Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Okay. Good morning, everybody. A great pleasure to have Ganesh Moorthy, the CEO of Microchip; and Eric Bjornholt, CFO, joining us today. Gentlemen, welcome. Thanks for making the time for us. [Operator Instructions] Before we get started, Ganesh, perhaps if you could just provide us with a quick recap of the quarter that just ended and what you highlighted in the earnings call about the near-term business trends.

Right. Thank you, Ambrish. Before we begin today, I wish to remind you that during today's discussion, we will be making some projections, the forward-looking statements regarding the future financial performance of Microchip. These statements involve predictions and the actual results may differ materially. I refer everyone to Microchip's filings with the SEC regarding some important risk factors about the company. So let me start with a few brief statements about our business, as you've recommended. The June 2021 quarter that we reported earlier this month was a record quarter for Microchip. And we set new records in just about every metric, revenue, non-GAAP gross margins, operating margins, EPS, adjusted EBITDA, cash flow from operations, so on and so forth. And we've guided the September 2021 quarter to even higher levels as we continue to execute our long-range plans, focusing on providing total system solutions to our customers. At the midpoint of our guidance, for the September quarter, our revenue will be 25.8% higher than the September 2020 quarter, and we expect to achieve our long-term non-GAAP operating model, 65% gross margin and 42% operating margin. Business conditions continue to be exceptionally strong for the June quarter with record bookings and backlog product that will be shipped over multiple quarters, accentuated by our preferred supply program, or PSP, which continues to be over 50% of our aggregate backlog and 100% of our backlog in the most constrained capacity in product terms. Demand outpaced the capacity improvements we were able to make in the quarter. And as a result, our unsupported backlog, which customers wanted shipped in the June quarter, continued to climb significantly, resulting in lead times for many line items continuing to stretch up. We expect our unsupported backlog to leave the September quarter at even higher levels than it was at the end of the June quarter, meaning the supply/demand imbalance continues to widen for us. We experienced constraints in all of our internal and external factories and their related supply chains. We continue to work closely with our supply chain partners who provide us foundry, wafer foundry, assembly, materials, et cetera, to secure additional capacity wherever possible. Through the combination of our internal and external actions that we have taken, we expect we will be in a position to support revenue growth for each of the next 4 quarters. Despite that, we also expect that wafer fab as well as assembly and test constraints will persist through at least the middle of 2022. Our capital spending plans are rising in response to growth opportunities in our business as well as to fill gaps in the level of capacity investments by our outsourced fab assembly and test partners in those technologies that they may consider to be trailing edge, but which we believe will be workhorse technologies for many years to come. Increase in capital spending will enable us to capitalize on growth opportunities, improve our gross margins, increase our market share and give us more control over our destiny for trailing edge technologies. And we believe our backlog position, especially the proportion of preferred supply program backlog, is giving us a solid foundation to prudently acquire constrained raw materials, invest in expanding factory capacity and also to hire employees to support our factory ramps. Finally, our Board of Directors is systematically moving towards a higher shareholder return model, and we are rapidly deleveraging our balance sheet with a continued focus on becoming the investment-grade rated company. We are planning to hold an Investor and Analyst Day later this year, at which time we expect to provide details about our longer-term annual growth rate, gross margin and operating margin targets as well as more specifics about our capital return strategy. We will provide the date and logistical details regarding the Investor and Analyst Day in the near future. With that, let me pass it back to Ambrish for the Q&A session.

Great. Thank you for that update. Pretty, pretty detailed. And yes, I think a lot of us are waiting for that Analyst Day to see where the model heads to. I just wanted to just touch on the operating model. You updated it not that long ago, about a year ago and then you hit it based on your guide. Can you just help us understand were you surprised by how quickly you're able to hit it? What were some of the factors that went in that were -- that worked in the favor was pricing an element? How do you navigate through the cost input increase?

Sure. So indeed, we are achieving the long-term operating model targets, which we just established under a year ago, much faster than we expected. We were helped in part by strong business tailwinds as we continue to ramp our internal factories and benefited from improved fixed cost absorbed in part from the increased internalization of manufacturing, particularly in assembly and test. And in part as our constrained capacity allocation favored higher-margin products, and we're achieving these results despite the headwinds of increasing input costs.

Got it. I just wanted to focus on capital allocation and put the investor perception in that as well. And I'm sure you -- both of you have heard this from investors is the characteristics of the business are very similar to high-performance analog like a Texan or ADI. Your gross margin, op margin, free cash flow margins, they all are in that direction, very close to top quartile of at least a company that I follow. And then in the past, capital allocation has had a big M&A element to it. And you've said now I think for quite a few quarters that you don't find the valuations attractive. So there's a very discernible very well communicated, articulated change in how you're thinking about capital allocation, but yet the conversations I have with shareholders and potential shareholders is that -- what am I missing? Why is the stock underperforming? And I know Ganesh and Eric, you're not running the business to get a certain amount of valuation. But how do you address that investor perception or lack of confidence that once your leverage comes down, you will be acquisitive again and lever up the balance sheet?

Yes. No, it's a great question. And sometimes after almost 10 years where we were doing lots of acquisitions, I think we need to say it many times for people to believe that it is what we intend to do and also provide the other bits of information that would help them see where it's at. So the Board is very, very committed to increasing our capital return to shareholders. You can see the steps we have taken. We began the process in February of this year. When we had line of sight to getting our leverage down sufficiently that we think we are on track to get to investment-grade rating within a year of February of 2021. So within about 6 months from now. With stronger-than-expected business results, we continue to increase the dividend meaningfully. We did that in May. We did it again in August, and that's the direction the Board has committed to. And we expect to continue to increase the capital return to shareholders while continuing to pay down debt. And as I mentioned earlier, we will layer this out in substantial detail in our upcoming Investor and Analyst Day session. And I think many of the questions that people may have, hopefully will get settled and done by the time that session is felt. But we are very, very clear. Our focus is on organic growth, that the debt has come down significantly, that we can start a significant increase in capital return. You've seen steps towards it. You will see even more in the coming days.

Got it. Got it. Great. We look forward to that. Let me just switch to the -- some of the elements of how you have been managing through these really, really tough supply/demand imbalances that seem to be ongoing. PSP, your preferred supplier program backlog and visibility, and you talked about it that your unsupported backlog has continued to go up. Is this a structural change we should be expecting? I think in one of the prior earnings call, Steve mentioned that JIT is dead or at least close to it, and just given how tough it's been to procure supply from your suppliers and get products out. So what's the right way for us to think about a structural impact to the business? Or is it once things ease up, we'll be back to a normal kind of pattern in terms of the orders that you see from the customers?

So I think the cycle has been different from other cycles and the responses -- certainly, the responses we've made have been different, too. So the PSP program, or the preferred supply program, as you mentioned, was something we launched uniquely, given the characteristics of the cycle. And the program is still in its infancy. It's only been about 5 months or so under our belt, and it certainly has struck a tremendous core with many of our customers as solving a critical business need for them in their planning. And in return, it is helping Microchip make capacity investments with more confidence and without the same fear as perhaps how imminent is their change in the cycle that's coming up. What we are sensing is that our customers in certain end markets are recognizing the criticality of semiconductors and their supply chain and the multiplier effect on their end OEM product that they're building and that they are likely to treat their procurement with semiconductors more strategically than before. And right now, we're in throes of the cycle, and everybody is doing whatever they can. I think we have to see how the cycle plays out. We have to see how people take learnings from this cycle. And we believe our PSP program will give them an excellent tool to be able to manage with confidence for their end markets. And I think the jury is still out on how that all plays out. But we are far more optimistic today that both we understand the need, we're striking a cord with customers and we're giving them a tool to be able to manage their business.

Right. Because I don't think we've ever seen a situation where that you, for that matter, any company has the confidence in semis to make -- to guide to growth for the next, you said, 4 quarters. So that's something we are not accustomed to having followed this group for a very long time. Can we just stay with the supply/demand and then about the inventory levels both at your end, 110 days, 111 days? And in the distribution channel, fairly low. Can you just kind of help us understand, should we expect distribution to stay at that? What is the sell-out versus sell-in that we should be expecting over the next few quarters?

So we typically don't try to manage what distribution does in terms of -- we provide them the product that they need for their demand. The reason the inventory is dropping is because as much as we have increased supply, demand is growing faster than that supply. And therefore, there isn't an opportunity for either us or our channel partners to grow that inventory just about everything we ship is getting shipped out from them. And so it is quite likely that, that imbalance for as long as it will last, will continue to drop inventory the end distribution has to figure out how much inventory they want to carry, how much can they carry given what their demand is. But I think for some time, it's not going to be easy for either us or our channel partners to be able to replenish their inventory. And that kind of imbalance at least in what we can see line of sight to is going to be with us for at least the end -- until the middle of 2022, possibly later. And we'll see how all this plays itself out.

Got it. Can we switch to manufacturing and capacity? Your CapEx is, I think the number for fiscal '22 is $300 million and $350 million, which is a pretty big step up over the last 2 fiscal years. So Eric, how much capacity has come online? And how much do you expect to add over the next few quarters?

Sure. So maybe start by just walking through the percentage of manufacturing that we do internally. So wafer fab last quarter was about 42% internal, assembly increased to be 59% that we did internally and final test was 63%. So on the back-end side, we're definitely making investments to take more control of our own destiny and those percentages will continue to go up. So the bottom line is capital is challenged right now. It's difficult to get the equipment in. We've got good layers of equipment that we've put out in terms of order with suppliers and it's coming online. The capital we're spending this year is for fab assembly and test. Fab is the more expensive in general. And so the weighting of our spending is a little bit higher there. But as I said, we're increasing the percentage of the assembly and tests that we do internally. So we're going to continue to make the right investments in the business to try to control what we can, but there's a large portion of, particularly on the fab side of things that is outsourced, and that is challenged in terms of that capacity coming online quickly.

Ambrish, I also think the last few years, probably not a good frame of reference, they were low because business conditions were weaker. I think if you look at a 3-year average, you'll find that it's pretty much in the range of what we have guided to as our CapEx intensity.

Yes. Got it. Got it. Yes, that is a fair point. And is most of the -- in terms of not leading edge technology, which is most unavailable out there along with leading edge. Are you finding any easing up on this front at all in terms of the external partners or it continues to be tight?

It continues to be very tight and it's very -- it's different based on different nodes and different partners we have. But there is no reprieve in the short term that is visible.

Great. Got it. Okay. Let me switch to the end markets. Occasionally, you folks do provide a split in terms of end market. Eric, I think about a year ago, you did provide it. Could you just update us on what are the different percentages of the businesses?

Sure. Because our business is spread over so many customers, approximately 120,000 customers, we do not track revenue by end market on a regular basis. We did complete an analysis in April for our fiscal '21 revenue, which was for the year ending March 2021. That analysis had our business as being 29% industrial, 18% data center and computing, 15% automotive, 13% in communication, which is mostly infrastructure, and then 13% in consumer, which is mostly home appliances, and 12% in aerospace and defense. These percentages generally don't change much from year-over-year, I think, and those percentages compared to fiscal '20, there was just a couple of categories that changed by 1% and we're really experiencing strength and growth in all 6 end markets today.

Got it. Got it. Maybe one of the topics I would like to go into is where are the investments being made in -- whether in terms of products, technologies and markets? Ganesh, how have the priorities changed over the last couple of years or so? And then kind of related to that, it would be great to get your view, and I know you've been working very closely with Steve for many years. But is -- are you looking at something differently and saying, okay, this is an opportunity that Microchip did not have before that we should target more aggressively?

Sure. So the investments are -- we run the company with about 24, 25 different business units. Each business unit investment we made has a specificity to that business, its growth, its profitability, its prospects and all of that. So we don't have a singular answer on kind of where it's going. Each business is getting a level of investment that it deserves because of its growth and profitability and the trajectory and opportunities that it has. So that's how we look at the business itself. There is not a single area that I would say is where we're trying to incrementally invest above everything else. That said, I think what has changed in the company is 2 things in the last 2, 3 years of time. One is we've taken a much stronger position of having a more complete portfolio that is available to us to go into these designs. And so that has built over time over many, many years of different acquisitions that build out different parts of the portfolio. We have a pretty strong complete signal chain today to offer our customers. We call this the total system solutions. We have the anchor products around the brains of the system. Those can be microcontrollers, microprocessors, FPGAs, ASICs, dsPICs, et cetera. And then we have everything that surrounds it, from timing to power, to mixed signal, to connectivity and security and everything else that goes with it. So I think it's the power of that portfolio plus our long-term way in which we have gone to market that gives us the opportunity to sell a complete solution. I think that is different as we have gone through the last few years in terms of both our understanding, but also our execution of what we're doing. The second thing is around our focus into where is the growth out there and the identification of 6 megatrends that are durable 5- to 10-year growth opportunities. And in those 6 megatrends, which are 5G, the Internet of Things and particularly, the industrial Internet of Things, the explosion of data center capabilities of electric vehicles, of advanced driver assist and artificial intelligence and machine learning. So those end markets and their needs are where we are focusing our product development as well as our total system solutions. So those will be the kind of 2 things that are significant parts of how we are charting a course and driving towards organic growth.

That's good helpful insight. Maybe just on the portfolio planning process, what are some of the metrics or benchmarks that you have that you're willing to share with us as teams come with their new product ideas?

Yes. As I mentioned, I think it's an understanding of growth rate. It's an understanding of what profitability can we achieve, both in growth as well as in operating margin. So how much expenses will it take to be able to achieve it? I think it also increasingly looks at how does it add to a total system solution? So we're looking at not only what one business does, but how does that business create opportunities for other business? And what kind of multipliers will it create? How sticky is the business? What end markets does it go into? And is it volatile? Is it durable or not? Et cetera. Those are all the set of metrics that we go through, we look at both for existing investments as well as new investments.

Got it. Got it. In terms of the mega trends, and this is the conversation I remember having with Steve a few years ago with the -- especially on the EV side, does that impact your existing business with the internal combustion as things move to the electric side? And what investments are you making to address that, whether on the analog side or on the microcontroller side?

Sure. So I think we have to take the EV and kind of break it into those applications that don't care, if you have an electric car or an internal combustion engine, right? So if you need a touch screen, if you need speed control, if you need a garage door opener, those are all common mode. And so whether it's on an EV side or an internal combustion engine, we're going to go after and win those sockets. Then you look at what are the incremental opportunities an electric car has and also some of the things that an electric car does not have, now largely in the places where there's engine control and those type of activities. We were not a big player in those in the internal combustion engine cars. And so those don't represent major losses for us. Where we do see substantial opportunities in the new requirements and electric vehicle has in charging, in the motors, in being able to do pedestrian object detection because of needing to create some sort of noise to alert people in some of the other power conversion requirements, and we have a large silicon carbide development effort that's going on that plays right into that. So between the strengths we have in power conversion, in motor control and charging and many of these areas, there is significant incremental opportunity in an electric vehicle that is not on an internal combustion engine. We don't lose a whole lot going from internal combustion to, I think, net-net, we gain more opportunity. And in total, we think that the semiconductor content in an electric vehicle could be as much as 2x the semiconductor content in an internal combustion engine car.

Among all the mega trends, at least in my mind, most of the opportunities are pretty relatively straightforward to understand, but this one in the past have struggled a little bit. Zooming up back to microcontrollers, and this has been something that you have been highlighting, educating investors for, I don't know how many years. So it's not just a matter of 8-bit, 16-bit, but there's some perception out there that the competitive dynamics are changing with the investments China is making in their own internal efforts. And microcontroller seems to come up as a topic that -- well, the microcontrollers are relatively easy to do. So how do you answer that concern that investors have?