Tanaonte/iStock via Getty Images
Tanaonte/iStock via Getty Images
Writing about Microchip Technology (NASDAQ:MCHP) a year ago, I was concerned more about the eventual shift in investor sentiment on semiconductor stocks than any fundamental issues with Microchip. Indeed, while Microchip continues to execute at a high level, the shares have lagged the SOX since that last update, and I do still see some risk to sell-side estimates as industry capacity eventually catches up to still-hot demand.
I like Microchip’s strategic shift to a focus on leveraging its broad capabilities across a range of markets, a move that should drive better sustainable margins and stronger cash returns to shareholders. What I don’t like as much is the relatively more modest leverage to faster-growing sub-markets, as well as the sour market sentiment on this sector. Mid-to-high single-digit revenue and FCF growth can support a decent high single-digit long-term return here, but there are cheaper names with better leverage to end-markets I like better.
One of my ongoing concerns remains the company’s lack of leverage to some of the faster-growing areas of the semiconductor market like EVs, automation, IoT, and so on.
“Lack of leverage” is relative, but management themselves believe that about one-third of growth over the next few years will come from faster-growing end-markets like EVs, 5G, IoT, datacenter, et al. With that, I find management’s guidance from the November 2021 Analyst Day to be interesting on a couple of levels.
Given the proliferation of chips virtually everywhere, I think management’s implied industry growth rate of 3% to 4% may well prove to be too low – I’m expecting something more in the neighborhood of 5%, with increasing chip content in areas like autos, communications, industrial, and medical complemented by new market opportunities like data center, AI/machine learning, IoT and so on.
By the same token, substantially exceeding industry growth rates could prove more challenging. I think Microchip has underappreciated leverage to opportunities in niches like EV charging, connectivity, and PCIe switching, but Microchip doesn’t have the same sort of leverage to discrete power growth as Infineon (OTCQX:IFNNY), ON Semi (ON), or STMicro (STM), nor the sort of leverage to areas like battery management as Analog Devices (ADI) or NXP Semiconductors (NXPI). ADAS is likewise an under-leveraged category for Microchip, and while the company has a strong MCU business (and the opportunity to offer a range of compute technology including high-end MCU and FPGA), it has never been particularly strong in the auto space.
I’m likewise not blown away with the company’s leverage to datacenter, as it’s largely driven by storage products, lacking the leverage to switching/routing, power management, or custom ASICs of other companies.
IoT will be a very interesting market to watch. Management expects low-to-mid-teens growth here, and the company has a robust portfolio of offers across compute (everything from 8-bit MCUs to 64-bit MCUs and FPGAs), timing/synch, power management, and wireless. The company isn’t as strong in wireless, though, as rivals like Silicon Labs (SLAB) or Texas Instruments (TXN), and this may be an area where the company looks for tuck-in deals.
Although I don’t think Microchip has the most robust revenue growth outlook of the MCU/analog space, I do see other positives in the company’s strategy.
I like that the company is actively engaging with smaller companies and getting design wins here – I believe one of the risks of TI’s shift away from distributors and toward direct customer engagement is that smaller players may get overlooked and take their business to customers like Microchip.
I also like the company’s Preferred Supplier Program (or PSP). In exchange for making orders non-cancellable, Microchip agrees to prioritize those orders in its production queue. PSP has proven popular enough to constitute over half of the company’s backlog, but I’ll be curious to see how this holds up once customers have the inventory they need – will they abide by those non-cancellable orders, or will this follow the trend of cycles past where supposedly non-cancellable orders could ultimately be canceled with little-to-no consequence to the customer?
Last and not least, I’m a fan of management’s strategy to focus on “total solutions” offerings – making the full breadth of its capabilities available to customers and actively working with them for optimal product designs. Microchip is one of the strongest players in both MCU and analog, and can bring a lot to the table, including mid-range FPGAs and complementary memory products, and there’s a long history here of designing products to work as complementary components.
Within this focus, management has signaled that its days of empire-building M&A are over – future deals will be smaller and more focused on tuck-in technologies/capabilities, and I would expect software to feature more prominently in those deals. Management is also working to build up its internal manufacturing capabilities; Microchip isn’t reinvesting in capacity to the same degree as TI (which will see capex climb to more than 10% of revenue) but is still expecting a significant increase from around 3%-4% of revenue to perhaps up to 6% of revenue.
Microchip has been a net share gainer in MCUs, but I would like to see a little more momentum on the highest ends of the market (32-bit and above). Even so, I like the strong leverage to both MCU and analog here, as well as the prospect of very strong gross margins (high 60%s) and operating margins (mid-40%s) as the company looks to that total solutions strategy to drive improved share-of-wallet with customers and improved margin leverage.
I don’t expect Microchip to outgrow the industry by 2x, but that’s largely because I have a higher expectation for industry growth – my modeling estimates lead to a long-term growth rate that’s just a bit short of the midpoint of management’s 6%-8% target. I am looking for solid margin leverage, though, and I believe adjusted FCF margins can climb into the high 30%s over time driving high-single-digit FCF growth.
Discounting those cash flows gives me a total annualized long-term return potential in the high-single-digits, a potential return that is finally more reasonable relative to what most leading players in this sector have offered over the last couple of years. Margin-driven EV/revenue and EV/EBITDA give me a near-term target more in the high $70s to low $80s.
Similar to my concerns in a recent article on Texas Instruments, my main concerns on Microchip today are leverage to growth categories (EVs, et al) and sentiment on the semiconductor sector as lead-times shrink, inventories build, and margins weaken – shares in this industry usually underperform when that happens. On the other hand, this is a high-margin leader in MCUs and analogs, and well-placed to leverage healthy chip volume growth over the next decade. With other chip stocks offering more upside, I’m not tempted to buy in today, but this is a good name for a watchlist today.
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