Arteris, Inc. Q1 FY2022 Earnings Call

Good afternoon, everyone. And welcome to the Arteris IP First Quarter 2022 Earnings Call. All materials contained in the webcast is the sole property and copy of Arteris IP with all rights reserved. For opening remarks and introductions, I will now turn the call over to Erica Mannion at Sapphire Investor Relations. Please go ahead.

Thank you and good afternoon. With me today from Arteris IP are Charlie Janac, Chief Executive Officer; and Nick Hawkins, Chief Financial Officer. Charlie will begin with a brief review of the business results for the first quarter ended March 31, 2022. Nick will then review the financial results for the first quarter, followed by the company’s outlook for the second quarter and full year of 2022. We will then open the call for questions. Before we begin, I’d like to remind you that management will make statements during this call that are forward-looking statements within the meaning of the federal securities laws. These statements involve material risks and uncertainties that could cause actual results or events to differ materially from those anticipated and you should not place undue reliance on forward-looking statements. Additional information regarding these risks and uncertainties and factors that could cause actual results to differ appear in the press release Arteris IP issued today and in the documents and reports filed by Arteris IP from time-to-time with the Securities and Exchange Commission. Please note, during this call, we will cite certain non-GAAP measures, including non-GAAP net loss, non-GAAP net loss per share and free cash flow, which are not measures prepared in accordance with US GAAP. These non-GAAP measures are presented as we believe that they provide investors with the means of evaluating and understanding how the company’s management evaluates the company’s operating performance. These non-GAAP measures should not be considered in isolation from, as substitutes for, or superior to financial measures prepared in accordance with U.S. GAAP. A reconciliation of these non-GAAP measures to the nearest GAAP measures can be found in the press release for the quarter ended March 31, 2022. In addition, for a definition of certain key performance indicators used in this presentation, such as annual contract value, design starts, active customers, and remaining performance obligations, please see the press release for the quarter ended March 31, 2022. Listeners who do not have a copy of the press release for the quarter ended March 31, 2022, may obtain a copy by visiting the Investor Relations section of the company’s website. Now I’d like to turn the call over to Charlie.

Thank you, Erica. And thanks to everyone for joining us on the call this afternoon. We are excited to report a strong first quarter to start 2022 with annual contract value plus trailing 12-month royalties of $52.8 million, up 26% year-over-year. Demonstrating our continued momentum, our active customers increased by seven new system IP customers in the quarter. Total customer design starts in the quarter were 19 SoC projects. Major new customer deals including IP licenses to Cambricon, Rapid Silicon, and Socionext. Cambricon selected Arteris IP SoC interconnect solution based on our strong technology track record for automotive machine learning applications. We also signed a key new deal with a major ridesharing company in the quarter and announced that BMW licensed Arteris IP for a neural network accelerator project. Additionally, Sondrel deployed Arteris IP for their next-generation automotive AI/ML SoCs. We believe these relationships underline that SoC creation is occurring at all stages of the automotive supply chain from semiconductor companies to Tier 1 vendors, automotive OEMs, and ridesharing companies as electrification, automated driving, and ECU consolidation revolutionize the industry. Besides the progress in automotive, we also continue a strong momentum in AI/ML, consumer electronics, enterprise, and 5G communication market segments. We continue to close new deals addressing AI/ML technology during the first quarter across numerous verticals. The market for machine learning at the edge continues to be promising with the continued addition of new customers and a broad range of applications. On the product front, in the first quarter, we continued our strong investment in engineering new system IP products and are confident that we will continue our multiyear track record of delivering at least one new major system IP product in 2022. The democratization of SoC design, as well as the disintermediation of the semiconductor supply chain, we believe is driving a strong need for automation of system IP solutions in order to compensate for a shortage of SoC architects and skilled interconnect IP engineers. While we are seeing strong demand for our products, we are also seeing worldwide inflationary pressures in terms of employee compensation and service provider pricing. As we discussed in our prior conference calls, we are seeing the regionalization of the semiconductor industry. However, the troubling events in Ukraine are driving the United States and Europe together into a more cohesive block than previously predicted. I should mention that Arteris IP has no current exposure to either Ukraine or Russia. We believe that it is important, however, for Arteris IP to continue to expand its multi-regional presence in order to be a global system IP provider. Lastly, in the first quarter, we continued to strengthen our management team by adding Michal Siwinski as our Chief Marketing Officer. Michal joins us following a 22-year career at Cadence Design Systems, including leadership roles in product strategy, solutions, and customer engagement culminating as a Corporate Vice President, Marketing and Business Development. With Michal’s addition, we now have a complete top management team with significant public company experience for our next stage of growth. With that, I will turn it over to Nick to discuss our financial results in more detail.

Thank you, Charlie, and good afternoon, everyone. As I review our first quarter results today, please note, I will be referring to non-GAAP metrics, a reconciliation of GAAP to non-GAAP financials is included in today’s earnings release, which is available on our website. Total revenue for the first quarter was $11.8 million, up 77% year-over-year. As a reminder for those of you who are new to the Arteris IP story, our revenue is derived from licensing intellectual property, licensing software, software maintenance services, providing professional services, training services, and royalties. Given the variation in revenue recognition methodologies between our product offerings, as a management team, we focus on annual contract value or ACV as a leading indicator of financial performance. We define ACV for an individual customer agreement as the total fixed fees under the agreement also referred to as the TCV or total contract value divided by the number of years in the agreement term. As this calculation does not include the contribution from royalty payments, we also refer to ACV plus trailing 12-month royalties as a metric, which provides a more complete picture of our total revenues. We monitor this metric to measure our success and believe that the historical increase shows our progress in expanding our customer’s adoption of our solutions. At the end of the first quarter, ACV plus trailing 12-month royalties and other revenue was $52.8 million, up 26% year-over-year, driven in particular by growth in automotive, AI/ML, consumer electronics, enterprise, and 5G communication market segments, and up 5% quarter-over-quarter. Remaining performance obligations or RPO were $60.5 million, up 28% year-over-year as of March 31, 2022. We define RPO as the amount of contracted future revenue. Gross profit in the quarter was $10.9 million, representing a gross margin of 92%, compared to $5.8 million or 87% in the prior year period. R&D expense in the first quarter was $8.2 million or 70% of revenue, compared to $6.3 million in the prior year period. The increase was primarily driven by additional headcount in our four R&D centers and payroll expenses, as we continue to invest in developing new and improved product offerings. Sales and marketing expense for the first quarter was $3.6 million or 31% of revenue, compared to $2.4 million in the year-ago period. We continue to invest in sales and marketing as we work to continue to drive awareness of the benefits of our solution in the market and expand our sales and application engineering force and marketing efforts to harness the significant potential in front of us. G&A expense for the first quarter was $3.2 million or 27% of revenue, compared to $3.7 million in the year-ago period. G&A reflects an increase in people and infrastructure related expenses associated with our transition to being a public company. Operating loss for the first quarter was $6.6 million or 56% of revenue, compared to a loss of $6.4 million in the year-ago period. Non-GAAP operating loss was $4.2 million or 36% of revenue, compared to a loss of $5.8 million in the year-ago period. Net loss for the quarter was $6.8 million or net loss per share basic and diluted of $0.22. Non-GAAP net loss for the quarter was $4.4 million or net loss per share basic and diluted of $0.14, based on approximately $31.6 million weighted average diluted shares outstanding. As a reminder, our IPO lock-up expired on April 23, 2022. While the lock-up expired, former employees, current employees, and other stockholders held approximately 9.8 million shares, which are no longer subject to lock-up and can be freely sold subject to normal restrictions such as having material non-public information or MNPI. Additionally, current and former employees and directors held approximately 8.3 million shares when the lock-up expired but were subject to outstanding options or reserved for future issuance pursuant to restricted stock unit grants as part of our employee incentive programs. These shares, assuming they satisfy the various best-in-conditions, can also be sold subject to normal restrictions. Turning to the balance sheet and cash flow, we ended the quarter with $82.2 million in cash, cash flow used in operations was $1.4 million in the quarter, while free cash flow, which includes capital expenditure, was negative $1.5 million. I would now like to turn to the outlook for the second quarter and the full year 2022. For the second quarter, we expect ACV plus trailing 12-month royalties of $49.5 million to $51.5 million and revenue of $11.5 million to $14.5 million, with non-GAAP operating loss margin of 19.4% to 34.4% and non-GAAP free cash flow margin of negative 29.4% to negative 44.4%. For the full year, we expect ACV plus trailing 12-month royalties of $51.6 million to $55.6 million and revenue of $48 million to $52 million, representing an increase from the prior guidance of $47 million to $51 million. Non-GAAP operating loss margin of 24.9% to 39.9%, similar to prior guidance of non-GAAP operating loss margin of 25.6% to 40.6%, reflecting the impact of wage inflation on our operating expenses and non-GAAP free cash flow margin of negative 10.5% to negative 25.5%, similar to prior guidance of negative 10.9% to negative 25.9%. With that, we will open up the call for questions. Over to the Operator.

Thank you. Our first question is from Josh Buchalter on behalf of Matt Ramsay with Cowen. Please go ahead.

Hey, guys. This is Josh Buchalter on behalf of Matt. Thank you for taking my questions and congrats on the results. First thing I wanted to ask about was the guidance, it calls for a sequential decline of ACV plus trailing 12-month royalty revenue, obviously, saw that you maintain the full year guidance. But I was wondering what would normal seasonality look like and was there any impact in the short-term related to China shutdowns whether a contract signed with that customers or royalty shipments? Thank you.

Yeah. Hi, Josh. Let me take that. I want to sneak in here and it’s a great question. I mean, you already know because we have spoken to you many times that we have a headwind in Q2, which is already sort of built into our prior guidance. But just so everybody else knows who is not familiar with this, there was a very substantial deal with HiSilicon in May of 2019 that ends this month, which creates a headwind of around $3 million in Q2. That’s not something new, but it is a headwind. Nevertheless, the other point you make which is the slight decline in ACV guidance for Q2 and plus royalties is due to two things really. One is, as you know, we do have a little bit of seasonality with our IPD business, and generally, our bookings and sometimes we can end up with a big deal falling into the end of one quarter or the beginning of another quarter. We are seeing a few Chinese deals, for example, falling out of the end of June into the beginning of July and that creates an instant ACV hit, which then picks back up again in the next quarter, which is why you are seeing the full-year not moving. The second issue is the royalties part of ACV plus trailing 12-month royalties. We are seeing supply chain constraints hitting our customers. This, of course, is hitting our customers and this is everything from fab capacity generally and things like novel gases, which are constrained by Russia, and that’s reducing our customers’ ability to ship volumes and then puts a dent in mid-term royalties looking to impact longer-term royalties, but it doesn’t impact the near-term. So that sort of gives a fulsome answer to the question.

Thank you for your detailed response. Throughout this earnings season and previous ones, we have frequently encountered discussions about supply constraints affecting vehicle units. However, there seems to be a positive shift towards a higher mix of premium in average contract values, which is accompanied by an increase in semiconductor content. Could you help clarify the net exposure regarding the shift to higher semiconductor content compared to the reduction in overall units? Additionally, how does this influence your near-term results and, more critically, your long-term outlook given the growing complexity of system-on-chips being used in vehicles? Thank you.

Yeah, this is Charlie. I will take that one. The automotive business continues to be strong. We are not experiencing any slowdowns in design cycles; more members of the automotive ecosystem are designing system-on-chips, which are becoming increasingly complex. This is favorable for our tariffs as far as we can see. The only potential challenges could stem from semiconductor manufacturing capacity constraints affecting royalties. However, people are building fabs at a strong pace, and we believe the manufacturing constraints will eventually subside. While we aren't sure when exactly this will happen, it could be in the second half of this year or early next year. There's a lot of interesting design activity happening, and the automotive sector appears particularly promising. Additionally, we anticipate an increase in military spending, which may also lead to more system-on-chip design starts.

Just one additional comment from the automotive side regarding the longer term. You may recall that we shared some third-party data indicating that the number of SoCs per vehicle is expected to rise from about three to four in 2020 to the low 20s, approximately 23 per vehicle by 2026. This reflects the trend you mentioned, which is more of a long-term viewpoint and doesn’t significantly impact the current quarter.

Understood. Thank you. I will hop back in the queue.

Thank you. Our next question is from Mark Lipacis with Jefferies. Please go ahead.

Thank you for taking my question. I'm unsure if this is for Charlie or Nick. You mentioned higher compensation expenses. Is this related only to new product development? Could you elaborate on how this is also affecting your customers' willingness to engage with you in order to address similar challenges they might be facing? Thank you.

Well, let me take this…

So we are…

I will address the first half of your question and then pass it over to Charlie for the more commercial and industrial aspects in the second part. Generally, we are experiencing primary and secondary inflation, which affects around 75% of our operating expenses related to our workforce. A significant portion of our costs comes from services, which also primarily involves people. This trend is occurring in the U.S., Europe, and Asia-Pacific, particularly in China, where wage inflation rates are high. We are making efforts to manage these costs as much as possible, but we are certainly facing upward pressure. Regarding our customers' willingness to continue doing business with us and whether they expect us to share the burden through cost reductions, I would say opinions on that matter are fairly divided. Now, I'll hand it over to Charlie.

Yeah. Yeah. We are not seeing any, I wouldn’t say that we are seeing particular margin pressures in our product. Our products generate a lot of value; they save customers a lot of money and so we are not seeing price pressure or margin pressure on our products at this time.

So, thanks for that. And I guess I was tackling this from the standpoint of, it seems to me like, if your customers are seeing similar wage pressures than given the prices of your licenses that it actually may make it easier for your customers to make a decision that they are in a make or buy decision that they are seeing the wage pressures and labor shortages.

Yeah.

And they may reach do more often and I was wondering if that was manifesting in your pipeline or not?

Yeah. I think that’s absolutely correct. The fact that our customers are also having difficulty finding their own labor and that labor is expensive for them as well basically means that automation is something that is going to get very good reception both near-term, medium-term, and long-term. So this does expand the opportunity for Arteris IP product adoption versus internal solutions.

Got it. Thank you.

Thank you. Our next question is from Hans Mosesmann with Rosenblatt Securities. Please go ahead.

Yeah. Thank you. Congratulations, guys. Good execution. Just a question on the royalty, the headwinds, what end market is driving that, is that wireless if there is a headwind?

So, yeah, I mean, I don’t know, Nick, if you want to take this or probably you take it. But basically, the smartphone royalties have been declining and the automotive royalties have been rising. As sort of the automotive adoption takes place and more of the existing designs make it into cars and get shipped in volume, that will lead to a rise in additional royalty revenue. So we think on a long-term basis we feel pretty confident in our royalty stream as the automotive royalties take over from the smartphone royalties, and ultimately, there will be some of the mixed-use learning designs, which are quite numerous recently will actually reach production and start generating volume.

Yes, you are correct. We have significant emerging contributors to our royalty revenue, one being consumer-related and the other more industrial, both of which are growing nicely. Specifically, the HiSilicon segment on the e-mobility side is not yet at zero but is nearing that point, showing a decline over recent quarters. However, automotive remains our core focus, and we are engaged with over 35 customers and more than 60 designs, giving us a solid presence across various industry players, including semiconductors, Tier 1 suppliers, and OEMs. We have a diverse representation in all sub-verticals, which is a strong position to be in, while we also see broad royalty revenue streams coming in from other areas.

That’s very helpful. And just as a follow-up question, on the BMW win on the neural network accelerator project, can you comment on who is the competition in that project or projects that are similar to that? Are those in-house efforts or are there other players that are going to be challenging you guys with this IP?

We have two types of competitors: one is ARM, and I'm not sure if there's a specific competitor in this case, and the other is internal. Developing internal interconnect is becoming more costly and challenging due to a shortage of interconnect engineers. Our main challenge in these sales cycles is to demonstrate that our solutions are well-suited for the customer's application and their specific needs. This is the primary obstacle we need to overcome for such designs. However, I believe the competitive landscape for Arteris, whether regarding the BMW deal or other projects, remains quite favorable.

Okay. Great. Thanks.

Thank you. Our next question is from Ambrish Srivastava with BMO. Please go ahead.

Hi. Thank you very much. I had a question on like you mentioned seasonality for ACV and TTM royalties, could you just explain how we should be thinking about it on a go-forward basis? And then the second kind of related question, you talked about China deals moving from end of quarter to the other. Is that largely because of the shutdowns that are very well-publicized shutdowns in China or is there something else going on there? And yes, I had a very quick follow-up after that, Nick, sorry.

Hello, Ambrish. It's great to talk to you again. I hope you're doing well. Regarding the situation in China and the Baltic region, I'll address them in order. First, about seasonality: Generally, the ACV plus TTM royalties are intended to remain relatively consistent. However, we do experience some fluctuations due to the timing of deals being signed and when the software is actually delivered, which usually occurs at the end of a quarter or the beginning of the next one, and this is largely out of our control since it depends on customer requests. If they need something on a particular day, we deliver it then; if they request it later, it gets pushed back. Therefore, seasonality remains fairly stable overall. ACV plus TTM royalties typically receive a boost in Q4 because of a strong set of bookings, but that is distributed over the following years according to the contracts. The situation in China is somewhat different, as it is indeed related to COVID. Our customers are located in areas that experienced severe COVID shutdowns. The Chinese authorities aim to eliminate the outbreak, which has made it challenging for people to work and collaborate. We believe that the deals have not disappeared; rather, delays occur because individuals are unable to get to their offices to finalize our licensing agreements. In China, having the necessary approvals is crucial, as you may know from the ARM circumstance. So that's the current situation in China.

Yes. Yes.

The other thing...

Sorry, go ahead.

... just to sort of add some color to the color. The revenue, of course, is much more smooth, the GAAP revenue is much more smooth when it’s an interconnect sale because that spreads evenly over the number of days in the license, so if it’s three years, if we have done 365 days spread. So you automatically get that. So it doesn’t have the same sort of lumps unless it’s a point in time revenue, which is more of an IPD software build. So you have another question.

I'm glad you addressed that because the comment about seasonality caught me off guard. It made sense to shift our focus from bookings to ACV and TTM because bookings can be inconsistent. However, your explanation clarifies that we should consider it more as a seasonal trend in the fourth quarter rather than throughout the entire year. Is that correct?

Correct. Exactly right.

Got it.

Okay. And my quick follow-up was the royalty revenues would be impacted by the supply chain being gummed up, but do you feel pretty comfortable with the annual guide that it should be, I mean, it’s a small number, but you feel pretty comfortable that situation should be alleviated by then? Yeah. I mean, we are not putting ourselves out as experts on the silicon supply chain.

Yeah.

There are much, much smarter people than me to give that sort of analysis. But the general sense we do follow what’s going on that we speak to our customers and out in the foundries. And our sense, generally it’s probably a 2023 solution to get that completely on government. But we are still signing contracts; all the interconnect contracts still have royalties, the royalty rates are generally strong increasing. So there is nothing changing in our model from that perspective. The only variable right now is the units out from our customers, which I am actually if you look at the Q1, it was pretty strong. But we are a little cautious on how that’s going to play out in the next couple of quarters. That helps…

Thank you, Nick.

Thank you. Our next question is from Gus Richard with Northland. Please go ahead.

Yes. Thanks for taking the question. I am seeing Qualcomm made good progress in getting in the automotive market and I know they have their own network on a chip IP. And I am just wondering is Qualcomm displacing any of the OEM designs that you would expect or having any other impact on any of the design activity that you are working on?

Qualcomm is a very agile company with their internal network on chip technology, making them a strong competitor in the automotive market. However, as Nick pointed out, our projections indicate that 2023 System on Chips will be present in every vehicle due to the advancements in electrification, automated driving, and industry consolidation. Qualcomm is expected to capture a portion of that market, but established players like Mobileye, NXP, and Bosch will also maintain their positions, allowing Qualcomm to take its share without pushing others out of the market anytime soon. While they will gain a share, I don't anticipate a significant impact on our tariffs considering the number of System on Chips per vehicle.

Got it. That’s very helpful. And then turning to China, so there is the ARM situation, which I am curious if that’s impacting potential customers in China in terms of their choice of interconnect and also as China pulls away from the U.S. and going to self-sufficiency, are there any EDA players rising there that could be a challenge and/or it’s too early to know about sanctions, but any thoughts along you sort of those dynamics?

We do not consider Arteris to be an EDA company; rather, we are a semiconductor IP company. Our technology is quite complex, and we aren't observing any domestic alternatives emerging from China. We continue to experience strong activity in China, although, as Nick pointed out, customers particularly in Shanghai are currently unable to access their chips to validate certain contracts, but this is only a temporary situation. At this moment, we are not seeing any developments from China that would threaten Arteris' position in the system IP market.

Got it. Helpful and sorry for mischaracterizing your business.

We have a lot of software that enables people to utilize our intellectual property, but the true value comes from our assistance in getting the chip produced and integrating our technology as the communication component of the chip.

Right. Totally understood. That’s it from me. Thanks.

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session, and I would like to turn the call back to Charlie Janac for closing remarks.

Yes. So this is an exciting time to be at Arteris IP and we look forward to continuing our momentum in the years ahead and updating all of you in the quarters to come. Thank you for joining our call today and for your interest in Arteris IP. Thank you very much.

Thank you. This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.