Microchip Technology (MCHP 1.51%) might not be the most exciting company, and it might not be in the most exciting business (microcontrollers and analog processors). However, the stock could be very exciting from an investing point of view.
After its recent fiscal-year first-quarter earnings, Microchip sold off sharply and is now down around 2% year to date. Trade war fears, along with difficulties integrating its new Microsemi acquisition, have hit the company's top-line guidance; nevertheless, Microchip's management team is proven, with a track record of successful past acquisitions. Therefore, Mr. Market's current concerns may present an opportunity.
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$10 billion for Microsemi
Microchip announced it was acquiring Microsemi in March of this year, closing the deal in late May. Microchip paid an equity value of $8.35 billion and total enterprise value of $10.15 billion, which includes Microsemi's debt.
That was only a 17% premium to Microsemi's stock price at the time, which seemed like a pretty good deal -- acquisitions typically go for a higher premium. Further, Microsemi's product lineup is highly complementary to Microchip's. For instance, Microsemi had a large presence in both the aerospace/defense and telecommunications industries, where Microchip has little exposure, and Microsemi also makes field-programmable gate arrays (FPGAs), a product Microchip didn't offer before.
In addition, Microchip has a history of successful acquisitions, most recently the $3.4 billion purchase of Atmel in 2016. Using the standard recipe of cost-cutting and cross-selling, along with price increases for Atmel's differentiated products, Microchip was able to exceed its initial synergy and EPS targets when that deal was first announced.
Buyer's remorse?
Despite the apparent synergies between Microchip and Microsemi, things have gotten off to a rocky start. Soon after the closing, Microchip discovered that Microsemi had been "stuffing the channel" in the quarters leading up to the acquisition. What does that mean? Basically, Microsemi was artificially inflating its revenue shortly before it was acquired. Not cool.
Accounting rules allow companies to record revenue when they ship products to distributors, even if that distributor does not in fact make a sale to the end customer. According to Microchip management, Microsemi executives habitually induced distributors into taking more product than they needed by offering discounts. That allowed Microsemi to "pull forward" its revenue, essentially inflating sales numbers (and likely the company's acquisition price).
Not only that, but Microchip also found a "culture of excessive extravagance and high spending," including private planes, luxury suites at sports stadiums, and costly event sponsorships. Microchip CEO Steve Sanghi didn't mince words, promising, "we are undoing commitments to all such spending," calling it "a waste of shareholders' money."
To top it off, Microchip has also incurred collateral damage in the trade wars. Sanghi acknowledged that while Microchip will not be directly affected by the Trump administration's tariffs on Chinese goods, general trade war uncertainty has caused some customers to pause spending until the smoke clears.
These headwinds materialized at an inopportune time for Microchip because the company financed its Microsemi almost entirely through debt, taking on $8.6 billion in notes, a bridge loan, and a revolving credit facility to fund most of the transaction. That ballooned total company debt to more than $10.3 billion, or around five times this year's EBITDA (earnings before interest, taxes, depreciation, and amortization), which is quite high for a tech company.
Why I'm still bullish
Despite the headwinds and heavy debt load, Microchip is an intriguing value play after the recent sell-off. This mostly comes down to my faith in management, which was very up front about the past quarter's struggles and the culture at Microsemi. Sanghi maintained Microchip's $300 million synergy target and said that the Microsemi inventory buildup should be cleared by the end of this year.
For its part, Microchip has always recorded revenue on a "sell-through" basis (not "sell-in" as Microsemi did), so investors will get a clearer picture of how the business is doing moving forward. Given management's track record with Atmel and other acquisitions, I believe the company can achieve its cost-savings targets, pay down debt, and achieve its goal of $8 non-GAAP EPS in fiscal 2021 (which ends in March of that year).
That would put today's shares at just over 10 times fiscal 2021 earnings, which is quite cheap. Those looking for a beaten-down stock in an otherwise expensive market might want to kick the tires on Microchip.
