MICROCHIP TECHNOLOGY INC annual report, FY2020

Business Context and Reporting Period

Microchip Technology Incorporated filed its Annual Report on Form 10-K for the fiscal year ended March 31, 2020, filed May 21, 2020. The filing is not a quarterly report for “2019 Q4”; it includes fourth-quarter results within the full fiscal-year reporting period. Microchip develops, manufactures and sells specialized semiconductor products for embedded-control applications, including microcontrollers, analog and mixed-signal products, FPGAs, memory, connectivity, timing, power-management and technology-licensing products.

The fiscal year included twelve months of Microsemi results, compared with ten months in fiscal 2019 following the May 29, 2018 acquisition. Microchip paid approximately $8.24 billion in total consideration and financed the transaction largely with new debt.

Financial Performance and Key Metrics

Metric	FY2020	FY2019	Change
Net sales	$5.274 billion	$5.350 billion	Down 1.4%
Gross profit	$3.242 billion	$2.931 billion	Up 10.6%
Gross margin	61.5%	54.8%	Up 670 basis points
Operating income	$647.1 million	$714.3 million	Down 9.4%
Operating margin	12.3%	13.4%	Down 110 basis points
Net income	$570.6 million	$355.9 million	Up 60.3%
Diluted EPS	$2.23	$1.42	Up 57.0%
Cash flow from operations	$1.544 billion	$1.675 billion	Down 7.8%

Product sales were led by microcontrollers at $2.818 billion, or 53.4% of sales; analog, interface, mixed-signal and timing products contributed $1.511 billion; FPGAs contributed $373.5 million; and licensing, memory and other products contributed $571.7 million.
FPGA sales increased 22.9%, primarily from the Microsemi acquisition. Microcontroller sales declined 3.6%, analog and related sales declined 1.3%, and licensing, memory and other sales declined 3.6%.
Interest expense was $497.3 million, compared with $502.9 million in the prior year. Amortization of acquired intangible assets increased to $993.9 million from $674.1 million.
Net income benefited from a $420.2 million income-tax benefit, including a $334.8 million benefit from intra-group transfers of intellectual property, $40.8 million of R&D credits and $28.5 million from audit closures and statute expirations. The filing indicates that tax authorities could challenge the intellectual-property valuation and related tax treatment.
Share-based compensation expense was $170.2 million. Dividends paid were $350.1 million, or $1.465 per share. No common-stock repurchases occurred during fiscal 2020.

Liquidity, Debt and Balance Sheet

Cash, cash equivalents and short-term investments totaled $403.0 million at March 31, 2020, down from $430.9 million a year earlier.
Gross debt principal was $10.59 billion, including $6.727 billion of senior secured indebtedness and $3.866 billion of convertible debt. Net debt after discounts and issuance costs was $9.482 billion.
Outstanding borrowings included $2.389 billion under the revolving credit facility, $1.724 billion under the term loan facility and $615.0 million under a bridge loan used to fund the cash portion of a convertible-debt settlement.
The revolving facility provided approximately $3.57 billion of commitments and matures in May 2023. The term loan matures in May 2025, while the bridge loan matures in March 2021.
Variable-rate debt totaled approximately $4.73 billion. Management estimated that a 50-basis-point increase in interest rates would increase annual interest expense by approximately $23.6 million.
Inventory declined to $685.7 million from $711.7 million, or 122 days from 128 days. Backlog increased to approximately $2.42 billion from $2.20 billion, although orders may be canceled or rescheduled and backlog is not considered a reliable sales forecast.
Capital expenditures were $67.6 million, compared with $228.9 million in fiscal 2019. Planned capital expenditures for the following twelve months were $50 million to $70 million.
Management stated that existing liquidity, operating cash flow and available revolver capacity should cover anticipated cash requirements for at least the next twelve months, subject to business and market conditions.

Material Changes Versus the Prior Comparable Period

Revenue decreased modestly despite the inclusion of a full year of Microsemi sales. Management estimated that adverse market conditions reduced fiscal 2020 sales by approximately 5%, while the additional two months of Microsemi activity increased sales by approximately 4%.
Gross margin improved substantially because fiscal 2019 included approximately $365.7 million of acquired-inventory fair-value charges related to acquisitions. Fiscal 2020 still included $47.2 million of unabsorbed capacity charges, up from $16.2 million.
Operating income declined despite higher gross profit because acquired-intangible amortization rose by $319.8 million and R&D expense increased by $51.5 million.
Operating cash flow decreased primarily because of lower sales, partially offset by acquisition-related synergies, process efficiencies and working-capital management.
Debt declined through repayments and the settlement of $615.0 million of 2015 convertible debt, but the company remained highly leveraged.
Microchip restructured its Fab 5 facility, transferred higher-volume products to other fabs and reduced clean-room capacity. It incurred $18.0 million of related costs in fiscal 2020 and expects less than $10.0 million of additional costs within the following year.
The material weaknesses in income-tax accounting and IT-system access identified in fiscal 2019 were reported as remediated as of March 31, 2020. Ernst & Young issued an unqualified opinion on both the financial statements and internal control over financial reporting.

Guidance, Outlook, Commentary and Risks

COVID-19 increased demand for products supporting medical devices, data centers, communications infrastructure, computers and contact-free applications, while weakening automotive, broad industrial, consumer, home-appliance and aerospace demand.
Manufacturing sites remained operational at year-end, but some operated at reduced utilization. Travel restrictions affected Philippine operations, subcontractors in Malaysia and China, and logistics providers. Management expected greater adverse effects in the quarter ending June 30, 2020.
Management expected June 2020 inventory days to range from six days below to eight days above the March 2020 level.
Key risks include COVID-19-related order cancellations and delivery rescheduling, semiconductor cyclicality, pricing pressure, dependence on distributors and external foundries, supply-chain disruptions, tariffs and export restrictions involving China, foreign operations, customer and distributor credit risk, cybersecurity, intellectual-property claims, tax audits and government-contract uncertainty.
Material legal and contingent matters include government investigations relating to the Microsemi acquisition, shareholder litigation, an Atmel-related automotive product claim alleging approximately $203 million of damages, and other acquired-company matters. Management stated that aggregate possible but not probable liability was approximately $100 million above recorded amounts.
The company disclosed $757.3 million of gross unrecognized tax benefits and stated that an April 2020 withholding-tax regulation could result in a future reserve; the potential financial impact was not estimable at filing.

Most Important Facts to Verify

Whether COVID-19-related cancellations, reduced utilization and supply-chain constraints materially affected post-March 31, 2020 results, particularly the June 2020 quarter.
The company’s ability to refinance or repay the $615.0 million bridge loan due in March 2021 and other near-term debt maturities.
Whether the unusually large fiscal 2020 tax benefit, especially the $334.8 million intellectual-property transfer benefit, is sustainable or subject to challenge.
Future gross-margin performance after the benefit of eliminating most fiscal 2019 acquired-inventory charges and amid continued underutilization charges.
Potential outcomes and reserves related to Microsemi investigations, Atmel litigation, product claims and other contingencies.
Whether the company realizes expected cost savings from Fab 5 restructuring, acquisition integration and increased internal assembly and test capacity.
Future goodwill and intangible-asset impairment risk, given goodwill of $6.665 billion and net intangible assets of $5.702 billion at year-end.