Silicom Ltd (SILC) 2010 Q2 法說會逐字稿

Welcome to Silicom's second-quarter 2010 results conference call. (Operator Instructions). As a reminder, this conference is being recorded July 22 -- 26, 2010. I would now like to hand over the call to Mr. Ehud Helft of CCG Investor Relations.

I would like to welcome all of you to Silicom's second-quarter 2010 results conference call. Before we start I would like to draw your attention to the following Safe Harbor statement. This conference call may contain projections or other forward-looking statements regarding future events or the future performance of the Company. These statements are only predictions and may change as time passes.

Silicom does not assume any obligation to update that information. Actual events or results may differ materially from those projected, including any results of changing industry and market trends [produced] and for our products, the timing, development of our new products and their [reception] by the market, increased competition in the industry and pricing reductions, as well as due to risks identified in the documents filed by the Company with the SEC.

With us on the line today are Mr. Shaike Orbach, the CEO, and Mr. Eran Gilad, the CFO. As usual, Shaike will begin with an overview of the results, followed by Eran, who will provide an analysis of the financials. We will then turn over the call to the question and answer session.

With that I would like now to hand over the call to Shaike.

Good morning everyone. Welcome to our conference call discussing our second-quarter 2010 results. We are particularly pleased with the strong results that we have reported today. We delivered another very strong quarter with exceptional top and bottom line growth, demonstrating both the strong operating leverage in our business as well as the continued progress on achieving our long-term, strategic objectives.

We reported revenue growth of 66% over the second-quarter of last year, a very high number. We also reported a quarter of strong profitability growth with an 822% increase in operating income and 440% increase in net income as compared with the second quarter of last year.

Our solid results are a reflection of the market's need for faster response times and increased bandwidth in an era of cloud computing, virtualization and Intranet-based applications. We see a number of factors underlying our performance. First, we continue to see a ramp up in order flow from many of our current customers. We believe such a ramp up is in line with what seems to be the gradual recovery of the whole IT market.

Second, several of our customers, including some of our larger customers in particular, have integrated additional products into more of their product lines, and therefore, are increasing their business in general with us.

Finally, we continue to increase our customer base through our addition of new customers which use our products, and this expands our platform for ongoing repeat orders.

In parallel we are also seeing increasing market traction for our external Bypass switches, encryption products and Redirector cards, as demonstrated by a growing flow of orders of these new products within all of our growth areas.

Our overall continued success is down to our correct read of the market, which lead us to correctly capitalize -- capitalizing on the positive trends in our market sectors and ensuring that we deliver the products that our clients need.

We also see a growing awareness of our products and technologies as effective solutions for overcoming bottleneck challenges, in particular, this is more evident in the environment of cloud computing and virtualization, each of which increases computing overhead and thus requires better solutions for performance.

Our reputation, combined with the continued investment in sales, marketing and R&D, is paying off with a steady increase in our sales and profits.

During the quarter we were very pleased to achieve VMware ready status for the first of our adaptors. This designation indicates that the Silicom Server Adapter has passed a detailed evaluation and testing process, managed by VMware, and is now listed on the VMware hardware comparability list. And we view this as an important achievement.

We believe that this VMware ready certification will enable us to further penetrate the VMware ecosystem, growing our sales to customers that require VMware certification as a precondition for their adapter purchases. For example, our certification has already enabled us to ensure a first sale to a new customer in Spain.

In parallel, as WAN optimization continues to develop in virtual environments, we believe that our investment in the VMware certification process, as well as in the development of VMware compliant products, will strengthen our hold over the WAN optimization market as well. Some of our major WAN optimization customers are already considering or evaluating our VMware compliance solutions.

I would like to provide an update on our new and recently launched SETAC products, which are all making significant headway. The SETAC, the newest and exciting part of our product strategy is seeing a growing awareness in the marketplace, and we continue to ramp up our SETAC customer base.

Our success so far confirms that we understand the market and its needs for a new type of flexible, reasonably priced server grade appliance. We feel that the SETAC momentum is continuously building, and we are optimistic regarding its ability to make a significant contribution to our future growth.

During the quarter we achieved our second-leading European network security customer for the SETAC, while also continuing to build out the pipeline of customers who are evaluating or considering it for their next generation appliances. For this customer we will work together with a system integrator, who will integrate Silicom SETAC units with a server grade motherboard and other system components.

The model of working together with an integrator is in line with the strategy that we originally envisioned for marketing and implementing the SETAC, confirming both the approach and the industry's need for the SETAC solution.

We see a very significant potential for SETAC. Its pipeline is becoming longer and deeper. The size and quality of this pipeline leads us to believe that the SETAC will succeed in generating significant, growing sales over the long-term.

As an example to the potential of SETAC, we are now in the process of securing a very important deal, which involves both a major Tier 1 security company and a major Tier 1 world-leading platforms company. We believe that we will be able to bring some good news with regard to this deal before the end of the year.

In terms of our continually strengthening balance sheet we ended the second quarter with a net cash position of $43.9 million. This strong and growing level of cash provides us with more than enough working capital to continually build on the strength of our business through R&D and marketing. It also allows us to take advantage of any opportunities that may arise, which will enable us to advance our technological and product leadership.

To summarize, Silicom is very much on the right track. Based on our continued good financial results, balance sheet strength and cash generation, our platform of globally diversified and satisfied customers, a broad range of current products which will sell to a growing roster of customers, as well as an exciting new product, which expect will significantly broaden our addressable market, we feel very well-positioned for both long-term and short-term growth, including the generation of sequential growth through the second half of 2010.

With that, I will now hand over the call to Eran Gilad, our CFO, for a more detailed review of the quarter results, after which we will open the floor for questions.

Thank you, Shaike, and hello everyone. Revenues for the second quarter of 2008 (sic - see press release) were $6.7 million, a growth of 66% compared with revenues of $4 million recorded in the second quarter of 2009. Our geographical revenue breakdown for the quarter was -- remained similar to the breakdown we have seen for the past few quarters, and was as follows -- North America, 69%; Asia-Pacific, 17%; and Europe and Israel, 14%.

The breakdown of revenue between Bypass and non-Bypass for the quarter were Bypass approximately 50%, and non-Bypass approximately 50%. This was similar to the breakdown we have seen for the past few quarters.

Gross profit for the second quarter of 2008 was $3 million, representing a gross margin of 43.9% and was higher than in prior quarters due to a favorable product mix. This is compared to $1.6 million or a gross margin of 39.8% as reported in the second quarter of last year.

Operating expenses in the second quarter was $1.6 million compared with $1.5 million in the second quarter of last year. This demonstrates the strong operating leverage inherent in the business that we are able to grow revenues strongly with only a small increase in expenses.

Operating income in the second quarter of 2008 (sic - see press release) was $1.4 million or 20.8% of revenues, a substantial increase compared with $152,000 or 3.8% of revenues as reported in the second quarter of last year.

Second quarter 2008 (sic - see press release) net income was $1.4 million or 20.5% of revenues. This is compared with a net income of $256,000 in the second quarter of 2009.

Earnings per diluted share were $0.20 in the quarter compared with $0.04 in the second quarter of last year.

Now turning to the balance sheet, as of June 30, 2010, the Company's cash, cash equivalents, bank deposits and marketable securities totaled $43.9 million, up $0.1 million compared with the end of the first quarter of 2010 and up $0.7 million compared with the end of 2009. Our current strong cash position represents a level of $6.44 per outstanding share.

That ends my summary, and we would be happy to take any questions. Operator?

(Operator Instructions). Marcel Herbst, Herbst Capital Management.

Good morning and congratulations to a great quarter. One of your main customers, Riverbed, recently announced that they're making a major push towards personalization, and they say it's going to be huge. I was wondering what the potential impact on Silicom is?

I can speak in general about virtualization, and not necessarily speaking about a specific customer, because as you know, we have never identified our customers by name.

But in general I think that the impact of virtualization would be very good for us, and that is because of several reasons. One reason is that once you are speaking about virtualization then the solutions are becoming more complex. That is why we have invested efforts in the area of virtualization, just like I said in my -- in what I have said just about a few minutes ago.

These more complex products will make it, I would say, would make the WAN optimization community more dependent on our solutions. For example, it is going to be more complex to just take solutions and use them on the motherboards or anything similar to that, because in order for the solutions such as Bypass, but not only Bypass, in the virtualization environment you need to either -- I don't want to go into too many details, but the solution is more complex. It could be both more complex in hardware and in software, and that would increase the dependency of our customers in us. That would increase the price of the products that we sell to our customers. And that is one part of it.

The other part of it is that the virtualization environment is suffering, I would say, from some additional overhead in the servers, in the platforms that they're running, and that makes an issue of the performance.

That means that in addition to the complexity which is involved with having a solution in the virtualization space, there is also a need to improve performance. That is another area which we are investing in right now, improving performance of various solutions specifically for the virtualization area, which is why we believe that the overall impact is going to be positive on us.

What products do you currently have that target the virtualization market?

It is divided into two areas. I would say that first area are Bypass products, which support virtualization. Because the regular Bypass card would not support virtualization. In order for a card to support virtualization, a Bypass card, you need to make additional development, which is something that we have done. So this is one part of it.

The other part of it is I would say use accelerators, which means that in addition to the Bypass itself, there could be some processor or redirectors or anything of that sort which would be able to help or assist in improving the performance. So a combination of products, which includes redirection or processing power with our Bypass supporting virtualization would be the products to go to this market.

What percentage of revenue came from your 10 gigabyte product line this quarter?

10 gigabytes, it is about 20%.

You mentioned you added new customers this quarter. What is the current count?

Of SETAC customers?

No, of overall customers.

Oh, overall customers. Well, we are not -- in the past where each new, even small customers, was important, I think we counted them very carefully. But now I believe it is about 75, 80 customers, something like that.

Can you talk a little bit more about the momentum in building your pipeline and how it is continuing? And what is the sentiment of your customers currently?

I take it that just like your earlier question you're asking about our general business, not specific --.

General business, yes, core business.

I would say the following several things. First of all, I would say that, indeed, almost all our customers and specifically the big customers are adding more cards into more product lines. So this is something, which is a very clear trend that we see that almost all of our customers are adding to that, and that helps us in growing. So that is one thing which is happening clearly.

Now that includes adding, at least with some of them, these sophisticated products or more sophisticated products that I was talking about earlier. So that is a very clear trend.

Now in addition to that while, for example, in the WAN optimization market we are already working with, I think, all of the market leaders, but we are still adding customers that we did not have before. So we're adding customers each quarter, adding more customers. And some of these customers, even though they are not very big at the moment, but they can turn out big, and that happens to us all the time.

I could just give you an example. Even in the WAN optimization, like one of the companies that was not considered to be so very big until now is becoming bigger and bigger, and we see that quarter after quarter. So they are becoming more important as well. So more customers and smaller customers becoming a little bigger, and the big customers are becoming bigger as well.

The other area that we see progress, and as I mentioned, that includes our more, I would say, sophisticated products, or our new generation of products. In addition to that we definitely see a trend without so many, I would say, wins at the moment, but still a clear trend for SETAC. We have announced one additional win in this quarter. But with the pipeline is really building up, so I believe this is going to be very significant.

Excellent, thank you.

Don McKiernan, Landolt Securities.

I noticed the inventories at the end of last year were $4.677 million, and then end of March, $5.886 million, and then here at June 30, $7.472 million, so a pretty significant bump. All that I can glean from that is you are building inventory anticipating higher sales over the near term. Would that be a correct analysis?

There are several reasons for the increase in inventory. We are hoping for increased sales as well. I mean, we are in a growth mode, so that is obviously one of the reasons, even though it is not the only reason.

Just to give you another example, I can tell you that right now we are in a time where the lead time for many of the components not only is being longer and longer, but it is becoming difficult.

What I mean by that is that the risk of placing orders for a component only to be advised by the vendor that he cannot deliver at a certain -- at the time that he promised is becoming higher and higher. Because demand are getting bigger and bigger, and there are more problems of getting the components in time. Which means that in order to be able to support your customers with these extended lead times, which in some cases come up to 20 weeks or 25 weeks or things like that, so we must increase our inventory for that reason as well. So a combination of these issues is I would say the main reason for that.

Then on your June 16 press release on the leading European security solutions company that chose SETAC in head-to-head competition over hardware appliances, can you give us a little more color on that as to why the customer chose SETAC over the hardware appliances, and anything that you give us a sense of how that came about? And maybe the trends going forward with similar situations that you might be working on?

Okay, I'll try. First of all, I think one of the important things is that in this case the customer I would say -- I mean, his original intention before he heard about SETAC was to go with one of the companies that we consider to be the major competitors for SETAC. These are the companies -- I would say the Taiwanese appliance builders, which are doing customized, I would say, motherboards and chassis, which include modular connectivity at the front.

And these are exactly the type of competitors that SETAC was built in order to address this kind of the market, which we could not approach before, because before SETAC we were not able to provide solutions with front modular connectivity.

So the customer was looking at one of these companies, one of the leaders of these companies when we came to him with a SETAC concept. Eventually the customer decided to select SETAC over this competitor, and that was because of the reasons that we actually say that that is the advantage of SETAC. The most important thing is, I would say, the maturity of the motherboard.

Motherboard is a sensitive issue. Once you work with a customized motherboard, even though in your preliminary testing you may not see any problems, but motherboard is something that you may see the problems later on.

So, indeed, the value of taking a standard motherboard, which has been thoroughly tested hours by hours and hundreds of hours by the manufacture of that brand name, I would say, motherboard, that was the main issue here, that the customer was able to select such a branded motherboard and still have the front modular connectivity which we provided with SETAC.

In addition to that, and other factors which contributed to that decision was the fact that the customer, even while he was selecting that very platform, he was -- started to think about the next generation. We could always -- could already come with a solution for the next generation as well, because the SETAC, whenever a new motherboard is coming to the market, it is available immediately. You could use it. It is a standard motherboard; you could use it just like you used the earlier motherboard. So the customer saw that it actually already have a solution for its next generation.

In addition to that, the customer wanted to use Silicom's cards, or modules come in that case, because of our reputation as delivering, I would say, the best such cards that are in the market. So combining all these with the appropriate price, which was more or less similar, I would say, to the competitor's price, that is what made him make this selection and choose us.

Very interesting. Then you referenced a Tier 1 security company, and a very important potential customer that you may have yet this year to announce. Can you go over that again? It is a Tier 1 security company and a Tier 1 something else; I didn't catch that.

Platforms vendor or manufacturer -- what did I say? A Tier 1 security company and a Tier 1 more leading platforms company.

What would be -- I understand the security company -- what would be a platform company? A server manufacturer or a --?

A platform company could be a server, an appliance, I would even say a motherboard, that type of things.

Great. Would you consider the opportunity in cloud computing to be similar to virtualization --?

Yes. This is more or less in I -- I mean, cloud computing is a more, I would say, top-level definition than virtualization, because virtualization goes to the actual operating system on the server and cloud computing is on top of that. But I consider that to be one thing.

And the percentage of revenues that you got from encryption this quarter, if you have that? And then that is all the questions I have, and thanks for answering my questions.

Encryption was about 8%.

Great. Thank you very much, and congratulations on a great quarter and outlook.

Walter Ramsley, Walrus Partners.

Congratulations, excellent quarter, for sure. I have a few questions about the profit margins. During the second quarter you indicated that the product mix was favorable, and that helped the gross margin. How much of a boost did that provide, and is that something that might continue or is that a one-shot thing?

The gross margin in terms of gross profit, I believe -- obviously, this is defined by the mix of the products. So that is one thing. So the figure that we had this quarter is a result of the mix that we have this quarter.

However, speaking generally, I would say that because -- I would say the mix of our products is somewhat including more of the more sophisticated products, so -- and these products, which include our IP, they tend to have somewhat higher margins. So I would say that our margins, if you look at what we have achieved this quarter and the earlier quarter, so that is more or less where we would be, which is, I would say somewhat more than 40%. That is the area that we are going to see ourselves. That is what I presume.

Great. During the second quarter, even though the sales were substantially higher, the Accounts Receivable were pretty flat. Did that indicate that there was pretty steady business throughout the quarter and you didn't get a bunch of sales at the end or -- how come you were able to keep the Accounts Receivable as under control as you did?

It is a question of the DSO, and our collection and this quarter was quite good.

Yes. I understand that. I am just wondering if that indicates that you were getting a lot of business earlier in the quarter and you didn't have to wait until the end of the quarter to --?

No, not necessarily.

In terms of the foreign currency effect, did that enter into the equation at all?

Yes, there was a small effect. First of all, the dollar evaluated by about 4%, 5% compared to the previous quarter. And it slightly decreased the operating expenses in this quarter compared to the previous one. It also improved slightly the financial income.

Okay. As far as the operating expenses are concerned, given -- if you allow for the currency effect, I mean, you still kept them really under pretty tight control. Now that the sales are advancing do you expect to increase the operating expenses over the second half of the year, or what is the prognosis?

It depends on the dollar, but assuming a more or less stable dollar, or a small changes in the dollar, we expect that operating expenses in quarter three and quarter four will be quite similar to what we have seen in quarter one and quarter two.

Not any dramatic change in anything.

Okay. And on competitive fronts, has anybody emerged onto the scene to potentially cause any trouble for the Company, or is it pretty much the same as before?

I think we are improving our position against competition, because we are addressing the right areas. That is what I truly feel. All those areas demonstrated by both SETAC on the one side, redirector on the other side, these are areas where we believe that our level of uniqueness is more emphasized than what it was used to be.

And in previous years, has there been normally a sequential slowdown in the third quarter? Like this year you're saying it is going to be a sequential improvement, but is this an unusual development or is this pretty typical?

I am not sure that there is any typicality to that. Last year there was a certain improvement in the third quarter compared with the second quarter. But that was not always the case, not -- it is not a seasonability issue that we can say that the third quarter is better than the second quarter. I think that what we are saying now about demonstrating sequential growth is a demonstration of our belief that we are growing, even in short-term.

Well, no, it looks great. Then just one last question, as far as the income tax rate is concerned there was, I guess what, 15% in the second quarter and 16% for the first half. Is that pretty much where it is going to be for the whole year?

I would say that the percentage in quarter one and quarter two would be a typical percentage for the coming -- for the upcoming quarters. (multiple speakers). Of course, it can be 2%, 3% higher or lower, but more or less around what we have seen in the first half of 2010.

Okay. Well, congratulations again. Thanks very much.

Jay Steinhilber, Morgan Stanley Smith Barney.

Can you talk about the SETAC. Am I correct, there is no SETAC revenue in your numbers this quarter or this year? And what would you expect through the end of year? And are we talking something that is going to contribute $2 million or $3 million next year, or is it something that could contribute upwards of $10 million in plus revenue?

There are revenues of SETAC even in this quarter, but they are not yet significant. Out of the two European companies that we mentioned, we are selling, or we are starting to sell SETAC components -- kits and solutions to them, but it is not yet significant.

We believe that we will increase SETAC revenues even this year, even though originally we didn't think that will happen. We thought it would take more time. It seems like this happening earlier than what we thought.

Now as to the next year, I definitely think that SETAC -- well, let me put it this way, SETAC definitely has a potential of selling $10 million and more than that. Whether that would -- in a year, I mean -- whether that would happen in 2011 or one year later, I don't know. I am not sure, because the sales cycle is quite long.

If, indeed, that important deal that I was talking about would happen just like we are saying, then we would sell more than $2 million of SETAC next year.

More than $2 million or more than $10 million?

No, no, more than $2 million. I said more than $2 million. I don't think this deal by itself would take us $10 million, but I'm saying SETAC potential is definitely for more than $10 million.

When you say insignificant, you're talking 5%, you're talking $300,000 or $400,000 of the revenue this quarter?

I am talking about something like $100,000.

(Operator Instructions). [Dave Duritti], Private Investor.

Good quarter, guys. Just give me -- on the SETAC product, give me the range of profitability? What is your margin there?

The margin is going to be similar to the margin that we exercise with our other products.

Great, thanks guys.

There are no further questions at this time. Before I ask Mr. Orbach to go ahead with his closing statement, I would like to remind participants that a replay of this call will be available within three hours on Silicom's website, www.silicom.co.il. Mr. Orbach, would you like to make your concluding statements?

Thank you, operator. Thank you everybody for joining the call. I would like to conclude by saying that we will continue to work hard with the ultimate goal of increasing value for shareholders over the long term. We look forward to hosting you on our next call in three months' time. Good day.

Thank you. This concludes Silicom's second-quarter 2010 results conference call. Thank you for your participation. You may go ahead and disconnect.