Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

All right, we're on. So welcome, everyone. So I'm Chris Caso, Credit Suisse semiconductor analyst. And our next presentation is a local company, a staple at the Credit Suisse conference for many years. And I'm pleased to be the first time. I get to introduce you at the Credit Suisse conference, Microchip Technology. With us from Microchip is Steve Sanghi, Executive Chairman; Ganesh Moorthy, President and CEO; and Eric Bjornholt, the CFO. Ganesh, you're going to start with some slides and prepared comments, but gentlemen, all of you welcome. Thank you for coming.

Thanks for having us.

All right. Thank you. Before I get started, during this presentation, we will be making certain forward-looking statements about the future financial performance of Microchip, such statements involve predictions, and actual results may vary materially. And we refer you to our filings with the SEC that identify certain risk factors about the company. That's the shorthand version of this slide. So a quick overview of Microchip. We have a broad portfolio of products that go into deeply embedded solutions, microcontrollers, analog, wireless, networking, timing, a really nice set of products that complement each other that go into these systems. We are in fiscal year '23, halfway through our fiscal year, we're at an $8.1 billion revenue run rate. It's an elite category of gross and operating margins and returns to shareholders. It's a diversified business that is also very resilient and plays in highly durable markets with what we have. And it's a solid track record of shareholder value creation and also shareholder returns. The purpose for -- that drives us is about empowering innovation. And this is empowering innovation that improves the human experience by providing smart, connected secure solutions. And these are just an example in different end markets, how our products end up being that ingredient to empower the innovation. So in many different end markets, our products play on a broad basis across them. Our results that we announced just under a month ago, records all the way from revenue to gross margin to operating profits to EPS to debt reduction to our leverage ratio, so almost any metric you pick, we had a record quarter in and free cash flow continues to be a strong part of what the company is able to generate and the capital returns continue to increase quarter after quarter throughout this time frame. The fiscal year '22 revenue. So this is measured at the end of March. This is what gives the company the durability of the end market. So you can see that other than the purple slice, 14%, which is in consumer appliance, everything else is in really still strong end markets and ones that have long life cycles associated with them. And even in the consumer, the smallest piece of the [ same ], a high percentage of it is replacement of consumer appliances. So we don't have much consumer electronics exposure. We have a lot of home appliances. And while that has been weaker, it's been more than made up for the strength in industrial, automotive, data center, comm infrastructure, et cetera. And even in consumer appliances, we have a high replacement market for existing homes that takes place. Our guidance for the December quarter was to be able to grow 4% at the midpoint of that guidance, more improvement in the gross and operating margins and record EPS as well. We reiterate that guidance yesterday. And importantly, we had at the conference call in early November, and again yesterday with our update, said, we will grow again in the March quarter, and we are as confident of that today as we were a month ago when we did our earnings call. And then you can see the long-term model is starting to get to where the results today are approaching that in many of the dimensions and then we will continue to work on improving the current results until we get to and past what the long-term model is going to be. We obviously recognize that many of you are concerned about, hey, what's happening in the macro? Why are you not affected? How are you planning for it? And we recognize that there are macro conditions that are weakening. We just don't see it in our business. And I think it has to do with the fact that we have these end markets which are much more durable. We have capacity that is constrained in the product lines that we manufacture. So the opportunity for excess inventory is diminished. And we've done a lot in terms of our own idiosyncratic growth with respect to focusing on total system solutions, bringing all our products to bear and customer solutions and the end markets and the megatrends that we have. And we've outlined a plan of if and when we see weakening in the market, what would we do and how would we preserve the model, preserve the model in terms of being able to cut gross margins, operating margins, cash flow to remain strong, and I'll show you in a minute kind of how that has been done over previous cycles and the history for where we've been. So first on the growth over this long period of time, almost stretching 30 years, that's been a 16.2% compounded annual growth rate. And what we have guided to is a 15% -- quick 10% to 15% growth over a 5-year period of time, starting with our fiscal year '21 baseline. So we remain on that track, and we continue to see good, strong long-term growth. Now there's always been questions well, is the industry still cyclical, cyclicality gone away. And you can see we're still a cyclical industry, the shape, duration, all of that has been different in different cycles. I don't know what this cycle will look like, but it is, at some point, cycles do come to an end and where they're at. So the question is not, is there a cycle. The question is, how does one perform through the cycles. And rather than trying to predict where it's going to be in the next one, I want to show you some data on how have we done it in previous cycles and then pick the cycle that you think is most likely to be what is ahead of us. And you can see how have we done in the history with those kind of cycles. So first is to look at the gross margin. So the non-GAAP gross margin targets, the blue line is overlaid on the cyclicality, which is the red line, which is the industry cyclicality. And you can see that over this whole period of time from peak to trough on any cycle, including dilutive acquisitions that we've had in many cases, has been less than 300 basis points that the gross margin has declined over that period of time. And in fact, once you go past all the acquisitions, which is 2018 and beyond, even that is less visible in where we're at. But that shows you the resilience of what gross margin does organically, how we have improved it during the acquisitions during the time when we were more acquisitive. Equally importantly is how has the operating margin performed over that same time frame. And you can see the same pattern of resiliency through the cycles, yes, it does decline, but it's a limited decline over that period of time, far less than what the industry cyclicality has been. And a pattern of higher highs and higher lows over time, resulting in the highest gross margins and highest operating margins that we've had over the last year. And finally, when you look at cash and free cash flow, and this is one where we're able to moderate where the cash consumption is for CapEx in a slower cycle. Our CapEx come down dramatically. And so while revenue may come down, the CapEx reduction more than makes up for that. And on the OpEx side, we are very good at being able to control our discretionary expenses, but also have a high component of variable bonuses that are able to bring down the expenses in a change in the cycle. And you can see throughout these cycles, ups and downs, the cash generation -- the free cash flow generation has been pretty strong throughout that whole time frame. A year ago, when we did our last Investor Analyst Day, we kind of outlined Microchip 3.0, and 3.0 really built on a strong foundation of 2.0 and 1.0, and it's been our journey over the prior 20 years. And let's take -- it's a good time to kind of look 1 year into Microchip 3.0, how are we doing? And so the growth on an organic basis remains a key component of our strategy. We're doing extremely well. Again, this year is continuing to grow at the mid-20s percentage to the first 2 quarters of the fiscal year. A 5-year organic growth rate using fiscal year '21, still tracking well inside of that 10% to 15% and even assuming any kind of a down cycle, we think we're nicely on track for that. Gross margins are at the upper end of the range we have provided and operating margins are really above the upper end at this point in time of the long-term model we have. EBITDA is running at about 50% at this point. Free cash flow, we got to make some more improvement, but we're in that 34%, 35% range, and we will continue to get the percentage of free cash flow off as well. We talked about the diversified end markets. That's been a very key part of how we have weathered the storm in the changes in the industry that have been taking place over the last 3 to 6 months of time. Our inventory, we bumped it up, but we have excellent products that have very, very long life cycles, and we are building up some of that inventory in raw materials and other areas. And we're comfortable that inventory has little to no risk of absorption. We are investing in capacity at a 3% to 6% of revenue range. We're at the closer to the higher end at that point in time. And that capacity allows us to balance our internal and external capacity in such a way that we get good gross margins. We get control on some of the capacity corridors that are more constrained and give us a good return on investment with what we put into it. On the capital return, we started a year ago at a 50% of free cash flow being returned to shareholders with a portion of it in dividend and that dividend has been growing at about 9% a quarter sequentially, almost 40% a year on an annualized basis. And the balance of it going into share buybacks. And so that has continued to grow from 50% to 52.5% to 55% to 57.5% to 60% as we go along. And the leverage ratio has continued to come down. We're just about 1.84x as of exiting September. And we will continue to pay down some of the debt and continue to bring down the leverage ratio. And at some point, we'll start to do 100% of the free cash flow return back to shareholders. And finally, what we do is as important as how we do it and 2 critical parts of our foundation. One is around culture and how we do things and how the team operates and second is around sustainability and both what we do to enable it for our customers, but also what we do to practice it for ourselves. And so I would tick the box on all of these -- well underway. In some cases, it's -- we're almost at the goals that we had set and it continues to be what guides us in terms of our actions. So the winning formula we see is a combination of consistent growth, growing that 10% to 15% organically, generating significant cash and the increased capital that we're able to do as that continues to improve and we bring the leverage ratio down. And all of that virtuous cycle being built on a strong foundation. And I absolutely believe the best of us is still ahead of us. And even in today's environment, we believe that we're providing some very differentiated views of how this business can run. And about the only question I have is it's a great time to be buying into these shares at the valuations that they're at. And I won't bring valuation into Chris' thinking again, although he might bring that up in his own questions. So on that note, I want to say thank you and hand it back to Chris.

Well, thank you. Yes, and we'll certainly get to some of that. I thought we were going to stay away from the price target and rating questions for now, but all fair for the arena. Maybe start with this and something that's certainly on people's minds and in your conversation, following Microchip for a long time, a lot of us have come to view Microchip as indicative of what's happening in the entire industry. And historically, I think that's been because of just the sheer breadth of your customers. You touch so many different customers that oftentimes, you would see things before the rest of the industry and not too far before. I want to give you the opportunity to speak to what's different this time. Is it this cycle? Is it that Microchip has changed since the acquisitions that you have done? And so what -- and certainly, you've seen some weakness as others. But what's different now in Microchip and where the cycle as compared to the past?

The mix of the business has evolved over time. And if you look at our end market exposure today, that mix is dramatically into those end markets that have done well or remained quite robust. And therefore, when you look at the weighted average of what our business is performing in those end markets, it is different from what it was, say, 5 years ago. And certainly, the last major acquisition we did with Microsemi, we brought 3 new components, aerospace and defense, data center and communications infrastructure. And all those 3 have continued to do well. The Microchip before Microsemi had industrial and automotive, and we've done more of that over the last 4 or 5 years. And so consumer was a much bigger part of our business 5-plus years ago. And I think over time, we have selected more of our new design activity, our pursuit of growth opportunities that are in the more durable end of the segments. That's one change. The second change is with PSP, we have a mutual commitment between our customers and us on how are we taking scarce resources and applying it to who is committed to be with us and who has a view of their business growing with our business. And I think the PSP backlog we have, the overall backlog, but particularly the PSP backlog has given us far more visibility and durability for the demand that we see. And then finally, maybe the trailing edge of capacity, which is where all the specialty technologies that we require remains constrained, has been underinvested for -- by the industry at large. And so the opportunity is to be able to overship or to create a major inventory issue are far less in those areas. And I think those are all perhaps changes from 5 years ago on where things are at.

Great. And I'd like to actually dig on each of the 3 points that you made. And maybe starting with end markets. And certainly, all of the other companies that have been on the stage today have expressed similar sentiment with regard to the industrial and auto end markets. Clearly, there's no tangible signs of weakness now and there's a lot of confidence that will continue going forward. Maybe you could speak to the view of that. And is it that -- and there's several theories why that may be? Maybe we've been supply constrained for the last 12 to 18 months. So some of the excess inventory that had been built in prior cycles just wasn't able to be built. Perhaps there's enough secular growth in some of those markets, such as automotive, that the growth rates are strong enough that does need to be a downturn. What's your view with the industrial and auto end markets?

I think there's a bit of all of that that's in there, right? There -- the markets are stronger. They're coming off of very weak 2018 -- 2019, 2020 time frame. They haven't been able to catch up for quite some time. And then there are new trends driving. So take industrial, for example, the whole renewable energy, factory automation, Industry 4.0, all of those are pretty large drivers of growth. And in general, in many, many end markets and many market trends, increased semiconductor content is what is driving differentiation for our customers, driving value for the products that they're creating. And I think that is creating a tailwind that if I go back 5 years ago, wasn't as strong as it is today. Those are the megatrends that we have spoken to, whether data center, electric vehicles, sustainability, driver assist, 5G, IoT. These are all major trends in which semiconductor content, irrespective of whatever short-term issues they're going to be are pretty strong drivers for how those markets are taking shape and how the players in those markets are delivering value.

All right. With the other element of that, the PSP program. And I think you've spoken about it a while. I think we understand why the program exists, why the customers want it to exist because of the scarce supply. Everyone wants visibility, you want visibility on the backlog. They want visibility on the supply. What do you speak to the non-PSP part of the business? Because that's the part where there would be likely more variability there. How has that backlog been changing? Does that provide you any clues looking forward into where revenues might go over the next 18 months?

Sure. So historically, backlog in prior cycles was all non-PSP and often in prior cycles, the cancellation window was anything outside 30 days. And what it drove in a constrained environment was piling on of tons of bookings that people just said, just in case, I'm going to place all these because it's easy for me to cancel. And we have non-PSP backlog. It's a smaller piece of this. And overall backlog is high. PSP is a high percentage of that. We have seen more cancellations, obviously, in the non-PSP side because that's where people can speculate and place more orders if they wanted to and where they're at. But the foundational business is delivering PSP priority using the scarce capacity and making it a tool that our customers have used so that they protect their business. We don't force anybody to take PSP. It's a choice that a customer makes, and it's a choice that they renew every month as to do they place another month of PSP backlog or not. And so are there pockets where people have placed more backlog in the non-PSP side? Sure. But if I look at all cancellations across the board for Microchip, at the conference call a month ago, I said it's under 5%. We checked again in the last couple of days, looking at the last 90 days of time. It's still running under 5% of where is that. So it's not particularly dramatic on the non-PSP side.

Yes. We should say that, that is on a mountain to backlog. We have a huge amount of backlog.

Right. More still more backlog than you can fulfill at this time?

Absolutely. Our unsupported backlog, ending September quarter. So orders that customers want to deliver it in September, which we couldn't deliver was larger than the revenue we shipped in the entire quarter. So that's how far behind we are.

And that gets to the premise of the soft landing and that the backlog is so high that even if we cut it out. And so far, the cancellations have been small enough such that you're taking off business that you wouldn't have been able to ship in the first place.

That's right.

Yes. It helps to support somebody who is unsupported when there's a cancellation that comes about. But there's so much that is unsupportive that it's a long way before all of that gets caught up.

Okay. I'll pause a moment if there's a question from the audience, if there's anyone. Randy has a question on.

I'm curious, some of the Asian foundries have seen pretty big pullback in consumer, which I think should be freeing up more capacity. Are you starting to see more potential to move product and clear up the constraints that way?

Incrementally, capacity from the foundries is more constructive today than it was 6 months ago. There are many corridors in the foundry that have seen improvement. There's also others that have not seen enough improvement. Now it's not just consumer capacity. It needs to be the specialized capability, which all supports analog, mixed signal, nonvolatile memory, all combined to create what we need. And those are not easily fungible, but has foundry capacity been incrementally more constructive? Yes, it's still far below what we need in many cases.

One follow-up, in China, China foundries have been particularly aggressive. How much of your capacity can you get from there? And are there any changes in terms of end customers, if you place orders into China foundry, just with more restrictions geopolitical as far as it makes you hesitate to use some of that available capacity?

So China foundries are a very small percentage of our foundry capacity. And so there are customers who have expressed questions, concerns with respect to that. But from our responses to them, it really affects a very small piece of the total business.

Let me follow on and there's a lot to talk about. But with regard to the capital return program. And you're pretty close to the 1.5x debt target. So maybe you could kind of speak to even in the event that macro does weaken further, your level of commitment to that? And what should we expect? Could this potentially be a situation where if the market weakens that you're ready at your debt target and you have the ability to return more cash to investors and therefore, kind of soften the cycle in that manner?

I'll give a quick answer, and then I'll let Steve elaborate more. So the Board makes that decision every quarter, right? They look at all the factors. Directionally, we're committed to where we're going. But there are also constant changes in the environment that we need to assess and observe and decide. So there is no lack of thinking or commitment in terms of what our commitment is. But how we respond to where the environment is at, we'll adjust as time goes on. Maybe Steve wants to answer more.

So what we have been doing is we have been increasing the percentage cash return to shareholders by 2.5 percentage points every quarter. We began with 50% about a year or so ago. And then following quarter was 52.5% and 55% and 57.5%. In the current quarter, we are returning 60% of the cash back to the shareholders and a combination of stock buyback and dividend, next quarter would be 62.5% and the quarter after will be 65%. So by the time we get to that 65% in 2 quarters, we expect we will hit the 1.5x leverage. And once we hit the 1.5x leverage than what we have said before is then we will rapidly accelerate it towards 100% return back to the shareholders in a combination of dividend and stock buyback. The big debate is, and we got into it last night at dinner with the investors. Some investors felt that we said, once we hit 1.5x, the following quarter, the return will go to 100%. What we had implied was that we will accelerate it and 16% to 5.5% will go to 100%, maybe in big churn, 65.5%, 75.5%, 85.5%, 95.5% and 100%. Board has to make that decision and Board hasn't met to make that decision because it's still 6 months away. Meanwhile, we're gathering input, we got investors' input yesterday. We're talking to other investors in other conferences. We're happy to take your input after the meeting, any time you like. There are clearly 2 sets of investors in earlier one-on-one meeting with investors. There were 2 investors. One said, go to 100% right away, buy the stock, stock is cheap. The other said, pay down more debt, interest rates are very high. And if you get there within a year, it's okay. So there is no consensus among yourselves. And there is no wonder there won't be any consensus either in the Microchip's management team or the Board, but we will come up with an answer, and we'll convey that answer to you most likely in the May earnings conference call.

It is a key assumption change from last year in November was interest rates are under 1% at that point in time and with where it is today and where it is headed. So it does play into the thinking that as the environment adjusts, and we need to rethink, does all the assumptions we made still play out or not. So stay tuned.

So one of the investors said last night that if we were to not immediately go to 100% accelerated dramatically, but not immediately go to 100%, it would be where as a negative sign because we're not confident on our business, we think the business would go down and the leverage will go high. That's why what we're doing it. So no matter what we do, some of you are going to read negative out of it. But we'll make the right decisions as owners of the business. Interest rates have continued to go high. We have to refinance that debt, some debt, which is under 1% today and refinance it to over 5%. In that environment is the right thing to pay a higher interest rate and give all the cash back to the shareholders or to take some of it and bring the leverage down further and pay down the debt. We don't know what the answer is right now, but we'll figure that answer in the next few months and give it to you.

But to be sure, the factor that you're -- that's driving the decision is the interest rates themselves, the fact that you're in a higher interest rate environment, not your confidence in having a 1.5x debt ratio or confidence in the business.

Our confidence in business has nothing to do with it because we're very confident in the business. Backlog is very strong. It goes out a year and more than a year. I think if you simply saw the math problem, is it more accretive to buy stock? Or is it more accretive to pay debt? Then the answer is very clear. It's more accretive to buy stock. If you just -- it's all the math problem but it's more than solving the math problem. And that's what really Board has to consider.

And I think the bottom line is we're going to be at 1.5x very soon, and we will rapidly move to 100% free cash flow return. It's just a matter what the timing is. Is a quarter, is it 4 quarters, it's -- that's the debate.

Right. And it probably has something to do with where the stock is at the time as well.

It depends on where the stock is, it depends on what the interest rates are. Some people think interest rates will start going back down and other people think it will be 7%. So it's all those factors we'll take into consideration.

And as a final question, with debt that may come to maturity that would need to be rolled over, what's the maturities that are coming up? And what rates are we talking about?

So we have 2 maturities in 2023. One is in June. I think it's $1 billion, it's either $1 billion or $1.2 billion. I should know that. Sorry.

It's a $1 billion.

It's a $1 billion. And that is at a 4.33% rate. Our line of credit borrowing rate right now is about 5.15%. We'll have room on our line to do that. So that one isn't a huge factor. We have another one coming due in September of next year, which is at a 2.67% rate. And so that one has a little bit more material impact. It's the next year when these 1% bonds that we have in place come due, and those are definitely more material if we had to reset that at 5% plus.

That's also making a prediction of where rates are then in 2024.

Exactly where the spread is.

Yes. And we'll get a better view in 6 to 9 months which way interest rates are headed.

The one in 2024, if you were to refinance it, its current interest rate is 97 bps. And if it goes from 97 bps to somewhere in the 550 bps, that's an average. But we don't have a major decision really prior to that. Other ones are smaller, different.

But we did do a great job in getting that sub-1% rate on those bonds. So we've got to get kudos for that.

Yes. Indeed. All right. With that, I think we're out of time, but it's a great discussion. So thanks, everyone, for attending. Thanks, gentlemen.

Thanks, Chris.