Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

This session is about Microchip, their ticker is MCHP. I have covered you guys for what, 17 something years I've known you, right?

Long time.

And you guys have made Microchip into a phenomenal business that generates a ton of cash. But right now, it's a very interesting time because there's a lot going on in the industrial and automotive space that I wanted to hit upon.

So maybe let's start there. You tell us what you guys are seeing in the industrial and the auto space, which is what is on top of the mind for Wall Street investors right now.

Okay. Sure. I'm going to do the general disclaimer that I'll be making certain projections and other forward-looking statements in our discussion today and refer you to our filings with the SEC that highlight important risk factors about Microchip. So with that out of the way, so when we announced our earnings for the June quarter and gave guidance for September, we really highlighted 2 areas of really significant weakness for us. So the first of those was China. And I would say China is the most weak for us of any geography. It's been that way for several quarters, and it has not and is not getting better for us today. The sell-through activity that we were expecting, what our distributors were expecting, did not materialize in the June quarter, distribution built inventory. This is not an industrial and automotive specific response, but those are 2 of our larger end markets and obviously are impacted by that. The other piece of it that ties into your question though is also Europe is showing signs of weakness for us. And Europe for us, particularly Germany, is a heavy industrial and automotive exposure area. And they're a high export economy. The GDP has been negative in Germany for the last 2 quarters. So technically, they're in recession. And we are seeing that in the order patterns of our customers in industrial and automotive that things are slowing down. We are getting requests for push out of backlog, and we are trying to accommodate those requests where we can and working with the customers to find kind of a win-win situation there. A lot of these orders came to Microchip under our preferred supply program. And that program was requiring customers back then to give us 12 months of non-cancelable, non-reschedulable backlog. And in return for that, they got priority in supply. Today, with the market softening, they're finding themselves either in an inventory situation or heading towards one if we ship them the backlog that they have on the book. So again, working proactively with them to reschedule that. And that's not having a material impact in the current quarter where we've guided the quarter at the midpoint to be down about 1% sequentially, but we've talked about the impact really being seen in the December quarter where we've talked about amplified seasonality. December is typically our most difficult quarter of the year, normal seasonal might be 3% or 4% down, and we expect it to be worse than that.

So with respect to the sort of slowdown that you're seeing, do you think it's happening because of slowdown in the end markets? Or do you think it's happening because of inventory excesses and how do I think about what it takes to burn it off? In other words, we just -- it's a situation where we just wait for these economies to turn? Or is it just a matter of excess inventory that will get burned off over time, and you get back to some sort of steady rate again?

Yes. So I think when the end markets slow down or a specific customer's end market slows down, it kind of can result in inventory, right? You have an expectation that the business is going to be performing at a certain level. And then when that does not materialize, either you've got excess inventory, you've got excess backlog that you have to work through. So we're kind of seeing that across the board, all end markets. . Now typically, in an inventory cycle or a semiconductor cycle, we see 2 to 3 quarters of weakness, and that is what we would expect this go around also unless there's something more significant that happens in the broader economy. I think it just takes time. It takes time for customers to kind of work through the inventory. We've been through many cycles. I think we're positioned well for this cycle. We can talk about that more in some of your follow-up questions.

Great. And you're pretty extremely diversified from what I understand. Could you give us a sense -- in every -- I think every couple of years, you give a breakdown, but I think you might have given one recently. Would you mind giving us a breakdown of how your business breaks down across the end markets?

Sure. We typically quantify our exposure to the end markets once a year at the end of our fiscal year. So for fiscal '23, which ended in March, industrial was our largest end market at about 41%. Second largest was data center and computing, which was about 19%. Automotive is about 17% of the business. Communications is 11% and consumer, which for us is primarily consumer appliance, is about 12%. And it doesn't really change much year-to-year. So from fiscal '22 to fiscal '23, I think industrial was up 1%. Data center computing was up 1% and the consumer appliance piece was down 2%.

But from what I understand, consumer for you is a lot of white goods, right? Like it's a lot of washer ride. It's not really giving key kind of consumer stuff, it's really like white goods. It's really in kind of borderline industrial stuff.

Yes. I mean I refer to it as a consumer appliance, but it is appliances and white goods is the vast majority of that.

So it's a little bit more resilient.

It's not cell phone exposure and things like that, that are fast moving, high volume.

All right. So you generate a ton of cash at this point in time. You sort of like -- sort of matured as a business, and you've got everything sort of steadied up and you're throwing off a bunch of cash. You already pay a tremendous dividend. So what do you intend on doing with the free cash flow that comes out of your business?

Yes. So since we acquired Microsemi back in 2018, we were very highly levered at that point in time. We had about 5x net debt to EBITDA on the balance sheet. And we've worked very proactively to bring that down. And at our Analyst and Investor Day back in November of 2021, we set a target to get down to 1.5x levered. And we've done that now. We ended last quarter at 1.29x on a net debt-to-EBITDA basis. And we have increased the amount of capital that we are returning to shareholders. So, this quarter, we are returning 72.5% of last quarter's adjusted free cash flow through a combination of dividend and buyback. Our dividend has been growing very rapidly. So last fiscal year that ended in March, we grew the dividend by about 40%. The board is increasing it 9% each quarter sequentially. This year, that's moved to 7%. And the board makes that determination each quarter. I kind of expect that 7% to remain in place this fiscal year. And so growing very fastly there. And then so our answer on the stock buyback, it's essentially a subtract answer, whatever your adjusted free cash flow was, times the percentage that you're returning back out the dividend. And this quarter, the dividend was about $223 million and the buyback was about $339 million. Now the trajectory for our capital return we've laid out that we expect to get to 100% free cash flow return by March of 2025. So every quarter, you should expect us to take that 72.5% this quarter increased it by 5%. So it will be 77.5% next quarter, and that run rate will take us to 100% free cash flow return in March 2025.

What happens if you need cash for whatever something attractive comes along or some of the reason for you to have cash, what happens when you're giving away 100% of your free cash flow?

I think it depends on what it is, right? I mean we feel -- the free cash flow calculation is obviously operating cash flow less CapEx, right? So we've got what we need there to invest in working capital in the business and capital expenditures. And our capital intensity is pretty low. Our CapEx intensity is 3% to 6% of revenue. . Your question might be geared a little bit more towards acquisitions which we've done a ton of acquisitions in our past, but we haven't done an acquisition since 2018 with Microsemi. And we've said publicly that we don't need -- we don't have a gaping hole in our product portfolio. So there's really no desire to go do a transformative deal. We will probably do some small tuck-in deals. We've done some of those over the last 5 years, but they are $5 million, $10 million, $15 million deals that don't move the needle, but help us acquire something on the IP side, an R&D team or something like that and advance our product direction in one of our business units. So you should expect more of that, but we're not in need of doing an acquisition. When we sent out of our acquisition strategy back in 2009, 2010 time frame, we were a $1 billion revenue company, we were primarily a microcontroller company. We had some analog. But through the process of growing both organically and inorganically to the $8.5 billion we did last fiscal year, we now have -- we've got a very broad analog portfolio. Obviously, we have everything in microcontrollers that we're really needing from low end to high end, low end 8-bit, high end of 32-bit. But now we have timing solutions, we have connectivity, we have security in the portfolio. So today, we can offer our customers what we call Total System Solutions, and that's going into a customer that has an embedded control need and not just being a microcontroller supplier. Being that first point of entry on the board, whether it's a microcontroller, a microprocessor, an FPGA. We offer all of those things in our portfolio and then selling the rest of the portfolio around that, speeding the customer's time to market, reducing their investment in R&D and becoming a more valuable supplier. So I think we're set up good for organic growth. That's what we've been doing in the last 5-plus years, and you should expect that to continue.

And you've got a bunch of different technologies and products in your -- under your Microchip umbrella -- if I had to say, Eric, could you rank for us the highest growth areas or the steadiest areas? How would that -- what would that list look like in terms of just growth?

So what we talk about publicly is our focus on the mega trends in the marketplace that we're targeting. And we've got our end market exposure that I talked about earlier in response to one of your questions. And then on top of that, we layer these mega trends, which we think are the fastest-growing areas for us to focus on over the next 5 to 10 years of growth and then combine that TSS or Total System Solutions strategy with that, but the mega trends -- and help me make sure I remember all of them, but it's data center, industrial IoT, it's EV, it's ADAS, sustainability, yes.

Sustainability. So again, pushing back a little bit growth rate with respect to that -- teens? Are we talking teens for the high-growth areas?

Yes. So what we expect is that those mega trends will grow at 2x the overall Microchip growth rate. And we've kind of proven that out over the last 2 years. So in fiscal '21 to fiscal '23, Microchip grew 55% in total and the mega trends for Microchip grew at 109%. So we expect that to continue, not necessarily at those percentage rates, but that ratio in the mega trend is growing faster than the overall size of the business.

And you -- I think your company, if I remember correctly, was the first one to come out with a program for customers where they could sort of be locked in, if you will, but preferred -- you call it Preferred -- PSP program. But it was the first program of its kind in the industry from what I understand, where customers would have guaranteed supply and this was during COVID times. It's called the PSP, Preferred Supply Program. Can you -- for the benefit of the people listening in, in this room, tell us how the PSP works and the mechanics of it?

Sure. So we introduced this program in February of 2021, and it was in response to customers wanting more assurity that they were going to have supply when they need it. There was a huge supply and demand gap in the industry. And so we worked with customers to develop the program. It's been very successful. It's been well in excess of 50% of our backlog for a long time. And that program for that priority in supply, the customer gave us in exchange for that 12 months of non-cancellable, non-reschedule backlog. Now we've recently changed that program. The supply and demand constraints in the industry are subsiding. Our lead times today ending last quarter were just under 26 weeks. So now we've changed new orders starting in August to only require 6 months of non-cancelable non-reschedule backlog. At the end of today, we are working with customers that are identifying inventory positions of a non-reschedule piece but not the non-cancelable piece. And what the PSP program did for us? I mean for the customer, it gave them priority of supply, kept them up and running in a very capacity-constrained environment. For us, what it did is it made sure that the backlog that we were receiving was good backlog. If we had not had this program, we would have had a massive amount of backlog stacked up just outside our cancellation window that customers could continuously push out. And with that, we wouldn't have known what we should go invest in where we had all this backlog, we didn't -- wouldn't have known what was real, what was not real. And how do you operate effectively in an environment like that when lead times are so long across the supply chain? We would have bought the wrong wafers from foundry, we would have invested in the wrong equipment, wrapped the wrong technologies in our own factory and it really helped us with that. So I think it's really positioned us well. And you think about it from the customer's perspective, they want a more secure supply chain but they have to think through the orders that they're placing. There's a lot of thought that gets put into that versus something that, hey, well, if we don't really need it, we'll just cancel it at a future date. They couldn't do that with PSP. Now, we're rapidly returning to more normal lead times, and we've actually put a letter on our website, indicating to customers that by the beginning of the next calendar year, we think lead times are going to pretty much be normalized, and that means that for 80% to 90% of what we call our standard products, standard microcontroller analog products, we expect lead times of 4 to 8 weeks. And that's where we've been historically. That's normal for us. What that means is rather than having a full quarter of backlog entering a quarter or multiple quarters of backlog, we'll be operating in a higher turns environment. And that's how we ran our business for decades.

Years, yes. Would you still have the PSP program then just because of the clarity that it gives you?

So the PSP program is a customer selected program. So it's completely optional. And I suspect that there'll probably be some customers that want to continue with PSP. If a customer is selling an end equipment or their end product has a really high value, right, do they want to take the chance that supply constraints arise again in the future, which they will at some point in time, and be stuck not being able to buy $5, $10 worth of semiconductors to prevent them from shipping a $50,000, an $80,000 piece of end equipment. So I think there are certain customers that will. We've had multiple of our PSP customers enter into what we call long-term supply agreements with us. And those customers saw a benefit in PSP. These long-term supply agreements are typically a 5-year agreement. It works similar to PSP in the short term where the customer gives us kind of 12 months of firm orders. And then after that, they just have a set of products and certain volume ranges that they need to purchase over the coming years and then they can place those orders as more firm as they approach a 12-month period. So there are certain customers that make sense. I think there's other customers that will say, "Hey, Microchip has short lead times again. PSP doesn't make sense." And again, that's completely the customer's choice.

So you'll leave it to the customer to decide and let it sort of work itself out. Let's talk about pricing for a second. So historically, semis have been sort of wild in pricing. Pricing would go -- or typically, pricing will go down every year. But I remember talking to Steve about 4 years ago, and he said it was about 4, 5 years of steady pricing. He hadn't cut prices in a while. And I think you're on that path and it appears that the industry is on that path, that pricing seems to be steady. I'm not saying that -- well, it's rising because of input cost maybe. But with all that's going on in China and Europe for you, have you seen any pressure on pricing at all? Are you -- is that something that you're even willing to talk about with customers?

So it's not really something we're willing to talk about. Clearly, over the last 2 years, as inflation was high, input costs were rising, high capital costs, high foundry costs, high labor costs. We pass those costs on to our customers and mark them up for a Microchip margin. So they weren't gross profit margin percentage accretive, but they were gross margin dollar accretive to Microchip. So we were fair. We were transparent with customers. We could have gouged them significantly, and we didn't because we really value those relationships. Now I am very hopeful that we're at a point of price stability. It's not fun to raise prices on your customers. But if, as an example, this is hypothetical, if foundries were to raise prices significantly on us again, we would pass those on to customers in terms of price increase. But you're -- going back to your conversation with Steve, we took the stance probably 7 to 10 years ago that we were going to hold prices flat. We're selling proprietary, high-value, design-in products. There's a lot of price competition and just competition in general at the design-in phase. But once you're designed in, you have that slot for the life of the design as long as you don't screw up with delivery or quality or whatever. And you have the customer has chosen you for a reason. So there is -- this is not a scenario where we're facing reductions and what our input costs are going to be. So my general expectation is pricing is flat. If we have to, we would raise prices, but that's not our intention.

You've got a little bit more flexibility this time around -- this cycle around than you did historically. Previously, I remember you would -- because your products have life cycles of 15, 20 years or whatever -- decades, you would effectively run. I mean, Steve would tell me and even Ganesh would tell me that he's going to run the factory steady even in lean times, use the balance sheet to build inventory bank and then when things get hot, he will still run it at the same exact rate and just deplete the inventory. I thought it was brilliant. But now it's a little bit different because I think you're 50-50 or maybe 60-40 in terms of manufacturing. How is it different for you this time around than the scenario that I just described?

Okay. So we do about 40% of our wafer fab in-house. The other 60% we use the professional foundries for assembly and test is higher. We do about 60% of our assembly and 67% or so of our final test in-house. But it's really a wafer fab discussion here. And our intention and plan of record today is to continue to run our internal wafer fabs hard. We'll modify our outside foundry purchases to get to the -- what we think is the right level of inventory for those products. But we have the balance sheet to support this investment in working capital, build a little bit of inventory in what we call [indiscernible]. So it's through the wafer fab through probe, and then it just needs an order and we can run it through assembly and test pretty quickly and have short lead times. And so our customers -- that's a great advantage for our customers for Microchip to have short lead times. The products that we build sell for decades, as you say, 10, 15, 20-plus years. And so we don't really face a true inventory obsolescence risk. And the amount of cost that we can take out if we cut utilization is really pretty small. Probably we can get 25% of the cost out, the other 75% of the cost is fixed. So why not invest that in inventory. It actually reduces your CapEx long term because you build inventory when things are slower then you can ramp up capital slower on the upturn. So same strategy that Steve has deployed for a long time. Ganesh has the same state of mind. It's the right way to run the business. And because we have such a long life for our products, it's the right strategy. We didn't necessarily do that in the last downturn because our balance sheet wasn't as strong. We've done all these acquisitions, we were highly levered. But today, our leverage is down. We're firmly investment grade, and that's going to be the strategy.

That's all I have. I mean the last thing I'll say is you've got a phenomenally strong business that I've personally seen over the last 2 decades. And it's trading at 12x, 13x on a P/E basis, throws off a ton of cash and your dividend is rising. So we love your stock.

All right. Thanks, Harsh. Appreciate it, everybody. Thank you.