Unless you have been on another planet, you know that the huge growth of the cloud and cloud computing has put a new charge under the semiconductor sector. And it is a sector that was sorely in need of a boost, as the huge drop in personal computer sales, combined with a maturing smartphone market, had slowed things considerably. One thing is for sure, the demands being generated by strong data center growth certainly will be a tailwind for some top companies.

In a new research report, analysts from Merrill Lynch remain positive on large cap chip names, but three small cap and midcap companies look especially promising to them now. In fact, they note that the sluggish enterprise spending, combined with overall market volatility, has created enhanced opportunity for smaller companies that are tied to data center growth.

Three top picks have emerged and all are rated Buy. The Merrill Lynch team cite as much as 23% upside potential, five to six times faster growth, and a small 7% premium as reasons to own these companies now.

Integrated Device Technology

This top company has traded sideways for almost three months and it looks to be ready to make a move higher. Integrated Device Technology Inc. (NASDAQ: IDTI) develops system-level solutions that optimize its customers’ applications. IDT’s market-leading products in radio frequency (RF), timing, wireless power transfer, serial switching, interfaces and sensing solutions are among the company’s broad array of complete mixed-signal solutions for the communications, computing, consumer, automotive and industrial segments.

The company just recently was upgraded by the analysts at Merrill Lynch to Buy. The main reason for the upgrade is that they feel sales of semiconductors to data centers will “show upside” in the second half of the current fiscal year 2017. In addition, company management is targeting a long-term goal of producing “30 percent annual free cash flow” margins on its revenue. At its current revenue run-rate of $666 million, that works out to $200 million in annual free cash flow, which would be enough to drop its price-to-free-cash-flow ratio to less than 15. That is low for a company growing at 19%.

The Merrill Lynch price target for the stock is $26, and the Thomson/First Call consensus price target is posted at $27.89. The stock closed Wednesday at $21.29 per share.

Inphi

This is another company that is a strong contender in the data center arena. Inphi Corp. (NYSE: IPHI) provides high-speed analog and mixed signal semiconductor solutions for the communications, data center and computing markets worldwide. The company’s end-to-end data transport platform delivers high signal integrity at leading-edge data speeds, addressing performance and bandwidth bottlenecks in networks, from fiber to memory. Inphi’s solutions minimize latency in computing environments and enable the roll-out of next-generation communications infrastructure.

Many on Wall Street feel that the battle for dominance in outsourced cloud services between Amazon, Google, Microsoft and others should continue to drive growth in data center capital expenditures. The analysts believe that cloud data center customers are more likely to embrace Inphi’s exciting 100G products like the PAM-4 solutions, ColorZ and others. The company reported solid first-quarter earnings, and it had positive guidance for the current quarter.

Merrill Lynch has placed a $37 price target on the stock, while the consensus price target is set at $38.57. Inphi shares closed most recently at $28.83.

M/A-Com Technology

This is a company that has been the subject of takeover chatter over the past year. M/A-Com Technology Holdings Corp. (NASDAQ: MTSI) supplies key enabling technologies for the cloud-connected apps economy and modern networked battlefield. Recognized for its broad catalog portfolio of technologies and products, MACOM provides high-performance analog RF, microwave, millimeter wave and photonic semiconductor products for diverse applications ranging from high-speed optical, satellite, wired and wireless networks to military and civil radar systems.

The company posted solid quarterly numbers that beat estimates and it raising forward guidance. The Merrill Lynch team cites the continued strength and product ramp-ups in the networking business, and they feel that the longer term upside comes from 100G data center optical. However, the analysts do point to the higher debt leverage and lumpy aerospace and defense business as risk factors.

The $47 Merrill Lynch price target is a bit lower than the consensus price objective, which is set at $48.82. The stock closed the day on Wednesday at $36.25 per share.

Three outstanding small cap and midcap stocks with tremendous upside potential for patient investors. These are best suited for accounts that are coded as aggressive growth, as they are subject to the potential for larger volatility price move.

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