Business Context and Reporting Period
Microchip Technology Incorporated designs, manufactures and sells specialized semiconductor products for embedded-control applications, including microcontrollers, analog and mixed-signal products, FPGAs, memory, connectivity, timing, power-management and security products, as well as technology licensing. This Form 10-K covers the fiscal year ended March 31, 2019. The request references “2018 Q4,” but the filing is an annual FY2019 report; its fourth-quarter FY2019 results are included in the quarterly data.
Microchip completed its acquisition of Microsemi on May 29, 2018 for approximately $8.24 billion, including assumed liabilities. Microsemi contributed approximately $1.57 billion of FY2019 net sales and significantly expanded the company’s FPGA, analog, timing, aerospace, defense, communications and industrial businesses.
Key Financial Metrics
| Metric | FY2019 | FY2018 | Change or comment |
|---|---|---|---|
| Net sales | $5,349.5 million | $3,980.8 million | Up 34.4%, primarily from Microsemi |
| Gross profit | $2,931.3 million | $2,420.7 million | Gross margin declined to 54.8% from 60.8% |
| Operating income | $714.3 million | $936.3 million | Operating margin declined to 13.4% from 23.5% |
| Net income | $355.9 million | $255.4 million | Continuing operations in both periods |
| Diluted EPS | $1.42 | $1.03 | Continuing operations |
| Operating cash flow | $1,674.8 million | $1,419.6 million | Up 18.0% |
| Capital expenditures | $228.9 million | $206.8 million | Primarily capacity, equipment and facilities |
| Cash, cash equivalents and short-term investments | $430.9 million | $2,196.6 million | Declined primarily because of the Microsemi acquisition |
| Gross principal debt | $11,659.3 million | $4,481.3 million | Increased to finance Microsemi |
Cost of sales was $2,418.2 million, or 45.2% of sales. Research and development expense was $826.3 million, or 15.4% of sales, and selling, general and administrative expense was $682.9 million, or 12.8% of sales. Acquired-intangible amortization was $674.1 million. Interest expense rose to $502.9 million from $199.0 million.
At March 31, 2019, inventory was $711.7 million, representing 128 days of inventory versus 112 days at March 31, 2018. Accounts receivable was $880.6 million. Total assets were $18.35 billion and stockholders’ equity was $5.29 billion.
Material Changes Versus the Prior Comparable Period
- Revenue increased $1.37 billion, primarily from including Microsemi for approximately ten months. Product mix shifted toward higher-average-selling-price Microsemi products, including analog, timing and FPGA products.
- Gross margin fell 600 basis points. Fiscal 2019 included approximately $365.7 million of acquired-inventory fair-value charges and a $19.0 million unabsorbed-capacity charge. The company also operated with increased reliance on external manufacturing suppliers.
- Operating income declined despite higher revenue because of acquired-intangible amortization, acquisition-related costs, higher research and development and SG&A expenses, restructuring charges and higher interest expense.
- Cash flow from operations increased, but investing cash flow was negative $6.81 billion, including $7.85 billion of net cash used for the Microsemi acquisition and $228.9 million of capital expenditures.
- Cash and investments declined by approximately $1.77 billion, while debt increased by approximately $7.18 billion in principal. The company prepaid $1.09 billion of term-loan principal during the year.
- Effective April 1, 2018, the company adopted ASC 606. Distributor revenue moved from sell-through recognition to sell-in recognition. The company reported that adoption reduced FY2019 net sales by $30.6 million and net income from continuing operations by $12.4 million compared with results without adoption, while eliminating deferred income on distributor shipments.
- Fiscal 2019 included a $151.4 million income-tax benefit. Significant items included a $95.4 million GILTI expense, a $90.6 million business-realignment benefit, a $75.1 million benefit from tax-audit closures and statute expirations, and a $657.8 million finalized transition-tax liability under the Tax Cuts and Jobs Act, recognized primarily in the prior fiscal year.
Guidance, Outlook, Commentary and Risks
Management expected June 2019 inventory days to range from 8 days below to 11 days above the March 2019 level. It planned capital expenditures of approximately $130 million to $150 million over the following twelve months and expected to fund them through cash balances and operating cash flow. Management stated that existing liquidity, operating cash flow and available revolver capacity should cover anticipated requirements for at least the next twelve months.
Backlog was approximately $2.38 billion at April 30, 2019, up from $1.83 billion a year earlier; however, orders may be rescheduled or cancelled and backlog is not a reliable forecast of future sales. Distributors represented 51% of FY2019 sales, and Arrow Electronics represented 10%.
Key risks include substantial leverage, variable-rate debt, semiconductor cyclicality, pricing pressure, distributor inventory and demand fluctuations, dependence on external wafer foundries and assembly/test contractors, tariffs and U.S.-China trade tensions, foreign operations, government-contract exposure from Microsemi, inventory obsolescence, intellectual-property claims, tax audits and integration risk.
The company disclosed an ongoing compromise of its computer networks and concluded that IT-system access controls constituted a material weakness. It also identified a separate material weakness related to income-tax accounting. Management planned remediation during fiscal 2020, but Ernst & Young issued an adverse opinion on internal control over financial reporting as of March 31, 2019. The financial-statement audit opinion itself was unqualified.
Other unusual items include $33.7 million of net special charges, primarily acquisition-related restructuring; $3.1 million of intangible-asset impairment; approximately $100 million of possible but not probable legal exposure in excess of accrued amounts; and potential technology-license indemnification payments of approximately $164 million where specified limits apply. No goodwill impairment was recorded.
Important Facts for Investors to Verify
- Whether Microsemi integration delivers expected revenue, cost synergies and cash-flow benefits, particularly given the acquisition’s large goodwill and intangible-asset balances.
- Debt repayment capacity, leverage-ratio compliance, refinancing needs and sensitivity to higher interest rates; a 50-basis-point rate increase was estimated to raise annual interest expense by approximately $26 million.
- Whether inventory days normalize and whether distributor inventory, sell-in accounting and price concessions affect future revenue and margins.
- Progress in remediating the income-tax and IT-access material weaknesses and the ultimate scope and consequences of the network compromise.
- Potential outcomes of shareholder, derivative, product-liability, intellectual-property and tax proceedings, including the Continental claim alleging approximately $208 million of damages.
- Exposure to tariffs, China-related demand, government shutdowns or export-license delays, and the continuing dependence on third-party foundries and assembly/test providers.
- Sustainability of the quarterly dividend, given cash of $430.9 million, annual debt service requirements and substantial contractual obligations totaling approximately $14.46 billion.