Microchip Technology Inc (MCHP) — Q3 2024 Earnings Call Transcript

Thank you, operator. Good afternoon everyone. During the course of this conference call, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are predictions and that actual events or results may differ materially. We refer you to our press release as of today, as well as our recent filings with the SEC, that identify important risk factors that may impact Microchip’s business and results of operations. In attendance with me today are Ganesh Moorthy, Microchip’s President and CEO; Steve Sanghi, Microchip’s Executive Chair; and Sajid Daudi, Microchip’s Head of Investor Relations. I will comment on our third quarter fiscal year 2024 financial performance. Ganesh will then provide commentary on our results and discuss the current business environment, as well as our guidance. And Steve will provide an update on our cash return strategy. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and on this conference call on various GAAP and non-GAAP measures. We have posted a full GAAP to non-GAAP reconciliation on the Investor Relations' page of our website at www.microchip.com, and included reconciliation information in our earnings press release, which we believe you will find useful when comparing our GAAP and non-GAAP results. We have also posted a summary of our outstanding debt and our leverage metrics on our website. I will now go through some of the operating results, including net sales, gross margin and operating expenses. Other than net sales, I will be referring to these results on a non-GAAP basis, which is based on expenses prior to the effects of our acquisition activities, share-based compensation, and certain other adjustments as described in our earnings press release and in the reconciliations on our website. Net sales in the December quarter were $1.766 billion, which was down 21.7% sequentially. We have posted a summary of our net sales by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were 63.8%, operating expenses were 22.5%, and operating income was 41.2%. Non-GAAP net income was $592.7 million and non-GAAP earnings per diluted share was $1.08. On a GAAP basis, in the December quarter, gross margins were 63.4%. Total operating expenses were $590.6 million and included acquisition and tangible amortization of $151.3 million, special charges of $1.1 million, share-based compensation of $38.8 million, and $1.5 million of other expenses. GAAP net income was $419.2 million, resulting in $0.77 in earnings per diluted share. The GAAP tax rate was favorably impacted from an IRS notice that clarified the treatment of costs incurred by a research provider under contract that we had been accruing for and that accrual was released in the quarter. Our non-GAAP cash tax rate was 13.2% in the December quarter. Our non-GAAP cash tax rate for fiscal year 2024 is expected to be just under 14% and is exclusive of the transition tax and any tax audit settlements related to taxes accrued in prior fiscal years. Our fiscal 2024 cash tax rate is higher than our fiscal 2023 tax rate for a variety of factors, including lower availability of tax attributes, such as net operating losses and tax credits, lower tax depreciation with our expectation for lower capital expenditures in the U.S. in fiscal 2024, as well as the impact of current tax rules requiring the capitalization of R&D expenses for tax purposes. We are still hopeful that the tax rules requiring companies to capitalize R&D expenses will be pushed out or repealed. The House actually passed the tax bill last night that would achieve this, and we will see how this progresses through the Senate. If this were to happen, we would anticipate about a 200 basis points favorable adjustment to Microchip's non-GAAP tax rate in future periods. Our inventory balance at December 31, 2023, was $1.31 billion. We had 185 days of inventory at the end of the December quarter, which was up 18 days from the prior quarter's level. Although we reduced inventory dollars in the quarter, we were not able to make as much progress as we would have liked, as we continue to accommodate requests by customers to push out delivery schedules for products that were very far through the manufacturing process. At the midpoint of our March 2024 quarter guidance, we expect inventory dollars to be up modestly and days of inventory to be in the range of 225 to 230 days due to the significant reduction in revenue and cost of goods sold. We also continue to invest in building inventory for long-lived, high-margin products whose manufacturing capacity is being phased out by our supply chain partners. These last-time buys represented 10 days of inventory at the end of December. Inventory at our distributors in the December quarter was 37 days, which was up two days from the prior quarter's level. Our cash flow from operating activities was $853.3 million in the December quarter. Included in our cash flow from operating activities was $30.4 million of long-term supply assurance receipts from customers. We have adjusted these items out of our free cash flow to determine the adjusted free cash flow that we will return to shareholders through dividends and share repurchases, as these supply assurance payments will be refundable over time as purchase commitments are fulfilled. Our adjusted free cash flow was $763.4 million in the December quarter. As of December 31, our consolidated cash and total investment position was $281 million. Our total debt decreased by $392 million in the December quarter, and our net debt decreased by $416.4 million in the quarter. Over the last 22 full quarters since we closed the Microsemi acquisition and incurred over $8 billion in debt to do so, we have paid down $7.1 billion of the debt and continue to allocate substantially all of our excess cash beyond dividends and stock buyback to bring down this debt. Our adjusted EBITDA in the December quarter was $796.2 million and 45.1% of net sales. Our trailing 12-month adjusted EBITDA was $4.26 billion. Our net debt to adjusted EBITDA was 1.27 times at December 31, 2023, down from 1.56 times at December 31, 2022. Capital expenditures were $59.5 million in the December quarter. Our expectation for capital expenditures for fiscal year 2024 is between $300 million and $310 million, which is down from the $300 million to $325 million we shared with investors last quarter as we are delaying certain capital given the more challenging economic backdrop. We expect that our capital investments will continue to provide us increased control over our production during periods of industry-wide constraints. Depreciation expense for the December quarter was $47.1 million. I will now turn it over to Ganesh to give us comments on the performance of the business in the December quarter as well as our guidance for the March quarter.

Thank you, Eric and good afternoon everyone. Our December quarter results were disappointing and below our expectations with net sales down 21.7% sequentially and down 18.6% from the year-ago quarter. Non-GAAP gross and operating margins came in at 63.8% and 41.2%, respectively, down from our recent strong performance, but somewhat resilient despite the significant sequential decline in revenue. Our consolidated non-GAAP diluted EPS came in at $1.08 per share, down 30.8% from the year-ago quarter. Adjusted EBITDA was 45.1% of net sales in the December quarter, continuing to demonstrate some resiliency. As a result, we had good debt reduction in the December quarter and despite the lower adjusted EBITDA we generated, our net leverage ticked down to 1.27x. However, we expect our net leverage ratio to rise for a few quarters, as trailing 12-month adjusted EBITDA drops when replacing stronger prior year quarters with weaker ones. Our capital return to shareholders in the March quarter will increase to 82.5% of our December quarter adjusted free cash flow, as we continue on our path to return 100% of our adjusted free cash flow to shareholders by the March quarter of calendar year 2025. My thanks to our worldwide team for their support, hard work, and diligence as we navigated a difficult environment and focused on what we could control so that we are well-positioned to thrive in the long term. Taking a look at our December quarter net sales from a product line perspective, our mixed-signal microcontroller net sales were down 22.3% sequentially and down 18.5% on a year-over-year basis. Our analog net sales were down 30.9% sequentially and down 29% on a year-over-year basis. Now, for some color on the December quarter and the general business environment. All regions of the world and most of our end markets were weak. Our business was weaker than we expected as our customers continue to respond to the effects of increasing business uncertainty, slowing economic activity, and a resultant increase in their inventory. In addition, many customers implemented extended shutdowns at the end of the December quarter as they manage their operational activities. We continue to receive requests to push out or cancel backlog as customers sought to rebalance their inventory in light of the weaker business conditions and the increased uncertainty that we're experiencing. We were able to push out or cancel backlog to help many customers with these inventory positions. With no major supply constraints, coupled with very short lead times and a weak macro environment, we believe that inventory destocking is underway at multiple levels: at our direct customers and distributors who buy from us, our indirect customers who buy through our distributors, and in some cases, our customers' customers. The very strong up cycle of the last two to three years drove many of our customers to build inventory in order to be able to capitalize on strong business conditions in an uncertain supply environment. The term 'just in case' instead of 'just in time' was used by customers to express their approach to these conditions. However, as the macro environment slowed, many of our customers found their business expectations to be too optimistic, resulting in high levels of inventory. As a result, they sought to cancel or reschedule backlog. An update on our PSP program. During the early stages of the up cycle, we launched our PSP program requiring non-cancelable backlog in exchange for supply priority in a hyper-constrained supply environment. The program aimed to discourage speculative demand and achieve mutual commitments between our customers and us for future demand. The program worked extremely well for many customers who participated during all of 2021 and 2022, as well as the early part of 2023, supporting strong growth in their businesses. However, the business challenges, which led to the creation of the PSP program, are no longer relevant. We have, therefore, decided to discontinue the program effective today. If business conditions warrant, we may at some point in the future initiate a similar program, which will have to be adapted to the situation at that time. Reflecting the slowing macro environment, our distribution inventory grew to 37 days at the end of the December quarter, as compared to 35 days at the end of the September quarter. We are working with our distribution partners to find the right balance of inventory required to serve their customers, manage their cash flow requirements, and be positioned for the eventual strengthening of business conditions. Our internal capacity expansion actions remain paused. Given the severity of the down cycle, our factories around the world will be running at lower utilization rates and also taking up to two shutdown weeks in each of the March and June quarters in order to help control the growth of inventory. We expect our capital investments in fiscal year 2024 and fiscal year 2025 to be low, even as we prepare for the long-term growth of our business. To that end, we reached a preliminary memorandum of terms with the Department of Commerce for $162 million in grants targeted at existing projects for two of our U.S. fabs. These grants are subject to diligence by the Chips office as well as capacity investments by Microchip over multiple years. We have been driving our lead times down and have reduced average lead times from roughly 52 weeks at the start of 2023 to roughly eight weeks by the end of 2023 on average. During a period of macro weakness and business uncertainty, we believe short lead times are the best way to help customers navigate the environment successfully and improve the quality of backlog placed with us as it enables our customers and Microchip to engage an uncertain environment with more agility and effectiveness. However, a significant reduction in lead times is also resulting in lower bookings and reduced near-term visibility for our business. We're also taking steps to reduce our expenses. In addition to the variable compensation programs, which provide automatic reductions during a down cycle and normal containment of discretionary expenses, we will be implementing broad-based pay reductions. Our team members who are not part of the factory shutdowns will take a 10% pay cut, and consistent with our normal practice, the executive team will take the largest reduction with a 20% pay cut. The shutdowns for manufacturing team members and pay cuts for non-manufacturing team members are consistent with our long-standing culture of shared sacrifices during down cycles and shared rewards during up cycles. This approach helps avoid layoffs while protecting manufacturing capability and prioritizing projects, which are important for our customers and us to thrive in the long term. We took similar actions during prior periods of business uncertainty, such as the COVID pandemic in 2020 and the global financial crisis in 2008 and 2009, which we believe were effective in navigating our business. Now, let's get into our guidance for the March quarter. As our customers take further actions to adjust to a weakening macro environment and uncertain business conditions, we are continuing to support customers and channel partners with inventory positions to push out or cancel their backlog. We recognize that our short lead times and increased flexibility with backlog will result in customers aggressively reducing inventory, which could lead to some degree of overcorrection. However, we are going to continue to work with our customers to absorb as much of the inventory correction as we can at this time. Taking all the factors we have discussed on the call today into consideration, we expect our net sales for the March quarter to be between $1.225 billion and $1.425 billion. The guidance range is larger than normal to reflect the macro uncertainty and resultant low business visibility. We expect our non-GAAP gross margin to be between 59% and 61.6% of sales. We expect non-GAAP operating expenses to be between 26.9% and 30.7% of sales. We expect non-GAAP operating profit to be between 28.3% and 34.7% of sales, and we expect our non-GAAP diluted earnings per share to be between $0.46 and $0.68. To keep things in perspective, while our business results have degraded significantly over the last two quarters, as a larger-than-normal inventory correction has played out, our full fiscal year 2024 revenue decline at the midpoint of the March quarter guidance is expected to be roughly 9.5%, which compares favorably with weaknesses that other industry players have experienced. Our non-GAAP operating margin for the full fiscal year 2024 at the midpoint of our March quarter guidance is expected to be 43.6% and will continue to be among the best results across other companies in our industry. While we don't know how and when the inevitable up cycle will play out, we believe the fundamental characteristics of our business remain intact. Finally, notwithstanding any near-term macro weakness, we are confident that our solutions remain the engine of innovation for the applications and end markets we serve. Our focus on total system solutions and key market megatrends continue to fuel strong design win momentum, which we expect will drive above-market long-term growth. With that, let me pass the baton to Steve to talk more about our cash return to shareholders.

Thank you, Ganesh and good afternoon everyone. I would like to provide you with a further update on our cash return strategy. The Board of Directors announced an increase in the dividend of 25.7% from the year-ago quarter to $0.45 per share. During the last quarter, we purchased $114.6 million of our stock in the open market. We also paid out $237.4 million in dividends. Thus, the total cash return was $352 million. This amount was 77.5% of our actual adjusted free cash flow of $454.3 million during the September 2023 quarter. Our net leverage at the end of December 2023 quarter was 1.27 times. Ever since we achieved an investment-grade rating for our debt in November 2021 and pivoted to increasing our capital return to shareholders, we have returned $3.6 billion to shareholders through December 31, 2023 by a combination of dividends and share buybacks. During this time, we have bought back approximately 26 million shares of our common stock from the open market, representing approximately 4.5% of our shares outstanding. In the current March quarter, we will use the adjusted free cash flow from the December quarter to target the amount of cash returned to shareholders. The adjusted free cash flow excludes a net of $30.4 million that we collected from our customers for long-term supply assurance payments. These payments are refundable when purchase commitments are fulfilled. The adjusted free cash flow for the December quarter was $763.4 million. We plan to return 82.5% or $629.8 million of that amount to our shareholders, with the dividend expected to be approximately $243 million and the stock buyback expected to be approximately $386.8 million, which will be a new quarterly record for stock buyback since we initiated our enhanced capital return strategy. Going forward, we plan to continue to increase our adjusted free cash flow returned to shareholders by 500 basis points every quarter until we reach 100% of adjusted free cash flow returned to shareholders. That will take four more quarters, and we expect that dividends over time will represent approximately 50% of our cash returned. With that, operator, will you please poll for questions?

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

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

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

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

Thanks a lot.

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

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

Right. I would say that as we discussed, customers and distributors feel they have excess inventory. Therefore, if they have backlog for those products, they are either not placing new backlog or if they have backlog in place, they are looking to see if there's an ability for them to at least push that out. We are having ongoing discussions, and I'd say that they are still at a relatively high rate.

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

Yes. All the revenue declines are really volume declines and not pricing related. Pricing is stable. It is not contributing to the revenue change that is in our guidance. Our business is one based on design-ins that are done one, two, three years before and production that occurs for many years. It's not easy to substitute products based on short-term price adjustments. Clearly, at the point where new designs take place, we will be price competitive to what the new design requires. But today's revenue adjustments downward are not driven by price. Price is stable.

Thank you.

Thank you.

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

As you said, inventory in some cases is obscured to us. We have to estimate based on where customers are placing orders and the feedback they're providing. We know we're going to substantially under ship to where consumption is going to be. But it's very hard to pinpoint a number on that and how much inventory has been taken out. In some cases, it is multiple layers of inventory, especially as people get to that point where they are less willing to carry inventory, perhaps even to the low end of what they might historically do since supply is plentiful. Not all of this is simply inventory reduction as you would normally expect. It’s going to be at multiple levels for our customers, their customers, and in some cases, if they have an OEM that goes to the OEM as well. So, we don't have a good way to provide specifics on what you're asking for.

Okay. Fair enough. One of the things you've also said in prior downturns is typically, you've seen three down quarters before you achieve a bottom; you're at that now although September quarter was obviously a much smaller magnitude than now. Given where we are right now, do you think that still holds? And perhaps you could characterize this downturn against some of the prior ones that you've been through?

Well, there's nothing typical about this downturn. And I don't think that is a good comparison to history. In magnitude, it is on the order of what we've seen in the global financial crisis. I think we were down 36% or so at that point in time. We have very limited visibility in today's market conditions. It is difficult to say where exactly this is, and as I mentioned, we believe we are significantly under shipping to end demand. However, we are unable to provide any kind of forecast or guidance beyond this quarter.

Fair enough. Thank you.

You're welcome.

Hi guys. Thanks for the question. So around cycle times and lead times, we have found that some of your products, particularly through distribution, they have lead times that are even below your cycle times. I'm assuming your cycle times are something like four weeks or six weeks, something like that. I guess my question is, how long would you expect this dynamic to last? I think this is – if you do have big inventory corrections like we're going through, you see that phenomenon occasionally, but how long might this last? And when are you expecting lead times to maybe again, obviously, we have some - an inventory dynamic we're going through here. But maybe talk about that lead times versus cycle times and when you think that those might actually rise again.

Chris, let me just define two terms and then we'll walk through it. Cycle time is the time it takes from when you begin with raw material and get to finished goods. That cycle time for semiconductors can be anywhere from three to five months, sometimes longer, depending on the specialty. So that's the typical production cycle time. We have always been able to manage lead times, which we define as from when a customer places an order on us to when we can ship the product to them to be a lot shorter than that. Historically pre-pandemic, that was four to eight weeks for 80% to 90% of our line items. Where we have come back to is where those lead times average less than eight weeks. In some cases, if we have it in finished goods, they can get it much sooner than that as well. I don't have a good view on when lead times will go back out. I’m not sure that's a good thing. We need to manage supply and demand consistently with where demand is headed. We believe we are going to see low lead times for quite some time. We have high inventory and will continue to grow into the March quarter. We need to position that inventory to take advantage of orders that come in with short cycles due to low visibility so that we can satisfy them quickly.

Maybe just one thing. I think, Chris, maybe what you were getting at is when we have product that is staged in die bank, so it's through the wafer fab that, in many cases, we can turn that through assembly and test in the four to six weeks you described. If that's the case, when it's in die bank, that would be the scenario. But we have finished goods today, staging high runners in die bank or lead times across the board are quite short.

Yes. Thank you very much guys. That was some good stuff there. Eric, while I have you, gross margin, just for simplicity's sake, my model is roughly 300 basis points below what I had previously. I don’t know if you can kind of walk us through that; what's mix versus underutilization versus inventory write-down? It sounds like pricing is not an issue here like-for-like, but would love to know how those various aspects contribute.

I would say the biggest change quarter-to-quarter is driven by factory utilization, a combination of continued attrition and lower production rates on a steady-state weekly basis. We are also having these two-week shutdowns in all three of our large factories, which is larger than the previous quarter. While inventory reserves will be included in gross margins, we had relatively significant charges last quarter, and I wouldn’t expect those to be significantly more this quarter. They will probably be larger, but the biggest piece will be utilization.

Excellent. Thanks guys.

Hi guys. Good afternoon and thanks for taking my question. Looking at the March quarter guidance, that's basically a peak to trough in revenue terms of more than 40%, all within the same fiscal year. So clearly, the rate of decay has been extreme. And I'm calling on your experience here, given that you've all been through a lot of cycles in the past and you hinted to in your prepared remarks, maybe some overcorrection on your customers' part in terms of inventory depletion. So calling on your experience, how would you say the slope of the recovery may look given your lead times? Is it a gradual one? Or are we going to see just sharper rebound as we saw in terms of this correction?

So I'll start and Ganesh or Steve can add to this. I think it is unknown at this point in time. We have limited backlog visibility as we look out in time, which you're inquiring about beyond this quarter. Lead times are really short, and customers are sitting on a certain level of inventory beyond what they think is necessary for their business today. Until we start getting short-term orders at our lead times and see that backlog start to build. It's hard for us to really imagine what it will do. As Ganesh mentioned before, clearly in this quarter with our revenue guidance, we are shipping below what end consumption is for our products, and we think that's relatively significant, but giving you any guidance in terms of the slope of the recovery is tough at this point.

I think the recovery has many components to it. If we assume business stays steady and as the inventory drains, people will, at some point, just have to order enough to get back to flat consumption. Also in play is the macroeconomic landscape and actual consumption over time, which is dependent on many factors like GDP and interest rates. These are all variables we can't currently quantify to predict when the next three or four quarters will look like, especially without visibility into backlog.

I know I was asking for a lot there, but I appreciate the color. So it sounds like your OpEx management is more variable versus structural. And you've obviously done this in the past. In this recent round when you've asked employees to take a 10% pay reduction, what was communicated to them in terms of when that might be recouped based on some revenue or performance metrics?

I have not been able to speak to the entire Microchip community until I do that on Monday morning. I did write them all a message today after the market closed and before this call to notify them of what we were doing. Those are details I'd prefer to first discuss with our employees. However, this is not new to us. We've done this multiple times. Our culture allows people to understand how shared sacrifice and shared rewards go hand in hand, creating excellent outcomes for the company and individuals during the process.

Thank you, Ganesh.

You're welcome.

Thanks for taking my question. Ganesh, I appreciate you're not going beyond the quarter, but I still wanted to get some help in getting some directional sense of whether June could be flat, up, or down because you do have some shutdowns in June, right? You are already planning for that. So that's not a great data point. But then June tends to also be seasonally up for you historically. So, just give us some more color. What is true demand right now? And if you were sitting in our shoes, would you think about June being kind of up, down, flat? Even if you don't have an absolute sense of where June might take out?

I think the shutdowns we've communicated based on the days of inventory we closed December with, and what we have indicated are going to be at the end of March are required steps we needed to take. Those are not indications of where the June business is going to be at. The reality is, I don't know. The world is not falling apart. We know that consumption is happening. We recognize that inventory needs to drain. We are trying to gauge between the market environment, inventory across multiple levels, and how all that will drain. We know this business will eventually return, as it has in previous cycles. However, I think you're asking for a level of precision, which we currently do not have empirical data to accurately predict.

And then my bigger question, Ganesh, is regarding your strategy of maintaining kind of a hybrid manufacturing model, right, where lead times can suddenly get extended, but your CapEx is low, and your profitability is high? How do you contrast that to other U.S. competitors who have higher CapEx yet manage to keep lead times very low and avoid large swings? Do you think what you're experiencing could change your strategy about possibly pursuing a larger CapEx in the future?

Again, there are many who fit the descriptions you've provided. Let me describe our strategy. We aim to run products we know how to produce cost-effectively and consistently within our manufacturing footprint. This includes our front-end and back-end processes. We have grown that front-end footprint over time, but our foundry products have also increased. This balance is roughly 40% internal, 60% external. We don’t dictate where that percentage needs to go; market demand drives it. We're aware of which products and technologies make sense within our footprint and what should be driven with our partners. Overall, barring any immediate changes like we've seen last quarter and this quarter, it has been a successful strategy in terms of how gross margins have improved over time, achieving higher peaks and lows through many cycles. Thus, we are satisfied with our strategy and I leave others to interpret theirs.

Thank you.

You're welcome.

Yes, thank you. So, my first question is on the PSP program. It was obviously put in place to try and avoid volatility and doesn't look like that happened. Maybe it was just the nature of the pandemic cycle, I don't know. But why do you think the PSP program did not buffer the volatility that we're actually seeing?

It's a great question. Although the PSP program aimed at discouraging speculative demand by making orders non-cancelable and providing us the confidence to invest in it, there was a combination of very strong OEM market demand, persistent shortages over a long period, and prolonged lead times. Customers ended up placing more backlog because they believed their business was stronger than it really was, trying to place orders for a longer duration than typical. So, this is how it played out in our perspective. While it was effective for those participating during all of 2021 and 2022, as well as the early parts of 2023, supporting strong growth in their businesses, at the end of the day, prolonged lead times mean greater risks in demand predictions, especially one year or 18 months out where demand becomes uncertain.

No, that's very fair. And then as my follow-up, I recognize that all end markets are going to be weak in the March quarter. But any sort of relative comments on the end markets, anything holding up a little bit relatively better than others?

Yes. I would say our aerospace and defense market has shown some strengths. The commercial aviation sector remains strong, and defense remains strong as well. However, space has always been very irregular. Our segment of the data center, specifically around AI platforms, is doing extremely well but it's not significant enough to impact Microchip's overall performance.

Great. Thank you very much.

You're welcome.

Thanks guys. I guess just a little clarification on the decline here. Any comments on just your sense of end demand, maybe talk about the end markets that have been the worst? And then also, given your revenue decline is notably more than some of your peers, why do you think it's hitting you more than some of the competition?

Sorry, what was the last part of your question? Why do you think what?

Why is your revenue declining much more than some of your competitors?

Okay. So on your second question, if you look at it over a year's period, you'll find that fiscal 2024 at the midpoint of our guidance is about 9.5% down from fiscal 2023. I don't think that’s outside of where the normal is. Within a two-quarter period, absolutely, we are correcting at a faster pace than where we were at. However, we must assess area under the curve for revenue rather than just peak to trough alone in terms of analysis. In terms of end markets, as I mentioned, it's weak across the board. We haven't tracked this at a granular level each quarter, but we have sufficient anecdotal data. We were among the earliest to note that automotive was starting to weaken, followed by industrial and data center. Currently, weakness spans across all areas except for aerospace and defense, alongside our portion of AI servers.

Thanks, Ganesh. And then just a quick clarification on the utilization rates. Do you guys anticipate utilization rates declining again in the June quarter from March? Or will they stay flat from March to June?

We don't know yet. We will have to see how the business evolves over the coming months.

Hi guys. Good afternoon and thanks for taking my question. Looking at the March quarter guidance, that's basically a peak to trough in revenue terms of more than 40%, all within the same fiscal year. So clearly, the rate of decay has been extreme. And I'm calling on your experience here, given that you've all been through a lot of cycles in the past and you hinted to in your prepared remarks, maybe some overcorrection on your customers' part in terms of inventory depletion. So calling on your experience, how would you say the slope of the recovery may look given your lead times? Is it a gradual one? Or are we going to see just sharper rebound as we saw in terms of this correction?

So I'll start and Ganesh or Steve can add to this. I think it is unknown at this point in time; we have limited backlog visibility as we look out in time. Lead times are really short, and customers are sitting on a certain level of inventory beyond what they think they need. Until we start getting short-term orders at our lead times and see that backlog start to grow, it's difficult for us to predict. We believe in this quarter, our revenue guidance suggests we are shipping below what end consumption is, which is significantly material but any guidance on the slope of the recovery is hard to give at this point.

I think the recovery has many components. Assuming business stays flat and inventory drains, customers may have to order enough to reach flat consumption. There are also macroeconomic drivers and actual demand growth, dependent on factors like GDP and interest rates. We can't plug those variables into a forecast, especially without visibility into backlog.

Thank you.

You're welcome.

Yes, hi. I had a quick question. I was wondering about the CapEx and the funding that Microchip was getting; how much capacity do you plan to add on the front end or back end looking into calendar 2024, I guess?

Our capital expenditures for fiscal 2024 are $300 million to $310 million. We haven’t provided a number for next fiscal year, but I expect it to be lower than that. We've taken in equipment this year that we have yet to release into production. Capital we've bought is paid for, positioned, and awaiting placement as the market normalizes, but I expect CapEx to remain low in fiscal year 2025.

Vijay, here's how I think about our growth positioning regarding capacity. Our initial response is to utilize the inventory built to ship. Our next move will be to get our factories to return to full utilization; we are currently underutilizing them. Third, we will place previously ordered equipment into production. Lastly, we will consider adding more equipment where bottlenecks exist as needed. We are confident we have enough resources to respond to an up cycle using these four methods.

Got it. If you combine all of that, you mentioned your channel distribution inventory was at 37 days versus an optimal high 20s, which you have mentioned before, and your in-house inventory probably goes up a little bit as you approach March. Any thoughts on when you actually see that stabilizing or coming down? Is that more of a second-half occurrence? When do you think that might happen?

If I were clearer on demand, I could provide a better answer. We are taking action on what we can control, including managing internal capacity, shutdown days, and reducing utilization. These steps are all in anticipation of recovery, first by producing less, followed by the market consuming more. Still, how and when that will occur is uncertain.

Got it. And my last question on the margin trajectory for the March quarter. Did you say that all of it was because of utilization? Should we expect underutilization to continue into June? Or how do you see that going? Do you expect utilization to rebound?

It’s not all utilization, but a large portion of the change is driven by it. There’s always product mix and inventory reserves that also play a role in varying that impact. It may be challenging for capacity utilization to increase in the June quarter due to ongoing attrition – it’ll take time to stabilize even if market dynamics improve. We’ll watch this closely to ensure we’re making the appropriate investments in people, but changes often take time.

Got it. Thank you very much.

Great. Thank you. I guess, I wonder if you could address a couple of bear cases that I hear. One, you've discussed what PSP accomplished and what it didn't. Do you think that having more flexibility about customer cancellations when they started to slow down would have lessened the issue now? Is the PSP part of the reason why the hole is a little deeper now?

Perhaps. In retrospect, as a Monday morning quarterback, I would know exactly what I would have done differently. However, during the critical periods of many quarters, including as recently as last March and June quarters, there were CEO-level calls pushing for getting more product than we had. Remember, we provided statistics about how much of unsupported demand existed, which we couldn’t fulfill. There may have been moments when perhaps we should have taken our foot off the accelerator. However, we couldn’t predict that with certainty. If we were to implement a PSP program again, we would apply lessons learned and adjust it accordingly to hopefully gain the intended outcomes while avoiding unwanted results.

Great. Thank you. And then the other kind of negative question I get is regarding China, which is building significant trailing edge capacity. Can you talk about what types – I don't think you see much direct competition from sovereign China today, but can you talk about how much of your business might see competition from that direction over the next few years? I believe you've indicated that being in single digits, but maybe you could just update us on your thinking there.

Sure. So, Mainland China today accounts for about 20% of our revenue. About half of it we estimate is designed elsewhere and simply manufactured in Mainland China. Some of that is moving out as customers diversify away from China. The point of design is beyond China, and we are comfortable with that. Therefore, the other 10% of our business in China designed in China has another half that consists of complex designs that are not easily replaceable, which involve significant underlying knowledge about systems and the integrations of hardware and software, among others. Therefore, about 5% of our business — one-fourth of our total business in Mainland China — pertains to broader microcontroller and analog products. In this space, fragmentation is advantageous for us. The market is very fragmented, with any one opportunity contributing minimally to overall revenue with it being challenging to infiltrate. Theoretically, if someone launched an identical offering, it’s worth noting that a lot of our business is not just about silicon. It’s about having the silicon, tools, design guides, and software support we provide customers. So while there is growth in China's trailing edge technology and capacitance, we'll pay attention and continue innovating, cost-reducing to ensure we can compete effectively. However, the portion of our business that might be more broadly impacted is less than 5%, and it is quite fragmented and complex, making it hard to penetrate.

Thank you. Yes, that's very helpful.

Thank you.

Hi guys. Thanks for taking my questions. I wanted to ask about utilization rates and the strategic decisions you're making to shut down the fabs for two weeks in March and June and also keep utilization rates lower over those two quarters. I guess, why start and stop the fabs but also why not just take the utilization rates much lower in the March quarter than see where things play out and given you're trying to get inventory down, but expectations are that it will still go up in March? Thank you.

It's a balanced decision that we had to think through and make. But as inventories climbed, there is a point at which the pain gets high enough. As we analyzed that, we felt this was a strategy to navigate through multiple scenarios that might unfold. And in the interim, we are comfortable that the high inventory will allow us to recover if the market does accelerate. We will have options in June based on how March performs. We simply need to prepare for both quarters to the best of our abilities while managing our current inventory growth.

And then as my follow-up, I know you have a formulaic approach to your capital return program, but you've mentioned in the past the possibility of opportunistically going above outlined rates as your free cash flow is depressed versus prior quarters. Any thought to using the balance sheet or returning more than what you had been under the formula you outlined? Thank you.

We actually have a very healthy cash return this quarter, right? We increased from 77.5% to 82.5% of our adjusted free cash flow from the December quarter; this is quite high. Moreover, dividends are also going up again, and it factors in a record stock buyback. So we think this is an appropriate level, and we're doing well with returning cash to shareholders this quarter. Steve, Ganesh can comment on if the Board would consider doing anything differently, but we believe this program is firmly in place. If the market changes, such as the stock price declining substantially, that could be an issue we discuss with the Board.

I think this represents a very healthy cash flow return of 82.5%, an increase of 25.7% in dividends from last year, with record stock buyback. We have emphasized enhancing shareholder returns, and in doing these activities consistently across quarters, we've maintained our commitment to our capital return strategy. Our preset formula for cash return is yielding very healthy results alongside an enhanced stock buyback this quarter.

We have maintained a steady approach, ensuring consistency through our capital return program without excessive fluctuations month-over-month. I believe both Steve and I, along with the Board, feel this approach should continue moving forward.

Thank you.

You're welcome.

Thanks for taking my question. I guess, the first one is for Eric. You talked about the lower utilization; you’re shutting down factories for two weeks in both March and June. I'm wondering if you could walk us through the accounting. How much of that hits you in the current period? How much of those lower utilization charges flow-through inventory? Given how much inventory you have, it could be something that hits gross margins for a longer time as it flows through inventory and then impacts the income statement. I’ve got a quick follow-up.

Yes. Our three large wafer fabs, even without the shutdowns, will run below what we consider normal utilization. These two-week shutdowns will be period costs in the current quarter and will not be capitalized into inventory. While we are running at lower rates than peak levels, the costs capitalized to inventory on a per unit basis are higher than when we were fully operational, but essentially, the two-week shutdown will impact the current period and not be moved into inventory.

That's very clear. Thank you. And just for Ganesh, you mentioned that you're ending the PSP program. Just to clarify, does that mean you’re no longer signing anyone to new PSP contracts? Does that mean existing PSPs have now been canceled and customers have greater rights to cancel the existing backlog? What happens now with the current PSP participants?

The backlog has been shrinking for some time. What we are communicating to customers is that we won't accept new orders for PSP. Existing customers have seen that lead times are short and capacity is available. The prime reason for PSP’s initiation has dissipated, so we're naturally letting it come to an end while we’ll avoid taking further orders as PSP.

Got it. Thank you.

You're welcome.

Great. Thanks for squeezing me. I was also going to ask about the PSP and the mechanics of how it rolls out of backlog. I think you just answered that, but I do have a financial question around it. I believe for many orders, customers were prepaying, and you might have been prepaying for capacity at the foundry. Can you walk through how those are rolled off your company’s financials and when you expect them to be in the rearview mirror? Is that by the end of the March quarter?

With PSP, those were typically not cash prepayments from customers. We have certain long-term supply agreements that had cash prepayment elements but those remain intact, separate from PSP cancellations. These agreements generally run three to five years and will run their course. Where customer demand isn’t meeting expectations, we work to find a reasonable resolution mutually. Prepayments base to suppliers remain unchanged as we can negotiate accordingly based on demand. We don't foresee significant financial disadvantage coming from those agreements but may have taken on more inventory across various types.

Great. Thank you.

Welcome.

Hi yes. Thanks for taking my questions. Can you provide insight into design activity? Although you mentioned seeing real cutbacks, could you provide clarity on visibility relative to what you experienced before? What’s going on that gives us better insight into the long-term outlook beyond the June quarter?

Design activity remains high by many measures. Customers were dealing with shortages and as those are resolved, they are refocusing on innovation. Our products and technologies strongly support the drive for innovation in many fields. Coordination with various partners, particularly catalog distributors, indicates solid design activity ongoing. Thus far, the innovation engine remains strong, despite the current inventory correction that will fade, leading to a return to growth based on increased semiconductor deployment in new applications.

That’s very helpful. And just one last one, if I could sneak it in. Is there any particular geography or segment you noticed that was seeing a faster rate of decline? I noticed that industrial as a percent of total was down from the supplemental slides. Could you offer further clarification regarding geography or end markets indicating the most weakness?

All segments are presently weak. While I don’t have the numbers to give you, I can confirm that China has been weak for quite some time, dating back to 2022 with the shutdown impacts that have yet to be addressed. We're witnessing declines in all geographies and most end markets, except those mentioned previously in aerospace, defense, and to a degree, AI-focused data centers.

That said, the end market data posted on our website references last full fiscal year, which hasn't updated. This is generally a yearly review process—so we'll ensure clarity on any confusion.

Okay. Thanks, guys. Appreciate it.

Thank you.

Okay. I want to thank everyone for taking the time to be on this call and all of your questions. We look forward to having further discussions during some of the conferences coming up this year. On that note, we are closing this call.