Silicom Ltd. Q4 FY2021 Earnings Call

Thank you, operator. I want to welcome everyone to Silicom's Fourth Quarter and Full Year 2021 Results Conference Call. Before we begin, I would like to highlight the safe harbor statement. This conference call includes projections or forward-looking statements about future events or the company's performance. These statements are predictions and may change over time. Silicom does not have an obligation to update this information. Actual events or results may differ significantly from those projected due to factors such as our increasing reliance on a small number of customers for revenue growth in the evolving cloud-based SD-WAN, NFV, and Edge markets, the speed at which solutions are adopted, the likelihood of relying more on customers offering solutions in these markets, challenges in marketing silicon products and services, maintaining brand protection and IP, competition, disruptions in manufacturing and development, and broader economic disruptions related to the COVID-19 pandemic, among other factors identified in the company's SEC filings. Additionally, after the company's disclosure of certain non-GAAP financial measures in today's earnings release, we will discuss those measures during this call. Management utilizes these measures to make strategic decisions, forecast future results, and evaluate current performance. They believe presenting non-GAAP financial measures is beneficial for investors' understanding of the company's core operations and future prospects. Unless stated otherwise, it can be assumed that the financials discussed in today's call will be on a non-GAAP basis. The non-GAAP measures provided by management are additional information for investors to assess our financial condition and operating results and do not replace GAAP. A complete reconciliation of non-GAAP to GAAP measures is included in today's press release, available on Silicom's website. Joining us today are Mr. Shaike Orbach, CEO; and Mr. Eran Gilad, CFO. Shaike will start with an overview of the results, followed by Eran who will analyze the financials. After that, we will open the floor for questions. Now, I will hand the call over to Shaike. Shaike, please proceed.

Thank you, Kenny. I would like to welcome all of you to our financial results conference call discussing our fourth quarter and summarizing our full year 2021 results. We are very pleased with the solid results of the fourth quarter, which were ahead of our targets as well as the strong results for 2021 in what has been, again, not an easy year for anybody. For the quarter, we reported a 10% sequential growth and year-over-year growth of 7% in revenues to $36.3 million, ahead of our expectations of between $34 million and $36 million. For 2021, we reported a solid 20% year-over-year growth in revenues to $128.5 million at the high end of our $120 million to $130 million range issued at this time last year. Performance, we are very pleased with. Looking back at 2021, we would define this year as a key inflection point in the demand for our products in which Silicom returned to strong growth. We are all the more pleased with our 2021 performance, delivering what we originally were targeting against a progressively worsening background of component shortages and tight supply chains throughout the year that all in our industry experienced. We placed significant effort throughout the year into maximizing what we were able to manufacture and deliver, meeting as much of the high demand as possible. Demand is in excess of what is currently possible to supply and underlies my optimism as we exit 2021 that we are at a real inflection point of growth for Silicom. In fact, without the component shortages, which negatively impacted our revenues by a few million dollars, we would have reported full year 2021 revenue well ahead of the guidance range we issued last year. I will provide a more detailed update on the shortage in a few moments as well as our guidance for the upcoming quarter. We have reported our 68th quarter of continued profitability with net income of $4.5 million, up 25% sequentially and 14% year-over-year, while earnings per share was at $0.65, up 25% sequentially and 16% year-over-year. Looking at 2021 as a whole, we reported net income of $14 million, up 27% year-over-year and EPS of $2.01, up 31% year-over-year. I would like to highlight an important aspect of the results. While in 2020, we reported $10.6 million in operating income at a margin of 9.9%. In 2021, we reported $15.9 million, an increase of 50% as an improved operating margin of 12.4%. This was due in part to our 20% growth in revenue while only needing to grow OpEx by 14%. This demonstrates the strong operating leverage inherent to our business model. In terms of shareholder value creation, our strong balance sheet and cash generation allowed us to continue our current $15 million share buyback program and we purchased $3.6 million in Silicom shares in the quarter. I note that since we started our share buyback programs in May 2019, we have purchased $39.1 million in Silicom shares. At the end of the quarter, we had over $61 million in net cash on the balance sheet. The source of our growth continues to be the disaggregation and decoupling trend, representing one of the most significant transitions of IT architecture in recent history. We have been preparing for this trend over the past 5 years, developing critical technologies and products needed for its success while building important relationships with hardware and software partners. The markets to which these trends play into are the growing SD-WAN market and the developing 5G O-RAN market. The SD-WAN market is at the growth phase of its life cycle and is today contributing tens of billions of dollars to our revenues. The 5G O-RAN market is still in its early development and introduction phase. And once this market starts to move into the growth phase, we anticipate it will also begin to contribute significantly to our growth as has been the case with SD-WAN. We introduced our SD-WAN Edge product in 2016. And now, 5 years later, we have built a full circle of telcos, OEMs, as well as partnerships and significant collaborations, including AT&T and Intel. Our partners are divided into 2 types: software and hardware. Having Intel as our hardware partner is a big advantage. Intel is the major supplier of x86 CPUs, the main building block of most SD-WAN platforms. Furthermore, working hand-in-hand with software partners and validating our systems with various SD-WAN application software is crucial in this world of decoupled hardware and software. These collaborations play a major factor in our success in this market. The success that we see with SD-WAN makes us optimistic about our future potential success in other similar markets like the 5G O-RAN market, which are endorsing the disaggregated and decoupling approach. As we have already achieved with SD-WAN, it is also important for us to build a strong ecosystem of customers and partners in the 5G O-RAN market. During 2021, we had impressive momentum on this front. In only 1 year, we have already achieved wins with Tier 1 telcos, service providers, and a leading mobile infrastructure supplier. And we believe this number will grow significantly as O-RAN enters the mainstream. As such, with our partnerships in place and with the additional products and opportunities in the pipeline, we can see the design wins achieved so far are just the tip of the iceberg. And looking out over the coming few years, 5G O-RAN has the potential to add significant traction to the growth of Silicom. Looking back at our business performance in 2021, I would like to elaborate on 3 major Edge design wins achieved in 2021 to stress their significant potential as growth drivers for Silicom. The one we announced in May 2021 was with a telco giant Telefonica, which plans to start deployments this year, so the impact of this design win is still ahead of us. The second one announced in October 2021 is a design win from a U.S.-based giant, which supplies infrastructure equipment to many telcos and service providers globally. This customer is already a very active player in the SD-WAN market, where it supplies both SD-WAN hardware and software. The customer selected our SD-WAN Smart platform for its branded solution while forecasting a run rate of tens of millions per year in full ramp-up. Besides the confirmation it gives to our product and strategy, it also represents a huge future potential as deployments will start this year. Finally, I would like to highlight our key design win in November demonstrating the importance of the close relationship as well as the ongoing support and communication that characterize all of our client interactions. We announced that an existing customer, which is a leading North American telco service provider, awarded us with a major design win with a potential to reach a steady-state run rate of $50 million per year for a customized version of our Edge Smart platform. We announced that the company has placed $30 million in purchase orders for equipment planned to be delivered primarily during the current year. Just a year ago, when we originally started working with this customer, its orders of our products were for relatively standard platforms, and were at the rate of just a few million dollars per year. But as our relationship developed, we became aware of more and more opportunities, which ultimately led to this major design win, one that is approximately 10x as large as the original. Beyond this, we believe there is further upside from this customer, and we are discussing additional significant opportunities. Specifically with this customer, a part of our role is to optimize for component availability. Given the unpredictable behavior of the component crisis and the customers' need to deploy the platforms under a tight schedule. In fact, we believe that our ability to carefully balance and optimize for availability on the one hand, while supporting the customer with the industry's best connectivity solutions on the other hand, helped us with this deal and our unique advantages of our value proposition. More broadly, we continue to see protracted delivery lead times for electronic components as we move into 2022, and this continues to remain a major issue in our industry. Looking ahead, we see this issue remaining with us throughout 2022 and possibly even beyond that. However, on the positive side, we've already had much of 2021 to work on mitigating these risks and our achievement of 20% year-over-year revenue growth with 50% operating income growth under these conditions demonstrate that we have done so successfully, which is why we're optimistic for 2022 as well. The steps we've taken and continue to take are leveraging our strong balance sheet to build up our inventory of raw materials carefully backed by customers, POs and commitments, buying available stock of components both from the vendors and in the free market and expediting delivery if need be; two, working with customers on optimizing availability and providing them with alternative solutions, for example, replacing products, the delivery of which is challenging with other products with better availability; three, redesigning products to use more available components to achieve optimized availability. Obviously, when designing new products, our current initial criteria is optimizing for component availability. Moving forward, while we predict that the shortages will persist, despite it, given our experience and success in dealing with the issue, combined with a very strong market demand for our connectivity solutions, and our broad range in increasingly large design wins, all this supports our expectations for continued solid double-digit growth rates for 2022 and beyond, which brings me to our guidance for 2022. For the first quarter of 2022, our actual revenues will be impacted by 2 opposing forces. The dramatic growth in demand for our products on one side, and the delivery constraints created by the global components crisis on the other. This makes a forecast slightly harder to pin down. So we're being a little more careful and providing a wider guidance range than we normally do. With that, for the first quarter, we expect revenues of between $31 million and $33 million, which at the midpoint represents growth of approximately 10% over that of the first quarter of 2021. I would like to note that these growth rates represent our estimates as to the level of our success in indeed mitigating the component situation; there been no such situation, our forecast would have been much higher. In summary, we see Silicom having now crossed a new growth inflection point, and we believe that Silicom will see double-digit compounded revenue growth for the coming few years. Our expectations are built on the recent major design wins the scale of which is well ahead of what we have traditionally experienced and provides us with strong revenue visibility over many quarters and even years. As we move into 2022, we already see a sustained long-term revenue growth path with further upside potential as we continue to successfully cement and broaden our relationship with some of the world's largest companies. More broadly, our long and growing list of design wins generating ongoing orders, our solid baseline of activities and strong market fundamentals with our focus on some of the fastest-growing markets in the networking space, as well as our current long and deep pipeline make us increasingly optimistic as time passes. With that, I will now hand over the call to Eran for a detailed review of the quarter's results. Eran, please go ahead.

Thank you, Shaike, and hello, everyone. Revenues for the fourth quarter of 2021 were $36.3 million compared with revenues of $33.9 million as reported in the fourth quarter of last year and $32.9 million as reported in the prior quarter. Our geographical revenue breakdown over the last 12 months was as follows: North America, 69%; Europe and Israel, 23%; Far East and Rest of the World, 8%. During the last 12 months, our top 3 customers together accounted for about 30% of our revenues. I will be presenting the rest of the financial results on a non-GAAP basis, which excludes the noncash compensation expenses in respect of options and RCUs granted to directors, officers and employees, acquisition-related adjustments, lease liabilities, financial expenses, as well as impairment of intangible assets. For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the fourth quarter of 2021 was $12.7 million, representing a gross margin of 34.9% in the upper part of the range of our gross margin guidance of 32% to 36% and compared to a gross profit of $11.4 million or gross margin of 33.6% in the fourth quarter of 2020. The variance in the gross margin is a function of the specific product mix sold in the quarter. Operating expenses in the fourth quarter of 2021 were $7.5 million, similar to the $7.5 million reported in the first quarter of 2020. Operating income for the fourth quarter of 2021 was $5.1 million, an increase of 31% compared to operating income of $3.9 million as reported in the fourth quarter of 2020. Net income for the quarter was $4.5 million, an increase of 14% compared to $4 million in the fourth quarter of 2020. Earnings per diluted share in the quarter was $0.65. This is a year-over-year increase of 16% compared with EPS of $0.56 as reported in the fourth quarter of last year. Now turning to the balance sheet. As of December 31, 2021, the company's cash, cash equivalents, and marketable securities totaled $61.3 million with no debt or $9.14 per outstanding share. During the quarter, we further executed on our third $15 million share buyback plan, which we started on May 4, 2021. During the fourth quarter, we purchased approximately 81,000 shares at a total cost of $3.6 million. That ends my summary. I would like to hand back over to the operator for the question-and-answer session.

The first question is from Alex Henderson of Needham & Company.

You guys are really executing superbly against a tough backdrop. I wanted to talk a little bit about the gross margin risk associated with component costs and how you're mitigating it. Obviously, you're doing such a great job on it. I think you guys have partnered with your customers, giving them the option to help you buy these components and not running that incremental cost through your income statement in terms of either revenue or margin impact. Can you talk a little bit about what you're doing there?

Yes. I mean there are several parts to that. First of all, indeed, we have a very close relationship with all of our customers. And that means that we're discussing this issue openly and very transparently with them. And yes, you're right. I mean because we are transparent with them, and they are aware, of course, of the situation. So in most cases, we're able, first of all, to make sure that the customer is actually undertaking the additional cost when it's significant. I mean, there are many cases where we are helping our customers. And then we are absorbing some of that. But when the extra costs are significant, our customers are coming into that and they're helping with that. Now yes, you're right. I mean we're not increasing our revenues due to that. I mean, even though they're helping us, we're not using this increase to increase our revenues artificially by doing that. And either they're buying that or we're finding a way that we just, I would say, taking that out of the revenues and the expenses because they are paying for that directly or any other mechanism like that. So I would say that overall, the increased cost does have a certain impact on our cost, and it should actually reduce our margins, but because of the mix of products, etc., you don't see that because we're doing that. This is happening only where the increase in cost is really minimal. When it's more than that, we're working on that together with our customers.

That's very helpful. And one of the companies that we follow, F5 Networks, reported the other night, and they specifically called out a significant erosion in the availability of parts with a 35% jump month-to-month in decommits and then went on to say that they had been buying some components in the spot market, and the spot market has completely dried up. You can't get anything. There's just nothing to be had. Have you seen any change in the supply chain availability of the components that are critical to your product or any other change in the environment over the last months?

I can't say that we've observed a change. The situation remains highly challenging. However, we are becoming more knowledgeable about the circumstances and are preparing ourselves better. This includes various measures I mentioned earlier. As I've stated, we do not see any improvement in the situation. We continue to face decommits and long lead times. We're becoming accustomed to this reality. We're starting to consider replacement components earlier and initiating redesigns sooner, particularly as demand is increasing. Consequently, we have more to manage, which is why the overall situation remains difficult. On the positive side, we are optimistic because this has become our regular focus these days.

The timeline of ramping these large contracts that you've gotten? Has there been any slippage or any pull forward or any change in the magnitude that you're expecting to in terms of available demand in 2022?

I mean we are on track with these projects. But it took some decisions that we had to make together with the customer along the way. I mean, we could have had to change a certain element of the specification in order to do something a little bit different, which is, once again, what we're doing in order to overcome all these challenges. But right now, we're on track with major products, major wins.

Below the line, there's a couple of things that were a little different than what we'd expected, assuming we plugged these currently, but the interest income took a little bit of a dive on seeing that at $193,000 cost as opposed to an income, which is normally what you see in that line. Can you tell us, a, what happened in there; and b, whether that should go back to an income in the March quarter?

Can you repeat, please, your question?

Yes. On the financial income line, we're showing $193,000 cost. We had expected a slight income, and it's normally an income. It looks like it spiked down somewhat. Can you talk about whether you expect that to go back to an income in the first half of '22?

Yes, I can. In the fourth quarter of 2021, we experienced a negative impact from exchange rate fluctuations totaling about $300,000. This shift caused us to move from a slight positive income to a loss. Predicting future outcomes is challenging, as exchange rate variations could significantly influence our financial income. Therefore, it is difficult to make definitive forecasts at this moment. Without considering the effects of exchange rate differences, we would expect an income of roughly $100,000 to $150,000. However, with those effects included, we cannot provide an estimate.

Understood. The tax rate also came in lower than normal. What tax rate should we consider for 2022? I assume it's around 15%. Is that correct?

Yes. Indeed, the effective tax rate in quarter four was lower than usual. This is due to very specific reasons for the quarter. I keep saying that the effective tax rate should be around 15%, a little bit more, a little bit less, but still in the range of 15%.

The costs, a lot of companies are seeing around wage inflation and staffing churn, have escalated the OpEx costs at a lot of companies. You guys seem to be able to mitigate that a lot more than most. Have you seen any impact on churn that's increased compared to, say, the 2019 staffing churn rates? And have you seen any change in wage inflation? My assumption is that you guys are able to hold on to people better than most companies because you have such a long-tenured group of employees. But can you give us any thoughts on churn of staffing and wage inflation?

Yes. Well, I think you're right. I mean we are able, I would say, to have a quite high retention rate of our employees. And I believe that this is because we have the reputation of a stable company, which holds and protects its employees, not only in good times but also in bad times. And I believe that this is why people are staying with our company probably for longer than they do with other companies. That being said, I would say that, yes, I mean, we're aware of what's going on. I mean, for example, getting new employees is becoming more difficult. And you need to pay more on the one hand, while on the other hand, you don't want to do that because you do not want to change the structure of the current wages that we're paying within the company. So I would say that overall, this is one of our challenges these days, but I would say also that it's a managed challenge, and we are able to eventually hire the people that we need or find ways to sometimes outsource or whatever, manage it in the right way so that the impact. The overall impact on OpEx, while I wouldn't say that it's 0, but we keep it to a minimum.

On top of that, I would like to add that in quarter four, as in the quarters before quarter four, there was a negative effect of exchange rate.

Yes, that's for sure.

The negative effect in quarter four due to the Shekel and the Danish krone was approximately $150,000. The exchange rate on December 31, the last day of the year, was particularly low, leading to a negative impact of around $150,000.

All right. The good news is that it's come back in since then. So hopefully, that will help you going forward. In terms of the pipeline of new opportunities beyond what you've already announced, it sounds like you've got roughly 6 major contract wins that are in one form or another positioned to ramp that are very significant in revenue. What's the rest of the pipeline look like for additional opportunities?

We have a strong pipeline of additional opportunities, including several large ones. Beyond what we've already announced, we have a substantial pipeline primarily focused on Edge opportunities, as well as the smart mix, particularly the 5G accelerators, with more customers expressing interest. We are currently designing the next generation of that card, and we have a significant pipeline in that area as well.

One last question then I'll see to the floor. 5G open RAN opportunities. Can you just talk a little bit more about where you are relative to winning those and when you think those might ramp?

In 5G, we are engaged in several initiatives. We are currently selling a 5G accelerator that operates within O-RAN, which contributed to our growth in 2021. We're providing this to a major telecommunications company and a significant service provider. Additionally, we have a win with a major equipment provider, which has not yet started ramping up. There are several customers in our pipeline as well. This offering consists of a range of solutions with various form factors and generations. Although we are already making sales, it's important to note that 5G and O-RAN are still in the early stages of deployment, and we expect significant growth from these solutions both this year and beyond. Moreover, we are investing in a time synchronization card that is currently being evaluated by many leading companies, including OEMs and telcos. We hope to achieve success with this product, which could yield quantities similar to those of the previously mentioned accelerator, but it carries a higher price point, resulting in greater revenue potential. Additionally, we have other smart cards in our pipeline that meet the demands of 5G. Overall, we view 5G and O-RAN as critical to our strategy. Even without the anticipated growth in 5G, we expect the Edge to remain a significant growth driver for us. We believe we can achieve double-digit growth this year and next year, provided we manage component prices as we have this year. Therefore, the potential of 5G and associated technologies will be an added benefit.

I just want to confirm that I understand correctly. We had initially thought that you had five major contract wins in the current year, and now there's an additional one that came in during the fourth quarter, bringing the total to six. Can you clarify if that's accurate?

It's a bit challenging to provide an exact number because there's varying significance among our wins. We obviously have many more than just five, and while you may have calculated the wins more accurately than I have, I can say that we definitely have at least five or maybe six key customers. I would like to confirm that. Additionally, some other clients, while perhaps slightly less significant, are still important due to our ongoing relationships with them. We are collaborating with all of them on further opportunities, and it's possible that one of these clients could emerge as a top contender in the next quarter.

There are no further questions at this time. Before I ask Mr. Orbach to proceed with his closing statement, I want to remind participants that a replay of this call will be available by tomorrow on Silicom's website. Mr. Orbach, would you like to make your concluding statement?

Yes. Operator, we actually have a follow-up question from Alex, if you want to take it?

Yes, sure. Alex, please go ahead.

Yes. I was expecting there to be someone else asking questions, so I wanted to be respectful. Since there aren't any more questions, I have a couple that I would like to address. Can you discuss any competitive issues or changes in the competitive landscape? Have you noticed any emerging alternatives in the major projects you're working on, or do you still feel you are uniquely positioned?

Let me break down my response about the different markets we are focusing on, especially the ones that are expanding for us. Firstly, regarding the Edge, we haven't identified any new competitors. One key factor behind our success in the Edge market is the years of effort we've put in. We entered this space around six years ago, and it takes time for the community and for us to reach our current status in the OEM market. I believe that by now, they recognize and respect our technology and solutions. Consequently, I feel our competitive position has greatly improved, which is why we are securing more wins. This improvement aligns with the market’s growth, so it's a combination of both factors. As the market expands, I believe our market share is increasing, and our potential customers are becoming more familiar with us, which further supports our competitive situation. Now, moving on to 5G and O-RAN, the scenario is somewhat the reverse. In the Edge space, we were late to enter because we were addressing a market previously served by competitors. However, with the O-RAN accelerators and the time synchronization organization, we are currently leading this market. We do see some competition emerging, but they haven't reached our level yet. At the moment, it's primarily us in this market, which makes securing wins relatively straightforward for those seeking cost-effective solutions. Nevertheless, the overall market is still in its early stages, so its size isn't substantial yet. As this market begins to grow, I believe we will continue to lead, even though competition will increase. Overall, I predict that our revenues in this sector will rise significantly, but so will the competition, as we cannot capture the entire market.

If there was a magic wand that we were able to wave over the industry, and supply chains were completely normalized overnight. Would you be producing 20% to 30% revenue growth or more?

Yes.

Can you quantify how much of the growth you are modeling, like 15%?

Yes. I mean, I don't know exactly, but you ask 20% or 30% or more. So you can delete the 20%.

Okay. And going back to the gross margin side of it. Obviously, these larger contracts do represent much higher volumes, higher volumes are great at driving revenue, but they often come with some margin compression. As we look at the gross margin outlook based on the current environment that you see and the constraints that you see, is it reasonable to think that the gross margins will be comparable to or just slightly lower than where you are today? I know you've got a very wide band out there, but that band is a little lighter than I'd like to forecast to. So can you talk a little bit about what you think is going to happen on GMs?

Yes, I find it challenging to specifically narrow down our outlook, which has indicated margins between 32% and 36%. This is due to various factors affecting that range. On one hand, as our contracts grow larger, the margins have been decreasing somewhat. However, as we expand, our efficiency improves and some of our fixed expenses, which factor into the margin calculations, are decreasing, leading to modest improvements. Additionally, the product mix also plays a role. Therefore, for 2022, I can only state that the margins are still expected to remain between 32% and 36%, and I cannot make a precise prediction within that range.

If we guess at, say, 34% for the two years, is that a reasonable...?

I think that's reasonable.

And then on the OpEx side, obviously, the shekel pressured your OpEx last year quite a bit. With the shekel now stabilizing a little bit more, particularly of late, are we talking about 5% to 10% growth in OpEx against, say, a 15% revenue growth rate? Is that kind of the right way to think about it?

I think the OpEx will be a little higher, more or less in the areas that you have mentioned. Yes, I mean, I don't believe it will be 10% higher, but, yes, 5%.

I've exhausted those questions. The only last one would be on the balance sheet side. Do you think you will generate net cash over the course of the year recognizing that you're still doing buybacks?

Well, I think that the ability to generate cash really is very much dependent on the status of the components crisis. And I think that due to the component crisis as long as it grows, we're buying. We're increasing our stock. We are increasing our revenues. So we want to be prepared for that. And unlike, I would say, regular kinds, we're not just buying under the theme of just in time because many vendors decommit. So whenever we feel pretty confident about the revenues which are coming, we're buying everything. So we're increasing inventory quite significantly. And that's obviously something which is difficult from a cash generation perspective. But I would say that once this crisis is over, and as I'm really confident about our growth and the continuation of such growth, that would be the time that we would definitely come again to generate cash even when we go ahead with the buyback.

Mr. Orbach, would you like to make your concluding statement?

Yes. Thank you, operator. Thank you, everybody, for joining the call. We wish you all health, and we look forward to hosting you on our next call in 3 months' time. Good day.

This concludes Silicom's Fourth Quarter 2021 Results Conference Call. Thank you for your participation. You may go ahead and disconnect.