Silicom's (SILC) CEO Shaike Orbach On Q1 2016 Results - Earnings Call Transcript

| About: Silicom Ltd (SILC)

Silicom Limited (NASDAQ:SILC)

Q1 2016 Earnings Conference Call

April 21, 2016, 09:00 AM ET

Executives

Ehud Helft - IR

Shaike Orbach - CEO

Eran Gillad - CFO

Analysts

Alex Henderson - Needham & Company

Marcel Herbst - Herbst Capital Management

Ronald Mullins - Segmark International

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom's First Quarter 2016 Results Conference Call. All participants are at present in listen-only mode. Following management's formal presentation, instructions will be given for the question-and-answer session. As a reminder, this conference is being recorded. You should have all received by now the company's press release. If you have not received it, please contact Silicom's Investor Relations team at GK Investor Relations or view it in the news section of the company's website, www.silicom-usa.com.

I would now like to hand over the call to Mr. Ehud Helft of GK Investor Relations. Mr. Helft, would you like to begin, please?

Ehud Helft

Thank you, operator. Good day to all of you. I would like to welcome all of you to Silicom's first quarter 2016 results conference call.

Before we start, I'd like to draw your attention to the following Safe Harbor statement. This conference call contains projections or other forward-looking statements regarding future events or the future performance of the company. These statements are only predictions and may change as time passes. Silicom does not assume any obligation to update that information. Actual events or results may differ materially from those projected, including as a result of changing industry and market trends, reduced demands for Silicom's products, the timing and development of new products, and their adoption by the market, increased competition in the industry, and price reductions as well as due to risks identified in the document filed by the company with the SEC.

In addition, following the company's disclosure of certain non-GAAP financial measures in today's earnings release, such non-GAAP financial measures will be discussed during this call. Such non-GAAP measures are used by management to make strategic decisions, focus future results and evaluate the company's current performance. Management believes that the presentation of these non-GAAP financial measures is useful to investors understanding and assessment of the company's ongoing corporation and prospects for the future. Unless otherwise stated, it should be assumed that the financials discussed in this conference call will be on a non-GAAP basis.

Non-GAAP financial measures discussed by the management are provided as additional information to the investors in order to provide them with an alternative method for assessing our financial conditions and operating results. These measures are not in accordance with or a substitute for GAAP. A full reconciliation of non-GAAP to GAAP financial measures is included in today's earnings release, which you can find on Silicom's website.

With us today on the call are Mr. Shaike Orbach, the CEO; and Mr. Nir Dagan, the CFO. Shaike will begin with an overview of the results, followed by Nir who will provide the analysis of the financials. We will then turn over the call to question-and-answer session.

And with that, I would like now to hand over the call to Shaike. Shaike, please?

Shaike Orbach

Thank you, Ehud. Good morning, everyone and welcome to our conference call to discuss the results of the first quarter of 2016. We are pleased with the results, it shows solid growth over the first quarter of last year and represented results ahead of the upper bound of guidance range. Revenues for the quarter were at $21.4 million, representing year-over-year growth of 14%. This rise reflects expanding sales activities as well as the deepening relationships with many of our top tier OEM customers.

It also demonstrates ongoing and increased sales across all product lines as well as the additional contribution of new product lines. In particular, our growing sales validate our continued success in our traditional networking appliance markets as well as the newer high growth segments of these markets, which we are targeting namely those driven by the cloud computing, SDN, NFV, IoT, virtualization, and other hot trends which depend on top performance connectivity.

Why we continue to focus on growing our sales, we also increased our investments in expanding our product portfolio, our new product introduction activities, and increasing our addressable markets by penetrating additional market segments and new customers. The design win that we announced in March, the details of which I will provide in a few minutes is a good example to such an investment. We are investing in designing a few flavors of smart cards, which is a significant R&D effort while the potential is not only limited to this specific customer but with others as well.

In fact, we are seeing more additional and very concrete opportunities right now which potentially support a step up in our revenues. On top of the R&D investments as these opportunities also represent new market segments and/or important strategic customers, we have also taken the decision to use lower margins towards some of these deals which we have indeed considered to represent with such strategic importance.

We believe that the new product resulting from our R&D investments and our improved competitiveness whenever it's required will help us to penetrate key new customers add incrementally more design wins and allow us to grow our revenues to the next level. While this will have a certain effect on our profitability in the near term, we have always managed Silicom with a focus on our leadership and growth in the long-term. We believe that the increased revenues from these efforts will ultimately result in a higher level of earnings per share.

The efforts and investments we are taking now very much support our long term vision for Silicom. In terms of profitability, we reported net income of $3 million for the quarter and generated a solid operating cash flow of $3.7 million. This continued cash generation has contributed to our strong cash position which currently amounts to $55.2 million providing us with ongoing significant financial flexibility. As we demonstrated in the past few quarters, it gives us the ability to act decisively when an acquisition opportunity arises.

In addition, it also allows us to share the fruits of our success with our shareholders as we just did this month with the issuance of a dividend amounting to $1 per share. From a revenue growth perspective, over the past 3 months we continued to make strong strategic progress adding design wins. In particular, we announced an important new design win from an existing top tier Cyber Security customer.

As you all know the Cyber Security space is a rapidly growing and critically important market, and our ongoing work with some of the leaders in the sector provides us with important references to further our penetration. The framework of this design win includes both the development phase and later a mass production phase. To date, this customer has submitted initial quantities of orders covering three versions of our smart card with each featuring an onboard network processor enabling higher application performance by offloading host CPU tasks.

We believe the sales from this design win will run gradually and in the mass production phase it can amount to several million dollars a year. This win is a typical demonstration of the success of our past investments and how we leverage an ongoing and enclosed relationship with our customers to bring new design wins penetrating further and deeper into their product range. Our 100 plus OEM customers represents a field with phenomenal potential for adding additional design wins especially when they are major organizations with multiple product lines such as this cyber leader. Furthermore, there is potential for our existing design win revenues to expand as our customers in turn grow their sales in their respective end markets.

This is particularly true in growing sectors such as cyber security and the cloud related markets. As such, customer service in our relationships are as important as the technological superiority of our product. The ongoing stream of our new design wins that we receive quarter after quarter validate our ever evolving R&D capabilities as we have proven over the long term we continue to make the correct read as both the current and future needs of our manufacturing customers and invest wisely to capitalize on those trends.

With regards to our guidance of the second quarter of 2016, we believe the revenues will be in the range of $21.5 million and $22.5 million or about 28% ahead of those of the second quarter of last year at the mid-point. In summary, we remain pleased with our year-over-year top line growth and the progress we have made. We continue to sell more product into more of the platforms of current customers. At the same time, we are investing and growing into new customers while offering new products to both existing as well as new customers. We believe strongly in our strategy of growth engine and our goal is to realize the full inherent potential of our multiple growth engines. Our expanding customer base. Our superior core technologies and our increasingly extensive product portfolio.

We believe that we are wise in investing the necessary resources in developing our product, our markets and penetrating new customers which will significantly benefit us over the long term. Over the past few quarters we actively expanded our total addressable markets through our ongoing research and development efforts as well as acquisition of complementary and synergistic technologies. We believe all these efforts will continue to contribute positively to the overall prospect of Silicom and underline our confidence in our long term prospect.

Finally, I would like to take this opportunity to welcome Eran Gillad, our CFO following a short leave for personal time, and Nir Dagan, who replaced him, temporarily will retain his previous role while Eran has again filled his CFO position.

With that I will now hand over the call to Eran for a detailed review of the quarterly results. Eran please go ahead.

Eran Gillad

Thank you, Shaike and I am glad to be back. With regards to the results of the quarter, revenue for the first quarter 2016 were $21.4 million representing year-over-year growth of 14%. Our geographical revenue breakdown for the first quarter of 2016 were as follows. North America 73%, Europe and Israel 17%, Far East and the Rest of the World 10%. I will be presenting the rest of the financial results on a non-GAAP basis which excludes the non-cash compensation expenses in respect of auctions and RSUs granted to the directors, officers and employees and acquisition related adjustments.

For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the first quarter of 2016 was $8.2 million, representing a gross margin of 38.6%. This is compared with $8 million or a gross margin of 42.6% in the first quarter of last year. As Shaike discussed earlier, the gross margin has been affected by our decision to sell some of our offerings at lower margins and varies between quarters as a result of the specific mix of product sold during the quarter.

Operating expenses in the first quarter of 2016 were $4.7 million or 21.9% of revenues, compared with $3.7 million or 19.9% of revenues in the first quarter of last year. Operating income for the first quarter of 2016 was $3.6 million or 17% of revenues, compared to $4.3 million or 22.7% of revenues as reported in the first quarter of last year. First quarter 2016 net income was $3 million or 14.2% of revenues compared to $3.8 million or 20.5% of revenues in the first quarter of last year.

Earnings per diluted share in the quarter were $0.41 in the quarter compared with $0.52 in the first quarter of last year. Now, turning to the balance sheet, as of March 31, 2016 the company's cash, cash equivalent, short term bank deposits and marketable securities totaled $55.2 million or $7.56 per outstanding share. Beyond the end of the quarter on April 14, 2016 we paid out $7.3 million as dividends to our shareholders.

That ends my summary. We would be happy to take any questions. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] The first question is from Alex Henderson of Needham & Company. Please go ahead.

Alex Henderson

Hey guys, so nice job on the revenue line and I am glad to see you are able to drive that. But the gross margins are definitely an issue here, so I was hoping we could get a little bit more clarity on how much of the pressure was result of temporary mix issues and how much is the result of the function of the decision to take lower gross margins? And given that decision how should we be thinking about the band for gross margins going forward. Obviously, you have had a long history in the 40 to 42 range, and this is quite a bit lower than historical.

Shaike Orbach

Okay. Yes you are right about that being less than current historically, and I would say if you look back for a longer period of time, then I believe we have been doing between 37% and up to 42% or 43% in the past. But indeed just like we’ve said, I mean this time the reason for the lower margins is not just a mix of products. There is the impact of the mix of products, but as we have said, there is a part of that we have in deed reduced the drive of some of our products to some of our customers and although in general to some of our customers, so I would say that our decision to do that was the most important thing in this quarter regarding why the gross profits went below what it was and in deed moving forward, we do not think that the gross margin would now be 42 or something like that. We'd rather say that moving forward it's going to be between 35% to 40%.

Alex Henderson

I'm sorry, 35% to 40% that's a pretty steep drop to get down to 35%. That's pretty big widening of the band. Is that, let me help you understand the mechanics here. I always understood your mechanics to be designed in over 18 to 24 month period a product and once it's designed in, it was pretty stable on pricing and pretty much locked and loaded. Why would you cut prices on product where you've already got designed in like that? What's the quid pro quo that you're getting back for that?

Shaike Orbach

First of all, let me say that, once again, if you look backwards, our traditional I would say, not only in the last two years, but our traditional margins were 37 to 43. Right now, I'm saying they're going to be 35 to 40 which is indeed a decrease that a decision that we have taken. Now let me explain several things about the mechanism which is working in here. First of all, our prices, even after we have designed in are far from being locked in as you've said, and the price is not fixed. In fact, most customers require a price reduction each and every quarter, some of them even requesting significant price reductions.

But on the other side, we are also definitely doing good on the cost reduction on our side because we're pushing the same thing to our vendors and suppliers. But that's not the main story in here. The main story in here is being able, in terms of prices, to penetrating the new markets that we're after and our cost in supporting our customers which are going to up to these new markets. So if our customers who, if a customer of ours who used to sell products, let's say to the Enterprise, but right now he's selling to the Cloud because his customers are now going to buy the services from the Cloud rather than buy the full appliance or server from him, and he is selling that to the Cloud where he needs to compete again in the Cloud environment rather than the Enterprise environment.

This customer is looking to reduce his cost in order for his appliances to be included in the Cloud, etcetera. So for that purpose in order for us to remain in the game and become sometimes a default scenario for this customer, then we need to decrease prices.

Alex Henderson

Right. So we should be using a new band of 35% to 40% for '16 and '17, is that the way to think about it and that’s sort of the new band?

Shaike Orbach

I think that's the right way to think about it. As I've said, I believe that all that together with our R&D investment, we'll improve and we'll demonstrate a growth of our revenues which eventually would give us a higher EPS that we have right now. But that's a process that will take some time.

Alex Henderson

So is there any change in your thought process in terms of the magnitude of your revenue growth rate as a result? Is there a quid pro quo here on our topline that we can use to offset some of this or do we just absorb it?

Shaike Orbach

Well, no, I mean we do believe that we're going to see the result, to begin and see the result of these investments and this policy even into 2016. Obviously, it would be more as we move ahead because especially when you're talking about R&D investments, this will take place a little later. But yes, I mean I think that even this quarter is some sort of a demonstration because we have been doing better than what we thought and that's a part of it, and we believe that we definitely will have a double digit growth in 2016 and more than that in 2017.

Alex Henderson

I'll cede the floor. Thanks.

Operator

[Operator Instructions] Next question is from Marcel Herbst of Herbst Capital Management. Please go ahead.

Marcel Herbst

Good morning and thanks for taking my question. Should we expect the current level of operating expenses to be similar to the rest of the year or were there any one-time items or are there any plans to ramp it up with NPI?

Shaike Orbach

Well overall it should be very much the same, but I mean we may have a need to increase somewhat our R&D expenses or even our sales and marketing expenses. I do not think any of that would be dramatic. All that being said this is without taking into consideration the impact of the Dollar of course which could play in there. But in general that should be where we would be during the year, potentially increasing somewhat mostly the R&D expenses. But again, I mean that would be happen. Only once we see a very specific and very concrete opportunities in front of us. I would like to repeat the example that I described before. I mean, take this design win that we've announced. This design win, we have been selected with something which we really we believe would amount to millions of dollars in revenues.

But on the other side it includes the development of three network processor based cards at development which is more complex, requires more resources than our standard cost development. So yes, when we have seen this kind of very concrete opportunity because we have been selected for that already, but we need to invest more than in this case. Yes, we would take this opportunity. And there are some additional opportunities like that ahead of us. Some of these are already included in our assumptions. But maybe more because the market seems for us to be very I would say receptive to such opportunities and because Silicom, while we are selling cards, our capabilities in terms of R&D especially now up to the acquisition of such that we can actually address not only any part of the technology but also any combination of technologies, then I believe we would have even more opportunities, concrete opportunities where once we'd be lying something, something and investing the development it would eventually be translated into significant revenues.

Marcel Herbst

Okay, and alongside what you just mentioned with the new product introduction activities, you mentioned that you are actually going for new additional target markets or segments that you haven't gone for before. Can you talk a little bit more about that? What kind of markets are these?

Shaike Orbach

Well in general I would say that these would be all the Cloud-related markets, mostly. It is not the only thing. I mentioned also IOD which is a part of that but the major part of that new market segment is whatever is related to the Cloud. When we're talking about the Cloud, even when we're talking about the Cloud, it's divided into two parts. It's the data center part of the Cloud to which we are targeting quite a few of products, and on the other side it's also the CPE or edged products which goes together with the operators which provide Cloud services, and we're trying to penetrate this market as well.

Marcel Herbst

Okay, thank you.

Shaike Orbach

Now if I may just add, I mean, this is of course, I mean it's not the new, the Cloud market is not something that we have heard about right now, going ahead with that. But it is now that we are working with our customers, et cetera, that we understand much better we believe the dynamics of that market which is why we need to make these investments and these things.

Operator

The next question is from George Marima [ph].

Unidentified Analyst

Hello, Shaike. I was wondering if you could talk about your capacity. Right now you're sort of getting close to this $100 million a year revenue mark. Have you made any investments in capacity in recent couple of years, and what sort of capacity do you have now a days to grow the topline?

Shaike Orbach

Okay. So we are taking two approaches in respect to capacity of delivering products. So I mean on the one side, yes, I mean we have increased our capacity internally as well. And as a part of that, last year, we moved to a new building. We did a lot of other things. We have increased, the configuration I would say of some of our testing servers, et cetera. So we've met a lot in that area allowing us to build more products, and we're ready for that on one side. On the other side because some of our customers are talking to us about very extensive upsides which hopefully will really happen this year so on top of that we have begun working or we have developed a relationship with CMs because our operational model right now is not at what we call a turnkey model. We are still doing a lot of the things which are part of the manufacturing effort. So in parallel to that we have put in place a mechanism which would include turnkey concept manufacturers where the capacity issues actually move from us to them and that would be used whenever we can upto some sort of the capacity issue. So right now I believe we are covered from that perspective.

Unidentified Analyst

Can you talk about the opportunity that exists with the Broadwell Server adapters and the Coleto Creek and further iterations of that and do these sort of new introductions offer a pathway to very strong growth?

Shaike Orbach

Well, I believe they are. As you know you mentioned Broadwell and Coleto which are being Intel Silicom and Intel has just recently decided that they would not support or the stocker would not provide a software which is needed in some of the areas that we are pursuing and they are actually working with us or looking at us to build a software together with the hardware that they provide and they will continue to support. Once we do something like that and that by the way is the case with Coleto Creek and to a certain extent, not fully but to a certain extent.

But there are several other silicon coming out and it seems like our leverage selling these products, working together with Intel, Intel now pushing us into the same customers that previously they were going to there, I mean they were just offering the chip with the software. We would get a significant boost from Intel as a partner to sell these products. So in general I would say that products which are based on silicon coming from Intel which is not their standard mix silicon, the prospects of selling this kind of product and Coleto and Broadwell definitely belong to this product lines is very significant. And by the way that is the part of the course of investment we are doing in R&D.

Unidentified Analyst

And can you give any idea about timelines for all this?

Shaike Orbach

Well, when you say all this, I will try to give you a few examples. So the opportunity that we have announced already which by the way does not exactly belong to the same description that I provided you before but still it is an opportunity where we invest and then we will see revenues from this opportunity this year already. We would see hopefully I mean that based on the forecast of our customer have given us, we would see increase of revenues, significant increase in 2017 but even that may not be the star point of these products which could amount to millions of dollars as I said before just as design win.

Now you mentioned Coleto. We do look at Coleto as providing us much more significant revenues during the second half of 2017, again these things they take some time and they will continue to take some time but in general I would say we would see impact of most of these in 2016 but then for sure in 2017.

Unidentified Analyst

Okay. Thank you, Shaike.

Operator

The next question is from Ronald Mullins from Segmark International. Please go ahead.

Ronald Mullins

Could you tell us a little bit about more favorable aids AGR and ADI are doing before we ask your expectations when you made those acquisitions? And I have a second question, considering the restructuring that was announced by Intel, do you think that will have any significant impact with your business with Intel and I also believe that was a major factor in your purchase of ADI, the relationship?

Shaike Orbach

Okay. So first of all with respect to Fiberblaze and ADI. So in general I would say yes, but I would like clarify also that with Fiberblaze I believe that the two companies are fully integrated. So it's actually impossible to look at the performance of Fiberblaze separately from Silicom. The teams have integrated both from an R&D perspective, sales perspective, customer approaching perspective. So it's difficult to say. But once again, we definitely see the, I would say the vision that we have when we acquired Fiberblaze happening because we see some key market leaders evaluating products which were now originally proposed by Fiberblaze and improved by Silicom then coming together for the customers. So these things are happening and that's exactly what we had in mind. With ADI, as you know we've been with ADI just about, I don't know, four, four and a half, five months or something like that. So it is still in its infancy. Right now I would say that, yes, I mean everything is happening as planned but we still need to careful about that because I mean sometimes you don't know everything up to five months and the integration there is not yet complete. Eventually we hope that it would be just as in terms of integration would be exactly just as it is. With the Fiberblaze fully integrated, obviously they are a credit to business so in generally, once again yes.

Now the second part of your question with respect to Intel; so we heard about that with you only yesterday, yesterday that it was that Intel announced about, the announcement I believe. But I think that for us this could be very good news, and the way I hinted to that what I talked before about some things that are happening with Intel, because now we can understand why Intel told us that there were several areas that they would like us to actually help them with the environment around the Silicom so that they would be able to help us again in pushing the Silicom. Because without doing that, but what that would mean is that actually we would have no competition or hardly any competition to these products once we have those developed, the glue or the interface, the software and sometimes hardware around the original product that would increase the stickiness level of our product with our customers make us practically very unique compared to any other competitor. This is also the case with ADI products. ADI engineering being those who are doing many of the reference designs for Intel, while before Intel could support that we believe that now it would be very much more dependent on whatever ADI is doing which would have the same impact just like I've said before.

Ronald Mullins

Thank you for that information.

Operator

There are no further questions at this time. Before I ask Mr. Orbach to go ahead with his closing statement, I would like to remind participants that a replay of this call will be available by tomorrow on Silicom's website www.silicom-usa.com. Mr. Orbach would you like to make your concluding statement?

Shaike Orbach

Thank you, operator. Thank you, everybody for joining the call. We look forward to hosting you in our next call in three months' time. Good day.

Operator

Thank you. This concludes Silicom's first quarter 2016 results conference call. Thank you for your participation. You may go ahead and disconnect.

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