Microchip Technology Incorporated: Fiscal 2014 Second-Quarter 10-Q Summary
Business context and reporting period
Microchip designs, manufactures and markets embedded-control semiconductors, including microcontrollers, analog, interface, mixed-signal and memory products, and licenses SuperFlash technology. The filing covers the three and six months ended September 30, 2013, the second quarter and first six months of fiscal 2014. Results include the August 2, 2012 acquisition of SMSC, which affects year-over-year comparability.
Key financial metrics
| Metric | Three months ended September 30, 2013 | Year-over-year change | Six months ended September 30, 2013 | Year-over-year change |
|---|---|---|---|---|
| Net sales | $492.7 million | Up 28.5% | $955.5 million | Up 29.9% |
| Gross profit | $288.9 million | Up from $194.2 million | $555.4 million | Up from $399.0 million |
| Gross margin | 58.6% | Up from 50.7% | 58.1% | Up from 54.3% |
| Operating income | $117.5 million | Up from $8.1 million | $215.9 million | Up from $104.4 million |
| Operating margin | 23.9% | Up from 2.1% | 22.6% | Up from 14.2% |
| Net income | $99.8 million | Compared with a $21.2 million loss | $178.4 million | Up from $57.5 million |
| Diluted EPS | $0.46 | Compared with $(0.11) | $0.83 | Up from $0.28 |
| Operating cash flow | Not separately provided | — | $319.4 million | Up from $192.3 million |
Net margin was approximately 20.3% for the quarter and 18.7% for the six-month period. Semiconductor products generated $467.8 million of quarterly revenue and $908.1 million for the six-month period; technology licensing generated $24.8 million and $47.3 million, respectively.
- Product mix: microcontrollers represented 65.2% of quarterly sales and 65.0% of six-month sales; analog, interface and mixed-signal products represented 22.0% and 22.2%; memory represented 7.1% and 7.2%.
- Microcontroller revenue increased 26.7% for the quarter and 25.9% for the six-month period. Analog, interface and mixed-signal revenue increased 54.8% and 80.5%, respectively. Memory revenue declined 4.3% and 10.8%.
- Approximately 84% of sales were to foreign customers, and Asia represented 60.6% of quarterly sales and 60.0% of six-month sales.
- Research and development expense was $78.3 million for the quarter and $151.3 million for six months. Share-based compensation expense was $15.0 million and $27.7 million, respectively.
- The effective tax rate for the six-month period was 11.5%, compared with 38.1% in the prior-year period, primarily because of the geographic mix of earnings and acquisition-related tax expenses in the prior year.
Cash flow, liquidity and capital structure
- Cash flow from operations was $319.4 million for the first six months. Capital expenditures were $55.2 million, and management expected approximately $90 million of capital expenditures during the following twelve months.
- Cash and cash equivalents were $344.2 million at September 30, 2013, compared with $528.3 million at March 31, 2013. Total cash, cash equivalents and investments were $1.982 billion, up from $1.836 billion.
- Net cash used in investing activities was $383.5 million, principally reflecting net purchases of available-for-sale investments and capital expenditures. Net cash used in financing activities was $120.0 million, including $139.8 million of dividends.
- At September 30, 2013, borrowings under the new credit agreement totaled approximately $640.0 million, consisting of a $350 million term loan and $290 million drawn on the revolving facility. The facility totals $2.0 billion and matures June 27, 2018. The company was in compliance with its covenants.
- The carrying value of the junior subordinated convertible debentures was $367.5 million; their principal amount is $1.15 billion and reported fair value was $1.804 billion. The conversion price was approximately $26.29 per share at quarter-end.
- Inventory increased to $275.1 million from $242.3 million, or 123 days versus 116 days. Distributor inventory was 33 days versus 30 days at March 31, 2013.
- Most liquidity was held by foreign subsidiaries: $1.964 billion of cash, cash equivalents and investments, versus approximately $18 million available for U.S. operations. Foreign earnings were generally considered permanently reinvested offshore.
Material changes versus the prior comparable period
- Revenue growth primarily reflected the SMSC acquisition, market-share gains, general economic and semiconductor industry conditions, and higher unit volumes. Semiconductor unit volumes rose approximately 21% for the quarter and 20% for six months; average selling prices rose approximately 6% and 9%, respectively.
- Gross margin improved substantially because the prior-year period included approximately $22.7 million and $24.2 million of acquired-inventory valuation charges for the quarter and six months, respectively. The company continued to operate its wafer fabs below normal capacity, generating approximately $5.0 million and $15.4 million of under-absorption charges.
- Prior-year special charges included approximately $10.9 million of SMSC severance and facility-closing costs and $11.5 million of SST-related legal settlement costs. Fiscal 2014 special items were comparatively limited: $1.7 million of net charges for six months.
- Interest expense increased to $12.4 million for the quarter and $24.2 million for six months, primarily because of higher borrowings associated with the SMSC acquisition.
- The company entered into a new $2.0 billion credit agreement in June 2013, replacing its prior facility.
Guidance, outlook, commentary and risks
- No specific revenue or earnings guidance was provided in the filing text. Management expected December 2013 inventory to be flat to modestly higher than September levels and believed existing inventory would support competitive lead times.
- Management stated that existing liquidity, operating cash flow and available borrowing capacity should satisfy anticipated cash requirements for at least the next twelve months.
- The quarterly dividend was increased from $0.3540 paid in September to $0.3545 declared for payment in December 2013. Future dividends and repurchases remain subject to board discretion and business conditions.
- Key operating risks include semiconductor cyclicality, short order visibility and reliance on turns orders, competitive pricing pressure, product mix changes, capacity utilization and manufacturing yields, and dependence on outside wafer foundries and Asian assembly and test contractors.
- Distributor sales represented approximately 53.7% of six-month revenue. Distributors generally lack long-term commitments and have price-protection, return and other channel rights that affect deferred revenue and margins.
- The company held $9.8 million of auction-rate securities with failed auctions and limited liquidity. Further market deterioration or credit-rating declines could require impairment charges.
- Unrecognized tax benefits totaled $192.0 million, and the IRS was auditing specified Microchip and SMSC tax years. The company also had $5.7 million of remaining SST-related contingent liabilities.
- Legal, intellectual-property, product-liability, indemnification, environmental, foreign-operation, Thailand flooding, cyber-security and potential debt-refinancing risks could adversely affect results, liquidity or operations.
Investor verification checklist
- Verify the sustainability of the approximately 58% gross margin as acquired-inventory effects fade and wafer-fab utilization improves.
- Separate organic growth from revenue contributed by SMSC and assess the integration benefits and additional amortization.
- Monitor memory-product declines, competitive pricing pressure and product mix, particularly the growth of analog and mixed-signal products.
- Reconcile total debt, conversion-related dilution risk and covenant headroom under the new credit agreement.
- Assess the location and repatriation restrictions of the company’s offshore liquidity, including the relatively limited cash available for U.S. operations.
- Track inventory days, distributor inventory and deferred income on distributor shipments for potential channel or margin pressure.
- Review the outcomes of IRS audits, other tax examinations, SST-related matters and any intellectual-property litigation.
- Confirm whether the stated capital-expenditure plan, dividend policy and liquidity outlook remain consistent with subsequent filings.