Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Great. Well, thanks, everyone, for joining. My name is Craig Hettenbach. I'm a semiconductor analyst at Morgan Stanley. Very pleased to be hosting Microchip. And with me today is CFO, Eric Bjornholt. So welcome, Eric.

Hi. Great to be here.

Great. Before we jump in, I just want to remind people, from a research disclosure perspective, you can find them at www.morganstanley.com/researchdisclosures. So with that, Eric, before we jump into the business, perhaps you can just address the news on earnings with Steve moving to the Executive Chair. Just what's the message there that -- as you guys have been communicating with investors?

Sure. So this has been a well planned out transition from Steve to Ganesh. Ganesh was originally hired by Steve as a new college grad in the early '80s back in Intel. They've known each other forever. I think Ganesh joined Microchip back 18, 19 years ago. And when we acquired Atmel, Ganesh actually moved to the President role, and ever since then, him and Steve have been managing the company jointly. So all the executive staff, including myself, have reported to both of them. He's been very involved in all strategy decisions. And so this is just part of ongoing succession planning. Steve turned 65 this past summer and didn't feel it was appropriate at that time to move into a new role with the pandemic. But since we're seeing some stability in the business, we planned this for March 1. And Ganesh is absolutely ready to do it. Investors have been asking what will change with Ganesh being in the CEO role. And we really don't think anything in the short term, as Steve and Ganesh have been, again, jointly involved in our strategy decisions over the course of time, very much aligned. And Steve is not disconnecting from the business. He's just taking an opportunity to be able to spend some more time with his family. But in the Executive Chairman role, he's still going to be working about 3 days a week and involved in all strategic decision-making and planning with the company and, obviously, be that interface with the management team and the Board. So well thought out transition, and investors really shouldn't expect a change with Ganesh taking over.

Got it. Yes. No, it certainly seemed like kind of a seamless transition as far as transitions go. So -- okay. So if we look at the business environment today, can you talk about kind of what you're seeing in the market? And any particular end markets that you would highlight?

So as we noted in our earnings call and updated earlier this week, bookings have been quite strong, and those bookings have been strong really across the board. All geographies are showing strength in bookings. The end market commentary is really no different than what we provided at our conference call, where we've got a very diversified business by end market and customer and that definitely helped us. If you look back at our results for the June quarter, we performed very well, and we were seeing strength in the business in data center, work from home, computing, some areas of medical, et cetera. And that was somewhat offsetting the very difficult times that automotive, as an example, were having at that time. So today, some of those things that were quite strong back in June have returned to a more normalized lower level. And now we're seeing automotive bounce back, which has been broadly talked about throughout the industry. Our industrial business is doing well. And so that's really we're seeing pretty broad based strength, but some of the things that were stronger back in the middle of calendar '20 has definitely returned to a more normalized level.

Got it. Maybe that's a good segue as you look out to 2021. Do you expect kind of a continuation of some of these recent trends, perhaps some of the markets like data center that moderated a bit will reaccelerate? Or how are you thinking about looking into next year?

Yes. When we've talked about data center, for us, we've definitely seen a pause from where we were back in June. And that probably continues for us through the March quarter and then we're expecting very good things out of that business long term. It's actually performed very well, data center specifically since the acquisition of Microsemi and has been a strength over time. But again, it got pretty heated and strong back in June, and we've seen a bit of a falloff since then. But long term, we've got -- it's one of the 6 mega trends that we've identified in the industry and something that we're quite excited about long term. And as I mentioned, the bookings have really been quite strong and are filling up nicely for the March quarter and even beyond that into June and September, and that's driven by just kind of broad-based strength that we're seeing.

Got it. And on that point around bookings and visibility, I know that's something that company has kind of been working through this year, right, in terms of there were ups and downs from a supply chain perspective, demand bounce-back. Perhaps, you can just touch on that. It feels like you're in a better place now in terms of getting visibility extended, but just anything else you'd add to that?

Sure. So just a reminder for investors that Microchip did issue a letter to our customers back in early July because we were getting so many orders with short-term deliveries, and customers were in a position where they were having a hard time kind of forecasting what their businesses are going to do because of the pandemic. But that message was not an investor communication. It was a customer communication to explain to them that what manufacturing cycle times and product lead times we were in. It helped us start to build some pretty good bookings activity and backlog moving out of the September quarter, and that has absolutely continued into the December quarter. We're in a relatively unique position today where our March quarter as -- and the backlog has filled in quite nicely. And the unique part right now is the bookings that we are receiving today are aging more into the December quarter -- I'm sorry, into the June quarter as compared to the March quarter. And that is quite unusual. So bookings have been strong. We are getting better visibility from our customers. And that just allows us to do a better job of meeting what their requirements are for their business and running our factories as efficiently as we can.

Got it. What about just from a lead time perspective? I know Microchip is increasing CapEx a little bit in terms of some of the growth that you see in the coming quarters. But for Microchip specifically and maybe even perhaps for the industry, anything to keep in mind in terms of as things tighten up a little bit here?

So in terms of lead times, Microchip specifically, still, we have a large portion of our standard products that still have 4- to 8-week lead times. It could be 75%, 80% of the products in that range. But it's the other 20% that causes you the challenges and where customers want product faster than you can produce it. That has caused some lead times to extend. And there absolutely are supply constraints in the industry. We are fortunate that we have some of our manufacturing that's done internally, about 40% of the wafer fab and roughly 50% of the assembly and test is done in-house. But we're seeing constraints and challenges in getting capacity from foundries, from the assembly and test suppliers. And so we have made the conscious decision to invest a bit more in our internal capacity, and you've seen our CapEx budget be increased in the current fiscal year. It's still at historically low levels in terms of percentage of net sales, and capital intensity of this business is generally pretty low. But we've talked about increasing the percentage of the assembly and test activities, specifically that we do in-house, and we'll be making those investments over the coming quarters and coming years to increase that percentage and increase our reliance on our own factories and take control of our own destiny.

Great. Maybe we can touch on the target model. You updated it this week. And perhaps it would be good just to have context of how you got here, right? I mean the last couple of years have been really difficult for the industry, a lot of pressure on revenue, on margins, but yet you held up pretty well close to your target. So maybe touch on that and then segue into the increased range for margins.

Right. So I think gross margins have absolutely been a highlight for us over the last 2 years at how well they have held up. Last quarter, September quarter, we produced 62.2% gross margins, which were near record levels. The current quarter has actually guided to record non-GAAP gross margins for Microchip, between 62.4% and 62.8%. And our previous long-term model on gross margins was 63%. We're ramping our factories. We've had some underutilization charges that have been -- being recognized in cost of sales. And those are reducing dramatically in the current quarter. And really, we expect in the March quarter those pretty much to be gone. And so with that, just -- that's a short-term tailwind to gross margin and gets us really back to the model that we were at before of 63%. And we've got a lot of other things that are quite positive in gross margin. We've got a significant amount of clean room space available to grow into as our revenue increases in the future and as we expand our internal capabilities. On the assembly and test side, we do about 40% of our packaging in-house today. We think that we can take that to over 60% over time. On the final test side, we do about 54% of that internally today. We expect to take that to over 70% over time. All of these are margin-accretive transactions that do take CapEx and take some time to implement. But these are all positive to gross margin. And then on top of that, we've got some smaller inefficient factories that we've acquired in our acquisitions that we will be transitioning out of over time. We closed the factory down in Oregon last year. We've got one in California that will be closed down this upcoming year and some others that we're working on transferring process technologies into our more efficient factories, all very good drivers of margin improvement. And then really, the last thing is you can make cost improvements. And if you aren't disciplined in your product pricing strategies, you can give that all away, but our intention is to continue to be quite disciplined on our ASP management, hold prices flat with customers and have that improvement in our cost structure flow down to gross margin improvement and to the bottom line.

Got it. Maybe we can touch on just capital allocation. The company has been very aggressive to pay down debt the last few years. Just an update on kind of where you stand. And then at some point, when you get closer to the 3 turns net leverage, what are you thinking about for the best use of cash?

Okay. So as you say, we have been very focused since closing the Microsemi acquisition on reducing our debt. Over the last 9 quarters, we paid down $2.95 billion of debt. We've been in a challenging revenue environment because of the trade war, followed by the pandemic. And so EBITDA has not moved significantly, but we're looking into a more positive outlook for calendar '21. And with that, if we get some revenue tailwinds behind us and some EBITDA expansion, that's really going to help because the cash flow from the business has continued to be quite strong and will only improve as we move towards our new target model. So we are very focused on becoming an investment-grade rated company. And so we are going to be continuing to use all of our excess cash generation beyond what we pay to investors as dividends to reduce debt. But we've highlighted to investors that we have a very solid, strong product portfolio today, and you know we've been on a series of acquisitions over the last decade. And we don't really see that there is a material acquisition in our future. We have the product portfolio required to be successful in the marketplace to provide total system solutions to our customers. And obviously, there's things that we're continuing to work on with new product introductions to fill out that portfolio. But the prices that we see transactions going forward in the marketplace today are not at levels that we would be comfortable paying. And so with that, we're focused on organic growth. And with that, as the leverage comes down, it's going to give us a significant amount of opportunity to change and increase our capital return plan to our investors. And obviously, those are Board discussions that will continue to happen as the leverage comes down. But dividends can increase. There can be share buyback programs. And investors are looking for some more parameters around that, which we're not willing to share at this time because we still do have some deleveraging to go. We've made good progress on deleveraging, and that's going to continue to occur over the next year.

Got it. I guess one of the good things about being early in M&A, if I look back at some of the prices, it looks like bargains in terms of multiples. So that's great. How about on just the balance sheet on the convert side? I know you guys have been pretty active in terms of convertible exchanges and really what's the motive behind that?

Okay. So ending last calendar year, we had $4.5 billion of convertible debt outstanding on the balance sheet. And converts are good instruments, but they get quite expensive when the company performs well and you get the share dilution that comes along with them. And so we've been very focused on doing transactions to reduce the amount of convertible debt in the portfolio. And today, after our most recent transactions, we're down to about $1.6 billion of convertible debt on the balance sheet. And the most recent transaction, it was kind of interesting because a number of the convert holders are hedge funds and they are willing to be exchanged for cash and shares. But there's many long-only holders also, and they wanted to have continued exposure to Microchip through a convertible bond. So we actually did issue a new bond for about $665 million with a shorter maturity, so a 4-year maturity, very low coupon. We put a capped call in with this instrument that prevents equity dilution until it's up 75%, and again, with a 4-year maturity, that the downside risk for that is smaller. So we think these have been very positive moves for our investors. If you look back to the first transaction that we did back in March, it was in a very challenging time to raise money. We raised $615 million bridge loan, bought back some of our converts when the stock was trading at $71. And that's a highly accretive transaction at this point in time because we've avoided that future share dilution, and we expect the same from our recent transactions. The converts that we've been taking out have had 5-year, 7-year and 17-year maturities. So a long time for those converts to continue to appreciate over time. And we think removing those from the capital structure is a very positive signal to our equity investors.

Got it. We'd like to spend some time just on Microsemi. We talked through some of the deleveraging. So for sure, you added leverage, and you're working through that. But there's a lot of positive elements of that deal in terms of approaching to new markets where you didn't play. It was a good margin business to begin with, and you're improving that. So can you maybe just talk about the strategic thrust behind Microsemi and how it's been playing out versus expectations?

Yes. So the Microsemi transaction has been a good transaction for us. It brought us a lot of diversity in our product lines, has brought us a lot of different products, and it also gave us diversity in our end market exposure, where Microsemi had a strong footprint in data center, communications and aerospace and defense, where Microchip did not have as large of a footprint over time. So I think that diversity in end markets, customers and products has been very positive for Microchip, and it played very well in this total system solutions sale approach that we have with our customers because now we've got a whole new set of products that we can cross-sell with the historical Microchip product line. So the integration has gone well. The business units and the sales organization is fully integrated at this point in time. We've got a little bit more work to do on some of the IT system integration and operations integration, but I would refer to that as kind of more standard blocking and tackling that we're going to continue to execute on over the coming quarters. And we're quite excited about what Microsemi has done for us. It's a great business. We've made improvements in the operating model, and those will continue.

Got it. And that's probably a good segue into total system solutions that you guys have talked about. I know you've provided some interesting block diagrams of extra technology what you have and what you can cross-sell. Can you maybe dig into that a little bit? I mean I guess just from a high level, like, what is this going to mean at the end of the day? Is it something that could add 100, 200 basis points long-term growth? Or how should investors think about as the strategy comes together?

Okay. So backing up just a minute. So our intention is to be able to, in every customer interaction, sell as much of the silicon solutions that they need to complete their board. And there's value in that for the customer as they've got more of a one-stop shop from -- and can bring them to market quickly with working solutions from a high-quality supplier. We cannot really today put a percentage around it in terms of what it's going to mean for future growth. You have to think about that many of the designs that we have came into Microchip with long life cycles well before we had this TSS strategy in place. So it takes time for that to build, but we're seeing that build in our design funnel. Whenever we do our business unit reviews, they are all expected to present, these are the wins that we got, these are the losses, and not only this is what we won for our business unit, but this is how we positioned the rest of the Microchip portfolio around that and won something, if it's an MCU product line, won analog or timer or connectivity also in that same system. And so it's a very good initiative for us. We see that it's definitely going to add to our growth rate. And with really stepping back from doing acquisitions, we think that is really going to be a driver of our outperformance above and beyond what the market is going to grow for Microchip over the course of time.

Got it. And how do you ensure just buying throughout the organization in terms of -- it sounds great in terms of the capabilities you have, and it can drive better growth. But what are some of the things you help to do to kind of make sure everyone's on the same page and knows that this is critical going forward?

So there's a lot of communication that happens on that. There's training for the sales and distribution network as well as through the business units. We make sure that our business units are talking with each other. We've seen in many of the transactions, M&A transaction that we've completed, that the business units tend to work as individual silos or individual companies within a larger company. And we've worked very hard to open up the communication boundaries. And so when we do our quarterly business reviews with each business unit, everybody is invited to participate on things. And so we learn from each other, learn from the various business units, get great ideas, sharing of intellectual property, strength and weaknesses and best find ways to maximize how we go to market with that. But it's a constant effort. It goes throughout sales, marketing, business units and the entire team working together to present Microchip in the best way possible to secure as much of that future design with a customer that we can.

Got it. Maybe we can just dig into some of the technologies, starting with MCUs and just Microchip has been kind of a steady gainer over time in terms of your position in the market. You also bought Atmel, which added some capabilities. But just what are your latest thoughts in terms of how you're positioned and what type of growth you're seeing in MCUs?

So our microcontroller business continues to do very well. We have everything from the low end of 8-bit to the high end of 32-bit, everything in between. We've got fantastic development tools, software tools that we can allow our customers to use or customers do use to design us in and get them to market quickly and cost effectively. So we get lots of questions about the 8-bit business and is it going to be consumed by the 32-bit business? 32-bit business is the largest of our microcontroller businesses today, but 8-bit is still doing quite well. We expect it to have another record in the future. And the business is doing great. We're investing in all of them. They play well together. And ultimately, we are trying to find the best solution for our customer. We don't care if it's 8-bit, 16-bit and 32-bit, just want to give them the solution that provides them with what they need to do at the best cost, lowest power consumption, et cetera. So we expect our microcontroller market position to continue to improve. We're the #3 player in microcontrollers today. Combining everything together, we're #1 in 8-bit. I think we're #5 in 16-bit and #4 in 32-bit. And we expect for all of those to show continued market share gains into the future.

Got it. In 8-bit, I feel like it often gets overlooked just because the 32-bit market has been growing faster. But at the same time, I think a lot of the companies moved away from 8-bit. And I think Microchip and Atmel, who you bought, were companies that actually stayed focused there. So what does that mean in terms of a market where you have less focus from competitors?

So it creates a lot of opportunity for us. I mean if you have a competitor that is solely focused on 32-bit, 32-bit can absolutely do the job of an 8-bit microcontroller, but it's not necessarily the best customer answer. Again, it might be a more complex product, more difficult to design with, might consume more power, take up more space. So there's lots of reasons why customers would want an 8-bit solution. And they can make that choice with Microchip. And so we give customers the broadest choice of options. We're investing in all 3 areas, 8-bit, 16-bit and 32-bit and introducing new products. And our customers really value that. And we believe it will be a continued way for us to gain share, not just in microcontrollers, but in the 8-bit market continue to gain, capture more share there even though we're a very dominant player today.

Got it. And as much as investors, I think, associate you with [ my control on the ] history, analog has also grown substantially organically and through M&A, I think up to like $1.6 billion or so and over 30% of the business. And so can you maybe just talk about that of how that business has evolved in recent years?

Sure. So we got our start in analog with a few products in the early '90s. We bought -- excuse me, the late '90s. We bought a company called TelCom Semiconductor in the early 2000s and then really grew that business organically for a long period of time and then have done multiple analog acquisitions along the way, whether it was Supertex or Micrel or a portion of both Microsemi and some of the other acquisitions that we've done. So we've expanded the portfolio greatly. We're a top 10 supplier in analog. We don't have the breadth and depth of portfolio that a TI or an ADI has. But we have a very broad portfolio. I think we've got over 8,000 or 10,000 products in the portfolio. We have lots of things that our customers are looking for. It sells very well with our microcontroller and other products in the portfolio and definitely is a growth engine for us into the future. So we're excited about analog. And again, it fits very well into our total system solution approach to the marketplace.

Got it. Maybe we can switch gears. I think one of the debates in the last year or 2 around geopolitical, China trade war, for the whole industry, not just Microchip. But just how do you feel about the focus on just China over time in-sourcing more, everything we just discussed about your portfolio, kind of how it stacks up and how insulated are you versus some of those threats?

So we think we're pretty insulated. Obviously, China has their 2025 initiative. The nature of our business is one of 100,000 SKUs in the portfolio, 120,000 customers, broad-based business, long life products, high quality. And what we've seen historically from China is that they try to make investments in things where they can get a large amount of revenue from a number of products. And that is just not possible in microcontroller and analog. Again, it's going to be the same thing for some of our broad-based competitors that we were somewhat insulated from that. So we're definitely continuing to have a very strong business in China. We ship in about 20%, 21%, 22% of our revenue into China. Maybe half of that is domestic consumption and the other half comes back to the U.S. or to Europe for ultimate consumption. And we haven't seen anything that has been significant in terms of this point in time of customers wanting to design us out. Ultimately, we have a great set of products, and customers choose to design with Microchip because we give them the best most cost-effective solution to come to market with.

Got it. And that's interesting just given the long product and design cycles, right, in many of your markets. So if you're not seeing it today, you're not going to see that in revenue for many years. How about just going back to maybe managing the business? Again, the margins performed very well. There's been a lot of different headwinds. And if you can just talk to just perhaps the agility of the organization or some of the things that allow you to kind of operate through cycle?

Yes. So I think that comes down to the culture of the company, which has been built over the last 30 years. And an example of that is how we deal with times of stress. We don't resort to layoffs of our employees. We look to keep everybody employed. And most recently, we've had our worldwide workforce on a pay cut. And luckily, that has gone away in the month of November. But what it allows us to do is keep everybody gainfully employed, focusing on new product introduction, on customer support activities and all the things that position us very well coming out of a downturn, which we've seen numerous times before by using these strategies to come out and gain significant market share because we've got the products, we've done the customer support, we've won the designs in the difficult times, and now we're really set up well to see that, just like we did coming out of 2010, which was the very steep downturn. We did the same methodology and gain significant market share in 2010, 2011 time frame. So yes, I think the company culture is unique. It's something that we focus on every day. Our employees care about each other and would rather step up with one of these pay cuts than see their neighbor or themselves lose their job. And it has really, really helped us over time to build comradery within the company, and we think that is absolutely a strategic advantage that we have.

Got it. And to that point around the pay cuts and variable comp, which has suited the model well, I know pay is coming back into the model. There was a slight tweak in OpEx spend into a new target. I think it was just 50 basis points, not big. But just maybe you can talk about as you go forward, what are some of the strategic things you're focused on from your spending or just how you want to manage OpEx?

Okay. So yes, you're right, we did tweak the OpEx model up just slightly. And we've been in a pretty difficult environment over the last 2 years. And we announced that initial model of 22.5% back before we closed the Microsemi acquisition when it was announced. And over that time period, it's been a tough environment where we haven't been giving a lot of raises to employees. We've had employees on a pay cut. We need to bring back those compensation programs. And on top of that, we need to make sure that we're making the right investments in -- whether it's in R&D, technical support activities for the customers or in the other support functions to position Microchip to not produce 40% plus operating margins in 2 years. Let's make sure that we're positioned to do that in 5 years, 10 years from now, have the right product set in place and all that. So it's a balance, and we definitely have some things that we need to continue to focus on funding. Our variable comp programs in the short term need to come back to a higher level. And hopefully, calendar '21 presents some nice growth opportunities for that to happen as well as make the necessary investments in the business. So I would view that as a minor tweak to the model. We just want to make sure we're under-investing in the business for the long term.

Got it. All right. I think we're coming right to the half-hour mark here. So really appreciate spending the time with you, Eric, in kind of walking through the business, and have a good day.

Craig, thank you very much, and we will talk to you soon.

All right. Take care.

Bye.