Microchip Technology Incorporated: Q2 FY2020 Form 10-Q Summary
Business context and reporting period
Microchip designs, manufactures and sells embedded-control semiconductor products and licenses intellectual property. Reported segments are semiconductor products and technology licensing. The quarter ended September 30, 2019 was the second quarter of fiscal 2020; comparisons are primarily with the quarter and six-month periods ended September 30, 2018. Results include a full period of Microsemi operations, versus only approximately four months in the comparable six-month 2018 period following the May 29, 2018 acquisition.
Key financial metrics
| Metric | Three months ended September 30, 2019 | Prior year | Six months ended September 30, 2019 | Prior year |
|---|---|---|---|---|
| Net sales | $1,337.8 million | $1,432.5 million | $2,660.4 million | $2,644.9 million |
| Gross profit | $827.5 million | $689.3 million | $1,642.7 million | $1,331.3 million |
| Gross margin | 61.9% | 48.1% | 61.7% | 50.3% |
| Operating income | $183.6 million | $102.7 million | $355.2 million | $234.9 million |
| Operating margin | 13.7% | 7.2% | 13.4% | 8.9% |
| Net income | $108.9 million | $96.3 million | $159.6 million | $132.0 million |
| Diluted EPS | $0.43 | $0.38 | $0.63 | $0.52 |
- Quarterly sales declined 6.6% year over year; six-month sales increased 0.6%, principally because of the additional Microsemi contribution.
- Operating income increased 78.8% in the quarter and 51.2% for the six months. Results benefited materially from the absence of the $182.1 million quarterly and $289.6 million six-month acquired-inventory fair-value charge recognized in the prior-year periods.
- Interest expense was $129.6 million in the quarter and $262.2 million for the six months. Six-month interest expense increased from $229.0 million because of acquisition-related borrowings, despite debt paydown reducing quarterly expense.
- Income tax benefit was $55.4 million in the quarter and $65.6 million for the six months. The filing states that effective tax rates were not meaningful because of significant discrete benefits, including releases of uncertain tax positions and Microsemi integration items.
- Net cash provided by operating activities was $776.6 million for the six months, compared with $789.9 million in the prior year.
- Capital expenditures were $41.6 million, versus $161.4 million in the prior-year six months. Net cash used in investing activities was $54.7 million, compared with $6.74 billion, which included the Microsemi acquisition.
- Cash dividends paid were $174.4 million. A quarterly dividend of $0.3665 per share was declared on November 5, 2019.
Balance sheet, debt and liquidity
- At September 30, 2019, cash and cash equivalents were $401.8 million, short-term investments were $3.3 million, and total liquidity including short-term investments was $405.1 million.
- Accounts receivable were $848.6 million and inventories were $734.2 million, or approximately 131 days of inventory, compared with 128 days at March 31, 2019.
- Gross principal debt was $11.09 billion; net debt including current maturities was $9.80 billion. Revolving credit borrowings were $2.88 billion and term-loan borrowings were approximately $1.72 billion.
- The revolving facility provided approximately $3.57 billion of commitments and matured in 2023. The September 2019 credit agreement amendment reduced applicable borrowing margins and permitted certain refinancing and receivables-factoring transactions.
- The company prepaid $188.0 million of term-loan principal during the six months and recognized a $2.0 million loss on debt settlement.
- Management stated that existing liquidity, operating cash flow and revolving-credit availability should be sufficient for anticipated requirements for at least the next 12 months. A 50-basis-point increase in interest rates would increase expected annual interest expense by approximately $23.0 million.
Material changes versus the prior comparable period
- Quarterly demand weakened across markets served, with management citing general economic conditions, trade restrictions and tariffs. Microcontroller revenue declined 10.4% in the quarter and 6.3% for the six months.
- FPGA revenue increased 31.6% in the quarter and 69.5% for the six months, primarily reflecting Microsemi and customer-demand effects.
- Microsemi increased the mix of higher-average-selling-price products, including analog, interface, mixed-signal, timing and FPGA products, and increased reliance on outside wafer foundries.
- Gross margin improved substantially as the prior-year Microsemi acquisition accounting charge did not recur. However, below-normal production generated unabsorbed capacity charges of $8.9 million in the quarter and $16.2 million for the six months.
- Acquired-intangible amortization increased to $248.2 million in the quarter and $496.7 million for the six months, compared with $169.9 million and $303.6 million, respectively.
- Special charges declined to $3.6 million in the quarter and $11.7 million for the six months, compared with $18.2 million and $58.3 million, respectively. The company expects $15 million to $25 million of additional restructuring costs for certain wafer-fabrication operations over the following year.
- The company adopted ASC 842 leases on April 1, 2019, recognizing $124.6 million of right-of-use assets and $137.3 million of operating lease liabilities at adoption.
Guidance, outlook, commentary and risks
- Management expected December 2019 inventory days to be flat to up 13 days from September levels and stated that current inventory should support competitive lead times and delivery performance.
- Planned capital expenditures for the next 12 months were $110 million to $130 million, funded through cash and operating cash flow.
- Management identified continuing risks from semiconductor cyclicality, weaker demand, trade restrictions and tariffs, pricing pressure, distributor inventory patterns, manufacturing utilization and yields, and reliance on external foundries and assembly/test contractors.
- Approximately 79% of six-month sales were to foreign customers; China, Taiwan and Germany represented approximately 21%, 15% and 11%, respectively. Further tariffs or trade restrictions could reduce demand, increase costs or constrain supply.
- The company disclosed an ongoing investigation by the Department of Justice and SEC concerning matters related to the Microsemi acquisition, including distribution-channel issues and business practices.
- Material litigation includes a former Microsemi officers’ lawsuit seeking more than $100 million in compensatory damages and more than $300 million in punitive damages, and a Continental arbitration claim alleging approximately $210 million of damages. Management believes ultimate resolution of pending matters will not materially affect the company, but outcomes are uncertain.
- The company reported an ongoing compromise of its computer networks and two material weaknesses in internal control over financial reporting: income-tax accounting and IT-system access. Remediation was expected to be completed by the end of fiscal 2020, but controls were not yet considered remediated.
- The 2015 Senior Convertible Debt was convertible during October 1 through December 31, 2019. Its value if converted above par was approximately $1.30 billion as of September 30, 2019, creating potential cash requirements and dilution exposure.
Important facts for investors to verify
- Whether demand stabilizes after the six-month sales benefit from the Microsemi acquisition and how much of future growth is organic.
- The sustainability of the approximately 62% gross margin after the prior-year acquisition accounting effects have fully rolled off, including the impact of utilization, product mix and inventory levels.
- Debt reduction progress, refinancing needs, convertible-debt conversion exposure and compliance with leverage and interest-coverage covenants.
- Resolution and potential financial impact of the DOJ and SEC investigations, shareholder and former-Microsemi litigation, and the Continental arbitration.
- Progress in remediating the tax-accounting and IT-access material weaknesses and the ultimate scope and consequences of the network compromise.
- Effects of tariffs, export restrictions, global demand conditions and customer or distributor inventory adjustments on future sales.
- Whether the Malaysian tax holiday is renewed after December 2019 and how tax-position releases and other discrete benefits affect future tax rates.