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

Alex Henderson - Needham and Company Chip Saye - AWH Capital.

Ladies and gentlemen, thank you for standing by. Welcome to the Silicom Third Quarter 2018 Results Conference Call. All participants are at present in a 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 & Public Relations at 1-646-688-3559 or view it in the News section of the company's website at www.silicom-usa.com. I would now like to hand over the call to Mr.

Ehud Helft of GK Investor Relations. Mr.

Helft, would you like to begin please?.

Thank you, operator. I would like to welcome all of you to Silicom's third quarter 2018 results conference call. Before we start, I'd like to draw your attention to the following Safe Harbor statement. This conference call contains projections or other forward-looking statements regarding future events or the future performance of the company.

These statements are only predictions and may change as time passes. Silicom does not assume any obligation to update that information.

Actual events or results may differ materially from those projected, including as a result of our increasing dependence for substantial revenue growth on a limited number of customers in the evolving cloud-based market; the speed and extent to which cloud-based and cloud-focused solutions are adopted by the market; the likelihood that we will rely increasingly on customers which provide cloud-based and cloud-focused solutions in this evolving market, resulting in an increasing dependency on a smaller number of larger customers; difficulty to commercializing and marketing Silicom's products and services; maintaining and protecting brand recognition; protection of intellectual property, competition and other factors identified in documents filed by the Company with the SEC.

In addition, following the Company's disclosures of certain non-GAAP financial measures in today's earnings release, such non-GAAP 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 investor understanding and assessment of the Company's ongoing collaborations and prospect 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 discussed by management are provided as an additional information to investors in order to provide them with an alternative method for assessing our financial conditions and operating results. These measures are not in accordance with or a substitute for GAAP.

A full reconciliation of non-GAAP to GAAP financial measures is included in today's earnings release, which you can find on Silicom's website. With us today on the line 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 now to hand over the call to Shaike. Shaike, please..

Thank you, Ehud. I would like to welcome all of you to our conference call to discuss the results of the third quarter of 2018. We are pleased with the results of the quarter, showing a solid 13% growth in revenues, as well as a 40% growth in net income over the prior quarter.

We are happy with the ongoing progress our business is making and we are increasingly excited with regard to the potential for the coming years.

Our revenue growth was in part due to the new products that we’ve been developing for some of the market’s hottest new segments, namely that of SD-WAN which is now finally beginning to demonstrate wide deployment, followed by NFV which is in a way SD-WAN’s big brother as it typically includes SD-WAN as one of its most demanded application.

These are both markets which are beginning to show significant growth rates and industry analysts expect this growth to accelerate and explode for the foreseeable future. As a company, we are ideally positioned to benefit from this growth.

The products and services which we have geared towards the SD-WAN market are gaining strong traction and are being increasingly deployed by our customers within this market segment. The features of our products address the challenges of SD-WAN deployments.

Our products have a reputation for reliability and robust performance, both key requirements in this high-volume, high network speed environment. Beyond that, Silicom is known for building long-term and deep relationships with our customers.

All this combined is why we are increasingly penetrating new customers and are being reselected over and over again by existing customers.

The highly positive market response to our offering confirms that we have indeed achieved a strong fit between the products and services we provide and the demands of telcos and OEMs which are increasingly embracing SD-WAN and NFV technologies as a part of their strategy.

This strategy which includes cloud architecture at its base with datacenters at the heart of the infrastructure and a variety of edge devices is clearly a powerful tailwind for us pushing our business forward in both the short and the long-term.

While SD-WAN and NFV represented current growth drivers happening right now, we continue to address other aspects of the cloud era as well. We are doing this through our offerings to the Cyber Security markets whereby security requirements are becoming more and more important in the cloud.

This is in addition to our offerings for other connectivity and acceleration needs within the cloud for which our smart adapters are considered.

And on top of all that, as we demonstrated by the bypass design win that we announced during the quarter, our other product lines also continued to show strength and as such remain important revenue generators.

The combination of these factors demonstrate that over the long-term, we have continuously invested in developing and brought to market the right products at the right time. Throughout our history, we have also built and cemented strong relationships with new and potential customers in many very key markets.

We were able to maintain tight bonds with customers because they recognize us for our superb customization and support capabilities giving us the highly valued development partner status.

They see us as a strategic partner bringing them the capabilities to cope with the challenges for today’s and tomorrow’s high data and high volume connectivity demand.

Today, our strategic plan focuses on targeting SD-WAN and NFV markets for short-term and long-term growth while maintaining and growing all our other product lines, in parallel we present more solutions and products storage to datacenters within the cloud, many of which address the Cyber Security market segment which further fuel our pipeline, focused on this part of the cloud architecture.

Our pipeline is becoming thicker, stronger, and broader and looking ahead, we see significant further potential opportunities which are much larger than what we have previously achieved. We hope and expect to bring you further and larger design wins announcements in the coming months and quarters.

And now, for our guidance for the fourth quarter, looking ahead, we expect continued sequential revenue growth with revenues in the range of $34 million to $35 million. In summary, our business is healthy, showing broad organic growth and we believe this will be apparent in 2019.

Our growing momentum underlines my confidence that Silicom has the right products with the right relationships in place. As we enter the last few months of 2018, we maintain over 400 active design wins across over 150 customers. Some of these are with the very top tier players globally which we all know well.

Many of these wins are still in the ramping stage providing a long-term runway for revenue growth and it gives us good visibility ahead. As we are gaining traction with some of the world’s leading telcos, OEMs and cloud players, we now see strong potential to increase our customer base and design win base significantly.

From a products perspective, what we are selling today covers the full spectrum of networking equipment which is relevant to us. The target market from the edge, gears, storage, SD-WAN and NFV all the way down through to the datacenter and cloud at the very base with solutions built on our FPGA-based smartcards.

Our growth pipeline is full of opportunities covering this broad spectrum.

Shipments of our SD-WAN and NFV solutions to customers are growing and we are exceptionally well positioned in these markets driven by tailwinds in these explosively growing markets together with the ongoing and expected evolution in demand for our other product lines, we are very excited as we advance in our growth strategy.

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

North America, 81%; Europe and Israel, 16%; Far East and rest of the world, 3%. During the last twelve months period, we had two 10% plus customers. These two customers together accounted for about 30% 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 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 third quarter of 2018 was $10.6 million, representing a gross margin of 34.1%, compared to a gross profit of $11.8 million in the third quarter of last year representing a gross margin of 36.4%.

Operating expenses in the third quarter of 2018 were $5.4 million or 17.2% of revenues, compared with $5.2 million or 16.1% of revenues in the third quarter of last year. Operating income for the third quarter of 2018 was $5.3 million, compared to $6.6 million as reported in the third quarter of last year.

Net income for the quarter was $4.7 million or 16.2% of revenues, compared to $5.7 million or 17.7% of revenues in the third quarter of last year. Earnings per diluted share in the quarter were $0.62, a sequential growth – a sequential increase of 40% over $0.44 in the prior quarter when compared with $0.75 in the third quarter of last year.

Now, turning to the balance sheet, as of September 30, 2018, the company's cash, cash equivalents and marketable securities totaled $51.1 million with no debt, compared with $30.7 million at the end of 2017. That ends my summary and we would all be happy to take any questions.

Operator?.

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

Thank you very much. I am glad to see you powering through the prior issues and delivering on the SD-WAN start looks good. I’ve got a couple of quick questions for you on the former large contract that you had with the cloud player.

Where are we in working down that inventory? It does look like inventory is still a little high relative to your sales rate.

Can you talk a little bit about where we are in working through the revenues of that prior contract?.

Well, I would say that, most of the issues has been resolved. But they have been resolved, I would say, during October. It’s not all of them, but most of the issues has already been resolved. There may – there are still some issues which are open which may take a longer time. But the majority of the issues which were open are now resolved. .

So, can you help us out in terms of understanding how that’s getting resolved? Is it – are we working down inventory? How much inventory is there?.

Yes, I mean, that would mean – I cannot give you accurate number, but that would mean that at least with respect to this big project, our inventory for the next quarter would be reduced by the amount that we have concluded with our customers. .

Well, that’s what I am, exactly what I am trying to get at, I’m going to assume that if you conclude working down some of that inventory that also goes into the revenues and therefore I am assuming that some of that benefit is not something that will sustain in future quarters but rather roll-off and be replaced with the SD-WAN business in the future quarters.

But I need to get some sort of sense of magnitude of it. .

Yes, I cannot give you accurate data for that right now. But the basic assumptions that you’ve made are correct. I mean, there would be some revenues which are – which would be related to this project, I presume in the fourth quarter and – but, I don’t know yet how big that’s going to be.

And we still need that to see that it’s really happening that all the aspects of this – of that conclusion are really happening. But in general, yes, I mean, you are right. There would be some impact of that in the fourth quarter. What exactly, we don’t know. .

So there is some revenue in 4Q in your guidance from that?.

Well, the revenues, right now in our guidance, we are assuming some part of that. But I think that this is – I mean, we are not saying that nothing will be there. We are not assuming that everything will be there. It is somehow weighted within everything else. So there is some part of that.

But in general, I would say that, it is not as if, I mean, our guidance for the fourth quarter. It is just because of this big project. I mean, we are assuming some of that, some of the revenues would be allocated to that project. .

I see. Okay, so, if I am looking at the gross margins in the fourth quarter, should I be assuming that as we are working down some of the inventory that that would be a drag on the gross margin levels? Is there, obviously….

No, we think that the gross margin in the fourth quarter would be very much the same as it is right now. Within this, I mean, we are saying continuously that our GM would be 32% to 36%. That’s what I am saying about the fourth quarter itself. .

Okay..

[Operator Instructions] There are no further questions at this time. One moment, we have another question in the line. We have a question from Chip Saye of AWH Capital. Please go ahead. .

Hello.

Can you hear me this morning?.

Yes. .

Yes, I wanted to ask you, if you could, I had two questions there, a little bit unrelated.

One is, can you talk about the significance of your 100 Gig bypass switch selection and what that means for you? And secondly, I know there was some discussion last night on the Mellanox call of SmartNIC and how the market, they are preparing their SmartNIC offering, but they need around another 18 months or so to work on their software.

I know that you had done some work with Titan earlier this year to work on some software libraries. If you could just talk a little bit about SmartNIC after you address the 100 Gig switch question? Thank you. .

Okay. So, first of all, with regard to your first question, I think that a most important thing of the announcement that we made with respect to the bypass is to demonstrate that all our product lines are strong.

I mean, we are continuing and I believe that we will live and grow, maybe not so dramatically such as the SD-WAN market is growing or whatever.

But we continue with our business which is not related to the cloud and SD-WAN and we are selling and we are getting new design wins and some of these design wins can even be very significant or at least, well, I wouldn’t use the word very, because right now, with the new design wins that we are targeting which are double-digit design wins, this is not one of these, but still quite a significant design win that would add to our revenues.

And I think that getting this kind of a design win is a demonstration to the fact that everything that we are doing with SD-WAN and the cloud, et cetera is in general on top of our – what we had before, rather than replacing. So that’s the importance of that specific design win. And there maybe others like that.

It would help us with revenues for sure and there maybe others of that sort. So that’s about the design win. Now about the SmartNIC.

So, SmartNIC, while I don’t think, I mean, my message would not be that we need 18 additional months or so to develop the software for what we are doing, but we do believe that the market for the SmartNIC is growing, I would say together with us. I mean, everyone is talking about SmartNIC.

Everyone is testing, is looking at things and so on and so forth. But it would take time for the market to really take decision and go into deployments with a – with such a SmartNIC.

And that’s why, I mean, we are also saying that we are looking at next year as a year to begin having design wins with the SmartNIC which are based on our FPGAs and revenues probably one year later. I mean, as our customers begin to deploy that. So this market for the SmartNIC, everybody is talking about.

I think and believe that it would grow as well, but unlike the SD-WAN and NFV, where we see the growth right now happening with that one it would take more time. .

Okay, thank you. .

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

Hey, thanks. Don’t know what happened there, we suddenly were disconnected. So, if this was just asked on the last question, I may have missed it when we were redialing in. But I was hoping to go back into the SD-WAN a little bit more granularly.

In terms of what you are seeing in terms of the slope of the ramps of these major projects, certainly, the business with the OEMs is fairly much driven by their businesses.

But the SD-WAN ramp at some of the service providers seems like it’s got a slope of its own and hard for us to sense what the rate of adoption and the rate of deployment of these large tier-1 service providers is who are notoriously slow.

So, can you give us any granularity on how you are seeing some of these two or three big top tiers ramping would be very helpful?.

Yes, well, I am not sure that I really can provide a good response which we hope – would help. Everyone understands what is actually happening with the big tier-ones in terms of deployment.

What I see is just accumulation of everything that is happening to us in this market and when I look at the accumulation of all accounts that we are working with, I see that it’s ramping up and that it’s significant. Now, it is a line with I would say the chronology of when we got our design wins and that’s very natural.

So, what we are seeing is, the design wins that we got earlier are now ramping up and obviously these are the design wins from which we see the more – more of the revenues while design wins that we have announced later on as you would expect, take more time to ramp up.

So, we are seeing that there are some difficulties, but we are seeing that these difficulties are being overcome. So, my overall feeling is that this market is definitely ramping up and even quickly, I would say so.

But in terms of any specific design win there could be a lot of issues that sometimes a technical issues, sometimes there are technical issues with the software, some – I mean, there could be a lot of things. So, I would say, overall, my feeling is very – and I am confident about that business ramping up.

For any specific customer, it’s difficult to say. Because, I mean, telcos are known to be slow in general and they are, but we see how the problems are being overcome, one-by-one, even with the telcos. It takes time. Wherever we had the design win earlier, it is ramping up already.

Some of the specific service providers are acting more quickly than others. Overall, the accumulation of the business seems to be ramping up and quite quickly. .

Maybe I could at a slightly different angle, if that would be okay. So, typically, you have a down sequential first quarter based off of the normal seasonal patterns.

Most of the seasonal patterns are associated with the product cycle, selling efforts of individual companies which follow the same patterns year end push for the fourth quarter and then a fall off in the seasonally weaker first quarter.

The SD-WAN stuff is somewhat different in the sense that obviously, you’ve got a program ramp and so, you may not have the same seasonal pattern, should we be thinking that that offset some of the seasonal decline in 1Q as the SD-WAN ramps against what would normally be a weaker quarter, but since the program is ramping it from early stages, maybe it’s up sequentially into the first quarter.

Is that the right mechanics here that we are looking at?.

Well, the answer of which I am confident regarding the level of accuracy that I can provide is that is I don’t know. And what I mean by that is, that you are right that SD-WAN may change the structure of our sales distribution between the quarters, it may, but we don’t know for sure right now. I mean, we are not sure how this would behave.

It may ramp up and create a situation where indeed the first quarter and I am talking about the sales of the SD-WAN right now rather than the full company, because, as you know, I mean, with the full company and the big project that you mentioned in the beginning, that could change things as well.

But in terms of the SD-WAN by itself it may change this equation. But we don’t know yet. .

Okay.

Going back to the inventory if I could, can you characterize what’s in the inventory? It does look a little rich relative to normal carry - levels? Is that because you are starting to stock inventory of SD-WAN products or is that – is inventory just a little high because you will developed some new programs? What would be the characterization of what’s in that inventory?.

Well, I don’t know if you are – well, if we are not talking about the inventory which is related to the big projects, then it’s our normal process.

Taking this aside, and when I am saying, our normal process, our normal process means that when we are seeing an upside, when we understand that we are going to ramp up, typically, the inventory would go up together with the forecast which are growing and so on and so forth in general.

As you asked before about the big projects, so this would be something that would asked in the other direction obviously. But other than that, in general, our inventory, to a certain extent will grow up – will grow as a result of the increased sales in generally for growing.

On top of that, we are still in the market where the lead times are very long and not only they are long, sometimes, I mean, vendors are canceling or postponing delivery times of components, et cetera which leads us into creating some sort of an inventory just to be 100% sure that we can deliver to our customers.

So this may have an impact as well once again, especially, when we were growing in sales. So, overall, when we grow and in general, I would say, we are growing not talking about the big projects of course, so we are growing and the trend of the inventory when we are growing would be to grow as well. .

The reason I was asking the question when I add to this, obviously SD-WAN has a different set of characteristics. I think you talked about having to stock some inventory in regional hubs for some of these tier-1 service providers. That’s not business that you’ve done in the past.

And I would think it would have a different slope to it in terms of inventory carry for those type of customers as you are ramping it.

One could easily look at the higher level of inventory and say, gee, there is some of that’s in there from the old large customer, but some people could easily look at it and say, well, the inventory is high as you are working that off because you are stocking up for SD-WAN ramp.

Can you talk just between those two?.

I think that in general, in terms of the level of inventory, there wouldn’t be a significant difference between the SD-WAN and the current market.

It may present some logistic challenges that we will need to resolve as to where we keep this inventory and how do we handle that, but I don’t think that in terms of the level or I would say, percentage of the level of inventory compared with the sales figures that are expected, I don’t think it would be a big difference.

The difference would be in the implementation of this inventory. Because right now, I mean, we still have even in all our business, I would say models that we have, we need to keep finished goods or quite a bunch of products for many of our customers. Some of them are in Israel.

Some of them are even provided to our customers, it’s our inventory until they consume them and then it would also be the case with the SD-WAN customers.

But there may be some additional logistic challenges that we would have to resolve, because they may ask us to do that in more locations than what we are used to and this is something that is under work. I mean, we are working and finding these solutions as they are asking that for us.

I don’t think that would have an impact on the level of inventory, at least not significant. .

Okay. If I shift gears, the tariffs are in the news a lot. I assume that you don’t have any production out of China.

But on the other side of the coin, are you seeing any customers who have historically sourced things from China and moving away from China and maybe picking up business with you guys? Is that something that’s an impact to your business?.

Well, I mean, I think that, everyone is now thinking about China. I don’t see any shift in business right now, but once again it would present challenges to whoever is manufacturing in China and to a certain end, we do some manufacturing in China, as well. We don’t see that the customers are, I would say, looking for an immediate solution right now.

We don’t think that this is something which is, I would say and that’s why we don’t think it would have an impact on the business overall, because, yet there is trend to go out of China and we are also looking to do in Israel or in several other locations what we do in China right now.

Most of the business is not being done in China and whatever it is, we are looking for some sorts of solutions. So, I don’t think it’s going to impact the business.

But once again, just like with the previous question, it would present us with some logistic issues that we would need to resolve just like the others would be presented with the same kind of challenges. .

And one last question if I could. So, can you remind us your position on hedging on the exchange rates. The shekels has come down considerably over the last six, nine, twelve months.

Just remind us what your policy is there?.

The answer is very simple. We do not hedge anything. .

Perfect. Thank you. I’ll see you next quarter. .

[Operator Instructions] There are no further questions at this time. Before I ask Mr. Orbach to go ahead with his closing statement, I would like to remind participants that a replay of this call will be available by tomorrow on Silicom’s website at www.silicom-usa.com. Mr.

Orbach, would you like to make your concluding statement?.

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

Thank you. This concludes Silicom’s third quarter 2018 results conference call. Thank you for your participation. You may go ahead and disconnect..