Microchip Technology Incorporated (MCHP) CEO Steve Sanghi on Q1 2019 Results – Earnings Ca…

Spread the love


Start Time: 17:00 January 1, 0000 6:29 PM ET

Microchip Technology Incorporated (NASDAQ:MCHP)

Q1 2019 Earnings Conference Call

August 09, 2018, 17:00 PM ET

Executives

Steve Sanghi – Chairman and CEO

Eric Bjornholt – VP and CFO

Ganesh Moorthy – President and COO

Analysts

Harsh Kumar – Piper Jaffray

John Pitzer – Credit Suisse

William Stein – SunTrust Robinson Humphrey

Chris Caso – Raymond James

Craig Hettenbach – Morgan Stanley

Kevin Cassidy – Stifel

Christopher Danely – Citigroup

Krysten Sciacca – Nomura/Instinet

Harlan Sur – JPMorgan

Gilbert Alexandre – Darphil Associates

Christopher Rolland – Susquehanna International Group

Craig Ellis – B. Riley FBR

Rajvindra Gill – Needham & Company

Mark Lipacis – Jefferies

Operator

Good day everyone and welcome to this Microchip Technology First Quarter and Fiscal Year 2019 Financial Results Conference Call. As a reminder, today’s call is being recorded.

At this time, I’d like to turn the call over to Microchip’s Chief Financial Officer, Mr. Eric Bjornholt. Please go ahead, sir.

Eric Bjornholt

Thank you and good afternoon, everyone. During the course of this conference call, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are predictions and that actual events or results may differ materially. We refer you to our press 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 first quarter fiscal year 2019 financial performance, and Steve and Ganesh will then give their comments on the results, discuss the current business environment as well as our guidance, and provide an update on our integration activities associated with the Microsemi 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 Web site at www.microchip.com, which we believe you will find useful when comparing GAAP and non-GAAP results.

I want to remind investors that during the quarter ending June 30, 2018, we adopted a new GAAP revenue recognition standard which requires revenue to be recognized at the time products are sold to distributors versus our historical revenue recognition policy where revenue on such transactions were deferred until the product was sold by our distributors to an end customer.

We are not able to provide guidance on a GAAP basis as we are not able to predict whether inventory at our distributors will increase or decrease in relation with end market demand as this is not how we manage our business. As evidence of this uncertainty in recent years, we have seen net inventory at our distributors increase or decrease by a significant amount in a single quarter.

Our non-GAAP revenue is based on true end market demand in which we measure the revenue based on when the product is sold by our distributors to an end customer. We will continue to manage our business and distributor relationships based on creating and fulfilling end market demand.

All of Microchip’s bonus programs will continue to work based on the amount of revenue earned from fulfilling end market demand. Therefore, along with GAAP results based on sell-in, we will also report our non-GAAP results based on sell-through revenue recognition.

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 using revenue based on end market demand and expenses prior to the effects of our acquisition activities and share-based compensation.

Non-GAAP net sales in the June quarter were 1.217 billion, above the midpoint of our guidance and up 21.4% sequentially from net sales of 1.002 billion in the immediately preceding quarter. We have posted a summary of our revenue by product line and geography on our Web site for your reference.

On a non-GAAP basis, gross margins were a record 62.2%, operating expenses were 23.3% of sales and operating income was a record 473.5 million and 38.9% of sales. Non-GAAP net income was a record 405.8 million. Non-GAAP earnings per share was a record $1.61, which was $0.13 above the midpoint of our guidance of $1.48.

On a GAAP basis, net sales in the June quarter were 1.213 billion, GAAP gross margins were 52.9% and include the impact of 3.6 million of share-based compensation, 107.7 million of acquisition restructuring and acquired inventory valuation costs and 3.4 million impact from changes in distributor inventory levels.

Total operating expenses were 509.7 million and include acquisition intangible amortization of 133.7 million, special charges of 40.1 million which includes 15.9 million of share-based compensation, 26.9 million of acquisition-related and other costs and share-based compensation of 25.8 million. The GAAP net income was 35.7 million or $0.14 per diluted share.

The non-GAAP cash tax rate was 3.5% in the June quarter. We expect our non-GAAP tax rate for fiscal ’19 and the next several years to be between 3% and 4%, exclusive of a transition tax and any potential tax associated with restructuring the Microsemi operations into the Microchip global structure.

We have many tax attributes in net operating losses, tax credits and interest deductions that will keep our cash tax payments low. The transition tax for the combined Microchip and Microsemi group is expected to be about 364 million, was recorded last fiscal year and will be paid over eight years.

The first transition tax payment was made in July 2018 in the amount of $35 million. We expect payments of about 28 million in fiscal years 2020 through 2023, 54 million in fiscal year 2024, 72 million in fiscal ’25 and 91 million in fiscal year ’26.

Microchip’s GAAP tax rate in the June quarter was 5.2% and was impacted by the various GAAP purchasing accounting adjustments from the Microsemi acquisition and prior acquisitions as well as one-time discrete benefits related to changes in U.S. and foreign tax laws.

Moving on to the balance sheet. Our inventory balance at June 30, 2018 was 1.105 billion including 359.7 million of inventory mark-up from Microsemi required for GAAP purchase accounting. Excluding the inventory mark-up, we had 119 days of inventory at the end of the June quarter.

Our targeted inventory levels are between 115 and 120 days. Inventory at our distributors in the June quarter were at 40 days compared to 36 days at the end of March. The historical Microchip distributor inventory was actually down by about a day in the June quarter, but the consolidated increase is driven by the high inventory in the Microsemi distribution channel. We expect the Microsemi distribution inventory to reduce through the end of calendar year 2018.

The cash flow from operating activities was 302.4 million in the June quarter. As of June 30, the consolidated cash and total investment position was 649.7 million. At June 30, our debt outstanding includes 3.3 billion of borrowings under our line of credit, $3 billion of term loan B, $2 billion of high-grade bonds and $4.5 billion of convertible debt.

Our net debt to EBITDA, excluding our very long dated convertible debt that matures in 2037 and is more equity-like in nature, was 5.0 at June 30, 2018. Our leverage is higher than we originally projected primarily due to lower EBITDA from the Microsemi business driven by needing to correct distribution inventory levels through lower shipment activity.

We are fully committed to using 100% of our excess cash generation beyond our dividend payments to reduce our debt levels and we expect our net leverage to decline dramatically over the next several years.

Capital expenditures were 89.4 million in the June 2018 quarter. We expect about 70 million in capital spending in the September quarter and overall capital expenditures for fiscal year 2019 to be about 220 million to 250 million.

We continue to add 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.

These capital investments will bring significant gross margin improvements to our business, particularly for the Atmel and Microsemi manufacturing activities that we are bringing into our own factories. Depreciation expense in the June quarter was $38 million.

I will now turn it over to Ganesh to give his comments on the performance of the business in the June quarter and provide an update on some of the Microsemi integration activities. Ganesh?

Ganesh Moorthy

Thank you, Eric, and good afternoon, everyone. Before we get started with the product line discussion, I thought it may be helpful to summarize what we said at our May 31st conference call in regards to our revenue reporting.

Classic Microchip, which is Microchip excluding Microsemi, used to report five product lines; microcontrollers, analog, memory, licensing and finally multimarket and other what we used to call MMO.

In fiscal year 2018, our revenue of 3.98 billion was split across the five product lines as follows; microcontrollers at 65.8%, analog at 23.9%, memory at 5%, licensing at 2.6% and MMO at 2.6%.

With the addition of Microsemi, we will add a sixth product line category called FPGA. Microsemi’s revenue reporting will be split across four of the six product line categories; in microcontrollers, analog, FPGA and MMO. Microsemi has no memory or licensing product lines and hence the contribution to these categories will be zero.

Directionally, on a combined basis, we expect our analog revenue percentage to tick up while our microcontroller revenue percentage will tick down. That’s exactly what the final results for FQ1 have shown with a partial quarter of Microsemi results included in our overall results.

Now let’s get to the product line performance. On a combined company basis, we performed a little better than we expected in the June quarter with sequential revenue growth of 21.4% as compared to the March quarter.

Microchip, excluding Microsemi, achieved a new record for revenue. The Microchip 2.0 transformation continues to make good progress especially in terms of new design opportunities as we enable our clients’ innovation with the very best smart, connected and secure solutions.

Taking a closer look at microcontrollers, our microcontroller business, excluding Microsemi, set a new record in the June quarter. Microcontroller revenue, excluding Microsemi, also outgrew classic Microchip overall.

Both 8-bit microcontrollers and 32-bit microcontrollers for classic Microchip set new records. On a combined basis, including Microsemi, our microcontroller business was sequentially up 10.8% as compared to the March quarter.

Our microcontroller portfolio and roadmap has never been stronger and we are seeing continued growth in our design and funnel which we expect will drive future growth as these designs progress into production over time.

We believe we have the new product momentum and customer engagement to continue to gain even more share in 2018 as we further build the best performing microcontroller franchise in the industry.

Now moving to our analog business, our analog revenue, excluding Microsemi, set a new record in the June quarter. Analog revenue, excluding Microsemi, also outgrew classic Microchip overall. And on a combined basis, our analog business was sequentially up 35% as compared to the March quarter.

Moving next to our licensing business, this business was sequentially up 0.2% as compared to the March quarter and up 5.8% as compared to the year-ago quarter. Our memory business was sequentially down 1.8% in the June quarter as compared to the March quarter. And finally, our MMO business for Microchip, excluding Microsemi, was down sequentially. However, it was up 63% sequentially when including Microsemi.

On a combined company basis, which has a full quarter of Microchip and a partial quarter of Microsemi, our FQ1 2019 revenue of 1.2 billion was split across the six product lines we report as follows; microcontrollers at 59.9%, analog at 27%, FPGA at 3.4%, memory at 4%, licensing at 2.2% and MMO at 3.5%.

We expect the tick down in microcontroller revenue percentage and tick up in analog revenue percentage will be further extenuated when we announce our FQ2 results in November as we will have a full quarter of Microsemi revenue included in the results.

Now an update on the Microsemi integration and our progress since our May 31st conference call. We made dramatic changes to the top level leadership structure in the first few weeks after the close. Essentially, all of the top leadership are no longer with Microchip. The reasons for this will be more evident after Steve provides you some color in his section.

As we have done in other large acquisitions, we have used our leadership depth and strong pipeline to insert Microchip executive leaders in the top positions to run the Microsemi enterprise.

The business unit restructuring is progressing well. We have retained several of the key Microsemi business unit leaders to continue to run their businesses, while selectively combining some of the smaller businesses where Microchip had similar product lines into the Microchip business unit structure. This eliminates duplicate infrastructure and creates synergy in the process.

We have also restructured some of the less profitable businesses and adjusted their going forward investment levels to be consistent with what is affordable. And we have some more to go.

The sales integration has commenced. We have converted the sales team to a Microchip style non-commission sales team and ended all incentives discount product for quarter end revenue maximization.

Teams from classic Microchip and Microsemi have started to identify and pursue product cross-selling opportunities and have also identified reference designs that can take advantage of our combined total solutions approach. Several of the sales office space consolidations have already taken place and many more are in the works.

The normal analysis of effectiveness of channels as well as of each channel partner is underway. One decision we have already made which was announced last week is a refranchising of Avnet, a Microsemi product thus adding more channel bandwidth to sell Microsemi’s products.

The operations integration work has started but it is an enormously complex undertaking as little to no integration of prior Microsemi acquisitions had taken place. For example, Microsemi has 21 ERP installations that we need to converge in our business system and operation integration plans.

We expect to have the plan worked out by the end of this month and start working towards specific business system and operational integration goals at that time. However, given the complexity we are seeing, we expect the operational integration will be a two to three-year project.

We’re also performing a detailed analysis of what outsourced operations can be in-sourced as well as evaluating the efficiency and cost effectiveness of Microsemi’s internal factories. Lastly, the normal task of working with the supplier base to find the best cost from either company and applying it to the other is happening as we speak.

In the G&A areas, we have eliminated some of the support organizational cost redundancies. More will happen after we get further along with our business system and operational integration plans.

Let me now pass it to Steve for some comments about our business and our guidance going forward. Steve?

Steve Sanghi

Thank you, Ganesh, and good afternoon, everyone. Today, I would like to first reflect on the results of the fiscal first quarter of 2019. I will then provide commentary on our first two months at Microsemi. I will then provide guidance for the fiscal second quarter of 2019.

Our June quarter financial results were good. Our consolidated net sales came in above the midpoint of our revised guidance that we issued on May 31, 2018 after the closing of the Microsemi transaction.

In discussion with our Board of Directors, the Board wants us to manage as a combined business from day one, not breakout the individual components of Microchip and Microsemi and proceed to integrate the businesses together at a rapid pace. The Board does not want to engage in the old controversy of organic versus inorganic growth and wants to measure us on the overall results achieved.

What we are driving towards is to produce an increasing non-GAAP earnings per share from the combined company. This worked well when we acquired Atmel and it should work well here. Therefore, we will not provide a breakdown of the two businesses other than some useful nuggets of information along the way.

I will refer to Microchip business without Microsemi as classic Microchip. When we include Microsemi, we will call it consolidated. So our classic Microchip’s non-GAAP revenue, non-GAAP gross margin and non-GAAP operating margins were all new records last quarter.

Our overall consolidated non-GAAP revenue, non-GAAP gross margin and non-GAAP EPS were also new records. Non-GAAP EPS exceeded the high end of our guidance. Non-GAAP earnings per share were $1.61, $0.13 better than the midpoint of our guidance. $0.05 of this EPS beat came from higher operating profits and the balance $0.08 of the EPS beat came from a much lower tax rate.

Our tax rate guidance was intentionally conservative in the wake of new tax laws and significant uncertainty of the tax rate of the combined company after acquisition of Microsemi. We consider the tax planning for the combined company to be a part of our plan to synergy and had intentionally modeled for it in our synergies planning. On a non-GAAP basis, this was also our 111th consecutive profitable quarter.

Our inventories at classic Microchip at the end of June 2018 were 119 days which is right at our target of 115 to 120 days. The total inventory, including Microsemi, is cluttered by purchase accounting adjustments where inventory is written up to market value and hence the total inventory indictor is not meaningful.

We have made enormous progress on the manufacturing side by bringing capacity online and decreasing lead times. Our lead times are now near normal with the majority of our products having lead times up between four to eight weeks, but scattered issues with certain products continue to cause longer lead times in those products.

Now let us shift gears. I will give you our observation from our first two months at Microsemi. This has been the time when we are able to get access to all the company’s information that we were not able to get before. And this is the time when we discover some of the weaknesses that we have found in other acquisitions like Atmel and Micrel. This is typically the low point in the acquisition. Things usually rapidly improve from here as we go to work to fix things and integrate.

In the case of Microsemi, we found that Microsemi management was extremely aggressive in shipping inventory into the distribution channel. Microsemi’s distributors had about four months of inventory whereas Microchip’s distributors carry about two and a half months of inventory. While we have seen some excess shipments of inventory into the distribution channel in other acquisitions, we have never seen as much excess as we found in the case of Microsemi.

Microsemi also over-shipped into the contract manufacturers by making deals and offering discounts. This excessive distribution in contract manufacturers’ inventory will provide some headwind for revenue for the next couple of quarters. Our trailing EBITDA in the next two quarters of cash generation will also be impacted by needing to correct this inventory for Microsemi products.

While excessive shipments into distribution and contract manufacturers has been the main issue at Microsemi, we also found a culture of excessive extravagance and high spending. The company had millions of dollars of sponsorships in several luxury suites in sports stadiums, luxury private plane travel and generous sponsorships for many conferences, stadiums and other venues that are wastage of shareholders’ money. We are undoing commitments to all such spending.

So what are we doing to clean up excess inventory and other spending? We did not make any deals with the distribution and contract manufacturers or end customers in the month of June to shift excess inventory. As a result, we shipped closed to $100 million less in the month of June than Microsemi ex-management would have shipped. That was nearly half the inventory correction accomplished in a single month. We expect to achieve the balance of the distribution inventory correction in the next two quarters and nearly complete the correction by the end of this calendar year.

Based on high inventory in distribution as well as inside Microsemi, we have substantially cut back on the manufacturing built plan in internal factories as well as foundries and assembly test subcontractors. The vast majority of Microsemi business is subcontracted so we will see a dollar for dollar cash saving which will offset the negative cash impact of – some of the negative cash impact of inventory correction.

While this may seem disappointing, we have seen such challenges before as the problems of the acquired company become more visible post close. We remain optimistic about the medium and longer-term prospects from the Microsemi acquisition and are not changing our longer-term thesis.

We have high confidence in the $300 million of synergies that we’ve previously communicated. Microsemi has a very good engineering team. We are still very bullish on the Microsemi products, the stickiness of the customers’ pockets and the end market opportunities for the combined company.

Our strategy for the better part of this decade has been to buy underperforming assets and turn them into world-class performers in the likes of Microchip. Here, we are starting with excellent products and excellent gross margins and we will correct the aggressive distribution and contract manufacturing shipments and high expense culture as we have done before, for example, at Atmel.

Now let us go into the non-GAAP guidance for the September quarter. In addition to the headwinds I described on Microsemi, there are several small factors that are starting to impact the business. Standalone, none of them will be material but all of them together are causing us to provide a cautious guidance for fiscal second quarter of 2019.

I would describe four reasons. Number one, the lead times in the market for some of the passive components continue to be long. We are seeing push-outs by several customers because they cannot complete the whole kit and hence do not need our devices. Number two, all the talk about tariffs and trade war is making our customers nervous. While it is hard to put your finger on it, it is hurting business confidence which makes people pull back on investments, expansion and capital spending.

A very small portion of products are made in China and even a smaller portion are imported back in U.S. So we are not worried about duties on our products imported into U.S., but we are concerned about our customers’ products imported into U.S. This is based on original July 6th tariff implementation. We are still analyzing the impact of expected August 23 tariff implementation.

There was a quote from one of our sources, one of our customers. “United States imposed 25% tariffs on some Chinese goods on July 6. U.S. issued a list of thousands of Chinese goods for the new tariffs. It makes manufacturers conservative in building product due to uncertainty of market demand.”

Third point, we are seeing the impact of not being fully able to ship to ZTE. While the Justice Department is now allowing shipments to ZTE, ZTE is still organizing and figuring out what the real demand is now and if they can assemble the entire build of materials with long lead times on passive components. So despite the release from the Justice Department, there has been some demand destruction at ZTE.

Number four, Microchip is a supplier to bitcoin mining industry by supplying microcontrollers and powered management products for the power supplies as well as Ethernet controllers. Bitcoin values have crashed. It has lowered the demand for new shipments to the bitcoin industry quite substantially.

With all this commentary, we expect total non-GAAP net revenue in the September quarter to be between 1.474 billion to 1.55 billion. Our best estimate for overall non-GAAP gross margin is between 61.3% and 61.9% of sales, a range wider than normal as we integrate and understand Microsemi as well as deal with the excess inventory in the channel and resultant reduction in the internal factory builds.

We expect non-GAAP operating expenses to be between 23.6% and 24.2% of sales. We expect non-GAAP operating profit to be between 37.1% and 38.2% of sales. And we expect a non-GAAP earnings per share to be between $1.65 and $1.83 per share. This includes more than the $0.15 of accretion from Microsemi that we had originally guided to. So you can see that despite a significant headwind on Microsemi’s revenue and cautious guidance, our non-GAAP EPS guidance at the midpoint is well above prior consensus analysts’ estimates.

This reflects our rapid pruning of some underperforming product lines, raising some prices on mature products and significant restructuring already at Microsemi. Our guidance also represents some excellent tax planning resulting in a lower effective cash tax rate. Our synergy assumptions included this tax planning for the combined company. We do expect our financial results to be a bit noisy for a couple of quarters as we correct distribution and subcontractor inventories and as we adjust the internal manufacturing based on inventory correction.

But our synergy assumptions for fiscal year ’19 and our long-term synergy assumption of $300 million and our fiscal year ’21 non-GAAP EPS target of $8 per share have not changed. The target for non-GAAP EPS of $8 per share in fiscal year ’21 may in fact seem conservative in light of the progress we have made in integration and a much lower effective cash tax rate. And we expect to exceed the $0.75 accretion guidance that we have provided as the annualized run rate accretion for the first year after close.

Given all the complications of accounting for the acquisitions, including amortization of intangibles, restructuring charges, inventory write-up on acquisitions and changes in distribution inventory, Microchip will continue to provide guidance and track its results on non-GAAP basis. We believe that non-GAAP results provide a more meaningful comparison to prior quarters and we request that the analysts continue to report their non-GAAP estimates to First Call.

With this operator, will you please poll for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. We’ll take our first question from Harsh Kumar with Piper Jaffray. Go ahead, sir.

Harsh Kumar

Hi. Thanks. Steve, it seems like you guys are going through the normal things when you acquire a company. Steve, I had a quick question for you and a follow up. You mentioned a lot of things that are coming into play; bitcoin, some other stuff, trade wars. I’m curious, does you guidance on the top line take into account obviously the Microsemi inventory clearing, but is there also a slowdown in your organic business or is it mostly all Microsemi that’s being played out in your revenue guide?

Steve Sanghi

We’re not breaking it out but it’s a combination. The bitcoin exposure was on the Microchip side. ZTE exposure was mostly on the Microsemi side. If there is any kind of demand slowdown because of tariffs if the customers would be nervous to drawdown their inventory because they do not know what the tariffs would be to bring the product into U.S., then that would really affect both sides, Microchip as well as Microsemi. So it’s really a combination of it. But a fair amount of correction really is on the Microsemi side.

Harsh Kumar

Got it, Steve. And then for my follow up, your margins in the September guide are slightly lower than your margins then what you reported in June. I’m assuming that that’s predominately a function of you guys taking down the Microsemi inventory quite down in the channel? And then how do you – you said you cleared 50% in one month. Do you expect the rest to be cleared evenly or you’re going to come down pretty hard in September again and then sort of ease-off with very little left in December?

Steve Sanghi

So several questions, let’s take the margin first. Microsemi margins are lower than Microchip’s classic margins. Many investors and analysts may have forgotten that Microsemi acquired a company called Vectron back in September and that company only had little over 30% gross margins. So that brought the gross margins low but during all this time they have been sort of in the acquisition, so they never reported – Microsemi never reported their March quarter where their margins were impacted by Vectron and prior quarter was some sort of ratio.

Eric Bjornholt

Just to clarify, that acquisition was in the November-December timeframe of 2017 not September.

Steve Sanghi

Okay, so I stand corrected and that makes my point actually better. So since it was in the November-December timeframe, the first full quarter of the lower Vectron margin would represent itself in the March quarter and March quarter was never reported by Microsemi anyway because they were already in acquisition. So we are seeing lower gross margins of Microsemi. So last quarter was only one month and this quarter we have the entire quarter. So therefore it has a larger impact of the lower gross margin. And this quarter we will also see the impact of substantial reduction of the build rates in the internal factories of Microsemi. So that was the answer on the gross margin side. The other part of your question was —

Eric Bjornholt

Distribution correction —

Steve Sanghi

Distribution correction. So roughly the $100 million less that we shipped was a combination of shipments, lower shipments from distribution to contract manufacturers and also to direct customers because they were essentially equal opportunity making deals with everybody and making – shipping excess product into every channel. So out of the $100 million a good portion, more than half of that was a correction in distribution. We will see another distribution correction in the September quarter and the December quarter. And right now we are expecting that that will complete the majority of the correction. The largest piece got down last month, in the month of June and then the September and December will be two roughly equal pieces. And if anything is left after that it’s kind of a tail, a very, very small portion here and there which will not be meaningful.

Harsh Kumar

Understood. Thanks, Steve and guys and best of luck.

Steve Sanghi

Thank you.

Operator

Thank you. And next we’ll hear from John Pitzer with Credit Suisse.

John Pitzer

Good afternoon, Steve, thanks for letting me ask the question. Steve, I just wanted to go back to yours and the Board decision not to kind of breakout Microsemi. I think that makes a lot of sense looking several quarters out, especially because you’re so confident in the revenue synergies of this transaction that you included it in the initial synergy targets. But as you kind of think about the June and September quarter, if you can just help me understand the rationale not telling us what Microsemi was and to the extent that you’re not, can you help us get some comfort level about how the classic Microchip business is performing relative to peers because in the absence of kind of not being able to do that math, I think it’s pretty easy for some of us to perhaps wrongfully conclude that maybe the core Microchip business just isn’t holding up as well as some of your peers in this environment.

Steve Sanghi

Well, John, I’m not surprised to get that question from you. Really rightly day one, we took our guy who runs our networking business and he took over the Ethernet business and all those products are combined and we’re getting a single forecast from that division; similarly the case where the analog products, power management products and others. I think if you go back to the Atmel scenario, if we had managed the business to look at Atmel’s 8-bit MCUs and Microchip’s 8-bit MCUs and Atmel’s 32-bit MCUs and Microchip’s and [indiscernible] products and automotive and others, we probably wouldn’t have got an as good results in Atmel as we were able to get, because we went at it as it’s really one business, shipped the lowest cost product at the highest ASP, wherever you have the best specs and best product and that’s really what we’re doing here. We just don’t want to spend and the Board doesn’t want to spend any of company’s energy to do it any other way. I think the Microchip business was fine and the Microsemi business was fine. One month can’t tell the story because the business was very nonlinear. So even though you’re looking at overall we achieved the numbers and slightly better than the guidance, both pieces were in the range, so basically not a problem. But reporting it is just like a slippery slope than – honestly, John, what you guys would like is really there are two clean spreadsheets; one and the other and everything adds up and two plus two is equal to 4.00000. And the world is too complex on our side. We got too many moving parts and things are moving too fast and this whole inventory correction got shoved on us from Microsemi that we were not aware of. There was so much inventory and the Board doesn’t want to put the energy on what doesn’t add value in us really driving the business.

John Pitzer

That’s helpful, Steve. And then you kind of updated or sort of reiterated a lot of the accretion targets around Microsemi. I’m just kind of curious given that there are some concerns about the leverage on the balance sheet relative to this deal, can you just give us an update on how we should think about leverage going forward and how aggressively you’re thinking about taking that leverage down? Thank you.

Steve Sanghi

Certainly. Eric can point that out to the leverage.

Eric Bjornholt

Okay. So as I mentioned in my prepared remarks, our leverage on a net basis, excluding a very long dated convertible, was 5.0 at the end of June. We had originally guided that we have about a turn reduction per year. And because of the distribution and inventory correction that we need to make, we think that in that first year we’re going to be somewhere in the 0.75 range in terms of reduction and then get back to the one turn per year. So it’s a little bit slower pace. And absolutely we are focused on deleveraging the balance sheet and using 100% of our excess cash generation beyond the dividend to pay down debt. So it’s a focus area of ours. We know that we have a lot of leverage at this point in time but we’re committed to bring it down.

Steve Sanghi

That reduction from one turn to 0.7 turns is largely because of shortage of the next two quarters. When you look at on the LTM basis a year from now, the September quarter and December quarter are going through substantial inventory correction, there is a shortage of the EBITDA. After that we get back to —

John Pitzer

That’s helpful, guys. Thanks for the details as always.

Steve Sanghi

Welcome.

Operator

Our next question will come from William Stein with SunTrust.

William Stein

Great. Thank you for taking my questions. I have two. First, I know in the past you have evaluated potential divestitures. I wonder in this case if you think that evaluation continues. Is it more or less likely than in the past? You highlight this lower margin Vectron business. Is there anything that you might want to divest? And then I have a follow up, please.

Steve Sanghi

Well, I think we always evaluate thing when we buy a company. And as you have seen in our prior acquisition, we have really divested very little. There was a tiny small piece out of the Atmel, there was nothing out of Standard Microsystems, there was nothing out of Micrel, nothing out of Supertex. We look at divesture more driven by it doesn’t fit at all rather than it isn’t performing well or it’s lower margin, because we fix margins. We fix pricing – increase pricing. We adjust the model mix of the products. We move the product into different set of customers, industrial or automotive and others where the margins maybe higher. We have done that in many, many acquisitions and we’ll do similar things here. The acquired company focus or the reach may be in a certain set of customers and we expand that and improve margins. So, so far we have not found anything we are going to divest but it’s only been a couple of months and that’s not where we are focused on, divesting. We are focused on improving.

William Stein

Thanks. And as a follow up, I just want to make sure I understand the discussion point around having – Microsemi having stuffed not only the distribution channel but other sort of channels, including it sounds like direct customers as well. And when we marry that up with Microchip’s approach to rev-rec which is sell-through, the reduction in inventory in the channel, that doesn’t actually reduce your non-GAAP revenue, maybe perhaps a shortfall in your outlook on the revenue side is more driven by the reductions in inventory perhaps at contract manufacturing and other direct customers but not what’s going to distribution. Is that the right way to think about it?

Steve Sanghi

Well, good question, very good question. That would be the case if everything was pure. But everything was not pure. They had also – ex-management has also taken – every quarter they would take some direct customers and move them to distribution by giving distribution some discounts so they could make a margin on it. And in doing so they will take the next couple of quarters of product for that customer and stuff them into distribution. So therefore you get to recognize higher selling revenue because to the end customer you will only ship 1x. But to the distributor you can give them 1.5x or 2x and they will do some of that every quarter. So there was overall more than couple hundred million dollars of direct accounts had to move to distribution over the last year or so. And you can’t totally put your finger on it, but a lot of that seemed to coincide when it was sort of decided when the company would be sold. There is some timeline you can triangulate to but it’s not something I can really prove.

William Stein

Thanks very much.

Steve Sanghi

Therefore, there is inventory sitting in distribution for the direct customers and those direct customers we are converting them back to direct customers but they won’t be buying anything for a little while until their distribution has cleared out their inventory shipping it to the direct customers.

William Stein

Got it.

Steve Sanghi

Does that make sense to you?

William Stein

Yes, it does help clarify. Thank you.

Operator

Thank you. Next from Raymond James we’ll hear from Chris Caso.

Chris Caso

Yes, hi. Thank you. Just a follow on to the other question. I guess as we look forward, I guess from what I’m hearing you saying is the quarterly revenue that we were seeing from Microsemi at least for the past couple of quarters was inflated if we looked at it on a pure sell-through consumption basis. Is there any way you can give us any help with where the correct run rate should be? I guess suffice it to say it’s lower than what we were seeing reported over the last few quarters.

Steve Sanghi

You’re correct. The revenue reported – I want to be very clear that there was no fraud involved because the ASC 606 allows you to recognize revenue shipped to distribution at sell-in. Now the question is —

Chris Caso

And so did the prior revenue recognition standard of 605.

Steve Sanghi

Yes, so ordinarily the management team in managing their business will ship it to distribution roughly what distribution ships out and has the distribution inventory grow only by the amount distribution is shipping higher amount in terms of business growing. That’s not really what happened here. Hiding under the revenue recognition that sell-in is a revenue recognition, there were large number of deals made with the distribution. When the inventory got higher and higher, they even offered interest subsidy to the distributor to carry inventory beyond a certain number of months because the distributor wouldn’t want to carry. There’s money tied up. And they will offer interest subsidy. So basically, shipping to distribution was made an art form almost. So yes, the revenue was higher than the real end market demand. Now at this point in time we’re not totally prepared to give you that number. I think it’s not extremely large. It’s in a few-percentage range. But we need to clear out this inventory over the next one or two quarters and ourselves be comfortable with what the run rate is. There will be – as we clean out this inventory over the next couple of quarters, there will be a larger revenue increase as we head towards the full board shipment because the inventory correction is over. So there will be some attenuation out in time of the growth rate and I think we’ll provide you some guidance over time, but not today.

Chris Caso

Okay, that’s helpful. If for my follow up, I can pivot onto the Microchip organic business and understood what you said about those four issues which were impacted revenue as we go into the September quarter. Can you talk to the sustainability of those headwinds? Is this what you would consider to be sort of a short-term issue? Maybe you could speak to the health of – outside of these four issues that you talked about the health of the remaining business and then what you’re seeing in terms of order rates? Any change in the fundamentals to the business I suppose.

Steve Sanghi

The core Microchip business does not really have any fundamental problem. I think there isn’t anything we’re trying to correct there. I think our issues are on the Microsemi side. But if you take those four points, the lead times on passives you have heard from many other companies, the whole industry is kind of being impacted. We do not know why passive lead times are that long and the growth has not been – it’s not like businesses have grown 30%, 40% where passives can’t be provided. But there must have been a significant reduction in passive capacity of some kind. So that’s not long lasting. I think as the industry corrects and passive lead times come down, that issue will go away. The tariffs and trade war is beyond our scope of being able to control it or fathom it and we don’t know any more than anybody else does what the effect of that would be. The ZTE situation, Microchip had a fairly small business with ZTE but the overall business – Microsemi had a larger business but it’s not huge. For the combined company, I can’t give you an exact number but let’s say it’s the order of 1%. Standalone, that wouldn’t be meaningful. That wouldn’t be all that large. You don’t highlight 1% kind of customers. But if there’s a demand destruction – significant demand destruction and 1 goes to 0.5, then 0.5% change on a sequential basis can be meaningful. And the bitcoin is similar. Bitcoin was on the core Microchip side. It’s not like it’s a huge business like it may be at some other companies like NVIDIA or something. For us it was like a 1% type business, but it’s down 70% or more. So standalone, it’s not really very much with all these moving parts you can make up with growth in other segments, but when you combine many of these sectors together and with all the headwinds from Microsemi, we cannot make up for these small components when you add these four together. I don’t know if that helps.

Chris Caso

Yes, it helps. Thank you.

Operator

Next we’ll go to Craig Hettenbach with Morgan Stanley.

Craig Hettenbach

Yes. Thank you. Steve, just going back to the topic of tariffs and the business confidence, are you seeing any change in terms of order activity that your customers had been placing?

Steve Sanghi

Yes, we are seeing it and order activity – more than that I think we are seeing it in distribution sell-through in China to those customers. Still a lot of business in China is done through distribution just because – just logistics and all that. We do business both direct and distribution. We’re seeing it in both channels. The distribution does business with lots and lots of small customers who build stuff, hardware that ships back into U.S. And we have always told you our business consist of long-tail thousands and thousands of – probably 70,000, 80,000 small customers which can adjust their build rates in real time. They’re very nimble. And when they think – they don’t really know whether they can pass on this cost to end customer in U.S., whether they are competitive with 25% duty, will this product have a duty or not have a duty, it makes them pull back on their builds. And we’re seeing that impact in sales out from distribution in China.

Craig Hettenbach

Got it. I appreciate the color there. And then on Microsemi, once you get through the inventory correction adjustments over the next couple of quarters, are there any parts of the business that you call out that you see is attractive from a growth perspective or have a better outlook once you get passed these issues?

Steve Sanghi

Well, we like lots of different businesses. They have very good FPGA business, they have very good business in the data center, they have very, very good business in analog, discrete, aerospace and defense. And then their certain businesses may be not as great. I mentioned one that the electronics business they bought. We don’t know why they bought that. We have some – that was a low margin business and Microchip would not have bought it. But yes, there are a number of good businesses. What attracted us to Microsemi in the first place really hasn’t changed. We had not imagined the seven months of inventory correction and crisis that we had to go through, but fundamentally we’re seeing fiscal year ’21 guidance that we gave you on $8 per share is now conservative. This year – we said by the end of this fiscal year we’ll be producing $0.75 of accretion. We think that is conservative.

Craig Hettenbach

Okay. Thanks.

Operator

And next we have Kevin Cassidy with Stifel.

Kevin Cassidy

Thanks for taking my question. On the CapEx guidance, it seems the second half of the year the CapEx comes down quite a bit to maybe 2.5% of revenue or so. Is that going to be the run rate going forward or is that just a temporary adjustment?

Eric Bjornholt

I would say longer term, Kevin, probably a good estimate to use is 4% of revenue. We need to continue to evaluate the Microsemi business and see with the investments there. Obviously we’ll be looking to see if there is ways that we can improve the margin on their products by making investments like we’ve done in other acquisitions and investing in assembly and test and bringing activities in-house. So I think that’s kind of the swing factor there. But we were more heavily weighted in the frontend of fiscal ’19 from a CapEx perspective.

Kevin Cassidy

And that heavily weighted those products you were targeting, certain long lead times. So as all your lead times, you feel like you’ve got the equipment in place to correct that?

Eric Bjornholt

Our lead times are in very good condition at this point in time. I think Steve mentioned that the majority of our products have lead times with four to eight weeks. And there’s always some exceptions to that and we’re making the proper investments to correct all of our lead times to the right level.

Kevin Cassidy

Okay, great. Thank you.

Operator

Our next question comes from Chris Danely with Citi. Chris, go ahead.

Christopher Danely

Can you hear me?

Steve Sanghi

Yes, Chris, go ahead.

Christopher Danely

Sorry, wrong mute button, fat fingers. Danely here. So just a couple of clarifications. So Steve, it sounds like the headwinds from Microchip and Microsemi are going to last a couple of quarters. I guess conceptually, how big of an impact should we be thinking about into the December and March quarters would it be? And then what gives you confidence that revenue should bottom in the March quarter? And then do you think that at least the slowdown you’re seeing on I guess the classic Microchip business, would you expect this to hit others in the space?

Steve Sanghi

Well, to the last question I don’t have any comment. For others, ask the others. We don’t comment on the industry, we comment only on ourselves. In terms of the inventory correction, inventory correction we can somewhat control because we’re working with distribution and contract manufacturers and end customers moving the end customers back from distribution to direct which will erroneously transfer to distribution and should not have been. And that we know complete sometime in the calendar fourth quarter. And to distribution, we are monitoring very, very carefully shipping less product to them. With the distribution, they didn’t want all this inventory. So in the month of June, we simply didn’t offer them any discounts and they didn’t take the inventory. You don’t have to do much. You just run the business, distribution buy what you need and it will get corrected by the end of the year. You don’t have to do much in that case because inventory was jammed through incentives and discounts and to smaller distributors even threatening. You don’t do any of that, inventory would correct. So we have high confidence that the inventory corrects. That’s not an issue. The impact of tariffs nobody can call. We really don’t know what happens in the trade war area. The passive components issue I think should go away because capacity is being added. I think that should go away. ZTE is temporary. ZTE will get its act together and figure out what the real demand is, what demand they have lost of their competitors. And the bitcoin is anybody’s guess. It’s not a huge portion of our business over a long period of time. For $1.5 billion roughly per quarter, 1%, we’re talking about $15 million a quarter. So it’s really not a huge, huge portion of the business and we don’t know whether bitcoin comes back to its old glory or not. So I think the main issue is the inventory correction one. That gets corrected in six months and then tariff one is not clear.

Christopher Danely

Thanks. I guess one last quick one before I leave. Were these guys worse than Atmel in terms of the shenanigans they were pulling out there? You guys corralled the Atmel stuff pretty handedly. Is this a similar situation or is it worse?

Steve Sanghi

Well, I’m not willing to accuse anything. I just think the accounting standing is wrong. And we have been seeing it from the beginning and we have already been in position to taper on it when the accounting standard was changed for its sell-in. All you need is a willing distributor or a set of distributors who are willing to take increasing amount of inventory which will ship out eventually some day. There are products in distribution from Microsemi that will take two years to clear. It’s not a huge amount like we’re seeing the majority of it will clear by the end of the year, but there are certain products every quarter they will take certain products, older products and slate them as end of life. Then they will build three, four years of inventory and give it to a distributor and recognize it for revenue in the current quarter. And next quarter do it with some more products. And standard allows it. Since it’s nonreturnable by the distributor, you gave them at a deep discount and you gave them interest subsidy so the distributor is willing to carry it. They will eventually ship it. The standard allows you to recognize it for revenue. So they didn’t do anything illegal. But the issue is they represented to us, to their own analysts before, to their customers or to the investors and everybody else that there was an end run rate. And legally there was a run rate because it will continue to do this for I don’t know how long, until some day it burst. That’s not how we do it. We have never stuffed the channel in our life. We have always recognized revenue on sell-through even though now GAAP standard says you have to account for sell-in, we are giving you that GAAP number but we’d give no GAAP guidance. We manage our business on sell-through. All our incentives are based on sell-through. So I’d just say – that’s really what happened. They did what they were allowed to do.

Christopher Danely

Okay. Thanks a lot for all the clarifications, Steve.

Operator

Our next question will come from Krysten Sciacca with Nomura/Instinet.

Krysten Sciacca

Good afternoon. Thanks for squeezing me in here. Maybe just a different take on the revenues for the second half of this fiscal year. So on prior calls you’ve noted that December and March typically tend to be the softer quarters seasonally with December being the weakest. Given the inventory issues that you are having with Microsemi, are you expecting any changes to the seasonality or do you expect this to still be the case?

Steve Sanghi

Well, we expect that still to be the case. But what you start to see is really certain products inventory corrects. It doesn’t all correct in one day. Certain products have high inventory, certain products have low inventory and every month certain products inventory corrects. So their run rate returns back to normal. So you got lots of moving parts where you should see an ordinary kind of December weak quarter to the extent certain products inventory has corrected, those see an uplift. So I think driven by all those, we should just see a normal low-single digit down kind of December quarter. I think that’s usually what we see.

Eric Bjornholt

I think in all our acquisitions in the past as well, seasonality – the blended seasonality will adjust and it will take some time before all that settles out. So I don’t think a historical seasonality would be an accurate predictor of future seasonality when there are acquisitions with different seasonality and different blending taking place.

Krysten Sciacca

Understood. Thanks for the detail. And then on a more positive note, can you just maybe detail what was behind some of the strong growth in analog and in your microcontroller segment for classic Microchip this quarter?

Ganesh Moorthy

If you’re asking for segments of growth, we don’t breakout any of the segments. Those businesses have been in a long-term growth mode. We have shared with you what we have been doing with Microchip 2.0 with the total system solutions. You have to note though that some of the growth this quarter that we’re showing sequentially is a combined company growth and so reflects some of the addition of Microsemi in those numbers. We haven’t broken out the classic Microchip microcontrollers or analog other than to give you some comfort that they both hit records, they both grew more than classic Microchip as an average so that you can see the underlying strength in those businesses.

Steve Sanghi

I would say some of the questions are overly focused on just the shortfall in revenue guidance. Nobody has mentioned that the earnings guidance is $0.07 better than consensus. I think the old consensus was $1.67 to $1.68 and the midpoint we’re guiding $1.74. So we’re doing very well actually. We’re increasing our assessment of the overall earnings for the year and going out of the year, the accretion we can get. So I think look at the glass also half full. And we at the end of the day deliver non-GAAP earnings per share increasing amount. That is our goal. That’s where all our incentives are built on. That’s what the Board manages us by. And even the EBITDA doesn’t give you the credit for a lower tax rate. If the earnings per share are better for a given share count, that’s creating higher amount of total profit after tax. So we feel pretty good about where we are and how we executed the quarter, how we are carrying out the integration. The issues and challenges we’ve seen in inventory correction, just straightforward. They are flexible. It’s not like we need to device a tool or do some invention. There are just the normal blocking and tackling to correct this. But otherwise, earnings per share are great.

Krysten Sciacca

Great. Thank you.

Steve Sanghi

Welcome.

Operator

Our next question will come from Harlan Sur from JPMorgan.

Harlan Sur

Good afternoon. Thanks for taking my question. I understand product line rationalization is kind of taking a second priority to some of the more structural changes you’re making in terms of business process improvements at Microsemi. But if I look at Microsemi’s data center storage and OTN optical product lines, these are very different products; leading edge silicon, leading edge packaging, big, complex chip designs. Very different versus Microchip’s focus on classic, embedded microcontroller, analog, memory and all the other complementary building blocks around this. So help me understand how the storage and the OTN optical stuff kind of fits into the Microchip 2.0 model?

Ganesh Moorthy

So they are standalone businesses. You’re right. They do have more leading edge process technologies and design technologies and packaging in many cases that they use. But that’s not different from when we went to SMSC five years ago, six years ago, in the acquisition. It brought a new degree of complexity. We adapt to it. It fits within the overall portfolio. We find the strengths that the acquired entity has and bring it into the rest of Microchip. We find the strength that Microchip has and take it back to the acquired businesses. And on a blended basis, if we don’t get out of our box, our growth opportunity is unlimited. So, of course, new product lines will bring new complexity but they also bring lots of opportunity to use the strengths of both companies and that’s the way we look at it and how we go forward. And in these two businesses, in specific, there’s also a substantial amount of Microchip classic content available to us to take into those markets where they have significant strength, customer presence and visibility into what else is needed. And in fact, some of the reference designs I talked about, where the joint sales teams have looked at, that’s coming from the joint teams looking and saying, wow, here’s things Microchip didn’t know could be done added to things that Microsemi does extremely well in certain applications and certain customers.

Steve Sanghi

I tell you guys after every acquisition that don’t underestimate, don’t undersell Microchip management’s ability to transform the company to take on the challenges that the new acquisition presents. In Standard Microsystems, the complaint was they’re vertical, you’re horizontal. Look at how well that thing has worked out. In the case of Atmel, they’re ARM and you’re MPS and all that. Look at how well that thing has worked out. So don’t underestimate Microchip’s ability and the management team and huge pipeline we have built internally that we prepare for this to take on the new challenges and expand our business. We’re about the eighth largest U.S. semiconductor market cab in a consolidating industry. You can’t just be sitting in your box and want everything to come with a nice bowtie, only microcontroller. We have to get into other businesses and grow our business in a consolidating industry.

Ganesh Moorthy

And it reinforces Steve’s point earlier that as we move forward, we focus on the combined company opportunities, rather than trying to box it and saying, well, let’s make the old one look good or the new one look good. It’s really the combined company opportunities that provide the richest forward-looking opportunities.

Steve Sanghi

A number of our business units are planning to leapfrog the lithography at the foundries by skip one generation and leapfrog because that leapfrog technology has already been used by Microsemi in some of the same business units that you’re mentioning with library available, with experience available, with EST structures and chip designs and all that kind of stuff available. It will accelerate our roadmap and leapfrog the technology to be able to reuse some of that stuff at Microchip. So I think that’s kind of how we look at it. The ship is very safe in the harbor but that’s not why ships are made for. We can’t sit in our box and just look for everything to be a neat little microcontroller. We have to branch out and be able to expand our business and we have done successfully that in the last decade.

Harlan Sur

Yes, absolutely. Thanks for the great insights.

Steve Sanghi

Thank you.

Operator

Next from Darphil, we have Gil Alexandre. Please go ahead, sir.

Steve Sanghi

Hello, Gil.

Gilbert Alexandre

Thanks for taking my question. I’ll get back to tariffs. Is there a willingness to compromise and how is it affecting your automotive business?

Steve Sanghi

Well, is there a willingness to compromise? Compromise by who? That compromise has to be between the Chinese and U.S. authorities and that’s way above my pay grade. That’s not – in terms of the automotive business, I think our automotive business – I don’t think our automotive business has yet been affected by tariffs.

Ganesh Moorthy

No. I think some of the uncertainties are there. Cars are built in the U.S. and shipped to other parts of the world. Cars are built in Europe and shipped into the U.S. And some of the discussions have created uncertainty. We’ll see how it all plays out. But I think Steve’s right. It’s not a current impact.

Steve Sanghi

So far automobiles are not included in the tariffs. Steel and all that are, but the built automobiles are not included. It’s still in negotiation. So when they had an edict on July 6 and then August 23, a set of products that have tariffs, washers and dryers and those things are included. Cars are not. Cars are not dutiable right now. Some of the car components are like steel. So this thing is still raw. Thank you for your question, Gil.

Gilbert Alexandre

I thank you and good luck.

Steve Sanghi

Yes. Thank you. Anybody else, operator?

Operator

Yes. Our next question comes from Christopher Rolland with Susquehanna International Group.

Christopher Rolland

Hi, guys. I think it’s nice to see you guys get out in front of this in the true Microchip way. I think it’s appreciated by guys who have known your track record. So, Steve, as we try to judge this snapback in revenue, once you work through this inventory, can you give us some perspective of perhaps how long this over-shipment issue was going on for? Was it just the last few quarters when they knew that they were in negotiations or was this accumulated over a couple of years?

Steve Sanghi

Well, there are a lot of moving parts and you can’t put a complete finger on it because there is some EOL mechanism with which they put the distribution inventory. Normal amount of inventory was very high. There was a huge nonlinearity. A lot of stuff was shipped undetermined. There was also this direct to distribution conversion. So there were a lot of these programs inter-layered. And I’m not accusing anything but I’m just saying that the timing, roughly it all started about a year or so ago which is more like when the conversations about the acquisition began. But I couldn’t prove that. I think it’s very, very rough.

Christopher Rolland

Yes, sounds pretty common in a lot of these deals. And then lastly, on Microsemi’s product pricing. After the Atmel deal, you saw a lot of kind of pricing imbalances. I can’t remember. Maybe they were selling some below gross profit, if I remember right, or priced it below gross profit. Are you seeing anything like that here and just any other tidbits on where you get more synergies?

Steve Sanghi

I think on that, think I will give kudos to the sales and marketing team. The prices are not below market or anything like that. But when they got an excellent price for a customer, then they inserted a distributor and kept the customer price the same and then they discounted to the distributor, gave an interest subsidy to carry the inventory. After a good price negotiated with the customer, they asked the customer to take much more inventory than the customer wanted and offered them a discount. So I think the pricing by marketing was done well. But then later on in the overzealous attempt to really recognize higher revenue, they kind of did their own thing on the top of that. So this one is easier to correct. It’s much harder to raise prices on the customer. It’s much easier simply not to offer the discount and say, just buy what you need, customer. I don’t want you to buy a lot of product that you don’t need. So we think this one is easier for us to correct that way.

Ganesh Moorthy

And the high starting gross margins are a good indicator of how that was far better disciplined than other acquisitions we’ve done. And hopefully there’s some upside from the discounting being rolled off that we’ll see in the coming quarters.

Christopher Rolland

Yes, good point. Thanks, guys.

Operator

Thank you. Next we’ll hear from Craig Ellis with B. Riley FBR.

Craig Ellis

Thanks for taking the question. And Steve and team, thanks for all the color on where you see things shaking out at this point of the integration. Steve, I wanted to follow up on a comment that you made in the Q&A regarding the deal’s accretion in the current quarter. I think you said your synergies are tracking above the prior expectation for $0.15 of accretion. And if I heard that correctly, the question is does that mean that while retaining longer-term accretion targets, $0.75 run rate first full year, $8 a couple years out, that you’re realizing your synergies earlier but you still have the same expectation, or do you think you’re tracking above prior expectations? And to the extent that’s the case, can you identify where you think that is?

Steve Sanghi

So a little bit of both. So I said that we believe that the accretion run rate at the end of the first year will be higher than $0.75. We didn’t numerically say what the number is because there is still – like I said, the numbers are going to be noisy here for the next couple of quarters because there’s just a lot of moving parts. But as we get out by June next year, we see a number higher than $0.75, which will represent really a little bit of pull-in based on our prior plan. Now in terms of $8 for fiscal year ’21, we see that as conservative also. Internally, we’re modeling a number higher than $8. So that is the incremental accretion. I think some of that difference is coming from tax rate, lower tax rate also.

Craig Ellis

That’s helpful. And then previously the company and on this call, the company had identified the 300 million in synergies targets. When do you think you’ll be able to provide some color on how that breaks out between revenue synergies, COGS synergies and other synergies?

Steve Sanghi

Really never. We’re just going to deliver it, never going to break it out.

Craig Ellis

Okay. Given that quick response, can I take a swing at another one? There’s been a lot of discussion on what you found with distribution and I’ve heard you talk a lot about levels and what happened with shipments. But the question is really an operational one. What have you found with respect to the appropriateness of the consignment versus demand generation distribution, geographic representation, and the degree to which you think you’ve got a good distribution fit for the business that exists there? And how long does it take to right-size any of the operational changes that are needed with distribution?

Steve Sanghi

So as we have interfaced with a lot of the distributors, some of them by the way, a fair number of them are common with Microchip. Their largest distributor was Arrow Electronics and our largest distributor is Arrow Electronics. And similarly there are some other common distributors in Asia and Japan and Europe and others. A large amount of interaction with the distributors was how much inventory they would take. It basically began around the middle of the quarter and large amount of I would say tension with the distributor was largely how much inventory would you take. And so as we have spoken with the distributors, distributors feel refreshed and saying that you’re not going to force me to take inventory I never wanted. You will in fact let me drain down my inventory. And so we can have a conversation about demand creation, reference design, how can we together build the business, let’s go call on common customers, let’s highlight and beef up the Web site and put reference designs and solutions on it. How do we take advantage of Total Systems Solution, Microchip and Microsemi common products going into the same platform, on and on and on? So conversations with distributors have turned into positive interactions regarding growing the business. And before that – and this distributors are telling us. The ex-management of Microsemi is gone. Distributors are telling us that this tension about such a large amount of inventory jamming took all the oxygen out of the room. It just consumed the entire energy and interaction with the distributors.

Ganesh Moorthy

And it’s actually liberated time within the company as well because the business units and others that were all part of that discussion process.

Craig Ellis

When do you start to see a positive benefit from this new conversation that’s occurring?

Steve Sanghi

You will start to see it as – if inventory bleeds out by the end of this calendar year, you’ll start to see the impact starting in the March quarter. So if you’re talking about getting brand new designs in production, that usually takes 12 to 18 months. But you’ll start to see impact on the funnel, impact on joint opportunities, probably as early as late this quarter.

Craig Ellis

Thanks for the insight, Steve.

Steve Sanghi

Thank you.

Operator

Thank you. Our next question will come from Rajvindra Gill with Needham & Company.

Rajvindra Gill

Thank you. Hi. How are you? Just switching to earnings, as you noted, Eric, what is the deleveraging campaign? Is that changing at all given the situation? And as part of the $8 per share in fiscal year ’21, how much of that is related to a lower interest reduction related to deleveraging? Just wondered if you could talk about that in the grand scheme of earnings being the end to be all of everything?

Eric Bjornholt

So the deleveraging approach is essentially all cash generation above and beyond the dividend is going to go to pay down debt. We aren’t going to do anything unnatural. We’re not going to push inventory into the distribution channel to generate cash and things like that.

Steve Sanghi

We’re not going to cut the dividend.

Eric Bjornholt

We’re going to run the business, going to get our synergies as quickly as we can and with that generate cash to pay it down. And so we are definitely a little bit behind schedule to start and we’ve got a little bit of a headwind in front of us. But long-term cash generation and operating profit generation from these businesses combined is very high. No real change in that long-term outlook. So hopefully that answers your question. And then obviously, as we pay down debt, there’s interest expense reduction. That’s built into our forecast but we aren’t going to give any real details in terms of how that lays out quarter-by-quarter at this time.

Steve Sanghi

One of his questions was really what portion of our incremental to possibly $8 is tax-related? Rajeev, what I would say is that in the past when R&D tax credit used to go away every year and then used to come back later in the year, most companies will have a much lower tax rate in the fourth quarter and then they’ll true up and have a much lower tax rate and sometimes make up the earnings miss with that tax rate and all that. And analysts and investors will discount the additional earnings per share coming by the tax rate. This is not that kind. This is real tax rate current quarter. There is nothing we’re taking from the past to our future. This is actual good old tax planning which for the next several years we’ll have a very low tax rate. So you should look at that as it’s no better or worse than earnings per share produced from higher gross margin or higher revenue or lower expenses or anything else.

Rajvindra Gill

No, that’s true. At the end of the day, that’s what it is. And last question, Steve, I know it might be difficult to understand the tariffs, but in late 2014, you saw a slowdown in China industrial, you saw a slowdown in China housing. You were one of the first ones to note that. And then we did see a slowdown in China in 2015. I’m just wondering is that a scenario that could repeat itself, or just any general thoughts on that? Thanks.

Steve Sanghi

Rajeev, I resigned from that job back in 2014. I would let those jobs be yours rather than mine. I’ll just talk about our business. I get no benefit from that. I’ll let you guys decode that.

Rajvindra Gill

Okay, got it. Thank you.

Operator

And our next question will come from Mark Lipacis with Jefferies.

Mark Lipacis

Thanks for taking my question. Just one for Eric. Eric, in the trailing previous four quarters, free cash flow tracked pretty close to the non-GAAP net income. This quarter, there’s a little bit more of a gap and I think that’s typical when you start integration process. I was wondering if you could give us a sense of when does the free cash flow start to track back to the net income, if you could give us any help on that, I’d appreciate it? Thank you.

Eric Bjornholt

I think we had a big correction in June as we’ve kind of talked about. I think it continues through the end of the calendar year to have a little bit of pressure on that because of the continued reduction that we expect in distribution inventory. But after that, I think it should return to a more normalized basis.

Mark Lipacis

Fair enough. Thank you.

Eric Bjornholt

Welcome.

Operator

And as that was our final question, gentlemen, I’ll turn the call back over to you for final comments.

Steve Sanghi

Well, we want to thank everyone for attending this call. We’ll see some of you on the road at conferences, which I think begin again late August and September. So thank you very much.

Operator

And that concludes today’s conference call. We thank you for joining.



Source link Technology

Like and Support us!
By clicking like you help our site to get better