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PMC-Sierra (NASDAQ:PMCS)

Q1 2014 Earnings Call

May 01, 2014 4:30 pm ET

Executives

Suzanne Schmidt - Managing Director

Gregory S. Lang - Chief Executive Officer, President and Director

Steven J. Geiser - Chief Financial Officer, Principal Accounting Officer and Vice President of Finance

Analysts

Kevin E. Cassidy - Stifel, Nicolaus & Company, Incorporated, Research Division

Sundeep Bajikar - Jefferies LLC, Research Division

Ryan Goodman - CLSA Limited, Research Division

Operator

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the PMC Q1 2014 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Thursday, May 1, 2014. I would now like to turn the call over to Suzanne Schmidt, Investor Relations for PMC. Please go ahead.

Suzanne Schmidt

Hello, everyone. Thank you for joining us on the call today. With me today are Greg Lang, President and CEO; and Steve Geiser, Vice President and CFO. Greg will begin the call with a discussion of the business and key highlights from the first quarter of 2014, and Steve will then discuss the financial results for the first quarter of 2014 and then the business outlook for the second quarter of 2014. Please note that our first quarter 2014 earnings press release was disseminated today via BusinessWire after the market close, and a copy of the release can be downloaded from our website.

Before we begin, I would like to point out that during the course of this conference call, we will be making forward-looking statements that involve a number of risks and uncertainties. And these risks and uncertainties include, but are not limited to, PMC's limited revenue visibility due to the variable customer demands, market segment growth or decline, customer concentrations, bookings rate, changes in inventory, foreign exchange rates and other risk factors that are detailed in the company's SEC filings. Actual results may differ materially from the company's projections. For further information about these risks and uncertainties, please read the company's SEC filings, including our Forms 10-K and 10-Q. Note that PMC undertakes no obligation to update any forward-looking statements.

Please note that for each of the historical non-GAAP financial measures mentioned on this call, a full reconciliation to the most comparable GAAP financial measures is included in our press release issued today. And in addition, a GAAP to non-GAAP reconciliation of financial measures noted in our outlook will be posted on our website under the Financial Reports section of the Investor Relations tab.

[Operator Instructions] Thank you. And I will now turn the call over to Greg Lang.

Gregory S. Lang

Thank you for joining us today, and welcome to our first quarter 2014 earnings call. We're off to a good start in 2014, as first quarter top and bottom line results came in above the midpoint of our outlook range. Revenues totaled $126.5 million and were driven primarily by strength in sales of our flash controllers and OTN products, 2 of our key growth drivers. This revenue is roughly flat sequentially and up 1% over Q1 2013. Non-GAAP net income was approximately $16 million, and non-GAAP EPS was $0.08 per share, an increase of 20% from Q1 2013.

With this backdrop, I'll give you an overview of the Q1 results. Storage revenues declined by approximately $3.7 million or 4% during the last quarter. While we saw continued strength in our flash controller products, these gains were more than offset by normal seasonality for the balance of our storage products. Our carrier revenue increased by approximately $3.3 million or 9% quarter-over-quarter, with optical upside driven by sales of our OTN products while mobile was essentially flat.

In terms of mix, storage represented 69% of total revenue. Optical came in at 19%, and mobile was 12% of the total. For those of you tracking the legacy portion of our revenue, it was approximately 5.5% of total revenue in Q1, up a bit from 4.5% in Q4 due to the strength in our SONET business.

Now a bit more detail in each of the market segments. First, in storage. We remain optimistic about the potential for our storage business from both the systems as well as the service side of the business. With the growing adoption of high-density, cloud-based delivery models and the rise of alternative storage architectures based on flash, we are positioned well. We continue to see strong interest in our flash controllers from next-generation cloud and enterprise data centers -- customers as well as large flash memory manufacturers. Additionally, with the pending transition to Intel's Grantley platform, we're poised to benefit from the design wins that we already have in place when the transition to 12-gig SAS is expected to occur in the second half of this year.

Revenue from our storage business overall declined by 4% versus last quarter. Within this market segment, we saw a continued strength in our flash controller business as one of our major customers finished their initial ramp. As we said in the past, we expect some lumpiness, as we are still working with a fairly narrow customer base and near-term sales are tied to buildouts of large data centers. Therefore, while Q4 saw a nice increase in revenue from our flash controllers, Q2 is expected to be lower due to timing of these buildouts and the ramp of new customers. We continue to believe we can generate incremental annual revenue from this business in the $20 million to $40 million range of share and believe that in the future, a broader base of customers will give us better diversification and continued growth of this revenue stream.

The balance of our storage business experienced normal seasonality in the 5% to 10% range. Entering the quarter, we thought this might be a bit better than normal seasonal, but as we've seen from the earnings of major storage companies, it was a challenging quarter for enterprise storage end markets. We saw a bit of pre-revenue from our 12-gig SAS products preparing for a late summer launch. Looking ahead to the second half of the year, we believe we remain very well positioned for share gains in the coming transition from 6- to 12-gig SAS.

Another important measurement of our success is industry and customer recognition. Let me share just a few of our achievements during the quarter in this regard. Early in the quarter, we announced the high-density storage connectivity for cloud data centers through our 24-port RAID adapter for the Open Compute project. Our RAID adapter enables the densest Open Rack storage capacity available in the industry, and we're excited about the potential this provides as the drive towards densification takes hold in cloud data centers.

Separately, we, together with Seagate, garnered tremendous interest in our 12-gig high-density RAID solutions at CeBIT, the world's largest international technology trade show. Together, we demonstrated the highest density and highest performance tiered storage solution, including SSDs, hard drives and advanced caching software and Series 8 RAID cards. And finally, I'm proud to say that our Adaptec Series 8 RAID card received an Innovation Award for dataset in China.

On the carrier side, the business was up $3.3 million overall, better than our expectations. Optical revenue was up $3.6 million sequentially. The majority of this increase was driven by our OTN product line, where revenues increased by more than 50% quarter-on-quarter and recorded a fifth straight quarter of growth. Orders from our third-generation family of products, collectively known as DIGI, led the increase. Some customers delivered their first production orders of DIGIs after completing trials with their carrier customers, but most are still completing internal system testing. The DIGI device has a footprint at 8 out of 9 of the largest transport OEMs, and PMC has more than 50 line cards in various phases of design at this time, with 3 achieving production status at the end of Q1. We expect another 40 line cards to go in production this year. This leads us to believe that OTN revenue ramp will continue throughout this year and next.

In addition to carriers, we see interest from data center customer operators that the OTN is an optimal solution to help with inter-data center traffic, and we believe adoption rates should continue to rise. Importantly, during the quarter, we also announced the successful interoperability of our DIGI 120 OTN processor family, and the Acacia 100-gig Coherent module, which enables the mass deployment of 100-gig OTN in metro networks. This is an important step to demonstrate that the ecosystem is ready for the 100-gig transition. Our design win position with OTN across most of the major OEMs puts us in an excellent position to see continued growth in this segment, which we believe will exceed $500 million in 2017.

Now on to the mobile business where our revenues were down about $300,000 or essentially flat from the previous quarter. Our WinPath business was down slightly, offset by an increase in the legacy ATM business shipping into 3G backhaul. We continue to see and hear aggressive plans in China, the U.S. and Europe for both 3G and 4G base stations where we have content and therefore benefit in the future as rollouts continue, especially in the U.S. and Europe. Our integrated radio chipset for mobile base stations is moving forward, and we believe this product has excellent growth potential, with likelihood of early revenue towards the end of this year but more material revenue in 2015.

And now for our outlook for Q2 2014. We expect Q2 revenues to be in the range of $121 million to $129 million. Considering today's backlog, we believe that the optical business will have another quarter of growth -- will have another growth quarter led by OTN. And overall, we expect storage to be down a bit in Q2. We expect our core storage products to be roughly flat after the slow end market reports from Q1, and our flash revenue will be down a few million dollars after the initial buildout of the first major customer, with growth resuming in Q3.

As we look ahead to the rest of 2014, we have 4 clear growth factors. First, our OTN business is very strong. After talking about this arena for a while, we're finally seeing this growth happening today. And we remain very confident in our expectations for continued growth based on the design wins we have on hand and the 50 line cards that are on their way to production over the next year. It's just a matter of getting these products into production.

Second is our flash controller business. We're off to an excellent start with this business, and while the growth trajectory may be lumpy from quarter to quarter, depending on data center buildout schedules and new customer ramps, we're confident we can generate annual revenue contribution from this business in the $20 million to $40 million range, as we have design wins in place with key data center customers, flash manufacturers, storage and drive OEMs.

And the third growth driver for us this year is 12-gig SAS. As we said before, we view this as a second half revenue driver tied to the Intel Grantley launch. Because we've already won the designs that represent 10-plus percentage gain share in the market -- market share, we believe we're well positioned for meaningful growth once this important technology transition arrives.

Lastly, we believe we benefit from the densification of the cloud data center. The move towards greater and greater density of systems in drives plays directly to our products' strengths and will allow us to expand our footprint in this growing part of the market.

Underpinning each of these 4 key growth drivers is a continued escalation of data traffic that is driving our customers to turn to us to help them solve the difficult challenge around transforming networks that connect, move and store Big Data. We're encouraged that 2 of our major growth drivers are starting to take off. It's an excellent base to build from. And as we head into the second half, we expect to see the start of our 12-gig share gains with Grantley to take hold and further penetration of the cloud data centers.

So with that, I'll turn it over to Steve for more details on the financials and our outlook.

Steven J. Geiser

Thanks, Greg. I'll now discuss our first quarter financial results and comment further on our outlook for the second quarter of 2014. First quarter revenue was toward the upper end of our outlook range at $126.5 million, up 1% over the first quarter of 2013 and roughly flat with the prior quarter. In Q1, we had 2 customers which each accounted for more than 10% of our revenues calculated on a rolling 12-month basis, namely HP and EMC.

Non-GAAP gross margin in the fourth quarter was 70.5%, at the midpoint of our outlook range of 70% to 71% for the quarter. Gross margins have been consistently above 70% for the past 8 quarters.

On a non-GAAP basis, operating expenses came in at $72.1 million for the first quarter, near the midpoint of our outlook range. Operating expenses were down by $2.9 million from the first quarter of 2013 as the result of several cost reduction initiatives implemented during the last year and slightly lower tapeout-related expenses. As anticipated, operating expenses were up approximately $1.8 million sequentially from the fourth quarter of 2013 as the result of a several million increase from the annual reset of employee benefits at the beginning of the calendar year, partially offset by cost reduction measures associated with the previously announced organizational changes that took place late in Q4.

Non-GAAP operating margin was 13.5% for the first quarter, up from 10.4% in Q1 '13 and down compared to 15.5% in Q4, with both changes driven by the fluctuation in non-GAAP operating expenses just discussed.

Non-GAAP net income was $16 million or $0.08 per share, up from $13.3 million or $0.06 per share in the first quarter of 2013 and down...

[Technical Difficulty]

Operator

All right, please start over.

Steven J. Geiser

Yes, this is Steve Geiser, CFO from PMC. Our line, unfortunately, was cut. I'm going to resume my prepared remarks in the discussion of our GAAP net results for the first quarter.

Q1 GAAP net loss was $4.2 million or $0.02 per share versus $0.08 net loss in Q4. The primary items reconciling GAAP to non-GAAP net income for Q1 are as follows: $12.3 million in amortization of purchased intangible assets, $6.2 million in stock-based compensation expense, $0.9 million of acquisition-related expense and $0.5 million in asset impairment. You can see our press release issued today for a full reconciliation.

Turning to the balance sheet. We ended the first quarter with a net cash position defined as cash and cash equivalents, short-term investments and investment securities net of outstanding debt of $188 million. This is an approximate $4 million increase from our Q4 ending position of $184 million. This increase arises from an $11 million of cash generated from operations and $9 million of new stock issuances from ESPP and employee stock option, partially offset by $11 million in stock repurchases completed during Q1 and $4 million of capital purchases in the quarter. Please note, the $25 million of the $30 million drawn against the debt revolving -- revolving debt facility as of the end of 2013 was repaid during the first quarter. The remaining $5 million drawn against the facility as of the end of the first quarter was repaid during the month of April.

Our net inventory at the end of Q1 was $30.2 million, $0.9 million or 3% lower than at the end of the prior quarter. With tight control of manufacturing activities by our operations team and sales coming in toward the upper end of the outlook range, we continue to improve net inventory turn up to 5.0x in Q1. Q1 ending deferred revenue balance decreased to $5.6 million from approximately $7.5 million as of the end of Q4, reflective of the relatively light levels of inventory held by our point-of-sale distributors. Overall, our inventory, including at distributors, remains well managed. In terms of lead times from our foundry partners, they have remained stable, and we have adequate labor supply to meet our forecasted demand.

I will turn to our outlook for the second quarter of 2014. As Greg mentioned, we expect Q2 revenues to be in the range of $121 million to $129 million or down 4% to up 2% sequentially. This takes into account current levels of demand and our expectation of booking rates through the balance of this quarter.

On a non-GAAP basis, we expect our overall gross margin percentage in Q2 to remain in the range of 70% to 71%. Non-GAAP operating expenses in Q2 are expected to be in the range of $70 million to $72 million, approximately $1 million lower than Q1 at the midpoint of this range. This decrease is mainly the result of realizing the full impact of cost reduction measures initiated in Q4 of last year but which were not fully implemented until early in the second quarter. We expect other income in Q2 to be 0 with interest income on cash balances largely offset by financing costs related to our line of credit.

We expect our non-GAAP tax provision in Q2 to be approximately $1 million. As a reminder, tax expense can be impacted by a number of variables associated with our ASC 740 liabilities, including, but not limited to a change in foreign income and product mix. At the midpoint of our outlook range, non-GAAP earnings per share for Q2 are projected to be $0.08, flat with Q1, with a decline in operating expenses offsetting the slight decline in revenues and gross margin. The EPS outlook for the second quarter assumes the diluted share count of 200 million shares.

Finally, a few comments regarding our stock repurchase activity. In the first quarter, we repurchased 1.4 million shares for $8.9 million. In total, since the authorization of the $275 million share repurchase program by the board in March 2012, we have repurchased a total of approximately 41.4 million shares for $248 million. In the coming quarters, we will continue to assess the best use of our capital resources and may continue to repurchase shares opportunistically up to the remaining $27 million of outstanding authorization.

With that, we'd like to open the call up to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Kevin Cassidy with Stifel.

Kevin E. Cassidy - Stifel, Nicolaus & Company, Incorporated, Research Division

On your flash controller business, will some of that be -- do you see any uptick related to Grantley, or is that only going to come from the SAS side?

Gregory S. Lang

That's a good question. There will be an uptick related to Grantley. One of our large customers just announced their product offering but -- and feedback with a couple of the large OEMs that they have platforms that are kind of specially designed to support 2.5-inch plug-in front-panel drives with the Grantley announcement. So there will be an uptick. Now having said that, I think the largest volume that we're expecting over the course of, let's say, the next 12 months is really going to be driven by the large data center guys. So it won't be a giant incremental up above what we have today, but it will be a plus overall.

Kevin E. Cassidy - Stifel, Nicolaus & Company, Incorporated, Research Division

Okay. And are you seeing anything early -- shipments into the large data center guys for, say, even in the June quarter?

Gregory S. Lang

Well, most of the volume, most of the revenue upside that we've seen last quarter in Q1, as well as in Q4, was all driven by kind of the first taker on the large data center side. So that's definitely happening. I think in terms of follow-on business from that, I think that is going to require some of the guys offering actual drives to come to market. There's one there now, although it's primarily the 2.5-inch drive. I think the data center customers are more interested in PCI Express-based drives as opposed to a 2.5-inch drive form factor. Maybe it's easier to say a card-based form factor instead of a drive form factor. But I expect those to be coming on by the time we get into the summer. So I think that will increase over time. Right now, it's primarily driven by one large -- one is large self-builder, and -- but we'll see that pick up over the course of the year.

Operator

And our next question comes from the line of Sundeep Bajikar with Jefferies.

Sundeep Bajikar - Jefferies LLC, Research Division

Can you give us some idea of the size of your cloud data center revenues? Would that be primarily Adaptec and flash controller at this point, or are there other pieces to it? And related to that, if cloud revenues are growing faster than the rest of storage, then how big could cloud become as a category as a portion of total revenues?

Gregory S. Lang

Yes. The first part of your question, we don't break this out. Part of the reason we don't break it out is it's kind of a tough number to get at because the -- for example, a portion of our revenue through our largest customer, HP, does go into cloud data centers where they win in the cloud data center markets, but that's clearly a way that we participate there. A lot of our revenue that goes through Dell, on the other hand, actually, is directly targeted at cloud data centers. And then a good portion of what we do in the channel goes into cloud data center. So it's kind of -- it comes in different forms, and it's pretty hard to track on a kind of a precise basis. And then most of the volume today on the flash controller side is in the cloud data center. So with that mix of things, overall, I think the overall market right now is around 15%, maybe approaching 20% of the server CPUs goes into cloud data centers. And I think that gives you an idea of what the potential is for us. I actually think our share could be greater in that space because we bring more density than our competitive peers do, and I think that will play well for us. But I think the potential is clearly in that 15% to 20% range, and that part of the market, as we know, is growing faster than the traditional enterprise. So not only [indiscernible] participation there will be higher, but also the growth there is faster.

Sundeep Bajikar - Jefferies LLC, Research Division

Okay, that makes sense. On the flash controller side, how many NAND suppliers or NAND makers do you currently have design wins with? And do you see opportunities to expand those relationships? And is it also fair to assume that all of those design wins with the NAND makers would be primarily for high-performance SSDs?

Gregory S. Lang

The last pair of questions was high-performance SSDs?

Sundeep Bajikar - Jefferies LLC, Research Division

High-performance SSDs, yes, the PCI Express high performance.

Gregory S. Lang

Okay, thanks. So today, the lineup is we have basically 2 of the top 5 on our NVMe controller roadmap, and yes, all of the designs are going to be targeted at what we call enterprise class. So that would be in that high-performance category that you're talking about. That's really where our product is best suited, and it's the sweet spot for what we do. So we have 2 of the top 5 that are on kind of our new technology roadmap, a third that is on the earlier ASIC roadmap. And I would say there is a general trend towards more dialogue for future roadmap discussions because I think the reality is that people are realizing this treadmill is harder than maybe they thought. And I do think that the dynamics should and could shake out in our favor where people that are kind of doing controllers and are specializing in controller-type products actually emerge as the primary providers of those types of capabilities, at least for the enterprise market. That's our belief.

Sundeep Bajikar - Jefferies LLC, Research Division

That's very helpful. And last one for me, if I could. If you could just talk about the PCI Express Switch technology you acquired from IDT. How soon can we see that technology ramp into production volumes? Is there a lot of industry or customer enabling that you need to do, or is the industry pretty much already set up to use that technology?

Gregory S. Lang

Well, we haven't announced the product in the space yet. So let me give you a couple of thoughts there short of any product announcement. As you point out, we did pick up the PCI Express Switch technology, the IP, as well as the people from IDT, along the way. We do think that PCI Express becomes a very important drive to interconnect for the industry, both enterprise as well as cloud data center. So we view this technology as fairly fundamental for the evolution of the market where there will be more and more PCI Express drives. And as you know, PMC is a clear leader and the #1 supplier of SAS switches that connect all the SAS drives, and we intend to execute to be the #1 provider of PCI Express-based connectivity as well for drives that run on PCI Express. We're probably quarters away from making an announcement in that space, but I think the market is in need of a storage-capable PCI Express-like device for the future drive connectivity, that's coming at us right now.

Operator

[Operator Instructions] Our next question is from the line of Srini Pajjuri with CLSA.

Ryan Goodman - CLSA Limited, Research Division

This is Ryan Goodman for Srini. First question, it looks like the legacy business took a bit of a tick up during the quarter. So I'm just curious how you expect that to trend in Q2 and then in the back half of the year.

Gregory S. Lang

Yes, that's a good observation. We've watched this legacy business kind of fall pretty, pretty quickly the last 2 years. But at some point, we expect it to kind of reach a flat spot or a bottom where it bounces around for a while or at least the drop-off slows down. And I think we -- I think what this suggests to me is that we've probably reached that point. The uptick came in the form of SONET. And then you heard on the mobile side we saw also a bit of an uptick on ATM from a 3G backhaul perspective. And the reason for that, I mean, let's just keep in mind that there's a whole lot of the world that is not in the developed market and they're still using older technology, and that's really where those products are targeted. So I think what the data suggest to me and we need a few more quarters to actually, I think, have some empirical data to support it is that we have probably found that place where we'll bounce around for a while for the legacy part of the business at this. I mean, the last quarter is 4.5. This quarter is 5.5, let's call it that 5 plus or minus a percentage point range. But I think that's a good thing. I think the fact that a lot of the legacy headwinds we have are behind us is a good thing and we get ourselves positioned for growing with the new technologies with LTE and beyond.

Ryan Goodman - CLSA Limited, Research Division

Okay, great. And then just for a follow-on question. You highlighted 4 growth drivers just in the outlook, the longer-term outlook. In terms of gross margins, can you give maybe some idea of which areas you look at as above corporate average, which ones are below corporate average and just generally how you expect the gross margin trends to go from here?

Gregory S. Lang

Yes. I think that's a fair question. And I think in the foreseeable future, meaning, let' say, over the next 4 to 6 quarters, we don't expect a major shift in our gross margin profile. And then specifically to your question, I think one way to think about the gross margin profile is the narrower the market, meaning the smaller number of units available to sell into a market, the higher the gross margins tend to be because you have fewer sockets to spread the R&D. So consistent with that, I mentioned OTN first. That will be above corporate average for the reason I just mentioned. I mentioned second -- I mentioned the 12-gig products. 12-gig, that will be in line with the company average. And then after that -- sorry, I mentioned flash controllers second. Flash controllers will be -- flash controllers will probably be slightly below the corporate average. And then the data center products will probably be in line. So we've got one above, one below and a couple in line with corporate average.

Operator

[Operator Instructions] And I'm showing no further questions. Ladies and gentlemen, this concludes our conference for today. Thank you for your participation. You may now disconnect.

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