TETRA Technologies Q1 2025 Earnings Call Transcript

Quartr
Provided by Quartr
September 4, 2024

There are 12 speakers on the call.

Operator

Ladies and gentlemen, thank you for standing by. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session. I would now like to turn the conference over to Dan O'Neil. Please go ahead, sir.

Speaker 1

Good afternoon. Thank you for joining our earnings call for the Q1 of fiscal 2025. Today, I am joined by Bill Brennan, Kratos' Chief Executive Officer and Dan Fleming, our Chief Financial Officer. As a reminder, during the call, we will make certain forward looking statements. These forward looking statements are subject to risks and uncertainties that are discussed in detail in our documents filed with the SEC, which can be found in the Investor Relations section of the company's website.

Speaker 1

It's not possible for the company's management to predict all risks nor can the company assess the impact of all factors on its business or the extent to which any factor or combination of factors may cause actual results to differ materially from those contained in any forward looking statement. Given these risks, uncertainties and assumptions, the forward looking events discussed during this call may not occur, and actual results could differ materially and adversely from those anticipated or implied. The company undertakes no obligation to publicly update forward looking statements for any reason after the date of this call to conform these statements to actual results or to changes in the company's expectations, except as required by law. Also during this call, we will refer to certain non GAAP financial measures, which we consider to be important measures of the company's performance. These non GAAP financial measures are provided in addition to and not as a substitute for or superior to financial performance prepared in accordance with U.

Speaker 1

S. GAAP. A discussion of why we use non GAAP financial measures and the reconciliations between our GAAP and non GAAP financial measures is available in the earnings release we issued today, which can be accessed using the Investor Relations portion of our website. I will now turn the call over to our CEO. Bill?

Speaker 2

Welcome to our Q1 fiscal 2025 earnings call. I'll start with a review of our Q1 performance and then discuss our future outlook. Our CFO, Dan Fleming, will then provide detailed Q1 results and share our expectations for Q2. For Q1, Credo reported revenue of $59,700,000 and non GAAP gross margin of 62.9%. Our product revenues of $57,300,000 were up 30% compared to the prior quarter, establishing a new quarterly record for the company.

Speaker 2

Product revenues were driven by rapidly expanding AI deployments. Credo is a pure play high speed connectivity company. We deliver a differentiated set of solutions including active electrical cables or AECs, optical DSPs, line card PHYs, SerDes chiplets and SerDes IP licenses for Ethernet port speeds ranging from 100 gig up to 1.6 terabits per second. The data center market is dynamic and evolving rapidly, which we believe will create even more opportunities for Credo. Although we are primarily targeting the leading hyperscalers, we are now observing increased spending by the next tier of data center operators.

Speaker 2

We see a group of emerging hyperscalers deploying an increasing amount of infrastructure to take advantage of opportunities presented by AI. With these customers, we find we have immediate credibility from our prior success with traditional hyperscalers and that has indeed helped us to win new programs across our product lines. This is translating into material revenue across several growing customers. Notably, we expect to see a new 10% customer in Q2. Pareto aims to extend its reach into new markets as data rates rise.

Speaker 2

Later this year, we intend to enter the 64 gig PAM4 PCIe Gen 6 market, offering retimer and AEC solutions that are optimized for signal integrity, latency, power efficiency and cost effectiveness. Now regarding our AEC product line. During the Q1, AECs continued to be our main source of revenue and we anticipate that AECs will play a crucial role in driving growth in fiscal 2025 and beyond. Today, we're in production with solutions for port speeds up to 800 gig and we expect to deliver power optimized 3 nanometer products in 2025 for the 1.6 t port market. We've delivered AECs in a wide variety of form factors and with a range of functionality designed to meet the diverse needs

Speaker 3

of our

Speaker 2

customers. We think our approach of offering system level products, blending customized hardware and software with fast turnaround time is crucial to maintaining our competitive edge. And as a result, we've developed deep relationships with our customers to deliver very innovative ADC solutions. Based on these customer relationships, market feedback and the inherent advantages of AECs compared to alternative solutions, we have seen AECs become the de facto solution for in rack connectivity at 50 gig per lane speeds and above. In addition, increasing rack power densities and the migration to liquid cooling are effectively reducing the physical lengths required for back end network connections and thereby increasing the opportunity for AECs.

Speaker 2

During Q1, our existing and new customer relationships continued to expand and develop providing us with more confidence in the growth prospects of our AEC business going forward. Given that, we continue to expect our ramp of AECs to drive an inflection point in our sequential growth in the back half of fiscal twenty twenty five. Now I'll turn to our optical DSP business. I'm pleased to report we're making continued progress with our optical DSP business on multiple fronts with AI deployments accelerating adoption of Credigo's solutions. Our optical module customers shipped AOCs and transceivers based on Credo DSPs to both U.

Speaker 2

S. And international end customers. Based on Q1 results and our outlook, we remain on track to achieve our goal for optical DSPs to be at least 10% of our fiscal 2025 revenue. Beyond our existing production programs, we remain excited about future growth prospects in this category for several reasons. We are currently working with numerous optical module manufacturers to develop AOCs and transceivers and notably we've secured our 1st design win with an industry leading module manufacturer.

Speaker 2

Last fall, Credo introduced the concept of LRO or linear receive optics, which maintains a DSP only in the transmit path of an optical module as an innovative way to reduce power in both 800 gig and 1.6 T optics. The LRO concept is increasingly being adopted within the industry and a new hyperscaler has decided to implement this strategy in their architecture. This application will target 800 gig module power of less than 10 watts, significantly below the typical 15 watts seen with full DSP architectures. We expect to start seeing LRO deployments in calendar 2025. At 800 gig and 1.6 T port speeds, we see energy efficiency becoming a more critical factor as power delivery and cooling infrastructure becomes even more challenging.

Speaker 2

Notably, power efficiency drove our decision to move directly to 3 nanometer for Credo's 1.6 T DSPs and we plan to tape out power optimized solutions with both full DSP and LRO options later this calendar year. Taking into account customer feedback and rising momentum, we anticipate sustained growth in our optical business. Now regarding our Line Card V business. In the Q1, our Line Card PHY business was once again an important contributor to our overall product revenue growth, driven by strong contributions from 400 gig and 800 gig solutions. Our Line Card PHY revenue comes from retimer and MECsec encryption products for port speeds up to 1.6 terabits per second.

Speaker 2

In this segment, our customers include networking OEMs for traditional switching applications and more recently server ODMs for emerging AI appliance applications. We see new demand for our LimeCard PHY solutions within Ethernet based AI appliances for scale out networks as rapidly increasing GPU performance places greater signal integrity demands inside the server. DC merging opportunities combined with traditional switch opportunities should lead to TAM growth into the future for our Linecard V solutions. Lastly, I'll review our Surtees licensing and chiplet businesses. We continue to make progress with customers and expand our funnel within our Surtees IP Licensing and chiplet businesses.

Speaker 2

For fiscal 2025, while we continue to expect quarterly variability due to the nature of revenue recognition, we see growth opportunities driven by a combination of license, royalty and chiplet revenues. With connectivity speeds rising, fueled mainly by the needs of AI applications, Kratos is poised for future growth. We offer a wide range of SerDes solutions up to 2 24 gig speeds in a wide range of process geometries from 28 nanometer to 3 nanometer. We continue to win due to our compelling combination of performance, power and exceptional technical support. To summarize, I'm very pleased with our team's performance in Q1, specifically in terms of the strong execution of our product ramp and our ongoing success engaging with customers.

Speaker 2

The rise of generative AI is driving greater demand for cutting edge, power efficient, high speed connectivity solutions and Credo is dedicated to advancing our range of solutions to address this growing demand. This month, Credo will have strong presence at the CIOE Optical Conference in Shenzhen followed by the ECOC Optical Conference in Germany. We expect these events will add to the momentum we've built since OFC in March. And next month, we'll be very visible at the OCP conference in Silicon Valley, showcasing a wide array of advanced solutions for AI clusters. Moving forward, we continue to see an inflection point in the second half of fiscal twenty twenty five driven by existing and new customer engagements across the entire range of our connectivity solutions.

Speaker 2

I'll now turn the call over to our CFO, Dan Fleming, and he will provide additional details.

Speaker 4

Thank you, Bill, and good afternoon.

Speaker 5

I will first review our Q1 results and then discuss our outlook for Q2 of fiscal year 2025. In Q1, we reported revenue of $59,700,000 down 2% sequentially and up 70% year over year. Our IP business generated $2,400,000 of revenue in Q1, down 14% year over year. IP remains a strategic part of our business. But as a reminder, our IP results may vary from quarter to quarter, driven largely by specific deliverables to pre existing or new contracts.

Speaker 5

While the mix of IP and product revenue will vary in any given quarter over time, our revenue mix in Q1 was 4% IP, below our long term expectation for IP, which remains 10% to 15% of revenue. Our product business generated $57,300,000 of revenue in Q1, up 30% sequentially and up 77% year over year. Our product business, excluding product engineering services, generated a record $53,800,000 of revenue in Q1, 21% higher than our previous product record and up 32% sequentially. Our top 2 end customers were each greater than 10% of revenue in Q1. Our team delivered Q1 non GAAP gross margin of 62.9 percent, just below the low end of our guidance range and down 323 basis points sequentially as a result of the lower IP contribution in the quarter.

Speaker 5

Our IP non GAAP gross margin generally hovers near 100 percent and was 96.8% in Q1. Our product non GAAP gross margin was 61.5% in the quarter, up 7.84 basis points sequentially and up 4.72 basis points year over year, primarily due to increasing scale. Total non GAAP operating expenses in the Q1 were $35,400,000 below the midpoint of our guidance range and up 8% sequentially due to a 14th week in the quarter. Our non GAAP operating income was $2,200,000 in Q1 compared to non GAAP operating income of $7,500,000 last quarter. Our non GAAP operating margin was 3.7% in the quarter compared to a non GAAP operating margin of 12.3% last quarter, a sequential decrease of 8.6 percentage points.

Speaker 5

We reported non GAAP net income of $7,000,000 in Q1 compared to non GAAP net income of $11,800,000 last quarter. Cash flow used in operations in the Q1 was $7,200,000 down sequentially primarily due to changes in working capital driven by a ramp in product shipments. CapEx was $5,900,000 in the quarter, driven by R and D equipment spending. And free cash flow was negative $13,100,000 a decrease of $32,400,000 year over year. We ended the quarter with cash and equivalents of $398,600,000 a decrease of $11,400,000 from the 4th quarter.

Speaker 5

We remain well capitalized to continue investing in our growth opportunities while maintaining a substantial cash buffer. Our Q1 ending inventory was $31,600,000 up $5,700,000 sequentially. Now turning to our guidance. We currently expect revenue in Q2 of fiscal 2025 to be between $65,000,000 $68,000,000 up 11% sequentially at the midpoint. We expect Q2 non GAAP gross margin to be within a range of 62% to 64%.

Speaker 5

We expect Q2 non GAAP operating expenses to be between $36,000,000 $38,000,000 and we expect Q2 diluted weighted average share count to be approximately 182,000,000 shares. As we move forward through fiscal year 2025, we continue to expect sequential growth to accelerate in the second half of the year. We expect non GAAP operating expenses to grow at half the rate of top line growth. And as a result, we look forward to driving operating leverage throughout the year. And with that, I will open it up for questions.

Operator

Thank you. Our first question comes from the line of Toshiya Hari from Goldman Sachs. Your line is open.

Speaker 6

Hi, good afternoon. Thanks so much for taking the question. My first question is on the AEC business and how we should be thinking about the acceleration in growth you guys spoke to as it pertains to the second half. Bill, I think on past calls you've talked about your second customer ramping in the AEC space and your engagements with additional customers in that space as well. Can you kind of speak to the key drivers that you see contributing to the acceleration in growth in the second half of the year and how you're thinking about your AEC opportunity outside of in rack connectivity as you move into calendar 202526?

Speaker 2

Sure. So I'll start with I think we're pretty happy with the fact that AEC adoption is continuing pretty broadly. It has really become a de facto standard for the lengths that we address, which is primarily in rack at this point, but may expand to rack to rack 5 to 7 meter cables in the future as we see rack densities increasing. So as that happens, typically, connections that were made with 10 meter to 20 meter optical solutions can now be made with 5 to 7 meter AEC solutions. So we do see broad adoption continuing and it's really with U.

Speaker 2

S. Hyperscalers, global hyperscalers, what we introduced a new term with emerging hyperscalers as well as service providers. So I think as we stand right now, we're really well positioned to see future growth with both 400 gig and 800 gig AEC solutions that are in development now engagements with customers. And in the future, as there's a move towards 1.6 t, I think we'll be in a really good position to address that market, especially because we'll really bring much differentiated power compared to competitors. I will say that as Ethernet back end networks are becoming more mainstream, we're seeing a focus shift within our customer base to really network quality.

Speaker 2

And it's important to point out, when they have a single hardware failure or a link flap, it can cost 30 minutes productivity and really cost them tens of 1,000 of dollars. And so if they look at the Pareto of things that would make their clusters more efficient, having solutions that have really high reliability is becoming really a primary objective. And so when we think about AECs, will there be time before failure of 100,000,000 hours and bit error rates of 5 orders or more better than IEEE requirements? And the fact that we've had billions of operating hours that will be flatless in a sense. There's really what we see as a shifting priority to move to these solutions, to move these active copper solutions.

Speaker 2

And so to further that, as I mentioned before, the I think there's a desire to even figure out networking topologies that allow them to make a portion of the back end network connections with longer 5 to 7 meter AECs that span 2 to 3 racks. And ultimately, I think we see this really driving an uplift in the AEC market and an expansion of the TAM long term. I hope that gives you color. We're quite bullish on this space.

Speaker 6

Yes, that's really helpful. Thanks, Bill. And then as a quick follow-up on the optical DSP side of your portfolio, It's really nice to hear the customer traction. I think you guys reiterated that for fiscal 2025, it should be more than 10% or at least 10% of your business. Longer term, given your current engagements, the customer back and forth you're having, what are your market share aspirations in this business?

Speaker 6

I know you're playing the role of disruptor, but curious how you're thinking about your market presence over time? And then within the context of LROs, I think on the last call you talked about 1.6 t potentially being a catalyst for increased adoption. Is that still the case? And if so, is that pretty much a 25, 26 dynamic? Thank you.

Speaker 2

Sure. So I'll say that we're quite happy with the optical DSP business. We are on track to achieve the goal that you reiterated, which is 10% or higher of our fiscal 2025 revenue. For sure, we're building momentum. When we think about our position in the market today, there are more than 2,000,000 modules with Credo DSPs that have been deployed in data centers.

Speaker 2

And this fiscal year, we'll ship more units than we've shipped in all previous years combined. So there is real momentum that's building. We've got programs identified that will drive sustained fast growth in fiscal 'twenty six and beyond. And the bottom line is, as we sit here today, we've got a compelling set of solutions at 50 gig and 100 gig per lane, ultimately measured by signal integrity, power and cost. So I think that the stage is set for there to be continued momentum that Credo builds in this market.

Speaker 2

From a market share standpoint, we're still small and rising. And the bottom line is it's one design at a time, converting one customer at a time is really the focus. And as I mentioned earlier, we feel very, very good about engaging in a first program and it will lead to multiple programs with a module manufacturer that's previously been considered a lock for the incumbent DSP competitor. The competitive landscape is shifting. And the bottom line as we look towards the 1.6 t market, we're going to deliver both full DSP and LRO solutions.

Speaker 2

And the key here for us is to deliver kind of a new definition of what competitive is for power. We believe we're going to deliver a full DSP solution that's on the order of half the power of the devices that have been introduced into the market, really almost prematurely in a sense that the power is so high in comparison to what the optical module market is looking for. And so we're agnostic as it relates to full DSP and LRO. The bottom line is we'll deliver a full DSP at the 1.6 T speed that ultimately is in the 10 watt range or less. And that will enable any optical player to actually build a standard OSFP or QSFP DD and fit within the power ceiling there.

Speaker 2

We'll offer options with LRO to take it even further down from an energy efficiency standpoint. So we'll ultimately let our customers make that decision.

Speaker 6

Thank you.

Operator

Thank you. One moment for our next question. Next question comes from the line of Tore Svanberg from Stifel, Nicholas and Company. Your line is open.

Speaker 3

Yes. Thank you. Bill, you just said something that caught my attention. You said you're going

Operator

to ship

Speaker 3

more DSPs in fiscal 'twenty five than all previous years. I mean, obviously, that includes the AEC business. But can you just elaborate a little bit on that because that seems like a pretty high number?

Speaker 2

Yes, the reference was not really in regards to AECs. This is really in reference to our optical DSP business. And so I will say that we continue to be engaged with First U. S. Hyperscaler in production as well as we see a return to spending the international space as well.

Speaker 2

And so I think that from our perspective, that's no surprise. I think we've alluded to the ramp that's going to take place in this fiscal year. And I think we're well positioned to continue that in fiscal 'twenty six.

Speaker 3

Got it. Thanks for clarifying that. My second question is you mentioned penetration or entrance into the PCIe retimer market. Could you just talk a little bit about why now? I mean, clearly, this is a market that's been around for a few years, but it seems to be expanding.

Speaker 3

So help us understand a little bit the timing of entering this market and when should we expect some early revenues for Credo in this market?

Speaker 2

Yes. So I think that we've talked about the intent to enter the PCIe market, specifically at the Gen 6 speed, which is 64 gig PEMF4. We opted not to pursue the Gen 5 market and we probably made a bad call on that. But we felt like from a Certi standpoint that entering the market at 64 gig PAM4 will enable us to deliver the same kind of compelling benefits that we brought to Ethernet and really specifically the 50 gig and 100 gig level. And so when we talk about signal integrity, we talk about energy efficiency, talk about having the lowest cost basis of any competitor in the market.

Speaker 2

And really with PCIe, there's an opportunity here from a latency standpoint and a DSP architecture standpoint for us to really be differentiated as well in a sense of having a CertiSe that's a full blown DSP with latency numbers that are much lower than competitive solutions that have been announced. And so we think the timing is right. I'll also mention that you'll see us enter the market and then accelerate the market to Gen 7. We've already got 128 gig silicon that has been tested by a lead partner in the market. And so as we see AI driving the demand for higher and higher bandwidth, this is something we'll really lean into at BCIE.

Operator

Thank you. One moment for our next question. Next question comes from the line of Suji Desilva from ROTH Capital. Your line is open.

Speaker 7

Hi, Bill. Hi, Dan. In terms of the customer concentration, you talked about a new expected 10% customer in F2Q. I just wanted to get a sense if that customer is kind of starting from the ground floor in F1Q or whether it's been a gradual growth? I just want to understand the contribution from that new ramp.

Speaker 2

Yes, sure. This is not a new customer. This is a customer that we've worked with for going on a couple of years now. And so we've seen that they've been really receptive to the solutions that we're delivering. And as their spending plan has increased, we've seen them become a much more significant customer for us.

Speaker 2

But yes, they've been a customer in the past, but we're encouraged by the fact that this would be one that we would consider an emerging hyperscaler. And we've talked about in the past how the market really driven by AI solutions starting to look like more than just the top 5 U. S. Hyperscalers. So I think this is like a first mover of the emerging hyperscalers.

Speaker 2

But we've been in a good position and we're in good position with others as well from the standpoint that they've adopted an architecture that deploys AECs.

Speaker 7

Okay, Bill. Good to hear the customer base diversifying. And then, you talked a little bit about the opportunity as racks densify, if you would, and being able to handle closer racks and shorter reach. Can you just give us some sense of metrics and kind of the cooling technology, maybe the hopper to Blackwell transition that makes that possible and some of the metrics to think about in terms of how the TAM increases for you guys?

Speaker 2

Yes. So I think we've all seen what leading edge solutions look like and the increase in densities that you're seeing just with that transition that you mentioned. But I think from our perspective, this is really going to be a customer by customer architecture decision. But theoretically, we could see the TAM expanding within a customer if they deploy a solution that implements rack to rack AECs. We can see a doubling in TAM easily when we look at it from that perspective.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Matt Ramsay from TD Cowen. Your line is open.

Speaker 8

Hey guys, it's actually Sean O'Loughlin on here for Matt and he sends his regards, but we'll get to that later. I wanted to ask a quick question on the optical DSP sort of product engagements. You mentioned the module maker, which sounds like really positive momentum there. But is this my naivety or should I be surprised that there's not more sort of connectivity between you guys and the hyperscaler customers themselves on the optical DSP solutions given you have the relationships at the AEC level and it's such an important power level conversation. Is there any engagement on the hyperscaler side that's kind of helping you maybe get pulled into some of these module maker designs?

Speaker 2

Absolutely. Yes, we've talked about this in the past that this is a market that's a bit unique in a sense that if you only engage with the optical module manufacturers, you really aren't guaranteed anything. And so we've had a multiyear effort in working directly with hyperscalers and we've been successful with some of them in even doing a joint development program where they specify the DSP that is to be used. But this is really an ongoing effort. It's really a 3 party conversation between hyperscalers, module makers and Credo.

Speaker 2

And so that's very much part of our strategy. And from the standpoint of breaking it down, we actually on a weekly basis internally, we break it down per hyperscaler as it matches up with module makers. So it's a very it's a very focused strategy that we've got.

Speaker 8

Got you. Yes, that's really helpful. And then just one clarification on the IP license revenue. I think last quarter, you had mentioned that you expected that to come in sort of at the higher end of the long term or the long term model. But license revenue obviously is lumpy and came in a little lower this quarter.

Speaker 8

Is that still your expectation for the full year? Or are we just thinking about it incorrectly? Thanks guys.

Speaker 5

Yes. For the full year, our expectation hasn't changed. So we expect it to be in that long term range of 10% to 15% for the full year. And you're right in that it was lighter than expected at only 4%. And as the quarter evolved, it was offset by strong turns bookings within the quarter to offset the lightness.

Speaker 5

But you're thinking about it right. As you say, it's very hard to it's hard for us to forecast IP in 90 day increments, but we do have confidence over a longer period of time like just when you're 25 that will be within that range of 10% to 15%.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Karl Ackerman from BNP Paribas. Your line is open.

Speaker 4

Yes, I have 2. Thank you very much. Gentlemen, first off, I wanted to discuss how active copper cables have received a lot of attention recently, which use a redriver instead of retimer that's used in active electrical cables. Each of course has their own trade offs, but do you view these applications kind of holistic to each other or is the market opportunity for passive copper cables large enough for both applications? And as you address that question, how am I using an AEC with a half free time DSP, improve the power and cost between, perhaps active electrical and active copper cables?

Speaker 4

And I have a follow-up. Thank you.

Speaker 2

Yes. So we see the market for passive coppers as well as what you refer to as active or ACC or what we refer to as amplified solutions. We see the market for both of those not being big long term. As it relates to some of the references in the market to ACCs, I think that's really been driven by NVIDIA's strategy. And so it's really not something that I would say is a broad market type of opportunity.

Speaker 2

And even with the introductions that they've made in the past 3 to 6 months, I think it's questionable as to what role ACCs will play or amplified solutions will play. The key is that we don't see anybody in kind of the rest of the market, meaning hyperscalers that are looking at building their own ecosystems. We don't see really anybody considering those solutions. And the reason is because really not following industry standards at this point. And so when we talk about interoperability and we talk about basically things like signal integrity, having the AEC or the fully retimed, fully equalized solution, that's really the way you deliver the kind of interoperability, the performance that would be expected.

Speaker 2

And so that's where we really haven't seen any competition, and that's globally really, especially at the 100 gig per lane level. As it gets to 200 gig per lane, 1.6 t, I think it plays even a smaller role. And that's I think generally in the market, the game is over. Fully retimed AECs are really the choice by the broad market. And when I refer to de facto, that's really the only solution that's being considered by many of the customers that we talk to.

Speaker 2

And so we can kind of go down the path of doing LRO for AECs. That has not really been a priority for the customer base just because the power levels we're delivering are meeting the objectives. But the opportunity would exist in the future if that becomes a priority amongst our customers.

Speaker 9

Yes, very clear.

Speaker 4

Thank you for that. I wanted to focus back on licensing revenue. I know it's hard to predict, but is there a seasonality component to the consumer USB licensing revenue? And I guess, more importantly, has your view changed at all on the licensing revenue being toward the 10% to 15% of your fiscal year revenue in fiscal 2025 and perhaps other people for fiscal 2020 6? Thank you.

Speaker 2

I would say

Speaker 3

we have not

Speaker 5

witnessed any sort of seasonality with IP revenue. In fact, if you look at the last 5 quarters, it goes each quarter is quite different than the last in terms of revenue mix or revenue contribution in total. So it's really difficult to draw too many conclusions from that. Again, we as we've said in the past, we view IP as a very strategic imperative for us where we're not incentivized to chase low value deals. We want to make sure that we get a good ROI on all the IP that we sell and we win where power tends to be an overriding feature that's required in the solution.

Speaker 5

So it's tough to predict quarter to quarter as we all know. Longer term, we stated 10% to 15%. We think that will be that way this year. Next year, we haven't talked about, but I would expect that would be the case as well. Longer term, when we're talking about much bigger shipments to customers with products, ultimately that will probably will reset that expectation probably lower in the future, maybe FY 'twenty seven and beyond.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Thomas O'Malley from Barclays. Your line is open.

Speaker 10

Hey guys, thanks for taking my question. This one is for Dan. I just want to be a little bit more specific on a question that's kind of come up a couple of times here. So in the July quarter, product came in much better and licensing came in much lower. Could you just describe first what drove that product uptick?

Speaker 10

And also if you look at the gross margins, they were much better as well. I know you said volume on the call, but I'd be surprised if volume drove all of that. And then looking into the October quarter guidance, like is your assumption that IP goes back to that kind of $10,000,000 a quarter range just because that obviously matters for what product does in the out quarter? I think that's what people are trying to figure out. So both of those would be super helpful.

Speaker 3

Yes.

Speaker 5

So as far as product being a little stronger than normal, it's ordinary that we have some amount of turns bookings. So they came in stronger than we would have expected entering the quarter. So and there's nothing really unanticipated or to talk about in terms of what it was versus what we've already talked about. Our largest AEC hyperscale customer contributed very significantly to the quarter and we expect them to really drive the ramp throughout the fiscal year. So maybe I could talk about gross margin impact as well since you mentioned that expansion of gross margin at the product level.

Speaker 5

So that's kind of from my perspective that's one of the really the headlines for Q1 or one of the key takeaways. If you look at product gross margin excluding product engineering services, it was up over 900 basis points sequentially to 59.6%. So recall though for last quarter, we had mentioned that we had some one time reserves in our Q4 number. So that lowered the product gross margin in Q4 a bit. But we're very happy in Q1 with the excellent progress we've made toward our long term gross margin expectation of 63% to 65%, which has not changed.

Speaker 5

So and as I've mentioned in the past, our long term model if you saw for the IP portion being 10% to 15% versus product that means the product gross margin used to be right around 60%. So in Q1 we were already in that same zip code. So throughout FY 2025, we expect to see some quarterly fluctuations you might see. But it really is it's driven by scale. There's of course some product mix impact as well.

Speaker 5

But the overarching impact of improving margins this year thematically is improving scale. And 32% was the sequential increase from Q4 to Q1 in terms of product shipments. So you do gain a lot of scale in that when that occurs.

Speaker 10

And then just the second part about your expectations embedded in the guidance. Kind of saying 10% to 15% for the year still, obviously lighter in Q1, so you would expect some acceleration. But just what is your expectation for October?

Speaker 5

Yes. So for October for IP, you might expect it to be slightly larger contributor to revenue than it was in terms of revenue mix than Q1. But as you saw in Q1, one of the important takeaways is in order to achieve our gross margin targets that we set out in Q2, we don't need an oversized contribution of IP. That's not critical for us to achieve the gross margin goals. But expect IP to contribute modestly more to our revenue mix in the quarter in Q2 than it did in Q1.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Quinn Bolton from Needham. Your line is open.

Speaker 11

Hey guys, congratulations on the nice results and outlook. I guess, Dan, maybe to beat on the gross margin here a little bit. Would you expect product margins to decline in the October quarter? Because I'm struggling to sort of see why margins wouldn't be at least at the high end of your 62% to 64% range if product gross margins flat and IP is a slightly higher percentage of the mix in the October quarter?

Speaker 5

Yes, I understand where you're coming at for that question. The one thing I'll say is everything is not always linear for us. We had quite a big step up in gross margin percentage in Q1. We've proven over the course of time it's not always linear. We don't have a specific expectation that it will decline or decline by much.

Speaker 5

But we remain our overarching theme is to remain conservative in the way we look at things and guide things. So hopefully that helps you a little bit quick.

Speaker 11

Got it. Yes, I know that does. And then just wanted to come back to the license and IP. I think in the script you'd mentioned royalty as part of that IP business. And I know you had a big consumer license a few years ago that wondering if you could just give us any update on specific royalties that you're looking for as part of that IP revenue stream.

Speaker 11

Does royalty become something to call out here at some point over the next year or so? Or do you think most of that IP is from straight licensing of your Surtees like it's been historically?

Speaker 2

Yes. I think you're right on with the assumptions you're making on the royalty and as it relates to our USB customer. We think that as we think about things going forward, we don't think that's going to be a part of the business that we look at as kind of material in comparison to the licensing revenues themselves. So we think that the weighting is going to still stay the same in a sense that the bulk of the revenues in this category will come from licenses.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Richard Shannon from Craig Hallum. Your line is open.

Speaker 9

Great guys. Thanks for taking my questions. Maybe a very quick 2 parter for Dan here. You called out record product revenues, record a couple of years, but I don't think it was any seats. Can you declare whether you had record agency quarter?

Speaker 9

And then also can you give us percentages of the 2%

Speaker 1

to 10% customers as well?

Speaker 5

Yes. So we did have record product revenue. We don't break out as you know by product line, but you can safely assume that AEC is a large driver of our story for the full year. So that was the most significant contributor revenue. Turning to 10% customers.

Speaker 5

We had 2 10% end customers in Q1, which I have mentioned in the prepared remarks. And they were in fact our first 2 AEC hyperscalers at the start. When our Q is filed in a day or so, you'll see that our first AEC hyperscale customer remained a 10% customer during Q1 right at 10%. And the second AEC hyperscale customer was our largest customer at 52%. So we expect that second AEC hyperscaler to continue their meaningful ramp throughout fiscal 2025 as we talked about.

Speaker 5

Of course, it might not always be a linear ramp. But as Bill mentioned earlier, we expect a new 10% customer in Q2. So even with a meaningful ramp at our second AEC hyperscaler, we expect significant revenue diversification from both a customer and product perspective throughout calendar year or throughout the fiscal year as that plays out.

Speaker 9

Okay, great. Thanks for that, Dan. And I'll follow-up with a question for Bill here. Bill, I probably typed in incorrectly here in response to earlier question here, but you talked about some next gen AI clusters and racks here kind of moving away from, I think if I caught you correctly, optics and moving towards the active copper in some manner here. Maybe you can just maybe delve into that a little bit more and maybe also comment on whether you think that is a dynamic that can sustain for more than one generation of systems that can go 2 or 3 generations?

Speaker 9

My suspicion is not, but love to get your comment on that. Thanks.

Speaker 2

Absolutely. And so when we work with our customers more and more, and really listen to their challenges, One of the big things that stands out is just the quality of AECs compared to solutions that are laser based optics. And again, get back to this link flap phenomenon that's been seen in AI clusters and it's becoming more and more of a topic in the industry. Just to reiterate, if you've got a single connection that fails and even if it flaps, it just goes down and it comes back up, it can shut down the entire cluster for up to 30 minutes and ultimately measured in dollar terms dollars 30,000 to $50,000 And so if you have 3 to 5 of these episodes per day, it becomes something that you really want to pay attention to. And so as we work with customers more and more, the focus is becoming on network quality.

Speaker 2

And when we think about AECs, they just don't have link flaps like laser based optics have. And so so it's absolutely something that will benefit the AEC TAM long term. And so you've got this other factor that's happening where racks are being built in a much more dense fashion. And so now there becomes a possibility to network and really connect racks and lean on the very high quality and reliability of the AEC products. And so moving to an architecture where they're connecting not just in the rack, but rack to rack and we're really talking 5 to 7 meters, we're seeing much more activity along these lines.

Speaker 2

And so again, it's a customer by customer driven architecture objective. But this is something that we see that definitely is encouraging as it relates to kind of a new factor that is driving demand this direction. I will say that in addition to what we're doing with our AEC family, we're also looking at other system level solutions that quite frankly help to address some of these areas of feedback that we're hearing. And so our experience in the AEC market has taught us a huge amount about these challenges. And we see potential to use this knowledge in the optical space, specifically to enhance AI cluster performance and energy efficiency.

Speaker 2

And so we've you've seen innovations from Credo along the lines of LRO that was specifically for power, but there's other things that we're working on to help improve network quality. And that's not something I'm going to be details about, but within the next, say, 9 to 12 months, we'll probably talk more about it as we deliver these solutions to the market.

Operator

Thank you. One moment for our next question. Our next question comes from Tore Svanberg from Stifel, Nicholas and Company. Your line is open.

Speaker 3

Yes, thank you. I just had two follow ups. Bill, as we sort of look at the second half of fiscal twenty twenty five, the ramps that you were expecting, could you talk a little bit about how broad those ramps are? I'm not talking about by customer here, but I'm thinking more about the different AEC form factors and especially when considering the 400 gig AI AEC back end network solution that you have been sampling the last few quarters.

Speaker 2

Sure. Sure. So I guess that would relate to our business with Amazon. And we feel good about where we are in the ramp there. As we've said previously, their ramp is expected to drive a significant portion of our growth this year.

Speaker 2

Dan alluded to the fact that we don't expect it to be a linear ramp quarter to quarter, but we do expect them to be our largest customer. With that said, we see increasing demand across the board for our solutions and realize from a range of customers that we feel good about in a sense that it will drive customer diversity over the upcoming quarters through the end of this year and even into fiscal 'twenty six. So as we've talked about before, we see Microsoft returning to historical levels. We've talked about a third hyperscaler. That relationship is really progressing and we expect that they will become a significant customer.

Speaker 2

And really towards the tail end of just the real tail end of fiscal 2025, but really into fiscal 2020 6. We've mentioned AECs continuing to gain traction broadly. Optical is going to contribute to that inflection point this year and into 'twenty six as we see that continuing as our fastest growth product line. And even the other product categories, we haven't really spent too much time talking about like Linecard PHYs or SerDes chiplets and licensing, it's expected that they're going to be a material contributor in our second half and into fiscal 'twenty six. And so that really gives you color near term.

Speaker 2

A lot of the fun that we have and Credo is talking about things that are really outside the topic of these calls, which is really very near term focused on fiscal 'twenty five. We have a lot of fun talking about next generation solutions that we're developing. There's a lot of energy that we've got around PCIe Gen 6 and Gen 7 and exactly how are we going to add our unique and compelling value to that market. And this idea of continuing to innovate at the system level is something that we're highly engaged on internally at Credo. We've had just great experience in the markets that we pioneered and we're going to continue that and we expect to really bring meaningful and compelling solutions to the market at again the system level.

Speaker 3

That's very helpful. Just last question for Dan. Dan, you said that OpEx would grow at half the rate of revenue growth. Is that a specific sort of target for fiscal 2025? Or was that more in reference to sort of your long term financial model?

Speaker 5

It's related to fiscal 2025. And in fact, I mean, it's even embedded in our Q2 guide, right? Revenue at the midpoint is up 11%, gross margin flat, OpEx up 5%. So we expect that year over year fiscal 2024 to 2025 that will be the case and it will extend probably into fiscal 2026 as well as we attain kind of that long term operating model where our operating margin should be in the 30% to 35% range next fiscal year.

Operator

Thank you. And there are no further questions at this time. Mr. Brennan, I turn the call back over to you.

Speaker 2

Absolutely. Thanks everybody for joining. We really appreciate the questions and we look forward to the callbacks. Thanks.

Operator

And with that, this concludes today's conference call. You may now disconnect. Everyone have a great day.

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Earnings Conference Call
TETRA Technologies Q1 2025
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