Microchip Technology Incorporated
Q2 2017 Earnings Call Transcript

Published: 8 Nov 2016

[Operator:]

Good day, everyone, and welcome to the Microchip Technology Second Quarter of the Fiscal Year 2017 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.

[J. Eric Bjornholt:]

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 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 fiscal 2017 financial performance and Steve, Ganesh will then 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 up [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 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 acquisition-related and other costs and special charges of $9.5 million. With all 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% and 9.5%. 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 was down from the June quarter level of 32 days. 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 in 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 is 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 fiscal year 2017. 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 fiscal year 2017 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 fiscal 2016, Microchip's dividends paid to its shareholders had been treated as return of capital, as Microchip did not have earnings and profits in the United States. In fiscal 2016, about 60% were treated as taxable dividends and about 40% were treated as return of capital. In fiscal 2017, 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 fiscal 2016 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 in the September quarter. Ganesh?

[Ganesh Moorthy:]

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 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 continued to feel reassured about Microchip's microcontroller roadmaps, 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 and 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 roadmaps, reduce redundant spending and rationalize priorities. Our 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 channeled 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 have 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 are 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 we'll have some residual benefit in future quarters. Finally, microcontrollers had over $2.2 billion in annualized revenue, representing 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 for 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 on 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 helped 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 is going forward and more about the Atmel integration. Steve?

[Steve Sanghi:]

Thank you, Ganesh, and good afternoon, everyone. Today I would like to first comment on the results of the fiscal second quarter of 2017 and then provide guidance for the fiscal third quarter of 2017. 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, and 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 midpoint 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 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 got 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 the distribution earned higher margin for demand creation. This is having a very positive effect on Microchip as the distribution sees a very strong portfolio from the combined Microchip and Atmel franchises and is increasing the commitment for demand creation for 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're 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 the 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 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's style of quarterly business unit reviews. With the entire company on a Microchip-type of common incentive program that values sales growth, gross margin, 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's sales and field applications 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 rewards 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 deciphering the financial results of Microchip from the fiscal second quarter. While we will refrain from providing a line-by-line breakdown 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

[Operator:]

Yes, of course. And we'll take our first question from Vivek Arya with Bank of America.

[Vivek Arya:]

Thanks for taking my question, and congratulations on your strong execution. Steve, for my first question, I am 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 share gains or just conservatism or pricing actions with Atmel products?

[Steve Sanghi:]

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've got great product, because 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 from our peers and competitors, and then you can compare them to our results and kind of make your own assessment.

[Vivek Arya:]

All right. 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.

[Steve Sanghi:]

Well, again, I think your questions and intent is always to kind of piece everything, break it up. But this is kind of hard to do. I gave you nuggets of information. There was a 400 basis points improvement on Atmel gross margin, Microchip's, the 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 a result of pricing increases, setting back many of the customer contracts in U.S. dollars back to where the contract was originally done, taking away the impact of weak euro, weak pound and those kinds of things. And there was a better mix on Atmel side also. So, again, lots of moving parts.

[J. Eric Bjornholt:]

And over time, as we are winning new business, it's on a more disciplined pricing basis that the new business is being won. So, in that, as it goes to production four, six quarters from now, it will all be at good margins.

[Ganesh Moorthy:]

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 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.

[Vivek Arya:]

Thank you.

[Operator:]

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

[William Stein:]

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 Microchip's. 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?

[Steve Sanghi:]

So, it's just all a matter of timing. Yes, Atmel's business structurally is slightly lower gross margin driven by a little 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 are building, the 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 the orders sins. Many of them we are correcting in increasing the prices, but many of them are old customer contracts which have clauses where we cannot change them.

[William Stein:]

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?

[Steve Sanghi:]

So, Ganesh commented on it, that our sales force 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 tried to capture that attach. But getting all this Atmel microcontroller business gives us new, fresh opportunity to identify all the analog attach opportunity around it. And our sales force is identifying opportunities. We're adding them to the funnel. In many cases, there are substitute products, in many cases, there are 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.

[William Stein:]

Thanks, and congrats on the good results.

[Operator:]

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

[Kevin E. Cassidy:]

Thank you and congratulations on all the hard work and results. You had mentioned 8-bit revenues 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?

[Steve Sanghi:]

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 have a cover page EE Times 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. The business did record on core as well as total, as Ganesh mentioned. We are 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 everyone away from 8-bit and turn to something else and we're enjoying this business quite a bit.

[Kevin E. Cassidy:]

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?

[Steve Sanghi:]

You want to take that?

[Ganesh Moorthy:]

Yeah. I don't think it's necessarily with Bluetooth and wireless. I think there are plenty of areas where people are trying to make devices smart. And if you have 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 are doing that not only on PIC but the Microchip product line before but also an 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 to many systems, they will. I don't think they're anything related necessarily to Bluetooth and wireless – and Wi-Fi specifically.

[Kevin E. Cassidy:]

Okay, great. Thank you.

[Operator:]

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

[Vinay Jaising:]

Hi. This is Vinay, 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 you touch upon the opportunities you are seeing for savings on the manufacturing front and any potential synergies on the back end longer term?

[Ganesh Moorthy:]

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

[Vinay Jaising:]

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

[Ganesh Moorthy:]

Oh, manufacturing front.

[Steve Sanghi:]

Manufacturing front. So we talked about it last quarter that we are – we have decided to keep the Colorado Atmel fab, which we found to be very cost-effective fab and very useful for our plans going forward. So we're not going to do anything. There were Street expectations that we're going to shut down that fab. We never said that and we don't know where that came from, but we are not shutting down Atmel's 6-inch Colorado fab. It's very, very nice fab. Now when you look at the back end, Atmel did 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 Philippines. If you compare that to Microchip, we do all of our wafer probe and about 60%, 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 at lower cost than some of that Atmel is using. And we have put plans together, and some of the lead products are 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.

[Vinay Jaising:]

Got it.

[Ganesh Moorthy:]

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 than just combined purchasing power. There 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.

[Vinay Jaising:]

Got it. That's helpful. From a follow-up, I want to touch upon your analog portfolio like where you have pretty good scale now, right, $900 million in annualized revenue. Could you touch upon some of the growth drivers do you see for the business longer-term?

[Ganesh Moorthy:]

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 then 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.

[Vinay Jaising:]

Thank you.

[Operator:]

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

[Harlan Sur:]

Good afternoon, and congrats on the solid quarterly performance in getting the op margins to 30%. You guys originally had a target of $4.25 per share of earnings power in fiscal year 2019. If I add the incremental Atmel accretion that you articulated, Steve, that goes to $4.40 per share but the overall core Microchip business seems to be doing extremely well as well. So how should we think about the new fiscal year 2019 earnings power?

[Steve Sanghi:]

Honestly, I don't have the math in front of me, and I don't want to make a comment that I haven't done any math on. I think I gave you the accretion map on Atmel and you could piece it back together, by figuring out what the core was and you can do your analysis. Unless I had it in front of me, I wouldn't want to make an error.

[Harlan Sur:]

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 to margins and again, when does that start to kick in?

[Steve Sanghi:]

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 only about, maybe, 10% or 15% of the overall product. Over the six months, 90% of it's 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 months, I think. By June, July timeframe, I think you would have seen about 90% of it.

[Harlan Sur:]

Thank you.

[Operator:]

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

[Christopher Brett Danely:]

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? And then what, if any, potential timing could this be?

[Steve Sanghi:]

There is no change. The change is that we're not going to buy the stock back. And when I wanted to buy the stock back at $40, where the opportunity presented as low as $38. But you recall there was – 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 January, as I was telling you there. But the wisdom that prevailed at that time was to not buy the stock back and now the stock is in $60s. So we believe this is not the time to buy back stock. Instead, we will keep the balance sheet as stronger than 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.

[Christopher Brett Danely:]

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 that is a little less than seasonal, or normal seasonality? And then any comments on what you think normal seasonality for the March quarter would be conceptually for the newly-combined company?

[Steve Sanghi:]

I don't have anything that I could give you from a guidance perspective. This will be our first quarter with Atmel last March quarter was really – you can't really compare 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. The rest we have to see how it works out? Microchips, core Microchip March business usually is up from a low-single digits, and we have to combine that with Atmel and figure out what would happen.

[Christopher Brett Danely:]

And then the December quarter, please?

[Steve Sanghi:]

In December quarter?

[Christopher Brett Danely:]

Yeah. The first part of that question was, is your December quarter guidance like normal seasonality? Or is it a little bit worse than that?

[Steve Sanghi:]

Well again, what's normal seasonality? I don't know what the normal seasonality is with Atmel mixed in.

[Christopher Brett Danely:]

Me neither. That's why I'm asking you.

[Steve Sanghi:]

I don't know.

[Christopher Brett Danely:]

Okay.

[J. Eric Bjornholt:]

So it must be normal.

[Christopher Brett Danely:]

Okay. Great. Thanks.

[Steve Sanghi:]

This is the normal. This is the first time, so this is it.

[Christopher Brett Danely:]

Got it. Okay. Thanks, guys.

[Operator:]

And we'll take our next question from Gil Alexandre with Darphil Associates.

[Steve Sanghi:]

Hello, Gil.

[Gil Alexandre:]

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?

[Steve Sanghi:]

The Christmas bills have shifted dramatically in time in the last five years or so and has been happening incrementally. And let me explain what the shift is. It used to be the case that most of the Christmas builds would be in our revenue in the September quarter because parts get built in Asia. So whatever is being built, equipment gets built by the end of September and gets on ships for six-week journey to U.S. over the ocean and arrives here in time for Thanksgiving when the stores are then full of merchandise. 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 sometimes it gets shipped by the sea and they arrive in November and December. And many a times, there are IOUs where certain product is not available before Christmas, and you 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 kind of gift gift-cards and then 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.

[Gil Alexandre:]

Thank you very much.

[Steve Sanghi:]

You're welcome.

[Operator:]

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

[Rajvindra S. Gill:]

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 help.

[Ganesh Moorthy:]

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 a 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.

[Rajvindra S. Gill:]

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, 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. 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?

[Steve Sanghi:]

Well, people ask us the same question when Freescale was getting acquired. They asked us the same question when Renesas was forming with NEC, Hitachi, 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 purchasing NXPI would 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.

[Rajvindra S. Gill:]

But you've seen consolidation in the microcontroller market because it's been fragmented, and 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 MC space.

[Steve Sanghi:]

Honestly, Raj, there is nothing in our strategy that is saying there are a bunch of new players coming in the microcontroller market, our strategy is not based on that, we're not seeing that. If the question is

[Ganesh Moorthy:]

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

[Steve Sanghi:]

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

[Rajvindra S. Gill:]

Thank you.

[Operator:]

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

[Craig A. Ellis:]

Thanks for taking the question and congratulations on the execution of both in Microchip and with the Atmel business. The first question I have, Steve, you commented that 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 design-in gestation cycle? Is that sometime later in fiscal 2017 or is that a tailwind for fiscal 2018's revenue?

[Ganesh Moorthy:]

We commented that that was a competitor in the channel.

[Steve Sanghi:]

Did he identify the competitor?

[Ganesh Moorthy:]

No.

[Steve Sanghi:]

Okay. So, a large competitor redefined their distribution program where they essentially said that the distribution will only serve the fulfillment part of the business and they will not have the distribution be creating demand and giving them registration and then giving them the demand creation margins. So, since then, we have seen a substantial desire on the part of 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're always some shorter-term opportunities where either the product was designed on both sides or customer has the option to build a model A versus model B, and model A was designed with that company, model B's 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.

[Craig A. Ellis:]

Thanks for that. And then the follow-up is for Eric. Eric, you mentioned that there would be a 25 basis point reduction in borrowing cost. Is that for part of the debt that is currently outstanding or would that be on any future debt?

[J. Eric Bjornholt:]

Well, 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 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.

[Craig A. Ellis:]

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

[J. Eric Bjornholt:]

That's right. And I can help you with that.

[Craig A. Ellis:]

Great. Thanks, guys.

[Operator:]

And we'll take our next question from [Mark Delaney] with Goldman Sachs.

[Mark Delaney:]

This is Mark Delaney 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 what percent, either quantitative or qualitative, you think is already being recognized? Are you a quarter of the way through or half? Any sort of relative sense about how far along you are with getting those fully into the financial metrics would be helpful.

[Steve Sanghi:]

We're 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 misreading by the customers on how much more to come because at some customers where we've 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.

[Mark Delaney:]

Got it. Understood. And then for a follow-up question, I was hoping to better understand some of the puts and takes to gross margin for the December quarter. You talked about some potential tailwinds around pricing and closing down the Micrel fab. Obviously, there'd be some reverse leverage from lower sales next quarter, so just help me just better understand the reason for gross margins being down a bit and what's offsetting some of the self-help gains around pricing and the Micrel fab?

[J. Eric Bjornholt:]

I'd say for the current quarter, it's really a product mix. There's so many puts and takes with gross margins, but I think it's probably driven primarily by a product mix one quarter to the next. We had very good product mix in the September quarter and that changes a bit in the December quarter.

[Ganesh Moorthy:]

The Micrel fab impact is farther out in time.

[Steve Sanghi:]

Yeah. Micrel fab closes in a couple of weeks and then it takes a little while to decommission it and all that. So Micrel impact is really more significant in the next quarter. I think a little bit of you're seeing also from Atmel it's still a lower gross margin than Microchips and driven by – I'm sorry, Atmel is lower gross margin than Microchip and driven by Atmel's mix in the current quarter, a little more consumerish, I think it's a mix when you mix it all together, it results into a slightly lower gross margin.

[Mark Delaney:]

Understood. Thank you very much.

[Operator:]

And we'll take our next question from Lena Zhang with Summit Redstone Partners.

[Lena Zhang:]

Thanks for taking my question. Congratulations as well. Only one question. And, Steve, besides the – you mentioned that your larger competitors have switched channel program to fulfillment program and as well as the pricing on Atmel, give Atmel product gross margin up 400 basis points. And then looking at the overall September quarter gross margin up around less than 200 basis points from the last quarter, is that fair to say there was significant ASP erosion in the quarter?

[J. Eric Bjornholt:]

No.

[Steve Sanghi:]

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

[J. Eric Bjornholt:]

Yes.

[Lena Zhang:]

Yes.

[Steve Sanghi:]

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

[Lena Zhang:]

Okay.

[Steve Sanghi:]

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

[J. Eric Bjornholt:]

Yeah.

[Steve Sanghi:]

Yeah.

[Lena Zhang:]

Okay. Thanks.

[Steve Sanghi:]

I think we can do the math. You could do the math. 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.

[J. Eric Bjornholt:]

Right. And we did make the comment that the Microchip gross margins were up in the quarter.

[Steve Sanghi:]

Yeah.

[J. Eric Bjornholt:]

Microchip, excluding Atmel.

[Steve Sanghi:]

Yeah.

[Operator:]

And moving on, we'll take our last question from Chris Caso with CLSA.

[Christopher Caso:]

Yes. Thank you. I'd just like to 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 repayments of 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 spoken in the past about some of the constraints from doing further M&A, one of which would be managing bandwidth. Obviously, your borrowing capacity would be the other. At what point do you think you would be ready to start contemplating doing something else?

[Steve Sanghi:]

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 these 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'll be actually more than that for the number of shares we issued in Atmel transaction will 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 is an opportunity available, we've got $650 million more available to go forward than the other way round. But there is 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 are not accretive and so on and so forth, we have always found at the right time the right deals. 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.

[J. Eric Bjornholt:]

To the Street's comments about leverage.

[Steve Sanghi:]

Yeah. Not you personally.

[Christopher Caso:]

Okay. Understood. Understood. As a follow-up, if we could talk a little about the utilization levels of the fab? 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 of the fab? And, I guess, the Micrel closure going forward over the next couple of quarters and maybe you could talk about the benefit of that to gross margins, if indeed that goes up?

[Steve Sanghi:]

So I think that's all a positive wind on the back coming. So, as the Micrel fab closes and as you start to burn that 6-inch inventory, you have to start producing that product in an 8-inch fab, which means more demand for 8-inch products. The year has been good. We were up sequentially in the March quarter, June quarter, September quarter. So, our inventory, we just reported is 103 days of inventory, which is kind of not high by any standards. It's kind of lower by any standard we gave you before, which was 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, 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 were 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 its real impact on gross margin is couple of quarters later when we ship that product. Does that makes sense?

[Christopher Caso:]

It does. Thank you.

[Steve Sanghi:]

Yeah.

[Operator:]

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.

[Steve Sanghi:]

Well, thank you very much for attending the conference call. We'll see some of you at the CSFB Conference here in our hometown, Scottsdale. So that's in early – late November. Thank you very much.

[Operator:]

Once again, that does conclude today's conference. Thank you for your participation. You may now disconnect.