Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good morning. Why don't we go ahead and get started. My name is John Pitzer, I head up Credit Suisse's research in the semiconductor and semiconductor capital equipment sector. I'd like to welcome everyone to day 2 of our 24th Annual TMT Conference. It's my pleasure this morning to introduce the management team of Microchip Technology. At least virtually, we've got Steve Sanghi, the Chief Executive Officer; we have Ganesh Moorthy, President and COO; we've got Eric Bjornholt, the Chief Financial Officer. Steve is going to go through a presentation of maybe 10 or 15 minutes in length, and then we'll have the remainder of the period to ask fireside questions. Remember, if you have a question from the audience, please e-mail them to my e-mail address, and I'll try to include those into my list of questions. And with that, I want to first thank Steve and his team for joining us early this morning, Arizona time, which is where they are, and turn things over to him. Steve?

Thank you, John, and good morning, everyone. Can you see my screen?

Yes. We can see it.

Okay. Before I begin, 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 involve predictions and the actual results may vary materially, so I refer you to Microchip's filings with the SEC regarding some important risk factors about the company. There's a longer safe harbor here that would be on the web, and you can read that in your own time. So with that, let's begin with our Q3 fiscal year '21 guidance and investor update. The strong bookings activity we saw in the September quarter has continued through the December quarter so far. We did call FQ1 and FQ2 of fiscal year '21 as bottom for the business cycle for Microchip. And for the current quarter, we provided a guidance which was flat to up 5% sequentially. Now we also said in our conference call that we will discontinue our practice of providing mid-quarter update. It was adding unnecessary volatility, and all the other companies do not provide a midterm guidance, so we said we will stop providing it. And we did that in a strong business environment, so it is not misread in any way that Microchip had bad news. Microchip continues to do very well, and the business activity is quite strong. We also guided to a record non-GAAP gross margin with a midpoint of 62.6% as well as the operating margin between the 38.7% and 39.7%. And the guidance for earnings per share was $1.51 to $1.63 on a non-GAAP basis. Today, later in the presentation, I will provide a non-GAAP long-term business model update today. This is something that we are approaching very close to our older long-term business model, and so therefore, we'll be updating it today. In the last quarter, we paid down $331 million of our debt, and we have paid down about $2.95 billion in the last 9 quarters. And in the current quarter, we also completed a convertible bond exchange for a portion of our 2025, 2027 and 2037 bonds, and that transaction closes today. So we have been talking about this Microchip 2.0 for some time, which is built on providing total system solutions in embedded control to our customers. We are experiencing leading customer preference to design with our microcontrollers and associated analog components. We are focused on multiple growth drivers across 6 megatrends of the industry and have a very diversified end market mix with exposure to industrial, data center, automotive, communication, consumer and aerospace and defense markets, and we have a long-term model with industry-leading operating profits. So this is how we look at the total system solutions. If you start from the left side, a customer's application may begin with a sensor of some kind, a temperature sensor, a pressure sensor, a motion sensor, some sort of sensor. And that signal is then amplified, filtered from noise, converted to digital, sent into a microcontroller, microprocessor or some sort of FPGA or SoC. And then all the surrounding components all around at the bottom, we have various kind of storage components, optical networking, USB, auto and industrial communication protocols, wireless protocols, Ethernet protocols. And on the top, we have some other things digital potentiometer, reference voltage, encryption, DC to DC converters. And on the right-hand side, on the output side, you have here some sort of drivers, LED drivers, motor drivers and other things. So this is the world of embedded control. If you go back a 1.5 decades ago, Microchip largely provided microcontrollers only to our customers. Today, we're able to provide a total system solution with every block on this page essentially covered and many of our customers' applications, they require nothing else but our products and resistors and capacitors and batteries and switches. So for a couple of years now, in every presentation, we have been adding a different block diagram showing you examples from various industries. Today, I chose a brand-new example from the automotive industry, electrical vehicle, and you haven't seen this block diagram before. And this is an actual design win. So it's not a reference design, it's actually an actual design of a customer. So what you're looking at here is really various blocks of an electrical vehicle charger. It needs to communicate, there is monitoring involved, there is control involved, and then there's a connection to the car and the charger. And the various colors represent various different product lines at Microchip. There are a couple of MCU32s in here doing monitoring and [ analytical ] control. There is a chip from our networking group, there's a chip from our timing group providing clocks. There are some power management blocks from our analog power group, computing product groups have a security chip on it, mixed signal, linear business unit has temp sensors, fan controller, proximity pin, et cetera, and the memory products group also provides a memory product, it's a flash memory. So you could see that how Microchip is able to provide a total system solution and have many of our business units engaged in adding content to an application all working together, trying to increase content of Microchip devices in various books. This is how our revenue by end market breaks out. This is based on our estimates for the fiscal year ending March 31, 2020. Industrial continues to be our largest market, followed by data center and computing, followed by automotive and then others. Now 6 megatrends, these are the 6 megatrends we have been talking about for some time now. The -- I'll touch just briefly about each one of them. The first one, 5G. So if you start with 3G, it started deployment at the start of the millennium, and only for about 10 years. 4G started about 10 years ago, and it's almost coming to an end now. And 5G deployment is just beginning and has another decade ahead of it, and we have good exposure in various different product lines for 5G. Investors understand IoT very well for smart, connected and secured nodes. It's really just taking off everywhere in the world. In the data center market, lots and lots of data is shifting from companies on data centers to cloud, and data is multiplying like crazy. By some estimates, 90% of the world of data was created only in the last 2 years. So that whole sector has a lot of growth ahead of it. The fourth is the electrical vehicles. I'm showing you an example of a charger, but overall, electrical vehicles are a small percentage of the market today, but various consumer, environmental and regulatory forces are driving that to be a significant growth market and the semiconductor content in electric vehicle is about 2x the semiconductor content of the gasoline vehicle. So over time, that sector presents significant growth opportunity. The fifth is the artificial intelligence and the machine learning. That's another explosive sector not only in the cloud but really lots of artificial intelligence being used at the edge. And finally, the sixth sector is advanced driver assistant, autonomous vehicles. Today's vehicle more and more and more have intelligence in it where it puts a cocoon in the cockpit of the car, showing a 360-degree view of everything around the car and providing various driver-assist functions leading someday to a completely autonomous car. Now this is a table showing our financial results and guidance over a longer period of time, getting it back to Q1 of fiscal year '17 when we first bought Atmel. So you could see that -- and maybe I should have shown a 1 quarter before Atmel, where our gross margin was in high 30 -- I'm sorry, our operating margin was in high 30s. And after combining it with Atmel, our gross margin was 55.8% and the operating margin dropped to 27.4%, combining the 2 companies together. And you can see in the subsequent 2 years, how we clawed back to a gross margin back in the approximately 62% and the operating margin hitting close to 40%, which was Q4 of fiscal year '18. And then I drew a yellow line vertically, and that's when we did the Microsemi acquisition, and Microsemi acquisition didn't have as much -- it didn't have a negative effect on our operating margin, some but not much because their operating expense were high. But as we then assimilated Microsemi acquisition into Microchip, scroll forward about 9 quarters, you can see that our gross margin is now again at a record of 62.2% and operating margin at 39.2%, really approaching our longer-term target. So if you look at the Q3 current quarter guidance, we provided guidance of -- this is up 0 to 5%. Gross profit in the record range, prior record was 62.2%. So really, in this entire range, it will be a new record. Operating expense of 23.1% to 23.7%. Operating income, 38.7% to 39.7%, and the diluted EPS, you can see. Okay. So this is a new slide. As we approach our older current model, the current quarter -- midpoint of the current quarter guidance is 62.6% and high end of the guidance is 62.9%, so we're kind of pretty much there at the model. So today, we're providing a long-term non-GAAP operating model update and upgrading our gross margin target to 65%, operating expense target revising it to 23%, and I'll talk about gross and operating expense in the next slide, resulting into an operating profit of 42%. So what are the drivers of gross margin expansion from here where we are already at a record? Well, first is that eliminating factory underutilization charges as our manufacturing activities ramp up. Last quarter, we still had little over $12 million in underutilization charges, which will go down substantially this quarter and will be pretty much eliminated in the March quarter. And then as we continue to ramp, we are cost-effectively expanding into our existing clean room space, both in our fabrication facilities as well as our back-end plans. We continue to bring significant assembly activity inside, that's in-sourcing of assembly activity from subcontractors. Currently, we are doing 45% of the assembly inside, 55% outside, and our target is to get to over 60% of the volume inside. Same thing for the final test. We're currently at 54% of test inside, and our target is to get to over 70% over time. And especially with Microsemi acquisition, we acquired a number of very small and inefficient and older fabs. And some of them are so small that they can be called the labs. And we are moving them to a larger, more efficient fabrication facilities. There was one small one in Bend, Oregon, which was closed about a year or so ago. There's one small one in Santa Clara that is slated for closure in the middle of next year. And then there are some other smaller ones, which are in the various stages of transferring to our larger factories. And we have a very disciplined product pricing strategy that has kept our gross margins very high and in general, improving up and to the right, sometimes impacted by acquisitions, which begin with lower gross margin and lower operating margins. But as you saw in the slide earlier, we've always clawed back to new record highs. And this time, we are really increasing our targets even further. So now on the operating expense side, as you can see that we actually increased the operating expense percentage target from 20%, 20.5% to 23%. Now one of the reason is we have lost a couple of years of growth. First, by all the U.S. China trade war and then by the COVID-19 issues and expenses have a way of feeding various business groups and employees need a raise once in a while. And with no growth for the last couple of years, it has put some pressure on the expense. We just came off this year with a 10% expense cut -- I'm sorry, 10% salary cut to all of our employees worldwide. The salary cut has been restored, but employees didn't get a raise this year. So there is some little stress on the system, and we need to continue to make investments in R&D across our strategic product lines to drive the high-margin revenue growth. And we also need to make investment in technical support activities. This total system solution require higher level of investment in technical support to capture the entire board that the customer have, multiple business groups working at each customer, capturing the entire board and providing technical support, and finally, investment in various store functions. So with that, we think, out of 2% additional gross margin, we have decided that we're going to hold back 0.5% for the operating expense and really give the other 1.5% for higher operating margin. If we have a substantial revenue growth in the coming years and we see that stress eases, there is another room for revision. But right now, I think we're going to hold back that 0.5% to the operating expense line. This slide shows our debt EBITDA and net leverage. The blue bars are Microchip's total debt that is coming down. The light blue line is the net leverage, which at the end of last quarter was 4.04, and we will break forward this quarter. And finally, the orange bars are the EBITDA, which is largely flat here over the last 9 quarters based on really industry conditions of U.S. China trade as well as COVID-19. And we're expecting -- you can see at the bottom of the EBITDA line that in FQ2 '21, it reverse course where it has been coming down and then it started going back up. And we should see another increase this quarter and increase continues going forward. So we expect to really pay down this debt significantly over time and bring this leverage lower and lower. I think this leverage should go down below 3 in not-too-distant future, and we're working towards really the investment-grade rating. So 1 question that investors have been asking is really what happens after we achieve our leverage with somewhere in the 2.5% to 3%, 2.5 to 3.0 leverage. When we come down in that range and achieve an investment-grade rating, what is our strategy for cash? And we have been signaling for a while that we find that we have completed Microchip's total system solution by acquiring various companies over time. And number one, do not have a strategic need to really have another acquisition because we can complete the solution now. Number two, we find the acquisitions to be very, very expensive and really not to our taste. And finally, we think, short term, we have high leverage, and we're paying down the debt. But even when the leverage comes down, we think, going forward, Microchip is much more dependent on the organic growth rather than the inorganic growth that we have also had in the past. So the high-profit business model of Microchip and very low capital intensity generates significant free cash flow. And today, we're using that cash flow to delever and achieve the investment-grade rating. But once we get there, we plan to use a combination of dividend growth and stock buyback to return large cash that we're generating every quarter back to the shareholders. So I'll summarize the presentation. We are a consistent revenue grower with multiple growth drivers across 6 megatrends of the industry. Our current quarter guidance is flat to up 5% sequentially. We paid down almost $3 billion of our debt over the last 9 quarters and are continuing to be levered. We retired and refinanced $2.9 billion of our convertible debt in this calendar year to help prevent future earnings dilution. We have a very high-margin business model and shareholder-friendly. And I wanted to end up with the final bullet of we are updating Microchip's premium long-term GAAP -- I'm sorry, non-GAAP financial model today and increasing the gross margin guidance to 65%, 23% operating expense and increasing operating income percentage guidance longer term to 42%. So with that, John, let me pass that on to you for some follow-on questions.

Perfect. Really appreciate the presentation. Steve, I promised myself not to get overly sentimental because whether you're aware of it or not, we've already signed you up for next year's conference where we're back at the Phoenician, at least for a dinner. But this will be the last time you presented at a Credit Suisse Conference as CEO, you're making that transition to Chairman and giving the CEO role over to Ganesh. I was looking at some data last night and trying to put your career into perspective. And one of the things I found out is when you first joined the semiconductor industry back in 1978, I think the leading-edge chip was the Motorola 68k. I think the 68K actually stood for the number of transistors on that chip. It was built at 3.5 micron. And if you look at today, the M1 that Apple just brought off is 5 nanometers and 16 billion transistors. I think even more impressively, when you joined Microchip back in 1990, I think revenue was about $60 million. Today, you're over $5 billion. When you brought the company public, you had a market capital of whopping $85 million. Today, that market cap is almost $40 billion. So clearly, just a stellar career. I think one of the questions I get asked is, one, why now? Why are you deciding to retire now? And I guess, Ganesh, the second half of that question is, as you take over, what do you think your top priorities will be?

Well, I'll answer the first half and Ganesh can answer the second half. So first of all, thanks, John. Industry has come a long way, and thanks for saying some of the things like how the industry has grown. Today, we can build 10,000 transistors in the cross-section of the human hair. So if you just look at it, we can build multiple transistors in the size of the growth of your nail in 6 seconds. That's incredible. That's like watch the paint to dry. So industry has come a long way. I'm really not fully retiring. I will be an Executive Chair, and I'll be working Executive Chair. I'm planning to work 3 days a week, will participate in all strategic processes and stay involved with the investors and analysts and others. You'll still see me at the conferences. And yes, Ganesh will present as the CEO, but if he can't make it to a conference, you might still find me presenting. It's an old habit, hard to break probably, but I'm really not totally going away. And in terms of what Ganesh will prioritize, what he will change, I would let him answer that.

Okay. So Steve and I have worked very closely over the last 5 years. So if there was something to change, he and I would have worked on it at this point in time and made it as part of the time when we were working together in the current roles that we're in. So I don't expect anything will change dramatically as we go past the transition. Obviously, in the coming years, we're going to have new challenges. We'll have new issues to work with, and we will work on how those challenges should be navigated and what that means to our priorities, et cetera. But I'm very fortunate, I'm inheriting the company at a time when it has tremendous foundation and tremendous performance that it has. And my role is to make sure that we build on it and it continues to achieve new highs and new records. And at some point in time, I hand it off to someone else in far better shape than as great a shape as I've received it.

That's great. Steve, I'm kind of curious. Way back when you started the M&A sort of strategy, which was well before everyone, we had a conversation in Phoenix that the driver of that strategy was your view that the organic growth in the industry just wasn't going to be that strong. Now since you've embarked on that strategy, I would argue that your organic growth has been stronger than perhaps you anticipated when you first went down that path. But I'm curious around your comments that you don't need M&A going forward, especially in light of the new business model. And especially in light of some of the positive comments you made about calendar year '21 growth on your recent earnings call. How should we as investors think about your growth rate going forward versus trend?

So I think we identified the M&A strategy back in 2010 with the first acquisition of Silicon Storage Technology back then. It is not that we were not expecting any organic growth. At that time, the company was still quite small. I forgot that -- how big we were, but it was really not a multibillion-dollar company with scale. And at that time, we still wanted a double-digit growth, and we didn't think that the double-digit growth was evident in our industry after the tech burst from 2003 to 2009, '10. I think the industry was going mid-single digit, and that wasn't sufficient enough for us. And then we added inorganic growth strategy with which we grew almost 17.6% per year over a long period of time, over a decade plus. And during that time, we built substantial scale, a multibillion-dollar company. And we did that very strategically and systematically, adding components that will help us enhance our total system solution around the board. And we now kind of have achieved that. So we now have scale and we have the total system solution. And forward-going, all we are saying is we don't really need it. If an acquisition was to be available at a good price, which meets our metrics, which checks all the boxes and it's not dilutive and all that, we would be happy to take a look at it. But it is not needed going from $5.3 billion, buy another $1 billion, go to $6.2 billion doesn't change the scale much. And if that company adds a huge amount of debt that takes 3 years to pay like we're doing right now, then I think the risk-reward ratio doesn't look as good anymore, especially with the valuation various companies are selling for at the late stage of this M&A merger mania. So I think that's...

Yes, in part, M&A was a way to try to get to maintain that double-digit growth rate. I'm just kind of curious, is that the right kind of trend growth we should think? Or the law of large number is going to work against that given your size today?

We're not talking about double-digit growth for the industry nor Microchip. We're not -- I'm not trying to say. At that time, we were a very small company and to gain scale compared to our larger competitors that we were competing with, we needed to have a double-digit growth to gain the scale. And in the last decade, we have achieved that. So now I think -- we think we will grow industry plus with a dominant strategy in the markets where we're participating, gaining share in microcontrollers, gaining share in other markets, networking, connectivity, analog, other areas, but we're not talking about double-digit growth.

That's helpful. And then, Ganesh, I know that you guys have put a lot of work into helping us better understand the business by giving us more end market breakdowns over the last several years than you have. Inevitably, when you do us a favor, we're going to push back. And I think the question I get is, when you think about your go-to-market strategy, you've been very distribution heavy and perhaps not as vertically integrated as some of your peers. Is that something that we should think about being an incremental strategy moving forward to have more of a vertically-integrated strategy? Or do you still see the distribution strategy is the best way to attack these broad markets?

I think the best way to describe Microchip is not so much as distribution or nondistribution. There are businesses within the company that do have a vertical approach with how we develop products and go to market and win. There are other parts of the business that are more broad-based that use distribution in the long tail of customers. We have both types of business models. They both flourish inside Microchip. We just need to adapt each business to the conditions of what is available for us to grow. And today, distribution is about half of our business and that choice of which -- where a customer buys from is really up to a customer. We're not trying to guide it to be more than half or less than half. And even many of the customers who buy through distribution, actually, their design-in phase is a very vertical approach that we take. But then the customer, for their own logistical reasons, chooses to buy through a distribution staff. But I think it would be a mistake to think of Microchip as 1 dimensional. We have multidimensional, adaptive to what the needs are in the different markets that we serve.

That's helpful. Guys, we've run into our time constraints in this fireside chat. But Steve, Ganesh and Eric, I want to thank you very much for participating at least virtually today. Pass along our hope that you, your family, your extended Microchip family are staying safe in what's been a trying year of 2020. We really appreciate the participation. I want to thank everybody for joining us this morning.

Thank you, John, and same to you.

Thank you very much.