SILICON LABORATORIES INC. quarterly report, Q2 FY2018

Business context and reporting period

Silicon Laboratories Inc. filed this unaudited Form 10-Q for the second quarter of fiscal 2018, ended June 30, 2018; the comparable 2017 quarter ended July 1, 2017. The company designs mixed-signal integrated circuits and software for IoT, infrastructure, broadcast and access markets, and relies on third parties to manufacture, assemble and test its products.

Financial performance

Amounts below are in millions of dollars, except per-share data and percentages.

• Q2 revenue rose 14.2% year over year, while operating income fell about 14% and net income fell about 14%. For the first half, revenue rose 14.5%, operating income about 24%, and net income about 27%.
• IoT revenue was $116.0 million in Q2, up 18.7%; Infrastructure was $51.5 million, up 34.8%. Broadcast revenue declined 6.8% to $34.2 million and Access declined 12.0% to $15.4 million.
• Q2 gross margin improved by 1.0 percentage point, principally on product mix, including a higher proportion of Infrastructure products. Unit volumes increased 16.9%; average selling prices declined 2.5%.
• Operating expenses rose to $113.3 million in Q2 from $92.3 million, driven by personnel, legal costs, acquired-asset amortization and new-product costs. Q2 operating margin was 8.3%, versus 11.0% a year earlier.
• Six-month cash provided by operations was $50.8 million. Cash and cash equivalents were $194.9 million, short-term investments $347.4 million, and combined liquidity $542.3 million at June 30. Accounts receivable was $93.8 million (39 days sales outstanding) and inventory $87.2 million (91 days of inventory).
• Convertible notes had $400 million principal and a $348.2 million carrying amount; they mature in March 2022 and bear a 1.375% coupon. There were no revolving-credit borrowings at quarter-end; the facility provides up to $300 million. The company reported covenant compliance. Stockholders’ equity was $1,028.5 million.

Material changes and unusual items

• The company acquired Sigma Designs’ Z-Wave business on April 18 for approximately $242.6 million in cash. Z-Wave contributed $7.6 million of revenue after acquisition through June 30. The preliminary purchase allocation included $108.5 million of goodwill and $125.7 million of intangible assets. Acquisition-related costs were approximately $4.9 million, with $2.1 million of acquired-inventory fair-value charges included in gross margin.
• ASC 606 was adopted at the start of fiscal 2018 using the modified retrospective method. It accelerated recognition of certain distributor sales. Adoption increased reported Q2 revenue by $7.5 million and net income by $4.5 million, and six-month revenue by $8.2 million and net income by $4.9 million. Prior-year amounts were not restated, so reported comparisons are not fully like-for-like.
• Cash declined from $269.4 million at fiscal year-end to $194.9 million, principally reflecting acquisition spending and other cash flows. Operating cash flow decreased year over year, in part due to working-capital outflows, including receivables and other current liabilities.
• The six-month tax benefit was $3.9 million, with a negative 10.7% effective tax rate, primarily reflecting tax benefits from stock compensation and the lower U.S. statutory rate. Accounting for the Tax Cuts and Jobs Act remained incomplete.

Outlook, commentary and risks

• Management’s Q3 fiscal 2018 outlook: revenue of $224–$230 million, gross margin of 58.5%, operating expenses of $111 million, effective tax rate of 0%, and diluted EPS of $0.40–$0.46. EPS and tax guidance exclude any potential impact from the subsequent Altera decision.
• Management expected R&D expense to increase in Q3 due to headcount and Z-Wave costs, and SG&A expense to decrease in absolute dollars. Fiscal 2018 capital expenditures were expected to be $34–$38 million. Management believed existing liquidity and available credit would cover requirements for at least 12 months.
• Key risks include volatile semiconductor demand and product pricing, lengthy design-in and customer qualification cycles, inventory and forecast risk, dependence on third-party foundries and assembly/test providers, distributor concentration, competition, and potential integration and impairment risks from acquisitions. Distributors accounted for 72% of first-half revenue; Arrow Electronics and Edom Technology each exceeded 10%.
• A Norwegian tax assessment concerning 2013 intercompany pricing could result in approximately $30 million of additional tax, excluding interest and penalties. The company disputes the assessment and expects the tax authority may request approximately $15 million during the 2018 appeal process; an unfavorable outcome could materially affect results.
• A patent suit filed by Bandspeed in June 2018 alleged infringement of eight U.S. patents; the company intended to defend itself, but could not predict the outcome or financial effect. A Z-Wave-related stockholder lawsuit and the Delaware Cresta patent case were dismissed; a separate Cresta matter remained stayed.
• On July 24, 2018, the Ninth Circuit reversed the Tax Court decision in Altera concerning stock-based compensation in intercompany cost-sharing arrangements. The company was evaluating the possible impact, which could be material. The filing also notes $6.0 million par value of auction-rate securities with failed auctions and contractual maturities in 2046; their liquidity timing is uncertain.

Important facts for investors to verify

• Whether underlying demand and growth in IoT and Infrastructure offset declines in Broadcast and Access, and whether Q3 guidance was achieved.
• How much reported growth reflects ASC 606 timing changes and Z-Wave, versus organic growth; prior-year periods were not restated under ASC 606.
• Whether operating cash flow, receivables and inventory improve, and whether acquisition integration delivers expected benefits.
• The resolution and potential cash impact of the Norwegian tax dispute and the Altera-related tax assessment implications.
• Any developments in the Bandspeed litigation, acquisition accounting, and the liquidity or valuation of auction-rate securities.