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.

Steve? Thank you, Ganesh, and good afternoon, everyone. I would like to reflect on our financial results announced today. and provide you further updates on our cash return strategy. Reflecting on our financial results, I continue to be very proud of all employees of Microchip that have delivered another exceptional quarter while making new records in many respects, namely record net sales, record non-GAAP gross margin percentage, record non-GAAP operating margin percentage, record non-GAAP EPS, and record adjusted EBITDA, and all of that in a very challenging supply environment. The Board of Directors announced an increase in the dividend of 9% from last quarter to 32.8 cents per share. This is an increase of 41.4% from the year-ago quarter. During the last quarter, we purchased $247.2 million of a stock in the open market. We also paid out $166.1 million in dividends. Thus, the total cash return was $413.3 million. This amount was 57.5% of our actual free cash flow of $718.5 million during the June 2022 quarter. Our pay down of debt as well as record adjusted EBITDA drove down our net leverage at the end of September 2022 quarter to 1.84 from 2.05 at the end of June. Ever since we achieved investment grade rating for our debt in November of 2021 and pivoted to increasing our capital return to shareholders, we have returned $1.457 billion to shareholders through September 30, 2022, by a combination of dividends and share buybacks. In the December quarter, we will use the September quarter's actual free cash flow of $682.9 million and plan to return 60% or $409.7 million of that amount to our shareholders. Of this $409.7 million, the dividend is expected to be approximately $181 million, and the stock buyback is expected to be approximately $228.7 million. With that, operator, will you please poll for questions?

If you'd like to ask a question, simply press the star key followed by the digit 1 on your telephone keypad. Also, if you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Once again, press star 1 at this time. We'll pause for a brief moment. Ambrish Srivastava of BMO has our first question.

Hi, thank you very much, Ganesh, Steve, and Eric. It's very appreciated that you put that investor slide deck where you talk about the playbook and the scenarios, and you've talked about the playbook. But I just can't help ask this question because weakness is rampant. It's everywhere. Many of your diversified peers have talked about weakness. Just kind of help us understand. The big concern I have is the longer the lead time stays stressed out, the higher the possibility of a harder landing. So just kind of help us understand, how are you managing the quote-unquote soft landing that you have addressed a few times? But I just wanted to readdress that issue, if you could please. Thank you.

Sure. So, you know, it starts with having high-quality backlog. And, you know, PSP being a high percentage of our backlog, well over 50%, is the highest-quality backlog. It is non-cancellable. It's customers who have put time into making a commitment to be non-cancellable, and that is always going to have far more thought that goes into it. It starts also with the supply side, where we're making calibrated investments every quarter. We're not trying to go satisfy all the demand that's out there. And our lead times are long, but they've also, in specific areas, started to improve. And that helps with customers who have visibility out in time. And then the end market exposure we have is another huge benefit to us, right? Most of these customers in these end markets are not in volatile markets where things can go up and down in short order. They're looking at the long term. They're looking at demand that is far more durable. And you put all that together and we feel we have a model that is outperforming. and for those reasons from a market standpoint, supply standpoint, and what we have done for ourselves in terms of total system solutions and the megatrends we're focused on and the design and activity that we have pursued. Okay.

Just a quick follow-up. Where are the lead times now? And I know the product line is very diverse, but the way you characterize it, what percent of lead times have come in versus staying at 52-plus weeks?

You know, the lead times are all over the place. We have some lead times which are as low as four to eight weeks. We have a lot of them which are at 26 to 52 weeks. It's corridor by corridor, product by product, where the constraints are. We go to work every day trying to improve it. And as long as supply improves, we're able to do that. Demand remains still strong. So there's not a single number I can give you or a single percentage that I can say, hey, this is what the lead times are at. but most importantly, it's not just the lead times, it's also how strong the demand is. And you can see with some of the end market data that we provide you, the information on the growth, right? The end market growth is keeping pace with what we're shipping in on a GAAP basis.

Got it. Thank you, Manish.

Thank you.

Next, we'll hear from Vivek Arya of Bank of America Securities. Thank you.

Thanks for taking my question. For the first one, it's very interesting. You're considering a 300-millimeter FAB. I was wondering what is driving that decision. What kind of capex will it require? Will it have any impact on your dividend or buyback philosophy? And does it mean you will bring back some of what you're giving to external foundries inside the company? Any more color on the 300-millimeter FAB? I appreciate it's probably still in early stages of discussion.

So, you know, you should look at it as it's a very strategic thought process and decision for us. It's something we think about over a 20-year-plus timeframe of what it will do for us, not unlike how when we bought our Gresham fat just about 20 years ago, right, it was a long-term investment that we made. We have many processes that are at 300 millimeters that are candidates. We have some specific ones we would look at as the early ones we bring in. But I wouldn't look at it as necessarily just bringing all this stuff inside as much as as we grow, we would have additional places where it can grow. This investment will happen over multiple years. It will be largely within the range of the CapEx that we have provided. And we do not expect it to have either an impact on our dividend or our share buyback or anything else with where we're at.

And for my follow-up, I think Ganesh, you mentioned that one reason that you might be seeing the strength is some customers are building some buffer inventory. I'm curious, how far along do you think they are in that process? And does it just pull forward their demand from outer quarters? Because I think what everyone is trying to get a sense for is that in most prior downturns, microchip was always the first one. to signal when the micro conditions weakened. This time conditions are weakening. Every one of your competitors is saying that, yet you're not seeing it. So what has changed versus your analog industrial peers? I can understand the consumer part, but what's different versus your peers who are also exposed to the same automotive industrial type markets? Thank you. Hello are you guys still there?

Please remain on the line while we reconnect our presenters. Thank you. You may proceed.

We're back. Vivek, if you're still on, we didn't get the entirety of your question. Would you repeat your question, please?

Yes. So basically what I asked, Kanish, was that you mentioned customers are building buffer inventory. I was just wondering how far along they are in that process. And in general, you know, if you contrast microchip today versus in prior downturns, right, when you had a somewhat similar mix of products, The company was always the first to see the downturn, but you're not seeing it now. So I was curious, what is the difference between the old microchip versus the new microchip?

Sure. So let me answer the second one first. If you look at the old microchip, we had more exposure to markets that perhaps were more volatile. We didn't have the same aerospace and defense data center infrastructure. We weren't as high in industrial and automotive. And those are far more durable. And we had a much higher consumer exposure rate. if you go back 10 years of the financial crisis in that timeframe. So that has changed to where we can see the customer and their end market demand as being far more durable today than it was in history. On your first question about what about the buffer, I think the amount that's being built is small because we're not able to ship, right? I mean, we're constrained in our ability to service all this backlog that is unsupported. But anecdotally, are there going to be some customers who are building in? Yeah, we're sure there is some of that. But we still think it's small. And mostly it is in the markets where there's a very large multiplier for the OEM's end product as compared to the value of the semiconductors that they carry. Thank you. You're welcome. Christopher Roland, Susquehanna.

Hey guys, thanks for the question. Um, uh, I guess my first one is, uh, for, for either Steve or Ganesh. Um, so, uh, you know, you had confident confidence enough to, to provide growth in the March, which is pretty incredible in this environment. Is this do you think you have this confidence and this visibility because of your kind of tough stance on your NC and our policy? Is it perhaps you're looking to channel inventories and keeping those tight? Is there some other difference here operationally or, you know, that kind of affects your confidence versus others out there? Is there something you're doing different?

So, firstly, you know, we have confidence both on the demand side as well as improving supplies we're making. But let me put it in perspective, right? Even if we accepted 100%, of all the cancellation and push-out requests of non-cancellable backlog, this factor alone would not have changed our September quarter results, our December quarter guidance, and we would remain poised to grow sequentially again in March. So, don't assume that it's the non-cancellability that is somehow propping us up.

Great. Thank you. Steve, you've talked before about industry capacity being tight and us not having enough as an industry moving forward. I think there's probably been some cancellations in terms of equipment and stuff like that, but would love an update here. How do you feel about that? Are you even more strong in that belief And is that what underpins the 300 millimeter thought process as well?

So, you know, it began a year and a half ago with capacity being constrained at all the nodes, trailing edge, leading edge, in the middle of the way. What has happened in the last few quarters is with the personal computers and cell phones, which are significant consumers of semiconductor, and mostly semiconductors on the bleeding edge of technology, processors and very high-end chips in the cellular phone. With the correction in that market, the bleeding edge capacity now is really no longer constrained. you have seen dramatic downside guidance by a lot of the very leading-edge people. So today, if you wanted, you know, a 7 nanometer, 10 nanometer, 14 nanometer capacity, you can have everything you need. But the trailing-edge capacity continues to be extremely constrained. On trailing-edge, we built some inside, and we also bought some from the foundries, and we are constrained on both. Inside, we haven't been able to get all the equipment we wanted. Most equipment that was even scheduled to be delivered got pushed out by many months, sometimes many quarters, because the equipment supplier wasn't able to get semiconductors for their parts. So the inside products that we run inside remain constrained on many different corridors. And the capacity we buy outside is really very similar. The trailing edge capacity remains constrained, and we currently believe will remain constrained well into 2023. I would add one more thing, right?

I think on 300 millimeter, if we started on a fab tomorrow, it's four plus years away before that fab is starting to ramp. So these are not decisions we make in a single cycle. We think through these across cycles on a long-term secular growth basis and what our position is and what we want our capabilities to be out in time.

You know, on the prior question, we were talking about, you know, backlog and why we are so resilient. And in the prior cycles, we used to be the first one to see this and why we're not seeing it today. I think I wanted to add a comment, you know, a couple of comments. You know, one that Ganesh mentioned, which is a dramatically different end market mix we have today than when you used to call us the canary in the coal mine. And secondly, I think we want to keep emphasizing that PSP backlog is a very high-quality backlog. When a customer has to commit 12 months, and in some cases 18 months and longer, non-cancellable, non-reschedulable backlogs, There is a lot more thought that goes into it, and it's not the junior purchasing manager who places the backlog. It goes up for approval. So it's a much, much higher quality backlog, and people don't just double order it thinking that they would cancel it, you know, because it's non-cancellable. They don't double order it thinking that, you know, Microchip would let them change the rules and would let them cancel it. So that backlog is very high quality. We've gotten... very small number of scattered requests here and there. And as Ganesh mentioned, if we were to take all of them for cancellation, it wouldn't change anything. It would not change our September, December, or March. It's just a minuscule percentage. It really means nothing almost. So take that into account. We've heard from a lot of investors and analysts that think PSP is you know, some sort of, you know, accident to happen because people are building inventory and we're not letting them cancel it and the fall would be even harder. I think that thinking is not correct.

Yeah. Thank you, guys. Appreciate it.

Great. Thank you.

Next we'll hear from Timothy Arcuri of UBS.

Thanks a lot um you mentioned PSP is more than half of backlog, but can you talk about how much of the September revenue is moving inside of PSP and and maybe Steve I know that you just made some comments about some requests for. For changes within PSP it sounds like they're still pretty small, but I guess, can you also just double click on the comment you just made because PSP doesn't really change demand, I mean to a certain degree. you just put product to customers that might not need it because they committed to it, you know, six to 12 months ago. So can you just kind of talk through that and then maybe answer the question about how much revenue is moving inside of PSP, thanks.

So firstly, in a given quarter, by the time we get to that quarter, PSP is an overwhelming percentage of what we ship in that quarter. That's what customers who place backlog back in time, receive priority for it, expect, and that's what we give them. And so... You know, farther out in time, there is more space, and new backlog can come in and fill it out. But near term, like what just happened in September or what is going to happen in December, has a very, very high percentage of it that is PSP backlog that is being fulfilled. Let me reiterate the point Steve made and which I made a little bit earlier on. PSP backlog is the highest quality backlog that's there. We make non-cancelable commitments to our suppliers And we don't make them lightly because there is a financial commitment that is required to have enough scrutiny. Similarly, our customers have significant scrutiny when they're trying to make commitments. They don't try to get excess capacity ordered from us. They, in fact, will try to undershoot so that they can actually hit it. So I want you to take from this that PSP backlog is the highest quality backlog. We have far more cancellations and requests on non-PSP But PSP backlog is very high quality.

And even outside PSP, I want to note that our standard cancellation window is 90 days. So when we enter a quarter, really everything that's on books for the quarter is non-cancelable, whether it's PSP or not.

You should also think that, you know, when we took the PSP backlog for the last year and a half, in the middle of extreme constraints, We made a choice to ship to the PSP customers and not ship to the non-PSP customers. All the non-PSP customers are not low-quality customers. Some of them are very good customers, but their business is such that they cannot make a one-year commitment, so they were non-PSP customers. They got very little product. So we made a choice to prioritize giving it to PSP customers and let the other customers go not get product, get somewhere else. So our PSP customers have benefited from the best of our attention in the last year and a half. And now, you know, they can't have the best of them and then be flexible and not really meet their part of the bargain. We have added capacity for them. We prioritize them. We lost the other customers whom we did not give any product. So I think this

I would say don't be fixated on it. This is our best demand. It's our best customer.

Got it. Got it. Got it. Thank you. Thank you. And then just as my follow-up, so you gave sort of some view on consumption and you called it end market demand. Does that include the inventory that's building at your customers? When you talk about end market demand, is that net of the inventory bill that your customers or is that inclusive of the inventory bill that your customers? Thanks.

So when we speak of end market demand, it is everything that we ship to our direct customers, which is no different than GAAP revenue. And then the other difference is the roughly 50% of our business that goes through distribution, it represents the distributor's sell-through to their customers rather than what we're selling in to the distribution channels. We do not have any kind of view in terms of exactly what our customers are doing with inventory. We service 125,000 customers, and that's just not data that we have or is possible for us to track.

Yeah, when we talk about potential inventory of customers, all we can see is what do they publicly report. But I can tell you that the level of expedites and customer escalations we're experiencing remain high, indicating that demand supply are imbalanced for many customer situations.

Thank you. Thank you very much. Appreciate it.

Our next question comes from William Stein of Truist Securities.

Great. Thanks for taking my questions. First, a little bit of an off-the-run question, and then I will have a follow-up. OPEX, I think you highlighted that it's below your target range as revenue continues to grow and you're not spending as much as sort of you would normally target. Over what timeframe should we anticipate your OPEX approaching your target percent of revenue?

You know, it'll be over many quarters. You can see in our guidance it's not happening in the December quarter. The hiring environment has been difficult. You know, perhaps we will do better as we go into 2023. So it'll be slow. Eric, do you want to say anything?

Yeah, I mean, it somewhat depends on what the revenue curve looks like out in time. Obviously, we're guiding for nice growth again in December. Ganesh has made comments about March being a growth quarter for us. So it's going to take us some time to catch up, Will.

Okay. Thank you for that. And then I want to linger on the same topic that so many other people have hit on, but I want to ask it sort of a different way. I understand the PSP is very high-quality backlog. You're not seeing many cancellation requests. Is even if you took all the cancels, you'd still have this good guidance and the comments on March. What it doesn't so much address is what might happen in a couple quarters if more customers, either doing PSP or otherwise, come in and request a cancel or a push-out. The question really is that this is one thing that has changed in maybe not the model, but in the way the company operates. Steve, in fact, used to talk a lot about how you'd never use distribution as sort of a mechanism to, let's say, stuff. Let's call it stuffing the channel for a moment. When you have to make a decision as to whether you force a customer to live up to an NCNR, that is remarkably similar to stuffing the channel in terms of at least the economic impact on your business. And I'm wondering how you're going to take that decision if you wind up in a position where more customers come to you to cancel, whether it's PSP or regular backlog. How do you make this decision? On the one hand, I want to make them live up to their commitments because you highlighted all those reasons. On the other hand, if you do that, you know you're damaging future demand and pushing out a painful situation. How do you plan on balancing those two dynamics? Thank you.

Well, this is not the first time we've had to deal with non-cancelable backlog. It has been a part of our business for basically ever, right? It's just that the percentage of that has grown. We work with customers on what their requirements are, but you can't have an asymmetric agreement where heads they win and tails we lose, right? You've got to make sure that there are commitments. This is why, if you make sure that there is an understanding that customers There is a responsibility with placing that backlog. They will moderate the backlog they place on us. If they have no responsibility, then there is no reason why they wouldn't just give us much, much higher backlog than where they're at. So we think, again, going back to the quality of the backlog, it comes because it has responsibility that goes with it. Outside of that, situation by situation with the customer, you know, we're in this to be in business. But we're not in this to say it's all risk-free or all the risk is on our side in what we go with it. And by the way, by and large, that's how customers have expected this thing as well. They're not pushing on us to say, hey, I didn't mean that it should be PSP and I now want something else different from what we had agreed to. So I don't see that as big of an issue. And by the way, if we didn't have PSP, the situation we'd have is far, far higher backlogs. and far bigger of a fall from that high backlog we had.

Yeah, I think one other thing I'd like to point out, Will, because you're talking several quarters out in time beyond March, right? A customer that's on PSP and has 12 months of backlog with us, every week or every month that goes by, they make a decision in terms of what the next backlog that they're going to put on us out in time. They could put zero backlog. They could put 50%. They could put 120% of what it was the month before. And so, you know, these – Fears of rising interest rates and recession, this is not new when we woke up today. This has been happening now for several months, and I think customers gradually adjust that over time. But as Ganesh has said, PSP is still a large percentage of our backlog. We still have tons of unsupported, and it's been a program that I believe has worked very well, not only for the customer, but for Microchip.

I think the gist of your question is that lots and lots of PSP customers want to cancel and we're just not letting them do it. And that is not the case. There is a negligible amount, at any point in time, you have customers that wanna move small things around. The PSP backlog is not gonna see the behavior that you're talking about. We're not inundated with PSP customers wanting to cancel the backlog and we're not canceling it. And that's not happening next quarter, it's not happening quarter after. I think that's the issue. That's your assumption that it would happen. We don't think we will face that because the PSP backlog is very high quality, and customers can easily start to adjust it by taking the foot off the gas pedal every month when they place the order 12 months out.

Let me give you one more piece of data. We're making a big deal of cancellations. If you aggregate all the cancellation requests we have, It's 4.5% of our total backlog, and that includes PSP, non-PSP, and it will be dominated by non-PSP. It is a negligible part of the business, guys.

Thank you.

You're welcome.

Next, we'll hear from Chris Dainle of Citigroup.

Thanks, guys. So I think someone asked you earlier about lead times, have they gone up or gone down or how much, and you said you really couldn't define that. You also said you still have some, I guess, quite a bit of business that's constrained or products that are constrained. Is there any, I guess, metrics that you could give us that would talk about your percentage of products or percentage of business that is constrained or in shortage now versus three months ago and what you expect to be three months from now, just so we could I guess, track the progress of that?

You know, the best metric probably is what is the unsupported backlog exiting quarters. And I'm going to tell you, it's high. It's probably not healthy to be there. And we will work to improve that. And it is to improve the customer service and the customer experience with it. But we have still substantial constraints that we're working through, and it will take us many, many quarters to work through them.

I don't know if Ganesh said that earlier, but our unsupported backlog leaving September quarter was another all-time high. So during the quarter, customer wanted more parts to be shipped in the September quarter that we couldn't ship, and the unsupported grew over the June quarter to another record. So that doesn't mean in any way that customers are feeling that the lead times are coming in. I mean, we are broadly constrained almost everywhere. I mean, we've got daily escalation calls from multiple customers every day. Yeah, that's what I was getting at. It hasn't even reached the peak. The unsupported hasn't even reached the peak and started dropping. It is still growing.

Yeah, that's what I was getting at. That's what it felt like. And then for my follow-up, so, you know, Steve, you've been through even more cycles than I have. If this continues where the competitors keep taking numbers down and the recession gets worse and worse and your business gets better and better or gets through it, do you think it's possible for you guys to make it through a global recession and a downturn unscathed or relatively unscathed? Did you see anything during this quarter other than the unsupported backlog that made you feel any better or any worse about Microchip's ability to do that?

Well, you have to define what unscathed meant. You know, as Ganesh talked about it in his remarks, that we're not seeing anything today, but we see the macro weakening in what all the other companies are saying. And what we are seeing is if macro ever catches up to us, then we have steps in place to create a soft landing. You know, when you say unscathed, you know, we're not saying we're going to keep growing 22% per year forever like we have been. But we will soft land the plane because of all the attributes Ganesh went over.

Yep. Thanks.

And then next we'll hear from Toshi Ahari of Goldman Sachs.

Hi, good afternoon. Thanks so much for taking the question. I was hoping you could talk a little bit about what you're seeing from a pricing perspective across your microcontroller and analog businesses. You know, your September quarter revenue was up 25% plus year over year. How much of that was pricing? And then, Steve, when you were at our conference a month and a half ago, you had hinted that pricing should be a tailwind in the early part of 23 as well, given some of the conversations that you were having with your foundry suppliers. I'm curious if anything has changed since then. I'd have a quick follow-up.

So pricing is stable. There are no price adjustments that are being made that are affecting where the the quarterly results are. We did make an adjustment at the beginning of this year or the early part of this year, and that's where it's at. You know, I don't think we have any price adjustment plans into 2023 that are in the offing, and so pricing is really not a factor today in terms of what we're executing, where we're going in terms of our new designs, and where we are in terms of our business.

Got it. As my follow-up, I guess this is a hypothetical, but given the visibility you have and given everything that you've said so far on the call, if your business in calendar 23 is, say, up 5% or flat or somewhere in that range and most of your peers are down 10%, would it be fair to say that in a recovery phase, say in 2024, you undergrow your peers or you perhaps don't participate in that recovery, or are you guys gaining permanent structural share across the analog and MCU businesses?

It's a hypothetical. We don't know what 24 is, but we believe we are gaining share. We are executing the total system solution strategy we have. We are focused on the fastest growing markets, and we are seeing substantial wins that are creating the tailwinds for us.

Thank you.

Our next question comes from Harlan Soar of JP Morgan.

Good afternoon. Thanks for taking my question. Channel or just the inventories still 40% below pre-pandemic levels. Your own inventories are kind of at the low end of your target range. So obviously, clear signs that demand remains strong given Given your capacity expansion plans, looking at your demand profile and backlog, do you guys anticipate increasing inventories with your Disney customers and moving towards the midpoint of your range on your own inventories over the next, call it two to three quarters?

So, you know, we actually grew quite a bit of inventory on our balance sheet in the September quarter, and you'll see just below our guidance table in our press release, we're expecting that to grow again this quarter. And in my prepared remarks, I kind of went through some of the reasons why that is happening as we're positioning the company for future growth. In terms of distribution, you know, distribution inventory stayed flat quarter on quarter at 19 days, and We think at some point in time there will be some level of restocking in the distribution channel. That's going to vary by distributor and how they manage the business. But in the meantime, with their inventory being relatively low, we feel that we need to have more inventory on our balance sheet to support the end customer needs. And so that's what we're doing. But really we are now within our target range of inventory days that we provided to the streets. back in our November analyst day. So we're managing it appropriately in a challenge supply environment, I would call it.

Yep. Thanks for that. And I know it's always somewhat complex to sift through end market demand trends because you've got such a broad portfolio of products, you're serving many different end markets. However, there is one segment where products are more easily tracked because they are very specific to that end market. That's your rad hard kind of high roll products that you're that's your aerospace and defense business i believe it's about 13 to 14 percent of your revenues much higher mix versus your peers seems like activity around commercial space programs new satellite constellations defense spending all look strong for not just next year but the next several years you guys are number one in space strong player in defense like help us understand the visibility in A&D, growth trends, and sustainability of this segment into a potentially weaker macroeconomic backdrop next year?

Sure. So aerospace and defense, I think, is about 9%, 10% of our revenue. It is performing extremely well for many reasons. And you missed commercial aviation. Commercial aviation is going through a strong resurgence. And so all three elements, space, defense, and commercial aviation, are all doing strongly here. in the current environment, and they are generally less influenced by shorter-term macroeconomic conditions.

Thank you.

Thank you.

Next, we'll hear from Matt Ramsey of Cohen.

Thank you very much. Good afternoon, guys. I think Tushia took my earlier question on ASP assumptions, so I'll just ask one. It's around the consideration of investing in the 300 millimeter fab i guess there's two parts to the question um ganesh as you consider that what would be just i don't know ballpark off the top of your head focus of which process nodes um mix in a facility like that as you consider it and then second is this um something that you guys felt you needed to do but didn't really feel like you could fund all of it until the CHIPS Act got passed, and now that's a reaction to potential funding from governments, or was this a decision that you were probably going to need to make? Anyway, thank you.

So, firstly on, you know, process technologies, those are still being worked, but largely we use our 300 millimeter, you know, foundries today on process technologies that are 90 nanometer and smaller in size, and the workhorse technologies for trailing edge tend to be at 40, 65, 90 in that general neighborhood. But we wouldn't limit ourselves just to that. Again, I want you to think of this as this is a 20, 25-year look at what we would do with a 300-millimeter fab. The reasoning for it is as our business has grown, the portion of our business that we do with 300-millimeter has also grown, and the investment in the trailing edge part of 300 millimeter technologies has not been there with many of our foundries at the level that we have wanted. But it takes a certain scale to get there. And if you had a full boat fab that you needed to build, the way in which the break-even points and the absorption points come about are different from when there is a a fab that can be built with government funding and the investment tax credits and whatever local things come in. So clearly that has changed the equation as to when does it make sense financially. But that's not the only reason why. We think trailing edge 300 millimeter technology is going to have constraints for a long time to come. And a portion of that being within microchip would allow us to better serve those markets.

Thanks, Ganesh.

Thank you.

Our next question comes from Joe Moore of Morgan Stanley.

Great. Thank you. If you look at your operating margins now, you're obviously much higher than you've been in prior cycles. It seems like a lot of that is secular, but when you contemplate these soft landing scenarios, do you expect your margins to sort of see the type of decline that you've seen historically? Could we go back to prior troughs? I know some of your competitors have talked about a target margin on kind of a trough revenue level. How should we think about primarily gross margin leverage in a sort of weaker environment?

Well, I'll give you a quick answer, and then Eric might want to elaborate more on it. Again, the best way to look at it is how have we performed over the last 15 years through the cycles? And you will see that on those metrics of gross and operating margins, From peak to trough across the cycle, about 200 basis points is the decline in that range, plus or minus 200, 300 basis points. And, you know, that's the way in which we manage the business. It's built into our DNA. It's built into our systems and processes. It's built into the soft landing that I described a quarter ago. Eric, do you want to add more to it?

Yeah, I mean, obviously we've continued to – you know, integrate acquisitions. We've got a different product mix than we've had historically. You know, we feel really comfortable with the margin targets that we've set out for the street, which we are above today, as you mentioned, on the operating margin side. Because the business has grown so well, we've got quite a bit of cushion. I would call it on our OpEx today with the level of bonuses that we're playing, variable comp, that will allow us to adjust if need be, if, you know, the macro catches up with us at some point in time. So, And we want to build inventory in our own factories. We think distributors will rebuild inventory. And so we don't want to give a specific number, but, again, the range that we've provided on a long-term basis, we think that we can operate within that, and obviously we're operating above it today.

And the mix of the business we have has end markets that are far more durable in terms of how they perform and what gross margin these products and solutions we bring are able to command. And it's not just silicon. It's silicon. It's software. It's systems. It's services. These are very, very sticky applications and markets that are not prone to perhaps what a pure consumer or mobile phone type of market may have.

Great. Thank you very much.

Tori Svanberg of Stifel.

Yes, thank you. And congrats on all the record metrics. I have a sort of a different angle on the pricing question. And it's kind of more related to ASP. So if you look at the 25.7% growth year over year that you're reporting this quarter, how much of that is coming from higher ASPs, meaning, you know, selling more value in the form of your total system type solutions?

There's not an easy way to break that up. You know, clearly, With constrained capacity, we will direct them and have been directing it to the highest value products that we're producing. We're shipping more units, so there's a lot of the growth that's coming from capacity and additions that we have made in it. But I certainly don't have a good way to parse out what comes from mix and pricing versus what comes from units alone.

That's fair. And then I had a question on the inventory, whether it's internal or channel. So obviously, you know, the channel sounds like you're going to sort of keep that a little bit constrained going forward. But is there maybe a secular trend here where basically, you know, maybe the right number is actually around 20 days of channel inventory and then your own inventories could maybe even exceed the high end of the range, which is 150?

No, we don't dictate what channel inventory needs to be. The channel decides what inventory do they need. In some cases, we may be constrained in shipping it to them And they may not be able to get what they want to. But, you know, Channel has history of what does it take to support the mix of product, the customer expectations that are there. And we are at the low end of what they have historically done. And whether they're going to be at 19 or 20 or 25 or 30 is really a decision they're going to make. We don't tell them what to do in terms of inventory.

Ultimately, they need to stock the level of inventory appropriate to support their customers, and they'll need to find the right level of that as supply becomes less constrained than it is today. We have a lot of unsupported backlog to our distributors today that we need to catch up on.

Well, for the last year, it doesn't really matter what distributor wanted. We just don't have the product to stock them. So that has not been a choice, and we don't think there's a choice for, you know, well into 2023. But someday, when we have parts available to start distribution, at that point in time, it will matter what they want to do. Right now, it doesn't matter.

Yeah, I guess my point was more, you know, maybe you have a better read on sell-through than they do, but so that's fair. Thank you.

Next, we'll hear from Raja Gill of Needham & Company.

Yes, thank you and congratulations on good results in this very uncertain environment. Just one question on gross margins. They continue to be at kind of record levels. I'm wondering kind of what have been the drivers of the margins so far and how do we think about those drivers going through into next year? Thank you.

Yeah, well, I think the biggest drivers are going to be factory utilization, right? I mean, we have you know, more backlog than we know what to do with at this point in time. And so the factories are running harder than they've ever been before. We're using every piece of equipment that we have to produce as much product as we can. And so with that, you know, our planning and operations team are able to schedule things and batch runs and try to produce as much product as they can. So that's a big thing. And then I think the other thing that we talked about in response to some of the earlier questions is just our product mix and how that's changed over time has continued to enhance the gross margin.

Thank you, Raji.

Next, we'll hear from Vijay Rakesh of Missoula.

Yeah, hi, guys. Just a quick question here. As you look at, you talked about your own inventory and the channel inventory. I was just wondering if you could give some color on what the OEM inventories look like because I think you're starting to see some of the OEMs like Stellantis and BMW this morning talk about worries about caution about a slowing down of sales with macro and rates, etc., and then add a follow-up.

So OEMs don't tell us what inventory they carry, right? Now, what we can gauge is how are they interacting with us on how they see business, how many escalation issues are we still working, and we don't see an abatement in terms of what they're trying to do, and OEMs also have not only a requirement to sell to their demand, they're also trying to replenish their dealers and what the dealer's inventory needs to be. They're trying to replenish what the rental car inventory needs to be out there. So demand is still running strong, and we don't see for our products an inventory issue that they're bringing to us to go solve. If anything, we're working more shortages and constraints with them.

Got it. And the last quick question on the pricing side, I know you talked about many different products, but obviously a lot of the microcontrollers are pretty long-life products there. So just wondering if you could take a step back and look at 2021 or 2022, as you exit 2022 here, for some of the long-life products that you guys have, how has that pricing changed or trended over the last two years?

So pricing over the history of Microsoft is a strategic exercise for a sole-sourced product that is proprietary from us. The only time when we have made a pricing adjustment that's been broad-based is over the last year to year and a half when we had cost increases with a view towards covering the cost increases that we were subject to in the way we passed on, margined up, for that. So, outside of that, pricing is not something we try to take advantage of when there are constraints, nor is pricing something that we give up on when there is extra supply.

Got it. Thank you.

You're welcome.

And it appears there are no further questions at this time. I'll turn the call back over to our presenters for any additional or closing comments.

Great. I want to thank everybody for hanging in there, and despite some of the technical challenges. We appreciate the questions, and we look forward to seeing many of you and talking to many of you in the phone calls and conferences we have coming up. So, thank you.

That does conclude today's call. Thank you all for your participation. You may now disconnect.