Microchip Technology Incorporated (MCHP) Earnings Call Transcript & Summary

Good afternoon, everyone. Welcome to day 2 of Citi Global TMT Conference. My name is Atif Malik. I cover U.S. semiconductors and semiconductor equipment stocks. It's my pleasure to welcome Eric Bjornholt, Senior Vice President, Chief Financial Officer at Microchip. I'll kick it off with my fireside questions. If you have a question, save it towards the end, or we'll send the mic to you and you can ask your questions. Welcome, Eric.

Yes. Thank you for having me. Hi, everybody.

Eric, I'll have to start with the customary, kind of, cycle question. Microchip has now delivered roughly 6 consecutive quarters of above seasonal growth. One of your peers is talking about this above seasonal growth continuing into next year, that's ADI. And your guidance suggests a seventh consecutive quarter of above seasonal growth. So a question is really, where are we in this recovery cycle today? And what are you seeing in terms of traditional drivers like channel restocking and inventories?

Okay. So before I start, I will be making certain forward-looking statements as part of this discussion and refer you to our filings with the SEC that identify important risk factors about the company. So we've been in a period of growth for quite some time. If you look at where we're guiding the September quarter to at the midpoint, it's up 40% year-over-year. Obviously, during that time period, margin profile has changed significantly and doing quite well. But customer order patterns have been very strong. Bookings activity, we mentioned that the June quarter was the strongest bookings quarter that we've seen in about 4 years, and that has continued here into the current quarter, both July and August bookings were good. So backlog continues to grow. Lead times are staying pretty steady for us. We've seen some pushouts on lead times for some of the outsourced capacity, and that always leads to the question of what are customers doing with inventory. But from what we see, we don't see that there's any significant inventory that's being built at this point in time. Actually, distribution inventory is quite low for Microchip at 25 days. And the order patterns continue to come in strong. sell-through through distribution is strong. And since lead times have stayed very competitive at this point in time, and we are delivering to customers when we say we're going to deliver, we don't think that there's really any significant stocking that has happened yet or restocking at customers.

Great. That's good to know. You talked about the strongest booking quarter in roughly 4 years. Can you help us understand the end markets, were the bookings strong across all end markets? Or there are certain regions or products that are seeing above stronger bookings?

Yes. Bookings have been strong across the board. It's really all product lines, all business units, all geography. There's not really anything to point out as being unique or different or weak in any way, but it's been across the board strength in bookings.

Okay. And how would you characterize the underlying demand trends across automotive and industrial?

So from our perspective, the industrial and automotive recovery was delayed compared to what we've seen in data center and aerospace and defense. But as it stands now, we think that those customers have corrected their inventories from the last cycle, are placing higher levels of orders on us. We produced information last quarter on a quarterly basis for the first time, we used to just do it annually in terms of breaking out end markets. And we showed in that slide that's posted on our website what the growth has been by end market year-over-year. And automotive grew like 29%, something like that. Industrial grew quite nicely. So really, all end markets are growing very good at this point in time, and industrial and automotive are really no different.

Eric, you guys make thousands of parts, microcontrollers, and we noticed that in periods of time when the oil prices started to go higher, the analog stocks, they start kind of stalling because the market thinks that this going to have some effect on your businesses. So in your kind of conversations with your customers, does this topic of oil pricing or this inflationary environment, it comes up? And do you think it has an effect to a certain level on your business?

I think on most customers, it really doesn't have an impact, right? They're looking at their business outlook. And if oil prices impact their business outlook, maybe they pump the brakes a little bit. But we haven't seen that as of yet. Like I said, the bookings activity has been really strong. Design win activity with customers continues to be very robust and some of the new products that we've been talking about publicly, which I'm sure we'll talk about in future questions that you have. So I am not seeing that impact from customers today in terms of what they're giving us in terms of orders and what they're giving us in terms of their outlook over the next year.

Yes. We clearly didn't see it when the Iran war started in terms of the demand profile. I'm curious if you can rank order the regional strength across North America, Europe and Asia for industrial and auto markets?

So we have a little bit less exposure in China, particularly in EV, and you would have seen that when some of our competitors saw that rise in revenue and then the drop in revenue. We really don't have any significant EV exposure in China. North America and European business in automotive is, I would say, trending equally with each other. I don't really see a difference, and we have a little less exposure, particularly in China.

All right. One of the lenses clients are looking at the analog stocks is their ability to supply more in this very strong demand environment. And you mentioned on your last call, you're not at 100% utilization, you have additional tools that can be brought online as demand recovers. But you're also seeing pockets of tightness across the supply chain, particularly OSATs. Where are those constraints showing up most today? And if demand surprises to the upside, can you flex between internal fabs and external partners?

Okay. So first of all, on internal capacity, we are in a very good position. Even though we closed one of our wafer fabs, our Arizona fab last year, we had expanded our cleanroom capacity significantly in the last up cycle. We've invested in tools that you had mentioned before that haven't been deployed yet. So our capital expenditures for the next several years, I expect to be quite low. They have been last year and this year, and I expect that to continue as we grow back into the capacity that we put in place. We have seen tightness in some of our foundry partner process technology nodes and also with some of the assembly and test vendors, as you've mentioned. I think a lot of that is driven by what's happening in AI and that's squeezing out some of the capacity. So we are doing the best that we can to have forecast from our customers, provide forecast based on history and essentially scratch and claw for the capacity that we need to support our customers and generally have been doing a pretty good job, but we have seen some lead times extend because of what's happening on some of the outside production activities.

Great. If you can just kind of dive into -- you shut down Fab 2, which was 25% of your 8-inch capacity. Remind us how much of your manufacturing in-house versus the external? And then also the back end, how much capacity headroom is left?

So as I mentioned, we shut down Fab 2 last year, which was the smallest of our 3 large fabs. We do not believe that we've limited our growth in any way from that. We do about 35% of our production in-house. The other 65% of the wafer fab is done externally. We took the tools out of Fab 2 that we could use in the Colorado and Oregon fabs, our other 2 large factories. And with that, we think that we can get back to peak revenue plus in our existing fab footprint and are in a very good position from that perspective. On the assembly and test side, we do more internally. We do about 70% of our production in-house in facilities in Thailand and Philippines, and have good capacity growth capabilities there also from kind of a floor space and land perspective that we had to expand very cost effectively.

Great. The pricing environment has been strong this year. Microchip implemented pricing adjustments effective from mid-August to early September. If you can just talk about what's driving the pricing environment and if you're seeing utilization rates and lead times continue to drive pricing higher?

So we had an issue as part of the last cycle and how that was managed with customer relationships. And that was one of Steve's -- one of his 9 points in his 9-point plan when he came back was rebuilding customer relationships. So we were very cautious about going out and raising prices on customers, although we were seeing supply chain increases over the last 9 to 12 months. So we absorbed those for a period of time. I would say investors didn't really see that because we had cut capacity so much that our gross margins had fallen quite a bit all the way down to 52% last March, and then we're growing quite nicely, but we were absorbing some costs in that. We feel that our customer relationships are in a very good spot today. And so we decided with some of the ongoing price increases that we were seeing from our supply chain coming through that it was time to increase prices on customers, and we did that in the current quarter, various effective dates but kind of mid-August to early September is when most of that went into place, and that was factored into the guidance that we've given the Street. That price increase went very, very well from a customer perspective. Many of our competitors were on their second and third price increase already, and it was our first, and it was quite modest. So well received. We are not using this as a way to amplify gross margin percentage. It's a way to maintain that and pass on the costs that we're seeing from the supply chain to customers. And again, they received that price increase very well.

Eric, you and Steve have done a great job in expanding gross margins, but our investors are greedy. They want to see more upside to the gross margins, particularly from the faster-growing data center and aerospace and defense segments. So as you look at your gross margin kind of projection, you're remaining flattish, 66% to 67% through fiscal '27. What are the biggest puts and takes around the gross margins?

Yes. So I want to point out that in the current quarter, when we're guiding to a 66.5% gross margin, we have a couple of onetime benefits that aren't repeatable. One of those is we have an expected higher licensing revenue this quarter. Within that business, we do some sales of intellectual property, and that's happening this quarter. That's the expectation, which will be 100% gross margin business that doesn't repeat after that. And also when we increase pricing, which we did in the middle of this quarter, there is essentially a write-up that has to happen on the product that's sitting in the distribution channel. When we recognize that revenue when we sold it in, it was based on old pricing. And when the quotes were increased, that causes a onetime benefit in revenue increase with no offsetting costs. So that's not repeatable. But the good thing is, is we expect because we'll have the price increase in place for all of next quarter as well as continuing to ramp our factories and our underutilization charges coming down, that pricing -- excuse me, gross margins can stay relatively flat in the December quarter and in that range of 66% to 67%. So I've been getting lots of questions from investors today is why can't gross margins go higher. And what I would like to say is we've put out this target of a 65% non-GAAP gross margin and 40% non-GAAP operating margin is kind of what we'd like to achieve through cycle and drift above that in the good times of the cycle and hopefully not drift too far below that when times are more difficult in the cycle. And we believe we'll be able to do that through proper inventory management, which we weren't able to achieve in the last cycle, but I think we're set up well to be able to do that. So margins are really healthy today. I think you also have to see that we're in competitive markets. Our margins compared to most of our peers are quite high, and we want to make sure that we are pricing our products appropriately in a marketplace where we can gain share and drive operating margin dollar improvement as fast as we can.

Awesome. Let's talk about the data center market. We, the sell-siders, appreciate you guys arekind of breaking out data center revenue, expected to grow 69% to around $1 billion this year, around 17% of sales. So we appreciate all the exercise you went to count all the parts that participate in the data center market. If you can just help us understand why you've seen such a strong inflection and hopefully separate kind of general purpose data center from AI?

Yes. Okay. So we used to break out end markets only once a year. And now we have moved to be able to do that on a quarterly basis, which investors have been asking for. We also used to combine data center and compute together, and we've broken those out separately and compute is only about 3.5% of the overall business. So with that, we broke the data center into 2 different categories. We have a specific business unit called Data Center Solutions, which purely focuses on products that service the data center market. And that business is growing nicely this year. We'll end this year at about $500 million in revenue for the calendar year. And within that, we've got our PCIe Gen 3, 4, 5, 6 products. We've got our recently introduced retimer products. We've got storage controllers, and we've got memory controllers. So those are pure-play data center products. We have another section of what we call our standard product portfolio, whether it's microcontrollers, analog, timing, security, et cetera, that sell into the data center market. We also expect that business to be about $500 million in calendar '26. And those 2 combined are going to grow about 69% this year. So we've given that breakout. That's a breakout that you will continue to see on a quarterly basis on an end market perspective, and we're excited about the growth possibilities within that end market for Microchip.

Great. Eric, you mentioned the PCIe product. So we were at the Hot Chips Conference a couple of weeks ago. And we certainly heard a lot of buzz around the PCIe Gen 6 design wins. You guys, I think, spoke about 14 design wins and $100 million opportunity, at least at one program in '27. So just on the PCIe switch and retimer market, how do you see the opportunity? What is your market share right now? If you can just give an assessment on like are there multiple hyperscalers that you're engaged? And where is the momentum coming from?

Okay. So I think you summarized it well. We have 14 design wins on Gen 6 so far. 12 of those are on PCIe and 2 of them are retimer. We've sized that market in 2030 based on external sources at about a $10 billion opportunity on PCIe and about $2 billion on retimers. And we're relatively small players today. Back in Gen 3 and Gen 4, we had a pretty heavy footprint in PCIe. In Gen 5, we missed the market opportunity. We were very late to market. We had done some internal development and were working to develop our own SerDes, and we were just late to market, and we were like 18 to 24 months late. And because of that, we missed out on a lot of the large opportunities when that market was really taking off. So now we're reentering with a very competitive product in Gen 6. We are the only Gen 6 PCIe product that is on 3-nanometer. That's with TSMC. Customer reaction to that product is very good and what it can provide from a power consumption savings standpoint. And we're excited about the opportunities, and we're targeting hyperscalers, enterprise OEMs, et cetera, with these products, but we haven't really broken out any specific customers. We did mention that one opportunity that you mentioned was about $100 million annually in calendar '27. I should point out that there's really no revenue from PCIe Gen 6 and retimers in the calendar '26 forecast that we provided of $1 billion of total data center as these design wins are really coming to production next year.

All right. Just stepping back and looking at the total data center opportunity, ADI has discussed an opportunity of roughly $1 billion to $1.5 billion of analog content per gigawatt of AI infrastructure deployment. Given your differentiated exposure to timing, power management, connectivity, PCIe fabric, is it fair to frame that your content opportunity per gigawatt is larger than that number?