Ehud Helft - Investor Relations Shaike Orbach - Chief Executive Officer Eran Gilad - Chief Financial Officer

Alex Henderson - Needham & Company Edward Balinsky - Segmark Josh Goldberg - G2 Investment Partners Donald McKiernan - Landolt Securities

Thank you, operator. Good day to all of you.

I would like to welcome all of you to Silicom’s third quarter 2016 results conference call. Before we start, I would like to draw your attention to the following Safe Harbor statement.

This conference call contains projections 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 passes.

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 changing industry and market trends, reduced demands for Silicom’s products, the timing and development of new products, and their adoption by the market, increased competition in the industry and price reductions as well as due to risks identified in the document filed by the company with the SEC.

In addition, following the company’s disclosure 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, focus future results and evaluate the company’s current performance.

Management believes that the presentation of these non-GAAP financial measures is useful to investors understanding and assessment of the company’s ongoing corporation and prospects for the future. Unless otherwise stated, it should be assumed that the financials discussed in this conference call will be on a non-GAAP basis.

Non-GAAP financial measures disclosed by management are provided as 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 to 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 on the call today are Mr.

Shaike Orbach, the CEO and Mr. Eran Gilad, the CFO.

Shaike will 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?

Thank you, Ehud. Good morning, everyone and welcome to our conference call to discuss the results of the third quarter of 2016.

We are very happy with our success in the financial results we achieved in the quarter. Our quarterly revenues demonstrated strong year-over-year growth of 27% to $24.7 million and a significant nine months revenue growth of 30% over the same period in 2015.

I know that these revenues are the highest level we have ever achieved in a third quarter and in the first nine months period by a wide margin. Our results confirmed that we are on the right path and our top line growth trend remains robust in line with our strategy for long-term leadership and growth.

Our growth strategy is built on consistently expanding our portfolio by broadening and updating our existing offerings, as well as introducing new product line, growing our addressable markets by penetrating additional market segments and new customers, and deepening our relationships and further penetrating into many of our existing customers, especially the top tier OEM. Our recent design win successes which I will discuss in a moment are again a solid demonstration of how we continue to keep a close watch on and predict the upcoming market trends.

They very much represent ongoing fruit of significant past investments we've made in R&D at the right time. We continue to invest heavily in R&D.

We currently see many new market trends which presents significant opportunity for Silicom. We are only too pleased to increase our investment in R&D in the short term to capitalize on these opportunities and maximize the long-term success of our company.

New and better products resulting from our ongoing investments combined with our continually improving competitiveness has helped us bring new customers, as well as penetrate deeper into existing customers over the long-term. This has allowed us to continually grow our revenues and step up them to the next level.

While our results continue to validate the ongoing success of penetration in our traditional networking appliances markets, they show increasing success in newer high growth segments which we are targeting and are seeing strong momentum. These markets include Cyber Security on the one hand and cloud-related technologies on the other namely SDN, NFV, IoT, virtualization in general and especially SD-WAN all of which depend on top performance connectivity.

You may remember that a few years ago we achieved strong market leadership with considerable success in the WAN Optimization segment building up strong relationships with many of the key players back then. The segment has matured and evolved over the past few years, and we are now experiencing the rise of software-defined WAN, SD-WAN for short in a cloud and virtualization era.

We are seeing service providers and enterprises alike deploying these types of technology faster than ever. In parallel providers are increasingly deploying network function virtualization or NFV, enabling the pairing of high-value software with powerful yet open hardware devices.

The providers of these latest technologies include many of our customers, in particular the traditional market players as well as increased traction with new entrance. All the players are rapidly increasing their sale and showing growth -- growing success in the SD-WAN segment.

Our market positioning is exceptionally good in the SD-WAN space. We have deep relationships going back a number of years with the traditional market players that sold WAN Optimization solutions back then and are now selling SD-WAN solutions.

These players are solid references to new potential customers. Furthermore, we can penetrate further into these older customers as we have a very relevant and broader product portfolio now.

This was manifested perfectly by our recent announcement that our virtual network EDGE/CPE appliances have been certified by Versa Networks as a branch hardware platform offering for managed software-defined WAN project targeted at several large service providers. These follows on from that quarter’s SD-WAN design win making the first penetration into a new important market player as well as the ongoing use of our cards in the SD-WAN space by our traditional customers.

We believe that our designs which are addressing SD-WAN market provide a unique price-performance balance which is desired by many OEMs, telcos and service providers. We are already working with potential telcos and service providers and these discussions underlie our optimism in achieving more wins in the SD-WAN space.

We firmly believe that SD-WAN is under threat to becoming the potent new revenue driver for us. During the past few months, we reported continuous progress with important design wins from both new and existing customers, providing us with long-term ongoing incremental revenue growth potential.

These wins are further confirmation of our favorable positioning in booming cloud and virtualization related market as well as the Cyber Security and Network Monitoring analyst or Analytic space. We have recently announced a key design win with a tier one monitoring company for our groundbreaking Time Stamping and Packet Processing cards.

This represents a confirmation of our leadership in the 100 gig Network Monitoring space. The customer will initially used our cards to boost the performance of the network monitoring infrastructure that is deploying for one of the world's leading communication service provider.

We see an initial ramp to $1 million in the next 12 months from this one design win. In addition since the customer will now begin standardizing on our next generation card for a variety of systems and solutions, we believe there is a much further potential beyond the initial ramp in revenue.

Given the relationships that this customer has with most of the world's leading end customers we see potential for this customer to become a multimillion-dollar account through additional design wins and revenue growth over time. We also received the new design win for an encryption product from a strategic Cyber Security customer whose initial engagement we announced back in early 2015.

This win is for an advanced Silicom Intel based encryption adapter that will be used to support the customers transition from software based encryption to hardware based offloaded encryption acceleration. At the same time, this customer is also interested in our broader product range.

This is demonstrated by the evaluation process that they are currently undergoing with other products from our range. When we initiated our relationship with this strategic client in 2015, we recognize its significant expansion potential and now as this new design win demonstrate it is starting to happen.

The customer uses a variety of appliances with different types of cause many of which have a clear need for our flexibility and performance edge. Given how pleased they have been with our products and relationship over the past 18 months, again as demonstrated by this new win and the multiple product evaluations underway, we believe that this customer also has the potential to become a several multimillion-dollar account over time.

Finally, we achieved a major design win from a top-tier local interception company which we see is a very high potential customer. This is the fruit of the long and persistence sales effort.

The win was for an Intelligent Bypass Switch the IS100 that we recently released for the 100 gigabit market. We expect that orders from this design win will ramp up to a level of several million dollars a year as well, and at the same time the potential of the relationship as a whole could be even greater with more do design win likely which we expect will become significant contributors to our revenues.

Our relationship with this customer began earlier with a small quantity win for our Redirective cost [ph] a strategic sale. They introduced our capabilities and established a good working relationship.

When they began developing products for the challenging 100-gig environment, they outgrew the capabilities of their existing bypass switch supplier and turn naturally to us for a high-performance alternative with onboard intelligence. Having now moved our relationship with this customer to the next level, we see opportunities for expanding the relationship and plan to propose additional connectivity products offering a broad variety of functionalities and speed.

In summary, we view these recent design wins a further confirmation of our technology, our design concepts, our service capabilities, our market insight, and build on the back of the strong relationships we have and continue to build with our customers. Looking ahead, with regard to our guidance for the fourth quarter of 2016, we believe that revenues will be in the range of $26 million and $27 million.

Looking further out with a solid pipeline from your existing design wins and stronger than ever sales activity across all of our product lines, we feel comfortable projecting continued strong year-over-year revenue growth in 2017 as well. In summary, we remain very pleased with our growth.

We continue to sell more products into more of the platforms of current customers, at the same time we're investing and growing into new customers while offering new products to both existing as well as new customers in new markets. We believe that we are correctly inventing the necessary resources in developing our products, our market, and penetrating new customers which will significantly benefit us over the long-term.

We continue to succeed in identifying IT fastest growing sectors and to address them creatively with must have robust solutions. With tailwinds behind us top-tier base of customer, a growing roster of design wins, and multiple exciting sales opportunities underway, we feel exceedingly well-positioned and look forward to reporting additional growth in 2017 and beyond.

With that, I will now hand over the call to Eran for a detailed review of the quarter’s results. Eran, please go ahead.

Thank you, Shaike. With regards to the results of the quarter, revenues for the third quarter of 2016 were $24.7 million, representing year-over-year growth of 27%.

Our geographical revenue breakdowns for the first nine months of 2016 were as follows; North America 69%, Europe and Israel 22%, Far East and the Rest of the World 9%. 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.

For the full reconciliation from GAAP to non-GAAP numbers, please refer to the press release we issued earlier today. Gross profit for the third quarter of 2016 was $9.7 million, representing a gross margin of 39.3%.

This is compared with $8.3 million or gross margin of 42.9% in the third quarter of last year. Operating expenses in the third quarter of 2016 were $5 million or 20.2% of revenues compared with $3.6 million or 18.7% of revenues in the third quarter of last year.

I note that the increase in operating expenses and in particular the growth in R&D expenses reflect our strategy to invest incremental resources in order to take advantage of the various opportunities that we seen in our end markets. As you know, we have been implementing this strategy for quite some time, but most significantly during the past few quarters.

Operating income for the third quarter of 2016 was $4.7 million or 19.1% of revenues compared to $4.7 million or 24.2% of revenues as reported in the third quarter of last year. Third quarter 2016 net income was $4 million or 16.1% of revenues compared to $4.2 million or 21.5% of revenues in the third quarter of last year.

Earning per diluted share in the quarter were $0.53 compared with $0.57 in the third quarter of last year. Now turning the balance sheet.

At the end of third quarter, our inventory level stood at $45.1 million. The higher than typical level of inventory was due to a number of factors.

First, a few of our largest customers specifically requested that we increase our stock levels in order to be ready for potential upside in orders. Second, we have seen the extended lead times for some of the fiber and other important [indiscernible] bill of material components which means that we need to maintain an increased buffer level in our stock.

And third, there was a higher than usual mismatch between the specific products we had originally forecasted to be sold in the quarter compared with the actual products we sold in the quarter. In terms of our cash metrics, as of September 30, 2016, the company’s cash, cash equivalents, short-term bank deposits and marketable securities totaled $40.3 million or $5.47 per outstanding share.

That ends my summary, and we will be happy to take any questions. Operator?

Hi, guys. So nice growth rate on the top line, the better than expected gross margins, lots of momentum in pretty much every side of your business, variety of tailwinds SD-WAN ramping.

I mean, pretty much everything going the right way and then you give guidance essentially flat to down. Can you explain the reason for the fairly cautious guidance for the December quarter relative to that very robust backdrop?

Yeah, okay. I'll try to do is to explain.

What I would say is not exactly flat, but I'll try to explain what I mean by day. First of all, please know that even last year if you look at the guidance that we provide for last year quarter and compared with it -- for last quarter last year and then you compare it with the guidance that we provide right now, you will see that our guidance for this fourth quarter is much higher than what we provided as guidance last year.

Now what's behind it is in general that, you know, last year what actually happened was outstanding and in a way unexpected. You need please understand that the way that we built our forecast is bottoms up.

So we take what our customers are giving us for each product, for each customer we apply to that our analysis, okay, does it make sense, is it okay, should we add a little bit to that, yes or no, and then we can -- we come up with a number and this number is what provides our guidance. It is built bottoms up.

We cannot tell in advance if the certain customers suddenly haven't entirely unexpected upside which no one forecasting advance and that happens which is exactly what happened last year, then we cannot predict that. And this does not become a part of our guidance.

It still can happen this year as well, but maybe it wouldn't. I mean, we don't have any way to predict that based on the way that we calculate our guidance.

And yes, I mean, even if we just do I would say and obviously I hope that we do that what we are providing you in our guidance I still believe that we are showing quite a positive and significant growth year-over-year when you look at full year of 2016 and compared it to 2015, it's going to demonstrate quite a significant growth rate, and we believe and hope the same thing could happen in 2017. You cannot just look at one specific quarter that certain things can happen which cannot be predicted and define either flat.

Overall, I don't think it's like.

Well, so, I guess this bodes down to here is you are up 47% 3Q to 4Q in 2013, 44% 3Q to 4Q in 2014, 41% 3Q to 4Q in 2015, and you are giving guidance of flat to down sequentially. So, is it just that you can't forecast it, and therefore you're being conservative?

Or should we not be thinking about just a much wider range anywhere from say flat to up 40% sequentially?

Well, first of all, in a way you can define us as a conservative company and this is something that has been proven looking at the actual results compared with the guidance in all previous quarters. But yes, I mean, we have a process and we're following this process in terms of how we calculate our guidance.

And just like in Q2, I mean in Q2 we had a guidance I don't remember exactly what was the guidance, but I mean definitely it was more than that. Even in -- in this quarter we are to a certain extent beating our guidance.

We did beat our guidance in Q1. We would be glad if that happened in Q4 as well, but we still stick to our very clear and defined methodology of how we provide guidance.

We built it bottoms up. We have figures that are provided to us by our customers as to what they are focusing, and we're using these figures and these numbers.

We add to that in some cases, we reduce that in some other cases, looking at the recent events. But we don't feel that just because last year Q4 was much better than Q3 and same thing happened the previous year, we need necessarily to do the same thing and to take this into account -- into our guidance right now.

I mean, for example, I mean, definitely in 2015 and 2014 we didn't have that percentage of growth in the first quarters. So we are consistent with our procedure of how we provide the guidance and definitely it could happen that we would sell more, but it cannot fit into our guidance process right now.

Okay. Thanks.

Good morning. I'm concerned about your amortization of your intangibles and tangibles.

I noticed that in the first quarter you are amortized over some quarters of $1 million and that drop down to $64,000 in the second quarter and now has jumped up almost $0.5 million. Can you give us any guidance as to what -- how the amortization of the intangibles will worldwide over the next several quarters?

This is something that we cannot give any guidance. It depends on many factors.

That's the best I can save this moment.

Surely you must have reviewed all -- reviewed the intangibles and gone through them and have some idea of whether it's going to be $50,000 dollars or 10 times that much over time, no?

First of all, the total amount of the intangible assets is currently approximately $5 million. All of that is -- most of that is connected to the two acquisitions we made a year ago and two years ago.

On top of that we have the contingent consideration which is the amount we amortized over the quarters. The total amount of that is $5 million.

All of that is connected just to the last acquisition of ADI. So the speed of the amortization and the amount of the amortization each quarter is not something that we can predict in advance.

This is something that we have to evaluate every quarter and to make the necessary adjustment. Again, the total amount is $5 million.

All of that is connected to one acquisition, only to ADI, Fiberblaze is no longer relevant. That's my answer.

All right. Well, thank you.

Thank you very much then.

Thank you.

Yes. Hi.

Good morning. Just curious honestly you're talking a lot about 2017 in your prepared remarks, as well as in the press release.

And it seems like if I have a little bit better sense of what's going on your customers and possibilities for upside in 2017, especially with your inventory the way it is. You guys usually manage inventory very well.

The first thing you highlighted it’s so high because possible upside. I guess my question is that as you look forward to 2017, do you feel comfortable that you're in a double-digit growth rate or can even close to 20% growth rate, not guidance per se, just based on what you're seeing?

Well, let me just say that, yes, I feel quite confident about the double-digit growth in 2017.

And do you feel that based on what you're seeing in terms of some of the customers that you've worked for a very long time, I know specifically one customer, you know, you were designed out of a project? Are you starting to see some of those customers come back and possibly redesigned you in to some of these very big projects?

Well, I could just simply say yes, but this would not provide a full picture because we never give up. And we're always wanted….

Why don’t you provide a half a picture, what happened?

Yeah I'm trying to give you some sort of the picture. And the picture is that we are in the process and I believe that we're moving forward.

No, I'm not -- I don't want to speak specifically about any certain customers right now. But there are a lot of processes going on and we are trying to get back this win that we lost a while ago.

And this is a process that we're moving forward with as well. It is not only one.

I mean, there are several things happening which combined together is what made me respond to you so simply by saying yes, I do see a double-digit growth in 2017, and that's -- what you were describing before is a part of that.

Okay. And terms of your big customers, can you just give us percentage of having to customers with this quarter?

Yes. We have two large customers.

The first one is about 20% of our total revenues. And the second one is approximately 10%.

And Shaike, last one for me. Any sense of how margins could trend if your growth continues to this level?

I mean, obviously, you hit a lower gross margin beginning of this year, but now you are picking up again.

I think that the information that we provided you about strategically deciding that we're willing to somewhat reduce our gross margins in order to penetrate some other markets, this is still in place. Now over that we do have the mix of products and obviously we're trying to make ourselves still even with then what we provided you in the past look at the highest level of margins.

I would say that we're looking at 38% to 40% right now, mostly that is more or less the range that I think that we're playing. I think that we have some -- we were able to have some significant successes in cost reductions, while at the same time obviously there are some price pressures as well.

In general, I would say that we are somewhere between 38% to 40%.

Thank you. It seems to me this opportunity in the SD-WAN space is rather significant, I thought the news of Personal Networks was an important news announcement for you?

Can you give us an idea of the magnitude of this marketplace and maybe the size of the addressable market it looks like a new opportunity for you?

Well, I don't have a specific numbers that I can give you as to our market, because -- I mean the data that is available in the market, in general, is data which includes the service and the software at desk obviously our -- what we deliver is only a part of that. However, that being said what we're seeing is that, I would say, all service providers around the world are running to propose this service and offer SD-WAN and offer the service to their customers worldwide.

And with the opportunities that we're having right now the numbers that we're seeing are indeed very, very significant. So, I mean, the business model is somewhat different and we're still learning that because -- I mean both business models are coexist, I would say, together in this market.

One business model is still the model of OEMs, we sell to OEMs though, we haven’t sold -- sell our hardware together with their software to the service providers who offer that to end-users, that's one business model. And the other business model, at least partially represented by the agreement with Versa is that they actually introduced us to the service providers and then we go directly after the service providers.

But when we're listening to each of them, so -- they're telling us, well -- each of these guys I mean, the Versa type of guys is talking about tens of thousands of units and we're having prices of, let's say, a few hundreds of dollars for each of these. And so I definitely agree that it is -- that it could become very significant and huge opportunity.

But we are at the beginning of this process. This is a very hot market, but it is at the beginning so which will take some time for that to wrap up and some time for us to better understand and be able to quantify it and say, well, okay, we're going to sell like that or like that.

I am a little bit hesitant to say I am not sure whether this is common to say, but I would say, I am not sure that I know everything right now about how this market behave. We are at the beginning of a huge wave.

This is what I feel about that, and that's why we're investing a lot in it.

Okay. Great.

Thank you.

Yeah, I just want to go back to the R&D line and I didn't -- I don't think I caught the headcount on the quarter. But on the R&D line obviously stepped it up.

It sounds like you've got a fair amount of investments that you want to do for the SD-WAN space in particular. Is that a kind of a new run rate?

What should we be thinking about that as we go out into 2017?

I think what you're seeing right now is more or less the run rate, that you would see in 2017. You may even see somewhat more in 2017, not nothing dramatic but somewhat more you would be able to see in 2017 as well, I believe.

So, like a 5% or so increase something in that's order.

Yeah.

Okay. And going down to the headcount, can you tell us what your headcount was in the quarter?

And what you think you're hiring is going to look like this quarter?

The headcount in the quarter was very, very similar to the first quarter, approximately in total 240 employees.

And flat again in the fourth quarter then?

Can you repeat the question?

Well, I mean, there may be some -- we didn't hear the last sentence. But I think that previously you asked about our plans for hiring more in the fourth quarter.

And I would say that, yes. I mean, I believe that there are two or three persons right now that we're planning.

But this -- I mean -- what we're doing right now is nothing significant as we're making all of our preparations for next year which we believe as I have said before that it's going to be another year of growth. This is overall planning.

Again -- and you would see some more recruits during 2017.

Come back to the SD-WAN opportunity, the Riverbed just disrupt their launch. They were describing that is potentially the largest driver of a new technology platform in the recent history of the networking space with potential to significantly display same POS [ph] given the MPLS router market is $10 billion market, and this potentially could disrupt that dramatically.

Do you think that that will come on quickly, or do you think that the ramp will take time? Or what do you think the slope looks like there?

We've seen some pretty aggressive programs from virtually every one of the service providers with a number of the customers that you have already cited or obviously have in hand.

Well, I can only tell you that the guys that we're talking to they are saying that it will happen relatively quickly. Based on -- of being in the industry I am always a little bit hesitant and I am saying that it will not happen as quickly as they're saying that it would which is why we're may be more careful.

I don't have first hand information that I can share with you because we are not very close to the end user in the food chain, in the food chain we are the suppliers to the Riverbed of the worlds. So we know what the Riverbed of the worlds are telling in most cases, and they're saying it's going to happen quickly.

Whether or not it would really happen quickly or not they know better than us and their customers know better and they do, so we are at the bottom of the food chain in that regard.

All right. So, I think Versa’s talking about a four to five x increase in 2017 versus 2016 and Riverbed was talking about a 60% savings versus traditional MPLS architectures.

So it seems like it should ramp pretty quickly. Anyway thanks for the answer.

One last question. Can you give us any sense what you're thinking is on the tax rate for 2017 at this point?

Yes, I believe it will be quite similar to 2016, which means approximately or in the range of the 14% to 15%

Okay. Thank you.

Yes. Thank you, operator.

Thank you everybody for joining the call. We look forward to hosing you in our next call in three months time.

Good day.