Two months ago, I published an article entitled More Positives Than Negatives For This Unsexy Chipmaker about microcontroller and analog chipmaker, Microchip Technologies MCHP. Since then I have been updating Framework members with what I have learned in my analysis of the firm’s business.

Long story short, it looks like Microchip represents a terrific investment, with modest downside risk and ample upside potential.

Last week, I sent Framework members a series of articles detailing Microchip’s competitive environment, my valuation assumptions for the company (along with a valuation model), and a review of possible investment structures and risks for an investment in Microchip. This article is a summary.

The most important point is that Microchip’s shares look undervalued by about 50% at present market prices.

Figure 1. Source: CBOE, YCharts (data), Framework Investing Analysis

In the image above, the triangle represents my best-case valuation scenario ($141 region), the square, my worst-case valuation scenario ($81 region), and the circle, the average of all eight valuation scenarios ($112 region).

The cone represents the option market’s conception of Microchip’s likely best- and worst-case future stock price range, and you can see that – while I agree with the market on Microchip’s upside potential – the market is forecasting the likelihood of much lower prices than we think are justified looking at the firm’s valuation drivers.

Valuation Drivers

We value firms based on their capacity to create cash flows, now and in the future. There are only three drivers leading to a company creating cash flows now:

  1. Revenue generation
  2. Profit conversion
  3. Investment spending

Microchip made a big purchase this fiscal year – acquiring industrial analog chipmaker Microsemi. Our revenue assumptions for this year are driven by that acquisition.

Figure 2. Source: Company Statements, Framework Investing Analysis

In the four years following, I have assumed best- and worst-case revenue growth in the high- to medium-single digit percent per year range. This forecast is based on increased demand for microcontrollers and analog chips due to the shift toward more feature-rich and connected devices, partially offset by the gradual loss of pricing power endemic to chip makers.

The thing that I have always admired about Microchip was its ability to manage its business in a no-drama, professional way. The firm’s management understands what it takes to squeeze profits out of a semiconductor business, and the consistency of its historical profitability profile provides good evidence of management’s skill. (Note that my preferred measure of profit is Owners’ Cash Profits (OCP), which I describe fully in my book.)

Figure 3. Source: Company Statements, Framework Investing Analysis

Before the acquisition, Microsemi was already a very profitable chipmaker. Microchip will make it even more profitable, if its track record for pulling up the profitability of lower margin firms it has acquired in the last 10 years is any measure.

Microchip has been investing a lot on acquisitions as it attempts to gain the kind of scale necessary to compete in the global semiconductor market. As such, its average Free Cash Flow to Owners (FCFO) – the cash flowing to owners after a portion of profits is invested – has dipped in the past few years. That said, Microchip will not make any more acquisitions for several years, and I believe that on a normalized basis, the firm can generate on the order of $0.25 of FCFO for every dollar of revenues it receives.

Figure 4. Source: Company Statements, Framework Investing Analysis

Microchip may not be a household name, but its products may be found in every household in America. The company enjoys a tailwind from the demand for feature-rich devices and the kind of connectivity found in smart homes and the Internet of Things.

Even professional investors misunderstand Microchip’s profit and value drivers, treating it like a cyclical chip manufacturer like Qualcomm, Micron, or Intel (each of which is in itself very different from the others).

Recent industry weakness has brought Microchip’s stock price down with the rest of the chips. I think an investment in Microchip at these stock price levels represents a great opportunity, and have put my money where my mouth is!