Microchip Technology Inc (MCHP) — Q2 2019 Earnings Call Transcript

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 Microchip's business and results of operations. In attendance with me today are Steve Sanghi, Microchip's Chairman and CEO; and Ganesh Moorthy, Microchip's President and COO. I will comment on our second quarter fiscal year 2019 financial performance, and Steve and Ganesh will then give their comments on the results, discuss the current business environment as well as our guidance, and provide an update on our integration activities associated with the Microsemi acquisition. We will then be available to respond to specific investor and analyst questions. I want to remind you that we are including information in our press release in 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, which we believe you will find useful when comparing GAAP and non-GAAP results. I want to remind investors that during the quarter ended June 30, 2018, we adopted a new GAAP revenue recognition standard, which requires revenue to be recognized at the time products are sold to distributors versus our historical revenue recognition policy, where revenue on such transactions was deferred until the product was sold by our distributors to an end customer. We are not able to provide guidance on a GAAP basis, as we are not able to predict whether inventory at our distributors will increase or decrease in relation to end market demand, and this is not how we manage our business. As evidence of this uncertainty, in recent years, we have seen net inventory at our distributors increase or decrease by a significant amount in a single quarter. Our non-GAAP revenue is based on true end market demand in which we measure the revenue based on when the product is sold by our distributors to an end customer. We will continue to manage our business and distributor relationships based on creating and fulfilling end market demand. All of Microchip's bonus programs will continue to work based on the amount of revenue we earned from fulfilling end market demand. Therefore, along with the GAAP results based on sell-in, we will also report our non-GAAP results based on sell-through revenue recognition. I will now go through some of the operating results, including net sales, gross margin, and operating expenses. I will be referring to these results on a non-GAAP basis, using revenue based on end market demand, and expenses prior to the effects of our acquisition activities and share-based compensation. Non-GAAP net sales in the September quarter were $1.513 billion, just above the midpoint of our guidance, and up 24.4% sequentially from net sales of $1.217 billion in the immediately preceding quarter. We have posted a summary of our revenue by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were 61.7%, operating expenses were 23.4% of sales, and operating income was a record $579.3 million and 38.3% of sales. Non-GAAP net income was a record $454.6 million. Non-GAAP earnings per diluted share was a record $1.81, which was $0.07 above the midpoint of our guidance of $1.74. On a GAAP basis, net sales in the September quarter were $1.433 billion. GAAP revenue was impacted by a significant reduction in the Microsemi distribution channel during the quarter, resulting in Microsemi distributor months of inventory being down to 2.6 months. We believe at the current levels, the distributors are holding the amount of inventory needed to support end market demand, and that the inventory levels are in line with the levels maintained by our distributors for our historical business. GAAP gross margins were 48.1% and include the impact of $3.9 million of share-based compensation, a $184.4 million of acquisition-related and acquired inventory valuation and other costs, and $56.1 million impact from changes in distributor inventory levels. Total operating expenses were $586.6 million and include acquisition intangible amortization of $169.9 million, special charges of $18.2 million, $6.6 million of acquisition-related and other costs, and share-based compensation of $37.5 million. The GAAP net income was $96.3 million or $0.38 per diluted share and includes one-time tax benefits of $115.6 million related to a variety of matters including tax reserve releases due to audit settlements and statute of limitations expiring, tax reform and transition tax refinement, and intercompany restructuring of intellectual property. The non-GAAP cash tax rate was 3.5% in the September quarter, and we expect a similar rate for all of fiscal 2019. We expect our non-GAAP cash tax rate for fiscal 2020 and fiscal 2021 to be 5% or less, exclusive of the transition tax, any potential tax associated with restructuring of the Microsemi operations into the Microchip global structure, and any tax audit settlements related to taxes accrued in prior fiscal years. We have many tax attributes and net operating losses, tax credits and interest deductions that will keep our cash tax payments low. The transition tax for the combined Microchip-Microsemi Group is expected to be about $364 million, was recorded last fiscal year, and will be paid over eight years. We have posted a schedule of our projected transition tax payments on the Investor Relations page of our website. For GAAP purposes, we had a significant tax benefit in the quarter for the variety of reasons I discussed earlier. Moving onto the balance sheet; our inventory balance at September 30, 2018 was $836.7 million, including a $120.1 million of inventory mark-up from Microsemi required for GAAP purchase accounting. Excluding the inventory mark-up, we had 117 days of inventory at the end of September quarter, which was down two days from the prior quarter levels. Inventory at our distributors in the September quarter was 37 days compared to 40 days at the end of June. As indicated earlier, we believe that our distributors are holding an appropriate level of inventory to support end market demand. The cash flow from operating activities was a record $487.6 million in the September quarter. As of September 30, the consolidated cash and total investment position was $464.2 million. We paid down $501 million of total debt in the September quarter, and the net debt on the balance sheet reduced by $315.5 million. At September 30, our debt outstanding includes $3.1 billion of borrowings under our line of credit, $2.733 billion of Term Loan B, $2 billion in high-grade bonds, and $4.481 billion of convertible debt. Our net debt to EBITDA excluding our very long-dated convertible debt that matures in 2037, which is more equity-like in nature, was 4.9 at September 30, 2018. Our leverage is higher than we originally projected, primarily due to lower EBITDA from the Microsemi business, driven by needing to correct distribution inventory levels through lower shipment activity in the month of June, as well as in the September 2018 quarter. As indicated earlier, we believe the distribution inventory correction for Microsemi is essentially complete. We are committed to using substantially all of our excess cash generation beyond our dividend payment to reduce our debt levels and we expect our debt levels to reduce significantly over the next several years. Our net leverage metrics are based on 12-month trailing EBITDA, which will continue to provide some headwinds due to the significant distribution inventory reductions which caused our shipment activity to be significantly less than end market demand for the past two quarters, as well as our guidance for the December 2018 quarter. Capital expenditures were $72 million in the September 2018 quarter, we expect about $50 million in capital spending in the December quarter, and overall capital expenditures for fiscal year 2019 to be about $230 million to $250 million. We continue to add capital to support the growth of our production capabilities for our fast-growing new products and technologies, and to bring in-house more of the assembly and test operations that are currently outsourced. These capital investments will bring some gross margin improvement to our business, particularly for the Atmel and Microsemi manufacturing activities that we are bringing into our own factories. Depreciation expense in the September quarter was $47.2 million. I will now turn it over to Ganesh to give his comments on the performance of the business in the September quarter, and provide an update on some of the Microsemi integration activities.

Thank you, Eric and good afternoon, everyone. As I review our product line performance, please bear in mind that the September quarter has a full quarter of contribution from Microsemi, while the June quarter only had a month of contribution from Microsemi. This along with the fact that Microsemi revenue only maps into four of the six product line reporting categories we have, while in some cases distorts the quarter-over-quarter comparisons of revenue by product line. Taking a closer look at microcontrollers; our microcontroller business was sequentially up 12.6% as compared to the June quarter. This benefited from a full quarter of Microsemi contribution in September as compared to a partial quarter for June. Our September quarter microcontroller revenue annualizes at almost $3.3 billion, putting us within striking distance in the next few years of the two industry players who are ahead of us in the 2017 microcontroller rankings. Our microcontroller portfolio continues to expand with several new product introductions, our roadmaps remain strong, and our design funnel is robust. We see all these as positive indicators for future growth. We believe we have the new product momentum and customer engagement to continue to gain even more share in the future. Now moving to analog; our analog business was sequentially up 33.6% as compared to the June quarter. This too benefited from a full quarter of Microsemi contribution in September as compared to a partial quarter for June. Our September quarter analog revenue annualizes at over $1.75 billion, firmly in the Top 10 of analog semiconductor players. With Microchip 2.0 and our total system solutions approach, we expect to continue to grow and gain further analog market share. Next up is our FPGA business, which came to Microchip through the Microsemi acquisition. Our FPGA revenue hit an all-time record even after going back through the Microsemi and Actel history. Our low power mid-range PolarFire family continues to garner strong market acceptance with revenue more than doubling sequentially as compared to the end market consumption in the full June quarter. Despite being a new product category for Microchip, we are optimistic about the prospects for the FPGA product line based on the highly defensible markets and applications they are designed into, as well as the intense design win focus and broad-based market application and customer focus requiring. These requirements are very similar to Microchip's microcontroller business requirements, and therefore, we expect the FPGA product line will very nicely leverage our capabilities. Moving next to our licensing business; this business was sequentially up 40.3% as compared to the June quarter. We achieved an all-time record for our royalty revenue. Additionally, our results also benefited from the sale of a patent license for a specific set of patents that can be used in non-competitive fields of play. We did anticipate this patent license to close in the September quarter and included it in our guidance. We continue to retain indefinite rights for these patents for the fields of play that are of interest to us. Even without the patent license sale, the September quarter licensing business revenue was sequentially up from June. Let me share some background regarding our thinking in regards to patent licensing. We have inherited a substantial patent portfolio from the companies we acquired over the last 10 years. Several quarters ago, based on licensing requests we were receiving, our licensing business unit embarked on a strategy to monetize certain patents, which have value to players in non-competitive fields of play. In all cases, we retained rights to use these patents in our products as well. The first results from this monetizing effort is what we saw in the September quarter results. There is a second such patent license sale for a specific set of patents which is in the advanced stages of negotiation, and is included in our guidance for the December quarter. Investors should expect that the revenue contribution in the future from this effort will be a little lumpy from quarter-to-quarter. Our memory business was sequentially down 3.8% in the September quarter as compared to the June quarter. And finally, our MMO, which stands for multi-market and other business was up 90.7% sequentially as we had a full quarter of Microsemi contribution in the September quarter, as compared to just a month in the June quarter. On a combined company basis, which has a full quarter of Microchip and Microsemi, our second quarter fiscal of 2019 non-GAAP end market demand revenue of $1.51 billion was split across the six product lines we report as follows: microcontrollers were 54.2%, analog was 29%, FPGA was 6%, memory was 3.1%, licensing was 2.5% and MMO was 5.2%. We expect this will be the approximate forward going revenue percentages by product line, and that quarter-to-quarter changes from here onwards will be relatively small. Now an update on the Microsemi integration progress; the business unit integration continues to progress well. We are restructuring underperforming businesses, while implementing the strengths and best practices from both companies to drive improvements across the board. The key Microsemi business unit leaders we retained continue to run their businesses, and are adapting to the Microchip culture and business expectations. New product development and design win momentum are continuing to happen as planned. The sales integration is also progressing well. We have converted the Microsemi sales team to a Microchip's style non-commissioned sales approach. Teams from Classic Microchip and Microsemi are working collaboratively as one team to drive new opportunities and pursue product cross-selling opportunities. Our internal reference designs are increasingly taking advantage of our combined total system solutions approach. A comprehensive analysis of our new channels and channel partners from the Microsemi acquisition was completed, and we are making the adjustments required for an effective combined company approach. The operations integration work is an enormously complex undertaking, as little to no integration of prior Microsemi acquisitions have taken place. Because of the size of the business and the absence of ERP integration by Microsemi, the business system and operational integration will be done in phases. The first phase for one of the business units went live on November 1 successfully, further phases have been planned with the quarterly cadence of go-live events for many quarters. We expect the overall operational integration will take about two more years to complete.

Thank you, Ganesh, and good afternoon, everyone. Today, I would like to first reflect on the results of the fiscal second quarter of 2019. I will then provide an update on our progress at Microsemi, followed by guidance for the fiscal third quarter of 2019. Our September quarter financial results were strong. Our consolidated non-GAAP net sales exceeded the midpoint of our guidance issued on August 9, 2018. Our consolidated non-GAAP gross margin was robust at 61.7% of sales. The non-GAAP operating margin for Microchip classic reached an all-time high. The consolidated non-GAAP operating profit, including Microsemi, was 38.3% of sales, near the high end of our guidance. Our consolidated non-GAAP EPS set a record at $1.81, also close to the high end of our guidance. Both Classic Microchip and Microsemi contributed significantly to EPS, with Microsemi providing more than our original guidance of $0.15 for the September quarter. This figure is based on non-GAAP revenue, which reflects actual market demand. Overall, this marks over 112 consecutive quarters of profitability on a non-GAAP basis. Now let me give you an update on our Microsemi integration progress. Regarding distribution inventory, we had indicated last quarter that we aimed to complete inventory reduction over two quarters, specifically September and December. I am pleased to report, thanks to the hard work of the combined teams from Microchip and Microsemi, along with distributor cooperation, we nearly completed this reduction within one quarter. The distribution inventory at the end of September was 2.62 months, down from roughly 4 months before the acquisition closure. This inventory level aligns with what distributors require to meet end market demand and is consistent with the inventory levels retained by distributors for the Microchip classic business. This reduction was achieved without negatively affecting distribution sales; the non-GAAP net sales from Microsemi based on direct shipments and distribution sales reached an all-time record. Next, regarding the termination of certain deals, since closing the Microsemi acquisition on May 29, 2018, we have terminated discounts and subsidies that were previously in place for sales into distribution and contract manufacturers. For example, we have ceased the Aero supply assurance program related to sales of end-of-life products. At the time of acquisition closure, approximately $47 million of inventory was in distribution under this program. We will not take any inventory back and will cease further shipments under that program. We also canceled the subsidy provided to some distributors based on their inventory and the production incentive program that allowed discounts to contract manufacturers for taking additional inventory. Canceling this program has not negatively affected contract manufacturers' willingness to purchase products. Furthermore, we transferred several OEM customers back from distribution, which accounted for about $110 million in annualized revenue, to direct customers, leading to improved margins for Microsemi. Although we had one business unit—the high reliability discrete products unit—where inventory was high at 8.6 months at the end of June, we successfully reduced it to 6.7 months by the end of September and will continue to further decrease it. As we reduced distribution inventory, we recognized that internal inventory at Microsemi would increase unless we adjusted factory production targets, which we did. We cut wafer starts at foundries and reduced loadings at assembly and test subcontractors. Many small fabs and assembly sites owned by Microsemi also faced substantial cuts, in some cases up to 50%. While temporary workers were let go and some plants were temporarily shut down to control inventory, the gross margin impact was minimal given that Microsemi did not produce a high percentage of their production on-site; we maintained an overall gross margin exceeding 61%. By the end of September, our internal inventory, including Microsemi, stood at 117 days, a decrease from 119 days at the end of June. This effort required significant focus and teamwork to ensure distribution inventory was reduced without allowing internal inventories to inflate. We have multiple teams from Microchip and Microsemi focusing on distribution inventory reduction, internal factory production control, and managing wafer starts and assembly loadings. Addressing inventory has created some headwinds regarding distribution revenue, but the non-GAAP revenue based on actual sell-through remains unaffected. I’m pleased to report that Microsemi achieved record non-GAAP net sales driven by end market demand. The second issue we mentioned previously was extravagance. We have been actively working to instill Microchip's frugal expense culture at Microsemi by shutting down the executive floor at headquarters, canceling the private jet account, terminating or selling many sports sky boxes, ending golf and auto racing sponsorships, and significantly reducing memberships. As we managed inventory and expenses, Microsemi has continued to perform well. We believe Microsemi possesses excellent engineering teams and products, with strong opportunities across their customer sockets. Our long-term strategy involves acquiring businesses and transforming them into world-class performers akin to Microchip. With effective expense management and inventory control in place, we are optimistic about meeting our long-term targets for Microsemi, and thus far, we are ahead of our initial goals. Additionally, in the September quarter, we paid down $501 million of our debt, achieved by optimizing cash flow from nearly 100 subsidiaries globally. This was made possible by the new tax law. Despite the significant debt reduction, our debt leverage remained relatively stable due to decreased EBITDA resulting from lower GAAP revenue at Microsemi and some softness in the Microchip classic business. Regarding our Classic Microchip business, all previously identified concerns that were incorporated into our guidance materialized. I had listed four primary concerns: first, long lead times for passive components affected sales since customers could not complete their kits. Second, tariffs became a significant concern that impacted bookings due to customer apprehension. Third, our inability to fully ship to ZTE due to previous restrictions continued to affect our business, despite some easing from the Justice Department. Lastly, our bitcoin-related business has diminished to nearly negligible levels. Now, I will provide guidance for the December quarter. Our cautious outlook for the September quarter indeed proved accurate, as anticipated conditions manifested broadly across the industry. We remain wary of the outlook for December, especially regarding automotive and industrial sectors, our two primary markets. Automotive is impacted by emission testing delays in Europe and weaknesses in China, while the industrial sector is adversely affected by tariffs. In contrast, communication, data center, and aerospace and defense sectors are showing resilience. Considering all these factors, we expect total non-GAAP net sales to decrease by 5% to 10% sequentially. We anticipate our non-GAAP gross margin will range from 61% to 61.5% of sales, non-GAAP operating expenses will be between 24.9% and 25.4% of sales, and the non-GAAP operating profit percentage will fall between 35.6% and 36.6% of sales. Additionally, we expect non-GAAP earnings per share to range from $1.49 to $1.64. Due to the complexities involved with accounting for acquisitions—such as amortization of intangibles, restructuring charges, and inventory adjustments—Microchip will continue providing guidance and tracking results on a non-GAAP basis, as we believe this offers a more meaningful comparison to prior quarters. We ask analysts to report their non-GAAP estimates to first call. Would the operator please open the floor for questions?

Hey guys, great quarter in light of some of the headwinds that we're having here, and great update on Microsemi as well. So Steve, maybe you can just elaborate a little bit more on some of the end markets there. You had a little bit more detail than others did perhaps on auto, maybe talk about industrial as well. And then some bright points maybe within data center and comps, maybe that's your optical business that you might be pointing to, any more details there would be great.

If you look at the auto business, we highlighted two areas, one is, there was a new emission standard implemented in Europe, effective September 1. There was a 1-year notice on it almost from September 1 of the prior year, however, testing agencies couldn't build up the capacity to test all the car production. So there was a significant bottleneck for cars waiting to be tested which brought the European car production down. And the whole China economy has been weak due to various reasons, some incentives were taken away, the concerns about tariffs in Chinese production and all sorts of other reasons; China automotive market has been weak. In the industrial area, the concerns are mainly tariffs, both driven by Chinese end products coming to U.S. which have a 10% duty today going to 25% in January. So there are a lot of people concerned about whether they will be competitive or not in selling products in U.S., and because of weak Chinese economy, industrial is weak in China too. The three markets which are doing stronger are; data center, communication, and defense and aerospace. If I take them in the reverse order, defense and aerospace, I think after years of drawing down defense spending, the defense and aerospace spending has been on the way up. And we are very broadly designed-in into essentially every single weaponry system, every single aircraft, helicopters and others; so that part of the business is doing well. The data center business, I think you probably have seen some other companies with higher exposure to data center, data center cloud, hyperscalers and all that, that part of the business has been stronger. So that business did well last quarter and is stronger relative to the automotive and industrial and other businesses. And third is the communication; I think we also see the communication business doing well.

Eric, I think you had cited a goal of 0.7 turns of deleveraging for I believe for this fiscal year. Can you maybe talk about if that gets impacted at all with this environment and currently based on what you're seeing? And also maybe one for Steve, and I won't ask a follow-up after this. Microchip was usually up in March, I think mostly MSCC was just all over the place. Maybe could you help us think about how we can think about modeling March just from your initial read on what you've seen in the business?

Sure. So I'll take the deleveraging one first and then pass it back to Steve. But we made really good progress in terms of paying down debt as both Steve and I mentioned in our prepared remarks, we took down $500 million worth of total debt and on a net basis $315.5 million. So did a really good job there of using all the cash that we could to pay down debt. We will continue to use substantially all of our excess cash generations after dividends to reduce our debt levels. And we expect our net leverage to decline dramatically over the next several years. Now with the correction of the Microsemi distribution inventory having a significant impact on our EBITDA in the June and September 2018 quarters and then combining that with our guidance for the December 2018 quarter, our trailing 12-month EBITDA will have significant headwinds over the next year. And our net debt to EBITDA will not trend down as fast as we had indicated back in August, but this is a very good cash flow business; like I said, we'll continue to pay down debt, but in the current quarter we probably expect that debt pay down to be somewhere in $160 million range; a broad range should be $150 million to $200 million, but we'll have to see how things trend here over the next few quarters to give you a longer-term forecast.

I'll pick up the second question you had, which was regarding the March quarter. So I remind investors that when we bought Atmel, it was not a small acquisition either. Atmel was about 40% to half of our business. And after we integrated Atmel, we didn't understand Atmel's seasonality for a while because companies on their own, their prior seasonality was based on sell-in; however, they worked for the distributors, the whole end market mix was different. And after we had Atmel for the entire year or more than a year, we fully understood the impact of Atmel seasonality on our business to be able to guide properly. Same is the situation now with Microsemi. We don't fully understand Microsemi's seasonality. We haven't had a March quarter where the Microsemi in it. And we do not consider the March quarter on a Microsemi's cloth to be a meaningful indicator for us regarding seasonality because that business was managed with a selling-driven mentality, with significantly high distribution inventory. Our guidance will be based on real market demand. And the end markets for Microsemi are quite different. They are stronger in defense, stronger in data centers, stronger in communication and almost no automotive, very little automotive and all that. So I'm not ready to talk about the March quarter in terms of guidance till we have some more experience on our belt in understanding their seasonality as well as being able to gauge the impact of the current correction when it is ending and how its impact would be in the March quarter.

I'll start with a clarification with respect to the strong performance on the Microsemi inventory cleanup in the quarter. Did that have a particular impact on any of the product segment revenues that you reported or was the impact spread about equally among MCUs, analog and other businesses?

So, it really did not have an impact on the sales-out activity that Ganesh talked about, breaking out by product lines. So it was really just more of correcting the inventory sitting in distribution. So I don't think there was really any end-market impact from the actions that we took.

We basically, we haven't broken out the sell-in data by product line. We only have broken out sell-out data by product line, and that did not change based on lowering the sell-in and cleaning up the inventory.

There were a couple of references to accretion and I just wanted to clarify, what was the exact amount of Microsemi earnings accretion in the quarter? And Steve, are you retaining all the prior synergies and accretion targets, the $300 million in synergies as well as the $0.75 plus in year one, and $8 and I believe fiscal '20 earnings?

Yes, we're not breaking out the exact numbers of Microsemi attrition because we kind of managing it as one company, but we gave you anecdotes that the accretion in the September quarter was higher than the $0.15 for the September quarter we had originally guided. And we feel very confident that going out of the first year, the accretion will be higher than the $0.75 that we guided and we remain committed to a longer-term accretion of earnings per share of $8 that we guided before. This is a short-term impact based on this business cycle environment, whatever one, two, three quarters last, it doesn't really have a long-term impact over three or four years because usually the bounce back will get you back to where you were.

First, really more of a housekeeping one. The share count was a little lower than expected in the quarter and in the outlook. Is that just owing to a share price and the treasury method accounting for average shares in the quarter? Or is there something else going on there?

No, that's exactly what it is. We post a schedule on our Investor Relations page under supplemental financial information that walks through what the share count approximately would be based on various prices. As you know, we have several convertible debt instruments outstanding and the share dilution from those has gone down with the stock price falling.

And the other is to address the GAAP to non-GAAP revenue adjustment. I think it was $81 million in the quarter. You noted that the channel inventory from Microsemi now approximates the sort of heritage Microchip business channel inventory. So it sounds like maybe there is a little bit more work to do, but it's mostly done. And so, while I understand that just the inventory is going to fluctuate somewhat quarter-to-quarter after this $81 million delta that we saw in the quarter you just posted, going forward, should we expect this number to sort of fluctuate around zero or average around zero over time? Is that the right way to think about it?

I'll take a stab at answering that and then Steve or Ganesh can chime in. So, we're really pleased with the progress that we made in getting the Microsemi inventory down to 2.62 months, which is right in line with where Microchip has been historically. We really are not able to project what distributors are going to do; some of that is going to be based on environment, it's going to be based on working capital needs, it's going to be based on lead times, there are so many things that factor into it. We have 120 or so distributors that we work with worldwide. We don't manage our business in a way where we get that type of visibility from them and really we're driving for end-market demand forecast versus sell-in. Would it surprise me in an environment like this, that distributors are going to be very tight with our working capital? But again, for us to be able to provide any sort of forecast of what it's going to do is quite difficult, and we don't feel we have capability to do that. Steve, do you want to add anything?

What I would add is, we do not put any effort into managing our business to put the inventory into distribution. We put our entire effort into creating market demand which pulls the inventory out of the distribution and then allow the asset managers of the distribution to buy the product they need to serve the end market demand. So as the quarter is approaching, the quarter-end is approaching, we don't look at sales out as this and sell-in as this and we got to go make another $10 million deal. So sell-in is lower than the sell-out or to hold back product because it's going to go up or lower. We don't manage both of those numbers. We only manage one number which is sales out. And like I told you last quarter, the standard has changed, the GAAP standard is sell-in. I told you that before we disagree with it. But we have to report a GAAP sell-in number which we do, and we'll continue to do it. But all our measurements, all our bonus programs what Board manages us is to a market demand driven number that we report as a non-GAAP revenue. And sell-in would be whatever distributors want based on their own asset management, their cash flow needs, lead times; there are hundreds of factors that go into what they do with their inventory. And we don't manage that.

Steve, understanding, you don't want to talk about the March quarter and seasonality yet, just for the core business, your commentary about kind of cautious into December, what type of signals are you looking for in terms of distribution or customers in terms of how far along we are for the correction here?

Well, we interact with a large number of customers and distributors over the course of this quarter. And based on that collective engagement with hundreds, if not thousands of customers in all three geographies, US, Europe, Asia, we will have an assessment by the time we announce the December quarter results, which will be in early February. If there is a meaningful information that developed before that and gives us enough data points that we can kind of make a call, then we'll use the opportunity at one of the conferences to make comments on it. But fresh coming from the elections yesterday with 1% of precincts reporting; we cannot make the call on the election.

That part of the business, appliance consumer part of the business is weak also. I cannot put it in the industrial. People who make wave conditioners and appliances and that's kind of industrial-kind of business; you may call it consumer, but yes, that is weak.

We haven't really seen a lot of impact in reality. There is a lot of talk about it, but it's not changing the funnel size in any way, partially because a very large portion of Microchip business is proprietary, such functionality with such low power or such features or performance that really is not available in any local kind of Chinese parts, which are really fairly low-end. So I don't think we have seen any meaningful difference in the funnel size or design activity. There is a lot to talk about it. I think your question is the right one and we hit that; but like I said, fortunately we're not easy to design up.

Steve, relative to the industrial weakness you should calling out tariffs. I know this is probably an impossible question to answer, but I'm going to ask your opinion anyhow. To what extent do you think customers are reacting to the 10% tariff that's already been levied? And to what extent do you think that they're actually trying to be anticipatory to the raise to 25% come in the beginning of the year? I'm just trying to get a sense as to whether or not you think there's another sheer to drop or not? And then my second question, you did a great job kind of talking about the distribution inventory at Microsemi. I'm kind of curious about direct customer inventory. What did you see as the quarter unfolded? Was there any meaningful adjustments you needed to make there those behind you and to the extent they might be behind you, could there be a potential tailwind which I think you referred to on the last conference call once this inventory depletion was done.

Let me address the first question regarding tariffs. The situation is dynamic as the tariff percentages on various products keep changing, which is affecting customer sentiment. Back in June and July, when tariffs were expected to take effect in August, some customers attempted to get ahead by producing and shipping products to the U.S. to avoid the tariffs, while others reduced production to manage their inventory, unsure if they could pass on the tariff costs to their customers who had other purchasing options. This was particularly evident with the 10% tariff. Throughout September, customers were lowering their production levels and depleting their inventories because they believed it would be uncompetitive to transfer the tariff costs to U.S. customers when alternatives were available from countries like Taiwan, Singapore, Vietnam, and Mexico. Recently, there was a belief that before the elections, a resolution would be reached, similar to how an agreement was quickly made with Canada after some harsh discussions. However, that resolution has not materialized, leading to concerns that tariffs might increase to 25%. As a result, some customers are now reconsidering their strategies, opting to expedite production and shipping at a 10% tariff rate before facing a potential increase to 25%. This situation has created a lot of fluctuation and uncertainty among our 50,000 customers in China, making decision-making challenging with short lead times. We are actively responding to our customers as their needs evolve, but I’m not certain if that fully answers your first question.

Understood. And I appreciate the color on the end markets, where you're seeing strength and weakness; any thoughts on consumer appliances; because that's the market that we've seen some potential slowing in China as well; do you have any thoughts there?

So that part of the business appliance consumer part of the business is weak also. I cannot put it in the industrial. People who make wave conditioners and appliances and that's kind of industrial kind of business, you may call it consumer, but yes, that is we call so.

I think about the inventory correction; as we communicated to you, our inventory at the end of September was 2.62 months, which is a significant improvement over the 4 months prior. And so, I think that we are focused on constantly managing our inventory levels as we go forward and need to reflect demand. In the same way, we continued to make adjustments to our supply chain and procurement strategies to help mitigate the impacts of the tariffs and where it's possible to increase visibility in the supply chain. But clearly, there are some challenges that we are facing, deriving from these market dynamics that are impacting various sectors of the business. You're very correct. We are seeing that, too. So two things are happening. One, if there are two sources of production, one in China and one outside of China, then some attempt is being made to take the Chinese production and sell it to Europe and Asia, and take the non-Chinese production and ship it to US. This way you can optimize and not pay any duties. Two challenges in that; number one, it's a lot of manual work and most people aren't set up to really differentiate the product where it should go, but manually, and then writing some automation, it's really being done. But it's not perfect, because in many cases the U.S. demand is not exactly equal to the non-Chinese production, and Europe and Asia demand isn't equal to Chinese production, so there are still problems. So to solve that problem, you're correct, there are many customers that are moving Chinese production to outside of China, but they are rapidly running into capacity issues. Where the outside factories are full, there was a little bit of space, and they're now full, and there is a lot more to be transferred from China but there is no place to put it till they really expand capacity, build more square footage and all that, and that's a slow process. So, yes, we're seeing that. We want to thank all of our customers and analysts for your patience and for your understanding. I think this has been a tough four months here, but I think we've done a lot of good work in cleaning up the Microsemi inventory. And at the same time, it's really the first acquisition whose timing was such that the wind is not on our back. We did a number of other acquisitions and the timing was great. Here, along with the Microsemi inventory challenges, we're also facing this downturn in the business; and so we're dealing with the dual challenges. But I think we posted a pretty good quarter, and despite sequentially down guidance, I think we're managing the inventory very well, the internal inventories in very good shape. Overall, gross margin and operating margins are still very, very good. And we look forward to really getting through these issues and getting back to our long-term $8 earnings target. So, thank you very much.