Earnings Call Transcript - SILC Q2 2022

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom Second Quarter 2022 Results Conference Call. All participants are present in listen-only mode. As a reminder, this conference is being recorded. You should have all received by now the company's press release. If you have not received it, please contact Silicom's Investor Relations team at EK Global Investor Relations at 1-212-378-8040 or view it in the news section of the company's website, www.silicom-usa.com. I would now like to hand over the call to Mr. Kenny Green, EK Global Investor Relations. Mr. Green, would you like to begin, please.

Kenny Green, Investor Relations

Thank you, operator. I would like to welcome all of you to Silicom's Second Quarter 2022 Results Conference Call. Before we start, I would like to draw your attention to the following Safe Harbor statement. This call contains projections or other forward-looking statements regarding future events or the future performance of the company. These statements are only predictions and may change as time passes. Silicom does not assume any obligation to update that information. Actual events or results may differ materially from those projected, including as a result of Silicom's increasing dependence on a limited number of customers in the evolving cloud-based SD-WAN, NFV and Edge markets, the speed and extent to which solutions are adopted by these markets, the likelihood that we will rely increasingly on customers which provide solutions in these evolving markets, resulting in an increasing dependence on a smaller number of larger customers; difficulty in commercializing and marketing Silicom's products and services, protecting brand recognition, protection of Intellectual Property, competition, shortages of component supply disruptions to our manufacturing and development, along with general disruptions to the entire world economy relating to the spread of the novel coronavirus and other factors identified in the documents filed by the company with the SEC. Following the company's disclosure of certain non-GAAP financial measures in today's earnings release, such non-GAAP financial measures will be discussed during this call. These non-GAAP financial measures are used by management to make strategic decisions, forecast future results and evaluate the company's current performance. Management believes that the presentation of these non-GAAP financial measures is useful to investors' understanding and assessment of the company's ongoing core operations. Unless otherwise stated, it should be assumed that the financial measures in this conference call will be on a non-GAAP basis. Non-GAAP financial measures disclosed by management are provided as additional information to investors in order to provide them with an alternative method for assessing our financial condition and operating results. These measures are not in accordance with or a substitute for GAAP. A full reconciliation of GAAP to non-GAAP financial measures are included in today's press release, which you can find on Silicom's website. With us on the line today are Mr. Liron Eizenman, President and CEO; and Mr. Eran Gilad, CFO. Liron will begin with an overview of the financial results, followed by Eran, who will provide the analysis of the financials. We will then turn over the call to the question-and-answer session. And with that, I would now like to hand the call over to Liron. Liron, please go ahead.

Liron Eizenman, CEO

Thank you, Kenny. I would like to welcome all of you to our financial results conference call discussing our second quarter 2022 results. This is my first quarter as CEO of Silicom after working for many years as COO of Silicom and CEO of our North American subsidiary. I would like to thank the Board for their confidence in my ability to lead Silicom ahead. Shaike Orbach, our former CEO, still remains involved in Silicom as Executive Vice Chairman. My aim is to continue and build upon the success he has brought to Silicom over the many years. Now to provide a short summary of the results of the quarter. We are very pleased with our continued solid performance for the second quarter of 2022. The second quarter was a period of growth in revenues, margins and EPS, driven by stronger-than-ever demand for our product, coupled with attention to operational efficiency. We demonstrated 13% revenue growth year-over-year to $34 million at the center of our expected guidance range for the second quarter. Furthermore, quarter-end backlog stands at record levels for Silicom. Our revenue growth continues to reflect the accelerating transition of mainstream players from industrial and online retail giants to telcos and service providers to disaggregated and decoupled networks driving demand for Silicom's enabling solutions. With significantly improved gross and operating margins, we are very pleased to report our 70th quarter of continued profitability with net income of $4.7 million, which was up 61% year-over-year. All of that resulted in earnings per share of $0.70, a very significant 67% increase year-over-year. We are all the more pleased with those results despite the continued background of ongoing component shortages and tight supply chains. Had it not been for the shortages, revenues for us would have been strongly higher. We're maintaining a strong delivery rate in the face of the global shortages primarily through determined product and operational innovation and careful inventory management. As you know, we have worked very hard to overcome the global component shortages situation. Using more readily available components where possible and improving our internal manufacturing processes, maximizing what we're able to manufacture and deliver to customers, our strong year-over-year growth in revenue, solid improvement in gross and operating margins and ultimately strong profit growth shows that we have indeed been successful. The good news is that, to us, it appears that the global component shortages have now stabilized and are not worsening. We are working on the assumption of an improvement in component availability during the first half of 2023. The exceptionally strong market demand for our product is broad and is across our full product range. While last quarter, we discussed reaching our highest ever backlog, as of Q2 end, our backlog increased further. I want to point out that our inventory growth has been a strategic move on our part. It was driven by the high market demand that we are experiencing and record backlog level on one hand and the global component shortages on the other. The strongly increased inventory is designed to support the expected level of upcoming product sales in coming quarters and to ensure we maintain internal availability of components and parts. We see this inventory position as a strategic asset and significant competitive advantage. It allows us to serve our existing customers better, delivering products which are not easily available today while attracting new customers and new business, which I have difficulty finding product elsewhere. In today's market, this strategy will provide an excellent long-term return. In terms of our forward expectations, we believe that our inventory will peak in the coming few months and we will allow it to start declining towards year-end, depending on the development in the ongoing component shortages. We continue to capitalize on the most significant transitions of IT architecture in recent history. The trends of disaggregation in decoupling, the markets to which those trends play into the most notably, the current fast-growing edge market and the developing 5G/O-RAN market, both markets in which we have very strong capabilities and a competitive edge. The Edge market in general, including the SD-WAN segment of that market already contributes significantly to our revenues, which is further demonstrated by one of our recent wins and remains in growth phase. The 5G/O-RAN market is still in the early introduction phase. In the last several years, we have built a full circle of major U.S. and European telcos adopting our products as part of their disaggregation methodology. This success makes us optimistic about our future potential, especially with telcos and service providers, which has been endorsed in the disaggregated and decoupling approach. We believe it's still early days in the leading market sectors that we're active in. Discussion continues with a broad variety of telcos, networking equipment providers and partners regarding exciting new opportunities. I would like to discuss the recent design win we announced in May. An existing customer, one of the largest vendors in the SD-WAN market placed a new $15 million initial purchase order for SD-WAN Smart platform. At the same time, the customer informed us that they expect to order at the level of $25 million per year for the next several years. We see this win as a vote of confidence in our company and its products, reflecting our product innovation, quality, features and performance, as well as the unparalleled level of service that we provide to our customers. This acceleration of our business with one of the major customers reflects booming global demand for SD-WAN solutions, whereby companies of all types from telcos to industrials to retail are increasingly adopting. As we predicted when we initiated our SD-WAN strategy five years ago, this space is now becoming mainstream with the growing momentum of disaggregated and decoupled architectures, driving more and larger design wins for Silicom in each and every quarter. We believe feedback from the market confirms that this trend will continue, positioning us as a growing provider of must-have enabling building blocks for today's and tomorrow's data network. In terms of our guidance for the third quarter, we expect to show continued growth with revenues at between $38 million and $40 million, which at the midpoint represents growth of approximately 18% over that of the third quarter of 2021. I would note that this growth rate takes into account the continued component shortages situation and our estimates as to the level of our success in indeed mitigating it. If there had been no such situation, our forecast would have been significantly higher. Given the sheer size of our pipeline and the speed at which our markets are growing, we believe we remain positioned for strong multi-year growth. In summary, we remain very pleased with our performance in the second quarter and the first half of 2022. Even despite the ongoing component shortages, we continue to stand by our expectations. More broadly, our focus on some of the fastest-growing markets in the networking space, which are developing under the trends, which we had correctly predicted and positioned ourselves for as well as our long and deep pipeline makes us further optimistic. Looking forward, given the all-time record level of our pipeline and our reputation as a can-deliver provider despite challenges compounded by the speed with which our target markets are developing, we are well positioned for continued double-digit compound growth rates in the years ahead. With that, I will now hand over the call to Eran for a detailed review of the quarterly results. Eran, please go ahead.

Eran Gilad, CFO

Thank you, Liron, and hello, everyone. Revenues for the second quarter of 2022 were $34.2 million, compared with revenues of $30.3 million as reported in the second quarter of last year. Our geographical revenue breakdown over the last 12 months was as follows: North America, 69%; Europe and Israel, 25%; and the rest of the World, 6%. During the last 12 months, our top three customers together accounted for about 25% of our revenue. I will be presenting the rest of the financial results on a non-GAAP basis, which excludes the non-cash compensation expenses in respect of options and RSUs granted to directors, officers and employees, acquisition-related adjustments as well as lease liabilities, financial income. For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the second quarter of 2022 was $12.3 million, representing a gross margin of 36%, at the top of the range of our gross margin guidance of 32% to 36%, and compared to a gross profit of $10.8 million or gross margin of 35.8% in the second quarter of 2021. The variance in the gross margin is a function of the specific product mix sold in the quarter. Operating expenses in the second quarter of 2022 were $7.3 million, compared to $7.3 million reported in the second quarter of 2021. Operating income for the second quarter of 2022 was $5 million, representing an operating margin of 14.6% and an increase of 39%, compared to operating income of $3.6 million as reported in the second quarter of 2021. Net income for the second quarter was $4.7 million, representing a net margin of 13.8% and an increase of 61%, compared to net income of $2.9 million in the second quarter of 2021. Earnings per diluted share in the quarter were $0.70, a 67% increase, compared with EPS of $0.42 as reported in the second quarter of last year. Now turning to the balance sheet, as of June 30, 2022, the company's cash, cash equivalents, and marketable securities totaled $48.1 million with no debt or $7.17 per outstanding share. That ends my summary. I would like to hand back over to the operator for question-and-answer session.

Operator, Operator

Thank you. Ladies and gentlemen, we will begin the question-and-answer session. The first question is from Alex Henderson of Needham & Company. Please go ahead.

Alex Henderson, Analyst

Well, let me start off not with a question, but rather with a statement. Liron, I understand you've been a major driver of the company's development of the newer products and direction of the company that has been so successful. And it certainly seems like a clear correct move to bring you up to the CEO job, and congratulations on that. It's clearly well deserved.

Liron Eizenman, CEO

Thank you very much, Alex.

Alex Henderson, Analyst

Hey, more than welcome. So I wanted to just talk a little bit about the cost side of the equation a little bit. Obviously, the strong dollar is a major challenge to international revenues based in dollars because of the price increase it implies to customers. But you also benefit tremendously from the weak shekel and other currencies where your OpEx are. So I'm looking at the numbers for the June quarter, and they're actually down $370,000 on OpEx, which we had not really expected that kind of decline. So I was wondering if you could talk about whether that's a temporary blip and that it will be up again as we go into the second half of the year. How should we think about the declines in all three items, R&D, sales and marketing, and G&A?

Liron Eizenman, CEO

Yes, absolutely. So, I mean, the impact here really is the dollar. And since it's hard for us to predict what would be with the dollar in the future, we don't know how to answer that right now, but I can say our structure remains pretty much the same. We're not increasing too much or definitely not decreasing. If we'll have significant design wins, we may increase more. But right now the structure is pretty much the same, and the impact is the dollar itself.

Alex Henderson, Analyst

So we should be using about the same level of spending in the back half of the year as in the front half of the year? Or in the June quarter?

Liron Eizenman, CEO

Yes, I would expect that. Again, the function would be the dollar itself, but from a level of investment in Silicom, yes, the answer is it's going to be the same.

Alex Henderson, Analyst

So assuming a flat dollar, it should be sequentially fairly stable. Okay, going back to the gross margins. Obviously, you had a nice pop, 36%. Obviously, that's driven predominantly by mix. Should we be assuming it returns back towards that 34.5% level that you've been doing the last four, five quarters and normalizes in the back half?

Liron Eizenman, CEO

So we still expect to be in the same range. We've always been in 32% to 36%. This quarter specifically, there was a mix of products that caused it to go a little bit higher, but we still believe we're in the same range of 32% to 36%.

Alex Henderson, Analyst

All right. Broadly speaking, macro headwinds are the primary issue that people are dealing with in a lot of the networking companies from Cisco and Juniper, Extreme, just as an example. So they're running backlogs that were in from 40% to 100% of annual product revenues and that gives them a lot of insulation. I know you guys have had a lot of wins, but it really isn't a hard backlog in the same way that it is for the systems companies as components driven by projects and programs that could easily be deferred, delayed or stretched. Can you talk a little bit about the implications of the macro versus the projects that you have? How firm are they? What are the major project leaders been telling you about their intention to continue to deploy on schedule or maybe slow down those deployments because of the macro environment? And specifically, how much of that's U.S.-centric projects versus international?

Liron Eizenman, CEO

So at the moment, we do not see any immediate impact for one. I mean, specifically on Q3 and even more than that, we don't see an immediate impact, but we are feeling the hard bit and monitoring the status all the time. We're discussing with our customers very openly on that. We're hearing what they see. And at the moment, at least what we see is we don't see any impact at the moment. And we think that our highest ever backlog also shows that the demand and the fact that last quarter, we said it's the highest quarter, and now we say again that we have the highest ever backlog again. So that means that the orders that came in are continuing to come in. And from what we see and what we talk with our customers today, they continue, and their plan is to continue with the plans that we have with them.

Alex Henderson, Analyst

Just to clarify on the backlog. A lot of companies are providing the backlog numbers in order to get a sense of how large it is relative to the scope of their business. Is it plausible to think that you're looking at seeing 20% to 50% of product annual product sales in backlog?

Liron Eizenman, CEO

While we don't provide the exact numbers, I can tell you that the growth from the previous quarter was quite significant, but we're not providing those exact numbers.

Alex Henderson, Analyst

All right. One more question on the shekel and exchange rates. Can you just talk about how you're hedged both in terms of your operating costs as well as receivables?

Eran Gilad, CFO

The answer is very simple. We do not hedge anything.

Alex Henderson, Analyst

Right. So you're immediately benefiting from the sharp decline in the shekel, and that's why your OpEx has come down.

Eran Gilad, CFO

Exactly.

Alex Henderson, Analyst

Any thoughts on change in the tax rate or interest income line share count as we move forward?

Eran Gilad, CFO

No, no change. Indeed, the tax percentage in the quarter was somewhat lower compared to the average, but we still believe in the around 15% range.

Alex Henderson, Analyst

All right. Great. I'll see the floor at this point, but I will come back into the queue. So if there's additional opportunity to talk.

Liron Eizenman, CEO

Operator, let’s move onto the next question.

Operator, Operator

The next question is from Jeff Meyers from Cobia Capital. Please go ahead.

Jeff Meyers, Analyst

Hi, guys. Thank you. Congratulations on a nice quarter. Just had a quick question. Did you guys buy back any stock during the quarter? And if so, how much?

Eran Gilad, CFO

Yes, the buyback plan ended in April this quarter. How much in total the third buyback plan, it was about $12.5 million.

Jeff Meyers, Analyst

I see. And is there a thought to renew that, I guess, going forward?

Liron Eizenman, CEO

So when we look at our cash and what's the best use for that cash, at the moment, we feel that the best thing to do with that is to build it into our inventory, so we can be in the best position we can to build products and provide them to our customers. So that is our plan at the moment.

Jeff Meyers, Analyst

Got it, okay. Thank you, guys.

Kenny Green, Investor Relations

Operator, let’s move to the next questions.

Operator, Operator

Yes, the next question is from Shawn Boyd of Next Mark Capital. Please go ahead.

Shawn Boyd, Analyst

Good morning. Can you hear me, okay?

Liron Eizenman, CEO

Yes.

Shawn Boyd, Analyst

Great. I understand we're not giving exact numbers here on the backlog, but perhaps you can help us with bookings. Given what's going on in the macro over the past couple of quarters here. Are your bookings and your excitement in your pipeline continuing to be as strong as they were? Or has that ebbed at all? And how do you think that rolls out into Q3?

Liron Eizenman, CEO

We consistently engage with our customers and are very focused on understanding their needs, especially now that we are traveling more and meeting them face-to-face. We notice a strong pipeline and believe that the design wins we've accumulated over the past few quarters, which are beginning to ramp up to varying degrees, will continue to do so. We have strong confidence in both our pipeline and backlog.

Shawn Boyd, Analyst

Okay. Very good, very good. So taking that kind of to the next level and thinking about that product going to the P&L and starting to see shipments there. On the component constraints, you mentioned that the situation has stabilized, no longer worsening. Now maybe we're just kind of at a bad level, but not getting better. Can you give us more color on that? What exactly are you seeing that tells you that? What gives you the confidence that we'll start to see those constraints ease? I guess if I heard it right, you think they're easing later in Q3 and Q4, but any more color you can give us specifically on that would be helpful.

Liron Eizenman, CEO

So first of all, we don't see that easing yet. We see that it's not getting worse, and our assumption is that it will remain until the end of the year at least. We hope that we'll start seeing improvement in 2023, but at least for 2022, our assumption and what we see right now is that it's going to be hopefully flat and not worse. The way that we understand the market is, again, a lot of work talking with suppliers, talking with suppliers' suppliers, talking with Silicom's vendors, talking with other manufacturers in the market, talking with distributors, just trying to understand what they see in their backlog. Do they see pushouts still? Are they seeing the lead times of the covenants going down or up or flat? Based on all of that, we kind of get an understanding of what we believe is going to happen in the component market. And our assumption, as I said, for now is 2022 will not get worse and that we are now going to be about flat with the lead times and the availability of the product. And in 2023, we hope to see improvement.

Shawn Boyd, Analyst

Okay. And just last question along this line is so far, have you had any cancellations? Have you had any customers where you have major wins where they've given the weaker macro and just time delays that are caused by these component constraints where they've basically pulled off and said, okay, we're going to revamp these plans? We're going to go elsewhere or we're just not going to do this program?

Liron Eizenman, CEO

Definitely not for the big programs. You may have some insignificance here and there, but none of our major design wins is nowhere near the situation.

Shawn Boyd, Analyst

Very good. And thank you for the additional color, guys.

Eran Gilad, CFO

Thank you, Shawn.

Liron Eizenman, CEO

Thank you.

Operator, Operator

Next question is a follow-up question from Alex Henderson of Needham & Company. Please go ahead.

Alex Henderson, Analyst

Great. I was hoping to talk a little bit about the employment environment that you're in, to what extent you're seeing churn and staffing, I assume that it's very stable, because that's the history of the company. And I know people tend to be there a long time. But have you seen any acceleration in churn? And when do you have annual bonus increases when? What are you doing on the compensation side? Obviously, the strong dollars also creating inflation in various geographies that leads to offset with compensation. So how should we think about the compensation going up given the backdrop?

Liron Eizenman, CEO

We are very pleased with the situation. I mean, we do not see significant churn even at all, I would say. Compared to what we see from around us and certain companies, we're very pleased with that. And from a bonus perspective and compensation perspective, we continue with the policy that pretty much we always had and continue to understand where we are compared to the market, but we don't expect to see any significant impact on that or on the P&L or anything of that sort.

Alex Henderson, Analyst

The annual compensation reviews and escalation generally is in the March quarter, is that correct?

Liron Eizenman, CEO

Usually, we conduct it at the end of the year, but it can vary from year to year.

Alex Henderson, Analyst

Okay. And going back to the components side of it. Can you talk a little bit about what's going on with your FGA PGA products? Are you seeing any traction with those? I know that the semi market has been complicated, but it's hard for us to put that into context with your FPGAs. Has there been any improvement there?

Liron Eizenman, CEO

Yes. I mean, there's definitely a few developments there. We continue our very close work with Intel on that. We have some opportunities that came maybe as part of COVID. Some, as we mentioned, some other suppliers are unable to provide products to their customers, so they're turning to us. Definitely, there are some opportunities here, some wins we've managed to do over the last few months. And we expect there to be growth, but the growth should be smaller than some other areas of our business. But we definitely see growth there as well.

Alex Henderson, Analyst

Another question around the trajectory of the top line. Historically, you've had a pretty nice pop into the fourth quarter and then a seasonal much softer March quarter. Clearly, the supply constraints make that seasonal pattern a little bit less likely. Should we be thinking about the fourth quarter as being more of a continuation of the sequential pattern over the course of the year and maybe not as much of a pop in the fourth quarter or as much as the decline in the first quarter? How should we be thinking about that piece of the equation, which is, I think, more supply chain driven than demand driven?

Liron Eizenman, CEO

We expect it to continue, I would say, pretty much at the same rate. We do not see a huge pop coming in. As I said, that we do not expect the supply chain situation to ease completely in Q4 and suddenly, we'll have all the components that we need to build all the products that we want. So, we think it's going to be growth, it's going to be pretty much at the same level that we've seen so far. Significant is in supply chain. We do not expect before 2023. So I expect this trend to continue of growth as pretty much similar to what we've seen so far.

Alex Henderson, Analyst

So that seasonality into the first quarter, the sequential decline that you've historically seen, which has been relatively steep. Is that something that we should anticipate again? Or is that the lack of full availability of parts make that smoother into the first quarter?

Liron Eizenman, CEO

I think it's too early for us to say at the moment about Q1, what our expectations are.

Alex Henderson, Analyst

Right, thank you.

Operator, Operator

The next question is from Robert Johnston from Herald Investment. Please go ahead.

Robert Johnston, Analyst

Good morning. Would you want to talk a little bit more about the two product areas and what you're seeing there demand-wise? And also, could you talk a bit more about the competitive landscape and what you're seeing there?

Liron Eizenman, CEO

Sure. First of all, I'll discuss the Edge. The Edge is one of our fastest-growing areas, and we've seen significant growth over the past few years. We believe it will be a major driver of our growth in the coming years as well. We have a clear advantage due to our strong relationships with Silicom vendors, our professional team, and our capability to deliver products despite the challenging supply environment, which constantly presents us with problems to solve, including engineering challenges. We are redesigning as necessary, which has positioned us well for continued growth. There is also a lot of innovation happening in this area, which attracts customers, resulting in an increasing number of design wins. We are confident that this trend will persist. Regarding the other area you mentioned, which I assume refers to the 5G O-RAN, that market is still developing and is in its early stages. Many telecom companies are currently in the process of proof of concepts or initial deployments. We are involved in many of those efforts, and we expect this market to grow over the next few years, but it is lagging behind the Edge market that I just discussed.

Robert Johnston, Analyst

Terrific. And competitively in the two markets, anything incremental or?

Liron Eizenman, CEO

We definitely see the advantage. In the Edge market specifically, we have become a well-known name. Everyone recognizes Silicom in that area. We are present in every RFP or similar bidding opportunity. We offer a wide range of products and have a strong roadmap. The same applies to the 5G and O-RAN markets, and we feel very confident about our position there.

Robert Johnston, Analyst

And so your customers are looking for a single source multiple sources and how are they doing Silicom versus other providers in terms of having a consistent supply?

Liron Eizenman, CEO

Well, definitely, we're not the only one in the market, and there is competition there, but our close relationship with the Silicom vendors and the fact that in many cases, we are the first to the market and that we are very innovative in our products that we come with gives us an advantage. And obviously, our obsession with making our customers happy and the fact that we are able to supply and go a long way in order to provide our customers with products are positioning us well. But definitely, there is competition there.

Robert Johnston, Analyst

Okay. Pricing, it's stable or going up with a shortage of components or?

Liron Eizenman, CEO

We are not making significant changes to that. However, our margins indicate that we are still operating within the same range. We believe we will continue to remain in that range, so there should be no significant impact from this.

Robert Johnston, Analyst

Yes. You can see that, but I was wondering what you're noticing in terms of competition?

Liron Eizenman, CEO

It's a challenging environment, definitely. And we're not the only ones suffering from that. Our competition is in a similar situation, so all of us are trying to do the best. And I think that is also a situation right now where the customers are measuring which are those customers or suppliers who are able to deliver and they can trust in the long-term. But yes, it's a very challenging environment from a price perspective, from a supply perspective, yes. And I think it will remain so at least until the end of the year and later on as well.

Robert Johnston, Analyst

Great. For the last question about the 5G O-RAN, it's just beginning to enter the mainstream. What are your thoughts on when it will start to gain momentum? Is it related to component availability, timing, or what do you believe will be the key milestone that enables this market to accelerate?

Liron Eizenman, CEO

I believe it's a mix of factors. On one hand, there are components involved, but I wouldn't say that's the main limiting factor. The technology is progressing, and there's a CapEx versus OpEx consideration that many telecom companies are keen on adopting. I don't think there's a single telecom company globally that isn't exploring 5G and O-RAN. Some are further along than others, and some are observing the larger players to learn from their strategies. However, as I mentioned, it's still relatively early for this market. I expect 2023 to be a significant year, and we will begin to see increasing deployments in 2023, 2024, and beyond.

Robert Johnston, Analyst

Thank you very much.

Liron Eizenman, CEO

Thank you.

Operator, Operator

The next question is a follow-up from Shawn Boyd of Next Mark Capital. Please go ahead.

Shawn Boyd, Analyst

Thanks for the follow-up. I'll keep it brief. Real quick on the inventory build. Can you just talk a little bit about what's in there? And the trajectory of that? I think you had indicated we should start to see that drop by the end of the year. But what exactly have you built up in there? And how is that helping in terms of kind of deep working through these component constraints?

Liron Eizenman, CEO

Sure. So most of it is electronic components because that's where we've been struggling the most. It's not parts which have short lead time that we can build quickly and metal parts or other things that are easy to get. It's the electronic parts that the entire industry is fighting to get. Some of those parts have a lead time of 60 weeks and more and our strategy has been to build this inventory so we can react and support our customers. So that's mainly what you’ll find in the inventory. And we think that we are now around the peak, I would say, of the inventory and depending on how the market will evolve, but if it will continue as we expect it right now to be kind of flat until the end of the year and then ease towards 2023, we think that towards the end of the year, we will start seeing a drop and at some point, we're probably going to go back to normal levels. But right now, we think it's still going to be a little high for a while longer and then go down.

Shawn Boyd, Analyst

Got it. We'll definitely assist in building working capital. My final question is regarding your incremental operating margins. From rough calculations, it appears the incremental operating margins were around 25% last year. While these margins can fluctuate each quarter, the first half of this year seems comparable to the same period last year. Should we expect this figure to remain a suitable benchmark moving forward, or could we anticipate even higher margins? If component constraints and design wins begin to increase, it seems that scale would be advantageous. Please elaborate on the 25% incremental operating margin.

Liron Eizenman, CEO

We have some leverage in the model, but we need to look at the dollar and other factors in order to really understand where it's going.

Shawn Boyd, Analyst

Okay. Good enough. Thanks so much, gentlemen.

Liron Eizenman, CEO

Thank you. Operator?

Operator, Operator

The next question is from Alex Henderson of Needham & Company. Please go ahead.

Alex Henderson, Analyst

Yes, just one more quick one. So one of the key metrics is decommits from supply chain. Have you seen any over the last quarter and have you seen any during the current quarter? What's the situation relative to supplier decommits?

Liron Eizenman, CEO

Yes, those still exist definitely. When we say that the situation is flat with the supply chain, it doesn't mean we aren’t experiencing push outs. It just means that the number of push outs we are experiencing is not higher than in previous quarters. However, we do find ourselves in situations where we occasionally get decommits on specific components, and we work on solutions for that, whether through alternatives, redesigns, or proposing different products to the customer. This still happens from time to time, and we anticipate it will continue until the end of the year and possibly into 2023, but perhaps at a lower rate by then. Nevertheless, this is a reality, and it’s a constant challenge to deliver products to our customers.

Alex Henderson, Analyst

Right. So at this point in time, in the third quarter, decommits have been as expected. No surprises there so far?

Liron Eizenman, CEO

Well, every decommit is a surprise, probably, but it's not a surprise as to how many decommits we get, I would say.

Operator, Operator

There are no further questions at this time. Before I ask Mr. Eizenman to go ahead with his closing statement, I would like to remind participants that a replay of this call will be available by tomorrow on Silicom's website, www.silicom-usa.com. Mr. Eizenman, would you like to make your concluding statement?

Liron Eizenman, CEO

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 three months' time. Good day.

Operator, Operator

Thank you. This concludes Silicom's second quarter 2022 results conference call. Thank you for your participation. You may go ahead and disconnect.