微晶片科技 (MCHP) 2005 Q4 法說會逐字稿

Good day, everyone, and welcome to this Microchip Technology fourth-quarter and fiscal-year 2005 financial results conference call.

As a reminder, today's call is being recorded.

At this time, I would like to turn the conference over to Microchip's Chief Financial Officer, Mr. Gordon Parnell.

Please go ahead.

Thanks, Audrey, and good afternoon, everyone.

During the course of this conference call, we will be making (technical difficulty) 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. (technical difficulty) today as well as our 10-K for the fiscal year ended March 31, 2004, and our 8-K current reports that we have filed with the SEC and that identify important risk factors that may impact Microchip's business and results of operations.

In attendance with me today is Steve Sanghi, Microchip's President and CEO.

I will comment on our fiscal year 2005 and fourth quarter fiscal 2005 performance, giving information by geography and product segment, and Steve will then give his comments on the results (technical difficulty).

On a GAAP basis, net income for fiscal 2005 was at record levels of 213.8 million or $1.01 per diluted share, up 55.8% from net income of 137.3 million or $0.65 per (technical difficulty) in the prior fiscal year.

On a non-GAAP basis, net income for fiscal 2005 was also a record, at 226.8 million or $1.07 per diluted share, an increase of 44.6% from net income of 156.8 million or $0.74 per diluted share in the prior fiscal year.

GAAP net income for the March quarter was 56.4 million or $0.27 per diluted share, an increase of 20.4% from GAAP net income of 46.8 million or $0.22 per share from the prior year's fourth quarter and an increase of 6.1% from GAAP net income of 53.1 million or $0.25 per diluted share from the immediately preceding quarter.

Geographic results reflected our overall expectations and the seasonal pattern for each of the areas.

Both Americas and Europe were up sequentially, 5.6% and 13.5%, respectively.

Affected by Lunar New Year, as we discussed in our guidance for the March quarter, Asia revenue was down 8.4%.

On the product line basis, both analog and memory product lines grew sequentially approximately 7.5% in each area, while microcontrollers were essentially flat.

We established record gross margins on an annual basis, as well as for the March quarter.

For the fiscal year, gross margins were 57.1% and for the March quarter, gross margins were 57.4.

Operating expenses were 24.6% of sales in the March quarter, compared to operating expenses of 24.9% in the previous quarter.

Research and development costs were 23.3 million, representing 11.2 percent of sales.

Sales in general and administrative expenses were 27.9 million, representing 13.4% of sales.

The tax rate for the March quarter and the fiscal year was in line with our guidance of 24%, and we're anticipating continuing at this rate for the current year.

The dividend declared today of $0.095 was an increase of 36% sequentially and an annual increase of 138%.

During fiscal 2005, dividend payments totaled $43 million, while the quarterly dividend payment based on the dividend declared today will be approximately $20 million.

Overall in fiscal 2005, we established new record levels in net sales, gross margins, operating margins and net income, and rebounded with the growth quarter after only one sequentially down period.

Microchip's total inventory position at March 31st was approximately 103.7 million, an increase of 5.9 million from the prior-quarter levels.

Inventory turns are at 3.4, with days of inventory representing 107 days, at the low end of the guidance we provided.

We anticipate that the inventory will peak at these levels, and we will start to see (technical difficulty) in the June quarter to approximately 100 to 104 days.

Distribution inventory is at very moderate levels in all geographies.

As of the end of March, our distributors held about 2.3 to 2.4 months of inventory, modestly lower than last quarter.

At March 31st, Microchip receivable days were 48, compared with 47 days at the end of the December quarter.

Overall trade receivable balance increased approximately $10.9 million or 10.7%, reflecting predominantly the pattern of POP purchases by the distribution channel during the quarter.

As of March 31st, Microchip's cash and short-term investment position was 734.6 million, with (technical difficulty) debt on the balance sheet.

During the fiscal year, Microchip generated cash flow from the business after capital costs, working capital, treasury activities resulting in adding 328.3 million to treasury, excluding our stock buyback activity.

We purchased 68.3 million of our common stock under our stock repurchase program during fiscal 2005.

Capital spending was approximately 8 million for the March quarter.

Depreciation expense for the March quarter was 28.7 million, versus 27.4 million for the same quarter last fiscal year and 30.2 million in the December quarter.

Capital spending for the fiscal year was $63 million, and depreciation for the year was $119 million.

As of March 31st, our facility in Puyallup, Washington has been reclassified to an asset held for future years from an asset held for sale.

We will begin depreciating this facility in fiscal 2006.

Looking forward to fiscal 2006, we anticipate capital expenditures of between $55 and $60 million and depreciation of $110 million.

With that, I will ask Steve to discuss the performance of our business, our guidance for June and update other business matters.

Thank you, Gordon, and good afternoon, everyone.

First, I would like to reflect on the results of the March quarter, and then discuss our guidance for the June 2005 quarter.

Since our January 25 earnings conference call, we have attended several financial conferences and have met a large number of investors and analysts.

Today, I would like to update our current position on several of the common questions that we have received.

This should help investors understand Microchip better.

Number one, during our January conference call, we indicated that we were seeing the inventory correction having run its course, and consequently guided to flat revenues for the March quarter.

In certain camps, our guidance was considered ambitious.

I am very pleased to be delivering March quarter results that exceeded that guidance in net sales, gross margin percentage, as well as earnings per share.

In January, we said that we were already seeing memory and analog inventory production over for our products.

In the March quarter, confirming that assessment, our analog and memory businesses were up approximately 7.5% sequentially.

We also said in January that we were seeing the beginning of the end of inventory correction for microcontrollers, and that it should play itself out during the March quarter.

I am pleased that the scenario we outlined was confirmed in the marketplace.

Our microcontroller business was essentially flat for the March quarter sequentially.

Number two, the second discussion area was related to our inventory strategy.

In January, we said that we planned to run the factories flat and allow the inventory to increase.

We expected inventory to peak out at 115 days.

Our inventory in the March quarter was 107 days, below the guidance we initially indicated.

With June quarter revenue expected to grow, we believe that our inventory has peaked at 107 days, well below the prior peak of 134 days.

And with the distributors' and customers' inventory sitting at very low levels, we do not consider our inventory to be high.

Microchip's products have a very long lifecycle.

We use this attribute of our business model to keep factories running, and therefore producing the product at very low incremental cost.

This moderates gross margin impacts during the semiconductor cycle.

With inventory peaked at 107 days and low level of inventory at our customers and distributors, we are starting to slowly ramp our factories again.

If we had cut back on the capacity and laid off our people in January, we would now be rehiring just when the severance would have run out.

Instead, we kept the factories running and only took some natural attrition of the personnel.

We are now starting to ramp again, which will have positive effect on gross margins.

We expect inventory at the end of June to be in the range of 100 to 104 days.

Number three, the third discussion topic we heard about is that gross margins were not sustainable.

Not only have the gross margins been sustainable, but we exceeded our previous record for gross margins and posted a new record gross margin of 57.4% in the March quarter.

The pricing power of our proprietary products is alive and well.

In the current inventory correction cycle, we experienced a peak-to-trough gross margin decline of only 40 basis points.

We have clearly exceeded our own expectations here.

The fourth question we have been getting is regarding Freescale, which is now an independent company from Motorola.

Freescale has been a very worthy competitor for many years.

We have never felt that they have ignored this market in the last 14 years, based on our interactions in the marketplace, and that going public has not changed anything in our opinion.

Over the years, they have launched a number of products and campaigns in this market, but it did not have any negative impact on Microchip.

Their Nitron product family was introduced 2.5 years ago and two CEOs ago.

It has failed to make any impact, and we do not see anything new.

Our calendar year 2004 microcontroller business was up 24% over calendar year 2003.

Gartner Dataquest recently cited industry 8-bit microcontroller business was up 11% in 2004.

Dataquest also said that Freescale's 8-bit microcontroller business was down 1%.

So Microchip was up 24% while industry was up 11% and Freescale was down 1%.

Our performance versus the industry and Freescale is not ordinary; it is really extraordinary.

During the last quarter, our Flash microcontroller business was up 6% sequentially.

It was up 39% over the year-ago quarter, and it was up 58% fiscal year 2005 over fiscal year 2004.

We are safely the largest manufacturer of 8-bit Flash microcontrollers. 8-bit Flash microcontrollers in the industry now make up about 35% of the total market in calendar year 2004, based on our estimates, and we expect it to become about 60% of the market in the next five years.

We are extremely well-positioned to continue to grow in this market.

In fiscal year 2005, ending March 31, we introduced a record 78 Flash new microcontroller products, significantly expanding our served available market.

We also sold a record 53,311 development tools, 24% above what we sold in fiscal year 2004.

In March 2005 quarter, we also sold a record 15,706 development tools, and we see tremendous momentum in our microcontroller business.

Now, while we have received comments concerning pressure on our gross margins from actions related to Freescale, we do not believe this is of significant concern.

Indeed, due to the cost reductions that we are achieving in our business, they are offsetting any pricing pressure, resulting in our gross margins increasing, not declining.

A little later, I will update our longer-term gross margin targets.

Number five, another discussion topic centered on book-to-bill ratio and the terms required.

Our book-to-bill ratio for December quarter was 0.88, and on January 1, 2005 it required a higher number of turns to make a sequentially flat quarter.

I have spoken about this topic during several conference calls.

The book-to-bill ratio and turns required do not correlate to business results, especially when it comes to our proprietary products.

The March quarter was not any different.

So, despite two weeks off in Asia during the Chinese New Year, a week off in January during the calendar New Year and some time off in Europe during Easter, our March quarter was sequentially up 1.3%.

So clearly, the book-to-bill ratio -- clearly, the turns required for the quarter, at the start of the quarter, does not really have any correlation to the end results for the quarter.

At the same time, we have also proven once again that Microchip normally recovers from the major industry events in a single quarter.

Number six, we also received questions concerning the production cuts at General Motors and Ford.

Our automotive business actually did better than the corporate average.

It was up 3.8% from December to March quarter, and it did not see the reduction that the production cuts at GM and Ford might imply.

Our automotive business is a global business.

When one car company loses market share, someone else gains market share.

We are widely penetrated in nearly every car model around the world.

The electronic content in the vehicle is the key driver for Microchip's automotive business.

Ford and GM are simply not a proxy for our automotive business.

Number seven, finally, we received comments from investors was about stock option and expensing.

We will be fully prepared to start expensing stock options when required by law.

With the latest ruling by SEC, we will be required to start expensing stock options with our quarter starting April 1, 2006, which is a year from now.

Microchip has historically granted 1.5% to 2% of its outstanding shares as options every year, which is substantially less than the industry.

In several studies by analysts and others, we have seen Microchip come up as having a very low dilution percentage based on option grants as compared to the industry.

We have been hearing that many companies in the industry will lower their option grants to about 3% to 3.5% of outstanding shares.

So, at 1.5% to 2% we are well below where the industry may get to, and the industry is a lot higher today.

These facts will certainly be reflected in comparative earnings when the option expensing takes effect.

Therefore, we are not currently planning to make any changes to our option program.

In summary, about the last quarter I am very (technical difficulty) and proud that our business model has held up once again during a very difficult period for the semiconductor industry.

Our growth and operating margin percentage remain among the best in the industry and far ahead of our closest competitors.

We have always managed our business to industry cycles based on a longer-term focus on the overall results, resulting in higher highs and higher lows in operating performance.

We certainly believe that to be the case in the current business environment.

We have already produced record gross margins in the last quarter, and we should produce record operating margins in the near future.

And now, I shall discuss our guidance for the June 2005 quarter.

As we look at the June quarter, we took many business factors into consideration.

First, we believe that the inventory correction of our products is over.

Our book-to-bill ratio for March quarter was approximately 1.

With April nearly over, the bookings for April are extremely strong.

April is heading to be the best first month of the quarter for bookings ever in our history.

The backlog is well above the March quarter backlog at the same point in time.

June is also Microchip's seasonally strong quarter.

So after taking all these factors into account, and after checking and rechecking expectations from our direct as well as distributor channels, we expect our net sales in the June quarter to be sequentially up about 5%, or revenue to be about $218 million.

We expect gross margins to be about 57.5%, which would be another record, and earnings per share to be about $0.28.

With the March quarter being back-end loaded, we expect to generate approximately $100 million of cash flow in the June quarter prior to our dividend payment of approximately $20 million.

And we look forward to sharing this cash with our investors with another increase in dividend.

On a longer-term basis, investors have been asking what Microchip can expect ever the next three to five years.

While we are not prepared to provide specific numerical guidance that far out, we can say the following.

Based on our strong momentum and market position, we will continue to grow net sales better than the overall industry.

Our gross margins should continue to increase as we continue to fill up Fab 4, create even higher value added to analog integration, we benefit from lower CapEx, and we start benefiting from fully-depreciated capital.

We expect our long-term gross margins to reach 60%.

Our prior long-term guidance was 59%, and we now feel more comfortable increasing that guidance to 60%.

We expect our CapEx, as a percentage of sales, to be less than 10% over the next three years.

With that, we expect to generate about 375 million plus of cash flow per year prior to dividend payments.

We look forward to sharing this enormous cash generation with investors, with continuing increases in dividends in the future.

And finally, on March 31, 2005, Microchip completed its 12th year as a public company.

We have taken the liberty to compare Microchip's stock price against a comprehensive list of 219 public companies in the semiconductor device, equipment, materials, foundry, assembly, test and other services.

And we can probably say that Microchip's stock was the number-one performer in the entire semiconductor industry during the past 12 years.

With that, Audrey, would you please poll for questions?

(OPERATOR INSTRUCTIONS).

Mark Edelstone, Morgan Stanley.

First off, congratulations on all the successes here, guys.

A question, Steve.

Obviously, you're showing you guys are running the business incredibly efficiently.

With the inventories where you're expecting them in the June quarter, can you just look out over maybe the next year, and talk about where you're kind of comfortable taking inventories to, going forward?

And then I've got a quick follow-up.

Well, we have modeled that with strong quarters ahead here, and the business starting to grow.

We expect inventory to continue to come down.

The September quarter should drop below 100, and then it continues to drop, probably goes below 90 by the end of the fiscal year, which provides us an opportunity to look at it at any point in time over the next few months to, at any point in time, possibly accelerate the capacity in Fab 4.

But that really will depend on the leadtimes, the business environment, what do they do and all that kind of stuff.

We're fortunate in that we have so much flexibility with Fab 4 in being able to turn that on effectively at really short notice.

We have found over the business cycle that there is not a static number we can guide to, that we are comfortable with an inventory of 90 or 80 or whatever.

It's really a complex equation, depending on what inventory the customers are carrying -- what inventory, especially, our distributors are carrying.

If distributors are carrying less inventory, very low inventory, like they are right now, we are comfortable with more ourselves.

If they are carrying more, then we are comfortable with less ourselves, so it will really continue to be that complex equation that we will continue to monitor.

We have shown over several business cycles now that we don't take inventory write-offs, one-time loss, inventory write-offs.

We have managed it very, very well over cycles.

We did not write off inventory during the huge cycles of like SARS and inventory correction.

Our products have very long lifecycles, and we truly, honestly, are on the top of it.

And we know how to keep the appropriate amount of inventory, when to allow it to grow and went to cut back.

Just as a follow-up, then -- Steve, obviously, you guys have just had what now appears to be just a one-quarter correction in the business.

So if you look at the Fab 4 ramp going forward, based on your view of the marketplace, is that now going to ramp on the same trajectory that you had before, just shifted out by one to two quarters?

No.

We have really not looked at any correlation to what we were doing a year or so ago.

It's basically a new environment, and we have internal forecasts.

And we are starting a slow ramp, because inventory is still above 100; it's 107 days.

So we need to really allow it to come down for a couple of quarters with a very, very slow ramp.

And then, as we get into six months, five or six months further, we need to look at it, what the outlook is and where the industry is headed.

If you look at second half 2005 and 2006 numbers from various industry analysts, there's really no consensus.

People are all over the place, so we really have our internal projections.

And as they are verified with our customers and with our design wins and new products, we will then be taking appropriate actions to accelerate the ramp.

Adam Parker, Sanford Bernstein.

Just a couple questions, a little bit more on the cash flow.

It seems like your stock is at about a 3.5-year low on price to cash flow, yet you sort of identified you have a lot of cash generation in front of you.

So I'm just trying to understand that disconnect.

Do you think investors are guiding to capital spending?

And maybe you could walk us through why it will remain so much lower in the next three years; you said less than 10%, versus the history.

Well, the history of Microchip was we started with having really no infrastructure.

If you compare it to a larger company, where you have five fabs or six fabs and you're adding one, incrementally it is a very small infrastructure chains.

But when Microchip went from a very small all-fab to adding the Fab 2 in Tempe, which was much larger, we went from having a capacity to about two to three times more capacity.

Then we converted our fabs from 5-inch to 6-inch, then 6-inch to 8-inch.

So there was a fair amount of infrastructure investment we needed to make.

Years ago, we also but the assembly and test plant in Thailand.

Then we bought Fab 3, then we bought Fab 4.

So you were looking for years of growth where we had very, very substantial infrastructure investments.

If you look at going forward, number one, we do not to need to make conversion from 8-inch to 12-inch.

I can't see it in our horizon even in the next 5 to 10 years, because the die size and lithography of our products -- we don't really gain anything in going to 12-inch or 300-mm wafers.

So that investment is really not going to happen.

Secondly, we have substantial, very low-cost capacity available in Fab 4 for several years, where we only have to add some incremental capacity for bottlenecks and really not overall capacity increase.

And third, as you listened to Gordon Parnell, with our Fab 3 now slated to go from assets held for sale back to assets held for future use, we have even future brick and mortar capacity without having to build another $0.5 billion fab.

So, for long periods of time, we really see substantial infrastructure ahead of us, and therefore we are fairly confident that we have migrated to a model where the CapEx is very, very low as a percentage of revenue.

I know you follow the stock carefully.

What do you think is this disconnect between the free cash flow you are about -- or just the cash flow from operations less the CapEx that you are about to generate going forward?

Obviously, it appears to be more powerful.

You have sort of a discount relative to your history.

To what do you attribute that disconnect?

Well, analyzing stock is really not my expertise; running the Company is.

I think that is your expertise.

And I don't really know; we are just frustrated by it.

I ran through a litany of questions that we have received from investors and analysts over the last quarter and basically for the last year, related to 8-bit microcontroller market-share growth, the Freescale, gross margin, whether it's sustainable, so on and so forth.

And I think, in each and every area, we have demonstrated consistently over years that we have called it right.

We have been public for 12 years now, and 90% of the quarters we have been right on.

And we missed about probably five quarters in the last 12 years, and each of those quarters correlated with some major industry events, turning points like to the tech bust or the inventory correction or whatever.

And other times we have always called it right, but there seems to be always skepticism out there.

And I think we have tried to address that to the best of our ability.

Maybe just switching gears, then, off the cash flow point, in your guidance of 5% up, what do you expect from maybe microcontrollers versus the analog and memory?

It seems like analog and memory created the upside this quarter, and I'm just trying to understand what is embedded in your guidance of up 5 in terms of the microcontroller business.

Well, we don't really have the ability to break it out in our 5% guidance among three components.

Our guidance essentially assumes that all three product lines will grow in the same range.

Our analog is smaller; it could grow faster, although it's smaller, so it tends to be more volatile, because a few customers can drive it this way or that way.

So our model assumes about 5% for all three product lines, and I think the actual will be somewhere around that.

So it does assume that microcontrollers will grow at 5?

Oh, absolutely.

It grew 24% last year, and every single quarter -- if one quarter, it does not grow, the year's old skeletons come out like, well, you have grown in the past, but you won't grow now.

Freescale is this, and somebody else is this.

And just look at it over year over year.

Over any length of time we have consistently grown, and we have no doubt -- microcontroller backlog is solid, and we are doing extremely well.

And there's no doubt in our mind that this quarter, microcontrollers will be up substantially.

And we have great confidence in our Flash-based products.

We see strong development sales as a good indicator of momentum.

So we have a high degree of confidence in that business segment.

Chris Danely, JPMorgan.

Just a couple questions.

On the gross margin ramp, can you just take us through what are the different levers there, as far as utilization rates versus declining depreciation, I guess, and how you expect that to ramp?

Should we expect it to go up after this quarter, or do you think that your gross margins will be flattish in the September quarter and then move up after that?

We expect that by the end of the fiscal year we can be north of 58%, and we were at 57.4 last quarter.

So it's just not enough to split it by quarter.

Most people give guidance plus or minus 100 basis points.

Our guidance has been much tighter, because I think our margins are not as variable.

But if you try to take 60 to 100 points here and divide it over four quarters, you just can't get any more precise; you're just going to have to make an estimate.

That's fine.

Could you just talk about the different levers and their different relative effects on the gross margins going up?

Well, it will be, obviously, absorption in the fab, so if we start ramping Fab 4 harder.

The second would be the product mix, relative to the various products inside the microcontroller and percentage of analog versus memory.

There is also effect of depreciation.

I think Gordon has guided with the depreciation is going to be in the current quarter.

So depreciation is slightly declining, so that certainly has an effect which is very numerical, and you can figure out the impact of that.

And there are lots of other small moving parts, ASPs and product mix and analog integration and --

Cost adoptions in our business is absolutely a key area that goes unnoticed but, again, contributes to overall profitability.

Steve, you talked about what percent of the MCU market you think is Flash-based.

What part of the ASIC (ph) market do you think is programmable, and how do you see that changing over the next, say, three to five years?

I didn't actually say Flash.

If I said that, I correct myself.

We believe, as of the last year, approximately 38% of the market was programmable microcontrollers, a combination of Flash and other field-programmable, which is EPROM-based.

And we expect that the total market, programmable market, goes from about 38% to over 60% in the next five years.

We have shown you those graphs before, I think, two or three quarters ago.

And we will update them in the near future.

And actually, I have gone back and looked at those graphs, and I think our projection was right on.

And we made that almost a year ago.

I think what we said was 35% currently is programmable.

Maybe I misheard, guys.

Thanks a lot.

Nice quarter.

Ambrish Srivastava, Harris Nesbitt.

Steve, just a clarification.

So your business, your MCU business is about roughly half is programmable and Flash.

Is that correct?

Half is Flash.

Programmable is almost all of it, well over -- in high 90's.

Then the question is would you please share your views on what you are seeing broadly, not just current quarter, looking out ahead, and help us put what we are hearing on the weak economic front, whether it's Europe or US, and put that in perspective with what you are seeing out there in the marketplace?

Well, that's a toughie.

The oil is low today, so it's good for the economy.

And oil is more expensive tomorrow, it's bad for the economy.

Consumer confidence was down today, so it's bad for the economy.

And GM and Ford cuts there, so it's bad for the economy.

Tomorrow the dollar is strong, it's good for the economy.

We can't run our business by watching the daily news.

Running a company with 4,000 employees and $850 million business requires a steady hand, and a consistent direction to the employees and managers to have longer-term goals and consistently drive to achieve those goals.

You can't get up in the morning, watch TV and start to take actions when you come to work.

So my answer to you is we just don't manage it that way, and it seems to have worked out very, very good for us.

I have really no response to it.

Our business is driven by penetration of microcontrollers in all sorts of appliances and automobiles and security systems, and so on and so forth.

Microcontroller is the most ubiquitous device, and whether the GDP is 2% or 3% or gets revised and looking back and -- it's just all a bunch of mumbo jumbo, and I don't really think it's ever correlated to anything.

Okay, fair enough.

I guess you guys have shown that you have outperformed the industry.

Randy Brandon (ph), Eaton Vance.

Could you just look a little bit on the thinking that what happened with Fab 3 -- I mean, you kind of looked around and, what are we going to get for this versus what do we do if we keep it, and it ain't worth it to sell it type decision?

And then, sort of the second thing is, in comparing your microcontroller business, there isn't anybody very big that is doing anything close to what you are.

So why not go after somebody like Silicon Labs that is going to grow it 50% year over year this year?

I mean, a 6.2 million in the first quarter, and they are selling, say, half the development kits that you are per million dollars or revenue.

But it seems like a more worthy thing to shoot at than Freescale.

Well, okay.

Let me take your second question first.

Worthy thing to shoot at -- $22 million business, you can take all of it, and we won't be satisfied with the growth in a single quarter that we need to achieve.

So I don't know what you're meaning there.

I bring Freescale up because that was the number-one question asked me by the investors over the last quarter, as we go talk to investors and analysts.

We are not shooting at anybody.

We don't really have any competitor in our crosshairs.

We focus on our customers and understand their common needs and try to meet them.

We gain market share from the market, not really from a competitor. (Indiscernible) the mathematical calculation of what somebody shipped divided by the total market size.

We don't really shoot at anybody.

If we look at a competitive environment, we see Freescale, we see ST, NEC, Atmel, Infineon.

We honestly -- I don't hear any commentary from our sales folks concerning silicon labs.

At 6.2 million a quarter, you are not --

That's right.

So it's too small to be really in a major way on the radar screen.

What is there to shoot at?

That's such a small target, and I am not a good shooter;

I'll probably miss it.

But let me go to your first question, which was regarding the Fab 3.

Fab 3 was on sale for two years.

There were a number of other fabs on sale in United States from various other companies, and none of them really sold.

The market environment has been such that there has really not been a strong market for those fabs.

So during that time, our business has grown; we're up substantially in the last two or three years.

Since 2001 -- I have not done the backward math, but our business is up a very, very large amount in the last four years.

Every year has been a record since then.

So we have gotten to the point where, if we were to now continue to sell Fab 3 and actually, let's say we were to succeed at selling Fab 3, within two to three years, we will have to start looking for the next fab.

If you have to build one, it takes about three years and will cost $0.5 billion to $1 billion.

And that is not consistent with keeping our CapEx very, very low.

So at this point in time -- if we had sold it a year, two years ago it would be great, but it's almost too late to sell it now.

I think, and the way we see outlook in our business, we're going to need it in future.

So therefore, we will keep it.

Nor am I willing to sell it at a price it might sell for an alternate use.

It just doesn't really make sense.

Our cost of holding that fab is very, very low.

And as we look at Fab 3 and the type of cost structure that we can generate out of that facility, complementing our overall fab strategy, we think it can enhance our overall business, and help us to make these transitions to higher margins that we have spoken of, over time.

And obviously, Fab 3 is somewhat further out than the near-term gross margin questions we have received today.

Thank you.

A good 12 years;

I look forward to the next 12.

(OPERATOR INSTRUCTIONS).

Mark Lipacis, Prudential.

Gordon, I think in your prepared comments you had noted that inventories at distributors were down slightly.

Is that an indication of their outlook for the end market?

How should we think about that?

Or is that just noise?

And maybe you could talk -- Steve, you spoke about how you thought about managing your business relative to the day-to-day data points on the economy.

Can you share with us, more broadly speaking, how your customers are thinking about the health of the end markets?

Clearly, Mark, with 65% of our business being in distribution, we couldn't see our business growing 5% this quarter without distribution being a significant component of that.

So the changes in inventory distribution are very moderate.

I think distribution has learned to have a working capital model that has allowed them to carry lower levels of inventory.

We see leadtimes generally in the industry are quite short at this stage, too.

So I just think it's the range of inventory could be between 2.3 to 2.7, and it really would just be noise level changes that we would see taking place from that perspective.

We continue to monitor the point-of-sale data, which is the key for our revenue recognition, and are very encouraged with what we are seeing toward the current quarter.

In answer to your second question, which -- let me rephrase it, and tell me if I understand it.

I said we don't really look at day-to-day economic data to really guide and point our business.

But what do our customers do?

Do they look at these economic indicators and how they see their business?

Do I understand the question right?

Yes, and also just to add to that, are they of the opinion that their customers are selling through the stuff that they are selling?

Are their customer seeing healthy demand for their products?

You know, depending on the market our customers are in, whether they build appliances or cars or security systems or toys or, really, what kind of stuff they build.

So Microchip is really one of the broadest companies there is.

We have got 46,000 customers around the world and it's a very ubiquitous microcontroller device, can almost go into anything.

So there is really no one single answer.

But in general, if there was a global economic change, then it would have effect on our global customers, in terms of the number of things they will build.

The problem often is we tend to react too much to US economic data.

That's really what we hear on TV, early morning.

And everybody kind of tends to react to that.

The US business is slightly north of 26%, 27% of our business.

A large amount of business is international; we do business with 128 different countries.

So we look at the global economic indicator, which is harder to get at.

It would have impact on the number of bridges (ph) our total customers are building.

But what you forget in that is the penetration of microcontrollers.

We have tracked this for a number of years.

Pick a customer, and for the last eight years, our customers have grown at 4% a year, and our business in those customers has grown 20%, 25% per year, because we keep taking more and more stuff to build which didn't have microcontroller yesterday and it has microcontroller today.

You know, adding intelligence with (indiscernible) and better control.

If you have a refrigerator in your home which is 15 years old and it doesn't work anymore, you throw it away.

It probably had no microcontroller; it was purely electromechanical.

And you roll in a brand-new refrigerator, a 27 cubic feet, high-end refrigerator.

It will have five to seven microcontrollers today.

So as this replacement cycle happens in item after item in the consumer world, same thing is true for garage door openers, security systems to washers and dryers to toys, to anything you look at.

So our customers don't necessarily need to be building more units.

Even with a very, very small amount of unit growth or even flat -- in the automotive area, with the declining unit growth, Microchip said consistently produced healthy growth in our business.

Chris Caso, Friedman Billings Ramsey.

Just wondering if you could talk about the analog business a little bit.

It obviously looks like you had a good quarter out of the analog business this quarter.

But looking out over the last year, year and a half or so, it has been pretty much growing in line with the microcontroller business.

I guess my question going forward, maybe over the next year or two years or so -- is that about where you expect the analog business to be?

Or are there ways you think you can get the analog business growing a little faster than the microcontroller business?

Well, the analog business has been lumpy in nature, because it's a fairly small portion of Microchip, and we have found it lumpy.

Whenever something happens in the industry -- during the SARS quarter, it took a major whack.

During the inventory correction of a couple of quarters ago, it took a larger drop then we would have liked.

So that is really one factor.

The second factor has been underlying in that analog business, we have driven the cellular phone portion of the analog business to really very, very small numbers because, unlike many of the companies, that business does not fit our business model.

Usually pricing are low, the volumes are high, it's very competitive, it's fast-moving models.

That's not our business model.

Our business model is thousands and thousands of customers at high margin and so on and so forth.

So when we acquired Telecom Semiconductor in 2001, cell phone business was 56% of our business.

It is in mid single digits today.

So, underlying in our analog performance is really the desirable analog business has more than doubled.

But you don't see it.

When I present it that way, you think of the 56% of the business as now only about 5% of the business, and the rest of the business has almost doubled, has done very well.

We have grown that customer base from 1,000 customers to about 9,600 customers.

The gross margins have gone 40's to 60's.

The business is profitable.

So there's a lot of underlying strength.

Our internal growth for goal for the analog business is to grow substantially higher than the microcontroller business, because it's smaller in nature.

And it does that for a quarter or two; it gets positioned, but then it gets whacked by some sort of inventory correction or SARS or something like that.

I believe we will gain the footing on it, and over time it will grow stronger than our microcontroller business.

But it hasn't, so far.

But it sounds like there's nothing -- aside from the actions you have already taken to reduce the cell phone exposure, nothing fundamentally different that you're during in approaching this business?

Well, we're adding considerably to our proprietary product content, and that is definitely helping to drive the kind of change that Steve was speaking to.

So that not only helps gross margins, but it helps us to find defensible positions in other parts of our customer base.

That really is an overall element of our strategy, as well.

Another element is that analog business for most of our competitors also has always been around microcontrollers and DSPs and -- you know, so analog is always in the sockets which are dominated by the microcontroller sockets, and we have shown diagrams at conferences where microcontroller is in the center, and it is surrounded by analog on all four sides.

If you talk of a pure analog company, and when they go in they essentially try to sell their analog.

When Microchip goes, we try to sell our analog as well as our microcontrollers, and 90% of our microcontrollers are very, very analog-rich.

So half the time, we win the design with a microcontroller with embedded analog versus stand-alone analog.

So it looks like analog performance is really less than what it is, but in reality a fair amount of analog gets integrated inside the microcontroller.

Shawn Slayton, SG Cowen.

Nice execution.

If you mentioned it, I missed it -- the breakout of MCU analog and memory, and also breakout by end markets, consumer auto, et cetera.

We didn't give any breakout by end markets.

We simply don't, Shawn.

We don't get enough real-time information, nor are we able to look into our distribution network to that degree.

What we did say is that both memory and analog grew 7.5% sequentially, and microcontrollers were essentially flat.

So you can take a look from last quarter's revenue and be able to get to --

Okay, understood.

Steve, you gave some longer-term forecasts regarding MCUs.

Here, entering May, can you share with us your growth estimate for the entire worldwide 8-bit market this year?

The whole market, not what you are hoping to do on a company-specific basis.

Let me introduce you to Ganesh Moorthy, which is the Vice President of our Microcontroller Division, and have him say a few words.

I think most prognosticators would try to look out 9 months, 12 months into an overall market, who usually don't get it right.

And so, rather than try to hazard a guess, you can take a look at how the microcontrollers have been growing.

You can look at how it grew last year; it grew about 11% for the 8-bit market.

You will expect to see that it will grow, but it's probably got a pretty good range around it as to what it can do, depending on how much strength the overall market sees going into the second half of the year.

Okay, thanks guys.

Nice job.

We don't wait to see what the market is going to do to grow.

From our perspective, what we're doing is taking the actions that we can take that are in our control to drive our growth, without waiting for what the market is going to do for its growth.

Paul Leming, Soleil Securities.

Steve, you have painted a picture of a company just with extraordinary cash generation potential for the next three, four, five years, and talked about returning cash to shareholders through dividends.

And you have obviously been very aggressive on increasing the dividend since you first instituted one a couple of years back.

I would just like to understand better, looking out over the next few years, do you feel that dividends are an efficient way to return the 700 million sitting on your balance sheet and the 300 plus million you are looking at generating annually?

Is that something that lends itself to a dividend policy to return to shareholders, or are there are other things you are looking at doing to put the cash to productive work going forward?

Well, it's a very good question, and we discuss it among ourselves here all the time.

There have been a lot of discussions with the Board.

And there are three or four different ways to use the cash.

One is to acquire somebody, and we have shown our disliking for acquisitions in the past, and I do it again.

I think most acquisitions don't really work out, and we are very focused on really what we're trying to do.

And we are really not interested in bundling all of our cash in the acquisitions.

The second way is to put more of the cash in our R&D and marketing.

We are growing healthily, and we are well-funded in our divisions and marketing and sales.

And even if you were to spend a little bit more here and there, you are not going to burn that kind of cash.

It has to be supported by P&L, and otherwise has to be supported by revenue growth, otherwise we could not add more to R&D or marketing.

So that's really not going to do much.

Then two other ways left are stock buybacks and dividends.

We have done some stock buybacks here and there, but honestly I tell you I talk to investors all the time, and I personally own a large amount of stock of other companies that have done hundreds of millions of dollars of buybacks, and the stock is lower than what it was then.

And the value in my portfolio is lower.

And I have really not seen stock buybacks really put the money in investors' pockets.

You lose interest on that money and share count goes down.

It's usually a wash on the earnings per share, and the investor may own a larger portion of the Company, but you can't make enough difference to really give the money back to the investors.

So we do not have extreme liking for stock buybacks.

Now, it's controversial;

I talk to a lot of investors who would like us to adopt a consistent quarterly stock buyback policy.

My feeling is stock buyback does not increase investors' wealth.

We like dividends.

We want to give the money back to you.

You could reinvest it in buying more Microchip stock, or feel free to spend it or give it back to your investors or buy another company.

We give you all the flexibility.

Now, there is a 15% tax on the dividend, which is much better than what it used to be.

I wish it was zero.

It is not zero, so from that standpoint, it is slightly less efficient.

But stock buyback money goes into the rat hole and I have never seen it comes to my pocket or anybody else's.

Not everybody agrees with me on that.

Fair enough.

I welcome your comments.

Pardon?

I welcome your comments on what I answered.

Well, one man's opinion -- I clearly come down on the side of it's a very efficient way to shrink the share base of the Company and increase the assets and earnings and revenue per share of the Company by buying back stock.

And if you are growing your top line 15% to 20% a year and shrinking the share base 5% a year, I'll take the cumulative 20% to 25% per year growth.

It's fair.

You are not alone in that opinion.

We have gotten that opinion.

We will continue to discuss that with the Board.

We have analyzed a number of companies who have done that consistently for the last four or five years, and we just see too many examples where they brought the stock at 60 and the stock is sitting at 25.

But I do just want to come back and follow up on the question.

Do you think dividends are an efficient way to return, theoretically, $1 billion of cash?

At $300 million a year of excess cash flow with your cash today, you're going to be there in a year, and it continues to grow.

Is that something you can pass to shareholders, in your mind?

Well, let me say this.

It's a very high-class problem.

It's a wonderful problem.

I would love to tackle that problem in the coming year.

And as we tackle that problem and have the deep discussions with our Board, do we swing back to a little bit more of a buyback like you are mentioning?

It's certainly a possibility.

We are not returning that kind of cash today; we are returning about $20 million a quarter at the current rate, which is about $80 million.

We keep increasing it.

But do you return $1 billion of cash over three years through dividend?

I think you have a very, very fair question.

I have to tell you that we hear that a lot, and I will be delighted to tackle that high-class problem.

We certainly feel our dividend yield is beginning to get into the range where it is quite attractive.

And certainly, as we have said, we intend to continue to discuss it with the Board.

And as we look at growing that, it will enhance that aspect.

So from an overall market perspective, and where dividend yields are, we think it will be a very positive process for investors.

It's always an option for us to set up either a DRIP or investors can really make their own DRIP by putting the money back in.

Then you get all the choices.

You essentially get the same effect as a stock buyback, and the ones who do not want to reinvest in the Microchip stock could do that.

So I think there are several options.

So let's just leave it there.

We understand it, and it's a case of the good news (ph) to deal with here.

I appreciate the question and the chance to be able to discuss it.

Tore Svanberg, Piper Jaffray.

I know you don't give guidance by product line, but I think you mentioned the backlog so far this quarter is strongest you have seen in a very long time.

Would that apply for all three product lines?

That's correct.

And could you also give us an update on your dsPIC business?

I think you mentioned you had four products in production.

Could you maybe talk a little bit about the applications that they are going into?

Well, the four products in production is probably nine-months-old news now.

We have 19 products in production.

The last time I spoke to you guys, we had 16 products in production, back in January.

So we have 19 products in production.

Our original plan was the first product family will have about 20 products, so we're almost there.

The last one is really very, very close.

And we have already moved to really expand that family to the second generation and third generation, so all the development has already moved.

In terms of the applications and where we are winning, we have really chosen to not talk about it because -- obviously, because of competitive reasons.

The competitors are too finely tuned on what is Microchip doing, why do we keep on winning, and where we are going and where these products have good hit (ph).

And therefore we have chosen to not speak about it, nor are we going to break out our 16-bit microcontroller business.

Nobody else does it, either.

And finally, a question for you, Steve.

You have talked about your competitors, and I think it's pretty clear that you have been outperforming them year in and year out for a while now.

What would it take for a new microcontroller company to sort of get closer to your business model?

Or perhaps maybe you can answer this way.

Can you talk about the three or four (ph) things that really make the barriers to entry so high for your business model?

Well, I really have no desire to share our barriers of entry in a public forum.

That's really for somebody else to then take point by point and try to build an organization to overcome them.

The thing I could say is there are large numbers of barriers of entry.

A microcontroller business is not like the Flash memory or dynamic RAM, where you produce a 1-gigabit dynamic RAM and 70%, 80% of the business will switch to that within a year or so.

The same thing tends to happen in Flash memory and microprocessors and others.

Microcontroller is a very fragmented business, just like sort of the analog.

We have 262 products in production, and we're going to produce another 60, 70 products this year.

And any one product does not make a very, very large portion of our business.

So too many people want to produce one or two products and assume them to be blockbuster, and they are going to come and change Microchip.

We see too many of those threats.

We've seen over the last 10 years, and it's the characteristics of the microcontroller business a lot of people haven't understood.

It is truly an analog business. 90% of our microcontrollers have a high amount of embedded analog, and if you take that analog out, we would not be selling it.

It's truly an analog business.

Its margins, it's characteristics, number of units, how many products you have got to produce, technology -- it's like an analog business.

Jeff Rosenberg, William Blair.

I just wanted to ask a little bit about unit growth versus revenue growth.

And I guess my question is, if you look at blended ASP, I was wondering whether or not, with the ramp in the ATM series doing more peripherals like you were just talking about, Flash memory, whether or not you're seeing an upward trend in your blended ASP, or maybe some comments here on the relative unit revenue growth.

Well, right and wrong -- our 18X (ph) is doing phenomenal.

Its growth is absolutely very, very strong.

But at the same time, our lower-end products -- the 6 pins, the 8 pins, the 14 pins -- I mean, they are doing just very good, too.

They are exploding into new applications where microcontrollers have never been used in converting the electromechanical designs to solid shared (ph) and better control designs.

So the blended ASP is not changing, but it's not changing because we're not succeeding at the high end.

It's because we are also succeeding equally well in the low end.

Is it also the case, though, that units and revenue growth are pretty much in synch?

I would think they would be better than the industry, where I would think that, looking at overall 8-bits, I would imagine that there is ASP erosion version there.

Is yours pretty much at the same rate?

There is no average ASP erosion in our business -- hasn't been for years.

And you mentioned the 6 pin.

Is that product at the point where you are starting to see that ramping up and contributing to sales?

Oh, absolutely, yes.

I wouldn't specifically, numerically give the number.

But it's doing very well, yes.

That has only been out for about a year, right?

Less than that.

That seems pretty quick, that it would be doing well already.

Sumit Dhanda, Banc of America.

Nice execution.

A couple of questions.

First, Gordon, on the incremental gross margins, does your inventories on a days basis come back to a normalized level?

How should we think about incremental gross margins?

I really think our grows margins are driven by all the factors that we have indicated.

We are slightly growing our fabs, we're looking at cost reductions, we're looking at product mix.

I don't think you can take that on a mathematical (ph) basis and be able to apply that.

We have given direction that we believe that we can be north of 58% by the end of the year, and our longer-term margins are 60.

Beyond that, it's more difficult to pin us down to specific mathematical ways to do that.

One more question.

On prior occasions, you have indicated what turns you need at the point in the conference call versus what you need at the beginning of the quarter, based on your backlog coverage.

Could you perhaps give out the same data?

Let me try to answer that.

We have spoken at a lot of different conference calls, and I even spoke about it in my comments today, that in Microchip, the starting backlog or the turns required for the given quarter have never really correlated to the end results of the quarter.

If you look at the last quarter, we had a high number of turns requirement, and there was a lot of concern on the part of investors and analysts that the guidance was very, very ambitious.

And that really was not the case; we actually beat the numbers.

So we have proven once again that in the proprietary business, it truly does not make a difference whether somebody placed the order on the 25th of March or the 5th of April.

But in a turns requirement for the quarter, that really seems to make a lot of difference.

We have a very, very good strong backlog for this quarter, turns quarter today are lower, so we have decided to use this opportunity to not give you the turns requirement numbers.

It confuses everybody.

It does not accomplish much.

If we had done that when the numbers were lower, everybody would doubt our intentions.

We're doing it now when it is strong.

In future, we're not going to give you the turns requirement.

Simona Jankowski, Goldman Sachs.

Just another question on your gross margin.

It came in quite a bit better than expected in the March quarter.

And actually, if you just look at the calculation for the incremental gross margin, it was close to 95%, which obviously is probably a one-time event.

But can you just go into a little more detail into the various other components of that improvement, other than just the topline sales, such as mix or cost reductions?

Well, certainly, we have seen very good cost reductions, in terms of our assembly and test component.

We have seen excellent progress in terms of our die yields and our shrinks in the wafer fab.

And we are really supported overall by a very good product mix, in terms of our business, in terms of the average selling prices.

We have also seen some benefits in terms of depreciation and other fixed-cost areas in our fabs and other manufacturing, as we have seen, obviously, the industry be a somewhat difficult environment.

And Microchip is showing great strength and taking the sort of industry adversity and changing that into very, very good cost factors in our business and returning that to gross margins.

Some of those improvements you mentioned, like assembly test, die yields, better mix -- were those, for some reason, particularly more concentrated in the first quarter, to kind of show that big improvement in the incremental pass-through margin?

Or is that something we can kind of expect to see periodically?

How should we think about the lumpiness in those kinds of improvements?

We've given you direction from an overall perspective through the end of the fiscal year and longer-term.

Obviously, we don't expect to grow margins to this extent each quarter from an incremental basis.

Some of these factors are very difficult to forecast, and we have just seen the combination of many positive factors in our business taking effect in the March quarter.

And just lastly, on the margins, you updated your long-term gross margin guidance.

Do you have any updates you can provide us on the OpEx line, or perhaps at what sales level you think that can go down to maybe 23%, 24%?

We are not guiding to that level.

OpEx in about the 25% range is where we're comfortable.

We need to continue to invest in our business and R&D areas and our sales infrastructure to support the growth of our business.

So we don't have any update on that for investors today.

Craig Ellis, Smith Barney.

It's actually Terence Whalen for Craig Ellis, and thanks for taking my question.

It relates to the observations you made that the inventory corrections last quarter would be done a little bit earlier for analog and memory than microcontrollers -- as you observed correctly.

Do you have any insight in your experience as to the timing variances of inventory corrections between those two products?

And also, going forward, you mentioned in April that bookings are extremely strong.

Perhaps, is there some restocking going on at your OEM customers?

It sounds like the distribution TOS is strong, so it sounds like distribution inventories might be level.

We do not have any commentary on the radius product line, how they lineup in terms of timing of the inventory correction and recovery from it during various cycles.

We believe every cycle is unique, and there are factors of leadtimes and others and what drives certain things.

And what is good for one company often is not good for another company, as we have seen.

Various companies could go into inventory correction over two to three quarters, sometimes.

We have seen certain companies in analog where they go down a quarter or two quarters later.

So it's really all over the place, and each cycle could be quite different.

So I only have a general commentary on what product line follows what timing.

The second question you had was --?

I guess the second question -- I'm trying to understand; it looks like your 5% sequential growth is in line with seasonal normal levels, now that the inventory correction is over.

And I know that September is a little bit stronger, typically, seasonally.

Do you see that pattern continuing now, with the inventory correction complete?

Or do you expect any variance in that type of normal seasonal strength going into the back half of the year?

We don't have any guidance out in time, but in general we believe the environment is normal, yes.

Michael Masdea, Credit Suisse First Boston.

It's Jeff Loff for Michael.

You sort of touched on this a second ago, but with respect to operating margins, in your commentary you said you would expect to reach a record in the near future.

What I am wondering is, is that fully driven by gross margin?

Is there anything happening with expenses either stabilizing or coming down?

And then, secondly, what's the timing and level we should think about, in terms of the operating margin target?

We just said that we expect operating expenses to stay in the range of 25%.

So the leverage for operating margins would be coming from gross margin improvement, as we moved to 58% plus by the end of this year and then beyond to 60% in our longer-term model.

Ruben Roy, Pacific Crest Securities.

My question was just asked and answered.

That is all the time we do have for questions at this time.

I'll turn the conference back over to Mr. Sanghi.

Please go ahead.

Thank you, Audrey.

And thank you for all the investors and analysts for attending today's conference call.

And we look forward to seeing some of you on the road, as we attend various conferences again this quarter.

And we will talk to you in this forum again next quarter.

Thank you.

That does conclude today's conference call.

Thank you for your participation.