Calculated Expansion And Capital Return Plan Poised To Boost Revenue And Sharpen Competitive Edge

Key Takeaways

• Expansion into the 64-bit embedded microprocessor market could significantly boost Microchip's revenue by increasing its total addressable market.
  
• Commitment to returning 100% of adjusted free cash flow to shareholders by March 2025 through dividends and buybacks may support earnings growth.
  
• Ongoing inventory corrections and financial pressures highlight potential challenges in demand, revenue growth, and operational efficiency for Microchip Technology.

Catalysts

Engages in the development, manufacture, and sale of smart, connected, and secure embedded control solutions in the Americas, Europe, and Asia.

• Expansion into the 64-bit embedded microprocessor market with a suite of products could significantly increase Microchip's total addressable market, potentially boosting revenue growth as these products gain traction in high-performance embedded processing applications.
  
• Commitment to a capital return plan, aiming to return 100% of adjusted free cash flow to shareholders by March 2025, may support earnings per share growth through dividend payments and share buybacks.
  
• Inventory management strategies, including building inventory for long-lived, high-margin products, could stabilize gross margins by ensuring supply for high-demand products despite broader market volatility.
  
• Adjustments in production activities to manage inventory levels and operational costs efficiently, along with strategic capital expenditures aimed at long-term growth, are likely to preserve or potentially improve net margins.
  
• Engagement in the CHIPS Act grants and investment tax credits, if successfully navigated, could provide financial benefits and support R&D efforts, further enhancing Microchip's competitive positioning and future earnings potential.

Assumptions

• Analysts are assuming Microchip Technology's revenue will grow by 4.7% annually over the next 3 years.
• Analysts assume that profit margins will increase from 20.8% today to 25.7% in 3 years time.
• Analysts expect earnings to reach $1.9 billion (and earnings per share of $3.72) by about August 2027, up from $1.4 billion today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting $2.4 billion in earnings, and the most bearish expecting $1.4 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 32.0x on those 2027 earnings, up from 28.9x today. This future PE is greater than the current PE for the US Semiconductor industry at 25.7x.
• Analysts expect the number of shares outstanding to decline by 1.44% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 8.37%, as per the Simply Wall St company report.

Risks

• The ongoing major inventory correction and the sequential revenue decline of 6.4% indicate potential prolonged demand weakness, which could impact future revenues.
  
• Increasing operating expenses to 28.4% of net sales and the rise of net debt to 2.02x adjusted EBITDA signal growing financial pressure, possibly affecting net margins and earnings.
  
• The cautious guidance for the September quarter, with expected net sales to be between $1.12 billion and $1.18 billion, reflects uncertainty in demand recovery, which could delay revenue growth.
  
• The need for turns orders within the quarter due to very low backlog visibility adds unpredictability to revenue forecasts, potentially affecting earnings predictability.
  
• High levels of distributor and internal inventory, with 237 days of inventory and plans to increase inventory dollars, suggest ongoing challenges in inventory management, which could impact cash flow and operational efficiency.

Valuation

• The analysts have a consensus price target of $95.1 for Microchip Technology based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $105.0, and the most bearish reporting a price target of just $80.0.
  
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $7.6 billion, earnings will come to $1.9 billion, and it would be trading on a PE ratio of 32.0x, assuming you use a discount rate of 8.4%.
  
• Given the current share price of $73.86, the analyst's price target of $95.1 is 22.3% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.