Do improving fundamentals make MCHP a buy?

The semiconductor industry is consistently one of the most interesting segments of the market to pay attention to; it seems to be a benchmark for the rest of the tech sector, and over the past few years has unquestionably lead the market from the standpoint of momentum and performance, to both the upside and downside. It’s an industry that is sensitive to economic cyclicality, but also on the cutting edge of technological innovation in practically every other segment of the market. Over the past year, the industry has particularly sensitive to trade news, with the trade war between the U.S. and China taking center stage. Yesterday President Trump indicated that tariffs against China could continue for some time, quelling some optimism among pundits and investors that a trade deal might be reached sooner than later. That means that semiconductor stocks could remain under some pressure for the foreseeable future; however it also means that among some of the industry leaders, there could be some terrific values to be had.

Through most of the latter part of 2018, semis led the market lower, selling off sharply as the market tested bear market lows. From that point, however many of those stock have rebounded pretty strongly, with rallies to this point in the year at 20% or more. Even so, many of those stocks remain significantly below their 2018 highs and could be offering some good opportunities for a value-oriented investor to start thinking about attractive long-term opportunities.

Microchip Technology (MCHP) is a company that was driven not only by industry pressure related to trade concerns, but also through most of the latter part of last year by a problematic balance sheet. The company completed the acquisition of Microsemi, a provider of semiconductor and system solutions for aerospace and defense, communications, data centers and industrial markets. MCHP borrowed approximately $8.1 billion – more than four times the roughly $1.9 billion that was on their books in March – to complete the acquisition. Initially hailed as an opportunity for the company to expand its presence into aerospace and defense in particular, MCHP management revealed, post-acquisition, that Microsemi’s managers had stuffed their sales channels with excess inventory in order to inflate revenues ahead of the deal’s closing, along with a culture of “excessive extravagance and high spending” that prompted them to immediately replace all of Micorsemi’s top leadership.

The deal certainly tamped down enthusiasm for the stock, as it plunged to a low in late October 2018 at around $61 per share. The company has been working aggressively since that point to pay down their debt, improve inventory levels throughout the company and improve their balance sheet. It looks like their work may be paying off; indications are that inventory hold times are within acceptable ranges, and the company’s Net Income, which had turned negative, has turned positive. Despite the fact the stock has rallied to just a little under $85 from that October low, it remains more than 20% its mid-2018 high around $104. If the company’s fundamentals continue to improve, this could offer an interesting opportunity to get in at a price that is still pretty attractive.

Fundamental and Value Profile

Microchip Technology Incorporated is engaged in developing, manufacturing and selling specialized semiconductor products used by its customers for a range of embedded control applications. The Company operates through two segments: semiconductor products and technology licensing. In the semiconductor products segment, the Company designs, develops, manufactures and markets microcontrollers, development tools and analog, interface, mixed signal and timing products. Its functional activities include sales, marketing, manufacturing, information technology, human resources, legal and finance. Its product portfolio comprises general purpose and specialized 8-bit, 16-bit, and 32-bit microcontrollers, a spectrum of linear, mixed-signal, power management, thermal management, radio frequency (RF), timing, safety, security, wired connectivity and wireless connectivity devices, as well as serial electrically erasable programmable read-only memories (EEPROMs) and serial flash memories. MCHP has a current market cap of about $20 billion.

Earnings and Sales Growth: Over the last twelve months, earnings have grown about 16%, while revenues increased more than 38%. In the last quarter, both numbers were negative, reflecting some of the work the company still needs to do to keep improving their bottom line. The company’s margin profile over the last twelve months showed Net Income was about 6.37% of Revenues over the last twelve months, but narrowed to 3.57% in the last quarter. I normally take that as a big red flag; but when you consider that in the quarter prior, Net Income was actually negative, the fact that last quarter’s Net Income was positive marks a major improvement in the company’s fundamental profile.

Free Cash Flow: MCHP’s free cash flow is healthy, at more than $2.77 billion. This is a healthy number that marks a Free Cash Flow Yield of nearly 14%. It is also remarkable in that it it represents an improvement of more than $1.6 billion since the Microsemi acquisition was completed.

Dividend: MCHP’s annual divided is $1.46 per share and translates to a yield of 1.7% at the stock’s current price.

Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for MCHP is $21.82 and translates to a Price/Book ratio of 3.86 at the stock’s current price. The stock’s historical average Price/Book ratio is 4.62, which puts a target price for the stock at about $101 per share, or nearly 20% above its current price and within range of its June 2018 highs.

Technical Profile

Here’s a look at the stock’s latest technical chart.

Current Price Action/Trends and Pivots: The red diagonal line measures the length of the stock’s downward trend from June to November of last year, and also informs the Fibonacci trend retracement lines shown on the right side of the chart. The stock’s decline from a high at around $104 is hard to miss, of course, but the stock’s upward trend in the months since that point are also informative. The stock picked up significant bullish momentum at the beginning of the year, pushed primarily by trade optimism that propelled the entire semiconductor industry higher. After hitting a high around $91 in February, the stock has tapered off, but appears to be stabilizing around $84 per share, and could be setting up for a new push higher along its upward trend. A break above the 61.8% retracement line at about $87.50 could see the stock build enough momentum to test $100 per share, which is where the stock’s long-term price target is right now. If it break below support at $84, it could easily test support at the 38.2% Fibonacci retracement line around $77 per share.

Near-term Keys: If you’re willing to bet that MCHP’s improving fundamentals are likely to continue, this stock could offer an interesting value play, even with the stock’s surge in price over the last five months. If you prefer to work a short-term, momentum-based trade, look for a break above $87.50 as the signal to either buy the stock or start working with call options. A break below $84 could be a good signal to consider shorting the stock or to buy put options, with a target price in that case at around $77 per share.