Microchip Technology Incorporated ($MCHP)

Okay. Good afternoon, everyone. Welcome back to the session of BofA Global Tech Conference. I'm Vivek Arya from BofA Semiconductor and Semicap Equipment research team and really honored to have the team from Microchip join us this afternoon. Steve Sanghi, Chairman and CEO; and Eric Bjornholt, Vice President and the Chief Financial Officer. We will start with some opening remarks from Steve, then I'll go through my questions, but please feel free to raise your hand if you'd like to bring anything up. With that, really warm welcome to you, Steve and Eric, really happy that you could join us at the conference. And Steve, maybe let me turn it over to you.

Thank you, Vivek. And before I begin, I wish to remind you that during this presentation, we may be making some projections and other forward-looking statements. These are predictions, and the actual results may vary materially. So I refer you to our filings with the SEC regarding some important risk factors about the company. So what I'm going to talk about is 2 things, which were both in the press release yesterday, you must have read them, but just going to expand on it a little bit more. The first is the data center. So we have been getting numerous requests from investors to give them more information regarding our data center business. So the challenge is that in our end market breakdown, we have been breaking out the data center and compute as one of the end market, which is about 18% of our business. On a calendar year basis where we provided the information based on our calendar year 2025 revenue, that 18% comes out to be about $787 million. There's plus or minus 2% error band because there's a lot of suppositions and estimates in there. Now out of that business, the challenge is that we have a data center solutions business unit, which is pure data center, 100% of their products going to data center. And that business unit produced $302.7 million in calendar '25, out of that $787 million total. Now that doesn't mean that our data center business was only $302.7 million, there are a lot of additional products, some of our microcontrollers, analog, timing products, security products, memory products and others, which go into multiple markets, data center being one of them, and many of these products are catalog products that also get sold through distribution and contract manufacturers which will bundle the total sale in a given product, some portion is going to data center, but some could be going to industrial. So there are a lot of estimates involved. And our total data center business is somewhere between that $303 million to $787 million. But since there is much more difficult because of going into multiple markets. What we decided to do is give you our revenue for just the Data Center Solutions business unit, which is 100% into data centers. And that was $302.7 million and expected to grow to about $500 million in calendar year '26. Now we'll continue to do more work on it and see if we can take the difference between $787 million and $303 million and break it out further into what is in compute and what is in data center, but we were not able to do that by yesterday. So that was the one part of the press release. And as I had various one-on-ones, I think some people were still confused where they thought the total size of exposure to data center was $302.7 million. That is not the case. That is only the data center solutions business unit. The second item in the press release was pricing. So until last week, we were essentially saying we're not increasing prices to our customers. Essentially, some of the operational cost increases we have incurred with people, chemicals, gases, transportation, energy, gold, copper and others, so far, we have absorbed them without giving a price increase to our customers. And despite all that, our gross margin in the last year has gone from 52% to 61.5% in the last quarter, and we're guiding to about 63 point -- I don't know what the exact guidance is this quarter, but...

62.75%.

62.75% this quarter. And that's happening despite us absorbing some of the cost increases. And so far, we were able to push back on our suppliers, foundry and OSAT and other suppliers that we can take a price increase and we didn't incur them. But now it's becoming much more difficult because essentially they have been able to pass those price increases to all of our competitors, and they're passing those price increases on us and there are dates and times and percentages by technology, by foundry, by OSAT, that will be coming up where our costs will be going up. So finally, and we've been doing this analysis for some time. But a decision was finally made 2 days ago, Sunday evening in a worldwide call where we put all this data together that we have been putting it together for some time and made a decision that we will have to increase prices to take the cost increase we're incurring and margin it up and give it to our customers. Now at this point in time, we have no estimates on the amount of cost increase or price increase on the customer, which products wIll see it and which customers will see it, how we will deal with distribution, how we will deal with direct customers. All that work has to be put together in the next 2 to 3 weeks. And then our salespeople and business unit leaders will take those price increases to our customers. So we don't really have any more detail on that. We will not be telling you the average price increase for obvious reasons, one, that's a competitive information. And second, if a customer knows what the average is, then nobody will take more than the average, and that would create a problem if we want to exempt some customers where we are still repairing our relationship. So we had to make that up by giving more cost increase to somebody who's a non-partner. But if you come up with an average number, then nobody will allow you to do that. So we will not be disclosing how much price we are increasing and just executed in the marketplace. So with those 2 updates, I'm happy to take any questions, Vivek.

Thank you, Steve. So maybe continuing on that pricing theme. As you mentioned, Microchip has -- by being somewhat more resistant to taking pricing, right, whereas many, I would say, in fact, all of your, in analog and kind of power semi competitors have taken pricing. How much of that, Steve, was just because you were still in the customer relationship repairing mode. And now when they see this, what do you think is going to be their reaction, does it impact that progress that you've been making?

So I think you have to look at through cycles. So in the last cycle, we took pricing up a little too much, one time longer than probably they did, and we were much harsher on our PSP program in the noncancelable, nonreturnable, nonreschedulable, then our competitors were. So we upset some customers where our competitors treated them better. Now fast forward in the last 1.5 years, we have done very good with our customers, repaired it lot of relationships. And this time, our competitors took the very first opportunity and raised the price on them, while we told our customers that we're absorbing the cost increases and you're not getting a price increase. So net flow of the customer has been towards us. We've won many, many designs and customers don't like our competitors today, they like us. And some of them have done 2 price increases already. We haven't even done one. So when we go back to them saying we have held a price increase now all year, and we've treated you better and all that, and they have seen 2 price increases from the competitors. So when they hear from us that we're doing a price increase, number one, they will not be surprised. And if the amount is reasonable, I think they would be understanding our relationship will still be very good.

Got it. And just to confirm, this is not happening because of shortages, right? I mean, your lead times are still, right, reasonable.

It has nothing to do with shortages or excess. It has nothing to do with increasing the price because we can. I mean if we really wanted to, we could increase the price more. So it's just purely have to driven where we don't want to gouge the customers but we don't want a headwind on our gross margin. So we'll take an estimate of our cost increases, margin it up and give it to them and be able to explain it.

Got it. And historically, Steve, has this resulted in some kind of prebuying or extra buying, anticipating that, oh, look, there is this another price increase coming? So let me buy more now? Or do you think it could be...

So it depends on how you implement it. If you say we're going to -- if you wait too long, give them too much of a time to buy the product, then they will try to buy some product in advance at the lower prices, we will increase the price on the backlog. And any incremental orders we see over and above the run rate, we'll schedule them at a new price after the price increase was effective. So therefore, there will be no incentive. And if anybody places the order, we'll schedule them after and then we are at the new prices. So there should be no games really. I mean it shouldn't affect our revenue. There should be no pull-in effect because we get to schedule it, and we'll -- just based on the lead times, today have 7 to 8 weeks, the window will probably give them will be shorter than that. So essentially, all that will fall outside of the price increase.

Got it. Makes sense. And then is there a scenario where this is a tailwind, albeit a modest one to gross margins? Or do you expect it to be neutral? Or how should we think about the benefit?

So a couple of things. We have absorbed some of the internal operational cost increases thus far. And when we're increasing the price, we're including in it. So there is a little bit of the recovery that we have incurred the cost and I will pass it on, which will make it slightly accretive. The second part is, our target is to be margin neutral, but you can never hit the bull's eye and I don't want to have the risk of being on the left side, so we want to be on the right side. So given at all, it will end up being slightly accretive, but only because of we can't be so precise.

Got it. This kind of bridges into the next few questions about your data center. Is it fair to think that most of your data center sales are coming from parts that you get from foundry. So if that is the fastest-growing part of the business that you are always kind of exposed to this inflationary impact?

Well, inflationary impact is not only on foundries. We are seeing the similar inflationary impact inside because foundries, their cost is going up on their people and chemicals and gases and energy and transportation and all that. And that shows up in their wafer costs and they give it to us a higher price. But our internal manufacturing is doing the same. They have the same inflationary cost increases. But in answer to your question, our data center solutions business unit products are all outside, but not our total data center exposure, some of our analog products, our microcontroller products, some of our security products, timing products that go into data centers are produced inside.

Got it. Okay. And the growth rate that you described for the data center business, I think, 60% plus. How do you benchmark that, right? Do you think it's the right growth rate because there's such a wide range of growth rates that we see across the data center, right, is like can that be sustained over the next few years? How should investors think about just your data center? First, maybe let's start with what is in that data center number? What specific end markets applications and then growth rate?

So in the Data Center Solutions business unit, we make 3 product lines with the fourth one coming. And the first product line is our storage controllers, storage accelerators and storage expanders. And in that product line, we have about 3x performance advantage to our nearest competitor. So it's very state-of-the-art and it's doing very well. The second product line in that is PCI memory controllers and CXL memory controllers. And there again, we're kind of leading the industry. And the third product line is PCI Express Switch. Now in PCI Express Switch, we did very well when we bought the business from Microsemi, they had done the Gen 2, Gen 3 and Gen 4. I'm sorry -- Gen 2 and Gen 3. Gen 4 happened after we had bought the business and Gen 4 happened on MYCLOCK when I was CEO last time, and we did very well in those. And then we screw up on Gen 5. That didn't happen on MYCLOCK but it happened under Microchip Clock. And we were 2 years late to the market on Gen 5. And therefore, all those Gen 5 designs went to the competition. When we eventually came up with the Gen 5 product that again happened in the last year, we won a lot of the designs again, but we got a fairly small share in the second source position, not in the primary position. So the commitment we made is that we've got to regain our Mojo, and that's why we produce the Gen 6 product on time on one of the best products in the industry, the only 3-nanometer product, significantly higher performance than the competition and 30% to 40% lower power. So that part is winning designs like crazy. Every single customer who did business with us is reengaged. We have publicly said in the last conference call, we have won 6 designs. And now we have won 2 more. We have 8 designs on Gen 6 Switch and we have won design on the retimer. Retimer doesn't go to production until January. So this is a very, very early win. So I think if we had not lost all that on Gen 5, then it will be a little bit easier to make assessments of how fast it will grow or what will accelerate. We know the market is very large. And the upside is just totally incredible. If you keep winning these designs, they go to production next year, we can acquire the capacity then this could be very big. But I think we are cognizant of the fact that we are coming from behind, having missed a Gen 5, then. And we're competing with a formidable competitor with a B name in it. And so we are just a little cautious in trying to forecast anything. Now, one of the things that's happening on the Switch side is, and you may have heard about it or read about it, during the training phase of large language models, it was the era of GPU. And the GPU to CPU ratio was as much as 10:1. But now as you convert from training phase to an inference phase, it is favoring the CPU and GPU to CPU ratio is going as much as 1:1, and I'm even starting to read 1 GPU and 2 CPU. And PCI Express connects the GPU to CPU, to CPU to CPU, GPU to memory, CPU to memory, CPU to anything, RAID card, memory controller, GPU. So as the new industries calling it CPU renaissance, if there is a new CPU renaissance and you're seeing Intel's capacity constrained, others are too. And as the CPU volumes explode, it is very, very positive for PCI Express. Because GPU to GPU connection is through NVLink. But GPU to CPU connection is through PCI Express, which is standard industry protocol. So the market strength and conversion from training to inference favors PCI Express. So if that market grows more than anybody expects and we should really get a fair share of the market. And I think demand is going to be strong enough with probably overall TSMC capacity limited that everybody will get their fair share to what the capacity they can acquire.

All right. Is there some simple math, Steve, that you have in mind? So if, let's say, the CPU market, right, people used to talk about $60 billion, then they went to $100 billion. Now the new number is $200 billion. What does that tell you about kind of the PCI opportunity associated with it?

It is probably calculated, I haven't done that yet. I think that CPU renaissance is relatively new. So I don't think I have seen the PCI Express estimate because of that change. And that will only describe the TAM, total available market. It still wouldn't -- still it wouldn't tell us what we could win. Like I said, we are making up the loss.

Is it as simple as your share of 3-nanometer allocation at TSMC? Is that kind of the first order way of looking at your share or that other...

What we need on 3-nanometer is 0.1% or 0.2% of our [ Jensen ] need. So I'll just tell them and give me all I need and [ Jensen ] -- may feel the change and it's working so far.

So is it deterministic what your share is? Or do you think that...

It's not deterministic. We -- the part goes to production at the end of this month and winning 8 designs before the part is in production is kind of unprecedented. So because the part is that good and it's doing that good in customer tests when they put them in the board. So we think we have a winner on our hands, but we are shy in forecasting until we actually start to see these wins going in production and then multiplying like crazy.

So is there a scenario where these kind of growth rates are sustainable? Or one could...

I hope they're not only sustainable, but they accelerate. But I'm not really willing to put a number on that yet.

Okay. Understood. Next thing, Steve, is just kind of the broader analog cycle, right? Where are we -- usually, these cycles have sort of the inventory replenishment phase and then the end demand improvement phase, right? Where are we? Just because the size of these markets, especially in the data center are getting so big, so it's hard to separate out a cyclical recovery from what are kind of the secular drivers.

That's a very good question, and I've been talking about it. So the first phase of our growth in the last year has predominantly come from customers and distributors that were buying product well below their consumption level because their inventories were high. And asymptotically, they're trying to reach where they're buying equal to the consumption level. So that fed the first part of the growth, which is typically inventory depletion driven semiconductor cycle growth. But what's being layered on it now is, 2 other things. One is the new design that we have won in the last 2 years and even in the data center, since we were so late to Gen 5 PCI Switch, we lost all those designs. But when we came back with it, we won a lot of designs where we are in the second source position. And so that PCI Express Gen 5 is ramping, waiting for the Gen 6 production to start. So we're getting some growth because of that. But now the third phase really is the innovation-driven growth. And there is innovation happening in 4 of our end markets. It's happening in, obviously, data center. It's happening in automotive. It's happening in aerospace and defense, and it's happening in industrial. I'll spend a minute on each of them. Data center, we have talked about, lots of innovation going on, it should grow. In the automotive, so number of automotive units per year grow in low single digits. So that has -- never been the story. The story is the consumption level inside. On some of the high-end automotive cars, we have 81 chips from Microchip in one car and 63 chips another car. So there's a large amount of Microchip content in the cars. And today, there are so many different protocols inside the car. There is a car area network. So there's a CAN bus, there's a LIN bus , there's an entertainment bus called the MOST bus. There's USB connection inside, there's Ethernet, there's RS232. And in the past, all these things don't need to talk to each other. Your microcontroller or tire pressure sensor. It doesn't need to talk to anything. But today, you could press the button and say, what's my tire pressure? And it will show you picture of your car, full tires, entire pressure in each of them. My Tesla does that. So then now the car is talking to every node that is outside in a car. So therefore, in the current car setup, you have to go through bridges to convert from USB to Ethernet, car area network to USB or through Ethernet, MOST bus to Ethernet. And these bridges are expensive and bulky and extra chips that need to be added. So where the cars of '28 and '29 and '30 are going is to consolidate all those protocols into a single Ethernet-based network requiring no conversions, everything is basically that. And we are leading that charge. That standard is called T1S, which ran on a single-twisted pair Ethernet wire, not the 8-strand wire you have in your office, but 2-strand wire, single-twisted there. And that should drive significant growth and -- there's a lot of innovation happening on it. So we talked about data center, automotive and quickly, the third one is aerospace and defense. So aerospace and defense has aviation, has military hardware and space. And they're growing in all 3, like Boeing is building planes like crazy again where MAX 7 production is back up. Military hardware, they're trying to replenish all the hardware they have used in the wars and Trump is asking primes to quadruple their production, and that's a long-term growth for us because primes are adding capacity with brick and mortar and all that, and that revenue should do very well. In space, U.S. as well as the world has a new fascination with space. The fascination that hasn't been seen since the Apollo days. And so we should do very well with all our space content. And the fourth final market is industrial with what's happening in industrial with onshoring, when the factories are being onshore. They're more highly automotive. They're more highly automated. There's a lot more robotics in them than the factories. They're moving from in China. So there's more content from us. Sensors, microcontrollers, PCI Express and all these parts in the factory. And then all our parts going into humanoid and robotics and moving factory line and all that. So I think all that is innovation-driven growth, that's leading on the top of the inventory driven growth, and therefore, future looks bright.

Got it. One maybe a question on margins. I'll bring Eric into the discussion. So gross margin, right, you mentioned 62.75%, right, in June. The target is to get towards 65%. I imagine most of that is just an underutilization, right, kind of recovery?

Let me have Eric address that.

Sure. So last quarter or the March quarter, we had $46.6 million of underutilization charges. And if you add that back to our gross margin last quarter, we're essentially at 65%. So it's just going back into our capacity. It's not all going to happen at once. There's going to be a steady state that we're increasing production in the factories. We're essentially ramping our Oregon factory as hard as we can this quarter. We are shipping at a level that is well above what we're producing at. And so that's why inventory has been coming down, and we want to make sure that we bridge that gap so inventory doesn't get too low. So those underutilization charges will get much, much lower by the end of the fiscal year.

Got it. So then what about the OpEx leverage side of it? Is there a certain revenue run rate where you can achieve your target operating margins also?

I think it very much depends on the slope of the revenue curve. Today, we brought back a lot of programs that went away when we kind of went through the doldrums of the downturn. So bonuses are back to high levels of our variable comp programs, merit increases are back for employees. So there's going to be growth in OpEx dollars, but a significant portion of that happened over the last 2 quarters as we are bringing these programs back. So this quarter, we are guiding to OpEx as a percentage of revenue at about 29%. Our long-term target is 25%. And you should expect as revenue grows, that OpEx is going to grow at a slower rate as we drive towards that model.

Got it. Last question, Steve, maybe on -- we always kind of look back at history and say, look at the last peak of Microchip was here, right? Now you're still like 30% below that. Many of your peers have caught up. Now your last peak was kind of unique because of its own characteristics. What is the right way to kind of frame what your growth trajectory? Like is looking at the last peak even useful, right? What is the right way to think about that?

It is not useful. In the normal past semiconductor cycles, you could do the analysis of area end of the curve, you ship to higher and then that has to be below and when you consume it, then it returns back. That analysis is much more difficult to do from the last cycle because when we were shipping at the peak of the cycle, we were shipping hundreds of millions of dollars into inventory. And so last peak, really, I mean, it was GAAP revenue by the definition of GAAP but it was not going into consumption. It was going into inventory. Customers, in many cases, didn't want the product, because of the LTSAs and PSP and all that, we jam that product down their throats. So therefore, that peak was very artificial. And secondly, in the history of semiconductors, other than the memory, there haven't been price increases, right? Microcontrollers, analog, you don't go through price increase cycles -- price goes down low single digits every year for the last 40 years. So therefore, the analysis is apple-to-apple. When there are so many price increases in the post-COVID cycle, then when you do the revenue-based analysis, it gets distorted, you've kind of got to -- go to the unit-based analysis and even in a unit-based analysis, the mix shifted a lot because during post-COVID, people gave on the low end of the businesses. So they can take the limited capacity and give it to the high end of the businesses, in high end of the businesses, there are more dollars but less units. So the unit-based analysis becomes very difficult. So I think pretty much in the last 1.5 years, every analyst or investors that have done that analysis on Microchip was really disappointed because that analysis didn't work. And we told them that it won't work, but nobody listened. So don't do that.

What is the right analysis, then?

There is none.

So how do you know whether you're at the right timeline?

How does it matter? We're growing from here and take the number and look at the opportunity ahead of us with all these 4 markets I talked about, and that's where it is. I'm already saying that the inventory depletion driven growth. It pretty much comes to an end in the next quarter or so. So rest is an innovation-driven growth. So what was the past peak? I mean, how does it help you?

Right. Makes sense.

It only confuses you.

Right. Okay. On that note, thank you so much, Steve. Thank you, Eric. Really enjoyed that discussion.