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

Hello, and welcome to Napatech 2021 Half Yearly Report. Today, I'm pleased to present CEO, Ray Smets; and CFO, Heine Thorsgaard. Please go ahead.

Good morning. I'm pleased to welcome you all to Napatech's 2021 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 2021 was released earlier this morning on the OSE and is available on the Investor Relations page on 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 resurgence of the global pandemic we've seen, I hope you're all staying well. We here at Napatech are completely healthy. Next page, please. As always, we want to be available to answer your questions. We'll answer your questions at the end of our presentation via text, which you can submit on the webcast page using the button below the presentation. We can take your questions on the phone if you prefer to. If you'd like to ask a question, follow the instructions on this slide. Next page, please. Please note that this presentation contains forward-looking statements that are subject to a number of risks and uncertainties. Our actual results may differ from those discussed in forward-looking statements. Next page, please. So let's get started. During this presentation, I will present our first half 2021 business highlights, including a summary of key financial achievements and an update of how Napatech is doing within the SmartNIC market. As always, Heine will provide a detailed review of our first half and Q2 financial results, and then I will disclose what our expectations are about the 2021 outlook for our business. Next page, please. Same as in Q1 2021, Q2 and first half 2021 have been on track and as expected, with both growth and profitability. We delivered first half revenue growth of 5% year-over-year in USD against a very strong first half last year. We've been guiding that our growth would be lower in the first half of 2021 due to the stronger compare. We forecasted this because our expectations of timing of revenue from several key large OEM accounts. If we were to remove one of our biggest clients who had a slower start as expected in first half 2021 from our results, the rest of our business grew at 23% year-over-year for the first half 2021. We generated solid gross margins of 71.8% in Q2 and nicely within our guided range. This is a continued validation of our value proposition in the marketplace. On the earnings front, overall earnings were significantly up and growing year-over-year, demonstrating the overall strength of our business from the top line to the bottom line. With these results, we have delivered 11 quarters in a row of year-over-year revenue growth adjusted for the 2018 sale of the underperforming Pandion product line. And we delivered a combination of year-over-year revenue growth and profit for the fifth quarter in a row. One of the key areas we are carefully watching is the general industry supply chain challenge for semiconductors and other vital technology components. We have strived to stay way ahead of this worldwide challenge by prepurchasing hardware components to ensure that we have them in place to support our planned revenue goals in the second half of 2021 and into 2022. So when it comes to free cash flow, which Heine will talk about in a few minutes, we put working capital into action to protect our supply chain, which resulted in negative free cash flow for first half 2021. Although this wasn't expected at the beginning of 2021, we have shown resilience with how we have managed this to the best of our ability. Next slide, please. To provide a little more color using several key metrics, take note of the chart on the left. First half 2021 revenue was USD 15.1 million, which is up year-over-year and up over the prior first half periods. Due to foreign exchange headwinds in the first half 2021 from USD to DKK, we were down in revenue in DKK as a result. However, the same foreign exchange headwinds on revenue were tailwinds for expenses. On the right side, shows that with well-managed expenses, we delivered record earnings, which demonstrates our business leverage and our potential for long-term profitability. We did all of this with another unpredictable year of challenges and distraction so far. All in all, our performance in the first half shows that we delivered as promised, but we are now operating within the new normal. We still have some employees working at home, virtually, and we have a global travel suspension in place for employees unless approved by me for the safety and security of our employees, customers and partners. But productivity is strong, and we are hiring new engineering and sales talent to keep on pursuing the big opportunity that sits in front of us. Next slide, please. So now let's talk about the opportunities that we are pursuing. Next slide, please. Napatech builds SmartNICs, which are the devices displayed in the middle of this slide. They are made to easily plug into any standard server, which are now the fundamental building blocks for all networks, clouds and data centers. These SmartNICs are built with a super powerful, reconfigurable microprocessor called an FPGA, which when combined with our software, accelerates applications across multiple application segments such as cybersecurity, monitoring, infrastructure, Cloud and Edge and mobile. These application areas require more and more compute power to operate and perform faster and securely. The demand for higher-performing compute for these applications creates demands for SmartNICs. But the key strategic advantage to our success is Napatech's software that runs on these SmartNICs that delivers the real value to our customers. The software provides the features that make our customers' software solutions work better, smarter and more securely. But when it's married to our hardware, we add the benefit of FPGA hardware performance to accelerate these applications even further. Next slide, please. So how does Napatech grow within a fast-growing programmable SmartNIC market? In an oversimplified way, we want more SmartNICs that we build, that little card in the middle of the slide, to be deployed inside as many servers, that large box on the right-hand side, as possible. Together, they are used to solve network application acceleration challenges. We design SmartNICs and SmartNIC software that deliver network application acceleration solutions in 5G mobile, the Cloud and Edge, networking, cybersecurity and financial services. Our solutions will keep getting faster to serve the growing demand that comes from increased network speeds, from 25-gig to 100-gig and now pointing towards 400-gig. Our customers benefit with improved TCO in their data center by making servers more powerful. That way, the data center needs less servers to do the same work, lower cost to power and condition them and reducing overall cost to deploy and operate. Next slide, please. In our business, we believe growth is optimized when we engage multiple paths to the markets that we serve. This requires us to build new partnerships to get us there. That is why we've been working hard in 2021 to put the right partnerships in place and then executing them to get them to revenue. As we presented previously, our announced partnership with Lenovo is noted as an important step for Napatech. Lenovo is a top 3 server maker with a long-standing deep relationship with the kinds of customers that we want to get access to. In this partnership, we have been testing our latest solution focused on virtual networking with key end user customers of theirs. We are expanding our newest link virtualization SmartNIC software designed to accelerate apps and services, meeting the most demanding virtual requirements of the 5G mobile telecom operators and Cloud service providers to meet the needs of their target end user customer base. Napatech estimates that the revenue potential of this design win to exceed $10 million over the life of the product once orders begin from their end-user customers. Together with Lenovo, we are fully engaged with several customer testing efforts right now, and our ambition is to achieve a design win potentially in the back end of 2021 and ramping product volumes into 2022 and beyond. Another key partnership we presented is with Silicom, a well-respected industry-leading provider of high-performance networking and data infrastructure solutions. Napatech software will power the Silicom SmartNIC, which is based on the Intel FPGA SmartNIC IPU reference design. This is a partnership to bring Napatech's link virtualization software combined with Silicom's leading Intel FPGA SmartNIC to the market. We continue to work with our friends at Silicom, and we'll work hard to help Silicom target use cases and win new businesses together. Napatech's partnership with Achronix was kicked off a few months ago back around the Capital Markets Day presentation and continues to take shape. We jointly announced a partnership with Achronix to create solutions that combine their Speedster7t FPGAs with Napatech software to deliver the optimal mix of price, performance and power and feature set for SmartNIC designs. Achronix is a leader in FPGA as an embedded FPGA IP, offering high-end FPGA-based data acceleration solutions designed to address high-performance, compute intensive and real-time processing applications. As we get this moving, we intend to create a win-win in an effort to provide a feature-rich, high-performing solution to a growing set of data center -- Cloud data center operators, 5G mobile telecom service providers, enterprise data centers and government agencies. And we expect that this will give us better access to the opportunities that are growing in the hyperscale and service provider 5G markets, needing higher speed from 100-gig and higher. This is a sampling of the efforts we're working on, but not to exclude our long-standing deep relationships we have with Intel and Xilinx too. These kinds of strategic partnerships take time and effort to pull them off. Then it takes time to make them win. We expect them all to be winners for Napatech in terms of new revenue streams in the future, and we expect to demonstrate an initial win in the coming second half of 2021. Next slide, please. As I like to show every quarter, here's a sampling of the logos of customers from all over the world who put their trust into purchasing Napatech's SmartNICs and software in Q2 alone. I've categorized our logos into the key market segments like networking and security, telecom and cloud, government and defense, in financial and technology or other. We had important sales in all of these segments with solid recurring business customers in the networking and security category, including key growing customers like IBM, LiveAction, Viavi, Neox Networks, Artiza Networks and Polystar, just to name a few. This is where speed and security against evolving threats are paramount. On the telecom and cloud side, we, among others, continue to see business with Facebook and we are building business momentum with key service providers like Orange, NTT, Vodafone, Sedmi Odjel and OEM partners selling service provider solutions such as Nokia and Mobileum. In these domains, higher speeds and the need for better performance is driven by 5G, increasing security threats and the need for greater visibility and faster packet processing. I'm also glad to see the business activity in the government and defense segment, which has been a growing focus area for us over the last couple of years with returning OEM customers like Rheinmetall and Axellio, and one of our newest customers SealingTech, all serving the cybersecurity defense market. But also end users and other customers like Airbus Defense, Raytheon, Rockwell, Harris and several of our newest customers, one called Per Vices Corporation, providing high-performance software-defined radios; and the preeminent Pacific Northwest National Laboratory, which is part of the U.S. Department of Energy's Office of Science. In these use cases, mission-critical apps need higher performance with 0 packet loss, but with the greater network visibility and control that we provide with our SmartNICs. In the fintech or other category, we continue to earn business with key OEM customers like PICO, Velocimetrics and Refinitiv and end-user customers like Bank of America, Handelsbanken of Sweden, the Eurex International Exchange and Capital Group, one of the largest investment management firms as well as Jump Trading, which is focused on algorithmic and high-frequency trading. We are also deployed in a use case where many people enjoy their coffee at Starbucks Corporation. Overall, we're pretty pleased with the customer wins in Q2, which is seasonally our slower quarter of the year. And as we build momentum, as the year matures, we're looking forward to the second half. Next slide, please. As we reported before, we like to keep our investors updated on the latest news of the overall NIC market and specifically the SmartNIC market. Our goal for showing this information is to assure our investors that we are approaching a large and growing market with plenty of headroom to thrive and grow. In the latest report showing results at the end of Q1 2021, the total overall NIC market is expected to approach $2.8 billion this year, growing at about 21% year-over-year. This new report reiterates forecasting for 2025 of $5.6 billion. In total, the overall market over this period will grow at a healthy 19% CAGR through 2025. In this total NIC market, Napatech continues to be reported as a top 10 player in the overall NIC market in Q1 2021, and we continue to be viewed as a nimble specialist that has proven world-class renowned ability to serve the highest performing needs in the network application acceleration market. Focusing on the programmable NIC market on the right-hand side of the slide, it's the orange bar at the top of the bar chart. Napatech holds a higher ranking among the growing and evolving mix of companies here. In this grouping, there are 2 kinds of companies. There are the large self-build players, namely Microsoft and Amazon, who up to this point don't buy commercially, but prefer to make their own programmable NICs for their own use. And the other kinds of companies are vendors who make SmartNICs for companies to buy and deploy. That's where we sit and that's where we exist. In this part of the programmable SmartNIC segment, Napatech ranks #6 among the vendors. The SmartNIC market is growing faster than the overall NIC market at 26% CAGR due to increased spending by target customers, like the ones we're doing business with already and other ones that we are targeting. And they need products that we are developing and deploying. We grow in this market by winning new designs and building pipeline, growing partnerships and expanding channels to get access to more and more customers. As we execute our product and go-to-market strategies, we aspire to approach the long-term growth rates of 30% or more per year in this area. We are also carefully tracking the progress in the server market where analysts have been reporting strong performance in 2021 so far. That's great to hear. However, they also report that demand for data center compute would have been much stronger had it been -- not been for the semiconductor supply shortages. These analysts are seeing a strong indication that shortages in the CPU substrate materials and other components are having an impact on the server supply in 2021. We're watching this because our NIC market could be negatively impacted if our customers cannot buy servers that they need to install our products. Next slide, please. Since when I took the role as CEO of Napatech a little over 3 years ago, I promised to keenly focus on our core competencies in building software and FPGA-based SmartNICs. Also with this, we have been executing on a 3-pronged strategy to grow our business, and this strategy has served us well. So just to reiterate, our plan for growth is to focus on our product strategy where; one, we expand our core product revenues with new competitive features; two, we grow new product revenues with new in-line features to access new firewall market opportunities; and three, we gain traction in the fast-growing virtual use cases with addressable market needing apps deployed in a -- as a virtual instance on a virtual machine, such as in the 5G mobile or Cloud and Edge domains. This multipronged approach assures we are building core revenues on a solid foundation and expertise, while enthusiastically building new revenues in areas where we think we can win. Next slide, please. Now let's go to the financial details. I'd like to turn the call over to Heine Thorsgaard to review more details about our second half and first half 2021 results. Heine?

Thank you. Slide 15, please. Revenue in USD in Q2 was up 4% compared to Q2 last year, but due to the weakened U.S. dollar revenue in DKK fell 5% compared to 2020. For the half year, revenue in USD was up 5% compared to last year and amounted to $15.1 million. In DKK, revenue in the first half amounted to DKK 93.2 million compared to DKK 97.4 million in 2020. Gross margins in Q2 ended at 71.8%, down 3.4 basis points compared to Q2 last year. Gross margins in first half of '21 was 70.9%, down 1.1 basis points compared to last year. Our staff costs and other external costs in Q2 amounted to DKK 29.9 million compared to DKK 27.5 million Q2 last year. For the first half of '21, staff costs and other external costs amounted to DKK 60.3 million compared to DKK 61 million last year. EBITDAC in Q2 amounted to DKK 3.4 million compared to DKK 9.4 million in Q2 last year. And EBITDAC for first half of '21 amounted to DKK 5.8 million compared to DKK 9.5 million, first half of 2020. Staff costs transferred to capitalized development costs in Q2 amounted to DKK 5.2 million compared to DKK 2.4 million in Q2 last year and DKK 11.6 million for first half compared to DKK 6.2 million in first half last year. EBITDA in the first half of '21 amounted to DKK 17.4 million compared to DKK 15.7 million last year, and EBIT amounted to DKK 7.6 million compared to DKK 4 million in the first half of 2020. Results for the period and first half amounted to DKK 11 million, up DKK 8.5 million compared to first half of 2020. Slide 16, please. Net cash flows from operating activities in Q2 amounted to negative DKK 0.9 million compared to positive DKK 14.7 million last year. For the half year of '21, net cash flows from operating activities amounted to negative DKK 13 million compared to positive DKK 18 million last year. End of Q2, net working capital was DKK 36.6 million compared to DKK 13.6 million, end of Q2 2020. In Q2, our working capital grew DKK 9.7 million and compared to end of Q2 last year, our inventories were up DKK 17 million. As we've mentioned, we have proactively been sourcing components for some time due to the uncertainty around the supply chain, and this conscious choice is reflected in the net working capital levels. Net cash used in investing activities in Q2 amounted to DKK 3.5 million compared to DKK 2.5 million in Q2 of 2020. And for the half year, net cash used in investing activities amounted to DKK 10.4 million compared to DKK 5.8 million last year. Free cash flow in the first half amounted to negative DKK 23.4 million compared to positive DKK 12.2 million in first half of 2020. Cash and cash equivalents end of Q2 '21 amounted to DKK 38.3 million compared to DKK 69.9 million at the end of Q2 2020. Now back to you, Ray.

Next slide, please. Thanks, Heine. Now let's turn our attention to our outlook for 2021. Next slide, please. We continue to carefully assess our situation as 2021 matures with 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 are reiterating our stated guidance for 2021. We remain committed to our previously published outlook for 2021, where we build near-term revenues and long-term growth. On the revenue front, we expect revenue to be in the range of DKK 210 million to DKK 230 million. As we stated and obviously notable from our first half year results, timing of revenue is expected to be significantly stronger in the second half of 2021 compared to the first half of 2021. We are confident in performing well in the second half of 2021 for several key reasons. First, we have better visibility to our second half 2021 pipeline, and we feel confident that we have sufficient targets and opportunities to deliver on the expectations for second half '21. Secondly, we expect to deliver strong sales performance from direct and channel sales who've reported momentum in each of our key focus areas. And thirdly, we also believe in winning new revenue in the range of $1 million to $2 million from our recently announced Link Virtualization solutions via our announced partnerships, which I reviewed earlier, and we've been building those all year. This kind of revenue does not -- does -- I should say this kind of revenue does take time to develop and build momentum. And we know there are some risks associated with timing. However, the feedback we're getting from these partnerships gives us the expectation that we are within reach of these new opportunities. So yes, we are going for it. We expect gross margins to be between 70% and 72% for the full year 2021, and we continue to focus on product cost optimization and maintaining our product value in the marketplace with ongoing investments and competitiveness of our products. We expect our staff and external costs in 2021 to be in the range of DKK 125 million to DKK 135 million, and we expect transferred capitalized development cost to be in the range of DKK 20 million to DKK 25 million. And we expect depreciation and amortization to also be in the range of DKK 20 million to DKK 25 million. We expect EBITDAC and EBIT to be in the range of DKK 22 million to DKK 30.6 million. With performance in the middle of the guided ranges, EBITDAC and EBIT will be DKK 26.2 million. We remain vigilant about the impacts being felt across many of the markets today due to the COVID-19 pandemic, but we feel good about our ability to execute, and we believe we're managing our business through these impacts of the pandemic well -- as well as possible. Next slide, please. So in conclusion, we are striving every day to build a company that's deeply rooted in what we do best, that's building innovative FPGA-based SmartNIC hardware and software solutions that solve real-world problems today, accelerating applications and improving the economics of the data center. We're looking to unlock opportunities within the expanding 5G networks and supporting the growth of apps running in the data centers. Over the years, we have delivered a combination of stability, growth and positive earnings. And in doing so, we build a good prospect for investment for our investors. Our increased focus on building key partnerships promises to support our goal of expanding into new parts of the market. We will always strive to give you a realistic view of what we can achieve, and then we are committed to find a way to beat it. Next slide, please. And now I'd like to invite Heine to join me to take your questions. [Operator Instructions] Operator, do we have any calls in the queue?

[Operator Instructions] While we are waiting for questions being registered, let's start with the written questions. Ray, please go ahead.

Okay. Operator, thank you very much. I appreciate that. We do have a handful of questions that are texted in. So we'll jump into a few related to our second half visibility. One question is with results reported in the first half of 2021. You have a large objective for second half. Can you further comment on visibility of your pipeline for second half? And another question that I'll combine in here is what do your OEM customers communicate in the second half? If I understood it correctly, you have good visibility from OEMs. Do you see pent-up demand already in Q3? Those are very good questions, and I'll try to cover all of the aspects of that to give you guys a good sense for second half. So as you know, historically, our second half tends to be stronger than our first half. In 2021, it will be no different. We've been reporting that since the beginning of the year, and we feel pretty good that we judged that very accurately. Also, in conjunction with second half being our strongest half of the year, Q4 is our largest quarter, and we're just now getting a better view of what could be possible in Q4 as well. So our pipeline visibility for second half is obviously underway. We're in the middle of Q3 and getting a good look at Q4, and we feel very confident that we have sufficient pipeline and sufficient targets to deliver on our objectives in the second half. We do tend to have a higher dependency on end user activity in the second half, especially in Q4, and that does have a shorter life in the pipeline. So these activities with the end user pipeline activity tends to be a little bit short, and our visibility tends to be a little bit weaker. But so far, so good in terms of what we're seeing as we enter the middle of the second half of the year. And on the OEM front, we do think that we'll be back to more of a standard normal business volume in the second half compared to the first half, as I had commented. One of our large OEM customers had a relatively slow start. So I think from a visibility perspective, we feel pretty confident with what we're seeing in the second half. Sales is reporting positive momentum as we move through Q3. And although nothing is guaranteed and obviously forecasts are subject to change, we're watching and executing this second half very carefully, and we feel very confident about reiterating our guidance. So thank you for that question. Operator, do we have any calls live that we should take? We do have other text messages here waiting.

We have received 1 question over the phone so far.

All right. Let's take it.

Yes. The first question is from Anders Knudsen at SEB.

Two questions. First of all, could you elaborate a bit further about the progress with Lenovo? And then secondly, if you could also, if it's possible, to add some further color to this OEM, as you said, that has been a bit slow in H1?