Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

The Microchip session here at the Stifel 2022 Cross Sector Insight Conference. My name is Tore Svanberg, I'm a senior semicon and I cover analog connectivity and processor semicon at the companies. It is a great pleasure and I'm very honored that we have Steve Sanghi here, who is Executive Chair of Microchip. And we also have Sajid Daudi, who is Head of Investor Relations. The particular format for this session is going to be a presentation by Steve, and then we'll have a little bit of time for Q&A after that. So welcome, and I'm going to pass it over to the company. Steve?

Thank you, Tore, and good afternoon, everyone. Maybe I think still morning. Before I begin today, I wish to remind you that during this presentation, I will be making some projections and other forward-looking statements regarding the future financial performance of Microchip. These statements involve predictions and the actual results may vary materially. So please look at the filings with the SEC regarding some important risk factors about the company. And this is just a longer version of what I just said. So in the presentation today, I'll just spend 2, 3 slides on telling you what Microchip makes, our end markets and our long-term growth. And then I'll switch and talk a lot about the cycle. I see a lot of the eyebrows go up when I say cycle. So I'm sure you're interested in that topic, and we'll spend a lot of time on that. So what does Microchip do? Microchip is a leading total system solutions provider for the embedded control market. We make all types of microcontrollers, all the related products that go around the microcontroller, mixed signal, analog, interface, security solutions, clocks and timing, wired and wireless connectivity, nonvolatile memory, both E2 PROMS and flash. The company was $6.8 billion in revenue in fiscal year that ended in March. And we have a number of these attributes that I will cover in slides later. Elite long-term non-GAAP profitability, a very resilient and diversified business model, durable end markets and a very solid track record of value creation for the shareholders. So these are our end markets. The largest end market is industrial. One change we have made is we have combined defense and aerospace and industrial together into a single market, industrial. We saw -- that's what all of our competitors do in the industry. The defense aerospace is about 9%, 10% of the business, if you're interested. Otherwise it's included in industrial. So we cover all these 5 end markets, and they are very good durable end markets. Participating in these end markets, we have created a very consistent revenue growth. Go back to our humble beginnings in 1993, when Microchip first went public with sales of only $89 million. And we finished our fiscal year '22 ended this last March with sales of $6.8 billion just quite a long where we have come. Now a few things you can see on this slide. You can see the split of MCU, analog and others. So while MCU is still the majority of the business, analog is now about 27%, 28% of our business. The other thing you can see is the long-term compounded annual growth rate of 16.2%, which is quite remarkable. And the third thing you see is we have posted 126 consecutive quarters of non-GAAP profitability. Even through all the downturns of the industry, various cycles, we have never lost money. And some of the cycles that you can see on this slide, like 2001, 2009, while there were very, very major events for the industry back then, looking back at it, they look like a mere blip on the slide because the slide is really on a long-term basis up and to the right. So with that now, let me quickly cover the last quarter and the current quarter guidance, all -- everything here is in the public domain. Last quarter was a record in every respect and in the current quarter, we guided again 6% quarter-on-quarter growth and 24.6% year-over-year growth, slightly higher gross margin, 40 bps at the midpoint and slightly higher operating margin, 50 bps up at the midpoint. On the earnings per share, I have a few stars on it. And the last quarter the earnings per share included $0.07 of non-repeatable onetime tax benefit. For the baseline for EPS last quarter will be $1.28, and the current quarter is $1.34, so significant growth despite having a much higher tax rate in the current quarter because the fiscal year '23 tax rate would be higher than fiscal year '22 as the debt is getting paid down we're losing a lot of the interest rate deductions. And looking at the long-term model, we have guided to a long-term model of 10% to 15% organic revenue growth from a baseline of fiscal year '21. We have guided to a gross margin of 67.5% to 68.5% and an operating margin of 44% to 46%. Now the midpoint of that is 45% and we're already guiding the current quarter to be slightly higher than that midpoint 45.2%. So that kind of makes it interesting. Now let's talk about cycle. I would say with all the news that we read and all the news that we watch on TV, on any other financial new stations, talk to any of the investors, talk to analysts, we would agree that we recognize that macro conditions are weakening with interest rate increasing, with all sorts of shortages, high inflation, gas price and all that, the macro conditions in the world with China lockdowns are decreasing, with macro conditions are weakening, although we saw zero signs of that in our business. Bookings are still very strong. We have a large amount of delinquency. We have still very capacity constrained. So ordinarily, for many, many cycles in the past, I saw the cycle coming from a distance and actually called it ahead of time. Today, I can stand here and say, I see zero sign of any weakness in the business. And we expect to be supply constrained in 2022 and 2023. But then I say, okay, let's say, sometime in the future if and when those macro weaknesses catches up to our business. What are we doing today and why we believe that we can achieve a softer landing in that downturn? So those are the items I cover. There are about 7 of them. The first being a very, very strong PSP backlog, which is well in excess of 50% of our backlog and in PSP backlog, customer gives us noncancelable, nonreschedulable orders for a year. And every month, as we ship the product, they add another month on the tail end and we will get a year worth of notice if a customer is thinking of lowering their orders out in time because they see us anything in their business. And that gives us a year to really adjust to whatever we need to adjust to manage that soft landing. Second, being a significant question from the near-term unsupported backlog. So if you look at the current quarter, based on the prior slide, we're shipping $1.955 billion. That's our current quarter guidance at the midpoint. Well in excess of that number, almost well above $2 billion of additional product is unsupported in the current quarter, which means if I had all the capacity in the world we will be shipping double the business. And that unsupported has increased every quarter in the last 6 quarters and will increase again this quarter. So any kind of macro weakness catching up has to work through really a large portion of that unsupported backlog, which will take many quarters to really work through and usually, by that time, the business is rising again, downturns are usually 2, 3 quarters. The next 2 points sort of on the inventory. So first, we have to replenish distri inventory. Distributors are carrying only 17 days of inventory, which is a historic low. A more normal inventory will be almost twice that. And today, distribution is not able to build inventory because we don't have enough to ship them and whatever we do ship them goes out the door because demand is very strong. So significant distribution inventory has to be rebuilt, which will keep our factories loaded. And then we have to build internal inventory. For the last 6 quarters, we have shipped product more than what we have built. So the finished goods are all drawn down, the die inventory is all drawn down. We're largely running on fumes. And in any equipment we're able to add in the quarter or the prior quarter, we're growing through that, and you have seen us grow quarter after quarter, and we expect to continue to keep growing. But that has not allowed us to really replenish any of the die and finished goods inventory, which we will have to do if the macro weakness catches up to us. And finally, a couple of more points. Our total system solutions that I will talk about later and megatrends also I'll talk about later. Megatrends revenue is growing at 2x the rate of the overall normal and that, combined with TSS will give us average secular growth -- above-average secular growth rate. Our capital needs usually dry up in a macro weakness. Our maintenance capital is a much smaller portion of the overall capital. So if we are no longer adding capital to expand, then all the cash flow comes down. Cash flow is maintained even in down cycle because you're not spending all that money on CapEx and a very high variable compensation, which in every cycle you have seen in the past, buffers our operating expenses. So because of all those factors, we think we have a very, very good chance we feel confident that we can really soft land the plane in the next down cycle, if and ever it comes. So let's continue talking about the cycle. These are the semiconductor industry year-over-year growth rates for the cycle all the way going back to 2007. But one thing it does prove is that industry is cycling. So you're right there, industry is cyclic. And based on that history, there would be another cycle. I do not see it yet. When we see it, we will call it and let you know, but we don't see it today. So what we are seeing today is really let's look at our performance. Now I'll show you a series of slides in which I will add Microchip metrics on the top of that cycle and have you look at how we performed in the prior cycles, which could give you a clue on how we can perform in the next cycle. And on the top of that, some of the items I talked about why the next cycle performance could actually be even better because of how we have prepared. So first one is cash flow. Through the cycles, our cash flow has been excellent. Minor drift in every cycle, but combination of the strong resilient business model, maintaining gross and operating margins, CapEx drawing up during the down cycles. All those things have cushioned the cash flow tremendously. The second one is gross margin. So you can see that in most cycles, the gross margin impact hasn't been any more than about 300 basis points. And in some of the prior cycles, we had a lot of the acquisitions also. We did a number of acquisitions and acquisitions when we buy them, would have a lower gross margin then we will work over 2 or 3 years to get their gross margin to Microchip standard. So some of this slide has acquisitions built in. And then when we stopped doing acquisitions, after 2018, which was the last acquisition of Microsemi, you can see gross margin has been kind of up and to the right. So I have heard many people in Street think gross margins are highly inflated and our 67% gross margin could go down to like 60% or something. Well, it never has before and we are even better prepared this time to keep the factories loaded. So I think real resilient profitability through the cycle. And this one is operating margin, very similarly, the operating margin plotted over the cycles. Very, very resilient profitability and improving efficiency through the cycles. So now kind of let's talk about organic growth. And before I talk about organic growth, let me take you back to 2009 when Microchip sales were about $700 million. And I basically found that we had 2 issues. One, we were subscale and had scale disadvantage to many of our larger competitors in microcontrollers and analog. And second, while we provided the microcontroller all the associated components in mixed signal, analog, USB, Ethernet, WiFi, connectivity, everything else came from our competitors. So our competitors were surrounding the microcontroller on a customer's board. And I wanted to elbow them out because when they visit the customer, to ship any of the analog or mixed signal or other products, they would knock on a microcontroller telling the customer their product line, what they could do. So I had 2 goals: one, to remove the scale disadvantage and second, to elbow out the competition from our sockets, which is what we achieved in the subsequent 10 years. By organic growth as well as series of very high-profile acquisitions that all became very, very successful we scaled the company 10x with $6.8 billion of sales in fiscal year '22, we scaled it 10x, which we set out to do. And second, in the process of acquiring as well as building inside, we've built out everything that's needed by our customers around our microcontroller to the point where we provide total system solution to our customers and can now successfully elbow out the competition. In fact, just prior to this, I was talking to an investor who spoke with the ex-employees, senior sales employee of one of our competitors, who admitted to him that why we lose analog is because Microchip wraps it along with a microcontroller now providing complete solution. Now a current employee of any of those companies will never admit to that, but this was an ex-employee who was admitting. So I think that thing is working. So after we completed that path, we have now switched to an organic growth strategy by focusing on total system solution with what we have built in the last 10, 12 years and by having software, firmware, reference designs, all of them to speed our customers' time to market and focusing on megatrends, which are providing 2x the growth rate of overall, we think we are well positioned to really drive organic growth for Microchip. And this is the total system solution I talked about. Is this slide a build? No? Okay. So in the center, you see the microcontroller, which is a mother chip, we also -- with various acquisitions, we have some microprocessors. We now have FPGA and SoCs. So that is usually the mother chip where the customer sits down and decides, what am I going to build around? Am I going to use a microcontroller, 816 or 32, am I going to use an FPGA? That is what they decide first. And as they start building their application, then 6 months down the line, I need the power management, I need an A to D, I need some memory, I need to connect to Internet, I need this, I need that. By the time the competitors show up, Microchip has swooped it all up. 10 years ago, I would have many of those blocks in different color because we didn't have them. Today, every single color block around is in the same blue color because we provide chips for every one of those blocks having completed the solution. I think that has been sort of a decade-long journey to become -- go from a microcontroller supplier to a complete solution supplier, which is very, very successful. And here on the right are the 6 megatrends, 5G, IoT, data center, electric vehicles, artificial intelligence and advanced driving assist. And on the left are our end markets. And many of those have crosscurrents. For example, 5G, we find 5G in industrial, data centers, communication, even automotive selectively. And when you look at IoT or artificial intelligence, you find those in all the end markets. Artificial intelligence is being added in the consumer market and appliances, in communication, in automotive, in driver assist and all these things. So our megatrend business is growing at 2x of our overall business. And as far as the end markets are concerned, I showed you a split of the end market in an earlier slide. Consistent, disciplined and balanced capital return strategy. So after Microsemi acquisition, from fiscal year '19 to fiscal year '22, we generated $7 billion of free cash flow. How we spent it, we spent $5 billion in paying down debt and brought the leverage ratio down from over 5 to now 2.3, and we have paid down debt for 15 straight quarters now. We spent $1.6 billion in paying dividend to the shareholders. We have paid dividend for 79 consecutive quarters, and we have guided that we'll be increasing dividend 9% sequentially, which becomes almost 40% year-over-year when you compound it. And we have spent $426 million in share repurchases. Share repurchases, we only began 2 quarters ago, and we'll now be doing it, and we have announced an active programmatic stock buyback of $4 billion over time, and we are executing to that. And we are targeting that once our leverage ratio drops to 1.5 then we will return 100% of free cash flow back to the owners of the business, which are our shareholders. In our November Analyst and Investor Day in New York, we also unveiled many of the things I talked about today into this logo of Microchip 3.0, most of these ingredients on this slide, I've already talked about. I talked about our sustained organic effort to grow. I talked about our 5-year organic growth rate. I talked about our non-GAAP business model of high growth and operating margin. I didn't talk about EBITDA margin target of 48% and a free cash flow target of over 38% of the business. We talked about end market. We didn't talk about inventory. Our long-term goal is to actually carry a slightly higher inventory of 130 to 150 days to be able to better serve our customers than we have been able to in the last couple of years. Invest in capacity for trailing edge technologies. As you have heard, many of our foundries are now saying that they will not invest in trailing edge technologies. Many of the analog and microcontrollers are built on trailing edge technology. So that is putting some of that burden on us and we have expanded our CapEx target between 3% and 6% of our revenue and in the current year probably will be higher than 6% where the guidance has been. And then the increasing capital return to our shareholders. I talked about as we hit 1.5x leverage ratio, we will then give 100% of the cash back to you. And very strong business foundation based on culture and profitability. So winning formula, just summarizing some of the same things I talked about, organic growth rate of 10% to 15% with expanding gross and operating margins, significant cash generation, which we give back to the shareholders and extend a strong foundation that has been built on culture and sustainability. The best of Microchip is still ahead of us. And the final slide, and I will close with this, a compelling valuation. So on the Y-axis is the next 12 months forward PE multiple. Then if you look at on the extreme right, that's where the Philadelphia semiconductor index forward PE multiple is at 16.7%. ADI is right there. TI is slightly ahead of it. And Monolithic Power and Silicon Labs are kind of outliers. Microchip on the left is at 13.2%. If Microchip multiple were to catch up and as we're paying down debt, and increasing the cash flow back to the shareholders over the next couple of years, if Microchip multiple without any other growth were to simply catch up where the Philadelphia semiconductor indexes or TI, it will require 30% to 50% growth in stock price just to close that multiple. And on the top of that, the earnings are growing substantially. Like in the current quarter, earnings growth is 45.2% versus the same quarter a year ago. So I think all that strong combination of growth, business durability, increasing profitability lots of free cash flow generation, leverage reduction and enhanced capital return strategy that we have talked about, all that available at a significant discount I think creates a strong, compelling value proposition. Thank you very much.

Sorry. Thank you, Steve. So we have a little bit of time for a few questions, and I really wanted to ask you this question, Steve, because it's -- I think it's something that's on investors' minds a lot, which is pricing in the industry. And we all know the historical pricing. We know how pricing has been through cycles. It just feels like things are a little bit different now. And by the way, there's 2 camps out there, right, of thinking here. Some investors believe that this is transitory. It's very similar to global inflation. Eventually, it will cool down. But then there's also a camp that say, "You know what? No, it's not that transitory. The industry has changed. Semiconductors have become critical for everyone's economies." So I would love to hear your thought on pricing, especially since you've seen it year in and year out for so long.

So one of the things you have seen in the slide I showed on gross margin over the cycles, we never lowered our prices during the cycle when there is a down cycle. Majority of our products are proprietary today, 95% plus of our revenue is really proprietary products, which are designed in. Almost a decade ago, we started training our customers that we don't give year-over-year price decrease. The things that we buy, we have to pay more to the people sometime cost of products we buy are inflationary in chemicals and gases and other things. Why is semiconductor industry, the only industry where the price go down year after year? We begin essentially saying there's no year-over-year price decrease. We sell on value almost a decade ago. Now a decade ago, we would win only 20% of the time and 80% of the time, the buyers will beat us down to really get a year-over-year, some sort of low single-digit kind of price reduction and we kept winning more and more often, the 20% went to 30% went to 40%, and pre-COVID, we were winning them 80%, 90% of the time that we were not giving a price reduction. So that has nothing to do with COVID. We had achieved that going from 20% to 80%, 85%, 90% pre-COVID. And then since COVID now the prices have gone up, we had increased some prices over the prior 10 years, especially on the trailing edge technologies. And now with all the costs that foundries and assembly test subcontractors have passed to us, some of the equipment costs have gone up because the used market for the equipment has dried up. And even on trailing-edge technologies, you have to add new equipment. All that has been well explained to the customers, they know this and our customers in large majority are not expecting that these prices go back down in the next cycle because some of the costs are now institutionally built in, higher cost capital has been put in place. It's depreciating and they can't get a price decrease. So I'm confident that our prices do not go down in the next cycle.

That's great perspective. The other question that I have is a bit more Microchip. So you talked about this big delinquent backlog. And obviously, that means you have to prioritize. And some of that is captured in your PSP program, obviously. But how do you prioritize the other big chunk of backlog? Is it based by customers' end market? I mean do you have conversations with the CEO of those companies to sort of make sure that it is true demand?

Yes. The engagement with customers is all-time high. Our executive team is in daily escalation calls with multiple customers through the day. We have understood every customer's minimum requirements to keep their factories running. And the first goal is that we provide minimum and then we provide above that, more than the minimum with the remaining capacity. So the goal is not to provide everything to the automotive and shut down the consumer appliances or industrial. The goal is to keep everybody alive. We serve 120,000 plus customers around the world. And in each one, many of them we have served for a long period of time. Longevity, consistency, delivery over cycles for 30 years, that has been the hallmark of Microchip. So I still, in my current role, I see customers, I talk to them all the time and go to work still 3 times a week. And with all the information that I personally experience, customers are telling us that Microchip has served them the best in this environment despite the shortages. Why? Because we didn't prioritize all our availability to 1 market, industrial or automotive and starved everybody else. We kept everybody alive. And since we did that, everybody can complain, but also everybody is happy that they got served better than from any other companies. So this large backlog -- customers could have canceled this backlog if they didn't need the product. I mean they have a good excuse saying, "You haven't supplied this to me quarter-after-quarter, you're delinquent, I no longer need it." And they haven't canceled. In fact, many of the customers are expediting. There are daily expedites, the daily escalation. So the backlog is of very high quality, and we have gotten there through a very, very substantial engagement with the customers. We probably serve about 5,000 customers directly and the large tail then is through distribution. So both direct customers as well as distribution, there has been a very, very high level of engagement.

Great. I just want to wrap up with one last question before we do our lunch. So you talked quite a bit about the TSA, the TSS, the total system solutions business. And just give us a little bit perspective what inning we're in because you said it's been in the works for 10 years, but I'm sure some customers they may be in the sixth inning, but I'm sure there's a lot of customers that may be only in the second inning. So overall, where would you say we are in that process of capturing so much more value with customers?

I think we are barely probably in the top of the second inning. So for years, we were building the entire ecosystem. When 8, 9 years ago, I talked to a customer and they said, "Yes, sure, we're buying your microcontroller. We'll look at your analog." Then they will look at handful of analog parts and they won't find the right fit. And they go back to TI or ADI and they do that again in their next design, again in the next design, then eventually say, well, you don't have enough deep enough portfolio for me to meet my needs. I always have to go to somebody else. So I don't think the first inning even began until about 2018, '19, maybe 2, 3 years ago. And I think now we're just really in the top of the second inning and there's a long runway ahead where there are some customers who are buying the whole plate from us, the steak and all the trimmings are all ours. So those are in the ninth inning but there are customers who are still in the first inning. I think when I just average it overall regarding where the customers are, I would say, we're in the second inning.

Great. That's great perspective. So with that, we run out of time. Thank you, everyone, for coming to the Microchip session. And Steve and Sajid, thank you so much for coming to our conference. Really appreciate it.

Thank you very much.