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The trend toward smaller devices and feature packed equipment and machines has provided revenue and profit momentum for microcontroller maker Microchip Technology (MCHP). But, semiconductors are typically seasonal and Q4 is historically the weakest quarter for microcontroller maker Microchip Technology.

Microcontrollers are the draft horses of the semiconductor world. They help devices run cooler and use less power. In a universe where next generation consumer and industrial devices and machines require far more monitoring, analysis and power to meet our insatiable appetite for feature rich applications, developers are embracing microcontrollers as a low cost solution in everything from cars to smart phones.

Distributors bulked up on Microchip inventory in Q1, 2010 ahead of growing demand. As a result, they exited Q1 with 41 days of inventory, the high end of their historical norm. Through Q2 and Q3, 2010, distributors worked inventory levels lower, finishing Q3 at 31 days, the low end of the historical norm. Given Q4 is typically the weakest quarter for Microchip, its unlikely distributors were willing to make big inventory bets.

However, the distributor headwind exiting Q4 will shift to tailwinds in Q1 as distributors begin to model forward demand from rising car, industrial equipment and next generation phone and tablet product sales.

Automakers have stashed more features in dashboards and under hoods, driving industry demand for microcontrollers higher as auto sales gain momentum. Edmunds estimates domestic auto sales are running at a 12.8 million unit annualized pace in January, better than December – a historically strong month for sales. Since most new cars hitting dealer lots packed with electronic features, demand for Microchip products is likely to be strong again in 2011.

Industrial equipment sales will also boost microcontrollers demand this year. Manufacturers are restarting lines, as evidenced by manufacturing capacity utilization moving up to 73.2% in December. Manufacturers are generating robust cash flow, thanks to recession era cost cuts, which supports spending on next generation, feature-packed industrial equipment.

Additionally, smart phones, tablets and other small consumer devices continue to boost microcontroller demand. As devices come to market, feature competition increases, boosting the demand for products, including 16-bit microcontrollers.

Microchip responded to strong sales growth last year by ramping production. In Q3, production was “above-normal”, running 90-95% or more. As production increased, margins improved to 58.9% of sales from 54.4% the prior year. Stable pricing and higher production allowed Microchip to guide future margins back toward 61% over time and it will be interesting to see how this shaped up in the seasonally week Q4.

Since Microchip controls its own production and design, and shares its architecture across its microcontroller and non-volatile memory products, they generate better margins and faster product development – important for maintaining pricing power.

The company enhanced its product pipeline in April with its acquisition of Silicon Storage Technology, Inc., spending $353.8 million to get SST’s patent portfolio and SuperFlash product line - technology Microchip will incorporate into future microcontrollers. The deal will add $0.32 to non-GAAP earnings for 2011, up from the company’s initial $0.14-0.18 estimates, and will add $0.40 to 2012.

In total, the company sold 168% more units in Q3 than it did in Q3, 2009 and 181% more units in Q2 & Q3 than the prior year and generated 67% of its Q3 revenue from microcontrollers.

Q4 is typically Microchip’s weakest quarter with the company’s book-to-bill entering Q4 at a meager 0.87. Low channel inventory and seasonal cyclicality suggest improvement in Q2.

Slightly more than half of Microchip’s sales come through distributors, however, no one distributor accounted for more than 10% of sales last quarter. We’ve seen signals distributors were unwilling to buy in Q4, as evidenced in Cree Inc (CREE) and Linear Technology Corp (LLTC) Q4 earnings reports. However, distributor sluggishness may not be as pronounced at Microchip as with other semi plays given the low levels of distributor inventory ending Q3. If distributors did balk in Q4, weakness can be attributed to a broader seasonal inventory correction and any sell-off will provide a nice entry point for investors.

In the meantime, investors will be paid to wait as Microchip currently pays a 3.7% yield, paid for by robust earnings growth. The company has plenty of dividend boosting and M&A powder too, with $7.38 per share in cash. Despite having beaten the Street in each of the past four quarters, short sellers remain too exposed. Short interest stands at 8 days to cover and provides a floor for any downside.

Source: Will Distributors Disappoint Microchip Technology Investors?