Arteris, Inc. Q3 FY2022 Earnings Call

Good afternoon, everyone, and welcome to the Arteris Third Quarter 2022 Earnings Call. Please note that this call is being recorded and simultaneously webcast. All material contained in the webcast is the sole property and copyright of our Arteris, Inc. 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 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 third quarter ended September 30, 2022. Nick will then review the financial results for the third quarter followed by the company's outlook for the fourth 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 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, uncertainties and factors that could cause results to differ appear in the press release Arteris issued today and in the documents and reports filed by Arteris 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 U.S. GAAP. The 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 measure can be found in the press release for the quarter ended September 30, 2022. In addition, for a definition of key performance indicators used in this presentation such as annual contract value, confirmed design starts, active customers and remaining performance obligations, please see the press release for the quarter ended September 30, 2022. Listeners who do not have a copy of the press release for the quarter ended September 30, 2022 may obtain one by visiting the Investor Relations section of the company's website. I will now turn the call over to Charlie.

Thank you, Erica, and thanks to everyone for joining us on the call this afternoon. We're excited to report solid results for the third quarter with annual contract value plus trailing 12-month royalties of $53.2 million, up 17% year-over-year. This is despite HiSilicon's contract ending in Q2, which removed $3.3 million of annual contract value as previously announced. We achieved a major company milestone with over 3 billion systems shipped with SoCs connected by Arteris system IP since inception. Demonstrating market demand for our solution, we added 10 active customers in the quarter, a company record. Total confirmed design starts were 21 SoC projects in the third quarter. Deals in the third quarter were driven by strong demand for Arteris system IP and deployment software across our core markets, including multiple transactions in automotive, consumer electronics, enterprise data center communications, machine learning and industrial applications. We're also seeing increasing demand for space-oriented applications. We closed a direct automotive OEM licensing deal with a major new international electric car manufacturer. This customer selected Arteris because of our track record of successful completion of automated driving SoCs by multiple customers and our ability to provide flexible technology, enabling the potential for this customer to create differentiated value and to meet their project goals and safety compliance. Arteris also extended and expanded a long-term automotive semiconductor agreement and saw strong automotive electronic demand globally. Arteris was also selected for a major space-oriented program due to the combination of technology, performance and reliability. In addition, our resilient technology was a primary reason for Arteris being selected for this environmentally challenging application. Additionally, Arteris was chosen by a leading 5G communications OEM to deploy our network on-chip interconnect technology. SiMa.ai also highlighted the use of Arteris IP for flexibility and adaptability as part of their new machine learning system-on-chip platform for the embedded edge announced in August. Furthermore, Microchip entered into a multiyear agreement, licensing Arteris IP to enhance performance, security, configurability and power for the next generation of microcontrollers used for aerospace embedded vision, embedded computing and machine learning. Also, we expanded our partnership with Arm in the automotive space to leverage leading-edge Arm processor IP with Arteris system IP to enable best-in-class solutions for autonomous driving cockpit and infotainment, vision, RADAR and LIDAR, automotive communication and other automotive subsystems. The partnership delivers solutions that should accelerate our mutual customers' ability to realize SoCs with high performance and power efficiency for complex and demanding safety-critical tasks with different workloads while reducing project schedules and costs. Arteris and Arm expanded technical collaboration, including early access to next generation of automotive processor IP. To ensure customer success, we are well aligned road maps, CMOS integration and optimize flows with the highest quality of results. This will, in turn, enable the more efficient creation of ISO 26262 compliant systems with the most rigorous automotive safety integrity levels to address today's and tomorrow's vehicle electronics design challenges. Lastly, as we recently announced, we are very excited to have strengthened our management team with the addition of Christel Mauffet-Smith as our new Executive Vice President of Global Sales. Christel comes to us with an extensive sales leadership background at Cadence and Synopsys. While there are macroeconomic uncertainties, including the latest U.S. commerce regulations with respect to China, we believe that Arteris is well positioned to make progress even in challenging economic environments. Despite potential headwinds, our customers are continuing to innovate in areas such as automotive, machine learning and 5G, driving the need for increased use of commercial system IP.

Thank you, Charlie. And good afternoon, everyone. As I review our third quarter results today, please note I'll 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 from the third quarter was $12.6 million, up 41% year-over-year. At the end of the third quarter, ACV plus trailing 12-month royalties and other revenue was $53.2 million, up 17% year-over-year and up 3% quarter-over-quarter. Remaining performance obligations for RPO were $59.3 million, up 17% year-over-year as of September 30, 2022. We define RPO as the amount of contracted future revenue. Gross profit in the quarter was $11.7 million, representing a gross margin of 93% compared to $8.1 million or 90% in the prior year period. Non-GAAP gross profit in the quarter was $11.8 million, representing a gross margin of 94% compared to $8.1 million or 90% in the prior year period. Non-GAAP R&D expense for the third quarter was $9.1 million or 73% of revenue compared to $7.3 million in the prior year period. The increase was driven by continued investment in new and improved product offerings in our 5 R&D centers across our full portfolio. Non-GAAP sales and marketing expense for the third quarter was $3.7 million or 29% of revenue compared to $3.2 million in the year ago period. We intend to continue to invest in sales and marketing as we work to continue to drive awareness of the benefits of our solutions in the market and expand our sales and application engineering force and our marketing efforts to harness the significant potential opportunity in front of us. Non-GAAP G&A expense for the third quarter was $3.2 million or 25% of revenue compared to $1.6 million in the year ago period. G&A expense reflects a significant increase in directors and officers liability insurance expense and increased headcount associated with the transition to being a public company, partially offset by a decrease in professional services expenses. Operating loss for the third quarter was $7.8 million or 62% of revenue compared to a loss of $4.5 million in the year ago period. Non-GAAP operating loss was $4.1 million or 33% of revenue compared to a loss of $4.0 million in the year ago period. Net loss for this quarter was $7.7 million or diluted net loss per share of $0.23. Non-GAAP net loss for the quarter was $4.2 million or diluted net loss per share of $0.13 based on approximately 32.8 million weighted average diluted shares outstanding. Turning now to the balance sheet and cash flow. We ended the quarter with $68.2 million in cash and cash equivalents and $6.4 million in short- and long-term investments. Cash flow used in operations was approximately $5.2 million in the quarter. While free cash flow, which includes capital expenditure, was negative $5.7 million. I would now like to turn to our outlook for the fourth quarter and the full year 2022. For the fourth quarter, we expect ACV plus trailing 12-month royalties of $47.5 million to $51.5 million and revenue of $10.8 million to $11.8 million with non-GAAP operating loss margin of 50.2% to 70.2% and non-GAAP free cash flow margin of negative 13.1% to negative 47.1%. For the full year, we expect revenue of $50 million to $51 million, ACV plus trailing 12-month royalties to exit 2022 at $47.5 million to $51.5 million, non-GAAP operating loss margin of 31.6% to 36.1% and non-GAAP free cash flow margin of negative 16.6% to negative 24.6%.

Our first question comes from Mark Lipacis with Jefferies LLC.

Sorry, I was speaking to myself there. Charlie, what do you think will happen to your business? Do you have enough data points to provide insight on how your business performs during a mild recession compared to a deeper recession? Do you see an increase in the number of projects because your payback becomes compelling for customers, prompting them to outsource interconnect capabilities to you? Or do you anticipate a drop-off in business? Any data points or historical context you could share would be really helpful. I also have a follow-up question.

Yes. In our experience, customers often try to navigate recessions by focusing on design. For instance, our third quarter confirmed design starts have stayed consistent. We also experienced a significant recession in 2008, which was more severe than what we expect now, yet the number of designs remained stable, even when we were a smaller company. Typically, manufacturing budgets get reduced while R&D and engineering budgets tend to be less impacted. Additionally, a noticeable effect of cost-cutting by major semiconductor companies is that firms are reconsidering whether to develop system IP solutions internally or outsource them to us for commercial solutions. Therefore, we believe the number of designs will not decline. The main challenge we foresee from a recession is a potential reduction in shipment volumes, especially in the consumer sector, which may lead to a slight drop in royalties in the short term. However, we anticipate that royalties from other sectors, including automotive, infrastructure, data centers, and industrial, will remain strong. Thus, we do not feel particularly vulnerable to the recession, and many future market share gains can actually be achieved by making strategic decisions during downturns.

If I can add one more piece of color back plus some data points. That is quite an interesting one. So Charlie's point on people design their way out of recessions. The third quarter, interestingly, was the third highest number of confirmed design starts in our history. So we're certainly not seeing any slowdown in that.

Got you. That's a great data point, Nick. Has the recent increase in restrictions on China impacted your pipeline at all? Is there anything we should keep in mind regarding those developments? That's all I had.

Yes. We are currently evaluating the potential impact on our business. Our analysis indicates that supercomputing applications, which have not traditionally been our strength, may be affected, particularly companies utilizing foundries in China with advanced process nodes below 16 nanometers. This could impact a few companies; however, many of our current and prospective customers utilize non-Chinese foundries, including those in South Korea and Taiwan. Additionally, automotive, consumer, and industrial customers in China using non-Chinese foundries or Chinese foundries that operate at less advanced nodes should not be affected. It is also important to note that a significant portion of our revenue comes from products originally manufactured in France, which are governed by French export regulations rather than U.S. rules. After considering all these factors, we believe that in a worst-case scenario, our overall growth rate could decline by mid- to single-digit percentages. We will continue to monitor and assess the situation as it develops from both the U.S. and Chinese perspectives.

To clarify, we are speaking about a decrease in the growth rate of up to mid-single digits percent, not a decline in revenue.

Our next question comes from the line of Hans Mosesmann with Rosenblatt Securities.

Yes. Good execution. Congrats. Can you guys give us a sense of how the quarter progressed in terms of its linearity, in terms of expectations? And also if you can give us a qualitative sense of how your customers have behaved as you look into Q4 and beyond.

Do you want me to take that one?

Yes. Go ahead.

Yes. The linearity in the third quarter was relatively normal, although Europe didn't seem to take an extended vacation in July and August. So, it was mainly focused on September, particularly regarding the IP deployment software. Regarding how this affects the fourth quarter, it’s a good question, and it does impact the free cash flow projections for that period. The fourth quarter can vary significantly based on when bookings occur, whether they are early or late in the quarter. We are observing more late-quarter booking, which means that because we typically have a 45-day payment term, these will likely be more cash relevant in the first quarter than in the fourth quarter. This explains the slight decrease in the total annual free cash flow projection, which we expect to improve in the first quarter of next year.

So Nick, what you're saying is that some of your customers are choosing to engage with you towards the end of a given quarter?

Yes, exactly. That's why we cautiously estimated our Annual Contract Value for the quarter. As we approach the end of the quarter, we are confident the deals will close, but there are some administrative challenges, especially in China. These challenges may cause some new licenses to be executed in the following quarter. This caution affects both our ACV and, to some extent, our revenue, which is having an impact on the business.

Okay. That's helpful. And as my last follow-up here, I promise. Just some clarity on the growth rate of your business at mid-single digits to high single digits. The growth rate, that's something that could potentially hit you, but it hasn't hit you yet. Is that the clarification here?

Yes. We did not experience any impact in Q3. The situation is new, and the macro environment is changing quickly. There are some challenges, like the effect on the growth rate in China, but there are also some advantages, such as major semiconductor companies being more willing to outsource their system IP development. Overall, we feel that these challenges and advantages are balancing each other out, allowing us to maintain our usual progress despite the current conditions.

Our next question comes from the line of Matt Ramsay with Cowen and Co.

This is Ethan Potasnick filling in for Matt. I wanted to delve into the outlook for the fourth quarter and the full year. I understand you mentioned the timing of deals, but considering the current macro environment and the softness we are observing, could you provide some insight into where the weaknesses lie within the business? This is especially relevant as this marks the second consecutive quarter that the outlook has been adjusted downward.

Nick, you want to take this one?

I'll handle that question, Ethan. It's nice to reconnect with you. As you know, we tend to provide conservative guidance. We want to be careful and not overestimate our outlook for the year-end. We're not observing any deals disappearing, but we are witnessing some deals closing towards the end of the quarter. If those transactions shift to the beginning of the following quarter, specifically Q1, and they are IPD deals, they won't be reflected in our revenue. This results in a minor decrease of $0.5 million from our total guidance of $50 million, which is about 1% overall. The same applies to ACV, though it's more pronounced because it directly impacts our interconnect, which is digital. An interconnect deal that shifts from the last week of December to the first week of January would negatively affect ACV at year-end. Therefore, there is a slight reduction in that area as well, but both instances are temporary since we are not experiencing any actual loss or erosion of business.

Okay, understood. Separately, I would like to ask about the partnership with Arm. You are both partners and competitors in the intellectual property area, with different core strengths but some overlap in the interconnect IP. Given the developments in the ADAS automotive sector, could you provide more details about the recent announcement?

We are very excited about this development, which has two main elements. First, due to Arteris's significant market share in automotive and the demand for enhancements in functional safety and performance, we have decided to collaborate with Arm in this area. Arm will recommend Arteris system IP to its automotive customers, which we believe will increase our revenue opportunities, especially in the automotive sector. The second part of this collaboration is that Arm will provide us with a stream of advanced automotive processors so we can emulate and test the integration quality before it reaches customers. This will allow us to tailor our interconnect technology to the latest Arm processors. We view this agreement as mutually beneficial, reinforcing Arteris's position in automotive system IP while also aiding Arm's entry into the automotive market. It's important to note that this partnership is limited to automotive; we continue to compete in other segments while maintaining a friendly relationship. Ethan, does that address your question?

Yes. Perfect.

Our next question comes from Ambrish Srivastava with BMO.

I wanted to revisit the question regarding China that Mark mentioned earlier. I'm a bit unclear, so I want to ensure we're aligned. Even though you see some challenges from these efforts, you do not expect the mid- to high single digits to affect the growth rate? Looking ahead to next year, we shouldn't adjust our forecast based on that because you believe there are offsetting benefits? So overall, the benefits balance out the challenges from China? Is that the correct takeaway from your comments?

Yes. That's our current feeling, yes. I don't know, Nick, do you want to add some other comments for this?

Yes. We are still navigating this situation, like everyone else in the industry. Frankly, we don't have complete clarity at this point. We recognize there are factors at play, but we lack applications in supercomputers, which is a major focus of U.S. export regulations. Additionally, we aren't involved in the DRAM or NAND flash sectors. It's possible some of our growth in China could come from sub 16-nanometer foundries, but we can't confirm that yet. Currently, we don’t perceive any significant immediate challenges, but we want to be cautious in our guidance. We estimate there might be a low single-digit percentage impact on overall revenue growth due to these circumstances. However, as Charlie mentioned, there are several positive factors that could counterbalance this, although the timing of these developments is uncertain. At present, we do not observe any decline in our business in China.

No, I think that makes sense. That's a pretty balanced assessment. I think there's a lot of uncertainty. Another thing for you, Charlie. Something you highlighted is the direct auto OEM engagement. Can you just give us some sense of where this was a year ago in terms of how many customers you're engaged directly in the auto space, a year ago versus now? And then more importantly, how is the business trending in terms of your engagement directly with these customers? Obviously, the whole auto industry has gone through such turmoil with all the shortages, so any perspective would be very helpful.

Yes, in the past, we struggled to secure meetings with automotive OEMs. When we did, there were doubts about why a company like ours, focusing on interconnect or system IP, was relevant. That situation has changed significantly, as OEMs now understand the importance of controlling their electronic architectures. They cannot rely on having numerous small MCUs in their vehicles from Tier 1 suppliers and still expect to compete with companies like Tesla. As a result, they have begun to design their own chips, with some delving quite deeply into this development. Generally, they establish the architecture needed for their software and collaborate with partners to create those chips, allowing partners to also sell these chips in the market. Consequently, we're now directly engaging with some of these OEMs. So far this year, we have established one direct OEM relationship each quarter. This trend is currently accelerating, and while we don't have any announcements yet, we are actively working with multiple OEMs simultaneously. Moving forward, we expect that nearly every operational automotive OEM will initiate some kind of SoC development program as part of their 2023 and 2024 budgets. We predict that our interactions with OEMs and ridesharing companies will increase in the future, which I consider one of the positive factors for our business.

So this should result in the total addressable market potentially being larger than what you were thinking when you went public?

Yes. One is the TAM becomes somewhat bigger. I mean the TAM was already pretty big. But it does certainly expand the SAM, the served available market. But what it also does is if the OEMs essentially standardize on Arteris, that also drives additional business in the supply base of those OEMs, right? So it's very much what happened with Arm and the phone makers when Arm started engaging directly with the companies that actually made the phones rather than just people who made the phone semiconductors. So it's a very similar strategy that we have. And there is, I would say, substantial evidence that it's working and it's successful and that the OEMs are happy with us. In this particular case, initially, this OEM essentially used Arteris interconnect to a partner and on a subsequent project decided to do a direct license with us.

Our next question comes from the line of Gus Richard with Northland.

Charlie, I want to ask if the automotive companies are shifting more towards ASICs than they previously did. How is this trend affecting both new and existing foundries in regard to IP reuse? How do you foresee the situation evolving, and what is your position amidst these changes?

The automotive industry is experiencing its largest disruption since World War II, transforming from a traditional car business into a connected vehicle ecosystem. Cars will soon connect to data centers and road infrastructure, eventually allowing them to communicate with one another, integrating into a vast transportation network. As a result, car manufacturers are beginning to design their own chips. However, they often lack the necessary volume and expertise, leading them to seek assistance from semiconductor partners. These manufacturers are defining the architecture since the primary investment in this shift is in software. Unlike the past, where chip makers like Intel released a chip for developers to program, manufacturers now focus heavily on software investments while designing Systems on Chip (SoCs) to optimize that software's performance and efficiency, addressing the limitations present in vehicles. Companies are not looking to create their own network-on-chip or processors; instead, they seek SoCs that can effectively run their software. This shift presents significant opportunities for commercial systems and IP usage in these designs, expanding the addressable market for companies like Arteris. We are fortunate to hold a strong position in the automotive sector and are dedicated to enhancing that position by collaborating with our customers and partners to deliver the technologies and features required for creating high-quality SoCs that can support advanced software needs.

Okay. Got it. And then just, typically, you guys introduce a new product around the end of the year, and I think the next one is going to be based around loosely IP-XACT. I was just wondering if you could give us an update on sort of the new product momentum here.

So we're very excited about our product pipeline. We're not ready to make any announcements or even to say what it is, but we would probably make some announcements, some early access deliveries probably sometime in the quarter and make announcements later on. So we're on track to meeting the one product per year commitment. And of course, the revenue impact will be 2023.

And we have a follow-up question from Mark Lipacis with Jefferies LLC.

Great. Charlie, could you discuss the Microchip announcement from five days ago? It appears to be related to FlexNoC. I'm curious about the opportunity to expand into other IP offerings beyond FlexNoC. In the press release, you mentioned looking forward to collaborating with additional design teams. Can you elaborate on that comment? Are you already initiating that engagement process? What should we keep in mind as we look ahead?

Yes. So we're not authorized to say what the initial application is. But the Microchip relationship is pretty much similar to others, where we sort of break in on the most complex, most difficult designs. And then over time, we expand into other teams doing perhaps less sophisticated-type designs. And so we're working to make that happen in Microchip as well as at other companies. So yes, it's a major relationship that has a start at a relatively focused application and then that we hope to expand from there.

Got you. And is this something that you had been working on for a while before you received approval to announce the customer? Or is it something that just recently happened, allowing you to make the announcement immediately?

Yes, this instance had a relatively short design cycle. It exemplifies a trend where design win cycles are becoming shorter compared to a couple of years ago. As our company's reputation grows, particularly following the IPO and other factors, we are making progress. Our ultimate goal is to establish ourselves as the standard for system IP solutions.

We have a follow-up question from the line of Hans Mosesmann with Rosenblatt Securities.

Nick, on gross margins, the implied gross margin from your guidance is over 92%. Is that something that we should assume is sustainable into the following year?

Yes, that's a great question. We've always indicated that our gross margins would fall between 90% and 95%, so this aligns well with our expectations. The primary cost associated with revenue is from field applications engineers, and that can vary slightly based on our accounting methods. Therefore, I believe that the midpoint of 92.5%, which is within the 90% to 95% range, represents a solid long-term planning figure, and it's essentially where we landed this quarter.

There are no further questions at this time. I will now turn the call over to Charlie Janac for closing remarks.

Thank you for joining us today. We appreciate the great questions, and we look forward to keeping you updated on the future progress of Arteris IP. Thank you very much.

That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.