Inphi Corp
Q2 2016 Earnings Call Transcript

Published: 9 Aug 2016

[Operator:]

Good afternoon and welcome to the Inphi's Second Quarter 2016 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. I would now like to turn your conference over to Deborah Stapleton, IR of Inphi Corporation.

[Deborah A. Stapleton:]

Thank you, and good afternoon, everyone. Thank you for joining us today to discuss Inphi's financial results for second quarter of 2016. I'm Deborah Stapleton, and with me today are John Edmunds, Chief Financial Officer; and Ford Tamer, Chief Executive Officer. John will begin with the Safe Harbor, then Ford will give you an overview of the business. After that, John will provide a financial summary of Q2 and the outlook for the third quarter of 2016. Then we'll be happy to take your questions. John?

[John S. Edmunds:]

Thanks, Deborah. Please note that during the course of this conference call, we may make projections or other forward-looking statements. These forward-looking statements and all other statements made on this call, which are not historical facts, are subject to a number of risks and uncertainties that may cause actual results to differ materially. These forward-looking statements speak only as of today's call. We do not undertake any obligation to provide updates after this conference call. For further information regarding risks associated with our business, please refer to our registration statements, as well as our most recent annual and quarterly reports on Forms 10-K and 10-Q, all filed with the Securities and Exchange Commission, accessible at www.sec.gov. Please refer, in particular, to the sections entitled Risk Factors. We encourage you to read these documents. Also during the course of this conference call, we may make reference to non-GAAP financial information. A reconciliation of this information is included in the press release and on our website, which is available at www.inphi.com. This information is not a substitute for GAAP and should only be used to evaluate the company's results in conjunction with corresponding GAAP measures. For this quarter, in particular, you will notice that we're reporting based on continuing operations and that historical numbers in the press release have been adjusted to reflect our recent sale of the memory business to Rambus. This is being done in accordance with GAAP rules for reporting discontinued operations. However for convenience we have included a reconciliation to the historical reports for both the GAAP and non-GAAP reporting by quarter on our website for the last six quarters. In general, the numbers we refer to in the conference call will be continuing operations. Where we refer to numbers that are not continuing operations we will so designate. Now, to begin our review of the quarter, let me turn our call over to the CEO, Ford Tamer. Ford?

[Ford G. Tamer:]

Thanks, John. Good afternoon. Thank you for joining us for our second quarter earnings call of 2016. Last week, on Thursday, August 4, we closed the sale of our memory business to Rambus and we're pleased to deliver an upbeat and positive report card in our first call as a pure play communications company. Our story today is both streamlined and focused. Once again, we delivered a very solid quarter beating expectations on both the top and bottom lines. We beat on our second quarter revenue with 12% sequential and 22% year-over-year growth in our continuing communications business. We also exceeded our plan on earnings per share with $0.32 in non-GAAP EPS, a 23% sequential increase and ahead of Street expectations. Non-GAAP gross margins from continuing operations exceeded our expectations at 73.6%. Non-GAAP income from operations in the second quarter was 24.4% of revenue from continuing operations. We're also very pleased to tell you that we're raising our guidance significantly for the third quarter representing a 43% year-over-year revenue growth. I could not be more proud of our team's ability to consistently deliver. Strength across all sectors of our business fueled our strong results, which allowed us to exceed projections. We strongly believe that these positive secular trends driving high bandwidth growth and Cloud, Enterprise and Service Provider markets will continue in 2016 and well into 2017. Let me now comment on our business in each of Inphi's three core segments

[John S. Edmunds:]

Thanks, Ford. Now, let me recap the financial results. In the second quarter of 2016, Inphi reported revenues of $60.5 million from continuing operations, which, as Ford told you, was up sequentially from Q1 by 12% and up year-over-year by approximately 22%. As described in the press release, were it not for the divestiture of our memory business, the $60.5 million from continuing operations would have been combined with $9.8 million from discontinued operations. This would then have resulted in a revenue achievement of $70.3 million for the quarter. This would have been well above the Street expectation of $69.4 million, which was established based on our April guide in the range of $68.4 million to $70.4 million. Core communications for Q2 was up approximately 41% year-over-year. Due to a higher outlook for the second half of 2016, we have revised upward our estimate of growth for core communications revenue. We now expect the year-over-year growth rate to be approximately 60% for the year, which is up from the 40% to 50% we were estimating last quarter. We define our core communications as amplifiers, drivers as well as 10 Gig, 40 Gig and 100 Gig physical interface products, all of which would sell into the Service Provider and Data Center Interconnect markets. The growth is coming from all three areas with drivers growing a bit faster off a smaller base. The core communications products continue to represent approximately 80% of communications, while the legacy communications products represent the remaining 20%. As expected, transport and legacy was roughly flat with Q1. For the year, transport and legacy is expected to be on target at about 18% of the business. Gross margins on non-GAAP basis in Q2 came in at 73.6%, which was down about 130 basis points from the same number in Q1. The decline is essentially due to customer and product mix in Q2 versus Q1. This is also down from a peak in gross margins in Q4 and Q1. So we believe in Q2 and Q3, we are just reverting back to the mean. In Q3, we expect the gross margins to decline by approximately 130 basis points based primarily on a higher mix of packaged drivers. All in, we estimate gross margins for Q3 to be in the range of 71.8% to 72.8%. On a GAAP basis, we had GAAP positive operating income in Q2 at $4 million, up from Q1 of $2.2 million and compared to a $1.3 million operating loss in Q2 one-year ago. The delta between GAAP and non-GAAP operating income is approximately $10.8 million. Essentially, this was the same as Q1 and made up of several basic recurring adjustments. As discussed previously, the GAAP measure includes stock compensation expense of $6.7 million, purchase accounting related adjustments totaling $3.2 million, divestiture-related differences in non-GAAP reporting of discontinued operations of $800,000. Finally, we had $2.6 million of non-cash debt cost amortization recorded in other income associated with the convertible bond issue and the overall associated tax effects of all of these adjustments of about $0.5 million on continuing operations. The Q2 GAAP net income result from continuing operations of $0.9 million or $0.02 per share compares to a loss of $0.5 million or a loss of $0.01 per share in Q2 2015. The Q2 2016 GAAP net income was more positive, coming mainly from better operating income offset by higher interest expense from the convertible debt and tempered by the relative tax benefits. Now, for further clarification and analysis of the operating results, let's turn to some additional non-GAAP measures and comparisons. On a non-GAAP basis then, net income for the second quarter of 2016 was $13.8 million or $0.32 per diluted share, which was up 23% compared to non-GAAP net income of $10.6 million or $0.26 per share in Q2 of 2015. Non-GAAP operating expenses for the second quarter totaled $29.8 million. This was up from $2.5 million in the March quarter due primarily to a $2 million R&D cost offset in Q1 of 2016. This is based on customer co-funding of R&D that did not recur in Q2. Overall, in Q2, we were able to deliver non-GAAP operating margin of 24.4%, which compares to 24.3% in Q1. The improvement is primarily due to a higher volume of revenue in Q2. In Q3, we expect an additional improvement in operating margin, again, based on a higher increment of revenue. In Q3, we are expecting operating margin to be in the range of 26.7% to 27.9%. GAAP other income of $2.75 million, when reduced by the non-cash debt cost amortization of $2.6 million, gives you GAAP net other expense of $0.13 million. Included in this number is a crude cash expense for the convertible debt of approximately $0.65 million, which is offset by interest income of $0.52 million. This resulted in a net carry cost associated with convertible debt of $0.13 million for the quarter. With regard to the Q2 non-GAAP tax provision due to a higher mix of international business, we have been able to project an effective tax rate for 2016 of 10%. In Q1 we used a 12.3% rate for continuing operations. So to adjust the year-to-date rate to 10%, we have posted a rate of 5.7% for Q2. The change in rate produced about a $0.02 benefit in earnings per share roughly $0.007 from the $0.02 is coming from the catch up benefit from Q1. Cash income taxes paid for the six months year-to-date was $183,000, about one-third of what we paid through the same period last year. Now turning to the balance sheet, overall cash at $327.8 million was basically flat with Q1's balance of $328.2 million. We continued to have strong cash flow from operations in Q2 of $11.6 million compared to Q1's $13.1 million; this despite an increase in accounts receivable of $6 million and an interest payment on the convertible debt of $1.3 million. The $11.6 million plus $1.8 million in employee option exercise proceeds was basically consumed by $4.7 million in capital expenditures and $8 million in stock withholding of RSU vesting in order to pay income taxes. This is akin to a stock buyback and resulted in a savings of 242,000 shares that would otherwise have been issued based on RSU vesting. We should also point out that cash flow information above was done on a combined basis and includes discontinued operations data as follows

[Operator:]

Our first question comes from the line of Quinn Bolton of Needham & Company. Your line is now open.

[Quinn Bolton:]

Hey, guys. First, I want to offer my congratulations on the nice results and guidance. Ford, just wanted to come back, obviously, it sounds like a number of drivers but was hoping you could spend some more time on the Metro market, obviously a big opportunity there. Can you just sort of talk to about your position on both the driver side and the TIA side, especially how you're surface mount package drivers are doing in the Metro as it looks to ramp over the next several years?

[Ford G. Tamer:]

Yes. Thanks, Quinn. The first – in our mind, the most important factor here is the difference between 16QAM and QPSK, and not too many people understand this. So I think maybe I'll spend a few minutes on this. 16QAM is basically what's enabling the carriers to deploy what's called Flex Coherent and deploying 200-Gigabit speed, and they can pretty much provision bandwidths on-demand, allowing them to get incremental revenue from their networks. And we've seen a tremendous amount of market share we've taken using this 200-Gig Flex Coherent using the 16QAM. Some other industry participants have announced weakness in Metro, and that's because they're stuck on the older QPSK modulation technique, which is limited to a 100-Gigabit. And so, if you're a customer buying Metro equipment today and making a decision on which Metro equipment you're going to roll out, you will deploy the 200-Gigabit Flex Coherent using 16QAM because that's going to future-proof your investment. So, I think that's probably the largest difference between us and our customers who are taking share compared to others that are talking about weakness in the space.

[Quinn Bolton:]

And maybe just follow up...

[Ford G. Tamer:]

Please, go ahead. No. Please, go ahead.

[Quinn Bolton:]

Well, I was just going to ask just then is the Flex Coherent or the 16QAM sort of enabled more by the driver or the TIA, or do you need the linear drivers and linear TIAs to enable that?

[Ford G. Tamer:]

Yeah. It's enabled by linear 32-Gigabaud driver and TIA. We've got both. So you need both driver and TIA 32-Gigabaud, linear 16QAM. That's what you need.

[Quinn Bolton:]

Great. And then just, obviously...

[Ford G. Tamer:]

I've got a whole bunch of other trends, Quinn, that are helping us grow the business. As I mentioned, the CFP2 ACO, the CFP DCO, the 45-Gigabaud, the surface mount technology packages, I can go on and on. So, I mean, this is not just one product in one segment. This is a multitude of products we've been working on for the past three years, four years in a multitude of segments, multitude of geographies across-the-board.

[Quinn Bolton:]

Great. And then you had made some comments on ColorZ in the prepared comments that you're now sampling to multiple, I think, hyperscale and OEM customers. What would that sort of timing – how long will you have to sample before design decisions might be made? I think on the last call you said you would hope to be in a position by end of 2016 or early 2017 to announce additional customers and wondering if the sample activity that you're seeing now – has that timeline perhaps moved in? Or is that still sort of the right timeframe to be thinking about potential additional ColorZ customers?

[Ford G. Tamer:]

Yeah. Got it. So I think the most important thing for us here is to produce high-quality deliverables to our customers, right? So in my prepared remark, I said we're very focused right now on fulfilling production orders and adding capacity for 2017. We're getting more and more confident that 2017 is going to be a bigger year, and 2018 will be even bigger year. So I think we do have quite a lot of interest for the ColorZ, but right now we're actually very focused just on production orders and then we're not sampling widely. We'll be sampling later on towards the end of Q3, early Q4 to other customers, and we're doing this on purpose to just go on a very measured pace because we are very focused right now on just getting to production and ramping capacity before we take on a whole bunch more customers. I mean, there's no issue with demand. I think the issue for us is really going a step at a time, making sure that we fulfill production orders, deliver quality products and put capacity in place.

[Quinn Bolton:]

Great. Okay. Thank you.

[Operator:]

Thank you. And our next question comes from the line of Tore Svanberg of Stifel. Your line is now open. Mr. Svanberg, your line is now open.

[Ford G. Tamer:]

Tore?

[Operator:]

If your phone is on mute, please take it off mute. And our next question comes from the line of Vivek Arya of Bank of America Merrill Lynch. Your line is now open.

[Unknown Speaker:]

Hi. This is Sankar (30

[Ford G. Tamer:]

Right now, we are in the phase of going towards production and increasing capacity, so we're beyond the technical risk. Right now we're into worrying about improving yields and putting the capacity in place. So we're beyond technical risk at this point, Sankar.

[Unknown Speaker:]

Got it. Got it. And then follow-up on that is given that you've sold the memory business and you have cash coming in, can you talk about – is there any consolidation opportunities in the optical market? Or asking the question another way, what is the best use for the cash moving forward?

[Ford G. Tamer:]

Yeah. So we raised this cash about eight months ago, and as you could see we're very patient. We're going to be very careful on what we do with it, and we're not in a big hurry to do something. We're on a regular basis looking at opportunities, and if one presents itself we're in a position to execute and move.

[Unknown Speaker:]

Got it. Thank you.

[Operator:]

Thank you. And our next question comes from the line of Ross Seymore of Deutsche Bank. Your line is now open.

[Sidney Ho:]

Thanks for taking my question. This is Sidney Ho calling on behalf of Ross, and congrats on the strong quarter and guide. For your third quarter guidance of 12% sequential growth for the midpoint, can you talk about what is driving the relative strength between your various segments

[Ford G. Tamer:]

So, first off, the revenue contribution from ColorZ will be small in Q3 and Q4. ColorZ really is a 2017 story and will even be a bigger story in 2018. For all of these Communications Interconnect, it takes, as I said, a long time to ramp, but once we ramp then it becomes sticky and long-lived. As a percent of revenue, the Optical Interconnect is the majority of our revenue today and the Networking Interconnect is a strong contributor. So I think you should expect the Q3 revenue to be proportional to the base from which we start. Both businesses would be growing strongly in Q3.

[Sidney Ho:]

Okay. Great. My follow-up question is now that you're a pure communications company, how should we think about your range of gross margin going forward? And it looks like you will continue to increase your R&D expense. How should we think about your OpEx as a percentage of sales?

[John S. Edmunds:]

So we believe that gross margins will be in excess of 70% as far as we can see at this point and the core communications products will continue to subsume the legacy, here. So we'll end the year with the transport and legacy being about 18% of the business, and it has been generally on a trajectory of about a 15% decline per year and we would expect that again next year. We're not investing in that particular market. We are in fact deploying the resources from the Cortina acquisition and other more fruitful areas. So that's what's happening with that particular mix of business.

[Sidney Ho:]

And in terms of optics as a percentage for the entire company?

[John S. Edmunds:]

We would continue to have – we believe that the company will continue to scale and that operating margins should be in the range of 26% to 29% as we get into the next quarter and that the company can continue to scale from there. I don't know that we're going to drive much beyond 30% in operating margin because we're also going to continue to invest for growth.

[Sidney Ho:]

Great. Thank you very much.

[John S. Edmunds:]

Sure.

[Operator:]

Thank you and as a reminder ladies and gentlemen, . Our next question comes from the line of Jorge Rivas of Craig-Hallum Capital. Your line is now open.

[Jorge Rivas:]

Hello, guys. This is Jorge calling on behalf of Richard. Congratulations on the great execution. So, first I wanted a clarification of some commentary in the prepared remarks. Ford, did you say that some Service Providers are testing PAM4 for 200 Gig and 400 Gig solutions?

[Ford G. Tamer:]

Yes, Jorge. That's correct.

[Jorge Rivas:]

Okay. Are those on single lambda or still dual lambda?

[Ford G. Tamer:]

Dual lambda.

[Jorge Rivas:]

And then, does that mean they are testing the solution with Inphi?

[Ford G. Tamer:]

Yes, yes. Of course.

[Jorge Rivas:]

Okay.

[Ford G. Tamer:]

So, our PAM4 solutions are being tested with 8 lasers for 400 Gigabit and with 4 lasers for 200 Gigabit.

[Jorge Rivas:]

Okay. Okay, great. And then, I want to get more detail on the CFP DCO in China. I know you are agnostic you can work either with the DCO or ACO, but do you foresee a transition in China where they either go to CFP2 form factor on DCO or will eventually go a solution on ACO. And if that's the case, will that happen this year or will that be a next year event?

[Ford G. Tamer:]

I think both geographies are going to adopt. I think all geographies will adopt both ACO and DCO. DCO is preferred in China for the ease of use, and the ACO seems to be preferred by some U.S. customers because of their control of the line card. So, it depends which perspective you're coming from. But, we're seeing ACO and DCO being adopted in all geographies.

[Jorge Rivas:]

Okay. Great. That's all for me. Thanks a lot.

[Operator:]

Thank you. And our next question comes from the line of Joseph Moore of Morgan Stanley. Your line is now open.

[Vinayak Rao:]

Hi, guys. This is Vinayak calling in for Joe. First of all, congrats on a solid quarter. Can you talk a little bit about, like, what are the trends you're seeing in the general service provider carrier spending environment? Like, are you still seeing good strength in China? And also touch upon Europe, like, any changes in customer behavior over the last one month or so?

[Ford G. Tamer:]

Yes. Thanks, Vinayak. So in China we're still seeing strong demand for 100-Gigabit backbone deployment, basically driven – the biggest leading carrier being China Mobile, as well as the other two following with a number of tenders. And we're still seeing also strength in the rest of geographies. The tenders in China are both wired and wireless. They are being driven by both national strategy called the Belt One Road (sic) [One Belt, One Road] (38

[Vinayak Rao:]

Got it. That's helpful. And digging a little deeper into the Long Haul business, like, there have been some mixed trends, right? Like Infinera had a very weak report on Long Haul then there's stack (39.20) and your core communications is coming in stronger than expectation. Could you dig a little deeper into that part of the market?

[Ford G. Tamer:]

As I said in my first answer to the first question, we do believe that's the difference between 16QAM that our customers are deploying and others that are reporting weakness being based on older QPSK technology.

[Vinayak Rao:]

Got it. Thanks again, guys.

[Operator:]

Thank you. And our next question comes from the line of Brian Alger of ROTH Capital Partners. Your line is now open.

[Brian Alger:]

Hi, guys. Good afternoon, and I'll echo the congrats. Nice job. Wondering if we could explore the China market a little bit. Obviously, a lot of people are reporting strength for the Long-Haul infrastructure. Is there any visibility as yet as to them transferring or transitioning towards a Metro build-out? And if not, when do we think that'll come along? I mean, if they are connecting all these Tier 1 and now Tier 2 and Tier 3 cities, don't they need to start connecting within the cities?

[Ford G. Tamer:]

Yeah. For us, again, it's the same component that is sold in both Long Haul and Metro. So, sometimes we have a harder time, Brian, in distinguishing between which percent is going to Long Haul versus Metro. We're seeing overall strength. We're being told that this is for both Metro and Long Haul. So, it's hard for us to exactly divide it up between the two.

[Brian Alger:]

Okay. Fair. And then you spoke a little bit earlier with regards to ColorZ and being past the technical risk and certainly having the demand. What is the primary barrier to ramping capacity there? Is it foundry capacity or what is it that basically is at this point preventing the more robust growth on that product line?

[Ford G. Tamer:]

Brian, it's just the regular prioritization of – the final stage of the prioritization. So just improving yields, putting capacity in place, making sure we meet X number of hours of rigorous testing on these components.

[Brian Alger:]

Thanks.

[Ford G. Tamer:]

So nothing unusual. Just time at this point.

[Brian Alger:]

Understood. Guys, thanks, again. I appreciate it.

[Operator:]

Thank you. And our next question comes from the line of Tore Svanberg of Stifel. Your line is now open.

[Tore Svanberg:]

Yes. Thank you and congratulations on the results and the divestiture. I guess my first question, I know you typically don't disclose your backlog and bookings but just can you elaborate a little bit on your current visibility in the quarter, perhaps in linearity bookings and how you see the quarter playing out?

[Ford G. Tamer:]

It's typical to what we've seen at this time in the quarter, Tore, so it's not strong but typical of what we've seen at this time in the quarter.

[Tore Svanberg:]

Sounds good. And perhaps a bit more of, I guess, I can call it a philosophical question but your gross margin is solidly in the 70s now. And as you know investors when they see 70s they get scared about the ability to grow at those types of margins. Just philosophically, how are you thinking about this? I mean obviously you have a lot of irons in the fire right now for the next two years, but just philosophically longer term, should we think of that 70% being sustainable?

[John S. Edmunds:]

Well, I think, Tore, it's always nice to have 70% gross margins. It's really indicative of the value of the product in a customer's eyes. That being said, I think we're not wedded to being a 70% gross margin company, we're actually much more focused as a company on investing for growth. And so the extent we see growth opportunities, we're willing to make those trade-offs to at least a certain degree. And our focus is on continuing to make superior products that will continue to drive that sort of gross margin.

[Tore Svanberg:]

Very good. Just one last question from me on inventory days. How do things change, John, as far as the inventory management now with the memory interface business out of the mix? Do you have to hold a little bit more or less or maybe you could just add some color there, please.

[John S. Edmunds:]

Well, I think you can see that our inventory has been turning over even more rapidly once we strip away the memory business. And so the numbers I quoted on the conference call, 87 days at the end of December and coming down to 66 days at the end of June, are based solely on the continuing operations of the company. So if you look at the balance sheet you'll see that all the assets held for sale have been grouped on one line item, and the liabilities held for sale are grouped on another line item. So the financial statements have been in a sense cordoned off to separate continuing operations from discontinued. So we have high demand for the communication product, and that's reflected both in our growth and in the inventory management taking place underneath.

[Tore Svanberg:]

And therefore also the better cash flows. Well, great job, guys. Congratulations. Thank you very much.

[John S. Edmunds:]

Thanks, Tore.

[Operator:]

Thank you. And our next question comes from the line of Dave Kang of B. Riley. Your line is now open.

[Dave Kang:]

Thank you. Good afternoon. First question is just a clarification. John, I think you gave out the OpEx number for third quarter. Can you repeat those number, the range?

[John S. Edmunds:]

Yeah, Dave. The OpEx range is $30.1 million to $30.9 million.

[Dave Kang:]

Got it. And then just wanted to also clarify once again. Did you say the core comp will be 50% growth this year, up from 40% to 50%?

[John S. Edmunds:]

No. We said it would be 60%.

[Dave Kang:]

60%?

[John S. Edmunds:]

60%.

[Dave Kang:]

Oh. That's what I thought. Okay.

[John S. Edmunds:]

Right.

[Dave Kang:]

Got it. And then just on capacity and supply constraints, some of the optical module guys, they've been saying about how their business was impacted by supply constraints. Were you guys impacted by that situation as well? And if so, how much?

[John S. Edmunds:]

We were not impacted by supply constraints.

[Dave Kang:]

Got it. And then my last question is on the PAM4. Can you just talk about the PAM4 ecosystem build-out? Is it still sort of niche, or is it becoming more mainstream?

[Ford G. Tamer:]

These things always take a long time. The one thing I would say is, it took about seven years to go from 10-Gigabit to 25-Gigabit on the optics. So the lasers, the optics are finally coming together at 25-Gigabit and the PAM ecosystem is coming together, the standards have been ratified. So we're seeing acceleration and interest in design wins, and that should result in acceleration of revenue, but these things take a long time. And we do believe we made the right decision to focus on this 25-Gigabaud TAM because if you think it took seven years to go from 10-Gigabit to 25-Gigabit, it will take another, in our estimate, at least a couple years to go back to now the 56-Gigabaud, which is the next generation. So we're seeing the ecosystem for 28-Gigabaud really come together and should help the revenue become more solid.

[Dave Kang:]

Got it. Thank you.

[Operator:]

Thank you. And I'm showing no further questions at this time. I would like to turn the call over to Mr. John Edmunds for closing remarks.

[John S. Edmunds:]

Thank you, Chanel. Inphi plans on attending the Oppenheimer Conference in Boston tomorrow on August 9, the Jefferies conference in Chicago on August 30, the ROTH conference in San Francisco on September 7 and the Deutsche Bank conference in Las Vegas on September 13 and 14. Ford and I and Deborah would like to thank you for joining us today, and we look forward to speaking again with you in the future.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.