Microchip Technology Standing Out As The Cycle Turns (NASDAQ:MCHP)

As the semiconductor boom rolls over, product and market exposure matters more, and that should benefit Microchip (NASDAQ:MCHP) at least to some extent. While the company doesn't have the high-end data center or auto exposure that I believe will serve companies like Broadcom (AVGO), Marvell (MRVL), or onsemi (ON) better over the next 12 months, Microchip does at least have limited exposure to weakening consumer markets, as well as stronger exposure to capacity-constrained specialized components like MCUs and FPGAs.

Microchip shares are down since my last update, but have nevertheless meaningfully outperformed the broader SOX index. Given the outperformance and the market/product mix, I find Microchip more of a "middle option" between beaten-down names with more near-term vulnerability (like companies with high smartphone exposure) and companies with stronger near-term leverage in the data center or EVs (Broadcom, et al). I like what I see as double-digit long-term annualized return potential from here, though, and the valuation makes this a name to consider now.

A Somewhat Sector-Typical Quarterly Performance, But Better Guidance

Microchip's reported fiscal second quarter results weren't so unusual compared to peers like NXP Semiconductors (NXPI) and onsemi, with revenue up more than 20% year over year and better margins, but where Microchip stood out was with its call for mid-single-digit sequential growth in the December quarter, as many companies have been guiding to a sequential slowdown.

Revenue rose 26% yoy and almost 6% qoq, just beating expectations. The MCU business appears to have outgrown the market, up 32% yoy and 11% qoq (NXP, for instance, reported 4% sequential growth, while the business housing STMicro's (STM) MCU operations grew 9% qoq), while Analog/Mixed Signal rose 17% yoy and declined 1% qoq.

Gross margin improved 240bp yoy and 60bp to 67.7%, beating by 20bp. Operating income rose 39% yoy and almost 9% qoq, with margin up 740bp yoy and 130bp qoq to 46.9%, beating by 90bp.

As I mentioned above, Microchip management guided to 4% sequential revenue growth, helped by a record-high backlog and ongoing industry constraints in many specialized trailing-edge products (like auto MCUs). It also certainly helps that Microchip has minimal exposure to the weakest markets today - PC and smartphone business makes up less than 5% of Microchip's revenue.

Markets Matter, But Mind The Inventories

As I said, Microchip doesn't have the high-end auto and data center exposure that I find more attractive with some chip companies today.

The auto market is important (around 15% or so of sales), but Microchip isn't really leveraged to battery/hybrid electric powertrains or ADAS. Still, the company does have exposure to automation-enabling MCUs that are becoming more common on new models, as well as connectivity and security products. Likewise, while the company does have data center exposure (around 15% of revenue), it's more "middle of the road" exposure, and Microchip doesn't have that high-performance hyperscaler leverage in switching, connectivity, or processing like Broadcom or Marvell.

Industrial exposure is a mixed blessing. While I like the opportunities that Microchip has in MCUs and FPGAs (as well as power management), I do see a near-term slowdown in industrial automation and other electrification products. Aero and defense, though, should be a meaningful offset as commercial aerospace continues to recover and defense projects accelerate in 2023.

Microchip's inventory days accelerated significantly in the quarter, up 27 days yoy and 12 days qoq, as availability improved. That puts inventory days above the long-term average (139 days versus 120), but distributor days are still well below the longer-term average (in the mid-30's).

Management acknowledged that lead-times have started to come in a few areas, and that the company has seen more requests for pushouts or cancellations, but the backlog is nevertheless at a record and more than half of that backlog is tied to the company's Preferred Supplier Program (or PSP) - a program that gives customers top priority for availability in exchange for committing to long-term non-cancellable, non-reschedulable orders.

The PSP program may well spare Microchip from some short-term risk, but making customers take product in excess of their needs and build inventory isn't exactly a risk-free proposition. I could see this leading to more pricing challenges and more caution with longer-term orders; many auto and industrial customers are trying to rebuild inventories, but forced builds will just eventually lead to lower order levels and a delayed impact on the financials.

The Outlook

Microchip management has talked about the risk of permanent (or at least long-term) capacity constraints for specialized trailing-edge products, and they're not the only company to point to this risk. Fabs have been investing huge resources into leading-edge nodes, but there's still growing demand for specialized chips built on 28nm or larger architectures. I expect that somebody will recognize and exploit this opportunity, but I do see a real risk of more extended capacity issues and it makes sense that management is considering building its own 300mm fab for specialized trailing-edge products in light of the CHIPS Act incentives.

I'm still expecting long-term revenue growth here in the neighborhood of 6%, which is above my underlying long-term growth assumption for the chip sector. I do think that margins are likely to plateau and decline over the next couple of years, but over the long term I expect the company's adjusted FCF margin to improve from the low-to-mid-30%'s into the high-30%'s, driving high single-digit FCF growth.

The Bottom Line

Between discounted cash flow and margin-driven EV/revenue and EV/EBITDA approaches, I believe Microchip shares are undervalued. I see double-digit long-term total annualized return potential from here, and I see nearer-term potential into the $70's. I do see a risk of further cuts to sell-side estimates and price targets on a sector correction that not all analysts seem to be modeling in yet, but I do think Microchip will hold up better than most. It's risky to buy into cyclical downturns, and investors have to understand the risk that the bottom hasn't been reached yet, but for patient investors who can deal with some shorter-term paper losses, this is a name to consider.

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