Microchip Technology Inc (MCHP) — Q2 2023 Earnings Call Transcript

Is a record $814.4 million. Non-GAAP earnings per diluted share was a record $1.46 and at the high end of our guidance range. On a GAAP basis in the September quarter, gross margins were a record at 67.4%. Total operating expenses were $642.8 million and included acquisition intangible amortization of $167.5 million, special charges of $4.3 million, $3.2 million of acquisition-related and other costs, and share-based compensation of $34.8 million. GAAP net income was a record $546.2 million resulting in a record $0.98 in earnings per diluted share and was adversely impacted by a $2.1 million loss on debt settlement associated with our convertible debt refinancing activities. Our September quarter GAAP tax expense was impacted by a variety of factors, notably the tax expense recorded as a result of the capitalization of R&D expenses for tax purposes. Our non-GAAP cash tax rate was 11.2% in the September quarter. We now expect our non-GAAP cash tax rate for fiscal '23 to be between 9.8% and 10.8%, 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. This is modestly higher than our previous forecast as we have refined our tax calculations for the year. A reminder of what we communicated last quarter, our fiscal '23 cash tax rate is higher than our fiscal '22 tax rate for a variety of factors, including lower availability of tax attributes such as net operating losses and tax credits as well as the impact of current tax rules requiring the capitalization of R&D expenses for tax purposes. There appears to be some momentum for the tax rules requiring companies to capitalize R&D expenses to be pushed out or repealed. If this were to happen, we would anticipate about a 300 basis point favorable adjustment to Microchip's tax rate in fiscal year 2023. Our inventory balance at September 30, 2022, was $1.03 billion. We had 139 days of inventory at the end of the September quarter which was up 12 days from the prior quarter's level. We have increased our raw materials inventory to protect our internal manufacturing supply lines. We are carrying higher work in progress to maximize the utilization of constrained equipment as well as to position ourselves to take advantage of new equipment installations which will relieve bottlenecks. We are investing and building inventory for long-life, high-margin products whose manufacturing capacity is being ended of life by our supply chain partners. We need to ensure that our supply lines can feed growth beyond what we expect in the December 2022 and March 2023 quarters, and our reported days of inventory are a backward-looking indicator. As gross margins rise, the effective days of inventory for the same physical inventory rise and with every 100 basis points of gross margin growth, it creates approximately three incremental days of inventory. Inventory days at our distributors in the September quarter was at 19 days which was flat to the prior quarter's level. With distribution inventory still being low, we will be carrying higher inventory at Microchip to ensure we can serve our customers. In the September quarter, we repurchased $36.9 million of principal value of our 2025 and 2027 convertible subordinated notes for cash and we also paid cash for the value of these bonds above the principal amount which was an additional $60 million. We used cash generation during the quarter to fund the amount of the convertible debt repurchases, and we believe that these transactions will benefit stockholders by reducing share count dilution to the extent our stock price appreciates over time. The principal amount of convertible debt on our balance sheet at September 30 was $766.6 million. This includes $665.5 million of convertible bonds maturing in November of 2024 with the cap call option in place that offsets any potential dilution from these convertibles up to stock prices of $116.15. At the beginning of calendar year 2020, Microchip had $4.481 billion of convertible bonds outstanding. So today, our overall capital structure is in a much better long-term position. Our cash flow from operating activities was $793.2 million in the September quarter. Our free cash flow was $682.9 million and 32.9% of net sales. As of September 30, our consolidated cash and total investment position was $306.8 million. We paid down $264.9 million of total debt in the September quarter and our net debt was reduced by $192.6 million. Over the last 17 full quarters since we closed the Microsemi acquisition and incurred over $8 billion in debt to do so, we have paid down almost $5.5 billion of debt and continue to allocate substantially all our excess cash beyond dividends and stock buyback to bring down this debt. Our adjusted EBITDA in the September quarter was a record at $1.056 billion and 50.9% of net sales. Our trailing 12-month adjusted EBITDA was also a record at $3.814 billion. Our net debt to adjusted EBITDA was $1.84 at September 30, 2022, down from 2.05 at June 30, 2022 and down from 3.0 at September 30, 2021. Capital expenditures were $110.3 million in the September quarter. Our expectation for capital expenditures for fiscal year 2023 is between $500 million and $550 million as we continue to take actions to support the growth of our business and the ramp of our manufacturing operations. We continue to prudently add capital equipment to maintain, grow and operate our internal manufacturing operations to support the expected long-term growth of our business. We expect these capital investments will bring gross margin improvement to our business and give us increased control over our production during periods of industry-wide constraints. Depreciation expense in the September quarter was $63.6 million. I will now turn it over to Ganesh to give his comments on the performance of the business in the September quarter as well as our guidance for the December quarter. Ganesh?

Thank you, Eric, and good afternoon, everyone. Our September quarter results continued to be strong, driven by our disciplined execution and our resilient end markets. Net sales grew 5.6% sequentially and 25.7% on a year-over-year basis to achieve another all-time record at $2.07 billion. While we don't normally provide information on a distribution sell-through basis which we refer to as end market demand, we are providing information this quarter to give investors some insight into consumption. September quarter end market demand grew sequentially at about the same rate as our GAAP net sales which is based on sell-in recognition. The September quarter was our eighth consecutive quarter where we achieved a net sales record and the first time we have ever crossed the $8 billion annualized net sales mark. Non-GAAP gross margin came in at the high end of our guidance at a record 67.7%, up 64 basis points from the June quarter and up 244 basis points from the year-ago quarter. Non-GAAP operating margin came in well above the high end of our guidance at a record 46.9%, up 127 basis points from the June quarter and up 438 basis points from the year-ago quarter. Due to a rapid increase in net sales over the last two years, operating expenses at 20.9% were about 160 basis points below the low end of our long-term model range of 22.5% to 23.5%. Our long-term operating expense model will continue to guide our investment actions to drive the long-term growth, profitability and durability of our business. Our consolidated non-GAAP diluted EPS was a record $1.46 per share, up 36.4% from the year-ago quarter and at the high end of our guidance. Adjusted EBITDA at 50.9% of net sales and free cash flow at 32.9% of net sales were both very strong in the September quarter, continuing to demonstrate the robust cash generation capabilities of our business. Net debt declined by $192.6 million, driving our net leverage ratio down to 1.84x, exiting the September quarter. During the September quarter, we returned $413.3 million to shareholders in dividends and share repurchases, representing 57.5% of the prior quarter's free cash flow. I would like to take this opportunity to thank all our stakeholders who enabled us to achieve these outstanding results, and especially thank the worldwide Microchip team for their continued efforts during challenging times to deliver results for our customers despite a large and persistent imbalance between supply and demand. Taking a look at our net sales from a product line perspective, our Microcontroller net sales were sequentially up 11% as compared to the June quarter and set another all-time record. On a year-over-year basis, our September quarter microcontroller net sales were up 31.9%, and microcontrollers represented 56.9% of our net sales in the September quarter. Our analog net sales sequentially decreased 1.3% in the September quarter. On a year-over-year basis, our September quarter analog net sales were up 16.6%, and analog represented 27.6% of our net sales in the September quarter. As we mentioned last quarter, there are quarter-to-quarter differences in supply constraints which can cause differences in net sales growth by product line. If you compare the trailing four-quarter net sales growth performance versus the prior four quarters for our analog and microcontroller product lines, the growth rates are almost exactly the same. In the September quarter, our technology licensing net sales achieved a new record. Business conditions continue to be strong as viewed through our internal indicators. Demand continued to be strong despite the capacity increases we have been implementing for some time now. As a result, our unsupported backlog, which represents backlog customers wanted shipped to them in the September quarter but which we could not deliver in the September quarter, climbed again. And we exited the September quarter with our highest unsupported backlog ever, with unsupported backlog well above the actual net sales we achieved. We are working hard to reduce our unsupported backlog to more manageable levels and expect to do so in the coming quarters but also expect to remain supply constrained through the rest of 2022 and well into 2023. We are, of course, cognizant of the weakening macro conditions resulting from rising inflation and interest rates and are monitoring such conditions closely. We're also aware that there is some inventory build at our customers, as can be seen in their balance sheets. Some of this, we believe, is due to strategic buffer inventory builds arising from the learnings of the last two years and some of this is due to the incomplete kits of the infamous golden screw effect. While we have seen an increase in requests to push out or cancel backlog, these requests remain a very small fraction of the very large backlog we have over multiple quarters and hence, they have not had a material impact on our business. We believe there are three reasons why Microchip's business is demonstrating more resilience in the midst of the weakness seen by some of the other semiconductor companies. First, on the demand side, the industrial, automotive, aerospace and defense, data center and communications infrastructure end markets which make up 86% of our net sales remain strong. The consumer end market, which is about 14% of our net sales, is experiencing some weakness but is dominated by home appliances. And home appliances are more resilient than other consumer markets as a high percentage of demand comes from replacements for appliances which have broken down and must be replaced. Hence, our demand is quite durable because of the end market mix we have consciously gravitated towards over the years. Second, on the supply side, a vast majority of our products are built on specialized technologies requiring trailing edge capacity. This is the capacity that has been most constrained over the last two years, which still remains constrained and where there was the least opportunity to overship consumption. And last but not least, our laser focus on organic growth through total system solutions and higher-growth megatrends for multiple years is giving us increased design win momentum and a resultant revenue tailwind. Given the crosscurrents of strong internal business indicators and some uncertainty in the macro environment, we have modeled a range of potential scenarios and are closely monitoring various indicators which should enable us to take deliberate action when we feel it's appropriate. Our goal is to deliver a soft landing for our business if or when there is a softer macro environment catching up with it. The playbook we shared with you last quarter for how we will deal with the macro slowdown remains unchanged. If you study Microchip's peak-to-trough performance through the business cycles over the last 15 years, you will observe our robust and consistent cash generation, gross margin and operating margin results. The investor presentation posted on our IR website provides details about our performance through the business cycles. If or when there is a macro slowdown and that impacts our business, we expect our cash generation, gross margin and operating margin to once again demonstrate consistency and resiliency. This will help us continue to execute our long-term Microchip 3.0 strategy and help insulate it from whatever short-term market challenges there may be. While we are seeing some loosening of constraints in our supply chain, we continue to have several internal and external capacity corridors that remain very constrained. We are continuing with our carefully calibrated capacity increases seeking to serve what we believe is a long-term consumption growth. We believe our calibrated increase in capital spending will enable us to capitalize on growth opportunities, serve our customers, increase our market share, improve our gross margins and give us more control over our destiny, especially for specialized trailing edge technologies. As you may have seen, Microchip has expressed its view that the recently approved CHIPS Act is good for the semiconductor industry and for America that enables critical investments which will even the global playing field for U.S. companies while being strategically important for our economic and national security. For a very long time, an important component of our business strategy has been to own and operate a substantial portion of our manufacturing resources, including wafer fabrication facilities in the U.S. This strategy enables us to maintain a high level of manufacturing control, resulting in us being one of the lowest-cost producers in the embedded control industry. In light of this strategy and potential grant funding from the CHIPS Act, the investment tax credit provision as well as state and local grants and subsidies, Microchip is in the early stages of considering a 300-millimeter U.S.-based fab for specialized trailing edge technologies. This fab project, if we decide to pursue it, would be intended to provide competitive growth capacity as well as geographic and geopolitical diversification. The availability of grants, subsidies and other incentives will all be important considerations in our analysis and will also help determine the location and timing for the fab. Now let's get into the guidance for the December quarter. Our backlog for the December quarter is strong and we have more capacity improvements coming into effect. Taking all the factors we have discussed on the call today into consideration, we expect our net sales for the December quarter to be up between 3% and 5% sequentially. We also expect our net sales based on end market demand to grow at about the same growth as our GAAP net sales. And further, we expect sequential net sales growth again in the March quarter. At the midpoint of our net sales guidance, our year-over-year growth for the December quarter would be a strong 22.7%. We expect our non-GAAP gross margin to be between 67.8% and 68% of sales. We expect non-GAAP operating expenses to be between 20.7% and 20.9% of sales. We expect non-GAAP operating profit to be between 46.9% and 47.3% of sales. And we expect our non-GAAP diluted earnings per share to be between $1.54 per share and $1.56 per share. At the midpoint of our EPS guidance, our year-over-year growth for the December quarter would be a strong 29.2%. Finally, as you can see from our September quarter results and our December quarter guidance, our Microchip 3.0 strategy which we launched a year ago is firing on all cylinders, as we continue to build and improve what we believe is one of the most diversified, defensible, high-growth, high-margin, high cash-generating businesses in the semiconductor industry. Let me now pass the baton to Steve to talk more about our cash return to shareholders.

Thank you, Ganesh, and good afternoon, everyone. I would like to reflect on our financial results announced today and provide you further updates on our cash return strategy. Reflecting on our financial results, I continue to be very proud of all employees of Microchip that have delivered another exceptional quarter while making new records in many respects, namely record net sales, record non-GAAP gross margin percentage, record non-GAAP operating margin percentage, record non-GAAP EPS and record adjusted EBITDA and all of that in a very challenging supply environment. The Board of Directors announced an increase in the dividend of 9% from last quarter to $0.328 per share. This is an increase of 41.4% from the year-ago quarter. During the last quarter, we purchased $247.2 million of our stock in the open market. We also paid out $166.1 million in dividends. Thus, the total cash return was $413.3 million. This amount was 57.5% of our actual free cash flow of $718.5 million during the June 2022 quarter. Our paydown of debt as well as record adjusted EBITDA drove down our net leverage at the end of September 2022 quarter to 1.84 from 2.05 at the end of June. Ever since we achieved an investment-grade rating for our debt in November of 2021 and pivoted to increasing our capital return to shareholders, we have returned $1.457 billion to shareholders through September 30, 2022, by a combination of dividends and share buybacks. In the December quarter, we will use the September quarter's actual free cash flow of $682.9 million and plan to return 60% or $409.7 million of that amount to our shareholders. Of this $409.7 million, the dividend is expected to be approximately $181 million, and the stock buyback is expected to be approximately $22.7 million. With that, operator, will you please poll for questions?

It’s very appreciated that you put the investor slide deck where you talk about the playbook and the scenarios and you’ve talked about the playbook. But I just can’t help ask this question because weakness is rampant. It’s everywhere. Many of your diversified peers have talked about weakness. Just kind of help us understand, the big concern I have is the longer the lead time stays stressed out, the higher the possibility of a harder landing. So just kind of help us understand, how are you managing the soft landing that you have addressed a few times but I just wanted to readdress that issue, if you could, please.

Sure. So it starts with having high-quality backlog. And PSP being a high percentage of our backlog, well over 50%, is the highest-quality backlog. It is noncancelable. It's customers who have put time into making a commitment to be noncancelable, and that is always going to have far more thought that goes into it. It starts also with the supply side where we are making calibrated investments every quarter. We're not trying to go satisfy all the demand that's out there. And our lead times are long, but they've also, in specific areas, started to improve. And that helps with customers who have visibility out in time. And then the end market exposure we have is another huge benefit to us, right? Most of these customers in these end markets are not in volatile markets where things can go up and down in short order. They're looking at the long term. They're looking at demand that is far more durable. And you put all that together, and we feel we have a model that is outperforming, and for those reasons, from a market standpoint, supply standpoint, and what we have done for ourselves in terms of total system solutions and the mega trends we're focused on and the design-in activity that we have pursued.

Okay. Just a quick follow-up. Where are the lead times now on the product line? I know it is very diverse, but what percentage of lead times have decreased versus staying at 52-plus weeks?

The lead times are all over the place. We have some lead times which are as low as 4 to 8 weeks. We have a lot of them which are at 26 to 52 weeks. It's corridor by corridor, product by product, where the constraints are, right? We go to work every day trying to improve it. And as long as supply improves, we're able to do that. Demand remains still strong. So there’s not a single number I can give you or a single percentage that I can say, 'Hey, this is what the lead times are at.' But most importantly, it’s not just the lead times, it’s also how strong the demand is. And you can see with some of the end market data that we provide you the information on the growth, right? The end market growth is keeping pace with what we’re shipping on a GAAP basis.

For the first one, it’s very interesting you’re considering a 300-millimeter fab. I was wondering what is driving that decision? What kind of CapEx will it require? Will it have any impact on your dividend or buyback philosophy? And does it mean you will bring back some of what you’re giving to external foundries inside the company? Just any more color on the 300-millimeter fab. I appreciate it’s probably still in early stages of discussion.

Yes. So you should look at it as it's a very strategic thought process and decision for us. It's something we think about over a 20-year-plus time frame of what it will do for us. Not unlike how when we bought our Gresham fab just about 20 years ago, right? It was a long-term investment that we made. We have many processes that are at 300 millimeters that our candidates. We have some specific ones we would look at as the early ones we bring in. But I wouldn't look at it as necessarily just bringing all the stuff inside as much as, as we grow, we would have additional places where it can grow. This investment will happen over multiple years. It will be largely within the range of the CapEx that we have provided and that we do not expect it to have either an impact on our dividend or our share buyback or anything else with where we're at.

For my follow-up, Ganesh, you mentioned that one reason for the strength could be that some customers are building buffer inventory. I'm curious how advanced they are in that process and whether this just pulls forward their demand from future quarters. Everyone is trying to understand that in most previous downturns, Microchip was always the first to indicate when macro conditions weakened. This time, conditions are weakening, and all your competitors are saying that, yet you aren't seeing it. So what has changed compared to your analog industrial peers? I can understand the consumer aspect, but what’s different from your peers who are also involved in the same automotive and industrial markets? Are you there?

We're back. Vivek, if you're still on, we didn't get the entirety of your question. Would you repeat your question, please?

Yes. So basically, what I asked, Ganesh, was that you mentioned customers are building buffer inventory. I was just wondering how far along they are in that process. And in general, if you contrast Microchip today, versus in prior downturns, right, when you had a somewhat similar mix of products, the company was always the first to see the downturn but you’re not seeing it now. So I was curious what is the difference between the old Microchip versus the new Microchip.

Sure. So let me answer the second one first. If you look at the old Microchip, we had more exposure to markets that perhaps are more volatile, right? We didn't have the same aerospace and defense, data center infrastructure. We weren't as high in industrial and automotive. And those are far more durable, right? We had a much higher consumer exposure if you go back 10 years or the financial crisis in that timeframe. So that has changed to where we can see the customer and their end market demand as being far more durable today than it was in history. On your first question about what about the buffer. I think the amount that's being built is small because we're not able to ship, right? I mean we're constrained in our ability to service all this backlog that is unsupported. But anecdotally, are there going to be some customers who are building in? Yes, we're sure there is some of that. But we still think it's small. And mostly, it is in the markets where there's a very large multiplier for the OEMs end product as compared to the value of the semiconductors that they're carrying.

My first question is directed toward either Steve or Ganesh. You have shown confidence in providing growth projections through March, which is quite impressive given the current environment. Do you think this confidence and visibility stem from your strict NCNR policy? Are you perhaps focusing on managing inventories and keeping them tight? Is there something else operationally that sets you apart and influences your confidence compared to others in the industry? What distinguishes your approach?

So firstly, we have confidence both on the demand side as well as the improving supply that we're making. But let me put it in perspective, right? Even if we accepted 100% of all the cancellation and pushout requests of noncancelable backlog, this factor alone would not have changed our September quarter results, our December quarter guidance, and we would remain poised to grow sequentially again in March. So don't assume that it's the non-cancelability that is somehow propping us up.

It started 1.5 years ago when capacity was limited across all areas, including trailing edge, leading edge, and mid-range. In recent quarters, demand from personal computers and cell phones, which are major consumers of semiconductors, has shifted as the production of leading-edge technology processors and high-end cellular chips has become less restricted. Consequently, if one needs capacity for 7-nanometer, 10-nanometer, or 14-nanometer processes, it is readily available. However, trailing-edge capacity remains highly constrained. We have developed some internal capacity and also acquired additional capacity from foundries, but we face constraints in both areas. Internally, we have not received all the equipment we required, and many deliveries have been delayed by several months or even quarters because suppliers could not obtain semiconductors for their components. As a result, our internal products continue to face limitations across multiple sectors, and the external capacity we purchase is similarly affected. We anticipate that trailing-edge capacity will remain constrained well into 2023.

I would like to add that for a 300-millimeter fab, if we were to start construction tomorrow, it would take over four years before that facility begins to ramp up production. These are not decisions we make quickly; we consider them over multiple cycles, focusing on long-term growth and our future capabilities.

In response to the previous question about backlog and our resilience compared to earlier cycles, I would like to make a couple of points. First, as Ganesh mentioned, our end market mix today is significantly different from when we were first identified as an early indicator of market changes. Additionally, I want to emphasize that our PSP backlog consists of high-quality commitments. When a customer commits to a noncancelable, non-reschedulable backlog for 12 months or, in some cases, 18 months or longer, it involves considerable thought and is not just a casual order. The decision-making process for placing that backlog goes through a higher level of approval, ensuring its quality. Customers are unlikely to place double orders because they know these commitments cannot be canceled. Despite receiving a few scattered cancellation requests, as Ganesh pointed out, these would have no significant impact on our September, December, or March outlook since they represent a very small percentage. Many investors and analysts may believe that PSP is at risk due to inventory buildups and cancellations, but I believe that perspective is misguided.

You mentioned PSP is more than half of backlog, but can you talk about how much of the September revenue is moving inside of PSP? And maybe, Steve, I know that you just made some comments about some requests for changes within PSP. It sounds like they’re still pretty small. But I guess, can you also just double click on the comment you just made because PSP doesn’t really change demand. I mean, to a certain degree, you just put product to customers that might not need it because they committed to it 6 to 12 months ago. So can you just kind of talk through that and then maybe answer the question about how much revenue is moving inside of PSP.

So firstly, in a given quarter, by the time we get to that quarter, it's an overwhelming percentage of what we ship in that quarter. That's what customers who place backlog back in time receive priority for it, expect. And that's what we give them. And so further out in time, there is more space, and new backlog can come in and fill it out. But near term, like what just happened in September or what is going to happen in December, has a very, very high percentage of it that is PSP backlog that is being fulfilled. Let me reiterate the point Steve made and which I made a little bit earlier on. PSP backlog is the highest-quality backlog there is. We make noncancelable commitments to our suppliers, and we don't make them lightly because there is a financial commitment that is required to have enough scrutiny. Similarly, our customers have significant scrutiny when they're trying to make commitments. They don't try to get excess capacity order from us. They, in fact, will try to undershoot so that they can actually hit it. So I want you to take from this that PSP backlog is the highest-quality backlog. We have far more cancellations and request on non-PSP, but PSP backlog is very high quality.

And even outside PSP, I want to note that our standard cancellation window is 90 days. So when we enter a quarter, really, everything that's on books for the quarter is noncancelable, whether it's PSP or not.

You should also think that when we took the PSP backlog and for the last 1.5 years, in the middle of extreme constraints, we made a choice to ship to the PSP customers and not ship to the non-PSP customers. All the non-PSP customers are not low-quality customers. Some of them are very good customers, but their business is such that they cannot make a 1-year commitment, so they were non-PSP customers. They got very little product. So we made a choice to prioritize giving it to PSP customers and let the other customers go, not get product, get somewhere else. So our PSP customers have benefited from the best of our attention in the last 1.5 years. And now they can have the best of them and then be flexible and not really meet their part of the bargain. We have added capacity for them. We prioritize them. We lost the other customers when we did not give any product. So I think this…

I would say don't be fixated on it. This is our best demand. It's our best customer.

Got it. Got it. And then just as my follow-up. So you gave sort of some view on consumption, and you called it end market demand. Does that include the inventory that's building at your customers? When you talk about end market demand, is that net of the inventory build at your customers? Or is that inclusive of the inventory build at your customers?

So when we speak of end market demand, it is everything that we ship to our direct customers, which is no different than GAAP revenue. And then the other difference is that roughly 50% of our business that goes through distribution, it represents the distributors' sell-through to their customers rather than what we're selling into the distribution channel. We do not have any kind of view in terms of exactly what our customers are doing with inventory. We service 125,000 customers and that’s just not data that we have or is possible for us to track.

Yes. When we talk about potential inventory at customers, all we can see is what do they publicly report. But I can tell you that the level of expedites and customer escalations we're experiencing remain high, indicating the demand-supplier imbalance for many customer situations.

First, a little bit of an off-the-run question and then I will have a follow-up. OpEx, I think you highlighted that it’s below your target range as revenue continues to grow and you’re not spending as much as sort of you would normally target. Over what time frame should we anticipate your OpEx approaching your target percent of revenue?

It will be over many quarters. You can see in our guidance which is not happening in the December quarter. The hiring environment has been difficult. Perhaps we will do better as we go into 2023. So it will be slow. Eric, do you want to say anything?

Yes. I mean it somewhat depends on what the revenue curve looks like out in time. Obviously, we're guiding for nice growth again in December. Ganesh has made comments about March being a growth quarter for us. So it's going to take us some time to catch up, Will.

I want to revisit a topic that has been frequently discussed, but I’d like to approach it from a different angle. I recognize that the PSP has a very strong backlog, and there aren't many requests for cancellations. Even if we accounted for all the cancellations, the guidance and comments for March would still reflect a positive outlook. However, it raises a question about what could happen in a few quarters if more customers, whether through PSP or other means, request cancellations or delays. This situation highlights a change in the company’s operations. Steve, you often mention that you wouldn't use distribution as a means to, let's say, impact inventory negatively. When deciding whether to require customers to switch to an NCNR, it closely resembles that negative impact on your business. I’m curious how you plan to approach this if more customers approach you to cancel, whether related to PSP or the regular backlog. On one hand, it’s important to hold them accountable for their commitments due to the reasons you’ve provided. On the other hand, doing so could harm future demand and lead to difficult consequences. How do you intend to balance these two dynamics?

Well, this is not the first time we've had to deal with noncancelable backlog. It has been a part of our business for basically ever, right? It's just that the percentage of that has grown. We work with customers on what their requirements are but you can't have an asymmetric agreement where heads, they win; and tails, we lose, right? You got to make sure that there are commitments. This is why if you make sure that there is an understanding that there is a responsibility with placing that backlog, they will moderate the backlog they place on us. If they have no responsibility, then there is no reason why they wouldn't just give us much, much higher backlog than where they're at. So we think, again, going back to the quality of the backlog, it comes because it has responsibility that goes with it. Outside of that situation by the customer, we're in this to be in business. But we're not in this to say it's all risk-free or all the risk is on our side in what we go with it. And by the way, by and large, that’s how customers have expected this thing as well. They’re not pushing on us to say, 'Hey, I didn’t mean that it should be PSP and I now want something else different from what we had agreed to. So I don’t see that as big of an issue. And by the way, if we didn’t have PSP, the situation we have is far, far higher backlog and far bigger of a fall from that high backlog we have.

Yes. I think one other thing I'd like to point out, Will, because you're talking several quarters out in time beyond March, right? A customer that's on PSP and has 12 months of backlog with us, every week or every month that goes by, they make a decision in terms of what the next backlog that they're going to put on us out in time. They could put 0 backlog. They could put 50%. They could put 120% of what it was the month before. And so these fears of rising interest rates and recession, this is not new when we woke up today. This has been happening now for several months. And I think customers gradually adjust that over time. But as Ganesh has said, PSP is still a large percentage of our backlog. We still have tons of unsupported. And it’s been a program that I believe has worked very well, not only for the customer but for Microchip.

I think the gist of your question is that lots and lots of PSP customers want to cancel and we're just now letting them do it. And that is not the case. There is a negligible amount. I mean, at any point in time, you have customers that want to move small things around. The PSP backlog is not going to see the behavior that you're talking about. We're not inundated with PSP customers wanting to cancel the backlog and we're not canceling it. And that's not happening next quarter. It's not happening quarter after. I think that's the issue. That's your assumption that it would happen. We don’t think we will face that because the PSP backlog is very high quality and customers can easily start to adjust it by taking the foot off the gas pedal every month when they place the order 12 months out.

Let me give you one more piece of data. We're making a big deal of cancellations. If you aggregate all the cancellation requests we have, it's 4.5% of our total backlog, and that includes PSP, non-PSP, and it will be dominated by non-PSP. It is a negligible part of the business, guys.

So, earlier someone asked about lead times and whether they have increased or decreased, and you mentioned you couldn't provide a specific definition. You also indicated that there is still a substantial amount of business or products that are constrained. Can you provide any metrics regarding the percentage of products or business that is currently constrained or in shortage compared to three months ago, and what you anticipate for three months from now, to help us track progress?

The best metric probably is what is the unsupported backlog exiting quarters. And I'm going to tell you, it's high. It's probably not healthy to be there, and we will work to improve that. And it is to improve the customer service and the customer experience with it. But we have still substantial constraints that we're working through, and it will take us many, many quarters to work through them.

I don't know if Ganesh said that earlier but our unsupported backlog leaving September quarter was another all-time high. So during the quarter, customers wanted more parts to be shipped in the September quarter that we couldn't ship, and the unsupported grew over the June quarter to another record. So that doesn't mean in any way that customers are feeling that the lead times are coming in. I mean we are broadly constrained almost everywhere. I mean we've got daily escalation calls from multiple customers every day. So it hasn't even reached the peak. The unsupported hasn't even reached the peak and started dropping. It is still growing.

Yes. That’s what I was getting at. That’s what it felt like. And then for my follow-up, so Steve, you’ve been through even more cycles than I have. If this continues, where the competitors keep taking numbers down and the recession gets worse and worse and your business gets better and better or gets through it, I mean do you think it’s possible for you guys to make it through a global recession and a downturn unscathed or relatively unscathed? And did you see anything during this quarter other than the unsupported backlog that made you feel any better or any worse about Microchip’s ability to do that?

Well, you have to define what unscathed meant. As Ganesh talked about it in his remarks that we're not seeing anything today, but we see the macro weakening and what all the other companies are saying. And what we are seeing is, if macro ever catches up to us, then we have steps in place to create a soft landing. When you say unscathed, we're not saying we're going to keep growing 22% per year forever like we have been. But we will soft land the plane because of all the attributes Ganesh went over.

I would like to know more about the pricing trends you're experiencing in your microcontroller and analog sectors. Your revenue for the September quarter increased by over 25% year-over-year. How significant was the impact of pricing on that growth? Additionally, Steve, during your presentation at our conference about six weeks ago, you suggested that pricing could provide a boost in the early part of 2023, based on discussions with your foundry suppliers. Has anything changed since that time? I also have a brief follow-up question.

So pricing is stable. There are no price adjustments that are being made that are affecting where the quarterly results are. We did make an adjustment at the beginning of this year or the early part of this year and that's where it's at. I don't think we have any price adjustment plans into 2023 that are in the offering. And so pricing is really not a factor today in terms of what we're executing, where we are going in terms of our new designs and where we are in terms of our business.

Got it. And then as my follow-up, I guess this is a hypothetical, but given the visibility you have and given everything that you’ve said so far in the call, if your business in calendar ‘23 is, say, up 5% or flat or somewhere in that range and most of your peers are down 10%, would it be fair to say that in a recovery phase in 2024, you undergrow your peers or you perhaps don’t participate in that recovery? Or are you guys gaining permanent structural share across the analog and MCU businesses?

It's a hypothetical. We don't know what '24 is, but we believe we are gaining share. We are executing the total system solutions strategy we have. We are focused on the fastest-growing markets, and we are seeing substantial wins that are creating the tailwinds for us.

Channel or just the inventories still 40% below pre-pandemic levels. Your own inventories are kind of at the low end of your target range. So obviously, clear signs that demand remains strong. Given your capacity expansion plans, looking at your demand profile and backlog, do you guys anticipate increasing inventories with your customers and moving towards the midpoint of your range on your own inventories over the next, call it, 2 to 3 quarters?

So, we actually grew quite a bit of inventory on our balance sheet in the September quarter and you'll see just below our guidance table in our press release, we're expecting that to grow again this quarter. In my prepared remarks, I kind of went through some of the reasons why that is happening is we're positioning the company for future growth. In terms of distribution, distribution inventory stayed flat quarter-on-quarter at 19 days. And we think at some point in time, there will be some level of restocking in the distribution channel. That's going to vary by distributor and how they manage the business. But in the meantime, with their inventory being relatively low, we feel that we need to have more inventory on our balance sheet to support the end customer needs. And so that's what we're doing. But really, we are now within our target range of inventory days that we provided to the Street back in our November Analyst Day. So, we're managing it appropriately in a challenged supply environment, I would call it.

Yes. And I know it’s always somewhat complex to is to end market demand trends because you’ve got such a broad portfolio of products. You’re serving many different end markets. However, there is one segment where products are more easily tracked because they are very specific to that end market that’s our rad-hard kind of high roll products that’s your aerospace and defense business. I believe it’s about 13% to 14% of your revenues, much higher mix versus your peers. It seems like activity around commercial space programs, new satellite constellations, defense spending all look strong for not just next year, but the next several years. You guys are number one in space, strong term defense. Like help us understand the visibility in A&D, growth trends and sustainability of this segment into a potentially weaker macroeconomic backdrop next year.

Sure. So aerospace and defense, I think, is about 9%, 10% of our revenue. It is performing extremely well for many reasons. And you missed commercial aviation. Commercial aviation is going through a strong resurgence. And so all three elements—space, defense, and commercial aviation—are all doing strongly in the current environment. And they are generally less influenced by shorter-term macroeconomic conditions.

I think Toshi took my earlier question on ASP assumptions, so I'll just ask one. It's around the consideration of investing in the 300-millimeter fab. I guess there's 2 parts to the question. Ganesh, as you consider that, what would be just, I don’t know, ballpark off the top of your head, focus of which process nodes mix in a facility like that if you consider it? And then second, is this something that you guys felt you needed to do but didn’t really feel like you could fund all of it until the CHIPS Act got passed? And now that’s a reaction to potential funding from governments? Or was this a decision that you were probably going to need to make anyway?

So firstly, on process technologies, those are still being worked. But largely, we use our 300-millimeter foundries today on process technologies that are 90-nanometer and smaller in size. And the workhorse technologies for trailing edge tend to be at 40, 65, 90 in that general neighborhood. But those—we wouldn't limit ourselves just to that. Again, I want you to think of this as this is a 20-year, 25-year look at what we would do with the 300-millimeter fab. The reasoning for it is we have—as our business has grown, the portion of our business that we do with 300-millimeter has also grown. And the investment in the trailing edge part of 300-millimeter technologies has not been there with many of our foundries at the level that we have wanted. And—but it takes a certain scale to get there. And if you had a full boat fab that you needed to build, the way in which the breakeven points and the absorption points come about are different from when there is a fab that can be built with government funding and the investment tax credits and whatever local things come in. So clearly, that has changed the equation as to when does it make sense financially. But that's not the only reason why. We think trailing-edge 300-millimeter technology is going to have constraints for a long time to come, and a portion of that being within Microchip would allow us to better serve those markets.

If you examine your current operating margins, they are significantly higher than in previous cycles. This appears to be largely a long-term trend. However, when you consider potential soft landing scenarios, do you anticipate your margins experiencing declines similar to what has occurred historically? Is there a possibility of returning to previous low points? Additionally, how should we view gross margin leverage in a weaker economic environment, especially in light of some competitors discussing target margins based on lower revenue levels?

Well, I'll give you a quick answer, and then Eric might want to elaborate more on it. Again, the best way to look at it is how have we performed over the last 15 years through the cycles. And you will see that on those metrics, the frozen operating margin from peak to trough across the cycle, about 200 basis points is the decline in that range, plus or minus 200, 300 basis points. And that's the way in which we manage the business. It's built into our DNA. It's built into our systems and processes. It's built into the soft landing that I described a quarter ago. Eric, do you want to add more to it?

Yes. I mean, obviously, we've continued to integrate acquisitions. We've got a different product mix than we've had historically. We feel really comfortable with the margin targets that we've set out for the Street, which we are above today, as you mentioned, on the operating margin side. Because the business has grown so well, we've got quite a bit of cushion. I would call it on our OpEx today with the level of bonuses that we're playing, variable comp that will allow us to adjust if need be, if the macro catches up with us at some point in time. So—and we want to build inventory in our own factories. We think the distributors will rebuild inventory. And so we don’t want to give a specific number. But again, the range that we’ve provided on a long-term basis, we think that we can operate within that. And obviously, we’re operating above it today.

And the mix of the business we have has end markets that are far more durable in terms of how they perform and what gross margin these products and solutions we bring are able to command. And it's not just silicon. It's silicon, it's software, it's systems, it's services. These are very, very sticky applications and markets that are not prone to perhaps what a pure consumer or mobile phone type of market may have.

Congrats on all the record metrics. I have a sort of a different angle on the pricing question, and it’s kind of more related to ASPs. So if you look at the 25.7% growth year-over-year that you are reporting this quarter, how much of that is coming from higher ASPs, meaning selling more value in the form of your total system-type solutions?

There's not an easy way to break that up. Clearly, with constrained capacity, we will direct them and have been directing it to the highest-value products that we're producing. We're shipping more units. So there's a lot of the growth that's coming from capacity and additions that we have made in it. But I certainly don't have a good way to parse out what comes from mix and pricing versus what comes from units alone.

That's a fair point. I have a question about the inventory, specifically whether it's internal or channel. It seems like you're planning to keep the channel inventory somewhat constrained going forward. However, is there a broader trend suggesting that the ideal channel inventory might be around 20 days, while your own inventories could potentially exceed the upper limit of the range, which is 150?

No. We don't dictate what channel inventory needs to be. The channel decides what inventory they need. In some cases, we may be constrained in shipping it to them, and they may not be able to get what they want, but channel has a history of what does it take to support the mix of product, the customer expectations that are there. And we are at the low end of what they have historically done, whether they're going to be at 19 or 20 or 25 or 30 is really a decision they're going to make. We don't tell them what to do in terms of inventory.

Ultimately, they need to stock the level of inventory appropriate to support their customers, and they’ll need to find the right level of that as supply becomes less constrained than it is today. We have a lot of unsupported backlog to our distributors today that we need to catch up on.

For the past year, the preferences of distributors haven't been important because we haven't had the product to begin distribution, so there hasn't been any choice. We don't anticipate having that choice for a while into 2023. However, once we have parts available for distribution, it will matter what they want to do. Currently, it does not.

Congratulations on good results in this very uncertain environment. Just one question on gross margins. They continue to be at kind of record levels. I’m wondering what have been the drivers of the margin so far? And how do we think about those drivers going through into next year?

Yes. Well, I think the biggest drivers are going to be factory utilization, right? I mean we have more backlog than we know what to do with at this point in time. And so the factories are running harder than they've ever been before, every piece of equipment that we have to produce as much product as we can. And so with that, our planning and operations team are able to schedule things and batch runs and try to produce as much product as they can. So that’s a big thing. And then I think the other thing that we talked about in the response to some of the earlier questions is just our product mix and how that’s changed over time has continued to enhance the gross margin.

I have a quick question. Regarding your inventory and the inventory in China, could you provide some details on what the inventories look like? It seems that some OEMs, like Stellantis and BMW, are expressing concerns about a slowdown in sales due to macroeconomic conditions and interest rates. I also have a follow-up.

So OEMs don't tell us what inventory they carry, right? Now what we can gauge is how are they interacting with us on how they see business, how they're—how many escalation issues are we still working? And we don't see an abatement in terms of what they're trying to do. And OEMs also have not only a requirement to sell to their demand. They're also trying to replenish their dealers and what the dealers' inventory needs to be trying to replenish what the rental car inventory needs to be out there. So demand is still running strong, and we don't see for our products an inventory issue that they're bringing to us to go solve. If anything, we're working more shortages and constraints for it with them.

Got it. And on the last quick question on the pricing side. I know you talked about many different products but obviously, a lot of the microcontrollers are pretty long-life products there. So just wondering if you took a step back and looked at 2021 or '22 as you exit '22 here for some of the long-life products that you guys have, how has that pricing change trended over the last 2 years?

So pricing over the history of Microchip is a strategic exercise for a sole-sourced product that is proprietary from us. The only time when we have made a pricing adjustment that's been broad-based, is over the last year to 1.5 years, when we had cost increases with a view towards covering the cost increases that we were subject to in the way we passed on margin up for that. So outside of that, pricing is not something we try to take advantage of when there are constraints, nor is pricing something that we give up on when there is extra supply.

Great. I want to thank everybody for hanging in there and despite some of the technical challenges. We appreciate the questions and we look forward to seeing many of you and talking to many of you in the phone calls and conferences we have coming up. So thank you.