it sector final report and stock pitch

Information Technology

Final Report & Stock Pitch

Prepared by:

Gokul Poduval Joshua Bloom

Gaurav Mani

March 2009

Finance 725: Applied Financial Analysis and Portfolio Management

Contents IT Sector Overview ........................................................................................................................................ 4

Semiconductors ........................................................................................................................................ 4

Overview ............................................................................................................................................... 4

Macroeconomic impact ........................................................................................................................ 4

Fundamental analysis ........................................................................................................................... 5

Software & Services Industry .................................................................................................................... 5

1. Internet software and services ........................................................................................................ 5

2. IT services ......................................................................................................................................... 6

3. Software ........................................................................................................................................... 6

Technology Hardware & Equipment ......................................................................................................... 7

1. Communications equipment ............................................................................................................ 7

2. Computers & peripherals .................................................................................................................. 8

Sector Alpha .............................................................................................................................................. 9

Quant Screening .......................................................................................................................................... 10

Specifying the universe ........................................................................................................................... 10

Our Screening Parameters ...................................................................................................................... 10

Momentum ......................................................................................................................................... 11

Value ................................................................................................................................................... 11

Smart Money....................................................................................................................................... 11

Quality ................................................................................................................................................. 11

Screen Results ......................................................................................................................................... 12

Qualitative Analysis ................................................................................................................................. 13

Tellabs Inc. (TLAB) ............................................................................................................................... 13

ManTech International Corporation (MANT) ..................................................................................... 14

Molex Incorporation (MOLX) .............................................................................................................. 15

Micrel, Incorporated (MCRL) .............................................................................................................. 16

National Instruments Corp (NATI) ...................................................................................................... 17

Hewitt Associates, Inc. (HEW) ............................................................................................................. 18

SRA International, Inc. (SRX) ............................................................................................................... 19

Advent Software (ADVS) ..................................................................................................................... 20

eVal Valuation of Hittite.............................................................................................................................. 21

Sensitivity Analysis .............................................................................................................................. 21

Information Ratio & Stock Alpha ................................................................................................................ 23

Detailed Analysis of Hittite Microwave Corporation .................................................................................. 24

Description of the Business ..................................................................................................................... 24

Stock metrics as of 3/27/09 and other Selected 2008 Annual Financial Data .................................... 26

Notable items from 2008 earnings call (held 2/19/09) ...................................................................... 26

Positives about the Stock .................................................................................................................... 26

Negatives about the Stock .................................................................................................................. 29

Neutral Comments about the Stock ................................................................................................... 30

Stock Views on Balance ....................................................................................................................... 31

IT Sector Overview The Information Technology Association of America (ITAA) defines Information Technology as “the collection of products and services that turn data into useful, meaningful, accessible information.”1 It consists of various industry groups like semi-conductors, software services and hardware manufacturers. The United States spends about 40% of the world’s expenditure in the IT sector, with overall spending close to $1.13 trillion in 2005, with a compound annual growth rate (CAGR) of 4%. IT comprises 8% of the US GDP, and IT intensive firms experience productivity growth rates of 3%, compared to 1.6% for other non-farm labor2. In line with GICS we divide the IT sector into 3 industry groups—semiconductors, software and services, and hardware and equipment—as discuss each separately.

Semiconductors

Overview Products within the semiconductor industry include integrated circuits, memory chips, microprocessors, transistors, and solar cells. The global market in 2008 was valued at $238 billion and is forecasted to grow to $302 billion by 2013. The industry has experienced a CAGR of 5.2% during the period of 2004-2008. Integrated semiconductors account for 84.4% of the global market share, and Intel has 13.8% of the total global semiconductors market share.

Macroeconomic impact The industry supply chain is heavily dependent on global computer sales, which in turn is effected by the overall macroeconomic outlook. Therefore, the semiconductor industry has a significant positive correlation with worldwide GDP. The recent global recession has had an adverse affect on computer sales and therefore has negatively affected the semiconductor industry as well. For example, Samsung (the 2nd largest semiconductor company in the world) just reported its first ever quarterly loss in Q4 2008. Due to the large fixed capital investments required to build the semiconductor manufacturing facilities and the debt required to finance them, the industry has a strong negative correlation with interest rates. The industry is also

1 http://www.itaa.org/news/docs/industryoverview.pdf 2 Digital Economy 2003, Economics and Statistics Administration, U.S. Department of Commerce

affected heavily by the commodity pricing of silicon, which is used as the semiconductor material for all products within the industry.

Fundamental analysis The semiconductor companies that outsource their manufacturing to third party foundries and concentrate on design have the flexibility to change rapidly as demand for semiconductor equipment changes. On the other hand, semiconductor companies with large manufacturing capacities will be more severely affected by a reduction in demand because of their high inventory levels. The contraction in the global economy will reduce demand for the end products of this sector, and might cause these manufacturing companies to take huge write downs to their inventory levels.

Solar cells require the use of silicon to hold photovoltaic cells that convert sunlight into electricity. The growth of this industry could prove to expand the semiconductor industry and provide manufacturers a diversification strategy from the retail electronics industry. The trend is becoming apparent with acquisitions in the news of late such as National Semiconductor acquiring Act Solar.

In addition to acquisitions, industry consolidation is likely in the near future. Semiconductor stock prices are very cheap right now, and large players might be looking to increase their intellectual property portfolios through acquisitions.

Software & Services Industry The software & services industry group is further divided into the following industries

1. Internet Software and Services 2. IT Services 3. Software

1. Internet software and services The internet is accessible to 1.46 billion people worldwide (21.9% of the world population) at the end of June 20083. The penetration in the richer economies of North America, Oceania and Europe is high, making it an attractive source of revenue, including advertising and sale of products. Internet Software & Services companies reach their customers over the internet, providing services like shopping, search, videos, music etc. Historically, the S&P Internet Software and Services sub-index used to perform better than the S&P 500, though the recent months have wiped out the margin.

3 Internet World Stats - http://www.internetworldstats.com/stats.htm

This industry is correlated to computer sales as well as GDP. There grim outlook on GDP for the next 2 years, as well as computer sales. Therefore, our group has a negative outlook on the near term profitability and growth of this industry. The positive future outlook for this industry is that the Obama administration is making it a priority to increase broadband penetration around the US, since only 56% of US households currently have access to high speed internet. In addition, internet usage around the world is expected to increase in several key markets with Asia representing the largest one. Our group has a positive outlook for this sector in a 5 year time horizon.

2. IT services Companies in the IT Services industry provide consulting services to help develop applications for clients, and also help in business process outsourcing (BPO). The slowdown in the US and worldwide economy is predicted to cause a reduction in demand for IT services. S&P estimates growth in this industry to be 4-8% for early 2009. IT spending will be especially crimped in the financial services industry, causing revenues from consulting services to decrease. However, corporations could turn to outsourcing in order to cut costs, thus benefiting the large outsourcing firms like Infosys, TCS and Wipro. Historically, the S&P IT Services subindex has underperformed the S&P 500.

3. Software The software industry is required to support the storage, management and networking of the global economy. After a growth stage in the 90s, the software industry is in a stable phase now. The software industry performance is closely tracking the S&P 500, except for a brief dip in mid 2006. This is because the software industry is dependent on the growth in the general economy now. Microsoft is the dominant player in this industry, dominating operating systems and office software. Other big players are IBM, Oracle and SAP.

The slowing of the world economy will cause reduction in demand for the software industry services. Financial service companies were one of the major customers, and the effect of the subprime crises will severely affect their plans of buying new software.

Internet Usage

Africa

Asia

Mid-East

Latam

Europe 0.00% 20.00% 40.00% 60.00% 80.00%

Africa

Mid-East

Latam

Aus

Internet Penetration

Technology Hardware & Equipment The Technology Hardware & Equipment industry is a very diverse industry, so an analysis of this industry must be done by further dividing it into sub-industry categories. The main categories are:

1. Communications Equipment 2. Computers and Peripherals

1. Communications equipment Communications Equipment companies are collectively those companies that manufacture the equipment used in computer and telephone networks, which spans the spectrum of national network infrastructure to mobile handsets. Per their August 2008 report, S&P estimates the size of this industry at $300 billion (by annual revenue), with the key drivers of growth being IT spending by businesses and capital expenditures by telecom service companies.

The growth in the $50 billion wireless infrastructure industry is being spurred by the expansion of 3G networks globally. The handset market, which is already the largest consumer electronics market in the world by units sold, is being driven by demand from emerging countries with low mobile phone penetration rates (40% in China and 20% in India vs. 80% in Japan and the US and 120% in Germany). In developed countries, the growth in the handset market is being driven by so-called smart-phones.

Fundamental analysis 1) Convergence. VOIP (Voice-Over-Internet Protocol), video being streamed to phones, and internet being accessed through TV, are all striking examples of convergence in communications. As a result, telecom companies are now competing with cable companies, and as a consequence, voice networking companies (like Alcatel-Lucent) must now compete with data networking companies (like Cisco). For the sector in general though, there is a lot of growth expected due to this phenomenon.

2) Video. The explosive increase in consumer demand for video, which is very bandwidth-intensive, will require service providers to upgrade their networks.

3) Technological Advances in Wireless Equipment. The current global 3G build-out, led by Europe and China, will require major wireless equipment spending, and beyond this 4G is already in the works.

The industry requires large capital expenditures and investments in research and development as well as infrastructure projects. In a recession, telecom companies are less likely to invest in these projects, which will have a significant negative impact on the hardware and equipment sector of the IT industry. Due to the current trend of cutting R&D expenditures as well as a lack of credit to fund large infrastructure investments, our group has a negative outlook on this sector for the near future.

2. Computers & peripherals It was estimated by S&P that this sub-industry accounts for about 39% of all global IT spending. This segment is most suitably categorized into 1) computer hardware and 2) computer peripherals. The $270 billion computer hardware market encompasses PCs (80% of the market) and servers (20%, of which the low-end “volume servers” account for 55% and the mid to high-end servers constitute 45% of sales).

As seen in companies such as HP, Apple, and Sony Corp, the trend in the computer hardware sector is to outsource their assembly operations and focus on design and development. This allows companies to be more flexible, and not have large PP&E investments and large depreciation expense line items associated with them. In the current economic environment, the companies that are more flexible and do not have a manufacturing presence will have lower risk of bankruptcy as well as be less affected by the decrease in demand. This is because they have less overhead costs to run operations, and can quickly ramp down their R&D to respond to the decrease in demand.

Fundamental analysis 1) Consolidation: Companies want to provide both hardware and software to reduce operating expenses through economies of scale and to be a one-stop-shop for the computer networking hardware demanded by businesses

2) PCs are becoming more like commodities because you have Microsoft OS’s in 80-90% and Intel semiconductors in 80% of all PCs, making products very similar and thereby inducing strong pricing pressure. One move by vendors is to add on peripherals, software, and warranties as extra sources of profits.

3) Long-term international growth due to low penetration rate

4) Customer demand for energy efficiency requires more efficient and compact storage equipment

5) Portable electronics like cell phones, portable GPS, and MP3 players will spur an increase in the demand for flash storage

6) Consolidation to gain economies of scale and to gain access to new technology

Heading into Q2 2009, Quarter over Quarter growth will be down due to traditional re-stocking of inventory levels in Q1 which follows the traditional seasonality of sales. Forecasts say that year over year sales could be down in Q2 as shipments start tracking end demand, which is weaker than last year.4

4 http://www.itaa.org/news/docs/industryoverview.pdf v Digital Economy 2003, Economics and Statistics Administration, U.S. Department of Commerce vi Factset vii Global Semiconductors Research Report, Data Monitor, December 2008 viii Semiconductors Industry Analysis, StandardandPoor’s NetAdvantage, November 13, 2008 ix Internet World Stats - http://www.internetworldstats.com/stats.htm x Yahoo Finance and Global Financial Data

Sector Alpha

Sector Alpha

P/E Required Growth to

return to normal level (4 year Horizon)

Annualized Growth

Sector Alpha

Avg. P/E (IT) 22.98 40.36% 8.85%

-1.36% Current P/E (IT) 16.37 Avg. P/E (S&P 1500) 16.67

47.53% 10.21% Current P/E (S&P 1500) 11.30

We derived our sector alpha by comparing the 5-year average P/E ratio of the IT sector to the S&P 1500. The IT sector would need annualized growth of 8.85% over 4 years to move from the current P/E to the average P/E which we considered the normal level. We chose a 4 year time horizon for this to occur based on what we know to be the consensus expectations of market forecasters and because we believe that bull markets typically last 4-5 times as long as the bear markets they follow. Based on this qualitative approximation, our sector’s alpha is currently negative 1.36%.

Quant Screening

Specifying the universe It was decided that the industries within the IT sector are not disparate enough to warrant differing quantitative screening criteria. So the designated universe in our testing was the IT sector (as defined by the S&P GICS definition) subject to the following stipulations in order to conform to the UMBS fund guidelines:

1. US listed equities. We did not consider ADRs in order to reduce the currency risk of the UMBS fund.

2. Market capitalization of between $50 million and $5 billion. The lower limit is specifically stated in the fund requirements. The upper limit was determined by us in order to limit large cap stocks that are subject to a lot of analysis, and thus are possibly priced fairly or overpriced. Note that the S&P Midcap constituents are required to have a market cap of between $750 million and $3.3 billion.

Our Screening Parameters We used value, momentum, quality and smart money criteria in order to come up with our screen. The final screen used is similar to the one we designed for the universal screening assignment, with some refinements. Some of these factors are relevant to many other sectors, but this short list in conjunction with the distribution of weights across the list reflects what we believe are the most important “quick” quantitative metrics in assessing mid-cap IT sector companies. Table 1 shows the parameters used and the relevant weights or constraints.

Parameter Type Target/Constraint Weighting 1 % (∆Price) / % ABS(∆Sector Price) Momentum Higher is better 1.00 2 3-year average P/S Value Lower is better 1.00 3 P/B Value Lower is better 1.00 4 Institutional Ownership of Outstanding Shares Smart Money ≤ 80% - 5 Insider Ownership of Outstanding Shares Smart Money ≥ 10% - 6 Total Debt % of Total Equity Quality Lower is better 1.00 7 Free Cash Flow (FCF) to Price Quality Higher is better 1.00 8 FCF Latest Quality ≥ $20 million 0.50 9 FCF 1 Year Ago Quality ≥ $20 million 0.35 10 FCF 2 Years Ago Quality ≥ $20 million 0.15

Table 1: Screening Parameters

We briefly discuss the reasons for choosing these criteria and constraints below.

Momentum % (∆Price) / % ABS(∆Sector Price): This measures relative strength of the stock to the sector performance. Since sector performance could be negative, the absolute value of the percentage movement in the sector needs to be considered. We used this factor because James O'Shaughnessey discovered that stocks with high relative strength tend to gain even more value over the benchmark. In our screen, we considered the 6 month change in prices.

Value 3-year avg. Price/Sales: A low 3-year average price-to-sales ratio is an indication of value in our opinion. Sales indicate the demand for the goods and are a primary driver of the growth of a business over the long-term. Compared to P/E, this metric also has the advantage that it is difficult for companies to manipulate their sales numbers in their GAAP statements. We used 3 year average rather than latest because we believe the company needs to show consistent strength rather than being a flash in the pan.

Price/Book Value: The price-to-book value ratio may at first not seem very meaningful given that, per current GAAP, internally developed intangible assets cannot be included on the balance sheet (only intangible assets acquired in a merger or acquisition may be valued on the balance sheet), and a disproportionate amount of the value of an IT company comes from intangible assets (price-to-book ratios have historically been very high for IT companies). So while we agree that on a stand-alone basis this ratio is not a good gauge of potential value, in a comparative analysis we believe it serves as a very useful balance sheet-based metric.

Smart Money Institutional Ownership: Institutions are able to employ several analysts, and when they hold a large position in a stock, it is likely to be already fairly priced. Our screen looks for shares where institutions hold less than 80% of the float. Though this is on the higher side, tightening the limit causes most stocks to fall out of our screen.

Insider Ownership: Companies where management or the board of directors hold a large percentage of stock is incentivized to do the best for their company. Therefore we only consider companies where insiders hold at least 10% of the outstanding shares.

Quality All the above criteria are important, but we feel the intrinsic quality of a stock is the most important factor in evaluating the stock as an investment opportunity. Consequently, quality parameters have the highest weight in our screen.

Total Debt % of Total Equity: Debt-to-equity must be low for any IT company, not only in the current tight-credit environment but in general, as companies in this sector must have the ability to adapt to the ever-changing IT landscape and have a clean balance sheet to finance acquisitions quickly. Low debt also reduces the change of failing to meet interest payments and seeking bankruptcy protection in today’s environment

FCF to Price: We prefer a FCF-to-price comparison over one between earnings and price (such as P/E) because FCF is less subject to manipulation and time-smoothing. High FCF is also desired in cases where the company is unable to obtain short term financing and has to rely on its own balance sheet to meet debt obligations.

FCF Latest, FCF 1 and 2 years ago: This constraint was imposed in order to weed out younger companies or companies that only recently stopped burning cash. We feel that these criteria will bring up stocks where business has been well established and management has shown the ability to generate earnings without relying on leverage or equity infusions.

Screen Results Table 2 shows the 9 best stocks picked up by our quant screen. Table 3 lists the features of the various stocks. Note that TLAB has negative relative strength because its stock price has actually risen in the past 6 months, as compared to a drop of 16.74% in the technology SPDR. We analyzed these stocks further on a qualitative basis in order to pick the best stock among the 9 below. After our qualitative analysis, we believe Hittite Microwave Corp. (HITT) is the best positioned for growth in the Information Technology sector.

Ticker Company Name Industry Market Cap ($m)

TLAB Tellabs Inc. Technology Hardware & Equipment 1,752.8 MANT ManTech International Corp. Software & Services 1,430.6 MOLX Molex Inc. Technology Hardware & Equipment 2,425.2 MCRL Micrel Inc. Semiconductors 484.6 HITT Hittite Microwave Corp. Semiconductors 935.1 NATI National Instruments Corp. Software & Services 1,486.7 HEW Hewitt Associates Inc. Software & Services 2,701.8 SRX SRA International Inc. Software & Services 808.6 ADVS Advent Software Inc. Software & Services 871.9

Table 2: Top 9 stocks from our screen

Ticker Relative Strength

P/S P/B Debt % Equity

Institution %

Insider %

FCF/ Price

FCF Latest

FCF (-1)

FCF (-2)

TLAB -0.5 1.6 0.9 9.7 75.9 10.2 0.2 80.7 73.7 250.6 MANT 1.0 1.0 2.8 6.5 59.4 40.2 0.1 122.2 60.6 79.2 MOLX 1.3 1.5 1.0 8.0 76.1 24.1 0.1 103.1 99.4 132.2 MCRL 0.6 2.6 2.4 0.0 69.3 44.0 0.1 32.7 40.6 42.2 HITT 0.2 7.2 3.8 0.0 72.1 28.7 0.1 54.7 44.4 33.5 NATI 1.3 3.1 2.8 0.0 64.6 26.7 0.0 61.3 95.5 60.4 HEW 0.8 1.1 4.1 123.2 77.1 10.9 0.0 249.7 346.8 251.1 SRX 1.2 1.1 1.4 21.8 75.0 26.5 -0.1 57.6 109.8 71.2 ADVS 0.3 5.8 8.0 0.0 61.0 37.6 0.0 53.8 27.6 30.3

Table 3: Stock features

Qualitative Analysis

Tellabs Inc. (TLAB)

Summary Tellabs, Inc. is engaged in designing and marketing equipment and services to communications customers worldwide. The Company’s products and services enable its customers to deliver wireline and wireless voice, data and video services to business and residential customers. It sells its products domestically and internationally through its field sales force and distributors/partners.

Key Facts: Closing Price (as of Mar 27 2009) $4.76 52 week range $6.32 - $3.10 1 year performance -11.36% Market Cap $1.88 billion P/E Ratio N/A Forward P/E (1 year) 23.8 EPS -2.33

Key Ratios

Q1 (Jan '09) Annual (2009)

Annual (TTM)

Net profit margin 3.13% -53.79% -53.79% Operating margin 1.57% -56.10% -56.10% EBITD margin - -51.05% -51.05% Return on average assets 2.03% -29.74% -29.74% Return on average equity 2.78% -39.08% -39.08%

Why the stock was rejected Declining Performance: Company revenues have been slowly declining since 2006 and cash flows have decreased as well. This is especially bad compared to our pick, HITT. Note that they did take a goodwill impairment charge of 1b which makes their numbers look especially bad, but that is a one-off charge.

ManTech International Corporation (MANT)

Summary ManTech International Corporation is a provider of technologies and solutions for mission-critical national security programs for the Intelligence Community; the Departments of Defense, state, homeland security and justice; the Space Community and other United States federal government customers. The Company’s capabilities include systems engineering and integration; software services; enterprise architecture; information operations and computer forensics; information assurance and security architecture; intelligence operations and analysis support; cyber security; network and critical infrastructure protection; information technology; communications integration and engineering support; global logistics, and supply chain management.

Key Facts Closing Price (as of Mar 27 2009) $42.66 52 wk range $62.06 – $37.07 1 year performance -6.7% Market Cap $1.51 billion P/E Ratio 16.75 Forward P/E (1 year) 12.84 EPS 2.55

Key Ratios

Q4 (Dec '08) Annual (2008)

Annual (TTM)

Net profit margin 4.97% 4.83% 4.83% Operating margin 8.36% 8.20% 8.20% EBITD margin - 9.10% 9.10% Return on average assets

10.00% 9.22% 9.22%

Return on average equity

14.84% 14.66% 14.66%

Why the stock was rejected Lack of diversification: MANT has only 1 customer – the US government. Though having only the US government as a business counterpart does reduce MANTs credit risk, it runs the risk of falling foul of any policy decision and losing its business. In light of the recent increase in government spending on bailout programs and the stimulus package, there is a chance of cuts in the defense budget in order to reduce government debt. This action would severely affect MANT.

Personnel and Corporate Governance: Among other factors, the President and COO of the company resigned recently, and he was considered instrumental to the company’s growth. Another grave risk is that a single person, George Pedersen controls 88% of the voting power due to his hold of special shares. He could thus prevent any action that is not personally aligned with his interest.

Molex Incorporated (MOLX)

Summary Molex Incorporated (Molex) is a manufacturer of electronic components. The Company’s core business is the manufacture and sale of electronic components. Molex’s products are used by a number of original equipment manufacturers (OEMs) throughout the world. It designs, manufactures and sells more than 100,000 products, including terminals, connectors, planar cables, cable assemblies, interconnection systems, backplanes, integrated products and mechanical and electronic switches. It also provides manufacturing services to integrate specific components into a customer’s product. The Company’s connectors, interconnecting devices and assemblies are used principally in the telecommunications, data, consumer products, automotive and industrial markets.

Key Facts Closing Price (as of Mar 27 2009) $14.17 52 wk range $30.61-$9.68 1 year performance -38.1% Market Cap $2.45 billion P/E Ratio 43.85 Forward P/E (1 year) 28.34 EPS 0.34

Key Ratios

Q4 (Dec '08) Annual (2008)

Annual (TTM)

Net profit margin -13.09% 6.47% 1.87% Operating margin -15.22% 9.55% 3.90% EBITD margin - 17.13% 11.94% Return on average assets

-10.16% 6.23% 1.77%


-14.00% 8.29% 2.40%

Why the stock was rejected Weak Outlook and high fixed costs: Molex’s core competency is manufacturing and therefore has lots of inventory on hand. Therefore, they are very susceptible to potential inventory write downs due to obsolescence and stagnant demand for their products. With 45 manufacturing plants and 32,000+ employees, Molex is not flexible and will be sitting on large depreciation expenses, overhead costs, and potential inventory write downs during the global economic contraction.

Micrel, Incorporated (MCRL)

Summary Micrel, Incorporated (Micrel) designs, develops, manufactures and markets a range of high-performance analog power integrated circuits (ICs), mixed-signal and digital ICs. Micrel ships over 3,000 standard products and sells standard analog and high speed communications ICs. The Company’s products address a range of end markets, including cellular handsets, portable computing, enterprise and home networking, wide area and metropolitan area networks, digital televisions and industrial equipment. The Company also manufactures custom analog and mixed-signal circuits and provides wafer foundry services, such as silicon wafer fabrication, IC assembly and testing, for customers who produce electronic systems for communications, consumer and military applications.

Key Facts Closing Price (as of Mar 27 2009) $7.36 52 wk range $10.77-$5.78 1 year performance -17.67% Market Cap $481.14 million P/E Ratio 18.63 Forward P/E (1 year) 21.03 EPS 0.40

Key Ratios

Q4 (Dec '08) Annual (2008)

Annual (TTM)

Net profit margin 8.87% 10.89% 10.89% Operating margin 10.44% 15.56% 15.56% EBITD margin - 22.96% 22.96% Return on average assets

7.27% 10.17% 10.17%


9.04% 12.68% 12.68%

Why the stock was rejected Revised downward guidance: Micrel projects fourth quarter revenues will be down approximately 18% to 20%, compared with the previous guidance issued on October 27, 2008 of down 7% to 13%. Fourth quarter earnings per diluted share are expected to be approximately $0.06 to $0.08, compared with the previous guidance issued on October 27, 2008 of $0.08 to $0.11. In an effort to control expenses and protect Micrel's earnings, the company has instituted a companywide 6% reduction in workforce. Also, Micrel manufactures all of their products in-house, and therefore has high plant and equipment on the balance sheet and also high inventory levels.

Exchange Rate Exposure: Micrel does not currently have a hedge against their exchange rate exposure, and most of their sales are exported outside of the U.S. Therefore, if the U.S. dollar strengthens, the prices of their products denoted in foreign currencies would rise and make them less competitive with local goods.

National Instruments Corp (NATI)

Summary National Instruments Corporation is a supplier of measurement and automation products that engineers and scientists use in a range of industries. The Company provides flexible application software, and modular, multi-function hardware that users combine with computers, networks and third-party devices to create measurement, automation and embedded systems. The Company's application software products include LabVIEW, LabVIEW Real-Time, LabVIEW FPGA, Measurement Studio, LabWindows/CVI, DIAdem, TestStand and Multisim.


Key Ratios

Q4 (Dec '08) Annual (2008)

Annual (TTM)

Net profit margin 9.56% 10.34% 10.34% Operating margin 10.82% 11.67% 11.67% EBITD margin - 16.19% 14.21% Return on average assets 9.14% 10.27% 10.27% Return on average equity 11.46% 12.80% 12.80%

Why the stock was rejected There are many positive factors for the company, its relative growth is better than peers, it is cutting operating expenditure. Government, communications and education sectors are providing are partially offsetting lack of business.

Lack of Alpha: We believe the stock is currently trading at a fair value level. The Mean Target is $18.67, and Median is $17.50 as per Yahoo Finance, while the stock is trading at $19.14.

Lack of Guidance: The company also does not provide EPS guidance, which we believe to be management’s lack of confidence in their business.

Hewitt Associates, Inc. (HEW)

Summary Hewitt Associates, Inc. (Hewitt) is a global provider of human resource benefits, outsourcing and consulting services. The Company operates in three business segments: Benefits Outsourcing, Human Resource Business Process Outsourcing (HR BPO) and Consulting. Through these segments it helps clients develop, implement and deliver strategies and programs for human resources business process design, administration and technologies, as well as manage the human elements necessary to acquire, develop, motivate and retain the talent required to meet business objectives.


Key Ratios

Q4 (Dec '08) Annual (2008)

Annual (TTM)


Why the stock was rejected High unemployment: Profit forecast was raised to $2.55 from 2.45 for year, but revenues are falling due to currency volatility. As unemployment rates and economic woes continue to rise, the human-resources industry has been benefiting as corporations seek their consulting and staffing services to weather the economic environment. Still, if unemployment rises for a prolonged period, benefits outsourcing operations could be hurt. Income rose due to lower tax rate, but profits dropped 15% at the benefits-outsourcing business amid a 3% revenue drop and lower margins caused by higher compensation costs. A single line of business, benefits outsourcing, makes up half of Hewitt's revenue therefore there is a lack of diversification in the business.

SRA International, Inc. (SRX)

Summary SRA International, Inc. (SRA) is a provider of technology and consulting services and solutions to clients in national security, civil government, and global health. The Company’s business incorporates a combination of services and products focused on delivering results for the clients. The Company offers a range of technology and strategic consulting services spanning the information technology life cycle, including strategic consulting, systems design, development and integration, and outsourcing and managed services.

Key Facts Closing Price (as of Mar 27 2009) $14.98 52 wk range $27.27-$11.22 1 year performance -39.16% Market Cap $842 million P/E Ratio 13.91 Forward P/E (1 year) 22.63 EPS 1.08

Key Ratios

Q4 (Dec '08) Annual (2008)

Annual (TTM)


Why the stock was rejected Lowered Outlook: The company reported second-quarter earnings that were below Wall Street estimates and lowered its outlook for 2009. The technology and consulting services company reported quarterly earnings of 19 cents a share, below analysts' expectations of 26 cents a share, and cut its 2009 earnings view to 94 cents to $1.00 per share from $1.12 to $1.22 a share.

Management changes: CFO and Executive VP, Steve Hughes recently retired, and the interim CFO was assigned as permanent CFO.

Advent Software (ADVS)

Summary Advent Software, Inc. offers software and services that automate work flows and data across investment management organizations, as well as the information flows between an investment management organization and external parties. The Company’s business is organized into two reportable segments, Advent Investment Management (AIM) and MicroEdge. AIM is its core business, and derives revenues from the development, marketing and sale of software products, data interfaces and related maintenance and services that automate, integrate and support certain mission-critical functions of investment management organizations primarily in the United States, Europe, Middle East and Africa. MicroEdge derives revenues from the sale of software and services for grant management, matching gifts and volunteer tracking for the grantmaking community primarily in the United States and United Kingdom.

Key Facts Closing Price (as of Mar 27 2009) $33.15 52 wk range $49.32-$17.51 1 year performance -26.26% Market Cap $803 million P/E Ratio 46.76 Forward P/E (1 year) 24.95 EPS 0.68

Key Ratios

Q4 (Dec '08) Annual (2008)

Annual (TTM)


Why the stock was rejected The stock looks overpriced with a P/E of 46.75 and P/S of 3.15. Current Liabilities of $181m is higher than current assets worth $131.29m.

eVal Valuation of Hittite We used eVal3 to evaluate HITT using a terminal (the terminal year being year 10) sales growth rate of 4% and cost of capital as 8%. We estimated terminal year ROE as the historical 5-year average semi-annual ROE for the semiconductor industry (with the industry classification according to GICS). We used the 5-year historical average to exclude the dot-com bubble and crash. We did not use a very long-term average that encompassed data prior to the dot-com bubble because the semiconductor industry today is intrinsically altogether different than it was prior to the bubble. Using the above parameters gives us an estimated price of $37.17, 19.29% higher than the 3/27/09 price of $31.16.

Sensitivity Analysis Using eVal, we produces the following sensitivity reports.

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Information Ratio & Stock Alpha The following is the risk decomposition of HITT outputted by Barra using the MidCap 400 as our benchmark:

Our valuation of the stock price is $37, however given our outlook on when market conditions will recover; we project a one-year price target of $35 based on an expectation that the $37 target is attainable in an 18-month period. This equates to an approximately 13% return for the year. Based on our estimation of the S&P’s growth rate for the year, our stock’s alpha comes out to be about 3% for the year. Correspondingly, our information ratio for HITT based on our expected return over the S&P benchmark is 0.06.

Detailed Analysis of Hittite Microwave Corporation

Description of the Business Hittite (founded 1985; IPO in July 2005; NASDAQ: HITT; employees: 332) is an engineering company that designs and develops integrated circuits (ICs), modules, and subsystems for OEMs (original equipment manufacturers) that produce advanced electronic systems that employ radio frequency, microwave, and millimeter wave technology. These electronic systems, which include applications from cellular phones to military radar, operate at different frequencies and require ICs that are optimized for these frequencies. Hittite makes ICs and their associated modules and subsystems for systems that operate in the 1MHz to 110GHz electromagnetic frequency range.

One reason that different systems employ different frequencies, aside of course from considerations for what these systems are used for, is that they have to; governments stipulate which services may use which frequency bands. In the cell phone segment, available frequency bands have become congested, and so providers of systems in this segment continue to develop more complex communications technologies that use existing bandwidth more effectively. This in turn requires more sophisticated ICs.

Here is how the company defines the 3 frequency bands it specializes in:

Band Frequency Range Examples of services that use this band Radio Frequency (RF) 1MHz – 6GHz Broadband, cell phones, GPS Microwave 6GHz – 20GHz Satellite TV, military electronic countermeasure Millimeter wave 20GHz – 110GHz Satellite communications, radar systems

Hittite supplies its products to customers in 8 different end markets; these markets as well as our outlook (scale: negative, neutral, positive) for each and supporting bullet points is shown in Table 4.

In 2008, the first 3 markets counted for 82% of the company’s revenue, and the broadband market was the only market not to see a growth in sales. 40% of its revenues came from the US, and 60% from abroad (Europe and Asia), and 18% from China specifically.

The sources of the company’s revenues with respect to market segment is by Hittite’s own admission very difficult to predict since it depends on turns business (orders that are booked and shipped out in the same quarter; vis-à-vis contractual orders) for most of its revenue. It is notable that in its military segment, which provided 20-25% of its 2008 revenues, and its space segment, orders are largely contractual and that its customers do provide the company with estimates of future demand. It is easier

to pin down a revenue profile by geography though, and we expect that the majority of revenues will continue to be sourced from abroad, particularly from Asia.

End Market End Products Outlook Comments 1 Cellular

Infrastructure Base stations & repeaters, GPS, handsets

Neutral • In the US & Europe cell-phones are necessities and therefore recession resistant; Asia will be the source of growth going forward, especially with China’s 3G rollout

2 Microwave & Millimeter Wave Communication

Radio systems, VSATs, short-range LANs

Negative • No expansion expected amongst retailers (who use VSATs) and businesses (who use LANs)

• Excess inventory levels 3 Military Communications, radar,

guidance, countermeasure, sensing and detection

Positive • US military will continue to be actively engaged for several years

• Spending on these end products is expected to be robust

4 Automotive GPS, collision avoidance, blind spot detection, intelligent cruise control

Positive • Though auto sales are down in many markets, onboard communications equipment in cars is fast-becoming the demanded norm

5 Broadband Cable TV, cable modems, sat. TV, wireless networks

Neutral • Service provider spending on equipment goes the way of GDP

• This may be offset by the sizable spending on broadband and wireless infrastructure by the US and Chinese governments

6 Fiber Optic Infrastructure, test equipment, data processing

Positive • We see fiber optic infrastructure as a growth area

• Sizable spending on communications infrastructure by the US and Chinese governments

• Currently Hittite’s smallest business but fastest growing

7 Space Imaging, command/ control/and communications for all types of spacecraft

Positive • Hittite is looking to expand its presence by vertically integrating in this area

• Company does not see excess inventory in this space

8 Test & Measurement

Medical and industrial imaging, homeland security, telecom test equipment, scientific and industrial equipment

Negative • Company sees excess inventory in this market • Less capex due to recession • However company plans to vertically integrate

in this area to take market share and increase margins

Table 4: Hittite Outlook

Stock metrics as of 3/27/09 and other Selected 2008 Annual Financial Data

Market Cap 935M 3-month Avg. Traded Daily Volume 260,000 Price 31.16 % Bid-Ask Spread 5.8% P/E (ttm) 17.92 Revenue 183M Net Income 54M ROE 23% ROA 21%

Notable items from 2008 earnings call (held 2/19/09) • 2009 Guidance: Q1 revenues expected to be down 18% on a sequential basis based on a sharp

reduction in order volumes in every single market in the month of January.

• Won $35M, 2-year US military contract with a potential for continuance. Though this contract can be terminated by the government at its convenience (this is usually the case with the contracts with the government), it is seen as low-risk because it is for a program in production.

• Book-to-bill ratio (# of orders in the book vs # of orders filled) at 1.02 (a number over 1 is good).

• Company looking to cut sales and marketing spending by half, but is committed to continue spending on R&D.

• Bookings were highest in Q3’08, and the same in all other quarters, however, the company notes a slowdown in bookings in January ’09. This may signal that the company has begun to feel the effects of the global recession.

Positives about the Stock 1. Company’s business expertise in specialized markets

Hittite operates in the high-end, hi-tech IC space with decades experience behind it and this is a factor that allows it to sustain high margins (its 2008 gross margin was 72% and its operating margin was 45%).

2. High barriers to entry

In general, ICs are very complex and require a great deal of scientific expertise, R&D and capital expenditure, and design experience. But for IC-makers who are already established, there are varying degrees of complexity within the IC space. The digital chips in computers for example are categorized as having low complexity and are in fact like commodities; they are almost completely price-driven. Hittite, however, makes analog and mixed-signal (combination of analog and digital) ICs that are inherently more complex. Unlike in the case of digital ICs, analog and mixed-signal ICs require knowledge of complex electromagnetic theory and an understanding of how external factors such as temperature and the interaction between elements in the circuit affect the functioning of the IC.

Add to this the demand from OEMs for smaller, more integrated circuitry which requires the IC-maker to have a firm understanding of the OEM’s product and the expertise to meld ICs into multi-chip modules and multi-chip modules into subsystems.

The many years of study, research, and experience required to compete in this end of the IC segment is a very high barrier to entry and a very significant advantage for Hittite. 3. Momentum in financial performance

The company posted a 34% annual compounded revenue growth rate over the past 5 years and a 49% annual compounded NI growth rate over the past 5 years. Though we believe that Hittite will feel the effects of the global recession throughout 2009, it is notable that in 2008 revenue grew by 15% and NI by 5%.

4. Stock price resilience

The stock price has held up very nicely compared to its competitors and the market over the past year.

Figure 1: Price comparison with competitors

Figure 2: Comparison to Benchmarks

5. Diverse product portfolio with a history and expressed business plan of continually introducing new products

In 2008 it launched 4 new product lines and 3 new product lines in each of 2007 and 2006. One of its stated goals is to diversify its end markets which will help make it more resilient in business down-cycles.

6. Fabless Operation

Hittite, unlike many other IC companies, does not own any foundries (IC manufacturing facilities) and instead outsources the manufacturing to a number of different foundries around the world. This in our opinion is an enormous competitive advantage as it eliminates the need to spend capital to execute the manufacturing of new IC designs and allows the company to roll out new products and expand into new markets quickly.

7. Very liquid & virtually no LT debt

The company had approximately $180M in cash at the end of 2008, spelling a current ratio of 17.5 and current assets to total assets ratio of 90%. Long-term debt as a percentage of total assets stood at 2% at the end of 2008. Liquidity and balance sheet health are extremely important for IT companies in order for them to be able to operate in harsh business climates such as the current one and to quickly finance acquisitions as opportunities are identified.

8. Does not have any goodwill on its books so currently no risk of goodwill write-downs

Goodwill write-downs are hard to estimate and they often constitute negative surprises in our opinion.

9. Solid R&D expenditure recently and expected going forward

Despite the recession around it, the company spent 32% more on R&D in 2008 than the year ago, which equates to 14% of its revenue. We like IT companies with a commitment to high R&D spending as this is likely to keep them at the forefront of tech innovation.

Negatives about the Stock 1. Global recession may take its toll in the near term

The semiconductor industry is particularly cyclical and sensitive to GDP. Despite the breadth of its product portfolio and international operations, it cannot escape the effects of a global recession. Though we are confident in Hittites growth prospects in the long term, a worsening recession would surely make the stock miss our one year price target.

2. Hittite’s success hinges on consistent innovation

Like most companies in the IT space, its growth depends on how effective it is in translating R&D expenses into high margin profits. Technological innovation in the semiconductor space is particularly rapid and keeping up with it, and hopefully leading it, requires Hittite to execute on a consistent basis, which is certainly not easy.

3. Concentration in the customer base

There were 3,000 different customers served in 2008 but historically Hittite has depended on a small number of customers for a large percentage of its revenue. Its 10 largest customers accounted for 34.6% of its revenue in 2008, 38.8% in 2007, and 42.7% in 2006 (with no single customer exceeding 10%). Although the composition of the 10 customers changes every year, a shortfall in large customers could materially reduce its revenue.

4. Stock price volatility

Figure 3: 1 year implied volatility for HITT vs. S&P 500

As can be seen from the above chart, Hittite has on balance been more volatile than the market index over the past year.

Neutral Comments about the Stock 1. Currency Exposure: Though much of its revenue is derived from abroad, the majority Hittite’s international contracts are denominated in USD, as are the majority of the international purchases it makes, so foreign currency exposure is very limited.

2. Interest rate risk: This is negligible since it does not rely on debt and so its exposure is limited to the interest it earns on its cash and cash equivalent holdings (bank deposits, money market funds, highly rated short term government and corporate paper).

3. Institutional ownership at 70%: Though this number is a little high in absolute terms, we found that many US IT sector stocks had high institutional ownership. The 70% is comprised of about 130 different institutions with the top 10 holders owning about 35% of the common, which is a broad dispersion in our opinion, although there is certainly price risk that comes with institutions selling in a coordinated fashion. On the flip-side, high ownership signals so-called “smart money” interest in the stock.

4. Primary insider has been selling: Yalcin Ayasli is the sole founder of Hittite. He has not been involved with the company since 2006 after retiring from the board, but he remains the largest shareholder in the company (just under 30%, slightly below his ownership more than a year ago at the end of 2007). He has been selling stock on a consistent basis but we do not at all view this as a negative indicator—he is no longer actively associated with the company and being in his mid-60s, we believe that he is simply seeking income generation. In addition, we note no other meaningful insider selling.

Stock Views on Balance On balance we recommend the stock. Our valuation of the price is $37, however given our outlook on when market conditions will recover; we project a one-year price target of $35 based on an expectation that the $37 target is attainable in an 18-month period. The company has a very solid balance sheet and outstanding growth till date. We believe that the sum total of its performance across its relatively diverse market-segments will continue to be impressive on a relative basis, and that its long-term growth prospects are very good given its inclination for heavy R&D spending, its business model that focuses on its core competency of development whilst outsourcing manufacturing, its leading-edge expertise, and its agenda of aggressively moving into new market segments and developing new product lines.

The primary catalyst for significant price appreciation in the stock is obviously the recovery in the broad, global economy. How this will be signaled is difficult to say, but two successive positive US quarterly GDP numbers (or even one!) may do the trick. A secondary catalyst might be the crystallization of a clearer and more positive picture of how the US and Chinese governments’ expenditures on telecom will filter down to Hittite in particular. Lastly, if Hittite is able to secure a sizable amount of future revenue through low-risk US military contracts, whilst keeping the sum-total of revenues from its other markets strong, this would probably be a positive surprise for the stock.

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