Ladies and gentlemen, thank you for standing by. Welcome to the Silicom Second Quarter 2020 Results Conference Call. All participants are 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 and Public Relations at 1 (646) 688-3559 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 Investor Relations. Mr.

Helft, would you like to begin please?.

Thank you, operator. I would like to welcome all of you to Silicom's second quarter 2020 results conference call. Before we start, I'd 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 our increasing dependency for substantial revenue growth on a limited number of customers in the evolving cloud-based SD-WAN, NFV and Edge markets; the speed and the extent to which solutions are adopted by these markets; the likelihood that we will rely increasingly on customers, which provides solutions in these evolving markets, resulting in an increasing dependence 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 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 cooperation 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 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 call – on the line are Mr. Shaike Orbach, the CEO; and Mr. Eran Gilad, the CFO.

Shaike would 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 second quarter results of 2020. I hope that you and your family are staying healthy during these unprecedented times. We reported revenue of just over $23 million for the quarter, which is an improvement over the prior quarter.

Furthermore, we reported our 62nd quarter of continued profitability and cash generation and continued our share buybacks, bringing increased value for shareholders. We achieved this despite the second quarter seeing the brunt of the global spread of the Corona pandemic.

During the quarter, we all experienced unprecedented working and logistical challenges, as well as various levels of economic shutdown in the countries in which we operate.

At Silicom, we managed to maintain business continually overcoming supply chain interruptions and component shortages demonstrating the resilience of our business, but all this was down to their professionalism and flexibility of our entire workforce, which I wholeheartedly thank for their efforts in this past quarter.

While we have all been adjusting to the new current reliably, the good news is that as we move through the third quarter, we see improved visibility with expectations of sequential double-digit revenue growth and I will discuss the guidance in a few moments.

While the current market environment may still see short-term delays in telco and cloud infrastructure investments, the rapid global shift to work from home and streaming video over the internet has led to a booming demand for natural capacity. This is leading to an accelerated growth of SD-WAN, NFV, Security and 5G network build-out plans.

We believe that these recent trends represent a fundamental market shift that ultimately increases long-term demand for our innovating enabling solutions, which increase network flexibility and capacity while reducing network costs..

Standardizing on our products, this integrator will use our unit for a major government infrastructure project. Furthermore, the integrator expects additional similar projects over time and we see this as a strategic relationship with potential to bring us further revenue growth in future.

It is one more demonstration of the continuous pipeline of opportunities that we see in each of our target markets. This win is also a demonstration that our business operates over long-term processes and even in one of the toughest quarters enables us to be resilient allowing business at Silicom to continue almost as unusual.

We continue to invest much time and effort in bringing new design wins in all our target markets. And the flow of such wins is indeed reflected in our results. While the environment remains uncertain, the underlying fundamentals of our target markets continue to be attractive and present high growth potential in post-pandemic world.

Throughout Silicom's history, spanning over decades, we have successfully navigated through many market cycles.

Our foresight and investments in the right area, especially in the past few years and positioning ourselves ahead of the various technology trends as they appear have enabled us to consistently emerge each time, a better and a stronger company. We believe that this will be the case again as the world emerges out of the COVID-19 pandemic.

I would like to spend a few moments discussing our guidance. If you remember following first quarter 2020 results released in April, we decided to withhold providing upcoming quarter guidance because visibility at that point was very limited.

While remaining cautious due to the continued uncertainty of the market environment, current improved visibility enables us to project sequential double-digit growth in revenues for the third quarter of 2020 as compared with the second quarter of 2020 with revenues expected between $26 million to $27 million.

Given our long and growing list of design wins generating orders, a healthy cash balance, solid baseline activities and strong markets fundamentals moving in our direction, we are well positioned and increasingly optimistic about our long-term prospects.

As such we continue to project that once our market returned to normal, we will achieve ongoing revenue growth at a double digit compound annual growth rate for several years ahead.

Before summarizing and moving over to Eran, I note that as of Q2 end Silicom has a record of $93 million in net cash, which was an increase of $13 million during the quarter, providing us with significant financial flexibility. It gives us more than enough capital to continue our internal investment in R&D to maintain and build our competitive lead.

It also allows us to continue our business development activities as we originally planned, ultimately fueling the long-term growth of our business. At the same time, it gives more than enough working capital to weather the current environment.

Furthermore, it also allows us to share the rewards of our continued profitability and cash generation with our shareholders. During the quarter, we completed our first $15 million one-year buyback plan meeting the target set by our board, which was announced on May 2, 2019.

We also made progress on our new second buyback plan of a further $15 million within a year, which was approved by our board and announced on April 30 of this year. In summary, while the second quarter was not easy for anyone, for Silicom we believe the worst is now behind us.

And given the improved visibility, we look forward to double digit sequential growth in the third quarter. Furthermore, the pandemic and work from home trend has had the impact of significantly accelerating SD-WAN, NFV, Security and 5G network build-out plans as telcos and cloud providers all markets where Silicom is centrally positioned.

Our optimism has increased, and I reiterate that once markets return to normal, we expect the coming few years for Silicom will be much greater than what we have achieved over the past few years. 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, 70%; Europe and Israel, 23%; Far East and rest of the world, 7%. During the last 12 months, our top three 10% customers together accounted for about 40% 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 auctions and RSUs granted to directors, officers and employees, as well as acquisition-related adjustments.

For the further reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the second quarter of 2020 was $7.8 million, representing a gross margin of 34% compared to a gross profit of $8.8 million or gross margin of 34.6% in the second quarter of 2019.

Operating expenses in the second quarter of 2020 were $5.9 million compared with $5.9 million in the second quarter of 2019. Operating income for the second quarter of 2020 was $2 million compared to operating income of $2.8 million as reported in the second quarter of 2019.

Net income for the quarter was $1.8 million compared to $2.9 million in the second quarter of 2019. Earnings per diluted share in the quarter were $0.26 compared with $0.38 as reported in the second quarter of 2019.

Now turning to the balance sheet as of June 30, 2020, the company's cash, cash equivalents, bank deposits and multiple securities were at all time high and totaled $93.2 million with no debt or $30.12 per outstanding share. That ends my summary and we would be all 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 and Company. Please go ahead..

Thank you very much. Hi guys. So there's certainly some countervailing directions in the broader macro environment here. Clearly, the stuff that you highlighted such as SD-WAN, 5G, Edge compute and the like are very robust and are benefiting from some of the trends from work from home and the like.

Conversely, a lot of the traditional appliance products that go into what I would describe as your traditional business are under pressure, for instance, the ADC market. It looks like it's seeing a decline of roughly 10% in terms of appliance sales.

Can you talk about what portion of your business is coming from the newer segments and what portion is coming from more traditional businesses? And what the trajectory you're seeing in the traditional pieces to give us some baseline to work with?.

All right. Okay, I'll try to give some color over the situation. We do not provide specific information about traditional versus new, especially as they begin in some ways I would say to merge together in a way.

I mean, just as an example, if you're talking about customers, then some customers that use to be ADC or so they’re now doing SD-WAN and sometimes the same products from our perspective are being used for both, so it's a little bit difficult to say.

But I mean, I still would like to respond to your question, giving you some, I would say, information or color about what's happening in general. So what is happening in general and you’re right with what you described right now. I mean, overall, the standard appliance business seems to be decreasing.

And on the other side, obviously, the SD-WAN, NFV and mobile networks deployment seems to be increasing. That's obviously accurate. And we see this decline.

However, that being said, I would like to say that even in the traditional markets, we do have opportunities because sometimes specific projects are being launched as an example, the one project that we have been awarded to, the design win that I was talking about.

So this actually belongs to our traditional line of projects or products, but still, I mean, it is an opportunity. And the fact that the overall demand for capacity in the network is growing has some influence in some areas, even when our traditional products are being used.

So while in general, I would say, yes, there is a decline, but we are looking for these opportunities. And once we, for example, deliver against this design win that I mentioned before, so we may see here and there opportunities where this decline is compensated by these new opportunities that we're seeing.

So, overall, yes, there is a decline and we base our growth on the growth of the growing markets rather than on the traditional market, which is declining, but we're still finding opportunities even within the traditional market..

Great, thank you. That's very helpful. So can you talk a little bit about whether there’s any implications from the consolidation that's going on in the SD-WAN market? There's been a number of companies that were acquired over the last couple of months that’s changing the landscape a little bit.

As you've been pulled – maybe pulled into some of these larger enterprises, does that give you an opportunity to build out some relationships with those companies in a way that would get you into some of their more traditional businesses that you might not have penetrated before? Has it changed the momentum in those businesses that were acquired?.

Yes, I would say that for us the impact is not significant. I wouldn't say that there is no impact at all, because, I mean, for example, one company which was acquired, the relationship there was not that I would say deep while if you look at the company that acquired this company that we have a better relationship with this company.

However, I would be hesitant to say that this is really significant that due to these acquisitions things for us would change dramatically. I think that we do have quite a solid pipeline with SD-WAN for – and also for UCPE mostly towards SD-WAN, but I don't think that these acquisitions or whatever would have a significant impact.

It would be more tactical rather than something that I would define as strategic..

And one more question, if I could. The U.S. Tier 1 service provider market, there are indications that those programs – that those companies are in fact seeing some pretty good growth in their SD-WAN business.

Can you update us where you are with the two Tier 1s that you've been trying to penetrate?.

So, I would say that with one of them we are growing and we're doing better and they are ramping up. Even though I would tell you that even this one is not ramping up at the rate that we were hoping for, and we hope that this would improve as we move forward, but one of them is pretty significant for us right now.

The other one is still going forward, but very slowly. I would also say that being said that on the other side, we were getting, I would say, smaller design wins even not as we speak, but we're getting more design wins, which are related to SD-WANs.

Not all of them are that dramatic or big, we do not announce any design win that we get, but SD-WAN is definitely something which is growing internally..

Thank you. I'll see the floor. Thanks..

[Operator Instructions] The next question is from Alex Henderson of Needham and Company. Alex, please go ahead..

Well, I couldn't let it pass if we're not going to get other questions, I can certainly add a few more..

Sure..

One of the obvious questions is on the interest income line to the extent that the rates have fallen to near zero globally, even as you're building cash, should we be expecting a continued contraction in interest income net? And how should we think about that line?.

I'm not sure I understood your question.

Can you repeat it please?.

Sure, as interest rates globally are falling towards zero even as you're building cash, should we still – should we therefore expect that – that line continues to trend lower on a year-over-year basis for the whole year?.

First of all, what you're saying is correct. The interest rates are lower compared to a year ago and two years ago. Currently, it does not affect our financial income, but definitely it will impact our financial income I would say from 2021.

In other words, I expect that the – our financial net income in 2000 – and as of next year will be – will start to be lower compared to this year and the previous year..

Similarly, can you talk a little bit about where you are on exchange rates? Obviously, at the end of the last quarter, it was a very nice situation when the exchange rate plummeted, but it looks like it's recapped virtually all of that decline and is back to pretty much where it was at its highs.

So how does that impact the numbers? And how are you thinking about that relative to your cost structure?.

Okay. First of all, indeed, the differences in exchange rates affected us. In quarter two, the effect was negative, but not dramatically, definitely not dramatically. The net effect on our operating expenses – the net negative effect on our operating expenses was less than a 100K dollars, which is indeed not a dramatic number.

And in addition, there was a net negative effect on our financial income, but again not a dramatic number, I would say about 100K more or less..

So going forward, given the rebound in the exchange rates, do you expect to moderate hiring? How do you see your spending intentions going forward in terms of staffing levels?.

Okay. If the exchange rate remains more or less as it was in quarter two or in 2020, it means that we will see similar effects on our next few quarters, which means nothing dramatic. We do not edge our expenses. We do not edge anything. And again, in most quarters, the effect was positive or negative, is not something dramatic.

It can be 100K dollars, 150K dollars, not more, not less than that, nothing dramatic..

Again, going back to the question, the question was, how do you expect to think about your hiring prospects for the back half of the year?.

No impact..

So, can you give us some sense of what your hiring expectations are as we go into the back half, which is really I'm trying to ask?.

Well, first of all, I mean the hiring expectation is not going to be a dramatic anyhow. And OpEx, operation expenses as we see them right now may go higher a little bit, but it's not going to be dramatic in any event..

But looking back at the guidance for the third quarter and the improved visibility, normally your fourth quarter is seasonally strongest quarter of the year. It looks like you've gotten back to growth in the third quarter.

Is it reasonable to think that given all of the macro uncertainties that – that improvement in SD-WAN and these are the areas to the new projects in the traditional market that that it's a more normalized kind of environment by 4Q? Or should we still be quite conservative in our assumptions for that….

I think this is what we're hoping for..

And any commentary on the mix relative to gross margins?.

What was that?.

And any commentary on the mix relative to the gross margin?.

I mean, gross margins were still – I think we will – are still within the 32 to 36 boundaries not being able to tell in advance or exactly we would be within these boundaries. But revenues, yes, I mean, we believe we are on the right track right now and we believe that the fourth quarter would indeed be better..

All right, great. Thank you very much. I don't have any other questions..

The next question is from Harris Leviton [Private Investor]. Please go ahead..

Hi. Just a few questions.

First of all, on buyback, how many shares did you buyback and what was the average price during the quarter? And then on the work – on working capital, can you just talk a little bit about what normalized levels are for some of the line item because it looks like inventories were up sequentially and then payables – one of the payable line items was up quite a bit as well, but then the payable line item looked like it was unusually low last quarter.

So maybe you could just give us a little color in terms of where your working capital should be on a more normalized basis?.

Okay. I will start with your first question about the buyback. In quarter two, we repurchased approximately 133,000 shares. Altogether, it amounted to $4.1 million. It's important for me to say that a part of the buyback was related to closing the first plan. And the second part is related to the new plan, which we announced at the end of April.

So altogether the two plans together were at the number I said 133,000 shares, $4.1 million in total, which means approximately $30, $31 per share. As to your question about the balance sheet, yes, there was one significant reason for the increase in that balance sheet item. It is connected to an advanced payment.

We received two the customer in the amount of approximately $15 million..

Okay. So that – so that's – so that you'll work that number down as the year goes on basically..

Yes, definitely. Definitely, yes..

Okay. And then the last question I have was on – obviously, we've seen a lot of news the last few days about Intel and the problems they're having. And they're obviously part of the ecosystem to many of the markets you participate in.

Are you fairly agnostic in terms of who that processor design goes to? Or how do you look at them versus AMD versus ARM or some of these other players? Or does it really not have much of a direct impact on you?.

Well, I think that Intel's issues right now are not meaningful to us at all and we're agnostic to that. Now, it is true that we consider Intel as a strategic partner.

But what I'm saying is that the areas in which we are partnering with Intel are not such that would be – would suffer from any impact from what’s being discussed in the news and this is not relevant for us right now.

Now, if you look, I don't know, many years ahead, then this situation may be different, of course, because we cannot know what's going to happen for the very long term, which is why I would say that Silicom is not only working with Intel. Intel is our most strategic partners right now, but we do have designs. We do have solutions.

We do have thoughts and processors both with AMD and obviously solutions, which are based on ARM processors as well. And this is done indeed to mitigate any potential risks that may happen in the future..

Okay, terrific. Thanks. Thanks for taking my question..

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, www.silicom -usa.com. Mr. Orbach, would you like to make your concluding statement. Mr. Orbach, there is an additional question.

Would you like to take it?.

Yes, sure..

The next question is from [indiscernible]. Please go ahead..

Hello.

Can you hear me?.

Yes, we can..

Okay, perfect. So this is the first quarter that you have not secured a new design win.

Is this due to the pandemic impact? Or I mean does the impact has or it could have in the future an impact in your ability to secure new design wins?.

Okay, let me – I may have not made myself clear enough. We definitely have secured design wins during this quarter, more than one.

And – but, I mean, our policy right now is that we do not necessarily announce all the design wins that we're securing, we only announced those, which we consider to be strategic, very important something which is, I would say, entitled to an announcement. So we have secured design wins during the quarter, but none of these was such at this point.

By the way, some design wins begin small and then they become more important at which time we announced them, so that could happen as well..

Perfect. And about the second part of my question….

Which was….

Yes, does the pandemic has or could have an – in the future an impact in your ability to secure new design win?.

I thought that was pause of the first question. Okay, I understand. So I would say that there is a certain impact. I wouldn't say that it's – there is no impact at all.

Where we see this impact mostly is when there is a need to do physical evaluation on our products and sometimes the company to which we – or the organization to which we send these evaluation units are instructed to work from home, et cetera, in which case such evaluations are delayed.

So I wouldn't say that there is no impact at all, but I would say on the other side that while things may be delayed here and there, but we don't see any impact on the overall demand. And I think that therefore eventually all these design wins that hopefully we will get, it may happen a little later, but eventually we'll get them..

Okay. And most specifically one month ago or so Intel posted a paper where you discussed when they discussed the project between you, Telefonica and flexiWAN.

So can you speak about this project?.

No. Right now, I mean, we are not allowed and we cannot elaborate or provide any details about that..

Okay. Okay, that’s right. And my final question is, are you worried about the coronavirus outbreak in Israel because….

Well, I wouldn't say that this is impacting us significantly at all. I mean, I am – as a citizen of the state, obviously, I would like the situation to improve as much as possible by on day to day life. The impact on us is negligible..

Okay, perfect. Thank you very much..

Thank you. Mr.

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

Yes, thank you, operator. Thank you everybody for joining the call. We hope you're all safe and we look forward to hosting you on our next call in three months time. Good day..

Thank you. This concludes Silicom's second quarter 2020 results conference call. Thank you for your participation. You may go ahead and disconnect..