As the semiconductor boom turns, product and market exposure matters more, and that should be beneficial Micro chip (NASDAQ: MCHP) at least to some extent. Although the company doesn’t have a high-end data center or automatic exposure I believe will serve companies like Broadcom (AGO), Marvell (MERLEY), or all of them (ON) better over the next 12 months, Microchip has at least limited exposure to weakening consumer markets, as well as greater exposure to capacity-constrained specialty components such as MCUs and FPGAs.
Shares of Microchip have dipped since my last update, but still significantly outperformed the broader SOX index. Given the upside and market/product mix, I find Microchip more of a “middle option” between bullish names with more short-term vulnerability (like companies with high smartphone exposure) and companies with stronger short-term leverage in the data center or electric cars (Broadcom, et al). I like what I see as double-digit long-term annualized return potential going forward, and the valuation makes this a name to consider now.
Somewhat sector-typical quarterly performance, but better guidance
Microchip’s reported fiscal second quarter results were not that unusual compared to other similar companies NXP Semiconductors (NXPI) and onsemi, with revenue growth of more than 20% year-over-year and better margins, but Microchip stood out with its call for mid-single-digit sequential growth in the December quarter as many companies headed for sequential slowdowns.
Revenue grew 26% year-over-year and nearly 6% quarter-on-quarter, beating expectations. The MCU business appears to have outperformed the market with 32% year-over-year growth and 11% quarter-on-quarter growth (NXP, for example, reported 4% sequential growth, while business residential STMicroMCU operations at (STM) grew 9% quarter-over-quarter), while analog/mixed-signal grew 17% year-over-year and decreased 1% quarter-over-quarter.
Gross margin improved 240bp YoY and 60bp to 67.7%, beating 20bp. Operating income grew 39% year-over-year and nearly 9% quarter-over-quarter, with margin growing 740 bps. on an annual basis and 130 bp.
As I mentioned above, Microchip’s guidance delivered 4% sequential revenue growth, helped by a record backlog and continued industry constraints in many niche, cutting-edge products (such as automotive MCUs). It also certainly helps that Microchip has minimal exposure to today’s weakest markets — the PC and smartphone businesses make up less than 5% of Microchip’s revenue.
Markets matter, but keep inventories in mind
As I said, Microchip doesn’t have the high-end automotive and data center exposure that I find more attractive in some chip companies today.
The automotive market is important (about 15% of sales), but Microchip is not really used for battery/hybrid electric drives or ADAS. Still, the company has exposure to automation-enabled MCUs, which are becoming more common in new models, as well as connectivity and security products. Likewise, while the company has data center exposure (about 15% of revenue), it’s more of a “middle-of-the-road” exposure, and Microchip doesn’t have the high-performance hyperscale of switching, connectivity, or processing that Broadcom or Marvell do.
Industrial exposure is a mixed blessing. While I like the capabilities Microchip has in MCUs and FPGAs (as well as power management), I see a near-term slowdown in industrial automation and other electrification products. However, aerospace and defense should be a significant offset as the commercial aerospace industry continues to recover and defense projects accelerate in 2023.
Microchip’s inventory days accelerated significantly in the quarter, to 27 days on a year-over-year basis and 12 days on a quarterly basis, as availability improved. This puts inventory days above the long-term average (139 days vs. 120), but distributor days are still well below the long-term average (mid-30s).
Management acknowledged that lead times have started to come up in several areas and that the company has seen more pushback or cancellation requests, but the backlog is still at a record high, and more than half of that backlog is related to the company’s Preferred Supplier Program (or PSP ) – a program that gives customers the highest priority for availability in exchange for committing to long-term non-cancellable orders without the possibility of rescheduling.
The PSP program may also save Microchip from some short-term risk, but forcing customers to accept products in excess of their needs and build inventory isn’t exactly a risk-free proposition. I can see this leading to more pricing challenges and more caution on longer term orders; many automotive and industrial customers are trying to restock, but the forced build will simply end up leading to lower order levels and a delayed impact on finances.
Microchip’s management talked about the risk of permanent (or at least long-term) capacity constraints for specialized, cutting-edge products, and they’re not the only company to cite this risk. Fabricators are investing huge resources in flagship nodes, but there is still growing demand for specialized chips built on 28nm or larger architectures. I expect someone will recognize and take advantage of this opportunity, but I see a real risk of problems with the more expanded capacity, and it makes sense for management to consider building its own 300mm fab for specialty cutting-edge products in light of the CHIPS Act incentives.
I still expect long-term revenue growth here of around 6%, which is above my baseline long-term growth assumption for the chip sector. I think margins are likely to plateau and decline over the next few years, but over the long term, I expect the company’s adjusted FCF margin to improve from the low to mid 30% to high 30%. , leading to high single-digit FCF growth.
The bottom row
I believe Microchip stock is undervalued between the discounted cash flow and margin-oriented EV/revenue and EV/EBITDA approaches. I see double-digit long-term total annual return potential from here and see shorter-term potential up to $70. I see the risk of further cuts to sellers’ estimates and price targets in a sector correction that not all analysts seem to be modeling yet, but I think Microchip will fare better than most. It is risky to buy in cyclical downturns and investors should understand the risk that the bottom is not yet reached, but for patient investors who can handle some shorter-term losses on paper, this is a must-have name given.