MCHP - Microchip Technology: Key Player In Megatrends Priced At 12x EPS

2023-06-07 14:43:12 ET

Summary

• Microchip Technology Incorporated is an undervalued investment opportunity with strong growth prospects in the semiconductor industry.
• Its products are at the forefront of key technological advancements, such as 5G, IoT, and self-driving cars, making it an essential player in these rapidly growing markets.
• Bears raise concerns about Microchip Technology's slowing growth rate and abnormally high inventory levels, which could impact its valuation.
• However, I believe that paying 12x forward EPS for Microchip Technology stock offers investors an attractive risk-reward profile.

Investment Thesis

Microchip Technology Incorporated ( MCHP ) is one of the companies at the epicenter of the semiconductor slowdown. Indeed, WSTS forecasts that the semiconductor industry could shrink by as much as 10% this year.

However, I believe that's probably old news already, even as it gets printed today. Why? Because investors are already attempting to sniff out if the bottom is close and are seeking to look out to 2024.

I make the case that Microchip Technology stock is not expensive at approximately 12x forward EPS. The bull case is not without blemishes, but as a whole, I believe there are reasons to be optimistic.

Why Microchip Technology? Why Now?

Microchip Technology is a provider of microcontroller products that are broadly used in various industries, including automotive systems and consumer electronics.

Microchip creates smart and connected products that help make things work and are deployed in automotive and consumer electronics. Simply put, they provide the essential parts and technology that make these innovations possible.

Their products are crucial for megatrend technologies like 5G, IoT, and self-driving cars, thereby enabling secure and reliable functionality. Microchip plays a fundamental role in making these innovations a reality.

Revenue Growth Rates Are Expected to Slow Down, So What's Next?

Above we get to the crux of the argument for both bears and bulls. The bears are quick to note that fiscal Q1 2024 points to sub-20% CAGR. That's the slowest growth rate that Microchip has reported in the past 7 quarters.

Indeed, as you know, a company with slowing growth rates means a more compressed multiple on its valuation.

For their part, the bulls are quick to retort that the chip industry right now is in turmoil. This insight has been widely publicized, and I've noted it in my analysis in both Applied Materials ( AMAT ) and Lam Research ( LRCX ).

On the other hand, bears can make the case that Microchip's inventory days outstanding are now abnormally high.

During Microchip's earnings call , as you'd expect, this was a hot topic. This led Microchips' management to state:

We feel that we need to take actions to help ensure that our supply lines can feed our growth beyond what we expect in the June 2023 quarter. We are targeting actions to reduce our inventory down between five and 10 days in the June quarter.

That being said, the fact of the matter is that one can make the argument that they are attentive to the inventory build-up, but unless the inventory figure returns to a more normalized level of around 130 days outstanding, bears will continue to have ample ammunition.

On the other side of the argument, Microchip states that they are building long-lived high-margin inventory for the megatrends, meaning that there's less risk of obsolescence.

Here's a quote that highlights the impact of the megatrends end market on Microchip's prospects,

As compared to fiscal 2022, our industrial business grew from 40% to 41% of our revenue. Our data center and computing business grew from 18% to 19% of our revenue and our consumer appliance business declined from 14% to 12% of our revenue. Automotive and communications infrastructure remained unchanged at 17% and 11% of our revenue respectively. As you can see from the data, slowly but surely, we continue to curate an increasing proportion of our business towards less volatile and more resilient end markets.

And this insight is displayed here graphically:

Microchip is clearly well positioned for rapidly growing markets. And its exposure to this market continues to increase.

Profitability Profile Should Turn Around

Despite the build-up of inventory, Microchip's gross margins for the quarter ahead don't appear to be weakening. In fact, it appears that despite having less revenues to work with, Microchip's non-GAAP gross margins could even expand by 10 basis points sequentially to 68.4% at the midpoint.

Simply put, I believe that paying around 12x next year's non-GAAP EPS is far from an expensive valuation for Microchip Technology stock. Particularly compared with other areas of the market.

The Bottom Line

Microchip Technology Incorporated stock is undervalued and has strong prospects.

Despite the expected revenue growth slowdown, the company plays a crucial role in megatrend technologies like 5G, IoT, and self-driving cars.

The bears highlight the slowing growth rate and abnormally high inventory, while the bulls argue that the chip industry's overall turmoil and that Microchip's exposure to less volatile and resilient end markets is increasing.

Although profitability is affected by inventory build-up, gross margins are expected to remain stable or even expand slightly into the next quarter.

Priced at approximately 12x forward non-GAAP EPS, Microchip Technology Incorporated stock is now a cheap investment with strong potential in the next 12 months.

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