Silicom Ltd. (NASDAQ:SILC) Q3 2023 Earnings Call Transcript

Silicom Ltd. (NASDAQ:SILC) Q3 2023 Earnings Call Transcript October 26, 2023

Silicom Ltd. beats earnings expectations. Reported EPS is $0.3, expectations were $0.24.

Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Silicom Third Quarter 2023 Result Conference Call. All participants are present in listen-only mode. Following management 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 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: Thank you, operator. I would like to welcome all of you to Silicom’s third quarter 2023 result conference call. Before we start, I would like to draw your attention to the following safe harbor statements. 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 Silicom’s increasing dependency for the substantial revenue growth on a limited number of customers in the evolving cloud-based SD-WAN, NFV, and Edge market; the speed and the extent to which solutions are adopted by these markets; the likelihood that Silicom will rely increasingly on customers which provide these solutions in these evolving markets, resulting in an increasing dependency on a smaller number of larger customers; difficulty in commercializing and marketing of Silicom’s products and services; maintaining and protecting brand recognitions; protection of intellectual property, competition; the disruptions to our manufacturing; sales and marketing; development and customer support activities; the impact of the war in Ukraine and the war in Israel; rising inflation; rising interest rates; volatile exchange rates and commodities prices; as well as any continuing or new effects resulting from the COVID-19 pandemic and the global economy uncertainty, which may impact customer demand through exercising greater caution and selectivity with their short-term IT investment plans; as well as other factors discussed in our annual report on Form 20F and other documents filed by the company that may be subsequently filed by the company from time-to-time with the Securities and Exchange Commission.

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 are useful to investors’ understanding and assessment of the company’s ongoing core operation 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 discussed by management and provided as 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 are included in today’s earnings release, which you can find on Silicom’s website. And 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 the call to the question-and-answer session. And with that, I would now like to hand the call to Liron. Liron, please go ahead.

Liron Eizenman: Thank you, Kenny. Welcome to our financial results conference call discussing our third quarter 2023 results. Our third quarter’s revenues were $30.1 million. This is in line with the expectations that we announced last quarter. In terms of profitability, we reported a third quarter net profit of $2.1 million and a third quarter earnings of $0.30 per diluted share. I would like to spend a few moments discussing the very limited visibility we are currently experiencing in the market, the factors currently at play which are impacting us as well as our expectations for the short and mid-term. As I’m sure you remember, since the global COVID shutdown three years ago in 2020, supply chains around the world became tight with very limited availability, especially of electronic components.

Silicom, like many other companies, leveraged strong balance sheets to put in the increase and maintain high inventory levels of components. This was to ensure that we could continue to build the products that our customers need in a timely way, maintain strong business continuity, and most importantly, keep our clients happy with continued top quality service provision. Similarly, over the past two years, our customers ordered a high level of our products for months, so they can manufacture products for their customers in turn. And this ordering, a good portion for inventory, drove above average demand and a high backlog for our products in both 2021 and 2022. However, the second half of 2023 has seen a reversal in this trend. The supply chain’s tightness has abated and customers which has built-up significant inventory are now drawing on their existing stock of our products where possible, and currently do not need to order significant quantities for months.

Another impact is related to industry and economic headwinds facing our customers that began to affect our revenue in the last quarter. Consistent with the rest of our industry, we expect a macroeconomics uncertainty to persist into 2024, which impacts our customers investment ability. This is leading to holding off and longer decision-making processes on new projects as well as delays in slowing in the investment and implementation of existing infrastructure projects. Some recent design wins are ramping up significantly more slowly than initially anticipated. Those projects are proceeding cautiously, diverging from the original timeline forecasted by our customers. Given the volatile environment over the past few years, with everything that has happened since COVID, as well as global economic downturn, we are also seeing some changes in our industry, which also possess new challenges as well as new opportunities in what is already a very low visibility environment.

To provide you with just two examples, due to supply chain and component shortage issues, many companies in our industry face manufacturing difficulties in recent years. As a result, those companies are now taking a strategic review of their entire operation process. A result of that may be a decision to change their decision-making processes and integration practices. With that, the selection of this specific server adapter vendor, which will be used for building their systems may be moved from the company to its integrator. While this may present an opportunity for us with companies, which currently do not use our server adapters, it may present a challenge with existing customers that we will face once such customer will exhaust the excess inventory it currently has.

During the last years, the ownership of few companies in our industry has changed throughout the series of mergers and acquisitions. Such ownership changes may result in significant changes in the identity of a decision-maker and may also result in a change in the customer’s business focus. Again, such changes may present an opportunity, as well as a challenge to Silicom, once such customer will exhaust the excess inventory. However, for now, it further reduces our already very low visibility. Taking all those factors into account, we expect to see Q4 revenues between $20 million and $21 million. Looking further to next year, giving our very limited visibility and the factors I just discussed, we expect 2024 to be a challenging year. However, we strongly believe that we will return to double-digit growth in 2025.

Given those recent impacts to revenue, we’ve already begun to take several actions to manage discretionary costs and align spending with the current environment. We are adjusting our expenses footprint to the right level relative to our expected revenue level, ensuring that we maintain investments in activities, which will bring Silicom Future Growth, while preserving technological knowledge in customer relationships. Those actions should allow us to reduce the negative impact on our non-GAAP earnings per share without compromising our long-term objectives. We believe that the actions we are taking now are well proven long-term experience in managing our expenses and our strong cash position, which currently stands at $67 million, will allow us to maintain a very strong balance sheet through the challenging period ahead of us.

In parallel, we intend to increase our focus on the sectors that have allowed us to grow so well in the recent times, and those that we believe will remain primary growth drivers for us into 2025 and beyond. Server adapters, including specific FPGA-based and hardware acceleration smart NICs and Edge Systems. We have already begun evaluations of all of our research and development and sales and marketing programs with the intention to increase our investments in our focus areas and stop our investments in any out-of-focus areas. We are optimistic about 2025. We believe that by 2025 we will convert some large projects in our pipeline into new design wins and the ramp up of existing ones will generate more meaningful revenues. Despite the current challenges over the immediate term, our mid to long-term outlook remains positive.

A computer network engineering team setting up a server array in a data center.

Our aim is to return to double-digit revenue growth and recovery in 2025, underpinned by a strong and continually growing list of design wins, many of which are with some of the world’s leading players in telco and networking space. I would like to share with you a few examples of the additional revenue potential inherent in our impressive growth driver Design Wins and in our potential Design Wins pipeline that underlies our expectations for 2025 recovery. Within this long list we can easily identify about 20 Design Wins, a few we have already won and not yet at the mass production stage, and others that are in the last stages of our potential design wins pipeline, each having a sales addition potential of between $0.5 million and a few million dollars by 2025.

Those design wins with leading networking security and service providers are for our advanced server adapters and Edge system products, our strategic focus area. Beyond that we are continuing to expand our business with a leading U.S. based provider of enterprise telecommunication services with which we have already won a few active design wins and we expect to win more in the coming years. This opportunity by itself has an additional sales potential of about $10 million in 2025 and furthermore we are expecting to transition from the proof-of-concept stage to the mass production sales stage for two design wins we have already won with two leading capacity companies with the sales potential of approximately $10 million in 2025. As SASE grows and given our both customers’ dominant position within the SASE market, we expect strong future growth in sales to those customers.

Our balance sheet remains very strong and has been the outcome of a very well planned and executed strategy over many years. As I said, our net cash position currently stands at $67 million with no debt. It represents an increase of $4 million during the third quarter. Our strong cash position remains a key strategic asset and enables us to continue investing in the long-term and overcome challenging periods ahead of us. As we have shown, we are very happy to share the rewards of our continuous profitability and cash generation with our shareholders. Based on our strong cash position, we intend to continue to repurchase our shares under the 15 million share repurchase plan that we announced six months ago. I would like to take a moment to address the situation in Israel.

We were all absolutely horrified by the terrible attack and kidnapping of ordinary citizens in the South of Israel, which led to the current war by Israel against HAMAS in Gaza. All Silicom employees have been affected in a very personal way. Giving the small size of our country, we all have friends and no families that were directly impacted by this attack. Many of us have sons and daughters that are in the Israeli Army. We all pray for the victims as well as their families, friends and loved ones, who have been directly or indirectly impacted. We are resilient people and unfortunately have much experience in working, overcoming challenging times. I wish to reaffirm to our employees, partners and shareholders that our operations and manufacturing have not been impacted in Israel or anywhere else in the world, despite our personal grievance.

Naturally, the safety of our employees remains our highest priority. Finally, I also want to personally thank each and every one who had reached out to us to express their support and best wishes. To summarize, Silicom is navigating a much more challenging short-term environment across many fronts. I want to stress though that Silicom is well positioned as a key player in our industry and giving the growing potential within our design win roster, our long and deep pipeline, and our continually growing total addressable market, I’m optimistic on our long-term future, especially from 2025 [indiscernible]. We believe that our drivers for long-term demand remain in fact, as we navigate the current situation, we remain highly focused on our first priority target of maintaining our market leadership, developing new products that will act as growth drivers and lead to design wins over many years, delivering on technology roadmaps and ultimately ensuring customer satisfaction.

At the same time, we continue to carefully manage the company expenses and cash positions. 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: Thank you, Liron, and hello everyone. Revenues for the third quarter of 2023 were $30.1 million, a 23% decrease compared with revenues of $39.2 million as reported in the third quarter of last year. Our geographical revenue breakdown over the last 12 months was as follows. North America, 82%, Europe and Israel, 15%, Far East and rest of the world, 3%. During the last 12 months, we had two 10% plus customers and our top three 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 non-cash compensation expenses in respect of options and RSU’s 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 third quarter of 2023 was $9.3 million, representing a gross margin of 31.1%, and compared to a gross profit of $14.1 million, or gross margin of 36% in the third quarter of 2022. The higher portion of Edge Systems sold in the quarter, combined with recent higher price pressures from customers, mainly a result of the macroeconomic slowdown, pushed this quarter’s gross margin below our expected range of between 32% and 36%. We are currently investigating the specific impacts of various factors on our future gross margin and intend to provide an updated gross margin expected range with the release of the next quarter results.

Operating expenses in the third quarter of 2023 were $7.4 million compared to $6.9 million as reported in the third quarter of 2022. Operating income for the third quarter of 2023 was $1.9 million compared to operating income of $7.2 million as reported in the third quarter of 2022. Net income for the quarter was $2.1 million compared to $6.9 million in the third quarter of 2022. Earnings per diluted share in the quarter were $0.30. This is compared with earnings per diluted share of $1.01 as reported in the third quarter of last year. Now, turning to the balance sheet, as of September 30, 2023, the company’s cash, cash equivalents and marketable securities totaled $67.3 million with no debt or $10.11 per outstanding share. During the third quarter, Silicom purchased approximately 144,000 shares at a cost of $3.9 million under the 15 million share repurchase plan we announced earlier this year.

In total, Silicom has purchased an aggregate $48 million in share buybacks in recent years. As mentioned by Liron, based on our strong balance sheet and improved cash position, we intend to continue repurchasing our shares at full pace. That ends my summary. I would like to hand back over to the operator for the question-and-answer session. Operator?

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Q&A Session

Operator: Thank you. Ladies and gentlemen, at this time we will begin the question-and-answer session. [Operator Instructions]. The first question is from Alex Henderson of Needham & Company. Please go ahead.

Alex Henderson: Great. Thanks operator. Hey guys. So, a lot of moving parts here. Can we start at the upper end of that discussion with respect to the ability to sustain profitability? I think you guys have had a track record over an extremely long time of maintaining profitability even in the toughest of events. Yet, when I put in the midpoint of the guide for the fourth quarter, and don’t change anything else in the model, even with a 33% gross margin, I’m getting a very slight loss per share based on the prior operating structure. So, as we’re looking into the fourth quarter and into the ’24 timeframe, is it fair to say that you guys are going to do whatever it takes to not produce a loss on a quarterly basis and sustain your profitability track record?

Liron Eizenman: Hey Alex, so maybe I’ll start with the end. I would say on a manual basis we still plan to be I’d say break even or profitable, right. That’s our goal on an annual basis and it does not mean that we will do everything we need to do in order to be there, because our plan based on the analysis we’ve done is that we can continue and develop the product that we need and continue to do everything that we need to do in order to grow the company in 2025 and beyond, and we don’t want to sacrifice that. That’s extremely important for us, but we took steps, we took a lot of steps in order to manage our cost to make sure that even at the estimated 2024 numbers or the plans that we have in mind we will be — it will be on an annual basis, be break even or profitable.

Alex Henderson: Right. So, it does sound like you think that there is a risk that you could go to a lost position to on a quarterly basis over that time frame. Is that a fair statement?

Liron Eizenman: It is possible, when we are looking mainly on the annual level. And as we said during the first part of this meeting, as we go into this situation with $65 million in the bank, we feel comfortable with that. So overall, we feel that we are getting into this bad situation in a reasonably good position.

Alex Henderson: So there is a risk of losses on a quarterly basis. Okay. So in that context, obviously the yen’s fallen out a bit and OpEx should benefit from the yen. The shackle has fallen out a bit. It’s down quite a bit partly because of the conditions, macro conditions partly because of interest rates, partly because of the war. And that should help your numbers. When will that start to benefit to the cost side?

Liron Eizenman: Basically already. I mean in Q3, we’ve seen again there was some increase from Q2, but the impact of the last two weeks obviously were not something you’ve seen in the Q3 numbers. But overall we think, yes, obviously it will impact the numbers from Q4 and beyond.

Alex Henderson: The company made a couple of comments on the call here. One, was the GM potential reset and the other one was the strategic review of your customers. What portion of the customer base do you think is at risk of a strategic review potentially shifting to integrators? And how much of a lag would that create in your — in the timing of purchases if that occurs with those customers? Can you quantify a little bit around that what portion of the business is related to it?