Ladies and gentlemen, thank you for standing by and welcome to the Silicon Motion Technology Corporation Second Quarter 2019 Earnings Conference Call.

[Operator Instructions] I must advice you that this conference is being recorded today Wednesday 31st of July 2019.This conference call contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 as amended.

Such forward-looking statements include, without limitation, statements regarding trends in the semiconductor industry and our future results of operations, financial condition and business prospects.

Although such statements are based on our own information and information from other sources we believe to be reliable, you should not place undue reliance on them.These statements involve risks and uncertainties and actual market trends and our results may differ materially from those expressed or implied in these forward-looking statements for a variety of reasons.

Potential risks and uncertainties include, but are not limited to, continued competitive pressure in the semiconductor industry and the effect of such pressure on prices; unpredictable changes in technology and consumer demand for multimedia consumer electronics; the state of and any change in our relationship with our major customers; and changes in political, economic, legal and social conditions in Taiwan.For additional discussion of these risks and uncertainties and other factors, please see the documents we file from time to time with the Securities and Exchange Commission.

We assume no obligation to update any forward-looking statements, which apply only as of the date of this conference call.I would now like to hand the conference over to your first speaker today, Mr. Chris Chaney, Director of Investor Relations and Strategy. Thank you. Please go ahead..

Thank you, Elisa. Good morning, everyone, and welcome to Silicon Motion’s second quarter 2019 financial results conference call and webcast. My name is Chris Chaney, Director of Investor Relations.

With me today is Wallace Kou, our President and CEO; and Riyadh Lai, our Chief Financial Officer.Following my comments, Wallace will make a -- provide a review of our key business developments and then Riyadh will discuss our second quarter results and our outlook.

We’ll then conclude with a question-and-answer period.Before we get started, I’d like to remind you of our Safe Harbor policy, which was read at the start of this call.

For a comprehensive overview of the risks involved in investing in our securities, please refer to our filings with the US SEC.For more details on our financial results, please refer to our press release, which was filed on Form 6-K after the close of market yesterday.

This webcast will be available for replay on our website at www.siliconmotion.com for a limited time. To enhance investors' understanding of our ongoing economic performance, we will discuss non-GAAP information during this call. We use non-GAAP financial measures internally to evaluate and manage our operations.

We have, therefore, chosen to provide this information to enable you to perform comparisons of our operating results in a manner similar to how we analyze our own operating results. The reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued yesterday.

We ask that you review it in conjunction with this call.And with that, I'd like to now turn the call over to Wallace..

Thank you, Chris. Hello, everyone, and thank you for joining us today. First, some financial highlights before I talk of our business. Our second quarter sales excluding FCI, increased 50%, 6% sequentially to $94 million.

Earnings per ADS for the quarter is -- were $0.52, up from $0.42 in the first quarter.Let me start by updating everyone on our business, starting with our SSD controller product line. In the second quarter, SSD controller sales grew sequentially at a solid 15% growth rate. Our SSD controller sales to a NAND flash maker grew 30% sequentially.

Our SSD controller sales to module maker customer, on the other hand were softer than anticipated as they continue to be at risk -- adverse because of rapidly falling NAND prices.With the NAND prices beginning to stabilize, we believe our business activity with module makers will pick up.

For full-year 2019, we believe our SSD controller unit shipments should grow at least at a faster growth rate estimated by industry analysts.

Gartner, for example, is projecting a lead 20% client SSD growth.In terms of our customers and end markets for the full-year, we expect stronger sales growth from both our NAND flash customers and module maker customers. And we expect stronger sales growth to the OEM market relative to the China market.

Our customers supplying to OEM are benefiting as they’re seeing very strong SSD design activity for PC, game consoles and other client devices. This year as OEM focus on SSD and transitioning their products from HDD to SSD.

PCs shipping with SSD will grow rapidly and conversely PCs using HDD could fall by as much as 50%.Our SSD controller growth this year is being driven entirely by PCIe NVMe SSD. The sales of SATA SSD declined. OEM are almost singularly focused on NVMe SSD. And all of our new controller design wins for OEM are for NVMe SSD.

China markets are primarily SATA SSD. But also gradually beginning to transition to NVMe. We expect to exit the year with more NVMe controller sales than in SATA sales.Our SSD controller design activities continue to expand and our market share likely also increased in the second quarter.

We continue to out ship our primary U.S competitor in terms of NVMe controllers and have secured a significant majority of design wins awarded by NAND flash maker to merchant controller supplier.

We are also seeing our small Taiwanese competitors lose traction and focus with customer due to the more limited capabilities.Separately, we do not believe our NAND customers are losing market share to NAND vendors who are now our customers.

And more broadly, we are seeing increasing business opportunity because growing interest by NAND vendor to outsource SSD controller for their mainstream and entry level client SSD.We believe we supply at least three quarters of the controller procurer by a module maker in Taiwan and China. And globally we supply roughly a third of the overall market.

Our client SSD controller business, however, is now without challenges. In the past, our blended SSD controller prices have been very stable. In the near-term, however, we expect blended prices to drift down because of three trends.

First, our customer are increasingly focusing on cost versus performance in managing their SSD product portfolio because SSD performance is already much better than HDD.

Lower cost product improved mainstream and entry level SSD and these devices use lower cost controllers.For example, a customer migrate from SATA to PCIe NVMe, they also are shifting a bigger portion of their requirement from more expense SSD, better require DRAM to less expensive [indiscernible] solution.

A related technology trend is of the capacity per NAND [indiscernible] increased faster than SSD capacity. SSD manufacturers are using [indiscernible] per SSD and also turning to lower cost fewer channel controller, such as two channel versus four channels.

Four channel versus eight channels.The other industry trend is rapidly falling NAND prices have being negatively affecting the profitability of both NAND flash makers and module makers. It is in our interest for our customer to survive and for us to maintain our diversified customer base.

It is all showing our NAND side partners [indiscernible] the diversified module maker customer base maintains, so they benefit from broader customer ecosystem.To maintain this diversified partnership ecosystem and since we supply to almost all these module makers, we need to be flexible with our controller pricing to a period of challenging industry conditions.

Industry consolidation is now in our interest. The other reason our blend ASP are currently lower than anticipated, if we want to price out our competitors thinking a small [indiscernible] in our marketplace. We believe we have being successful with this strategy.Let me turn to our enterprise SSD controllers.

These controllers are now shipping first to customer in China and the fourth quarter to U.S customers.

Our enterprise SSD controller are now using our Shannon Open Channel SSD that are now commercialized -- commercially deployed in the data center of Alibaba and in other BAT customers.In the fourth quarter, we will begin initial sale of these enterprise SSD controller to a U.S customer, while their data center is standard NVMe SSD.

Sales of our enterprise SSD controller this year will be small, but we are encouraged by these initial milestone and expect more meaningful contribution next year. I look forward to sharing more about our enterprise SSD controller business activity in upcoming quarters.Turning to our eMMC plus UFS controllers.

While we have not seen any meaningful pick up in android smartphone build activity, especially in China, our eMMC plus UFS sale this quarter were much better than expected, growing 20% sequentially.

This upside is a result of our Chinese module maker customers, bringing their eMMC embedded memory solution to Chinese OEM, ahead of the expectations.As we have previously discussed, we are being actively supporting 6 to 7 module makers entry into eMMC market [indiscernible] smartphone to set top box and speakers.

We expect our eMMC controller sales to these customer to scale rapidly in the next few quarters. Our large NAND flash eMMC customer continue to diversify their overall NAND sales away from the mobile market.

Nevertheless, we continue to expect our sales of eMMC controller to this customer to remain stable for the rest of the year.For our other NAND customer UFS programs we continue to make good progress in helping them bring their product to their OEM customers.

Recently, we have this [indiscernible] partner launch a second generation UFS solution with best-in-class endurance.Now I will provide some detail SSD solutions. In the second quarter, SSD solution sales fell about 40% sequentially with our Shannon product accounting for most of the decline.

Order for our legacy Shannon [indiscernible] product declined sharply and miss [indiscernible] to our targets. Our sales of the [indiscernible] appliance and [indiscernible] product also missed expectations.More positively our Open Channel NVMe SSD are now commercially deployed in the data center of Alibaba and in other BAT customers.

These are important milestone for us and also for the SSD industry as these Open Channel SSD are the first commercial deployment of this technology in the world.Application operation from this data center are now using our Shannon Open Channel SSD, which enable SSD performance to be optimized for applications, a benefit [indiscernible] standard SSD.

While these Open Channel SSD milestone are very important for us, both of our BAT customers have significantly reduced procurement plan of our product in the second half of this year.With these SSD continues to perform satisfactorily, we are well positioned to bring our second generation Open Channel SSD for qualification and testing in Alibaba and the other BAT for the next year projects.

We acquire Shannon in May 2015 to leverage our unique controller technology to create incremental value by supplying customized enterprise SSD.[Indiscernible] to our customized Ferri industrial SSD and also as a vehicle to [indiscernible] our enterprise SSD controller development.

Also, we cannot just sell enterprise SSD controller to Chinese hyperscalers. We needed to provide them with a complete SSD solution which embed our controllers.2019 is also a challenging year for our other two SSD solution products.

We customize [indiscernible] form factor of Ferri industrial SSD and our new [indiscernible] startup appliances, which enable virtualization of enterprise storage infrastructure.

Sales of our FerriSSD declined sequentially, since NAND prices have fallen sharper than expectation.We are excited by our long-term Ferri growth, given our growing and diversified portfolio of automotive, infotainment, commercial printer system and regulated gaming equipment design wins. We believe the worse is now behind us and looking to next year.

We believe, we are well positioned for renewed growth. Our SSD controller are expected to continue growing. Our eMMC plus UFS controller are expected to be flat to up next year.2019 will be very challenging year for our SSD solutions. [Indiscernible] in channel SSD in commercial deployment, our Shannon SSD will return to growth.

Next year, our FerriSSD will also return to growth.Now I will turn the call over to Riyadh to discuss our financial results and our outlook..

SSD controllers, eMMC plus UFS controllers and SSD solutions. Current indications from customers suggest our Q4 revenue could grow 15% to 20% sequentially.Let me provide color on our three key products. We expect our SSD controller sales to grow sequentially in both Q3 and Q4 with stronger sequential growth in Q4.

For the full-year, we expect our SSD controller shipments to grow at least as fast as the growth rate forecasted by industry analysts. Though our SSD controller sales growth will be lower than shipment growth because of product mix shift, strategic and tactical reasons discussed by Wallace earlier.

Our SSD controllers are very well positioned for further growth next year as our OEM programs continue entering volume production and a more favorable NAND pricing environment benefits to our module maker customers.We expect eMMC plus UFS controller sales to grow sequentially in both Q3 and Q4.

For the full-year, our eMMC plus UFS will decline meaningfully compared to last year and should be flat to up next year as our module maker activities and U.S flash partners -- UFS growth offset downside from eMMC transitioning to UFS at our Korean flash partner.We expect our SSD solutions sales growth to grow sequentially in both Q3 and Q4 with new Shannon Open Channel SSD sales and growth from our FerriSSDs.

For the full-year, however, our SSD solution sales will be down sharply as our legacy Shannon direct I/O SSDs declined faster than expected and procurement plans for Open Channel SSDs have been reduced.

Also our FerriSSD sales declined as NAND prices fell more than expected.We expect our SSD solutions to grow next year because we are now well positioned to introduce our next generation Open Channel SSDs for our two BAT customers 2020 projects.

With more favorable NAND pricing conditions next year, we also expect our FerriSSDs to return to growth.Q3 gross margin is expected to be between 48% and 50%, lower than the 51.5% in Q2, primarily because of ramping lower gross margin SSD solution sales and secondarily because of slightly lower SSD controller margins.

We expect Q4 gross margin to decline further because of the two same reasons. Further gross margin is -- full-year gross margin is expected to be between 47.9% and 49.9%, roughly similar to the 49.1% last year.Q3 operating margin is expected to be between 17.3% to 20.3%. We expect both Q3 and Q4 operating expenses to be roughly similar to Q2.

For the full-year, we expect operating margin to be in the range of 17.6% to 20.6%, lower than the 27% last year.

Full-year operating expense should be roughly 10% higher than last year.Stock-based compensation in Q3 is expected to be in the range of $2.4 million to $3.4 million and full-year stock comp in the range of $14.8 million to $16.8 million, lower than the $20.2 million last year.

Our effective tax rate in Q3 and Q4 is expected to be approximately 15%, our model tax rate.Before I wrap up, let me brief -- briefly -- brief everyone about impairment issues at Shannon.

We acquired Shannon in mid 2015 to leverage our unique controller technologies to create incremental shareholder value by supplying customized enterprise SSDs and now it goes to our customized Ferri industrial SSDs and also as a vehicle to accelerate our enterprise SSD controller development.Many aspects of our Shannon operating performance have come in below expectations.

The competitiveness of our legacy custom direct I/O PCI 8HC1 SSDs declined faster than expected and they are now superseded by standard PCIe and NVMe SSDs.In our custom Open Channel NVMe SSDs enter production a year behind schedule and at significantly lower volume than planned.

Our over buildup products and over stock of NAND components combined with rapidly falling NAND prices have led us to write-off $5 million of inventory this quarter.Additionally, a significant portion of our $34 million of goodwill and intangible assets from our Shannon acquisition is now likely impaired due to lower projected future profitability and cash flow.

We are still conducting our impairment evaluation and we expect to take a large impairment charge later this year. Finally, you should expect us to be repurchasing our shares this quarter.This concludes our prepared remarks. We will now open the call to your questions..

Thank you. [Operator Instructions] Your first question comes from the line of Karl Ackerman of Cowen. Please ask your question..

Hey, good morning, Riyadh and Wallace. Perhaps more a technological question initially.

Your client SSD business has been doing quite well, but as the industry transitions from SATA to NVMe protocols, and you comment on how you view your technological advantage relative to your customers, some of which are keen on building up internal design team controller resources.

And I guess if you truly have a technological advantage, why the need to lower controller prices to step off competition. And I have a follow-up. Thanks..

So regarding lowing our controller costs during the period due to NAND price decline sharply and most of our module maker and some of our NAND maker shipping to OEM customer adopt [indiscernible] PCIe NVMe solution. So our average ASP [indiscernible] controller is lower than the DRAM base PCIe controller.

Second is due to majority of our module maker SSD customer, they cannot make a profit. So we’re really -- really want to make sure they can survive and continue and working on the SSD business in the industry. So diversify is our strategy. We like to see they can rebound gradually from second half and be successful in 2020.

That’s why we need to reduce our ASP to meet our customer expectation and need and to building a strong infrastructure for SSD product line..

Karl, let me also add to what Wallace have said and just to summarize. There's three big categories of what’s happening with our ASPs and we’re really talking about blended ASPs. The first relates to product mix. The second is about strategic decisions we have -- we made in order to maintain or diversify ecosystem.

And the third is tactical to drive off the small competitors who are seeking a foothold in our marketplace. So as Wallace mentioned, the first is relating to product mix. Now SSDs have become full performance oriented relative to hard disk drive.

Already the performance is so much better than hard disk drive that it's not about just performance, it's also about costs. And this is leading customers initially module makers and now also flash makers to speak lower cost controller solutions. And then in the past it was about module makers using DRAM less solutions for a SATA drive.

Now even the flash makers are using DRAM less solutions, but DRAM less solutions for PCIe and NVMe. So OEMs moving from SATA to PCIe NVMe, but as they move to NVMe, they’re also adopting a lot of DRAM less solution which is causing our blended ASPs to shift to the lower price points.

So it's not so much about reducing our price, it's about our blended ASPs coming down because of our customers blending to lower cost parts, given the already very favorable performance that you can get from the DRAM less solutions as they converged from better controller designs that we’ve introduced, giving them this capability..

That’s very helpful. As my follow-up -- Riyadh, thanks for the color on the segments.

Is the lower procurement for Shannon SSDs and [indiscernible] that the design completion production window for your custom SSD products to both providers in the second half of this year and I guess if it is, how should we think about the commercial deployment opportunity both in the second half of 2019, but also the first half of calendar 2020? Thank you..

So we are in the real commercial production with the real workload in the BAT customers in second half. So this is about -- around 6,000 SSD units with a 1,000 server, the real workload running. I think after the so-called grade task, next year I think you can expect the order will be around 600 petabyte to 1 zettabyte range.

And this is the same -- because this year we don’t want to be too aggressive in Shannon Open Channel due to the price decline and certain procurement strategy from our customers.

So we really prefer and make sure they go through the real workload rounding the real system [indiscernible] server, then we become the major supplier, two of the major NAND maker together. So this is our plan and we [indiscernible] looking forward to strong recovery for 2020 next year..

Could you please repeat your second question?.

Sure, Riyadh.

How should we think about the commercial deployment opportunity with Shannon SSDs in the first half -- both the second half of calendar '19 and versus the first half of 2020? I guess, how should we think about the linearity of product momentum perhaps first half 2020 versus second half 2019? What appears to be a nascent [ph] but depressed base in the second half of '19? Thank you..

Well, for this year as Wallace mentioned, our products are now in commercial deployment, our two BAT customers. But bear in mind, the lower levels of procurement by our two customers this year is a big part of our result is -- our first generation product is frankly massively delayed.

Originally we were planning to bring this into production in the second half of the year, but Open Channel SSD design and performance tuning has taken a lot longer. It's a lot more challenging than we had originally anticipated, but we’ve finally overcome all these issues and have brought our products into commercial deployment.

But given that we already well pass the half year mark for this year, the procurement needs from our customers have been dialed down [ph]. So what we’re doing now is more gearing ourselves up for next year.

So we’re very excited about next year given that we’ve really gone to a lot of the learning, gone to some very sharp learning curves to get to where we’re today.

So we are now getting our second generation of our Open Channels ready for testing and qualification, but this should be a lot smoother this time around and gearing ourselves to bring our products to -- our second generation products to our two customers..

Thank you..

Operator, could you take the next question, please?.

Sure, sir. Your next question comes from the line of Anthony Stoss from Craig-Hallum. Please ask your question..

Hi, guys. Riyadh, can you tell us how much revenue is Shannon Systems was in Q2 or what percentage of revenues? And given it's been very lumpy, have an executed plan, what can you do to further cut costs within that division? And then I had a couple of follow-ups..

Revenue levels at Shannon is now down to barebones. We’ve -- our -- the products at Shannon used to sell were these legacy Direct I/Os, so these are the pre-PCIe NVMe drives with custom driver software, those have largely been superseded by PCIe NVMe. And so sale of those products, for example at Alibaba ended last year.

We still had some legacy customers that we’ve been shipping to in Q1 and Q2, so we’re down to barebones. And so we are now gearing up for the sales of our NVMe, our Open Channel NVMe drives in Q3. These already in commercial deployment, we already shipping and these will ramp in Q3 and further in Q4..

Where do you need Shannon Systems just as a grip to breakeven? What kind of quarterly revenue run rate?.

Well, Shannon has been breakeven in past years. But this year it's only not given that revenue levels have fallen so much, but we’re expecting Shannon to return to breakeven next year..

Okay. And then kind of [indiscernible] gross margins for year as you’re always targeting 50% to 52% somewhere in that range, [indiscernible] it's only for the quarter kind of 48% to 50%, is that the new long-term gross margin perspective now that you cut prices and really can't take that back.

Is 48% to 50% the new level going forward?.

Well, it depends on product mix. We have a -- the ASPs of our SSD controllers have come down a bit and the margins have also come down a bit largely from product mix as our customers have shifted to lower cost components in order to sell more attractively priced lower cost SSDs.

But as we move into next year and the following year, we’re expecting our enterprise SSDs to start contributing and that's going to have a positive momentum both in terms of our ASPs as well as our margins.

And broadly, given that our products are highly diversified, we are always seeking to bring high-value products to customers, means for us to continue to bring more value and hence opportunity for us to blend up our gross margins..

One last question, if I may. Last quarterly conference call and throughout the quarter you talked about turning away business on the SSD -- client SSDs, because lots of design folks are coming to you and you can't handle it.

Any -- how does that rectify versus your guiding levels through full-year, maybe you're only going to grow in line with the market versus again taking resources from, say, Shannon Systems and deploying them more towards the client side?.

So, first of all, the Shannon R&D resources they are focused on enterprise. So [indiscernible] they quite be in the client site. We [indiscernible] continuing increase our resource and also use our resource smartly assigning to the major OEM customer project.

Now we believe we have been through the worst condition in Q2, because now most of our product line from client [indiscernible] as a firmware to support all kind of NAND are almost ready. That's why we see the customer and because NAND price is stable, so picking up the demand and forecast our visibility is much better than the first half.

Now we do see if the NAND pricing remains stable, supply sufficient, we now can see continued growth on both our NAND OEM customer as well as module maker customers..

Okay. Thank you..

Your next question comes from the line of Craig Ellis from B. Riley FBR. Please ask your question..

Yes, Wallace, Riyadh, thanks for taking the questions and good evening. I wanted to start off just by following up on some of the gross margin questions. It looks like if we just back into the math in the fourth quarter that gross margins are expected to be in the 46% range.

So, one, is that correct? And two, Wallace, can you just frame the risk that the three drivers that are impacting gross margins in the near-term could either become more adverse exiting this year and become more of a headwind to a rebound in gross margins as we go through 2020, or conversely work more to your favor and frankly provide upside to what is I think an expectation for another 100 or 200 basis points step down in gross margin in the fourth quarter?.

Yes, from [indiscernible] controller portion, we believe should have proper product mix in the near future when we ship more PCIe controller in SATA, when we ship more high-end PCIe controller than value line PCIe, our gross margin will be going higher.

And when we ship more UFS 3.0 than UFS 2.1 controller, our gross margin blended business will be higher. So that will be potential contribution for our gross margin growth.

However, when we ship more SSD solution, our Ferri base solution and that product line -- these product line can now maintain our corporate average gross margin and that will drift down our average gross margin. So it really depend on product mix.

And so I think in the future when if we -- our solution -- our SSD solution and the Ferri base can grow much faster, I think we will look at a [indiscernible] is a really positive result such as gross margin.

So from controller side, we believe in the near future, especially 2020, and we will see more PCIe controller and UFS 2.1 move to 3.0 and will benefit for higher ASP and better gross margin. So controller [indiscernible] revenue, we should have a better gross margin than 2019..

Craig, let me also go back to your first question, your earlier question about our fourth quarter gross margins. Yes, the number you have quoted is roughly in a ballpark of what we’re expecting in Q4. Normally when we look at our gross margin, it's really the mix between our solutions and our controllers.

Our controller gross margins are generally very stable and above corporate average, while our solutions are generally meaningfully below our corporate average. But this time around in the second half of the year, our SSD solutions gross margins are going to be extremely low, especially because of our Shannon products.

As you may recall from our prepared remarks, we have just written off $5 million of Shannon inventory, which means we're essentially going to be selling the rest of the inventory which are now mark to fair market value, at close to zero gross profitability. It's still positive, but it's just a few percentage points above zero.

And so, as these products sell and ramp in the second -- in Q3 and further in Q4, it's going to drag down our overall blended gross margins. This issue will go away as we consume all these expensive NAND components and SSDs that we built in past quarters.

Once we consume all these and we bring in newly purchased NAND components at more that reflect today's NAND prices, our gross margins for our SSD solutions will go up meaningfully. But even when they go up meaningfully, they’re still going to be below our corporate average levels..

Thanks for all the details there. That's helpful. The second question is regarding some of the comments that were made regarding the business with Flash OEM customers, which had a very nice performance in the quarter. One of the comments that was made was that you see continued signs of outsourcing interest with those customers.

Can you provide further color on whether that's a continuation of trends that we have seen in the past or if there is something new that’s happening that provides you with visibility into new vectors of growth either as you look at the back half of this year or next year?.

At the moment we cannot comment the details, but we have a very strong visibility engagement with some other NAND makers. We do see they plan to outsource to third-party in 2020. So we started dialogue engagement and hopefully and they reflect to our 2020 financial performance..

Got it. And then lastly, nice to see that the company will be taking advantage of current stock prices with what is a very robust cash position.

Can you give us some sense for the intensity with which you intend to approach the buyback or if the Board has agreed on a certain buyback amount that the company would target either this quarter or next quarter, how you'd approach the use of cash? Thanks, guys..

Yes, we have a $200 million share buyback program that was authorized in the fourth quarter of last year, it's a two year program. We have already used roughly $35 million of the $200 million authorization every year-- every quarter before we put our buyback program into deployment, we have to get cash disbursement authorization from our Board.

And as part of that authorization, our Board will discuss with us about our business visibility and the terms for the upcoming quarters purchases. So we generally take a measured approach and we -- as you know, we are generally fairly conservative of how we deploy our cash.

But at the right moment we will buy our shares and you should expect us to be in the market this quarter repurchasing our shares..

Thank you..

Your next question comes from the line of [indiscernible] from Needham & Company. Please ask your question..

Yes, thanks for taking my questions. Going back to the client SSD business, just trying to reconcile the commentary, it appears that we are reaching kind of the saturation point with respect to performance of SSDs versus hard disk drive.

And therefore the OEMs or the customers are not willing to pay up a premium over hard disk drives anymore, because performance now is already intact.

How do we think about that going forward with respect to overall ASPs? I understand that you are hoping to ship more PCIe and other higher margin products within the client SSDs, but it appears to be that there is going to be kind of a structural change in the margin profile of that business going forward.

So I kind of want to get a better understanding, is this more of a structural change now in the industry, a change in the structural pricing, or is there kind of a hope that that this can be reversed through a better mix of product?.

Yes, I think this is a very good question. So we always -- and also planning for this as a direction. As you know the market is changing, PCIe Gen 4 is coming, although AMD launch in Q1, Intel product will launch around late Q, 3Q for next year. So the PCIe Gen 4 will bring new category of product line and to compete in their market.

But, however, for PC OEM in commercial line, the [indiscernible] will stay with 512 gigabyte and [indiscernible] gigabyte, because that’s there for [indiscernible] user. For consumer product line, I think you’re going to see 1 terabyte and 2 terabyte and they’re going to move to higher density to meet the consumer expectation.

So the NAND will diversify, one performance driven, one is a cost driven and our controller we see that we can add more value in QLC base that’s a [indiscernible] controller itself, the cost structure will be higher, because we need to increase the performance to meet the PCIe Gen 4 category.

In the same token, based on TRT base, we can really leverage our technology to create -- more creative way moving from mainstream product like premium line product then our controller will have a more value and customer willing to pay for the ASP.

And so blended business -- based on blended basis, we need to carefully leverage our multiple SSD controller product line, and so it can give us overall the price contribution and margin contribution could be higher.

And we see that’s a trend, become NAND and going to [indiscernible] next year and we will benefit more because our controller will be ready ahead of the most of our competitors in this market..

[Indiscernible], let me also add to what Wallace has said. So just to summarize, there are two technology trends that are taking place.

And one of the trends is just to bring low-cost SSDs to displace hard disk drives and so this is more of a commodity play, especially when you have the NAND flash makers with a lot of NAND that they need to dispose off and consume, right? The other trend is all about performance.

You have that PC OEMs already using SSDs where they’re more performance oriented devices, and for that part of market it's about performance bringing higher and better performing SSDs to them and so right now the balance is more towards the cost side, but over time we expect them to shift back to performance when the balance moves in the other direction..

Thanks for the insight. And just to follow-up, roughly what percentage of your client SSD revenue is to module makers versus OEM? This to get a sense of the impact of that business, because of the fall in NAND pricing.

And just along those lines, I just want to get a sense of what your view is now of the tax rate, the overall tax rates of client SSDs in the PC market.

Any sense in terms of what the percentage of that is now?.

I think for this year, particularly this year, OEM sell revenue for client SSD will be higher than we sell to module maker. So that's probably around 60% for OEM customers. But in [indiscernible] the past, we are roughly 50-50 balance between PC OEM and module maker customers. Regarding the ….

The tax rate..

And regarding tax rate, I think around about 55% to 60% of all PC, including desktop, adopt the SSD today. So this year around 50% -- 40% of the storage device is opportunity for SSD to replace -- for HDD in the next few years..

Thank you..

[Indiscernible], let me also add, the market is not just PCs. While the PC market we have seen the highest adoption of SSDs. We also have consumer electronics and external storage. Consumer electronics include game consoles like the Xbox and PlayStation. The adoption of SSDs for those devices have not even started.

And then you also have the external storage and surveillance markets. And so we are looking at 220 to 250 million client HDDs are still shipping today for PCs, consumer electronics, and external storage. And all these are opportunities for conversion to SSDs..

Your next question comes from the line of Mehdi Hosseini from SIG. Please ask your question..

Yes, two questions. First one is for both Wallace and Riyadh. You’ve had about $10 of net cash per share on the balance sheet for quite some time. It seems to me basis on what you have reported on a pro forma basis in first-half of '19 and outlook, it seems to me that the peak earning happen in 2016 and I understand the challenges of the new market.

But I want to better understand your strategy, how we are going to utilize your cash other than just the capital return? Is there anything that you are contemplating or are there different scenarios in your long-term strategy that could enhance by committing more cash and helping with better earnings prospect. And I have follow-up..

Mehdi, generally the cash on hand is intended to provide adequate working capital for our business to support continuing dividend programs and opportunistic share repurchase.

We also look at having the cash on hand for opportunistic acquisitions and also provides the cash on hand also provides peace of mind to our large OEM customers, all of whom are much bigger than we are.

They also provide peace of mind to our foundry partners and employees that we're going to be around for the long haul, especially since we are in a business that is very dynamic and volatile.

So for the two -- the key pieces of our cash beyond the cash related to just running our business, our dividend, share repurchase, the dividend part of it, we're going to revisit again at the end of the year.

Our current program we’ve paid our third installment, so one more installment and at the end of the year our Board will, we then have to decide whether to keep the same dividend amount or to raise it. The other is opportunistically we will continue to repurchase our shares, so that is another use of cash.

And thirdly, we do look at M&A opportunities, but those are hard to predict. So it's also important to keep our powder dry..

Sure. So business as usual. And one -- this follow-up is for Wallace. I see some disruption in the NAND supply, somewhere between 20% to 30% of the available NAND next year will have to go through a change in architecture from one technology to other floating gate to charge trap.

Is that also creating some headwind in forecasting for you, is there another reason for you to be rather conservative in your embedded solution? And I'm just wondering if -- how do you see those changes impacting your 2020 opportunities..

I cannot comment what specific NAND makers regarding technology change of their strategy. But I think, well, I can comment is, I believe and the transition could be very smooth. We don't see there will be any obstacle are challenging for our business to grow for 2020.

And we believe we work with our own NAND maker, including China NAND maker and we pay out to have a good rebound in 2020..

So, in other words, if there is an unanticipated disruption as we go through these technology change that could cause another source of challenge or overhang for your embedded solution? I don't get a sense that’s being diluted …?.

I think the NAND maker itself, they all would have [indiscernible] in production and the next generation preparing for future production. So they will make adjustment to allocate the capital investment, also the capacity output, the NAND output, based on their technology maturity, right? They will not -- they cannot change generation in one night.

So they were based on transition frankly for the new technology and moving based on the yield, based on the cost structure and transitioning from current generation to next generation.

So I believe transitioning will be smooth and based on whenever they’re ready, they were based on their cost structure moving the capital transitioning from current floating gate to charge trap to the next generation..

Maybe let me also add.

We see a lot of technology transitions in our industry over the course of the last decade or so, right?.

We have seen transition from 8-inch wafers to 12-inch wafers, we’ve seen the transition from SOC to 2 bits MLC to TLC and now the QLC we’ve seen a transition from planar NAND to 3D, we’ve seen transition from floating gate to charge trapping and generally they have been the six and seven NAND flash makers have made the transitions very smoothly.

The industry is full of profit maximizing business leaders with great engineers and they’ve generally done a phenomenal job in transitioning technology -- one [indiscernible] technology after another. And we also see just the more routine and then pass about [indiscernible] strength and now its adding more and more layers.

They’ve all continued to be very smooth and as a controller supplier we are very well-positioned to help them, the issues in for them to bring their components to the marketplace whether for their own products or to sell their NAND to module makers..

So let me just ….

I would actually argue that the past technology transitions where net positive for Silicon Motion as it had some positive impact on changing the controller, but the upcoming transition is more of a device and I'm not sure if it would -- if it goes smooth at best case may not have a positive impact, but if there is any interruption could limit a bit availability..

Yes, so Mehdi, we -- first, we cannot comment NAND maker, what is the strategy they’re applying to do and how they allocate, what portion is floating gate, what portion will be charge trap.

But what I can tell is that we are working with our partner, so for both mobile and client SSD, we’ve a [indiscernible] we’ve same controller [indiscernible] but different generation NAND simultaneously. So that’s why we assure the transitioning will create a impact for the business. We are not creating that for our business..

Got it. Thanks for the detail..

Your next question comes from the line of Suji Desilva from ROTH Capital. Please ask your question..

Hi, Wallace. Hi, Riyadh. So, I think if I’m correct, you guided the SSD controller to actually grow faster in the fourth quarter than in the third quarter.

Can you talk about the factors you are seeing that are driving that? Is that seasonality, the lower NAND pricing driving elasticity or just secular SSD attach rate, any color there and the visibility into the fourth quarter would be helpful..

It's just because I think entering the second half we have much better visibility. Our OEM customer, NAND partner have a better visibility, so it gave us forecast in Q4 it looks much stronger growth than in Q3. That's why we are confident Q4 have better outlook than Q3..

Plus, Suji, we have our programs one after another lining up to go into production with OEMs and so we have visibility related to that. And finally, with NAND prices beginning to show signs of stabilizing we are also seeing greater confidence from our module makers to want to be more active in building SSDs.

So all these are adding to improving expectations for the rest of the year..

Okay. And then a question on the cost -- on the gross margin guidance.

I'm wondering if this is a lever you can pull, but are there any -- is there any ability to cost down your products to help offset the gross margin [indiscernible] or is that kind of the cost structure of products locked in relative to your kind of product roadmap?.

Yes, we will -- we do look very [indiscernible] to reduce our manufacture cost. But in the same time, I think that our Shannon Open Channel SSD solution is going to ramp up in Q4 with more meaningful volume. That's why they dilute our gross margin, average gross margin.

But we believe that, Riyadh said, after we use all the [indiscernible] NAND and for next year, we believe our gross margin for Shannon SSD solution will be much better. So the blended basis will have a better solid gross margin moving to 2020..

Okay. And then last quick question on SSD solutions.

Is there any opportunities for customers beyond the two China BAT customers you have? How should we think of those two being the drivers of '20 revenue?.

We do have customer beyond the two BAT customer [indiscernible]..

Okay.

Any colors at U.S hyperscaler or any color there?.

Both on China and U.S..

Okay, great. Thank you, Wallace. Thank you, Riyadh..

Your next question comes from the line of Charlie Chan from Morgan Stanley. Please ask your question..

Hi, Wallace, Riyadh. So my first question is about the eMMC pieces outlook, because I [indiscernible] seems to be cutting 2D NAND protection still.

So any chance you can get into the 3D NAND eMMC or UFS in the coming quarters?.

I think the -- of course, our Korean partner transition 2D NAND to 3D NAND, [indiscernible] 2D NAND capacity. We are still working with our Korean partner and they are also looking for the high-end UFS product because they need to evaluate and what controller is better [indiscernible] third-party controller are, but they have a different strategy.

We maintain very closely range with the Korean partner and not just in mobile business but also in the SSD business and the enterprise side too. So I think the -- I cannot comment, I think we will grow faster in the Korean partner customer, but may not be the current Korean partner, it could be more Korean partner customer, especially in 2020..

Okay. And then client SSD ASP, I mean I can understand the margin pressure, but in terms of blended ASP given you’re still doing the PCIe mix and that is still -- should be at a bit premium to SATA [indiscernible].

So in terms of blended ASP, can you give us some range of the absolute orders or the trend in two coming quarters?.

Charlie, we don't think it's that meaningful to talk about our ASPs for our parts, since they go through a wide range, they have their own product life cycles. But what we can comment about is that the blended ASP trends of our business.

This year as our product transition from SATA to PCIe, they are also transitioning -- a lot of our growth is now for the PCIe parts are the DRAM list variety of the PCIe versus the with DRAM. So we are talking about the SSDs using PCIe for more mainstream and lower cost entry-level products, and so the ASPs are going to be lower.

Furthermore, as we mentioned in the past, we have provided more favorable pricing of our SATA SSD controllers to our module makers. And so these have caused our overall blended ASPs to be lower than what we had expected at the start of the year..

Okay. Thanks. And lastly, Ferri pieces, I felt it should be less sensitive to the NAND price rise, because when NAND price comes down, consumer product may be half of it [indiscernible]. When NAND price goes up, it will be [indiscernible], but for Ferri, I thought the end market should be more like industrial.

Why that is suffering the NAND price decline?.

So, Charlie, you’re absolutely correct. Our Ferri was in the industrial sector. However, entering 2019 due to the NAND inventory and price decline, we do see NAND maker gradually entering to the market and with unbelievable price. That's what impact our price position.

But, however, we do because that we do start to see the rebound in growing from the server side as well as automotive sector, and we still see that quite strong rebound for our Ferri business for 2020 and when the -- when NAND price go into the more stable condition..

Hey, Charlie, let me also add. Since NAND price is dollar for gigabyte, price of NAND have come down so much compared to last year.

Even if our unit shipments of our Ferri products were flat or up and our densities remain fairly stable, the amount of revenue that we’re going to be receiving is going to be a lot less than what they were -- what we were able to enjoy last year. And so these are factors that you’ve to consider when you look at our business..

Okay. Yes, I guess, that’s all for me. Thanks..

There are no further questions at this time. I would now like to hand the conference over back to Wallace..

I would like to thank all of you for joining us today and your continued interest in Silicon Motion. We will be attending several investor conferences in Asia and U.S during this quarter. Details of this event will be available in our website. Thank you for joining us tonight..

Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect..