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Microchip Technology (NASDAQ:MCHP)

F2Q07 Earnings Conference Call

October 25, 2006 6:00 pm ET

Executives

Steve Sanghi - Chairman, President and CEO

Gordon Parnell - VP and CFO

Ganesh Moorthy - EVP

Analysts

Adam Parker - Sanford Bernstein

Michael Masdea - Credit Suisse First Boston

Romit Shaw - Lehman Brothers

Craig Ellis - Citigroup

Mark Edelstone - Morgan Stanley

Simona Jankowski - Goldman Sachs

Chris Danely - JP Morgan

Chris Caso - Friedman Billings and Ramsey

Uday Joshi - UBS

Tore Svanberg - Piper Jaffray

Sumit Dhanda - Banc of America

Jeff Rosenberg - William Blair & Company

Presentation

Operator

Good day everyone, and welcome to the Microchip Technology Second Quarter and Fiscal Year 2007 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 Mr. Gordon Parnell, Chief Financial Officer. Please go ahead, sir.

Gordon Parnell

Thank you so much. Good afternoon and welcome to our Second Quarter 2007 Conference Call. During the course of this call, we will be making projections and other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are predictions and that actual events or results may differ materially. We refer you to our press release of today as well as our 10-K for the fiscal year ended March 31, 2006, and our 8-K current reports that we have filed with the SEC that identify important risk factors that may impact Microchip's business and results of operations.

In attendance with me today are Steve Sanghi, Microchip's President and CEO; and Ganesh Moorthy, Executive Vice President. I will comment on our second quarter performance reviewing geographic data and discussing balance sheet and cash information, and Steve and Ganesh will then give their comments on the results, outline our guidance for the December quarter, and update other pertinent matters regarding our business. We will then all be available to respond to specific investor and analyst questions.

Our net sales for September quarter were at record levels of $267.9 million up approximately 2% from net sales of $262.6 million in the immediately preceding quarter and up approximately 17.9% from net sales of $227.3 million in the prior year's second quarter.

On our earnings per share, we are continuing to include additional information in our press release that relates to the adoption of FAS 123R. Our non-GAAP results exclude the effect of the adoption of this accounting standard providing comparability to prior GAAP results.

Our non-GAAP net income for the September quarter was at record levels of $84.2 million or $0.38 per diluted share, an increase of 3.4% from non-GAAP income -- from non-GAAP net income of $81.4 million or $0.37 per diluted share in the immediately preceding quarter and an increase of 28.2% from GAAP net income of $65.7 million or $0.31 per share in the prior year's second quarter.

GAAP net income for the September quarter was $79.5 million or $0.36 per diluted share inclusive of all share-based compensation expenses. The impact on earnings related to the adoption of share-based compensation in the September quarter was 6%. Our sales in Asia grew by approximately 4.5% sequentially in the September period while both Americas and Europe were essentially flat. In the summer quarter while we got the performance in Europe as being seasonally strong, Asia continues to be our largest geography representing approximately 45% of total sales. Americas and Europe were both at approximately 27.5% of total sales. This measurement is based on where the product is delivered for manufacturing purposes for our customers, but doesn't represent where the design activity initially took place.

Take a look at operating P&L information; initially our gross margins, they continue to improve reaching 60.45% in the September quarter. For comparative purposes in operating expenses, this is prior to the effects of share-based compensation; operating expenses were 24% of sales in the September quarter, essentially the same as they were at the previous quarter.

Research and Development costs were $26.5 million, representing 9.9% of sales, and sales and general administrative expenses were 37.9 million, representing 14.1% of sales. Total operating expenses on a GAAP basis including the effects of share-based compensation were 26.4%. The tax rate for the September quarter was in line with our guidance of 24% and we expect that to continue for the rest of this fiscal year. The dividend declared today of $0.25 per share was an increase of approximately 6.4% sequentially and an increase of 56.3% over the same quarter in fiscal 2006. The dividend payment that will be made in the December quarter will be approximately $54 million.

Let's turn our attention now to the balance sheet, and initially Microchip's inventory, excluding the impact of FAS 123R, inventories were essentially flat in dollars at $114.4 million representing approximately 99 days, a decline of two days from the June quarter. Including the adoption of share-based compensation, inventories were $117.6 million or 101 days of inventory.

Distribution inventory continued to be at very moderate levels in all geographies. As of the end of September, our distributors held about 1.9 months of inventory down from two months at the end of June. Combining inventories on our balance sheet and other distributors, they would represent 134 days of total inventory, the lowest total inventory that we have seen in the last five years.

Microchip's receivables at September 30 were $123.2 million, lower than the levels at the end of June by $14 million. Payment performance by our customers continued to be strong, delinquency in payments were minimal. The principal reason for the decline in receivables related to distributor inventory reductions that I mentioned earlier.

On our cash position at September 30, Microchip's cash and total investment position was approximately $1.3 billion with $80.8 million of short-term debt on the balance sheet. During the quarter, Microchip generated net cash flow from the business of $128.5 million. Payments related to our cash dividend of $0.235 or $50.5 million and we also reduced our short-term borrowings by $56.5 million. We anticipate continuing to pay down the short-term borrowings over the next two quarters.

Capital spending for September was approximately $17 million for the September quarter. Depreciation expense for the September quarter was 29.2 million versus 27.6 million for the same quarter last fiscal year, and 289.1 million in the June quarter. Our capital expenditure forecast for fiscal 2000 is now $70 million and previously it was $80 million and our depreciation forecast is expected to be approximately 150 million for the full fiscal year.

With that I'll ask Steve and Ganesh to discuss the performance of the business, our guidance for the September quarter, and update other business markets. Steve?

Steve Sanghi

Thank you, Gordon and good afternoon, everyone. Today, I would like to make a brief comment reflecting on the results of the September quarter and then pass it on to Ganesh Moorthy who was promoted today to Microchip's Executive Vice President. Ganesh will comment on the product lines and then I will discuss the guidance for the December 2006 quarter.

All of the figures in our comments will be prior to share-based compensation expense in order to do a fair comparison to prior quarters. The figures with share-based compensation expense are all available in the press release.

We delivered another record quarter in every respect despite very challenging industry conditions in the late quarter military led coup in Thailand. The political situation in Thailand is calm and there are no lingering effects from the coup. We achieved record net sales, record gross margin percentage, record operating profit percentage, record after-tax profit, and also record earnings per share. We also achieved record sales in each of our strategic product lines 16-bit microcontrollers, 8-bit microcontrollers, Flash microcontrollers and analog products.

Now I shall pass it on to Ganesh Moorthy for some extended comments on the individual product lines. Congratulations, Ganesh, on your promotion.

Ganesh Moorthy

Thank you, Steve and good afternoon everybody. Let me now comment on the individual product lines. Starting with microcontrollers, our microcontroller business grew by 1.6% sequentially and was up 19.3% over the year ago quarter. Our Flash micro Controller business was even stronger and grew by 6.7% sequentially and was up 42.3% over the year ago quarter. Flash microcontrollers now represent over 64% of our microcontroller business. We shipped 16, 275 new development tools last quarter demonstrating continued, strong design win activity. 16-bit microcontrollers our 16-bit microcontroller business was up 53% sequentially in the September quarter and up 210% over the year ago quarter.

The growth of our 16-bit microcontroller business continues to be similar to that of our high end 8-bit microcontroller architecture called PIC18 at a similar stage of its market ramp. After 2.5 years since the start of production, we believe 16-bit microcontrollers have reached the tipping point, with a large number of designs reaching production stage. The number of high volume customers grew to 484 in the September quarter, from 349 in the June quarter, an increase of 39%.

And in terms of 16-bit customers of all volumes, that number is in the thousands. We now have 78 16-bit microcontrollers in production and four more that are sampling. Based on the momentum we see, we expect 16-bit microcontrollers to be up another 15% to 25% sequentially in the December quarter.

Moving to analog products our analog business was up 2.2% sequentially and up 43% over the year ago quarter. The market for analog products has been tough with a majority of competitors guiding to a sequentially down quarter in December. We believe that we are continuing to gain market share in analog. The number of customers buying our analog products grew from 11,546 -- sorry, to 11,546 from 11,369, in the previous quarter; a growth of 177 customers. And on our Serial E-Squared memory business, this was up by 5% sequentially. Business rebounded from the weak conditions of the last several quarters and we continue to focus on serving our strategic customers, whenever we can attach Serial E-Squared products to a microcontroller or analog product.

Pricing in this segment remained essentially flat, quarter-over-quarter. Let me now pass it back to Steve, for some comments on our guidance for the December quarter. Steve?

Steve Sanghi

Thanks Ganesh. Before I discuss our guidance for December 2006 quarter, I would like to make one important comparison. This comparison is important before our largest competitor, Freescale Semiconductor leaves the public marketplace, emerging as a private company. Freescale reported that their September quarter sales of TSPG segment where microcontrollers are housed were down 2% sequentially. Microchip's microcontroller sales were up 1.6% sequentially. On an annual basis, Freescale's TSPG sales were up 7%, while Microchip's microcontroller sales were up 19% over a year ago quarter. A substantial difference, so despite the significant questions, we keep hearing regarding Freescale, we're continuing to gain substantial market share. Now the guidance for the December 2006 quarter.

As we look at the December quarter, we took several factors into account. We looked at our own bookings and business activity in various product lines. Our book-to-bill ratio was 0.94 and the starting backlog for December Quarter for direct customers, as well as distributors was lower, than that of September quarter. We also looked at the inventory situation. The inventory at our distributors continues to be at the lowest level of our historical range. The historical range has been 1.9 months to 3.3 months. Current distribution inventory is 1.9 months.

Our own inventory is lower than the middle of our historical range. The historical range has been 74 to 134 days. The inventory is currently at 99 days lower than the middle point and has been dropping for several quarters. We also looked at lead times. Our lead times remain in the 3 to 5 week range which is the shortest amounts to competitors. Looking at it geographically, we expected this to be a strong quarter for Asia, but we are continuing to see softer build activities. We are engaged with all of our customers, but the run rates in general are lower than expected. In the other two geographies of Americas and Europe, this is a seasonally weak quarter due to Christmas holidays. Taking all these factors into account, we expect net sales in the December quarter to be down approximately 5% sequentially.

Looking at the current market conditions, we have lowered our capital expenditure forecast for the fiscal year from, $80 million before to $70 million now. Gross margin for December quarter are expected to be about 60.25%. I'd remind investors that our long-term growth margin guidance continues to be 62%; however, we're seeing a temporary pause in the growth of gross margin due to market conditions. Earnings per share are expected to be about $0.36. This is prior to the share based compensation. Earnings per share with share based compensation expense should be about $0.33. We expect to build approximately $100 million of net cash flow before payment of $54 million of dividend just announced today. And we look forward to sharing this cash within investors with another increasing dividend in the next quarter. So, let me summarize a few key points.

Our net sales are expected to be down approximately 5% sequentially and now without the equity compensation expense, our gross margins are expected to be about 60.25%, operating expenses to be about 24.5% to 24.75% of sales, and earnings per share are expected to be about $0.36. With that [Talarie] will you please poll for questions?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Adam Parker with Sanford Bernstein.

Adam Parker - Sanford Bernstein

Yeah, hi, guys. Just trying to understand some of the data you're giving us. I mean do you think that the guidance here in terms of being particularly weak is just a function of all demand or do you think there is demand in weakness or do you think there is maybe some of your inventory at your distributors, customers? Or can you help us at all with why they kind of look at it and say maybe this is the second worst December in the history of the company, is it all just macro or --

Steve Sanghi

Well, Adam some of the conditions in the industry are similar to what was experienced in 2004. But it doesn't look as bad as it was 2004. The book-to-bill ratio was better the general environment just does not look as bad. Looking at the other companies guidance, everything doesn't look as bad as 2004. So I'm sure there is some component of inventory. The distributor inventory itself does not affect our sales, because we do not take that as revenue but if distributors' customers have some inventory, that's really hard to get at when you have 50,000 customers and a majority of them being served by distribution. As far as our own customers are concerned which are really the direct customers we serve, that's approximately were 38% of our business roughly?

Gordon Parnell

35%-36%.

Steve Sanghi

Yeah, so in that range, 36% of our business. Those customers, we don't really see any signs of major inventory correction. We just see the run rates to be lower as everybody seems to be cautious just given the market conditions, GDP, and all of the other data and all of the talk, so everybody is just cautious.

Adam Parker - Sanford Bernstein

So, it's just a weakening economy of yours about that, I guess.

Steve Sanghi

I'm sure there is some built-in inventory correction in there at some customers here and there, but it's really not broad-based. It doesn't look to be all inventory correction.

Adam Parker - Sanford Bernstein

Okay, the follow-up that I have or the second question I have is you guys made some comments, you made some changes I guess in your distribution network and I was trying to understand if you're feeling that there was too much order fulfillment and not enough incremental revenue generation, can you just talk a little bit about what your strategy there is and how it's evolved and why it's good for you guys going forward?

Steve Sanghi

Well, we have been tweaking our demand creation for a better part of about 40 years now through several layers of changes. In one, we added some dedicated production win reps which only carry Microchip product line and do not carry any other competitor product line. We added a layer of regional distributors in various territories in the world, and regional distributors again do not carry any competitive lines. We made changes to the global network where our experience was that the global network, I would say with the exception of future electronics, was really not creating any demand for us and was largely really all fulfillment, so we adjusted the compensation scheme. So we were paying appropriately only for the demand fulfillment, and with several years into these changes, it's quite clear that we made the right call there and despite lot of (inaudible) on all sides and our sales are growing faster than our competitors.

I gave you comparison to Freescale, our funnel is full with demand creation, our 16-bit microcontrollers sales are exploding and went up 53% sequentially, albeit from a small base, and basically, we were seeing that the global distribution network, again with the exception of future, wasn't really creating any demand on 16-bit. We didn't win a single design from them, so we took control of it ourselves, added a lot of direct people, added some reps, regional distributors, and some other things, and the results are very obvious. Our analog business was up 42% over a year ago, or 43, and so all of the strategic product lines are growing, Flash microcontrollers are growing. So in answer to your question, I think that data is here. We made the right call.

Adam Parker - Sanford Bernstein

Okay, great. Thanks, guys.

Steve Sanghi

Welcome.

Operator

And we'll move next to Michael Masdea with Credit Suisse First Boston.

Michael Masdea - Credit Suisse First Boston

Yeah, thanks a lot. I guess I just have another follow-up on the (inaudible) comment. It seems a little bit surprising that these all-time lows and that they are going to further reduce in the fourth quarter, is it the case that there's something that allows them to get even lower than we've seen before or do you think they're pushing too far?

Steve Sanghi

Well, really aren't sure. If you listen to the Arrow's call this morning, they reduced inventories by $200 million quarter-over-quarter, Michael. They took their inventories down by about 12% on their balance sheet, and while they were a little bit more reticent in indicating exactly where they are going forward, they said that lead times were supporting them in their goal of getting tons versus earns basis in their model, and so we've seen that really across the board in many of our distributors as they continue to exercise better control of their capital as lead times continue to be short, and that's just part of the phenomenon that we have to deal with. Now having said all of that, with the type of reductions that our was an instance here did in their inventory, their sales were flat. So obviously the reduction in inventory isn't a reflection of the business conditions that they're seeing directly, much more related to how they intend to manage their business. We can't influence that. Unfortunately, we're not a POP supplier. We're much more focused on creating demand or fulfillment through some of our global distributors to the benefit of Microchip.

Michael Masdea - Credit Suisse First Boston

Okay. That makes some sense. One just follow-up and the second question, which is on the microcontroller side. With such explosive growth in the 16-bit strong growth in Flash, help us out with what was going on with the remaining segment, where the relative weakness at least came from?

Steve Sanghi

Ganesh?

Ganesh Moorthy

In the September quarter. I think we broke down, so we have growth in the analog business. The analog business.

Steve Sanghi

He is talking micro.

Michael Masdea - Credit Suisse First Boston

Within micro, it is just -- is at the 8-bit and what parts of the 8-bit were relatively weak?

Gordon Parnell

We don't usually break that out. We provide the microcontroller data in its totality, and we put 8 and 16 bits combined there. We break out the 16 in terms of the growth rate, but not the rest of the pieces.

Michael Masdea - Credit Suisse First Boston

Was there -- maybe not in terms of numbers, but was there any segment or is it all just the push off from Asian build where you saw the weakness, the relative weakness rather than just giving us numbers, can you give us a little color?

Gordon Parnell

We have such a broad-based business with so many customers, so many applications and segments, there's not really one piece I can point to which was the sole or primary cause for where we ended.

Ganesh Moorthy

No, if you look at geographically, trying to add to that answer, our European business was very strong last quarter. European Business in summer is always down because of the European holidays, but our business was flat, so that was seasonally good. The majority of the weakness came out of Asia. U.S. was okay, was slightly weak, but the biggest weakness came out of Asia and when we made a press release back in the middle of September, we totally saw that we were seeing a push out and slowdown of the Asian build related to Christmas. Asia business should have been up quite significantly than it was. It was up 4.5%. It was strongest geography, but that was a geography that missed the most regarding what they should have done.

Michael Masdea - Credit Suisse First Boston

Okay, thank you.

Steve Sanghi

Welcome.

Operator

And next we have Romit Shaw with Lehman Brothers.

Romit Shaw - Lehman Brothers

Thanks, given your plans to reduce CapEx by a little more than 10%, is it fair to assume that you guys expect this softness in build activity to potentially spill into next year or is the visibility at this point too low?

Ganesh Moorthy

Well, the CapEx is simply -- we needed to spend the capital in the current quarter and the next quarter to grow to another record sales, basically that's what drives CapEx. We needed to buy some fab-equipment, assembly and test method equipment to get to another record level of sales. With sales down 5%, you don't have to get to another record level and then it will take whatever time it would take to get back to the record sales, so it's a push out of the capital that we would have needed in the next three-six months, which we do not need anymore because sales are lower the record, which means we have largely the equipment in place already and there's always some capital need here and there for some small issues, but there is no incremental capital needed because we do not have to jump the high bar. This is that simple.

Gordon Parnell

And long-term design visibility continues to be strong, so we're very confident in the longer term direction of the business with new products that we've brought to bear. Certainly, the short-term backlog visibility is what we're speaking to as we move into December, but that doesn't give us any concerns as to the future direction over strategic products.

Romit Shaw - Lehman Brothers

Just on OpEx, Steve do you think you have leverage with OpEx, meaning if the current conditions persist, can you bring down SG&A as a percentage of sales?

Steve Sanghi

Well, even in our current guidance, there's a substantial -- you have the numbers Gordon.

Gordon Parnell

Yeah, theirs is obviously at the levels that we've projected, there is a substantial reduction in operating expenses.

Romit Shaw - Lehman Brothers

In absolute dollars?

Gordon Parnell

In absolute dollars, but not in percentage terms and we'll continue to exercise areas where we believe using those elements at our discretion in our business to further the business model, but the backdrop of that also Romit is we have 36 % operating margins, and we're driving this business not entirely for next quarter, but also for the future. So we have to be selective when we make those decisions because we don't want to find ourselves not being able to effectively promote and market our products for future revenue opportunities.

Steve Sanghi

The entire reduction in OpEx from September quarter to December quarter is driven by the variable compensation bonuses and just general tightening of discretionary spending and stuff like that. There is no reduction in headcount, not needed with just extremely profitable. In fact we are continuing to make investments in our 16-bit microcontrollers and our sales force and other strategic areas, they are continuing to be open acquisitions in the company to build for the long term future. We think it's a one quarter problem. If you look at this seems to be similar to 2004, we were down in December quarter 2004 and we came right back up and we grew in the March quarter and grew substantially in the June quarter and this doesn't even look that bad as it was in 2004. So for now, we think internally that this would be a one quarter problem again, because this quarter being down 5%, it sets up an easy comparison for the March which is historically a weak quarter, but then this quarter isn't strong then it makes it easier. So there is really no long term reduction needed in expenses of our R&D expenses last quarter were 9.9% of sales that's about half of the many other technology companies spend. So we're already the most profitable in terms of return on R&D dollars. And we want to keep spending that wisely.

Romit Shaw - Lehman Brothers

Okay. Just one final question on stock compensation expenses. And maybe my numbers are incorrect, but it looks like the stock comp expense increases by a significant percentage this quarter. Any color, Gordon on why?

Gordon Parnell

Absolutely. We've talked about this before. Manufacturing expense starts to flow through inventory into the P&L. That's the absolute reason for it, so there's some timing involved with share based compensation for through inventories into the P&L. So the change is always like primarily driven by that. The reduction in revenues makes some increase in terms of the percentage also, but it's in line with what we said initially of between 7% and 8% when fully deployed.

Romit Shaw - Lehman Brothers

Thank you.

Gordon Parnell

You're welcome.

Operator

And we'll move on to Craig Ellis with Citigroup.

Craig Ellis - Citigroup

Thanks, good afternoon guys. Starting with the clarification on the gross margin line, with the guidance in the calendar fourth quarter, down about 20 basis points, is that a utilization dynamic that's at play or is that more of a mixed dynamic, as we think about the 16-bit business growing and some of the other businesses say the 8-bit and the analog business declining sequentially?

Steve Sanghi

It is pretty much coming out of utilization dynamics. I mean, of the 20 basis points if you just look at the percentage it is up, 60.5%. It's just a very, very small number I mean we are just -- just a minor tweak and the guidance always is plus/minus 20 basis points or 20 basis points difference is really truly very, very small. We have reduced the manufacturing build in the back-end largely because for guiding down them how many units we're going to need and it's just purely a utilization dynamics driven from that. We don't expect much mixed change at all. We expect a healthy increase of 16-bit microcontroller which is positive. Analog should do well and that's positive, and then leaves the 8-bit micro and memory, you know which wherever they will come.

Craig Ellis - Citigroup

Okay, Steve. And then as we think about just uses of cash in the past, the company has been pretty (inaudible) about maintaining a dividend and now you've got the stock buyback plan. Can you just share the thinking on with why you went with the stock buyback plan now and how should we think about your appetite for using that buyback plan?

Steve Sanghi

Definitely. That's a good question. We continue to be committed to dividends and continuously increasing dividends over time. The stock buyback, we have announced today is just basically a measure as we have said before that we only buy stock when we believe, that the street has thrown the baby with the bathwater and that -- you know, last time that happened was in 2003, right after Warren (inaudible) when stock was 17 and people were calling it 12 and it went to 30 within six months. So those are the kind of occasions when we like to buy the stock, when there is a high level of misunderstanding about the company's opportunities. And a single down quarter somehow drives into a downdraft. It did not happen in 2004 and we cannot call it, we cannot predict it, how market will react at this time. So, it's a safety net in place to be ready to buy a large amount of stock. We have money available to invest and we're telling you now in this conference call that the company continues to do extremely well, on all of it's metrics in terms of design wins and new products and gross margins and everything and this is a temporary phenomena driven by the market conditions we're seeing. And I think after street having seen the results of many of the other semiconductor companies who have reported similarly, we hope that the results will be understood. But if there's any misunderstanding, the buyback gives us a safety net.

Craig Ellis - Citigroup

Okay that's a clear message, Steve and one last question for Gordon. Just a clarification on the balance sheet. Deferred income to distribution was down about $13 million sequentially. As I look for precedent in my model, I think the most significant percentage decline since 2001, on a dollar basis, goes back further than that. Is that what you expect going into the quarter and anything that's surprising as you look at that line?

Gordon Parnell

I think it's a little lower than we would have expected, going into the quarter. I think that some of the -- I mentioned our own and other distributors are following similar patterns where they're looking to hold lower levels of inventory and they are supported by the fact that our lead times are continuing to be very short. 90% of our products are available in three to five weeks. They obviously see some level of uncertainty in their business, plus they are trying to improve their working capital management overall. So it's definitely the lowest levels we have ever seen. Today, we expect that to be flat to down, just based on the feedback we're getting, not that that is directly an indication of business conditions, but I think it's directly related to how distributors are managing their business in the current environment.

Craig Ellis - Citigroup

Okay, thanks, guys.

Operator

(Operator Instructions). And we'll move to Mark Edelstone with Morgan Stanley.

Mark Edelstone - Morgan Stanley

Good afternoon, guys.

Steve Sanghi

Hi.

Ganesh Moorthy

Hello Mark.

Mark Edelstone - Morgan Stanley

Hey Steve, are you seeing any difference in terms of the order patterns between analog and say the 8-bit controller business, specifically in Asia?

Steve Sanghi

We're not. Very similar, you know we are engaged with all of the 8-bit customers. We're engaged with all of the analog customers and many times the customers are the same. You know where they are essentially buying a kit and both parts go in then and then the run-rates are lower. You know, run rates across-the-board would be seeing bookings and the run-rates are pointing to a lower number than we experienced in the September quarter.

Mark Edelstone - Morgan Stanley

Okay, great.

Steve Sanghi

No customers are going away. Seem to be no loss of market share anywhere. No larger designs going away, not a single major design loss or a major customer loss. It doesn't seem to be just one thing. It's just everybody is less confident about their business.

Mark Edelstone - Morgan Stanley

And then you talked about tightening up things on the backend. Are you also slowing wafer starts at this stage?

Steve Sanghi

We tend to not make wafer start changes, as quickly unless we see a longer term phenomenon and the reason being to run at the so high yield and so consistency that we run at. The training required in the front-end is much, much laborious. So we don't really tend to move the wafer starts. We just allow usually, we did this again in 2004 also. We just allow the inventory to grow up a little bit and when the sales grow in the next quarter and two, the inventory comes back down and you've seen that a number of times. So no we have not changed wafer starts.

Gordon Parnell

The entry days getting to maybe only 106 at the end of this quarter, Mark, we're still in very good shape. Long life products, no obsolescence issues in our business, that's all and so we're in very good shape from that perspective.

Steve Sanghi

A high point at the end of the 2004 cycle was somewhere in the 118-120 days, somewhere in there. So when we are doing extremely well. We manage inventory extremely well in this up cycle. We kept lowering inventory quarter after quarter for the last five, six quarters almost, and at that time, we could have actually ramped Fab harder with a slightly higher gross margin. We decided to keep the inventory low because in the next cycle we did not want to have to take the Fab down and which is what's happening right now. So we're running the Fab at the same cycle as we ran last quarter.

Mark Edelstone - Morgan Stanley

Right. Now, you're in great shape and I guess what I was trying to figure out is unless we get a big snap back in the March quarter, it sounds like we should probably expect to see another slight uptake in days inventory in the March quarter before maybe starting to head back down again in June?

Ganesh Moorthy

Our internal analysis for the March quarter, obviously I can't give you the guidance here, but the inventory was actually comes down slightly.

Steve Sanghi

And obviously it depends on what the demand environment is.

Ganesh Moorthy

And make revenue assumption, but our inventory actually comes back down little bit from the high watermark we set in this quarter.

Mark Edelstone - Morgan Stanley

Okay, thanks a lot guys.

Steve Sanghi

Thank you.

Ganesh Moorthy

Welcome.

Operator

And we'll move to Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs

Hi, thank you. Just a quick modeling question first on your guidance of $0.33 for next quarter. Can you just expand on it, is that's based on a flat share count or should we assume a declining share count behind that guidance just as a starting basis point?

Steve Sanghi

Well, a lot of that is going to be based on what the stock price is over the next 90 days and so we're waiting in there, but we would expect it to be plus or minus half a million shares probably.

Simona Jankowski - Goldman Sachs

Okay. So that didn't include any of that benefit basically if there was a benefit from the buyback?

Gordon Parnell

Didn’t include a large stock buyback.

Steve Sanghi

No, it did not.

Simona Jankowski - Goldman Sachs

Okay. And then the other question, and I'm not sure if you'll be able to really comment on this or not, but it was interesting earlier today on arrow's call, they commented on having a book-to-bill, which was between 1 and 1.1 across their end markets and in particular, commented on reasonably decent demand by their small-to-mid sized customers, and this is something that is definitely not consistent with what most of the other analog components suppliers are saying, so just curious if you guys are in any position to maybe comment on why they are seeing a stronger pattern than yourself and others that you compete with?

Steve Sanghi

I think that that book-to-bill ratio is very encouraging for our sales and for other suppliers generally speaking. Certainly, our book-to-bill ratio is colored by their inventory holding pattern. We look at our book-to-bill ratio for our distributor business versus our direct business. Our direct business was higher than the 0.94 reflecting the fact that they are absolutely taking inventory out of the channel and out of their business, so we see that as a positive indication. They said that their small-to-medium customers really have limited inventory and they see no issues from that, but obviously they did indicate that their larger customers, it's more difficult to see where that's going. So overall, we're quite encouraged, it's sort of confirmed our feeling relatively in the marketplace that this is not a long-term phenomenon that this is really fairly short-term in nature.

Simona Jankowski - Goldman Sachs

Sure, and I guess maybe just to reconcile, so the percentage of your business that is actually direct, the reason that that book-to-bill was not necessarily above one is because those tend to be larger customers. That's why they're direct. Is that the kind of correlation to that?

Steve Sanghi

That's true. The larger customers in general tend to be direct and larger customers have larger volumes, so when they have any kind of reduction, they're more meaningful. If you look at the smaller customers Simona, we have grown our customer base from about 50,000 customers we have recorded in the past to 55,000 customers that we have really calculated very recently. If you look at our analog customers that grew by 177, if you look at our 16-bit customers, they are now in thousands and even the volume 16-bit customers were up 38%. So if you count all of the smaller new customers we're adding, that book-to-bill can easily be positive, but see, we don't take bookings from those small customers. Our distributors take bookings from the small customers so that number could be extremely positive for us too. That's why all of the strategic product lines with small volumes, new customers are all growing.

Simona Jankowski - Goldman Sachs

Okay. So we can really think of that as a somewhat leading indicator for you guys?

Gordon Parnell

I would think so, but the conclusion with Arrow with their book-to-bill ratio that they quoted is they still guided diving on their components business to be flat to minus four. So even with a book-to-bill ratio, that was not the one, the phenomenon of fewer workdays or ship days or other elements are obviously reflected on their overall business also.

Steve Sanghi

It also means the impact of larger customer is larger than even the smaller customers having positive book-to-bill.

Simona Jankowski - Goldman Sachs

Great. Thank you very much.

Steve Sanghi

Welcome.

Operator

Next we have Chris Danely with JP Morgan.

Chris Danely - JP Morgan

Thanks, guys. Quick question on gross margins. If we just assume that March quarter revenue is flat or flat to slightly up, does that mean your gross margins would probably be flat or down or up in that environment?

Steve Sanghi

If March quarter is flat, our gross margin probably would be flat to maybe even slightly up.

Chris Danely - JP Morgan

Got it. And then Steve, can you just talk about the transition to Ganesh? I mean, can we expect you to completely phase yourself out over the next year and why now? Anything else?

Steve Sanghi

Oh. There's really no, you know, as the press release said, there's really no change in the direct responsibilities that Ganesh has in terms of his managing advanced with microcontroller business, all of the 16-bit microcontroller business, digital signal processor business, you know, any future architecture with developing, he has the automotive business. He also manages the Microchip Thailand plant. So he has substantial responsibility but in the global marketplace today, him and I both travel like crazy, so we have set a system where when I'm traveling, none of the activity has to essentially go on hold because if he's here and if he's traveling and I'm here, so he will just help me in broader functions of the company like strategic planning, our annual operating plans, our quarterly reviews, our monthly reviews and internally and externally and all that, but there is no timetable for me phasing out. I'm only 51 years old. Don't push me out yet!

Gordon Parnell

Chris many of the investors have met Ganesh and when we've gone to conferences and you can expect to see him a little more visible there. Again, helping, he shares a lot with Steve when Steve's traveling, visiting customers or other business activities.

Chris Danely - JP Morgan

Okay thanks, guys.

Operator

Next we have Chris Caso with Friedman Billings and Ramsey.

Chris Caso - Friedman Billings and Ramsey

Yes, thanks. I wonder if you could just clarify some of the earlier comments, I'll let you know what I heard and correct me if I'm wrong. It sounds like that majority of the weakness that you saw coming into the quarter was related to the seasonal businesses that are based in Asia. I guess if you comment a little bit on the daily run rates that I guess you have seen and are seeing in the U.S. and European markets which I guess are a little more tuned to the industrial markets, have those held up or are those daily run rates down also?

Steve Sanghi

Europe is doing very good. What would you say for Americas? I would say slightly weaker.

Gordon Parnell

Slightly weaker, sure, than our expectations.

Steve Sanghi

Europe is doing extremely well. Either we just got a bit of product traction or the general, our regional distribution network in Europe has always been significantly stronger. There are really no regional distributors left in the U.S. They have all been covered by Arrow or Avnet. So in the last several years, we have built the demand creation engine in U.S. And is doing extremely well in Future Electronics is do being extremely well for us. But when you go to Europe, in each of these countries, the biggest distributor in every country we have in Europe is usually one or two regional distributors so that's very, very mature network and over the last several years, they have responded extremely well to our new products, 16-bit analog and others because they never had any competitive line for those products. So we are doing actually extremely well in Europe. Last quarter was really pleasing and the European economies are doing relatively better than U.S and other economies. Asia was the weakness.

Chris Caso - Friedman Billings and Ramsey

Okay. Well and I guess if you just remind us kind of typical seasonality is as you go into the March quarter? And I guess typically you have more selling days in the U.S and Europe and typically that picks up and Asia turns down. Is that correct assessment?

Steve Sanghi

Yes. I think in many years what we see is Asia has a couple of weeks off during the Chinese New Year, so driven by that, you do less number of days. Asia is usually flattish. It can be down too but it's usually down to flattish. It has an overall growth but because of loss of number of days, it really -- the general growth makes up for the number of days lost. Europe does very well and U.S. Does okay, so we have a good chance of really being up here in the March quarter.

Chris Caso - Friedman Billings and Ramsey

Okay. And I guess the swing factor there, we will you be watching would be those daily run rates in U.S. and Europe, I guess. For revenue to actually be up in the March quarter then?

Steve Sanghi

Yes, and the daily run rates also in Asia. I mean, Asia has still 43% of the business.

Gordon Parnell

Yeah, right.

Chris Caso - Friedman Billings and Ramsey

But you would still, typically expect that to be down in the March quarter in a typical year though?

Steve Sanghi

Well the daily run rates are not down. They just have less number of days.

Chris Caso - Friedman Billings and Ramsey

I see.

Steve Sanghi

If you want the daily run rates to grow and if there's any softness now, we expect that to recover I mean the economy is starting to get positive. The consumer confidence is starting to get positive. Lot of the other consumer numbers came out, were pretty good. So oil prices have come down, so whatever is driving the current weakness, it's already on the way to mending and hopefully, by next quarter we see that the consumer is back on the mend and we want the daily run rates including Asia to be up but then there are less number of days.

Gordon Parnell

Asia comes back from Chinese New Year and generally speaking, the rate of activities in the factories compensates for the fact that they've been off for five or six or seven days. And that's being the pattern that we've seen and that leads into June and September which are obviously traditionally our strongest periods.

Chris Caso - Friedman Billings and Ramsey

Okay, great. That’s great color. Thank you.

Operator

And next we have [Uday Joshi] with UBS.

Uday Joshi - UBS

Hello. Thanks for taking my question. Can you quantify for us the impacts of the Thai Coup, if there was any -- but are you able to make up the lost business during that period and if some of that spilled into the December quarter guidance?

Steve Sanghi

In the Thailand coup we basically were impacted for a portion of just one day.

Uday Joshi - UBS

Okay.

Steve Sanghi

The day the coup happened, all the government offices were closed and public transportation system was closed and the airport was closed down and so that was really the only day and you know, if it happened in the middle of a quarter, there will be absolutely no issue. If it happened about ten days or so before the end of the quarter, so it created a flurry of activity and out of -- there was another issue where Thailand changed their airport in Bangkok. They shut down the airport on exactly 29th of September and opened a new airport they have been building for awhile and whoever scheduled that airport start on the 29th of September should be shot. But somebody had a key result to make for the quarter, (inaudible). So there was some flurry of activity there. Altogether, I don't think we lost much. I think we made up most of it but there was some impact in a few hundred thousand dollars, not really very meaningful.

Uday Joshi - UBS

And just one last question. Thanks for that by the way, just one last question on the December quarter guidance. Revenues were down 5%, gross margin is kind of flattish and yet the EPS is going to be flat. How do we think about how you're going to flex OpEx and would that be a new run rate to use if you think about the March quarter?

Ganesh Moorthy

No, EPS is down from $0.38 to $0.36 on a non-GAAP basis and it's down a further penny on a GAAP basis, so…

Steve Sanghi

Just look at GAAP to GAAP and non-GAAP to non-GAAP. It's really the FAS 123 really confuses it. The numbers we just announced were $0.38 without the effect of equity compensation and that $0.38 comes down to $0.36.

Uday Joshi - UBS

Right.

Steve Sanghi

The GAAP numbers were $0.36 and they come down to $0.33.

Uday Joshi - UBS

Okay, that's clear. Just let me just get back on one point. If I look at your June quarter, if I had to look at gross margin on a GAAP basis, also are you able to quantify that for me just so that I can have a clear idea of what the impact is and have a good comparison for June and September and into December?

Steve Sanghi

June quarter was 60.36%

Gordon Parnell

Correct.

Uday Joshi - UBS

And this includes this on a GAAP basis?

Gordon Parnell

On non-GAAP.

Uday Joshi - UBS

On non-GAAP, on a GAAP basis do you have that?

Gordon Parnell

They were the same. There was no impact of share based compensation in the June quarter, because it wasn't flowing through from the inventory into the P&L. The First Quarter that's going to occur is in the December quarter.

Uday Joshi - UBS

Okay. That's very clear. Thank you very much.

Gordon Parnell

You're welcome.

Operator

Next we have Tore Svanberg with Piper Jaffray.

Tore Svanberg - Piper Jaffray

Yes, good afternoon. First of all, Steve, you said there's a good chance maybe business bounces back in March. Is that more predicated on what you saw a couple years ago or are you actually also hearing from your customers that this will be a very temporary slowdown?

Steve Sanghi

Well, you know, I'm just reading the tea leaves. What I hear, what I see, you know, the customers are still relatively positive about their business prospects, the new designs we're winning, the economy seemed to be on the mend, when you read the reports from other large consumer giants and the system companies and what they're saying. There's a lot of money going back into consumers pocket to a significant decrease in interest rate. I'm sorry, increase in oil prices and gas prices and stuff like that. So I'm just building a view from that. I don't have bookings to reflect that. That’s just in this environment you don't really get a tremendous amount of bookings for the next quarter year.

Tore Svanberg - Piper Jaffray

Great, thanks. And also, Gordon, maybe I can ask the inventory question little differently. You said combined with the channel the level is 144 days -- 134 days. And that's quite long historically. At what level would maybe the supply chain get nervous? Are we talking about this level or could it go down further?

Gordon Parnell

Well, you know, I think that (inaudible) from the distributors are they feel that they can take it down modestly lower, but I'm not sure that we have the insight to know what their end goals are here, Tore. Certainly our lead times continue to be short. We are well placed to be able to deliver. Part of the concern we have is then, are we really getting brokered to an extent and again, one of the factors that the distributors earn their margin on is based on inventory holding, as well as receivables and design creation and other factors. So it's at a stage where I wouldn't expect to see substantially -- substantial reduction in those channel inventories, but I suspect if you'd ask me that question when it was at 2 or 2.1 months, I might have probably answered the same way. So the right guys to ask are Arrow and Avnet and see if you can get some commentary out of them.

Tore Svanberg - Piper Jaffray

Fair enough. Finally, is your analog gross margin still running ahead of your corporate average?

Steve Sanghi

We don't break the gross margin for product lines for comparative reasons.

Tore Svanberg - Piper Jaffray

Okay thanks again.

Operator

Next we have Sumit Dhanda with Banc of America.

Sumit Dhanda - Banc of America

Hi, just one question. Steve, when you actually lowered guidance for the September quarter, just a little before the quarter closed. My recollection was that your analog business was tracking towards the high end of expectations. Did it see a very sharp slowdown right at the end of the quarter? Though it happened and has that been the area where the slowdown has been the most dominant early through this quarter?

Steve Sanghi

Well, you know, I do not think that when we change the guidance for the quarter, we had modeled that new guidance across the product lines to break them out by-product line. You may recall, the coup had happened the night before. And not knowing the impact it would have on our manufacturing plant on a business. And not having fully modeled what the impact of Asia and all that might be, we were going to a conference and we were going to get a ton of questions. And we were -- it was actually your conference?

Sumit Dhanda - Banc of America

Exactly.

Steve Sanghi

Right, yes and we were in the air as the press release had been drafted. So we had not modeled the impact of that reduced guidance which was from 4% to 2% across the product lines. And I don't think we implied anything different. If we did, we had not modeled that completely.

Sumit Dhanda - Banc of America

Okay, because my recollection was that, you had indicated that 16 and analog was tracking behind of expectations. Okay, all right thank you very much.

Steve Sanghi

16 definitely yes. Analog we do not imply that I think.

Gordon Parnell

I think the volumes in analog are such that it's getting to be somewhat of a more mature business. We certainly didn't have the visibility to imply that. If we said that unintentionally certainly, that was not what we were intending to do.

Sumit Dhanda - Banc of America

Okay thank you very much.

Steve Sanghi

Welcome.

Operator

And we have time for one more question and that's from Jeff Rosenberg with William Blair & Company.

Jeff Rosenberg - William Blair & Company

Hi thanks. I guess my question is I may have missed it, but did you give the breakout of percentage of sales of microcontrollers, analog and memory for the quarter?

Steve Sanghi

We did not. We gave the growth, for the last quarters' numbers, but we can also give you the percentage.

Gordon Parnell

Sure. Just hold on one second.

Jeff Rosenberg - William Blair & Company

While you're looking, I'll ask you qualitative question. On the 16-bit, when you look at the volume customers, is that still heavily weighted towards the dsPIC product lines? Or do you start to see some of the newer product lines from a year ago, begin to enter volume productions -- I mean, getting designs going into production?

Steve Sanghi

The volume of customers obviously is still predominantly from the dsPIC30, but we definitely have the PIC24 and the dsPIC33 starting to ramp in volume as well, but in terms of number of customers, it's still dominated by (inaudible). We have long design cycles if you remember. It takes 24 months to design in, so on average and we have some that are faster but for the most part, today's volume of customers are primarily in the dsPIC30.

Jeff Rosenberg - William Blair & Company

So, when you look at the dsPIC30 and where it's been successful, I mean do you feel like it's weighted in one action towards niche-type DSP type applications, like motor control and things like that or is it more towards areas where it's the more robust just microcontroller capabilities are really what drives success? I mean, is there a waiting towards where you see the products been the most successful?

Steve Sanghi

Well the dsPIC30 is really is a 16-bit microcontroller with a DSP engine on it. So its core applications are primarily micro Controller applications that need higher computational power and it goes into a very, very broad set of applications. So yeah, motor control certainly is one of those applications, but there are many, many others as well that gets designed into.

Jeff Rosenberg - William Blair & Company

Okay. And I guess --

Gordon Parnell

On the revenue split, Jeff, so for September, microcontrollers are 80.1%. That's down modestly. It was 80.5% in the prior quarter. Memory is about 12% that was 11.7%, in the prior period and analog is about level at about 7.9%.

Jeff Rosenberg - William Blair & Company

Okay, thanks.

Gordon Parnell

You're welcome.

Operator

And that does conclude our question-and-answer-session. I'll turn the call back over to Mr. Sanghi for any final or additional remarks.

Steve Sanghi

Okay thank you very much for joining our conference call and we'll see you on the road at some of the conferences coming up. Otherwise we'll talk to you on the next Conference Call. Thank you.

Operator

And that does conclude our conference call. We do thank you for your participation.

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Source: Microchip F2Q07 (Qtr End 9/30/06) Earnings Call Transcript
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