MICROCHIP TECHNOLOGY INC annual report, FY2016

Microchip Technology Incorporated — Fiscal 2016 Form 10-K Summary

Reporting period: Fiscal year ended March 31, 2016. The filing is an annual report rather than a “2015 Q4” filing; quarterly fourth-quarter results are included for the three months ended March 31, 2016.

Business Context

Microchip develops and sells specialized semiconductors for embedded-control applications, including 8-bit, 16-bit and 32-bit microcontrollers; analog, mixed-signal, power, timing, connectivity and memory products; development tools; and Flash-IP technology licensing. The company reports two segments: semiconductor products and technology licensing.

Approximately 84% of fiscal 2016 sales were to foreign customers; China, including Hong Kong, represented approximately 30% of sales and Taiwan approximately 12%.
Distributors generated approximately 53% of net sales, compared with 51% in fiscal 2015.
Approximately 39% of sales came from products manufactured at outside wafer foundries.
Microchip had 9,766 employees at March 31, 2016.

Financial Performance and Liquidity

Metric	Fiscal 2016	Fiscal 2015	Change
Net sales	$2,173.3 million	$2,147.0 million	Up 1.2%
Gross profit	$1,205.5 million	$1,229.6 million	Down 2.0%
Gross margin	55.5%	57.3%	Down 180 basis points
Operating income	$352.3 million	$425.6 million	Down 17.2%
Operating margin	16.2%	19.8%	Down 360 basis points
Net income attributable to Microchip	$324.1 million	$369.0 million	Down 12.2%
Diluted EPS	$1.49	$1.65	Down 9.7%
Cash flow from operations	$744.5 million	$721.2 million	Up 3.2%
Capital expenditures	$97.9 million	$149.5 million	Down 34.5%

Fourth-quarter fiscal 2016 sales were $557.6 million, gross profit was $302.8 million, operating income was $79.9 million and diluted EPS was $0.31.
Product mix shifted toward analog, interface, mixed-signal and timing products. Analog sales increased 18.8% to $595.5 million, while microcontroller sales declined 3.5% to $1,345.5 million and memory sales declined 11.6% to $116.9 million.
Research and development expense increased 6.6% to $372.6 million, or 17.1% of sales. Selling, general and administrative expense increased 9.8% to $301.7 million.
Fiscal 2016 gross margin was affected by approximately $44.9 million of acquired-inventory fair-value charges, compared with $24.4 million in fiscal 2015, as well as product mix and inventory write-downs.
Cash, cash equivalents and short- and long-term investments totaled $2.565 billion at March 31, 2016. Cash and cash equivalents alone were $2.093 billion.
Working capital was $2.715 billion, compared with $2.311 billion in fiscal 2015. Inventory was $306.8 million, equivalent to approximately 110 days of inventory.
Outstanding borrowings under the revolving credit facility were $1.052 billion. The total revolving facility was $2.774 billion, and the company was in compliance with its debt covenants.
Carrying amounts of the senior and junior convertible debentures were $1.235 billion and $196.3 million, respectively. Their disclosed fair values were substantially higher, at $1.762 billion and $1.143 billion.
Contractual obligations totaled $4.073 billion, including debt principal and interest, leases, capital commitments and other purchase obligations.
Microchip paid $291.1 million in dividends and repurchased 8.6 million shares for $363.8 million during fiscal 2016.

Material Changes Versus the Prior Comparable Period

Sales grew modestly because of the August 2015 Micrel acquisition, partially offset by weaker global economic and semiconductor industry conditions. Unit volume increased approximately 6%, while average selling prices declined approximately 3%.
Profitability declined despite higher sales. Gross margin fell 180 basis points, and operating margin fell 360 basis points, primarily due to acquired-inventory charges, product mix, higher R&D and SG&A expenses, and acquisition-related amortization.
Interest expense rose to $104.0 million from $62.0 million, largely due to the 1.625% senior convertible debentures and related non-cash debt-discount amortization.
Fiscal 2016 benefited from a $42.6 million income-tax benefit, including benefits from tax-audit closures and expirations of tax reserves, intercompany prepaid-tax amortization and R&D credits. The fiscal 2015 tax benefit was $19.4 million.
Cash flow from operations increased, while investing cash flow was positive $800.4 million, primarily because of sales and maturities of investments. The company also spent $343.9 million, net of cash acquired, for Micrel.
Goodwill increased to $1.013 billion from $571.3 million, primarily due to Micrel. Net intangible assets increased to $606.3 million from $504.4 million.

Guidance, Outlook, Commentary and Unusual Items

Management expected June 2016 inventory to increase by approximately one to nine days from the March 2016 level, excluding inventory acquired from Atmel, to support competitive lead times and delivery performance.
Management planned approximately $140 million of capital expenditures over the following twelve months, funded primarily through cash balances and operating cash flow.
Management stated that existing liquidity, operating cash flow and available credit were expected to satisfy anticipated cash requirements for at least the next twelve months.
On April 4, 2016, after the reporting date, Microchip completed its acquisition of Atmel for approximately $3.47 billion, including approximately $2.98 billion in cash and 10.1 million Microchip shares. The transaction was funded with approximately $2.04 billion of foreign-subsidiary cash and investments, $0.94 billion of additional borrowings and approximately $489 million of stock issuance.
Atmel contributed no revenue or expenses to fiscal 2016 reported results. Pro forma fiscal 2016 results assuming Atmel had been acquired at the beginning of the period were sales of $3.346 billion and net income of $167.7 million; management stated that these figures were not indicative of future results.
Atmel materially increased post-closing leverage, integration requirements, goodwill and intangible assets. The Atmel purchase-price allocation remained preliminary at the filing date.
Fiscal 2016 special charges were $4.0 million, consisting primarily of acquisition-related severance and office-closing costs and legal settlement costs, partially offset by an $11.5 million insurance settlement.
Key risks include semiconductor cyclicality, pricing pressure, short order visibility, distributor dependence, reliance on foundries and Asian assembly/test contractors, manufacturing yields, inventory obsolescence, foreign operations, China exposure, Thailand disruption risk, acquisition integration, debt and refinancing risk, tax audits, intellectual-property litigation and potential product-liability claims.
The company is subject to IRS audits for fiscal 2011 and 2012 and had $220.7 million of gross unrecognized tax benefits at March 31, 2016. It also had approximately $3.4 billion of undistributed foreign earnings treated as permanently reinvested.
Following the Atmel acquisition, Microchip became involved in product-liability and labor-related litigation. The filing states that outcomes were uncertain and that Atmel intended to defend the matters vigorously.
Revenue recognition guidance under ASC 606 was expected to change distributor accounting from sell-through recognition to recognition at distributor shipment, subject to estimated returns and allowances. The company had not selected a transition method or quantified the impact.

Important Facts for Investors to Verify

Post-acquisition Atmel revenue, earnings contribution, integration costs, synergies and the final purchase-price allocation.
Pro forma and reported leverage after the additional Atmel borrowings, including compliance with credit-facility covenants and refinancing requirements.
Sustainability of the 55.5% gross margin given pricing pressure, acquired-inventory charges, product mix and manufacturing utilization.
Underlying demand for microcontrollers and memory products, particularly in China, automotive, industrial, consumer and communications markets.
Cash availability by jurisdiction, the tax cost of repatriating foreign earnings and the effect of future U.S. or foreign tax-law changes.
Potential exposure from Atmel-related litigation, intellectual-property claims, product-liability matters and indemnification obligations.
Impact and implementation timing of ASC 606, including changes to deferred distributor revenue and reported sales trends.
Whether operating cash flow remains sufficient to fund dividends, capital expenditures, share repurchases, debt service and acquisition-related obligations.