Microchip Technology Incorporated: Fiscal 2019 Second-Quarter Form 10-Q
Reporting period: Three and six months ended September 30, 2018; filed November 7, 2018. The interim financial statements are unaudited and include Microsemi results from the May 29, 2018 acquisition date. Microchip develops, manufactures and licenses semiconductor products serving embedded control, automotive, industrial, aerospace and defense, communications, computing and consumer markets.
Financial performance and position
| Metric | Three months ended September 30 | Six months ended September 30 |
|---|---|---|
| Net sales | $1,432.5 million, up 41.5% | $2,644.9 million, up 33.3% |
| Gross profit | $689.3 million; 48.1% margin | $1,331.3 million; 50.3% margin |
| Operating income | $102.7 million; 7.2% margin | $234.9 million; 8.9% margin |
| Net income | $96.3 million | $132.0 million |
| Diluted EPS | $0.38 | $0.52 |
| Operating cash flow | Not separately provided | $789.9 million |
Gross margin declined from 60.7% to 48.1% for the quarter and from 60.4% to 50.3% for the six-month period. The principal driver was $182.1 million of acquired-inventory fair-value step-up cost in the quarter and $289.7 million year to date related to Microsemi. Operating expenses also increased due to Microsemi integration, higher research and development, selling, general and administrative costs, and acquired-intangible amortization.
- September 30 cash, cash equivalents and short-term investments totaled $464.2 million, down $1.73 billion from March 31, 2018.
- Net cash used in investing activities was $6.74 billion, including $7.85 billion for the Microsemi acquisition, net of cash acquired; capital expenditures were $161.4 million.
- Net cash provided by financing activities was $5.50 billion, primarily reflecting acquisition-related borrowings.
- Inventory was $836.7 million, or 103 days of inventory; excluding the remaining $120.1 million Microsemi inventory fair-value markup, inventory was 117 days.
- Gross principal debt was $12.31 billion and net long-term debt, including current maturities, was $10.89 billion. Variable-rate debt was $5.83 billion; management estimated that a 50-basis-point rate increase would raise annual interest expense by approximately $29.2 million.
- The company had $3.10 billion outstanding under a $3.60 billion revolving facility and was in compliance with its debt covenants at September 30, 2018.
- Dividends paid during the six months were $171.4 million. A quarterly dividend of $0.3645 per share was declared for payment in December 2018.
Material changes versus the prior comparable period
- Microsemi acquisition: Completed for approximately $8.24 billion of total consideration, financed primarily with approximately $8.10 billion of new borrowings. Microsemi contributed approximately $431.7 million of quarterly sales and $620.2 million of year-to-date sales, but reported net losses of approximately $216.4 million and $250.4 million, respectively, in the consolidated periods.
- Goodwill increased to $6.79 billion and net intangible assets to $6.83 billion, largely from the acquisition. The preliminary purchase-price allocation remains subject to revision.
- Net sales increased primarily because of Microsemi. Product mix shifted toward analog, interface, mixed-signal, timing and FPGA products, while microcontrollers represented a smaller percentage of sales.
- Interest expense rose to $138.6 million for the quarter and $229.0 million for six months, compared with $49.5 million and $98.9 million, respectively, in the prior-year periods.
- Research and development increased 66.1% for the quarter and 49.2% for six months; selling, general and administrative expense increased 54.5% and 49.0%, respectively.
- Special charges were $18.2 million for the quarter and $58.3 million for six months, primarily employee separation, contract-exit and impairment costs associated with acquisition integration.
- Effective April 1, 2018, ASC 606 changed distributor revenue recognition from sell-through to sell-in. The adoption eliminated deferred income on distributor shipments and increased opening retained earnings by approximately $241.9 million, before other accounting-standard adjustments.
Guidance, outlook, commentary and risks
- Management expected December 2018 quarter inventory days to be flat to up 10 days from September levels and believed existing inventory supported competitive lead times and delivery performance.
- Management expected approximately $170 million of capital expenditures over the following 12 months and believed cash, operating cash flow and available borrowing capacity would fund anticipated requirements for at least the next 12 months.
- Gross margins are expected to fluctuate with product mix, capacity utilization, manufacturing yields, fixed-cost absorption, competitive pricing and economic conditions.
- Management expects additional acquisition-related restructuring and integration costs but cannot estimate their total amount. Future goodwill or intangible-asset impairment is also possible.
- Key risks include the substantial increase in leverage, interest-rate exposure, Microsemi integration and realization of expected synergies, reliance on third-party foundries and assembly/test contractors, distributor inventory and sell-in revenue volatility, semiconductor cyclicality and pricing pressure, foreign operations and currency exposure, and dependence on government-related demand.
- Contingencies include Continental arbitration claims alleging approximately $227.7 million of damages, shareholder class actions related to Microchip disclosures, former Microsemi officer litigation, and other acquired-company matters. Potential liabilities that were possible but not probable were estimated at approximately $100 million above recorded amounts.
- The company had approximately $681.8 million of gross unrecognized tax benefits at September 30, 2018. Tax reform estimates, GILTI accounting, tax audits and the provisional transition-tax calculation remain subject to further developments.
Investor verification priorities
- Verify the final Microsemi purchase-price allocation, integration costs, acquired-inventory step-up consumption and resulting normalized gross margins.
- Assess debt reduction capacity, covenant headroom, refinancing needs and the effect of variable interest rates on cash flow.
- Reconcile reported revenue and distributor inventories under ASC 606 with prior-period sell-through presentation.
- Monitor inventory days, distributor stock levels, demand, pricing pressure and capacity utilization.
- Review the sustainability of cash flow after dividends, capital expenditures, transition-tax payments and acquisition-related obligations.
- Track litigation, tax audits, uncertain tax positions, purchase-price adjustments and potential goodwill or intangible impairments.