Fitch Rates Microchip Technology's Senior Notes 'BBB'

Fitch Ratings has rated Microchip Technology, Inc.'s senior notes offering 'BBB'.

The notes will be pari passu with all of Microchip's existing and future senior unsecured indebtedness. The company intends to use net proceeds to repay a portion of the outstanding balances under the commercial paper (CP) program.

The ratings and Positive Outlook reflect Microchip's strengthened financial structure despite weakening demand conditions and the company's increased focus on capital returns. CP balances include borrowings used to partly repay $1.4 billion of senior notes that matured on Feb. 15, 2024, and Microchip faces $1 billion of senior notes due Sept. 1, 2024.

Key Rating Drivers

Strengthened Financial Structure: Fitch forecasts gross EBITDA leverage is 1.5x and will remain below our 2.0x positive rating sensitivity through the forecast period. Fitch also estimates CFO-Capex/Total Debt in the 40%-50% range through the forecast period, well above median levels for the 'BBB' rating category. Meanwhile, Microchip is committed to returning all of its cash flow to shareholders over time. The company will continue targeting 50% of pre-dividend FCF for common dividends and increase share repurchases to gradually increase total capital returns to 100% of pre-dividend FCF.

Ongoing Share Gains: Fitch expects Microchip's broad product set, which enables increased customer penetration with via total systems solutions (rather than discrete component sales) in markets with longer-product life cycles, will drive market share gains. In addition, Microchip's focus on faster growing markets from increasing semiconductor content, particularly automotive and industrial that, combined, represent more than 55% of consolidated revenue, should also support the company's outperformance of the broader semiconductor market.

Shift to Organic Model: Fitch expects minimal acquisition activity for Microchip going forward, given the company's significant product breadth supporting its total systems solution strategy, in part due to historical acquisitions. Deal flow slowed considerably due to intensified regulatory scrutiny and still elevated transaction multiples. Microchip's focus on capital returns and organic growth opportunities, rather than incremental deals, will result in a stronger and more stable credit profile.

Meaningful Revenue Diversification: Diversification moderates the company's considerable exposure to cyclical end markets, particularly automotive and industrial, which recovered aggressively from sharp downturns stemming from public pandemic-mitigation policies. Microsemi Corporation increased Microchip's already significant sales to fragmented industrial markets and added meaningful exposure to communications and datacenter, computing, and aerospace and defense markets, as well as high-voltage power management, high-reliability discretes, storage and field-programmable gate array products.

High Operating Leverage: Microchip's higher mix of in-house production amplifies revenue growth while structurally higher baseline revenue supports the company's industry-leading profit margins. A weakening macroeconomic back-drop is reversing supply chain constraints related to government pandemic-related policies, leading to backlog deferrals and cancellations.

Derivation Summary

Microchip's operating profile is strongly positioned for the rating, given its top-three share in growth markets, diversified end market and customer base and broad product set, all of which enable increasing customer penetration via customized solutions with long product lifecycles.

The company's focus on secular growth markets from increasing semiconductor content and total-systems solutions approach should result in above-market revenue growth. Profitability in line with the 'A' category is not uncommon for leading semiconductor makers, but Microchip's internalized production strategy increases operating leverage and results in higher peak profit margins than those of competitors.

Compared with 'BBB' rated peers, Microchip is well positioned from an operating profile standpoint. Micron Technology, Inc. (BBB/Stable) and NXP Semiconductor N.V. (BBB+/Stable) are in line with Microchip, although Micron, which serves memory and storage markets, is considerably larger within a more consolidated competitive landscape. However, it is also far more cyclical and investment intensive, resulting in annual FCF averaging roughly equal to that of Microchip.

NXP competes directly with Microchip in microcontrollers and is the share leader in a number of automotive and industrial markets. However, NXP does not benefit from as much end-market diversification or product breadth. Following the acquisition of Microsemi, Microchip is more focused on organic growth than it was historically, and, therefore, financial policies are more predictable than Broadcom, Inc. (BBB-/Stable), positioning Microchip favorably despite Broadcom's robust FCF and share leadership.

From a financial profile perspective, Microchip should be positioned in line with a strong 'BBB', given Fitch's expectation that EBITDA leverage will remain below 2.0x through the forecast, roughly in-line with the company's 1.5x net EBITDA leverage target. Micron is similarly positioned with stronger liquidity and leverage metrics that are also in line with a strong 'BBB' rating on average. Microchip is positioned in-line with NXP, which also has significant automotive and industrial exposure with focus on shareholder returns while maintaining net leverage closer to 1.5x (despite NXP's 2.0x net EBITDA leverage public target.

Fitch forecasts $1.5 billion-$2.0 billion of annual FCF over the rating horizon, providing ample financial flexibility to meet debt maturities with available cash should business conditions deteriorate or interest rates remain elevated. Microchip's financial flexibility is in-line with a strong 'BBB' rating. This supports Fitch assigning an 'F2' rather an 'F3' rating to the CP program, which is fully back-stopped by the $2.75 billion revolving credit facility (RCF) expiring Dec. 16, 2026.

Key Assumptions

High single-digit negative revenue growth in fiscal 2024, driven by weakened demand conditions and production cuts;

Low double-digit negative revenue growth in fiscal 2025 as markets correct more broadly, followed by slow recovery through the remainder of the forecast period;

Gross profit margins in the mid-60% over the nearer-term driven by higher revenue levels before moderating to low-60% through the forecast period;

Capital intensity is 4% in fiscal 2024 and 2025 due to market conditions but returns to 5% in the out years;

Dividends grow in-line with pre-dividend FCF and Microchip increases allocation of FCF for capital returns to 100% through the forecast period.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Microchip refinances a meaningful portion of the $2.4 billion of debt maturing over the next 18 months with permanent debt;

EBITDA leverage sustained below 2.0x and CFO-capex to total debt sustained near 30%;

Share gains resulting in structurally higher profitability and cash flow and demonstrating technology leadership.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

EBITDA leverage sustained above 2.5x and CFO-capex to total debt sustained below 20%;

Share losses resulting in structurally lower profitability and cash flow and demonstrating a lack of technology leadership.

Liquidity and Debt Structure

Adequate Liquidity: As of Dec. 31, 2023, Microchip's liquidity was adequate and supported by $281.0 million of cash, cash equivalents and short-term investments and just over $2.0 billion of availability under the company's $2.75 billion revolving credit facility (RCF) due 2026. Fitch's forecast for $1.0 billion-$2.0 billion of annual FCF also supports liquidity, and we expect the company to use FCF for capital returns.

Issuer Profile

Microchip Technology, Inc. is a provider of microcontrollers, analog and mixed-signal solutions serving industrial, automotive, DC, communications and consumer markets. Microchip is a top three player in the more than $15 billion microcontroller market.

Date of Relevant Committee

11 September 2023

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.