Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Gwyn Lauber – Director, IR

Eyal Waldman – Chairman, President and CEO

Michael Gray – CFO

Analysts

Daniel Amir – Lazard Capital

Glenn Hanus – Needham & Co.

Joseph Wolf – Barclays

Kevin Cassidy – Stifel Nicolaus

Dan Harverd – Deutsche Bank

Brent Bracelin – Pacific Crest

Brian Freed – Wunderlich Securities

John Pitzer – Credit Suisse

Harlan Sur – J.P. Morgan

Shebly Seyrafi – FBN Securities

Alex Gauna – JMP Securities

Mellanox Technologies, Ltd. (MLNX) Q3 2012 Earnings Call October 17, 2012 5:00 PM ET

Operator

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

[Operator Instructions]. As a reminder this conference is being recorded.

I will now turn the call over to Gwyn Lauber, who will introduce today’s speakers. Please begin.

Gwyn Lauber

Good afternoon and welcome to Mellanox Technologies’ fiscal third 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 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 statements that 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 August 3, 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'll turn the call over to Eyal for his opening remarks. Eyal?

Eyal Waldman

Thank you, Gywn. Good afternoon, everyone, and thank you for joining us. On today's call I will highlight our third 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 fourth quarter guidance. After that we will be happy to take your questions.

For the third quarter of 2012 Mellanox reported quarter revenue of $156.5 million, up 17.2% from $133.5 million in the second quarter of 2012 and up 129.6% from $68.2 million in the third quarter of 2011. The third quarter non-GAAP gross margins were 70.5%; non-GAAP operating income was record of $60.9 million or 38.9% of revenues; and non-GAAP diluted earnings per share was a record of $1.37, representing 38.4% growth quarter over quarter from $0.99 in the second quarter. Sequential growth in non-GAAP operating income was 42.5% while sequential growth in revenue was 17.2%.

Our cash and investments increased $77.6 million during the third quarter. We generated cash from operations of $74.4 million, ending the quarter with $405.4 million in cash and investments.

During the quarter we continued to benefit from our growth in FDR InfiniBand products which represented 57% of revenues compared to 54% in the second quarter of 2012 and 31% in the first quarter of 2012. Revenue from our 10 and 40-gigabit Ethernet products increased during the third quarter, and we continue to provide the industry's only comprehensive end-to-end 40-gigabit-per-second Ethernet solution.

On Monday we announced our sixth generation switch IC, SwitchX-2, which enables the world's highest performing software-defined networking infrastructures over InfiniBand or Ethernet. SwitchX-2's advanced feature set enables the creation of larger flat software-defined networks with lower cost and higher performance. Mellanox's SwitchX-2 virtual protocol interconnect switch leads the industry with the highest throughput capacity, lowest latency with nearly zero jitter, as well as advanced software-defined network interfaces for control and management. Our fast RDMA-based interconnect technology leads the competition in terms of performance, software-defined network technology, and return on investment, advantages it brings to IT application managers.

Last month Microsoft officially released Windows Server 2012 with our InfiniBand and Ethernet RDMA interconnect drivers in-box. Mellanox's RDMA interconnect solutions accelerate and improve performance of Windows Server 2012 based storage, cloud, Web 2.0 and high-performance applications. Our collaboration with Microsoft has resulted in new capabilities and performance records with Windows Server 2012 and will enable the creation of efficient cloud and database infrastructures based on Hyper-V and SQL. Using the Microsoft Mellanox solution with help IT managers to simplify deployment and to meet their performance goals at a much lower total cost of ownership.

Through our continued innovation, Mellanox has become the first company to provide an end-to-end InfiniBand and Ethernet interconnect solution with SRIOV over VMware ESXi 5.1. Our 40-gigabit Ethernet interconnect products have demonstrated record virtualization performance over VMware ESXi 5.1, maximizing the number of virtual machines running on its server.

In addition, our new Voltaire storage accelerator Virtual SAN software appliance utilizes RDMA, InfiniBand and Ethernet hardware acceleration to deliver 6x faster performance than using fiber channel SAN storage systems. This reduces the cost of fiber channel and storage system infrastructures while enabling unprecedented application performance over our virtualized infrastructure. With Mellanox's fast interconnect solutions, IT managers can deliver to their users superior application performance over a virtualized server and storage environment while reducing overhead, simplifying management, and maximizing their data center infrastructure return on investment.

Our InfiniBand solutions continue to be the interconnect foundation for Oracle's data center and storage products. In addition to Exadata, Exalogic, SuperCluster, Exalytics and VSS storage, InfiniBand now connects their new public and private cloud services, enabling seamless communications.

We are seeing more cloud providers moving to InfiniBand from Ethernet to better enable their scalable, on-demand cloud-hosting platforms and infrastructures. Examples include ProfitBricks who through Mellanox InfiniBand is able to deliver 4x higher transfer rate at nx lower latency than their competition who use 10-gigabit Ethernet. In addition, leveraging InfiniBand's performance, efficiency and scalability capabilities, Atlantic.net can perform server provisioning in just seconds, provide extremely fast disk performance, reduce their cloud infrastructure costs, and provide better services to their customers. We expect to experience growth of InfiniBand utilization in the cloud into 2013.

Now, I'll turn the call over to Michael for a review of our third quarter 2012 financial results and our expectations for the fourth quarter of 2012. Michael.

Michael Gray

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

Total revenues in the third quarter were $156.5 million, up approximately 17.2% from $133.5 million in the second quarter of 2012 and up approximately 129.6% from $68.2 million in the third quarter of 2011.

Our non-GAAP gross margins in the third quarter were 70.5%, unchanged from the second quarter 2012 and compared to 68.2% in the third quarter of 2011. Major reconciling items from GAAP to non-GAAP gross profit are share-based compensation expenses of approximately $406,000 and the amortization of acquired intangibles of roughly $1.9 million.

A few selected Q3 2012 revenue metrics for you. Combined revenues from our IC and board products represented approximately 53% of our third quarter revenues. Switch systems revenues accounted for about 30% of our revenues.

Revenues from our 56-gigabit-per-second InfiniBand-based products represented 57% of revenues in the third quarter, up from 54% in the second quarter. Revenues from our 40-gigabit InfiniBand based products represented approximately 31% of our third quarter revenues, unchanged from the second quarter of 2012. Our 20-gigabit InfiniBand-based products represented roughly 4% of revenues in Q3 compared to 5% in Q2 of 2012. Ethernet-related revenues represented approximately 7% of third quarter revenues, similar to 7%, the same figure, in the second quarter of 2012.

We had three greater than 10% customers in the third quarter that, combined, represented approximately 48% of revenues. They were HP at 19%, IBM at 18% and Polywell Computers at 11%.

Third quarter non-GAAP operating expenses decreased by approximately $1.9 million sequentially to $49.5 million and represented approximately 31.6% of revenues, compared to $51.4 million and approximately 38.5% of revenues in the second quarter of 2012. Major reconciling items from GAAP to non-GAAP operating expenses are stock-based compensation of $9 million and amortization of acquired intangibles of $439,000.

Moving down our income statement, our non-GAAP research and development expenses were $31.3 million in the third quarter compared to $33.1 million in the second quarter, representing a sequential decrease of approximately 5.4%. The decrease was primarily due to lower tape-out costs, decreased employee-related expenses, which were partially offset by increases in outsourcing expenses and internal purchases.

Non-GAAP R&D expenses for the third quarter represented approximately 20% of revenues, down from roughly 24.8% of revenues in the second quarter. Our non-GAAP sales and marketing expenses were $13.5 million in the third quarter compared to $13.3 million in the second quarter, representing a sequential increase of approximately 1.7%. The increase was primarily due to higher employee-related expenses. Non-GAAP sales and marketing expenses for the third quarter represented approximately 8.7% of revenues, down from roughly 10% of revenues in the second quarter.

Non-GAAP general and administrative expenses were $4.6 million in the third quarter compared to $4.9 million in the second quarter of 2012, representing a sequential decrease of approximately 6.2%. The decrease was primarily due to a decrease in employee-related expenses. Non-GAAP G&A expenses for the third quarter represented 2.9% of revenues, down from 3.7% of revenues in the second quarter of 2012.

Non-GAAP operating income was $60.9 million in the third quarter and represented 38.9% of revenues compared to $42.7 million or 32% of revenues in the second quarter of 2012. Through the first nine months of 2012, our non-GAAP operating income has increased approximately 273% compared to the first nine months of 2011 while our first nine months of 2012 revenues have grown roughly 103% compared to the same period last year.

Other income of $585,000 in the third quarter was primarily associated with higher interest income and foreign exchange gain. This compared to other income of $221,000 in the second quarter of 2012.

Our non-GAAP income before taxes was $61.5 million or 39.3% of revenues in the third quarter compared to income before taxes of $43 million or 32.2% of revenues in the second quarter of 2012. The third quarter tax expense of $1.4 million compares to $100,000 tax expense in the second quarter of 2012. The increase in the current quarterly tax rate is attributable to the recognition the deferred tax assets in Israel in the amount of approximately $900,000 in the second quarter of 2012.

Our third quarter non-GAAP net income was $60.1 million or $1.37 per diluted share and included adjustments of $9.4 million for share-based compensation and amortization of acquired intangible assets of $2.3 million. This compares to our second quarter 2012 non-GAAP net income of $42.9 million or $0.99 per diluted share and included adjustments of $8.4 million for share-based compensation and amortization of acquired intangible assets of $2.3 million. Our third quarter 2011 non-GAAP net income was $13 million or $0.34 per diluted share.

Our GAAP diluted share count for the third quarter 2012 was 44.4 million compared to 43.5 million in the second quarter of 2012. GAAP basic shares count used in computing income per share for the third quarter was 41.9 million compared to 40.9 million for the second quarter of 2012.

Moving on to the cash flow statement, our operating activities provided approximately $74.4 million of cash during the third quarter compared to $59.2 million in the second quarter of 2012. Net cash used in investing activities during the third quarter was $73.9 million and consisted of net purchases of short-term investments of $63.2 million and purchases of property and equipment and leasehold improvements of $10.5 million. Net cash provided by financing activities during the third quarter was $13.6 million and consisted primarily of cash proceeds from option exercises of $13 million and excess tax benefits from option exercises of $1.1 million, partially offset by $481,000 for capital lease payments.

Turning now to the balance sheet, our cash and investments were $405.4 million compared to $327.8 million at June 30 of 2012. Our accounts receivable decreased approximately $2.1 million or 3.8% to $52.6 million during the quarter. Our day sales outstanding decreased to 32 days compared to 35 days in the prior-year quarter. Approximately 99% of our outstanding AR amounts are current or less than 30 days overdue.

Third quarter ending inventory increased $2.9 million or 9.4% to $34.3 million compared to $31.4 million in the end of the second quarter. Our inventory turns were at 5.9 times during the third quarter compared to 5.2 in the second quarter. Net intangible assets and goodwill were $18.4 million and $132.9 million, respectively, at the end of the quarter. Our total liabilities were $134.6 million at quarter-end, of which $103.4 million were current and $31.2 million were long term.

We currently expect the fourth quarter 2012 non-GAAP Mellanox results to be as follows: quarterly revenues of $145 million to $150 million, translating into annual revenues of $524 million to $529 million; our Q4 2012 gross margins of 68.5% to 69.5%, reflecting our latest forecasted product mix. We expect a sequential increase in non-GAAP operating expenses of approximately 6% to 8%. We estimate our fourth quarter 2012 stock comp expense to be between $10.5 million and $11 million. Non-GAAP diluted share count guidance for the fourth quarter is 44.1 million to 44.6 million shares.

I will turn things back now to Eyal for a few closing comments. Eyal?

Eyal Waldman

Thank you, Mike. We are pleased with our record financial results for the third quarter. We are excited to be tracking to a doubling of our revenues from 2011 to 2012 with $526.2 million, at the midpoint of our guidance, grow year-over-year EPS more than 3x, and expand our non-GAAP gross margins year-over-year to approximately 70%.

In Q1 we had approximately $10 million in large Romley opportunities, in Q2 we had approximately $30 million in pent-up demand, and in Q3 we had approximately $25 million from three large deals, with the largest coming from Polywell, a large Chinese system integrator. In Q4, without any Romley pent-up demand or individual large deals, our guidance implies a revenue base line of $150 million.

InfiniBand continues to 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. This is particularly true with storage platforms where InfiniBand is becoming more dominant as a storage interconnect across various markets and applications such as Web 2.0, HPC, cloud and database. The storage interconnect market is large, sized at several billion dollars, and we expect this momentum to grow in the coming years as the design wins we are working on with our storage OEM customers go into production.

InfiniBand adoption is increasing in Web 2.0 and cloud data centers based on architectures similar to what we see in HPC environments. We expect to experience growth in InfiniBand integration in this market going into 2013.

We continue to see large HPC deployments worldwide use our FDR InfiniBand interconnect solutions. This growth will be fueled by new solutions like our new Connect-IB adaptor. We also are encouraged by the momentum of our 40-gigabit solutions in the Web 2.0 financial services storage and cloud markets. As the only vendor providing end-to-end 40-gigabit Internet solutions, we are working with multiple partners to provide 40-gigabit Internet solutions into those markets.

Moving forward as we expand our business worldwide, our investment in headcount will grow to support the increased adoption of our solutions. We are looking forward to the Supercomputing 2012 show from November 12 through November 15 in Salt Lake City, Utah, and hope to see you during the show.

Operator, we will now take questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions].

Our first question is from Daniel Amir of Lazard Capital. Your line is open.

Daniel Amir – Lazard Capital

Thanks a lot. Thank you for taking my question. So, a couple things here. First of all, can you give a little more visibility into kind of the Q4 guidance given that it looks like you don't have a lot of new pent-up demand in Q4? And if that's the case, can you a little more clarify about that?

And then the second is, it looks like this quarter your switch business was actually down on a revenue basis versus the previous quarter. So, if you can expand a bit on that as well, that would be helpful. Thanks.

Eyal Waldman

Yeah. So, on the Q4, you're right, we're actually now seeing the $150 million as our baseline and we're seeing Web 2.0, cloud and other storage database opportunities fill in where in the past we had multiple large deals that filled up our Q1, Q2, and Q3.

Regarding the switch percentage, I'm not sure it went down.

Michael Gray

It went down slightly from the prior quarter, and offsetting that was the fact that our IC business was up from Q2 to Q3, Daniel.

Daniel Amir – Lazard Capital

Okay. And in terms of seasonality, I mean, Q1 historically, I guess the HPC business tends to be down in the first quarter on a seasonal basis. I mean, can you give us any insights how to look into the first quarter?

Eyal Waldman

You know, we don't have visibility into Q1. In the recent years we've actually seen us get out of this HPC seasonality. But we don't see -- we don't have enough visibility to Q1 of '13.

Daniel Amir – Lazard Capital

Okay. Thanks.

Eyal Waldman

You're welcome.

Operator

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

Glenn Hanus – Needham & Co.

Good afternoon. So, could you give a little more clarity on the three deals in the third quarter? Were those all HPC related? And then, so basically in the fourth quarter, HPC is going to be down sequentially?

Eyal Waldman

Most of them were HPC oriented. And Q4, we don't see significant large deals that we've seen due to the Romley pent-up demand, and we're actually pretty happy to see that we're still staying with the baseline of $150 million.

Michael Gray

And the one material deal, Glenn, was the Polywell during the quarter, which we noted was about 11% of our Q3 revenues.

Glenn Hanus – Needham & Co.

Have you seen some push-out of some deals into next year recently or some business in other sectors move out into next year? I think generally the Street was probably expecting a little bit more here in the fourth quarter.

Eyal Waldman

Oh, we don't see things push out. We're actually seeing Q1, we hope to be building pretty nice. But again what we've seen in the first three quarters, pent-up demand for Romley, in Q4 we are able to fill the gap with other opportunities from other segments of the market.

Glenn Hanus – Needham & Co.

How do you view the opportunity for the ongoing Romley refresh in HPC as we go into next year, and the health of the HPC sector contributing to your business next year?

Eyal Waldman

We think it's going to continue in growing. We think it's going to continue growing in 2013 and people will continue to build large supercomputers based on Romley and future generations from Intel.

Glenn Hanus – Needham & Co.

Okay. Thank you.

Michael Gray

Thank you.

Operator

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

Joseph Wolf – Barclays

Hi. Thank you. Just a couple of questions. I guess on the product side, if we -- are any -- are you sensing any economic influence to what's going on right now? Or is -- or do you believe that your business right now is strong enough or is really independent of things that are going on, or you heard any macro concerns from any of the customers right now? And how is that trending across certain businesses? That's my first question.

Eyal Waldman

So, again, we're isolated somewhat in terms of we are still a small portion of the market that we can -- that we're playing in. So we don't specifically feel the macroeconomic environment directly on Mellanox.

Joseph Wolf – Barclays

And then just to come back to the question on the switches, on the 10-gigabit market, can you just give us a little bit more color on the current product that you're selling, where that is, how competitive it is, and what that market is in terms of the switch solution that you guys are talking about? Is the transition that you're seeing now an adjustment in a product or is it just a customer demand issue?

Eyal Waldman

So, the majority of our 10-gigabit Ethernet revenues come from the endpoints, from the network interface card. We are starting to see more traction with our Ethernet switch products. And again, this is like on a quarter-by-quarter basis, it depends on the customer, so we will see a different percentage for the switch, the silicon, the boards, and so on.

Joseph Wolf – Barclays

Okay. And then finally on the...

Eyal Waldman

It's not a trend. Basically it's not a trend that we're seeing, it's --

Joseph Wolf – Barclays

Is there a product -- is the product you're selling helping right now or is that a -- it's just a question of what the customers are looking for specifically?

Eyal Waldman

I didn't understand the question.

Joseph Wolf – Barclays

I'm just wondering, just in terms of -- as you added -- as you've added software and gone more end-to-end, how has the market reception been for the 10-gig switching, or is it just kind of just a question of how the mix falls in a quarter?

Eyal Waldman

It's just a question of how the mix falls in the quarter.

Joseph Wolf – Barclays

Okay.

Eyal Waldman

Basically we see some customers use us end-to-end, we see some customers use us as their endpoint. And it depends really on the end-customer, the OEMs and who we work with through the channel.

Joseph Wolf – Barclays

And then finally, for Mike, on the cash side with the balance having risen to this level, could you just talk about the -- any of this cash in terms of where it's domiciled, how much would be considered to be restricted, and whether there's any intention in terms of investment, share buyback or that kind of use of cash in the near term given the balance?

Michael Gray

Okay. So, in terms of restricted, it's a small number; it's typically in the single digits in terms of millions, and most of it's associated with a larger facility that we have in Israel where our headquarters is. In terms of distribution of cash, I'd say about today, about two-thirds of it is domiciled here in the US, about a third is domiciled in Israel. In terms of stock buyback, we don't currently have plans to pursue a stock buyback at this time.

Joseph Wolf – Barclays

Okay, geat. Thank you.

Michael Gray

You're welcome.

Operator

Thank you. Our next question is from Kevin Cassidy of Stifel Nicolaus. Your line is open.

Kevin Cassidy – Stifel Nicolaus

Thank you. Thanks for taking my questions. As you look out to next quarter, are you expecting FDR to remain a high percentage of revenue?

Eyal Waldman

Yes.

Kevin Cassidy – Stifel Nicolaus

And are you getting requests from your customers to get to the 100-gigabit per second? Is that still a target to get to by the end of next year?

Eyal Waldman

They're definitely requesting 100-gigabit per second. I don't think we'll be able to meet the schedule end of next year. But yes, people are asking for the 100-gigabit per second.

Kevin Cassidy – Stifel Nicolaus

Okay. Also on the R&D number coming down rather than up in the quarter, you mentioned lower tape-out and lower employee expenses. Can you break out how much that was? And what was the reason for the lower tape-out?

Michael Gray

Well, remember we did have a significant tape-out in the second quarter, Kevin. So we didn't have a tape-out in Q3. I mean that was the largest of the two significant items. The other are just employee, you know, kind of employee headcount related expenses. So out of the two, the decrease was a larger portion was the fact that was tape-out related, that we had a major tape-out in Q2, we didn't have in Q3. And then secondarily were just lower headcount related expenses.

Kevin Cassidy – Stifel Nicolaus

Okay. So in your guidance you weren't including any tape-out on the OpEx increase?

Michael Gray

No. No. We had some -- we had incorporated some spend, but not a major tape-out in Q3 in the guidance, or for Q4 either.

Kevin Cassidy – Stifel Nicolaus

Right. Just one other question on inventory. Inventories came down. Were you preparing for a lower backlog or is there something else with inventory coming down? Is that the new --

Michael Gray

Our inventory actually grew slightly quarter to quarter. No, it was up a couple of million. Our third quarter inventory increased just below $3 million, so, $2.9 million. So it was $34 million and changed up from $31.4 million in the prior period. So it was up slightly. But our turns were still well above five.

Kevin Cassidy – Stifel Nicolaus

Right. Yeah. I guess I was looking at days of inventory. That came down. Is that the level you want to be at? It was around 30.

Michael Gray

Yeah. I think we're comfortable with the inventory and where we're at. I would think we're probably a little lower than what we had -- where we had wanted to be at the end of March and June. So I don't see the roughly $3 million increase in inventory during the quarter as a cause for concern.

Kevin Cassidy – Stifel Nicolaus

Okay, great. Thank you.

Michael Gray

Thank you.

Operator

Thank you. Our next question is from Dan Harverd of Deutsche Bank. Your line is open.

Dan Harverd – Deutsche Bank

Hi. Thank you. A couple of questions. Firstly, on the storage side, could you give a breakdown of how much storage was in the quarter and how much you would expect it to be as the base going forward?

Michael Gray

You know, we don't have information, you know, or estimated information on revenue by market segment, so I'm not in a position to provide that.

Eyal Waldman

We do expect our storage revenue, that's also the storage percentage, to grow in 2013 and 2014.

Michael Gray

Yeah. And I can tell you that historically it's probably been in the range of about 10% to 14% on average for the first three quarters of the year. I just don't have specifics for Q3 available.

Dan Harverd – Deutsche Bank

And then just in terms of visibility of the business, have you seen any change over the last quarter? Because I mean you're still providing guidance one quarter out. Do you see any improvement or direction in that general visibility?

Michael Gray

Historically the majority of our business is turns on a quarterly basis, and we certainly expect that for Q4 the majority of the business to be turns as well.

Dan Harverd – Deutsche Bank

Okay. And then just a final question, a longer-term question. We've seen Intel during the quarter put out a road map for its plans in InfiniBand, of potentially integrating a controller into the CPU. Can we get your thoughts on that and how that would affect your business there? Any thoughts?

Eyal Waldman

Yeah, you know, obviously we are working with Intel in multiple dimensions. Intel will try to come out something in the 2015/'16 time frame with their 100-gigabit-per-second solution. It's yet to be seen how we work together, if we work together at that timeframe. And obviously Mellanox, we continue to develop our own solutions for the 100-gigabit-per-second which we think will come out in 2014 timeframe. So we still hope to continue leading this market and keep taking market share away from our competitors.

Dan Harverd – Deutsche Bank

And if they were to come up with an integrated product, would that change -- how would you see that changing the fundamentals of the market?

Eyal Waldman

Well, then we'll find the right way either to work with them or to compete with them.

Dan Harverd – Deutsche Bank

Okay. Thank you.

Eyal Waldman

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. A couple questions if I could here. Relative to just linearity in the quarter, I know we heard from IBM that kind of demand fell off at the end of the month, in September, [and Telica] had some similar commentary. Did you guys see any sort of slowdown in demand in the last month of the quarter, any change relative to linearity you saw last quarter?

Michael Gray

I would tell you, Brent, that our linearity in terms of Q3 versus Q2, we were more front-end loaded in Q3 than we were in Q2.

Brent Bracelin – Pacific Crest

Okay. And then as we look at the Web 2.0 space, if I recall, last quarter you talked about a large Web 2.0 customer accounting for the outsized increase at HP and IBM. I believe they were 49% of the mix. That fell to 37% of the mix. Should we assume that the Web 2.0 large customer orders dropped sequentially this quarter? And if so, what's the type of visibility you have on the cloud side of the business going into Q4? Do you expect another potential drop there on the Web 2.0 cloud side?

Eyal Waldman

Some of those same customers have a pattern of buying not every quarter; it could be every other quarter or every third quarter, so on. It really depends on their build-out of their data centers and refresh of the data centers. So, specifically, there is a very large deal in that quarter, and we expect to see more such deals going into 2013.

Michael Gray

And in Q2, I mean, Brent, HP was 30% of our businesses of the second quarter, IBM was 19%. As you'll recall, we did call out that behind the HP 30% -- it was just HP, it wasn't HP and IBM -- but behind HP's 30% of our revenues in the second quarter was a large Web 2.0 account that on its own would have been a greater than 10% customer. So if you adjust for that account in Q2, I would tell you the percent of our business attributable to HP and IBM was pretty consistent in percentage terms, 19% for HP this quarter, 18% for IBM, similar to Q3 in terms of percent of revenue for the two relative to Q2.

Brent Bracelin – Pacific Crest

Okay, helpful. And then as I just look and break apart the business by segment, it looks like over the last six months the IC and board business almost doubled and the switching business is only up 30% to 40%. These are great numbers, right, of course. But I would have thought that, particularly with most of the revenue coming from InfiniBand, there'd be a higher attach rate of switches to every IC and board that you ship. Are you seeing any sort of change in customer buying behavior, were they buying more ICs and boards, or do you have large customers that are kind of building their own switches? I'm just trying to understand the disconnect between the momentum that you're seeing on ICs and boards for the last six months and then just slightly slower momentum on switches.

Eyal Waldman

Again, it's on a quarter-by-quarter basis. In the future, some of the Web 2.0 guys, customers that we have, build their own stuff with our silicon, so we expect to see more changes in terms of more silicon in some quarters, more systems in other quarters. But there's no significant trend that we're seeing that we can point to.

Michael Gray

And we would tell you that our switch system business has historically been in the low 30s, so I wouldn't read that much into the fact that it was 30% last quarter, and our ICs and boards, while they were just below 50% in Q2, about 53% as we called out in Q3, we did have a pretty nice IC-based order that drove the increase from what was 48% of those combined two categories to 53% in the third quarter.

Brent Bracelin – Pacific Crest

Great. And my last question is really going back to 2008, which was the last time we saw a Q4 for you, guys, that was down sequentially. It looked like your business back in 2008 was down sequentially for both Q4 and then into Q1. Wondering if, as you think about kind of what happened then and as we think about the sequential decline in the business, should we model and think about the business being down sequentially in both Q4 and Q1, or how should we kind of think about normal seasonality and then when the last time you actually had a sequential decline in Q4 back in 2008, are conditions different this time? Just trying to understand how we should model that going forward.

Eyal Waldman

No. I don't think you should read from our Q4 guidance into Q1. We don't see the correlation. This was an event then, but we don't see this trend from what happened in Q4 into Q1.

Michael Gray

And I think Q4 2008 was really more of a macroeconomic environment. I think most people on a similar situation -- we were certainly able to grow year-over-year despite the headwinds in the economy back in that second half of 2008. So I don't think there's necessarily a clear comparison to what took place then versus what we're dealing with now.

Brent Bracelin – Pacific Crest

Okay. Fair enough. Thank you.

Michael Gray

Yeah.

Eyal Waldman

Thank you.

Operator

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

Brian Freed – Wunderlich Securities

Good afternoon. Real quick question. As you look at the large deals in your pipeline, and obviously with a limited number of them closing in December and kind of a lack of visibility, if you look at your longer-term pipeline of large deals relative to Intel cycle, do you still see a pretty significant pipeline of large HPC deals ahead of the next turn of the Intel chipset, or do you think we're going to have to see another turn of the Intel chipset before we get another flurry of large HPC deals?

Eyal Waldman

No, we do expect to see large HPC deals in 2013 before the next Intel chipset.

Brian Freed – Wunderlich Securities

Okay. Thanks.

Eyal Waldman

You're welcome.

Operator

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

John Pitzer – Credit Suisse

Yeah. Congratulations. I guess, Eyal and Michael, if you can help me understand, you guys have done a good job kind of talking us through the OEM and reseller concentration each quarter, but as you think about the kind of the $60 million increase to this new base from March, sort of $80 million to $150 million or $90 million to $150 million, how many end-users would that represent? And I guess if the big deals are slowing down in the Q4, what would you expect kind of the concentration of the top two or three customers to be in Q4 versus Q3? And then I've got a follow up.

Eyal Waldman

We did add significant customers to Mellanox in 2012, end-customers in the Web 2.0 and the cloud markets. And I think this changes some of the way that we see our business plan, and that's why you see the growth go from like the $90 million to the $150 million baseline. In terms of our channels, we still expect our channels mainly to go through our main OEMs. Specifically in the past years it was HP and IBM and also moving forward we still continue to expect those to be our large channels into the markets.

John Pitzer – Credit Suisse

So, Eyal, when you talk about sort of the size of the deals coming down in Q4, that's at the end-user level, correct?

Eyal Waldman

Yes.

John Pitzer – Credit Suisse

Okay. And then as you think about $150 million as the new quarterly baseline, that kind of gives you a $600 million run rate. How do you guys think about kind of the longer-term growth off of this new base? Are you thinking a 10% to 15% growth rate, a 15% to 20% growth rate? Again I'm not really thinking about Q1, it's more of a multi-year type of growth rate for the business. And is there another kind of step function up from here at some point or is it more kind of linear growth than what we've seen over the last couple quarters?

Eyal Waldman

You know again, we don't give guidance or visibility more than one quarter. We do expect to continue to grow nicely into 2013. We are seeing design wins that are materializing. We are seeing more opportunities that now we're working on a daily basis. The momentum of people that plan to use us is growing, both on the storage and the compute side; and we're encouraged by the momentum we're seeing behind us. And we believe we'll be able to continue growing nicely into 2013.

John Pitzer – Credit Suisse

And then, Eyal, you guys have clearly been taking advantage of new platform introduction out of Intel, the first Nehalem, now kind of Romley. You've got sort of Xeon 5 coming out I think in the fourth quarter from Intel this year. And that kind of hits right into what's historically been a very sweet spot of your business in the supercompute, high-performance compute market. Is that going to be another incremental driver? Is that just more Intel taking share from a GP architecture that already exists and do you guys already leverage?

Eyal Waldman

You know, again every time you see an introduction of a larger CPU or more memory architecture like flash and so on, you'll see higher demand for better interconnect and you'll see a significant higher attach rate for our connectivity, like you've seen from Q1 of this year to Q3 in and also into Q4 of this year. So we believe every time you’ll see a new CPU with more performance more capabilities. Every time you’ll see another generation of flash solutions out there, you’ll see higher attach rate of Mellanox interconnect, both and InfiniBand and Ethernet into the markets.

John Pitzer – Credit Suisse

Great. And guys, as my last question, for Mike. First, Mike, congratulations and good luck on the retirement. But kind of curious, I think you said OpEx could be up 6% to 8% sequentially in the December quarter. Is that just incremental tape-outs, or can you help me understand what's driving that? If you've explained that and I missed it, I apologize.

Michael Gray

No, it -- we didn't call out a specific tape-out in the fourth quarter. We may have some smaller metals spins, but I would tell you that the lion's share of that would be headcount related and then we also have some major sales related events, SC12 that Eyal alluded to in Salt Lake City is a big showcase event for the company in the fourth quarter, and then we also have an internal sales event that's complementing the SC12 event. It's mostly headcount related and a couple of specific material activities within the sales side of the house.

John Pitzer – Credit Suisse

Perfect. Thanks, guys.

Michael Gray

Sure.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question is from Harlan Sur of J.P. Morgan. Your line is open.

Harlan Sur – J.P. Morgan

Hey, thanks, guys, and good afternoon. As it relates to the fourth quarter guidance there's been a lot of questions on deals and specific programs in specific quarters. But maybe just to kind of summarize things for us, if you could just step back one level and just give us more color on what customer end-market segments, you know, HPC, Web 2.0, cloud, Enterprise data center, what of these segments are growing in the fourth quarter, and which of those segments may be exhibiting a slight pause in their deployments of your technology in December?

Eyal Waldman

Yeah. We don't provide such a breakdown of the markets for revenues.

Harlan Sur – J.P. Morgan

Okay.

Eyal Waldman

It's not just that, but because we ship mainly to the OEMs and then the OEMs ship to the end-customer, sometimes we don't have full visibility through the channel.

Harlan Sur – J.P. Morgan

Okay. Then maybe looking at it from kind of a more of a midterm perspective, as you look into your customer programs and deployments for the first half of next year and looking at your forecast, right, not orders, but looking at your forecast, seeing the programs, and I know you've been working with a lot of these Web 2.0 guys and your cloud customers for quite some time, so I oftentimes feel like you guys actually do have quite a bit of visibility. Do you see the potential for a better growth in the first half of next year versus second half of this year?

Eyal Waldman

Yes.

Harlan Sur – J.P. Morgan

Okay, great. And then one last question. Lots of discussion about software-defined networks, you know, you rolled out the SwitchX-2 for the larger, flatter sort of network architecture, higher densities. When do you expect SDN type architectures to start to have a bigger footprint on future deployments? And how is Mellanox differentiating from competitors like Broadcom for example who recently rolled out their Trident 2 switch product which is also optimized for SDN?

Eyal Waldman

Right. So let's remember, first, we're shipping SDNs in 2001. Right? We're shipping software-defined network since 2001, because every InfiniBand subnet is a subnet manager, which is basically a software-defined network. We now have the same technology on top of our Ethernet stuff and we're working with multiple partners and customers to enhance the capability of the software-defined network on top of the Ethernet similar to what we're doing on top of InfiniBand and soon also the Virtual Protocol Interconnect capabilities to both InfiniBand and Ethernet SDNs.

So we think we have the capability. We have things that are working. And in the next 2013 timeframe, you'll see more SDN capabilities out there.

Harlan Sur – J.P. Morgan Okay, great.

Thanks, Eyal.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question is from Shebly Seyrafi of FBN Securities. Your line is open.

Shebly Seyrafi – FBN Securities

Hello. Yes. I'm wondering whether this Polywell revenue, which was, I calculate, $17 million, is resulting in some lumpiness in your business. And so I mean your ex-Polywell revenue in calendar Q3 was $140 million. Can you give us a sense of what Polywell was in calendar Q2 and how the ex-Polywell business trended?

Eyal Waldman

Yeah, they were less than 10% in Q2. We did see some revenues for them in Q2. What happens there is, you know, typical large deal, whether its a Cloud or HPC deal, they're similar in nature. And the majority of the deal was executed and shipped in Q3 of 2012.

Shebly Seyrafi – FBN Securities

Right. So, is it fair to say that ex-Polywell business will perhaps likely grow sequentially in calendar Q4 -- fiscal Q4? That would work of course if Polywell goes to virtually nil or a couple of million or something like that.

Eyal Waldman

Yes. Probably, yes.

Shebly Seyrafi – FBN Securities

So the answer is yes, it will grow sequentially. So, before you talked about a new baseline of $150 million per quarter in revenue, and I -- are you abandoning that? I know you're not going to hit in Q4, but I mean going forward, are you basically abandoning that? And separate, or related to that, is there like a new minimum, if you will, because you spiked so much a few quarters ago that maybe the new minimum is $130 million but you're perhaps abandoning the $150 million as a baseline?

Eyal Waldman

No, we actually said it, this is the base and this is what we guided to. Basically we're still there. The guidance $145 million to $150 million is the $150 million baseline.

Shebly Seyrafi – FBN Securities

Okay. So you think you'll be around $150 million going forward and -- okay. And your gross margin, you're guiding it to decline and you just had a decline in your switch segment as a percent of revenue. Do you expect your switch segment to rebound strongly? Is this all mix related for the most part, explaining the gross margin decline sequentially?

Michael Gray

It is really mix related. As you know, today we make our best margins on our IC products. That was a very healthy number and grew from, in absolute dollars, from Q2 to Q3. So really the margin guidance we give every quarter is a function of the mix between the ICs, the boards and the switch systems.

Shebly Seyrafi – FBN Securities

Okay. Just as a few more, your deferred revenue grew quite nicely to $18 million, up like 40% sequentially, 137% year-to-year. Can you explain what drove that?

Michael Gray

You know, we had one particular part of that is [DISD]. You know our [DISD] business, we're deferring revenue until it sells through based on point of sales reports from the [DISDs] themselves. The service piece of our business, the service and support is a growing portion and that's increasing. So part of the growth was also associated with deferred service revenue. And then we did have an account in the Far East where the transaction was both a combination of some hardware and software and services and part of that was deferred. So I'd say really three items, one account, the increase in [DISD], and then also the increase in the service portion of our business.

Shebly Seyrafi – FBN Securities

Okay. Last one for me is I don't know if -- I may have missed this, but did you talk about how many large deals you had in fiscal Q3 and whether you expect that number to increase or decline sequentially in Q4?

Michael Gray

We didn't say -- we said that we had three significant deals in Q3 and the most notable one was the Pollywell, because Pollywell on its own was a greater than 10% customer. As you may recall, we had a large Web 2.0 account in Q2. But we said we didn't expect any significant large deals relative to the size of the Polywell transaction in Q4.

Shebly Seyrafi – FBN Securities

Okay. Thank you very much.

Michael Gray

Thank you.

Eyal Waldman

Thank you.

Operator

Thank you. Our next question is from Alex Gauna of JMP Securities. Your line is open.

Alex Gauna – JMP Securities

Thanks very much for taking my question, and congratulations on another record quarter. I was wondering if you could, and I know it's an important driver, but backing out some of the big deals, Romley as a percentage of your business, what is that doing sequentially? What was it in Q3 and what do you expect it to contribute in Q4?

Michael Gray

I mean, the most visible metric for us, and again, the lion's share of our business goes through OEM, so we don't have perfect visibility to the end-users, bBut I think the most visible metric for us is the percent of our business that 56-gigabit, because 56-gigabit has been engineered to get the most out of Romley. And that did grow sequentially in terms of percent of our revenues. It grew from 54% of our revenues in the second quarter to 57% of our revenues in the third quarter. We certainly think there is more runway for that to increase. But to speculate as to how much it might grow from 57% of our revenues in the third quarter, we're just not in a position to do that.

Alex Gauna – JMP Securities

Fair enough. And, Al, I know you said you see growth in this category for years to come. But is it not fair that we're getting a little deeper into the Romley upgrade cycle. Are there any signs at all that we could be hitting some sort of asymptote either in a quarter or two on that front or the next generation cycles come in?

Eyal Waldman

Yeah. But guys, let's not forget that people continue deploying regardless of new introductions. People need to continue and enhance their compute and storage platforms and capabilities. And this is an ongoing thing. In some cases where there's a big super community being built, those guys will wait until they can use the new architecture and so on. And again, some of them will just continue deploying as they need to have the performance capabilities. But if you look at the other segments, they deploy day in and day out, more computing, more storage system as their business needs.

Alex Gauna – JMP Securities

Okay. Thanks very much.

Eyal Waldman

Thank you.

Operator

Thank you. This ends the Q&A portion of today's conference. I would like to turn the call over to management for any closing remarks.

Eyal Waldman

Thank you. First we thank you for being on our call today and your interest in Mellanox. We look forward to seeing you and many of our -- Analyst Day on Friday in New York. Thank you very much.

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.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Mellanox Technologies' CEO Discusses Q3 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts