Calix, Inc.
Q3 2013 Earnings Call Transcript

Published: 30 Oct 2013

[Operator:]

Greetings and welcome to the Calix Third Quarter Fiscal Year 2013 Financial Results Conference Call. At this time, all participants are in a listen-only-mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. David Allen, Director of Investor Relations and Treasurer for Calix. Thank you, Mr. Allen, you may begin.

[David Allen:]

Thank you, Operator, and good afternoon, everyone. Before we begin the call, I want to remind you that this conference call contains forward-looking statements regarding future events, including but not limited to our expectations for the next quarter, our development of new products that will continue to help our customers transform their networks, the future business and financial performance of the Company and our expectations of revenue, gross margins, earnings per share, stock-based compensation and amortization of intangibles. These forward-looking statements are based on our estimates and judgments and current trends in market conditions, and involve risks and uncertainties that may cause actual results to differ materially from those contained in the forward-looking statements. I would encourage you to review the Company’s various SEC reports, including our Quarterly Report on Form 10-Q for the period ending June 29, 2013 available at www.sec.gov, in which we discuss these risk factors. All forward-looking statements are made as of the date of this conference call and except as required by law, we do not intend to update this information. Also on this conference call, we will be discussing GAAP and non-GAAP results. We are providing the non-GAAP estimates to enable interested parties to evaluate our performance in the same manner in which we evaluate our own operations. These non-GAAP measures exclude certain charges and benefits which we do not consider to be part of our ongoing activities or meaningful in evaluating our financial performance including stock-based compensation expense, amortization-related expense if any, and amortization of acquisition related intangible assets. To help you better understand those results, we have included a reconciliation of our GAAP and non-GAAP results in our earnings press release. All numbers that are discussed in today’s conference call are non-GAAP unless otherwise noted. This conference call will be available for audio replay in the Investor Relations section of the Calix website at www.calix.com. In addition to our earnings press release, we have posted financial data on our Investor Relations website which you may want to review in conjunction with our press release and conference call remarks. I’d now like to turn the call over to Calix’s President and CEO, Carl Russo. Carl?

[Carl Russo:]

Thank you, Dave and good afternoon, everyone. Joining me on our call today is Michael Ashby, our Executive Vice President and Chief Financial Officer. Michael is in California, while I am in Las Vegas at the 10th Annual Calix User Group meeting. Q3 was a record quarter for Calix, driven by a strong strategic execution by the entire Calix team. Record revenues, strong gross margins, allied with disciplined investments in OpEx, yielded strong earnings performance. After Michael discusses the details, I will come back and share with you what I've heard from our customers here at the User Group. Michael?

[Michael Ashby:]

Thank you, Carl, and good afternoon, everyone. If you've not already done so, I would encourage you to go to the Investor Relations portion of our website and download the financial slides that we posted concurrent with our press release earlier today. My prepared remarks will provide an overview of our financials and our related business trends. I will close by providing guidance for the fourth quarter of 2013. As a reminder, the guidance we provided in July for the third quarter called for revenue between $102 million and $106 million, gross margin between 46% and 47%, operating expenses in a range of $41 million to $42 million and the result in EPS between $0.11 and $0.15 per share. Actual revenue for the quarter was a record $103.6 million in the mid-range of our guidance. Gross margin was 48.1%, significantly ahead of our guidance. Operating expenses came in at $40.3 million, below our guidance. We had a benefit to our tax revision which I will explain later. As a result, EPS was significantly ahead of our guidance at $0.20 per fully diluted share. We had another strong cash flow generating quarter and ended the quarter with total cash of $80.1 million. Putting it all together, it was another very solid quarter for us with revenues over $100 million for the first time, another strong gross margin quarter, operating expenses under control, which resulted in operating income planning to just over 9% of revenue. We also achieved GAAP profitability for the first time. Revenue for the quarter was up 27% compared to the same period last year, and on a year-to-date basis, revenue was up 21% from the prior year. Our international revenue was 10% of total revenues and we had one 10% customer this quarter. Gross margin at 48.1% was better than we had expected. Gross margin strength was across the board both in product mix and customer mix. Operating expenses at $40.3 million was lower than anticipated, an increase by less than $400,000 from the prior quarter. As I mentioned, we had the benefit of a tax credit this quarter, which was a result of an AMT offset that Occam has granted prior to our acquisition of Occam. We have told you at investor conferences and meetings over the last three quarters that our objective for 2013 and 2014 were to return to revenue growth while continuing to improve gross margin percent, control our operating expenses and increase our operating profit. We have shown steady improvement in each of the first three quarters of this year and are very pleased of the progress that we have made. Improving our operating income has been a major area of emphasis for us this year and we are pleased to have seen steady improvement with operating margin this quarter over 9% of revenue. Before I turn my attention to the balance sheet, I would like to remind you that on a non-GAAP basis we exclude certain charges that we do not consider to be a part of our ongoing activities or are not meaningful in evaluating our financial performance as a company. These charges, the amortization of intangibles and the amortization of stock-based compensation are both non-cash items. As I mentioned earlier, Calix was profitable this quarter on a GAAP basis for the first time. Turning to the balance sheet, we continue to manage our working capital and ended the quarter with total cash of $80.1 million, an increase of $10.7 million. DSO was 46 days, down from 56 days in the previous quarter. Inventory levels increased a little this quarter to $39.4 million, and inventory turns improved to 5, up from 4.4 in the previous quarter. Deferred revenue amounted to $63.4 million, down $7.7 million from the prior quarter as expected, reflecting the completion of a number of BBS projects. Let me now move to our guidance for the fourth quarter of 2013. We are pleased with the progress we have made over the last several quarters and the strength we have seen in our business. While we normally have the benefit of some year-end spend during the final quarter of the year, our Tier 2 and Tier 3 customers have indicated that while spending has been strong so far this year and activity levels remain very positive, they do not see much additional year-end spend. Accordingly, we are more cautious about our outlook for this quarter. So while we expect the fourth quarter to be another good quarter for the company, we are guiding to a more conservative revenue range of between $97 million and $103 million. We expect gross margin to come in between 46% and 47%. This expected decline reflects the completion of several BBS projects and include professional services where we have lower margins. We believe that this is a one-time gross margin impact. And as we have previously stated, we believe that over any fourth quarter period, we will see a gradual increase towards our long term target of gross margin in the low 50% range. Q4 operating expenses will be in the range of $43 million to $44 million. The increase in Q4 operating expenses reflect expenses associated with our Annual User Group meeting, which we are holding this week, an increase in the payment on our Employee Bonus plan as well as some increases in headcount as we continue to grow the business. The result in EPS will be in the range of $0.03 to $0.08 per share. For 2013, EPS will be between $0.39 and $0.44 per share, a considerable increase from the $0.15 per share achieved in 2012. DSOs should be in our normal range of around 55 days. Inventories will be flat to slightly up and once again we plan on being cash flow positive for the quarter. At this point, I’d like to turn the call back over to Carl.

[Carl Russo:]

Thank you, Michael. The 10th Annual Calix User Group Meeting set another record with over 1,700 attendees. First, let me echo Michael's comments as our customers have made it clear that we should not expect any year-end spend driven by funds left over in their budgets. While occasionally, we have heard this admonition in years past, this time it is widespread. And as such, prudence clearly dictates our guidance. However, the level of excitement for 2014 is exactly the opposite. There is huge energy around delivering high value services at gigabit speeds and Calix is well-placed to ride this wave. So with that, I would like to turn the call over for questions. Operator?

[Operator:]

(Operator Instructions) Our first question is from Tim Quillin of Stephens, Inc. Please go ahead.

[Tim Quillin:]

Good afternoon. Could you go through the reasons that you're hearing some caution for Q4 and why you think that changes up to an optimistic outlook in 2014?

[Carl Russo:]

Tim, this is Carl. I'll let Michael to add color afterwards. It's actually from near as I can determine pretty simple. I think everyone is now starting to sort out how they want to go and invest. As you may be aware from our previous calls and as we've watched the market, there has been a lot of uncertainty, especially amongst the North American service providers about how they are going to deal with government regulations, et cetera. I believe what we are seeing from our customers is they are now getting clarity over how they want to go and invest. And obviously, we're past the build season for many of our customers. And I believe they are looking at this and saying they're going to marshal their capital and, as they approach their programs going into 2014, make their investments. So that's the reason as near as I can determine it. And, by the way, it is quite widespread. Michael, anything you'd like to add?

[Michael Ashby:]

No, I agree with you, Carl. I think that, like you said, I think that all movements towards gigabit networks had people starting to look at that more closely and to find where they want to invest that money going forward. And I think there's a movement towards more interest in fiber and gigabit networks and then, who knows what this government shutdown had some impact. That's very difficult for us to judge.

[Tim Quillin:]

Right. But all the drivers of the trend towards fiber networks you still see and think that CapEx can free up for 2014?

[Carl Russo:]

It's much clearer and more so, yes. I mean, it's very difficult. It's impossible for me to be pessimistic sitting with 1,700-plus attendees. It's frankly difficult to be even prudent because the energy is so high. But there's a very clear guidance that resources are going to be marshalled. Going into 2014, I think there's good clarity of where folks are going to invest.

[Tim Quillin:]

Okay, good. And then, Michael, with regards to the deferred revenue on the Broadband Stimulus work, I think you had maybe $50 million or so in the deferred revenue at the beginning of the quarter. Was the $8 million drawdown in deferred, did that work this total down to $42 million or where exactly is that, and how should we expect that to be recognized over the next several quarters?

[Michael Ashby:]

Yes, that's basically correct. The deferred revenue balance is now $63.4 million, or which approximately $21 million is extended warranty, and so the remainder is product. The vast majority of like the BBS projects that we will recognize probably over the next three quarters. I expect by the middle of next year, that will have gone down to its more normal level which is probably closer to the $30 million to $40 million range.

[Tim Quillin:]

Okay. And how do you think about that being recognized in the fourth quarter? And does the government shutdown impact the timing of government signoffs on some of those BBS projects? Thank you.

[Michael Ashby:]

We expect to see some signoffs in the fourth quarter. I don't think the government shutdown is going to change that. We weren't quite sure for a while but it seems now that that should be okay. So we are expecting to see some project completions and signoffs in Q4 and then the remainder into Q1 and Q2 of next year.

[Tim Quillin:]

All right. Thank you.

[Operator:]

Thank you. The next question is from Simon Leopold of Raymond James. Please go ahead.

[Simon Leopold:]

Thank you. A couple of things, I wanted to just – a very quick clarification. I missed the operating expense pro forma guidance. I think you said that was $43 million to $44 million, is that correct?

[Michael Ashby:]

Yes, that's correct. I did say $43 million to $44 million for Q4, yes.

[Simon Leopold:]

Okay, great. So two things I wanted to check on

[Carl Russo:]

So let me go to the first one first. Obviously, we're not giving guidance for Q1 but let me just color that to your point. Judging by the energy I'm seeing here, I'm expecting very strong things in 2014. Having said that, I'm listening to the messaging I'm getting in Q4. I'm still going to make sure that we vet Q1 when we get there. So the likelihood of having the same seasonality is probably not the same, but I'm not sure I would necessarily say that – I'm not sure what I would say as far as the number goes and I will let Michael speak to that in a moment. On the second piece, there is no question that this trend is moving at a much more rapid pace than even I would have anticipated earlier this year. It's becoming a much more widespread phenomena. And part of it is driven by the economics of where fiber deployments have started to get to, i.e. lower upfront costs with much better operating economics, versus where continually extending the copper is going if the service provider is in a competitive environment. That said basically, it's not that much more expensive and, in many cases, not more expensive to simply take fiber all the way to your consumer business premises and go forward on those services. So it is material and it's going to become increasingly material, Simon.

[Simon Leopold:]

Any order of magnitude you could give us to get some sense of what you mean by that? And I guess what I'm looking for, when you say material I generally interpret that as in the order of at least 10% of revenue. Is that a fair way to think about it?

[Carl Russo:]

For sure.

[Simon Leopold:]

Okay, great. Thank you.

[Operator:]

Thank you. The next question is from Amitabh Passi of UBS. Please go ahead.

[Amitabh Passi:]

Hi, thank you. Michael, first question for you. I'm a little perplexed about the OpEx guidance, and how should we be thinking about OpEx as we go back into the early part of 2014? It seems like you kept it pretty controlled for much of this year, but again we're seeing a pretty significant move up in the fourth quarter.

[Michael Ashby:]

Yes, Amitabh. The guidance is $43 million to $44 million, that's up in Q4. Q4 is always up and it's up for one big reason, it's our Annual User Group meeting, all the expenses, which fall into this quarter and, believe me, it's quite an expense. As you know, Carl is in Las Vegas with 1,700 people and that's not cheap. So that's the big part of it. We're also increasing our Employee Bonus in the fourth quarter. That is something which we'll attempt to continue to maintain during 2014. And then we have some head count growth. So generally speaking, I think we are capable of and comfortable with keeping tight control of our operating expenses but we always see a bump in Q4 followed by somewhat of a decrease in Q1.

[Carl Russo:]

And if I may add, Amitabh, when we set out the planning for this year's User Group, given what we thought was going to be a modest 2013, we actually were planning on struggling to get back to the numbers we had last year in attendance. And, in fact, we're up over 20% and just blew away every plan that we had. So look, it's great news and it's exciting news, but it obviously also raises the OpEx a bit from an investment standpoint.

[Amitabh Passi:]

Just as a follow-up, I apologize if you talked about this, I missed what your commentary was on international investors domestic revenue. And if you could give us a sense of just having international opportunity set in funnel that's developing for you?

[Michael Ashby:]

International is 10% of revenue in Q3. For the first three quarters of the year, it was 12%, so up from 7% in the prior year. So we've had a good increase in international revenue. And I think, as you've said before, that increase is primarily we've added a lot of new customers. We had small orders to begin with, but you start with small orders and then build from there. So we're very pleased with – I think the number of new customers you got it and the reach that we've added internationally. And I don't know, Carl, if you want to comment, to get more on the funnel going forward?

[Carl Russo:]

Well, there's a number of observations and let me start with those. As I promised, I would try to give you as much color as I could directly here from the User Group. Last year, you know, was really a North American User Group with some international attendees. This year, it's clearly a global conference. We have folks from around the world in virtually every region here and a much larger international contingent. The interest level is very high. The funnel is building. But as you remember, Amitabh, we talked about this before, building out the products and the things that we needed to do to bring our products through the Ericsson channel are starting to come to fruition at the end of this year and early next. We are beginning marketability this quarter on a number of those efforts for basically order taking next quarter. So actually we see a lot of good excitement, a lot of partnering. And, as a matter of fact, Ericsson is here obviously at our User Group, participants in the show presenting some pieces, et cetera, and lots of co-marketing going on. So I think we're very well-situated for 2014 as we go forward.

[Amitabh Passi:]

Okay. I'll jump back in the queue, thanks.

[Carl Russo:]

Well thanks, Amitabh.

[Operator:]

Thank you. The next question is from Simona Jankowski of Goldman Sachs. Please go ahead.

[Simona Jankowski:]

Hi, thanks very much. Just first on the near-term guidance, could you just help us understand if more of the decline is coming from the Tier 2 or the Tier 3 customer base?

[Carl Russo:]

You mean the decline as far as the budget flush lack of spending?

[Simona Jankowski:]

Exactly yes, so just as far as kind of a near-term caution on the sequential decline and the expected revenue.

[Carl Russo:]

It's widespread. I wouldn't comment on what percentage of it. It's across the board, Simona.

[Simona Jankowski:]

Okay. And then if you talked about the energy you're seeing and clearly with 20% increase in attendance, I can see what you're referring to there, what is your sense of the funding for gigabit projects into next year? A lot of the Tier 2s have been reducing CapEx quite significantly this year and for the Tier 3, it's been a bit unclear as well. Are people thinking about tapping into cash or what other sources do you see for potential CapEx increases next year?

[Carl Russo:]

Good question. Look, the whole government piece, we see it influencing. But I'll tell you, the vast majority of these folks, to be truthful, are looking at it from funding it out of operations. There's a little bit of jaundice, if you will, amongst a lot of these service providers around the government programs. And many of them have just sort of pulled themselves up by the bootstraps and have convinced themselves that they ultimately have to build that enterprise that's bereft of government financing and they best get on with it. So most of it is actually internally driven.

[Simona Jankowski:]

And do you see some of this fiber premise project into next year coming from the Tier 3 customer base? Or are you mostly looking at the Tier 2 base?

[Carl Russo:]

More so in the Tier 3 base actually.

[Simona Jankowski:]

Got it.

[Carl Russo:]

We see them globally. We see them from many different areas. I would say when you think about clinically the Tier 2s, we would see less from the Tier 2s than we would from the other segments actually. Does that make sense?

[Simona Jankowski:]

Yes. I mean it's just a little interesting to kind of see how they will actually be able to fund it in the Tier 3 space just given that I don't get the sense there is a lot of excess cash flow generation there.

[Carl Russo:]

I'll tell you exactly what drives it, is they typically do a pretty good job of intimate marketing and they get very good take rates. And so in the programs they've done in the past, whether they'd be pilots or experiments, they seem to be able to drive to strong take rates in the community with much low return. And so it makes them feel much, much better about making that investment and making sort of an incremental "I'm a little bit better at broadband than you are" investment.

[Simona Jankowski:]

Got you. And then another question just on the margin side, I think you mentioned that the dip in the fourth quarter is likely to be one tiny nature. Can you just go a little bit into what is driving that dip? I think you commented on professional services, but if you can just maybe break down for us the components like fixed cost absorption, services or anything else that may be causing the dip?

[Carl Russo:]

Yes. Michael, can you take that one please?

[Michael Ashby:]

Sure. Yes, Simona, that relates primarily to Broadband Stimulus projects where we have contractors give professional services for these customers. And we do not run our own professional service organization. We have professional services people that we outsource a lot of that work. We outsource it so we don't get a particularly high margin on that. There are some projects remaining from the BBS where we have a fairly high percentage of professional services and the margin on that is lower. Those have been in deferred revenue so those would come back into the recognized revenue that has a negative impact on margin momentarily.

[Simona Jankowski:]

And are those professional services just a one-quarter phenomenon or is there some kind of a mismatching when the cost flowing through the P&L versus when you're actually delivering the services?

[Michael Ashby:]

No, it's only just when we recognize the revenue, at the point we recognize the revenue. So in Q4, we have some projects that are completed where we expect to recognize the revenue. And those have a high percentage of professional services that we'll get to recognize at the same time.

[Simona Jankowski:]

I see, got it. Okay. Thanks very much.

[Operator:]

Thank you. The next question comes from George Notter of Jefferies. Please go ahead.

[George Notter:]

Hi, thanks a lot. I guess I wanted to ask about the guidance in the context of – it feels like you've got some moving parts here. You've got some lumpiness of revenue recognition around the Broadband Stimulus program. I get that sense just given the decline in deferred revenues and the movement on gross margins, but at the same time I think what you're saying is that some of the smaller operators spent more of their budgets earlier in the year than maybe they had in the past and so you're getting a softer Q4. I guess I'm just trying to understand the different kind of pieces that work here and how that funnels into the guidance for Q4. I'm a little bit confused.

[Carl Russo:]

Let me address the last piece first, George and, Michael, feel free to chime in. There are clearly moving pieces as there are always, George. You said something related to a number of folks who are giving us guidance that don't expect the year-end spend that's driven by budget flush. If you think that through, it's actually not that they had actually overspent early in the year. It's actually that I think they're getting more strategic in their investments. They're starting to get better clarity around where they want to go and invest and just trying to realize, "Okay, so why do we need to spend it in Q4? Let's marshal those resources to go invest in the building season into 2014." And that's what lines up for us when we listen to what their aspirations are for 2014 and the plans they have, the programs they're looking at, the markets that they're looking at building out and see looking into. That lines up better with that fit. Does that help you on that side?

[George Notter:]

Okay. I mean the pushback would say, "Look –." These operators historically I'd presume that this isn't the first time they thought more strategically about their business. And what you're suggesting is just so significantly contrary to the seasonality you guys have put up in years past. I mean if I look at March quarters the last five years, I think you've averaged a 20% sequential decline. But in December, it's been roughly a 20% sequential growth, right? And so this is a really big spin on what you guys have seen historically. And I guess I'm just trying to understand that.

[Carl Russo:]

And, by the way, I reserve the right to be wrong. I mean there's a part of me that's in here and says, "Yes, yes, yes, we've heard this before," and then you end up with the spend, right? So the reason I'm saying I think we need to be prudent is because we are seeing it widespread. This is not something where if you pulled me aside and said, "Hey, for next year, we're not going to spend money," it's all across the table here.

[George Notter:]

Got it, okay. So build-up in the sales funnel based on conversations with customers and hence down sequential Q4?

[Carl Russo:]

That's one piece. And the second piece, if I look at it and then look forward as to what their plans are – you know, we spoke about this last year, George, you and I specifically, about the cloudiness around people's clarity as to what they were going to do. I'm not seeing that this year. I'm seeing a lot of folks focused on how they want to go deliver the next generation set of services, how they're going to go to market and what their infrastructure is going to be. So there's a great deal of excitement around 2014. I'm not talking about my excitement. I'm talking about the people that I am in the building with.

[George Notter:]

Got it.

[Carl Russo:]

But that's the only way I can put it. Michael, any additional comments?

[Michael Ashby:]

No comment. I agree with you. I just would like to emphasize, I don't think we had any additional spending in the first three quarters of the year. I think that spending was normal, what we've just seen, is that they're making their decisions as to how to spend in the future and not going to rush into spending it in Q4.

[George Notter:]

Got it. And then one last thing, you were talking about the Ericsson relationship and how there were a number of milestones or triggers that were getting put in place here such as you could start taking orders in Q4. Could you remind us what those pieces are? Is that integration of the E-series products into your management system? What exactly is driving that?

[Carl Russo:]

It's a good question. It's a set of things, but it's all around the E-series through the Ericsson channel. Part of it are the BLM systems; part of it is bringing through their productization processes, they are a big company; part of it is expanding the premises portfolio; part of it is expanding the VDSL2 portfolio. So there were just a set of factors that, in essence, ready us for global for footprint. Some of them have directly to do with Ericsson, some of them are just frankly things that you have to do to be global. But because Ericsson is our partner, we sort of put them into all that same bucket. Does that make sense?

[George Notter:]

Yes, great. Thank you very much.

[Carl Russo:]

Thanks, George.

[Operator:]

Thank you. (Operator Instructions). The next question comes from Sanjiv Wadhwani of Stifel. Please go ahead.

[Sanjiv Wadhwani:]

Thanks. Carl, I wanted to ask you a question about 2014. I think you've used the word about modest expectations coming into 2013 and it looks like the environment for 2014 seems to be much more favourable. Qualitatively, could you talk about what we should be thinking about growth in 2014 as it relates versus 2013? Thanks.

[Carl Russo:]

I'll leave this one to Michael, but the best I could tell you is we've sort of stuck to – we expect to be able to deliver double-digit growth given the markets that we are playing in and focusing on. And I don't know that there's anything that's actually changed my view of 2014. Michael?

[Michael Ashby:]

No, I agree with you, Carl. I think what our call is saying is that meeting with customers and discussing the view of 2014. I think we'd see a lot of activity and we'd see a lot of positive things happening. I don't think we are prepared to guide over to 2014 now except to say that we still believe we can grow the business at double-digit revenue. We can continue to improve the gross margin up towards the 50%. We can continue to hold operating expenses at reasonable levels and improve our operating income.

[Sanjiv Wadhwani:]

Got it. Thanks.

[Carl Russo:]

Thanks, Sanjiv.

[Operator:]

Thank you. (Operator Instructions). It appears we have no further questions in queue at this time. I’d like to turn the call back over to Mr. Allen for any closing remarks.

[David Allen:]

Thank you, operator, and thank you, everyone, for joining us once again. This quarter we'll be participating in three investment conferences. We hope you can join us at one of those conferences including the Needham's Second Annual Next-Gen Networks Conference on November 5 in New York, the Goldman Sachs US Emerging Growth Conference on November 14 also in New York and the UBS Global Technology Conference this year in Sausalito, California on November 20. Information about these conferences is available on the Investor Relations section of Calix.com. Thank you again for joining us today. We remain focused on executing against the opportunities ahead of us and we look forward to speaking to you at one of these forums. Goodbye for now.

[Operator:]

Thank you. Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.