Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Welcome back, everybody. I'm Joe Moore, Morgan Stanley Semiconductor team. Happy to have the management team of Microchip, Eric Bjornholt, CFO; and Richard Simoncic, COO. So thanks, guys, for coming. Really appreciate it.

Thanks for having us.

A lot of interest in Microchip these days. You guys have probably the best rate of change off the low point and a lot of faith in Steve's ability to kind of get the business reoriented. You guided March up 6% sequentially, quite a bit stronger than seasonal. Can you help us understand that? Is how much of that is customers not depleting inventory anymore? Any indications of restocking, half of the customers destocking and still like just where are we in that dynamic?

Sure. So let me start by saying during this discussion, we'll be making some forward-looking statements about the future financial performance of Microchip, and we refer to our filings with the SEC that identify important risk factors about the company. So yes, we're guiding the current quarter up 6.2% at the midpoint. I think it's a combination of things. We've got good product momentum in various areas, which Rich can talk about as we go through some of your other questions. But bottom line is distribution inventory is kind of normalized at this point in time. If you look back a year ago, we had like a $100 million difference between what we were selling to the distributors and what they were selling through. And now that's collapsed down to only be about $12 million last quarter. I think customer inventory is still normalizing a little bit at the end customer and at distributors' customers. So there's still a little bit to go there, but the distribution is completed at this point. And then we've got, as I said, some pretty good product momentum in certain areas that we'll touch on throughout this discussion.

Great. And you've talked a little bit about visibility building. You talked about a good January bookings month when you reported. You talked about June backlog looking better, getting that forward-looking visibility a little bit. How much of that feels like it's end demand related? And did that persist after the Chinese New Year holidays?

So I think the demand environment is definitely improving. Our February bookings were also quite strong. And if you look at the first 2 months of the current quarter, they are the highest first 2 months we've seen in bookings since, I think, the June quarter of fiscal year 2023. So booking...

There's a lot of math when you say stuff like that, I got to go back.

All right. I got to make sense of it, it's been a long time.

It's been pretty good, yes.

And it's been good. So backlog is filling up nicely, giving us confidence, obviously, in the current quarter guidance and then giving us better visibility into June and beyond.

And are customers wanting you to have that visibility? Or are they still believing that you can turn stuff in a pretty quick fashion?

They mostly believe that we can still turn it in a pretty quick fashion. We've got 200 days of inventory still on the balance sheet. So we -- and our lead times are generally short. There are some anomalies to that or some instances where lead times have extended, if it's on very advanced process technology, it could be some things with substrates and some of our back-end assembly and test manufacturing. But generally, lead times are still short.

Okay. And then you mentioned distribution inventory looks cleaned up, but direct is mixed. I guess that seems a little bit more cautious than what we're hearing elsewhere. Some of that due to maybe the excess inventory build that you guys saw at the last peak. But just what's your visibility into that starting to get cleared up?

So you know we have this program called PSP, the Preferred Supply Program. And with that, many of our small to midsized customers didn't get inventory when they wanted it. They had to wait because that capacity and inventory was consumed by those that came first for the product. And so with that, when they finally could get product, they bought more than what they needed, right? They did not want to get caught in that situation again. In some cases, bought a year's worth or 2 years' worth of product, and that's what's taken this long time to really drain through. But I think we see significant progress in that. We're waiting to see a nice inflection in sell-through from distribution. That's the next thing we're really looking for because now distribution inventory is corrected for the most part. But when there -- are their customers now correcting or in the process of correcting, that will lead to higher sell-through and the distributors will need to buy more.

Helpful. So when Steve was here last year at this time, he walked us through a 9-point strategic plan, and we're kind enough to orient that around our conference, which we appreciate. The numbers is part of it, we know, the inventory aspects and gross margin and things. But how are we progressing on the customer relationship improvements, the sort of product focus and those elements of the plan at this point?

I'll let Rich speak to customers and products.

So on customer progress, we really revamped. We changed our whole ethos and how we actually work with customers and talk to customers. We really sped up the rate at which we are releasing products within the company and getting answers to customers. And Microchip for a period of time there, had become arrogant -- right? I don't know how to say that. And we had to fix that whole relationship with customers. And so that has significantly changed over time. And then at the same time, we're doing that, working with customers on where do we need to move to. So we really doubled down on wired connectivity, ASA, camera connectivity, robotics. We launched PCIe Gen 3 and Gen 4, believe it or not, 12- and 24-lane switches for industrial applications. And all of those are taking off and doing much better in the marketplace, providing much better growth than a more traditional microcontrollers and basic analog products.

You have a very rich business portfolio, all the acquisitions that you did we know all the pieces that are in there. I guess if you went through that period where you were maybe a little bit arrogant, are those cultures still there, the richness of the product portfolio is still evident. We'll get into some of the specific drivers, but how do you feel overall about the Microchip portfolio? And are you going to give us at some point more -- we sort of have the 3 segments, but like...

So there was quite a bit to fix over the last 2 years. We reorganized the company to remove the silos of technology, and we've built it into now just 5 pillars, right? So it used to be 8-bit and 32-bit and 16-bit and everything was separate, right? And so now we've changed the organization. So all microcontrollers are run under one person, right? And all of compute is under one person. All of connectivity is under one person. All of analog is under one -- and then we have those groups then working together based on megatrends to put together reference designs and bundled products that actually work together. And so we got rid of some of the personalities that were in there that were preventing us from actually working as one cohesive team. And that's actually really moved our product development substantially.

Okay. That's helpful.

So I think you had a second part of your question there that was kind of talking about how we disclose things today. Right now, we disclose microcontroller, analog and other as our product lines, and we are working internally to find ways to better and more frequently update The Street in terms of how some of these faster-growing areas are growing because right now, it all kind of gets lumped together. We update end markets only once a year. So we're working on that and more to come on that probably in our next earnings call.

Okay. Yes, because I just asked the question because you've got a lot of really interesting businesses that I knew that old -- I've been doing this a long time. I know the companies you acquired. You have PCR is in there instead of Microsemi...

Yes, FPGAs -- FPGA and other and all of -- everyone in here is timing on their devices. Microchip keeps the world's time. All of the cesium clocks or every GPS -- every credit card transaction, that's all based on our atomic clocks that are out there. And that's also part of other that's in there.

Okay. Great. I look forward to more clarity on that. Underutilization, you mentioned inventory is still north of 200 days. You've been absorbing underutilization charges. What's the target there? And at what point do you view that as being less of a headwind.

So that's going to take us a while to work through. I think in the December quarter, last reported quarter, our utilization charges were about $51 million. And the majority of that is coming from our 2 large wafer fabs. There's some of it that is in our assembly and test factories. We built up significant capacity during the last up cycle, and we have to grow back into that over time. We did do a fab rationalization, where we shut down our Arizona fab, and so that's in a better position, but we still have a lot of capacity that we need to grow into. So it's going to take us some time -- some of the growth areas that we'll talk about are actually not internally produced from a fab perspective. Anything in FPGA, most of Ethernet, our data center products are all externally produced. And so those growing is not going to help us with the fab utilization. It has to be more of our standard microcontrollers and analog, timing, memory products that grow to help us grow back into that footprint. And it will happen, but it's going to take some time. I think it's still going to be a couple of years that those charges hang on. Now we'll be increasing production as we move through and revenue is increasing. We're increasing capacity this quarter. But you shouldn't expect that $51 million charge to go down by $15 million or $20 million in a single quarter. It's going to be more gradual.

Okay. And what is the target inventory level? And is that different from the external versus internal fabs?

So our total days of inventory target is between 130 and 150 days. We ended last quarter with still 200 days of inventory. So we have progress that we need to make. We are significantly underproducing from what we're shipping today from our internal fabs. So it is coming down and will continue to come down. And we can't wait for it to get to 150 days until we start to ramp because there's some limitations on how quickly we can add people and get them trained and start more wafers in the factory. So we'll be doing it gradually and making sure we don't get too low, but we still have a ways to go on inventory correction internally.

Is the reason you don't take it down further quickly is because it ends up being disruptive?

Well, there's a mix issue, right? During the up cycle, we were adding capacity and building inventory at the peak of the cycle. And when the cycle crashed and revenue went down so much, the product that we have was out of mix from where orders are coming in today. So it doesn't mean that product isn't going to sell eventually, but it's going to take time.

Many of these devices, it's a foot deep mile wide application space, right? So there's -- some wafer lots we produce may produce products for 5 years off of that. So it's going to take a while to lead that off.

Okay. Makes a lot of sense. You have talked about 65% being a realistic long-term gross margin target, and that seems consistent with your business mix. But it's going to take a while, as you said. Any other aspects to that improvement besides utilization?

So it's utilization and then it's product mix. So we are guiding to a midpoint this quarter on gross margin on a non-GAAP basis at 61%. So there's 400 basis points improvement to come. If you added back the underutilization charges from last quarter, we'd essentially be there. Again, that's a longer-term process to get there. But we also have very high gross margin products that are going to be ramping at a faster rate than Microchip is growing overall, whether it's PCIe 6 in data center, the Ethernet products that we talked about in our last earnings call, FPGA, and they all have higher than corporate average gross margins. So that will be a tailwind to gross margin. Again, it doesn't help fab utilization, but helps with the overall profitability.

Makes a lot of sense. Maybe if we could talk about some of the growth drivers. Data center, you've been pretty vocal on PCI Express Gen 6. Can you just give us an overview of that technology? We had [ Adsterra ] on stage earlier today. Obviously, they've had some first-mover advantages there. Can you talk about your progress?

So we launched our product line in September of last year. To date, we've gotten 4 confirmed design wins. One of those is -- one design win is $100 million plus per year usage dollars. There's about 20 others that are in design at different customers. Feedback that we're getting from customers is the power consumption is about 20% to 30% less than everyone else's. And typical gigabit data center, PCI switching is about 8% of the power, 20% power saving is pretty significant. And then the security that's built in. So all of the form fit and function is really exceeding a lot of customer expectations. And for short distances, the fidelity of the device is -- the feedback from customers is so good that there is not a need for retimers in some of the applications. And we're also working on a series of retimers to match up with this PCIe Gen 6 product. And and we'll be releasing that over the next month or 2.

I don't think Rich said this, but just a reminder that we are the only company that has a 3-nanometer Gen 6 switch. So we are the most advanced product out there in this area.

That's helpful. And you have a long history in PCI.

Yes. So we started in PCI switches with Gen 3 and Gen 4. We were the market leader in Gen 3 and Gen 4. Unfortunately, for Gen 5, we decided to roll and build our own SerDes inside rather than licensing it. That delayed our release to market by 12 to 18 months, and we lost our #1 market status. And so -- we decided -- in the midst of that, we decided not to come out with a 5-nanometer device, but to jump ahead to 3-nanometer and take that risk. And then we developed a bunch of IP partners to help develop and bring that vision to life. And the whole reason to jump to Gen 6 on 3 nanometers was to be able to quickly come out with Gen 7 within 12 months. And so we are planning to have that Gen 7 device within a very short period of time.

That's helpful. In general, as you think about data center, it seems like a lot of opportunities for Microchip, knowing the portfolio, again, of the historic acquisitions that you've done. Can you talk about your focus in data center? Any other things like besides PCI?

So within data center, we've also got timing products, precision timing products that we build around these products. All GPUs utilize our security compute devices for Root of Trust in data center. We also, for AC to DC or DC to DC power supplies, almost all of those power supplies using our microcontrollers with integrated DSPs to form the basis of their digital power within data centers. And that's a pretty big growth engine for us in that space -- so it's not just the switches, there's many other areas. And then what we're also seeing now is that most data centers are now implementing our cesium-based clocks into the data center for precise clocking within the racks.

I was an engineer, I did clock chips 35 years ago, engine history. FPGA for you guys. I actually -- speaking of me being old, I did the Actel IPO covered it for a decade.

Really?

It didn't really grow until you bought it.

It's actually grown significantly because when...

After you bought it, it grew nicely.

Yes. When it's fascinating, they were so focused on the aerospace and defense market. They failed to see just if you brought that low-power value proposition to industrial control, medical markets, there was so much more opportunity for that. And -- and so that's essentially what we did is Microchip is our largest market segment is industrial control. And so we brought that into all of our customers, and we've seen tremendous uplift in design wins. And now what we're doing is where we've worked -- one of the things that we had to educate our FPGA team on, we shouldn't -- it shouldn't take a PhD to write the software code for every FPGA. And I remember going out and visiting with the development team a couple of years ago and I sat down with them and I said, it is ridiculous. I don't want a PhD to write the code. I want it much simpler. And now we're bringing out a whole development suite later on this year, much like we did with our microcontrollers that use AI and VS code and will generate a great deal of the code. So you don't have to have an advanced degree to get a product out to market.

It seems like a pretty exciting space. I mean, given the 2 biggest companies have been acquired and various distractions that they have to deal with kind of you and Lattice have really sold opportunity to really pursue this.

There's really only 4 players out there within the FPGA space, right? And where we're really winning is in just that low-power space. And so a lot of customers will bring us in for those particular low-power fleets. We're still winning a great deal within satellites that are being launched, the Artemis rocket that was up there, whether it's an Airbus or Boeing, our FPGAs are all over those particular products.

Yes. Great. Cool. Connectivity, automotive, industrial connectivity, you have a broad portfolio of products in those markets. Can you talk about the progress there? And when does that turn...

More top line growth? So we announced just this past quarter that our working relationship with Hyundai Kia Motors. And so we've designed in our Ethernet products within the Hyundai Kia Motor software framework. We are working with other manufacturers. We just -- BMW just announced something with ASA, where they're using our connectivity for cameras and advanced vehicle architectures going forward. And so we've -- Ethernet, whether it's in data centers, industrial control, robotics, a lot of the humanoid or robotics that are being built up out there, all are using our Gen 3 and Gen 4 12-lane switches in those humanoids. And that's also a new growth area connected with our Ethernet products. So a lot of activity there. A lot of this ramp or this conversion starts to really take hold later part of this year, 2027, 2028.

Okay. Okay. Great. And then aerospace defense, a market that is definitely in favor with semiconductor investors at this point. You guys have a pretty big portfolio with the Microsemi assets, big increases in defense budgets. Can you talk about the growth prospects? And then maybe wrap in low earth orbit and data centers in the space, any excited about there.

Yes. So that is a huge growth area for us. Typical satellite may have anywhere from 25 to 200 devices from us inside of it, whether it's FPGAs or power products, discretes, Mill 19, 500 devices or all part of those satellite systems. So there's -- there really isn't a satellite system that launches without something from Microchip in it, right? And it's just that the LEO launch, and there's significant content from Microchip in that satellite system. And almost anything that goes to Earth's atmosphere has -- from any country has something from Microchip in it.

That's helpful. So maybe moving away from the products, talk about some of the trends. Can you talk about pricing? You've talked about pricing discipline. Are you seeing any change in competitive dynamics there? You've actually seen a couple of companies raise prices on the back of commodities prices rising input costs. Just how do you think about the role of pricing?

Yes. So pricing has been stable for us. We have not done a wholesale price increase on our customers. We are very conscientious with our customers today about preserving and enhancing relationships. That was one of the 9-point plan points was to get our customer relationships back where they needed to be. So if there is any area that we see a significant increase in raw material costs or whatever it might be, we would selectively share that with the customer and raise prices on them, but this is not any sort of wholesale program that we have. So no intention to do that.

Okay. So really more stability than...

Yes. I just mentioned before, we have become arrogant in some ways and just trying to stay away from that.

And then China, an important market for you guys, one where you do have some domestic competition, but you've talked about it as being relatively small impact. Can you give us a sense of -- is China different than the rest of the world.

Yes. So China, where we're focused in China, China is really acting at typical with our customers, China speed, right? They're trying to get out the best products as fast as possible. Cost is always part of the conversation. It seems like acting with speed is more important to them right now. And so that's where we're focused on. So we're bringing in our Ethernet products, our ASA products. And so they're really fascinated by the new technology and how can they use it and get newer products and newer technology out to market sooner. So that's where we're focused. I think there was too much discussion on China for China and this. And at the end of the day, what we found in meeting with a lot of customers, just give us great technology and a reasonable cost and let's move.

Yes. And do you see any parts of that market as being vulnerable to domestic competition that's different than other parts of the world?

There's always been -- I remember my first acquisition that I did there was always domestic competition of telecom way back when -- where they were building the products locally. It's always been there. There's always whether someone that has similar products to our microcontrollers or analog products with the same part numbers, that's always been a part of the marketplace there.

Yes. So I think I'd summarize it as we are going to be cautious about it. We're going to make sure we're protecting our intellectual property. That is really key for us that we're not turning over our manufacturing technology IP, so it can be copied. And that's going to be important for us to maintaining our margin structure long term.

Yes. And I don't think building there is as important as making sure that you have the right technology at the time.

And is the traditional microcontroller business changing at all? I mean there's been sort of a migration from a bunch of custom architectures to more ARM types of technologies. It doesn't seem to have changed the margin dynamics at all, which you said it wouldn't, but...

Yes. I think there's a lot of -- I think ARM is still prevalent out in the marketplace, but I think customers are interested also in RISC-V now to some degree, whether it's 64-bit or 32-bit, they're interested in common accelerators between the devices as they adopt AI on the edge to do more autonomous decision-making. So I think the core becomes less of importance rather -- I think tools and software support are actually more top of mind for customers than what the hardware actually is.

Helpful. So I have a couple more financial questions, and then I'll open it to the audience. Leverage, is it still a little bit elevated? How quickly are you looking to pay down debt? Is there a cash return in the future as you think about that? It would be above and beyond the dividend, which...

Yes. So leverage is still high. Essentially, we've flatlined our dividend at this point in time. The Board is 100% committed to keeping the dividend where it's at, so investors don't need to worry about the dividend being cut, but that's consumed a lot of cash flow, and it was really just last quarter where we had the first quarter in quite some time where we generated enough cash to pay the dividend. We were borrowing for a period of time. And that's not a good position to be -- so we've turned the corner on that. Obviously, revenue and earnings and EBITDA is growing significantly. So net leverage is coming down, but we're still focused on anything above and beyond dividend is going to be used to pay down debt for, I would say, the foreseeable future. We haven't set a new net leverage target. We set one back on our Analyst Day in like November of 2021, which was 1.5x. And when we got below that, we were returning 100% of free cash flow between dividend and share buyback. Unfortunately, at that time, that was at levels of earnings that were not sustainable during the up cycle and then EBITDA crashed and we got ourselves in a situation, where we issued essentially an equity instrument that's mandatory convertible preferred last March to ensure we maintained our investment-grade rating, which is important to us. But we don't want to find ourselves in that again. So focus is going to be maintain the dividend and anything above and beyond that, pay down debt. And I think we're going to be in that mode for some time.

Yes. Okay. And then just generally, how are you guys feeling about all of this? I mean you talked about that the company had become kind of arrogant about certain things. You feel like you're on a path now that people are excited. I know Steve in his book talked about shared pain and kind of we don't lay people off, and I know you had to because it got very difficult. How are you guys feeling about the trajectory from here from the standpoint of morale and customer relationships and things like that?

I think employee morale has definitely improved a great deal, right? And that the whole PSP program created a lot of tension with customers for a period of -- we are beyond that with customer interfaces. We spend a lot of time visiting customers on the road. Next week, I was invited to do the keynote for opening of embedded world, where I'm talking about autonomous edge and what we're doing on creating AI at the edge for our customers, right, the software environment and everything we're putting together and have a ton of customer meetings all next week, totally full. So customers are graciously and we're graciously working with them to much better than we've ever done in the past.

Great. Well, I have to follow up on AI at the edge. So a really popular theme this time last year that people kind of have moved away from and AI is now just a data center thing for people. But ultimately, when the AI gets deployed, there's a lot of applications where we're going to need stuff at the edge. What are you going to talk about next week?

So in one application, there's -- I have a narrative. We have a drill, a ready battery-operated drill, right? And you wouldn't think that you would use an ML model inside a drill. But we work with the customer, we collect the data. We figured out how to get 15% more battery life from that drill by putting a simple model, about 200,000 bits of memory on that drill. No hardware changes, just software, 15% more battery life. That's a drill. And so I think as we're working with customers, a lot of applications with just simple software models or changes just -- and we're not talking large language models or Gen AI. We're just talking ML, machine learning models, right? Well-done suite of models that customers can use for wear and tear or vision, keyword spotting, a number of different applications where you could benefit from this technology.

Yes. That's very cool. All right. So let me stop there and see if we have questions from the audience.

When do you think we'll start to see the impact of these new ML models or edge AI, physical AI? So what would that impact be on your company financially?

Yes. Great question. So we spent a lot of time visiting and working with customers to find out what they -- what do you really need, right? Are we just going to throw out a microcontroller with 100 TOPS accelerator and then go to town on it. And what we found is that some microcontroller manufacturers have 4 versions of accelerators and 4 different software making it relatively impossible to scale or move this around. So what we did was we formed a group to just focus on the software suite, no hardware. So -- and that -- we're a hardware company, right? And so we gave this group a different charter. We said, we want to develop the best software suite. And we've been acquiring companies and putting that together and create that software suite. And then I worked with and the team, CEVA Technologies to bring in CEVA accelerators anywhere from 50 TOPS to 1,000 TOPS, so that we can put that same accelerator across our FPGAs, our risk-based products, our ARM-based products, our 8-bit products or what -- it doesn't matter, right? But what matters is that we have the same accelerator topology anywhere from 55 nanometers to 3 nanometers, but we have a software suite and model suite that can work across all of the products, right? And so that's the division that we set up for this group. And that vision is resonating well with customers because in many -- more than half of the applications that we found, you don't need an accelerator. You just use your standard hardware, just help me develop a model that I can program on a device. Does it have sufficient memory for me to run that? And do I have sufficient memory to store the code required.

What about SaaS model.

Yes. So there will be a SaaS model to that, Software as a Service. There will be a place for people to put models in terms of working with that. So there will be a SaaS portion to that as we go. SaaS as well as hardware as well as just trying -- like the battery-operated drill, it just was not obvious to customers. They had people coming in and selling, no, you have to buy this new $10 microcontroller with a 100 TOPS accelerator on it. No. Just keep buying the same $1.50 device and add the software.

We need to replicate the cloud in our power drill.

Yes. And there's a lot of applications like that, that we're finding out there, a lot of them.

Great. Well, that brings us up to the end of our time. So Eric, Rich, thanks so much.

Appreciate it.

Thanks, everybody.

Thank you.