Good morning, welcome to CEVA, Inc. third quarter 2017 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw that question, please press star then two. Please note this event is being recorded. I will now turn the conference over to Richard Kingston. Please go ahead.
Thank you. Good morning, everyone, welcome to CEVA's third quarter 2017 earnings conference call. I'm joined today by Gideon Wertheizer, Chief Executive Officer of CEVA, and Yaniv Arieli, Chief Financial Officer of CEVA. Gideon will cover the business aspects and the highlights from the quarter and provide general qualitative data. Yaniv will cover the financial highlights for the third quarter and provide the fourth quarter and full year guidance for 2017. I will start with the forward-looking statements. Today's conference call contains forward-looking statements that involve risks and uncertainties as well as assumptions that if they materialize or prove incorrect, could cause the results of CEVA to differ materially from those expressed or implied by such forward-looking statements and assumptions.
These forward-looking statements include our financial guidance for the fourth quarter and full year 2017, optimism about the licensing pipeline and our product portfolio, anticipated licensing opportunities and potential royalty revenue in trends relating to 5G and LTE IoT, projected customer ramp-up schedules, and optimism about the success of growth in the non-handset space.
The risks, uncertainties, and assumptions include the ability of the CEVA signal processing IPs for smarter connected devices to continue to be strong growth drivers for us, our success in penetrating new markets, specifically non-baseband markets, and maintaining our market position in existing markets, the ability of new products incorporating our technologies to achieve market acceptance, the speed and extent of the expansion of the LTE and 5G networks, LTE IoT, and IoT space generally, our ability to execute more broad portfolio license agreements, customer ramp-up schedules, and the impact on royalty revenues, the effect of intense industry competition and consolidation, global chip market trends, and general market conditions and other risks relating to our business, including but not limited to those that are described from time to time in our SEC filings.
CEVA assumes no obligation to update any forward-looking statements or information, which speak as of their respective dates. With that said, I would now like to turn the call over to Gideon.
Thank you, Richard. Welcome everyone. Our third quarter financial results dramatically exceeded our expectations driven by record licensing revenue and activities. Across all our product lines, we are experiencing favorable licensing dynamics as customers are increasingly placing greater value in our platform-based strategy, which offers a holistic solution to high entry barrier technologies, in particular 5G neural networks and short-range wireless. Revenue for the third quarter came in at record high of $24 million, significantly higher than our guidance and up 35% year-over-year. Licensing and related revenue was also an all-time record high at $14 million, up 88% year-over-year. GAAP and non-GAAP net income and non-GAAP EPS also set company records. During the third quarter, we concluded eight deals, of which two were for our DSP cores and platform and six were for our connectivity IPs.
All of the deals were for non-handset baseband applications, and three were for first-time customers. Customer target markets for the licenses completed in the quarter were 5G base stations, surveillance, industrial, and consumer IoT. On royalties, revenue came in at $10 million, down 4% versus last year, reflecting strong seasonal weakness in the smartphone market. This was, however, partially offset by new shipments of our non-handset baseband segment, primarily for base station chips and computer vision products within smartphones, action camera, and 360 degrees camera. Let me take the next few minutes to update you on recent market development, which we plan to capitalize on by leveraging our technology excellence and strong track record in cellular. Those developments present ongoing licensing opportunities and substantial royalty revenue potential as chips enabled by our technology will reach mass production.
Last March, the 3GPP, which is the body in charge of cellular standardization, decided to accelerate the milestone for finalizing the 5G new radio standard toward the end of 2017. This paves the way for 5G trials as early as 2018, followed by commercial products in 2019, one year ahead of what was originally planned. 5G is a disruptive technology, a pivot for multiple new services and products, among which are high-definition video streaming, untethered virtual reality, augmented reality, autonomous driving, AI, and more. 5G will also be the key enabler for Industry 4.0 initiative, for which machines and factory automation will be revolutionized by using AI algorithms available in the cloud that will be accessible through fast and reliable 5G networks. These substantial opportunities drive governments and wireless carriers to expedite investment and regulation for 5G.
In June, the Chinese government announced that it would invest over $400 billion in 5G deployment over the next 10 years. In the U.S., the FCC has been working to free up millimeter wave spectrum for carriers to enable faster 5G networks. In this respect, Verizon and AT&T have announced 5G services at 28 and 39 GHz spectrum for the last mile delivery. It enabled a much cheaper alternative to home broadband internet services compared to fiber optics. South Korea is planning a commercial 5G network in time for the 2018 Winter Olympics. Last, the approval of the Department of Justice on the pending acquisition of Time Warner by AT&T and Verizon acquisitions of AOL and Yahoo set the stage for video streaming services over 5G.
Our new advanced DSP platform, the XC12, is already being licensed to three out of the top five base station OEMs, who are intensively working on in-house chip solution for 5G. We are also making progress with few other key players in the space, which we have not had business relationships with in the past. Furthermore, we have number of customers designing 5G mobile broadband chips for smartphone and home router based on our CEVA-X and CEVA-XC platforms. First of all, 5G is a technology breakpoint requiring new expertise and product offerings. We foresaw these needs and invested ahead of the market, enabling us to offer our customer a head start as the 5G market takes off. An additional recent market acceleration is LTE IoT, a provision of LTE standards specifically targeted for low power, low data rate for IoT applications.
According to a recent report from GSMA, by 2026, as many as 308 billion LTE-based IoT connections will be in operation for applications such as smart meter, smart cities, shared bike, agriculture, and more. China Mobile is leading the pace, aiming to invest $6 billion in the next two years. The pace of the proliferation of LTE IoT-based chips and applications, we have taken significant steps with our technologies to reduce the entry barrier for many semiconductor companies who have no prior experience in cellular and are looking to benefit from this sizable and diversified market. In this regard, we have recently expanded our partnership with ASTRI of Hong Kong, a reputable RF and analog design service IP company. CEVA-X as a one-stop shop for complete drop-in Narrowband IoT solution.
In China, SangChip, formerly known as ZTE Microelectronics, has already launched the RoseFinch7100, its first Narrowband IoT chips based on our CEVA-X IoT processor. This chip is expected to be in high volume production early next year. Moving to royalties. The third quarter royalty revenue reflects a soft smartphone market due to what appears to be a combination of transformation in the high-growth Indian smartphone market, where HD penetration is still small, and the push out of a top-tier flagship sensor. We, however, were encouraged by the growing shipment of base station, baseband, and vision products in smartphone and camera, which partially offset the decline in the handset royalty revenue. To conclude, I'm very pleased with all our all-time high licensing performance and profitability in the third quarter on the back of stellar first half of the year.
We are extremely excited about the recent licensing dynamic driven by lucrative opportunities in 5G, LTE IoT, neural networks, Wi-Fi, Bluetooth, and VoLTE. The impact of this licensing momentum goes far beyond the initial revenue from this deal, as this momentum possess significant future royalty revenue potential for those extremely sizable markets. That said, let me turn the call over to Yaniv for the financials and the guidance.
Thank you, Gideon. I'll start by reviewing the results of our operations for the third quarter of 2017. Revenue for the third quarter was at an all-time record high of $24 million, up 35% on yearly basis. The revenue breakdown is as follows. Licensing and related revenue was approximately $14 million, representing 58% of our total revenue, 88% higher as compared to the third quarter of 2016, the second sequential record high. Royalty revenue was $10 million, reflecting 42% of our total revenue and 4% lower on a year-over-year basis. Gross margins were 93% on both US GAAP and non-GAAP basis. Our non-GAAP quarterly gross margin excluded approximately $0.1 million of equity-based compensation expenses. Total operating expenses for the third quarter were just over the mid-range of our guidance at $16.1 million.
OPEX also included an aggregated equity-based compensation expense of approximately $2.1 million and $0.3 million for the amortization of acquired intangibles of RivieraWaves. Total operating expenses for the third quarter, excluding these two items, were $13.7 million, just over the mid-range of our guidance. US GAAP net income and diluted EPS for the quarter both increased dramatically by 73% to $5.8 million and to $0.26 per share, respectively, third quarter of last year. US GAAP net income also reached an all-time record high. Non-GAAP net income and diluted EPS for the third quarter both reached an all-time record high and increased 59% and 50% year-over-year to $8.3 million and $0.36 per share. Figures exclude an equity-based compensation expenses net of tax of $2.1 million, and the impact of amortization of acquired intangibles of RivieraWaves of $0.3 million. Other related data.
Shipped units by CEVA's licensees during the third quarter of 2017 were 250 million, down 7% and 10% sequentially, and from the third quarter reported shipments of last year, respectively. Of the 250 million unit shipped, 189 million or 76% were for handset baseband chips, reflecting a sequential increase of 15% from 220 million units of handset baseband chips shipped during the second quarter of 2017. A 13% increase from [167 million units.] units shipped a year ago. Non-handset baseband volume shipments continued to increase, about 30% sequentially and 3% on a year-over-year basis. The sequential increase is due to higher quarterly Bluetooth, vision, and baseband shipments. From a revenue perspective, third quarter non-baseband royalty revenue increased sequentially by strong double digits with volume increase, and on a year-over-year basis, approximately double, contributing approximately $2 million of royalty revenue in the quarter.
As for the balance sheet items. End of September 2017, CEVA's cash equivalent balances, marketable securities, and bank deposits grew to shy of $178 million. Our DSOs for the third quarter were 49 days compared to the prior quarter of 46 days. During the third quarter, we generated $7.1 million net cash from operations, depreciation was half a million dollars, and purchase of fixed assets were $1.1 million, mainly due to new software activations. End of September 2017, our headcount was 306 people, of which 246 were engineers. Now for our guidance. Licensing has demonstrated throughout this year, we experienced good interest for our technologies.
Also, we expect acceleration in 5G standardization and the proliferation of LTE IoT to create demand on our cellular solutions. As such, we are once again raising our annual licensing target, the third time this year, from approximately $32 million last year to a new annual target of just $43 million for 2017, representing over 35% annual growth. Royalty, after a soft third quarter in the handset space, we expect sequential increase in the fourth quarter in both the handset baseband and non-handset-based products. Overall, this should enable us to record a new all-time annual royalty revenue of over $43 million or approximately 7% annual growth. Our guidance for the fourth quarter of 2017 is as follows. Revenue for the fourth quarter is expected to be in the range of $20.5 million-$21.5 million. Gross margin is expected to be approximately 90% on GAAP basis and 91% on non-GAAP basis.
This exclude an aggregate $0.1 million of equity-based compensation expense. Both gross margin planned for the quarter are a bit lower than the norm due to the cost of goods expenses associated with our new partnership in the Narrowband IoT space. Overall, OpEx should be similar to the third quarter. Q4 OpEx is expected to be in the range of $15.6 million-$16.6 million. Of our anticipated total operating expenses for the fourth quarter, $2.4 million is expected to be attributed to equity-based compensation expenses and $0.3 million to the amortization of acquired intangibles. Therefore, our non-GAAP operating expenses is expected to be slightly lower than the third quarter we just reported and in the range of $13 million-$14 million. An interest income is expected to be about $0.75 million.
Tax rate for the fourth quarter, similar to the third quarter actual level, on GAAP basis is 17% and on non-GAAP basis, 13%. Share count for the fourth quarter is expected to be about 23 million shares. That will bring us to US GAAP fully-diluted earnings per share, is expected to be in the range of $0.12-$0.14. Non-GAAP EPS is forecast excluding the equity-based compensation expenses and amortization, is expected to be in the range of $0.23-$0.25 per share. For the full year, revenues are forecast to be in the highest level of the company's history and just shy of $87 million. On a non-GAAP, fully diluted EPS of approximately $1.16, which represents over 20% year-over-year growth. Operator, we could now open the Q&A session, please.
Okay. We will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. We do ask that if you're using a speakerphone, to please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Again, if you have a question, please press star then one. Our first question comes from Gary Mobley with The Benchmark Company. Please go ahead.
Hey, guys. Congratulations on a strong third quarter licensing number. Yaniv, as a point of clarification, did you say base station SoC royalty dollars in the just reported quarter were $2 million?
In not just the base station, but all the non-handset royalties were $2 million, which is double from where we were a year ago.
What contribution are you now seeing on the base station front, and is that from just one royalty contributor of the two so far?
It's initial ramp-ups, I think we said in the past that we are still sort of studying and learning as we go, the timing, the magnitude, the ramp-up of this, it's one customer for now. It started, I think, like two quarters ago, our first report, and it's continuing. We still don't know the full effect and the full growth opportunity, but there's no doubt that this is a very large market opportunity both for CEVA and our customers, which they're gaining market share from Freescale, the TIs of the world that have dominated the space.
Hi, Gary. Gideon. One more thing to add to what Yaniv said. The contribution, the base station started two quarter ago, last quarter we have seen another SKU or another chip that went into production.
Okay. What were the LTE royalty units in the quarter?
Gary, did you hear the question?
What were the LTE royalty units in the quarter?
It's 66 million. One thing to remember, back on the base station, we signed another deal with a new customer on the base station from this last quarter. That's, of course, no royalties yet, but another deal. This is the third out of five big players that we could be enabling their solution. All these three base station deals are for 5G.
Okay. One last question I want to address related to the licensing front. I'm curious to know what drove the average deal size up. Presumably, it was up substantially since you had only eight licensed deals versus 13 last quarter, and obviously a big sequential increase in revenue. Yet your deferred revenue went up sequentially as the main source of backlog. Point questions are, what drove the average deal size increase, and why are you expecting a blow in licensing revenue on what has been a pretty stellar fiscal year 2017?
Sure. No, good question. I'll try to help you out. We always explain from time to time that it's not right to take the licensing revenue and divide it by the number of deals, because not necessarily you're able to recognize all the deals that you signed within the quarter. We are reporting deals that were signed. It's not necessarily the deals that you recognize. In the last two quarters, if you recall, we have increased our backlog. Last quarter, we reached all-time record high in backlog. That backlog, we were able to pull it in into Q3 because of the massive R&D investments that we had to deliver by the end of the quarter to a significant customer, a big piece of technology. As soon as we have done that, we were able to release the backlog.
The backlog is not necessarily in deferred revenue. It depends if they paid or not. More importantly, the fact that in the last two quarters, we signed deals, not necessarily we pulled or recognized all of them. Two very large deals were delivered and fully executed from an R&D point of view, from a delivery point of view in Q3, and that's what pulled in revenue, maybe from Q4 or for future quarters, because we were able to get the work done.
Okay.
That said.
Let me ask a follow-up to that. Is the backlog down substantially on a sequential basis? How would you charac-?
I wouldn't say that the backlog went down substantially. Let me give you the context of what is referred to backlog. This is in connection to what I said about the 5G. People are rushing to go into the 5G. We were asked by our customer to deliver technology in Q4. We were asked to expedite delivery, and that's the reason we recognize out of the gate. The licensing, I think I said it in the remark, looks very good, not just in the 5G space, but across all our product 5G vision, Bluetooth in the case of smart watch products, new products. There's no change in this regard. Given that we have that large backlog, some customization.
Okay.
This is if we finish it and deliver it, the customer can go ahead. The actual backlog at the end of the third quarter is lower, of course, than the second quarter because of that. Back to the other part of your second question, Q4 guidance for licensing, we're back to normal. This was a nice add-on. Hopefully, we could add more like this in the future. I think we're looking at the same level as Q1, the $9 million-$10 million that we started the year with, and we've seen quite a few achievements around that. There's normal business. Nothing is wrong. We didn't take the licensing down for the next quarter because this Q4 was much higher than that. On the contrary, we're back to the normal levels, although we had a very good quarter.
This is the reason that we're taking the annual licensing revenue up from $40 million a few months ago to north of $43 million. That's the reason.
All right.
[Some].
Thanks, guys.
The next question comes from Matt Ramsey with Canaccord Genuity. Please go ahead.
Thank you very much. Appreciate you taking my questions. I guess the first question I would ask, congratulations on adding a third base station player into the licensing mix. Gideon, maybe you could talk a little bit about, in aggregate, what percentage of the, I guess, 4.9 and 5G base station rollout volumes you guys are anticipating being represented by CEVA-based silicon in the base station modems from the aggregate of those three big players that you now have, just so we can get an idea of context as to what it means for your business as the 5G business rolls out.
Thanks. I don't want to be specific on what will be the percentage, let me say the following. When it comes to 5G, the landscape, the ranking of who will be first, second, and third is about to change because there are few companies that invested ahead, who have an advantage. This new landscape favors us. LTE, we just started shipment two quarter ago. Things are moving. I also said that we are seeing another chip, another SKU, that just came out into our royalty, meaning shipped in this quarter. We wait for a few more quarter to better see the trend and the Back on the call?
Thanks, guys. Sorry, I think I'm having some audio issues on my end, thank you for that, Gideon. In follow-up there on the licensing side, Yaniv, maybe you could talk about expectations for next year. I know it's early, this year was obviously great organic performance in the licensing business and had a couple of one-time big bumps. How should we think about licensing business in aggregate for 2018 and the run rate going forward? Thanks.
What we've seen this year is that these new technologies, new market, really managed to open up much bigger opportunities for us to license our technology and to offer our technology, multiple markets, multiple customers in each of these markets. The licensing activity has paid off. Our R&D investments have paid off, and we've seen that in the licensing line. As you said, it's a bit early. In next quarter and general earnings call, we'll give much more detailed guidance on licensing. I think we said already throughout the year that we would like to keep these types of, let's say, the 40-ish type of licensing revenue versus the 30-ish that we were for the last couple of years before 2017.
Where exactly we end up and how we will guide and what will be the input, we need to do a little bit of research and talk with our customers and potential ones and new ones in each of these markets, and we'll try to prepare and get you a good answer in few months. There's no doubt that we are seeing more interest, and we will want to keep these higher numbers as part of our model going forward.
Got it. Just let me squeeze one more in. Gideon, the 3G number in terms of baseband unit shipments in the royalty business has declined pretty sharply, and I think the market's certainly moving to 4G quickly. I guess a couple quarters ago, Samsung brought in MediaTek as a supplier in that mid-tier range, and a few bumps in the road potentially for Spreadtrum. maybe you could talk us through a little bit about how that 2G, 3G combined base of your royalty business in terms of unit shipments with partners might go from here or potentially stabilize, or just how those trends are in the mid-tier. Thank you, guys. I appreciate the questions.
I agree with you, Matt, that about 3G is something like in between a sandwich between the 2G and the LTE. The 3G has three lives, in particular in India, and you mentioned the variant of a feature phone, which is in. In terms of growth today, building flagship in India and emerging markets, and in particular LTE, the penetration there is very low. It's a transition. That's the reason that we face some softness in the second quarter, which we said that it doesn't look like an industrial issue or market issue. It's more like a transition. We need to go to the price point. We still need to do some work in this price point. I think in this respect, Spreadtrum will flourish, and potential is there.
The question is the pace, how fast India will move to LTE. They will move to LTE, further that, all the emerging markets. There are good billions of subscribers that are about to upgrade. We will be there in big time.
Thank you.
Thank you.
The next question comes from Suji DeSilva with Roth Capital. Please go ahead.
Hi, Gideon. Hi, Yaniv. Congratulations on the strong licensing progress here. Thanks for breaking out the non-baseband revenue. It's helpful. The royalty revenue came in about 20% and grew nicely the last few quarters. Maybe one or two years out, you could talk about what the expectation of the mix would be. I know there's a lot of moving parts in the royalty with the baseband smartphone and the non-baseband several segments. Could you handicap for us what you think the non-baseband % might be as we look out four to eight quarters or so?
Sure. Sure, it's not easy, but we've promised you guys that probably early next week, we'll update our three Next year, not next week. We'll update the famous three year or four year expectation in volume and maybe even in $ in royalties. This is what we have put in place back in 2015, when we started this diversification and looked at the four year from beginning of 2015 to the end of 2018 and wanted to see and print out how we see these markets evolving for us. Some numbers we're hitting, some maybe not on the volume side, and some are doing very well, maybe a bit slower. Bluetooth, two years ago when we started, we were less than 40 million units a year, and we're up to maybe 200 million, two and a half years after.
This is the run rate for more or less the end of this year. We're seeing a lot of these markets start to build in. There's no doubt that if in the past, for many, many years, 90% of our royalties came from handsets. This last quarter was the first time that that 10% grew to 20%. Of course, we want to see it. We want to be in a position that the non-baseband is as big as the handset side, if not even potentially bigger with all these design wins that we are seeing and these licensing activities will flourish in three or four years down the road.
Again, I don't have the full picture of how that slide yet will look, but all our licensing activity and all our customers are eager to get into production, are eager to sell their new chips into these new markets. I'm not sure if we mentioned yet, in the prepared remarks, but in the last quarter, we saw two consumer devices go into production for the first time with our solutions inside, one in the vision, one in another consumer device. The more we continue to see there, and that we'll have a better picture of how those royalties will look like. For sure, it's not that we don't want it to keep saying they're 20%, but much, much more.
Suji, let me add my perspective. The quick or non-handset baseband, different market and behavior is different than the cellular. In cellular, we deal with mega customer and a certain point, when you go from zero to few hundred percent, here it's a more gradual buildup. It's composition of many small companies that are getting, and because the licensing activity was so intensive and we signed so many, all of them are more or less getting the integration. Yaniv mentioned, last quarter, three new royalty payers from the non-handset baseband started to ship. We added this one, the newest SKU in the base station that, again, characteristic that we do every quarter, we're going to see how fast, how much we need to get to a point that, to the full swing point, and then we'll be able to be more specific.
Yes. Hello. Sorry. Then, on the licensing effort, you talked about some customers expediting you this past quarter. Can you talk about what end markets and products those customers were targeting? Where there's a rush to get into that you saw this quarter?
The contribution of the license revenue in the quarter is basically two components. One is licensing with the element of design and we sign. The other one is the pulling of 5G delivery to a customer. I mentioned in prepared remarks that we see expedition and the pulling of 5G. We were asked to pull in and our R&D for doing the job in expediting and pulling. Easier we could recognize it. Component of the licensing business.
Yeah. Okay, thanks, guys.
Again, if you have a question, please press star then one. At this time, this concludes our question and answer session. I'd like to turn the conference back over to Richard Kingston for any closing remarks.
Thank you. Thank you all for joining us today and for your continued interest in and support of CEVA. We will be attending the following upcoming events and invite you to meet us there and get an update. The Roth Technology Corporate Access Day on November 15th in New York, Exane BNP Paribas MidCap Forum on November 29th in London, and Barclays Global Technology, Media and Telecommunications Conference on December 6th in San Francisco. Please visit the investor section of our website for further information on these events and other events we will be attending. Thank you all, and goodbye.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.