I believe it doesn’t trade at my target price yet since Microchip levered up significantly to acquire Microsemi. It is now engaged in a long-term process to reduce that debt steadily. During the last quarter, Microchip paid down $378 million in debt and reduced net debt on the balance sheet by about $350 million. The company is committed to using excess cash generation beyond dividend payments to pay down debt.
Microchip Technology develops and manufactures specialized chips used in a wide variety of technology products. Microchip is a leading microcontroller (MCU) company. MCUs are a low-cost component that form the “brains” of most electronic devices, except PCs. These chips are found in a wide variety of common electronic devices, from garage door openers to electric toothbrushes, and many others in between. MCUs recognize inputs, execute a program, and send an output. MCUs are often accompanied by analog chips that process real-world inputs such as current temperature and pressure. For example, a thermostat can recognize the current temperature, so it can turn the heating unit on or off. Microchip's signature products include a broad family of proprietary 8-bit and 16-bit field programmable MCUs under the PIC name, designed for applications requiring high performance, fast time-to-market, and user programmability. Microchip's historical strength has been the 8-bit MCU segment. These chips tend to be used in a wide range of simpler electronic products, and as a result, Microchip benefits from not being overly exposed to a single technology segment or customer. The firm’s analog chip business has grown at a nice pace both organically and as the firm makes bolt-on acquisitions (e.g. Microsemi).
► Microchip sells to tens of thousands of end customers, so it is not overly dependent on sales to any one client.
► The trade war fears are factored into the current stock price. It’s not a matter of if, but when, the resolution takes place which will be a positive for Microchip and the sector.
► The IoT and autonomous vehicles is a growth catalyst for the company and is not being fully accounted for in their growth projections.
► Microchip is a smart acquirer and exerts higher than expected synergies. Microsemi was a good purchase and will follow the same script.
► Microchip has solid management in place that is focused on growing FCF to pay a steady dividend and pay down debt to 2.5x EBITDA.
► CEO Steve Sanghi says March will mark the bottom of the cycle for the company and has been right before.
► Microchip faces competition in analog chips and microcontrollers from larger firms, such as Texas Instruments and STMicro.
► Microchip is the market-share leader in 8-bit MCUs but trails a couple of other firms in 16- and 32- bit MCUs.
► Microchip has done an exceptional job of integrating M&A targets in the past but is too leveraged now.
► The Microsemi purchase is different than those in the past. There may be more problems integrating than just channel stuffing.
► If the Trade War between the US and China is not resolved, Microchip will be hit hard with higher costs and lower demand.
Microchip sells to tens of thousands end customers. The company is not overly dependent on sales to one customer nor can one customer exert pricing pressure.
Microchip has a great track record of extracting higher-than-expected synergies out of its acquisitions. The acquisition of Microsemi has already added an annualized run rate of 75 cents of non-GAAP EPS accretion along with a future $300 million in synergy and cost savings.
Switching costs of their product is high as specific designs need to be made for MCUs. Once an electronic product is made with
Microchip’s MCU, it will need to be replaced with that same specific chip over the life of the product and cannot be substituted.
MCU’s are a tiny cost of a product and customers tend to focus on performance rather than price helping Microchip retain pricing power. Currently, Microchip’s gross margins stand at 61.5%.
Microchip operates in the highly cyclical semiconductor industry and has the associated risks of a slowdown in end user demand, but all semiconductor companies are not created equal.
Microchip acquired Microsemi in March 2018, closing the deal in late May. Microchip paid an equity value of $8.35 billion and total EV of $10.15 billion, which includes Microsemi's debt.
Microsemi's product lineup is highly complementary to Microchip's. For instance, Microsemi had a large presence in both the aerospace, defense, and telecommunications industries, whereas Microchip had little exposure, and Microsemi also made FPGAs, a product Microchip didn't offer before.
Microchip has a history of successful acquisitions, most recently the $3.4 billion purchase of Atmel in 2016. Using the standard recipe of cost-cutting and cross-selling, along with price increases for Atmel's differentiated products, Microchip was able to exceed its initial synergy and EPS targets when that deal was first announced.
Microsemi came aboard with strong engineering teams, excellent products, and 'sticky' customers but Microchip found out that prior management had been sending larger orders to distributors in exchange for discounts to make its recent quarters look better, or channel stuffing. It has recently fixed the problems at the company and is already on track to beat its Microsemi closing targets:
Microchip financed the Microchip purchase with approximately $1.6 billion of cash from the combined company balance sheets, $3.0 billion from Microchip’s existing line of credit, $5.0 billion in new debt and $0.6 billion of a cash bridge loan.
IoT encompasses everything connected to the internet including autonomous vehicles, but it is increasingly being used to define objects that "talk" to each other. Microchip’s products are well positioned to capitalize on this growth.
Worldwide technology spending on the Internet of Things to reach $1.2T in 2022, attaining a CAGR of 13.6% over the 2017-2022 forecast period according to IDC. Ericcson is forecasting the number of cellular IoT connections is expected to reach 3.5B in 2023, increasing at a CAGR of 30%. I take all these estimates with a grain of salt as every firm has different projections on IoT growth but nonetheless there should be accelerated growth as technology improves, gets cheaper, and the world gets more interconnected.
Most sell-side models project Microchip’s growth a little over regional GDP. There are larger players in the IoT revolution, but even if Microchip captures a small percentage of the explosive growth in the interconnected devices market, this would prove to be a top line growth driver. Microchip even sells separate IoT developer kits.
Microchip Technology was founded in 1987 when General Instrument spun off its microelectronics division as a wholly owned subsidiary. Microchip Technology became an independent company in 1989 when it was acquired by a group of venture capitalists and went public in 1993.
In April 2010, Microchip acquired Silicon Storage Technology (SST), and sold several SST flash memory assets to Greenliant Systems in May that year.
In August 2012, Microchip acquired Standard Microsystems Corporation (SMSC). Among SMSC's assets were those it had previously acquired from Symwave, a start-up that specialized in USB 3.0 chips, and two hi-fi wireless audio companies.
As you can see, Microchip is a serial acquirer which is good as they have experience acquiring and extracting synergies from companies.
The trade war with China has hit the semiconductor industry along with the projected slowdown in China. Microchip is not immune to this as a large amount of its sales come from China and neighboring countries.
Sales to foreign customers account for a substantial portion of Microchip’s sales. During the first nine months of fiscal 2019, approximately 81% of their net sales were made to foreign customers, including 23% in China/Hong Kong, 14% in Taiwan, and 10% in Germany.
The application of trade restrictions or tariffs by the U.S. or other countries may adversely impact the industry supply chain. For example, the U.S. administration has recently increased tariffs on products that have China as their country of origin and which are imported into the U.S. Likewise, the China administration has increased tariffs on products that have the U.S. as their country of origin and which are imported into China. We have taken steps to mitigate the impact of these tariffs on our business; however, there remains a possibility of future tariffs imposed by the U.S., China or other countries. If the U.S. were to impose additional tariffs on components or equipment that we or our suppliers source from China, our cost for such components or equipment would likely increase. We may also incur increases in manufacturing costs in mitigating the impact of tariffs on our operations. This could also impair sourcing flexibility.
A resolution to the trade tensions between China and the US is a positive for the sector and Microchip stock. Steve Sanghi said on the latest conference call:
A settlement of trade would be a bonanza. Our customers and distributors are so cautious. There is low visibility. They're building bare bones what they need for the backlog from their customers. Nobody wants to get stuck with anything depending on what happens.
Good corporate governance would suggest a separation of Chairman of the Board and CEO positions, but with Steve Sanghi being the founder and the largest single shareholder, I don’t view this as a negative. His goals are aligned with the rest of the shareholders.
Steve Sanghi is the Chairman of the Board of Directors and Chief Executive Officer for Microchip. He is also the company's founder, and first president.
He was named the President of Microchip in August 1990, Chief Executive Officer in October 1991 and the Chairman of the Board of Directors in October 1993. Before joining the company, Mr. Sanghi was Vice President of Operations at Waferscale Integration, a semiconductor company, from 1988 to 1990. Mr. Sanghi was employed by Intel from 1978 to 1988, where he held various positions in management and engineering, the most recent serving as General Manager of Programmable Memory Operations.
He co-authored a book on the turnaround of Microchip titled, Driving Excellence: How the Aggregate System Turned Microchip Technology from a Failing Company to a Market Leader. The aggregate system encompasses all the internal and external workings of a company together rather than in isolation.
Barring any material negative development on the trade front, we see the March 2019 quarter to mark the bottom of the cycle for Microchip. We cannot yet say what the shape of the recovery would be, whether the recovery be V-shaped, U-shaped or L-shaped. That will depend somewhat on the outcome of the trade talks. What we do see a bottom forming and believe that the March quarter will mark the bottom for this cycle for Microchip.
This a bullish sign for Microchip and the industry. Mr. Sanghi’s predictions have been accurate before. He famously called a weakness in the U.S. housing market in July 2007 followed by calling the bottom to the ‘great recession’ in February 2009.
Debt was $10.54 billion in 3Q19, reduced from $10.9 billion in 2Q19 and from $11.4 billion in 1Q19. Microchip plans a 'rapid de-leveraging' via growth in free cash flow, which will be used to pay down debt, with a goal of attaining 2.5-times debt to EBITDA leverage. This could take 2-3 years to reach this target. I model the revolver being paid off in the middle of FY’21 which is what Microchip is paying off first. Net debt-to-EBITDA, excluding very long-dated convertible debt that matures in 2037, which is more equity-like in nature, is currently at 4.8x. The convertibles will most likely be in the money at maturity but can be settled with cash as to not dilute the holders of the stock.
Microchip’s short interest is around 15% of the shares outstanding while a direct competitor like Texas Instruments is around 2%. Could people really be that bearish on Microchip? The simple answer is no. Microchip has a lot of its debts in convertible notes as seen above. For example, the MCHP 1.625% 4/15/2025 note is in the money (converts to around $62.56 per share). The convertibles also have the Incremental Share Factors. A lot of convertible bond traders do not take a position in the stock and sell short their associated delta risk. This why the short interest is so high without the market being overly bearish on the company.
Analog Devices trades at 19x forward earnings with 2.31x debt/EBITDA. Most if its sales come from integrated circuits and the company does not sell MCUs (Microchip’s main product).
Marvell Technology produces analog, mixed-signal, digital signal processing, and embedded and standalone integrated circuits. It trades at 21x forward earnings and 5x debt/EBITDA.
Maxim Integrated designs, manufactures, and sells analog and mixed-signal integrated circuits. It trades at 21.5x forward earnings with 1x debt/EBITDA.
This is a direct competitor to Microchip’s MCU business. They separate out their MCU’s into business lines, with automotive taking the lion-share. It was a takeover target of Qualcomm but failed to win Chinese regulatory approval and the share price fell significantly. There was uncertainty around the business model going forward and it has lower gross margins (51.7%) which may explain why it trades cheaper.
ON Semiconductor manufactures analog, MCUs, DSP, mixed-signal and advanced logic chips. It is another serial acquirer. It trades at 11x forward earnings with a debt/EBITDA of around 2. Why does it trade so cheap? It has severely higher costs, its gross margins were 38% versus Microchip’s gross margins of 61.5%.
As of 2018, Renesas Electronics was the largest MCU seller. They are a direct competitor of Microchip. They are headquartered in Japan and trade in Yen. They report in IFRS versus US GAAP. Initial research shows they trade more expensive than Microchip with lower debt.
Silicon labs trades at a forward P/E of 20x with a 2.27x debt/EBITDA. 53% of its sales came from sales of IoT products like MCUs.
STM looks to be the cheapest multiple wise, but it’s not a direct comparable company. It is partially owned by the French & Italian governments and has a declining microcontrollers (MCU) business among other company specific issues but its analog business grew last quarter.
Texas Instruments trades at a higher forward P/E (18x) with low debt/EBITDA (0.67x). 75% of its sales were related to analog chips in 2018 and 25% of its sales were embedded processing (includes MCUs).
Xilinx mainly sells a broad range of FPGA which is the market that Microsemi operated in. It trades at a 36x forward P/E and 1.6x debt/EBITDA.
As seen above, Microchips trades cheap. I believe the this is the case due to its current inflated leverage. As Microchip pays down debt, you can expect P/E multiple expansion. I do not expect it to trade in-line with peers yet (18x-20x forward P/E), but it should trade higher.
Microcontrollers are used in a wide variety of electronics and has been growing in sales for Microchip as shown from the 2018 Microchip investor presentation.
My model assumptions start with 1% down QoQ in sales to account for the March “bottom” as called by Steve Sanghi. Going forward and adjusting for seasonality, I call for a growth rate of regional GDP multiplied by an additional 5% growth which I believe is modest considering the catalysts I have outlined.
You arrive at a $106 stock price. Historically, Microchip has traded at a three- and five-year forward P/E of 16.5x and 17x, respectively. I chose a 15x multiple to be conservative and reflect its current leverage. As Microchip pays down debt, I expect forward P/E multiple expansion.
With the PEG Model, you arrive at a $110 stock price. I used a 5 year growth rate of 15.53% after my model instead Yahoo! Finance estimates of 12.13% which I believe undervalues the company’s growth potential.
My DCF value arrives at a $313.26 stock price. My growth assumption of 3.5% is regional GDP multiplied by percentage of sales in that region. Obviously, $300 is high, but my assumptions aren’t extraordinary. All DCF’s models are highly sensitive to inputs. I don’t believe it’s the correct way to value Microchip.
After paying off excess debt, Microchip can pay a higher dividend. I believe they can increase the dividend substantially in FY23. I estimate Microchip will continue to increase the quarterly dividend by $.0005 until debt is paid down to manageable levels. I’ll use a 20% pay out ratio for FY23E earnings of $12.22 or $2.44. This payout ratio is less than the pre-Microsemi payout ratio of 26% to be conservative.
When finding the increase in working capital we ignore cash & near cash items because the change in cash is what we are calculating.
Increases in working capital drain a firm’s cash flows, while decreases in working capital increase the cash flows available to equity investors.
The working capital decreases so much year over year due to the integration of Microsemi. I used last quarters percentage of sales to extrapolate the future A/R, Inventory, and A/P.
The Constant growth FCFE Model suggests a $219 stock price. I put less weight in this model due to the assumptions necessary to formulate it. It is highly sensitive to inputs like the DCF model.
You could also do a sum of the parts (ex-Microsemi & ex-Atmel) valuation but in my view, it doesn’t make sense since there may be some inflated revenue numbers due to channel stuffing at Microsemi, and it’s a combined company now.
Some analysts also look at EV/EBITDA, but that wouldn’t make sense either in this case as Microchip took out significant debt to acquire Microsemi, temporarily inflating Enterprise Value.
I view price to forward earnings as the best method to value Microchip’s equity. My view that the stock should trade at $106 is based on a conservative 15x my estimated FY’20 earnings of $7.09. I chose 15x forward earnings to reflect the current balance sheet. Historically, Microchip has traded at a three- and five-year forward P/E of 16.5x and 17x, respectively. Microchip is committed to paying a dividend (22% payout ratio as of FY’19 Q3) and paying down debt with free cash flow. As they pay down debt, I believe you will see P/E multiple expansion. Semiconductor stocks are highly cyclical so there are risks, but with 28%+ upside (including dividends), I rate this as a convincing buy.
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.
Electronic Components Company, Electronic Chip Purchase - Xi Da,http://www.xida-electronics.com/