Microchip Technology Incorporated

This question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Eric Bjornholt, CFO. Thank you, Eric. You may begin.

Thank you and good afternoon, everyone. During the course of this conference call, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are 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 MicroTIPS business and results of operations. In attendance with me today are Steve Sange, Microchip's President and CEO, Rich Simonsek, Microchip's COO, Matthias Kastner, Microchip's VP of Networking and Connectivity Business Units, and Saja Dowdy, Microchip's Head of Investor Relations. I will comment on our third quarter fiscal year 2026 financial performance. Matthias will provide an update on our networking and connectivity business. And Steve will then provide commentary on our results and an overview of the current business environment and our guidance for the fourth quarter of fiscal year 2026. 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 GAAP to non-GAAP reconciliation on the investor relations page of our website at www.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 leverage metrics on our website. I will now go over 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 earnings press release and in the reconciliation on our website. Net sales in the December quarter were $1.186 billion, which was up 4% sequentially and well above the high end of our original guidance provided on November 6th. 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 60.5%, including capacity under utilization charges of $51.7 million and new inventory reserve charges of $58.4 million. Operating expenses were at 32% of sales and operating income was 28.5% of sales. Non-GAAP net income was $252.8 million and non-GAAP earnings per diluted share was $0.44, which was $0.04 above the high end of our original guidance. On a GAAP basis in the December quarter, gross margins were 59.6%, total operating expenses were 555.2 million, and included acquisition and tangible amortization of 107.6 million, special charges of 4.8 million, which were primarily driven by activities associated with our closure of FAB II, share-based compensation of 62.1 million, and 1.1 million of other expenses, Gap net income attributable to common shareholders was $34.9 million, or six cents per share. Our non-GAAP cash tax rate was 9.6% in the December quarter. We expect to record a non-GAAP tax rate of about 10% for all of fiscal year 2026, which is exclusive of the transition tax and any tax audit settlements related to taxes accrued in prior fiscal years. Our inventory balance at December 31st, 2025 was 1.058 billion, which was down 37.6 million from the balance at September 30th, 2025. We had 201 days of inventory at the end of the December quarter. Included in our December quarter ending inventory was 17 days of a long life cycle, high margins products, whose manufacturing capacity has been end of life by our supply chain partners. Inventory order distributors in the December quarter was at 28 days, which is in the range of what we would consider to be normal. Distribution sell-through was about $11.7 million higher than distribution sell-in. Our cash flow from operating activities was $341.4 million in the December quarter. Our adjusted free cash flow was $305.6 million in the December quarter. And as of December 31st, our consolidated cash and total investment position was 250.7 million. Our total debt decreased by 12.1 million sequentially in the December quarter and our net debt decreased by 26 million sequentially. Our adjusted EBITDA in the December quarter was 402 million and 33.9% of net sales. Our trailing 12-month adjusted EBITDA was 1.23 billion. Our net debt to adjusted EBITDA ratio was 4.18 at December 31st, 2025 and was down from 4.69 at September 30th, 2025. Capital expenditures were 22 and a half million in the December quarter. We expect capital expenditures for fiscal year 2026 to be at or below $100 million. Depreciation expense in the December quarter was 37.8 million. I will now turn it over to Matthias, who will provide an update on our efforts in the Ethernet T1S emerging standard for connectivity in the automotive and industrial space.

Matthias? Thank you, Eric, and good afternoon, everyone. I'm Matthias Kästner, Corporate Vice President and Leader of the Data Center Networking Connectivity and Automotive Business Units at Microchip. Today, I want to report on the meaningful momentum in our connectivity business driven by two primary architecture modernization cycles. Let's have a look at the automotive market segment first. In today's cars, up to 20 different connectivity technologies are used to transmit data between electronic control units, while the amount of data is increasing exponentially. The resulting complexity is a major roadblock to implementing higher levels of self-driving capabilities, over-the-air updates, and advanced infotainment systems in a cost and time efficient manner. Therefore, car manufacturers are moving away from the multitude of legacy connectivity standards towards networking architectures that are predominantly Ethernet-based. This in turn reduces software complexity and improves software reusability. Ethernet, in particular the new 10BST1S standard, has the potential to replace several billion automotive legacy connectivity nodes per year. Microchip has developed automotive Ethernet solutions to support this transition. including a market-leading portfolio of 10BASE T1S products, switches, transceivers, endpoints, and bridges. Automotive Ethernet is complemented by PCI Express connectivity for the highest-speed data communication needs in the main vehicle computer, and by ASA, a new open standard that transfers high-speed raw camera data to the main vehicle computer efficiently. We derived automotive-grade PCIe solutions from our leading PCIe switches for data centers, and we were first to market with Acer MotionLink for standards-based high-speed ADAS camera and display connectivity. We believe Microchip is well-positioned across these new connectivity standards. We have design wins and serious engagement with multiple leading global automotive OEMs and Tier 1 suppliers. Today, we issued a press release in which we announced a strategic collaboration with Hyundai Motor Group to integrate our Tempest T1S solutions into next-generation vehicle platforms. Designs are moving from sample evaluation and validation phases, representing platform commitments and next-generation vehicle architectures. The second growth driver for modern connectivity is Industry 4.0. an industrial modernization cycle across factories, robotics, automation systems, and autonomous logistics networks that all require real-time, mission-critical connectivity. The industrial backbone is already Ethernet-based. However, many devices and systems at the edge are connected to legacy connectivity standards such as industrial CAN, RS-232, RS-485. These legacy standards are now being replaced by Ethernet solutions. Like in the automotive segment, our comprehensive Ethernet portfolio, including single-pay Ethernet and EtherCAT, industrial PCIe switches, and AESA camera connectivity solutions are well positioned to capture this opportunity and are already helping customers bridge legacy and advanced industrial connectivity. In both segments, automotive and industrial, we are tracking numerous design wins. We believe that our competitive advantage is straightforward. We offer a complete portfolio spanning multiple connectivity speeds integrated with microcontrollers and analog solutions. Customers deploy a unified microchip system, including silicon and firmware, rather than assemble components from multiple vendors, reducing complexity, cost, and time to market. Industrial connectivity design cycles typically span 18 to 24 months from architecture decision to production revenues. Our recent engagement aligns with pilot production ramps expected in the second half of 2026 and ramping further into 2027. We feel that our market opportunity is substantial. While industry estimates vary, research suggests that the temp for automotive and industrial Ethernet connectivity together represents tens of billions of dollars by 2030, reflecting a once in several decades modernization cycle. Looking ahead, we expect our connectivity business to be a significant contributor to company growth as these modernization cycles accelerate. I will pause here and turn the call over to Steve to provide an update on our business and the guidance going forward. Steve.

Thank you, Matthias, and good afternoon, everyone. We had an excellent December quarter, and I will start by highlighting a few salient points so far. financial results. Our net sales grew 4% sequentially and 15.6% over the year-ago quarter. Net sales were up sequentially in the Americas and Europe and about flat in Asia. Sales from our microcontroller and analog businesses were both about flat sequentially, which was well above the typical seasonal level for the December quarter. The growth primarily came from our networking, data center, FPGA, and licensing business units. We are continuing to see the inventory go down at our distributors, at our distributors' customers, our direct customers, and contract manufacturers. The distributors' sell-in versus sell-through gap shrank to only $11.7 million in the December quarter. down from $52.9 million in the September quarter. This is something we have been expecting for some time, and I have been telling you we also feel that this is a sign that the distribution inventory has largely corrected. In the December quarter, non-GAAP gross margin was 379 basis points sequentially, was up 379 basis points sequentially. Non-GAAP gross margin reached 60.5 percent. We had been expecting a sixth handle on non-GAAP gross margin percentage in the March quarter, but we achieved it a quarter earlier. Non-GAAP operating margin reached 28.5 percent in the December quarter and was up 418 basis points sequentially and up 800 basis points over the year-ago quarter. Now to the market environment. We are seeing recovery in most of our end markets. Automotive, industrial, communication, data center, aerospace and defense, and consumer are all looking better. The strongest sales performance last quarter was in the A&D sector and in our networking data center solutions and licensing business units. We believe we are extremely well positioned with our Gen6 PCIe switch, with it being the only three nanometer-based device currently sampling in hyperscale and in enterprise data center customers, beating our competitors in virtually every specification metric. Today, I have three design wins to report on our PCI Express Gen6 switch, each without the customer's name. The first one is a small design win that will start production in second half of this year. It is a small win but significant for us in establishing credibility based on who the customer is. The second one is a larger win and will start production in CQ1 2027 based on current customer forecast This win is expected to bring $100 million plus in revenue in calendar year 2027. The third win is a small win with an established long-term customer who buys a prior generation Gen 4, Gen 5 products and will be buying our Gen 6 product. This design goes to production in late 2027, early 2028. and we are working hard to win a lot of other large and small designs. As Mathias said in his prepared remarks, we are also doing extremely well in the automotive and industrial networking space with T1S, ASA, and PCIE connectivity products. Now let's get into our guidance for the March quarter. The bookings for the December quarter were significantly higher than those for the September quarter. The book-to-bill ratio for the December quarter was well above one, resulting into a much higher backlog entering the March quarter compared to when we entered the December quarter. A comment about lead times. While lead time for our products have been four to eight weeks for some time, We are continuing to experience lead times bounce off the bottom and we are experiencing increases on some of our products. We are running into challenges on certain kinds of substrates and subcontracting capacity and also some foundry constraints on very advanced nodes. These challenges were isolated to specific areas but are now starting to spread more broadly. Our customer requests for expedited shipments have increased significantly from a couple of quarters ago, pointing to some customers' inventories running low. Taking all these factors into account, we expect our net sales for the March quarter to be $1.26 billion, plus or minus $20 million. This at the midpoint would be 6.2% sequential growth. and up 29.8% from the year-ago quarter. We expect our non-GAAP gross margin to be between 60.5% and 61.5% of sales. We expect our non-GAAP operating expenses to be between 31.3% and 31.7% of sales, and we expect our non-GAAP operating profit to be between 28.8 percent and 30.2 percent of sales. We expect our non-GAAP diluted earnings per share to be between 48 cents and 52 cents per share. Finally, a comment on our capital return program for shareholders. Last quarter, we decreased our net debt balance by $26 million as we produced free cash flow that exceeded our dividend commitment. In future quarters, as we have excess free cash flow above dividends, we intend to continue to use this to bring down our borrowing. With that, operator, will you please pull for questions?

Thank you. We will now be conducting a question and answer session. If you would 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 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Thank you. Our first question comes from the line of Matthew Prisco with Cantor Fitzgerald. Please proceed.

Hey, guys. Thanks for taking the question. I guess to kick off, when thinking about the above-seasonal guide for March and growth beyond, how should we be thinking about that continued strength versus seasonality? And what gives you confidence there as the tailwind from the closing of the sell-in versus sell-through gap theoretically fades? Is that based on is it better end demand, potential restocking, idiosyncratic opportunities, or perhaps something else?

Thanks.

This is Eric.

I think it's a variety of things. We feel that distribution inventory is pretty much corrected at this point in time, but there's still customers that we sell to directly and customers that our distributors are selling to that are still burning through some inventory. We have really strong backlog for the current quarter and the bookings have been quite high, so the backlog is continuing to grow. We can't say that we have great visibility outside of the current quarter because lead times are still short. But we can see the order book growing, and through discussions with customers, we feel confident that heading into what is typically seasonally our strongest quarters of the year, which is the June and September quarter, that we are really poised nicely for growth.

Thanks. And then maybe on the growth margin front, Can you give us an update on how we should be thinking about the inventory reserve and underutilization charges rolling off? And then as we move more squarely into this broad-based recovery, are there other levers for gross margins that should really move the needle here? Thank you.

So we feel that as we move through the current quarter that the inventory reserves are pretty much going to be normalized at this point in time. We're guiding at a midpoint to 61% non-GAAP gross margin. Inventory reserves are a little bit unpredictable, but we feel that those charges are definitely going to continue to come down this quarter compared to the prior quarter and get to more normalized levels. The underutilization charges, which were a little over $50 million last quarter, are going to continue. We are ramping the factories this quarter, but this is going to be a couple-year process for us to kind of get those inventory charges for underutilization down. So they'll be modestly down in the current quarter, which I think Steve said in his prepared remarks, but still at a relatively high level. And that's really the biggest driver as we move outside of this quarter to improving gross margin outside of improved product mix over time. We've talked about some of these growth vectors. Last quarter we talked about our data center business, This quarter we're talking about our Ethernet and connectivity businesses, and these are areas where the gross margin can be quite high, and we think that that, as we see the revenue from that come through, will help from a product mix perspective to keep gross margins high and eventually take us back to our 65% long-term target.

Thanks, guys. Thank you.

Our next question comes from the line of Vivek Arya with Bank of America Securities. Please proceed.

Thanks for taking my questions. For the first one, I just wanted to get a clarification. For December, your microcontroller and analog segments were kind of flattish, which I realize is better than seasonal, but the growth came from the other segment. I'm curious, is that what you had planned for originally? Basically, what really drove the December upside versus your original guidance? Was it what I'm just calling the product segments, or was it more the other? And then similarly, as we start the March quarter, what are you expecting from the product segments versus the other segment, just so that we can model it appropriately?

Vivek, the higher revenue on the licensing side was modeled in our original guidance. So that's not where the upside came from. It was up substantially from the prior quarter, but that was in our model. The upside came on the products. The microcontrollers, the analog, the FPGA, and all the other businesses were substantially stronger. Remember, in December quarter, usually it's down minus 3% to minus 4%, minus 3% to minus 5%. but the fact that microcontrol and analog were flat, so that's where the upside came from, and so was the FPGA and some of the product lines.

And March, Steve, how are you thinking about kind of just relative segment behavior versus the 6% sequential guidance?

March looks quite strong. Seasonally, March is up usually 2% to 3%, and after producing a very large upside, you know, in the December quarter. Our original guidance for the December quarter, I think, was 11-29. That's right. And we produced 11-86. So even after such a large, you know, increase, and some of that came in with the customers pulling their backlog from March into December, but the March kept filling up even further. So despite pulling a lot of product from March into December, the March quarter backlog started very strong. And that's why we gave a 6.2% sequential guidance, much above typical seasonality, and pretty much most product lines are positive. So microcontroller is growing, analog is growing, FPG is growing further, networking, connectivity business, data center, timing businesses, they all essentially seem higher in the current quarter.

And then on the gross margin, you know, very strong drop through in December. You're guiding it to 61 for March. What is the timeline to get to this mid-60s target? Like if we just assume normal seasonality for the next several quarters, is that something that Microchip could get to sometime this calendar year? Or do you think that it would require, you know, much faster growth and it's more a 27 outcome?

I can't give you the exact timing, but for the last several quarters, we've been doing the math for you with the product gross margin being above 65%, but having two charges bring it down. One was the inventory write-off charge, and the second one was the underutilization charge. The inventory charge has dropped quite a bit, and as Eric said, we expect that the inventory charge will be about normal this quarter, may have a little more to go, but largely normalizes. And then you're left with about a $50 million underutilization charge, which will take some time to go away and bring the additional 400 plus basis points of gross margin, which will get us to our model. And how fast we ramp the factories and how fast that underutilization charge goes down really depends on the growth here in the coming quarters and the next year here. It depends on the growth really from internal products. We do about 37 to 40 percent of the products internal and 60 percent plus external. The underutilization largely is in our internal factories. It largely depends on the growth from the internally produced products. And it's hard to predict out in time, but every quarter you should see some improvement and eventually taking it to 65% gross margin.

Yeah, I totally agree with everything Steve said. I would just say I don't want the street to get ahead of where they should be, and it would not be our expectation. I don't know if he said this calendar year or fiscal year, or this next fiscal year, that we can get to that mid-60s. I am not predicting that's going to happen. I think it's going to be steady growth from where we're at, guiding at for this quarter.

Thank you. Thank you. Our next question comes from the line of Jim Snyder with Goldman Sachs. Please proceed.

Good afternoon. Thanks for taking my question. I was wondering if you could maybe talk to your customers' inventory behavior, specifically OEM inventories. It sounds like customers are still maybe drawing down inventories a little bit. I'm curious if you're seeing any signs of customers restocking their own internal inventories, and if so, are you seeing that across any specific verticals, or are we still in reduction mode?

So we're not seeing customers restocking, but You know, we've got thousands of customers, and not every customer is in the same place on inventory. What we're seeing is that the direct customer inventory was high. So if you go back a year and a half ago, two years ago, inventories were quite high. Some customers had up to a year worth of inventory. And they have been taking that inventory down, and customers don't only buy one SKU. The customers who buy, you know, 100 SKUs, I know a customer that buys 500 SKUs. So as the inventory comes down, it's like the water in the lake. When it starts coming down, the lake bottom is never flat. The rocks start showing up. So that's kind of what's happening. As the customer inventory has come down, the rocks are showing up, which is leading to this expedite, which is exponentially up from a couple of quarters ago. But there are some other products of the customer which still have inventory, and they're continuing to reduce that inventory. But on the remaining products, on some products, they're starting to buy at their consumption rate. And every month, more and more products are falling into that position where the inventory has corrected, and they're buying at the consumption rate. The restocking phenomena, I think, I say restocking when customers are increasing their inventory, buying more than their consumption. I don't think that is happening yet because lead times are still relatively in check. But as I said, the constraints are broadening. Even a run-of-the-mill foundry process, and for confidentiality I can't name the foundry or the specific node, but it's a very generic run-of-the-mill foundry process, and it's full. So when that starts to happen, you know, the next step is the capacity goes tight. Now, when the capacity goes tight, one thing that happens is pricing firms up, not necessarily increased price, but the customer conversation leads with availability rather than price. So, you know, that is healthy, too, for the business. And I think we're approaching where, you know, relatively soon in a quarter or so, we'll be facing a situation where customer is more worried about availability than price.

That is helpful to color. Thank you.

And then maybe could you just sort of speak to the backlog you're seeing building for the June quarter, if at all? You talked about the higher starting backlog for the March quarter. Maybe talk about sort of the level of orders you've seen thus far this year and sort of where you expect the June quarter to potentially fall from a normal seasonal basis. Thank you.

So the month of January was extremely strong. you know, uncharacteristic because, you know, it kind of starts out slow and, you know, a lot of people don't return from the holidays until January 7th or something, depending on where the calendar falls. If there are two or three days after January 1, it's going to be a very dead time usually until the following Monday. But January backlog was extremely strong. December backlog was extremely strong. People kept booking parts for the holidays until You may recall we were very conservative going into the quarter because of Thanksgiving as well as Christmas holidays. Thanksgiving came and went and the momentum continued. Then we were worried about Europe shutting down in the middle of December. Usually that happens because of Christmas and other holidays. Everything just kept going strong. Bookings were very good. Then we were concerned about the start of the new year. which always starts slow, but January was extremely strong. And now we are watching the Chinese New Year, which starts next week, and we'll find out whether we missed something on the Chinese New Year. But really, it has all been very, very strong, and that's why we just continue to post good numbers and keep getting stronger, and I'm fairly optimistic on the business. If you look at the next quarter as of today, so today is February 5th, the June quarter backlog is higher today than the March quarter backlog was on November 5th. That's the way to measure it at the same point in time. So we are optimistic that we'll have a good June quarter.

I don't know if I have anything else to add.

Thank you.

Thank you. Our next question comes from the line of Blaine Curtis with Jefferies. Please proceed.

Hey, thanks for taking my question. I had two. I want to ask, I know it's small numbers, but I'm just kind of curious to move in. The other product revenue was up 18% sequentially. I think you said in the filing it was a license sale. So I don't know if you can add any color to that. And then does that not repeat into March?

But it was not only licensing. In others, we have licensing, we have FPGA, we have memory.

Timing systems.

Timing systems. There's another phenomenon happening in memory. As you know, high bandwidth memory is really constrained. And in general, just the NAND as well as the flash memory is very constrained. And some of that you know, shares capacity with our serial E-squared business. So a lot of our competitors, especially in Asia, are moving that serial E-squared capacity into the broader flash memory. And therefore, we're picking up market share and we're getting a lot of strength in our memory business because our serial E-squared memory business is largely produced in our internal fabs where we have a lot of capacity, and we still have a fair amount of inventory. And that falls into others, so we're getting some strength there also, which is quite sustainable because this entire memory shortage isn't going away anytime soon. It could be a couple-of-year phenomenon. And as we look towards the March quarter and the June quarter, memory business looks quite strong too. So does FPGA, with a lot of strength coming from aerospace and defense and industrial also. And our networking and connectivity business backlog is very strong, and so is our data center.

And just to add on to one point there that you had asked, we are not expecting the same benefit that we got on the licensing business in the December quarter to repeat in the March quarter. And in spite of that, we're still guiding up 6.2% at the midpoint.

Gotcha. Yeah, I guess that maybe follows into my gross margin question because you are guiding kind of flat. I think if you calculate the inventory write-offs like 5%-ish points of a headwind, you won't get it all back. But it sounded like you expected to do step down in March. So shouldn't you get a couple percent benefit from that? I'm just trying to understand the moving pieces into March on gross margin.

We are guiding up. The midpoint of guidance on gross margin is 61% versus the 60.5% we produced last quarter on a non-GAAP basis. Again, that licensing benefit that we got in the December quarter, that's 100% gross margin that doesn't repeat. Again, that is a headwind in the current quarter to gross margin. And in spite of that, we're showing some nice growth, and that's our expectation that those inventory reserves continue to come down to be more normalized this quarter. Did that address your question?

Yep, makes sense. Thank you.

Thank you. As a reminder, please press star 1 to ask a question. Our next question is from Vijay Rakesh with Mizuho Securities. Please proceed.

Hi, Steve and Eric. Just a quick question. Where are FAB utilizations now blended and how should we look at OPEX for the rest of the year? And a quick follow-up. Thanks.

We don't break out the FAB utilization numerically. We just guide you whether it's going up or down. We run a very complex product process mix. It's not a FAB that just has one dynamic RAM process, and you can say whether the utilization is 80% or 70% or 60%, we run a very complex mix with hundreds of different processes for our microcontroller, analog, memory, and other products. And there's a different utilization factor on different processes, so really averaging it is really not very meaningful. But having said that, I would say current factory utilization is quite low, and therefore there is a significant upside of the order of $50 million or so in gross margin eventually as we bring the factories to full production. And the other piece of his question was?

The second piece was on OPEX. So you can see based on our guidance that OPEX is growing – in dollars in the current quarter, and it's coming down as a percentage of revenue. And we've been kind of signaling to analysts and investors that there's investments that we need to make in our people, right? We need to bring bonuses back to target levels. That is factored into what we're guiding to in the current quarter. And then we've got pent-up demand for, you know, raises. You know, we had people on a pay cut last year, and, you know, cash raises need to come back, and that's really what's driving the increase in OPEX, but we're still laser-focused on, you know, bringing OPEX down as a percentage of sales and driving towards, over time, our long-term model, which is 25% of revenue, but we've got a ways to go to get there. But, you know, these investments are really required to make sure we are retaining and attracting talent, that we need to drive the R&D efforts of the company, the product development efforts, and the sales support activities to drive the health of our business three and five years out in time.

Got it. And just a quick one. Aerospace defense, I think this has been a huge driver for Microsoft. I think you guys are one of the biggest suppliers there. Any thoughts on how we should look at how that segment does 26, 27, I guess? Thanks.

I think if you just look at what's happening geopolitically, starting from the U.S., one of the largest defense budget in the U.S., and microchip is in every offensive and defensive weapon, in our military arsenal. There's also commercial airplane production that's building up. Boeing wasn't building MAX planes for a while, and now they're building MAX planes at a record speed. So that's doing very well. Now, when you go to Europe, Europe is under a lot of pressure. NATO countries are under a lot of pressure to triple their defense budget because they haven't spent what they were supposed to spend under the NATO treaty They're increasing their budgets and we are handsomely benefiting with a lot of European customers doubling, tripling their production. I think the last piece would be everybody's exploring space. Even India landed a rover on the dark side of the moon. It was loaded with a product. As a Space exploration picks up, and with all these new companies like SpaceX and all that, launching satellites and others, they all have essentially our products in it. So it's facing multiple wins on the back that's driving in this sector.

Thanks, Steve.

And it's also one of the comments there, too, there's also quite a bit of investment in new defense and new aerospace as well. drone manufacturers and new defense manufacturers that are popping up and also consuming quite a bit of those products.

Thank you.

Thank you.

Our next question comes from the line of Joe Moore with Morgan Stanley. Please proceed.

Great. Thank you. You mentioned the FPGA business a couple times within the other category. Can you give us a sense for What kind of growth you're seeing there and generally anything we should be thinking about from a growth or market share perspective in this coming year in FPGAs?

Well, FPGA is seeing a very good growth and I would say very large growth and we're gaining share in FPGA. Considering that it's very hard to get competitors' FPGA numbers where Xilinx is better than AMD and Altera is now private, so we can't get their numbers. I think giving RFPG a number would just be giving benefits to the others. So we're not ready to kind of break it out. After the year finishes, the fiscal year, maybe we'll give you some sort of bracketed number. But for now, I would say we're gaining share over the others and it's seeing a very large growth.

Great, thank you. And then if I could follow up on the PCI Express switching comments on the hyperscale side. You talked about the three customers and $100 million customer next year. Can you give us a sense for, you know, are those scale-up types of applications? And what does the roadmap look like? Do you need to move to Gen 7? Do you move to E-Link, UA-Link? Like, how do you maintain the revenue momentum once you've established it?

So, you know, Gen 6 has quite a bit of runway. I mean, we're hardly getting started. On the research side, we're already working on Gen 7. So Gen 7 is already underway, and it has been for about, I would say, nine months to a year. But on the Gen 6, now is in the design phase with the customers. We have a number of engagements. We released three design wins, and hopefully we'll be coming up with additional design wins in the coming quarters. We're working on some mega design wins. Don't have one to announce yet. And if we get some, then this $100 million could look small.

Thank you very much. One of those questions was on scale up versus scale out. I don't know if Steve or Matthias wants to address that.

I don't know if we are willing to disclose that. I just think, you know, It's a very sensitive subject because of, you know, how some of the competitors are with customers. And any competitor, I'm sorry, any customer who is openly known to then buy from Microchip could get the wrath of, you know, one of the competitors. So we're really keeping it very guarded.

Thank you.

Thank you. Our next question comes from the line of Chris Casso with Wolf Research. Please proceed.

Yes, thanks. Good evening. The first question is about gross margins and just coming back to the progress on gross margins as we proceed here and presumably as revenue gets better. Eric, in the past, we've used a fall-through model, maybe something in the mid-70s or so of incremental revenue falling through. Now that the inventory reserves, they sound like they're going to normalize in the March quarter. Is that the right way to look at it? And if so, what would be the fall-through level?

Yeah, I mean, I know that makes it easiest to model. I'm not uncomfortable with using something like that, but it will absolutely be lumpier. It's not going to be as smooth as just putting it in a forecast. It's going to be, you know, how we ramp the factory is what the mix of product is in any given quarter. But clearly, we still have a ways to go from 61% to our 65% target. And again, I'm not uncomfortable with it being modeled that way, but it will clearly the quarterly results will be a bit different than kind of straight lining it.

I would add to that. Let me add this thing. I think we are seeing stronger growth on the products that we get from foundry versus inside. You know, SVGA is 100% outside. It doesn't run inside our fabs. Data center products are 100% outside, do not run in our fabs. Our networking products, T1S products that Mathias talked about, are all running outside. They do not run inside. Maybe some runs inside, but mostly outside, that business unit. So there is a lot of growth coming from outside, and this underutilization is largely in our fabs inside. So that's why the underutilization part would, would take longer and be slower to come, but all these products that are running outside, these are all very high margin products, well above corporate average. So what we will not get on the utilization side will pick it up in the higher than corporate margin on these high growth products from outside. So gross margin will still continue to accrete.

Right, but it's happening because of mix as opposed to utilization.

It's both. Utilization is increasing also, but I just want to make the point that the gross margin improvement is not going to come 100% from the utilization only because mix is richening.

In our fabs, today we are significantly underproducing compared to what we're shipping, and that's why inventory is coming down. And so that will change gradually over time, and we'll grow back into the capacity. So underutilization will come down as we move ahead, but not at a lightning speed.

I can almost guess your next question. If all these products are higher than corporate gross margin and they're growing faster, then is our long-term model higher?

Let us get there first. Yeah.

Okay. I won't ask that follow-up then. As a follow-up, on the use of cash, and you had talked about the desire to take down debt, could you go into a little more detail there? And does that mean that you're going to be pausing buybacks even as cash flow improves and prioritize the reduction of debt? And if so, what level of debt are you targeting? How long does that continue for prioritization of debt?

So I think I don't have a hard number for you, but I can talk about it in general. We are honestly spooked by this last cycle, how difficult the cycle was and how close we came with a high level of debt. And as the profits came down with the down cycle, you know, the leverage was going to go above six almost, which would be a junk rating, and we had to go raise $1.5 billion of almost this preferred convert to keep our debt rating and all that. So we're largely spooked by a very large debt. So we're going to be bringing down debt for quite some time and keep the dividend flat and not do any buyback till the debt has come down significantly and debt leverage has come down significantly to a number that I can't give right now because we haven't figured that number out.

Right. Sonia, you remember way back in late 2010, 2021 at our analyst day, we set a one and a half times net leverage target. We did better than that in the up cycle, but that was on earnings that really weren't sustainable looking back. We want to be conservative from a balance sheet perspective, get that down. The quarter we just completed was the first quarter in a long time that our adjusted free cash flow exceeded are dividend payments. So that's coming down, that's heading in the right direction, but we've got a ways to go, as Steve said.

No, debt leverage was over four. It was 4.18. So, you know, trying to drive a number right now based on any past experience of one and a half or so is a mute exercise. I mean, we're so far away. So let us make some progress, and as we get closer, then we'll try to drive to a number.

Good, thank you.

Thank you. Our next question comes from the line of Harlan Schur with JP Morgan. Please proceed.

Hey, good afternoon. Thanks for taking my question. Steve, relative to 90 days ago when you guys guided revenues down 1% sequentially with the view that, you know, customers are wanting to take down their inventories into year end, Comparing that to what you just delivered, I mean, it looks like your turns business, your short lead time orders booked and shipped in the same quarter came in much stronger than expected. So is it fair to assume that your turns business as a percent of total revenues came in well above historical trends, typically, which is what you would expect right in the early phases of an upcycle? And are you still seeing the same or higher level of turns mix this quarter and expedite requests so far increasing this quarter as well?

Yes, correct. January was very, very strong. The terms component in the bookings was quite high. We continue to get the pull-in requests. See, a lot of the backlog was getting pulled in from January into December based on customer requests, and now we're seeing the same thing. A lot of the backlog is being pulled from April into this quarter based on customer requests, and bookings are strong, and they're replacing that backlog for April while they're pulling the existing one into this quarter. I appreciate that. The largest piece was somehow, you know, because of less inventory, everybody worked through holidays. People didn't stop in Thanksgiving. They didn't stop in Christmas. They didn't stop in the New Year holidays and we'll find out what happened in the Chinese New Year. So usually, you know, For example, a lot of the distribution business is based on number of shipping days. And if you have a bunch of holidays where warehouses are closed, then it affects the revenue. Nothing affected revenue last quarter. We just kept getting upsides. Everybody wanted product. Bookings were very strong. They were pulling it in. They were expediting. There were just all sorts of – it was an upcycle kind of behavior, which was You know, really, certainly we didn't model that going into the December quarter. And all that is continuing in the current quarter. You know, I expect 6.2% sequential growth to be a very strong guidance.

Yes.

You know, we haven't grown 6.2% in a very long time sequentially. Yeah. You know, so this is very, very good.

I appreciate that. And, you know, if I X out licensing revenues, your other segments still grew close to like 8% sequentially, right? As you mentioned, some of the product growth was FPGA, data center memory networking. I didn't hear you mention this, but, you know, I seem to recall historically that the team has had very strong traction in data center SSD controllers, both the chip, but even more importantly, like you guys, I think, have a very strong firmware stack. Right now, data center SSD demand is very strong, right? AI compute is finding all of these new use cases for SSDs. Is the microchip team benefiting from this? Are you guys still committing R&D investments to the data center SSD franchise?

Yeah, go ahead. Absolutely. So we support and continue investing in the storage segment of data centers into the switching segment of data centers. both for and the storage both for FLASH as well as for HDD. So we've got three solid product lines that we're supporting and continue to invest in.

Thank you.

There are no further questions at this time. I'd like to pass the call back over to Steve for any closing remarks.

Well, we want to thank all the investors for sticking with us through this last year of recovery and We finished the year pretty good, and we're looking for an outstanding calendar year 2026. And we'll see some of you on the road as we go to some conferences this quarter. Thank you.

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