Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Great. Good afternoon, everyone, and welcome back to those who've been with us the entire day. My name is Toshiya Hari. I cover the semiconductor and semiconductor capital equipment space here at Goldman Sachs. We're very excited and very honored to have Steve Sanghi, Chairman of the Board and Chief Executive Officer; and Eric Bjornholt, Senior Vice President and CFO from Microchip with us this afternoon. This fireside chat will be about 40 minutes. Steve will kick us off with opening remarks. I'll follow with a list of questions, but I'll certainly try to weave in any questions you may have through the webcast. With that, Steve and Eric, thank you very much for joining us and supporting the conference. Steve, the floor is yours.

Thank you, Toshiya, and good afternoon, everyone. Before I begin, I wish to remind you that in today's fireside chat, I will be making some projections and other forward-looking statements regarding the future financial performance of Microchip. These statements involve predictions, and the actual results may vary materially. I refer you to Microchip's filings with the SEC regarding some important risk factors about the company. I'll provide you a brief update about the business environment and then update on where we are on some of the matters that may be interesting to the investors. So the business environment has continued to strengthen. The pace of bookings that we have seen since September has continued to strengthen further every month for most. As we mentioned [indiscernible] time record bookings in the December quarter, and the backlog is also at an all-time record. Now remember that bookings as well as backlog is what is shippable in the next 12 months, therefore, do not equate to record bookings and record backlog to record revenue. But having said that, backlog for March quarter is quite strong. And we have guided to really a midpoint of the guidance really points towards a record revenue. I'll talk a bit about capacity constraints. The business is feeling broad-based capacity constraints in all parts of our manufacturing supply chain. We currently perform 39% of our wafer fabrication in-house, 55% of product assembly and 57% of our test in-house. With the strong demand and low levels of inventory both at Microchip and in the distribution channel, we saw constraints in practically all internal and external factories. We started ramping our factories in September and also started to negotiate a higher allocation of foundry and back-end capacity in the same time frame. Our overall capacity will continue to grow every quarter from here, from December to March to June to September to December. While our capacity will continue to grow, we still see that the current plan for capacity that we can get is lower than the demand we see. Therefore, some constraints are here to stay through the rest of 2021, at least. Now our lead times is getting longer with strong bookings. We're getting both near-term as well as longer-term orders way out into January, February of next year. So a lot of capacity is already getting booked up, and we're getting a pretty broad-based lengthening of the lead time. Lead times are very product-specific, though. There are some products where there is still capacity in the current quarter. There are other products where there's no capacity even in the September quarter. So there's really no such thing as an average lead time. So in response to such strong business environment, we have taken 3 actions that I will describe briefly. First, in the middle of December, we changed our cancellation and pushout policy with our customers and distributors. We used to have a 45-day policy of no cancellation or reschedule, and we went to 90 days. And we did that so that we can start the quarter with a solid backlog, and then the backlog is not changeable within the quarter. We got no cancellations or reschedules from that. And as of January 1, the backlog was very solid. The second action we took was, we sent a letter to our customers on January 4 informing them that we are seeing broad-based cost increases and some aggressive commercial terms from our supply chain. And we must pass these cost increases to our customers through a very broad-based price increase. So these price increases sort of were effective at various times in this quarter. Many went effective in January, and some are going effective on March 1. The third action we took was launching Microchip's Preferred Supply Program or PSP. We spoke about this in our earnings call. This program offers our customers the ability to receive prioritized capacity in the second half of 2021 and first half of 2022 by placing 12 months of orders which are noncancelable and nonreschedulable, and then they have to keep refreshing it. It gives us a 13-month of order every month. So that action was just announced really last week on last Thursday. So with that, I will now pass it over to Toshiya for the Q&A session.

Yes. Steve, thank you very much for the overview. I wanted to start off by asking you about the current cycle. Steve, obviously, you lived through many, many cycles. I realize every cycle is different. But given your experience, when you compare and contrast this upcoming ongoing upturn with prior upturns, what are some of the fundamental similarities and the differences between the current one and the prior one? And to your statement in your prepared remarks, you did note that you expect the supply-demand imbalance to persist at least through 2021. What sort of factors or indications lead to that sort of bold statement?

So this is the most pronounced cycle that I have seen in my 40 years plus of business career. There have been many segments -- many cycles, but one thing in this cycle we are seeing is that customers are placing orders well out into the future that we didn't see before. We started this March quarter with the highest backlog as a percentage of what our target is for the current quarter. Usually, you have some backlog, but you have to take a large number of turns. The quarter was so much booked up by the time we entered the quarter and same thing we're seeing it for the June quarter. On a lot products, the June quarter backlog is almost equal to the March quarter backlog. And in some products, the June quarter backlog is already higher than March quarter, and we haven't even entered the June quarter with 5 months more left to book for the June quarter. So it's just -- really just a, I would say, sort of a Four Sigma or Six Sigma kind of cycle. So that's the biggest difference I'm seeing. The other issue is, especially in this cycle, the auto industry cut back too steep and too deep last year during April, May, June, where the auto demand really went to 20% of the demand at the worst part of the cycle. And now they're trying to get back to 100%. So when they cut back that much, number one, nobody added capacity. And the capacity that was available or came from the auto capacity, it got reused up in work-from-home programs and building better broadbands and PCs and data center needs and medical and other. And now when the auto customers are trying to go back to full production, there is just not enough supply for them. So you're reading headlines in international papers and major auto companies announcing shutdowns. And I've heard a number as much as $61 billion of revenue loss because of not being able to get chips this year. So I think those are some of the differences, I would say.

And Steve, you explicitly called out automotive as one of the industries where, in hindsight, they cut a little too deep, and now they're sort of scrambling for components. Is the current shortage very much focused in automotive? Or is it a little bit more broad-based?

It's very broad-based. We have constraints in industrial, in home appliances and even PC supply chains. So it's really broad-based. But like I just described, the autos cut back the most. So they have the largest hill to climb. And when they cut back the most, even though we begged for visibility in future orders and tell us what the rate of recovery would be and place those orders while we're building the products, they just had nothing to do with it. There were no orders. The safety stocks dried up. Backlog was very weak. And so therefore, what does a downstream supplier have to do? We depleted our safety stock. We depleted our inventory. We didn't want to take the risk of getting stuck with all that. We didn't know where the auto demand was going. And when the demand came back, there is evidence that the end [indiscernible] companies, the OEMs like the [ GMs ] and Daimlers and others, gave information to the first tiers regarding what the rate of recovery would be and how many cars they would be building. But the Tier 1s never passed those orders to us. So they're now caught in the middle where they are really being blamed by the auto guys that they can't supply. And they're asking us for more supply, which they never gave the orders. So that's what's happening.

Got it. Thanks for the color. The PSP program is certainly an interesting one. I realize it's been only about a week since you went to your customers with the idea of a long-term contract. To the extent you have received any feedback from customers, I'd love to hear it. Any positive feedback from customers or any pushback so far?

So since launching of this program just 6 days ago, we received a tremendous response, I would say. Essentially, every one of our strategic global accounts has expressed interest in participating in the program. The details of the program and the placing of the order is really being worked out. And many, many out of more than 100 of our distributors around the world have also expressed interest in participating in the program. The legal part of that, the T&Cs are really kind of being done and being hashed out. But I believe we get the first order, a very large order, 12 months plus a quarter from one of our major automotive customers due tomorrow, something I personally worked on. And they committed yesterday in writing that they'll place the order in 48 hours and should have it tomorrow. So I think that's the front end of it. But we believe as the message continues to go out to distributors, to end customers in every market, we should have a pretty good uptake of it. The other part is, China is on a Lunar New Year holiday right now and much of Asia. Chinese customers and distributors did not want to return from Lunar New Year and then find that the capacity is already booked up. So we received just enormous orders before they left for the holiday. The size of the orders are just unthinkable, and I believe that -- and this is just a belief that they placed those orders because they didn't want to come back from Lunar New Year and find there is no capacity available. And I believe that when they return, some of those orders and many of those orders will get converted to PSP. So with 6 days gone, I think we're encouraged about the reception of the program.

And Steve, I can see the introduction of the PSP being accretive to how efficient your operations become going forward in terms of manufacturing, planning, logistics, procurement, so on and so forth. But when you think about sort of the margin profile, the pricing, more of the financial side of the equation, how do you see the introduction of PSP contributing to the business?

So PSP was not -- the purpose of the PSP was not to enhance prices. It was a totally separate program where we raised the prices, too, but we raised the prices well before PSP was announced. And those 2 are not tied. But the PSPs might affect lowering our costs somewhat as we become more efficient, as every product we produce gets shipped for revenue because we're building to a solid backlog for a year. So from that standpoint, it could be slightly margin accretive. But its whole intent was really not to drive margins. Its intent was to drive better support to our strategic and large customers and giving them a preferred supply.

Got it. And then on pricing, you talked about price increases going into effect at different points in time. But when you think about the price increases that you're putting through across your portfolio, is it primarily MCUs or is it broad-based? And in terms of the magnitude of the price increases, are you simply passing on the magnitude at which costs are increasing? Or are you being a little bit opportunistic here and trying to positively impact margins given the tightness?

Yes. So first, the price increase was very, very broad-based, not only in MCU, across our portfolio in analog, in mixed-signal, in networking, in discrete parts and others. So it was really very, very broad-based. We have over 100,000 SKUs. So it was really a major task. So the increase of the prices was really not all effective on one day because that would be a very, very large task to put it together what the new prices should be. So it kind of sort of happened in waves. There were 3 or 4 different effective dates when those prices went into picture. And the intent of the price increase was to really pass the cost increases we're experiencing and not to realign the prices with the value that we offer. However, with many, many other self-help cost reductions also happening in parallel, some of them increasing capacity, and the incremental capacity is accretive, bringing some more stuff inside from outside to inside, which is margin accretive, some possibly cost reduction impact of PSP, so many things are intertwined. And we are expecting our margins to go up, but the price increase wasn't geared towards that.

Got it. Super helpful. And then in terms of capacity additions, I know Microchip is currently working on growing capacity both internally as well as working with your foundry partners. In terms of the pace at which you grow capacity in the next couple of quarters and particularly into the second half, how should we think about the pace or the cadence at which you grow capacity both internally as well as outside the company?

So we have many, many corridors of capacity. We get wafers probably from about 30 fabs or so around the world and some of them our own, but others from our subcontractors. And similarly, we work with a very large number of assembly and test plants, multiple plants owned by companies and many companies also. And it's a very, very complex mix, 6-inch, 8-inch and 12-inch wafers on many, many different lithographies and many, many different package types and many, many different test platforms. And we are growing capacity across the board. There's incremental capacity coming online almost every month from equipment that was added the prior month. And they brought into production some plant capacity increase every week. It's very, very difficult to kind of pull all that together into a number or a percentage. We can do that over only a short-term basis. We did that for this quarter and gave you the guidance, and the capacity we are bringing online this quarter would be 100% next quarter because capacity is coming on at various times this quarter. So there'll be a -- if we added no more capacity, we'll have a higher capacity next quarter. But we haven't stopped. We're continuing to add equipment and people and to grow capacity, both inside and outside. So there'll be an increase next quarter. And for the increase next quarter, that will be fully productive the following quarter, and the capacity is continually being added. So we can't put a numerical number in front of it, and we'll be doing it quarter at a time. But we could just say that there is an additional capacity coming online every quarter.

Understood. In terms of how you're thinking about internal versus external from a capacity standpoint, I think in the past, you've talked about aspiring to get to 60% plus for assembly and 70% plus for test. I think you're at 55% and 57% today, respectively. Given what you're experiencing today from a supply-demand standpoint, has your view on the long-term internal versus external debate, if you will, has that evolved at all? Or are those still your targets long term? Maybe if you can speak to the front-end process as well, that would be helpful.

So the targets we have given you, higher than 60% of assembly, higher than 70% test, are really -- we never said that could be long-term ultimate targets. I would say those are the intermediate targets we were trying to get to. Assembly was only about 43% or so just 2 or 3 quarters ago. In the entire supply chain of fab assembly/test, the worst constraints fell in assembly. So therefore, we put a lot of effort in and brought significant more capacity online last quarter, which jumped that number to 55%. And going from 55% to 60%, assembly is still the most constrained, and we're adding a lot of capacity. So I think we will get there and are likely to increase that number as we get much closer to it. The 70% test still has a way to go. And no assembly, no test and no given package type, we want to bring 100% inside. We actually don't want to go higher than 80% because we want our internal capacity to be full even in soft times. And in terms of addressing the front end, in front end, we're only at about 39%, 40%. Because a large number of advanced nodes and 12-inch wafer capacity, we get 100% outside. We don't have those, and 12-inch fabs and equipment are extremely expensive. And there's no immediate plan, no near- to midterm plan to buy or build 12-inch fab. So there, I think we continue to build a lot of trailing-edge technologies in-house, a lot of leading-edge technologies we buy from outside. On the trailing-edge technology, there's a healthy mix of also inside and outside, and there are a few technologies that we can do in both places. So that provides us some buffer. If times are soft, we can really bring more inside. If more capacity is available outside, we can take it outside. So we don't expect to move the fab inside/outside mix as much as we have moved the assembly and test.

Got it. And Steve, given what you just said, it seems like the 3% to 4% long-term capital intensity target is unlikely to change. Is that still the steady-state capital intensity number that we should keep in mind?

Yes. That's correct. I'll actually have Eric talk about it a little bit. Eric?

Yes. So that's the target we've given to investors. And clearly, we've been well below that the last couple of years. We're adding capacity pretty rapidly right now. And so we haven't given a full forecast for next fiscal year. But in the Q we just filed, we indicated somewhere $180 million, $200 million over the next 12 months. And so we'll probably be on the upper end of that scale in the next fiscal year. And we'll give more details of that when we get to our next earning call entering the next fiscal year. But we're still comfortable long term with that general target of 3% to 4% of net sales.