Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Hey, guys. Thank you for joining us for a fireside chat with the execs from Microchip. That ticker is MCHP. It's one of our favorite companies. Today, we are very fortunate to have Ganesh and Nawaz. I think most of the folks joining in today have either met or heard from Ganesh and Nawaz in the past. But Ganesh and Nawaz, thank you for your time for our viewers and for Piper.

Let me just -- if you don't mind, I'll just jump into the questions. There's a lot that's coming up in the semi space these days. So let me start at the macro level with an interesting topic that keeps coming up. Can you maybe help us -- because you see a lot. You're very broad as a company. Maybe you can help us understand or provide an update on your views on how things are evolving across the supply chain. It's a very -- it's a topic that comes up a lot in conversations these days.

So supply chains over the last 9-plus months have been responding to a much stronger demand environment, maybe closer to the 9- to 12-month window of time as the industry began to see recovery in about -- just about this time last year. There have been significant increases in output from the supply chain, both from IDMs and their internal factories as well as outsourced factories as well. If you have a measure of that, taking Microchip as an example, in the September quarter, if you use the midpoint of our guidance, we are almost 26% over last year's September quarter. So that gives you a measure of how much more output we're shipping today than we were last year. However, supply chains remain extremely constrained because demand has grown even faster than that. And the gap between supply and demand has continued to expand each quarter, and we forecast it will grow again between the end of June and the end of September. So supply chains remain under duress not because they're not producing more but because they can't produce as much as where demand is growing, which is faster than the supply.

That's amazing. It's been a year since we've heard about supply challenges. Maybe Ganesh and Nawaz, if I could ask you, maybe loosely speaking, what kind of products or end markets or kind of components are the tightest for a company like Microchip today?

So when I look at our markets and products, we have very broad-based products that play in all markets. So there is not a component part of our business that is having less constraints. They're all constrained to various degrees to where they're at. And it depends to some extent on how much of it is in our internal manufacturing control versus how much is external, but they're all constrained. The end markets, early on, we saw automotive being the most vocal about the constraints. That was late last year, beginning of this year. But really, since then, all end markets have been constrained and to various degrees. Maybe the end market that is least constrained, so to speak, is aerospace and defense because it tends to not move as much up or down. And so it is constrained in some places but not as much as perhaps others. But there is no end market, there is no product line that is not constrained today.

Wow, that's amazing. Now you've got a -- Microchip has an interesting manufacturing model. You do some inside Microchip's facilities, and there's a lot that's outsourced as well. It's an exchange over the decade, but -- the acquisitions that your company has made. But I'm curious to the sense that you can control your own manufacturing, how much have you been able to do from an industrial manufacturing footprint standpoint to be able to offset supply chain? Or is the issue that the equipment isn't available or you just really can't do anything about it?

So the answer is a little bit different between the front end of manufacturing, which is where wafers are produced, and the back end of manufacturing, which is where the -- really the packaging and testing is done. Over the last 12 months, we began to invest more cautiously at the time a year ago in some back-end capital additions. And the -- each month and each quarter, we would continue to increase that. And we've been able to bring a reasonable amount of back-end capacity online, which had we not done, would have substantially tied our hands if we could only get external capacity, so much so that when we exited the June quarter, our percentage of in-house assembly was about 58% or 59%, almost 10 percentage points higher than where it was in the September quarter of last year on growing volume. And our test as a percentage in the June quarter was about 63% done in-house, again, almost 10 percentage points higher on much higher volumes. So that's a big change that we were able to effect through the investments we made, deploying that capacity, qualifying the customers and all that in the course of the year, that mitigated the effects of constraints that otherwise we would have faced on all that outsourced assembly and test if that was our only source. We did increase assembly and test outside, too, but we were able to do much more of it in-house because of the investments we were able to make. On the front-end side...

Sorry, please go ahead.

Yes. No, on the front-end side, we are increasing -- we have invested in increasing capacity, but it is slower to come in place. Back-end capacity can be brought on board in 6, 7 months, sometimes a little longer now with equipment taking longer. Front-end capacity easily takes 9 to 12 months and longer in today's environment. And so we did make certain investments that are starting to hit our factories. And then you also need to hire people, which has been a challenge in the current environment as well to bring that capacity on board. But it is coming. And one part of what we see into 2022's growth is where our front-end capacity comes more into play than it did in 2021.

So that brings me a little bit to the next question almost perfectly. When does Microchip see demand and supply hitting sort of equilibrium and balance? Are there any markets where you might achieve that earlier than others?

With our present line of sight, we do not see a -- maybe in the next -- well, through the middle of 2022, we do not see supply and demand coming into balance. It doesn't mean we see it in the second half. Kind of we take 4 quarters' view at any given point in time. But there is nothing that gives us a sense that between now and the middle of 2022, we would have any semblance of supply and demand coming into equilibrium. So it is well past that, quite likely past 2022.

And so interestingly, you have a very interesting program, PSP program that I think you guys came up with. And it's been a pretty successful program from what we've been able to tell from the earnings call. Could you maybe talk about if you -- what kind of trends you're seeing with bookings for the PSP program and if customers have sort of wholeheartedly adopted that program?

Sure. So the Preferred Supply Program or PSP is something we kicked off -- we announced it in February. We began to take orders starting March. What it provides customers with is priority of supply in exchange for certainty of demand measured by noncancelable, nonreschedulable backlog for 12 months on a continuous basis. So you have to have 12 months. So every month, you're adding a month of backlog to it. First customers started on the program in March. More joined in April, more in May, more in June. And so this month in September was the first month that -- oh, and by the way, a preferred supply customer would, for the first 6 months, not see any benefit but, starting from month 7 onwards, would start to receive priorities. So this month is the first month in which somebody who placed PSP orders in March began to see benefit of priority in September. And more will see it in October and November and December, et cetera. The program has been enormously successful with customers. These are -- it actually was designed based on inputs and feedback from customers in the December, January and February time frame. We are -- well over 50% of our backlog is on PSP. That backlog is over multiple quarters. And in certain capacity corridors that are very constrained, we have 100% of our capacity that is all in the PSP backlog itself. And we continue every month since March. Anybody who signed up in March is remaining on the program. We haven't lost anybody in the program, and they've all been adding 1 extra month of backlog every month that is noncancelable 12 months out.

That's -- those are some amazing stats. Not a single customer walked out on the PSP program. I mean that tells me right there that the supply is pretty critical at this time. You brought up a couple of interesting things about the PSP program where they have to maintain orders and they can go out a certain time frame. Are customers voluntarily placing orders, Ganesh, that are past the sort of the minimum stipulated time frame that you guys have talked a little about? In other words, are they coming on their own and going beyond that just to assure supply?

Great question. And very much to our surprise, even though the program required 12 months of continuous backlog, we have had customers come and ask for 18 months, 24 months. The longest we have is 36 months where a large customer wanted to ensure that they had their backlog wrapped up for 36 months on the PSP program. And so the vast majority is 12 months, but there is a meaningful number of people that have gone past 12 months.

Let me ask you on that. So another thing -- another question we get a lot from our investors is on double ordering. It's that famous word in semi at the end of cycle. I'm hearing you talk about shortages in supply, strong demand, but at the same time, I think investors are worried about double ordering. I guess my question would be what kind of steps is Microchip taking as a company to make sure that customers aren't excessively going overboard with orders? I know that the orders are noncancelable, nonchangeable, so that's one guarantee for sure. But are there other things you're doing beyond that?

Right. So firstly, when you double-order in the traditional sense, our products are -- 99% are proprietary products, and the -- it isn't a multi-sourced product for a customer. So it is not like somebody places an order on us and on 2 other people, hoping that one or the other will certainly fulfill it. So that type of double ordering doesn't enter into proprietary products. Second, through our distribution channel, you could have multiple distributors who carry our products. But there is no economic benefit to a distributor to accept double orders because they will not get the economic relief -- the price relief that they need to be able to fulfill from multiple distributors from the same customers. So our products are all controlled in terms of who gets price relief by a registration that they make. So only one distributor can make money transacting with a given customer in the way we've set it up. So we don't think there's double ordering in distribution that can take place. The final way is somebody who just says, I'll place more orders on you. I'll give you 20% more or 30% more or whatever it is that they would like to go place. And that is definitely something that you can't discount. There is only one challenge, which is while you can place double orders, in a constrained environment, you can't get double fulfillment because our inventory is declining. Our channel inventory is declining. And so it's very, very hard for people to get double fulfillment even though they may place double orders in the situation. Besides that...

So I assume that it's -- oh, sorry. Yes.

You mentioned the disincentives of noncancelable orders, so financial commitments that people are making, right? I mean those are disincentives to overordering, which you don't need because you're then financially committed for 12 months, in the case of PSP, for 9 -- or 3 months in our normal backlog. And we think those may not be perfect, but they are certainly disincentives.

I also assume that if somebody shows a pretty dramatic increase in orders versus last year or versus seasonally historical pattern, Microchip then questions the orders, and it goes back to the folks that ordered and saying, what's the -- where is the increase coming from? We just want to make sure that this is legitimate. I assume you're doing something like that, too?

Yes. So that would be normally something that would flag someone in the system to say that's an extraordinary booking. And sometimes it's real. There's a new program that we didn't have last year that's growing. And if it's not, we will appropriately disposition there.

Understood. So Microchip is very broad. It competes in a lot of end markets, a lot of different programs, a lot of different products. When you look out, let's just say, now through the next year to 2 years, what are some of the drivers that you see for growth for Microchip? And what are some of the end markets that you see growing fastest?

Okay. So I would describe maybe 3 growth drivers that are the predominant ones. The first one is because we're broad and we're in many, many applications and because we have the anchor design defined by the brains of the system, the microcontroller or the processor, the FPGA, we have a tremendous influence on what part of the Microchip content gets designed in. We call that the total system solutions approach by which we bring our analog, our mixed signal, our timing, our security, networking attached to whatever the brains of the system are. So total system solutions is element 1 of our growth driver by maximizing the Microchip content that goes on to a design. The second element is around ensuring that we are present in those end markets that have the largest growth and more specifically those that -- those market trends where the largest growth is. Those we have defined as the market megatrends. There's 6 of them that we focus on. It's 5G infrastructure. It's the Internet of Things but specifically around industrial. It's data centers, electric vehicles, advanced driver assist and artificial intelligence and machine learning. And so in those 6 megatrends are significant Microchip content that will take advantage of the growth being afforded by those markets in which there is significantly higher growth than normal. The third part is our Web and what we have done to enable a long, long tail of customers who may not be covered directly by us, may not even be covered directly by some of our channel partners but who have an ability to use the resources on our Web to be able to design successfully and also to transact using our Web e-commerce capability as well. And so those are 3 large parts of the growth strategy, the organic growth strategy that Microchip has and that we're building on. And we'll speak a lot more about them during the Investor Day coming up on November 8.

Awesome. And I want to hit upon one of those topics, Ganesh, and there was -- I want to hit upon the electric vehicle. It's been called a megatrend not just by you but by several other companies, a tremendous amount of content increases. Maybe you could lay out for us just very simply, very broadly, what are some of the areas that -- Ganesh, that Microchip is playing in, in the electric vehicle space to your product set?

Sure. So there are many applications that are common to electric vehicle and the internal combustion engine, right? So if you think of your access control, your garage door opener, your touch screen, seat control, et cetera, et cetera, those all don't care whether you're an electric car or whether you're an internal combustion engine car. Then there are applications that are unique to an electric car, and they have to do with the powertrain, the power conversion, the charging infrastructure, the motors that are going to be driving things, even the generation of noise to prevent pedestrian accidents, et cetera, as examples. And so all of those are well represented in our product portfolio of microcontrollers and analog and networking and all of that. And even more so with a technology we inherited with -- from Microsemi called silicon carbide, which is a power -- or a power-efficient type of product that goes into electric vehicles and other industrial type of applications as well. So we are well represented in the electronic content for electric cars, in the applications that are unique to the electric cars.

Great. And let's -- I want to switch to financials. I mean you guys have just done an amazing job. I've covered you guys for, I think, 15 years now. And every year, clockwork, outside of a major recession, you keep pushing. So let's talk about your margins, your gross margins. You're at a pretty high level at this point in time, very, very admirable gold standard level. So what could be the major drivers from here for the margins, Ganesh? And then maybe just some symbolic headwinds that you -- that come to mind when you think about the puts and takes around growth versus -- growth in margins versus maybe some of the things you can run into from here?

So our gross margins, we'll lay out more of that on November 8. But there is a fair amount of this, which is the normal blocking and tackling of what we do, which is, how do we continue to get more efficient in our manufacturing operations? How do we change the mix and utilize richer mix of products? How do we create products that have higher value and therefore higher margin in how the customer views those products? And so those are the elements of what we have had. Our factories are continuing to expand, and we will get accretion as we fill those factories and get higher volumes running in our internal factories. We've done a lot of that in the last year, and we will do more of that in the coming years as well. So those are all going to be significant continuing drivers for gross margin, but they're also going to take time, right? Each of these things has a time line of improvement, and gross margin continues to get harder to eke out as you get to higher and higher levels as well. Can you repeat your second question again?

Yes. The second question was, are there any headwinds that you see, any obvious headwinds to that growth of gross margins?

So the growth -- the headwinds are in the area of input costs that have risen. There are input cost increases in materials, in equipment cost, in our supply chain who does outsource work for us, in people costs, which have gone up quite significantly, in freight costs that have gone up as well. So all of those, if they remain as they are on a sustained basis, and some are likely to be, will all be headwinds that we will need to overcome to get from where we are to wherever gross margins can go to.

Sure. Ganesh, so you laid out a very strong case with sustained bookings, the PSP program, the success there, the visibility. So we tend to believe that there will be some dramatic -- tremendous amount of growth for your company from here on. So let's talk about OpEx for a second. Microchip's had a very interesting philosophy about OpEx. You guys shared the pain, I still remember, in 2019 -- or 2009. The management took the brunt of the pain before it was passed on to lower and lower levels. How is the philosophy of OpEx versus growth today?

So -- and by the way, we took a pay cut in 2020, too, just -- and it is part of our shared sacrifice, shared reward philosophy of how we run things as a company. So we're disciplined about OpEx, and we have an OpEx model that we try to live within. And it's built around how do we differentiate between what do we spend on R&D, sales and marketing and then support and infrastructure for the company. We think it is important to be invested in the parts of OpEx that create long-term value. And we think if gross margins and growth in business is the goals that we -- as we drive towards those goals, the right OpEx investments are what create the capability to be able to do it. And so it's a flexible operating expense structure with a variable component of spending that in prior cycles we have shown, we are able to take cost away when conditions get to be tough and then bring them back on slowly as conditions get to be better. But I think that's how we view the OpEx, is it's at a place where it is fine-tuned for growth and profitability, and it's got flexibility for the business cycles.

Ganesh and Nawaz, that's all I had. You guys have done an amazing job as a company over the last decade plus that I've covered you, and it's always onward and upward. So we really appreciate it. The investors really appreciate it. I cannot thank you enough for your time to be here for Piper and for the investment community. Thank you so much.

Thank you. And I think there are 20,000 people behind both of us who really make all that hard work happen. So thank you.

Thanks, Harsh.

Appreciate it.