Business Context and Reporting Period
Microchip Technology Incorporated designs, manufactures and sells embedded-control semiconductor products, including microcontrollers, analog, interface, mixed-signal, timing and FPGA products, and licenses technology. This unaudited Form 10-Q covers the three months ended June 30, 2019, the first quarter of fiscal 2020, compared with the three months ended June 30, 2018. Results include a full quarter of Microsemi operations in 2019 versus approximately one month in 2018 following the May 29, 2018 acquisition.
Key Financial Metrics
| Metric | Q1 FY2020 | Q1 FY2019 | Change |
|---|---|---|---|
| Net sales | $1,322.6 million | $1,212.5 million | 9.1% increase |
| Gross profit | $815.2 million | $642.0 million | 27.0% increase |
| Gross margin | 61.6% | 52.9% | Up 8.7 percentage points |
| Operating income | $171.6 million | $132.3 million | 29.7% increase |
| Operating margin | 13.0% | 10.9% | Up 2.1 percentage points |
| Net income | $50.7 million | $35.7 million | 42.0% increase |
| Diluted EPS | $0.20 | $0.14 | Increase |
| Operating cash flow | $380.6 million | $302.4 million | Increase |
| Capital expenditures | $23.9 million | $89.4 million | Decrease |
Interest expense increased to $132.6 million from $90.4 million, primarily because of debt incurred to finance the Microsemi acquisition. The company recorded a $10.2 million income tax benefit versus a $2.0 million tax provision in the prior-year quarter; management stated that effective tax rates were not meaningful because of the level of pretax income and discrete tax benefits.
At June 30, 2019, cash and cash equivalents were $434.0 million, short-term investments were $3.1 million, and total cash and short-term investments were approximately $437.1 million. Accounts receivable were $936.8 million and inventories were $733.1 million. Total assets were $18.25 billion.
Gross debt principal was $11.40 billion, consisting primarily of $3.20 billion drawn on the revolving credit facility, $1.72 billion under the term loan facility, $2.00 billion of senior secured notes and $4.48 billion of convertible debt. Net debt recorded on the balance sheet, including current maturities and after discounts and issuance costs, was $10.09 billion. The company was in compliance with its debt covenants at June 30, 2019.
Cash dividends paid were $87.1 million, or $0.3655 per share. A quarterly dividend of $0.3660 per share was declared for payment in September 2019. No common shares were repurchased during the quarter.
Material Changes Versus the Prior Comparable Period
- Revenue growth was driven primarily by the full-quarter contribution from Microsemi, which increased reported sales by approximately 18% relative to the prior-year comparison. Management estimated that adverse demand conditions, including economic weakness, trade restrictions and tariffs, reduced sales by approximately 7% excluding acquisition timing.
- Microcontroller sales declined 2.0% to $708.3 million, while analog, interface, mixed-signal and timing sales increased 16.4% to $386.4 million. FPGA sales increased to $91.0 million from $37.8 million, primarily because of Microsemi.
- Gross margin improved substantially because the prior-year quarter included approximately $107.5 million of cost of sales from the fair-value step-up of acquired Microsemi inventory. The current quarter included a $7.3 million unabsorbed capacity charge from operating below normal manufacturing capacity.
- Research and development expense increased 27.5% to $219.1 million, primarily from Microsemi-related costs. Amortization of acquired intangibles increased to $248.5 million from $133.7 million.
- Special charges declined to $8.1 million from $40.1 million. Current-quarter charges primarily related to employee separation, impairment and other restructuring activities associated with acquisitions.
- Operating cash flow increased by $78.2 million. Investing cash use was only $26.3 million compared with $6.67 billion in the prior-year quarter, when the Microsemi acquisition was completed and investments were liquidated to help fund it.
- The company voluntarily prepaid $188.0 million of term-loan principal and recorded a $1.9 million loss on debt settlement. Revolving borrowings declined to $3.20 billion from $3.27 billion, and term-loan borrowings declined to $1.72 billion from $1.91 billion.
Guidance, Outlook, Commentary and Risks
- Management intended to spend approximately $110 million to $130 million on capital expenditures over the next 12 months, funded through cash balances and operating cash flow.
- Management expected September 2019 inventory days to be five days lower to two days higher than the 132 days reported at June 30, 2019, and believed inventory levels supported competitive lead times and delivery performance.
- The company believed existing liquidity, operating cash flow and revolver availability would be sufficient for anticipated requirements for at least the next 12 months.
- Key operating risks include semiconductor demand cyclicality, pricing pressure, customer and distributor inventory changes, tariffs and trade restrictions, reliance on third-party wafer foundries and assembly/test contractors, manufacturing utilization and yields, and government-related demand within Microsemi’s business.
- The company disclosed an ongoing compromise of its computer networks. It began implementing a containment plan in May 2019 and had not identified a material adverse financial impact, but the scope and type of compromised information remained under evaluation.
- Management identified material weaknesses in internal controls over income-tax accounting and IT-system access. Remediation was underway and was expected to be completed by the end of fiscal 2020; disclosure controls and procedures were therefore considered ineffective at quarter-end.
- Legal and regulatory matters include shareholder and derivative litigation related to the Microsemi acquisition, a former-Microsemi-officer lawsuit, Department of Justice and SEC investigations concerning Microsemi-related distribution and business practices, and an Atmel-related product liability arbitration. Aggregate possible but not probable liability was estimated at approximately $100 million above accrued amounts.
- The company adopted the new lease standard on April 1, 2019, recognizing operating lease right-of-use assets of $124.6 million and lease liabilities of $137.3 million at adoption. Lease liabilities totaled $139.3 million at June 30, 2019.
Important Facts for Investors to Verify
- Whether Microsemi integration produces the expected revenue growth, cost synergies and debt reduction without further material restructuring costs.
- Underlying organic demand after separating acquisition-related growth from the reported 9.1% sales increase.
- Trend in gross margin as the prior-year acquisition inventory step-up no longer affects comparisons and capacity utilization remains below normal.
- Ability to reduce the approximately $11.40 billion of gross debt while continuing quarterly dividends and planned capital investment.
- Status and financial impact of the IT-system compromise, related remediation and the two disclosed material weaknesses in internal controls.
- Effects of tariffs, trade restrictions, China and Japan-South Korea trade tensions, and broader semiconductor demand conditions on future orders and margins.
- Progress and potential exposure from the SEC and Department of Justice investigations and litigation related to Microsemi and Atmel.
- Potential impairment of the $6.66 billion goodwill balance and $6.43 billion net intangible asset balance if operating performance or valuation assumptions deteriorate.