All improvement: Cavium Management Discusses Q4 2013 Results

Executives

Angel Atondo - Marketing Manager

Syed B. Ali - Founder, Chairman, Chief Executive Officer and President

Arthur D. Chadwick - Chief Financial Officer, Principal Accounting Officer, Vice President of Finance & Administration and Secretary

Analysts

Blayne Curtis - Barclays Capital, Research Division

Sundeep Bajikar - Jefferies LLC, Research Division

John Spencer Ahn - JP Morgan Chase & Co, Research Division

N. Quinn Bolton - Needham & Company, LLC, Research Division

Anil K. Doradla - William Blair & Company L.L.C., Research Division

Richard E. Schafer - Oppenheimer & Co. Inc., Research Division

Sujeeva De Silva - Topeka Capital Markets Inc., Research Division

Sanjay Chaurasia - Nomura Securities Co. Ltd., Research Division

Dean Grumlose - Stifel, Nicolaus & Co., Inc., Research Division

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

Ruben Roy - Mizuho Securities USA Inc., Research Division

Betsy Van Hees - Wedbush Securities Inc., Research Division

Gary W. Mobley - The Benchmark Company, LLC, Research Division

Vijay Bhagavath - Deutsche Bank AG, Research Division

Cavium (CAVM) Q4 2013 Earnings Call January 29, 2014 5:00 PM ET

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Cavium Inc. Fourth Quarter 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Wednesday, January 29, 2014.

I would now like to turn the conference over to our host, Ms. Angel Atondo, Senior Marcom Manager. Please go ahead, ma'am.

Angel Atondo

Thank you. Good afternoon, everyone, and welcome to Cavium's fourth quarter 2013 financial results conference call. Leading the call today are Mr. Syed Ali, President and CEO of the company; and Art Chadwick, Vice President and Chief Financial Officer. Before we begin, I would like to remind you that various remarks that we make on this call, including those about our future financial results, including revenues, gross margins, operating expenses, design wins, product plans, our competitive situation, market trends and our anticipated growth and profitability, all constitute forward-looking statements for the purpose of the Safe Harbor provisions under the Private Securities Litigation Reform Act. These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties that may cause actual results to differ materially. We refer you to our most recent Form 10-K and Form 10-Q filed with the SEC, in particular, to the section entitled Risk Factors, and to other reports that we may file from time to time with the SEC for additional information on factors that could cause actual results to differ materially from our current expectations. These forward-looking statements speak only as of the date hereof and we disclaim any obligation to update these forward-looking statements.

In addition, Cavium reports gross margin, operating expenses, net income from operations, net income and EPS in accordance with GAAP, and additionally, on a non-GAAP basis. Management believes that non-GAAP information is useful because it can enhance the understanding of the company's ongoing economic performance, and Cavium, therefore, uses non-GAAP reporting internally to evaluate and manage the company's operations. Cavium has chosen to provide this information to investors to enable them to perform comparisons of operating results in a manner similar to how the company analyzes its operating results.

The full reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued earlier today. And we ask that you review it in conjunction with this call. Additionally, the information we provide on this call regarding sales by market segment involves certain management judgment as to which market each sale is assigned, and you should consider that when analyzing such information.

I will now turn the call over to Syed Ali. Syed?

Syed B. Ali

Thanks, Angel, and thanks to everyone for joining us today. Q4 was another excellent quarter on major metrics that we track, including top line growth, non-GAAP gross margins, non-GAAP operating margins, cash flow and design wins.

In brief, Cavium's fourth quarter revenue was $81.13 million, up 3% sequentially and up 22% year-over-year. This was our seventh quarter in a row of sequential revenue growth. Non-GAAP gross margins were 66.3%, and non-GAAP net income was $17.4 million or $0.31 per diluted share. GAAP net income was $187,000. Art will discuss our Q4 financial results and Q1 guidance in more detail shortly.

In Q4, growth was driven by chip sales into our core service provider, Enterprise and Data Center markets. Sales into the broadband and consumer markets were down double-digit. In Q4, we saw growth in the Enterprise and Data Center markets with strength in enterprise switches, routers and security equipment. While Data Center growth was driven by our LiquidIO cards. In the service provider market, we saw continued strength in wireless infrastructure market being offset by weakness in wireline and telecom market.

Sales into the broadband and consumer were down as sales into discontinued legacy consumer segments trail down.

In Q4, our top customer was once again Cisco Systems, which came in at 19% of sales and was up 8% sequentially. In Q4 2013, Cisco was up 36% compared to Q4 of 2012. Growth was primarily driven by RAMs of newer designs going to production.

I would now like to provide an update on Q4 design wins. Q4 capped a record year for design wins for Cavium with wins across the Enterprise, data center and service providers segments. Design wins in the quarter were specially strong in wireless infrastructure, security and our new 28-nanometer OCTEON 70 and 71XX products.

Overall, in 2013, we saw a reacceleration in design win momentum, driven both by our existing products and the newer products in our product line like our 28-nanometer OCTEON III, LiquidIO, Fusion small cell and NEURON products. Design wins in 2013 in our core products were up by greater than 50% year-over-year compared to 2012. We believe this shows the strength of our product line up and our strengthening competitive position in our served end markets.

Now I'd like to give an update on other new highlights since our last earnings call. Our new 28-nanometer, OCTEON III 70, 71XX products, have been sampled extensively to a very wide range of customers and applications, shipping in the thousands of units already. These processes integrate high-performance MIPS64 cores, with full hardware virtualization, deep packet inspection, packet processing, security and QoS capabilities, along with very sophisticated power management in a highly integrated system on a chip, with leading performance per watt and performance per dollar metrics. This product line has been our best product line to date in terms of total customer pipeline and speed of ramp up of design wins post product sampling.

We already have over 20 customers for this product and have won over 35 design wins in a very short time period. We're especially pleased with winning a number of sockets that in the previous generation was being serviced by incumbent competitors.

As I've already pointed out in previous earnings calls, this product line adds a substantial new serviceable TAM for Cavium. And we believe that we have a winning product line, which will enable us to gain a significant market share in this segment. We are also seeing a significant increase in design win traction for our OCTEON and NITROX products for robust network security, driven by the latest hacks and overarching concerns about securing networks and the rise of multi-tenant cloud data centers. This is driving our customers to add robust line rate high-performance security to their equipment. This in turn is driving increased content design wins for next-gen systems at both existing customers like VA Networks, Cisco, Dell and others.

We're also seeing our products being designed into other Tier 1 customers that we have never sold to before. We see security as a long-term secular tailwind for us, as we have a very strong leadership presence in this market. We're also seeing an acceleration in traction for our OCTEON Fusion small cell products. Issues related to coexistence with macro base stations, backhaul and physical site procurements that slowed the deployment ramp are being resolved rapidly. And we are seeing a significant uptick of interest by service providers to deploy them.

The value proposition that we are bringing to market compared to our competitors is high-performance, high user count up to 128 users, and an extremely robust fi [ph] and layer 2, layer 3 software stack along with low-cost, form factor -- small form factor reference designs that have performed excellently in our ongoing trials.

We also expect design wins for our NEURON family to accelerate in 2014, with the release of new network processors with native optimized support for our NEURON chips. We also completed [indiscernible] V valves [ph] at 2 new Tier 1 customers who have now certified and ready for use as a legacy standard TCAM replacement.

Project Thunder developments are continuing in full swing and are on track on silicon software and system development schedules. Project Thunder provides a highly scalable family of 64-bit ARMv8 processors incorporated into a highly differentiated SOC architecture that integrates high-performance compute, networking, security and storage, along with targeted workload application acceleration and high-speed industry standard I/Os fully optimized for next-generation cloud and data center applications. We have a number of customers developing software on our Thunder SDK. The developed software will be able to run out-of-the box in our silicon.

Customer feedback continues to be extremely positive. Our expectation is that our solution will be the most differentiated solution compared to other announced ARM-based offerings in this space, which are all pretty similar to one another.

Now I would like to move on and give a brief outlook on our served end markets for Q1. For Q1, we expect to see growth in the Enterprise, Data Center and wireless infrastructure markets. We expect wireline and telecom to be soft due to seasonality and some inventory work downs. We also expect the broadband and consumer business to be down in Q1.

On that note, I would now like to turn the call over to Art Chadwick, who will provide a detailed discussion of Q4 financial results and guidance for Q1. Art?

Arthur D. Chadwick

Great. Thanks, Syed, and thanks to all of you for joining us today. I'll first go through Q4 financial highlights and then provide guidance for the first quarter of 2014. As Syed mentioned, Q4 was another excellent quarter for us. But first, I'd like to do a quick recap of this last year. 2013 was a record sales year for the company, with sales of $304 million, a 29% increase over sales in 2012. We had record design wins and introduced a number of significant products during the year. We executed restructuring activities that reduced R&D resources, away from certain consumer products and reinvested those resources back into our core businesses. As a result, we managed to keep non-GAAP operating expense growth to only 7% year-over-year, while at the same time, significantly expanding our OCTEON and Thunder design teams, as well as increasing investment in other new programs.

Non-GAAP gross margins increased more than 300 basis points during the year, increasing from 63% in 2012, to 66% in 2013. Non-GAAP operating margins increased from 7% in 2012 to 20% in 2013, due to our top line sales growth, expanding gross margins and operating expense leverage. Non-GAAP net income more than doubled from $22.8 million in 2012, to $56.2 million in 2013. In addition, we generated very positive cash flow during the year, increase in our cash balance by more than 65% during the year.

We increased our cash balance by more than $50 million, and ended the year with $127.8 million in cash and equivalents.

For the fourth quarter just reported, we had sequential revenue growth, expanding non-GAAP gross margins, expanding operating margins, sequential non-GAAP EPS growth and positive cash flow. Revenue in Q4 was $81.135 million, up 3% sequentially and 22% year-over-year.

Sales into the enterprise service provider and data center markets were $71.1 million or 88% of total sales. This was up 5% sequentially, and up 38% year-over-year. Sales under broadband and consumer were $10.0 million or 12% of sales, down 14% sequentially, and down 32% year-over-year due to our exit from certain consumer businesses. Sales to our largest customer, Cisco, were $15.7 million or 19% of sales, up 8% sequentially.

Non-GAAP gross margins were 66.3%, a record high for the company. This was a 30 basis point sequential improvement over Q3, due primarily to favorable product mix. Non-GAAP operating expenses were $36.1 million, up 3% sequentially. Non-GAAP R&D expenses were $24.6 million, and non-GAAP SG&A expenses were $11.5 million. Non-GAAP operating income was $17.7 million or 21.9% of sales.

Income tax expense was just $120,000, which was lower than normal due to certain favorable international taxes at yearend. GAAP net income was $187,000. Non-GAAP net income was $17.4 million or $0.31 per share, compared to $16 million or $0.29 per share in Q3. To recap, we had strong non-GAAP EPS growth this entire year, going from $0.19 per share in Q1, to $0.23 in Q2, to $0.29 in Q3 and $0.31 in Q4.

As a result of actions we took related to certain consumer products, amortization of acquired intangible assets this quarter were higher than normal due to a $2.7 million onetime, noncash intangible asset impairment charge. In addition, we took a $2.9 million onetime, noncash charge due to the reduced expected life of certain consumer product licenses.

Q4 non-GAAP results exclude $17.2 million in non-GAAP adjustments, which includes the consumer-related onetime charges I just mentioned, stock-based compensation expense and other expenses, as detailed in our reconciliation between our GAAP and non-GAAP results, as reported in our press release.

During the quarter, we generated $17.6 million in cash from operations, $0.7 million from financing activities, and used $3.5 million for the purchase of property and equipment. As a result, our cash balance increased $14.8 million this quarter and ended with a balance of $127.8 million.

Inventory at the end of the quarter was $45.8 million, an 8% sequential increase due to new product builds and the staging of inventory for early 2014 shipments. Accounts receivable were $43.6 million. This equates DSOs of 49 days, which was 5 days less than DSOs of 54 days in Q3.

I'd now like to provide some more specific guidance for the first quarter of 2014. We expect revenue will be between $80 million and $83 million in the first quarter. By segment, we expect continued growth in sales and enterprise and data center markets, and a decrease in sales into broadband and consumer. We expect non-GAAP gross margins in Q1 will be approximately 66% plus or minus 25 basis points.

Non-GAAP operating expenses are expected to increase sequentially by between 2% and 3%. So at the midpoint, this would put non-GAAP operating expenses at approximately $37 million. Interest and other non-operating expenses are expected to be approximately $500,000.

Income taxes in the first quarter are expected to be approximately 4% of non-GAAP income. And taxes for the balance of 2014 are expected to be between 5% and 7% of non-GAAP income. The non-GAAP share count in Q1 is expected to be approximately 56 million shares. And based on those assumptions, non-GAAP EPS in the first quarter is expected to be between $0.27 and $0.29 per share. So in summary, we had an excellent 2013, and are looking forward to a great 2014.

And on that note, I'd like to hand the call back to Syed for a few closing comments on what we see coming in 2014.

Syed B. Ali

Thanks, Art. I would like to take this opportunity to provide a quick outlook on what we expect our growth drivers will be in 2014. We expect continued year-over-year sales growth in 2014. We expect growth across all of our core enterprise, data center and service provider markets. We expect to see very robust revenue growth over the year in the wireless infrastructure market across macro base stations, radio network controllers and EPC at all our major customers, including MSN, Samsung, Huawei and ALU, as some new model systems rollout starting in Q2 of 2014, and large infrastructure builds in Asia and others across the world ramp over the year.

In the Enterprise and Data Center segment, we expect growth to be driven by routers, switches, security equipment, server load balances. In our newer product category, we also expect extremely strong year-over-year growth from the group of newer products, including LiquidIO, small cells and NEURON products, with LiquidIO leading the charge, leading to meaningful revenue contributions in 2014. In the wired -- service wired segment, we expect growth from equipment such as core and edge routers, CMPS head ends and transport equipment. We also expect 2014 to be the most significant year for new product introduction and sampling ever in our history. We expect these new products to address major new market discontinuities and growth opportunities in the cloud, SDN and enterprise and service provider infrastructure. We believe that as 2014 progresses, we will have an extremely strong product line, addressing these new high-growth segments with breakthrough solutions, which will help drive continued growth for us.

With that, I would now like to turn over the call to the operator for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Blayne Curtis with Barclays.

Blayne Curtis - Barclays Capital, Research Division

Syed, you've seen some pretty strong trends in Enterprise and Data Center. You mentioned meaningful revenue from LiquidIO, I'm assuming that's still a small number, but if you could maybe frame where that is today and how meaningful that could be and then what was the other drivers in Enterprise and Data Center that's strong in the December and March quarters?

Syed B. Ali

As in my prepared comments, Cisco is a good bellwether for the enterprise market, and they were up pretty nicely sequentially for us 8% quarter-over-quarter. And then, other markets like server load balancers, customers like F5, Citrix all contributed to that. Overall, for our newer products, we are targeting somewhere in the high single-digit to double-digit revenue contribution for these new generation of products, which is kind of LiquidIO, small cells and Fusion to add that much more to our revenues in 2014.

Blayne Curtis - Barclays Capital, Research Division

Okay. And then, on the service provider side, lots of people are seeing weakness in wired, maybe where -- what particular areas in wire are you seeing and do see any signs of that coming back, and then, if you could just give a little color, there's been a lot of focus on wireless, it seems like it's picking up a bit, are you seeing -- what's the trajectory of wireless into this year, are you starting to see those orders out of Asia, and if you could just provide any color, that would be helpful?

Syed B. Ali

So overall, again, wireless infrastructure seems pretty strong and I think we will see in strengthen also across the year. In terms of the wireline, it is slow and it was fairly decently broad-based, but I believe that with the numbers that we've baked into guidance for Q1 and in having some conversations with our customers for 2014 forecast, we expect that to start upticking in Q2.

Operator

Our next question comes from the line Sundeep Bajikar with Jefferies.

Sundeep Bajikar - Jefferies LLC, Research Division

First, can you tell us what portion of total revenues in 2013 was generated from applications related to software defined networking, and how should we think of that mix changing in 2014?

Syed B. Ali

Regarding at the end, the main product that we're going to put out there is LiquidIO. So that one just started to shift in Q3 and kind of ramped a bit in Q4, and it should ramp across the year in 2014. So that is -- from a standalone product viewpoint, that is our primary exposure to SDN. Obviously, our processors also go into SDN-enabled equipment, but that would be processors like the OCTEON, which have also shown very healthy growth in 2013.

Sundeep Bajikar - Jefferies LLC, Research Division

Okay. And then, amongst the SDN applications that Cavium is shipping into currently on the -- is it primarily into the service provider side, and if it's within service provider, is it more weighted towards wireline or wireless infrastructure?

Syed B. Ali

These particular products, primarily, the initial ramp is in data centers. Obviously, the product has been sampled by a number of customers, but I'm basically highlighting that the revenues are coming from data center customers and even customers who are deploying their appliance in the cloud itself.

Sundeep Bajikar - Jefferies LLC, Research Division

Okay. Great. And then, last one for me. In terms of wireless infrastructure contribution in 2013, was it somewhere between 20% to 25% of revenues, and any color you can provide on the size of said bucket now in 2013 would be great.

Syed B. Ali

So if you take a look at the overall kind of 2 big buckets, the Enterprise Data Center and the service provider. They are fast approaching parity. These to be, if you remember, a year or 2 years ago, at least 2 to 1, between Enterprise Data Center and the service provider, that gap has narrowed down fairly considerably. So the approximate revenues that we're generating are in that ballpark range if you will.

Operator

Our next question comes from the line of Harlan Sur with JPMorgan.

John Spencer Ahn - JP Morgan Chase & Co, Research Division

This is John Ahn calling in for Harlan. Great quarter. I guess, what I'm trying to figure out here is your 28-nanometer OCTEON III sounds like you're gaining some traction, I think, you mentioned 20-plus customers, you got some new sockets that you're winning from your competitors. I'm just trying to get an idea of the mix of the applications that you're seeing there. I mean, is it primarily in the base station area or is it in the enterprise, any kind of color you can give there would be great.

Syed B. Ali

Yes, it's actually the application area is pretty widespread. So it can go anything into -- from applications such as a line card processor in a big piece of equipment or it can go into a low-end SMB or VPN or router or WiFi AP. So it is a very wide range of applications, very nicely mixed between both control plane, which the one of the data center is -- I'm sorry, which the one in the line cards controller will be. So it's control plane applications, data plane applications and complete being becoming the main CPU in the lower end, low-performance box.

John Spencer Ahn - JP Morgan Chase & Co, Research Division

Okay. Great. That certainly helps a lot. And a question for Art, in terms of gross margins, I mean, you've made tremendous progress in 2013, as you've alluded to before, as well as in the operating margins, just trying to get a better idea of how you see your gross margin, as well as your operating margin profile going into 2014?

Arthur D. Chadwick

Sure. Well, we talked about this, I think, on our last call also. There's a high correlation between core count and gross margins for us. And as the world moves to higher and higher core count product, that's kind of the underlying driver towards higher gross margins for us. Having said that and looking at 2014, we have a lot of new products coming out. And those mass sets get amortized over a 12 month period and get amortized through our cost of sales. So that will temper some of that, otherwise, gross margin expansion. So what we've been saying for 2014 is that margins would be relatively flattish, they could be up a little, they could be down a little, but relatively flattish going from 2013 to 2014, primarily because we've got so many new products coming out and a lot of mass sets that are rolled through cost of sales.

Operator

Our next question comes from the line of Quinn Bolton with Needham & Company.

N. Quinn Bolton - Needham & Company, LLC, Research Division

I just wanted to come back to Blayne's question, make sure I heard your answer right on the top products, particularly LiquidIO. Did you say that by the end of 2014, you thought that the new products in aggregate would be roughly 10-ish percent sales?

Syed B. Ali

Yes. I'm talking about it for the year as a whole. So as you go towards the end of the year, obviously, that percentage should be higher than that.

N. Quinn Bolton - Needham & Company, LLC, Research Division

And the new products include OCTEON III or is it really just LiquidIO, Fusion or NEURON?

Syed B. Ali

It does not include OCTEON III, this is just new set of products that we have introduced over the last, whatever, 12 months or so.

N. Quinn Bolton - Needham & Company, LLC, Research Division

Okay. So it sounds like it exits -- 10% for the full year exits at a higher rate?

Syed B. Ali

Yes. So what I said is kind of high single-digits to double-digit for the year and exiting the year at higher than 10%.

N. Quinn Bolton - Needham & Company, LLC, Research Division

Great. And then, second question, just Open Compute was being held this week, wondering if there are any announcements or any update sort of from a supply chain perspective for ARM servers that came out at a conference that you could give us an update on, whether it's software tools, operating systems, any noteworthy announcements coming out of Open Compute from your perspective?

Syed B. Ali

I think, there was very significant announcement by ARM along with their partners, of which we are one of them in this segment, about the standardization of the ARM server profiles. So that, essentially, there would be a lot of commonality in the firmware and how the firmware behaves between the different vendors. So that, I think, is going to be a very, very good thing for the entire ARM ecosystem. The second kind of major aspect that we've seen is that even companies like, I think, Microsoft had an announcement where they are adopting alternate architect -- where they would be adopting these alternate architectures. So overall, we are starting to see a fairly significant speed up in development of the entire ecosystem, whether it's in operating system side, whether it's in the software side, whether it's in the ODM food chain itself. So overall, I think, the pace is really starting to pick up.

Operator

Our next person comes from the line of Anil Doradla with William Blair & Company.