Microchip Technology Inc. (NASDAQ:MCHP) is not in the business of selling cakes. Rather, Microchip is more akin to a chef selling cake mix in the form of microcontrollers to hungry designers with a sweet tooth. All that the customers need to do is add some water to the mix, and voila they have all the ingredients necessary to make a cake.
Making a cake may sound simple, but the real magic comes as a result of the baking chef exploring the endless possibilities across colors, flavors, sizes, frostings, and accessories. The microcontroller business is similar in many respects. Microchip provides the essential tools (ingredients) to efficiently and cost-effectively build solutions for an almost infinite number of applications. Microcontrollers can be found in a diverse mix of products and gizmos, ranging in size from an iPod Nano (NASDAQ:AAPL) and Tickle Me Elmo toy to a Whirlpool (NYSE:WHR) washing machine and a butt-warming car seat in a Porsche (OTCPK:POAHF) 911 Turbo. From a verticals standpoint, Microchip services more than 60,000 customers globally (75% of revenues internationally) in the automotive, aerospace, communications, computing, consumer, and industrial control markets, among others.
What the Heck is a Microcontroller?
You can think of a microcontroller as a computer-on-a-chip, and these mini-computers, which are embedded into all types of applications, allow designers to create all types of products. The low-cost computer chips handle simple functions such as turning products on and off and setting speeds in consumer products, cars, telecommunications and office equipment. More specifically, these microcontrollers provide designers with the ability to introduce or expand functionality, reduce power consumption, and create further efficient designs, thereby potentially leading to lower costs and higher profits. Even though talking about the digital world of 1’s and 0’s sounds sexy, in the real world we are surrounded by analog factors like time, temperature, sound, music, and video – analog functions that require the heavy lifting of a microcontroller to process digital data after it has been converted from analog.
These microcontrollers aren’t multi-hundred dollar microprocessors manufactured in multi-billion dollar fabrication facilities at Intel Corp. (NASDAQ:INTC) – rather these more mundane (although essential) components sell often for a few bucks each. What’s more, the pricing in microcontroller and analog land is more stable at Microchip relative to the annual -20-30% price cuts common in the microprocessor world.
On top of performance (speed, power, heat, etc.) and cost, ease of design is a way Microchip gains market share away from competitors through its PIC architecture – the software platform that designers program Microchip’s microcontrollers. The company devotes extensive resources to spreading the PIC gospel to designers around the world and Microchip engineers are constantly upgrading the programming software. To date, Microchip has almost shipped 1,000,000 development tools to designers and developers. The software and design kits add to the company’s revenues, but the real profitability kicks in when the customers reorder chips related to multiyear product life cycles. For example, you can think of a television company that must order a microcontroller for a five-year old, broken TV remote control that a child stepped on… hmm, sounds familiar.
Expanding Pie (or Cake)
This is no puny market; the overall microcontroller segment of the semiconductor market is estimated to have generated $10.7 billion in sales during 2009. Microchip has managed to not only become the 800 pound gorilla in the 8-bit microcontroller space, but in recent years it has also made significant headway in the higher functionality/performance markets of 16-bit and 32-bit microcontrollers. In total, Microchip offers its customers more than 650 flavors of its microcontroller products.
One would think the company is busy enough with its core microcontroller business, but Microchip is not sitting on its hands. It is employing a Velcro strategy by attaching other embedded features on its “computer-on-a-chip,” including analog, memory, DSP (digital signal processing), and other capabilities. Already, Microchip’s analog business has grown to more than 10% of the company’s revenues (about 600 analog products and > 14,000 customers), and Microchip’s foray into the digital signal controller sector (dsPIC product family) is expanding the company’s total addressable market as well. Consistent with this Velcro strategy, Microchip recently purchased Silicon Storage Technology Inc. (NYSEARCA:SST) for $354 million, focusing on SST’s high margin flash memory licensing business. Thanks to shrewd negotiating and jettisoning of non-core SST segments, the deal will solidify Microchip’s embedded solution positioning and is expected to add $.14 – $.18 cents to Microchip’s 2011 earnings per share (EPS).
The Head Chef
The head chef of the technology kitchen is Steve Sanghi. In 1990 (after 10 years of employment at Intel Corp.), when he took over as President of Microchip, the kitchen was a complete mess. Not only was the company losing money, but it was spread too thin across disparate technologies. His accomplishments were recognized immediately and Sanghi became CEO shortly thereafter in 1991. Microchip, which was originally founded in 1989 as a spinoff from General Instrument, eventually went public in 1993. Despite a tough technology market post the technology crash of 2000, Microchip has managed to gain market share from struggling competitors like Atmel Corp. (NASDAQ:ATML). Under Sanghi’s leadership, Microchip has more than doubled profits over the last decade and sales have almost multiplied 12-fold to $950 million since the company went public 17 years ago.
Besides pumping out microcontrollers, Microchip pumps out a lot of cash as well. In their recently completed fiscal year (ending in March), the company generated close to $400 million in free cash flow (cash from operations minus capital expenditures), by my definition. With a market capitalization of around $5 billion this relationship implies an almost 8% free cash flow yield – a bit nicer than the 3.17% yield recently offered on the federal government’s 10-year Treasury Note. Microchip’s cash metrics look even that much more impressive when you consider the company has more than $1.1 billion in net cash piled up on the balance sheet. Since the capital intensity of the microcontroller and analog businesses is so much less demanding than the microprocessor world, Microchip has plenty of flexibility in paying a nice, big fat, 5%+ dividend (about $1.37 per share annually), which has increased modestly in each of the last three quarters. On a Price-Earnings basis (P/E), Microchip’s share price is currently trading at an attractive 13 x’s the company’s $2.11 consensus Earnings-Per-Share (EPS) estimate.
Microchip is not a risk-free Treasury investment and the company faces significant cyclical sensitivity to global macroeconomic trends, as we saw in fiscal 2009 (ending March). The pace of global design activity will generally be responsive to overall business confidence. In spite of Microchip’s dominance in the 8-bit market, some skeptics also question Microchip’s ability to gain market share in the 16-bit and 32-bit markets.
In addition to those concerns, another hazard relates to the company overpaying for future, potential acquisitions. Traditionally Microchip has focused on internal growth, however in recent years the company’s appetite for acquisitions has increased – most notably the failed merger of Atmel Corporation for roughly $2.3 billion in early 2009. If history serves as a guide, Microchip has been prudent in acquisitions – for example, the timely $183 million purchase of Gresham, Oregon manufacturing plant in 2002 for cents on the dollar or the recent opportunistic and accretive SST deal.
Momentum and Visibility Improving
With the global upturn occurring, Microchip has seen a +189% increase in its backlog (orders in hand for future delivery) to $528 million. Having these orders in hand allows Microchip to plan and invest more appropriately for growth in the coming year. Fourth quarter sales (without SST’s contribution) increased by more than 60% from last year and Non-GAAP earnings mushroomed by more than 200% on a year-over-year basis.
The ease and affordability of new product design will be an accelerating trend of new product proliferation. As I wrote in an earlier article (Revenge of David), the simplicity of design has become dramatically easier. A laptop and internet connection affords any designer the ability to download free design software, build a prototype with a 3-D printer, order Chinese manufacturing services through Taobao.com (parent Alibaba Group (OTC:ALBCF)), and wait for UPS to deliver the product to its doorstep in fairly short order. This design tailwind only serves to increase demand for Microchip’s microcontroller solutions over time.
Ever since the company’s IPO (Initial Public Offering), Microchip has had a phenomenal track record of success led by Steve Sanghi’s direction. Microchip is a much more mature company since going public in 1993 at a stock price of $0.57 per share (split-adjusted), but if the stock price can appreciate a fraction of the +4,623% already achieved, then my clients and I should be able to purchase a lot of cake mix.
Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, MCHP, AAPL, and Treasury securities, but at the time of publishing SCM had no direct positions in WHR, Porsche, Volkswagen, INTC, ATML, SST, UPS, General Instrument, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision.