MCHP - Microchip: Why The Market Gave A Thumbs Down After A Record-Breaking Quarter

2023-08-11 14:29:21 ET

Summary

• MCHP broke a number of records in its latest report, but the stock dropped as the report contained some worrying developments.
• MCHP has been on a record-breaking pace for the last three years, but it’s worth asking how much of the growth was due to real demand.
• There is a case to be made that MCHP is in much less of a strong position despite all the records set, depending on how much demand was inflated.
• MCHP can recover in the long term from a downturn, but, in the short term, the risk is skewed towards lower sales, EPS and stock prices.

Microchip ( MCHP ) did much to help please shareholders with the release of the Q1 FY2024 report on August 3. Similar to prior earnings reports, the word "record" featured prominently in the Q1 report with revenue, gross margin, operating income and GAAP EPS all reaching record highs. MCHP also raised its dividend by 36% to $0.41. However, the stock still sold off the day after. Why will be covered next.

Many new records were set in the Q1 FY2024 report

MCHP has been on a record-breaking streak for the last three years. For instance, the last time quarterly revenue was less than the preceding quarter was in 2020, back when COVID-19 caused all sorts of disruptions to businesses. This did not change in the latest report. Q1 FY2024 revenue increased by 2.5% QoQ and 16.6% YoY to $2,288.6M, the eleventh consecutive sequential increase in quarterly revenue and a new record high. The table below shows the numbers for Q1 FY2024.

GAAP EPS increased by 34.4% YoY to $1.21 and non-GAAP EPS increased by 19.7% YoY to $1.64. Note that stock buybacks contributed to the increase with MCHP spending about $140M to buy back 1.8M shares in Q1, which caused the weighted-average of shares outstanding to drop to 551.4M, 10M less than a year ago. This is set to continue with about $2.5B remaining out of the $4B MCHP committed to stock buybacks in 2021.

MCHP finished with cash and short-term investments of $271.2M and long-term debt of $4,632.2M on the balance sheet, down from $5,041.7M in the preceding quarter. Remember that MCHP used to sit on a lot more debt, especially after the 2018 acquisition of Microsemi that carried an enterprise value of $10.15B. MHCP has focused on paying down debt and, as a result, debt has been reduced by about $6.8B in the last five years.

Source: MCHP Q1 FY2024 report

The tide is changing

Q1 FY2024 was undoubtedly a strong quarter with many new records set. However, if the outlook is any indication, Q1 FY2024 may have been the top. Guidance calls for Q2 FY2024 revenue of $2,220-2,312M, an increase of 9.3% YoY, but also a decrease of 0.99% QoQ at the midpoint, which would make it the first sequential decrease in 12 quarters. The forecast expects GAAP EPS of $1.18-1.21 and non-GAAP EPS of $1.60-1.64, which are both up YoY, but down QoQ at the midpoint.

MCHP is suggesting the record-setting streak is likely to come to an end. MCHP may be about to see something it has not seen in years, which is contraction instead of growth. Management therefore provided some color as to what is driving the change. In a nutshell, while MCHP can still count on a backlog, demand is getting weaker, particularly in China, pushing up inventories and causing customers to pull back on orders from MCHP. From the Q1 FY2024 earnings call:

"Now for some color on the June quarter. While our overall business remains steady, our customers continue to feel the effects of slowing economic activity and increasing business uncertainty. Starting in early June, we saw business conditions deteriorate in three areas.

First, our China business was much weaker than our expectations and has not recovered from the shutdowns of last year and the Lunar New Year holidays in the March quarter. This manifested in weak sell-through activity and the building of inventory in the distribution channel in China.

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.

And third, we are seeing early signs of an impending slowdown in Europe, exacerbated by some of our European customers being dependent on exports to countries like China, whereas we know that the business environment is much weaker than expected.

As a result, we continue to receive requests to push out or cancel backlog as customers start to rebalance their inventory in light of the weaker business conditions and increased uncertainty they were experiencing. We were able to push out meaningful amounts of non-reschedulable backlog to later quarters to help many customers with inventory positions."

A transcript of the Q1 FY2024 earnings call can be found here .

The chart below shows how the stock lost about 7% in response to the latest updates from MCHP on August 3, which is not long after the stock hit an all-time high of $94.30 on July 31. Still, MCHP has tripled in value since the March 2020 low of $26.58. The stock has risen in the last three years with a temporary interruption in 2022 when the entire semiconductor sector sold off, primarily due to changing macro conditions with the Federal Reserve embarking on monetary tightening after years of loose monetary policy.

This rally in the stock was enabled by strong growth in both the top and the bottom line during this time. As mentioned before, quarterly revenue increased sequentially for 11 straight quarters. Quarterly revenue grew by almost $1B from $1,310M in September of 2020 to $2,289M in June of 2023. During this same period, GAAP EPS jumped from $0.14 to the record high of $1.21 in the latest report.

Note that this growth spurt was preceded by a couple of years with little to no growth. For instance, quarterly revenue was rather flat from $1,330M in March 2019 to $1,310M in September 2020, a span of seven quarters. Keep in mind that MCHP acquired Microsemi in 2018 and the lack of growth in combination with a heavy debt toll to service put MCHP in a precarious position.

This became even more so when COVID-19 caused all sorts of problems for the U.S. economy, and MCHP by extension. In fact, things got so bad that MCHP was forced to ask its employees to take a pay cut, a clear sign of a company in financial distress. A past article from 2020 goes deeper into the precarious position MCHP found itself in at that time.

How much of the growth in the last three years at MCHP was due to real demand?

However, MCHP believed the bottom was in as growth was starting to pick up fast in the latter part of 2020, which paved the way for the record-breaking growth of the last three years. Keep in mind though that this growth took place under extraordinary circumstances, made possible by the COVID-19 pandemic or more specifically the global response to the pandemic.

This response included trillions of stimulus, fiscal and monetary, in the U.S. alone, let alone the rest of the world. All this had a positive impact on spending, including on the consumer side, as much stimulus found its way back to people's wallets. This consumer spending lifted demand for all sorts of products, including those that rely on semiconductor chips such as the MCUs and other types of chips that MCHP provides.

The question that comes to mind is whether the record-breaking growth in demand that MCHP experienced in the past three years was mostly the end result of this artificial boost in demand. Remember that MCHP was not growing prior to the introduction of the stimulus in the wake of COVID-19, so whatever caused growth to take off, it came at an excellent time for MCHP.

This is not to say all the recent demand growth was due to stimulus. For instance, there is a real need for more automotive-grade MCUs and that demand growth is likely to be real. At the same time, it's possible most of the growth in the last three years was not primarily the result of an increase in real demand, but the consequence of one, the artificial increase in consumer demand due to massive stimulus and second, the inventory building of semiconductor chips due to possible supply chain disruptions caused by COVID-19. Both could cause sales and thus earnings to spike.

This would help explain why MCHP is now beginning to see weaker demand in places like China as mentioned in the earnings call earlier. The reason why demand has not returned to previous levels and is unlikely to do so anytime soon is because of the absence of the stimulus that raised chip demand in the last few years. Ditto for inventory building as COVID-19 has been brought under control, which means there is less need on the part of companies for additional inventories to protect against the possibility of production being negatively affected by supply chain disruptions.

It also has important implications for MCHP. If demand was artificially increased and real demand is not as high as once believed, then MCHP may be in for a period of contraction. Customers of MCHP would need to adjust to lower demand and they will need time to get rid of excess inventories build up in the preceding years, which could keep demand sluggish for some time to come.

Investor takeaways

Some could argue long MCHP is still worth it. Guidance still calls for a solid YoY increase in sales and EPS and, while down QoQ, they not far removed from the record highs. While MCHP may experience soft demand in the short term, long-term demand still looks promising, especially for things like automotive-grade MCUs. MCHP has earned $6.30 in terms of non-GAAP in the last 12 months, which gives MCHP a P/E ratio in the low-to-mid teens with the stock priced at $84.06 as of August 9. Some might say that does not look so bad.

However, while valuations may not seem unreasonable now, they could become so if earnings collapse along with demand. Keep in mind that MCHP posted non-GAAP EPS of $0.66, or $1.32 before the 2021 stock split, on revenue of $1.29B in the December quarter of 2019, the last quarter prior to COVID-19. While real demand has most likely increased since then, it's not impossible for MCHP to return to those numbers, depending on how much demand was inflated.

If a downturn causes the numbers to shrink and MCHP earns something along the lines of $0.66 per quarter or $2.64 on an annual basis, then MCHP would trade with a multiple in the thirties with the stock where it is. Such a multiple would be much less to people's liking, causing them to sell and the stock to fall.

While MCHP has done outstanding in the last three years, its performance should be viewed with at least some caution. There can be little doubt trillions of stimulus increased demand for semiconductor chips, although one can debate the extent to which it happened. Without this artificial raising of demand, MCHP would likely not have seen sales and EPS grow as much as it did in the last three years. Remember how MCHP struggled from 2018 to 2020 with little to no growth, prior to the arrival of COVID-19. It's entirely possible the COVID-19 stimulus was the real driver of demand.

I am neutral on MCHP. MCHP has a very diverse portfolio with many products for sale and MCHP has a shot at growing over the long haul, but in the short term, the stock could very possibly trade significantly lower, especially with the stock not far from the record highs, depending on how much demand was inflated in recent years.

It's difficult to pin it down, but if demand was mostly real and only inflated by a small amount, then the downturn that MCHP seems to be alluding to could be a relatively short one. But if most of the demand growth in 2020-2023 was inflated, then MCHP could be in for several years of contraction as the bubble gets deflated. The recent weakness that MCHP is seeing in the market could be the consequence of an economy beginning to feel the effects of the withdrawal of unprecedented stimulus.

Bottom line, MCHP is suggesting demand is going down and sales and EPS will likely go along, which will put pressure on the stock that has been riding higher on the back of record-setting growth in the last three years. MCHP can recover in due time, but in the short term, the risk is skewed towards sales, earnings and the stock price all going down. Shareholders may want to prepare accordingly.

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