Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good afternoon, everyone. Before we get started, if you are a member of the press or media, please disconnect at this time. This is a restricted line. Any unauthorized party in this meeting or any unauthorized use of the information communicated in this meeting is subject to prosecution to the fullest extent of the law. Any unauthorized person, including the media that is on the line at this time, please disconnect. Please note, today's call is being recorded.

Good afternoon, everybody, or good morning, whatever the case is, if you're on the West Coast. My name is Gary Mobley. I'm one of the semiconductor analysts at Wells Fargo Securities. I appreciate everybody joining us for the fifth annual Wells Fargo Securities TMT Conference. And I appreciate Eric Bjornholt, CFO of Microchip joining us in as well. We have Sajid Daudi, I hope I'm pronouncing that correctly, Sajid. But Sajid has joined Microchip in the Investor Relations role. Some of you may have met them at the company's Analyst Day just under a month ago. And considering that Microchip just hosted an Analyst Day event and as well, the management team was featured at a competitor's conference what I hope to do is drill down a little deeper into a handful of topics and hopefully reveal something that hasn't been discussed within the past month. And I hope that's all right with you, Eric. But perhaps with that as an introduction, I can hand it over to you and perhaps you can highlight maybe the few things, 3 or 4, maybe even 5 things that you guys wanted to communicate the most at your Analyst Day.

Sure. Thanks, Gary. Appreciate you hosting us today. And just want to say as an intro here that during the course of this discussion, I will be making certain projections and other forward-looking statements regarding the future financial performance of the company. And I wish to caution you that such statements are predictions and that actual events may differ materially. And I refer you to our filings with the SEC that identify important risk factors about the company. So overall, business remains very strong. Our backlog continues to grow. The backlog that is part of our preferred supply program also continues to grow. The supply and demand imbalance that we're seeing in the industry continues to expand, and we expect that it's going to persist through much of 2022 and possibly into 2023. We've been extremely focused on paying down debt ever since we've acquired Microsemi coming up on 3.5 years ago. And last quarter, we meet a leverage target of just below 3, which was a great achievement for us. And within about a week of our Investor Day earlier in November, we did receive an investment grade rating from both of the rating agencies that rate us, Moody's and Fitch. And with that, we are now in the market buying our stock and following through on the capital return strategy that we laid out for investors at our Investor Day. And so that what we're doing today is returning about 50% of our free cash flow to investors through a combination of dividend and this addition now of share buyback. And the way the Board has laid this out is we expect to take that 50% return to 100% return as we make progress in getting our debt leverage metric down to 1.5x. So we'll continue to use a large portion of the cash flow to pay down debt. We've added the share buyback element to the strategy. And that is kind of the new Microchip 3.0 that we introduced at the Analyst Day, and we're excited to be on that journey and have gotten the investment-grade rating maybe even a little bit earlier than we thought we were going to. So also as Microchip -- as part of Microchip 3.0, we laid out a new business model. That business model indicates that we expect to grow at 2x the industry growth rate driven by our focus on total system solutions and some of the key mega trends, which I think Gary and I will discuss as part of this session today. We've got a new gross margin target of 68% at the midpoint and a new operating margin target of 45% of the midpoint. And we expect to drive free cash flow as a percentage of revenue to about 38%. We're increasing our investment in inventory and in capital. We've raised our CapEx target to be between 3% and 6% of revenue. Over time, it's on the higher end of that in the current fiscal year, and that may continue in the next fiscal year and looking to hold more inventory on the balance sheet in the future. Now that the leverage is down that we have investment grade, we can afford to make that investment in inventory that has a very long life, can help us support our customers better and have us have very competitive lead times. But that's going to take us some time to get there. Today, we've got about 112 days of inventory on the balance sheet and our new target is to be between $130 million to $150 million. So with that, I'd like to turn it back to Gary for the Q&A session. Thank you.

Sure. I appreciate the overview, Eric. I know that you guys only break down your end market mix at the end of each fiscal year. And I believe you break it down to roughly 6 different markets, the 2 As, the Is and the 3 Cs in terms of end market. And with the exception of industrial, it's a fairly even distribution of the remaining 5. And so my question to you is based on what you know today, and I don't know you don't have perfect visibility into your distribution channel. But can you give me a sense of where you're seeing the most amount of strength in diversely, which end markets might be showing the most amount of weakness or maybe better said the demand and supply being balanced?

Yes. So you know that many of our products sell across all of the end markets. We'll have a standard product that can sell into automotive, it can sell into industrial and it can sell into consumer, et cetera. And right now, capacity is so constrained, and our PSP program has been rolled out really to all customers, right? So all customers have a choice of participating, and we're seeing good participation across all end markets. probably the highest percentage level of participation by customers and PSP is in automotive, understandably, given the situation that we all read about in the press, but it's a very popular program with all in one. So the end market strength, I'd say is across the board, the supply constraints are impacting all end markets. And really, we do not track our business on an end market basis on a quarter-to-quarter basis it's an exercise we go through once a year, as you mentioned, at kind of the start of your question there. So it's hard for us to really judge that, particularly with 50% of our business going through distribution, and a lot of it going through contract manufacturers also. It's hard to give you kind of a midyear update. But everything is strong right now.

Okay. But if I can read between the lines, what you're insinuating is that where the gap between demand and supply is the widest is where you see the most participation in your preferred supplier program?

Well, I think the challenge that happened there is automotive, when COVID hit, they just slam on the brakes, right? And inventory was drained out of consignment locations, out of vendor-managed inventory, and they weren't giving us backlog visibility. And so there were other pieces of our business that were quite strong during that time period. Anything related to work from home, so computing, data center, medical, which is part of our industrial business was strong, and that capacity got allocated elsewhere. And then when automotive came back and said, hey, we want to go back to 100% after being at 10%, 15%, 20%, that capacity wasn't there. And so I think the -- I'm going to call it, learn their lesson, maybe that's the harsh way of saying it, but learn their lesson through that, and they signed up very early to be part of the PSP program and we're some of the customers that were asking for us to design a program that could help them.

Okay. And so let's double-click on the Preferred Supply Program. Can you give us an overview of what that is and how it is a win-win for both you and your customers?

Absolutely. So the PSP program was introduced in February of this year. And it was based on customers asking, is there anything that we can do? Is there a program we can create that can give them more surety of supply. And so we developed this program, working with our customers. And what it is, is they provide us with 12 months of noncancelable, nonreschedulable backlog. And in turn, they get priority and supply starting 6 months from the date that they enter the program. So we're not going to -- the intention of the program was not to anybody that had backlog with us in the next 6 months and not kick them out of their line in terms of being able to get product. And so lots of customers have signed up for this. And now we have well over 50% of our backlog is PSP. We have customers that are giving us well beyond 12 months of PSP backlog today. In certain cases, we have lead times that are more than 52 weeks. And so they are making sure that they get their spot in the manufacturing line. And so it's helpful to the customer because they get that priority. They do a good job of thinking through with their demand needs are going to be. And rather than having a 90-day cancellation policy and having just a ton of backlog in months 4 and 5 that the customer continuously pushes out, they have to give us thoughtful backlog because they have skin in the game. And for Microchip, what it does, it allows us to make investments, confident we make investments in raw materials, in people, in capital that allows us to meet those needs that go 12 months plus out in time So customers like the program. They're seeing the benefits of it, that they are getting priority of supply and being able to plan appropriately for what they're able to manufacture because they've got that spot on the line early enough for us to be able to respond to it.

Okay. And so let me double-click on that 12-month period. Is that a static 12-month period? Or is it a monthly rolling forecast. In other words, each month, can a customer come to you, give you an update and say, hey, we want to extend this another month beyond the end of our current scope.

That is correct. So in order to remain in the PSP program, the customer's commitment is, is that as a month of backlog rolls off, they put that next month along with us. And one of the benefits the Microchip of this PSP program is it gives us another indicator looking out in time or things changing in the marketplace, right? So we haven't had that type of backlog visibility before. And as we see in the future, it's not happening today, PSP program is continuing to grow. But as we see in the future that customers maybe aren't giving us that next month of backlog or reduce the run rate by 20%, 50%, 80%, we can draw conclusions from that about the entire customer base and modify our investments. And again, people, materials, inventory, equipment and try to navigate to a soft landing out in the future. And there's other things that can help us navigate soft landing too. One is distribution inventory is at all-time record lows, and that will need to replenish at some point in time. The distributors want more inventory than we can ship them. There are fewer distribution customers that are on PSP program, although it's available to them. There's fewer that are on PSP compared to direct customers. And so that pipeline is going to have to refill again. And so that helps us navigate the soft landing. I think also having a higher target for inventory days gives us flexibility from a manufacturing perspective is when we can build a little bit more inventory, keep our factories running at a more steady rate, and that just allows our operations team to manage the business much better.

Okay. All right. So as a leading metric in trying to answer the $64,000 question that every investor has, an indication that you're starting to catch up with demand from a supply perspective. We might see the rolling next 12-month PSP backlog began to level off. And we might also see maybe your CapEx starting to level off. That might be an indication of you prepping for soft lane, correct? But that's -- just to be clear, that's not the situation today?

That is not the situation today. But at some point in time, that will happen, right? PSP backlog is not going to be at where it's at today for eternity. We think this program will likely survive in some form, long-term customers like it. But there's going to be customers that say, hey, I just don't have that great of visibility and now that lead times are shorter. In the future, they choose to not participate in the program. And we can modify the program to the environment over the course of time as things progress.

Sure. These are take-or-pay agreements, but I'm curious to know what the penalties are should a customer decide that they don't want the product.

So we have written agreement with the customer that they are on the hook for the product. And again, we're making investments to support that. So it is our intention to require the customer to take the product. And -- so there's -- I've heard investors say, well, there's good and bad with that, right? Maybe you delay the pain at some point in time because customers get themselves into an over-inventory position that they can't correct quickly, but it allows us to manage through these things in a much smoother way. And again, if we have skin on the game for making these investments, we're requiring the customer to have skin in the game, too. And we've had NCNR, noncancelable, nonreturnable product in the portfolio for years, but we haven't ever had it to this extent.

Okay. All right. I appreciate that. And can you give us a sense of what percentage of your backlog today is comprised of customers that PSP? And how has that trended over the past couple of quarters?

Yes. So we are not breaking out a specific percentage any longer, but it is over 50%, and that percentage has grown each quarter that we've had the program, and the PSP backlog is continuing to grow as our total backlog grows. So it's a high percentage of the background.

Okay. I want to switch gears and talk about your R&D focused. I mean you talked about the market mega trends that at your Analyst Day you quoted as being 1/3 of the total revenue. I would presume that, that is where your R&D focus was heavily weighted towards. But looking at the different product breakouts between microcontrollers, FPGAs, analog and memory, where are you -- where does the R&D investment outweigh the percentage of revenue that particular product category represents. In other words, where are you -- where are your most R&D intends right now?

Yes. So we have a mix of various product lines in the portfolio. Some of those are more mature. I mean we're still in so a bit microcontroller and we have that in the portfolio forever. We're continuing to invest. But the ongoing investment in R&D is at a lower rate than what you might find in FPGA or data center to take a couple of things as an example. Now all of those products, FPGA and the data center products can have multiple uses, particularly in FPGA and MCU -- into MCU. They can go across where any of these mega trends, data center is a little more specific. So that's not as good as an example. But we're investing where we see the market opportunity. The key for us is positioning all of the products together when we go to a customer to get as much of the semiconductor bill of materials that we can. And that total system solutions and how that intersects with the megatrends and the various end markets that we service. And we feel that we've got just an amazing product portfolio today. Microcontrollers, microprocessors, FPGAs, analog products, connectivity products, security, memory, timing. With all these products, we are positioned better than anyone to fulfill all the requirements that a customer needs and their total system solutions. And what it means to the customer is we can reduce their investment in R&D, we can speed their time to market and we can make them much more efficient. And so we're getting really good traction here. We can see this building in our design funnel, which speaks to future revenue opportunity. And the mega trends are a big piece of it. We -- this is the first time at our Analyst Day where we've really kind of broken out the mega trends being about 1/3 of the revenue and break -- broken it into various categories of how it represents that 1/3 today. And it's heavily weighted the data center and IoT, but there are emerging trends in EV and ADAS and AI and ML, to name a few, that we see as durable long-term trends, we've got the right products to have success in these markets. And our teams are really focused on bringing these opportunities to customers and maximizing that revenue possibility, and we think that, that's going to help us grow at 2x the industry rate and the mega trends should grow at approximately 2x what the overall Microchip growth rate is.

Okay. Appreciate that. We've already talked a little about the inventory situation, distribution inventory for you specifically is well below the norm 19 days versus 22 to 47 normal days, your own inventory level at 112 days also below normal. At what point in time might you have the opportunity to replenish both levels of inventory?

So I don't see the opportunity to replenish distribution inventory anytime soon. And it bounce around by a day or 2, yes. But there's just so much gap now between supply and demand. It seems like everything that we're shipping in the distribution is being sold out to their end customers, and they're asking for what product than we can provide. So I don't have a crystal ball. I don't know exactly when that's going to happen. I mean, these things are always correct over the course of multiple quarters. But I don't think in the short term that we have any chance of restocking distribution inventory in any material way. Our own inventory, I mean we've been growing the dollar amount of inventory on the balance sheet. Finished goods inventory has been reduced. But we've made investments in raw materials to make sure we can run things through the line. Our work in progress in the factories is growing as we're ramping our capacity. And that gives us confidence that we are going to be able to produce more every quarter for the next 4 quarters and Ganesh Moorthy has said publicly, and we think that will allow us to be able to be in a position to grow revenue for 4 quarters straight.

And if not mistaken, that's an improved -- a higher number of sequential quarters than you were previously forecast. If not mistaken, that's you're now predicting 1 extra quarter of improved visibility is really expects sequential growth path.

That's correct. When we spoke to investors in August, we said 4 quarters and then when we spoke in November, we said 4 quarters again, so we extended it out by a quarter.

Okay. All right. And so you talked about strategic value of Microchip eventually carrying more inventory, essentially being able to turn a customer's order fairly quickly and utilizing that as a competitive advantage. But on the flip side of this severe once-in-a-lifetime chip shortage, how do you think customer behavior will change with respect to how they manage their inventory, say, for example, the automotive OEMs, their inventory that they direct with their Tier 1s, their Tier 2s, the distribution channel for the automotive chips. Do you think we're going to enter a new paradigm where instead of carrying a couple of weeks of inventory, the inventory looks more like a complete production cycle time in terms of the length of time?

So I don't know the answer to that. I mean we hear a lot of talk instead of just in time having just in case and what that means in terms of multiplier on the inventory that they keep, do they keep 1.2x, 1.5x, 2x what they've had historically, I don't know. And is it a permanent change, right? We think that this cycle is absolutely proving out the value that semiconductors have and that this is not something simple like a piece of metal that you can fabricate quickly and get out to the customer. These are complex devices that have very, very complex supply chains, that when something goes wrong in the supply chain, it can cause months, if not quarters of backup like we're experiencing today. So I think that purchasing managers and companies may get religion on this. Does it hold long term? I am hopeful that it does. But we'll have to see how it plays out.

Okay. Want to switch gears and talk about the different levers to your gross margin target. And so you pointed out that the new long-term target is 68% at the midpoint. And these are -- if I'm not mistaken, that's a 200 basis point improvement from where you're roughly at today. I'm wondering what are the different levels? Does PSP mix play a factor into to what extent is operations factor in versus, say, product mix? And how has some follow-up questions related to it as well.

So I mean, these are really operational matters that are within our control, right? So we've highlighted new targets for the percentage of manufacturing that we expect to do internally. So we expect to take assembly to about 70%. It's just under 60% today. We expect to take final test to about 80%. It's in the 63%, 64% range today. And wafer fab, we actually indicated in the Analyst Day that we expect to take it to about 45% of the total that we'll do internally and today, it's closer to 40%. So we're taking more control of our own destiny with the CapEx that we're investing. And with that, there are margin improvements that come from that. The assembly and test comes quite quickly. Typically, the investments that we make in assembly and test, we look for a payback of 2 years or less in the cash return. And we end up using this equipment. We depreciate it over 7 years and likely we'll use it longer than that. So these are kind of no-brainer investments. It's just a matter of have getting the equipment in, having the time to get it qualified and R&D test programs written and things like that. So those things will help gross margin. As we grow, we end up expanding capacity in our existing factory footprint. And with that, we're spreading the fixed cost over a larger volume of products. So growth definitely helps you grow gross margin. We expect to have a richer product mix over time. We're introducing new and innovative products with high margin and that can help gross margin too. So there's a number of things. When you have a high-margin business model, it's hard to make night and day improvements in the gross margin, but these are -- we've made significant improvements over the last several years, and we expect those things to continue to get us to the 68% level.

Okay. I know I asked this question at your Analyst Day, and I think you punted the question. I'll ask it again and see if maybe you can answer it a little bit. But I'm curious to know -- let's see here. Well, so with 0 cost inventory, that's something you disclosed now in your 10-Q. And I believe there's been a higher-than-usual licensing mix that has also benefited gross margin in the past couple of quarters. And arguably, that's perhaps not sustainable. So even with that 150 basis point tailwind that you've been experiencing recently, perhaps us being unsustainable, you still expect all those different levers you talked about to translate in the 68% gross margin?

So we do. And I would say that licensing is sustainable. Your licensing business grows as the industry grows. And so we're getting a royalty when somebody is using our embedded flash and a foundry partner or whatever and getting a royalty on that. So that's a sustainable business. The inventory, there's always a certain amount of what I'd call sludge or just slow-moving inventory. And that product, as customers are scrambling to get product, they're finding creative ways to be able to use another product that they weren't able to use before. And so that has definitely helped gross margin in the short term. But we have all these other self-help things with the internalization of manufacturing and just growing the business that we are confident that we can get to the 68% level in spite of maybe not having as high a sell-through in the future of previously written off inventory.

Okay. You, like anybody else in the industry, are trying to pass along inflationary pressures to your supply chain. And -- can you give us a sense of the magnitude of the pricing increase that we may see on a like-for-like product in the calendar year 2022 time frame, both in terms of when they kick in and sort of the magnitude of the price increase. Just trying to get a sense of the unit growth versus ASP expansion as we think about calendar year 2022.

Yes. So we don't necessarily know what's going to happen with supply chain cost. Historically, we haven't raised prices in any significant way on our customers. Sometimes on older products, we do because it's taking up valuable floor space, but we've got a customer-driven obsolescence policy and customers are willing to pay for that because it saves some R&D dollars of redesigning. But we've had a couple of price increases in 2021. And essentially, as we are seeing increases in costs from our supply chain partners and our own manufacturing, whether it's in people or capital or raw materials, we're passing those on to customers and margining them up. So we're maintaining our gross margin on those increases. Now there's been increases in foundry pricing, assembly and test pricing, raw materials and labor costs. We don't think these are transitory in any way. We think these are here to stay, and I'll talk to foundry specifically. They're having to make significant capital investments to drive what's needed to support the industry and they're having to do that on brand-new facilities and brand-new equipment that just raises their cost. And so they're passing those costs on to us. Customers understand that, and they are willing to pay for it. So what it means in 2022, I don't know. If you would ask me this at the same time last year, and are we going to be raising prices like we need to do? I would have said no, because it's not normal. But we're not going to jeopardize our gross margin as we see those price increases come through from our supply chain, we will have to pass them on. So we are absolutely confident that we're going to be able to grow unit volume production out of our factories, but there could be an element of price increase too that gets factored in.

Okay. Can you give me sort of a broad picture of the cost of goods sold inflationary pressures that you're dealing with?

Sure. So labor costs -- labor is hard to find across the board, and it's absolutely the case in manufacturing. So we've had to increase what we are paying people throughout the company and particularly in the direct labor force. Capital is a big one. So it used to be that we could go out and find used 8-inch capital equipment on the market and buy it or we'll call it pennies on the dollar at a significant discount. All that equipment is gone, right? And so when we're adding equipment, we are mostly having to add new equipment at higher prices than what we've had to pay historically. And that increases our cost of production as we increase output. So I think those are the main things. And then we're seeing those same things happening at all of our suppliers, and they're having to pass those costs on to us.

Got it. Okay. I think we're out of time. And so Sajid and Eric, I appreciate the time you spent with us today, and I hope you've had a productive day so far, and I hope it's productive for the remainder of the day. I appreciate everybody who dialed in on this as well. And with that, let me conclude, and thank you all again. Take care.

Thanks, Gary. Thanks, everybody. Bye.