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Mellanox Technologies, Ltd. (NASDAQ:MLNX)

Q2 2014 Earnings Conference Call

July 24, 2014 17:00 ET

Executives

Gwyn Lauber - Director, Investor Relations

Eyal Waldman - President and Chief Executive Officer

Jacob Shulman - Chief Financial Officer

Analysts

Sanjay Chaurasia - Nomura

Steve Milunovich - UBS

Andrew Nowinski - Piper Jaffray

Joseph Wolf - Barclays

Srini Nandury - Summit Research

Rajesh Ghai - Macquarie

James Kisner – Jefferies

Kevin Cassidy – Stifel

Saqib Jalil - JPMorgan

Bill Choi - Janney

Alex Gauna - JMP Securities

Operator

Good afternoon and welcome to the Mellanox Technologies’ Second 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) And as a reminder, this conference is being recorded.

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

Gwyn Lauber - Director, Investor Relations

Good afternoon and welcome to Mellanox Technologies’ second 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 have 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 our 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 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 - President and Chief Executive Officer

Thank you, Gwyn and good afternoon everyone and thank you for joining us on our earnings call. On today’s call, I will highlight our second quarter 2014 results and achievements before turning the call over to Jacob Shulman, our Chief Financial Officer, who will discuss our second quarter financial results in more detail and provide our third quarter of 2014 guidance. After that, we will take your questions.

For the second quarter of 2014, we reported revenue of $102.6 million compared to $98.7 million in the first quarter of 2014 and $98.2 million in the second quarter of 2013. Second quarter 2014 non-GAAP gross margins were 69.1%. Non-GAAP operating income was $6.4 million and non-GAAP diluted earnings per share for the fiscal second quarter of 2014 were $0.15. During the quarter, we generated $7.2 million in cash from operating activities. We grew our revenues sequentially. This growth represents our increasing penetration into new markets beyond high-performance computing, which today contributes approximately 50% of our revenue.

In the second quarter, Mellanox as well as several of our partners made important announcements that I would like to highlight. These announcements reflect many of the opportunities that we have in our primary markets. At the June International Supercomputing Conference, we announced Switch IB, the world’s first 100-gigabit per second EDR InfiniBand switch. Switch IB features 100-gigabit per second ports and the lowest latency in the industry in the industry with the ability to deliver 5.4 billion packets per second. We believe that Switch IB is the best switch solution for high-performance computing, cloud, Web 2.0, database and storage infrastructures.

We expect to launch our 100 gigabit per second adapter in the 2014-2015 timeframe and believe we will be the only company to offer a full end to end 100 gigabit per second solutions. We are very proud of these accomplishments and our leadership and innovation in interconnect solutions. Also at the conference the top 500 list of super computers was released. InfiniBand continued to be the most used interconnect on the list and increased its percentage and its penetration to 222 systems or 44.4% of the top 500 list. FDR InfiniBand systems nearly doubled year-over-year increasing from 67 systems in June of 2013 to 126 systems in June of 2014. For the first time FDR is the leading InfiniBand solution on the list. InfiniBand enables 24 out of the 25 most efficient systems on the list and is the most used interconnect for Petascale systems. With an unmatched 99.8% efficiency and superior performance, we believe our share will continue to grow in the HPC hyperscale and commercial markets.

During the quarter there were several announcement regarding products enabled by Mellanox’s interconnects. We announced that HP’s Apollo 6000 and 8000 families of data center solutions use our FDR 56 gigabit per second InfiniBand and our 10 and 40 gigabit per second Ethernet solutions to maximize their customer’s return on investment and optimize their application performance. Using these new systems end users get the same performance from a single rack compared with four racks that the previous systems required while consuming significantly less power.

EMC recently announced its new VMAX 3 enterprise data service platform which uses FDR 56 gigabit InfiniBand interconnect bringing cloud like agility, efficiency and control within the data center. Utilizing the InfiniBand connectivity the new platform offers three times faster performance and 50% lower total cost of ownership than prior VMAX family. Mellanox has partnered with EMC on multiple solutions including Isilon, XtremIO, Pivotal, ScaleIO and now VMAX. And we believe this partnership will enable customers to better optimize their data centers. We are very pleased that the VMAX 3 solutions is going into production. And we expect design wins from additional storage partners to go into production in 2014 and 2015. We expect our revenue from the storage market to grow as trends like cloud and distributed storage create increased demand for our solutions.

IBM announced this week a new cloud solution from SoftLayer that utilizes FDR 56 gigabit per second InfiniBand technology to provide high performance, scalable and efficient cloud services. The new solution enables very high data throughput speeds within the cloud, allowing companies to move their applications, work loads such as data analytics to the cloud. In the second quarter our CloudX program based on Mellanox open cloud architecture expanded. To-date we have partnered with all major distributors including Red Hat, Mirantis and Ubuntu to offer the CloudX platform recipe for building efficient flexible cloud platforms using off the shelf building blocks. As more companies move their data center to the cloud, Mellanox will enable them to build efficient, open, scalable clouds with unmatched access to storage.

Over the few quarters – over the last few quarters, we talked about our efforts to become more competitive in the Ethernet market by closing the gap in our software development. To that end we announced that we signed an agreement to acquire Integrity Project, a team of software veterans who specialized in connectivity, real time applications and security. We believe that this acquisition will allow us to develop richer software solutions including layer 3 software and internet switch software features and to provide best in class compute and storage platforms like CloudX and to enable our end users, end markets including web to cloud storage to handle the increasing amounts of data quickly and efficiently.

We are starting to see our interconnect being used with 64 bit ARM based platforms. This powerful combination will enable better performance, lower latency and higher bandwidth to its end users. This is another example of Mellanox commitment to enable the most efficient compute and storage platforms based on any CPU architecture including x86 power and ARM.

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

Jacob Shulman - Chief Financial Officer

Thank you, Eyal. Good afternoon everyone. Let me now review some more financial details relative to our second quarter of 2014. Our total revenues in the second quarter were $102.6 million, up approximately 3.9% from $98.7 million in the first quarter of 2014 and up approximately 4.5% from $98.2 million in the second quarter of 2013. Our non-GAAP gross margins in the second quarter were at 69.1%, up from 68.6% in the first quarter of 2014 and down compared to 69.4% in the second quarter of 2013.

Major reconciling items from GAAP to non-GAAP gross profit are share-based compensation expenses of $532,000, amortization of acquired intangibles of $1.6 million and acquisition-related expenses of $535,000. The following are a few selected Q2 2014 revenue metrics for you. Combined revenues from our IC and board products represented 43% of second quarter revenues. Switch system revenues accounted for 34%. Revenue from our 56 gigabit per second InfiniBand based products represented 50% of revenues in Q2 2014, down from 52% of revenues in Q1. Revenues from of 40 gigabit per second InfiniBand based products represented 15% of revenues in Q2 2014, up from 14% of revenues in Q1. Ethernet related revenues represented 19% of the second quarter revenues, unchanged from Q1.

We had one more than 10% customer in the second quarter. IBM represented approximately 11% of revenues. Second quarter non-GAAP operating expenses increased by $1.7 million sequentially to $64.5 million and represented 62.9% of revenues compared with $62.8 million or 63.7% of revenues in the first quarter of 2014. Major reconciling items from GAAP to non-GAAP operating expenses are stock-based compensation of $11.4 million, amortization of acquired intangibles of $1.2 million and acquisition related charges of $509,000.

Moving down our income statement, our non-GAAP research and development expenses in the second quarter were $42.2 million compared to $41.1 million in Q1 2014 representing a sequential increase of 2.8%. The increase was primarily due to higher employee related expenses and higher development and tape out costs. Non-GAAP R&D expenses for Q2 2014 represents approximately 41.2% of revenues, down from 41.6% of revenues in Q1. Non-GAAP sales and marketing expenses were $15 million in Q2 compared to $15.6 million in Q1 2014 representing a sequential decrease of 3.5%. The decrease was primarily due to lower employee related expenses and lower trade show and promotion expenses. Non-GAAP sales and marketing expenses for Q2 2014 represented 14.7% of revenues, down from 15.8% of revenues in Q1 2014.

Non-GAAP general and administrative expenses were $7.3 million in Q2 compared to $6.2 million in Q1 2014, representing a sequential increase of 17.2%. The increase was primarily due to higher professional service expenses. Non-GAAP G&A expenses for second quarter represented 7.1% of revenues, up from 6.3% of revenues in Q1. Non-GAAP operating income was $6.4 million in Q2 2014 and represented 6.2% of revenues compared to $4.9 million, or 5% of revenues in the first quarter. Other income was $356,000 in the second quarter compared to $234,000 in Q1 2014.

Non-GAAP income before tax was $6.7 million or 6.6% of revenues in Q2 compared to income before tax of $5.1 million, or 5.2% of revenues in the first quarter of 2014. We recognized a tax benefit of $77,000 in the second quarter compared to a tax expense of $654,000 in first quarter 2014. The non-GAAP tax rate for the second quarter was 1.1%. Our Q2 2014 non-GAAP net income was $6.8 million or $0.15 per diluted share and included adjustments of $11.1 million for share-based compensation, amortization of acquired intangible assets of $2.8 million, and acquisition related charges of $1 million.

This compares to our first quarter 2014 non-GAAP net income of $4.5 million, or $0.10 per diluted share, that included adjustments of $11.6 million for share-based compensation, amortization of acquired intangible assets of $3.5 million and acquisition related charges of $728,000. Q2 2013 non-GAAP net income was $13.8 million or $0.30 per diluted share. Our GAAP diluted share count for the second quarter was 44.7 million shares compared to 44.3 million shares in the first quarter of 2014. Our non-GAAP diluted share count used in computing income per share for the second quarter was 46.5 million shares compared to 46.2 million shares for the first quarter.

Moving on to the cash flow statement, cash provided by operating activities during the second quarter of 2014 was $7.3 million compared to $10.5 million of cash provided by the operating activities in the first quarter of 2014. Net cash used in investing activities during the second quarter was $11.4 million and consisted of net purchases of short-term investments of $6.8 million, and purchases of property and equipment and leasehold improvements of $4.5 million. Net cash provided by financing activities during the second quarter was $133,000 and consisted primarily of cash proceeds from option exercises and employee share repurchase program of $410,000 million, partially offset by capital lease payments of $277,000.

Turning to the balance sheet, our cash and investments at the end of the quarter were $343.7 million compared to $348.1 million at the March 31, 2014. During the quarter, our accounts receivable increased $4.3 million to $69.4 million. Our days sales outstanding were 60 days in comparison to the prior quarter of 62 days. Approximately 97% of our outstanding accounts receivables are current or less than 30 days overdue. Second quarter ending inventory decreased $1.7 million to $37.1 million compared to $38.8 million in the first quarter of 2014. Our inventory turns remains unchanged at 3.6 times. Net intangible assets and goodwill were $47.9 million and $199.6 million respectively at the end of the quarter.

Total liabilities were $148.2 million at quarter end, of which $101 million were current liabilities, and $39.2 million were long-term liabilities. We currently expect our Q3 2014 non-GAAP results to be as follows; quarterly revenues of $114 million to $118 million, Q3 2014 gross margins up 68% to 69%. We expect a sequential increase in non-GAAP operating expenses of 3% to 5%. We estimate our Q3 2014 stock compensation expense to be between $11.1 million to $12.4 million. Non-GAAP diluted share count guidance for Q3 is 46.6 million shares to 47.1 million shares.

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

Eyal Waldman - President and Chief Executive Officer

Thank you, Jacob. Moving into the second half of 2014, we expect our revenue to continue to grow following the launch of the new CPU platform and as many of our partners programs begin to ramp. In the 2014, 2015 timeframe, we believe we will be the first vendor to offer full end-to-end 100 gigabit per second solutions to the market. Our history of innovation and execution in bringing new generations of interconnect solutions to market gives us the experience to develop products that end users need to solve the challenges that they face today and they will face tomorrow.

Our solutions enable end users to utilize the vast amounts of data generated so that they can make mission critical business decisions, reducing application times from days to hours and maintain their competitive advantage. Companies face huge challenges in computing and storing data and their success depends on how well they can move their data. As an innovator and the first to market with 100-gigabit per second solutions, 40-gigabit per second Ethernet solutions, RDMA, and other advanced technologies, we enable these companies to utilize their data leading to better research products and services.

We believe that our strong position and technology roadmap will help us to grow our revenue in the coming quarters. We continue to see additional storage platforms from tier one OEMs going to production with InfiniBand as the backend interconnect. InfiniBand is becoming the de facto interconnect for backend storage, replacing fiber channel and proprietary interconnects. We believe this trend will continue and more design wins will go into production in the future.

We expect both our InfiniBand and Ethernet to take more market share for frontend storage connectivity due to superior performance and latency. We’re making progress with our cable technology which we believe will lead into significant revenue in 2015 and beyond. We developed solutions that are unmatched in the market offering flexibility, features, price performance and interoperability that the market requires. We believe that, by our continued success in developing innovative solutions, we will maintain our competitive advantage and drive demand for our products.

As we see the world move from traditional dedicated hardware datacenters to cloud-based datacenters, the need to provide cloud solution that is easy to deploy user maintain while at the same time providing the highest return on investment is important and we believe that Mellanox CloudX platform is the most efficient cloud solution. We continue to see more applications and markets that can utilize the CloudX architecture solution.

Operator, now we will take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Thank you. Our first question is coming from Sanjay Chaurasia with Nomura. Please go ahead.

Sanjay Chaurasia – Nomura

Hey, guys. Congrats on the great results.

Eyal Waldman

Thank you.

Sanjay Chaurasia – Nomura

Eyal, first question on your guide, seems like multiple items are driving your outlook for the third quarter. I was just wondering if you could provide some clarity how much is being driven by HPC, what’s some of the platform launches you are seeing in the storage area? And with that, one other question on HPC is that, how do you see this cycle as you have seen some feedback from your customers, some initial traction, how would you relate this refresh cycle versus the last cycle? And then I have a follow up. Thanks.

Eyal Waldman

So we expect to show the growth in the second half from HPC from storage and from Web 2 markets for us. The initial feedback for HPC is positive and we are starting to see now for the past year and a half and so or so we didn’t see significant large deals in our revenue stream. We are now starting again to see large deals come back and we expect to see multiple large HPC high performance computing deals in the next coming in four, six quarters.

Sanjay Chaurasia - Nomura

Okay. And I just wanted to, Eyal get your sense on Intel’s announcement of Omni Scale. And also within that what happens to the customers, which are using Intel’s InfiniBand QDR solution, do you expect those customers to move Mellanox based FDR solution? Thanks.

Eyal Waldman

So the Intel proprietary interconnect, which we think is an issue obviously because it’s proprietary, is expected to start showing in 2015, but I think mainly in the 2016 timeframe. So we have some time for that. Obviously, when they come out with that there is going to be the multiple hurdles to pass. For example, provide resilient, robust, scalable to tens of thousands of nodes interconnect, all those are not easy tasks, add on top of that putting the software that we have already developed and qualified for multiple markets and multiple applications. So there are still some challenges in front of Intel to make this successful starting in 2016.

So, we have sometime, we think that if we continue to innovate and integrate with our partners including x36 into the various markets we will continue to take market share. Regarding the QLogic QDR solution as we have seen in the past and now including when it’s part of Intel, we don’t believe that QLogic interconnect solution as an efficient one. It actually requires a lot of CPU bandwidth, a lot of CPU performance is dedicated to manage the interconnect. While we offload those tasks to our silicon, the QLogic Intel architecture loads the CPU with the tasks of managing the interconnect. So we are seeing better cost performance, better efficiency and utilization in the data center, both in compute and storage platforms. And we believe this will continue maybe also with Omni Scale interconnect by Intel.

Operator

Thank you. Our next question comes from Steve Milunovich with UBS. Please go ahead.

Steve Milunovich – UBS

Thank you. Jacob, first of all do you still expect a high-single digit tax rate for the year?

Jacob Shulman

Yes, we still expect high-single digits for the full year.

Steve Milunovich – UBS

Okay. And over the last year, cables have increased as a percentage of revenue, and boards have decreased, could you talk about what’s driving those trends?

Eyal Waldman

Well, we are successfully getting design wins for our cables into the markets. So we like what we see I think with the new technology that we will bring in 2015 from the two companies we bought, IPtronics and Kotura and the new cables we are bringing to market we will continue to take market share on the cable market. So we continue to expect cables to be a more significant revenue contribution to our revenue stream.

Steve Milunovich – UBS

Is that a lower margin contributor or with the new cables, is that not the case?

Eyal Waldman

Well. Obviously, with the new cables it will be higher gross margin than with the previous cables, but it’s still on the lower side of our gross margins, still you have seeing that even with the increase of cables as a percentage of our revenues we have still been able to generate 69.1% gross margins in Q2. And we guide to I think 68% to 69% in Q3.

Steve Milunovich – UBS

And then – and why were you able to do 69.1% relative to – sequentially, what was different, what drove that up?

Eyal Waldman

I think it’s a combination of things.

Jacob Shulman

It’s a product mix mainly.

Steve Milunovich – UBS

Specifically, what about the product mix?

Jacob Shulman

Our revenues from silicon was higher comparing to previous quarter and that we got better margins on our silicon products.

Steve Milunovich – UBS

Okay, got it. And could you bring us up to date in terms of the situation in Israel and any concerns about your people, are you taking any backup plans, etcetera?

Eyal Waldman

Yes, so, in terms of operations, we moved the inventory to both the Far East and the U.S. so we don’t expect any interruptions in our shipments and providing solutions to our customers. In terms of headcount, we had a number of employees go to reserve duties. We’ve found the right structure to replace and have us small impact as possible to our execution. So, this is not the first time it happening in Israel. And we’re kind of used to that. I think we need to do some stuff there and I hope that everybody is going to comeback in the coming weeks and we’ll go back to normal.

Steve Milunovich – UBS

Great, thank you.

Eyal Waldman

Thank you.

Operator

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

Andrew Nowinski – Piper Jaffray

Good afternoon. Nice quarter. Nice guidance.

Eyal Waldman

Thank you.

Andrew Nowinski – Piper Jaffray

Just had a question for Eyal on grant lease, HPC customers I think had pause spending in Q1. So, in light of the announcement that Intel made that they’re shipping to HP customers now, did you see any sort of pent-up demand coming through in Q2, or did it start shipping too late in the quarter?

Eyal Waldman

Not really in Q2, we expect to see it more in the second half and first half of ’15.

Andrew Nowinski – Piper Jaffray

Okay. And then with regard to 100-gig, in your announcement in June, are you seeing any customers deploying those switches with 100-gig ports even though your adapters aren’t ready yet?

Eyal Waldman

Yes, people want to build the backbone at 100-gigabits so they need less cables and it’s more efficient so, I believe that we will see later this year backbone of 100-gigabits solution with adapters at 56 and moving to full end to end 100-gigabits stack in the first half of 2016.

Andrew Nowinski – Piper Jaffray

Okay, great. Last question from me, and then on the OpEx side, you came in at the low end of your guidance this quarter, although, I didn’t really hear any specific reasons for that, I guess were there any projects or hiring that fell behind that you are pushing into the September quarter, I guess I’m just trying to understand is that 3% to 5% sequential growth the new normal because previously I think you had talked about 2% to 4%?

Eyal Waldman

It’s all depends on the timing of recognition of these expenses and at the long-term, we kind of still maintain 2% to 3% quarter-over-quarter growth. We did not grow in Q1. Our growth in Q2 was roughly 2.7% so really it’s kind of long-term in line with our previous expectations.

Andrew Nowinski – Piper Jaffray

Very good. Thank you.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question comes from Joseph Wolf with Barclays. Please go ahead.

Joseph Wolf – Barclays

Thank you. Just I guess flush out maybe a little bit of the prior question, if you look at the expectations for the third quarter, could you give us a little bit more flavor, you talked about 50% HPC. The FDR business has been kind of flat. Where is the $13 million or so in incremental revenue coming from in terms of product mix? Given the higher margin, can we expect a recovery in the FDR market?

Eyal Waldman

We actually think going from 52% to.50% is nothing significant rate and yes, we do expect to have higher HPC revenues in the third quarter so, we do expect to see more FDR system deployed in – or FDR being a higher percentage in the Q3.

Joseph Wolf – Barclays

Okay.

Jacob Shulman

And just to add to that, FDR revenues actually grew in absolute dollars.

Joseph Wolf – Barclays

Yes, I was looking at the dollars. I was looking at – if you look at the $13 million in incremental if that – if a lot of that’s coming from a specific area or it will be a mix.

Eyal Waldman

It will be a mix.

Joseph Wolf – Barclays

And then when you guys talk about HPC being 50%, does that include cabling or is that another part of HPC which is not part of the 50%?

Eyal Waldman

It includes everything shipped to HPC.

Joseph Wolf – Barclays

Okay. And so, if you think about the end of the year and you talked about growth in storage, Web 2.0 and HPC do those three categories – how many – what percentage of the total is that right now?

Eyal Waldman

I don’t think we specify breakout everything.

Joseph Wolf - Barclays

Okay. And I guess just one last question, the acquisition that you made – can you rope us into the whole – to the 100-G story in terms of the contribution from the software side, the optical side, and then I guess also the Ethernet side, given I think the comments you’ve made so far in EDR have been more InfiniBand? Will both be ready at the same time and is the market ready? And I guess there has been some commentary that 40-G is being kind of pushed – is not happening that is the greatest demand as people thought. And there is a move to 25G as a split of 100, could you just address those – that issue at 100G?

Eyal Waldman

Yes. So, we are seeing deployments of 40-gigabit per second Ethernet obviously InfiniBand at 56 and 40. We do expect people to start deploying 100-gigabit per second in very late this year and early next year and we see demand for the 100-gigabit per second. And yes, there is also a new standard of 25-gigabit per second, but I think if you look at the data amounts that people want to work with more bandwidth they have, the lower latency, the better their systems are. So, I think we will see a mix of demand for 10, 25, 40, 56 and next year also 100-gigabit per second. And we have the solution for all of the above. We will have the solution for all of the above.

Joseph Wolf - Barclays

Perfect, thank you.

Eyal Waldman

Thank you.

Operator

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

Srini Nandury - Summit Research

Thank you for taking my call. Congratulations on the good quarter. My questions are a couple of questions on Grantley. Can you comment about the large deep pipelines and your visibility as you look into the level of Grantley in September?

Eyal Waldman

Yes. So, I think like we said before, in the past 18 maybe even 24 months, we didn’t really see significant large deals in our revenue stream. And now we are seeing significant large deals that will be deployed in the coming, I don’t know, year to 18 months. So we are happy to see that.

Srini Nandury - Summit Research

Okay. With the impending Grantley arrival, obviously, that HPC will benefit, but what about, do you see any Cloud, Web 2.0 guys also upgrading the servers, so you could see additional demand there?

Eyal Waldman

We believe some of them will, but those guys deploy when they need, not only when there is a new architecture out. So, from them we are seeing a continuous revenue stream and our continuous deployments. They don’t wait for the new platforms to come.

Srini Nandury - Summit Research

Okay. And finally, one question on the inventory, I mean, are you guys doing any special inventory management for prepping up the company for impending rush orders that come through?

Jacob Shulman

Yes. We definitely tried to anticipate the customer orders and prepare our inventory levels and our product mix to meet that demand.

Srini Nandury - Summit Research

Alright, that’s it for me. Thank you.

Eyal Waldman

Thank you.

Operator

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

Rajesh Ghai - Macquarie

Hi, thanks. I had a question on the VMAX platform from EMC obviously a very large platform kind of probably contributes about $3 billion to $4 billion of annual revenue for the company. I was wondering what is the total opportunity that you could get from – just from that platform going forward and how is that ramp looking as far as Q3 is concerned? I understand that VMAX 3 is going to start shipping in September, is most of the q-on-q increase that you are seeing between Q2 and Q3 related to these new platforms or is it also related to Grantley?

Eyal Waldman

No. I mean, VMAX impact on Q3 is smaller as you said the launch is late in Q3. And most of the platforms that we will ship in Q3 already we have shipped for revenue for that. So, the impact of VMAX on Q3 is not that substantial.

Rajesh Ghai - Macquarie

But in terms of the overall opportunity as far as VMAX is concerned, how much do you think that could be when it’s fully ramped on an annual basis?

Eyal Waldman

We don’t give such guidance or visibility, but we think it’s going to be a significant platform to ship and generate revenue for us.

Rajesh Ghai - Macquarie

So, InfiniBand has replaced as whatever they had in the past completely or is it – is that also going to be coexistent with InfiniBand?

Eyal Waldman

This is EMC data and I am not sure we can share that with you, but we like the use of InfiniBand as the back end interconnect in those platforms. We expect to continue seeing revenue from this platform and more in the future.

Rajesh Ghai - Macquarie

On the cloud side, obviously the SoftLayer vendors were quite strategic and important I would think, given IBM is investing so much money in that line of business. How penetrated are you going to be with InfiniBand in that account? Is it going to be only for a very small portion of the cloud or do you expect over time to kind of see pretty deep penetration of InfiniBand across all their datacenters?

Eyal Waldman

Sorry. First, we expect InfiniBand to take a nice portion of the cloud, but beyond that because now you’re starting to utilize RDMA and some more offload engines (indiscernible) and so on, we believe that similar accounts, they do this for InfiniBand, will then also start using us for Ethernet because they have similar outflows and better performance than plain vanilla Ethernet. So we penetrate with InfiniBand and then we hope to expand in the same accounts in the same clouds to also take the Ethernet portion of that. So, it’s a significant opportunity for us.

Rajesh Ghai – Macquarie

And my final question’s on Ethernet, 19% of revenue last quarter, 19% this quarter. How do you see that ramping going forward in terms of the pipeline? Do you see more cloud customers, more (indiscernible) customers coming on which could potentially keep this contribution at the same level, even though HPC ramps and InfiniBand ramps along with that?

Eyal Waldman

We hope that will continue to grow Ethernet revenues and because we have a smaller share of the Ethernet market. We believe we can grow it faster.

Rajesh Ghai – Macquarie

All right, thank you so much. Congratulations.

Eyal Waldman

Thank you.

Operator

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

James Kisner – Jefferies

Thank you. So, just first of all, I want to clarify the Integrity software, I take it that’s fully – the full impact of that is going to be seen in Q3 or in your guidance?

Eyal Waldman

That’s correct. Our guidance includes any potential impact of the acquisition.

James Kisner – Jefferies

And is there any – I guess this is more of a people acquisition, like there’s no real, like, cost synergies here for a private company. Like, we wouldn’t expect that to be kind of a – it wouldn’t get better over time necessarily. It’s just in the numbers now, and it’s going to stay there?

Eyal Waldman

It’s primarily a team acquisition, correct.

James Kisner – Jefferies

Okay, great. And so, I was hoping you’d talk a little bit about a couple things. First, on Web 2.0, you guys mentioned that as a source of strength going forward. Is that a 40-gig upgrade cycle or is that just more 10 gig? Can you talk about that at all?

Eyal Waldman

Yes, the majority is 10 gigabit per second and we do start to see some of the Web 2.0 customers go to 40.

James Kisner – Jefferies

And on – so, I know you’re not guiding to Q4. You’re talking about the second half. But, I mean, obviously, the street has a pretty reasonably big ramp expectation for Q4, I mean, do you have any sense as to whether or not some of these HPC deals might impact fall and Q4 in addition to Q3, or could we initially see a gap into next year?

Eyal Waldman

No, we do expect some nice sales in Q4 if they materialize it.

James Kisner – Jefferies

Awesome. And then just final question, on IBM, I know there was some uncertainty around that divestiture. It’s nice to see them pop up as a 10% customer. Is there any kind of update there in terms of what you’re seeing with customers in terms of disruption from that divestiture?

Eyal Waldman

Again, we’re second hand in regard to what we see. We don’t touch the end customers. But, as you’ve seen they become more than 10% customer again and we expect to continue working both with IBM and Lenovo so we expect to work with Lenovo on the x86 and X systems portion and with IBM on the power and the other systems that they have and continue to grow with both IBM and Lenovo. Obviously, IBM revenues, once Lenovo has – that transaction’s completed will take revenue from IBM and IBM revenue we expect to go down, but we expect to grow from that point, both at IBM and Lenovo.

James Kisner – Jefferies

Great, thank you very much.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question comes from Kevin Cassidy with Stifel. Please go ahead.

Kevin Cassidy – Stifel

Thanks for taking my question, and congratulations again on a great quarter. The 100-gig devices, how would you compare this ramp compared to when the FDR first came out? Are you expecting it to be a faster adoption in the market?

Eyal Waldman

It’s hard to see, it’s going to be hard to be faster. We’ll be happy if it would be similar.

Kevin Cassidy – Stifel

Okay. And you’re part of the consortium for 25-gig and 50-gig Ethernet. Can you say a little more where that – those applications fit? They – do they replace 40-gig or is it a separate type of market and is it a higher volume market?

Eyal Waldman

I know we believe we’ll see coexistence of 10, 25 and 40 for quite some time. It really will depend on the applications. It’s – whether it’s the class or whether the software is distributed or not or centralized so, I guess we’ll see deployments of 10 or be the majority 25 and 40 in the coming quarters.

Kevin Cassidy – Stifel

And maybe just a little more granularity on that, do you expect to be first to market with those products?

Eyal Waldman

With the 100?

Kevin Cassidy – Stifel

No, 25 and 50?

Eyal Waldman

So 56, we already have.

Kevin Cassidy – Stifel

The Ethernet consortium?

Eyal Waldman

Right, so (indiscernible) I don’t know if we will be the first, but we will have products when we have them, so I do expect us to be one of the earlier guys, but I wouldn’t say we will be the first, I am not sure.

Kevin Cassidy – Stifel

Okay, great. Thanks.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question comes from Harlan Sur with JPMorgan. Please go ahead.

Saqib Jalil - JPMorgan

Hi, good afternoon. This is Saqib Jalil for Harlan Sur. Thanks for taking my question. Eyal regarding your comment on the big deals related to Grantley upgrade cycle, the size of these initial deals you are seeing as big as what you saw with the Romley upgrade, also what kind of visibility in terms of order patterns are you seeing related to this upgrade cycle, historically demand visibility has been limited for you guys?

Eyal Waldman

It slightly improved but it’s limited. But we do so more visibility for the next I would say in 18 months of deals in the size from several millions of dollars to in the teens millions of dollars.

Saqib Jalil - JPMorgan

Okay. And then you have mentioned in the past that Grantley upgrade cycle will be smaller for you guys versus Romley upgrade cycle, are you still of that view or anything has changed since introduction and shipment of Grantley?

Eyal Waldman

I think what we meant is there will be a smaller pent up demand as we have seen in Romley in the 2012 timeframe where everything packed into like the second half of 2012. At this time Grantley is not as latest as Romley was, so people will deploy it and there will not be such a huge bump like we had in Q3 of 2012.

Saqib Jalil - JPMorgan

Okay. Great. Thanks. And I was also wondering if you could – would be able to quantify perhaps the content increase or ASP increase you see with this upgrade cycle for you guys?

Eyal Waldman

No, we don’t have too much data. We don’t expect to see ASP increase.

Saqib Jalil - JPMorgan

Okay. Those will be the questions I had. Thank you.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question comes from Bill Choi with Janney. Please go ahead.

Bill Choi - Janney

Okay. Thanks for the nice guide there. There are many things going well for you now, so it is tough to understand the sequential growth how much of the $13 million growth is coming from what, so a lot of positive comments about HPC, cloud and storage as well. So can you kind of rank order where you might get the greatest sequential revenue growth from?

Eyal Waldman

We believe HPC will demonstrate nice growth and after that storage and cloud we don’t know which one is going to be higher than the other one.

Bill Choi - Janney

Okay. And then on HPC side Intel when they talked about that they are already starting to ship to some of the web and HPC customers, but it’s not broadly available yet, how much is actually being delivered to your partners, is that a major gating factor as we look at the ramp over the next quarter or two?

Eyal Waldman

Delivering what?

Bill Choi - Janney

Partners, your partners getting sufficient supply of Intel chips?

Eyal Waldman

Of the CPU you mean, the Grantley?

Bill Choi - Janney

Yes.

Eyal Waldman

Yes. So we are seeing I think we are part of those platforms. So people that need the bandwidth and the performance are using us with those platforms.

Bill Choi - Janney

Right. But as your partners are working on delivering to customer orders, at this point are they getting sufficient volumes, and it’s just Intel said it’s not fully commercial and launched yet, just wondering about supply?

Eyal Waldman

Yes. When it comes out, it’s usually like this when Intel comes out with the new platform you see like alpha, beta, you see multiple cycles. So we don’t control this we – it depends more on Intel than us.

Bill Choi - Janney

Okay. More recently we have seen up more interesting commentary about different clouds using InfiniBand I guess the latest one is IBM software obviously as you already uses it, can you talk about how big some of these cloud deployments are getting whether it’s more InfiniBand versus Ethernet and there also seems to be a little more interest from other players, I am talking about other vendors in RDMA over Ethernet, what is driving that?

Eyal Waldman

Performance. So, it’s cost performance driving that.

Bill Choi - Janney

Okay.

Eyal Waldman

They need to scale to a large number and that’s how we do it.

Bill Choi - Janney

And any comments about these new build-outs from guys like SoftLayer, how meaningful they are? Is it fairly small in terms of overall offering for the cloud or is InfiniBand fabric-based cloud is going to be quite substantial when you talk to some of these cloud customers?

Eyal Waldman

We don’t think this is going to be large it’s going to be in places where they need it. It’s going to grow later. And like I said, I think we are going to take off some of the Ethernet portion because of the capabilities that our Ethernet are similar to our InfiniBand interconnect.

Bill Choi - Janney

Okay. Last question, any update on switch chips for Ethernet? Facebook’s got their wedge switch out. I am curious whether you are participating with your – at least your chip or if you are able to get any of your ASICs designed into these switches and where we are with software that might ignite some of the switch sales? Thanks.

Eyal Waldman

Yes. So part of the acquisition we have done there last quarter was to enhance our software development capabilities. And we are kind of closing the gap and think that we will have more of a complete stock later this year. And then we will see some more design wins and use of our Ethernet switch products in various markets and applications. And we will tape out new switch to record in the future, like we announced the InfiniBand. We also believe to have one with Ethernet in the future.

Bill Choi - Janney

Any comments on relationship with Facebook?

Eyal Waldman

We like using Facebook.

Bill Choi - Janney

Okay. Alright, thanks.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question comes from Alex Gauna with JMP Securities. Please go ahead.

Alex Gauna - JMP Securities

Thanks for taking my question and congratulations on the nice quarter. Eyal, I know you have already talked a lot about Grantley and you have talked about improved visibility over the 18-month, the big deals that are coming back into view? But, just pressing you a little bit on the nearer term, are you getting a big bump in terms of your Q3 visibility from the HPC customers trying to get better – get built for the supercomputing show such that you are getting a big benefit from Grantley right now in Q3 or would you say that not so much we are still in the early phases and the big benefit will come in Q4?

Eyal Waldman

It’s hard for us to say, but I would tend more to say that it’s still early and we will see more benefit later on, but again, we don’t have enough visibility to be very accurate here.

Alex Gauna - JMP Securities

Okay. And I know that IBM came back to being a 13% customer. Last quarter, you talked about some disruption from the Lenovo transition. Can you maybe ballpark where we are in terms of the overhang from that deal still not having settled and what IBM might have been pro forma without this transaction hanging over you?

Eyal Waldman

We don’t like guessing too much. So, we don’t have any firm data to provide you numbers with, so…

Alex Gauna - JMP Securities

Okay. And you just talked a little bit about your Layer 3 efforts, I am just kind of curious next year, what’s the bigger deal for you, your open Ethernet initiative and engaging with people and cloud vendors and 2.0 or is it the Layer 3 that you are hopeful is the bigger driver next year?

Eyal Waldman

Well, it’s not the Layer 3.

Alex Gauna - JMP Securities

And then progress on Layer 2 and open Ethernet, how are those efforts going in terms of winning support and maybe getting new membership?

Eyal Waldman

I think the Facebook initiative of Wedge and FBOSS is similar to our approach of having open Ethernet and the – only the boot process on top of our switches, which is open source. So, I think we are aligned with the big Web 2.0 and cloud guys in terms of strategic partition of hardware versus software. And I think we will see in the future once we have the software for that, we are ready and more platforms and more features, people will use our Ethernet switches more in their datacenters.

Alex Gauna - JMP Securities

Okay, great. Thank you. Nice quarter.

Eyal Waldman

Thank you.

Operator

Thank you. It appears we have no further questions. At this time, I will turn it back to Mr. Waldman for any closing remarks.

Eyal Waldman - President and Chief Executive Officer

Well, thank you everybody for your interest in Mellanox and thank you for joining in. Goodbye.

Operator

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

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