Microchip Looks Undervalued, But There Are Short-Term Challenges To Consider

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About: Microchip Technology Incorporated (MCHP), Includes: ADI, RNECY
by: Stephen Simpson, CFA
Summary

Microsemi channel inventory issues, lead times, and trade-related business confidence are near-term challenges for the outlook, but Microchip is well-placed in attractive MCU and analog markets.

MCUs will play significant roles in emerging markets like IoT and advanced auto systems, while Microsemi broadens Microchip's capabilities in analog and in new areas like FPGAs.

The next couple of quarters could be rocky for Microchip and the industry as a whole, but the long-term value opportunity looks very interesting.

Buying good companies on stumbles is a time-tested strategy, but one that stills carries risk – it’s not always easy to separate a stumble from a prolonged tumble down the stairs. In the case of Microchip (MCHP), while issues related to its recent Microsemi purchase loom larger in the short term, I’m a little more concerned about the potential impact of extended lead times and weakening demand in important end-markets.

I believe Microchip has proven itself to be a well-run chip company, and I like the company’s diverse capabilities across microcontrollers (or MCUs) and analog, as well as the new opportunities brought in with the Microsemi deal (including FPGAs, timing products, data center products, and so on). Although this may not be the ideal time to buy given sentiment toward the semiconductor space, the long-term value proposition makes this a name worth considering for more value-driven investors.

Are Strong MCU Sales At Risk?

Although the reported year-over-year and quarter-over-quarter growth rates of 15% and 11% for the microcontroller business were boosted by the Microsemi deal, the underlying business was still very strong in Microchip’s fiscal first quarter (calendar second quarter), as the company continues to gain share and reap the benefits of strong demand in end-markets like industrial and auto.

The question, though, is whether that momentum can continue. The Semiconductor Industry Association data for July was weaker than generally expected, with overall sales growth at the lowest point since January 2017 (albeit still at healthy levels) and microcontroller sales up less than 1% yoy. Granted, that’s just one month, and Microchip still has market share growth opportunities, but it is certainly a trend to watch.

I’d also note a few other points. Analog Devices (ADI) saw not only the third straight quarter of deceleration in its industrial business in its last quarter, but also missed expectations. Continental (OTCPK:CTTAY) recently warned about weaker auto conditions in Europe and China, and multiple Japanese automation companies have been warning of weakening demand among Chinese industrial companies, and MCU market leader Renesas (OTCPK:RNECY) is seeing a brutal inventory correction cycle in its auto MCU business, while also reporting weaker industrial demand in China.

Longer term, though, I am not remotely worried about Microchip’s MCU business. Through acquisition and internal execution, Microchip has built itself into the #3 player in MCUs (Renesas is #1), with a significant leadership presence in 8-bit and improving share in 16-bit and 32-bit. Not only is Microchip looking at expanding market opportunities in key end-markets like industrial (automation, IoT) and auto (advanced ADAS and advanced controls), the company has also built one of the best-regarded ecosystems around its MCU business, with a strong set of software tools and support functions – a key consideration when companies are choosing MCUs, as they generally have to live with that choice for a while (switching out MCUs without full-scale product redesign can be difficult).

Microsemi – Pain Before The Gain

Microchip sold off sharply after its last earnings report due in large part to weaker guidance (about 4-5% lower at the midpoint). While management regrettably didn’t quantify the sources of the weakness, recently-acquired Microsemi is a significant part of it.

Microsemi was in play as a takeout candidate for several quarters and it looks like management tried to spur a better price by jamming product into its distribution channel and making the business look stronger than it was; Microchip reported that channel inventories for Microsemi products were at four months (Microchip tends to run closer to two months) and that the company was giving discounts to distributors and OEM customers to accept the shipments. Although unsavory, this is not all that uncommon (it’s likely part of the problem with Marvell (MRVL) and Cavium’s inventory corrections) and Microchip has been through this before with prior deals. Still, it will weigh on results for a couple more quarters.

Microchip also took Microsemi to task for its expense structure, using words like “extravagance” and “lavish”. That’s curious given Microsemi’s prior reputation as a cost-cutter (though it would explain why Microsemi struggled to hit their own targets), and it’s also worth remembering that Microchip’s CEO has a bit of a history for a flair for the dramatic and calling out the prior management of acquired companies. In any case, I’d actually regard this revelation as a positive – while it may mean less near-term accretion from the deal, Microsemi’s top-level management is gone now and this “lavish” spending should ultimately lead to more cost-cutting opportunities for Microchip.

The Opportunity

I like how Microchip is positioned today. The company has a demonstrated history of excellence in MCUs, and these products are only going to become more important as IoT takes off. While companies like Silicon Labs (SLAB), Texas Instruments (TXN), and STMicro (STM) can offer strong integrated IoT packages (MCUs, sensors, wireless connectivity, etc.), not all IoT customers will want integrated offerings and/or to make compromises with the MCU. What’s more, Microchip does have some connectivity capabilities in-house and could look to acquire more.

Microchip also has a strong, somewhat specialized analog business. Microchip has historically focused this business on serving as a complementary asset to the MCU business, and the company continues to add more MCU cores to its most complex analog products, but there are longer-term opportunities, particularly with Microsemi in hand, to grow in more specialized directions.

Speaking of Microsemi again, that acquisition will significantly expand Microchip’s presence in markets like aerospace/defense and data center, while adding new products/technologies like FPGAs, timing, silicon carbide, memory controllers, and optical products. Whether the company chooses to stay in all of these businesses long-term is an interesting question, though, as the higher cost of leading-edge products (the products Microsemi acquired with the PMC-Sierra deal) may not fit with Microchip’s preferred model going forward.

I am concerned about longer lead times for passive components weighing on growth in the short term, and I’m likewise worried about the impact of tariffs and global trade tension – not so much in terms of direct impact on Microchip, but rather the impact on Microchip’s customers and overall business confidence. Still, I don’t think my long-term assumption of low-mid single-digit revenue growth is all that aggressive, and I do see opportunities for Microchip to go back to M&A to augment its business once it pays down the Microsemi-related debt (probably a two-to-four-year process).

On the margin side, I do expect Microchip to wring meaningful savings out of the Microsemi deal and drive toward low-to-mid 30%’s adjusted FCF margins with non-GAAP operating margins approaching 40% in 2020/2021 on gross margins in the low-60%’s.

I expect double-digit FCF growth from Microchip, supporting a high single-digit to low-double-digit total annual return on a discounted cash flow basis. Looking at margin-driven EV/revenue, I believe these shares should trade over 6x forward revenue given the level of gross and operating margins.

The Bottom Line

If you’re sensitive to short-term paper losses, Microchip may not be the best idea for you today, given the weakening sentiment in semiconductors and the risk that extended lead times as softer industrial/auto demand will lead to a few challenging quarters in the near future. For more patient and/or value-driven investors, though, I think the share price today is rather appealing and an opportunity worth considering given the strong margin profile, market share position, and history of product development and execution.

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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