Silicom Ltd (SILC) 2010 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom third-quarter 2010 results conference call. (Operator Instructions). As a reminder, this conference is being recorded October 25, 2010.

If you have not yet received a copy of today's press release and would like to do so, please call CCG Investor Relations at 1-866-704-6710, or view it in the news section of the Company's website, www.Silicom.co.il.

I would now like to hand over the call to Mr. Kenny Green of CCG Investor Relations. Mr. Green, would you like to begin?

Thank you, operator. I would like to welcome all of you to Silicom's third-quarter 2010 results conference call.

Before we start, I would just 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 as a result of changing industry and market trends, reduced demand for our products, the timing development of new products and their adoption by the market, increased competition in the industry, and price 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, CEO, and Mr. Eran Gilad, CFO. As usual, Shaike will begin with an overview of the results, followed by Eran, who will provide the analysis of the financials. We will then turn the call over to the question-and-answer session.

With that, I would like to hand over the call to Shaike. Shaike, go ahead, please.

Thank you, Kenny. Good morning, everyone. Welcome to our conference call discussing our third-quarter results.

We are particularly pleased with the strong results that we reported today. We delivered on another solid quarter with exceptional top- and bottom-line growth, demonstrating both a strong operating leverage in our business, as well as the continued progress on achieving and actualizing our long-term strategic objectives.

We reported a quarter of very high revenue growth, reaching 59% over the third quarter of last year. We also reported a quarter of strong profitability growth with operating income five times and net income four times what it was in the third quarter of last year.

In terms of our continually strengthening balance sheet, we ended the third quarter with a net cash position of $44.9 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, and places us in a position of strength to take advantage of any opportunities in the market.

Our quarter was also a successful one from a strategic point of view. We gained new and important customers for both our traditional server adapter business, as well as for the SETAC -- for the traction we are seeing in the market has been well beyond our expectations, demonstrating that our long-term strategy is sound and working.

Our solid results are a reflection of the market's continuing need for faster response times and increased bandwidth in an era of WAN optimization, cloud computing, virtualization, video on demand, and Intranet-based applications. Our continued investment in R&D in order to bring out the right product that the market demands is paying off with a continued increase in our sales and profits.

Our traditional business is continuing to make headway. Our business is being driven both by our increasing penetration amongst the market players, as well as growth in the market itself. This is true especially of the WAN optimization segment as was demonstrated by the recent particularly strong results of Riverbed. WAN optimization continues to be a significant portion of our business, and we are providing server adapters to all the leading players in the WAN optimization market.

We announced two significant customer penetrations in the quarter. One was with a WAN optimization leader, a customer that itself is growing very quickly. The customer selected more of our product for use in their next-generation systems, so their orders with us are ramping due to the fact that, A, they are using more of our cards in a broader range of appliances and, B, because their sales volume is fast growing.

The other win we announced was with a new division at an industry-leading Japanese server manufacturer.

Both these deals demonstrate how we are leveraging our relationships with existing customers to increasingly penetrate new products and additional divisions. Just from our existing client base, the scope of the business opportunities open to us is phenomenal. On top of that, we have time and again proven our success at entering new customers and building long-term and successful relationships.

While we are very satisfied with the performance of our traditional business of server adapters, in parallel the SETAC, our new growth engine, is providing us with tremendous potential and upside. The third quarter was key in realizing a number of our SETAC goals.

In August, we announced a breakthrough deal for SETAC. We partnered with a Fortune 100 company, a pioneering developer and builder of high-performance server platforms, to deliver SETAC-based appliances to a top-tier network security company. The Fortune 100 company will integrate our SETAC components into its servers before delivering them to the network security customer for its next-generation lines of the security appliances.

This deal, so far, has been a phenomenal success. While we were originally expecting to implement this deal in the second half of 2011, our customer has enthusiastically embraced our product, and we are well ahead of schedule to the point that sales are expected to start from the beginning of next year or even earlier. In fact, the customer has already given us their initial production orders and sales forecast.

We can tell you that, based on these, we expect revenues to start ramping from the deal from the first quarter of next year and will amount to around $3 million in the first full production year.

This deal is very significant for us for three reasons. First, the revenue potential from the deal is large, since our customer is one of the top providers of network security appliances. Second, as soon as this major customer launches its appliances, this will become a showcase and strong reference to other potential customers, including security companies as well as other networking appliances companies in areas such as WAN optimization, application delivery, et cetera. This will lower the initial market adoption hurdle and make it much easier for new customers to adapt to our SETAC.

Third, the fact that a top 100 -- a top Fortune 100 company is working with us, integrating our SETAC solution into their platforms. But not just limited to joint work on this one networking security customer. They are also interested in expanding their cooperation with us and proposing the solution to other customers, and given the size of this company, their other customers amount to most of the market. This could have a very significant impact on our business.

This truly validates our SETAC concept and confirms the success of its development, marketing, and implementation strategy. This deal supports our ever-increasing optimism regarding the SETAC's momentum and its ability to drive our business to a whole new level.

Beyond this win, the SETAC pipeline is long and deep, and as I mentioned before, this will -- win will go a long way in providing us with an excellent reference to bring in additional customers.

Our new customer penetrations, together with our breakthrough deal for SETAC, demonstrate two independent growth avenues for Silicom. Our traditional business of server adapters continues to grow. This trend is driven by the addition of new customers, the sale of more products to current customers, the penetration of new divisions at existing customers, as well as through wins with our customers' new solutions, and in parallel, our SETAC strategy, which is gaining such tremendous traction and consequently can significantly complement our revenue stream in the coming quarters and years.

These factors underscore our optimism for the business, both in the short and long term.

To summarize, as you can see from our results and the traction of our products, Silicom remains very much on the right track. Based on our continued strong financial performance, balance sheet strength, and cash generation, our platform of globally diversified and satisfied customers, a broad range of current products which we sell to a growing roster of customers, as well as our new products which have already significantly broadened our addressable market, we feel very well positioned for our continued success.

With markets that meet our solutions, strong traction in our established business, and growing acceptance of our new product line, we are optimistic in regard to our ability to maintain our growth for the foreseeable future. Based on this, we would expect to see continued revenue growth for the remainder of 2010 and for 2011.

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

Thank you, Shaike, and hello, everyone.

Revenue for the third quarter of 2008 (sic - see Press Release) were at $7.4 million, a growth of 59%, compared with revenues of $4.6 million recorded in the third quarter of 2009 and a 10% increase compared with $6.7 million for the second quarter of 2008 (sic - see Press Release).

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, 71%; Asia Pacific, 18%; and Europe and Israel, 11%.

The breakdown of revenue between bypass and non-bypass for the quarter was 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 third quarter of 2008 was $3.2 million, representing a gross margin of 43.7%. This was similar to the second quarter and was higher than in the prior quarters, due to a favorable product mix. This is compared to $1.8 million, or a gross margin of 39.1%, as reported in the third quarter of last year.

Operating expenses in the third quarter was $1.7 million, compared with $1.5 million in the third quarter of last year. The strong operating leverage inherent in the business is demonstrated by the fact that our revenues grew 59% compared with only a 13% growth in expenses, which also was increased due to the weakening of the U.S. dollar versus the Israeli shekel. This is a clear demonstration of our ability to grow revenues strongly with only a small increase in expenses.

Operating income was substantially higher than that of last year, reaching $1.6 million, or 21% of revenues, in the third quarter of 2008. This is -- of 2010. This is compared with $333,000, or 7.2% of revenues, as reported in the third quarter of last year.

Third-quarter 2010 net income was $1.4 million, or 19.5% of revenues. This is compared with a net income of $346,000, or 7.5% of revenues, in the third quarter of 2009.

Earnings per diluted share were $0.21 in the quarter, compared with $0.05 in the third quarter of last year.

Now, turning to the balance sheet, as of September 30, 2010, the Company's cash, cash equivalents, bank deposits, and marketable securities totaled $44.9 million, up $1 million compared with the end of the second quarter of 2010 and up $1.7 million compared with the end of 2009. Our current strong cash position represents a level of $6.60 per outstanding share.

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

Jay Steinhilber, Morgan Stanley.

I know you mentioned via a Company presentation that a longer-term goal would be $100 billion revenue for the Company, of which half would be existing products, half would be your new SETAC line, and also you mentioned, if I recall, in previous calls, that a Tier 1 customer could eventually lead to $10 million or $15 million in annualized revenue, and I just was wondering how confident you are in the $100 million long-term projection. And can you give us some more insight into SETAC? In other words, once these companies commit to the product, are they primarily locked in -- for several years? Is it difficult to change course? Can you give us some insight there?

Okay, I'll try to give as much as I can about that. First of all, regarding the $100 million, so obviously this is a long-term projection.

We feel very good about that because we think that SETAC can really provide us with, I would say, something which is similar to what we currently have with our current business, and we do see that our current business are growing or is growing as well, even significantly, and we do believe that overall, this set SETAC volume could be identical to the current business, and that's why we feel -- we believe very, I would say, strongly that this is achievable.

With respect to the SETAC itself, then yes, I would say that once a company selects SETAC, it would stay with this solution for SETAC for several years. Typically, I would say, it would be around three years at the minimum.

It doesn't mean to say that after these three years it's going to something else. More than that, as a matter of fact. If the experience is successful, then typically they would stay with that later on as well, but once someone starts with a new appliance, in most cases it is something which is around three years or even, I would say, three years to four years to go on with a specific selection of an appliance. So we believe that's the way that it's going to be.

A couple of other very quick questions. This is probably for Mr. Gilad. Do you foresee any surprises on the tax rate over the next 12 months? I know we were sitting at 10%, and then all of a sudden one quarter it jumped up to 20%, and it's been sitting there since.

And then, finally, in the annual report, you mentioned the possibility of hedging your expenses. At what point does one dollar -- how weak does a dollar need to get before you might consider doing that?

Okay, you have two questions. First of all, the tax percentage, during 2010, both in quarter one, quarter two, and quarter three, was quite stable at around, more or less, 15%. I would expect a similar percentage in 2011. So this is my answer for the first question.

Regarding your second question, we have never discussed hedging. We do not hedge, and at the moment, we are not planning any hedging activity.

Walter Ramsley, Walrus Partners, LLC.

Thank you. Congratulations. Another fantastic quarter. I just had a quick question. The non-cash stock option expense, could you tell us what that was for the quarter and also for the nine months?

The stock option expense in the nine -- in the quarter and in the nine months is quite negligible. It amounts to a few thousand -- a few -- a few dozen -- a few dozen thousand dollars per quarter.

The Company has signed two other SETAC agreements. Do you have any revenue built in to your forecast for those two?

Yes, we have some revenues from SETAC as well. These companies are still ramping up. They're not even in a steady state as of yet, but we do include sales for SETAC in the last quarter.

And next year, are they likely to come anywhere near to the big company you referred to? Or (multiple speakers) still at a pretty low level?

No, these are smaller -- these are much smaller companies. Not much smaller, these are smaller companies, I would say. They are still leaders in the security market in Europe, but they are smaller companies. I do believe they would ramp up, and as a matter of fact, this is happening as we speak that they are ramping up, but they're not going to be a $3 million account like the big company that we were discussing.

Right. Okay. And then, as far as the adapter business goes, it looks pretty strong at the moment. Is there anything on the horizon that might slow that down?

I think there are several things in the horizon which would ramp that up as well.

Good.

Because we do have some additional customers who are -- and that's actually almost, I would say, a steady-state situation that some customers are evaluating more cards and more possibilities, so we think that will grow as well.

Congratulations. You guys are doing a great job.

Don McKiernan, Landolt Securities.

Thank you, and congratulations as well. What percent of the revenues were in the 10 GB space?

The 10 GB in this quarter was about 17%. And the percentage for the -- for quarter one to quarter three is about 18%, on average.

And then, number of bypass and non-bypass cards in the quarter? I know it was 50-50 on the revenue split.

Total number of cards that were sold during the quarter was almost 21,000 cards, of which bypass drove that -- bypass products, slightly above 8,000, and non-bypass products, about 12,500.

And then, on Redirector, do we have one customer for Redirector now or do we have more than one, and how is that going?

We have more than one. We have one which is bigger than the others. But we have more than one.

This specific customer is ramping up the quantities of the Redirector that it is buying, and the other customers, at least one of them, is also ramping up the quantities that it is buying, but this ramp-up of the other customer is not very significant in overall quantities, while with the first customer, it is significant.

My last question -- just some thoughts on the encryption area. Is that ramping up as well?

Overall, I think -- I don't have the number with me right now for the quarter, whether this big ramp-up in the quarter or not, but overall the trend is to have more encryption solutions as well. I can tell you that even in a part of what we are having within the big SETAC deal would include encryption.

One more question, I'm sorry. SETAC patent situation, now is that -- have you been able to patent that yet, or -- ? (Multiple speakers). Thanks for taking my question.

It's still pending. It has not been approved as of yet. As you know, we take some time, but it is still pending.

Marcel Herbst, Herbst Capital Management.

Congratulations to a great quarter. I wanted to find out, what is the nature of the sequential increase in operating expenses and decrease in financial income?

The increase in operating expenses compared to the previous quarter and compared to the quarter three last year is mainly due to the weakening of the U.S. dollar against the Israeli shekel. The dollar decreased during the quarter by about 6% compared to the shekel, and it affected our expenses in the quarter compared to the previous quarters.

And the financial (multiple speakers)

Okay, and regarding the financial -- the weakening of the dollar also affected our financial. The amount is about -- the negative amount is about $60,000, $70,000.

Okay, good. How many customers do you currently have that buy your external units and how is the pipeline looking regarding new customer interest?

There are several things to say about the external units. I think that we're having approximately 10 customers right now for the external units, but what I believe is more important is that some of these customers -- right now, I can speak about two customers for which the buying of these external units is becoming, I would say, or having some sort of a steady growth.

So with these customers, it takes the pattern that we used to see and are still seeing, of course, with our adapters, which means these are OEM customers, they have decided that these external units are a part of what they sell. They start to buy, they buy from us one type, they are considering buying another type. The amount of buys or the amount of -- the quantities and the revenues generated by these units that they buy is growing steadily quarter by quarter, so that, I believe, is very important.

In addition to that, just like with the adapters, we are adding customers to that as what -- customers to that branch of our business as well.

Okay, good. What was the revenue from China and what's on the horizon there?

First of all, I think, Eran, you can mention the number -- the revenues from China --

I cannot just for China. For the all Asia-Pacific.

For the all -- okay, but all Asia-Pacific is not only China. And that was -- the whole Asia-Pacific was around 17%. I think that approximately half of that came from China.

Now the most important thing, and I think this is important to mention, is that there is, I would -- okay, let me put it this way with respect to the Chinese market. First, there is one relatively big customer that we have in China, which is the server company who, if you remember about that was, I believe, maybe two years ago or something like that, 2.5 years ago, provided us with a very big purchase order, so this customer has not placed any such big order, but it is -- as a matter of fact, whatever this customer is buying in terms of networking cards, it is buying it from us.

Now, so that means that we are getting orders continuously from this customer. It's not just like a regular OEM customer because this server manufacturer is buying per project. So, in one quarter it could be that they buy from us $300,000 or $400,000. In another quarter, it may be less or in another quarter it could be more.

But on the average, there is a customer which is not insignificant in China -- that's the server company -- who buys from us on, I would say, hundreds of thousands of dollars per quarter. In addition to that, there are several other customers who are at the moment smaller who are buying from us. And on top of that, there are several customers that we're speaking with in the Chinese market, and they represent a very significant potential, if indeed we can secure the win. That's a part of our pipeline of customers that we're dealing with.

Excellent. That sounds like good momentum going on there. I have one last question regarding your balance sheet. What are your plans for your large cash position?

Okay. The large the cash position -- I would say that it is divided into two parts. So one part of that, as mentioned before, of course it allows us and gives us all the strength to plan ahead in working capital and things like that.

And one needs to remember that this is very significant right now. We're talking to bigger and bigger companies. We need to build against their forecast, we need to prepare inventories for them, even though sometimes they are committed to take them, but still, we need to build for them, so we need to be in a strong cash position for that as one side of our business.

The other side of that is that while you haven't heard anything, because there isn't anything specific at this point, but it doesn't mean that we're not looking. We are looking -- we are continuously looking for opportunities in the market, and should we find such an opportunity which is synergetic to what we're doing in which we believe that we should go ahead, then we would go ahead and use that cash for that purpose.

So we want to keep it. It is on the table, even though not specifically on the table, but this is something that we continuously look at.

Josh Goldberg, G2 Investment Partners Management.

Just quickly, on the SETAC business, is that a higher gross margin than what you're doing right now? And so, when you look at that increase in revenue next year, how does that translate into earnings per share?

This is supposed to be more or less the same gross margin as the one that we're having right now.

Okay. Could you give us just a little more color on the size of that opportunity, not just in that one customer, but how big you think that market could be for you over the next few years?

You mean the SETAC?

Yes.

Well, I think that SETAC can help us in several ways to increase our revenues, and right now we're only starting to do that because the SETAC contributes to our revenues from several aspects.

First of all, even if we had a customer who used to be our customer and now would move to SETAC with exactly the same kind of networking demands, we would immediately increase our revenues towards this customer because the SETAC -- as soon as -- when we sell SETAC to such a customer, we sell more in revenues than what we sold when we sold only cards. The SETAC itself is more than what we had before. That's number one.

Number two, still speaking about our current customers, SETAC allows for an increased port density in terms of networking. And as the revenues are actually per port, so the same customers, even when we are talking about the same customers, when they buy SETAC, they buy more ports. When they buy more ports, our revenues are increasing.

Furthermore, still talking about the current customers, and I would then move to other customers, so to new customers. Once we move into SETAC, SETAC defines the form factor of the cards or the modules which are being bought, and that means that if a certain customer used to buy some cards from us and some other cards from someone else, once it moves to SETAC, it would buy all the cards from us. So, that again would increase our revenues from this specific customer.

Now (multiple speakers) -- but that's not all of that, and I'm sorry for jumping in because I didn't even mention the most important thing. I waited with that a little bit. And there are two such factors. One is there are -- there is a significant -- a relatively significant segment in the market which wanted to have appliances with connectivity in the front and modular. This segment of the market, we did not have any access to until now. They used to buying some customized appliances from Taiwanese companies.

Now we have, for the first time, an opportunity to address this market. That would -- that is very, very significant. That could increase our revenues vary significantly because we have a part of the market which we now can address before. Before that, they would not be able to buy from us.

And on top of that, all these guys may now move and buy from us the full appliance and not only the components of the SETAC or the card, and that would even increase the revenues even more.

Does that answer your question, sir?

[Edward Belinsky], [Segmark].

My question really has to do with the movement of the stock and the price. Can you tell me if there is any way in which -- to which the prices and the volumes of the sale of SETAC on the Israeli exchange is reflected in the reported U.S. volumes and prices? Do they get incorporated in the NASDAQ volumes and prices, or are they just kind of -- they're out in limbo with some reference, just by virtue of arbitrage?

I believe the question has to do with the relationship between (multiple speakers) Israel (multiple speakers)

(Multiple speakers) on the Israeli exchange, reported anywhere in the U.S.?

No, there is no connection between the exchange rate of the Israeli shekel compared to the dollar and the price at the -- on the NASDAQ. There is no connection.

I see, fine. Thank you very much, then.

(Operator Instructions). Don McKiernan, Landolt Securities.

Thank you. I wanted to clarify on the currency, dollar shekel, translation, it was an impact to financial income of $60,000 to $70,000, is that correct?

Correct.

How about the rest of the income statement with respect to revenues and other expenses? Did you identify any impact there?

As I said, there are two effects. The first one is on the financial, and we said that the amount was about $60,000 to $70,000 in the quarter, and the second effect was on our operating expenses, and I would say that most of the increase in our operating expenses compared to the previous quarter is a result of the weakening of the dollar.

With respect to the second quarter this year or year-ago quarter?

Both.

Okay, great. Thank you.

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 in three hours on [Vdon's] website, [www.vdon.co.il]. Mr. Orbach, would you like to make your concluding statement?

Yes, thank you, operator. Thank you, everybody, for joining the call. I'd 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 third-quarter 2010 results conference call. Thank you for your participation. You may go ahead and disconnect.