Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good afternoon. We're going to get started here. I'm Tim Arcuri. I'm the semiconductor analyst here at UBS, and very pleased to have Microchip with us. And with Microchip, we have Steve Sanghi, who is the CEO, I think that everyone knows Steve; and Eric Bjornholt, who is the CFO. So thanks to you both.

Thank you, Tim.

Thanks for having us.

So just to start with, I wanted to open with Microchip's recent leadership change, which has seen you return as the interim CEO, and announcements you made yesterday that revenues are at the low end of guidance and that Fab 2 will be closed. So I just wanted to open it up and see if you wanted to say anything about that.

Sure. So let me sort of start with the leadership change. I want to start by thanking Ganesh Moorthy, who worked for Microchip for 23 years. And he was a very hard worker, had a number of positions at Microchip for 5 years, from 2016 to 2021. He was the President when I was CEO, and he was too in the box with me. I couldn't have had a better wingman. He was just a great executor when I pointed him in the right direction. And then in 2021, I stepped down from the CEO role, and he became the CEO. And the results, especially in this cycle and the last couple of years, Microchip has substantially underperformed. So he stepped down from his role and retired. I had retired completely. I actually had moved out of the Valley. I still had a house here, but I was living in Prescott, in the mountains, having fun, hiking peaks, navigating lakes and playing with the grandkids and family. And then Board asked me if I would step back in. And I, with my team, built this company for 31 years. And when the duty called, I couldn't say no. So here I am. I moved back in the house in the last week. So one of the questions people have, two questions people have is, what does interim mean? My title is Interim CEO and President. And number two, what am I going to do different? So the definition of interim is I'll be in this role for as long as it is necessary. It is not weeks. It's much longer. Microchip, if you look at our performance today, we're down 55% in revenue from the peak; 1,000 bps down in gross margin; 2,000 bps down in operating profit; severe cash crunch, we're not producing even enough cash to pay our dividend, we're borrowing money to pay dividend. So I kind of look at it as a turnaround story almost. And we need to get all these things fixed before there is even a thought of another CEO transition. So there's no search out today. We're not looking for another CEO. I'm it for a while, whether you like me or not. So should I keep going? I just didn't want to have you get cut off from your question.

Keep going.

So what am I going to do? I'm on a massive, with a sense of urgency, program to review the entire Microchip from top to bottom in the next 90 days. And I'm going to give you a 9-point plan that we're going to look at. The first one is resizing the manufacturing footprint. So Microchip's manufacturing footprint today is too large. We had a peak revenue, which was more than 2x our current revenue, and we were adding capacity to grow beyond that. And some of that capacity is installed and much of that capacity is not even installed. It's an equipment sitting in our fabs that we can install and go substantially above our prior peak. So at the current revenue level and with any kind of expected growth, even significant growth, we got inventory, just incredible amount of capacity. And in trying to keep those fabs with some reasonable utilization, we have continued to build inventory, and we just can't do that anymore. We're drowning. So yesterday, we decided to close down one fab, Fab 2, which is our smallest fab. And a lot of people have been asking the question that by closing that fab, are we cutting off our upside. I'm really not worried about the upside. We have so much capacity and so much inventory. It was the smallest fab. The other fabs are capable of doing 3x of what they're doing today. So the upside is not an issue. So that's number one. And so this is resizing just the fab, but we have other factories. We have 4 factories, large factories, in the back end: 2 in Thailand, 2 in Philippines. And we have other smaller fabs around the world, 2 in Germany. We have a plant in Ireland. We've got 3 in Massachusetts. So all that structure, I'm going to look at it and review what needs to be combined, what needs to be done what. So the second issue is the inventory, which is tied to the capacity. For 31 years I ran Microchip as a CEO, I never had inventory go higher than 135 days on our balance sheet. Last quarter, the inventory in our balance sheet was 246 days. And this quarter was going to go to 276 days. And that was before we lowered the guidance yesterday. So it's going to go higher than that. And the outside inventory, what we buy from foundries, is about 234 days. So the inside inventory is even higher than the number I gave you. It's probably closer to 300 or higher. That's over 2x the inventory. I mean it's just like way too much. Enough is enough. So we're going to aggressively bring the inventory down. Our inventory is too high even on the foundry. So we're dramatically cutting starts from the foundry to bring that inventory down. The system inventory is closer to 300 days. Systems is 10% of our business, where we build the boards and systems and development tools and others. And why does it have 300 days of inventory, it should be 100 days lower, so I'm going to mount a program to bring that down. The third one is there are a lot of growth initiatives in the company. There is mega trends, there is TSS, there is AI. And I need to review each one of those programs and see what is working, what is not working, maybe take one away, maybe add one, add more resources to this because there's higher potential, take resources from this because it's not working as well. And so I'm going to do that entire review in the next 90 days. And then the fourth one is a review of the business unit. We have 25 business units in the company. We actually, every quarter, see 25 P&Ls. And some of the business units are quite small. They were started for a reason maybe 5 years ago, 10 years ago. Is that reason still valid? Is that promise still there? In some cases, maybe it's not. So they should be combined or closed or sold, or I'm just going to review everything and see what needs to be changed. So that's the fourth. The fifth one is the channel strategy. So you're aware of significant changes in the distribution strategy in our industry where many other companies have done. Microchip channel strategy hasn't changed in several years. We do business with about 100 distributors around the world. Some are global, some are regional, some are catalog. And I'm going to do a comprehensive review of that channel strategy to see what are we paying everybody. Is that too much? Or is that too little? Should something be terminated? Should something be added? And I think the whole channel strategy need to be looked at again. Number six is strengthening our customer relationships. I think in the times of extreme shortage and after that, when the industry came down and there were a large number of noncancelable, non-reschedulable orders on our books and, in certain cases, customers didn't want the product but since we helped them in good times, in bad times, we wanted them to help us and keep taking that product, I think we stressed certain relationships. And call it an apology tour, call it forgiveness tour, I think we are on it, and we've got 125,000 customers, we cannot visit them all, but we need to take top 5,000 customers and ensure that we love them, but do they still love us. And some of them have 6 months of inventory. They're not buying as much from us today because they have inventory. But when the inventory runs out, are they still our customers? Are they going to still buy from us when we have the next design? I think we do. I think it's okay. But we just need a falling on the sword and apologize and give them some TLC and ensure that our customer relationships are strengthened. Number seven is the business model. Now our business model that we have still has a remnant of elements from peak performance. When growth was very high, gross margin was very high. There were expedited charges. There were price increases. Customer is willing to do anything to get the parts. And the operating expense percentage was very low because the revenue was so high and you couldn't add operating expenses fast enough. So the business model that is still in our presentation, which has been taken out, really had remnants of peak performance in a super cycle, which is not representative of the real world. So I'm going to recast that in 90 days. I don't know what changes will happen in there. When I look at it on the gross margin side, actually some of our businesses that are higher than corporate gross margin are doing better than our businesses that are lower than corporate gross margin. So gross margin could actually be accretive for all I know. But there is also pricing pressure, things happening in China. So there are things on both sides of the ledger, and I need to put it all, process it all together and see what the new growth number is, what the new gross margin is, operating expenses, and give that business model to you and then aggressively execute to get there. So that was number seven. Number eight is on the OpEx side of the equation. Our OpEx today is 35% of our revenue, and that was before we lowered the revenue yesterday, so it's even higher. Plus, all year, we have been on a pay cut. That pay cut was reversed 2 Fridays ago just before I joined. It was the decision made before. So when I look at the next quarter, the full pay will be for the entire quarter. And when that happens, so when we have a full quarter of full pay, the OpEx in dollars will rise some. Plus, in the first quarter, all the FICA comes back for the higher-paid people because usually, in the third and fourth quarter, the company matching part of FICA is not there. So I think I'm concerned that the operating expense goes higher and gets farther away from a model that I like to see at. So what needs to be done? What portion of it will actually self-correct when the revenue comes back? And what portion doesn't come back and we need to do something in terms of weeding and feeding, and business units or whatever? So that's just a question right now. I don't have the answer to that. And the final one, number nine is review the CHIPS grant. The grant was applied to maybe almost a year ago when everybody thought that the factory capacity was never enough and the world is going to build silicon fabs forever. And today, we have too much capacity. And government gives you $0.15 of every dollar you spend. Do I want to spend $100 million to get $15 million back from the government? If I don't need it, then I don't want to spend the other $85 million myself. So I don't know what the answer would be. With 10 days back at the job, I just need to reopen that. I have put the negotiations with CHIPS office on hold for now until I get my arms around it. And probably by the time I get my arms around it, we're into the new administration. I don't know what their take is, which people they put, is the money still available. But whatever happens, then we will deal with it. So that's kind of what I'm going to do. And the plan is to get this accomplished in 90 days, which is a Herculean task. I don't know how much of it gets done, but that's what the attempt would be. And we'll bring some of the output back to you probably at one of the conferences in March and give you some update. So that's kind of where I am. Sorry for the long answer.

That's great. Thank you, Steve. As I hear you talk and I think about how sharp the recovery could be for Microchip in particular, given just the depth of how far things have come down, I would think that when things come back, they come back pretty sharply and more sharply for you than maybe some of your peers. Now that might be a while from now, we can debate when that is. But the pace of the recovery ought to be pretty quick because of your reliance on distribution and all those factors. So how much does that come into your mind when you're thinking about these cuts? You don't want to overcut. I mean, you've been around a long time. You've seen a lot of these cycles.

So I'll answer the second part of your question regarding the cut and then maybe Eric can answer how sharp the recovery can be. I'm not worried about the upside portion of it. I take the example of, if you ask me to hit the bull's eye, the chance for me to hit the bull's eye is 0. But if you say, "Make sure that you're on the left of it and never go right," then I can do it every time. I'm not worried about the right side of it, the upside of it, because we have so much inventory and so much capacity. Even after closing this fab, our other 2 fabs can do 3x of what they're producing today. So I have no concern about the upside. I have the concern on the downside because, for 4 or 5 quarters, we've been calling it a bottom and we're probably still dribbling at the bottom. And the current quarter is down, what, 12% from last quarter sequentially. And the inventory has been growing. Every quarter, we guide down, and the inventory grows further. So I think that's my concern. The upside is covered. We just want to make sure that through all these actions, we don't build inventory. Today, there is probably $800 million to $1 billion of excess cash tied up in inventory and CapEx. And if we didn't have that, we probably didn't need to refinance one of our loans. So one of the things we need to do is liberate the cash through inventory, liberate some cash through CapEx and liberate some cash through growth of the business that is likely to come in the coming quarters and, by a combination of all those, get the free cash flow above where our dividend is. Today, we're borrowing money to pay the dividend. There's no plan to cut the dividend. Dividend is not at risk. We may have to borrow money for a couple of quarters, which we will do. But as we liberate cash and the cash flow becomes higher than the dividend, then we'll take the remaining upside cash and pay back down this loan that we're borrowing right now to pay the dividend. Once we have done that and the total debt has gone back to where it was pre-borrowing for dividend, and we have more money left over, then we'll have a conversation what we do with it. But that's not immediately in the next quarter or so. So I'm not worried about the upside, but like what sort of recovery you think can happen? What do you want to say about that?

Well, we know that there is a lot of inventory that is being drained throughout our customer base and their customer base today. I mean we can quantify the piece that's distribution. We've quantified the last 3 quarters. That's been about $100 million per quarter that distribution sell-out has been in excess of what we're selling in. And we expect something around that again this quarter, and that is with distribution sell-through falling because distribution customers are draining inventory, right? And so that's on a little less than 50% of the business that goes through distribution. Same thing is happening on the direct side, but we don't get any kind of real-time reporting from the customers. So I'm with you that I think this can have a really nice bounce off the bottom, but projecting where exactly that bounce takes us to is an impossible thing to do today. We have very limited visibility.

Sure. Got it. And Steve, we do all these scrapes of disti websites. And microcontrollers, in particular, are sort of an outlier in terms of the inventory sitting at these distis. And it's not just Microchip. Is there something unique about MCU? I mean, part of it probably was PSP and all the things that you talked about. Yes, there is that lag effect where you were putting product to customers. But how much of sort of what's going on in microcontroller is industry related? And how would you tie that back to the environment for demand across the different end markets?

I don't know if there's anything in a microcontroller product compared to any other product that it should have a higher inventory. I can't put my finger on it. But one thing I look at is TI, Silicon Labs, Microchip, NXP, they all had new CEOs in the last business cycle, and they all built a huge amount of microcontroller inventory. I don't know if there is anything else common. I think for all those CEOs, it was the first business cycle. I don't know how else to say it.

Okay. And then can you talk to China? I know this is more of a structural question. China is sort of seen as this melting ice cube, and it's seen as just only a matter of time until everyone in the industry begins to feel the indigenization of what China is trying to do. From your seat, how much do you see the indigenization efforts as a threat to your business in China?

So historically, what we have said is China is 18% of our business. And half of that business is selling to multinationals who are doing manufacturing in China, but their product then moves back out to U.S. or Europe or Japan, somewhere. And we didn't think that, that one was at risk because products they're manufacturing for Western will not likely use a local Chinese parts. Then the other 9% of the business that's remaining, half of that are very complex parts, FPGA, data center parts, high-end Ethernet parts, high-end microcontrollers, well-integrated parts, so which are not the parts that the Chinese are trying to make or copy in all this boutique Chinese industry developing. So if you take all that out, it only leaves about 4%, 5% of the business, which is commodity-like microcontrollers that are going to the Chinese customers, which could be vulnerable to the local Chinese supply. So that's really what we have historically said. And it's largely still correct, but I think you're starting to see some chinks in the armor where, for example, European car manufacturers have assembly plans for cars in China, and they're getting government pressure to use local Chinese parts. And here and there, you're starting to see designs pop up. It's not making any significant difference. It'd probably be years before it makes any meaningful difference. And automotive design is 3 years away from production usually. It's a long cycle. But I think that thing is no longer 0. There are some cracks starting to develop. And then China is applying more and more pressure for the industry to use local parts. Now local companies don't really have a broad enough product line. I have said for years, if you recall this conversation, that usually 70% of microcontroller customers do not go to production with the device they first designed with. A year, 1.5 years, it takes to go to production, usually, the spec changes. Marketing comes in and says, "Well, we need to add a color display, black and white is not good enough," "USP connectivity was fine, but now we need to connect it to Internet," or "The power is too high, we need a low-power part." So during the design phase, the spec changes. And when that spec changes, if you're designing with a local Chinese person who has 2 or 3 microcontrollers, you don't find another part that fits in there, which allows you to do what you do. We have 20,000 microcontrollers, distinct microcontrollers; parts with USB, Ethernet, WiFi, Bluetooth, TWMs; low power, high power, high speed, low speed; pin counts, 8 pin, 16 pin, 32 pin, 40 pin, 68 pin. And so when the customer definition changes and he needs a different part, he can preserve his investment in design and firmware and usually find a different part, which has what it needs from a Microchip portfolio. But he can't find that kind of diversity to fit into the same socket from a local Chinese guy who designed 2 parts. And the second thing is when a Chinese guy designs 1 or 2 parts, there is no microcontroller in our portfolio that will make even 0.1% of our business. But 20,000 [ microcontrollers ], that make up our business. So it's highly fragmented and that high fragmentation is our friend because you can't attack that kind of fragmentation. You have to produce all these devices. So competition is increasing. But hundreds and hundreds of these Chinese companies funded by government are going bankrupt in 2, 3 years, but some of them are prevailing. And the ones who are prevailing are starting to make some small inroads no matter how small they are. They're not affecting the revenue today. It's of the order of less than 1%. But it's an issue in the next 5 years and 10 years. So what is needed, and some of our competitors are looking at the same thing, where you need a China for China strategy, where there's a Chinese company that we fund, which is based in Shanghai with a Chinese name, with a Chinese logo. We have actually just trademarked a Chinese Microchip. When you read it, it's in Chinese. But apparently, it says Microchip, I can't tell. And then you sell the die to this company and this company locally assembles and tests and markets it with a Chinese data sheet with Chinese engineers, with Chinese management, with a Chinese Managing Director. That's one model. There are versions of the other model. People are talking about it. So once you become that, then you're part of the ecosystem with the strength of our 20,000 parts, with the strength of our design capability, marketing muscle, all the app notes and website and on and on and on. So you take your global strength and you apply it with a Chinese frontage and then the locals cannot make a dent, and you participate in the growth of the Chinese business. We're going to land at doing something. I don't know what that form would be. So I think that's the answer there.

I think some of the challenge, though, is that the rules are ever changing. What works today might not work 12 months from now, right? So you have to be on top of it and not be so dedicated to one approach and then have that approach not work.

As you go through this evaluation, who knows what the new administration will do? But the talk about tariffs and all this kind of stuff, I mean, how does that play into your thinking about what you want to do?

So what the tariffs and all that have done is it has stressed relationships with Chinese customers. I was talking to our Head of Applications in China, it was a couple of years ago. And he was complaining that some Chinese customers are saying, "U.S. government shut down ZTE. They shut down Huawei. Why should we design with an American product? They could shut us down someday." So I said, "Well, let's take the example of ZTE. ZTE, they sold parts to Iran in violation of the embargo. Don't you think they should be penalized for that?" And his answer was, "Why does China care? That's a U.S. problem. You don't like Iran. They are our friends." And that's the attitude. They say, "Hey, we don't have any problem with Iran." So the problem is when we are shutting down those customers, how would our customers in the U.S. feel if China shuts down Cisco over there, like we shut down Huawei? When you think of the reverse of that, it's frightening. But one thing China hasn't done so far is they haven't retaliated much at all. I think there was some sort of note this morning that they're going to control germanium or something. But all this time, while we have put sanctions on them and we have put tariffs on them, they haven't retaliated. And if Trump comes in and puts more sanctions and shuts down more companies and things like that happen and the relationship get even worse, and then Chinese start to retaliate, hold rare earth materials, not allow us to sell and all that, then that becomes much more difficult. But my take on that is, number one, it's not likely to happen because China and U.S. cannot exist without each other. There's too much dependence on materials and products and others. Neither can Chinese nor U.S. can complete a server or equipment without having some material or parts coming from the other country. So I don't really think a self-destruction is likely to happen. Some wisdom will prevail there. And secondly, whatever happens, whatever rules are, our job is to achieve what is achievable better than our competitors. And if you can do that, then that's the best that can be achieved. Today, we are underperforming to our competitors, and that's not acceptable. And I'm here to change that. And whatever happens, if under those circumstances, under those rules, think of it like, "I cannot change the flow of the river, but I can navigate the boat, around the boulders and around the waterfalls and achieve the maximum speed and get ahead of the competitors," that's what we need to do.

Great. Eric and Steve, thank you so much. Appreciate it.