MCHP - Microchip Technology: Well-Positioned For A Smooth And Soft Landing

Summary

• Microchip Technology Incorporated enjoys growing top line and supported with high quality backlogs.
• The company maintained growing margins with improving efficiency in its total operating expenses.
• Microchip Technology enjoys growing free cash flow despite its growing CAPEX budget.
• The firm is appealing because to its long-term strategy to return 100% of free cash flow to shareholders through dividend payments and share buybacks.
• Microchip Technology is trading at a logical support and it remains fundamentally steady, making the stock an appealing buy-on-fear candidate.

Microchip Technology Incorporated ( MCHP ) provides a comprehensive portfolio that is tailored toward the delivery of smart, connected, and secure control software solutions. In addition, they are well-known for their synergistic product line-up, which benefits from today’s digitalization. One of its main revenue contributors is its Microcontroller product line, which analysts predict will continue to expand despite a possible recession. In fact, management remains firm that the demand environment will remain strong this year.

With its consistently expanding top line and its growing operating margin, Microchip Technology Incorporated is demonstrating some resiliency once again. Furthermore, the company has substantial backlogs, which will aid MCHP in managing a soft landing during the expected recession this year. Lastly, MCHP is still stable at its core, which makes it an attractive buy-on-fear stock.

Company Overview

MCHP's double-digit year-over-year top line growth of 25.66% recorded in fiscal Q2 '23 is evidence of the company's resilience. Additionally, MCHP posted diluted EPS of $0.98 this quarter with an outstanding 127.91% YoY growth. Despite today’s challenging operating environment, MCHP managed to record an all-time high gross margin (Non-GAAP) of 67.7% and to snowball into its record operating margin (Non-GAAP) of 46.9% this quarter. Interestingly, despite the Semiconductor market's expected slower growth in 2023 compared to 2022, MCHP continues to have positive topline revisions and no downward revisions, as seen in the image below.

This is due to the favorable demand condition and their record backlog, as quoted below.

Demand continued to be strong despite the capacity increases we have been implementing for some time now. As a result, our unsupported backlog which represents backlog customers wanted ship to them in the September quarter but which we could not deliver in the September quarter, climbed again. And we exited the September quarter with our highest unsupported backlog ever, with unsupported backlog well above the actual net sales we achieved. Source: Q2 2023 Earnings Call Transcript

Furthermore, as stated below, Microchip Technology Incorporated remains transparent and assures the quality of their total backlog.

So it starts with having high-quality backlog. And PSP being a high percentage of our backlog, well over 50%, is the highest-quality backlog. It is noncancelable. Source: Q2 2023 Earnings Call Transcript

Furthermore, the enacted CHIPS Act of 2022 is a favorable stimulus for MCHP. According to management, they will continue to grow their capacity, which will enhance the company's top line and margin, as cited below.

For a very long time, an important component of our business strategy has been to own and operate a substantial portion of our manufacturing resources, including wafer fabrication facilities in the U.S. This strategy enables us to maintain a high level of manufacturing control, resulting in us being one of the lowest-cost producers in the embedded control industry. In light of this strategy and potential grant funding from the CHIPS Act, the investment tax credit provision as well as state and local grants and subsidies. Source: Q2 2023 Earnings Call Transcript

As a result, management anticipates ongoing revenue growth, as seen in the image above. This is supported by record-high and quality backlogs, as well as expanding capacity. Furthermore, management plans a growing CAPEX amounting to $500 million to $550 million in FY23 for the purpose of additional manufacturing capacity development.

Controlled Margin And Cash Flow

Microchip Technology Incorporated is one of the few companies in the industry to maintain a growing operating margin. In fact, this quarter, the management forecast a growing adjusted operating margin of 46.9% to 47.3% in Q3 ‘23. On top of this, MCHP shows efficiency in its total operating expense ratio, as shown in the image below.

This operating efficiency snowballed to an improving free cash flow margin of 32.9%, up from 32.3% recorded in Q2 ‘22. This allowed MCHP to return 57.5% of its free cash flow, and the management expects to return 60% of its free cash flow in FY '23, as stated below.

In the December quarter, we will use the September quarter's actual free cash flow of $682.9 million and plan to return 60% or $409.7 million of that amount to our shareholders. Of this $409.7 million, the dividend is expected to be approximately $181 million. Source: Q2 2023 Earnings Call Transcript

Furthermore, as management plans to pursue its 300-mm fab project, they reassured investors that there will be no major impact on its share buyback and dividend payment.

Relative Valuation

Peers: ON Semiconductor ( ON ), STMicroelectronics N.V. ( STM ), Infineon Technologies AG ( IFNNY ), NXP Semiconductors N.V. ( NXPI ), Analog Devices, Inc. ( ADI )

MCHP is selling at a trailing P/E ratio of 21.34x and a trailing EV/EBITDA ratio of 12.56x, which is slightly higher than the average of its peers, as seen in the image above. However, when we look at MCHP's historical data and evaluate its 5-year average of 99.51x and 17.52x, we can see that there is a significant discount to consider. With an outstanding gross margin of 66.52% and a net margin of 24.14% performance, I believe MCHP remains attractive in comparison to its peers.

At an implied P/E of 16.71x and an implied EV/EBITDA of 10.42x, and utilizing analysts' estimates of EPS of $5.94 and EBITDA of $4,188.80 million in FY '23, we can come at an average blended fair price of $83 as of this writing. This offers decent upside potential, but with a recession on the horizon, I think it would be better to scale in slowly or wait for a better entry point.

Trading Near Its Support

As illustrated in the chart above, MCHP broke its multi-month resistance trendline in November of last year. As of this writing, MCHP appears to be appealing near this trendline, which is presently functioning as its immediate support. This is especially true considering its psychological support indicated by its 20- and 50-day simple moving averages. When looking at its MACD indicator, it stays above the zero line, indicating that bulls are still in charge. If the MACD prints a bearish crossover, I believe its 200-day moving average will operate as a solid support to monitor.

Key Risk

In addition to the anticipated slowdown in the semiconductor sector and the expected recession this year, which may negatively impact its future top line, MCHP posted concerning days in inventory ratio.

Our inventory balance at September 30, 2022, was $1.03 billion. We had 139 days of inventory at the end of the September quarter which was up 12 days from the prior quarter's level. Source: Q2 2023 Earnings Call Transcript

As a result, in uncertain times, this might have an impact on its gross margin and company's overall profitability.

Final Key Takeaways

On top of its growing EPS, Microchip Technology Incorporated managed to improve its trailing book value per share amounting to $11.10, up from $10.63 recorded in FY ‘22 and $9.76 in FY ‘21. Thanks to its focus to deleverage, in fact, the company lower down their total debt to $7,335.6 million, better than its 5-year average of $7,983.22 million, this snowballed into its improving debt-to-equity ratio of 1.20x better than its 5-year average of 1.52x.

Finally, with its expanding free cash flow and improved trailing EBITDA $3,622.1 million, MCHP may see additional improvement in its net debt of 1.84x this quarter, putting it in a good position to achieve its long-term goal of returning 100% of free cash flow to shareholders. This makes Microchip Technology Incorporated attractive and well-positioned for a soft and smooth landing.

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