Microchip Technology Incorporated (NASDAQ:MCHP) Q3 2024 Earnings Call Transcript

Microchip Technology Incorporated (NASDAQ:MCHP) Q3 2024 Earnings Call Transcript February 1, 2024

Microchip Technology Incorporated isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Greetings and welcome to the Microchip’s Third Quarter Fiscal Year 2024 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, CFO, Mr. Eric Bjornholt. Thank you. You may begin.

Eric Bjornholt: Thank you operator. 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 release as 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 Moorthy, Microchip’s President and CEO; Steve Sanghi, Microchip’s Executive Chair; and Sajid Daudi, Microchip’s Head of Investor Relations.

I will comment on our third quarter fiscal year 2024 financial performance. Ganesh will then provide commentary on our results and discuss the current business environment, as well as our guidance. And Steve will provide an update on our cash return strategy. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and on this conference call on various GAAP and non-GAAP measures. We have posted a full 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 our leverage metrics on our website.

I will now go through some of the operating results, including net sales, gross margin and operating expenses. Other than net sales, I will be referring to these results on a non-GAAP basis, which is based on expenses prior to the effects of our acquisition activities, share-based compensation, and certain other adjustments as described in our earnings press release and in the reconciliations on our website. Net sales in the December quarter were $1.766 billion, which was down 21.7% sequentially. 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 63.8%, operating expenses were 22.5%, and operating income was 41.2%. Non-GAAP net income was $592.7 million and non-GAAP earnings per diluted share was $1.08.

On a GAAP basis, in the December quarter, gross margins were 63.4%. Total operating expenses were $590.6 million and included acquisition and tangible amortization of $151.3 million, special charges of $1.1 million, share-based compensation of $38.8 million, and $1.5 million of other expenses. GAAP net income was $419.2 million, resulting in $0.77 in earnings per diluted share. The GAAP tax rate was favorably impacted from an IRS notice that clarified the treatment of costs incurred by a research provider under contract that we had been accruing for and that accrual was released in the quarter. Our non-GAAP cash tax rate was 13.2% in the December quarter. Our non-GAAP cash tax rate for fiscal year 2024 is expected to be just under 14% and which is exclusive of the transition tax and any tax audit settlements related to taxes accrued in prior fiscal years.

Our fiscal 2024 cash tax rate is higher than our fiscal 2023 tax rate was for a variety of factors, including lower availability of tax attributes, such as net operating losses and tax credits, lower tax depreciation with our expectation for lower capital expenditures in the U.S. in fiscal 2024, as well as the impact of current tax rules requiring the capitalization of R&D expenses for tax purposes. We are still hopeful that the tax rules requiring companies to capitalize R&D expenses will be pushed out or repealed. The House actually passed the tax bill last night that would achieve this, and we will see how this progresses through the Senate. If this were to happen, we would anticipate about a 200 basis points favorable adjustment to Microchip’s non-GAAP tax rate in future periods.

Our inventory balance at December 31, 2023, was $1.31 billion. We had 185 days of inventory at the end of the December quarter, which was up 18 days from the prior quarter’s level. Although, we reduced inventory dollars in the quarter, we were not able to make as much progress as we would have liked, as we continue to accommodate requests by customers to push out delivery schedules for products that were very far through the manufacturing process. At the midpoint of our March 2024 quarter guidance, we would expect inventory dollars to be up modestly and days of inventory to be in the range of 225 to 230 days due to the significant reduction in revenue and cost of goods sold. We also continue to invest in building inventory for long-lived, high-margin products whose manufacturing capacity is being end of life by our supply chain partners and these last time buys represented 10 days of inventory at the end of December.

Inventory at our distributors in the December quarter were 37 days, which was up two days from the prior quarter’s level. Our cash flow from operating activities was $853.3 million in the December quarter. Included in our cash flow from operating activities was $30.4 million of long-term supply assurance receipts from customers. We have adjusted these items out of our free cash flow to determine the adjusted free cash flow that we will return to shareholders through dividends and share repurchases, as these supply assurance payments will be refundable over time as purchase commitments are fulfilled. Our adjusted free cash flow was $763.4 million in the December quarter. As of December 31, our consolidated cash and total investment position was $281 million.

Our total debt decreased by $392 million in the December quarter, our net debt decreased by $416.4 million in the quarter. Over the last 22 full quarters since we closed the Microsemi acquisition and incurred over $8 billion in debt to do so, we have paid down $7.1 billion of the debt and continue to allocate substantially all of our excess cash beyond dividends and stock buyback to bring down this debt. Our adjusted EBITDA in the December quarter was $796.2 million and 45.1% of net sales. Our trailing 12-month adjusted EBITDA was $4.26 billion. Our net debt to adjusted EBITDA was 1.27 times at December 31, 2023, down from 1.56 times at December 31, 2022. Capital expenditures were $59.5 million in the December quarter. Our expectation for capital expenditures for fiscal year 2024 is between $300 million and $310 million, which is down from the $300 million to $325 million we shared with investors last quarter as we are delaying certain capital given the more challenging economic backdrop.

We expect that our capital investments will continue to provide us increased control over our production during periods of industry-wide constraints. Depreciation expense in the December quarter was $47.1 million. I will now turn it over to Ganesh to give us comments on the performance of the business in the December quarter as well as our guidance for the March quarter. Ganesh?

Ganesh Moorthy: Thank you, Eric and good afternoon everyone. Our December quarter results were disappointing and below our expectations with net sales down 21.7% sequentially and down 18.6% from the year ago quarter. Non-GAAP gross and operating margins came in at 63.8% and 41.2%, respectively, down from our recent strong performance, but somewhat resilient despite the significant sequential decline in revenue. Our consolidated non-GAAP diluted EPS came in at $1.08 per share, down 30.8% from the year ago quarter. Adjusted EBITDA was 45.1% of net sales in the December quarter, continuing to demonstrate some resiliency. As a result, we had good debt reduction in the December quarter and despite the lower adjusted EBITDA we generated, our net leverage ticked down to 1.27x.

However, we expect our net leverage ratio to rise for a few quarters, as trailing 12-month adjusted EBITDA drops when replacing stronger prior year quarters with weaker ones. Our capital return to shareholders in the March quarter will increase to 82.5% of our December quarter adjusted free cash flow as we continue on our path to return 100% of our adjusted free cash flow to shareholders by the March quarter of calendar year 2025. My thanks to our worldwide team for their support, hard work, and diligence as we navigated a difficult environment and focus on what we could control so that we are well-positioned to thrive in the long-term. Taking a look at our December quarter net sales from a product line perspective, our mixed-signal microcontroller net sales were down 22.3% sequentially and down 18.5% on a year-over-year basis.

And our analog net sales were down 30.9% sequentially and down 29% on a year-over-year basis. Now, for some color on the December quarter. and the general business environment. All regions of the world and most of our end markets were weak. Our business was weaker than we expected as our customers continue to respond to the effects of increasing business uncertainty, slowing economic activity and a resultant increase in their inventory. In addition, many customers implemented extended shutdowns of closures at the end of the December quarter as they manage their operational activities. We continue to receive requests to push out or cancel backlog as customers sought to rebalance their inventory in light of the weaker business conditions and the increased uncertainty that we’re experiencing.

And we were able to push out or cancel backlog to help many customers with these inventory positions. With no major supply constraints, coupled with very short lead-times and a weak macro environment, we believe that is inventory destocking underway at multiple levels at our direct customers and distributors who buy from us, our indirect customers who buy through our distributors, and in some cases, our customers’ customers. The very strong up cycle of the last two to three years drove many of our customers to build inventory in order to be able to capitalize on strong business conditions in an uncertain supply environment. The term, just in case, instead of just in time, was used by customers to express their approach to these conditions. But as the macro environment slowed, many of our customers found their business expectations to be too optimistic and ended up with high levels of inventory.

And as a result, they sought to cancel or reschedule backlog. An update on our PSP program. During the early stages of the up cycle, we launched our PSP program requiring noncancelable backlog in exchange for supply priority in a hyper constrained supply environment. The program was aimed to discourage speculative demand and achieve mutual commitments between our customers and us for future demand. The program worked extremely well for many customers who participated during all of 2021 and 2022, as well as the early part of 2023, supporting strong growth in their businesses. However, the business challenges, which led to the creation of the PSP program are no longer relevant, and we have, therefore, decided to discontinue the program effective today.

If business conditions warranted, we may at some point in the future, initiate a similar program, which will, of course, have to be adapted to whatever that situation requires. Reflecting the slowing macro environment, our distribution inventory grew to 37 days at the end of the December quarter, as compared to 35 days at the end of the September quarter. We are working with our distribution partners to find the right balance of inventory required to serve their customers, manage their cash flow requirements and be positioned for the eventual strengthening of business conditions. Our internal capacity expansion actions remain paused. Given the severity of the down cycle, our factories around the world will be running at lower utilization rates and also taking up to two shutdown weeks in each of the March and June quarters in order to help control the growth of inventory.

We expect our capital investments in fiscal year 2024 and fiscal year 2025 will be low even as we prepare for the long-term growth of our business. To that end, we reached a preliminary memorandum of terms with the Department of Commerce for $162 million in grants targeted at existing projects for two of our U.S. fabs. These grants are subject to diligence by the Chip’s office as well as capacity investments by Microchip over multiple years. We have been driving our lead times down and have reduced average lead times from roughly 52 weeks at the start of 2023 to roughly eight weeks by the end of 2023 on average. During a period of macro weakness and business uncertainty, we believe short lead times are the best way to help customers navigate the environment successfully and improve the quality of backlog placed with us as it enables our customers and Microchip to engage an uncertain environment with more agility and effectiveness.

However, a significant reduction in lead times is also resulting in lower bookings and reduced near-term visibility for our business. We’re also taking steps to reduce our expenses. In addition to the variable compensation programs, which provide automatic reductions during a down cycle and normal containment of discretionary expenses, we will be implementing broad-based paid reductions. Our team members who are not a part of the factory shutdowns will take a 10% pay cut and consistent with our normal practice, the executive team will take the largest reduction with a 20% pay cut. The shutdowns for manufacturing team members and pay cuts for non-manufacturing team members are consistent with our long-standing culture of shared sacrifices and down cycles and shared rewards and up cycles.

That’s avoiding layoffs, and in the process protecting manufacturing capability, as well as high priority projects, which are important for our customers and us to thrive in the long-term. We took similar actions in prior periods of business uncertainty such as the COVID pandemic in 2020 and the global financial crisis in 2008 and 2009, and we believe such actions were quite effective to navigate our business. Now, let’s get into our guidance for the March quarter. As our customers take further actions to adjust to a weakening macro environment and uncertain business conditions, we are continuing to support customers and channel partners with inventory position to push out or cancel their backlog. We recognize that our short lead times and increased flexibility with backlog will result in customers reducing inventory aggressively, and that this could result in some degree of overcorrection.

However, in response to these conditions, we are continuing to work with our customers to absorb as much of the inventory correction as we can at this time. Taking all the factors we have discussed on the call today into consideration, we expect our net sales for the March quarter to be between $1.225 billion and $1.425 billion. The guidance range is larger than normal to reflect the macro uncertainty and the resultant low business visibility. We expect our non-GAAP gross margin to be between 59% and 61.6% of sales. We expect non-GAAP operating expenses to be between 26.9% and 30.7% of sales. We expect non-GAAP operating profit to be between 28.3% and 34.7% of sales and we expect our non-GAAP diluted earnings per share to be between $0.46 and $0.68.

To keep things in perspective, while our business results have degraded significantly over the last two quarters, as a larger-than-normal inventory correction has played out. Our full fiscal year 2024 revenue decline at the midpoint of the March quarter guidance is expected to be roughly 9.5% and comparing favorably with weakness that other industry players have experienced. Our non-GAAP operating margin for full fiscal year 2024 at the midpoint of our March quarter guidance is expected to be 43.6% and continuing to be among the best results across other companies in our industry. While we don’t know how and when the inevitable up cycle will play out, we believe the fundamental characteristics of our business remain intact. Finally, notwithstanding any near-term macro weakness, we are confident that our solutions remain the engine of innovation for the applications and end markets we serve.

Our focus on total system solutions and key market megatrends continue to fuel strong design win momentum, which we expect will drive above-market long-term growth. With that, let me pass the baton to Steve to talk more about our cash return to shareholders. Steve?

Steve Sanghi: Thank you, Ganesh and good afternoon everyone. I would like to provide you with a further update on our cash return strategy. The Board of Directors announced an increase in the dividend of 25.7% from the year ago quarter to $0.45 per share. During the last quarter, we purchased $114.6 million of our stock in the open market. We also paid out $237.4 million in dividends. Thus, the total cash return was $352 million. This amount was 77.5% of our actual adjusted free cash flow of $454.3 million during the September 2023 quarter. Our net leverage at the end of December 2023 quarter was 1.27 times. Ever since we achieved an investment-grade rating for our debt in November 2021 and pivoted to increasing our capital return to shareholders, we have returned $3.6 billion to shareholders through December 31, 2023 by a combination of dividends and share buybacks.

During this time, we have bought back approximately 26 million shares of our common stock from the open market, representing approximately 4.5% of our shares outstanding. In the current March quarter, we will use the adjusted free cash flow from the December quarter to target the amount of cash returned to shareholders. The adjusted free cash flow excludes a net $30.4 million that we collected from our customers for long-term supply assurance payments. These payments are refundable when purchase commitments are fulfilled. The adjusted free cash flow for the December quarter was $763.4 million. We plan to return 82.5% or $629.8 million of that amount to our shareholders with the dividend expected to be approximately $243 million and the stock buyback expected to be approximately $386.8 million, which will be a new quarterly record for stock buyback since we initiated our enhanced capital return strategy.

Going forward, we plan to continue to increase our adjusted free cash flow returned to shareholders by 500 basis points every quarter until we reach 100% of adjusted free cash flow returned to shareholders. That will take four more quarters and we expect that dividends over time will represent approximately 50% of our cash returned. With that, operator, will you please poll for questions?

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Q&A Session

Operator: [Operator Instructions] And our first question comes from the line of Timothy Arcuri with UBS. Please proceed with your question.

Timothy Arcuri: Hi, thanks a lot. I wanted to ask about how much of a headwind the inventory inside of distribution still is. Shipments into distribution were down about 30%, well, actually more than that, and yet some of your largest cities are still saying that they’re having a hard time working down inventory. So can you provide any guidance like does the March guidance assume that shipments into distribution will be down a lot more than what the corporate guidance is, again, just like it was in December?

Ganesh Moorthy: We are expecting that we will drain inventory in distribution in the March quarter.

Timothy Arcuri: Okay, great. And then, Eric, can you talk about utilization rates and the potential for some write-downs? We sort of haven’t been at a level yet where you would write things down, but can you talk about that? Thanks.

Eric Bjornholt: Sure. So we have been working on an employee attrition basis in our three large fabs, and through the December quarter, that did not put us in a situation where we were taking underutilization charges from those three fabs. That will change this quarter as we have continued to attrit. And as Ganesh kind of walked through, we’ve got two-week shutdowns scheduled in all three of those large factories. So, we aren’t going to break out a utilization percentage, but underutilization is absolutely impacting our business, our gross margins in the current quarter. And on top of that, with the change that we’ve seen in demand and inventory still being high. We have been taking relatively large charges for inventory reserves based on our accounting policies that we have in place. And all those things are really factored into the margin guidance that we’ve given to the Street.

Timothy Arcuri: Thanks a lot.

Operator: Thank you. Our next question comes from the line of Toshiya Hari with Goldman Sachs. Please proceed with your question.

Toshiya Hari: Hi thank you. My first question is on cancellation rates and what you’re seeing from a customer pushout perspective. Are you seeing any signs of stabilization, Ganesh, in terms of cancellation rates or pretty much the same so far in the quarter relative to December and September of last year?

Ganesh Moorthy: We don’t have a numerical tracking process. We still have customers that have asked for help. We have done a lot of that and built it into what we have into our guidance. I don’t know if you have a better view, Eric, on cancellation rates.

Eric Bjornholt: Right. I would say, as we kind of talked about customers and distributors are feeling like they have excess inventory. And with that, if they have backlog in place for those products, they are either not placing backlog. But if they have backlog in place, they’re looking to see if there’s an ability for them to at least push that out. So, we’re having those ongoing discussions and I’d say that they’re still at a relatively high rating.

Toshiya Hari: Got it. Thank you. And as my follow-up, I was hoping to get your comments on pricing, the headwinds you’re seeing today, is it mostly volume-driven or are you starting to see price erode as well between your microcontroller business and analog business? It seems like at the industry level, you’ve got more supply coming online over the next couple of quarters, several quarters. So, curious how you’re – what you’re seeing today and how you’re thinking about pricing as we progress through calendar 2024? Thank you.

Ganesh Moorthy: Yes. All the revenue declines are really volume declines and not pricing related. Pricing is stable. It is not contributing to the revenue change that is in our guidance. Our business is one which is based on design-ins that are done one, two, three years before and production that takes place for many, many years. it’s not an easy substitution that takes place on short-term price adjustments, et cetera. Clearly, at the point of where new designs are taking place, we will be price competitive to what the new design requires. But today’s revenue adjustments downward are not happening because of price. Price is stable.

Toshiya Hari: Thank you.

Ganesh Moorthy: Thank you.

Operator: Thank you. And our next question comes from the line of Chris Caso with Wolfe Research. Please proceed with your question.

Chris Caso: Yes, thank you. Good evening. My question is – and it’s a difficult question about sort of where you think aggregate inventory levels are and how much progress with some of these lower revenue shipment rates that we’ll make in getting those inventories down over time. I know that’s difficult to answer for your end customers, your indirect customers, but perhaps you could address it from the distribution channel where you have a little more visibility and where the target inventory levels are and where you expect to get over time?

Ganesh Moorthy: As you said, inventory in some cases is obscure to us, we have to estimate based on where customers are placing orders, what kind of feedback they’re giving us. We know we’re going to be substantially under shipping to where consumption is going to be. But it’s very hard to put a number on what that is and how much of the inventory has been taken out. And as I said, in some cases, it is multiple layers of inventory and especially as people are getting to that point where they are less willing to carry inventory, perhaps even take it to the low end of what they might historically do, because supply is plentiful. Not all of this is just inventory reduction as you would normally expect. But it is going to be at multiple levels to our customers, to their customers and in some cases, if they have an OEM that goes to the OEM there as well. So we don’t have a good way to put a number on what you’re asking for.