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Cavium Networks, Inc. (NASDAQ:CAVM)

Q3 2008 Earnings Call

October 20, 2008 5:00 pm ET

Executives

Angel Atondo – Marketing Communications Manager

Syed Ali – President and Chief Executive Officer

Art Chadwick –Vice President and Chief Financial Officer

Analysts

Tim Luke – Barclays

Sanjay Devgan – Morgan Stanley

Krishna Shankar – JMP Securities

Arnab Chanda – Deutsche Bank

Dan Morris - Oppenheimer

Kevin Cassidy – Thomas Weisel Partners

Gary Mobley – Piper Jaffray

Sandy Harrison – Signal Hill

Quinn Bolton – Needham & Co.

Christian Schwab – Craig-Hallum Capital

Operator

Welcome to the Cavium Network third quarter 2008 earnings conference call. (Operator Instructions) With that I will turn the call over to Angel Atondo, Marketing and Communications Director.

Angel Atondo

Leading the call today are Mr. Syed Ali, President and CEO of the Company, and Art Chadwick, Vice President and Chief Financial Officer.

Before we begin, I would like to remind you that various remarks that we make on this call, including those about our future financial results, including revenue, gross margin, operating expenses, design wins, product plans, our competitive situation, market trends, and our anticipated growth and profitability all constitute forward-looking statements for the purpose of the Safe Harbor provisions under the Private Securities Litigation Reform Act. These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties that may cause actual results to differ materially.

We refer you to our most recent Form 10-K and Form 10-Q filed with the SEC in particular to the section entitled Risk Factors and to other reports that we may file from time to time with the SEC for additional information on factors that could cause actual results to differ materially from our current expectations. These forward-looking statements speak only as of the date hereof and we disclaim any obligation to update these forward-looking statements.

In addition, Cavium reports gross margins and net income and basic diluted net income per share in accordance with GAAP and additionally on a non-GAAP basis. Management believes the non-GAAP information is useful because it can enhance the understanding of the Company's ongoing economic performance and Cavium, therefore, uses non-GAAP reporting internally to evaluate and manage the Company's operations.

Cavium has chosen to provide this information to investors to enable them to perform comparisons of operating results in a manner similar to how the Company analyzes its operating results. The full reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued earlier today and we ask that you review it in conjunction with this call.

I would now like to turn the call over to Syed Ali.

Syed Ali

Today we are extremely pleased to report yet another record quarter with strong double digit sequential growth and further accelerated year-over-year growth.

In brief, Cavium’s third quarter revenue was a record $24.5 million which represents a 14% sequential and 73% year-over-year growth. Non-GAAP gross margins came in at 62.8%. Non-GAAP operating margins increased from 16.8% in Q2 to 19.2% in Q3. These higher operating margins along with higher revenue increase non-GAAP operating income 30% sequentially. Non-GAAP net income was $4.6 million or $0.11 per share and our GAAP net income was $1.8 million or $0.04 per share.

Art Chadwick, our CFO, will provide more details on the Q3 financial results and Q4 guidance shortly.

I will now move on to give you some more details on our Q3 revenues along with a general update on the demand environment after which I will discuss design wins and new customer and partner relationships. Following this I will give you an update on the Star Semiconductor acquisition.

In Q3 we saw strong growth in both the broadband consumer and the enterprise and data center segments. The enterprise and data center segment continued to be the largest segment at 64% of product sales and grew 8.5% quarter-over-quarter. The remaining segments including consumer broadband, access service provider and software services segment combined to achieve 36% of sales for the quarter and grew 22% sequentially.

By contrast, in Q2 the enterprise data center segment grew 7% sequentially while the non-enterprise data center segment grew about 40%. The broadband and consumer segment continued to experience extremely robust growth with continued strong sales into the home segment for Sumitomo in Japan and a European service provider.

We also have some new designs starting to go into production in the SOHO and some B segments for the 802.11 wireless plan and broadband routers. Growth in the enterprise and data center segments was driven by record sales into the network security segment and new product cycles in the data center with customers such as F5 networks and [Centrix].

Now I would like to discuss the current demand environment. All of us are aware of the uncertain macro environment outlook that exists today so it would be prudent for us to prepare ourselves for increased customer cautiousness this quarter. Reducing some pockets of softness in certain areas of our run rate business and one area of our concern for us this quarter, which is Q4, is demand for higher end boxes for the service provider and data center segment. This is typically equipment in the $20,000 to $100,000 range. Although this is not yet a huge segment for us it nevertheless will have some impact for us.

On the positive side, in Q4 we expect to see continuing growth in the broadband, SOHO and medium business segments in Q4. We are particularly excited about the prospects of Actiontec and GTE. We have announced that Actiontec CPE Box for Verizon’s file service uses a dual core Cavium OCTEON processor. Volume shipments will begin late this year and we expect this deployment to deliver excellent growth during the first half of 2009.

We also announced today a design win at China based ZPE Corporation, a global leader in telecom equipment and network solutions. ZPE will use our OCTEON processor in a feature rich, 3G wireless wide band CDMA broadband router for customers’ premises equipment to support the growing wireless broadband access deployments worldwide. This will start shipping nominal quantities in Q4 with accelerating shipments in the first half of 2009.

I would now like to provide an update on actual Q3 design wins. This past quarter we had record design win rates which continued our strong design win momentum from the first half of 2008. We continue to win new designs across a broad range of applications in all of our four major target segments. Design wins were spread across all major segments with high number this quarter in the enterprise data center and service provider segments.

We closed multiple new design wins at a number of tier one customers including Alcatel Lucent, Aras, Sienna, Cisco, [DLink], Juniper and Nokia Siemens. In the enterprise and data center segment we won major new designs in enterprise routers, services line cards, wireless LAN controllers, financial transaction messaging routers and fiber channel gateways.

In the access and service provider segment, we won significant new designs in next generation cable modem, application systems, service provider routers, APCA ANC systems and a broad range of LTE and Wi-Max equipment including base stations and ASN gateways.

In the broadband and CPE gateway market we won new designs for SOHO and SME routers, 802.11 and access point, IP surveillance and NAS products. Our pipeline of potential new design wins across our target market segments remains extremely strong at approximately 2X our quarterly design win rate which indicates that we will continue to maintain these accelerated design win rates in the foreseeable future.

All in all we do not see any major impact of the current macro environment in design win rates. Customers are continuing to start new designs as well as execute on pushing current systems which are in the design phase now into production as quickly as possible.

During the first quarter we made major progress in new product introductions or the NPI phase for our entire OCTEON plus product line. Our OCTEON Plus 58 XX processors achieved production status and initial OEM customer products using these have already started to ramp. The OCTEON plus 5.0 XX achieved production qualification status in the previous quarter and has seen the fastest ramp in unit volumes of any product in the history of our company. The OCTEON plus 56 XX, 57 XX, 54, 55 and 52 XX products sampled in significant quantities to over 15 early access customers and are making excellent progress towards reaching production in the coming months.

We also released updated software developments to support the new OCTEON plus processors for our customers and [e-commerce] partners. The OCTEON plus CD5XX line offers a number of industry leading features and benefits. Networking, wireless, storage and security applications. Additionally it makes up a majority of our current design win dollars that we are winning every quarter. This bodes well for both new design wins and associated revenue ramps using our OCTEON plus product lines in 2009.

Now moving on to relationships, in Q3 our customers released new Cavium powered equipment to market. We also continue to strengthen our support [eon] system as a number of leading solution providers release OCTEON phase II and application software optimized for Cavium processors. Wind River, a global leader in device software optimization announced that it has released its newest device development tools for the OCTEON processors. These new Wind River tools help multi-core development and reduce time to market.

Monte vista, a leading embedded Linux vendor announced availability of its Linux carrier grade edition for the OCTEON processors that deliver telecom standard compliance for our products. Mail Shelf, a leading provider of email applications, anti-spam and anti-phishing engines announced that its replication service and spam detection [SEK] support Cavium’s Network’s OCTEON multi-core processor family. We also demonstrated comprehensive broadband, SOHO and SME designs as a broadband work forum in Brussels. As I mentioned before this is a strongly growing segment for us.

We also announced three new volume customers in the segment including [DLink] Actiontec and ZTE.

Now, I would like to make some quick comments about our acquisition of Star Semiconductor. We added 49 Star employees to the Cavium family last quarter. The acquisition closed in early August and the integration was executed flawlessly on all fronts including engineering, operations and finance. Within the first 45 days we have successfully defined the next generation products, selected the technology and FAB and started executing the design.

The next generation of products are targeting a wide range of applications in the broadband, digital home and office and consumer applications. These products will deliver highly optimized solutions for low cost and low power along with a rich feature set. The initial customer response to these products has been extremely positive. We are very excited about the TAM expansion and revenue potential of these products when they come to market next year.

On that note I would now like to turn the call over to Art Chadwick who will provide a detailed discussion of the Q3 financial results and guidance for Q4 and after that we will be happy to take your questions.

Art?

Art Chadwick

Thanks Syed. Thanks to all of you for joining us today. I’m first going to go through our Q3 financial highlights and then provide some guidance for Q4. As Syed just described, Q3 was another record quarter for us. Third quarter revenue of $24.5 million continued our history of strong sequential and year-over-year growth. Sales were up 14% sequentially and 73% year-over-year. Sales to Cisco systems were 24% of total sales, down from 33% of sales in Q2. Sales to Sumitomo were also strong this quarter and accounted for 13% of total sales. Sales to F5 Networks increased from less than 10% of sales in Q2 to 12% of sales in Q3. Sales to our top five customers accounted for 57% of total sales. Sales to those top five customers rose slightly from Q2 to Q3 with the increase in sales to F5 Networks offsetting much of the decrease in sales to Cisco.

Sales to seven of our top ten customers increase sequentially and total sales to those top ten customers increased 13% sequentially. Sales increased sequentially in the U.S. and internationally. Domestic and international sales were each 50% of total company sales. In our press release we announced both GAAP and non-GAAP results. Our non-GAAP results this quarter exclude $1.8 million in stock based compensation and remaining payroll tax expenses, and $1.0 million in amortized acquired intangibles and other acquisition related costs related to Star Semiconductors.

GAAP gross margins were 58.8% but these were impacted by nearly $1 million in Star Semiconductor acquisition related costs. Non-GAAP gross margins in Q3 were 62.8%. This was lower than Q2 by approximately a percentage point due to the higher percentage of broadband and consumer product sales but it was absolutely consistent with our guidance. Operating expenses excluding stock based compensation were $10.7 million, a 5% sequential increase over Q2 due to increased spending in both R&D and SG&A.

Non-GAAP R&D expenses increased from $5.6 million in Q2 to $5.8 million in Q3. Non-GAAP SG&A expenses increased from $4.6 million in Q2 to $4.9 million in Q3. We had 291 employees at the end of September, an increase of 61 employees during the quarter, 49 of whom joined us as a result of the acquisition of Star Semiconductor.

We believe that non-GAAP operating margins are an important financial metric of our business. We have continued to expand operating margins on a sequential basis every quarter since our IPO. Non-GAAP operating margins increased from 12.6% in Q1 of this year to 16.8% in Q2 to 19.2% in Q3. This 240 basis point expansion from Q2 to Q3 was the result of sales growing more than twice the rate as our operating expenses.

We had a strong increase in non-GAAP operating income due to the higher sales as well as due to the higher operating margin. Non-GAAP operating income in Q3 was $4.7 million. This was a 30% sequential increase from Q2.

Net interest income for the quarter was $384,000. All of our funds are invested in high grade money market accounts which provide good liquidity and safety but it also means our interest income has declined significantly as rates have fallen. Net interest and other income has gone from $1.2 million in Q4 of last year to less than $400,000 this quarter. That is a decrease equal to $0.02 per share a quarter. As a result our non-GAAP net income was $4.6 million, or $0.11 per share. This was a 20% sequential increase over Q2.

On a GAAP basis, GAAP net income in Q3 was $1.8 million or $0.04 per share. As Syed mentioned during the quarter we completed our acquisition of Star Semiconductor. Our new Taiwan based organization has significantly expanded our design capabilities and they now have been nicely integrated into the company. The final net cash purchase price for that acquisition was $9.6 million.

We generated $4.4 million in positive cash flow from operating activities in Q3 and ended the quarter with $92 million in cash and equivalents and no bank debt. Accounts receivable were $13.5 million at the end of the quarter which equates to DSO’s of 49 days. Furthermore our AR aging is extraordinarily clean. Less than one-half of one percent of our outstanding AR is more than 30 days overdue. Inventory at the end of the quarter was $15.3 million. This was an 18% sequential increase from Q2 which is consistent with our business growth rate in the same time frame.

So now I would like to provide some guidance in how we see the fourth quarter. Though we are not totally immune from the current macro economic environment we believe we are more insulated than many other companies. Because of the design win nature of our business and our broad design win penetration as long as our customers do not significantly push out the development and introduction of their next generation products we believe we can and will continue to grow sales into Q4 and beyond. However, as Syed mentioned the current macro environment may have some short-term impact on our run rate business. Therefore we are being a bit more cautious than usual in regards to guidance for next quarter.

For Q4 we currently expect sales to increase sequentially to between $25.5 million and $26 million due to continued customer demand across multiple customers and markets as well as additional sales growth in the broadband and consumer markets. We believe Q4 non-GAAP gross margins will be in the 61% to 62% range. This is lower than in Q3 again due to a higher than expected percentage of sales going into the broadband and consumer segments. However, as more of our large enterprise design wins go into production in 2009 we would then expect gross margins to trend up as they re-level.

Net interest income should remain relatively flat quarter-to-quarter. Stock based compensation expense in Q4 is expected to be approximately $2 million. Amortized acquired intangibles are expected to be approximately $500,000 and income taxes are actually expected to decrease in Q4 due to the benefit of certain R&D tax credits that were passed in October.

Our fully diluted per share count used for non-GAAP EPS should remain relatively flat in Q4 at approximately 44 million shares. We expect Q4 non-GAAP EPS to be in the range of $0.12 to $0.13 per share.

So in summary, in Q3 we showed strong sequential and year-over-year sales growth among a broad base of customers and markets. Due to the leverage in our business model we continue to expand operating margin, operating income and non-GAAP EPS. Though the economic climate is clearly not as robust as we would all like, we still firmly believe we can and will continue to grow our business in Q4 and beyond. Furthermore, we have a very solid and liquid balance sheet that will continue to provide a strong, competitive advantage in today’s environment.

With that we are ready to go to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Tim Luke – Barclays.

Tim Luke – Barclays

I was wondering if you could provide some color on how you saw Cisco and F5 as a percentage of the revenue being more than 10% in the third quarter and then remind us in the guidance you are giving of 25.5-26 it sounds like you see broadband and enterprise up sequentially with the service provider flatter or lower. Could you just provide some color on that? I was also wondering if you could give us some color on the inventory level which went up a bit and how you expect that to trend going forward.

Art Chadwick

In regards to Cisco and F5, as I mentioned in my discussion Cisco was 24% of our business in Q3 and F5 was 12% of our business in Q3. In terms of the market segment going forward we didn’t get that specific in our guidance.

Syed Ali

Let me just add on to that in terms of F5 they were not a 10% in Q2 and became a 10% customer and this was primarily driven by their new product cycles of new products that have been launched over the past few months. Cisco traditionally has a strong Q4 which is the end of their fiscal year and a little bit more muted Q1 and pretty much that is what reflects in our revenues.

Tim Luke – Barclays

As you see it today, having guided up from the mid singles in the fourth quarter, how do you see the shape of 2009 progressing? Is it kind of a similar sequential growth through March and June and then a strong second half or how should we think about that?

Syed Ali

I think at this point if you take a look at it you had made a comment broadband and consumer was the fastest growing segment and that is absolutely true with enterprise growing somewhat modestly. Obviously we have a little bit of caution in terms of the service provider and data center side just because these boxes are more expensive and some sales may not be as good as in the past. Having said that I think you will see over the next quarter or two strong growth in the broadband and consumer side which is going to be the primary driver of our sequential growth but I do believe as we get into the first half of 2009 and beyond that we will start re-accelerating our sequential growth as we move along.

Tim Luke – Barclays

Any comment on the inventory?

Art Chadwick

Our inventory increased 18% from Q2 to Q3. If you look at our product cost of sales going from Q2 to Q3 that also increased 18%. So what that means is our inventory increase is absolutely consistent with the growth in our business. Going forward I would expect our inventory will continue to increase though I do expect our inventory will continue to grow at a slower rate than our sales growth. I think we are starting to get some economies of scale that you will see in the next couple of quarters in regards to our inventory. So inventory should grow at a slower rate than our top line over the next couple of quarters.

Syed Ali

Another comment on that is if you take a look at the two recently announced customers which is Actiontec and ZTE these are fairly high volume designs that tend to ramp pretty quickly so we want to make sure we have enough products for these ramp customers.

Tim Luke – Barclays

Just to clarify, the op Ex and the tax guidance, what was the guidance for tax and op ex?

Art Chadwick

We didn’t provide detailed guidance for op ex. For taxes I mentioned our taxes in Q4 should be down from what they were in Q3 in absolute dollars. That is correct. Bottom line our guidance was for non-GAAP EPS of between $0.12 and $0.13.

Operator

The next question comes from Sanjay Devgan – Morgan Stanley.

Sanjay Devgan – Morgan Stanley

I was wondering if you could comment, given the macro issues that are surrounding us right now if you could kind of talk about your linearity as you went through the quarter for your existing run rate business, not for the new ramps, if you could just talk to that and tell us if there is anything different from what you would normally see quarter-to-quarter.

Art Chadwick

In terms of linearity for the most part our orders come in relatively linear throughout the course of a quarter. Some quarters can be a little more so than others but this quarter really wasn’t much different than any past quarters in terms of the linearity of our order run rate.

Sanjay Devgan – Morgan Stanley

If you talk about the continued traction of your design wins. Can you give us a sense of the dollar values of these design wins that you are getting today versus a couple of years ago? I am assuming the value is much more but I was wondering if you could help us kind of quantify what that actual uplift is on the dollar value of the design wins today relative to a year or year and a half ago?

Syed Ali

If you take a look at it and compare it to a year to a year and a half ago, the design win dollars that we are winning every quarter is approximately 2X of what it was 12-18 months ago.

Sanjay Devgan – Morgan Stanley

These are, like you said, pervasive across broadband, enterprise and data service provider or is this kind of like you are expecting your service provider wins will be 2X but we may have to wait 36 months or 24 months for those to kick in or is it across all segments?

Syed Ali

This is kind of a weighted average across all end markets and one of the things you are seeing is you are seeing the broadband segment ramp up fairly quickly over the past quarter or quarter or two and essentially it is broadband boxes are small boxes that go to production the quickest. So you start seeing more of the enterprise mid range and higher end boxes start following them somewhere in the 6 months or so later. So this is a very well spread out mix of design wins across all our major end market segments.

Sanjay Devgan – Morgan Stanley

You have entered a number of new markets over the last 15 months or so including wireless infrastructure, the storage markets, in addition to the networking and the threat management security market. I’m just wondering if there are any new markets we should be on the lookout for kind of adjacencies you guys see? Obviously the consumer is a big focus given the Star acquisition but if there anything else we should look for? What are some of the adjacent markets that we can kind of look to drive further growth for your business?

Syed Ali

I think when I kind of step back and look now at the new products we have introduced, we have done by far the best in the wireless infrastructure business and this is everything from base stations, radio network controllers, XGSN type products all the way now down to the newly announced wireless broadband routers. So our penetration rate has been absolutely phenomenal in kind of the 3G, 4G Wi-Max infrastructure. On the storage side it took about a quarter or two longer than the wireless to really start getting penetration but we again over the last three months to six months started seeing a phenomenal uptick on the storage side too with design wins at absolutely tier one brand names. We will start seeing these roll into production in the second half of 2009 and beyond.

So if you look at adjacent markets, the most obvious one and we are making a big focus on this market is the PR control plane market which is kind of the single core, dual core 500 MHz to 1 GHz control plane market. This is a large portion of the existing embedded market and we are starting to see a fairly nice expansion in that area.

Operator

The next question comes from Krishna Shankar – JMP Securities.

Krishna Shankar – JMP Securities

As you look at the broadband segment which seems to be showing pretty good growth here, do you have any concerns about the broadband consumer slowing down in Japan, Europe or the U.S. as consumer slows down? What is your visibility in the broadband consumer in imports and here with Verizon?

Syed Ali

One of the good things here is the broadband deployments we are in the beginning stages of the deployment. These are new deployments that are replacing existing shipping deployments so we are starting with a pretty low base. So, if you are running full throttle at the maximum level at every one of these places there could be fluctuations up and down but as we look at it first Sumitomo came on board, a European service provider came on board and Verizon is going to come on board later this year and China is going to come on board so we have a nice frame of design wins going to production that should be able to deliver pretty good growth for us over the next few quarters.

Krishna Shankar – JMP Securities

On the enterprise side you have indicated 2009 will be a pretty big year for some next generation enterprise boxes and customers like Cisco and Juniper. How does the current macro slow down impact some of those next generation enterprise design wins?

Syed Ali

Those are some of our highest revenue per design win opportunities in enterprise. We track them almost on a twice a month basis. You are right in saying there are a significant number of new enterprise design wins that will start going into production in 2009 and pretty much all of the critical ones are pretty much on schedule. In fact some of them are a month or a month and a half ahead of schedule and we are not seeing any slow downs or any push out in terms of drive for them to go to production. So these are absolutely the designs that we are very, very excited about and as Art pointed out we go to production on the broadband side in about 12 months. On the enterprise side it takes about 18-24 months and the service provider data center side may take 24-30 months. So you have kind of seen the first train if you will of the broadband going to production which is then going to be followed by enterprise. So as Art pointed out, as the enterprise and higher end boxes go to production we should also start benefiting positively on the gross margin side of it.

Krishna Shankar – JMP Securities

So you feel that your long-term gross margin target of 60-62% is still valid despite this accelerated pace of broadband design wins?

Art Chadwick

As a long-term model we are sticking with the 60-62%, absolutely.

Operator

The next question comes from Arnab Chanda – Deutsche Bank.

Arnab Chanda – Deutsche Bank

You talked about your run rate business seeing some impact from the macro conditions. Could you talk a bout qualitatively how much of your run rate business is? Is it half of your business? Is it more security; is it your processor business? Have you adequately managed for that as in if you are just starting to see it is there a risk that it can actually get worse?

Syed Ali

I think if you look at our run rate business it will typically range in the 65-70% with 1/3 of it roughly being new products that are in the early stages or slightly later stages of production. So it is roughly about 2/3, 1/3.

Arnab Chanda – Deutsche Bank

Could you talk a little bit about design wins you are seeing today in what are the biggest end markets? You talked about enterprise. Are there specific areas you want to talk about that have a bigger growth opportunity that we should be looking out for?

Syed Ali

I think if you take a look at it in terms of design win dollars in the wireless infrastructure number one. CMPX is number two which is kind of the cable modem type infrastructure. Also, in enterprise routers and appliances. These are probably the 2-3 highest dollar design wins we are getting. And obviously there is a nice mix of broadband too as we announced today with ZTE but there is a whole range of other similar products most in the wireless structure CPE equipment in which we are pretty excited about.

Arnab Chanda – Deutsche Bank

In your gross margins there was either inventory charge or inventory write off. Could you explain what that is? Do you have too much inventory? What exactly is going on there?

Art Chadwick

Not at all. That has to do with our Star acquisition. When you acquire a company you have to write up their inventory to a value similar to what a distributor would take it in as, so when it gets sold it is like a 10% gross margin. So you have to write that inventory up and then charge it off to cost of sales as it gets sold. So that completely distorts the ongoing non-GAAP performance of the company. So it is an accounting entry you have to make when you make the acquisition and then you sell that material. That is what that adjustment was. You have to do the write up of inventory that we acquired with Star and then the impact that had on the cost of sales this quarter as that product was sold.

Operator

The next question comes from Dan Morris – Oppenheimer.

Dan Morris - Oppenheimer

You had mentioned there was pocket weakness that was maybe related to higher end boxes for both service provider and enterprise. Could you help us understand why maybe it was hitting the higher end boxes first and then also were there any other areas that you might have seen some weakness?

Syed Ali

A lot of the higher end boxes go either to service providers or to financial institutions. Because of the recent upheaval there may be some softness in demand in that particular area.

Dan Morris - Oppenheimer

Were there any other pockets of weakness that you saw outside of the higher end boxes?

Syed Ali

No, other than that it pretty much is business as usual. In fact, like we said on the broadband side business is a little bit better than we expected it to be.

Dan Morris - Oppenheimer

Your sales seem to have sort of jumped around quite a bit this year especially compared to last year where we saw pretty stable, as a percent of revenues anyway, between 22-24%. Is there a reason it has been jumping around a bit this year?

Syed Ali

Not really. I think the reason it kind of jumped around from quarter-to-quarter is in some quarters Cisco will buy a bunch of product for preproduction release quantities. Then this product actually kind of goes out there and it takes a quarter or two before it really ramps in production. So you can have certain quarters where you have 2-3 designs where you buy these pre-production quantities and then there will be no significant sales in the following quarter. That is one aspect of it. The second aspect of it is there is some visibility in that for example typically we see that at the end of Q4 or fiscal Q4 we generally tend to have a larger quarter than in the first quarter after that. So this is more of a general up and down range but overall I think in the guidance given in any given quarter will be between 20% and 30% of sales.

Operator

The next question comes from Kevin Cassidy – Thomas Weisel Partners.

Kevin Cassidy – Thomas Weisel Partners

You had mentioned you have defined products for Star Semiconductor. Can you say is that going to be an arm based product or a mixed based product?

Syed Ali

The position is for it to be an arm based product.

Kevin Cassidy – Thomas Weisel Partners

You had also said it was going to be introduced next year. It seems earlier than you said in the last conference call, or at least what expectations were for revenue?

Syed Ali

I think we have done a very good job at the integration of Star and finalizing the definition of the product, like I said at 45 days it is all done and it is already in execution. So, we expect to really start seeing some penetration into that market in the latter half of 2009.

Kevin Cassidy – Thomas Weisel Partners

So you think there will be revenue in the latter half of 2009? Or is that just announcing design wins?

Syed Ali

No, actually some early revenues coming in the earlier half of the year.

Kevin Cassidy – Thomas Weisel Partners

For next year do you expect to have the same kind of leverage with the top line growing twice as fast as the operating, or op ex line?

Art Chadwick

For the most part. We have always talked about our long-term operating margin being kind of 22-25%. So if you look at our history over the last few quarters we have continued to expand our operating margins and our intention is to do that going forward. Op ex going forward will at some point start to more fully map the slope of our sales growth. Once we get closed to our long-term operating margin. But, shorter term our plan is to increase operating expenses at a slower rate than our sales. That is true.

Operator

The next question comes from Gary Mobley – Piper Jaffray.

Gary Mobley – Piper Jaffray

With respect to your Q4 revenue guidance between $25.5 to $26 million do you have more or less dependence on terms business to hit that number?

Art Chadwick

Every quarter on average our customers give us about 8 weeks lead time going into a quarter. That gives us backlog of between 50-60-70% during the quarter on average going into a quarter. That really hasn’t changed significantly over the last few quarters. We don’t see that is really going to change significantly going from Q3 to Q4.

Gary Mobley – Piper Jaffray

What is the current stance on a share repurchase program in light of recent activity?

Art Chadwick

We actually talked about it internally. At this point, the way a company used to look at it as what is the best use of your cash, is it to go out and buy back shares or to use it for other opportunities to grow the company? Last quarter in Q3 we invested a little less than $10 million of our cash to go acquire Star Semiconductor and I think that is going to be a really excellent acquisition for us. It adds to our design team and other things we have talked about. So we decided that $10 million is better used to do an acquisition rather than buy back stock. Going forward if we find other opportunities out there to invest our cash I think we would take advantage of that. So having said all of that at this point in time it probably makes more sense for us to invest that cash in our business rather than going out and simply buying back our stock.

Gary Mobley – Piper Jaffray

On the topic of cash management, should we assume in perpetuity that you are going to continue to invest that cash with some short-term treasuries with fairly close on the yield curve?

Art Chadwick

Let me say this. We have discussed this quite a bit. We have done a very good job of managing our cash. We did not buy any auction rate securities like other companies did. We have not stretched ourselves into any type of risky investment. We invest strictly in very high grade money market accounts and our intention is to continue to do so. The downside of course is when we earn a couple of percentage points on earnings, but the upside is as we haven’t lost any of it and we have no intention of losing any of it going forward.

Operator

The next question comes from Sandy Harrison – Signal Hill.

Sandy Harrison – Signal Hill

From a competitive landscape with the toughening macro environment are you seeing any changes as I think one of your competitors was actually trying to go public or talked about going public at some point and you don’t seem to see that happening right now. Is that helping or hurting them? Any other folks out there trying to protect themselves out there leaving you with some opportunities in the market that otherwise might have not?

Syed Ali

If you take a look at it, in good times a good guy will carry even good or bad companies up. So, we believe that in these more challenging times that this really helps us put distance between us and our nearest competitors. We are actually seeing from our design win rates right now that we are essentially strengthening our position in the market against both public and private competitors.

Sandy Harrison – Signal Hill

You mentioned in our prepared remarks some opportunities in the IP surveillance market and referred to a couple of announcements about that in different areas. What is the opportunity there and is that something you see as an interesting market or is it one of those fillers in between other adjacent markets?

Syed Ali

If you take a look at the visually connected home and office and consumer IP surveillance it is an interesting market and it is certainly a new market for us and we actually had a design win in that particular area in Q3. So we are studying more the requirements of this market and we are incorporating more special features in our next generation products to really be able to address this market but overall this market is an interesting market. I think it is well over $1 billion in terms of revenues of end system revenues and $100 to $200 million today in terms of semiconductor processor revenues in that particular area. So it is not an insignificant market and we are looking at and seeing how we can be much more competitive in those segments.

Sandy Harrison – Signal Hill

If you look at sort of the cancellations or if you look at the softness that you alluded to in your prepared remarks, Syed you travel quite a bit and see many of these customers, when you look at the softness and where it is coming from do you believe that softness is in fact the end market slowing down or do you believe that softness is the supplier to that end market anticipating a slow down and therefore ordering less?

Syed Ali

I think if you take a look at it they are probably both affect the softness. One obviously is in times like these customers become a bit more cautious and want to have a lot less inventory in the channel and in process. Secondly, a small portion of that obviously could also be attributed to a softer demand.

Operator

The next question comes from Quinn Bolton – Needham & Co.

Quinn Bolton – Needham & Co.

I just want to go back I think you had said you hadn’t seen any meaningful slow down or push outs in the schedules for a lot of these design wins and you talked about accelerating design win rates. I just wanted to come back to those schedules again and make sure across the existing design wins you haven’t seen any meaningful slips in any of the targeted end markets.

Syed Ali

Absolutely. And again we are tracking the most important design wins, like I said, twice a month to discern the status and pretty much across the board we are actually seeing customers trying to bring new products to production faster than they would have normally maybe even in an up economy just because they want to get new products which are most competitive in the market which have a better shot of gaining market share against their competitors. So pretty much across the board we see absolutely no signs for us. Last quarter and this quarter we are seeing business as usual in terms of business going on. Obviously like I said in this macro economic environment some pockets of softness, but overall we have a mixture of both.

Quinn Bolton – Needham & Co.

I know you guys sort of put enterprise and data center in the same bucket but I was just wondering to the extent that some of this weakness you are seeing in the very high end boxes for service provider and data center extends to the enterprise, can you just sort of quantify what you run rate enterprise business is right now? Can we see that IP spending really start to slow down or decline in 2009 or what kind of exposure you would have on a run rate business?

Syed Ali

It is pretty much you have some boxes that are doing a little bit better than normal and some boxes that are doing a little bit worse than normal. I really don’t have the exact split between data center and enterprise because we don’t look at them…the data center is in the enterprise primarily we take a look logistically as within the group.

So, it is kind of push and pull there. Some boxes are doing much better than we expected and some boxes are doing softer than we expected.

Quinn Bolton – Needham & Co.

You talked about earlier the big platforms for 2009 you are tracking are on schedule if not slightly ahead of schedule?

Syed Ali

That is correct.

Operator

The next question comes from Christian Schwab – Craig-Hallum Capital.

Christian Schwab – Craig-Hallum Capital

The R*D tax credits coming back what should we be assuming for a tax rate in 2009? Will it lower it?

Art Chadwick

That impacts our Q4 numbers.

Christian Schwab – Craig-Hallum Capital

Just Q4?

Art Chadwick

Yes. So our tax is coming down a few hundred thousand dollars in Q4. For 2009 we talked about this in our last conference call we think our long-term worldwide tax rate is going to be closer to 20% and that would apply to the entire year of 2009.

Christian Schwab – Craig-Hallum Capital

So no changes to that at all?

Art Chadwick

No changes. That is correct.

Christian Schwab – Craig-Hallum Capital

Regarding Cisco, visibility since being public have you ever missed an internal number for them?

Syed Ali

I think if you take a look on a quarter by quarter basis we have been pretty much plus or minus a few percent from our forecast.

Christian Schwab – Craig-Hallum Capital

So no big huge negatives. When they refresh their entire product line some time in 2009 would it be correct to assume we could see a latter step up in the second half of 2009 at Cisco from whatever run rate they run up until then with?

Syed Ali

On a quarter by quarter basis on any given quarter you may have boxes going to production and it is really just depends upon the size of the design win in dollars of that box going to production that is going to determine the quarter-over-quarter growth at Cisco. So we have a range of designs going to production over 2009. In some quarters the rate will be significantly sequentially higher and in some it may be more muted based upon which particular design is going to production in that quarter.

Christian Schwab – Craig-Hallum Capital

Do you have any idea on that currently as you look to 2009?

Syed Ali

Yes I do but I would rather not get into details of that.

Christian Schwab – Craig-Hallum Capital

What is the core policy regarding potential acquirers interest at Cavium? Do you make it known immediately if they come and start negotiations? Do you bring it to investors attention should somebody make an offer and you don’t take it? Can you just walk us through that?

Art Chadwick

We have been public since May 2007 and I don’t think we have had to address that.

Syed Ali

So there hasn’t been any recent interest? There have been some rumors of recent interest that I just wanted to make sure the validity of that and that answers that question.

Art Chadwick

Operator on that note we are going to have some closing comments from Syed and that will conclude our conference.

Syed Ali

Q3 was another stellar quarter for Cavium on all metrics. We are continuing to execute well as a company despite the macro environment. The wide diversification of end markets we serve and new product cycles are helping cushion the near term impact on us. We are continuing to win designs on accelerated rates at tier one customers worldwide which is enabling us to strengthen our competitive position across all end markets. All in all we believe we are in a strong market position today and believe we are making the right moves to continue delivering robust growth over time. Thank you for your interest in Cavium.

Operator

Ladies and gentlemen this concludes the Cavium Network third quarter 2008 earnings conference call.

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Source: Cavium Networks, Inc. Q3 2008 Earnings Call Transcript
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