MICROCHIP TECHNOLOGY INC quarterly report, Q1 FY2011

Business Context and Reporting Period

Microchip Technology Incorporated filed this unaudited Form 10-Q for the three months ended June 30, 2010, the first quarter of fiscal 2011. The company designs, manufactures, and markets embedded-control semiconductor products and, following its April 8, 2010 acquisition of Silicon Storage Technology, Inc. (SST), licenses Flash intellectual property. Results include SST from April 9, 2010.

Financial Highlights

Metric	Q1 FY2011	Q1 FY2010	Change
Net sales	$320.8 million	$192.9 million	Up 66.3%
Gross profit	$199.4 million	$96.4 million	Up 106.8%
Gross margin	62.2%	50.0%	Up 12.2 percentage points
Operating income	$106.6 million	$31.2 million	Up 242.0%
Operating margin	33.2%	16.2%	Up 17.0 percentage points
Net income	$89.6 million	$27.4 million	Up 227.3%
Diluted EPS	$0.47	$0.15	Up $0.32
Cash flow from operations	$133.3 million	$115.1 million	Up $18.3 million

Net income from continuing operations was $89.6 million, while discontinued operations produced a $49,000 net loss. The effective tax rate from continuing operations declined to 12.7% from 16.2%. Net margin was approximately 27.9% versus 14.2% in the prior-year quarter.

Product revenue was $305.4 million, and licensing technology revenue was $15.4 million. Microcontrollers represented 76.4% of sales, memory products 7.2%, analog and interface products 11.6%, and technology licensing 4.8%.
Average selling prices declined approximately 4% year over year, while unit volumes increased approximately 66%.
Research and development expense increased to $38.7 million from $27.6 million; selling, general and administrative expense increased to $53.7 million from $36.4 million.
Share-based compensation was $9.5 million, including $7.5 million in operating expenses.

Balance Sheet, Cash Flow, Debt, and Liquidity

Cash and cash equivalents were $523.5 million at June 30, 2010, compared with $492.1 million at March 31, 2010.
Short-term and long-term investments totaled $952.5 million. Cash, cash equivalents, and investments totaled approximately $1.476 billion.
Total assets were $2.693 billion and stockholders’ equity was $1.567 billion.
The company had $1.15 billion principal amount of 2.125% junior subordinated convertible debentures due 2037. Their carrying value was $342.2 million and estimated fair value was $1.132 billion.
Operating cash flow was $133.3 million. Investing cash flow was an outflow of $45.8 million, including $112.7 million for the SST acquisition and $34.1 million of capital expenditures. Financing cash flow was an outflow of $56.1 million, primarily reflecting $63.5 million of dividends.
Inventory increased to $128.1 million from $116.6 million, while accounts receivable increased to $193.5 million from $137.8 million.

Material Changes Versus the Prior Comparable Period

Sales growth reflected improving semiconductor conditions, market-share gains in microcontroller and analog products, and $18.4 million of continuing SST revenue.
Gross margin benefited from production at or above normal capacity, compared with under-absorption charges of approximately $12.1 million in the prior-year quarter, as well as favorable inventory-related effects and SST licensing revenue.
Operating expenses increased in dollars because of restored compensation programs and SST-related costs, but declined as a percentage of sales.
Other income declined materially: the prior-year quarter included a $5.4 million gain on trading securities, whereas the current quarter reported $0.5 million of other expense, net.
Capital expenditures rose to $34.1 million from $3.8 million, and investing cash flow changed from a $77.0 million inflow to a $45.8 million outflow, primarily because of the SST acquisition.

Acquisition, Discontinued Operations, and Unusual Items

SST was acquired for total consideration of $353.8 million, including $295.4 million of cash and $58.4 million of SST shares previously acquired. The preliminary purchase price allocation included $44.5 million of purchased intangible assets and $9.1 million of goodwill; the allocation remained subject to revision.
Selected SST product lines were classified as discontinued operations or held for sale because management determined they were not strategically aligned. A business sold to Greenliant Systems on May 21, 2010 involved approximately $23.6 million of assets and generated no recognized gain or loss.
Assets held for sale totaled $43.5 million at June 30, 2010. Discontinued operations generated $52.8 million of sales and a $49,000 net loss.
The company recorded $0.5 million of SST-related severance costs and a $0.5 million impairment charge on certain auction rate securities.
The company exercised its rights to sell $7.1 million of student-loan-backed auction rate securities at par; cash settlement occurred July 1, 2010.

Guidance, Outlook, Management Commentary, and Risks

Management expected to spend approximately $120 million on capital expenditures during the next 12 months to maintain and selectively increase capacity, funded from cash balances and operating cash flow.
Management stated that existing liquidity and operating cash flow should be sufficient for anticipated cash requirements for at least the next 12 months.
A quarterly dividend of $0.343 per share was declared on August 5, 2010, with an expected aggregate payment of approximately $63.7 million.
Management expected gross margins to fluctuate with capacity utilization, product mix, manufacturing yields, fixed-cost absorption, pricing, and economic conditions. No specific revenue or earnings guidance value is provided in the filing text.
Key risks include semiconductor cyclicality, pricing pressure, dependence on distributors and short-cycle orders, manufacturing yield and capacity risks, reliance on Asian and third-party manufacturing operations, foreign political and economic conditions, intellectual-property litigation, tax audits, investment impairments, and the integration and realization of benefits from SST.
Failed-auction securities, marketable equity investments, and non-marketable investments remain subject to valuation and liquidity risk. A hypothetical 30% change in marketable equity prices would have changed their value by approximately $11.0 million.
The company reported no material off-balance-sheet arrangements. Disclosure controls were considered effective, although SST systems and controls were still being integrated and were expected to transition by the end of fiscal 2011.

Important Facts for Investors to Verify

Reconcile reported growth and margin expansion excluding SST revenue, licensing income, discontinued operations, and the prior-year under-absorption charge.
Monitor the final SST purchase price allocation, acquired intangible-asset amortization, goodwill allocation, contingent liabilities, and integration costs.
Assess the recoverability and liquidity of auction rate securities, marketable equity investments, and the $27.4 million of non-marketable investments.
Evaluate the $1.15 billion convertible debenture principal, its cash-settlement strategy, fair value, interest burden, and potential dilution.
Review distributor inventory, deferred income on distributor shipments of $108.1 million, pricing concessions, and sell-through trends.
Track capital expenditures, capacity utilization, manufacturing yields, inventory levels, and the sustainability of the 62.2% gross margin.
Follow IRS audits for fiscal 2006–2008 and the $96.2 million long-term income-tax payable balance, as well as the $13.0 million acquisition-related contingent liability.
Confirm the continuation and amount of future quarterly dividends, which remain subject to board discretion and business conditions.