MICROCHIP TECHNOLOGY INC quarterly report, Q3 FY2020

Business Context and Reporting Period

Microchip Technology Incorporated designs, manufactures and sells embedded-control semiconductor products, including microcontrollers, analog, interface, mixed-signal, timing, FPGA, memory and related products, and licenses semiconductor technology. The company operates through semiconductor products and technology licensing segments. This Form 10-Q covers the quarter and nine months ended December 31, 2019, the third quarter of fiscal 2020, with comparisons to the corresponding periods of fiscal 2019. Results include Microsemi for the full current-year periods versus seven months in the prior-year nine-month period following the May 2018 acquisition.

Key Financial Metrics

Metric	Three months ended Dec. 31, 2019	Year-over-year change	Nine months ended Dec. 31, 2019	Year-over-year change
Net sales	$1,287.4 million	Down 6.4%	$3,947.8 million	Down 1.8%
Gross profit	$785.5 million	Up from $779.6 million	$2,428.2 million	Up from $2,110.9 million
Gross margin	61.0%	Up from 56.7%	61.5%	Up from 52.5%
Operating income	$131.2 million	Down from $194.7 million	$486.4 million	Up from $429.6 million
Operating margin	10.2%	Down from 14.2%	12.3%	Up from 10.7%
Net income	$311.1 million	Up from $49.2 million	$470.7 million	Up from $181.2 million
Diluted earnings per share	$1.20	Up from $0.20	$1.84	Up from $0.73

The quarterly net income increase was substantially affected by a $300.5 million income tax benefit, including discrete tax benefits. The nine-month effective tax rate was not meaningful and included a $337.0 million benefit from an intra-group transfer of intellectual property rights.

Quarterly research and development expense was $217.1 million, or 16.9% of sales; nine-month expense was $656.0 million, or 16.6%.
Quarterly selling, general and administrative expense was $170.7 million; nine-month expense was $510.9 million.
Acquired-intangible amortization was $248.7 million in the quarter and $745.4 million year to date, materially higher than the prior-year periods because of the Microsemi acquisition.
Special charges were $17.8 million in the quarter and $29.5 million year to date, primarily related to restructuring and wafer-fabrication actions.
Net cash provided by operating activities was $1.17 billion for the nine months, compared with $1.27 billion in the prior-year period. Capital expenditures were $55.7 million, versus $188.8 million.
Cash, cash equivalents and short-term investments totaled $402.3 million at December 31, 2019, including $397.1 million of cash and cash equivalents.
Inventory was $708.8 million, representing 129 days, compared with 128 days at March 31, 2019. Distributor inventory declined to 28 days from 35 days.
Cash dividends paid during the nine months were $262.1 million. The quarterly dividend was $0.3665 per share; a $0.3670 dividend was declared for payment in March 2020.

Debt, Liquidity and Capital Resources

Gross debt principal was $10.83 billion at December 31, 2019; net debt including current maturities was $9.58 billion after discounts and issuance costs.
Debt consisted principally of $2.62 billion drawn under the revolving facility, $1.72 billion under the term loan facility, $2.0 billion of senior secured notes and $4.48 billion of convertible debt principal.
The company repaid $188.0 million of term-loan principal during the nine months and reduced revolving-facility borrowings from $3.27 billion at March 31, 2019 to $2.62 billion.
The revolving facility provided approximately $3.57 billion of commitments and matures in 2023. The company was in compliance with its debt covenants at December 31, 2019.
Approximately $4.35 billion of debt carried variable interest rates. Management estimated that a 50-basis-point increase in rates would increase annual interest expense by approximately $21.7 million.
Management expected existing liquidity, operating cash flow and revolver availability to cover anticipated requirements for at least the next 12 months. Planned capital expenditures for the next 12 months were $100 million to $120 million.

Material Changes Versus the Prior Comparable Period

Sales declined despite the inclusion of a full nine months of Microsemi revenue in the current period. Management attributed the decline primarily to adverse demand conditions, general economic weakness, trade restrictions and tariffs. For the nine-month comparison, management estimated that adverse conditions reduced sales by approximately 7%, partly offset by approximately 5% from the additional Microsemi contribution.
Gross margin improved substantially because the prior-year period included $86.0 million of quarterly and $375.7 million of nine-month charges for the fair-value step-up of Microsemi acquired inventory. The current period nevertheless included below-normal-capacity charges of $17.1 million for the quarter and $33.3 million year to date.
Operating margin declined in the quarter because acquired-intangible amortization increased to $248.7 million and special charges increased, despite the improved gross margin. Nine-month operating margin improved because of the prior-year acquisition accounting charges and integration benefits.
Interest expense declined in the quarter to $119.7 million from $137.6 million as debt was paid down, but increased for the nine months to $381.9 million from $366.7 million because the prior-year comparison included fewer months of acquisition-related borrowings.
The company began reducing the clean-room footprint at its Colorado six-inch wafer facility and transferring higher-volume products to Arizona and Oregon facilities. It incurred $11.7 million of related costs during the quarter and expects significant cost savings over the next several years.
The company adopted the new lease accounting standard on April 1, 2019, recording $135.7 million of right-of-use assets and $153.9 million of lease liabilities at December 31, 2019.

Guidance, Outlook, Commentary and Risks

Management expected March 2020 inventory days to be flat to down by 14 days from the December 2019 level and believed current inventory supported competitive lead times and delivery performance.
Management expected capital expenditures of $100 million to $120 million over the following 12 months and anticipated funding them with cash and operating cash flow.
Gross margins are expected to fluctuate with capacity utilization, product mix, manufacturing yields, fixed-cost absorption, competition and economic conditions.
The company identified material weaknesses in internal controls relating to income-tax accounting and IT-system access. Remediation was underway and expected to be completed by the end of fiscal 2020; disclosure controls and procedures were therefore considered ineffective at period end.
The company continued investigating a sophisticated compromise of its computer networks. Management did not believe the compromise had yet materially affected the business, but stated that the ultimate impact could not be determined.
Material risks include semiconductor demand cyclicality, trade restrictions and tariffs, foreign operations and suppliers, reliance on distributors and third-party foundries, manufacturing capacity and yield risks, competitive pricing pressure, high leverage, cybersecurity, tax audits, litigation and the integration of Microsemi.
Pending matters include shareholder and derivative litigation related to the Microsemi acquisition, governmental investigations by the Department of Justice and SEC, and a claim by former Microsemi officers seeking more than $100 million of compensatory damages and more than $300 million of punitive damages. Management estimated aggregate possible-but-not-probable liabilities of approximately $100 million above accrued amounts.
An arbitration claim related to Atmel products sought approximately $204 million from the company’s subsidiaries. Management stated that the ultimate resolution of pending matters was not expected to have a material adverse effect, but outcomes were uncertain.

Important Facts for Investors to Verify

Separate recurring operating performance from the $300.5 million quarterly tax benefit and the $337.0 million year-to-date intellectual-property-transfer tax benefit.
Assess debt repayment capacity, upcoming maturities, variable-rate exposure and compliance with leverage and interest-coverage covenants.
Monitor whether semiconductor demand, tariffs and trade restrictions continue to pressure sales, particularly in Asia and China.
Evaluate the sustainability of the 61.0% quarterly gross margin after excluding prior-year Microsemi inventory step-up charges and considering current underutilization.
Track progress and costs of Microsemi integration, Colorado facility restructuring and the expected inventory reduction.
Confirm remediation of the tax-accounting and IT-access material weaknesses by fiscal year-end.
Monitor developments in the cybersecurity investigation, SEC and DOJ investigations, shareholder litigation, the Peterson matter and the Atmel-related arbitration.
Review the large goodwill and intangible-asset balances, totaling approximately $12.60 billion, for potential future impairment risk.