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Morningstar | Microchip Sees Potential for a Bottom in Latest Chip Industry Downturn; Maintain $112 FVE

Microchip Technology reported predictably soft fiscal third-quarter results that were in line with our expectations. The far bigger news, in our view, is that the company believes the latest chip industry downturn is forming a bottom in the March quarter. Management believes that chip demand in China is not getting any worse at the moment, as customers and distributors are ordering well below consumption because they do not want to be stuck with excess inventory in the event of a full-blown trade war. Barring a further escalation of the trade tensions (say, if 25% tariffs on $200 billion of goods are actually implemented March 1), Microchip foresees a recovery in chip demand in China at some point down the road, even calling it a "bonanza" for the company if a trade deal gets done.

Microchip has long been considered a canary in the coal mine for chip demand, given its broad base of 120,000-plus customers and a history of being relatively accurate with its predictions, including being one of the first chipmakers to call the latest downturn in China a few months ago. In this case, we note that STMicro, a microcontroller rival, also provided similar bullish commentary two weeks ago, so green shoots may actually be appearing this time around. Such comments give us even greater confidence that Microchip will ultimately weather this latest chip industry storm, and we continue to view the firm as fundamentally undervalued. We will maintain our $112 fair value estimate for wide-moat Microchip and consider it one of our Best Ideas in the technology sector.

Microchip's adjusted revenue in the December quarter was $1.42 billion, down 6% sequentially but in line with previous guidance as chip demand in the quarter played out as expected for the firm. Despite lower sales levels, adjusted gross margins actually rose about 50 basis points to 62.2%, and the firm continues to extract attractive synergies from its acquisition of Microsemi.

For the March quarter, Microchip forecasts GAAP revenue of $1.251 billion-$1.403 billion, a rather wide range but an understandable one as the firm is now required to report revenue on a sell-in basis (rather than sell-through to end customers) and faces uncertainty in the buffer of chip inventory sold to middlemen like distributors. On a GAAP basis, at the midpoint, the forecast implies a 3.5% sequential decline.

More important, Microchip believes that chip demand in China is forming a bottom, as the pause in orders is not getting any worse. The company cannot predict the pace of any recovery (that is, a snapback in demand or a long road to prior sales levels) and did not offer broad macroeconomic commentary on the state of the world. However, the firm believes that its customers and distributors have paused their manufacturing activity and the building of new factories as much as possible. A trade settlement may lead to a shot in the arm for manufacturing activity in China, as factory build-outs and manufacturing activity may resume. Given Microchip's broad customer and product breadth, any uptick in demand bodes well for revenue growth.

We are also encouraged that Microchip has already achieved its targeted synergy run rate of $0.75 of EPS from the Microsemi merger. We've long believed in Microchip's exemplary management team and its strong record in generating better-than-expected synergies upon completing acquisitions, and Microsemi is playing out in line with our thesis. We still view the U.S.-China trade spat as the lone (albeit large) issue that can derail Microchip from exceeding its prior target of $8 of adjusted EPS in fiscal 2021 after the merger with Microsemi.