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Operator
Good afternoon, everyone, and welcome to the Arteris IP second quarter 2022 earnings call. Please note that this call is being recorded in simultaneously webcast. All material contained in this webcast is a sole property of and copyright of Arteris IP and with all rights reserved. For opening remarks and introductions, I will now like to turn the call over to Erica Mannion at Sapphire Investor Relations. Please go ahead.
Erica Mannion at
Thank you and good afternoon. With me today from our TRS-IP are Charlie Janik, Chief Executive Officer, and Nick Hawkins, Chief Financial Officer. Charlie will begin with a brief review of the business results for the second quarter ended June 30, 2022. Nick will then review the financial results for the second quarter, followed by the company's outlook for the third quarter and full year of 2022. We will then open the call for questions. Before we begin, I'd like to remind you that management will make statements during this call that are forward-looking statements within the meaning of federal securities laws. These statements involve material risks and uncertainties that could cause actual results or events to materially differ from those anticipated, and you should not place undue reliance on forward-looking statements. Additional information regarding these risks, uncertainties, and factors that could cause results to differ appear in the press release our Terrace IP issued today and in the documents and reports filed by our Terrace IP from time to time with the Securities and Exchange Commission. Please note, during this call, we will cite certain non-GAAP measures, including non-GAAP net loss per share and free cash flow, which are not measured prepared in accordance with U.S. GAAP. These non-GAAP measures are presented as we believe they provide investors with the means of evaluating and understanding how the company's management evaluates the company's operating performance. These non-GAAP measures should not be considered in isolation from, as substitutes for, or superior to financial measures prepared in accordance with U.S. GAAP. A reconciliation of these non-GAAP measures to the nearest GAAP measure can be found in the press release for the quarter ended June 30, 2022. In addition, for a definition of certain of the key performance indicators used in this presentation, such as annual contract value, confirmed design starts, active customers, and remaining performance obligations, please see the press release for the quarter ended June 30, 2022. Listeners who do not have a copy of the press release for the quarter ended June 30, 2022 may obtain one by visiting the investor relations section of the company's website. Now I'd like to turn the call to Charlie.
Charlie Janik
Thank you, Erika. And thanks to everyone for joining us on the call this afternoon. We're excited to report our continuing momentum in 2022 with annual contract value plus trailing 12-month royalties of $51.7 million in the second quarter, up 18% year-over-year, despite HiSilicon's contract ending in Q2, which removed $3.3 million of annual contract value. Demonstrating the strength in market demand, our active customers increased by nine in the quarter, while total confirmed design starts were 18 SOC projects. Major new customer wins, including Telechips in automotive, Pleops in consumer, and Sunrise Memory in enterprise, as well as a leading automotive OEM, leading enterprise hyperscaler, and a leading machine learning, artificial intelligence, semiconductor company. Deals in the second quarter were driven by strong demand for our terrorist IP across our core markets, including multiple transactions in automotive, consumer electronics, enterprise around data center applications, and AI ML. These were broadly distributed geographically across APAC, EMEA, and the U.S., Within EMEA, there was an increase in innovative Israeli startup wins, including Inuitive for development of next generation of vision processing for edge devices, for robotics, drones, augmented reality, virtual reality, and mobile products. On the product front, we continue to invest heavily in development of innovative system IP products. In the second quarter, we made a major release of our Encore cash-coherent product to multiple automotive and enterprise customers. With respect to the IP deployment software product line, we partnered with major customers to implement continuous IP block integration flows for new designs and incremental changes which accelerate their delivery of new SoC platforms and derivative chips. We also delivered a framework for automatic SOC assembly scripting, which lowers the difficulty and cost of integration for internal design automation groups. While there are macroeconomic uncertainties, we believe that Arteris IP is well positioned to make progress even in challenging economic environments. We are seeing increased silicon content of electronic systems as they are engineered to be smarter and in some cases autonomous. One of these markets is the automotive market where vehicles are becoming endpoints of a vast transportation network. Furthermore, we see ever higher levels of silicon integration to the point where electronic systems are made up of complex semiconductors on relatively few circuit boards. This is driving system houses to become involved in silicon design at some level, either by themselves or together with partners. Before turning over the call to Nick, I'd like to mention in the second quarter we announced the addition of Claudia Fan-Munchie to the Arteris IP's board of directors. Claudia contributes a wealth of experience which includes a distinguished 30-year career at IBM, where she held various positions, including executive roles in engineering, IP licensing, and IBM Ventures. She is also a Stanford University lecturer and sits on the board of directors of major public companies. With that, I'll turn it over to Nick to discuss our financial results in more detail.
Erika
Thank you, Charlie, and good afternoon, everyone. As I review our second quarter results today, please note that I will be referring to non-GAAP metrics. A reconciliation of GAAP to non-GAAP financials is included in today's earnings release, which is available on our website. Total revenue for the second quarter was $14.8 million, up 37% year over year, benefiting from higher than expected concentration of point-in-time IP deployment revenue. As a reminder, IP deployment deals are largely recognized as point-in-time revenue as opposed to our interconnect license agreements, which are generally recognized ratably. Given the variation in revenue recognition methodologies between our product offerings, as a management team, we focus on annual contract value, or ACV, as a leading indicator of financial performance. we define ACV for an individual customer agreement as the total contract fees under the agreement, also referred to as total contract value or TCV, divided by the number of years in the agreement term. As this calculation does not include the contribution from royalty payments, we also refer to ACV plus trailing 12-month royalties as a metric which provides a more complete picture of our total revenue. At the end of the second quarter, ACV plus trailing 12-month royalties and other revenue was $51.7 million, up 18% year-over-year, in particular driven by growth in automotive, consumer electronics, AIML, enterprise, and 5G communication market segments, and down 2% quarter-over-quarter, reflecting the removal of the $3.3 million gap ACV associated with the 2019 High Silicon License Agreement, which ended in May 2022. Remaining performance obligations or RPO were $55.7 million, up 11% year-over-year as compared to June 30, 2022. We define RPO as the amount of contracted future revenue. Gross profit in the quarter was $13.8 million representing a gross margin of 93% compared to $10.0 million or 92% in the prior year period. R&D expense for the second quarter was $8.8 million or 59% of revenue compared to $6.1 million in the prior year period. The increase was driven by continued investment in new and improved product offerings in our five R&D centers across our full product portfolio. Sales and marketing expense for the second quarter was $3.7 million or 25% of revenue compared to $2.2 million in the year-ago period. We intend to continue to invest in sales and marketing as we work to continue to drive awareness of the benefits of our solutions in the market and expand our sales and application engineering force and marketing efforts to harness the significant potential opportunity in front of us. G&A expense for the second quarter was $3.2 million or 22% of revenue compared to $4.6 million in the year-ago period. G&A expense reflects a decrease in professional services associated with our transition to being a public company in 2021. Operating loss for the second quarter was $5.4 million or 37% of revenue compared to a loss of $3.5 million in the year-ago period. Non-GAAP operating loss was $1.9 million or 13% of revenue compared to a loss of $3.0 million in the year-ago period. Net loss in the quarter was $5.7 million or diluted net loss per share of 18 cents. Non-GAAP net loss in the quarter was $2.2 million or diluted net loss per share of $0.07 based on approximately 32.3 million weighted average diluted shares outstanding. Turning now to the balance sheet and cash flow, we ended up the quarter with $81.3 million in cash. Cash flow from operations was approximately $0.2 million in the quarter while free cash flow, which includes capital expenditure, was positive $0.1 million, reflecting the benefit of both the previously mentioned IP deployment deals and also the earlier-than-expected collection from a major customer. I'd now like to turn to the outlook for the third quarter and the full year 2022. For the third quarter, we expect ACB plus 12-month royalties of $51.2 $0 million to $53.0 million and revenue of $10.5 million to $12.5 million with non-GAAP operating loss margin of 41.2% to 56.2% and non-GAAP free cash flow margin of negative 41.2% to negative 56.2%. For the full year, we expect revenue of $49.5 million to $52.5 million representing a $1.0 million increase at the midpoint compared to prior revenue guidance. ACV plus 12-month royalties to exit 2022 at $48.0 million to $52.0 million, representing a $3.6 million decrease at the midpoint compared to prior ACV plus TTMR guidance. reflecting the removal of the $3.7 million ACV associated with the 2020 DGI license agreement, which ends in December 2022, and some caution on the timing of fourth quarter deals as a result of the current economic uncertainties. Non-GAAP operating loss margin of 24.3% to 39.3%, representing an improvement of 60 basis points at the midpoint compared to prior guidance, inclusive of the increased revenue guidance partially offset by the impact of wage inflation on our operating expenses. And non-GAAP free cash flow margin of negative 10.1% to negative 25.1%, representing an improvement of 40 basis points at the midpoint compared to prior guidance. With that, I will turn the call over to the operator and open it up for questions. Operator.
Operator
Thank you. Ladies and gentlemen, at this time, we'll be conducting a question and answer session. If you'd like to ask a question, you may press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, It may be necessary to pick up your handset before pressing the star key. Our first question comes from the line of Matt Ramsey with Calend. Please proceed with your question.
Matt Ramsey
Yeah, thank you very much. Good afternoon, guys, and thanks for taking the questions. I guess for my first one, congratulations on the results. Nick, it sounds like the software deployment and stuff that's getting recognized sort of point in time is what drove the upside to the revenue. If I look forward into the third quarter and maybe even the implied fourth quarter revenue from the full year, how much of that sort of turns business are you assuming in the revenue guide for the back half of the year, or is that fairly de-risk and would represent potential upside if the turns business actually comes through as it did in the second quarter? Thanks.
Erika
Yeah, hi, Matt. Nice to speak to you again. These things come around so quick. But yeah, you're absolutely right. We kind of indicated a large part, even though in fact all the business, i.e. the interconnect and the IP deployment software, and in fact even some of the royalties were really strong in Q2, the big sort of outperform was really the cadence of IP deployment deals. And there was a certain amount of rebalancing by customers in terms of when they wanted to place their orders, whether it was Q1, Q2, Q3. And particularly there was a rebalancing between Q2 and Q3. So, yeah, big outperforming Q2. And the reason for the slightly lower guidance in Q3 is because some of those deals were previously slated for Q3 and they came forward a little bit. So there's an element of that. Quite a big element further out for the rest of the year. Again, you've got the same, actually the revenue we're guiding slightly up. That's really just general strength across the board. We're not expecting as much IP deployment software revenue, which is mainly pointed in time in Q3. But for the full year, it's still way some. Does that give you a sort of a good sense for where we're at?
Matt Ramsey
No, it does. Thank you for that. So it sounds like much less of the sort of turns business in the back half of the year implied in the guidance, and we'll just kind of see how things go is kind of how I read that. Is that fair?
Erika
Yeah. I mean, as you know, we have a huge repeat rate. We have around about a 90%. Right now we have a 90% visibility of revenue for the year in terms of gap revenue. which is very sort of comforting. So there's still sort of a 10% terms, but the dependency is much lower. The dependency, of course, in ACB terms is more significant on terms business. And to the extent that we are being a little bit cautious because of the economic uncertainties around the world on how Q4 might end up, That has much more of a direct impact on ACV as we exit the year, as it does revenue, which is mostly ratable. Certainly all the interconnect is ratable, so it has any deals that flow from Q4 into Q1, for example, don't really impact revenue at all, just ACVs, which is why we're being a little cautious on Q4 ACV exit point.
Matt Ramsey
Got it. Thank you. Thank you for that, Nick. As my follow-up, I wanted to kind of pick back up on that. In the macro environment that we're in and in the market that we're in, investors definitely have their radars up for commentary. Like you mentioned the sentence there about maybe a little bit more caution on license activity and deal activity in the fourth quarter. I don't know, Charlie, do you have any – just commentary generally, are we talking about business in China? Are we talking about, uh, um, maybe what end market and what geography have you seen things maybe push out a tiny bit? Um, any, is it broad? Is it one deal? Uh, just any kind of context there would be really helpful. Thanks guys.
Charlie Janik
Yeah. Um, so I, you know, certainly, uh, you, you, you want to be conservative, but, um, we're kind of seeing the headwinds and the tailwinds balance, particularly for licensed revenue, right? You know, on the tailwind side, we're seeing some inflationary pressures across the globe. You've got strict lockdowns in China that may have slowed down some activity there, although generally our China business remains strong, right? But you also have a number of headwinds. The automotive, you know, the car is becoming a supercomputer on wheels, so there's many more designs being done for the car. There's more system houses designing chips. So I think the view is that at least on the license side, things are pretty much in balance for our kind of business.
Matt Ramsey
Got it. Appreciate the comments there. I'll jump back in the queue. Thanks, guys.
Operator
Our next question comes from the line of Ambresh Srivastava with BMO. Please proceed with your question.
Ambresh Srivastava
Hi, thank you. Good talking to you guys again. I had a couple of questions. Actually, we'll start off with the inflationary part first. How do you balance the negative impact to your P&L versus the ability to pass along costs? Because most of your contracts are set in pricing earlier. So can you just help us understand that part? And then I had a quick follow-up clarification.
Erika
Charlie, do you want to take that one?
Charlie Janik
Yeah. So we have some subscription contracts. They're a multi-year. But we are able to pass some costs along. I think we've increased our prices, I think, about 10% in the last few months. So we have some ability to pass along inflationary costs. But we are definitely seeing inflationary pressure, particularly with salaries and personnel retention costs and those kinds of things. But, you know, again, you just manage that as best as you can. And you're also trying to make sure that the customers are happy and that they understand how you're dealing with the situation.
Ambresh Srivastava
Got it.
Erika
Sorry, Nick. A couple of bits of color that might help you there in terms of unpacking that and sort of modeling it. The first is that we are largely seeing the wage inflation pressures in the rearview mirror. It was a big pressure in the first half, particularly in the first quarter. As you know, wage inflation was right. We're seeing that less of an issue now. It's not gone away, but it's not as bad, not as extreme. Second point is just for sort of mathematically, around 70% of our OpEx is people-based. And so it just gives you an idea of how wage inflation can can impact our non-grant OpEx. That said, we are keeping a lid on OpEx, and it's actually increasing at a fairly slow rate.
Ambresh Srivastava
Got it. That is helpful. That is helpful. My quick follow-up is on the ACV side. You mentioned two factors to the delta. DJI versus macro. Can you just please help clarify how much of it is the impact from DJI versus macro? the factoring in macro. Thank you.
Erika
Sure thing, yeah. So if you look at the whole year with the exit point of 22 versus the exit point of 21, which is really the way that it should be sort of characterized because it's sort of an annual measure, the headwind between HiSilicon, don't forget them, who ended in May, and DJI, which ends future in December, the headwind between those two is $7 million on ACV. The second piece is kind of the unknown. ACV right now is growing nicely, as you've seen. The unknown is how Q4 might turn out. And there are enough things going on in the world, which I don't need to tell you about. There's a lot of newsworthy things going on, including sort of economic performance, inflation, GDP, Now two centres of geopolitical tensions and so on. So we just feel like it's wise to be a little cautious in the way that we think of Q4 in terms of the cadence of deals. We do have a small number of large value deals that can impact how ACV turns out for the year if they end up ending in Q1, for example, instead of Q4. And we don't know until we get there. frankly. Basically, for new biz, where it's repeat biz, the repeat biz we're very confident on because customers have to continue to buy our products, be it deployment software or be it interconnects, to continue designing and making chips, complex SOC chips. Whereas new customers are Maybe there could be some delay. We just don't know. We're just exercising a degree of caution on how we guide people.
HiSilicon
Okay. Thank you. Thanks, Ambush.
Operator
Our next question comes from the line of Mark Lepatius with Jefferies. Please proceed with your question.
Mark Lepatius
Hi. Thanks for taking my question. Carly, maybe for you... Putting aside disruptions that are associated with COVID and inability for teams to meet together, how would you expect either an inventory correction for an industry or a downturn? How would you expect it to impact your business specifically? Are you of the view that you guys offer a value proposition that's, that's counter cyclical in nature because you're, you're offering so much value that the, you know, your, your, your, your pricing is such that, you know, you're, it's like a payback for your customer instantaneously. And so that you'd see more incoming requests or is, is it more along the lines of, well, when, when, you know, when things go South or other companies, they, Did they just cut everything? And if you have any precedents that you can refer to, I think that would be interesting as well. That's the first question. Thank you.
Charlie Janik
Sure. So if there is an inventory correction and a recession, you would expect some impact on royalty volumes, right? Yeah. So that could get affected. On the other hand, on the design side, our customers typically try to design their way out of recessions. And so the design activity, we're just not seeing any slowdown in design starts or in SOC projects. Now, that is not going to be uniform. You're going to see... maybe more starts in machine learning and in automotive and maybe some impact in consumer, possibly. But overall, we think we're not exactly kind of cyclical, but we're not going to see, we don't think we're going to see a huge impact for us on the design start side. And, you know, you sort of asked for a historical sort of evidence of that or comparison. So the one recession that we went through was 2008, which was probably much deeper than what we're gonna see here. And we did not really see any effect at all. So at that time we had no royalties, but we saw no effect on the design start from the 2008 recession, which was a pretty deep recession, right? So we think that this one, which isn't gonna be as deep, is gonna be pretty similar And we're not going to see a huge impact on the design start side, on the license side.
Mark Lepatius
Great. That's really helpful. And a follow-up, if I may. Are you guys sharing, like, trends on ASP per project on a quarterly basis or annually? Or is there any color that you can share on ASP per project in the last several quarters? Thank you.
Charlie Janik
So we are not reporting that as a KPI. And on a quarterly basis, I think it'd just be a little too granular. It's more of a long-term trend. But we are definitely seeing increased, just as we said on the roadshow, we are seeing a significant increase in basically the average selling price of system IP where In fact, you know, the price of each individual component of our product line isn't necessarily going up, but people are using much more system IP. So one evidence of that is that we started, for example, whenever we sell a network on chip, either cache, non-convenient, or both, we're also starting to sell the IP deployment software with it right up front, right? And so that by itself will raise the ASP. So we see the increased use of system IP as a long-term continuing trend that favors Arteris. There's just going to be more and more system IP in these chips.
HiSilicon
Very helpful. Thank you.
Operator
As a reminder, it's star one to ask a question. Our next question comes from the line of Hans Mosman with Rosenblatt Securities. Please proceed with your question.
Hans Mosman
Yeah, thanks for taking my question. Hey, Charlie, I'm curious. Do you guys have a sense of what process technology these new design engagements are going to be? Is it 5 nanometer or 3 nanometer? And if you do, what are they by particular end market, like ML, AI, communications, enterprise, and that kind of stuff?
Charlie Janik
Well, it's kind of surprising, right? The automotive industry sort of was behind and typically used trailing edge processes. But many of the leading edge ADAS designs are on 5 nanometer. And some of our customers are hoping to start their next set of projects in 3 nanometer. So they're completely on the leading edge. And it kind of makes sense, right, because you really need as much compute power as you can get while not going high on power consumption, right? So it makes sense that those projects will use leading-edge processes. You're also seeing the use of the leading-edge processes on servers, you know, those sort of high-end – high-end designs, data center designs, those kinds of things. And you would see sort of trailing edge processes being used on more cost-sensitive types of applications for consumer. And machine learning is kind of all over the place, right? The data center part of it, the training would be very much leading edge processes. the edge would typically generally not be, right? They would be 16 nanometer, maybe five, those kinds of things. So it's all over the place. But the leading edge guys are, you know, that we're involved with are kind of the ADAS, the ADAS level four kind of application.
Hans Mosman
Okay, that's very helpful. And then for my follow-on, if you can give us some, some granularity on that engagement that you have with an AIML company. I think you may have mentioned on the press release it's a semiconductor company. Is this an engagement that you guys were going after for a while? Did they come to you? Just maybe a little qualitative commentary on that particular one. I'd be interested.
Charlie Janik
Yeah, if I recall correctly, that one was kind of average in terms of sales cycles, right? We've had some discussion with them earlier, but the deal came together fairly quickly. I think it was like a six-month kind of sales process. But we are starting to see an increasing number of customers that just come to us where they're kind of saying, hey, you're kind of the the system IP solution, uh, you know, let's, let's, let's get to work on the project instead of doing an evaluation. Right. So, um, I would say in the aggregate, we're starting to see a shrinkage of the, uh, of the, of the sales cycle periods. Right. Very helpful. Some amazing outliers, right. Uh, there's some people who buy in a month and, and, and we've had sales cycles that take us, uh, you know, five or six years, right? Those are outliers, but on the average, um, it's, uh, it's really shrinking.
HiSilicon
Very helpful. Thank you.
Operator
There are no further questions in the queue. I'd like to hand the call back over to Charlie Janik for closing remarks.
Charlie Janik
Well, um, uh, you know, we'd like to thank you for your time and interest in Arterios IP. Uh, we, uh, We look forward to meeting with some of you at the upcoming investor conferences that we're participating in the next couple of months, and we look forward to updating all of you on our business progress in the quarters to come. So thank you.
Operator
Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.
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