Editor's note: This Breakout Stocks alert was originally sent to subscribers July 24 at 1:26 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.


We are adding Microsemi ( MSCC) to our Watch List of stocks. Shares currently trade at $23.34, and we would consider using weakness closer to $20 a share to initiate a position. In the meantime, we will continue to monitor this company and pounce should its potential risk/reward increase in the near term.

Microsemi is a leading provider of analog and mixed-signal integrated circuits. The company's core competency, its power-management chips, is built on the ability of its chips to control voltage surges and reduce power consumption in products that require a steady state of energy, such as heart devices and notebook computers.

We like Microsemi's long-term growth prospects as the company is leveraged to multiple strongly growing segments of the economy. Specifically, some 17% of its revenue comes from its medical-devices business, which focuses on implanted cardiac defibrillators (ICDs).

Also, the company is making headway in the liquid crystal display (LCD) market, where its chips can be used to lengthen the life of a flat-panel display because of an extended battery life. This division makes up 15% of its total revenue. Last, the company sells its products to the U.S. military for communications devices used in the cockpit of fighter planes and other equipment, a segment that accounts for approximately 44% of the company's total revenue.

Even so, the near-term prospects for Microsemi's end markets lead to a cautious stance on the company's earnings potential. The ICD market has had its troubles recently due to product recalls from Guidant, which was acquired by Boston Scientific ( BSX) in April, and from Medtronic ( MDT). Also, the major ICD manufacturers have had higher-than-industry-average inventory levels of late, which likely led to a pause in orders to Microsemi over the past few months.

With respect to the recalls, problems with the defibrillators that are disclosed on the Federal Drug Administration (FDA) Web site include a shorting defect that occurs in some ICDs. While this is a near-term negative for Microsemi, we believe the company has an opportunity to sell its power-control management products as a solution that would comply with any future FDA regulations regarding ICD batteries.

In addition, new FDA regulations to ensure that ICDs do not fail would likely increase the amount of technology needed in each device, and thus the dollar content per ICD that Microsemi can address. This would create a larger market opportunity for future sales growth. Even so, the recalls have created some near-term uncertainty in the ICD market and lengthened the FDA-qualification process for new devices to receive market approval.

On the LCD front, the company is seeing strong demand for its products from LCD manufacturers, which sell their products to electronics retailers. Microsemi's products offer critical power, light and sound management, and give backlights -- which are key components of flat-panel displays -- a longer usable life.

The life span of a flat-panel display is a key selling point for manufacturers, so Microsemi's products should see continued sales growth as flat-panel displays penetrate deeper into the consumer market, given the increasing use of flat panels in televisions, PC monitors, laptops, cell phones and digital cameras.

According to Microsemi, 30% of the products sold in the LCD market contain one of its devices. The company estimates that it generates $1.32 in revenue for each television shipped that includes its technology, but that its potential revenue per television is closer to $8. While the company will likely never ship $8 worth of chips per television, we believe that Microsemi will continue to grow its technology content per television, thus leading to both continued double-digit percentage top-line growth and operating margin expansion. In fact, the company estimates it could double its business to $2.64 per television over the next few years.

Similar to the ICD market, the LCD market has its share of near-term problems. Namely, inventories of LCD televisions have been on the rise, with manufacturers such as Korean partnership LG Phillips, AU Optronics ( AUO) and 3M ( MMM) all noting that LCD sales slowed in the second quarter. While this slowdown will likely be transient in nature, with an uptick toward the end of the year as the holiday shopping season unfolds, the near-term uncertainty surrounding the LCD market could dampen the potential expansion in Microsemi's price-to-earnings ratio.

In November 2005, Microsemi announced the acquisition of chipmaker Advanced Power Technology (APT) in a deal valued at $136 million. The deal closed in April of this year, and management's comments at an investor conference we attended in May indicate that the integration of the two companies is progressing quite well.

In fact, management believes that APT, which expands Microsemi's line of power-management chips, will add more value to Microsemi than originally anticipated, though we will wait to see this show up in the numbers over the next few quarters before we factor in additional synergies and revenue-generating opportunities.

We believe that Microsemi's stock trades at an attractive valuation, but a weak second-quarter earnings report or guidance that's lower than analysts are forecasting could send shares closer to the $20 level. Microsemi is set to report earnings Thursday, July 27, and analysts are looking for the company to earn 27 cents a share on revenue of $99.6 million.

An in-line quarter would mark impressive 63% bottom-line growth from year-ago levels, with the top line jumping some 35% over the same period. The company is benefiting from a great deal of operating leverage due to cost reductions, improved manufacturing efficiencies and closures of manufacturing facilities. Plus, the successful integration of APT, as well as Microsemi's plans to lower the commissions paid to salespeople and further expand margins validate the Street's lofty 2007 EPS growth assumptions.

We will update subscribers should we decide to take action in this name. Also, Thursday's earnings results will be critical to our long-term thesis, and we will provide an update should our long-term bullish stance change.

P.S. A Message from Dave Morrow, Editor-in-Chief, TheStreet.com

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The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research associates at TheStreet.com. In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please click here.

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