微晶片科技 (MCHP) 2007 Q3 法說會逐字稿

Good day, everyone, and welcome to this Microchip Technology third quarter fiscal year 2007 financial results conference call.

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

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

Please go ahead, sir.

Thanks, Amy, and good afternoon, everyone.

During the course of this conference call, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the Company.

We wish to caution you that such statements are predictions and that actual events or results may differ materially.

We refer you to our press release of today as well as our 10-K for the fiscal year-ended March 31, 2006.

And our 8K current reports that we have filed with the SEC that identify important risk factors that may impact Microchip's business and results of operations.

In attendance with me today are Steve Sanghi, Microchip's President and CEO, and Ganesh Moorthy, Executive Vice President.

I will comment on our third quarter performance reviewing geographic data and discussing balance sheet and cash information, and Ganesh and Steve will then give their comments on the results, outline our guidance for the March quarter and outdate other pertinent matters regarding our business.

We will then all be available to respond to specific investor and analyst questions.

So, initially, in summary, our net sales for the December quarter were $251 million, this was down approximately 6.3% from net sales of $267.9 million in the immediately preceding quarter, and out approximately 6.9% from net sales of $234.9 million in the prior year's third quarter.

On earnings per share, just a reminder that we are continuing to include additional information in our press release related to the adoption of FAS 123R.

Non-GAAP results exclude the effect of the adoption of this accounting standard providing comparability to prior GAAP results.

Non-GAAP net income for the December quarter was 78.7 million, or $0.36 per diluted share, a decrease of 6.5% from non-GAAP net income of 84.2 million or $0.38 per diluted share in the immediately preceding quarter, and an increase of 11.3 from non-GAAP net income of 70.7 million, or $0.33 per share in the prior year's third quarter.

Our GAAP net income for the December quarter was 72.8 million, or $0.33 per diluted share, inclusive of all share-based compensation expenses.

The impact on the earnings related to the adoption of share-based compensation in the December quarter was 8%.

Geographic and divisional information, sales in all geographies in the December quarter were all sequentially down.

Asia was down 8.5%, Americas was down 4.8%, and Europe was down 4.2%.

Asia continues to be our largest geography, now representing approximately 44% of total sales.

Americas and Europe were both at approximately 28% of total sales.

This measurement is based on where the product is delivered for manufacturing purposes for our customers but doesn't necessarily represent where the design activity has taken place.

Looking at operating P&L levels, and for comparative purposes I am using a gross margin and operating expenses information prior to the effects of share-based compensation initially.

Gross margins were in line with our expectations, they were 60.3%, in the December quarter.

Operating expenses were 24.7% of sales in the December quarter, an increase from 24.1% in the prior quarter.

Research and development costs were 25.6 million, representing 10.2% of sales.

Sales and general administrative expenses were 36.5 million, representing 14.5% of sales.

Gross margins including share-based compensation were 59.6%, and this was actually the first quarter that gross margins were impacted by the adoption of FAS 123R, in prior periods those costs were capitalized into inventory.

Our total operating expenses on a GAAP basis including the effects of share-based compensation were 27.2%.

The tax rate for the December quarter was in line with our guidance at 24%.

The dividend that we declared today of $0.26.5 per share was an increase of approximately 6% sequentially and an increase of 39.5% over the same quarter in fiscal 2006.

The dividend payment to be made in the March quarter will be approximately $57 million.

Let's turn to the balance sheet now, and Microchip's inventory and excluding the impact of FAS 123R, inventories increased approximately 4.1 million to 118.5 million, representing approximately 108 days, an increase of nine days from the September quarter.

Including the adoption of share-based compensation, inventories were 121.9 million, or 110 days of inventory.

Distribution, the inventory holding patterns of our distributors were pretty much unchanged from the September quarter, and as of the end of December our distributors held about 1.9 months of inventory.

Combining inventories on our balance sheet and at the distributors, they would represent 143 days of total inventory.

And receivables, at December 31st, our receivables were 120.1 million, lower than the levels at the end of September by about $3 million, approximately.

Payment performance by our customers continues to be strong with only 1.6% of total receivables beyond what we would consider reasonable payment terms based on the terms that we have with each individual customer.

Our cash position at the end of -- as of December 31st, Microchip's cash and total investment position was approximately $1.3 billion, with $29.5 million of short-term debt on the balance sheet.

During the quarter, Microchip generated net cash flow from the business of $104.4 million.

Payments relating to our cash dividend of $0.25 were $54 million, and we also reduced our short-term borrowings by $51.3 million.

We anticipate paying down the remaining short-term borrowings during the current period.

Capital spending for the December period was approximately $16 million.

Depreciation expense for December was $29.1 million versus $26.7 for the same quarter last fiscal year, and $29.2 million in the September period.

Our capital expenditure forecast for fiscal 2007 is now $65 million, and the depreciation forecast for the -- for fiscal '07 is $150 million.

With that, I will ask Ganesh and Steve to discuss the performance of our business, and guidance for the December quarter.

Ganesh?

Thank you, Gordon and good afternoon, everyone.

I will now comment on the individual product lines after which Steve will walk you through our guidance for the next quarter.

So let's start with microcontrollers, our microcontroller business was up 7.4% over the year-ago quarter and declined sequentially by 6.8%.

Our flash microcontroller business was up 24% over the year-ago quarter and declined sequentially by 5.3%.

Flash microcontrollers now represent over 65% of our microcontroller business.

We shipped 21,444 new development tools last quarter, which was another all-time record.

The record shipment of development tools demonstrates continued strong designment activity and acceptance of our products.

Next, on 16-bit microcontrollers, our 16-bit microcontoller business was up 143% over the year-ago quarter and essentially flat sequentially in the December quarter.

The pause in sequential growth after several quarters of strong growth is reflective of the inventory correction in the industry, that the industry is going through and our short lead times.

Our 16-bit designment momentum and development tool sales remain strong in the current environment which bodes well for continued strong growth.

The number of 16-bit volume customers grew to 638 in the December quarter from 484 in the December quarter.

In terms of 16-bit customers of all volumes, that number remains in several thousand.

In terms of total products that we have in production for 16-bit microcontrollers, we have 78 in production currently and expect to have about 90 by the end of the March quarter.

Moving to analog products, analog products are up 20% over the year-ago quarter, and down 1.3% sequentially.

The market for analog products has been challenging with the majority of competitors reporting significant sequential declines in the December quarter.

With our near flattish revenue performance sequentially, we believe that we're continuing to gain market share in analog.

The number of customers buying our analog products grew to 11,687 from 11,546 in the prior quarter.

And finally, on Serial E's core memory products, Serial E's core memory net sales were down 6.3% sequentially, the pricing decline moderately quarter over quarter.

Now, let me pass it to Steve for some general comments and our guidance for the March quarter.

Steve?

Thank you, Ganesh.

And welcome everyone.

Today I would like to make a brief comment reflecting on the results of the December quarter, then I will discuss the guidance for the March 2007 quarter.

All of the figures in our comments will be prior to share-based compensation expense in order to do a fair comparison to prior quarters.

The figures with share-based compensation expense are all available in the press release.

We delivered a fairly decent quarter despite very challenging industry conditions and a broad-based inventory correction.

While our net sales were down 6.3% sequentially, we were able to maintain a fairly high gross margin of 60.3%, down only 15 basis points from the peak.

We also achieved an operating profit of 35.6%.

This quarter also marks the 65th consecutive quarter that we have been profitable.

A testament to the resilience of Microchip's business model over many, many business cycles.

We shipped a record number of new development tools indicating strong acceptance of our products, and very strong designment activity.

The record shipment of development tools is also an indicator of the success of Microchip's demand creation initiatives.

In the last several years, we have increasingly taken more direct control of demand creation.

We have taken it out of the hands of our global distributors, except future electronics, and we have added Microchip's direct resources as well as regional distributors, catalog houses, design houses and manufacturers' representatives.

All in all this retooling of demand creation has been very successful.

Before I discuss our guidance for the March 2007 quarter, I would like to make one important comparison.

We now have microcontroller revenue data for the entire calendar year 2006 for Microchip.

We have three-quarters of data for Freescale, while we are estimating their fourth quarter based on average industry conditions.

As you may all know, they have gone private now, so data may be hard to get.

This comparison clearly shows that Microchip in 2006 became the number one supplier of 8-bit microcontrollers in revenue.

Now, recall that we have been Number 1 in units shipped for 40 years now, but we were Number 3 in revenue behind Freescale and also because Hitachi and Mitsubishi merged into a single company called Renaissance, our analysis shows that in 2006 we crossed both Freescale and Renaissance to become Number 1.

While the SIA, Semiconductor Industry Association data shows that the 8 and 16-bit microcontroller industry grew by about 1.8% in 2006, Microchip's microcontroller business grew by 16.25%, 1.8% versus 16.25%.

This difference in our performance versus the industry's performance has significantly widened which continues to validate our demand creation strategy.

Now, the guidance for the March 2007 quarter.

As we look at the March quarter, we took several factors into account.

We looked at our own bookings and business activity in various product lines, our starting backlog for March quarter was slightly higher than that for the December quarter.

We also looked at the inventory situation.

The inventory at our distributors continues to be at the lowest level of historical range.

The historical range has been 1.9 months to 3.3 months.

Current distribution inventory is 1.9 months, in fact, in the last quarter we saw no inventory correction at our distributors, because the distributor inventory was flat at 1.9 months, and at the lowest historical levels.

The inventory correction was at the end customers.

And our own inventory continues to be in good shape.

While inventory went up from 99 days in September to 108 days in December, it continues to be in the middle of the historical range of 74 to 134 days for Microchip.

We also looked at our lead times.

Our lead times remain in the three to five weeks range with most products available off the shelf.

Looking at it geographically, we expect this to be a very strong quarter for Europe and a weak quarter for Asia because of Lunar new year holidays, and America should be in the middle.

We have also looked at the pattern of last inventory correction and our own revenue during that cycle.

This cycle seems to be very similar to the one that we saw in December of 2004.

Microchip has returned to sequential growth after one quarter of decline in every cycle, with the 2001 tech bust as a full exception.

We believe the December quarter revenue marked the trough of the revenue for Microchip in this cycle.

We have also tracked the revenue guidance of many others in the semiconductor industry, like Texas Instruments, Intercell, ST Microelectronics, Linear, Fairchild, LSI Logic and others.

The average guidance for these companies is about minus 7.5%, and some even higher.

As we look at our numbers, bottoms up, coming from our direct as well as distribution channels, we just could not see a further drop in our revenue.

We see most of the inventory correction behind us, any remaining inventory correction should be balanced by our strong momentum in many new product lines.

Therefore, we strongly believe that the December quarter revenue marked the trough of the revenue for Microchip in this cycle.

Now, while our December quarter book-to-bill ratio was 0.97, our three-month book-to-bill ratio ending January has now recovered to essentially 1.

After a seasonal slow start in January, the bookings for the month of January actually ended quite strong.

Therefore, taking all these factors into account, we expect our March quarter net sales to be flat sequentially.

Microchip has exposure to a broad array of applications and markets, and has a very diversified revenue stream.

We are less exposed to cell phone communications and PC markets, as compared to some of our peers and competitors.

In addition, we believe that we are doing a better job of demand creation for our products and continue to gain market share as evidenced by the widening market share gap for 2006.

Now, because of sequentially down December quarter, we have lowered our CapEx forecast for the fiscal year 2007 to $65 million.

It used to be $70 million.

We are estimating that we will spend about the same, $60 to $65 million in capital expenditure in fiscal year 2008.

Gross margins for March quarter should remain about flat at 60.3%, earnings per share expected to be about flat at $0.36.

The earnings per share is without share-based compensation expense.

Earnings per share with share-based compensation expense should be about $0.33.

Also, I wanted to mention that historically first quarter, the June quarter is a strong quarter for Microchip Technology, so after this flat quarter in March, we should return to sequential growth in June.

And, therefore, the 60.3% gross margin guidance will result into only a 15-basis points drop in gross margin from peak to trough in this cycle, which is the best we have ever achieved.

We expect to build approximately $85 million of net cash flow before payment of $57 million of dividends just announced today, and we look forward to sharing this cash with investors with another increase in dividend in the next quarter.

So let me summarize a few key points.

Our net sales are expected to be about flat sequentially, and without the equity compensation expense, our gross margins are expected to be about 60.3%, flat to the last quarter, operating expenses to be about 24.75 to 25% of sales, and earnings per share are expected to be about $0.36.

With that, Amy, would you please poll for questions.

Yes, sir.

[Operator Instructions ]

We'll start with Mark Edelstone of Morgan Stanley.

Hi guys, nice job in controlling the business overall here.

Thank you, Mark.

I guess the main question I have, Steve, is you kind of pointed out some of the similarities between now and what we saw in the last cycle, and there certainly are many.

With your confidence that the business basically bottomed in December, as you look out and take into account the product flow you have today which is probably stronger than where it was two years ago, what's your general sense as to the trajectory of the recovery as it begins to happen here in June and beyond for fiscal 2008?

Well, it seems a very similar as we look at the guidance coming from other companies, it seems to be a lot worse in the March quarter, I believe, than what we saw two years ago, although I haven't gone back and looked at everybody's guidance back then.

But if you look at our own business which we have looked at a lot more closely, our backlog started higher, it continues to be higher than at a similar point last quarter at the end of January, the book-to-bill ratio was very good in January to the extent that three-months book-to-bill ratio return essentially to one.

Our business looks good.

And we can't give guidance yet looking out, but we believe that the inventory correction should be fully behind us.

I think most of it is gone, and with the strong momentum of products we should have good growth here in the June and September quarters.

Just a follow-on, when you look at the manufacturing side of the business now, what do you expect inventories to do as you go through fiscal 2008?

I'm assuming that we're probably peaking out here in days on your books now.

Does it start to come back down as you get into maybe the second half of this calendar year?

We are essentially running factories flat.

Our inventory is very well under control, so there's really no reason to take, for example, we didn't take any shutdown over the holidays like we heard some other companies do.

We do not need to do any layoffs.

You know, there's really nothing needed, our business is in very good shape, in gross margin, operating profit, in everything.

The inventory in the current quarter rises by about three days, we believe, from 108 to 111, and then it starts coming back down with the growth in June quarter.

So that would be better than we have done really in the prior cycle in terms of inventory.

And gross margin.

Once again, we remind you to please limit yourself to one question.

Moving on we go to Michael Masdea with Credit Suisse.

A quick question on the backlog, it sounds like you're saying it's higher than last quarter, starting last quarter, but in the press release it also said higher than September, your book-to-bill has been below one, just walk me through the math there, make sure I'm not misunderstanding how you can have higher backlog.

Backlog is for 12 months, Michael, so that's how we reflect the overall booking.

So what that says is that with the type of activity and the visibility issues that there are generally in the industry, our customers are giving us good short-term visibility, but they're not as comfortable going out beyond that period.

So of although book-to-bill was slightly below 1, they were giving us better visibility from a near-term perspective.

That makes sense.

On the inventory front, it sounds like your comfortable with your levels but they are about 10 days higher than where you were in the '04, '05 time frame that you are talking about, and more like you were in late '01, early '02.

Is there any reason for that or reason that needs to stay up there or you just pretty happy with it where it is?

My recollection is that the peak of the inventory in the last cycle was 115 days.

We are right now at 108, and we go to 111, then come back down.

Unless you're looking at a different figure.

We'll try to confirm it afterwards.

Our product line has substantially broadened.

We have 78 products in the 16-bit, since 2004 we have probably 100 new product in analogs, which tend to be fragmented and lots of small, small products with broad range of revenue.

We're quite comfortable with inventory.

Serving our customers with short lead times and availability of the product has been historical strength of Microchip and life cycle of our products is very, very long.

We can go back in history, we don't write off inventory, we don't -- we're not taking write-downs in inventory in probably many, many years.

So we feel very comfortable.

We sold all the inventory after the last cycle, 2001 cycle, and after war on SARS, so this is really not a problem at all.

The inventory's right in the middle of the historical range.

Continuing to keep the vast majority of the inventory in die stores and that gives us the greatest flexibility.

And particularly as you have seen distribution partners hold less inventory, again, it helps our flexibility and short lead times have been an important competitive factor for us.

We have shown at conferences that a combined total of Microchip inventory plus distribution inventory and taking Microchip inventory in the middle of the range and distribution inventory at the rock bottom of the range, our total inventory is actually on the lower end of the historical range.

Next we'll hear from Chris Caso of Friedman, Billings, Ramsey.

Yes, thanks.

I was wondering if you can talk a little bit about what your customers are telling you with respect to consumption.

And I realize that you've got a lot of different customers in a lot of different segments, but how much, typically when inventory builds, it's also a function of the customer's demand perhaps not being quite as strong.

We've heard that with some of the customers of your competitors.

Can you talk a little bit about that, what your customers are telling you about both the fourth quarter and how they're looking into early 2007?

Well, the inventory and demand sort of go hand in hand.

Inventory, customer often feels comfortable with a given level of inventory at a given demand with slightly lower confidence on their part, they want to keep less inventory.

So that kind of goes hand in hand.

And this correction is a combination of probably slightly weaker demand and lower inventory.

Having said that, the actual consumption as we speak, and in the last quarter, was higher than the shipments, because the inventory of the customers was dropping and depleting.

So the end rate at which the customers are using the product is higher than the revenue they're upholding, which really bodes well for as we come into the other end of the cycle, in the June time frame, we should have really significant growth as we even just return back to the run rate, plus the growth of new products.

But generally with respect to consumption for the first quarter, general terms, are there areas where you have customers that are running consumption rates below what they otherwise expected, below what would be seasonally normal, separate from the inventory issues?

Go ahead.

I think we have so many customers, I don't think we have that level of specific visibility.

I think Steve's comment about generally speaking, the correction being behind us, is probably the best reflection of going forward where we should see consumption starting to pick back up and as there's less inventory, customers that that begins to add to the growth.

I guess we're not seeing consumption fall off the log anywhere at there large customers, there's minor seasonal weakness, there is some weakness given by the economy and especially compared to six, eight months ago.

But that's really in the numbers.

We believe the actual consumption today is higher than the revenues we're reporting.

So looking forward, that's good news.

Okay, thanks.

Now we'll hear from Chris Danely with JP Morgan.

Thanks, guys.

On the inventory, Steve, it sounds like it peaks this quarter and then should trend down throughout the year.

Can you talk about how you expect your gross margins to trend after that?

Should we assume that they're flattish for a couple of quarters?

Go ahead, Gordon.

Our gross margins are reflective of a number of moving parts, Chris.

Certainly the activity levels in our business will remain relatively flat.

There are always cost improvements and cost reductions that we see in our business from new processes or just the general thrust of moving to platforms as they mature in our business.

So as we approach the next year to 18 months, we would expect that we'll start to move towards our longer term model in terms of gross margins.

But in the short term, that will be somewhat muted from an activity perspective.

Sure.

And then as my follow-up, on your demand creation strategy, can you guys just talk about the percent of sales you're deriving from Arrow and has that gone down?

And also, with the signing up of World Peace are they more of a demand creator and does that fill the void left by Arrow over in Asia?

Well, Arrow did not leave any void in Asia, it was the best thing that happened, because the demand creation was zero. 100% of the business from Arrow was transferred either to other distributors or to Microchip direct.

We did not lose any piece of business, which was done almost a year ago.

Our demand creation effort in Asia is actually a lot stronger, because we don't have to deal with that channel that does not move.

Total Arrow's business now is 10% or less?

It's still in that 10% range.

That's -- there's a significant confusion on the street.

People mix numbers, they hear over 60% of Microchip's business is distribution, and "Oh, my gosh," 60% issue. 60% of Microchip's business is distribution, but only 10% is Arrow.

And that's where the relationship is not strong.

We have added significant more channels in new distributors that we have added, not only in Asia but in Europe and other places and additional Microchip resources, the total demand they're creating well, well exceeds anything we ever got.

In fact, next time I go to a conference I would show a slide that shows the market share gains of Microchip in 2006 compared to 2005 and 2004 and others, you will see that when we relied on these global distributors, the market share shifts had narrowed.

We were gaining market share but the gap had narrowed.

And in the last year and a half, two years, we have proved a substantial widening of that gap again with Microchip's growth of over 16% and the industry growth of less than 2%.

The gap has substantially widened, again, showing that we're doing a substantially better job of demand creation than the rest of the industry and our competitors.

When we look at demand creation from a regional distributors, from our catalog houses, from our production reps, and we mind that to the additional resources that we've put in place in our own business, that's very evident from the operating expenses, as you know, we're absolutely on the right track in terms of design creation direction for Microchip.

Would you guys put World Peace in the demand creator category?

There are parts of which are that way, and there are other parts of which are fulfillment.

Nobody tends to be pure.

I don't know how World Peace sees themselves, we have a very good relationship, so I'd rather not comment on what -- and it's a multiple geography, Asia is not one country.

An organization is different, certain office is one way, ceratin offices have specialists, other offices don't, so most of these relationships are very broad relationships.

But I don't know why you're hung up on World Peace, just even outside of World Peace we've added over 10 or 12 regional distributors with dedicated demand creation resources for Microchip where their FA's do nothing else but lead with Microchip in every single socket and are creating record demand.

Okay.

That was the only one I could figure out.

So-- thanks.

Now from Banc of America, we'll hear from Sumit Dhanda.

Sumit Dhanda, your line is open.

Hi, Steve, hi, Gordon.

Hey, Sumit.

Nice job on the quarter.

I had a couple questions, first, Ganesh mentioned the product mix, 78/16, products and production, currently, 90 by the end of the March quarter.

Now what percentage of your total products does this represent and when might this be, again, a loaded question, be reflective of your actual revenue streams?

Today we have over 400 microcontroller products in our portfolio.

So you can see it's probably in the 20% range, 16-bit microcontrollers.

We're not stopping any investment in 8-bit microcontrollers, we continue to grow that very nicely as well.

Over time, certainly the 16-bit portfolio will grow, and be part of what drives the incremental growth over the 8-bit business.

Let me ask this differently.

In terms of the lag between the current production mix versus your actual revenue recognition, what is that typically?

In terms of from when we have products to when they become revenue?

Right.

So it depends by product line.

If you go to the high end of our 8-bit product lines, those tend to be closer to 18 months.

If you go to our 16-bit product line those tend to be 24 months and there's a variation associated with them.

The more complex designs take a longer design cycle and often customers have end products that also have a farther verification cycle that they go through.

But the normal tendency we've seen is more complex products, longer times.

And today I would put 16-bits in the two-year category of roughly as an average for the design-in time.

As a follow-up along those lines, do you expect to see any kind of an ASP improvement as 16-bit gets to be a more dominant part of the mix or will you just keep dropping prices so the blended ASPs for the portfolio stay flat?

I think if you look at our overall ASPs over time in our public filings, you see very little ASP degradation.

Historically that's been, obviously higher end 8-bit microcontrollers in the last few years beginning to add to the product portfolio, offsetting some of the declines in pricing that we've seen in some of our earlier product offerings and in some of our memory areas, and certainly, 16-bit will help to continue that trend.

And as it grows it, it will become a larger portion of that element.

We're not substituting 16-bit for our 8-bit products so we expect that the 8-bits will continue to grow and that the 16-bit will have its growth as well, and combined gives us the results that you're seeing in the ASP.

The general analysis in the marketplace always tends to be Moore's Law, all the 8-bit designs will go to 16-bit.

I think we have said that hundreds of times before, we don't really see any transition in our product line.

All 16-bit business is incremental.

So when the business is incremental and the largest dollar growth at Microchip is still coming out of 8-bit microcontrollers, the percentage in terms of ASP and percentage mix change is very slowly.

If your strategy is built on transition where 8-bits are going to decline rapidly and 16-bits are going to rise rapidly, then, true, the 16-bit percentage rises rapidly, and along with the ASP.

That's not our strategy. 8-bit business stays and continues to grow, in fact, contributing more dollars incremental per quarter than anything else.

Sixteen-bit is growing rapidly, was up about 150% or so last year, doing well, but it's not substituting anything from 8-bit.

We see the gross margin characteristics of both 8 and 16 has been very comparable.

So that's more important than the ASP element and the end result.

Can I ask a follow-up on inventory and backlog, Gordon?

Sure.

On the -- so just a clarification, because I think this got asked earlier.

Was your backlog up slightly only from December but was it up also versus September?

It was up versus December is what the press release should have said.

The press release was in error.

So it says -- it says September, but it should have said December.

And then on the inventories, I guess there's one way to think about your higher balance sheet inventory, the fact that you're earning 1.9 months of distribution, whereas I think, again, relating to a prior question, at the same point last cycle you were running about 2.5 months, and you were running slightly lower balance sheet inventories, but net-net you're not too far from the mark.

Is that -- is that a continuing trend in your opinion, and then is that the right analysis here?

Is your question that there a continued trend of distribution inventories going down?

Yes.

I think we have talked about that before, the continued trend in distribution is to maintain lower inventories and improve the return on assets and get more turns and stuff like that.

With a very, very broad product line like microcontrollers and analog, it's harder to do because they don't have the right mix of products.

So I believe 1.9 is pretty low, and, in fact, in this inventory cycle they're reducing inventories on everybody else but Microchip's inventories did not come down.

So I think we're in the range where it's likely to be.

Could it come down by another 0.1, 0.2 months?

It's certainly possible.

I don't really think any major changes short-term are going to happen from here.

We're modeling internally that the distribution inventory stays flat for the next quarter or two.

Okay.

Thank you very much.

You're welcome.

Now, we'll hear from Joseph Osha with Merrill Lynch.

Hi guys, two questions.

First, can you talk a bit about how the competitive environment in 16-bit is different from the competition you faced in 8-bit or is it at all?

Well, there are a lot of similar things and there are a lot of different things.

It's a fairly complex question.

Sort of the objective of my question is to understand what it's like to compete, my impression is that there are perhaps better run and more aggressive companies in the 16-bit space as compared to the 8-bit space.

Well, the world is more vigilant, Microchip is not a little company anymore, and they know what we have done in 8-bit, so as we come into 16-bit, the world is more vigilant.

The number of competitors are about the same.

We competed probably with 25 competitors in 8-bit originally and there are less competitors, actually, in 16-bit.

And most of the competitors are the same, Freescale, Renaissance, NEC and others, we're already used to competing with them and TI.

So from that standpoint it isn't anything new.

But Microchip is a much stronger player, too.

We go to market with -- we have produced -- by the end of the fiscal year we will have produced 90 products in three years, versus producing 90 products in probably about seven years back on 8-bit.

Competition is stronger, more vigilant, but we're stronger, we've got a lot more resources in terms of end customer willing to make a commitment with Microchip architecture today is backed by much stronger support and architectural support and FA support, cash in the company and all that, versus a private, underfunded, unown company back in 1990 where the customers would have concern whether they wanted to make a commitment.

So there are pluses and minuses on both sides.

Okay.

Originally back in 1990, field programability was a very big issue.

We were the first ones to bring cost-effective field programability to the market.

In a 16-bit microcontrollers, field programability has been established.

Others have it, we have it.

Some of the performance comparisons, we have the same advantage as we had back then.

Our 16-bit microcontroller DS PICs, for example, are 50% faster than on 7 in a 32-bit environment.

We're comparing to 32-bit microcontroller and 50% faster and 75% faster in execution to an operating arm 7 in a 16-bit mode.

Our original 8-bit microcontrollers with risk performance were similarly very good, much faster than the competition and many times in 8-bit we took the business away from 16-bit.

A significant number of our 16-bit designs today were competing against ARM and winning every time we go against it.

So I would say, in a nutshell, one could do pluses and minuses on the balance sheet, but net-net I think we're doing pretty good.

Okay.

Thanks.

And then just the follow-up is looking at your analog business, is there any overarching strategy there, is this focused on data converters adjacent to dsPIC, for example, or is it broader than that?

Well, the way I've highlighted it before, and I'll repeat that, in analog we've been in that business now for about six, 6 1/2, seven years.

We deployed a three-pronged strategy.

The Phase I for our analog launch was to essentially sell analog on the coattails of our microcontroller business.

So we attached it, converters, up ends, supervisors, power management, switchers, whatever we could, along with microcontrollers in the same bowl, either the input side or the output side or on the periphery.

That was quite successful and at the peak of it, we mentioned to the street that we were attaching 71% of our microcontroller business actually were to customers who also bought our microcontroller.

After achieving that success three or four years ago, we started the Phase II of our analog strategy which was to not only limit that thrust with Microchip's microcontrollers, why not other microcontrollers?

If we cannot win a given microcontroller socket because Akmel or Phillips or Freescale has a better part or has legacy, we still want to get the analog sockets around that microcontroller, because our analog were designed very well to work with microcontrollers.

So that was a Phase II of the strategy to sell our analog parts around all microcontrollers, not only Microchip.

That worked very well and we grew with that.

And then in the last, I would say at least two, 2 1/2 years, we went to the next stage which is a third phase which is sell analog anywhere and everywhere in FPG sockets, in DSP sockets, in 32-bit microcontrollers, along with A6 and anything else.

Because Microchip has over 500 analog products now, large number of products have won awards, one of our RF analog product just won Analog Zone's Product of the Year Award for last year, a number of our OP ends and products have won similar awards.

We have many best-in-class products, and we're essentially selling analog head on going against TI, Linear, Maxim, Intercell or anybody else.

And we're succeeding.

We're up 20% in analog year over year.

Analog business last quarter was down only 1.3%.

The average industry was down 7, 8, most of our competitors are guiding down nine, I think we're going to be closer to flat.

So I think again there we're doing a better job, all three parts of the strategy are working now.

As for the development of the new product is concerned, which was probably the second phase of your question, it's really combination.

Still, our preference is always to design products which will sell along with our microcontroller, because you get a bundle sale.

But we're also designing products that will sell outside of our microcontrollers.

Thanks for the detailed answer, Steve.

You're welcome.

Now from UBS we'll hear from Steve Eliscu.

With respect to your demand creation activities, you indicated success in terms of accelerating growth relative to the industry, but one of the things it seems like your SG&A has been continuing to creep up as a percentage of sales, and is now in the 16% range.

Should we expect that to stay at this level?

Do you feel comfortable with that?

Or is that going to come down over time as you solidify this strategy around increasing sales?

Well, you're not on correct point.

We believe that demand creation on these complex products, especially when you want to take a personal control of demand creation like we have and gain market share which is 14 points higher than the industry's growth requires investment in resources.

And that's what we have done in the last couple of years.

Some of the increase in SG&A is driven by sequentially down revenue.

So if you kind of go back to the number we had in the September quarter for SG&A, that's the number I think we can achieve longer term.

And wouldn't come down from that.

But the December quarter number popped up, driven by -- dividing by a smaller number in terms of sequentially downed revenue.

So over the next year or so the number should kind of come down closer to really where we were back in the September quarter.

Longer term, we have guided to a 24% to 25% below-the-line expenses.

We've been doing that for several years now.

In September quarter we were 24.1, in the current quarter we're guiding to 24.85 or so at the middle of the point.

Those are the two ranges.

We don't believe longer term we will need 25, but we are leaving ourselves room in case the marketplace requires that we have to make that investment.

Okay.

On a different note, if I do the math, it looks like your year-on-year growth, or I should say decline for your OTP microcontroller business is somewhere down in the negative 20% range.

Do you see that as an accelerating decline in this business that could limit your overall growth or is this just part of the inventory correction?

Over time the -- for example, in the last five years, all of the new products we brought to market are flash-based products.

We expect that the OTP products will stay for a long time, but they're on a slow decline.

And the flash growth is more than making up for that in the market.

Basically, we haven't made an OTP product in five years, new product.

How many semiconductor companies would you know that didn't invest in products and still had substantial revenue five years?

Most companies will have their revenue go to zero.

But after five years, we said flash was 65% of our revenue.

So 35% of our revenue is still OTP products.

That tells you the length and life cycle of these designs and products that we work on.

Right.

But are we accelerating toward the end of life, that was basically the question.

These products are going to hang around for a long time.

We'll be selling these products another five years from now.

Now we'll here from Simona Jankowski of Goldman Sachs

Hi.

Thank you.

Steve, just wanted to follow up on your comment that you think -- you are seeing the end of the inventory correction here as far and your end-customers go.

Can you just give us a little more color on visibility, given that your customers are so many and so fragmented just so we get a little bit more understanding of that?

Well, I'm not claiming visibility to be extremely high.

In fact, I said the visibility is still kind of low at this point.

But visibility is a tiny bit better than it was last quarter, being the current backlog being higher so there are less turns to take slightly than we had to take at a similar point in time.

At a similar point in time, you're facing November and December, the two months filled with holidays, with substantial insert and the next two months are February and March, March is often a very, very strong month, February has the Lunar new year holiday, only in one geography of the world.

When I put it all together, I think visibility is better than it was, but not as good as historically it was many quarters ago or many years ago.

The January bookings performance also is indicative of improving conditions.

And, as we said, it started seasonally slow but was really quite strong, taking us to a 1 book-to-bill ratio, as we look at our 90-day element as we typically do.

Another indicator I look in the business usually is the number of expedites.

Okay.

Because when the customer's inventory is running out and when the customer believes that the products are available, they give you less visibility and less backlog.

All of a sudden the business improves or the inventory runs out or for whatever reason they need to acquire some product and get there tomorrow, it doesn't get there tomorrow sometimes, and takes a couple of weeks and that often results into an expedite.

I need to have that product faster than that.

The expedites right now are four times higher.

I mean, it's just -- I look at it two ways, the total number of expedites in our factory, and number two, the number of items that will reach my desk.

Because most times it's done at the planning level, manufacturing level, they ask for it, it kind of goes into the line and gets done.

But it's on a rare occasion it will filter up because it's more difficult or more expensive to do because they're asking us to do something special.

And the thing that's starting to reach my office which is a sign of demand pull.

Thank you, that's very helpful.

Just another question, if I may, a little bit bigger picture.

When I talk to a lot of the ARM-based competitors, I understand that you're not necessarily going head-to-head against a lot of these guys in particular in the 32-bit space, it seems they're talking much more than they used to about a lot of pricing pressure in their part of the business, which I understand you're not facing.

But I was just wondering if you can maybe offer some perspective of if anything is changing in that part of the business and if there might be a time a couple years from now or later that that does in any way affect Microchip or why would we be perceiving anymore pricing pressure there?

Clearly your business is still pretty stable in that respect.

Well, Simona, in 8-bit microcontrollers years ago we used to hear exactly same comments about 8051, which many many competitors used to make, we heard the same comments about Freescale, the pricing pressure from them, from Cypress, from Akmel, these questions haven't gone away in 15 years, we're seeing the same questions in 16-bit.

We are very competitive in 16-bit.

I believe one of your competitors had done some sort of cost ASP analysis which was published about a year ago, our products are extremely good.

They're significantly higher performance.

Parts have significantly higher pilot efficiencies, many case in ARM or other competitive 32-bit products, significant more memory capacity so you're dealing with a much larger product to do a job versus what we can do with Microchip.

We are extremely competitive and doing extremely good.

We have garnered several thousand customers in a short two or three years.

Now having said that, your ARM question will probably never go away.

We have answered that many, many times.

I am not sure we're going to satisfy you, Simona on the ARM question.

So the answer also that the pricing decline that they are seeing is really kind of the same as it's been over the years, there's not been an acceleration in that or do you think there's an acceleration but regardless, it shouldn't really affect your business?

Well it's a business they're in and we're not.

We're getting in.

Probably are pricing a lot lower and they're probably trying to match it, maybe we're the ones putting the pricing pressure.

There's not much we got to lose because we have a very small business there, we're on the gaining side of it.

There's a pricing pressure, they're the ones who are going to be losing.

I don't really know how else to satisfy you, I think I have personally shown you comparisons, you've seen them, we have shown it at the conferences.

I'm really not sure how else to answer and satisfy that question.

Simona, if I can add some perspective as well on this, I think for these competitors if they really don't have points of differentiation, then price becomes their point of where they're trying to differentiate between ARM-based competitors.

You may be seeing some of that where one ARM competitor is trying to show how low they can go versus another ARM-based competitor.

We think there are many other ways to differentiate the product line in a way that creates value for the customer.

Hence it's really not impacting our business, and the business that we go after where ARM is competition in that opportunity.

We have 8-bit microcontroller products we can still sell for $3 or $4.

So why would somebody pay that when somebody can advertise a 32-bit ARM product for a $1?

That's what Ganesh shows.

I think it's a part of nothing else, it's really -- it doesn't have the peripherals, it doesn't do the job, it doesn't have the analog, it doesn't have all these things.

When a person adds all these things, the real cost of ownership is much higher.

You're reading headlines and we're much better than that.

We've been in this business for a very long time.

If we saw as a significant issue, then it would be reflected in our strategy somehow, we'd be doing something about it.

What we're doing, is really we think we're doing the right thing for our business.

Thank you so much.

You're welcome.

Now we'll hear from Kevin Cassidy of Piper Jaffray.

Thank you.

A lot of my questions have been answered.

Maybe I can just go to the federal tax credit for R&D.

Will you be able to take advantage of that?

We actually have, obviously that was determined in the December period.

However, as we looked at our tax calculation in December, there were other factors, other pertinent factors in our tax calculation that needed to be considered.

When we're all netted down, the really reflected themselves into the 24% rate, which is very comparable to what we'd seen previously.

So 24% going forward is the tax rate we should consider?

Excuse me, yes, that's correct.

Okay.

Thank you.

You're welcome.

Now from William Blair & Company we'll hear from Jeff Rosenberg.

Hi.

Do you know offhand what percentage of revenue you have that goes into contract manufacturers?

It seems like that's been a source of significant inventory buildup for a lot other guys, I'm wondering whether or not given your mix you've got a little bit less exposure there?

Well, we do not know the exact answer to that because of a very broad, 55,000 customers around the world.

However, the contract manufacturing play in applications like cell phones or the kind of things that Cisco builds, and all those things are much, much higher.

PC's, cell phones, a lot of these are built at contract manufacturing.

Microchip parts with the largest section of our business going into consumers, in garage door openers, in washers, in dryers, in security systems and others the amount of contract manufacturing is significantly lower than so-called cell phones.

And that historically, I think is a better profile of the business to not have as much in the contract manufacturing.

From a broader point of view, I think maybe that's part of it.

Also I think of the microcontroller business and analog components as being somewhat tied, and are you surprised that you're not seeing the same level of correction in your business that's been hitting the analog guys?

I mean, anything else that you see that -- I guess the question is, were you surprised by that, that your weakness has been less pronounced?

Well, you know, we're not surprised by it, because we go to work every day in making that happen.

It's not accidental where we are.

It's 14 points gain of market share in the last year versus the industry growth, and broadening of the analog product line, a 3/5 strategy, we've executed in that.

Carving ourselves out of the very large exposure to the cell phone market, even though in times of significant cell phone growth, it may look negative to somebody, we got eye on the ball long term.

We want a very diversified business model, we do not want these high moving markets with low gross margins with billions of units going into a single kind of market segment which leaves a company very, very vulnerable with a very large beta.

We're not surprised because we go to work every day to make it happen.

Okay, fair enough.

Thanks.

You're welcome.

Next we'll hear from Paul Leming of Soleil Securities.

Good afternoon, I wanted to ask a question on financial policy.

You guys have been doing a phenomenal job returning cash to shareholders with your dividend increases over the last three or four years.

And yet while you've been doing that, cash on the balance sheet keeps going up every quarter.

Could you talk about your long-term philosophy on the dividend?

Why not get the dividend up to the point where you're basically paying out the cash you generate every quarter, and not growing the cash on the balance sheet yet further.

Well, what a high-class problem.

What a high-class problem.

And, you know, it could end there, with a high-class problem.

I think you could be asking that question to a lot of other management teams that are sitting on a substantially larger amount of cash and are giving much lesser offered.

We are aggressive in improving dividends.

We believe in continuous improvement of indicators rather than step function which are sustainable or may have to come down.

You double dividend tomorrow, it pleases somebody who owns it today, but then it's a negative for all the guys that want to then get on the train.

So we believe in continuous improvement of dividends, that's why we're improving it every quarter, not every year, like some companies do, every quarter and bold has discussed it many, many times and we believe we're already well above the highest dividend paid by any other semiconductor industry, it's probably not appropriate to come to the request that we double it from here.

We will grow it continuously every quarter, but anybody who gets on the train today or next quarter or quarter after, there is more gravy to go.

All right, thanks.

You're welcome, sir.

Now from Lehman Brothers we'll hear from Romit Shah.

Thanks for taking my question.

I'm trying to reconcile your reduction in CapEx and peak to trough in sales during this correction.

Based on my notes, you lowered CapEx from 80 million to 70 million last quarter and in this quarter, if I heard you correctly, you're lowering it down to 60 to 65.

That equates to about a 20% reduction in CapEx but your sales are only bottoming about 5% from the peak.

I'm just trying to understand, does the CapEx reduction reflect what type of snap back you guys are expecting, visibility or something else?

I think it's really none of that.

The reduction in CapEx is a sign of our ability to continue to utilize the equipment that we have in our facilities.

We do not -- our business doesn't believe in Moore's Law.

We don't have to constantly rapidly upgrade the facility to next generation, next wafer size.

As a result, it's not as close a tie-in where the business grows 20% and CapEx has to go up 20%, something like that, we're able it get substantial growth out of the business out of the existing assets.

You may recall that our FAB4 in Oregon is still running at a fraction of the overall capacity.

So if the business grows harder in the 2007 and after the March quarter, number one, we're going to be sitting on about 111 days of inventory, which can be brought down to about 90 or so, so it can really grow for a few quarters without having to spend a whole lot.

After that, there's still a significant amount of equipment sitting in our Oregon facility and only equipment we have to add is largely an assembly and test, a wafer probe or some maintenance kind of capital and FABs.

But there is really no general increase in manufacturing capacity in the FABs needed because we've got a lot of it still.

Does that help you?

Yes.

So you're comfortable with the inventory you've built on your balance sheet should demand come back?

Oh, absolutely.

Absolutely.

Okay.

As a follow-up, could you help us understand the order run rates in the last quarter and into January between your 8-bit business and the analog business?

Are there any discernible trends?

Is one segment coming back more so than the other?

There really isn't.

You're dealing with a flat guidance.

You're dealing with product line numbers which are plus, minus, just very low numbers.

So there's really no discernible trend in there.

Okay.

Thank you.

Thank you.

And due to time constraints, we'll take one last question from Craig Ellis of Citigroup.

Thanks for sneaking it in.

Two quick questions.

One, I know you announced the stock buyback a quarter ago.

It looks like you didn't use any of it, I know the purpose was mostly as a backstop.

Given the guidance should we expect that you won't be using the buyback from here near term?

A strategy that we have highlighted to the street always is we like dividends, we do not like stock buybacks.

We only like stock buybacks when we believe the street has lost the story and has thrown the baby with the bath water.

And the best example of that I give is really what happens after war on SARS in April of 2003.

So only on such occasions and only other unique occasions when we find a significant opportunity in the marketplace we try to buy our stock.

That's not a representation of we believe our stock is high.

That's not a representation of we believe our stock is low.

But we simply believe our stock isn't selling half of what it should be.

And those are the times when we buy stock, or extreme opportunity.

That kind of opportunity hasn't arisen.

We are quite pleased, actually, how, with this inventory correction and even the -- there's been a negative article or so heading there, and it happens every cycle when the numbers are sequentially down, it's very easy to build a case about Arrow or anything else and those kind of stories just haven't stuck.

I think we've answered them correctly.

So this time we haven't seen a rundown on the stocks as we saw in some of the prior cycles, like back in 2003.

So, therefore, the opportunity hasn't arisen for us to buy stock.

If such performance continues, you shouldn't expect any stock buyback in this quarter or soon.

Thanks, Steve.

And then secondly, you've talked a lot on today's call about changes you've made to demand creation in your model over the last couple years.

Looking prospectively, do you feel you've got the model optimized now or are there further changes to make over the next six months to 18 months?

The model is optimized.

However, not all the things that we have invested in are fully productive yet.

Because there are things we invested in just six months ago, there are things we invested in a year and the output of those are not in the numbers.

So we believe it gets better, but it's still harvesting investments we have made.

We're not making additional tweaks, but we're simply strengthening what we have and getting those resources completely trained and efficient in producing.

Okay.

Well, we'll look forward to seeing the fruits of that.

Thanks, Steve.

Thank you.

And we have run out of time for the question-and-answer session.

Gentlemen, I turn it back over to you for any closing remarks.

We want to thank the investors and analysts for being on the call today.

We'll be going to a number of conferences in the near future and we'll probably see you on the road at one of these conferences.

Thank you.

This does conclude today's conference, and we do thank you for your participation.

You may now disconnect.