Arteris, Inc. (NASDAQ:AIP) Q3 2023 Earnings Conference Call November 7, 2023 4:30 PM ET

Company Participants

Erica Mannion - Sapphire Investor Relations

Karel Janac - Chairman, CEO & President

Nicholas Hawkins - VP & CFO

Conference Call Participants

Matthew Ramsay - TD Cowen

Hans Mosesmann - Rosenblatt Securities

Kevin Garrigan - WestPark Capital

Mark Lipacis - Jefferies

Operator

Good afternoon, everyone, and welcome to the Arteris Third Quarter 2023 Earnings Call. Please note, this call is being recorded and simultaneously webcast. All material contained in the webcast is sole property and copyright of our Arteris, Inc. with all rights reserved. For opening remarks and introductions, I will now turn the call over to Erica Mannion of Sapphire Investor Relations. Please go ahead.

Erica Mannion

Thank you, and good afternoon. With me today from Arteris 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 third quarter ended September 30, 2023. Nick will review the financial results for the third quarter followed by the company's outlook for the fourth quarter and full year of 2023. We will then open the call for questions.

Before we begin, I would like to remind you 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 actual results to differ appear in the press release Arteris issued today and in the documents and reports filed by Arteris 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. The 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 September 30, 2023. 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 September 30, 2023. Listeners who do not have a copy of the press release for the quarter ended September 30, 2023, may obtain a copy by visiting the Investor Relations section of the company's website. I will now turn the call over to CEO, Charlie Janac.

Karel Janac

Thank you, Erica, and thanks to everyone for joining us on the call this afternoon. We're pleased to report a solid third quarter with annual contract value plus trailing 12-month royalties of $57.3 million and the addition of 22 new customer chip designs. We added 2 new customers and numerous license expansion deals from existing customers, 3 of which were with top 10 global technology companies. Our customers' design pipelines continue to be robust across enterprise computing, consumer electronics, automotive, industrial and communications with many SoC projects incorporating machine learning or AI applications.

As we have stated previously, we believe that SoC design complexity, including in the emerging chiplet market, continues to grow, leading to increasing importance of commercial system IP. Several established companies who today develop the bulk of their system IP internally are looking to either augment those capabilities or improve their schedules and costs by outsourcing system IP connectivity to commercial vendors such as Arteris. We are seeing an emerging confirmation of this strength in our customer base.

One of the customers we added in the third quarter is another top semiconductor company, securing a long-term foundational relationship with yet another industry leader. Arteris is now engaged with the majority of the world's top semiconductor companies who have historically used internal system IP solutions. Though some of these relationships are only initial engagements, these design wins demonstrate the willingness of major semiconductor companies to deploy commercial system IT products from leading and proven commercial vendors such as Arteris.

Deals in the third quarter were characterized by strong demand across all our core market segments, led by design wins in enterprise computing, consumer electronics, communications, and automotive. The growing wave of artificial intelligence and machine learning or AI/ML applications is evidenced by our licensing activity as over half of our licensing deals in the third quarter are enabling AI/ML design. As an example of our continuing AI/ML momentum, we recently announced the deployment of Arteris FlexNoc interconnect used in NeuReality's Inference Servers SoC. As part of this new Inference Server, Arteris provided connectivity for their NR1 SoC to support the movement of very large amounts of data and generate AI applications.

The challenges that NeuReality was facing required addressing SoC density and latency performance to provide improved total cost of ownership. This NeuReality Inference Server connected by Arteris is further proof that our system IP is an essential part of building and deploying such AI solutions. Another example is our partnership with Fraunhofer IESE, a leading research institute in the area of software and system engineering methods to accelerate the development of AI and now SoCs.

In very high bandwidth applications, such as those used for generative AI and large language models, ERM performance is a critical piece of the puzzle to move the amount of data needed with customer AI requirement. The performance of Arteris System IP, coupled with Fraunhofer memory exploration framework, is expected to enable mutual customers to improve performance, reduce cost, and accelerate the development of AI and now electronics.

We are also seeing continued success with leading semiconductor industry players across multiple verticals, including high-performance computing, mobile handsets, networking and more as highlighted by the announcement of our partnership with AlChip, a top-tier provider of silicon design and production services. Through this partnership with Arteris, AlChip can deliver to its customers highly optimized SoCs, taking full advantage of the efficiency, scalability, and configurability of our NOC technology with particular focus on AI, autonomous driving, vision systems, and consumer electronic products.

We are seeing a growing number of different processor IPs deployed, ranging from those provided by ARM to various risk 5 providers and internal architectures often connected together on the same SoC. Arteris is working closely with ARM and several RISC-V providers, including a recently announced partnership with Semidynamics who provide customizable RISC-V processor IP and specializes in high-bandwidth, high-performance cores. The partnership aims to provide a better joint solution with data center-oriented AI/ML applications.

I'm proud to mention Ateris' continuous innovation was recognized with 2 awards granted during the quarter. The first, Technical Innovation of the Year, was given in the 20th Annual International Business Awards, while FlexNoC 5, for Physically Aware NoC. Arteris was chosen among over 3,700 nominations from organizations in over 60 countries. The second award, Autonomous Vehicle Technology of the Year, was given by Autotech Breakthrough for Arteris' fundamental role in building advanced driver system systems, ADAS, and autonomous driving SoCs which combine AI and functional safety. Autotech Breakthrough analyzes the industry's automotive and transportation technology innovation, and Arteris was chosen among over 1,600 technology innovations from 15 different countries.

Moreover, I'd like to provide an update on the momentum of our recent product release, which we believe is the industry's first and only commercially available physically aware FlexNoC 5 NoC IP, which we launched at the end of the second quarter. Given the growing need for effective physical closure for all SoCs below 16-nanometer, we are seeing strong customer interest. We have now shipped FlexNoC 5 to 9 customers, including several top technology companies. In addition, we are seeing growing customer interest in FlexNoC 5 adoption in the fourth quarter of 2023 and out into 2024 and subsequent years.

Finally, I'm pleased to announce that we achieved an important milestone with the ISO 9001 quality management system certification setting the solid foundation for further growth as we continue to expand our product portfolio and silicon deployment, which has already reached 3.5 billion devices. Currently, certain macroeconomic headwinds, including geopolitical uncertainties and global recessionary concerns, remain in place. We continue to be impacted by U.S. BIS restrictions with respect to China U.S. trade as well as tightening credit conditions globally, which is impacting the ability of our smaller customers to raise capital. Notably, in the third quarter, we saw increasing softness in the China market as well as further lengthening of sales cycles globally. While these dynamics may create near-term headwinds, we believe that the scale and the scope of our long-term opportunity remains robust.

The fourth quarter has historically been our strongest quarter. We're encouraged by what we're seeing in the current fourth quarter. We have a robust product pipeline of new system IP technologies and solid relationships with some of the largest electronics companies in the world who continue to innovate in exciting areas such as generative AI and autonomous driving. With that, I'll turn it over to Nick to discuss our financial results in more detail.

Nicholas Hawkins

Thank you, Charlie, and good afternoon, everyone. As I review our first quarter results today, please note that I'll 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 third quarter was $13.3 million, up 5% year-over-year and exceeding the midpoint of our guidance range. At the end of the third quarter, annual contract value, or ACV, plus trailing 12-month royalties and other revenue, was $57.3 million. As Charlie mentioned, in the third quarter, we began to see increasing softness in the China market that resulted in ACV plus trailing 12-month royalties coming in below the midpoint of our guidance range. So far this quarter, we have not seen any improvement in the Chinese market.

GAAP gross profit in the quarter was $12.0 million, representing a gross margin of 90%. Non-GAAP gross profit in the quarter was $12.2 million, representing a gross margin of 92%. Total GAAP operating expenses for the third quarter was $20.4 million compared to $19.4 million in the prior year period. Non-GAAP operating expense in the quarter was $16.8 million compared to $16.0 million in the prior year period and to $17.9 million in the second quarter, representing a sequential OpEx decrease of $1.1 million or 6%, benefiting from tight cost control coupled with some limited onetime credits.

The year-over-year increase was primarily driven by continued R&D investments in next-generation NoC IP and SoC integration automation software products. In the fourth quarter and going into next year, we will continue to proactively manage operating expenses, limiting investments to strategic areas. GAAP operating loss for the third quarter was $8.5 million compared to a loss of $7.8 million in the year ago period. Non-GAAP operating loss was $4.6 million or 34% compared to a loss of $4.2 million in the year ago period.

Net loss for the quarter was $8.2 million or diluted net loss per share of $0.22. Non-GAAP net loss for the quarter was $4.2 million or diluted net loss per share of $0.12 based on approximately 36 million weighted and diluted shares outstanding.

Turning to the balance sheet and cash flow, we ended the quarter with $56.6 million in cash, cash equivalents and investments. Cash flow used in operations was approximately $2.8 million in the quarter. Free cash flow, which includes capital expenditure was approximately negative $3.1 million, in line with our guidance.

I would now like to turn to outlook for the fourth quarter and the full year 2023. For the fourth quarter, we expect ACV plus trailing 12-month royalties of $52 million to $56 million and revenue of $11.3 million to $12.3 million, with non-GAAP operating loss margin of 56.1% to 76.1%, and non-GAAP free cash flow margin of negative 32.4% to negative 52.4%.

Incorporated into this guidance are 2 recent trends. First, due to the dynamics within China, we anticipate continued softness in demand in the fourth quarter. Second, as Charlie alluded to, we are encouraged by the deal activity in the fourth quarter. But at the same time, we are seeing customers take a closer look at project pipelines given the macroeconomic environment which impacts the timing, duration and volume of deals signed in what is traditionally our strongest quarter.

Given the fluidity of the macro situation, we are seeing interest from some customers to extend the duration of deals of their own design cycles lengthen. While our near-term impact ACV, we broadly view this as a favorable dynamic as it demonstrates the importance and stickiness of our technology. It is no longer a question of whether to use Arteris. At this stage, it's more tactical on how they can align their development costs with their advised design cycle timelines.

For full year 2023, our guidance is as follows. Revenue of $52.5 million to $53.5 million, reflecting the slowdown in the Chinese economy. While we do expect a seasonally strong fourth quarter in terms of new licenses and additions to RPO, these will have a relatively muted impact on fourth quarter revenue as a result of our fully ratable revenue recognition. ACV plus trailing 12-month royalties to exit 2023 at $52 million, with $6 million non-GAAP operating loss margin of 39% to 44%, better than prior guidance as a result of reduced operating expenses. We are continuing to actively control operating expenses with the goal of achieving meaningful savings in 2024 when compared to previous plans.

Non-GAAP free cash flow margin of negative 33.1% to negative 38.1%, primarily driven by the expected change in working capital in 2023, and to a lesser extent, the industry dynamics I referenced earlier. Going to 2024, we are committed to keeping our collections and costs in alignment. As a result, we do not expect any meaningful degradation of our cash position next year. With that, I will turn the call over to the operator to open up for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question comes from Matt Ramsay, TD Cowen.

Matthew Ramsay

Thank you very much. Good afternoon, everybody. Guys, it makes sense that in the guidance you talked about some slower deal flow in China, just given what's going on in the economic situation. Charlie, I wonder if you might expand on that a little bit? Is it -- do you see it as maybe slowness to bring in new customers in China? Is it programs at existing customers? Or maybe a combination of both? If you could just give us a little bit more detail there. And then I guess the second part of the question on China, if, and I think this is a big if, they can get supply of all the different components, it seems like Huawei is inclined to ship some more smartphones again. Would your old license deals that would then pay royalties on high silicon parts still be in effect? Or given all the political turmoil, are those different than they were back when HiSilicon was a material customer? Thanks.

Karel Janac

Yes. We're seeing two things happening in China. One is that the BIS actions, and particularly the one that happened in the second half of Q3, has had a fairly major impact on sort of the smaller companies in China. Now as we mentioned before, we're fairly well diversified in terms of export controls because a number of our products are from France and so subject to French export rules. But the problem is that some of the Chinese companies can't get the other components, exactly as you've implied. That has caused the slowdown that we're seeing. The other thing is that there is a capital shortage in China. Some of the smaller companies now have a very difficult access to capital. Between BIS and the capital shortage in China, you're looking at a fairly difficult situation. Now the big companies I think are okay. Huawei would be okay, people like Tencent, Alibaba, Baidu, they will figure out how to get access to what they need. But for the smaller companies, it's much more difficult. As far as the old HiSilicon contract, it would still be in place if it is a current processor. If it's not a current processor, it would not be in place

Matthew Ramsay

Got it.

Karel Janac

Does that answer the question?

Matthew Ramsay

Yes, it does. Thank you, Charlie. Thanks for the color. I guess my follow-up question is sort of unrelated and it's more to the long term with FlexNoC 5. Maybe you could give a little bit more detail on the breadth of the traction, the early traction that you're seeing. And just from a license monetization standpoint and then eventual royalty monetization standpoint, like what kind of an uplift are we looking at here versus the prior generation? Thanks.

Karel Janac

Right. FlexNoC 5 has a major innovation which has physical awareness, which essentially allows customers to estimate physical effects of their architectures very early in the design process. That essentially allows them to turn over physically verified architecture and RTL to the place on our team which essentially would reduce the number of places at iterations and the number of time and effort that has to be placed in during physical design. Obviously, we charge a bit more for this, and so this is about a 33% uptick in terms of ASP, and that's kind of what we're seeing in the market. Now, we have shipped this -- we started shipping toward the very end of Q2, in June, and we shipped some few licenses immediately in Q2. But we also shipped a significant number of licenses in Q3. It was basically 17 FlexNoC 5 licenses to 9 unique customers. And so that's a pretty satisfactory uptake. And the evaluation pipeline for FlexNoc 5 continues to be robust, and the product seems to be of great interest, and so we think that this is something that people are going to keep buying on an ongoing basis this quarter, in the fourth quarter, and also in 2024 and 2025.

Nicholas Hawkins

Hey, Matt, this is Nick. Just a little bit of extra color on that as far as your royalties question goes on FlexNoc 5. I mean it's still early days, we've only had 9 licenses at the end of third quarter, and we're seeing a lot more now. We've seen some upgrades from 4 to 5 already. And we have a very robust pipeline of FlexNoC 5 new deals that we expect to land. The use cases for those licenses are predominantly at the moment in automotive, which is a very rich royalty stream as you know. And also communications, interestingly, which is also a very rich royalty seen. It's also being used in GenAI. Now that, of course, is a very nascent product stream as far as royalty is concerned. We wouldn't expect that to earn royalties for a while. We are actually seeing a little bit of AI traction, but it's very, very early days. But we think in the long, long term, AI chips will start to yield some decent piece of royalties, but that's a ways out.

Matthew Ramsay

Thank you both for that. Appreciate it.

Operator

Your next question comes from Hans Mosesmann of Rosenblatt.

Hans Mosesmann

Hey, guys. You guys have indicated in the past that based on automotive licensing engagements that the number of SoCs by platform over the next several years could be 20, maybe as much as 25. Has that dynamic changed at all? Is it getting pushed out? Specific to automotive?

Karel Janac

Yes. No. Automotive continues to be robust. There is a continued number of projects. The interesting dynamic is going to be whether the OEMs are going to do their own ADAS solutions, both short term and long term, or whether it's going to coagulate down to a few major players such as Mobileye and NXP. We don't know the answers to that, but we keep pursuing every single automotive opportunity there is. We keep having pretty good success there. And we think that automotive continues to be a very -- one of the biggest opportunities in high tech over the next 20 years.

Nicholas Hawkins

Hans, this is Nick. In terms of your other question, which is about sort of concentration, the concentration of auto chips per vehicle, which is I think the other part which is that we think longer term is up to sort of 25 plus, that is unchanged. And really isn't impacted as to whether the OEMs do their own designs or whether they look for somebody else to do their designs for them.

Hans Mosesmann

Okay. That's helpful. And then one last question. If we look at outside of China, how is that, the non-China business, doing in terms of licensing engagements? Or are there some delays there as well?

Karel Janac

Obviously, people are looking at their roadmaps. That's -- I would say people are looking at what projects they will do. At the same time, what we're seeing is that some of the larger companies are now sort of looking at, okay, do we want to build the next-generation system IP for our products or do we want to outsource that? And we're having I would say a significant amount of success in being selected for some of these projects where before they would do everything internally. The other sort of issue is that there's also a capital difficulty in the smaller U.S. companies, but the larger companies are unaffected. I would sort of note that the number of design starts in Q3, which was 2022, is basically the same as we had in second quarter. While there is some shifts in the non-China market, I think overall the effects are I would say neutral.

Nicholas Hawkins

Yes. Essentially, it's a pivot away from the start-up community to the larger guys. As Charlie said, the sort a number of new customers is a lot less. We used to get most of our new customers actually from China. But the, as Charlie said, the number of design starts is the same. But one of the other dynamics that was kind of following on from your question, and is really driving the reduction in guide on ACV for the fourth quarter, is that customers are generally having a look at -- they're aligning their product roadmaps to their expenditure cycles. And in some cases, that's pushing out design or engagements into Q1 from Q4. And same kind of thing as we saw at the end of '22 if you remember. There's a number of different vectors going on. And in addition, there is a tendency among some of the majors, not many, but there's a tendency among some to take longer to do their designs. And that actually that has a direct impact on ACV and revenue intensity. It just lasts for longer. It's -- we're okay with that because it demonstrates the stickiness and the importance of our technology to the customer if they're prepared to engage for longer. But in terms of ACV, obviously annual, the A word, means the TCV is divided over a longer period.

Operator

Your next question comes from Kevin Garrigan, WestPark Capital.

Kevin Garrigan

Thanks for taking my question. Your 22 design starts. I know you had noted that 12 were for AI technologies. Can you give us some color on what markets these design starts were in? And to Hans' question, you had noted automotive was still robust. Any kind of markets that were weaker that surprised you?

Karel Janac

Outside of China, not really. The -- there is a huge amount of investment in generative AI. As we discussed earlier, the query costs are quite high with the existing GPU technologies, and so people are investing extensively in essentially ASICs that are lower power and lower query costs for generative AI. That's a big tailwind. I think one of those designs that we've talked about is the NeuReality design in Israel, which is a data center design. There's a lot of generative AI inference work being done in the data center. But we eventually see generative AI being expanded to the edge and to the endpoints, even into things like portable devices like smartphones and things like this. Generative AI is a strong, I would say strong tailwind for new designs. And I think we said on the earnings call that about half of the designs of the 22 were at least this quarter were related to machine learning.

Nicholas Hawkins

A bit over half. A bit more than half. I mean, to your -- if you looked at, I mean here's the complexity, is obviously that the AI/ML is actually horizontal. We kind of get a bit mixed up in terms of horizontal or vertical sometimes. But if you look at the verticals where we saw the most intensity of design starts in Q3, the enterprise compute actually, which is obviously where a lot of these designs end up popping up in the vertical sense, that was the second highest quarter on record in terms of design starts. That's a good indication. The second was actually automotive, but that's fairly typical and there's a lot of machine learning applications within automotive anyway.

Kevin Garrigan

Okay. Got it. That's very helpful. And then just as a quick follow-up, can you, at a high level, can you kind of give us a sense of your royalty rates and then the opportunities that you kind of see to increase these rates in the future? And how do you kind of go about having those conversations to basically increase the rates?

Karel Janac

Yes, I'll take that one, Kevin. Directionally, royalties are always upwards. We don't take lower royalty deals. The growth is, any increase in royalty rates, can only really follow increased functionality. You don't get a sort of increased royalty rate just because the customer likes you. We have to actually give them something in terms of functionality. And so over time, you'll see more higher rate of royalties for the newer products. And if you remember, automotive is actually -- automotive is the richest, or certainly a lot richer than say consumer. Or the old consumer communications like cellphones, smartphones, and automotive is where we're having probably the biggest success and it now represents about 55%, 60% of the total royalty stream followed interestingly by communications and industrial. A lot of use in industrial.

Operator

[Operator Instructions]. Your next question comes from Mark Lipacis, Jefferies.

Mark Lipacis

I just want to make sure I understood. I had the same question as the previous caller. Was it -- was it 50% of the licenses over the last year were enabling AI? Is that -- was that the right --

Karel Janac

This quarter.

Nicholas Hawkins

This quarter, yes, Q3.

Mark Lipacis

And of all the kind of AI design wins you have, I think, Charlie, you started to answer this, but I don't know if you qualified it. Are -- I appreciate that at the end of the day, this is going to come to the endpoints. But are the design wins that you have, are they for endpoint AI applications? Or are these mostly data centers? I'm just trying to understand like what you saw in the last quarter, what you've seen recently, to what extent is the AI workload or application manifesting in the big data center chips versus the maybe the smaller chips that would go into IoT devices or cars or something closer to the endpoint? Thank you.

Karel Janac

Yes. The early generative designs that we've seen are data center designs. There's a lot of activity in the hyperscaler community for those designs, so those are going into the data center. The NeuReality one that we are allowed to talk about is going into data center, but there's others. Those would be high-priced, low-volume chips. But we think that Generative AI is going to expand to the edge and it's going to expand to the endpoints, and we're gaining valuable experience working with our customers to be able to provide high-performance system IP that allow people to move incredible amounts of data in these designs. And one of the things that we did was we created a kind of an XL package for -- because some of these generative AI things need buses or NoCs that are 20-bit, 2,048-bit wide because of the amount of data that has to be moved. And so that again provides us the ability to slightly increase the ASP for these kinds of very demanding applications. But generative AI is evolving very, very quickly right now and people are actually starting to move on from the transformer architectures into some other types of implementations, and so we're just following that and we're providing the data transport for those projects.

Mark Lipacis

Got you. Okay. That's very helpful. And then and I apologize if I'm asking you to repeat this, my line dropped. I think you started to talk about how the larger customers are starting to shift to your solution from internal. And I think this has been part of the Arteris story longer term anyway. But can you play that back? Is there -- was there something about the current macro environment that gives you higher conviction or you're seeing an acceleration of that trend? If you could play that back again, I'd appreciate it. Thank you.

Karel Janac

Yes. I mean if you look at the investment that it takes to do the next-generation system IP, it is tens and tens of millions of dollars, right? And so, the CFOs of those companies are basically asking, okay, do we want to make that kind of an investment for the number of projects that we do or do we want to stick with what we have for existing projects? But for the new technologies, do we want to go to someone like Arteris? And that's starting to play out. We have I think a very nice penetration of some of the companies that have had, were 100% internal before. We added one. We talked about 3 of them last quarter, and there was kind of beachhead deals. We got one of the ones that we did in Q3 was fairly large. That's for a company that was almost 100% internal. And so that's one of the tailwinds, right, is that people in this macro environment are more willing to outsource the system IP to proven commercial vendors such as Arteris. And we're seeing evidence of that.

Operator

Thank you. That concludes our question-and-answer session. I will now turn the call over to the CEO for closing comments.

Karel Janac

Well, thank you for joining us on the third quarter Arteris earnings call, and we look forward to updating you for our future quarters. Thank you very much.

Operator

Thank you. Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.