Microchip Technology Incorporated

Good day everyone and welcome to this Microchips third quarter fiscal 2020 financial results conference call. As a reminder, today's call is being recorded. At this time, I would like to turn the call over to Mr. Eric Bjornholt, Chief Financial Officer. Sir, please begin.

Thank you and good afternoon everyone. During the course of this conference call, we will be making projections and other forward-looking statements regarding the 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 today as well as our recent filings with the SEC that identify important risk factors that may impact Microchips business and results of operations. In attendance with me today are Steve Sanghi, Microchips Chairman and CEO, and Ganesh Mourthy, Microchips President and COO. I will comment on our third quarter fiscal year 2020 financial performance and Stephen Ganesh will then give their comments on the results and discuss the current business environment as well as our guidance. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and in 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 .microchip.com which we believe you will find useful when comparing our GAAP and non-GAAP results. We have also posted a summary of our outstanding debt and our leverage metrics on our website. I want to remind investors that during the June quarter of 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. As discussed in previous earnings conference call we continue to track and measure our performance internally based on direct revenue plus distribution sell through activity and each quarter we will provide a metric for this called end market demand in our earnings release. Therefore, along with our GAAP and non-GAAP 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 based on end market demand. End market demand in the December 2019 quarter was $1.324 billion. End market demand was about $36.1 million more than our GAAP revenue in the December 2019 quarter. 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 as described in our press release. Net sales in the December quarter were $1.287 billion which was down .76% sequentially and near the high end of our updated revenue guidance provided on January 6, 2020. We have posted a summary of our GAAP net sales and end market demand by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were 61.5%. Operating expenses were at 26.4%. And operating income was .1% and above the high end of our guidance. Non-GAAP net income was $340.8 million. Non-GAAP earnings per diluted share was $1.32 which was above the high end of our last provided non-GAAP EPS guidance from December 3, 2019 of $1.30. On a GAAP basis, gross margins were 61% and include the impact of $5.7 million of share based compensation expense. Total operating expenses were $654.3 million and include acquisition and tangible amortization of $248.7 million, special charges of $17.8 million, $10.9 million of acquisition related and other costs and share based compensation of $37.8 million. The GAAP net income was $311.1 million or $1.20 per diluted share. Our December quarter GAAP tax benefit was significantly positively impacted by the tax benefit related to the intragroup transfer of certain intellectual property rights. The non-GAAP cash tax rate was 6% in the December quarter. We expect our non-GAAP cash tax rate for fiscal 20 to be about 6%, exclusive of any transition tax, any potential tax associated with the restructuring of the micro semi operations and the microchips 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 US 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 $245 million and will be paid over the next six years. We have posted a schedule of our projected transition tax payments on the investor relations page of our website. Our inventory balance at December 31, 2019 was $708.8 million. We had 129 days of inventory at the end of the December quarter, down two days from the prior quarter's level. Inventory at our distributors in the December quarter were at 28 days compared to 30 days at the end of September. We've only had one quarter in the past 15 years, which was Q3 of fiscal year 2013, where our days of inventory at distribution have been at lower than the current levels. The cash flow from operating activities was $395.5 million in the December quarter. As of December 31, the consolidated cash and total investment position was $402.3 million. We paid down $257 million of total debt in the December quarter, and the net debt on the balance sheet was reduced by $254.2 million. Over the last six full quarters, since we closed the micro-semi acquisition and incurred over $8 billion in debt to do so, we have paid down $1.986 billion of the debt and continue to allocate substantially all of our excess cash generation beyond dividends to aggressively bring down this debt. We have accomplished this despite the adverse macro and market conditions during most of this period, which we feel is a testimony to the cash generation capabilities of our business. We expect our debt levels to reduce significantly over the next several years. Our adjusted EBITDA in the December quarter was $503.4 million, and our trailing 12-month adjusted EBITDA was $2.125 billion. Our net debt to adjusted EBITDA, excluding a very long-dated convertible debt that matures in 2037 and is more equity-like in nature, was $4.58 at December 31, 2019. Our dividend payment in the December quarter was $87.7 million. Capital expenditures were $14.1 million in the December 2019 quarter. We expect between $20 million and $25 million in capital spending in the March quarter, and overall capital expenditures for fiscal 2020 to be between $76 million and $81 million. We continue to add capital to support the growth of our production capabilities for new products and technologies, and to bring in-house more of the assembly and test operations that are currently outsourced. We expect 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. Appreciation expense in the December quarter was $41.4 million. I will now turn it over to Ganesh to give his comments on the performance of the business in the December quarter. Ganesh?

Thank you, Eric, and good afternoon, everyone. Before I get started, I'd like to remind you 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 .1% as compared to the September quarter. We continue to introduce a steady stream of innovative new microcontrollers, including next generation Bluetooth 5.0 dual mode audio solutions, production ready open source tools for managing our Adaptech smart storage offerings, and industry support for development of the Open Compute Projects Accelerator infrastructure through our PCIe switches. Microcontrollers represented .6% of our end market demand in the December quarter. Moving to analog, our analog business was sequentially down .6% as compared to the September quarter. During the quarter, we continue to introduce a steady stream of innovative analog products, including the IEEE 802.3 BT compliant power over ethernet injectors and mid spans that enable up to 90 watts of power without changing switches or cables. Analog represented .1% of our end market demand in the December quarter. Our FPGA business was sequentially flat as compared to the September quarter. During the quarter, we introduced the radiation tolerant Polar Fire FPGA for space and other high reliability applications, as well as the Early Access Program for the Polar Fire System on Chip FPGA, offering the world's first hardened, real-time, Linux capable RISC-V based microprocessor subsystem. Design wins for the Polar Fire family continue to grow strongly, and we remain optimistic about the prospects for this product family. FPGA represented .9% of our end market demand in the December quarter. Our licensing, memory and other product line, which we refer to as LMO, was sequentially down .7% as compared to the September quarter. During the quarter, we delivered a new family of electrically erasable RAM products, providing cost effective alternatives to non-volatile RAM solutions at a number of memory densities. LMO represented .3% of our end market demand in the December quarter. An update regarding coronavirus and what we're seeing. First, all our employees are safe, and that remains our highest priority. We implemented travel bans in and out of China, Hong Kong and Taiwan two weeks ago. We also implemented self-quarantine requirements for anyone who may have traveled to these countries, mandatory medical assessment and clearance for anyone who may have symptoms, a screening questionnaire for all external visitors to any microchip facility, and common sense preventive sanitizing steps on a continuous basis in all our facilities worldwide. As you well know, most provinces in China have extended the Chinese New Year holidays to February 9th. Hubei province, where Wuhan is located, has extended the holidays to February 13th. Our manufacturing footprint in China is small, and we expect little impact to our operations from this extension. Also, at this time, we do not anticipate any significant supply chain issues for materials sourced from China. Some of our customers could be affected by the extended Chinese New Year holidays. It is too early to determine what impact there may be, as most are not yet back from the extended holidays. Because Chinese New Year this year was early in the quarter, there is more time for our customers to catch up lost production within the quarter. We also believe there is slack in manufacturing capacity, which can be of help while recovering lost production. These outbreaks are unpredictable, and there may yet be other twists and turns to come in the days ahead. We continue to process the news daily, as well as monitor information from the Center for Disease Control and the World Health Organization. We will adapt our response as needed and focus on the things that we can control. Finally, over the last few months, we started to share six megatrends that we believe provide significant growth opportunities for microchip over the next five to ten years, and I'd like to summarize them. First, the 5G infrastructure rollout, which is just getting started and has a decade ahead of it. Each prior generation of wireless infrastructure deployment, 2G, 3G, and 4G, lasted for about ten years. The Internet of Things, comprised of smart, connected, and secure end nodes, is picking up steam, especially for industrial IoT, where there are compelling business models for customers to make money, save money, and mitigate risk. Third, for data centers, the data center demand, the store and process data is exploding. As data is created at a hyper-exponential rate. To put this in perspective, estimates are that 90% of the world's data was created in just the last two years, and that trend continues, unabated. Fourth, electric and hybrid vehicles are riding a wave of consumer and regulatory forces, which are driving substantial investment in technology and capacity. Fifth is the advanced driver assist, which is already a growth application, and its proliferation to more car models, and its natural progression to increasing levels of autonomous driving. Sixth is finally the artificial intelligence and machine learning, which we see as another explosive growth area, not only in the cloud, but even more so at the edge. These megatrends cut across the diverse end markets we serve, and guide our product development priorities. We believe these megatrends, in conjunction with our total system solutions -to-market approach, will provide key opportunities for organic growth in the coming years. With that, let me pass it to Steve for some comments about our business and our guidance going forward. Steve?

Thank you, Ganesh, and good afternoon, everyone. Today, I would like to first reflect on the results of the fiscal third quarter of 2020. I will then provide guidance for the fiscal fourth quarter of 2020. Our December quarter was an interesting one, in which we revised the midpoint of our guidance upwards twice, once on December 3, 2019, prior to the Credit Suisse Conference, and second on January 6, 2020, prior to JPMorgan Conference. Our final December quarter gap net sales were on the high end of our latest guidance, and came in at $1.287 billion, down .76% sequentially. Our end market demand based on sell-through was $36 million higher than gap sales, which we believe shows that the channel was continuing to manage their working capital conservatively by reducing inventory due to uncertainty. December was the seventh consecutive quarter where our sell-through revenue was higher than our sell-in revenue. Our consolidated non-gap gross margin of .5% was just above the high end of our guidance. Our consolidated non-gap operating margin of .1% was also just above the high end of our guidance. Our consolidated non-gap earnings per share was $1.32, which was also above the high end of our revised guidance. So overall, December quarter turned out to be a lot better than originally guided. On non-gap basis, this was also our 117th consecutive profitable quarter. In the December quarter, we paid down $257 million of our debt. Our total debt payment since the end of June 2018 has been about $2 billion. The pace of debt payments has also been strong, despite the weak and uncertain business conditions underlining the strong cash generation characteristics of our business, as well as our active efforts to continue to squeeze working capital efficiencies. Now, before I provide you guidance for the March quarter, let me comment on some of the inflection points that we saw during the December quarter. Our December quarter bookings were up double-digit percentage over the September quarter bookings that resulted in our starting backlog for March quarter to be up double-digit percentage over the starting backlog for the December quarter. Our starting backlog was up in each of the geographies of North America, Europe, and Asia. From an end-market perspective, we saw strength in data centers and start of recovery in industrial and automotive. Continuing on the inflection points, the -to-bill ratio for December quarter was well above 1 after multiple quarters of -to-bill being below 1. Our distributor inventory at the end of September was already at low level and lowest in 15 years, except one quarter in fiscal year 13. In December quarter, the distribution inventory went even lower. During December quarter, we saw increased level of customer-requested pull-ins, many of which required factory expedites. Seeing these multiple signs of inflection point, we called the December quarter to be a bottom for microchip for this cycle, barring any negative developments on the US-China trade front or the impact of coronavirus. Now I turn to guidance for March quarter. The backlog for March quarter that started out quite strong continued to fill in during the month of January. Taking all these factors into consideration and after rolling up revenue expectations from sales regions as well as business units, we expect gap net sales based on selling revenue recognition for our products to be up between 2% to 9% sequentially in the March 2020 quarter. The midpoint of our guidance for the March 2020 quarter reflects what we believe our business can deliver, assuming no extraordinary events. However, the wider than normal guidance range is to help account for the uncertainty associated with the evolving coronavirus situation. We are still in the early days of how this situation is playing out. We have no way to model how the rest of the quarter will play out for the coronavirus situation and what the consequent business impact may be. But we believe that our guidance range incorporates our best judgment for the possible scenarios. Regarding capex, we expect to finish fiscal year 2020 with a capex of between $76 million and $81 million, a significant reduction from fiscal year 2019 capex of $229 million. This is consistent with what we have said before, that our capex is divided between growth capital, maintenance capital, and new products and technology capital. In a fiscal year like 2020 in which our net sales declined, the growth capital, which is the largest portion of the capex, declines to virtually nothing and therefore the total capex declines significantly. For December quarter, it should be for March quarter, for March quarter we expect our non-GAP gross margin to be between .5% and .9% of sales. We expect non-GAP operating expenses to be between 25% and .2% of sales. We expect non-GAP operating profit percentage to be between .3% and .9% of sales. And we expect our non-GAP earnings per share to be between $1.35 per share to $1.51 per share. 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-GAP basis except for net sales, which will be on a GAP basis. We believe that non-GAP results provide more meaningful comparison to prior quarters and we request that the analysts continue to report their non-GAP estimates to First Call. With this operator, will you please hold for questions?

Yes, sir. Due to time constraints, please try to limit your questions to one. If there is time, follow-up questions will be addressed. If you would like to ask a question, please signal by pressing star one on your telephone keypad. If you are using a speakerphone, please make sure that your mute function is turned off to allow your signal to reach our equipment. Again, please press star one to ask a question. And our first question will come from Craig Hittenbach with Morgan Stanley.

Yes, thank you. Steve, just a question on the expedite activity. Can you just maybe put that into context with currently kind of where your lead times are and things you're looking to do to maybe kind of address that as business improves?

So, you know, during this down cycle, we built a substantial amount of inventory that is held in the die bank. So when an order comes in, it's really taking the die from the die bank and processing it through, which can be anywhere to, you know, as low as three weeks to as much as six, seven weeks, depending on where it has to go inside or outside or what difficult package or assembly test it might be. What we are finding is that, you know, customers stationed a fair amount of backlog just outside the corridor. And then when they need the product, they expedite into the corridor. This way they kind of have both choices. They could not take it in the corridor and leave it out or push it out further if they need it, ask us to pull it in. We've been seeing this strange phenomenon now, not only this corridor, we've been seeing it for some time, but it really became even more accentuated. So there's a fair amount of backlog sitting outside the corridor in April and customers are expediting it into the corridor. Does that answer your question? Yes, thank you.

Thank you. Our next question comes from the Zek Arria with Bank of America.

Thanks for taking my question. Steve, I'm curious, what are you expecting your distributors to do in the March quarter? I think you're giving a net sales outlook, so any color on sell-in and sell-out trends would be helpful. And in general, what are they saying to you? Why are they taking down microchip inventory to such low levels? Because it's such an outlier and we don't hear of any of your other peers, their inventories being taken down to similarly low levels.

Well, I don't really know if as we speak distributors are taking down inventory further, but they have in the last seven quarters or so through December. We don't really have a guidance for the March quarter on sell-through. We can't really provide both ends of the guidance. It's just too much work. So we're providing the sell-in guidance that we have given you. And in the December quarter, when we provided the guidance, we expected that distributors will reverse the trend and will start to build some inventory towards normalization. It did not happen in December. We're expecting it would happen again in March, but there's no guarantee distributors will do what they will do. I think part of the reason is for 30 years, the culture at microchip, business units, sales organization, up and down through the change with the distribution, our conversations with the distributors are winning designs, creating a large funnel, and pulling those designs to production and creating sales out. That's how we pay our salespeople. That's how we pay our business units. That's how all the bonuses are structured. And we don't really have a whole lot of conversations regarding what we give into the distribution. That has always been less important to us because we manage our business based on sell-through. So distributors take the inventory what they want to run their business and based on getting returns for their business. In contrast, I think we see many of our peers and competitors are more focused on selling revenue recognition where they may make deals to put more product into distribution and arresting the fall of the inventory that way.

I would add one more thing. We've always had low lead times on our products, and I think that gives distributors an opportunity to run the inventory to whatever the lowest level they think they can get away with while continuing to focus on sell-through. So short lead times give them the opportunity to carry less inventory as well.

I would also add that sometimes we charge expedite charges for expediting the product. Sometimes expedite charges require us to spend weekends, pay overtime, or pay for the product or pay expedite for shipping, going through hand-carry products and all sorts of charging can incur. We often pass those to the customers. It doesn't move the needle in terms of revenue, but if somebody wants to expedite the parts, it's not always free.

But you're not assuming any restocking benefit, any major restocking benefit in March?

We have no way to model it.

Okay,

thank you.

Thank you. Our next question comes from Gary Mubly with Wells Pargo.

Hey guys, thanks for taking my question. I wanted to ask about your relative performance in the microcontroller segment. It looks like for the full calendar year 2019 you outperformed the microcontroller market in terms of sales growth, if you believe in the SAA sales metrics. But in the second half of the year, it looks like in particular in the fourth calendar quarter, it looks like you might have underperformed the market. To what should we attribute that to? Is it just sort of a short-term disruption or anything to look into there long-term?

I'm not sure what data it is that you're referring to. So we were sequentially down .1% on microcontrollers September to December. If you look at the -of-year numbers, where on microcontrollers we're down about 5, .5% somewhere in that neighborhood. The story is not written. We don't see any annualized numbers that are out yet. Maybe SIA has some early numbers. We'll get that by March, April, and we'll at the next conference call have the typical Gartner 2019 numbers. There's nothing in our business that has any indication that something was better in the first half and got worse in the second half. I think if

you look at the quarter results sequentially and compare it to a very large competitor, I think we substantially outgrew them.

Either on quarter or by -over-year. Understood. Thank you,

guys. Thank you. Our next question comes from Chris Casso with Raymond James.

Yes, thank you. Good evening. A question with regard to gross margins and assuming we have started recovery, we'd hope to see some gross margin improvement as a result. Perhaps you could answer it in terms of production utilization levels with some of the better order rates. Has that caused you to change any production levels? And then from a cost standpoint, as we go forward, I think you still have some integration benefits still to come. Could you help to quantify those and when they kick in and how that helps leverage if indeed we're in a recovery?

Sure. This is Eric. In the December quarter, we incurred about a $16 million factory utilization charge that was reflected in our cost of sales. That was up about $7 million quarter on quarter. We expect that charge to be lower in the March quarter, particularly in our back-end assembly and test operation. We're running the factories higher. Steve talked about in an earlier response that our die bank is pretty healthy. But back-end operations, we've been draining finished goods and looking to run the factories harder this quarter, which should help in the gross margin and the guidance that we're giving. So that's a piece of it. We continue to run our factories as efficiently as we can. We're continuing to invest to bring some of the outsourced assembly and test in-house at a moderate rate. And all those things are going to benefit gross margin long-term and lead us to our long-term guidance, which is to get to about 63% non-GAAP gross margins as a long-term model versus the .7% we're guiding to at the midpoint of guidance for the current quarter.

Thank you. All right. Thank you. Our next question will come from William Stein with SunTrust, Robinson Humphrey.

Great. Similar topic, only not just gross on operating as well. Maybe, Eric, you can take a step back and frame up relative to where you are now and contemplating your longer-term goals. What's the path to getting there? Is it just a modest amount of revenue recovery? Is mixed part of the equation? Is there still restructuring for micro-semi? I know you're still bringing capacity in-house. It seems to us that it seems fairly likely that you'll be able to exceed these long-term targets given the revenue level that you're achieving today relative to what the next peak could be, for example. Thank you.

Okay. So, you know, I think I've kind of touched on gross margins so far, and we've been told by others that they think that's a conservative forecast, but, you know, we're not going to update that model until we get to the target. And on OPEX, you know, we're guiding the current quarter to be between 25% and .2% of sales, and our long-term model is 22.5%. I would say we have been pretty conservative in how we've been managing the business during this current cycle. And with that, you know, we need to make sure that we're making the appropriate investment, whether it's in R&D, support functions, technical sales, outreach to the customers to make sure we drive the long-term health of the business. And, you know, some of our variable compensation programs, too, will kick back in as revenue grows. So, you know, we have confidence in the long-term model, which is just above 40% operating margins, and we've got a ways to go when we're guiding the current quarter at the midpoint of guidance to about 36.1%. So I'd say be patient. We do need revenue growth to get there, but I think we're well positioned with the investments that we've made to drive to higher levels than what we're seeing today.

Thank you. Thank you. Again, to ask a question, please press star 1 on your telephone keypad. Our next question comes from Embrish Sirvatse with BMO Financial Group.

Hi. Thank you very much, Steve. I was wondering if you could give us a little bit more detail on the source of strength in bookings, whether in markets or geos. I believe last earnings call you had indicated that China was stronger in terms of geos, so any update on that front would be helpful. Thank you.

So I think from an in-market perspective, we said that data center has been strong all along, and we are seeing a start of a recovery in the industrial market and the automotive market. The communication market remains weak and the appliance market remains weak, and aerospace and defenses can always lumpy and it's hard to call. From a geographical perspective, yes, we saw strength in the China market last quarter, but you would see the weakness in China market this quarter driven by the Lunar New Year, and nobody knows what's going to happen with the coronavirus. So this quarter you would see stronger U.S. and Europe and weaker China. Okay. Thank you.

Thank you. Our next question comes from Rajah Gill with Needham and Company.

Yes, thank you. If we think about the security in the business now that we have some time, how do we think about it coming out of the pandemic and the impact of the coronavirus? I'm just trying to get a sense of the seasonality of the acquisitions post the bottom of the cycle.

I think, Raji, seasonality is still hard to measure with all of the acquisitions that we have completed. The events that have happened in the last couple of years, all the trade tension situations, general economic conditions, now the coronavirus, prior to that we had a significant inventory correction event on especially the -semi-inventory. We really haven't finished enough quarters in a healthy business environment to pick up to peg a seasonality, so I would think it still remains difficult.

Thank you. Our next question will come from Craig Ellis with B. Riley, FBR.

Yeah, thanks for taking the question, and congratulations on the good execution. I wanted to go back to some of the comments around the performance on debt reduction, which over the last six quarters at almost $2 billion is very strong. The question is perhaps both to you, Eric, and you, Steve, as you look ahead and given the trajectory you're on, it seems like you could be at a 3x net debt to EBITDA level in as soon as four quarters or so. How do you think about deploying the cash to create value for shareholders when you get to that level? Would a vast majority of available cash still go to debt pay down or would you start looking at other things and what would the priorities be at that point? Thank you.

Let me take that and Eric can add to it. First of all, I don't think – I have looked at a model which will take the leverage down to 3x in four quarters. That seems awfully aggressive, although I don't know what assumption you're making in the revenue growth of the recovery. It will largely depend on that. But basically, yes, we need to bring the debt leverage below a three handle, kind of have it somewhere in the high twos. Once we get there, then we'll still be generating somewhere of the order of well over a billion dollars of free cash per quarter. We need to figure out what we do. We haven't been in that situation in quite a long time. You have obvious choices. You could pay down more debt and bring leverage down further. But more preferably, you could increase the dividend. You can start a buyback program. And that all assuming that there is not a further M&A possibility. We have said before that we think by the time we come up for air, majority of the companies or smaller companies that we would like to buy probably would have been bought. And there isn't as much more opportunity there. But there could be one more possibly. But secondly, we think that the remaining assets are very expensive. There is a large amount of M&A bid on them already because every small company is really on sale. And we don't really pay that kind of multiple that we have seen paid in the recent deals. You know, Cypress as well as some other deals, those multiples were way, way too high for our taste. So if we cannot find a reasonable other acquisition, then our focus will switch to other uses of cash including higher dividend, more stock buyback and possibly some more debt pay down.

I think what I'm going to add to that is just kind of a short-term view here as well because I know we'll get this question a lot is what do we expect for debt pay down in the current quarter, the March quarter? And really we expect that to be somewhere between $225 million and $250 million. Last quarter was $257 million. But our starting accounts receivable balance is lower just because revenue was down last quarter. So really to get some tailwinds behind us from a revenue perspective, as the top line grows, I think EBITDA will start growing nicely and that's going to help with the leverage metrics coming down. But it kind of depends on what the environment is going to be over the course of the next year. If we were able to get to that three times number that you mentioned, I think we'd need some pretty good revenue growth.

Got it. Thanks, guys.

Thank you. Again, to ask a question, please press star one. And our next question comes from Chris Danily with Citi.

Thanks, Steve. Steve, you mentioned that some customers were expediting orders out of the June quarter into this quarter. So do you think that the June quarter could be at risk of a little bit of a disappointment, like we're robbing from the June quarter to pay the March quarter? And then further to that, you talked a little bit about lead times. Do you think that there is risk of extended lead times as the expediting continues?

The lead times are not at risk short term because we have firm order inventory and there's a firm order capacity slack in the system since the revenues are down year over year. The backlog bottomed out some time ago and the total extended backlog is really growing nicely. So when people are taking backlog from June quarter moving into March quarter, that's not putting June quarter at risk. There is a higher and higher backlog. The overall backlog is growing. Book to bill was strongly positive, so it put a very large amount of total backlog on the system.

Chris, we had expedites in the December quarter where people had placed backlog in the March quarter and pulled it in. You're seeing a stronger March quarter despite that. So as you go into an upward trend in the business, it is not unnatural. We've seen it in other cycles where customers start to see their business recovering and wanting to have products sooner than they had originally

planned for. Yeah, in addition to those orders that are being pulled in by customers requesting them into the current quarter, we're also receiving orders that are just within our normal published lead times, and that can create some expedite activity also. Often with short lead times, yeah. And

Chris, this phenomenon is not a new one. We have seen it before in prior cycles, and we've been seeing it in this cycle. I kind of call it have your cake and eat it too. So customers will place an order where they are still in the cancellation or push-out window, and if they don't want it, if their business is not strong, they can push it out or leave it out. But if their business is stronger than they need it, then they ask us to expedite it, kind of have their cake and eat it too. It's not a new phenomenon, but we're seeing it quite a centuator right now, and that's why I called it out.

Okay, thanks

a lot, guys. Yeah.

Thank you. Our next question comes from Horshkumar with Piper Sandler.

Yeah, hey, Steve. I was curious with the sudden pickup in China. Are you aware of any areas of shortages, not just in your business but in the industry overall?

I'm not seeing any shortages. I mean, China right now is shut down, so you really wouldn't get any data. They were shut down for the Chinese New Year. They're just about coming back, but most provinces have extended it until February 9th. But prior to going for the Chinese New Year, no, we were not experiencing any shortages.

Thanks, guys.

Thank you. Our next question comes from Christopher Rowland with Susquehanna International Group.

Thanks for the question. Eric perhaps asked another way, if you could talk about Atmel and Microsemi bringing them in-house, remind us kind of where we are on front end and back end, and then also the gross margin benefits that you would get there. Also, how you're able to do this in such a small capex envelope as well. Thanks.

Okay, so there's a couple pieces to that. So we did tighten our investment criteria in terms of making those capital investments over the course of the last year when business was difficult. And so we shortened the window, the payback window from a cash flow perspective from two years down to a year. And we really haven't changed that at this point in time. So that's one of the reasons it's been lower. And this is very detailed work, so it's package by package, part by part. And none of these investments are needle movers, but in aggregate, they do help gross margin slowly over time. So I think that's responsive to your question, unless these guys have anything else they'd like to add. I think to give

them the percentage we have inside and outside for FAB assembly and test.

Yeah, so FAB is 39% internal, assembly is 45%, and test is 54%.

That's useful. Thank you.

And we would expect those assembly and test percentages to increase over time as we gradually make these investments.

Thank you. Thanks, Eric. Our next question will come from Harland Sir with James and Morgan.

Good afternoon, guys. Thanks for taking my question, and congrats on the strong start to 2020. I know lead times are still pretty short, but given the strong bookings trends coming off of the depressed September quarter, strong bookings thus far here in the March quarter, and maybe some backlog build for June, we're not really looking at the potential issues for coronavirus. But do you think you're setting up, given the backlog that you're seeing, at least for a seasonal June quarter, which is typically one of your seasonally strongest quarters?

Well, you know, we are not giving guidance or commenting on the June quarter, especially in the light of significant uncertainty because of the coronavirus. Remove those uncertainties, and let's say there's no impact and business comes back and the virus is contained rapidly and all that, then your assessment for the June quarter would be correct.

Yeah, and I think I would just add that we are very well positioned from a capacity perspective to be able to respond quickly to upside if that develops.

Got it. And then I guess on that note, you know, back in early January when you did your update, you know, it didn't sound like you were going to be increasing front-end utilization near term just because you guys have pretty substantial dive banks. But let's say as the March quarter progresses and the backlog, you know, is indicating the potential for normal seasonal growth for June and September, I assume the team would start to ramp capacity utilization say in the back half of this quarter. Is that kind of the right way to think about the potential timing of utilization going up?

So this is Steve. Let me take that. I think let's start from the back end first and we'll come to the front end. The back end utilization is going up as we speak, and as we ramp, it will continue to go up because we depleted the finished goods, and when the orders are strong, we got to, you know, take the dive bank and finish them. So that will continue to have a positive effect on gross margin pretty much starting now. When you look at the front end, the front end still has a firm on a dive bank, but there also you got to separate it on the production we do inside versus the production we buy from outside. The inventory on the products we buy from outside was depleted to a lower level, and there we are increasing the buy, you know, as we speak, but there's not a utilization impact of that because that was being done outside. What we were doing inside, that's where we had the substantial dive bank, and I think it will, you know, at least take it, you know, a few more quarters before we have to start increasing the production in our fabs.

Got it. Okay, but then the lowering of the underutilization charges here in the March quarter is simply because you are filling out your packaging and test assembly utilization are going upward. Is that the primary driver for the lower underutilization charges?

Yes. Well, you know, there's always lots of moving parts mixed and all that, but yes, that is a new phenomenon where even in the December quarter we were depleting finished goods.

You know, we were,

the quarter back end utilization was lower than the September quarter, and the March quarter will be up significantly from the December quarter. I wanted to add one more comment on the question you asked regarding the June quarter seasonality, how it would be, and the comment was made that June quarter will at least be seasonal. I would say I hope that, you know, one of these quarters, current quarter as well as June quarter and September quarter are well above seasonal because the inventories are so low, and if I take any cues from any prior recoveries, whether it was from SARS or was it a recovery from 2009 cycle or any other cycle recovery, you know, usually you got two or three quarters of well above seasonal recovery that takes the business back to the old heights and then goes from there. So, you know, I like to think that any kind of forecast here becomes very conservative.

Yeah, that's a fair point, Steve. Thank you.

All right, thank you. Our next question will come from BJ Rakesh with Missy Securities.

I was wondering, as you look at your business, I was wondering if you could give some color by markets and markets, automotive, industrial, how you see that playing out to the rest of the year? Thanks.

So, as Steve mentioned, you know, we're starting to see automotive and industrial picking up from the bottom that they were at. They had pretty bad years in 2019, and our expectation is that, barring any outside events, as we go through 2020, both those end markets should see continued improvement.

And on the industrial and other end markets, do you see a similar trend in the back half or do you see a stronger first half year?

So, my comment was for both automotive and industrial. We've talked about data center. It was strong. It remains strong. We don't see anything that suggests it's different. You know, there may be some communication, you know, market changes that are driven by what happens with coronavirus. We don't know, but there is a large 5G cycle, investment cycle that's starting. And then as far as defense and aerospace, it tends to be pretty, you know, steady in how it goes. It remains steady with where it's at. And then the consumer cycle, you know, we have yet to see if we'll see some benefits. It needs further trade resolution for it to see any significant benefits, but nothing new to report on that on the consumer end of the market.

Very good. Thanks.

All right. Thank you. Our last question will come from John Siser with Credit Suisse Group.

Yeah, guys, thanks for letting me get in. I've been jumping around calls, so I apologize if this is a repeat. But, Steve, if you kind of look at the operating model for the business, historically you guys have always made good progress and then kind of taken a step back as you've made acquisitions to then kind of move forward again. I'm just kind of curious, if we go to an extended period where you're not sort of in the acquisition game, how should we be thinking about operating margin targets and incremental gross and op margins for the business over time? So,

John, you know, you're very correct that, you know, we make substantial progress in gross and operating margin after an acquisition. You know, and then when we do another acquisition, most times we're not buying businesses that are over 60% gross margin and 40% operating margin. So our overall company margin gross and operating drop, and then we, you know, work back upstate steps only to take a fall again when we buy the next acquisition. Now, if you make the assumption that for an extended period of time we were to not do another acquisition, then first thing that would happen is that we will reach our operating model. So our operating model, to remind everyone, is 63% gross margin and .5% operating expenses, leading to a .5% operating profit. So two ends of it, you know, first the gross margin. We're guiding .7% gross margin this quarter. That's 130 basis points away. If you just take the underutilization charge of 16 million, that pretty much gets you there, you know, almost. The second issue is the operating expense. So operating expense, you know, basically we're guiding 25 to 26.2, and there's a huge leverage there with the revenue increase. The current revenue is, I think, what, a couple hundred million dollars behind the past record,

you

know, in a very round number. So once you gain that, you know, you have a significant leverage where the operating expense comes down. Some leverage still remains in integration of micro-semi, you know, with all these go lives and all that that are happening, which will take another nine months. But once we get all that done, then you have achieved gross margin as well as the operating expense, and you have reached the model. Now if your question is, you know, where does the model go? Do we continue to go higher in gross margin and continue to go higher in operating margin? For that, you know, get in line and we'll talk about it when we get there.

That's helpful. And then just secondly on micro-semi, you know, with an acquisition you kind of made as the industry was going into a correction, and you're talking a little bit about kind of the expense leverage there. I'm just kind of curious from a revenue leverage. I mean, one of the things you guys have always done well as you bought these assets is go in and kind of apply a better pricing discipline to the business. Is there still more to go with the micro-semi acquisition, or has that mostly played out?

You know, first of all, I don't think we had the same pricing discipline issues in micro-semi as we did at Atmel. Micro-semi, just to remind you, was gross margins that were, you know, right around 60% when we did the acquisition. The product lines at micro-semi are extremely sticky products, and many of them have very long life cycles. And to that extent, you know, those margins will stay high. The product line revenues will stay high. Now, we have, in the time we have owned micro-semi, started to work on, so how are we going to take advantage of micro-semi's position in the end markets they were strong in, data center, communications, and aerospace and defense, to be able to sell a more complete portfolio? And that work is well underway. And reverse, how can we take micro-semi products into the end market that microchip was strong in prior to the acquisition, automotive, industrial, and home appliances? And that work is going in. Now, we have a six-, seven-quarter window where the environment has been weak. And as we emerge from a weak environment and we go into a more normal environment, all the hard work that has been done will begin to play itself out. And so I think there are revenues synergies yet to come. But in part, it's work to be done. And a lot of that is underway and has been for some time. But a lot of it has to come as the environment strengthens.

And, John, I think if you, you know, study some of the past cycles, I know you and other analysts are very good at, you know, studying the past analysts, you know, past cycles, what really happens is nobody believes the depth of the downturn. And the estimates always stay high and they get cut multiple times. In this cycle, the estimates probably have been cut four times. They're not only for microchip but for the industry and various other players. Could be more than four times. And then when the reverse happens, you know, the estimates always go higher, beat and raise, beat and raise, beat and raise for many quarters. I have seen this in prior cycles because nobody has the confidence to guess the revenue or guide the revenue to be higher than seasonal. And it continues for many quarters in the other direction. That's what I'm hoping for. But not guiding to.

All right, thank you. And at this time, there are no further questions in the queue. So I would like to turn the call back over to Mr. Steve Senge for any closing remarks.

Well, we want to thank everyone for attending this call. Thank you, everyone. We're going to have a little bit of a break. And we're going to about three different conferences, I think, this quarter. So we'll see some of you at those conferences. Thank you.

Thank you, ladies and gentlemen. This concludes today's teleconference. And you may now disconnect. Please enjoy the rest of your evening.