Market's Too Tough on Microchip

We view other revenue headwinds, such as lower demand from bitcoin customers, lost business at ZTE, and the ramifications of a passive component shortage, as near-term bumps that don’t concern us long term. Perhaps more important, the company continues to see long-term synergy and cross-selling opportunities from Microsemi, which has made its prior fiscal 2021 adjusted earnings per share target of $8 appear “conservative,” consistent with our long-term thesis that Microchip and its exemplary management team will extract greater profitability from Microsemi.

All in, we are maintaining our $112 fair value estimate for wide-moat Microchip. The shares traded down after the earnings release, probably because of the short-term revenue commentary. Although the forecast (at the midpoint) was in line with our prior expectations, it missed Street estimates by about 5%. The tariff issue bears watching, just as it does for the health of the global economy, but otherwise, we view the short-term sell-off as another long-term buying opportunity in a high-quality, broad-based chipmaker with excellent exposure to secular tailwinds in the automotive sector and the Internet of Things.

Microchip’s adjusted revenue was $1.22 billion in the first quarter, in line with the company’s updated guidance given May 31 upon closing the Microsemi acquisition, and up 21% sequentially and 25% year over year as it includes one month of revenue from Microsemi. Adjusted gross margin rose about 50 basis points sequentially to 62.2% as higher-margin Microsemi products were brought into the mix. Adjusted EPS of $1.61 exceeded management’s revised guidance, mostly due to a lower ongoing cash tax rate.

For its fiscal second quarter, Microchip expects adjusted revenue of $1.47 billion-$1.55 billion. Microchip only provided adjusted revenue estimates and did not provide a GAAP revenue forecast, as the company disagrees with recent accounting rules that require it to report revenue on a sell-in basis to distributors, rather than its longtime policy of recognizing revenue on a sell-through basis once the chips are delivered to end customers. Further, Microchip found that Microsemi’s prior leadership team had encouraged the latter company to stuff the distribution channel with inventory--sometimes offering pricing discounts to do so--thus inflating near-term revenue. Microchip intends to eliminate this practice of offering discounts to distributors in order to take on more inventory, which is likely to lead to GAAP revenue headwinds through fiscal 2019 as the company ultimately sells more chips to end customers (sell-through) than into the distribution channel (sell-in).

Looking at true end-market demand, Microchip cited four factors that led to the midpoint of its adjusted revenue guidance of $1.51 billion coming in about 5% short of the prior consensus estimate of $1.58 billion. In Microchip’s words, none of these factors should be material in isolation, but when combined, they will lead to the expected shortfall.

First, shortages of passive components have caused some customers to fail to manufacture enough goods, in turn leading to fewer orders of Microchip’s semiconductors that go into such devices. We expect this shortage to persist through 2018. However, we don’t believe these shortages will weigh on true long-term demand for Microchip’s products.

Second, Microsemi lost revenue that would normally go to ZTE, a company that was banned from buying parts from U.S.-based companies. ZTE is a roughly 1% customer for the combined company.

Third, some of Microchip’s parts are used in bitcoin mining as they surround the graphics processing units and application-specific integrated circuits used in processing. The cryptocurrency’s crash has led to reduced demand, again to the tune of about 1% of revenue, per management.

Fourth, and by far the most concerning, in our view, was softening demand due to concerns about tariffs and a trade war, particularly in China. Microchip’s products are not at issue, as few semis are manufactured in China and imported into the United States. However, the company’s customers may feel the pain of tariffs. Microchip didn’t cite any specific end customers or products at risk, except to say that automotive demand has not been hit thus far, but given its broad customer base, we can’t rule out the company facing some softness down the line. Microchip did not explicitly foresee the issue worsening in the months ahead, but we note that the business typically faces seasonal headwinds in the December quarter as a result of fewer manufacturing days during the holiday season.

On the basis of both the revenue headwinds and the inventory correction to soon occur with Microsemi’s products, Microchip forecast a 60-basis-point reduction in gross margins to 61.6% at the midpoint. However, we note that the company’s adjusted EPS guidance met consensus estimates (as well as ours), which will probably come from prudent operating expense management and a lower ongoing tax rate.

Taking the long-term view of the Microsemi deal, we were quite pleased to hear that management sees a couple of its prior targets (fiscal 2019 adjusted EPS accretion of $0.75 and fiscal 2021 adjusted EPS target of $8.00) as conservative. Both estimates struck us as conservative at the outset of the merger, but as we expected, Microchip’s management team has gone to work in identifying opportunities for cost savings and margin improvement. Cited examples include the reduction of discounts given to distributors on the revenue side and a detailed look at the manufacturing efficiency of Microsemi’s fabs on the product cost side. For operating expenses, Microchip has reduced costs by replacing Microsemi’s top leadership (as expected), intends to better integrate Microsemi’s previously acquired businesses (these various chip units within Microsemi were running 21 different enterprise resource planning systems), and will reduce Microsemi’s “luxury” perks such as corporate suites at sporting events and extravagant sponsorships. These are exactly the types of measures Microchip undertook in prior acquisitions, and we have little doubt that its record of finding similar ongoing synergies will continue as it integrates Microsemi.

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