Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

All right. I think we're ready to go. We still got some people filtering in, but we want to go ahead and get started. I'm Melissa Fairbanks. I'm the Semiconductors and IT Supply Chain Analyst here at Raymond James. Good morning to everyone. We are thrilled to have Eric Bjornholt here from Microchip, the CFO. I think Eric wants to make a few brief comments to get started, and then we'll go into the Q&A.

All right. Good morning, everybody. So during the course of this discussion, I'll be making certain forward-looking statements about the future financial performance of the company. I refer you to our filings with the SEC that identify important risk factors about the company. So Microchip has been executing very well. This will be our 9th consecutive quarter of revenue growth. We're going to post record non-GAAP gross margins, non-GAAP operating margins this quarter. We are actually getting right to our non-GAAP gross margin target, which is 67.5% to 68.5%. This quarter, the midpoint of guidance is 67.9%. Our operating expenses are below our target model. This quarter, we're forecasting again at the midpoint to be at about 20.8% of sales. So driving towards over 47% non-GAAP operating margins, the long-term target that we introduced just last November at our Analyst and Investor Day was 44% to 46%. So we're just executing very well in a challenged supply chain environment for us. We ended last quarter with unsupported backlog, meaning backlog that customers wanted to have us deliver to them in the September quarter that we couldn't deliver in September and we'll deliver in a future quarter that was in excess of the revenue that we actually achieved in the September quarter. So well over $2 billion of unsupported backlog. That speaks to the gap that we still have between supply and demand. And supply is coming on every quarter for us, and we do about 40% of our wafer fab in-house, the other 60% we're reliant on the external foundries. And there's still many capacity corridors that are constrained for us, and we expect that to continue throughout 2020-'23. We are making excellent progress on our deleveraging. Back when we acquired Microsemi 4.5 years ago, leverage went to about 5. And we ended last quarter with leverage of 1.84. Our target, again, that we announced at our Analyst Day last year was to get leverage down to about 1.5x. And then move rapidly from where we are today, which is about 60% free cash flow return to shareholders to 100%. So within the next couple of quarters, we'll meet that 1.5x leverage metric. And then the Board will make decisions in terms of how rapidly we move to 100% free cash flow return. But executing quite well on that front. Cash generation is high. We'll probably pay down another $300 million or so of debt in the current quarter and business is quite good. So there is a disconnect in semiconductors about what's happening with some companies versus others. And we think our end market exposure that we have is really helping Microchip. We still are very much supply constrained, as I mentioned. And we think our focus on providing total system solutions, which is a result of the acquisitions that we've done over the last dozen years or so, having really a complete embedded control portfolio that we can offer to our customers, and focus on some of -- the fast-growing megatrends in the industry is helping our design win funnel and positions us well for future growth. So with that, I'll turn it back to Melissa for questions.

Great. That was a great overview. We do have a much more recent update, too. Just last week, you reiterated your guidance for the quarter. December quarter revenue implies 4% sequential growth, and this is against some of your peers guiding for a sequential decline this quarter. I think you've even guided to another quarter of sequential growth in the March quarter. You kind of touched on the total system solutions. Can you maybe explain how that differentiates you and maybe how some of your acquisitions over the past several years that have helped you differentiate? And then beyond that, how much of -- not just the portfolio differentiation, but maybe some of the component shortages over the past couple of years. Has that impacted your backlog and your visibility into the backlog?

Sure. So first, on the portfolio of products that we have. So historically, again, dating back prior to our acquisitions, Microchip was known as a microcontroller company. And we are much more than that today. Microcontrollers are still the largest portion of our revenue, I think about 28% of our revenue was analog. We've got really any -- all types of connectivity in the portfolio. We have security products, we have memory products, we have timing products. And so all that combined gives us the ability to go into a customer with a working reference design, position the product portfolio and win the microcontrollers still, but then win much of the components that go around that, and that is an amplifier to our revenue growth and also makes us a much more valuable supplier to our customers. And so that's really been the focus of the acquisitions. And we get questions on M&A and what's next. And really, we have what we need to be successful. So we are not looking to do another large-scale M&A, we might do some small tuck-in acquisitions over time. but those will be more small, non-needle movers acquire some IP or a small technology team. And really we're happy with what we have. Obviously, there's a lot of organic development that we're continuing to do and new product introductions. But the portfolio is in a great place. The second piece of your question was what?

How much has supply constraints across the industry over the past couple of years impacted either the order rates or the backlog? Are you attracting new customers based on -- or landing and kind of expanding new customers where maybe they weren't able to be serviced by some of your peers? And then now they're understanding what your portfolio offers.

Yes. So the supply constraints have been challenging for ourselves, our competitors and more importantly, our customers. And we have done our best to support our customers the best that we can. We'll probably talk about this a little bit more, but we introduced this program called the Preferred Supply Program back in February of 2020 based on customers' requests in terms of how can I get more assurance that I will get the supply when I need it. And so what that program does is it has customers give us 12 months of non-cancelable, non-reschedule backlog. In exchange for that, they get priority of supply. And the program has been wildly successful. Customers who have participated in that program have been serviced well. And that backlog has been a very high component. It's well over 50% of our backlog today. And customers are continuing to place orders under that program. Essentially, every month or every week that rolls off, they then place the next week or month of backlog with us. And those trends are still quite good. The PSP backlog, as a percentage of total backlog, is still quite high and not really changing in terms of the overall percentage. So that's one way that we responded to customers' requests in terms of how can you support us better. And the engagement that we've got from that has been incredible. So it's not just Microchip having these discussions with the engineer, the purchasing manager. These are C-suite level discussions, executive-level discussions with our customers figuring out how we can better help each other and provide support. And we think that those relationships that have been built are going to be an amplifier on our growth for the future. So it's been a very successful program. Investors have some concerns on that program. And it's -- those concerns center around, well, do customers have visibility 12 months out in time. And if they don't, does that mean that those customers are absolutely going to be building inventory. And our response to that is investors have been asking us about, hey, there's weakness coming for the last year. And if investors have those feelings, if our customers -- 125,000 customers have those feelings, they are going to naturally adjust their order patterns, whether it be PSP or non-PSP backlog to adjust for that and heads themselves to make sure they don't get overextended. And again, every week or month that passes by, they have the opportunity to adjust their orders up or down in the future. And so we think that the backlog that we have in the PSP program is better than if we didn't have the PSP program. We have a typical 90-day cancellation window. And without the PSP program during the environment that we've been through, I guarantee you that our backlog would have been higher than it is with the PSP program. And we wouldn't have known which backlog was good and which backlog was bad, what to invest in terms of people, materials, capital equipment. And with PSP, it's helped us better navigate that for ourselves and for our customers.

I think that's a really excellent point. And it's important to note that not 100% of your customers order backlog has to go through PSP. They have the ability to run certain orders through the program. And then the rest just kind of manage as they normally would. Is that correct?

They do. PSP is a choice and customers can pick which products are on PSP and which are not.

Are there certain areas where you're seeing the backlog kind of more concentrated in the PSP for specific either product lines or end markets? Or is it just kind of very broad-based across your portfolio?

It's very broad-based. I mean, I would say, once the program got rolled out and there was significant challenges in the automotive industry, most automotive customers joined the PSP program, not surprisingly. But we've got consumer appliance companies that are on PSP program. Really, all end markets have participated pretty heavily in the PSP program. And this is just not a large customer program. It's rolled out to small, medium, large sized customers, to distributors, et cetera. And so we've got good participation across the board.

We've heard you and some of your peers talk about a soft landing before. And I know we never really got to test that soft landing in 2020 because of the pandemic. I think you've mentioned that the PSP program does actually help you manage through a softer landing than we would normally see. Is that because of the 12-month visibility? Do you see a time period where maybe you're going to get an increase in order cancellations or maybe your customers are not willing to re-up to extend their participation through -- extending by an extra week or an extra month? Have you seen any activity like that so far?

So we really haven't seen the activity, and we actually have a slide that we've had in our investor presentations for the last couple of quarters that talks about navigating and soft landing. And I will tell you that it is not our plan that we have to soft land. But we want to highlight to investors the areas that we have that we believe that if the macro catches up with us, which many investors feel it will eventually, again, that's not our plan of record, that -- what are the strains of the levers we have to pull to navigate through that. And PSP is one of those things where we think that we will get early indicators from our customers in terms of how they are participating in that program, in terms of being able to make gradual adjustments to our investments in capital and people and commitments that we're making to the suppliers to help soft land that. But there's other things also. I mean, Microchip's balance sheet is in a much better position today than it was during the last downturn. Our leverage is way down. We have the ability to invest in inventory. If we're in a position where we have a period of softness, we can build inventory, keep the wafer fabs running, the manufacturing facilities running, keep our gross margins high. As I mentioned in my introductory comments, our operating expenses are quite low today as a percentage of revenue below our target model. And that's with paying our variable comp bonus programs, which are quarterly programs at levels that we've never paid before. And so we can pull back on those things if we hit a soft spot, be able to manage to keep our gross margins high, our operating margins high and the free cash flow also.

Okay. you did kind of touch on inventory. How have you been using inventory to your advantage? Either building more internally, holding more internally versus releasing it to distribution or to the channel, how do you view that as a competitive advantage or in supporting your consistency of margins?

Yes. So we have not had the luxury to build, what I would call, excess inventory to support customers. We've got so much unsupported backlog, as I mentioned before, we're trying to support our customers. So we have absolutely invested in raw materials to make sure that the factories can continue to operate at a high level, and we can make the increase in starts that we need to within manufacturing. Our work in process is growing. We're ramping all of our large wafer fabs. And so with that, the WIP in the factory has grown. But with the high level of backlog and unsupported backlog that we have, when we get something to finished goods, we want to ship that to a customer or a distributor. And we are not managing distribution inventory. Distribution inventory is at quite low levels compared to historical places that it's been. It's at about 19 days. Maybe the normal is about 30, and I don't know if it goes back to 30, but it's very low today. And with that, there will be some restocking that happens at some point in time when supply catches up with demand and we can actually ship what the customers want.

To the extent that you are holding some work in process, is there any risk of obsolescence of that inventory?

There really isn't. Microchip's products sell for 10, 15, 20 years. I mean, we're still selling in volume today products that we introduced in 1995 to some of our industrial and aerospace and defense customers. So you can have to take an accounting charge for obsolescence just based on your inventory obsolescence policies, but the inventory that we're building is good inventory that will sell. And if we built inventory in a downside scenario, we don't have concerns that, that inventory won't be effective for us. And that allows us to build some inventory, keep margins high, but it actually reduces our CapEx requirements coming out of a downturn when you have an up-cycle because you have affected inventory based on customer history. You're building the right things, you essentially build it into, what we call, die bank. So it's through the wafer fab. And then you can turn it through an assembly and test pretty quickly and have relatively short lead times to support customers in an up-cycle.

Excellent. So talking about a potential down cycle, what's your current view of the cycle? Where do you think the broader analog industry is? Do you think Microchip is maybe at a different point in the cycle than some of the peers which would kind of explain some of the discrepancy between growth rates versus some declines already in other areas?

Yes. We tend not to want to make a call on the industry but speak to our own business. And we know that we are still very supply constrained. We know that we have several capacity corridors that will continue to be constrained all the way through 2023. We do about 40% of our production in-house in our wafer fabs, as I think I mentioned, that other 60% we are reliant on the professional foundries for. And some capacity is freeing up at foundry with weakness that is seen and end markets that we don't really play in, cell phone, consumer PC. It's freeing up some capacity. But the challenge is that capacity has to be a perfect match for the foundry and the process technology node where we are in short supply. And things have gotten better, but there's still some capacity corridors that are very tight. And I think that extends it. And so I think that's maybe the difference that some in the industry are seeing. Some of it is driven by end market exposure. We have only about 14% consumer exposure, and most of that is actually in the home appliance market, where there's always a refresh cycle. Yes, housing starts are down. That is the weakest part of our business. But the other 86% of our business is industrial, aerospace and defense. That's about 40% of our business in total, those markets; data center, automotive. Those are our 3 largest markets. Those are all doing well. And then communications is the other piece of it.

Okay. Do you have any view of when some of those capacity corridors that are still really tight, it's obviously still tight through 2023. Is there any view of when those do start to ease? And is it purely a function of the industry kind of catching up with capacity, maybe shifting some capacity from areas that are weaker? And is there anything that Microchip can do to kind of mitigate those supply constraints?

Yes. So probably the biggest challenge for us is still foundry capacity at certain process technology nodes. And you hear about foundries investing in trailing-edge technology, that trailing edge is very different typically than Microchip's trailing edge. That might start at 28-nanometer. We have some production at 28-nanometer, but the vast majority of the 12-inch product that we source from foundry is on 40-nanometer, 65-nanometer and 90-nanometer, and there really isn't much investment being made there. And so that's the challenge for us. We're working with our foundry partners and hopefully, that they will start investing more. But we think that those process technology nodes are going to be tight through 2023, at least.

Okay. That's going to lead me into my next topic of conversation, but I want to stop here and just check to see if there are any questions. Eric?

Yes. I wanted to ask whether you -- as you look at your backlog and your order rates for some of the items any way from the 32-bit where you maybe tighter right where you have shorter leads. Are you still seeing really long visibility and re-up in order rates?

Yes. Yes. So just for the audience and those on the webcast, the question is outside of 32-bit, are we seeing that order rates are changing because capacity is freeing up in any way? And we really aren't. As I mentioned earlier, PSP program percentage of total backlog stays at a high level. We aren't really seeing a differentiation by product. We're constrained on microcontrollers, we're constrained on analog, we're constrained on FPGA. So it's really across the board. And yes, there is some capacity freeing up. But our backlog is very extended at this point in time. And so we do have certain products that have relatively short lead times, but I think the center of gravity still is hovering around 52 weeks.

Okay. Right. So on the last earnings call, you indicated you are evaluating the need to build out a new 300-millimeter fab in the U.S. I think this would be the largest scale project that you've undertaken in a while. Most of the capacity additions that have happened recently have been kind of iterative or productivity freeing up extra capacity. We know your CapEx has been running above your long-term plan. But what's giving you the confidence in the need for additional capacity? And what's the time line for evaluating that need?

Yes. So a 300-millimeter investment for Microchip would be a significant undertaking for us. We actually have never built a wafer fab before in our history. We've always bought used fabs on the marketplace. The last large fab that we bought that didn't come to us through acquisition was our Oregon factory, which is the 8-inch factory that we purchased from Fujitsu back in 2002. Fujitsu had invested over $2 billion in that factory. We bought it for $183 million, and we've used it for the last 20 years, we'll use it for the next 20 years. So that's been our history. But the challenge that we have today is our foundry partners not making firm commitments to invest in these process technology nodes that I mentioned before where things are very tight. And we see significant growth in our business over time in those corridors. So the CHIPS Act has at least given us an opportunity to see if it makes sense for Microchip to do this on our own and not be relying on the foundries for it. But there's a lot of complications that go along with it. One, it's a very significant investment. You can think of a 300-millimeter fab for Microchip probably being a $5 billion investment. And this could be over a decade plus, so it doesn't all happen at once, so don't freak out. But CHIPS Act money could potentially support some of that, state and local government funding could support some of that. Is there an opportunity for us to have a partner? And I don't mean a financial partner, I mean another semiconductor company potentially join us in those actions. But honestly, it's not our first choice. Our first choice would be that the foundries that we are relying on that they make those investments. But CHIPS Act is having us evaluated. That's kind of what Ganesh walked through at our conference call is we're in the evaluation stage. We'll probably finish that process over the next couple of months, and we'll share with you the results of that and what our plans are. But it's definitely not a firm commitment at this point. It's just the valuation seeing what could be available for us from an incentive standpoint. Obviously, there's the investment tax credit that we're going to take advantage of as part of the CHIPS Act. That would apply to a 300-millimeter expansion, but also applies to what we're going to do in 2023 in just our normal business and supporting our 8-inch growth.

Okay. To the extent that a lot of your product lines, your customer engagements are very long-lived, 5, 10, 20 years even, are you having discussions with your customers? Or is it customer discussions about what their future needs are going to be, either in industrial or automotive where you do have longer-term visibility. Is that kind of what's helping through this evaluation process?

It's part of it. I mean we know that the products that we've introduced over the last several years and what their life cycle will be just based on our history and the end markets that we serve, that these process technology nodes are super important for us. The one thing that I should have mentioned in the 300-millimeter commentary is if Microchip had a 300-millimeter factory tomorrow, we couldn't run a single wafer in it because we don't own the process technologies that are run at the foundries. Those are owned by the foundries. And so another complication of this is we would need to take a license from one or more of our foundry partners to their technology. And we've done that historically. We talked publicly last year about doing this on an 8-inch process technology that one of our foundry partners wasn't going to invest in, and they saw that as a benefit to them is because they had a revenue stream and we had capabilities to bring that into our Oregon factory. And we've done that over the last year, and we'll start producing that in volume in 2023. But that's another complication with doing a 300-millimeter facility. We don't have the technology. We don't own it to do it today. So no.

That's very interesting and important point. So obviously, we've heard about a lot of other semiconductor companies making investments in building out their own internal capacity partnerships, obviously, taking advantage of CHIPS Act money. A lot happening in Arizona in particular. Is that part of the equation when you're kind of looking at -- is it almost a game of trying to balance not bringing on too much capacity in the industry? And are there discussions going on? I know Microchip is very active with the SIA and kind of in part of these lobbying efforts. How much of that factors into your decision as well?

So I mean, there's been a lot of education that's happened over the last year plus with the Department of Defense, the Department of Commerce in terms of the criticality of trailing edge semiconductors to everything that's built in the world, right? You can build a complex system with an advanced semiconductor node in it, but you're not going to complete it without the trailing edge. And so those discussions have gone well. I think that has kind of helped in the process in getting trailing edge technologies for the CHIPS Act. I think there's about $10 billion that's allocated to support that over time. But it's an extended process. We are working on what we would do in terms of an application process today. Those application process won't be defined and be able to be submitted until I think February at the earliest. So we've got some time to work through it. It's very new. You ask about is what the competition doing influencing what Microchip is doing? And I would say no, right? We are making investment decisions based on what we need for our business and what our customers need long term. And again, our foundry partners have been very supportive of us historically and we would like that to continue. And I'm sure it will to some capacity, but we're evaluating what can we do on our own, financially, does it make sense? And could we have the volume in a factory -- a 300-millimeter factory to make it cost effective.

Okay, excellent. I want to be sure to leave enough time to discuss our shareholder return program. You've really made tremendous progress on that front. I think you touched on it in your opening remarks, returning 60% of free cash flow now to shareholders on the path to 100%. You've accelerated the shareholder returns and dividend growth as part of this process toward it. What's the ultimate goal? Is there -- is it going to be returning 100% of free cash flow and then just kind of maintaining that? Or will you see the balance between either dividend growth, buybacks shift as you get to that 100% equation?

Yes. So the Board is still working on defining what the split between dividend and buyback will be. I think originally at our Analyst Day, we kind of talked about that, it's probably a 50-50 split over time. But we've made tremendous progress over the last year. Leverage has come down very quickly. We've been very consistent quarter-to-quarter in increasing the percentage of free cash flow that return to shareholders. It's gone up about 2.5% per quarter since we last introduced it last November. So it's at 60% today. We think over the next 2 quarters, we get to the 1.5x leverage, as I mentioned. And so with that, we'd probably be at about 65% free cash flow return at that time. And then it's just a matter of how quick we get there. The dividend has been growing really rapidly. We've been increasing at about 9% sequentially each quarter, so about a 40% annual compounded growth rate and that we have room to continue to do that. But again, ultimately, it's going to be a Board decision. We have a mix of input from investors in terms of you should be buying back your stock, your stock is undervalued, do that now, that makes sense. And we've been very consistent so far in terms of increasing that percentage of free cash flow return each quarter, increasing the dividend by roughly 9% and then have the buyback be the subtract answer. Does that change as we accelerate from what I mentioned is about 65% when we expect to get to 1.5x going to 100%, the mix between buyback and dividend is still to be determined by the Board.

Maybe some more recent developments. How might rising interest rates begin to impact your decisions? Are they already impacting your decisions in terms of retiring debt or -- what's the equation there?

Yes. So rising interest rates have an impact on our financials. We still have quite a bit of leverage on the balance sheet in absolute dollars. And we have some maturities coming due in 2023. We believe that we will not have to issue a new bond. We could, but we don't believe we will have to because we'll have room under our revolving line of credit to retire those bonds in 2023. And then in 2024, we actually have some very low coupon bonds coming to maturity. We were fortunate enough to issue some 3-year bonds with a sub-1% interest rate. It's just crazy low rates. And today, if we were to issue those same bonds, they'd probably be 5.5% or something like that. So -- and our line of credit borrowings have changed significantly, too. Just over a year ago, it was like at 1.7%. And the recent reset on that with rising interest rates is about 5.5%. So interest rates have an impact. I think if you do the financial analysis on buyback versus paying down debt, that rates would probably have to go to above 7% or something like that to really have us make a change. But it's for consideration by the Board. We'll put an analysis in front of them, and it will be evaluated. But right now, we're on the path to get to 100% free cash flow return. Once we get there, our intention is to stay there.

Excellent. Well, we have one minute left. Are there any questions from the audience? I think we'll go ahead and wrap it up there unless you've got some closing remarks.

I don't. Thanks, everybody, for your attendance and talk to you soon.

Thanks very much.