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Welcome to the Rambus Second Quarter and Fiscal Year 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. At the conclusion of our prepared remarks, we will conduct question-and-answer session. [Operator Instructions] As a reminder, this conference call is being recorded.
I would now like to turn the conference over to Rahul Mathur, Chief Financial Officer. You may begin your conference.
Thank you, operator, and welcome to the Rambus second quarter 2020 results conference call. I'm Rahul Mathur, CFO; and on the call with me today is Luc Seraphin, our CEO. The press release for the results that we will be discussing today have been furnished to the SEC on Form 8-K. A replay of this call will be available for the next week at 855-859-2056. You can hear the replay by dialing the toll-free number and then entering ID number 1788075 when you hear the prompt. In addition, we are simultaneously webcasting this call. And along with the audio, we're webcasting slides that we will reference during portion of today's call. So even if you're joining us via conference call, you may want to access the webcast with the slide presentation. A replay of this call can be accessed on our website beginning today at 5:00 P.M. Pacific Time.
Our discussion today will contain forward-looking statements including our financial guidance for future periods; product and investment strategies; timing of expected product launches; demand for existing and newly acquired technologies; the growth opportunities of the various markets we serve; the expected benefits of our merger, acquisition and divestiture activity including the success of our integration efforts; risks and the potential adverse impacts related to or arising from the novel Coronavirus or COVID-19 and the effects of ASC 606 on reported revenue, amongst other things. These statements are subject to risks and uncertainties that are discussed during this call, and may be more fully described in the documents we file with the SEC, including our 8-Ks, 10-Qs and 10-Ks. These forward-looking statements may differ materially from our actual results and we're under no obligation to update these statements.
In an effort to provide greater clarity in our financials, we're using both GAAP and non-GAAP financial presentations in both, our press release and also on this call. A reconciliation of these non-GAAP financials to the most directly comparable GAAP measures has been included in our press release in our slide presentation and on our website at rambus.com on the Investor Relations page under Financial Releases.
The order of our call today will be as follows: Luc will start with an overview of the business; I will discuss our financial results, including our guidance for future periods, and then we will end with Q&A.
I'll now turn the call over to Luc to provide an overview of the quarter. Luc?
Thanks, Rahul, and good afternoon, everyone. This was another excellent quarter for Rambus delivering in line or above expectations for the eighth consecutive quarter. We delivered $69.9 million in revenue, and most notably, $62 million in cash from operations, breaking a 10-year record for quarterly cash generation. This tremendous performance was enabled by our sustained focus on quality and execution, demonstrating our ability to consistently deliver.
The team is fully adjusted to remote operations and continues to maintain high levels of productivity, as well as our commitments to our customers. One thing that has remained constant during these uncertain times is the increased demand for data bandwidth and performance driven by the significant increase in online activity from corporations and consumers. We expect the outlook for data center to remain healthy as trends like working-from-home and online learning are likely to continue longer term. As a result, we are seeing sustained investment from our customers in products and solutions that will help improve the performance of the global data infrastructure.
Memory and interface chips led our strong performance with the fifth consecutive quarter of record revenue. This sustained growth trajectory is driven by a combination of ongoing data center and OEM qualifications and strong overall demand in the market. The confluence of existing technology trends like AI at the Edge and the transition to the cloud, with a paradigm shift to remote collaboration, is accelerating infrastructure deployment and upgrades. This translates into greater demand and increased shipments for cloud DRM and server modules.
From an operational standpoint, our supply chain remains strong with solid wafer supply and good cycle times on test. The operations team has done an excellent job of actively managing any potential risks; and as a result, we continue to meet all of our customer commitments. Based on the latest round of data from our customers and the industry, we believe first half inventory levels is in the overall service supply chain was slightly above normal, but remained healthy given the increased uncertainty in the current environment. As of this time, we expect demand to remain as consistent and stable in the second half, but we've continued to monitor inventories.
Looking forward, DDR size continues to progress with the recent formal publication of the specification by JEDEC. We are working closely with the industry and our customers, as illustrated by the recent micro-announcement of their DDR5 Ecosystem Enablement program to support the rollout of our next-generation systems. Rambus remains poised as the first mover and will be on the forefront of DDR5 deployment with our customers.
Finally, for silicon IP, we maintained our momentum with further interface and security IP design wins at Tier 1 SOC makers across data center, AI and communications. We continue to deliver solutions that enable new architectures and capabilities for high-performance systems across our focus markets.
In closing, we continue to deliver excellent results, demonstrating the resilience of our business model and ability to execute in these unprecedented times. Rambus is developing products and solutions to address the megatrends which are reshaping the data center and the network at large. We are confident in our ability to execute on our technology roadmap, and believe we are well-positioned to capture the growing opportunity in data-centric applications.
With that, I'll turn the call to Rahul to discuss the quarterly financial results. Rahul?
Thanks, Luc. I'd like to begin with our financial results for the second quarter. Let me start with some highlights on Slide 5.
As Luc mentioned, we continue to execute in our product businesses and delivered excellent financial results at the high-end of our revenue and earnings expectations while continuing to strengthen our balance sheet. We've adopted ASC 606 using the modified retrospective method, which does not restate prior periods, but rather runs the cumulative effect of the adoption through retained earnings as the beginning balance sheet adjustment. Any comparison between our results under ASC 606 and prior results under ASC 605 is not an accurate way to track our company's progress.
We will continue to provide operational metrics such as licensing billings to give our investors better insight into our operational performance. We delivered revenue of $59.9 million and licensing billings of $60.7 million at the high-end of our expectations. We have a very strong balance sheet and ended the quarter with cash, cash equivalents and marketable securities of $486.1 million, up from the previous quarter due to cash from operations of $62 million, our best quarterly performance in over 10 years. Our continued execution on our strategy and our operational discipline have yielded excellent financial results and a strong balance sheet that affords us flexibility on our strategic initiatives.
Now, let me talk you through some revenue details on Slide 6. Revenue for the second quarter was $59.9 million at the high-end of our expected range due to another record quarter for our buffer chip business. Royalty revenue for the second quarter was $17 million, while licensing billings was $60.7 million. The difference between licensing billings and royalty revenue primarily relates to timing as we don't always recognize revenue in the same quarter, we bill our customers. Going into additional detail; our product revenue was $31.7 million, consisting primarily of our buffer chip business. Our contracted other revenue was $11.2 million, consisting primarily of our silicon IP business. Our silicon IP business was down quarter over quarter as expected due to the timing of customer engagements. As you saw in our press release, we expect this to return in Q3.
For the year, there's roughly $35 million of our silicon IP business that's being reflected in our licensing billings. This is almost double what we expected in our Analyst Day last year due to the structure of our contracts and acquisition accounting.
Let me walk you through our non-GAAP income statement on Slide 7. Along with our excellent revenue performance in Q2, we again exceeded our profitability targets. Total operating expenses, including COGS for the quarter came in at $59.5 million, operating expenses of $47.7 million were lower than our expectations due to lower spending on employee-related expenses. With higher revenue and disciplined execution on spending, our profit was nicely above our expectations.
We ended the quarter with headcount of 670 flat from 665 in the previous quarter. Under ASC 606, we recorded $3.7 million of interest income related to the financing component of our fixed fee licensing arrangement for which we have recognized revenue but not yet received payment. We incurred $0.8 million of interest expense primarily associated with our convertible notes. This was offset by incremental interest income related to the return on our cash and investment portfolio.
After adjusting for non-cash interest expense on a convertible note, this resulted in non-GAAP interest and other income for the second quarter of $3.8 million. Excluding the interest income related to the financing components related to ASC 606, this would have been $0.1 million. Using an assumed flat rate of 24% for non-GAAP pre-tax income, our non-GAAP net income for the quarter was $3.2 million.
Now, let me turn to the balance sheet details on Slide 8. Over the past several years, we've built a very strong balance sheet. Cash, cash equivalents and marketable securities totaled $486.1 million, up significantly from the previous quarter, primarily through cash from operations of $62 million. As I mentioned previously, this is our best performance in over 10 years. In the first half of this year, we've generated nearly $100 million of cash from operations.
At the end of Q2, we had contract assets worth $444.5 million, which reflects the net present value of unbilled AR-related licensing arrangements for which the company has no future performance obligations. I expect this number to continue to trend down as we bill and collect for these contracts. It's important to note that this metric doesn't represent the entire value of our existing licensing arrangements, as several customers have royalty-based agreements that allow us to recognize revenue each quarter under ASC 606.
Second quarter CapEx was $14.9 million and depreciation was $4.8 million. We delivered $47.1 million free cash flow in the quarter. Looking forward, I expect roughly $19 million of CapEx for the third quarter and roughly $36 million for the full year of 2020, a third of which is related to the relocation of our headquarters facility. I also expect depreciation of roughly $5 million for the third quarter, and roughly $20 million for the full year of 2020.
Our strategic refocus on our core markets and operational efficiencies has set a solid foundation for our company. Our predictable high margin licensing business has put us in a position to come out of the current environment stronger than ever. We continue to build cash and have limited debt with a disciplined financial approach that is, built capital while investing in growth, we are well-positioned to grow both organically and inorganically.
Our historical and ongoing investments in technology R&D has helped us build a patent portfolio that is foundational to our industry. Our historical agreements, including those we signed this quarter position us well for our licensing renewals in the upcoming periods.
Now, let me turn to our guidance for the third quarter on Slide 9. As a reminder, our forward-looking guidance reflects our current best estimates. And our actual results could differ materially from what I'm about to review. In addition to the financial outlook under ASC 606, we've also been providing information on licensing billings, which is an operational metric that reflect amounts invoiced to our licensing customers during the period adjusted for certain differences. As you see in the supplemental information, we provided on Slide 13 of our earnings deck, licensing billings closely correlates with what we'd historically reported as royalty revenue under ASC 605.
We feel that we are very well positioned in the market, but remain cautious regarding a near-term outlook due to the lack of visibility created by COVID-19. With that said, under ASC 606, we expect revenue in the third quarter between $54 million and $60 million. We expect royalty revenue between $9 million and $15 million. We also expect licensing billings between $55 million and $61 million.
Quarter over quarter, we expect growth in our silicon IP business to offset small productions and patent licensing. We expect Q3 non-GAAP total operating costs and expenses, which includes COGS to be between $64 million and $60 million as we continue to invest in programs. Under ASC 606, non-GAAP operating results for the third quarter is expected to be between zero and a $10 million loss. For non-GAAP interest and other income and expense, which exclude the interest income related to ASC 606, we expect this to be approximately zero which includes $0.6 million of interest expense related to the notes due in 2023.
Based on the tax legislation passed at the end of 2017, we expect our pro forma tax rate in 2020 to remain consistent with our 2019 pro forma tax rate of roughly 24%. The 24% is higher than the statutory rate of 21%, primarily due to higher tax rates in our foreign jurisdiction. As a reminder, we pay roughly $20 million of cash taxes each year driven primarily by our licensing agreements with our partners in Korea. We expect non-GAAP taxes to be between a benefit of zero and $2 million in Q3. We expect our Q3 share count to be roughly $116 million basic and diluted shares outstanding. This leads you to between a non-GAAP loss per share of $0.07 and $0.00 for the quarter. While we don't provide guidance beyond Q3, as a reminder in Q4, we will see our last step down related to one of our large licensing agreements. With no other changes, this represents incrementally better profit than current consensus estimates for Q4.
As I've mentioned previously, in the coming years, I expect licensing billings to stabilize at the same level we expect to see in 2020. Our product growth will then provide leverage on both the top line and the bottom line.
Let me finish with a summary on Slide 10. We are proud of the excellent performance by our team and the progress we continue to make against our strategic initiatives to drive long term profitable growth. While we understand that ASC 606 added a level of complexity to our financial reporting, it's important to reiterate that the underlying financial strength of our business remains strong, reflected in our demonstrated ability to generate cash. We have refocused our product portfolio around Rambus's core strength in the semiconductor industry, improved our operational efficiency and profitability, generated solid cash from operations and leveraged our strong balance sheet to support our strategic initiatives.
We continue to focus on our core markets and are well-positioned to come out of the current environment stronger than ever. Before I open up the call to Q&A, I would, once again, like to thank our employees for their amazing resilience during these uncertain times. Everyone, please, stay safe and take care of yourself and your families.
With that, I'll turn the call back to our operator to begin Q&A. Could we please have our first question?
Thank you, Rahul. [Operator Instructions] Your first question comes from the line of Gary Mobley with Wells Fargo Securities. You may now ask your question.
Yeah, thanks. Hey, guys. Let me start out by asking about some reconciliation items from GAAP to non-GAAP results, and focusing specifically on substituting billings -- substituting royalties for billings. If I make that adjustment that gets to a -- just the revenue number, put just reported quarter of roughly $103.6 million. Am I doing the math right there?
So, Gary, it's Rahul. Great to hear your voice and I hope that you and your family are well. I think what you're doing is you're substituting licensing billings for what we typically report for royalty revenue. And, obviously, that's not a GAAP measure. But if I were to do the math, I'd get the same number.
Okay. And translating down the different GAAP -- the non-GAAP reconciliation items from the expenses, you get to roughly what? $0.29 for the quarter?
Yeah, Gary. If I were to do that math, if you did, I would get the same number. But again, those aren't numbers that we present.
Understood. All right. I want to ask about sustainability of your buffer chip business. It's been great now for several quarters. There's been a lot of chatter and concerns as you addressed on the -- on your prepared remarks about inventories of DIMs in the channel related to that -- some buffer chip inventory. And so, to the best of your knowledge, how much of your strength in that portion of your revenue has been driven by sustained demand for server capacity in Data Center Operations versus inventory increases versus market share shifts, vis-Ă -vis your handful of competitors? And any sort of step up in the market for what you're addressing, just given the various changes in Intel process -- processor cycles?
Hey, Gary. Nice to talk to you. We heard a little bit of all happening, so we continue to gain market share in the DDL for generation of products as Cascade Lake ramps into the market. And we expect our design wind progress to continue as new generations hit the market. By the end of this year, Ice Lake is going to be introduced and we have a very good footprint there, there's going to be an increase of number of channels with Ice Lake, which can probably also increase the total demand. So the traction in the market is there, and again, is driven by the demand for work from home, learn from home, online entertainment.
Now, we don't see without direct customers, a building of inventories, we sell directly to our customers, and we're able to meet their commitments. We hear some slight inventory buildup at the system level. I think people took some caution about, you know, any possible disruption in the supply chain. So we've seen a little bit of buildup during the first half of this year, but we don't expect to have a huge correction in the second half. We're prudent for the second half, but I think the inventory buildup is very reasonable. And is there to just prevent any possible disruption with the supply chains, given that -- the COVID-19 environment.
Okay.
Now, in the long run, we see more demand for buffer chip. You know, when we move to Ice Lake, we're going to have another chip with DB, when the market moves to DDR5, we expect the markets to be probably twice the size is what it is today, by 2024. DDR5 is going to see more content on the modules and we are going to invest in all of these chips that are going to be on DDR5 modules. So in the long run, we're going to see very high market growth for these products. So, we continue to be very optimistic in the long run with this business.
Okay, it's helpful, Luc. And on the topic of the buffer chip business, I think maybe your originally guidance business, you know, a couple years ago to be at best 60% gross margin business. It was 63% in 2019. It's 68% in the most recent quarter, what's the limit on this? And what's sort of sustainable over the long term?
Hey, Gary, it's Rahul. So yes, we've been delighted with our gross margins. And any given quarter, it'll go a little bit higher, a little bit lower, just depending on mix and shipments and these other things as well. And, obviously, as we continue to ramp volumes, as you've seen, record time and time again over the last five quarters, then we get to leverage some of our existing costs.
You know, what I talked about is gross margins in the 55% to 60% range long term. We've been posting, as you know, to closer to about 65%. But I think somewhere in that 60-odd range, long term is sustainable for us.
Thanks, guys. I'll turn it over.
Thanks, Gary.
As a reminder, to limit your question to one question and one follow-up. Your next question comes from the line of Sydney Ho with Deutsche Bank. You may now ask a question.
Hi, this is Jeff Rand on for Sydney. Congratulations on the nice quarter. With the licensing step down in Q4, do you think this points towards a sequential revenue decline in 4Q, or do you think your product and contract growth can offset this?
Yeah, Jeff, nice to talk to you. And I hope that you're well. We gave guidance for Q3 because we guide one quarter at a time. So, you know, as we mentioned in the prepared remarks, as well, there's still a little bit of lack of visibility related to COVID-19. So, if everything else stayed flat, then you'd see exactly that. I think what I've talked about historically is that specific contract has a step-down. It's just structural. It was something that negotiated, I think, five, seven years ago, of about $5.5 million in Q4.
That steps back up in Q1. So all of the things being held equal, you'd see a Q4 that was down $5.5 million on the top line, and we run that through, and that's -- we run a pro forma 24% tax rate. So that's about $0.04. So right now, it's kind of hard to gauge what's going to happen in the fourth quarter. We're very pleased with the progress that we have across our businesses. Licensing has come in exactly as we thought. At the beginning of the year, you're seeing buffer chip perform very, very well. We expect to see our silicon IP business rebound in Q3. But right now, we're taking it one quarter at a time.
Great, thank you. That's helpful. And you've had some design wins recently. How should we think about the incremental revenue opportunities from these wins and how quickly should they ramp up?
The design wins -- Hey, Jeff, this is Luc. The -- we continue to have design wins on the buffer chip as we talked about earlier with our customers and with our customers' customers. And every time a new processor, a new DRAM or a new DIM architecture is introduced to the market, that gives us an opportunity to win designs. And that explains the growth we have on the buffer chip.
We continue on the IP cores and security to have a healthy design win history and pipeline. Most of our design win, half of them are in the data center fields. The other half is split between IoT 5G and AI type of applications. The business model for IP cores is a bit different. People pay us for license and sometimes royalties or reuse fees. So the revenue comes quite quickly after we win the designs, typically within the year, a year and a half that follows that design.
And our design win pipeline is healthy. We had some, you know, slowdown in Asia earlier in the year whenever things shut down, but productivity is -- continues to be healthy.
Great, thank you so much.
Thank you, Jeff.
[Operator Instructions] Your next question comes from the line of Suji Desilva with ROTH Capital. You may now ask your question.
Hi, Luc. Hi, Rahul. Congratulations on the strong cash flow here. Very impressive. So just following up on Gary's question --
Thank you
Yeah, sure, following up on Gary's question about the revenue EPS, just asking about now the third quarter, the guidance stuff. If I do my math here, I think it implies $103 million, just slightly down; sequentially revenues and EPS of $0.27, also down a little bit. Does that math sound right, Rahul?
So I think, Suji, again, what you're doing is you're taking the guidance for licensing billings and substituting that for what we guide for royalty revenue. And then if I were to do the same math, I'd get the same view which is $103 million. And on a like comparison, that's roughly flat quarter over quarter.
And I'm sorry, what did you say on the bottom line?
$0.27.
Yeah, same thing. If I run that through in our pro forma expense and tax effect at the 24%, I get the same.
Great, okay. And then a question of the business on the memory interface side. You've kind of crossed currents in the marketplace, you have strong share gain and growth for your memory buffer, but maybe some people took some -- some customers took some excess in the beginning to kind of prepare for the second half. Could you talk about the memory interface business and whether you expect it to continue to grow steadily at this point or would potentially pause after five quarters of growth? Any color there would help.
Yes, Suji, hi. So I think we saw some -- as we said in the first half of the year, we saw our customers taking some precaution because of COVID-19. But we believe that the inventory levels are still healthy. Going into the second half of the year, we are prudent with our outlook for buffer chip. We don't think there's going to be a correction, we think that the inventory level is still healthy. We'll continue to, you know, support that business with design wins. At the end of the year, we're going to start seeing Ice Lake popping up. And next year, Ice Lake is going to ramp, DDR5 is going to start to run. And as I said, when DDR5 ramp because we were one of -- we were the first to introduce DDR5 samples in the market; we believe our market share is going to continue to increase. And in addition to that, we're developing companion products that are going to go in the same DDR5 beams [ph]; so the potential market for us is going to further increase when that happens. But second half, as I said, inventory levels are healthy, but we're just prudent.
Okay. Understood. And then last question coming off of Intel's earnings, you talked about the manufacturing challenges and emphasized perhaps use of chiplets. And I think -- I'm curious, for your silicon IP business [indiscernible], if that's a potential tailwind. And if so, you could kind of maybe talk about how important that could be to that kind of breaking up with the chip and having to connect them, chips and connecting them.
Yeah, that's a great question, Suji. When you move into very thin technologies like seven nanometer or thinner like five nanometer, the cost of masks and the complexity of designing especially analog passes is increasing. So one of the solutions to that problem is to actually separate the interface from the main chip itself and produce chiplets, high-performance chiplets. And we have those developments in house. We are full speed developing 112 gig, very short-range IP interface that can be used in chiplets. So that's an area that we watch very, very closely. I think there is a great market potential for that. And that plays into one of our strengths, which is very short reach 120 gig service and technology.
Okay, thanks, Luc. Well, congratulations again.
Thank you.
Thank you.
[Operator Instructions] This time there are no further questions. This concludes the question-and-answer session. I would now like to turn the conference back over to Luc.
Thank you, everyone, who has joined us today for your continued interest and time. We hope each one of you stays safe and healthy. And look forward to speaking with you again soon. Have a great day.
Thank you. This now concludes today's conference. You may now disconnect.