Cavium (CAVM) Syed Basharat Ali on Q2 2016 Results - Earnings Call Transcript

| About: Cavium Networks, (CAVM)

Cavium, Inc. (NASDAQ:CAVM)

Q2 2016 Earnings Call

July 26, 2016 5:00 pm ET

Executives

Angel Atondo - Senior Manager-Marketing Communications

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Analysts

Blayne Curtis - Barclays Capital, Inc.

Anil Kumar Doradla - William Blair & Co. LLC

Harlan Sur - JPMorgan Securities LLC

Matthew D. Ramsay - Canaccord Genuity, Inc.

Joe L. Moore - Morgan Stanley & Co. LLC

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc.

Gary Mobley - The Benchmark Co. LLC

Melissa A. Fairbanks - Raymond James & Associates, Inc.

Operator

Good day, and welcome to the Cavium, Incorporated Q2 2016 Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Angel Atondo, Senior Mar Com Manager. Please go ahead.

Angel Atondo - Senior Manager-Marketing Communications

Thank you. Good afternoon, everyone, and welcome to Cavium's second quarter 2016 financial results conference call. Leading the call today are Mr. Syed Ali, President and CEO of the company; and Art Chadwick, Vice President and Chief Financial Officer.

Before we begin, I'd like to remind you that various remarks that we will make on this call will constitute forward-looking statements for the purpose of the Safe Harbor provisions under the Private Securities Litigation Reform Act, and will be based on information currently available to us. We disclaim any obligation to update these forward-looking statements. These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties that may cause actual results to differ materially.

We refer you to our most recent Form 10-K and Form 10-Q filed with the SEC, in particular to the section entitled Risk Factors, and to other reports that we may file from time to time with the SEC for additional information on these risks and uncertainties that could cause actual results to differ materially from our current expectations.

In addition, in this call, we will discuss non-GAAP financial measures. Reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued earlier today, and we ask that you review it in conjunction with this call.

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

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Thanks, Angel, and thanks to everyone for joining us today. In brief, Cavium's second quarter revenue was $107.2 million, up 5% sequentially. Non-GAAP gross margins were 67.3% and non-GAAP net income was $17.2 million or $0.29 per share. Art will discuss our Q2 financial results and Q3 guidance in more detail shortly.

Q2 revenue came in line with our expectations. Sales into our core infrastructure markets were up. Sales into the access and service provider markets were up due to a continued recovery in the wireless infrastructure markets. Sales into the enterprise and data center were also up, primarily driven by growth in data center markets. Sales into broadband were also up sequentially.

Now, as usual, I will talk about design traction and a status update on our major new product lines. Design wins for our OCTEON product line during Q2 remained very strong with new key Tier 1 wins in wireless and security infrastructure applications. During the past quarter, we made product announcements about our two-core to 24-core ARM-based embedded multicore product line, the OCTEON TX. This product line has four new product families that leverage our highly optimized ARMv8 cores and broad open source software ecosystem, along with our leading dataplane acceleration from the OCTEON line.

These processors are opening up a new range of customers and markets, especially in the control plane applications as an alternative to x86 processors, which are currently used heavily in control applications in the networking and communications space. We have already commenced customer sampling of the first two product families, the CN81XX and the CN80XX up to four cores, and we plan to sample the mid-range 8-core to 24-core products in the coming months. We have already started getting design wins for this new line, starting in Q2.

In Q2, we had continued strong design win activity on our NITROX product line, with our first major NITROX V win in the cloud data center. We see this as a new revenue opportunity for NITROX V. There are several other cloud data center customers evaluating NITROX V who are expected to finish their evaluations in the next few months.

Now, I will move on and give an update on our new product families. We continue to see growing demand for ThunderX production products, with additional major ODM platforms reaching production-stage for their platforms. Key customer highlights include the following. Successful deployment of ThunderX production systems at a large Asian mega scale data center customer in two of their data centers running their first workload in production. These servers have now been running for multiple weeks in a stressful production environment. The customer plans to add additional servers in Q3 and plans to start the deployment of their next application on ThunderX.

Additionally, in Q2, two new U.S. customers are planning to deploy racks for cluster-level testing in Q3. They have already finished the server level benchmarking and qualification in Q2. GIGABYTE launched a greatly expanded portfolio of 14 production-ready ThunderX based server SKUs at a launch event in Shanghai, China. Now, GIGABYTE has an optimized form factor and configurations for many of their targeted applications for ThunderX. The joint launch was intended to significantly expand the ThunderX footprint in China to beyond the current customers that we are working with.

Two cloud providers, one in the U.S. and one in Europe, are working on enabling bare-metal services on ThunderX services in Q3 and offering them as a service. Lenovo and Lenovo's customer jointly presented details of the ThunderX blade for Lenovo's NeXtScale platform at the ISE 2016 conference last quarter. Sugon, one of the largest server OEMs in China, and a leader in the HPC space in China, launched a ThunderX blade for their Galaxias SDC1000 high-density platform at ISE 2016.

We are continuing to invest in building out our ThunderX roadmap. At Computex in May, we announced the next generation of ThunderX, the ThunderX2, which delivers 2X to 3X performance of ThunderX, at both the core and at the socket level, which makes it into a significantly more competitive platform that can address a much larger cross section of the mainstream server market. Other ThunderX2 highlights including integration of next-generation of data center networking technologies, 25G, 50G and 100G, along with 2X the increase in memory bandwidth, sophisticated power management and the next-generation of security and OCTEON dataplane style accelerators. Customer response has been extremely positive and we are starting early customer and ODM engagements.

In addition, we also announced our CloudScale Rack, a full data center level solution using only Cavium data center technologies, including ThunderX-based cloud servers and appliances, XPliant-based switches, end-to-end security enabled through LiquidSecurity and intelligent offload enabled through LiquidIO adapters. With production platform availability, which is very wide, independent third-party benchmarking reports are starting to be published and these articles highlight ThunderX's competitiveness in the market. As we move to Q3, our backlog remains strong and we continue to see acceleration in demand compared to previous quarters.

I will now move to a discussion about our LiquidIO II products. We had mentioned in previous calls that we are working closely with two large lead data center customers, one in the U.S. and one in Asia. We also have active engagements at several other customers worldwide, including major hyperscale and Telco Cloud providers. In Q2, we had shipped initial quantities to our lead customers. The highlight for Q3 is that we will now ship our first volume production shipments to the end customers.

Now, moving on to the XPliant switch product line, we are working very closely with our lead switch OEM customers to achieve production status, resulting in general availability of XPliant switch platforms in the marketplace in the coming months. Design traction in Q2 continues to be strong for the XPliant product line, where we now have won a new large OEM and one of our current OEM customers has kicked off additional XPliant design SKUs. In addition, we continue to expand our third-party software ecosystems with the addition of a new network operating system partner. Finally, we have also entered evaluation at two large mega data centers. A major highlight for this quarter is that we now have received our first volume production orders for XPliant switches for shipment this quarter.

In Q2, our OCTEON Fusion-M product line started ramping in production, with shipments being driven by operator demand for our customer products, ranging from macro BTS to micro cells to centralized RAN. Our leading OEM customer has secured several key operator design wins enabled by the OCTEON Fusion-M technology and has commenced volume equipment shipments. The OCTEON Fusion-M products provide a new feature and price performance metric that opens new market opportunities for our OEM customers. We now currently have a very strong backlog already in place for the second half of 2016. We are also now engaged with three other potential customers.

Moving on to LiquidSecurity, LiquidSecurity appliances are seeing strong data center customer traction. These products have market-leading features for cloud deployments that require multi-domain and multi-tenant support along with high performance key management and large key storage. We now have integration work in progress at three of our lead customers. In addition, several customers, including major hyperscale enterprise and Telco Cloud providers are currently evaluating this product. We expect revenues for this product line to start ramping in Q4 of this year.

Now, I would like to move on and give a brief outlook on the market environment that we are seeing for Q3. Over the past few months, our visibility into growth in the second half of 2016 has improved significantly both on our existing products and on new products. This is being driven by early ramps of our OCTEON III products at a number of customers which we expect to accelerate over the coming quarters. In Q3, in addition to ThunderX shipments, we are seeing strong backlog for volume shipments for our OCTEON Fusion-M and volume production shipments at lead customers for LiquidIO II and XPliant products, which we also expect to accelerate over the coming quarters. As a result of these positive trends, we expect to see strong growth in Q3 across all our market segments.

Now, I would like to provide a quick update on QLogic. As previously announced, Cavium and QLogic have entered into a definitive agreement whereby Cavium will acquire QLogic for a combination of cash and stock by means of an exchange offer. As previously reported, we expect the transaction to close subject to the satisfaction of the minimum tender condition and other customary closing conditions before the end of the third quarter.

Teams at both Cavium and QLogic have been working on integration plans that would go into effect after the deal closes. We have met with many of QLogic and Cavium's customers, and the feedback from them regarding the acquisition has been very positive. For details regarding the exchange offer, please refer to the Schedule TO and the prospectus/offer to exchange and other tender offer materials filed with the Securities and Exchange Commission.

As we scale up the company, we're also making changes to scale up our management team and our board. Today, I'm extremely pleased to announce the appointment of Raghib Hussain, Cofounder of Cavium as Chief Operating Officer. Since his founding in 2000, Raghib has been an instrumental contributor to Cavium's growth and success as a member of the executive management team. His deep experience in engineering and astute understanding of industry trends along with strong marketing and customer management experience uniquely position him for the COO role at Cavium. As Chief Operating Officer, Mr. Hussain will assume primary responsibility for Cavium's product line business units and product business operations and will continue to report to me.

Additionally, we announced the addition of two new industry veterans to our board of directors. We are extremely pleased to welcome Brad Buss and Dr. Ed Frank to our board of directors. They each have decades of semiconductor industry experience. In addition, their individual experiences will prove extremely valuable to Cavium as we grow and expand our infrastructure product footprint in multiple markets.

On that note, I would now like to turn the call over to Art Chadwick, who will provide a detailed discussion of Q2 financial results and guidance for Q3. Art?

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Great. Thanks, Syed, and thanks to all of you for joining us today. I'll first go through Q2 financial highlights and then provide guidance for the third quarter of 2016. Revenue in the second quarter was $107.2 million, up 5% sequentially. Sales into the enterprise and service provider market were $98.8 million or 92% of sales, up 5% sequentially. Sales into broadband were $8.4 million or 8% of sales, up 6% sequentially.

We had two 10%-plus customers this quarter, and sales to those two customers accounted for 37% of total sales. Gross margins continued to expand. Non-GAAP gross margins were 67.3%, up 20 basis points sequentially. Non-GAAP operating expenses were $54.3 million. This was up 2% from Q1, which was less than one half the top-line sequential growth. Non-GAAP operating income was $17.8 million or 16.6% of sales, up 160 basis points from Q1. Income tax expense was $273,000. The GAAP net loss was $7.4 million as compared to a GAAP net loss of $3.8 million in Q1. However, the non-GAAP net income was $17.2 million or $0.29 per share.

Non-GAAP results exclude $24.6 million in non-GAAP adjustments, comprised of $14.5 million in employee stock-based compensation expense, $3.7 million in acquisition-related amortization and $6.3 million in QLogic acquisition-related transaction costs.

The quarter-end AR balance was $82.1 million, up from $79.6 million in Q1. The resulting DSOs were 70 days, down from 71 days in Q1. Inventory was $52.7 million, up from $48.1 million in Q1, in anticipation of higher third quarter sales. We generated $28.7 million in positive cash flow from operations. We paid $16.4 million for the purchase of masks, test equipment and tangible assets, made payments of $2.7 million towards capital lease and technology license payments and generated $1.2 million in proceeds from stock option exercises. As a result, our cash balance increased by $10.8 million. We ended the quarter with a net cash balance of $140.4 million.

I would now like to provide more specific guidance for the third quarter of 2016. We expect strong third quarter revenue growth driven by both new products and OCTEON III ramps. We expect sales will be up between 6% and 8% sequentially, which at the midpoint would put revenue at approximately $114.7 million.

Non-GAAP gross margins are expected to increase to approximately 68% plus or minus, due to increase in new product sales and reduced wafer costs. Non-GAAP operating expenses will increase only incrementally and are expected to be approximately $55 million. Other expenses are expected to be approximately $200,000 and income taxes are expected to be approximately 3% of non-GAAP income or about $700,000. The non-GAAP share count in Q3 is expected to be approximately 60 million shares. And based on those assumptions, we expect Q3 non-GAAP EPS will be between $0.36 and $0.38 per share.

And on that note, I'd like to hand the call back to the operator to begin our Q&A session. Operator?

Question-and-Answer Session

Operator

Certainly. Our first question comes from Blayne Curtis with Barclays. Please go ahead. Your line is open.

Blayne Curtis - Barclays Capital, Inc.

Hey, guys. Thanks for taking my question and nice results. I was wondering, Syed, you talked about your existing business being up and that's been a big concern. I was just wondering if you could talk about the stage that OCTEON III is in its ramp, and just your visibility in that core business growing for you in the future. Can you talk about what visibility you have into backlog, and the competitive environment for OCTEON III?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, so OCTEON III is in the early stages of ramp, as you know that some of our lead customers started doing the first shipments in Q2, and our visibility on these products has improved considerably now, as we have gotten the backlog put together for Q3. And the visibility for the embedded product cycles is a lot more predictable. So, we see the OCTEON III continuing to ramp through the back half of the year and also be in position to deliver a strong 2017.

Blayne Curtis - Barclays Capital, Inc.

Thanks. And then I just wanted to ask, now that you've met with the customers of QLogic as well as your own customers, can you maybe just talk about how the Ethernet business fits into yours and where you see the opportunities to grow that business?

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Yes, Blayne, we would love to talk a lot about the QLogic acquisition, but we're in the process of the tender offer, so we have to stick to what we filed with the SEC in terms of the details of our tender offer and all of the other terms associated with the business and the combination of Cavium and QLogic. So I don't think we're going be answering too many questions on this particular call, just because of the timing of the tender offer, so I do apologize for that.

Blayne Curtis - Barclays Capital, Inc.

Okay. Fair enough. Maybe if I could just ask you about, you talked about reaching volume production with Thunder. Can you talk about, you said you have first orders for production for a client. Can you talk about your visibility into those ramps and what the kind of slope of the revenue curve could be here, and when do you deem a product production-worthy in terms of a design win? And is everything still on track for the client?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes, so everything is on track, as we can look at it, as I said in my prepared comments, the ThunderX, the Xpliant, the LiquidIO II and the OCTEON Fusion-M is actually coming in a bit higher than our expectations were, since we didn't really have the visibility a quarter ago. And all of these are production orders, not kind of prototype orders. So these are starting to add meaningful revenues to our growth.

Blayne Curtis - Barclays Capital, Inc.

Okay. Thanks.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Thanks.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Thanks, Blayne.

Operator

Thank you. We'll go next to Anil Doradla with William Blair & Co. Please go ahead.

Anil Kumar Doradla - William Blair & Co. LLC

Hey, guys. Good to see a strong reversal to growth. So a couple of questions, Syed. You talk about being incrementally positive on your visibility, backlog, and so forth. Now if you were to parse it between the OCTEON III transition versus end-market recovery, how would you characterize the outlook, so to speak?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Anil, if we take a look at the end markets, right, we are shipping OCTEON I, OCTEON II, OCTEON III into the end markets. So the growth that is coming is primarily from the OCTEON III ramps at our customers.

Anil Kumar Doradla - William Blair & Co. LLC

So where I'm going with this, Syed, is, wireless has been kind of a mixed bag over the last couple of quarters. The commentary is incrementally positive on wireless. So I think where I'm trying understand is, is this largely driven by OCTEON III transition with kind of no changes to the end market? Or there's a component of the wireless end markets are also positively reacting? Or there's some improvement there.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes, as I've said, right, in our previous calls and in tech conferences, our content, going from OCTEON I to OCTEON II and then OCTEON II to OCTEON III, our content even in the same box increases substantially, right. So even if the unit volumes there are relatively flat, the content increases that we have across the OCTEON III product line at our end customers drives good growth for that particular product line.

Anil Kumar Doradla - William Blair & Co. LLC

So that's an important thing, Syed, right. So even if the market is as is over the next two, three quarters, basically what you're saying is that the growth momentum that you guys have set out with is sustainable?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes.

Anil Kumar Doradla - William Blair & Co. LLC

Okay. Very good. And one small housekeeping question. Obviously ARM's got taken out by Softbank. The whole focus over the next several quarters will be obviously Thunder which is based on ARM. Help us understand what it means, Softbank's acquisition? I mean no changes? Is it incrementally positive for the ARM ecosystem because they'll be more willing to invest into some of the software? How do you look at it?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes, I think the way we look at it is, we are an architecture licensee of ARM, right. So we really don't take any core deliverables or other IP deliverables from them. So we are pretty much on our own irrespective of what happens on the other side. But having said that, the way we look at it is that ARM is going private, right, and when a company goes private, they have a lot more flexibility to increase investment significantly to enhance their competitive position. So we see this as from neutral to being positive to the ARM licensees.

Anil Kumar Doradla - William Blair & Co. LLC

Excellent. And congrats and looking forward to this good Thunder ramp.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Great. Thanks, Anil.

Operator

Thank you. We'll go next to Vivek Arya with Bank of America Merrill Lynch. Please go ahead.

Unknown Speaker

Hi. Thanks for letting me ask the question. This is Shankar (25:29) on behalf of Vivek. Just on the Q2 numbers, so in Q1 when you guided for Q2, you said the gross margin can go up by 50 bps and OpEx will probably be flat to up. But the gross margin came in a little below that and OpEx was slightly above that. I know that I'm nitpicking on this. But can you just walk us through what were the drivers for the gross margin? I'm assuming new products came in at 8% to 10% of the revenue. But If not, can you just highlight what your Q2 new product exposure was and what is it embedded in Q3 guidance as well?

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Sure. So there are a few questions there. In terms of the new products. Yes, we had given some guidance embedded in our guidance for the quarter, and it was in line. Our whole quarter was in line. We did exactly what we said we would do, total sales up 5% sequentially. So we're very happy with that. Gross margins 10 basis points or 20 basis points, it can move around just based on mix and very small things. I think the important point here is that gross margins continue to trend up. We're up another 20 basis points this quarter and that's a positive trend.

And I guided up pretty nicely for Q3 and there's very strong reason for that. One, it's a higher sequential growth rate, also higher new product revenue in Q3 as we increase that quarter-to-quarter, and we have some significant wafer cost reductions that kick in in Q3. So we expect to see some very nice gross margin expansion going from Q2 to Q3.

And our OpEx, our stated goal has always been that within our model we would increase OpEx at or below half the rate of sequential growth. Sequential growth in Q2 was 5%. OpEx grew 2%. So I think we did a very nice job of growing the company, managing gross margin expansion, and really limiting, if you will, the amount that OpEx increased quarter to quarter. So we're very happy with the quarter and we generated very significant positive cash flow.

Unknown Speaker

Got it. But in the past you've said the new product exposure for second half would be ending the year mid-teens to high teens, I think. Could you tell us where do you expect it right now given your strong guidance?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes, we expect it to be at least that, if not more.

Unknown Speaker

Got it. And one follow up on the OCTEON III, if I may. So you talked about the OCTEON III transition starting to happen right now. But if I look at the crossover point for the OCTEON II, when should we expect that? And over the next like say three, fourth quarters, are you going to see the ASP benefit from an OCTEON III transition just coming as a 10% increase? Or do you see this it'll start to come out when you hit the crossover point, maybe like a year from now? I don't know.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

No, I think the product line will increase quarter by quarter as the unit volume shipments of the OCTEON III increase. So there isn't any classic crossover. Obviously there is a crossover in revenue. But what determines the OCTEON III or any new OCTEON product line in the first two years of the ramp is the slope of the line, right. So if you look at our OCTEON I versus OCTEON II versus OCTEON III, the slope of getting from zero to $100 million in annual revenues has improved from OCTEON I to OCTEON II, and in OCTEON III we think that slope will be significantly faster just because of the increased content per box.

Unknown Speaker

Got it. Thanks.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Great. Thanks.

Operator

Thank you. We'll go next to Harlan Sur of JPMorgan. Please go ahead.

Harlan Sur - JPMorgan Securities LLC

...and nice job on the quarterly execution. It's good to see the reacceleration year-over-year in Q3. On the core service provider business, the ramp into Reliance is a bit delayed in Q2. So is this program on and ramping and contributing to the growth this quarter? We all know that the lumpiness of some of these service provider build-outs can be just that lumpy. Can you comment on visibility for the remainder of the year, i.e., do you think that the build-out at Reliance will continue to drive growth for the Cavium team through the end of the year?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes, as I've said in my prepared comments, this was one of the best product lines that we have visibility into in both Q3 and Q4. And the answer is yes. Reliance is definitely a significant portion of it, but also Japan and other Asian geographies are starting to contribute. So it's a pretty broad-based growth there and our visibility on this product has just become phenomenally good.

Harlan Sur - JPMorgan Securities LLC

Good. Good to see the diversification there too. You started shipping production ThunderX into one of your large Asia-based hyperscale customer this quarter. I know you've got a lot of customers in qual. There's some other smaller customers ramping. But do you have any visibility on when you'll start to ramp production shipments into your next largest hyperscale customer?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes, currently our expectation is that will be Q4 of this year.

Harlan Sur - JPMorgan Securities LLC

And this is a different customer relative to the large...

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes, yes.

Harlan Sur - JPMorgan Securities LLC

...customer you're shipping today?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yes. Yes. Let me put it this way, it's another large customer.

Harlan Sur - JPMorgan Securities LLC

Okay.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

And I think the other thing that I'd point out, and I don't know if the takeaway was very clear in my prepared materials, but if you look across our product line, whether it is Thunder or OCTEON Fusion-M or Xpliant or LiquidIO II, once customers start going into production, obviously the visibility improves. So last quarter at this time without production orders you don't know whether it's going be a month late, two months late or three months late. But now with the advent of meaningful production orders for all the products in Q3, we obviously expect that in Q4 that these numbers will be higher for every one of these product lines.

Harlan Sur - JPMorgan Securities LLC

Great. Thanks, Syed.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Thanks, Harlan.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Thanks, Harlan.

Operator

Thank you. We'll go next to Matt Ramsay with Canaccord Genuity. Please go ahead.

Matthew D. Ramsay - Canaccord Genuity, Inc.

Thank you very much. Good afternoon, guys. Syed, I wanted to talk a little bit about ThunderX2. That is obviously a very impressive-looking product and from what I'm hearing in the channel quite a bit of interest in that product even relative to the strong ramp you're now going to see for Thunder the first generation. Maybe you could talk about traction for that product, at least in mind share and how you see the addressable market for the second generation of Thunder as it comes out.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Sure. So when we launched ThunderX, for most customers it was, okay, let me check it out. Let me kick the tires. So some of them took the product. They ramped some initial benchmarks. They say, oh, this looks pretty competitive. Let's run some of the target applications which fit well in with ThunderX. They ran them and some of them have gone to production, some of them are very close to running to production.

But having said that, with many of the customers already having access to ThunderX I, the confidence level on ThunderX2 execution is dramatically better, right. So in terms of we had to have the entire ecosystem built up for ThunderX1 from scratch. The entire ODM ecosystem needed to be built up. But for ThunderX2 we are really seeing a significant, dramatic change in interest at the mainstream of several users compared to ThunderX1, which was more applicable or they applied it more in a limited set of applications.

So there was a lot of learning we had in ThunderX1, so it took a little bit longer for us to go to production with that because having all the BIOS, the UEFI, the BMC, all the operating systems qualified, took a little bit of time. But with ThunderX2 at the gate, at time T0 everything will be ready. Production platforms will be ready; all the software ecosystem will be ready, so we believe that the time to revenue for ThunderX2 will be significantly shorter than ThunderX1. So we are very excited about this. ThunderX1 is going to continue to ramp at multiple customers in the type of applications that we do well in, whereas ThunderX2 will be a much more broader, a much more significant product line because it addresses more mainstream applications than the ThunderX1 does.

Matthew D. Ramsay - Canaccord Genuity, Inc.

No, that's really helpful. And just a couple follow-ups for me I guess. First on the explanation that you gave on ThunderX2, maybe you could update us on timing. And then second, it was interesting to me to hear the commentary that you gave, the positive commentary on OCTEON TX is that embedded processor line moves to ARM. Maybe you could help me understand a little bit more the differentiation or how you guys are taking the product to market. What the differentiation between, say, OCTEON TX at the same core count as the first generation ThunderX, for example. Any help there would be helpful? Thanks.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, so the OCTEON TX, it basically addresses both the control plane and data plane application. And the significant difference about the ARM-based OCTEON X versus the MIPS-based OCTEON product line that we have, is the ecosystem is significantly larger for ARM. So, for example, if you want to run third-party services on it, if you want to run Java on it, if you want to run the standard types of stuff you run on the server, even in appliances for services, it is much easier to do that because of the ARM ecosystem.

So one of the areas where – it will obviously be used in some of the similar applications like data plane, but the big upside, the big potential we see, is for it to be used in the control plane. So today in the control plane for low-end applications, it's primarily x86, some Atom-based platform, two-port, four-port, six-port, those type of platforms. And in the midrange it goes to like a Xeon-D, eight-core and above, right? And the reason why it has been x86 primarily is because of the ecosystem, right? They need standard operating systems, they need all the tools, all the goodies that come with it.

Whereas now, ARM has all those same goodies available. So this can be a much more lower cost, much more better TCO for even pure control plane applications, than – and be very, very competitive to the x86. So this market is – the control plane market in networking and communications is well over $500 million. So this is kind of a new market segment that the TX will be able to address, which the MIPS version could not address.

Matthew D. Ramsay - Canaccord Genuity, Inc.

Thanks, Syed. I appreciate it.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Thanks, Matt.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Thanks, Matt.

Operator

We'll go next to Joe Moore with Morgan Stanley. Please go ahead.

Joe L. Moore - Morgan Stanley & Co. LLC

Great. Thank you. With ThunderX I guess, looking at some of the online benchmarks, kind of interesting that they seem to have gotten a lot better since launch, just because you can kind of – the drivers mature quickly. The drivers that were benchmarked at the beginning were a little bit immature. Where are we with that? How mature do you see the ThunderX ecosystem now? And to your point earlier, how does that – are you going to see better optimization right at launch with ThunderX2?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Right. So in ThunderX1, obviously a year ago, a lot of the operating systems were very primitive. Kind of the first generation Ubuntu 14, it had some limited areas and its performance was not great. Similarly, some of the other software, whether it's through drivers or like SSL, they were very immature. But over the last six months, the speed of the maturation of the eco system on ThunderX has been very, very phenomenal. I mean, every new version of every new operating system we test is improving the performance of ThunderX, even-though the piece of silicon is still the same.

So we expect that by the end of this year – and by the way, the improvements have not stopped. If you kind of take a look at the window today of certain performances of SQL or Java or what have you, six months from now, towards the end of this year, they'll be even much more better compared to what they are now. So this is a system that is – and I think in some of the third-party benchmarking they've really noticed the stark differences in performance in just different versions. Whereas with the x86, it is completely mature. And one version to the other version is not giving it a significant improvement. So now moving on to the X2, right out of the gate, we will have all this goodness available to it right from time t0.

Joe L. Moore - Morgan Stanley & Co. LLC

Great. That's helpful. Thank you. And then just a nitpicky question for Art, I guess. The DSOs are – did come down, but they're still a little bit higher than where they were over the course of last year. Can you just talk about what's driving that and what's the direction of that?

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Sure. Part of it is – some of it is the same reason as last quarter where some of our new products are going out near the end of the quarter rather than earlier in the quarter, which is just based on the order cycle from our customers and the timing of production ramps for those products. And the other item has to do with a couple of our large customers who have more extended payment terms than some of our smaller customers. And that affected us greatly in Q1. It's impacted us in Q2. I think over time, as some of our other customers ramp, these larger customers become a lesser percentage of our sales, that'll help our DSOs going forward.

Joe L. Moore - Morgan Stanley & Co. LLC

Great. Thank you very much.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Thanks, Joe.

Operator

We'll go next to Rick Schafer with Oppenheimer. Please go ahead.

Unknown Speaker

Hi. This is Corey Grady (40:13) on for Rick. I just wanted to ask, flowing the hub transition at Amazon, can you talk a little bit about where we stand with the related excess inventory?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, so obviously, that has come down and Amazon has picked up in Q2 compared to Q1. So I think those inventory issues are kind of behind. Now it's purely going to be based upon their demand.

Unknown Speaker

Thanks.

Operator

Thank you. We'll go next to Kevin Cassidy with Stifel. Please go ahead.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc.

Thanks, and congratulations on a good quarter. Was there any change to your top 10% plus customers quarter-over-quarter?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

No. No. No.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc.

Okay. And then as you're ramping the new products, would there be more leverage in the model as revenues accelerate? Or will OpEx still be growing at about half the rate of the top line?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, generally, as we have seen Cavium over the years, right, we are very, very dependent upon the top line. If our top line accelerates significantly faster, obviously, we don't keep the OpEx at half – if we increase by X amount, we don't say, okay, since we are increasing by X amount, we're going to increase OpEx to half. We have a plan for increasing it. And obviously, if the sequential quarter-over-quarter growth becomes higher, that percentage will go down.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc.

Okay. Great.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

And I think you see that in our Q3 guidance, Kevin. At the midpoint of our top line growth, we were guiding 7% sequential growth. And OpEx is going up substantially less than that, in our guidance.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc.

Right. So do you have a target for where operating margins can go?

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Well, they'll continue to improve. The guidance for Q3 shows some very nice improvements. And we think we can do that quarter-over-quarter.

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, continuously incrementally improve. Some quarters may be a little bit less, some quarters may be a little bit more based upon the mix. But the outlook is improvement.

Kevin E. Cassidy - Stifel, Nicolaus & Co., Inc.

Okay. Great. Thank you.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Thanks, Kevin.

Operator

Thank you. We'll go next to Gary Mobley with Benchmark. Please go ahead.

Gary Mobley - The Benchmark Co. LLC

Hi, guys. Let me extend my congratulations as well. I want to start out by sort of dissecting the revenue delta you're expecting for the third quarter. That $7 million plus in revenue delta sequentially in Q3, how much of that is being catalyzed by new product versus recovery in, say, end markets such as wireless, et cetera?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, so overall, I would say it's roughly about 60% to 65%. Somewhere in that ballpark is new products and the balances are existing products.

Gary Mobley - The Benchmark Co. LLC

Okay. In the past you've given us some rough estimation in terms of revenue expectations for ThunderX. Could you share with us an approximation of ThunderX contribution to Q2 and what it may look like for all of fiscal year 2016?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, we have four or five different products. ThunderX has been the single largest contributor in the first half obviously. We have said at approximately half. In the second half there's a lot of other product lines ramping. So it's a little bit difficult to give that percentage. But the overall number for new product revenues that we have talked about for the back half we believe we will be at or greater than that number.

Gary Mobley - The Benchmark Co. LLC

Okay. Question on the balance sheet. Art, looking at various different balance sheet items, it would indicate that the third quarter might be front-end loaded. Is it any more front end loaded than normal, and was sort of embedded in your overall revenue expectation for the third quarter in terms of linearity for the second half of the quarter?

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Yeah. We're only one month into the third quarter, so I really don't want to comment on linearity at this point. But we do think third quarter's going be a very good quarter for us. I gave the detailed guidance. We've got strong backlog going into the quarter, especially on new products. And we can talk more about the quarter when we finish it up. But we feel very good about Q3, I'll say that.

Gary Mobley - The Benchmark Co. LLC

All right. Very good. Thank you, guys.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Thanks Gary.

Operator

Thank you. We'll take our next question from Melissa Fairbanks with Raymond James. Please go ahead.

Melissa A. Fairbanks - Raymond James & Associates, Inc.

Hey, guys. Great quarter and great guide. This is Melissa Fairbanks for Steve Smigie. Just a couple of quick things. With the new product ramps, are we still early enough that we should see consistent sequential growth going forward? Or is there some seasonality we should factor into some of these new products?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, I think for the new products, you're not going to see much seasonality. Since they are in the early stages of the ramp, we expect them to grow from Q2 to Q3 and Q3 to Q4. Once some kind of a run rate has been established, then you may see some seasonality obviously coming in. But since we are in the early stages, whether it's on ThunderX, whether it's on Fusion-M, LiquidIO II, Xpliant, these are so early in the stages that we expect strong growth in Q3 and in Q4. So until they kind of get to a run rate we don't really expect to see seasonality.

Melissa A. Fairbanks - Raymond James & Associates, Inc.

Okay. Great thanks. And then one more quick one. I was wondering if you might be able to give us some insight into how much of the opportunity for Fusion-M is coming from other potential – maybe displacing some other potential OCTEON opportunities? Or how much are you counting on coming from share gains versus some of the incumbent suppliers at those customers?

Syed Basharat Ali - Chairman, President & Chief Executive Officer

Yeah, I think it's both, right. At our lead customer, obviously it's a subtract answer, right. We have been shipping OCTEON products in there, those products have gone to zero, right. and OCTEON Fusion obviously has taken up all that. So there is a cannibalization of our OCTEON II at our lead customer. But having said that, this platform over the last three months has really taken on the biggest competitors, and won major contracts across the world, and won significant share of those contracts primarily because of the highly integrated nature, the cost structure of this platform is very competitive, the power consumption is very competitive, and the performance is industry leading.

So having said that, we have the cannibalization of OCTEON II with Fusion, but on the other hand, this is increasing the TAM that our lead customer is addressing and his market share, we think is going to significantly increase with this platform, number 1. Number 2, we've also engaged now with a few other customers. They are more medium sized customers right now, but they still will contribute meaningful revenues to us and that will be a complete market share gain because they currently don't use any OCTEON products.

Melissa A. Fairbanks - Raymond James & Associates, Inc.

Excellent. That's great to hear. That does it for me. Thanks, guys.

Arthur D. Chadwick - Chief Financial Officer & Vice President of Finance & Administration

Great. Thanks, Melissa.

Operator

Thank you. I'll pause just a moment for any final questions to queue. It appears we have no further questions at this time. Today's call will be available for replay by dialing 719-325-3611 and entering passcode 6871184. Again, for a replay of today's call, dial 719-325-3611 and enter 6871184 when prompted. This does conclude today's conference. We appreciate your participation, and you may disconnect at any time. Have a great day.

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