Microchip - Q3 2026
February 5, 2026
Transcript
Operator (participant)
Welcome to Microchip's Q3 fiscal year 2026 financial results conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Eric Bjornholt, CFO. Thank you, Eric. You may begin.
Eric Bjornholt (CFO)
Thank you, and good afternoon, everyone. During the course of this conference call, we'll be making projections and other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements are predictions and that actual events or results may differ materially. We refer you to our press releases of today, as well as our recent filings with the SEC, that identify important risk factors that may impact Microchip's business and results of operations. In attendance with me today are Steve Sanghi, Microchip's President and CEO; Rich Simoncic, Microchip's COO; Matthias Kaestner, Microchip's VP of Networking and Connectivity Business Units; and Sajid Daudi, Microchip's Head of Investor Relations. I will comment on our Q3 fiscal year 2026 financial performance.
Matthias will provide an update on our networking and connectivity business, and Steve will then provide commentary on our results and an overview of the current business environment and our guidance for the Q4 of fiscal year 2026. We will then be available to respond to specific investor and analyst questions. We are including information in our press release and on this conference call on various GAAP and non-GAAP measures. We have posted a full GAAP to non-GAAP reconciliation on the investor relations page of our website at www.microchip.com, and included reconciliation information in our earnings press release, which we believe you will find useful when comparing our GAAP and non-GAAP results. We have also posted a summary of our outstanding debt and leverage metrics on our website.
I will now go over some of the operating results, including net sales, gross margin, and operating expenses.
Other than net sales, I will be referring to these results on a non-GAAP basis, which is based on expenses prior to the effects of our acquisition activities, share-based compensation, and certain other adjustments as described in our earnings press release and in the reconciliation on our website. Net sales in the December quarter were $1.186 billion, which was up 4% sequentially and well above the high end of our original guidance provided on November 6. We have posted a summary of our net sales by product line and geography on our website for your reference. On a non-GAAP basis, gross margins were 60.5%, including capacity underutilization charges of $51.7 million and new inventory reserve charges of $58.4 million. Operating expenses were at 32% of sales, and operating income was 28.5% of sales.
Non-GAAP net income was $252.8 million, and non-GAAP earnings per diluted share was $0.44, which was $0.04 above the high end of our original guidance. On a GAAP basis, in the December quarter, gross margins were 59.6%. Total operating expenses were $555.2 million and included acquisition and tangible amortization of $107.6 million, special charges of $4.8 million, which were primarily driven by activities associated with our closure of Fab 2, share-based compensation of $62.1 million, and $1.1 million of other expenses. GAAP net income attributable to common shareholders was $34.9 million, or $0.06 per share. Our non-GAAP cash tax rate was 9.6% in the December quarter.
We expect to record a non-GAAP tax rate of about 10% for all of fiscal year 2026, which is exclusive of the transition tax and any tax audit settlements related to taxes accrued in prior fiscal years. Our inventory balance at December 31, 2025, was $1.058 billion, which was down $37.6 million from the balance at September 30, 2025. We had 201 days of inventory at the end of the December quarter. Included in our December quarter ending inventory was 17 days of long life cycle, high margins products, whose manufacturing capacity has been end of life by our supply chain partners. Inventory at our distributors in the December quarter was at 28 days, which is in the range of what we would consider to be normal.
Distribution sell-through was about $11.7 million higher than distribution sell-in. Our cash flow from operating activities was $341.4 million in the December quarter. Our adjusted free cash flow was $305.6 million in the December quarter, and as of December 31, our consolidated cash and total investment position was $250.7 million. Our total debt decreased by $12.1 million sequentially in the December quarter, and our net debt decreased by $26 million sequentially. Our adjusted EBITDA in the December quarter was $402 million and 33.9% of net sales. Our trailing twelve-month adjusted EBITDA was $1.23 billion.
Our net debt to adjusted EBITDA ratio was 4.18 at December 31, 2025, and was down from 4.69 at September 30, 2025. Capital expenditures were $22.5 million in the December quarter. We expect capital expenditures for fiscal year 2026 to be at or below $100 million. Depreciation expense in the December quarter was $37.8 million.... I will now turn it over to Matthias, who will provide an update on our efforts in the 10BASE-T1S emerging standard for connectivity in the automotive and industrial space. Matthias?
Matthias Kaestner (VP of Networking and Connectivity Business Units)
Thank you, Eric, and good afternoon, everyone. I'm Matthias Kaestner, Corporate Vice President and leader of the Data Center, Networking, Connectivity, and Automotive Business Units at Microchip. Today, I want to report on the meaningful momentum in our connectivity business, driven by two primary architecture modernization cycles. Let's have a look at the automotive market segment first. In today's cars, up to 20 different connectivity technologies are used to transmit data between electronic control units, while the amount of data is increasing exponentially. The resulting complexity is a major roadblock to implementing higher levels of self-driving capabilities, over-the-air updates, and advanced infotainment systems in a cost and time-efficient manner. Therefore, car manufacturers are moving away from the multitude of legacy connectivity standards towards networking architectures that are predominantly Ethernet-based. This, in turn, reduces software complexity and improves software reusability.
Ethernet, in particular, the new 10BASE-T1S standard, has the potential to replace several billion automotive legacy connectivity nodes per year. Microchip has developed automotive Ethernet solutions to support this transition, including a market-leading portfolio of 10BASE-T1S products, switches, transceivers, endpoints, and bridges. Automotive Ethernet is complemented by PCI Express connectivity for the highest speed data communication needs in the main vehicle computer, and by ASA, a new open standard that transfers high-speed raw camera data to the main vehicle computer efficiently. We derived automotive-grade, PCIe solutions from our leading PCIe switches for data centers, and we were first to market with ASA Motion Link for standards-based, high-speed ADAS camera and display connectivity. We believe Microchip is well positioned across these new connectivity standards. We have design wins and serious engagements with multiple leading global automotive OEMs and Tier One suppliers.
Today, we issued a press release in which we announced a strategic collaboration with Hyundai Motor Group to integrate our 10BASE-T1S solutions into next-generation vehicle platforms. Designs are moving from sample evaluation and validation phases, representing platform commitments and next-generation vehicle architectures. The second growth driver for modern connectivity is Industry 4.0, an industrial modernization cycle across factories, robotics, automation systems, and autonomous logistics networks that all require real-time, mission-critical connectivity. The industrial backbone is already Ethernet-based. However, many devices and systems, at the edge, are connected to legacy connectivity standards such as Industrial CAN, RS-232, RS-485. These legacy standards are now being replaced by Ethernet solutions.
Like in the automotive segment, our comprehensive Ethernet portfolio, including Single Pair Ethernet and EtherCAT, industrial PCIe switches, and ASA camera connectivity solutions, are well positioned to capture this opportunity and are already helping customers bridge legacy and advanced industrial connectivity. In both segments, automotive and industrial, we are tracking numerous design wins. We believe that our competitive advantage is straightforward. We offer a complete portfolio spanning multiple connectivity speeds, integrated with microcontrollers and analog solutions. Customers deploy a unified Microchip system, including silicon and firmware, rather than assemble components from multiple vendors, reducing complexity, cost, and time to market. Industrial connectivity design cycles typically span 18-24 months, from architecture decision to production revenue.
Our recent engagement aligns with pilot production ramps expected in the second half of 2026 and ramping further into 2027. We feel that our market opportunity is substantial.
While industry estimates vary, research suggests that the TAM for automotive and industrial Ethernet connectivity together represents tens of billions of dollars by 2030, reflecting a once-in-several-decades modernization cycle. Looking ahead, we expect our connectivity business to be a significant contributor to company growth as these modernization cycles accelerate. I will pause here and turn the call over to Steve to provide an update on our business and the guidance going forward. Steve?
Steve Sanghi (Executive Chair)
Thank you, Matthias, and good afternoon, everyone. We had an excellent December quarter, and I will start by highlighting a few salient points of our financial results. Our net sales grew 4% sequentially and 15.6% over the year-ago quarter. Net sales were up sequentially in the Americas and Europe and about flat in Asia. Sales from our microcontroller and analog businesses were both about flat sequentially, which was well above the typical seasonal level for the December quarter. The growth primarily came from our networking, data center, FPGA, and licensing business units. We are continuing to see the inventory go down at our distributors, at our distributors' customers, our direct customers, and contract manufacturers. The distributors' sell-in versus sell-through gap shrank to only $11.7 million in the December quarter, down from $52.9 million in the September quarter.
This is something we have been expecting for some time, and I have been telling you, we also feel that this is a sign that the distribution inventory has largely corrected. In the December quarter, non-GAAP gross margin was up 379 basis points sequentially. Non-GAAP gross margin reached 60.5%. We had been expecting a six handle on non-GAAP gross margin percentage in the March quarter, but we achieved it a quarter earlier. Non-GAAP operating margin reached 28.5% in the December quarter and was up 418 basis points sequentially and up 800 basis points over the year-ago quarter. Now to the market environment. We are seeing recovery in most of our end markets. Automotive, industrial, communication, data center, aerospace and defense, and consumer are all looking better.
The strongest sales performance last quarter was in the A&D sector and in our networking data center solutions and licensing business units. We believe we are extremely well positioned with our Gen 6 PCIe switch, with it being the only 3 nanometer-based device currently sampling in hyperscaler and enterprise data center customers, beating our competitors in virtually every specification metric. Today, I have 3 design wins to report on our PCI Express Gen 6 switch, each without the customer's name. The first one is a small design win that will start production in second half of this year. It is a small win, but significant for us in establishing credibility based on who the customer is. The second one is a larger win and will start production in Q1 2027.
Based on current customer forecast, this win is expected to bring $100 million plus in revenue in calendar year 2027. The third win is a small win with an established long-term customer who buys our prior generation Gen 4, Gen 5 products, and will be buying our Gen 6 product. This design goes to production in late 2027, early 2028, and we are working hard to win a lot of other large and small designs. As Matthias said in his prepared remarks, we're also doing extremely well in the automotive and industrial networking space with T-one S, ASA, and PCIe connectivity products. Now, let's get into our guidance for the March quarter. The bookings for the December quarter were significantly higher than those for the September quarter.
The book-to-bill ratio for the December quarter was well above one, resulting in, into a much higher backlog entering the March quarter compared to when we entered the December quarter. A comment about lead times. While lead time for our products have been 4-8 weeks for some time, we are continuing to experience lead times bounce off the bottom, and we are experiencing increases on some of our products. We're running into challenges on certain kind of substrates and subcontracting capacity and also some foundry constraints on very advanced nodes. These challenges were isolated to specific areas, but are now starting to spread more broadly. Our customer requests for expedited shipments have increased significantly from a couple of quarters ago, pointing to some customers' inventories running low.
Taking all these factors into account, we expect our net sales for the March quarter to be $1.26 billion ±$20 million. This, at the midpoint, would be 6.2% sequential growth and up 29.8% from the year ago quarter. We expect our Non-GAAP gross margin to be between 60.5% and 61.5% of sales. We expect our Non-GAAP operating expenses to be between 31.3% and 31.7% of sales, and we expect our Non-GAAP operating profit to be between 28.8% and 30.2% of sales. We expect our Non-GAAP diluted earnings per share to be between $0.48 and $0.52 per share. Finally, a comment on our capital return program for shareholders.
Last quarter, we decreased our net debt balance by $26 million as we produced free cash flow that exceeded our dividend commitment. In future quarters, as we have excess free cash flow above dividends, we intend to continue to use this to bring down our borrowings. With that, operator, will you please pull for questions?
Operator (participant)
Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad.... A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment please, while we pull for questions. Thank you. Our first question comes from the line of Matthew Prisco with Cantor Fitzgerald. Please proceed.
Matthew Prisco (VP in Equity Research)
Hey, guys. Thanks for taking the question. I guess to kick off, when thinking about the above seasonal guide for March and growth beyond, how should we be thinking about that continued strength versus seasonality? And what gives you confidence there is that the tailwind from the closing of the sell-in versus sell-through gap theoretically fades? Is that based on, is it better end demand, potential restocking, idiosyncratic opportunities, or perhaps something else? Thanks.
Eric Bjornholt (CFO)
So yeah, this is Eric. I think it's a variety of things, right? So we feel that, you know, distribution inventory is pretty much corrected at this point in time, but there's still customers that we sell to directly and customers that our distributors are selling to, that are still burning through some inventory. We have really strong backlog for the current quarter, and the bookings have been quite high, so the backlog is continuing to grow. We can't say that we have great visibility outside of the current quarter because lead times are still short, but we can see the order book growing, and through discussions with customers, we feel confident that heading into what is typically seasonally our strongest quarters of the year, which is the June and September quarter, that we are really poised nicely for growth.
Matthew Prisco (VP in Equity Research)
Thanks. And then maybe on the growth margin front, can you give us an update on how we should be thinking about the inventory reserve and underutilization charges rolling off? And then as we move more squarely into this broad-based recovery, are there other levers for growth margins that should really move the needle here? Thank you.
Eric Bjornholt (CFO)
So we feel that as we move through the current quarter, that the inventory reserves are pretty much going to be normalized at this point in time. You know, we're guiding at a midpoint to 61% non-GAAP gross margin. Inventory reserves are a little bit unpredictable, but, you know, we feel that those charges are definitely going to continue to come down this quarter and be compared to the prior quarter and get to more normalized levels. The underutilization charges, which were a little over $50 million last quarter, are going to continue. We are ramping the factories, this quarter, but, you know, that this is gonna be a couple year process for us to kinda get those inventory charges for underutilization down.
So they'll be modestly down in the current quarter, which I think Steve said in his prepared remarks, but still at a relatively high level. And that's really the biggest driver as we move outside of this quarter to improving gross margin outside of improved product mix over time. We've talked about some of these growth vectors. You know, last quarter, we talked about our data center business. This quarter, we're talking about our Ethernet and connectivity businesses. And, you know, these are areas where the gross margin can be quite high, and we think that as we see the revenue from that come through, will help from a product mix perspective to keep gross margins high and eventually take us back to our 65% long-term target.
Matthew Prisco (VP in Equity Research)
Thanks, guys.
Operator (participant)
Thank you. Our next question comes from the line of Vivek Arya with Bank of America Securities. Please proceed.
Vivek Arya (Managing Director, Senior Analyst)
Thanks for taking my questions. For the first one, I just wanted to get a clarification. For December of your microcontroller and analog segments, you know, were kind of flattish, which I realize is better than seasonal, but the growth came from the other segment. I'm curious, is that what you had planned for originally? Basically, what really drove the December upside versus your original guidance? Was it, you know, what I'm just calling the product segments, or was it more the other? And then similarly, as we start the March quarter, what are you expecting from the product segments versus the other segment, just so that we can model it appropriately?
Steve Sanghi (Executive Chair)
So, Vivek, the higher revenue on the licensing side was modeled in our original guidance, so that's not where the upside came from. It was up substantially from the prior quarter, but that was in our model. The upside came on the products. The microcontrollers, the analog, the FPGA, and all the other businesses were substantially stronger. Remember, in December quarter, usually is down -3% to -4%, -3% to -5%. But the fact that microcontroller and analog were flat, so that's where the upside came from, and so was the FPGA and some other product lines.
Vivek Arya (Managing Director, Senior Analyst)
March, Steve, any... How are you thinking about kinda just relative segment behavior versus the 6% sequential guidance?
Steve Sanghi (Executive Chair)
March looks, March looks quite strong. Seasonally, March is up usually 2%-3%, and after producing a very large upside, you know, in the December quarter, our original guidance for the December quarter, I think, was $1,129.
Eric Bjornholt (CFO)
That's right.
Steve Sanghi (Executive Chair)
We produced 1.186. So even after such a large, you know, increase, and some of that came in with the customers pulling their backlog from March into December, but the March kept filling up even further. So despite pulling a lot of product from March into December, the March quarter backlog started very strong, and that's why we gave a 6.2% sequential guidance, much above typical seasonality. And pretty much most product lines are positive. So microcontroller is growing, analog is growing, FPGA is growing further, our networking, connectivity business, data center, timing businesses, they all, they all essentially seem, you know, higher in the current quarter.
Vivek Arya (Managing Director, Senior Analyst)
Got it. And then on the gross margin, you know, very strong drop through in December. You're guiding it to 61% for March. What is the timeline to get to this mid-60s% target? Like, if we just assume normal seasonality for the next several quarters, is that something that Microchip could get to sometime this calendar year? Or do you think that it would require, you know, much faster growth, and it's more a 2027 outcome?
Steve Sanghi (Executive Chair)
So I think, you know, I can't give you the exact timing, but for the last several, several quarters, we've been doing the math for you with the product gross margin being above 65%, but having two charges bring it down. One was the inventory write-off charge, and second one was the underutilization charge. The inventory charge has dropped quite a bit, and as Eric said, we expect that the inventory charge will be about normal this quarter. It may have a little more to go, but largely normalizes. And then you're left with about a $50 million underutilization charge, which will take some time to go away and bring the additional, you know, 400+ basis points of gross margin, which will get us to our model.
And how fast we ramp the factories and how fast that underutilization charge goes down really depends on the growth here in the coming quarters in the next year here. And it depends on the growth really from internal products. You know, we do about 37%-40% of the products internal and 60%+ external. The underutilization largely is in our internal factories, so it largely depends on the growth from the internally produced products. And it's, you know, hard to predict out in time, but every quarter you should see some improvement and eventually taking it to 65% gross margin.
Eric Bjornholt (CFO)
Yeah, I totally agree with everything Steve said. I would just say, I don't want the Street to get ahead of where they should be, and it would not be our expectation that I don't know if you said this calendar year or fiscal year, that, or this next fiscal year, that we can get to that mid-sixties. I am not predicting that's gonna happen. I think it's gonna be steady growth from where we're at, guiding at for this quarter.
Vivek Arya (Managing Director, Senior Analyst)
Thank you.
Operator (participant)
Thank you. Our next question comes from the line of James Schneider with Goldman Sachs. Please proceed.
James Schneider (President)
Good afternoon. Thanks for taking my question. I was wondering if you could maybe talk to your customers' inventory behavior, specifically OEM inventories. It sounds like customers are still maybe drawing down inventories a little bit. I'm curious if you're seeing any signs of customers restocking their own internal inventories, and if so, are you seeing that across any specific verticals, or are we still in reduction mode?
Steve Sanghi (Executive Chair)
So we're not seeing customers restocking, but, you know, we got thousands of customers, and not every customer is in the same place on inventory. What we're seeing is that the direct customer inventory was high. So if you go back a year and a half ago, two years ago, inventories were quite high. Some customers had up to a year worth of inventory, and they have been taking that inventory down, and customers don't only buy one SKU. There are customers who buy, you know, 100, I know a customer that buys 500 SKUs. So as the inventory comes down, you know, it's like the water in the lake. When it starts coming down, the lake bottom is never flat. The rocks start showing up. So that's kind of what's happening.
As the customer inventory has come down, the rocks are showing up, which is leading to this expedite, which is exponentially up from a couple of quarters ago. But there are some other products that the customer would still have inventory, and they're continuing to reduce that inventory. But on the remaining products, on some products, they're starting to buy at their consumption rate, and every month, more and more products are falling into that position where the inventory has corrected, and they're buying at the consumption rate. The restocking phenomena, I think, you know, I say restocking when customers are increasing their inventory, buying more than their consumption. I don't think that is happening yet because lead times are still relatively in check. But as I said, you know, the constraints are broadening.
Even a run-of-the-mill, you know, foundry process, and for confidentiality, I can't name the foundry or the specific node, but it's a very generic, run-of-the-mill foundry process, and it's full. So when that starts to happen, you know, the next step is the capacity goes tight. Now, when the capacity goes tight, one thing that happens is pricing firms up. Not necessarily increased price, but the customer conversation leads with availability rather than price... So, you know, that, you know, that is healthy, too, for the business. And I think we're approaching where, you know, relatively soon, in a quarter or so, we'll be facing a situation where customer is more worried about availability than price.
James Schneider (President)
That is helpful to color. Thank you. And then maybe could you just sort of speak to the backlog you're seeing building for the June quarter, if at all? You talked about the higher starting backlog for the March quarter. Maybe talk about sort of the level of orders you've seen thus far this year and sort of where you expect the June quarter to potentially fall from a normal seasonal basis. Thank you.
Steve Sanghi (Executive Chair)
So the month of January was extremely strong, you know, uncharacteristic, because, you know, it kind of starts out slow, and, you know, a lot of people don't return from the holidays till January 7 or something, depending on where the calendar falls. If there are two or three days after January 1, it's gonna be a very dead time, usually till the following Monday. But January backlog was extremely strong. December backlog was extremely strong. People kept booking parts through the holidays. You may recall, you know, we were very conservative going into the quarter because of Thanksgiving as well as Christmas holidays.
Thanksgiving came and went, and the momentum continued. Then we were worried about Europe shutting down in the middle of December. Usually, that happens and, you know, because of Christmas and other holidays, and everything just kept going strong.
Bookings were very good. And then we were concerned about, you know, the start of the new year, which always starts slow, but January was extremely strong. And now we're watching the Chinese New Year, which starts next week, and we'll find out, you know, whether we missed something on the Chinese New Year. But really, it has all been very, very strong, and that's why we just continue to post good numbers and keep guiding stronger. And I'm fairly optimistic on the business. If you look at the next quarter as of today, so today is February fifth, the June quarter backlog is higher today than the March quarter backlog was on November fifth. That's the way to measure it at the same point in time. So we are optimistic that we'll have a good June quarter.
I don't know if I have anything else to add.
Eric Bjornholt (CFO)
Yeah.
James Schneider (President)
Thank you.
Operator (participant)
Thank you. Our next question comes from the line of Blayne Curtis with Jefferies. Please proceed.
Blayne Curtis (Managing Director and Equity Research)
Hey, thanks for taking my question. I had two. I want to ask, I know it's small numbers, but I'm just kind of curious the move in the other product revenue was up 18% sequentially. I think you said in the filing it was a license sale, so I don't know if you can add any color to that. And then does that not repeat into March?
Steve Sanghi (Executive Chair)
Well, it was not only licensing. In others, we have licensing, we have FPGA, we have, memory-
Eric Bjornholt (CFO)
Memory, timing systems.
Steve Sanghi (Executive Chair)
Timing systems.
Eric Bjornholt (CFO)
One more.
Steve Sanghi (Executive Chair)
So there's another phenomenon happening in the memory. You know, as you know, high-bandwidth memory is really constrained. And in general, just, you know, the NAND as well as the flash, NOR flash memory is very constrained. And some of that, you know, shares capacity with our serial EE square business. So a lot of our competitors, especially in Asia, are moving that serial EE square capacity into the broader flash memory. And, and therefore, we're picking up market share, and we're getting a lot of strength in our memory business, because our serial EE square memory business is largely produced in our internal fabs, where we have a lot of capacity, and we still have a fair amount of inventory. So...
And that falls into others, so we're getting some strength there also, which is quite sustainable because this entire memory shortage isn't going away anytime soon. It could be a, you know, couple of year phenomena. And as we look towards the March quarter and the June quarter, memory business looks quite strong too. So does FPGA, with a lot of strength coming from aerospace and defense and industrial also. And our networking and connectivity business backlog is very strong, and so is our data center.
Eric Bjornholt (CFO)
And just to add on to one point there that you had asked, we are not expecting the same benefit that we got on the licensing business in the December quarter to repeat in the March quarter. And in spite of that, you know, we're still guiding up 6.2% at the midpoint.
Steve Sanghi (Executive Chair)
Thank you.
Eric Bjornholt (CFO)
Gotcha.
Steve Sanghi (Executive Chair)
About it.
Blayne Curtis (Managing Director and Equity Research)
Got it. Yeah, I guess that's maybe follows into my gross margin question, because you are guiding kind of flat. I, I think if you calculate the inventory write-offs, like 5 percentage points of, of a headwind, you won't get it all back. But it sounded like you expected to do step down in March. So shouldn't you get a couple % benefit from that? I'm just trying to understand the moving pieces into March on gross margin.
Eric Bjornholt (CFO)
So we, you know, we are, we are guiding up. The midpoint of guidance on gross margin is 61% versus the 60.5% we produced last quarter on a non-GAAP basis. And again, that, that licensing benefit that we got in the December quarter, you know, that's, that's a 100% gross margin that doesn't repeat. So again, that, that is a headwind in the current quarter to gross margin. And in spite of that, you know, we're showing some, some nice growth, and that- that's our expectation, that those inventory reserves continue to come down to be more normalized this quarter. Did that address your question?
Blayne Curtis (Managing Director and Equity Research)
Yep, makes sense. Thank you.
Operator (participant)
Thank you. As a reminder, please press star one to ask a question. Our next question is from Vijay Rakesh with Mizuho Securities. Please proceed.
Vijay Rakesh (Senior Technology and Semiconductor Equity Analyst)
Yeah. Hi, Steve and Eric. Just a quick question. Where are fab utilizations now blended, and how should we look at OpEx through the rest of the year? And a quick follow-up. Thanks.
Steve Sanghi (Executive Chair)
We don't break out the fab utilization numerically. We just, you know, guide you whether it's going up or down. We run a very complex product process mix. So it's not a fab that just has one dynamic RAM process, and you can say whether the utilization is 80% or 70% or 60%. We run a very complex mix with hundreds of different processes for our microcontroller, analog, memory, and other products, and there's a different utilization factor and on different processes. So really, averaging it is really not, not very meaningful. But, you know, having said that, I would say our current factory utilization is quite low, and therefore, there's a significant upside of the order of $50 million or so in gross margin eventually, as we bring the factories to full production.
The other piece of his question was?
Eric Bjornholt (CFO)
The second piece was on OpEx.
Steve Sanghi (Executive Chair)
You can take that.
Eric Bjornholt (CFO)
You can see based on our guidance, that OpEx is growing in dollars in the current quarter, and it's coming down as a percentage of revenue. And, you know, we've been you know, kind of signaling to analysts and investors that there's investments that we need to make in our people, right? We need, we, we, we need to bring bonuses back to target levels. That is factored into what we're guiding to in the current quarter, and then we've got pent-up demand for, you know, raises. You know, we had people on a pay cut last year, and, you know, cash raises need to come back, and that's really what's driving the increase in OpEx.
But we're still laser focused on, you know, bringing OpEx down as a percentage of sales and driving towards, over time, our long-term model, which is 25% of revenue. But we've got a ways to go to get there. But, you know, these investments are really required to make sure we are retaining and attracting talent that we need to drive, you know, the R&D efforts of the company, the product development efforts, and the sales support activities to drive the health of our business three and five years out in time.
Vijay Rakesh (Senior Technology and Semiconductor Equity Analyst)
Got it. And just a quick one, aerospace defense, I think this has been a huge, you know, driver for Microchip. I think you guys are one of the biggest suppliers there. Any thoughts on how we should look at, you know, how that segment does, 2026, 2027, I guess? Thanks.
Steve Sanghi (Executive Chair)
Well, I think, I think, you know, if you just look at, what's happening geopolitically, you know, starting from the U.S., there is one of the largest, you know, defense budget in the U.S., and Microchip is in every offensive and defensive weapon, in our military arsenal. There's also commercial airplane production that's building up with, you know... Boeing wasn't building MAX planes for a while, and now they're building MAX planes at a record speed. So that's doing very well. Now, when you go to Europe, Europe is under a lot of pressure. NATO countries are under a lot of pressure to double or triple their defense budget because they haven't spent what they were supposed to spend under the NATO treaty.
And so they're increasing their budgets, and we are handsomely benefiting with a lot of European customers doubling, tripling their, you know, their production. And I think, you know, the last piece would be, you know, everybody's exploring space. I mean, even India landed a rover on the dark side of the moon. And-
Vijay Rakesh (Senior Technology and Semiconductor Equity Analyst)
Chandrayaan-1.
Steve Sanghi (Executive Chair)
It was loaded with our products. So, you know, as space exploration picks up and with all these new companies like SpaceX and all that are launching satellites and others, they all have essentially our products in it. So it's facing, you know, multiple winds on the back that's driving in this sector.
Vijay Rakesh (Senior Technology and Semiconductor Equity Analyst)
Yeah.
Steve Sanghi (Executive Chair)
Yeah, go ahead.
Vijay Rakesh (Senior Technology and Semiconductor Equity Analyst)
Thanks, Steve.
Eric Bjornholt (CFO)
It's also one other comment there, too. There's also quite a bit of investment in new defense and new aerospace as well. Drone manufacturers and new defense manufacturers that are popping up, and also consuming quite a bit of those products.
Vijay Rakesh (Senior Technology and Semiconductor Equity Analyst)
Yeah. Thank you.
Eric Bjornholt (CFO)
Not just... Yeah.
Operator (participant)
Thank you. Our next question comes from the line of Joe Moore with Morgan Stanley. Please proceed.
Joseph Moore (Semiconductor Industry Analyst)
Great. Thank you. You mentioned the FPGA business a couple times within the other category. Can you give us a sense for what kind of growth you're seeing there and generally anything we should be thinking about from a growth or market share perspective in this coming year in FPGAs?
Steve Sanghi (Executive Chair)
Well, FPGA is seeing a very good growth, and I would say very large growth, and we're gaining share in FPGA. Considering that it's very hard to get competitors' FPGA numbers, where Xilinx is buried in AMD and Altera is now private, so we can't get their numbers. I think giving our FPGA number would just be giving benefits to the others. So we're not ready to kind of break it out.... after the year finishes, the fiscal year, maybe we'll give you some sort of bracketed number, but for now, I would say, we're gaining share over the others, and it's seeing a very large growth. Great, thank you. And then if I could follow up on the PCI Express switching comments on the hyperscale side. You talked about the three customers and a $100 million customer next year.
Can you give us a sense for, you know, are those scale-up types of applications? And what does the roadmap look like? Do you need to move to Gen 7? Do you move to E-link, UALink? Like, how do you maintain the revenue momentum once you've established it? So, you know, Gen 6 has quite a bit of runway. I mean, we are hardly getting started. On the research side, we're already working on Gen 7, so Gen 7 is already underway, and it has been for about, I would say, 9 months to a year. But on the Gen 6, now is in the design phase with the customers. We have number of engagements. We released 3 design wins, and hopefully, we'll be coming up with additional design wins in the coming quarters.
We're working on some mega design wins. Don't have one to announce yet. And if we, you know, get some, then this $100 million could look small. Great. Thank you very much.
Eric Bjornholt (CFO)
One of the questions was on scale up versus scale out. I don't know if Steve or Matthias wants to address that.
Steve Sanghi (Executive Chair)
Maybe let Matthias. I don't know if we are willing to disclose that. I just think, you know, it's a very sensitive subject because of, you know, how some of the competitors are with the customers. And any competitor—I'm sorry, any customer who is openly known to then buy from Microchip could get the wrath of, you know, one of the competitors, so we're really keeping it very guarded. Thank you.
Operator (participant)
Thank you. Our next question comes to the line of Chris Caso with Wolfe Research. Please proceed.
Chris Casso (Managing Director)
Yes, thanks. Good evening. The first question is about gross margins and just coming back to the progress on gross margins as we proceed here and presumably as revenue gets better. You know, Eric, in the past, you know, we've used a fall-through model, you know, maybe something in the mid-seventies or so of incremental revenue falling through. You know, now that the inventory reserves, they sound like they're gonna normalize in the March quarter, is that the right way to look at it? And if so, what would be the fall-through level?
Eric Bjornholt (CFO)
Yeah, I mean, I know that makes it easiest to model. I'm not uncomfortable with using something like that, but it will absolutely be lumpier. It's not gonna be as smooth as just putting it in a forecast. It's gonna be, you know, how we ramp with factories, what the mix of product is in any given quarter. But clearly, we still have a ways to go from 61% to our 65% target. And, again, I'm not uncomfortable with it being modeled that way, but it will, clearly, the quarterly results will be a bit different than kind of straight lining it.
Steve Sanghi (Executive Chair)
I would add to that-
Chris Casso (Managing Director)
Because of mix, yeah.
Eric Bjornholt (CFO)
Yeah.
Steve Sanghi (Executive Chair)
Let me add this thing. I think we are seeing stronger growth on the products that we get from Foundry versus inside. You know, FPGA is 100% outside, doesn't run inside our fabs. Data center products are 100% outside, do not run in our fabs. Our networking products, T1S products that Matthias talked about, are all running outside. They do not run inside. Maybe some runs inside-
Chris Casso (Managing Director)
Yeah
Steve Sanghi (Executive Chair)
... but mostly outside that business unit. There is a lot of growth coming from outside, and this underutilization is largely in our fabs inside. So that's why the underutilization part would take longer and be slower to come. But all these products that are running outside, these are all very high-margin products, well above corporate average. So what we will not get on the utilization side, will pick it up in the higher-than-corporate margin on these high-growth products from outside. The gross margin will still continue to accrete.
Chris Casso (Managing Director)
Right. But it's happening because of mix as opposed to utilization?
Steve Sanghi (Executive Chair)
It's both. I mean, utilization is increasing also, but I just-
Chris Casso (Managing Director)
Right
Steve Sanghi (Executive Chair)
... want to make the point that the gross margin improvement is not gonna come 100% from the utilization only, because mix is richening.
Eric Bjornholt (CFO)
Right. So in our fabs, we are today significantly underproducing compared to what we're shipping, and, you know, that's why inventory is coming down. And so, you know, that will change gradually over time, and we'll grow back into the capacity. So underutilization will come down as we move ahead, but not at a lightning speed.
Steve Sanghi (Executive Chair)
I can almost guess your next question. If all these products have a higher-than-corporate gross margin and they're growing faster than, you know, is our long-term model higher?
Eric Bjornholt (CFO)
Let us get there first.
Steve Sanghi (Executive Chair)
Yeah.
Chris Casso (Managing Director)
Okay. I won't ask that follow-up then. As a follow-up, the-
Steve Sanghi (Executive Chair)
When is this?
Chris Casso (Managing Director)
On the use of cash, and you had talked about desire to take down debt. Could you go into a little more detail there? And does that mean that you, you're gonna be pausing buybacks as even as cash flow improves and prioritize the reduction of debt? And if so, what level of debt are you targeting? What you know, how long does that continue for prioritization of debt?
Steve Sanghi (Executive Chair)
I think I don't have a hard number for you, but I can talk about it in general. We are honestly spooked by this last cycle, how difficult this cycle was and how close we came with a high level of debt. And as the profits came down with the down cycle, you know, the leverage was gonna go above six almost, which would be a junk rating, and we had to go raise $1.5 billion of almost this preferred convert, to keep our debt rating and all that. So we're largely spooked by a very large debt.
So we're going to be bringing down debt for quite some time and keep the dividend flat and not do any buyback till the debt has come down significantly and debt leverage has come down significantly to a number that I can't give right now because we haven't figured that number out.
Eric Bjornholt (CFO)
Right. So, you know remember way back in late 2021 at our Analyst Day, we set a 1.5x leverage, net leverage target, and, you know, we, we did better than that in the upcycle, but that was on earnings that, that really weren't sustainable, looking back. So, you know, we, we wanna be conservative from a balance sheet perspective, get debt down, and, you know, we're, we're—this is the, the quarter we just completed was the Q1 in a long time that our adjusted free cash flow exceeded our dividend payments. So debt, debt's coming down, that's heading in the right direction, but we've got a, got a ways to go, as Steve said.
Steve Sanghi (Executive Chair)
No, debt leverage was over 4. It was 4.18. So, you know, trying to drive a number right now based on any past experience of 1.5 or so is a very moot exercise. I mean, it's so far away. So, let us make some progress, and as we get closer, then we'll try to drive to a number.
Chris Casso (Managing Director)
Good. Thank you.
Operator (participant)
Thank you. Our next question comes from the line of Harlan Sur with J.P. Morgan. Please proceed.
Harlan Sur (Managing Director)
Hey, good afternoon, thanks for taking my question. Steve, relative to 90 days ago when you guys guided revenues down 1% sequentially with the view that, you know, customers are wanting to take down their inventories into year-end. Comparing that to what you just delivered, I mean, it looks like your turns business, your short lead time orders, booked and shipped in the same quarter, came in much stronger than expected. So is it fair to assume that your turns business as a percent of total revenues came in well above historical trends, typically, which is what you would expect right in the early phases of an upcycle? And are you still seeing the same or higher level of turns mix this quarter and expedite requests so far increasing this quarter as well?
Steve Sanghi (Executive Chair)
Yes, correct. January was very, very strong. The turns component and the bookings was quite high. We continue to get the pull-in request. See, a lot of the backlog was getting pulled in from January into December based on customer requests, and now we're seeing the same thing. A lot of the backlog is being pulled from April into this quarter based on customer requests, and bookings are strong, and they're replacing that backlog for April while they're pulling the existing one into this quarter.
Harlan Sur (Managing Director)
I appreciate that.
Steve Sanghi (Executive Chair)
The largest piece, the largest piece was somehow, you know, because of less inventory, everybody worked through holidays. People didn't stop in Thanksgiving, they didn't stop in Christmas, they didn't stop in the New Year holidays, and we'll find out what happened on the Chinese New Year. So usually, you know, for example, a lot of the distribution business is based on number of shipping days, and if you have a bunch of holidays where, you know, warehouses are closed, then it affects revenue. Nothing affected revenue last quarter. We just kept getting upsides.
Everybody wanted product. Bookings were very strong. They were pulling it in, they were expediting, there were just all sorts of... It was an upcycle kind of behavior, which was, you know, really suddenly we didn't model that going into the December quarter. And all that is continuing in the current quarter.
You know, I expect, 6.2% sequential growth to be a very strong guidance. I mean-
Harlan Sur (Managing Director)
Yes.
Steve Sanghi (Executive Chair)
You know, and we haven't grown 6.2% in a very long time, sequentially.
Harlan Sur (Managing Director)
Yeah.
Steve Sanghi (Executive Chair)
You know, so this is, this is very, very good.
Harlan Sur (Managing Director)
I appreciate that. And, you know, if I exclude licensing revenues, your other segments still grew close to, like, 8% sequentially, right? As you mentioned, some of the product growth was FPGA, data center, memory, networking. I didn't hear you mention this, but you know, I seem to recall historically that the team has had very strong traction in data center SSD controllers, both the chip, but even more importantly, like you guys, I think, have a very strong firmware stack. Right now, data center SSD demand is very strong, right? AI compute is finding all of these new use cases for SSD. Is the Microchip team benefiting from this? Are you guys still committing R&D investments to the data center SSD franchise?
Eric Bjornholt (CFO)
Absolutely.
Steve Sanghi (Executive Chair)
Yeah, go ahead.
Eric Bjornholt (CFO)
Yeah, absolutely. So, we support and continue investing in the storage segment of data centers, into the switching segment of data centers, both for... in the storage, both for flash as well as for HDD. So we've got three solid product lines that we are supporting and continue to invest in.
Operator (participant)
Thank you. There are no further questions at this time. I'd like to pass the call back over to Steve for any closing remarks.
Steve Sanghi (Executive Chair)
Well, we want to thank all the investors for sticking with us through this last year of recovery, and we finished the year pretty good, and we're looking for an outstanding calendar year 2026. We'll see some of you on the road as we go to some conferences this quarter. Thank you.
Operator (participant)
This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.