Interview with Silicom's Founder and Chairman of the Board

The interview first appeared in Israel Opportunity Investor, our subscription newsletter:

• • •

Can you tell us a bit about the history of Silicom (Nasdaq: SILC)?

Avi Eizenman, Founder and Chairman of the Board: When we founded the company in 1987, our original idea for the firm was that we would be a fabless IC company. We were profitable almost from day one, and this is something that’s in the fabric of the company.

We quickly found that larger companies didn’t want the risk of having a fabless supplier in Israel. So, from ICs we moved to communication solutions for portable computers in 1993. We developed a solution to use the computer’s parallel ports to communicate with LANs. We pretty much missed the market as a larger, better funded U.S. firm launched a similar product before we did. We then evolved into creating PMCAs.

As we dual listed on NASDAQ and the Tel Aviv Stock Exchange [TASE] in 1995, sales grew to $7-8 million with profit of $1 million in 1996. The stock was trading in the mid-teens. From here, we saw early on that as the server market was moving from general servers to more developed appliances, the need for connectivity adaptors would increase geometrically. So by 2007, we are putting up revenue numbers close to $27 million, which is 66% growth year over year. Our net margins are over 20%.

Why the current focus on server adaptors?

AE: There are many reasons to add additional ports to servers. It’s not easy to put multiple ports on a card. It requires a high level of quality in the engineering process. There just aren’t too many companies doing this. We like to think about what’s happening by looking at another Israeli company, Check Point (Nasdaq: CHKP). A while back, the firm said, “Hey, we’re a software company.” If you want a firewall, buy the software from us but you’re going to need to buy a box from someone else. Now Check Point sells an integrated box. This trend to supply both hardware and software in appliances has led to increased demand for connectivity ports.

We have 60 different products today, and most of the sales come from about 10 products. We feel that having a broad selection is extremely important for a vendor to win new OEM business.

What’s the sales model?

AE: We know from previous experience that we’re not capable of selling to end users. Instead, we know how to sell via OEMs and that’s what we do. For server adaptors for general purpose servers, you would have to sell to the millions of end users by dealing with computer distributors. In the server appliance industry, distributions occurs directly with the firms who make the appliances — companies like Check Point (CHKP), Cisco (CSCO), and Juniper (JNPR).

Is there a technology advantage that Silicom sports?

AE: We do have IP in our products. We’ve developed a fail open bypass solution with an algorithm to ensure connectivity in event of a failure at the device level. This has been an differentiator.

How so?

AE: While other companies have also developed a similar solution, we have about 50% market share in bypass server adaptors. We probably have about 10% of the general server adaptor market. Both markets are probably growing at the same pace.

So what does your competition look like?

AE: We’ve got one very large competitor, Intel (INTC) that competes with us in the server adaptor market. Intel doesn’t have a bypass solution so about 20-30% of our sales has overlap with Intel. Intel has a name, huge distribution channels, and history in the market. They probably have almost 90% of the general purpose market. We think they may have lost market share in the appliance market because of how important having a bypass has become.

We also see a Silicon Valley-based firm called Interface Masters as direct competition. They have good products and a good model.

Two companies provide ICs for server adaptors. Intel can provide ICs on one side and server adaptors on the other which means that they compete with their customers. Broadcom (BRCM) does ICs only and chooses partners to do the server adaptors.

Are you seeing new design wins?

AE: We saw eight design wins in 2007. We typically see two new design wins every quarter. We see growth coming in three different ways. First, we are attracting new customers. The lifecycle for a appliance is about 3-4 years. When a new appliance launches, OEMs open up to new vendors. Secondly, we’re able to sell more products to existing customers. Lastly, we are riding the wave of a market that’s growing.

Is there leverage in the model?

AE: Given the fact that we sell mostly to OEMs, it isn’t hard to increase sales while keeping sales expenses relatively flat. The downside of this leverage means that we don’t have a lot of forward visibility into our sales pipeline. While we have had some downside surprises, we typically have gross profit of about 50% and operating margin of 25-26%. This has room to grow, as well.

What about employee growth?

AE: We have about 70 employees. We are seeing slow growth in head count but we are growing. Silicom is an unusual company. I’ve been with the firm for 21 years. There are over 10 people who have been with Silicom for over 10 years. People stay here longer which is atypical in high tech.

Do you have any upcoming catalysts for the company?

AE: Given the fact that we work so closely with our OEM customers, we feel that we learn a lot about their businesses. Based on customer feedback, we’ll be launching a new encryption product line soon. As processing speeds increase, software is having an increasingly harder time keeping up to move at 10 GB/sec. We’re first to market with a 10 GB/sec bypass product.

For a small firm, you have a significant amount of market cap in cash. What are your plans for your balance sheet?

AE: We’ve identifies some future product lines we’d like to get into. The money is all in liquid bonds, paying around 5%. We may want to hire more business development and R&D people.

What are you doing to raise interest in Silicom in the investor community?

AE: I do a quarterly roadshow after every earnings season. I spend about one week a quarter in the U.S., and see between 20 and 30 different potential investors. We also conduct quarterly conference calls.

What kind of risk do you see for Silicom going forward?

AE: While we don’t see INTC getting aggressive about our market, we do think that the risk in our model comes from IT spending levels in the economy. If IT spending takes a big hit, we’ll be negatively affected. But what’s interesting is that we traditionally don’t see price erosion in a market that generally erodes over time because we’re frequently in a single supplier situation.

Disclosure: The author’s fund has a position in SILC as of May 21, 2008.

Comments

[coadtex]

Why didnt you ask about the decline in the share price?

[Zack]

We met with SILC a week or two before the precipitous drop in May. Stock price was hanging in then.