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Mellanox Technologies, Ltd. (NASDAQ:MLNX)

Q1 2012 Earnings Call

July 18, 2012 5:00 p.m. EDT

Executives

[Gwen Laver] – Company Representative

Eyal Waldman – Chairman, President and CEO

Michael Gray – CFO

Analysts

Kevin Cassidy – Stifel Nicolaus

Glenn Hanus – Needham & Co.

Joseph Wolf – Barclays

John Pitzer – Credit Suisse

Rajesh Ghai – ThinkEquity

Daniel Amir – Lazard

Brent Bracelin – Pacific Crest

Harlan Sur – JPMorgan

Ruben Roy – Mizuho Securities

Brian Freed – Wunderlich Securities

Operator

Good afternoon and welcome to the Mellanox Technologies second quarter 2012 financial results conference call.

(Operator Instructions). As a reminder, this conference is being recorded.

And now I would like to turn the conference over to [Gwen Laver] who will introduce today’s speakers. Please go ahead.

[Gwen Laver]

Good afternoon and welcome to Mellanox Technologies fiscal second quarter 2012 conference call. Leading the call today will be Eyal Waldman, Chairman, President and CEO of Mellanox Technologies, and Michael Gray, Chief Financial Officer.

By now you’ve seen our press release and associated financial information that we furnished to the SEC on Form 8-K this afternoon. In addition to reviewing our financial results, some of our comments today will include forward-looking statements within the meaning of Section 27a of the Securities Act of 1933 as amended and Section 21e of the Securities and Exchange Act of 1934 as amended based on our current expectations.

These forward-looking comments entail various significant risks and uncertainties that could cause our actual results to differ materially from those expressed in such forward-looking statements. Forward-looking statements in this conference call are generally identified by words such as believes, anticipates, expects, intends, may, will and other similar expressions. However, these words are not the only way we identify forward-looking statements. In addition any statements that refer to expectations, projections, forecasts, predictions or other characterizations of future events or circumstances are forward-looking statements.

Listeners are cautioned not to place undue reliance on these forward-looking statements which speak only as of today. We undertake no obligation to update any of the information contained in any forward-looking statement we make.

We have provided additional information about risk factors that could cause our actual results to differ materially from those in the forward-looking statements in today's conference call, in our press release, in our Form 10-Q filed with the SEC on May 4, 2012, or in our Form 10-K filed on February 28, 2012. If you do not have a copy of our 10-Q or 10-K you can find it at ir.mellanox.com or we will be happy to provide you with one.

Now I will turn the call over to Eyal for his opening remarks. Eyal?

Eyal Waldman

Thank you, Gwen [ph]. Good afternoon, everyone, and thank you for joining us.

On today's call I will highlight our second quarter 2012 results and achievements. I will then turn the call over to Michael Gray, our Chief Financial Officer, who will discuss the financial results in more detail and provide our fiscal third quarter guidance. After that we will be happy to take your questions.

For the second quarter of 2012 Mellanox reported record revenue of $133.5 million, up 50% from $88.7 million in the first quarter of 2012 and up 111% from the $63.3 million in the second quarter of 2011. Second quarter non-GAAP gross margins were 70.5%. Non-GAAP operating income was a record of $42.7 million or 32% of revenues. And non-GAAP diluted earning per share was a record of $0.99, representing 94.1% growth quarter-over-quarter from $0.51 in the first quarter. Sequential growth in the non-GAAP operating income was 87% while sequential growth in revenue was 50%.

Our cash and investments increased $60.2 million during the second quarter. We generated cash from operations of $59.2 million, ending the quarter with $327.8 million in cash and investments.

Our FDR InfiniBand products represented 54% of revenues compared to 31% in the first quarter of 2012 and 40% in the fourth quarter of 2011. In the current quarter we benefited primarily from FDR InfiniBand growth in the high-performance computing and Web 2 markets. Our large Web 2 customer contributed to the current quarter's FDR InfiniBand sales. During the quarter, multiple storage systems were announced by OEMs with Mellanox FDR InfiniBand. InfiniBand is becoming the interconnect of choice for storage systems.

With the announcement of our next-generation InfiniBand adapter Connect-IB, Mellanox is the first company to deliver over 100 gigabit per second interconnect throughput on a single PCI Express 3 adapter IC and card through two 56 gigabit per second ports. Connect-IB is the fastest InfiniBand adapter on the market today and we expect, along with our comprehensive lines of switches, cables and software, to continue to gain traction in the marketplace. We have delivered Connect-IB prototypes to customers and partners.

The June 2012 top 500 list highlighted for the first time that InfiniBand-based super-computers have surpassed Ethernet-based super-computers. This leadership position is a significant milestone and achievement for Mellanox. We believe InfiniBand surpassing Ethernet in high-performance computing is a further sign that Infiniband is becoming the interconnect of choice for cloud and Web 2 data centers as they are based on similar architecture constants. We’re working closely with Microsoft on their upcoming Windows Server 2012 operating system to be released in the fourth quarter of 2012.

New protocols developed by Microsoft take advantage of Mellanox interconnect technology with benchmark results demonstrating significantly faster application performance over competing interconnect solutions. This unprecedented performance eliminates storage bottlenecks, enables data centers to operate closer to their theoretical performance limits and provides Microsoft product with a competitive advantage. Using the Microsoft-Mellanox solution will help IT managers to simplify deployment and to meet their performance goals at a much lower total cost of ownership.

Revenue from our 10 and 40 gigabit per second Ethernet products increased during the second quarter. Mellanox provides the industry’s only comprehensive end-to-end 40 gigabit interconnect solutions.

In the third-party benchmark test performed by the Tolly Group, Mellanox demonstrated its 10 and 40 gigabit per second Ethernet switch leadership, achieving record performance with leading energy efficiency, over 2x better than the closest competitor. These results are testament to Mellanox’s 10 and 40 gigabit Ethernet performance and the energy savings they deliver to data centers across various industries and markets.

We are seeing initial traction of our 40 gigabit Ethernet products in the financial services and Web 2 markets. For example, Strive Technologies deployed our end-to-end 40 gigabit Ethernet solutions to connect a large US-based exchange. Mellanox's 40 gigabit Ethernet enables the US-based exchange to achieve the fastest response time for their high-frequency trading applications.

We are also working with partners to develop robust, highly scalable, flexible and affordable 40 gigabit Ethernet based solutions that provide cloud and big data customers with best-in-class performance, ease of use and rapid return on investment.

Finally, during the quarter we expanded our Ethernet OEM channel by adding companies including Sugon in China and Quanta in Taiwan and in the United States. This is in addition to our existing relationships with HP, IBM, Dell and others.

Now I will turn the call over to Michael for our view for our second quarter 2012 financial results and our expectations for our third quarter of 2012. Michael, please.

Michael Gray

Thank you, Eyal. Good afternoon, everyone. Let me review now some more financial details relative to our second quarter 2012.

Total revenues in the second quarter were $133.5 million, up approximately 50.4% from $88.7 million in the first quarter 2012 and up approximately 110.7% from $63.3 million in the second quarter of 2011. Our non-GAAP gross margins in the second quarter were 70.5% compared to 70% in the first quarter of 2012 and 68.9% in the comparable quarter last year. The sequential increase in our gross margin percentage was due primarily to the increased shipment of our FDR InfiniBand products.

Major reconciling items from GAAP to non-GAAP gross profit are share-based compensation expenses of approximately $441,000 and the amortization of acquired intangibles of approximately $1.9 million.

A few selected second quarter 2012 revenue metrics for you: combined revenues from our IC and board products represented approximately 47% of the second quarter revenues. Switch systems accounted for approximately 36%. Revenues from our 56 gigabit per second InfiniBand based products represented 54% of revenues in the second quarter of 2012, up from 31% in Q1 of 2012. Revenues from our 40 gigabit per second InfiniBand based products represented approximately 31% of revenues in the second quarter compared to 45% in the first quarter of 2012. Twenty gigabit per second InfiniBand based products represented roughly 5% of revenues in the second quarter compared to 9% in the first quarter of 2012.

Ethernet-related revenues represented approximately 7% of second quarter revenues compared to 10% of revenues in the first quarter. We had two greater than 10% customers in the second quarter that combined represented approximately 49% of revenues. They were HP at 30% and IBM at 19%. There was a large Web 2.0 account associated with these customer concentration figures.

Second quarter non-GAAP operating expenses increased by $12.1 million sequentially to $51.4 million and represented approximately 38.5% of revenues compared with $39.3 million and 44.3% revenues in the first quarter of 2012. Major reconciling items from GAAP to non-GAAP operating expenses are stock-based compensation of $8 million and amortization of acquired intangibles of $439,000.

Moving down our income statement, our non-GAAP research and development expenses were $33.1 million in the second quarter 2012 compared to $24.8 million in the first quarter 2012 representing a sequential increase of approximately 33.7%. The increase was primarily due to higher employee-related expenses, increased [take-out] costs and an increase in HR related costs.

Non-GAAP R&D expenses for the second quarter represented approximately 24.8% of revenues, down from roughly 27.9% of revenues in the first quarter of 2012. Non-GAAP sales and marketing expenses were $13.3 million in the second quarter compared to $10.7 million in the first quarter of 2012, representing a sequential increase of approximately 24.1%. The increase was primarily due to higher employee-related expenses, an increase in trade show and advertising expenses and higher HR-related costs.

Non-GAAP sales and marketing expenses for the second quarter represented approximately 10% of revenues, down from 12.1% of revenues in the first quarter of 2012. Our non-GAAP general and administrative expenses were $4.9 million in the second quarter compared to $3.8 million in the first quarter 2012, representing a sequential increase of approximately 30.4%. The increase was primarily due to an increase in employee-related expenses and higher HR-related costs. Non-GAAP G&A expenses for the second quarter represented 3.7% of revenues, down from 4.2% of revenues in the first quarter of 2012.

Our non-GAAP operating income was $42.7 million in the second quarter and represented 32% of revenues compared to $22.8 million or 25.7% of revenues in the first quarter of 2012. Through the first six months of 2012, our non-GAAP operating income has increased 227% compared to the first half of 2011 while our first half 2012 revenues have grown 88% compared to the same period last year.

Other income of $221,000 in the second quarter was primarily associated with higher interest income, partially offset of by foreign exchange losses. This compared to other income of $184,000 in the first quarter of 2012.

Non-GAAP income before taxes was $43 million or 32.2% of revenues in the second quarter compared to income before tax of $23 million or 25.9% of revenues in the first quarter of 2012. The second quarter tax expense of $100,000 compares to $1 million of tax expense in the first quarter of 2012. The decrease in the current quarter tax provision is attributable to the recognition of deferred tax assets in Israel in an amount of roughly $900,000.

Our second quarter 2012 non-GAAP net income was $42.9 million or $0.99 per diluted share and included adjustments of $8.4 million for share-based compensation and amortization of acquired intangibles of $2.3 million. Our first quarter 2012 non-GAAP net income was $22 million or $0.51 per diluted share and included adjustments of $7.2 million for share-based compensation and amortization of acquired intangibles of $2.4 million. 2011 non-GAAP net income was $10.3 million or $0.27 per diluted share.

Our GAAP diluted share count for 2012 the second quarter was $43.5 million compared to $42.4 million in the first quarter 2012. GAAP basic share count used in computing income per share for the second quarter was $40.9 million compared to $40 million for the first quarter of 2012.

Moving on to our cash flow statement, operating activities provided approximately $59.2 million of cash during the second quarter compared to $23.6 million in the first quarter of 2012. Net cash used from investing activities during the second quarter was $55.4 million and consisted of net purchases of short-term investments of $47.8 million, purchases of property and equipment and leasehold improvements of $6 million, and equity investment of $1.4 million in a private company. Net cash provided by financing activities during the second quarter was $8.9 million and consisted primarily of cash proceeds from option exercises of $8.1 million and excess tax benefits from option exercises of $837,000.

Turning now to the balance sheet, our cash and investments were $327.8 million compared to $267.6 million at March 31 of 2012. Our accounts receivables increased roughly $7.5 million to $54.6 million during the quarter. Our day sales outstanding decreased to 35 days compared to 49 in the prior quarter. Approximately 97% of our outstanding AR amounts are current or less than 30 days overdue.

Second quarter ending inventory decreased $900,000 to $31.3 million compared to $32.2 million in the first quarter of 2012. Our inventory turns were 5.2 times during the second quarter compared to 4 times in the first quarter of 2012.

Net intangible assets and goodwill were $20.8 million and $132.9 million respectively at the end of the quarter. Total liabilities were $114 million at quarter-end, of which $89.9 million were current and $24.1 million were long term.

In terms of guidance, we currently expect the third quarter 2012 non-GAAP Mellanox results to be as follows: quarterly revenues of between $150 million and $155 million, Q3 2012 gross margins of 70% to 71% which reflect our latest forecasted product mix, we expect a sequential increase in non-GAAP operating expenses of approximately 6% to 8%, we estimate our third quarter 2012 stock comp expense to be between $8.4 million and $8.9 million, non-GAAP diluted share count guidance for the third quarter 2012 is 43.4 million to 43.9 million shares.

I will now turn things back over to Eyal for a few closing comments. Eyal, please.

Eyal Waldman

Thank you, Mike. We are pleased with our second quarter financial results for the second quarter. We continue to see InfiniBand take market share in various markets as the leading interconnect for server and storage platforms, providing the best return on investment to information technology infrastructure users. We are seeing InfiniBand become more dominant as a storage interconnect across various markets and applications. The storage interconnect is a large market sized at several billion dollars and we expect this revenue momentum to materialize in the coming years as the design wins we are working on with our storage OEM customers go into production.

We are seeing continued adoption of InfiniBand as the leading interconnect in Web 2.0 and cloud data centers and expect to experience growth of InfiniBand utilization in this market in the second half of 2012 and into 2013. We continue to see large, high-performance computing deployments worldwide use our FDR InfiniBand interconnect solutions. We expect continued growth moving forward with our new Connect-IB adapter.

We are encouraged by the momentum of our 40 gigabit Ethernet solution in the Web 2, financial services, storage and cloud markets. As the only vendor providing end-to-end 40 gigabit Ethernet solutions, we are working with multiple entities to provide 40 gigabit Ethernet solutions into these markets. We expect continued worldwide growth in revenues and, thus, we are increasing our headcount presence around the world. The best match for Intel-only based platforms are Mellanox's FDR InfiniBand and 40 gigabit Ethernet interconnect solutions, specifically our Virtual Protocol Interconnect product. We believe that with the increased adoption of Romley we will see higher attach rate and market share. We expect to demonstrate continued growth during these macroeconomic headwinds.

Operator, we will now take questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions).

We have a question from Kevin Cassidy. Your line is open.

Kevin Cassidy – Stifel Nicolaus

Thanks. Thank you very much for taking my question, and congratulations on tremendous results and all your years of hard work. Can you say yet what the split would be in storage versus server? What are your exposures? What are your expectations for the September quarter?

Eyal Waldman

Usually, we think as about 15% to 20% of revenues coming from storage. That’s kind of our estimation today.

Kevin Cassidy – Stifel Nicolaus

Okay. And do you expect that to be a faster growing market?

Eyal Waldman

It depends when, I think all of our markets will grow and I think storage will be one of them. But, yes, we’re seeing a very nice storage design win momentum, and we expect to see even more growth in 2013.

Kevin Cassidy – Stifel Nicolaus

Okay. And maybe on the Ethernet business, you say it as Ethernet. What is that split between 10 gigabit and 40 gigabit, or can you say what that split is?

Eyal Waldman

Yeah. The majority of our Ethernet revenue is from 10 gigabit per second. We do see some 40 gigabit prototypes and some deployment, but the majority is still 10 gigabit. We expect 40 to grow later this year and in 2013.

Kevin Cassidy – Stifel Nicolaus

And just one other question from me, but I think you'd mention the take-out costs. How many take-outs are you working on right now?

Eyal Waldman

You mean devices?

Kevin Cassidy – Stifel Nicolaus

Right.

Eyal Waldman

We're working on about two devices [and products].

Kevin Cassidy – Stifel Nicolaus

Two? Okay. Thank you.

Eyal Waldman

Thank you.

Michael Gray

Thanks, Kevin.

Operator

Thank you. Your next question is from Craig Hanus of Needham & Company. Your line is open.

Glenn Hanus – Needham & Co.

Hi, Glenn Hanus at Needham. Can you talk a little bit about -- I mean you've raised the third quarter here very significantly, you know, the drivers of that? Are there a number of, you know, you had I think you said five to seven significant HPC deals for the June quarter, are there a whole group coming here in the September quarter, is that the primary driver the upside? And then should we -- how far are we in this HPC upgrade cycle to 56 as we go -- as we think about our models for December then, the December quarter, should we think in terms of there having been a lot of one-time business in the September quarter or should we think about growth again sequentially in the December quarter? Thank you.

Eyal Waldman

Sure. So we can't give you any guidance for the December quarter. Regarding Q3, yes, there are a number of large deals as we had in Q1 and in Q2, we also have a number in Q3, which we’re happy to see continuous flow for those deals with our InfiniBand interconnect. And the HPC market continues to deploy. It's not like there's a certain amount of super-computers being built and most of them are being built in the first half. It's like every -- we already are working on and know of super-computers that will be built in 2014, 2015 and 2016 that people are working out with us. And so there's a continuous flow of super-computers to be built in the next coming two or three years that we already are aware of.

Glenn Hanus – Needham & Co.

But maybe you could -- you had mentioned for June sort of $30 million of one-time near-term deals, can you quantify for the September quarter? Are we looking at again a sort of select group of be it $30 million or $40 million worth of, you know, roughly how many deals and how much of that does the upside represent?

Michael Gray

Yeah, Kevin -- or Glenn, sorry. This is Mike. The $30 million that we referenced when we guided Q2 when we announced our Q1 results was really pent-up demand associated with the Romley introduction. So I mean, in light of the guidance we gave, I think it's safe to say we're seeing continued momentum in terms of adoption, not just in HPC but also in Web 2.0 and storage. And so the $30 million that you made reference to accurately was really pent-up demand with Romley because, as you know, that was introduced in early March and we had a full benefit of that in the second quarter. But in conjunction with the guidance we gave for Q3, it's really a healthy growth that we're expecting really not just in HPC but also in the other target markets, specifically Web 2.0, storage and the enterprise data center.

Glenn Hanus – Needham & Co.

Okay. Thank you.

Michael Gray

Sure.

Eyal Waldman

Just to add to that, we do see a number of large deals both in, like Mike said, HPC and cloud and Web 2. So we do -- we can identify a number of them that are very large.

Operator

Thank you. Our next question is from Joseph Wolf with Barclays. Your line is open.

Joseph Wolf – Barclays

Thanks. I guess, can we go into I guess a little bit the visibilities question right now, is something I'm curious about. As you move into more end-markets, Web 2.0 and data center, is the visibility improving more than it was when it was -- when you had a higher exposure to the HPC market?

And then a second question, I guess if you want to take that one first, I wanted to go into a little bit on the gross margin side and the mix and how that continues and where pricing goes in FDR as it becomes a bigger percentage of sales?

Eyal Waldman

Yeah, in terms of visibility, we still don't see more than one, you know, half a quarter to a quarter. We do get into the quarter with more -- or need to less turns in the quarter, but the visibility has not changed significantly. Mike, do you want to take the second question?

Michael Gray

Sure, sure. And just to add to Eyal's comment on the visibility, visibility did improve throughout Q2 and a percentage of our turns business is expected to decline, but in terms of beyond 90 days, our visibility is still fairly limited.

Relative to the gross margin, it's really mix. You know, as we sell more FDR products, and you saw the percentage of our revenue certainly increased very nicely from 31% to 54% -- remember we can charge a premium on our higher bandwidth solutions relative to our predecessor of lower bandwidth solutions. So I think consistent with the fact that our FDR revenues accelerated, also -- you know, that was good news. Also in the fact that was offset to some degree by the mix of our business that was cables as well as Ethernet-related. So it's really a mix scenario that I think kind of evolved similarly to the category splits in terms of actual for the quarter that really drove the 70.5% gross margin results we have.

Joseph Wolf – Barclays

So we can assume a similar mix given the gross margin guidance for the third quarter?

Michael Gray

Well, we guided 70% to 71% for gross margin. Again, we still have business to close, but that gross margin guidance was based on our latest forecast of mix between product categories.

Joseph Wolf – Barclays

And just one last question, cash is now even above where it was ahead of the Voltaire acquisition, and I'm wondering if you can give us some thoughts on cash management over the next 12 months?

Eyal Waldman

You know, basically we're very conservative in the way we declare our cash reserves and we’re looking for, not eagerly, we don't need to do any acquisitions to grow, but if opportunities do present themselves and we think they're interesting, we may do acquisitions. But for now there's nothing imminent.

Joseph Wolf – Barclays

Is any of the cash, just one last follow-on, is any of this cash restricted in Israel in terms of not having paid taxes on it that you really can't touch or is most of it freed up to do whatever you'd like with?

Eyal Waldman

There's some small amount of restricted cash but it's really associated let's say with facilities that we have there. But separate from that, I mean there's no particular restriction in terms of movement of cash that is being imposed on us.

Joseph Wolf – Barclays

Okay, great. Thanks, guys.

Eyal Waldman All right. Thank you.

Operator

Thank you. Our next question is from John Pitzer of Credit Suisse. Your line is open.

John Pitzer – Credit Suisse

Yeah, good afternoon, guys. Congratulations. Eyal, I don't want to beat a dead horse relative to the revenue guidance for September, but clearly in the June quarter you guys kind of went out of your way to talk about some one-time buys around Romley demand and you're clearly not sort of characterizing September like that. And so is the takeaway here that this is sort of the new sort of baseline relative to attach rate of InfiniBand for your products, or are we still seeing the benefit of a Romley ramp that could mean sequentially down quarters beyond September?

Eyal Waldman

You know, again, we don't have visibility beyond September, and thus we only guide for one quarter. But we think is roughly where our baseline for our revenues is.

John Pitzer – Credit Suisse

And then, Eyal, just on some of the visibility around the HPC and Web 2.0 kind of projects that are out there, can you help me understand as you think that some of the projects you're working on, what's sort of the duration of number of quarters before those projects get filled? Is this sort of a one-and-done or do you see projects out there that span over multiple quarters? Or just tell me dynamically how that works.

Eyal Waldman

I mean we see products that span years, not just quarters. But there's no hard confidence that this will be Mellanox's deployed super-computers. We know that they're there, we see that involvement, and we work with them and we compete in terms of which interconnect and which architecture with those large super-computers will be build around. So we have very soft visibility in terms of large programs and large deployments, but the decision is being made close to deployment. They don't want to make the decisions earlier. And once this has been made, then it becomes on backlog or we get orders, and only then we see this good visibility hard backlog in Mellanox. Before that, we just consider this as a soft possibility with low probability in our forecast.

John Pitzer – Credit Suisse

Perfect. And then you’d mentioned in your opening comments how you're working with Microsoft around Windows Server 2012. Is that just a technical relationship or will there will be some sort of joint sales relationship as Microsoft goes to market with the new OS?

Eyal Waldman

I mean the new OS will have in-box support for RDMA, both on InfiniBand and in Ethernet, both for compute and for storage. And the performance that Microsoft, Mellanox and others using the Windows 2012 with RDMA is really screeching, it's great performance. So we do expect that once this is released out to the market, the attach rate of InfiniBand and Ethernet with our RDMA will grow even further. So we do expect that the Microsoft will contribute to our growth once the Windows 2012 is released.

John Pitzer – Credit Suisse

Perfect. And then, Eyal, just my last question, relative to the competitive front, just kind of curious in the 10 gig E market first, how do you think you're stacking up? And I guess more importantly, given that Intel has bought some InfiniBand assets, is there anything new on that front or do you just still feel like the competitive landscape on InfiniBand is -- you guys are the clear leader?

Eyal Waldman

On the InifiniBand, yeah, we have a generation advantage. On the Ethernet on the NIC side we also have a generational advantage; we're the only guys that have 40 gigabit NICs as far as we know, and also an end-to-end 40 gigabit end-solution. So we feel today comfortable with our leadership position. We need to continue executing and to maintain this position moving forward.

John Pitzer – Credit Suisse

Perfect. Thanks, guys. Congratulations.

Eyal Waldman

Thanks, John.

Operator

Thank you. Our next question is from Rajesh Ghai of ThinkEquity. Your line is open.

Rajesh Ghai – ThinkEquity

Hi. Yes, thanks. Rajesh Ghai, ThinkEquity. Congratulations.

Eyal, InfiniBand has always had higher bandwidth and lower latency compared to other competing interconnects. Why has an inflection point been hit by the Romley? You know, what exactly happened that caused such a big surge in demand for InfiniBand from the Web 2.0 and HPC as well as storage markets?

Eyal Waldman

I think it's a combination of events, it’s not just the Romley. I think the storage is more mature now and more applications. Early in 2011 we had put resources in Web 2 and cloud where before that we did not quite focus on Web 2 and cloud, and we're seeing now the results of the, you know, the development, the focused development we've done in Web 2 and cloud. And I think what you're seeing, that with Romley and PCI Express 3, it's unleashing the bandwidth, the interconnect, the IO bandwidth, out of X86 platforms and people are now utilizing this more, so we shine more. Our return on investment is better exploited with PCI Express 3. So when more people try us out and do a proof of concept, they get much better results with PCI Express 3 and thus the attach rate is growing.

Rajesh Ghai – ThinkEquity

Great. And as far as competition is concerned, Intel seems to have given the [statistic generation pass], InfiniBand seems to be going to 100 gig. How long a runway do you expect on 56 gig without any competition and given that you're -- you have 54% of revenues this quarter from 56 gig, how long do you think this generation is going to last until 100 gig makes its way into InfiniBand?

Eyal Waldman

We expect 100 gigabit per second InfiniBand and Ethernet to come around 2014, 2015 timeframe.

Rajesh Ghai – ThinkEquity

Okay. And this end-to-end Ethernet supported your Ethernet strategy, does that entail that you need to build a direct sales force in order to go after end-customers like most of the networking companies do, or would you still have to -- would you still utilize your regular channel, OEM channel to go after that market, that product?

Eyal Waldman

No, we will not need to deploy different sales force, we will use our current channels with the OEMs, HP, IBM, Dell, storage companies, those three, and Oracle obviously, those would be our channel to the market.

Rajesh Ghai – ThinkEquity

And my last question is, this large Web 2.0 customer, are you able to disclose the identity of that or that’s going to be essentially something that will be a mystery for sometime?

Eyal Waldman

Yeah. No, we’re not in the position to disclose the identity.

Rajesh Ghai – ThinkEquity

All right, thanks. Congratulations.

Operator

Thank you. Your next question is from Daniel Amir of Lazard. Your line is open.

Daniel Amir – Lazard

Thanks a lot, and congratulations on the quarter and guidance. A couple of questions here. First of all, on the 10 gig side, in the past you guys have talked about kind of the software update that you need for Layer 3, kind of where do you stand there, is it still on track, and how do you see the 10 gig Ethernet upgrade cycle? And then I have a couple of other questions. Thanks.

Eyal Waldman

On the Layer 3, we’re continuing to work on, and like we said, later this year or early 2013 is when we’ll be ready with that. So still we don’t yet have it and the team is still working. On the endpoint on it -- and we are selling Ethernet switches which require Layer 2, and we are deploying our end-to-end Ethernet switches both 10 and 40. And then we are also seeing our Ethernet mix being utilized with, say, other OEM switches, and that’s something that’s working.

Daniel Amir – Lazard

So I mean, can we see the 10 gig Ethernet business growing as fast as the InfiniBand business next year?

Eyal Waldman

We have no visibility. We’ll have to wait and see.

Daniel Amir – Lazard

Okay. All right. The other question is you added Quanta as kind of your customer this quarter. I mean, can you expand a bit how you're seeing the landscape if at all changing on the customer base OEM versus ODM? I mean, is that really kind of depending on the Web 2.0 set of customers as some of them might be shifting towards using ODMs? And if so, does it impact your business in any way?

Eyal Waldman

We have worked with OEMs, ODMs and various entities that use interconnect in different levels. So, to some of them we sell our silicon products, some of them we sell boards, some of them subsystems, [sound systems], some full end-to-end solutions. So to different entities we sell different products and subsystems and we keep doing this. This change is nothing that we have not been working in the past years and quarters on, so I don't expect anything new here.

Daniel Amir – Lazard

Okay. And then, Michael, what type of tax rate should we be looking at for the rest of the year? I might have missed that if you talked about it in the guidance.

Michael Gray

No, I didn't raise it but it's a great question. I would assume mid single digit for effective tax rate for the balance of the year so probably somewhere in the neighborhood of like around 6%.

Daniel Amir – Lazard

Okay.

Michael Gray

It was much lower this quarter due to the DPA that we had established in interim.

Daniel Amir – Lazard

Okay, great. Okay, thanks a lot.

Michael Gray

You're welcome. Thank you.

Operator

Thank you. Our next question is from Brent Bracelin of Pacific Crest. Your line is open.

Brent Bracelin – Pacific Crest

Thank you. Eyal, I wanted to go back to what's changed in the last six months. I know you're characterizing the business as some one-time buys in Q2 and Q1, now the guidance up to 150, 155. It does feel like a sea change in your business. And as we think about what's changed, what's really giving you confidence now that this is sustainable, what are you seeing, what are you hearing from customers? Is this more than just Web 2.0? Is this kind of broad-based enterprise, storage, cloud, all of the above, that kind of gives you the confidence here? I'm just trying to understand as you think about characterizing the upside in your business in the last six months as one time and now feeling much more confident about sustainability going forward.

Eyal Waldman

Again, we don't have visibility beyond one quarter. So we haven't given any guidance for Q4 or anything but we see the repetitive business that we've experienced Q1, Q2 and Q3 and we continue to see our growth. We continue to see penetration to the markets we've been talking about. And we are enjoying the deployment of InfiniBand into more markets, more applications and larger customers. That's what we're seeing and that's what we're telling you guys.

Brent Bracelin – Pacific Crest

Perfect. And then maybe specifically on the Web 2.0 side and cloud side, what are some of the drivers that you're seeing? Is this an increasing number of Web 2.0 customers or is this applications, be it maybe a flash deployment at a Web 2.0 customer, exposing a bottleneck on the IO side that then brings in InfiniBand? What are some of the drivers that you're seeing, specifically with Web 2.0 and cloud that they’re moving to InfiniBand? And is this a couple of large customers or is this multiple Web 2.0 customers and the surprise here is that the number of Web 2.0 customers and cloud customers interested in InfiniBand?

Eyal Waldman

So, first, we have Web 2 customers using our Ethernet products and then Web 2 customers using our InfiniBand products, and both are growing. Second, what we’re seeing is that they’re using us in various applications, various -- some for storage, some for compute, some for both, and it’s just growing. Both the number of entities, Web 2 and cloud entities that’s using us is growing. And second, we’re seeing that people had already started using us, the number of applications and data centers were being deployed is growing. So that’s just basically all of the above you just mentioned we’re seeing growth in, both in cloud and Web 2, and we expect to continue this in the future.

Brent Bracelin – Pacific Crest

Have you been surprised by the pace of adoption as they start to deploy InfiniBand initially or 10 gig Ethernet initially and have you been surprised by the pace of adoption at these customers? Again, I'm just trying to understand what are some of the changes that you're seeing in the business, obviously to go from you're talking about $17 million a quarter in Q4 last year, now $150 million a quarter today. So I'm just trying to understand what’s been the biggest surprise on the Web 2.0 side.

Eyal Waldman

You know, we’ve been working with those guys for several quarters now, and it’s just that once they decide to deploy, some of them deploy in a wide range and wide capacity. And that’s something that happened in Q2. We do expect them to continue to deploy. We don’t know the rate or the pace, but we see them continue to deploy in the coming quarters.

Brent Bracelin – Pacific Crest

Okay. And –

Michael Gray

Brent, to add to add to Eyal’s point, I mean separate from Web 2.0, I think the fact that 56 right now, we’re in a very unique position by having FDR available to sell, and I think it has proven itself in the past that there is an appetite for higher bandwidth solutions, and the HPC market accordingly, which has historically been our primary market, certainly we’ve diversified into many new markets, the HPC market is anxious and has been transitioning to FDR.

Brent Bracelin – Pacific Crest

Shifting gears on the enterprise side, historically enterprise outside of kind of more the internal InfiniBand adoption, has it really looked at kind of external widespread InfiniBand adoption? With PCI Gen 3, are there any specific application support or potential, other drivers that could drive adoption of InfiniBand on the enterprise side?

Eyal Waldman

Yeah. I think our virtualization offload support with [SRIOV] and other offload engines we have inside the ConnectX-3 and soon also Connect-IB will actually also help drive our adoption into the data center.

Brent Bracelin – Pacific Crest

And those will ship later this year, early next year?

Eyal Waldman Well, some of them already are shipping, and every week that passes or every month we add more features and more capabilities into our devices, and with the integration with companies such as VMware and Microsoft HyperV and KBM, not all of them are shipping as yet but we're working with them and developing with them to adopt our interconnect.

Brent Bracelin – Pacific Crest

Perfect. My last question, I certainly apologize for so many questions, but I wanted to address the end-to-end capabilities that you have given the momentum you saw in the cable business, the switch business this quarter. Again, historically this was a business dominated by [season] boards, but if we look at the last couple of quarters, a very strong momentum and adoption of the switches and cable. So what's the take rate and attach rate we should kind of assume on a go-forward basis on switches and cables? And is there interest in that whole end-to-end bundle going forward? And how much of a differentiator is that for you?

Eyal Waldman

So, some companies will prefer to use our end-to-end, it’s a good nice strategy. And basically for FDR, the attach rate of our cables is very high because I think the majority of the FDR cables both fiber optics and copper are shipped by Mellanox.

And in terms of switches and endpoints, we don't lock you down to Mellanox end-to-end. You can actually enter, operate and connect us to anyone you want, both from the Internet side and obviously on the filament side with Intel previous QLogic. So we do see a lot of people using us end-to-end, but also we do see many people use us as just an endpoint and connect to someone else's switches or use our endpoint and switches using other people's cables. But the fact that we have endpoints, cables, switches and software on top of the switches and the endpoints really help us and our customers deploy faster, cleaner and easier.

Brent Bracelin – Pacific Crest

Helpful. I'll cede the floor.

Eyal Waldman

Thank you.

Michael Gray

Thanks, Brent.

Operator

Thank you. Our next question is from Harlan Sur of JPMorgan. Your line is open.

Harlan Sur – JPMorgan

Thanks, guys, and solid job on the execution and the forward business outlook.

Eyal Waldman

Thank you.

Harlan Sur – JPMorgan

Eyal, you mentioned on the call that obviously the Romley cycle is helping to increase the attach rates of your products to new platforms given the band for lower latency and faster throughputs. I'm just wondering has the team been actually measuring the improvements in attach rates? It doesn't really increase your overall time, but it certainly increases your overall sound, and that's probably helping to drive the higher revenue run rate on a go-forward basis. I was wondering if you had any numbers around the attach rates?

Eyal Waldman

We don't have those -- the OEMs don't share this with us. But you're right, the more high-end CPUs are being utilized, the higher attach rate and the higher [SAM] that Mellanox has and we can serve.

Harlan Sur – JPMorgan

You’ve been fostering some closer partnerships with the server vendors focused on the cloud. I know you mentioned Supermicro last quarter. You announced your partnership with Quanta during the quarter. So, as you focused on some of these cloud-based projects, what's sort of the typical cloud project scope in terms of number of nodes to be deployed, and are these new build-outs more focused on Ethernet connectivity or InfiniBand connectivity?

Eyal Waldman

It really depends. Some of them deploy hundreds of nodes, some in thousands, some of them ten thousand, and some tens of thousands in multiple data centers around the US and around the world. So there's a wide span of deployments for cloud and for Web 2 applications. We have multiple of them using InfiniBand and then we have multiple of them using Ethernet. I think, moving forward, there'll be a trend more of people using InfiniBand we serve than with RDMA on top of Ethernet, the same [inaudible] that we do with InfiniBand. But moving forward, I believe they'll be using more InfiniBand. Today we have both Ethernet and InfiniBand in cloud than Web.

Harlan Sur – JPMorgan

Okay. Thanks a lot, guys.

Eyal Waldman

Thank you.

Michael Gray

Thank you, Harlan.

Operator

Your next question is from Ruben Roy from Mizuho Securities. Your line is open.

Ruben Roy – Mizuho Securities

Thanks. Michael, I just wanted to touch on the model. You mentioned that potentially we're at a new run rate here and it's record operating margin last quarter. Have you thought about kind of how you're going to invest and run the business and potentially kind of look at a longer term operating margin target or goal? Thank you.

Eyal Waldman

Okay. So you know historically prior to the Voltaire acquisition, we were able to generate operating income as a percent of revenue in the mid to high 20s. Certainly our business has changed most of all to acquisition. So our long-term model, we do believe we'll still be, in terms of gross margins, in the mid to high 60s and operating margin, certainly, into the mid to high 20s.

But obviously if you've seen we're kind of beyond both the high end of the long-term model in terms of gross margin as well as operating income as a percent of revenue, again both on a non-GAAP basis over the past two quarters. And we're certainly going to continue to drive to maximize those numbers, but I think for the time being our long-term model, because again, the market's continuing to evolve and we will be dealing with product mixes, category mixes in terms of InfiniBand, Ethernet, silicon switch systems, et cetera, I think for the time being we'll keep the long-range model, long-range being two to three years out, unchanged but there's no question near-term we've exceeded both on the high end on gross margin and operating income. There's no question. We like to target 30% on a go-forward basis, but I don't think we're at a position where we're thinking about changing our long-term financial model.

Ruben Roy – Mizuho Securities

Thanks, Michael. That's helpful. And then Eyal, just in terms of -- you mentioned the two devices under development right now, is there any thought about accelerating some of the development cycles coming up as you look out into 2013? Or is the cadence going to be similar to how you forecasted your tape-out [ph] cadence in the past at this point, given how well the business is going?

Eyal Waldman

You know we obviously are trying to do thing faster than we are -- we've done in the past, but there's a certain cadence that we can't do faster. Until now we picked out about 13 devices, some of them were production worthy with the first silicon or just a metal screen. So we continue to develop, we have a lot on our plate and we just need to continue executing.

Ruben Roy – Mizuho Securities

Okay. Thanks, guys. Congratulations.

Eyal Waldman

Thank you very much.

Michael Gray

Thanks, Ruben.

Operator

Thank you. Our next question is from Brian Freed of Wunderlich Securities. Your line is open.

Brian Freed – Wunderlich Securities

Hey, guys. Congrats on a great quarter. A couple of quick questions, first you guys have kind of made a parallel between HPC and Web 2.0, is it oversimplifying for me to think of the parallel being that Web 2.0 is scaling a single application across thousands of cores very similar to HPC?

The second question I had is on DSOs, 37 days is a week lower than the best quarter you've had in the last half decade that I've got modeled, can you talk a little about linearity in the quarter and where there's some large deals that pushed into the September quarter that aid to your visibility there? And then the third --

Eyal Waldman

Wait, wait, wait, we won't remember all them.

Brian Freed – Wunderlich Securities

Okay.

Eyal Waldman

So let's do it --

Brian Freed – Wunderlich Securities

All right.

Eyal Waldman

Okay. So --

Michael Gray

I'll take the visibility if you want to take the first one.

Eyal Waldman

And what was the first one?

Brian Freed – Wunderlich Securities

The first one was the parallel between HPC and Web 2.0.

Eyal Waldman

So, basically if you think of that, Web 2.0 is based about building a very large computer or computer engines and storage engines that can then server millions if not tens of millions of users. If you want to be able to serve tens of millions of servers, you need to have very large compute capacity and storage capacity. It's the same thing as building a supercomputer. One of the advantages of those big Web 2.0 guys is having a very large compute and storage engine and that's where they're similar. And you can the, the compute and storage engine in a similar way. Those HPC guys are doing that. Okay?

Brian Freed – Wunderlich Securities

Okay.

Eyal Waldman

Okay. Mike?

Michael Gray

In terms of linearity, every quarter is very different. I think it is -- I think when we spoke and articulated about our Q1 results, that was probably one of the most linear quarters we've experienced, pretty close about a third, a third, a third in months one, two and three. Obviously our visibility did improve throughout the quarter and I think in terms of the percentage of our business invoiced in month one, month two and month three, obviously you see the results in terms of AR only increasing -- what was it? I think $7 million from quarter-to-quarter.

No question linearity improved in Q2 relative to Q1 with Q1, like I said, as the baseline being fairly linear through month one, two and three. So we have better linearity in terms of invoicing in Q2 which really played hand-in-hand into our overall cash position as well as into the improvement of DSO and the fact that really, despite a 50% growth in revenues quarter-to-quarter, our AR only increased $7.5 million.

Brian Freed – Wunderlich Securities

Great. Okay. And then my third question. You guys have touched on Intel a little bit but if you look over the past 6 to 12 months, they've made three or four different investments in high performance interconnect technologies. There's Cray [ph] and Ethernet and the QLogic and Sentaband [ph] acquisition. As you think about the competitive landscape and the development cycle of next generation interconnect, how much of the technology to catch up in the next round can be acquired and integrated through the acquisitions? And how much of it do you view as this pure raw development and man hours?

Eyal Waldman

It could be 50/50. You may have some of the basic technologies from the acquisitions that Intel has made and then maybe to develop another 50% of their mechanisms, architecture and so on. Sometimes they'd be better off starting from scratch, but they're trying to catch up and intercept, I think, over the 100 gigabit per second platforms.

Brian Freed – Wunderlich Securities

Okay. Thank you.

Michael Gray

Thank you.

Eyal Waldman

Thank you.

Operator

Thank you. We have no further questions at this time. I'd like to turn the call over to management for any closing remarks.

Eyal Waldman

Thank you. So we want to thank everybody for joining us for this conference call. We'd like to thank all of our employees worldwide for contributing to the success. Thank you for joining us.

Michael Gray

Have a good afternoon.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a wonderful day.

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