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

Welcome to the NASDAQ Investor Conference in partnership with Jefferies. Let's go live to London.

Okay. Great. Well, welcome, everybody. Thanks for coming this morning. My name is Mark Lipacis. I'm the senior semiconductor analyst at Jefferies. Very honored to kick off the first session of the day and privileged to have Allegro MicroSystems here. So we have the CEO and the CFO, Vineet Nargolwala and Derek D'Antilio. Vineet has served as the President and CEO and as a member of the Board of Directors since June of 2022. He is a tech executive with over 25 years of global executive leadership experience. Prior to joining Allegro a year ago, Vineet served as the EVP of Sensing Solutions at Sensata Technologies. And prior to Sensata, he was with Honeywell International. Derek joined Allegro in January '22 with more than 20 years of financial and operating experience in semiconductor and high-tech companies. Prior to joining Allegro, he served as a CFO for a Summit Partners Portfolio Company, as CFO at IDEX Biometrics and has been previously at MKS, HP, Xerium. And also he was previously a CPA and Audit Manager at PwC. So with that, gentlemen, welcome. Thank you for coming today.

Thank you, Mark.

So I want to kick off. Vineet, this -- I believe, you celebrated your -- just your 1-year anniversary as the CEO of Allegro.

That's right.

So can you just share with us, maybe reflect a little bit on the first year, what went well, what you are most proud of accomplishing.

Yes, absolutely. It's hard to believe it's already been a year. I guess, time flies when you're having fun. I think reflecting back on the past year, I'm incredibly proud of the team and what we've been able to accomplish in a very short period. I have to start with the record results. Great revenue performance, strong growth coming off a year where we already had 30% growth. Great margin performance, great EPS results. I think laid on top of that is how the team has really responded to the sharpening focus on our strategic growth segments, of e-mobility, clean energy and automation, really leaning forward on the customer intimacy side and building up our innovation engine, making sure that we are serving customers in the right way. Coming out of the pandemic and really a supply crisis, we've been able to really come out of that strongly, not just with great business performance, but also improving our customer service. A lot of work still remains to be done, but I think we are on the right track. We are laying the right foundation. We're building the right teams in the right places. And so I'm really proud of what we accomplished here in the last 1 year.

Great. Well, congratulations on the first year, and it's been a successful one. And I want to move to the successful operating performance, but before we do, I'm hoping that you can just level set everybody on the technology at Allegro. And so when we first started doing the work, we learned about the magnetic IC business, right? And I'm electrical engineer, and I covered semis for 25 years as a sell side, and I hadn't really heard about magnetic IC. So maybe if you could just help everybody understand what is a magnetic IC, what is differentiated by your solution, functionally, what is it doing in the car.

Yes. So magnetic sensing and magnetic sensing semiconductor, or ICs, are really important to Allegro. We are the world leader in magnetic sensing. We've been doing it for the longest time. And over the years, we've built up really a deep application expertise and technology expertise in magnetic sensing. At its core, magnetic sensing is effectively sensing the magnetic field that's generated when you're around magnets, when current passes through our product. And the earliest application is really speed and position sensing. But very quickly, that is now developed into current sensing, which is a fast-growing application for electric vehicles. When we think about our leadership in magnetic sensing, it starts really at the wafer level. We used to be a fab owner. We're now fabless, but we do carry still a deep knowledge of wafer technology, and we use proprietary technology for magnetic deposition on top of CMOS. We're able to integrate a lot of different functionality like high voltage, EPROM memory, et cetera, into our ICs. And so that continues to extend our differentiation. We have over 1,300 patents, and a vast majority of them are in magnetic sensing. So we're really proud of what we've built in magnetic sensing, and we continue to invest a big chunk of our R&D into magnetic sensing, into innovating for our customers. We have a large base of all-effect magnetic sensors, but now we are extending that leadership with xMR technology, notably TMR technology, which brings more accuracy, more robustness for a lot of the demanding applications that our EV customers demand. And so we're, again, really proud of our leadership in magnetic sensing.

And functionally, can you just -- like what are the most popular applications of magnetic sensing in the car?

Yes. It's -- we started off with speed and position sensing. So if you think about transmission speed, transmission position, cam track sensors in an engine, now when you think about an EV, it's current sensing. So in an EV, you've got a 400 or an 800-volt battery source, but everything around an EV operates on 12 volt, 24 volt or 48 volt. So there's a really significant power conversion challenge. And every time you convert power, you have to measure current to make sure you're doing it efficiently and accurately, and that's where our current sensors come in. And there's close to 40 applications on an EV on current sensing. So that's really now the signature magnetic sensing application for us, and it's just one of the fastest-growing.

So in the process, or as you develop your expertise in magnetic sensing, you also had to develop an expertise in current sensing, and that you leveraged into the power functionality in the cars. Is that a fair way to think about it?

So I would say that the natural evolution from speed and position sensing into current sensing was around magnetic sensing. We also have a power portfolio, which is centered around motor drivers, regulators and LED drivers as well as PMICs and gate drivers. And we are now building that portfolio out as well to match it to our leadership in magnetic sensing centered around e-mobility, centered around clean energy and automation, the end markets that we are focused on.

Got you. Okay. And so can you talk about your -- just to level set everybody, your end markets. It's 70% automotive, I believe, and then 30% is other. What are the biggest other markets for you?

Yes. So that's right. So about 70% of our sales are in automotive. We are really an automotive-first company. That's our DNA. But we design and build products for automotive, and then we take it to industrial markets where the same technology has a lot of resonance, and our automotive pedigree resonates in those markets. And those markets are clean energy and automation. So Industrial is about 20% of our sales, and then 10% is what we call other, which is consumer and so on, where we're not strategically focused per se, but we get a lot of pull-through, through the distribution. So for example, our magnetic sensing ICs are in consumer gaming products like the Xbox. And the reason they get used there is because of the robustness, the automotive-grade performance, our ICs take a beating and keep on taking, if you will. But really, our focus is on clean energy and automation in the other markets, and that's really been fast growing for us. And we see a lot of complementary applications in those markets, similar to what we saw in automotive. So in clean energy, especially around renewable energy, the challenges of the -- the renewable energy has not generated the same place that needs to be consumed. So you need to store it, you need to transmit it, you need to do it efficiently. And our current sensing, our motor driver applications, our regulators, our gate drivers are all important components that help make those solutions become more efficient.

Got you. And as you -- can you talk about how your content per car has -- how it has expanded in the past and where you see it going ultimately? And to the extent that you can talk about maybe the legacy expertise you have versus the new expertise you're developing, I think that would be interesting for investors to understand.

Sure. So the way we think about our content on cars is on an ICE car, an internal combustion engine-driven car. Our content is roughly about $40 per vehicle. That's the content opportunity, okay? When you transition to a battery electric car, that content opportunity grows to almost $60 a vehicle. And with our latest acquisition of Heyday, which brings to us a really unique high-voltage isolated gate driver technology, which will then allow us to drive GAN devices and SIC devices, we see that content opportunity going to as high as $100 a vehicle. So we're really excited about our portfolio today and where we are driving it in terms of our roadmap to continue to bring to our customers great technology and products to help solve their energy transition challenges.

So I think a lot of times, you -- investors might be concerned that you're tied to the internal combustion engine vehicles. And as there's a transition, that you lose out on that. But it sounds like the exact opposite is true. Is that...

Yes, yes, it is a great positive for us. We've shared in our most recent quarter, e-mobility, which is the combined sales into EV powertrain as well as ADAS feature sets, was about 47% of our automotive sales. What's even more exciting is that our design win pipeline now is majority in e-mobility. So we're seeing that transition happen. And as that happens, that's a net positive for us from a content standpoint.

Got you. And just to come back on the other market and in the industrial markets. I understand that one of the products -- or one of the end markets for you is the data center, right? These days, it's fashionable to be an AI play. So would you make the case that you are an AI play or a data center play with the products you're selling into the data center if you're thinking about those?

Yes. So we are not an AI play as it relates to data centers. Within data centers are stories that of energy efficiency, and we are part of the infrastructure transition to a more efficient energy infrastructure. So the transition from single-phase cooling fans to 3-phase cooling fans, the transition to a 48-volt back plane where our ICs make that transition happen in a very efficient way. Our motor drivers are central to the cooling fans that are used in data centers globally. And so we are really proud of our business and our association with partners in that space, but I wouldn't call us an AI play.

Fair enough. Okay. You may be the first person to admit that. So -- and could you take maybe just one layer deeper on your technology. You talked about xMR, TMR. What does that mean practically? And what should investors think about what that does for Allegro?

Yes. We see xMR technologies, whether it's TMR, which is tunnel magnetoresistance, or GMR, as the next evolution in the technology from Hall-effect sensors. So Hall-effect sensors have been around for a very long time. But as applications, especially related to EV or e-mobility, get more demanding, there is a need for more accuracy. There's a need for more robustness. There is a need for better performance across temperature -- a wide temperature range and across the entire life of the product. We believe that the transition to TMR allows us to bring all of those capabilities for our customers. And so we're really excited about our TMR portfolio or our xMR portfolio, more broadly, and we are leading the transition to xMR technology for the industry.

Great. And can you talk a little bit about your sourcing strategy? So you mentioned you had a factory. It was carved out before the IPO. You came out fabless. The idea -- or the pitch was, well, you were going to migrate, it was a higher cost provider. You're going to migrate to Asian factories. And -- but it seems like you're increasing your relationship with a regional foundry. Can you just talk about that?

Sure. Yes, I'll get started, and then maybe Derek can jump in as well. So when -- the company originally was an IDM, and we have now completed the transition to being a fabless company. We still own 30% of Polar, which is a joint ownership with our -- with Sanken Electric, which owns 32% of Allegro as well. And the initial hypothesis was that the Asian suppliers will be more cost competitive. I think the last couple of years have brought parity from a cost competitiveness standpoint. Polar has done some really nice things in terms of becoming more cost competitive. We've seen some pricing changes from the Asian suppliers as well. So I think we are in a point where cost competitiveness is a given. We're now looking for supply chain resiliency and geographical diversification in our supply chain as well.

Yes. And the sourcing strategy today, Mark, really is we have 3 partners we work with. UMC is our largest in Taiwan. Polar Semiconductor located in Minnesota is a nice U.S.-based fab that we own 30% of, as Vineet mentioned. And then TSMC rounds that out, right? We continue to look for additional partners in certain geographies of the world, as geopolitics plays out. But we look at technology, first and foremost, and have redundancy of technology across those fabs. So that's important from a resilience standpoint. And of course, cost and efficiencies play into that. And we've been very fortunate over the last couple of quarters where those partners have helped us build up some strategic wafer bank, which allows us to be very competitive on lead times against our competitors as well.

Got you. And over the last several years, the geopolitical dynamics has -- have changed. Can you talk about how that -- has that manifested in a different set of requirements from your customers? Are they asking you to source more domestically?

Yes. So the last couple of years have been very trying for all of the semiconductor industry and our customers, in general. And I think the big lessons learned for everybody are not to be boxed into a single source, single location and so on. So I think supply chain resiliency is now the key phrase. And so it's less about customers saying thou shall only manufacture here or thou shall manufacturer here or here. It's more about, let's make sure there's supply chain resiliency, let's make sure you have multiple sources coming in. And luckily for us, we're very fortunate to have Polar, UMC, TSMC as part of our supply base. We do 50% of our assembly in-house. We use subcontractors for the rest. And so I think we are in a really good position, and we're able to then assure our customers that we have supply chain resiliency. We are increasing our capacity. We put a lot of capital investment in our back end as well. And so we're taking all the necessary steps to make sure that we're building more resiliency into our supply chain. And I think customers are really happy with that.

Great. And can you talk about what has happened? You talked -- we've seen in semiconductors, a lot of semiconductor companies have raised their prices, along with increasing input costs. And it's no secret, you open up any trade rag, various foundries around the world take their prices up. And it seems you've been successful in convincing your customers that you should be able to pass that along. Can you talk about how that has played out? And maybe Vineet and Derek, maybe you could talk -- you guys have been in the components industry, the auto industry and semiconductor industry for a long time. Like is that -- that seems like a different dynamic than in the past. Maybe you could discuss today that dynamic today versus in the past.

Yes. It's a really great question for us because we are so exposed to automotive. 70% of our sales are in automotive. We've never really been able to take a transactional view of pricing. So our pricing has always been value-proposition-based. A lot of our agreements are multiyear agreements that preceded the pandemic and the inflationary impacts that came afterwards. And so we didn't really take a transactional input costs are going up x and sort of prices going up x type approach. Some of that happened in distribution for sure, where we took a transactional approach. We remain very agile and adaptive there. But with our direct OEM relationships, we've been very value-proposition-based. So a big chunk of our margin performance has actually come from mix, not price, and that mix has been because e-mobility as a portion of our sales has continued to expand. And that's where we are funneling a lot of our investment dollars, that's where we're driving a lot of our innovation. We're solving some really tough problems for our customers. And as a result, we're able to get value and a premium for some of the products that we're bringing into those markets. So I think that's been a big part of our margin story as opposed to just pricing. Obviously, we've taken some view, as I said, in distribution with respect to our input costs. And I believe that we feel really good about our price position and our margin position and its stickiness as we go forward.

Got you. And maybe you could talk about the profitability, the operating model. Where are you today? What is your bogey? And how do you get to that bogey? How do you bridge the gap between where you want to be and where you are?

Derek, you want to take that one?

When the company went public 2.5 years ago, they put out a financial target to be at 55% gross margin, 30% OpEx and about 25% operating profit. Over the past 2.5 years, we've achieved that. As Vineet mentioned, there's been an extreme focus on these markets where we add a lot of value. So the mix between -- the auto mix to e-mobility, the mix towards the growth in our industrial business, which has slightly better gross margins, the focus on distribution channel, which has better gross margins. And then the management of OpEx has really helped us achieve that model over the last 2.5 years. So we're at the model now. We had an Analyst Day 2.5 months ago in March. And at that Analyst Day, we put out a new financial target model. So low double-digit growth rate on the top line, we continue to see that based upon the things that Vineet talked about. And this is over the next several years kind of a CAGR. Gross margins at or above 58%, and we think we have a path towards that between mix, leveraging our supply chain as we grow and continued optimization in our own back-end facility. OpEx at about 26% of sales and then operating margin of about 32%. And very importantly, free cash flow of 25%. So we have some time to get there. The last 2 years, we've had significant growth of 30% and 27%, so there's some working capital build. We'll also continue to make investments in CapEx to build out our back-end facility to align that with wafer capacity and projected demand. So that's targets we put out 2.5 months ago. We have a path to that over the next several years, and we view that as sort of a milestone on the journey to the next step-up.

Got you. And can you talk about -- you talked about building inventories. And so inventories is a fun topic to talk about for semiconductor investors. You have built some inventories, and you said that you're very glad to. If you look downstream, there's -- if you look at distributors or contract manufacturers, their inventories are at the highest levels for 20 years. And so that gives investors a reason to be cautious. And so what do you say to investors who express that concern to you that there's a big inventory build, and the orders you're getting may reflect building of inventory safety stock more than actual consumption? Like how do you -- what do you say to investors who have that question? And how do you manage that dynamic with your customers?

Yes, I can start on the distribution side where we get visibility every week. So distribution is about 60% of our overall sales. And there, we have really good visibility. We get weekly point-of-sale sell-through. We get inventory metrics. So we watch that really closely, and that's a good bellwether for the entire market. I'm sure Vineet can talk about the OEM side of it a little bit better. But in the distribution channel, we troughed about 4 weeks of aggregate inventory about a year ago, and that was really low. And we had stock outs in different regions. We're trying to bring on new distributors. It was actually a customer service challenge. Over the last 4 quarters, we've been able to rebuild that. We exited Q4 with about 9 weeks in inventory in the distribution channel in aggregate. Some areas, I think we have some work to do to continue to restock. Other areas, for example, you touched on data center in Taiwan, there, we have some inventory that we saw starting to get to levels we were uncomfortable with, so we stopped shipping into that channel. So we monitor that really closely, and I think that's a good bellwether for the overall market.

Yes. I would say that in our direct business, we're not really seeing any evidence of inventory build. In fact, we have some delinquent backlog we're still trying to work through. And as Derek pointed out, we've built up some wafer and die bank, and that's given us some optionality because we have significantly cut down with the inventory build, the amount of the lead time it takes us to run the entire cycle through our supply chain. And so now we can -- when the inventory is sitting in wafer or a die bank, it's more fungible, and we then have more optionality late in the lead time cycle to divert it to where it needs to go. So I think we've built some more flexibility into our operations to serve the customers in a way they need to be served.

So -- and this may not be a fair question, but I'll ask it anyway. If you look at distributors, like their inventories are all-time high. And you have visibility to your inventories, and they're at very low levels or lean levels. How would you reconcile that? Like can you help us reconcile that? And maybe you just don't know what other distributors are holding, and you can't. So -- but if you have insight, we'd love to hear it.

Yes. So I would say that we don't believe that our inventory at our distributors is at an all-time high. We think it's finally coming back into a normal range. And as -- 60% of our sales go through distribution. In some cases, even for OEMs who use it as a fulfillment center, it's really important for us to have that inventory at the point of sale, right? And availability is paramount. So we feel really comfortable with the level of inventory. And I think our internal inventory as well is just getting back to sort of normal levels. So overall, we're in a comfortable spot. But as Derek said, we continue to monitor it very closely.

And last question for me here. The last couple of years with really tight supply change, I think, has increased the dialogue between component solutions providers, such as yourselves, and your customers and your suppliers. Can you talk about, again, reflecting back on your decades of experience in the auto supply chain and semi supply chain, what -- how have your relationships changed with your customers or how you do business with customers and your suppliers?

Yes. So I would say that what is changing, what is new is that as a semi player, we now have more direct relationships directly with the OEMs. It used to be that most of our business was conducted through tiers. As the ecosystem of a car changes to be more IC-centric as opposed to be more mechanical-centric, we are now seeing conversations around choices of ICs, whether it's for domain controllers, for wireless communication or for the powertrain start to become center stage. So cars are being designed around those IC choices. And so OEMs want more direct engagement with us. The supply crisis has only exacerbated that, right, or elevated that need. And so that gives us a bird's eye view of new platforms that are coming, new technologies that are coming. And with Allegro's traditional leadership in automotive and in magnetic sensing specifically, that means that we are getting invited very early in the design cycle now, even earlier than we traditionally have. So we can be sitting side aside with our customers' engineers addressing these technical challenges as they are tackling them and come up with innovative solutions. So I think the nature of the relationship is changing. And on the supply side as well, I would say, what used to be very transactional now is becoming more strategic. And so we feel that we have the right supply base, the right strategic partners. And we're thinking more long term than short term. So I think on both sides, I'm really pleased with the direction that the nature of the conversations around our partnership is creating.

And that's kind of the longer-term picture. And then tactically, are you getting more visibility from your customers from the standpoint of understanding what they're really using, like from the standpoint of your own strategic planning and planning your of manufacturing operations? I can -- I might imagine there are scenarios where you get calls late at night or on the weekend from a customer who is strongly urging you to expedite an order for them. Like how does that dynamic play out?

Yes. So it's less and less now as we are coming out of the supply chain crisis because we have a big exposure to automotive and the long design cycles in automotive. So what gives us the advanced visibility for our planning purposes is really a design win pipeline. That then turns into orders as the program gets closer to launch. So I think, for us, the long visibility into the customers' programs is a great asset that allows us to plan appropriately, whether it's our supply chain, our factory operations or our workforce.

Great. Well, I think that's a great way to wrap it up. Vineet, Derek, thank you very much for joining us today and supporting the conference, and hope to see you again next year.

Thank you, Mark.

Thank you.

Thank you, Mark. Thank you.