Microchip Technology Inc (MCHP) — Q2 2021 Earnings Call Transcript

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 releases of today as well as our recent filings with the SEC that identify important risk factors that may impact Microchip's business and results of operations. In attendance with me today are Ganesh Moorthy, Microchip's President and COO; and Eric Bjornholt, Microchip's CFO. I will first comment on our CEO transition and Board appointments. Eric will then comment on our second quarter financial performance. Ganesh will then give his comments on the results. I will then discuss the current business environment as well as our guidance. We will then be available to respond to specific investor and analyst questions. So let me begin by commenting on the CEO transition announced today and the addition of Board members. Today, we announced that I will transition to an Executive Chair role effective March 1, 2021. Microchip's current President, Ganesh Moorthy, will step into the role of President and CEO effective March 1, 2021. Ganesh will also join the Board of Directors effective January 4, 2021. I joined Microchip in February 1990 as Senior Vice President of Operations and was promoted to President to lead this company in July 1990. Microchip then had sales of about $60 million, and it was losing about $10 million per year. The main product line at that time was commodity e-comm, and the gross margin of the company was about 30%. The turnaround of the company was documented in my book, Driving Excellence: How the Aggregate System Turned Microchip from a Failing Company to a Market Leader. We took Microchip public in March of 1993, with annual sales of $89 million and a market capitalization of $85 million. In the last 27 years as a public company, Microchip's net sales grew to $5.2 billion, and its market capitalization grew to approximately $30 billion. Today, Microchip produces industry-leading gross and operating margins. Since its IPO, Microchip's stock price has grown approximately 20,000%, excluding dividends. Microchip has also completed its 120th consecutive quarter of profitability on a non-GAAP basis. In the last 30 years, Microchip transformed from a small company focused on nonvolatile memory products to an embedded solutions powerhouse with a broad and innovative range of solutions as well as leadership positions in the industrial, data center, automotive, communications, consumer and aerospace and defense markets. We have also been an industry consolidator, having acquired about 20 companies, including well-known industry names like Silicon Storage Technology, Standard Microsystems, Micrel, Atmel and Microsemi. All of the acquired companies were successfully integrated into Microchip's business and created outstanding value for the stockholders of Microchip. Leading Microchip for the last 30 years has been the greatest privilege of my 42 years in the semiconductor industry. I turned 65 in July of this year. I often thought about transitioning to an Executive Chair role by that date. I discussed this with our Board of Directors as part of our succession planning process earlier this year, but no decision was made at that time. Then given the unexpected COVID-19 pandemic, the Board and I thought it was best to delay any transition so that it would not occur during a very turbulent and unpredictable time. I have now decided that the time is right to make this change. The overall decision was made easier given that Microchip has someone as qualified as Ganesh to assume the CEO role and given the strength of the rest of our management team. I have known Ganesh for 39 years since hiring him as a new college graduate at Intel in 1981. He has a demonstrated track record of success. And our proven partnership over the last 19 years at Microchip makes him my logical successor. He is an energetic, articulate and thoughtful leader who is widely respected amongst our customers, partners, suppliers, investors and analysts as well as the entire Microchip employee base. Ganesh joined Microchip in 2001 and served as the vice president of multiple business units. In 2006, he was promoted to Executive Vice President, with extended business unit and manufacturing responsibilities, and assumed the role of Chief Operating Officer in 2009. Ganesh has served as President and Chief Operating Officer from February 2016. Since then, Ganesh and I have jointly led Microchip. Now starting March 1, 2021, Ganesh will become the President and CEO of Microchip. I will remain as an Executive Chairman. I will work with Ganesh to continue to drive the strategic direction of this company and maintain a strong culture and succession planning that we have developed here. We also announced today that starting January 4, 2021, Karen Rapp will join the Board of Directors of Microchip and will also join its Audit Committee. Karen is no stranger to the technology investment community. She's currently the CFO of National Instruments. She also serves on the Board of Plexus, which is a contract manufacturer. Karen brings with her extensive large company experience and significant leadership accomplishments in financial management, financial governance, information technology and cybersecurity. We are all very pleased to have Karen join our Board. I will now pass this call to Eric Bjornholt, and he will cover the earnings part of this conference call. Eric?

Thanks, Steve, and good afternoon, everyone. 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 microchip.com, which we believe you will find useful when comparing our GAAP and non-GAAP results. We have posted a summary of our outstanding debt and our leverage metrics on our website. We will now go through some of the operating results, including net sales, gross margin and operating expenses. Other than net sales, I will be referring to these results on a non-GAAP basis, which is based on expenses prior to the effects of our acquisition activities, share-based compensation and certain other adjustments as described in our press release. Net sales in the September quarter were $1.31 billion, which was flat sequentially and above the high end of our narrowed guidance range from September 9, 2020, when net sales were expected to be down between 2% and 6% sequentially. We have posted a summary of our GAAP net sales as well as end market demand by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were very strong and near record levels at 62.2%. Operating expenses were at 23%. And operating income was an outstanding 39.2%, all better than the high end of our revised guidance from September 9. Our factory underutilization charges decreased from $13.9 million to $12.2 million sequentially as we started to ramp our factories to respond to the stronger-than-expected business conditions. We expect the continued ramp of our factories to lead to lower underutilization charges in the December quarter. Non-GAAP net income was $416.4 million. Non-GAAP earnings per share was $1.56, $0.15 above the midpoint of our guidance and $0.10 above the high end of our guidance from September 9. On a GAAP basis in the September quarter, gross margins were 61.7% and include the impact of $6 million of share-based compensation expense. Total operating expenses were $581.7 million and include acquisition intangible amortization of $232.9 million, special charges of $4.3 million, $0.7 million of acquisition-related and other costs and share-based compensation of $43.7 million. The GAAP net income was $73.6 million or $0.27 per diluted share. Our September quarter GAAP tax expense was impacted by a variety of factors, including tax reserve releases associated with the statute of limitations expiring, offset by tax reserve accruals associated with developments of the Altera court case during the period, deferred tax impacts of enacted changes in tax law occurring during the period, deferred tax impacts of our convertible debt exchange transactions occurring during the period and other matters. Our non-GAAP cash tax rate was 5% in the September quarter. We expect our non-GAAP cash tax rate for fiscal '21 to be about 5.5%, exclusive of the transition tax, any potential tax associated with restructuring 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 and tax credits as well as U.S. interest deductions that we believe will keep our cash tax payments low. The remaining cash tax payments associated with the transition tax are expected to be about $221 million and will be paid over the next 5 years. We have posted the schedule of our projected transition tax payments on the Investor Relations page of our website. Our inventory balance at September 30, 2020 was $661.4 million. We had 120 days of inventory at the end of the September quarter, up 3 days from the prior quarter's level and primarily a result of our strong gross margin performance. Inventory at our distributors in the September quarter was at 30 days, which was flat to the prior quarter. We believe distribution inventory levels for Microchip are still low compared to the historical range we have experienced over the past 10 years, which is between 27 and 47 days. Our cash flow from operating activities was $455.8 million in the September quarter. As of September 30, our consolidated cash and total investment position was $370.3 million. We paid down $331.1 million of total debt in the September quarter. Over the last 9 full quarters since we closed the Microsemi acquisition and incurred over $8 billion in debt to do so, we have paid down $2.95 billion of the debt and continue to allocate substantially all of our excess cash beyond dividends to aggressively bring down this debt. We have accomplished this despite the adverse macro and market conditions during most of this period, which we feel is a testimony to the cash generation capabilities of our business as well as our ongoing operating discipline. We continue to expect our debt levels to reduce significantly over the next several quarters. In the September quarter, we also exchanged $796.1 million of our 2025 and 2027 convertible senior subordinated notes for cash and shares of common stock. While these transactions did not impact the overall level of debt on our balance sheet, we believe that these convertible exchanges will benefit stockholders by significantly reducing the share count dilution to the extent our stock price appreciates over time. Our adjusted EBITDA in the September quarter was $566.7 million, and our trailing 12-month adjusted EBITDA was $2.181 billion. Our net debt-to-adjusted EBITDA, excluding our very long-dated convertible debt that matures in 2037 and is more equity-like in nature, was 4.04 at September 30, 2020, down from 4.24 at June 30, 2020. Our dividend payment in the September quarter was $95.3 million. Capital expenditures were $6.3 million in the September 2020 quarter. We expect about $35 million in capital spending in the December quarter and overall capital expenditures for fiscal '21 to be between $110 million and $120 million. Our capital expenditure forecast for fiscal '21 has increased as we prepare for growth in our business as well as actions we are taking to increase our internal capacity in the face of constraints our outsourcing partners are experiencing, which Ganesh will talk more about. We continue to add capital to maintain and operate our internal manufacturing operations, support the production capabilities of new products and technologies as well as to selectively bring in-house some of the wafer fabrication, assembly and test operations that are currently outsourced. We expect these capital investments will bring gross margin improvement to our business and give us increased control over our destiny during periods of industry-wide constraints. Depreciation expense in the September quarter was $39 million.

Thank you, Eric, and good afternoon, everyone. Let's start by taking a closer look at microcontrollers. In a weaker-than-normal macro environment, our microcontroller revenue performed better than we expected. Our microcontroller revenue was sequentially down 1.8% as compared to the June quarter. On a year-over-year basis, our microcontroller revenue was up 0.8%. Microcontrollers overall represented 53.7% of our revenue in the September quarter. Now moving to analog. Our analog revenue was sequentially down 2.3% as compared to the June quarter. On a year-over-year basis, our analog revenue was down 8.2%. The weaker year-over-year performance of our analog revenue as compared to our microcontroller revenue was primarily due to our product lines which originated from Microsemi, which had higher exposure to Huawei, the communications end market in general, the commercial aviation market and the space market. Analog represented 27.6% of our revenue in the September quarter. Our FPGA revenue was up 24.8% sequentially as compared to the June quarter and achieved an all-time record even going back to the Microsemi history. On a year-over-year basis, our FPGA revenue was up 16.3%. I would like to caution investors that although the FPGA revenue trajectory is positive, the revenue does have some lumpiness associated with it because of the large exposure to the aerospace market. FPGA represented 8.3% of our revenue in the September quarter. Our licensing, memory and other business, which we refer to as LMO, was flat in revenue as compared to the June quarter. LMO represented 10.4% of our revenue in the September quarter. In October, we completed the acquisition of 2 small private companies. The first acquisition was New Zealand-based Tekron International, a global leader of timekeeping technologies and solutions for smart grid and other industrial applications. Timing is an operational necessity for real-time smart grid management and monitoring. Modernization, complexity and cybersecurity challenges within the power utilities are driving the need for more precise, secure and reliable time. Acquiring Tekron enables us to expand our offering for the expanding smart energy and industrial markets. The second acquisition was Toronto-based LegUp Computing, whose high-level synthesis tool expands our FPGA edge compute solution stack to make it easier for software engineers to harness the algorithm accelerating power of Microchip's PolarFire FPGA and PolarFire system-on-chip platforms. The LegUp acquisition also complements the VectorBlox acquisition we made a year ago, which added domain expertise in the areas of machine learning algorithms and vector processing for edge compute applications. Tekron and LegUp were very small tuck-in acquisitions, more akin to acquiring intellectual property along with domain experts to help us accelerate our business agenda in specific laser-focused areas. Both acquisitions were valued in the mid-single-digit millions of dollars and hence not material to the rate at which we're paying down our debt. The 2 acquisitions are expected to add less than $1 million of revenue in the December quarter. In mid-September, per the U.S. Department of Commerce regulation, we stopped all shipments to Huawei. Our Huawei-originated revenue represents about 1% to 2% of Microchip's overall revenue and was sequentially down from the June quarter to the September quarter. We are working with the Department of Commerce to apply for licenses for products and technologies that we believe have no impact on U.S. national security interests. We do not know if or when such licenses may be granted. Therefore, we have no Huawei revenue in our December quarter guidance that Steve will provide. During the September quarter, we began to experience rising constraints in our supply chain due to a number of industry-wide factors, among them, Huawei's push throughout the supply chain to complete manufacturing of all their products prior to the shipment ban; competition for market share by Huawei's competitors seeking to replace them, which further stressed the supply chain; and ongoing shift of semiconductor manufacturing out of China to avoid tariffs and trade sanctions, pressuring the capacity in other Asian countries where we manufacture through our partners; a very significant mobile phone refresh cycle, which competes for the same outsourced capacity we used; and last but not least, the rising demand from the automotive, industrial and consumer markets, which we saw. The confluence of these factors created supply chain constraints, which are continuing into the December quarter. At times like this, we are fortunate to have our internal factory capabilities, and we are making strategic capacity investments as we seek to better position our business for growth. Given the current market dynamics, we are providing some qualitative trend insights into our principal end markets for the September quarter. As expected, we saw the automotive, industrial and consumer home appliance markets start their recovery. Medical devices for elective procedures, like hearing aids, pacemakers, et cetera, which experienced a slowdown in the June quarter as individuals and hospitals delayed elective procedures, also started the recovery in the September quarter. As expected, we also saw the work-from-home-related markets of computing and data center as well as medical devices for hospitals revert to more normal demand patterns as the surge we saw in the June quarter dissipated. In general, enterprise demand remains weak as most businesses remain predominantly with work-from-home policies, thus deferring enterprise spending for the office environment. Finally, before I hand off to Steve, I would like to take the opportunity to express my deep gratitude to Steve and to the Microchip Board of Directors for the responsibility being entrusted in me when the baton gets handed next March. As we all know, Steve will be leaving big shoes to fill, with an impeccable 30-year history as CEO of Microchip. Yet the partnership we have forged over many years of working together, in addition to the support of our long-tenured executive team at Microchip, gives me confidence to lead the next phase of Microchip. I would especially like to thank Steve for being my mentor and my partner through the many years that we have engaged in business challenges and opportunities together, and for everything I've been privileged to learn from him. I am particularly glad and thankful that Microchip and I can count on his continued support and advice in his Executive Chair role. Thank you, once again, Steve. Let me now pass it to Steve for comments about our business and our guidance going forward.

Thank you, Ganesh. Today, I would like to first reflect on the results of the fiscal second quarter of 2021. I will then provide guidance for the fiscal third quarter of 2021. The September quarter continued to demonstrate what the best of Microchip culture and its people represent. Our global team of operations, business units, sales and marketing and support groups all came together in the middle of a global pandemic while working with a pay cut and delivered a superb quarter. Despite the COVID-19 pandemic challenges, we delivered net sales of $1.31 billion that was essentially flat sequentially and down only 2% from the year ago quarter. This is compared to our net sales guidance, which was to be down 4% sequentially at the midpoint as we capitalize on strong turns opportunities in September. We also delivered outstanding non-GAAP gross margin of 62.2%, which were near an all-time record level. We also achieved non-GAAP operating margin of 39.2%, above the high end of our guidance. Our consolidated non-GAAP EPS was $1.56, $0.15 above the midpoint of our guidance. Our bookings were very strong in the September quarter. We began the September quarter with a backlog position on July 1 to be down 8% from the backlog for June quarter on April 1. With strong bookings and strong turns still in the quarter, we ended the quarter at essentially flat compared to minus 4% at the midpoint of our guidance. Now I will discuss our guidance for the December quarter. Our bookings have remained strong in October. We are seeing a good recovery in the automotive, industrial, home appliance, and medical devices for elective procedures markets. At the same time, work-from-home-related markets of computing and data centers, as well as certain medical devices that surged with the pandemic, revert to more normal demand. There is one other factor that we have to account for in our guidance for the December quarter, which is the Huawei effect. Huawei was an over 1% customer in the September quarter, and it will be 0 in the December quarter. Taking all these factors into consideration, we expect our net sales for the December quarter to be between flat to up 5% sequentially. Considering that, seasonally, the December quarter is down by approximately 2% to 3% and counting the minus 1% Huawei effect, we believe that our guidance is well above seasonal and represents multiple industries recovering as well as Microchip continuing to gain market share in multiple end markets and product lines. Investors and analysts have asked us in the last few months about making a call about the bottom of this cycle. With tremendous uncertainty about the COVID-19 situation and the elections, we have not been willing to make the call. Today, we are making that call. We expect that June and September quarters were the bottom for this business cycle for Microchip. We are guiding to a much stronger-than-seasonal December quarter. And we expect significant growth in calendar year 2021. Based on the much better-than-expected financial results in the September quarter, we gave our employees half of their September quarter salary sacrifice back in the form of a bonus. We have also been gradually lowering the percentage of salary sacrifice. And just yesterday, the Board of Directors approved the entire company to revert back to full salary later this month. These salary changes are dialed into our guidance that we are providing today. We thank all of our employees worldwide that have traveled this journey of shared salary sacrifice with us in the past 3 quarters, enabling us to be prepared for multiple contingencies as COVID-19 uncertainties unfolded. This represents the best of Microchip culture and the commitment of our employees to ensure the long-term success of the company. For the December quarter, we expect our non-GAAP gross margin to be between 62.4% and 62.8% of sales, which will be a new all-time record. We expect non-GAAP operating expenses to be between 23.1% and 23.7% of sales. We expect non-GAAP operating profit to be between 38.7% and 39.7% of sales. We expect our non-GAAP earnings per share to be between $1.51 per share to $1.63 per share. We also expect to pay down another approximately $300 million of our debt in the December quarter. We continue to believe in the strength and diversity of the businesses and end markets we are in to achieve long-term growth in excess of the average semiconductor market growth. I would like to advise investors and analysts about one other change. In the past, we have been providing a mid-quarter update often to coincide with our presentation at sell-side financial conferences. Our peers and competitors typically do not provide a mid-quarter update. Beginning this quarter, we will discontinue this practice and no longer plan to provide such updates. Given all of the complications of accounting for our acquisitions, including amortization of intangibles, restructuring charges and inventory write-up on acquisitions, Microchip will continue to provide guidance and track its results on a non-GAAP basis except for net sales, which will be on a GAAP basis. We believe that non-GAAP results provide a more meaningful comparison to prior quarters, and we request that the analysts continue to report their non-GAAP estimates to first call. With this, operator, will you please poll for questions.

Steve, congratulations, and you'll be missed. And Ganesh, congratulations to you as well. I guess you'll have to take over Steve's role to keep us on our toes when we get on this call to ask a question.

It's a hard act to follow.

I know it's a big responsibility, but we are looking forward to your input. I have two questions. The first one is regarding the constrained situation. Can you explain how that has affected lead times? Also, if there were no constraints, what would the business look like, or what guidance would you provide? The second question, which Eric might address, relates to capacity. There are many factors at play here. What is the breakdown between outsourced and in-sourced capacity for both the front end and back end? Additionally, what should we anticipate for the increase in capital expenditures, and how will that affect gross margins?

Do you want to take the lead times, Steve?

No. You go ahead. Take it.

So on lead times, the vast majority of our line items still have a 4- to 8-week type of lead times for standard products. There are specific package combinations that do have longer lead times. What is happening is, for the factors that I described, it is eating into multiple layers of the supply chain, so into the packaging and some of the subassembly involved in the packaging and into the testing infrastructure as many of these things come together at the same time. So we don't have huge issues with supply issues, but we have spot issues with specific package product combinations where they are. But by and large, for the vast majority of our products, we still have pretty good lead times. Go ahead, Eric.

The second part of your question touches on several aspects, primarily regarding our capacity challenges. We are actively investing in wafer fabrication, assembly, and testing to enhance our capacity. In the previous quarter, we managed approximately 39% of our wafer fabrication in-house, 47% of our assembly, and around 54% of our testing. These metrics are relatively slow to change, even with the investments we're making. However, we do anticipate that the percentages for assembly and testing will increase over time as we continue these investments. The metrics may be slow-moving, but the investments we are undertaking are expected to improve our gross margin. We have revised our gross margin guidance upward for the current quarter and are also anticipating reduced underutilization charges as our factories ramp up. Additionally, the increased capacity we are adding across fabrication, assembly, and testing should ultimately enhance our gross margin in the future.

But we are currently unable to quantify how to consider the longer-term aspects, specifically regarding what the steady-state assembly and testing processes will look like, comparing in-source versus outsourced.

So again, I don't expect the wafer fab to move significantly in terms of the percentage that we do in in-source versus outsourced. As the business grows, obviously, we're making investments. On the assembly and test side, we do expect those percentages to go up. Ganesh, do you want to give a comment on where you think they can go over time?

Yes. They move a little bit more slowly over time, and we expect that they will probably be in the north of 60% longer-term for assembly probably north of 70% for test. And there's a lot of moving parts into going into that. But that's what we like to be at. It gives us some control. It gives us capacity when it's difficult to get outside, gives us some control on our costs as well. And it all pays for itself in short periods of time in the way we measure what we do or don't do.

With the Micrel, Microsemi, and Atmel acquisitions, we were at about 70% assembly and 95% test. So as we bought these 2 large companies, Atmel and Microsemi, they were much more outsourced than we were, and our percentages dropped quite dramatically. And we've been working our way up and ideally would like to get back to the higher than 60% assembly and probably higher than 80% test, but it's a painful and slow transition because there's just too many variants, too many packages, too many test programs to correlate and all that. So it's an ongoing effort that will go on for years, but there are really no quick movements.

And congratulations and best wishes to both Steve and Ganesh. Steve, my question is both near term and the growth you are expecting for next year. When I look at near term, in the September quarter, your microcontroller and analog sales were down a little bit. Year-on-year also, they are down a little bit. So I'm curious what is giving you the confidence to say we are at the bottom of the cycle when there is still some macro uncertainty because of elections and lockdowns. I'm just curious to hear those views. And then when you say significant growth for calendar '21, when I look at consensus growth numbers right now, they are for about, I think, 7% or so sales growth. What does significant mean? Does it mean 5%, 10%, 15%? What is significant in your book?

We have confidence because we analyzed the situation carefully. Back in February and March, many analysts and investors predicted a significant drop due to COVID, estimating declines of 20% to 30%. Some of our competitors were modeling their businesses similarly to the 2009 global financial crisis. However, we anticipated a smaller impact, and we were correct; our business actually grew in March, dipped only 1.3% sequentially in June, remained flat in September, and is set to increase in December. We are seeing a strong backlog building up, with the current quarter's backlog much stronger than last quarter's, even though this is typically a seasonally slower period. We anticipate doing well and have significantly large bookings coming in, which are rolling into the next quarters. Some of this surge is due to supply chain concerns, leading customers to place orders earlier. While our backlog isn't notably larger compared to the same time last year, not all of this will translate into future growth since earlier bookings may not contribute to new growth. Regardless, we expect the March quarter to show substantial improvement, with growth significantly exceeding the 7% consensus you mentioned.

So I'll add my congratulations to both Steve and Ganesh. And Steve, I appreciate all the help over the years. I'm sure a lot of the analysts on the call feel the same way. I guess my first question is, Steve, you're calling sort of for the bottom of the cycle, June, September levels. I think what's very impressive is where your operating margins are despite the fact that we're at the bottom of the cycle. I'm just kind of curious, I know that expenses have been a little bit light this year because you guys have pulled back on things like variable comp. But given that you're not in the market of buying assets and you're really going to be just focusing on operational efficiencies, how should we think about incremental operating margins and kind of where operating margins can go from here?

So I think we have given a longer-term model, which is 63% gross margin, 22.5% operating expense and 40.5% operating margin. We're not quite there. We're getting close. The midpoint of our guidance is about 62.6% in gross margin this quarter, and I don't quite have the number on the top of my head on the operating margin. We got a little bit more to go before we really get to our numbers. And we will be analyzing going into the next fiscal year. We'll be looking at all that and at some point in time, coming back to The Street with a new longer-term target when we think that current targets have either been achieved or within a striking range.

That's helpful. And then for my follow-up for Ganesh. Your commentary around FPGAs in your prepared comments, notwithstanding kind of your caution that's a lumpy business, I'm just kind of curious if you can talk a little bit about kind of your core advantage in that market. That's becoming sort of a rarer asset over time now with some of the M&A activity in the space. What kind of longer-term prospects do you see in the FPGA space for you?

Sure. So in the FPGA market, we play specifically in the midrange of FPGAs, which is measured by how many logic elements there are in it. We don't go after the very high end. There are other players who are invested there. But in the midrange and lower end, we focus on applications that need low power. We have nonvolatile memory on these products that have security needs, that have robustness needs. And those take us into end markets that we really like. Those end markets are defense and aerospace. They're automotive, now with Microchip taking FPGA products into our historical strength, and industrial, once again, Microchip taking FPGA into our historical strength. So those are the end markets that we believe we're able to take, over the long term, the advantages of what we bring with our FPGA products in terms of low power, security, robustness and being able to position it into the markets where we have the strengths.

And congrats to both Steve and Ganesh. Steve, you talked about your December quarter guidance being roughly 5 percentage points above typical seasonality, maybe 6% when you take into consideration the Huawei dynamic. You also talked about end market strength and share gains contributing to that outperformance. What portion of that 5% to 6% outperformance relative to typical seasonality is share growth? And what percentage is end market strength? And you sort of alluded to this before, but are you concerned at all that customers are pulling in end demand and you see a correction in sometime in the first half of '21?

It's challenging to break down the growth into the two components you mentioned: the part that is market share and the part that is purely better end market conditions. This is particularly difficult to assess on a short-term basis. A more in-depth analysis can be made over the long term by comparing growth rates and observing how others perform. We cannot predict how other companies will perform this quarter, next quarter, or next year, so I don't have a definitive answer to that. Regarding your question about a potential correction next year due to customers pulling in demand, we perceive that customers are not pulling back; rather, they are placing orders and scheduling them for the next quarter and the one after. We requested that customers provide us with a longer-term backlog along with their near-term orders to help us plan and allocate capacity. The customers have responded positively, resulting in strong bookings. The part of the bookings that is expanding into the next quarter and even into the following one looks very promising. We already have significant backlog for the June quarter and robust backlog for March. Customers are scheduling their orders to ensure they are not left short in case of any constraints.

So I'll add my congratulations to both Steve and Ganesh. And Steve, I appreciate all the help over the years. I'm sure a lot of the analysts on the call feel the same way. I guess my first question is, Steve, you're calling sort of for the bottom of the cycle, June, September levels. I think what's very impressive is where your operating margins are despite the fact that we're at the bottom of the cycle. I'm just kind of curious, I know that expenses have been a little bit light this year because you guys have pulled back on things like variable comp. But given that you're not in the market of buying assets and you're really going to be just focusing on operational efficiencies, how should we think about incremental operating margins and kind of where operating margins can go from here?

So I think we have given a longer-term model, which is 63% gross margin, 22.5% operating expense and 40.5% operating margin. We're not quite there. We're getting close. The midpoint of our guidance is about 62.6% in gross margin this quarter, and I don't quite have the number on the top of my head on the operating margin. We got a little bit more to go before we really get to our numbers. And we will be analyzing going into the next fiscal year. We'll be looking at all that and at some point in time, coming back to The Street with a new longer-term target when we think that current targets have either been achieved or within a striking range.

That's helpful. And then for my follow-up for Ganesh. Your commentary around FPGAs in your prepared comments, notwithstanding kind of your caution that's a lumpy business, I'm just kind of curious if you can talk a little bit about kind of your core advantage in that market. That's becoming sort of a rarer asset over time now with some of the M&A activity in the space. What kind of longer-term prospects do you see in the FPGA space for you?

Sure. So in the FPGA market, we play specifically in the midrange of FPGAs, which is measured by how many logic elements there are in it. We don't go after the very high end. There are other players who are invested there. But in the midrange and lower end, we focus on applications that need low power. We have nonvolatile memory on these products that have security needs, that have robustness needs. And those take us into end markets that we really like. Those end markets are defense and aerospace. They're automotive, now with Microchip taking FPGA products into our historical strength, and industrial, once again, Microchip taking FPGA into our historical strength. So those are the end markets that we believe we're able to take, over the long term, the advantages of what we bring with our FPGA products in terms of low power, security, robustness and being able to position it into the markets where we have the strengths.

And congrats to both Steve and Ganesh. Steve, you talked about your December quarter guidance being roughly 5 percentage points above typical seasonality, maybe 6% when you take into consideration the Huawei dynamic. You also talked about end market strength and share gains contributing to that outperformance. What portion of that 5% to 6% outperformance relative to typical seasonality is share growth? And what percentage is end market strength? And you sort of alluded to this before, but are you concerned at all that customers are pulling in end demand and you see a correction in sometime in the first half of '21?

It's challenging to separate the growth into the two components you mentioned: the market share gain and the overall improvement in the end market. This type of analysis is particularly difficult on a short-term basis. A more effective approach would be to look at comparisons over a longer term by examining the growth rates of others in the industry. We cannot predict how others will perform this quarter, next quarter, or even next year, so I don't have a clear answer for that. Regarding the anticipated correction next year due to customers adjusting their demand, we don't actually observe a decrease in demand; instead, we see customers placing their orders and scheduling them for delivery in the next quarter and beyond. We had requested this from our customers in a letter back in July, asking for not just immediate orders but also for a longer-term view on their requirements given the current constraints. Customers have responded positively, resulting in strong bookings. However, we have a significant portion of these bookings aging into the next quarter and even into the following one, which is promising. We already have a solid backlog for the June quarter and an even stronger backlog for the March quarter. So, customers are not reducing their deliveries; rather, they are placing orders and scheduling deliveries to ensure they are adequately supplied in the event of any constraints.

So I'll add my congratulations to both Steve and Ganesh. And Steve, I appreciate all the help over the years. I'm sure a lot of the analysts on the call feel the same way. I guess my first question is, Steve, you're calling sort of for the bottom of the cycle, June, September levels. I think what's very impressive is where your operating margins are despite the fact that we're at the bottom of the cycle. I'm just kind of curious, I know that expenses have been a little bit light this year because you guys have pulled back on things like variable comp. But given that you're not in the market of buying assets and you're really going to be just focusing on operational efficiencies, how should we think about incremental operating margins and kind of where operating margins can go from here?

So I think we have given a longer-term model, which is 63% gross margin, 22.5% operating expense, and 40.5% operating margin. We're not quite there. We're getting close. The midpoint of our guidance is about 62.6% in gross margin this quarter, and I don't quite have the number on the top of my head on the operating margin. We got a little bit more to go before we really get to our numbers. And we will be analyzing going into the next fiscal year. We'll be looking at all that and at some point in time, coming back to The Street with a new longer-term target when we think that current targets have either been achieved or within a striking range.

That's helpful. And then for my follow-up for Ganesh. Your commentary around FPGAs in your prepared comments, notwithstanding kind of your caution that's a lumpy business, I'm just kind of curious if you can talk a little bit about kind of your core advantage in that market. That's becoming sort of a rarer asset over time now with some of the M&A activity in the space. What kind of longer-term prospects do you see in the FPGA space for you?

Sure. So in the FPGA market, we play specifically in the midrange of FPGAs, which is measured by how many logic elements there are in it. We don't go after the very high end. There are other players who are invested there. But in the midrange and lower end, we focus on applications that need low power. We have nonvolatile memory on these products that have security needs, that have robustness needs. And those take us into end markets that we really like. Those end markets are defense and aerospace. They're automotive, now with Microchip taking FPGA products into our historical strength, and industrial, once again, Microchip taking FPGA into our historical strength. So those are the end markets that we believe we're able to take, over the long term, the advantages of what we bring with our FPGA products in terms of low power, security, robustness and being able to position it into the markets where we have the strengths.

Great. Congratulations on the results. Maybe a question on my side, going back to the supply chain constraints, which exact category of products are impacted there? And Ganesh, in your prepared remarks, you talked about Huawei, you talked about the mobile phone refresh and some reshuffling of share as well in capacity maybe. It seems more short-term related. So the question is, do you think these constraints dissipate from the March quarter? Are they here to stay with us for some time? And I have a follow-up on the gross margin.

So the general comment would be that it affects the supply chain of people who are packaging product, their supply chain, which can be lead frames, it can be substrates, can be equipment that does bonding and various other things. And so it may not be things that we are directly involved in, but it consumes bandwidth and capacity of the supply chain, both directly what we deal with and then their supply chain as well. And so all of these compete in many cases for either the materials or the equipment capacity that is out there that we would otherwise be using. And then as we go to use them, we find that, in some cases, they're constrained. We've been able to manage through a lot of it. We do have second sources for some of these things, and we do have a lot of internal capability. And as Eric mentioned, we are accelerating, bringing more capacity internal for some of the package types. So what normally happens in business is, when you have these constraints, the companies that are in the business of providing that capacity or that material respond with what they can do to take advantage of that situation. And so there is a capacity response that they come with. Some of it also, it's possible that there could be a surge in demand that then begins to dissipate. We can't really predict where that is. But we think that they're all going to be constrained through the December quarter, and it's possible some of that will spill over into the March quarter as well. But I don't have any line of sight into exactly when all the constraints will dissipate.

Great. This is the last question from Steve's final call, which is quite an honor. Congratulations, Ganesh, and thank you, Steve, for all the valuable insights you provided. I will miss them. I have a strategic question for Steve regarding the scenario where M&A activity slows down during a deleveraging cycle followed by a capital return cycle. What should investors take away from this in relation to the semiconductor industry? Does it indicate that different requirements will emerge for Microchip's customers? Should we expect a shift in Microchip’s approach, perhaps a Microchip 3.0? What insights should investors consider? Or is Microchip 2.0 sufficient for the upcoming trends in semiconductors and for Microchip specifically?

If you look at Microchip from ten years ago, our business primarily focused on microcontrollers, which accounted for over 80% of our revenue. The remaining portion came from a limited range of analog or memory products, which didn't allow us to provide complete customer solutions. When we approached customers, we mainly offered microcontrollers, along with a few additional products. Customers would then integrate our microcontrollers with analog components from other suppliers such as Maxim, ADI, TI, or Intersil, and source connectivity solutions from other vendors. Back in 1993, when we went public, we had a partnership with Maxim that worked well for about five years. We would hold seminars together, with our team educating customers on using our microcontrollers while Maxim would explain how to incorporate their analog products. However, the partnership ended when Maxim's founder, Jack Gifford, sought more compensation, claiming we were attracting customers while they benefitted from the sales of their analog products. This situation led us to enter the analog market ourselves. Fast forward to today, we are now generating between $1.6 billion and $1.7 billion in analog sales, pairing our own analog products with microcontrollers. We have also developed and acquired essential technologies like USB, WiFi, Ethernet, and Bluetooth. From the customer's standpoint, we now offer comprehensive solutions, reducing the need for further acquisitions to meet their needs. While we could still pursue acquisitions to enhance our offerings, our existing design teams are effectively addressing these solutions. Currently, we are aware that industry valuations have risen significantly. For instance, we acquired Microsemi at five times sales and Xilinx at ten times sales. We believe these valuations are excessive, so we won't be pursuing additional acquisitions, as our customers are already well-served by what we provide.

I think when I thank our investors who have been with us for long, and I certainly have great relationships and a long career with all of you. I'll still be here. I'm not going away. We still have a conference coming up, a Credit Suisse conference in early December, then the next earnings call in February. And then on March 1, I become Executive Chair, but you will still see me at the investor circuit and conference calls and investor conferences and others. So I'll still continue to be involved with Microchip and not going away. Thank you very much.