I'm Vivek Arya from the BFA Securities Semiconductor Equipment team. Welcome to all of you, and I'm absolutely delighted and honored to have our guests from Microchip, President and CEO, Ganesh Moorthy, and CFO, Eric Bjornholt. What we will do is maybe start with some opening comments from Ganesh, and then we will get into Q&A. If in, you know, during the Q&A, please feel free to raise your hand if you would like to bring up a question as well. With that, welcome, Ganesh, welcome, Eric, and Ganesh, over to you.
Great. Thank you, Vivek. Let me start with the obligatory. During the course of this discussion, we will be making some forward-looking statements regarding future events and future financial performance of the company, and we wish to caution you that such statements are predictions, and the actual events may differ materially, and refer you to our SEC filings. Our June quarter business remains steady and on track to the guidance we provided a month ago at our earnings call, and we continue to believe that it's unlikely that the September quarter is going to be a sequentially down quarter for Microchip. We do recognize we operate in a cyclical industry.
We're not immune to business cycles, but if you also review Microchip's peak-to-trough performance, through the business cycles over the last 15-plus years, you'll observe how robust and consistent that cash generation, gross margin, operating margin have been throughout the cycles. Although we don't foresee a significant decline in our business, if we were to experience any kind of a inventory correction or other adjustment, we expect that our performance on these metrics of gross margin, operating margin, and cash flow will remain robust and resilient, as we have consistently over the many years. Microchip 3.0 is the strategy that we have been working on now for just over 18 months. It's firing on all cylinders.
We're delivering premium results, exemplified by a five-year compound annual growth rate, which we had shown of 10%-15%. We're ahead of that track at this point in time, using fiscal 2021 as our baseline. In fact, over the last 30 years, our compound annual growth rate is 16.4%. Our trailing 12-month non-GAAP gross margin is 67.8% of gross margin percentage. Our trailing 12-month non-GAAP operating margin is at 46.9%. All high, you know, and on track to the long-term guidance we provided. Our trailing 12-month EBITDA is $4.3 billion, just over 50% of revenue. Our leverage is down under 1.5 or 1.45% at the end of March and continue to head down into this quarter.
Free cash flow as a percent of revenue is in the 88th percentile of all S&P 500 companies. The capital return to shareholders increased 76% last fiscal year and is on track to be a 100% return on free cash flow by the March quarter of 2023, 2025. Lastly, our valuation based on a enterprise value to EBITDA as compared to, pick a S&P 500 stocks index, some of the high performance peers, et cetera, we believe presents a compelling opportunity for long-term investors to buy premium results at a discount. On that, I'll hand it back to you.
Excellent. Couldn't have said it better myself. Thank you. Maybe, let's start with the macro, Ganesh, and then, you know, work our way into the micro. If we look at your results by end market, right, versus what the assumptions were at the start of the year, could you help us contrast how you see the demand trends in the big end markets, industrial, automotive, data center, consumer, comms? What do you see now versus what you thought would be the case start of the year?
You know, when we look at it over the last 6 months, incrementally, customers have become more cautious. Their own markets have become weaker, and I think there is a great deal of uncertainty that everyone is operating under. In that sense, what we have seen in our own results and guidance and all that reflects where our customers are seeing business at. There is still strength inside of that in certain segments, but I would say in any given segment, there are pockets of strength and pockets of weaknesses. It's just some are many more strengths than weaknesses.
You take automotive, you take industrial, yes, they are in the aggregate still strong for us, but within it, we've got some customers who are feeling more stressed, but on the average, more customers feeling still confident about what they're going off and building. The segment that has been the weakest for us has been consumer. It is dominated by consumer appliances, but there's many other consumer type of products that go into it as well. And then I would say, you know, data center is taking a pause in terms of where it's been at. Even within data center, things like AI servers and all that have continued to be strong for us. Net result is six end markets. five end markets. There's no uniform. It's all strong or all weak.
It's the degree of weakness or strength among customers in each segment.
I see. Is there any certain geographical, you know, area which you think is, you know, getting weaker or is stable at the margins?
Of all the regions, China has been the weakest. It has not bounced back the way we expected it to post the shutdowns and post the Chinese New Year. It is consistent with what we had expected when we came into the quarterly guidance and all of that, but it is definitely weaker than what a normal June quarter in China should be, and what the bounce back most of us expected would be coming out of the two quarters of December and March with its own unique weaknesses.
All right. Now, normally, Ganesh, this area of, you know, diversified chip makers, it's not really a, you know, share bin loss area over small periods of time. When I just look at the difference in the growth rates, right, yourself versus a peer. Your trend suggests that Microchip could grow sales almost double-digit, right, this year, whereas one of your largest peers is expected to have sales that are declining. Why do you think there is such a contrast in terms of relative growth rate? Is it just mix, or is it something that Microchip is doing that's helping you outgrow your peer group?
There's probably two or three things, right? One is, our relative end market exposures can be different. Depending on the strength of that end market, whatever exposure you have, you may have a weighted average that helps you there or not. I don't know each person's exact end market exposure. There are two things unique to us. One is, what we have done for the last four or five years to focus on Total System Solutions, which is how do we harness 10+ years of both organic and inorganic acquisitions and be able to take it as a complete solution to the market, and how we make it sticky with hardware, software, services, all that put together to make these solutions grow and grow disproportionately. Second, our attachment to the six megatrends that we have picked.
I reported at the conference call that those megatrends in the last 2 years for us grew at 2x the rate that Microchip grew. Microchip's numbers were about 55% growth over 2 years. The megatrends grew close to 110% over those 2 years. That is giving us both high content from TSS and a higher growth rate from the application segments and megatrend markets, where we have the most amount of growth taking place.
Got it. One unique thing that, I think Microchip, you know, kind of started, and then many of your peers followed, was this notion of, right, having, you know, what you would describe as a Preferred Supplier Program. Give us a sense for, you know, how would you grade that? Like, if you had to do the Preferred Supplier Program. Maybe first explain what it is, right, you know, where you are in terms-
Sure.
-of how it represents your backlog. Let's say, if you had to do it all over again, what would you change about that program?
Sure. Preferred Supply Program was something we started in February of 2021, so it's, like, almost 2 and half years old. It was done at a time when there was a tremendous imbalance between supply and demand, and it was done at the behest of customers who were looking for ways in which they could have a better sense of having priority in the constrained supply that was there. The bargain was that a customer would be willing to pay, would be willing to place orders that are 12 months of non-cancellable backlog on a continuous basis. In exchange for it, they got priority over everybody else in what they did, and it was driven by when they placed orders and all that. The program has been phenomenally successful, right?
When we kicked it off, we thought, at best, maybe we'll see 25%-30% of the backlog that would take that type of program, and it's been well, well in excess of 50% for what it's done. It's been pretty consistent as a percentage of our total backlog for the last 18 months of time, so it is not something that customers have taken their foot off of in terms of the desire for PSP. Overall backlog has come down, and with the PSP backlog in absolute, it's come down, but as a percentage, it's staying pretty consistent with it. I would rate the experience of the customers who give us feedback on it as an A to an A plus on what it has done for them. It did exactly what they wanted. They wanted peace of mind.
Those that signed up for it did extremely well with their end businesses, because they got the supply that they needed from us without having to come through the battles that many others who came in late went for. Had we to redo it at each point in time. You know, we make small adjustments as we go along, and but at no point would I have said, with what we knew at the time we launched it and as we went along, would we have made a change. It's been a phenomenally successful program for us. We'd do it all over again. It's a tool, right? It's one that when it outlives its use, when customers no longer see value in it, we'll sunset it.
Got it. What percentage of your backlog are these PSP orders now, and how has that mix trended over time?
We haven't broken out the precise percentage because it got frighteningly high, but as we've said, it's over 50%, well over 50%. As a percentage of total backlog, it has stayed remarkably consistent within 1% or 2% of each other for the last 18 months.
All right. Now, one concern that investors have is, right, which is kind of a broad industry concern, is that many semiconductor companies have, you know, their versions of the PSP program, but how enforceable will they be, right, if we get into a moderate or severe downturn? How enforceable will these orders be, or will you give flexibility to customers to push out? Like, are you going to be flexible on units or pricing or both, in case the macro- environment changes?
PSP is not the first time we have had entered into non-cancellable orders, right? It's been a piece of our business historically as well, on certain types of a custom product or something that was a unique requirement that went into it, and we've always managed that business under those terms. PSP just increased the amount of the business that began to go through a non-cancellable process. You know, the bargain in this is that we went off and made investments based on the customers signing up for non-cancellability as well, and we think, in general, customers don't sign up for non-cancellable backlog unless they've done their diligence, they've done their, you know, buyoff from inside of the company, et cetera, just as we. We don't place a non-cancellable order on a supplier.
Right.
-Without Eric or Eric's senior team looking and approving at it. It does go through a degree of scrutiny that is much more than normal backlog. That said, we know conditions change. We know customers are not prescient for everything that's in front of them, and as those change, we will work with them, and we have worked with them, and we have, over the last, you know, six plus months, been indicating that we are taking and, as much as we can, pushing out product, to help them out with it. What we are not very flexible on is the non-cancellability. This is not gonna be a, you know, a customer who says, "Heads, I win, and tails, you lose." That is not a recipe for long-term, mutual benefit, in this kind of a program.
What we are willing to be flexible on is how does the rescheduling, which is typically non-reschedulable.
H ow can we work on that, and what can we do to help each other in the process of doing that? We're reasonable business people on that.
Got it.
The last part of your question, I think, had to do with pricing.
Yeah.
PSP was never a pricing program. It was a unit volume program.
I see.
If pricing changes, the customers are subject to that.
Oh, okay. That's a good distinction, to know. Have there been examples where customers have come back and said, "Look, I was under the PSP program, but I need it rescheduled for, I don't know, six months, nine months," In that kind of scenario, how has Microchip reacted?
Yeah, I mean, there's, you know, with the amount of customers we have, and how high the PSP percentage is, there's every flavor of a customer needing help that comes about. Sometimes it's, you know, a month or three months or six months, and probably in some cases they've been 6-9 months as well. It all depends, right? It's not a digital answer. We might be able to do a portion of it for a certain period of time, a portion more for future out in time. Our objective is to help the customers out, smooth out any overhang there may be in the inventory that is in the channel or in the customer's hand itself. I mean, in the end, this is helpful to us as well.
We don't want a hard landing at some point in time as well. In that sense, you know, and we want our customers over the long run to be successful customers, and we wanna continue to work with them on future stuff as well.
Right. Makes sense. one more near term, and then some longer-term, questions. You mentioned that September you think is unlikely to, you know, decline, sequentially. If you could give, you know, any more color around that. How much of that is based on the assumption of normal seasonality, right? You mentioned consumer is weak. Like, is it just the consumer coming back because it's a seasonally stronger period, or do you think that, you know, that view is based on your core industrial auto data center, businesses continuing, right, to be resilient during that timeframe?
It's, it's largely a function of how do we read the tea leaves for all the information we have, by customer, by product, by backlog, where we think things are gonna be, et cetera. We're not relying on a consumer comes back, trend or something else that's out there on it. You know, we haven't put any numeric thing about what it is, but I think when I look at the trends, we feel comfortable that it's unlikely to decline. I don't know if you wanted to add more on it.
I think I mean, a lot of it is just driven off of backlog and our ability to provide a baseline capacity that's in place.
Right. Just conceptually, do you think we should think about September kind of the way we think about June, right, in terms of that? Is it kind of sustaining the kind of trends you're seeing in June persisting through September, or is there something very different that can happen in September?
What we're unsure of is: Where does the macro go as time goes on, right? We can only see. It's a bit like fog, driving in fog. You can only see a certain distance.
Right
But does not complete clarity. That's what we don't know, is, you know, does China have any improvement that happens in the second half of the year? Is there something else with interest rates that might affect what happened in the U.S. or what happens in Europe, et cetera? It's a time of uncertainty, and I think, we're trying to provide the best clarity we can.
Right
Within reason, for where we see our business.
Got it. On the automotive end market, you know, for the most part, we have seen companies, you know, sound very confident, right, and optimistic. Very recently, one of your peers kind of suggested that they have started to see some softening of demand. How do you see your automotive business?
That's exactly what I said at the beginning, which is, I think in any segment, automotive included, there are pockets of weaknesses, and there are pockets of strength, and it just, the pockets of strength outweigh the pockets of weakness. There is no segment that is uniformly strong, with perhaps the exception of aerospace and defense, where everything is strong, at this point in time. aerospace and defense is 9% of our revenue, so it's not, you know trivial.
Right
... in terms of where it's at. Yeah, with that set aside, everything else is a mix of strength and weakness, and just a matter of does the points of strength outweigh the points of weaknesses? Certainly it does in automotive.
Got it. Have you seen any recent, you know, any increase in cancellation activity, any change in customer behavior in automotive?
As I said, in automotive, we have customers who are, you know, looking for help. We have many other customers who have shortages. We still have shortages, by the way. This is, we're not done with shortages in some of the products, so we have that, too, going on in it. The balance is more in the areas of strengths than it is in the areas of weaknesses within automotive.
Got it. On a longer-term basis, Ganesh, we have situation where all the semiconductor companies exposed to more mature nodes, right? They went through a period of shortage, but now there are investments that are coming up, right? One large player is planning to, you know, build a tremendous amount of capacity. How do you see that in the context of the industry? Like, when should investors start to get nervous that, oh, there is too much capacity, right, that could come on in? How do you deal with maybe a competitor who has not actually added too much embedded capacity, now planning to do so? How do you see that and how big of a competitive threat can that be?
You know, the strategies that each company pursues is defined by their view of the world. You know, our view of the world is that the capacity we have split internal versus external, is exactly where we want it to be.
Right.
The additions we're making, in measured steps, you know, and we will pause and accelerate from time to time in where we wanna go, is exactly where we want it to be. It is to give us the growth and profitability that we see is an important part of how we try to manage the company. We're trying to manage the company towards this 10%-15% compound annual growth rate on a five-year basis, using 2021 as the, fiscal 2021 as a baseline, to have the gross and operating margins and the cash flow that we want to generate, deliver the results that we have promised.
To create the free cash flow, and particularly the free cash flow per share, that we want to have available to come out of this whole thing and what we can return to shareholders as well. Our actions are governed by what we, you know, we call it Microchip 3.0, but what we, what we're trying to do in there. I'm sure there are other options, other you know, actions that can be taken, and there's nothing in the market today that suggests that, "Oh, my god, somebody's gonna come in and use up all their capacity to take all the market share away." These are very, very complex products and applications, with very long design and cycles, and very sticky sockets that we're in.
You know, this isn't subject to a variation in market share or something else, or price. By the way, it's possible that these competitors, whoever they may be, are also subject to larger portions of their business being in commodity spaces. If you're a commodity player, you should be afraid about where the capacity is at. If you're a proprietary player, you sell on a different basis than price.
Got it. You know, at some point, I believe in the past, you had considered, right, exploring 300 mm fab options. What made you consider that, then what made you change that view? You know, don't you think it will be an advantage, right, to have 300 mm capability?
Yeah, no, great question. When we went down that path, there was uncertainty whether our partners. By the way, you know, all our 300mm is done with outside foundry partners, whether they would be willing and then have the bandwidth to invest in the types of technologies that we needed. All right, most of what we need are trailing at 300 mm technologies, 28, 40, 65, 90, in those primary nodes and where they were at. When we couldn't get that, we had a growth agenda, and we had a business objective that couldn't be achieved through that, we said, "Okay, we're gonna look at other options.
Right.
The CHIPS Act helped us to de-risk some of those options from where we went on. We did a complete review, you know, had it thing on it. What we came to the conclusion was, you know, we could do it. Financially, we could do it, and had there been no other option, we probably would have done it because the revenue and gross margins we could generate were still good. For a period of time, when you have a factory, a factory is of large fixed cost. If you don't have loading in that factory, your underloading costs are gonna be quite significant, and you will have to absorb that for any number of years until you bring enough loading into that factory.
We didn't see that as a timeline that made sense, and we thought from a return on invested capital standpoint, once our foundry partners began to see the light of what needed to happen, and they were willing to make the investments, and they were willing to do it at a scale that made sense, that was a far better ROIC answer for us, and it gave us the same requirements. I mean, the second thing we needed was geographic diversity, which we were also, at that point, you know, getting a lot of questions about, and we have absolute commitments from our foundry partners on what they will do to help us achieve that as well. That outside of the China, Taiwan theater is where we'll see some of the incremental capacity come online over the next five, six, seven years of time.
It met all our business objectives by going the route of staying with our foundry partners, and in fact, created significant risk for us and in cash, you know, consumption and all of that, in doing it ourselves. We had absolute confidence in doing it. We just didn't see the business benefit of doing it.
The other thing that became clear to our foundry partners is that the market was willing to pay because the capital costs.
Right.
Capital intensity had gone up significantly, and they saw through the cycle that we just went through, that their customers, Microchip and whatnot, and then our customers, are willing to pay those higher capital costs that were required to make those investments and justify that to them.
Got it. Makes sense. On gross margins, you know, if somebody had told you that Microchip would be doing 68% gross margin, like, five years ago, would you have believed that? Like, what has led to these kind of gross margins?
I'll let Eric talk about it. I'm usually the optimist in this thing, so.
I am usually the pessimist in the room, so I might not have believed it. You know, the bottom line is, you know, what's happened over the last 5 years is we have integrated Microsemi. There's been a lot of improvements from that. five years ago, we had some underutilization charges in our factories, too. Those have gone away. You know, the pricing environment has been good, and, you know, we haven't used that for gross margin % improvement, but, you know, we've proven over the last really eight to 10 years now that, you know, there is not really a need for the proprietary products that we sell to offer ASP discounts to customers every year. It's a design in business, sticky products, as Ganesh talked about, and these prices are sticky and will stay.
Lots of moving parts, but, you know, utilization and product mix are a huge impact related to gross margin, and we're in a very good spot today with that.
Got it. Maybe, on the positive side, how much is, you know, pricing a factor in terms of growth, this year? Even if it's neutral to gross margin, still adding to growth. What is the assumption on pricing for this year? Then kind of the other side of it is that, what needs to happen to take gross margins down? Like, are these kind of gross margins sustainable? Let's say, hypothetically, we get into a year where sales go down 5% or 10%. What is the leverage on the gross margin side?
With, you know, we don't really break out pricing versus units. We've said the last two fiscal years that volume has been the larger driver.
Mm-hmm.
-of sales improvement than pricing. I'd expect that to be the case, going forward, too. You know, Our margins are very consistent. If you look at the last 15 years of histories through cycles, you know, our gross margins have fallen 200-300 basis points during a downturn.
Right.
I wouldn't really expect it to be any different this go around. It might even be better. We are a little bit less dependent than we were in some of those earlier periods on internal manufacturing. You know, it's a little less than 40% was fab in-house last year. Our internal inventory, so inventory that's manufactured internally, is still quite low. Our buy banks are lower than we'd like them to be, and we're a little bit higher on the foundry side, where we took advantage of capacity freeing up in the December and March quarter and took some of that inventory in. I think that's gonna allow us to continue to run our factories at a high level and maintain very high gross margins throughout the cycle.
In fact, some of the historical numbers even included dilutive acquisitions before we made the improvements.
That's right.
It was not all our, gross margin, decline only. It was just the additive number that came.
Got it. Finally, on use of cash, where is Microchip in the journey? I know your plans are to, you know, get towards that 100% free cash flow returns by March 2025, if I remember correctly. At what point, you know, does M&A also come back on the table?
We're bang on schedule with what we said back in November 2021. We've been very consistent with the programs of how we have deployed the free cash flow that we wanted to return. It's been a combination of both dividend growth as well as the share acquisitions. Those are progressing to where 100% of the free cash flow by the March 25 quarter is returned to shareholders, ideally in about a 50/50 year split. Obviously, the dividend will be the fixed component. The share buyback will be the variable component of that. That's very much where we're headed to. M&A, for us, is not a top-of-mind issue. It is not part of our strategy. We have a pretty rich portfolio. We have the scale.
We will do small, pinpoint acquisitions of specific technologies or markets or other things that we would be interested in, and you will see some of that. We've done about half a dozen of them in the last few years, and we'll do more of those as well going forward. There's no large M&A that we see as required or imminent in our future.
Got it. Actually, I wanted to ask one other question, which is, you know, we don't normally think of Microchip as a big player on the data center side, but I think you have a very interesting portfolio there. You know, I can't let a presentation go by without mentioning the two good words of AI. Maybe this is the chance to.
I'll speak to AI, but more specifically around data center, right? Nobody knows what we do in the data center, and it's about 17 and a half % of Microchip's revenue at this point in time. And it is split between, you know, the compute and storage infrastructure, the memory infrastructure, the solid state drive control that we provide, the data center interconnects, the timing and precise timing that you're gonna need, the root of trust, the power management, you know, on and on and on. There's a whole bunch of things that we are, you know, deeply embedded into. And within that, there's a subset of things that are specifically around AI servers themselves.
A, this is not in the last two weeks, you know, this has been there for three, four years of time, that as AI servers have been, you know, growing significantly, it's been a big part of what has driven our data center growth as well. Specifically, in an AI server, where you have multiple GPUs and maybe one or two CPUs, switching of data is one of the most critical things that takes place there, and we have the PCIe switches that are in many of these data center platforms. With every GPU, you're gonna need a precise clock. We're often the clock that goes, sits next to it. With every GPU, not just one per system. Then you need root of trust requirements.
You need some of the memory infrastructure to help it be moving that stuff faster. There's many, many elements of data center in general, both compute and storage, and then of AI, specifically on the parts of the market that are more AI-driven.
Great. Have you seen this big upsurge in activity in the last few weeks, or it's?
You know, we've been designed into many, many of the data center platforms and AI platforms themselves, and with it, whatever happens in that market, we will get our unfair share.
Understood. Terrific. Thank you so much, Ganesh. Thank you, Eric. Really appreciate your time today.
Thank you. Thank you very much.