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Mellanox Technologies Ltd (NASDAQ:MLNX)

Q1 2014 Results Conference Call

April 24, 2014 / 5:00 P.M. E.T.

Executives

Gwyn Lauber – Director, IR

Eyal Waldman – President, Chairman, CEO

Jacob Shulman – CFO

Analysts

Kevin Cassidy – Stifel Nicolaus

Steve Milunovich – UBS

Andrew Nowinski – Piper Jaffray

James Kisner – Jefferies

Rajesh Ghai – Macquarie - Analyst

Srini Nandury – Summit Research

Sanjay Chaurasia – Nomura

Bill Choi – Janney Capital Markets

Glenn Hanus – Needham & Co.

Alex Gauna – JMP Securities

Joseph Wolf – Barclays

Operator

Good afternoon and welcome to the Mellanox Technologies' first quarter 2014 financial results conference call.

At this time, all participants have been placed in a listen-only mode and the floor will be opened for your questions following the presentation. (Operator instructions.) As a reminder, this conference is being recorded.

And now I would now like to turn the conference over to Gwyn Lauber, who will introduce today's speakers. Please go ahead, ma'am.

Gwyn Lauber

Good afternoon and welcome to Mellanox Technologies' first quarter 2014 conference call. Leading the call today will be Eyal Waldman, 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. If not, you may access them on our website at ir.mellanox.com.

As a reminder, today's discussion includes predictions, expectations, estimates, and other information, all of which we consider to be forward-looking statements. Throughout today's discussion, we present important factors relating to our business that may potentially affect these forward-looking statements.

These forward-looking statements are also subject to risks and uncertainties that may cause actual results to differ materially from statements made today. As a result, we caution you against placing undue reliance on these forward-looking statements and we encourage you to review our most recent SEC reports, including our 10-K and 10-Q, for a complete discussion of these risk factors and other risks that may affect our future results or the market price of our ordinary shares.

And finally, we are not obligating ourselves to revise our results or publicly release any revisions to these forward-looking statements in light of new information or future events.

Now I will 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 first quarter 2014 results and achievements. I will then turn the call over to Jacob Shulman, our Chief Financial Officer, who will discuss our first quarter financial results in more detail and provide our second quarter 2014 guidance. After that, we will take your questions.

For the first quarter of 2014, we reported revenues of $98.7 million compared to $105.5 million in the fourth quarter of 2013 and $83.1 million in the first quarter of 2013.

First quarter 2014 non-GAAP gross margins were 68.6%. Non-GAAP operating income was $4.9 million, or 5% of revenues. And non-GAAP diluted earnings per share for the fiscal first quarter of 2014 were $0.10.

During the quarter, we generated $10.5 million in cash from operating activities.

Turning to our solutions, our FDR 56 gigabit per second InfiniBand revenue contribution was 52% of total revenue compared to 55% in the fourth quarter of 2013. Contributions from Ethernet products increased to 19% of revenues.

We believe that the market for 40 gigabit Ethernet solutions is in the early stages and that revenue from these solutions will grow as end users upgrade from 1 and 10 gigabit to 40 gigabit Ethernet solutions.

While our revenue fell slightly short of our guidance for the quarter, we believe this softness is temporary and that we will grow sequentially each quarter in 2014. We believe that revenues were below our expectations because our HPC customers paused as they wait for the new CPU platform launch, as well as lower than expected revenues from one of our largest customers.

We also believe that our core data center business is undergoing a transformation as enterprises move to using more private and public clouds. We believe that this change is positive for Mellanox.

The shift to utilizing private and public clouds aligns with our focus on cloud optimized solutions and sales channels. As cloud vendors struggle to handle the exponential growth in data while achieving the highest return on investment, we believe they will continue to turn to Mellanox to help them solve these challenges.

An example of this transition was seen in Dell's 12.5% contribution to revenue this quarter. We attribute much of this increase to cloud development projects in which Dell participates.

During the quarter, we announced CloudX, a platform that enables companies to build the most efficient private and public clouds. CloudX improves compute and storage infrastructure efficiency, reduces costs, enables applications to process vast amounts of data in real-time, and accelerates business analytics and decision making.

Using our recipe for efficient virtualized, network-based, open cloud architecture such as CloudX, companies can build efficient cloud platforms using off the shelf building blocks. CloudX supports open source distribution including integrated support for our solutions by major cloud software providers, including Red Hat, OpenStack, and Canonical Ubuntu, and positions Mellanox as a leader in this sector.

An example of our success with CloudX is our recently announced relationship with Australia's National Computational Infrastructure. The NCI deployment is based on Mellanox' 40 and 56 gigabit per second virtual protocol interconnect adapters and switches, supporting both InfiniBand and Ethernet.

The advanced NCI cloud also utilizes RDMA over Converged Ethernet, or RoCE, to implement a scalable cluster using OpenStack. This deployment is the first that takes advantage of CloudX RoCE, OpenStack plug-ins, and hypervisor offloads that our end-to-end solution delivers.

Furthermore, Microsoft presented at the Open Network Summit Conference their Azure cloud platform, which leverages RoCE to achieve 40 gigabit per second storage bandwidth and 0% CPU utilization. This gives Microsoft a competitive advantage while realizing significant cost savings.

During the quarter, we announced LinkX, a comprehensive product portfolio of cables and transceivers supporting interconnect speeds of 10, 40, and 56 gigabit per second for both Ethernet and InfiniBand data center networks.

Our LinkX solution provides the highest reliability, scalability, and performance as well as easy installation using standard form factors such as QSFP modules.

Looking ahead to 100 gigabit per second, we demonstrated both 100 gigabit per second silicon photonics models and 100 gigabit per second VCSEL-based solutions at the Optical Fiber Communications Conference in March. We are the only company to demonstrate working 100 gigabit per second 4X fiber cables. This is a significant milestone achieved and is part of our plan to release a complete end-to-end 100 gigabit per second solution in the 2014/2015 timeframe.

Our Ethernet solutions continue to gain traction. Early in the quarter, we announced the availability of our 40 gigabit Ethernet NICs based on open compute project design.

We believe our 40 gigabit Ethernet NIC technology offers OCP-based systems unmatched performance and a rich future set that enables superior data center productivity and efficiency. We also announced that our 10 and 40 gigabit Ethernet NICs support Microsoft's OCP cloud server and storage specifications.

Enabled with RoCE and overlay network offloads, the solution offers optimized application latency and performance. We look forward to our continuing collaboration with OCP, Microsoft, and other companies that are working to advance the initiative.

Our storage business remained strong this quarter as trends like flash arrays, cloud, and distributed storage continued to create demand for both frontend and backend storage connectivity solutions that improve customers' experience and provide better price performance, density, and flexibility.

We recently announced our collaboration with Dell for availability of our 10 and 40 gigabit Ethernet solutions in Dell's Fluid Cache for SAN, providing end users with a scalable solution with higher efficiency and density. In 2014, we expect more design wins to go into production and continued revenue growth from our storage related customers.

Finally, I want to mention that our channel business continues to contribute a growing proportion of revenue. We view growth in the channel as evidence that our value proposition resonates across a broad spectrum of customer profiles and requirements.

Now I will turn the call over to Jacob for a review of our first quarter 2014 financial results and our expectations for the second quarter of 2014. Jacob?

Jacob Shulman

Thank you, Eyal. Good afternoon, everyone. Let me now review some more financial details relative to our first quarter 2014.

Our total revenues in the first quarter were $98.7 million, down approximately 6.5% from $105.5 million in the fourth quarter of 2013, and up approximately 18.8% from $83.1 million in the first quarter of 2013.

Our non-GAAP gross margins in the first quarter were 68.6%, up slightly from 68.5% in the fourth quarter of 2013 and up compared to 68.1% in the first quarter of 2013.

Major reconciling items from GAAP to non-GAAP gross profit are share-based compensation expenses of $522,000, amortization of acquired intangibles of $2.2 million, and acquisition related expenses of $84,000.

The following are a few selected Q1 2014 revenue metrics for you. Combined revenues from our IC and board products represented 44% of first quarter revenues. Switch systems revenues accounted for 33%.

Revenues from our 56 gigabit per second InfiniBand-based products represented 52% of revenues in Q1, down from 55% of revenues in Q4 2013. Revenues from our 40 gigabit per second InfiniBand-based products represented 14% of revenues in Q1, down from 17% of revenues in Q4 2013.

Ethernet related revenues represented 19% of first quarter revenue, up from 15% of revenues in Q4.

We had one more than 10% customer in the first quarter. Dell represented approximately 12.5% of revenues.

First quarter non-GAAP operating expenses decreased by $400,000 sequentially to $62.8 million, and represented 63.7% of revenues compared with $63.2 million, or 59.9% of revenues, in the fourth quarter of 2013.

Major reconciling items from GAAP to non-GAAP operating expenses are stock-based compensation of $11.1 million, amortization of acquired intangibles of $1.2 million, and acquisition related charges of $600,000.

Moving down our income statement, our non-GAAP research and development expenses in the first quarter were $41.1 million compared to $40.3 million in Q4 2013, representing a sequential increase of 1.8%. The increase was primarily due to one-time projects.

Non-GAAP R&D expenses for Q1 2014 represented approximately 41.6% of revenues, up from 38.2% of revenues in Q4 2013.

Non-GAAP sales and marketing expenses were $15.6 million in Q1 compared to $15.5 million in Q4 2013, representing a sequential increase of 1%. The increase was primarily due to higher employee related expenses, partially offset by a decrease in tradeshow and promotions activity.

Non-GAAP sales and marketing expenses for Q1 2014 represented 15.8% of revenues, up from 14.6% of revenues in Q4 2013.

Non-GAAP general and administrative expenses were $6.2 million in Q1 compared to $7.4 million in Q4 2013, representing a sequential decrease of 16.6%. The decrease was primarily due to lower legal expenses.

Non-GAAP G&A expenses for Q1 2014 represented 6.3% of revenues, down from 7.1% of revenues in Q4 2013.

Non-GAAP operating income was $4.9 million in Q1 2014 and represented 5% of revenues compared to $9.1 million, or 8.6% of revenues, in Q4.

Other income was $234,000 compared to $301,000 in Q4 2013.

Non-GAAP income before taxes was $5.1 million, or 5.2% of revenues, in Q1 2014 compared to income before taxes of $9.4 million, or 8.9% of revenues, in Q4.

The first quarter had a tax expense of $700,000 compared to a tax benefit of $300,000 in Q4. The non-GAAP tax rate for the first quarter was 12.8%.

Our Q1 2014 non-GAAP net income was $4.5 million, or $0.10 per diluted share, and included adjustments of $11.6 million for share-based compensation, amortization of acquired intangible assets of $3.5 million, and acquisition related charges of $700,000.

This compares to our Q4 2013 non-GAAP net income of $9.7 million, or $0.21 per diluted share, that included adjustments of $11.7 million for share-based compensation, amortization of acquired intangible assets of $4.4 million, and acquisition related charges of $900,000. Q1 2013 non-GAAP net income was $4.3 million, or $0.10 per diluted share.

Our GAAP diluted share count for Q1 was 44.3 million shares compared to 43.9 million shares in Q4 2013. Our non-GAAP diluted share count using computed income per share for the first quarter was 46.2 million shares compared to 45.8 million shares in the fourth quarter of 2013.

Moving on to the cash flow statement, cash provided by operating activities during the first quarter 2014 was $10.5 million compared to $30.7 million of cash provided by the operating activities in the fourth quarter of 2013.

Net cash used in investing activities during the first quarter was $32.1 million, and consisted primarily of net purchases of short-term investments of $24.5 million, purchases of property and equipment and leasehold improvements of $5.8 million, and an investment in a privately held company of $1.4 million.

Net cash provided by financing activities during the first quarter was $6.4 million, and consisted primarily of cash proceeds from option exercises and the employee share repurchase program of $6.7 million, partially offset by capital lease payments of $284,000.

Turning to the balance sheet, our cash and investments at the end of the quarter were $340.1 million compared to $330.2 million at the December 31st, 2013. During the quarter, our accounts receivable decreased approximately $5.5 million to $65.1 million.

Our days sales outstanding were 62 days in comparison to the prior quarter of 63 days. Approximately 99% of our outstanding accounts receivables are current or less than 30 days overdue.

First quarter ending inventory increased $2.8 million to $38.8 million compared to $36 million in Q4 2013. Our inventory turns decreased to 3.6 times from 4.3 times at Q4 2013.

Net intangible assets and goodwill were $50.8 million and $199.6 million respectively at the end of the quarter.

Total liabilities were $139.8 million at quarter end, of which $98.8 million were current and $41 million were long term.

We currently expect our Q2 2014 non-GAAP results to be as follows – quarterly revenues of $100 million to $105 million, Q2 2014 gross margins of 68% to 69%, reflecting our latest forecasted product mix. We expect a sequential increase in non-GAAP operating expenses of 4% to 6%.

We estimate our Q2 2014 stock compensation expense to be between $12.1 million to $12.6 million.

Non-GAAP diluted share count guidance for Q2 is 46.3 million to 46.8 million shares.

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

Eyal Waldman

Thank you, Jacob.

For the remainder of 2014, we believe we will demonstrate quarter-over-quarter growth, and expect it to accelerate in the second half with the launch of the new CPU platform.

We'll continue to execute on our roadmap to 100 gigabit products, and believe we will be the first vendor to offer end-to-end 100 gigabit per second solutions to the market, which will be available on the 2014/2015 timeframe.

Coupled with the CPU refresh cycle, we believe that we will see increased demand from the HPC market for our 100 gigabit per second solution. We expect the transition from 10 to 40 gigabit per second Ethernet solutions to ramp in 2014.

We remain the only company with proven 40 gigabit network interface adapters and 40 gigabit end-to-end solutions. We believe our Ethernet market share will grow in 2014 and beyond.

We see significant traction for CloudX deployment around the world, and expect to have more than 10 deployed throughout the second quarter of 2014. The ease of deployment of a cloud platform based on off the shelf building blocks and the significant ROI that can be achieved compared with other solutions is appealing to many OEMs, ODMs, integrators, and private and public cloud vendors.

The momentum behind the open cloud architecture is growing, and we already have tens of companies participating in this ecosystem. We believe this platform will continue to generate momentum around the world with this off the shelf, high performance cloud infrastructure.

Investing in innovation and innovative technologies has made us a leader in providing high performance interconnect solutions to the server and storage markets. These investments have enabled us to expand from being an HPC component vendor to an end-to-end solution provider supplying multiple additional markets.

Data is growing exponentially, and there is a strong need for high bandwidth solutions to support current market trends. Customers today are demanding higher bandwidth interconnects to cope with the continued growth in data.

Our investments today in end-to-end 100 gigabit per second solutions, Ethernet switching, and advanced interconnect technologies put us in a strong position to serve this demand and to increase our market share. Therefore, we believe that our revenue will increase in the coming quarters.

Operator, 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 Kevin Cassidy at Stifel. Please go ahead.

Kevin Cassidy – Stifel Nicolaus

Yes. Thanks for taking my questions. You had mentioned that the HPC market was weaker than you expected. Was that push outs, or were there – you were expecting to get some orders that didn't come through and they're going to wait until Grantley comes out? Could you give us a little more details on how that happened?

Eyal Waldman

Yes. We think that some of the HPC deployments will be pushed out until the Grantley platform is out there.

Kevin Cassidy – Stifel Nicolaus

On the Grantley platform, are you expecting that in the September quarter?

Eyal Waldman

We expect it in the second half of this year.

Kevin Cassidy – Stifel Nicolaus

And maybe as we move to gross margins, gross margins were a surprise to the upside. But, what's a little confusing is your mix of ICs and boards was a lower percentage of gross margin – or of revenue, and that's typically your higher gross margin business. Can you explain how the gross margins increased?

Jacob Shulman

Sure, Kevin. We had better than – we had improved margins from our cable product category.

Kevin Cassidy – Stifel Nicolaus

Okay. And as you look out to next quarter, is there a similar mix? Is that what you're expecting?

Jacob Shulman

We currently don't expect any significant changes in the product mix.

Operator

And we'll go next to Steve Milunovich from UBS. Please go ahead.

Steve Milunovich – UBS

Thank you. A couple housekeeping items, first of all. I think you had previously said the tax rate would be around 8%. It was a bit higher than that. Do you still expect it to be single digit for the year?

Jacob Shulman

Yes, we still expect the tax rate to be high single digits for the full year.

Steve Milunovich – UBS

Okay. And the share count went down sequentially and year-over-year, but you're suggesting that next quarter it's up. Why was it low this quarter?

Jacob Shulman

The non-GAAP share count went up year-over-year.

Steve Milunovich – UBS

What was that number, Jacob?

Jacob Shulman

The non-GAAP share count a year ago was 44.8 million shares in the first quarter of 2013. In the first quarter of 2014, it's 46.2 million shares.

Steve Milunovich – UBS

Ah, okay. Sorry about that. I think you had earlier indicated on the last call that you had a few $5 million plus type HPC deals in the pipeline. Are those still there for later this year?

Eyal Waldman

Yes, I think that we'll see them going into deployment in Q3, Q4, and Q1 of 2015.

Steve Milunovich – UBS

Okay. And on the cloud side, is that primarily Ethernet, or is that InfiniBand as well?

Eyal Waldman

It's a combination. We see some of the vendors deploy Ethernet, some deploy InfiniBand.

Steve Milunovich – UBS

Okay. And I was curious. On the visibility side, back when you had the issue with inventory at a large OEM, it sounds like you doubled down to really try to understand what's going on at your OEMs. Do you find that your visibility has improved to some degree because of that, or it doesn't really change things?

Eyal Waldman

Not drastically. I mean, we do have more visibility, but I wouldn't say it's a significant achievement.

Steve Milunovich – UBS

Okay. And then, can you review what you think the competitive situation might be in 100 gigabits? Obviously, we all expect Intel – what's the latest, and you're thinking of Intel timing. And we've also heard Brocade might be doing something.

Eyal Waldman

I don't know about Brocade, but we hear about two or three companies that may have 100 gigabit per second switching sometime this year. We don't know of anyone that will have a 100 gigabit per second NIC anytime soon except for us and then also [Okado].

So, Mellanox, as far as we understand, is only one of two, but everything – the only company that will have the full end-to-end 100 gigabit per second in this timeframe of the next year or so.

Steve Milunovich – UBS

Okay. The last question, in terms of Ethernet products, what are you selling, primarily NICs?

Eyal Waldman

The majority of the volume of our Ethernet products is NICs, then I would say cables, and then I would say switches. This is kind of the order of volume.

Steve Milunovich – UBS

And where are we in terms of getting the Layer 3 software on the switches?

Eyal Waldman

We expect – we're making progress. We expect that by the end of this year we'll have the vast majority of the Layer 3 protocols for Ethernet.

Steve Milunovich – UBS

Okay, great. Thank you very much.

Eval Waldman

Thank you.

Operator

Our next question comes from Andrew Nowinski from Piper Jaffray. Please go ahead.

Andrew Nowinski – Piper Jaffray

Okay, good afternoon. Just wondering, could you quantify how much revenue was perhaps lost or pushed out by the HPC customers and then that one large customer that came in lower than expected? Any idea of how much that cost you this quarter?

Eyal Waldman

I don't think we've specified that.

Andrew Nowinski – Piper Jaffray

Was it, I guess, single digits, or was it a bigger impact than that?

Eyal Waldman

Are you talking about both, or the one? Again, we don't specify those.

Andrew Nowinski – Piper Jaffray

Okay, fair enough. I guess I'm just trying to understand. I guess did any of that revenue push into Q2, and is that factored into your guidance?

Eyal Waldman

For that customer, we don't think so. For the HPC, we think that some did push to the second half, not the second quarter, the second half of this year.

Andrew Nowinski – Piper Jaffray

Okay. So, it's not included in the Q2 guidance? That's just a clean number?

Eyal Waldman

No, we think – Grantley, I think, is scheduled to be in the second half of this year, not second quarter.

Andrew Nowinski – Piper Jaffray

Got you. Okay. And then, can you just talk about how does the guidance – at the midpoint, the $102.5 million, how does that compare to your normal seasonality? Is that basically what you normally expect this quarter, or is that above or below?

Eyal Waldman

Well, that's what we forecast for Q2.

Andrew Nowinski – Piper Jaffray

I'm just trying to gauge. Is it better than normal?

Eyal Waldman

What I think we're seeing is a push out because of the HPC customers waiting for Grantley. So, I think it's lower than what we'd have expected.

Andrew Nowinski – Piper Jaffray

Okay, fair enough. And then, on the OpEx side, it looks like it came in lower than I guess you guided to, lower than the 2% to 4% sequential growth in Q1 and then for Q4 – excuse me, Q2. Is that guidance, the 4% to 6%, accounting for the lower than expected spending in Q1?

Eyal Waldman

Yes.

Andrew Nowinski – Piper Jaffray

Okay. So, then if they're just catching up in Q2, should we still assume 2% to 4% sequential growth for Q3 and Q4?

Jacob Shulman

We would like to reiterate our guidance for sequential increases of low single digits from quarter-to-quarter going forward.

Andrew Nowinski – Piper Jaffray

And Q2 is just a catch up?

Jacob Shulman

Q2 is just a catch up, yes.

Andrew Nowinski – Piper Jaffray

Okay, great. And then, just last question for me, any idea what percentage of the Ethernet revenue this quarter – it was very good growth. What percentage of the mix was 40 gig versus 10 gig?

Eyal Waldman

I don't think we spell this out.

Andrew Nowinski – Piper Jaffray

Okay. Thanks guys.

Eyal Waldman.

Thanks.

Operator

Our next question comes from James Kisner from Jefferies. Please go ahead.

James Kisner – Jefferies

Hi, guys. Thank you for taking my question. Just want to clarify housekeeping really quick here. Both IBM and HP were both not 10% customers? Is Dell the only 10% customer this quarter?

Jacob Shulman

That's correct.

Eyal Waldman

Yes.

James Kisner – Jefferies

Okay. Yet, you guys said that only one customer was – large customer disappointed you. Did you expect one of those customers to be weak this quarter?

Eyal Waldman

They were closer to where we expected them to be.

James Kisner – Jefferies

Okay, fair enough. So, one thing I want to clarify also is, Eyal, you said that you still look for the Grantley in the second half, but then you also said that HPC deals could hit in Q3, Q4, or 2015. Can I infer from that that there are – ?

Eyal Waldman

No, no, no, Q3, Q4 2014, and Q1 2015.

James Kisner – Jefferies

That's what I meant, right. But, if you look at that, you're not sort of saying – I'm just wondering if there are other HPC deals that could hit in Q3, $5 million plus deals that are not dependent on Grantley, or are they pretty much all tied to Grantley?

Eyal Waldman

I wouldn't say all tied to Grantley, but the majority are.

James Kisner – Jefferies

Okay. So, it's possible that some large HPC deals could hit in Q3 even if Grantley was not on time.

Eyal Waldman

I think they'll wait for Grantley.

James Kisner – Jefferies

You think they'll wait for Grantley, okay. Just on the expenses, turning to the expenses for a second here, were there any silicon spinouts in Q1? Is that something that slid to Q2? Is that why we're seeing the catch-up?

Eyal Waldman

I don't think we're talking about that since we don't think it's a material event anymore and we hope to tape-out the more frequent devices. So, I don't think we specify this.

James Kisner – Jefferies

Okay, great. And I guess the one final question is to clarify on the softness. I mean, we have heard from some vendors that the government has been kind of pressured. Obviously HPC still has a pretty big government component. Do you think also that there could be some fiscal budget pressures that are causing some of the softness right now, or is there any way to tell? Any thoughts on that would be greatly appreciated. Thank you.

Eyal Waldman

We don't have visibility into this. We think the majority is because of the Grantley piece.

James Kisner – Jefferies

All right. Thanks very much, guys. I'll pass it.

Eyal Waldman

Thank you.

Operator

Our next question comes from Rajesh Ghai from Macquarie. Please go ahead.

Rajesh Ghai – Macquarie

Yes. Thanks. On the last call, Eyal, you mentioned that you didn't expect Grantley to be as big as Romley in terms of refresh cycle. Just wanted to understand, obviously the first half of 2014 has just started off on a slow note on the HPC side. Do you kind of see a similar demand – pent up demand kind of building up, even though there is potentially now going to be a delay in Grantley?

And in terms of just the fact that the amount of data that's being crunched through in the HPC environments keeps them growing and it's two years since the last refresh, why is there – why couldn't Grantley be almost as big as Romley, just from the point of view of the fact that the amount of big data and amount of HPC kind of use cases are only growing and it's two years since the last refresh?

Eyal Waldman

We just don't anticipate this in such a big way. We think it's going to be smaller. That's all.

Rajesh Ghai – Macquarie

Okay. Is that more conservative then, or is that kind of more just the fact that it's – you don't have the delay in the refresh cycle?

Eyal Waldman

I think the Romley pent up demand was caused for – because it's a larger delay in the schedule. Here it's, I think, a shorter delay in schedule, so we don't anticipate such a big pent up demand.

Rajesh Ghai – Macquarie

Okay. And as far as the cloud market is concerned, how – is CloudX being – is CloudX going to be a catalyst for you in that market this year? What's the early reception to CloudX in that market?

Eyal Waldman

Yes. We expect CloudX to contribute to revenues this year for us in the cloud market, yes.

Rajesh Ghai – Macquarie

And storage market seems to be – seems to have gone into a decline this year, especially if you look at the results of all the large OEMs. Do you feel – are you feeling any of the impact in their declines, or you kind of see InfiniBand as kind of gaining share in a declining pie so it probably won't be affected as much?

Eyal Waldman

We believe InfiniBand is gaining share. So, I don't think we'll see a significant decline, if at all.

Rajesh Ghai – Macquarie

All right. Thank you.

Eyal Waldman

Thank you.

Operator

Our next question comes from Srini Nandury from Summit Research. Please go ahead.

Srini Nandury – Summit Research

Thank you for taking my call. A clarification first. Into which bucket do you lump your RDMA solutions? Does it go into InfiniBand or Ethernet in revenue?

Eyal Waldman

Both. We have RDMA running both on InfiniBand and Ethernet.

Srini Nandury – Summit Research

Okay. So, can you provide some color on the adoption of RDMA solutions, perhaps some metrics around what's happening in there?

Eyal Waldman

Oh, we're seeing RDMA solutions being adopted in Web 2 customers, in cloud customers, in storage, financial services, or with the HPC. So, all of those applications and markets can benefit from RDMA.

Srini Nandury – Summit Research

Okay. This quarter – your 56 gigabit InfiniBand decreased this quarter. Can you provide some color? What happened there?

Eyal Waldman

Again, I think it's mainly due to the HPC part.

Srini Nandury – Summit Research

Okay. So, for your guidance for the next quarter, I mean, how much of your decline are you expecting in the HPC market? I mean, do you expect it to continue? And are we going to see the repeat performance of what we saw in 2012, basically $50 million getting pushed out, that kind of a scenario?

Eyal Waldman

Again, we don't have that visibility, but we do see people push out some of the deployments into the second half of 2014 and maybe even Q1 of 2015. But, we don't have the visibility to give you numbers or stuff like that.

Srini Nandury – Summit Research

Okay. I've got one last question. Can you comment on the Ethernet switching business and the NIC business now that the Broadcom assets have been bought by QLogic? And QLogic has basically got a lot of footprint in various OEMs. And so, what do you guys think about the whole situation now?

Eyal Waldman

We don't understand this move, actually. We're trying to ourselves figure this out.

But, what we're seeing is that we're continuing to grow our market share. And we see more Intel as a bigger competitor for us in the 40 and 100 gigabit per second NIC business. So, we don't know what was the motivation between Broadcom and QLogic in this deal.

Srini Nandury – Summit Research

All right. Thank you, gentlemen.

Eyal Waldman

Thank you.

Operator

Our next question comes from Sanjay Chaurasia from Nomura. Please go ahead.

Sanjay Chaurasia – Nomura

Hi. First question is Ethernet revenue seems that it grew pretty strongly. By my estimates, it seems it grew mid teens. I was just wondering if you could provide any color on which end markets you saw the growth from.

Eyal Waldman

Yes, we saw the main growth come from the Web 2 and cloud markets.

Sanjay Chaurasia – Nomura

And based on this strong start on Ethernet, could you provide us any more color in terms of what you expect for the full year on Ethernet?

Eyal Waldman

We don't have that visibility. We expect to grow, obviously, but we don't have the visibility on how much and the number. So, we can't give you any guidance on this.

Sanjay Chaurasia – Nomura

How do you see your Ethernet traction? Like next year, currently you are the only one playing in the 40G Ethernet space. Let's say we have more competitors next year. Are you building any stickiness? What is it that differentiates you? How do you – how would you think your business next year when you have more competitors?

Eyal Waldman

Yes. So, first we don't see any competitor coming with RDMA yet. And maybe also even next year I don't think they'll have RDMA. So, I think this is a big differentiator for us.

Second, I think people have already written their software to run on top of our NICs. So, that's another – software is a very heavy lifting qualification and development process. So, we think this too will lead to more use of Mellanox. So, the barrier of entry for our competitors is pretty high.

Sanjay Chaurasia – Nomura

That comment is interesting. Could you update us on what's happening on the lossless Ethernet side? Because they obviously are trying to add RDMA functionality in the 40G Ethernet space, and it seems like you believe that they are still behind in terms of getting the software and getting the implementation done.

Eyal Waldman

Yes. Not just the software, I think also they don't have silicon that has the RDMA. So, it's more than just the software. It's much more. It's just having the features in the silicon itself. They don't have that.

Sanjay Chaurasia – Nomura

And one last question on FDR. It's been – I've got 10 quarters that you are shipping our FDR solutions. And when I look at the top 500 supercomputer list, I think the FDR penetration is only about 15% to 20%. Any reason you think why the penetration hasn't gone up? Because, number one, they are obviously high performance clusters, why they are stuck at 15% to 20% penetration? Are they using 40Gbps Ethernet as connectivity, or you think that's should increase with the Grantley launch?

Eyal Waldman

No, we don't see 40 gigabit Ethernet used significantly in the top 500. I think it's just a matter of time, and I think you'll see growth in the 56 gigabit adoption in HPC.

Sanjay Chaurasia – Nomura

Thank you so much.

Eyal Waldman

Good. Thank you.

Operator

(Operator instructions.) Our next question will come from Bill Choi from Janney. Please go ahead.

Bill Choi – Janney Capital Markets

Boy. That's a tough request after all those questions. Maybe I'll give you two. You know we're still trying to understand what the actual appreciation for the HPC market pause was. Was that down year-over-year from a fairly easy comp from a year ago? Can we assume that at least all of the miss from the midpoint of your guidance, which is roughly about $4 million, came from HPC? And is that – what are you assuming that percentage to do – contribution percentage in HPC sequentially?

Eyal Waldman

Again, we have seen a number of deployments that we expected to happen in the first half being pushed out to the second half. We expect this actually to accumulate more in Q2, and then I think we'll start seeing deployments really go into production – or to be deployed in Q3 and Q4 of this year and continue in Q1 of 2015.

Bill Choi – Janney Capital Markets

Okay, that's helpful. So, no material improvement you're expecting for Q1 to Q2 in the HPC market?

Eyal Waldman

No, not significant, nothing significant.

Bill Choi – Janney Capital Markets

Okay. The second part is, thinking about the demand for 100 gig, you mentioned in your press release you already see demand for that. Where exactly are you seeing that, and what kind of adoption curve would you expect for that perhaps relative to what you saw in 56 gig?

Eyal Waldman

We actually are seeing Web 2 and cloud customers tell us they want 100 gigabit per second switching now.

Bill Choi – Janney Capital Markets

Okay, but nothing in the HPC segment?

Eyal Waldman

Well, the HPC will use it once it's there. So, that's not a – they are always early adopters. So, it's HPC, Web 2, and cloud, all of them want to have 100 gigabit per second solutions today.

Bill Choi – Janney Capital Markets

Okay. Are any of these big deals in HPC also going to have potential impact if your 100 gig's not ready? Is any of these large deals dependent on your 100 gig, not just Grantley?

Eyal Waldman

No. No. They will use FDR.

Bill Choi – Janney Capital Markets

Okay. All right. I'll pass.

Eyal Waldman

Thank you.

Operator

And our next question comes from Glenn Hanus from Needham. Please go ahead. Your line is open.

Glenn Hanus – Needham & Co.

Yes. Maybe you could talk a little bit more about some of the other verticals in terms of opportunity for some large deals out in the second half and into the first half of 2015 in the Web 2.0, cloud, and even give us an update on kind of how the Oracle business is going.

Eyal Waldman

We expect to continue to take market share in the Web 2 and cloud, more specifically in the cloud. We expect to see more cloud companies using our interconnects.

Glenn Hanus – Needham & Co.

And how is kind of the data center Oracle business going?

Eyal Waldman

Oh, that's going pretty well. No surprises here.

Glenn Hanus – Needham & Co.

Okay. And I think in the opening, I think you made a comment about data center transformation to the cloud. And were you talking about sort of contributing to some pause here, or could you just restate or just kind of explain that a little bit more, what that comment was?

Eyal Waldman

Yes. I think some of the Dell success this quarter of becoming the first time more than 10% customer was due to some cloud customers of Dell. So, the reason they have been successful to climb and be our number one customer this quarter is because of some cloud deployments.

Glenn Hanus – Needham & Co.

Okay. Thank you.

Eyal Waldman

Thank you.

Operator

Our next question will come from Alex Gauna with JMP Securities. Please go ahead.

Alex Gauna – JMP Securities

Jacob, I know you said that the gross margin strength on the quarter was attributed to the strength in cables, but I'm noticing also the strength in Ethernet. Can Ethernet continue to outperform – do you expect it to outperform without having a detrimental impact on margins? And if so, why?

Jacob Shulman

We expect Ethernet margins to continue at current levels. As you know, today our 10 gigabit Ethernet margin is below corporate, but 40 gig is comparable to InfiniBand. So, we don't expect material changes in gross margins as a result of increased portion of revenue from Ethernet products.

Alex Gauna – JMP Securities

Okay. And Eyal, I believe you characterized some of these – the shortfall in HPC as in anticipation of Grantley, but we've always known Grantley was coming in the second half. Is Grantley actually maybe coming faster such that people decided to wait for it? I don't understand why anybody would have changed their plans based on what's going on with Grantley.

Eyal Waldman

Well, we have seen that – it could be because they didn't expect it to come so soon. But, what we're seeing is the people that were expecting to deploy this quarter pushed out.

Alex Gauna – JMP Securities

Okay. Thank you.

Eyal Waldman

Thank you.

Operator

Our next question will come from Joseph Wolf from Barclays. Please go ahead.

Joseph Wolf – Barclays

Thanks. A question on the optical contribution. Is it running where you thought it would be? And I guess if you look at that business, what is the mix of the legacy Kotura business versus what's going on right now at current optical contribution and where you think datacom will be towards the end of the year?

Eyal Waldman

I don't think we've specified those.

Joseph Wolf – Barclays

All right. So, then I'll try one more here. If you look at the comments about the – or if you think about the comments you made about the 100G and cloud and Web 2.0 asking for it already, do you think the 40 gig Ethernet cycle or even – is going to be shorter than any other cycle and your customers are going to jump from 10 to 100, and 40 will be an interim step or it may not even be taken by many of your customers?

Eyal Waldman

No. No, I think the majority of the customers will use 40 and it will have its own life cycle. Some in some applications will start using 100 sooner than we expect.

Joseph Wolf – Barclays

Okay. And then finally, if you look at the one large customer which impacted revenue and the fact that they're not – you don't expect that to come back in the second quarter, if you go back to the inventory experience from the last server round, was any inventory built here, or it's clean?

Eyal Waldman

No. No, no inventory built.

Jacob, Gwyn, I have to run for a meeting. So, I'm leaving you with the rest of the questions.

Jacob Shulman

Thank you.

Gwyn Lauber

Thank you.

Eyal Waldman

Thank you. Bye bye, guys.

Operator

And we'll take our next question from Kevin Cassidy. Please go ahead. Your line is open.

Kevin Cassidy – Stifel Nicolaus

Yes. Thanks for taking my follow up question. During the quarter, you made a promotion for a VP of Channel Sales. Can you talk more about that strategy? And what percentage of revenue is channel sales and what kind of visibility do you get from the channel?

Jacob Shulman

Yes. We see an increased revenues from channels. It's really part of our strategy and really reflects significant achievement in adoption of our products by a broader customer base.

Today, channel represents high teens of the business. It's really doubled from just less than two years ago. So, we see nice growth in the channel business.

Kevin Cassidy – Stifel Nicolaus

And the visibility? Do they give you good forecasts?

Jacob Shulman

In channel business, first of all, we recognize revenue based on sell through. So, any unsold inventory, we don't take revenue on that. And we have good forecasting capabilities with the channel guys. We work with multiple channel partners.

Kevin Cassidy – Stifel Nicolaus

Okay. Thank you.

Jacob Shulman

You're welcome.

Operator

And we'll take a follow-up question from Alex Gauna from JMP Securities. Please go ahead.

Alex Gauna – JMP Securities

Yes. Jacob, I'm wondering, in terms of your guidance, is there anything normal – abnormal to the kind of turns you'd need to do to hit it? Is it still that typical 50% level?

Jacob Shulman

In terms of turns, again with same historical pattern where we – when we enter the business, we have less than 50% of orders on the books.

Alex Gauna – JMP Securities

Okay. And as far as Dell as a greater than 10% customer, is there a pipeline around it such that – I'm not asking you to guide them specifically at quarter, but can they stay at these levels, like HP and IBM did for several quarters in the past, or is this a one-off that they've emerged this strongly?

Jacob Shulman

No, Dell has always been a significant partner to us. It's hard for me to predict whether they will hit more than 10% line next quarter, but they've been a significant partner for us for a very long time.

Alex Gauna – JMP Securities

Okay. And then, with the recent IBM results and some of the color they offered around their server business, is anything structurally changed with the relationship and any update on what's going on with the Lenovo transition?

Jacob Shulman

So, obviously the deal hasn't closed yet and we are still learning what this transaction may impact. It seems that there might be some uncertainty with end customers about what it means for them, IBM/Lenovo transaction. And we see some short term uncertainty around this transaction.

Alex Gauna – JMP Securities

And do you think that uncertainty impacted this last quarter that you just reported?

Jacob Shulman

We can't say who is the customer.

Alex Gauna – JMP Securities

Okay. Thank you.

Operator

And our next question comes from Bill Choi from Janney. Please go ahead.

Bill Choi – Janney Capital Markets

Yes. Also questions about your top customers. When we talk about HPC pause that impacted the quarter and – well, Q1 and Q2, is that largely coming through these large OEMs in such a way that the drop off in IBM and HP are directly correlated to the HPC pause, or are they for different reasons?

Jacob Shulman

These large OEMs that typically fulfill to various market segments, not just HPC, although a material portion of HPC business comes from these OEMs.

Bill Choi – Janney Capital Markets

So, did you think that majority of the HPC and IBM drop off was HPC related, or no?

Jacob Shulman

A significant portion was HPC related, but there was some also related to some other market segments.

Bill Choi – Janney Capital Markets

Okay. And then, I apologize. Can you just go over the percentage mix by product again? I kind of missed that at the beginning.

Jacob Shulman

Sure, absolutely. So, ICs and boards represented 44%. Switch systems represented 33%. The rest was cables, software, services, and other.

Bill Choi – Janney Capital Markets

Okay. Thanks.

Jacob Shulman

Welcome.

Operator

I would like to turn it back to Mr. Shulman for closing remarks.

Jacob Shulman

Thank you very much for your interest in Mellanox. Have a good evening. Thank you very much.

Operator

Thank you. This concludes today's conference call. Please disconnect at your lines at this time, and have a good day.

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