Microchip Technology Incorporated

And welcome to this Microchips fourth quarter fiscal 2019 financial results conference call. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Eric Bjornholt, Chief Financial Officer. Please go ahead, sir.

Good morning, everybody. During the course of this conference call, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are predictions and that actual events or results may differ materially. We refer you to our press releases of last evening as well as our recent filings with the SEC that identify important risk factors that may impact Microchip's business and results of operations. In attendance with me today are Steve Sange, Microchip's chairman and CEO, and Ganesh Murthy, Microchip's president and COO. I will comment on our fourth quarter and full fiscal year 2019 financial performance, and Steve and Ganesh will then give their comments on the results, discuss the current business environment, as well as our guidance, and provide an update on our integration activities associated with the MicroSemi acquisition. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and this conference call on various GAAP and non-GAAP measures. We have posted a full GAAP to non-GAAP reconciliation on the investor relations page of our website at www.microchip.com, which we believe you will find useful in comparing GAAP and non-GAAP results. I want to remind investors that during the quarter ending June 30th, 2018, we adopted the new GAAP revenue recognition standard, which requires revenue to be recognized at the time products are sold to distributors versus our historical revenue recognition policy where revenue on such transactions were deferred until the product was sold by our distributors to an end customer. We continue to track and measure our performance internally based on direct revenue plus distribution sell-through activity, and we'll provide a metric for this called end market demand in our earnings release each quarter. Therefore, along with our gap and non-gap results based on distribution sell-in, we will also provide investors with our end market demand based on distribution sell-out, but will not provide a P&L on end market demand. End market demand in the March 2019 quarter was $1.34 billion, which was $10.4 million above our gap revenue. I will now go through some of the operating results, including net sales, gross margin, and operating expenses. I will be referring to these results on a non-GAAP basis, which is based on expenses prior to the effects of our acquisition activities, share-based compensation, and certain other adjustments. Our fiscal 2019 non-GAAP results are calculated as the sum of the non-GAAP sell-through based information we disclosed previously for each of the first three quarters of fiscal 2019 plus the non-GAAP sell-in based information disclosed today for the fourth quarter of fiscal 2019. Net sales in the March quarter were $1.33 billion, which was above the midpoint of our guidance and down 3.3% sequentially. We have posted a summary of our GAAP net sales and the end market demand by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were 62.2% and well above the midpoint of our guidance, which was 61.5%. Operating expenses were at the low end of our guidance range at 25.8% of sales. And operating income was $484.1 million and 36.4% of sales. Non-GAAP net income was $370.4 million. Non-GAAP earnings per diluted share was $1.48 which was over $0.08 above the midpoint of our guidance of $1.39 and a half. For fiscal 2019, on a non-GAAP basis, net sales were a record $5.476 billion and up 37.6% year-over-year. Gross margins were a record 62.1%, operating expenses were 24.3% of sales, and operating income was 37.7% of sales. Net income was a record $1.636 billion, and non-GAAP EPS was a record $6.55 per diluted share. Please note that for fiscal year 2019, our non-GAAP results are based on our publicly reported non-GAAP results, which Q1 through Q3, as mentioned before, were based on sell-through revenue recognition in the distribution channels, and Q4 was based on sell-in revenue recognition in the distribution channels. Fiscal year 2020 non-GAAP results will be based on sell-in revenue recognition, in line with our GAAP revenue reporting, and the revenue recognition standard adopted during the first quarter of fiscal 2019. On a GAAP basis, gross margins were 61.7% and include the impact of $4 million of share-based compensation and $1.8 million of acquired inventory valuation costs. Total operating expenses were $535.9 million and include acquisition and tangible amortization of $176.9 million, special income of $23.3 million, $4.4 million of acquisition-related and other costs, and share-based compensation of $35.1 million. The gap net income was $174.7 million, or $0.70 per diluted share, and includes an income tax benefit of $23.5 million. The GAAP tax benefit in the quarter related to a variety of matters, including tax reserve releases due to statute of limitations expiring, tax reform refinements, and tax benefits associated with restructuring the microsemi operations into the microchip global structure. On a GAAP basis for fiscal 2019, net sales were a record $5.35 billion and up 34.4% year-over-year, Gross margins were 54.8%, operating expenses were 41.4% of sales, and operating income was 13.4% of sales. Net income was $355.9 million, and EPS was $1.42 per diluted share. The non-GAAP cash tax rate was 1.4% in the March quarter and 3% for fiscal year 2019. For cash planning purposes, we were able to defer the payment of some of our fiscal 19 taxes into fiscal 20, and this is one of the reasons our FY19 tax rate was lower than originally projected. We expect our non-GAAP tax rate for fiscal 20 to be between 5% and 6%, exclusive of the transition tax. Any potential tax associated with restructuring the micro-semi-operations into the microchip global structure and any tax audit settlements related to taxes accrued in prior fiscal years. We have many tax attributes and net operating losses and tax credits, as well as U.S. interest deductions that we believe will keep our cash tax payments low. The future cash tax payments associated with the transition tax is expected to be about $246 million and will be paid over the next seven years. We have posted a schedule of our projected transition tax payments on the Industrial Relations page of our website. Moving on to the balance sheet, you will notice that Microchip's accounts receivable balance is up significantly from the prior quarter. We have made an accounting presentation change to reclassify the distributor price adjustments that reduce the amount of cash we ultimately receive from our distributors from a reduction in the AR balance to an increase in accrued liabilities. Remember that we generally sell to our distributors at a price that is higher than the ultimate sales price, and then that price is reduced by a distributor price adjustment when the ultimate sale occurs to the distributor's customers. Excluding this reclassification, our accounts receivable balance was up about $5 million in the quarter. Our inventory balance at March 31st, 2019 was $711.7 million. All the inventory markup for micro-semi required for GAAP purchase accounting has now been sold through and is no longer reflected in the ending inventory balance. We had 128 days of inventory at the end of the March quarter, up five days from the prior quarter's level. Inventory at our distributors in the March quarter were at 35 days compared to 36 days at the end of December. We believe that barring any negative developments in the U.S.-China trade front, our distributors are holding a reasonable level of inventory to support end market demand. The cash flow from operating activities was $403.4 million in the March quarter. As of March 31st, the consolidated cash and total investment position was $430.9 million. We paid down $277.5 million of total debt in the March quarter, and the net debt on the balance sheet reduced by $272.3 million. At March 31st, our debt outstanding includes $3.267 billion of borrowings under our line of credit, $1.912 billion of term loan B, $2 billion in high-grade bonds, and $4.481 billion of convertible debt. Our EBITDA in the March quarter was $544.4 million, and our trailing 12-month EBITDA was $2.212 billion. Our net debt to EBITDA, excluding our very long-dated convertible debt that matures in 2037 and is more equity-like in nature, was $4.8 at March 31, 2019. Our net leverage metrics are based on 12-month trailing EBITDA, which will continue to provide some headwinds due to the distribution inventory reductions that were made in the June and September quarter for microsemi, which caused our shipment activity to be significantly less than the end market demand during these periods. The weaker economic environment also is negatively impacting our EBITDA in the December 2018 and March 2019 quarters. We are committed to using substantially all of our excess cash generation beyond our dividend payments to reduce our debt levels and we expect our debt levels to reduce significantly over the next several years. Our dividend payment in the March quarter was 86.7 million. Capital expenditures were 40.1 million in the March 2019 quarter and 228.9 million in fiscal year 2019. We expect about 35 million in capital spending in the June quarter and overall capital expenditures for fiscal year 2020 to be between $130 and $150 million. We continue to add capital to support the growth of our production capabilities for our new products and technologies, and to bring in-house more of the assembly and test operations that are currently outsourced. These capital investments will bring some gross margin improvement to our business, particularly for the outsourced Atmel and MicroSemi manufacturing activities that we are bringing into our own factories. Depreciation expense in the March quarter was $48.4 million. I will now turn it over to Ganesh to give his comments on the performance of the business in the March quarter and provide an update on some of the microsemi integration activities. Ganesh?

Thank you, Eric, and good morning, everyone. Before I get started, I'd like to clarify that the product line comparisons I will be sharing with you today are based on end market demand, which is how Microchip measures its performance internally. Let's start by taking a closer look at microcontrollers. Our microcontroller business was sequentially down 4.6% compared to the December quarter, reflecting the broad macro weakness in the markets we serve. Microcontrollers, however, were up 8.6% from the year-ago quarter. On a fiscal year basis, fiscal year 19 microcontroller revenue was a record at over $3 billion and grew 15% over fiscal year 18. microcontrollers represented 53.3% of our end market demand in the March quarter. During the quarter, we continue to introduce a steady stream of innovative new microcontrollers, ranging from the industry's first arm-based microcontroller with space-qualified versions that have scalable levels of radiation performance, new dual- and single-core DSPIC33 digital signal controllers with built-in functional safety, the industry's smallest IEEE 802.15.4 compliant module that combines an ultra-low-power microcontroller with a sub-gigahertz radio. And last but not least, we unveiled our unified 32-bit microcontroller software framework called Harmony, extending support for Atmel-originated SAM microcontrollers in Microchip's development tool environment. We now support our MIPS-based microcontrollers as well as our ARM-based microcontrollers on a single development environment of MPLAB and Harmony. Last month, Gartner released their microcontroller market share report for calendar year 2018. We are pleased to report that Microchip retained the number one position for 8-bit microcontrollers. Once again, we gained market share as we grew faster than the 8-bit microcontroller market overall. And in fact, we are now 73% larger than the number two player. In the 16-bit microcontroller market, we remained in the number five position and continued to gain significant market share as we grew faster than all our top competitors and at about 5x the growth rate of the 16-bit microcontroller market. In the 32-bit microcontroller market, we remained in the number six position and gained significant market share as we grew almost at 2x the growth rate of the 32-bit microcontroller market. We were also the fastest growing franchise among the top six players who make up over 80% of the 32-bit microcontroller market. These results are despite Gartner rolling up our 32-bit microcontroller revenue to be 30% lower than the over $1 billion revenue that we informed you of in our last conference call. Had Gartner used our actual calendar year 2018 32-bit microcontroller revenue, we would have moved up to the number four rankings. Additionally, our 32-bit microcontroller revenue in fiscal year 19 was over $1.1 billion, demonstrating continued momentum. For microcontrollers overall, we remained in the number three position and grew faster than the two players ahead of us. The Gartner reported revenue is considerably lower than our publicly reported revenue for calendar year 2018. Using our publicly reported revenue, we would be approximately 13% and approximately 18% away from the top two players ahead of us as we continue our relentless march towards the number one spot. Our microcontroller portfolio and roadmap has never been stronger. We believe we have the new product momentum and the customer engagement to continue to gain even more share in 2019 as we further build the best performing microcontroller franchise in the industry. Now moving to analog, our analog business was sequentially down 5.8% compared to the December quarter, reflecting the same broad macro weakness of microcontroller business experience. Analog, however, was up 60.2% from the year-ago quarter. On a fiscal year basis, fiscal year 19 analog revenue was a record at well over $1.5 billion and grew 64.6% over fiscal year 18. Analog represented 29% of our end market demand in the March quarter. During the quarter, we continue to introduce a steady stream of innovative analog products, including a new analog-to-digital converter family that enables high-speed, high-resolution analog-to-digital conversions in harsh environments. Our FPGA business was sequentially down 5% as compared to the December quarter, reflecting the same broad macro weakness. However, design wins in our new, low-power, mid-range polar fire family continue to grow strongly, and we are optimistic about this product family adding another leg of growth for the future. During the quarter, we introduced the PolarFire FPGA imaging and video solution that supports resolution as high as 4K in the small, low-power form factors necessary for a wide range of imaging and video applications. We also released our Libero SoC design tool, which delivers a unified design suite, FPGA represented 7% of our end market demand in the March quarter. Moving next to our licensing business, this business was sequentially down 42.3% as compared to the December quarter. The production activity of our licensing customers has been cut significantly in response to industry conditions. Also, as we mentioned in our February conference call, we did not expect nor have any meaningful patent licensing revenue in the March quarter. while we did in the December quarter. Our patent licensing strategy is to monetize portions of the substantial patent portfolio we inherited through our acquisitions by licensing select patents to players in noncompetitive fields of use, while retaining the rights to these patents in our products as well. Investors should expect that the revenue contribution from patent licensing in the future will be lumpy from quarter to quarter. Our memory business was sequentially up 3.8% in the March quarter, as compared to the December quarter. And finally, our multi-market and other business was up 3.5% sequentially as compared to the December quarter. A quick update about our microsemi integration as we come up on the one-year anniversary after the close. Business units, sales, operations, and support groups are all making good progress. Our thanks go to the combined company employees who are working hand-in-hand to achieve accelerated synergy results. Overall, we're ahead of our synergy targets and expect continued synergy gains for many quarters to come. Business systems and operations integration is taking the longest time to complete as we are conducting this complex transition in phases. The first and second phases were completed on November 1st and February 1st, respectively, for a combined total of four business units. The third phase went live on May 1st and involved four more business units. With that, we are about one-third of the way through the business systems and operations integration, and more phase releases are planned every quarter. We expect the overall business and operational integration will take about another 12 to 15 more months to complete. Finally, prior to our acquisition, MicroSemi had announced the closing of a small 4-inch fab in Bend, Oregon. The last wafers came out of this fab at the end of the March quarter, and we ceased production on schedule. Additionally, we were able to find a buyer for the fab and close the sale last week. The sale price was not material to Microchip. Let me now pass it to Steve for some comments about our business and our guidance going forward. Steve?

Thank you, Ganesh, and good morning, everyone. Today, I would like to first reflect on the results of the fiscal fourth quarter of 2019. I will then provide guidance for the fiscal first quarter of 2020. Our March quarter gap and non-gap net sales based on selling revenue recognition came in just a tad above the midpoint of our guidance. The business in the quarter proceeded as we had expected. Our end market demand measured by sell-through was about 10 million higher than the selling revenue, but unfortunately we cannot call sell-through based market demand as revenue anymore. based on the new revenue recognition standard. The end market demand was stronger than sell-in revenue, which is consistent with our thesis that the channel is continuing to manage their working capital conservatively by reducing inventory due to uncertainty. Our consolidated non-GAAP gross margin at 62.2 percent exceeded the high end of our guidance Our consolidated non-GAAP operating margin of 36.4 percent was also above the high end of our guidance. These gross and operating margin percentages are the highest results we have ever posted at the bottom of a cycle. Our consolidated non-GAAP earnings per share exceeded the midpoint of our guidance by over eight cents per share. On non-GAAP basis, this was also our 114th consecutive profitable quarter. I want to thank all employees of Microchip, including employees from all of our acquisitions, for their contribution. One other area I wanted to point out is our debt payments. In the March quarter, we paid down $277.5 million of our debt. Our total debt payment since the end of June 2018 has been $1.156 billion. With expected $250 million payment in this June quarter, we expect to have paid down about $1.4 billion of our debt since the closing of the micro-semi-transaction on May 29, 2018, which we feel is excellent progress. In addition, with Federal Reserve Board expected to be on hold for any further interest rate increases, we are optimistic that the peak of our debt to EBITDA leverage is behind us, and we should see meaningful reduction in leverage in the next one year starting this June quarter. Now I will provide you guidance for the June quarter. The guidance we provided for the September quarter of last year which reflected our caution on business conditions, turned out in retrospect to be spot on and was a harbinger for broader industry weakness through the last several quarters. In our last quarter's earnings call, we said that barring any negative development on the trade front, we see the March 2019 quarter to mark the bottom of this cycle for microchip. Secondly, we said that last quarter, we did not know the shape of the recovery, whether it is V, U, or L-shaped, and it would depend somewhat on the outcome of the trade talks. Towards that end, we did not get a settlement on the trade front. In fact, in recent days, the rhetoric has turned more negative of Chinese goods expected to go into effect this Friday. Therefore, the uncertainty related to U.S.-China trade relations continues. Given this continued uncertainty, we see weaker than seasonal business conditions for microchip. We continue to operate our business prudently for long-term shareholder value, and we believe that the end market demand will continue to be stronger than the gap selling revenue in the June quarter, and the channel and customer inventory will continue to decrease. Given this color about business conditions, we expect net sales for our products to be about flat sequentially, plus or minus 5 percent in the June 2019 quarter. We want to correct some of the analysts' and investors' perception about what is the seasonal growth for us in the June quarter. If you take our past year's revenue as reported and average them for the calculation of the June quarter seasonality, you will get a very wrong result. It is because several of our acquisitions closed in April. Supertech's acquisition closed on April 1, 2014. Atmel acquisition closed on April 3, 2016, and Micro Semi acquisition closed on May 29, 2018. If we make the calculation based on removing the acquired company sales in the first quarter, then based on the last seven years, our average net sales in the June quarter were up about 3% sequentially. Therefore, our current flattish guidance at the midpoint for June quarter is below historical seasonality for classic microchips. We expect our non-GAAP gross margin to be between 61.8 percent and 62.2 percent of sales. We expect non-GAAP operating expenses to be between 25.3 percent and 26.3 percent of sales. We expect a non-GAAP operating profit percentage to be between 35.5 percent and 36.9 percent of sales. We expect our non-GAAP earnings per share to be between $1.26 per share to $1.49 per share. Now, the next question is what happens after the June quarter? The hints coming out of Washington regarding the status of U.S.-China trade talks continue to oscillate between positive and negative. While there is no guarantee that talks will end successfully with a settlement, We believe that any finality of such talks will remove some of the uncertainty and will have positive effect on the business. China has already taken a number of stimulus measures to boost business, including a cut in the VAT from 16 percent to 13 percent, cutting the personal income tax rate, and cutting reserve requirements of the banks. thus increasing the money supply. We have seen some strength in our China business from the bottom in the March quarter and expect more strength to pick up in the second half of calendar 2019. The automotive business continues to be weak around the world because of car production down in U.S., Europe, and China. We expect that our automotive business, bottomed in March quarter two, and should start to recover from the low base and strengthen into the second half of calendar 2019. Considering all of the above factors, we are renewing our belief that barring any negative developments on the trade front, we will expect the business recovery to pick up in the second half of calendar 2019. Given all the complications of accounting for our acquisitions, including amortization of intangibles, restructuring charges, and inventory write-up on acquisitions, Microchip will continue to provide guidance and track its results on non-GAAP basis, except for net sales, which will be on a GAAP basis. We believe that non-GAAP results provide more meaningful comparison to prior quarters, and we request that the analysts continue to report their non-GAAP estimates to First Call. With this operator, will you please poll for questions?

Of course. Thank you. Ladies and gentlemen, if you wish to ask a question at this time, please press star 1 on your telephone keypad. Please ensure that the mute function is switched off to allow your signal to reach our equipment. And if you wish to remove yourself from the queue, you may do so by pressing star 2. Due to time concerns, we ask our participants to ask one question and one follow-up during today's Q&A session. If you wish to ask more, you may rejoin the queue by pressing star 1 again. We will now pause for just a moment as we wait for our participants to signal for questions. We will now take our first question from John Pitzer from Credit Suisse. Please go ahead. Your line is open.

Good morning, guys. Thanks for letting me ask the questions. Steve, my first question, very helpful to help us understand how you're viewing seasonality into the June quarter. But just given all the acquisitions, and I think a couple of quarters ago, you talked about still trying to understand the seasonality of all the new businesses together. I'm wondering if you could just level set everyone on the call and help us understand how you think about seasonality in September, December, and March, as well as June.

John, we're not able to give forward-looking seasonality for multiple quarters yet. We haven't had enough experience on the micro-semi-front Some of the last year's performance was affected by the inventory reduction we undertook in distribution. So we haven't had a number of normal quarters. Then we got hit by all this U.S.-China trade issues for the last couple of quarters that we have been fighting and are now looking for the recovery. So the historic seasonality for June quarter I mentioned, was to remove the acquired company's first quarter revenue and then average the last seven years. We certainly can do that for the September and December quarter and provide that information to the investors, but that would be backward-looking seasonality. We are not yet able to give you information on the forward-looking seasonality.

That's helpful. And then just as my follow-up, On the CapEx guidance for the new fiscal year, it's down fairly meaningfully year over year. To what extent is that just a reflection of the weak business environment? Or is this just really some of the CapEx projects you had in place to help integrate the acquisitions are mostly behind you? And how do we think about kind of the run rate of CapEx, whether as a percent of sales or an absolute dollar number from kind of what you're projecting for the current fiscal year?

Okay, this is Eric. I can take that question. So as indicated, we're projecting somewhere between $130 and $150 million in CapEx for fiscal 20. That's down from about $230 million in fiscal 19. Fiscal 19, we had some kind of one-time events associated with some building projects that we talked about the last few conference call that was in the $60 to $70 million range. And we had put capacity in place in the first half of last fiscal year you know, expecting the environment to be stronger. So I think we're pretty well positioned. And then we also have a full year of micro-semi, you know, a couple more months in fiscal 20 compared to fiscal 19. So all that combined, you know, I think our CapEx projection is, you know, reasonable range for the current year. I think over the course of time, you know, we'll be in that 3% to 4% of sales, and there'll be peaks and valleys to that just based on the environment that we're facing at that time.

Thanks, guys.

Thank you. We will now take our next question from Chris Denley from Citi. Please go ahead. Your line is open.

Thanks, guys. So, Steve, your tone seems a little more pessimistic than it did three months ago. So has anything changed? Is this Just because we're looking at another $200 billion, has anything changed in your business over the last week or the last, I guess, three months since you were last on the call to make you a little more pessimistic on how things are going?

Well, what changed is really the tone on the U.S.-China trade front going from a lot of positive signals coming from various officials, including Secretary Mnuchin and all that over the last couple of months and then turning into a tweet by President Trump on Sunday that the 25% tariffs on $200 billion of Chinese goods are going into effect this Friday, resulting into cancellation of the visit by Vice Premier of China first, and then later on he put back the visit and he's now arriving on Thursday. So the rhetoric has turned meaningfully negative here and causing significant uncertainty. Now, there hasn't been a lot of time since that news to gauge the reaction of our distributors and customers. And as you know, we have very broad distribution and thousands and thousands of customers. And in a couple of days, you cannot really gauge all that. So, yes, our tone has turned distinctly negative due to those developments.

Sure. I guess if this wasn't going on, you know, maybe last week or the week before, what would your guidance be and what have you heard from your customers kind of as the quarter has progressed on their tone of business?

I think that's kind of, you know, would I, should I, could I? You know, we don't know. but certainly our guidance would have been much more narrower in the range versus the wide range, and the guidance would have been more positive on the midpoint than the one we have provided now.

Chris, I would add also the trade resolution has also been delayed. So not only is the most recent news from the weekend, When we were speaking to everybody back in February, there was a much earlier date for resolution. So that continues to push out and create uncertainty as well.

During our conference call last quarter, which I think was on February 9th or something, the trade resolution was supposed to happen prior to March 1, so it was relatively imminent. Then it was delayed to May 1, and then it didn't happen on May 1, and then the events turned negative. So there has been a substantial delay and change on that front.

Okay, thanks.

Thank you. We will now take our next question from Harlan Sur from JP Morgan. Please go ahead.

Good morning. Thank you for taking my question. You know, last year at Analyst Day, which was held in early March of last year, you guys were able to accurately call out the trends for the June quarter. and even provide June quarter sequential growth outlook. And I think a big part of the analysis back then was the rate of backlog build for the June quarter post-Chinese New Year's, which in a normalized demand environment kind of flattens out during CNY and then rises post-Chinese New Year's. So I guess the question is, or it seems like you didn't see this type of recovery in the backlog this year. So maybe if you could just provide us with some color here on the backlog trends post-CNY this year, and what are the current backlog trends telling you about the September quarter?

So I think the environment is of significant uncertainty because of U.S.-China trade talks this year than it was last year. There was no such uncertainty. The only uncertainty we were dealing with last year was investors' perception about the letters we had written a year before, which many investors felt that pulls the demand up and there will be a correction. And I think we showed through the charts that there was no such effect of the letters we write. Those letters are simply to inform our customers, broad-based of 120,000-plus customers, the environment we were dealing with. And through a backlog in terms and various metrics, we showed to the investors that our business was in good shape and we were not really seeing any challenges. The environment today with uncertainty with the two largest markets we have, which are the U.S. and China, together they make close to 50 percent of our business, if not more, is of significant more uncertainty. Simply looking at the backlog and terms and all that in the middle of the quarter cannot make up for a large amount of customer sentiment. So having said all that, our backlog on April 1 started lower than our backlog was on January 1 because last quarter bookings were weak, so our backlog started lower. However, the bookings quarter to date in this quarter for the month of April and a few days in May has been stronger than the bookings we got during the same time last quarter from January 1 to February 8 timeframe. So, the bookings are stronger and the terms coming from those bookings are stronger because the lead times are short. But with significant change in the sentiment driven by just the events of last few days, it's very difficult to project what the distributor and customer sentiment would be in the balance of the quarter. You know, just imagine if you were a supplier and you didn't know whether you'll be able to pass on a 25 percent tariff increase to your customers. whether your customer will then choose to buy that product from Korea or Taiwan or somewhere else and not from the Chinese supplier. In that environment, you would take actions to protect your business by not having a large amount of inventory, only building to firm orders and negotiating with your customers what kind of price increase you can pass on. Those are all uncertainties that thousands and thousands of customers have been dealing with for quite a while impacting our business.

I think the one other thing I would add to what Steve said is comparing the sentiment at March 1st last year when we did our analyst day to today, the other significant change over that time period is lead times have contracted significantly. And so that gives customers flexibility to place very short-term orders on us and to be responsive, which wasn't necessarily the case over a year ago back in March.

Great. Thanks for all the insights there. My follow-up question is, you know, strong showing on the market share front in MCUs for 2018. On 32-bit, you guys grew your business almost 900 basis points faster than the overall market, and I don't think Microsemi had any 32-bit MCUs, so pretty much all organic. You've got your MIPS architecture. You've got your ARM family. If you guys could just help us understand the drivers of the strong outperformance, I assume... Maybe part of it is helping your customers move up to stack. But what are some of the other dynamics driving the strong market share performance?

So it is not completely correct that MicroSemi had no 32-bit microcontrollers. They did have a class of what we call specialized microcontrollers, which are 32-bit microcontrollers. But in general, the classic Microchip 32-bit products of both architectures, MIPS and ARM, have been doing extremely well. As you know, we acquired the ARM microcontrollers through the Atmel acquisition. So that has given us the ability to serve a broader set of customers, a broader set of applications. And so that combination of both what classic Microchip could do with the 32-bit microcontrollers we had that are more general purpose, plus some of the specialized microcontrollers that came through MicroSemi, all contributed to the last 12 months or the calendar 18 growth numbers that you see.

Great. Thank you.

Thank you. We will now take our next question from Rajvindra Gill from Needham Company. Please go ahead. Your line is open.

Yes. Thank you for taking my question. Just to follow up on the China trade issue. I'm trying to get a sense in terms of how the issues with trade and how it translates to actual orders on the ground. A lot of the companies in the coverage space saw kind of an abrupt cut in orders from their customers in China starting in December, different from kind of past cycles, and then have been starting to see some rebound. And given kind of your guidance in June reflecting kind of weaker seasonal trends, even though the comment from Trump came out on Sunday, I'm just trying to reconcile your guidance and just the short nature of the change in sentiment, because it only happened last week, and the actual impact that you're seeing on the ground. to give way to give the guidance in the first place?

Dr. Well, Rajiv, you know, it's very, very difficult to accurately assess the impact of a substantial negative turn on the developments of trade talks. You know, that's why we have a fairly broad guidance, not being accurately able to model the impact. You know, these are not the issues where there is a, you know, historic record of what happens. I mean, these kind of things haven't happened in history. It's only in the last, you know, couple of quarters, and I think, you know, we predicted the downturn better than anybody in the industry. We were the first one to predict that. And in many of the earnings reports, this season came before the Trump's tweet on Sunday, citing that talks had turned negative. So having that knowledge that these talks have turned negative, in our announcement last night in our earnings, We had to put the possibility of negative customer behavior. One thing I have described before to analysts and investors in various calls and meetings is the world economy largely runs on people building to forecast. Every manufacturer builds a large amount of their products on forecast. from electronic stores to grocery stores to furniture stores. You go to a store and the grocery store is full of grocery, and you put it in the bags and you go home. If the manufacturers did not put the grocery store inventory, you would go there and just place your order and come back in two days to pick it up. So in an uncertain environment, when our customers are not able to figure out the demand for their products because they do not know whether they will be able to pass a 25 percent tariff to their end customers. In that environment, they stop building to a forecast, and they largely want to build to hard orders where they can negotiate the price increase, and that is happening with you know, with our industrial customers, with our, you know, consumer customers, housing appliance customers. You know, you have heard where prices of washers and dryers and others have gone up 20%. So in that environment, the ecosystem squeezes down the inventory from end customer inventory to loading docks to, you know, intermediate hubs to, you know, stores to everywhere else. And that creates a negative impact on our ability to supply chips, which then eventually go into parts. And you have seen that phenomena experienced by every other semiconductor manufacturer whose revenue has fallen in the last six, nine months, where back in August, nobody was confirming that there's a problem when we said there was a problem. Does that make sense, Rajiv?

Hello?

Yes.

I think that makes sense. It's a moving target. I just read that now that Trump says the Chinese vice premier is coming to the U.S. to, quote, make a deal. So I guess it's a constant change. But I appreciate it. Thank you.

Thank you. We'll now take our next question from Vivek Adia from Bank of America. Merrill Lynch, please go ahead.

Thanks for taking my question. Steve, I know we are trying to get the best sense for June, and I understand and appreciate that it's a moving target, so the conservatism is justified. My first question is that just in terms of what you have actually seen so far in terms of bookings from your customers in China or U.S. or Europe, is it fair to say that any of these concerns about trade have not yet reflected in those bookings so far? Have you seen any trend? I realize that we are just within a week of all these political developments, but so far, is it fair to say that you have not really seen any negative development in bookings from any geography or end market or anything along those lines?

So Vivek, You have to first decide from what timeframe you're comparing. If you're simply comparing it to what we thought last Friday, yes, we have not seen an impact in the last two days because it's just too hard to gauge. But if your timeframe is February 9th, our last call, then we have seen the impact. At that time, the trade settlement was supposed to happen prior to March 1st. Then it got delayed to May 1. Then we didn't see it on May 1 either. So all that time, we have seen the impact on bookings and customers' ability to want to, you know, build the appropriate amount of inventory for the business from the endpoint inventories to loading docks to hubs to everything else. So if your reference point is, Our last earnings call, yes, the business is weaker than what it could have been if there was a settlement on March 1.

Got it. I ask that, Steve, just because I think your March numbers were actually fine, and I think what you mentioned was that so far in June, the bookings have also been fine, but... Let me leave that aside for a second. On microsummit, could you remind us how much earnings accretion you finally saw now that fiscal 19 is over and how much earnings accretion we should be thinking about from a fiscal 20 perspective? Thank you.

Okay. So, you know, we have not broken out in the current quarter what the quarter we're just reporting what the micro-semi contribution was. We are definitely ahead of schedule. We had mentioned last quarter that we had achieved our kind of one-year target of run rate of 75 cents accretion. We were above that as of the end of December. And, you know, things are continuing to progress. We're taking costs out of the system. Ganesh gave commentary in terms of how we're doing on business units and sales and support groups from an integration perspective. So making good progress. We still feel good about our long-term synergy numbers and are working towards that, but we haven't broken out and aren't breaking out at this point in time the specific accretion that we have achieved so far.

Thank you.

Thank you. We will now take our next Question from William Stein from SunTrust. Please go ahead.

Great. Thanks for taking my questions. I have two. First, the company posted some better than expected results on the gross margin line. Can you help us understand whether that's attributed more to mix or cost savings from microsemi or anything else? And then I have a follow-up, please.

Okay, so I'll take that. So we exceeded the midpoint of our non-GAAP gross margin guidance by about 70 basis points. You know, the very strong gross margins were driven by a variety of reasons, including favorable product mix and ongoing cost reduction. So, you know, it always is a mix of things. There's a lot of moving parts. But we're making good progress on integration, and, you know, the product mix was favorable in the quarter also to help us with that. And even at the mid-term, our guidance in the current quarter at 62%, we're only really 1% away from our long-term target of 63%. So I think things have really held up well in this downturn. Yes, our inventory situation is a little bit higher than our target, but with short lead times and customers and distributors been in a pattern of decreasing their inventory levels, it gives us the best ability to respond very proactively to their needs.

I would reemphasize one point that I made in my prepared remarks, that as we go through various cycles, you can look at in the last 20 years, this would be the highest gross and operating margin nearly at the bottom of the cycle. In the past, you will see this kind of gross and operating margin usually on the top of the cycle. So, you know, this is how much we have improved creating you know, higher highs and higher lows. So from now on, as we go further in the next couple of years, complete this integration, you know, have better loading in our factories with the demand coming back, you know, it's really a good feeling to think about where the growth and operating margins could go.

I appreciate those comments. One follow-up, if I can, turning to the micro, semi, acquisition, less about the integration, but more about the inventory. I understand from the prepared remarks that you've worked through all of the microsimmy inventory that was on your own balance sheet. I was hoping you can comment on inventory, not only in the channel, but in any other places like at customers to the degree you can see it. Is that work down to more normal levels where this is less of a deterrent to growth going forward, or is there still some inventory in channel or at customers to work down? Thank you.

Yeah, so I think we've done a good job of working through the issues that were identified early on in the acquisition. The micro-semi distribution inventory take you back to the September quarter. It was reduced to about 2.6 months over the course of the first four months of holding the asset, and the shipment activity into distribution was impacted dramatically by that. But that has stayed very constant. That 2.6 months has stayed the same. in the December quarter and the March quarter. So we think we've got a good balance there. There can be a business unit or two that has a little bit of elevated inventory, and it's just taking some time to bleed that down. But overall, I think we're in a good position. And the other things that we had talked about was contract manufacturing inventory and things like that. And I think all those have been corrected at this point in time. Steve or Ganesh might have some additional comments to make.

The only comment I'd make is I think in terms of end customers, we really don't get inventory reports. So We don't think there's a big overhang there, but we don't have much visibility into it. Our own inventory internally, we're continuing to work down. So this is our production areas, and we have been running lower than what the sell-through is in terms of what we're building. And that is slowly coming back into levels it should be, but it's not completely where it needs to be.

Thank you.

And we did take a under-capacity utilization charge in the quarter overall for various factories of a little over $7 million in the last quarter.

And as the demand comes back and when that $7 million charge goes away, that $7 million lands up in the gross margin.

Yeah, eventually.

Thank you. We will now take our next question from Craig Ellis from BRally FBR. Please go ahead. Your line is open.

Yeah, thanks for taking the question. I'll start with clarification on two operating items. First, debt reduction came in much better than expected, at least on my front, and the outlook suggests that the improvement that the company saw versus expectations is structural. So I wanted to get some clarification on that and And further on the comments that Ganesh had in his prepared remarks where he outlined three milestones that had been achieved with business integration, the clarification there is, is the financial benefit fairly linear with the milestones achieved so that we're about a third of the way through the financial benefit, or is it front-end loaded or back-end loaded?

So, Craig, just to clarify, you had started off with – it's an OPEX question, right? Right.

The first one is debt reduction and the $277 million. I thought that was above the expectation of the company. What's the cause of the positive variance?

Okay. All right. So we've continued to really manage our working capital requirements quite tightly and had good execution there and just managing our overall cash balances worldwide. So we've outperformed on debt pay down, no doubt about that, over the last couple of quarters. And and made good progress. I mentioned that our debt to EBITDA is still 4.8, and we expect as we progress in the second half of 2019 and the EBITDA improves, we're going to continue to be using all of our excess cash generation to pay down debt, that we will see some significant improvements in our debt to EBITDA. So I think it's working capital management We talked about CapEx a little bit earlier. Also, CapEx being down significantly in fiscal 20 as a projected number compared to fiscal 19 will also help on the cash flow, and we should expect to see the debt come down significantly over the course of the next 12 months.

To your second question on the business and operations integration, it's, you know, on a longer-term basis, it's more linear, but quarter to quarter, we're going to see more or less effects depending on are we able to retire some of the prior ERP systems completely or not. And so it's not entirely linear looking at it quarter to quarter.

Thank you. And then the follow-up is for Steve. Steve, you've given us a very clear picture of the dynamic that you're seeing now and the way recent political developments are impacting your thinking. What I wanted to do is reconcile that with comments that I thought I heard you say that there could be a pickup in the back half of the year. Is that potential pickup more predicated on a favorable set of developments that could happen on the macro front, or is it closer proximity to typical enterprise and consumer builds that would take place in the back half of the year or something else? Thank you.

I think there are two possibilities on the trade front. Actually, three. One, the worst would be that trade talks break and there's 25% duty not only on the 200 billion of goods but another 325 billion of goods that are threatened, that would be the worst case scenario. But the other possibilities are there is some very good settlement where whatever the issues are between the two countries on IP theft and forced transfers of technology and all those things there's a system put in place to monitor all these and issues are resolved and tariffs come down. That would be the best case scenario. And the other one is that there is some sort of finality, but it's not as good as the U.S. wants. As long as there is a finality on the settlement where the people know what the rules are, then the manufacturers can adjust to those rules and can negotiate with their customers to pass the additional cost, whether it's 5%, 10% duty cost, as long as there's a finality, I think it will be positive for the business. Of course, it will be extremely positive if there's a settlement and duties go away and there is a very good environment. But even if it is not the ultimate best, but there's some sort of finality, I think that would be better than the uncertainty we're dealing with.

That's very helpful. Thanks, gentlemen.

Thank you. We will now take our next question from Harsh Kumar from Piper Jeffery. Please go ahead. Your line is open.

Yeah. Hey, guys. First of all, we appreciate your position, trying to guide in all this CSAR trade chatter and running the company prudently for the long term. Steve, now you've taken share for quite a bit of time in what is a mature 8-bit market. What do you think are some of the things that Microchip specifically is doing that is helping you take share in that market?

Well, I don't really want to tell my competitors how I'm taking shares. I would simply say that if somebody doesn't develop any more 8-bit parts and adds no innovation to them, simply because they buy a thesis that 8-bit market is not growing and put all their energy in the 32-bit, then they will continuously become more and more uncomparative in the 8-bit and will continue to gain share, which is really what's happening. There are many more things we are doing, but we are continuously able to show 8-bit customers how they can keep on utilizing our newer and newer 8-bit microcontrollers and continue to add innovation and not having to go to 16 or 32-bit microcontrollers. And therefore, we're taking a lot of share.

Fair enough. Steve, thanks for that color. And then I wanted to ask about, you know, you cited some bookings data and some other data, all of which seems to be improving. The backup commentary is improving. What if Be fair for me to assume that, you know, that you basically haircutted what you might have. Let's say you were doing earnings last week. You might have had a completely different commentary, completely different set of guide. You simply haircutted that based on the developments this week. Is that a fair assumption?

Yes, that's a fair assumption.

Okay, thank you.

Thank you. Just as a reminder to all the participants, if you wish to ask a question, it's star 1 on your telephone keypad. We'll now move on to our next question from Kevin Cassidy from Stifle. Please go ahead. Your line is open.

Okay. Thank you for taking my question. Steve, you had mentioned the automotive market. You thought that that had hit a bottom and is coming back. Can you give a little more details around that and also just maybe what your content increases might be for this year?

So I think the way to think about it is not that it is rebounding into this quarter. I think we said it's hitting bottom and it is heading to where, as we look into the second half, things are getting better. The content increase is a constant effort that we drive. We have shown you some of the slides in investor forums where we have 60, 70, 80 different components. And that continues to take place in various car makers and It may not be for the same design in every car maker, but it is a part of how we drive the market. It is a part of how the market is evolving. There is more and more electronics that is going into safety, into convenience, into some of these new electric and electrification and ADAS, those type of trends. And we have a fair share in all of those areas. And I think the last piece is the European... WLTP regulational change, I think the last remnants of that will get cleared by the end of this quarter. It has taken longer to clear, but we believe that all of that clears as we go through the end of this quarter. So those are all the different factors going into some of the color that Steve provided.

Okay, maybe just as a follow-up, the China VAT tax, have you seen a more positive effect bookings from the Chinese automotive companies?

We haven't really broken down the Chinese automotive specifically. I think if you look at China overall, we are seeing stronger bookings. There should be a part of that reflected in most of the other areas, markets that are in China.

The lower VAT went into effect, I think, on April 1. Just like in the U.S., when tax law changes or, you know, sales tax changes in a city or a state or some other rule change or interest rate changes. I mean, it takes a while to affect the economy, and I don't know if that's enough time, you know, for us to measure that a Chinese customer changed their orders, you know, based on the VAT. I think that takes longer term to take hold in the economy. We're going to get orders from Chinese customers based on them having orders from their customers to build modules, build cars, or whatever, and that's not likely to change in four weeks of ad changing.

Okay. Thank you.

Thank you. We will now take our next question from Mark Delany from Goldman Sachs.

Yes, good morning. Thanks for taking the questions. First question was on operating expenses, which was pointed out, came in at the low end or just below guidance. Can you help us better understand to what extent those are structural cost takeouts that helped the better performance on cost or more timing or other temporal factors?

Sure. So, I mean, we've done what I consider to be a very good job in managing OpEx over the last several quarters. We've essentially beat significantly on OpEx in both September and December and came in at the low end of guidance here in the current quarter. So we're managing the operations very tightly given the environment that we're facing. And as the environment improves in the second half, if it improves, we will have investments to make in the business that will have those dollars go up. So we're holding OpEx flat at the midpoint of guidance in the current quarter. And, you know, that's pretty tight control. And, you know, again, would expect that OpEx will increase over time as we need to invest in the business to drive the long-term health at 40% plus operating margin goals that we have.

That's helpful. There's a lot of discussion on the call about the distribution business. I was hoping maybe to pivot a little bit and better understand some of the trends in the direct business that came over from microsemi acquisition. I believe servers and storage were markets that were served on an OEM direct basis. Can you help us understand how bookings and market share is trending in those areas? I think cross-selling the full portfolio was part of the strategy. How successful has that been? Thank you.

So, you know, there is weakness in some of those markets, as you have seen reported by other players as well. I don't think there's anything particular about bookings that would give us any insight there. In terms of the cross-selling, those customers have given us access for other solutions that classic Microchip had, and we're having good progress in discussions on how those can be incorporated into next-generation designs using Microchip classic solutions that surround some of the storage and other networking solutions that Microsemi brought. So the customer access has been extremely useful to take solutions that are necessary in the market, but we did not have as good customer access as Microchip standalone.

Thank you. We will now move on to our next question. It comes from Christopher Rowland from Sasukina International Group.

Sasukohana. Yes. One for Eric and then one for Steve. I guess, Eric, the $7 million underutilization, is there a level of company utilizations which you deem underutilized? And then also if you could talk about where utilizations are now and your inventory levels and if you have plans to bring them down. Thanks.

Okay, so really the underutilization is looked at on a factory-by-factory basis, based on kind of historical norms, so there isn't kind of a one-size-fits-all for that. We've got our three large fabs, three large assembly and tests that Microchip Classic has had historically, and then a bunch of smaller factories that have come through the micro-semi-acquisition, so it's kind of a case-by-case scenario that we look at that. and we don't break out a specific capacity utilization percentage. We just haven't done that historically, but we've got lots of capacity in place, and so we're well poised to be able to respond to growth as it comes in the future with pretty low CapEx, so that's a good thing. The second piece of your question was what?

It was internal inventories, and do you guys have a plan to work that down? How do you feel about that level?

Okay, so inventory was up five days in the quarter to 128. We've kind of had a target of 115 to 120 that we've talked about. So inventory is on the higher end, but I think it is prudent for us to hold that level of inventory given the fact that the distribution inventory has come down and customers are managing their own inventory quite conservatively. We believe, again, we don't get real-time reports from them. So it allows us to respond quickly in this uncertain environment where customers are needing to respond quickly when they get demand because they're not building the forecast, as Steve kind of described before. So longer term, our goal would be to get the inventory down to 120 days or less, but that's not the environment that we're facing right now.

A little extra inventory at this part of the cycle also prevents CapEx expenses on the other side of the cycle. So these are products with very long lives. There is little to no obsolescence risk. And so it does help from an overall cycle standpoint to have some inventory investment that can then defray capex spending on the other side of the cycle.

I would say also that our inventory is a lot lower than some of the large other analog players' inventory I have heard about. So, you know, while our target is 115 to 120, you would expect that this part of the cycle, when you're at the near bottom of the cycle, the inventory to be higher than the higher end of that. And yet, I think when I compare it, our inventory is lower than a lot of other players.

Many are 150-ish. Yep, that is fair.

And then, Steve, for you, If a trade deal was reached, would you still view the return of business as a potential bonanza, or are you more tempered here? Is there something that makes you more tempered? Just as these negotiations, it seems like even if we think something's finalized, they may not be.

I think having seen the yo-yo sentiment on On the trade talks, I would rather, you know, wait for the talks to conclude, then analyze what that finality is, whether it ends up at, you know, 10 percent duty or something higher than that, or goes all the way to zero, and have a chance to understand our customers' and distributors' reaction, you know, through our salespeople and talking to some directly. to really make an informed opinion rather than just throw something out. Yeah, that's fair. Thanks, guys.

Thank you. We will now take our next question from Craig Hattenbach from Morgan Stanley. Please go ahead. Your line is open.

Thanks. I understand all the focus on China in terms of what's happening from a macro, but was hoping, Steve, you can talk about you know, trends that you're seeing in Europe and the United States as well?

Well, you know, trends in, you know, US and Europe are really not that great either. A lot of US customers are impacted because of the same trade issues. Industrial customers build a lot of their products in China and, you know, are having to pay the tariff costs, which are currently 10% going to 25%. So our industrial business in the U.S. is impacted. Our consumer business, which is in the consumer appliance area, is impacted. The automotive business is impacted, not because of tariffs, but I think the automotive in general, automotive production is down in all three geographies.

Well, China is weak, too, and so China was a big export for European automotive.

Yes. So go ahead, comment on Europe.

I was going to go there. So I think Europe is seeing some of those headwinds that are – none of these are confined to just one geography. There is an interconnection between how global economies play. And so, for example, on the European carmakers, especially the luxury carmakers, they've had significant declines because the China market has been very weak for them. And that ripples through into some of the lower – or in recent times, lower GDPs coming through some of the European economies. And many of them, like Germany, are highly export-oriented and affected by any impact in other regions of the world. And so there is a continued uncertainty and weakness that expands beyond just China and the U.S., but in part driven by what's happening in these economies.

Got it. And just a follow-up question on the commentary of inventory, the expectation that you think it'll be to run down again in the June quarter. Do you think that the customers or distributors will be reaching kind of limits of how far they will take it down, or if things remained uncertain directionally, you think it would still go lower in terms of their inventory management?

I think distributors will assess what the sales out is. And if the sales out is decreasing because of whatever, then they will continue to draw down inventory. If they expect that sales out is increasing, then they would start to grow inventories to serve that sales out. So it's not that the inventory is changing that much in months of inventory. It's mostly a multiple of really what their expectation of sales out is. And many of the Chinese distributors, their sales out has been much lower in December and March quarters, a lot of it driven by trade issues because their end customers couldn't sell the product given the duties.

Got it. Appreciate your call.

Thank you. As there are no further questions at this time, I would like to hand the call back over to you, Ms. Sankey, for any additional closing remarks.

Well, we want to thank you. There was a very large participation on this call compared to what we have had in the last several quarters. We got lots of very, very good questions from investors and analysts, and thank you for giving us a chance to explain our views on U.S.-China trade, where the things are, how the business is. And we'll see some of you as we get on the road to various conferences this quarter. Thank you very much.

This will conclude today's conference. Thank you all for your participation. You may now disconnect.