MICROCHIP TECHNOLOGY INC annual report, FY2010

Microchip Technology Incorporated — FY2010 Form 10-K Summary

Business context and reporting period

Microchip designs, manufactures and sells specialized semiconductors for embedded-control applications, including PIC and dsPIC microcontrollers, analog and interface products, power-management devices, security products, and serial EEPROM memory. The filing is an annual report for the fiscal year ended March 31, 2010; it is not a quarterly filing for 2009 Q4. Fiscal 2009 and 2008 comparative figures were retrospectively adjusted for cash-conversion accounting for the convertible debentures.

Financial performance and key metrics

Metric	FY2010	FY2009	Change
Net sales	$947.7 million	$903.3 million	Up 4.9%
Gross profit	$534.2 million	$516.5 million	Up 3.4%
Gross margin	56.4%	57.2%	Down 0.8 percentage points
Operating income	$245.0 million	$233.3 million	Up 5.0%
Operating margin	25.8%	25.8%	Flat
Net income	$217.0 million	$245.6 million	Down 11.6%
Diluted EPS	$1.16	$1.31	Down 11.5%
Cash flow from operations	$452.0 million	$308.7 million	Up 46.5%

Average selling prices declined approximately 7%, while unit volume increased approximately 12%.
Microcontroller sales rose 4.9% to $767.7 million; analog and interface sales rose 21.3% to $99.8 million; memory sales fell 10.3% to $80.2 million.
R&D expense was $120.8 million, or 12.8% of sales. SG&A was $167.2 million, or 17.7% of sales.
The effective tax rate was 8.8%, including an $8.5 million benefit from settlement of IRS audits for fiscal 2002–2004. Fiscal 2009 included unusually large tax benefits and reported a 5.8% effective tax benefit.
Cash, cash equivalents and short- and long-term investments totaled $1.532 billion at March 31, 2010. Cash and cash equivalents were $492.1 million.
Working capital was $1.408 billion; total assets were $2.516 billion; stockholders’ equity was $1.533 billion.
Capital expenditures were $47.6 million, compared with $102.4 million in fiscal 2009. Management expected approximately $90 million of capital expenditures over the following 12 months.
The company paid $249.6 million in dividends and declared a subsequent quarterly dividend of $0.342 per share.
Inventory declined to $116.6 million, or 97 days, from $131.5 million, or 134 days, at March 31, 2009.

Debt, liquidity and commitments

Microchip had $1.15 billion principal amount of 2.125% junior subordinated convertible debentures due December 2037. The balance-sheet carrying value was $340.7 million because of the separate accounting for liability and equity components; reported fair value was approximately $1.146 billion. Fiscal 2010 interest expense was $31.2 million, including $6.3 million of non-cash debt-discount amortization. Total contractual obligations were $1.873 billion, including $1.827 billion of principal and interest on the debentures.

Management stated that existing liquidity and operating cash flow were sufficient for anticipated requirements for at least the next 12 months. The company had $37.2 million in auction-rate securities, including $14.1 million of securities with estimated fair values based on Level 3 inputs. The company intended to exercise a put right for $24.9 million of student-loan-backed auction-rate securities beginning June 30, 2010.

Material changes versus the prior comparable period

Revenue recovered from the fiscal 2009 downturn, with improving semiconductor conditions and market-share gains across strategic product lines.
Manufacturing utilization improved: Fab 2 and Fab 4 operated at or above normal capacity during the latter part of the third quarter and all of the fourth quarter of fiscal 2010. However, $22.3 million of under-absorbed manufacturing costs was charged to cost of sales, compared with $18.6 million in fiscal 2009.
Gross margin declined despite higher sales because of lower utilization during portions of the year, product mix, pricing pressure and manufacturing-cost absorption.
Net income declined despite higher operating income, principally because interest income fell to $15.3 million from $32.5 million and the prior year included significant tax benefits.
Operating cash flow increased substantially, aided by $87.0 million of net sales of trading securities versus $73.5 million of net purchases in fiscal 2009.
Distributor concentration moderated: distributors represented 61% of sales versus 64% in fiscal 2009, while the largest distributor represented approximately 12% versus 14%.
On April 8, 2010, after the reporting date, Microchip completed its acquisition of Silicon Storage Technology for $353.8 million, including its previously acquired $58.4 million stake. The purchase-price allocation was incomplete when the filing was issued.

Outlook, commentary, risks and unusual items

Management described an upturn in key markets during fiscal 2010 but warned that semiconductor demand, pricing, product mix, capacity utilization and manufacturing yields can cause significant volatility.
Backlog was approximately $527.6 million at April 30, 2010, versus $182.8 million a year earlier, but orders were generally cancellable or subject to delivery changes and therefore were not a reliable indicator of future sales.
Key risks include intense competition and price erosion, dependence on short-cycle orders and distributors, customer and distributor inventory levels, foreign sales and operations, Thailand-related operational and political risks, supplier and subcontractor dependence, intellectual-property claims, product liability, environmental and export regulations, tax audits, foreign currency movements, information-technology disruptions and future acquisition integration.
The company depends heavily on international markets: approximately 77% of fiscal 2010 sales were to foreign customers, and China including Hong Kong represented approximately 25% of sales.
Special charges were $1.2 million in fiscal 2010 for a patent license. Fiscal 2009 included $6.4 million of special charges, including patent-license costs, abandoned Atmel acquisition expenses and in-process research and development.
The company recorded a $4.7 million impairment charge on certain auction-rate securities in fiscal 2010. No goodwill or long-lived-asset impairment charges were recorded.
An SST shareholder class action alleges breaches of fiduciary duty in connection with the merger and names Microchip as an alleged aider and abettor. Microchip stated that it believed the claims lacked merit and intended to defend them vigorously.
The IRS was auditing fiscal 2006–2008, and fiscal 2009–2010 remained open for examination. Gross unrecognized tax benefits were $57.1 million at March 31, 2010, plus approximately $4.7 million of accrued interest.
Management and Ernst & Young reported effective internal control over financial reporting, and the financial-statement audit opinion was unqualified.

Facts investors should verify

Whether the fiscal 2010 recovery in demand and backlog translated into sustained revenue growth after March 31, 2010.
Whether gross margin improved as both wafer fabs returned to normal or above-normal utilization, and whether pricing pressure or product mix offset utilization benefits.
The final purchase-price allocation, operating contribution and integration costs associated with the SST acquisition.
The liquidity and eventual resolution or valuation of auction-rate securities and any related impairment exposure.
The cash-flow impact and refinancing or settlement strategy for the convertible debentures, whose principal amount materially exceeds the accounting carrying value.
Outcomes of IRS and foreign tax examinations, including potential changes to the $57.1 million unrecognized tax-benefit balance.
Progress and potential costs related to the SST shareholder litigation and other intellectual-property or product-liability matters.