Silicom Limited (NASDAQ:SILC) Q3 2022 Earnings Conference Call October 31, 2022 9:00 AM ET
Company Participants
Liron Eizenman – Chief Executive Officer
Eran Gilad – Chief Financial Officer
Ehud Helft – GK Global Investor Relations
Conference Call Participants
Alex Henderson – Needham & Co.
Shawn Boyd – Next Mark Capital
Operator
Ladies and gentlemen, thank you for standing by. Welcome to the Silicom third quarter 2022 results conference call.
All participants are at present in listen-only mode. Following management’s formal presentation, instructions will be given 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 GK Global Investor Relations 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. Ehud Helft of GK Global Investor Relations. Mr. Helft, would you like to begin, please?
Ehud Helft
Yes, thank you Operator. I would like to welcome all of you to Silicom’s third quarter 2022 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 dependency for substantial revenue growth and the 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 in an increasing dependency on a smaller number of larger customers; difficulty in commercializing and marketing Silicom’s products and services, maintaining and protecting brand recognition, protection of intellectual property, competition, disruptions to our manufacturing and development along with general disruptions to the entire world economy relating to the spread of the novel coronavirus – COVID-19, 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 financial 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 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 our financial condition 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 are 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 turn over the call to the question and answer session.
With that, I would now like to hand the call over to Liron. Liron, go ahead please.
Liron Eizenman
Thank you Ehud. I would like to welcome all of you to our financial results conference call discussing our third quarter 2022 results.
We are very pleased to report a very impressive quarter with strong revenues, margins, and profit growth across the board. This is all a clear demonstration of the power and leverage inherent within our business model.
We reported very good performance with revenue growth up 19% year-over-year to $39.2 million. Our higher quarter-end backlog continued to demonstrate the high demand for our products. The strong operating leverage within our business model allowed our revenue growth to translate into much higher profit growth because we did not record a corresponding growth in our expenses. This is demonstrated by our operating margin expanding to an impressive 18.4% for the quarter versus 12.8% last year. All this led to our 71st quarter of continuous profitability with net income of $6.9 million, up a very strong 91% year-over-year with earnings per share at over $1.00, a sequential increase of 45% over Q2 of 2022.
I want to stress that we achieved all this and our performance would have even been better had it not been for the ongoing global component shortages crisis which still continued to impact our revenue to some extent in the third quarter. As you know, we have worked hard over the past year to overcome this situation. Our solid results show that we have indeed been successful and proved our ability to mitigate issues and deal with continued challenges.
Looking ahead, the good news is that in recent months, the global component shortages have now stabilized and we’re starting to see minor improvements. We are working on the basis of an improvement in component availability during the first half of 2023 despite the fact that the shortage for certain parts may continued until the end of 2023 or even beyond.
Over the past year, we have used our cash position, currently at $43 million, to build up our inventory levels to support demand and protect us from shortages and non-commits by chief vendors. We see this continued strong cash position as a strategic asset and significant competitive advantage. It allows us to serve our existing customers better, delivering products which are not readily available while attracting new customers and new business which have difficulty finding product elsewhere.
With of signs of some lessening in component shortages, we expect that peak inventory levels are now behind us. While those levels are still at the higher level than what we would normally need, we do expect to gradually decrease those levels due to availability improvements from several of our component vendors.
As our results clearly demonstrate, from our perspective we continue to see no let-up in the demand for more end markets. The exceptionally strong market demand that we are experiencing is broad and is across our full product range, but more importantly for us, we believe that we have seen significant growth in our total addressable market potential.
As our Edge product initially targeted for SD-WAN markets became a clear growth driver for us, we realized that the same products are attractive for many broader applications and markets, giving the features, performance, cost and flexibility advantages. As a result, we now have a record pipeline of design wins and opportunities for our Edge product in multiple varied markets, as well as interest from potential new customers for our products.
Telecos, service providers, enterprises, cyber and networking companies, and cloud players are using our Edge products for applications as disparate as SD-WAN, virtual CPE, teleco dedicated routing, secure access service edge, and more. An example of this trend is the design win we announced in August. This was an initial $3 million new design win and order from a U.S.-based leading provider of cloud-based secure access service edge solutions. This fast-growing cloud cyber security leader will use our customized Edge platforms to provide both wired and wireless connectivity to its end customers.
This customer explained to us that they chose us due to our combination of product functionality, price, rapid customization capabilities and support, directly meeting their needs for their next generation systems and applications. This win for our Edge products represents proof of their value for multiple markets and represents significant expansion of our addressable markets.
The value of our Edge product is well beyond SD-WAN alone, our original target market for this innovative technology. Our Edge products offer the exact functionality, features and cost that telecos, service providers, enterprises, cyber and networking companies, and cloud players need for their next generation systems and applications. This coupled with our ability to deliver rapid customization, on-boarding and ramp-up support positions us ideally for SASE and other markets that use edge platforms. This is all the more demonstrated by the large and growing pipeline that we have built from a variety of significant design wins and opportunities.
As I mentioned, we now see that the total addressable market for our Edge product is much larger than we initially planned, and as we grow our share, we expect them to contribute significantly to our future growth. Our existing wins, our continued high backlog combined with the potential opportunities in our pipeline underline our optimism that our achievements so far are just the top of the iceberg.
Looking ahead in terms of the guidance for the coming fourth quarter and full year 2022, we expect to show continued growth with revenues at between $43 million and $45 million, which at the midpoint represents growth of approximately 21% over that of the fourth quarter of 2021. This guidance implies full year revenues of $148 million to $150 million and at the midpoint 16% over that of 2021 revenues. I would note that we continue to take into account the continued component shortage situation in our estimates as to the level of our success in indeed mitigating it. Had there been no such situation, our forecast would have been higher.
In summary, we remain very pleased with our performance in the third quarter of 2022 with strong year-over-year growth in revenue and a significant acceleration in our profit growth proving the operating leverage inherent in our business. In fact, we are very pleased that our operating margin of 18.4% and net margin of 17.5% achieved in this quarter surpasses the target margins indicated in the long term model that we have been including in our investor presentations for a few years.
Our exceptionally strong backlog provides us with continued visibility in our revenue growth over the quarters ahead. More broadly, the success of our Edge product and its broader application into multiple markets well beyond what we imagined earlier on means that our total addressable market today is significantly greater than our previous estimates, and this makes me increasingly bullish with regards to our prospects over the mid and long term. With our total addressable market larger than ever, a record pipeline and a stronger than ever momentum, we have never been better positioned and look forward to multi-year expansion.
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
Thank you Liron, and hello everyone.
Revenues for the third quarter of 2022 were $39.3 million, up 19% year-over-year compared with revenues of $32.9 million as reported in the third quarter of last year. Our geographical revenue breakdown over the last 12 months was as follows: North America 70%, Europe and Israel 24%, Far East and rest of the world 6%. During the last 12 months, our top three customers together accounted for about 25% of our revenues.
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 and 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 third quarter of 2022 was $14.1 million, representing a gross margin of 36%, at the top of the range of our gross margin guidance of 32% to 36%, and compared to a gross profit of $11.3 million or gross margin of 34.3% in the third quarter of 2021. The variance in the gross margin is a function of the specific product mix sold in the quarter.
Operating expenses in the third quarter of 2022 were $6.9 million compared to $7.1 million reported in the third quarter of 2021. Operating income for the third quarter of 2022 was $7.2 million, an increase of 72% compared to operating income of $4.2 million as reported in the third quarter of 2021.
Net income for the third quarter was $6.9 million, an increase of 91% compared to $3.6 million in the third quarter of 2021. Earnings per diluted share in the quarter were $1.01 compared with EPS of $0.52 as reported in the third quarter of last year.
Now turning to the balance sheet, as of September 30, 2022, the company’s cash, cash equivalents and marketable securities totaled $43.2 million with no debt, or $6.44 per outstanding share.
That ends my summary. I would like to hand back over to the Operator for the question and answer session. Operator?
Question-and-Answer Session
Operator
[Operator instructions]
The first question is from Alex Henderson of Needham & Company. Please go ahead.
Alex Henderson
Thanks. You guys are, facetiously I say this, making me feel like I can’t forecast by crushing my numbers every quarter, so thanks so much for that. Great job, super impressed.
I wanted to start off with the obvious, which is the quarter was strong, the guidance reasonably strong. You’re still supply constrained. Can you give us any quantification of the magnitude of the supply constraints in backlog – I mean, is it a slice or is it a loaf, or is it a bread truck? How much of the outlook–how much better would the outlook be if you had the ability to ship what you wanted to ship in the quarter?
Liron Eizenman
First of all, thank you for the warm words before we start. I would say that, first of all, it’s an evolving situation right now. The situation is, I would say, changing on a daily basis. It is improving to some extent, not from all vendors and not on all parts. It depends–really depends sometimes. You may hear that the company is doing better, but we just need a specific part from them and that specific part is hard to get. It’s hard to give numbers exactly on how much it’s impacting, but definitely it’s impacting. If there was no shortages at all, we would be at much higher numbers, and the same goes for looking forward–looking forward, the same, we have visibility, we have a big backlog, as we said, but it’s a daily battle to continue and get more parts and more parts. But roughly, I would say it’s in the millions.
Alex Henderson
Okay, similar kind of a question on the other direction, though. You have a lot of major project wins, and those project wins are projects that your partners that you’re selling to need to ramp, and in this environment where the economy of Europe in particular but also in the U.S. and internationally are under a lot of duress, so what is the risk that some of these large projects get stretched out, delayed, downsized versus the magnitude of the partnerships you have? You’ve got so many of them that it seems like even if some of them are flattened or delayed, you would be able to offset that. Could you talk to how you’re balancing macro pressures on project timing versus the magnitude of the wins that you’ve been able to bring down?
Liron Eizenman
Absolutely, so definitely we are ramping up on several design wins right now, and what we’re doing is working very, very closely with the customers to understand what they need compared to their original plans. I can say that in the short term, we almost see no risk. In the longer term, who knows? We’re tracking that. The global economy, I think it’s unclear yet where it’s going, but what we can do is talk with our customers all the time, understand exactly what their plans are, and so far, as I said, at least in the very short term, we see almost no impact.
Alex Henderson
I think coming out of the last quarter, going into the back half of the year, you talked about visibility at least through year end. Is it at this point out into the middle or back half of the June quarter that you have visibility to that demand?
Liron Eizenman
I would say that is very customer specific. In some cases, we are able to gain more visibility; in some cases, they give us a little less, but in general we have visibility deep into 2023, but not until the end of 2023.
Alex Henderson
Right, great. Gross margin, high end of the band, the last two quarters above the midpoint of the band, and the first quarter is seasonally the weakest quarter of the year. What should we be thinking here is the result of that? Is that a function of the environment and you’re able to get better margins, or is it a mix issue? What’s going on, on the gross margins, and how should we be thinking about for the fourth quarter?
Liron Eizenman
First of all, it’s a result of the very hard work, I would say, by the team to try and maintain this GM, but in general it is a function of the mix of products that we sold during this quarter. Very happy with this result, obviously, and then the hard work done by the team. We still keep our guidance between 32 and 36.
Alex Henderson
All right, and then on the opex, a little surprised that it’s declined now two quarters in a row. I would assume that some of that has to do with the shekel versus the dollar, but I would also expect that there’s some project timing and things of that sort, particularly in the R&D line, which was down from $5.1 million to $4.4 million.
Can you give us a little bit of guidance on what we should be thinking as we go into the fourth quarter for that, and for that matter, any sense of what your plans are for 2023 at this point?
Liron Eizenman
You’re right about the dollar versus the shekel, but actually it’s actually even more strong on the dollar versus the Danish krone. As you know, we have our team in Denmark and that’s also impacting even, I would say, percentage-wise higher than the dollar versus the shekel, but there are a few, I’d say one-time items in the R&D expenses that are causing the reduction as well.
In terms of looking forward, we still when we look at those numbers and on an annual basis, we still look at the opex at around $30 million a year, and that’s what we expect for 2023.
Alex Henderson
All right, so in the fourth quarter, should we assume that rebounds up into the $5 million range, or is it going to stay at the lower levels that it’s been here? It’s impossible for us to read that.
Liron Eizenman
Sorry, can you repeat the question?
Alex Henderson
Yes, just for the fourth quarter, is the R&D going to rebound here in the fourth quarter?
Liron Eizenman
There is a chance for that. I think it’s hard for us to know. Also, we don’t know exactly what happens with the dollar versus the shekel and versus the krone. I think for 2022, as I said, we are looking at around $30 million for opex, and for 2023 for around $33 million.
Alex Henderson
Okay, 33–I get it, that helps clarify it. Okay.
Going down to the interest line, you’ve got rising interest rates and a very large cash balance, and great cash flow. Should we start to see the interest income go up meaningfully over the next two or three quarters as a result of the short-term instruments rolling to higher interest rates, and what might that look like, say, by the middle of next year on the interest line?
Eran Gilad
First of all, as you mentioned, exchange rate differences is a big factor in the financial income number. In quarter three, there was a positive effect of exchange rate differences. The real financial income should be $100K or even a little bit less than $100K, so assuming no effect of exchange rate differences and no other one-time items, the real financial income is up to $100K.
Alex Henderson
And no benefit from rising interest rates?
Eran Gilad
No, because the part of our investment currently is not so high, so even if we reinvest, our–even if we reinvest our available funds, the impact will not be significant.
Alex Henderson
All right, that’s understandable. Any guide on the tax rate for next year? It looks like 15% is sort of the baseline. Are we comfortable with that still?
Eran Gilad
Yes. As we could see, the tax rate in quarter three was quite low, approximately 10%, and for the first three quarters it was about 12%. It was–it is a little bit low due to one-time reasons which will not affect our long term guidance. Our long term guidance remains at the range of 15%.
Alex Henderson
As we look out to next year, given the close rates you produced this year and the backlog constraints, is it reasonable to think that we could do growth on par or even better than the ’22 rate?
Liron Eizenman
We believe so. I mean, a lot of unknowns, it’s a time–I mean, a lot of things that are unknown at the moment, the global shortages, if it really will go down in 2023 as we expect, if the global economy will be as some people say or not. From our perspective, when you look into the visibility and we look at the projects that need to ramp up and our discussions with customers, we do believe we will continue with double-digit growth. That’s what we believe, that’s what we’re working towards, that’s our assumptions from a planning perspective, so we believe very much this is going to be the case.
Alex Henderson
Great, I’ll cede the floor. Thanks.
Operator
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 poll for more questions.
The next question is a follow-up question from Alex Henderson. Please go ahead.
Alex Henderson
Oh, there are no other questions in the queue? Okay.
Can you talk about the pipeline of deals that you’ve got in the headlights that haven’t been signed yet, particularly around some of the verticals – openRAM, I think is one that some people have talked to, who own the stock, are really interested in. Can you just give us some sense of what that pipeline of potential deals look like?
Liron Eizenman
So first of all, where we see the biggest growth from our perspective is DH, definitely. As I pointed out in the earlier part of the call, we see that the products that we initially thought are going to be for SD-WAN maybe not only but mainly, actually we see that our addressable market is much, much bigger than that. If it’s SASE or if it’s teleco routing or if it’s other applications, we see more and more demand for that, more and more products that our customers are asking us to design for them, and we see the growth coming from that perspective very, very strong.
If we looked at, for example, enhanced internet, that’s another domain that we are becoming more active in. All of that together is really driving our belief that this is our main growth driver, and we believe that’s where our future lies.
Alex Henderson
So just going back to the question in terms of the number of projects that you’re chasing that haven’t been penned yet, is it larger than your historical pipeline, is it the same as your pipeline? I’m pretty clear that the Edge has lots of different parameters.
Liron Eizenman
Yes, it’s much higher. I mean, if you look at the pipeline, not all of that is, as you said, not signed maybe, but in serious discussions with customers, we have many projects, some of them bigger, some of them smaller, but a lot of discussions and a lot of potential wins.
Alex Henderson
Can you talk about 5G a little bit? Is that still an area that is getting a lot of attention, or has that been subsumed by these other opportunities?
Liron Eizenman
First of all, this is an area where we are generating revenues today. We have a few design wins that are already fully ramped up, some of them going to ramp up. In general, this is an area that we’re very happy with. In general I would say worldwide, not related to Silicom specifically, 5G all around is not in mass deployment today, and as we–I believe as it will get more mature, it will also mean for Silicom more business; but at the moment, it’s still a little bit premature.
Alex Henderson
All right, and then looking out into next year, you guys have taken a differential tact on the gross profit approach by not including costs associated with, or revenues associated with parts that have been priced significantly above normal levels. You’ve worked with your customers to allow them to buy those products and to help fund those products, and in that way it doesn’t distort either your revenue or gross margin. Am I reading that correctly?
Liron Eizenman
Yes.
Alex Henderson
So as we go out into 2023 and you start working through your inventory, are you expecting that inventory to have any charges or cost variances associated with it, or are you able to pass on any carried benefits of having higher prices in the current environment than what you may have paid for the product? Will your inventory help or hurt your gross margins in ’23?
Liron Eizenman
The way that we have–and we have a big team focused really on that, on managing those risks, and the way that our system is built is in order to make sure that we’re not taking unnecessary risks here. We do not believe that this should have any impact, or I would say a minor impact if at all.
Alex Henderson
You brought up the security vertical as an area that you’re expanding into and have new wins with. Can you talk to what portion of your business is going into the security market?
Liron Eizenman
I cannot say a specific percentage, but in general I would say that, both for our more classic products and also for our new products, because we know that, for example, SASE, which I mentioned earlier, is actually a domain that came from networking and added more security features on it, so vendors that used to be networking vendors are now networking and security vendors, so that is also part of the reason that we’re seeing growth in cyber. But in general, we also had our more traditional products in cyber as well.
Eran Gilad
And as can be seen on our investor presentation, which will be uploaded very shortly, during the last 12 months, the portion of cyber security was approximately 30%.
Alex Henderson
So that’s got to be a higher growth segment of your business, I would assume?
Eran Gilad
Right.
Alex Henderson
I wanted to talk a little bit about seasonality, just to make sure that we have it correct in our head in this environment. Historically, the December quarter has been a seasonal spike, typically up $3 million, $4 million, $5 million in revenues but also the largest quarter of the year in terms of EPS. It sounds like given your guidance on opex and the 36% gross margins that you posted in the mid two quarters, that that will not be the case this year for the fourth quarter. But then again, the March quarter is typically seasonally much weaker, typically down by a third or more. Is that likely to be the scenario again in ’23? How do we think about that seasonal pattern over the next two quarters?
Liron Eizenman
We do expect to see the seasonality. We do expect–I don’t know about this quarter, what we’ll see at the end of fourth quarter, what we’ll see at the end of the quarter, but definitely we expect Q1 of next year to be usually how we see Q1 every year – it will be going down a little bit and climbing up from there.
Alex Henderson
All right. I hope there’s some other people queued. I don’t have any more questions for you. Thanks.
Liron Eizenman
Thank you.
Operator
The next question is from Shawn Boyd of Next Mark Capital. Please go ahead.
Shawn Boyd
Good morning. Can you hear me okay?
Liron Eizenman
Yes, good morning.
Shawn Boyd
Great. Gentlemen, just two from me. The first is related to the market expansion on the Edge products and how you originally were targeting the SD-WAN market but that now we’ve got some additional markets beyond that. Can you talk to the size of these opportunities versus the SD-WAN market? I know that some of the early wins there, we were thinking revenues could be in the tens of millions per year eventually, not now obviously, but what do these other markets look like in terms of scope and size?
Liron Eizenman
From what we see, those markets would be bigger, maybe even double the size of what we’ve seen for SD-WAN. SASE, I think those numbers are even public, some analysts trying to estimate the size of the SASE market compared to the SD-WAN market. Proportionally, we should be–our market share should be similar, so that means that we see opportunities with new markets that could be even double the size of the SD-WAN market for us.
Shawn Boyd
Very good, so maybe just going to that example that you brought up earlier, talking about the August design win, $3 million from a U.S. provider of cloud-based security. How does a ramp with that contingent business look like? If it starts at $3 million, help me on for year one, year two, year three, just rough ranges here would be great.
Liron Eizenman
First of all, I have to say that it’s also a little bit constrained by supply, as we said, because they would be very happy to get many products quickly here to get going. We do believe that that $3 million is a very initial order and the annual revenue from that could even be bigger than the first order that we received. We’re working with them. There’s still some last phases of introducing the product on their end, some global certification that we need to do, but definitely we see the ramp-up already starting, but it will probably be sometime in 2023 before they are fully ramped up.
Shawn Boyd
Got it, okay. That’s helpful.
My second line of questioning is simply on margins. I get that there is certainly a small currency benefit right now related to op expenses, but your incremental operating margins, whether we look at it quarter over quarter or year over year, are providing well in excess of 40%, so can we think about each incremental piece of business you’re adding dropping 40%-plus to the bottom line, give or take?
Liron Eizenman
From a gross margin, we still believe that we’re going to be in the same range that we always have – 32% to 36%. Definitely on the operating margin, eventually if we will be able, and we hope we will and, as we said, we believe we have some leverage here, we’ll continue to increase our revenue and with the same level of expenses, obviously that will be very good news. We will materialize on the leverage that we believe that we’re showing, but it’s–time will say, we will see as we go along.
Shawn Boyd
Got it. Okay, congrats on the quarter, and that’s it for me. Thank you gentlemen.
Liron Eizenman
Thank you very much.
Operator
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
Thank you Operator. Thank you everybody for joining the call. We wish you all health, and we look forward to hosting you on our next call in three months’ time. Good day.
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