Microchip Technology Incorporated

Good day, everyone, and welcome to Microchip's third quarter fiscal 2021 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 Chief Financial Officer Eric Bjornholt. Please go ahead.

Thanks, Chloe, and 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 are our 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 Steve Sange, Microchip's Chairman and CEO, and Ganesh Murthy, Microchip's President and COO. I will comment on our third quarter financial performance, and Steve and 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 had an unintentional posting of our earnings release on our website shortly before the normally scheduled timing today. Once we determined this occurred, we moved quickly to get the releases sent out over our normal distribution processes. We are including information in our press release and our 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 also posted a summary of our outstanding debt and our leverage metrics on our website. I 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 December quarter were $1.352 billion, which was up 3.3% sequentially and above the midpoint of our quarterly guidance. We have posted a summary of our gap net sales by product line and geography, as well as our total end market demand on our website for your reference. On a non-gap basis, gross margins were a record at 63%, operating expenses were at 23.2%, and operating income was a record 39.8%. Our factory underutilization charges decreased from $12.2 million to $3.7 million sequentially, as we continue to ramp our factories to respond to the strong business conditions. We expect the continued ramp of our factories to lead to no underutilization charges in the March quarter. Non-GAAP net income was $444.9 million. Non-GAAP earnings per diluted share was $1.62, five cents above the midpoint of our guidance. On a GAAP basis in the December quarter, gross margins were a record at 62.6%, and include the impact of $6.4 million of share-based compensation expense. Total operating expenses were $600.2 million and include acquisition and tangible amortization of $231.6 million, special charges of $4.3 million, $5.4 million of acquisition-related and other costs, and share-based compensation of $44.8 million. The GAAP-MED income was $36.2 million, or 13 cents per diluted share, and was adversely impacted by a $142.1 million loss on debt settlements associated with debt refinancing activities in the quarter. Our December quarter GAAP tax expense was impacted by a variety of factors, notably the tax benefit recorded on the convertible debt exchange transactions occurring during the period. Our non-GAAP cash tax rate was 4.25% in the December quarter, We expect our non-GAAP cash tax rate for fiscal 21 to be about 4.8%, exclusive of the transition tax. Any potential tax associated with restructuring the micro-semi-operations and 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 taxes low in the future. Our inventory balance at December 31, 2020, was $666.1 million. We had 120 days of inventory at the end of the December quarter, which was flat at the prior quarter's level. Inventory hour distributors in the December quarter were at 26 days, which is a record low level, and down from 30 days at the end of the prior quarter. In the current environment, it is quite challenging for microchip or its distributors to increase days of inventory. In the December quarter, we exchanged $1.086 billion of our 2025, 2027, and 2037 convertible subordinated notes for cash, shares of our common stock, and a new convertible bond that matures in 2024. 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 share count dilutions to the extent our stock price appreciates over time, which Steve will comment on further in his prepared remarks. In calendar year 2020, we reduced the amount of convertible bonds on Microchip's balance sheet by approximately $2.9 billion. In the December quarter, we also issued a $1.4 billion senior secured bond with a maturity date of February 15, 2024, and an interest rate of 0.972%. and used the proceeds from that transaction to pay off our term loan B, which we were paying an interest rate of about 2.15% on. Our cash flow from operating activities was $509.7 million in the December quarter. As of December 31st, our consolidated cash and total investment position was $372.7 million. We paid down $289.7 million of total debt in the December quarter, But please remember that this is inclusive of the cash paid for our various debt financing activities in the quarter, including putting a capped call in place for our newly issued convertible bond. Over the last 10 full quarters since we closed the microsemi acquisition and incurred over $8 billion in debt to do so, we have paid down $3.24 billion of debt and continue to allocate substantially all of our 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 business, as well as the ongoing operating discipline we have. We continue to expect our debt levels to reduce significantly over the next several years. Our adjusted EBITDA in the December quarter was a record 593.4 million, and our trailing 12-month adjusted EBITDA was 2.271 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 3.93 at December 31, 2020, down from 4.04 at September 30, 2020. But please note that the amount of the 2037 bonds were reduced by $407.7 million during the December quarter as part of the financing transactions, which has impacted this metric. Our dividend payment in the December quarter was $96 million. Capital expenditures were $21.4 million in the December 2020 quarter. We expect between $50 and $60 million in capital spending in the March quarter, and overall capital expenditures for fiscal 21 to be between $87 million and $97 million. In last quarter's conference call, we explained that our capital expenditure plan for fiscal 21 had increased as we more rapidly prepared for growth, and our business, as well as actions we were taking to increase our internal capacity in the face of constraints our outsourcing partners are experiencing. Our fiscal 21 capital expenditures are coming in lower than we indicated last quarter due to longer equipment lead times and deliveries pushing out due to overall industry conditions. We continue to add capital to maintain and operate our internal manufacturing operations, support the production capabilities for our new products and technologies, as well 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 December quarter was $40.3 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. Let's start by taking a closer look at microcontrollers. Our microcontroller revenue performed well, with revenues sequentially up 3.3% as compared to the September quarter. On a year-over-year basis, our microcontroller revenue was up 5.9%. We continue to introduce a steady stream of innovative new microcontroller solutions, including the first safety-certified capacitive touchscreen controllers for the home appliance market, the first trust-and-go Wi-Fi module delivering powerful 32-bit microcontroller functionality and verifiable identity, the industry's highest-density secured Ethernet switching solution for hyperscale data centers and telecom service providers, and last but not least, three new broad-market 8-bit microcontroller families to extend our leadership in this product line. Microcontrollers overall represented 53.7% of our revenues, in the December quarter. Moving to analog, our analog revenue also performed well and was sequentially up 3.1% as compared to the September quarter. On a year-over-year basis, our analog revenue was up 2.6%. During the quarter, we continued to introduce a steady stream of innovative analog products too, including the first cryptographic companion device supporting in-vehicle network security solutions, a new family of configurable 12-bit digital-to-analog converters, the first highly integrated radiation-hardened motor controller, and finally, a family of low-latency PCI Express 5.0 and Compute Express Link re-timers. Analog represented 27.6% of our revenue in the December quarter. Our FPGA revenue was down 8.5% sequentially as compared to the September quarter. On a year-over-year basis, our FPGA revenue was up 7.1%. As we cautioned on our prior conference calls, FPGA revenue does have some lumpiness associated with it because of the large exposure to the aerospace and defense markets and the associated purchasing patterns. During the quarter, we announced a radiation-hardened fourth-generation FPGA family and a low-power radiation-tolerant fifth generation PolarFire FPGA family. FPGA represented 7.3% of our revenue in the December quarter. Our licensing, memory, and other product line, which we refer to as LMO, was up 13% in revenue as compared to the September quarter, with strength in licensing revenue driving this growth. LMO represented 11.4% of our revenue in the September quarter. A quick note about our product line reporting. Given the relatively smaller size of our FPGA product line, at about 7% of our revenue as compared to our microcontroller and analog product lines, we have decided that starting in calendar year 2021, we will no longer break out the FPGA product line separately. Our FPGA products remain important to our overall total system solutions goals. We continue to make significant investments in our FPGA products and expect those investments will help drive our long-term growth and total system solutions initiatives. Going forward, we will combine our FPGA revenue with our LMO, our licensing, memory, and other revenue into a new category that we just call other. From an end market standpoint, we continue to see the automotive, industrial, and consumer markets strengthened further in the December quarter. approximating a V-shaped recovery in the second half of calendar year 2020 as compared to the first half. The end markets that benefited earlier in the year from the work-from-home related demand surge, namely computing, communications, and data center, remained at more normal demand patterns as the surge we saw in the June quarter dissipated. The Huawei ban, which was in effect for all of the December quarter and represented 1% to 2% of our overall revenue, had a more pronounced negative impact on our data center business, where it was a more meaningful percentage of that business. Finally, demand for our products that go into the office environment, which we refer to as enterprise demand, remained weak, as most businesses remain predominantly with work-from-home policies, thus deferring enterprise spending for the office environment. The supply chain constraints that started in the September quarter continue to grow through the December quarter, a robust overall business environment, accentuated by rising demand from the automotive, industrial, and consumer markets, combined with low levels of inventory in the distribution channel, resulted in constraints in practically all of our internal and external factories. Since September, we have been ramping our internal factories, as well as investing in capital additions to further expand our internal capacity. We have also worked with our supply chain partners to increase our FAB assembly, and test capacity allocation. However, based on the current strength of the business environment, we expect that the constraints we are currently seeing are likely to continue through much of calendar year 2021 and possibly into calendar year 2022. As a result, we have seen our lead time stretch out for many of our products where the constraints are most acute. We have also experienced increases in material and subcontracted manufacturing costs and have taken steps to secure capacity for 2021. Steve will discuss more in his prepared remarks about our actions to address the current environment of increasing manufacturing costs and seemingly insatiable demand. Let me now pass it to Steve for 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 2021. I will then provide guidance for the fiscal fourth quarter of 2021. The December quarter represented the shift of the business cycle back to revenue growth with a 3.3% sequential growth in a quarter where ordinarily we would see a 3% sequential decline from typical seasonal factors. December quarter revenue also grew over prior year's December quarter by 5%. We started ramping our internal factories in September, as well as investing in capital additions to expand our internal capacity. We also started working with our supply chain partners to receive more allocation from wafer foundries and assembly test subcontractors. These efforts improved product availability in the December quarter, but still constrained some of the revenue upside. We delivered a record non-GAAP gross margin of 63%, helped by significant reduction in factory underutilization and better overhead utilization from revenue growth. We also achieved non-GAAP operating margin of 39.8%, an all-time record, and getting very close to an emotional 40% mark. We also hit a record EBITDA of $593.4 million, despite revenue not at a record yet showing the robust strength of our business model. Our consolidated non-GAAP EPS was $1.62, five cents above the midpoint of our guidance. This was also our 121st consecutive quarter of non-GAAP profitability. Now I will discuss our guidance for the March quarter. Our bookings were exceptionally strong in the December quarter and were an all-time record. We received bookings both for short-term as well as into the future quarters. The backlog is also an all-time record. Please remember that bookings as well as the backlog is what is shippable in the next 12 months. The backlog for the March quarter is the strongest starting backlog I have ever seen. Our bookings have remained strong in January. On the operational side, the December quarter was constrained by product availability. We will have more internal and external capacity in the March quarter since we have had multiple months to ramp, although I believe that wafer fab as well as backend constraints are here to stay with us through calendar year 2021. In response to the business environment, we have taken three actions. First, in the middle of December, we changed our cancellation and push-out terms with our customers and distributors. The standard terms used to be that an order cannot be canceled or pushed out once it is within 45 days of shipment. We changed our standard terms so that an order cannot be canceled or pushed out within 90 days of shipment effective January 1, 2021. We gave customers a couple of weeks to adjust their backlog before it went firm for 90 days. In response to our change in terms, we did not see any unusual cancellations or push-outs, which indicates to us that the backlog was firm and needed by our customers. That gave us a solid backlog for the March quarter, which cannot be canceled or pushed out. Therefore, we can batch process the orders and use our manufacturing assets most efficiently, knowing that what we build will get shipped. The second action we took was that we sent a letter to our customers on January 4, 2021, informing them of the business environment. We also informed them that we are seeing broad-based cost increases in and some aggressive commercial terms from our supplier base, and we must pass these cost increases to our customers through a broad-based price increase. The third action we took just this morning, we posted a letter on our website and sent it to our customers and distributors announcing a new program called the Microchip Preferred Supply Program, or PSP. This program offers our customers the ability to receive prioritized capacity in the second half 2021 and first half 2022. The program has the following elements. The customers participating in this program will have to place 12 months of orders, which will be non-cancellable and non-reschedulable. The capacity priority will begin for shipments in July 2021. The program will not be a guarantee of supply. However, it will provide the highest priority for those orders which are under this PSP program. And the capacity priority will be on a first-come, first-served basis until the available capacity is booked. We will, of course, reserve a portion of our capacity for new customers, small, long-tail customers, and new designs. We expect that a significant portion of our capacity will be booked under this new program With a large committed non-cancellable backlog for 12 months, Microchip will be in a stronger position to make capacity and raw material commitments to our suppliers, buy capital equipment with confidence, hire employees and ramp up manufacturing and manufacture products more efficiently. Taking all these factors into consideration, we expect our net sales for March quarter to be up between 5% to 10% sequentially. The March quarter guidance at the midpoint would represent record GAAP net sales with the prior record being in the September quarter of 2018. The September quarter of 2018 based on GAAP sell-in revenue recognition was $1.432 billion. Some of you may still carry a sell-through base number of $1.513 billion for September 2018 in your historical financial model spreadsheets. The MAS quota will also be limited by product availability on many product lines. Our guidance assumes working through a myriad of capacity constraints, qualifying incremental equipment installed, qualifying alternate subcontractors in some cases, and still dealing with the risk of production constraints with a new wave of COVID cases plaguing the planet and at the same time ramping up vaccinations. For the March quarter, we expect our non-GAAP gross margin to be between 63.3% and 63.7% of sales, which would be a new all-time record. We expect non-GAAP operating expenses to be between 23.2% and 23.6% of sales, and we expect non-GAAP operating profit percentage to be between 39.7% and 40.5% of sales. We expect our non-GAAP earnings per share to be between $1.67 per share to $1.79 per share. We also expect to pay down another approximately $350 million of our debt in the March quarter. Finally, I want to cover one other area, which is our future cash return strategy. At the rate we're paying down debt, we expect to break a net leverage of three within a year and continue to decrease from there. At that time, we expect to begin distributing more of our substantial amount of free cash flow to the investors in the form of dividends and stock buybacks. Regarding buybacks, Through multiple tranches of convertible debt buyback, we have essentially bought a substantial amount of stock back from the future. This is because as the stock price rises and exceeds the conversion price of the debt, convertible debt dilutes the share count. Buying converts back prevents future dilution as the stock price rises. Our first convert buyback was in March 2020. when Microchip's stock price was about $71. Since then, we have done four other buyback transactions at various stock prices. By doing these various buyback transactions, we have purchased a total of $3.525 billion in face value of our convertible bonds. For the transactions from March 2020 to September 2020, we issued a total of about 20.4 million shares of our common stock to the investors for in the money value of their bonds. If these bonds had remained outstanding until an assumed stock price of $140 per share, the stock price about now, the dilution would have been about 26.4 million shares. Thus, our repurchases had the impact of creating a savings of about 6 million shares worth $840 million savings to our investors at $140 per share. This calculation does not include our November 2020 transaction, which was very recent and executed at $133.47 per share, so it is not yet accretive. Therefore, while we have not done any open market stock buybacks in the last year, our convert transactions have had the impact of a buyback of approximately 6 million shares. At some point in the future, we expect to start pure stock buyback from the open market. We are also initiating a path to higher dividends and not waiting until our leverage reaches a given number before the dividend starts to increase. In this regard, we announced today that the Board of Directors have approved a dividend increase of 5.8% sequentially 39 cents per share, up from 36.85 cents previously. We expect to continue to increase dividends quarterly as part of our cash return strategy. 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 expect that the analysts, and we request that the analysts continue to report their non-GAAP estimates to First Call. With this, Chloe, will you please poll for questions?

Certainly. If you would like to ask... Certainly, if you would like to ask a question, please signal by pressing star 1 on your telephone keypad. Due to time constraints, we ask that the participants limit themselves to one question at this time. If you have a follow-up question, please re-enter the queue. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star 1 to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal. And we'll take the first question at this time. Caller, please go ahead.

I'm not able to hear you. Maybe you're on mute.

Steve, can you hear me?

Yes, now.

I apologize. I didn't hear my name get called. I just heard caller. I apologize for that. Just really quickly, we've lived through multiple times of you sending out customer letters to and we kind of have an understanding of how the market responds to that. I'd be kind of curious, the preferred supplier agreement that you talked about in your opening remarks, is this the first time that you have done that? And if it's not, what's been the historical response to programs like this?

So the preferred supplier program is brand new. I have not ever implemented it in my 42 years of career, and I have never seen anybody else do that too. The program is largely a response to the current environment because bookings level is just so strong and people are booking parts out in time. The industry seems to be, you know, 30% plus sure to really what the capacity requirement is. And many of our customers have been asking, you know, what can they do if they give us longer-term demand longer-term orders, you know, will that give them parts? Would that give them better support? Now, you know, customers can give us longer-term orders, but if the orders are cancelable or reschedulable, you know, after 90 days, which was the case prior to the program, then I could have a lot of orders for September and December and could buy capital, hire people to rent, but just before I get there, people could cancel. If there was a double ordering, people were asking more than they need, and they canceled part of the orders. So that is often the problem always, and you guys ask the question, is there any double ordering or whatever? And this program basically eliminates all that. It asks the customers to place 12 months of backlog, which will be non-cancellable, non-reschedulable, So I can take that one to the bank, buy raw material, do batch processing, grow the capacity, and give them preferential supply. So this is the first time we have implemented it. It's just the need of the times.

And I know it was just this morning, but what do you expect the intended response to be from your customers?

Well, you know, a small number of customers, you already have feedback through the day. including a couple of distributors, the response is positive. They would place such orders. I don't expect any customer to place their entire backlog on every product on the PSP program because customers themselves have some programs where they are solid, that the demand is good, they have a good market share on that particular design, but some others could be some new programs where The demand is yet not known. So I think customers will really take a lot of the product and put it on PSP and some others that they want.

Perfect. Thank you, guys.

You're welcome.

We'll take the next question. It comes from Tashia Hari. Please go ahead.

Hi. Good afternoon. Thanks so much for taking the question. Steve and Ganesh, given the current supply and demand situation, What are your thoughts on pricing across your microcontroller and analog business? And if you can kind of speak to gross margins on the back of that, that would be helpful. And I guess sort of related to that, given the preferred supplier program, how should we think about the economics of that program? Thank you.

So, you know, we sent a letter to our customers on January 4th really informing them first of the business environment, and also informing them that we were seeing, you know, broad-based cost increases and some very aggressive commercial terms from our suppliers who were facing, you know, similar issues from their suppliers, really up and down the supply chain, and we must pass these cost increases to our customers through really a broad-based price increase. So after writing that letter, then we need to really develop that program, and we got a several hundred thousand SKUs and going through the price increase on which part and how much and passing on to the customers, working through their contracts and long-term prices and stuff like that. So all that really has been implemented at this point in time. We aren't breaking out what portion of the guidance is price increase. That's kind of relatively difficult. But the price increases have already been made effective. As far as the economics of the PSP program, the economics of the PSP programs really are in having a committed, non-cancellable, non-reschedulable backlog on the books that we can build it in batches, buy raw material ahead if we wanted, increase the inventory if we wanted to serve that, and build it whenever we have a lull. Essentially, that's where the economics are, to be able to serve the customers better who join the program and microchip not be subject to ordering more than they need and double ordering because they're not going to double order and order more than they need if they cannot reschedule or cancel. So that's where the economics are. There's no price change with that. Price program is totally separate. I don't know if that answers the question.

Thanks.

We'll take the next question. It comes from Vivek Arya. Please go ahead.

Thanks for taking my question. Steve, you used this phrase, significant revenue growth in calendar 21, and you're starting the year at about 10% year-on-year growth. Is that a significant number? Is it something higher than that? And more importantly, What kind of growth can your supply chain support this year?

Well, you know, I don't know. You must have noted what I said. I thought I talked about the question really was that, you know, street had 7% growth. Do you expect something higher than that? And my answer was yes. So, you know, whatever anybody interpreted, I don't know what significant means. and I can't really give you a number for the growth for the year, although I think the revenue is more constrained by capacity than the demand, at least now and for the next several quarters, which leads to your second question, what kind of growth does the supply chain support? I think one of the problems that we're dealing with is that The supply chain is not as stable. We're finding that an assembly test subcontractor will commit that they can do X number of parts per week. As we get there, they would change that number. They would lower that number or push it out by a couple of weeks. What happened? What happened was they got a decommitment from their supplier. They didn't get some bonders they were expecting. They couldn't hire some people. Somebody tested positive for COVID, so they had to send 50 people home who had come in contact with it. So, you know, there's no slack in the system. Everything that gets built gets shipped. There's absolutely no slack in the system. So any perturbation, there was an earthquake in Taiwan. We had a car that hit our substation in a fab in Oregon that knocked out about three or four days, partial knockout, not complete. You know, none of those things are makeable because all factories are working seven days a week, you know, full board. So any delay in equipment just leads to a decommitment. So I think those are all the myriad of problems we're dealing with in adding equipment, adding people, qualifying additional subcontractors, getting our customers to waive qualification. You know, automotive are the hardest customers to qualify production in a different plant or to approve a change. And in the last six months, we have been so successful in getting even all the automotive customers that they would buy the product from this alternative assembly site or test site or all that. So we're getting help in that area, but it's still a very, very complicated process to put it all together, and therefore we're not willing to dollarize the number or what percentage we could grow. Not yet.

Thank you. We'll take the next question that comes from Craig Hettenbach. Please go ahead.

Yes, thanks. Steve, just a question on the DISTI inventory at 26 days. You know, when would you expect that to perhaps get back to kind of within normal ranges and any trends you could share just by geography in terms of DISTI resales?

Well, you know, distribution would love to grow the inventory in this environment to serve the end customers better. But, you know, this inventory can't grow. There is not enough product available to grow the inventory because the product keeps getting shipped out. Another point I would like to make is that our inventory, as well as distributor inventory, is calculated based on last 90 days of sales. So it's based on the prior quarter. So essentially, you know, the real value of the inventory is to support the future. So if you take our guidance and take the midpoint of that guidance, let's say, and calculate the days of distributor inventory or microchip inventory based on that guidance, then the inventory numbers are extremely low. But they're calculated as we report, which is a standard convention based on the prior quarter. 90 days. In a very stable environment, flat sales, it doesn't matter. But in a significant growth, the real inventory is actually much lower than the numbers we're reporting. And we don't think it's going to grow. I think our internal inventory will drop this quarter. We expect by several days, and distribution may do the same.

Got it. And then just a follow-up for Ganesh on the total system solution Any progress there or things you can share with us in terms of developments?

Sure. So, you know, it's not a one-quarter progress. It's a multi-quarter activity that we've had. The processes that need to be put in place have been there. New processes are going in. It is reflected in how we see the design activity taking place, some of which we've shared anecdotally in some of the conferences. We will share some more this coming quarter as well. But I think the power of the whole coming together, putting all the different parts of Microchip on a customer's board, is very much strong and alive, and a key part of our growth strategy.

Got it. Thank you.

We'll take the next question. It comes from Gary Mobley. Please go ahead.

Hey, guys. Thanks for taking my question. So I know you started the December quarter with your distributor inventory levels slightly below average. And it looks like you, you know, undershipped into the channel by about $26 million in the December quarter. Is that how we should think about perhaps what, you know, how much higher your revenue could have been if you had, you know, available, you know, production capacity and whatnot in a similar amount as we look out into the March quarter?

Well, you know, we had unsupported orders for every geography, for every product line, for direct as well as for distribution. So just picking a number that the distribution inventory went down by and just saying, you know, that's the revenue we missed for the December quarter will not be accurate. We're not breaking up the number, but... The total amount of revenue that we missed also was also from direct and essentially negative geography.

Okay. As a follow-up, I wanted to ask about your philosophy towards M&A when you get to that magical net leverage ratio of less than three times. Should we take that to mean that you're also open to some M&A transactions at that point as well?

I think we have spoken extensively about this in the past, saying that we believe there was an era of M&A. In the last 12 years or so, we did 16, 17, 18 acquisitions, a few large ones public and lots of them small private, and all that was intent to scale the company 10x or so, and now we are over a $5.4 billion company. and really not have a scale disadvantage to our competitors. I think we have achieved that, and today we have a product line with which we can complete a customer's entire solution and essentially have all the parts built out of microchip products and other than resistors and capacitors and connectors and battery, everything else is really made from microchip. So today there is not... you know, that need for M&A and there are no gaping holes. So we are really building a strategy going forward on organic growth built from really large amount of success in providing total system solutions to the customers. It could be a tuck-in acquisition here and there, you know, private, small, you know, really buying some people, which is a, you know, technology pipeline or something like that, but there is really no plan currently for doing any kind of large acquisition even after we reach a certain leverage.

Appreciate it. Thank you.

We'll take the next question. It comes from Chris Casso. Please go ahead.

Yes, thank you. The first question is about some of the capacity additions that you're undertaking now. Could you talk about, one, the direction of CAMPEX over the next couple of quarters as you try to address some of these supply constraints. How long does it take to get the capacity in place? And then lastly, to what extent are you looking to address these constraints through internal means as opposed to getting them through outsourcing? What's going to be the quicker and more sustainable path to getting some more product to your customers?

Thank you. Want to take the CapEx question?

Sure. Sure. So we've indicated that in the very short term, so the March quarter, we're expecting to spend between $50 and $60 million in CapEx. We've kind of given general guidance to the street. The longer term, we expect our CapEx with the percentage of net sales to be somewhere between 3% and 4%. This quarter, we'll be going through our annual operating plan for our next fiscal year. We'll provide kind of a more detailed forecast in fiscal 22, but I wouldn't be surprised if we're on the high end of that range for next fiscal year. We've been well below it for the last two fiscal years. And so clearly the demand environment is driving that. And I'll start with the second piece of the question, and Steve or Ganesh can add on to it. But we have been making significant investments in assembly and test expansion. And actually this last quarter we did 55% of our assembly in-house. That's up significantly quarter on quarter. And we did 57% of our final test in-house. So these metrics tend to be slow moving, but we are making progress on that and is allowing us to take a little bit more control of our own destiny. So with that, I'll turn it back to Steve.

So I think one of your questions implied that what portion of the capex we were spending for internal versus external. I think 100% of our capex is really being applied to grow the capacity internally. The external capacity growth, we're getting it just by getting larger allocation and negotiating for a larger piece of the total capacity pie at foundries and subcontractors. We're not really spending our CapEx dollars in growing their capacity. But our capacity is growing significantly outside also. But overall, as Eric mentioned, You know, especially in the assembly and test area, a large portion of the capacity growth is happening inside.

All right. As a follow-up, you know, given the strongly better than seasonal March, the fact that you've got, you know, backlog that's difficult to fill all of that, you know, how do we think about seasonality through the rest of the year? And there are always difficult questions right now, but, you know, any kind of qualitative comments that you can provide would be helpful.

I think, you know, seasonality has been difficult to define for Microchip for some time because of, you know, all these acquisitions and especially with MicroSemi, the end market mix changed so much that we said, You know, if you've got a year or two years of stable environment, then one could figure out what the seasonality would be, and we haven't gotten that stable environment. First was the U.S.-China trade, then last year was the COVID, and this year is this runaway growth or capacity constraint. So in this environment, it's not the seasonal factor that's changing what you can or cannot do. It's a combination of how much capacity you can grow, what the overall demand is, So I can't really comment much on seasonality in this kind of environment.

Thank you.

We'll take the next question. It comes from Harlan Sur. Please go ahead.

Good afternoon. Thanks for taking my questions. Maybe as a follow-up to the last question, and I know the difficulties and complexities in quantifying full-year revenue generation potential, but maybe more near-term, you know, I assume that the team is almost fully booked for the June quarter. Maybe you guys can confirm that. And that would include any unshipped delinquencies from March. In June, you know, we could argue, you know, about seasonality, but typically June is up sequentially, right? So your foundry wafer requirements are probably already fixed for June, given the lead times from your foundry partners. But wondering if you guys would be able to bring on, you know, and qualify additional wafers in assembly and test capacity in time to support higher levels of revenues from where you are here in March, if it plays out that way in June?

So you can't qualify different fabs in a matter of three months or six months. you know, depending on what the process and products are, you know, it's a much longer effort. So a lot of the capacity growth is really coming out of, you know, growing capacity where the processes are already installed. You know, we got some processes that are installed outside as well as inside. And most of the other majority of our processes either run outside or run inside. And when they run outside, they usually only either run in one foundry or the other foundry. So there's really no process that runs in three or four different foundries. They may run in three or four different fabs of the same foundry. You know, like take TSMC. It could run in three different fabs of TSMC, but it doesn't run in TSMC as well as global, as well as UNC or something. So the capacity growth is largely coming from where the processes are already installed from a TAP standpoint. From an assembly test standpoint, yes, we're qualifying additional alternate assembly subcontractors which could give additional capacity. But there also, majority of the growth in assembly as well as test is coming from buying capital and installing in three of Microchip's large facilities, two in Thailand, And one in the Philippines, they're basically doing a record amount of assembly and tests every day, and capacity is rising every week, every month, every quarter for the rest of the year.

So there was a second comment there from Harlan talking about or kind of implying that June quarter is fully booked, and that is not the case. June quarter isn't fully booked. March quarter isn't fully booked. It can be fully booked on certain products, and maybe Ganesh can expand on that a little bit.

Yeah, I mean, you know, even for this quarter, we have strong backlog, but we have some turns yet to take, and there is – turns to take for the June quarter. As Eric mentioned, there are certain product lines which can be, you know, much closer to being booked up. And that's typically, you know, it is starting at a much higher backlog than a normal quarter would be. But there is still work to be done, and there's capacity coming online, which will help with some of the growth, both that's helping this quarter, as you can see, versus December, and some more into June.

Okay, so you answered what was going to be my third question, or what was my third question, which is irrespective of how the demand plays out, if June quarter backlog ends up suggesting a higher June quarter, you guys would have the capabilities in place, foundry or internal, to drive higher revenue levels sequentially in the June quarter?

Absolutely, yes.

Okay. Thank you, Steve. Thank you, Ganesh.

You're welcome.

We'll take the next question at this time. It comes from Bree Srivastava. Please go ahead.

Hi, thank you. On the near term, and then I had a longer term, Steve, and really just wanted to make sure I understood that part. On the near term, the preferred supplier program you started just this morning, but does the guide for Mars, does it include the change in cancellation from 45 to 90, is that part of – has that been implemented long enough to reflect in the March guide?

So that was told to the customers in early December. Maybe it was the middle of December, around maybe 8th or 10th of December. And we gave them then the following three weeks or so to make any changes to the backlog they wanted to make. And on January 1, the backlog will go hard for the 90 days. So there were very few changes made. There were just meaningless, very small changes. So as of January 1, then whatever was on our books for the March quarter became firm, but no changes could be made. And that backlog position for the March quarter was very strong, strongest we have ever seen in our careers. Now, as Ganesh answered earlier and Eric answered, that doesn't mean the March quarter was fully booked because you always have products where there's product available and customers and distributors can continue to come and buy those products where the lead time is still fairly short and shipable within the quarter. But, you know, a very large number of products were also completely booked and nothing available for March and some products even nothing available for June. So the impact of that 90 days was effective on January 1. And then as you go, as you finish the month of January, then the backlog is now hard for February, March, April. By the end of February, the backlog will be hard for March, April, and May. So that was the 90-day program. The PSP program is an entirely new program. The 90-day program was applicable to all customers worldwide direct to distribution. The PSP program is a customer's option. We can't force them to give us one year of backlog. So that was an option given to the customer that they can have an ability to get preferred supply support if they would give us 12 months of non-cancellable backlog, which helps us in bringing capacity online and buy capital and hire people with confidence And it gives them preferential capacity, so there is something in it for both.

Got it, got it. I just want to make sure this is clear. I want to make sure this is clear that that has zero impact on the March quarter.

Or the June quarter, for that matter.

Yes. The PSP program support starts from July. Now, the order is they can place it now for 12 months. But if they come up with a whole bunch of new orders for March, April, May, June, they can't get the supply ripped off from other people who have placed the backlog before. So PSP capacity support does not begin until July.

Got it. I wasn't confused about PSP. I just wanted to make sure that the March quarter is – it sounds like you were able to pull together a lot of internal and external support to guide to what you did. And it also has some back or some solidity, lack of a better word, because of the 90 day that you started in December. That's what I wanted to understand, because there's a concern about double booking. That sounds like the way you have framed it and the way you're running the business at this point, it seems like you, you have quite a lot of visibility on that. My longer term questions, Steve, and thanks for addressing that your business model is transforming. And you've been talking about M&A being less of a priority given where the valuations are and focus on organic. So the question, and you addressed it by saying the buyback, even though not directly, you have been bringing down dilution. What was the point you made on dividend? I missed that. What's the formula that you have in place for dividend growth?

We don't really have a formula in place. We just... You know, board will meet every quarter and decide the dividend for every quarter. In the current quarter, we grew the dividend by 5.8%. And you could, you know, expect that board will grow the dividend every quarter. And that's really a commitment. We told in the last couple of quarters that we would build a glide path towards a higher dividend. And this is a glide path towards a higher dividend. So if you accumulate the increase in dividend for four, five, six quarters, then by middle of 2022, you already would have a significantly higher dividend after seeing six increases of the kind we just did. That's really what we're trying to do, to get to higher dividends. And by that time, leverage would have come down and that higher dividend would really be supportable at that point in time from the cash flow and still have enough cash available to keep bringing that debt down further.

Got it. Thank you.

We'll take the next question. It comes from Chris Dainley from Citi. Please go ahead.

Hey, thanks, guys. I guess just a little bit of color on the capacity constraints and shortages. So, you know, Steve, you talked about it being in the automotive, industrial, and consumer sectors or end markets. Most of your competitors are just saying automotive. Would you expect this to spread to those other end markets for your competitors and other folks in semis? And then when do you remember these shortages being this bad? Do we have to go back to like 2010 or 2000?

I do not remember shortages being this bad ever. So this is a six sigma event in terms of shortages. I call it a black swan event, although that's more meant for negative. I don't really know what other competitors are saying what, but our capacity for automotive products and industrial products and consumer products is really common. It runs out of same fabs, the same processes. Sometimes they're the same parts that we can ship into an automotive or ship into an industrial product. So, you know, the capacity constraints would really be shared by all markets. Now, the largest increase in demand has been in automotive, where in the June quarter, automotive demand went to 20% of normal because all the factories shut down. And as the demand has gone back to a 95% of normal, 100% of normal, that's a 5X increase in auto demand. So they are seeing sort of the worst shortages, because they didn't place their orders, they didn't really guide towards having this strong V-shaped recovery, so their cart is a little worse than that, but the capacity is common.

Okay, thanks.

There's also a fact that in automotive, a $1 part can prevent a $40,000 car from shipping. In industrial, a $1 part could just prevent a 1999 power drill from not shipping. So the hurt factor is quite different, so therefore the noise from automotive, the escalations of the management chain, you know, and the pressure and all that is really at a different level.

We'll take the next question that comes from Harsh Kumar. Please go ahead.

Yeah, hey, guys. First of all, congratulations on the tremendous guy that gets to sign up. Steve, I had two, and I'm just going to lump them all into one. I wanted to go back to what Harlan was talking about earlier. As you get over your supply issues, let's say whether it's June or July, am I incorrect in thinking based on your kind of what you mentioned, the press releases having a very strong year, as you're able to supply, should you not expect a second half that is better or stronger? Or help me think about linearity from here. And then for Eric, the question is on gross margin. If I'm not mistaken, you're at your target or very close to it. With no M&A, would there not be a potentially to think about that gross margin and get more and more efficient?

So I think taking the question of capacity, you mentioned somehow that we catch up by June, July. We don't expect to catch up on demand capacity balance for the balance of the calendar year 2021 and could possibly go into 2022. I mean, we already know that the demand on lots and lots of products exceeds where we have no product available. If you place an order today, we're shipping you in September, October, and people are booking September, October, November, you know, fast. And with PSP programs, we're going to get backlog all the way through next January, February. So I don't think the capacity issue is getting solved in the next four, five, six months. I think we're talking a 12-month, you know, at least to solve that, you know, to really have the capacity to get in balance. I don't remember the other part of your question.

I'll take the gross margin question. So We did actually update our long-term targets for gross and operating margin back in December. We took the gross margin target to 65% and the operating margin target to 42%. So we essentially achieved what was our prior target of 63% on the gross margin with these last quarter results and are guiding at the midpoint to about 63.5%. So, you know, gross margin has absolutely been a highlight over the last couple of years, and we're continuing to do all the right things to be efficient in our operations to drive improvement. And I'm not sure if you have more follow-up than that, but we definitely have outlined, you know, five or six things that are going to help us continue to make improvement on gross margin into the future, and we can go through that separately if you'd like, Harsh. I appreciate the clarification, Eric. No, I'm good. Thank you.

We'll take the next question that comes from Janet Ramkasoon. Please go ahead.

Nice creativity, guys, with this new program. I was going to ask a question about the margins as well. It just seems to me that if you have a lot of visibility and you could procure supplies in a more timely and efficient manner and you just plan better, generally speaking, as you exit 2021, you should be in a position where you would hit those target margins. You could hit those target margins a lot sooner. Am I correct in thinking that, Steve, or is there something I'm missing?

Well, you know, the PSP program, you know, doesn't really do anything to the margin. Anecdotally, you know, it could make us more efficient if we get a large amount of backlog, lots and lots of customers take up on that offer, and then we can, you know, build the product more efficiently. It could help a little bit on the cost side of the equation, but PSP program wasn't launched to drive margins. It was It was launched to get a firm customer backlog that we can be confident of growing our capacity and not have any double ordering or excess ordering in that backlog, which could go away when we get there. That's why it was launched. It was not launched for margin, and I don't think it's going to have a lot of impact on margin. Now, as we are going through this growth period, you know, you have three or four things happening. You know, number one, all the underutilization is going away. Most of it has gone away in March, but some could be going away in June. Number two, as the incremental capacity is being added, the incremental capacity usually is more productive, you know, because you're not adding the entire, every machine. You're adding bottlenecks here and there. So when you add that capacity... the incremental margin thrown for every dollar of revenue tends to be better, and you could go back in the price cycles and calculate incremental margin to get some idea. The third being, you know, we are bringing some products, both in fab and assembly and test, from outside to inside, and those moves are accretive. There could be something else. The impact of price increase, I think, is going to be relatively benign because we largely launched that to offset the cost increases, but you can't always increase the price on a product where you have seen the cost increase. You've got to look at the product, whether there's a competitive element there or it's a proprietary product, so the price increase and cost increase don't completely match product by product. But overall, you know, we might get some benefit, certainly in revenue, probably not in margin.

That's very helpful. Thanks very much. Great quarter.

You're welcome.

We'll take the next question at this time. It comes from Dennis Piacanin. Please go ahead. Hi.

Thanks for taking my question. I'm here to ask the question on behalf of Raji Gill. Is there any chance you could provide us with some more color on the various kind of end market gross margins? Kind of how did those move throughout the last quarter? So, you know, if you maybe can break it out by your reporting segment.

We don't break out gross margins either by end market or by product line. So we report at a company level, and that's all we have.

And if you don't, as a follow-up, how do you expect kind of the recent investments into the internal capacity to impact, you know, your margins over the next three quarters? Would you say that there's going to be a noticeable impact of the internal capacity coming online? And, you know, has that been factored into your guidance? Or do you expect that to maybe hit towards the kind of the end of the calendar year?

Come on.

Go ahead. Go ahead.

No, I'm going to say I think these come on slowly. They're not going to make big quarter-to-quarter changes in what they're at. Directionally, each of them is a small step in the roadmap that we have set. We want to improve our gross margins to the long-term target. But I would not be looking for quarter-by-quarter. These are making big changes in the gross margin of the company overall.

I see. That was all. Thank you.

We'll take the next question that comes from Christopher Roland from Susquehanna. Please go ahead.

Thanks for the question, guys. Just two quick ones for me, and then I'll get off. I guess, Steve, first of all, PSD, ultimately what percent of revenue do you expect to go through the PSD program versus other? And then secondly, as you bring some internal capacity home, even on the wafer side. Does this bring up a conversation about a 300-millimeter FAB or not? Is that, you know, at what point does that become of interest to Microchip?

So I think the first part of your question, what portion of the revenue we expect to go through PSP, we really have no idea. You know, it's never been done before. It is being launched by, you know, taking on questions from many large customers saying, what can you do to make sure I get capacity support in the second half? I'm delinquent now. You're not giving me everything I need. How can I ensure that I get that in future? And so we came up with this program and saying if you commit to that your orders for the next 12 months are non-cancellable, non-reschedulable, then we will go with confidence, build a product, and give you potential support. So we do not know what the uptake would be. I'm just purely guessing. We just launched it this morning, and I've gotten three or four inputs since then, one from a major distributor and a few from customers, one customer that I've talked to personally. So I think this is hot off the press. So that's that. The other part of your question was the 300 millimeter. There is no plan to do any 300 millimeter inside. We continue to have two large 8-inch fabs and one large 6-inch fab and a number of small, you know, 4-inch sort of fabs that we are transitioning product away from those 4 inches to our 6-inch and 8-inch fabs. The 12-inch epic capacity continues to be at our foundries for any foreseeable future.

Thanks, guys.

There are no further questions at that time, and that ends our question and answer session for today. I'd now like to turn the conference back over to Mr. Sankey. Please go ahead.

Yeah, I want to thank everyone for attending the call. I also want to say that this is my last call as CEO. As many of you know, Ganesh Murthy would be the CEO starting March 1. I would still attend the calls. I would stay engaged with the investors. But Ganesh will take the lead role. And if some of you are expecting to find a softer version of Steve, you may not get that. Internally, he's five years than I am, but we'll see externally how Ganesha acts. So thank you all. Bye-bye.

This concludes today's call. Thank you for your participation. You may now disconnect.