Microchip Technology Incorporated ($MCHP)

Good afternoon, everyone. I'm Matthew Prisco, analyst at Cantor Fitzgerald, covering semis and semi cap. Today I have the pleasure of hosting Eric Bjornholt, CFO at Microchip; as well as Sajid Daudi, Head of IR. So thank you both very much for joining us today.

Thanks for having us.

I wanted to open this chat with some near-term level setting. Last quarter, Microchip highlighted a number of positive developments in terms of cyclical indicators, one being booking strength as December quarter moved significantly higher and strength into January. Can you offer some color around any particular areas of strength within those bookings? Any particular areas that could be lagging? And then how have these dynamics develop through February and early March?

Sure. Sure. So I'll start by doing the safe harbor and saying I refer you to our filings with the SEC that identify important risk factors about the company. And we'll be making some forward-looking statements during this presentation and discussion. So bookings have been really strong. So both January and February bookings were very, very strong. It's the strongest first 2 months of the quarter that we've seen since like the first quarter of fiscal 2023. So bookings have continued to be good, and that's even with the Chinese New Year falling in there. So it's been really good. Backlog is building nicely, obviously, filling up the current quarter and then building our visibility into the June quarter, giving us confidence. The bookings have really been broad-based in nature. It's not one particular end market or geography that's driving it. It's broad-based. We think there's a lot of customers that are now coming back. They've depleted inventory or now having to buy in line with what end consumption is. So that's good to see. We have some secular drivers that I know we'll talk through as part of this discussion. We are seeing strength in data center aerospace and defense and some of our networking areas are also quite strong right now.

Okay. And I know you guys talked about expedites increasing significantly and lead times extending in spots as well. So -- can you offer us some more detail on specific areas where these dynamics are most prevalent today? And maybe how you expect these trends to develop over the coming quarters?

So what we're seeing in expedites is customers are placing orders and they might place them out in April and then try to pull those in, into March because once they know that we've got them started in our manufacturing line, we have capabilities to have pretty quick turns to them. So we're seeing quite a bit of that activity that's continued last quarter into this quarter. Second piece of your question was?

And then lead times, lead times are extending. And how do you think these dynamics kind of progress from here based on just what you're seeing in customer conversations?

Yes. So lead times are generally quite short, but there are some pockets where lead times have extended out. Everybody knows that 3-nanometer as an example, some of the more advanced process technologies are pretty full at the foundries. So we're seeing extension of lead times there. Also some of the substrates impacting some of the assembly and test portions of our business where we subcontract that out to a third party have extended, and we're reflecting those in our lead times, being sure that we're communicating with customers. They know what they are. But I'd say for 90% of our products lead times are still very short. We've got 200 days of inventory on the balance sheet and more capacity than we need at the current time. So I expect lead times for a lot of the products to stay quite short, but there's going to be these pockets and it tends to be that, that it will expand a little bit over time. But right now, it's a pretty small subset of products.

Okay. And maybe on the inventory front, how should we think about the duration of the customer inventory, I believe, in your direct customer inventory? I know from a [ disti ] side, it sounds like things are pretty good there. So how do you think about the customer side? When does that start really tracking your shipments in line with demand?

Yes. So as you said, distribution, we think, is pretty much corrected at this point in time. Last quarter, we ended with 28 days of inventory in the distribution channel, which is normal. The difference between what was sold out of distribution and what was sold in was only about $12 million last quarter that sell-through exceeded sell-in. And those might even normalize to be nothing. This quarter, we'll see how it plays out. On the direct side, I think there is still pockets of inventory that are out there. We don't have great visibility into that other than through customer discussions and discussions with our distributors in terms of what they're seeing from their end customers, but we are watching things in distribution in terms of distribution sell-through. We would expect as that inventory depletes from their customers, the distribution sell-through will have to pick up. And in turn, what we're selling into distributors will rise with that. So we look at sell-through very closely. And what we are seeing in many cases that we have new bookings activity coming in from customers that haven't bought from us for some time, and that's a clear sign that they've depleted out their inventory and need to come back and start to buy in line with end consumption. Many customers buy multiple products from us. And so it doesn't happen for each product at the same time, but this gradual increase that we're seeing, I expect that to continue for the next few quarters.

Okay. Let me move into the segment side, starting with the industrial market, which accounts for roughly half of your revenues overall. How have you seen the recovery play out here today across the subsegments? And what gets you most excited in terms of growth here over the next few years?

So industrial is a big piece of our business, including aerospace and defense, which is about 18% of the business. We include that in Industrial. In total, it's about 48%. Aerospace and defense has been a really strong segment for us for quite some time. We are a large supplier to the Department of Defense. And obviously, conflict around the world isn't great, but that is a benefit to our business. And so we are seeing some upsides there and it's been very steady, high-margin business for us for quite some time. Other areas of industrial, and Sajid can chime in here also, but we're seeing anything, Industry 4.0, factory automization, robotics, things like that. Medical even is doing quite well. Anything else you want to add?

Yes, some of the edge IoT type of activity and FPGA plays on that. Industrial content growth, generally speaking, is increasing as well. And so other products are finding space there, too, in the value chain.

Perfect. Maybe digging a little bit deeper into aerospace and defense, given the current geopolitical landscape, can you give us any help in breaking down the revenue pay between those 2 markets? And -- where is Microchip best positioned? And have you seen any change in order patterns or customer conversations over the past couple of weeks?

So A&D has 3 broad categories for those defense, there's commercial aviation and there is space. And defense is the biggest piece of it. We don't break it out specifically. But obviously, the defense side is where we're seeing really good traction right now. Space also, there's a lot of things that are being launched up into the atmosphere. You've got new space, which Sajid again could talk about a little bit more if you'd like him to dig into it a bit. But we're seeing good activity there. Commercial aviation is also strong. We sell a lot of products into all the planes that are going up. And with that, our content has continued to grow. FPGA has a strong position in aerospace and defense for us, and that's been a really strong area of growth for us.

Okay. Perfect. I believe you've recently highlighted these new product introductions, which should start ramping in 2026 and bolster growth for Microchip. So can you maybe walk us through this dynamic? Any particular area that these wins have been accruing more than others? And how should we be thinking about the magnitude of these ramps and how that can contribute to outsized growth versus the market in '26? And does that continue through into '27?

Yes. So -- yes, absolutely, right. So we have actually two very significant platform level products that are ramping into '26-'27 time frame. And these are general and architectural changes rather than kind of a one-off product technology change. And so the first area is the Ethernet side, which is the automotive Ethernet side, and this is our 10BASE-T1S product. And here, we already have actually a platform design win with Hyundai Motors, which we announced last earnings call and additionally, some other kind of Tier 1 OEMs. Basically, these companies or these customers as they're looking to modernize their legacy architecture, which has traditionally been LIN and CAN [ archit ] nodes into the Ethernet side. That's really where this product kind of comes into play. And we feel that as we kind of progress to a zonal-based architecture into the next-generation EVs and a ADAS platform, the 10BASE-T1S product category, that's a pretty prevalent lift in here. It's a refresh cycle. It's a once in a multi-decade type of transition that's happening here. And so all these legacy nodes will be eventually replaced by 10BASE-T1S on communicating in different areas of the car. So very exciting. And again, early stage. We just are ramping in there. So I think revenue contribution will be minimal in the '26 calendar time frame, but really ramp -- start ramping in the early, mid-, late '27 and beyond standpoint. And this is like I said, a multiyear trend that we think is happening.

And this isn't replacing anything you currently do. This is all fresh...

This is going to be all fresh, right? So this would be existing. So we're not going to cannibalize. Some of the existing legacy nodes. Obviously, we have a presence there, but then this will be incremental there. And then the other thing exciting thing that we have on the data center side is our -- so we now have the first production-ready Gen 6 PCIe switch on 3-nanometer. And this is something that's been -- again, Microchip has a long history of acquisitions and through our last one, which is Microsemi, we acquired this piece of the equation, and Microsemi was rolling up a whole bunch of players as well. So this kind of legacy goes back to the PMC-Sierra days for those who are familiar. And so Microchip today is really the only company that has -- so PCI is not a new area for us. So today, we're serving it with Gen 3, Gen 4, Gen 5 and Gen 6. Gen 5, we had a little bit of misstep on where we tried to develop some SerDes in-house, and that delayed that product category. So we lost some share there because of that delay. And so for the Gen 6 launch, we went a technology improvement there from where competitors are on 5-nanometer. So we went 1 node lower to 3 nanometers. And what that does is just there creates quite a bit of value proposition where our product just going from a technology difference drives 15% to 20% greater power efficiency or better power efficiency using our products. And again, as you kind of think of a gigawatt style data center, that's substantial savings and when the GPU clusters are expanding to no end. So that's another area. And again, like I said, that's ramping. We announced this. The product went to production a couple of quarters ago. And so last quarter, we announced 3 design wins on it as well. And so again, that's going to ramp minimal in the '26 time frame, but more so in the '27 area and again, a multiyear trend there. And our opportunity there is kind of multifold, right? A, just again being a technology leader, so just a pure play a share gainer from some of the established players in there. And then the other part would be as a dual source partner for a lot of these customers because as they look for optionality, that will be an opportunity as well. And so -- like I said, today, we're the only one that's providing that entire suite of PCIe switches, which becomes a critical piece. One point I'll make is, even as you think of some of these new generation areas like robotics and stuff, a Gen 4 PCIe switch is more than capable to deliver some of that. So it doesn't need to be kind of the latest, greatest. And typically, what you see is hyperscalers as the first adopters of the latest generation. And then quickly followed by 18 months or so with enterprise adoption and stuff. So we think we have a good runway ahead of us in this area. And certainly, we have to kind of reestablish ourselves a little bit, but certainly, those are the 2 areas that we're pretty excited about, and the ramp is going to start coming through in the '27 area, more so significantly.

And on this PCIe, this is roughly a $2 billion market today and industry estimates are it's going to grow to about $10 billion by 2030. So the growth opportunity is large here.

Perfect. And I definitely want to dig more into data center, but just to wrap up Industrial quick. You guys made an interesting comment recently saying that hardware is becoming a little bit less important versus the tools and software being offered to customers and enabling the intelligent edge. So firstly, does that mean that the hardware such as the MCUs becoming generally kind of commoditized at this point with a broad array of offerings that are good enough? And if not, how does Microchip differentiate there? And then second, where does Microchip stand with the toolings and software? What are you offering to customers here? How should we think about investment focus in the space from the company? And maybe how do you differentiate from the competition?

Yes. So the hardware is still a very important element. You've got to have the right product that does what the customer needs you to do. But software is a growing element and we are doing lots of things to make the customers' journey and use of our products easier and provide more tools to them. We're doing all sorts of things internally with AI and machine learning, making some of that available to customers where we've trained this stuff for 5 or 6 years internally and now opening it up and they can use this. And from a tools perspective, from a design perspective, to save 30%, 40%, 50% of design time by using it. And that just -- everybody is limited on resources that they have on the engineering side. And so anything that we can do to help them with that is extremely important. Sajid, would you add anything else?

No, I think you kind of captured it well.

I mean is that bolstering the ASP side? Is that bolstering the margin side? Is it part of TSS? Like how does this kind of change Microchip story, not just today, but kind of looking out over the next 3, 5 years?

It's all those things, right? So TSS is selling total system solutions, and we've been working on that through the acquisition strategy that we essentially executed over about a decade. And so you go in with a base kind of anchor product, and that could be an MCU, it could be an FPGA, it could be MPU. And that's kind of the brains of the system. And then there's all this other stuff that goes around it, whether it's analog, timing products, security products, memory products, all these things. And we offer all that to our customers. We provide them working reference designs for that and then speed their time to market where they're not trying to get chips from 6 different companies to interact well with each other. We do that for them and give them a head start and bringing the market quicker. So that's a strategy we've been employing for the last decade or so, and it's just getting more refined every year, and we're helping customers save money.

Okay. Now shifting over to data center. You already touched on the PCIe Gen 6 opportunity there. I think the last quarter, you had said 3 customers. And I think intra-quarter, you guys said 4 customers. How do we think about kind of that pipeline converting from here? Can you, I guess, first give any color on those 4 customers that you have? And then how do these new customers roll in? Is it kind of proof of concept with these early customers to make sure it's working. And then we'll see in 6 months here is the next tranche of customers? Or -- just how does that kind of work?

So we started sampling back in October time frame. And it takes time. These are complex products. We have many designs that are in various phases right now. We've talked about 3 or 4 wins that we've had there. One of those wins is material from a revenue perspective that it's expected to be $100 million plus in calendar year '27. So that's important. And we've got, again, 20 or so others that are in various phases of design and we've got a product that we think has a very significant competitive advantage over the rest of the competition from a power consumption standpoint, what Sajid mentioned before. In these gigawatt data centers like 8% of the power is consumed by PCIe. So if we can provide a 20% advantage there a reduction, it's a meaningful advantage and people are strongly considering our products. So we're super excited about it, and we think the growth opportunity is quite large.

Yes. And even -- I'll just add to that is that even on the PCIe side, you almost vendor-agnostic, right? So you can have a media style GPU or an AMD or custom ASIC and still be able to use our PCI switches. So certainly, we're today sampling across the board with everybody and some. So really very healthy kind of sampling activity going in there and timing will just be defined by as these customers start coming in. But today, the reach is very strong, and the response has been really good. So we talked about 15%, 20%. I think if you really talk to our business leader there, you'll say field tests are coming back even more positive. And so this is what everybody is trying to solve for is what the power efficiency in the data center. And so we certainly have a solution there, and interest levels are very high at this point.

And we have more products coming over the next couple of months, we expect for our retimer products to come to market also that can sell alongside the switches.

I guess maybe how should we be thinking about Microchip's ability to maintain its advantage to transition to the Gen 7 PCIe switch. I think that's theoretically coming out this year. I mean, what type of improvements should we expect gen-over-gen, you talked about the 15% to 20% you're seeing now? Is that something similar next time around? And then maybe what are the technology shifts that would drive the customers to kind of adopt this next-gen offering?

So I think we're in a very good position because we're already on 3-nanometer, right? And Gen 7 will also be on 3-nanometer. So since we were the first there, I think we were a step ahead of the competition, which will likely transition to 3-nanometer and next gen, and it's always most difficult that first time that you're bringing up a new technology. So that's an advantage, and we absolutely expect that product to be out in the next 12 months. Anything you want to add to Gen 7?

And I think just the fact that we are today kind of have all of the generations in there. Once you get designed in the first 18 months or so is really where a lot of this design capture is happening. So once you get designed in and you can deliver to the customer that you have a viable product, and the next generation, the incumbent always just has an advantage, right? So it adds to that stickiness aspect to that relationship. So I think -- and again, I will just emphasize like today, we're really the only ones that are offering that Gen 3 to Gen 6 type of activity. And the product road map goes well beyond Gen 7, too. I think you talked to the team there, they have it scoped out for a very long time. And I think by Gen 10, Gen 11 is when you get to just a direct Ethernet connection at that point, right? So there's no intermediary in that area. But certainly, yes, long tail ahead of us along...

How about looking at the retimer opportunity to pair with these switches. Can you talk about expected adoption trends there? And what would drive the customer to choose the Microchip part here and maybe help size this opportunity versus whether it's switch, whether data center revenues?

Yes. So it's really complementary to the PCIe switch, right? As you kind of think of what a switch does, it's kind of giving you that communication between a GPU to GPU or memory controllers, this really kind of extends that communication out further distance, right? So it's really a complementary product there. And again, I think as you think about the opportunity size here, like Eric was saying, the retimer business is an incremental $2 billion to the $10 billion TAM that we said the industry size in there. So again, a smaller area, but goes pretty hand-in-hand. So that -- think about that total solution systems that we're providing. It just helps address a bunch of different areas for a customer as they're looking to design new products. So I think, again, the product is expected to be out next month. I think there's obviously active dialogues with existing customers that may be looking out to kind of trial it out and then go from there. But I think once we have more data points around what the customer feedback is and once it's out in the marketplace, we'll have more color to share. But at this point, we think it's very complementary and expected to come out very soon here.

And just to clarify that, the $2 billion that Sajid mentioned, that's a 2030 number that you're talking about for TAM, not today.

Okay. So $10 billion from the switches, $2 billion from retimers?

Correct.

Okay. How outside of the switch and retimer dynamic, what are other areas in Microchip's portfolio that excite you on the data center side of the business? And I don't know if you could help us understanding the composition of that portfolio.

Yes. So I can start, Eric. So it's really kind of -- it's a full stack solution. So obviously, we've got the switching connectivity side as kind of the one stack there. Then on the storage side, we have kind of RAID-on chip controllers. We have the NVMe, SSD storage controllers. We have the IO switches there as well, then included kind of beyond that as well as the power management products that we offer. So voltage regulators and again, just kind of balancing what the density of a lot of these required density requirements for a lot of these data centers are. So we have a lot of tools on the power side. Then kind of extending it further, you get into the clock and timing side of the equation, when you look at Root of Trust activity and all that, we have a lot of product offerings there as well. And so really a full stack solution and a kind of depth of product areas that we touch the data center with. And again, it's not limited to just the hyperscalers. Obviously, the enterprise data center side, which is a refresh that everybody is kind of waiting to happen because all the spend is going into the AI side today. But I think those would be the areas that would be kind of areas to highlight for the data center offerings.

When you think about those other areas, is there a share gain story we should be thinking about here? What's your market positioning? How should we think about growth? Is this just going to be linked to hyperscale CapEx? Is it going to be linked to something else?

It's probably the best way to think about it it's more linked to the size of the market, but we have competitive solutions in all these areas that Sajid talked about. And when you win some of these larger sockets, it opens up doors for you to have the discussions with these customers about where else we can win.

Yes. And that, I think kind of gets us to an interesting dynamic as well. So anybody that's been following Microchip, you always hear kind of 2-pillar story, right, where there are Fortes like microcontrollers and analog products primarily. And now today with connectivity and some of these other areas, these are kind of new pillars that are coming and getting established, meaning this is where customer dialogue is starting at and then you have a lot of attach opportunity based on what the customer wants to design. So Microchip, you're starting to see a shift from the kind of 2 key pillars to 5 pillars, which is connectivity, data center and AI/ML on the software tool side. So certainly just an expanding growth story here.

Perfect. So gross margins, they came in nicely ahead of expectations last quarter with decline in inventory reserve charges and better product mix. And maybe starting on that inventory reserve charge side of things. How should we be thinking about that number kind of normalizing into the March quarter? And what gives you confidence for a rather meaningful sequential decline there? And then how do we think about that kind of level throughout the remainder of the year?

Sure. So maybe just to highlight, previous quarter, the December quarter had kind of an abnormal event in it where we had an IP sale within our licensing group that added another $20 million, $25 million of revenue at 100% gross margin. So that helped the upside in gross margin that we saw compared to maybe what The Street was expecting, although it was in our forecast for the quarter. This quarter, we're still showing gross margin improvement. I think it's going at the midpoint of guidance to 61% compared to 60.5% last quarter. And that is with that licensing business not repeating in the current quarter. So we had a bit of a headwind on that front and still showing nice growth in revenue and margin. Specifically on the inventory reserves, they were -- so new inventory reserves were about $58 million last quarter. I kind of like to view it that when things aren't normal, inventory is rightsized, demand is normal, that it's probably $15 million to $25 million a quarter. So we've got a continued benefit that's coming as those reserves reduce. I think we're pretty close to normalize this quarter when you combine what the new reserves are going to be plus what is likely to sell through of some inventory that was previously reserved based on our accounting policies. So with the 61% margin that we're forecasting this quarter at the midpoint, I think inventory reserves are pretty much normalized in that number. Now on top of that, we've got underutilization charges in our factories of about $51 million, $52 million per quarter right now. And those are going to take longer to come down because we need to grow back into our capacity. And I'm projecting that's probably going to take us a couple of years to burn through those, but they should be coming down modestly each quarter as we move through the next 2 years.

Is there anything we should look to, to inform us of that decline? Like I know it has to be the internal products that grow for obviously utilization to tick higher. So what focus -- what areas should we be focusing on to kind of tell that your utilization rate is going to climb higher than your utilization charge can come down?

Yes. So I mean, we will be pretty specific with you on our earnings call and what our expectations are, but we need to ramp the factories. And we only do about 35% to 40% of our production in-house from a wafer fab perspective. We outsource the other 60% to the professional foundries. So we need growth on the products internally. Our internally produced products, which are kind of our standard microcontroller analog products, some of our timing products, some of our memory products get produced inside, so we need those to grow. Now a lot of the secular things that Sajid was emphasizing here as growth drivers for us, whether it's the data center products, our FPGA products, some of our Ethernet networking type products, most of those are outsourced. So we need growth on kind of the core MCU analog products to grow back into our capacity, which will happen over time, but it might not be as fast as growing as what we see coming from some of these secular areas where we rely on the foundry. So it takes some time, but we're confident we'll grow back into the capacity and have really high confidence about our 65% gross margin target that we have on the non-GAAP side. We've been giving some data each quarter about, hey, if we didn't have these inventory reserve charges under utilization, the underlying product gross margins are like 67%, 68%. So the health of the product line is there. The good thing with some of these growth areas we've talked about in FPGA, in data center, in Ethernet, these have higher than corporate average gross margins. So they aren't going to help us fill the factories as they grow. But we'll have a bit of a tailwind on the gross margin side because they're highly complex, high-value products to our customers.

Perfect. How about the pricing side? How are you thinking about Microchip's pricing power today, particularly we've seen a number of analog pricing increases year-to-date. So how do you think about that today? And maybe moving forward, as we think about that annual pricing decline of low single digits typical in the industry. Any changes in the customer collaboration you have, the TSS, we're talking about all these dynamics they can kind of change that?

Yes. I would describe our pricing as stable. You're right that many of our competitors have raised prices. We were actually one of the last of our competitors to raise prices in the last up cycle. And you know one of the things when Steve Sanghi came back as CEO was he really wanted to focus on customer relationships. And so we want to be very careful with what we do from a pricing perspective and not gouge customers in any way. So there are clearly some increases that we are seeing in cost in the supply chain, right? It could be gold costs are up or some of the assembly and test subcontracting costs are up. And we will likely do something that is more specific with customers and be very transparent that, "Hey, if we have to raise your ASP by 3%, this is why, and here's the details behind this." But we're not really thinking about a broad-based increase in pricing of the customers. We want to -- our gross margins have improved dramatically from the low that they were at last March at 52%. We're guiding to 61% non-GAAP gross margins. So margins are moving upward very nicely and getting closer to our target. We're not going to use pricing as a lever to get there. We want to focus on winning more designs at customers and gaining -- having them gain their confidence in us that Microchip is going to treat them the right way.

Got you. Okay. So with a minute left, I got one last question here, I'll give it a quick one. You talked last quarter about kind of increasing transparency in end markets and maybe something new is coming up. I guess, first, what's the impetus for doing that today? And second, what should we expect to see here in May when you kind of come out with the new thinking?

So a lot of our competitors give more details on a quarterly basis than we do on end markets or certain growth areas. And we've kind of used a once-a-year process to do that. So we've been refining our systems and processes and finding a way and discussing it as an executive team, how best to update investors in a consistent manner. So I can't share the details now. We'll share that in our May earnings call for the March quarter, but it is likely that you're going to see more information to allow you to gain some insights on how Microchip is growing in some of these secular areas because they get bundled into 3 categories. It's microcontroller, analog and other. We know we need to give more information on data center on FPGA as an example, on networking. And we'll do that. So we'll define that more and more to come in early May.

Perfect. Well, thank you guys so much. Really appreciate it.

Thanks for having us.

Thank you.