Silicon Motion Technology CORP Q1 FY2020 Earnings Call

This conference call contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 as amended. Such forward-looking statements include, without limitations, statements regarding trends in the semiconductor industry and our future results of operations, financial condition and business process. Although such statements are based on our own information, and information from other sources we believe to be reliable, you should not place undue reliance on them. The statements involve risks and uncertainties and actual market trends and our results may differ materially from those expressed or implied in these forward-looking statements for a variety of reasons. Potential risks and uncertainties include, but are not limited to: continued competitive pressure in the semiconductor industry and the effect of such pressure on prices. Unpredictable changes in technology and consumer demand for multimedia consumer electronics, the state of and any change in our relationship with our major customers and changes in political, economic, legal and social conditions in Taiwan. For additional discussion of these risks and uncertainties and other factors, please see the documents we file from time to time with the Securities and Exchange Commission. We assume no obligations to update any forward-looking statements, which apply only as of the date of the conference call. Ladies and gentlemen, thank you for standing by. Welcome to Silicon Motion Technology Corporation First Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After speaker sensation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would like to hand the conference over to your first speaker today, Mr. Chris Chaney, Director of Investor Relations and Strategy. Thank you. Please go ahead.

Thank you, Carina. Good morning, everyone. And welcome to Silicon Motion's First Quarter 2020 Financial Results Conference Call and Webcast. As Carina mentioned, my name is Chris Chaney, I'm the Director of Investor Relations at Silicon Motion. Joining me today on this call are Wallace Kou, our President and CEO; and Riyadh Lai, our Chief Financial Officer. Following my comments, Wallace will provide a review of our key business developments, and then Riyadh will discuss our first quarter results and our outlook. We will then conclude with a question-and-answer period. Before we get started, I would like to remind you of our safe harbor policy, which was read at the start of this call. For a comprehensive overview of the risks involved in investing in our securities, please refer to our filings with the U.S. Securities and Exchange Commission. For more details on our financial results, please refer to our press release, which was filed on Form 6-K after the close of the market yesterday. This webcast will be available for replay in the Investor Relations section of our website for a limited time. To enhance investors' understanding of our ongoing economic performance, we will discuss non-GAAP information during this call. We use non-GAAP financial measures internally to evaluate and manage our operations. We have therefore chosen to provide this information to enable you to perform comparisons of our results in a manner similar to how we analyze our own operating results. The reconciliation of GAAP to non-GAAP financial data can be found in our earnings release issued yesterday. With that, I'd like to now turn the call over to Wallace.

Thank you, Chris. Hello, everyone, and thank you for joining us today. I hope you and your family have remained safe and healthy during these uncertain times. Before I talk about our business, let me take a moment to send our thoughts to those affected by the virus and to thank our public healthcare leaders, doctors and nurses, who have been working tirelessly to keep our community safe during this crisis. At Silicon Motion, we have planned accordingly to keep our employees safe and business running. Our employees in the U.S. are sheltered and have been working from home. Our large operations in Taiwan with our controller R&D team and our corporate function as well as our foundry and back-end partners located here, have safely been less affected due to solid containment efforts by the government. Nevertheless, in the unlikely event containment is breached, we are ready to roll out necessary work from home contingency plans to maintain business continuity. And in China, our employees primarily in Shenzhen and Shanghai started working from home in late February, and since mid-March have all safely returned to our offices. While we are very much aware of the growing economic consequences of this pandemic, in the near term, our business has held up well despite the challenging broader environment. In the first quarter, we saw the tech supply chain restart inventory depleted after long extended Lunar New Year holiday in China and the building of safety stock. Sales to the channel market, which is more fully dynamic, have benefited from restocking. Sales to the OEM market, on the other hand, have largely been uninterrupted, with sales taking place according to forecast. And for this OEM market, we currently have reasonable procurement visibility through the third quarter. We have also been seeing gradual recovery in Chinese retail consumer demand post-lockdown. In our first quarter, sales declined 13% sequentially to $133 million but grew 49% year-over-year. Our SSD controller, eMMC + UFS controller and SD solutions all grew strongly year-over-year. Earnings per ADS for the quarter were $0.80, down from $0.96 in the fourth quarter of last year but up from $0.42 a year ago. While our business visibility is now more limited due to global economic uncertainties, we believe we remain well positioned to grow our business meaningfully this year led by our growth from all three of the key products: SSD controller, eMMC + UFS controller and SD solutions. Let me now talk more about our key products. Afterwards, I will hand over the call to Riyadh, so he can discuss details of our financial performance and provide guidance. Starting with our SD controllers. Sales of our SD controllers were down 15% in the first quarter, but up 40% year-over-year. We expect our positive year-over-year momentum to continue at a more major pace over the balance of this year as the benefit of NAND price reduction last year continues to play out in terms of a stronger OEM interest in adopting more SSD in PCs. PC sales were more than seasonally down in the first quarter as the COVID-19 outbreak affected demand and manufacturing supply chain in China. However, towards the end of the first quarter, we started seeing stronger surge in demand for notebooks with SSDs driven by work from home and online learning as the rest of the world began shuttering in place. Separately, towards the end of the first quarter, we started seeing gradual recovery of our SSD sales in the channel market, which includes fragmented retail and online sales in China and elsewhere as well as system integrators for many industry verticals. The channel market will nevertheless remain fully dynamic with limited visibility. We believe strong demand for PCs with SSDs will continue into the second quarter. Additionally, we can already see some of these OEM programs extending through the third quarter. While currently PC demand is strong, it is likely demand could weaken later this year as global economic issues worsen. We are, however, expecting client SSD sales to continue growing through this year, even if PC sales were to decline meaningfully due to increasing adoption of SSD versus HDD. TAM prices fell sharply last year, which incentivizes PC OEMs to design more PCs with SSDs. As previously discussed, we won a disproportionately large share of SSD controllers for these OEM programs awarded to merchant controller suppliers last year. Most of these design wins are now shipping, and we expect our SSD controller sales to grow this year both from increasing adoption of SSDs by OEMs and from market share gain. Towards the end of the year, we will be bringing to market four different PCIe Gen 4 controllers to specifically address four different market segments, from enterprise to client, high-performance to mainstream and value line. Applications covered by our solution will include data centers, PCs and game consoles. Separately, planning ahead, our engineering work is already well underway in architecting controllers for the next generation of PCIe technology, PCIe Gen 5. Newly returned, the strength of our SD controller sales momentum later this year will depend on NAND supply-demand conditions and related NAND price expectation. As hyperscale data center demand for enterprise SSDs continue to be strong in the second half of the year, incremental supply of NAND for client SSDs could be more limited and our sales momentum could decelerate. On the other hand, our sales momentum could accelerate in the second half if there is excess NAND supply from continued weak smartphone sales and the slowdown in hyperscale data center investments. Moving over to our enterprise SSD controllers, we have been shipping our enterprise controller for both Alibaba and Baidu's open channel PCIe MVNa SSD used in their data center since the third quarter of last year. Sales of these controllers will scale further this year as we ship through the full calendar year at a much larger volume. Separately, we have been shipping our 16-channel SM2270 for Kingston's U.2 data center class DC1000M aCd, and our ASM2262EN for Kingston KC2500 SSD with end-to-end data protection, targeting the workstation and high-performance computing market. Now turning to our eMMC + UFS controller for the mobile embedded storage market. eMMC + UFS controller sales declined 20% sequentially but grew more than 100% year-over-year. We expect our positive year-over-year momentum to continue though at a more moderate pace over the balance of the year as smartphones continue to quickly transition from legacy eMMC to newer UFS embedded storage technology. Two-thirds of our mobile embedded storage controller sales are already UFS controllers. Last year, UFS was adopted primarily by premium phones. This year, we expect a meaningful portion of the much larger mainstream phone segment to also adopt UFS. For the full year, we are expecting strong UFS controller sales to our UFS customers and solid eMMC and UFS controller sales to Chinese module maker customers and anticipate further contraction of our legacy eMMC controller sales to our Korean customer. We are excited that our U.S. UFS customers in the industry technology leader, the first to bring to the smartphone market high-performance uMCP with LPDDR5 mobile DRAM, a product well positioned with OEMs to scale rapidly. We are already shipping in volume UFS 3.1 controllers and planning ahead, R&D work for UFS 4.0 with data transfer rate even faster than PCIe Gen 4 has already begun. Nearer term, we still have risk exposure relating to our Korean customer. But let me put this into perspective. Sales to this customer have already been smaller than sales to our Chinese module maker customers, and we expect module maker sales to grow this year to largely offset this Korean downside risk. Our module maker customers continue to successfully grow their eMMC sales to Tier 2 and Tier 3 low-end smartphone OEMs in China as well as to set-top boxes, smart TVs, and other device OEMs. Since COVID-19 has expanded from a regional epidemic to a global pandemic, we now expect demand for smartphones to fall below our original expectations from early this year. In the first quarter, smartphone manufacturing and sales in China were affected by the lockdown in the country, but since the end of the lockdown, smartphone sales in China have started to improve. However, with the viral outbreak now a global issue, smartphone demand in the rest of the world has also been affected. Nevertheless, we continue to expect strong UFS growth this year because we believe the transition from eMMC to UFS will more than offset weakened smartphone sales. Now I will provide a few comments on our SSD solutions. SSD solutions sales grew about 15% sequentially in the first quarter and about 70% year-over-year. We expect our positive year-over-year momentum to continue at roughly this pace over the balance of this year as our Shannon Open Channel SSD for Alibaba scales further, supported by Ferri industrial SSD sales growth. Beginning in the second quarter, our Alibaba project will be entirely on a consignment basis. Our commercial agreement, where Alibaba procured NAND flash and consigned it to us for our contract manufacturing to build SSD. Our Alibaba projects are progressing smoothly both in the delivery of SSDs as well as engineering work for next year's new projects. To summarize, our first quarter performance was within our guidance, and we remain optimistic about growing our sales through the rest of the year despite the challenges posed by the COVID-19 pandemic. Our position in each of the three main engines of growth, SD Controller, eMMC + UFS controllers and SSD solutions remains solid, and we are actually working to expand our market leadership with next-generation technology and solutions. We believe scientists and doctors will soon find a way to defeat COVID-19, and we would like to come out on the other side with an even stronger business. Now I will turn the call over to Riyadh to discuss our financial results and our outlook.

Thank you, Wallace, and hello, everyone. I will discuss additional details of our first quarter results and then provide our guidance. First, I would like to mention that our comments today will focus primarily on our non-GAAP results unless otherwise specifically noted. A reconciliation of our GAAP to non-GAAP data is included with the earnings release issued yesterday. In the first quarter, revenue declined 13% sequentially, but increased 49% year-over-year. Controller sales were seasonally soft and furthermore, were affected by China's COVID-19 lockdown. SSD solutions grew sequentially with the ramp of new Shannon data center SSD projects. Gross margin in Q1 decreased to 48.2% from 49.3% in the prior quarter due to changes in product mix. This quarter, sales of lower gross margin SSD solutions grew while higher gross margin controllers declined. Gross margins for both controllers and SSD solutions were stable sequentially. Operating expenses in Q1 were $37.3 million, down almost $0.8 million from the prior quarter, primarily due to slightly lower R&D tape-out expenses. Operating margin in Q1 was 20.1%, a decrease from 24.4% in the prior quarter. Our effective tax rate in Q1 was essentially 0 because of a one-time tax benefit relating to the reversal of a previous accrual for tax risk. This risk did not materialize after a recent tax audit, and so the accrual was reversed. Earnings per ADS in Q1 were $0.80 compared to $0.96 in the fourth quarter last year. Stock-based compensation in our operating expenses, which we exclude from our non-GAAP results, was $2.5 million in Q1. We had $372 million of cash, cash equivalents, restricted cash and stock and short-term investments at the end of Q1 compared to $300 million at the end of the prior quarter. We paid $12 million in dividends to shareholders, the second quarterly installment of our $1.40 per ADS annual dividend that was announced in October of last year. We did not repurchase any shares in the first quarter. Now let me turn to our second quarter guidance and forward-looking business trends. For the second quarter, we expect revenue to grow in the range of flat to up 8% sequentially to approximately $133 million to $143 million. Because of growing global economic uncertainties, we are guiding a wider than normal guidance range. We expect sales growth of all three of our key products to be flat to up in the second quarter. We remain optimistic about growing our full-year sales and continue to believe all three of our key products should contribute toward full-year growth. In the second quarter, we expect gross margin to be in the range of 47.5% to 49.5%, with the midpoint slightly higher than what we delivered in the first quarter. Gross margin for our controllers should remain stable sequentially, and gross margin for our SSD solutions should improve as Alibaba sales change to a consignment arrangement. In the second quarter, we expect operating margin to be in the range of 20% to 22%, with midpoint roughly 1 percentage point higher than in the first quarter. We expect our effective tax rate for the second quarter and the full year to be in the 10% to 15% range. We are well positioned financially to weather a potentially severe economic recession. We have a debt-free balance sheet and $372 million of cash. Our business continues to generate strong free cash flow, $33 million in the first quarter. Our flexible capital-light fabulous business model is resilient and has been stress tested. In 2009, during the severe recession that followed the global financial crisis, our sales halted, but we continued to generate positive free cash flow. We quickly rebounded and sales recovered within 2 years. Obviously, this is not a situation that we welcome again, and we do not know the severity of the upcoming economic slowdown but must prepare. Given limited business visibility later this year, we believe it is more prudent to preserve liquidity, and so we will not be repurchasing our shares during the second quarter. This concludes our prepared remarks. We will now open the call to your questions.

Your first question comes from Anthony Stoss from Craig-Hallum. Please go ahead with your question.

Nice execution, especially on the gross margin improvement side, guys. A couple of questions. In the past couple of conference calls, you talked about having roughly 1% of the infrastructure spend in Alibaba, and a whole lot of goal for several years later to get to 20%. Has anything changed or improved in that, that makes you more confident that you can move well above 1%? That's the first question. Second question, on the ASP side. So in the past, you've talked about taking market share. You discussed that this morning. Can you walk us through kind of conversion from SATA to PCIe? And how your ASPs are improving? And then I had a follow-up after those two.

Tony, first, on the Alibaba business, we are clearly executing very strongly. Our products that, our open channel products from, that we started delivering in the third quarter last year, we continued to deliver. The projects that we were working on last year are now in execution, we have been delivering since the first quarter, and we will deliver throughout the rest of this year. We're already working on projects for next year. So very well set up for further growth next year. And so we're fairly confident that our share of business of SSDs at Alibaba will continue to increase in the next few years. To your second question about ASPs and market share, our ASPs have been improving, and this is a typical situation where we have older products cycle out and newer products cycle in. So we have the SATA recycling, the legacy product cycling out and the new PCIe growing. Furthermore, Wallace talked about the upcoming PCIe Gen 4 that we will be bringing to market later on this year. This will all be very helpful in our overall ASPs and margin profile. As we continue to stay ahead in terms of technology, for example, investing in PCIe Gen 5, this will help us continue to maintain our market leadership in terms of technology and solutions that we bring to our customers.

Then two quick follow-ups. Wallace talked about having visibility through Q3 now on the SSD control side. Would you expect your Q3 sales from that segment to be above seasonal or above what you've seen in the past? And then also, Riyadh, I know you're not guiding to it but any thoughts just on where gross margins go from Q2 levels into the back half of the year?

I think it's very clear to us. OEM customers give us, released the PO to the end of Q3 and with a very clear forecast. And we do see the program, because every PC OEM, they started to change the new program from the end of September. That's why our visibility extends to the current program through the end of Q3. I think regarding our, the momentum for accelerating for the growth, it's all dependent on NAND allocation from a major NAND partner. As you all know, the first half data center demand was very strong. Some NAND makers are allocating tremendous NAND output to data center. In the second half, the NAND, the data center demand still maintains strong. We see our SSD acceleration will be slowed down. However, if data center demand becomes more moderate and smartphone remains very weak, we do see NAND makers will allocate more NAND to client SSD controllers. So our situation to whether we can see further acceleration of our SSD controller all depends on NAND balance in the market.

Tony, let me also address your fourth question really regarding our gross margin profile for the second half of the year. We expect our gross margin for our controllers to continue to remain stable throughout the rest of the year. They've been stable in the first half of the year, and we expect gross margins for our controllers to be stable for the rest of the year. At the same time, beginning in the second quarter, our gross margins for our SSD solutions have improved a bit with the transition of our Alibaba sales to a consignment business arrangement, which helps our gross margin there. So as the year progresses, what we'll need to focus on is the mix of products, the mix of our controller sales versus our mix of solution sales. The more controller sales, the better our gross margin. Conversely, the more solution sales, gross margin could dip a bit from period to period.

Your next question comes from the line of Mehdi Hosseini from SIG.

I want to go back and revisit the gross margin profile. Your solutions business is seeing improving gross margin because of the consignment. Your mobile exposure, I would expect you would also see a better gross margin because of UFS. In that context, why should gross margin remain stable? Why should it improve from here on? And I have a follow-up.

Okay. Let me give you the answer quickly. For Alibaba consignment business, the ramp-up is expected mainly in Q3 and ramp down in Q4. So Q2 just started to ramp. The consignment contribution for gross margin in Q2 is not as significant. Regarding UFS Controller, I cannot comment regarding the gross margin. But I think the primary, we sell to one of our U.S. customers, but ASP is much higher. However, the volume is also, momentum is higher. But gross margin, it all depends on business turn with our major customer.

And Mehdi, let me also add further to what Wallace said. We have a lot of products. We have a lot of controllers. We have older products, newer products within our mobile embedded storage product class. We also have a lot of products within our SSD controllers, from our older SATA programs to our newer PCIe. We have many different categories of products, and so we are always constantly blending old products and new products. As a result, we've been able to hold our gross margin quite stable. Part of blending obviously is coming from new products like the UFS products and the PCIe Gen 4 products.

Sure. And then one question for Wallace and specifically regarding strategy. You're doing a good job in accruing cash. I understand why you want to be prudent and put the buyback on hold. But I guess I'm also thinking that in an uncertain environment like the current environment due to the coronavirus, there may be M&A opportunities as the prices may become depressed. In that context, Wallace, do you see M&A now a higher priority than buyback?

I think under the market uncertainty with many, many potential changes is not a good time to do the share buyback. We are not trying to compete with our shareholders regarding purchasing cheaper stock. Our main goal is to add value to our shareholders and continue building for the business.

Does that mean that M&A becomes a higher priority?

It probably won't be the best timing either regarding M&A during this moment.

Yes. Broadly, Mehdi, there is just a lot of uncertainty, especially as the year progresses. As you know, transactions take time to execute and the more uncertainty, the more difficult it is to plan accordingly for the execution of these type of projects.

Your next question comes from the line of Craig, B. Riley from FBR.

Congratulations on the good execution in the first quarter. So I just wanted to start with a follow-up to the point on SSD solutions and the generations of products that you have shipping to your lead customer. The question is, as you go from shipping first generation, since the third quarter of last year to second generation and third generation later this year, is there overlap in those product sales? Or as you're bringing out next-generation product, does that really cannibalize prior generation? And what are the margin implications within that business as you get from one generation to the next?

Regarding the enterprise SSD solution business model, we aim to leverage last year's design wins. This year, all products in development are set to drive revenue growth next year, which is ahead of schedule for revenue generation. Pricing discussions were finalized by the end of last year. This year's volume and pricing will be influenced by NAND supply and qualification requirements. As for Alibaba's consignment, they handle their own NAND procurement, which does not involve us. When we transition to the second generation, we are still focusing on the same solution to ensure product shipment stability, as enterprise customers value that consistency.

Craig, let me also add what Wallace has said on the gross margin. The gross margins of our Alibaba program last year were less attractive because of NAND pass-through. We were not selling to Alibaba under a consignment model last year. Last year's business with Alibaba, we bought the NAND, and NAND would flow through our balance sheet and our P&L, so the gross margin related to these sales were fairly low. Beginning in the first quarter, we started transitioning from this buy and sell to a consignment. Going into the second quarter, all of our sales to Alibaba will be on a consignment basis. So as we move to a consignment basis, the gross margins are going to be a lot more attractive. If you look into next year, when everything should be full consignment model, gross margins will continue to be quite good for our Alibaba sales.

Excellent. And then just a follow-up regarding next year since both you mentioned it within the last month or so, there's been reports that that customer's planned CapEx for next year will increase very significantly over a multiyear period. So can you just talk about the volume expectations that are part of the discussions you've been having with the next-gen products for calendar '21? How has that changed year-to-date in light of the changing expectations?

We feel very happy for our customers to have such a big capital investment for the data center. However, we cannot really discuss the portion of how much we got from our customers. We remain in a very strong relationship and are working on new technology to grow together for next year.

Excellent. And then if I could just follow up with one more back on the SSD controller side of the business. I believe there was a mention of gaming platforms and the potential to participate in those. Can you just talk about that opportunity? And how that could unfold? Are there some other similar end supply implications for participation there? What are the key variables that will determine whether you could be in? Any thoughts on share would be helpful as well.

I think our customers are all interested in growing their presence in key market segments, consumer electronics, of which game consoles are a part, is one of the three client segments. The other two segments are PC and external storage. Our focus is to provide the controller so our customers can compete to win. Our customers are programming in their choices of market segments and customers to focus on when they have that choice. Game Console OEMs are starting to introduce their first devices with SSD later this year with a per year volume likely small. I think you should expect to see our controller in game console SSD in the near future as volume scales. The OEMs refresh their console designs annually, and we do have a very strong product for PCIe Gen 4 in that category.

Your next question comes from the line of Karl Ackerman from Cowen.

How would you characterize controller inventory levels at your mobile and SSD controller customers? And additionally, are you also seeing any abnormal amount of order cancellations or push-outs from either mobile or consumer SSDs or perhaps any order pushouts from the social media company in your Shannon business? Then I have a follow-up.

It's very hard for us to comment on the inventory levels from our customers. I think for large customers, they all have different strategies and allocation when they see certain market declines, moving toward data center client SSDs. We don't know exactly how they manage because every major customer for smartphone makers, minimum they have to keep a two-month inventory. That's a standard rule. But we cannot comment. We don't know the inventory level.

Got it. That's, Okay. And just back on capital allocation and inventory. I know that inventory has ticked up a few weeks in the March quarter. How do you think about working capital for the June quarter and for the balance of the year, particularly as you switch to a consignment model for your SSD solutions business?

Karl, our inventories at the end of the first quarter went up a bit. It went up to roughly 128 days, which is higher than 101 days in the prior quarter, but it's still much lower than the 154 days we had a year ago. If you were to look at our last four quarters and average inventory days, they averaged about 132 days. So 128 days that we had in Q1 is still lower than the average of last year. We feel fairly comfortable about our inventory days. We've been investing in terms of working capital, in terms of inventory, building inventory to support our OEM SSD and mobile control programs. So these are all very necessary working capital investments to support our customers.

Your next question comes from the line of Suji Desilva from Roth Capital.

A nice job on the execution in these challenging times. So a couple of questions. First of all, on the SSD controller, do you expect, what was your share in SATA? And then do you expect a similar or higher share in PCIe controllers?

So we think we mentioned in the last fourth quarter, the first time we see our PCIe sale revenue exceed SATA, but we didn't really comment regarding the unit. So far, we've seen the SATA, the total unit still maintain very healthy in the channel market, and they're going to stay the long tail in the channel market. But PC OEMs are quickly transitioning from SATA to PCIe. Most of our new design socket design projects, all PCIe and eMCP.

So probably, let me also add, Suji. We believe our market share has been increasing. It was roughly one-third last year and likely has inched up, and we believe will continue to inch up as this year progresses.

Okay. So PCIe has already crossed over here. And then, second question on SSD solutions. A lot of questions on the call, I know, but can you compare what you expect the peak revenue to be, given all the moving parts for this business in the next few quarters versus what it was the prior peak, just to understand relatively quantitatively and qualitatively how it will compare?

In normal regular season, the peak sales revenue for all these solutions will be in Q3.

And I was talking about the magnitude of the peak, Wallace, whether it would be similar to the prior peak or whether it be higher or lower, given the...

We really cannot comment on the relative peak, what the magnitude will be, but really, Q3 will be the major sales demand from the SSD solutions, especially for Alibaba.

Okay, fair enough. And then my last question is on the UFS market and smartphone. Do you have a sense of what the end exiting '20 attach rate or mix of UFS in the smartphone market is relative to the end of '19? Just to understand how quickly it's ramping up in the midrange versus the premium?

Because we see Qualcomm really supported uMCP, this is a UFS controller with NAND and mobile DRAM, that really speeds up the transition for uMCP to replace eMCP for mainstream smartphones. We see the transition moving very quickly. By the end of this year, I think the uMCP and UFS will be more than 50%, 60% of the total smartphone market. So the transition is very, very fast. We do see all the major smartphone OEMs favor UFS and uMCP solutions.

Your next question comes from the line of Gokul Hariharan from JPMorgan.

First of all, let me ask a little bit about how you feel about demand? I understand that there are a lot of volatility and variability in demand. But if I think about the second half, among the three segments, on a half-on-half basis. Do you feel that all three segments are likely to struggle, and we should see probably flattish or even declining half-on-half momentum for all three segments? Or do you think that some segments could actually still power through and continue to grow in the second half of the year? And also on the demand side, can you talk a little bit about compared to the previous call for the Q4 '19 earnings call? Could you talk a little bit about where the demand has increased especially because of the stay-at-home, work-from-home kind of demand? Has it been primarily SSD controllers in the PC OEM side? Or have you also seen some increases in the SSD controller for channel customers as well as on the SSD solutions? I had a follow-up question as well.

Okay. Let me answer the first question regarding COVID-19 impact. Regarding the second half, although our visibility is not clear for the second half, we believe for SSD solutions and our client SSD will maintain strong growth. Regarding mobile, there is a big uncertainty because we think we have good momentum, because we have great design wins and pipeline from both U.S. OEMs and China module makers. We own the majority of China module maker design wins. However, it's very difficult to predict smartphone trends. As you can see, Samsung and Apple cut their forecasts. We have confidence all three product lines are going to grow compared with last year. However, we are pretty sure that our SSD solutions and client SSD controllers will continue to grow.

Do you worry that there is any sort of pull-in demand that has happened in Q1 and Q2, which could result in some weakness on the PC side of the equation? I think some of the other semiconductor companies, such as Intel and AMD, have talked about PCs likely to cool off going into the second half given a lot of the pull-in demand. So do you still feel comfortable that SSD controller can still grow even if PC demand sits down half-on-half in the second half of the year?

That is correct because our major customers for the first half, the NAND makers, are allocating much more NAND output to data center. We do not benefit from stronger PC OEM demand for the first half, but we already see the growth because we have a much broader socket from a broader customer base. We see that in the second half if data center demand slows down and smartphone remains weak, our NAND makers will reallocate NAND output to client SSD.

Gokul, let me also add, when we look at our visibility, we're looking at our visibility from two different perspectives, the perspective of our order books and the perspective of a more theoretical approach. Our order books today for our OEM programs relating to both on the controller side as well as on the SSD controller side. We already have visibility extending through to the third quarter. It's the fourth quarter that's a little more problematic, right? At the same time, when we look at our overall business from a more theoretical approach based on a sensitivity analysis, what we also see is even if overall PC sales were to decline meaningfully, and also what if overall mobile phones were to decline fairly meaningfully this year. We believe our overall SSD controller as well as UFS controller sales will continue to do very well because of the transition. The transition on the PC side from HDD to SSDs. The speed of this transition will continue to offset the slowdown, potential slowdown of PCs. Likewise, on the smartphone side, if smartphones were to decline meaningfully, the speed of the transition from eMMC to UFS will more than offset the decline of overall smartphones.

Okay. One quick follow-up on the inventory. Could you talk a little bit about the inventory that you carry on the balance sheet mostly solutions related, NAND flash, for example? Or is it that a significant part of it is controllers as well? And any thoughts on how your inventory is likely to look at, especially for the controller side exceeding Q2?

Gokul, most of our inventory are for controllers. Controllers that we have built out for the important OEM programs that we're expecting to ship in upcoming months and quarters. But we also do have some flash that we've built for our non-Alibaba SSD solutions projects. Those are also important for business that we're expecting in the upcoming quarter.

And let me add a comment regarding our inventory. As you all know, TSMC, the foundry capacity is overbooking. It's about 100% overbooked to 50% overbook. That's why the lead time has become much longer. In normal periods, the lead time is about two months to 2.5 months. Now the lead time is 4 to 6 months depending on the geometry and technology. That's why I think 128 days is really at the minimum we need because the cycle time when you give yield to wafer out, it takes that much time for 4 months. That's standard for TSMC policy here today.

Our next question comes from the line of Ariel Shusterman from Needham & Company.

This is Ari. I'm taking the question for Raji Gill. So first, I wanted to talk about your expectations for client SSD growth in the second half of 2020, given how different scenarios you guys outlined, particularly regarding hyperscale SSDs. The growth, how the growth looked at, the supply of clients SSDs in their business?

We're expecting our overall SSD controller sales to continue to grow strongly. With PC, near term, we have a lot of demand from our customers for work-from-home and online learning that is driving a lot of incremental procurement in the near term. As the year progresses, we're going to continue to expect more PCs to ship with SSDs as they transition away from hard disk drives. This is a longer-term trend that we've been seeing, and we will continue to see through the rest of this year.

Okay. And yes, regarding your Ferri product line, can you provide some color on the traction that has been received?

Ferri product line, last year, due to the price declines, we slowed down a little bit. But this year, we are growing in the right direction. Major growth from Ferri product line is one for automotive; second is really for the server boosted storage product. We will see very strong growth and rebound starting from Q2 this year.

Your next question comes from the line of Donnie Teng from Nomura.

My first question is also regarding the gross margin. I think it probably has been answered, but just a little bit curious about because in the first quarter of guidance, you gave a relatively conservative gross margin guidance, but in the result, you reached over 48% gross margin, and the second quarter gross margin guidance also not that bad compared with the first quarter guidance. So just curious of what exactly changed when we gave out the first quarter guidance early this year, first as the result and guidance right now? Is there any new products that maybe previously we did not include in our guidance, such as infrastructure-related controllers? Just curious about that.

Well, Donnie, originally, we were expecting slightly stronger overall revenue growth for the first quarter, and we ultimately came in the lower half of what we had guided. So for us to have made our stronger number that we were originally anticipating, we were anticipating a slightly stronger SSD solution sales. If we had stronger SSD solution sales, our overall gross margin would have been blended down more than what we saw when the SSD solutions were at slightly lower levels. Additionally, our SSD solutions' gross margin also improved a little bit versus what we had originally anticipated. So the combination of these two factors helped boost our overall gross margin profile for the first quarter.

So just a quick follow-up. Is there any organic gross margin improvement for the controller business as well? Or is it just maintained at the previous level like last year?

Our controller gross margins sequentially from fourth quarter to first quarter were very stable, essentially unchanged sequentially.

Got it. My second question is about your outlook for the second half. It seems like, as Wallace mentioned, you are feeling more positive about SSD solutions and client SSD controllers. I'm curious about what our growth momentum looks like in terms of both quarter-over-quarter and year-over-year, or are you just referring to year-over-year growth?

For both.

Both?

For both, quarter-to-quarter, year-over-year.

Understood. May I ask a follow-up? You mentioned that some NAND suppliers might shift their NAND to consumer products in the second half if there is a demand decrease on the server side. Are you mainly referring to customers like Intel? I'm asking because Intel appears to be doing well in the server segment in the first half, and it seems that our client SSD controller shipments for Intel's products in the first quarter are relatively low.

We cannot provide comments on individual customers since each has their own choices and priorities for maximizing their interests and profits. However, we believe our client SSD will continue to experience strong growth in the second half, whether it be quarter-on-quarter or year-over-year. It doesn't matter if NAND's data center demand is stronger or weaker; we can achieve growth in mobile, client SSD, and enterprise SSD solutions across the board.

Your next question comes from the line of Jeff Hsu from MS.

I want to follow up on Donnie's question regarding the opportunities for our China SSD solutions. Let me rephrase the question. Considering your key customers in China and their recent announcements about cloud investments, how does that impact your outlook compared to the last time you shared your SSD solutions forecast?

I think their announcement is for three-year capital investment. I don't think it will affect our outlook for this year. Just remember, our business with Alibaba is changed to consignment based. Revenue at a dollar sale is not that great, but the margin will be wonderful.

Okay. And maybe just a very quick follow-up. When you mentioned first quarter SSD solution, revenue was tracking a little behind your original expectations, does, and I understand how long is your typical order visibility in your SSD solution business?

Regarding the Q1, particularly, our SSD solution portion, there's a couple of million dollars which we were supposed to ship and we could not ship. It's not because the customer canceled or postponed, it's because if certain material was impacted by the China lockdown and customers could not produce and ship the product to their end customer. That's why that revenue has been postponed. Normally, I think our visibility is very high for SSD solution; the orders would probably reflect POs to us.

Okay. That's very helpful. And maybe if I may ask a second question on your full year outlook. So if you look at, just to recap the comments you mentioned during this call, so a client SSD outlook remains pretty strong with visibility extending at least at the OEM side into the third quarter, China solutions, SSD solutions visibility also seems pretty well. So I'm curious, by withdrawing your full year guidance, does that imply fourth quarter uncertainty is really high and that may fluctuate so much compared to your previous guidance you provided?

Jeff, there are a lot of, broadly, what we've seen is a regional epidemic issue centered in China, that expanded into a massive global pandemic with economic issues, a regional economic issue broadening into a massive global economic recession, likely a severe one. As the year progresses, the more we will be facing more and more uncertainty. From our own perspective, our order books, we have order book visibility through the third quarter. However, when it comes to the fourth quarter, we no longer have that. Given all the various moving parts, we felt prudent to not guide what we do not have.

There are no further questions at this time. I would like to hand the conference back to Wallace Kou for closing remarks.

Thank you, everyone, for joining us today and for your continuing interest in Silicon Motion. In the second quarter, we will be attending virtual investor conferences hosted by several banks. The schedule of our attendance will be posted on our website. Until we next meet, stay safe, goodbye for now.

Ladies and gentlemen, this concludes this conference call. Thank you for participating. You may all disconnect.