Allegro MicroSystems, Inc. (ALGM) Earnings Call Transcript & Summary

Good morning, everybody. My name is Gary Mobley. I'm one of the semiconductor analysts at Wells Fargo Securities. With us today, we have Vineet Nargolwala, who is the Chief Executive Officer of Allegro MicroSystems. And we also have furthest away from me, Derek D'Antilio, I apologize if I miss pronouncing your name, who is the Chief Financial Officer of Allegro Micro. Both of you guys are fairly new to the company. So maybe Vineet, if I can defer to you for some opening comments, maybe you can give us an overview of the company, a little bit about your background and so on.

Sure. Thanks, Gary, and good morning, everybody. It's great to be here. Thank you for the opportunity to talk a little bit about Allegro. For those of you who don't know Allegro, Allegro is a young public company. We went public in October of 2020, but we have a long legacy of history of engineering excellence and innovation in the semiconductor world. Allegro initially got started at Sprague Electric back in the 1950s.

1926.

1926. And by all accounts, probably had the first fab in the Continental U.S. But then that -- we call that the origin story for those of you who are super hero buffs, Allegro 1.0. And then Allegro became part of Sanken Electric, which is a Japanese electric conglomerate. And a few years ago, a private equity company helped to carve it out, make it stand-alone and made a ton of operational improvements and took it public, and we call that Allegro 2.0. And now where we are, we are looking at a legal 3.0 and what the future holds. Just by way of more background, we are a fabless semiconductor company. And the way to think about us really is that we are an automotive first semiconductor company. Automotive is in our DNA. It's about 70% of our sales. But we design, build and launch products for automotive. And we've been in automotive for over 30 years, long before it was sexy and cool to be in automotive. And automotive really drives our company. And so everything we do we design for automotive and then we tweak for select industrial markets where we get great technology leverage and so -- and technology and economic leverage. And so as I said, 70% of our sales are in automotive, about 20% are in select industrial markets really around clean energy, which is EV charging, solar renewables data centers where, again, there's an energy efficiency story and then in industrial automation, which is really a motion-control story. Within automotive, we are increasingly focused on e-mobility. That's the collection of electric vehicle content as well as ADAS feature sets. And today, e-mobility is roughly about 40% of our automotive sales, but we expect that to continue to grow at a very rapid clip and become more than 50% of our automotive sales over the next, call it, 24 months. The financial performance of the company since we've gone public has been really strong. We grew 30% in our last fiscal year, which was fiscal 2022. And we're projected to grow about 24% in our current fiscal year, which is fiscal 2023. The other thing I would point out is that we have really strong product leadership. Our portfolio is small but mighty. We are #1 in magnetic sensing ICs globally. And magnetic sensing, which originally got started as position in speed sensing ICs is now seeing a great application in current sensing across an electric vehicle. And when you think about what an electric vehicle architecture looks like, essentially drawing power from a 400-volt or 800-volt battery source and then sending power to AC applications or DC applications all through the car there are immense number of current sensing applications, more than 40 across the electric vehicle because you want to measure the efficiency of the power transfer at every stage, and that means current sensing. So our magnetic sensing ICs are widely used in that application. And our second big product category is power management ICs. Power management is obviously a very large and fragmented space. We focus on niches like motor drivers, power management ICs and our newest acquisition of Heyday brings to us isolated gate driver technology that we are really excited about, and we think is going to find great application in driving wide-bandgap devices. The final point I'd like to make before I turn it back to Gary, is that it's a great time at Allegro. We've got a very strong and experienced management team with over 150 years of experience in semis and automotive and industrial markets. And it's a great mix of folks who've been at Allegro for a long time and also new talent like Derek and myself that have just joined, but we bring a large public on the experience, experience putting in place the right management operating system as befits a public company experience doing M&A and really delivering at a high level.

Thank you for that overview, Vineet. It's very helpful. I purposely follow a lot of automotive semiconductor companies because I think it's one of the most attractive end markets in the semiconductor space. But not only is it a secular growth end market with more content growth, more content per vehicle manufactured, but you also have a pretty strong cyclical recovery in the industry, what I heard is stronger for longer. But I get a lot of pushback on that from investors. People really wondering why the divergent trend in the automotive semiconductor market versus light vehicle production. So maybe with that, you could give us an overview of how you see the market landscape, how you see the firmness of your backlog and perhaps how you stress tested that backlog?

Yes. Maybe I'll comment a little bit on the market and then Derek can talk about how our backlog is looking and what we've done to stress test it. So Gary, as you and I have chatted before, the automotive production was at 94 million units of production not too long ago, right? This year, we'll be somewhere in the range of 82 million to 84 million units of production depending on whose report you believe. So we are a far cry from being at the peak of the market. We believe that equilibrium is probably somewhere in the range of 90 million units of global production. That's where our OEM lines are running at high utilization. They like to run it close to 100% utilization. They're far away from it today. Supply/demand are more in balance. Pricing of cars is more rational inventory at dealer loss starts to come into more balance. So we think 90 million units is probably where equilibrium is. And we think over the next few years, we get there, right? So there's -- from a base production standpoint, there is room to run for us, for the entire industry. Then you take into account the EV penetration, which is what we care about, and the adoption of ADAS feature sets, and that's where we start to get really excited. So regardless of whose report you read and believe the trend in EV penetration and sales is undeniable. And we believe that by 2030, more than half of the total global production is going to be battery electric. We believe that Europe is probably going to lead the way with all the regulations that have come in and probably somewhere close to 80% to 90% of new vehicle sales in Europe by 2030 are going to be battery electric. China is probably next with some in the range of 65% to 70%, and North America is probably the laggard. But even in North America, we think close to 50% of all new vehicle sales are probably going to be battery electric. And so we see this real big bow wave and a long-term secular trend that's going to take almost a decade to play out. And that's where we feel really good about the automotive industry and specifically our position within the automotive industry. Derek, you want to talk about the backlog?

Sure. And in terms of managing the business, we're looking at lots of different leading indicators. The first one, looking at the medium to long term is design wins. We've incentivized our sales team and our management team around focusing on design wins in e-mobility in some of the select industrial areas that we focus on, clean tech, data center, industrial automation. So design win is a key metric. We continue to see robust design wins, particularly in e-mobility and even in other areas of automotive like safety, comfort and convenience and, of course, ADAS. And we haven't seen a slowdown yet, really material slowdown yet in ICE. So that's the first metric we look at. Secondly, we have over a year worth of backlog. And I continually look at probably on a daily basis, look at things like what's happening with pushes and pulls in that backlog and we did just recently open up that backlog window that will allow for select cancellations to allow us to work down our past due with our customers and allow us to schedule orders efficiently in our own factories and with our wafer manufacturers. We had some uptake on that. We saw a 2% decline in our backlog from Q1 to Q2, which ended in September, but it wasn't material. So we continue to believe we have a robust backlog that's well over a year. We look at other things like our distribution inventory channels which makes up about 40% of our sales. In our distribution channel, we have seen some inventory growth. We saw that grow from about 4 weeks, which was kind of unhealthy in a historical low to around 6 or 6.5 weeks, which is still below pre-pandemic levels of 8 to 10 weeks, which we think is a healthy level. So looking at all those metrics, we feel really good about the backlog numbers.

Okay. You mentioned stress testing your backlog, giving customers an opportunity to cancel essentially is perhaps what you did. That was, what, late summer, midsummer, are you going to do that again? Have you done it recently?

Yes, it's an ongoing process. So we had -- most of our orders were non-cancelable non-reschedulable. So this is a customer service matter. It's really 2 things. One, a customer service matter going to our customers where we have long-term relationships and offering them an opportunity to either move those orders or to cancel those orders. And as Gary mentioned, we did have some uptake on that, and that result in a, I would call, a small immaterial 2% decline in the backlog. But more importantly, many of those orders were just rescheduled and it allows us to efficiently schedule our ordering within our factories. That continues to be an ongoing effort with our customers right now, and we haven't seen a material uptick in cancellations. We have seen some pushouts, I mean, but that's, I think, healthy for our business, given that about 1/3 of our backlog at one point was actually past due. So we're trying to work that down as well.

Derek. You recently raised your fiscal year '23 revenue growth outlook from 20% to 24%. What was behind that?

Sure. Coming into the year, we had given some guidance. We grew 30% last year, as Vineet talked about. We came into this year thinking we were going to grow just below mid-teens growth from '22 to '23 fiscal, which ends in March. And any incremental increase we've had to that up to 20% last quarter and now 24% is all really related to our secure of the commitment on wafers. So we continue to get incremental wafers from our suppliers. No change in demand. We've had over a year of backlog for well over 2 years. It's really just incremental supply that we -- as I get more comfortable with the incremental supply, we're able to increase our shipments and able to increase our confidence in the shipments for the next 2 quarters.

Got it. I wanted to move in the direction of content growth, specific to you in the automotive market. And so as you think about the automotive market in the baseline of light vehicle production growth, on top of that, how do you -- how should we think about the algorithm for your growth in automotive?

Yes. So when we think about our content growth, we are targeting about 7% to 10% above market growth, right? So production growth and then 7% to 10% content growth. And that -- a lot of things go into that, right? So it's how we think about the content shift between ICE and EVs take rate of ADAS feature sets, how ICE vehicles are going to fare. And so we feel pretty comfortable with that range and modeling that range for the next few years.

Okay. And I think you mentioned that what, roughly 41% of your automotive sales is coming from either EV applications or autonomous driving applications. Can you give us maybe sort of an anecdotal case study of how your content may differ in the pure battery-electric vehicle skateboard design or dedicated platform design as they refer to it versus an internal cobustion engine and then as well the different levels of autonomous driving?

Yes. So if you start at a high level, we see about $40 of content on a pure internal combustion engine-driven car. That moves to about $60 of content on a battery electric car, okay? And that's all in, right? So it's everything from sensors or ICs that might go on cam and crank applications or transmission speed applications to HVAC applications, your seat heating and cooling, your blower fans in ICE car. And then when you think about a battery electric car, we retain a lot of the applications in the safety, comfort and convenience sphere. Some of the applications like cam and crank and transmission speed obviously fall off because there is no transmission in an electric car, no need for a camera crank sensor. But we start to get enormous content on the electric architecture of the car. And so that looks like, as I said before, you've got a 400 world battery or 800 world battery increasingly, that is the power source and all of your systems within the car are either running on 12-volt, 24-volt at 48-volt and then you've got AC motors, obviously. And so there's a tremendous need for conversion of DC to AC and also DC to DC power step down. And at each stage, whether you're using inverters or DC to DC power conversion modules, you need current sensors, you need power management ICs. And as the volt transitions to wide-band gap materials, they will need isolated gate drivers as well. And so that's what gets us excited. So if you include our high-voltage gate driver technology, we think the total content opportunity on a battery electric car will go as high as $90 a car.

I wanted to shift gears, and maybe this is a topic for you, Derek, or Vineet if you want to take it as well. Your manufacturing footprint. So at the time you went public just over 2 years ago, you were getting a lot of your products from Polar. I think Polar supported a lot of the revenue upside you produced over the last 2 years, but maybe if you can help us better appreciate the shift toward UMC and TSMC to what extent is that 24% revenue growth you're forecasting for this year still constrained based on the availability of supply? And how does the transition to TSMC and even maybe UMC help make your products better or more differentiated.

Sure. Great question. So the company has really transformed itself from being an integrated device manufacturer 4 years ago. We had our own fab in-house, plus we had Polar we owned. We have another fab in Western Massachusetts. We had 2 back-end facilities. So the transformation is really we only own 30% of Polar today and we only have one back-end facility. So a lot of the gross margin improvement that we'll talk about there. But our 3 fab partners right now are Polar, UMC and TSMC. TSMC is a relatively new fab partner that we've been working with for the past 3 years. They're up to about 15% of our overall wafer receipts right now. UMC is still our largest and Polar makes up the remainder about 40% of our wafer reseats. So all 3 are good partners, all 3 of them are well balanced in terms of having a U.S. supply in Polar. So Polar is a very strategic partner, U.S.-based fab with proprietary technology that knows our company well and knows our power devices very, very well. UMC has been the large part of the upside that we've seen over the last 2 quarters or so. TSMC is really good about committing to what they'll give us, and they're giving us exactly what they said about a quarter ahead. We've not been able to get any upside from them in terms of wafers beyond what they were originally committed to. Right now, we see through the end of fiscal '23 through the end of March, still see tightness in our 200-millimeter wafers and more on 0.18 micron. So it's very specific and very proprietary technology. So it's not as portable to digital and those sort of things. We see tightness for the next 2 quarters. Beyond that, right now, we're in negotiations with all 3 of those fab partners for capacity and pricing for fiscal '24 and fiscal '25, and we feel optimistic about that.

Thanks, Derek. One of the common questions that I get from investors is them trying to appreciate the technical differentiation for magnetic sensors because you have a market-leading position, but it's still a fairly fragmented market, not mistaken. And so how do you differentiate from a software perspective, a monolithic chip design perspective? And to what extent does the supply chain partnerships you have help you differentiate?

Yes, I can speak to that. So as I've mentioned before, everything we do is with automotive in mind. And so it's not just magnetic sensors as a product. It's magnetic sensors as applied in automotive. I think it's what is unique about us. And it starts with our process technology. So with all of our fab suppliers we actually deploy our proprietary process technologies. And so that sort of limits us in some ways. We can't go to just any standard process that TSMC or others might have. We have to work with them for several years to put a proprietary process onto their technology. And then it starts -- then it is about how we spend time with our customers' engineers, truly understanding applications. In a lot of cases, we are combining things onto the same dye. So we might include, for example, a magnet package with our dye as we bring the systems together and hence the name MicroSystems as opposed to just ICs. And so we'll do a lot of things to help bring down the total cost of ownership for our OEMs. And that's what I think really differentiates us. One of the things that we take pride in is that most of our proprietary technology is dual qualified at all of our fab partners. So that gives us a redundancy from a supply chain and a reliability standpoint as well.

And the same question applies for your Power IC business. What allows you to differentiate in that market from maybe a voltage perspective or from a chip design perspective?

Yes. So as I mentioned before, the power management space is much larger and much more fragmented. And we are really focused on niche applications where we can differentiate and build leadership. So take our motor drivers, for example. We have learned over the years, especially in automotive, how to spin motors really fast, really efficiently and really quietly. And so that comes into play if you've got lane departure warning or lane keep in your car and if your motor is not quiet or efficient or smooth, you will feel the jitter in your hand, right? And so OEMs really care about that field. And so our motors are the basis of design in the vast majority of OEMs, lane departure systems because of how quietly, how efficiently, and how smoothly we are able to spin the motors. And so it's the differentiation in these markets that really gives us the leadership position.

Okay. And related to that, and I think this is a very underappreciated dynamic to the Allegro story is that your power IC business has been growing close to multiples faster than the rest of the business, the Magnetic Sensors business, right? And so my question to you is, is that sustainable long-term? What's the secret ingredient behind that?

Yes. So I can take it and then Derek can add to that. We've been really pleased with the growth in our power management business. So while we take pride in our global leadership in magnetic sensing ICs, our power management business has actually outgrown our magnetic sensing business for the past few quarters, I would say, maybe in the past year. And there are 2 main contributors to that. One is the increased take rate in automobiles, right? As our motor drivers and power management ICs get higher take rate in EV applications. The second is we're seeing -- we've seen some really great progress in our data center business. And so the same attributes that make our motor drivers so attractive in automobile applications are the reasons why data center motor manufacturers love our motor drivers. We are efficient, we are quiet, and we get the job done because we are highly reliable. So the fact that we are automotive grade means we operate at very high quality levels. And so that's what gives us the cache in the industrial markets as well. And our data center business has grown significantly for us over the past couple of few quarters and certainly over the past year. And so we think that long-term, as we look at the transition to 48-volt and the adoption of 3-phase motors in data center, we think that's a sustainable secular trend as well. So we feel really good about the future of our power management business. Derek, I don't know if you got more to add.

Yes. To add to that. Our power business now is 40% of our overall sales in sensors is 60%. Coincidentally, the power business grew about 39% to 40% in the past year. Some of that is the things Vineet talked about. Some of that is allocation we're shipping from backlog, so we're making allocation decisions every month, every quarter around where we're going to ship products based on what customers need. But I do think there's a sustainable growth, and we continue to invest heavily in parts of the power business, in particularly the high-power part of our business, including an acquisition we can talk about that we did in September of Heyday Integrated power. So that's an area we continue to invest both R&D and CapEx and with M&A.

Derek, you have always outlined a long-term vision of generating roughly 55% gross margin and roughly a mid-20% operating margin. You're exceeding both those metrics. So as it relates to the question, is Allegro over-earning right now? Or is there -- has there been a structural change to the business that allows you to outperform those metrics long-term?

Yes. I would say there's been a significant structural change that allowed us to go from about 40% gross margins 3 years ago as we talked about going from an IDM to a fabless company and much more of a focus on these strategic focus areas. Now we're -- this past quarter, our non-GAAP gross margins were 56.2%. That 56.2% included about 120 basis points of favorable foreign exchange. So we take that out, it's about 55% of what we thought would be. We think that's sustainable, not only sustainable, but I think we're going to continue to grow beyond that. There's plenty of opportunities to grow beyond that. Over the past year, the growth in gross margins have come from really mix, focus on the strategic focus areas where we have higher I'll call ASPs and value content, some pricing and leverage of our back-end facility. There's continued opportunities in all 3 of those areas, plus wafer optimization with at all of our wafer partners and leveraging wafer technologies at lower diode features and also on potentially 300-millimeter wafers in the future. So I think there's continued growth in gross margin. And then we'll continue to see leverage on OpEx. The last several quarters, our EPS has grown at double the rate of sales and OpEx has grown significantly less than the overall sales growth. As we've said before, we expect to continue to invest in the business now. So I expect 15% of our sales will be invested in research and development, and you'll see very modest increases in SG&A. We've already had a run rate of OpEx where we're established public company. So sales, we expect to outgrow that and you'll get the leverage on the operating income.

Okay. You went public just over 2 years ago. And during that time, you've been generating a lot more cash than probably you expected to at the time of the IPO. And in here we sit [25:12] today, what seems to be too much cash for the company's needs. And so how are you rethinking your capital allocation strategy, whether that be from an M&A perspective or dare I say, even buying back stock or paying a dividend?

Sure. So I'll start and let Vineet talk a little bit about some of the M&A pieces. But I mean we've generated $35 million in free cash flow last quarter, which was about 15% of sales, still below where I'd like it to be, but that's coming off of a growth of 9% sequentially and 10% investment in CapEx to build out our back-end facility equipment. We grew 30% last year, 24% this year and still maintaining 15% free cash flow with that working capital build and with the CapEx build. So I do expect that free cash flow number to increase. And as Gary mentioned, we ended the quarter with over $300 million in cash and virtually no debt, $25 million in debt. So our capital allocation strategy, as we've stated, is, first and foremost, to invest in the business, continue to make investments in research and development, strong investments in research and development, particularly in those areas that we believe are growth areas to be the leader. Number 2 is we invest in CapEx to ensure that both on the proprietary wafer side and in the back end, we can have the capacity to meet those demands. And number 3 would be select mergers and acquisitions. We've done a couple of small tuck-ins. I don't think there's enough room for more tuck-ins when you look at the OpEx leverage we want to get. But we view M&A as a very integrated piece of our growth strategy, not adjacent to that. So what I mean by that is when I look at M&A, and Vineet and I look at M&A, we look at it and say we want to grow and select the areas that we've talked about. That can come through organic or it can come through M&A, but it has to have a strong strategic fit, first and foremost. We have to be able to sell those products to our existing customers in most cases, which we can with Heyday. And thirdly, in my opinion, I think they have to be financially accretive at this point.

Okay. You guys have brought up the Heyday acquisition a couple of times, but I think it's probably worth double-clicking on that acquisition. The company is in the business of developing isolation ICs, specifically for dedicated EV platform designs, if I'm not mistaken 800 volts and higher. Maybe if you can talk about where you stand with commercializing that technology and where you see the market opportunity long-term?

Yes. So we're really excited about the technology that the Heyday team brings into Allegro. Fundamentally, it's isolated gate drivers that can drive GaN or SiC based devices, right? We are already sampling GaN-based drivers today, and there is a SiC-based driver that's in the works. And the team is a small but mighty team, but we are augmenting now with more resources. So we're diverting more resources from our core Allegro engineering team into that team in order to grow, accelerate the product development. We're probably still 2 or 3 years away from commercializing all of that and seeing that turn into revenue. But we're getting some great momentum in meetings with customers where there's a lot of excitement about the total cost profile that we can bring versus what's available in the market. We have great IP around the technology that Heyday brings to us. And so we're really excited about what this could mean and really bullish about what this could mean in terms of long-term growth for the company.

It seems like a good fit for your existing product portfolio. And so related to that and the Heyday acquisition, how would you characterize the perfect acquisition for Allegro?

Yes. So I'll build on what Derek said, right? So for us, Derek and I think a like on this. So M&A is not a separate strategic pillar. It emanates out of our overall company strategy. And so our company strategy is very clear. We want to be a leader in e-mobility, and we want to grow in select industrial markets that we outlined around clean energy, around industrial automation and around data center, which is really, again, an energy efficiency play. And so an asset that brings to us the right technology pieces, the right market position helps us to accelerate our journey in those target markets and is accretive out of the gate, I think would be very attractive to us, right? It's hard to get into size dynamics because there are companies of all shapes and sizes that are operating in these spaces, but you can expect us to become more active over the coming years in that space.

Great. Vineet, Derek. I appreciate you joining us today, and I want to also thank all the people in the audience today. So again, thank you.

Thanks for the opportunity.

Thank you, Gary. Thank you all.