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Mellanox Technologies, Ltd. (NASDAQ:MLNX)

Q4 2012 Earnings Call

January 23, 2012 5:00 pm ET

Executives

Gwyn Lauber - Investor Relations

Eyal Waldman - Chairman, President and CEO

Jacob Shulman - Chief Financial Officer

Analysts

Jon Roy - UBS

Brian Freed - Wunderlich Securities

Joseph Wolf - Barclays

Rajesh Ghai - Craig-Hallum

Philip Lee - Lazard Capital Markets

Kevin Cassidy - Stifel Nicolaus

Alex Gauna - JMP Securities

Glenn Hanus - Needham & Company

Brent Bracelin - Pacific Crest

Srini Nandury - Summit Research

Ruben Roy - Mizuho Securities

Operator

Good afternoon and welcome to the Mellanox Technologies Fourth Quarter 2012 Financial Results Conference Call. At this time all participants have been placed in a listen-only mode and the floor will be open for your questions following the presentation. (Operator Instructions). As a reminder, this conference is being recorded.

Now, I would like to turn the conference over to Gwyn Lauber, who will introduce today's speakers. Please begin.

Gwyn Lauber

Good afternoon, and welcome to Mellanox Technologies' fourth quarter and fiscal year 2012 conference call. Leading the call today will be Eyal Waldman, Chairman, President and CEO of Mellanox Technologies and Jacob Shulman, Chief Financial Officer.

By now, you've seen our press release and associated financial information that we furnished to the SEC on Form 8-K this afternoon. In addition to reviewing our financial results, some of the comments today will include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities and Exchange Act of 1934 as amended, based on our current expectations. These forward-looking comments entail various significant risks and uncertainties that could cause our actual results to differ materially from those expressed in such forward-looking statements.

Forward-looking statements in this conference are generally identified by words such as believes, anticipates, expects, intends, may, will, and other similar expressions. However, these words are not the only way we identify forward-looking statements. In addition, any statements that refer to expectations, projections, forecasts, predictions or other characterizations of future events or circumstances are forward-looking statements.

Listeners are cautioned not to place undue reliance on these forward-looking statements which speak only as of today. We take no obligation to update any of the information contained in any forward-looking statements that we make.

We have provided additional information about risk factors that could cause our actual results to differ materially from those in the forward-looking statements in today's conference call, in our press release, in our Form 10-K filed with the SEC on November 2, 2012, or in our Form 10-K filed on February 28, 2012. If you do not have a copy of our 10-Q or 10-K, you can find it at ir.mellanox.com or we will be happy to provide you with one.

Now, I would turn the call over to Eyal for his opening remarks. Eyal?

Eyal Waldman

Thank you, Gwyn. Good afternoon, everyone and thank you for joining us. On today's call, I will highlight our fourth quarter and fiscal year 2012 results and achievements. I will then turn the call over to Jacob Shulman, our Chief Financial Officer, who will discuss the financial results in more detail and provide our fiscal fourth quarter guidance. After that we will be happy to take your questions.

For the fourth quarter of 2012, Mellanox reported revenue of $122.1 million, compared to $156.5 million in the third quarter of 2012 and $72.7 million in the fourth quarter of 2011. Fourth quarter non-GAAP gross margins were 70%; non-GAAP operating income was $36.2 million, or 29.6% of revenues; and non-GAAP diluted earnings per share were $0.69.

We generated cash from operations of $25.4 million in the fourth quarter and the record of $182.5 million for the year. Highlighting our record year-over-year results, revenue was record $500 million, $0.5 billion, up 93% from $259.3 million in 2011 and non-GAAP net income was record $155.7 million, compared to $45.6 million in 2011 at 241% increase.

We ended the year with $426.3 million in cash and investments, an annual increase of $184.9 million. For 2012, we grew IC unit volume shipment approximately 95% to 1.1 million units shipped, highlighting the increased adoption of our technology in server and storage systems.

During the FDR InfiniBand products represented 39% of revenues, compared to 57% in the third quarter of 2012. As we mentioned earlier, we had a cabling issue in the fourth quarter that affected sales of our FDR solutions. The cabling issue has been resolved and is not expected to further impact revenue.

Revenue from our 10 and 40 gigabit Ethernet products increased during the quarter to 11% of revenues. Mellanox continues to provide the industry's only end-to-end 40 gigabit per second Ethernet interconnect solutions.

During the quarter, we launched a variety of new solutions into the market including MetroX, our new line of long haul InfiniBand and Ethernet interconnect solutions. MetroX extends RDMA over InfiniBand or Ethernet beyond the single data center network location sense of up to 40 kilometers now, and in the future up to 100 kilometers to help connect multiple data centers together in local, campus and even metro environments.

We introduced a new 12-port FDR 56 gigabit a second InfiniBand switch. We released our Unified Fabric Management, software defined network appliance, which provides a comprehensive management solution for scalable compute and storage infrastructures. With the UFM-SDN, appliance, IT administrators can effectively manage their data center resources, reduce data center deployment time, improve its performance and provide the capability to monitor provision and optimize in real time manner, all in an easy install package.

As highlighted in November top-500 list, we continued our lead as the global interconnect solution provider for the industry's highest performance systems. InfiniBand penetration grew to 224 clusters, nearly 20% more than that 189 Ethernet connected systems.

Since June of 2012, the number of FDR 56 gigabit per second InfiniBand system has more than doubled including the top two ranked InfiniBand systems showing the growing demand for higher interconnect performance, scalability and efficiency.

InfiniBand is providing the highest system utilization in the top-500 for both, high performance computing as well as clouds. For example, InfiniBand has enabled Microsoft Azure to be the most efficient cloud infrastructure on the top-500 with more than 30% higher efficiency than other cloud solutions listed.

We grew our cloud penetration to approximately 10 cloud providers worldwide demonstrating the momentum of cloud infrastructures using Mellanox's interconnect solutions. A recent example include Sakura Internet and OrionVM, who through InfiniBand are able to offer customers a significantly higher performance cloud computing platform at the lower price. We expect growth of InfiniBand utilization in the cloud in 2013.

Our InfiniBand interconnect solutions are the industry's best choice to provide leading performance for big data systems to maximize return on investment and accelerate time to value for end customers. For example, we recently announced Teradata's inclusion of Mellanox InfiniBand solutions in their new Teradata Aster Big Analytics Appliance.

By utilizing InfiniBand, the appliance offers up to 19 times better data throughput and performance analytics up to 35 times faster than typical off-the-shelf commodity bundles. We announced the creation of Mellanox Federal Systems, a wholly subsidiary of Mellanox Technologies.

Mellanox Federal Systems will be responsible for driving sales to federal government agencies and the federal integrator market. Mellanox is currently working with many government agencies and organizations and the formation of Mellanox Federal Systems is natural evolution for us to expand ourselves to the U.S. government.

We are disappointed that we missed our fourth quarter revenue guidance. This is the first time in 24 quarters that we did not meet our revenue and earning goals since Mellanox became public in February of 2007. In the first and second quarters of 2012, our guidance reflected pent-up demand and included large deals we didn't expect on a regular basis.

In the third quarter, sales were stronger than expected and we saw sequential growth. In the fourth quarter, anticipated end customer demand did not materialize and there was a buildup of inventory levels of approximately $30 million at one of our OEM customers. We believe, the majority of the inventory will be depleted in the first quarter of 2013, and we expect our growth to resume in the second quarter of 2013 and thereafter.

Now, I will turn the call over to Jacob for a review of our fourth quarter and fiscal year 2012 financial results and our first quarter 2013 guidance. Jacob?

Jacob Shulman

Thank you, Eyal. Good afternoon, everyone. Let me now review our financial details relative to our fourth quarter 2012. Total revenues in the fourth quarter were $122.1 million, down approximately 22% from $156.5 million in the third quarter of 2012 and up approximately 68% from $72.7 million in the fourth quarter of 2011. Total revenues for fiscal year 2012 were $500.8 million, up approximately 93.2% from $259.3 million for fiscal 2011.

Our non-GAAP gross margins in the fourth quarter were 70%, down from 70.5% in the third quarter of 2012, and up compared to 67% in the fourth quarter of 2011. Major reconciling items from GAAP to non-GAAP gross profit are share-based compensation expenses of $445,000 and the amortization of acquired intangibles of $1.8 million. Our non-GAAP gross margins in the fiscal year 2012 were 70.3%, up from 68.1% in fiscal year 2011.

A few selected Q4 2012 revenue metrics for you. Combined revenues from our IC and board products represented 50% of fourth quarter revenues. Switch systems revenues accounted for 35%.

Revenues from our 56-gigabit per second InfiniBand-based products represented 39% of revenues in Q4 2012, down from 57% in Q3 2012. Revenues from our 40 gigabit per second InfiniBand based products represented 37% of revenues in Q4 2012, up from 31% in the third quarter. 20 gigabit per second InfiniBand-based products represented approximately 7% of revenues in Q4 2012, compared to 4% in Q3 2012. Ethernet-related revenues represented approximately 11% of the fourth quarter revenues, compared to 7% of revenues in the third quarter.

We had two more than 10% customers in the fourth quarter that, combined, represented approximately 31% of revenues. They were IBM with 17% and HP with 14%.

Fourth quarter non-GAAP operating expenses decreased by $209,000, sequentially, to $49.3 million and represented approximately 40.4% of revenues, compared with $49.5 million or 31.5% of revenues in the third quarter of 2012. Major reconciling items from GAAP to non-GAAP operating expenses are stock-based compensation of $9.5 million and amortization of acquired intangibles of $448,000.

The fiscal year 2012 non-GAAP operating expenses increased by $61.2 million to $189.4 million and represented approximately 37.8% of revenues, compared with $128.2 million and approximately 49.5% of revenues in the fiscal year 2011.

Moving down our income statement, our non-GAAP research and development expenses were $30.3 million in Q4 2012, compared to $31.3 million in Q3 2012, representing a sequential decrease of approximately 3.2%. The decrease was primarily due to lower employee-related expenses, partially offset by an increase in depreciation and amortization expenses.

Non-GAAP R&D expenses for Q4 2012 represented approximately 24.8% of revenues, up from 20% of revenues in Q3 2012. Non-GAAP sales and marketing expenses were $13.7 million in Q4 2012, compared to $13.5 million in the third quarter, representing a sequential increase of approximately 1.1%. The increase was primarily due to higher tradeshows and promotion-related expenses.

Non-GAAP sales and marketing expenses for Q4 2012 represented approximately 11.2% of revenues, up from approximately 8.7% of revenues in Q3 2012. Non-GAAP general and administrative expenses were $5.2 million in the fourth quarter, compared to $4.6 million in the third quarter, representing a sequential increase of approximately 14.3%. The increase was primarily due to higher legal expenses. Non-GAAP G&A expenses for Q4 2012 represented 4.3% of revenues, up from 2.9% of revenues in Q3 2012.

Non-GAAP operating income was $36.2 million in Q4 2012 and represented 29.6% of revenues, compared to $60.9 million, or 38.9% of revenues in Q3 2012. In the fiscal year 2012, our non-GAAP operating income increased 237.3%, compared to the fiscal year 2011, while our 2012 revenues grew 93.2% compared to last year.

Other income of $269,000 in Q4 2012 was primarily associated with higher interest income, partially offset of by foreign exchange losses. This compared to other income of $585,000 in Q3 2012.

Non-GAAP income before taxes was $36.4 million, or 29.8% of revenues in the Q4 2012, compared to income before taxes of $61.5 million, or 39.3% of revenues in Q3 2012. The fourth quarter tax expense of $5.7 million compares to $1.4 million of tax expense in the third quarter of 2012. The increase in the current quarter tax expense is attributable to a reduction in deferred tax assets due to the re-measuring of this asset at an expected lower future effective tax rate and changes in recognition of R&D expenses for tax purposes.

Our Q4 2012 non-GAAP net income was $30.7 million, or $0.69 per diluted share and included adjustment of $10 million for share-based compensation and amortization of acquired intangible assets of $2.3 million. This compares to our Q3 2012 non-GAAP net income of $60.1 million or $1.37 per diluted share, which included adjustments of $9.4 million for share-based compensation and amortization of acquired intangible assets of $2.3 million. Q4 2011 non-GAAP net income was $13.1 million or $0.31 per diluted share.

The non-GAAP net income for fiscal year 2012 was $155.7 million, or $3.60 per diluted share, compared to the non-GAAP net income for fiscal year 2011 of $45.6 million, or $1.16 per diluted share.

Our GAAP diluted share count for Q4 2012 was 44.6 million shares compared to 44.4 million shares in Q3 2012. GAAP basic share count used in computing income per share for the fourth quarter was 42.5 million shares, compared to 41.9 million shares for the third quarter of 2012.

Moving onto the cash flow statement, operating activities provided approximately $25.4 million of cash during the fourth quarter of 2012, compared to approximately $74.4 million in the third quarter of 2012. In fiscal year 2012, operating activities provided approximately $182.5 million of cash, compared to approximately $61.2 million of cash in the fiscal year 2011.

Net cash used in investing activities during the fourth quarter was $50.9 million and consisted of net purchases of short-term investments of $42.3 million, purchases of property and equipment and leasehold improvements of $9.6 million, partially offset by a $1.2 million of decrease in restricted cash.

Net cash provided by financing activities during the fourth quarter was $4.6 million and consisted primarily of cash proceeds from option exercises of $2.7 million and excess tax benefit from option exercises of $2.2 million, partially offset by $279,000 for capital lease payment.

Turning onto the balance sheet, our cash and investments were $426.3 million at the end of the quarter, compared to $405.4 million at September 30, 2012. During fiscal year 2012, cash and investments increased by $184.9 million. Our accounts receivables increased approximately $6 million to $58.5 million during the quarter. Our day sales outstanding increased to 42 days, compared to 32 days in the prior quarter, approximately 98% of our outstanding accounts receivables amounts are current or less than 30 days overdue.

Fourth quarter ending inventory increased $9 million to $43.3 million, compared to $34.3 million in the third quarter of 2012. Our inventory turns were at four times during the fourth quarter, compared to 5.9 times in the third quarter of 2012.

Net intangible assets and goodwill were $16.1 million and $132.9 million, respectively at the end of the quarter. Total liabilities were $143.2 million at quarter-end, of which $108.6 million were current and $34.6 million were long-term.

We currently expect the Q1 2013 non-GAAP Mellanox results to be as follows. Quarterly revenues of $78 million to $83 million. Q1 2013 gross margins of 67% to 68% reflecting our latest forecasted product mix. We expect a sequential increase in non-GAAP operating expenses of 7% to 9%. We do expect to incur tape-out cost in the first quarter of 2013. We estimate our Q1 2013 stock compensation expense to be between $10.5 million to $11 million. Non-GAAP diluted share count guidance for Q1 is 44.4 million to 43.9 million shares.

I will turn it back to Eyal for a few closing comments. Eyal?

Eyal Waldman

Thank you, Jacob. Our business fundamentals remain unchanged. We are playing in a large market we estimate to be approximately $6 billion. We maintain our leadership position. We are generation ahead of any competitor and are not aware of any market share erosion. In fact, we are gaining market share as demonstrated by the growth of unit shipments in Q4 and all of 2012.

We are playing in a very lucrative market, where the need to migrate data is become a more strategic competitive advantage. The growth of data continues its exponential path. And today, corporations use less than 5% of their data. One of the major limiting factors for utilizing such data is the size meaning bandwidth and latency of the interconnect or pipe for storing, retrieving and computing the data. Big pipes are required to move to the next stage of data mining and Mellanox provides the largest pipes both, with InfiniBand and Ethernet technologies that we believe, we will continue to grow our market share in the markets we are playing in.

We continue to see the momentum of utilizing our solutions in the high performance computing Web 2.0, cloud, storage, database, financial services and more market end applications. The adoption of our products in this market has not slowed. As such, we expect growth to resume in the second quarter and continue throughout 2013.

Alice, we will now take questions.

Question-and-Answer Session

Operator

The floor is now open for questions. (Operator Instructions). Thank you. Our first question is coming from Jon Roy with UBS. Please go ahead.

Jon Roy - UBS

Yes. Thank you. So, I want to get this straight. Your revenue guidance is $78 million to $83 million for the next quarter?

Eyal Waldman

Yes. That's true.

Jon Roy - UBS

That's true, and you expect the second quarter to need to resume growth. That means year-on-year growth?

Jacob Shulman

We expect grow [quarter].

Jon Roy - UBS

Sequential growth?

Jacob Shulman

Yes.

Jon Roy - UBS

Okay. So, can you give us an idea? At one point in the past, you had said that your expectations for baseline business were 150, obviously that's off the table now. Can you give us an idea what your expectations are for baseline quarterly numbers. Just kind of round numbers?

Eyal Waldman

We don't give this kind of guidance. We have now visibility, but in our guidance and you've seen our guidance to what we think is an inventory, so you can do the calculation.

Jon Roy - UBS

All right. thank you.

Operator

(Operator Instructions). We'll go next to Brian Freed with Wunderlich Securities. Please go ahead.

Brian Freed - Wunderlich Securities

Could you give a little more color as to one, why the dramatic size of sequential decline in Q1 first of all. And second, in the past you've indicated, Eyal, that you do expect that 2013 will be a growth year for Mellanox. Do you still believe that, and if not? What's fundamentally changed?

Eyal Waldman

Right. So, you know, the sequential decrease in revenues is mainly due to the inventory buildup in the fourth quarter of 2012, of $30 million and we need to wait and see the depletion of this inventory and which we believe the majority will happen in the first quarter of 2013. From there on, we expect to grow through the quarters of 2013, and you know today we just guide for one quarter. We do expect to grow through the quarters of 2013.

Brian Freed - Wunderlich Securities

Okay. Can you give a little more clarity on this inventory buildup? Inventory is much of a balance sheet issue than a revenue issue, so why is an inventory build affecting revenue.

Eyal Waldman

It's very simple. The customers that has built the inventory instead of taking products from Mellanox will now ship from its [inventory], so the inventory that we may have seen additional $30 million on top of the guidance we gave just now goes from this customer's inventory to their end customer, so that's why you see a significant decrease quarter-over-quarter.

Brian Freed - Wunderlich Securities

Okay. So, we saw a similar issue in Q4 with one of your two OEM customers pulling down inventory, so it's a continuation of that. Is it limited to one customer, or is it both?

Eyal Waldman

We've actually seen the accumulation of this inventory and buildup. We didn't realize during Q3. We realized this in the second half of Q4, and as a result we are estimating this is about $30 million and yes for now it's one OEM customer that we are with.

Operator

Thank you. We'll go next to Joseph Wolf with Barclays Capital. Please go ahead.

Joseph Wolf - Barclays

Thank you. I'll just follow-up with what happened in the fourth quarter on the spending side. The original guidance was for an increase in the operating cost and that turned out to be about flat, which means, I am wondering when in the quarter you made the kind of adjustment on the cost side to match up with the expected revenues in dollar terms.

And then as we think about headcount and spending going forward, what kind of quota should be, how is the company thinking about growth now that we are back down to a year ago levels in terms of revenue, or are you looking at your base case as maybe through your 78 plus 30 in terms of how you are sizing the business going forward. Then I have a follow-up question.

Jacob Shulman

You know it was very late in the quarter. We did not adjust our expenses during the quarter. Meaning, we did not reduce expenses. We just did not do our tape-out that expected and will probably happen in the first quarter of 2013, and that's why we see the increase from Q4 to Q1. So, some of the activities that were supposed to happen in Q4 were delayed to Q1, and this is why the expenses were not met.

In terms of growth, we believe we will continue to grow both, in headcount and resources slower than we did obviously in 2012 and the reason is the opportunities we see in front of us. We continue to see us grow in Web 2, in cloud, in storage and so on, so we do expect to continue to need to add resources to meet the programs that our customers or end customers expect us to deliver.

Joseph Wolf - Barclays

Okay. Thanks. Just I want to go back to the cabling issue that's happened during the quarter. I understand that business. If you look at what happened with the cables that weren't working, how we are resourcing the cables. You've talked about being vertically integrated in the past, and I am wondering if we could get little bit more detail if that's not happening again, are there more sources of cables. You have agreements with multiple cable suppliers. And when you say that Mellanox makes the cable, what exactly does that mean in terms of other cable vendors that we can find to assign to the 56 particular when you guys have such high end market share, why would you also be selling cables into that sector?

Eyal Waldman

Yes. So, we do have multiple sources for 56 gigabit per second cables, and like we've explained in the past this was one of the components in the cables that we'd be out. We have identified the problem, we nailed the root cause. We have implemented income screen procedures to prevent the opportunity of having lower quality cables shipped in the future and this problem is behind us. In terms of selling cables 56, yes, for our customers not the 100% of our customers are buying 53 gigabit per second from us, so that's why we aren't.

Operator

Thank you. We'll go next to Rajesh Ghai with Craig-Hallum. Please go ahead

Rajesh Ghai - Craig-Hallum

Yes. Thanks. I wanted to understand the competitive dynamic. As it stands right now, you are the only game in town as far as 56 gig InfiniBand is concerned, but are you seeing any change in the market where customers may be looking at using 40 gig instead of 56 gig?

And increasingly given that they have two players to play with. They can dual-source or, I'm just trying to understand that is there a possibility that OEMs that are not ordering now are looking to use 40 gig from your competitor or 40 gig Ethernet instead? What [of issues] not competitive?

Eyal Waldman

Now, we're actually not seeing this. Example for this is approximately 10 cloud vendors that we've just mentioned during the call. All of them, all of the cloud vendors that we have identified are using us for InfiniBand, and we are actually seeing growth of InfiniBand adoption in multiple markets, so no this is not the case where people are moving away from InfiniBand, we are accessing more Web 2, more cloud, more storage, big data appliance has moved to InfiniBand, so we don't see any market share erosion.

Rajesh Ghai - Craig-Hallum

Looking ahead at Q1 given this substantial reduction in your revenue outlook, is your mix of verticals going to change, is HPC declining as a result of this inventory buildup? Is storage of Web 2.0, or cloud, kind of increasing in the mix? Where exactly is the buildup happening in terms of verticals or the end markets that you sell to?

Eyal Waldman

Yes. We do expect as a percentage wise to have a Web 2, cloud and storage to grow as a percentage of our revenues.

Rajesh Ghai - Craig-Hallum

Okay. Just talking about Ivy Bridge, obviously, you had a pretty big ramp in demand as a result of Romley in 2012. Is there a possibility that there is a pause ahead of Ivy Bridge, and then you start seeing a positive impact of that going forward in the second half of this year?

Eyal Waldman

Again this is something that we have seen in 2012. We should partition these two types of customers. Some of the very large HPC deployment can stall and wait for the new generation of CPUs out there, but if you look at the regular ongoing cloud, Web 2 enterprise data center, customers they do not stage the deployment and wait for the newest security. They continue deploying on a regular basis. And because, we believe our growth will come more from the Web 2 cloud and storage, we do think that we'd see some pent-up demand when the new CPU comes out in the second half of 2013, but we don't think it's going to be as significant as it has been in the past.

Rajesh Ghai - Craig-Hallum

And one last question for me. Inventories went up over $9.5 million inventory turns kind of came down. Jacob, what drove that?

Jacob Shulman

Obviously, Rajesh, our revenues were lower than expected. When we were building inventory, we forecasted higher revenues, which did not materialize and that resulted in increased inventory levels on our books.

Rajesh Ghai - Craig-Hallum

You expect the turns to go back up again next quarter or do you think…

Jacob Shulman

Yes. We expect to get to normal.

Operator

Thank you. Our next question comes from Daniel Amir with Lazard Capital Markets. Please go ahead.

Philip Lee - Lazard Capital Markets

Hi. Thanks for taking my question. This is actually Philip Lee on behalf of Daniel. At the 1Q revenue run rate, how are you guys evaluating your OpEx, and when can we see your R&D investments actually translate to revenue? And given the lower guidance, do you still view 2013 as a growth year?

Eyal Waldman

In terms of, we think the investments ongoing base are translated to revenues and on a quarterly basis, we are seeing more people use us with more applications and adopting more of our products into their solutions, so this is an ongoing process not like something that we invest now, we'll come out in 2015. The software investments and system investments turn to revenue in a very short time.

In terms of, again, visibility, we expect to grow from Q1 to Q2 and beyond for 2013. And, again, we are not planning to reduce our OpEx and you've seen me actually expect to grow from Q4 to Q1, and we think those are very well managed investments into product that will be deployed and released to the market during 2013.

Philip Lee - Lazard Capital Markets

Thanks, Eyal. And, as a follow-up, do you see the mix moving back to a higher percentage of FDR once the cabling issue is resolved and inventory gets depleted at your largest customer, and how should we view the gross margins from here given the current lower mix of 56 gigabit per second?

Eyal Waldman

Yes. We believe that once the inventory is depleted, then we will see because I think the large majority of this inventory is FDR products and we do expect to see it grow to the percentage that was before like in Q3. In terms of percentage wise, you've seen we've guided down, I think, to 67%, 68% gross margin. We expect our gross margins to be in the high 60s for 2013.

Operator

(Operator Instructions). We'll go next to Kevin Cassidy with Stifel Nicolaus. Please go ahead.

Kevin Cassidy - Stifel Nicolaus

Thanks for taking my questions. Just going back to your customers' inventory, are you putting in any programs to help them move that inventory? Any discounts or programs like that?

Eyal Waldman

We are obviously trying to help them over their inventory, but no. We are not putting any specific discount from our perspective. The inventory we know there's customers that will probably consume the product in the near future, so we feel comfortable that it will be depleted.

Kevin Cassidy - Stifel Nicolaus

Okay. Do you have a program in place also to be able to track the inventory build at your end customer?

Eyal Waldman

Yes. We are putting mechanism, so that we can have visibility into their inventories. We are also trying to even stretch beyond to their customers buildup, so we have more information to the floor from TSMC through our inventory, through the OEM inventory and then even to the end customers. In some cases, it's easier to do some cases it's more difficult to do.

Kevin Cassidy - Stifel Nicolaus

Do you have visibility into the pipeline of supercomputer installations that are expected for this year?

Eyal Waldman

We have some visibility to some, lot will happen this year, but there are not solid because we are not 100% sure we are going to win them, but yes we do haves some visibility two large deals that will happen in 2013. Obviously the amount and the size is lower than what we've seen in the first three quarters of 2012.

Kevin Cassidy - Stifel Nicolaus

And is that because of [authority] measures from governments or what's causing the lower.

Eyal Waldman

I think it's a cyclical business and we deployments happen every so often and that's what we think today. Now this can change in the second half of 2013, but that's what our visibility shows us today.

Operator

Thank you. We'll go next to Alex Gauna with JMP Securities. Please go ahead.

Alex Gauna - JMP Securities

Thanks so much for taking my question. I was wondering with regard to that $30 million in excess inventory, do you get a sense that that customer simply overestimated their revenue needs for the product, or do you know if they got cancellations along the way that surprised even them and then also if you could say have you essentially zeroed out that customer in terms of your guidance for the next quarter?

Eyal Waldman

No we have not zeroed out that customer. We think we will still see some revenues from that customer in Q1, but obviously not to the size they are usually buying from us and it's a combination of things that have caused this build up of inventory in that customer. There is not one thing.

We don't think there was a significant cancellation that they have seen. It's just that they came into the rate of what happened in Q1, Q2 and Q3 and just they continued with the momentum and then they realized hey the demand's not there and that's where the buildup of the inventory occurred.

Alex Gauna - JMP Securities

Okay. And I was wondering, you mentioned that you are now providing InfiniBand to 10 cloud providers worldwide. Can you ballpark what percentage of your revenues that single demand base represents for you right now and what you think it might be growing at?

Eyal Waldman

Yes. So, today's it still very small, but we think it's going to grow to be more significant later in 2013.

Operator

Thank you. We'll go next to Glenn Hanus with Needham & Company. Please go ahead.

Glenn Hanus - Needham & Company

When you did your update in the beginning of January, you talked about $8 million ordering ahead of demand roughly, so can you just reconcile that with the $30 million inventory buildup?

Eyal Waldman

Yes. That was when we realized and we started digging into those numbers. At the beginning of the quarter, the number that we have come up with and the time reconciled with past few days is $30 million of inventory and our customers' inventory for beginning of 2013.

Glenn Hanus - Needham & Company

So was, say, some of your revenues from even the September quarter going to this customer and building up in inventory, or do you think it was just in the December quarter?

Eyal Waldman

The revenues from that customer in Q4 was significantly lower than in Q3, so we believe they go themselves and they've stopped the rate of ordering they've done in Q3 and the inventory was built between Q3 and Q4.

Glenn Hanus - Needham & Company

Then with the $20 million of cable issue, have you been able to sort of quantify roughly? You said some went out as QDR, so it wasn't all in effect revenue waiting to go. Was the QDR portion just a $2 million and the rest is still in backlog, if you will, to be FDR?

Eyal Waldman

We do think there is some deployments that will happen in Q1 and Q2 for FDR. We don't have those numbers to provide.

Glenn Hanus - Needham & Company

With the majority of it is, of the $20 million is still kind of in the backlog.

Eyal Waldman

We see some of it in the backlog and some time we hope we'll join the backlog in the future.

Glenn Hanus - Needham & Company

Is most of the $20 million targeted towards Q2?

Eyal Waldman

We don't know how much will be in Q1 or Q2. We just know that not everything will be in Q1.

Glenn Hanus - Needham & Company

The gross margin, 67% to 68%, are coming down this quarter mix, so the mix, is that because it's less FDR or what is kind of within the mix that's driving it down 200 basis points or so sequentially this quarter?

Jacob Shulman

Glenn, this is Jacob. This is the combination of two factors. One, is the lower revenues without some fixed cost that go into COGS, and with the lower revenue, the impact of those cots is higher and also when we guide to the quarter, we don't always as you know majority of our revenues come from (Inaudible). Sometime we should kind of forecast the mix and based on the current forecast, we feel that the portion of lower margin products will be high in the mix.

Glenn Hanus - Needham & Company

It's fair to say the vertical market concentration with this customer was heavily oriented to HPC? Is that fair?

Jacob Shulman

No.

Glenn Hanus - Needham & Company

It's spread across your verticals like sort of like your revenue base is spread across your verticals?

Jacob Shulman

I think that it is more like HPC and Web 2.

Glenn Hanus - Needham & Company

Okay. All right. The legal expenses, is that going to continue at this recent rate or is that coming down?

Jacob Shulman

It's expected to come down.

Glenn Hanus - Needham & Company

Okay, I'll let someone else. Thank you.

Operator

Thank you. We'll go next to Brent Bracelin with Pacific Crest. Please go ahead.

Brent Bracelin - Pacific Crest

Thank you. Eyal, I'm kind of having hard time here just given the magnitude of the slowdown that we are seeing here is unprecedented. $30 million inventory build is something we've never really seen before out of you. It seems highly unusual given the application of InfiniBand. There's pretty specific use case scenarios today so how do you know there is not a displacement or an alternative technology that the customer is choosing or moving forward with and how you support pricing in this environment given there is that much inventory out there? That's really my first question.

Eyal Waldman

So, first, we are talking to the end customers. We are seeing the deployments, we are seeing the momentum, we are seeing the activities, the design wins that we have with Web 2 with cloud and storage, so we don't see again any market share erosion that either InfiniBand or our Ethernet. We are actually seeing growth at more places and there are more applications for our solutions and products.

In terms of pricing, people get so much value of what we provide just one example. There was a large Web 2 entity that used to do some data manipulation whether it's restructuring or recovering activity. And it used to take them seven days to do this activity and they did it every so often weeks or so on. We took this number from seven days to four hours. From seven days to four hours because of the big pipes we provided them and this is with no turning and nothing. Just trying this out, so this significant return on investment, we don't see any pricing issues for now.

Brent Bracelin - Pacific Crest

Okay. Then if I were to rewind the clock a year ago, you guided to kind of this $80 million kind of level in Q1 of last year, fast-forward today and you talked about some one-time kind of opportunities. As you think about kind of what you are guiding to kind of this quarter, we are back at $80 million.

Now, as you think about that guidance of $78 million to $83 million, is there any sort of one-time benefit baked into that guidance? I'm just trying to understand what's actually baked into that number? Is that a worst-case? You have complete coverage of that number or are there some cable spillover benefits that deals pushed out last quarter that are going to help hit those numbers? I'm just trying to understand, relative to what you guided to last year and what you're guiding to now.

Eyal Waldman

Right. Well, there is a big difference, right? There is $30 million inventory in the room. So, when we guided like Q1 of last year when there was $30 million inventory. Today there is.

Brent Bracelin - Pacific Crest

And the assumption to hit that kind of $80 million is that assuming 50% turns? How should we kind of think about the composition of what you are kind of baking in and how conservative that guide is for Q1?

Eyal Waldman

In that regard, basically when the regular rates of kind of our backlog and we've missed our guidance Q4. This is the first time in six years that it's happened. We are disappointed that we did not meet our revenue guidance and we are trying not to have this occur again. We do know that company sometimes they miss, and they miss the second time. We are definitely doing a lot not to miss the second time, so we are trying to be as responsible as we can.

Brent Bracelin - Pacific Crest

Okay. Then as I think about kind of the run rate going forward even if I assume kind of a 20% sequential growth rate in each consecutive quarter this year, it would still imply about a 14%, 15% year-over-year decline in full-year revenue, I'm getting to about $1.80 to $2 in earnings estimate for the full year. That's assuming kind of costs don't go up from here.

What are you doing on the cost front? Obviously, you guided this quarter for expenses to go up. Are there any plans to put in place some tighter cost controls until you actually start to see kind of a rebound on the inventory side? How should we think about what you are going to do to kind of grow and expand profitability going forward from this new run rate?

Eyal Waldman

Yes. So, no, we are not going. We are obviously going to be more responsible in the growth of our operating expenses. Today, we don't have plan to cap operating expenses. Again, I don't know if your base line of 20% growth was from the 80 or from the 110. It really depends where you are coming from, but today we continue to invest and grow in terms of our capability to serve the market, the customers and applications were being pulled to serve.

Jacob Shulman

And just to add to that, our guidance for increasing operating expenses assumes tape-out cost in Q1.

Brent Bracelin - Pacific Crest

Okay. Tape-out cost, and just to be clear, as we think about modeling the full year, should we assume two tape-outs this year? Four tape-outs this year? Six tape-outs kind of for the full year?

Eyal Waldman

Well, it's going to be at least two tape-outs for this year. At least two, maybe three.

Brent Bracelin - Pacific Crest

Okay. Very helpful. Thank you.

Operator

Thank you. As we near the top of the hour, we do ask that you limit yourself to one question at a time. We'll go next to Srini Nandury with Summit Research. Please go ahead.

Srini Nandury - Summit Research

Thank you for taking my call. I'm looking at the comments made by Fusion-io regarding hyper scale computing. Do you guys play in that market, and how do you address the white box vendors and so on and so forth?

Eyal Waldman

Yes. We do play in that market and we do work with companies like Quanta, Wistron and other ODMs in Taiwan, China and the U.S.

Operator

Thank you. We'll go next to Ruben Roy with Mizuho Securities. Please go ahead.

Ruben Roy - Mizuho Securities

Hi. Thanks, Eyal. I had a follow-up on Brent's question around the Q1 guidance and the cabling revenues that you guys lost in Q4. What were your assumptions for that portions of that revenue coming back in Q1?

Then when you mentioned the kind of baseline of $110 million potentially taking into consideration the $30 million in inventory out there, I'm just wondering if you have assessed if some of your other FDR business was impacted as customers became aware of the cabling issue. And if so, if that cabling issue of $20 million is actually larger. Thank you.

Eyal Waldman

You know, our estimations don't show it to be larger than $20 million. By the way, when we mean FDR business, it's not just the cables impacted, but the whole solution, the switch, the HCAs and so on. Because, when the cables have issues, the whole end-to-end solution is not being deployed. So, again, this is the number that we have, which is $20 million and it's behind us and we expect people to resume their deployments of FDR InfiniBand and feel comfortable and have a resilient and robust solution.

Ruben Roy - Mizuho Securities

So, you've talked to all of your other customers that had already deployed these systems that we are using potentially. They don't know if they had harmed cables or not, but you've gone through your customer list and you feel comfortable that you are not going to get returns at this point or customers coming back with issues?

Eyal Waldman

Yes. We have through and talked to all of the customers that had suspected cables with issues and we've replaced. I'd say most of them. I think there is one customer who waiting for the right opportunity to replace their cables, but other than that, yes, we've communicated with all of them and we do not expect additional returns of cables for this reason.

Ruben Roy - Mizuho Securities

Okay. Thanks. That's all I had. Thanks, Eyal.

Operator

Thank you. We'll go next to Brian Freed with Wunderlich Securities. Please go ahead. Brian Freed, your line is open. Are you possibly on mute?

Brian Freed - Wunderlich Securities

Yes. Sorry. Coming back to your inventory, it looks like, for the full year, HP did about $103 million in total revenue. If you take into account the $8 million or so that they drew down in Q4 and there is still another $30 million out there and assuming it's your biggest customer. That means almost 40% of their purchases are bottled up in inventory.

To me that reflects something in the range of horrible accounting control to let that much inventory build at a single customer, so can you talk a little bit about, one, how it happened. And, two, specifically what you've done about it, because I don't know how investors or analysts can be confident in anything on a go forward basis without some of those answers.

Eyal Waldman

Yes. So, basically there was a personnel change at that customer and we have seen the demand from the customer that has built the inventory and we have realized this in the second half of [2004] that the inventory exists. Today, we are putting mechanisms to have more visibility into our customers' inventory and our customers' warehouses.

Brian Freed - Wunderlich Securities

So, can you talk specifically about those mechanisms? I assume they are drawing from a hub. They currently give you some sort of hub report. What additional information are you getting now?

Eyal Waldman

No. It's not a hub. It's delivery from our warehouses to their warehouses and we are having a kind of on a weekly meeting and exchanges in databases and are trying to implement an electronic mechanisms of database exchanges between them and us. Not all of our customers are obliged to provide us their inventory scenarios.

Operator

Thank you. It appears we have no further questions at this time. I'll turn it back to Eyal for any final remark.

Eyal Waldman

Thank you, Alice. Thank you for joining the call and thank you for the interest in Mellanox. Thank you very much.

Operator

Thank you. This does conclude today's conference call. Please disconnect your lines at this time and have a wonderful day.

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