Can More Be Squeezed From Microchip Technology In This Cycle?

| About: Microchip Technology (MCHP)
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Summary

Microchip Technology is a leading player in microcontrollers, with particularly strong share in 8-bit MCUs.

The Internet of Things could be a multibillion-device opportunity for those companies with lower-power MCUs and integrated connectivity.

Microchip Technology doesn't look very cheap on a discounted cash flow or operating margin/EV/sales basis.

I'll state off the top that I like Microchip Technology (NASDAQ:MCHP) as a company. The company has established itself as a top five player in microcontrollers (or MCUs) and is poised to benefit from the growing Internet of Things (or IoT) opportunity, as the company offers strong complementary technologies in MCUs, analog, and connectivity. The downside is valuation, where I just don't see as much upside potential and would prefer Atmel (NASDAQ:ATML) on a head-to-head basis.

Growing Share In A $16B Market

Microchip Technology has remade itself over the years into a company with strong margins and a solid, growing share in the $16 billion microcontroller market. MCUs are basically small, low-cost computers that sit on a single integrated circuit that includes a processor core, memory, and various input/output interfaces. Simple 8-bit MCUs might run a car seat or door lock, while more advanced 32-bit MCUs can run a car's stability system or control the engine. MCUs typically don't cost that much, but they're found all over the place in cars, industrial applications, computing, consumer goods, medical devices, mobile, and communications gear - making up that $16 billion overall market opportunity.

A top-five player, trailing Renesas, Freescale (NYSE:FSL), Atmel, and Texas Instruments (NYSE:TXN), Microchip has grown its market share fairly steadily over the last decade, helped by a transition from 8-bit to 16-bit and 32-bit, and new product introductions. Like Atmel and Renesas, Microchip uses a proprietary architecture (called PIC), but also licenses MIPS from Imagination Technologies. Microchip is not a licensee of ARM Holdings (NASDAQ:ARMH), and that could represent a risk, as ARM architecture has grown to about 18% of the overall MCU space and about two-thirds of the 32-bit segment.

Microchip is also a little unusual in its industry exposures. The company has only about half the industry-average exposure to autos (where Renesas and Freescale are quite strong) and average exposure to industrial (where Renesas, Texas Instruments, and Atmel lead), but about two and a half times more exposure to "consumer" than average.

Not Just About MCUs

MCUs represent around two-thirds of Microchip Technology's revenue, but that's not all there is to the company. Microchip also has a fairly significant Analog and Interface business (more than 20% of revenue) that sells various power management, mixed-signal, thermal management, RF linear, and interface products. The company also has a memory business (EEPROMs, serial flash, etc.) and a small technology licensing business.

The takeaway on this part of Microchip's business is the extent to which it complements the MCU business. Non-volatile memory, RF, mixed-signal chips and so on are usually complementary to embedded processors and it offers a chance for respectable add-on business and greater share-of-wallet with the company's customers.

Internet Of Things Likely To Be A Big Thing

The "Internet of Things" is admittedly a subject that has a disturbing, if not annoying, amount of buzz around it. Nevertheless, more connectivity between devices seems to be an inexorable trend, whether it is in auto, industrial, medical, communications, or consumer markets. Intel has estimated that there could be nearly 4 billion IoT device opportunities in 2015, with ABI Research estimating an explosion to 30 billion devices in 2020.

Microchip Technology looks well-positioned for this move. In addition to low-power MCUs (which seem well-nigh essential to play a major role in IoT), Microchip has assembled good connectivity technology both through internal development and acquisitions like the recent deal for Taiwan's ISSC Technologies and its strong low-power Bluetooth connectivity business (and IP). Freescale and Atmel are certainly going to fight Microchip for this business, and both are stronger today in 32-bit MCUs. Silicon Labs (NASDAQ:SLAB) also has its hat in the ring, with a particular focus on lower power consumption.

I see little chance that this becomes a winner-takes-all opportunity, but I would note that Microchip's relatively weaker position in 32-bit is not as damning as it might seem. First, the company has been introducing products and gaining share in 32-bit, and it's also well worth noting that it has a strong position in 8-bit and a solid position in 16-bit - and there is very little to be gained in using a 32-bit chip where a 16-bit or 8-bit chip will do.

Good Internal Operations, Punctuated With R&D

Microchip knows what it is, and focuses on being a well-run version of that. Gross margins have trended between 50% and 60% over the past decade, with operating margins between 25% and 35%, excluding the FY2013 anomaly (which largely vanishes through non-GAAP accounting). Returns on invested capital and assets have generally been in the double digits and the dividend has grown nearly 13 times over the past decade.

In addition to running a good business punctuated by product introductions offering lower power consumption, better connectivity, and other value-adding features, Microchip has been a willing acquirer. Since 2010, Microchip has acquired SST (which has generated a very strong ROIC), SMSC, Supertex (a high-voltage analog/mixed-signal company), and most recently ISSC. Microchip has paid up for these latter two deals, but the premium isn't so bad considering the margin improvement potential that Microchip management can bring, let alone the opportunity to take acquired technology and leverage it across Microchip's business.

The cyclical nature of the chip market precludes smooth growth curves, but I do believe that Microchip Technologies will grow at an overall average long-term rate of 6% to 7% as demand from IoT applications kicks in. I also see some incremental margin/FCF generation potential, sufficient to bump the FCF growth rate above 8% (again, on a long-term CAGR basis).

The Bottom Line

The downside to all of the above is that Microchip Technology just doesn't look that cheap. On a discounted cash flow basis, fair value seems to be around $48.50 and the company's operating margins suggest a fair value in the same range on the basis of a forward EV/revenue multiple of about 4.2x. Given the relative valuations, I'd be more inclined to own Atmel today, though my objections and complaints with Microchip really don't go much beyond price and value today.

Disclosure: I 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.