Microchip Technology Inc (MCHP) — Q4 2021 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 may differ materially. We refer you to our press releases 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, and Steve Sanghi, Microchip’s Executive Chairman. I will comment on our fourth quarter and full fiscal year 2021 financial performance. Ganesh will then give his 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.

Thank you, Eric, and good afternoon, everyone. Our March quarter was also strong by every key metric, closing a tumultuous fiscal year on a very positive note, which was otherwise dominated by the effects of the COVID-19 pandemic. March quarter revenue was an all-time record at $1.467 billion, growing by 8.5% sequentially. Non-GAAP gross margins were another record at 64.1%, up 110 basis points from the December quarter as we benefited from improved factory utilization and product mix. Non-GAAP operating margin is also a record at 40.7%, the first time we have broken through the 40% mark. Our journey towards our long-term business model of 65% gross margin and 42% operating margin is off to a good start, but still has a lot of hard work ahead of us to achieve. Our consolidated non-GAAP EPS was above the high end of our guidance at a record $1.85. EBITDA was very strong and achieved another record at $652.3 million, continuing to demonstrate the robust profitability and cash generation capabilities of our business through the business cycles. The March quarter also marked our 122nd consecutive quarter of non-GAAP profitability. I would like to take this occasion to thank all our stakeholders who enabled us to achieve these outstanding and record results in the March quarter, especially thanking the worldwide Microchip team whose tireless efforts not only delivered our strong financial results, but also supported our customers to navigate a difficult environment and worked constructively with our supply chain partners to find creative solutions in a hyper-constrained environment. Reflecting on our fiscal year 2021 results, we achieved a number of highlights and records in the last year. Revenue was a record at $5.438 billion, non-GAAP gross margin was a record at 62.8%, non-GAAP operating margin was a record at 39.6%, and non-GAAP EPS was a record at $6.59. All in all, the record March quarter results and the record March ending fiscal year 2021 results marks a seamless transition between Steve and me as we each embark on our new roles to build the next phase of Microchip's long-term success. I'm truly fortunate to be the beneficiary of Steve's years of managing Microchip for the long term.

Thank you, Ganesh, and good afternoon, everyone. Today, I would like to provide you further updates on our cash return strategy. But before I do that, I would like to say how I continue to be very proud of all employees of Microchip who have delivered a flawless quarter and made new records in many respects: namely, record net sales, record non-GAAP gross margin percentage, record non-GAAP operating margin percentage and record EBITDA. Now, I will turn to updating you on the cash return strategy. We completed the March quarter with a net debt leverage ratio of 3.71, excluding the long-dated 2037 maturity converts that are more equity-like in nature. At the rate we are paying down debt, we expect to break the net debt leverage ratio of 3 within a year and continue to decrease from there. Around that time, we would also expect to achieve an investment grade rating, but the exact timing will depend on the analysis of the rating agencies. At that time, we expect to begin distributing more of our substantial amount of free cash flow to our investors in the form of dividends and stock buybacks. Regarding buybacks, through our various convertible debt exchanges, we have essentially bought a substantial amount of stock back from the future. This is because as our stock price rises and exceeds the conversion price of the debt, convertible debt dilutes the share count. Buying converts back prevents future dilution as the stock price rises. Our first convert buyback was in March of 2020 when Microchip's stock price was about $71. Since then, we have completed five other buyback transactions at various stock prices. By doing these various buyback transactions, we have purchased a total of $3.884 billion in face value of our convertible bonds. For the transactions from March 2020 to December 2020, we issued a total of about 27.5 million shares of our common stock to investors for the in-the-money value of their bonds. If these bonds had remained outstanding until an assumed stock price of $160 per share, the dilution would have been about 36.4 million shares. Thus, our repurchases had the impact of creating a savings of about 8.9 million shares, worth $1.424 billion in savings to our investors at that assumed price of $160 per share. This calculation does not include our February 2021 transaction, which was very recent and executed at $163.25 per share, so it is not yet accretive. While we have not done open market stock buybacks in the last year, our convertible transaction had the impact of a buyback of approximately 8.9 million shares or about 3% of our outstanding shares. We expect to start stock buybacks from the open market after we achieve an investment grade rating, which we expect within a year depending on the rating agency. Meanwhile, we did not want to wait to start higher dividends until our leverage ratio reaches a given number, so we initiated a path to higher dividends in our February 2021 dividend announcement with a 5% dividend increase. We are continuing on this path as we announced today that the Board of Directors has approved a dividend increase of 5.9% sequentially to $0.41 per share, up from $0.39 previously. We expect to continue to increase dividends quarterly as part of our cash retention strategy. With that, operator, will you please poll for questions?

Steve, I had a question for you about the PSP program. On the surface, it seems like you instituted this program to help customers on a more tactical basis. But I wonder if you believe there are secular drivers that ultimately may have led you to the PSP kind of program anyway. And do you think—now that you have this program, do you think it becomes a more permanent part of your standard operating model going forward?

Well, going back to when we implemented the program and why we implemented the program, let's revisit that history. The backlog was so strong and constraints were so widespread—As Ganesh mentioned, in his 40-year career and mine, 42-plus-year careers, we have never seen this kind of shortage and constraints in the semiconductor industry. So the question really became how do we take our key customers in various segments, not only automotive but industrial, communications, data centers, and PCs, and allow them some mechanism where they can get preferred supply of parts? It was something in it for them and something in it for us. And the design of that program became this Preferred Supply Program in which we asked that if you could give us 12 months of non-cancelable, non-reschedulable backlog, there would be a tremendous benefit to Microchip. We could buy supplies ahead, hire people, and make capital investments with the assurance of a very, very large, solid, non-cancelable, non-scheduleable backlog—that's a benefit to us. What the customer gets is, after that six-month period—we designed that six-month period because we didn't want to create a lot of churn in the first six months, and there was more availability of capacity after six months—at that point in time, we said if anybody provides a PSP backlog, they will get the preferred supply. If there is any shortage at that time, it will be spread among the non-PSP customers. So it’s a long answer, but that's how the program came about, not knowing what the acceptance would be, and the results have been absolutely tremendous. We have billions of dollars of PSP backlog—44% of the total backlog exceeding the constraints of supply corridors. The PSP backlog is almost equal to 100% of capacity. You can see the advantage where we could go ahead, make those investments, or buy additional equipment. Now, leading to your question, could this become a permanent landscape? I think it will depend largely on the experience of our customers and Microchip together in the year as we progress. When the cycle ends in the other cycle, when there is a lot of capacity available, customers may not be willing to make a year-long commitment that is non-changeable. That's what the customers would be thinking, but the environments go back and forth. Our intent would be to show the customers how well we serve them because they had PSP and what the benefits are if they continue with that program going forward. And I think—let Ganesh comment on that—it’s really going to be how we manage it going forward.

So my view is we're in the early innings of PSP. We've just launched it. It's been a couple of months. It's going extremely well. I think we continue to fine-tune the program. It's too early to tell how long-term it will be. For many customers, they've learned in this cycle that running low on inventory or low on backlog visibility can have extreme impacts on their business. So give it a few more months; let's see how it looks.

A lot of buzzwords and programs the industry develops—some of them last for a short period of time in a cycle or so, and some of them last a very long period of time. I think you're seeing the beginning of the end of the word GIT. The losses in the industry by our customers due to constraints are so large that they have lost more money than all the money they saved for a decade on GIT. That could be the long-term benefit where the industry plans better rather than just in time—give me 50% more, where does it come from and lead times are very long.

When investors look at this extreme level of supply-demand imbalance, their reaction is that this will surely create a hard landing. I’m curious to get your perspective, Ganesh or Steve—will the situation be resolved in an orderly way? When does the industry get back to a more balanced environment? What is your visibility into inventory at your end customers? Just when do we get back to normal, and what does normal look like, or is there a hard or soft landing that you have to go through?

We do not have a line of sight for when things get to be normal. As I mentioned, the gap between demand and supply grew in the March quarter and continues to be quite large. However, we have taken a number of steps to get ahead of whatever change in the cycle will come to soften how that landing will take place. So we just discussed the PSP in quite a bit of detail, and that gives us 12 months of continuous non-cancelable backlog. That will enable us to spot and plan for whenever that change becomes apparent to us on longer-term backlog. The capacity additions we're making—we're not trying to solve the entire gap all in one quarter. We're making measured steps every quarter and improvements over multiple quarters. To the extent we see a change, we will taper off the build plans and capacity additions consistent with that. Third, if you look at our inventory and where you look at our channel inventories, they are at historic lows from the channel perspective and pretty low for us as well. That gives us time and the ability to continue to replenish that inventory. It will help to minimize any under-absorption that might have happened otherwise and positions us well to capitalize on whatever the subsequent up-cycle will be. There is going to be an up-cycle to whatever the next down-cycle brings. When that happens, we can actually push out capital requirements because we replenished some of that inventory. Finally, if and when there is that next hard landing or soft landing, our bonus programs and other variable compensation programs, as you've seen in prior cycles, give us a fair amount of flexibility to mitigate which way our expenses go through the cycles. That flexibility in operating expenses is one more item that helps us in terms of getting to a soft landing.

Congrats on the strong finish to the year. What a difference a year makes. I wanted to ask about your target margin goal of 65% and 42% on gross and operating margin, respectively. It seems to me that you're in the most optimal of conditions to see the achievement of those goals with respect to revenue mix and manufacturing utilization. My question is, is that target a best-case scenario, or is it sustainable over the long term? What revenue level are you looking for to achieve those targets?

We're making good progress towards that. We obviously, from quarter to quarter, can make rapid progress, and sometimes it will be a little slower beyond that. So I wouldn't take last quarter and apply that as how it's going to be every quarter going forward. We just introduced this new model in December, so it's not been that long. We've made a good start here. Conditions are strong for where we're at. We're executing well in the many different areas we outlined for investors as to how we will achieve the gross margins. There are also other pressures. There are cost pressures in some of the materials and input costs as well that we're working through. Operating expenses— we continue to have investments we need to make so that the long-term growth and profitability of the business can be realized. So let's continue to have several more quarters as we go through this. But we feel good about these long-term targets, and we think we're working on the right things operationally, as well as in our business units and our other operating expenses to reach a place where we have a combination of good balance between growth and profitability.

I had a philosophical question. With this kind of a supply-demand environment, is seasonality out the door in the near to midterm? And then I have a follow-up.

So seasonality has been hard for us for many quarters. There hasn't been a normal environment for quite a while. We went through trade and tariff, which was an overriding issue. Then we went through COVID, which was an overriding issue. We're now in this significant demand growth environment. Clearly, there is an underlying seasonality that has contribution, but these externalities are driving a much higher multiplier on that. So for the moment, we don't have clear bearings on seasonality other than directional statements as to where they will be.

And Ganesh, one more for you. With the PSP program, you're seeing tremendous success. Are you seeing that backlog in the PSP program, mostly for the sole-sourced kind of items that are the ones that are mostly very constrained? Is there also a risk that you may lose some of the customers that are not able to commit, or is supply simply that bad that there's no place for these guys to go?

So pretty much just about everything we do is sole-source proprietary products. We don't have a commodity product line that's a big piece of this. Some of our memory products may come closest, and even there, we’re often in very highly protected positions in those sockets as well. The short answer is exactly what you said: There is not another place people can go to get capacity today. In fact, there's a lot more coming to us, trying to find ways in which we can help support them as they flee some of the other suppliers who are not able to provide them capacity in today's environment.

PSP is not an absolute requirement. A customer who does not have visibility into their own business, and does not want to give us a non-cancelable 12-month backlog, can just place normal orders over 12 months, and 90 days of those orders would be from non-cancelable, and after that, they can change it. The only difference is they would not be preferred. If there was strong demand among the PSP customers, then they could get allocated much more harshly. But that doesn't mean that they won't get any part, and they should really go with somebody else. If they go with somebody else, other people are similarly constrained and may not have PSP programs to really help them. So I think there is no reason for loss of business. We're actually gaining business in this environment, having people come from other companies where they cannot get the support.

I've got a two-part question on some of the capacity additions that you spoke of. First, if you could give us some sense of the timing of these capacity additions, we know you're growing CapEx throughout the year, but there are some constraints in getting tools. So when does capacity become available to you? And then secondly, if you are adding this capacity through the year and you're expecting to remain supply-constrained with, I guess, some visibility from the PSP program, is there any reason why your revenue wouldn't just continue to grow sequentially as we go through the end of the calendar year?

So firstly, on the capacity additions, they are happening. There's not a single discrete event when it happens. It’s happening every month, every quarter. We have equipment on order, we have materials on order, we’re hiring people—there are multiple activities that are all in place to facilitate it. It will be a continuous process through the year. Sometimes we experience delays on equipment. Sometimes we are able to get the equipment on time we hoped for. That’s how we see it for the rest of the year, and therefore, we are expecting that our capacity will be higher than the prior quarter, which should give us the ability to have continued growth as we go into the second half of this year.

Steve, I had a follow-up question on the capital allocation. That's a substantial increase on dividends over the last couple of quarters. What's the rate we're seeing until you get to the net leverage that you're targeting? And then longer-term, what are your thoughts on dividends versus buybacks? Any color or thoughts you could share on that would be helpful. I had a quick follow-up on PSP, Ganesh. How do you hedge for—the pricing is set earlier on when the customers are committing to this—how do you hedge for the cost side of it when costs go up unplanned? So just help us understand that factor as well.

Let me take the capital allocation part of that, and then Ganesh will cover the pricing on the PSP backlog. We have internally had discussions with the Board on what happens now until we receive an investment grade rating and what happens after as we bring the stock buyback into the mix. But we’re not prepared to dollarize that for you well into the future regarding how much stock buyback and how much dividend, and when does it start, and all that. So I think it's directionally the Board is committed to continue to increase dividends every quarter. Then, as we get to that investment grade rating, we will add stock buyback into the mix. What that mix would be could also change from time to time depending on market conditions and stock price and all that. So it’s not all figured out for the next five years. There have been some discussions, and I think we will continue to advise you every quarter as we make further decisions.

Ambrish, on your PSP question, the PSP is a priority for capacity. It is not a guarantee of price, and we will not be just making price changes without good reasons. If there are input costs that are unexpected that need to be passed on, PSP backlog can receive price changes at that point in time. We’re not anticipating that it needs to happen. Nothing in the PSP backlog precludes price adjustments if there are significant cost increases.

With the current backlog—the PSP backlog—it paints a pretty good picture for demand, and based on that, combined with your current booking trends, how far above your current supply capabilities is overall demand trending? Is it 20% higher, is it 30% higher? Given the strong demand trends, it seems like you and your distribution partners are building and buying products and immediately shipping them out. Given that and despite your capacity increases, do you anticipate your days of inventory and distributor inventories declining again in the June quarter?

Firstly, to give you a sense of what our unsupported demand in a given quarter looks like, a quarter ago, we had said we have 30% more that we could be shipping than we are planning to ship, and that number has since grown to over 40% that we could be shipping. So that's what we meant earlier as—as we add capacity, demand grows even faster. A significant amount of unsupported demand exists in each quarter. Every quarter, we ship a little more, and we squeeze a portion of it out into subsequent quarters. Was there a second part of the question?

Yes, he was asking about what our expectations were for distribution inventory. That's very difficult to forecast. It went down four days last quarter. Distribution inventory is at record lows. What we're shipping in, they're shipping out right away to meet their customers’ demand. So, I don't anticipate it going up, but it’s at very, very low historic levels, so I don't anticipate a large change.

I've got a two-part question that speaks to the supply-demand imbalance that both Steve and Ganesh have talked about. I'm just kind of curious, on the supply side, we've seen a significant amount of consolidation in the semiconductor industry over the last decade. You guys have been a big driver of that. I’m wondering, Steve or Ganesh, if you can comment on how that's impacting both yours and the industry's ability to actually grow supply? On the demand side, I'm just kind of curious—typically when your demand is this strong, we're usually in an economy that's firing on all cylinders, and yet we still have an economic backdrop that’s probably best described as under potential. If we go into the back half of the year, Steve, when we start to see a macro recovery, is there a real risk that supply shortages actually accelerate even further? Why not get ahead of that with even more CapEx?

Let me start on the supply side. If you look at our eight to ten years of acquisitions that we have done and the consolidations from our perspective, the percentage of what we build—particularly from a fab standpoint—internal versus external has changed. We used to have a higher percentage of it in-house. We're now down to about 39% of it being in-house, and the balance is with foundries. We have a higher degree of control and ability to influence the capacity that we build in-house than we do from a foundry standpoint. In that sense, that has changed over this period. It has never been an issue until this cycle where the imbalance has been so large that the instantaneous response from the foundry has been difficult. A high percentage of what Microchip does through foundry is what foundry would consider to be the trailing edge of capacity they have. That has also not been where all their investments have gone. They're making some but the majority of the investments have been in leading edge, which is where not a lot of our capacity requirements are. Packaging and testing, we've been able to do more in-house, and we've reported on the increases. We’re now into the mid-50s as a percentage of our packaging that had been as low as in the high 30s and low 40s. So there, as we can, we're going as fast as we can. We are looking at our capital investments—what we need to be doing, and a bit of this is finding the right mix between stepping on the accelerator where we have high confidence. The PSP backlog, for example, gives us high confidence, and being a little more thoughtful where we have the risk of putting a lot of capital in place, and then having under-absorbed capacity. That’s always a judgment call we make every month, every quarter on what our capital posture should be. We could yet change and have an increased capital posture in the second half of this year if that demand imbalance continues to persist.

I want to add some thoughts on the macro side of your question. So, John, what happened last year was that the biggest destruction of demand primarily occurred on the service side: hospitality, hotels, airlines, travel, restaurants, golf courses. The service side of the industry was decimated last year because of social distancing and all that. The manufacturing side didn’t perform too badly. There was not a single quarter where our revenue even went down by 10%. Most companies in the technology and manufacturing industry did reasonably well. Automotive was really bad for one quarter, but overall, it wasn't too bad. Now, looking at the recovery side of it, a fair amount of recovery is likely to take place on the service side, which was heavily impacted—restaurants, hotels, airlines, travel, vacationers, cruise lines, and all that coming back. When they come back, and people have more money in their pockets with more jobs, certainly some of that money will flow to electronics and cars and other things where our product goes, and we will benefit from this trend. But the grasp of the surge is really going to come from the service side. Given this strong demand situation, as you mentioned, when the economy picks up further steam with all these people coming back on the job, could it get even hotter? The answer is definitely possible. But the other part of your question is why not add more capital now? Well, we can't get it. We have so much capital on order and lead time is long. Some of the scheduled capital gets delayed by a month with short notice because the supplier is also constrained. It's not just what you can order; we're willing to order more. It's a question of what you can get. We can't get everything we want.

Ganesh, you talked about higher utilization rates and gross margins in the quarter. I'm curious what you saw from a pricing perspective in March relative to December. I was a little surprised at how fast you were able to grow your microcontroller business and analog business on a sequential basis. I'm guessing pricing played a role. If you could speak to that, that would be super helpful. Separately, assuming you guys manage to execute on the CapEx that you have planned for the year, where do you see your internal capacity exiting the fiscal year versus where it is today?

On the pricing front, we announced and did raise prices in the March quarter. It wasn't in place for the entire quarter, but it was in place for a good amount of that quarter. Not all prices changed at the same time—contractual requirements, different product lines and different things—but prices go up. With that, we also had costs go up that we were trying to offset with the price increases. We continue to see increases coming through our supply chain. So we think the price increases contributed some but were really not the major part of what drove our growth in the March quarter. Do you want to take the second part, Eric?

The second part was about what our internal capacity can do in fiscal '22, which we’re just entering. I don't expect the fab mix to be much different. Last year, in the year we just finished, we did 39% of our fab internally. I don't expect that mix to change. For fiscal '21, we did 53% of our assembly and 57% of our test in-house. Those percentages should go up as we're continuing to invest and bring some more capacity internally. I don't have a specific number for the end of the year— it depends on the demand environment and how quickly we can respond with the CapEx.

Some of the internal capacity takes time as it comes through, and it may have an ongoing impact as we go into the next fiscal year.

My question wasn't so much on the mix exiting the year. But again, assuming you guys do get all the tools that you're asking for and you manage to spend $250 million, how much higher could your internal capacity be in 12 months? Is it 10%, 20%? A rough ballpark number would be super helpful.

I don't think that's a number we're willing to disclose. As Ganesh says, it takes time for that capacity to come on board at different stages. Something in fab is going to take longer than it might in assembly or test, and we're not providing revenue guidance outside of the current quarter.

There are too many corridors of capacity, both internally and externally, by process, by wafer size, by technology complexity. Somewhere, the capacity is being added; the other capacity is not being added. To roll all this into just a general number for capacity increases is complex—I'm not willing to share that.

Just briefly, I know you mentioned shortages. Could you give us an idea of which segment you're seeing the highest shortages? Where are things starting to get to more normalize in terms of lead times?

I think if you listen to the media, you would think that automotive is the only place where there are shortages; clearly, they've been the most vocal. Shortages are in every single segment taking place to varying degrees, and we do not see any segment starting to come back to some form of equilibrium. Shortages are present and growing imbalances in every market segment we're in.

I know you mentioned very strong backlog orders as you look at the June quarter here. Wondering as you look into the back half, in terms of calendar Q3 and out—are you expecting a better-than-seasonal outlook given how strong demand is and the pretty strong sign-up on the PSP side as well?

We talked earlier about seasonality. Right now, our revenue is not limited by the demand side of the equation. Seasonality speaks to where the demand is and how it comes about. Our growth at this point is limited by how much we can manufacture and ship, and that's where all hands are on deck. Thus, seasonality isn't as meaningful in the current environment.

I had a question on data centers and communications—that's been an area that's been consolidating for several quarters. Just want to get a sense of what you're seeing in that market and if there's any visibility as to how you think it will trend as we go through the year.

We're not trying to provide guidance on how those will do by market segment as we go through the year. In the December quarter, we indicated it seems to have bottomed out, and that held true for the March quarter, with a slight bit of improvement from there. We're quite optimistic about the data center segment, in particular, as we look into fiscal year '22. The communication sector has its own set of infrastructure rollouts that are taking place, but that's about as much as we're able to provide. We don’t track at the level of specificity with exact numbers—we have more of a directional statement.

This is Denis here asking a question for Raji. I was wondering if you could speak about as far as these component supply constraints go up, which end markets are currently doing the best in terms of having some inventory available? What proportion of these constraints is on the front end or the back end?

There is no— as I said earlier, there is no end market with available supply that's any better. They're all constrained to varying degrees. We have constraints in both internal and external factories, in the back end and front end of the material supply chain. Depending on what exact combination, what capacity corridor you're in, there might be more constraints and maybe less constrained, but they are all constrained.

Maybe a follow-up on the thoughts you shared, Steve, earlier. What changes do you foresee in the level of inventories that the industry needs to hold? Who in the supply chain is going to be forced to carry more inventory if that's the case, and who is going to foot the bill for these higher inventories? If you could talk around that, how you see that, that would be great.

Let me take a shot at that, and Steve may want to add to this as well. I think what inventory people need to carry is going to have to be determined by the ultimate end market equipment manufacturers, the OEMs. I think it can be very different in different product lines. When you build an $80,000 car and you're constrained by $10 of semiconductor content, the decision you may arrive at could be different from when you're building a $200 consumer product. Each industry, depending on the value of the product they're creating and the profitability of that industry, has to decide based on their experience what inventory level they need to assure themselves of the value of the product they’re trying to ship. Those answers are going to be different. Some got burned quite badly, and I suspect they will be the ones that want to do the most here. But there is not a single answer that comes with it. The manufacturer, the original equipment manufacturer, will foot the bill and more than likely pass that on in terms of what they're building to their end customer to the extent that they can. If the choice is to invest in inventory that is two to three orders of magnitude less than the value of the product they’re creating, many will have to rethink what just-in-time makes sense for them.

I don't have much to add, but I would say that if you look at some of the Japanese car manufacturers, they did much better this time around because they learned their lesson during the tsunami when a lot of the renaissance and other factories were shut down due to earthquakes, and radiation impacted them. They learned from that time and built a structure where they were not as reliant on just-in-time and arrived at the current time with a level of inventory on semiconductor parts, which allowed them to perform better. That is a lesson the US and European auto manufacturers need to learn. Time will tell when the cycle shifts; if it's lost, it's just the same standoff. I don't know. They have to rethink how building semiconductors is different than getting a bent metal for a doorknob. We sometimes hear comments that are laughable, such as what's the big deal about lead frame—just bend the metal and make my parts. It's simply not that simple. Building semiconductors is different. We don’t directly ship parts to car manufacturers. We have people like Contis, GenTechs, Aptiv, and Hella in between. They are the buffers.

A positive step is many of the carmakers have been at the forefront of embracing a PSP program and requiring the Tier 1s to participate. At least for the moment, we can see how we're trying to drive towards having a level of inventory that reassures them they can build their very expensive or highly valuable end products. How that will persist a year or two from now remains to be seen.

It's a little more open-ended here, but, Ganesh, you said in 40 years, you haven't seen a supply-demand imbalance as acute as this one. Steve, you may want to chime in here as well. Can you talk about maybe something that was similar—the number two or number three most acute time—and are there any analogies to this? How did that eventually unwind to create a balance?

All cycles eventually come to an end as the participants in the battlefield work on adjusting to the situation. In past cycles, semiconductor companies put in additional capacity and began to align their self-interests to grow. The sharpest rebound was probably 2008–2009. Again, we were extremely fortunate at that time because we did not shut down our factories and continued running our factories, growing our inventory. However, not all players did that. It’s led to dislocations. Steve, would you like to add?

In 2008 and 2009, we didn’t close our factories, although we had some rotating time off. We entered the upcycle with a good amount of inventory. We didn't replicate that this time because we had very high debt leverage, which prevented us from choosing to invest in inventory and keep our factories running. Last year, investor concerns arose about what would happen if your demand dropped by 35%—would you miss the covenant? Sometimes memories can be short. This environment presents different challenges, so we are unable to replicate the experience of 2009 and are now trying to build our inventory without success since we are shipping as we build. Some customers express demand that leads them to order a bit more than needed, which we can't specifically track or detect; if that’s what you call double ordering, there is some excess ordering by customers we can’t confirm. But we are in daily phone calls and escalation meetings with many customers who threaten or experience line downs. No one is receiving their full demands, and everyone gets only a fraction of what they need. That leaves ample runway ahead with such high demand, likely throughout the rest of the fiscal year. We're simply trying to get our heads above water.

Unlike prior cycles, we have non-cancelable windows that are significantly longer than we have had in other cycles, putting a lot more responsibility on the customer to have orders they need—not orders they don't need.

Let me ask another question. Just, Eric, on the target model: I'm curious about the gross margin line. The impressive part has been the incremental margins you’ve been able to put up over the past six to eight quarters—on quarters with sequential growth, incremental gross margins have hovered around the 80% mark. Was there anything unusual that drove such high incremental gross margins, and where should we consider that going forward?

There are a couple of things to mention. In recent quarters, significant underutilization charges have basically vanished. Those costs are now being capitalized to inventory. We're running our factories fuller, so those costs are gone. We had a large acquisition in Microsemi that we were integrating over that timeframe, and we found ways to improve margins on the acquired business. Those are the two main points I would highlight. Steve or Ganesh, do you have anything to add?

The only other thing I’d add is that we continuously add value to many of our products through a combination of hardware and software, making them more valuable which improves gross margins. As we arrive at a weighted average of all these products and consider what we’re doing to enhance their value, it ultimately reflects positively in the aggregate gross margin.

We want to thank everyone for taking the time to join us. We do have investor meetings coming up that we look forward to. But have a good afternoon. Thank you.