Microchip Technology Incorporated

Good day, everyone, and welcome to today's second quarter fiscal year 2023 financial results conference call. Today's call is being recorded, and now at this time, I'd like to turn the call over to Eric. He'll be on hold. Please go ahead.

Thank you, and good afternoon, everybody. Thank you for bearing with us. We had some conference call dial-in challenges that we've worked through now, so appreciate your patience with that. During the course of this conference call, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are predictions and that actual events or results may differ materially. We refer you to our press releases of 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 CEO, Steve Sange, Microchip's Executive Chair, and Sajid Dowdy, Microchip's Head of Investor Relations. I will comment on our second quarter financial performance. Ganesh will then provide commentary on our results and discuss the current business environment, as well as our guidance. And Steve will provide an update on our cash return strategy. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and on this conference call on various GAAP and non-GAAP measures. We have posted a full gap to non-gap reconciliation on the investor relations page of our website at www.microchip.com and included reconciliation information in our press release, which we believe you will find useful when comparing our gap and non-gap 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 September quarter were $2.073 billion, which was up 5.6% sequentially. We have posted a summary of our GAAP net sales by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were a record at 67.7%, operating expenses were at 20.9%, and operating income was a record 46.9%. Non-GAAP net income was a record $814.4 million, non-GAAP earnings per diluted share was a record $1.46, and at the high end of our guidance range. On a GAAP basis in the September quarter, gross margins were a record at 67.4%, Total operating expenses were $642.8 million and included acquisition and tangible amortization of $167.5 million, special charges of $4.3 million, $3.2 million of acquisition-related and other costs, and share-based compensation of $34.8 million. Gap net income was a record $546.2 million, resulting in a record $0.98 in earnings per diluted share, and was adversely impacted by a $2.1 million loss on debt settlement associated with our convertible debt refinancing activities. Our September quarter GAAP tax expense was impacted by a variety of factors, notably the tax expense recorded as a result of the capitalization of R&D expenses for tax purposes. Our non-GAAP cash tax rate was 11.2% in the September quarter. We now expect our non-GAAP cash tax rate for fiscal 23 to be between 9.8% and 10.8%, exclusive of the transition tax, any potential tax associated with restructuring the micro-semi-operations into the microchip global structure, and any tax audit settlements related to taxes accrued in prior fiscal years. This is modestly higher than our previous forecast, as we have refined our tax calculations for the year. A reminder of what we communicated last quarter. our fiscal 23 cash tax rate is higher than our fiscal 22 tax rate for a variety of factors, including lower availability of tax attributes, such as net operating losses and tax credits, as well as the impact of current tax rules requiring the capitalization of R&D expenses for tax purposes. There appears to be some momentum for the tax rules requiring companies to capitalize R&D expenses to be pushed out or repealed. If this were to happen, we would anticipate about a 300 basis point favorable adjustment to Microchip's tax rate in fiscal year 2023. Our inventory balance at September 30th, 2022 was $1.03 billion. We had 139 days of inventory at the end of the September quarter, which was up 12 days from the prior quarter's level. We have increased our raw materials inventory to protect our internal manufacturing supply lines. We are carrying higher work in progress to maximize the utilization of constrained equipment, as well as to position ourselves to take advantage of new equipment installations which will relieve bottlenecks. We are investing in building inventory for long life, high margin products whose manufacturing capacity is being end of life by our supply chain partners. We need to ensure that our supply lines can feed growth beyond what we expect in the December 2022 and March 2023 quarters, and our reported days of inventory is a backward-looking indicator. As gross margins rise, the effective days of inventory for the same physical inventory rises, and with every 100 basis points of gross margin growth, it creates approximately three incremental days of inventory. Inventory days at our distributors in the September quarter was at 19 days, which was flat to the prior quarter's level. With distribution inventory still being low, we will be carrying higher inventory at Microchip to ensure our customers can be served. In the September quarter, we repurchased $36.9 million of principal value of our 2025 and 2027 convertible subordinated notes for cash. And we also paid cash for the value of these bonds above the principal amount, which was an additional $60 million. We use cash generation during the quarter to fund the amount of the convertible debt repurchases, and we believe that these transactions will benefit stockholders by reducing share count dilution to the extent our stock price appreciates over time. The principal amount of convertible debt on our balance sheet at September 30th was 766.6 million. This includes 665.5 million of convertible bonds maturing in November of 2024, with a cash call option in place that offsets any potential dilution from these convertibles up to stock prices of $116.15. At the beginning of calendar year 2020, Microchip had $4.481 billion of convertible bonds outstanding. So today, our overall capital structure is in a much better long-term position. Our cash flow from operating activities was $793.2 million in the September quarter Our free cash flow was $682.9 million and 32.9% of net sales. As of September 30th, our consolidated cash and total investment position was $306.8 million. We paid down $264.9 million of total debt in the September quarter, and our net debt was reduced by $192.6 million. Over the last 17 full quarters since we closed the micro-Semi acquisition and incurred over $8 billion in debt to do so, we have paid down almost $5.5 billion of debt and continue to allocate substantially all our excess cash beyond dividends and stock buyback to bring down this debt. Our adjusted EBITDA in the September quarter was a record at $1.056 billion and 50.9% of net sales. Our trailing 12-month adjusted EBITDA was also a record at 3.814 billion. Our net debt to adjusted EBITDA was 1.84 at September 30th, 2022, down from 2.05 at June 30th, 2022, and down from 3.0 at September 30th, 2021. Capital expenditures were 110.3 million in the September quarter. Our expectation for capital expenditures for fiscal year 2023 is between $500 and $550 million as we continue to take actions to support the growth of our business and the ramp of our manufacturing operations. We continue to prudently add capital equipment to maintain, grow, and operate our internal manufacturing operations to support the expected long-term growth of our business. We expect these capital investments will bring gross margin improvement to our business and give us increased control over our production during periods of industry-wide constraints. Depreciation expense in the September quarter was $63.6 million. I will now turn it over to Ganesh to give his comments on the performance of the business in the September quarter, as well as our guidance for the December quarter. Ganesh?

Thank you, Eric, and good afternoon, everyone. Our September quarter results continue to be strong, driven by our disciplined execution and our resilient end markets. Net sales grew 5.6% sequentially and 25.7% on a year-over-year basis to achieve another all-time record at $2.07 billion. While we don't normally provide information on a distribution sell-through basis, which we refer to as end-market demand, we are providing information this quarter to give investors some insight into consumption. September quarter end-market demand grew sequentially at about the same rate as our GAAP net sales, which is based on sell-in recognition. The September quarter was our eighth consecutive quarter where we achieved a net sales record and the first time we have ever crossed the $8 billion annualized net sales mark. Non-GAAP gross margin came in at the high end of our guidance at a record 67.7%, up 64 basis points from the June quarter and up 244 basis points from the year-ago quarter. Non-GAAP operating margin came in well above the high end of our guidance at a record 46.9%, up 127 basis points from the June quarter, and up 438 basis points from the year-ago quarter. Due to a rapid increase in net sales over the last two years, operating expenses at 20.9% were about 160 basis points below the low end of our long-term model range of 22.5% to 23.5%. Our long-term operating expense model will continue to guide our investment actions to drive the long-term growth, profitability, and durability of our business. Our consolidated non-GAAP diluted EPS was a record $46 per share, up 36.4% from the year-ago quarter, and at the high end of our guidance. Adjusted EBITDA at 50.9% of net sales and free cash flow at 32.9% of net sales were both very strong in the September quarter, continuing to demonstrate the robust cash generation capabilities of our business. Net debt declined by $192.6 million, driving our net leverage ratio down to 1.84x, exiting the September quarter. During the September quarter, we returned $413.3 million to shareholders in dividends and share repurchases, representing 57.5%, of the prior quarter's free cash flow. I would like to take this opportunity to thank all our stakeholders who enabled us to achieve these outstanding results and especially thank the worldwide Microchip team for their continued efforts during challenging times to deliver results for our customers despite a large and persistent imbalance between supply and demand. Taking a look at our net sales from a product line perspective, our microcontroller net sales were sequentially up 11% as compared to the June quarter. and set another all-time record. On a year-over-year basis, our September quarter microcontroller net sales were up 31.9%, and microcontrollers represented 56.9% of our net sales in the September quarter. Our analog net sales sequentially decreased 1.3% in the September quarter. On a year-over-year basis, our September quarter analog net sales were up 16.6%, and analog represented 27.6% of our net sales in the September quarter. As we mentioned last quarter, there are quarter-to-quarter differences in supply constraints which can cause differences in net sales growth by product line. If you compare the trailing four-quarter net sales growth performance versus the prior four quarters for our analog and microcontroller product lines, the growth rates are almost exactly the same. In the September quarter, our technology licensing net sales achieved a new record. Business conditions continue to be strong as viewed through our internal indicators. Demand continued to be strong despite the capacity increases we have been implementing for some time now. As a result, our unsupported backlog, which represents backlog customers wanted shipped to them in the September quarter but which we could not deliver in the September quarter, climbed again and we exited the September quarter with our highest unsupported backlog ever. With unsupported backlog, well above the actual net sales we achieved. We are working hard to reduce our unsupported backlog to more manageable levels and expect to do so in the coming quarters, but also expect to remain supply constrained through the rest of 2022 and well into 2023. We are, of course, cognizant of the weakening macro conditions resulting from rising inflation and interest rates, and are monitoring such conditions closely. We're also aware that there is some inventory billed at our customers, as can be seen in their balance sheets. Some of this, we believe, is due to strategic buffer inventory bills arising from the learnings of the last two years, and some of this is due to the incomplete kits or the infamous golden screw effect. While we have seen an increase in requests to push out or cancel backlog, these requests remain a very small fraction of the very large backlog we have over multiple quarters, and hence they have not had a material impact on our business. We believe there are three reasons why Microsoft's business is demonstrating more resilience in the midst of the weakness seen by some of the other semiconductor companies. First, on the demand side, the industrial, automotive, aerospace and defense, data center, and communications infrastructure end markets, which make up 86% of our net sales, remain strong. The consumer end market, which is about 14% of our net sales, is experiencing some weakness but is dominated by home appliances. And home appliances are more resilient than other consumer markets as a high percentage of demand comes from replacements for appliances which have broken down and must be replaced. Hence, our demand is quite durable because of the end market mix we have consciously gravitated towards over the years. Second, on the supply side, a vast majority of our products are built on specialized technologies requiring trailing edge capacities. This is the capacity that has been most constrained over the last two years, which still remains constrained, and where there was the least opportunity to overship the consumption. And last but not least, a laser focus on organic growth through total system solutions and higher growth megatrends for multiple years is giving us increased design momentum and a resultant revenue tailwind. Given the cross-currents of strong internal business indicators and some uncertainty in the macro environment, we have modeled a range of potential scenarios, and are closely monitoring various indicators which should enable us to take deliberate action when we feel it's appropriate. Our goal is to deliver a soft landing for our business if or when the softer macro environment catches up with it. The playbook we shared with you last quarter for how we will deal with the macro slowdown remains unchanged. If you study Microchip's peak-to-trough performance through the business cycles over the last 15 years, you will observe our robust and consistent cash generation, gross margin, and operating margin results. The investor presentation posted on our IR website provides details about our performance through the business cycles. If or when there is a macro slowdown that impacts our business, we expect our cash generation, gross margin, and operating margin to once again demonstrate consistency and resiliency. This will help us continue to execute our long-term Microchip 3.0 strategy and help insulate it from whatever short-term market challenges there may be. While we are seeing some loosening of constraints in our supply chain, we continue to have several internal and external capacity corridors that remain very constrained. We are continuing with our carefully calibrated capacity increases, seeking to serve what we believe is a long-term consumption growth. We believe our calibrated increase in capital spending will enable us to capitalize on growth opportunities, serve our customers better, increase our market share, improve our gross margins, and give us more control over our destiny, especially for specialized trailing edge technologies. As you may have seen, Microchip has expressed its view that the recently approved CHIPS Act is good for the semiconductor industry and for America. as it enables critical investments which will even the global playing field for U.S. companies, while being strategically important for our economic and national security. For a very long time, an important component of our business strategy has been to own and operate a substantial portion of our manufacturing resources, including wafer fabrication facilities in the U.S. This strategy enables us to maintain a high level of manufacturing control, resulting in us being one of the lowest cost producers in the embedded control industry. In light of this strategy and potential grant funding from the CHIPS Act, the investment tax credit provision, as well as state and local grants and subsidies, Microchip is in the early stages of considering a 300-millimeter U.S.-based FAB for specialized trailing edge technologies. This FAB project, if we decide to pursue it, would be intended to provide competitive growth capacity as well as geographic and geopolitical diversification. The availability of grants, subsidies, and other incentives will all be important considerations in our analysis and will also help determine the location and timing for a FAB. Now let's get into the guidance for the December quarter. Our backlog for the December quarter is strong and we have more capacity improvements coming into effect. Taking all the factors we have discussed on the call today into consideration, we expect our net sales for the December quarter to be up between 3% and 5% sequentially. We also expect our net sales based on end market demand to grow at about the same growth as our GAAP net sales. And further, we expect sequential net sales growth again in the March quarter. At the midpoint of our net sales guidance, our year-over-year growth for the December quarter would be a strong 22.7%. We expect our non-GAAP gross margin to be between 67.8% and 68% of sales. We expect non-GAAP operating expenses to be between 20.7% and 20.9% of sales. We expect non-GAAP operating profit to be between 46.9% and 47.3% of sales. And we expect our non-GAAP diluted earnings per share to be between $1.54 per share and $1.56 per share. At the midpoint of our APS guidance, our year-over-year growth for the December quarter would be a strong 29.2%. Finally, as you can see from our September quarter results and our December quarter guidance, Our Microchip 3.0 strategy, which we launched a year ago, is firing on all cylinders as we continue to build and improve what we believe is one of the most diversified, defensible, high growth, high margin, high cash generating businesses in the semiconductor industry. Let me now pass the baton to Steve to talk more about our cash return to shareholders.