Earnings Call Transcript - SILC Q2 2023

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom Second Quarter 2023 Results Conference Call. All participants are at present in a listen-only mode. Following management presentations, 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. I would now like to hand over the call to Mr. Ehud Helft of EK Global Investor Relations. Mr. Helft, would you like to begin?

Ehud Helft, Investor Relations

Thank you, operator. I would like to welcome you to Silicom second quarter 2023 results conference call. Before we start, I'd like to draw your attention to the following Safe Harbor statements. 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 they 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 dependency for substantial revenue growth on a limited number of customers in the evolving cloud-based SD-WAN, NFV, and edge market; the speed and the extent to which solutions are adopted by these markets; the likelihood that Silicom will rely increasingly on customers which provide solutions in these evolving markets, resulting in an increasing dependency on a smaller number of larger customers; difficulty in commercializing and marketing Silicom's products and services; maintaining and protecting brand acquisitions; protection of intellectual property, competition; disruptions to our manufacturing; sales and marketing; development and customer support activities; the impact of the war in Ukraine; rising inflation; rising interest rates; volatile exchange rates and commodities prices; and any continuing or new effects resulting from the COVID-19 pandemic and the global economic uncertainty, which may impact customer demand through their exercising greater caution and selectivity with their short-term IT investment plan; as well as those other factors discussed in our earnings report. In addition, 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. Such non-GAAP 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 operation 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 discussed by management are provided as additional information to investors in order to provide them with an alternative method for assessing our financial conditions 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 is included in today's earnings release, which you can find on Silicom's website. And now with us today on the call are Mr. Liron Eizenman, President and CEO; and Mr. Eran Gilad, the CFO. Liron will begin with an overview of the 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 like to hand over the call to Liron. Liron, please?

Liron Eizenman, President and CEO

Thank you, Ehud. I would like to welcome all of you to our financial results conference call discussing our second quarter '23 results. We are happy to report a good set of second quarter '23 results. We grew our second quarter revenue to $38.1 million, in line with our expectations, which is a 12% increase over the second quarter of last year. We are indeed happy with those results, especially against the background of a more challenging economic environment and limited visibility, which I will discuss in a few minutes. Our continued success has added to more than 18 years or more precisely, 74 quarters, of uninterrupted profitability, and we reported second quarter earnings of $0.66 per diluted share. Our strong balance sheet has been the result of a planned and executed strategy by the management. As we discussed a few quarters ago, as supply chain issues improved, we continued to decrease our inventory. In this quarter, we further decreased our inventory by $10 million, moving towards a normalized level of inventory that matches current components' lead times. Also, as discussed a few quarters ago, we continue to improve our cash, which currently stands at $63 million with no debt. It represents an increase of $10 million during the second quarter. Our strong cash position remains a key strategic asset that enables us to capitalize quickly on opportunities. We are happy to share the rewards of our continued profitability and cash generation with our shareholders. Based on our improved cash position and our expectations to remain profitable in the coming years, we intend to accelerate the pace at which we repurchase our shares under the $15 million share repurchase plan announced three months ago. Our strategic decision to focus on the edge market as a primary growth driver continues to bring us further designs. During the quarter, we announced that we were selected again by a leading U.S. enterprise telecommunications service provider to develop an innovative edge networking product for them. The customer-based initial orders of around $5 million and delivery will follow the successful completion of the development and testing processes. This customer expects orders to scale up over the next several years as the product enters mass deployment. The fact that this leading telco service provider turned to us is gratifying, and we are excited about the potential of the new use cases it brings to market. Apart from the long-term sales to this customer, we believe this product will be attractive to a broader customer base, adding to the strong momentum which has been building for our edge product lines. This win confirms our value proposition and serves as further evidence of the significant growth potential we see in our edge product family. Our momentum in edge networking has clearly broadened well beyond the SD-WAN space with growing interest from customers seeking enhanced performance and flexibility for their next-generation networks. It demonstrates the unique value proposition of our full-service model and the broadest portfolio of edge networking offerings, namely our innovative best-in-class products at attractive price points, rapid development and customization capabilities, partnership approach, and uncompromising total support. In parallel, we continue to achieve design wins for the acceleration of server adapter products. In April, a Tier 1 U.S.-based cybersecurity vendor awarded us with two NIC design wins: one for an advanced encryption offload acceleration card and the other for an FPGA-based product. Both will be incorporated into two customers' next-generation solutions, which are sold to some of the world's largest, most technologically advanced companies to secure and optimize their networks and applications in the cloud, on-premise, and at the edge. We expect those design wins to start ramping up towards broad deployment in 2024. These two design wins demonstrate the innovation underlying our technology, our broad portfolio and the uniqueness of our full-service package as well as our reputation for performance-boosting solutions. We also announced the first in a new line of Edge AI products under our partnership with Hailo, a leading artificial intelligence chip maker. According to Polaris Market Research, in 2022, the global edge AI hardware market was valued at $1.2 billion and is expected to grow at a compound annual growth rate of 21% to $8 billion by 2032. Our new Edge AI product line integrates Hailo's AI accelerators into Silicom's existing Edge platform, solving performance challenges for Edge AI use cases. As a result, Silicom's products will be able to offer visual processing in AI inference at the edge at a uniquely attractive price-performance ratio. By integrating AI into our product, we are making it cost-effective to move behavioral analytics, human intrusion detection, facial recognition, and vehicle analytics to the edge, opening up many new use cases and potential revenue streams for our customers. We are already engaged in proof-of-concept discussions with customers on various uses. We are excited about the opportunities created by the meteoric growth of AI and especially its new soft training and inference networking problems. The architecture we have built for this product can easily be extended for use with other AI chip vendors like NVIDIA and others. The requirements of the specific use cases determine the right chip for the product. I would now like to spend some time discussing the factors impacting our guidance and outlook for the third quarter. Since the global COVID shutdown in early 2020, supply chains around the world became tight with very limited availability of electronic components. Silicom, like many other companies, took the correct decision to significantly increase its inventory of raw components. This was to ensure that we could build products that our customers needed in a timely way, maintain strong business continuity, and most importantly, keep our clients happy. Over the past two years, many of Silicom's customers ordered high levels of our product to manufacture their own products, which drove above-average demand and backlog for our products in both 2021 and 2022. As we enter the second half of 2023, supply chains are no longer tight, and our customers are lowering their inventory levels, reducing their backlogs, and drawing on their existing stock of our products where possible. As a result, the revenues we had originally projected for the third quarter have been pushed out to later this year or next. Additionally, due to the broad expectation of a slowing macro economy, some recent design wins, which we had expected to ramp up quickly in 2023, are proceeding cautiously and ramping up slower than we had originally discussed. I highlight that they have not paused, and we are still seeing growing revenues from these design wins, just at a slower pace than what we had originally expected. Considering these factors, Q3 is expected to be a slower quarter, and our expectations are revenues between $30 million and $31 million. While the factors I mentioned impact our revenue expectations in 2023 and may affect our first half of 2024 results, we believe that we are currently under-shipping end-market demand across our business, and the overall longer-term picture remains strong. With that, we remain positive that our fundamentals and long-term growth story remain intact. Despite current challenges, our mid- to long-term outlook remains positive. This is underpinned by a strong and continually growing list of design wins with leading players in the telco and networking space. While the ramp-ups of recent design wins tend to be slower than our original expectations, I stress that we have not experienced any significant cancellations or displacement by a competitor. Highlighting some recent design wins: over the last 18 months, two leading companies—a U.S. communication service provider and a large SD-WAN vendor—have granted us three significant design wins. All three design wins are still at the early ramp-up stage, meaning our revenue from those wins in 2023 will be less than half of their full annual potential. While this ramp-up is slower than expected, the full potential indicated by the customers represents strong long-term potential for Silicom. Our work with two leading SASE players is just beginning to ramp up, with over $3 million worth of product shipped in the first half of 2023. As SASE grows, we expect strong future growth in sales to those customers. We continue to see growing opportunities in edge AI and markets within the broader trend of disaggregation and decoupling. Notably, we have been developing a line of white label switches, further expanding our total addressable market. White label switches separate the hardware and software, running on off-the-shelf chips, offering strong customization abilities. They are essential for software-defined networks, enabling network programmability with distinct advantages over traditional switches. Based on our expertise in networking, hardware acceleration, and edge platforms, coupled with superb customer relationships and market recognition, we are perfectly positioned to benefit from this market. These switches are gaining popularity due to their high-end performance, simplicity, user choice freedom, fast innovation, and cost-effectiveness. We are currently pursuing a significant design win with a Tier 1 cybersecurity customer, adding to our optimism about the future. In summary, we have every reason to be optimistic. Silicom is well positioned as a key player in our industry, and given the growing potential within our design win roster, our extensive pipeline, and our increasingly growing total addressable market, including the recent addition of Edge AI and white label switches, we are excited about the opportunities ahead. Despite the tougher environment we are facing, we are happy with our second quarter '23 results. When smoothing out the over-ordering in 2020 and 2021, and accounting for the digestion of inventory starting in the second half of 2023, we would still have shown solid growth over the past three years. The total addressable market for our Edge Networking product is much larger than we had initially estimated only a few years ago and underlies our expectations for continued growth over the long term. We maintain an impressive roster of top-tier customers and design wins, many of which are only in their initial ramp-up stages. Our robust pipeline of future design wins holds significant further growth potential for us. We believe that our drivers for long-term demand remain firmly intact. As we navigate the current situation, we remain highly focused on our long-term growth target by achieving new design wins, delivering on our new product and technology road maps, and ensuring customer satisfaction. While managing the Company to maintain profitability and cash generation. With that, I will now hand over the call to Eran for a detailed review of the quarter's results. Eran, please go ahead.

Eran Gilad, CFO

Thank you, Liron, and hello, everyone. Revenues for the second quarter of 2023 were $38.1 million, up 12% compared with revenues of $34.2 million in the second quarter of last year. Our geographical revenue breakdown over the last 12 months were as follows: North America, 79%; Europe and Israel, 17%; Far East and the rest of the world, 4%. Over the last 12 months, we had one 10%-plus customer, and our top three 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 noncash compensation expenses for options and RSUs granted to directors, officers, and employees, acquisition-related adjustments, as well as lease liabilities and 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 2023 was $12.3 million, representing a gross margin of 32% compared to a gross profit of $12.3 million or a gross margin of 36% in the second quarter of 2022. The variance in gross margin is a function of the specific product mix sold in the quarter and remains in line with the expected range of our gross margin guidance of between 32% and 36%. Operating expenses in the second quarter of 2023 were $7.5 million compared to $7.3 million in the second quarter of 2022. Operating income for the second quarter of 2023 was $4.8 million compared to operating income of $5 million in the second quarter of 2022. Net income for the quarter was $4.5 million compared to $4.7 million in the second quarter of 2022. Earnings per diluted share in the quarter was $0.66, a year-over-year decrease of $0.04 compared with EPS of $0.70 in the second quarter of last year. For the first half year of 2023, our earnings per diluted share were $1.27, an increase of $0.13 compared with EPS of $1.14 in the first half last year. Now turning to the balance sheet. As of June 30, 2023, the Company's cash, cash equivalents, and marketable securities totaled $63.3 million with no debt, or $9.31 per outstanding share. During the second quarter, Silicom purchased approximately 25,000 shares at a cost of $0.9 million under the new $15 million share repurchase plan we announced during the quarter. In total, Silicom has purchased an aggregate of $44 million in share buybacks in recent years. As mentioned by Liron, based on our strong balance sheet, improved cash position, and our expectations for continued profitability in the coming years, we intend to accelerate the pace of our share repurchase. That ends my summary. I would like to hand back over to the operator for the question-and-answer session.

Operator, Operator

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

Alex Henderson, Analyst

So a couple of baseline questions here. So clearly, the question on the revenues needs to be asked. Is the steep decline in expectations for the September quarter cleaning up the inventory to a large degree? Or is there going to be a process of cleaning up that will retain this type of level of revenues out through the March and into the June quarter of next year? What do you think the slope of that cleanup looks like? And when do you expect that you'll be able to get back to year-over-year growth? Is that all the way out into the September quarter of next year?

Liron Eizenman, President and CEO

I would say that we still have a low-visibility situation. It's hard to say, and it's also different from one customer to the other, so it's very hard for me to answer that question right now. But we have at least several quarters here; some customers more, some customers less that will see the over-inventory situation still.

Alex Henderson, Analyst

The December quarter historically has had a significant seasonality to it. And I get it that there's an inventory correction going on, but do you expect a little bit of a seasonal pop sequentially in the December quarter? Or do you expect that the inventory drawdown will fully offset the seasonality in the December quarter?

Liron Eizenman, President and CEO

I think I would have to say that it is hard for me to say. I mean, I don't know if the regular seasonality will be in effect here or not. It really depends on our specific customers and their level of inventory.

Alex Henderson, Analyst

Given that outlook, what should we be thinking about in terms of your ability to address the cost side of the equation so that profitability doesn't get hit too badly?

Liron Eizenman, President and CEO

From a GP perspective, we are not anticipating any changes, so it remains at 32% to 36% as previously mentioned by Eran. On the operational expense side, we are committed to ongoing investments. Our focus is on long-term growth, and we intend to keep expanding in that direction. We believe we have strong design wins that we are ready to accelerate, and we have a solid pipeline. To support all of this, further investment is necessary.

Alex Henderson, Analyst

Are we talking about $30 million-plus in OpEx for the year? Is that kind of the right range of expectations?

Liron Eizenman, President and CEO

I think that makes sense.

Alex Henderson, Analyst

All right. And just going back to the question of baseline, you made the comment that the last year or two have been artificially enhanced by people building inventory, and now you're saying that they're under-spending. What do you think the real baseline is that you'll be growing off of as we get past this process? What should the '23 full year revenue be if there was no correction? You're saying the $30 million to $31 million in the September quarter is well below that, so I'm assuming it's somewhere up in the $35 million range-plus. Is that right?

Liron Eizenman, President and CEO

Maybe, I think it's reasonable to say this number. However, it's not only about inventories. I mentioned before that economic concerns are also in the mix. It is a bit hard to distinguish between the two. But when analyzing the data, we looked at least $10 million-plus that were pushed out from this quarter based on our expectations on customer orders. So, $35 million maybe a little more could be reasonable, but it's very hard to say an exact number given the mixture of reasons here.

Operator, Operator

There are no further questions at this time. Before I ask Mr. Eizenman to proceed 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. Mr. Eizenman, would you like to make your concluding statement?

Liron Eizenman, President and CEO

Thank you, operator. Thank you, everybody, for joining the call and for your interest in Silicom. We look forward to hosting you on our next call in three months' time. Good day.

Operator, Operator

Thank you. This concludes Silicom Second Quarter 2023 Results Conference Call. Thank you for your participation. You may go ahead and disconnect.