Good afternoon, everyone. Welcome to day two of Citi Global TMT Conference. My name is Atif Malik. I cover U.S. semiconductors and semiconductor equipment stocks. It is my pleasure to welcome Eric Bjornholt, Senior Vice President, Chief Financial Officer at Microchip. I will kick it off with my fireside questions. If you have a question, save it towards the end and we will send the mic to you, and you can ask your questions. Welcome, Eric.
Yeah, thank you for having me. Hi, everybody.
Eric, I will have to start with the customary kind of cycle question. Microchip has now delivered roughly six consecutive quarters of above-seasonal growth. One of your peers is talking about this above-seasonal growth contouring into next year. That is ADI. Your guidance suggests a seventh consecutive quarter of above-seasonal growth. Question is really where are we in this recovery cycle today, and what are you seeing in terms of traditional drivers like channel restocking and inventories?
Before I start, I will be making certain forward-looking statements as part of this discussion and refer you to our filings with the SEC that identify important risk factors about the company. We have been in a period of growth for quite some time. If you look at where we are guiding the September quarter two at the midpoint, it is up 40% year-over-year. Obviously, during that time period, margin profile has changed significantly and doing quite well. Customer order patterns have been very strong. Bookings activity, we mentioned that the June quarter was the strongest bookings quarter that we have seen in about four years, and that has continued here into the current quarter. Both July and August bookings were good. Backlog continues to grow. Lead times are staying pretty steady for us.
We've seen some push-outs on lead times for some of the outsourced capacity, and that always leads to the question of what are customers doing with inventory. From what we see, we don't see that there's any significant inventory that's being built at this point in time. Actually, distribution inventory is quite low for Microchip at 25 days. The order patterns continue to come in strong, sell-through distribution strong. Since lead times have stayed very competitive at this point in time, and we are delivering to customers when we say we're going to deliver, we don't think that there's really any significant stocking that has happened yet or restocking at customers.
Great. That's good to know. You talked about the strongest booking quarter in roughly four years. Can you help us understand the end markets? Were the bookings strong across all end markets, or there are certain regions or products that are seeing above stronger bookings?
Yeah. Bookings have been strong across the board. It's really all product lines, all business units, all geography. There's not really anything to point out as being unique or different or weak in any way. It's been across the board strength in bookings.
Okay. How would you characterize the underlying demand trends across automotive and industrial?
From our perspective, the industrial and automotive recovery was delayed compared to what we've seen in Data Center Solutions and aerospace and defense. But as it stands now, we think that those customers have corrected their inventories from the last cycle, are placing higher levels of orders on us. We produced information last quarter, on a quarterly basis for the first time. We used to just do it annually in terms of breaking out end markets. And we showed in that slide that's posted on our website what the growth has been by end market year-over-year. And automotive grew, like 29%, something like that. Industrial grew quite nicely. So really, all end markets are growing very good at this point in time, and industrial and automotive are really no different. Yeah.
Eric, you guys make thousands of parts, microcontrollers, and we noticed that in periods of time when the oil prices start to go higher, the analog stocks, they start kind of stalling because the market thinks that it's going to have some effect on your businesses. So in your kind of conversations with your customers, does this topic of oil pricing or this inflation environment, it comes up, and do you think it has an effect to a certain level on your business?
I think on most customers, it really doesn't have an impact, right? They're looking at their business outlook, and if oil prices impacts their business outlook, maybe they pump the brakes a little bit. But we haven't seen that as of yet. Like I said, the bookings activity has been really strong. Design win activity with customers continues to be very robust on some of the new products that we've been talking about publicly, which I'm sure we'll talk about in future questions that you have. So I am not seeing that impact from customers today in terms of what they're giving us in terms of orders and what they're giving us in terms of their outlook over the next year.
Yeah. We clearly didn't see it when the Iran war started in terms of your demand profile. I'm curious if you can rank order the regional strength across North America, Europe, and Asia for industrial and auto markets.
We have a little bit less exposure in China, particularly in EV, and you would've seen that when some of our competitors saw that rise in revenue and then the drop in revenue. We really don't have any significant EV exposure in China. North America and European business and automotive is, I would say, trending equally with each other. I don't really see a difference, and we have a little less exposure, particularly in China.
All right. One of the lens clients are looking at the analog stocks, is their ability to supply more in this very strong demand environment. And you mentioned on your last call, you're not at 100% utilization. And you have additional tools that can be brought online as demand recovers. But you're also seeing pockets of tightness across the supply chain, particularly OSATs. Where are those constraints showing up most today? And if demand surprises to the upside, can you flex between internal fabs and external partners?
Okay. First of all, on internal capacity, we are in a very good position. Even though we closed one of our wafer fabs, our Arizona fab, last year, we had expanded our clean room capacity significantly. In the last up cycle, we'd invested in tools that you had mentioned before that haven't been deployed yet. So our capital expenditures for the next several years I expect to be quite low. They have been last year and this year, and I expect that to continue as we grow back into the capacity that we put in place. We have seen tightness in some of our foundry partner process technology nodes, and also with some of the assembly and test vendors, as you'd mentioned. I think a lot of that is driven by what's happening in AI and that squeezing out some of the capacity.
We are doing the best that we can to have forecasts from our customers, provide forecasts based on history, and essentially scratch and claw for the capacity that we need to support our customers and Generally have been doing a pretty good job. But we have seen some lead times extend because of what's happening on some of the outside production activities.
Great. If you can just kind of dive into, you shut down Fab 2, which was 25% of your 8-inch capacity. Remind us how much of your manufacturing in-house versus the external, and then also on the back end, how much capacity headroom is left.
Okay. As I mentioned, we shut down Fab 2 last year, which was the smallest of our three large fabs. We do not believe that we have limited our growth in any way from that. We do about 35% of our production in-house. The other 65% of the wafer fab is done externally. We took the tools out of Fab 2 that we could use in the Colorado and Oregon fabs, our other two large factories, and with that, we think that we can get back to peak revenue plus in our existing fab footprint and are in a very good position from that perspective. On the assembly and test side, we do more internally.
We do about 70% of our production in-house in facilities in Thailand and Philippines and have good capacity growth capabilities there also from kind of a floor space and land perspective that we have to expand very cost effectively.
Great. The pricing environment has been strong this year. Microchip implemented pricing adjustments effective from mid-August to early September. If you can just talk about what is driving the pricing environment and if you are seeing utilization rates and lead times continue to drive pricing higher.
We had an issue as part of the last cycle and how that was managed with customer relationships. That was one of Steve's nine points in his nine-point plan when he came back, was rebuilding customer relationships. We were very cautious about going out and raising prices on customers, although we were seeing supply chain increases over the last 9 months - 12 months. We absorbed those for a period of time. I would say investors didn't really see that because we had cut capacity so much that our gross margins had fallen quite a bit, all the way down to 52% last March, and then were growing quite nicely. But we were absorbing some costs in that.
We feel that our customer relationships are in a very good spot today. We decided with some of the ongoing price increases that we were seeing from our supply chain coming through, that it was time to increase prices on customers, and we did that in the current quarter. Various effective dates, but kind of mid-August to early September is when most of that went into place, and that was factored into the guidance that we had given the street.
That price increase went very well from a customer perspective. Many of our competitors were on their second and third price increase already, and that was our first, and it was quite modest. So well received. We are not using this as a way to amplify gross margin percentage. It is a way to maintain that and pass on the costs that we are seeing from the supply chain to customers. They received that price increase very well.
Eric, you and Steve have done a great job in expanding gross margins, but our investors are greedy. They want to see more upside to the gross margins, particularly from the faster-growing Data Center Solutions and aerospace and defense segments. As you look at your gross margin kind of projection, you are remaining flattish, 66%-67% through fiscal year 2027. What are the biggest puts and takes around the gross margins?
Yeah. I want to point out that in the current quarter, when we are guiding to a 66.5% gross margin, we have a couple of one-time benefits that are not repeatable. One of those is we have an expected higher licensing revenue this quarter. Within that business, we do some sales of intellectual property, and that is happening this quarter. That is the expectation, which will be 100% gross margin business that does not repeat after that. Also, when we increase pricing, which we did the middle of this quarter, there is essentially a write-up that has to happen on the product that is sitting in the distribution channel. When we recognized that revenue when we sold it in, it was based on old pricing, and when the quotes were increased, that causes a one-time benefit in revenue increase with no offsetting costs. So that is not repeatable.
But the good thing is, we expect, because we will have the price increase in place for all of next quarter, as well as continuing to ramp our factories and our underutilization charges coming down, that pricing, excuse me, gross margins can stay relatively flat in the December quarter and in that range of 66%-67%. So I have been getting lots of questions from investors today is why can't gross margins go higher? What I would like to say is we have put out this target of a 65% Non-GAAP gross margin and 40% Non-GAAP operating margin is kind of what we would like to achieve through cycle, and drift above that in the good times of the cycle, and hopefully not drift too far below that when times are more difficult in the cycle.
And we believe we will be able to do that through proper inventory management, which we were not able to achieve in the last cycle, but I think we are set up well to be able to do that. So margins are really healthy today. I think you also have to see that we are in competitive markets. Our margins compared to most of our peers are quite high, and we want to make sure that we are pricing our products appropriately in the marketplace where we can gain share and drive operating margin dollar improvement as fast as we can.
Awesome. Let's talk about the Data Center Solutions market. We, the sell-siders, appreciated you guys kind of breaking out Data Center Solutions revenue, expected to grow 69% to around $1 billion this year, about 17% of sales. So we appreciate all the exercise you went to count all the parts that participate in the Data Center Solutions market. If you can just help us understand why you are seeing such a strong inflection and hopefully separate kind of the General purpose data center from AI.
Yeah. Okay, so we used to break out end markets only once a year, and now we have moved to be able to do that on a quarterly basis, which investors have been asking for. We also used to combine data center and compute together, and we have broken those out separately, and compute is only about 3.5% of the overall business. With that, we broke the data center into two different categories.
We have a specific business unit called Data Center Solutions, which purely focuses on products that service the data center market. That business is growing nicely this year. We will end this year at about $500 million in revenue for the calendar year. Within that, we have got our PCIe Gen 3, Gen 4, Gen 5, Gen 6 products. We have got our recently introduced retimer products. We have got storage controllers, and we have got memory controllers.
Those are pure play data center products. We have another section of what we would call our standard product portfolio, whether it is microcontrollers, analog, timing, security, et cetera, that sell into the data center market. We also expect that business to be about $500 million in calendar 2026, and those two combined are going to grow about 69% this year. We have given that breakout. That is a breakout that you will continue to see on a quarterly basis on an end market perspective, and we are excited about the growth possibilities within that end market for Microchip.
Great. Eric, you mentioned a PCIe product. We were at the Hot Chips conference a couple of weeks ago, and we certainly heard a lot of buzz around the PCIe Gen 6 design wins. You guys, I think, spoke about 14 design wins and $100 million opportunity, at least at one program in 2027. Just on the PCIe switch and retimer market, how do you see the opportunity? What is your market share right now? If you can just give an assessment on, are there multiple hyperscalers that you are engaged, and where is the momentum coming from?
Okay. I think you summarized it well. We have 14 design wins on Gen 6 so far. 12 of those are on PCIe, and two of them are retimer. We have sized that market in 2030, based on external sources, at about a $10 billion opportunity on PCIe and about $2 billion on retimers, and we are relatively small players today. Back in Gen 3 and Gen 4, we had a pretty heavy footprint in PCIe. In Gen 5, we missed the market opportunity. We were very late to market. We had done some internal development, and were working to develop our own SERDES, and we were just late to market, and we were like 18- 24 months late, and because of that, we missed out on a lot of the large opportunities when that market was really taking off.
Now we're re-entering with a very competitive product in Gen 6. We are the only Gen 6 PCIe product that is on 3 nanometer. That's with TSMC. Customer reaction to that product is very good and what it can provide from a power consumption savings standpoint. We're excited about the opportunities, and we're targeting hyperscalers, enterprise, ODMs, et cetera, with these products, but we haven't really broken out any specific customers. We did mention that one opportunity that you mentioned was about $100 million annually in calendar 2027. I should point out that there's really no revenue from PCIe Gen 6 and retimers in the calendar 2026 forecast that we provided of $1 billion of total Data Center Solutions, as these design wins are really coming to production next year.
All right. Just stepping back and looking at the total Data Center Solutions opportunity, ADI has discussed an opportunity of roughly $1 billion- $1.5 billion of analog content per gigawatt of AI infrastructure deployment. Given your differentiated exposure to timing, power management, connectivity, PCIe fabric, is it fair to frame that your content opportunity per GW is larger than that number?
We don't look at it in that way. I think maybe our power opportunity is a little bit less than what ADI has, just based on the mix of the portfolio that we have. We more tend to tie the growth of kind of our standard products that are going into that Data Center Solutions market more tied to hyperscaler CapEx growth, which is a big number, but we haven't tied it to gigawatts or per blade or anything like this that some of our competitors have.
Okay. Let's talk about the aerospace and defense. Sales doubled from $600 million in 2022 to roughly $1 billion today. What's driving your share gains in the market, and where do you think your portfolio is most differentiated?
We have a very rich history in the aerospace and defense market. A lot of this business came to us through the Microsemi acquisition back in 2018, where they brought us all sorts of products that are radiation tolerant, radiation hardened, have really high reliability, and things that make you successful in those markets. We've expanded on that, continued to invest over the course of the last eight years. That business was pretty steady through the down cycle. It did experience a little bit of the down cycle, but held a lot steadier. It jumped, I think, from fiscal year 2024-fiscal year 2025, from 11% of the business to 17% of the overall business. With all that's happened around the world with the conflict and whatnot, the armaments have been really depleted.
We think we have a multi-year cycle in front of us as those things get rebuilt. We are really the largest supplier to the Department of Defense of semiconductor products today. It's not just U.S., but with NATO's increased investment, the NATO countries increased investment in defense, I think Microchip is really well-positioned for multi-years of growth here.
Eric, I know you guys don't break out within aerospace what is satellite or LEOs, but when you look at what SpaceX plans to do, can you kind of expand on your exposure to the satellite and the terrestrial side of things?
You're right, we don't break it out. What we say is of the aerospace and defense business, defense is the largest, followed by space, followed by commercial aviation. They all have various growth drivers behind them. We historically, with the Microsemi business that I mentioned, have been more kind of deep space versus low orbit, but we have products that absolutely can play there. Because we're known for the reliability and the radiation tolerant and hardened products, I think we are kind of go-to for certain customers in terms of who they want to utilize for these products, so we're well-positioned. Some of the lower orbit guys are using more automotive and industrial grade type products and just putting redundancy in place, but we play well there also. We've got good exposure that is growing and view that as a nice opportunity for us.
Great. Let me pause here and see if there are any questions in the audience. If you have a question, please raise your hand. Let's keep going. Eric, there has been a string of M&A activity in the physical AI, Edge AI space, on Synaptics, then ADI, I think there was some news today, and you guys made an acquisition of Hailo. My question is really around the strategic rationale behind acquiring a tuck-in type Hailo acquisition, and is Edge AI and physical AI really the next phase of AI deployment?
Yeah. When Steve Sanghi came back to Microchip 18 months, 21 months ago, we formed a separate product division that we called AI ML, or AI on the Edge. We have been working on new products in that area. We are excited about this Hailo acquisition. It hasn't closed yet, so we're probably not going to talk in depth about it. But we actually had some of the Hailo management participate in our annual MASTERs Conference, which we hold in Arizona in the middle of August, where nobody wants to come to Arizona in August, but the engineers do because they get training on the products. The feedback from customers and distributors was really positive, and we think this accelerates our product roadmap in that product division by three to five years. We're excited about the opportunity.
There'll be more disclosure on that once the deal closes later this month and definitely on our next earnings call.
Okay. But is this something structurally you're starting to see across with the AI model companies? There's a lot of discussion on variables using AI. But is it something that you think that the ball is going to be here in three years, five years, or are you starting to see some action from your customers?
We are starting to see action from customers today that they are asking for these types of products, and again, Hailo is going to accelerate our product roadmap pretty significantly. Feedback that we have recently got from customers about the acquisition is very good, and we will be integrating our teams together. Hailo brings a lot of very talented engineers to us, and we are excited, and there will be more to come on that in future earnings calls.
Sounds good. Then just broadly speaking on the capital allocation, obviously, the AI Data Center Solutions opportunity is a once in a lifetime kind of an event. Is that changing your kind of capital allocation strategy across dividend and tuck-in acquisitions and all those sort of things?
It is really not. We have been very focused on getting the balance sheet right after the depths that we went through in the last cycle, and leverage has come down significantly. We have started to pay down the debt on the balance sheet, and that is going to continue to be the focus, is keeping the dividend flat where it is at for a period of time. I believe that we will end the current quarter with a net debt- to- EBITDA of under 2.5x. So heading in the right direction, but we want to take it lower and the board is focused on that, getting it much lower before we start back doing any stock buyback or increasing the dividend.
And we have plenty of capital available to us if these small tuck-in acquisitions continue to come up, whether it is Hailo or something else, and we would be willing to do that, but you should not view Microchip as doing some mega scale acquisition at this point in time that is more transformative in nature. There will be tuck-ins to help accelerate product roadmaps.
Okay. The topic around China, it does not come up as much, but are you seeing increased competition in China? Is there a threat from domestic competitors in China? Just comment on your China sales. Are they growing kind of in line with the rest of the market?
Yeah, they really are. I think our China revenue is like 17%, 18% of revenue, and it has been pretty consistent at that level recently. There is some increase in competition, but the bottom line is customers want to design with Microchip because we have got high quality products, good support, track record of support, having inventory in place for them, and they do not want to change. So, we are going to continue to support those customers. Longer term, will competition continue to increase? It probably will. With that, we are deploying resources throughout the world in areas that we think is going to give us the biggest return on those investments, whether that is in India or other emerging markets.
Great. I think you guys— When Steve puts his focus and mind on fixing things, he does it, and we have seen that. He has delivered on the multipoint program that he has talked about. From here onwards, where are the priorities for Steve? You guys have gotten to your gross margin healthy level, and you are trying to get more supply going and the market is super strong. So what is his focus from here onwards?
Yeah. So, we are pretty much done with the nine-point plan. We are not quite at the operating margin level yet, but we are very close. We will be there very shortly. So you can almost consider that plan being done. He is really focused on day-to-day execution, right? Product lines, making sure the investments are being made in the right areas that are going to drive growth for us, making sure we are managing capacity appropriately, whether that is internal capacity, external capacity, focusing on customers and growing the business. So, doing the normal things that a Chief Executive Officer does, but the very difficult work that he laid out when he first came back is really completed at this point in time.
Sounds good. Let me see if there's questions in the audience before we wrap it up. One second. Let's get the mic come.
You talk about the design wins in PCIe retimer. How should we think about that translating to revenue?
Those design wins, there's really nothing happening in the short term. It's more calendar 2027 and calendar 2028 for all of the PCIe wins that we talked about, both retimer and the switch.
Is there a market share aspirations? You sized the market to be roughly about $12 billion.
We have our internal aspirations. It is a large market. We have a long ways to go, and that is not something that we are going to disclose publicly, but we are going to go after every customer that we can and grow the business as quickly as possible.
Is the fact that you were not in PCIe 5.0 an impediment to you getting share, or, the fact because you were strong in PCIe 3.0 and PCIe 4.0?
We are well known from a customer base because we have been around in that market for quite some time. This is another business that came to us through Microsemi, and it was their acquisition of PMC-Sierra years ago. Very strong in Gen 3.0 and Gen 4.0. It is not that the Gen 5.0 product is bad, it was just late to the market, right? That does stick with customers. We have customer repair and kind of prove it to me that we need to do that we are going to be on time with our products in the future, and I think our Gen 6.0 PCIe switch product is proof of that to customers. But we have to say, "Hey, this is what we are doing with Gen 7.0, and this is what our goals are from a timing perspective," and then we have to hit those goals.
It is a continuous process. Just because we have a really good product on Gen 6.0 does not mean we are going to win. We have to go out and continue to execute.
Thank you.
You're welcome.
Questions? All right, we can wrap it up here. Eric, thank you for coming to the Citi conference.
All right. Thanks for having me. Bye, guys.