Silicom - Q2 2024

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom Q2 2024 Results Conference Call. All participants are present in listen-only mode. Following management's formal presentation, instructions will begin for the question-and-answer session. As a reminder, this conference is being recorded. 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 EK Global Investor Relations at 1-212-378-8040 or view it in the News section of the company's website, www.silicom-usa.com. I would now like to hand over the call to Mr. Kenny Green of EK Global Investor Relations. Mr. Green, would you like to begin, please?

Kenny Green (Co-Founder and Director)

Thank you, Operator. I would like to welcome all of you to Silicom's Q2 2024 Results Conference Call. Before we start, I would like to draw your attention to the following Safe Harbor statement. This conference call contains forward-looking statements. Such statements may include, but are not limited to, anticipated future financial and operating results and Silicom's outlook and prospects.

Those statements are based on management's current beliefs, expectations, and assumptions, which may be affected by subsequent business, political, environmental, regulatory, economic, and other conditions, and are subject to known and unknown risks and uncertainties, and other factors, many of which are outside of Silicom's control, which might cause actual results to differ materially from expectations expressed or implied in the forward-looking statement, and which include, but are not limited to, Silicom's increasing dependence for substantial revenue growth on a limited number of customers, the speed and extent to which Silicom solutions are adopted by relevant markets, difficulty in commercializing and marketing of Silicom's products and services, maintaining and protecting brand recognition, protection of intellectual property, competition, disruptions to its manufacturing, sales, and marketing, development, and customer support activities, the impact of the war in Israel and in the Ukraine, rising inflation, rising interest rates, volatile exchange rates, as well as any continuing or new effects resulting from the COVID-19 pandemic, and the global economic uncertainty, which may impact customer demand through their exercising greater caution and selectivity with their short-term IT investment plans.

The factors noted above are not exhaustive. Further information about the company's businesses, including information about factors that can materially affect Silicom's results of operations and financial conditions, are discussed in the annual report on Form 20-F and in other documents filed by the company and that may be subsequently filed by the company from time to time with the Securities and Exchange Commission, the SEC.

Therefore, there can be no assurance that actual or future results will not differ significantly from anticipated results. Consequently, you are cautioned not to rely on these forward-looking statements. Silicom does not undertake to update any forward-looking statements as a result of new information or future events or developments except as may be required by law. 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 the company's current performance. Management believes that the presentation of these non-GAAP financial measures is useful to investors' understanding and assessment of the company's ongoing core operations and prospects for the future. Unless otherwise stated, it should be assumed that the financials discussed in this conference call will be on a non-GAAP basis.

Non-GAAP financial measures disclosed by management are provided as additional information to investors in order to provide them with an alternative method for assessing the financial condition and operating results of the company. 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's website. With us on the line today are Mr. Liron Eizenman, President and CEO, and Mr. Eran Gilad, CFO. Liron will begin with an overview of the results, followed by Eran, who will provide the analysis of the financials. We will then open the call for the question-and-answer session. With that, I would now like to hand the call over to Liron. Liron, please go ahead.

Liron Eizenman (CEO and President)

Thank you, Kenny. Welcome, everyone, to our conference call to discuss the results of the Q2 of 2024. The Q2 was a period of focused execution of our strategic plan to generate significant long-term value for our shareholders. Our sales and R&D activities are operating under a renewed focus as part of the plan, with the goal of building a deeper pipeline, acquiring new customers, and ultimately increasing revenue and long-term upside. Those efforts have already brought us an exceptionally broad and deep pipeline of new and high-potential sales opportunities. This is making us increasingly optimistic about the long-term prospects for Silicom. In parallel, however, the sales cycles for all our product lines have become longer than they were in the past, negatively impacting the pace of progress in our strategic plan.

Beyond that, we continue to believe strongly in the long-term potential of our main product lines, including server adapters and edge systems, which continue to garner strong customer interest despite the current slowdown. A further element of our strategic plan was the stabilization of operating expenses, which we completed early in 2024. We believe that our business is now appropriately sized, enabling us to support long-term growth with expenses aligned to the plan's objectives. We will continue to tightly control expenses with only minimal increase expected in 2025 and beyond, based on our plan's needs. In terms of our financial performance for the Q2, we reported revenues of $14.5 million with a net loss of $0.9 million.

I stress that our strong balance sheet built up over many years enables us with the ability to continue and ensure that we can maintain adequate investment in our business and its growth engines without compromise at the revenue and expense levels predicted by the strategic plan. Regarding our balance sheet strength, our current working capital and marketable securities at the end of Q2 were $131 million, with a very high quality of inventory equal to $45 million, accounts receivable, net of accounts payable of $8 million, as well as $78 million in cash, cash equivalent, and very highly rated marketable securities. All this represents above $21 per share. A further element in our strategic plan aims to enhance shareholder value by leveraging our strong cash position through a share buyback, which is planned to reduce our share count by 1.6 million shares in total.

I know that the first half of the year, while we generated over $13 million in cash, we used around half of that, $6.6 million, for the repurchase of 410,000 shares. Our current share count stands at 6 million shares. In terms of our guidance for the Q3 of 2024, revenues are expected to remain similar to those of the first and Q2 at between $14-15 million. This takes into account the longer-than-expected sales cycles that I mentioned earlier, the prolonged excess inventory digestion periods of several large customers, and a continued global economic slowdown in our markets. All of those are having a negative impact on our revenues that is likely to persist for several more quarters through 2024 and 2025.

With that, we expect that the second half of 2024 revenues will be at a similar level to those reported in the first half, and that 2025 will show only a slight increase over 2024 from the revenue standpoint. Long-term, due to the market's slowed sales cycles, which have significantly lengthened and time frames of our design win processes and sales ramp-ups, we have extended our strategic plan by one year. We now expect strong annual growth rates of 20%-30% to materialize in 2026 based on 2025 as a baseline, with the ultimate goal to exceed earnings per share of $3 as we return to revenues of $150-160 million.

I want to take a few minutes to discuss why I'm optimistic about Silicom's long-term prospects and why I believe our strategic plan will bring us back to a strong level of growth in future years, and more and more of our broad and deep pipeline of high-potential sales opportunities will be converted to design wins and revenues. To give you some more color, I would like to provide you with a number of examples of the upside we see given the thicker and longer pipeline we have built in recent months, with each example potentially representing annual revenue potential of $5 million and above. First, some of our existing customers of low and mid-range networking solutions are in discussion with us to potentially extend their engagement towards higher-end networking systems.

This expansion mirrors our previous experience with server adapter customers, where we began with one or two products, and after a few years of successful relationship, we expanded the business to include additional products. It is exactly the same pattern by which we have grown much of our business over the years. To support this growth, we are broadening our system portfolio with more powerful CPUs, additional cores, increased memory, and enhanced networking interfaces. We have several such potential customer engagements at various stages of discussion, each of which could contribute additional business of between $5 million-20 million per year at full scale. Second, we are engaging with major new customers with whom we have been in a dialogue for a long time who are considering a variety of our products, including FPGAs, SmartNICs, and systems.

Some of those products will implement new and advanced features specifically requested by those customers. Those customers return to Silicom due to our cutting-edge technologies, advanced product capabilities, and customizable features, which allows us to tailor our products to their specific needs. Those potential design wins involve products that we have either recently launched or are about to launch soon. Beyond the potential with those customers, the new products and features requested have significant potential with other customers as well. Third, we see existing SmartNIC customers evaluating the possibility of extending their business with us to include higher-end SmartNICs, including FPGAs, and potentially expanding to full systems. This broadening reflects their growing confidence in our ability to provide a comprehensive end-to-end solution that meets their demanding needs. We currently see this type of potential from several customers at various stages of engagement.

If we successfully close those opportunities, each could contribute a few million dollars to tens of million dollars per year at full run rate. Fourth, we have current SASE customers who are looking to gradually ramp up their business with us as they gain increased confidence in Silicom as a critical supplier for their needs. We are in discussion with those customers to potentially add both higher-end and lower-end systems to their current mid-range purchases. Our existing business with those customers continues to grow steadily, and with the addition of those new products, our total business with them has the potential to reach approximately $10 million annually at full ramp-up. Fifth, we are engaged in promising discussions for a new line of ruggedized systems, with demand coming from companies in verticals such as energy, retail, restaurant chains, and connected vehicle operators.

Those systems are designed to withstand harsh environments and demanding conditions, making them ideal for industries requiring durable and reliable solutions. We are already customizing our systems to meet the specific environmental conditions of the various potential customers, and each engagement has the potential to be very significant. Our early discussions have so far indicated strong potential for this new line. Taking a broader perspective, our long-term growth trajectory will be supported by a diverse and expanding pipeline of both existing and potential design wins with new and existing customers. It will add a layer of stability to our business by diversifying our revenue streams and will provide us with multiple avenues to pursue additional growth in our business. Our pipeline includes engagements with some of the most prominent names in the networking, telco, and security space, which demonstrate the strength and appeal of our technology offering to industry leaders.

While the assumption in our strategic plan remains conservative, there is an upside potential and much to be excited about. The broadening and deepening of our pipeline in recent months is a testament to the initial success of our strategic plan. We are seeing early results of our strategy to target small to medium design wins, which are strongly expanding our pipeline of future potential design wins. At the same time, we continue to give much attention to opportunities within our pipeline that could generate substantial additional revenue, some with potential in the range of $20 million annually. The realization and fast ramp-ups of one or more of the potential upside deals mentioned earlier will bring to our strategic plan a goal a lot sooner than currently indicated in the plan.

In summary, we have much to look forward to. Given our strong balance sheet and exceptionally high level of working capital for our needs, a design win roster full of tier-one customers coupled with our superb products, a bursting pipeline of opportunities, along with a staff with the networking hardware industry's best minds, we are optimistic about our ability to successfully execute on our strategic plan and return Silicom to renewed strong growth and profitability. With that, I will now hand over the call to Eran for a detailed review of the quarter results. Eran, please go ahead.

Eran Gilad (CFO)

Thank you, Liron, and good day to everyone. Revenues for the Q2 of 2024 were $14.5 million, a decline from revenues of $38.1 million as reported in the Q2 of last year. The geographical revenue breakdown over the last 12 months was as follows: North America 83%, Europe and Israel 14%, Far East and rest of the world 3%. During the last 12 months, we had 10% plus customers. I will be presenting the rest of the financial results on a non-GAAP basis, which excludes the non-cash compensation expenses in respect of options and RSUs granted to directors, officers, and employees, acquisition-related adjustments, as well as lease liabilities, financial income. For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today.

Gross profit for the Q2 of 2024 was $4.3 million, representing a gross margin of 29.7% and compared to a gross profit of $12.3 million or gross margin of 32.2% in the Q2 of 2023. As discussed previously, in the near term, our gross margin is expected to be at the lower end of our 27%-32% expected range, and as our revenues grow from current levels, over the longer term, it will increase towards the upper end. Operating expenses in the Q2 of 2024 were $6.7 million compared to $7.5 million reported in the Q2 of 2023. Operating loss for the Q2 of 2024 was $2.4 million compared to operating income of $4.8 million as reported in the Q2 of 2023.

Net loss for the quarter was $0.9 million compared to net income of $4.5 million in the Q2 of 2023. Loss per share in the quarter was $0.14. This is compared with diluted earnings per share of $0.66 as reported in the Q2 of last year. Now, turning to the balance sheet, as of June 30, 2024, the company's cash, cash equivalents, and marketable securities totaled $78.3 million with no debt. This represents an increase of over $13 million compared to the end of 2023. We used about half of that at $6.6 million for the repurchase of 410,000 shares during the first half of this year. That ends my summary. I would like to hand back over to the operator for the question-and-answer session. Operator.

Operator (participant)

Thank you. Ladies and gentlemen, at this time, we will begin the question and answer session. If you have a question, please press star one. If you wish to cancel your request, please press star two. If you are using speaker equipment, kindly lift the handset before pressing the numbers. Your questions will be polled in the order they are received. Please stand by while we poll for your questions. The first question is from Alex Henderson of Needham. Please go ahead.

Alex Henderson (Senior Research Analyst)

Thanks. I wanted to spend a little bit of time talking about the balance sheet. If I look at the inventory levels, $44.5 million, any risk to that inventory? In other words, is there any portion of that inventory that is getting long in the tooth or specialized for a particular customer that may not be achievable that might cause you to have to write down any of that inventory? Or conversely, are you feeling confident that that inventory is all going to be utilized going forward?

Liron Eizenman (CEO and President)

We don't see such a risk. It's a very high-quality inventory.

Alex Henderson (Senior Research Analyst)

Similarly, any risk to the receivable side of the equation?

Liron Eizenman (CEO and President)

No.

Alex Henderson (Senior Research Analyst)

So essentially, $22 and change in asset values per share, you're confident that those total current assets are all solid assets and are not going to be impaired. If I look at the liability side of the equation, I think it's $13.7 or $2.30 a share or so in liabilities that are current. Is there anything in there that we should be aware of?

Liron Eizenman (CEO and President)

Nothing special. All standard.

Alex Henderson (Senior Research Analyst)

Okay. So the balance sheet looks clean. Then the question then is, how long do you think it takes to get back to break even on the earnings front? Do you think you can hit that in 2025, or is that all the way out into 2026?

Liron Eizenman (CEO and President)

Yeah. I don't believe it will happen in 2025. As I said, I believe that the increase of revenue from 2024 to 2025 will not be that significant, which means we're still going to be in a situation that we're not break even. We expect that to happen in 2026. I'd say during 2026, probably in the second half of 2026.

Alex Henderson (Senior Research Analyst)

All right. And if I look at the quarter, the EPS came in a little bit better than we'd expected, but it looks like a lot of that was below the line, particularly in the tax line. We were expecting a tax cost, not a tax benefit. Can you talk to what you think the tax line is going to do in the back half of calendar 2024?

Eran Gilad (CFO)

Yes. First of all, the tax income that we saw in quarter two is a result of a one-time reason. This is due to almost $1 million, one-time tax returns from previous years. Again, this is a one-time occasion. Looking forward, assuming 2024 or 2025 will not be profitable, we expect annual income tax in a very low amount of about $0.1 million, more or less.

Alex Henderson (Senior Research Analyst)

$0.1 million per quarter, about $100,000 per quarter?

Eran Gilad (CFO)

Per year. A very low amount of tax expenses. So $0.1 for the full year.

Alex Henderson (Senior Research Analyst)

For the full year. So essentially, near zero per quarter.

Eran Gilad (CFO)

Exactly.

Alex Henderson (Senior Research Analyst)

All right. When I look at the income statement based off of the commentary about the numbers on the top line, it sounds like you're still talking about around that $60 million level in 2025. Is that back half weighted, or do you expect the income statement to be fairly low in the first half of the year and then start to recover in the back half of 2025 to get to a higher level of, say, $16 million or something like that in the back half, or $14 million in the front half, or do you expect it to be fairly flat around the current levels of $15.5-$16 million range?

Liron Eizenman (CEO and President)

I expect, let's say, the first two quarters of the year to be similar to what we're seeing right now, give or take. Then from there, it will increase a little bit as we go into the second half. It will be more weighted on the second half, but not very dramatically.

Alex Henderson (Senior Research Analyst)

Okay. But something in the vicinity of $60 million is kind of what you're thinking about in terms of the year?

Liron Eizenman (CEO and President)

Roughly, yes.

Alex Henderson (Senior Research Analyst)

All right. And the gross margins on that, any mechanical change in the mix here that you're assuming, or are we still kind of around that 30% level?

Liron Eizenman (CEO and President)

I think it will be very similar to what we're seeing right now.

Alex Henderson (Senior Research Analyst)

All right. So continued. So that suggests you're kind of looking at about a $10 million operating loss in 2025 and another $5 million or so in the back half. So we should be thinking then that roughly $15 million in burn rate. Is that a reasonable assumption for the cash burn?

Eran Gilad (CFO)

Yes.

Liron Eizenman (CEO and President)

I think we were talking something in the range of 10, maybe more than that, 15, I think. But it really depends on, I mean, when we're looking at that, we're also thinking about future projects and when we will need to start getting more inventories ready for supporting the new product. So hard to give a very conclusive answer to that, but I—

Alex Henderson (Senior Research Analyst)

Well, if you hold the OpEx fairly flat at current levels, around $27 million, and have a 30% margin on just under $60 million, that's a 10% or excuse me, $10 million operating loss. So I would assume that if you're going to build inventories, it's going to be more than that in 2025, plus you got the first half or the back half of 2024 to deal with, which is another, what, $5 million of operating loss? So I would think it's at least $15 million plus any build-in inventory that happens late in 2025.

Liron Eizenman (CEO and President)

If you're including also the second half of 2024 and the full year of 2025, then yes. But I would also add the fact that we are expecting to get some financial income as well that could improve the situation, again, depending on what will happen on that side. But give or take, the number 15, I think it's a reasonable number.

Alex Henderson (Senior Research Analyst)

All right. I get it. Going back into the mechanics of the business, I know that you guys had been chasing a lot of large deals, and that looked pretty attractive when those deals looked like they were probable to metastasize into the revenues and drive the business. Obviously, those projects did not materialize as expected. And now I understand that you've shifted to more of the traditional model of going after design wins that are what I would call singles business, $2 million a year potential for each design win. But design wins generally take longer to materialize.

You've got to design it in, the company's got to put it in their product, and then they've got to launch the product, and that just takes longer. Is that part of why this timeline to recovery is slower than you thought, or is it just simply the macro is causing deep uncertainty and therefore we can't count on these revenues?

Liron Eizenman (CEO and President)

So a few points. So first of all, you're right that when we're designing in, when our customers design us in, then it's a process. They need to get rid of their current inventories. They need to launch it and market the new product. And it usually takes time. The bigger the design win is, by the way, usually it takes longer to do so. So with smaller and medium design wins, it may happen faster than with very big design wins. The macro right now and the overall situation of high inventories with customers are causing those processes to be longer even than what we used to see in the market. So that means that this is why we see a delay even in the timeline that we expected, which is causing the process to take longer.

Alex Henderson (Senior Research Analyst)

Yeah. But what I'm trying to determine is, is the change in the strategy to do more singles business part of the reason why you're anticipating a slower recovery?

Liron Eizenman (CEO and President)

No.

Alex Henderson (Senior Research Analyst)

Obviously, maybe an increased visibility to that recovery as those design wins are very persistent business.

Liron Eizenman (CEO and President)

No. This shift in strategy is not what's causing a slower recovery. What's causing the slower recovery is the fact that customers are sitting still on inventories, is the fact that making decisions on new products and new technology for the customers takes longer than it used to be, again, because of the macro and because of the situation that they are struggling to sell their product sometimes, or they've been more optimistic than the reality. So all of that together is putting us in a place that it takes longer. But it's not because of the shift to smaller and medium design wins. And I would also add that we didn't stop looking for the big design wins.

It's just that we are also focusing very much on the small and the medium because our experience when we looked back showed us that sometimes the small and medium, they become large over time, whether it's with this specific design win or whether it's with a new design win that we get from the same customer. So we're not focusing solely on the big ones. We're focusing on small and medium while we still have our list of the very big design wins, which I talked about a little bit, that could be even $20 million a year, but we're not focusing only on those.

Alex Henderson (Senior Research Analyst)

I see. Okay. I'll cede the floor. Thanks.

Operator (participant)

If there are any additional questions, please press star one. If you wish to cancel your request, please press star two. Please stand by while we pull for more questions. There are no further questions at this time. Before I ask Mr. Eizenman 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, www.silicom-usa.com. Mr. Eizenman, would you like to make your concluding statement?

Liron Eizenman (CEO and President)

Thank you, Operator. Thank you, everybody, for joining the call and for your interest in Silicom. We look forward to hosting you on our next call in three months. Good day.

Operator (participant)

Thank you. This concludes Silicom's Q2—