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Executives

Angel Atondo - Marketing Manager

Syed B. Ali - Founder, Chairman, Chief Executive Officer and President

Arthur D. Chadwick - Chief Financial Officer, Principal Accounting Officer, Vice President of Finance & Administration and Secretary

Analysts

Sundeep Bajikar - Jefferies & Company, Inc., Research Division

Sanjay Devgan - Morgan Stanley, Research Division

Harlan Sur - JP Morgan Chase & Co, Research Division

Anil K. Doradla - William Blair & Company L.L.C., Research Division

Blayne Curtis - Barclays Capital, Research Division

Steven Eliscu - UBS Investment Bank, Research Division

Quinn Bolton - Needham & Company, LLC, Research Division

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Sujeeva De Silva - ThinkEquity LLC, Research Division

Raj Seth - Cowen and Company, LLC, Research Division

Arnab K. Chanda - Avian Securities, LLC, Research Division

Brian T. Modoff - Deutsche Bank AG, Research Division

Ruben Roy - Mizuho Securities USA Inc., Research Division

Alex Gauna - JMP Securities LLC, Research Division

Cavium (CAVM) Q2 2012 Earnings Call August 1, 2012 5:00 PM ET

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Cavium, Inc. Second Quarter 2012 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, August 1, 2012.

It is now my pleasure to introduce our host for today, Ms. Angel Atondo. Please go ahead.

Angel Atondo

Thank you. Good afternoon, everyone, and welcome to Cavium's Second Quarter 2012 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 would like to remind you that various remarks that we make on this call, including those about our financial results, including revenues, gross margins, operating expenses, design wins, product plans, our competitive situation, market trends and our anticipated growth and profitability, all constitute forward-looking statements for the purposes of the Safe Harbor Provisions under the Private Securities Litigation Reform Act.

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 factors that could cause actual results to differ materially from our current expectations. These forward-looking statements speak only as of the date hereof and we disclaim any obligation to update these forward-looking statements.

In addition, Cavium reports gross margin and net income and basic and diluted net income per share in accordance with a GAAP, and additionally, on a non-GAAP basis. Management believes the non-GAAP information is useful because it can enhance the understanding of the company's ongoing economic performance and Cavium, therefore, uses non-GAAP reporting internally to evaluate and manage the company's operations.

Cavium has chosen to provide this information to investors to enable them to perform comparisons of operating results in a manner similar to how the company analyzes its operating results. The full 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 this call over to Syed. Syed?

Syed B. Ali

Thanks, Angel, and thanks to everyone for joining us today. In brief, Cavium's first quarter revenue was $55.3 million, up 5% from Q1. Non-GAAP gross margins came in at 60.6%. Non-GAAP net income was $3.5 million or $0.07 per share. Our GAAP net loss for the quarter was $11.8 million or $0.24 per share.

In Q2, we saw very positive trends emerge in our core enterprise and service provider markets. We saw strong growth in the service provider market, driven by ramps of designs to production especially in the wireless infrastructure market. New design ramps covered the entire spectrum from base stations, to radio network controllers, to the evolved packet core EPC across both 3G and 4G markets.

The enterprise market also delivered good growth across a broad range of markets. These trends drove double-digit growth in the enterprise and service provider markets in Q2, despite some reminance of inventory correction at a couple of our customers.

Sales into broadband and consumable is flat, and sales of software and services was down due to the realignment of resources in the service sector that I talked about in the last conference call.

Overall, booking trends were up significantly in Q2 when compared to Q1 and remained strong across the entire quarter, driven by product ramps at existing customers and several newer customers starting to go to production.

In Q2, our top customer was once again Cisco Systems, which came in at 29% of sales and was up 11% sequentially. There were no other 10% customers. Art will provide more details on the Q2 financial results and Q3 2012 guidance shortly.

I would -- like usual, I would now like to provide an update on actual Q2 design wins. Our overall design win momentum and pipeline remained very strong and similar to what we have seen over the recent quarters. Design wins in Q2 were once again spread across product families, target markets and low- to high-performance points.

The enterprise and service provider market -- segment delivered the highest design wins based on expected annual revenues. In the enterprise and service provider market, we closed multiple new design wins at a number of Tier 1 customers including Alcatel-Lucent, Cisco, IBM, Huawei, Juniper, Nokia Siemens and Samsung.

In this segment, we won major new designs in applications such as enterprise routers, service provider IP routers, security services gateways and routers, wireless LTE base stations, storage systems, SoC blades, and ADA cards.

On the broadband and consumer side, we won designs at a range of customers including D-Link, NetGear and NEC. Our designs in the segment were for applications such as over-the-top video gateways, wireless display adapters, SMB wireless LAN and cloud gaming devices.

Our market position and share in our core business continues to improve nicely. Based upon latest market size and share report data recently published by the Linley Group, Cavium was the fastest-growing provider of embedded communication processors over the past 2 years, from 2009 to 2011, with a compound annual growth rate of over 50%.

Further, according to the Linley report, we have increased our market share to 33% in the high-growth, high-value embedded multi-core segment to achieve the #2 market position. With our strong list of design wins, we expect to continue to drive market share gains and continue to outgrow the market.

Two wireless display receiver designs from major handset OEM customers reached the market in the past quarter and additional designs at multiple customers are making great progress. These 2 initial designs will start shipping in Q3.

Now I would like to give you a status update on our new products and information on major initiatives. Firstly, our entire OCTEON II processor line has now achieved mass production status and is ramping up as part of a broad range of customer designs. Our flagship 32-core OCTEON II processor demonstrated significantly higher performance over other high-end alternatives with actual Tier 1 customer applications while consuming significantly lower power. It is now in volume production.

The unique deep packet inspection hardware in our high-end OCTEON II enabled us to demonstrate an unmatched 100 gigabits per second, in fact, unmatched in capability in a single chip and has enabled us to convert designs from other architectures.

Next, an update on our OCTEON Fusion product line. Globally, service providers are prioritizing swift rollout of LTE small cell to deliver the data bandwidth required for these applications to their large subscriber bases. Cavium can rapidly alleviate spectrum and capacity limitations and expand their existing LTE micro-cell-based networks with an overlay of small cells using Cavium's OCTEON Fusion base station-on-a-chip hardware and software platform.

During the quarter, we hit important milestones with our OCTEON Fusion solution including 4G/LTE software stack and interoperability. Based upon customer feedback, we believe that we offer the most robust, high-performance LTE small-cell solution in the market today. We also announced today that major telecommunication carriers in South Korea, SK Telecom and KT, have both selected Cavium's OCTEON Fusion base station-on-a-chip processor for one of the largest, if not the largest to date, 4G/LTE small-cell deployments in the world.

The OCTEON Fusion platform was selected for robust interoperability, functionality and leading performance to fuel these large-scale LTE small-cell deployments. This deployment begins in late next quarter, in late Q4 2012 and will be ramped up in 2013.

We also are happy to announce that we taped out our NEURON Search Processor product, which delivers up to 10x capacity and performance per watt over alternative solutions. We are extremely pleased with the ongoing NEURON engagements at major Tier 1s, several of whom have validated NEURON's value proposition. We expect to sample the product soon and start reporting design wins.

Both these product lines show the strengths of Cavium and our ability to identify brand-new markets, develop disruptive products with extremely modest investments, execute a product line from scratch in less than 2 years and win designs at Tier 1 customers. We believe that this core competency will be a key engine of our growth in the coming years.

Today, we also announced the Project Thunder Initiative to reshape the next generation of cloud and data center. This is an extremely significant initiative for us that dramatically expands our addressable market. Project Thunder will deliver a family of highly-integrated, multi-core system-on-a-chip processors that will incorporate highly optimized, full-custom course built from the ground up based upon the ARM V8 construction set architecture into an innovative SoC that would redefine features, performance, power and cross metrics for the next-generation cloud and data center markets.

Project Thunder process the solutions for intelligence compute and storage applications will compliment OCTEON and NITROX processor families to greatly expand Cavium solution for print across this rapidly growing market.

Enterprise, mobile, consumer applications and storage are rapidly moving to the cloud. In the enterprise, corporations are implementing a range of mission-critical applications and virtual desktop from the cloud. These applications share across multiple corporations that require multi-tenancy and scalable environments with strong security.

In mobile and consumer networks, millions of users are simultaneously accessing services and applications and collaborating with unprecedented growth and scale. Furthermore, these applications require real-time provisioning to support unpredictable P close. These trends are driving a dramatic change in the data center architecture, causing convergence of computing, networking, security and storage along with virtualization. This requires data centers to consolidate workloads, to virtualize networks and to implement application-optimized service and storage with dynamic provisioning and real-time scalability in a dramatically lower power and cost envelope.

Project Thunder leverages significant amounts of in-house IP and builds up on Cavium's proven track record of developing and delivering 2 to 48 core SoC processors with industry-leading performance, scalability and integration based upon both the MIPS and ARM architectures.

Cavium has chosen to use MIPS or ARM architectures based upon the target end markets, industry trends, installed software base, ecosystem and customer demand. Furthermore, through the significant views across OCTEON and Project Thunder product lines, our incremental R&D operating expenses are relatively modest.

Additionally, we announced that Cavium's relationship with ARM has expanded and that we are an ARM 64-bit V8 architecture licensee. This multiyear license enables us to develop full custom and highly differentiated process of cores and system architecture to deliver unmatched value proposition for target applications relative to vendors that license off-the-shelf cores and are primarily focusing on SoC integration.

We have been working on Project Thunder over the past few quarters with lead Tier 1 customer engagements in our target markets who have given their inputs into the product definition and features. We are also doing competitive benchmarking and working to build a robust ecosystem around our products. The initial feedback on our value proposition has been very positive. We are very excited about our prospects in these markets.

In June, we also announced a collaboration with Qualcomm to offer a mobile adapter solution based on the industry's emerging WiFi-display standard, now known as Miracast; and optimized to provide enhanced peer-to-peer connections with Qualcomm's Snapdragon platform. As a result of the collaboration, major smartphone and tablet OEMs will have access to a standards plus wireless display reference solution capable of robust and high-quality video transmissions with optimized video compression and low latency.

The reference solution consist of a Miracast-enabled mobile adapter featuring Cavium's PureVu SoC and Qualcomm's Atheros 802.11n dual-band WiFi, which is optimized for end-to-end connectivity with Qualcomm's latest generation Snapdragon processor platform. Live demonstrations of the reference was shown at the Computex show in Taipei in Q2.

In the recent quarter, we also showcased our products and solutions at a number of trade shows and conferences including the Computex show in Taipei and the Interop show in Las Vegas.

Now I would like to move on and give a brief outlook on our third end markets for Q3. For Q3, we are seeing a robust demand environment with broad strength across both our enterprise and service provider markets. We are seeing continued strength at both our existing customers, as well as newer customers as product ramps based on both our OCTEON II and NITROX III product lines ramped over the second half of this year.

On the service provider side, our customers have won significant contracts for 3G/4G infrastructure in the U.S., Europe, India and the APAC regions, which will drive growth as deployments start. On the enterprise side, new product ramps and routers, application delivery controllers, switches and security equipment will be the primary growth drivers over the next few quarters.

On the broadband and consumer side, we are seeing initial volumes for our mobile phone WiFi display customers starting in Q3. As I've talked about in our last conference call, we are tightening our R&D focus within the company and realigning resources on both the hardware and software side more towards our core markets. These efforts, which were started in Q2, will be largely done in this quarter. We should exit this quarter with our resources tightly aligned to our focus products. We have a strong roadmap lineup for both existing and new products that significantly expand our talent. We continue to have strong design win momentum and have a very healthy pipeline of design win opportunities which are driving our market share gains.

In summary, we are optimistic that we are very well-positioned to continue driving growth over the coming quarters and years.

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. And after that, we'll be happy to take your questions. Art?

Arthur D. Chadwick

Great. Thanks, Syed, and thanks to all of you for joining us today. I'll first go through Q2 financial highlights and then provide our guidance for the third quarter of 2012.

But first, I would like to remind you that in our press release, we announced both GAAP and non-GAAP results, and ask that you refer to our press release for the detailed reconciliation between the GAAP and non-GAAP results that I will discuss in a moment.

Additionally, the information we provide on this call regarding sales by market does involve certain management judgment as to which market each sale is assigned, and you should consider that when analyzing such information.

Bookings in Q2 were strong with a book-to-bill ratio well in excess of 1:1, driven by strong order growth especially in the enterprise and service provider markets. Revenue in Q2 was $55.3 million, up 5% sequentially. Sales increased to 8 of our top 10 customers during the quarter. Sales into enterprise and service provider market were $38.5 million or 70% of total sales, up 12% sequentially.

Sales into broadband and consumer were $10.6 million or 19% of sales, essentially flat with Q1. And sales of software and services were $6.2 million or 11% of sales, down 21% sequentially. Sales to Cisco were $16.2 million or 29% of sales, up 11% sequentially. Sales to our top 5 customers accounted for 53% of sales, up from 49% last quarter. And sales to our top 10 customers accounted for 66% of sales, up from 62% last quarter.

Non-GAAP gross margins were 60.6%. This was 120 basis points lower than Q1 due to lower gross margin, legacy Celestial business, as well as lower software and services revenue, partly offset by strong enterprise and service provider product mix and higher sales volume.

Non-GAAP operating expenses in Q2 were $32.2 million, a decrease from $32.6 million in Q1 due to cost reduction effort during the quarter. Non-GAAP R&D expenses for the quarter were $20.6 million, and non-GAAP SG&A expenses were $11.7 million.

We ended the quarter with 871 employees, a net decrease of 14 during the quarter. Non-GAAP operating income was $1.2 million or 2% of sales, an improvement over the $58,000 loss in Q1. Income taxes were a net credit of $2.3 million for the quarter. The resulting non-GAAP net income in Q2 was $3.5 million or $0.07 per share, up from $920,000 and $0.02 per share in Q1.

Non-GAAP results excluded $15.3 million in non-GAAP adjustments, comprised of $9.7 million in ongoing stock-based compensation expense, $2.5 million in amortization of acquired intangible assets, $1.7 million in other acquisition-related and restructuring charges and $1.4 million in stock-based compensation expense due to restructuring activities during the quarter.

The GAAP net loss was $11.8 million or $0.24 per share. We ended the quarter with $61.4 million in cash and equivalents, a decrease of $3.7 million from Q1. Inventory at the end of the quarter was $42.1 million, which was an increase of $1.7 million from Q1 in preparation for Q3 shipments. Accounts receivable were $37.8 million, which equates to DSOs of 62 days, as compared to in May, our balance of $37.9 million and DSOs of 65 days in Q1.

I would now like to provide more specific guidance for the third quarter of 2012. Our starting Q3 backlog was higher than it has been in many quarters which bodes well for strong revenue growth in Q3. We expect sales in the third quarter will increase between 8% and 11% sequentially, which would put total sales between approximately $59.7 million and $61.4 million. We are projecting that sales will increase for 8 out of our top 10 customers and will be at least flattish for the remaining 2.

By market segment, we expect enterprise and service provider sales will increase sequentially on a percentage basis in the low double-digits and that sales into broadband and consumer and software and services combined will be flat to up. Non-GAAP gross margins in Q3 are expected to be between 62% and 63%, which would be a 140 to 240 basis points improvement over Q2 due to good product mix, driven by higher service provider and enterprise sales as well as higher overall sales.

We expect further gross margin improvement in Q4 and in calendar 2013 due to improving product mix towards core markets, continued product cost reductions as well as higher overall sales. Non-GAAP operating expenses in Q3 are expected to be between approximately $32.5 million and $32.7 million. We expect to recognize a tax credit of between $0.5 million and $1 million in Q3, a smaller tax credit in Q4 and expect taxes to increase to between 5% and 7% of non-GAAP income in calendar 2013.

Our non-GAAP share count in Q3 is expected to be approximately 53 million shares. Non-GAAP net income in Q3 will exclude approximately $10 million in stock-based compensation expense, $2.5 million in amortized intangible assets and approximately $2 million in restructuring charges. Based on those above assumptions, non-GAAP EPS is expected to be between $0.11 and $0.12 per share.

And at that note, I'd like to hand the call back to the operator so we can begin our Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Sundeep Bajikar for Jefferies.

Sundeep Bajikar - Jefferies & Company, Inc., Research Division

Could you start off by telling us what portion of your revenue is approximately from wireless infrastructure? And off that, how much was base station versus other types of wireless infrastructure?

Syed B. Ali

I think the large majority of our shipments in the wireless infrastructure are non-base-station-related. So it's more some of the RNCs, GSN, the basic back-end infrastructure. Base station was probably I would say kind of 30% of the wireless infrastructure revenues. And wireless infrastructure revenues were roughly 70%, 75% of our service provider revenues.

Sundeep Bajikar - Jefferies & Company, Inc., Research Division

Okay. And on the Cisco front, could you just remind us how many different platforms Cavium is shipping into Cisco currently? And what's the right way to think of the outlook for the Cisco business over the next year or so, just in terms of additional platforms at Cisco or additional content in existing platforms?

Syed B. Ali

Well, currently at Cisco, I don't have an exact number, but the shipping platforms are somewhere in kind of the 20 to 25 range and about 25 I would say. And we are -- been designed into over 50 different ones. So there is still a lot of growth ahead of us.

Operator

Our next question comes from the line of Sanjay Devgan with Morgan Stanley.

Sanjay Devgan - Morgan Stanley, Research Division

Just had a question on Project Thunder, Syed. As you look at this kind of on a go-forward basis, you've had a lot of -- you already have a lot of in-house IP with respect to processor architectures. You have a great design team with a lot of the original deck alpha team members on your team in Cavium. You also have expertise with ARM with the ECONA products. So I was wondering on a go-forward basis, how quickly do you think you can come to market with a product? You talked about recently taping out the NEURON product that's been a really -- relatively aggressive timeline. I was wondering if you can give us any color there. And then beyond that, can you talk to how you kind of rationalize the investments MIPS versus ARM kind of go forward, and give us some kind of color on the served end markets for each of these processor types.

Syed B. Ali

Yes, I think it has been clearly highlighted in our press release for Project Thunder that we have a range of different solutions. We have MIPS in kind of a networking and communications market. We have ARM 32 in more the broadband and consumer. And in the cloud and data center, we are basically taking into market the V8 ARM 64-bit architecture. So what we try to do is we essentially choose A or B based upon what the install software base is, what the ecosystem is and what customers in that end market demand. So having said that, obviously, when you take a look at our OCTEON product lines and our NITROX product lines, then you'll see the multi-core nature of it, you see the significant amount of IP in it. There is a fair amount of IP that can be essentially reused between the 2 product lines. So again, market by market, we will make a determination in terms of which architecture fits us the best instead of trying to full-speed one architecture into a market which is not ready for it.

Sanjay Devgan - Morgan Stanley, Research Division

Fantastic. And then I guess just a follow-up question just for Art. Art, I missed the tax outlook for next year. Just a clarification, was that 5% to 10%?

Arthur D. Chadwick

5% to 7%...

Sanjay Devgan - Morgan Stanley, Research Division

5% to 7%.

Arthur D. Chadwick

On non-GAAP income. Correct.

Operator

And our next question comes from the line of Harlan Sur with JPMorgan.

Harlan Sur - JP Morgan Chase & Co, Research Division

You've redeployed your internal development resources to your core business, and I'm assuming that Project Thunder is one of the reasons for the redeployment, however, I think it's a pretty huge undertaking with the architecture license developed a 64-bit-based ARM core from the ground up. So I guess, Syed, how confident are you that the current run rate on the OpEx is sized properly given Project Thunder? And what is the team doing to leverage the existing infrastructure that you have?

Syed B. Ali

That's a good question, Harlan. When you take a look at it essentially, you've done a number of things. One thing is obviously taken -- reduce the number of chip developments, if you will, on the broadband and consumer side and reallocating that OpEx that would have been spent to projects like Project Thunder. That's number one. And number two, overall, we've done a fair amount of work already on this. We've been working on this for a few quarters now. So we believe that we can execute this in a timely fashion and have a very, I would say, a very, very competitive product in the market.

Harlan Sur - JP Morgan Chase & Co, Research Division

Great. And then on the Cisco, nice growth in Q2. Do you expect further growth in that customer in Q3? And how much of it is just getting back to kind of a more normalized run rate post the hub transition? And how much of the growth is due to new programs ramping? And maybe if you could just highlight some of the new products that you're -- or programs that you're shipping into at Cisco?

Syed B. Ali

Harlan, we don't give out -- specifically give guidance for a customer whether, what they'll be doing. But on an overall basis, Q2 was still a recovery quarter from the hub transition. That's what obviously taken us a couple of quarters longer than we would have liked. But having said that, we still have some room to grow based upon the run rate business alone. And on top of that, we have several programs in the second half starting to go to production, but should really in the back half, I would say, starting Q3 more than Q4 timeframe, these new designs going to production will continue to drive growth for the next few quarters. So in the first half, it's more kind of hub transition-related. Moving into Q4 and beyond, it will be more new designs going to production-related.

Operator

And our next question comes from the line of Anil Doradla with William Blair Investment Management.

Anil K. Doradla - William Blair & Company L.L.C., Research Division

A couple of questions. On the 4G deployment side, the small cells, it sounds like the deployments are happening a little sooner than expectation. Is that a fair way to characterize it? And beyond the Korean customers, how does the trajectory look? And I have a follow-up.

Syed B. Ali

Anil, that's a correct observation. This is a market that has moved quicker than our expectations. It's always good to have some of the markets behave in this way rather than the other way around. But we're going to have the deployment start in Q4. And it's really nice to see. I mean if you take a look at it 2 years ago, we had nothing in this product line. And 2 years later, we have a product in the market and winning a major deployment of what is arguably, maybe it's not the first, but at least it's a very large 4G/LTE small-cell deployment. So I think overall, the team at Cavium, even though the size is very modest, have done a really good job in getting this to market. So it should start in, like I said, the next quarter and then kind of ramp over 2013. Regarding other customers, we are getting a lot of support from various types of customers, whether it is large OEMs or whether it is more ODMs-based. So when you take a look at the small-cell market, there's going to be -- unlike the macro base station, which pretty much was driven by Tier 1 or very large telecom -- telcos -- telecom OEMs, the small-cell market is a mixture of end requirements both for the enterprise and for the service provider deployment. So you're going to see a much more traditional mix of vendors and a larger bag of vendors bringing products to market than for example micro base stations. So we have multiple engagements going on. And one of the really good things about this deployment is, once it goes into mass deployment, this really validates the technology, both from a system viewpoint and software viewpoint. And believe it -- believe me, the interoperability aspects and the robustness is a huge factor, and this will really help I think drive design wins that in other locations and other customers also just because it's already being deployed in one major deployment in the world.

Anil K. Doradla - William Blair & Company L.L.C., Research Division

Great. And coming to the wireless display technology, your PureVu technology in the mobile handsets. I mean it's clear that your technology has been embraced by several Tier 1 handset vendors. What is the outlook for that segment? And clearly, you'll have some near-term benefits with some of the initial production. But as we look out, maybe a couple of quarters from now, how does that pan out?

Syed B. Ali

The initial production shipments from the 2 that have launched along with their mobile phones, production shipments have started. The second one -- the first one actually started kind of late Q2. The second one is just starting in Q3. So we have some modest unit volume on backlog for Q3. We expect it to grow. But once again, I think, to put a number on it, until we kind of see it sell-through and see what the customer demand is over the next quarter or 2, I think we'll get a better idea.

Operator

Our next question comes from the line of Blayne Curtis with Barclays.

Blayne Curtis - Barclays Capital, Research Division

Maybe first for you, Art, with a strong gross margin guidance, I'm assuming that the mix to enterprise and service provider you've been talking about, but maybe talk about what contributed to that. And as you look out, it looks like you're targeting continued strong growth in that segment, is that going to be a tailwind? And then as you look at some of these new projects, like Project Thunder, how does some of these tape outs affect the gross margin of actual quarters?

Arthur D. Chadwick

Sure. Well, I think your observation is correct in terms of the product mix. Again, our gross margins in enterprise and service provider are very strong, higher than our corporate averages. So that becomes a larger percentage of our overall sales, which is what's happening in Q3 that drives higher gross margins. Also as our top line increases, then the cost of sales, which is a more relatively fixed cost of sales for us, becomes a smaller percentage. So that also helps gross margins going forward. In terms of tape out, we've had tape outs every year. We amortized it pretty quickly over 12 months, and I don't really see a significant change in that as a percentage of sales over the next year or so. So I don't think that's going to have a significant impact one way or the other next year versus this year. But I think the general message is that we do -- we have a good tailwind with our gross margins. They're improving nicely in Q3. They're going to improve more in Q4, and I think they'll continue to improve in 2013 for exactly those reasons.

Syed B. Ali

And just another comment, Blayne. Project Thunder gross margins will be in the higher end of the spectrum.

Blayne Curtis - Barclays Capital, Research Division

Got you, helpful. And then the software business was down as planned with the reallocation. Is this the new level, or is there some more that will fall off there?

Syed B. Ali

We think that this is approximately the level at which we're going to stabilize it at, based upon the resources we have taken out. So I would just look at it as kind of flat to slightly up now over the next few quarters.

Operator

And our next question comes from the line of Steven Eliscu with UBS.

Steven Eliscu - UBS Investment Bank, Research Division

First question here. Just given some of the visibility you have with your service providers contracts, can you give us a sense with the growth you're seeing in Q3, the trajectory into Q4? I guess the concern would be that you have a nice build this quarter and then it tails off next quarter just given some of the macro headwinds. Or are you in a position where some of your design wins actually are giving you more of a tailwind into Q4?

Syed B. Ali

One of the things about our service provider wireless infrastructure business, is it is multi-customer based. It's not a single customer. It's multiple geography-based and it's multiple product base. So we see this -- the service provider as kind of a tailwind. Obviously, in some quarters the growth maybe lower, in some quarters higher. But over the next few quarters, we expect this business to grow nicely.

Steven Eliscu - UBS Investment Bank, Research Division

Okay, great. And also just looking at Project Thunder, I guess looking at the competitive landscape, clearly Intel is driving this very aggressively. If we look a couple of years out in their micro server product line, just given what they've talked about recently, they should be at 40-nanometer with at least some of their products. Given the foundries you're working with won't necessarily be quite at that level, how do you -- how will you offset the process disadvantage through architecture?

Syed B. Ali

I think in any large market, whoever the incumbents are, if you basically are driving the -- trying to drive the same value proposition, you're not going to be very successful. We believe that we have carved out a very differentiated position amongst this market. And there is several interesting, I would say, subsegments where we can add a significant amount of value.

Steven Eliscu - UBS Investment Bank, Research Division

Can you elaborate a little bit on that?

Syed B. Ali

Steve, due to competitive reasons and others, I would rather leave it at that. We will be announcing more details of this as we go along on the execution of this project.

Steven Eliscu - UBS Investment Bank, Research Division

And just one final question here, OpEx percentage of sales, you've talked about around 50% is your goal. Just given the scope of this project, do you think you can maintain that?

Arthur D. Chadwick

Steve, we do. We think that between now and probably the end of 2013, so that's going out 6 quarters, that OpEx should grow at about 1/3 of the rate that our top line grows. And the answer is, yes, we think that we can fund these programs with that type of OpEx. Just to remind you, the OpEx in Q2 that we just finished included a fair amount of Thunder development as does the guidance that we gave for Q3, and it is reusing a lot of the IP that we have in-house. So we believe that we can continue the development of the programs that we've announced with OpEx at these levels.

Operator

And our next question comes from the line of Quinn Bolton with Needham & Company.

Quinn Bolton - Needham & Company, LLC, Research Division

I wanted to ask about the KT and SK Telecom wins. I believe one of your competitors, Mindspeed, is also sort of claiming wins at both of those carriers. So can you just sort of talk about the competitive landscape in Korea and takes into these are multi-sourced. Any sense of what share of the small cell requirements at those carriers you'll be able to supply?

Syed B. Ali

Quinn, I don't want to make any comments about any other competitor. I think it's best if you ask them. But I can make a comment about our participation in this market. We are -- we believe we are going to get an, I would say, unfair share of this first-stage deployment.

Quinn Bolton - Needham & Company, LLC, Research Division

Okay. And then on Project Thunder, it sounds like obviously, with an ARM-based solution, you guys are going to be going after sort of -- but also running some of that, that the key applications in the data center and cloud is -- I mean I know you don't want to say too much, but is this going to be targeting things like LAMP or Hadoop-type applications or is that getting to a level of specificity that you don't want to talk about yet?

Syed B. Ali

We don't want to kind of get into the details of the workload that we are targeting and what kind of value proposition we'll be bringing to those markets quite yet. But it's suffice to say that we are working with Tier 1 customers who have helped really define the product, give us benchmarks in terms of what we need to hit at what cost and what power points. So we do all this work before we kind of jump in to execute the product. We're not a company that says, "Let's design a product today and then, hey, when it comes out, let's go and check if there's a market for it and we can be competitive." There's a lot of the groundwork has been done and we're pretty confident that we are really going to bring a very different and enhanced value proposition in terms of kind of performance cost power metrics compared to the existing way of doing things.

Quinn Bolton - Needham & Company, LLC, Research Division

Syed, just on that notice, obviously, you've got 64-bit MIPS architectures in a portfolio already is -- does ARM just bring you a lower power consumption capability, and hence, the reason to look at that architecture for some of these data center and cloud applications?

Syed B. Ali

Like I said in my -- in our prepared comments, right, when you take a look at the networking and communications market, we have gone with MIPS because MIPS had a more established customer base and more established install software base and ecosystem. When you look at the data center, definitely the equity picks as its king, but the -- but ARM is spending a lot of investment in really developing the ecosystem of that. So we have kind of chosen the ARM V8 architecture for this market and this is one of the main reasons for it.

Operator

Our next question comes from the line of Hans Mosesmann with Raymond James.

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

Also on Project Thunder, just 3 areas. What's the size of the market or the TAM expansion opportunity overall for Cavium? What's the timing? And what is your special soft compared to other options that are going to be out there from a pipe micro NVIDIA and LSI?

Syed B. Ali

Hans, do you want to sign an NDA?

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

Oh, sorry. Then the other 2 questions.

Syed B. Ali

Okay. So essentially, from a timing viewpoint again, for competitive reasons, we are not giving much granularity on that. But in terms of the value proposition, again, we have looked at everything in the market today and what we expect to come down over the next couple of years. And again, we feel pretty confident that we have our I's dotted and our T's crossed in terms of value proposition that we want to bring to market. And what was the other question, Hans?

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

It's just the size of the market or how...

Syed B. Ali

Yes, so this is definitely what we think is the kind of the target markets amongst this overall large market that we're looking at and kind of compute in storage and data Center, the TAM addition is definitely in the few billion dollars plus range, the market that we are going to be able to address.

Operator

And our next question comes from the line of Krishna Shankar with Roth Capital.

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Syed, can you talk about the -- what you see as sort of the market opportunity with the micro-cell deployment by SK Telecom and KT? What the sort of revenue opportunity is for you over the next 12 to 18 months?

Syed B. Ali

I don't want to kind of get into that granularity, but it's definitely a large scale deployment and it's going to cover pretty much many of the metro areas. So, it's, without kind of getting specific in terms of the actual number, it will be meaningful to our revenues.

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Okay. And then maybe I missed it, but can you talk a little more about the 2 smartphone design wins you have for PureVu and what the ramp there might be?

Syed B. Ali

I think we announced HTC as one and then the other large mobile phone manufacturer also launched with us. So at this quarter, it's in kind of a few hundred thousand pieces range and maybe the jury's out in terms of what the volumes will grow. Well, I think we will have decent growth in this market over the next few quarters. Again, we are taking a pretty conservative outlook. Let's see what happens before we get the numbers to become too big.

Krishna Shankar - Roth Capital Partners, LLC, Research Division

Okay. And my final question, the pickup in service provider and enterprise, is a lot of those platform ramps driven by OCTEON II or is there some OCTEON Plus also in there?

Syed B. Ali

Pardon? No, there's OCTEON -- there is some OCTEON Plus. But the newer ramps -- it is actually a mixture of both, I'm sorry. But the OCTEON II is in the early stages.

Operator

And our next question comes from the line of Sujeeva De Silva with ThinkEquity.

Sujeeva De Silva - ThinkEquity LLC, Research Division

In terms of the Asia wireless infrastructure market, I know you guys have design wins there on your content. Is that a market you're seeing recovering? Or are you gaining share perhaps offsetting maybe demand weakness there?

Syed B. Ali

Again, I don't think Asia is one homogeneous market. There are pockets. I mean in Q2, I talked about inventory correction was still going on in certain regions of Asia-Pacific. But the good thing is that their backlog already is higher than it was last quarter. So we feel pretty good that we've kind of worked our way through that. There's a primary reason for the growth. When you take a look at our total revenues in this segment versus our total design win dollars, there is a long, long way to go. So it's essentially we have taken share from the existing vendors used to supply into the space and those designs are the ones that are starting to ramp.

Sujeeva De Silva - ThinkEquity LLC, Research Division

Great. And then on the opportunity you have in Korea, can you talk about if that's with a Tier 1 OEM into the telcos? Or are you selling it through an ODM who's helping make it through the carriers?

Syed B. Ali

If you look at it actually, there's a mixture of both.

Sujeeva De Silva - ThinkEquity LLC, Research Division

Okay. And last question for Project Thunder. Is that going to bring new customers into your mix or is this existing customers?

Syed B. Ali

Definitely, it will bring a whole bunch of new customers into the mix.

Operator

Our next question comes from the line of Raj Seth with Cowen and Company.

Raj Seth - Cowen and Company, LLC, Research Division

Syed, could you update us on the anticipated ramps of the base station wins you have? As I recall, sort of from here through next year, the 3 base station vendors where I believe you have wins are a material growth driver. Can you talk about what the trajectory of that ramp may look like?

Syed B. Ali

Raj, the first base station, obviously -- the first customer who started to ship in volume has already done that starting Q2 and is going to grow for the next several quarters until he kind of gets to run rate. The second customer is just starting late this quarter, not a whole lot of volume. There'll be more in Q4. And then towards the end of the year, we have a third guy starting to go to production. So essentially, when you take a look at base station sales, many of these base station customers are using us in the base station also use us in the backhaul, whether it's [indiscernible] for 3G and GSM or it's EPC. So it -- when you deploy base stations, it -- you also deploy everything in the back end, otherwise, that becomes kind of the bottleneck, if you will. So again, like I said in our prepared comments and to some of the Q&A, that we expect for the next several quarters, service provider business especially in the wireless infrastructure will be a good tailwind. Obviously, there may be some quarters which are lower and some quarters that are higher. But in aggregate, over the next several quarters, I think this will be one of our shining stars, if you will.

Raj Seth - Cowen and Company, LLC, Research Division

And you mentioned, Nokia, I presume, was the one who started to ramp at some point in the next couple of quarters reaching its sort of run rate. What's the best way to think about what the contribution for base station can be over time? And just how...

Syed B. Ali

I think what -- in previous tech conferences and Q&A, we've kind of sized a base station opportunity as roughly in kind of the $20 million to $25 million A customer range. Obviously, for a customer, there are many, many different SKUs. Some that go into certain markets with certain spectrums, some that go -- so there's a lot of SKUs. There's tens of SKUs within a base station. And there are different standards, there is WCDMA, there is LTE, there's HSPA+, the VMDF. There's a whole bunch of standards. So overall, I think at the highest level, some will be larger, some will be smaller. But on an aggregate, we model them at roughly in the $20 million to $25 million a year for a customer.

Raj Seth - Cowen and Company, LLC, Research Division

Right. One quick one for Art, if I might. Art, ARM architectural licenses are expensive. Can you just review the accounting on a deal like that? You just amortize over the life? Or how does that work?

Arthur D. Chadwick

Yes, that's exactly right. So we amortize it over the life of the license, which is multiple years.

Operator

Our next question comes from the line of Arnab Chanda with Avian.

Arnab K. Chanda - Avian Securities, LLC, Research Division

Just a couple of questions. First, for either Syed or Art, so if you look at the wireless infrastructure market, in the base station side, the market is dominated by sort of 5 major suppliers, maybe 6. It seems like you have a pretty good position there. Can you first talk about how -- you're talking about 33% market share. I would presume that's more in the enterprise market historical. How do you see your market share in the sort of wireless base station, large base station market, where it seems like there's a bunch of other legacy guys like TI and then there's a couple of new entrants like LSI and maybe even Mindspeed?

Syed B. Ali

Arnab, our goal in the wireless infrastructure, overall, I'm not talking only about base stations, but the entire, the whole backhaul too which includes radio network controllers EPC. Our target is over 50% of this market. And we believe that where we stand with the design wins that we have and what are in process that we could become the major player in this market.

Arnab K. Chanda - Avian Securities, LLC, Research Division

Okay, great. And then if you could just talk specifically about the sort of micro cell or the small cell. It seems like you've been kind of aggressive earlier than some of the other players. It seems like they've kind of either missed it or haven't tracked it. I guess I have 2 questions in that area. One is, is that do you think that could be kind of a Trojan horse for you, given in the towards the macro side and increase your share? Is there some cannibalization within the macro? And then also, are you going to get new customers there? You're saying it sounds like there are some ODMs and other people, or maybe not in the macro market, want to get in there.

Syed B. Ali

Yes. I mean this -- the small-cell market I think has the highest number of announced products, but the fewest amount of product that can be deployed, which are ready for prime time. So essentially, our value proposition has been very simple. We have a very, very disruptive architecture on the hardware side. But also very importantly, we are delivering a complete solution. If you take a look at the many of the other vendors, they try to cobble together a software solution that is bits and pieces from company A, company B, company C, their licenses and put it together. And guess what, I mean in the service provider environment, the corner cases and the reliability and the improbability are so important that -- and that has been one of the reasons why we have come from almost starting from standstill, being able to get into the first deployment. And regarding your second part of the question whether it also helps in driving our macro base station business, the answer is absolutely yes. If you take a look at the small cell, the Layer 1 and Layer 2 stuff, whether it's the physical layer or base band, we have that technology and that technology can be scaled to address even larger requirements.

Arnab K. Chanda - Avian Securities, LLC, Research Division

Okay, great. And then just one last question about Project Thunder. So obviously, there's been one company, the MCC, has been very public and has been talking about these things for a long time, FPG, et cetera. There's other companies like NVIDIA have sort of public, private secret things going on like Project Denver. If you look at your position, this is obviously a new market for you in terms of market, are you able to leverage your current OEM relationship? Or do you think this gets you into new OEMs? Then how do you compete in a market where some other people can definitely make a little bit of noise in cores?

Syed B. Ali

I think the answer is it's a mixture of both. From an overall view point, again, I think we are further ahead than you would think. So again, without getting too much into the specifics of the product and timing. Looking at everything that is there in the market today and what we expect to come down over the next 2 years, we believe that we will have a very competitive product, number one. And number two, we already are engaging with some of the Tier 1 customers. We are engaging with the software ecosystems. So you'll be hearing more and more about this over the coming quarters.

Operator

Our next question comes from the line of Brian Modoff with Deutsche Bank.

Brian T. Modoff - Deutsche Bank AG, Research Division

Just one question. Just -- I'm just trying to understand if kind of the guide was in line, and I know that it's a tough environment so it's good to see that. But you've talked very bullishly about a book-to-bill and I'm curious, is there -- is some of this really falling into the beyond quarter or into next year? Can you talk a little bit about -- give us a little color on the -- or on the makeup of the book-to-bill? Is this kind of from a timing standpoint? Just trying to understand the correlation between the strong order trends and the in-line guide.

Syed B. Ali

Just a correction, Brian, I think the guide is not in line, but that's your opinion. When you take a look at the guide that we've given which was the bookings, we have obviously taken a conservative view. And even with that, we are giving a guide which is much more stronger than probably most of the peers.

Brian T. Modoff - Deutsche Bank AG, Research Division

Okay, fair enough. And can you give us some color, though, on the outlook beyond that? I mean how are you looking into Q4, just kind of little longer term?

Syed B. Ali

Well, Q4 is still far away. But again, I've talked to you about the trends. Service provider should be up over the next several quarters, great growth. Enterprise has been growing well, but now we have some special designs -- not special, but newer designs going to production with product cycles, app companies like Cisco, F5, Citrix, Palo Alto Networks for example is a new customer that is ramping very well for us and they use us top to bottom. So we are getting a mixture of new products, designs at existing customers and newer customers going to production and being very successful in the market with our products. So on any given quarter basis, it's difficult to say. But kind of looking over the next few quarters, we feel that we should see a good demand environment. And obviously, if the macro improves, that will be good for everybody and that will just be additive to what we talked about.

Operator

Our next question comes from the line of Ruben Roy with Mizuho Securities.

Ruben Roy - Mizuho Securities USA Inc., Research Division

Syed, I had a question just around resources. Obviously, with the shift of the software resources, I understand those resources are being redeployed. But as you think about Project Thunder and look at some of the other programs that you've been working on like a PureVu, et cetera. Are you going to be deemphasizing any specific programs either in enterprise service provider or broadband and consumer as you look ahead and you add what seems to be an ambitious project with the Project Thunder?

Syed B. Ali

No. If you take a look at my last conference call, I did address this question. We are reducing the number of chip developments on the broadband and consumer side significantly and focusing on just a couple of verticals where we believe we have a strong value proposition. And essentially, the OpEx room it has opened as comfortably large enough for us to be able to fund things like Project Thunder. No other project, whether it's in OCTEON or a NITROX or a Fusion, is going to be affected at all by this. It's just -- it takes some away from the broadband and consumer market, applied -- and applying it to the Thunder market. And overall, we are aggressively hiring people for our core products.

Ruben Roy - Mizuho Securities USA Inc., Research Division

Okay, great. And then just a quick follow-up on the NEURON. You mentioned the validation process kind of going on initially with some large customers. How does that compare to kind of your expectations on timing? And has anything changed with any of your sampling expectations, revenue expectations, et cetera?

Syed B. Ali

Compared to expectations, Ruben, this has actually surpassed our expectations in terms of customer pull. Also, we have added a bunch of customized features for I would say 2 or 3 Tier 1 customers under this product. So it will be a very, very easy kind of design in once we get the product out. So we are very bullish about this market and our ability to be a significant player.

Operator

Our next question comes from the line of Alex Gauna with JMP Securities.

Alex Gauna - JMP Securities LLC, Research Division

I was wondering if with those significant projects under customers you're talking about, are any of those internal, meaning, somebody major cloud vendors, something like iCloud pulling on your solutions?

Syed B. Ali

Alex, we are engaged in a number of places. And again, it's a mixture of Tier 1 guys, cloud guys and ecosystem guys. So essentially, our goal here is to run like hell and get the product out into the market. We believe if we do that, that will be accepted pretty nicely because of the value proposition we're bringing in.

Alex Gauna - JMP Securities LLC, Research Division

And I apologize, I missed part of your call, the run like hell, what is the timing you're getting in this into the market are your estimates?

Syed B. Ali

We have not given any estimates for competitive reasons and for a whole bunch of other reasons. You'll see stuff coming out over the next few quarters.

Alex Gauna - JMP Securities LLC, Research Division

Okay. Can you give some color on PureVu and where it's engaged right now? I was wondering are there opportunities with any of the other standards out there like WiFi Direct to fold into that dovetail off of that with PureVu? Or is it doing its own thing distinctly by itself?

Syed B. Ali

No, this particular product, our PureVu product works with both the standard WiFi and WiFi 802.11n. It also works with WiFi Direct. So that is essentially the WiFi piece. And our chip does the processing once the data comes off the wireless -- the WiFi channel. So we inter-operate with pretty much any physical layer device, whether it's WiFi. Some people are doing it with over power line. So there's a mix, but the value proposition of the functionality it brings is very similar.

Operator

We have no further questions. Ladies and gentlemen, thank you for participating in the Cavium, Inc. Second Quarter 2000 (sic)

Earnings Conference Call. If you would like to listen to today's replay, the phone number is 1 (800) 406-7325, access ID 4549886. Thank you for your participation. You may now disconnect.

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