Microchip Is A Buy On Atmel Transformation

| About: Microchip Technology (MCHP)
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Summary

Microchip has a record of making good acquisitions.

Atmel had low margins due to problems Microchip is fixing.

EPS should show strong growth starting in fiscal Q2.

Microchip Technology (NASDAQ:MCHP) is one of the world's sales leaders in microcontroller chips and related semiconductors. Microcontrollers combine a computer with the ability to take input from sensors and then control output devices. They are now in almost every industrial and medical tool, in home appliances and in cars. They are one of the crucial components of IoT (Internet of Things).

Microchip has a history of both growing organically and making smart acquisitions. Most recently it acquired Atmel, which is the focus of this article. Before that it acquired Silicon Storage Technology in 2010, ISSC Technologies in 2014, Supertex in 2014 and Micrel in August 2015.

Microchip semiconductors are in such a variety of final products that to a large extent they are a proxy for the global economy. Sales grow at about the rate of global growth, plus the company's usually increasing market share, plus growth through acquisitions. That does make Microchip subject to global slowdowns, or even to sector inventory corrections. However, the last 5 years show revenue growth but with EPS down lately:

Fiscal Year

Revenue in Millions

EPS

2012

$1,383

$1.65

2013

$1,582

$0.62

2014

$1,931

$1.82

2015

$2,147

$1.65

2016

$2,173

$1.49

Microchip also has a long record of rewarding shareholders with dividends. The current dividend is $0.3595. Lately, the dividend has typically been increased $0.0005 each quarter. MCHP started dividend payments in the third quarter of fiscal year 2003 and has increased its dividend 49 times since then.

Microchip's stock price has been trending up this last year. The 52-week low of $37.77 was hit back in August of 2015. The 52-week high of $53.17 was hit a few days ago on June 8. Microchip is a large-cap stock, with market capitalization currently near $11 billion.

Atmel Acquisition

Atmel microcontroller chip

Atmel was one of the first companies I invested in, back in 2001, after the Internet bubble burst. It was founded in 1984 to make memory chips, but like Microchip its main business came to be microcontrollers and related chips. Atmel used a different computer architecture, AVR, and then added the ARM architecture when that became popular. Microchip uses the PIC architecture.

On February 29, 2016, Atmel reported full-year 2015 results: revenue of $1.17 billion, down 17% from $1.41 billion a year earlier. GAAP net income was $27 million, down 16% from last year's $32 million. GAAP EPS was $0.06, down from $0.08 in the previous year.

So by revenue in 2015 Microchip was not quite twice the size of Atmel. But GAAP net income for Microchip in 2015 was $324 million, over ten times as high as Atmel's.

In short, Atmel had lousy margins and Microchip had healthy margins. If Microchip can manage the old Atmel business up to its own margins, there will be a lot of happy shareholders.

The acquisition was completed on April 4, 2016, after fiscal Q4 2016 ended for Microchip.

So most likely Q1 will see a very large bump in revenue, but nothing like that bump for net income or EPS. Depending on how accounting rules affect the merger, there could even be a drop in Q1 earnings due to acquisition-related charges.

Then in fiscal Q2 we might start seeing improvements in EPS.

You could argue (and some have) that given Atmel's pitiful net income, Microchip overpaid: "Microchip completed its acquisition of Atmel Corporation for $8.15 per share consisting of $7.00 in cash and $1.15 in shares of Microchip common stock. The acquisition price represented a total equity value of about $3.47 billion, and a total enterprise value of about $3.43 billion, after excluding Atmel's cash and investments net of debt on its balance sheet of approximately $39.3 million at the closing date." [Microchip Q4 press release]

$3.5 billion would make sense if Atmel were generating something like $100 million or more per year in net income. So it might make sense if Microchip can maintain or grow Atmel revenue while increasing margins.

Fixing Atmel

The math is simple. Microchip had an operating margin of 14.9% in 2015. Atmel had an operating margin of 2.5%.

Assuming a slight round-up in Atmel annual revenue to $1.2 billion, with an operating margin of 14.9%, the net income contribution of the old Atmel to Microchip would be $179 million.

Getting there may not be easy. Perhaps Atmel's low margin is inherent to its business. For instance, Atmel's products could have been just as expensive to make as Microchip's, but commanded inferior prices due to competition with Microchip, Renesas, Freescale, Texas Instruments and the many other semiconductor manufacturers. Microcontrollers are a very competitive segment of the semiconductor market. In that case improving margins substantially would be difficult.

Microchip management, including CEO Steve Sanghi, addressed this issue in depth at the Q4 earnings call. Overall, having had the business for a few days, "We remain confident we can achieve 25 cents of accretion to non-GAAP diluted earnings per share from Atmel in fiscal 2017."

He reported that Microchip is developing detailed integration plans for Atmel, including rebuilding Atmel's 8-bit microcontroller business. But the company had already closed the Atmel Dresden wireless development center. Atmel's mobile touch business will be sold.

Asked what were Atmel's best growth segments, the answer was it was focused on 32-bit and touch. "We will add 8-bit." Microchip would like to attach its analog circuits to Atmel's 8-bit AVR chips. Atmel's crypto products could make Security a growth area.

Questioned regarding the IoT business, Steve said Microchip's wireless business has been doing well. Atmel's wireless business was smaller and was losing money, but it did have some good products. It was not as good as the company had indicated to analysts and investors. So the wireless businesses will be merged.

Steve was adamant that Atmel management had poor cost controls. In fact, he thought, Atmel was poorly managed in several ways, including giving themselves bonuses regardless of how the company was doing. They had poor pricing discipline and poor teamwork. Microchip has a reputation for strong teamwork and many of the new personnel are already responding enthusiastically.

In addition, Atmel had a poor pricing business. Some parts were sold at negative gross margins to some customers. There are three key variables: brand, product and price. Atmel had good products, medium brand, poor pricing. Microchip will put price discipline in place.

At the time of the conference, Microchip saw no large customers who were dropping out. To the contrary, it sees more customers that are attracted to its increased size.

Finally, Atmel sometimes made deals with distributors at quarter-end to boost revenue. That hurt margins. Microchip does not do that.

While each of these statements is qualitative, it seems reasonable to me to conclude that over time the combined companies will be able to get back to Microchip's historic margins.

Cash

End of quarter cash was $2.57 billion against about $1 billion in debt. The acquisition will deplete cash and may increase debt, but Microchip has very healthy cash generation ($196 million in the quarter), so I am not concerned.

Conclusion

I believe that over time Microchip will return to its historic margins, but on the much larger revenue base from acquiring Atmel. I have no way of predicting whether that can be done in two or three quarters, or whether it will take one to two years.

The combined company will have annual revenue of about $3.4 billion. Annual net income should approach $510 million with about 230 million shares. So EPS of about $2.22.

Again, that is a long-range forecast (a guess) and has all the assumptions mentioned above, including a relatively steady global economy. If the microcontroller segment sinks, or if Microchip loses market share to competitors, or if it is not able to improve margins in the Atmel part of the business, it could creep along closer to the fiscal 2016 EPS of $1.49.

Because of volatility, stock prices are even harder to predict than earnings. I believe part of Microchip's current price ($51.59 at close on June 22, 2016) already reflects some hope from the Atmel acquisition. Given the current P/E Ratio of 34.6, we could project a stock price of $76 if and when the scenario predicted works out. In the mean time, I would make the safer prediction that Microchip is headed towards $60 per share over the next 3 to 4 quarters. Throw in the dividend and that is an attractive return, without assuming too much risk.

Disclosure: I am/we are long MCHP.

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.