Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

So you have 60% of your foundries [indiscernible] internally, okay? And is there a difference of technology mix, which that would come to mind this, that kind of thing [indiscernible] what that strategy [indiscernible].

Sure. So just for anybody listening in, the question is really on what do we in-source for wafer fab and what do we outsource and why is that as it's based online with our process technology. And it absolutely is. I mean, we've done a lot of acquisitions in our history over the past 12 years, and we've acquired a lot of companies that have outsourced their production. And with that, we've essentially stepped into their shoes in terms of the foundry partners that they are using for historical products. And then we determine the best foundry partner for future development. But there's a lot of process technology that we can't do internally. We go down to about 110-nanometer within our own factories, and anything below that, we are reliant on the professional foundries for. We have 1 6-inch factory, 2 large 8-inch factories internally. Anything that is 12-inch, we outsource the professional foundries. And we're doing some things to internalize some of that 8-inch production that is currently at some of our foundry partners. We took a license that we've talked about publicly to bring one of their process technologies in-house into our Oregon factory, and that development has been going on for the better part of a year now, and we expect that to come online for us in 2023. So today, we do about 40% of our wafer fab in-house. We expect that to gradually move up over time to about 45%. But at this point in time, we really feel that we are going to continue to be dependent on the professional foundries for our 12-inch needs and advanced process technology needs. And advance to Microchip in terms of process technology is much different than it might be to somebody that's more on the leading edge.

Okay. Any other questions? Great. So Eric, I believe that CHIPS Act is being signed today. I was wondering if you could just comment on the CHIPS Act and do you guys see any sort of benefit to you from it?

So we do actually, our CEO, Ganesh Moorthy, is at the White House this morning for the signing. And I think that was happening in as we speak or just a few minutes ago. So we're excited about the opportunities that it brings with the investment tax credit. So what that is, it's a 25% direct credit against our U.S. taxes for investment that we're making in semiconductor equipment and facilities in the U.S. for items that are placed in service between 2023 and 2027, I believe, is what it is. You don't get the full 25% benefit because you reduce the depreciable basis of your assets. So it turns out to be about 19.5% benefit. But it's still a great benefit for us. In terms of funding under the CHIPS Act, obviously, we believe we are a prime candidate for that. As I mentioned before in my introductory comments or in the response to one of John's questions is we are the largest supplier of semiconductors to U.S. aerospace and defense. So from a national security perspective, that should be viewed quite favorably. And we've really been educating congressional leaders over the course of the last year in terms of how trailing-edge technology, which would be what I would describe what Microchip does for the vast majority of our products, how important that is for building really all systems. If you're only investing in the advanced nodes, you can't create a system because that's just a piece of what that system needs. So we are going to aggressively go after any funding that we can get. But whether we get $0 or whether we get $1 billion, I have no idea. So we'll keep working it through our governmental affairs, government affairs people and operations team and see what we can get.

Great. Thanks, Eric. Maybe we can talk a little bit about PSP gear. PSP, I think you talked about remains much greater than 50% of your backlog. However there are some concerns that as we go through a potential correction at some point that customers are going to try to renegotiate some of these long-term agreements. I think, over the last week or so, some of your semiconductor peers maybe with more exposure to the mobile markets have talked about trying to renegotiate some of the long-term wafer agreements that they signed last year. So I'm just wondering if we do see a correction at some point. How do you see this kind of playing out with your customers and their long-term commitments to PSP?

Okay. So again, the PSP program requires a customer that's participating in it to provide us with 12 months, at least 12 months, of noncancelable, nonreschedule backlog. And in exchange for that, they get priority in supply. It's been a great program for us. Customers that have been participating are continuing to place additional backlog with us. I talked about how the PSP backlog in absolute dollars grew from the March quarter to the June quarter. And you can think about this is that every month that rolls off, that customer is required to give us the next month, 12 months out in time or month 13 of backlog, and we aren't seeing anything material happen with that at this point in time. They're continuing to place that. But what we feel about that PSP backlog is we have much more solid backlog than we'd have without it. If we just had standard 90-day cancellation term window, we'd have just a mountain of backlog piled up in month 4 that customers, which could continually just push out so they didn't have a financial commitment to it. So they have skin in the game in order to make a commitment like that, they have to go to higher levels within their companies and say, hey, this is what we see our requirements are, and this is what we place. And we don't know if they place 100% of what they're expecting in month 12. Do they book 80% of that, 70% of that? But what we believe is that over time, as things start to change in the marketplace from a supply and demand perspective, is that customers will slowly start making adjustments. They might be booking 100,000 units per month today. And then they might say, hey, the next month, I might have placed 80,000 or 50,000, and we're going to be able to make trends and assessments from that. We service 125,000 customers. So 1 customer doesn't make a difference. But make trends from that and then start adjusting what we're doing from a capital intensity perspective, our hiring plans, our investment in inventory. And it's not like you just flip a switch and 125,000 customers turn off overnight. I think these things happen a little bit more gradually. And again, we think we have better, more solid backlog that's reliable from our customers because of the commitment that they have to us. So it's not our intention to not hold customers accountable for the backlog that they placed on us, but we think that they will gradually make adjustments to their backlog to adjust to the environment.

So Eric, you mentioned that the booking trends remain pretty healthy in PSP. Can you clarify how the booking trends trended in the quarter versus the previous quarter? Can you comment on whether your cumulative PSP backlog did increase or not?

Yes. So our cumulative PSP backlog has grown in every publicly reported quarter that we've had since we put the program in place. So yes, it continues to grow. Customers are active in the program. And we aren't really seeing significant signs of any wavering on that. As I said, it grew quarter-on-quarter in terms of total backlog.

Great. Obviously, I think there's a little bit of nervousness here just in terms of being a peak cycle. But obviously, if things do soften, I'm wondering if you could just talk about just what sort of kind of cushion you guys currently have relative to your backlog?

Okay. All right. So my interpretation is that there's more than a little bit of nervousness from the Street in terms of what they're seeing in inflation and rising interest rates. But we're running our business based on what the signs are that we are seeing. And as an executive team, we evaluate a number of leading indicators every week, every month in terms of what we're seeing. And there's no significant red flags at this point in time. There's concern by some that, hey, maybe there's some inventory building at customers. And with 125,000 customers, there likely is some inventory builds in certain places. But the level of escalation calls that we are continuing to get are very significant. And so with that, we know there's still many customers that are entirely needed capacity. But when we look at how would we manage through a soft landing, I think we've got a number of things that are working in our favor. One is this PSP backlog, which we talked about, I think, will give us very much advanced warning of when things are changing in the marketplace and kind of back off on our commitments. We have a much lower level of inventory on our balance sheet than we want to have longer term. So we are comfortable, given the strength of our balance sheet today with our leverage have coming down significantly. 4 years ago, Microchip was almost 5x levered. Today, we just ended the last quarter at just over 2x where we reduce again nicely this quarter. So the balance sheet is quite strong. we can make that investment in inventory. We build products that last for many, many, many years. So we don't really face an obsolescence issue. So that's something that we would do. Our channel inventory, we do about 47% of our business through the channel. Channel inventory is very low. It's sitting at 19 days. The all-time low is 17 days. But if you go back 10 years, that's ranged from that 17-day low level to 37 days. I don't know where distribution inventory could go. But clearly, distribution needs more inventory than they have today to properly service customers' needs. So that's another lever that we have to pull. From an operational perspective, or I will call it OpEx perspective, we are paying bonuses at a very high level to our employees today. We have a highly variable compensation program. And if the world fell apart tomorrow for Microchip, we could stop that and really manage our OpEx to a much lower level in terms of dollars, and we believe, maintain very high gross and operating margins through the cycle. We have some slides that we have on our website that looks at the last 15 years of history, and that history is a little bit clouded by all the acquisitions that we've done. But it shows you kind of peak to trough gross margins through any cycle has been about 300 basis points. And that was with doing more of our production in-house than we do today. So back in those days, we would have had higher underutilization charges when we're running our factories slower with only 40% of our production from a wafer fab perspective done in-house. That's muted. And as I said, we're comfortable building more inventory in the current cycle than we were last cycle because our leverage has come down so much. So I think all those things really kind of point to us being able to manage through this appropriately whatever the environment is.

So on that part, I just wanted to follow up on pricing. I think there's a lot of concerns that companies in this cycle have been overearning. I know you guys have been dealing with higher input costs like everybody else and have had to initiate kind of price increases. What's your level of confidence that pricing is going to be able to hold if we do correct? Or would you expect some level of kind of pricing adjustments going forward?

Yes, that's a question that we get a lot from investors. And we have raised prices last fiscal year, we had a couple of pricing increases. But really, we've been passing on the cost that we -- with the increased costs that we've been getting from our supply chain to our customers. And our customers are seeing inflationary elements in all pieces of their business. So it was not a surprise to them. Capital equipment is much more expensive today than it was for us in previous cycles. It used to be in wafer fab, we would go by used 8-inch equipment on the marketplace. That's not available any longer, right? So we're buying new equipment. That's more expensive. There's been a ton of wage inflation, right, that has impacted not only our internal manufacturing, but that of our suppliers. And raw material costs have gone up. And so we've been fair with our customers in terms of just passing on the costs that we're seeing and margining that up. So we're earning Microchip margin on it, but we're not price gauging them. And so we think these costs that have changed are permanent in nature, and with that, we do not expect to have any reduction in our ASPs. And again, being fair with our customers, having an open conversation with them. When we change prices, customers have the ability to cancel their backlog on us. And under the PSP program, they have 5 days to evaluate that pricing increase and say, hey, I'm not accepting that price increase, and then it comes back to Microchip and we can either allocate that supply to somebody else when we have tons of customers, in most cases, waiting for that product. So that's something we can do. We can say, hey, too bad customer, you just can't have the old pricing, or we could ship to them for a period of time and have it implemented at a later date. So we work well with our customers, and we've really seen no material cancellations from the price increases that we've implemented. And we don't know. We're not planning another price increase right now, but there's talk about foundry prices increasing again in 2023. And if that happens, we would not hesitate to pass those costs on to our customers. And this is design and business to proprietary products. 98%, 99% of what we sell is proprietary. So it's not pin-for-pin compatible with the competitors. And we think our competitors have actually found religion on pricing also. I mean, there's been a lot of consolidation in the industry, and I think people are behaving better -- other of our peer companies are behaving better than they might have in the past. But our pricing strategy is very firm.

Following up with the pricing question. So just operationally, when we think about business with 125,000 customers. These price increases, is it a Microchip sales going into one of your 125,000 customers with instituting a 5% or 6% price increase? Are these the C level indicator, all these things are happening, and so you want to have the price increases?

No, it really happens on a customer basis down at the sales personnel level that it's rolled out. And a lot of those 125,000 customers go through distribution. So we engage closely with our distributor partners to make sure that message comes across appropriately.

Because at that level, I would expect the pushback to be a lot. I mean, at C level, we get the inflationary impacts that once the inflationary impacts subside next year, wouldn't it be normal for these sales force and much of this are getting a lot of push back from their, because they were 60% last year, but now your margin comes down, whatever, 30-point percent, so why can't you get it done, would you expect that [indiscernible]?

Okay. So just so people online can hear the question is, if the supply-demand environment changes, won't customers come back and say, hey, you gave us an x percent increase last year, but now your costs are coming down. Why shouldn't we benefit from that? And the honest answer is, if our costs were coming down, that might be the situation, but the majority of the costs that we are seeing increasing is going to be on cap equipment, right? That's what the foundries are seeing, right? Their capital equipment costs, the investments they are making that they need to pay for with their profits are increasing. So those costs don't go away, and the labor costs don't go away either. If freight costs come down, that's a very small piece of our overall cost of sales and doesn't really move the needle from a customer's perspective, and we are continuously seeing some pricing increases because of the inflationary nature of the economy right now. So we don't see that. But again, we'll be fair with our customers, but we think the vast majority of cost increases that we've seen in our business are permanent cost increases, and we would expect our customers to share in that in terms of what they're paying.

Great. With that, it looks like we're out of time. Thank you, Eric.

Okay. Thank you, everybody.