Silicon Motion Technology Corp

SWB:S9M

Earnings Call Transcript 2018-Q3

[Operator]

Ladies and gentlemen, thank you for standing by, and welcome to the Silicon Motion Technology Corporation Third Quarter 2018 Earnings Conference Call. This conference call contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 as amended. Such forward-looking statements include, without limitation, statements regarding trends in the semiconductor industry and our future results of operations, financial conditions and business prospects. Although such statements are based on our own information and information from other sources we believe to be reliable, you should not place undue reliance on them.

These statements involve risks and uncertainties and actual market trends and our results may differ materially from those expressed or implied in these forward-looking statements for a variety of reasons. Potential risks and uncertainties include, but are not limited to continued competitive pressure in the semiconductor industry and the effect of such pressure on prices; unpredictable changes in technology and consumer demand for multimedia consumer electronics; the state of any change in our relationship with our major customers; and changes in political, economic, legal and social conditions in Taiwan.

For additional discussion of these risks and uncertainties and other factors, please see the documents we file from time to time with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements, which apply only as of the date of this conference call.

At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. [Operator Instructions] I must advise you that this conference is being recorded today.

And I will now hand the conference over to your first speaker, Mr. Jason Tsai. Thank you. Please go ahead.

[Jason Tsai, Senior Director, IR and Strategy]

Thank you, and good morning everyone and welcome to Silicon Motion’s third quarter 2018 financial results conference call and webcast. My name is Jason Tsai, and with me here is Wallace Kou, our President and CEO; and Riyadh Lai, our Chief Financial Officer.

The agenda for today is as follows: Wallace will start with a review of our key business developments; Riyadh will then discuss our second quarter financial results and provide our outlook; we’ll then conclude with Q&A.

Before we get started, I’d like to remind you of our Safe Harbor policy, which was read at the start of this call. For a comprehensive overview of the risks involved in investing in our securities, please refer to our filings with the U.S. SEC.

For more details on our financial results, please refer to our press release, which was filed on Form 6-K after the close of market yesterday. This webcast will be available for replay on our website, www.siliconmotion.com, for a limited time.

To enhance investors’ understanding of our ongoing economic performance, we will discuss non-GAAP information during this call. We use non-GAAP financial measures internally to evaluate and manage our operations. We have, therefore, chosen to provide this information to enable you to perform comparisons of our operating results in a manner similar to how we analyze our own operating results. The reconciliation of the GAAP to non-GAAP financial data can be found in our earnings release issued yesterday. We ask that you review it in conjunction with this call.

With that, I will turn the call over to Wallace.

[Wallace Kou, President and CEO]

Thank you, Jason. Hello, everyone, and thank you for joining us today.

I will first update you on our business, and Riyadh will review our financials and provide our outlook later on this call.

We are pleased to report third quarter revenue of $138.6 million, which is flat sequentially but up 9% compared with the same quarter last year. Earnings per ADS this quarter was $0.95, an increase of 68% compared with last year. In the third quarter, while overall sales were flat sequentially, sales of our client SSD controllers increased 35% sequentially. Compared to the last year, our SSD controller sales this quarter are almost 80% higher. Separately, and as expected, our SSD solutions declined in the third quarter due to timing of the technology transition at our major hyperscale customer. Our eMMC controller sales were soft, primarily due to smartphone market weakness.

Our client SSD controller sales growth continued to exceed our own expectation at the start of this year and three months ago. We now expect our client SSD controller sales to grow 35% for the full-year. Growth has been accelerating with the falling price of NAND, which makes SSD increasingly affordability in PC and other client devices. This quarter sales of both our NAND flash partners and module makers, was strong, but especially sales to our flash partners.

While NAND prices have fallen a lot since the start of the year, supplies of the NAND is essentially just back down to early 2016 levels. Supplies of client SSD today are also roughly what they were 2.5 years ago, though moving lower quickly. We believe that price of the NAND and the price of SSD can fall a lot further, especially since the cost of NAND today is significantly lower than what they were two years ago.

Today 64-layer 3D NAND are ready in high-volume production and NAND makers have started initial production of 96-layer NAND. Additionally, Intel and Micron are already involved in production of their 64-layer, 4-bits per cell QLC NAND. And we expect majority of NAND makers to begin production of 96-layer QLC next year.

The NAND industry is currently being oversupplied and the price of the NAND will continue to fall rapidly. With NAND industry’s supply expected to continue to grow, we believe current oversupply conditions will continue, likely through the middle of next year and possibly even through the second half of next year.

We believe client SSD demand will continue to grow rapidly as NAND prices continue to fall. Approximately 300 million client HDDs are shipping annually for use in PC, game consoles and other client devices, all displaceable by client SSD.

This quarter, we are proud to help both Intel and Micron bring to market the world’s first client PCIe NVMe SSD using 64-layer QLC NAND. We believe PC OEMs are keenly interested in these low-cost high-performance SSDs, using QLC NAND. And QLC-based SSD shipments will scale more meaningfully early next year. Furthermore, you should expect to see even lower cost and higher production volume of QLC NAND when 96-layer QLC NAND enters production next year. This will further reduce the cost of NAND and SSD, and further accelerate the adoption of SSD in the client devices.

QLC NAND is harder to manage compared to the TLC NAND because of the worsening data retention, lower endurance, slower rewrite data rate, and other issues. We are extremely well positioned with our QLC controller technology and believe QLC further extended our technology leadership.

Additionally, our highly configurable hardware plus firmware controller platform held by our NAND flash partners quickly and cost effectively converts NAND component into competitive value add SSD solution. Today, a large percentage of our SSD controller projects with our flash partners involve QLC NAND.

Now, let me update you on the progress of our data center and enterprise NVMe and open-channel SSD controllers. We are happy to announce that our controller has passed final testing with two hyperscale customers. And SSD these controllers are scheduled to begin initial production this quarter. However, initial shipments will be small. SSD solutions using this controller will still need to undergo live data center application testing, before they grow up extensively in the second half of next year.

Turning to our eMMC+UFS controller. Sales this quarter were down modestly, the result of smartphone industry viewed weakness as well as sales lumpiness relating to smartphone OEMs transitioning from eMMC to the UFS mobile embedded memory. We believe UFS adoption will accelerate next year. When leading mobile chipset vendor introduced mainstream application processor that support uMCP which combine user controller with NAND and mobile DRAM in a single BGA packaging.

We are excited that smartphone OEMs have already extensively designed flagship devices using UFS and are actively bringing many of these UFS phones to market. However, the design activity with our flash partner continued to grow. Already, our UFS controllers will account for more than 10% of our overall eMMC+UFS sales this year. We expect our UFS controller sales to continue to grow rapidly next year as the market transitioning further from eMMC to UFS and uMCP, and our customer design activity continues to pick up.

As part of the transition from eMMC to UFS, we are also diversifying our customer concentration on sales primary to SK Hynix, to a more balanced customer mix, which are also meaningful contribution from Micron, a Chinese flash maker and module makers.

Now, let me discuss about our SSD solutions business. Sales for this sector declined sharply as sales relating to our new project were delayed and will be further delayed. We have been transitioning our Shannon Data Center SSD from FPGA-based controller to ASIC-based that includes open-channel and standard enterprise-grade NVMe controller that I have previously talked about. Our open-channel controller recently passed testing at our two hyperscale customers and our Shannon SSD are literally days away from passing final qualification before initial production. We expect this open-channel SSD will be testing live application with the objective of production to scale in second half of next year.

Let me summarize by saying that while overall sales this year will be lower than originally projected, caused primarily by large SSD solutions project delay, we have made up on some of delayed SSD solutions sales by our stronger than expected SDD controller sales. We expect our SDD controller sales to continue growing strongly through next year.

Given our large pipeline of projects and very favorable tailwind of declining NAND flash trend, on our SDD solutions after a brief delay, we have delivered a major milestone in our SDD solutions to start scaling beginning around the May of next year.

Now, let turn the call over to Riyadh to discuss our financial performance and outlook.

[Riyadh Lai, CFO]

Thank you, Wallace, and hello, everyone.

I will summarize our financial results and then provide our outlook. Before I begin, I would like to reiterate that our comments today will focus primarily on our non-GAAP results, unless otherwise specifically noted. A reconciliation of our GAAP to non-GAAP data is included with earnings release issued yesterday.

Our Q3 revenue was flat sequentially and in line with our guidance. For Q4, we expect revenue to be in the range of $120.5 million to $127.5 million, down 8% to 13% sequentially.

Let me point out that while our revenue this year will be lower than expected, our gross margins are higher than expected because of stronger SDD controller sales. And with operating expenses tightly controlled, we anticipate our full-year earnings to remain consistent with what we were expecting at the start of the year and in the ballpark of analyst consensus.

I will now walk you through the performance of our key products before taking you through key elements of our P&L and the rest of our financials. In Q3, sales of our SSD controllers grew approximately 35% sequentially and nearly 80% year-over-year. In Q4, we expect our SSD controller sales to be stable sequentially but up 50% year-over-year. For full-year 2018, we expect our client SSD controller sales to grow 35%, much stronger than the 20% we were expecting at the start of the year and better than the 30% growth expected three months ago. We expect strong SDD controller sales to continue through next year.

In Q3, sales of our eMMC+UFS controllers declined 5% sequentially and stable year-over-year. In Q4, we expect our eMMC+UFS controller sales to also decline modestly due to weak smartphone market demand and our transition from eMMC to UFS. We believe our eMMC+UFS controller sales next year will likely be flat to down, depending on the speed at which we can scale our UFS controller seals relative to declining eMMC usage in a mature, zero growth smartphone market.

In Q3, sales of our SSD solutions declined approximately 40% sequentially. In Q4, we expect our SSD solutions sales to decline further and rebound in the middle of next year when our new Shannon SSDs are expected to ramp and scale.

Moving to gross margins. Gross margin increased from 47.5% in Q2 to 51% in Q3 due to strong sales growth of higher gross margin SSD controllers and a decline in lower gross margin SSD solutions sales. We expect our Q4 gross margins to remain stable in the range of 50% to 52% because higher gross margin SSD controller sales as a percentage of sales mix will increase, and blended gross margin of our other products will decline a bit. Operating expenses increased from $30.2 million in Q2 to $33.1 million in Q3, a more normalized level of spending compared to a year ago. As discussed last quarter, Q2 operating expenses were light because of lower R&D project tape-outs and other expenses.

Our operating margin increased from 25.7% in Q2 to 27.1% in Q3 because of higher gross margin, partially offset by higher operating expenses. For Q4, we expect operating margin in the range of 25% to 27%.

Total headcount at the end of Q3 increased to 1,292, which is 19 more than at the end of Q2. Our effective tax rate in Q3 was 12%, higher than the 10% in the previous quarter. While our long-term model tax rate remains at 15%, recently, we have been benefiting from a series of short-term and one-time tax gains. In Q4, our effective tax rate should fall to 11% due to a one-time R&D tax credit.

In Q3, EPS was $0.95, higher than $0.92 last quarter and significantly better than the $0.57 a year-ago. In Q3, stock-based compensation in our operating expense, which we exclude from our non-GAAP results, was $4.5 million, higher than the $0.7 million in the previous quarter, due to the seasonal timing of RSU awards. For Q4, we expect stock-based compensation to increase to between $12 million and $13 million, again the result of seasonal timing of RSU awards, similar to prior years.

We had $308.2 million of cash, cash equivalents and short-term investments at the end of Q3, $56 million less than in the previous quarter and $25 million less than a year ago. Cash flow from operations generated $30 million in cash in Q3. In Q3, we had $63 million of CapEx, $4 million from routine purchase of software and design tools, and $59 million for the purchase of land for our future office building in Hsinchu.

Let me spend some time discussing our rationale for the purchase of land for our future office building. For quite some time, we have been evaluating the consolidation of office spaces in Hsinchu, some of which we owned and others we rent, especially since our engineering headcount has grown and continues to grow, though recently at a more measured rate. Additionally, our currently owned and leased office space does not allow for meaningful headcount expansion in the future as space is close to being fully utilized and availability of additional existing office space nearby is very limited. Also, we believe consolidating engineering resources in one site improves productivity and communications.

Recently, we located an empty lock next to the Hsinchu high-speed rail station, which we can use to construct our own office building. Operating from that site will have the travel time between our Hsinchu and Taipei offices through the use of the high-speed rail. This 66,000 square-foot piece of land was purchased this quarter for $59 million. On this land, we are planning a building with 360,000 square-foot of office space. This building will be sufficient to house our current 600 employees in Hsinchu, as well as future hires. We anticipate construction to begin late next year and construction to take three years at an estimated cost of approximately $70 million. Total land plus construction cost will be approximately $130 million.

Since the market for build to lease is financing is not well-developed in Taiwan, we need to sell finance and manage the construction of our office building. Once the building is complete, we plan to enter into sale and leaseback arrangement with a finance company. Since we are fabless semiconductor company, we believe a sale and leaseback arrangement is consistent with our capital light business model. Additionally, once we move into our building, we anticipate selling the office space, which we currently own that has a current market value of between $30 million and $35 million.

In August, we paid $10.8 million for dividend to shareholders, the fourth $0.30 per ADS quarterly installment of our annual $1.20 per ADS dividend that was announced in October of last year. Recently, on October 26th, our Board declared a new $1.20 per ADS annual dividend to be paid in quarterly installments. Please note that while the Company’s profitability, cash flow and long-term outlook continue to be strong, the Board has decided to maintain the same annual dividend as last year, given the current volatile global economic conditions and uncertainty. Our Board will revisit our annual dividend in January 2019 with timing to coincide with our annual operating -- our operational timing, so we can better align decisions about our dividends with business, earnings and cash flow goals and objectives.

This concludes our prepared remarks. We will now open the call to your questions.

[Operator]

[Operator Instructions] Our first question comes from Anthony Stoss from Craig-Hallum. Please ask the question.

[Anthony Stoss, Craig-Hallum]

Hi, guys. Three part question. I just wanted to confirm Wallace that you mentioned Shannon Systems part that’s been delaying the project that it will be qualified in a few days. Secondly. Riyadh, maybe you can highlight the amount of revenue that you are expecting in your Q4 guide from Shannon Systems? And lastly, given where the stock is trading, I think it’s below where you guys have highlighted in the past, a potential share buyback, no commentary whatsoever on share buybacks. I’d love to hear your view on that.

[Wallace Kou, President and CEO]

Yes. The Shannon SSD solutions, we are in the final stage I think in the qualification. But being through the past three to four months, very intense qualification; now will go to the live application through the data center. We believe we will start to ship small volume this year and being through different business units, and they will start to ramp up from probably late Q2 and middle of next year.

[Riyadh Lai, CFO]

Let me also address your second and third question. We don’t break into granular details specifically relating to our Shannon revenue. But, what I can say is, our SSD solutions sales declined quite sharply in Q3, declined approximately 40% in Q3, and we expect to continue to decline sharply in Q4.

To your other question about share repurchase -- before I move to share repurchase, let me also say that our SSD solutions, after declining to lower levels in Q4, will be stable going into next year and should stabilize the lower levels in Q1 and Q2 before starting to rebound in Q3 of next year as our new Shannon SSD move into production and ramp and scale.

So, moving onto your third question about share repurchase, as you know, our Board has authorized share repurchase programs in past. But, you should expect that our primary way of returning capital to shareholders is through our dividend. We will also utilize our cash to explore M&A opportunities as well as small tuck-in acquisitions that could make sense to extend our expertise and leadership in the storage industry.

[Anthony Stoss, Craig-Hallum]

If I may follow up again related to Shannon Systems then, it’s been quite a few periods, probably over the last year of miss-execution on the Shannon Systems side. I know the reasons or the rationale behind the acquisition was to get you entry into China. Is there anything you can do to tighten up management of that operation or give us a sense that this isn’t going to be an ongoing surprise every other quarter?

[Wallace Kou, President and CEO]

No. I think, the open-channel is also very new in China market. We work closely with our partners. So, the fine-tuning performance not only relies on our own firmware, our own driver, also depends on the hyperscale, their server and their host software fine-tuning. So, this is really very major milestone for both companies naturally with our partner together to reach that performance. And this will be -- after the finish, I think we can see very, very strong momentum, scalability for revenue growth. We are getting reassurance from our partner hyperscale is leading in China. They really want to move to open-channel; that is their long-term plan. And there is no hesitation, when the product is ready they are going to ramp quickly.

[Anthony Stoss, Craig-Hallum]

Thanks, Wallace.

[Riyadh Lai, CFO]

Tony, let me also add to what Wallace has said, so you get a full explanation -- to your question. Most of our SSD solutions technical issues have been fixed. This relates to the project that we’ve been talking about. We still need to further tune the performance of our products with our hyperscalers host server and applications, but we feel good entering production in mid of 2019. And we expect our Shannon business to return to growth again next year as these programs ramp.

[Operator]

Our next question comes from the line of Karl Ackerman from Cowen. Please ask the question.

[Karl Ackerman, Cowen]

I had two points. As sort of a follow-on to this Shannon Systems business, I was hoping if you can help us frame the opportunity and visibility for your Ferri solution office and industrial markets. Does that rebound at a faster rate than your Shannon Systems business? And I have follow-up.

[Wallace Kou, President and CEO]

Yes. The traction we are seeing with our Ferri product is accelerating and our breadth [ph] of customer and end market continue to grow rapidly. Ferri will continue to be an important growth driver for SSD solutions business long-term. Ferri addresses markets that need robust industrial or commercial grade SSD. And these products tend to have a long qualification cycle, but sale to this OEM tend to last for several years as well. As if we are confident that we continue to see strong demand for FerriSSD for automotive and surveillance system and networking and enterprise server boost storage. The reason we slowed down a little bit this year is due to NAND transition from 2D NAND to 3D TLC NAND. That qualification takes longer for our end customer. We have high confidence we are going to rebound very strongly for 2019.

[Karl Ackerman, Cowen]

I appreciate that. As a follow-up, how are you thinking about the gross margin equation as the open -- as your custom SSD business and Ferri solutions business advances from here? I mean, how sustainable is this uplift in gross margins, particularly in light of NAND ASP [ph] deceleration that should extend into the first half of ‘19, why wouldn’t margins remain into the 50s?

[Riyadh Lai, CFO]

Our margins for our SSD solutions, whether they are Ferri or Shannon have consistently in the past been below corporate average, and we expect them to continue to be below corporate average because by definition, a big part of the bill [ph] material for these sort of SDD solutions are coming from the NAND components. NAND accounts for a very large bill materials. And as a result, the gross margins for these products are below corporate average. And so, you should expect the gross margins for these products to remain below corporate average going forward. But, what you should be aware as we blend lower gross margin products against our higher gross margin products, higher gross margin products being our controllers in general and we’ve been blending down in order to drive earnings accretion where it’s possible.

[Operator]

Our next question comes from the line of Rajvindra Gill from Needham & Company. Please ask your question.

[Rajvindra Gill, Needham & Company]

The open-channel opportunity at your two hyperscaler customers, wondering if you could characterize the importance of this transition to open-channel, number one. And number two, how that will affect your business in terms of higher ASPs to your controllers, any sense in terms of the revenue opportunity for Shannon when these open-channel opportunities start to come to fruition?

[Wallace Kou, President and CEO]

So, let me explain about our product plan and game plan for open-channel. Open-channel, we co-develop our hyperscale partner in China with two leading hyperscalers. But, if you take the main purpose for open-channel, it allows the cloud [ph] maker, they can monitor the health of the NAND component. So, in the past the cloud maker can only treat SSD solution, the product as a one black box. Now, they can go to the open-channel to handshake, boost driver to host level, they can monitor each main component independently. And you can repartition NAND component into multiple function and reduce the latency. So, they can really help them to decide which media move to where, when they can move around the data. And because you know the 3D NAND, the single die if on 512 [ph] gigabit move to a 1 terabit, and we’re going to see 2 terabit single die in 2020. So, when you put a die -- into 1 BGA, that’s about 1 terabyte or 2 terabyte. And we don’t need to mention the SSD solutions could even move to 16 terabyte or 32 terabyte. So, that’s a very expensive if cloud maker can only view SSD as a one black box. They like to see more down to component level. So, that needs tremendous different software handshake and housekeeping and maintenance between the controller side versus solutions move system layer with the host developer. That will help them to save the money and also can more efficiently manage the data because they know the data the best then the controller, then SSD solutions.

[Riyadh Lai, CFO]

Rajiv, let me also add. Our open-channel is part of our broader data center plus enterprise SSD controller strategy. We have the opportunity of driving economics directly relating to our controllers and also then participating in the economics of the entire SSD module that we are codeveloping with the hyperscalers, the products that they need to go into their data center. Same time, by working with the hyperscalers, we are able to greatly tune our SSD controller that we can then offer as a standalone to customers who don’t need the solution from us where we can just sell the controller and generate the economics as a controller merchant supplier.

[Rajvindra Gill, Needham & Company]

On the eMMC+UFS business down modestly and kind of flat to down next year forecast, trying to count the risk there. And how you’re thinking about the acceleration of UFS and the impact to your business with SK Hynix and possibly offsetting that with Micron and Chinese flash maker. Do we expect that those to kind of share shift in either direction, either positive or negative to kind of accelerate next year? And when you’re providing kind of the flat to slightly down guidance, what assumptions are you making in terms of share shift with respect to SK Hynix, with respect to Micron, Chinese flash makers, the module makers et cetera?

[Wallace Kou, President and CEO]

I think the primary eMMC business we are doing with the Hynix is eMMC. The main [ph] for the UFS we’re doing today with the Micron. We do see UFS transition now become stronger due to Qualcomm promotes the UFS solution from flagship premier line and really transitioning to the mainstream, the Snapdragon 600 family. So, we believe uMCP will become main driver to move to mainstream smartphone adopt UFS controller. But same time, we also want the other China flash makers to start eMMC as well as UFS simultaneously. And we do see China’s several module makers this year will start to ramp up eMMC as well prepare UFS for next year. So, we see we are probably going to maintain the more balanced position next year. We see Micron UFS traction is accelerating and UFS sales are growing quickly this year, but they are for a small base. We believe UFS will account for more than 10% this year, they will be more than double next year for our eMMC UFS combination. And we expect our eMMC+UFS sales to be flat to down next year. It’s all dependent eMMC -- how fast they transition to UFS. But, we believe around the ballpark, we should see around flat, but Hynix portion decline, Micron portion increase, module maker increase, our China, the other flash maker increase, so all beneficial to SMI.

[Rajvindra Gill, Needham & Company]

Just a follow-up though, clearly as you just said, Qualcomm is promoting UFS from mainstream phones. And so, your business, SK Hynix has primarily been in mainstream OEMs. So, they adopt UFS and SK Hynix using internal UFS solution. Could that have a greater impact next year compared to your ability to offset that with Micron and others?

[Wallace Kou, President and CEO]

We see this, like MTK, their mainstream still remain eMCP. So, Qualcomm, although they promote UFS more, but they also support eMCP. So, it is really upto end customer decides, which standard they want to choose.

[Operator]

Our next question comes from the line of Suji Desilva from Roth Capital. Please ask your question.

[Suji Desilva, Roth Capital]

As you talk about the SSD market looking into ‘19, year-over-year growth in the ‘19 market for SSDs accelerate or remain consistent with ‘18 growth? And what quarters in 2019 does the 96-layer NAND become available to help benefit you guys?

[Wallace Kou, President and CEO]

We believe client SSD growth will be continued through 2019 and our growth rate definitely will be above the industrial average growth. And because -- through the current designing pipeline with NAND OEM we are confident we can maintain the growth rate through 2019. 96-layer TLC I’d say majority NAND makers just start, enter small production. But, through the first half of 2019, all the NAND maker will enter full production for 96-layer. But QLC, we are going to see -- 96 layer QLC, we are going to see at least four to five makers enter production by Q2 next year. So, we believe this going to help and further reduce the cost for client SSD. And we believe by end of 2019, majority value line [ph] SSD will all use QLC NAND but with 96-layer.

[Suji Desilva, Roth Capital]

And then on the enterprise SSD use by hyperscalers, not SSD solutions but the enterprise SSD, kind of that adoption increasing in the hyperscalers more generally. You talked about right now, there are kind of field testing versus lab testing. How many quarters in the field do you think the hyperscalers need to have enterprise SSDs running before they feel comfortable ramping up volume, how many quarters does that process take?

[Wallace Kou, President and CEO]

I think it will take at least about two quarters. But so far, I think we have been what with the fixed [ph] server, the provider in each of the hyperscaler provider. And we are almost there, it’s just -- it is all dependent business allocation of which unit, which [indiscernible] use what -- will have high priority to use open-channel solution.

[Riyadh Lai, CFO]

Suji, let me also add. We expect to complete testing of our solution. I mean, let me go back a second. Our controllers have already passed testing qualification. The next step is the actual SSD solutions. SSD solutions using our new controllers are literally days away from passing the qualification before they go into initial low-volume production where these SSD solutions need to be tested in live applications, which then have to go through further tuning of our driver software as well as the host device software before they are able to go into high-volume production of both the SSD module itself as well as our controllers used in those SSDs. And the timing of this we believe should happen somewhere around the mid of next year.

[Operator]

Our next question comes from the line of Mike Crawford from Riley. Please go ask your question.

[Mike Crawford, Riley]

Can you elaborate more on the progress of your SM2270 controllers with PCIe Gen3 channels that also bring you up in the enterprise space in addition to what the work you are doing with these two hyperscalers?

[Wallace Kou, President and CEO]

Yes. Our 2270 is our first enterprise controller to support open-channel as well as the NVMe standard. We are in good progress to engage with U.S. major supplier I think and we are engage with the several. And I think the first production will be around late Q1 or already Q2 next year. And we also have second generation of 2270 coming in Q3 next year because we get tremendous feedback from U.S. major leader and we add the certain security key value into the controller. And that will expand further regarding umbrella. Because other car makers in U.S. they not really follow the standard, there is no such car standard open-channel, but they all have a similar concept like open-channel. So, that gives a tremendous opportunity to support customization to meet their internal need. And we are exploring these concepts in our experience with hyperscaler in China and transfer into the U.S. market to selling our enterprise controller into China in server side as well as in car [ph] side.

[Operator]

Our next question comes from the line of Gokul Hariharan from JP Morgan. Please ask your question.

[Gokul Hariharan, JP Morgan]

Couple of questions from my side. First of all, on the SSD solutions, I think you also ship a lot of non-open-channel stuff also into your hyperscale customers. Could you talk about what is happening from a procurement view in addition to the delay of qualification of some of your new SSD solutions? Is it just that the spending overall on storage has been pushed out or is it very specific to this model related delay? And I have one follow-up.

[Wallace Kou, President and CEO]

For standard enterprise SSD solutions in this year because we have to make a business decision, how many units you want to sell because our gross margin in that particular segment is not compelling. The open-channel gave us much better opportunity to sell, value add to the customer. That’s why we worked with two hyperscalers in the very beginning as this open-channel SDD solution gave us as much better margin and better profit and moving forward. However, to say that, we are also in the transition of our standard NVMe solution for all these enterprise customers and e-commerce customers, because the NAND -- the key is how to secure a lower cost 3D NAND. And now, we are in the process to make commerce deal. And we believe next year, we might able to grow standard NVMe as well as open-channel, while primary focus is still open-channel because that gives us better margin and better future or long-term growth.

[Gokul Hariharan, JP Morgan]

As you look into next year, do you feel that most of your open-channel controller sales is going to be bundled SSD solutions, or do you anticipate some open-channel controller sales on a standalone basis as well?

[Wallace Kou, President and CEO]

So, in China, most of our open-channel controller will be in the solution base because there are very few customers who’ll use the controller base. However, in U.S., there will be more controller base.

[Gokul Hariharan, JP Morgan]

Next year, most of it is going to be solution based given China seems to be...

[Wallace Kou, President and CEO]

That’s correct.

[Gokul Hariharan, JP Morgan]

One last follow-up. I just wanted to confirm, you mentioned next year you’re expecting the mix of UFS sales within the mobile solutions is going to be double up this year, 20% plus or do you think that it is going to be much higher next year?

[Wallace Kou, President and CEO]

It will be at least double in our own pool, our eMMC+UFS. This year will be 10%; next year will be minimum double.

[Operator]

Our next question comes from the line of Charlie Chan from Morgan Stanley. Please ask your question.

[Charlie Chan, Morgan Stanley]

So, my first question is really about that enterprise SSD delay do you see there is any demand related issue, meaning associated to the recent CapEx cuts at the customers?

[Wallace Kou, President and CEO]

We have heard about overall CapEx spending slow down by Chinese hyperscalers. Our Shannon business is much smaller scale. So, we see it’s not impacted by this. As you know, server [ph] channel SSD can be lumpy as a timing of SSD procurement can fluctuate from time to time. And we have successfully passed testing qualification for new [ph] generation and with customer. And we are confident next year we are going to ramp by mid of next year.

[Charlie Chan, Morgan Stanley]

Okay. Next question is regarding the SSD penetration because according to our industry survey, it seems like the emerging markets PC users still want big storage, for example 1 terabyte hard disk because they don’t really have the access to cloud drive et cetera. So, in your assumption or in your interaction with customers, do you think you need like 1 terabyte SSD or 512 gigabyte SSD for the penetration in low-end segment to happen?

[Riyadh Lai, CFO]

Charlie, with SSD pricing continuing to fall sharply, the price of 1 terabyte drive in the year’s time or two years’ time is going to be significantly cheaper than what they are today. Prices will continue to come down. Prices today for SSDs have reached a level -- just reached the level that we saw in 2016 before NAND prices started to increase, with OEM pricing for SSDs becoming increasing competitive relative to HDDs and also the higher density SSD coming down. We’re going to see meaningful step up in adoption and interest. SSDs continue to be cheaper and cheaper, and it will become cheaper and cheaper with the low cost QLC and the 96-layer version of the QLC. So, we are seeing more and more OEMs designing SSDs into PCs, game consoles and client devices whether for developed markets or emerging markets.

[Wallace Kou, President and CEO]

Now, Tony, I think the 1 terabyte for PC OEM, it won’t be mainstream line next year, they probably have to wait for 2020 or even further. I think next year, 256 gigabyte will become mainstream or come to value line. But 1 terabyte [indiscernible] But most of the PC OEMs are happy even with 256 gigabyte for the main value line.

[Charlie Chan, Morgan Stanley]

So, 256 gigabyte is going to be acceptable by those low end segments. And I think after 40%, 50% SSD price -- drop year-to-date. Can I assume that next year the penetration of SSD in notebook to be like 80%, 90%?

[Wallace Kou, President and CEO]

I think commercial lines, already about 70%, 80% but consumer line is still not, it’s still about just 20% range today.

[Charlie Chan, Morgan Stanley]

So, I’m just asking you 256 gigabyte density is good enough, what would be the penetration for consumer segment next year?

[Wallace Kou, President and CEO]

Because of PCIe. As consumer line mainly really is Intel promotion transition of satellite to PCIe; for HDD, you don’t have a PCIe, only the SSDs have PCIe. So, HDD is going to with SATA. That’s why the transition when moving from PCIe and cost become more competitive, they’re going to have more PCIe and transition or even consumer line from HDD to PCIe. At the same time, and even some desktop we see the transition from HDD to SSD due to the PCIe demand.

[Charlie Chan, Morgan Stanley]

Okay. And lastly on that eMMC+UFS product line. So, I hear you that there are several dynamics, for example, your customers’ market share and demand et cetera. But can we get kind of anchor now, what was in-source ratio of Hynix eMMC controller IC today? So from that point we can gauge the potential decline for that eMMC business. So, what is in sourcing ratio today?

[Riyadh Lai, CFO]

Well, Hynix continues to use our eMMC controllers. We still have a lot of sales to Hynix. And as we grow our sales to Micron and to the Chinese module makers, a part of our strategy is to have a more diversified customer base.

[Wallace Kou, President and CEO]

So, Charlie, let me give you another angel, so you can do analysis yourself. As you can see this, the NAND transition from 2D NAND to 3D NAND, because 3D NAND becomes more affordable, more cost effective. And that thing becomes bigger. For eMMC in the past, they really needed 2D NAND because they had so many different densities, especially for the low end. When you go to higher density, you have to transition to 3D NAND. That’s why that motivation moved the whole market transitioning from eMMC, eMCP to UFS due to the 3D NAND transition because that becomes more cost effective than legacy 2D NAND. So, how soon, how fast moving depend on the price to transition. That’s why we see fraction model this year 128 gigabit or above. Next year, you are going to see even 256 gigabit. And we see 512 gigabyte UFS. So, that momentum transitions due to cost driven. And you see more momentum and we are going go to see more eMMC transition into UFS next year and the year beyond. So, I think that’s all because of the industrial changing from 2D NAND to 3D NAND is driving more attractiveness to the mobile phones adapt to UFS because of UFS 3D NAND.

[Charlie Chan, Morgan Stanley]

And lastly, last earnings call, you mentioned that some new opportunity, you had China memory customers, like OEM PC. [Ph] But, I think yesterday, there was restriction from U.S. fables shipment to some memory makers in China. So, do you think that your opportunity as a China customer will get delayed given that U.S. China trade attention?

[Wallace Kou, President and CEO]

Charlie, we cannot comment China customers. And by the way, China memory customers, we didn’t say it’s OEM PC either. So, you might mix together. But, there could be some customers who have contract with the NAND maker to assure. That’s why we do see our eMMC UFS also growing from that particular China customer.

[Riyadh Lai, CFO]

Charlie, let me also add. The sanction was against a DRAM company, not a NAND company, and we don’t know whether these sort of sanctions will spread more widely or whether it’s more company specific as what we saw yesterday.

[Operator]

Our next question comes from the line of Donnie Teng from Nomura Securities. Please ask your question.

[Donnie Teng, Nomura Securities]

My first question is regarding to fourth quarter sales growth outlook for your different business units. I’m wondering if you could give me more detailed guidance on that.

[Wallace Kou, President and CEO]

Donnie, for our fourth quarter, we expect our SSD controllers to be flat sequentially. We expect our SSD solutions to continue to come down. We expect our UFS eMMC to be flat to down a bit. And those are essentially our primary products.

[Donnie Teng, Nomura Securities]

My second question is regarding to the enterprise SSD and open-channel SSD opportunity. So, I know it’s a whole new product and a whole new technology. And also Wallace mentioned on the call, controller has pass the qualification but overall system probably still takes time to pass through the whole qualification process. But could you elaborate more what kind of process we will need in order to get all customer qualification? And if we are looking into next year, what kind of sales contribution we will have from open-channel SSD opportunity? And with those assumptions, based on that our open-channel SSD controllers are all bundled with Shannon Systems products?

[Wallace Kou, President and CEO]

Yes. In China, first of all, in China, majority is [Indiscernible]. There is almost no customer will take enterprise controller only. It’s quite different in U.S. Now, we have a been working with our customers for more than one year, but our solution with the software ready just about four months ago, so we have been through very intensive qualification with customers and with the server provider. Each of the hyperscale customer have a 5 to 6 different server providers. We have need to go through at least 300 to 500 servers and go through the very intensive test. We are in the final stage. Controller [indiscernible] has been verified. But, our hyperscale customers need to fine tune the performance regarding how to meet the latency, how to meet all the heavy traffic, how to meet all the different applications, different workloads, different media. So, this is for their decision.

For our hyperscale customers, we have to win the design. Now their decision is how they can transfer different business units to provide us bigger chunk of business for 2019. Now, we are preparing those more intensive fine tuning deterioration with our customers. So, I think we are in the final stage and we have been verbally committed by our customers. They are very exciting to see the open-channel solution and in the final stage. They really want to move into mass production. So, we are in the trial, in the live data center test and make sure that we will go through all the commercial in the different business units. For financial service, our online shopping, the work is all different. So, this is how we are working with our customers.

[Donnie Teng, Nomura Securities]

How about the -- do you have any preliminary view on the sales contribution from next year? And if I can -- I just wonder if we can assume that currently the open-channel SSD controller should be bundled with shipment products…

[Riyadh Lai, CFO]

Donnie, we are expecting are overall SD solutions to grow next year, and this growth -- big part of the driver will be the ramp and scaling of our Shannon SSDs beginning mid of next year.

[Operator]

I’ll now hand the call back to today’s presenter. Please continue.

[Wallace Kou, President and CEO]

I would like to thank all of you for joining us today and your continuing interest in Silicon Motion. We will be attending several investor conferences in Asia and U.S. in the fourth quarter. Details of these events will be available on our website. Thank you and good bye for now.

[Operator]

Thank you. Ladies and gentlemen, that does conclude our conference call today. Thank you for participating. You may all disconnect.