TXN - Differentiated Exposures Still Serving Microchip Technology Well

Summary

• Microchip posted a beat-and-raise quarter and a time when many peers are reducing guidance, and management believes they can post sequential growth through the June quarter.
• Differentiated exposure to supply-constrained auto/aero/industrial MCUs and mid-range FPGAs is benefiting Microchip today, but managing customer orders and pricing will be challenging.
• Trailing-edge capacity is likely to remain limited for many of Microchip's products, but there is a risk that Microchip sees a cyclical correction as others are returning to growth.
• Mid-to-high single-digit growth can support a respectable return from here, and there could be more upside if the market is willing to treat recent (2021-2022) chip valuation parameters as the new normal.

It can pay to be different in the semiconductor space, and that has been the case for Microchip Technology ( MCHP ), as the company has done well on the back of lower leverage to weaker markets and stronger leverage to more supply-constrained key components (sometimes called "golden screws") like microcontrollers (or MCUs) and FPGAs. Microchip has likely also benefited from its policy of prioritizing customers willing to commit to more stringent policies regarding order scheduling and cancelation.

Up about a third since my last update , Microchip has done a little better than the broader chip space. As investors are getting more comfortable with the idea of a mid-2023 bottom (chip stocks have historically moved around six months before turns in the business), though, I have some concerns that Microchip could get surpassed by "first in, first out" peers that saw earlier declines in their business. I can still make an argument for Microchip's shares, particularly if the market is on its way to more normal/typical chip stock valuations, but it's no longer as much of a standout.

A Beat-And-Raise Quarter When That Has Become Rare Among Chip Stocks

The trend for most of Microchip's peers, and semiconductor companies in general, has been weaker guidance as inventory corrections among customers drive weaker orders and as improving availability (and weaker end-user demand) weakens pricing leverage. That hasn't been the case for Microchip yet, though, as the company continues to leverage comparatively longer lead times for trailing node MCUs and FPGAs in markets like aero/defense, auto, data center, and industrial.

Revenue rose 23% year over year and almost 5% quarter over quarter, good enough for a modest beat versus Street expectations. MCUs were healthy, with revenue up 26% yoy and almost 4% qoq, and better than STMicroelectronics ( STM ) on a sequential basis (up 4% versus up <1%). Analog and the Memory & Other categories were even stronger, with 6% sequential growth.

Gross margin improved two points from the prior year and 40bp sequentially to 68.1%, beating expectations by 20bp. Operating income rose 31% yoy and 6% qoq, beating by close to 2%, with margin up 290bp yoy and 60bp qoq to 47.5%, beating by 40bp.

The Good Times Are Still Rolling...

Unlike NXP Semiconductors ( NXPI ) or Texas Instruments ( TXN ), Microchip continues to see enough demand to drive sequential growth. To that end, the company guided for 2.5% qoq growth (at the midpoint), about 1.5% above the Street and well above the 7% and 9% sequential contraction expected by Texas Instruments and NXP, respectively, in the March quarter.

Management claims backlog coverage for sequential growth through June, but there are some signs of stress. Inventory is starting to rise, with inventory days up 13 days qoq to 152 and likely to hit 160 in March, though distributor channel inventories are still tight. Management has also acknowledged increased requests for order pushouts - despite Microchip (and other semiconductor companies) pledging that they would not relent on no-cancellation/no-reschedule policies, I always assumed that when push came to shove, these companies (the smarter ones, at least) would show some flexibility and work to accommodate at least some of their customers.

How Microchip's business decelerates from here will be interesting to watch. The company, and the industry, remain capacity-constrained at trailing nodes for certain higher-value applications like auto MCUs, though I believe weaker foundry demand for other applications/markets is freeing up some capacity. Lead times for auto and certain industrial MCUs have stayed higher for longer, but they're starting to correct, and Microchip's management expects lead times to move below 26 weeks in the second half of 2023 (roughly a one-third decline from here).

Between improving supply and flagging demand, not to mention likely weaker pricing leverage in 2023, there's a risk that Microchip will see its cycle correction begin as others are starting to pull out of theirs, leading to a risk of relative underperformance for the stock. I'm not entirely sure, though, that Microchip is going to see the same cycle as everyone else but just on a delayed timeline.

Auto production should be healthy in 2023, and particularly with new EV model launches. I also expect further recovery in aerospace, better demand in defense, and a relatively modest correction in industrial demand that could already show recovering demand and restocking later in 2023. There is a risk that Microchip mismanages demand (being too stringent/stubborn with order rescheduling/cancelation policies) and has more inventory to burn through, but the basic supply/demand conditions in Microchip's strongest areas (auto/aero/industrial MCUs, FPGAs, complex analog, and attached memory) could well mean that Microchip sees a less steep correction than its peers/rivals.

The Outlook

I found it interesting that the company has now decided that they don't need to build their own 300mm fab and that relying on foundries will serve them better. That's interesting because not that many fabs are prioritizing adding capacity at trailing nodes, and Texas Instruments seems more committed than ever to building and controlling more of its own capacity.

By and large, you do well to do what TI is doing, though of course these are different businesses. The risk here, then, is that TI could conceivably be in a position down the road to use capacity/availability to gain share - something they did successfully this last cycle (though not necessarily at Microchip's expense).

I've kept my revisions modest at this point, and I think Microchip will manage through the cycle without significant revenue correction - maybe a quarter or two of low-single digit sequential contraction. At this point, my numbers are a little higher than the average for FY'23, a little below average for FY'24, higher than the average for FY'25, and a bit below average for FY'26, and I can say that there's a wide range of opinions as to how Microchip's revenue will track from here - some analysts expect declines in FY'24 and FY'25 before a big rebound in FY'26, while others look for no year-over-year declines.

Long term, I'm still looking for revenue growth of around 6%. I'm feeling more comfortable with the margin outlook, and I think pricing for in-demand components like auto MCUs will sustain better gross and operating margins than I'd previously expected. I'm still looking for more than a point of contraction between FY'24 and FY'23, a mid-40%s operating margin is still quite healthy, as are long-term free cash flow margins in the mid-to-high 30%s (and high-single-digit FCF growth).

Discounted free cash flow suggests high-single-digit total long-term annualized return potential here, but the valuation gets more interesting when we move to the multiples. If you believe that the market is on its way back toward "normal" semiconductor valuations, a fair value in the $90s is no problem. If you believe the market will reinflate back toward more recent valuations (historically above average), valuations around $110 or higher start making sense.

The Bottom Line

I wouldn't buy Microchip counting on a $110 share price over the next 6 to 12 months, but there are still a lot of things working for the company. Even with the risk of being out of sync with its peers (and seeing its multiple shrink while others are reinflating), I think this is still no worse than a decent hold, even if there are chip stocks out there that appear to offer more upside.

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