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Cavium, Inc. (NASDAQ:CAVM)

Q1 2014 Earnings Conference Call

April 30, 2014 5:00 pm ET

Executives

Angel Atondo - Sr. Marketing Communications Manager

Syed Ali - President and CEO

Arthur Chadwick - VP of Finance & Administration and CFO

Analysts

Blayne Curtis - Barclays Capital

Rick Shafer - Oppenheimer

Joseph Moore - Morgan Stanley

Anil Doradla - William Blair & Company

Ruben Roy - Piper Jaffray

John - JPMorgan

Sundeep Bajikar - Jefferies & Company

Vijay Bhagavath - Deutsche Bank

Kevin Cassidy - Stifel Nicolaus

Brian Peterson - Raymond James

Alex Gauna - JMP Securities

Sanjay Chaurasia - Nomura Securities

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Cavium Incorporated First Quarter 2014 Earnings Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) This conference is being recorded today, April 30, 2014. I would now like to turn the conference over to Angel Atondo, Senior Marketing Communications Manager. Please go ahead.

Angel Atondo

Thank you. Good afternoon, everyone, and welcome to Cavium's first quarter 2014 financial results conference call. Leading the call today are Mr. Syed Ali, President and CEO of the Company; and Art Chadwick, Vice President and Chief Financial Officer.

Before we begin, I would like to remind you that various remarks that we make on this call, including those about our future financial results, including revenues, gross margins, operating expenses, design wins, product plans, our competitive situation, market trends and our anticipated growth and profitability, all constitute forward-looking statements for the purpose of the Safe Harbor provisions under the Private Securities Litigation Reform Act.

These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties that may cause actual results to differ materially. We refer you to our most recent Form 10-K and Form 10-Q filed with the SEC, in particular, to the section entitled Risk Factors, and to other reports that we may file from time to time with the SEC for additional information on factors that could cause actual results to differ materially from our current expectations. These forward-looking statements speak only as of the date hereof and we disclaim any obligation to update these forward-looking statements.

In addition, Cavium reports gross margin, operating expenses, net income from operations, net income and basic/diluted net income per share in accordance with GAAP, and additionally on a non-GAAP basis. Management believes the non-GAAP information is useful because it can enhance the understanding of the Company's ongoing economic performance, and Cavium therefore uses non-GAAP reporting internally to evaluate and manage the Company's operations. Cavium has chosen to provide this information to investors to enable them to perform comparisons of operating results in a manner similar to how the Company analyzes its operating results.

A full reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued earlier today, and we ask that you review it in conjunction with this call. Additionally, the information we provide on this call regarding sales by market segment involves certain management judgment as to which market each sale is assigned, and you should consider that when analyzing such information.

And now, I will turn over the call to Syed. Syed?

Syed Ali

Thanks, Angel, and thanks to everyone for joining us today. In brief, Cavium's first quarter revenue was $83.2 million, up 3% sequentially and up 20% year-over-year. This was our eighth quarter in a row of sequential revenue growth. Non-GAAP gross margins were 65.4% and non-GAAP net income was $17 million or $0.30 per diluted share. GAAP net income was $2.3 million. Art will discuss our Q1 financial results and Q2 guidance in more detail shortly.

In Q1, which typically has traditional seasonality, we saw growth in our core service provider, enterprise and data center markets. Both service provider and enterprise data center markets grew sequentially. Sales into the broadband and consumer markets were down double-digit. In the service provider market, sales into wireless infrastructure market continued to be strong. Although sales into the wireline and telecom were weak during the quarter, they came in better than expected due to a partial recovery in this segment at certain customers.

Growth in the enterprise and data center markets was primarily driven by customers in the data center and security appliance markets. Sales into the broadband and consumer were down as legacy consumer sales declined, as we had discussed during our last earnings release. We believe the declining consumer headwinds will be behind us by the second half of the year. Sales into the broadband market should start driving growth later this year and in 2015 as new designs based on our low-end 28 nanometer OCTEON III 70/71XX family start go into production.

As usual, I would now like to provide an update on Q1 design wins. We had another strong design win quarter with broad-based wins across all product lines and markets from low-end to high-end performance points. We see strong design win momentum for our 28 nanometer OCTEON III products as well as for our new products such as LiquidIO, OCTEON Fusion and NEURON in the enterprise, data center and wired and wireless infrastructure markets. Overall in Q1, we saw a continued design win momentum in both our traditional as well as in new markets.

I would like to specially highlight some areas where we are seeing a significant increase in design win momentum. In the security segment, our design win rates are increasing for NITROX, OCTEON and the highest level security, FIPS, which stands for the Federal Information Processing Standard products, driven by market demand for robust line rate high-performance security in next-generation firewalls, unified tech management appliances, deep packet inspection blades, cloud security and secure HTTPS Web servers.

This further validates the heightened focus on end-to-end security, the need for pervasive intelligent security across the network and the value of our strong leadership presence in the market. In the data center market, we are seeing significant traction with our LiquidIO product line where we now have several design wins and ongoing evaluations at multiple Tier 1 customers worldwide. Strong design win momentum is being driven by strategic initiatives at cloud service providers and data centers to provide high-performance networking and software defined networking services with increased throughput, high-performance security and reduced latency.

We are also seeing excellent and growing design win momentum for our low-end 28 nanometer OCTEON III 70/71XX product family in a wide range of applications in markets and with customers that we already sell into as well as new markets such as industrial controls, mill aerospace, and IOT. We have now shipped prototype and sample units to over 50 customers worldwide. We also had new wins with Fusion in small cells and NEURON in enterprise applications.

Now, I would like to move on and give an update on our low-end OCTEON 28 nanometer 70XX, our highest end OCTEON 78XX and Project Thunder product development efforts. First, our low-end 2 to 4-core OCTEON III family of products will be production qualified this quarter and is ready to start production volume shipments in the second half of 2014.

This quarter we are also extremely pleased to announce that we are commencing widespread shipment of samples and prototype units of our flagship 48-core OCTEON III 78XX product family to multiple Tier 1 customers worldwide. This family implements the latest MIPSr5 architecture with full virtualization capabilities at core frequencies of up to 2.5 gigahertz. The OCTEON III 78XX is the highest performance multi-core processor in the OCTEON III family and delivers over 100 Gigabits of application performance per chip as well as coherent multi-socket scaling for even higher performance.

The 2.5 gigahertz 48-core OCTEON III processor provides the most compute power of any standards-based communication processor chip at an unmatched 120 gigahertz of 64-bit compute processing per chip. The 78XX also incorporates best-in-class proven hardware acceleration engines with hundreds of hardware accelerator engines dedicated to deliver the highest Layer 2 to Layer 7 yeah packet processing, quality of service, security, compression and deep packet inspection.

It also integrates Cavium NEURON Search processor technology which is an industry first. It also includes broad support for the latest high-capacity I/Os and memory with over 500 Gigabits of I/O connectivity per chip. Interfaces include multiple ports of 40-gig, 20-gig, 10-gig and Gigabit Ethernet, Interlaken, Interlaken/Latin America, PCIe Gen3, SATA, USB as well as support for both DDR3 and DDR4 DRAM memory.

The OCTEON III 78XX delivers up to 4x higher application performance than the market leading OCTEON II, with significantly superior performance per watt. The 78XX family of products will set new industry benchmarks in terms of performance, functionality and performance per watt and performance per dollar metrics. We have extremely strong customer traction for this product family and we expect it will do very well in the market and cement our position as the leading vendor of multi-core processors for the networking and communications markets. I would like to take this opportunity to congratulate the entire engineering team of Cavium for their execution in delivering this performance monster chip.

Now moving on to Project Thunder, we also continue to make excellent progress on our Project Thunder development. In addition to the chip development, which is going very well, we are deeply engaged with the software and hardware ecosystem vendors. We have strong ongoing engagements with the software ecosystem vendors for OS, virtualization, BIOS, Java development tools and application software stacks, many of whom are using our Thunder Software Development Kit for development.

We are also engaged with hardware ODMs to build a range of form factors for our target end markets. Customer attraction continues to be extremely strong as we have a very differentiated and competitive product compared to both incumbent as well as other announced ARM vendors in terms of integration, performance and power efficiency for our target markets. Stay tuned for our upcoming Thunder product launch announcements.

We are also active at a number of trade shows this quarter. We attended the Mobile World Congress in Barcelona where we showcased a range of wireless infrastructure solutions for the radio access network, core and cloud RAN, based upon our OCTEON and OCTEON Fusion products. At Interop, we showcased a range of scalable secure solutions for the virtualized enterprise and cloud infrastructure based upon our OCTEON, NITROX and LiquidIO adapters.

Now, I'd like to move on and give a brief outlook on the market environment that we see for Q2 and the balance of 2014. During our last financial conference, we talked about major growth drivers for 2014 across our served end markets and across our portfolio of existing and new products. We are now seeing that growth scenario playing out earlier and faster than expected three months ago. Q1 bookings were very strong and we now expect strong broad-based sequential growth in Q2, driven by product ramps in multiple markets including 3G/4G wireless infrastructure, enterprise and data center markets. Art will provide more specific Q2 guidance in a moment.

On that note, I would now like to turn the call over to Art Chadwick who will provide a detailed discussion of Q1 financial results and our guidance for Q2. Art?

Arthur Chadwick

Thanks, Syed, and thanks all of you for joining us today. I'll first go through Q1 financial highlights and then provide guidance for the second quarter of 2014. As Syed mentioned, Q1 was another excellent quarter for us. Q1 revenue was $83.2 million, up 3% sequentially and 20% year-over-year. Sales into the enterprise data center and service provider market were $75.6 million or 91% of sales, up 6% sequentially and 30% year-over-year. Sales into broadband and consumer were $7.6 million or 9% of sales, down 24% sequentially and down 33% year-over-year due to our exit last year from certain consumer businesses.

Our customer base continues to diversify. In Q1, we had three customers, Cisco plus two other customers, that each had sales in excess of 10%. In total, those three customers accounted for 42% of sales.

Non-GAAP gross margins were 65.4%. This was 90 basis points lower than in Q4, due primarily to changes in product and customer mix. Non-GAAP operating expenses were $37.2 million, a 3% sequential increase over Q4. Operating expenses increased due to annual employee raises, beginning of the year payroll taxes and the addition of new employees. Non-GAAP R&D expenses were $26.0 million and non-GAAP SG&A expenses were $11.2 million.

Non-GAAP operating income was $17.2 million or 20.7% of sales. Income tax expense was $243,000, which was less than 2% of non-GAAP income. The GAAP net income was $2.3 million. The non-GAAP net income was $17.0 million or $0.30 per share and this is up 67% from $10.2 million or $0.19 per share in the same quarter last year. Q1 non-GAAP results exclude $14.7 million of non-GAAP adjustments, which include stock-based compensation expense and other expenses as detailed in our reconciliation between GAAP and our non-GAAP results, as reported in our press release.

The quarter ending accounts receivable balance was $56.8 million, which were a $13.2 million increase from Q4. AR was higher due to the higher sales but we also had several customers who were more than $6 million in payments until just two days after the end of the quarter. DSOs in Q1 were 61 days, close to our long-term model of 60 days. Inventory at the end of the quarter was $49.0 million, an increase of $3.3 million during the quarter, due to purchases needed to support Q2 sales growth. We ended the quarter with a strong balance sheet and a consolidated net cash balance of $124.1 million.

I'd now like to provide more specific guidance for the second quarter of 2014. We are starting Q2 with record backlog and expect strong revenue growth in Q2. Sales to each of our top five customers are expected to increase from Q1 to Q2. We expect strong growth in our core enterprise, service provider and data center markets, but a decline in broadband and consumer sales. As a result, we expect second quarter revenue will be between $89 million and $91 million, which at the midpoint would be 8% sequential growth.

Second quarter non-GAAP gross margins are expected to be approximately 64%, down slightly from Q1 due to customer and product mix and new product mask cost. However, improving mix, product cost reductions and high margin new product sales should have a positive impact on gross margins in the second half of 2014, starting in Q3.

We expect Q2 operating expenses will increase approximately 2% sequentially, which would put non-GAAP operating expenses at about $38 million. Interest and other non-operating expenses are expected to be approximately $200,000. Income taxes in the second quarter will be approximately 3% of non-GAAP income. Taxes in Q3 and Q4 are expected to be between 4% and 6% of non-GAAP income, increasing to between 8% and 10% in 2015. The Q2 non-GAAP share count is expected to be approximately 57 million shares.

So based on those assumptions, Q2 non-GAAP EPS should be between $0.32 and $0.34 per share. And on that note, I'd like to hand the call back to the operator for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Blayne Curtis with Barclays. Please go ahead.

Blayne Curtis - Barclays Capital

Thanks for taking my question and great results and guidance. Syed, maybe you can talk about, in service provider, I'm assuming that's the contributor to a lot of the strong bookings. Maybe you can talk about the visibility, whether you have any visibility into Q3 and just kind of any thoughts on the shape of this curve? It obviously ticked up quite quickly to bookings, you're starting to see a really strong Q2 as well, any thoughts there would be helpful.

Syed Ali

Yes, Blayne. In terms of the overall visibility, the overall visibility has improved fairly substantially in Q1 compared to even the back half of 2013. So we've got good visibility from our lead customers not only on the wireless infrastructure side but also in the other segment. So we feel pretty good about where the visibility is in Q2 and beyond.

Blayne Curtis - Barclays Capital

Great. And then you talked about last quarter new products and potentially being over 10% of sales, I know probably overlooked with the strong thirst about it here, but if you can just talk about the traction there? You mentioned some wins with LiquidIO. Is that tracking to plan and any color on the incremental wins there would be helpful.

Syed Ali

In terms of the commentary that we had given for the new product, we are currently at or maybe even slightly ahead of the indications we gave in our last earnings release.

Blayne Curtis - Barclays Capital

Okay. And then just finally, Art, is this a mix issue? I'm assuming base station wins would have lower margin. Is that all that's going on with the margin ticking down?

Arthur Chadwick

That's basically correct. As I mentioned, we now have three customers that are more than 10% of our sales, so that is very good news. Obviously larger customers get slightly better pricing and that has a slight impact in the gross margin percentage, but it's obviously very positive on the top line and very positive on the bottom line.

Operator

Our next question is from the line of Rick Shafer with Oppenheimer. Please go ahead.

Rick Shafer - Oppenheimer

I'll add my congratulations. Maybe kind of a follow-up question on the talk about the wireless side of the business, I mean can you discuss maybe the linearity of your base station sales ramp this year and maybe remind us, I mean do you still expect to exit this year at roughly $100 million run rate in that base station business?

Syed Ali

In terms of – one of the things I'd like to point out, and I've done this in several earnings release calls before but I would like to highlight it again, is we have three customers on the base station side and we are shipping not only into 4G, 4G obviously is an important factor, but we've also started shipping volume into the latest 3G designs. So it's a fairly diversified customer base, not just linked to one customer or to one deployment.

So having said that, the service part of business itself on the wireless infrastructure side tends to be a bit lumpy on a quarter by quarter basis, but when we look at the fact that we have multiple customers, like I said three on the base station side and somewhere in the range of five on the backhaul side, some customers may be up or some customers may be down in any given quarter but the general trend seems pretty strong for 2014 right now with recently linearity so far. So, obviously moving ahead, we don't know exactly where it will end up, but we feel pretty good about the ramp in Q2 and even beyond that.

Rick Shafer - Oppenheimer

Great, and then just one follow-up. You mentioned Project Thunder and told us to stay tuned for design win announcements. I guess would you care to ballpark or give any kind of range of revenue expectation for 2015? I know you talked about launching the product later this year. Maybe talk about the number of engagements you have today or quantify that or talk about maybe, is it mostly with the Web 2.O guys or is it ODMs primarily you're talking to?

Syed Ali

Regarding the announcement, what I referred to was the product launch announcement where we will basically talk about the product, its features, its capabilities, its competitiveness. So that is what basically you have to stay tuned for. Now overall, we've got excellent customer engagements across what I call three major channels, one essentially being kind of the Tier 1 server guys, number two essentially being the cloud or the Web 2.0 guys, and number three is the ODM channel. So we have good engagements across the board on this.

And I think once again, I've talked about this in earlier calls, I think once we launch the product or announce the product, I think it will become very, very clear why we believe this product is so differentiated from any other offering in the market and why we believe and are very optimistic about its prospects. Now regarding actual numbers, it's kind of too early to get into that, but overall we feel that we are in a very good position.

Operator

Next question is from the line of Joe Moore with Morgan Stanley. Please go ahead.

Joseph Moore - Morgan Stanley

I wonder if you could clarify the comment on DSOs going up, Art. You said the specific customer [inaudible] is beginning for this quarter.

Arthur Chadwick

Yes, so there's kind of two pieces to this answer. One is, in Q1 in particular we had a couple of customers that simply held payment until just after the end of the quarter. So AR went up $13 million during the quarter. I collected $6 million of that on day one and day two of April. So it's a little bit of an anomaly. But the other point that I think is relevant is, we have more larger customers now. As I mentioned we have three 10% customers. These are much larger customers and their DSOs, their payment terms are generally a little bit longer than the corporate average. So going forward, I think DSOs in the 60 day range is kind of the right range for people to model.

Joseph Moore - Morgan Stanley

Okay, great, thank you. And then it seemed like the business did shift towards service provider a little bit. Any indication of what the ratio is enterprise to service provider at this point?

Syed Ali

I think it's starting to approach – about a year or two years ago, we were like 2 to 1, to 2.5 to 1, with enterprise and data center being the larger ones, but now it's kind of probably in the 1.5 this range or coming down from that.

Operator

Our next question is from the line of Anil Doradla with William Blair. Please go ahead.

Anil Doradla - William Blair & Company

Congrats. A couple of questions. Syed, I mean clearly when I look at your large tone, there's a qualitative improvement based on the business fundamentals. Trying to understand how much of it is driven by new products versus kind of your existing products, and I know it's spread across the board. Can you give us a little bit more color on what's really going on in the end markets, that would be helpful and I have a follow-up?

Syed Ali

Yes, Anil, when you take a look at our revenues that we are already shipping in Q2, you know a very, very large majority is still from our older products, right. So if you take a look at the base station ramps, if you take a look at the lot of the security product ramps, they are all based upon OCTEON II products. These were designed in whatever two to three years ago and are starting to [work the] (ph) production. So, a very large majority of the revenue is from that. The new products we've already talked about, what type of percentages that we are expecting on.

Anil Doradla - William Blair & Company

Good. Now, when you look at your new products, Thunder, Fusion, LiquidIO and NEURON, I mean you talked about some growth characteristics that you're seeing in 2014. Now, is it fair to say that what you're seeing today, you feel more optimistic on their contribution? I think you gave some sense earlier on that they could be contributing about half of your growth in 2014. Is there any way to kind of handicap how much of a contribution that would be? And how would you argue against some of the critics who say that LiquidIO is the only viable product in your portfolio today? Thanks a lot.

Syed Ali

I think everybody will see as we go through '14 and '15 that we will have good contributions from pretty much every product we make. So regarding the overall number, we have not said what portion of the revenue will LiquidIO be. We just gave an absolute number of what we think the LiquidIO plus NEURON plus Fusion will add overall onto our revenues. So, what percentage they tend to be of the total, I think we'll know that by the end of the year. But overall, again, when you take a look at our designs, high volume design starting to ship, excellent competitive position in terms of winning new designs, new products ramping, I don't think there's much we see to complain about frankly here.

Anil Doradla - William Blair & Company

Great, and congrats once again.

Operator

Our next question is from the line of Ruben Roy with Piper Jaffray. Please go ahead.

Ruben Roy - Piper Jaffray

Syed, did I hear you say that wireline improved during the quarter, and if so, can you talk about – I think you said certain customers – sort of what you're seeing from those customers inter-quarter if that's what happened and if there are any specific geographies for end service provider investment cycles that are starting up that you're seeing right now on the wireline side?

Syed Ali

So the wireline side, if you take a look at our last earnings call, we had highlighted that we expected this to be fairly weak in Q1. It actually turned out to be a little bit better in terms of when you compare it to what expectations we had for revenue in Q1 at the beginning of Q1 versus actual. But overall, it did improve at certain customers and in Q1 compared to expectations.

And then Q2, again, we are kind of modeling it to be kind of flat to slightly up. So it's not going to hit the ball out of the park, but definitely we see improving trends, and hopefully by second half of '14 we expect them to start getting back to a fairly wide customer base – improvements on a pretty wide customer base.

Ruben Roy - Piper Jaffray

Okay, thanks, Syed. And quickly on the wireless side, are all three of your base station customers ramp at this point or is one still lagging into the second half of the year?

Syed Ali

No, definitely even in Q2, all our customers have not ramped up. Customers are in different stages of ramp. So they are still a long way to go.

Operator

Our next question is from the line of Harlan Sur with JPMorgan. Please go ahead.

John - JPMorgan

This is John for Harlan. Great job guys on a good quarter and a great outlook. Kind of wanted to touch upon your design win pipeline, obviously been very strong for the past several years [inaudible], but I think you talked about a 50% design win growth last year in 2013. Wondering what's the progress so far this year. Are you still trending into 42% to 50% design win capture, and also what products or segments are you seeing most of this strength?

Syed Ali

The design wins itself, the design win really started off in 2013 and kind of accelerated into the back half of the year, and we have started off 2014 in a very strong fashion also. And every time, every quarter, at the end of the quarter I take a look at all the designs that we have won and every quarter I get a little bit amazed at the breadth of penetration that we are getting both in terms of customers, in terms of end markets, in terms of low-end to high-end performance points.

So, we believe that across our product line that we have a very strong competitive position right now, and that is what is really driving growth. But also, we are starting to feel that with shipping, we're starting to ship out our OCTEON III products, our LiquidIO products, our Fusion, our NEURON. So essentially, we are kind of widening the product portfolio for which we can win design. So, we feel very good about the competitive position that we are in.

John - JPMorgan

Okay, excellent, sounds good. Also let's say kind of getting into more your customer related questions, your Cisco business, I mean do you still expect your Cisco business to grow this year? I think you had mentioned that it should be back to growth phase this year. And in relation to that, what are going to be driving some of the – what products are going to be the big drivers at Cisco?

Syed Ali

For this year, we do expect growth in Cisco and the growth is primarily coming from kind of newer products, either ramping further from where they are right now in production, some of our designs are maybe 60% ramped, so there's still way to go in those sockets for us to grow on, but we also have a bunch of newer platforms that are starting to go to production which we should add to the top line growth there.

John - JPMorgan

Okay, great. And if I can just kind of sneak in one more, just in terms of op margins doing very well there, you guys still on track to maintain OpEx growth at about half the top line growth rate in 2014?

Arthur Chadwick

Yes, so very fair question. So the answer is, yes. For this year in total, our goal is to increase OpEx at about half the rate of our top line growth. That difference will fall obviously to our operating margin. So we do expect expansion of our operating margins during the course of the year. It's not perfectly linear. As you'll notice in Q1, our top line growth grew 3% sequentially and our OpEx also grew 3% sequentially, but Q1 is kind of the unusual OpEx quarter because you have annual raises in the beginning of the year, payroll taxes. But if you look at our Q2 guidance, the midpoint of our top line was 8% growth and we're guiding 2% OpEx growth. So there, it's just kind of a catch-up. So the answer is, yes, we expect to expand our operating margins during the course of the year, it's not perfectly linear, but that is our target and our goal.

John - JPMorgan

Okay, perfect. Thanks so much.

Operator

Our next question is from the line of Sundeep Bajikar with Jefferies. Please go ahead.

Sundeep Bajikar - Jefferies & Company

A big picture question first. Given all the big changes occurring with software defined networking and other secular technology inflections, can you talk about the opportunity or potential for Cavium to collaborate at a higher level with white box providers or ODMs in Asia, a number of which are direct suppliers into the cloud base in the market? Is this something Cavium is already doing or planning to do, because I guess ultimately do you think it would be interesting at some point for Cavium to get into the box or system making business selling custom equipment directly to a Google or a Facebook?

Syed Ali

So let me begin, Sundeep, by saying we have no intention of selling box or system equipment. Have you taken a look at their gross margins recently? So that's something that we will not do. But overall, in terms of the market trends for cloud and software defined networking, we believe that we are in a very good position and we have solutions across the board. I mean when you take a look at it, whether it's OCTEON and kind of NFC type applications, whether it is going to be Project Thunder and the cloud data center type environment, whether it's LiquidIO attaching to an existing x86 server and doing a lot of the flexibility and networking and security offload, across our product lines, we have a very, very good fit to where the market is going. So, we feel fortunate that we have developed IP over the years that is becoming a very important piece for solutions in 2015, 2016 and 2017. So, we feel very good about our positioning there.

Sundeep Bajikar - Jefferies & Company

Okay, great. Next question, OCTEON III, if you could just help characterize the ramp profile, when do you expect high-end OCTEON III to enter volume production? And related to that, are you seeing any changes in foundry availability of that 28 nanometer node?

Syed Ali

So for OCTEON III, obviously the lower end products, the 2 and 4-core type devices, they will go into production starting the latter half of this year, so starting maybe in Q4, because their development cycles are relatively shorter compared to the big equipment and we sampled that in second half of 2013. So we should get our first OCTEON III revenues starting in kind of the Q4 range.

And regarding the high-end, 78XX, we will have a production qualified in kind of the first half, by Q1 or so of 2015, but revenues – since this goes into really large equipment, we expect revenues from this to really start coming in, in the back half of '15. So, we have a number of customers who have already designed boards. So they are ahead of the curve. So guys who have already designed the boards, they should be able to get into production in the back half of '15, for brand-new guys obviously that cycle could take a little bit longer.

And regarding the overall kind of foundry availability, at the end of the day, the total number of wafers, even at this revenue level that we have, the total number of wafers that we consume are pretty small. So we don't see any issue in terms of capacity.

Sundeep Bajikar - Jefferies & Company

Okay, great. And just a last one for me on gross margins. I know you said in the back half, you expect margins to be stronger. If you could just help kind of breakdown some of the drivers of margins coming back in the second half, that would be helpful.

Arthur Chadwick

Sure, very fair question. So, as I mentioned, margins will decrease a little bit going from Q1 to Q2, and that's really more driven by the fact that we've got these larger customers with slightly better pricing, just because they're buying such larger quantities. However, having said that, by the second half of this year we have a couple of things that move in our favor. Our expected mix moves slightly in our favor. We have a lot of product cost reductions that are taking place and those cost reductions will start positively impacting our gross margins starting in Q3. And lastly, we have some of our newer products that generally generate higher gross margins.

As we've said before, there's a pretty high correlation between core count and gross margins, and there is a larger and larger trend towards higher and higher core count product, and that will help drive the higher margins in the second half of the year. So, the point here is, margins dip a little bit from Q1 to Q2 but they should come back in Q3, and at this point we expect them to increase from Q3 to Q4 at some point.

Sundeep Bajikar - Jefferies & Company

Great, thank you so much and nice job on the quarter.

Operator

Our next question is from the line of Vijay Bhagavath with Deutsche Bank. Please go ahead.

Vijay Bhagavath - Deutsche Bank

Calling on behalf of Brian. The first question is on order strength you discussed in the call. Help us understand where the orders are coming from, is it primarily coming from security equipment, virtual appliance, such as [inaudible], give us some color and understanding of where the order strength is coming from?

Syed Ali

The order strength, Vijay, is coming from across the board. It's wireless infrastructure, it is data center, it is enterprise, it is security appliances, it's a very wide base, it's not – we're not – our growth or the increased order rates are not being driven by one customer in one end market with one type of box. It's fairly diversified.

Vijay Bhagavath - Deutsche Bank

Okay, thanks. And then the second question is the LiquidIO, if you look at the Application Acceleration Adapter versus NITROX, help us understand, the chips you are competing for with the same type of use cases, for example SSL offload, or help us understand how you sell these three chips into different set of users [inaudible]?

Syed Ali

No, I think it's fairly straightforward, Vijay. When we take a look at it, NITROX is a coprocessor that basically offloads IPsec/SSL compression, those type of functions. So that basically racks as kind of an add-in card into an existing x86 server. The LiquidIO is based upon OCTEON technology. So it's a special function OCTEON technology and this basically offloads a lot of the networking functions, SDN functions, distributed firewalls, those type of applications. So, it's a very, very different application set.

Operator

Our next question is from the line of Kevin Cassidy with Stifel Nicolaus. Please go ahead.

Kevin Cassidy - Stifel Nicolaus

Just expanding a little more on the gross margin, you had said that mask cost were putting some pressure on the gross margin next quarter. Can you say [inaudible] over six quarters [inaudible]?

Arthur Chadwick

So, yes, as we've said before, mask cost gets amortized to cost of sales, and this year we have a lot of new products coming out. We've talked about some of them, some of them are yet to come out. Those masks will get amortized to our cost of sales. So that has an impact on our cost of sales this year. That is one of the pieces that are decreasing our gross margin percentages from Q1 to Q2. Mask cost will continue to be amortized through the balance of this year and beyond. I wouldn't put a lot of emphasis on it. It is one of the many factors that go into our cost of sales, and the only reason we mention it is because we do have a lot of new products coming out. So that's kind of the good news here.

Kevin Cassidy - Stifel Nicolaus

Okay, great. And just for some clarification, on the OCTEON III, your low-end device that has a 2 and 4-core, will that be cannibalizing some product you already have or are they going into new markets and maybe taking market share?

Syed Ali

Our OCTEON III 70/71XX are not cannibalizing anything because in our previous generation, the OCTEON II, we really did not optimize it for the low end. It was basically focused, OCTEON II was primarily focused on midrange and high-end products and the low-end product was not really targeted for the end markets of that 70 and 71XX. So for us, this is a fairly new greenfield opportunity in terms of a time edition, if you will. So this is completely incremental compared to our OCTEON II family.

Operator

Next question is from the line of Hans Mosesmann with Raymond James. Please go ahead.

Brian Peterson - Raymond James

This is Brian Peterson in for Hans. Could you maybe split out the percentage of Cisco sales this quarter and the percentage of sales from the top three customers in the first quarter – the fourth quarter of last year?

Syed Ali

From this quarter on, when you take a look at it, we have more than one 10% customer. So, Art, do you want to address that?

Arthur Chadwick

Yes, so as I mentioned, we had three customers this quarter greater than 10% sales. So in the past, we've always announced our sales to Cisco and what percentage it is of the total. Cisco was our only 10% customer. And now that we have multiple 10% customers, we really don't want to put emphasis on any one customer and in the future we may have more than three 10% customers. So we're going to use a little more industry-standard reporting here to talk about how many 10% plus customers we have, what their combined sales are in total, which we did this quarter. In Q1, it was 42% of our total sales for those three customers combined. And we think it's just best not to talk specifically about any one particular customer, because now at this point, we've got multiple large important customers and hopefully more to come.

Brian Peterson - Raymond James

Okay, just I'll follow up with that. Is there any way to say, if excluding those top three customers, were sales up sequentially in the March quarter and maybe how would we look at the growth for those top customers next quarter?

Arthur Chadwick

You know what, I think that's too granular for a call like this. I think the basic message is really clear. We had good sales growth in Q1, we're going to have very strong sales growth in Q2, our large customers are driving a lot of that growth, but we've got a lot of other customers that are driving growth too. So trying to get more granular than that on a call like this is probably just not the right thing to do.

Syed Ali

And I think Art in his prepared comments talked about the fact that five out of our top five customers will grow in Q2. So I think that's the granularity already.

Arthur Chadwick

Right.

Brian Peterson - Raymond James

Okay, thanks guys.

Operator

Our next question is from the line of Alex Gauna with JMP Securities. Please go ahead.

Alex Gauna - JMP Securities

Syed, you had talked about your success in NITROX and Fusion IO. What happens with those products – or LiquidIO I'm sorry – what happens with those products when we get the Grantley server refresh in the back half of the year and what are your expectations around timing and competition from that?

Syed Ali

I think from an overall viewpoint, it's more to do with adding these capabilities onto existing – into the new servers. So, obviously if the Grantley server increases the volumes that our end customers are taking, obviously the number of units that we would ship would increase. But this is a brand-new functionality. So whether – and attach rate is not only with new x86, I mean new Grantley servers but it's also with [indiscernible].

Alex Gauna - JMP Securities

Got you. Is there anything happening with Grantley in terms of the I/O speeds that would move the market more towards your solution or cause you to have to go to a new upgrade on your solution?

Syed Ali

No, I think when you take a look at Intel, it will continuously enhance their products and we have our own roadmap that we consistently enhance our products. So for example in this generation, the LiquidIO addresses a certain percentage of the opportunity. Our next generation products will significantly increase that opportunity. So both the guys have roadmaps and we try to keep pretty much in line, such that our product is adding value at any new Intel server node.

Alex Gauna - JMP Securities

Okay, and one more if I could. With Thunder, I'm wondering, as you make progress on that product line, are you able to share whether you're getting more optimistic around going to market with OEM partners or if we be going through more your EMS supply chain and more with the end market software providers implementing solutions based on your technology?

Syed Ali

I think from the view now, right now it seems like the cloud type guys will adopt it faster, even though a lot of the Tier 1s are developing products to address this, we think revenues will ramp in the cloud and in the white box sector a little bit ahead of the traditional server vendors.

Alex Gauna - JMP Securities

Okay, thank you. Great quarter.

Operator

Our next question is from the line of Sanjay Chaurasia with Nomura Securities. Please go ahead.

Sanjay Chaurasia - Nomura Securities

Great quarter, guys, and great guide. Just to push in on linearity of LiquidIO product, my understanding is, this is currently ramping key customer, and if you could give us any sense as to what happens when they are ramped up and what is your expectation in terms of timelines and how do we think about a steady-state kind of a growth for this product? And then I have a follow-up.

Syed Ali

Yes, the LiquidIO is now shipping to more than one customer, so that's a good thing. The second thing is, overall it seems fairly linear. Obviously on any given quarter, there could be some lumpiness, but overall from what we are seeing for the first half of the year and what we expect in the back half, it should have decent linearity, though in any one quarter you could have a little bit up or down but the general trend is up. And as we add the newer customers, that obviously helps improve that even further.

Sanjay Chaurasia - Nomura Securities

And my second question is a bit on the long-term design win momentum that you may be seeing, you have competitors, Freescale, who have come out with ARM based multi-core solution. I'm just wondering if you could give us any sense on what you're seeing in design wins for out quarters and what share ARM-based processors are taking versus your MIPS-based designs?

Syed Ali

We have – I think if you take a look at our product lines, we have both MIPS and ARM. So essentially, for the guys who have a lot of software in MIPS, who want to continue with MIPS, we'll have products for them. For guys who want ARM, we'll have products for them. We think in fact, overall when we take a look at it, our competitiveness is not going to change. In fact, if anything, it will improve.

Operator

At this time, there are no further questions in queue. I'd like to turn the call back over for closing remarks.

Arthur Chadwick

Alright, thank you very much. That concludes our call for today. Have a great day, everybody.

Operator

Once again, ladies and gentlemen, we'd like to thank you for your participation and you may now disconnect.

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