All right, good morning everyone. Day three of the Raymond James Conference. I'm Melissa Fairbanks. I cover analog semis and IT supply chain here at Raymond James. We are thrilled to welcome Eric Bjornholt, the CFO of Microchip, this morning. I think he'll just have a couple of brief remarks just as an intro, and then we'll dive into Q&A.
Okay. Thanks, Melissa. Good morning, everybody. So during the course of this discussion, we'll be making certain forward-looking statements about the financial performance of Microchip, and I refer you to our filings with the SEC that identify important risk factors about the company. So, you know, we have been through a pretty crazy upcycle, and, you know, with that, we are in the middle of a downcycle as we speak. You know, we are guiding the current quarter revenue to $1.325 billion ± $100 million. That's down significantly from where our peak revenue was back in June of this last year. We are clearly going through an inventory correction. The $1.325 billion is nowhere close to what the true end-market consumption of our products are. This quarter, distribution is draining inventory. We believe our customers are draining inventory.
Distribution sell-through is down, and that's an indication because there's not anything that's really changing dramatically in the global economy. So we believe that our distribution customers are also draining inventory. So we're in the middle of it right now. We have pretty limited visibility. Our lead times are extremely short. When we entered calendar 2023, our lead times were 52 weeks plus for the vast majority of our products. We ended calendar 2023 with average lead times of eight weeks. So a big change that customers have been through. And since lead times are so short, we do not have great visibility. So right now, the Street has us modeled at relatively flat revenue for the June quarter. We have not made a call on that yet.
To be at that levels, Microchip will need turns, turn orders, new orders coming in within lead times to meet that revenue expectation. And that is not unusual. Go back pre-COVID, you know, we always had a large amount of turns that we would enter any quarter with, and short lead times support that. But, you know, really what we're watching in the short term is when do we start getting those short-term orders within lead times showing us that inventory is corrected, at least for a portion of the customer base. But, you know, the bottom line is we have high confidence in our business. The products that we've introduced over the last several years, the end markets that we're serving, are focused on some of the fastest-growing areas of growth in the semiconductor industry, which we call the Megatrends.
Then how we pair that with what we call our Total System Solutions approach to the marketplace where we're trying to sell as many of the semiconductor products that we offer into each customer opportunity, not just sell the microcontroller or the analog, but sell connectivity, security, timing, memory, all these things to be a more value-added partner to our customers and help accelerate revenue. And we're seeing good traction there. I'd say design activity is very high today. That wasn't necessarily the case as we were going through the upcycle because customers were scrambling just to find a way to get their products to market when semiconductor supply was so short, and they might have had to tweak a design to, you know, still use a Microchip product but use something that was available rather than something that had a 52-week lead time.
So customers have been through a lot. We're supporting them through this journey. With that, I will turn it over to Melissa for Q&A.
Okay. Great. Thanks very much. I think it would be helpful. I want to kind of focus more on longer-term, the longer-term model. But I think it would be helpful in the recent quarters and the current quarter what you're seeing in terms of the end-market variances. So we've kind of seen across some of your peers a rolling correction, for lack of a better term. But maybe you have a very broad-based portfolio, very limited consumer exposure, you know, which proved to be, you know, pretty helpful. But maybe talk about what you're seeing across industrial, automotive, and those types of trends.
Okay. So really, the vast majority of end markets are weak for us right now, and customers are correcting inventory, as I talked about in kind of the opening comments. The exceptions to that are the aerospace and defense market is still strong for us. So, and that's about 8% to 10% of revenue. We include that in our industrial exposure, which overall last fiscal year was about 41% of revenue. Automotive is weak. Data center, outside of anything that we're selling into kind of the AI server portion of that market, which has been strong. Rest of that is weak. Consumer, which is consumer appliance for us, is pretty weak right now. The other piece is communications. So we aren't seeing a lot of strength right now.
It just tells us that customers are dealing with the inventory situation and a new environment where lead times are short and they can get products on short order. If a product has a four-week lead time, you know, customers aren't giving us great visibility because they don't have to. They're managing their business appropriately based on where lead times are at.
So as the supply has kind of normalized, lead times have come in. What are some of the trends that you're seeing in pricing? We saw a lot of price inflation over the past few years, mainly because of rising input costs. What are some of the trends that you're seeing there?
Okay. So pricing is stable for us. You know, pricing is always competitive at the point of design, and we're seeing that today. But that's always the case. And, you know, we're at the point of design, we're working on a design that might come to market in 18 months or 36 months, depending on what the end market is. And we can be more competitive on that from a pricing perspective. But once we are designed in, you know, that product, typically the ASP or the average selling price, is stable over the life of the product. There were some exceptions to that that happened in this last upcycle because of the inflationary pressures that the industry and the world economy was going through. There was a significant increase in wages. Capital equipment was very expensive.
You know, those are two of the largest costs that we see in our cost structure. Those things haven't changed, right? We bought capital, or our foundry partners bought capital during the upcycle. Those costs are fixed and are going to depreciate over time. Labor costs aren't going down. Maybe the rate that they're going up has moderated, but they're still, so those ASPs are solid. Our customers understand that. We did not gouge customers with price increases. We were very transparent in terms of just passing on the increase in costs that we were having in our business. We were fair with our customers. So we're not seeing significant pricing pressure. You know, whenever you're in a new design opportunity, there's pricing pressure, but that's normal.
Great. Great. I think that was one of the concerns, you know, going through a correction that we were going to see kind of a step function decline. It's good to hear that that's pretty stable. So Microchip, you implemented the Preferred Supply Program when lead times were well beyond 52 weeks. Maybe it would be helpful to talk about your peers. You know, there were different ways of approaching tight supply and ways of allocating the supply that you had. If we can touch on what the Preferred Supply Program was, how it helped you through some of the tight times and now as that's unwinding, what the impact of that is.
Yeah. So we implemented PSP, the Preferred Supply Program, back in February of 2021, I think it was. And, you know, that was really based on customer input that, you know, lead times were stretching out, they were having challenges getting the product that they need, and they wanted more assurance that they were going to be able to get that supply. So the PSP Program originally was a program where customers would provide us with 12 months of non-cancelable, non-reschedulable orders. And with that, you know, based on kind of the first-in, first-out orders under those PSP programs, they got priority. And it worked really well for customers. Customers were supported very well.
You know, what then happened is as we went out in time and customers had 12 months of visibility with us, and then their end-market perception changed, or maybe they were hedging themselves because they were so tight on capacity and didn't want to get caught short that they said, "Hey, instead of keeping two or three weeks of inventory, I want to keep two months of inventory or three months of inventory," based on their expectation of what demand was going to be 12 months out in time. And nobody has a crystal ball on what that's going to be. And as I talked about, lead times compressed significantly over this last year, and we have made changes to the PSP Program over time. So in August of 2023, we changed that 12-month requirement to a six-month requirement.
Then come February, when lead times are extremely short, so February of 2024, we just did away with the program. Any new orders coming in, PSP is not an option for the customers. The customers can still provide us with longer backlog, and they get priority based on when they place those orders. But because lead times are short, it's not as big of an issue as it was back then. We get questions. Was the PSP a good program? Absolutely, was it a good program? The vast majority of our competitors had some form of extended NCNR also. Maybe you didn't call it PSP, but had another term for it. It was a good program. Looking back with hindsight, could have we maybe changed it a little bit earlier than we did? It's possible.
But when we made the change to six months back in August of 2023, you know, in June and July, we had customers still screaming at us that, "Hey, I need more product." So it's easy in hindsight to look back and say, "Hey, we could have changed it three months earlier." But, you know, we're in a good spot today.
How did the program, or even just the past few years of the supply chain disruption, change the way that you're communicating with your customers? And are you working more closely directly with your customers in order to get some of that visibility into their needs?
So we are. That was one of the big benefits that came out of the supply-demand crisis, was, it made our customers and senior managers at our customers and our customers' customers aware of how complex the semiconductor supply chain is. So there was a lot of CEO to CEO or C-suite to C-suite discussions at these customers that didn't happen before. You know, those relationships have lasted and will benefit us into the future. Again, the customers at a higher level have a better understanding of the complexity of supply chain, and those communications are ongoing.
And so I would say, you know, you can have a discussion with a purchasing manager, and they might be beating us up on PSP or whatever it might be, that the PSP Program, the CEO or the other C-suite business unit executive that we're talking to fully understands that the program was good, how it helped them get through a very difficult environment, and, you know, they're satisfied with Microchip and want to continue to use us as a preferred supplier.
Okay. I think it's really important to note how resilient your margins have been, even as we've had a couple quarters of pretty significant correction. You're dealing with the easing lead times. You know, inventories are rising. But we've now kind of seen the floor of margins peak to trough has risen over the past few years. Can you discuss, you know, through M&A, some of the things that you've done over the past several years that's provided that resiliency?
Sure. So, I mean, we've got a long-term business model of about 68% non-GAAP gross margins and 45% non-GAAP operating margins. We exceeded both of those during the upcycle and obviously have dropped below that with the contraction of revenue that we've seen. But nothing that's changed in the model that wouldn't allow us to get back there as revenue improves, which it will. We've done a lot of things. So you mentioned M&A. And so we haven't done large-scale M&A since we closed on the Microsemi acquisition back in May of 2018. So it seems like a lifetime ago, but 5.5+ years ago. But, you know, through that integration, we've improved the margin structure of that business, which was a large business that we acquired. Over that time period, we've continued to introduce more advanced, high-performing, higher-value products to the Street that drive a higher margin.
And so it's product mix, it's improvement in manufacturing and operations over time that allows us to show that improving margins, which we've really shown throughout our company history.
Maybe it's important to talk about your balance between your internal utilization, using external suppliers, how you balance that, and then how that also helps you kind of maintain this band of margins through peak to trough.
Sure. So we own some of our manufacturing resources, and we are reliant on outsourcing some of it. So we do about 40% of our wafer fab in-house. We've got three large fabs in the US, one in Arizona, one in Colorado, and one in Oregon. That creates that 40% we do internally. And then we are relying on the professional foundries for about 60% of our production. Anything 12-inch-related and anything that is really 90-nanometer or below, we outsource. The rest is either done internally. Some of it we've acquired through acquisitions, and it uses an external partner. So it's a mix of that. On the back-end assembly and test side, we do about 60% of our assembly in-house and about 70%, 67%, I think, is the number of tests. And those percentages will likely increase over time.
We have a target to get to about 80% of final tests in-house. We've got four factories located in Thailand and Philippines that are very cost-effective. You know, owning those resources is important for us over time. The assembly probably goes to about 70% over time from the 60% that it's at today. It's a good balance. You know, obviously, we are reliant on external manufacturing. Our partners are committing to us to have capacity in place. We share kind of where our revenue needs to be on various process nodes over the next five years. You know, our foundry partners are continuing to invest in their business. Everybody has capacity at this point in time, but that is not going to be the case for the industry forever.
We want to make sure that they have that visibility, and we know that they are investing appropriately for us in the long term, and we're comfortable that they are.
How does some of your manufacturing strategy provide a competitive advantage? Some of, you know, bringing more of the assembly and tests in-house, is that helping you to create greater value in terms of, you mentioned Total System Solutions, just getting more content per look?
So there is some of that. And there can be a cost advantage in assembly and test also. It provides us more security that we own that supply chain and can turn things through it. So we'll tend to keep a large amount of our inventory in what we call die banks. So whether it's run through our own factories or through the foundries and have it probed and then not build it into a finished good until we get an order from a customer that allows us to have short lead times. And owning those assembly and test resources really helps us from a lead time perspective, keep our lead times very competitive. And, you know, the cost structures in these factories are very good, too.
You know, when we can do it internally, we take away the margin that a subcontractor would earn and then be able to keep some of that for us and our shareholders and pass some of that benefit on to customers.
Okay. Talking about the competitive landscape, you know, I get asked a lot about threats from China. You know, there are, obviously, we've had a lot of industry consolidation, some new capacity coming online. Everyone pretty much across the board has seen a rising, you know, kind of margin profile. What do you view in terms of your competitive landscape, risks from more capacity coming online in China? And how do you compete with that?
So we sell about 20% of our revenue into China. We think about half of that is designed outside of China for consumption outside of China. And there's probably half of it that is designed in China for either domestic consumption or export. We think of that 10% that is designed in China, that about half of that are things where Microchip has a dominant share technological advantage. It's a complex product that is not really subject to China competition. And so you're left with about 5% of the revenue, which is, you know, kind of more standard catalog microcontroller analog product that is subject to competition over time. Now, clearly, those customers have chosen Microchip for a reason, right? We have the right product, we have the right support, we've got the right roadmap for them.
Where a new Chinese entrant into the marketplace is going to struggle is, you know, Microchip has 100,000-plus SKUs in our portfolio, and, you know, so do our larger competitors. If a new competitor enters the market with 20 products or 30 products, it might be a good fit for a particular application. It might be targeted at something that's more high volume in the consumer sector where we don't really focus our business. But in industrial, automotive, data center, where we have the lion's share of our business, you know, customers are looking for a product roadmap because when they start their design, what they typically go to market with is likely going to be something different because they get market feedback, they need to add features and functionality. If you don't have a product roadmap that allows them flexibility to move around, they get stuck.
So, again, there's all these reasons why customers have chosen us, and we think they'll continue to choose Microchip over time. Doesn't mean we won't be subject to more competition, but it's on a relatively small piece of a revenue base. And many of these products that we are selling into today in that space are designed in the application that have five, 10, 15+ years of runway in front of them. So any bleed that we'll see there, I think, is going to be a slow bleed, and we're going to continue to innovate and try to gain share.
Okay. Great. I'll stop here in case. Are there any questions in the audience? Okay.
So on the PSP Program, maybe go over the contractual terms because we thought it would protect you in terms of visibility and revenue. It seems like it maybe protected customers from liability.
Okay. Okay. The question is asking about PSP and the terms of PSP and how that either protected Microchip or protected the customer. As I mentioned before, it started off as a 12 months of non-cancelable, non-reschedulable backlog. We were pretty firm on that for a long period of time. As lead times started coming down and clearly there started to be some issues with customers having inventory in the industry and for Microchip's customers, we started to be more flexible with that and allowing push-out activity. We've tried to avoid the cancellation because in many of these cases, we've gone out and secured wafers from a foundry or invested in capital and equipment, started wafers in our own factory. The customer needs to have accountability in the situation.
But we don't want to damage the relationship with the customer long-term and are allowing them to push out. But we're looking for what we would call a win-win scenario. So if a customer, "Hey, if Microchip is helping you, what can Microchip get out of it? Can you open up a new design opportunity for us?" You know, we might be in a design. Is there an analog opportunity or a timing opportunity or something else that we haven't had access before? So customers are pretty good about that. And, you know, they're looking for help to manage them, manage themselves through their working capital challenges and inventory challenges.
We're just trying to find a mutually beneficial situation because it can't be that, "Hey, Microchip has, you know, built these products for you, and then you can just cancel them." Just like with our suppliers, if we've had to enter into long-term agreements with them for wafers or substrates or whatever it might be, you know, we can't get stuck in the middle and take the pain on both sides. So it's a negotiation.
Anyone else? Okay. I think it's very important to talk about the capital return strategy. You did have some pretty sizable M&A that you've done. I can't believe it's been over five years since Microsemi. You've kind of changed your approach to shareholder returns since that acquisition on a path to return 100% of free cash flow to shareholders. Let's talk a little bit about that.
Okay. So at our Analyst and Investor Day in November of 2021, we talked about, "Hey, when Microchip becomes investment-grade rated, we are going to start really an accelerated capital return strategy with a goal of getting to 100% free cash flow return." We've been on that journey now for quite some time. It's been very consistent. We got investment-grade pretty much right after that analyst meeting occurred and now have been increasing dividends very rapidly and increasing the percentage of our free cash flow that we return each quarter. So in the current quarter, we are returning 82.5% of last quarter's adjusted free cash flow. Dividend increases based on whatever the board approves each quarter. Then the buyback is a subtract answer. So this quarter, I think we're paying a $242 million or $243 million dividend. And our share buyback is like $387 million.
So we're buying back a lot of stock this quarter based on last quarter's adjusted free cash flow. That 82.5% this quarter will go to 87.5% next quarter, increased by five percentage points each quarter until March of 2025, where we'll be at 100%. And over time, we expect the split between dividend and buyback to be about 50% over a year's time frame. It's been more skewed towards the buyback over the last couple of years. I suspect next quarter is going to be more skewed towards dividend. This is not going to be a great cash-generating quarter for us. Dividend will likely go up again. So it's going to be higher dividend, less buyback next quarter. But I think that's temporary in nature. The operating margins and free cash flow margins are going to increase as revenue starts to climb again.
It's been a very good program for us. We've got excellent investor feedback from it. Our margin profile is one that is going to continue to generate a bunch of cash. Our capital intensity is relatively low, and that also helps the free cash flow. So we're on this path and making good progress. In another year, we'll be at 100%.
So question?
How do you write a dividend split? How does that sort of maximize shareholder return over the long term? Seems like increasing the dividend in a cyclical business or cyclical cash flow business, you know, sometimes gets stuck, and that's going to be out of whack, as you pointed to, at least.
Yeah. But I think that it will be out of whack for a couple of quarters. I mean, these cycles in the industry tend to be, you know, pretty steep down and pretty steep back up. So we're not too worried about that. I think once we get to 100% free cash flow return, the board will probably give management some flexibility in terms of how we manage the buyback portion of that. So dividend will continue to grow. But buyback might be less one quarter, more the next quarter, and over the course of a year, you know, get us to, you know, the target for the year. So it's a board discussion. You know, it can change in the future, but, you know, dividend is fixed, and the buyback can be a little bit more flexible than that.
You know, we take feedback from our large shareholders in terms of what they view as more advantageous. Some like dividend better, some like buyback better. 50/50 split seems to work. Yep.
Okay. Outside of shareholder returns, what are some of the priorities for your cash use? How are you thinking about longer-term capacity investment, capacity expansion, R&D investment? What are some of those priorities for you?
Yeah. So we have about 25 different business units within the company. They all have different models that they're driving forwards towards growth, growth in operating margins, and investments required. We obviously have an overriding business model that drives the 45% operating margin target. So we are limited within that in terms of how we invest. But we make sure that we are investing in the fastest-growing, highest-profitability areas that we see long-term for the business, focused on these industry Megatrends and the business units collaboratively working together to make sure we're going to have the right product set to support our customers. So I think what's important in the current environment is how Microchip manages through a downturn. So we do not do broad-based layoffs of our employees. In the current environment, we've implemented a pay cut. Executives are on a 20% pay cut.
Most of the employee base is on a 10% pay cut. That makes it difficult for employees. So I don't want to just skip by that. It is difficult, but it is short-term in nature. And it allows us to make sure that we keep our R&D efforts on track, our customer support activities on track. And when we've done this in past cycles, it has always resulted in Microchip coming out stronger than the competition and gaining market share because we've had our employees working hard to have those new products in place, support our customers on new designs, and allow us to gain market share long-term. So that's the focus. I mean, again, with 25 business units, I'm not going to go into anything specific from a product perspective.
Responding to that question, we've got a lot of exciting areas that we're investing in and focusing on these Megatrends we think will provide us outsized growth compared to the industry and allow us to continue to gain share.
I'm glad that you brought that up. I think that approach is somewhat unique to Microchip, and it has been very successful in past cycles. So it's good to hear that, you know, keeping the employees happy is important.
It's not easy to implement a pay cut. In the US, we can cut people's pay tomorrow. In most of our European and Asian locations, you need the employee's consent to cut their pay. And to think about being able to do that in a 22,000-employee organization and get a very high percentage rate of the employees signing up for that, it speaks to the uniqueness of our culture, which we think is a competitive advantage to us to be able to implement something like that without having kind of a mass fallout from employees.
For sure. So you do have a pretty diverse geographic footprint globally. You have received, already announced, some CHIPS Act funding. Maybe talk about how is CHIPS Act impacting your decisions in terms of capacity planning or where you're going to invest?
Yeah. So what we announced regarding the CHIPS Office is that we came to a preliminary memorandum of terms, and there is ongoing due diligence that is happening on that. So we don't have a final contract in place. But the contract is supporting about $162 million of funding for our Colorado and Oregon fabs over time. And we'll provide more information to the Street as we get to more of a final understanding of terms. But, you know, I think we've got a very good case to be made to the US government. I mean, we are the largest supplier of semiconductors to the Department of Defense. Much of that business came to us through the Microsemi acquisition that we talked about earlier. And, you know, the US has a vested interest in Microchip doing well and continuing to invest.
And, you know, clearly right now, we are in an excess capacity situation given where revenue levels are today. Again, that's not going to last for a long period of time. And as revenue bounces back, we will be looking to invest. And this will allow us to accelerate some investments in the US, have a little bit more onshore manufacturing, which is in line with what the US government is trying to achieve.
Okay. Longer term, how do you think about capital intensity? You've got like a very—I think you mentioned—your capital intensity is fairly low in terms of CapEx spending. But longer term, how far of a view out do you look in terms of what your needs are going to be as we've got higher complexity, more content, more electrification across the industry?
Yeah. So our capital intensity is between 3% and 6% of revenue. We're pretty comfortable with that range. And it was at the high end of that last fiscal year, kind of be in the middle of that of this fiscal year. And I suspect next year will be pretty low. We'll give you a, you know, our fiscal year ends in March, and we'll give you a view of that in our next quarterly earnings call. But we've got excess capacity right now. We've actually received quite a bit of capital in because lead times for capital equipment was long. We've received capital in that we have not deployed for manufacturing as of yet. So I suspect capital intensity in fiscal 2025, which starts in April, will be pretty low. But we'll give you more guidance there. Second piece of your question was what? I'm sorry?
Do I remember?
Okay.
Just in terms of longer-term capacity investments, you know, how you're thinking about geographic distribution or what you need to bring in-house or continue to outsource?
Yeah. So, you know, it's really based on process technology, as I mentioned before. Anything that is 90 nanometer or below, we are relying on the professional foundries for. And anything that's above that are things that we have the capability of doing internally in most cases. So, you know, that's really how we look at it. You know, we have, for example, a couple of years ago, took a license of a technology on 8-inch from one of our foundry partners where they were not going to continue to invest. We've implemented that in our factory, and that allows us to build up that production over time. We have several process technologies that we own that are run at foundries. We call those customer-owned technology. Most of these came to us through the Atmel acquisition that we did in 2016.
We are qualifying some of those in-house also to better utilize our own factories. And, again, that's a good thing for domestic supply. But we're somewhat limited on what we can do there. So I don't think the 40% internal versus 60% external fab will change dramatically. It'll move around by a few percentage points, but we'll still have a heavy reliance on the foundries.
Okay. Great. Hard to believe, but we're out of time already. We are going to head downstairs for the breakout session and can address some more of your questions down there. Thanks very much, Eric.
Okay. Thanks, everybody. Thanks, Melissa.