Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good afternoon. Welcome to the second to last session of the Cowen's -- TD Cowen's 51st Annual TMT Conference. Almost done having to look at me in that. I'm very pleased to be joined by Eric Bjornholt and Sajid Daudi of Microchip. Thank you both for joining us.

Thank you for having us.

Let's just try to get the short-term stuff out of the way as much as we can. It's a very dynamic business environment. I can't recall, and you've been doing this longer than me as cycle where the end markets moved at such different paces and different times. Can you maybe walk us through -- remind us what you said on the last earnings call, what you're seeing across the different end markets? And how auto and industrial doing compared to consumer, computing and whatnot?

Sure. So I mean we've said the last couple of quarters that consumer has been the weakest part of our business. For us, that's consumer appliance, it's only about 12% of our business. Our larger end markets are Industrial, which includes Aerospace and Defense, Data Center and Automotive. And they've all been hanging in there pretty well. We were very supply constrained for a long time, and that is obviously getting better. Foundry capacity is more readily available. Our own capacity has come online. But we've still got a lot of backlog that is unsupported. So we're shipping to those customers. What's changed recently is we've got a few more requests for pushouts from customers, and we're trying to accommodate those even if they're part of our PSP program. And we can talk about that more if you guys want to in a bit.

For sure. Let's talk about it now, I guess. So you mentioned in the last call there were more pushouts. Are those primarily focused on the consumer markets? And also, can you help tie that together with your commentary on inventories? I think you were at 169 days, which came in higher than you expected and are expected to trend down in the back half of the year. Can you walk through your comfort with current levels? Is it a soft trying to take down? Are you cutting utilization? What are you doing to manage levels now?

Okay. So I'll address the inventory question. So as you said, we ended our fiscal year in March with 169 days of inventory. There's a few components of that. So we had about 7 days that relates to last time buy inventory from some of our foundry partners that are end-of-lifing process technologies that we see 10, 15 years of opportunity for sales to customers at very high margins. So we've taken that inventory in, and that will stick with us for a period of time. So that's -- although it not permanent, it will be with us for some time. The other piece is our internally manufactured product from our own fabs is still pretty low. Our die banks are lower than we'd like them to be. So we're continuing to run our internal factories hard. But foundry capacity as it started to free up in the December quarter and the March quarter, our business units and our operations teams and our customers were really starved for product. And so we took advantage of that capacity coming online and took quite a bit of inventory on and that was really the driver of the growth. So in the current quarter, we've actually guided the Street that inventory will decline in dollars and in days. We're targeting about a 5- to 10-day reduction in inventory. Foundry will be a piece of that. And then also, as the supply chain has loosened up, we were carrying higher levels of raw materials and we'll start to bring that down. The other piece that impacted inventory last quarter is we were starting to accept some pushout activity from customers. And so we had a product that was further along in the manufacturing process, some even in finished goods that we ended up holding and we'll ship to customers at a later date.

Got it. I think can you spend a minute talking about the PSP program and when you have a customer that's in the -- I think there's some confusion between PSP program, noncancelable orders and enforcing those. And when you have a customer in the PSP program, that comes to you and says, we'd like to push out our orders. How does that conversation go? And then perhaps most importantly, are the pricing levels firm within the PSP program?

Okay. All right. So PSP, we put it in place in February of 2021. It was based on customers requesting a program to give them more surety of supply. And so the program was developed for customers to provide us with 12 months of noncancelable, non-reschedulable backlog. And customers who have participated in that program has been serviced very well. So it's been a very good program for customers. But customers do not always have a crystal ball of what demand is going to be. And obviously, the demand environment has weakened in some end markets, in some geographies. So with that, we have received some requests for cancellation and/or pushout. We are not really accepting cancellation requests. We might offer up a cancellation fee that would be punitive to the customer. And ultimately, the customer is going to need this inventory. So we're working with customers who are self-identifying these inventory positions and allowing some pushout of that product as it makes sense for us. In some cases, there's another customer that's desperately waiting for that product. So that's an easy thing for us to do to satisfy the one that's in need of the product and the one that wants to push it out a little bit. And in other cases, we're just giving customers some flexibility.

Eric, would you characterize the -- maybe you can walk us through the end markets where you're seeing those activities, right? I wouldn't imagine that, that would be uniform across the business where people are coming back and asking for pushouts or those cancellations. So maybe what types of products, what end markets? Are there anything unique geographically? Just -- and maybe we could start there and then we can dive in further after that.

All right. So it actually has been really across all the end markets that we've had some of these requests. So it's not that we've been completely constrained in data center and now no customer is requesting a pushout activity. So we've seen it across all. And again, these are selective. This isn't the vast majority. What we've always said about PSP backlog is it is better backlog than if we hadn't had the program in place because if a customer doesn't have skin in the game, they can book an order, schedule it's right outside the cancellation window, which for us would normally be 90 days and then just continuously push that out or cancel it at some point in time. And Microchip then doesn't know what we need to go and invest in from a capital perspective or people or make commitments to our foundries. So with PSP, a customer generally needs to go to a higher level within their organization and ask for an approval or sign off on that type of order. That's what would happen at Microchip. I need to sign off of it, can assure a Senior VP. So I think customers naturally kind of hedge themselves a little bit with that program. We've all first 6 months of PSP backlog is fuller than month 7 through 12. And so with that, I think that the backlog is still good under PSP, but in some customers over forecasted a little bit, and we're giving them some relief.

Got it. I'm going to ask one more on this. So I just wanted to date to the audience. We do want to make this somewhat interactive. So if you guys have questions, just wave your arms around, and we'll sort that out. The follow-up that I guess wanted to dig into a little bit more is if -- when you guys signed up customers for PSP originally and they wanted to sign up, do you guys get any view into customer inventory levels as part of the program is? And just speaking more broadly, you can monitor your distribution inventory. I'm sure you do very, very closely as most of your peers do. Different ones of your peer companies have different levels and different programs to get on at customer inventory level visibility. And I just wondered, like the closeness of the partnership with yourself and your customers through PSP, you get any of that data back, how has the visibility changed over the last, I don't know, 24 months?

So we don't get any sort of reporting from our direct customers on their inventory levels. Distributors all are required to provide us with inventory and sell-through reports every month. We reconcile their inventory and do all that. On the direct customer side, it's more anecdotal in terms of having discussions. And PSP does allow a higher level of conversation to be had between senior management and Microchip and the customer. And so I think there's better interaction than there used to be. But we do not get any sort of real-time regular reporting in terms of inventory levels at our customers. And remember, our customer base is very diversified. We serviced 125,000 customers. Our top 10 customers are around 10%, 12% of our revenue. So it's -- and many of the larger customers in that are contract manufacturers that are servicing dozens and hundreds of customers.

Any just anecdotal view on levels of customer inventory? I mean you've talked pretty openly about where things are with the distribution inventory. But I don't know, just got a feel about customer inventory now.

So our gut feel still is, is that we were so constrained for so long and still are constrained. We have a lot of what we call unsupported backlog, backlog of the customers have requested that we are delinquent to their request date that because we are manufactured on these trailing edge technologies where a lot of these supply constraints were, we don't think there's been enough time for significant inventory to be built up. But with the diversified large customer base that we have, there's no doubt there's pockets of inventory out there that have built up, but we can't quantify that.

A lot of your peers have talked about deemphasizing the channel and going more direct. Is that -- I would be curious to hear your views on that. Is that a short-term thing that, I guess, companies are doing in light of the current environment? Is it a structural change because of the difference in exposure of trailing edge semiconductors now. I'd be curious how your strategic view of the channel long term?

So the channel is super important to us. So we probably have 120, 130 distributors that we work with and that's a variety of the global distributors like the Arrows and Avnets of the world that you're all familiar with. Digi-Key and Mouser that kind of seed the market with new design activity. And then the larger piece of our distribution revenue comes through regional distributors that are really dedicated to the Microchip product line, get trained just like our sales force and do a good job of actually going out and creating demand for us winning designs. And the way our distribution program works, if a distributor is providing logistics type services, fulfillment services, they earn a fulfillment, lower margin. If they're involved in the design activities, they earn a higher margin. And we monitor or manage that through the way we sell the distributors and a uniform higher price. Once the distributor goes out and identifies an opportunity, they register that design with us and then that distributor is the only distributor for that product going to that customer that can get a reduction in that original purchase price. So it's worked well for us for a long time. We are not deemphasizing the channel. The percentage of our revenue that goes through distribution has been pretty steady over the last 3 or 4 years. It's declined just modestly. We saw maybe about 2 years ago, maybe it's 1.5 years ago, that distribution took a little bit of a sharper drop down in a particular quarter. But that was more based on distribution being later to join the PSP program that many of our direct customers, because our distributors then had to go on if they were going to be on PSP, had to then go work that with their customers to negotiate NCNR of their own because that's not our relationship. That's their relationship to manage. But it's kind of bounced back. It's about 48% of our business today.

I'm trying to make this one the last short-term one. There's widespread concern of pricing that's been up objectively in the drilling and semiconductor industry for the last 3 years. But starting to soften as your end markets soften, your results and your peers have objectively shown that, that's not happened. When things soften or if and when things soften in auto and industrial, further, do you anticipate a sharp change in pricing? Have your conversations with your auto and industrial customers changed versus the past? Or are they willing to, I guess, work with you more when demand softens?

We are not anticipating price decline. We took the stance with our customers probably 8 to 10 years ago of not granting annual price declines, right? The semiconductor was giving away value with that. And so we made that change and gradually got better and better, better at enforcing that. So pre-COVID, there was really no annual price declines that were happening with customers. Now the supply and demand situation and the increase in inflation cause inflationary pressures on our business, increased capital cost, increased labor costs in our factories. So that impacted Microchip directly with our cost structure. And then our foundry partners and other suppliers were experiencing the same thing. So we have passed those cost increases on to customers through pricing increases, not to be gross margin percentage accretive, but we are earning a Microchip type margin on those increases. And so we had price increases the last 2 fiscal years. What we've said is the majority of our revenue growth was driven by unit volume, not by pricing increases. Now we think that those prices are very sticky and here to stay. The 2 largest components of those cost increases were capital, which once you buy the capital, it's fixed and going to be depreciated over 5 years, 7 years, 10 years, whatever that schedule is and labor costs aren't going down. And we think that our supplier base is seeing the same thing. So there's still inflationary pressures on the business today. It is not our intention to pass on additional price increases to customers, but if inflation continues the way that it has, we would need to consider that. But we have no intention of decreasing prices, and I don't think our customer base expects that either.

Unless there's a question in the audience, we will shift gears a little bit. Sajid, Microchips identified, I think it's 6 megatrends. And the last we heard were about 45% of revenue. Can you walk through what are the growth compositions of this versus your legacy business? And what are some of the more, I guess, meaningful growth drivers underneath those 6 megatrends that the Microchip team is excited about?

Yes. I'll highlight a couple of them in there, a couple of mega trends, right, which make up a bigger proportion, automotive and industrials largely. So you kind of think about automotive, it's about 17% of our total revenue today. And there's a lot of areas that we see opportunities -- growth opportunities in current and new opportunities as well, right? So in electric motors, a lot of our components go in there. These are motor controllers, positioning controllers and the DC to DC converters, we play a big role in. We also have EV chargers and bunch of other areas. So automotive is a nice growth opportunity for us. Supplementing automotive or complementing it is on the ADAS side as well. Lots of opportunities there with sensors, controllers. We're seeing a kind of shifting and we talked about that earlier, too, on kind of the automotive architecture as well, and that's going to create, I think, a ton of opportunities for us largely on the Ethernet side and the PCI Express side as well because as these ECUs get replaced by a central compute, you're going to have a lot more sensors, a lot more data that's getting processed at the point of collection and that creates opportunities for us. So lots and lots of areas of where we think that's good on the industrial side with -- we are in -- industrial, the design activity is longer on the industrial side. But once it starts -- once it's designed in, the ramp is 12 to -- 8 to 10 -- 10 to 12 years, right? So that's a very meaningful ramp there. And a lot of the areas that we're in is your kind of core industrial application, right? So think of some of the newer stuff would be the smart city infrastructure that's going through smart lighting on the streets. Traditional, you get factory automation, right? That's a big evolving process there that's happening. Automation, access -- building access points, a lot of the smoke detectors and medical is a big piece of industrial as well. So lots of different areas of focus. So there's not really one specific core area that we are dominating in. It's just really our products are used across the board. Same thing with -- on the 5G side. Again, as that connectivity goes through, we're still probably in the early stages of that 5G transition as well. What else? e-Mobility, right? So we talked about e-Mobility a little bit, and that's on the automotive side. Industrials, I would just point out one thing that's currently about 41% of our revenue. That moved up from 40% to 41% last year. Within that, about 8% to 10% is aerospace and defense and that -- of the total revenue. So 8% to 10% of the total revenue, representing about 25% of the industrial component. In the Aerospace and Defense segment, you probably think about it in 3 partitions, right? The commercial aviation, space and defense side of things. And all 3 have been doing really well. Commercial Aviation recently has come out. And yesterday, we were at a different conference, and we put up some slides that showed our content in a large airplane, which is greater than $100,000. I forget the model of it. But it was one of the larger Boeing plans. So certainly a broad -- and that, I think, is what drives some of that resilience and differentiation that you're seeing. Like Eric pointed out, a lot of our consumer stuff is separated from that. And so that would be the kind of areas that we're excited about there. Sustainability, sorry, is another one that we've recently added as a megatrend, and we're just seeing a lot of applications come through, right? These are energy preserving or gas house reduction type of tools or better and more energy-efficient tools. So megatrends are expected to go 2x our core revenue. And so we're pretty excited about what we can bring. And that's where a lot of the TSS activity happens as well.

Yes. And we showed at our Analyst Day back in November of '21 kind of a baseline of where those megatrends were at about 1/3 of our revenue and leaving this last year, just 2 years forward, fiscal '21 to fiscal '23, that represent 45% of our revenue. Over that 2-year period, Microchip grew about 55%. And the megatrends grew double that rate.

I guess within auto specifically, a lot of attention gets paid to high-voltage power discrete and ADAS processing because they're it's easier to model with an attach rate. But there's a ton of other semiconductor components that are getting pulled into the vehicle, both because of those and in addition to those trends of EVs and ADAS. One of your larger peers recently took up their long-term target model because -- explicitly because of auto and industrial growth, and they're not exposed to those high-voltage power semi verticals either. What's a reasonable rate, in general, auto semis have grown mid- to high single digits? It feels like we've hit a knee in the curve here, but we're coming off 2 very strong years. How should we think about the longer-term growth rates of auto and industrial growth for your core exposure?

So we don't break any of our end market out in terms of what they are going to grow in the future. I mean we've consistently outgrown the market year after year. I mean we've been organic growers for the last 5 years since we've acquired the Microsemi acquisition. EV and ADAS are a significant growth driver for us. but it's really the whole electronification of the car, the data center on wheels that's going to help continue to push that forward as well as then the consumers' expectation of what's in a high-end vehicle today moving down into lower level models over time. So we're excited about automotive. Again, it's not the largest piece of our business. It's at 17%, but it grew kind of in line with the corporate average last year. And it's not really all about the number of cars produced. It's about the content in those vehicles. in our slide deck that we've got up on our website. You'll see an example of a vehicle, the new Iconic 6 (sic) [IONIQ 6]. It's got 88 different parts from Microchip controlling all sorts of features throughout the vehicle to something very simple like a power window, power door walk to more sophisticated systems within an automobile with touchscreens and things like that.

Eric, I'm going to switch gears just a little bit. You guys are talking about megatrends, but one of the things that needs to happen for you to serve that kind of growth is capital investment and capacity, right? So you guys have a high remodel. We get a bunch of capacity from outside the company. You obviously have your own fabs and you're investing. There's been a lot of back and forth over the last, I don't know, 12 months on the strategy there. And I just wanted to -- maybe we could revisit how that conversation has gone with yourself and Ganesh and the Board and there was thoughts maybe to do a 300-millimeter fab yourselves, then that got shelved and you're not going to pursue that anymore. The market has been dynamic for a while. You couldn't get tools -- now you see some of your peers in trailing edge semi spending gangbusters over the next 5 years to build out capacity. Some have leaned more into external foundry that there's a lot going on around your company and different competitors of yours are taking an extraordinarily different tack as to how they're going to pursue in the next 5 years. Maybe you can just revisit the last 24 months leading up to this and just how you're thinking about that now.

Sure, sure. So I mean, first, I'm going to say, we're very comfortable in our own skin and what our competitors are doing from a CapEx perspective doesn't really drive decision-making within Microchip. So maybe start with the 300-millimeter fab that we explored. So we do not own intellectual property to run the process technologies that our foundries have in our own factory for 12-inch because we don't make 12-inch products today. We have 6-inch and 8-inch factories. So that was going to be a challenge for us. What we found is when foundries are not looking to expand in a certain area. They are willing to grant us a license. We got license from one of our major foundry suppliers a couple of years ago now to take inside an 8-inch process technology that they were no longer going to invest in. So they could turn it into a long-term revenue stream for them, made sense for them, made sense for us to bring it in-house because we saw 10, 15, 20 years growth on these products. So that's kind of how we evaluate these things over time. With chips at funding, we thought it was appropriate to evaluate the possibility of a 300-millimeter fab. We were talking with state and local governments would have liked to have done this outside of the public domain, but we were having these discussions, and there was a very high likelihood that word was going to leak that Microchip was talking to, Arizona, Oregon, other municipalities. So we said, hey, we're evaluating it, and this is why there was a period during the up cycle where foundries were not making commitments to invest on the trailing edge, right? And they were seeing a higher benefit for them to invest on the leading edge. But now what's happened is that the foundries and the industry has seen that with these higher capital costs, right, there's no 8-inch used equipment in the marketplace as an example, 12-inch equipment is very expensive that customers are willing and able to pay a higher price for these products to support those capital investments. And so as we were going through the analysis of should we do this ourselves, should we do it with a partner? Or should we allow the foundries to be able to support this for us, that's the analysis we went through. Ganesh had lots of detailed discussions with upper management and our larger foundry partners and got comfortable through that process that they were going to make the appropriate investments in appropriate locations that made sense for us to drive our capacity needs for the next 5 to 10 years. So I'm not going to sit up here and tell you that we'll never have a 12-inch fab in our future. It's possible. But there are challenges from a loading perspective and from a process technology perspective, where we don't own the IP rights. But capital in general, the capital costs are significant. We spent near the high end of our range of our long-term model last fiscal year. Our long-term model is 3% to 6% of revenue. We laid that out at our Analyst Day 1.5 years ago, 2 years ago. And we feel very comfortable staying within those bounds. This fiscal year will be lower. We've guided to $300 million to $400 million or $350 million at the midpoint of guidance versus last year, which was about $500 million. Capital equipment lead times have been long. So we made a lot of commitments over the last 2 years. And some of those are going to continue to come in, in the current fiscal year. If we need it from a capacity perspective, we'll install it, place them in service. If we don't need it, we'll wrap it for a period of time and use it in the future. So I don't know if I answered all your questions, but I think I got most of them.

No, I think so. No, thank you for that. There's a lot of moving parts there. The mix of the business -- I guess, the follow-up to that then is the mix of the business that you expect to be external versus internal, has that through this whole evaluation of the 300-millimeter facility and the decision you made? Has that long-term balance changed?

It really hasn't. So we finished this last fiscal year at 37% or 38% internal fab production. The rest is outsourced professional foundries. At our Analyst Day, which I mentioned before Analyst and Investor Day, we talked about potentially getting to about 45% internal over time. I still think that's possible, but I think it's within that range where we are up to 45%. And on the back end, assembly and test side, we do more of that in-house. Today, we do about 60% of our assembly, maybe 67% of our tests and those percentages will likely go higher over time.

I guess since we're on this sort of evaluation of the business kind of tone, Microchip for a long, long, long time under Steve's leadership was a very M&A-intensive organization. And then that strategy completely changed, right, to be one much more focused on capital return as the portfolio matured, valuations have changed up, down and sideways. I don't think we've ever seen the last 5 trading days in semis like there's just been, so we can revisit this conversation hour by hour. But how are -- are you still on this firm commitment to capital return side of the pendulum there? Have we swung back toward the middle at all in consideration of smaller M&A, larger M&A? I mean -- and then, I guess, the big picture from your perspective, was there anything large enough to be material to Microchip that you think you could actually get done given the regulatory environment?

Yes. All good questions. So -- on the M&A side, we started a journey in doing M&A kind of in the 2010 time frame. At that point in time, we were about $1 billion in revenue. We were primarily a microcontroller company. We had a nice portion of analog, but it was smaller. And what we just wanted to do over the next multi-years was to expand the portfolio, not just through our organic efforts, but use the cash flow of the business, the business model that we had to go out and acquire various pieces of the semiconductor pie that made sense for us in providing more complete solutions to our customers. And so post the Microsemi acquisition, there was a lot of acquisitions between that 2010 and 2018, when we acquired Microsemi, we've acquired. So we've got a very robust analog portfolio today. It's about $2.4 billion. We've got everything from the low end of 8-bit to the high end of 32-bit in micro controllers. It's not that's that. We've got FPGAs that came from Microsemi. We've got all sorts of connectivity products within the portfolio. We have timing. We have security. We have memory. And that allows us today to go to our customers and present them with more complete solutions where we can come in with a working reference design, speed their time to market, have them avoid the hassle of dealing with parts from various different companies, interfacing with each other, reduce their efforts in R&D and become more valuable, sticky suppliers for them. So that was the goal all along. And post Microsemi, we don't look at the portfolio and think that we have a gaping hole that we need to fill through a large-scale transformational acquisition like a Microsemi was like Atmel was for us at the time. So today, we're very comfortable with the portfolio that we have. We think that we're providing our customers with what we need. Now we will likely do some small acquisitions, tuck-in IP, R&D teams, things like that. And we've actually done some of those post Microsemi, but they're a blip from you guys' perspective. It doesn't take a lot of cash. These are kind of sub-$20 million deals that just help us propel some of our road maps further. So today, we have been focused on -- or post Microsemi, we've been focused on the megatrends in the industry, growing organically, selling TSS, or Total System Solutions, to our customers. And through that time period, reducing the leverage on our balance sheet. So we've taken it from about 5x down to last quarter, it was about 1.45x. And now we've laid out a very clear path for investors that we want to get to 100% free cash flow return by the March 2025 quarter, so that's 7 quarters from now. And we're just going to execute on that. Today, we're doing 67.5%. We'll increase it by 5% each quarter until we get to the 100%. And when we get there, I can't look at our business and see it's much different from some of our high-quality competitors in the analog space, when you look at gross margins, operating margins, free cash flow and capital return. And there's a huge valuation discount that we have today. All of you can look at that and make your own assessment, but that valuation gap should close as we move towards 100% free cash flow return.

Well, well done. Right on time. Thank you, Eric. Thank you, Sajid. Really enjoyed the conversation, and thank you for your participation.

Right. Thanks, everybody.

Thanks, everyone.