Microchip Technology Inc (MCHP) — Q2 2026 Earnings Call Transcript

Thank you, operator, and good afternoon, everyone. During this conference call, we will be making projections and other forward-looking statements regarding future events or the financial performance of the company. We want to caution you that these statements are predictions, and actual events or results may differ materially. We recommend reviewing our press release from today and our recent filings with the SEC for important risk factors that may impact Microchip's business and performance. Joining me today are Rich Simoncic, Microchip's COO; Eric Bjornholt, Microchip's CFO; Brian McCarson, Microchip's VP of Data Center Business Unit; and Sajid Daudi, Microchip's Head of Investor Relations. I will reflect on our fiscal second quarter 2026 financial results, then Brian will update our data center business, and Eric will discuss our financial performance. I will then provide an overview of the current business environment and our guidance for the third quarter of fiscal year 2026. We will be available to answer specific investor and analyst questions afterward. Now, I will highlight a few key points from our financial results. We achieved 6% sequential sales growth, with net sales increasing in the Americas and Asia while remaining flat in Europe, which is decent for a summer quarter in Europe. Sales from our microcontroller and analog businesses were also up sequentially. Specifically, our MCU business rose 9.7% sequentially, driven by strong contributions from 32-bit MCUs, while our analog business saw an increase of 1.7% sequentially. Our Gen 4 and Gen 5 data center products are experiencing strong sales growth, albeit from lower levels as customers appear to have completed their inventory correction. In new products, we made a significant announcement on October 13, introducing the industry's first 3-nanometer-based PCIe Gen 6 switch aimed at supporting modern AI infrastructure. Brian McCarson will discuss this further later in the call. Our non-GAAP gross margin increased by 236 basis points sequentially, with an incremental non-GAAP gross margin of 95%. Our non-GAAP operating margin rose by 364 basis points sequentially, with an incremental non-GAAP operating margin of 84.6%. These incremental gross and operating margins are very encouraging. Inventory decreased by $73.8 million sequentially, and year-to-date, inventory has been reduced by $261 million. Inventory days were 199 days, and over three quarters, our inventory days have dropped from 266 to 251 to 214 to finally 199. Underutilization in our factories during the September quarter was $51 million. The product gross margin for the September quarter was 67.4%, reflecting a rich product mix driven by our data center products. We recorded $71.8 million in new inventory write-offs and a $51 million underutilization charge, totaling $122.8 million. When this is divided by net sales of $1.1404 billion, it results in a non-GAAP gross margin impact of 10.8 percentage points. Subtracting this from the product gross margin of 67.4%, we arrive at a reported non-GAAP gross margin of 56.7%. Thus, the product gross margin remains very healthy. We still need to address the inventory write-offs and underutilization charges. We are pleased to announce that we have entered into a purchase and sales agreement to sell our Fab 2 wafer fabrication facility in Tempe, Arizona to a third party. This sale is part of our previously announced restructuring plan for our wafer fabrication operations. As part of this plan, we closed Fab 2 in May 2025 and began transferring process technologies from Fab 2 to Fab 4 in Gresham, Oregon, and Fab 5 in Colorado Springs, Colorado, both of which have ample clean room space for expansion. The transaction is subject to closing conditions and is expected to close in December 2025. Now, we have a special guest today. I would like to introduce Brian McCarson, Corporate Vice President of our Data Center Solutions business unit. Brian will discuss our recent announcement of the industry's first 3-nanometer-based PCIe Gen 6 switch.

Thank you, Steve, and good afternoon, everyone. I'm the Corporate Vice President and Leader of the Data Center Solutions business unit at Microchip. And today, I'm excited to introduce you to the latest addition to our Switchtec family of products. Our new Gen 6 PCIe switch announced on October 13 marks a significant milestone in Microchip's technological leadership within the AI and enterprise data center infrastructure markets. The build-out of AI data centers continues to accelerate with hyperscalers committing to gigawatt scale deployments. Some recent announcements have outlined single infrastructure projects in the 5 to 10 gigawatt range, targeting completion between 2026 and 2027. These developments are driving our current design engagement cycles. It is critical to understand that regardless of whether our customers deploy NVIDIA, AMD, Intel or custom ASICs, all require high-performance PCIe switching infrastructure. This is where Microchip's Gen 6 Switchtec products are designed to excel. Last month, at the Open Compute Project Global Summit in San Jose, California, we introduced the industry's first PCIe Gen 6 switches manufactured using 3-nanometer process technology. These new devices deliver 4 distinct competitive advantages. First, PCIe 6 doubles the bandwidth to 64 gigat transfers per second per lane compared to PCIe 5.0, eliminating GPU to storage, memory and CPU bottlenecks that constrained previous generations. Our new Gen 6 switch features an industry-leading maximum of 160 lanes per device, significantly increasing total data transfer capacity. Second, our 3-nanometer implementation provides 15% to 20% power per lane advantage over competitors' products developed on 5-nanometer and older technology nodes. This is critical when deploying hundreds of thousands of GPUs and switches in multi-gigawatt data centers. Choosing Microchip's devices enables customers to lower total power consumption without compromising performance. Third, all our Gen 6 Switchtec devices offer advanced device telemetry and multicast capabilities, allowing a single GPU data packet to be transmitted to multiple devices simultaneously, thereby improving GPU efficiency. And fourth, we have implemented a secure boot-based hardware root of trust that supports post-quantum cryptography and is CNSA 2.0 compliant, meeting or exceeding both government and commercial security requirements. This represents industry-leading device security. We are now sampling these products to qualified customers and recent engagements have been validating both our technical approach and our market timing. From a financial perspective, we believe this represents a significant growth opportunity for the company. AI servers require substantially more PCIe switching infrastructure than traditional servers to enable resource pooling and the composable architectures that hyperscalers demand. Our total addressable market encompasses the entire data center PCIe fabric, not just a subset. We are vendor agnostic, selling into all data center and AI architectures. Design win cycles typically span 12 to 18 months from initial engagement to production, aligning our current sampling activity with initial production starting in June 2026 and volume ramping towards the end of calendar year 2026. Looking ahead, our Gen 6 Switchtec devices position us to capture a meaningful share of the committed AI infrastructure build-out across 3 growth vectors: hyperscale training infrastructure, enterprise AI training and inference deployments and high-performance computing applications. I will pause here and turn the call over to Eric for comments about our financials.

Thanks, Brian, and good afternoon, everyone. We are including information in our press release and in this conference call on various GAAP and non-GAAP measures. We have posted a full GAAP to non-GAAP reconciliation on the Investor Relations page of our website 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 September quarter were $1.14 billion, which was up 6% sequentially and $10.4 million above the midpoint of our September quarter guidance provided on August 7. 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 56.7%, including capacity underutilization charges of $51 million and new inventory reserve charges of $71.8 million. Operating expenses were at 32.4% of sales and operating income was 24.3% of sales. Non-GAAP net income was $199.1 million and non-GAAP earnings per diluted share was $0.35, which was $0.02 above the midpoint of our guidance. On a GAAP basis in the September quarter, gross margins were 55.9%. Total operating expenses were $549 million and included acquisition intangible amortization of $108.1 million, special charges of $6.3 million, which was primarily driven by our activities associated with our closure of Fab 2, share-based compensation of $53.3 million and $12.3 million of other expenses. The GAAP net income attributable to common shareholders was $13.9 million or $0.03 per share and was positively impacted by our settlement of an audit with the IRS dating back to fiscal year 2007. Our non-GAAP cash tax rate was 9.5% in the September quarter. We expect to record a non-GAAP tax rate of about 10.25% for all of fiscal year 2026, which is exclusive of the transition tax and any tax audit settlements related to taxes accrued in prior fiscal years. Our inventory balance at September 30, 2025, was $1.095 billion, which was down $73.8 million from the balance at June 30, 2025. We had 199 days of inventory at the end of the September quarter, which was down 15 days from the prior quarter's level, driven by our inventory reduction actions. Included in our September ending inventory was 16 days of long life cycle, high-margin products whose manufacturing capacity has been end of life by our supply chain partners. Inventory at our distributors in the September quarter was at 27 days, which was down 2 days from the prior quarter's level. Distribution sell-through was about $52.9 million higher than distribution sell-in. Our cash flow from operating activities was $88.1 million in the September quarter. Our adjusted free cash flow was $38.3 million in the September quarter. And as of September 30, our consolidated cash and total investment position was $236.8 million. Our total debt decreased by $82 million in the September quarter, and our net debt increased by $247.7 million. Our adjusted EBITDA in the September quarter was $341.8 million and 30% of net sales. Our trailing 12-month adjusted EBITDA was $1.103 billion, and our net debt to adjusted EBITDA was 4.69 at the end of the quarter. Capital expenditures were $36.5 million in the September quarter and included approximately $20 million for a building purchase in India, supporting our ongoing R&D activities in Bangalore. We expect capital expenditures for fiscal year 2026 to be at or below $100 million, and depreciation expense in the September quarter was $39 million. I will now turn it back to Steve, who will provide some additional commentary on our September quarter results and our guidance for the December quarter.

Thanks, Eric. As you saw in the last quarter, our net sales continued to grow sequentially. We are continuing to see the inventory go down at distributors, at our distributors' customers, our direct customers and contract manufacturers. The distributor sell-in versus sell-through gap did not shrink last quarter. It was $49.3 million in the June quarter, and it was $52.9 million in the September quarter. The good thing about that is that distributor inventory went down even further. We expect that the distribution sell-in will eventually rise to meet the sell-through over the next couple of quarters. Next is gross margin. As I described in my summary earlier, product gross margins were very healthy at 67.4%, but our inventory write-off and underutilization charges knocked down the non-GAAP gross margin to 56.7%. We still need stronger sales to drive down inventory write-off and underutilization charges. However, our customers and distributors are taking advantage of short lead times and are continuing to drive down their inventory. Now to the market environment. We are seeing some recovery in our key end markets in automotive, industrial, communication, data center, aerospace and defense and consumer. They're all looking somewhat better. The strongest sales performance last quarter was in the data center market, albeit from depressed levels as the inventory at end customers and distributors corrected, we saw a large increase in bookings and shipments of our Gen 4 and Gen 5 products, which included PCIe switches, memory, flash controllers, storage and rate cards. We believe we are extremely well positioned with our Gen 6 PCIe switch with it being the only 3-nanometer-based device currently sampling in hyperscaler and enterprise data center customers, beating our competition in virtually every specification metric. Now let's get into our guidance for the December quarter. Our backlog for the December quarter started lower than the starting backlog for September quarter. The bookings for July were higher than bookings for any month in the last 3 years. August bookings were seasonally low, but better than our expectations and September bookings were quite strong as expected and the best booking month in 3-plus years. Overall, September quarter's bookings were 10% higher than those of June quarter. The book-to-bill ratio for the last quarter was 1.06. October bookings were higher than July, so we have a good start to this quarter's bookings, and November bookings so far are very strong. Embedded in these strong bookings is the observation that customers and distributors are scheduling these for March delivery and are continuing to lower their inventories into this calendar year-end. A comment about lead times. While lead times for our products have been 4 to 8 weeks for some time, we are continuing to experience lead times bounce off the bottom and are experiencing increases on some of our products. We're running into challenges on certain kinds of substrates and subcontracting capacity and also some foundry constraints on very advanced nodes. These challenges remain isolated to specific areas. Our customer requests for expedited shipments have increased significantly from a couple of quarters ago, pointing to some customers' inventories running low. I also want to remind investors that December is seasonally our weakest sales quarter of the year and is typically down low to mid-single digits sequentially. This is mainly due to a lot of holidays in the quarter and our customers shutting down their factories during the holidays. Taking all of these factors into account, we expect our net sales for the December quarter to be $1.129 billion, plus or minus $20 million, which would be down 1% sequentially at the midpoint. We expect our non-GAAP gross margin to be between 57.2% and 59.2% of sales. We expect our non-GAAP operating expenses to be between 32.3% and 32.7% of sales, and we expect our non-GAAP operating profit to be between 24.5% and 26.9% of sales. We expect our non-GAAP diluted earnings per share to be between $0.34 and $0.40. I want to highlight the operational discipline in our business model. Despite a seasonally challenging December quarter with expected slightly lower revenues, our operational improvements are expected to deliver strong profit performance. Non-GAAP operating profit is projected to increase by over $13 million sequentially at the midpoint of our guidance. This operational discipline is evident in our business model's ability to deliver significant flow-through of incremental revenue to operating profit in normal business environments. While we are only providing 1 quarter of guidance, and that is for this current December quarter, which is seasonally the weakest sales quarter of the year with a lot of holidays and customer shutdowns, we currently expect 3 strong quarters of March, June and September 2026. March quarter backlog is currently strong, and we currently expect March quarter sales to be stronger than a seasonal low single digit up sequentially. Finally, a comment on our capital return program for shareholders. Starting this quarter, we expect our adjusted free cash flow to be roughly even with our dividend payment driven by increasing profitability, low CapEx and liberating cash inventory. In future quarters, as we have excess free cash flow above dividends, we intend to use this to bring down our borrowings. With that, operator, will you please poll for questions?

I guess to start, maybe you could characterize what you're seeing now versus what you saw 90 days ago. At that time, you did talk about expectations for better than seasonal growth in both the December and March quarter. It sounds like December is on the better end of normal seasonality. But how do you feel now against what you thought 90 days ago?

I think you've noticed from various industry announcements by our peers and competitors that the overall business environment has shown a slightly softer trend. This has been evident throughout this earnings season, and we are no exception. Our guidance for the December quarter is better than the usual seasonal decline, which typically ranges from a decrease of 3% to 5%, and we are only seeing a decline of 1%. If we reflect on 6 to 9 months ago, I would have anticipated small sequential growth even in the December quarter. However, the softer overall business climate, along with the effects of tariffs on customer sentiment, has caused hesitation in making capital investments, leading people to hold back. These factors contributed to the guidance we provided. Interestingly, our bookings last quarter were 10% higher than expected. Had we maintained the pace of bookings from the September quarter, the December quarter figures would have been significantly higher. However, as I mentioned, we are seeing customers deferring these bookings to the March quarter while they continue to reduce their inventory, which makes for a complex situation in the market. Therefore, we believe we need to brace ourselves for this quarter, which is typically the weakest of the year, but we anticipate strong momentum going into March and expect several solid quarters ahead.

Understood. As a follow-up to that, you mentioned that the product gross margins were holding up, but obviously, the charges are what's weighing on the gross margins. Could you give us an update on what you expect from both the inventory reserve charges and underutilization charges as you go through with presumably those next stronger quarters as you get into next year? How quickly can some of those charges start to roll off?

In general, we don't have insights or guidance for future quarters. We review past performance to inform our outlook, and the current quarter showed a sequential decline of 1%. With sales decreasing by 1%, it's challenging to create a significant impact. We anticipate making minor reductions in inventory shortly. Currently, I don't have projections for utilization or inventory write-offs for this quarter. However, looking ahead to the next several quarters, especially March, June, and September, we plan to start ramping up our factories and hiring towards the end of this quarter. As we increase production and reduce inventory, this should help address underutilization. Regarding inventory write-offs, the products being written off now are not due to excess production. A year or a year and a half ago, we had significant excess inventory due to a larger factory footprint and production that exceeded demand. Today, our internal fabrication plants are underutilized, and inventory is decreasing. However, many products produced two years ago based on prior customer demand have slower sales now, leading to necessary write-offs as they age. While sales aren't at zero for these products, they're not selling quickly enough to avoid write-offs. I feel we're nearing the end of this inventory write-off phase and the underutilization challenge. This quarter, which is typically the weakest, might impact our overall performance, but I'm optimistic that following this quarter, we’ll see consecutive strong quarters that will significantly improve our inventory write-offs and utilization.

I think I'll just add a little bit to what Steve said. So we did talk about how our plan was to ramp output out of the wafer fabs in the December quarter. We are still doing that. So it is increasing. The impact on underutilization charges in the current quarter will be modest. They'll be down, but just ever so slightly. And then our assumption is that the inventory reserves will come down. But as Steve said, it is hard to predict. But we are guiding a pretty nice sequential increase in the non-GAAP gross margins to like 58.2% at the midpoint of guidance. So we are still seeing some benefit there in a tough quarter.

Steve, so I wanted to understand just kind of what's going on. I know it's sort of this weird environment where December is soft, but people are booking out into next year. And you can kind of see it in the backlog. I know you stopped giving backlog breakouts in the filings. But in March, your current backlog was very low and a lot of it is parked in LTSAs still. So what are these LTSAs? I mean, it's coming down very slowly. Why is it taking so long to bring these down? And I mean, if customers want product, I would think that like what's the point of parking stuff out in March and June and giving you no visibility in the near term?

We don't have any more LTSAs out there. When I came back last year, we actually here this month, very rapidly, we dismantled our program and essentially removed many of the customers' obligations on these long-term projects. And we took some cancellations. We took pushouts. We essentially allowed the customer to reset their backlog. So there's no impact on LTSA today. Customers are not taking any product they do not need. But...

Steve, let me just insert one thing there, Steve. So you're referring to PSP. We still have some of these LTSAs in place, and we've been flexible with customers in terms of pushing out their requirements. They might have put in a 5-year expectation with us, and we aren't holding them accountable for taking that inventory and allowing flexibility to push that out by a year or 2 years, whatever they need to keep that engagement strong. And that's what Tim is referring to that he sees in our public filings on the LTSAs. They are coming down, but coming down slowly.

I was referring to the dismantling of the PSP program. Regarding the LTSAs, we are not requiring customers to purchase anything unnecessary. We are providing flexibility, allowing them to buy only what they need. This isn't causing any issues. I had hoped that with low customer inventories, there would be significant orders from both direct customers and distributors in the December quarter. However, we are seeing strong bookings that are being scheduled for March. Lead times are relatively short, and customers are taking risks by lowering their inventory more than I expected.

I understand. So, it seems like the question is about the purpose of having these long-term supply agreements, especially since they aren't really decreasing significantly. Ultimately, the key factor is the current portion, which, as of March, was quite minimal. So, what is the rationale behind having these agreements if they don’t offer any coverage in a quarter like December?

It basically incentivizes the customer to continue to design with us. If you are sitting on a push where they can use our part or they could use TI or NXP's part and they're equally good and prices are similar, if they have an LTSA with us, I think that breaks the push. So there are those kinds of benefits in engagement. But in general, it's no longer providing us any extra visibility, and we're not forcing the customer to take the product they don't need. What got us into the trouble in the first place.

Right. One thing I want to clarify, Tim, is we have not changed anything in terms of what we disclosed in terms of backlog. That is a requirement that we put that number in our 10-K, so we do that once a year, but it has never been disclosed to my recollection in our quarterly 10-Q filing. So it's once a year thing that we do with the 10-K filing.

It was in the Q actually last year, but totally get it.

Steve, I'm curious what's driving your confidence to expect the next 3 quarters to be above seasonal? Your lead times are still low. There are so many macro cross currents. And most of your peers, as you mentioned, founded a little more defensive and were hesitant to guide more than the current quarter. So I'm curious, what are you seeing that they are not seeing to suggest that the next 3 quarters would be above seasonal?

So March quarter is driven by just the visibility of the backlog. If you look at our backlog today for March quarter and compare it to what the December quarter backlog was, on August 6, I think that would be a 1 quarter difference, right? The backlog for March quarter today is much higher than December quarter backlog was on August 6. And the bookings that are coming in, its turns component into the March quarter is very strong. So March quarter, my comment is largely driven by visibility and the rate of bookings and turns. Now beyond that, I think customers are stretching their neck a little bit, distributors true by taking inventory down this quarter, which really they should not. In many cases, where the inventory is low enough, but they are basically dressing up their balance sheet for the end of the quarter and want the product in March, with the customers' inventory having come down significantly and distributor inventory coming down significantly, there is still a $50 million gap in sell-in and sell-through, which we think some will correct in March and the balance will correct in June probably. And then the rate of bookings is likely to continue as customers replenish their inventory. So my outer quarter commentary is driven by just the inventory will even get lower and they will need the product for June quarter and September quarter. And June and September quarter are historically our 2 strongest quarters of the year. They were both up nicely this year and many times, they're up usually even in soft years. So I'm less concerned about June and September and March quarter is driven by the visibility.

Understood. And for my follow-up, gross margins are going up nicely in December. Is that mostly utilization driven? I think on the last call or before that, you had mentioned that you expect it to take utilization up by 15%, 20%. I'm wondering what level are you taking it up? And do you expect to increase it again in March? And is there like a target level of inventory in dollars or days that we should think about until which point you will be more careful with taking utilization up further?

Eric, can you take that?

Yes, we are managing our manufacturing output on a weekly and monthly basis. I won't specify the exact percentages we'll be increasing, but we are shipping significantly more from our factories than we are currently producing. We need to ensure that our production levels remain balanced, as we cannot quickly ramp up factory output. This process will take time. I anticipate we will continue to increase our production capacities as we assess the situation each month, considering factors such as inventory, backlog, and revenue expectations. What was the second part of your question?

Sorry, do you expect to increase it again, Eric, in March, right? If you're expecting several above seasonal quarters, then does it mean that there's an expectation that you'll continue to increase utilization?

Yes. We will need to continue to ramp the factories over time. It probably won't be a steady increase. It's just going to depend on the environment. But in the case that March, June and September have revenue growth, we would definitely be doing that.

I was curious if you could comment, is there any specific end markets that you can point to that you're seeing this kind of push, pull more than others?

I don't really know if there can be an end market-specific commentary on it. I think we're getting bookings across the board on most segments, bookings are fairly strong, but the bookings delivery requested is in the March quarter, leaving the December quarter as per our guidance.

Yes. As you know, we don't break out end markets on a quarterly basis, and it's a little more difficult for us to track it. We break it out once a year, but it seems like this is a pretty broad-based phenomenon that we're seeing.

Yes. So we see a really healthy long-term strategic relationship with our foundry supplier in 3-nanometer, which is TSMC. And we believe we have the line of sight to the capacity that's needed to support our customer needs.

I wanted to just ask because maybe I had this wrong. I thought that the inventory charges were supposed to go away pretty sharply into the end of the fiscal year. I guess you're guiding to continue in December. So I guess what changed? I guess, as forecasts start going up, I thought that the kind of the level of inventory would match the increased forecast and you wouldn't have this charge. I know you're saying the mix is now different. So is that what's changed? And kind of how far out should these inventory charges extend?

I think with this weak quarter of December, we got to get through. But after that, I think we should in the stronger quarters, start to sell the inventory, significant inventory and have the charges really start to drop. Honestly, I expected charges to drop a little more than they have, and this weak quarter isn't helping. But I still feel that the inventory charges will come down rapidly as the year-over-year sales growth improve. So I think that's the key thing, and I've talked about it before, because you take the prior 1 year of sales and multiply it by 1.5 to get 18 months equivalent, and then you compare your inventory to that number. And if your inventory is higher than that number, then you have to write off the balance. So while our sales have been improving in the last 2 quarters, our year-over-year sales have been negative. So every quarter, the last 12 months sales have been coming down. And therefore, it's 18 months equivalent has been coming down. And that's what kind of has been driving some of the inventory charges. And starting this December quarter, that phenomena is reversed year-over-year starting to grow. When that happens, I think it will have impact on write-offs, inventory write-offs coming down.

And then just to wrap some math behind that, I guess, the current impact is around, call it, 5% percentage points to gross margin. So you said it should come down over the next several quarters. So is that the right way to kind of add back that 4%, 5% headwind to the 58% that you just guided to? And then I'm assuming utilization would help by a few points as well. Is that the right way to frame gross margin over the next couple of quarters, 4 quarters?

So that's the right way to look at it. For the September quarter, if you combine the underutilization with the inventory charges, they totaled $122.8 million, which had a 10.8 percentage point impact on revenue. As these charges decrease, the gross margin will increase dollar for dollar. This is our route to achieving a 65% gross margin. Last quarter, our product gross margin was 67.4%, meaning we are currently surpassing our long-term target from a product gross margin perspective. However, we need these charges to reduce, and the current soft quarter is not beneficial, but I believe we'll regain momentum starting in the March quarter.

Thanks, Steve.

And we have said this publicly, but that $71.8 million charge we had this last quarter, that charge never goes to 0. There is always some level of inventory reserves that are taken. And we do believe that at some point in the future, we will start to get a benefit of selling through a higher level of what's previously been written off. We just don't have line of sight to that, and that is hard to predict, but there's always some level of charge.

Steve, during the September quarter, the analog business was a bit slow to recover. Most of the sales during that time were driven by microcontrollers. Do you anticipate a similar trend for the December quarter, or do you expect a more balanced contribution from both MCUs and analog?

In the June quarter, we saw stronger growth in analog compared to microcontrollers. Someone asked if we could expect the same trend in the September quarter. However, in September, that trend flipped; microcontrollers outperformed while analog lagged. These shifts are common since both categories involve many product lines and a vast customer base. It’s not a straightforward pattern, with one sometimes rising while the other falls in different quarters.

Fair enough. When I think of Microchip, leading-edge 3-nanometer products are not what come to mind as your focus. However, you are highlighting it in this earnings call. Is this indicative of a strategic shift towards targeting more leading-edge data center products? Some insight into your strategy would be appreciated.

Yes, you should absolutely take that as a strategic shift. We hired Brian McCarson into Microchip. After I came back last year, I think, Brian, you joined us in when exactly?

January of this year.

In January of this year, just a couple of months ago, Brian is focused on advancing our data center products to be among the best in the market. The 3-nanometer Gen 6 Switchtec device is the first of these innovations, and you can expect a series of new, top-tier devices to emerge from this business unit, aimed at capturing significant market share in the rapidly expanding data center sector. This initiative is not our only focus; we also established an AI business unit a few months ago, and updates from that group will be forthcoming. Additionally, we are dedicating considerable resources to our FPGA business unit, with new product announcements expected in the upcoming year. You may recall our recent announcement regarding high-performance space computing, where we are developing the next-generation space computer under a NASA contract. This represents a strategic shift that not only continues our work with microcontrollers and analog products but also includes more advanced, high-performance offerings with lower power consumption. These products are poised for significant growth, which will enhance Microchip's overall compound annual growth rate. That is the essence of the strategic shift.

Steve, any estimate or best guess as to when the underutilization charges and inventory write-downs get to sort of a normalized level where maybe we'd see the product margins just show on the non-GAAP P&L without a whole lot of adjustments. Maybe I guess that takes us to somewhere between 65 your target and where you're running now a little bit higher than that. Is that something we should expect sort of in the early part of fiscal '27, do you think? Or will it be further out?

I'm not comfortable forecasting at this point in time, especially in an otherwise soft quarter. I think we will make substantial improvement in the next fiscal year. We'll make improvement in March. And then again, June is the start of the next fiscal year. So you're not directionally wrong. I just don't want to put an absolute time frame or an absolute figure.

I think we're confident in saying that the inventory write-offs normalize quicker than the underutilization goes away. Both will be moving in the right direction, but underutilization will take longer is our expectation, but we're not putting a time frame around it.

That's helpful. As a follow-up, when I talk to investors, especially those optimistic about Microchip, they point to these two charges and believe they will eventually disappear. They also expect to see some improvement in gross margins. I want to clarify my understanding of this because I believe the underutilization charges are meant to simulate a 90% utilization level. You might experience higher margins from product mix, but regarding utilization, can you confirm whether we won't see gross margins exceed the product gross margins you mentioned unless we surpass 90% utilization? Is that about right?

Eric?

Yes. When Steve mentions the 67% plus product gross margin, we advise against using that figure in models because it reflects where we could end up. Our long-term model is at 65%, and we recently reported a gross margin of 56.7%, with guidance for 58.2% at the midpoint. There’s still a significant distance to cover. Each factory operates at what we consider normal utilization, which could be 90% in one case and 75% in another, depending on how revenue mix fluctuates. During the upcycle, we operated at over 100% capacity in nearly every factory, leading to a temporary gross margin exceeding 68%. However, this is not typical. Our goal is to reach 65%, and as we approach that benchmark, we will reassess and offer updated guidance.

Can you provide an update on the closure of Fab 2 and the resizing of Fab 4 and Fab 5 from the June quarter? You were aiming for about $115 million in annual cost savings, which translates to approximately 250 basis points of gross margin improvement at the current quarterly revenue run rate. Is all of that reflected in your current gross margin profile, or is there more to come?

Eric?

Yes. For Fab 2, we discussed achieving $90 million in annual cash savings, and we are progressing toward that goal. However, as Steve mentioned, we have an agreement in place that is still subject to closing conditions. If it closes in December, we will receive some cash from that, although we cannot disclose the amount yet. The costs associated with it are not currently affecting our non-GAAP gross margins. The primary issues are the charges from underutilization and the inventory write-offs. It is encouraging that we have reached this stage with the factory, and we expect to eliminate it from our cost structure by the end of the quarter, which will be a positive development for us.

Thank you for the update on your PCIe switching portfolio. On a segment reporting basis, data center and compute accounted for 19% of your total revenues in fiscal '25. What is the approximate mix of data center compared to client or PC compute? I assume the majority of the segment is focused on data center. Is there any way to quantify it? Is it around 60-40 or 70-30? These products are more application-specific, making them easier to track. I assume you monitor this mix closely, but can you provide any details on the mix differences?

Yes. We don't break that out to that level of degree to everyone. Majority of that is related to data center more than anything within that bucket of 19%.

I would like to inquire about the visibility of the backlog. You mentioned that there are more customers interested in placing orders in March compared to December, which makes sense given the shorter lead times. However, since the backlog has decreased sequentially and you're anticipating a strong March following what appeared to be a robust December, could you elaborate on what gives you confidence for strong results over the next two to four quarters? Are you seeing demand signals, or do you expect inventory restocking because customers are concerned about low stock levels? I'm trying to understand the indicators you're observing as we approach 2026.

So I think as we get on the other side of the December quarter, you have several wins on the back kick in. Number one, the difference between sell-in and sell-through has to close. Distributor inventories are going to become normal here. They have come down very significantly. There is maybe a little bit to go here and there, but they're largely getting corrected. So when the correct in another quarter or so, you have a $50 million sell-in to sell-through gap that needs to close. So that is a wind on the back. And it will close by people buying more product on sell-in, which is a GAAP revenue. The second is the same phenomena on our direct customers, contract manufacturers. As their inventory corrects, they will start buying what they're consuming. Today, they're buying much less than what they're consuming. So that's another wind on the back. And third, June and September are seasonally strong quarters. December is our weakest quarter. March is the next better and then June and September usually are strong. So we have strong quarters coming up, plus we have this inventory phenomenon in distributors, direct customers and contract manufacturers. All of that together, I think we'll have a decent financial performance.

I wanted to follow up on the 3-nanometer PCIe switch. Can you provide some details on your expected go-to-market strategy and the maturity of your commercial engagements? You're using 3-nanometer technology while your competitors are on 5-nanometer. Are you focusing on performance over cost because of this? Should we anticipate significant revenue contribution in 2027 with the product launching at the end of 2026?

We are targeting this family of products at hyperscalers, enterprise OEMs, and ODM customers. This approach covers all segments of both AI data center and enterprise data center markets. Along with the customers I've mentioned, we see a significant market opportunity. We believe the total available market for our Switchtec family of devices should exceed $2 billion per year today. Although there are varying expectations for growth, we anticipate a compound annual growth rate of over 10% for that total market through 2035. We expect to begin production by June 2026, and considering typical design win cycles with customers, we anticipate first revenue will start appearing in 2027 and late 2026.

So Steve, just going back to your earlier comments, you said that you expected the December quarter to be a little better and things seem to get a little softer at some point in the September quarter. Can you just talk about, I guess, when that happened? And did any particular areas like geos or product lines or anything stand out on the softer side and why you think that happened? Do you think there were some tariff-related pull-ins earlier in the year? Or is something else happening?

So I think our bookings remain strong. July was one of the best booking months in 3 years. And then August was slower, but still better than expected, and I have talked about the August was always slow because of the holidays and vacations and all that, but it was better than expected. And September was very, very strong, best booking months in 3-plus years. And the book-to-bill ratio was positive. The bookings were up 10% sequentially. The only reason why I say December is a little softer and disappointing is the customer decided to give us strong bookings, but schedule them in January and essentially address their balance sheet for calendar year-end. So therefore, the turns component of that wasn't as strong as I would have expected. With the inventory corrected, I thought customers and distributors will restock. Well, they decided to restock 3 weeks later, not restock on December 26, but restock on January 15. And that's kind of the difference we're talking about. Therefore, the backlog for March looks good. On certain product lines, the March quarter backlog is stronger than December quarter backlog. Not across the board, but on some key product lines. So this is the observation which changed what I thought would happen. I thought with all this inventory correction, December quarter would be a lot stronger, low single-digit up rather than minus 1%. But this phenomenon that they decided to buy that product in January rather than buy it in December has changed that equation.

Okay. And just my follow-up. So you mentioned some constraints. It sounds like they're still mostly on the back end. Are those constraints getting worse? When do you think you can get them under control? And is it causing you to miss out on any sales?

So, nothing is disastrous. We are managing the situation, but we have a significant constraint in substrate capacity, as you may recall from a couple of years ago. With the introduction of advanced products and the demand from AI and high-end data centers, substrate capacity has become critical. Last quarter, we were also competing for substrate with cell phone production for the December quarter due to high demand. Fortunately, that demand was tied to a product launch, and now that phase has passed. While some constraints have eased, the situation remains precarious. In some instances, customers expected to receive their products in September or December, but we are shipping them a quarter later. While it's not hundreds of millions of dollars in lost revenue, it is still significant.

I wonder if you can just help us try to triangulate where the demand actually is. Looking at your bookings levels, 1.06 is pretty good, but your revenue is about half of what it was at the peak. And I guess the real consumption is somewhere between that peak number and where you are now. But just as you look at the bookings pattern, do you have any updated sense on where we're going to get when we get to consumption levels?

I cannot help you or anybody else to figure out where the exact consumption level would get to. I would agree with you that it's somewhere between the peak and where we are. But which one it is closer to where it is, I think that's a million-dollar question. Honestly, this entire recovery has been a lot slower than anybody would have expected. I think all these tariffs and customer concerns about capital investments in automotive to EV to gasoline shift, and there have been a lot of curves that have been thrown at this market. And the overall progress has been less than I personally would have wanted. So we'll continue to make that progress. I think pick up pace in the March quarter, but I'm not willing to guide where we eventually reach equal to consumption. I think that remains a challenging exercise.

Okay. Fair enough. And then with my follow-up, the data center products, when you talk about the new switch and things like that, where do you guys stand in terms of hyperscale cloud relationships? Do you have partnerships there where they're coming to you and saying, here's the product we need. Can you help us to develop that? I know you have a lot of data center businesses that were acquired when they were sort of enterprise-centric. Can you just update us on where you are with going to market with these bigger cloud customers?

So Brian, we do business with all of them. Why don't you take that question?

Yes. We have active engagements with all the hyperscalers and OEMs you would expect across this broad both AI data center and enterprise data center market. We do not work on custom ASIC products as our main business. So we instead focus on understanding the workloads that our customers are most interested in accelerating and optimizing within the data center and build the right competitive features to best meet their needs. And I think this latest announcement around our first-to-market 3-nanometer Gen 6 PCIe switch demonstrates that with industry-leading security features, industry-leading telemetry, industry-leading power and performance per lane. And so we will continue to build our products with the hyperscaler OEM, ODM and enterprise data center markets directly in line.

Yes. Thank you very much, everybody, for hanging in there. And as I said, after this quarter, I think we should get back strong momentum, and we'll see some of you on the conference circuit this quarter. Thank you very much.