Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Okay. Good morning. I'm John Vinh. I cover semis here at KeyBanc Capital Markets. We're pleased to have Microchip with us this morning, and we have Eric Bjornholt, CFO. Welcome, Eric.

Yes. Thanks for hosting me. Appreciate it.

Obviously, just very topical right now is just kind of the cyclical recovery. I think you and your peers are seeing similar recovery trends. Maybe just take a minute, Eric, just to walk us through what you're seeing from a recovery perspective, maybe talk about bookings trends and book-to-bill and lead times and customer inventories?

Sure. I'm going to start with the disclaimer that during the course of this discussion, I'll be making certain forward-looking statements. I refer you to our filings with the SEC that identify important risk factors about the company. So with that out of the way, bookings have definitely improved. We broke out a book-to-bill ratio in the March quarter. It was 1.07. It was above 1 in June, and then we made the comment on our earnings call last week that our July bookings were the largest bookings that we've seen in 3 years. So bookings have improved, obviously, coming off a low base after the kind of the inventory correction. But definitely, March marked the bottom for us, and we have seen an improvement in bookings. And obviously, we had a really good quarter this last quarter, growing 10.8% sequentially and seeing improving metrics in gross margin, operating margin, et cetera.

Great. Maybe just a couple of follow-ups there. Given that July bookings were your largest in 3 years, your guidance into third quarter was kind of largely seasonal. So if the bookings were the largest in 3 years, why not a more optimistic outlook there?

So I would say that our guidance for the quarter was above seasonal. We're guiding 5.1% up. We don't have any quarter that is seasonally up 5% plus. And bookings obviously age out in time. We have a high level of inventory today. We have extremely short lead times for most of the product portfolio. And so there's a lot of turns involved to get to the number that we guided to. And the bookings dry up the further you go out in time, right? So visibility is pretty low, and that's just a function of where lead times and inventory are today.

Okay. To that point, I'm wondering if you could just clarify this point that I think Steve had talked about on the call how you're sending out letters to your customers and encourage them to book further out that typically at this point in the cycle, you're going to potentially see an extension of lead times. There may be some concerns that there's maybe some elements of that PSP program. Can you just clarify exactly what you're trying to encourage and what you're trying to do with that sort of notification to customers?

Okay. So, actually, the only notification that we've given to customers was through our earnings call. And in that call, Steve, our CEO, said, "Hey, we've got pockets of lead times extension at this point in time." I think you're referring to historically, we used to post on our website, hey, customers get your orders in because lead times are extending. And we haven't done that as of yet. But we are seeing -- we outsource roughly 30% of our assembly and test, and we're seeing that some of that capacity is pretty tight right now as some of the OSAT suppliers are working on iPhone builds and maybe data center AI activity that is pretty hot right now. And so that capacity is getting consumed and lead times have extended. And it's actually at the point where some of our data center business could be stronger this quarter, but we're not able to deliver what the customers want because those lead times have stretched. So that's typically how these things work that it starts to get lead time extension on a portion of the product portfolio, lead times start to extend and then you start over time, getting better backlog visibility. What we're trying to prevent is customers getting surprised and you have 10 customers come in and order the same product and the lead times go from 6 weeks to 12 weeks, and they can't get the product when they need it. So it's just general communication that we're doing.

Okay. Have you gotten any sort of feedback from your customers since you've made that sort of announcement on the earnings call?

So it's early, quite honestly. So I haven't got any specifically. Obviously, traveling here this week, I haven't got feedback from the sales team. But I think customers will take notice, and we'll highlight these things to customers, particularly those that are buying those products that are seeing the lead time extension and hopefully get some traction with better backlog coverage. And there's really no penalty for the customer to do that. They can cancel or reschedule that product anytime before 45 days before the delivery date. So if they gave us 16 weeks of coverage, they still have flexibility to push things out or pull things in.

Okay. Is 45 days the same cancel window that you had previous to COVID?

So it has changed over time. I think at one point in time, for some of our products, it was as short as 30 days. It extended out to be like 90 days during COVID, and now it's back to 45. And I think that's a good spot for us to be.

Okay. Obviously, your June quarter results were extremely strong. Can you just talk about how much of that strength that you saw in the quarter was due to tariff-related pull-ins versus just recovery?

So we think it's mostly recovery. We go out every quarter, our sales team and talk to customers and have our distributors talk to their customers that had any significant change in their quarter-on-quarter or year-over-year revenue and get that feedback and say, what's happening, right? Most of that feedback is that, hey, our inventory is drying up, and we're needing to start purchasing more in line with what the consumption is. And we did get a few customers, particularly in China that did note tariff related. And when we expand that out, we think it was probably a $5 million to $9 million impact on the quarter of pull-in. But I think there's equal amount of customers that are kind of frozen in their tracks waiting for all this whole tariff situation to get resolved and understood because once they buy our part, then they have to manufacture their good, whatever it could be, washing machine, automobile, et cetera. And they want to know what that final landed cost is going to be, and that's difficult when things are in flux. So I think it's on both sides. We think it was a pretty immaterial impact on the quarter.

Right. It sounds like you feel very confident that kind of the inventory levels at your end customers are largely normalized. Obviously, if you look at distribution inventory, it's easier to get your handle on that. Can you just walk us through what the process you use because you have so many customers out there to get kind of a sense of where the end customer inventories are and why you have confidence that things are normalized there?

So it is challenging, right? We do 47% of our business through distribution. We get real-time reports from our distributors every month that tell us what their inventory levels are. We obviously know what they're shipping through to customers, and we know what we're selling to them. So we can measure that pretty easily. And distribution inventory has been coming down dramatically over the last 7 quarters. The difference between sell-through and sell-in, sell-in being our GAAP revenue recognition was $103 million in the March quarter, that dropped to $49 million in the June quarter. So it is coming down. I think there's still a bit more of distribution inventory to come down, but they're definitely seeing that they've got plenty of products where inventory is kind of at rock bottom and they're needing to order again. Now the direct customers, many of these customers signed up for the PSP program early and got preferential treatment. And so I think there still is some level of inventory that our direct customers are working through. We can't quantify that for you because we don't know exactly what it is, but we see a lot of good signs in the business. One of the things we saw this last quarter is that distributions sell-through increased for the first time in 8 quarters. So that tells me that, hey, the distribution customers are working through inventory and eventually are going to start purchasing more in line with what consumption is. When that happens, the distributors will need to buy to support that activity. And the same thing will happen at the direct customers, but we can't quantify it exactly. But there's pockets where customers are running out, and there's pockets where they still have some inventory.

Right. When you look at this recovery and you look at the different segments or end markets, where are the areas where you're seeing the most amount of strength? And maybe what are some of the areas that are still lagging a bit?

So we are obviously seeing really good traction in aerospace and defense today. That was 18% of our business in fiscal '25, which completed in March, and defense budgets are going up around the world. We are the largest supplier of semiconductors to the U.S. Department of Defense. So that works in our favor. So that's an area that's quite strong. We're seeing the data center business starting to come back, which is good to see. General industrial is obviously a large piece of our business, and that's a mix there where some customers are buying again and other customers are still working through inventory. Automotive has been a little sluggish, which I think is kind of familiar with what you're hearing from other companies.

Great. Aerospace defense, obviously, has been a pretty consistent area of strength for you, obviously. Can you just talk about your portfolio there? What's differentiating yourself with that market? And is that largely the Microsemi portfolio there?

So a large piece of it is the Microsemi portfolio. Obviously, that's a company that we acquired in 2018. So we've been working with customers and our product divisions to get more of our products qualified that we can sell those into customers. So it's FPGA, has a heavy footprint in aerospace and defense, but we're selling standard microcontroller and analog products today, some of our memory products, some of the timing products, some of our system-level products go into aerospace and defense. So it's broad-based. It's more than just Microsemi, but that's the largest piece.

Great. You had acknowledged that there was maybe 6% of your customer base where you had some work to do to kind of improve your relationships there. Obviously, some of this obviously had to do with the follow-up from the PSP program. Can you just talk about what you are doing specifically to improve on those customer relationships? And maybe just give us an update in terms of what kind of progress you're making there?

So we've made really good progress. And I think at this point, we don't have a customer issue any longer, right? There's going to be the small percentage that have hurt feelings or whatever. But we've met with them, fallen on our sword. We've explained to them how we got to the point we were at. They understand it, right? Everybody had extended lead times in some form of NCNR program, noncancelable, non-reschedulable program during the upcycle. We clearly stuck with our program a couple of quarters longer than we should have, and we talk through that with customers, and then we find ways that we can partner with them to provide value. And that's why they've obviously selected Microchip to work with historically. And ultimately, the engineers like working with us. We deal with the purchasing managers and help mend fences there and with the C-suite. And I think we're in a good spot today. We -- Steve announced this as part of his 9-point program. And when we went through that work between kind of when he came back in November and really our early March earnings call, we had made a lot of progress in that time frame. It's continued over the last 4 months, and I think we're in good shape. So I think customer relationships are healthy.

Right. I think you were also very transparent in acknowledging that maybe the PSP program wasn't kind of the best program to implement during this last pandemic cycle. What have you really learned about it? What safeguards have you implemented in this next recovery? And what are you planning to do differently going forward?

Yes. So PSP was definitely not all bad. There are many customers that were PSP participants that would sit here and tell you we had a great experience. We got supply when we needed it. We didn't have lines down situations because of Microchip. So there was good that came out of it. But it extended too long. We didn't have appropriate safeguards across what we were doing, where you could have a situation where a customer has been a steady customer for the last 5 years and buying 10,000 units a month, right, and fluctuating modestly. And the PSP program could have consumed capacity to them where that steady long-term customer couldn't get product for 52 weeks because lead times stretched so long. So we're putting certain things in place where we can look at customer behavior and past history, not just direct customers, but through distribution to make sure that we reserve capacity in the future for those customers and don't let it get consumed when lead times stretch again and backlog goes up because it will in the future. And so we're using AI and machine learning to help us with that to identify those things, and I think we're going to be in a much better spot in the future. And I don't think we'll ever do a program like PSP again that goes out 12 months for NCNR. But NCNR is important in some instances. I won't say that we'll never use it, but PSP, a program like it will not come back in that exact form again.

Great. As part of your 9-point program, or turnaround plan, there is some fab rationalization in there. What are you doing in terms of just optimizing your fab footprint to take into consideration that concerns around Section 232 tariffs and some of the geopolitical related tariff risk there?

Right. Okay. So we do a little less than 40% of our wafer fab in our U.S. factories. It used to be 3 factories. Now it's 2 factories. We closed the Arizona fab. The last production came out of there in May. But none of that production that was produced in Fab 2 is moving outside of the U.S. It's moving to our other 2 U.S.-based fabs, 1 in Colorado and 1 in Arizona. So the production in the U.S. for us is not changing because of that. We expanded clean room capacity and equipment capacity significantly during the up cycle, and we think that we can support peak revenue plus again from those other 2 factories because they've got the largest footprint. Fab 2, which we closed was our smallest of our 3 domestic fabs. So from a 232 perspective, I think we're actually in a really good spot, right? We have domestic manufacturing today. We continue to invest in that. I mentioned before that we are the largest supplier to the U.S. Department of Defense, which is pretty important. And we're continuing to invest. And then when you look at some of our foundry partners. We use foundry partners that actually have U.S. footprint also. So if you look at the dollars that we source through U.S. fabrication, through our own fabs and then our partners that have facilities here. So TSMC has a fab in Washington, GlobalFoundries has a fab in New York. X-Fab has a fab in Texas. You combine those together, we do about 50% of our wafer fab domestically, which I think should qualify us to be exempt, but we'll see how the final rules play out.

Great. One follow-up I had on that is, are you supporting any sort of fungibility between some of your overseas capacity with your U.S. capacity? Is that something that you're working on at all?

So there's some of that, right? We have certain products that can run in our internal factories, and they can run in an external factory because we have process technologies that are qualified both in our internal fabs and an external partner. And essentially what we've done is we have mapped out for our customers where they can see this is the point of fab, this is the point of assembly, this is the point of test and done that in a way where depending on where all this tariff stuff falls out, they can pick and choose where material is sourced from that gives them the best answer for them depending on where we're shipping that product. So it's not perfect. I mean, there's lots of product that is produced on advanced nodes where we don't have the ability to do those by ourselves internally, but our foundry partners might have multiple locations where they can do that, and we'll maximize that to the extent that we can.

Are there any questions? There.

Kind of [indiscernible] mandated, the new kind of architecture, how do you implement that [indiscernible] that you talked about, I think, on the call?

So, that is definitely a new thing for us. We're making investments there and supporting what customers need and obviously want to be compliant with everything that we need to be on a global basis. So it's just continued investment that we need to make over time. And I don't think it's a material needle mover for us, but something that's important to a portion of the customer base.

Does it go across the entire [indiscernible] portfolio?

I do not know the answer to that. We can follow up separately. If you want to follow up I can get the business unit person to chime in.

Any other questions? Great. Eric, maybe you can talk about kind of the China market right now. Maybe just walk us through your China for China program. Are you also just giving -- given the geopolitical tensions out there, are you seeing more pressure on your Chinese customers to kind of move to local sources? I know there's always been competition in that domestic market, but maybe just talk about that.

Right. So we talked about a China for China plan back in March, and I think with all the tariff that have changed between then and now and still waiting for some of that to get finalized, that is not a completely finalized plan as of yet. Again, we've mapped out our sourcing of each product, so our customers can see that, and we can work with them to find the optimal manufacturing flow that works for them depending on the country of location. China competition is definitely an issue for a portion of our product over time. We do about 18% of our revenue in China. We think about half of that is done through multinationals that we ship product into a foreign trade zone over there. It's manufactured and then it ships back to the U.S. or Europe. So that really isn't at risk. But the 9% that is kind of domestic consumption is something we obviously look at. We think about half of that is products that Chinese competitors don't have, and so there really isn't competition for us domestically there and the customers need to use our product line. So an FPGA could be an example of that. A data center product could be an example of that. It has a couple of examples of there. But leaves probably 4% to 5% of the revenue that is subject to domestic competition, I'll call that kind of standard microcontroller and analog product. And clearly, those customers have chosen Microchip because they want to work from us -- with us. But there is pressure from the local government for them to source domestically if they can, and that's where our China for China program will come into play and finding a way to make as much of that product, be sourced from an area, could be sourced from Taiwan. Is that considered China or not, right? China would probably think so, Taiwan would not. But there's a lot of permutations and combinations, and we will work with our customers to best service their needs. But there's going to be more and more competition on that 4.5% of revenue, and we'll continue to invest and support our customers and invest elsewhere where we think we can get the biggest bang for our buck.

Great. Can you talk about the pricing environment right now? And maybe also just comment on how does that compare to the pricing environment you're seeing in the China market?

So I would say pricing for Microchip is pretty stable. We are being aggressive at the point of design, which is normal for this point in the cycle. All of our competitors have excess capacity and are fighting for sockets just like us. So we're being aggressive with pricing there. We talked about likely a mid-single-digit pricing decline this fiscal year, and then it probably gets more stable after that. But that's really just being aggressive at the point of design. But once we're designed in, those prices tend to hold through the life of the application. All the work is done upfront. The pricing is set there and then the customer is designed in with a proprietary product that is not pin-for-pin compatible with any of our competitors. So pricing is stable.

Great. As part of the turnaround plan, I think you talked about adding an AI business unit. What's your AI exposure today and what are the opportunities that you see to grow that franchise?

Yes. So this is new, the AI business unit. So we created an Edge AI business unit that is really looking today at maximizing the benefits of the portfolio that we have today and building a go-to-market strategy around that, and then getting all the business units that support the AI ecosystem to work together for common sets of IP, common go-to-market strategy, feeding our sales force with the proper collateral material to make ourselves successful. So there's definitely IP investment that's going to be made. There's helping to shape new product development for some of these business units that have the opportunity to really do well there. It could be MCU, MPU some of our wireless products, our data center products, et cetera. And with that, it's a relatively small portion of our business today, but it's got a growing footprint, and we are very well positioned with some of the products that we have today, just kind of enhancing the software working with the customer to do that to do really well.

Great. Can you talk about just the puts and takes of how we think about kind of the gross margin expansion as we continue through this recovery?

Sure. So our long-term target model on gross margin is 65% on a non-GAAP basis. The last quarter was just over 54%. We're guiding the current quarter to 56%. And there's 2 significant charges that are impacting gross margin today. We have underutilization charges from our factory, which were just over $50 million last quarter. And then we have accounting charges for inventory reserves, which fell last quarter to about $77 million. It was $90 million the quarter before, but those are going to come down very rapidly as we move ahead. The basis for those calculations, you take a snapshot of inventory and look at 12 months of trailing revenue demand, and we've been in a falling revenue environment and inventory has been up until the last couple of quarters, pretty stably quite high. And so inventory is coming down rapidly. We've got a goal this year to reduce inventory on the balance sheet by $350 million. So that alone will take those charges down. And then with the revenue inflecting upwards, that's also going to take those charges down. So those charges never go to 0. There's always some inventory that is subject to those charges, but that $77 million could come down to $20 million, and that's $57 million of gross margin improvement or 5 percentage points that will come back to gross margin pretty rapidly here over the coming quarters. And then the capacity underutilization charges will be more gradual. I think that will spread over a couple of years. We are -- that charge is going to come down just modestly in the current quarter, and that is really from our back-end factories ramping assembly and test activities. We drained finished goods last quarter. We don't want to do that again this quarter. And then we've indicated publicly that we plan to increase wafer starts in our factories starting in December, and we'll gradually do that over time as revenue and inventory supports it.

Great. Looks like we're out of time. Thank you, Eric.

All right. Thanks, everybody. Thanks, John.