Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Okay. Good morning, and welcome to the third day of JPMorgan's 51st Annual Technology, Media and Communications Conference. My name is Harlan Sur, semiconductor and semiconductor capital equipment analyst for the firm. Very pleased to have Eric Bjornholt, Chief Financial Officer of Microchip here with us today. Microchip is the #2 largest microcontroller supplier in the world. It's been a busy earnings season. So I've asked Eric to maybe kick us off with some opening commentary and then be more than happy to jump into the Q&A. So Eric, thank you very much for joining us this morning.

All right. Thanks, Harlan. Thanks for having me. So good morning, everybody. Just give you kind of a quick summary of the business environment for us. Microchip just reported a couple of weeks ago, our fiscal year ended March 31, '23, we had a record year, a record quarter, and we're guiding again for growth in the current quarter, guiding up 2.5% sequentially, expect to have record gross and operating margins, operating margins that's just above 48%, which is above our long-term model. So the company is performing really well. Obviously, we've been in a supply-constrained environment and the environment is changing a bit. Lead times are coming down. And with that, our backlog has shrunk, but we still have a lot of backlog. I'm sure we'll have some questions on the PSP program, but it's still a very popular program and represents well over 50% of our backlog. So the company is executing quite well. We're moving forward with our capital return plans. So we have plans laid out for investors to get to 100% free cash flow return by the March 2025 quarter, so just 7 quarters from now. This quarter, we're returning 67.5% of last quarter's adjusted free cash flow to investors. So the company is executing well, very strong operating margins, great cash flow. CapEx was a bit higher last year and is moderating a bit in the current year as we are catching up on supply. But overall, business is working very well. We had some comments from one of our competitors this morning that I'm sure we'll get some questions on. But with that, I'd like to open it up to Harlan for the Q&A.

Yes. So why don't we start off with that? I mean your conference call wasn't that long ago. As you mentioned, one of your peers in the high-performance analog space reported today and they talked about seeing some weaker dynamics in their end markets and more of a normalization of the business activity going forward. I'm wondering since the time of earnings, has the dynamics change? Obviously, you just talked about sequential growth. This quarter, I know Ganesh had qualitatively said that you certainly don't see declines in the September quarter. I'm wondering if the demand environment has changed? Has the supply side changed? Any differences relative to what you communicated to us back at earnings.

So really, really no change from a couple of weeks ago. We are getting a certain level of request for cancellations and pushouts from customers, but I would say that's really stabilized at this point in time. From an end market perspective, we're still seeing strength in industrial, automotive and our data center business is holding up quite well also. You know that we have a very low exposure to consumer and what we have is really consumer appliance, and that's been the weakest of our end markets for a couple of quarters. But really no change to point out since our earnings call, and we still feel it's very unlikely that the September quarter would be down.

So as is the case during these periods of sort of macro uncertainty, and I know you touched upon it, but -- and demand weakness, you go through periods of customers wanting to reschedule their backlogs. In your case, rescheduling regular and PSP backlog, right? And in addition to seeing a deceleration in order rates, obviously, Microchip team has a very strong backlog coming into this period of weakness. Your customers didn't really have a chance to accumulate, I think, excess inventories due to the industry capacity constraints. All of this is helping to sort of cushion you through this weaker period. But as it relates to request for pushouts, reschedules as well as the current order trends, I mean, have these noisy dynamics, have they all started to stabilize relative to, let's say, the past sort of 2 to 3 quarters?

Yes. I think there is some stabilization that is happening there. Clearly, bookings have been weak for the last couple of quarters, and that's to be expected when we went from being severely supply constrained. And now capacity coming online, whether that's in our internal factories where we do about 38% of our production internally and through the wafer foundry. So capacity is definitely freeing up. We still have a few demand corridors that are constrained but it's getting better. And with that, customers are not feeling the need to give us that extended backlog coverage that they had before. And just a reminder that in a normal environment, Microchip operates in a relatively high turns environment in any quarter. That has not been the case for the last couple of years. Clearly, not the case in the current quarter that we've guided to. But eventually as lead times comes down, we will be in a terms environment. Again, Microchip functions very well in that environment. But the supply environment has definitely improved significantly over the last few quarters.

We had discussed China demand dynamics back in the February earnings call, right? But it was a little bit too early to tell because it was right after the Chinese New Year's holiday. There definitely seems to be slower consumer, corporate spending profile of recovery in this region. And I noticed that your Asia business, which is largely China, was down about 5% sequentially in the March quarter. What did you see in March? And has the team seen any signs of a pickup in China distribution, POS sell-through?

So we really haven't seen a significant increase in activity in China, post-Chinese New Year. So China is definitely our weakest geography today. It was last quarter, as you mentioned, and continues to be today. China is about 21% of our revenue based on where we ship the product. Taiwan is roughly about 15%.

But is it just -- is it sort of just stable/bouncing along the bottom? Or are you continuing to see some declines there? How would you characterize just the profile of that business?

Yes. I say it's okay, but a lot of investors were asking, post Chinese New Year, was there going to be a significant pickup in demand, and we have not seen that develop.

As you mentioned on the last earnings call, you're seeing -- and today, you're seeing better supply availability. The equipment suppliers seem to be catching up now that their leading edge customers are pulling back, right? But still seems as if mature and specialty manufacturing capacity is somewhat tight, right? Especially at 28-, 35-, 55-, 65-nanometer nodes, which support your high-volume, 16- and 32-bit microcontrollers, which are produced by your foundry partners. But I wanted to get your views. I mean, do you anticipate continued tightness with your foundry suppliers, and your views on when you sort of get back to normalized lead times?

So we have several constrained corridors, both at foundry and internally. I would say they are all getting better. You mentioned some of the nodes that we have had constraints on, but we do see improvement happening there, but some is still very tight. And in those tight corridors, we still have a high degree of backlog and lead times have not come down significantly. But that's more the exception than the norm at this point in time. Most capacity corridors are freeing up.

Perfect. Before I move away from sort of the near to midterm, does anybody have any questions? Feel free to just raise your hand, and we'll get a mic over to you. So this didn't come up on the earnings call, but you did point it out in your quarterly presentation, but the team mentioned signing several long-term supply agreements with some of your major customers, right? I assume these are very different from your PSP agreements, which are typically only 12 months in length. And so it's great to have these longer-term agreements in place because it gives the team the ability to plan your longer-term capacity needs. It obviously gives your customers peace of mind in future assurance of supply. But other than longer-term horizon, I mean, how do these LTAs differ from your PSP program? And what is primarily -- what is -- who is it you're primarily focused on? Is it primarily your industrial and automotive customers?

Okay. So these long-term supply agreements or LTSAs, as we call them, have been put in place with several of our larger customers. This is the customers that have been participants in the PSP program and been served very well for that. And typically, there are customers that have durable demand, the end products that they are selling, the semiconductor content in those products tends to be a very small percentage of the end sale price of whatever it is they're selling. And so those that have been hurt during supply and demand crunch and also serve us very well through PSP, are doing things proactively to make sure that their supply is going to be available for them. And essentially, customers that have these LTSAs have the highest degree of a surety from Microchip that we will meet what their expectations are from the demand. So in the short term, these are typically 5-year agreements. They can vary a little bit, but typically 5-year agreements. And in the short term, they tend to function just as PSPs. So customers required to give us 12 months of kind of exact visibility of what they need. And then there's an appendix to the agreements that kind of list out the types of products, or the specific products that they will be buying, and then they can vary the volume on that as they get out in time beyond 12 months. So let's just make sure that Microchip is going to be able to support them well. Again, they get the highest level of support from us, and these are all happy customers. And essentially, these LTSAs give us a great opportunity to continue to build on these relationships that strengthen actually through the supply and demand crunch, and having much higher level conversations at suite levels with customers and open up new design opportunities for us. Typically, there's skin in the game from the customer where they give us a prepayment for a portion of that supply that extends over 5 years. And then the expectation is, is when Microchip delivers and customer places orders over that 5-year period that they earn that cash back.

Is pricing fixed over that 5-year period? I know volume is a little bit flexible, but is pricing fixed over the life of the LTSA?

Pricing is not fixed. Just like the PSP program, it's a unit volume program. And if we have inflationary pressures in the business, which we hope we don't, but we've definitely seen that in the last 2 years, we can pass those pricing increases on to the customer. That's not our intention, but if the environment calls for it, the customer understands that it is not a pricing program. It's a commitment on units that we will provide.

On the motivation for customers or major customers that want to enter into these LTAs, there appears to be some growing momentum for auto, industrial, defense-related customers to ensure more domestic chip usage on future programs, right? U.S. National Defense Authorization Act, which was put in place in December, had some additional restrictions on some China chip suppliers selling into U.S. military and government entities. I know auto suppliers selling to -- auto and industrial customers, I think, are getting wind of this. They're getting a big concern on a broadening maybe of these types of restrictions. And then you layer on top of that the past 3 years and the supply disruptions and so on. This is probably a mid- to longer-term driver of the business, but I mean, has the team seen a pickup in customer engagements driven by all of these dynamics?

I wouldn't say that it is significant. Obviously, we do have our wafer fab footprint for what we manufacture internally is in the U.S. Our 3 major fabs are in Arizona, Oregon and Colorado. And so that can be helpful for certain customers. But ultimately, customers are looking for a surety of supply and diversification of the supply chain. And our foundry partners are getting the same message, either from us, other of their customers or from the end customers that they ultimately support and are making appropriate investment decisions based on that in multiple geographies.

Any questions from the audience? So let's talk about your technology, market share position and a few other dynamics. So the Gartner share numbers were out for calendar '22. I know they underreported your MCU share. But whether by your numbers or the Gartner numbers, you guys delivered another strong year of share performance, right? You outgrew the MCU market by 7-plus percentage points. You gained about somewhere between 100 and 200 basis points of share. You took share in all of your markets, 8-bit, 16-bit, 32-bit. But the fastest growing was your 32-bit. Here, you grew 32-bit by 30% plus versus the market at 26%. Is it your total system solution strategy, driving the strong share gains? Is it the megatrends, which we'll talk about in a second? Or was it just relatively better supply versus your competitors that drove the strong share performance last year?

It's going to be a variety of factors. Ultimately, you have to have the right product set to make customers successful. You have to have not just the hardware, but you have to have the software, and then the support that goes around that. Some of that can be TSS, the total system solutions and what we provide: Reference designs, the application support. So all those things over time is what help us gain market share year in and year out. I can't point to a single thing this last year. Everybody was supply constrained. And clearly, that impacted Microchip, it impacted others, too. So I don't think that was a major driver of share gain this last year.

Your FPGA business, I mean, you drove record FPGA revenues in your fiscal year ended in March, where it was up 38%-plus higher than corporate average gross margins. Number 3 or number 4 in global FPGA share, strong position in the midrange segment of the market, right? Your Polar family has been sort of the workhorse of the portfolio. You have some newer products like your Fusion family that integrates analog, mixed signal, along with your FPGA blocks. What end markets, applications, is this team really driving the most growth and seeing the most customer adoption?

Yes. So our FPGA business is doing great. It's very high margin, both in gross and operating margin business for us, and it's grown quite well, as you pointed out, and Ganesh talked about on our last earnings call. So really, the product is known for being really the lowest power in the industry, having exceptional reliability and then having excellent security on top of that. From an end market perspective, clearly Microsemi, where this business came from, had its roots in aerospace and defense, industrial and communications. But we also have a growing presence in automotive and FPGA solutions. So it's a broad-based business. It's doing extremely well. We've got new product introductions that are coming out that are going to expand even on what the PolarFire product has done historically. So it's doing really well. We're excited about it, and it fits in really well with our total system solution approach to the marketplace because these tend to be complex systems that the FPGA is being sold into and create a lot of opportunities for our other products to cross-sell around it.

Yes. That's a good lead into my next question, which does want to focus on your total system solution strategy, right? And I asked this question every year, hoping that the team will have an update for us, because I believe this is a big part of the growth in share gains. And you can get a sense of the breadth of your TSS offerings by just looking at -- I always look at 2 of your major distributors websites. And by my last check, they listed something like 4,200 reference designs for Microchip, and that's up substantially from a few years ago. How effective are these reference designs in helping to drive TSS? And do you have any updated metrics you can share with us? And if not, maybe qualitatively on a year-over-year basis, is the team continuing to drive increasing dollar content per customer engagement?

Okay. Yes. So TSS has been a focus for us for a number of years now. And really, post the Microsemi acquisition, when we've been purely focused on organic growth and not busy looking for the next acquisition or integrating an acquisition, that's been the team's focus. And so it's been a major driver of our growth. We can see it in our design funnel. Absolutely, the number of parts per system is growing. We haven't shared those metrics externally. But I think at the end of the day, the results are shown, and the results that Microchip has produced in terms of revenue growth, and the market share gains, some of which that you've pointed out. So it's doing fantastic. It's a key element of our business fundamentals going forward. There's not a customer discussion that happens where we don't try to bring value to them. We mentioned reference designs, right? So that's a great starting point for an interaction with the customer. And we can tweak that design to the customers' end application need. But we're trying to be more valuable suppliers to our customers and be more sticky over time. And the more products that we can sell to them make their life easier from an engineering perspective, speed their time to market, it's helpful in building those relationships.