Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Welcome back to this session. Really delighted to have Eric Bjornholt, CFO of Microchip Technologies join us. I'm Vivek Arya from BofA's semiconductor team. What I plan to do is go through my questions, but please feel free to raise your hand if you have a question, and we'll be sure to get a mic to you. But a very warm welcome to you, Eric. Really appreciate you joining us.

Thank you. Thanks for having me.

And we'll go through the business, but I just wanted to kind of touch on the most recent right thing with the Microchip. You recently issued a convert. And I was hoping you could describe that, what is the rationale behind that? And I think you had a covered call as part of that versus the standard bond. So, maybe just give us some more color around that.

Sure. So maybe before we start, I'm going to do the standard disclosure that during the course of this discussion, we'll be making certain forward-looking statements about the financial performance of Microchip and I refer you to our filings with the SEC that identify important risk factors about the company. So, we were in the market last week with a convertible debt transaction. It's a 6-year instrument. It has a couple of relatively unique features to it. We purchased a cat call up 75% and that cost us about $104 million to do that. This is a $1.25 billion convert. The other unique feature of this convert is it has an investor put feature that the instrument can be put back to us and really that at 1 day in time, 3 years out, June 1, 2027, that gave us a lower coupon, but does give the investors the ability to put it back to us. And really the only reason they would do that is if the stock price is kind of around the levels that it's at today or lower, which obviously the hope is that, that is not going to happen. But if it does, we have cheap money for 3 years, and then we would go and reinvest that. So we think it's going to be a good transaction for us. We think the cost of capital over the 6-year period would be about 2.25% if the stock does not exceed that 75% up and it would be cheaper than investment-grade bond issuance over the same period, which would probably be at about a 5.5% rate all the way up to a stock price of about $194. So anyway, that's the transaction we executed last week.

Got it. And at a high level, Eric, what does it mean to kind of the P&L math for this year?

So I mean, it has a positive impact on interest expense in the short term. Now we do have a couple of maturities coming up that are at lower rates. So, we have a investment-grade bond that is coming due in September at about a 1% interest rate. So the coupon on that is similar to where we are at the convert, but it was not a convertible transaction, right? The interest-rate environment 3 years ago was very different than it was today. And then we've got a $665 million convert that matures in mid-November. And essentially, we're using these proceeds to be able to address those. In the short term, the proceeds, we've paid down our commercial paper balances and that has about a 5.6% interest rate, replacing that with the 0.75%. So clearly a cash cost savings there for us and then we have the ability to use our line of credit or issue additional commercial paper to take out these maturities that come up later in the year.

Makes sense. Let's go to the business. Maybe you could just start with the state of the union, right? Every company is going through its own time line of inventory adjustments. Where does Microchip sit today? And if you could maybe walk us through whether it's by product type, whether it's by end-market type or geography, whichever way you think is the right way to kind of segment your business, where you are in that inventory adjustment process?

Yes. So clearly, we're in a pretty significant inventory adjustment phase at this point in time. Our last quarter was down 25% sequentially. We're guiding the current quarter down another 6.5%. And if you look at our business year-over-year, midpoint of June guidance to June of last year, it's down almost 46%. So, we are clearly shipping way below consumption today. Now last June, we were obviously feeding inventory into the channel unknowingly at the time, but customers have gone through a significant supply-demand correction and we're fearful on getting products and we're ordering product out in time that ultimately they did not need at the run rates that they needed. So, distribution is correcting inventory. We made a comment related to our March quarter results that distribution drained about $125 million of inventory last quarter, and that is on what I perceive to be depressed level of sell-through because distribution customers are also draining inventory. Our direct business in the March quarter was down 30% sequentially. And clearly, we think that they are going through an inventory correction also. So, we're going to have 2 back-to-back quarters that are down pretty significantly. And we know that the business will bounce back to much higher levels, but it's a matter of how each customer has managed the cycle and their inventory position in terms of when that correction comes. Now we are seeing what our CEO, Ganesh, calls green shoots in the business, right? We are seeing bookings improve on a monthly basis and I'll just walk through that. February was the highest month of bookings that we had in 8 months. March was the highest level of bookings that we had in all of fiscal '24, which ended in March. April was higher than that. And then May, which just completed was higher again than April now. It was higher by a small amount. So it's not like bookings are going through the roof, but it is improving. But bookings are still well below where we need them to be to get back to kind of a normalized revenue run rate as customers work through the inventory situation. But lead times are short. And with that, we are seeing a change in behavior of customers. We are seeing much fewer requests for push-out and cancellation. We are seeing more on the other side of that where customers might have an order that is scheduled out in time in August and now they need it in July. So we'd call that a pull-in. It's not a new booking. It's an order that's already outstanding, but they're pulling it in for an earlier delivery date. And then the bookings that are coming in are coming in more in line with where our lead times are, which are really short today. The vast majority of the products have lead times that are 8 weeks or less.

Got it. Given -- Eric, you have been through a few of these cycles, right, before. Obviously, cycles are different every time. But do you think the recovery -- the shape of the recovery this time around is -- is it a V-shaped recovery? Is it something that you need to have a couple of flat quarters before you start to see the recovery on the other side? Like when will you know that now you can trust that the recovery is happening?

So you kind of have to make assessments based on what we've seen in other cycles. And these green shoots, as we refer to them, are kind of the early signs that the recovery is coming. And there -- we still need turns to have the September quarter be up from the June quarter, we have significant turns that we would need to take, right? So there's no guarantees on this, but these are classic signs that customers are starting to get through their inventory challenges. And with 125,000 customers that we service, that all doesn't happen at once, but to see the signs that that's starting to happen for a portion of the customer base. And it's not geographic specific, it's not end market specific. We can have a very similar customer in industrial that one of them is pulling product in and the other is saying, you know what, I don't need to book anything for the next 3 months because I've got inventory. So each customer, as I said, handled the supply and demand environment and what they did from an inventory perspective differently during the last upcycle.

Got it. On the industrial side, I think what I remember from the last call was that, look, certain customers are getting better, certain customers are worse. Help us understand what are the big moving pieces of your industrial business, right? Is it more exposed to aerospace or defense or factory automation or test and measurement? Like what are those big moving pieces? And are you seeing a distinction between what is getting better versus what is not improved yet?

Yes. So to address the second piece of that first, it is very customer-specific and we can't say that just because somebody is in test and measurement that they're through the inventory correction or if they're in safety and security, they still have inventory that they're working through. So our industrial business is very broad. It's about 43% of our overall revenue. The strongest piece of that over the last year has been our aerospace and defense business and that's 11% of overall revenue. So it's about 1/4 of our industrial business in aerospace and defense and that continues to perform very well. Outside of that and really the AI piece of data center, which I think you have a question on later, that -- those are the stronger areas of the market and everything else is going through this pretty significant inventory correction. So the industrial business is our broadest business. You mentioned a few things. So A&D, we talked about testing and measurement, safety and security, factory automation, smart cities, all these things as part of that as well as medical.

I see. And outside of aerospace and defense, you think that we should be prepared for more downside in the next couple of quarters? Do you think that we are getting to a flatlining level in those other non-aerospace, non-defense markets within industrial?

Yes. I mean the visibility is low right now, but I'd say we are seeing the formation of a bottom for sure. These signs that we're seeing with these green shoots tell us that the bottom is forming.

Okay. On the automotive side, what is Microchip's positioning on the automotive side? And I am asking these questions because Microchip has never described itself as a play on one thing or another, right? That it's a broadly diversified company. Many of your peers describe themselves as a play on one thing or another. So, what are Microchip's kind of key focus areas in a car? And how is -- what's happening in the automotive market, right, flat production this year, EVs maybe growing? How does that inform us about how you can do in automotive?

Yes. So automotive in total is about 18% of Microchip's business. I think that increased by 1% from fiscal '23 to fiscal '24. We have a very broad set of products that go into the automotive market. We show a couple of different sets of pictures to investors, but it's not uncommon for a high-end automobile to have 80 of our parts doing various different functions within the automobile. It could be something very simple like a power window, door lock, seat. It could be lighting. It could be the infotainment system in the vehicle. It could be a touch screen. It could be USB. It could be camera system. So, it's very broad based. There's not one thing that is driving the growth. Now we have the megatrends that we're focused on and 2 of them are automotive-specific and that's ADAS and EV. And EV has obviously had a few short-term challenges. But longer term, we think that's an area that there's going to continue to be growth and an area that we're focused on.

What's your average content in an EV versus a traditional car?

So I mean, a lot of the same functions go into an EV versus a combustion vehicle. Generally, we think that the opportunity is probably about twice the size in an EV from a dollar content perspective. And EV, this is in the megatrends that we break out, is about 3% of our revenue. So of the 18% that's automotive, 3% of the total revenue is in EV today.

Got it. In line with how EV side as a percentage of the automotive market?

Yes.

In the automotive market, is that a market you still think that's -- that there is a -- there is a sense that maybe still the last shoe to drop in terms of whether it's excess inventory at Tier-1s or at OEMs? Do you sense that also? Do you think you have a much better handle on the automotive business?

I don't think we necessarily have a better handle on it. I think that customers across the end markets, including automotive, have inventory and are working through that. One thing that we thought would change based on this last crazy upcycle that we went through and the supply and demand shortages is that customers who were producing high-value end equipment and it could be automotive, it could be data center, it could be medical, whatever it could be, would learn their lesson that semiconductors is a complex supply chain. These aren't commodities. There's lead time involved. And we still hope some of that sticks, but it seems like these lessons are kind of short-lived and the purchasing managers are back to really managing working capital, taking inventory down. And again, I hope we don't find ourselves in a situation like we did last time where automotive stopped buying during COVID. And then it set off one of these very huge supply-demand imbalances that we've had, the largest that I've seen in my career in Microchip and that was very painful for our customers. And obviously very difficult for a company like Microchip to respond to.

Right. Based on these bookings, right, improvement, I know you said it's not the normal level, right, May better than April, better than March and Feb and so forth. Is automotive recovering faster? Or is industrial recovering faster in your bookings?

This sounds a little funny, but I really don't have a way to break that out, right? We do not track our business by end market on a quarterly basis. We summarize it for investors once a year. And we just don't have reporting within the company that tells us to that level of detail of what's happening. But it is true that there is more of the business that is direct in automotive than in some of the other end markets. But general feedback is, again, that automotive is still correcting inventory. And you can just see the difference that's happened in terms of the vehicles that are on the lots today versus what it was 18 months ago. I think the Tier 1s are sitting on quite a bit of inventory and I think some of that needs to get rationalized still.

I see. And you mentioned last quarter, direct sales went down more than distribution right sales. Conceptually, why wouldn't Microchip have better visibility into your direct customers, right, versus distribution? Or you think that direct customers just don't provide you with that level of feedback?

So we do not get any sort of inventory reporting from our direct customers. At least distribution, at least once a month provides us an inventory report. They provide us a sell-through report. We can see if inventory is going up or down. We don't get that from our direct customers. Now there are interactions and discussions that are had on a Microchip salesperson to the direct customer, but you do not get any sort of reporting that shows you that inventory has gone up or down.

I see.

So it's less clear. Distribution is easy for us to quantify.

Right. Over time do you think that Microchip will have -- so how much is distribution right now? Is it what about 60%?

Distribution is 47%.

47%.

Yes.

So you think over time does it get to be a bigger part of your sales? Or you think direct distribution remains? Does distribution become a smaller part of your sales? Or do you think it stays at this level?

I think it stays in this general range. I mean, we are pretty agnostic in terms of how the customer chooses to go to market. They can come to our website that we call microchipDIRECT and order product and have relatively little interaction with the salesperson from either the distributor or Microchip. They can pick and choose the type of support that they want. Tends to be that the larger customers are direct customers. But some of those might choose to purchase through distribution because distribution is providing a service that they value that it might be kidding, it might be programming, it might be logistics, it might be payment terms, right? So, definitely distribution has a role and we have multiple types of distributors that we work with. We have catalog distributors that tend to see the market that could be like the DigiKeys and the Mousers of the world. We have the global distributors that you're all familiar with. There are some Avnets. And then we have regional distributors that tend to be a little bit better at demand-creation activities. They're fully trained on our product set. They tend to only carry, as an example, one microcontroller line and can go on be proponents for our products in selling them to our customers and really showing them the benefits of what Microchip brings to the table. And if the distributor isn't involved in the demand creation activity, we are willing to pay them a higher margin.

Got it. On the data center side, Eric, it's -- we don't think of Microchip as a data center, right, company. But it's almost as big as your automotive business. So maybe help us unpack what is in your data center? What do you see as the big growth drivers for that?

So there's probably a point that I should make here because Ganesh made it at the Stifel conference earlier today is that with this rollout that we did of our end market data that we posted on the website today for fiscal '24, that the data center business was relatively flat year-over-year in terms of [Audio Gap].

18%.

But of that business, about 5%, just under 5% of revenue is AI related. So that was new information that we shared with the Street today. And so it's a little bit less than 1/3 of our data center business that is focused on the AI portion of the market. Now we provide a lot of different products to data center. Your data center specific business unit came to us through the Microsemi acquisition and they do things like PCI switches. They do SSD controllers as an example. But also that goes into the AI portion of data center. You're going to have things like microcontrollers. There can be FPGA opportunities, there's timing opportunities, there's clogs, there's power management, all these things. And Microchip tries to position those things around an NVIDIA GPU or an AMD product in a reference design and our business grew very well last year in AI. So the AI portion of that business grew significantly last year. Data center overall was down. CapEx spending in data center was down and that impacted our business, but the AI piece of it was up nicely.

Got it. So that is correlated to what we are seeing in the accelerator?

That's right.

Got it. Okay. On the CapEx side, your large competitor is building out a really large fab footprint, right, in the U.S. How do you think that changes the competitive dynamics over time?

So I don't -- it definitely doesn't change anything that we are doing. You'd have to ask them in terms of their strategic rationale behind that, and I'm sure there is rationale behind it. But we essentially have a different model. We do a little less than 40% of our wafer fab internally and the rest we were reliant on third-party foundries for us, TSMC, UMC, GlobalFoundry and others. And we are comfortable with that model. We do not have a 12-inch factory. We evaluated during COVID, during kind of discussion of CHIPS Act, would it make sense to make that investment and it didn't for us from a volume perspective. We just couldn't make it cost-effective. And then any process technology that is 90-nanometer or below, we use the foundries for. And we're comfortable with the model. We're comfortable that the foundries are investing appropriately for us. And for the capacity that we own, that's roughly 40% of the business, we have made significant investments. We ramp significantly to be able to drive us to $2.3 billion of revenue in the quarter. That was what June of 2023 was and equipment lead times were very long at that point in time. So we've actually received quite a bit of equipment. I think it's about $350 million that is sitting not depreciating, not being used for manufacturing today that is paid for and ready to go when the next upcycle comes. So I think our capital intensity over the next few years will be quite low. And that's not saying that we don't expect good things from the market, but we've got the capacity in place and we're comfortable that we've got what we need.

Got it. So you don't think having a lot of U.S.-based capacity can give you a competitive edge?

I think for some customers that might be important, but it's not necessarily if it is U.S., it is if it's outside of China or maybe for some customers if it's out of China and Taiwan. And so our foundry partners are working on investing outside of those areas to help drive the growth that our business needs over time and we're comfortable that they're committed to make those investments.

On pricing, is the thinking that pricing is relatively stable, right, this year? So, does it mean that there are products where pricing is still going up and products where pricing is still going down? What are the kind of the puts and takes because stable sounds like such a clean and efficient, right, assumption and I'm sure there is more to it?

Well, there's a little bit more to it than that. But in general, once we are designed into an application, that product can hold that average selling price or that selling price for that particular customer in that socket through its life. It doesn't mean that purchasing managers might not come and ask for it. But the pricing is always competitive at the point of design. And you win based not only on specs, but you have to have the right price that makes it cost-effective for the customer. But once you're designed in, that product can hold that pricing for its life. And we've taken this tact with customers for the last 10 years and that we've been very successful with it and customers are accepting of it. And again, they choose Microchip for a reason because we provide them the right specs, we provide them a cost advantage, we speed their time-to-market. Whatever the reason they might choose to design with Microchip, that holds through the life of the product. But we do have to be competitive on price at the point of design and we've always done that and we'll continue to do that.

Got it. But I think, historically, we have had that same situation. Still industry pricing came down before. So why can't the same thing happen again?

So we don't run our business based on what the industry is doing, right? We run it based on what makes sense for us. Obviously, we want to support our customers appropriately. Like I said, we made this change about a decade ago and have been very firm on that. And the only time that we've had any significant movement in prices over that time frame is either an acquisition that changed something or when we had the high inflationary costs that happened over the last few years, we were passing those costs on to our customers.

Got it. Makes sense. On gross margins, so about 60% or so in June, 8-plus points away from the high. Can we assume 60% is kind of the line in the sand that Microchip should hold this level of gross margins? Or if not, what are the kind of the puts and takes around whether it's mix, whether it's further factory utilization actions that you might take?

Yes. I believe that around 60% is the floor for us. That's the guide for this quarter. There hasn't been much of a change in what we're doing from a factory perspective quarter-over-quarter. In the March quarter, I think it was 60.3%. We're comfortable at this level. We are taking underutilization charges in the P&L today where we have 2-week shutdowns in all of our wafer fabs. We're taking days off in our assembly and test factories. All that is factored into the gross margin. Utilization is significantly lower than what it was at the peak. So the costs that are being capitalized to inventory today are higher. So our cost per unit is higher sitting in inventory than what it was a year ago. But we're taking the underutilization charges. We've taken some pretty significant inventory reserve charges based on our accounting policies. And as the business improves, those things will go away, and we're very confident in our long-term model of 68% non-GAAP gross margins.

How much is underutilization as part of the 8-point delta from the peak that you were?

So it was $32 million last quarter, and I'm not expecting it to be materially different than that in the June quarter.

Got it. And then on the OpEx side, you have taken some pretty drastic actions, right, to control spending. So as the market normalizes, should we be prepared for some sudden jump in OpEx as a catch-up? Because I think your quarterly OpEx is almost $100 million off, right, over the last several quarters. So, should we be expecting a quarter where as soon as you get to, let's say, seasonal sequential growth, right, whenever that is, that we suddenly see a $100 million jump in OpEx also in that same time?

So -- no, that's not what you should expect. So June quarter of last year was our peak revenue, and it was our peak OpEx. The OpEx was about $465 million on a non-GAAP basis. This quarter's guide is somewhere around $353 million, $354 million, so over $100 million of OpEx reduction. So that's come from a different -- couple of different areas. One is just general expense and control from the employee population. But the 2 biggest pieces are we have quarterly bonus programs, and those bonuses were paying out at roughly 300% of target last year at this time. Those bonuses are 0 today. So, that's a big change. We also have the entire employee population on a 10% pay cut and executives are on a 20% pay cut. And you should view that as temporary, right? We can't have our employees on a pay cut forever. But we will start to bring those back as the P&L can afford it, as revenue grows and then we would expect OpEx as a percentage of sales to come down, but dollars to come back. But that full amount of $110 million that we have taken out, you should not expect that to come back in the short-term because bonuses were at exceptionally high levels when revenue and profitability was so high.

Got it. On free cash flow margins, so they have stayed pretty strong, right, 30%, which is remarkable given how much the business has fallen off. What are your thoughts about free cash flow returns as the business starts to get to normal? I know there is a very specific formula, right, that you're following. So when do we get to the point at which dividends start to grow at a more kind of normalized pace and you're able to devote a lot more to whether it's buybacks or M&A?

Okay. So as you said, we've got a pretty specific laid-out program of how we're moving from where we are today to 100% adjusted free cash flow return. And so the plan is by March of 2025, so just a few quarters from now, we'll be at 100% free cash flow return. We're at 87.5% this quarter, and that's 87.5% of last quarter's adjusted free cash flow. Next quarter we'll move to 92.5%, the quarter after that, 97.5%, and then we'll be at 100% come March. Now, our desire or the Board's desire over time is for that to be roughly a 50-50 split between dividend and buyback, and that's never going to be kind of perfect math that happens. We're never going to cut the dividend. The Board definitely has decreased the amount of the quarterly increases in dividend. And all of last year, the buyback was higher than the dividend and that is not the case in this quarter as an example. So, we need revenue and profits to return to a higher level to generate the cash flow to do that. But the Board is fully committed to this program. I think a piece of your question was kind of M&A-related. We have no plans to do large-scale M&A. We did a couple of small tuck-in acquisitions in April and we reduced the amount of the buyback that we did this quarter for the dollar amounts that were paid for those acquisitions. But again, they're small, and those are really kind of IP, R&D team-type acquisitions to help accelerate a particular business unit in a certain area. But large scale M&A is challenging. First, we don't have any sort of large hole in the portfolio like we had historically when we were doing acquisitions that we think we need to fill through doing an M&A transaction. Secondly, if -- when we did our past 2 large acquisitions of Atmel and Microsemi, from the signing of the definitive agreement to close was about 90 days. And today, you'd be lucky to get a deal done in a year, maybe 2 years. And if you take 2 years to do a transaction, the company that you're acquiring is totally different. There's just a lot of change, there's a lot of churn, a lot of uncertainty, a lot of turnover. So it's just not something that we are actively pursuing today, and we're comfortable with the assets that we have, the investments that we're making, and you should expect that there'll be more of these kind of small tuck-in acquisitions that don't move the needle financially, but position us well for growth.

That's terrific. Thank you so much, Eric. Really appreciate your time.

Thank you, Vivek.

Thanks, everyone.