Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good morning, everybody, and welcome to the KeyBanc Technology Leadership Forum. I'm John Vinh and I cover semis here at KeyBanc Capital Markets. We are pleased to have Eric Bjornholt, CFO of Microchip join us. The format of this session will be a Q&A fireside chat. [Operator Instructions] But before we get started with the Q&A, Eric has some introductory remarks. Eric, you want to kick us off?

All right. Thanks, John, and hi, everybody. Before I begin today, I wish to remind you that in today's discussion, I will be making some projections and other forward-looking statements regarding the future financial performance of Microchip. These statements involve predictions and actual results may differ materially, and I refer you to our filings with the SEC that identify important risk factors about the company. So let me start with a few brief statements about our business. The June 2021 quarter that we just reported last week was a record for Microchip. We had new records in revenue, non-GAAP gross and operating margins, EPS, adjusted EBITDA and cash flow from operations. And we've guided the September quarter to even higher levels. At the midpoint of our guidance for the September quarter, we're guiding to be up 5% in revenue, and we actually expect to achieve our long-term operating model targets of 65% non-GAAP gross margins and 42% non-GAAP operating margin. So the business is performing very well. I'd say that business conditions continue to be exceptionally strong through last quarter with record bookings and backlog. That's really been accentuated by our Preferred Supply Program, which continues to be greater than 50% of our overall backlog. And it's over 100% or 100% of the backlog in some of our most constrained capacity product areas. So demand outpaced capacity improvements that we were able to place in the quarter. And as a result, our unsupported backlog, which customers have requested to be shipped in the June quarter that couldn't be shipped until a future quarter, ended at all-time record highs, and we expect that unsupported backlog level as of the end of the current quarter, the September quarter, to be even higher than that. So because of that, the supply and demand imbalance continues to widen for us. We're really experiencing constraints in all of our internal and external factories and the related manufacturing supply chains. We continue to work closely with our supply chain partners who provide wafer foundry, assembly and test and materials to secure additional capacity wherever possible. And through the combination of internal and external actions that we've taken, we expect to be in a position to support revenue growth for each of the next 4 quarters. Despite that, we are also expecting that our wafer fab as well as assembly and test constraints will persist at least through the middle of 2022, and we believe our backlog position, particularly that, that's in the Preferred Supply Program is giving us a very solid foundation to prudently acquire constrained raw materials, invest in expanding factory capacity and hire employees to support our factory ramps. The last thing I'll mention before I turn it back to John is that our Board of Directors is systematically moving towards a higher shareholder return model. And we're rapidly deleveraging our balance sheet with a continued focus on becoming an investment-grade rated company, which we expect to have happen by the end of this fiscal year. So with that, let me pass it back to John for the Q&A session.

Great. That was an excellent overview. Maybe we can start with your backlog visibility. It sounds like it's excellent as you guys obviously are talking about supporting sequential revenue growth over the next 4 quarters. I'm wondering if you could talk about how much of this has been enhanced by PSP versus just the supply-demand situation in the market? And maybe on the PSP program, it sounds like it's been quite a success for you. We're hearing very good things about it. But there are some concerns that, that PSP program maybe is maybe artificially extending your backlog there and not really reflecting true demand. Maybe if you could also address that, that would be great.

Sure. So the PSP program has definitely extended our visibility beyond what it otherwise would be without the program. So with extended lead time, customers would naturally place more backlog with us, but the PSP program has put structure around how customers are providing this backlog to us where they're making commitments for 12 months on a non-cancelable, non-reschedulable order basis. And in return for that, they are getting priority in supply as capacity becomes available. So PSP really makes customers think through their long-term needs before placing these orders with us as they are committed to take these orders, and we're committed to do our very best to be able to meet their supply needs and having that long-term visibility that gives us a better chance of doing that. So you're right, this has been a success with our customers. Customers like the program. But there really is not a target for us to where we want this PSP program to be. It's purely an optional program for our customers. And as I said in my introductory comments, it's over 50% of our backlog today. Until the supply-demand imbalance begins to correct itself and lead times start to improve, we continue to expect really high participation in the PSP program. And so we're not really able to forecast whether the PSP continues to increase over the next few quarters or not, but we're confident in saying that the supply and demand imbalance is not getting corrected anytime soon.

Great. Just a follow-up on PSP, Eric. I know you said, hey, there's no real target level, but it has increased over the last couple of quarters from 44% of your backlog coverage to 50%. Would you expect over the next several quarters that your PSP backlog coverage should at least trend upwards from here?

So I mean, we've had the program in place and I think we first introduced it in February. And so it's been an option for customers now for quite some time. And the take-up from the program has been very good. We don't, as I think I said, have a specific target of where PSP is going to go. But with the supply and demand imbalance continuing to widen, we think this is going to have continued very large participation in the program for multiple quarters here.

Got it. I wanted to follow up on just the supply side a little bit. You had said that your unsupported backlog continues to increase. It sounds like in the September quarter, it's expected to increase again. So the supply-demand gap continues to widen. I'm wondering if you could just kind of help us understand why the gap continues to widen, right? We've been in this kind of very robust demand environment for quite some time. And based -- and obviously, you have been really trying to add capacity quite a bit. And it sounds like you have been successful to add capacity. Given that you have been able to add capacity, you also have a higher percentage of internal capacity on average versus your peers. Why does that supply-demand gap continue to widen? And why aren't you have been able to do a better job at kind of getting rid of these delinquencies here?

Yes. So it's challenging. So I'm going to talk a little bit more about that unsupported backlog to make sure that investors really understand what it is. So unsupported backlog, again, is backlog that a customer has requested in the current quarter, but we can't deliver that product until a future date beyond the current quarter. So we have a very high backlog visibility and orders continue to come in at a high rate. And with backlog building, more and more of our capacity is filling up, which pushes lead times out. We have not been able to add capacity at a rate that keeps up with how our backlog is growing. And thus, that supply and demand gap continues to grow. Capacity is added at a rather slow rate as it takes time to bring on new equipment, get it qualified, hire and train employees to run the equipment and have access to the materials that are needed to run the equipment. And all of these supply chain challenges make capacity increases come on slowly. We're working hard to increase capacity, but it just doesn't come on in large chunks. I mean you mentioned that Microchip has control of a certain level of our manufacturing. And last quarter, we did 42% of our wafer fab in-house, 59% of our assembly and 63% of our final test. So you could say, on average, about 50% of our production capabilities are really reliant on third parties. And foundry capacity is quite challenged right now. Foundries that have large capacity improvement plans this year, but a lot of that capital that is being invested is on the leading edge of technology where the large portion of our products are on trailing edge technologies. So we don't get the advantage of that. And so we think that this extended lead times are going to continue to be here for quite some time. And we're doing everything we can to add capacity, but it is coming on at a slower rate than what demand is increasing at today.

I see. You talked about your assembly and test capacity. It sounds like it's, on average, around 60%. And on the call, you'd commented that in Southeast Asia, where you've got a lot of your back-end capacity, you are seeing some COVID impacts there, particularly in Malaysia, and it sounds like you do have some contingency plans there and plans to vaccinate your workers there. But right now, we're not really seeing any sort of impacts. What about with your outsourced kind of back-end capacity? They tend to also have a lot of their facilities and capacities in Southeast Asia. Are you seeing any sort of impacts there on the outsourced side?

Yes. We've experienced some minor issues, but nothing that has amounted to a significant loss in production for us. There's always a risk that one of our sites or one of our subcontractors could get adversely impacted in the future because of the COVID outbreak, which could have a material impact on our results. But most companies, including Microchip, have put backup plans in place. A prime example of that is what we did in the Philippines last year, and we were housing, I think, about 800 of our workers on site, so we could keep our production up and running. So there's contingency planning that's been made, but it's a very fluid environment and us as well as our suppliers are adjusting to what's hitting them on a day-to-day basis. But so far, so good. We've only had minor issues.

Got it. Maybe we can talk about some of your end market segments. I think historically, if I look at your MCU business, your analog business, they've trended pretty largely in line with one another. But I saw in the last reported quarter, your MCU business significantly outperformed analog, I think upgrowing it by 900 basis points. I'm wondering if you could just comment on that. Is that just a function of the end markets or exposures that they have? And what's driving that outperformance on MCU versus analog?

Yes. So we expect our product lines to grow at different rates over time depending on end market exposure and application exposure. We guide our actions by overall Microchip growth rather than a specific product line. Analog products are very well represented in our total system solutions approach to the market. But their average selling prices can be quite different from what we call the anchor products in those total system solutions, which would be microcontrollers, microprocessors and FPGAs. So that's going to affect the rate of revenue growth from different product lines. Another thing that we've highlighted on analog over the course of time is we report product lines publicly as microcontroller if the product has a microcontroller core. And there's more and more analog functionality that continues to be incorporated into all of our microcontroller products that sometimes you end up selling a single chip that might have done the job of 3 chips historically. So all those things have an impact. So I don't think you should make too much out of the difference in our publicly reported microcontroller and analog growth. They're both doing quite well and are synergistically selling with each other.

I see. In terms of end markets, I thought it was interesting that I think a quarter ago that you had commented that there's a lot of press that you see in terms of factory stoppages related to kind of automotive, but that you were also seeing factory stoppages in some of your other end markets such as on the industrial side. I'm wondering if you could maybe give us some perspective in terms of whether these stoppages are getting worse, the same or are they staying the same. And then when do you think things could normalize where maybe things are tight, but we don't see as many stoppages as we see today?

Yes. So as we said on our earnings call last week, really, all end markets are demonstrating strong growth characteristics at this time. A large portion of our products service many end markets and the supply constraints are thus being felt across all the end markets that we serve. We're absolutely doing what we can to prevent our products from causing any factory stoppages for our customers. But that being said, the Microchip executive team and customer support teams continue to feel tons of calls from customers requiring products as soon as they possibly can get them so they don't go lines down. So we don't really have a current view on which end markets will normalize first. Quite honestly, we don't track our business in that manner on a day-to-day basis. I don't get any sort of reporting that shows me end markets. Typically, once a year, we go through a process of updating our end market exposure, and those tend to move on a relatively small basis on a year-to-year basis. So anyway, there's challenges in the supply chain across all of the end markets, and we're doing our absolute best to support our customers.

Also, obviously, one of the kind of ongoing concerns in this tight supply environment is just concerns around overordering. Can you just talk about just what you guys are trying to do to kind of mitigate kind of the risks of overordering? And then also just related to that, do you think you have a better view of true demand with your PSP program that -- given that obviously all the backlog that goes into there is noncancelable?

Yes. Yes. So overordering, first of all, high 90% of our products are proprietary. And really, there's only one source to get those products. So that helps from that perspective. Our distribution program and how we register customer designs to not have multiple distributors servicing the same account is also helpful in that process. Right now, we look at inventory on our balance sheet being quite lean. Distribution inventory is the lowest that it's ever been at 20 days. It used to be, if you look back a year ago, that low I think was 27 days, and it's just continued to come down. So inventory, we believe, remains quite lean. Now we can't say that there isn't a pocket of inventory that's building up somewhere with 120,000 customers that we serve. But the supply and demand imbalance is significant at this point in time, and we're having to essentially manage our capacity in a way to keep our customers up and running. And clearly, customers in the PSP program have priority in the supply, and that's been a good program for them. So I think the PSP program provides us some benefits when we're looking at when does the cycle change at some point in time. And it's one of the signals that we'll look at is what's happening with that PSP backlog, where as another month rolls off, customers in the PSP program need to provide us another month of backlog coverage. And as that slow down at some point in time and give us an early signal, it's just a metric that we haven't had at our disposal in the past to look at as we're trying to make adjustments long term and how we're running the business to adjust to the supply and demand environment. And obviously there's a lot of other things that we'll look at, but just gives us one more thing to look at that can give us some early insights into when things are changing.