MCHP - Microchip Technology: Business To Bite The Bullet For Weak H2 2024

2023-10-05 02:33:53 ET

Summary

• Microchip Technology is transitioning to a more standard supply and demand environment after benefiting from a strong backlog of microcontrollers.
• The recommendation for MCHP is a hold rating due to expectations of weak performance in the near term.
• While the outlook is negative, there is a potential upside if the broader economy experiences significant growth.

Summary

I am recommending a hold rating for Microchip Technology ( MCHP ), as I expect the near-term (2H24) quarters to be very weak performing. The weak performance will certainly impact share price sentiment, especially if the downcycle impact is larger than the market expects. In light of this, we recommend that potential investors stay on the sidelines and evaluate the situation again when we have more information on where the trough is. As timing is important here, I am holding off finding the “price target” for MCHP until management shares more insight.

Business

Embedded control solutions, such as microcontrollers and memory products, are among MCHP's many specialties. After merging with Microsemi in 2018, MCHP was able to significantly increase its product offerings and market share. Because of this merger, MCHP's revenue jumped from around $3.4 billion before the merger to $8.4 billion in FY23, a significant increase. The combined business was able to increase its EBIT margins by an astounding 18pts between FY17 and FY23 as a result of economies of scale. During this same period, EPS also exhibited impressive growth, with a CAGR of 29%.

Financials / Valuation

MCHP saw a 17% increase in revenue in 1Q24 , totaling $2.29 billion. The company also reported a non-GAAP gross margin of 68.4% and non-GAAP EPS of $1.64. By division, MCHP's sales increased by 24% in the MCU sector to $1.31 billion, by 20% in the Analog sector to $695 million, and by -13% in the Others sector to $281 million.

Based on my outlook on the business, I believe the business is at best fair valued in the near term. I am modeling a very generous assumption for FY24 (flattish growth), giving MCHP the benefit that the bulk of normalization impact will come in 2H24. Suppose 2H24 negative decline nets off the positive 1H24 growth, I believe the stock is worth $75 at 13x forward PE. MCHP is currently trading at 13x forward PE, which I expect to remain at this level as the market should already be expecting a decline in the near term (management is effectively communicating to the investing community). However, I would note that the stock could see further downside if the normalization impact is a lot larger than what I expected (this is hard to quantify).

Comment

MCHP is returning to a more typical supply and demand environment after several quarters of a robust backlog for microcontrollers, which served as a cushion during a period of slowing macroeconomic conditions. This means that deliveries will closely mirror consumer needs. Since shipments are currently adjusting to the lower demand in the market, I am pessimistic about the near future. In addition, many of MCHP's clients across different application sectors are sitting on unusually high stockpiles (refer to 1Q24 earnings transcript ). As a result of all of these factors working together, I see MCHP in a situation where cyclical demand is low, customer inventory levels are high and is going to comp against an exceptionally successful period in the past few quarters. Also, with such strong and fast growth over the past few quarters, there is reason to believe that the downturn will be more severe than normal. If events play out as I expect, it could have a negative impact on investor sentiment in the second half of 2024.

This year, we expect that our normal seasonality in the December quarter will likely be amplified by the macro weakness and business uncertainty that our customers are experiencing. Source: 1Q24 earnings

My belief above can be well inferred and seen in the 1Q24 results. In early June, management noticed a gradual decline in performance due to weaker-than-anticipated growth in China, the automotive and industrial sectors, and Europe. In line with their comments, management has provided forward guidance of a 1% sequential decline for 2Q24 and an even larger than seasonal sequential decline for 3Q24. Further confirmation of near-term weakness can be seen from the tech conference that management attended. Note that the date of the conference is September 6, which means management already has 2 months' worth of data for 2Q24. At the conference, management restated their previous comments about the gloomy short-term demand outlook, pointing to the continuing slowdown in China and, to a lesser extent, in Europe. They also mentioned how customers still wanted to be pushed back, bookings were slow, and lead times were becoming more typical. Notably, management also reaffirmed that the December quarter is predicted to see a larger drop in revenue than is typical for the period. With this much information in the bag, I believe it is wise to avoid this incoming freight train and wait for a better time before investing.

Second, we started to see initial signs of weakness and uncertainty in the automotive and industrial segments, reflecting the impact of high inflation and high interest rates driving more cautious spending.

We're going to see some of that weakness in China, but we'll also see some of the weakness in Europe when their exports are not quite that. Source: 1Q24 earnings

If you're one of the many investors betting on MCHP's ability to raise prices to compensate for a drop in volume, you might like to know that the company has been doing just that for the past few years. Management indicated at the tech conference that future prices may remain relatively unchanged. However, there are many knobs that management can turn, so I anticipate a smaller decline in earnings than revenue. Employee bonuses, which have been on an upward trend, were cited as a potential source of savings if the economic climate were to worsen.

And we do not want to be in the business of raising prices on our customers on a regular basis. It's very disruptive to them. Source: Goldman Sachs Communacopia & Technology Conference

Risk & conclusion

I think it is inevitable that revenue and earnings will fall from here. The potential upside risk is that the entire economy goes into a massive bull run for whatever reason, thereby driving up underlying demand. This would certainly push out the downcycle, leading to positive stock price momentum in the near term.

In conclusion, I recommend a hold rating for MCHP due to my pessimistic outlook for its near-term performance in the second half of 2024. The company, which specializes in embedded control solutions, experienced a significant revenue increase after its merger with Microsemi in 2018 but is now facing challenges as it transitions to a more typical supply and demand environment. With lower demand in the market and many of MCHP's clients holding high levels of inventory, the company is likely to encounter a more severe downturn compared to typical cycles. Management's guidance and comments confirm this outlook.

While there is a potential upside risk if the overall economy experiences a significant upturn, driving increased demand, I advise potential investors to stay on the sidelines for now and wait for more information on the depth of the downturn before considering investment.

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