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Silicom Ltd  (NASDAQ:SILC)
Q2 2019 Earnings Call
Jul. 25, 20199:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom's Second Quarter 2019 Results Conference Call. [Operator Instructions]. You should have all received by now the company's press release. If you have not received it, please contact Silicom's Investor Relations team at GK Investor and Public Relations at 1 646 688-3559 or view it in the news section of the company's website at www.silicom.co.il.

I would now like to hand over the call to Mr. Ehud Helft of GK Investor Relations. Mr Helft, would you like to begin, please?

Ehud Helft -- GK Investor Relations

Thank you, operator. I would like to welcome all of you to Silicom's Second Quarter 2019 Results Conference Call. Before we start, I'd like to draw your attention to the following safe harbor statement. This conference call contains 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 our increasing dependence on -- for substantial revenue growth on a limited number of customers in the evolving cloud-based SD-WAN, NFV and Edge markets; the speed and extent to which solutions are adopted by these markets; the likelihood that we will rely increasingly on customers, which provide solutions in these evolving markets, resulting an increasing dependency on a smaller number of larger customers; difficulty in commercializing and marketing Silicom's products and services; maintaining and protecting brand recognitions; protection of intellectual property, competition and other factors identified in the documents filed by the company with the SEC.

In addition, following the company's disclosure of certain non-GAAP financial measures in today's earnings release, such non-GAAP financial measures will be discussed during this call. Such non-GAAP measures are used by management to make strategic decisions, forecast future results and evaluate company's current performance. Management believes that the presentation of these non-GAAP financial measures is useful to investors' understanding and assessment on the company's ongoing cooperation and prospect for the future.

Unless otherwise stated, it should be assumed that financials discussed in this conference call will be on a non-GAAP basis. Non-GAAP financial measures discussed by management are provided as an additional information to investors in order to provide them with an alternative method for assessing our financial conditions and operating results. These measures are not in accordance with or a substitute for GAAP.

A full reconciliation of non-GAAP to GAAP financial measures is included in today's earnings release, which you can find on Silicom website. With us today on the call are Mr. Shaike Orbach, the CEO; and Mr. Eran Gilad, the CFO. Shaike would begin with an overview of the results followed by Eran, who will provide the analysis of the financials. We will then turn over the call to the question-and-answer session.

And with that, I would now like to hand over the call to Shaike. Shaike, please.

Shaike Orbach -- President, Chief Executive Officer and Director

Thank you, Ehud. I would like to welcome all of you to our conference call to discuss the results of the second quarter of 2019. We are satisfied with the results of the quarter with revenues in line with our expectations, ongoing profitability and continued cash generation. We reported $25 million in revenue and net income of $3 million. We also generated $6 million in positive cash flow, further strengthening our balance sheet. Our cash position stands at the highest level it has ever been at over $87 million with no debt. We ended the quarter with shareholders' equity of over $164 million as a result of 14 years of ongoing and continued profitability.

Our strong balance sheet gives us significant financial flexibility and enables us to pursue any opportunities that may arise, whether through internal R&D investment or external acquisitions. As you know, our main long-term growth drivers come from 2 directions, our uCPE plus Edge products, targeting primarily SD-WAN, NFV and other networking and telco-related sectors as well as our advanced FPGA solutions. These markets are currently at the early adoption phases of their growth curves, which presents a huge opportunity over the long term for Silicom.

As we discussed with you last quarter because of the emerging nature of this nascent market, there are timing and visibility issues in the short term from our major SD-WAN design wins. This is primarily due to the excess inventory accumulated by one of our major SD-WAN customers and also due to the slower-than-expected ramp-up and timing of our major telco wins. We believe this is a short-term issue, and I would like to take a few minutes to explain why we believe that this is indeed the case. Regarding our major OEM customer, given the large growth in quantities, we see this particular customer selling in turn to their customers, which is reflected by the rate at which they are drawing from their existing inventory.

We see that the actual quantities of our Edge units being deployed is growing significantly in 2019 compared to 2018. Thus, we feel confident that this major SD-WAN player will resume placing high-volume orders with us at the strong levels we expect by early 2020. Furthermore, this customer has just begun to place orders for another configuration of our Edge device, and while this new configuration will also take time to ramp up, it will increase the volumes that we can expect even further. As to our telco wins, similarly, we believe it is only a timing issue before we begin to see the full and huge potential of these wins.

With regard to our earlier telco design win, the customer made a decision to change the configuration of the unit it was buying from us, which caused significant delays. With this new configuration in place, we now expect the quantity to ramp up toward the end of 2019 or the beginning of 2020. Likewise, our latest significant telco win is ramping up more slowly than expected, as within this win, we have 4 models, which were customized to meet customer requirements and the process is inherently a long one. Once again, we believe we will begin to see the ramp-up we were hoping for in 2020.

Summarizing what I discussed, once the excess inventory with our major OEM SD-WAN customer is depleted and the ramp-up of our existing design wins progresses, we expect our revenues in total will return to growth in 2020. More broadly, as each quarter passes, we are becoming increasingly excited with regard to the potential we see for our Edge business. Our design wins in the Edge segment, now amount to over 10 wins, some of which have a long-term revenue potential measured in the tens of millions of dollars per year at full deployment. Customers continued to embrace and plan for integrating SD-WAN as a part of their IT and networking strategy going forward. Subsequently, our pipeline is broad, deep and growing consistently and includes further such potential wins with significant long-term revenue potential for Silicom.

Furthermore, the launch of our powerful New Intel Xeon-D D2100-based Edge Computing Platform for streamlining the deployment of white box services opens up additional opportunities and is another engine for growth in the high-potential Edge Computing market. And now to our FPGA-based solutions. Momentum and interest from customers and potential customers for our new FPGA-based offerings continues to build. We continue to invest significantly in developing and advancing our FPGA technology, and we consider it to be an important element in Silicom's long-term growth strategy. In fact, in recent months, we announced several FPGA wins that we expect will translate into growing revenues next year, and we are working to transform a significant portion of our FPGA pipeline into new wins.

At the same time, we continue to invest in expanding our technological lead in the space. Our technology bridges the gap between bare FPGA chips and cards to fully functional FPGA-based integrated solutions, allowing our customers to tailor solutions to their exact needs. One of the major selling point is that our Smart NIC uses a unique Packet Mover technology, a feature enabling both us and our customers to easily integrate their own specific or generic IP into our core FPGA framework.

Our leading technology has been attracting strong interest from customers in our traditional cloud data center networking target market is demonstrated by our cloud-related win in March as well as interest from the broader industry. This was demonstrated also by a recent win, whereby a technology giant in the process equipment space, selected us to design a customized 400-gig FPGA networking cloud. Apart from the incremental revenue, a key reason we're excited with this particular win is because this customer comes from outside our traditional target market of the cloud and networking space.

While our sales and development focus remains the cloud, telco and other networking-related markets, this win and other such potential wins in the pipeline prove that our technology is relevant to a much broader market than we originally anticipated. It demonstrates companies beyond our primary focus market are actually seeking us out without us needing to broaden our development, sales and marketing efforts.

This was, in fact, our third key FPGA design win in 2019, which follows the win we announced back in March with a leading cloud player, which we expect would eventually ramp up to more than $10 million at the peak. Together with our earlier strategic win announced in January with a leading ISP, the potential of our FPGA-based solutions to become a significant growth driver for us is clear. Just like with our Edge units, we have a strong pipeline, and we expect to achieve additional FPGA design wins in 2019 with the associated ramp-ups in 2020 and accelerated growth in the years following.

However, I want to stress again that the ramp-up process is gradual one, and it will take time for the revenues from our current FPGA wins to reach their full potential. With regard to our guidance for the third quarter. As I mentioned, visibility in the Edge NFV space is currently unclear. With that in mind, we are providing guidance for the third quarter and project revenues at between $24 million and $25 million. Looking further out into the next year, we believe that the short-term issues with our SD-WAN-related revenues will be behind us, and we will also begin to benefit from our FPGA-related wins as well as from new wins in the SD-WAN space, which altogether will likely be translated into a return to double-digit year-over-year growth in 2020 and even more accelerated growth in 2021.

In summary, overall, we are satisfied with our performance, both our second quarter 2019 results and cash generation and just as importantly, our strategic progress toward our longer-term goals. Our focus continues to build our business for the long term, and we look forward to accelerated growth in 2020 and beyond. We remain positive with regard to the long-term prospects of our SD-WAN and NFV Edge-related business. As always, our success will be built on the ramp of our already existing design wins, which includes wins with major telcos, service providers and leading SD-WAN player as well as new design wins in that space.

Beyond that, we are optimistic about the potential of our new growth engine, our FPGA technology, which has the potential to become a significant growth driver over the long term for our business. We expect to see a solid ramp and real contribution from our new FPGA business starting into 2020. Broadly speaking, the opportunities for Silicom remain huge, and we are much greater than what -- and are much greater than what we have achieved today. We look forward to reaping those rewards in the coming years.

With that, I will now hand over the call to Eran for a detailed review of the quarter's results. Eran, please go ahead.

Eran Gilad -- Chief Financial Officer and Company Secretary

Thank you, Shaike, and hello, everyone. Revenues for the second quarter of 2019 were $25.4 million compared with revenues of $27.6 million as reported in the second quarter of last year. Our geographical revenue breakdown over the last 12 months were as follows: North America, 80%; Europe and Israel, 16%; Far East and Rest of the World, 4%. During the second quarter of 2019, our top 3 customers together accounted for about 35% of our revenues. I will be presenting the rest of the financial results on a non-GAAP basis, which excludes the noncash compensation expenses in respect of options and RSUs granted to directors, officers and employees, acquisition-related adjustments, as well as discontinued project-related write-offs.

For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the second quarter of 2019 was $8.8 million, representing a gross margin of 34.6% compared to a gross profit of $9 million in the second quarter of last year, representing a gross margin of 32.5%. Operating expenses in the second quarter of 2019 were $5.9 million or 23.4% of revenues compared with $5.5 million or 19.8% of revenues in the second quarter of last year. Operating income for the second quarter of 2019 was $2.8 million or 11.1% of revenues compared to operating profit of $3.5 million or 12.7% of revenues as reported in the second quarter of last year.

Net income for the quarter was $2.9 million or 11.4% of revenues compared to $3.4 million or 12.2% of revenues in the second quarter of last year. Earnings per diluted share in the quarter were $0.38 compared with $0.44 as reported in the second quarter of last year. Now turning to the balance sheet. As of June 30, 2019, the company's cash, cash equivalents and bank deposits and multiple securities totaled $87.4 million with no debt or $11.56 per outstanding share. This is up $5.9 million compared with $81.5 million at the end of the first quarter and up $13.4 million compared with $74 million at the end of 2018.

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

Questions and Answers:

Operator

[Operator Instructions] The first question is from Alex Henderson of Needham & Company. Please go ahead.

Alex Henderson -- Needham & Company. -- Analyst

So I was hoping if you could explain what a process equipment space is, little confused by the term around that customer win. Just can you give us a little bit more sense of what category that is?

Shaike Orbach -- President, Chief Executive Officer and Director

Yes. I mean it's going to be a little bit difficult simply because we're careful to identify the customer because if I go into details, it may lead you to understand who the customer is and we're not allowed to do that at the moment, which is why it's difficult. What I can say is that this customer is a technology company. So we're not talking about the process control or process equipment in, I would say, chemical industry or anything like that. It's a high-technology company involved in the technology business and the processes that we're talking about are processes within the technology segment.

Alex Henderson -- Needham & Company. -- Analyst

So this is kind of a production equipment for manufacturing something?

Shaike Orbach -- President, Chief Executive Officer and Director

That could be an example to that. Yes.

Alex Henderson -- Needham & Company. -- Analyst

Okay. That's what I would -- that's clear enough. Second question is, the last couple of times, we've talked about the outlook. You were still little concerned about the rate of drawdown of the inventory. This call you sound a lot more confident. Should we assume that the rate of pull-down over the information you have relative to the rate of pull-down of that excess inventory has either accelerated or the visibility has improved around it since we last talked?

Shaike Orbach -- President, Chief Executive Officer and Director

Yes. I mean we definitely have more data. I wouldn't say that it helps us in terms of visibility toward what's going on, but it definitely gave us some data point at least looking back so that we understand what's going on. So last time, when we were talking about this major OEM customer, we only knew that it had a lot of inventory and we didn't know how much time it would take the customer. This is something we still don't know for sure, but at least we have some data points. We didn't know anything about the rate at which -- what's going to happen with this inventory, is it something that is happening with this customer, is it something, which is happening in the market as to why all that stopped, and so on and so forth.

Now we have collected some data, which while it does not give us clear visibility as to what would happen in the very short term, but we were able to see that, OK, the inventory of these units was X at a certain point in time, 3 months ago and now when we're asking for data right now, he said, OK, now the inventory that we have is that one. So that allowed us to calculate the rate at which this customer is actually deploying our systems. So we're saying that if this continues, it gives us -- first of all, it does give us the confidence because we were able to compare this rate with what we were with the rate that we -- that actually happened in 2018, so we were able to analyze and say, yes, well, the quantities that we actually deploy in the field, maybe not the quantities that we sell, but the quantities which are in the process of being deployed in the field are growing.

So unlike what exactly we've got, I mean we see the process and the process is that, yes, the customer may have had some issues due to reaching both much more than what we wanted to do, but we do have a certain rate right now, which is higher than the rate that we had last year, which is why we believe that if he continues by that rate at the beginning of 2020, he is going to begun with all this inventory and then continues with that rate that gives us confidence that this -- these sales are going to come back to us by the beginning of 2020. So yes, this is dependent on the assumption that the same rate will continue. It may be a little slower. It may be a little higher. So we cannot go for sure, but we do see the movement of our units as they are being deployed in the field, and this is definitely encouraging.

Alex Henderson -- Needham & Company. -- Analyst

So if I look at the commentary you're giving, it sounds like you have a baseline understanding of what the underlying growth rate in SD-WAN is. When I look at the commentary out of Gartner and other surveys that have been done around SD-WAN, it shows growth rates anticipated for the industry in the 40% to 60% range. You don't seem to be cleaving to that, yet you sell to almost all of the underlying players that they're measuring.

How do we reconcile that discrepancy? Is it just a timing issue? Is that -- are there forecasts off? How do we reconcile that? We just did a survey that showed cloud direct modeling and SD-WAN was one of the most aggressively sought out technologies in a sample of 50 companies in the $500 million to $6 billion range. It's just not putting -- how do we reconcile it?

Shaike Orbach -- President, Chief Executive Officer and Director

Well, what I would say is that the data that we have, which may not be representative of the full market, but it does not contradict the data that you're giving. Because, to be honest, I mean, what's happened to us was that by the end of 2018, in a way, we were, I would say, mislead by the fact that we had one in a way, I would say, even more than one, but let me talk about this specific customer because that was the main factor that led us to these conclusions. We have received a huge order toward the end of 2018, which eventually turned out to be exaggerated and not needed. Now if we take just what was actually needed by that customer during that time, during 2018 and then we look at the current rate that we're hoping to get in 2019, yes, that may definitely be 40% or maybe even more.

Only, you cannot take what we saw in 2018 and expect a 40% growth over that because this what we sold to this customer in 2018 was that actually reflecting the need of the market, but rather some assumptions that this specific customer said. So talking generally, yes, I mean, I'm not -- I think it may make sense that our growth rate in SD-WAN could be quite similar to what you've said in -- but that would -- we would feel that in terms of significance in total revenues that would be significant in 2020. 2019 may not be that significant.

Alex Henderson -- Needham & Company. -- Analyst

So if that's the case and the market is, in fact, growing 40% plus then I'm struggling with the explanation of why the 2 large service providers who want to participate in that space have delayed so much. Last quarter, you gave an explanation that you thought part of the reason why those 2 Tier 1 customers in the U.S. didn't deploy white box SD-WAN was because they were seeing weak underlying sales at the OEMs, and therefore, they were no rush to undermine their MPLS business. Can you revisit that assumption relative to the delays of those 2 Tier 1?

Shaike Orbach -- President, Chief Executive Officer and Director

Yes. I mean I think that last quarter we gave several potential reasons for the delays, and we thought that possibly some of these reasons were related to a slower-than-expected ramp-up of SD-WAN and NFV. When we looked at that closure and analyze the numbers, so indeed, I'm saying that I don't see based on the numbers that we now looked at, I don't think there is a slower-than-expected rate of growth of the SD-WAN. There still may be a relatively slow deployment in terms of NFV but not in SD-WAN. Now as to your specific question, so your specific question about these 2 big wins.

So -- and I addressed that in what I described, but I'll try to give you some more color into that. So the first one of them was starting actually to launch our systems with SD-WAN and then there was a decision there to change the configuration that they wanted to launch. Now, bear in mind, they may have several programs. These are huge organizations. So they may be growing in one area, but this area, not due to the market, they decided to change the configuration and they put on hold everything. And as I said, I mean, now the definition of the new configuration is completed. We have started to provide them with the new configurations. So we believe that by the end of this year or beginning of next year, everything will be in place to ramp up just like we hoped for in the beginning. I believe that we have said that this win will ramp up to approximately $15 million right around per year.

Now the process is actually just beginning again. I mean we hope it would begin last year -- by the end of last year and then it was delayed by almost a year. That's what I'm saying right now due to this change in configuration, which is something specific to this account to this SD-WAN deployment specific to us. That's with one of these. The second one is a different story. This one, I mean, this win was with one of our, I would say, off-the-shelf boxes. The other win was inherently a longer process, which was supposed to account for both NFV and SD-WAN, SD-WAN being an application, which is run on a universal CPE in this case. But this one was inherently a longer process because unlike the first win at the telco win that was based on an off-the-shelf unit.

In this one, we had to design or customize 4 different separate models for this customer. So this is a development process, a testing and approach, changes, etc. and this is just moving slower than expected. I guess this might be expected with these giant companies that they have a request to -- for a small change here, someone need to approve, someone here, someone there, they did not seem to be in an extreme hurry, which could be explained by the fact that it was not a pure SD-WAN, which is -- everyone is trying to push as fast as possible but rather some sort of a combination of NFV with SD-WAN application. They're still pushing it, and we're moving forward with that. And looking at the process right now and also understanding better this customer because now we understand how it works, we expect this to ramp up by the beginning of next year.

Alex Henderson -- Needham & Company. -- Analyst

All right. One last question, if I could. Just on the cost side of the equation. So the shekel has had a pretty good run. Should we be expecting a little bit more cost inflation as we go into the back half and into 2020 as a result? Thank you.

Eran Gilad -- Chief Financial Officer and Company Secretary

I cannot tell about the second half because nobody can tell. I can say that, indeed, the shekel was stronger compared to the dollar in quarter 2 compared to quarter 1, which means that there was a negative effect on our operating expenses in the amount of about $100,000 in Q2 compared to Q1.

Operator

The next question is from Alexander Kuznetsov of Perkin Hardy Strauss. Please go ahead.

Alexander Kuznetsov -- Perkin Hardy Strauss -- Analyst

I'm kind of curious how you think about your net cash position going forward. I was surprised to see that there were not much buybacks, if at all during the quarter, even though you had the authorization and you had more than like 1/3 of your market cap is now net cash and keep generating quite a bit of it. So can you just share your thoughts on how it tends to deploy it and so on?

Shaike Orbach -- President, Chief Executive Officer and Director

You talk about the buyback, I'll talk about everything else.

Eran Gilad -- Chief Financial Officer and Company Secretary

Correct. So I will comment about the buyback issue that you raised. I'm not necessarily agree with what you said because the buyback plan is progressed as planned. We intend to meet the target, which was set by our Board of Directors, which means the buyback of up to $15 million within 1 year. You should remember that we announced the buyback plan at the beginning of May and actually started it a little bit afterwards, which means that you do not see a full quarterly effect of the buyback plan.

Operator

We have a follow-up question from Alex Henderson. Please go ahead.

Alex Henderson -- Needham & Company. -- Analyst

Sure. Great. So I just wanted to talk a little bit about the margin structure a little bit. Obviously, you've had some pressure on the really big programs that would have pushed down the gross margins. Gross margin came in at 34.6% in the quarter. I think that's a function of mix. It sounds like that mix is persisting into the back half since neither of the very large Tier 1 programs are really ramping yet, and you're still primarily selling to OEM projects. Is that a reasonable level of margin to think about for the back half of the year persisting at that level?

Shaike Orbach -- President, Chief Executive Officer and Director

Well, I would say that your analysis is correct. I think, overall, yes, but still you need to remember that it is a function of the mix of product as well. Even within our OEM older, I would say, products, there still could be deviations in the margins, which is why we continue to say that the margins would be between 32% to 36% because it is dependent on mix. But generally speaking, I mean, you're right, I mean, that's where we are, so.

Alex Henderson -- Needham & Company. -- Analyst

Okay. So you've absorbed about $100,000 in currency impact in the quarter to OpEx. Your OpEx came in essentially flat. Are we offsetting the cost of exchange and new hires and other issues on inflation so that we are still looking at fairly flattish OpEx with a very slight bias upside sequentially or what's the trajectory of OpEx at this point?

Shaike Orbach -- President, Chief Executive Officer and Director

Yes. We think it's more or less going to be flat. Of course, I mean, cannot say 100% and there could be some deviations here and there. But in general, more or less flat.

Alex Henderson -- Needham & Company. -- Analyst

Okay. Down on the tax rate, it came in a little lower than we'd expected them. We're using 15% in the back half. Is that still the guide?

Eran Gilad -- Chief Financial Officer and Company Secretary

First of all, correct. The tax rate in quarter 2 was lower than usual, mainly due to onetime effects, which will not continue in the future. I would say that the expected tax rate for the next few quarters should be as before, approximately 15%.

Alex Henderson -- Needham & Company. -- Analyst

Perfect. That's all I had on those. One last question, if I could. Going back to kind of whatever described as the historic business selling into traditional OEM customers. I mean I looked at the 5 numbers from last night as an example, they are moving heavily to soft only. And as a result, the appliance business was down 11% year-over-year. So I mean, not just talking about them specifically, but rather that is a general trend. Have you seen an acceleration in the erosion of the legacy appliance end market business? Or is that continuing to be fairly flat? Can you give us any help on that side of the business?

Shaike Orbach -- President, Chief Executive Officer and Director

Yes. I mean we haven't seen any dramatic change. But I would say that, but I wouldn't say it's flat. I mean the trend is a decline, but we're not seeing it as a sharp decline. I mean we're seeing a very slow decline. Now it may be partially, I'm not sure that the information is that I'm giving you is really representing what's happening in the market because you need to understand that even though we do not invest too much in that, but even because these customers like us, we get new design wins from these customers as we speak. And so these new design wins sometime they compensate for whatever is happening in the market. So the fact that we're saying decline, which is close to flat behavior does not necessarily mean that that's the market. But for us at least, we see a very soft, easy decline as the trend that you're seeing.

Operator

[Operator Instructions] 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 by tomorrow on Silicom's website at www.silicom.co.il. Mr. Orbach, would you like to make your concluding statement?

Shaike Orbach -- President, Chief Executive Officer and Director

Yes. Thank you, operator. Thank you, everybody, for joining the call. We look forward to hosting you on our next call in 3 months' time. Good day. Thank you.

[Operator Closing Remarks]

Duration: 38 minutes

Call participants:

Ehud Helft -- GK Investor Relations

Shaike Orbach -- President, Chief Executive Officer and Director

Eran Gilad -- Chief Financial Officer and Company Secretary

Alex Henderson -- Needham & Company. -- Analyst

Alexander Kuznetsov -- Perkin Hardy Strauss -- Analyst

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