Microchip Technology Incorporated

Please stand by. We're about to begin. Good day, everyone, and welcome to Microchip's second quarter fiscal 2021 financial results. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Microchip's president and chief executive officer, Mr. Steve Senge. Please go ahead, sir.

Thank you, operator. Good afternoon, everyone. 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 or 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 Microchip's business and results of operations. In attendance with me today are Ganesh Murthy, Microchip's President and COO, and Eric Bjornhold, Microchip CFO. I will first comment on our CEO transition and board appointments. Eric will then comment on our second quarter financial performance, and Ganesh will then give his comments on the results. I will then discuss the current business environment as well as our guidance. We will then be available to respond to specific investor and analyst questions. So let me begin by commenting on the CEO transition announced today and the addition of board members. Today we announced that I will transition to an executive chair role effective March 1, 2021. Microchip's current president, Ganesh Murthy, will step into the role of president and CEO effective March 1, 2021. Ganesh will also join the board of directors effective January 4, 2021. I joined Microchip in February 1990 as senior vice president of operations and was promoted to president to lead this company in July 1990. Microchip then had sales of about $60 million and it was losing about $10 million per year. The main product line at that time was commodity EPROM, and the gross margin of the company was about 30%. The turnaround of the company was documented in my book, Driving Excellence, How the Aggregate System Turned Microchip from a Failing Company to a Market Leader. We took Microchip public in March of 1993, with annual sales of $89 million and a market capitalization of $85 million. In the last 27 years as a public company, Microchip's net sales grew to $5.2 billion and its market capitalization grew to approximately $30 billion. Today, Microchip produces industry-leading growth and operating margins. Since its IPO, Microchip's stock price has grown Approximately 20,000% excluding dividends, Microchip has also completed its 120th consecutive quarter of profitability on a non-GAAP basis. In the last 30 years, Microchip transformed from a small company focused on non-volatile memory products to an embedded solutions powerhouse with a broad and innovative range of solutions. as well as leadership positions in the industrial, data center, automotive, communications, consumer, and aerospace and defense markets. We have also been an industry consolidator, having acquired about 20 companies, including well-known industry names like Silicon Storage Technology, Standard Microsystems, Microwell, Atmel, and Microsemi. All of the acquired companies was successfully integrated into Microchip's business and created outstanding value for the stockholders of Microchip. Leading Microchip for the last 30 years has been the greatest privilege of my 42 years in the semiconductor industry. I turned 65 in July of this year. I often thought about transitioning to an executive chair role by that date, I discussed this with our board of directors as part of our succession planning process earlier this year, but no decision was made at that time. Then, given the unexpected COVID-19 pandemic, the board and I thought it was best to delay any transition so that it would not occur during a very turbulent and unpredictable time. I have now decided that the time is right to make this change. The overall decision was made easier given that Microchip has someone as qualified as Ganesh to assume the CEO role and given the strength of the rest of our management team. I have known Ganesh for 39 years since hiring him as a new college graduate at Intel in 1981. He has a demonstrated track record of success and a proven partnership over the last 19 years at Microchip makes him my logical successor. He is an energetic, articulate, and thoughtful leader who is widely respected amongst our customers, partners, suppliers, investors, and analysts, as well as the entire microchip employee base. Ganesh joined the microchip in 2001 and served as the vice president of multiple business units. In 2006, he was promoted to executive vice president with extended business unit and manufacturing responsibilities. and assumed the role of Chief Operating Officer in 2009. Ganesh has served as President and Chief Operating Officer from February 2016. Since then, Ganesh and I have jointly led Microchip. Now, starting March 1, 2021, Ganesh will become the President and CEO of Microchip. I will remain as an Executive Chairman. I will work with Ganesh to continue to drive the strategic direction of this company and maintain a strong culture and succession planning that we have developed here. We also announced today that starting January 4, 2021, Karen Rapp will join the Board of Directors of Microchip and will also join its audit committee. Karen is no stranger to the technology investment community. She's currently the CFO of National Instruments. She also serves on the Board of Plexus, which is a contract manufacturer. Karen brings with her extensive large company, large public company experience, and significant leadership accomplishments in financial management, financial governance, information technology, and cybersecurity. We are all very pleased to have Karen join our board. I will now pass this call to Eric Bionhold, and we will cover the earnings part of this conference call. Eric?

Thanks, Steve, and good afternoon, everyone. 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 when comparing our GAAP and non-GAAP results. We have posted a summary of our outstanding debt and our leverage metrics on our website. We will now go through some of the operating results, including net sales, gross margin, and operating expenses. Other than net sales, 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 September quarter were $1.31 billion, which was flat sequentially and above the high end of our narrow guidance range from September 9, 2020, when net sales were expected to be down between 2% and 6% sequentially. We have posted a summary of our gap net sales as well as end market demand by product line and geography on our website for your reference. On an on-gap basis, gross margins were very strong and near record levels at 62.2%. Operating expenses were at 23%, and operating income was an outstanding 39.2%. all better than the high end of our revised guidance from September 9th. Our factory underutilization charges decreased from $13.9 million to $12.2 million sequentially as we started to ramp our factories to respond to the stronger than expected business conditions. We expect the continued ramp of our factories to lead to lower underutilization charges in the December quarter. Non-GAAP net income was $416.4 million, Non-GAAP earnings per share was $1.56, 15 cents above the midpoint of our guidance, and 10 cents above the high end of our guidance from September 9th. On a GAAP basis in the September quarter, gross margins were 61.7% and include the impact of $6 million of share-based compensation expense. Total operating expenses were $581.7 million and include acquisition and tangible amortization of $232.9 million and special charges of $4.3 million, $0.7 million of acquisition-related and other costs, and share-based compensation of $43.7 million. The GAAP net income was $73.6 million, or 27 cents per diluted share. Our September quarter GAAP tax expense was impacted by a variety of factors, including tax reserve releases associated with the statute of limitations expiring, offset by tax reserve accruals, associated with developments of the Altera court case during the period, deferred tax impacts of enacted changes in tax law occurring during the period, deferred tax impacts of our convertible debt exchange transactions occurring during the period, and other matters. Our non-GAAP cash tax rate was 5% in the September quarter. We expect our non-GAAP cash tax rate for fiscal 21 to be about 5.5%, exclusive of the transition tax, any potential tax associated with restructuring the microsemity 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 remaining cash tax payments associated with the transition tax are expected to be about $221 million and will be paid over the next five years. We have posted a schedule of our projected transition tax payments on the Industrial Relations page of our website. Our inventory balance at September 30th, 2020 was $661.4 million. We had 120 days of inventory at the end of the September quarter, up three days from the prior quarter's level, and primarily a result of our strong gross margin performance. Inventory at our distributors in the September quarter were at 30 days, which was flat to the prior quarter. We believe distribution inventory levels for Microchip are still low compared to the historical range we have experienced over the past 10 years, which is between 27 and 47 days. Our cash flow from operating activities was $455.8 million in the September quarter. As of September 30th, our consolidated cash and total investment position was $370.3 million. We paid down $331.1 million of total debt in the September quarter. Over the last nine full quarters since we closed the microsemity acquisition and incurred over $8 billion in debt to do so, we have paid down $2.95 billion of the debt and continue to allocate substantially all of our cash, excess cash 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 businesses, as well as our ongoing operating discipline. We continue to expect our debt levels to reduce significantly over the next several quarters. In the September quarter, we also exchanged $796.1 million of our 2025 and 2027 convertible senior subordinated notes for cash and shares of common stock. While these transactions did not impact the overall level of debt on our balance sheet, We believe that these convertible exchanges will benefit stockholders by significantly reducing the share count dilution to the extent our stock price appreciates over time. Our adjusted EBITDA in the September quarter was $566.7 million, and our trailing 12-month adjusted EBITDA was $2.181 billion. Our net debt to adjusted EBITDA, excluding our very long-dated convertible debt that matures in 2037 and is more equity-like in nature, was 4.04 at September 30th, 2020, down from 4.24 at June 30th, 2020. Our dividend payment in the September quarter was 95.3 million. Capital expenditures were 6.3 million in the September 2020 quarter. We expect about $35 million in capital spending in the December quarter, and overall capital expenditures for fiscal 21 to be between 110 and $120 million. Our capital expenditure forecast for fiscal 21 has increased as we prepare for growth in our business, as well as actions we are taking to increase our internal capacity in the face of constraints our outsourcing partners are experiencing, which Ganesh will talk more about. We continue to add capital to maintain and operate our internal manufacturing operations, support the production capabilities of new products and technologies, and as well as to selectively bring in-house some of the wafer fabrication, assembly, and test operations that are currently outsourced. We expect these capital investments will bring gross margin improvement to our business and give us increased control over our destiny during periods of industry-wide constraints. Depreciation expense in the September quarter was $39 million. I will now turn it over to Ganesh to give his comments on the performance of the business in the September quarter. Ganesh?

Thank you, Eric, and good afternoon, everyone. Let's start by taking a closer look at microcontrollers. In a weaker-than-normal macro environment, our microcontroller revenue performed better than we expected. Our microcontroller revenue was sequentially down 1.8% as compared to the June quarter. On a year-over-year basis, our microcontroller revenue was up 0.8%. Microcontrollers overall represented 53.7% of our revenue in the September quarter. Now moving to analog, our analog revenue was sequentially down 2.3% as compared to the June quarter. On a year-over-year basis, our analog revenue was down 8.2%. The weaker year-over-year performance of our analog revenue as compared to our microcontroller revenue was primarily due to our product lines, which originated from MicroSemi, which had higher exposure to Huawei, the communications end market in general, the commercial aviation market, and the space market. Analog represented 27.6% of our revenue in the September quarter. Our FPGA revenue was up 24.8% sequentially, as compared to the June quarter, and achieved an all-time record, even going back to the microsemi history. On a year-over-year basis, our FPGA revenue was up 16.3%, I would like to caution investors that although the FPGA revenue trajectory is positive, the revenue does have some lumpiness associated with it because of the large exposure to the aerospace market. FPGA represented 8.3% of our revenue in the September quarter. Our licensing, memory, and other business, which we refer to as LMO, was flat in revenue as compared to the June quarter. LMO represented 10.4% of our revenue in the September quarter. In October, we completed the acquisition of two small private companies. The first acquisition was New Zealand-based Tecron International, a global leader of timekeeping technologies and solutions for smart grid and other industrial applications. Timing is an operational necessity for real-time smart grid management and monitoring. Modernization complexity, and cybersecurity challenges within the power utilities are driving the need for more precise, secure, and reliable time. Acquiring Tecron enables us to expand our offering for the expanding smart energy and industrial markets. The second acquisition was Toronto-based LegUp Computing, whose high-level synthesis tool expands our FPGA edge compute solution stack to make it easier for software engineers to harness the algorithm-accelerating power of Microchip's PolarFire FPGA and PolarFire's system-on-chip platforms. The LegUp acquisition also complements the VectorBlocks acquisition we made a year ago, which added domain expertise in the areas of machine learning algorithms and vector processing for edge compute applications. Tecron and LegUp were very small token acquisitions, more akin to acquiring intellectual property along with domain experts to help us accelerate our business agenda in specific laser-focused areas. Both acquisitions were valued in the mid-single-visit millions of dollars and hence not material to the rate at which we're paying down our debt. The two acquisitions are expected to add less than a million dollars of revenue in the December quarter. In mid-September, for the U.S. Department of Commerce regulation, we stopped all shipments to Huawei. Our Huawei-originated revenue represents about 1% to 2% of Microchip's overall revenue and was sequentially down from the June quarter to the September quarter. We are working with the Department of Commerce to apply for licenses for products and technologies that we believe have no impact to U.S. national security interests. We do not know if or when such licenses may be granted. Therefore, we have no Huawei revenue in our December quarter guidance that Steve will provide. During the September quarter, we began to experience rising constraints in our supply chain due to a number of industry-wide factors. Among them, Huawei's push throughout the supply chain to complete manufacturing of all their products prior to the shipment ban, competition for market share by Huawei's competitors seeking to replace them, which further stressed the supply chain, an ongoing shift of semiconductor manufacturing out of China to avoid tariffs and trade sanctions, pressuring the capacity in other Asian countries where we manufacture through our partners, a very significant mobile phone refresh cycle, which competes for the same outsource capacity we used, and last but not least, the rising demand from the automotive, industrial, and consumer markets which we saw. The confluence of these factors created supply chain constraints, which are continuing into the December quarter. At times like this, we are fortunate to have our internal factory capabilities and we are making strategic capacity investments as we seek to better position our business for growth. Given the current market dynamics, we are providing some qualitative trend insights into our principal end markets for the September quarter. As expected, we saw the automotive, industrial, and consumer home appliance markets start their recovery. Medical devices for elective procedures like hearing aids, pacemakers, etc., which experienced a slowdown in the June quarter as individuals and hospitals delayed elective procedures, also started the recovery in the September quarter. As expected, we also saw the work-from-home related markets of computing and data center, as well as medical devices for hospitals, revert to more normal demand patterns as the surge we saw in the June quarter dissipated. In general, enterprise demand remains weak, as most businesses remain predominantly with work-from-home policies, thus deferring enterprise spending for the office environment. Finally, before I hand off to Steve, I would like to take the opportunity to express my deep gratitude to Steve and to the Microtour Board of Directors for the responsibility being entrusted in me when the baton gets handed next March. As we all know, Steve will be leaving big shoes to fill, with an impeccable 30-year history as CEO of Microchip. Yet the partnership we have forged over many years of working together, in addition to the support of our long-tenured executive team at Microchip, gives me confidence to lead the next phase of Microchip. I would especially like to thank Steve for being my mentor and my partner through the many years that we have engaged business challenges and opportunities together, and for everything I've been privileged to learn from him. I am particularly glad and thankful that Microsoft and I can count on his continued support and advice in his executive chair role. Thank you once again, Steve. Let me now pass it to Steve for comments about our business and our guidance going forward. Steve?

Thank you, Ganesh. Today, I would like to first reflect on the results of the fiscal second quarter of 2021 and I will then provide guidance for the fiscal third quarter of 2021. The September quarter continued to demonstrate what the best of microchip culture and its people represent. Our global team of operations, business units, sales and marketing, and support groups all came together in the middle of a global pandemic while working with a pay cut and delivered a superb quarter. Despite the COVID-19 pandemic challenges, we delivered net sales of $1.31 billion. That was essentially flat sequentially and down only 2% from the year-ago quarter. This is compared to our net sales guidance, which was to be down 4% sequentially at the midpoint as we capitalized on strong turns opportunities in September. We also delivered outstanding non-gap gross margin of 62.2%. which were near an all-time record level. We also achieved non-GAAP operating margin of 39.2% above the high end of our guidance. Our consolidated non-GAAP EPS was $1.56, 15 cents above the midpoint of our guidance. Our bookings were very strong in the September quarter. We begin the September quarter with a backlog position on July 1, to be down 8% from the backlog for June quarter on April 1. With strong bookings and strong terms filled in the quarter, we ended the quarter at essentially flat compared to minus 4% as the midpoint of our guidance. Now I will discuss our guidance for the December quarter. Our bookings have remained strong in October We are seeing a good recovery in the automotive, industrial, home appliance, and medical devices for elective procedures markets. At the same time, work from home-related markets of computing and data centers as well as certain medical devices that surged with the pandemic revert to more normal demand. Here's one of the factors that we have to account for in our guidance for the December quarter. and that is the Huawei effect. Huawei was over 1% customer in the September quarter, and it will be zero in the December quarter. Taking all these factors into consideration, we expect our net sales for the December quarter to be between flat to up 5% sequentially. Considering that seasonally December quarter is down by approximately 2% to 3%, and counting minus 1% Huawei effect, We believe that our guidance is well above seasonal and represents multiple industries recovering as well as microchips continuing to gain market share in multiple end markets and product lines. Investors and analysts have asked us in the last few months about making a call about the bottom of this cycle. With tremendous uncertainty about COVID-19 situation and the elections, we have not been willing to make the call. Today, we are making that call. We expect that June and September quarters was a bottom for this business cycle for microchip. We are guiding to a much stronger than seasonal December quarter, and we expect significant growth in calendar year 2021. Based on the much better than expected financial results in the September quarter, we gave our employees half of their September quarter salary sacrifice back in the form of a bonus. We have also been gradually lowering the percentage of salary sacrifice. And just yesterday, the Board of Directors approved the entire company to revert back to full salary later this month. These salary changes are dialed into our guidance that we're providing today. We thank all of our employees worldwide that have traveled this journey of shared salary sacrifice with us in the past three quarters, enabling us to be prepared for multiple contingencies as COVID-19 uncertainties unfolded. This represents the best of Microchip culture and the commitment of our employees to ensure the long-term success of the company. For December quarter, we expect our non-GAAP gross margin to be between 62.4% and 62.8% of sales, which will be a new all-time record. We expect non-GAAP operating expenses to be between 23.1% and 23.7% of sales. We expect non-GAAP operating profit to be between 38.7% and 39.7% of sales. We expect our non-GAAP earnings per share to be between $1.51 per share to $1.63 per share. We also expect to pay down another approximately $300 million of our debt in the December quarter. We continue to believe in the strength and diversity of the businesses and end markets we are in to achieve long-term growth in excess of the average semiconductor market growth. I would like to advise investors and analysts about one other change. In the past, we have been providing a mid-quarter update often to coincide with our presentation at sell-side financial conferences. Our peers and competitors typically do not provide a mid-quarter update. Beginning this quarter, we will discontinue this practice and no longer plan to provide such updates. Given all of 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?

Certainly. If you'd like to ask a question on today's call, please press star 1 on your telephone keypad. We ask that you please limit yourself to one question. Once again, that is star one to join the question queue. And we'll take our first question from Ambresh Srivastava with BMO. Please go ahead.

Thank you, Steve. Congratulations, and you'll be missed. And Ganesh, congratulations to you as well. I guess you'll have to take over Steve's role to keep us on our toes when we get on this call to ask a question.

It's a hard act to follow.

I know, big shoes for Phil, but we'd be expecting you to. Two questions for me. One is on the constraint side. Could you just help us understand how has that translated into lead times? And then if you didn't have the constraints, how much of the business or what would the guidance have been? And then the second question is, maybe Eric can help us on this one, is on the capacity side. So a lot of moving parts there. So what was the, what has been the outsourced versus insourced, both front-end, back-end, and then the capacity, the capex increase, what should we be expecting both those two to be, and how is that going to impact gross margin? Thank you.

Do you want to take the lead time, Steve?

No, you go ahead. Take it.

So on lead times, you know, the vast majority of our line items still have a four- to eight-week type of lead times for standard products. There are specific package combinations that do have longer lead times. What is happening is, for the factors that I described, it is eating into multiple layers of the supply chain, so into the packaging and some of the subassembly involved in the packaging and into the test tank. infrastructure as many of these things come together at the same time. So, you know, we don't have huge issues with supply issues, but we have spot issues with specific package product combinations where they are. But by and large, for the vast majority of our products, we still have pretty good lead times.

Go ahead, Eric. Okay. So, the second piece of your question was there was kind of multifaceted there, but we've got some capacity questions. So, We are making investments as we walk through in our prepared remarks in wafer fab assembly and tests to increase our capacity. And, you know, if you look at last quarter, we did about 39% of our wafer fab in-house, 47% of our assembly, and about 54% of our test. You know, these are relatively slow-moving metrics, even with making investments. But over time, we absolutely would expect the assembly and test percentages to go up as we make these investments. But again, they're relatively slow-moving metrics. But the investments that we're making are all gross margin accretive. And you can see that our gross margin we're guiding up in the current quarter. And we are expecting lower underutilization charges in the current quarter as we ramp our factories. And all these incremental adds to capacity that we're making, whether it's fab assembly or test, should all add to gross margin benefits for us down the road.

Unable to quantify at this point, Eric, as to how to think about the longer-term, not the gross margin, what would the steady-state assembly and test would look like and front-end would look like in-source versus in-source?

So, again, I don't expect the wafer fab to move significantly in terms of the percentage that we do in-source versus out-source. As the business grows, obviously, we're making investments. On the assembly and test side, we do expect those percentages to go up. Ganesh, do you want to give a comment on where you think they can go over time?

Yeah, you know, they move a little bit more slowly over time, and, you know, we expect that they will probably be in the north of 60% longer term for assembly and probably north of 70% for test. And there's a lot of moving parts into going to there. But that's what we like to be at. It gives us some control. It gives us capacity when it's difficult to get outside. It gives us some control on our costs as well. And it all pays for itself in short periods of time in the way we measure what we do or don't do.

Very good. Thank you. Congrats.

Prior to Microsoft Semi and Atmel acquisitions, we were at about 70% assembly and 95% test. So as we bought these two large companies, Atman and Microsemi, they were much more outsourced than we were, and our percentages dropped quite dramatically. And we've been working our way up, and, you know, ideally we'd like to get back to, you know, the higher than 60% assembly and probably higher than 80% test, but, you know, it's painful, slow transition because, There's just too many variants, too many packages, too many test programs to correlate and all that. So it's an ongoing effort that will go on for years, but there are really no quick movements.

Great. Got it. That's good perspective on the historical. Thank you.

We'll go ahead and take our next question from Vivek Arya with Bank of America Securities. Please go ahead.

Thanks for taking my question, and congratulations and best wishes to both Steve and Ganesh. Steve, my question is both near-term and the growth you're expecting for next year. When I look at near-term in the September quarter, you know, your microcontroller and analog sales were down a little bit. Year-on-year also they're down a little bit. So I'm curious, what is giving you the confidence to say we are at the bottom year? of the cycle when there is still some macro uncertainty because of elections and lockdowns. I'm just curious to hear those views. And then when you say significant growth for calendar 21, when I look at consensus growth numbers right now, they are for about, I think, 7% or so sales growth. What does significant mean? Does it mean 5%, 10%, 15%? What is significant in your book? Thank you.

Well, you know, what gives us the confidence is really, you know, we have worked through all the, if you go back to February, March timeframe, many of the, you know, estimates that the analysts and investors had were, you know, very, very large drop because of COVID of the type of 20%, 30%. Many people were modeling the business like the 2009 global financial crisis, even some of our competitors were. You know, we saw it clearly, and we were not modeling the business to be down that much. And we were right. Our business was up in March. It was down only 1.3% sequentially in June. It is flat in September, and it's going up in December. So, you know, we kind of have been relatively more correct than anybody else. We are seeing substantial backlog building up. The backlog for the current quarter is is significantly stronger than the backlog for the last quarter. And this is supposed to be a seasonally down quarter. Still, we think we're going to do pretty well. And then the bookings we're receiving, which are aging into the next quarter and the quarter after, are just very, very large. We're getting very, very strong bookings. Now, some of that is concerns about the supply chain, a lot of constraints and all that. So people are giving orders earlier, you know, not that a backlog is much larger than before at a similar point in time, but that doesn't mean all that becomes growth because people give you orders earlier and then the crawl chart rolls off because you already got the bookings. But despite all that, we're expecting a much, much better March quarter and significant growth after that. You asked what does significant mean. It means a lot more than 7% that you have a consensus.

Thanks very much, Steve.

Welcome.

And we'll go ahead and take our next question from John Fitzgerald with Price.

Please go ahead. I'll add my congratulations to both Steve and Ganesh. And Steve, appreciate all the help over the years. I'm sure a lot of the analysts on the call feel the same way. I guess my first question, Steve, you're calling sort of for the bottom of the cycle, June, September levels. I think what's very impressive is where your operating margins are, despite the fact that we're at the bottom of the cycle. I'm just kind of curious. I know that expenses have been a little bit light this year because you guys have pulled back on things like variable comp. But given that you're not in the market of buying assets and you're really going to be just focusing on operational efficiencies, How should we think about incremental operating margins and kind of where operating margins can go from here?

So, you know, I think, you know, we have given a longer-term model, which is 63% gross margin, 22.5% operating expense, and 40.5% operating margin. We're not quite there. We're getting close. You know, midpoint of our guidance is about 62.6% in gross margin, you know, this quarter, and I don't quite have the number on the top of my head on the operating margin. You know, we've got a little bit more to go before we really get to our numbers, and we will be, you know, analyzing and going into the next fiscal year. We'll be looking at all that, and at some point in time, coming back to the street with a, you know, new longer-term target when we think that, you know, current targets have either been achieved or within a striking range.

That's helpful. And then for my follow-up for Ganesh, Your commentary around FPGAs and your prepared comments, notwithstanding kind of your caution that's a lumpy business, I'm just kind of curious if you can talk a little bit about kind of your core advantage in that market. You know, that's becoming sort of a rarer asset over time now with some of the M&A activity in the space. What kind of longer-term prospects do you see in the FPGA space for you?

Sure. So in the FPGA market, We play specifically in the mid-range of FPGAs, which is measured by how many logic elements there are in it. We don't go after the very high end. There are other players who are invested there. But in the mid-range and lower end, we focus on applications that need low power. We have non-modelable memory on these products that have security needs, that have robustness needs. And those take us into end markets that we really like. Those end markets are defense and aerospace markets. They're automotive, now with Microchip taking FPGA products into our historical strength, and industrial, once again, Microchip taking FPGA into our historical strength. So those are the end markets that we believe we're able to take over the long term, the advantages of what we bring with our FPGA products in terms of low power, security, robustness, and being able to position it in the markets where we have the strengths.

Thank you, guys.

And we'll go ahead and take our next question from Toshia Harvey with Goldman Sachs. Please go ahead.

Hi, guys. Thanks for taking the question, and congrats to both Steve and Ganesh. Steve, you talked about your December quarter guidance being roughly five percentage points above typical seasonality, maybe 6% when you take into consideration the Huawei dynamic. You also talked about end market strength and share gains contributing to that outperformance. What portion of that 5% to 6% outperformance relative to typical seasonality is share growth, and what percentage is in market strength? And you sort of alluded to this before, but are you concerned at all that customers are pulling in demand and you see a correction sometime in the first half of 21? Thanks.

Well, you know, first of all, it's impossible to break down you know, the growth better than seasonality into the two components that you described, what portion of the growth is market share and what portion of the growth is really just better in market. That's really very, very difficult on a short-term basis. You could really do a, you know, longer-term comparison on a growth rate basis looking at how everybody else grew. We have no idea how everybody else is going to do this quarter or next quarter or next year. So I don't really have a good answer to that question. But your question about, you know, a correction next year because, you know, customers are pulling in, we don't really see customers pulling in demand. We see customers pulling in, placing their orders, and then scheduling them into the next year, next quarter, and the quarter after. And this is something we asked for through our letter back in July, We ask the customers that in addition to the near-term orders that you've been giving us, please give us a longer-term backlog. Tell us your requirements in the time of building constraints so we can plan accordingly and put the capacity in place. And customers have responded very strongly. So we're getting very strong bookings, but the component of the bookings that – you know, that's aging into the next quarter and even a quarter after is very, very good. We have a lot of backlog already for the June quarter, and we have very, very strong backlog for the March quarter. So they're not pulling in deliveries. They're pulling in placing orders and scheduling the deliveries so they're not, you know, left short in case there are constraints.

Got it. And then as a quick follow-up, Steve, obviously you've had a very successful career over multiple decades. Anything you feel like you left on the table? I know you're not necessarily leaving the company, but anything on your to-do list that Ganesh and the team can potentially move forward with? Thank you.

Well, you know, I don't have any regrets in the timing of, you know, as I'm doing it, it's much more age-related and family situation and grandkids and all that. But I could really, you know, go back to the micro-semi-acquisition which we announced in, you know, 2018. And the goals we had set out in terms of earnings per share and overall accretion, we were talking about, you know, achieving $8 by the end of the third year. Some of those got interrupted by, you know, two major industry events. You know, one was the entire U.S. sign-off. trade war that took some wind out of the sails, and then the COVID-19. And due to those two events, you know, credit rating came under pressure. The leverage became, you know, much higher in an uncertain situation, which was comfortable in a growing business, but not as comfortable in a situation when leverage is high and the business has a lot of uncertainty. you know, back in the March timeframe, analysts and investors were asking me questions regarding what happens if your business goes down 35%. And I was telling them, our business is not going down 35%, and they were not believing it. You know, like, you know, why not? You know, what if it happens? So, you know, so I would say that, you know, last two years have been difficult, and if we were able to have the normal level of growth in the last two years, and all the attrition that we have achieved on the top of that, you know, we would be, you know, over $8 of earnings per share today, and hopefully that would be near $200 rather than where it is today. And I leave that for Ganesh to put a 2-0-0 in front of it.

Thank you, and good luck, Ganesh.

Thank you.

And we'll take our next question from Harlan Sir with J.P. Morgan.

Good afternoon, and let me also offer my congratulations to Steve and Ganesh. I guess first question, what was booked to build in the quarter? And then given the strong demand environment and constraints, now may not be the right time to be executing to this, but I believe that you guys still have a network of very small fabs in your manufacturing footprint. So if you can just maybe how much of this has yet to be consolidated? Can you just remind us how much more cog savings are still to come? as you consolidate these smaller FABs and over what period of time?

So we're not specifically providing a book-to-bill ratio for Q2. I think we have given the reason for that many times in the past. Book-to-bill ratio was very good, and usually we have seen investors and analysts essentially take the book-to-bill ratio and try to translate that into a growth number. which does not really work because I already said that a lot of the strong bookings that we are receiving are actually aging into the March quarter and some even into the June quarter. So the bookings we receive for aging over the next 12 months, and you divide that number by billings in one quarter. So it's a little bit apples and oranges. Bookings over the next 12 months, aging over the next 12 months, but billing shifted into the last quarter. The number was very good, but providing that numerically, that number, we have seen investors not interpret it correctly. What was the second part of your question?

It had to do with cost of sales improvement and ongoing consolidation of factories and things like that. So I'll start, and then Steve or Ganesh can add on to that. Okay. We announced last November some restructuring of our Colorado wafer fab, and we're making excellent progress on those fronts and have achieved a large amount of the cost savings that we outlined at that time, and you've seen our gross margins hold up extremely well. There's still work to be done. Our operations teams and both the front-end operations and the back-end operations are extremely busy, and we've talked about our capital expansion plans and the improvement that we'll see in gross margin there, and obviously the more product running through our own factories absorbs the large flywheel of activities that we have on the cost side. So we've got a lot of good things working on gross margin. We've guided at the midpoint this quarter the 62.6%, which isn't very far away from our 63% target. We feel good about that, but I don't think we're going to talk specifically about some of the specific actions that are being taken, but we're doing well on, you know, structuring the operations appropriately. Steve, are you going to ask anything to add to that?

Well, yes. You know, what I will add is that if you look at our gross margin and operating margin performance in this down cycle, I mean, it's been exemplary, and compared it to any of the prior cycles, You know, we did, you know, just extremely well. Our gross and operating margins did not go down by many hundreds of, you know, basis points. I think gross margin used to go down by 600-plus basis points. Now, you know, why is that? You know, I think that's partially the result of diversifying the business, creating several end markets. The acquisitions we did, you know, really helped us build that. you know, serving the entire solution of the customer with total system solution. So, you know, the revenue didn't fall as much, the gross margin didn't fall as much, and the operating margin didn't fall as much. And we are sitting at, you know, near record gross margin and just a tad shy of the record operating margin at the bottom of the cycle. And as we go from here, as the revenue increases, And we are ramping all of our factories, as I spoke about, and all our high-volume fabs and assembly and tests are all on a rapid ramp to provide the growth that we see into next year. We have increased our capital expense budget. So as we achieve that ramp, the incremental cost of the next product we make is much lower than the cost of the product we're making today because you get better absorption and And, you know, the incremental gross and operating margin, you understand that concept. So it's a very, very exciting time we're going into where at the bottom of the cycle, we are near a record. And then from there, as the factories ramp and the underutilization first goes to zero, and then you go above that and incrementally starts dropping gross and operating margin, that would be, you know, very, very good. And what we need to do is really put some numbers around it and at some point in time talk to you regarding what does that mean in the long-term model that we're not prepared to do today.

Got it. Okay. And maybe just a quick follow-up on the product side. I saw that you guys actually introduced the RISC-V-based FPGA product, but wanted to get your views on any initiatives that the team has in terms of RISC-V open architecture as in addition to your MCU product portfolio. Thank you.

So we are part of the RISC-V foundation through the microsemi acquisition. It had started before us. The first point of implementation is on the FPGA SSE product lines, and we did introduce that, as you noted. There are many possibilities with RISC-V, and, you know, they are being evaluated within microtrip. There's really nothing to report at this point beyond what we have done on FPGA.

Thank you.

And we'll go ahead and take our next question from Craig Hedbach with Morgan Stanley. Please go ahead.

Thank you. Certainly quite the journey, Steve, in the last few decades to see that the company evolved just organically and through M&A. You know, on the last point, including M&A, I think one of the things that's in focus now is with total system solutions, Maybe you can just give some context or update of kind of where you stand with that and some of the efforts you're driving through this Salesforce.

So I think, you know, when you look at an embedded control system, a microcontroller-based system, you know, it has a large number of components around it. And over the years, the number of components have increased. Now, you know, even go back 10, 15, 20 years ago, It will usually have, you know, some sort of power management, A to D converters, reference devices, maybe some discrete devices, you know, some static RAM, some, you know, memory, flash memory, nonvolatile memory. It will have those kind of things. But, you know, over the years, the amount that goes around that microcontroller has increased substantially, and it increased substantially with connectivity. So today, You know, you need a USB, Ethernet, Wi-Fi, Bluetooth, you know, display driver, touch functionality. So just, you know, high voltage sensors and others. So the number of components that go into an embedded control system have really multiplied in the last 20 years. And we began our journey of really selling things around a microcontroller you know, beginning in about 1999, 2000, and then we did a small analog acquisition of Telcom Semiconductor in 2001. And with those resources and adding to it, we started building our analog franchise. And then we didn't really start doing drum roll of acquisitions until about 2010. But the results have been that we have added All those products now available from microchip, you can buy them as a kit, or you can buy them separately. But if you now look at a reference design for an application, almost find any embedded control application in home, in industry, in car, in, you know, in any place, you know, open an appliance and look at its, you know, circuit board, you can essentially have everything on that from microchip today. A microcontroller, a memory, analog, converters, opt-ins, some sensors, power management, drivers, connectivity, Bluetooth, Ethernet, Wi-Fi, 802.11, anything else. And so we feel that, you know, we have done all that, and now we have a powerful franchise of, to be able to sell that entire solution. And the challenge in the last couple of years has been now training the sales force to really be able to take that kind of message to the market, and they're doing very well at it. So at this point in time, we do not really feel a burning desire to have to do another acquisition. The valuations are sky high, you know, will never meet our taste. And number two, we still have high leverage working down debt. And we have clearly signaled to the street that when our leverage goes down and then we're still producing a large amount of free cash flow, a more likely use of that free cash flow is the increasing dividend and stock buyback and all that and not the new set of acquisitions. So I think that's where we are because we feel we have completed the solution. We have an enormous scale and do not have the scale disadvantage anymore. And with that, we are going to grow the business organically.

Got it. Thanks for all that.

Thank you. And we'll go ahead and take our next question from William Stein with Truist Securities. Please go ahead.

Thanks for taking my question, and I'll add my congratulations on the transition in the It's been quite a run. So congrats on that. I want to dig into the concept of book to bill and backlog that you've made very positive comments around Steve, but maybe I can ask about it this way. It sounds like the book to bill was very strong backlogs up a lot, but it's coming more in the form of duration of backlog as opposed to what's deliverable in the near term. is there any metric you can give us around that, around the duration or around maybe what portion of March you think is now filled? And then the concurrent question with that is those behaviors from customers typically happen under one of two conditions. Either the customers suddenly have a lot more confidence or optimism in their business, and the other is when they think they're not going to be able to get supply. I wonder if you could comment as to which of those you think is driving the improved duration of the backlog?

So, you know, I think it's a combination of it. Obviously, you know, having such a broad customer base of 125,000 plus customers, you know, you often don't really know how the customer is thinking. So, you know, you get samples of it, you know, as you talk to the large customer and visit them and we're really not even visiting them these days. Interaction is largely virtual. But I think it's a combination of customers reading about, you know, strengthening lead times in the industry, constraints they're hitting, and when they have an experience from not being able to acquire one component, let's say, from one of the other suppliers, the purchasing manager's action often is to really go ahead, secure, and place the order on all the components you know, whether the lead times are going out at a particular supplier or not. And in our case, we specifically advised the customers back in March that we were getting largely short-term orders, and we need short-term orders to make a quarter. That's great. We sent them, but we also needed your longer-term orders so we can more efficiently build the parts and batch process it and, you know, place the orders on our suppliers ahead of time and so on and so forth. And what I would say is that the customers have responded, you know, extremely well. I mean, our customers have always responded to our letters extremely well. And what you have seen is a quarter later, exactly a quarter after we wrote that letter, and customers have placed a large amount of backlog, you know, that ages into the following quarter.

Maybe just want to clarify one thing Steve said there. He mentioned the letter to the customers in March. It was actually in July. I know that's what he meant to say, but just for the record.

I mentioned, yeah, July 7 was the date I thought. December, early July.

Thanks, guys.

And we'll go ahead and take our next question from Sean Harrison with Loop Capital. Please go ahead.

Hi, afternoon, and my An easy question, hopefully, and then a question more on distribution. With the volatility in FPGA associated with the aerospace business, should we assume that you kind of see more of a normalization here into December quarter? And then second, Steve, how are the distributors reacting to the tightness in supply or the tightening of supply out there? I know you highlighted that, you know, channel inventory days are still low, but is there any pressure for them to add more microchip stock?

So I'll take the distribution. What was the first part of the question?

On the FPGA trends. Why don't I take that one, Steve?

Go ahead.

So as we have said many times, FPGA is a more lumpy business. Trajectory-wise, if you plot the last many quarters, you'll find that it is up and to the right. Quarter to quarter, there are going to be changes depending on which lumpy business is coming through or is delayed for whatever reason, and that's what you will continue to see. But if you look at it over eight, nine, ten quarters, you'll see that it is up and to the right as an overall FPGA business for us. Go ahead, Steve.

So, you know, on the distribution front, you know, we're getting, you know, huge orders from distribution just as well as we are getting it from, you know, direct customers. So our bookings were strong in both, in the distribution channels as well as in the direct channels. And the behavior is largely similar where we're getting bookings to make the, you know, we got the bookings to make the September quarter and we're getting good bookings to fill up the December quarter. But very large number of bookings are really actually aging into the March quarter and some even in the June quarter. So distributors also are layering in the backlog so that if the lead time push out further, you know, they're not impacted. and they're placing the backlog already going into the next quarter. So when we wrote the letter, the letter was not only to our direct customers. It was also the same message to the distributors, and they have responded in kind. And our distribution overall inventory has been low for quite some time. I think it hit 15-year low, and then from that, It has only come up a day or two. So in the coming year, as we are expecting significant growth, you know, my sense is, you know, it's really up to distribution, but my sense is that the distributor will have to increase their inventory and can't sit at a 15-year low.

Fantastic. Thank you.

And we'll go ahead and take our next question from Chris Casso with Raymond James.

Yes, thank you. And Steve and Ganesh, congratulations to you both. It's been a pleasure working with you both. The question is regarding seasonality. And you mentioned your view of normal December seasonality down 2% to 3% sequentially. I know in the past, since the micro-semi acquisition, you've hesitated to make a call on seasonality because there really hasn't been much of a normal environment since that acquisition closed. You know, given that you've offered that for December, do you have a view or an updated view on what you'd consider to be normal seasonality for the March, June, and September quarters?

We really don't. I think we're going to have to run a whole year normal and kind of start to look at it. If you go back prior to the micro-semi acquisition, then, you know, March quarter will usually be up sequentially. I would say, you know, a couple of percent, 2%, 2.5%. This year, March was up 1.3%, although it got impacted at the late part of March with, you know, the China not coming back from the COVID-19 crisis. Despite all that, I think we were up a couple of percent and could have been more. So I think the March seasonality is somewhere around, you know, 2%, 2.5%. But I think there are less data points on it, you know, with the acquisition than would be otherwise. If you take the micro-SME out, then I feel comfortable with a couple of two, two and a half percent. Add the micro-SME in, we don't have enough data points.

Right. Okay, understood. Just as a follow-up with regard to the repayment of debt, Eric, this is for you. Could you give us a sense of what your expectations will be over the next few quarters? You know, again, assuming that there is some degree of recovery, as you say, you should be generating more cash. And how does that affect the timing on getting to your net debt target, which I believe is three?

Yes. I mean, we've been generating a bunch of cash each quarter. You know, we indicated that we expect about a $300 million debt pay down in the current quarter. You know, there's some Positives and negatives. Obviously, if, you know, revenue is growing, we're going to throw off more operating margin. And we are, you know, specifically trying to invest a bit more in capital, as we talked about. So our CapEx was extremely low in both the June and September quarters. And it's going to be higher here in December and March. So a bit of an offset. But, you know, I would expect, you know, $300 million plus range. And, you know, as the business environment improves, that's only going to go up. So we're making really good progress on debt paydowns. and expect that to continue. And you mentioned the three times or less, and that's what we're looking for, looking to be an investment-rated company. And over time, we will absolutely get there.

Got it. Thank you.

As a reminder, in the interest of time, if you could please just limit yourself to one question to allow everyone in the queue be able to pose their question. Once again, That is star one to join the question queue. We'll take our next question from .

Please go ahead. Congratulations, guys. Steve, thanks very much. It's been a real pleasure to be along your side for the last 30 some years since you became CEO, and again, congratulations to all. I have actually two really quick. Jake, can you give a little color on what's going on in the auto business? Do you feel that there's a secular change happening in demand for autos because of COVID and safety? And secondly, can you provide a little more color on Huawei? When did you apply for the license? And what is, can you give us what your best case scenario might be if you were to get the license? And when you get it, how fast can you ramp up?

Well, first of all, you know, thank you. I think you've been with us for probably the entire 30 years or so, or 27 years as a public company, and prior to that even. Long association, so thank you. And I remember you came to visit a booth in Las Vegas at the CES conference earlier this year. Regarding your specific question on Huawei and automotive, so, you know, the automotive business is, you know, saw the largest decline out of any end market back in the June quarter because many, many factories just downright shut down. And then in the September quarter, they started to bring the factories back up, and the business was up from June quarter to September quarter. But the September quarter factories were not full, you know, from the beginning. They were ramping during the quarter. So there is a, you know, quite a substantial growth in the automotive segment, at least for us, from September quarter to December quarter, you know, as the factories continue to ramp. So the automotive business now, you know, from this point on, kind of looks normal. You know, cars are selling, the inventory is low, so they're rebuilding their inventory. Lots and lots of automotive customers are making investments into electric vehicles where we have, you know, significant content, and the content in an electric vehicle is actually higher than the content in a, you know, regular vehicle. So automotive business should look going forward from here. The other part of your question is a Huawei license, when did we apply? Let me hand it off to Ganesh to answer that question.

Yeah, so our application was within the last month. It is a very uncertain process of how it navigates through Department of Commerce and whoever else would have to weigh in on it. I think it's impossible to give you a an estimate of what might happen and when and what would it mean. You know, the business with Huawei has many products and is not just a single license. We would need multiple licenses, and each one has a separate application you'd have to go through, and we have a prioritized process that we're going through with it. Given the uncertainty of the process, we did not believe trying to count on any revenue made sense. And once we have line of sight to the license, we would still need to work with Huawei on what they would need, when we would be able to ship the product, to be able to provide any kind of guidance on what does it mean to our business.

Thank you. Thanks very much.

Thank you, Janet. Great. You're welcome.

And we'll go ahead and take our next question from Matt Ramsey with Cowan. Please go ahead.

Thank you very much, good afternoon, and congrats to you both. Ganesh, I wanted to ask a question. I know that some of the private company tuck-ins and some of the investments that you've been making over the last few quarters regarding the edge opportunities, our team's done quite a lot of work on edge as an emerging market and both on edge clients and on sort of edge cloud And I wonder if you might give a little context as to how big of an opportunity you guys might think about this being over the next three to five years for microchip and if it's something that might evolve out of your FPGA franchise or out of your microcontroller franchise or if there's need for a bit heavier-handed compute that might be required as you guys approach some of these edge opportunities. Thank you.

When we think of the edge, it all comes around the megatrend of artificial intelligence and machine learning that we have spoken about. And we think of that in three different buckets, so to speak. There's a part of it which is the best known for many people, which is what happens in the cloud. And that is the domain of many people who have very large and highly processor-intensive computers. We do play in the cloud, but our role in the cloud is predominantly around PCIe switches and a few other things that are associated with how CPUs, GPUs from other companies are taught. The edge is the second part, and edge is an exceptionally important part as you think of factory automation and the industrial IoT, because at that edge compute for the factory is where much of that machine learning is going to be taking place and the application of artificial intelligence. There, we have introduced, using FPGA as one of the platforms, a number of solutions. Smart Embedded Vision is one piece of that, which can go into machine vision for factories, physical security, medical vision, depending on that end application. But surrounding these products are many of our standard products, too. It needs microcontrollers, analog, security, things that process things. And then the third element of artificial intelligence machine learning we're looking at is all the way at the end where the sensing is taking place. And there again, we're looking at our standard microcontrollers and some of the other products as to how can they do to a lesser extent for what is exactly needed at the end nodes, the learning and the inferencing that is needed using standard microcontrollers. So it's a much bigger field than just the edge alone in terms of our interest. or certainly FPGA at the edge is a key part of how we intend to prosecute that.

Thanks for the perspective. Really appreciate it.

And we'll go ahead and take our next question from David O'Connor with Exane BNP Parivas. Please go ahead.

Great. Thanks for taking my question and congratulations on the results. Maybe a question on my side going back to the supply chain constraints. Which exact category of products are impacted there. And Ganesh, in your prepared remarks, you talked about Huawei, you talked about the mobile phone refresh and some reshuffling of share as well and capacity maybe. It seems more short-term related. So the question is, do you think these constraints dissipate from the March quarter? Are they here to stay with us for some time? And I have a follow-up on the gross margin.

The general comment would be that You know, it affects the supply chain of people who are packaging product. Their supply chain, which can be lead frames, it can be substrates, can be equipment that does bonding and various other things. And, you know, so it may not be things that we are directly involved in, but it consumes bandwidth and capacity of the supply chain, both directly what we deal with and then their supply chain as well. And so all of these, you know, compete in many cases for either the materials or the equipment capacity that is out there that we would otherwise be using. And then as we go, you know, to use them, we find that in some cases they're constrained. We've been able to manage through a lot of it. We do have second sources for some of these things. And we do have a lot of internal capability. And as Eric mentioned, you know, we are accelerating bringing more capacity internal for some of the package types. You know, what normally happens in business is when you have these constraints, the companies that are in the business of providing that capacity or that material respond with what they can do to take advantage of that situation. And so there is a capacity response that they come with. Some of it also is possible that there could be a surge in demand that then begins to dissipate. You know, we can't really predict where that is. but we think that there are going to be constraints through the December quarter, and it's possible some of that will spill over into the March quarter as well, but I don't have any line of sight into exactly when all the constraints will dissipate.

That's very helpful, and maybe a quick follow-on on the gross margin for Eric. Eric, the You talked about the strength in the March quarter, and it seems from just the higher utilization, you could hit that 63% gross margin in the March quarter. My question is on the additional capex that you've budgeted for calendar year 21. How much of a headwind is that as that capacity comes online? Does that come on slowly through 21, or is that going to come initially, and we have to factor that as a gross margin headwind into 21? Thanks.

So in terms of when the capacity comes online, it depends, whether it's wafer fab, assembly, or test. And so it just depends on what qualification we have to go through and the work that needs to be done in our factory. So it comes on gradually over time. I don't view it at all as any sort of headwind to gross margin. It's just a matter of can we get it installed and up and running and and get product out the door. So I think gross margin is in good shape. I didn't make a specific comment on gross margin for the March quarter. So I want to make it clear we were just speaking about the current quarter, but there are lots of things that we're doing in our business and not the least of which is if we get into a better revenue environment as we look forward into 21, you know, that's going to do very good things for our gross margin and we'll continue to evaluate the long-term model because we're getting close.

I'd like to clarify one thing. You know, you said somehow the capacity of a CapEx adds a headwind to the gross margin. That's entirely opposite of what we will experience. I believe the comment of, you know, the CapEx providing headwind to the gross margin comes from, you know, when you build a large greenfield fab and you spend a billion dollars you know, then the, you know, process has to be qualified and it slowly ramps. Meanwhile, the factory is depreciating. That's the kind of headwind of the gross margin probably you're talking about. And we experienced that, you know, back in 2003 when we were bringing our Fab Four up in Gresham, Oregon. The kind of capacity we're talking about is not that. It's, you know, made up of... you know, $300,000 to a $1.5 million various pieces of equipment in assembly and test and fab and diffusion tubes and others, incremental capacity, and it becomes productive really the quarter after it is added, and it never has a headwind to the gross margin. It's always accretive to the gross margin because the product it produces, it produces at an incrementally lower cost than the average product without that. So there is no headwind to the gross margin. There's only accretion to the gross margin.

All right, and we'll go ahead and take our next question from Vijay Rakesh with Mizuho.

Please go ahead.

Yes, I'd like to congratulate Mr. Steve and Ganesh here. Just I'll combine my two questions. I know looking at the back half here, you're seeing some strength in auto industry and also a Nice recovery in China. Just wondering what your revenue exposure was in that industrial auto and especially over into China. And lastly, I'm sure there's some COVID impact on the gross margin line, even though margins are very impressive where they have rebounded. Just wondering what that, if you have kind of sized that COVID impact and that should go away or resume into next year. So that's it. Thanks.

I don't know if I got all that. I think the first part was really asking the mix of industrial and automotive. Ganesh, we have that for the last quarter. We only provide it once a year.

Yeah, and it doesn't move dramatically quarter to quarter. You know, what we have shown publicly measured at the end of March for the prior year was that industrial was 28% of our revenue. Automotive was 15% of our revenue. Obviously, in the June quarter, there was more headwinds in those two end markets, but I don't really have a number. And then those are all reversing as we went into the September quarter and into the December quarters itself. So those end market percentages for us usually don't change that dramatically over time. And then I'll pass it back on the other part of the question.

I didn't understand the gross margin question. Can you reset that?

Oh, I was wondering in terms of COVID on a logistics and operational basis, I would assume there's an impact. So I was just wondering what the COVID impact was to the gross margin. And I would assume that would reverse, it would be a tailwind next year.

It's very small. The impact of COVID and gross margin was more like in the June quarter when We ran our factory in Philippines at a much lower capacity because we couldn't get all the people in, and we had 150 people living in the facility and working and sleeping there, you know, at 30% of the factory's capacity. There was no COVID impact in September quarter. I mean, you know, mine are providing meals and others to the people who are living there, but there was really no meaningful impact in September quarter, and there is no recovery of that next year because there's no impact now.

Right. The amount in the June quarter was $2.8 million, and you'll see that in our press release, but there was nothing that we broke out separately because it was immaterial to the September quarter results. Great.

Thanks. And we'll go ahead and take our last question from Mark Lepakis with Jefferies. Please go ahead.

Great. The last question on Steve's last call, that's quite an honor. So thank you for taking the question, guys. Congratulations. And Steve, thanks a lot for all the great insights that you saved. I will miss them. I just had a kind of a strategic question for Steve. You know, you kind of described a scenario where the M&A slows down. You enter a deleveraging cycle and a, you know, and then a capital kind of a capital return cycle. What does that say, what should investors take away, what that means about the semiconductor industry? And does it necessarily mean that, you know, ultimately that there's a different set of requirements from microchip to their customers? Does it mean that there has to be a re-gearing of microchip, a microchip 3.0, if you will? You know, what should investors take away from that? Or is microchip 2.0, you know, the perfect equation for what we expect to see next in Semicent for microchips specifically? Thank you.

Well, I think, you know, if you look at a microchip of, you know, 10 years ago, it was providing predominantly microcontroller, which was, you know, 80% plus of our business, and a small amount of business remaining was either some analog products or memory products, but they were, you know, largely we couldn't complete a customer solution, so when we called on a customer, we largely provided microcontroller, maybe a little bit of other stuff they wanted, and the customer would surround our microcontroller with analog coming from Maxin, ADI, TI, InterCell, or others, would buy Wi-Fi or connectivity from people who made, you know, maybe a, you know, USB from Cypress, maybe Ethernet from, you know, some Ethernet company and so on and so forth. And we, you know, many times, you know, there's an old story. I think if you have, you know, a couple of minutes, I'll tell you. Back in 1993 timeframe when we went public, We used to have a partnership with Maxim where we will, you know, get hotel rooms where we will invite the customers and give seminars jointly. And, you know, we will take the front half of the room and Maxim will take the front half of the day and Maxim will take the back half of the day. We'll tell them how to design our microcontrollers and Maxim will teach them how to add analog around our microcontrollers. And it was a great partnership. It lasted for about five years. We both benefited, you know, shared the expenses, and we didn't have any analog products at that time. And the story is 20 years old. It was with Jack Gifford of Maxim, who died many years ago, so many people wouldn't know it. And then Maxim, Jack Gifford, wanted Microchip to pay him something because he said, we're bringing all the customers, and you're benefiting from it. selling their microcontrollers. And I said, this has been a great partnership for five years. We sold microcontrollers. You sold analog. You know, why are you disturbing this partnership? But he got greedy, and that broke the partnership, so we decided to go into the analog business. And fast forward 20 years, we're doing $1.6, $1.7 billion in analog now, attaching our own analog around microcontrollers, And in the process, we have acquired or built USB, Wi-Fi, Ethernet, Bluetooth, you know, flash memory, Static RAM, and all the others. So when you look at it from a customer's perspective, a customer is getting a complete solution available from us today. And a future M&A is not really required from a customer's perspective because we can complete the solution now. Now, you can always have and acquisition at further depth in any area, acquire more analog, acquire more Wi-Fi, acquire more something. But we also have a large number of design teams that are building and completing those solutions. So what we really said is that, you know, at the late stage of industry consolidation, the valuation have run sky high. You know, we bought microsending at 5Xs, And, you know, A&B just paid 10 X sales for guidance. So, you know, we believe the valuations are way too high. We're not going to pay that. We don't need other acquisitions. And our customers are going to be very, very well served by our complete solutions already. Does that make sense?

That's very helpful. Thank you, Steve. Really appreciate it. Thank you.

And that concludes today's question and answer session. I'd like to turn the call back over to Mr. Sankey for any additional or closing remarks.

So I think I want to thank our investors who have been with us for long, and I certainly have a great relationship and a long career with all of you. I'll still be here, not going away. We still have a conference coming up, a Paris-South conference, and in early December, then the next earnings call in February. And then on March 1, I become executive chair, but you will still see me at the investor circuit and conference calls and investor conferences and others. So I'll still continue to be involved with Microchip and not going away.

Thank you very much.

Once again, that does conclude today's conference. We do appreciate your participation. You may now disconnect your phone lines.