Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good evening, good afternoon, good morning, wherever you're joining us from. This is Matt Ramsay from the Semi's Research team, Cowen. Thank you for joining us for another session at the Cowen TMT conference. We really appreciate all the investors participating and obviously, all the management teams as well. In this conversation, really happy to be joined by Eric Bjornholt from Microchip. He's their CFO of obviously one of the larger companies in the semiconductor space that touches on a whole number of end markets with their leading products. So it's really happy to spend half an hour with Eric today. It's a rather unique time in the market. So Eric, thank you so much for your time. And do you have any a few words to set the stage or kick things off? I've prepared some questions, but please take some time if you like.

Yes. Thanks, Matt. And just for everyone's benefit, also and Nawaz Sharif is with me today, and Nawaz runs our European finance organization and does IR for us in Europe. So before we begin, I just wish to remind everybody that in today's discussion, we'll be making some projections and other forward-looking statements regarding the future financial performance of Microchip. These statements involve predictions, and actual results may vary materially. We refer you to our filing with the SEC that identify important risk factors about the company. So let me just start with a few opening remarks on the business. The March 2021 quarter, which we just reported a few weeks ago, was a record in many respects. We had record revenue, record non-GAAP gross and operating margins and EPS. And we've guided the June 2021 quarter to be even higher as we continue to execute on our long-range plans and providing total system solutions to our customers. Business conditions remain extremely strong. Backlog is at record levels for product to be shipped over multiple quarters, and demand increases continue to outpace the capacity improvements that we're able to make and hence, the gap between supply and demand continues to widen. With strong demand and low inventory levels for both Microchip and our distribution partners, we're experiencing constraints in really all of our internal and external factories and the related manufacturing supply chains. We're continuing to ramp production in all of our factories. We're investing in capital additions to expand our internal capacity based on the strength of our backlog and particularly our noncancelable Preferred Supply Program, which we'll talk about a little bit more later. We're working closely with our supply chain partners who provide wafer foundry, assembly and test and materials to secure capacity. And through a combination of internal and external capacity actions that we've taken, we expect our overall capacity will continue to grow every quarter in calendar year 2021. While our capacity will continue to grow every quarter, we also believe that our wafer fab as well as assembly test constraints will stay with us through calendar '21 and possibly into calendar '22. So about 4 months ago, 4.5 months ago, we launched our preferred supplier program to provide customers with priority on supply beginning 6 months after their orders. And in exchange for that, customers provide us 12 months of non-cancelable, non-reschedulable orders. And customers' response to the program has really exceeded our expectations, with direct customers of all sizes and distributors alike participating. And at the time of our earnings call a few weeks ago, PSP backlog accounted for about 44% of our backlog. Today, it's about 50% of the backlog. And in some cases, it's 100% of our backlog for what we'd call some of our most constrained capacity corridors. So the PSP backlog continues to grow every week, and this really gives us a solid foundation to enable us to prudently acquire raw materials, invest in capital equipment, expanding factory capacity, and hire employees to support our factory ramps. So probably the last thing in just my opening remarks here is our Board is really systematically moving towards a higher shareholder return model. And we're rapidly deleveraging the balance sheet with a laser focus on becoming an investment-grade rated company. So with that, let me pass it back to Matt, and we'll go through the Q&A.

Thanks, Eric, for -- you touched on quite a lot there in your opening comments. It's -- I guess, just to start off from my side, and we'll see what the questions come in to me from investors. But it really is a unique situation in the last 18 months, right? We've gone from demand essentially evaporating in the auto industry and some big challenges in some other verticals and then a surprisingly sharp recovery in the market that just outstripped supply pretty much across the board. From your opening comments, it doesn't sound like there's been anything that's improved in the last several weeks since your earnings. And in fact, with the PSP backlog that you mentioned, it sounds like the gap between supply and demand has continued to widen. Are there any things that you might call out? Or is it just a continuation of the same that we've been seeing and the gap just widening?

It's really a continuation of the same. We're seeing strength across really all the end markets. We're seeing strength in direct and distribution in all geographies. And so the orders are outpacing what we can do from a supply standpoint. And as I said, we're systematically adding supply to increase our capacity, both internally and with our external partners. But the demand environment is really, really, really high right now. And with that, we're playing catch up every day.

Yes. I wanted to focus a bit on -- there is an investor concern right that there's some overordering out there, and we're running too hot from a demand perspective. And I always try to make a distinction between overordering is one thing, but the industry sure is all not overfulfilling, right? And so maybe we could talk or spend a little bit of time on, is that a concern for you guys? How are you monitoring? And how does the preferred program help you monitor committed orders and committed relationships versus the froth that the industry might have seen in this type of situation generally.

So I think the preferred supplier program helps with that. Obviously, customers that are participating in that program are making a commitment of 12 months of non-cancelable, non-reschedulable orders. And so we feel with that, that the orders that they are placing on us and again, it's about 50% of our backlog today, are really well thought through, right? I mean, if a customer knows that semiconductor suppliers, they have a cancellation or reschedule window that's 60 days or 90 days out in time, they can load up orders outside of that and then just continuously push them out or cancel them as they approach that cancellation window. So in addition to the PSP program, we also implemented kind of a 90-day NCNR, non-cancelable and non-reschedulable program for all orders. So everything in the next 90 days is a firm order from a customer and can't be rescheduled. And then like I said, with the PSP program, we really think that for many customers, it makes a lot of sense. They've got good visibility in their business, steady run rates, and they can give us that long term order. We can then make the appropriate investments in people and capital and raw materials to make sure that we can meet their orders out in time. So that priority of supply is something that customers are really valuing in this environment. And we think it allows us to run our operations more efficiently, too, because we know the orders that we have on the books and the PSP program are orders that are firm, that customers are going to take that they want, and we can plan for it appropriately.

No, that makes sense. I wanted to focus a little bit on the channel. You guys have traditionally run a fairly distribution heavy business in certain parts of the business. And your company and some of your peers have made similar comments that you're running far below the target inventory levels in distribution. Could you give a little bit of an update there on like how far under the target are you? And is it uncomfortably lean? Is it across the board? Or is it in specific subsectors? And I don't know, how long do you think this situation might last? I'm just trying to get a sense of if we do get a normalization of end demand to supply, is there another several months, several quarters, what's the duration that we need to get the channel back to some level that you feel is appropriate for the business?

Yes. Okay. So putting a little context around it. We ended the March quarter with all-time record low channel inventory at 22 days. And last quarter alone had reduced by 4 days from what was already a record low of 26 days before that. So the range that we've seen over the last decade or so has been distribution inventory days between 22 and 47 days. And it's really hard for me to say what is the right level. But the historical average is in the mid-30s or so. And at 22 days, it's extremely lean. I wouldn't say that there's pockets of high inventory. I mean, it's just -- it's lean across the board, really all distributors, all geographies are sitting on low inventory. We have a lot of what we call unsupported backlog to distribution. That just means orders that distribution have requested in the current quarter that we can't deliver until a future quarter. And so distributors would like to have more inventory. But at this point in time, we just aren't able to fulfill distribution or end customers' short term needs. And so it's going to take some time for that to rebuild. I just -- our general sense is today is that everything that we're shipping into distribution is shipping right out the door. So I don't expect distribution inventory to have any significant upward movement in the near term. And over time, that we'll need to restock, and it will be interesting to see what levels it goes to. But I think that's going to take quite some time before it returns to a more normalized level.

Yes. Any sense of talking to your key distribution partners and even larger end customers in some of the market verticals? There's been a conversation around permanently higher levels of inventory in certain markets like automotive and others that people might want to keep post us getting back to some level of balance. Different companies have had different views on whether that might be true or not depending on their own exposure, but the -- you get the sense that we're -- that many of your end markets are thinking or considering about keeping permanent levels of higher inventory?

There's definitely discussions of that going on. I think we're going to have to wait and see how this all plays out. You hear about it specifically in automotive. If you don't ship $10 or $20 of semiconductors and you're preventing a $50,000 or $60,000 or $70,000 automobile from being produced and shipped. Obviously, just in time, doesn't make sense to find yourself in that situation. So I think there probably will be some permanent change that comes to this, to the extent of it, I don't know, will it impact all industries? Really hard to. Say, automotive makes the most headlines, but there is supply constraints across the board in all end markets. Many of Microchip's products are standard products that can sell in automotive and industrial and consumer and other markets. And so with that, this is not just an automotive issue, although it's getting a lot of the headlines today.

So we spent so far in the conversation talking about sort of the state of affairs and supply-demand imbalance. I guess the next logical question is, what [Technical Difficult]. And you guys have talked about how you're trying to add internal capacity, you're trying to work with foundry to get additional capacity, and that's all tight. There's multiple layers to supply tightness in terms of test and [ back-end ] packaging in those areas. If you could just, I don't know, give us the state of affairs as you see them currently? Any particular part of this getting worse as the supply demand imbalance gets wider? And what are the steps that Microchip is able to take the scarcity of equipment, et cetera, that can help alleviate some of these challenges?

So I mean there's scarcity of resources really from the top to the bottom of the supply chain, right? I mean, it's challenging to get the raw materials that you need, the capital equipment, hiring employees in certain jurisdictions and manufacturing locations that we have is challenging also. And so you need really all those things to come together to be able to grow capacity. And our supply partners, we do 40% of our wafer fab in-house and the rest is outsourced. Our supply partners in foundry and assembly and test have similar challenges. So this is going to be a slow, steady increase in capacity that comes on over time. And so there's no quick fix to this situation and the demand environment, global GDP, there's a lot of things pointing in very positive directions. And I just think it's going to take a number of quarters. And we've said it's not going to get fixed in calendar '21, it may extend into calendar '22. It's just going to take multiple quarters to overcome the supply and demand imbalance. And are there permanent changes that happen after that as your question goes to just-in-time inventory. That time will tell, but we're -- we've got good relationships with our suppliers, where we've got good places in line for bringing in capital equipment over the course of the year. You've seen where our CapEx budget is, and we can talk about that more later, if you'd like. But all these things just take time to implement. If we make a decision to add more capacity in wafer fab today, and we need to buy equipment to do that and it wasn't planned for earlier, it can take us 12 months to get that equipment. And then we need to install it and qualify it and get it ready. And so -- and then once you start product in the manufacturing line at the beginning of wafer fab, it's a pretty significant cycle time from start to finish. So you can see that these things just take time. We started ramping capacity back in September. So it's not like we're just starting on this today. But again, those are gradual moves and just take time to layer in.

No, that all makes sense. You did mention CapEx, and you're essentially going to double CapEx this year. How are you allocating the capital that you're spending and those increases? I guess that's the first question. And secondly, just given the demand and supply imbalance, if you felt like you had opportunities to get more -- I mean, would you spend more if it made sense? Something you spend it on.

Yes. So over the past 2 fiscal years, our CapEx has been extremely low due to the weak industry conditions, driven by the U.S.-China trade war, followed by the pandemic. And so today and over the last several quarters, we've been prudently expanding to incrementally try and reduce the unsupported backlog that I mentioned earlier. So our CapEx forecast for the current fiscal year, which will end in March, is between $225 million and $275 million. We've always told investors that on average, we expect our CapEx to be 3% to 4% of revenue, and it was significantly lower than that the last couple of years. So if there are opportunities for us to do more, and it makes sense, we'll make those investments. But again, lead times on equipment will be somewhat of a limiter on that, but we'll see how things progress as we move through the fiscal year. We're investing in both front-end manufacturing for wafer fab and also in back end. As I mentioned before, we do about 40% of our wafer fab in-house. I don't really expect that to change over time with the capital investments that we're making. I expect that to remain pretty steady. But the CapEx that we're doing in assembly and test, it's not just to maintain the percentage we do internally, which is roughly about 55% in fiscal '21, which we just finished. But we expect to increase those percentages as we move through the next couple of years and probably should end fiscal '22 with more than 60% of that capacity done internally. So that's generally where we are from a CapEx perspective. We -- like I said, we've got spots in line for the equipment. It's coming in. All the semiconductor equipment is built with semiconductors. And so there's some challenges there, and it's a bit of a circular equation sometimes. But we're definitely making progress. New capacity is coming on every month, which increases our ability to meet our customers' needs.