Maybe in the context of what's been happening. Early part of this year, I think you went out to your customers and talked about lead times coming down from, you know, into the kind of 26-week range by mid-year. Obviously, that's not having any negative impact on your business through the first half. Like, how are people reacting to that? Do you see, as lead times come in, do you expect people to need to maybe hold less inventory because they have more visibility on their ability to get stuff?
No. Great question. Firstly, to clarify what we said. What we said is we expect in the second half of 2023 that lead times on average will be 26 weeks. We still expect some to be higher than that and some to be lower than that and where we're at, and it's a gradual improvement as time goes on, as we balance supply and demand over that time. At this point in time, it's not having an effect on the business itself. I think it's giving customers a better view into how to plan as they go into the second half of the year. Our backlog remains strong. Our bookings are continuing. You know, we do expect that some of that over time, you know, bookings were unhealthily high, backlog was unhealthily high, needs to come back to normal.
The changes are slow and there are gonna still be constraints in certain areas and improvements in other areas.
Yeah, I mean, you've talked about, you know, even as lead times on average coming down, that you still have significant unsupported backlog. You know, what are the pain points at this point that where you still can't meet end demand?
It has two components. One is, you know, demand continues to be strong, and then supply is improving, but you can only improve it at a certain rate. They are in all of the specialized technologies, the trailing edge technologies. Capacity for them is incrementally getting better, but not at the point where we can, you know, magically erase all of the unsupported backlog that we have. In a way, I think, you know, we're trying to solve the supply-demand imbalance incrementally every quarter, rather than trying to solve it all in one quarter.
Okay. All right. Can you talk about some of the bigger dynamics within Microchip around the PSP program, around people's really attempt to get visibility on their supply chains, and how you guys are working around all of that in the context of potential economic deceleration? How flexible are you gonna be about delivery times? How proactive are you gonna be to try to keep inventory from being too excessive? Just how are you thinking about those dynamics?
Yeah. You know, PSP is actually coming up on two years since we kicked it off, and it's been a phenomenally successful program. We've had customers who have loved it, customers who still have a high percentage. In fact, the percentage of the backlog that is in PSP today remains unchanged from where it was six-to-nine months ago, with all the different dynamics that might be going on in the market in terms of where new backlog is coming in and how that's all being done. We have been flexible on the PSP on the non-reschedulable part of it. PSP requires noncancellable and nonreschedulable because we're making significant investments in putting that capacity in place, paying up front in many cases or adding fixed costs in many cases.
The non-cancellability part of it is really not where we wanna spend time negotiating. The non-reschedulability, we have done significant amount of movement out of the quarter, out into future quarters, and we've been doing that now for 6 months. We remain there. Because we understand that at the end of the day, excess capacity at a customer location on a distribution channel really is not helpful long term. You know, we are as part of our steps towards a smooth or a soft landing, making sure that we are managing some of the requests for rescheduling in a way that is orderly, but retains a degree of responsibility with the customer for orders that they have placed in terms of, you know, non-cancellability. Reschedulability, we're willing to be more flexible.
Great. You know, maybe I'll just ask this as bluntly as people ask it to me, 'cause I have an overweight on Microchip stock. You know, and we believe that you're gonna manage through these headwinds pretty well. The pushback is, you know, because of PSP, because of these dynamics, that your outperformance in the first half of this year is largely a function of your customers not being able to cancel stuff. Can you just talk directly to that?
You know, that was the pushback in the last half of last year too, was that, you know, it wouldn't last beyond the end of the year, and then it wouldn't last beyond the calendar Q1, wouldn't last. It's a, you know, we manage the business for the long term. We obviously have customers who have wanted to put PSP backlog in place, and to this day, we have customers who are increasing the amount of long-term supply agreements. These are not 12-month agreements like PSP is. These are 3 to 5-year agreements. I think what's missing sometimes is that people don't fully understand the end market characteristics of the customers we have, and it is heavily weighted towards very resilient end markets.
These are customers who make very highly valuable end products in which the semiconductor content is a small fraction of the total value that they create. That end market exposure gives us some advantages in terms of how the business is run, how the backlog is placed, how resilient and/or how high quality the backlog is, and that's all part of what you see in the numbers we're posting.
Great. You've talked about, you know, you don't talk a lot about end markets, but you sort of talked on the most recent call that sort of 86% of your business is outside of consumer, and that the markets that the exposures you do have are stronger. You know, I guess people are starting to call some of that into question, particularly data center, where there has been some inventory correction. Can you just talk generally to those demand drivers?
Sure. No end market is monolithic in how it performs, right? In every end market, there are customers who have, you know, shortages and expedites that they're pushing us on, and there are other customers who have inventory that they would like help with. That is true in, even in the 86% of our resilient market. In the aggregate, those end markets are much, much stronger than perhaps the consumer electronics and consumer PCs and gaming and those which have had far bigger declines in recent quarters and where they're at. You know, we are seeing that those end markets are performing better than most. Clearly, you know, we indicated at our last conference call, we are seeing some stress in some parts of data center.
We're still gaining market share in data center. There are segments in which there are usually only two or three players, and we're gaining share from a smaller market share perspective and outgrowing it. You know, in time, we'll see where all of the data center requirements shake out. For the moment, data center remains a reasonable market for us to be in.
You mentioned your consumer exposure probably better than some, given that, you know, you're talking about more household appliances and things like that, as opposed to, you know, stuff that benefited from work from home, gaming, things like that.
Right. Consumer appliances or home appliances tends to be the, you know, dominant portion of our consumer exposure. That includes small tabletop kitchen appliances, whether that's coffee makers and microwaves and all that, or much bigger air conditioners and washing machines and, you know, microwaves, et cetera. Those are all the places where we're at. It's more resilient only in that when many of those things break, they still need to be replaced. Perhaps somebody who's looking to upgrade wants a nice LCD screen on whatever it is that they have, you know, they may wait in terms of that. We do have... Our consumer business is not as strong as the other end end markets we're in.
Great. Just regionally, your demand, you know, China seems like a weak spot for everyone right now. It also feels like a market that will obviously come back over the course of this year. How are you thinking about that China and demand dynamic?
China in the December quarter was weak. It was weak first because of all the lockdowns that took place, and then it was weak because, you know, just 90% of the people got COVID, certainly 90% of our employees did, and we saw that across customers and all that. That's all behind us. Chinese New Year is behind us. We see China business normalizing, and I think there's an opportunity to strengthen as we go into the second calendar quarter. I think this week there is a China's National People's Congress that I think will have a lot more certainty for some of the business policies that they're gonna follow and see where that all goes. You know, I'm optimistic that China will get better incrementally as we go through 2023.
Great. Just my last demand question. You know, I guess why make this comment today about the June quarter? You normally come to these conferences and reiterate the current quarter. You know, is it more the anxiety that the investors have? Is it the visibility that you're seeing in your business? What kind of led you to come out and talk about the June quarter at this point?
It's a little of both. I want people to know how confident we are in our business, what we see. We're not trying to get into a pattern of multi-quarter forecast. I think there remains some question of, hey, you know, how likely is the growth gonna be into the June quarter or into the second half? There's always a six months from now, you know, question mark that's out there. Given where we are, given all the uncertainties that are in the macro, I thought we needed to be clear as to how we see the June quarter, and therefore, the update.
Great. Okay. In terms of thinking about downside scenarios, which I think is an important exercise, just given people's anxiety about the macro, you know, you've talked about a soft landing with bookings. Can you talk about what that means to you? Like, when you think of a soft landing, are you thinking, lead times come down and revenues don't decline? They decline a little bit. Just how are you defining that term?
Yeah. When we think of a soft landing, what we wanna deliver is a minimal decline in revenue, ideally no decline. If there is a minimal decline, and a holding up of the gross margin, operating margin, and free cash flow that we have. We don't want deterioration in those beyond the normal, you know, variation that takes place. We want the business to fundamentally hold up in terms of growth. We don't want it to have a large crash in revenue or a large crash in any of the other metrics.
Great. Then your comment that you would expect to see a 40% operating margin in a really difficult environment, that you would expect to still be able to hold operating margins at that level. I mean, that's what you've done historically in terms of the degradation from here. It's been relatively minor in any kind of downturn. You know, what are the levers that you can pull to protect your income stream to get to that kind of 40% baseline?
On the gross margin side, you know, we have 60% of our wafers that we buy from foundries, 40% that we build in-house. In any downside, what we would do on our internal factories is we would continue to run it, you know, get the full absorption benefits, grow the inventory. These are products with very, very long life cycles, and we would be extremely well-positioned for when a cycle changes. On the foundry side, we would cut back on the amount of wafers that we're buying from the foundries through that cycle as to whatever is needed in that time. The gross margins, we think, you know, have a degree of support that comes from a combination of how our inside-outside mix is built up.
On the operating expenses, we have a pretty significant amount of variability that we can control with our bonus programs and with our discretionary spending, as you can see in prior cycles and what we've been able to do. Between those two, we think the operating margins and the free cash flow are going to be, you know, fairly well managed. Even the CapEx begins to come down in a down cycle because we don't need to continue to be able to grow the capacity at a rate that we had thought at one point in time. All those metrics of gross and operating margins and free cash flow in any cycle, we have shown we can maintain and in some cases improve.
I guess the counterpoint, the pushback that I get from people is, you know, okay, historically, the company's only seen a few hundred basis points of margin erosion in a downturn, but these operating margins now are much higher than they've been historically. Some elements of that, you know, the big foundry wafer prices increases that you've pushed through and things like that have been sort of, you know, one time in nature. How do you answer that? How do you think about, you know, does this look different from a normal environment because the upturn has been so, has had so many positive drivers?
You know, the gross margins, improvements are not short-term improvements that we have made. I mean, there are fundamental improvements in the mix of the product, in the cost structure of the product, in, you know, the value of the products that we're creating, you know, how much more sticky, how much higher gross margins that they command and where they're at. Then of course, there's a factory cost structure, which I spoke to. We don't feel that the gross margins are subject to volatility based on where short-term demand is going to be at. Same with the operating expenses, right?
I mean, we have been, you know, underspending to where our targets have been, and we have been able to have, you know, a variable compensation at the upper end of what we typically pay built into what our operating expenses are. All that has an ability to be reversed as time goes on to where we take the bonuses down, we are able to absorb any changes in the revenue or gross margin changes that may be happening. We don't think this cycle and where we are with gross and operating margins now is any different from where we were at at different points over the last 15 years when there were new peaks.
We've had higher highs throughout this timeframe, and you could have made the argument at any one of those times that, hey, at that point in time, you know, you wouldn't be able to do what you did the last time around. We don't feel any, you know, discomfort with, where we can and how we will, operate the business.
Great. That's helpful. I wanna leave more time for questions, than normal 'cause there is breaking news here, but I'll just ask one more. You know, at one point, you talked about evaluating a 300mm fab, and then you said on this last quarter, you've elected not to move forward with that. Can you talk about that decision and your sort of thoughts about capital spending generally?
Sure. When we were evaluating a 300mm fab, we were informed by two critical objectives we had. Objective 1 was we did not wanna be limited in our growth on specialized trailing edge technologies from 300mm. At the time, it was not clear that our partners were willing to invest at a priority that we required of them. The second thing we were looking at was how would we, in time, create geographic and geopolitical diversity to our supply chain. As we worked through the options of building a 300mm fab, in-house, we solved the first 2 of those issues, or those goals that we had.
We were able to get more capacity, you know, higher investments from our partners and more capacity allocation to us, and some of those that will take place geographically spread out to where they're at. In fact, it lowers the risk overall for Microchip because a 300mm fab has very high fixed cost, will take a significant amount of loading to be able to absorb the flywheel costs that are gonna be there. On balance, when I looked at the overall risk profile of where we're at, the commitments we're able to get out of our partners, the return on invested capital that we would be looking at under different scenarios, it made sense for us to stay the course with our partners with the changes that they were making on 300mm.
Great. Let me pause there and see if we have questions from the audience. I think there's one over here.
Yeah. There's a lot more capacity available at foundries now, I believe. How has that changed your business competitively, but also from a future. I would think your lead times would continue to move more quickly because of that.
Can you repeat the question? All right.
The question is there appears to be more capacity from the foundries, and how is that affecting our business and changing the lead times, perhaps. Substantial amount of capacity that is available out of the foundries is at the bleeding edge of technology. They're at nodes which are much smaller in size than what we use in our production. At those nodes, you're absolutely right, there's plenty of capacity available to any amount that you want. At the nodes that we're on, which are more specialized nodes, it is incrementally more positive. We are getting more wafers than we were getting six months ago, 12 months ago, but there are still constraints that we're working through. Lead times are improving slowly but steadily, but they're not instantaneously going to, you know, whatever they were two years ago.
Seems like a consistent message of, like, 55 nm non-volatile memory processes are still really tight, those kind, those types.
Right. When you add non-volatile memory, which is where all of our microcontrollers run, then it becomes even more tight in terms of capacity. You're right, about 40 nm and larger in size is typically where the specialized technologies are, that have still got, you know, reasonable constraints, improving, but reasonable constraints. I don't think I can hear you.
The question is just around distribution inventory. Can you talk about inventory levels and distribution, as well as what is contemplated around distribution inventory levels in your outlook?
Sure. Distribution decides what inventory they wanna carry, and sometimes they wanna carry more, and we can't give them enough, right? Over the last couple of years, I think they have wanted to carry more. We just haven't been able to ship them more. We got to the absolute lowest inventory for distribution in the last cycle. And, you know, today, distribution inventories have improved some, but they're not anywhere close to where they were in historical terms and where they're at. What they will decide to carry is really up to them. They have to manage the cash flow and hang on it. In some cases, they wanna carry more and we can't supply. In other cases, you know, they're happy with where they're at, and they don't need to get more.
It's all over the place, but distribution inventory is lower than where it has been historically. Okay. Any questions from the audience?
Maybe you could talk a little bit about, you know, the CHIPS Act and the degree to which you see Microchip as a beneficiary, and how that frames your thinking going forward about where your capital spending will be?
Sure. There's one part of the CHIPS Act, which is very deterministic and, you know, it's there now. It's called the Investment Tax Credit. Basically, any capacity that you deploy, either building or equipment starting January 1 of this year is eligible for a 25% Investment Tax Credit. Easy, simple. We will take full advantage of that. There's a second part of it, which are grants, and these are grants for which rules of engagement just got published within the last few days, and there's still a lot of questions on how that's all gonna process. We're studying them. We're working through it. We will make applications for the grants. We don't know what the results will be. We don't know what percentage of a project's value will be supported out of the grants.
We don't know what other strings are gonna be attached to the grants. We'll see. I would say at this point, they are less deterministic. The Investment Tax Credit is great. We're moving full speed ahead on that. The grants are in the process of being studied and applied for in the coming months. All of it obviously helps us to have confidence in investing more into the factories that we have into the U.S., with that, creating both the supply chain strength, national security strength, that comes with those products.
How much are your customers focused on the geography of supply chain now and, you know, TI is obviously gonna go out pretty heavily marketing, how much domestic capacity they're building, as something that provides certainty to their customers? You know, do you think customers that's resonating and how do you react to that?
You know, 80% of our revenue comes from outside of the U.S. If there's relevance on U.S. production for a U.S. customer, that's 20% of our business. At this point in time, with rare exceptions, people are interested in making sure that you've got a resilient supply chain, that there are options for China, Taiwan, that are in the supply chain and where we're going. The U.S. is clearly one of those options, not the only option that is available to us.
Great. Last question from me. The leverage target 1.5x, you alluded to this upfront, you're approaching that target. You know, how are you thinking going forward about cash return? Does M&A come back into the picture for you at any point? Just how are you thinking about those dynamics?
Right. M&A is off the table. You know, we wanna grow organically through the Total System Solutions and the focus on mega trends that we have. That has been the focus over the last several years and will remain so. We are generating tremendous amounts of free cash flow, and as we have paid down the debt, as we have brought the leverage ratio down, we'll be under 1.5 this quarter. We will continue to pay it down for several more quarters, but we are increasing the rate at which we're returning capital. This quarter, the March quarter, we are returning 62.5% of last quarter's free cash flow. We've been raising it about 250 basis points every quarter.
Starting next quarter, we will raise it 500 basis points every quarter. Next quarter will be 67.5% of this quarter's free cash flow. Following quarter will be 72.5% of the prior quarter free cash flow. That'll take about eight quarters, by which time we will be at 100% of the free cash flow that is returned. It is split between a dividend, which is growing, and that will be, you know, it's the sacrosanct portion. Then the balance of the free cash flow will go into share buybacks. We have an approval for over $4 billion of share buybacks. We've done just over $1.1 billion at this point in time. There's a lot of powder left, both on the dividend growth, and the share buyback.
All right. Ganesh, thank you so much for your time. Appreciate it.
All right. Thank you, everyone.