Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Okay. Why don't we go ahead and get started. Again, good morning. Thank you for attending JPMorgan's 18th Annual Technology Investor Forum here at CES. Again, my name is Harlan Sur. I'm the semiconductor and semiconductor capital equipment analyst. Very pleased to have Steve Sanghi, Chief Executive Officer of Microchip, here with us. This is Microchip's first time presenting at our conference. So we thank them for that. The Microchip team positively updated their December quarter revenue outlook yesterday and also provided positive commentary on the March quarter. I'll have Steve start off with some comments about that, and then we'll jump into the Q&A. So with that, Steve, thank you very much for joining us this morning.

Thank you. Good morning, everyone. It's nice to be here in Las Vegas. Before I begin today, I wish to remind you that during this presentation, I'll be making some projections and other forward-looking statements regarding the future financial performance of Microchip. These always involve some predictions, and the actual results may vary materially. So I refer you to the filings with the SEC that identify some important risk factors. Now I'll take you through some of the comments we made in our press release yesterday and also add some more color that might benefit you. So bear with me. Starting with the bookings. We earlier mentioned that bookings started to be strong starting October and then they continued strong through the quarter. The December quarter bookings overall were up double-digit percentage over the bookings in the September quarter. So just going to give you that color. For December quarter, we narrowed the range. The range before was midpoint of minus 5% with a range of 3 -- minus 3% to minus 7%. We tightened the range yesterday to minus 3.75% to minus 4.25% with a midpoint of minus 4%. We -- the starting backlog for March quarter is also double-digit percentage higher than the starting backlog was for the December quarter. However, we need to account for Chinese New Year. While in December quarter, we needed to account for the holidays and in March quarter, you have to come for Chinese New Year. But just wanted to put that out. Starting backlog is up in each of the geographies of U.S., Europe and Asia. We're seeing strength in particularly 3 end markets. Data center is very strong, and industrial and automotive are both recovering from the earlier weaknesses. Data center stayed strong through the entire cycle. The book-to-bill ratio for December quarter was above 1 after multiple quarters of book-to-bill being less than 1. Regarding the distributor inventory, in our September quarter conference call, we mentioned that our distributor inventory was 15-year low with only one exception, which happened in Q3 of fiscal year '13. But otherwise, distribution inventory was very low. Now we expected in December quarter the distribution inventory to start building up, start replenishing. That didn't happen. The sell-through in December quarter exceeded sell-in again, which means in -- the dollar value of the distribution inventory went even further lower, which for future result is a good sign. But -- because sooner or later, if the sell-through stays that strong, the distributions have to really start replenishing. The Chinese New Year is early this year. It's in the late part of January, which is usually good for business because there are always more production days post-Chinese New Year. And in China, especially after the Chinese New Year, there is a new optimism always and there are more production days. So that's good for business. Other thing we are seeing is substantially increased expedites and pull-ins by the customers, which is usually an early sign of strength seen. Now the lead times have been relatively short, but short lead times are still 4 to 8 weeks lead time. If you have the product in die form, it still takes 4 weeks plus to deliver it to the customer. And we're seeing a large number of orders come in and saying, I need it now or I need it in 2 weeks or I have it scheduled in 8 weeks, but can you pull it into 4 weeks for me. So substantially increased expedites, which is usually a good sign. So all this points to multiple inflection points. And therefore, I call the bottom for Microchip for this business cycle with the obvious caveat of really any negative developments on the U.S.-China trade front or any unexpected fallout from the geopolitical events. Now as we look forward for the March quarter, we have built an excellent die position during the downturn. So pretty much across the board in all business units and probably 90% plus of our products, maybe 95% plus of our products, we have significant die position. That's where we have been holding the product rather than putting into the finished goods to keep the inventory low. So now we have to take it from the die and take it through the finished goods to ship it to the customer. So we are ramping our back-end factories and subcontractors. We are not ramping our front-end factories yet because we have significant die position and the overall inventory at the end of September was, I think, 132 days, if I recall. And our target is usually 115 to 120. So we'll be using up the die inventory but taking them to the back end factories and subcontractors to meet the increasing demand of our customers. And we are targeting to ramp those factories to deliver better than a mid-single-digit sort of sequential growth for the March quarter. And the last point I want to make, but not the least is, this March quarter is expected to be up over a year ago March quarter, reversing the year-over-year trend that has -- that we have seen for many quarters where the year-over-year quarters have been down. And this March, we expect the year-over-year quarter would be up reversing that trend. So thank you, and I'll sit down.

Yes. Thank you, Steve. Appreciate the opening commentary. So actually, before you made your opening commentary, we were getting a lot of questions from clients. And the biggest question was -- and you seemed to answer that, which was, how much of this is just -- you exited the September quarter with near 15 low channel inventories. And the question I was getting from investors is how much of this is channel inventory replenishment? But you answered that question. I think you said that sell-through was actually stronger than sell-in. So it actually does seem to be less inventory build, let's say, by your distributors, but maybe could it be more inventory build by their customers in terms of the end customers? Or do you think that some of the areas of strength like you've seen like cloud data center and auto and industrial that you see signs of true end demand coming back?

Well, the current strength is driven by strength in sell-through. And the inventory replenishment has not begun. But usually, that's how it begins. You start with end market strengthening and customers are asking additional products and expedites both through direct customers asking us and also through distribution and distribution asking us. So expedites also include large number of line items, which distributor is asking us to expedite because their end customers are pushing them, I need the product now and the distribution inventory is low. So this kind of dynamically sets it up where distributors finally get the message and they say, "We've got to stock up more product because our inventory is 15-year low and our customers are asking us that we carry more inventory." So when that phase begins, it actually accelerates the whole process. And shipments even go higher because now you not only have to ship to increase the end demand, but you also have to build up distribution inventories, which had depleted in the last 6 quarters.

I know it's hard for you guys to sort of gauge this but given that the end demand seems to be quite healthy. And for several quarters in a row, you talked about just very weak trends, down year-over-year pretty strongly in your industrial and automotive businesses. Are you seeing signs of, let's say, in industrial, I mean, are the China guys starting to think about firing up some of their factories or continuing to build-out their factories that they had put on hold?

So there are signs everywhere that the demand is returning. China also did some sort of stimulus in the last month or so where they lowered the requirement that the banks have to hold. And those kind of things usually have a very positive effect in China, especially across the small customer base, which work on credit and are always tight with money. And that typically forms our customer base, 120,000-plus customers, we work a lot in the long tail of the customers. So that was positive. The automotive market in all geographies, U.S., Europe and Asia, has largely been destroyed in the last year. Europe did a self-destruction with all these new emission standards and all that. The China destruction was really with the U.S.-China trade war with a lot of the components duty and the high-end cars that Europe were shipping into China. Their demand for high-end cars in China went very low. So -- and there was a U.S. strike at GM and other issues. So all those things are kind of on the mend, and we see some automotive demand coming back. And if you add the content on the automotive, that's always a further positive.

I think you might have mentioned it, but what -- are you seeing a similar demand trend and demand pull from your direct customers?

Yes.

Okay. From a geographical perspective, again, you talked about strength in all 3 of your geographies. But I remember a quarter back you were talking about all 3 of your geographies being down quite heavily year-over-year, with maybe China showing a bit better strength. So help us -- take us through the time line of when you started to see the various geographies kind of starting to improve as you moved through the December quarter?

So it started -- recovery started in China first. Now remember, December quarter was still sequentially down, okay?

Yes.

It was better than what we said before, but it was still down. And after several quarters, we are expecting the March quarter to be sequentially up more than the mid-single digit. And in that March quarter buildup, we are seeing strong backlog in U.S., Europe and Asia. And we'll expect all 3 geographies will be sequentially up.

And again, remind us, so how does the -- so Chinese New Year's is 11 days earlier than it was last year, so how does the earlier Chinese New Year actually impact the demand dynamics for the March quarter?

So just math-wise, one would think that whether Chinese New Year is on January 31 or February 28 shouldn't make any difference because the same number of days off. But history and experience shows that Chinese return from Chinese New Year with a new sense of rigor and optimism and many times, Chinese government put some incentives and all that as the people come back. And when the people return back to the factories, the production level of the factories post-Chinese New Year is always significantly higher than the production level pre-Chinese New Year. And if the Chinese New Year is earlier, that always results into better results than the other way around. It doesn't make sense, but it has made sense for 25 years.

So I know lead times are still -- I think you mentioned that lead times are still pretty short. But given what you've -- the normalization that you've seen in the December quarter, given the strong bookings trends -- coming off of a depressed base but the strong bookings and billings trends in the March quarter, do you think that you're setting up for a -- at least a seasonal June and September quarter, which is typically your seasonal strongest quarters?

Yes. I mean we have really not said anything that passed. I mean even giving you a March quarter indication that we are ramping our factories is uncharacteristic, but I thought because of the significant change we are seeing, it would make sense to say that. So we haven't said anything about the June or September quarter. But I would say that, yes, June and September are historically the 2 strongest quarters of the year. And those are also the quarters, I think, you could expect that this whole distribution inventory replenishment also picks up more steam. It might happen, some of it in the March quarter, but certainly it will pick up steam in the June and September. So there is reason to be fairly optimistic.

You mentioned -- I was going to ask you this question, but you actually answered it on stage, which is that you had talked about -- given the strong bookings and backlog for the March quarter preparing for your factories and subcons to support the better shipment outlook, it doesn't sound like you're going to be increasing utilizations because you have pretty substantial die bank. But let's say, beyond the March quarter, as you, again, head into the seasonally stronger June and September quarters, would you expect the team to start to ramp capacity utilizations?

So March quarter utilization will increase in our back-end factories. So remember, we do a -- we have 4 large back-end factories. Two that Microchip owned, 1 that came with the Atmel acquisition and 1 that came with the Microsemi acquisition. And during the last several quarters, we have been attriting people in those factories because the demand has been down and we didn't need to put as much more product into finished goods and we depleted the finished goods to keep our inventory lower. And now those -- so that created underutilization in the back-end factories. And our back-end factories are all already hiring and replenishing those people that have attrited over the last year. So the utilization will go up from the back-end factories this quarter. Where the utilization would not yet change will be from the front-end fabs, and we have 3 large front-end fabs, where I think that utilization change will take a little bit longer because -- as we deplete the die.

Got it. Got it. And then -- so -- but I'm assuming that whether it's the front end or the back end that the underutilization charges, right, there were definitely a tangible impact on -- it's been a tangible impact on the gross margin. So I would assume that with at least your back-end factories starting to come back online that we'd see underutilization charges probably lower in the March quarter versus December?

Yes. The answer to that is yes. There is a couple of months delay usually because we ship in first in, first out. So if you ramp the production, then the lower cost usually ships in the next quarter, a couple of months later. It's not immediate. The product we produce today -- the product you produce in March, for example, often doesn't ship in March. It ships in April. So there's a little delay, but you should start to see back-end utilization -- underutilization charges going down and almost getting eliminated in a couple of quarters, and then the front end will join.

You mentioned in terms of end-market strength, cloud data center, automotive, industrial. I know you're going to talk about the 6 megatrends, and I'll ask you that in a minute, but you also have very good exposure to 5G. You also have very good exposure to aerospace and defense. And it feels like both of those segments are relatively healthy as well. Maybe you can sort of talk about some of the current demand trends that you're seeing there.

So as I mentioned, the data center never weakened and that's a very strong market. We're seeing recovery in industrial and automotive for various reasons I described. That leaves 3 other end markets: one is consumer appliances, second is communication and third is aerospace and defense. Now Congress just passed a record budget for aerospace and defense.

Yes. Up 4%, right, from last year.

Yes. So we expect that aerospace and defense, as that budget starts getting spent in this coming year, that business should do very well. But that's really not dialed into the numbers yet because we're not seeing orders from aerospace and defense from that budget yet, but that should do very well. Communication should pick up steam as the 5G infrastructure rollout and all that continues, so that should recover in time. And then the last one is really the appliances. That sector got hammered the most as the duties on washers and dryers and refrigerators and others made out of China were 25% and they still are. So as this Phase 1 agreement gets signed and there is further reduction in duties or that production is going out of China to Vietnam, to Thailand, to others as that further picks up steam and those companies become competitive again and not have a 25% overcharge in the U.S., we think that market would get healthy, and that will probably be the last market to get healthy.

I appreciate it. I appreciate all the comment on the near-term environment. Before I move on to some longer-term trends, are there any questions from the audience? If you do have a question, please wait for the microphone. Okay. Well, let's talk about some of the longer-term, maybe, trends. And despite the weak environment, your business is troughing on a quarterly basis, down about 9% year-over-year, like you said, given your March quarter guidance, is actually going to be up 2% or 3% or better year-over-year in the March quarter. And all of this is much better than some of your other broad-based peers, which are down 15% plus year-over-year here in the December, January quarter. What's your view on the drivers of the better revenue sustainability? Is it market share gains? Is it end market exposure? You have good exposure to data center and other areas, which are relatively good right now? Is it just more -- is it just a more diversified business?

Yes. I think it's all of the above because I can't put this on just 1 factor. We are in 6 different end markets. We do business direct in distribution. I think we have had a stronger, better distribution program that over the last 3 or 4 years has on the edge benefited us. We have historically gained market shares in our end markets and that is continuing, but I can't put this all on 1 theme. If there is a difference between our performance and the others, I think it's really kind of quite distributed. And I would say that I don't know of no other company that is -- that has as much exposure as we have to all the 6 megatrends. Some companies have just exposure to data center. Somebody else may just be communication. Somebody else just may be military or defense. I don't know if there's any company that has as much exposure to the 6 megatrends as we do.

Yes. So why don't you take us through those 6 megatrends? I'm really glad that you're -- the team is focusing more at the sort of end market trends and the products that drive that. So take us through the 6 megatrends.

So the 6 megatrends that we have talked about are -- starting with 5G. So if you look at the 3G infrastructure, it started to be put on at the start of the century and went for about 10 years. And then 10 years ago, 4G started and it's just about getting done as the 5G is beginning. And the 5G will continue for the next 10 years. And so that's a significant strong trend. The second one being IoT. Our total focus on smart, connected and secure node is picking up steam. And I think IoT needs less explanation for this audience than almost anything else. Third is data centers. We have been talking about data centers. 90% of the world's data has been generated in the last 2 years. And there is just tremendous need for data, creating it, storing it, managing it, securing it. The fourth trend is electrical vehicles. Today, there are a small number of electric cars sold, but there are just too many forces, consumer forces, environmental forces, green movement and all that, that is driving substantial investment in technology as well as capacity to build electric cars. The next one is advanced driver assist someday leading to autonomous driving. But meanwhile, lots and lots of features, lane change, keeping a safe distance, building a cocoon around the car in the cockpit area, so you can see everything around, who's around you. And all these things require cameras and processing of the camera, sensor, analog, microcontroller, processing the information, making some sort of decision. So Microchip is very exposed to that. And the last one is the artificial intelligence and machine learning, where -- if you look at in the data center area, Microchip's products, PCIe switches help the data centers carry the AI workload. In the car, you need tremendous amount of reduction in latency and our PCIe switches are helping process the information by GPUs and CPUs and all that and taking the information from cameras to the central processing unit. And as I described, with all these autonomous features, the use for analog and microcontrollers and security is just tremendous. So in all 6 markets, we are just seeing tremendous, tremendous exposure. I didn't give you as much on IoT because I think you kind of already know it. But if I were to spend another minute on it, there are 3 areas in IoT. There is smart factories, smart home and smart cities. And some of the parts are the same and some are different. And in smart factories, just a tremendous need for actuators. Then you got your artificial intelligence, security, authentication, time-sensitive network and all the sensors and processing of the information. When you look at smart home, you got human machine interface with touch everywhere from your thermostats to appliances, then you have clocks and timing and wired and wireless connectivity, USB, Ethernet, Power over Ethernet, analog, security and authentication technologies. Then when you go to smart cities, you're looking at various technologies and smart lighting across the cities, sensors, actuators, wired and wireless connectivity, LoRa and all sorts of those kinds of nodes and security and authentication. So when you kind of put it all together, I think we got multiple business units focused on harvesting multiple end markets and multiple megatrends. And then on the top of all that, you put our TSS focus, which is total system solutions that we have talked about, and you're looking at a single customer board that is populated with 10, 12, 14 Microchip devices and pretty soon it adds up.

Yes. And actually, that's a good segue into my question because one of the things in terms of the 6 megatrends is, obviously, dollar content per opportunity within those 6 megatrends. And one of the key metrics that the Microchip team tracks is the number of Microchip products per project. The idea being that over time with the portfolio systems focus, you're going to drive more dollar content or attach. Last you updated us, you were driving about a 20% year-over-year increase in number of Microchip products per customer program. You've got a plethora of analog, interface, connectivity, memory, FPGAs to offer alongside your core MCU and processor products. Are you still driving this metric at a double-digit percentage year-over-year growth rate?

Yes. We absolutely are. Now when you acquire a new company and you -- and we acquired Microsemi last year, then first thing that happens is that the indicator you were tracking goes down. Why? Because the company you just acquired, they were not focused on putting our parts on their system. So when you add all their customers and all their designs and all their reference designs to our database, then first thing happens is that indicator goes down, but the opportunity goes up because now you've got all these acquired companies, applications and boards. And in the prior conferences, we have talked about example of an FPGA board that had 14 analog devices around it and 2 happened to be Microchip devices, just what Microsemi had done. And the other 12 were from Maxim and TI and ADI and Linear and Intersil and other devices. Today, that new reference design board and also in the next-generation board has 100% of those devices from Microchip. So the indicator went down for a while, but the opportunity goes up. So yes, all that trend is continuing in spades.

We have time for one more question. It's going to be a financial question. So the team has sustained margins extremely well even in this difficult macro environment, which says a lot about the diversification of the business, improving mix, much better pricing environment versus prior cycles. When thinking about the 63% gross margin, 40.5% operating margin targets, can you just help us understand some of the levers to get there outside of just revenue growth from where we are today?

Yes. So I think we were 62.2% or something like that just about a quarter or 2 ago. So if you start from a 62% kind of level, getting to 63%, 63.5%, you're only talking about 100 basis points and there is probably 60 basis points plus just in utilization. And then the mix is constantly richening. There is still major thrust to bring outside products that we're running outside to inside, which is constantly accretive and have a few bps of gross margin improvement every quarter. So yes, I think this shouldn't be very challenging to really get there not in a very long distant future and doesn't require a humongous amount of growth, but does require some growth so the factories can be put back to work and the utilization becomes better.

Great. Well, we're just about out of time. Steve, I want to thank you for participating. Hopefully, you'll make this an annual event at our CES conference.

Certainly.

Yes. Thank you for joining us.

I'm always here. Thank you.

Thank you.

Thank you very much.