Napatech A/S (NAPA) Earnings Call Transcript & Summary

Hello, and welcome to the Napatech 2020 half yearly report. Dear speakers. Please begin.

Good morning. I'm pleased to welcome you all to Napatech's First Half 2020 Half Year Report Presentation Webcast. I'm Ray Smets, CEO of Napatech. I'm located in Copenhagen today and joined by Heine Thorsgaard, our Chief Financial Officer. Today's half year report for 2020 was released earlier this morning on the OSE and is available on the Investor Relations page of our website at napatech.com. For your information, a recording of this webcast will also be available on the Napatech website as soon as possible later today. Given the current situation of the global pandemic, I truly hope all of you are staying, well, I'm happy also to report that our Napatech family is also well and staying healthy. Next slide. Although our webcasts aren't always super interactive, we want to be open to your questions, whether live directly following our presentation today or any time via e-mail. We will conduct a Q&A session following our presentation. If you would like to participate. [Operator Instructions] Next page. Please note that this presentation contains forward-looking statements and are subject to a number of risks and uncertainties. Our actual results may differ from those discussed in forward-looking statements. Next slide, please. During this presentation, I will present our first half 2020 business highlights, including a summary of our key financial achievements. I will also provide an update of how Napatech is doing within the SmartNIC market and what we have strived to do in the last quarter to be positioned for growth. As always, Heine will provide a detailed review of our first half and Q2 financial results, and then I'll close with our expectations and about our 2020 outlook for our business. Next slide, please. Business highlights. Despite the unusual circumstances we've had been dealt in 2020, impacting our global economy, Napatech has been a reset of positive news, and we plan to keep it that way. We had an exceptional period in first half 2020, crossing a few important thresholds around growth and profit long before we guided to do so. In regard to revenue, we maintained our momentum through Q2 and delivered solid growth of 25% during the first half of 2020. This is compared to what was a solid start in first half of 2019. We built revenues as promised on a solid foundation that we established last year, and we are growing 2020, one brick at a time. We're also laying the bricks in such a way to support growth in 2021 and beyond. Growing good revenue is the lifeblood of a prosperous business, we know this. So we consider this to be our #1 priority. We know we need to deliver good results across the board to be a respected investment. We racked up another good quarter in Q2 when it comes to gross margins of 75.2% and 72% for first half 2020, but the story only starts there. We had best ever free cash flow in first half 2020 compared to past half year periods, and we again delivered positive and growing EBITDAC and a positive earnings for the first time ever. We know that solid revenues, growth, good cash management and managing our operating expenses will equate to profit for our shareholders. So we thought we would deliver a bit of good news to brighten your summer. Next slide, please. To put some additional context around our first half 2020 results, the trends tell a story worth noting. Reported revenue in the first half were the best first half revenues for Napatech over the past 3 years. If we consider the cost structure and the activity in the market we're seeing today, management at Napatech considers our financial situation now to be the best compared to past periods. To further underscore the obvious news on the right side of this chart, the dramatic growth in positive free cash flow thickens the plot for the story you'll see on the next page. Quality revenue growth built on a solid foundation, progressive product strategy with an eye on growth, combined with good operating structure, is part of the plan to build the leverage that we've been promising since early last year. After a full year of positive free cash flow in 2019, which was a first for Napatech since we went public in 2013, we delivered a positive bump in free cash flow again in the first half of 2020 and well on our way for a full year 2020. Next slide, please. Here is where you begin to see the next part of the story unfold. In the first half of 2020, we delivered best ever EBITDAC performance, which is a sign that we have the right investment strategy to manage today's costs and build our future products. And the cherry on top is positive earnings. How is that for a surprise end? Considering where we have been in the past, we are proud of this achievement. All in all, our performance in the first half of 2020 delivered better than we promised. We planned and we executed and despite the global pandemic, we focused on the goal, but we are committed to keep up the good work because this is what good focused execution looks like. Next slide, please. We are still not out of the woods with the potential impact that COVID-19 might cause. Our preparedness and progress so far is a sign of our ability to stay focused and execute. First, in terms of our most important asset, our employees are healthy and productive. After Denmark loosened its shelter in place restrictions in late June, we carefully moved into a phase of bringing employees back to our work location in Copenhagen. We can work remotely and productively, but safely working together in the office as a team, doing what we do best as a team of engineering and operations people work together, is a positive. And there's a real buzz here in the office. If we have to move back to remote work conditions, we will be fine. In other parts of the world, we remain on a mandatory travel restriction policy I have set in the past for sales and marketing, and we've been very productive closing business and delivering products to customers. Our supply chain and manufacturing are well-managed too, and we do not anticipate any issues as we move through the second half of 2020. In other words, we haven't missed a beat. Secondly, our customer markets are doing what they have to do to respond to the pandemic to be viable long term. In general, our customers are spending budgets to transform their businesses in response to the new normal, boosting network capacity, relying more on applications that conduct business internally and externally. Our solution suits the needs of their shift in response to the pandemic. We still believe the impact to our business is low-risk at this moment. Our key target markets, including telecom, mobile, network infrastructure, cloud and edge providers, network monitoring, cybersecurity and financial services companies have demonstrated resiliency implementing digital transformation projects where we can assist. We are not immune to the negative impacts that may occur from the pandemic or, worse yet, a potential second wave, but we do generally see a tailwind from the overall impacts to the market. As such, we remain cautiously optimistic about our updated annual guidance for 2020 that we'll talk about later. Next slide, please. I like to show this slide every quarter. It delivers a lot of real and positive data about our business. All of these logos at the top of the slide represent customers from all over the world that ordered Napatech FPGA-based SmartNICs in Q2 alone. Below those on the right bought products from us specifically in Q2, while the logos on the left are customers who bought Napatech products in the prior quarter, too. As always, you see large existing customers like Cisco, IBM, Corvil, Polystar, Facebook, Morgan Stanley, Citadel, Nokia, Airbus and TOYO Corporation, who bought from Napatech quarter-over-quarter. The other logos on this slide are either new or existing customers who purchased in Q2 also. Some of these are notable customers buying for new projects like the U.S. Army, the Japanese Ground Self Defense Force, or Lenovo, just to name a few. Several of these customers are beginning new projects with us using our core products as well as testing our new products. They span use cases across key markets like cybersecurity or network monitoring, infrastructure, cloud and edge, mobile and financial. We expect that these customers will continue to buy more products as they deploy more servers in their data centers for the key use cases we help them solve. The key trends leading these customers to Napatech are that they do not compromise on performance, especially SmartNIC performance, and we deliver. Some are interested in our virtual switching solution, and we hope that they will bring us into the mainstream deployments once they fully tested our solutions in their labs. And others on this list are explaining -- are expanding their data centers or deploying new mission-critical applications that need the horsepower that we provide, and they are all satisfied with Napatech. Next slide, please. Now let's turn our attention to the broader market, how we are emerging and how we are working to expand within it. Next slide, please. Napatech sits at the crossroads of 2 major market forces. On the bottom of this slide is our physical addressable market, where networks are built at massive scale on low-cost commercial off-the-shelf servers. In every one of these servers, network interface cards or NIC cards must reside. It is the SmartNIC, which is what Napatech designs and sells to be deployed in these servers that delivers the high-performance and the value to accelerate applications that need the extra horsepower. At the top of the slide is a growing set of critical applications across a spectrum of areas, cybersecurity, network monitoring, financial services, mobile or in the cloud and edge. These application areas require more and more commute -- compute power to operate and perform faster and securely. The demand for higher performance compute for these applications create demands for SmartNICs. Napatech sits at the position where these 2 markets intersect. Our position is to play at the high end of this market where FPGA technology is needed to run those mission-critical compute-intensive applications faster, more efficiently and more securely with unmatched performance. That is where Napatech will focus its expertise to catch and grow future revenues. So where do we fit in the overall NIC market? Let's talk about that. Next slide, please. I've said before, not all NICs or network interface cards are created equal. According to the industry experts, the total NIC market is expected to exceed $2 billion this year. And these experts have been dividing the NIC market into 3 major segments. The basic NIC market, which is the low-cost, low-margin part of the market that offers a basic fixed function NIC with no programmability mostly used to connect service to networks. The offload NIC segment is slightly more expensive and provides a simple offloading function but offers very little in the way of flexibility or application acceleration and often target specialized areas. And then there's the programmable NIC segment. Which is where the premium-priced high-performance solutions reside, focused on ultra high-performance and functionality and with the ability to be reprogrammed to meet the needs of the ever-changing and faster-growing mission-critical application landscape. We are addressing the market mostly in the programmable NIC parts of the market and to a lesser extent, the offload part of the market. Napatech was pleased to be reported as a top 10 player in the overall NIC market in 2019, as reported by Omdia in their most recent industry report. We are certainly in good company with big brand companies on the list. Although our market share is small compared to some of the big guys like Intel, NVIDIA or Broadcom, we have emerged as a nimble specialist that has proven world-class and renowned ability to serve the highest performing needs in the network application acceleration market space. Now let's take a closer look at the programmable NIC segment, especially. Next slide, please. Leaving the other NIC segments aside for just a moment. Let's focus on the programmable NIC market. It is a combination of two kinds of companies. There is one large self-build player, namely Microsoft, who up to this point, just doesn't buy commercially and prefers to make their own programmable NICs for themselves and for their own use. The other kind of company on this chart are vendors who make SmartNICs for companies to buy and deploy. That's where we exist. In this part of the programmable NIC segment, Napatech ranks #3 amongst the vendors. From an FPGA perspective, Microsoft is the largest consumer of FPGA-based SmartNICs, but given that they're self-build, if we exclude Microsoft, Napatech is the largest vendor making commercial SmartNIC technology with FPGAs from both Intel and Xilinx. So we're pretty well positioned to grow in this fast-growing emerging market. We're very pleased with our results. In this report. Next slide, please. Taking a step back to put all the numbers of all the segments into perspective, you can easily see the relative size of each of them. Take special notice of the programmable NIC segment in orange at the top of each of these bars. As reported by the industry experts, it is today, the smallest of the 3 major segments of the NIC market, but expect it to grow and be the largest in just a few years, with a 45% CAGR from 2019 to '25 and where it is expected to be a $2.2 billion market within a $4.4 billion overall NIC market. This market is growing due to increased spending by target customers, like those that we're already doing business with who need products we are developing and deploying, winning new designs and building pipeline, growing partnerships and expanding channels to get access to more and more customers. The added value of being in this market is increased visibility by industry analysts to track and report progress in the space like Omdia who published this report. No one really knows what the mix in this market will look like over the next 3 to 5 years, but it is growing, so this creates space for us at Napatech to grow too. This is a great market for an industry player like us to thrive. Next slide, please. So how does Napatech grow within this fast programmable NIC market? In an oversimplified way, we want more SmartNICs like those little cards on the slide. Those are the things that we build to be deployed in as many servers, the big box on the right of the slide, as possible that are used to solve network application acceleration solutions that we are targeting. We will design SmartNICs that deliver network application acceleration solution in the cloud and the edge, 5G mobile, cybersecurity and financial and now the virtualized switching customer application segments. Our solutions will keep getting faster to serve the growing demand that comes from increased network speeds from 25-gig to 100-gig and beyond. And if we do our job, the investments by our customers will be justified because we will improve the TCO of the data center by making servers more powerful. That way, the data center needs less servers to do the same work, lowering cost to power and condition them and reducing overall cost to deploy and operate. It's a pretty good proposition for customers. Next slide, please. In Q2, we announced our new product called Link Virtualization, which is the centerpiece of our new product strategy. We are bringing our expertise to solve a new and growing problem as networks are increasingly deployed in virtual networks. On servers and data centers. Our product solution is a new breakthrough in SmartNIC software that focuses on accelerating a virtual switching application called OVS, which is a mission-critical application in next generation networks for cloud service providers, 5G mobile, telco and enterprise networks. The way it works with our software, running on our Napatech FPGA-based SmartNIC, just like the NT50 SmartNIC, we also announced in Q2, the little silver NIC that you see here on the slide. The customer accelerates the OVS application with our SmartNIC, giving back the expensive server CPU horsepower, so that they may be used for other applications or networking and reduce the overall total cost of the network, the virtual network deployment. The benefits of this new product are increased performance, improved efficiency, greater scalability in the smallest, most flexible, most energy-efficient SmartNIC with the newest FPGA chip that we have delivered ever. Next slide, please. And another key expansion to our solution for customers, especially end-user customers who use our solutions and mission-critical deployments, we officially announced our Link-Assure premium professional services product. In the most basic terms, we intend to access a latent opportunity for Napatech to sell and renew recurring maintenance for our more recently purchased and deployed hardware and software solutions, providing support and hardware replacement options, developing a new recurring revenue stream for the business. As we gain momentum with Link-Assure, we also endeavor to expand our offerings to increase the professional services some of our customers need to assess, integrate or install their new Napatech solutions. Next slide, please. So in summary, from a market and product perspective, we have been staunchly focused on a three-pronged plan of attack since 2019 and into 2020. It is the basis of our growth strategy focused on our unique core competency, leveraging our expertise in FPGA software, building new growth product lines and application acceleration for virtualized networks and cybersecurity solutions. We have been making good progress in all 3 of these attack vectors. The first is built on our FPGA-based SmartNIC leadership, which is our current packet capture solutions. This part of our business is rich with opportunity and remains a stabilizing foundation for growth now and in the future. Second, we are evolving our SmartNIC leadership in packet capture to address new higher growth areas for our in-line use cases, including cybersecurity applications like next-gen firewalls. We are essentially supercharging our FPGA solution for new firewall applications here. Thirdly, we have worked hard building an innovative approach to accelerate virtual switching in order to find ways to emerge in new opportunities in the edge, cloud computing and the 5G mobile space. Next slide, please. Let's get into the financial details. Now I'd like to turn the call over to Heine Thorsgaard to review more details about our first half 2020 results. Heine?

Thank you, Ray. Slide 21, please. Revenue in Q2 was up 23% to DKK 48.9 million compared to DKK 39.6 million in Q2 '19. For the half year, revenue was up 25% compared to last year, amounted to DKK 97.4 million. Gross margins in Q2 ended at 75.2%, up 2.6 points compared to Q2 last year. Gross margins in first half of 2020 was 72%, up 0.9 points compared to last year. Gross profit in Q2 grew 28% compared to last year and 27% for the half year. Staff costs and other external costs amounted to DKK 27.5 million in Q2 compared to DKK 30.2 million in Q2 '19. For the first half of 2020, staff costs and other external costs amounted to DKK 61 million compared to DKK 61.7 million last year. EBITDA in Q2 amounted to DKK 9.4 million compared to negative DKK 1.7 million in Q2 last year. And EBITDA for first half of 2020 amounted to DKK 9.5 million compared to negative 3 -- DKK 6.3 million in the first half of '19. Staff costs transferred to capitalized development costs in Q2 amounted to DKK 2.4 million compared to DKK 2.8 million in Q2 '19 and DKK 6.2 million for first half, the same as first half last year. EBITDA in Q2 amounted to DKK 11.8 million and EBIT amounted to DKK 5.9 million compared to EBITDA of negative DKK 1.1 million and EBIT of negative DKK 5.1 million in Q2 last year. EBITDA in the first half of 2020 amounted to DKK 15.7 million, up DKK 15.8 million compared to last year and EBIT amounted to DKK 4 million, up DKK 16.8 million compared to last year. Slide 22, please. Net cash flows from operating activities in Q2 amounted to DKK 14.7 million compared to DKK 7.1 million last year. For the half year, net cash flows from operating activities amounted to DKK 18 million, up 61% compared to last year. End of Q2 2020, net working capital was DKK 13.6 million compared to DKK 14.7 million end of Q2 '19. Net cash used in investing activities in Q2 amounted to DKK 2.5 million compared to DKK 2.9 million in Q2 '19. And for the half year, net cash used in investing activities amounted to DKK 5.8 million compared to DKK 6.5 million last year. Free cash flow in first half of 2020 amounted to DKK 12.2 million compared to DKK 4.7 million in first half '19. Cash and cash equivalents end of Q2 2020 amounted to DKK 69.9 million compared to DKK 59.9 million end of Q2 '19. Now back to you, Ray.

Okay. Thank you, Heine. Next slide, please. Now let's turn our attention to our revised outlook for 2020. Next slide. We have carefully assessed our situation as 2020 matures with a respect to business momentum, the realism of the changing nature of the pandemic in the world market and our ability to execute on our goals. Therefore, we're making some notable changes to our stated guidance for 2020. Firstly, with the backdrop of the changing foreign currency exchanges, such as the recent drop in the value of the USD against the DKK, we reiterate that we expect revenue to be in the range of DKK 185 million to DKK 205 million, which guides about 20% growth on the high end of the range. We believe it is good to maintain this expectation despite the fluctuations in foreign exchange, which affect this outcome. If you take the latest foreign exchange fluctuations of USD into consideration, without changing our prior guidance in DKK, it is equivalent to an underlying raise of the revenue guidance in U.S. dollars, where prior U.S. dollar guidance at the beginning of 2020 was $27.2 million on the low end to $30.7 million on the high end, to $28.3 million on the low end to $31.4 million on the high end. Also, we are updating our gross margin guidance to be 70% and 72% for the full year 2020. We are focused on cost optimization and maintaining our product value in the market. We are also updating our guidance on the operating expenses in 2020 to deliver a narrower range of between DKK 120 million and DKK 125 million. We're doing pretty well here, and we're building the leverage we intended to build in our earnings for 2020. Additionally, we are updating our guidance on transferred capitalized development costs, showing that we are doing well with an updated guidance range of DKK 13 million to DKK 18 million. Lastly, we reiterate our prior guidance for depreciation and amortization in the range of DKK 20 million to DKK 25 million. With performance in the middle of these guided ranges, EBITDAC would be DKK 16 million, up from the previous guidance of DKK 6.5 million. EBIT would be DKK 8.9 million up from the previous guidance of DKK 1.5 million, delivering and exceeding the promise of positive earnings for the year. As we've stated earlier, we remain vigilant about the impact being felt across many of the markets today due to the COVID-19 pandemic. We have shown what good planning and execution looks like in the face of these turbulent times, and we will strive to do the same in the second half of 2020 as well. At this time, we believe we are managing our business impacts well, and we have low-risk for Napatech to fulfill its goals in the second half of 2020. Next slide, please. In conclusion, investors are looking for growth companies that have what it takes to be viable and deliver results for years to come. Striving to be that kind of company, deeply rooted in what we do best, building FPGA-based SmartNIC solutions that solve real-world problems today, accelerating applications and improving the economics of the data center. We have delivered a combination of stability, growth and now earnings, and we hope our investors are feeling rewarded for the work that we've done to attain it. But we're just really beginning. Our new investments will expand our potential into new parts of the market that we know pretty well. We will work hard to assess and access that market and grow within it, all making smart decisions, earning our customers' trust in delivering results that our investors are willing to invest in. You can be assured that with the team of technology professionals that we are, we really do strive to improve our spot in the business world. We're solving real-world problems that just won't go away, but they're solved with the technology and the expertise that we bring to the market. And in doing so, we build a good prospect for investment for you, our investor. And we will always strive to give you a realistic view of what we can achieve. And then we're committed to go find a way to beat it. So now we just need to get the job done. Next slide, please. And now I'd like to invite Heine Thorsgaard to join me to take your questions. [Operator Instructions] Operator, do we have any calls in queue?

[Operator Instructions] First question comes from Anders Knudsen.

It's Anders Knudsen from SEB. Two questions. You talked about TCO on Page 16. I don't know whether it's possible for you to add any numbers in terms of how much you can actually lower the TCO for your clients? And then a bit more trivalent one. On the guidance, thank you very much for the updated numbers, but as you also focused on during the presentation, free cash flow, how do you think this guidance should translate into free cash flow for 2020, please?

Anders, thank you very much for your question. So I'll kick off the first one regarding TCO. I'm glad that you picked that up. One of the value propositions we offer our customers is to reduce the overall cost of data center, but there's a very large variation in terms of what that computation can look like based on either the application that we're accelerating. And the level of performance we can get from this application. So it's a little bit of a different -- difficult question to answer with a nice bow on top because it really depends on the application and the deployment strategy. But I can tell you, rest assured that the reason why we're making progress in the marketplace is because the performance we provide on the SmartNIC does offload the server CPU, and the end-user customer basically benefits in terms of reduced number of servers, reduced power, reduced energy consumption, reduced cooling, reduced floor space and greater performance of their servers. So it's a bit of a complicated equation, but it results in good end user sales. I hope that answers your first question to some degree. And your second question, we've had a couple of questions come in also online regarding the same subject regarding our guidance and the strong free cash flow that we've had and whether or not we're actually establishing the right level of guidance given the current circumstances. So basically, what I've just reported in our results, is we've not been accused as a team that is overly optimistic. We tend to take a very realistic posture. In terms of second half guidance, Q4 and, to some degree, Q3 tend to be a little bit harder to establish visibility around. Although we're very optimistic about our approach and our progress going into the second half of the year. But we do have a couple of things that are weighing in our favor and against us as well at the same time. We mentioned that foreign exchange has dramatically shifted over the last 60 days. We're not exactly sure how that will continue to shift over the second half. So we should maintain a very prudent position. We didn't change our DKK guidance, our guidance in DKK because if you do the foreign exchange on USD, which is where -- we do business in USD primarily, we noted that there would be a difference in USD production to produce the same DKK guidance. The numbers that we quoted was in the old -- and with the prior foreign exchange, the range would be in U.S. dollars between $27.7 million and $30.7 million. With the updated foreign exchange for USD to DKK, the U.S. dollar production would have to be somewhere between $28.3 million to $31.4 million. So we feel pretty confident about the second half, but we also feel like it's prudent, given the changes in foreign exchange that we maintain a more realistic posture on what that may look like. And we can also minimize the issues around COVID-19 and what may come from that. We feel like we have that in very good order, where we consider it to be low-risk in the second half. So we think that the guidance, reiterating the guidance with the current range is the right thing for us to do.

Absolutely. But -- and I completely sympathize with the way that you're phrasing it. However, the EBITDAC -- is that the best way to look at the free cash flow? Or is there anything here that we should think that this should deviate from the DKK 16 million that you're currently guiding at the mid-range.

I'll give it on the -- yes, you're right. EBITDAC is very close to our free cash flow expectations. So in the way of what to expect from a free cash flow perspective, looking at the EBITDAC that we've communicated around would be a fairly good estimate. So that's also the reason why we are -- we've been communicating a lot around the specific key performance figure.

Thank you. We have no further audio questions. Dear speakers, back to you.

Okay. We do have a couple of other questions that have been texted in. So we'll take the second question here. The question is, see, given the -- let's hold on the -- what are the key drivers behind gross margin, and given the strong first half margin, what should investors expect for, say, 2020 and beyond? And I'll let Heine take the first part of that.

Thank you. Basically, our margins vary from quarter-to-quarter due to changes in the product mix. SmartNICs with more software features on them have higher margins. And when we ship SmartNICs with fewer software features, that brings lower margins with it. So we have this change from quarter-to-quarter related to the product mix. As we also communicated on our Capital Markets Day last year, going forward, we are expecting margins to be around 70%.

And just as additional information on that one that I think is worth noting is gross margin, in addition to managing the cost of our product, it is also a very good indicator of the value of our product in the marketplace. So we're getting growth without having to discount our weight to success. So I think that's a very strong indicator to the value proposition that the company provides with its FPGA-based SmartNIC. The next question we have online is the last question, I see. None others have been texted in, but we'll still wait if any others come in. This question -- there's 2 questions in the same subject. Has there been any M&A interest concerning Napatech, if so please elaborate, what are your thoughts on M&A generally speaking? And a related question regarding the solid financial backbone we're building with the free cash flow capability, is it possible for us to consider some consolidation in the SmartNIC market? So from an M&A perspective, our posture is very, very simple. We're focused on organic revenue growth and long-term value creation. We think that that's the best posture to take in this industry. And you've seen the results of that approach in the marketplace. We also have to realize that the industry is consolidating at certain points. There has been some M&A activity out there. And we're going to remain very involved, and we're going to maintain a very savvy posture about what's happening in the industry as to whether or not there's opportunities for us, in any way, shape or form, to create value for the business. So when we get to that point, we'll certainly make that known to our investors. But at this point in time, we're focused on long-term revenue and value creation. I think with that, that is -- that are all the questions we have. I want to go ahead and thank everybody for participating in today's call. And thank you to our existing and long-term investors for your support. I would like to also give our employees a hearty thank you for an amazing job in the first half of 2020. And I look forward to your questions on e-mail or other forms as we go forward. So don't hesitate to ask any questions if you have them about our business, we'd be happy to answer them. And I'd like to wish everyone best of health, and have a good day.