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Morningstar | Microchip's Long-Term Earnings Remain Promising Despite Near-Term Sales Concerns; Maintain $112 FVE. See Updated Analyst Note from 09 Aug 2018

Microchip's fiscal first-quarter earnings report and second-quarter forecast was noisy and eventful, as the firm incorporated its recent sizable acquisition of Microsemi, noted strategic steps to improve this newly acquired business and cited a handful of headwinds with various near-term implications for short-term revenue for both the combined Microchip and, perhaps, for many other broad-based chipmakers. We are mildly concerned that management was cautions about chip demand associated with products wrapped up in worldwide tariff negotiations, although we note that the guidance doesn't imply that sales are falling off a cliff any time soon. For a firm that is often considered a "canary in the coal mine" for semis, however, tariffs may loom as a growing concern for the industry in the months ahead. We view other revenue headwinds, such as lower demand from Bitcoin customers, lost business at ZTE and the ramifications of a passive component shortage, as near-term bumps that don't concern us long term. Perhaps more important, the company continues to see long-term synergy and cross selling opportunities from Microsemi, which has made the firm's prior fiscal 2021 adjusted EPS target of $8 per share appear "conservative," consistent with our long-term thesis that Microchip and its exemplary management team will extract greater profitability out of Microsemi. All in, we will maintain our $112 fair value estimate for wide-moat Microchip. Shares traded down 7% after hours, likely due to the short-term revenue commentary. Although the forecast (at the midpoint) was in line with our prior expectations, it missed Street estimates by about 5%. The tariff issue bears watching, just as it does for the health of the global economy, but otherwise, we view the short-term sell-off as another long-term buying opportunity in a high-quality, broad-based chipmaker with excellent exposure to secular tailwinds in the automotive sector and the Internet of Things.

Microchip's adjusted revenue was $1.22 billion, in line with the firm's updated guidance on May 31 upon closing of the Microsemi acquisition, and up 21% sequentially and 25% year over year as it includes one month of revenue from Microsemi. Adjusted gross margin rose about 50 basis points sequentially to 62.2% as higher-margin Microsemi products were brought into the mix. Adjusted EPS of $1.61 exceeded management's revised guidance, mostly due to a lower ongoing cash tax rate.

For the September quarter, Microchip expects adjusted revenue in the range of $1.47 billion-$1.55 billion. Microchip only provided adjusted revenue estimates and did not provide a GAAP revenue forecast, as the firm disagrees with recent accounting rules that require the firm to report revenue on a sell-in basis to distributors, rather than the firm's longtime policy of recognizing revenue on a sell-thru basis once the chips are delivered to end customers. Further, the firm found that Microsemi's prior leadership team encouraged the company to stuff the distribution channel with inventory (sometimes offering pricing discounts to do so), thus inflating near-term revenue. Microchip intends to eliminate this practice of offering discounts to distributors in order to take on more inventory, which will likely lead to GAAP revenue headwinds through fiscal 2019 as Microchip ultimately sells more chips to end customers (sell-thru) than into the distribution channel (sell-in).

Looking at true end market demand, Microchip cited four factors that led to the midpoint of its adjusted revenue guidance of $1.51 billion coming in about 5% short of the prior consensus estimate of $1.58 billion. In Microchip's words, none of these factors should be material in isolation, but when combined, will lead to the expected shortfall. First, shortages of passive components have caused some customers to fail to manufacture enough goods, in turn leading to fewer orders of Microchip's semiconductors which go in to such devices. As we discuss in our June 21 note on passive component leader Murata in Japan, we expect this shortage to persist through 2018. Yet longer term, we don't believe these shortages will weigh on true long-term demand for Microchip's products. Second, Microsemi lost revenue that would normally go to ZTE, a company that was banned from buying parts from U.S.-based firms, and ZTE is a roughly 1% customer for the combined firm. Third, some of Microchip's parts are used in bitcoin mining as they surround the GPUs and ASICs used in processing, and the cryptocurrency's crash has led to reduced demand, again to the tune of about 1% of revenue, per management

Fourth, and by far the most concerning, in our view, was softening demand due to concerns about tariffs and a trade war, particularly in China. Microchip's products are not at issue, as few semis are manufactured in China and imported into the U.S. Yet Microchip's customers may feel the pain of tariffs. Microchip didn't cite any specific end customers or products at risk, except to say that automotive demand has not been hit thus far, but given the company's broad customer base, we can't rule out the company facing some softness down the line. Microchip did not explicitly foresee the issue worsening in the months ahead, but we note that the business typically faces seasonal headwinds in the December quarter due to fewer manufacturing days due to the holiday season.

Based on both the revenue headwinds and the inventory correction to soon occur with Microsemi's products, the company forecast a 60 basis point reduction in gross margins to 61.6% at the midpoint. However, we note that the firm's adjusted EPS guidance met consensus estimates (as well as ours), which will likely come from prudent operating expense management and a lower ongoing tax rate.

Looking at the long-term view of the Microsemi deal, we were quite pleased to hear that management views a couple of its prior targets (fiscal 2019 adjusted EPS accretion of $0.75 and fiscal 2021 adjusted EPS target of $8.00) as conservative. Both estimates struck us as conservative at the outset of the merger, but as we expected, Microchip's management team has gone to work in identifying opportunities for cost savings and margin improvement. Cited examples include the reduction of discounts given to distributors on the revenue side and a detailed look at the manufacturing efficiency of Microsemi's fabs on the product cost side. For operating expenses, Microchip reduced costs by replacing Microsemi's top leadership (as expected), intends to better integrate Microsemi's previously acquired businesses (as these various chip units within Microsemi were running 21 different enterprise resource planning systems) and will reduce Microsemi's "luxury" perks such as corporate suites at sporting events and extravagant sponsorships. These are exactly the types of measures Microchip undertook in prior acquisitions, and we have little doubt that its track record of finding similar ongoing synergies will continue as the firm integrates Microsemi.

In turn, we note that, at a recent share price of $91, Microchip is trading at roughly 14 times our fiscal 2019 EPS estimate and only 11 times its "conservative" fiscal 2021 EPS estimate of $8.00.