Microchip Technologies: Great Results Point To Further 20% Upside - Seeking Alpha

In general, semiconductor stocks have had a great year, likely playing a bit of follow the leader given the rally that technology companies have had. Anything that supplies or sells to the electronics/technology industry is certainly in favor, and for investors that are a little late to the party it can be daunting to pull the trigger. It's only natural to feel like it's too late, but there are still a few pockets of value to be found. Despite record results, market share gains, and massive organic revenue growth, Microchip Technology (MCHP) has been left behind in this rally to some extent, despite the gains of the past year.

Some investor concerns likely still lie with the company’s aggressive acquisition spree, which has totaled near $5B over the past four years, and feelings that those deals might come to bite the firm. Still, large investors don't see much risk; institutional ownership of the firm is extremely high, and even after factoring in institutional shorts hedging convertible debt, I don't believe many retail investors own the company, instead focusing on other more well-known semiconductor peers. Concerns over acquisitions appear overblown, and as the spread between non-GAAP and GAAP reported results tighten, the firm is likely to have more room to run. In my opinion, fair value per share is $110, representing roughly 20% upside from current share prices.

Business Overview, Market Fundamentals

Microchip Technology primarily supplies microcontrollers (“MCUs”), which are commonplace as the controlling point of a wide variety of common electronic devices, from products like cameras, remotes, street signs, and point-of-sale terminals. In addition to this, the company sells analog (power/thermal management, timing, wireless, etc.) and memory (flash memory, EEPROMs, etc.) as well, which are complementary supportive products for its core MCU products, which creates a sort of one stop shop for customers when it comes to building out the electronic architecture of a device. Customers include Honeywell (HON), Zebra Technologies (ZBRA), Eaton (ETN), General Electric (GE), and Bosch (OTC:BSWQY), which should be household names for many investors.

Top-line expansion at the company has been aggressive, driven by both acquisitions and stellar organic growth. As we go about our everyday lives, it can be easy to forget how many objects we encounter have some sort of electronic integration that require MCUs to function. This will become more true with time, as more and more devices develop an electronic component and are connected to the Internet of Things (“IOT”); industry participants pin likely medium-term growth (through 2020) at mid to high single digits. Microchip Technology sells primarily to the industrial, automotive, and consumer end markets, and is now a top ten supplier by revenue in these niches. The Industrial market in particular looks favorable to me, given the industry has lagged behind others in regards to electronification and connectivity for its equipment and devices. Automotive looks strong as well, given expectations of increased amounts of sensors and controls as vehicle designs become more complex to meet more stringent environmental regulations in terms of emissions and engine efficiency.

Microchip Technology’s dominant position is within 8-bit MCUs; market position within 16 and 32-bit MCUs is materially weaker, although the company has been making strong inroads in winning customers in slightly more complicated applications. Surprisingly, this isn’t a headwind; growth rates from 2012-2016 for 8-bit and 32-bit MCUs have been the same: 6.5% annually, with similar expectations for near-term growth. 8-bit MCUs are still more than powerful enough currently to fit needs for most devices, so there isn’t much risk from the outsized exposure to this technology. While 32-bit MCUs do cost more (and cost is a consideration), that isn’t the only factor incentivizing 8-bit MCUs when engineers are choosing a product for an application. Engineering cost (32-bit MCUs require more development time) and power draw (8-bit MCUs draw substantially more power, particularly at idle) are also extremely important during the design phase.

Overall, I like the industry niche here. The types of devices using 8-bit MCUs are generally not leading-edge, so capital investment for product development for MCUs tends to be less than what can be found at other leading semiconductor firms like Intel (INTC). Further, the MCUs are cheap, and make up just a small portion of overall product cost for the company’s customers. As a result, customers tend to select suppliers based on product performance over cost, as well as their perception of suppler business health. This occurs because design-in cycles are often long (two years), and some of these products have very long useful lives (ten or more years). Company customers don’t want to have to deal with headaches revolving around a bankrupt/distressed chipmaker (not uncommon) in the middle of a product’s lifecycle. Microchip Technology has been around for nearly three decades now, and has shipped tens of billions of MCUs, so that fact, coupled with the company’s financials, means there is little worry that the firm will be not be around years down the line. Switching costs are high, margins are attractive, and the customer base is incredibly diverse, so there is no outsized reliance on any specific customer. It’s a great business overall.

Recent Results And The Bridge between GAAP and non-GAAP

Results have been favorable. Inventory at distributors was 31 days, which is historically low for the firm (indicative of strong sell-through demand). The company had y/y revenue growth of 15.8% in fiscal Q2 2018, all of which was organic. MCU revenue was up 20%, and all of the company’s product lines (8-bit-, 16-bit, 32-bit) set new revenue records. Sales were up in every major geography. Simply put, there isn’t any real weakness to point to, and numbers could have been higher, but there were back-end capacity constraints on Atmel products within analog, which are set to be relieved over the next few quarters, particularly given new analog attach designs. Management fully expects analog product line revenue growth will be at or above Microchip’s consolidated growth profile, which points to healthy expansion. Long term, expectations are for high single-digit growth, with management targeting operating profit of 40% (38.6% non-GAAP in most recently reported quarter). As a result, fiscal Q2 2018 points to what the company is looking to earn on a go-forward basis, with the spread between non-GAAP and GAAP reported results contracting with time.

That spread has been wide recently. A key component of growth has been from acquisitions, which included Atmel in April of last year ($3,400M), Micrel in 2015 ($744M), and the acquisitions of ISSC and Supertex in 2014 ($541M for both). There has been a flurry of non-GAAP to GAAP activity as a result of these purchases, which has muddled reported results under GAAP. Broadly, trends are quite favorable, particularly within selling, general, and administrative (“SG&A”) costs, where the firm is really starting to get some leverage. I personally add-back stock-based compensation expense (real and recurring cost in my view), but fiscal Q2 2018 SG&A/revenue came in at 12.2% still, which is down 1,600 bps from fiscal 2014 levels (when revenues were half of the current run rate). The impact on other non-GAAP exclusions in financials brings forward interesting discussion, such as the add-back of intangible asset amortization. There are more than $2,000M in purchased intangible assets remaining to be amortized over the next several years, the bulk of it relating to customer relationships and technology, and Microchip Technology excludes all amortization relating to these intangibles in their non-GAAP earnings calculations. I’ve seen the other side’s view that acquired customer relationships do not necessarily have finite lives, or at the very least, their useful lives are unclear and could have no margin impact once officially depleted under GAAP. The amortization of core and developed technology, including in-process research and development, is less clear to me, particularly since technology is almost assured to age with time, and margin/cash flow is likely to be extended once their value is depleted. As a result, I think investors need to be careful at taking non-GAAP earnings as a reflection of what margins will be when acquisition accounting rolls off, but instead use it as a means to more accurately compare earnings from quarter to quarter. The reality is, from both perspectives, Microchip Technology has been executing. Despite higher non-GAAP adjustments last year, fiscal 1H 2018 operating margin came in at 38.6%, versus 30.5% last year. Even factoring in debt discount amortization (more on that below), earnings per share was up as well, to $2.72/share versus $1.78/share in the comparable period. Worries concerning the Atmel integration appear unfounded, and Microchip Technology’s reputation for great deal integration looks to have been extended.

What is unusual is that Microchip Technology has opted to pay for its acquisitions via convertible debt versus traditional unsecured senior note offerings. The firm has:

• $2,070M of gross convertible debt issued in 2017 (due 2027)
• $1,725M of gross converitlbe debt issues in 2015 (due 2025)
• $686M of gross converitble due issued in 2017 (due 2037

The rest of the debt is immaterial as of the most recently reported quarter. Investors might have noticed that the coupon interest costs on this debt, which range between 1.625 and 2.25%, do not align with annual interest costs, which is running at a $196M/year run-rate in fiscal 2018, as well as that the reported net debt on the balance sheet is “only” $3,052M versus $4,498M gross.

The reason can be pinned on GAAP. Under GAAP, as each of the convertible notes can be settled with cash, Microchip Technology broke the original debt into a liability component and an equity component, recorded at fair value at issuance. The equity piece of this bifurcation is calculated as being the difference between initial principal value and fair value of the liability, and that discount gets amortized to interest expense over the contractual life. This is non-cash, which means a large portion of interest expense gets adjusted out on the cash flow statement. As a result, companies like Microchip Technology can appear deceptively cheap compared to other firms with more normal structures, such as peers like Texas Instruments (NYSE:TXN) or Intel (INTC). Also, without paydowns, net debt reported on the balance sheet will close the gap with gross as the convertible bonds near maturity, so leverage could move higher in the long term.

Valuation, Takeaway

That is the case today, as it looks like Microchip Technologies is going to generate $1,400M in GAAP operating cash flow this fiscal year, or $1,250M given current run-rate capital expenditures. 5.9% free cash flow yield looks juicy compared to the sector as a whole, given the entirety of the peer group (Texas Instruments, Intel, Qualcomm (QCOM), Broadcom (AVGO), Taiwan Semiconductor (TSM), etc.) trade in the 4-5.5% range on calendar Q2 2017-Q2 2018 results, once adjusted for working capital. Once cash flow is adjusted to be in line with GAAP accounting standards on the income statement (which represents a more realistic idea of future settlement costs of the debt), Microchip Technology trades in line with the peer group. On an EV/EBITDA basis, the firm trades at a premium to peers, largely due to aforementioned acquisition amortization charges; as these charges roll off (as they have started doing over the past year due to accelerated amortization), that multiple will contract in-line as well.

There looks to be decent upside left. Given the current top-line growth outlook, Microchip Technologies looks poised to continue to steal market share in what have been strong underlying markets for semiconductors. This is balanced to some extent by the leverage, but there is little to no risk of near-term default. The company has more than $2,800M in liquidity within its revolving credit facility, and substantial room for potential earnings contraction before it could come close to violating financial covenants. Actual cash interest costs are low given the convertible debt structure. The company is heavily recommended by sell-side analysts on Wall Street ($106/share price target, or 16.5% upside), which actually looks like a spot-on valuation to me.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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