We view wide-moat Microchip Technology (MCHP) as one of the highest-quality semiconductor companies that we cover. Its pending acquisition of Microsemi remains on track, with management expecting the deal to close in June. We believe that this acquisition will be nicely accretive to Microchip and that management might even be conservative about the potential synergies from the deal. In the off chance the Microsemi deal were to unexpectedly fall apart, our $112 fair value estimate would probably revert to around $97, which was our valuation before the merger announcement. Thus, we think Microchip is undervalued even on a stand-alone basis.
Microchip is a leading supplier of microcontrollers, or MCUs, which are semiconductors that act as the brains in a wide variety of common electronic devices, from garage door openers to electric razors and many products in between. We view Microchip as one of the best-run companies in the MCU market and especially like its focus on higher-margin chip opportunities across a wide array of end markets.
MCUs essentially recognize inputs, execute a program, and send an output. MCUs are often accompanied by analog chips that process real-world inputs such as temperature and pressure so that, for example, a thermostat can recognize the current temperature and tell the MCU so that it can decide to turn the heating unit on or off.
The businesses of MCUs and analog chips have many desirable features. Neither type of chip is overly dependent on leading-edge designs, so capital investments tend to be relatively low. These chips are selected based on performance rather than price, because they make up only a tiny portion of a product's overall cost. Customers tend to be loyal, and chips have long product lives because switching to a competing MCU could involve redesigning the entire end product. Thus, MCU and analog companies are able to maintain high margins and returns on invested capital. Microchip's historical strength has been the 8-bit MCU segment. These chips tend to be used in a wide range of simpler electronic products, and as a result, Microchip benefits by not being overly exposed to a single technology segment or customer. Microchip’s position in more advanced 16- and 32-bit MCUs is relatively weaker, but the company has been gaining ground in recent years, and its analog chip business has grown at a nice pace both organically and as the company makes bolt-on acquisitions.
Overall, we foresee healthy demand for Microchip’s products. As more and more electronic devices become "smarter" and connected to the Internet, Microchip’s MCUs and analog chips stand to benefit. Microchip is likely to make additional acquisitions in order to further expand its product portfolio.
Microchip’s Moat Is Wide
Moats for analog and MCU chipmakers like Microchip tend to come from intangible assets around proprietary chip designs and manufacturing expertise, as well as switching costs that make it difficult to swap out analog and MCU chips for competing offerings once they are designed into a given electronic device. Given Microchip’s record of stellar profitability in recent years and ability to retain its leadership position in MCUs while expanding its analog business, we think it is more likely than not that the company will earn on excess capital over the next 20 years.
Looking at intangible assets, leading analog and MCU chipmakers face stringent quality requirements in some end markets, such as the automotive space, where defects can only be tolerated as infrequently as one part per million. Although the analog and MCU chip industries are quite fragmented, it would be difficult for any new entrant to achieve this level of quality while still satisfying high-volume production. Furthermore, Microchip’s 8-bit MCUs are based on its proprietary PIC architecture, and although the MCU industry is fairly fragmented and MCUs by definition perform simple processing functions, we think there is a bit of uniqueness to Microchip’s designs. We see similar distinctiveness in the company’s AVR-based MCUs acquired from Atmel.
Analog and MCUs tend to make up only a small portion of a product's bill of materials, so purchasing decisions tend to be based on performance rather than price, helping Microchip retain pricing power. Once electronics manufacturers select an analog chip or MCU, they tend to stick with the chip for the life of the device because it is costly to redesign a device in order to swap in a competing chip that might not necessarily be compatible with the rest of the product. We think this is especially important for Microchip, as engineers become accustomed to its design tools associated with its MCUs. Furthermore, automotive, industrial, and communications infrastructure customers in particular are unlikely to choose an inferior chip in order to save pennies on the cost of a piece of equipment worth tens of thousands of dollars.
Microchip takes this switching cost benefit one step further by concentrating on end markets where product lives are measured in decades, as opposed to the increasingly short lifecycles associated with consumer devices like PCs or handsets. Microchip is also well diversified and not overly reliant on any single customer or end market. Companies that can sell in lower volume to a broader base of customers don't have to make the types of price concessions seen by those that sell into the handset or PC markets, for example, where chip orders are made in the hundreds of millions rather than the thousands.
Ultimately, we think these intangible assets and customer switching costs enable companies like Microchip to benefit from long useful lives associated with certain chip products. In turn, chipmakers like Microchip tend to benefit from lower ongoing research and development and capital investments, which contributes to healthy returns on capital for shareholders.
There are some risks, however. Even though the company serves a diverse and fragmented market, the semiconductor industry is notoriously cyclical, and Microchip's sales levels tend to ebb and flow with the chip industry and the overall global economy. Another risk is the potential for limited growth in stand-alone sales of analog chips, where Microchip is now competing head to head with larger companies that have greater resources in a fragmented industry. Finally, Microchip lags a couple of other large chipmakers in sales of 16- and 32-bit MCUs. Despite its strong position in 8-bit MCUs, revenue growth could suffer if higher-end MCUs are able to displace more and more 8-bit chips in electronic devices.
Management Is Exemplary
We think Microchip has done a stellar job of distributing cash to shareholders. The company has a very attractive dividend policy, paying out over half of its earnings and increasing the dividend (albeit by tiny amounts) on a quarterly basis. We believe Microchip's management team understands the importance of its dividend as part of an investment thesis; for example, the company accelerated a dividend payment at the end of 2010 out of concern that U.S. tax policies would change and dividends would be taxed at a higher rate in 2011.
The company has made reasonable moves on the M&A front; acquisitions of Silicon Storage Technology, Standard Microsystems, ISSC, and Supertex involved buying only the pieces of each company that either generate, or have the potential to generate, strong profitability, while spinning off less desirable product lines that would weigh on returns on capital. Microchip's largest deals, for Micrel and Atmel, are following a similar playbook. Although the Atmel deal put Microchip into a net debt position, the company is generating better-than-expected accretion from these deals, and once again, they appear to be shrewd moves made by this exemplary management team.
Microchip has walked away from potential deals that no longer made financial sense, such as its failed bid to acquire CSR, which was eventually acquired at a higher price by Qualcomm. Ultimately, we think Microchip has room to expand its product portfolio and become more of a one-stop shop in the chip market, similar to Texas Instruments today, and we foresee further acquisitions at reasonable valuations over time.
Brian Colello, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.