Operator: Good day ladies and gentlemen and welcome to the Q2 2013 PLX Technology Earnings Conference Call. My name is Ashley, and I will be your operator for today. At this time, all participants are in listen-only mode. Later we will conduct the question-and-answer session. As a reminder, this conference is being recorded for replay purposes.
I’d now like to turn the conference over to your host for today, Mr. Art Whipple, Chief Financial Officer. Please proceed.
Arthur O. Whipple - CFO: Good afternoon, and thank you for joining us today. The delay in the start of this call was a result of an error on the part of the conference call provider. We apologize for any inconvenience that may have caused.
I will start this session with a review of our second quarter financial performance and David Raun, our CEO, will provide more information on our business and recent events.
As we begin, I’d like to point out that certain statements made in the course of this call regarding our expectations and associated projections will be forward-looking statements. These statements will include comments relating to the introduction and adoption of new products, financial guidance, the development of next generation technologies, the Internet machines litigation and other areas, and will be made in both our prepared remarks and the subsequent Q&A session.
Our forward-looking statements deal with future events and are subject to risks and uncertainties, and our actual results could differ materially from our current expectations. Some of the factors that could cause such differences are described in our press release dated today July 22, 2013, and in our various SEC filings, including our report on Form 10-K for the year ended December 31, 2012 and on our report on Form 10-Q for the quarter ended March 31, 2013.
Let's discuss the results of operation. Net revenues for the second quarter were $26.8 million, up 2.4% from $26.2 million last quarter. PCI Express revenues increased by 7.8% to $20.1 million, a new record. Compared with the second quarter of 2012, PCI Express revenues increased by 16.9% from $17.2 million and now represents 75% of revenues. Connectivity revenues decreased by 10.9% to $6.7 million. A decrease in connectivity revenues was anticipated in Q2 as the prior quarter sales included some last time buy shipments for several devices within this product line.
In the second quarter, gross margin was 56.1%. This compares with 59.2% in the prior quarter. The strong margin in the first quarter and the lower margin in the second quarter, both reflect unusual product and customer mix. Year-to-date gross margin was 57.7%
On June 19, the judge in the ongoing Internet Machines litigation in the Eastern District of Texas ruled on a series of post-trial motions relating to the jury verdict rendered in February 2012. Although these rulings were generally not in our favor, we believe that the documented errors in the trial and the case presented will have a different outcome at the appellate level. We expect to see a ruling by the middle of 2014. Even though we expect to win the appeal, the current rulings necessitate that we accrue for possible damages for accounting purposes. We had already accrued $1 million in connection with the verdict, and during the second quarter we accrued an additional $900,000 for post-verdict royalties and interest based on the judge’s ruling. Also based on the judge’s order for the devices with its feature, we will start accruing a 9% royalty on U.S. sales to cost of goods starting in the September quarter. This translates to a margin impact of less than 1% for PLX overall. If we eliminate the feature for applications that do not use it, this margin impact drops significantly. We are making these accruals based on GAAP requirements, but we believe that it is likely that these accruals will be reversed when we complete the appeal process in mid-2014. Accordingly, we are identifying these accruals those amounts that we will remove when we present our non-GAAP measures.
Excluding stock option and Internet Machines accruals, R&D and SG&A spending came in at $6.3 million and $5.5 million respectively. SG&A costs were slightly lower in this quarter, reflecting start of your expenses including payroll taxes and audit fees in the first quarter. Spending was lower than we had expected when we provided our business outlook in April. Some of our planned hiring took place later than expected and costs associated with consultants and other third-party activities were eliminated or deferred to later this year.
The Company continues to look for ways to increase efficiencies and control spending. The combination of strong revenues and lower OpEx yielded a GAAP profit of $1.7 million. This compares with a $500,000 loss on continuing operations in the same quarter a year ago. We also present non-GAAP measures in our press release that we believe are helpful to investors. Excluding such things is Internet Machines litigation accruals, discontinued operations, acquisition and restructuring costs, amortization of intangibles, and stock comp. Our non-GAAP P&L shows net income for the past three years and the most recent quarter. Our non-GAAP P&L this quarter was $3.1 million.
On the balance sheet, cash and investments increased by $1.9 million in the current quarter to $15.5 million. This was a result of cash generated by operations. Inventory increased $1 million to $10.6 million. Accounts receivable was $12.2 million compared with $13 million last quarter. The decrease reflects a more linear shipping pattern this quarter. DSO stood at 41 days for the current quarter. Collections remained excellent.
Now, David Raun will provide further comments on the business.
David K. Raun - President and CEO: Thank you, Art. Good afternoon, everyone. We continue to stay laser focused on our market-leading PCI Express product lines. This includes our in-the-box standard switch families in production today as well as our market expanding out-of-box ExpressFabric product line in development. Our 8% PCI Express growth in Q2 produced our first $20 million quarter for this key product line. This growth was driven by record sales with our new Gen 3 families as well as our Gen 2 switches. The continued growth of Gen 2 products, which were introduced in 2007 demonstrate the long life for these products. We estimate that the PCI Express market will grow about 15% to 25% in 2013.
Looking at our revenue by market segment, we saw increased sales with networking customer as well as our dual GPU and high-end gaming motherboard customers. Sales into the embedded market were down. Overall enterprise storage was mixed with some customers up and others down, but this remains our largest market segment, and we’re expecting significant continued growth.
One exciting growth driver for the PCI Express switch market within the enterprise storage space is the rapid adoption of PCI Express solid-state drives or SSDs. Every time a PCI Express SSD is added to a system, it requires at least one PCI port. The more SSDs you add, the more PCI ports you need. The need for additional port in a system is the number one reason switches are used today. There are more than 30 companies either shipping or developing enterprise class systems, utilizing SSDs, including suppliers like EMC, NetApp, Fusion-IO, IBM, (Violin), Dell, HP and many others. The enterprise SSD market served by these lead OEMs by some estimates is expected to grow by 43% a year and be 3.5 billion by 2016. This includes I/O drawers, appliances, SSD cards and servers. This trend towards more SSDs rather than spinning hard drives has been well-publicized in the marketplace and PCI Express provides the highest performance interface.
When a switch is needed to create those extra ports, PLX will be the primary supplier with is current broad Gen 3 offering and other innovative products in development to service this explosive market. We continue to have strong design win traction across our markets, including the impact of the PCI Express SSDs as just discussed. The enterprise storage and communication or networking markets delivered the highest design wins this past quarter based on expected annual revenues in the future.
In the terms of the product and technology roadmap, we have a market-leading 18 Gen 3 products available today, ranging from 12 to 96 lanes with up to 24 ports. On the customer design front, we had another solid quarter without a single known significant loss and we even had a few previously lost designs come back to PLX based on the performance of our product and our long-term commitment to this market.
Part of our engineering effort is focused on the development of the exciting ExpressFabric solution, which leverages PLX’s PCI Express technology, strength and system fabric experience. ExpressFabric is a disruptive technology within the datacenter and cloud, because it can eliminate the traditional array of costly and power-hungry fabric controllers and switches, currently found within many server and storage racks. This rack scale solution is about one-half the cost and one-half the power of alternative comparable fabric schemes. The power savings are well received since the datacenter’s 24/7 operation drives significant costs.
In addition to the traditional server systems, we have seen significant interest in ExpressFabric for microserver solutions. This was evident at the PCI-SIG Developers Conference last month where we had standing room only for our presentation. We plan to have a live ExpressFabric demo this quarter at the Intel Development Forum followed by one at the Supercomputing Conference in Denver in Q4. We continue to work closely with several leading datacenter equipment partners that plan to take advantage of this technology to build next-generation datacenters much more efficiently. Some of these customers are expected to launch products late next year, driving additional growth for PLX in 2015 and beyond.
We are excited by the PCI Express market opportunity and continue to execute against our plan. Although we’ve seen some swings up and down, PLX’s compounded annual growth rate for PCI Express since 2006 has been approximately 25%. The record design wins, which achieved over the past couple of years with virtually every market leader in the growing datacenter and cloud space, are ramping into production this year and next. We anticipate solid revenue and earnings for years to come from our in-the-box switch solutions.
Our highest-ever PCI Express switch market share, now more than 70%, combined with winning nearly all the Gen 3 designs and the increasing need for switches to support the fast-growing SSD market, helps ensure this growth. Our penetration and market expansion outside the box with the ExpressFabric solution provides a continued growth opportunity for the Company. We believe the combination of all these factors expands our addressable market to $0.5 billion within five years.
Most importantly, in contrast to the losses last year at the same time, the combination of PCI Express growth in the first half of 2013 along with tight cost controls produced the most profitable first six months of any year in company history. We will continue to manage operating expenses as we grow, so we can improve profits, build our cash position and deliver solid results for our shareholders.
With that, let me pass it back to Art to discuss Q3.
Arthur O. Whipple - CFO: Thank you, Dave. In the third quarter, we expect PCI Express revenues to increase again with greater shipments to enterprise storage and communication customers. We expect our legacy connectivity business to be down. We expect to exit the year with connectivity revenues accounting for only 20% or less of our total business. Therefore, we expect revenues to be approximately $25.5 million to $27.5 million in the third quarter of 2013. This reflects growth in PCI Express products and continuing decline for connectivity products.
Starting next quarter, we expect to make a GAAP-based adjustment to cost of goods sold for Internet Machines royalties of less than 1% of sales. Non-GAAP gross margins are expected to remain strong at approximately 58%, with GAAP margins at approximately 57%.
Quarterly spending continues to be lumpy. Our first two quarters were a little lower than expected. For the third quarter, we're expecting GAAP operating expense to be about $13.6 million, including about $600,000 of stock comp and other GAAP items. The increased spending in Q3 is associated primarily with new product development expenses. With tight cost controls in place, we are lowering our annual non-GAAP OpEx spending from $52 million to $51 million.
Now let's open up the lines for questions related to the business.
Operator: Krishna Shankar, Roth Capital Partners.
Krishna Shankar - Roth Capital: Congratulations on some good results here in Q2. As you look at your guidance for Q3, you said that the three growth areas for your PCI Express switches was networking, storage and embedded. Do you expect both networking and storage to grow in Q3? What's the outlook for the embedded portion of the business, which was weak in Q2?
David K. Raun - President and CEO: As far as the different markets segment, we expect storage to be up, networking up, server to be about flat, embedded to be flat, and PC consumer to be down.
Krishna Shankar - Roth Capital: Then on ExpressFabric, when would you anticipate the first revenues from that new product line?
David K. Raun - President and CEO: This is more of a 2015 and beyond event. We may make some shipments in 2014, but nothing to impact the revenue.
Krishna Shankar - Roth Capital: But meanwhile, your (indiscernible) out of PCI Express in-the-box business, you think is capable of growing at 15% to 20% a year for the next 12 to 24 months?
David K. Raun - President and CEO: Yes. We believe, based on the design activity we have, that is the case.
Krishna Shankar - Roth Capital: Then I know that your, one of the competitors, IDT, has sold their PCI Express business to PMC-Sierra. Can you talk about changes in the competitive landscape and what you see in terms of PMC-Sierra's new position on this market?
David K. Raun - President and CEO: Yes, absolutely. For those not familiar with it, IDT sold their PCI Express SSD controller. They moved the entire engineering team that had developed the switches and the SSD controller along with switch IP over to PMC. IDT continues to sell the current parts without an engineering team. So, moving forward, I think IDT will continue to sell those products in the market. One of the issues they may have is just supporting the customers when real technical issues surface. As far as PMC-Sierra, they have the ability to build a switch with their IP in that team. I think, really, the question for you to ask them, will they focus on that as opposed to the SSD controller market, which is very competitive, and it's hard for a team to go idle and not continue to develop in that space. So we think the competitive landscape just continues to improve for us.
Operator: Brian Yurinich, Craig-Hallum Capital
Brian Yurinich - Craig-Hallum Capital: This is Brian on behalf of Christian Schwab. On the ExpressFabric, when you talk about the potential for your total PCI TAM to be maybe $500 million within five years, what percentage of that is you kind of think like your typical Gen 3 switches versus the ExpressFabric?
David K. Raun - President and CEO: I don't have the Gen 3 broken out right in front of me, but the Gen 3 standard switches would be a significant part of the – by that point in time, it's going to be Gen 3 and Gen 4, actually, standard switches and then the ExpressFabric layered on top of that. I would say on that time, half of the business is something related to PCI Express or some other innovation.
Brian Yurinich - Craig-Hallum Capital: So it should be 50% switches and 50% fabric by that time period?
David K. Raun - President and CEO: Yes, in the market.
Brian Yurinich - Craig-Hallum Capital: Then does anyone else beside you have a fabric solution?
David K. Raun - President and CEO: We're not aware of anyone with a PCI ExpressFabric solution.
Operator: At this time, there are no further questions in queue. I would now like to turn the conference over back to Mr. David Raun, Chief Executive Officer. Please proceed.
David K. Raun - President and CEO: Thank you. Although we still have significant work to do, I believe this quarter was another step in the right direction. The entire organization is focused on PCI Express, keeping spending and control and bringing new innovative products to market. PLX is uniquely positioned as the top supplier of PCI Express switching to the market leaders throughout the fast-growing datacenter. Our strong design activity, increased market share, dominant Gen 3 portfolio and market-expanding ExpressFabric products in development should fuel our growth and profits for years to come. Thank you for your time.
Operator: Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.