near-Term Results Don't Point To Much Momentum
I can understand if investors take a look at LSI, and its last quarter, and don't see why I'm excited about this stock. After all, revenue was down 9% in the first quarter, with storage revenue down 10% and networking revenue down 14%. While gross margin held up very well indeed (actually improving on a year-over-year GAAP basis), operating income was down more than one-quarter.

And it gets a little bit worse from there. The company has been losing share in hard drive controllers to Marvell (Nasdaq:MRVL), and now has less than one-third of the market (in contrast to LSI's results, Marvell's hard drive controller-based revenue was up about 9%). While management is hopeful that the first quarter was the trough for this business and design wins at Western Digital (NYSE:WDC) should help, the prospect of falling share in a lagging market is not encouraging.

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But The Future Should Be Different
The bull story on LSI is all about the future being a lot different than the present. While most bulls believe that LSI can stabilize its hard drive chip business, and maybe still grow a bit, nobody is really look for this to be the growth driver.

What makes LSI interesting are its prospects in flash and networking. In flash, the company is the #2 player in PCIe flash cards. Right now, that means only about 7% or 8% share against Fusion-io's (NYSE:FIO) 80% (or more). But this business grew 162% in the first quarter and LSI boasts big-name partners like Oracle (Nasdaq:ORCL), IBM (NYSE:IBM), NetApp (Nasdaq:NTAP), Cisco (Nasdaq:CSCO), and EMC (NYSE:EMC). I'd go so far as to say that if you believe that flash memory has a meaningful place in the future of data centers (and particularly in enterprise storage), LSI has the partners to bring its share up significantly in the coming years.

Networking is also an under-appreciated potential growth driver for LSI. LSI has a majority share of the server adapter chip market (in a duopoly with PMC Sierra (Nasdaq:PMCS)), and the company's Axxia processors have logged significant design wins with companies like Cisco and Ericsson (Nasdaq:ERIC). Assuming that demand for products like base stations picks up again (which most analysts regard as a “when, not if” question), this should be a meaningful driver for higher revenue and profits for LSI.

The Bottom Line
With weakness all across the board in storage, networking, communications, and so on, it's pretty clear that LSI's bright future doesn't exactly begin tomorrow. Even so, I believe the trends for flash are very strong, as is the company's technology, and likewise for LSI's position in networking. As these business grow and contribute more revenue, LSI should see strong margin leverage and improved cash flow production. With that, and likely little need for a showy high-value M&A transaction, LSI could start returning capital to shareholders.

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I'm looking for LSI to grow its revenue at a long-term CAGR of about 6%, with free cash flow growth of around 10%. Those are pretty strong growth rates compared to companies like Altera (Nasdaq:ALTR), Marvell, and so on, and quite a lot depends upon strong share gains in flash and solid market growth in flash and networking. With a discounted fair value above $9, though, and a current price in the $7's, I think LSI is a worthwhile speculation for investors willing to take on some risk and uncertainty in the pursuit of growth.

At the time of writing, Stephen D. Simpson owned shares of EMC.

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