Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good afternoon, everybody, and good morning to the gentlemen in Phoenix, Arizona, representing Microchip. My name is Gary Mobley. I'm 1 of 3 semiconductor analysts at Wells Fargo Securities. One of the companies I cover is Microchip. And with us today from the management team of Microchip, we have Steve Sanghi, the CEO of the company, longtime CEO; and we have Eric Bjornholt, if I could say that correctly, pronounce it correctly, is with us as well. He's the CFO of Microchip, longtime CFO, I should add.

And with that, I don't know that it's necessarily to go over all of Microchip's history. And I think most people have a pretty good understanding of the company. But Steve, what I was hoping that you could do is give us an overview in terms of the rate of improvement in the overall semiconductor industry, discuss what's hot, what's not in terms of end markets? And I know you guys presented yesterday at a different conference, and you updated your investor deck and your long-term projections and whatnot. But maybe if we could just start out by discussing sort of market trends with you, Steve?

Definitely. So I think the market trends this year really all been driven by the effect of COVID. When the COVID was peaking back in the June quarter, the 3 markets for Microchip, which were under most stress were automotive, industrial and consumer appliances. And the 3 markets or some of the markets that benefited were PC market, data center market and parts of the medical market, all related to work from home. Many, many of our employees and other employees around the world that work in the offices, many of them have workstations or desktop computers. So when they got sent home to work from home, they needed to get a PC. They needed to get a broadband connection, maybe faster router, have a camera, buy a printer. So the demand for all those products rose significantly because of work from home. And as the lots and lots of data got transferred onto the cloud, the demand for data center products was also very strong. The other sector that benefited was the medical, the parts going into ventilators, the digital thermometers, temporal scanners, oxygen pumps, oxygen sensors, the demand for all those products was very strong. But the demand for more elective surgery products, X-ray machines, MRIs and other -- dental surgeries and other equipment, that demand was down because people were really not getting those done. And then what happened in the September and December quarter is, it has completely flipped. The markets which were weak, automotive, industrial and appliances are going through a V-shape recovery, and the demand is very strong. And the demand for data center products, PCs and all that medical stuff related to COVID that is already very weak right now.

It's a good overview. I know that you have an IR deck published on your website from yesterday, and you have in their quote strong bookings activity in the September 2020 quarter has continued into December 2020 quarter. Is that just a quote from your November -- early November earnings call? Or have you seen in the subsequent 4 weeks from that, the continuation in strong bookings?

We have seen continuation of strong booking.

Okay. And in particular, is it primarily automotive, which represents 15% of your total revenue? Is industrial as you summed up a minute ago, are those really 2 main drivers of that continuation in strong bookings?

No. So bookings are pretty much strong everywhere with the exception of data center and some other -- some of the PC market. So same markets that I described as strong bookings are very strong. The markets that I described as weak, the bookings are weaker. But overall, they're very strong.

All right. Eric, in that same slide deck that I'm referencing, you basically take up your long-term gross margin outlook in the past. It was 63%. Now you're looking for long-term gross margin target of 65%. Could you speak to what were the factors that are driving that 200 basis point upward revision in your expectation?

Sure. So just a reminder for everybody that in the December quarter, we're guiding to record -- historical record gross margins for the company. Our underutilization charges, which were about $12 million in the September quarter are being reduced significantly in the current quarter. And really, we expect by March that they're completely gone or almost gone. So that's continued very short-term tailwind to gross margin. And we're very close to that previous long-term target of 63% at that point in time. And so on top of that, we've got lots of clean room space in the wafer fab side that we can expand into over the course of time. That's very cost effective expansion as revenue grows in the future. We've talked about historically on the assembly and test side of how we're going to continue to in-source some of that activity and laid out some specific targets on that, taking assembly from about 45% today to over 60% long term. And then on the test side, from about 54% today to over 70% in the long term. And those are incremental investments that we make over time and can do those within our CapEx budgets that we've kind of laid out for the Street. And we continue to be quite disciplined in terms of our pricing strategies with customers and ASPs are generally staying flat over the course of time. And so these improvements that we're making in our cost structures we expect that to really fall through to the bottom line and allow us to achieve this new target.

Okay. You have in there quote just some of the pricing strategy, price increase. And related to that, could you highlight some areas where you're seeing from a product perspective, the most pricing power?

Gary, we lost you along the way. I didn't hear the whole thing froze for a while. Can you repeat that question?

Sure. So I think part of the gross margin -- the improved gross margin outlook is "a disciplined pricing strategy." So I'm curious to know if that's another way of saying some price increases? And could you speak to the different product categories that might be showing the most amount of pricing power?

Yes. So it doesn't mean increase. And I'm actually surprised that, that line has been kind of so misunderstood because I've gotten that question from a lot of investors. It simply means all the other things in that slide, we achieve all that [indiscernible] reduce the cost, get better utilization and all that, that lowers the cost and then don't give it all the way to the customer. As the volume rises, as the business grows, as many undisciplined players do, we have people in the industry whose gross margin is lower than our operating margin. I call them the undisciplined players. So don't do that, essentially, don't pass that on to the customer. Keep it for ourselves. That's all -- really all it means.

Okay. And Eric, your operating expenses on a non-GAAP basis are down about 10% here in the first half of the fiscal year '21 compared to same period last year. How much of that is temporary? And when does it bounce back? And to what degree when salary and wages return back to normal?

Right. So that's a big piece of it. So you're seeing an increase in OpEx dollars in the current quarter. We -- our Board has taken away the salary cuts that our employees have been on that was effective in November. So employees are back to full salary. We'll have the full impact of that reflected in the March quarter. And then we've got our variable compensation programs, which have been quite low from a cash payment perspective, and those will need to come back over time. And really, over the last 2 years, we've been in a pretty difficult environment, right? We went through the China trade war, we got the pandemic, and so we haven't been giving a lot of raises. There's some pent-up demand for investment. And we just want to make sure that we're making the investments in our business in R&D, technical support and other support functions to drive the long-term health of the business, so we're producing these high operating margins just not 2 years from now, but it's 5 years, 10 years from now, we've fed the system appropriately.

And just to be clear, in spite of operating expenses coming up, you are raising your long-term operating margin target from the previous 40.5% to 42%. So you're bringing through 150 of the 200 basis point gross margin improvement -- improved outlook. And so what are the considerations as it relates to the earnings power from that? And I guess, maybe asked a different way, at what revenue level do you need to be at to achieve that target operating margin level?

So we don't break out a specific revenue level. These are things on the gross margin side that we're going to see incremental improvements as we move along. And I think Microchip is known as good operators, not just on the production side, but also in how we run the business from an investment standpoint. So there's definitely leverage to be had there. The OpEx message is we just want to make sure that we're not underinvesting in the business to drive the long-term health, as I said before.

Let me add to that answer. I think in trying to get to that 65% gross margin, there are 2 levers which are adding value: one is the time lever and other is a growth lever. So if you look at our last couple of years, we have had no revenue growth in the last couple of years. And still, you have seen a substantial improvement of gross and operating margins because we've been bringing stuff in and making improvements and cost reductions. So that is the value of the time lever. So just with time, as we bring the stuff in, we can improve gross margin. The second lever is the growth lever. If we get growth, then all the existing Microchip stuff that runs into our factories had higher revenue and the incremental production will be at a lower cost and it improves our gross margin, plus the value of what we bring it in is now higher because we're running at a higher revenue level. So there is the value of the growth lever. If both engines are working, the time lever and the growth lever, we get to those numbers faster. I can't tell you when, but they will work faster. If only 1 is working where industry has another problem and growth is not there, and we only have the time lever, then it takes longer. So I think it's a 2 question equation to solve in a way, and both are helpful.

Inventories. Your distributor point of purchase has slightly exceeded your point of sale. And I mean slightly by the -- for each of the past 2 quarters. However, you're 30 days of inventory in the distribution channel is still with the lower end of your normal 27 to 47 day targeted range. What sort of behavioral changes have you seen from customers and distributors with respect to relying too much on Microchip's ability to turn around an order very quickly. And what are you telling customers now with respect to order lead times and perhaps the need to give you guys more visibility?

So we informed our customers and distributors back in July through the July 7 letter that we need them to be placing long-term orders, so we can build the requirements efficiently. The customers and distributors who listen to us have really done very well because the situation has gotten worse in terms of supply line and lead times and constraints in industry as these end markets are going through significant V-shape recovery, lots and lots of products are really not available and are getting constrained. And so the customers who didn't listen are now expediting, they're in trouble, going through hoops in terms of trying to get products and through alternate channels or whatever. So we're not really telling customers anything different than what we told in that letter. But any interactions we're having with customers, and we're having a lot because customers are sure. And first thing is why don't you listen to us, and we're asking them to continue to place longer-term backlog, so their needs are understood. And we can put the capacity in place to build to their requirements.

Sure. Okay. Some executives from some companies similar to Microchip have described the market conditions as being somewhat exuberant or frothy. And so I'm wondering to hear your perspective on whether or not you feel like the resurgence in bookings is reflective of true end demand and perhaps related to that, what Microchip is doing to ensure that customers and distributors aren't building too much inventory.

So the distributor inventory is well understood because we reported, we get data on it all the time. We watch it. And there's no build up distributor inventory. It was 1-day last quarter. So still sitting at nearly 15-year low. We think distributors will try to build inventory. But in this environment, I don't think they'll be able to build inventory because the product is just not available. And whatever they can get, the demand is strong and they'll sell it to their end customers. Think of this way, the distributor is always going to be opposite of where we want to be. When lots and lots of parts are available, we want them to buy the parts. So it cushions the [ solid ] revenue, but they don't because parts are easily available, they don't want to buy it. And when the parts are not available, lead times are longer, now they want to buy the parts, now the parts are not available. So I don't think much of distributor inventory is going to get built anytime soon. Might get built at the later stage of the recovery, but not right now. In terms of the end customers, end customers are all hand to mouth. Demand has gone up substantially. They didn't place the orders in time and how they're placing the orders within the lead time and are complaining about lines down and shortages and expedites and other stuff. Whoever is telling you that it's frothy is telling you that correctly, and some of it is frothy. But I think what happens is all of it really can't get shipped. So at the end of the day, as you start allocating, people fight much harder for what they absolutely need and they don't fight for the trout. So it's kind of a self-correcting mechanism. What is trout gets pushed out because the product isn't there, what is actually needed to gets serviced.

Okay. Transition the discussion towards China. According to your 10-K, China represents slightly more than 20% of your overall revenue. I'm not sure if that's reflective of China end market consumption levels or whether that just happens to be where products are made or where you're shipping to production. But I'm curious to know how difficult to spend and navigate the U.S.-China geopolitics and in particular, whether or not Microchip has suffered from an anti-U.S. sentiment as these geopolitics has certainly strained U.S.-China relations.

So China is about 22% of our business. Our estimates are that half of it is really built in China for shipment outside of China to U.S., Europe or other parts of Asia, and the other half, which would be 11%, is really designed, built and consumed by indigenous Chinese. So the 1 that is shipped outside, it's been now 2 years [ battle ], and a lot of that has been moving outside of China. So our customers who were producing in China are now producing in Malaysia, Philippines or elsewhere, but not all has moved out. I mean it's still -- there was -- China was such a large manufacturing footprint that if you say, okay, we're going to take it outside of China, and there's just not enough demand -- I'm sorry, there's just not enough capacity. So the factories outside of China are running at 130% and the factories inside of China, some of them are underloaded. So the ones that is built in China for outside consumption, there will be no effect that will be fine. They'll either move out of China or they'll keep producing it in China, continue to use our parts, and there'll be absolutely no issue. The other 11% that is built in China and consumed in China, true, there has been some anti-American sentiment, but we haven't really seen a revenue impact because of that. Number one, we make very good parts and these high-quality parts and breadth of products, 8,000 different microcontrollers and 10,000-plus analog parts, they're very, very hard to duplicate. No product that Microchip makes even 0.5% of our business. I haven't looked at it, but I don't think even makes 0.1% of our business because it's so broad. So country after country, when they want to come after the semiconductor market, taking examples of Japan and Taiwan and Korea, they have either done it with a memory market or they have done it with a higher-end SoC chips or custom chips or whatever. The generic microcontrollers, you have to build hundreds of mask sets to accumulate enough revenue that moves the needle. So that is not very conducive. So therefore, we're kind of on the back of the line in priority for our people to really design and build microcontrollers themselves, they're trying plenty of other things. So therefore, there is really no short-term impact on that part of the business that is really built and used in China. The business that is built in China, but is shipped outside, has gone through significant navigational hassles , of course. First -- 2 years ago, when the duties were first place, it was a problem for our customers. Because they were building a thing in China and then going outside, their landed cost was rising. In certain cases, we built our product in China, and then we were shipping it to the customers in U.S., and we asked that we have passed the tariff cost to them, which we did dollar for dollar. So for everybody it was a big hassle and nobody wanted to build the inventory, distributors didn't want to build the inventory because the settlement was always 90 days away. And if you bring the parts in, pay the tariff on it, then there is a settlement, no customer will refund you for the tariff. No, you're going to have to eat it. So that created a lot of navigational challenges in 2019. Early 2020, there was a settlement with China, and it was peace and we thought it would be good, but then came COVID and you had entirely new chain of problems, and then came Huawei, which created totally different issues where -- I mean, it kept -- different rules kept coming from Department of Commerce and finally, leading to a complete stoppage. So right now, we're shipping 0. We have applied for a number of licenses to the Department of Commerce and haven't gotten any licensees product by product, so -- which is kind of very inefficient. So that's where we are. So it has been complicated, dealing with China, dealing with Huawei,dealing with tariffs, dealing with all that situation. But we're paid to solve problems, and we're solving problems along the way.

Appreciate that. I'm going to ask you, Steve, to get a little philosophical a little reflective for a minute. Now that you've announced your retirement and the transition to the Executive Chairman role. You guys announced that Ganesh Moorthy is going to take over as CEO. You have mentored Ganesh for 25 years and under the idea that perhaps the Apple doesn't fall far from the tree. I'm curious to know how much latitude Ganesh has to do things differently? Or perhaps as well, where you and Ganesh maybe differed fundamentally as it relates to things like vertical integration, outsourcing, M&A or anything else?

So I first hired Ganesh as the new college grad in 1982 at Intel, and then he worked down in my organization for several years, and then I left Intel and he stayed there for another 12 years and kind of grew a lot. And I hired him -- we got reconnected back in 2001, and I hired him at Microchip with an eye towards being a potential successor. So Ganesh and I have known each other now for 38 years. So last 4 years, he has been my partner completely where we are 2 in the box, essentially running the business with Eric and all Eric's other colleagues, the VP of Sales, the VP of Manufacturing, the VP of Fabs, the VP of Product Lines and all those have worked for us together. So it's not like half team work with him, half work for me. They both work for us together and we make joint decisions. Any changes that Ganesh wanted to make, he has of put in those ideas in the last 4 years, and we have implemented those changes already. When other people have asked Ganesh that question, he is really answering the same that if you felt any change was made -- needed to be made, would have made it this year, we have made it last year. We made it a year ago. In terms of latitude, yes, of course, CEO has a latitude, but he doesn't feel that he doesn't -- that he needs really use any latitude. If any changes come, they will come as the response to change in the environment or some sort of competitive move with which we need to transform or change something because business as usual would not work, which we don't see today. And secondly, I'll stay in that box, still be his partner, planning to work 3 days and invest the other 2 days with the family. Be involved with all the strategic decisions, with succession planning. I mean Ganesh is only 4 years younger to me, so he doesn't have a lot of years. And I consider both my job and his job to produce 1 more CEO from internally who's the next guy that's going to take on for Ganesh. And if God help us, something happens to Ganesh, Microchip will always have Steve Sanghi, who will jump back in 100% and do this again.

Got it. Got it. Okay. And as you look back at your 30-year career at Microchip, what are you most proud of in terms of shareholder value-enhancing decisions? And conversely, what are you -- what would you have done differently?

Well, so I think the accomplishments are quite too many to rattle a lot and I won't. I did do some of that in the earnings conference call. But when I joined, I raised the first money at a $10 million valuation privately and then took it public at a valuation of $85 million and now it's a $45 billion enterprise value. So there's a lot that has gone on in between. And I think it's been a proud journey. And I'm just honored to have that opportunity to have done it. I can sit with customers, I can sit with the distributors, I can sit with our suppliers or I can sit with employees in any parts of the world and hold my high head and that I serve their needs and they respect me and and added value to their cause. And I think that's the lot to say.

Appreciate that. I know it's hard to talk about your own successes. Eric, before we move on, I wanted to hit on the topic of debt restructure a bit. It doesn't sound like an exciting topic, but I don't want to -- I think it's important to emphasize the importance of removing that share dilution overhang. And so could you talk about the different rounds of debt restructure that you have done, what the main purpose is in terms of extending the debt maturity, lowering the interest rate, removing the equity dilution? And what sort of factors in terms of Microchip's current share price need to be in place for additional convert replacement?

Okay. Sure. So we've been super active over the course of the last year. We did our first transaction back in March, which was a very difficult time to be raising money. We actually got a bridge loan for $615 million. This was in the height of COVID, right? And the world was crashing in some people's views that it's difficult to raise money. But we ended up using those funds to take out some of our converts when the stock price was $71, right? And the stock has run-up tremendously. From then, it's been extremely accretive transactions. And we view the converts as they were good instruments for us when we put them into place, but they're our most expensive form of capital. And so back on March 1, we had $4.5 billion of convertible debt in the structure. Today, as of our last transaction that we just completed and closed on yesterday, we've got $1.6 billion of converts. So we've really reduced that exposure. The combination of all these have been quite accretive to earnings. All of them initially, if the stock price doesn't move, they're slightly dilutive to earnings because you're having to compensate the convert holders for the time value that they still have in those bonds. But we're bullish on the company long term. The converts that we took out with the recent transaction mature in 5 years, 7 years and 17 years, and there's no doubt that these are going to be highly accretive transactions for us. And there's a mix of holders with the converts. Some of them are hedge funds, and we've been able to entice them to be able to take those bonds out for cash and shares. But there's others that are long-only that want to be long in the company and hold that paper, and so recently, we issued a new convert that's included in the $1.6 billion that I say is outstanding and shorten the maturity. We got a lower coupon. We put a cap call in place to limit any dilution from starting until the stock is up 75%. So I think we've taken all the right moves. And now we're really focused on becoming an investment-grade company. If 2021 turns out to be a good year for us and the industry, we had a tailwind on revenue and EBITDA expands with the cash generation that we have, we're well on our path to get there. So we've made a lot of good progress. And could there be more restructuring in the future? Sure. But I think we've done a lot in the last 4 quarters.

Okay. Guys, I think we're out of time. I appreciate the 30 minutes you gave me for this fireside chat, and I hope you enjoy the rest of the TMT Conference. And as well, enjoy your holidays. Thanks, guys.

Thank you, Gary. Same to you.

Thank you. Take care.