Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good morning everybody. Welcome back. I'm Joe Moore. Very happy to have with us today the executive team from Microchip, Ganesh Moorthy and Eric jornholt, CEO and CFO, respectively. So I think Ganesh is going to provide some opening remarks and some updates, and then we'll go right into Q&A.

Great. Thank you, Joe. 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. We wish to caution you that such statements are predictions and that actual events or results may differ materially. And we refer you to our filings with the SEC for some important risk factors that may impact business results. To start with, business remains strong, but demand increase continuing to outpace the supply increases we've been able to put in place. The demand strength is in all markets, all regions of the world, and we expect this supply-demand imbalance to persist throughout 2022 and into 2023. Our growth is predominantly limited by how quickly we can bring on additional capacity to support this demand. Our December quarter revenue was up 30% from a year ago quarter, annualizing at over $7 billion for the first time. All financial metrics were records, resulting in very strong cash generation, and we have guided the March quarter for further revenue growth and strong financial metrics. The strong cash generation enabled rapid debt paydown, which dropped our net leverage ratio at the end of the December quarter to 2.58%. Our debt was upgraded to investment grade by both Moody's as well as Fitch with a positive outlook, and it was upgraded again in January by Moody's to the equivalent of BBB rating. With confidence in continuing cash generation, we announced a 9.1% sequential increase in our dividend this quarter, and we expect this sequential increase rate to continue for quite some time, representing an annual dividend growth rate of over 40% for multiple years to come. We also commenced the stock buyback last quarter as an additional element of our capital return strategy. We bought back $166 million of shares last quarter, and we're on track to buy back about $259 million this quarter, consistent with our capital return strategy. At our November 8 Investor Day, we shared that using our fiscal year '21 revenue as a baseline, we expect our long-term revenue growth rate to be 2x the industry growth rate, assuming a historical backward-looking growth rate of 3% to 4%. With the benefit of more time and a few more months of analysis that we've been able to do, today, we're clarifying that our 5-year annualized growth rate using fiscal year '21 again as the baseline is a target of 10% to 15% per year over a 5-year period of time. It is a much clearer number than a 2x backward-looking number, and that's what the feedback we've gotten from many investors is. This increased growth rate is driven by the strength in our backlog, continues to be very strong, expected improvements in our supply over the course of the many quarters ahead of us here. With a growing number of long-term agreements we have with our customers, many that they are pushing on us to be able to provide that agreement for continued strong pricing environment. And finally, the design win success we have with our total system solutions and our focus on our key megatrends itself. To summarize, the essential elements of Microchip 3.0, organic growth rate of 10% to 15% in the fiscal year '22 to fiscal year '26 time frame, operating margin targets of 44% to 46%, free cash flow target of 38% and increased capital return to shareholders starting at 50% of free cash flow in the December quarter we just finished, increasing every quarter from there, going up to 100% of free cash flow as we bring our net leverage down to 1.5. We expect [ 36% ] of revenue and investing in inventory, 130 to 150 days of our inventory over the business cycles. And we maintained all of this with a strong foundation for the company built on our culture and built on our sustainability. And as you can see from our results in December, our guidance for March, we are laser-focused on achieving Microchip 3.0. And with that, thank you, Joe, and we're ready for questions.

Great. Thank you. Well, there's a lot to go through there. I'll touch on maybe some of it as we move through. I guess, first, like from your perspective, how did we get here? We've been in this environment for a couple of years where the supply chain has been really kind of a crisis for your -- not just your customers but all semiconductor customers. Did you sort of see that coming? And are you surprised by it? And what are the steps to resolving these supply chain issues?

I think we're clearly surprised by how strong and how long this cycle has lasted. This is stronger than any cycle, I can remember, at least in my time. And this imbalance of demand to supply has never been this bad in 40-plus years that I've been in the industry. I think the roots of how we got here begin about the second half of 2018. It's when the tariffs begin. And as the tariffs began, there wasn't a direct impact on us. We didn't have as much that was subject to tariffs, but certainly, many of our customers began to feel the effects of that. It caused dislocations. People had to move manufacturing, people like to raise prices, people in some cases, cut back production. And 2019 continued with more of those tariffs. And in fact, 2019 for the industry was a down year. As we began to come out of it in late 2019, people readjusted manufacturing, got to the point where they said, all right, we know what these tariffs are. They're not going away. We got whacked by COVID. And COVID had a simultaneous shock first on the supply chains as people were unsure, different countries were shutting down, companies were shutting down as to what that meant. And with that, at first, demand spiked down in the specific industries like the automotive industry, consumer industry, et cetera. And then demand spiked up by the second half, the third quarter or so of 2020. And so there was a lot of pent-up demand that was there. People were also at home, without money being spent on services. So all that money was starting to get redirected into products rather than services. Work from home, drove a cycle of new buying. There was some medical buying, et cetera, that went into it. So all of those -- and in the meanwhile, supply has not been positioned anywhere in the industry to respond to this kind of growth. So continued shocks into the supply system and a supply-demand imbalance that continues.

And when you think about those higher growth rates over the next 5 years, you're extrapolating from a period that's been extremely strong now. There's a lot of anxiety about the economy next year, the year after, given some of the global events that are happening, what gives you the conviction to sort of call out that kind of growth over that long of a time frame?

So it's 2 or 3 things. So there'll be a cycle somewhere. We're not saying that we're immune to cycles. Whenever that happens, it happens. But what we look at is how are secular growth trends developing and where are they happening and why? And I think what we are seeing is a significant increase in digitization that's taking place in the content of semiconductors that's going into devices. And we see these major trends, as we call the megatrends, which are driving 5-, 10-year growth that is quite durable in these end markets. And by being in the places where there's the most growth, by aggregating all of our products that can be designed into these systems and then working on the fundamental increase of semiconductor content, we think there is substantial growth ahead of us for many years to come.

Great. And you've done some innovative things to deal with the magnitude of the supply chain issues around your PSP program. Can you talk a little bit about that and how you've implemented that and what the feedback is from customers.

Sure. So PSP started about this time last year. It originated because we had many, many customers starting to see dislocations from about September, October of 2020, we were 6 months into it asking for help, asking for ways in which they could insulate themselves or at least do better in that constrained environment. The program we came up with, with their help and design was to allow a customer to have priority in the supply chain. So we couldn't guarantee anything because there was suddenly enough uncertainty, but we said, you get priority as long as you commit to 12 months of noncancelable backlog. In prior cycles, that unwillingness to commit has been one of the concerns that semiconductor makers have had because if you put too much capacity in place, and then demand changes and people cancel orders in 30 days or 60 days, it takes away a significant amount of the investment that you've made. So here's what we had, and we were surprised. We said maybe 20%, 30% of the people would get there. We were surprised at how strong it was accepted. How much higher than 50% we were able to get to and how many customers have not only given us 12 but want to go to 18 and 24 months of backlog. And I think it represents many of the end markets we're in, which are more durable end markets that people are able to make that kind of commitment.

And there's probably some cyclicality in that. I mean, in an environment like this people are willing to pick up further. How do you guys see it playing out over a full cycle? I mean at some point, you're not going to be able to have 12 months of visibility you might have 9 months of visibility. We'll all react negatively to that, I'm sure, but that's normal, right? And I guess what's your expectation? And then what's your expectation beyond this when we get past the supply chain crisis how customers are going to treat their inventory levels beyond that?

So I think how PSP evolves over time is yet to be determined. It's only been around for a year. And as you said, it's still on this side of the cycle. We'll offer the program for as long as customers see value. And in many, many of the conversations we've had, people would like to see a version of this program continues. So we have started long-term agreements with certain customers that see the benefit in how semiconductors play in their innovation cycle. And so I think that will outlast whatever this cycle is going to be. In terms of what will customers do, I think it will be a function of what is the multiplier on the end market value of the systems that they're building. So you take an example of an automobile, which is the one that is in the news, right, an automobile average car is somewhere $50,000, $60,000. A highly outfitted luxury cars north of $100,000. The semiconductor content in them is $500 or so in that plus or minus. I think the manufacturers of these very expensive systems, whether it's cars, medical equipment, data servers, et cetera, are seeing that semiconductor content drives the value of their end product, yet is a small percentage of the total BOM of what they're building. They will start making changes on how do they want to be able to prepare so that through future cycles, they will be buffered and not have risk of revenue, which many of them have gone through this time. And they are talking to us. There are different ideas people have for what they want to do. But I think they are all at the point where they want to make sure that the next cycle, they are far better prepared. And I think that does mean inventory that they will carry or they will have their supply chains carry for them.

Yes. That makes a lot of sense. And then the PSP program in the sense of when your costs start coming up, foundry costs or other input costs that you may have, are you still able to pass those along? And there have been some reports of price increases for semiconductor products this quarter? Do you have the flexibility to react to those changes in your cost structure?

Yes. No, it's a great question. And especially the last year has been an incredible year in terms of cost increases that the entire industry has faced. And the PSP program allows complete freedom to raise prices. We give customers the information about a change in price. They have 5 days in which to decide do they want to keep or cancel their orders. At the end of 5 days, if they have kept their orders, they stay on at the new price. If they wish to cancel their orders or if they wish to not accept the price increase, we have a choice. Do we want to leave it at the old price? Do we want to have a different price at which we want to do it. But I can tell you there are almost no cancellations of consequence coming out of the price increases we've made.

Okay. And that's for the most part, that is just passing along the cost increase that you made.

Yes. And we want to maintain a constant margin for where we're at, so it's margin to it. But yes, we're just passing along. Pricing for us has always been a strategic exercise. The products we make are proprietary products. They are sole-sourced products. We really want customers to have peace of mind when they make a decision to choose us, that pricing is not a capricious process going forward. This is the only time I can recall in 40-plus years that in the last year, where so many input costs have gone up by so much, so fast that we've had to go do it. But we do not want to have pricing become a supply and demand-driven issue where we raise prices when supply is tight and we lower prices when supplies is much more available. That's not the way proprietary products work.

Okay. Makes a lot of sense. And then you mentioned some of the idiosyncratic supply disruptions, things that happened around tariffs, various trade issues, then, of course the pandemic created a lot of issues in the supply chain. And I guess most of us were sort of looking at 2022 as a return to stability and now everybody is worried about Ukrainian neon and Russian palladium. Can you just generally talk about your impact from those areas? Do you see it as something that could trip you up down the road?

Sure. So firstly, we have no operations in either -- R&D or manufacturing operations in either Ukraine or in Russia. We have a sales structure that's based out of a distribution partner, who services those areas, the former Soviet Union countries. It's a very small number for us. So it's not material in terms of our revenue. We're fully compliant with all the changes that just took place last week. And there is no change in this quarter's guidance and as a result of what's happening there. We are obviously subject to some of the materials that come from there. Neon and palladium are the 2 that have been spoken about the most. We have both second sources. And we have inventory. And we'll need to see how the geopolitics play out in the coming weeks to see what happens there, what if any disruptions there will be. But we're not anticipating any major issues coming out of there.

Okay. Great. So looking at the capacity side of this, you and your peers have invested fairly heavily in the last year. It seems like this year, maybe quite a bit more so. At the Analyst Day, you outlined your goal of bringing more front-end and back-end capacity in-house. Can you talk about the progress that you've seen? And what is your longer-term plan and your balance that you have between external, internal wafers, things like that?

Sure. So we began bringing or at least committing to adding internal capacity as early as September of 2020. So as we began to see this change. And some of it originated when we were underloaded in our factories, and we said, we want to bring in more loading to be able to grow what we built internally. Well, as it turned out, all of that investment that we put into place began to just give us upside as the up-cycle hit. We have taken our -- starting with the front end of our fabs. We are at about 38%, 39% or so back in that time, internal manufacturing. The balance is external. We're bringing more capacity in-house. We expect over the next 3, 4, 5 years, we'll take it from about 40% to about 45% in-house. We still have a pretty large external footprint that will continue through this. On the assembly side, we were probably in the mid- to high 40s. If I go back to the 6 quarters ago time frame, today, we're in the high 50s, heading into the low 60s as a percentage. And with a target to get to about 70% of our assembly, 65% to 70% of it in-house. And finally, on the test side, I think we were in the low 50s, where today, we're in the low to mid-60s and with a goal to get to in the 80s. And each and every one of these is going to be a decision we'll make based on what's the payback. We have relatively short paybacks on these. How accretive is it to our gross margins. And every one of these has helped us on the gross margin journey, which is what has given us over the last 1 or 2 years, a significant boost, both in filling our factories. So taking the absorption costs down, but also in giving us a more internal capacity at the cost that we have running internally. So it's a balanced strategy that we intend to follow. We're never going to be 100% inside or 100% outside. But in these ranges, 45% internal fab, 60%, almost 70% internal assembly, about 80% internal test of the targets that we want to get to.

Okay. Great. So I guess, obviously, you have noncancelable backlog for most of this year, so if not all of this year. So this year is pretty good. I guess do you see the sense of supply chain urgency diminishing over the course of this year. And I mean it seems like, to some degree, we actually need some of that to ease so that we can build more stuff. And that's right, I think people in my side of this, kind of get into the habit of like when lead times stop going up that, that's kind of the second derivative beginning of the end. At the same time, when these things happen, we can build a lot more cars, we can build a lot more end equipment. So how do you see the kind of year playing out? Obviously, good from a revenue standpoint, but in terms of these dynamics with your customers?

So we're actually producing more product, substantially more product than we were back in the December '20 time frame, right? So it's not that we're not producing more, we're not shipping more. What is -- and if you look at last quarter's December quarter revenue, we're 30% higher than the December 2020 quarter. What is happening is the strength of demand is outpacing the strength at which we're able to bring more supply on. That's what's caused 5 consecutive quarter. This quarter will be a 6th consecutive quarter where the gap between demand and supply will just continue to grow. And we don't see any line of sight into that bending curve. No, it will. We know it will happen at some point in time. But that pace of demand growth higher than supply increases is what is keeping the constraints. It's what is pushing out visibility into what might happen well out of '22 and into '23.

Great. And I guess moving to the balance sheet. I mean you guys -- you highlighted upfront the progress that you've had in deleveraging, getting to investment grade. Can you just talk a little bit about that and then what your priorities are going forward for...

Sure. Eric, you want to take that?

Sure. So we've made a lot of progress in paying down debt since we acquired Microsemi back in May 2018. When we acquired Microsemi, our leverage was almost 5x on a net basis. And as Ganesh mentioned in his opening remarks, we're down to 2.8 with the goal to get down to 1.5x with our capital return strategy continues to grow. So we've done a lot of things. We've taken a lot of convertible debt that we had on the structure out, which was highly dilutive to earnings as the stock price increases. And so we're happy with what we've done there. We've put some other bonds in place at very low rates with good timing, and we'll continue to restructure the balance sheet as we move forward and there's opportunities to do that. So we're in a really good position today and leverage should continue to come down nicely.

Okay. And obviously, the focus is now kind of much more on organic growth versus where you've been in the past. But where do you stand on M&A? And as stocks come down, do you think there might be opportunities for you?

We don't see any immediate needs for us to go do M&A of the size and scale that perhaps the big ones we did before were. We continue to do small tuck-in technology acquisitions. These are typically small in both dollars. What we're trying to acquire technology teams, access to a market that perhaps somebody is in early in where they're at. We have achieved largely the objectives of M&A from 10 years ago when we embarked on the program. One was scale. We were less than $1 billion at the time. We're $7 billion annualized at this point. So scale is not a reason for us for acquisitions. We had a breadth of product line at that time that was quite narrow. We have significantly increased the breadth of that product line. And we continue to invest in the product lines we acquired, our next generations and future generation centers. So we feel quite good about the portfolio that we have, and there is no pressing need for us to go do acquisitions ease of our size or for given product lines.

Okay. Great. So maybe pivoting to a little bit on the demand side. You've touched on some of this, but when you think about double-digit growth for 5 years, what are the end markets that you're excited about to get you to that level of growth? And what are the products that you're excited about to get at that level of growth?

So our products are quite broad-based and almost a multitude of products go into every one of these. But when I look at the end markets that are growing, I mean, we see strong growth in automotive, in industrial, in data center, and comm infrastructure in home appliances, maybe the end market that is less muted or more muted would be aerospace and defense. And even that is starting to come back as a commercial aviation is starting to pick back up. I don't know what will happen with the defense spending with what's going on right now. But those tend to move a little bit slower. But all the other ones are seeing insatiable demand. And I think an underinvestment in certain years in the past that people are trying to catch back up on.

Okay. Great. Let me see if there's any questions from the audience. If not, we can keep going. The -- I guess, coming back to the balance sheet, you talked a little bit more about the desire to hold more inventory on your own books, maybe that's some of the flexibility that you have from being investment grade and having a little bit more freed up of cash. Can you talk about those objectives?

Let me start, and maybe Eric can talk more about it as well. So we have a highly fragmented product line and thousands of products, thousands of customers. And so inventory is a way by which we run reliably from a manufacturing standpoint, from a customer support standpoint. Historically, we have carried more inventory. But in the last cycle in -- when we were going through 2020, we were constrained by the depth that we had and the cash generation that was required to pay down the debt, even in that time of uncertainty. With that largely starting to look in the rearview mirror, we think investment in inventory on products that have very long life cycles to customers who have requirements that are quite durable is a good investment to go make. And it also allows us to run our factories a lot more smoothly. So keep running the factory at a fairly consistent level in the ups and downs of the industry. drain the inventory during the up cycles, build the inventory in the down cycles, use the assets a lot better, and therefore, not have to go buy capital for the peaks. You smooth out the capital investments that you have over time. Eric, you want to add to it?

So I think you hit all the key points. I think the other thing I would touch on, on inventory is how low distribution inventory is right now. So we have the opportunity to build inventory on our own balance sheet, but based on the targets Ganesh just talked about. The distribution inventory is at 19 days. It's the lowest we've ever seen in our history. Historically, it's been between that low of 19 and 47 days. And at some point, distribution will need to restock. So that's a buffer too as the supply and demand imbalance corrects itself at some point in time, that distribution will need to restock, and we can build a bit more inventory on our own balance sheet.

And any sense for the end customer inventory, obviously, there are shortages of a lot of things -- so in those cases, it's pretty close to 0. But there is anxiety about incomplete kitting inventory that's waiting for other components. How do you think that might affect you guys?

I know, and I read the reports of where that is. I can see some of the contract manufacturing folks and what they're doing with inventory. I think what we look at in addition to all of that is what is from our perspective, what is the intensity of shortages that we're working. That has not changed. Second, what is the intensity of demand being placed on us, meaning if someone had inventory, are they slowing down the rate at which they're ordering out in time. We don't see that changing either. But there's a part of it, which is this what I call the golden screw syndrome where people are carrying inventory waiting for whatever that last piece is going to be. We don't see that in direct terms where a customer doesn't tell us what they're carrying. All we see is, what are their order of patterns, what are their expedite patterns, what are they telling us in terms of what their issues and problems they're working on are. We see it in distribution where we can see through where the channel inventory is at. But I can't deny that there are customers in the contract manufacturing side. We do have inventory, and I don't know what the inventory is.

Yes. I mean it seems like more often than not, you guys are the part that people need to get right away. So that gives you some comfort that there's not...

And I think the reason why is, if you look at where our products are, most of our products are built on what I would call trailing edge technologies. So these are the technologies in which there's very little investment that took place in the last 5-plus years. These are the places where these are not where the foundries are investing. These are other places where many IDMs were investing. And it is a place that we have both -- we are investing, but we also have the most amount of shortages are in these types of products, they are standard microcontrollers that are analog, they are power clocks. So we are seeing perhaps a larger number of shortages on these products, which are of the trailing edge, which aren't getting as much capital investment.

Yes. That makes a lot of sense. I guess my other question is, the way you guys talk about the business, you have a lot of really interesting businesses that you've acquired and things that AMCC acquired and FPGA business and storage controllers and different things. And you tend not to talk too much about that stuff. You tend to be a little bit understated in the way there's not a lot of hype from you guys. What's the philosophy there? And what -- because I'm sure you could give us lots of PowerPoint slides about lots of businesses that are growing at pretty high rates, and you've kept the discussion instead further high level. What's the philosophy of how you want to talk about these things?

So we did share more at the Investor Day on November, and we did give you a lot more insight into where we are and what we do in the data center. But some of those also tend to be places where there are fewer competitors. And so being a bit understated is not bad because we don't really provide much insight into what we're doing, where we're going with it. They're extremely important to us. They're growing very nicely for us. But at the same time, we give you more aggregated information that, hopefully, as investors, you find that's the summation of what the company is doing. But from time to time, when we do these Investor Days, we'll give you more insight into where are we focused and where are we winning?

Yes. And I appreciate the conservatism around it. And you don't try to get -- because we all know what's the overall growth rate is, so if you try to get us excited about individual pieces growing faster, it doesn't.

Yes. At any given point in time, I mean, we have businesses inside Microchip that are growing 50%, 60%, 70%, 80% a year. You don't hear about it. We don't make a big deal of it, but you might find a smaller company where that's our entire focus. That's where they're giving you the data on.

Okay. Great. Well, thank you very much for the update. Appreciate it.

Right. Thank you, Joe.