Microchip Technology: A Smart Chipmaker
During times of economic adversity, investors may shy away from semiconductor stocks because of perceived industry risks. Wild swings in companies' earnings, rapid product commoditization, and significant capital investment commitments may be too much to stomach during down cycles. Although we at Standard & Poor's Equity Research believe there are several appealing companies with this profile in our semiconductor coverage, we view a few less-publicized chipmakers as vastly different from the well-known semiconductor names. One such company is Microchip Technology (MCHP), which we believe exhibits steady and stable growth, offers notably less business risk than its industry peers, and even pays healthy dividends. Based on these criteria, and what we view as a compelling valuation, we strongly advise buying Microchip shares.
Microchip has not only been profitable every year over the past decade, but it has consistently increased earnings for most of those years. We believe this reflects the company's relatively stable product-demand environment and an exceptional sales and business model. By consistently increasing market share and expanding its already extensive end-customer base, which reached about 60,000 in fiscal year 2008 (March), Microchip has taken advantage of a microcontroller market that is characterized by long product cycles and stable growth. Having already shipped 6 billion devices, the company has wide exposure to many end-markets and geographies, leading to revenues that we calculate to be less variable than those of the broader semiconductor industry.
The company has become the share leader in the 8-bit microcontroller market, and has produced revenue growth that has, on a compounded average, outpaced that of the semiconductor industry. Microchip is now quickly penetrating the faster-growing 16-bit microcontroller unit (MCU) market, which is almost equivalent in size to the 8-bit MCU market, and is even aiming at the larger 32-bit MCU space. By assessing shipments of the company's development tools—used by potential customers looking to employ microcontrollers in their product designs—as a leading indicator of future sales, we think growth of Microchip's 16-bit MCU sales will follow a path similar to that of its successful 8-bit MCU products. The company's top-line has outpaced that of the applicable MCU market, which has generally grown by single digits in recent years. We see this trend of revenue outperformance continuing over the next couple of years.
Growth Without Volatility
We believe Microchip effectively manages its sales growth and operations, exhibited by operating margins that are consistently among the highest and most stable in our semiconductor coverage. Gross margins have widened every year since fiscal year 2002, reflecting what we view as favorable segment pricing, effective management of variable costs, and benefits from leverage of fixed manufacturing costs. Similarly, operating margins, adjusted for nonrecurring items, have expanded over 10 percentage points from fiscal year 2002 as the company has consistently and efficiently invested in high-return projects and extended its customer base while keeping a tight focus on expenses. We believe the efficient cost structure translates into competitive product pricing, and consequently, increasing sales opportunities, new customers, and contracts.
We also think Microchip's operations model, along with its sales levels, provides a profitable and less-variable growth profile, differing significantly from higher-profile chipmakers that tend to exhibit more volatile margins and earnings. This proficient model is one of the main reasons why the company can turn a modest, single-digit top-line advance into double-digit operating profit growth, by our analysis. We believe Microchip is on the verge of exceeding its long-term gross margin goal of 62% (currently around 61%), and is well on track to meet its operating margin target of 37% (near 32% now) over the next few years. We are modeling wider margins from better scale as sales rise, plant capacity achieves higher utilization, and more favorable average selling prices result from increasing penetration of 16-bit and 32-bit MCU markets.
In addition to our favorable view of growth and business risk, Microchip's return on equity, free cash flow generation, and return on invested capital all measure above those of many chip companies in our coverage. The company recently re-capitalized by adding long-term debt and in doing so, increased its financial risk compared to the industry. But given the company's profitability and cash flow, we do not think the added financial leverage is cause for concern. In fact, the added leverage has provided a higher return on equity, which is near the top of those in our coverage. Additionally, we do not think Microchip needs to invest heavily in expensive advanced capital equipment like microprocessor and memory chipmakers, so we expect relatively high returns on invested capital and more stable free cash flows over the longer term.
Given the aforementioned considerations, we believe that Microchip's shares are undervalued. In our opinion, the company's strong fundamentals merit premium relative valuations vs. the industry average. Economic uncertainty is of some concern, but given Microchip's customer diversification, we think company earnings will hold up better than its peers' and will accelerate at a faster pace than they did last year. Lastly, Microchip's 4%-plus dividend yield is one of the industry's highest.
Under the PIC name, Microchip, based in Chandler, Ariz., primarily offers a broad family of proprietary 8-bit, 16-bit, and 32-bit field programmable microcontrollers designed for applications requiring high performance, fast time-to-market, and user programmability. Microcontrollers are essentially the brains of various applications, and are used in a wide range of electronic devices such as toys, remote controls, appliances, and various automobile control systems, among many others. The company also offers high performance linear, mixed-signal, power management, thermal management, battery management, interface devices, and memory products. By main product lines, microcontrollers provided 80.4% of sales in fiscal year 2008 (80.2% in fiscal year 2007), memory products contributed 11.6% (vs. 11.8%), and analog and interface products added 8.0% (against 8.0%).
The company, which has shipped over 6 billion PIC microcontrollers since 1990, serves approximately 60,000 customers, with the 10 largest accounting for 9% of total revenue in fiscal year 2008. Foreign sales accounted for 75% of fiscal year 2008 net sales, up from 74% in fiscal year 2007. By major region, fiscal year 2008 sales came from Asia (43.8%), Europe (29.8%), and the Americas (26.4%). Approximately 20% of fiscal year 2008 sales were sourced from China, including Hong Kong, and Taiwan accounted for about 10% of sales. About 64% of net sales in fiscal year 2008 were made through distributors.
For a long time, Microchip operated two wafer fabrication plants in Arizona, but it consolidated operations into the newer facility in the spring of 2003. This main production plant has been operating at high utilization rates, which have supported gross margin expansion and better profitability. The older, former manufacturing facility is still an integral part of the company's campus and is being used for wafer-probe, mask-making, and other manufacturing-related activities. In August 2002, the company bought a wafer fab in Gresham, Ore., and started ramping production there in the fall of 2003. Microchip states that both plants should have sufficient capacity to handle future demand. For back-end operations, Microchip performs assembly and test operations at its facilities in Bangkok, Thailand, and outsources the remainder to various Asian contractors.
We have a neutral fundamental outlook on the semiconductor industry, and have a cautious growth view. We anticipate that revenues will be supported by solid computer growth from consumer purchases of laptops and enterprise replacements. We also believe sales will benefit from projected accelerating growth of higher-end wireless handsets, which generally carry more chip content per phone. The use of semiconductors in products is proliferating, which could help balance possible unit growth deceleration in other application end-markets. However, we caution that eroding average selling prices (ASPs) for memory and microprocessor semiconductors could impede the industry's growth. Whereas aggressive capacity expansion led to oversupply issues last year, notable ASP deterioration and continuing macroeconomic weakness could conceivably lead to reduced demand for goods that contain semiconductors over the near term, causing higher inventory levels and further ASP deterioration. With low memory prices and consumer spending uncertain, we think there are substantial risks to industry growth.
According to data gathered by the Semiconductor Industry Assn. (SIA), annual sales growth averaged 16% from 1975 through 2000. Worldwide chip sales growth was 18% in 2003 and 28% in 2004, but has been in the single-digit range since 2005. We project a 4% advance for 2008, compared with the SIA's 4.3% forecasts for this year. With our sales growth projection, and reasonably high industry plant utilization rates, we think chipmakers will benefit from more favorable operating leverage, leading to healthy earnings growth. We also think year-over-year growth comparisons will be aided by relatively weak results in 2007, when the industry faced excessive inventory levels and dramatic memory-price deterioration. In the long term, as top-line growth is expected to slow, we see more tempered variability and cyclicality in margins, leading to more stable profits and less risk.
Given current economic and market conditions and relative valuations that are generally above those of the market, we remain cautious on the industry's overall valuation. Semiconductor stocks are cyclical, and can continue to fall if the economy and stock market weaken. Although the group has large international exposure and strong balance sheets, shares have fallen notably since the beginning of the year.
Given our cautious industry outlook and the current downturn in the stock market, we think that semiconductor companies such as Microchip—which has stable growth, large international exposure, and a lower risk profile—will outperform the industry over the near term.
Our 12-month target price of $38 is based on a blend of our price-to-earnings (p-e) and price-to-sales (p-s) analysis. Applying a 20 multiple to our fiscal year 2009 EPS estimate of $1.70, we derive a price target of $34. This earnings multiple is below the company's historical p-e average, but above the peer-based average of about 17. We think this premium is justified, given our inclusion of stock option expense, which reduces our forward EPS estimate by approximately 9%, and our view of notable earnings growth on less margin variability, compared to peers. We anticipate above-industry, high-single-digit sales growth over the next couple of years, with steady margin expansion as the company continues to effectively leverage fixed costs to benefit profitability, all leading to even higher operating profit growth. With a lower diluted share count following a large recent share buyback, we think annual EPS will increase at a double-digit pace this fiscal year.
Applying a 7 multiple to our forward 12-month sales per share estimate of about $5.90, we obtain a value of $41. We used a sales multiple slightly below the historic average of around 7.5 to account for the company's larger sales levels and what we see as near-term economic uncertainty. Nonetheless, we believe that Microchip's well-diversified end-market exposure, market share lead in the 8-bit microcontroller market, long product cycles, and little dependence on any single customer for a substantial percentage of revenues should help reduce major swings in sales. Furthermore, we expect the faster-growing 16-bit and 32-bit markets to provide notable growth opportunities over the next few years.
We have a favorable view of certain aspects of Microchip's corporate governance practices, including that a majority of the company's board is made up of independent outsiders and that the nominating and compensation committees are both composed of independent outside directors. On the negative side, however, we are concerned that shareholders do not have cumulative voting rights in director elections. Furthermore, we are wary that the chairman of the board, Steve Sanghi, also serves as the chief executive officer. In general, we believe a non-affiliated chairman better serves the interest of the shareholders.
Risks to our recommendation and target price include a worse-than-expected global economic slowdown, the potential of share loss in the 8-bit microcontroller market, and the possibility that new products will not gain traction in the growing 16-bit microcontroller market.
Although the company has a well-diversified customer base serving a wide variety of end-markets, we think that, as a result of this, sales performance will correlate more closely to global economic growth. Foreign sales accounted for 75% of sales in fiscal year 2008, with about 44% coming from Asia. We believe that steep global economic declines can negatively impact the company's sales growth and management's ability to efficiently manage operations.
Microchip is the share leader in the 8-bit microcontroller market; and although we believe that it has the business model and technology to maintain its leading position in this market and achieve similar gains in the 16-bit market, we are cautious about the potential pressures that the company will face in this already competitive market segment.
We see Microchip stock providing an attractive opportunity for capital appreciation, given our view of the company's less risky growth potential in a steady growing market segment, an efficient operating model, and an underappreciated share price. The stock's 4%-plus dividend yield and resultant total return potential further supports our strong buy recommendation.