Earnings Call Transcript - SILC Q3 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to Silicom's Third Quarter 2020 Results Conference Call. All participants are present in listen-only mode. Following management’s formal presentation, instructions will be given for the question-and-answer session. 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 GK Investor and Public Relations at 1-646-688-3559 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 of GK Investor Relations. Mr. Green would you like begin please?

Kenny Green, Investor Relations

Thank you, operator. I would like to welcome all of you to Silicom's third quarter 2020 results conference call. Before we start, I would like to draw your attention to the following Safe Harbor statement. This conference 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 our increasing dependence for substantial revenue growth 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 revenues; maintaining and protecting brand recognition; protection of intellectual property; competition; disruptions to our manufacturing developments, along with general disruptions to the entire world's economy relating to the spread of the novel coronavirus COVID-19; and other factors identified in the documents filed by the company with the SEC. In addition following the company's disclosure of certain non-GAAP financial measures in today's earnings press release, such non-GAAP financial measures will be discussed during this conference call. Such 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 are useful to investors' understanding and assessment of the company's ongoing core operations and prospects for the future. Unless otherwise stated, it should be assumed that financials discussed in this conference call will be on a non-GAAP basis. Non-GAAP financial measures disclosed by management are provided 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 non-GAAP to GAAP financial measures are included in today's earnings press release which you can find on Silicom's website. With us on the line today are Mr. Shaike Orbach CEO; and Mr. Eran Gilad CFO. Shaike will begin with an overview of the results followed by Eran who will provide the analysis of the financials. We will then turn the call over to the question-and-answer session. And with that I would like to hand the call over to Shaike. Shaike please go ahead.

Shaike Orbach, CEO

Thank you, Kenny. I want to welcome everyone to our conference call regarding our third quarter 2020 results. We are very pleased with the strong improvement in both revenue and profit. We reported revenue of $28.4 million, which is an 18% increase compared to the same quarter last year, and a robust 23% increase from the previous quarter. Additionally, we achieved our 63rd quarter of profitability with a net income of $2.9 million, the highest this year, representing a 15% increase over Q3 last year and a 59% increase compared to the last quarter. We ended the quarter with over $86 million in net cash, utilizing our strong cash position to advance our share buyback, aimed at enhancing shareholder value. Despite the ongoing challenges posed by the coronavirus pandemic, we have managed to maintain business continuity and return to growth. This reflects the resilience of our company and our capability to navigate supply chain disruptions and component shortages we encountered earlier this year. Our visibility for revenue is improving, and we expect further growth into the fourth quarter. I will share guidance shortly, but first, I want to highlight trends we are focusing on, particularly in the telco and mobile markets. As you know, we have seen a decline in demand for our server adapter products due to a shift towards cloud data centers from enterprise data centers, while our SD-WAN business has shown solid growth. This growth results from a transition toward disaggregated and decoupled architectures that separate hardware and software, utilizing open protocols. The reduced demand for server adapters was balanced by our success in the expanding SD-WAN market. Our achievements in this area, strong partnerships with leading software vendors and telcos, and close collaboration with Intel give us optimism for the future. During this work-from-home period, we are witnessing a global demand for increased capacity, which boosts the demand for our SD-WAN products. The core principle of SD-WAN is the separation of software from hardware, which is also pushing other markets forward and becoming key growth drivers for Silicom. This approach is significantly evident in the infrastructure segment of the mobile market, especially among global telcos and mobile operators. Historically, this market has been centralized, led by Nokia and Ericsson with proprietary equipment. To reduce costs and enhance efficiency, telcos are now considering disaggregated solutions using x86 platforms with specific add-on cards and accelerators. This trend is exemplified by the Open Radio Access Networks (O-RAN) initiative, which all telcos are adopting. The new era of open solutions brings significant opportunities to Silicom since telcos can now leverage x86-based hardware for various nodes in their infrastructure and augment these platforms with specific functionalities and acceleration. We are positioned at the forefront of these developments, focusing our innovations around this concept of disaggregation and decoupling within mobile infrastructure and the telco cloud. Unlike conventional white box manufacturers, we provide integrated solutions that include additional valuable components. For example, our acceleration cards based on either Intel's eASIC or FPGA solutions offer comprehensive acceleration capabilities. Both card types were developed in collaboration with Intel, and this partnership extends to joint go-to-market and sales efforts. Another example is our upgraded time synchronization products that deliver unique solutions for 4G and 5G networks either as a fully integrated product or a standalone add-on card. Our FPGA solutions for acceleration within O-RAN are equipped with time synchronization features and serve as a platform for enhancing user plane functionality and other cloud-related capabilities. Our potential customers and partners recognize the unique benefits that our combined expertise in x86 technology, time synchronization, acceleration, and FPGA solutions offer. This has led to discussions with many of the largest telcos, independent global software vendors, and prominent server manufacturers. We can illustrate the distinctive advantages of our integrated solutions and how they are greater than the sum of their parts by leveraging our best-of-breed technologies. Given the current interest, ongoing evaluations, trials we are engaged in, and the breadth of our pipeline, we believe that the telco market segment—whether through OEMs, integrators, or directly with telcos—will serve as a significant growth driver for Silicom in the years ahead. While the sales process in the telco sector can be lengthy, each design win tends to be on a larger scale than our traditional experiences. We are confident that our considerable investments will yield results in the coming years. Our recent announcements highlight our increasing momentum from the trends of disaggregation and decoupling. We have secured new uCPE device wins with some telcos, translating to a combined revenue potential of around $10 million annually at stable delivery rates. This success stems from collaboration over the past two years between Silicom and a leading SD-WAN software vendor, integrating our latest generation hardware CPEs with their software-based disaggregated routers. These wins underscore the demand for our feature-rich uCPE devices resulting from the disaggregation trend. Last week’s announcement illustrates how this concept can drive significant future growth. We announced that a Tier 1 mobile operator has chosen our O-RAN-ready architecture for its next-generation distribution unit for field trials. This architecture fits the disaggregation model and offers an integrated solution that meets all requirements for a 4G/5G distribution unit. It is based on our x86 Edge units intended for disaggregated SD-WAN NFV applications. Should this solution enter mass production, the revenue potential could reach tens of millions of dollars from this customer alone. Moreover, as we plan the field trials, we are also discussing potential next-generation acceleration solutions based on our FPGA technology with the customer, which could further enhance this revenue opportunity. Our ability to provide solutions for substantial 4G/5G infrastructure projects, alongside a complete range of complementary product lines, prepares us well to seize these emerging opportunities. We believe the 4G/5G market and telco demand—including various aspects of planned deployment from the Edge to the core and into the telco cloud—represent a large future growth driver for Silicom. I would like to share our guidance for the fourth quarter. We anticipate sequential revenue growth, expecting revenues between $30 million and $31 million. Our expanding list of design wins generating orders, solid baseline activities, strong market fundamentals, and focus on growth markets put us in an excellent position. I am optimistic that as markets stabilize, we can achieve sustained revenue growth at a double-digit compound annual growth rate for several years. In summary, the disaggregation and decoupling trend significantly enhances Silicom's potential in the SD-WAN market and mobile operators' infrastructure, particularly at the Edge and in the telco cloud—areas where Silicom is strategically positioned. This is already shown by our SD-WAN successes, and we expect similar achievements in the mobile operator sector. Our optimism is growing, and I reiterate that we foresee a much more prosperous year ahead for Silicom compared to our recent past. I will now turn the call over to Eran for a detailed review of the quarter's results. Eran, please proceed.

Eran Gilad, CFO

Thank you, Shaike and hello, everyone. Revenues for the third quarter of 2020 were $28.4 million. This is a year-over-year increase of 18% compared with revenues of $24.1 million as reported in the third quarter of last year and a sequential increase of 23% over the $23 million reported in the prior quarter. Our geographical revenue breakdown over the last 12 months were as follows: North America 68%; Europe and Israel 25%; Far East and Rest of the World 7%. During the last 12 months our top three customers together accounted for about 35% of our revenues. 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, as well as acquisition related adjustments. For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the third quarter of 2020 was $9.4 million, representing a gross margin of 33.3% compared to a gross profit of $8.5 million or gross margin of 35.2% in the third quarter for 2019. The variance in the gross margin is a function of the specific product mix sold during the quarter. Operating expenses in the third quarter of 2020 were $6.3 million compared with $6 million in the third quarter 2019. Operating income for the third quarter of 2020 was $3.2 million, an increase of 26% compared to operating income of $2.5 million reported in the third quarter of 2019. Net income for the quarter was $2.9 million, an increase of 15% compared to $2.5 million in the third quarter of 2019. Earnings per diluted share in the quarter were $0.41. This is a year-over-year increase of 31% compared with EPS of $0.34 as reported in the third quarter of last year and a sequential increase of 58% over the $0.26 reported in the prior quarter. Now turning to the balance sheet. As of September 30, 2020, the company's cash, cash equivalents, bank deposits and multiple securities totaled $86.6 million, with no debt or $12.36 per outstanding share. During the quarter, we executed on our new $16 million share buyback plan, which we started on May 4, 2020. During the third quarter, we purchased approximately 100,000 shares at a total cost of $3.6 million. This means that we are on track to execute the full buyback plan on time. That ends my summary, and we would all be happy to take any questions.

Operator, Operator

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

Alex Henderson, Analyst

Thank you very much. So, I just wanted to start-off with a little bit of granularity around the contract conversations here. You said, I think, three wins that you've announced are $10 million. And then, you talked about the Tier 1 O-RAN project. I'm assuming that is not included in the $10 million as the O-RAN project is still in testing and it has to go through the rest of the process. So, that's upside to the $10 million, correct?

Shaike Orbach, CEO

We were selected for field trials for the Tier 1, and that is not included in the $10 million. The $10 million comes from SD-WAN wins, while the recent announcement about the Tier 1 pertains to O-RAN, not SD-WAN.

Alex Henderson, Analyst

Yeah. I understand. I just want to make it clear. Now, we had also talked about two Tier 1s in the U.S. that were expected to ramp fairly large projects with you. I think one has progressed. The other one seems to have stalled a little bit. Can you give us an update on those two?

Shaike Orbach, CEO

This has not changed from last quarter, and your description is pretty accurate. One of them has ramped up and is contributing quite significantly to our revenues. We're even hoping that in the future it would be more. The other one, however, did not ramp up. They are still in the process of deciding their strategy, and it hasn't ramped up for us yet. We're still hopeful, but nothing is happening right now.

Alex Henderson, Analyst

There's been some consolidation of some of the players in the SD-WAN space. Is that for several acquisitions? Has that changed or altered your trajectory with any of those OEMs?

Shaike Orbach, CEO

Let me put it this way. Typically, when our partners or customers are acquired by larger companies, the short-term impact is usually positive, as they prepare for more and increase their purchases. However, sometimes over time it seems they may have prepared too much, which has happened to us in the past. The long-term effects are uncertain. We observe varying impacts; on one hand, the acquiring company may prefer to use its own hardware. On the other hand, if they choose to continue using our hardware given their larger market presence, it might be beneficial for us. Overall, it’s challenging to predict the exact impact. Generally, in discussions with these companies, I tend to believe it will have a positive effect, although I cannot guarantee this since it could also result in no impact or even a slight negative impact in the long run. I definitely do not foresee any short-term negative impact.

Alex Henderson, Analyst

I see. And so, just to round that out. If you look at the rest of the appliance, legacy product lines, the more traditional business, have you seen any change in the rate of decline in that business as a result of COVID shifting spending within the enterprise, or alternatively, is it still relatively stable to declining slightly?

Shaike Orbach, CEO

In the area of server adapters, which is a key aspect of our legacy products, I wouldn't characterize it as an accelerating decline. That might be too strong a term. Over time, the demand decline isn't exactly consistent. I've not performed precise statistical analysis for this quarter, so I can't definitively say whether the decline in demand is accelerating. However, it's clear that there is a decline in demand.

Alex Henderson, Analyst

I see. And as you're looking forward, are you anticipating any change in the trajectory of that? I assume that from your answer that that's kind of steady.

Shaike Orbach, CEO

Yes. The demand for server adapters from our appliance customers will certainly continue to decrease.

Alex Henderson, Analyst

You mentioned changes in market growth, and I've noticed Intel's announcements highlighting the interchangeability of their products with yours. It seems like your importance to Intel has increased significantly. Can you discuss how that relationship is developing? This press release certainly reflects that positively and prominently.

Shaike Orbach, CEO

Okay, Intel. Yes, Intel. Their positive comments about your role in their announcements are quite striking. Can you elaborate on the impact this will have and how your collaboration with Intel is enhancing your visibility among the larger cloud companies? Also, how long do you think it will take for these changes to take effect? The collaboration with Intel is indeed expanding in scope and is of significant importance to us. Currently, we are working together in three major areas where Intel supports us by recommending our products and introducing us to various customers. The first area is the platforms we are developing with them, which was highlighted in our Tier 1 announcement last week. The second area is the mutual development of eASIC cards. eASIC technology allows for quicker production of ASICs, and Intel has developed one for offloading 5G technology, while we created a corresponding card that is unique in its market segment. We currently have a competitive advantage in this space, and Intel is actively promoting and facilitating sales for these cards. Additionally, we are collaborating on FPGA card developments, which will also be presented as joint products, further supported by Intel's market reach. Alongside these new initiatives, we continue to develop our time synchronization card with the standard Intel support model. The recent projects with platforms, eASICs, and FPGAs represent a significant shift in our relationship with Intel over the last two years, and we view these developments as critically important.

Alex Henderson, Analyst

So if I look at the press release that they put out, it talks about penetration and a variety of different major players, including SK telecom, Twitter like these labs and some other stuff. And it's tied into the Barefoot Networks acquisition that they did. So it sounds like they're putting a lot of emphasis on this. So how do we see this program and projects ramping beyond what we've already heard?

Shaike Orbach, CEO

Well, actually this is a part of what I said, because we mentioned telco and telco cloud and cloud. And for many of these we were indeed using again in cooperation with Intel IP that was developed by Intel and it's now being integrated with our cards in order to be presented to all these customers. So this is a reason for our optimism. However, as we cautioned in what I've said earlier, the processes, the decision and the decision, the evaluation and all these parts of the equation with telcos and telco clouds are long. So – and that's why unlike the SD-WAN, where we're seeing the fruit, even of this cooperation in – even in this year compensating for the decline in demand of the server adapters. And definitely in next year, all these things I believe they would have an impact on revenues in 2021 as well. But really I think the more significant contribution to revenues would happen later on 2022 or later. So some impact in 2021 but not that significant. And then in the most part, there is a significant part of that later on.

Alex Henderson, Analyst

So one last question on this front. Is the margin gross margin you're expecting from these cards similar to your current gross margins around 33% higher lower? What are your thoughts in terms of where this plays out?

Shaike Orbach, CEO

I think it would be about the same type of gross margin. I'm referring to the average because the pricing for these components will depend a lot on the quantities. For lower quantity opportunities, the prices and margins could be somewhat higher. Conversely, with very high quantities, the margins might be lower, but in terms of overall profitability for the company, it would still be justified. If we secure one of these large opportunities currently in the pipeline, I expect our manufacturing to be efficient, and that the relationship between R&D and quantities will also be strong. Therefore, even if margins are somewhat lower with these opportunities, they will still make a significant contribution to the bottom line.

Alex Henderson, Analyst

So if I look at it from that perspective, your margins have come down a little bit over time if you go back to 2018 – 17%, 18% on the 2018 time frame. And prior to that actually it was above 20%. Can you talk to us a little bit about whether you think you can bring those margins back up into the 15% plus range over the next two or three years? Is that a viable expectation?

Shaike Orbach, CEO

I think that at the bottom line that could happen. I'm not sure yet. I mean there are some unknowns because we're moving into an entirely different era with quantities per product, which might be much bigger on the one side. And if you take any of these deals on a P&L basic by itself, it may definitely demonstrate higher margins at the bottom line. But on the other side, I mean on the operating, if you just are calculating gross margins it may be even lower. But the quantities may become much bigger.

Alex Henderson, Analyst

All right. And then just one last question a little bit more minor. Any change in the tax rate thinking as we go forward here?

Shaike Orbach, CEO

Eran?

Eran Gilad, CFO

No. There is no change during quarter one to quarter three. The average tax rate – effective tax rate as can be seen is around 15%. And currently we believe that this is the range that we should expect in the short and medium term 15%.

Alex Henderson, Analyst

Perfect. Let me give the floor to anybody else who’s got question. Thanks.

Operator, Operator

The next question is from Sergey Mascaro from Wall Street. Please go ahead.

Sergey Mascaro, Analyst

Good morning. Congratulations for the results. We have been waiting a long time for this. Hello?

Shaike Orbach, CEO

Yes. Thank you.

Eran Gilad, CFO

Thank you.

Sergey Mascaro, Analyst

Okay. My first question is about the FPGA segment. Some of your competitors like Napatech and Eternity have a constant gross margin between 70% and 50%. Silicom has a 32% gross margin. As you said, we could expect pressure in the gross margin as revenues ramp up. Can you give us more color on what do you do differently versus your competitors?

Shaike Orbach, CEO

I can certainly explain that. I prefer not to focus too much on our competitors, but I'll share a few thoughts. You mentioned two competitors; one of them has gross margins that are not particularly relevant since they generate less than $2 million per year. With such low sales, comparing gross margins is not very meaningful. The other competitor is indeed a significant player, but most of their sales in the FPGA market come from the capture market. Our margins in that market are similar, but that's not where our strategic focus lies. Our key areas are the cloud, telco cloud, and SD-WAN. These markets offer a different potential for higher revenues, which is why our business model diverges. If we were to target just those markets, we could maintain the same gross margins as those companies, but that doesn't align with our strategy. As you can see, our quarterly revenues are substantially higher than theirs, suggesting that we are addressing different markets with varied products. While the margins in our targeted markets are lower, the revenue potential is significantly greater, and that is our goal.

Sergey Mascaro, Analyst

Yes, yes, perfect. Thank you. So, can you speak about FPGA on where we are? I think that we have not had FPGA design wins for a while and these other competitions are growing 20% plus. So, can you explain us where we are in FPGA terms?

Shaike Orbach, CEO

Yes, I can explain our current situation with FPGA. This is related to my previous response. We have not announced any FPGA wins, which could suggest that we haven't had any, but that's not the case. We simply aren't publicizing every win. However, it's true that we haven't disclosed any significant wins with FPGAs. The reason for this is that we have shifted our FPGA strategy. We are now developing new cards aimed at other target markets, specifically the telco O-RAN infrastructure. This development has been done in collaboration with Intel, as previously announced, and it's a process that takes time. While we still secure some design wins in our traditional markets, like capturing cards and high-frequency trading, we've chosen to concentrate on the O-RAN sector, which aligns with all our other activities. This transition requires time, but our recent announcements with Intel indicate progress in this direction. We anticipate that FPGAs will play a crucial role in this emerging market for us within mobile infrastructure, which is where we foresee significant wins.

Sergey Mascaro, Analyst

Okay. I see. So, 128 Technology was bought by Juniper earlier this month.

Shaike Orbach, CEO

What? Okay 128 yes. Go ahead, please.

Sergey Mascaro, Analyst

So does it have an impact on you since you are partners and you reported some design wins in collaboration with that company?

Shaike Orbach, CEO

Well, first of all, I think, I'm not 100% sure that while the fact that we are partners with 128 is public information, but specifically about design wins, I'm not sure that there is any information. So, I cannot refer specifically to any design wins. However, I can repeat the general answer that I provided before about impact of consolidation within the SD-WAN industry, where we definitely do not see any negative impact short term, probably a positive impact on the short term and as for the longer term, cannot tell yet. It may be positive, may also be negative in some cases. We hope based on discussions that we have with 128 that it's going to be positive, but we cannot be sure about that.

Sergey Mascaro, Analyst

Okay. Do you know anything about the Silicom Telefónica flexiWAN project posted by Intel? Any progress on that that you can share with us?

Shaike Orbach, CEO

I cannot share. I mean, we have been in the conversation that we are involved in discussions with many of the world's leading telcos. And unfortunately, I cannot provide any specific information more than that right now.

Sergey Mascaro, Analyst

Yes, I understand. Do you have any visibility into the next year 2021?

Shaike Orbach, CEO

I believe that 2021 will be a growth year. There are still many unknowns including the impact of COVID-19 on the business, which could affect us from various angles, not only due to supply chain disruptions but also concerning the pace of evaluations and deployments in certain regions. Therefore, we cannot be entirely certain at this point. There is ambiguity, but we view it as a year of growth.

Sergey Mascaro, Analyst

Great. The Federal Reserve is saying that, interest rates are going to stay at 0% level for a long time for some years. You have a net cash position of one-third of your market capitalization. In my opinion, you are not going to need around $30 million of this cash for working capital needs. Do you have any plans with this extra cash? I think, it would be a really nice opportunity for you to do a tender offer increase or accelerate the share buyback program.

Eran Gilad, CFO

As we said over the call, we are in the middle of the second buyback plan. We progress as planned and intend to meet on the targets set by our Board, which means the buyback of $15 million. This is currently our plan.

Sergey Mascaro, Analyst

Okay. And anything from M&A?

Shaike Orbach, CEO

Well, just like we always say, M&A, there’s nothing specific on the table right now. But we are always looking. Our strategy is not to go for an M&A just because we have the cash. But definitely having this cash encourages us and makes us look around, look for synergies. And if we find something, we would go for it.

Sergey Mascaro, Analyst

Yes, I understand. And now about the COVID pandemic. Did you have any COVID cases at Silicom? How did you deal with them?

Shaike Orbach, CEO

Yes. We had two employees who were affected by COVID-19. We're implementing measures that allow us to operate effectively by dividing the company into smaller groups. As a result, the room we usually use for conference calls is now a lab because we decided to separate the labs into several divisions. This way, if someone contracts COVID, it doesn't mean everyone else has to stay home since we have multiple labs. Being a hardware company, it's essential for us to have people working on-site. We've taken the necessary precautions, which have paid off. Even though two of our employees were infected, the number of those who had to be quarantined was minimal—around two to three in each case. The company has been able to continue functioning normally.

Sergey Mascaro, Analyst

Amazing. Perfect. And my final question, do you expect the lockdowns in Europe have an impact on you?

Shaike Orbach, CEO

Lockdowns may cause an impact. I don't think that the lockdowns in Europe, specifically, would have a dramatic impact, but they may cause an impact. I mean, we have, as you know, a subsidiary company in Denmark. I mean, right now, they're not impacted, of course, but we have customers in other territories which could be significant for us. So it may have an impact. That's a part of what I said before, that in 2021 there is still definitely some areas which are not clear as to how and what would develop and that's definitely a part of that.

Sergey Mascaro, Analyst

Thank you. Perfect. That’s all. Thank you for your time.

Shaike Orbach, CEO

Thank you.

Eran Gilad, CFO

Thank you.

Operator, Operator

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

Shaike Orbach, CEO

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 three months' time. Good day.

Operator, Operator

Thank you. This concludes Silicom's third quarter 2020 results conference call. Thank you for your participation. You may go ahead and disconnect.