Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Great. Well, thank you, and welcome back. I'm Joe Moore from Morgan Stanley. Very happy to introduce Ganesh Moorthy. I think he's going to have some upfront remarks, and then we can do some Q&A at the end.

Okay [Audio Gap] Grown over time. Thank you.

Great. Thank you for that. Maybe if we could just kind of parse some of the stuff you just gave us, maybe in the context of what's been happening. So early part of this year, I think you went out to your customers and talked about lead times coming down from -- into the kind of 26-week range by midyear. Obviously, that's not having any negative impact on your business through the first half. But like how are people reacting to that? And do you see -- as lead times come in, do you expect people to need to maybe hold less inventory because they have more visibility on their ability to get stuff?

Yes. No, great question. So firstly, to clarify, what we said, what we is we expect in the second half of 2023 that lead times on average will be 26 weeks. We still expect some to be higher than that, and some to be lower than that where we're at. And it's a gradual improvement as time goes on as we balance supply and demand over that time. At this point in time, it's not having an effect on the business itself. I think it's giving customers a better view into how to plan as they go into the second half of the year. Our backlog remains strong. Our bookings are continuing. And we do expect that some of that over time, bookings were unhealthily high. Backlog was unhealthily high, needs to come back to normal. But the changes are slow, and there are going to still be constraints in certain areas and improvements in other areas.

Yes. I mean you've talked about even as lead times on average coming down that you still have significant unsupported backlog. What are the pain points at this point where you still can't meet in demand?

So it has 2 components. One is demand continues to be strong, and the supply is improving, but you can only improve it at a certain rate. And they are in all of the specialized technologies, the trailing edge technologies. Capacity for them is incrementally getting better, but not at the point where we can magically erase all of the unsupported backlog that we have. And in a way, I think we're trying to solve the supply-demand imbalance incrementally every quarter rather than trying to solve it all in 1 quarter.

Okay. All right. And then can you talk about some of the bigger dynamics within Microchip around the PSP program, around people's really attempt to get visibility on their supply chains, and how you guys are working around all of that in the context of potential economic deceleration? How flexible are you going to be about delivery times? How proactive you're going to be to try to keep inventory from being too excessive? Just how are you thinking about those dynamics?

Yes. So PSP, it's actually coming up on 2 years since we kicked it off, and it's been a phenomenally successful program. We've had customers who have loved it. Customers still have a high percentage. And in fact, the percentage of the backlog that is in PSP today remains unchanged from where it was 6 to 9 months ago with all the different dynamics that might be going on in the market in terms of where new backlog is coming in and how that's all being done. We have been flexible on the PSP, on the nonreschedulable part of it. So PSP requires noncancelable and nonreschedulable because we're making significant investments in putting that capacity in place, paying upfront in many cases or adding fixed costs in many cases. The noncancelability part of it is really not where we want to spend time negotiating. But the nonreschedulability, we have done a significant amount of movement out of the quarter -- out in the future quarters. And we've been doing that now for the 6 months, and we remain there. And because we understand that at the end of the day, excess capacity at a customer location on a distribution channel really is not helpful long term. But we are, as part of our steps towards a smooth or a soft landing, making sure that we are managing some of the requests for rescheduling in a way that is orderly, but retains a degree of responsibility with the customer or orders that they have placed in terms of noncancelability. But reschedulibility, we're willing to be more flexible.

Great. And maybe I'll just ask this as these people ask it to me because I have an overweight on Microchip stock, and we believe that you're going to manage through these headwinds pretty well. But the pushback is because of PSP, because of these dynamics, that your outperformance in the first half of this year is largely a function of your customers not being able to cancel stuff. Can you just talk directly to that?

That was the pushback in the last half of last year or 2 was that it wouldn't last beyond the end of the year, and then it wouldn't last beyond the calendar Q1. I wouldn't last. So it's -- we manage the business for the long term. We obviously have customers who have wanted to put PSP backlog in place. And to this day, we have customers who are increasing the amount of long-term supply agreements. So these are not 12-month agreements like PSP. These are 3- to 5-year agreements. I think what's missing sometimes is that people don't fully understand the end market characteristics of the customers we have. And it is heavily weighted towards very resilient end markets. These are customers who make very highly valuable end products in which the semiconductor content is a small fraction of the total value that they create. And so that end market exposure gives us some advantages in terms of how the business is run, how the backlog is placed, how resilient and/or how high quality the backlog is. And that's all part of what you see in the numbers we're posting.

Great. And you've talked about the -- you don't talk a lot about end markets, but you sort of talked on the most recent call that sort of 86% of your business is outside of consumer. And that the markets that you -- the exposures you do have are stronger. I guess people are starting to call some of that into a question, particularly data center where there has been some inventory correction. Can you just talk generally to those demand drivers?

Sure. So no end market is monolithic in how it performs, right? In every end market, there are customers who have shortages and expedites that they're pushing us on. And then there are other customers who have inventory that they would like help with. And so that is true even in the 86% of our resilient market. But in the aggregate, those end markets are much, much stronger than perhaps the consumer electronics and consumer PCs and gaming and those which have had far bigger declines in recent quarters and where they're at. We are seeing that those end markets are performing better than most. Clearly, we indicated on our last conference call, we are seeing some stress in some parts of data center. We're still gaining market share in data center. And there are segments in which there are usually only 2 or 3 players, and we're gaining share from a smaller market share perspective and outgrowing it. In time, we'll see where all of the data center requirements shake out. But for the moment, data center remains a reasonable market for us to be in.

And you mentioned your consumer exposure probably better than some given that you're talking about more household appliances and things like that as opposed to stuff that benefited from work-from-home, gaming, things like that.

Right. Consumer appliances or home appliances tends to be the dominant portion of our consumer exposure. That includes small tabletop kitchen appliances, whether that's coffee makers and microwaves and all that. Or much bigger, air conditioners and washing machines and microwaves, et cetera. So those are all the places we're at. It's more resilient only in that when many of those things break, they still need to be replaced, but perhaps somebody is looking to upgrade, wants a nice LCD screen on whatever it is that they have, they may wait. But we do have -- our consumer business is not as strong as the other end markets we're in.

Great. And then just regionally, your demand -- China seems like a weak spot for everyone right now, but it also feels like a market that will obviously come back over the course of this year. So how are you thinking about that China end demand dynamic?

So China in the December quarter was weak. It was weak first because of all the lockdowns that took place and then it was weak because just 90% of the people got COVID, certainly 90% of our employees did and we saw that across customers and all that. So that's all behind us. Chinese New Year is behind us. We see China business normalizing, and I think there's an opportunity to strengthen as we go into the second calendar quarter. I think this week, there is a China Congress that I think we'll have a lot more certainty for some of the business policies that they're going to follow and see where that all goes. But I'm optimistic that China will get better incrementally as we go through 2023.

Great. And then just my last demand question. I guess why make this comment today about the June quarter? You normally come to these conferences and reiterate the current quarter, what is it that -- is it more the anxiety that the investors have? Is it the visibility that you're seeing in your business? What kind of led you to come out talk about the June quarter at this point?

It's a little of both. I want people to know how confident we are in our business, what we see. We're not trying to get into a pattern of multi-quarter forecast. But I think there remains some question of, hey, how likely is the growth going to be into the June quarter or into the second half? There's always a 6 months from now a question mark that's out there. But given where we are, given all the uncertainties that are in the macro, I thought we needed to be clear as to how we see the June quarter and therefore, the update.

Great. Okay. And then in terms of thinking about downside scenarios, which I think is an important exercise just given people's anxiety about the macro. You've talked about a soft landing with bookings. Can you talk about what that means to you? Like when you think of a soft landing, are you thinking lead times come down and revenues don't decline? They decline a little bit? Just how are you defining that term?

Yes. So when we think of a soft landing, what we want to deliver is a minimal decline in revenue. Ideally no decline. But if there is a minimal decline and a holding up of the gross margin, operating margin and free cash flow that we have. And so we don't want deterioration in those beyond the normal variation that takes place. So we want the business to fundamentally hold up in terms of growth. We don't want it to have a large crash in revenue and a large crash in any of the other metrics.

Great. And then your comment that you would expect to see a 40% operating margin in a really difficult environment, that you would expect to still be able to hold operating margins at that level, I mean that's what you've done historically in terms of the degradation from here, it's been relatively minor in any kind of downturn. What are the levers that you can pull to protect your income stream to get to that kind of 40% baseline?

So on the gross margin side, we have 60% of our wafers that we buy from foundries, 40% of we build in-house. In any downside, what we would do on our internal factories is we would continue to run it, get the full absorption benefits, grow the inventory. These are products with very, very long life cycles, and we will be extremely well positioned for when a cycle changes. On the foundry side, we would cut back on the amount of wafers that we're buying from the foundries through that cycle as to whatever is needed in that time. So the gross margins, we think, have a degree of support that comes from a combination of how our inside-outside mix is built up. On the operating expenses, we have a pretty significant amount of variability that we can control with our bonus programs and with our discretionary spending, as you can see in prior cycles and what we've been able to do. And so between those 2, we think the operating margins and the free cash flow are going to be fairly well managed. And even the CapEx begins to come down in a down cycle because we don't need to continue to be able to grow the capacity at a rate that we had thought at one point in time. And so all those metrics of gross and operating margins and free cash flow in any cycle we have shown we can maintain, and in some cases, improve.

I guess the counterpoint, the pushback that I get from people is, okay, historically, the company has only seen a few hundred basis points of margin erosion in a downturn, but these operating margins are much higher than they've been historically. And some elements of that, the big foundry wafer prices increases that you pushed through and things like that have been sort of onetime in nature. How do you answer that? How do you think about -- does this look different from a normal environment because the upturn has been so -- had so many positive drivers?

The gross margins improvements are not short-term improvements that we have made. I mean there are fundamental improvements in the mix of the product, in the cost structure of the product, in the value of the products that we're creating, how much more sticky, how much higher gross margins that they command and where they're at. And then, of course, there's a factory cost structure, which I spoke to. So we don't feel that the gross margins are subject to volatility based on where short-term demand is going to be at. Same with the operating expenses, right? I mean we have been underspending to where our targets have been, and we have been able to have a variable compensation at the upper end of what we typically pay built into what our operating expenses are. All that has an ability to be reversed as time goes on to where we take the bonuses down, we are able to absorb any changes in the revenue or gross margin changes that may be happening. So we don't think this cycle and where we are with gross and operating margins now is any different from where we were at a different point over the last 15 years when they were new peaks. So we've had higher highs throughout this time frame. And you could have made the argument at any one of those times that, hey, at that point in time, you wouldn't be able to do what you did the last time around. We don't feel any discomfort with where we can and how we will operate the business.

Great. That's helpful. So I want to leave more time for questions than normal because there is breaking news here, but I'll just ask one more. At one point, you talked about evaluating a 300-millimeter fab. And then you said in this last quarter, you've elected not to move forward with that. Can you talk about that decision and your sort of thoughts about capital spending generally?

Sure. So when we were evaluating a 300-millimeter fab, we were informed by 2 critical objectives we have. Objective one was we did not want to be limited in our growth on specialized trailing edge technologies from 300 millimeters. And at the time, there were -- it was not clear that our partners were willing to invest at a priority that we required of them. The second thing we were looking at was how would we, in time, create geographic and geopolitical diversity to our supply chain. As we work through the options of building a 300-millimeter fab in-house, we solved the first 2 of those issues or those goals that we had. And we were able to get more capacity, higher investments from our partners and more capacity allocation to us. And some of those that will take place geographically spread out to where they're at. And in fact, it lowers the risk overall for Microchip because a 300-millimeter fab has very high fixed cost, will take a significant amount of loading to be able to absorb the flywheel costs that are going to be there. And so on balance, when I looked at the overall risk profile of where we're at, the commitments we're able to get out of our partners, the return on invested capital that we would be looking at under different scenarios, it made sense for us to stay the course with our partners with the changes that they were making on 300-millimeter.

Let me pause there and see if we have question from the audience. I think there's one over here.

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Can you repeat the question?

Yes. So the question is, there appears to be more capacity from the foundries and how is that affecting our business and changing the lead times perhaps. So substantial amount of capacity that is available out of the foundries is at the edge of technology. So they are at nodes, which are much smaller in size than what we use in our production. And at those nodes, you're absolutely right, there's plenty of capacity available to any amount that you want. At the nodes that we're on, which are more specialized nodes, it is a mentally more positive. We are getting more wafers than we were getting 6 months ago, 12 months ago. But there are still constraints that we're working through. So lead times are improving slowly but steadily, but they're not instantaneously going to whatever they were 3 years ago.

It seems like a consistent message is like 55-nanometer nonvolatile memory processes are still really tight, those kind -- those types of...

Right. And when you add nonvolatile memory, which is where all of our microcontrollers run, then it becomes even more tight in terms of capacity, which you're right about. 40-nanometer and larger in size is typically where the specialized technologies are -- that have still got reasonable constraints. Improving, but reasonable constraints.

Well, the question is just around inventory. Can you talk about inventory levels and distribution as well as what is contemplated around distribution inventory levels in your outlook?

Sure. So distribution decides what inventory they want to carry. And sometimes, they want to carry more and we can't give them enough, right? So over the last couple of years, I think they have wanted to carry more. We just haven't been able to ship them more. We got to the absolute lowest inventory for distribution in the last cycle. And today, distribution inventories have improved some, but they're not anywhere close to where they were in historical terms and where they're at. And what they will decide to carry is really up to them. They have to manage the cash flow and anything on it. In some cases, they want to carry more and we can't supply. In other cases, they're happy with where they're at and they don't need to get more. So it's all over the place, but distribution inventory is lower than where it has been historically.

Questions from the audience? Maybe you could talk a little bit about the CHIPS Act and the degree to which you see Microchip as a beneficiary and how that frames your thinking going forward about where your capital spend is?

Sure. So there's one part of the CHIPS Act, which is very deterministic and it's there now. It's called the investment tax credit. Basically, any capacity that you deploy, either building or equipment starting January 1 of this year is eligible for a 25% investment tax cut. Easy, simple, we will take full advantage of that. There's a second part of it, which are grants. And these are grants for which rules of engagement just got published within the last few days. And there's still a lot of questions on how that's all going to process. And we're studying them. We're working through it. We will make applications for the grants. We don't know what the results will be. We don't know what percentage of a project's value will be supported out of the grants. We don't know whatever the strings are going to be attached to the grants. So we'll see. There, I would say at this point, they are less deterministic. So the investment tax credit is great. We're moving full speed ahead on that. The grants are in the process of being studied and applied for in the coming months. All of it obviously helps us to have confidence in investing more into the factories that we have into the U.S. and with that creating both the supply chain strength, enough security strength that comes out with those products.

How much are your customers focused on the geography of supply chain now, and [ PI ] is obviously going to go out pretty heavily marketing how much domestic capacity they're building as something that provides certainty to their customers. Do you think customers that's resonating? And how do you react to that?

80% of our revenue comes from outside of the U.S. So if there's relevance on U.S. production for a U.S. customer, that's 20% of our business. At this point in time, with rare exceptions, people are interested in making sure that you've got a resilient supply chain, that there are options for China, Taiwan that are in the supply chain and where we're going. And so the U.S. is clearly one of those options, but not the only option that is available to us.

Great. And then last question for me. The leverage target, 1.5x, you alluded to this upfront. You're approaching that target. How are you thinking going forward about cash return? Does M&A come back into the picture for you at any point? Just how are you thinking about those dynamics?

Right. So M&A is off the table. We want to grow organically through the total system solutions and the focus on mega trends that we have. That has been the focus over the last several years and will remain so. We are generating tremendous amounts of free cash flow. And as we have paid down the debt, as we have brought the leverage ratio down, will be under 1.5% this quarter. We will continue to pay down for several more quarters, but we are increasing the rate at which we're returning capital. So this quarter, the March quarter, we are returning 62.5% of last quarter's free cash flow. And we've been raising it at about 250 basis points every quarter. Starting next quarter, we will raise it 500 basis points every quarter. So next quarter will be 67.5% of this quarter's free cash flow. Following quarter will be 72.5% of the prior quarter free cash flow. And that will take about 8 quarters by which time we will be at 100% of free cash flow that has returned. It is split between a dividend which is growing and will be the sacrosanct portion. And then the balance of the free cash flow will go into share buybacks. We have an approval for $4 billion of share buybacks. We've done just over $1.1 billion at this point in time. And so there's a lot of powder left both on the dividend growth and the share buyback.

All right, Ganesh. Thank you so much for your time. Appreciate it.

All right. Thank you, everyone.