Apparently Silicon Labs (Nasdaq:SLAB) still has work left to do in finding the right mix of products and addressable markets. Although this chip company's current results aren't all that bad, the uncertainty about growth and margins is likely to weigh on the shares. The stock does look cheap today, but it's difficult to feel confident about a company that always seems to be in transition.

See: Industry Handbook: The Semiconductor Industry

Reasonable First Quarter Results
Silicon Labs did fine on the top line, as year-on-year growth of 5% (and a 1% sequential decline) led to a small revenue beat. Growth was helped by better sales of LCD TV tuners and touch controllers used in Samsung's Galaxy Wave Y. Overall, the company's broadcast business saw flat sequential performance, while broad-based was up 4%, and access declined 10%.

Margins are where things get a little more complicated. Gross margin was rather weak (down more than a point sequentially), largely because of the higher revenue contribution of lower-margin video chips. Management did well controlling operating expenses, though, and operating income improved 11% from the fourth quarter.

See: A Look At Corporate Profit Margins

Trying to Outrun Its Legacy
One of the challenges for Silicon Labs is to transition from so-called "legacy" addressable markets with less dynamic growth potential to more exciting growth markets. This is an inexact and subjective process, but one that management is taking seriously.

Management mentioned that it was re-evaluating its future in the touch controller space. While this is still a solid volume-growth market, Silicon Labs hasn't been able to get much traction outside of the low end. Management mentioned increased competition from Asia, but I suspect the cost of innovation and competing with Atmel (Nasdaq:ATML) and Cypress (Nasdaq:CY) is also a consideration. Simply put, Silicon Labs is in an uncomfortable place between cheaper lower-end Asian suppliers and more advanced U.S. offerings.

If touch is no longer a growth market for Silicon Labs, a rough back-of-the-envelope calculation suggests that about one-third of Silicon Labs' business could be considered "legacy" and the video business could be heading in that same direction. This puts a lot of pressure on the company to identify new growth markets, including considering more deals. Remember, too, that companies like Texas Instruments (Nasdaq:TXN) and Maxim (Nasdaq:MXIM) want growth and are likely looking at broadly similar markets.

The Bottom Line
Silicon Labs flummoxes me. On one hand, management seems to have a keen focus on profitable growth and a willingness to exit businesses ahead of them becoming commoditized. Management has also done a reasonably good job of identifying and pursuing new growth opportunities. Unfortunately, this is an up-and-down process and Silicon Labs' revenue trajectory is more volatile than many investors want.

This has been a good stock for contrarian investors willing to buy into the bad news and sell into the good, but that's not a strategy that comes easily to most investors. Silicon Labs has a clean balance sheet and plenty of ammunition with which to pursue deals, but investors should understand the risk that this stock stagnates while other chip stocks enjoy solid recoveries.

I do believe that Silicon Labs is undervalued, and maybe more than 30%. I have to confess that a lot of the cash flow growth I predict is based on the belief that management "will do something," as opposed to identifiable growth in current businesses. That ups the risk in these shares, but then Silicon Labs has never been the safe pick in chips.

See: Value Investing: Finding Undervalued Stocks

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