Microchip Technology Q1 2022 Earnings Call Transcript

Quartr
Provided by Quartr
August 3, 2021

There are 15 speakers on the call.

Operator

Good day, everyone, and welcome to Microchip's First Quarter Fiscal 2022 Financial Results. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Microchip's CFO, Mr. Eric Bjorn Hult, please go ahead, sir.

Speaker 1

Thank you, and good afternoon, everyone. During the course of this conference call, we will be making projections and other forward looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are predictions and that actual events or results may differ materially. We refer you to our press release as of today as well as our recent filings with the SEC that identify important risk That may impact Microchip's business and results of operations. In attendance with me today are Ganesh Moorthy, Microchip's President and CEO and Steve Sanghi, Microchip's Executive Chair.

Speaker 1

I will comment on our Q1 fiscal year 2022 financial performance. Ganesh will then provide commentary on our results and financial business environment as well as our guidance, and Steve will provide an update on our cash return strategy. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and this conference call on various GAAP and non GAAP measures. We have posted a full GAAP to non GAAP reconciliation on the Investor when comparing GAAP and non GAAP results.

Speaker 1

We have also posted a summary of our outstanding debt and leverage metrics on our website. We will now go through some of the operating results, including net sales, gross margins and operating expenses. Other than Sales are referring to these results on a non GAAP basis, which is based on expenses prior to the effects of our acquisition activities, share based compensation and certain other adjustments as described in our press release.

Speaker 2

Net sales in

Speaker 1

the June quarter were $1,560,000,000 which was up 7% and geography as well as our total end market demand on our website for your reference. On a non GAAP basis, gross margins were a record at 64.8 percent and operating income was a record 41.7 percent. Non GAAP net income was a record 550 $800,000 Non GAAP earnings per diluted share was a record of $1.98, $0.08 above the midpoint of our guidance. On a GAAP basis in the June quarter, gross margins were a record at 64.2% and include the impact of $8,800,000 of share based compensation expense. Total operating expenses were $638,800,000 and include acquisition intangible amortization of $215,600,000 Special charges of $10,500,000 $3,600,000 of acquisition related and other costs and share based compensation of $47,800,000 GAAP net income was $252,800,000 or $0.89 per diluted share.

Speaker 1

Our June quarter GAAP tax expense impacted by a variety of factors, notably tax reserve releases associated with the statute of limitations expiring. Our non GAAP cash tax rate was 6% in the June quarter. We expect our non GAAP cash tax rate for fiscal 'twenty two to be about 6%, Exclusive of the transition tax, any potential tax associated with restructuring the Microsemi operations into the Microchip global structure and any tax audit settlements related to taxes accrued in prior fiscal years. Our inventory balance at June 30, 2021 $683,800,000 We had 111 days of inventory at the end of the quarter, which was down one day from the prior quarter's level. Inventory of our distributors in the June quarter were at 20 days, which is a record low level and down from 22 days at the end of the prior quarter.

Speaker 1

We are ramping capacity in our internal and external factories, so we can ship as much product as possible to support customer requirements. In the June quarter, we issued a $1,000,000,000 senior secured note maturing on September 1, 2024 and bearing interest at 0.983 percent. We used the proceeds from this bond offering to repay a $1,000,000,000 senior secured note that matured on June 1, 2021 that had an interest 3.922 percent. We believe this was another excellent transaction for us as we continue to enhance our capital structure on our path to becoming an investment grade rated company. Our cash flow from operating activities was a record at $629,900,000 in the June quarter.

Speaker 1

As of June 30, our consolidated cash and total investment position was 279,700,000 We paid down $388,000,000 of total debt in the June quarter. Over the last 12 full quarters since we closed the Microsemi acquisition And incurred over $8,000,000,000 in debt to do so, we have paid down almost $4,000,000,000 of the debt and continue to allocate conditions during most of this time period, which we feel is a testimony to the cash generation capabilities of our business as well as our ongoing operating discipline. We continue to expect our debt levels to reduce significantly over the next several years. Our adjusted EBITDA in the June quarter was a record $711,700,000 and our trailing 12 month adjusted EBITDA was also a record at 2,524,000,000 Our net debt to adjusted EBITDA excluding our very long dated convertible debt that matures in 2,037 and is more equity like in nature was 3.34 at June 30, 2021, down from 3.71 at March 31. Our dividend payment in the June quarter was $113,100,000 Capital expenditures were $86,300,000 in the June quarter.

Speaker 1

Our forecast for the September 2021 quarter's capital expenditures is between $75,000,000 $95,000,000 Our capital expenditures for all of fiscal year 2 are expected to be between $300,000,000 $350,000,000 As a reminder, our fiscal year 2021 capital expenditures We continue to add capital equipment to maintain, grow and operate our internal manufacturing operations to support the expected growth of our business. We expect these capital investments will bring gross margin improvement to our business and give us increased control of our production during periods of industry wide constraints. Depreciation expense in the June quarter was $41,200,000 I will now turn it over to Ganesh to give his comments on the performance of the business in the June quarter, as well as our guidance for the September quarter. Ganesh?

Speaker 3

Thank you, Eric, and good afternoon, everyone. Our June quarter results continue to be strong, Leading off our fiscal year 'twenty two on a positive note. June quarter revenue was an all time record of $1,570,000,000 Growing 7% sequentially and was 150 basis points higher than the midpoint of our guidance provided on May 5th. On a year over year basis, our June quarter revenue was up 19.8%. Non GAAP gross margins were another record 64.8%, up 70 basis points from the March quarter as we continue to ramp our internal factories and benefit from improved fixed cost absorption.

Speaker 3

Non GAAP operating margin was also a record at 41.7%, up 100 basis points from the March quarter. Our consolidated non GAAP EPS was above the high end of our guidance at a record $1.98 per share. Adjusted EBITDA for the June quarter was again very strong and achieved another record at $701,700,000 continuing to demonstrate the robust profitability and cash generation capabilities of our business through the business cycles. The June quarter marked 123rd consecutive quarter of non GAAP profitability. I would like to take this occasion to thank all our stakeholders who enabled us To achieve these outstanding and record results in the June quarter, I especially thank the worldwide Microchip team whose tireless efforts Not only delivered our strong financial results, but also supported our customers to navigate a difficult environment and who worked constructively with our supply chain partners to find creative solutions in an extremely constrained and challenging environment.

Speaker 3

Taking a look at our business from a product line perspective, our microcontroller revenue was sequentially up 10.7% as compared to the March quarter and set a new quarterly record. On a year over year basis, our June quarter microcontroller revenue was up 26%. Each of the 8 bit, 16 bit and 32 bit microcontroller product lines established new all time revenue records. As we have told you many times in the past, rumors of the death of 8 bit and 16 bit microcontrollers have been greatly exaggerated. The customers and applications served by microcontrollers are highly fragmented and require a wide range of solutions that span the breadth of our microcontroller product lines.

Speaker 3

Microcontrollers represented 57.5 percent of our revenue in the June quarter. Our analog revenue was sequentially up 4.1 As compared to the March quarter, also setting a record in the process. On a year over year basis, our June quarter analog revenue was up 16.7%. Analog represented 27.5 percent of our revenue in the June quarter. Other revenue was sequentially up 5.1% in the June quarter, Bouncing back from a 6.4% sequential decline in the March quarter, other revenue represented 15% of our revenue in the June quarter.

Speaker 3

Taking a look at our business from a geographic perspective, Americas was up 6.1% sequentially. Europe was down 2.3% sequentially, which is better than typical seasonal performance and came off of a very strong 30.4% sequential growth in the March quarter. Asia was up a strong 11.1 percent sequentially, reflecting better than typical seasonal growth. From an end market perspective, All end markets were strong in the June quarter. Business conditions continue to be exceptionally strong through the quarter With record bookings and backlog for product to be shipped over multiple quarters, accentuated by our preferred supply program or PSP, which continues to be over 50% of our aggregate backlog and 100% of our backlog in the most constrained capacity product areas.

Speaker 3

Demand outpaced the capacity improvements we were able to make or we were able to implement in the quarter. As a result, our unsupported backlog, which customers want to shift in the June quarter, continued to climb significantly, resulting in lead time for many line items continuing to stretch out. We experienced constraints in all of our internal and external factories and their related manufacturing supply chains. We continue to work closely with our supply chain partners We provide wafer foundry, assembly test and materials to secure additional capacity wherever possible. Through the combination of internal and external actions that we have taken, we expect we will be in a position to support revenue growth for at least each of the next 4 quarters.

Speaker 3

Despite that, we also expect that wafer fab as well as assembly and test constraints will persist through at least the middle of 2022. We believe our backlog position, especially the proportion of PSP backlog, is giving us a solid foundation to prudently acquire constrained raw materials, invest in expanding factory capacity and hire employees to support our factory ramps. Our capital spending plans are rising in response to growth opportunities in our business as well as to fill gaps in the level of capacity investments by our outsourced fab, assembly and test partners in technologies that they may consider to be trailing edge, but which we believe will be workhorse technologies for us for many years to come. The increase in capital spending will enable us to capitalize on growth opportunities, improve our gross margins, increase our market share And give us more control over our destiny for trailing edge technologies. We will of course continue to utilize the capacity available from our outsourced partners, But our goal is to be less constrained by their investment priorities, which may not align with ours.

Speaker 3

We also expect that while our capital intensity may be slightly higher in any given year than the 3% to 4% of revenue guidance we have provided in the past. When looked at in the context of a rolling 3 year view, We believe we will very much be in the range of our capital spending guidance. Now, let me get into the guidance for the September quarter. Our backlog for the September quarter is very strong. In addition, we have considerable backlog requested by customers in the September quarter that currently cannot be fulfilled until later quarters despite us growing capacity from last quarter.

Speaker 3

This is because the entire semiconductor supply chain remains very constrained. Taking all the factors we have discussed on the call today into consideration, we expect our net sales for the September quarter to be up between 3% and 7% sequentially. Our guidance range assumes continued operational constraints, some of which we will work through during the quarter, others that will carry over to be worked in future quarters. At the midpoint of our revenue guidance, our year over year growth for the September quarter would be 25.8%. We believe achievement of this revenue level would be remarkable in and of itself, But even more so given how resilient our business was a year ago during the pandemic because of the diversity of our end market exposure, thus making the year over year comparisons that much tougher and meaningful.

Speaker 3

For the September quarter, we expect non GAAP gross margins to be between 64.8% 65.2 percent of sales. We expect non GAAP operating expenses to be between 22.8% and 23.2 percent of sales. We expect non GAAP operating profit to be between 41.6% 42.4% Sales. And we expect our non GAAP earnings per share to be between $2.05 per share and $2.17 per share. We also expect to pay down another approximately $350,000,000 of our debt in the September quarter.

Speaker 3

We recognize that our gross and operating margin percentage guidance effectively gets us to the long term targets we shared with you just 9 months ago. We will be working to update our business model for annual growth, gross margin and operating margin percentage, And we'll share our conclusions with you later this year. Given all the complications of accounting for our acquisitions, including amortization of intangibles, Restructuring charges and inventory write up on acquisitions, Microchip will continue to provide guidance and track its results on a non GAAP basis, except for net sales, which will be on a GAAP basis. We believe that non GAAP results provide more meaningful comparison to prior quarters, And we request that analysts continue to report their non GAAP estimates to 1st call. Now, let me pass the baton to Steve to talk about our cash return to shareholders.

Speaker 3

Steve?

Speaker 4

Thank you, Ganesh, and good afternoon, everyone. Today, I would like to reflect on our financial results announced today and provide you further updates on our cash return strategy. Reflecting on our financial results, I continue to be very proud of all employees of Microchip that have delivered another exceptional quarter And making new records in many respects, namely record net sales, record non GAAP gross margin percentage, Record non GAAP operating margin percentage, record cash flow from operations and record adjusted EBITDA. Also, each of our strategic product lines, 8 bit, 16 bit and 32 bit microcontrollers and analog Individually achieved all time new records in net sales. Reflecting on our journey since the acquisition of Microsemi 3 years ago, I note the following.

Speaker 4

Number 1, at the time of the acquisition, We provided a long term operating model target of 40.5 percent non GAAP operating margin, which we exceeded for the first time in the March 2021 quarter and were significantly above that in the June 2021 quarter at 41.7%. At the time of the acquisition, we also indicated that we anticipated Achieving an $8 non GAAP EPS run rate by the end of the 3rd year after the acquisition. Between the $1.98 EPS for the June quarter we just announced and $2.11 EPS we guided to for the September quarter At the midpoint of our guidance, we have effectively delivered on this expectation. These exceptional results were achieved Despite the numerous headwinds we faced from international trade tensions and tariffs as well as the global pandemic, which matters were not predictable 3 years ago. Number 2, we financed the Microsemi acquisition by adding $8,100,000,000 of Debt, driving up our net leverage ratio in the June 2018 quarter to 4.95, which we know was a concern for many of you.

Speaker 4

In the last 3 years, we have paid down a cumulative $4,000,000,000 of debt and brought our net leverage ratio down to 3.34. We continue to allocate substantially all of our cash generation beyond what we pay to shareholders in dividends to pay down significant debt every quarter. Number 3, within the last quarter, based on the debt pay down we had achieved And the continued strong cash and adjusted EBITDA generation of our business, both Moody's and Fitch Change the rating outlook from stable to a positive outlook. At the rate we expect to pay down our debt and bring our net leverage further down, we believe we are on target to achieve an investment grade rating sometime by the end of fiscal year 2022. Regarding our cash return strategy, We are continuing to provide more cash return to the shareholders.

Speaker 4

Just today, we announced a dividend of $0.437 per share, Our 3rd largest dividend increase by increasing the dividend by 5.8% sequentially and 18.75% over a year ago quarter. And in the coming quarters, we expect to continue with more actions To increase the cash returned to shareholders. With that, operator, will you please poll for questions?

Operator

Absolutely. Thank you so much. And reenter the queue for any follow ups you may have. And our first question today will come from Toshiya Hari with Goldman Sachs.

Speaker 5

Hi, guys. Thank you so much for taking my question and congrats on the strong results. Just wanted to ask about gross margins In the June quarter and the outlook going forward, clearly very strong results in the quarter with margins coming in above the high end of guidance. I'm curious what drove the upside vis a vis your expectations? Was it primarily utilization rates or was there something Behind the beat.

Speaker 5

And Ganesh, you talked about you guys performing already in line with your long term model. As you think about your ability to expand gross margins going forward and as you in source, I guess both front end For processing as well as assembly and test, how should we think about the potential upside there going forward, again, in terms of gross margin? Thank you.

Speaker 3

Let me have Eric Respond to the first part and I'll respond to the second part.

Speaker 1

Okay. So gross margin in the quarter, we are utilizing our manufacturing resources Fully at this point in time, we have more orders than we know what to do with. And with that, we're being quite efficient in our manufacturing So it's really best utilizing our capacity and we're obviously continuing to make investment in capital bringing that online as quickly as we can, increasing The percentage of assembly and tests that we do internally, but the major driver was just effective utilization of what factories and equipment that we have.

Speaker 3

To your second question, give us some time to put some thought into how we see gross margins building over time, what the long term model should be. And we will come back to you later this year with a more complete picture of what that will be and what the drivers will be. Many of them are what you just described, which is as we do more in sourcing, there's a richer product mix that comes into play, there's pricing Glenn, those are all going to be important parts, but we need some time to process where we are, where we can get to, how we get there and then we will come back to you with some numbers.

Speaker 5

Understood. Thank you.

Operator

Thank you. And next we'll hear from John Pitzer with Credit Suisse.

Speaker 6

Yes, guys. Congratulations on strong results. Thanks for letting me ask the question. Ganesh, it's pretty astounding that disti inventories are now down to 20 days. It kind of makes the disty model kind of a little bit less valuable.

Speaker 6

I'm kind of curious, what is the risk That your end customers can't rely on disti and so there's more of an inventory build going on there than you can see, 1. And 2, on the more positive, Given what's happening in disti and this idea of just in time inventory management going to just in case, do you see yourself getting closer to end customers Over time strategically and what might that mean for margins?

Speaker 3

So John, the Distribution inventory is low in part because we are constrained, right? So distributors continue to service customers, But we are not able to help them grow that inventory. At some point, we will be able to, as we get our production up, be able to ship them more for them to help build that. But for the moment, neither their customers nor distribution has the ability to grow inventory in any meaningful form. When we look at where are the number of customer requests we're getting either direct or indirect through distribution On shortages, lines down and all that, it's pretty well represented across the spectrum.

Speaker 3

It isn't that one group of customers is doing better than the other. There are a large number of customers who are unable to get what they want and are in the short or medium term Trying to get more product, in some cases trying to get product through more than one source if they can. But the constraints are all over the place. And so I'm not seeing channel inventory or customer inventory building In a way that you can read something into the distribution days of inventory.

Speaker 6

And good answer. My second half of the Does this change the distribution model structurally for you? And is there an opportunity to get closer to customers and maybe capture some of that disty margin that you're giving them now?

Speaker 3

So, we have 125,000 or so customers we serve. Clearly, distribution is an important part of that model to reach that long of a tail of customers. And customers make the final choice on Where do they want to buy? They have an opportunity to buy direct. They have an opportunity to buy from our web channel.

Speaker 3

They have an opportunity to buy from distribution. And they buy from distribution when they see that the value that distribution is bringing them in support, in payment terms, in pipelining of inventory and other ways that distribution Value is good for them. But we continue to serve customers through the channel that they find to be the most effective For them. And if that is someone who wants to move direct, so be it. If that is someone who wants to stay with channels, so be it.

Speaker 3

But we're relatively channel agnostic in what we're doing. Clearly, in a time of escalation, more distribution customers are reaching through directly to us to get help. But that does not necessarily mean that they will shift off of distribution and to us directly.

Speaker 4

John, I will add that carrying inventory for customers is only one part of the value The distribution provides and clearly they have very low inventory today also to do with our inability to ship. But that's not the only value distribution provides. They provide kitting, payment terms, programming. They provide all sorts of services for which they charge. So I think distribution will continue to be an important element of Microchip's go to market strategy, which reaches a very, very long tail.

Operator

Thank you. And next we'll hear from Vivek Arya with Bank of America Securities.

Speaker 7

Thanks for taking my question. You gave a 3% to 7% sequential growth rate for the September quarter. It's kind of in line with the sequential growth rates You have seen in the last few quarters, is this being really driven by supply growth? And if that is the case, How should we think about incremental supply that could come online in the next several quarters? Because I believe, Ganesh, you said that you expect to grow sequentially For the next 4 quarters, if I heard correctly.

Speaker 7

So should we be keeping this 3% to 7% sequential growth rate in mind As we try to model out the next 4 quarters? Thanks.

Speaker 3

So, I want to be clear, we're not providing any kind of guidance that goes beyond the September quarter. We are clearly working on supply improvements. And today, all of our growth is constrained not by demand but by supply. There are supply improvements we're making that are in our control, which is what runs through our manufacturing internally, what we're doing there to increase capacity In each of our fabs, our assembly, our tests, we're working with our supply chain partners who are bringing us materials and all of that. And we're working on capacity improvements with our partners That we do outsourced work through.

Speaker 3

So, I think we'll give you the quarter by quarter growth As we get to the guidance for the December March June quarters and all that. But I think what we do see is enough capacity coming on In the subsequent quarters. And the timing is a bit hard to call because we don't have a stable environment in which We know exactly what equipment will come on, when will it bring on the capacity and all that. But we're confident enough in how we see capacity coming on that we do expect Thank you.

Operator

And next we'll hear from Ambrish Sirajasava with BMO.

Speaker 2

Hi. Thank you. Can we get back Go on to the PSP program. So I think you were 44% of the business was under that and Ganesh you said over 50%. Is there a natural ceiling to this?

Speaker 2

And then kind of tied to that, getting back to the capacity, and this must be a tougher A question to get to is, it's a very fragmented industry, both microcontroller and analog. So how do you balance Capacity increase versus what others are doing. It's not like DRAM where there's only 3 guys and everybody kind of thinks they know what the other person is doing. So Ganesh and Steve, how do you balance the capacity increase versus down the road when there could be a potential oversupply?

Speaker 3

So let me start first on your PSP question, right. Our PSP backlog exiting the June quarter was over 50%, and it grew throughout the quarter. And we have customers continuing to enroll in the program as well as extend the time that they're providing us the backlog. But the metric is really something that was important to us to convey during the early stages of launching the PSP program. And so At this point in time, rather than trying to provide a month by month or quarter by quarter update, it's a part of our normal business that we're doing.

Speaker 3

Certain capacity corridors, as I've explained, are 100% booked already, and we will just manage it. It gives us visibility. It gives us a better ability to service those customers who have long term backlog that they can place that are not that's non cancelable. That was the whole objective of what we take. And then to your second question, in many ways, PSP is one element of what we have that helps us To make sure that the other side of the cycle, whenever it is, can be managed well.

Speaker 3

We're also bringing capacity on in measured We're not trying to get all of the unsupported done in a short period of time. So every quarter, we're increasing capacity. And so combination of what we're doing with measured steps in capacity, what we're doing with the PSP program and all of that, It gives us reasonable confidence to be able to manage the cycle in such a way that we don't get over committed on the capacity side.

Speaker 2

That makes sense. Thank you.

Operator

And thank you so much. Our next question will come from Harsh Kumar with Piper Sandler.

Speaker 8

Yes. Hey, guys. First of all, congratulations on stellar results. I had actually a couple. I wanted to go back to the question that Vivek asked about growth for the next 4 quarters.

Speaker 8

So, let me see if I understand this correctly, Ganesh. You expect supply constraints for the next 4 quarters, But you also expect demand environment to remain pretty solid or robust and therefore you're pretty comfortable forecasting growth for the Revenue growth in the next 4 quarters or you're just referring to that you will have enough supply to be able to meet should demand exist?

Speaker 3

We have a very strong demand backlog on us. We have a substantial portion of PSP backlog on us. We continue to have a large amount that is unsupported. So, the demand environment we see is very, very strong. Now, The balance is really what can we supply and how much can we bring on.

Speaker 3

And our supply lines, as we can see, continue to give us the ability To bring more supply on quarter after quarter after quarter for at least the next 4 quarters, giving us that line of sight And to having the capability to take advantage of that demand and grow every quarter.

Speaker 8

Understood. Thanks for that clarity. And then for my follow-up, Maybe

Speaker 3

one for Steve. Steve, so everybody in

Speaker 8

the semi industry that's established like yourself, other life guys are talking about the cash That is more on cash when you come. But at the same time, there's very good growth in the industry. So, we appreciate the cash return. But with the industry still growing, Why not use some of that cash for things like acquisitions or maybe other things like growth? Just could you help us balance that argument?

Speaker 4

I think the way we have described before is that we began our acquisition process Back about 13 years ago, when we were well below $8,000,000,000 company And we were I think we were probably about only $700,000,000 $750,000,000 company. And we were trying to scale the business 10x So that we don't have a competitive disadvantage against our larger competitors. So TI is still larger, but many of the others Infineon and STs and Maxines and ADIs and we've really caught up to all of them In the last 12, 13 years, by scaling the business almost 10x at the current quarter guidance, we're running Somewhere in the excess of $6,500,000,000 And we wanted to do that while building a portfolio of Product around the microcontroller so that we can provide the entire total system solution to the customers, Having analog, some memory, some connectivity, USB, Ethernet, Wi Fi, Bluetooth, In all that, power management and everything else. So those two things we accomplished. We scaled the business almost 10x And we acquired organically built all these products to be able to complete customers' solution.

Speaker 4

So at this point in time, and I think we have said a couple of times that we don't find the next acquisition to be necessary. Given small acquisitions here and there, tuck in ties, if the opportunity arises, we would. But We're not really working on looking at any large acquisition because that's strategically not needed today. We have enough product portfolio and we're working very hard to train our sales force and customers to be able to use the entire Total system solution from Microchip and show the organic growth. And as we adopt that strategy And as we pay down substantial amount of debt already and continue to pay it further, Then you have a large somewhere around $1,500,000,000 burning hole in your pocket.

Speaker 4

And what do you do with that? You're saying why don't we acquire? And I'm saying we do not find that strategically needed today. So what we're planning to do is, as we achieve the investment grade rating and as The debt level comes down further, then we start giving larger and larger amount of cash back to the shareholders, Some in the form of dividend and some starting a buyback program. So that's sort of the summary of where our current strategy is.

Speaker 3

And Harsh, if I may add to with respect to your question, I think any OpEx or CapEx that is needed to grow the business It's part of what we're doing every quarter, right? That's built into our business model. It's really then the capital allocation of what we do beyond that, That as Steve was describing. And some

Speaker 4

of the smaller companies may be acquiring, I think they're really sort of copying our Strategy, which we concluded in the prior 13 years when they were not buying and maybe they're buying something today. We don't do something because somebody else I think we had a laid out strategy. We completed that phase. And that part of the strategy is no longer important. So therefore, we're going to the next phase.

Operator

Thank you. And next, we'll hear from Harlan Sur with JPMorgan.

Speaker 9

Good afternoon and congratulations on the strong results and execution. Back in early May, I think the team had said that the demand trends were 40% above your ability to supply. And then by late May, the gap had widened to 50%. It sounds like the gap either remained extended or may have even expanded. So if you can just give us a sense Of how wide the demand supply gap is today?

Speaker 9

Is it sitting above 50%? And it sort of seems as if we move into the second half of the year, demand is only getting Stronger. You have areas like data center and enterprise, for example, which were weak last year and into the first half of this year, Which are starting to pick up. Any other end markets where demand is strongly accelerating from a softer first half?

Speaker 3

So, Harlan, first on the unsupported backlog. Exiting June, that Unsupported backlog was higher than what it was, both what we said in our conference call as well as where it was at the end of March. The demand increase in the June quarter outpaced the supply improvements we could make. And hence, we expect As we go in through September, every indication we have is that the percentage of unsupported exiting September will be higher And where it was at the end of June. So, that trend continues.

Speaker 3

We are not seeing demand and supply starting to convert or get into any kind Balance itself. And was that a second part of the question?

Speaker 9

Just in terms of end markets That were weak either last year and into the first half of this year, for example, like data center and enterprise, which feel like they're starting to accelerate as we move into the second half. Is that a dynamic that you're seeing in any other end markets where demand is strongly accelerating from maybe a slightly softer first half?

Speaker 3

So, as we said, all end markets were strong as we went through the June quarter. Some have been strong in prior quarters as well. We don't track End markets on a quarter to quarter by end market basis on it. But anecdotally, some of what you're saying is correct. And we do see strength in data centers in And I don't recall what the year over year comparisons were on them.

Speaker 3

But right now, there is no market that is feeling weak.

Speaker 9

Great. Thank you very much.

Operator

Thank you. And next, we'll hear from Gary Mobley with Wells Fargo Charities?

Speaker 10

I wanted to ask about some long term supply agreements that may support that 60% of your sales that are sourced externally on the front end side and the 40% on the back end side. I know some of your competitors are entering LTSAs and quantifying them in SEC filings and I haven't seen your Q yet, but Have you guys officially entered into more LTSAs? And maybe you can just sort of give us a sense How they rank relative to your sales or how they rank relative to last quarter? And then on the flip side of the coin, I was curious to know what your financial penalties may be for those customers that have entered to non cancelable, non returnable backlog agreements with you guys?

Speaker 3

So, with respect to LTAs, right, we have a range of how we Have those agreements. I don't believe any of them have been big enough to be in our queues. So, you're not going to see something there. We have a long set of partners, both on the front and the back end. We've worked with them quite constructively At this point in time.

Speaker 3

So, that's where we are on it in terms of our capacity for 2022 And beyond and what we need to do to secure it. On the NC and R agreements themselves, Those are there's a legal agreement, that's a purchase agreement that we enter into, which have obligations on our side, obligations And we've had these this is not new. We've done this for many, many years on a smaller subset of our business, and We have not found problems in enforcing the NC and R portions of our purchase contracts. Thanks, Hinesh.

Operator

Thank you. Our next question will come from William Stein with Chiuis Securities.

Speaker 10

Results. First, I'd like to ask clarification around capital allocation. What is your target leverage ratio? When would you slow down or stop the debt repurchases? And what would be the plan after that?

Speaker 10

Because naturally, typically get to a certain leverage Ratio, if you're continuing to grow EBITDA and not adding debt, then you wind up having that ratio continue to decline. So Wondering if you can clarify the plans around sort of tapering the debt repurchase?

Speaker 1

Okay. Well, I'll start and Steve and Ganesh can add on to this if they want. So we don't have a stated target For our net debt to EBITDA, but we've made it very clear that we're focused on achieving an investment grade rating And you believe that that's something that we can achieve in this fiscal year, independent decision obviously by the rating agencies, but we're making good progress on that. And Even once we get there, you shouldn't assume that we stop paying down debt. We will continue to pay down debt, but we'll have more flexibility to Increase dividends more, have a stock buyback program and flex that as it's appropriate for our business.

Speaker 1

So Steve, what would you like to add to that?

Speaker 4

I think you said it well. The Board has not defined a bottom number For the debt leverage at which we will essentially start paying down debt and give 100% of the cash back, They have not really defined that number. In future, they might. In addition, even if we at some day stop paying debt, As the business rises and EBITDA rises, the leverage will continue to come down without even paying the debt, which was one of your point also. So that's where we are.

Speaker 4

I think it's a work in progress. We keep giving you update every quarter. We're getting fairly close to the investment grade rating. In my comments, I said by the end of fiscal year 'twenty two, which is March next year. Again, it's an independent decision by the rating agencies, but we expect that We achieved the financials and leverage metrics, which should get us there by then.

Speaker 4

And at that point in time, The Board will have a lot more flexibility to give a to start a buyback program and also increase dividend. That's where we are today.

Speaker 10

That helps.

Speaker 1

Steve, I would just add to that. We have made significant Increases in our dividend in the last three quarters and it's up 18.8% year over year with the 3 large Sequential increases that we've made. So we're definitely heading in the right direction from a capital return standpoint, but the next step is investment grade and then we'll take it from there.

Speaker 10

Great. One more if I can. We're in this environment, you could Some people describe it as peak, some people describe it as peaking or extended peak or there are a lot of ways to think about it, but it's certainly very good Part of the cycle and maybe raises questions as to how close to rolling over we are. I wonder if you could maybe highlight for us How you compare this cycle to others? Which prior cycles this one reminds you of?

Speaker 10

And What are sort of the key signs you're going to be looking for to provide a warning to yourselves around how to manage the business for A fade or a role in the cycle? Thank you.

Speaker 3

I don't think this one resembles any prior cycle. And to some extent, many of these extraordinary cycles are all unique in and of themselves. It's a question of what Precipitated them and what is happening. So, this is a cycle unlike one we have seen before for many reasons. We constantly look at a set of internal indicators to look ahead and peek around the corner To see when is something possibly changing, they run the gamut of bookings, billings, sell through, The rate at which customers are able to have confidence in what they're placing with us in backlog, our anecdotal conversations with the executives Many of our customers, of our channel partners.

Speaker 3

So, it's a process of many, many points of data That we as a team meet on a weekly basis and compare notes and see what we see in terms of what does the data tell us. And Historically, we've been able to see things early. I hope we will do the same this time too. At this point, there is no indication of any early warnings. Thank you.

Operator

Thank you. And next, we'll hear from Janet Ramkisson with Quadra Capital.

Speaker 11

Congratulations guys, nice quarter. I was wondering if you might be able To give us any insights on what your demand might be from China or just More in terms of what the trends are and what you see going forward? And also if you can make some comments about What you see in the auto industry specifically? Thank you.

Speaker 3

So China is part of our reporting for Asia. In fact, it's a substantial portion of our Asia revenue. I think it's about 2 thirds or so of that revenue. We reported that geography grew 11% last quarter, a little over 11%. It is performing as we expect.

Speaker 3

It remains strong. So, there are no China demand issues that are visible in what we see. With respect to automotive, we are continuing to increase the shipments to automotive. We are shipping well above where we were pre pandemic, but the automotive demand also is quite substantially higher. It is a matter of they have many, many companies that supply product to build a car.

Speaker 3

And so, you do hear about Factory shutting down and customers not able to build what they want. And we are providing the products that we can provide At a rate that is consistent with our manufacturing, but we're still short to what automotive would like to buy For their growth and for their growth plans.

Operator

Thank you so much. And next we'll hear from Chris Danely with Citi.

Speaker 10

Hey, thanks guys. Ganesh, you talked about All these cycles being different and we read all these headlines about worst shortages ever and apparently the politicians are going to try and make sure that there's Never any cycles in semis again. I just appreciate your guys' perspective. Do you think that this is, I guess the worst upturn ever from a customer standpoint or I guess alternatively you could argue that it's the best upturn ever From a semiconductor supplier and are you guys looking to do anything differently or is the industry looking to do anything differently in future cycles That prevent these kinds of shortages or do you think that this is just the normal course of business?

Speaker 3

There were an extraordinary set of circumstances That's got us to where we are. The pandemic was one part of that. The trade and tariff issues the year before that was another part of that. Pandemic not only created supply side issues, but created a lot of money That consumers had and they wanted to spend it and they spent it on things that required electronics for it. They required things to work out of the home.

Speaker 3

So, I think there are all kinds of factors that came into where we are. And of course, many customers in uncertainty In the pandemic, took their demand down and then realized that they have taken it down too far. I don't know what the future brings. Clearly, many of our customers are thinking through how should they, from an inventory standpoint, be preparing themselves So that they are able to run more stable through these cycles, etcetera, and where they go. I think there is a continued strong demand where people are And selling through what they're doing.

Speaker 3

I don't know what the shape of the next cycle would be and more importantly, what would be the causes of the next cycle. And I think to a large extent, Those will determine what the responses will be in it. I certainly don't think government help is going to be the answer to any of these cycles. And from usually when a government begins to think of something, the cycle is long past before they can even act with respect to that. So, I am very confident that the industry through many, many, many cycles has figured out how to make adjustments and how to build In such a way that is consistent with where the market is at and that we'll do the same in this cycle.

Speaker 3

I don't know, Steve, you've got longer years on this than I do.

Speaker 4

I think in the last several years, we have read reports, people calling the end of Cyclicality in the semiconductor business, there will be no more cycles. I think all that is wrong. Like Ganesh said, the events that precipitated this cycle would not have been forecasted 2 years ago. So when that happens and it put a major pressure on the industry from both sides, Decreasing the supply line and increasing the demand in certain cases driven by work from home and medical and others, It created the super cycle that we haven't seen in 40 years. Similar other situations were to come in 5 years from now, 10 years from now, It will create a cycle again.

Speaker 4

So those cycles have really not been repealed. People will make some adjustments, maybe keep larger inventory And do some other things. Some people are trying to get long term agreements for supply, but it's not predictable how much supply is needed 5 years And many of those agreements, you will see will have a bad ending. If there is a recession, people are not going to need that product, There'll be that excess inventory, pay for play agreements don't work out very well usually.

Speaker 10

Got it. Thanks for the perspective, guys.

Speaker 4

Thanks.

Operator

Thank you. And our next question will come from Rajeev Gill with Needham and Company.

Speaker 12

Yes. Thanks for taking my questions and congratulations as well. A couple of questions, if I may. 1 on the pricing environment. Last quarter, Ganesh, you had mentioned that you were engaged in some price increases and that was reflected in the revenue.

Speaker 12

I'm wondering how you're describing the pricing dynamic this quarter. How is that affecting the revenue? How is that affecting kind of the gross margin improvement on Sequential basis as well.

Speaker 3

Sure. So, the price increases largely have attempted to I'll pass on cost increases that we've had. And we continue to get cost increases on a pretty regular basis in the current environment, Depending on what the material of the product that we need to buy are. And as they come along, We don't do it all instantaneously. We will batch it and figure out points at which we would do the increase in prices to go with it.

Speaker 3

And so, that's a continuous process as and when it is needed in terms of us collecting the data. And at this point in time, there is nothing In our pricing thought process, that would be different from what I said 3 months ago. If there is a need, If there are cost increases that we cannot absorb and we batch it at some point in time and we pass along the price increase.

Speaker 12

And for my follow-up, you had mentioned that you will have capacity to support revenue growth in each of the next Four quarters. I was wondering if you could elaborate further in terms of the capacity increases. Is that Coming on the foundry side, on the test and assembly, which areas do you think are easier to get more capacity? Which areas are harder? I would think that the foundries have been reluctant to spend on kind of lagging edge nodes.

Speaker 12

So on the wafer side, it might be a bit more challenging. But Any color specifically in terms of the capacity that would be helpful. Thank

Speaker 3

The area we have the most and the way we have been investing for multiple quarters It's in our internal factory. So we expect that there will be more help coming where we have more control, which is in our fabs, Power assembly and test factories, etcetera. It doesn't mean we're not getting anything from our partners. We are. It's selective.

Speaker 3

It really depends on the situation and where we're getting. But, it is correct that more help is coming from the factories we control than from our foundry and assembly test partners.

Speaker 12

Appreciate it. Thank you.

Operator

Thank you so much. Next, we'll hear from Matt Ramsay with Cowen.

Speaker 13

Thank you very much. Good afternoon, guys. Two questions, a little bit unrelated. One is a follow-up on pricing, Ganesh, From the last question, and given what the margins are, you're obviously going to be able to pass on some of the higher input costs to customers. But If the input cost situation were to change and come down a bit with the long term agreements that you're putting in place under the PSP program, how Stable or durable or how much length is there to some of the new pricing negotiations you're having?

Speaker 13

Or do you expect those to sort of moderate As input costs moderate if and when they do. And the second question completely unrelated is I noticed some press releases about silicon carbide from you guys Within the last week, it seems like a much more expansive program than you might have had in the past. Is that the right read? And I guess how important of a program is that for you guys going forward? Thank you.

Speaker 3

Okay. So, on the pricing front, right, I mean, I think there is no into which way input costs are growing. At this point in time, every indication is that input costs are going up in 2022 And we're already starting to hear of input costs going up in 2023. If and when there is a change in the trajectory of input costs, We will relocate it at that point in time. And so nothing to really say about input costs Changing directions at this point in time.

Speaker 3

In regards to silicon carbide, it is a program that is important, Has focused and we have been bringing out products on a pretty consistent basis there. And is an important part of our growth strategy is to capitalize on the markets, which have both industrial and automotive Components with Industrialize realizing revenue sooner by bringing the benefits of silicon carbide to those markets. They go nicely hand in hand with many of our microcontrollers that play into these power conversion opportunities, which is where silicon carbide plays. So, yes, we haven't made a big deal of it, but it is an important product line and an important initiative for growth for us.

Speaker 1

Thank you very much.

Operator

Thank you. And next, we'll hear from Chris Caso with Raymond James.

Speaker 10

Yes. Thank you. Good evening. I wanted to ask a bit more about what you talked about earlier about relying a bit more on internal capacity as opposed First, what happened within the industry that is kind of causing this Shortage in foundry and recognizing that industry really didn't foundry industry didn't really Expand capacity and lagging edge nodes in the past. But why are we at the point now where there's just none left and no willingness To extend that.

Speaker 10

And then following that, if you are going to increase your reliance on internal capacity, How is it that you stay within the same 3% to 4% of revenue CapEx model? How does that work going forward?

Speaker 3

So, first of all, I think from an industry perspective, it's just the rate of growth That foundry is seeing on these lagging edge technologies is so far ahead of any normal planning that they have done That it's overwhelming what the capacity available is. Well, the normal reaction you would say is, well, why aren't they building more? Well, the economics of that for the foundries and the opportunity cost versus other capital objectives that they have, Don't always lend themselves to saying that trailing edge capacity is where they want to be invested. It's not that they're making no investments, they are. But they're not fast enough And they are not at a rate for products that we consider to be important for us.

Speaker 3

We are not doing it across the board. We are just picking and choosing places where we think There is significant constraint for us or opportunity for us to make that investment. And that is true not only in the FAS, it's true in assembly and test as well As to why we're doing it and what we're seeing. It will mean that we will continue to use all of the capacity available from our foundry and assembly test partners. Plus, we will try to make sure that we have, where we can, additional capacity to be able to not be constrained by what is available only from our outside partners In terms of the CapEx itself, I mean, you've seen if you go back and look at our history last 5, 10 years, you'll find that we have Gone above and below that 3% to 5 3% to 4% number.

Speaker 3

I think the 2 years previous to this, we were at about 1%. And that's where the cycle was, that's what we needed in that. So, I think a 3 year look gives you a better sense. And we could spend more than 3% to 4% in any given year. As we look at investing at a time when that need is there and then we'll breathe with that capacity and let it all build out over that time.

Speaker 3

But at this point in time, that's what we feel comfortable with. If that changes in time, we'll keep you posted. But all this capital that we're investing, all the capacity we're bringing on, All of it we think will be accretive to our gross margins and will enable growth that we could otherwise not have had if our only choice was to take it outside.

Speaker 5

I'd like to clarify

Speaker 4

the foundry part of the answer. Ordinarily, When the industry has a normal kind of growth rate, whatever it was over the last 10, 15 years, Usually, a movement to the faster node by the leading edge guys kept freeing up enough trailing edge capacity So that the trailing edge guys didn't get constrained because the leading edge capacity of today is a trailing edge capacity of 5, 6 years down the line. And that's how trailing edge capacity became available because it was originally built for people who wanted more leading edge And then many years later, there was available for the trailing edge. But when the industry grew, This year, at the rate it has grown, most companies have announced year over year growth rates of 20% plus. Our September guidance is, I think, About 25% up versus same quarter a year ago, then that is the growth rate on the trailing edge technologies much, much higher Then really what would become available through ordinary process of nodes moving up.

Speaker 4

And so therefore, the leading edge capacity is constrained also today. It's not like there's all the capacity available at 40 nanometer and 28 nanometer, they're all constrained also. But foundries are willing to add on the more leading edge nodes than they are on the trailing edge. Given the choice of the capital allocation and their priorities, They are working on more relieving the leading edge capacity, leaving the trailing edge much more constrained because of the such an aggressive growth. If the growth of the industry returns back to a much more normal over the 10 years, then it's quite possible That the drilling edge capacity will not be as constrained again.

Operator

Thank you. And our next question will come from Christopher Rolland with Susquehanna.

Speaker 14

Hey, guys. Thanks for the question and good quarter. What's the plan around just the inventory? Do you guys plan to Increase that from 20 days kind of ASAP or is this on hold as you kind of service Your PSP customers or direct customers first, any color there on your timing around replenishment?

Speaker 3

We don't drive distribution to what inventory they should carry. The numbers we report What their decisions are, both in terms of what they see as a demand, but in the current condition, what they see as the supply available to them. PSP customers are coming to us as much from distribution as well. So I would not take PSP and say it's direct customers only. Many, many customers who are distribution customers are placing PSP orders on it.

Speaker 3

The issue is that when demand So far exceeds supply, you cannot build inventory internally or in the channel at that point in time. Until we get to the point where we can help provide more product than they're shipping out, distribution inventory is not likely to go up.

Speaker 4

We're shipping higher and higher amounts of distribution every quarter, but it sucks out the door because of the strong demand for sales out. So, because the supply is so constrained, you cannot really build inventory anywhere.

Speaker 14

Yes, understood. And this is definitely a longer term question. But is there any point or condition when You guys would ever consider a 300 millimeter fab. For example, ON has the same revenue as you guys and has one. Or is it something that given your product sets and the volumes that you guys have and the runs that you guys have that you wouldn't have any interest in?

Speaker 3

No, there are scenarios in which a 12 inches fab may make sense for us, There's nothing really to talk about at this point in time.

Speaker 4

The company you mentioned is not a good example for us. Our operating margin is higher than the gross margin.

Operator

Thank you. And we'll take a follow-up from Harlan Sur with JPMorgan.

Speaker 9

Yes. Thank you for taking my In terms of potential uncertainties, unfortunately, we are seeing a resurgence in COVID-nineteen delta variant. Southeast Asia seems to be quite impacted, right? Do you have assembly, wafer and final tests in the Philippines and Thailand? Some of your sub cons are in Malaysia, which is probably the hardest hit.

Speaker 9

The team managed through COVID-nineteen shutdowns very well last But for the recent surge, how is the team mitigating the potential for supply chain disruptions?

Speaker 3

So, firstly, taking our own internal factories, right. So, many of the protocols that we implemented last year To operate safely, to have backup plans if people need to be inside of the factory. All that is normal part of our contingency planning. In addition, we have taken steps to accelerate how vaccines can be brought in and deployed. For example, over the course of last week and this week, a substantial portion of our Thailand factory is going to be fully vaccinated.

Speaker 3

We're taking steps to get preventive things we can do. We're trying to do the same thing in the Philippines, and we have some challenges to overcome to get there. We're working with our factory partners. And from where they're operating, there are challenges. So far, nothing is really a major enough issue for us To result in significant loss in production.

Speaker 3

So as that data unrolls and as we see what the Rules and regulations are, we will manage around it and as best as we can. We have contingency plans. But there's no answer which says we have all scenarios talked through. So far, no major issues, And we're okay with where things have at, but being prudent on where things might go.

Speaker 9

Absolutely. Thank you.

Operator

Thank you. And that concludes today's question and answer session. Mr. Morthe, at this time, I'll turn the conference back over to you for any additional or closing remarks.

Speaker 3

Well, I want to thank everybody for attending the call today. We have several investor events coming up over the next month, month and a half of timeframe, and We look forward to talking to many of you at that point in time. So, thank you.

Operator

Thank you. And this concludes today's conference. We thank you for your participation. You may now disconnect.

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Earnings Conference Call
Microchip Technology Q1 2022
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