Arteris, Inc. (NASDAQ:AIP) Q2 2022 Results Conference Call August 9, 2022 4:30 PM ET

Company Participants

Erica Mannion - Sapphire Investor Relations
Charlie Janac - Chief Executive Officer
Nick Hawkins - Chief Financial Officer

Conference Call Participants

Matt Ramsay - Cowen
Ambrish Srivastava - BMO
Mark Lipacis - Jefferies
Hans Mosesmann - Rosenblatt Securities

Operator

Good afternoon, everyone, and welcome to the Arteris IP Second Quarter 2022 Earnings Call. Please note that this call is being recorded and simultaneously webcast. All material contained in this webcast is the sole property of and copyright of Arteris IP and with all rights reserved.

For opening remarks and introductions, I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations. Please go ahead.

Erica Mannion

Thank you, and good afternoon. With me today from Arteris IP are Charlie Janac, Chief Executive Officer; and Nick Hawkins, Chief Financial Officer. Charlie will begin with a brief review of the business results for the second quarter ended June 30, 2022. Nick will then review the financial results for the second quarter, followed by the Company's outlook for the third quarter and full year of 2022. We will then open the call for questions.

Before we begin, I'd like to remind you that management will make statements during this call that are forward-looking statements within the meaning of federal securities laws. These statements involve material risks and uncertainties that could cause actual results or events to materially differ from those anticipated, and you should not place undue reliance on forward-looking statements. Additional information regarding these risks, uncertainties and factors that could cause results to differ appear in the press release Arteris IP issued today and in the documents and reports filed by Arteris IP from time to time with the Securities and Exchange Commission.

Please note, during this call, we will cite certain non-GAAP measures, including non-GAAP net loss, non-GAAP net loss per share and free cash flow, which are not measures prepared in accordance with U.S. GAAP. These non-GAAP measures are presented as we believe they provide investors with the means of evaluating and understanding how the Company's management evaluates the Company's operating performance. These non-GAAP measures should not be considered in isolation from, as substitutes for or superior to financial measures prepared in accordance with U.S. GAAP. A reconciliation of these non-GAAP measures to the nearest GAAP measure can be found in the press release for the quarter ended June 30, 2022.

In addition, for a definition of certain of the key performance indicators used in this presentation such as annual contract value, confirmed design starts, active customers and remaining performance obligations, please see the press release for the quarter ended June 30, 2022. Listeners who do not have a copy of the press release for the quarter ended June 30, 2022, may obtain one by visiting the Investor Relations section of the Company's website.

Now I'd like to turn the call over to Charlie.

Charlie Janac

Thank you, Erica, and thanks to everyone for joining us on the call this afternoon. We're excited to report our continuing momentum in 2022 with annual contract value, plus trailing 12-month royalties of $51.7 million in the second quarter, up 18% year-over-year despite HiSilicon's contract ending in Q2, which removed $3.3 million of annual contract value.

Demonstrating the strength in market demand, our active customers increased by nine in the quarter, while total confirmed design starts were 18 SoC projects. Major new customer wins, including Telechips in automotive, Pliops in consumer and Sunrise Memory in enterprise as well as a leading automotive OEM, leading enterprise hyperscaler and a leading machine learning, artificial intelligence semiconductor company.

Deals in the second quarter were driven by strong demand for Arteris IP across our core markets, including multiple transactions in automotive, consumer electronics, enterprise around data center applications and AI/ML. These were broadly distributed geographically across APAC, EMEA and the U.S. Within EMEA, there was an increase in innovative Israeli start-up wins, including Inuitive for development of next-generation of vision processing for edge devices, robotics, drones, augmenting reality, virtual reality and mobile products.

On the product front, we continue to invest heavily in development of innovative system IP products. In the second quarter, we made a major release of our Ncore cache coherent product to multiple automotive and enterprise customers. With respect to the IP deployment software product line, we partnered with major customers to implement continuous IP block integration flows for new designs and incremental changes, which accelerate their delivery of new SoC platforms and derivative chips. We also delivered a framework for automatic SoC assembly scripting, which rose difficulty in cost of integration for internal design automation groups.

While there are macroeconomic uncertainties, we believe that Arteris IP is well positioned to make progress even in challenging economic environment. We are seeing increased silicon content of electronic systems as they are engineered to be smarter and, in some cases, autonomous. One of these markets is the automotive market, where vehicles are becoming endpoints of a vast transportation network. Furthermore, we see ever higher levels of silicon integration to the point where electronic systems are made up of complex semiconductors on relatively few circuit boards. This is driving system houses to become involved in silicon design at some level, either by themselves or together with partners.

Before turning over the call to Nick, I'd like to mention, in the second quarter, we announced the addition of Claudia Fan Munce to the Arteris IP's Board of Directors. Claudia contributes a wealth of experience which includes a distinguished 30-year career at IBM, where she had various positions, including executive roles in engineering, IP licensing and IBM Ventures. She is also a Stanford University lecturer and sits on the Board of Directors of major public companies.

With that, I'll turn it over to Nick to discuss our financial results in more detail.

Nick Hawkins

Thank you, Charlie, and good afternoon, everyone. As I review our second quarter results today, please note that I will be referring to non-GAAP metrics. A reconciliation of GAAP to non-GAAP financials is included in today's earnings release, which is available on our website.

Total revenue for the second quarter was $14.8 million, up 37% year-over-year, benefiting from higher-than-expected concentration of point-in-time IP deployment revenue. As a reminder, IP deployment deals are largely recognized as point-in-time revenue as opposed to our interconnect license agreements, which are generally recognized rapidly.

Given the variation in revenue recognition methodologies between our product offerings, as a management team, we focus on annual contract value, or ACV, as a leading indicator of financial performance. We define ACV for an individual customer agreement as the total contract fees under the agreement, also referred to as total contract value, or TCV, divided by the number of years in the agreement term. As this calculation does not include the contribution from royalty payments, we also refer to ACV plus trailing 12-month royalties as a metric which provides a more complete picture of our total revenue.

At the end of the second quarter, ACV plus trailing 12-month royalties and other revenue was $51.7 million, up 18% year-over-year, in particular, driven by growth in automotive, consumer electronics, AI/ML, enterprise and 5G communication market segments, and down 2% quarter-over-quarter, reflecting the removal of the $3.3 million ACV associated with the 2019 HiSilicon license agreement, which ended in May 2022. Remaining performance obligations, or RPO, were $55.7 million, up 11% year-over-year as compared to June 30, 2022. We define RPO as the amount of contracted future revenue.

Gross profit in the quarter was $13.8 million, representing a gross margin of 93% compared to $10.0 million or 92% in the prior year period. R&D expense for the second quarter was $8.8 million or 59% of revenue compared to $6.1 million in the prior year period. The increase was driven by continued investment in new and improved product offerings in our five R&D centers across our full product portfolio. Sales and marketing expense for the second quarter was $3.7 million or 25% of revenue compared to $2.2 million in the year ago period.

We intend to continue to invest in sales and marketing as we work to continue to drive awareness of the benefits of our solutions in the market and expand our sales and application engineering force and marketing efforts to harness the significant potential opportunity in front of us. G&A expense for the second quarter was $3.2 million or 22% of revenue compared to $4.6 million in the year ago period. G&A expense reflects a decrease in professional services associated with our transition to being a public company in 2021.

Operating loss for the second quarter was $5.4 million or 37% of revenue compared to a loss of $3.5 million in the year ago period. Non-GAAP operating loss was $1.9 million or 13% of revenue compared to a loss of $3.0 million in the year ago period. Net loss in the quarter was $5.7 million or diluted net loss per share of $0.18. Non-GAAP net loss in the quarter was $2.2 million or diluted net loss per share of $0.07 based on approximately 32.3 million weighted average diluted shares outstanding.

Turning now to the balance sheet and cash flow. We ended up the quarter with $81.3 million in cash. Cash flow from operations was approximately $0.2 million in the quarter, while free cash flow, which includes capital expenditure, was positive $0.1 million, reflecting the benefit of both the previously mentioned IP deployment deals and also the earlier-than-expected collection from a major customer.

I would now like to turn to the outlook for the third quarter and the full year 2022. For the third quarter, we expect ACV plus trailing 12-month royalties of $51.0 million to $53.0 million and revenue of $10.5 million to $12.5 million with non-GAAP operating loss margin of 41.2% to 56.2% and non-GAAP free cash flow margin of negative 41.2% to negative 56.2%.

For the full year, we expect revenue of $49.5 million to $52.5 million, representing a $1.0 million increase at the midpoint compared to prior revenue guidance. ACV plus trailing 12-month royalties to exit 2022 at $48.0 million to $52.0 million, representing a $3.6 million decrease at the midpoint compared to prior ACV plus TTMR guidance, reflecting the removal of the $3.7 million ACV associated with the 2020 DJI license agreement, which ends in December 2022 and some caution on the timing of fourth quarter deals as a result of the current economic uncertainties. Non-GAAP operating loss margin of 24.3% to 39.3%, representing an improvement of 60 basis points at the midpoint compared to prior guidance, inclusive of the increased revenue guidance, partially offset by the impact of wage inflation on our operating expenses. And non-GAAP free cash flow margin of negative 10.1% to negative 25.1%, representing an improvement of 40 basis points at the midpoint compared to prior guidance.

With that, I will turn the call over to the operator and open it up for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Matt Ramsay with Cowen.

Matt Ramsay

Yes. I guess for my first one, congratulations on the results. Nick, it sounds like the software deployment and stuff that's getting recognized sort of point in time is what drove the upside to the revenue. If I look forward into the third quarter and maybe even the implied fourth quarter revenue from the full year, how much of that sort of turns business are you assuming in the revenue guide for the back half of the year? Or is that fairly derisked and would represent potential upside if the turns business actually comes through as it did in the second quarter?

Nick Hawkins

Yes. Matt, nice to speak again. These things come around so quick. But yes, you're absolutely right. As we kind of indicated, a large part, even though in fact, all the business, i.e., the Internet and the IP that belong to the software. And in fact, even some of the royalties were already strong in Q2. The big sort of outperform was really the cadence of IP deployment deals and a certain amount of rebalancing by customers in terms of when they want to place their orders, whether it was sort of Q1, Q2, Q3. And particularly, there was a rebalancing between Q2 and Q3. So yes, big outperform in Q2.

And the reason for the slightly lower guidance in Q3 is because some of those deals were previously slated for Q3 and they came forward a little bit. So there's an element of that, quite a big element further out for the rest of the year. Again, you've got the same -- actually, the revenue we're guiding slightly up. That's really just general strength across the board. We're not expecting as much IP deployment software revenue, which is mainly points in time in Q3. But for the full year, it's still raising. Does that give you sort of a good sense for where we are at?

Matt Ramsay

No, it does. So it sounds like much less of the sort of turns business in the back half of the year implied in the guidance, and we'll just kind of see how things go is kind of how I read that, is that fair?

Nick Hawkins

Yes. I mean, as you know, we have a huge repeat rate. We have around about 90%. Right now, we have a 90% visibility of revenue for the year in terms of GAAP revenue, which is very sort of comforting. So there's still sort of a 10% terms. But the dependency is much lower. The dependency, of course, in ACV terms is more significant on turns business.

And to the extent that we are being a little bit cautious because of the economic uncertainties around the world on how Q4 may tender that has much more of a direct impact on ACV as we exit the year as it does revenue, which is most ratable. Certainly, all the interconnect is ratable. So it has any deals that flow from -- swept from Q4 to Q1, for example, don't really impact revenue at all, just ACV, which is why we're being a little cautious on Q4 ACV exit point.

Matt Ramsay

Got it, Nick. As my follow-up, I wanted to kind of pick back up on that in the macro environment that we're in and in the market that we're in, investors definitely have their radars up for commentary. Like you mentioned the sentence there about maybe a little bit more caution on license activity and deal activity in the fourth quarter. I don't know, Charlie, do you have any just commentary generally? Are we talking about business in China? Are we talking about maybe what end market and what geography have you seen things maybe push out a tiny bit? Any -- is it broad? Is it one deal? Just any kind of context there would be really helpful.

Charlie Janac

Yes. So certainly, you want to be conservative, but we're not seeing the headwinds and the tailwinds balance, particularly for license revenue, right? On the tailwind side, we're seeing some inflationary pressures across the globe. You've got strict lockdowns in China that may have slowed down some activity there, although generally, our China business remains strong, right?

But you also have a number of headwinds. The automotive, the car is becoming a supercomputer on wheels. So there's many more designs being done for the car. There's more system houses designing chips. So I think the view is that at least on the license side, things are pretty much in balance for our kind of business.

Operator

Our next question comes from the line of Ambrish Srivastava with BMO.

Ambrish Srivastava

I had a couple of questions. Actually, we'll start on with the inflationary part first. How do you balance the negative impact to your P&L versus the ability to pass along cost because most of your contracts are set in pricing earlier? So can you just help us understand that part? And then I had a quick follow-up clarification.

Nick Hawkins

Charlie, you want to take that one?

Charlie Janac

Yes. So we have some subscription contracts, they are multiyear. But we are able to pass some costs along. I think we've increased our prices, I think, about 10% in the last few months. So we have some ability to pass along inflationary costs. But we are definitely seeing inflationary pressure, particularly with salaries and personnel retention costs and those kinds of things. So -- but again, you just manage that as best as you can. And you're also trying to make sure that the customers are happy and that they understand what -- how you're dealing with the situation.

Nick Hawkins

A couple of bits of color that might help you there in terms of unpacking that and sort of modeling it. The first is that we are largely seeing the wage inflation pressures in the rearview mirror. There was a big pressure in the first half, particularly in the first quarter. As you know, the wage inflation was right. We're seeing that less of an issue now. It's not going to wait, but it's not as bad, not as extreme. Second point is just for sort of mathematically around 70% of our OpEx is people-based. And so this gives you an idea of how wage inflation can impact our non-GAAP OpEx. That said, we are keeping a level on OpEx, and it's actually increasing at a fairly slow rate.

Ambrish Srivastava

Got it. That is helpful. And then my quick follow-up is on the ACV side. You mentioned two factors to the delta. The DJI versus macro, can you just help clarify how much of it is the impact of DJI versus the factoring in macro?

Nick Hawkins

Sure thing. Yes. So if you look at the whole year with the exit point of '22 versus exit point of '21, which is really the way that it should be sort of characterized because it's sort of an annual measure, the headwind between HiSilicon who ended in May and DJI, which ends future in December, the headwind between those two is $7 million on ACV. The second piece is kind of the unknown. ACV right now is growing nicely as you've seen. But the unknown is how Q4 might turn out. And there are a lot of things going in the world, which I don't need to tell you about. There's a lot of newsworthy things going on, including sort of economic performance, inflation, GDP, now two centers of geopolitical tensions and so on.

So we just feel like it's wise to be a little cautious in the way that we think of Q4 in terms of the cadence of deals. We do have a large -- a small number of large value deals that can impact how ACV turns out for the year if they end up -- ending in Q1, for example, instead of Q4. And we don't know until we get there, frankly. But basically for new biz, will it repeat this, we repeat this, we're very confident on because customers have to continue to buy our products, be it blunt software or be it infinite to continue designing and making chips, complex SoC chips. Whereas new customers, maybe there could be some delay, we just don't know, and we're just exercising a degree of caution on how we guide people.

Operator

Our next question comes from the line of Mark Lipacis with Jefferies.

Mark Lipacis

Charlie, maybe for you, putting aside like disruptions that are associated with COVID and inability for teams to meet together, how would you expect like either an inventory correction for an industry or a downturn, how would you expect it to impact your business specifically? Do you -- are you of the view that you guys offer a value proposition that's countercyclical in nature because you're offering so much value that your pricing is such that your -- it's like a payback for your customers instantaneously and so that you'd see more incoming requests? Or is it more along the lines of -- well, when things go south for other companies, they just cut everything? How -- and if you have any precedents that you can refer to, I think that would be interesting as well. That's the first question.

Charlie Janac

Sure. So if there is an inventory correction and a recession, you would expect some impact on royalty volumes, right? So that could get affected. On the other hand, on the design side, our customers typically try to design their way out of recessions, right? And so the design activity, we're just not seeing any slowdown in design starts or in SoC projects, right? Now that is not going to be uniform, right? You're going to see maybe more starts in machine learning and in automotive and maybe some impact in consumer possibly.

But overall, we think we're not exactly kind of cyclical, but we're not going to see -- we don't think we're going to see a huge impact for us on the design starts side. And you sort of asked for a historical sort of evidence of that comparison. So the one recession that we went through was 2008, which was probably much deeper than what we're going to see here. And we did not really see any effect at all. So at that time, we had no royalties. But we saw no effect on the design start from the 2008 recession, which was a pretty deep recession, right? So where we think that this one, which isn't going to be as deep is going to be pretty similar, and we're not going to see a huge impact on the design start side, on the license side.

Mark Lipacis

Great. That's really helpful. And a follow-up, if I may. Are you guys sharing like trends on ASP per project on a quarterly basis or annually? Or is there any color that you can share on ASP per project in the last several quarters?

Charlie Janac

So we are not reporting that as a KPI. And on a quarterly basis, I think it'd just be a little too granular. It's more of a long-term trend. But we're definitely seeing increased -- just as we said on the road show, we are seeing a significant increase in basically the average selling price of system IP, where, in fact, the price of each individual component of our product line isn't necessarily going up, but people are using much more system IP. So one evidence of that is that we started, for example, whenever we sell a network on chip, either cache coherent, non-coherent or both, we're also starting to sell the IP deployment software with it right up front, right? And so that, by itself, will raise the ASP. So we see the increased use of system IP as a long-term continuing trend that favors Arteris. There's just going to be more and more system IP in these chips.

Operator

[Operator Instructions] Our next question comes from the line of Hans Mosesmann with Rosenblatt Securities.

Hans Mosesmann

Charlie, I'm curious, do you guys have a sense of what process technology these new design engagements are going to be? Is it 5-nanometer or 3-nanometer? And if you do, what are they by particular end market, like ML, AI, communications, enterprise and that kind of stuff?

Charlie Janac

Well, it's kind of surprising, right? The automotive industry serve us behind and typically use trailing-edge processes. But many of the leading edge ADAS designs are on 5-nanometer. And some of our customers are hoping to start the next set of projects in 3-nanometer. So they're completely on the leading edge. And it kind of makes sense, right, because you really need as much compute power as you can get with -- while not going -- high on power consumption, right? So it makes sense that those projects will use leading-edge processes.

You're also seeing the use of the leading-edge processes and servers, those sort of high end designs, data center designs, those kinds of things. And you would see sort of trailing edge processes being used on more cost sensitive types of applications for consumer and machine learning is kind of all over the place, right? The data center part of it, the training would be very much being this processes. The edge would typically generally not be, right? They would be 16-nanometer, maybe five, those kinds of things. So it's all over the place, but the leading-edge guys are -- that we're involved with are kind of the ADAS Level 4 kind of application.

Hans Mosesmann

Okay. That's very helpful. And then for my follow-up on if you can give us some granularity on that engagement that you have with an AI/ML company, I think you may have mentioned in the press release, it's a semiconductor company. Is this an engagement that you guys are going after for a while? Did they come to you? Just maybe a little qualitative commentary on that particular one I'd be interested.

Charlie Janac

Yes. If I recall correctly, that one was kind of average in terms of sales cycles, right? We've had some discussion with them earlier, but the deal came together fairly quickly. I think it was like a six-month kind of sales process. So -- but we are starting to see some -- an increasing number of customers that just come to us where they're kind of saying, hey, you're kind of the system IP solution. Let's get to work on the project instead of doing an evaluation, right? So I would say in the aggregate, we're starting to see a shrinkage of the sales cycle periods, right? There being some amazing outliers, right? There's some people who buy in a month, and we've had sales cycles that take us five or six years, right? Those are outliers. But on the average, it's really shrinking.

Operator

There are no further questions in the queue. I'd like to hand the call back over to Charlie Janac for closing remarks.

Charlie Janac

Well, we'd like to thank you for your time and interest in Arteris IP. We look forward to meeting with some of you at the upcoming investor conferences that we are participating in the next couple of months, and we look forward to updating all of you on our business progress in the quarters to come.

So thank you.

Operator

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.