Microchip Technology Incorporated

Greetings and welcome to Microchip's Q2 Fiscal Year 2025 financial results conference call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I'd like to turn the conference over to our host, Mr. Eric B. Aernhold,

CFO.

Thank you. You may

begin. 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 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, Ritz Simonsek, Microchip's COO, and Saja Doughty, Microchip's Head of Investor Relations. I will comment on our second quarter Fiscal Year 2025 financial performance. Ritz will then review some product line updates, and Ganesh will then provide commentary on our results and cash return strategy as well as an overview of our current business environment. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and this conference call on various GAAP and non-GAAP measures. We have posted a full GAAP to non-GAAP reconciliation on the investor relations page of our website at .microchip.com and included reconciliation information in our earnings press release, 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 that are described in our earnings press release and in the reconciliation on our website. Net sales in the September quarter were $1.164 billion, which was down .2% sequentially. We recently settled an ongoing legal matter with one of our licensees. The impact of this settlement was the release of a $13.3 million accrual, which increased revenue and gross profit by $13.3 million in the September 2024 quarter. We have posted a summary of our net sales by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were just above the midpoint of our guidance at 59.5%, including capacity underutilization charges of $25.9 million as we continued to manage production activities to adjust to challenging business conditions. Without the benefit of the legal settlement mentioned earlier, the non-GAAP gross margins would have been 59.1%. Operating expenses were at .3% of net sales and operating margin was 29.3%. Non-GAAP net income was $250.2 million and non-GAAP earnings per diluted share was $0.46, which was three cents ahead of the midpoint of our guidance and positively impacted by two cents from the aforementioned legal settlement. On a GAAP basis, in the September quarter, gross margins were 57.4%. As you may recall, on August 20th, we announced that a cybersecurity incident had impacted our business operations, and on September 4th, we announced that this incident was unlikely to materially impact our financial condition or results of operations. During the closed process for the September quarter, we evaluated the financial impact of the breach, including unscheduled factory outages, and although the incident did not materially impact our financial condition or results of operations, we determined that the total cost impact of the incident was approximately $21.4 million. The majority of this cost is attributed to incremental factory underutilization charges resulting from a cybersecurity incident. Total operating expenses were $521.9 million and included acquisition and tangible amortization of $122.7 million, special charges of $1.5 million, share-based compensation of $42 million, and $3.6 million of other expenses. GAAP net income was $78.4 million, resulting in $0.14 in earnings per diluted share. Our non-GAAP cash tax rate was 13% in the September quarter, which was in line with our guidance. Our non-GAAP tax rate for fiscal year 2025 is expected to be about 13%, which is exclusive of the transition tax and any tax audit settlements related to taxes accrued in prior fiscal years. We are still hopeful that the tax rules requiring companies to capitalize R&D expenses will be pushed out or repealed. If this were to happen, we would anticipate about a 200 basis points favorable adjustment to microchips, non-GAAP tax rate, and future periods. Our inventory balance at September 30, 2024, was $1.34 billion, which was up $31.6 million from the end of the June 2024 quarter. We had 247 days of inventory at the end of the September quarter, which was up 10 days from the prior quarter's level. At the midpoint of our December 2024 quarter guidance, we would expect both inventory dollars and days to increase. We also continue to invest in building inventory for long-lived, high-margin products whose manufacturing capacity is being -of-life by our supply chain partners, and these last-time buys represented 18 days of inventory at the end of the September quarter. Inventory under distributors in the September quarter was at 40 days, which was down three days from the prior quarter's level. Distribution took their inventory holdings in the September quarter down, as distribution sell-through was about $95 million higher than distribution sell-in. Our cash flow from operating activities was $43.6 million in the September quarter and was negatively impacted by the timing of interest and tax payments, including the transition tax payment that is paid annually and was part of the 2017 Tax Cuts and Jobs Act. We have one more transition tax payment that is due in the September quarter of 2025. Hence our adjusted free cash flow was $14 million in the September quarter. As of September 30th, our consolidated cash and total investment position was $286.1 million. Our total debt increased by $256 million in the September quarter and was negatively impacted by the higher tax and interest payments than the previous quarter. Our adjusted EBITDA in the September quarter was $405.7 million and .9% of net sales. Our trailing 12-month adjusted EBITDA was $2.161 billion. Our net debt to adjusted EBITDA was $2.85 at September 30th, 2024, up from $1.28 at September 30th, 2023. Capital expenditures were $20.8 million in the September quarter. Our expectation for capital expenditures for fiscal year 2025 is about $150 million and we expect fiscal year 2026 capital expenditures to be lower than that as we have a lot of capacity to grow back into as well as capital that we purchased during the up cycle that has not yet been placed in service. Depreciation expense in the September quarter was $41.2 million. I will now turn it over to Rich who will provide some commentary on our product line performance and innovations in the September quarter.

Rich? Thank you, Eric, and good afternoon, everyone. We are strategically investing in and launching innovative technologies across high growth sectors. We believe these advancements are positioning us to capture emerging opportunities and drive long-term value creation. In a microcontroller space, our new DSPIC 33A digital signal controller core with its 32-bit architecture and double precision floating point unit is driving innovation in critical sectors. In industrial automation, it's enabling more precise, energy efficient motor control for smart factories and renewable energy systems, powering advanced grid inverters and solar installations as well as power supplies for GPU and CPU-based data centers. We believe this positions us strongly in a growing clean energy market as evidenced by recently released electric vehicle charger reference designs. We have further expanded our MPU offerings with our PIC64GX multi-core 64-bit microprocessors, targeting secure intelligent edge systems that require multiple applications to run simultaneously on a single platform. Similarly, our new PIC64 high performance space computer radiation-hardened MPU, complete with built-in AI accelerators and advanced Ethernet connectivity, represents a significant step forward for the compute needs of space exploration and satellite deployment. For high performance space computers, we are sole sourced in aerospace and defense applications for this compute function and working with numerous customers on early development of applications. In our data center and networking business, we are focused on evolving data center needs. Our family of PCIe switches and high performance PCIe SSD controllers are now in mass production. And widely adopted by customers. These product families are designed and optimized to meet the high speed connectivity and high performance storage needs of standard and AI accelerated servers. We also see increased end customer qualification activity with our CXL controller solutions which will enable larger server memory footprints and improve the efficiency of data center We believe these solutions position us well to address the evolving needs of next generation data centers. In the automotive sector, we are expanding our single pair Ethernet portfolio with our new 1000 base T15s supporting extended cable links. Additionally, we are excited about the launch of our Velocity Drive software platform and automotive qualified multi gigabit Ethernet switches which are now available to support the next generation of software defined vehicles and industrial applications. These innovations underscore our commitment to providing cutting edge solutions across renewable energy, automotive, aerospace, defense and data center sectors. We are making it easier for our customers to develop smarter, more efficient products laying the groundwork for future growth in these dynamic marketplaces. With that, I will pass the call to Ganesh for comments about our business and guidance going forward. Ganesh.

Thank you Rich and good afternoon everyone. As Eric described in his prepared remarks, our September quarter results benefited from the settlement of legal matter with one of our licensees. Including this benefit, our net sales were down .2% sequentially and our non-GAAP gross margin, non-GAAP operating margin and non-GAAP diluted EPS were all better than the midpoint of our guidance. Excluding the benefit of the legal settlement, our September quarter results were consistent with our guidance with net sales down .3% sequentially. As we continue to navigate through an inventory correction that's occurring in the midst of significant macro weakness for many manufacturing businesses, especially those in the industrial and market. Excluding the legal settlement benefit, non-GAAP gross margin came in just over the midpoint of our guidance at .1% while non-GAAP operating margin came in at the midpoint of our guidance at .5% as we continue to manage our expenses by balancing the short-term realities and the long-term growth opportunities. Our consolidated non-GAAP diluted earnings per share came in a penny ahead of guidance at 44 cents per share. My thanks to our worldwide team for their support, hard work and diligence as we continue to navigate a difficult environment and focus on controllable actions that we believe position us well to thrive in the long term. Now for some color about the September quarter and the general business environment. All regions of the world and most of our end markets exhibited varying degrees of weakness. The exceptions were aerospace and defense and the artificial intelligence subset of data center. Our business in Europe, which is concentrated in the industrial and automotive markets, was particularly weak with revenue down almost 22% on a sequential basis. Our broad base of customers continue to manage their inventory tightly and adjust their purchasing plans in the face of a weak macro environment for manufacturing. High interest rates, inventory in their channels, very short lead time for our products and an uncertain business outlook. This combination of factors we believe is driving lower consumption and continued inventory de-stocking as well as reductions in target inventory levels at multiple levels. At our direct customers, at contract manufacturers and distributors who buy from us, at our indirect customers who buy through our distributors and in many cases at our customers' customers. The early signs of green shoots in our business we saw in the March and June quarters progressed at an uneven pace with bookings staying flatish on a quarterly basis but continuing to age over shorter periods of time with an increasing number of requests for expedites of new orders as well as shipment date pull-ins for previously placed orders and with cancellations and push outs declining to normal levels. We believe these factors are positive signs for the formation of a bottom in our business despite low customer confidence in the macro environment and resultant low visibility for our business. Our average lead times continue to be about eight weeks or less. While the short lead times are resulting in reduced near time visibility as customers delay placing orders since they have high confidence that supply is readily available, we also believe short lead times during a period of business uncertainty are helping customers navigate the uncertain environment successfully and improve the quality of backlog placed with us. We have adjusted our operational systems to adapt to this uncertain environment and prepositioned semi-finished and finished goods inventory as best as we can to be able to accept and ship the terms orders we need for the December quarter. Our factories around the world are continuing to run at lower utilization rates in order to help control inventory levels. Our internal capacity expansion actions remain paused and we expect our capital investments in fiscal year 25 as well as fiscal year 26 will be at or below the low end of our long term range of three to six percent of revenue. As we plan to use the inventory we have invested in as well as our underutilized capacity to support the initial phases of the next up cycle. We're also prepared for the long term growth of our business on the one hand in partnership with our foundry and outsourced assembly and test partners and on the other hand with the optionality of deploying capital which we have purchased but not yet placed into service for our internal factories. While there remains uncertainty about the shape of the future recovery, we do expect it to arrive as it has in all prior semiconductor cycles and we believe we are well prepared for the things we can control to exploit whatever the market recovery will look like. On the CHIPS Act front we are making progress towards concluding a final agreement that is consistent with the goals of the CHIPS program and with our business values and we are cautiously optimistic that this could happen no later than the end of December. Now let's get into the guidance for the December quarter. While we believe substantial inventory destocking has occurred at our customers, channel partners and their downstream customers, we remain in an environment of continuing macro uncertainty for our customers and result in low visibility for us. Additionally, the December quarter has historically been our seasonally weakest quarter and it's the time of the year when there are the most manufacturing holidays especially in Europe and the Americas and it is also the time of the year when customers tend to reduce inventory on the year ending balance sheet. In the current economic environment many customers have also indicated that they intend to take an extended year end shutdown. While we need turns orders and customer driven pull-ins within the quarter to meet our guidance and operating in a high turns environment has historically been normal for microchip, it is challenging to predict and plan for during abnormal times as we're in today. Taking all the factors we have discussed on the call into consideration, we expect our net sales for the December quarter to be between 1.025 billion and 1.095 billion. We expect our non-GAAP gross margin to be between 57% and 59% of sales. We expect our non-GAAP operating expenses to be between .2% and .8% of sales. We expect our non-GAAP operating profit to be between .2% and .8% of sales and we expect our non-GAAP diluted earnings per share to be between 25 cents and 35 cents. We expect our long-term growth to be driven by a combination of our new product innovation as well as the strength of our design and activity. Rich has already provided a summary of several of the new product innovation results. On the design end front, after two plus years of dealing with shortages and redeploying their innovation resources towards mitigating the impact of shortages, our customers for the last year plus have returned to prioritizing their innovation projects. The result is a strong design end pipeline across all end markets, megatrends and key customers, which is amplified by a total system solutions approach to take advantage of our broad portfolio of solutions. The impact of this growing design pipeline is muted in the current environment where excess inventory gets most of the attention and design and activity takes time to gestate into production. But design end momentum is what we expect will drive above market long-term growth. We believe the fundamental characteristics of growth, profitability and cash generation of our business remain intact, but is suppressed in the current business environment. We're confident that our solutions remain the engine of innovation for the applications and end markets we serve. This down cycle we're in has been the most prolonged and challenging down cycle I can recall during my 43 years in the industry. And we believe it could set up a strong cycle reversal at some point in 2025. And we remain committed to executing our strategic imperatives, which we believe will deliver sustained results and substantial shareholder value. Let me wrap up with an update about our capital return to shareholders. In the September quarter, we returned $261 million to shareholders through a combination of $243.7 million in dividends and $17.3 million in stock purchase in the open market. This represented .5% of our adjusted pre-cash flow in the June quarter. Since achieving investment grade rating in November 2021, we have returned $4.8 billion of capital to shareholders through the September 2024 quarter, of which 2.4 billion represented shares we purchased, which is about 5% of our shares outstanding. We are continuing towards our target of returning 100% of our adjusted pre-cash flow to shareholders by the March 2025 quarter, with the dividend being the fixed component and share buybacks being the variable component. We expect that due to the timing of cash payments, occasionally our adjusted pre-cash flow may dip below the fixed component represented by the dividend. In such situations, as you heard during Eric's prepared remarks about the September quarter, we expect to temporarily increase our borrowings to pay the dividend and then repay those borrowings in subsequent quarters from the pre-cash flow generated that is in excess of the dividends paid. With this approach, we aim to stay consistent with our capital return strategy without causing it to increase our debt permanently. With that, Matt, would you please poll for questions?

Great, thank you. At this time, we'll be conducting a question and answer session. If you'd like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 to remove yourself from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment, please, we'll repoll for questions. First question is from Timothy Arcuri from UBS. Please go ahead.

Thanks a lot. Ganesh, I kind of wanted your perspective on how long you think it could take the distribution channel to sort of get back to normal. If I look at your drawdown in revenue, basically it was all of distribution this quarter, so it seems like things are actually relatively okay beyond that channel. If you kind of look at inventory days, it's about 2X what it was before COVID. I mean, do you think that 20 days of inventory is still what that channel wants to hold? And sort of given your discussions with them, how long do you think it could take to sort of clear that channel?

So maybe two points of data first. 20 days was towards the low end of where we were during COVID. If you look at over time, closer to 30 plus or minus is where distribution days of inventory have been. Second, those days of inventory are calculated on a backward-looking revenue basis. And when you are in a steep decline and expecting to bottom and grow again, the backward-looking days of inventory isn't always the most helpful calculation, although it is the calculation that is consistent across quarters. Now that said, in this cycle, the distribution inventory is not just driven by what are they carrying, but sometimes their customers and their customers' channels also have inventory that is de-stocking. And so what we're seeing is, depending on which customer, what region, which distributor, there's some of this where the distribution de-stocking is taking place. But what is less visible is de-stocking taking place at other places farther downstream that it had all been collecting during the strong quarters as we were in 2023 and 2022 as well. So it's a bit more difficult to see. We know that distribution is de-stocking at the rate quite significantly over the last three quarters. But they have to get enough of a signal from their customers on that coming back. We do see some early signs of that, but there are requests for expedites, there are requests for pull-ins and all of that. But it's hard to read beyond that given how little visibility there is in the market.

Thanks a lot. And then Eric, just a question on underutilization and how it could affect the shape of the gross margin of recovery. The last quarter where you didn't take charges, I think, was the end of 23 when revenue was at 1.8 a quarter. So if your capacity hasn't really changed since then, does revenue have to get all the way back to 1.8 before you're no longer burdened by underutilization? Can you talk through all that?

Thanks. Yeah, so that depends on what the slope of the revenue curve is and what our forecast is out in time when we get to that point in terms of how we're going to be ramping. So I can't put a revenue number around it of where that's going to be, but we're significant underutilized today. That's going to continue, obviously, in the current quarter, and then we'll just gauge it as we go. But underutilization charges are having a pretty significant impact on our gross margin and our operating results. And on top of that, then we're building inventory. And because we don't have great historical sales at this point in time looking backward a quarter, and then as we look forward, don't have a lot of backlogs, our inventory reserve charges have been quite high also. And that at some point in time is going to provide a tailwind to gross margin as the environment improves.

Thank you.

Our next question is from Zivik Aria from Bank of America Securities. Please go ahead.

Thanks for taking my question. Ganesh, when we look across the space, there seems to be kind of a wide range of corrections that we have seen across the diversified names. It seems like microcontrollers have been more impacted than analog, industrial more exposed than autos, but this combination of microcontrollers and industrial has corrected the most. What would you attribute that to? Because it's just hard to imagine this kind of 50% plus peak, hopefully trough correction. And then what is giving you the confidence that this is an industry and a cycle issue? And maybe, is there something company specific in terms of share ships or China insourcing? Just give us kind of the perspective of how is microchip stacking up versus the industry that you're in.

I think you're right that this is an asynchronous up cycle and down cycle. And so depending on exposure to end markets and exposure to certain regions of the world, the results are going to be different. I think as I mentioned a quarter ago at our conference call, there was also different ways in which people tried to deal with the up cycle and how to tackle the demand for our city that was taking place at the time. And so there is an overhang obviously that microchip has and I think many others have had but to different degrees that is based on what people were buying in excess of what they needed. And so all of that has to correct and come through. Now, what gives us confidence in our business is the connection to the customers that we have on programs, on plans that they have. And really as they give us more visibility into what is happening with their customers and their channels, the change in revenue isn't because revenue is moving from one supplier to a different supplier. It's really customers who got very, very optimistic, built ahead of demand, thinking that their historical in 21, 22 time frame was going to be persistent demand. And then they ran into a macro issue where not only do they have high growth plans, higher inventory, but a much slowing demand. So those are all what is correcting through. The customers we have remain the customers that are working with us. We are working with them on next generation programs that they will launch as they get to the point where the current inventory is burned off and a new product can be launched. But our confidence comes from this is a market that has long cycles, long design end, long production cycles. And we just need to get through. We are not in the early innings of a correction. We are in the later innings of a correction. And that's why our confidence is that this thing will turn around. It has turned around. And just as when we were on the upside, it looked like it was impossible to know how could we ever satisfy the demand. On the down cycle, you get the sense that how can we ever turn this thing around? But it does happen. It is a cyclical industry and it will happen.

For my follow-up, just kind of near-term clarification, what is the level of turns business that you are assuming for December versus normal? And then I know March is still a little bit further away, but if I go back in history usually your March sales tended to be flat to up 1 to percent. So any conceptual way you would help us kind of think through what March might look like? Thank you.

Let me take the second one and then I'll let Eric speak for the first one. I think with as little visibility as we have, we have a hard enough time trying to call the December quarter, let alone the March quarter. But the puts and takes of March typically are, we'll see the Chinese New Year and usually there's about a 10-day or 14-day impact that comes. So that's the headwind. The tailwind is we have fewer production holidays in the western countries, in Europe and the Americas, and so you get more production days that happen and typically those have strength. And then you have to put into place whatever else takes place in terms of inventory that has been de-stocked and needs to be starting to building closer to consumption. So a lot of puts and takes that go with it, but we're far away from trying to have visibility into the March quarter as we struggle through getting enough visibility into the December quarter. I'll let Eric answer the first question relative to

turns. Yeah, so we don't break out turns specifically. You know, Ganesh gave commentary that bookings continue to be weak in the September quarter. They were pretty much in line with where bookings were in the June quarter and our -to-bill was below parity. So our visibility continues to be not great out in time, but we've got short lead times and inventory available and can respond quite quickly. And the orders that we are receiving from customers now are more in line with where our lead times are and we're well positioned for that. So the level of terms that we need is not outside of what we've seen historically. Microchip to be able to execute on and is obviously contemplated in the range of guidance that we gave today.

Thank you.

The next question is from Toshio Hari from Goldman Sachs. Please go ahead.

Hi, good afternoon. Thank you so much for taking the question. I had two questions as well. My first one, I'm just curious how you're thinking about the gap today that exists between what you're selling in versus what is being sold through. And I know you don't have perfect visibility, but your December quarter revenue outlook, I think at the midpoint is, you know, 20 or 25% below where you were pre-pandemic. And if I recall correctly, late 2019, back then you were going through a cyclical correction. So you must be shipping well, well below what's being consumed. I'm curious if you have, you know, an estimation of how big that gap could be today.

So we don't have a – we absolutely agree with you. We are shipping considerably under where consumption is taking place. As I speak to our customers, define how are they seeing the business, right? It is nowhere close to the magnitude of what our business is going through. And I think that is the bullwhip effect we're seeing on the reverse side, where they're trying to manage through their inventory, their channels and where they're at, plus some macros that they're – macro things they're going through. But our customer business is down substantially less than what our business is down. And that is what gives us the comfort that as they correct the inventory, they have to go back to a consumption level that is a lot higher than where we're at today.

Got it. And then as my follow-up, I'm curious how you're thinking about blended pricing into calendar 25. And I know Ganesh, historically you've said that, you know, you operate a strategic business and, you know, it's less transactional than it used to be back in the day. But you've had a couple of peers point to low single digit declines next year, mid single digit declines next year. I'm curious how at Microchip you're thinking about pricing as of today. Thank you.

You know, I think in general our direction hasn't changed. Our pricing is pretty consistent year over year. The environment for new designs is, of course, a lot more competitive. There are players who are, you know, in some cases, you know, being more aggressive than they were historically at. And we will match them to make sure that in the business that is important to us. But we also have a substantial discipline in our process and how we will run it. And remember, it isn't just pricing, but we also have cost reductions that we're bringing on, which is what are we doing in terms of design shrinks and other things we can do to be able to drive the margin side of the equation as well. So, you know, will there be pricing pressure as we go throughout 2025? Yes. But a lot of it is going to be on new designs as they start to go into production. And, you know, a substantial amount of existing designs that will continue to stay with where pricing and terms are today.

Thank you.

Thank you.

All right, next question is from Chris Casso from Wolf Research. Please go ahead.

Yes, thank you. I guess the first question is on what you've been seeing by geography. And it looks like there's some sharp differences there with particularly what you're seeing in Europe. And is that, you know, just simply end market dependent, I guess, saying, you know, with the exposure to industrial and auto there? In addition, you know, we've seen some others in the space talk about some strengths in China. Can you speak to that and if that's been a partial offset for you?

Sure. So, Europe has a couple of factors in it. Historically, I don't know for whatever reason, Europe seems to enter cycles, you know, one to two quarters behind when we see it in the Americas. So, you know, on a down cycle, they start a little bit slower than that. But a big part of what we're seeing in Europe and the large sequential decline that we have seen and year over year declines we've seen have been the high percentage of industrial and automotive end market, you know, customers that we have there. So, yes. And I think you've seen that in the commentary for many others and I see that in the commentary for many other industries with high exposure to Europe as well. That's where the biggest challenges are for anyone with a large industrial and automotive side of the business. With respect to the other geographies, your question was about China. I would say that we don't quite break out China, but when you look at greater China for us, which is, you know, Taiwan, China, Hong Kong, all combined on it, off the four regions or the three regions, you know, the subset of Asia that represents greater China would be the one where at least there is not weakness. There's not great strength, but it doesn't have the same weakness as we see in Europe and the Americas.

Got it. As a follow-up, you mentioned in the prepared remarks about some borrowing that you were contemplating around the dividend. I wonder if you could give some of the details around that, you know, some of the background of why you're choosing to do that. And maybe more broadly, you know, given the downturn that's lasting longer than most of us have thought, you know, what's kind of your general view towards the borrowing levels right now?

Sure. So maybe I miscommunicated in my prepared remarks, so let me go through them again. In any given quarter, the adjusted free cash flow we generate will vary depending on various actions, particularly when we have concentrations of tax payments or interest payments, which happen a little bit more lumpy. In that quarter, we may generate less adjusted free cash flow than the dividend that we pay. And all that I was trying to say is that in subsequent quarters, what we would do is take some of the adjusted free cash flow that was in excess of the dividend and compensate for that so that we didn't have a net borrowing between quarters where the adjusted free cash flow was less than the dividend payment. So it's really borrowing from within microchip, not so much borrowing from the bank. We did in the last quarter, as Eric said in his prepared remarks, have to increase the debt in order to pay the dividend because our adjusted free cash flow was lower than what the dividend payment was. And there will be subsequent quarters as we go back into a recovery where we will generate more. And what we will do is just bring the debt level down so that the 100% capital return can still happen without raising the aggregate debt. Do you want to add anything to that, Eric?

Just maybe take a real simple example. So if, for example, the dividend in the current quarter is in excess of the prior quarter's free cash flow calculation by $100 million, and then we fast forward to the June quarter of next year and hypothetically the adjusted free cash flow is $200 million higher than what the dividend would be, but forward we would start buying back stock, we would back out that $100 million that in Ganesh's kind of terminology we borrowed in the current quarter to pay the dividend. So over the course of time it's 100% free cash flow return. Without a structural

increase in debt levels.

That's exactly what we're targeting. And a commitment to our shareholders that the dividend is strong and continue to be there and that our cash generations continue to be strong over the long term.

Okay, got it. That's clear. Thank you.

The next question is from Blaine Curtis from Jefferies. Please go ahead.

Hey, good afternoon. Thanks for your question. I had two. I'm just kind of curious on the message on the guidance. So it sounded like last quarter you were hopeful of some green shoots. You said they were uneven. So I'm just kind of curious, are you seeing any areas either product-wise or geography that you're feeling better about? And then I guess for the guidance it sounds like you're just assuming less turns. Is that anything you're seeing or is it just as you explained, seasonal, and you're just being conservative on that?

So as I mentioned, the two places where we continue to see strength is in aerospace and defense as well as the AI subset of data centers. So that has been continuing now for multiple quarters. I think in this quarter, beyond the normal macroeconomic forces and all that stuff, also we know that the quarter ends in December when there are more holidays and so less production days. And people will take the opportunity to tamp down any production plans as well as to cut back on inventory because many of them have year ends for their balance sheets and they want to have a balance sheet without excess inventory sitting on it. And we've already heard from some customers who have production shutdowns that are in the latter part of the quarter. So I think all of that plays into us trying to get a sense of where is this quarter going to go. And at this point in time, I think the guidance tries to reflect that combination of what are we able to do, what are we expecting will come, and where are the places where there's going to be some challenges to work through.

And just to clarify, we didn't break out a turns percentage. We aren't necessarily expecting less turns, but our backlog has continued to fall as our book to bill has been less than one.

Got you. And then maybe just on OpEx, over the next couple of quarters here, I had thought that you had some pay cuts that would kind of come back in. I'm assuming with the lower forecast though, maybe the variable comp is down from, I think you're guiding it up 12 million bucks sequentially for December. But how do you think about the next few quarters beyond that?

Yeah, so on a non-GAAP basis, it's a little bit more at the midpoint of guidance. It's a little bit more than $8 million up quarter on quarter, December to September. And then we are reinstating the salary cut, taking the majority of employees that are kind of below a director level back to 100% salary this quarter, and that is factored into that $8 million increase. And so I would expect that OpEx, because we'll have a full quarter of that effect in the March quarter, will go up again in dollars, and we'll see where the revenue comes in terms of percentage of sales and all that. But those are things that we feel that we need to do. Our employees will have been on a pay cut for nine months, and we want to make sure that we've got an engaged group that is being compensated for the work that they're performing.

Thank

you.

Thank you.

Our next question is from Chris Rowland from Susquehanna International Group. Please go ahead.

Hi guys, thanks for the question. You had some comments about some data center products, which was nice to see, PCI switching, some SSD, SXL, some other stuff as well. I guess a couple of questions here. Is there a home run product amongst this group? Is this outgrowing, I would assume, the rest of your other end markets? The last update that you guys had, I think, data center was 18% of revenue. But it hasn't necessarily grown over time. Would you expect, given this product lineup, for data center to expand as a percentage of your total over time?

Thanks. In the long run, we are very confident about data center as an end market, as a mega trend, and our participation in the opportunities within that. It's pretty broad in terms of what all we bring in there. In the short run, the data center subset, which is driven by accelerated computing, or the AI portion of the subset, and we had estimated that to be about 30-ish percent of the overall data center revenue we had, that is in fact continuing to be strong and growing. But as you know, overall data center budgets are being squeezed on the non-AI portion of what they're spending. Eventually it will come back because they do need to go back and put some of that infrastructure in place. But today, the data center overall growth is constrained because the non-AI portion does not have the same capital expenses that end customers are putting in place while they build out some of the AI infrastructure at the pace that it's going on. But long run, the data center is a huge opportunity for us with multiple growth areas inside of it.

Very good. Perhaps secondly, CAPEX, it seems like you guys paused. You're sick in silicon. I was wondering longer term, how should we be thinking about CAPEX? And you mentioned also an update on the CHIPS Act. Remind us what you're playing for there and the timing of payments.

Thanks. Okay, well I'll answer the CAPEX question. So our CAPEX for the current fiscal year, which will end in March, is expected to be about $150 million. It was pretty front-end loaded where we had about $70 million in the June quarter, and then it's going to be at this lower rate through the end of the fiscal year. We do expect fiscal 26 CAPEX to be even lower than fiscal 25, and that's because we've made a lot of investments in capacity that we need to grow back into. During the upcycle, we were planning for growth and brought in a bunch of equipment that's been received now that is sitting in a undepreciated state that we can deploy. So we've got maintenance CAPEX. Obviously we'll be investing in growth areas of the business, but CAPEX I expect to be quite low again in fiscal 26 for CHIPS Act. I'll turn it back to Ganesh.

So we don't yet have an agreement on the CHIPS Act. We're working through it. We're optimistic about it. I think the CHIPS Act has a piece of it, which is the investment tax credit has been taking place over some time, but we would need to be deploying capital to be able to take advantage of that, and that will happen in time, but it's not something near-term we need to go off and do. And then there are grants, and those grants are the ones we're still negotiating, and those would be determined based on when would we bring on capabilities or capacity consistent with what those grants were delivered for. So I'm not looking for any short-term benefit that comes out of the CHIPS Act in the next one, two quarters or so, but over a three, four, five-year period of time, as demand returns, as we continue to expand and deploy the capital we have and live up to the commitments that we're making into the CHIPS Act, they will all be beneficial to us.

Excellent. Thanks, Ganesh. Thanks, Eric.

Thank you.

Our next question is from Harlan Sir from JP Morgan. Please go ahead.

Yeah, good afternoon. Thanks for taking my question. Lots of questions on the near-term cyclical dynamics, maybe just one for me on your products and technology. So you guys mentioned your customers are back to focusing on innovation. Your TSS strategy continues to play out. The team has a very comprehensive system in place to track the opportunity pipeline, also content growth for opportunity. I don't know, can you guys quantify how successful TSS has been? How has the microchip dollar content per customer opportunity increased over the past several years? Any way to convey your success with TSS?

You know, it's more, we have, because we have 120,000 customers, you know, a substantial number of them through the distribution channel, it's hard to pick that data off on a very consistent basis. But we do have, you know, subsets of what we look at, subsets of some of the large customers, subsets of specific megatrends, subsets of things. And so internally we track, as we look at these subsets, how is it performing? And really the same processes we know are creating that multiplier effect in other places as well. So I think that's the best way. We don't break it down by each, you know, initiative or each megatrend in terms of what we're doing. But we do know and we do see that the TSS reflected by the total content in these applications is growing in the areas that we're focused on. And we'll think about is there a way to provide some of that insight? And over the years we have shown some of the customer designs without putting any names on them showing all the different content. It doesn't go to your question of dollars, but it does go to your question of content. And maybe we'll bring some of that back into the investor circuit. Did you have any other?

Yeah, you know, maybe a good way for you to look at that too is on our website. We now have a very extensive reference design section that we're adding reference designs to every quarter. And you could probably see from that what markets and about how many devices are in each of those reference designs for those target applications. And that gives you a good idea of where we're targeting and what's happening.

Yeah. Okay, thank you. That's helpful. Thank you.

Thanks, Harlan. Our next question is from Tori Svensberg from Stiefel. Please go ahead.

Yes, thank you. Ganesh, I had a question on your Terns business. I mean, I assume the percentage each quarter now is very, very high. You obviously have short lead times. You have inventory, but so do your peers. So I'm just curious what's your view on how long we're going to be in this period. And I'm not suggesting maybe revenue is going down every quarter, but could we be in a very high Terns environment for a while just given all the inventory that all the broad-based companies have at this point?

Yeah, it's hard to tell, right? So I mean, let me reverse the thing, go back to the middle of 2023. We had 52-week lead times, and it looked like lead times would never come down. And pretty soon, it's rapidly on one. And I think the reverse could happen here as well. What will determine this is when do customers either feel the need to place backlog because they feel there is risk if they don't place it or have confidence in their business and say, hey, I want to get going with it. Right now, our customers in the markets that we've described are uncertain about their business, are uncertain what is the rate at which their inventory will drain, their new orders will come in at. And as long as they're uncertain and there are short lead times available, there's no need to place backlog. And if they don't place backlog, that means we have higher Terns that go with it. It will turn around, and it will turn around when they get to the point where they either get concerned, they may not get product because they need to place a backlog, or they get confidence in their own business having turned around. And some of the things, the external conditions have started to, with interest rates starting to come down, that is a good stimulus in the right direction is happening here. It's happening in Europe. I think we've got to get some of the uncertainty with the elections and some of that stuff out of the way. But as all that works out, and every quarter, inventory is draining, right, which means that their margin of error if they don't place orders is increasing. And I think all of that will come back, but how it comes back and how fast it comes back is not very predictable. But we have seen it, and we have seen it come back pretty quickly when we thought it's going to be here taking a long, long time before it recovers.

Well, that's great, Kaller. As my follow-up for Eric, Eric's on CAPEX, obviously it's going to be lower her next fiscal years. But from a capacity perspective that Microchip has, and I do recognize that you obviously outsource too, right, but I mean, is it fair to say that the company can double its quarterly revenue with basically just maintenance at CAPEX at this point?

Yeah, I mean, in theory, if the mix stayed what it was today, we could do that. You know, what the mix is going to be at where we get there, it's hard to tell, right? And we'll have new products that accelerate their pace in the marketplace, and we'll need to make investments to support that. So it's not a completely straightforward answer. It'll be somewhat mix-dependent, but we've got a lot of capacity to grow back into.

Very good. Thank you. Our next question is from William Stein from Truist Securities. Please go ahead.

Great. Thank you for taking my question. I'd like to ask about the green shoots, as you characterize them, and the uneven way that they're playing out. This sounds to me as an outsider looking into the company that this is essentially just expedites, which are easy to sort of confuse as like upsides or urgent demands when in reality the customers are just depending on you to have ever shorter lead times. How do you distinguish between those two sort of demand triggers? And where do you think the mix, like are there a lot of customers that are viewing demand in the way that they really need upside, or they need it faster than before? It's real pull-ins, or should I think of this mostly as just responding to your very short lead times?

You know, I'm sure customers are taking advantage of the fact that there are short lead times. But we also know that we have customers who didn't have to place and didn't place orders for two or three quarters, and they've started to place orders. And in some cases they had previously placed orders for farther out in time, but now recognize that they have used up what they had placed and need to pull in. So those are the effects that we see. And the fact that we have short lead times is just our ability to then respond to what they are seeing as the demand signal. They don't have very much visibility in their demand signals, but as they sell through, they recognize they need to build more. And as they need to build more, they're starting to place orders on us, or place orders on us at short lead times, or pulling in orders previously placed on us. Those are the green shoots that we think reflect consumption and the need to place orders on us that are starting to get closer to where their consumption is at.

One follow-up if I can. I appreciate that answer, Ganesh. I think at the last Analyst Day the company highlighted a 6% to 8% long-term growth, but then there was a conference call or an investor conference perhaps where the company cited a 10% to 15% long-term sales growth view. I'm not expecting you to update this or to tune that outlook up, but I think there's a more basic question investors have, which is what's the actual rate of end demand, even if it weren't really growing much? We're under shipping today. Clearly you are over shipping at the peak. Do you have any, even if it's a qualitative way to get at what you think, sort of normalized demand is on a, let's call it sort of a sell-out basis or an end demand basis?

The noise on that signal is so high it's hard to give you a useful number at this point in time. We were for two years in a row growing at 25% annually, and we didn't take our growth rates up as that happened because we knew that these things run in cycle. Today we're in a deep down cycle, and we're not trying to reflect that this is how it's going to be. I don't have a good answer. I think we've gone through the most unusual cycles here in the last three plus years. We're all trying to get our bearings on, okay, what part of that cycle was a secular growth versus what were things that were maybe pull-aheads because of COVID or because of other issues, et cetera. I don't think anybody knows precisely where that is. So I don't want to give you an answer today reflecting where today's end of the cycle is, just so I didn't want to give an answer that was optimistic when the upper end of the cycle was there.

Yeah, and we really feel that our focus on these areas that we call the megatrends where our products play that we think are the faster growing areas of the market that we can participate in as well as TSS is going to allow us to consistently gain market share over time.

Well, I think the way if I step back and look at this, I look and say, okay, there's a lot of noise in the short term, et cetera, but how is innovation in what you and I and others and everybody else counts on and uses and what we do and how we run things, et cetera, being delivered? And that innovation has a substantial semiconductor content on which is being delivered. And if you believe that that semiconductor content is essential for how growth and innovation is being delivered by the customer base for all of us as consumers to be able to take advantage, right? There's a lot of optimism on where this thing goes in the long term. But the noise in the short term is just too high to be able to discern where that is in the long term.

Great. Thank you.

Thank you.

Our next question is from Chris Bailey from Citi. Please go ahead.

Hey, thanks, guys. So clearly this downturn has gone on longer and deeper and farther than any of us expected. If we're still in this muck, let's call it another couple of quarters or whatever, is there any risk of an inventory write down or structuring or would you guys have to cut the deal? The dividend.

So, you know, I think that the answer to that on, you know, a cut in the dividend or a significant inventory write down, those aren't things that we lose sleep over. You know, our products have really long lives. You know, we know this is going to come back, you know, timing of that. And the size of the bounce back is hard to predict. But that's not anything that we're worried about. The cash generation from this business is there and the dividend is there to stay. I don't know if I've addressed all pieces of your question. Was there anything else?

That's fine. And then the last one is a little provocative. So, you know, some of your or most of your peers have already reported and I'm sure you see that your sales are down substantially more than any of the competitors. You know, why is there not anything sort of wrong with Microchip or what do you attribute your, you know, deeper sales decline versus all the competitors to?

So, you know, I talked about it a quarter ago. I think if you aggregate over time, you know, we had a steeper increase to if you go back and look at 22 and 23. And so, you know, did some of our shipments take place ahead of what others were at? You know, we all have had different ways in which we have navigated through the cycle. Clearly, for many of our customers in the industrial marketplace and some of the automotive marketplace, they also had policies about carrying far more inventory. They were building quite valuable end products. And so, you know, some of those customers have had a higher inventory that they're starting from which they're burning down. But when I look at the aggregate of how much revenue on an index basis has everybody been able to generate going back to the December quarter before COVID, to December 2019, I think you'll find that the total area under the curve is very similar. That said, you know, we're down significantly and therefore we expect that the opportunity to grow significantly is also an important part of what is ahead of us in Microchip.

Yeah, and I think with that growth should come a nice acceleration return to a more normalized level in our operating profit, which is obviously down significantly at this point in time. So, I think that's an opportunity. That's fair. Thanks, guys.

Thanks, Chris.

Our next question is from Joshua Buchalter from TD Cowan. Please go ahead.

Hey, guys. Thanks for taking my question. As we bridge to the December quarter gross margin, any help you can give us on expectations for directionally? I know you usually don't comment on utilization rates, but directionally how you would expect on the utilization charges to trend in the quarter and maybe similar question regarding expectations for potential investment. In inventory write downs, I know that's been moving a little bit the last few quarters. Thank you.

Yeah, you know, I think it's going to be, you know, more of the same of what we've seen the last couple of quarters that we're going to continue to run the factories at much less than optimal utilization. So those utilization charges are going to be going to be with us. And so we'll have the manufacturing teams executing on that. And inventory reserves are going to be a result of where inventory ends up and, you know, where our sales for the quarter and over the last couple of periods are going to be. So inventory reserves are going to be high again. And, you know, the good thing is, is, you know, we don't believe we're building inventory that isn't going to sell, right? Long life products are really going to help us in the future. And even though we'll have a write down currently, you know, the chances of that inventory selling through at some point in the future are quite high.

Okay, thank you. And then maybe a bigger picture question. I mean, the disc is obviously an issue right now and where you still have work to do on the inventory side. And I mean, through this cycle, a lot of your peers have sort of the emphasize the channel and distribution partners. I'm just wondering, I guess, coming out of this cycle, are you thinking about your relationships and the importance of the channel and how you expect it to treat it? I guess long term strategically as you prioritize your inventory. I'd be curious your thoughts coming out of the cycle. Thank you.

You know, we have, I think, somewhere in the order of about 100 channel partners across the world. They're an important part of our sales process. They reach a large number of customers that we would not be individually able to go. We have different models by which we work with them based on the work that they're able to do and the results that they're able to provide. And we believe that channel partners remain an important part of our strategy. They've been hanging right about at the 50 percent plus or minus, you know, five, 10 percent for a long time to come. But we do evolve. How do we work with them and how do we work to incentivize and also compensate for performance with them?

Thank you.

Thank you.

Our next question is from Horace Kumar from Piper Sandler. Please go ahead.

Yeah. Hey, guys. Thanks for squeezing me in. Can I just add a question on pricing in this cycle? This is a period of kind of high capacity, low product uptake. I was curious as you're negotiating prices with your customers for your next contract for the next 12 months, are you starting to see any pressure at this point in time or is pricing still pretty firm?

Oh, there's always pressure. Right. Any purchasing manager worth their salt would be pushing for that. The question is, you know, what is a reasonable deal that allows a win-win outcome that comes from it? And what is the true risk of losing something on price? And, you know, the vast majority of our products are designed in, have long design cycles, long production cycles that go with them. But, you know, we're business people and we work to make sure that, you know, if we can make the pie bigger and generate a significant amount of overall business that for both the customer and for us is a good win-win relationship, we'll go with it. But I would say in the aggregate, that isn't what is moving gross margins for us. It's really at this point in time some of the underutilization and other issues that are there. Pricing on a long-term basis is a lot more stable, a lot more disciplined.

Got it. And for my last question, Ganesh, you talked about green shoots. This is the second quarter, I think, you're seeing those signs of cancellation. And this is probably very typical of being at the bottom. But I was curious if you could give us some color on these green shoots. Are these green shoots getting stronger for you? Are they just about the same? I mean, I'm kind of nitpicking here, but I want to see if there's something to be taken away from the demand signals that you are seeing at the bottom.

You know, it's hard to tell. I would say the green shoots were a lot greener two quarters ago. And, you know, at this point in time they're still green, but maybe not quite as green. I think, you know, there's a malaise in terms of where the market is at. We're seeing the expedites, the pull-ins continuing to rise. So that's goodness. We are seeing, you know, the cancellations and all of that, you know, has bottomed out. That's good news. What we haven't seen quite yet is sufficient confidence in customers to give us more bookings and backlogs because they don't have quite that same confidence. So I think that's the missing piece that we want to see come through.

Thanks,

Vinish.

Great. Thanks, Harsh.

Next question here is from Janet Ramkison from Core De Capo. Please go ahead.

Oh, yes. Just to follow up on the CHIP Act question that was asked before. I just want to make sure that I understand this right. You were awarded, what was it, a talk of an award in brackets for $162 million. And $90 million was for the expansion of the Colorado Springs facility. And $72 million was for a fabric expansion in Oregon. And, you know, from January to today, one would think that something would have happened. Is it the situation where the Commerce Department just made these awards and it's a situation where it's very difficult for you to meet the requirements to actually get these grants? Is there any color that you could provide that could help us understand why this was awarded and nothing has happened?

So let me kick it off and then I'll hand it to Rich. So, you know, what you're referring to in January was what's called a preliminary memorandum of terms. So it's really an LOI, so to speak. It needed work to be done. They needed to do due diligence. And then there was an agreement. We have worked through a fair amount. And, you know, the Commerce Department, this is new for the CHIPS office in terms of what needed to happen. So there was a lot of learning for us and for them in terms of where it's at. We've run into, you know, things that were not necessarily the right answer for Microchip that we have to educate them on. But, you know, we have worked through a lot of that at this point in time. And maybe I'll let Rich speak to it because he's been spearheading that for Microchip in terms of where we are and kind of why we feel at this point that there is a reasonable chance that we might get the final agreement done this year.

You know what, this is probably the first true public-private partnership with government in terms of investment in the U.S. And as Ganesh said, there was quite a bit of learning on both sides in terms of what it took to invest and grow this industry. This semiconductor device is probably the most complex industrial product that we make with some of the longest cycle times and the most capital-intensive industry that there is out there today. And so there was a great deal of education back and forth. In most cases, you know, federal government is dealing with much simpler products that they had to deal with and not something as complex or high-tech as making a semiconductor chip. And not familiar with just how intertwined the world's supply chain and support chain is to make a semiconductor chip. It's not contained in one geography or one area. You know, to make a chip or install equipment in a factory, we need support from all over the world to make that happen. And so as Ganesh said, it took a while to get through and educate each other on what was needed. There was quite a bit of constituents within Washington that weighed in on the CHIPS Act. And we had to go through and work with those various constituents to make sure that we met their needs as well as the business needs, as well as the structural needs of the CHIPS Act in terms of what it was intended for.

So did you, you do have some equipment that you haven't deployed yet. At any time, did you feel that you were just trying to get one step ahead in terms of buying equipment to meet the obligations that you would have if you got that 162 million with the breakdown through Colorado Springs and Oregon. It does require a little bit of lead time to be able to deliver on whatever you were promising, wherever the Commerce Department thinks that they're getting. So do you feel like you tried to order equipment a little earlier because you think you felt that you were going to get this money?

No. So we ran the business the way we needed to run the business. We weren't running the business to be able to time it with something that the CHIPS Act would end up having to go do. It was all running in parallel. Obviously, the markets have changed and things have changed. But all of what we did largely is driven by what do we need to do to run the business.

Okay. That's fair. Thanks very much for the color. I appreciate it.

All right. Thanks, John. This concludes the question and answer session. I'd like to turn the floor back to Mr. Moorthy for any closing comments.

Great. Well, thank you, everyone, for your patience in sitting through the meeting. And we appreciate the questions and we look forward to meeting many of you on the road in the coming weeks. Thank you.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you again for your participation.