Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good afternoon. Why don't we go ahead and get started? I'd like to welcome everyone to the fireside conversation with the management team of Microchip Technology. It's my distinct pleasure to welcome on stage with me. To my immediate left, Steve Sanghi, the Founder and Chairman of Microchip. To his left, Ganesh Moorthy, the President and Chief Executive Officer; and then Eric Bjornholt, the Chief Financial Officer. The format is fairly simple. We've got about 30 minutes in this room. There is going to be some time for some Q&A from the audience. If you have a question, there is a mic in the middle of the room. We're not passing the mic around this year under COVID protocol. But if you have a question, please feel free to stand up. And I know Ganesh, you wanted to make a few sort of opening comments. I'm going to turn the floor over to you and let you talk about Microchip.

Great. Thank you, John. During the course of this discussion, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the company, and we wish to caution you that such statements are predictions and that actual results may differ materially. And we refer you to our recent filings with the SEC that identify important risk factors. First of all, business remains strong with demand continuing to increase and outpaced the supply increases that we're putting into place. We expect that the demand-supply imbalance will persist through much of 2022 and possibly into 2023. And we expect to be in a position to support revenue growth for at least each of the next 4 quarters. Strong debt paydown has dropped our net leverage ratio at the end of September quarter to just under 3% at 2.99%. With that and a strong business outlook, both Moody's and Fitch have upgraded our debt to investment grade. This in turn has enabled us to commence our stock buyback as we discussed at the last Analyst Day and earlier this month, that we would be beginning that as soon as we got investment grade, adding another capital return element to what we have done in addition to the strong dividend growth that we've been doing. The Microchip 2.0 strategy over the last decade employed serial acquisitions to give us a solid foundation and to build scale and a breadth of product lines and significantly improved our gross and operating margin model. We have now transitioned to the next phase of Microchip strategy, which we call Microchip 3.0, that builds on this solid foundation of Microchip 2.0. And the essential elements of Microchip 3.0 are, first, organic growth at 2x the industry growth by focusing on total system solutions and on the 6 megatrends that we have outlined. Operating margin results of 44% to 46% as a target with free cash flow target of 38%. An increase in our capital return to shareholders to 50% of free cash flow right away and further increasing this to 100% as free cash flow -- for 100% of free cash flow as net leverage continues to decline, and our long-term net leverage target is at 1.5x. We are increasing our CapEx investment to 3% to 6%. It's a small tick-up from where we've been at 3% to 4% of revenue. And we are investing in inventory to get to about 130 to 150 days of inventory over the business cycles. And we are maintaining a strong company foundation, built on both culture and sustainability. With that, John, we're ready for the questions.

Great. I appreciate that introductory comments well said. I guess, Ganesh, the most significant question that investors continue to try to ask is where are we in the cycle? How long is this going to last? You reiterated something you said at the Analyst Day, which you see at least 4 quarters of sequential growth. So I'm assuming that's December through September of next year. . Help us understand kind of the confidence level you have in that? And to the extent that your sequential revenue growth seems to be gated by supply, how should we think about your ability to bring on incremental supply from here?

Sure. So Firstly, in terms of confidence, I think this is the second quarter in a row we have said we expect it to grow for 4 consecutive quarters sequentially. And I think that is based on both the backlog and demand that we see but also how capacity comes online, mostly from internal capabilities, some of it through our external partners as well. And as every quarter goes, we'll get a better view of that. But the backlog strength is great. And our ability to service it with supply is really what limits our ability to grow as we go forward.

And then, Ganesh, you guys were quite early on with the sort of the PSP program, the preferred supplier program. How does that help you kind of manage the current environment and perhaps actually make better decisions around capacity additions over the next 1 to 2 years?

So first to paint what PSP is. So PSP is a program in which a customer commits a minimum of 12 months noncancelable, nonreschedulable backlog and maintains it. So every month, they add a month. So that is a continuous 12 months. In exchange, what we provide the customer with is priority so that if you're not on PSP, you don't get the product if you're constrained. If you're on PSP, you get the priority for it. That has now been taking place for the last 8, 9 months of time. So we began in the late February, early March time frame. The interest in the PSP program is completely voluntary for any customer who wants to do it, but the interest has been extremely high. We're well above 50% at this point in time. And we're seeing many customers who want to extend beyond 12 months. So people are giving us 18 months as much as 24 months, in some cases as well. What that gives us is the visibility to allow us to prepare for the material, the equipment as well as our other capacity actions, including hiring of people to be able to build with confidence that the [ drug ] doesn't get pulled out of us at some point in time. It also gives us the ability to see early how do customers see a change in their market or change in the demand and would give us a lot more time than we normally would have had to prepare for that in terms of how would we begin to adjust our plans consistent with where our customers are going. So we think it's a good program. It's got great feedback from customers. We are, in some cases, a 100% full with just PSP, sometimes more than a 100% in certain corridors. But in many, many other cases, customers are getting priority and acknowledging that, that helps them plan for their business.

And then, Ganesh, you mentioned in your prepared comments that your capital spending for the next few quarters is going to be above kind of sort of the historical trend. I guess help us understand why that isn't a problem cyclically? It's not just you. I would argue that many of your peers are also raising CapEx. And from the outside looking in, that's what creates cyclicality in the industry because you're raising your CapEx to rev ratio against revenue, which might be being overstated by actual inventory restocking we don't really know. So why isn't that a cyclical concern, one? And two, why are we -- why shouldn't we just expect structurally higher capital intensity for your business, especially as you start to look at a growth rate that is doubling over what you've historically seen?

So when you look at the CapEx spending, where we are incrementally spending is in the areas of what we call trailing edge technologies. And in trailing edge technologies, there is not the spending that our partners are willing to make in the relative priority of what they can spend. So there's a lot of money going into the leading edge and bleeding edge of technology. So what we are really doing is filling in for capacity that is not coming on anywhere else and allowing us to continue to service customers and markets that have very, very long life cycles with good capacity that is cost-effective and accretive to gross margins. That's on the fab side of things. On the back-end side of things, what we have done is -- what we've done for many, many years, which is incrementally bring in more and more assembly, more and more test in-house. And in this environment, having it in-house has also given us a higher degree of control on ability to respond to upsize, et cetera. But our target for assembly capacity is 70% in-house. Our target on test capacity is 80% in-house. We're lower than that at this point in time. So even if there are changes in where the market is going to be, we're well underneath what that market change is going to be. Same within the fab, our internal production capacity is about 40%, 41% today. In the longer term, it heads up to about 45% of our capacity. So we view this as capacity that has long-term needs for durable demand in end markets that have pretty good consistency in how they go about things. And I think it gives us a great opportunity to continue to improve gross margins by building it in-house and using our infrastructure.

And then, Ganesh, at the Analyst Day earlier this -- I guess it was this month or late last month, I can't remember now.

Early this month.

In New York, you talked about kind of you're doubling the growth rate of the industry to kind of a 6% to 8% kind of long-term growth rate. You further sort of segmented that between sort of 1/3 of your business, which I think is your growth businesses, which include things like data center, IoT, ADAS, EV, 5G, AI, ML, and that's a 15% CAGR. And then 2/3 of your business is more kind of industry average growth. And you kind of add that together and that's how you get to the 6% to 8%. I'm wondering if you could spend a few minutes just talking about some of the individual growth buckets that you have sort of earmarked at a 15% CAGR what your leverage is? And what's really driving that accelerating growth, maybe starting with data center?

So when you look at -- so where do we participate in data center? So we're in storage networks. We're in all the power suppliers. We're in security, we're in timing. We are a number of places in the data center that we spend that we have our solutions in. I think what we step back and look at is how is data center as an end application end market growing. And it is growing tremendously. We're all taking advantage of cloud and cloud-based systems and where that is going. . And so that's the megatrend we see is that data center as a market is growing much faster than the industry, and we are putting ourselves in a position with the solutions we have to write that. And so we expect that data center is going to grow, and we will grow in fact, slightly faster over the last 3 years we have, and we expect to continue to grow in the segments we play in. So -- and if you want to look at individually in storage, and we're in places -- we're in controllers, we're in expanders, we're in switches. We're in hard disk -- the solid-state drive controllers. So specific areas within it, where all the power supplies, where it needs digital power, high energy efficiency and where they're at. So lots of places inside the data center within which we have roles to play and solutions to offer.

And then, Ganesh, just generically, you spent more time at this Analyst Day talking about end market drivers and sort of megatrends that I think most of us are used to with Microchip. Microchip is sort of that broad-based company that has thousands of customers across distribution. It's always been difficult to sort of figure out what the real drivers were. So I'm kind of curious, as you think about kind of reorganizing the revenue in this way, to what extent was this a way to help illuminate things to Wall Street versus a real fundamental change in how you're sort of running the business?

So we do have a tremendous broad-based business. And as 2/3 of our business, we talked about how resilient it is and how it plays into end markets that are longevity, et cetera. We have known for some time that there are end markets where there is faster growth available. And so we didn't talk about megatrends at this event for the first time. We probably talked about it for 2 or 3 years may not have resonated as much at that point in time. I think we spent more time explaining how are these megatrends creating opportunities for us. And in the course of the acquisitions we made in the past, we have made tremendous assets that both from Microchip as well as through our acquisitions have enabled us to play in these things. So these megatrends are going to be there with or without us. What we're really highlighting is how are we taking advantage of it? What are the industry drivers for why these trends are going to have above normal growth? And then the differentiated solutions we bring into each of those that allow us to then drive growth at about 2x the rate that Microchip will be growing at, pulling up the overall average growth for us as a company.

Sticking with the megatrends, can you kind of illuminate a little bit on the automotive side, kind of what you think you're most levered to? Is it ADAS? Is it EV? Is it a combination of both? And I'd be curious to hear about what efforts you might be making in the silicon carbide market, which is an area you touched upon at the Analyst Day as well?

Sure. So if you look at our pie chart of the megatrends EV is a smaller piece than some of the other pieces as is the ADAS. So we do have great presence and off of small base growing extremely well. Within the electric vehicle, we have many of the things we do in the other parts of automotive in body electronics and all the way from when you get into the car, the access to it, the screen that you interface with, the heaters, the HVAC control, the movement of the seat, the garage door openers. We got tons of these applications that we have our products but they don't distinguish between EV versus non-EV. In EV specifically, we then have incremental plays that are in terms of the power conversion, that are in the motor control that is needed to be able to drive the motors in electric vehicles, that are in some unique requirements, regulatory requirements about how sound is generated for safety purposes with electric cars, in the charging infrastructure that plays complementary to the electric vehicles themselves. And so we see tremendous growth in EV overall and our role within it. And then as a subset, when you look at power, there is a large effort to be more efficient with how that battery technology, and therefore, the power consumed is. And silicon carbide is an enabler to doing it. Silicon carbide is a technology that came to Microchip through Microsemi. It had been honed in for defense and aerospace purposes and, therefore, had there's huge capability around how robust the technology is. In the areas of power conversion, there are lots of high voltages, 700,000, 1,500 volt. And so it is prone to damage if they don't have high robustness. And so that robustness is what we have taken, along with new product lines, diodes, MOSFETS, MOSFET drivers, et cetera, into the electric vehicle market. We also have silicon carbide playing in other markets. We talked about defense and aerospace. It's also in industrial. But we think automotive will be an important area. And we have another capability, which is around not just chips, but modules. And especially in automotive, people are also looking at how can I have modules with silicon carbide for the power conversion itself.

And then ones, I know this was a little bit of a controversy at the Analyst Day, but if you look at your margin profile versus other people in the silicon carbide supply chain, I think one of the questions that was asked is how are your high margins consistent with what we see with other silicon carbide players? Maybe you can help us better understand where in the value chain you really want to play as it pertains to silicon carbide and why are you able to get better margins?

So if you come from a background of MOSFETs, your gross margin model and thought process comes from what that can give you. And today, if you look at the players in it, gross margins there are lower. And if you then say, well, I got a silicon carbide-based product, your margins are colored by that. What we focus on is where will people see value in what we're doing? How can we convert robustness into a figure of merit that shows cost of ownership? How do we convert chips into modules that can have a cost of ownership reduction for them? So we are focusing not to say we've got to take every single silicon carbide solution that's out there. We want to find the ones where there is value, it's recognized and gets paid for. Not different from what we have done in other areas. Microcontrollers sell into cars, and there are players who sell them at 40% gross margins. There's players who sell them in at 50% gross margin, then we do it at well north of 60%. As long as we can show how what we bring adds value and is sticky and makes the cost of ownership lower, we think we can get higher margins.

Sticking on the trends of megatrends. I'd love to talk a little bit about your IoT and edge computing business. I think a lot of us in the investment community like the fact that you've been a little bit more discerning on how you define that business than some of your peers. Can you talk a little bit about, one, definitionally, how do you define that business? And two, kind of the drivers you see of growth going forward?

Sure. So IoT is a very broad-based business, right? So it started from, and which is why many others, they include anything which has got a microcontroller analog can be defined as part of that, it's a thing. It may or may not connect to anything. We have more narrowly defined it as it has got to have computational capability and it's got to have communication capability, can be wired to wireless and often has security built into it as well. And so with that, we kind of outlined it's -- while megatrends is about 1/3 of our business, of that, about 36% or so it is in the IoT part of the market. It's very broad based. It goes into many, many industrial applications. And so it rides on the trends of where people are using that connected capability to make better decisions and there are business models that support making money, saving money, mitigating risk that industrial customers would see. And so the whole industrial Internet of Things is a major focus for where our IoT focus is. Of course, it's got consumer and other players that go with it.

And then I like the fact that you guys accelerated your growth rate, but not really the industry growth rate. Again, I think the message is 2x industry growth rate. And I think when asked the question, you're like, listen, if the industry comes in a little bit stronger, we would expect to still try to maintain that 2x industry growth rate. . Question for both Ganesh and for Steve. Why wouldn't the overall industry be growing more quickly, especially I look at what you, Microchip, has done over the last 10 years in the consolidation of the industry, the M&A that you've done the better pricing discipline that, that is driven, why can't we see a better growth rate in the overall semiconductor market going forward?

We might. We're trying not to be overly optimistic in terms of that. I think when you look at longer periods of time, we have seen over 10-year periods of time with some recessions thrown in, et cetera, what kind of growth rate does the industry have. And that's the frame of reference we use. You could always pick a shorter window. If you looked at this year as your frame of reference as some people have done, you can get double-digit growth rates by using this year as a frame of reference starting point up or where it's at. . So there is no right answer or wrong answer. I think we have said, hey, it's a 3% to 4% baseline growth. If that ends up being 5% or 6%, great, we'll double on whatever that is. But that's the way we thought about it. It's not a scientific number that we came up with as much as what's the historical growth rate that we've had. And there are plenty of arguments you can make on, hey, there's more digitization, there's more content, there's more things getting smart and we could come up with a different number. We just picked that. Steve, do you want to add to that?

I think if you define a time frame, for example, one of the company gave a 10% kind of guidance for 3 years starting from 2020 baseline so including 2021. If you do that from Microchip and take our growth rate for 2021 and add whatever numbers you want to add for '22 and '23, you get more than a double-digit growth rate. So partially, it's kind of marketing how you want to position it. The way Ganesh tried to position it is we don't really know what the industry growth rate is. But if it is 3% to 4% that has been for the last 15, 18 years, we can do twice that. If the industry driven by megatrends does better than that 3% to 4% number, then we could do 2x that. So I think it's kind of that. It's been a constant question ever since the Analyst Day, probably we left that in a confusion a little bit, but that's the clarification. I think maybe choosing 1 or the other rather than 2, 2 extra growth rate and 6 to 8, those 2 brackets don't jive. Maybe that's a problem.

Well, no. I mean, maybe another way to ask the question, Ganesh, is how do you think about pricing from here? I mean, clearly, everyone's benefiting from at least passing along inflationary price pressure -- cost pressures in your own business. But in general, I mean, as I look at the historical data, there was sort of a demarcation point, late '90s and earlier semis used to see kind of average selling pricing go up about 3% to 5%. For a whole host of reasons in the late '90s, that kind of reversed and we started to see ASP declines of about 3% to 5%. It's sort of been our argument that for a whole host of reasons, we're back into a world where maybe semi companies start to regain some pricing power or -- and whether that's an absolute or relative, it's more powerful statement. So how are you thinking about pricing beyond kind of the cyclical uplift that you're seeing?

So first, we think of pricing as it's a strategic process, not a tactical process driven by supply and demand, right? We have customers committing proprietary products, sole source to us. They need to trust that the pricing we give them can be used and can be run for many, many years on it. So -- and that could be different for other people who may look at it tactically saying, I can go get more pricing today. . Second, the consolidation of the industry, which took place over Microchip 2.0 in those 10 years, right, took out many bad actors in terms of pricing. And that in itself has made pricing power, more reasonable and the balance between suppliers and buyers and where things are at. And the first effect of that was this annual price reduction dance stopped, at least we stopped it in many, many places in what people are doing. Third is today, we have structural cost increases that I don't believe will roll back whenever the cycle changes. That structural cost, we have passed on a structural price increases. And especially when we're coming back to this question of trailing edge technologies, right, trailing edge technologies historically have had more depreciated asset base that has gone behind them as it has to be built with new asset bases, that structural cost is higher, and those prices will be higher as well. And largely, we've been able to pass on cost increases. Our customers have been able to pass on price increases to their end customers as well. And I think that's going to stay. Now will we ever get to the point where instead of talking about annual price reductions, you start talking about annual price increases? I don't know. I hope so, but I don't know.

I'll purpose is by saying I agree 100% with the pivot to Microchip 3.0. I'm sure that doesn't whether I do or don't, I'm sure is not -- you're not going to lose any sleep over that. But to play a little bit of devil's advocate, given how successful Microchip 2.0 was. And given how successful you've been like managing other people's businesses that were being under managed, why not to continue to pursue that strategy, especially because when you look at the markets that you play into, they're more consolidated than they were, but they're still relatively fragmented markets?

Yes. No, great question and one we ask ourselves from time to time as well. I would -- and there's 3 reasons. Firstly, our objectives when we began the 10-year process of acquiring and consolidating was, number one, we wanted to be able to build scale. We were a $1 billion company that scaled up to a $5 billion to $6 billion company in that process. Number two, we wanted to have substantial breadth. We wanted more solutions than what we had at that point in time. And through the acquisitions, the analog portfolio grew dramatically. We added new capabilities, timing, FPGA, the microcontroller processor portfolio grew dramatically, et cetera. But third, and I think more importantly is, I think, in a large portion of the window when we were doing acquisitions, valuations were reasonable. We could see how we could take assets, buy them at reasonable valuations, make significant improvements, accretively improve gross margins, operating margins, drop to the bottom line, the EPS in it. We just don't see valuations in today's environment at a point where it would meet our internal hurdles. And it may meet other people's hurdles and what it said, just doesn't meet ours. And so those will be the 3 reasons where we don't see that as something that is important or necessarily good from the way we think of acquisitions at this point in time.

And then, Ganesh, I asked this question at the Analyst Day, but I think it's an important one to kind of repeat, especially as you think about accelerating some of your capital spending. There's clearly a push by world governments to incentivize domestic production of chips. I think most people on Wall Street focus too much on the bleeding edge. And I like the term that you used at the Analyst Day, mission-critical. Help me understand where Microchip sits relative to things like the chipset, especially given how important you are to defense and aerospace and other mission-critical applications?

So it's a great question. And I think there's 2 components to how we're thinking about it. There's a component of it, which is we're the largest defense and aerospace semiconductor company. And we want to make sure that the infrastructure on which we're building those products that go into every one of our offense or defensive capabilities every one of our space programs has a strong foundation. It is today built on a foundation of factories and infrastructures, which are 30, 40-years-old. So that's 1 part of what we're trying to influence is how does the spending there help shore up the defense and aerospace part of the infrastructure we have. The other part of it is that there is insufficient investment in some of the trailing edge technologies that are important for the end applications that we play in. You can't just go build a car, a computer, a telecom infrastructure, et cetera, with just leading-edge products. It needs a complement of leading-edge, middle of the road, trailing edge technologies. And so all of those are important mission-critical however you want to call it. And that investment is not happening at the rate that it needs to happen, which is what is causing a lot of the shortages today you're seeing is it's coming from the more trailing edge types of product lines. And we think we can offer an ability to have domestic manufacturing that shores that up. That helps many, many industries in the U.S. that today are struggling with that. It's not a short-term decision, it's a long-term decision. But I think that's the second part of what we can do is bring in more of these technologies that are not bleeding edge, but being able to bring it into U.S. manufacturing and be able to provide it to the broader market, served by our U.S. customers.

And then sort of my last set of questions is just around capital allocation and cash return to shareholders. Steve, at the Analyst Day, you gave a pretty specific presentation on what you're planning to do with your cash. And as usual, you're right about getting the IG upgrades relatively quickly. Perhaps it makes some sense to just go through those parameters kind of one more time. And I think you're uniquely driving the dividend up sequentially almost every quarter. Help us understand kind of the thought process behind that dynamic?

Sure. It's a great story. I'll let Steve -- go ahead.

So we begin in the current quarter with 50% of the cash flow to be returned to shareholders in the form of dividend and stock buyback. So we have begun the stock buyback process already. We started right after we got the IG rating. And then when we go to the following quarter, the cash return goes up from about 50% of the free cash flow to about 52.5% and the following quarter goes to 55% and then goes to 57.5% we increased that about 2.5% every quarter. Then you take the cash flow -- free cash flow from that quarter and take that percentage, let's say, for 5% in 2 quarters from now, take up the dividend, which will be increasing at the rate of 7% roughly per quarter, and the balance will be the stock buyback. So it's just a math problem after that. So you continue that process down the line. So we'll still be paying a significant amount of debt every quarter. The total cash going towards the debt will be decreasing because the cash return to shareholders increasing but debt would still be going down and the EBITDA will be rising. So the combined effect of EBITDA rising and the debt decreasing will continue the downward slope of the total debt leverage getting to 1.5% someday, you could actually -- if you want to start with some of the revenue assumption, you can do a math on it and see where we get there. But basically, every quarter, we will increase the total return, increase the dividend by about 7%, and the stock buyback is a calculus after that. And if we get the opportunity, start getting to a downdraft of some kind, we have the option to then buy a larger amount of stock, maybe do 2 quarters work at that low price. So we have all the option available because the stock buyback authorization is very large. But barring that onetime large purchase, it will be a continuous process, very structured, will have constantly bid on our stock pretty much every day the window is open for us. And remember, our window closes in the third month -- half of the third month and most of the very first month of the quarter when an acquired period. So when the window is open, we'll be continuously buying stock pretty much every day by that kind of number. So that's the strategy.

Great. I'm sorry, Steve.

And on the other side of it in X number of years, you could do a calculation, hopefully, we get to 1.5x leverage get to near 100% return back to shareholders. And then leverage would still continue to drop because even though you're giving all the cash to the shareholders, the EBITDA would be right.

Makes sense. With that, I think we've ended the session in this room. I want to thank everyone for joining, but especially for Steve, Ganesh and Eric, I really appreciate the conversation this afternoon.

Great. Thank you.

Thank you.