微晶片科技 (MCHP) 2017 Q2 法說會逐字稿

Good day, everyone, and welcome to the Microchip Technology's second quarter of FY17 financial results conference call.

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

At this time, I would like to turn the call over to Microchip's Chief Financial Officer, Mr. Eric Bjornholt.

Please go ahead, sir.

Good afternoon, everyone.

During the course of this conference call, we'll 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 releases of today, as well as our recent filings with the SEC that identify important risk factors that may impact Microchip's business and results of operations.

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

I will comment on our second quarter FY17 financial performance, and Steve and Ganesh will give their comments on the results, discuss the current business environment as well as our guidance, and provide an update on the integration activities associated with the Atmel acquisition.

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

I want to remind you that we are including information in our press release and this conference call on various GAAP and non-GAAP measures.

We have posted a full GAAP to non-GAAP reconciliation on the Investor Relations page of our website at www.Microchip.com, which we believe you will find useful when comparing GAAP and non-GAAP results.

I will now go through some of the operating results including net sales, gross margin, and operating expenses.

I will be referring to these results on a non-GAAP basis, prior to the effects of our acquisition activities and share-based compensation.

Non-GAAP net sales in the September quarter were a record $873.8 million.

They were well above the high end of our guidance and were [3.5%] sequentially from net sales of $844 million in the immediately preceding quarter.

Non-GAAP net sales were $2.5 million higher than GAAP net sales, as we are reporting non-GAAP net sales on a full sell-through revenue recognition basis, while GAAP recognizes the Atmel Asia distribution network as having sell-in revenue recognition.

Our non-GAAP results are being presented on a full sell-through basis to provide investors with a better view of the true end market demand for our products.

We will start recognizing revenue on a sell-through basis for the Atmel Asia distributors effective October 1. We have posted a summary of our revenue by product line and geography on our website for your reference.

On a non-GAAP basis, gross margins were 57.2% in the September quarter, and significantly above the high end of our guidance which was 56.2%.

Non-GAAP operating expenses were 26.7% of sales, significantly below the bottom end of our guidance range of 27.2%, and non-GAAP operating income was 30.5%, well above the high end of our guidance of 29%.

Non-GAAP net income was a record $219.6 million resulting in record earnings per diluted share of $0.94, which was $0.05 higher than the high end of our guidance of $0.89, up 11.6% on a sequential basis, and up 42.6% as compared to the same quarter last year.

On a GAAP basis, net sales were $871.4 million, and gross margins including share-based compensation and acquisition-related expenses were 47.1% in the September quarter.

GAAP gross margins include the impact of $4.1 million of share-based compensation, $1.5 million of gross margin impact from the distributor revenue adjustments I mentioned earlier, and $84.3 million in acquired inventory valuation costs.

Total operating expenses were $347.9 million, and include acquisition intangible amortization of $80.4 million, share-based compensation of $20.3 million, $4.1 million of acquisition-related and other costs, and special charges of $9.5 million.

With all of the purchase accounting adjustments, the Atmel acquisition-related charges and the related tax impacts, GAAP net income from continuing operations was $35.6 million or $0.15 per diluted share.

In the September quarter, the non-GAAP tax rate was 9.1%, and the GAAP tax rate was negative 40.9%.

We expect our longer term forward-looking non-GAAP effective tax rate to be between 8.5% to 9.5%.

The share-based compensation for Microchip in the June 2016 quarter was extraordinarily high at $59.6 million related to the restructuring we had with the Atmel acquisition.

The share-based compensation came down significantly in the September quarter to $24.4 million, and we expect the share-based compensation to be about $23 million in the December quarter which is more indicative of the ongoing run rate for these expenses.

Moving on to the balance sheet.

Our inventory balance at September 30, 2016 was $424.7 million, and all of the fair value markup on the Atmel inventory as required by GAAP purchase accounting is now off of the balance sheet.

There is still $12 million of fair value markup relating to Atmel sitting in the distribution inventory balance at the end of September.

Excluding the purchase accounting adjustments, Microchip had 103 days of inventory at September 30, 2016, down 4 days from the end of the June quarter.

Excluding purchase accounting adjustments, inventory at our distributors was at 31 days, which is down from the June quarter level of 32 days.

The cash generation in the September quarter excluding our acquisition activities, our dividend payment, and changes in borrowing levels under our revolving line of credit was a record $211.2 million.

As of September 30, the consolidated cash and total investment position was $490.8 million.

Our borrowings under our revolving line of credit as of September 30 were $1.678 billion, and will result in a 25 basis point reduction in our borrowing rate, once we file our September quarter 10-Q later this week.

Excluding dividend payments, changes in borrowing levels and our acquisition-related activities, we expect our total cash generation to be approximately $170 million to $200 million in the December quarter.

We continue to make good progress on our leverage, with our net debt to EBITDA ending the September quarter at 2.91.

This was down from 3.22 at the end of the June quarter, and better than our projection we had shared with the Street last quarter of 3.02.

We expect our net debt to EBITDA to be about 2.35 by the end of FY17.

Capital spending was approximately $18.2 million in the September quarter.

We expect about $30 million in capital spending in the December quarter, and overall capital expenditures for FY17 to be about $110 million.

We are selectively adding capital to support the growth of our production capabilities for our fast growing new products and technologies, and to bring in house more of the assembly and test operations that are currently outsourced.

Depreciation expense in the September quarter was $30 million.

For several years prior to FY16, Microchip's dividends paid to it shareholders had been treated as return of capital, as Microchip did not have earnings and profits in the United States.

In FY16, about 60% were treated as taxable dividends, and about 40% were treated as return of capital.

In FY17, we expect our dividends paid to shareholders to be treated as return of capital.

Please note that the first quarter of calendar year 2016 will have approximately the same 60% taxable dividend, and 40% return of capital split as the FY16 dividends.

We will continue to keep investors updated if anything changes on our expectations of the dividend treatment as we progress throughout the year.

I will now ask Ganesh to give his comments on the performance of the business, and the September quarter.

Ganesh?

Thank you, Eric, and good afternoon, everyone.

Let's take a closer look at the performance of each of our product lines starting with microcontrollers.

Our microcontroller business in the September quarter was up 3% sequentially, as compared to the June quarter, setting a new record in the process.

Our microcontroller business excluding Atmel, as well as Atmel's microcontroller business were each up nicely in the September quarter, as compared to the June quarter as we continued to experience broad-based growth in our business.

In addition, each of our 8 bit, 16 bit, and 32 bit microcontroller businesses were up sequentially and achieved new records for revenue.

Even as we grow our 16 bit and 32 bit business in leaps and bounds, Microchip's overall 8 bit microcontroller business, as well as Microchip's 8 bit microcontroller business excluding Atmel achieved new records for revenue in the September quarter, once again demonstrating the resilience and consistency of this business.

We believe that reports of the death of the 8 bit microcontroller market are greatly exaggerated, and limited only by the imagination and willingness to offer innovative new solutions.

During the quarter, Atmel's customers continue to feel reassured about Microchip's microcontroller road maps going forward, exemplified by the introduction of the first new AVR microcontrollers and [SAM] 32 microcontrollers on Microchip's watch.

As a result, we are seeing continued growth in our design-in funnel, and expect this to drive future growth as these designs progress into production over time.

In regards to the microcontroller business units integration.

We had already made significant progress in the June quarter, and largely completed the remaining integration efforts in the September quarter.

The wireless business restructuring which was still a work in progress at the end of June, has progressed significantly since then and will be completed by the end of December.

This business was running at a large loss, and required significant and rapid surgery to combine road maps, reduce redundant spending, and rationalize priorities.

The touch and gesture business focused on automotive, industrial and commercial markets took further shape in the September quarter, and we are driving opportunities with a stronger set of customers and channel relationships, as well as a stronger combined sales team.

Steve will give you an update a little later on the sale of the mobile touch business which did not fit our business goals that we had been marketing for sale to interested buyers.

We implemented Microchip's disciplined pricing process to ensure that not only are we being competitive, but that we're also getting appropriately rewarded for providing innovative solutions that enable our clients to successfully achieve their business goals.

The benefits of the pricing changes we made were partially seen in the September quarter, and will have some residual benefit in future quarters.

Finally, microcontrollers had over $2.2 billion in annualized revenue, represented 63.4% of Microchip's overall revenue in the September quarter.

We remain pleased with the performance and competitiveness of our 8 bit,16 bit and 32 bit microcontrollers in the broad-based market, which have been augmented by the addition of Atmel's portfolio.

We continue to gain market share and have the new product momentum and customer engagement to continue to gain even more share, as we further build the best-performing microcontroller franchise in the industry.

Moving now to our analog products.

Our analog business was up 4.7% sequentially in the September quarter, as compared to the June quarter and also set a new record.

At approximately $900 million in annualized revenue, our analog business represented 25.7% of Microchip's overall revenue in the September quarter.

During the quarter, we continued an active effort to find opportunities to attach Microchip's vast portfolio of analog products to Atmel microcontrollers at customers and applications that we otherwise did not have visibility into.

This effort is progressing well, and will pay dividends over time as new design wins go to production.

We continue to develop and introduce a wide range of innovative and proprietary new linear, mixed signal, power, interface, timing and security products to fuel the future growth of our analog business, as we march relentlessly towards making analog a greater than $1 billion revenue business for Microchip.

Moving to our memory products, our combined Microchip and Atmel memory businesses were down 2% in the September quarter, as compared to the June quarter.

In this business too, we implemented Microchip's disciplined pricing process to the Atmel business to ensure that while we are competitive, we're not chasing bad business in the pursuit of profitless prosperity.

Summarizing some of the other Atmel integration elements.

Our sales integration is progressing well, with extensive cross-training of our direct sales teams, as well as our channel partner sales teams.

Microchip's major channel partners are now franchised to carry Atmel products, and most Atmel channel partners are franchised to carry Microchip products.

Between training and enabling our channel partners, we want to leave no stone unturned, as we work to ensure that we maximize the cross-selling of products for new customer design activity.

We are in the midst of planning for and testing to integrate our business systems, and expect to go live on the Microchip systems on January 1, 2017.

This is the largest and most complex acquisition we have done, and we are taking extra time to ensure we thoroughly test the changes before we go live.

All in all, the second quarter of integrating Atmel has progressed on or ahead of our plans.

Our thanks go out to the many employees across the globe who have gone above and beyond to contribute to the rapid integration and help deliver synergy results that are well ahead of forecast.

Let me now pass it to Steve, for some general comments about our business, our guidance going forward, and more about the Atmel integration.

Steve?

Thank you, Ganesh, and good afternoon, everyone.

Today I would like to first comment on the results of the second quarter of FY17, and then provide guidance for the third quarter of FY17.

I will also make comments on the progress of integration for Micrel, and make extensive comments on Atmel.

Our September quarter financial results were extremely strong.

Our non-GAAP net sales, gross margin percentage, operating profit percentage were all better than the high end of our guidance, while our non-GAAP operating expenses were less than the low end of our guidance.

Additionally, our non-GAAP earnings per share was $0.07 per share better than the mid point of our guidance, and up 11.6% sequentially, and up 42.6% from the September quarter of a year ago due to improved gross margin percentage, operating expense leverage, and accretion from both Micrel and Atmel.

We achieved record results from our core business, and sequentially grew both in our core business at Microchip as well as from Atmel.

I want to thank all of the employees of Microchip including acquired employees from Micrel and Atmel worldwide for delivering a record quarter in every respect.

This was also our 104th consecutive profitable quarter.

In the last quarter's conference call, we shared with you our first 100 day assessment of Atmel, its products and its operations.

Now with 200-plus days behind us, I would update you on what we have done to correct Atmel's weaknesses in order of priority.

Number one, lack of pricing discipline.

We have completely turned the situation around.

There are no low price low margin quotes being given anywhere in the world.

It seems that Atmel's prices were well below the market prices, and there was an air gap between the Atmel selling price and the market price.

Our price increases, while painful for some customers are largely filling the air gap, as we bring prices closer to the market price.

Most of the products are proprietary, and therefore we would not be concerned about losing business.

On the distribution front, we caught a lucky break, as one of our largest competitor has changed their distribution program where they will be using distribution only for fulfillment, and are terminating their registration program under which their distribution earned a higher margin for demand creation.

This is having a very positive effect on Microchip, as the distribution sees a strong portfolio from the combined Microchip and Atmel franchises, and is increasing their commitment for demand creation from Microchip.

Number two, high operating expense culture.

Atmel had a culture of high operating expenses which routinely ran over 40% of sales.

In the September quarter, Atmel's operating expense was below 28% of sales, and many of the expense reductions done were not for the entire quarter, so you will see the operating expenses continue to drop.

Number three, swinging for home runs, and getting large customers at low margins.

This has now been corrected, as we are aligning many of Atmel's sales focus consistent with that of Microchip.

Number four, accountability.

I said at the last conference call that Atmel had a culture of poor accountability.

With a broad-based implementation of Microchip type of bonus plans which are based on overall Company growth and profitability, we are rapidly changing that culture.

In our world presentations, at Atmel, our communications with them, and classes at Atmel, we are teaching that at Microchip management is accountable.

Number five, poor teamwork.

Atmel did not have a culture of teamwork.

Bonus and equity grants were very large at the top at Atmel, and less than 30% of the employees had bonus and equity.

At Microchip, 100% of our employees are on a bonus program, and nearly 100% of our non-Thailand labor employees are on equity program.

Rather than large equity grants at the top, Microchip spreads equity throughout the organization, so that they share in the responsibility and rewards of having a stake in the Company.

We have also implemented Microchip-style of quarterly business unit reviews.

With the entire Company on a Microchip type of common incentive program that values sales growth, gross margins, operating expense, and operating profit and with our managers role-modeling the culture of accountability and teamwork, we believe that we are turning the situation around rapidly.

Number six.

Atmel made no investment in training and development of employees.

In a short six months, over 2,200 Atmel employees, or over two-third of the employee base have gone through at least one training class at Microchip.

We are putting Atmel sales and field application engineers through a two week extensive training that we call boot camp, in which we train the employees on Microchip's client engagement process, our values, our culture, and align them with our goals and reward system.

With no training for more than a decade at Atmel, we have much work to do, but rapid changes are taking place, and employees are bonding to the superior systems at Microchip, and the results are starting to improve.

Now let us continue with the deciphering the financial results of Microchip from the fiscal second quarter.

While we will refrain from providing a line by line break down of our results between core Microchip and Atmel, we will provide some useful [nuggets of] information on Atmel as well as Microchip.

So here are those nuggets.

We achieved all-time record net sales in our core Microchip business, and the gross margins and operating margins in the core business were both stellar, and sequentially up from the June quarter.

Now on Atmel, probably one of the best accomplishments is that gross margin on Atmel improved dramatically by approximately 400 basis points sequentially, and was the highest gross margin achieved at Atmel in over five years.

There are a lot of moving parts, but price is a big one, price increases, the new price book, changing worldwide prices to US dollars, and pegging it back to when the contracts were done, and protecting Microchip from a large euro and pound depreciation against the dollar were significant items.

Beyond that, there was a very favorable mix also, with higher growth in MCUs and the memory business, and there are plenty of cost reductions mixed in.

Regarding, Atmel's operating expense, I mentioned earlier that Atmel's operating expense in March quarter was over 40% of net sales.

Atmel's operating expense in September quarter was below 28% of net sales.

With the combined effect of better than expected net sales, substantially higher gross margin percentage, and substantially lower OpEx, we achieved Atmel's operating margin of over 23% of sales, which is again the highest operating margin achieved at Atmel in over five years.

We achieved an accretion from Atmel of $0.145 per share versus our guidance of $0.09 to $0.11 per share.

By any measure, our September quarter, the results are stellar.

Going into Atmel acquisition, the investors and analysts had three major concerns, they were can we grow Atmel's business, can we improve Atmel's gross and operating margins, and can we improve Atmel's execution?

The answers to those questions are yes, yes, and yes.

We have grown Atmel's business.

We have dramatically improved Atmel's gross and operating margins, and we are improving on the executions.

And when I say we, it does not mean we at classic Microchip.

We means the new Microchip, that includes all of the worldwide employees of Atmel that are doing a great job, improving the financial results of Atmel.

So now let us go into the non-GAAP guidance for the December quarter.

We expect total net sales to be sequentially flat to down 6%.

We expect gross margin to be between 56.6% and 57.2%.

We expect overall operating expenses from continuing operations to be between 26.5% and 27% of sales.

We expect operating profit percentage to be between 29.6% and 30.7% of sales, and we expect earnings per share to be between $0.85 and $0.95 per share.

The earnings per share guidance includes an accretion from Atmel of between $0.13 and $0.17 per share.

Last quarter, we increased the FY17 accretion target from Atmel from $0.25 at the deal announcement to $0.40.

We are again increasing the accretion target from Atmel from $0.40 to $0.50 per share for FY17.

We have also assessed whether the upside in accretion from Atmel is pulling off long term accretion or upside.

As I said last quarter, there is some of both, so let me catch up the math for everyone.

Our original accretion target for FY17, FY18, and FY19 was $0.33, $0.66, and $0.90, respectively, all with full stock buyback of shares issued in the Atmel transaction.

This is the target we gave you at deal announcement for FY17, FY18, and FY19 to be $0.33, $0.66 and $0.90, respectively, all with full stock buyback of shares issued in the transaction.

Now after we decided not to buy the stock back, the accretion math took the accretion to $0.25, $0.53 and $0.75 for FY17, FY18, and FY19, respectively.

Now we believe the opportunity for stock buyback when the stock was under $40 is now passed.

So we're not going to buy the stock back, and instead cleared the balance sheet for a future acquisition.

So our reference point for accretion for FY17, FY18, and FY19 is $0.25, $0.53, and $0.75 without any stock buyback.

So once again, our reference point for accretion for FY17, FY18, and FY19 is $0.25, $0.53 and $0.75 without any stock buyback.

So now our new efficient target for FY17, without any stock buyback I already gave you is $0.50, which is up from $0.25 originally, almost a full year ahead of schedule.

The new accretion target for FY18 goes from $0.53 originally to $0.70 now, and for FY19 the accretion target goes from original $0.75 to $0.90 now.

In fact, our new accretion targets are now at or above our original targets when we assumed buying back stock.

For FY17, our new accretion target is 100% higher than our initial estimate excluding stock buyback, and 50% per higher than our initial estimate including the stock buyback.

This is all a testament to how well the Microchip team has executed the Atmel integration in the first seven months since the close of the transaction.

On Micrel's side, the integration is complete.

The fab will close at the end of next week.

The last of wafers are coming through the fab as we speak.

A large number of fab employees have already been let go.

After closing the Micrel fab, we save approximately $26 million in annual wafer cost, which will find its way into the profit and loss statement over the coming quarters, as we ship more and more 8-inch wafers and deplete the 6-inch inventory.

After we close the fab, the final operating profit margin model for Micrel will meet or exceed our long term target of 33%.

We also announced last week, the result of the sale process for the mobile touch business unit.

We sold the business unit in a cross-border transaction consisting of an asset purchase and IP license agreement, the sales agreement for the inventory of mobile touch business unit, and the transition services agreement.

We expect this deal to close later this week.

Finally, with the success we have seen so far with Atmel and Microchip, and with great results on the core Microchip business, we now expect that we will achieve our long term financial model at the end of FY18, versus three to four years that was embedded in our forecast when we announced the Atmel deal.

To remind everyone, that financial model is 59% gross margin, 26% operating expense, and 33% in operating margins.

With this, operator, will you please poll for questions?

Yes, of course.

(Operator Instructions)

We will take our first question from Vivek Arya from Bank of America.

Thanks for taking my question, and congratulations on your strong execution.

Steve, for my first question, I'm wondering, you have reported very strong results for the last couple of quarters.

How much of that would you attribute to a better organic demand environment versus a share gains, or just conservatism or pricing actions with the Atmel product?

We are unable to break that out for you.

It's a sum total.

And when we win a business, we don't know whether we're winning that business because we have great product, or we're gaining share, whether the customer end demand was stronger.

It's really always a combination.

I think the sense of the overall market demand, you can get that from the average of industry announcements in our peers and competitors, and then you can compare them to our results, and kind of make your own assessment.

And my follow-up, on the gross margin, you upsided this last quarter.

I was curious what drove that upside, was it the pricing action?

And just if I take that forward, what is the path from the current levels you're at to your 59% target, how much of that would be based on revenue versus other sort of self-help actions that you can take?

Thank you.

Well, again, I think your questions are intended as always piece everything, break it up.

This is kind of hard to do.

I gave you nuggets of information.

There was a 400 basis point improvement on Atmel gross margin.

Microchip's core Microchip business, gross margins were also up nicely.

The increase on Microchip business was much more organic, better mix, better absorption with the growth, better this, better that slightly.

But the 400 basis points impact on Atmel gross margin, I broke it out for you, was the result of pricing increases, setting back many of the customer contacts in US dollars, back to where the contract was originally done, taking away the impact of the weak euro, weak pound and those kind of things.

And there was a better mix on the Atmel side also.

So again lots of moving parts.

And you know over time, as we are winning new business, it's on a more disciplined pricing basis that the new business is being won.

So and that, as it goes to production for six quarters from now will all be at good margins.

Right.

I think the last piece of your question, was getting to the 59%.

There's a lot of different things that factor into that.

We've got the Micrel accretion from shutting the fab which Steve dollarized for you about in his comments, lots of cost reduction activities that are happening between the combined factory management teams of Microchip and Atmel.

So lots of good things coming.

Thank you.

Moving on, we'll take our next question from William Stein with SunTrust.

Thanks for taking my question.

Steve when you closed -- or when you announced the Atmel acquisition, you talked about that company's gross margins as being structurally lower than Microchips.

And I'm wondering as you've integrated and improved that business, if there's any chance for a change in that view, could you see Atmel's margin structure approach what classic Microchip has delivered?

So it's just all a matter of timing.

Yes, Atmel's business structurally is slightly lower gross margin, driven by a little bit more consumer mix, and really where they have done a lot of the contracts and pricing over time.

Now as we proceed forward, the new products we're building, new products we're introducing, the new contracts we're doing, the work we're doing with distribution, they will all be very good similar gross margins to Microchip.

But it will take a long period of time before you can pay back all of the old sins.

Many of them we're correcting, in increasing the prices, but many of them are old customer contracts which have clauses where we cannot change them.

And one more if I can related to Atmel still.

Can you comment on any revenue synergies you're seeing?

Obviously the pricing discipline has helped a lot.

What about cross-selling the product?

So Ganesh commented on it, that our salesforce is very much focused on identifying the analog attach opportunity across all of the Atmel's microcontroller and other products.

We have done this traditionally with Microchip microcontroller products, where there's a large amount of analog that goes around it, and to the best of our ability we try to capture that attach.

But getting all of this Atmel microcontroller business gives us new fresh opportunity to identify all the analog attach opportunity around it.

And our sales forces are identifying opportunities, we're adding them to the funnel.

In many cases they are substitute products, in many cases they're design-in products which will take a year or so to go to production.

But in the coming quarters, you will see significant impact from analog attach to the Atmel products.

Thanks, and congrats on the good results.

We'll take our next question from Kevin Cassidy with Stifel.

Thank you, and congratulations on all of the hard work and results.

You had mentioned the 8 bit revenue still increasing, and could you explain a little more if it's current customers expanding their revenue, or are there many new applications?

Is this a phenomenon of the Internet-of-Things?

Well, it's all of the above.

We have never bought Street notion that 8 bit is dead, everything is going to 32 bit.

That notion has been around from 1994, and I recovered a [page eTimes] article from that time.

And so, Microchip has been short for those people since 1994, when the stock was $0.57 in the current currency.

So our 8 bit business is extremely profitable, extremely good margins, operating as well as gross.

And the business did record on core as well as total.

As Ganesh mentioned, we're continuing to introduce a large number of new products with new features.

We're garnering new customers, existing customers where businesses are growing.

We are not seeing what everybody keeps talking about, but please everybody keeps talking about, because that takes everybody away from 8 bit and to something else, and we are enjoying this business quite a bit.

Okay.

Maybe as a follow on, do you see attach designs like with wireless or Bluetooth with the 8 bit, would that be an indicator of new applications?

Do you want to take that?

Yes, I don't think that it's necessary it with Bluetooth and wireless.

I think that there are plenty of areas where people are trying to make devices smart.

And if have you innovative new products available as 8 bit microcontrollers, often they are the most cost effective products to apply to these new systems that are being designed.

And we are probably the minority of companies that has innovated to put lots of new capabilities in 8 bit microcontrollers.

We're doing that not only on PIC, but the microchip product line before but also in AVR, the Atmel product that we've inherited.

And I think if you have products that are innovative, at the right price point, which are easy to design-in into many systems, it will.

I don't think there are anything related necessarily to Bluetooth and wireless and Wi-Fi specifically.

Okay, great.

Thank you.

(Operator Instructions)

We'll take our next question from Craig Hettenbach with Morgan Stanley.

Hi.

This is [Anil] calling in for Craig.

Congrats on a solid quarter.

I want to touch upon Atmel integration, and acknowledging it's still early on, but you're making very good progress.

Could we touch upon the opportunities you're seeing for savings on the managed action front, and any potential synergies on the back end longer term?

Could you clarify, what is the managed action fund you said?

Oh, any savings that you can accrue on the manufacturing front?

Oh, manufacturing front.

The manufacturing front.

So we talked about it last quarter, that we have decided to keep the Colorado Atmel fab which we found to be a very cost effective fab, and very useful for our plans going forward.

So we're not going to do anything.

There were Street expectations they were going to shutdown that fab.

We never said that and we don't know where that came from, but we're not shutting down Atmel 6-inch Colorado fab.

It's a very, very nice fab.

Now when you look at the back end, Atmel did a majority of the assembly and test, all at the subcontractors.

They did no assembly themselves, and 90% of the test was outside.

They only did some wafer probe in the Philippines.

If you compare that to Microchip, we do all of our wafer probe, and about 60% to 70% of our assembly, and about 90%-plus of our test ourselves.

So that's where we see some opportunities, where as we compare the assembly and test cost structure, Microchip's testing technologies, assembly technologies lack lower cost then some of it that Atmel is using.

And we have put plans together, and some of the lead products already getting qualified, and would be in production next quarter, where we're going to be shipping many of these products through Microchip's back end at much lower cost than they currently are.

We have not given any guidance on what the impact of all that would be in the coming years.

And I think as we get further down, we'll give you more update on that.

And that's what we've done on all our previous acquisitions by the way.

There are benefits to be had, that are faster on materials, and just combined purchasing power that are benefits to be had, in bringing selectively some of the manufacturing into our own factories, and having the economies of scale to go with it.

And it all takes time to put it together, qualify it, get customers qualified, but eventually it does happen.

Got it, that's helpful.

For my follow-up, I want to touch upon your analog portfolio, like where you have pretty good scale $900 million annualized revenues.

Could you touch upon some of the growth drivers do you see for the business longer term?

Analog is made up of thousands of products.

There's no single silver bullet that's going to drive the growth.

Across the various categories I talked about power, mixed signal, linear, interface, security, clocks, all of these product lines need many, many permutations and combinations to service the broad range of requirements in the marketplace.

And there we're seeing nice growth in the many different categories of analog, and that's ultimately how it gets built is in a broad range of products and applications.

Thank you.

We'll take our next question from Harlan Sur with JPMorgan.

Good afternoon, and congrats on the solid quarterly performance, and getting the Op margin to 30%.

You guys originally had a target of [4.25%] in earnings power in FY19.

So if I add the incremental Atmel accretion that you articulated Steve, that goes to [4.40%], but the overall core Microchip business seems to be doing extremely well as well, so how should we think about the new FY19 earnings power?

Honestly, I don't have the math in mind, in front of me, and I don't want to make a comment that I haven't done the math on.

I think I gave you the accretion math on Atmel, and you could piece it back together by figuring what the core was, and can do your analysis.

Unless I had it in front of me, I wouldn't want to make an adder.

Okay, on the closure of the Micrel fab in October, obviously that did not contribute yet to the gross margin performance, but how long roughly is it going to take for you guys to deplete the inventories out of that fab, and start recognizing the benefits of the lower cost 8-inch fab?

And how should we think about the impact of margins, and again, when does that start to kick in?

So I would say that, we've been shipping some of the 8-inch products already as of last quarter and this quarter.

The amount we're shipping from 8-inch right now is probably only about 10% or 15% of the overall product.

Over the six months, 90% of it is probably gone.

And then there is a tail end which is longer term, which continues afterwards.

So the bulk of that really comes into our numbers in the -- next six to nine quarters, six to nine months I think -- by June or July time frame, I think you will have seen about 90% of it.

Thank you.

We'll take our next question from Chris Danely with Citigroup.

Hey, thanks, guys.

Steve, in the prepared remarks you talked about building cash for an acquisition.

Is this a little bit of a change from what you've been thinking in the last three to six months, why, what do you see out there, is there some sort of sense of urgency or anything like that?

Or what if any potential timing could this be?

There is no change.

The change is that we're not going to buy the stock back.

I mean, I wanted to buy the stock back at $40 when the opportunity presented as low as $38.

But you will recall, there was a -- the Street was really concerned about China at that time, and they were concerned about the leverage, and they didn't want us to buy the stock back.

And we were not concerned about China back in June, we were seeing -- telling you that.

But the wisdom that prevailed at the, was to not buy the stock back and now the stock is in the $60s.

So we believe this is not the time to buyback stock.

Instead we will keep the balance sheet there as strong, and levering it further by stock buyback, and really prepare for the next acquisition, which we were going to do anyway.

We're always looking for acquisitions as you have seen over time.

Okay, great.

And then a little bit of a near-term question for my follow-up.

For the guide for the December quarter, for the combined Company, would you say that is a little less than seasonal, a normal seasonality?

And then any comments on what you think normal seasonality for the March quarter would be conceptually for the newly combined Company?

I don't have anything that I could give you from a guidance perspective.

This will be our first quarter with Atmel in the March quarter.

Atmel, last March quarter was really, you can't really compare it against that.

They were under an acquisition and the March quarter was terrible, they lost money in that, and all these other things.

So I would say, Atmel's business in the March quarter, the consumer part of the business should be down and the rest we have to see how it works out.

Microchip's core Microchip March business usually is up, low single-digits and we have to combine that with Atmel, and figure out whatever happened.

And then, the December quarter, please?

In the December quarter?

Yes, the first part of that question was is your December quarter guidance like normal seasonality, or is it a little bit worse than that?

Well, again what's normal seasonality?

I don't know what the normal seasonality is with Atmel mixed in.

Me neither, that's why I'm asking you (laughter).

I don't know.

Okay.

So it must be normal.

Okay, great.

(laughter) Thanks.

This is normal.

It's the first time, so this is it.

Got it.

Okay, thanks, guys.

We'll take our next question from Gil Alexander with Darfil Associates.

Hello, Gil.

Question.

As you look on the contract business which is coming back to the states for Christmas, how do you see that business versus last year?

The Christmas builds have shifted dramatically in time in the last five years or so, and have been happening incrementally.

But let me explain what the shift is.

It used to be the case that most of the Christmas builds will be in our revenue in the September quarter, because parts get built in Asia.

So whatever is being built, equipment, in equipment gets built by the end of September, and then gets on ships for a six weeks journey to US over the ocean, and arrives here in times for Thanksgiving, when the stores are then full of merchandise.

Now that used to be the case.

Increasingly in the last five years plus what we have seen is, the Christmas build is later and later and later.

Nobody rushes to build it in September anymore.

Parts get built all the time in October and November.

A lot of it gets shipped by air, rather than getting shipped by sea.

And even the heavy items, some time it get shipped by the sea and they arrive in November and December, and many times they're IOUs where certain product is not available before Christmas, and put an IOU under the Christmas tree, and then you take delivery in January.

A lot of the gift card giving has driven that also, where people are going to get gift cards and they're actually buying the merchandise in January.

So the entire Christmas buying, which largely used to happen prior to the end of September is now really spread out.

All right.

Thank you very much.

You're welcome.

We'll take our next question from Rajvindra Gill with Needham & Company.

Yes, thank you, and congratulations as well.

I was wondering if you could maybe talk a little bit about what you're seeing by end markets, any kind of color commentary with respect to automotive, industrial, medical equipment?

Any insights there would be helpful?

We see some of the strengths that others have responded to as well, in automotive and industrial, but there's nothing that stands out.

We have --part of our business that has a computing exposure to it, and the same strength that players in that space have seen, we've seen as well.

But it's nothing dramatic in one direction or another.

It's generally consistent with what industry patterns have been.

And I know it might be difficult to assess now, but given the consolidation that's been going on in the semiconductor industry, and namely a massive merger in your space, microcontroller space with NXPI and Qualcomm coming together.

Well, wondering how you're looking at the competitive environment going forward, given the consolidation that's happening around you?

You've made an acquisition as well.

I just wanted to get -- maybe a high level thought process in terms of how you're positioning the Company in light of all these external events?

Well, people asked us the same question when Freescale was getting acquired.

They asked us the same question when Renesas was forming with NEC Mitsubishi.

And now we're getting the same question with NXP, and I think microcontroller market remains competitive.

There are a number of players.

We compete with Renesas, NXP, STMicro, Microchip, and others -- some smaller players, the market remains vibrant and competitive.

And Qualcomm pursuing NXPI will not really change anything because Qualcomm was not a microcontroller supplier.

So the same product line that NXP had will continue, and we're not seeing any change now, although the close of the acquisition is about a year away.

We're not expecting to see any change coming out of that.

But you've seen consolidation in the microcontroller market, because its been fragmented, so you've seen that occur over the course of several years.

And so, I'm just wondering do you see -- do you anticipate more consolidation in the market within the microcontroller market, or other players perhaps moving into the market that are outside of the [MCU] space?

No, honestly, Raj, there is nothing in our strategy that is saying there are a bunch of new players coming in the microcontroller market.

Australia is not based on that.

We're not seeing that.

The question is, would there be more consolidation?

That is sure to happen.

I think there have been companies acquired in the last year especially Altera and NXP Freescale that we would not have -- and Linear, we would not have expected those mergers to happen.

So if those can happen, I'm sure there will be more mergers.

But what we're not seeing, is that these mergers are changing competitive landscape in any way.

The players, the companies are getting large, and we're getting larger ourself, and have much, much larger product portfolio, full product portfolio across many dimensions of automotive, industrial, computing, IoT, so on and so forth.

So we're a formidable competitors ourselves today, but NXPI and Qualcomm merging together doesn't make NXPI anymore scarier or not scary.

NXPI and Freescale merging together didn't change anything.

So if your question is about scale and our concern about that, we really don't see that as an issue.

I think we've been asked that question from prior acquisitions as well.

We believe we have the scale we need.

There's nothing that another acquisition in its scale in some way creates a competitive disadvantage that we see.

It is not clear that Qualcomm's salesforce had a similar focus in NXPI, and they didn't have the salesforce to call on all of the thousands of NXPI customers.

(Inaudible) they have as much of a distribution line.

We didn't think Qualcomm had factories themselves where NXPI could leverage.

So there were reasons for that acquisition, whatever Qualcomm's reasons were to diversify, it's not clear to us that, in terms of the microcontroller and analog offerings of NXPI, the Qualcomm acquisition makes them anything different, which could be troublesome to us.

We don't see that.

Thank you.

We'll take our next question from Craig Ellis with B. Riley.

Thanks for taking the question, and congratulations on the execution both within M and with the Atmel business.

The first question I had was, Steve, you commented as you've been executing with the Atmel products and the Microchip products in the channel, a competitor has made a move away from their demand creation initiatives with the channel.

If that's favoring you, how long does it take for that positive to show up in the financials that we would see, recognizing that microcontrollers have a design-in gestation cycle?

Is that some time later in FY17, or is that a tail wind for Y18's revenue?

We commented it was a competitor in the channel.

Did we identify the competitor?

No.

Okay.

So a large competitor redefined their distribution program, where they essentially said, that their distribution will only serve the fulfillment part of the business, and they will not have the distribution be creating demand and giving registration, and then giving them the demand creation margins.

So since then, we have seen a substantial desire on the part of the distribution to bond with Microchip, and our combined product line is formidable, Microchip and Atmel combined.

So we're getting a lot of that focus, and it will have the usual lead time of design-in which is a year and a half or so in this business.

Although there are always shorter term opportunities where either the product was designed on both sides, or the customer has the option to build model A, versus model B. And model A was designed with that Company and model B was designed with us, and distribution promotes this model.

So I think there is no negative we see coming out of this.

We'll get some short-term and medium-term advantage, but a significant long term advantage.

Thanks for that.

And the follow-up is for Eric.

Eric, you mentioned that the -- there would be a 25 basis point reduction in borrowing costs.

Is that for part of the debt that is currently outstanding, or would that be on any future debt?

That's the debt that is outstanding today.

Future debt would all be based on what our debt to EBITDA is at that point in time.

If we went, and had a new borrowing next week, that rate would apply until we file our next 10-Q.

And that's the point where we always have to calculate what the leverage is, and what the borrowing grid would produce.

Okay.

So what we need to do is look at the change in rate, and the pace at which you're paying down debt, and use those two inputs to derive our interest expense?

That's right, and I can help you with that.

Great.

Thanks, guys.

We'll take our next question from [Emaar Danley] with Goldman Sachs.

This is Mark Delany from Goldman.

Congratulations on the good results, and thanks very much for taking the question.

The question was on the Atmel price increases, which the Company has talked about taking some time to fully play out.

Can you help us better understand at what percent, either quantitative or qualitative, you think is already being recognized?

Or are you a quarter of the way through the path, any sort of relative sense of how far along you are with getting those fully into the financial metrics would be helpful?

We are unable to provide further guidance on how far we are, and how much more to go.

Part of that could be competitive information, and we don't want any mis-reading by the customers on how much more to come, because as some customers will be completely done.

Other customers, we haven't even started.

So if you start to put the percentages on it without communicating with the customers, then it will create unnecessary concern in customers that we will be going back to them for further increases.

So we cannot provide any further guidance on that.

Got it.

Understood.

And then for follow-up question I was hoping to better understand the puts and takes to gross margin for the December quarter?

You talked about potential tail winds around pricing and closing down the Micrel fab.

Obviously, there'd be some reverse leverage from lower sales next quarter.

So just helping us better understand the reason for gross margins being down a bit?

And what's offsetting some of that self-help gains around pricing and the Micrel fab?

I'd say, for the current quarter, it's really a product mix.

There's so many puts and takes with gross margin, but I think it's probably driven primarily by a product mix, one quarter, the next.

We had very good product mix in the September quarter, and that changes a bit in the December quarter.

The Micrel fab impact is farther out in time.

Micrel fab closes in a couple of weeks, and then it takes a little while to decommission it and all of that, so Micrel impact is really mostly begins in our next quarter.

I think a little bit of you're seeing also from -- Atmel is still lower gross margin than Microchip's, driven by -- I'm sorry Atmel is lower gross margin than Microchip and driven by Atmel's mix in the current quarter, little more consumer-rish.

I think it's a mix, when you mix it altogether, it results into a slightly lower gross margin.

Understood.

Thank you very much.

We'll take our next question from Liwen Zhang with Summit Redstone Partners.

Thanks for taking my question.

Congratulations as well.

Only one question.

And Steve, you -- beside the -- you mentioned that your larger competitors switched channel program to fulfillment program, and as well as pricing at Atmel, give Atmel gross -- product gross margin, up 400 basis points.

And then, looking at the overall September quarter gross margin, up less than 200 basis point from the last quarter, and is that fair to say that there's an ASP, there were significant ASP erosion in the quarter?

No.

No, no, Atmel is less than half of our business, right?

Yes.

Yes.

So there's 400 basis points improvement on Atmel's business, but you have to average it with the overall business.

Okay.

Gross margin was sequentially up both on core as well as Atmel, and the overall gross margin was up by a couple hundred basis points?

Yes.

Yes.

Okay.

Thanks.

You could do the math.

I -- you're just really misunderstanding it.

We didn't say there was a 400 basis points improvement on overall.

It was 400 basis points on Atmel.

Right, and we did make the comment that the Microchip gross margins were up in the quarter, Microchip excluding Atmel.

Yes.

Moving on, we'll take our last question with Chris Caso with CLSA.

Yes, thank you.

I'd just ask a follow-up on some of your previous comments regarding your intention to build up some cash for M&A.

If you talk about how you balance that against some of the repayment of the debt, I would guess, that net debt is probably important, if you're looking to do another deal.

But if you can clarify that?

In addition, you've spoke in the past about some of the constraints from doing further M&A, one of which would be management bandwidth.

Obviously, your borrowing capacity would be the other.

At what point, do you think you'd be ready to start contemplating doing something else?

Well, one thing I don't want anyone to read is that, there is an acquisition tomorrow.

We've got nothing on our plate.

We are extremely busy with Atmel.

We haven't done go live, combining all the systems yet.

We're doing that on January 1. We are 130% consumed.

We can't do anything very short-term.

So my point simply was, that rather than spending $500 million, it would be actually more than that for the number of shares we issued in Atmel transaction, would now be $600 million, $650 million.

Rather than spending $650 million on buying the share back, which is really kind of a lost promise now, we're going to not do that.

And instead, leave that -- leave the balance sheet with lower leverage, so when there is new acquisition, when we are ready to do something, when there's an opportunity available, we've got $650 million more available to go forward, than the other way down.

But there's really nothing happening short-term.

When that happens, when we find the right deal, we're not going to do a wrong deal, and we're not going to pay exorbitant prices that aren't accretive and so on and so forth.

We have always found at the right time, the right deal.

When we find the deal, then I'll find the money to do the deal.

I'll find the money to do the deal, and next time I'm not going to listen to your talk about leverage.

To the Street's comments about leverage.

Yes, not you personally.

Okay.

(laughter) Understood.

Understood.

As a follow-up, if we could talk a little bit about your utilization levels of the fab, and I know there's a lot of moving parts there.

You talked a bit about channel inventory, you talked about your own internal inventory, both at pretty low levels.

How does that affect utilization levels with the fab?

And I guess, the Micrel closure going forward over the next couple of quarters, and maybe talk about the benefit of that to gross margins, if indeed that goes up?

So I think that's all a positive wind on the back coming.

So as Atmel -- as the Micrel fab closes, and as you start to burn that 6-inch inventory, you have to start producing that product in our 8-inch fab, which means more demand for 8-inch products.

The yield has been good.

We were up sequentially in the March quarter, June quarter, September quarter.

So inventory, we just reported is 103 days of inventory, which is not high by any standards, it's lower by any standard we give you before, which is more in the 115 days range.

And then, the Atmel inventory when we bought them, which was very, very high inventory.

And over the last year, seven or eight months, we have brought Atmel inventory down significantly, where it's almost corrected, not across the board, but there are places where it's really pretty much corrected.

So over the next quarter or so, I think you could see basically, wafer starts going up in all three fabs possibly.

And that's really what you're asking.

And when that starts to happen, then you have wind on the back.

Now when you increase the wafer starts, the wafer cost comes down, but first, it goes into inventory.

First in first out, and it's real impact on gross margin is a couple quarters later, when you ship that product.

Does that make sense?

It does.

Thank you.

And that concludes today's question and answer session.

I'd like to turn the call back over to Steve for any additional or closing remarks.

Well, I think, thank you very much for attending the conference call.

We'll see some of you at the CSFP conference here in our hometown of Scottsdale, so that's in early late November.

Thank you very much.

Once again, that does conclude today's conference.

Thank you for your participation.

You may now disconnect.