Investors have been getting yet another reminder over the last two months that stocks don't go up in a straight line. A myriad of worries cropped up this summer, including higher interest rates, higher oil prices (a key contributor to stubborn inflation), and renewed predictions of a coming recession.
After reaching new all-time highs over the summer, shares of Microchip Technology (MCHP 1.51%) have fallen nearly 20% in the market pullback. Why is it down, and is it time to buy the dip in this top semiconductor stock?
More than just an outlook problem
After the last quarterly earnings update in August, I wrote about Microchip's stellar performance even as many of its peers specializing in chips for industrial use have taken a tumble in the past year. A fairly steep drop in semiconductor demand has cropped up this year, but the company has outperformed with its so-called "total system design" expertise that spans customized chips to software that runs on them.
Even so, some red flags have appeared as Microchip has begun to lose a bit of momentum. Management indicated some customers were trying to pare back their orders headed into 2024. This is a situation worth monitoring closely.
But that isn't the only reason for the recent tumble in the stock price. Some of those bigger-picture economic issues are the likely cause -- rising interest rates in particular being one of them. The Federal Reserve has indicated it will likely hold its interest rate higher for longer in an attempt to bring down inflation. The rates on 10-year Treasuries have risen to multi-decade highs this year in response.
Data by YCharts.
As a reminder, higher interest rates lower the present value of stocks. The recent run-up of interest rates seems to be a key reason Microchip has fallen as of late.
Microchip's balance sheet is also a concern
Interest rate increases could have an even more tangible impact on Microchip in the near future. It took on significant debt to make its big acquisition of Microsemi back in 2018.
Management's use of debt when interest rates were near historic lows was prescient, but it's been furiously paying off that debt ($6.8 billion was paid down over the last five years), and for good reason.
As of the end of June 2023, Microchip still had about $6 billion in long-term debt, most of which will need to be paid off or refinanced within the next two years. At the end of June, the company only had $271 million in cash and short-term investments.
Management has indicated it will use a credit account with a variable interest rate to service this debt. Long story short, Microchip's expense on interest payments is set to increase in the coming quarters as it continues to get its balance sheet back into tip-top shape.
Data by YCharts.
A cheap stock to buy now?
The good news, though, is that the company is highly profitable and now cranking out plenty of free cash flow (FCF). It has generated $3.3 billion in FCF in the last year alone. At that rate, its balance sheet will be in stellar shape in no time, and high interest rates will be of little concern.
However, the thing to watch now is how a looming slowdown in Microchip's sales could affect this FCF generation, which would limit the ability to pay off debt and reaccumulate cash.
The stock now trades for just 13 times trailing-12-month FCF, a real long-term bargain if this top semiconductor stock continues to expand and manage its windfall profits. For investors looking for a potential market-beating tech stock over the long term, Microchip could be a great buy right now.
I'm waiting for the next earnings update (likely to be announced in early November) to see if the company reports any changes in its growth outlook for 2024.
