Description

Microchip Technology is an incredibly high-quality, well-run business with approximately 40% upside to fair value, and good chances of greater upside from continuing to make accretive acquisitions in a consolidating industry with secular growth trends.

Background:

Microchip is a leading manufacturer of specialized semiconductor chips for embedded control applications. The company’s products are the brains that run a host of everyday devices. For example, they make the microcontrollers that run smart refrigerators and smoke detectors and thermostats and microwaves and aircraft avionics and automotive sensors and touchscreen pads and Bluetooth radios, and thousands more.

Microchip has very diverse customer exposure with over 120,000 customers and no more than 2.5% of sales coming from any single customer. These customers span a broad variety of industries:

While Microchip may sound like just another manufacturer of cheap, commodity semiconductors, the reality is much different.

Microchip is high-quality:

Microchip’s products are designed specifically for their end application. The company claims that 98% of their products are not swappable for a competitor’s, and these products have very long lives of 10-20 years, after a 2-3 year design-in period -- far longer than the typical semiconductor life cycle. For example, the chip running the smoke detector in your home, or the touchpad on your washing machine is designed for that specific application, and the company that makes the product isn’t switching for another chip supplier next year just to save another few pennies. This customization makes for high switching costs, and “embeds” Microchip in its relationships with customers, leading to very attractive returns.

Further driving the sticky relationship Microchip has with its customers is the company’s total system solution strategy--which it calls Microchip 2.0--that has emerged as the company has successfully acquired many other related, specialized semiconductor companies over the past 20 years. With a portfolio of over 10,000 products now, Microchip has become more and more of a one-stop shop for its end customers. In addition, Microchip has built significant software and training tools that make it easier for its customers to create package solutions. This ecosystem is a driver of significant value to customers, and has helped drive sales growth and market share gains.

The quality of the company is seen across multiple dimensions, from its history of improving margins and returns on invested capital, to its resiliency to the underlying semiconductor cycle as well as to economic downturns, to its success in making accretive acquisitions.

Here is their trend in returns on tangible invested capital:

While Microchip is not immune to the semiconductor cycle or to economic downturns, the company remained highly profitable even during the great financial crisis, and has consistently improved its profitability with every cycle. Consider the following comment by President and COO Ganesh Moorthi, in Feb of 2018:

I think the difference is in how we manage through the cycles, right. We make sure that we don't get a large overhang during an up cycle that then creates major inventory issues in the other side of the cycle. We make sure that our expenses have a significant amount of flexibility and variable expenses to make sure that we don't have huge layoffs and expense reduction that needs to be done. And through it all, if you go back and look at, absent the acquisitions which kind of change things, if you look at our ongoing gross margin performance, our ongoing operating expense performance and our operating profits, we've managed through the worst of the worst, even in the global financial crisis of 2009. If you go back and look at our operating margins, our operating margins at the lowest point were over 20%.

While operating margins may have dipped close to 20% in the global financial crisis, they are far higher now, in the mid-to-high 30s, during a dip in the semiconductor cycle that has impacted many companies in the space. Microchip just recently projected that the current quarter will represent the bottom of the cycle we are in now. (As a side note, Microchip has acquired a reputation for correctly calling the beginning and end of the semi cycle for many years.) Note what CEO Steve Sanghi said about margins in Feb of 2019:

In the current quarter, we're guiding towards 61.5% gross margin, 35% operating profit. I think those numbers are higher than the prior peak, so the bottom of this cycle is higher than the peak of the last cycle.

For context, the company’s long-term target margins are 63% for gross margins, and over 40% for operating margins, so even in the middle and possibly end of a painful down cycle, the company is able to maintain high profit margins, not far from its long-term targets, and higher than its prior peak.

This theme of constant improvement is also seen in the company’s strong track record of integrating acquisitions. Ganesh Moorthi elaborated on this in Feb of 2018:

Every acquisition we've done so far has a gross and operating margin that is lower than Microchip, right. And the goal is that we can buy an underperforming asset and be able to improve it. So, soon after an acquisition, our gross and operating margins do decline as a combined company. And then we go on that relentless phase of improving all aspects of the company. Most of the acquisitions that we've done, the large public company acquisitions, when we buy them, the operating margins are in the mid-single-digit to higher single-digit kind of range. When we're finished with them, they're all with a three-handle at least… from an operating margin standpoint. It doesn't happen by chance, it's a lot of hard work, a lot of work that we have honed in over the years… And you can go back and look at us over 20 years of time, we've had higher highs and higher lows in terms of where the profitability of the company has gone and on a consistent path to growth and higher profitability over that timeframe.

Through this path of integrating some 18 acquisitions over the past 10 years, the company has vaulted up the rankings in market share:

The company added Microsemi Technology last summer, its biggest acquisition to date, and has reported it is already made substantial progress and is ahead of schedule in delivering its targeted synergies.

While the company plans to focus on paying down the debt it used to acquire Microsemi for the next couple years, it is likely that consolidation will continue, and that Microchip will have future opportunities for additional accretive acquisitions. Ganesh Moorthi commented in Sept of 2018:

The fundamental forces that are driving M&A haven't really changed and those forces are that the rate of growth available in the market as we've grown to be such a large industry, is not sufficient for many companies' goal to what they want to be able to achieve. And so, a component of inorganic growth, along with organic growth, is what companies have been driving towards. And those who have been unwilling to make those moves, even when they're large and profitable, have become the targets of being acquired as well. And so, I think, we are still in that phase… You can go back and look at what happened in the pharmaceutical industry, the automobile industry, the hard disk drive industry, the PC industry, over a course of when the consolidation begins. In every one of those, you can fairly reliably plot that over a 15-year period of time, consolidation largely brings it down to the final 10, 15 type of players that are left behind... And I think, the semi industry is on that – if you plot it, we're exactly on that same slope... And there's probably another 5 to 10 years of consolidation left... I don't believe M&A is going away... It's a fundamental force for the industry for many years to come.

Microchip’s long product lives and sticky customer relationships, high and positively trending returns on invested capital, resilience to economic and industry cycles, and history of successful acquisitions all underscore what a high-quality company it is.

Growth opportunity:

Not only is Microchip a high-quality company, it has good growth prospects. Before acquiring Microsemi, the company targeted 7-9% organic revenue growth, driven by 3-5% industry growth that was augmented by market share gains. Industry growth is expected to be slightly higher than GDP growth because small chips and sensors are getting embedded in more and more objects around us every day -- for example, the “internet of things” -- and by long-term secular growth in data storage and communications end markets.

The addition of Microsemi, which comprises about 30% of combined company sales, moderates the company’s growth prospects slightly, as Microsemi is more of a mid-single-digits organic grower. While the company hasn’t issued new long-term growth guidance for the combined company, they have affirmed their 7-9% target for core Microchip growth. Blending the existing growth rates for core Microchip and Microsemi, and not assuming any revenue synergies though these are likely, still results in a company with very attractive growth potential.

Why is it cheap?

Last summer, right after closing on the company’s acquisition of Microsemi, Microchip announced a major disappointment. They found that Microsemi had stuffed the channel to exaggerate their sales ahead of the acquisition. CEO Steve Sanghi commented in the company’s August earnings call, “While we have seen some excess shipments of inventory into the distribution channel in other acquisitions, we have never seen as much excess as we found in the case of Microsemi.” This surprise was a temporary setback, as the company said it would be able to clear those inventories within a couple of quarters, and that their confidence in the medium-to-long term prospects for Microsemi was unabated. However, this disappointment led to the stock falling 11% that day, and the forward multiple compressing from 14x to 11.5x over the next couple weeks.

Then Microchip got caught up in the selloff of semiconductor stocks, as well as the selloff in value stocks, as was seen across the market last fall.

While Microchip is affected by the semiconductor cycle, it is much more tied to the overall economy than to the semiconductor space. Microchip is not the classic, high capital intensity semiconductor company that tends to overbuild along with competitors to chase market share, and then must produce at a loss to keep expensive fabs open, thus experiencing extreme cyclicality. Its plant to sales is 20% compared with over 70% for Intel. With over 120,000 customers across many end markets, its health is much more a reflection of the overall economy than the state of the semi cycle, though its stock price may be driven by the market’s views on the semiconductor space.

In addition to the downdraft caused by the semiconductor space, last year was a divergence from the long-term trend of cheap stocks outperforming expensive. In fact, last year was the mirror image opposite, as valuation had an inverse correlation with market returns. As a relatively inexpensive stock, Microchip was likely affected by this pressure. As a value investor, I believe last year was the anomaly, and that the long-term outperformance of inexpensive stocks will continue.

Valuation:

To estimate fair value for MCHP, I assume the company hits its guidance for $8.00/share of earnings in fiscal March 2021, and grows sales at 5% thereafter, and reaches its target of 40.5% operating margins, and then uses a portion of cash flow to buy back shares to generate low double-digit earnings growth of approximately 12%. I conservatively assume no further acquisitions, even though the company has explicitly said they plan to continue acquiring if deals meet their requirements. My low double-digit earnings growth assumption compares to the company’s 20-year history of generating 14% earnings growth, and a 5-year history of 20%. With a solid track record and prospects for growth substantially higher than the market, I believe MCHP should trade at a premium to the market. If I assume the company only earns a single turn above the long-term market average, despite significantly higher growth prospects, and discount that another year forward (17.5x one-year forward discounted to 15.6x two years forward), I reach a rough estimate of fair value of $125, just over 40% above current prices.

Risks:

Material exposure to cyclical industries such as automotive, data center, communications, aerospace and defense. I believe this risk is tempered by a trend toward increasing electronic content, but a downturn in any of these industries would impact Microchip.

General economic risk. As I have argued, Microchip is more tied to the overall economy than to the semiconductor cycle. When we have another recession, Microchip will be impacted.

Leverage. The company has levered up significantly to acquire Microsemi (currently at 4.2x net debt/NTM ebitda). Leverage is always a risk and it compounds others, such as the above two. Microchip has committed to using all available free cash flow to pay down debt until it is down to around 2.5x, and with the company's substantial cash flows, is able to reduce leverage by about one turn per year.

Catalyst

Continued execution on integrating Microsemi and delivering forecast synergies.

A recovery in the semiconductor industry, which Microchip has forecast likely to occur after the current quarter.

Continued organic growth. A company's earnings trajectory always wins in the long run. If Microchip continues delivering sustained earnings growth, its multiple will eventually reflect intrinsic value.