Marvell Technology, Inc.
Q2 2008 Earnings Call Transcript

Published: 5 Aug 2008

[Operator:]

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Cavium Networks Q2 2008 Earnings Conference Call. All lines have been placed on mute to avoid any background noise. After the presentation there will be question-and-answer period. Please limit your question to one and refrain from multi-part questions in order to give management time to answer as many questions as time permits. If time permits additional questions will be taken. With that, I will turn the call over to Angel Atondo, Marketing Communications Manager. Please go ahead.

[Angel Atondo:]

Thank you. Good afternoon, everyone, and welcome to Cavium Networks second quarter 2008 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 revenue, gross margin, 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 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 margins and net income and basic diluted net income per share in accordance with GAAP and additionally on a non-GAAP basis. Management believes the 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 reconsolidation 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. I would now like to turn the call over to Syed Ali. Syed?

[Syed Ali:]

Thanks, Angel, and thanks to everyone for joining us today. Today we are extremely pleased to report a record quarter with record sequential growth and further accelerated year-over-year growth. In brief, Cavium's first quarter revenue was a record $21.6 million, which represents an 18% sequential and 70% year-over-year growth. Non-GAAP gross margins came in slightly above our guidance at 64.2%. Non-GAAP operating margins increased from 12.6% in Q1 to 16.8% in Q2. These higher operating margins, along with the higher revenue, increased non-GAAP operating income 56% sequentially. Non-GAAP net income was $3.8 million, or $0.09 per share, and our GAAP net income was $2.1 million, or $0.05 a share. Art will provide more details on the Q2 financial results and Q3 guidance shortly. I will begin by giving some more color on Q2 revenues, along with a general update on the demand environment, after which I will discuss design wins, product news, and relationships. Following this, I will talk about the Star Semiconductor acquisition, which we announced just this evening. In Q2 we had a strong growth across the board in all segments of the market we serve. This quarter we saw an accelerated diversification in our revenue mix. The enterprise and data center segment was the largest segment at 65% of sales and grew 7% quarter-over-quarter. The remaining segments, including access service provider, broadband consumer, and software and service segment combined to achieve 35% of sales for the quarter and grew 40% sequentially. By contrast, in Q4 the enterprise – I'm sorry in Q1 the enterprise data center segment grew 5% sequentially, while the non-enterprise data center segment grew at about 34%. So we had increased growth in both segments of the market. Our growth this quarter was driven by lead customers in all three market segments that we serve. Sales to Cisco Systems continue to be very strong as newly introduced products started to ramp in the enterprise and access and service provider market segments. Sumitomo Electric Networks, Cavium's customer in the broadband fiber-to-the-home segment, to whom we started shipping volume production to in Q1, also had an extremely strong quarter in Q2. We also saw growth from F5 Networks and Blue Coat Systems in the data center segment as new platforms went to production. Now I would like to move on and give you some more color on the overall demand environment in our target end markets. In past conference calls, we have been talking about the 10X growth in line rates at every node in the network. We have talked about a range of new Web 2.0 applications in the enterprise and at the consumer that are driving the need for intelligent processing at the Layer 4 to Layer 7 level, the exponential growth of video traffic and mobile data traffic. We have also talked about the need for Layer 3 to Layer 7 security across the network. These long-term growth trends have recently been published by Cisco as part of the Visual Networking Index initiative which forecasts and explores the implications of the growth of IP, video, mobile data and enterprise data traffic from 2007 to 2012. I will summarize some of the interesting findings from this study which forecasts phenomenal growth in all areas. According to the study, global IP traffic will approximately double every two years. Video is a huge growth driver contributing to traffic growth with video to the PC through peer-to-peer and Internet video like YouTube driving the growth today. The next big growth drivers will be Internet to TV, which will be followed by a surge in interactive video communications as price points for teleconferencing and telepresence type applications come down. These trends are being compounded by the move to high-definition. Today, Internet to PC video is already about 22% of all traffic. By 2012 all the three forms of video traffic that I talked about are expected to constitute approximately 90% of global IP traffic. Also, mobile data traffic is expected to double every year, which would lead to mobile data traffic becoming 20 times of what it is today by 2012. This tremendous growth rate is being enabled by email-enabled cell phones, broadband-enabled laptops, and the growing use of mobile broadband instead of fixed broadband. These trends are driving the need for higher performance packet processing, intelligent Layer 4 to Layer 7 processing and network security across all nodes of the network. We are seeing that these trends manifest themselves through our extremely robust design win activity for us in all segments of the market, including enterprise, data center, access and service provider, 3G, 4G, WiMAX, wireless infrastructure and fiber-to-the-home broadband. The wide range of processes that we offer fits in many of the sweet spots where demand is approaching inflection points, which should result in extremely strong growth rates for us in the coming quarters and in the coming years. I would now like to provide an update on actual design wins for the quarter. Design wins rates were very strong this quarter, continuing the high design win rates we saw in Q1 2008. We are now halfway through 2008, and we are well ahead of the internal design win goals we set at the beginning of the year, both in terms of the number of design wins and in terms of the expected annual revenues we expect to generate when these designs ramp to production. Design wins were broad-based across all major segments with somewhat higher numbers in the service provider and broadband segments of the market. We closed multiple new design wins at a number of Tier 1 customers, including Alcatel-Lucent, ARIS, Brocade, Sienna, Cisco and Citrix. During the quarter we saw increased engagements and wins in the storage segment with fiber channel, iSCSI gateways, and secure, intelligent I/O adapters, as well as the use of Cavium's OCTEON processor for control plane applications. In the enterprise and data center segment, we won major new designs in enterprise routers, security appliances, financial transaction messaging routers, data-at-rest security applications, and fiber channel to IP gateways. In the access and service provider market segment, we won significant new designs in LTE and WiMAX base stations, wireless convergence equipment, session border controllers and ATCA and AMC systems. In the broadband and CPE gateway market, we won new designs for satellite broadband routers and for next generation fiber-to-the-home, SOHO and SME routers, wireless mesh equipment and 802.11n access points. Additionally, we saw several of our high revenue design wins hit significant intermediate milestones on their way to production this quarter. These designs are on track to deliver revenues when they reach first customer shipments and ramp during 2009 and 2010. Our pipeline of potential new design wins across our target market segments remains extremely strong at approximately 2X of our quarterly design win rates, which indicates that we will continue to see these accelerated design win rates in the coming quarters. During the second quarter, we introduced our new OCTEON Plus Based PCI-Express Accelerator Cards for networking, storage, and security applications. The cards integrate the OCTEON Plus CN55XX six core through the CN57XX 12 core multi-core MIPS64 processors with integrated hardware acceleration for packet processing, quality of service, TCP, compression/decompression, encryption/decryption, iSCSI, RAID, data duplication and I/O virtualization. This new family of accelerators extends the reach of Cavium Networks' high-performance acceleration capabilities to a wide range of new and emerging PCI-Express based systems designed for storage appliances, Layer 4 to Layer 7 switches, and wireless infrastructure equipment. Now I would like to talk about some of the significant announcements that we had during our second quarter. In Q2 our customers and partners continued to release products to market based on Cavium processors. Our customers continue to win awards and set industry-leading benchmarks for performance, features, and low power consumption. For example, Palo Alto Networks PA-4000 Series next generation firewall that is based on Cavium 16 core OCTEON processor won the highly coveted Interop 2008 Grand Prize Award, as well as Best of the Show Award in the security category at the recently concluded Interop 2008 in Las Vegas. In benchmarks run by Network World Magazine, Cavium's customers, SonicWALL's Gen5 E7500 appliance broke speed records, delivering three times the UTM performance as compared to their competitors. This appliance is also based on Cavium's 16 core OCTEON processor. Emerson Network Power, the global leader in enabling business critical continuity, expanded its ATCA blade portfolio with the ATCA-9305, which is Emerson's second ATCA high-performance blade based on Cavium's OCTEON multicore processors. Equipped with dual Cavium OCTEON Plus 16 core processors, the ATCA-9305 enables network equipment to handle both data planes and control plane applications in the same hardware, improving the price/performance ratio and helping to focus on delivering new and differentiated services faster and more cost effectively for applications such as 4G LTE wireless, WiMAX, and IPTV. Kontron, a leading global provider of standards-based and custom embedded and communications solutions, debuted its family of OCTEON processor-based Advanced MC/AMC cards for Layer 4 to Layer 7 data and security processing, targeting network equipment providers who design 3G, 4G, GPS, RNC, GSM and media gateways. General Electric Fanuc and Interface Corporation introduced AMC and PCI-X packet accelerator cards to address the emerging needs of security, depacket inspection, packet routing, and policy-based forwarding and pattern matching functions required in next generation networks for use in ATCA, MicroTCA and rack-mount server platforms. Cavium Networks' partner, Effnet, announced the availability of its industry-leading robust header compression software on OCTEON for use in wireless infrastructure equipment. And Sumitomo Electric Networks selected OCTEON to power triple-play home gateways for the next generation fiber-to-the-home service. Now I would like to discuss our acquisition of Star Semiconductor, the rationale behind it, and the plans we have for it moving forward. Star Semiconductor is a private Taiwan-based design house based in Hsinchu, Taiwan. Their core competency and expertise is in building highly integrated, low power, and very cost-effective ARM-based System-on-Chip processors for the broadband market. They have a team of approximately 50 people with SOC design expertise in processor, software, and reference boards. In the broadband market segment, over the past few quarters, we have identified several opportunities for adding more value through integration and power and cost reduction. Now by adding the Star design team, we can now build even more integrated and highly optimized products for the broadband segment. Additionally, we also identified several related markets and product areas in the broadband and network connected device segments, which we could address with the additional design resources. Before we made the decision to acquire Star, we looked at several design teams worldwide and decided that the Star team was the best choice for us. They are an excellent team that has had very low turnover over the years. They have a lot of experience in designing highly integrated low power and low cost System-on-Chip processors for the broadband and network connected devices market. In addition, they are located in a low-cost location, and they are physically close to many of the new emerging applications and customer ODM base in Taiwan and Asia. We believe that this is truly a win-win situation for us. Our existing design resources can focus on the higher performance segments of the market, and the Star design team can focus on developing more customized, lower power, and lower-cost solutions, not only for the broadband segments we currently address, but also to expand our penetration into a broader range of value-added applications in the broadband and network connected device end markets for the digitally connected home and office. Today, Star has two existing product families of products targeting these markets. However, their current revenue is extremely modest. Star's products consist of an ARM CPU core, packet processing and NAT hardware acceleration, 10/100 and Gigabit Ethernet, USB, PCI and many multimedia I/Os. Their products are primarily marketed and sold in Taiwan to Taiwan-based ODMs such as Gemtek and SerComm and OEMs such as Belkin. Star uses the same fab and assembly houses that Cavium uses. We will continue selling these products through our sales channels, but the primary focus will be on developing next generation new more highly integrated, lower cost, and lower power products combining Cavium and Star IP. We are excited about the Star acquisition and its potential impact over the next few years, and we welcome the Star team to the Cavium family. Last quarter we also strengthened our management team with the addition of Sandeep Vij as Vice President, Strategic Markets and Business Development. Sandeep brings to Cavium over 20 years of senior level general management and marketing experience in the semiconductor business. He will be responsible for accelerating Cavium's growth in key strategic market segments through a variety of corporate initiatives. Prior to joining Cavium, Sandeep held the position of Vice President of Worldwide Marketing, Services and Support for Xilinx across all divisions, products, end markets, channels, and geographies. We are extremely excited to have him on board and believe his experience and impressive track record will further accelerate our ability to increase market share and expand our business in existing and new markets. In summary, Q2 was another stellar quarter for Cavium on all metrics. We are continuing to execute well as a Company and delivering stellar growth, despite the overall environment. We are strengthening our front-end customer acquisition and support capabilities, while making prudent investments in both organic and acquired R&D resources to support expanding our footprint in the market. We continue to attract and hire top-class talent in all areas. All-in-all we are extremely excited about our position today and believe that we are making the right moves to continue delivering robust growth over time. On that note I would now like to turn the call over to Art Chadwick who will provide a detailed discussion of Q2 financial results and guidance for Q3, and after that we’ll be happy to take your questions. Art?

[Art Chadwick:]

Great. Thanks, Syed, and thanks to all of you for joining us today. As Syed mentioned, I will first go through second quarter financial highlights and then provide some guidance for the third quarter. As Syed just described, Q2 was another great quarter for us. Second quarter revenue of $21.6 million continued our history of strong sequential and year-over-year revenue growth. Sales were again 18% sequentially and up 70% year-over-year. Cisco Systems remained our largest customer and accounted for 33% of total sales, up from 30% in Q1. During the quarter we had one additional customer that exceeded 10% of sales, which was Sumitomo. Sales to Sumitomo were 15% of sales for the quarter. Sales to our top five customers comprised 65% of total sales as compared to 54% in Q1. Within our top 10 customers this quarter, sales increased sequentially to Cisco Systems, Sumitomo, F5 Networks, Juniper Networks, Alcatel-Lucent, Huawei-3Com, and Blue Coat Systems. In terms of geography, our strongest growth was in international. International sales went from 42% of sales in Q1 to 52% of sales in Q2. In our press release, we announced both GAAP and non-GAAP results. Our non-GAAP results this quarter exclude $1,742,000 in stock-based compensation and related payroll taxes and $32,000 in amortized acquired technology. Non-GAAP gross margins were 64.2%, which was about 50 basis points lower than in Q1 but on the high side of our guidance. Operating expenses, excluding stock-based compensation, were $10.2 million, a 7% sequential increase over Q1 due to an increase in both R&D and SG&A spending. Non-GAAP R&D expenses increased from $5.4 million in Q1 to $5.6 million in Q2. SG&A expenses increased from $4.1 million in Q1 to $4.6 million in Q2, due primarily to our participation in five important industry trade shows this quarter. Total Company headcount increased by 17 people this quarter, and we ended the quarter with 230 employees worldwide. We believe that non-GAAP operating margins are an important financial metric of our business. We continue to expand operating margins on a sequential basis every quarter since our IPO. Non-GAAP operating margins increased from 12.6% in Q1 to 16.8% in Q2. This addition of more than 4 points of operating margin was a result of our increasing sequential sales at a rate that was more than twice the rate at which we increased our operating expenses. Non-GAAP operating income increased even more significantly. Non-GAAP operating income in Q2 was $3.6 million, which was 56% higher than in Q1, again, showing the strength of our business and leverage in our business model. Net interest and other income for the quarter was $474,000. All of our funds are invested in high-grade money market accounts, which provide good liquidity, but it also means that our interest income has declined significantly as rates have fallen. Net interest and other income has gone from $1.2 million in Q4 of last year to less than $0.5 million this quarter, a decrease of more than $700,000, which by the way is nearly $0.02 per share. Non-GAAP net income was $3.8 million, or $0.09 per share. This was a 32% sequential increase over Q1, and again this growth was achieved even though interest income decreased quarter to quarter. On a GAAP basis, GAAP net income was $2.1 million in Q2, or $0.05 per share. We ended the quarter with a very strong balance sheet. Cash and cash equivalents were $99.3 million, an increase of $3.7 million during the quarter. We had an excellent collections quarter. Accounts receivable were $10.9 million, which was $2.9 million less than at the end of Q1, even though sales were substantially higher. DSOs for the quarter were unusually low at 45 days. Now in Q3 we do expect DSOs to increase and trend towards our longer-term target of 60 days. Inventory at the end of the quarter was $12.9 million. This is a 20% sequential increase from Q1, entirely consistent with our 18% sequential sales growth. I would now like to provide some guidance on how we see the third quarter. In Q3 we expect continued strong, sequential, and year-over-year sales growth. We also expect continued operating margin expansion and growth in earnings per share. For Q3 sales guidance we expect sales to increase sequentially to between $24.0 million and $24.4 million, due to increasing customer demand across multiple customers and markets, as well as some nominal sales from the Star acquisition. At the midpoint this guidance provides for an approximate 12% sequential growth over Q2, which by the way is the same sequential growth rate guidance we gave one quarter ago going from Q1 to Q2. We believe non-GAAP gross margins in Q3 will be approximately 63%, down about one point from Q2. Operating expenses in Q3 will increase due to the addition of some Star expenses, but other expenses such as tradeshow expenses are expected to decline. We, therefore, expect total third quarter expenses, excluding stock-based comp, to increase about 4% to 5% sequentially. Non-GAAP operating margins are expected to continue to expand and should increase by another few points in Q3. Net interest income is expected to remain relatively flat at approximately $0.5 million in each Q3 and Q4. Stock-based compensation expense is expected to be approximately $1.8 million in Q3, and about $2.0 million in Q4. Amortized acquired technology is expected to increase to approximately $400,000 in Q3, and $600,000 by Q4, due primarily to the Star acquisition. Income taxes in Q3 are expected to be approximately $300,000, and beginning in 2009 we expect our long-term tax rate to be approximately 20% as a result of our international structure. Our fully diluted share count used for non-GAAP EPS should remain relatively flat in Q3 and Q4 at approximately 44 million shares. In regards to our acquisition of Star Semiconductor, we truly look forward to their joining the Cavium family. This acquisition should nicely expand our design capabilities and do so in a cost-efficient location. We expect this will be a good, long-term combination for the Company. But in the short-term, as we integrate the team, it will likely be $0.01 to $0.02 dilutive on a non-GAAP basis during the second half of 2008. Given the uncertainty of the exact timing of the close of the Star acquisition, there is a bit more volatility in our EPS guidance than usual. We expect Q3 non-GAAP EPS will be approximately $0.11 a share, though it could be as high as $0.12. So in summary, we continue to experience very strong sequential and year-over-year sales growth across a broad base of customers and markets. And due to the leverage in our business model, we are expecting solid sequential increases in operating margins, operating income, and EPS. In addition, we have a very solid and liquid balance sheet that provides a strong competitive advantage and security in today's environment. And with that, I think we are ready for Q&A.

[Operator:]

(Operator instructions) And our first question comes from the line of Tim Luke with Lehman Brothers. Please go ahead.

[Tim Luke:]

Thanks so much. Guys, congratulations on the new deal and the revenue for the quarter. With respect to the EPS guidance that you just outlined, could you just remind us what the assumptions are with respect to the closure of the acquisition? Does that assume that the deal is closed in the quarter, and what are the key variables I guess in saying that you think it’s going to be $0.11 but could be $0.12? And just in terms of the contribution from Star for the September quarter revenue, what should we be thinking about? And maybe some help on what it may be adding to the OpEx. And otherwise in guiding the OpEx to the $10.7 million level or thereabouts, is the upside primarily R&D, or is it SG&A as well? Thanks

[Art Chadwick:]

Well, thanks, Tim. That is a lot of questions. Starting with the EPS guidance, if you take the guidance that we gave for sales, gross margins, and OpEx, it would be somewhere between $0.11 and $0.12, as I mentioned. However, the earlier we close the Star acquisition, the more it will be dilutive in Q3. As I mentioned, the Star acquisition, though we think it’s really a fantastic addition to the Cavium team, it will be $0.01 to $0.02 dilutive in the second half of 2008. So if we close it earlier in the quarter, it will be more dilutive, and the EPS will trend towards the lower end of our range.

[Tim Luke:]

And what’s the midpoint of your expectation there this coming month of July or August or–?

[Art Chadwick:]

We didn’t get that precise. We expect to close it this quarter. Again, we’d rather close it earlier rather than later, but to the extent that we close it earlier, our EPS will be at the lower end of our range versus the higher end of the range. In terms of OpEx, the run rate there that we are going to assume is somewhere between $600,000 and $700,000 a quarter. So, again, the impact on Q3 has a lot to do with when that clock starts. But longer-term, starting in Q4 at least, it will be between $600,000 and $700,000 a quarter. In terms of the revenue that comes from Star, they are at very early stages of revenue, and it’s little literally just a few hundred thousand dollars a quarter. So, very little pickup in revenue. The real benefit of doing this acquisition, as Syed mentioned, is the product plans that we want to implement, and the new products that we want to get out sometime in 2009 that we think really can have a significant impact on our top and, of course, bottom line.

[Tim Luke:]

In terms of just incremental revenue lift that you are guiding in the third quarter; could you give us a feel for what elements are principally driving that? And maybe beyond Sumitomo, any commentary on other broadband plays, and as part of the gross margin guidance, is that revenue growth in broadband the principal variable in the slightly lower gross margin?

[Art Chadwick:]

Yes, so in regards to the gross margin, yes. As we have said for a long time, as the percentage of our sales that go into the broadband market increases, that will change the mix, and generally our margins will go down a little bit. So the decrease from Q2 to Q3 is primarily due to broadband business.

[Syed Ali:]

Tim, regarding which customers we continue to see growth in Q3, I think we will see growth across a broad range of customers. And in the broadband segment, Sumitomo obviously is in production now. But we also have started to see some of the SOHO, SMB products from companies like Linksys and NETGEAR and also some of the smaller appliances starting to go to market, which will start driving that revenue. We also have seen some early revenues from a smaller fiber-to-the-home deployment in Europe start in Q3 also.

[Art Chadwick:]

And the other comment I would like to make about gross margins just to always remind the market, and that is even if our gross margins go from the 64.2% in Q2 down to 63% in Q3, on the higher expected sale and given our expectation on increase in OpEx, we are still expanding our operating margins. We have expanded operating margins every single quarter. And our expectation is that we will continue to do so, even if our gross margins come down the point or so that we are providing guidance for in Q3.

[Tim Luke:]

Excellent. Thank you.

[Syed Ali:]

Thanks, Tim.

[Operator:]

Thank you. The next question comes from the line of Quinn Bolton with Needham and Company. Please go ahead.

[Quinn Bolton:]

Hi guys, I apologize for the background noise, but I wanted to ask the Star products, and when you say devices for the home, connected devices for the home, are these things probably portable media players, or are they more service provider based devices like home gateways, residential gateways, things like that?

[Syed Ali:]

Yes, Quinn, this is Syed. Yes, these have a wide range of devices, everything from kind of a media server like a NAS media server, video surveillance, home gateway, those type of applications.

[Quinn Bolton:]

Would they be sold more through traditional consumer electronic retail outlets, or would they be sold more through IT distribution or service provider outlets?

[Syed Ali:]

I think there will be a mixture of both.

[Quinn Bolton:]

Okay. And then just it ticks into that business ramps, would it still fit within your long-term gross margin model of 60% to 62%?

[Art Chadwick:]

Yes, essentially it does. But, we expect the gross margins in this business to be very consistent with the margins that we currently get in our broadband business. We're not viewing any change to that mix.

[Quinn Bolton:]

Okay, great. And then just a question on the mix in third quarter. It sounds like the broadband and consumer was very strong in the second quarter. Do you expect that mix to continue to shift over to broadband and consumer in Q3?

[Syed Ali:]

If you take a look at it, Quinn, the – both the broadband and consumer segment – obviously the broadband and consumer segment had the biggest growth. But we also had some good growth on the access and service provider side and in the enterprise side, too. So that kind of tended to mix it out and keep the gross margins at a little bit higher level than we were forecasting. In Q3 it should be we think very similar to maybe the broadband segment becoming a little bit larger in terms of the total percentage.

[Quinn Bolton:]

Okay. But broadband becoming larger is sort of what’s pushing the margin down towards the 63% guided range?

[Syed Ali:]

That’s right.

[Art Chadwick:]

Yes, it is the broadband business that essentially is driving our guidance.

[Quinn Bolton:]

Okay, great. And then just one clarification. Syed, in your prepared comments I think you mentioned something about design opportunities being about 2X the level of design wins. I just wanted to clarify if I heard you correctly on that design opportunity figure?

[Syed Ali:]

That’s correct. So, for example, if we are doing say X design wins a quarter, we are right now in various stages of evaluation such that the overall pipeline is over 2X that.

[Quinn Bolton:]

And that is on a dollar basis again?

[Art Chadwick:]

Yes, that is on a dollar basis. Yes.

[Quinn Bolton:]

Great. Okay. Thank you.

[Operator:]

Thank you. Next question comes from the line of Krishna Shankar with JMP Securities. Please go ahead. Krishna Shankar – JMP Securities Yes, congratulations on a very good quarter. Cisco continues to be a very strong customer for you, 33% of revenues. Can you talk about the ramp within various divisions of Cisco, and how that will trend through the second half of '08?

[Syed Ali:]

Krishna, this is Syed. Yes, Cisco continues to be a very, very strong customer for Cavium, and it’s – the revenue that we are getting from Cisco is now coming from four or five different divisions. So it’s very highly diversified. And the growth, like I said before, has been coming from new products going to production. So I think as we go through the second half of '08 we will start seeing even a wider diversification of revenues from Cisco for Cavium.

[Krishna Shankar:]

And within the enterprise area, can you comment on some of the new product ramps that customers like F5, Juniper, SonicWALL and some of the security-related products?

[Syed Ali:]

Yes, if you look at some of the newer products, F5 has released a whole range of new products that use our processors. Blue Coat Systems has released products based upon Cavium processors recently. And SonicWALL has released an entire line of Unified Threat Management appliances that use our single core all the way up to 16 cores into the market.

[Krishna Shankar:]

And my final question, Syed, as you look at sort of the macro outlook, can you comment on what you see in terms of enterprise and service provider both in the U.S. and internationally? Are you seeing any – I know Cisco had some – somewhat cautious comments a couple of weeks back. Can you talk about what you see in the macro environment?

[Syed Ali:]

I think overall in the macro environment in the end markets that we are serving, since we have new design wins going to production, we tend to see good growth in them anyway despite the macro environment. Obviously, if you take a look at it, there are two pieces of our revenue. One is kind of the run-rate business and one is new products going to production. We do have some upheaval now and then in kind of the run-rate products going to production, but this kind of gets completely covered by the overwhelming growth that is being driven by new products going to production. So, overall, I mean we don’t see any changes in the macro environment between the first half and the second half for us.

[Krishna Shankar:]

A final question for Art. If Star Semi succeeds in a very strong manner, would that still lead to your long-term gross margins being 60% to 62%?

[Art Chadwick:]

We think that that’s still a reasonable assumption and the reason is this. One of the big advantages for Cavium for bringing that team on board is that they can focus on these broadband products. And what that will do is that will alleviate some of the development pressure on our current design teams so that they can focus more on new and additional products that are higher performing.

[Syed Ali:]

And higher margin.

[Art Chadwick:]

And higher margin. So to the extent that they can crank out more products that are higher performance and higher margins, that’s going to offset additional sales in the broadband space. So again it’s a win-win for Cavium. So we think the long-term model actually doesn’t change.

[Syed Ali:]

Also, another comment, Krishna. If you take a look at Cavium's lower end products today, we use a lot of the elements of our higher end technology in those designs. And as such, really from an overall viewpoint for the market that we are addressing today, they are not as optimized in terms of cost and power as they could be. Now with these new design resources, we can just have a completely parallel effort to do more integration, do more value-added, to actually improve the cost and performance for that market. So in some cases maybe it’s going to get even better.

[Krishna Shankar:]

Great. Thank you.

[Art Chadwick:]

Thanks, Krishna.

[Operator:]

And your next question comes from the line of Allan Mishan with Oppenheimer. Please go ahead.

[Allan Mishan:]

Hey guys, I've got a couple of questions. First, are the Star Semi teams going to work on ARM-based designs, or are you going to transition them over to MIPS?

[Syed Ali:]

What we believe, Allan, is that if we take a look at the overall market, MIPS has a very, very strong presence in the networking market, and ARM has a very strong presence in kind of the digitally connected home, digitally connected office, in those type of applications. So depending upon the product and end market, we will decide whether it’s a MIPS processor or an ARM processor. And we will choose the right instruction set for the right market because we really don't believe if you try to force the wrong instruction set into a particular market that you will have much success. So we will be doing both MIPS and ARM processors as we move ahead.

[Allan Mishan:]

Okay, great. And then was OCTEON figured in NITROX in Q2, or do we have to wait for Q3 for that?

[Syed Ali:]

Yes, Allan, it did cross over in Q2.

[Allan Mishan:]

Okay, great. And then over on the access and service provider and broadband side, which one was larger? Was access and service provider still larger than broadband in Q2?

[Syed Ali:]

They were almost similar with the broadband being a little bit bigger, but kind of almost similar.

[Allan Mishan:]

Okay, great. Then last question, as you ramp up with Sumitomo, how much of NTT's deployment do you think you could be sort of on a percentage of quarterly adds? What kind of target have you got for your market share in that particular deployment?

[Syed Ali:]

It’s difficult to say, Allan, a specific market share on a per-quarter basis. But Sumitomo is one of the important suppliers to NTT, and they will get a fair share in terms of market share. So we expect it to be in certain cases 50%, in some of the other boxes maybe 40%, so somewhere in that ballpark is probably where we will be at.

[Allan Mishan:]

Okay, thanks very much.

[Art Chadwick:]

Thanks, Allan.

[Operator:]

And your next question comes from Gary Mobley of Piper Jaffray. Please go ahead.

[Gary Mobley:]

Hi guys, congratulations on the operating margin expansion. But I did just want to nitpick for a minute. I think if I am not mistaken, the operating expenses for the quarter were a little bit above expectations. Was this purely a function of the greater tradeshow presence that you articulated?

[Art Chadwick:]

Well, that’s part of it, but again the way we try to manage our business is, we look at what our top line growth is going to be, and that kind of sets our expense budget. So, as you will notice, our top line did nicely better than our guidance. And as we walked through the quarter and realized that was happening, we loosened the purse strings a little bit on operating expenses. We spent a little more on the tradeshows. We ended up hiring 17 people instead of a few less. So we manage that as we go along. Since sales were higher, we let expenses run up just a few points higher. Again, the operating margins expanded more than four points, and that’s what we were managing to.

[Gary Mobley:]

Sure. And I did want to ask a follow-up question to a previous one. I am just curious how much caution you put into your guidance when coming out with it. Have you now assumed a lower turns rate for the quarter in light of what may be some softer enterprise capital spending for your run-rate business? Any elaboration there would be great.

[Syed Ali:]

I think the guidance that we are giving is with the best visibility we have. We are, whatever, two weeks into the quarter. So we should have a pretty good idea. And it’s kind of as conservative or as aggressive as we have been in the past I guess.

[Gary Mobley:]

Okay. Thanks.

[Art Chadwick:]

Thanks. Gary.

[Operator:]

And your next question comes from the line of Sandy Harrison with Signal Hill. Please go ahead.

[Sandy Harrison:]

Yes, thanks for taking my call this afternoon, gentlemen. You talked about Sumitomo and some of the wins there. Is that something that you think is portable to other applications and other markets, or was this a particular flavor of fiber-to-the-premise that you guys were optimized for, or are you sort of agnostic to that?

[Syed Ali:]

If you take a look at fiber-to-the-home, our dual core processors have a very, very good fit, and we have got good opportunities in Asia, in Europe and in the U.S. with the same product. So this is not something which is only very specialized towards Japan.

[Sandy Harrison:]

And what’s the application that you are providing within the box itself? Is this sort of the general-purpose processor? Is it providing specific functions? If you can add any flavor to that.

[Syed Ali:]

Yes, essentially we do all the functions for the gateway which sits inside the home. So when you buy fiber-to-the-home service, you will get this box which is installed in your home, and it does all the routing, the packet processing, security, and services that the service provider offers. So this is – our product is the main CPU. There is a switch Fi [ph] memory, magnetics and the box. It’s a tiny little box, actually.

[Sandy Harrison:]

Got you. And if you would characterize Sumitomo's current business, a majority of it would be coming from one or two customers, or is their reach with this box relatively diverse at this point?

[Syed Ali:]

Yes, I think currently obviously they are shipping to a service provider in Japan, but they do go ahead and sell to other service providers both in Japan and worldwide.

[Sandy Harrison:]

Got you. And then finally just sort of looking at your expenses and Art saying as far as the percentage of revenues, if revenues increased a little more, he can let the expenses run a little bit. And if you look at Star's run rate, are they expected to get any synergies from the two? And, in fact, is this sort of the highest expenses could be and you could get some leverage out of that? Or just what’s sort of your opinion on how you can integrate the two and what you get from it?

[Art Chadwick:]

Sure. Well, in terms of synergies, there is kind of two pieces. One is the product cost piece, and the other is operating expenses. On operating expenses there is very little synergy. I mean this is a design team, and the design team is going to remain relatively intact. We will handle a lot of the administration and the order entry and the whole – that aspect of the business through our current system. So there's very little overlap. So there's not a lot of synergy in terms of operating expenses. In terms of product costs, again they use the same vendors that we do for fab and assembly. And we think that there are some things that we can do to improve the costs on their current products based on some of those synergies.

[Sandy Harrison:]

Economies of scale, if you will?

[Art Chadwick:]

Yes, economies of scale. Exactly.

[Sandy Harrison:]

Got you. Okay. And then lastly, as you talk and there has been a number of questions on gross margins, I get the sense that there is really no change to what your expectations are here. And, in fact, Syed, one might think that if, in fact, you get some upside potential to some of the products depending upon which they are in those divisions outside of enterprise data center, there actually could be some potential upside if you look out into '09. Is that a fair characterization?

[Syed Ali:]

Yes, I think so. We are kind of unusual for a company our size in kind of the range of products we offer and the range of end markets we play in. So if the mix starts trending as some of the higher end boxes go to production to the 16 core processors, that will give a positive impact definitely to gross margins. So mix is obviously a big issue, and that’s why it's a little bit more challenging for us than if we made one product for one end market with one ASP. That’s a lot easier to predict gross margin.

[Sandy Harrison:]

Great. Thanks for taking my call, guys.

[Art Chadwick:]

Thanks, Sandy.

[Operator:]

And your next question comes from the line of Kevin Cassidy with Thomas Weisel Partners. Please go ahead.

[Kevin Cassidy:]

Thank you. Thanks for taking my call. You had mentioned that Star's revenue right now is very modest. Do you expect any of these – the two products to ramp into any significant revenue in '09?

[Syed Ali:]

Yes, I mean we have just – we will just be taking them over this quarter, and we do see opportunities to increase our revenue rates. But again, even if we get a design win next quarter, it takes 12 months to go to production. So there will be modest increases in '09, and we expect then our new products that we are going to co-define with them to really start kicking the revenue up in a more significant way in late ‘09, ‘10.

[Kevin Cassidy:]

Okay. So if you look at it, you are saying right now it’s $0.01 to $0.02 dilutive in second half '08. Do you see them still as dilutive a little less than $0.01 a quarter until these products ramp?

[Art Chadwick:]

By next year it’s probably earnings neutral. And if things go well, it could be slightly accretive.

[Kevin Cassidy:]

Okay. Great.

[Art Chadwick:]

But I wouldn’t bake anything into the model at this point for next year, one way or the other.

[Kevin Cassidy:]

Alright. Congratulations on a great quarter.

[Syed Ali:]

Thank you.

[Art Chadwick:]

Thank you.

[Operator:]

And your next question comes from the line of Arnab Chanda with Deutsche Bank. Please go ahead.

[Arnab Chanda:]

Thank you. A couple of questions, first, maybe for Syed or Art, either one. I was taking a look at the products for Star, and a couple of questions about that. First of all, are you planning to sort of gain an ARM architectural license or really launch a lot of products in the ARM market? And is this sort of – or are you really getting a processor design team, and you are going to go to bolster your expertise in that?

[Syed Ali:]

I think the answer to both questions is a yes. We are getting a processor design team, and based upon what end markets we target them for, it will either be an ARM core or a MIPS core. But overall, on the ARM side, if we take a look at it on the MIPS side, we are an architectural licensee, and we build the course from the bottom up in a full custom fashion. In the ARM type market, we will just basically take the RTL code, license it from ARM and basically then do the integration by ourselves.

[Arnab Chanda:]

Okay, great. And then just one other question. It seems like there are UMC investments, so is this also a strategy to diversify your foundry supply? I mean there is obviously talk about price increases in the foundry market. Do you gain some diversification there? Is that also a consideration?

[Syed Ali:]

Right now if you take a look at it, we do produce both at TSMC and UMC currently. So it’s basically now a second product line that will go into UMC.

[Arnab Chanda:]

Okay, great. And then a question for Art. So, what you are saying is that for a full quarter we should assume somewhere between $600,000 to $700,000 in operating costs, I am assuming mostly R&D. Does that mean that for a full quarter of Q4 we should assemble that sort of as baked in on whatever happens in Q3? How should we think about the OpEx? I understand you are not predicting any real revenues, but how should we model that?

[Art Chadwick:]

Sure. So for Q4 our expectation is that we will close in Q3, so by Q4 we will have $600,000 to $700,000 of additional Star expense in our OpEx, and you can kind of back into it. If it’s $0.01 dilutive in Q4, it is about $400,000, and you can back into kind of a nominal revenue level. And so that’s the way I would do it. Again, there is a little uncertainty as to exactly what the revenue is going to be. And so we don't want to be too precise with this guidance because on the one hand it's just not that material to us. But that’s how I would think about it. Expenses $600,000 to $700,000, about $0.01 dilutive. Everything else falls out from that.

[Arnab Chanda:]

Great. And then last question, Syed. If you look at it, some of the customers you are talking about, obviously they are – some of them are experiencing different types – obviously Sumitomo has seen a lot of growth. But (inaudible) business tends to be relatively volatile, and it probably was not even important two quarters ago. Some of the other customers such as Blue Coat I think has had some problems. When you give guidance for sort of next quarter or longer-term, sort of what assumptions are you making? Are you sort of taking a conservative view about their business, or is it about your product ramp? I mean are you watching inventories? What qualitative metrics are you using? Because obviously a lot of the companies in the universe are sort of seeming like they are having some difficulties. Thanks.

[Syed Ali:]

Yes, typically if you take what we do now is, Arnab, is we don't do much of qualitative forecasting. It’s a very, very quantitative approach that we have. The sales guys have very good relationships with the big customers, and they give us a bottoms up forecast for the quarter. And then we kind of take a look at their history and what is happening to that product in the market, and we will put some guard bands on it. So it’s a very, very quantitative approach that we have. Not just saying, hey, this thing is going to grow 10% a quarter and just build that in. But we look at it on a quarter by quarter basis. Some of the customers may be higher one quarter and slightly lower in the other quarter. And we forecast it and manage it according to what we are hearing from the customer.

[Arnab Chanda:]

Okay, great. And then just one last question about your infrastructure, sort of the new products in service provider, as well as for storage. When do you think you will see significant contribution from that? And does that add to the – causes a further acceleration to your revenues, or it sort of grows – causes you to grow generally in line with your growth? Now that your OCTEON is actually a bigger part of your revenue, should you assume growth accelerates or remains the same? If you could answer those two, thank you.

[Syed Ali:]

On the service provider side, as you know, we have a number of access and edge router products that have just started to go to production or are in early stages of production. Also – that are already there. So you should see some growth in those areas in the second half of '08. But in '09 we will start seeing I think significant revenues coming in from kind of the wireless infrastructure designs that we have been winning now over the past six to nine months. They should start going into production in kind of first-half and second-half of '09. The storage revenues we think probably by mid to second half of '09 will start accelerating. So essentially if you take a look at all these three segments, there will be a little bit of growth in '08, some acceleration starting in the first half of '09 and further acceleration in the second half of '09.

[Arnab Chanda:]

And OCTEON versus NITROX?

[Syed Ali:]

OCTEON is going to become a larger and larger percentage. Even though we have growth from 2007 to 2008, we have got growth in both our NITROX and our OCTEON product lines, and the growth rate in terms of percentage is dramatically higher for the OCTEON. So as OCTEON becomes a bigger and bigger percentage, that should bode well for us for growth in the coming quarters.

[Arnab Chanda:]

Thanks, Syed, thanks, Art.

[Syed Ali:]

Okay. Thanks.

[Art Chadwick:]

Operator, we have time for one more question.

[Operator:]

And your last question will come from the line of Sanjay Devgan with Morgan Stanley. Please go ahead.

[Sanjay Devgan:]

Hey guys, thanks so much for squeezing me in. Just a couple of questions on the Star acquisition. I guess, first off, you mentioned there are roughly 50 employees. Is it safe to assume that they are all engineering, or what is kind of the split between engineering and admin I guess?

[Syed Ali:]

It’s mostly engineering. There is about out of the 50 that they have, probably 40 are in chip design and software engineering, a few people in the operations side, and a few people on the G&A side.

[Sanjay Devgan:]

Okay. And then just roughly, if you can help us get a better understanding of – you talked about the TAM expansion opportunities that the Star acquisition will afford you. Can you remind us what your kind of perceived TAM is for the broadband market just as Cavium alone, and if you can give us a sense of what that expansion opportunity is with the Star acquisition, just for the broadband market segment?

[Syed Ali:]

The overall TAM expansion that we think we can address – I'm sorry, the overall TAM of the market that we can address with the combined Cavium products, Star products and the future roadmap products that combine both our IP, is somewhere in kind of the $300 million to $500 million range. And right now we are probably addressing maybe $100 million of that segment.

[Sanjay Devgan:]

Okay. And then one last question if I may. You talked about the design win activity kind of at the same levels that you had in Q1. So is it fair to assume that your cumulative design wins to date are now north of 500 or in that range?

[Syed Ali:]

Yes, it should be in that ballpark. I don't have the exact number, but yes, it is kind of in that ballpark.

[Sanjay Devgan:]

Okay. Great. Thanks so much.

[Art Chadwick:]

Thanks, Sanjay.

[Syed Ali:]

Thanks, Sanjay.

[Art Chadwick:]

Operator, that concludes our call. We want to thank everybody for joining us today.

[Syed Ali:]

Thank you.

[Art Chadwick:]

Thank you.

[Operator:]

Thank you. Ladies and gentlemen, we do thank you again for your participation, and at this time you may disconnect.