Ladies and gentlemen, thank you for standing by. Welcome to the Silicom's first quarter 2018 results conference call. All participants are present in listen-only mode. Following management's formal presentation, instructions will be given for the question-and-answer session. As a reminder, this conference is being recorded. You should have all received by now the company's press release. If you have not received it, please contact Silicom's investor relations team at GK Investor & Public Relations at 1-646-688-3559 or view it in the news section of the company's website, www.silicom-usa.com. I would now like to handle over the call to Mr. Ehud Helft of GK Investor Relations. Mr. Helft, would you like to begin?

Thank you, operator. I would like to welcome all of you to Silicom's first quarter 2018 results conference call. Before we start, I'd like to draw your attention to the following Safe Harbor statement. This conference call contains projection or other forward-looking statements regarding future events or the future performance of the company. These statements are only predictions and may change as time passed. Silicom does not assume any obligation to update that information. Actual events or results may differ materially from those projected, including as a result of our increasing dependence for substantial revenue growth on a limited number of customers in the evolving cloud-based market; the speed and extent to which cloud-based and cloud-focused solutions are adopted by the market; the likelihood that it will rely increasingly on customers which provide cloud-based and cloud-focused solutions in this evolving market, resulting in an increasing dependence on a smaller number of larger customers; difficulty in commercializing and marketing Silicom's products and services; maintaining and protecting brand recognition; protection of intellectual property, competition and other factors identified in documents filed by the company with the SEC. In addition, following the company's disclosures of certain non-GAAP financial measures in today's earnings release, such non-GAAP financial measures will be discussed during this call. Such non-GAAP measures are used by management to make strategic decisions, forecast future results, and evaluate the company's current performance. Management believes that the presentation of these non-GAAP financial measures is useful to investor understanding and assessment of the company's ongoing collaborations and prospect for the future. Unless otherwise stated, it should be assumed that financials discussed in this conference call will be on a non-GAAP basis. Non-GAAP financial measures discussed by management are provided as an additional information to investors in order to provide them with an alternative method for assessing our financial conditions and operating results. These measures are not in accordance with or a substitute for GAAP. A full reconciliation of non-GAAP to GAAP financial measures is included in today's earnings release, which you can find on Silicom's website. With us today on the call are Mr. Shaike Orbach, the CEO, and Mr. Eran Gilad, the CFO. Shaike will be begin with an overview of the results, followed by Eran who will provide the analysis of the financials. We will then turn over the call to the question-and-answer session. And with that, I would like to turn over the call to Shaike. Shaike, please.

Good morning, everyone, and welcome to our conference call to discuss our first quarter 2018 results, our outlook as well as some of the recent events impacting us. In the first quarter, our revenues reached $29.5 million, up 16% over last year, and our non-GAAP net profit grew 12% to $4.3 million. Eran will elaborate on the financial results in a few minutes. As I'm sure you are aware, a few weeks ago, we were very disappointed when our top 10 cloud client aborted its plans to implement a new type of cloud infrastructure, a program which promised to be a significant revenue generator for us. As the customer noted in its cancellation letter, determination of the program was an internal decision of the customer, entirely based on a modification to its technical and business strategy, and was not in any way related to Silicom's product, development or support, which were flawless. I note that our first quarter financial results still include revenues and expenses related to the canceled project. They'll remain outstanding purchase orders associated with this project and we are in discussions with the cloud customer and its server manufacturer partners in regards to the remaining liabilities to Silicom. This is a long process which will take time to resolve, but we're having open and constructive discussions with all the parties. While it is hard to predict the outcome of these discussions, this quarter we have recorded a $5 million write-off related to this aborted program. Also, these discussions may result in certain arrangements that will allow us to record additional revenues from this project in upcoming quarters and at the same time may have short-term negative impact on our gross margins. While we are obviously disappointed from the cancellation and immediate impact, our general growth strategy remains…

Thank you, Shaike. And hello, everyone. Revenues for the first quarter of 2018 were $29.5 million, an increase of 16% compared with revenues of $25.3 million as reported in the first quarter of last year. I note that our first quarter 2018 revenues include revenues related to the cancelled project. Our geographical revenue breakdown over the last 12 months were as follows: North America, 80%; Europe and Israel, 16%; Far East and rest of the world, 4%. I will be presenting the rest of the financial results on a non-GAAP basis, which excludes the non-cash compensation expenses in respect of options and RSUs granted to directors, officers and employees and acquisition-related adjustments. I should note that the larger-than-usual difference between the GAAP and non-GAAP numbers this quarter is due to the discontinued project-related write-offs, amounting to $5 million, and this was attributed to the cancelled project as Shaike discussed earlier. For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the first quarter of 2018 was $9.6 million, representing a gross margin of 32.5%. This is compared with $9.7 million or gross margin of 38.2% in the first quarter of last year. This gross margin is largely affected by the specific mix of products sold during the quarter, including the products related to the cancelled project. Operating expenses in the first quarter of 2018 were $5.2 million or 17.5% of revenues compared with 5.1 million or 20.3% of revenues in the first quarter of last year. Operating income for the first quarter of 2018 1was $4.4 million compared to $4.5 million reported in the first quarter of last year. Net income for the quarter was $4.3 million 14.7% of revenues, a growth of 12% compared to $3.9 million or 15.3% of revenues in the first quarter of last year. Earnings per diluted share in the quarter were $0.56, a growth of 9% compared with $0.52 in the first quarter of last year. Now, turning to the balance sheet, as of March 31, 2018, the company's cash, cash equivalents and marketable securities totaled $40.5 million with no debt. That ends my summary. And we would be happy to take any questions. Operator?

[Operator Instructions]. The first question is from Alex Henderson Alex Henderson of Needham & Company. Please go ahead.

A couple of quick housekeeping stuff. First off, can you tell us what the ending headcount was?

Yes. Headcount at the end of the quarter was approximately 265 employees.

And about 10% customers?

During the last 12 months, we had three 10% plus customers.

So, looking back into the first quarter, what was the contribution from the cloud customer in terms of its revenue and what would the gross margin look like if that had not been in the mix in the quarter?

This is not an information that we provide. We never provide information for a specific customer revenues or percentage and so on and so forth.

We have also never had a customer dropout that was significant like this before that we need a baseline without that customer's impact in it. Might you consider adding a little bit more content than normal here given the unusual circumstances?

Well, I think that it may even be more difficult right now due to the NDA, the non-disclosure agreements, that we have with this customer. So, this is not something we can do. However, I think that, in a way, providing the guidance for the second quarter gives you some sort of an idea, even though the second quarter still would include some revenues from this customer. But as I've said, these revenues are diminishing gradually.

So, if I recall, you had a business model that was predicated on a 40% type gross margin prior to bringing on these cloud customers and bringing on the SD-WAN customers which were, obviously, different scale than your traditional business. If the cloud customers dropped out of the mix, I think your revenues were essentially flat at around $100 million in CY 2017. Will you be able to generate growth excluding that as we look forward into CY 2018 excluding that cloud customer? And why wouldn't the margins rebound towards your original margin mix once that customer drops out?

Okay. So, let me try and explain what's happening right now. So, there are two trends. One trend is that is still the revenues from this big project, they are there. We would have revenues from this customer in the second quarter and possibly even in the third quarter. But they are being decreased. We approximate that each quarter that we still have revenues, it will be less than the previous quarter. So, this is, I would say, a trend of going down. On the other side, we have a trend of growing which is mostly attributed to our successes in the area of SD-WAN and NFV, et cetera. And the design win that we have announced today is just an example of that. Now, obviously, we do not know exactly when these two trends will match each other. But because the biggest ever win could not go – could not become less than zero – sort of – so we definitely believe that at a certain point in time, we will resume growing because the new design wins that are accumulating such as the one that we announced today and the other one which is around the corner and the more which are coming would be more than what we lost due to the disappearance or diminishing of the big win. When exactly that's going to happen, I cannot tell for sure, but this is going to happen. I feel very confident about that even though I cannot say a specific date about that. Now, with respect to the margins, it is – I think that we will remain in our target gross margins as we have defined them in the past, which are between 32% to 36%. And that's because while this big project is disappearing, the projects that we're talking about that will sort of replace this project are also within the same environment of the cloud, SD-WAN, NFV and they have the same kind of pressure on gross margins just like the biggest ever win had. So, overall, taking about these margins, I do not expect any changes moving forward. And I believe that our margins would still be within the boundaries of 32% to 36%.

That's helpful. Thank you. So, is it reasonable to think as we look at the lower end of your guide here in the June quarter, down about 10% year-over-year that were down roughly 10% year-over-year as the projects fall out and before the SD-WAN gets up towards its growth that we've returned to growth in 2019 as opposed to year-over-year growth in the June, September or December quarters? Is that the right way to think about it?

I think it's the right way to think about that. Again, of course, I cannot commit being very accurate about that, but this is the right way to think about that.

Okay. And just wanted to ask a question, there was a AT&T Open Compute forum presentation that AT&T and Silicom were involved with. That's actually on the Web. And they talked about a pretty significant universal CPE project in there. I assume that's not the project that you just signed in with the SD-WAN, that that's more of a second program that might come down the pike. Can you give us a little bit of background on what was announced at that Open Computer summit in March?

Because it was not our announcement, so I cannot comment to that. The only thing that I can say is what we've actually said. There is one design win that we announced today. There is another one which we believe is around the corner. We have – as you know, we have our criteria as to when we announce the design wins. Typically, we do that when we feel that we are really confident that this is the real win or real award that we can move forward with. And we will continue to do that obviously.

Well, at least – and the timeline that they put up in that presentation, they were talking about finalized design by the end of 2018. So, I assume this is more of a 2019 type of project. Is that the right way to be thinking about this?

Again, I cannot comment any specific project which is referred to by AT&T because we were not – as you know, we're not disclosing the names of our customers unless we're formally allowed to do that. And so…

Okay. I will back off on the subject. Thank you.

Okay.

The next question is from Jason Ader of William Blair. Please go ahead.

Yeah, thank you. I have two questions. First, I guess, it doesn't matter hugely at this point, but just out of curiosity, why do you think the big cloud customer changed strategies? Or at least what did they explain to you? And second question is on the US telco – tier one telco contract that you announced – or design win that you announced. Are you selling directly to the telco? Or is there an OEM in the middle there? And I assume – or somebody that's doing the software for this EDGE device. And I'm just curious as to whether that's something that you were not involved in or maybe explain a little more of the mechanics of how that product actually gets to market with a full hardware/software solution?

Okay. So, first question, the only thing that I can tell you is just what I've said that this was the result of an internal IBM decision based on modification to their technical and business strategy. Everything else could be only a speculation. And that's why I'd rather not elaborate on what I think and what I believe. But that's what they've told us. That's the only thing that they've told us. And that's why that's the only thing that I can say about that. As to the design win that we announced today, also several issues there. So, first of all, we are working directly with the telco. That's for sure. And the selection process and the decision to use our devices has been taken by this telco giant and not by anyone else. Now that being said, moving forward, they may select some sort – and that happened with many other customers in the past. They may select some sort of a fulfillment partner who would actually place all the purchase orders and we may, in that case, deliver to that kind of partner. But the the relationship and the selection process has been with the telco giant, and only with the telco giant on that one. Now, what we deliver to this customer, I would say is the hardware. And if there is any software in that, it is only the software which is very much related to the hardware itself. And it has nothing to do with the application that the customer is running. Now, this is a part of what is happening. And I think it's important to understand because all these models are happening. So, it seems to us – or at least the way that it looks – is that these giants they…

Okay. That's helpful. And do you think, over time, the direct relationships with the telcos is going to be a bigger part of your business than working with OEMs that are then selling to either telcos or enterprises directly? Do you have a sense of relative size of the opportunity for Silicom?

Well, first of all, yes, I do believe that a direct relationship with telcos would become significantly or much more significant than it was in the past. We see that bigger the telco is, the more it is, I would say, ready to undertake on itself this separation of software and hardware, working with us directly on the hardware, which is why I believe that working directly with telcos will be a significant – a much more significant part of our business. Now, there is another part to it. I also believe that selling to telco through OEMs would also become a more important part of our business. And that's because the overall migration of these telcos to, I would say, cloud-related architecture with virtual CPEs and so on and so forth. So, even if they decide not to separate the software from the hardware, they still would have a need for vCPEs or uCPEs. Only, in some of these cases, our sales into these telcos would be through the OEMs, which would increase – which would actually create another segment for us of growing our business into the telcos. So, what I would say is that our telco business – that's what I believe – would grow significantly. A major part of that would be working directly with these giant telcos. Another part of that would be selling to these telcos through OEMs.

Okay. And last quick question is on the $15 million to $20 million in annual revenues that you talked about for this specific design win, when do you think you could get to that type of annual run rate? Would it be 2019? 2020?

I think that, by 2019, we will get to that rate. Sometime during 2019. That's what I believe. That's what I feel. And that's more or less what the customer is saying. But you should note that when there is a forecast for the very short term, typically, there is visibility and they know what they're talking about. When we're talking about 2019, everything is vague to a certain extent, but that's what I think and that's what I believe.

Okay, thank you. The next question is from Don McKiernan of Landolt Securities. Please go ahead.

Yeah. Thank you. Good morning. My question concerns the customer behind the cancelled cloud win. Do they have other design wins with them? And also, I think at the beginning of the call, you had talked about this customer and some other additional developments with them. Can you elaborate on that too?

Well, first of all, I'll first answer your first question because it's a simple answer and then I'll ask you to make sure that I understand properly your question with the second half. So, yes, we have other wins with that customer, but they are way smaller than the major design win that was cancelled. Now, as to your second question, when you were talking about development, are you talking about what's happening with the cancelled project or are you talking about development as if in R&D, research and development?

Yeah. R&D and other opportunities with this customer. And characterize the relationship too.

Well, so I would say that, on the one side, at the moment, there is no concrete discussion about any new project other than those wins that we already have with them. But that being said, the relationship with this customer is very, very good. The customer tells us that it would like to have more meetings with us to understand our full portfolio because he liked working with us and he would like to do things with us as long as we have the right product. Specifically, we are targeting discussions with regard to FPGA-based solutions for the cloud to move forward with that customer. That would happen once all the details about the current project are concluded and when everyone has a little bit more time and energy to deal with, I would say, a next-generation of cloud, at which time we will come in front of this customer, will begin the process. The only one comment I would like on that, it's not going to be a short process. FPGAs by itself are more complex designs. We are pretty confident that the market will move there, but it would take some time.

Okay, thanks.

We have a follow-up question from Alex Henderson of Needham & Co. Please go ahead.

Yeah, thanks. So, a couple of questions. First one, just on the operating model. Your cost of goods sold – your sales and marketing and G&A costs came in a little lower than we had expected. Should we be expecting more of a rebound in that spending in 2Q to more normalized levels? Kind of a quarter of the full year 2017 plus a hair. Is that the right way to think about the expenses on those two items?

Yeah. I believe it is. We do expect a rebound like that.

So, generally speaking, are you expecting over the full year that you will be investing in those line items or how should we be thinking about it on a full year basis?

Well, what do you mean investing in those line items?

Putting money into building staffing, putting more expenses in, dealing with inflation?

Dealing?

In other words, will those expense line items be going up on a year-over-year basis given the outlook for the cloud customer?

Well, I don't think it's going to be anything dramatic. I think, overall, we are investing. We'll continue to invest. But I don't think anything dramatic is going to happen due to that.

Second question along the same lines is can you detail what the FX impacts were during the current period?

You asked about the tax? Did you ask about the tax?

No, no. Exchange rates. FX.

Exchange rate.

The effect of exchange rate differences was positive for us during the quarter, both in terms of operating expenses, as well as in terms of financial income. Not dramatic, but positive.

One of the other things that happened during the quarter was you decided to discontinue your dividend, I believe, that, ultimately, that decision is probably driven off of your expectations of ramping production with these cloud – with these telcos. Is that the way we should be thinking about the line of logic behind that? Can you talk a little bit about the reasoning?

Yeah. I think you were 100% right. That's what was behind that. We expect these projects, the one that we announced already and the others as well, to ramp up and we would be needing cash for that purpose.

Can you give us some sense of what the scale of the requirements are relative to stocking inventory? Will that be multiple locations? What portion of the revenues do you think you'll need to have in inventory in case these programs ramp? How should we thinking about that aspect of your business model from a cash flow perspective?

I think that – first of all, I believe that all these wins, the one that we got and the others as well, are going to be very significant. As I've mentioned, even the one that I was talking about being around the corner, I believe it could be more significant than the one that we announced today. And on the other side, the one that we announced today, this same customer is having another project in the pipeline which could be bigger than this one. So, all in all, these would be very significant wins, all of which would require us to build inventory, to invest in new designs, et cetera, which is why mostly in order to be on the safe side and be 100% sure that we can really support these. That's why we have taken this decision. I think it's an indication as to how really optimistic we are with respect to these potential wins.

So, I guess, the question I have in that context is taking a $5 million write off here on the trailing cloud project given the margins associated with that project is a pretty significant hit. Would we be looking at protection on that inventory, so that we wouldn't have that type of exposure going forward? We're talking about significant inventory builds for a particular project area. Like you said, seems like it's very customer specific inventory.

So, let me say a few things about that. First of all, when a project as big like that is canceled, obviously, we're hoping that other projects – big project, especially – would not be canceled that way. But when you have a big project like that, you're taking a lot of steps and you're trying to cover yourself and protect yourself, which is something that we did. Now, however, when a big project like that is being canceled, no matter how well protected you believe you are, there would always be some situations where you may not be protected. So, the $5 million of write-off is our estimation as to what would happen about that in this specific project. We would continue with future projects as well to seek all the protection that is possible, such as making sure that their purchase orders are noncancelable and the forecast is a committed forecast. All these things are things that we did with this project as well. But when something big like that is happening, everyone is trying to see how he can still capitalize as much as possible and save some money and reduce his liability. And that's why we took this measure for the write-off because you can never tell. You can never be 100% protected. So, my answer to your question would be, we would make any possible protection for these future projects, just like we did with that on. If there is a cancellation happening, there would always be issues. Let me just say that – and I think it's pretty obvious that our profit out of this project overall would be – would justify what happened to us, taking that into consideration. So, trying to summarize my response, we did prepare ourselves and try to protect ourselves the best that we could. We're making this write off right now because no matter how protecting – how much you're trying to protect yourself, there's always a risk in these projects. And we will take the same approach with these upcoming projects and wins. Hopefully, they wouldn't be canceled in the way that this project was. I can tell you one thing. This project was really a unique project in terms of the way that the customer behaved from the beginning. And I think you may remember us talking about the fact that we're selling, we're selling, but there are still challenges, there are still challenges, there are still challenges. And I think these projects that we're talking about right now, first of all, the challenges would be resolved and then we would be moving forward.

One last, closing the book on this cloud project that was cancelled, I know you've said very clearly in the press releases and the verbal commentary that this was something that was internal to the customer and did not reflect on your product working in the – the deliverables that you have produced. But on the other side of that coin, I have heard significant commentary around the need for the product to be integrated into their orchestration system. and to that extent that they needed to develop software interfaces and software elements for their system to facilitate that. So, the question I have for you is, is there a need for you guys to spend more time developing open APIs on your product, so that they're more fungible into conventional operating environments? Is that something that would avoid this type of cloud issue in the future? Or is that – am I barking up the wrong tree on that thinking?

Let me try to explain. We do have products which would fit into a variety of cloud architectures, which use this open API that you mentioned and so on and so forth. The reason that this specific product was not like that because is only because this is the architecture that the customer has decided about. We have developed this product for or against the customer's specifications. It is what the customer wanted to do. So, this product was developed exactly per this customer's decisions and specification. It was a unique product from various aspects and also the integration of this product within their architecture was unique. And once again, this was a part of their decision. It was not an off-the-shelf product that we developed. So, yes, the overall architecture is the one that they have decided to back off from and do something different, but it has nothing to do with the, I would say, standard way that we develop our products.

Okay. I'll cede the floor. Thanks.

The next question is from Robert Sussman with Bentley Capital. Please go ahead.

One last question on this cloud issue. Are you confident that the $5 million is sufficient? And is it possible you'll get into litigation with this client over the size of the discharge on what it might potentially cost you?

Okay. So, I'm just looking for the right word here. $5 million is what we estimate right now as a reasonable amount for the write-offs. This is what we believe is reasonable. And if that happens, then there would be – if we're right in our estimations, then there would be no litigations and nothing of that sort. There are obviously – just like always when you have an estimation, the actual situation could be somewhat better than that and it could be worse. I can tell you that if it's worse, then there would be litigations come from our side, not from the customer side. I don't see any scenario under which we would be exposed to litigation. It seems just like I mentioned in my call that right now all the discussions that we're having with those who are – that we're dealing with, which means the customer and its two server manufacturer partners, they are constructive at this moment. I really believe that the $5 million that we wrote off is sufficient, but you can never tell. This is still an estimation. Until we conclude everything, you cannot be 100% sure about that. We believe that we took the right decision with these $5 million.

One follow-up. If the project has been ended, why are you still delivering more product in the second and third quarter?

That's because we had open purchase orders from the customer and these open POs are still in place. They were non-cancelable, these POs. But, of course, once the customer no longer needs these devices, it wouldn't make sense for anyone to go on and just take the material that we did acquire and built full systems with them when they work in progress, where the project – part of the product is built to certain levels. So, they will take these devices eventually. That's what we believe in and that's why we will continue to sell to them. But on the other side, we wouldn't fulfill the full amount of this open purchase orders and this is exactly what the discussions are about – what exactly we're supposed to deliver to them.

Is it possible that this project that has been cancelled could morph into something – a similar product with a slightly different technology that you would be involved in, so that you would still end up doing a lot of business with this customer in the cloud area?

I think that there is a good chance we will be doing business with this customer in the cloud area, but I don't think it's going to happen with these products.

Okay.

These products, they have decided to move away with the architecture which needed these products. And I don't think this is reversible.

Okay.

This specific decision. I believe we have a good chance in their next generation.

Okay. And how far off do you think that next generation is? Is it a year off? Two years off?

I think it's more than a year off.

Okay, thank you.

[Operator Instructions]. There are no further questions at this time. Before I ask Mr. Orbach to go ahead with his closing statements, I would like to remind participants that a replay of this call will be available by tomorrow on Silicom's website, www.silicom-usa.com. Mr. Orbach, would you like to make your concluding statement?

Thank you, operator. Thank you, everybody, for joining the call. We look forward to hosting you in our next goal in three months' time. Good day.

Thank you. This concludes Silicom's first quarter 2018 results conference call. Thank you for your participation. You may go ahead and disconnect.