MICROCHIP TECHNOLOGY INC annual report, FY2013

Business Context and Reporting Period

Microchip Technology Incorporated filed this Form 10-K for the fiscal year ended March 31, 2013. The supplied metadata references “2012 Q4,” but the filing reports fiscal 2013 annual results and includes an unaudited fourth-quarter fiscal 2013 period ended March 31, 2013.

Microchip develops and manufactures specialized semiconductors for embedded-control applications, including microcontrollers, analog and mixed-signal products, memory products, connectivity solutions and Flash intellectual-property licensing. The August 2, 2012 acquisition of Standard Microsystems Corporation (SMSC) materially expanded the company’s connectivity and mixed-signal product portfolio.

Key Financial Metrics

Metric	Fiscal 2013	Fiscal 2012	Change
Net sales	$1,581.6 million	$1,383.2 million	14.4% increase
Gross profit	$838.5 million	$799.3 million	4.9% increase
Gross margin	53.0%	57.8%	480 basis-point decline
Operating income	$178.6 million	$396.5 million	55.0% decrease
Operating margin	11.3%	28.7%	1,740 basis-point decline
Net income	$127.4 million	$336.7 million	62.1% decrease
Diluted EPS from continuing operations	$0.62	$1.65	62.4% decrease
Cash flow from operations	$446.2 million	$396.5 million	12.5% increase
Capital expenditures	$50.8 million	$62.4 million	18.5% decrease

Fourth-quarter fiscal 2013 net sales were $430.1 million, gross profit was $239.0 million, operating income was $56.7 million, net income was $59.7 million and diluted EPS was $0.28. Fourth-quarter revenue increased from $338.9 million in the prior-year quarter.

Fiscal 2013 product mix: microcontrollers 65.5% of sales, analog/interface/mixed-signal products 19.4%, memory 9.0% and technology licensing 5.3%.
Microcontroller revenue increased 11.5%; analog, interface and mixed-signal revenue increased 79.8%, primarily from SMSC and market-share gains.
Memory revenue declined 20.5%, and technology licensing revenue declined 3.7%.
Research and development expense increased to $254.7 million, or 16.1% of sales, from $182.7 million, or 13.2%.
Special charges increased to $32.2 million, including SMSC integration costs, contingent-consideration adjustments and an SST-related legal settlement.

Liquidity, Debt and Balance Sheet

Cash, cash equivalents and short- and long-term investments totaled $1.836 billion at March 31, 2013, compared with $1.788 billion at March 31, 2012.
Cash and cash equivalents were $528.3 million; short-term investments were $1.050 billion; and long-term investments were $257.5 million.
Working capital was $1.895 billion, and total assets were $3.851 billion.
Borrowings under the revolving credit facility were $620.0 million at year-end. The facility has total commitments of $750 million and matures August 12, 2016. The company was in compliance with its covenants.
The carrying value of the 2.125% junior subordinated convertible debentures was $363.4 million; principal value was $1.15 billion and maturity is in 2037. The reported fair value was $1.639 billion.
Total contractual obligations were $2.573 billion, including $1.754 billion related to the convertible debentures and $662.0 million related to the credit facility, including assumed interest.
Management stated that existing liquidity and operating cash flow should be sufficient for anticipated requirements for at least the next 12 months.
Foreign subsidiaries held $1.782 billion of cash, cash equivalents and investments, while approximately $100.0 million was available for U.S. operations. Foreign earnings were considered indefinitely reinvested offshore.

Material Changes Versus the Prior Comparable Period

Revenue growth was primarily attributable to the SMSC acquisition, which contributed approximately $234.3 million of fiscal 2013 revenue, partially offset by weak global economic and semiconductor-industry conditions.
Profitability deteriorated despite higher revenue. Gross margin declined because of approximately $53.6 million of acquired-inventory fair-value charges, under-absorption of fixed manufacturing costs, inventory write-downs and product mix.
Reduced production levels generated approximately $31.7 million of unabsorbed-factory costs charged to cost of sales, compared with $6.7 million in fiscal 2012.
Amortization of acquired intangible assets rose to $111.5 million from $11.0 million, primarily because of SMSC-related acquired intangibles.
Goodwill increased to $271.3 million from $93.5 million, and net intangible assets increased to $530.1 million from $90.4 million, primarily due to acquisitions.
Accounts receivable increased to $230.0 million from $170.2 million, while inventory increased to $242.3 million from $217.3 million. Reported inventory days improved to 116 from 138.
Distributor sales declined to 53% of total revenue from 59%, reflecting SMSC’s greater direct OEM exposure. Deferred income on distributor shipments increased to $139.0 million from $108.7 million.
Fiscal 2013 included $32.2 million of special charges compared with $0.8 million in fiscal 2012.
The company corrected the presentation of acquired-intangible amortization in prior periods. The reclassification did not affect operating income, pretax income, taxes or net income.

Guidance, Outlook, Commentary and Risks

Management expected June 2013-quarter R&D expense to be relatively flat sequentially and to decline as a percentage of sales as SMSC integration synergies and operational efficiencies continued.
Inventory was expected to increase modestly in the June 2013 quarter because of higher purchases from third-party foundries. Management expected existing inventory to support competitive lead times and relatively low fiscal 2014 capital expenditures.
Management intended to spend approximately $80 million on equipment and facilities during the following 12 months.
Backlog was approximately $611.0 million at April 30, 2013, compared with $328.8 million at April 30, 2012; however, orders were generally cancellable or subject to delivery changes, so backlog was not considered a reliable indicator of future sales.
Major risks include semiconductor cyclicality, weak global demand, pricing pressure, customer and distributor inventory changes, limited turns-order visibility, manufacturing under-utilization and yield risk, reliance on third-party foundries and Asian assembly/test contractors, and dependence on foreign markets.
Approximately 83% of fiscal 2013 sales were to foreign customers, including 27% to China. Approximately 33% of fiscal 2013 sales came from products manufactured at outside wafer foundries.
Thailand operations and inventory remain exposed to political instability, flooding, transportation disruption and other natural-disaster risks.
Failed auction-rate securities totaled $33.8 million at March 31, 2013. The company recorded a $0.4 million fiscal 2013 impairment and could incur additional charges if liquidity or credit conditions deteriorate.
The IRS was auditing Microchip’s fiscal 2009 and 2010 tax years and SMSC’s fiscal 2011 and 2012 tax years. Unrecognized tax benefits increased to $152.8 million from $70.5 million.
Pending intellectual-property, product-liability, tax and other legal matters could produce costs or liabilities, although management stated that currently pending matters were not expected to have a material adverse effect.
No goodwill or long-lived-asset impairment charges were recorded in fiscal 2013 or fiscal 2012. Future impairment remains possible if operating performance, market capitalization or projected cash flows deteriorate.
The company paid $273.8 million in dividends during fiscal 2013 and declared a subsequent quarterly dividend of $0.3535 per share. Future dividends remain subject to board approval, liquidity and business conditions.

Important Facts for Investors to Verify

Determine how much of the reported revenue growth and future growth is attributable to SMSC versus organic demand and market-share gains.
Assess whether gross margins can recover as acquired-inventory charges end and manufacturing capacity utilization improves.
Review the sustainability of cash flow after dividends, acquisition spending, capital expenditures and debt service.
Monitor the $620 million revolving-credit balance, covenant compliance, refinancing requirements and potential dilution from convertible debentures.
Evaluate the recoverability of $530.1 million of intangible assets and $271.3 million of goodwill, including projected amortization of $100.7 million in fiscal 2014.
Review exposure to foreign markets, China, Thailand operations, external foundries and Asian assembly/test contractors.
Validate the collectability and economic value of distributor-related balances, including $139.0 million of deferred distributor income and $70.1 million of distributor advances.
Track the resolution of IRS audits, uncertain tax positions, SST-related liabilities and intellectual-property claims.
Confirm the liquidity and valuation assumptions for the $33.8 million of failed auction-rate securities.