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Morningstar | Microchip Remains Well Positioned to Move Past Sluggish Near-Term Demand; Maintain $112 FVE

Microchip's fiscal second quarter was messy after its recent acquisition of Microsemi, but in our view, the company reported decent results. The firm's third-quarter forecast was predictably weak in light of sluggish chip demand in China, consistent with comments from peers in recent weeks. Nonetheless, we were encouraged that the firm's prior synergy targets were reiterated, if not called conservative. Despite soft near-term demand, and even though Microchip carries far more leverage than its peers, we continue to view these risks as more than priced into the firm's shares.

We're maintaining our $112 fair value estimate for wide-moat Microchip and continue to view it as one of our Best Ideas within Technology. Even if demand gets worse before it gets better, we see strong secular demand tailwinds in automotive and the Internet of Things for Microchip and see an attractive margin of safety for long-term investors.

Adjusted revenue in the quarter was $1.51 billion, just above the midpoint of the firm's previous guidance as discussed in July and far above prior-year and prior-quarter sales levels, as this was the first full quarter with Microsemi revenue. Adjusted gross margin of 61.7% was also ahead of guidance, but down about 50 basis points sequentially, causing adjusted operating margin to fall 60 basis points sequentially to 38.3%. We were encouraged that Microchip reduced its net debt by $315 million, and even with soft demand, we fully expect the firm to generate healthy cash flows to deleverage even further.

For the December quarter, Microchip expects adjusted revenue to fall 5%-10% sequentially with adjusted gross margins falling to 61.0%-61.5%. Microchip continues to see weak demand in China in the automotive sector (tied to fewer car sales). China industrial demand is also weak as Microchip's customers are cautious about its production plans due to tariff concerns, yet we still view these issues as cyclical rather than structural in nature.

We're pleased to hear that Microchip corrected the inventory issues that plagued the Microsemi business after its acquisition, as Microsemi appears to have offered discounts to distributors in order to pad sales and take on higher chip inventory than otherwise desired. Such issues weighed on Microchip's GAAP revenue, which was $81 million lower than adjusted revenue, as GAAP requires revenue to be reported on a sell-in basis, rather than sell through to end customers, that is, Microchip's adjusted revenue. Management noted the inventory issue as mostly completed, and we continue to view the Microsemi inventory issue as a short-term headwind that should have little effect on the health of the long-term business.

We also like that Microchip reiterated its synergy targets from the Microsemi deal, noting that adjusted EPS accretion in the September quarter was above its prior target of $0.15 and that accretion after the first 12 months of the deal will still come in at $0.75 or more. Microchip still targets $8.00 of adjusted EPS in the long-term; the company's prior target was to attain $8 in fiscal 2021 (ending March 2021), but we note the somewhat obvious caveat that industry demand needs to be in a healthy, midcycle or better demand environment (rather than a prolonged cyclical downturn). We continue to believe Microchip's $8 target is attainable, if not conservative, in fiscal 2021, as we assume a bounce back in demand to a midcycle environment.

On the downside, we note that Microchip was an early chipmaker that hinted at tariff-related demand concerns in China. Unfortunately, Microchip isn't ready to call the end of the cyclical slowdown in demand, stating that it doesn't foresee the other side of the cycle in the March quarter either. Tariffs and trade wars appear to be plaguing manufacturing activity, in turn weighing on new chip orders with Microchip as customers are pausing before building new factories, inventories of white goods and appliances, and so on.

Again, we view these issues as cyclical, rather than structural. We don't foresee Microchip losing existing customers in China as MCU design wins tend to be quite sticky. We've heard some investor concerns that, for new product designs, the U.S.-China trade war may lead to Chinese customers taking an anti-U.S. sentiment toward buying new microcontrollers, or MCUs, and perhaps moving away from U.S. firms like Microchip and toward European MCU leaders like STMicro, Infineon or NXP. Microchip does not appear to have faced material new design losses to date.