Ehud Helft - Investor Relations Shaike Orbach - Chief Executive Officer Eran Gilad - Chief Financial Officer.

Alex Henderson - Needham & Company Edward Balinsky - Segmark.

Presentation:.

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom Second Quarter 2016 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 Investor Relations or view it in the news section of the company’s website, www.silicom-usa.com. I would now like to hand the call over to Mr. Ehud Helft of GK Investor Relations. Mr.

Helft, would you like to begin?.

Yes, thank you, operator. I would like to welcome all of you to Silicom’s second quarter 2016 results conference call. Before we start, I would 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 changing industry and market trends, reduced demands for Silicom’s products, the timing and development of new products, and their adoption by the market, increased competition in the industry and price reductions as well as due to risks identified in the document 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, focus 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 corporation 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 our financial conditions and operating results. These measures are not in accordance with or a substitute to 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. Now, with us on the call today are Mr. Shaike Orbach, the CEO and Mr. Eran Gilad, the CFO. Shaike 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. And with that, I would like to hand over the call to Shaike.

Shaike, please?.

Thank you, Ehud. Good morning, everyone and welcome to our conference call to discuss the results of the second quarter of 2016. We are exceptionally pleased with the results we achieved in this quarter.

Our revenues at $26 million represented outstanding 52% growth in year-over-year revenues, while our non-GAAP net income grew even stronger demonstrating a year-over-year increase of 59%. These superb results which are the highest we have ever achieved in a second quarter confirmed that Silicom is very much in a solid growth phase.

We see our achievements as a testament to the success of our strategy. Our growth reflects our continually expanding sales activities as well as the deepening relationships with many of our customers, including the top tier OEMs. It also demonstrates increased sales across all our product lines.

In particular, these results validate our ongoing success in our traditional networking appliances market and they also show increasing success in our newer high growth segments, which we are targeting where over the past recent months we have begun to see strong momentum.

These markets includes cyber security on the one hand and cloud-related technologies on the other which include SDN, NFV, IoT, SD-WAN and virtualization all of which depends on top performance connectivity. We reported net income of $4.7 million, up 59% over last year and 55% sequentially over the first quarter. This is a fantastic achievement.

And we delivered this growth even while we are increasingly investing in the future accelerated growth of our business. We managed Silicom with the focus on our leadership and growth over the long-term.

To achieve these goals, we consistently invest heavily in expanding our product portfolio, our new product introduction activities and growing our addressable market by penetrating additional market segments, providing additional solutions which address more needs of existing customers and adding new customers.

The recent design wins which I will discuss in a moment are good examples of how we made a correct read of the market trends in the past and are the recruits of the investments we made at that time.

We believe that the new product which will result from our investments combined with the continually improving competitiveness will help us to design in additional products into more of our customer systems to increase revenues per system and per customer penetrate key new customers as we demonstrated in the past few months and allow us to grow our revenues to the next level.

During the past three months, we announced a number of important design wins. Most of these wins were penetrations of new customers we have not worked with before as well as into new market segments.

All these design wins are a testament to the increasing success of our growth engines and are a classic demonstration of how we are capitalizing on new market trends. We announced a first design win from a new customer, a Tier 1 network monitoring company.

This design win was for our 40-gig time-stamping and packet processing card representing the successful conclusion of a multi-year intensive evaluation and product definition process. The sales cycle, which led to this design win, was indeed long.

However, years ago, we show a market need to our time-stamping offering and we have always had a strong conviction that our efforts in this segment would pay off. We now finally see this beginning to become an actuality and look forward to seeing a solid return on our investment in this segment.

To-date, this particular customer has placed orders totaling around $0.5 million for both the product for which it has awarded the design win and for another time-stamping product which is currently in the process of evaluation indicating an intention to design in this additional product.

In parallel, this customer continues to evaluate additional products of ours. As such, we expect this customer will give us many additional design wins over time and has the potential to eventually become a multimillion dollar account for us.

We also achieved the first design win from a fast growing cyber security company for our IBS products, which is short for Intelligent Bypass Switch. This company will use our product as a part of its security solution for a client, a leading Fortune 500 healthcare company.

Cyber security is already a very hot area and we only see it continuing to grow rapidly. Given our offerings with this market, we are already seeing and expect to continue to see strong sales momentum in this segment. To achieve this design win, our IBS offerings went through a rigorous evaluation and qualification phase.

This design win has already generated revenues for us in only a few months. And in addition, the cyber security company has begun planning a next generation security system that will use additional Silicom bypass products.

This particular design win is a demonstration that not only our OEM customers themselves, but also the major enterprise and service provider customers recognized and demand the performance edge of our products.

Consequently, we have begun to enjoy increased exposure that we believe will translate into increased sales into next generation cloud, SDN and NFV infrastructure systems. A further design win which we announced only two weeks ago was in the emerging software-defined wide area network arena or SD-WAN for short from a leader in that space.

Several years ago when the cloud space began to hit us, we foreshow the needs for industrial strength hardware offload capabilities to handle the immense traffic levels that were projected to develop, especially for processor heavy operations like encryption.

This particular design win was for an Intel-based encryption offload card to boost server throughput. The customer has already placed an initial production order and forecasts that its order run rate will ramp up gradually to approximately $1 million per year.

At the same time, we are engaged in discussions with this customer regarding the use of additional Silicom products. We believe that this successful penetration will lead to further growth in this increasingly important market segments. We are also seeing increased momentum and customer interest in our cloud platform product lines.

These include our Switch SETAC can accelerate Switch SETAC products which saves space, energy and costs for cloud based service providers while easing their transition to the SDN, NFV environment.

We recently announced that based on the positive results from an initial Switch SETAC deployment, a leader cyber security player placed a 750,000 order with plans of additional orders in 2016 and beyond.

The momentum that is building for our cloud platform product demonstrates the strong industry need for cloud performance solutions and the excellent fit of our Switch SETAC products.

The strong growth in industry interest gives us confidence in projecting multi-million dollars sales for these design wins alone and steadily growing sales for the Switch SETAC product line in general.

Looking back at our success over the past few months we are proud that all these trendsetting companies have turned to us confirming once again the innovation of our concept, the quality of our technology and the depth of our understanding and needs of our customers.

In summary, the stream of new design wins that we achieved quarter-after-quarter validates the success of our long-term strategy.

As we continued to demonstrate our multi-year timeframe, we make the correct reads of both the currents and future needs of the markets we are active in and of our many customers and invest wisely to capitalize on these needs.

Our investments in cyber security under one side and cloud related technologies on the other side have more than proven they were this quarter.

Looking ahead, with regards to our guidance for the third quarter of 2016, we believe that revenues will be in the range of $24 million and $25 million or about 26%, ahead of those of the third quarter of last year at the midpoint. For the first nine months of 2016, our midpoint guidance represents a year-over-year growth of about 30%.

With a solid pipeline and stronger than ever sales activities across all of our product lines, we feel comfortable projecting strong revenue growth for the full year of 2016. In summary, we will remain exceptionally pleased with our strong top and bottom line growth.

We continued to sell more products into more of the platforms of current customers, at the same time we are investing and growing into new customers by offering new products to both existing as well as new customers in new markets.

We believe that we are correctly investing the necessary resources in developing our products, our markets, our relationships with existing customers and penetrating new customers which will significantly benefit us over the long-term.

We continued to succeed in identifying IT’s fasting growing sectors and to address them creatively with must have robust solutions.

With the growing list of long-term design wins, a full roster of presales trials underway and new products with significant potential nearing launch, we are pleased with our progress and looks more to our continued growth. With that, I will now hand it over the call to Eran for a detailed review of the quarter’s results. Eran, please go ahead..

Thank you, Shaike. With regards to the results of the quarter, revenues for the second quarter of 2016 were $26 million representing year-over-year growth of 52%. Our geographical revenue breakdowns for the first six months of 2016 were as follows; North America 68%, Europe and Israel 23%, Far East and the rest of the world 9%.

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 and acquisition related adjustments.

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 2016 was $9.9 million representing a gross margin of 38%. This is compared with $7.2 million or gross margin of 42.3% in the second quarter of last year.

As Shaike discussed during the first quarter conference call, the gross margin has been affected by our decision to sell some of our offerings at lower margins and varies between quarters as a result of the specific mix of products sold during the quarter.

Operating expenses in the second quarter of 2016 were $4.6 million or 17.8% of revenues compared with $3.9 million or 22.6% of revenues in the second quarter of last year. Sequentially, compared with the first quarter of 2016, our operating expenses were almost the same.

Operating income for the second quarter of 2016 was $5.3 million or 20.2% of revenues compared to $3.4 million or 19.8% of revenues as reported in the second quarter of last year. Second quarter 2016 net income was $4.7 million or 18% of revenues compared to $2.9 million or 17.2% of revenues in the second quarter of last year.

Earning per diluted share in the quarter were $0.63 in the quarter, a significant step-up of 58% compared with $0.40 in the second quarter of last year. Now turning the balance sheet, as of June 30, 2016, the company’s cash, cash equivalents, short-term bank deposits and marketable securities totaled $40.1 million or $5.46 per outstanding share.

In the second quarter of 2016 we shared a total of $7.3 million as a dividend to our shareholders and paid $4.3 million in earn-outs to former shareholders of our recent acquisitions. That ends my summary and we would be happy to take any questions.

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. Alex, please go ahead..

Thank you very much. So super quarter guys. I am pleased to see you guys were producing such good revenue numbers and I guess you got the margin guidance pretty much on target.

A couple of questions off of that, so obviously the enormous acceleration here in the second quarter, I guess I am not sure I understand why would low sequentially into the third quarter, can you delineate between sort of demand drivers that are industry and macro related and what’s new product related and what’s just baseline related can you break it out a little bit for us, we have some sense of how those drivers played out?.

Well, I will try to add something to and there are two parts of a – to your question. First of all obviously, while what we provided guideline for – guidelines for Q3 is less than what we have done in this quarter. But it’s obviously much more than what we did last year.

So what we are saying here, I mean the general message here is we are definitely growing right now. Now we are trying to provide figures or numbers which we – with which we are confident. I mean things could happen.

I mean, last quarter three months ago when we were discussing revenues, we were forecasting or providing guidelines for the revenue of the second quarter and in the actuality as you could see I mean we have done much better than that, because there are some things that we couldn’t see in advance.

Now, so the guidance that we provide for the third quarter is based on what we see right now just like it happened in the previous quarter, some other things could happen in the same way.

So, we believe that we will demonstrate, I would say, more or less the same annual growth rate moving forward and that’s what we see right now and that’s what we are committing to. Now, in terms of one other fact that we need to tell you about the way that we build our guidance, we are building bottoms up.

So, we look at the customers and their forecast what they are telling us that from that going up we build the revenues model.

Now, when things are happening in the good way, which is what happened this quarter and we hope it would have happened next quarter as well, but we are not – we could not be sure about that, then there are some things that you don’t see in there happening and that provides you better results than what you expected.

Hopefully, that would happen in the second quarter as well, but building it from the bottoms upwards, that’s the result that we get.

Now, in terms of the trends, so yes, I mean, I believe that there are some trends that we could see happening in this quarter and they were helping us and these trends whether with our existing customers and with new customers, whether with existing products or with new products, but we see these trends in I would say several market segments, which are important to us.

So, the first of these segments is the cyber security. Cyber security grew significantly for us in the second quarter. It was significant I would say even step function in growth of the cyber security market segment for us. And we believe that because it is a trend, it will indeed continue towards the third quarter.

What exactly the figure is or the number is? We base that as I have said bottoms up on what we got from the forecast from our customers, but we expect that to continue to grow.

Platforms and/or solutions, which are related to the cloud industry, they also demonstrated growth in this quarter and we have seen that and we believe that would continue as well. So, these trends were actually trends within I would say existing customers that actually experienced significant growth during this quarter.

But at the same time, still within this trend and one more thing that I would mention in a minute, so we also got in these design wins speak for themselves, we got some new customers as well, which are acting within this trend. So, we hope that these customers once we announced the design wins, then the revenues ramp up and they ramp up gradually.

So, I am not sure we have a forecast. Sometimes, the forecast for that what is going to be only the second quarter after the design win is already significant, some other times, it’s not that significant. It gave some time to build up.

Now, on top of these two trends that I mentioned cyber security on the one side and cloud related solutions on the other side, we have also mentioned the design win of the network monitoring of the long discussed time-stamping product.

So, again, I think that’s an extremely important win for us even though the development of the revenues around that design win may take some time.

So, not necessarily immediately in the third quarter, maybe take some more time, but all these are trends, all these markets are markets which are extremely important and represent the trends in the industry and I believe that they would help us..

One last question on the fundamentals here, I am still trying to understand the mechanics of the gross margins, it seems to me that your historical business model was always predicated on essentially the 40% type gross margin and what you normally would get when you see a transition in margins is not a step function, but rather a gradual movement in the margins down as you mix shifts over time.

Can you help us understand how the gross margin is feathering? Should we be assuming the gross margin will continue to edge lower as the mix shifts to more white label, more cloud related stuff or are you now comfortable with where you are on the gross margin in the middle of that band that you gave earlier?.

Okay. We need to remember that the gross margin is not only a function of the strategic shift that we have made, it’s actually a combination of both the mix of products and then we have made a strategic move offering some of our products at a gross margin which is lower than the gross margin that we used to have before.

So, I mean, that’s why we are saying we said last time, 35% to 40% as the range of the gross margin, but not necessarily it’s going to go down, go down and go down, because the actual result of a certain quarter say for example this quarter is a combination of both this strategic move that we have decided, which just like you have said, you wouldn’t see the impact of that on all our products.

You would see that on some of our products. And then the other part of that is a mix. So, in general, I am not saying that if we were around right now, 38, I am definitely not saying that we would go quarter after quarter lower and lower until we are at 35.

No, that I don’t think that’s going to happen, because the mix of the products is going to take us towards the higher limit as well. For modeling purpose, I would take something like the mid-range of what we defined as something where we would be for relatively long time..

Okay.

Just one last question, can you give us the headcount at the end of the quarter?.

The headcount at the end of the quarter is very similar to the previous quarter which means approximately 240 employees..

Thank you..

Thank you. The next question is from Edward Balinsky of Segmark. Please go ahead..

Thank you.

I am interested in the contingent consideration, with regard to Fiberblaze at the end of the period allotted you reversely in all of the contingent consideration, can you tell us what portion of the contingent consideration has actually been earned in this up till June 30?.

Okay. First of all, the contingent consideration related to Fiberblaze is no longer valid which means….

Yes, I understand that.

But was ADI, now I am talking you have almost $5 million worth of contingent consideration on the balance sheet, the question is I assume that you are keeping a little decent paper in you desk draw indicating what – how much of that considerations are ADI, are for ADI has been earned – has actually been earned?.

Right now we believe that the number which appears on the press release is the appropriate number which forecasts the future..

I see, alright. Thank you then.

When you say forecasting the future, this if you believe that this is what you will wind up paying out when the period earning of contingent consideration ends?.

Exactly..

Okay, alright. Thank you very much..

[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 the replay of this call will be available by tomorrow on Silicom’s website www.silicom-usa.com. Mr. Orbach would you like to make your concluding statement..

Yes. Thank you, Operator. Thank you, everybody for joining the call. We look forward to hosting you in our next call in three months time. Good day..

Thank you. This concludes Silicom’s second quarter 2016 results conference call. Thank you for you participation. You may go ahead and disconnect..