Extreme Networks, Inc.
Q1 2017 Earnings Call Transcript

Published: 2 Nov 2016

[Operator:]

Good afternoon and welcome to the Extreme Networks’ First Quarter Fiscal Year 2017 Earnings Results Conference Call. This call is being recorded. With us today from the company is Ed Meyercord, the President and Chief Executive Officer; Drew Davies, the Executive Vice President and Chief Financial Officer; and Frank Yoshino, the Vice President of Treasury and Investor Relations. At this time, I would like to turn the call over to Frank. Please go ahead, sir.

[Frank Yoshino:]

Thank you, Heidi, and welcome to Extreme Networks’ first quarter fiscal year 2017 earnings conference call. This conference call is being broadcast live over the Internet and is being recorded on behalf of the company. The recording will be posted on Extreme Networks’ website for replay shortly after the conclusion of the call. By now, you’ve had a chance to review the company’s earnings press release. I would like to remind you that during today’s call, management will be making forward-looking statements within the meaning of the Safe Harbor provision of the Federal Securities Laws. These forward-looking statements involve a number of risks and uncertainties, which could cause actual results to differ materially from those anticipated by these statements. For a detailed description of those risks and uncertainties, please refer to our most recent reports on Form 10-K, Form 10-Q and Form 8-K filed with the SEC. You should not place undue reliance on forward-looking statements, which speaks only as of today. We undertake no obligation to update these statements after this call. Throughout this call, we will be referencing both GAAP and non-GAAP financial results. Non-GAAP information should be considered a supplement to and not a substitute for financial statements prepared in accordance with GAAP. Reconciliation of non-GAAP to corresponding GAAP measures is in our earnings press release issued today. For your convenience, a copy of the release and supporting financial materials are available on the Investor Relations section of the company’s website at extremenetworks.com. Now, I will turn the call over to Extreme’s President and CEO, Ed Meyercord, for some opening comments.

[Ed Meyercord:]

Thank you, Frank, and thank you all for joining us this afternoon. I am pleased to announce the closing of our acquisition of the Zebra Wireless LAN business over the weekend, along with solid first quarter results that came in slightly ahead of the midpoint of our non-GAAP earnings guidance at $0.07 a share. For the sixth consecutive quarter, we delivered earnings that met or exceeded our guidance. We drove higher gross margins and operating efficiencies that generated higher cash flow with non-GAAP operating income up 18% year-over-year on a lower revenue number. The improved cash flow from operations during our fiscal Q1 is evident in our balance sheet, where we’ve made steady progress, increasing our cash and paying down debt. In addition to delivering on our operating plan to drive higher cash flows, we are executing on our strategy to deliver industry-leading solutions and services to our enterprise customers. We’re the only networking company with a strategy solely focused on delivering quality of experience for enterprise campus customers, and we are number one in service. Our larger competitors play in hyper-scale cloud, hyper-converged networks, Tier 1 and Tier 2 data centers, service provider, low-latency high-frequency trading markets, not Extreme. We said no to playing in all these markets, so we can focus where we can win. Our biggest opportunity for growth is to go after enterprise customers and our targeted verticals with complete solutions. By targeted, we mean enterprise campuses and verticals where we’re investing

[Drew Davies:]

Thanks, Ed. I would like to start with a few financial highlights from our first fiscal quarter, specifically pointing out the increase in our gross margin and the continued improvements in our balance sheet. Our non-GAAP gross margin improved 1.5 percentage points quarter-over-quarter from 54.8% to 56.3% and improved 1.1 percentage points year-over-year from 55.2%. Our non-GAAP product margin was up 200 basis points quarter-over-quarter and year-over-year for Q1. These increases were driven by more disciplined approach to discounting, positive purchase price variance and lower charges for excess and obsolete inventory. In Q1, we continue to see improvements in the strength of our balance sheet. We ended the quarter with over $102 million in cash, improving our net cash position or cash and equivalents less debt by $11 million quarter-over-quarter and $33 million year-over-year. These improvements were driven by our increase in cash earnings, strong cash collection efforts, pay down of debt and our diligence in managing inventory. Please refer to our Q1 presentation on our IR website for details. We’re pleased that we can report these results and we are focused on continuing to strengthen our financial position in the future. Now let’s move to the fiscal first quarter details starting with revenue. Q1 non-GAAP revenue was $122.8 million at the lower-end of our guidance range compared to $140 million in Q4 and $125 million in Q1 a year ago. GAAP revenue for Q1 was $122.6 million also at the lower end of our guidance compared to $139.6 million in Q4 and $124.6 million in Q1 a year ago. Revenue was impacted by lower than expected E-Rate filings in the quarter, a couple of large education deals outside of E-Rate pushing into Q2 and our decision not to take some low margin opportunities as we focus to improve our levels of discounting. The geographic split of revenues were as follows

[Operator:]

[Operator Instructions] Your first call comes from Mark Kelleher with D.A. Davidson. Your line is open.

[Mark Kelleher:]

Great. Thanks for taking the question. Just a clarification first on Zebra. You said there’ll be two months of contribution, but there really won’t be very much revenue recognized, is that correct, because of the distribution?

[Drew Davies:]

Yeah. So, we will get a partial quarter there, because we’ve got to work that that inventory through the channel, but we will get some revenue. We’ll get about two-thirds of the service business. And then on the product revenue side, we’ll be impacted by that inventory working through the distributor channel.

[Mark Kelleher:]

Okay, got it. And can you just talk a little bit about E-Rate, what’s the problem there, what’s going on, what’ the delay or the issues with the government?

[Ed Meyercord:]

Sure, Mark. This is Ed. Last year, we had a slower funding process. As you recall, there were – the overall volumes of E-Rate projects were lower. At Extreme, we held our market share, a lot of that had to do with complications with a new portal that they put in place to register for E-Rate. And then, the system that they put in place as it reflects payments for E-Rate projects and the funding process from the FCC has just been slower. So we knew there was going to be a reduction in overall volumes, but then the pace of E-Rate projects have been coming out more slowly. So, we still have our E-Rate projects in our pipeline, in our backlog. It’s just a question of when we get the funding letters from the FCC.

[Mark Kelleher:]

Okay. That’s it. Thanks.

[Drew Davies:]

All right. Thanks, Mark.

[Operator:]

Your next question comes from the line of Simon Leopold with Raymond James. Your line is open.

[Unidentified Analyst:]

Hi, guys. This is Victor in for Simon. Can you speak about where the levers are for gross margin expansion? And what your expectations are for the timing around those improvements?

[Ed Meyercord:]

Sure, let me – I’ll start and I’ll let Drew add. First of all, when we sell solutions and we talk about leading with our software portfolio, which is our management control and analytics, when we have these kinds of software driven sales, we tend to have higher gross margins. And so, we’re focusing our selling initiatives, our go-to-market strategy with our field forces are leading with solutions and leading with solving business issues of our customers. When we do that we change the discussion. We’re able to move away from price. We’re able to sell it at higher gross margins. So strategically that’s part of the rationale for us leading with our software and software driven solutions. Then operationally, there were lot of tactical initiatives that we’ve taken to drive gross margins. And this is more from the bottoms up. And this has to do with how we sell in terms of our pricing policies, our discount authorization process. It has to do with our supply chain in terms of how we end of life products and phase out products, efficiency and our distribution network. We have over 20 different line items that are projects that we’re pursuing. All of which will help us improve that gross margin and drive improved gross margins. We believe that 60% gross margins are achievable over the next couple of years. Drew, do you want to add any color?

[Drew Davies:]

Yeah, I think you covered it. The one thing I would add is that with Zebra coming on board, we’ve got the opportunity for supply chain consolidation and some opportunities to save money there on the cost side.

[Unidentified Analyst:]

Okay, great. And I guess just can you speak about – regarding Zebra, can you just speak about the degree that WLAN amplifies campus switch sales and I guess may be what the potential cross-selling and sell-through opportunities there?

[Ed Meyercord:]

Sure. When you think about Zebra wireless LAN, you have to think about large customers with distributed campus environments, so very large networking opportunities. It’s different from your typical enterprise campus like, let’s say a college university with thousands and thousands of users in a concentrated space. Here you might have 1,000 Kroger stores spread out with smaller number of access points and users in the environment, but it’s a distributed environment with lots of locations. And the way operating system that we pick up and the Motorola solution that was sold into Zebra, now that we’re acquiring, has been designed for these larger scale products. Over the past couple of years, Motorola solutions team has been handicapped somewhat, because they don’t have a bundled switch. So there is a very obvious opportunity for us to add our switching portfolio to their wireless LAN portfolio and expand the overall opportunity we have with these larger customers; and we also pickup new technologies that they bring to bear. From a security perspective, air defense was and is the leading Wi-Fi security software platform. They have a guest portal that we think is very attractive in all of our verticals location-based technology. And then we’re getting into the managed services business, which brings us a recurring revenue stream, although it has a slightly lower gross margin. We have a higher operating margin from that business. It brings us a lot closer to these customers. The size of opportunity that we’re seeing with the Zebra customers is significantly larger than what we’ve traditionally seen at Extreme and Enterasys that we’re talking about much, much larger deal sizes and opportunities. We may have timed it right around the refresh cycle, where we’re seeing a lot of these big customers contemplating refreshing wireless LAN and upgrading the network in their various locations. So we think our timing is somewhat fortuitous, but that’s what we’re really excited about. You could also see it, Victor, with the partners, at our partner conference, the kinds of opportunities that they’re talking about, their level of excitement and the size of deals they’re bringing is on a different scale of what we’ve dealt with before. So, it could be a game changer for us in terms of the kinds of deals that we bring to the table and the impact it will have on our top-line.

[Unidentified Analyst:]

Great and that’s very helpful. Thank you.

[Operator:]

Your next question comes from the line of Rohit Chopra with Buckingham Research. Your line is open.

[Rohit Chopra:]

Hey, Ed and Drew. How are you?

[Ed Meyercord:]

Hey, Rohit.

[Drew Davies:]

Hi, Ro.

[Rohit Chopra:]

A couple of questions that I wanted to ask and then maybe just a clarification on your thought process as the whole of Zebra is sort of into a normalized mode. But first question is, are you still expecting that $29 million to $35 million in revenue range for Zebra as you looked at it on the close? And then, can you give us a split on the product and service within that range? That would be my first question.

[Ed Meyercord:]

Yeah. Yeah. So, we still expect 29% to 35% and the service would be about just under 20% of that.

[Rohit Chopra:]

20%-ish, okay.

[Ed Meyercord:]

Yeah.

[Rohit Chopra:]

All right. And then theoretically, would it be – so $29 million would be their low point, obviously from a seasonality perspective? And March is typically a tough seasonal quarter for you guys as well just because of the buying patterns? But is it theoretically the right way to look at this model as to look at what Extreme was standalone and add $29 million of revenue in the March quarter? Or do you still think there is some ramping that’s required as you look out into the second half of the year?

[Ed Meyercord:]

I think that’s fair. They’ve been a lot more linear than we have, because they’ve had sales to some huge customers. They’ve had some big deals. Their business has had some lumps because of that in the past. But, in general, they haven’t had the same seasonality that we’ve had. So, I would think that we anticipate that that’s fair to have $29 million for that quarter…

[Rohit Chopra:]

Last question, last question is related to something Ed you mentioned in your prepared remarks, but Broadcom has been in the news I guess for the last few days. And you mentioned that you’re receiving something from Broadcom. I just wanted you to explain that a little bit more, just to try to understand what you’re getting from Broadcom and how that helps you go-to-market, if you don’t mind?

[Ed Meyercord:]

Sure. So, we have an excellent relationship with the senior leadership at Broadcom as they have been increasing price on most vendors in the industry and the technology space, particularly in networking. We negotiated a strategic deal with them by leveraging their FASTPATH operating system. We have an opportunity to actually lower our costs. So, we just signed this agreement. They consider us to be a strategic partner. They would like to see us take share and they really like our focus. So there is a potential with us with Broadcom. We obviously can’t comment or speculate on what they’re doing from a strategic perspective. But we know that they consider us a strategic partner and we know they’ve only entered into a couple of these kinds of agreements. So any kind of strategic activity could create new opportunities for Extreme.

[Rohit Chopra:]

Okay. Hey guys thank you very much. I appreciate that.

[Ed Meyercord:]

Thanks Ro.

[Operator:]

Your next question comes from the line of Matt Robison with Wunderlich. Your line is open. Your next question comes from Matt Robison. Your line is open.

[Matt Robison:]

Hello? Hello?

[Ed Meyercord:]

Hey, Matt.

[Matt Robison:]

Yeah, thanks. Thanks for taking my question. I apologize if you guys covered this already, because I had a jump on, a couple different calls going on today. But it’s good to see Europe come back. Can you give a little perspective on what caused your EMEA to perform relatively well this time around? And why the comps were a little bit more challenging in the other two regions?

[Ed Meyercord:]

Sure. We’ve seen a rebound with our team in Germany, what we call the DACH region, which is Germany, Austria and Switzerland. They are our most advanced solution selling team. And across our verticals, we saw strength. And this is two quarters in a row where we’ve seen excellent performance. I will comment that we’ve had new leadership in EMEA. We’ve restructured and refocused our regions. Along with this, we’ve seen good momentum in other Western European countries. We’ve seen great momentum in Spain with some big wins there; Volkswagen, large Volkswagen plant in Spain. We won a large university in Italy, in Milan, and big wins in France too. So, we’ve reenergized our teams in Western Europe. Our EMEA lead now resides in the UK, the former head used to be in Germany. And so, the team we have in Germany is very strong and it’s been complemented by team and new growth in Western Europe and we see that continuing.

[Matt Robison:]

So the year-over-year drop in Americas, is that the E-Rate story?

[Ed Meyercord:]

Yeah, it’s predominantly E-Rate and offset by growth in government in the U.S. And our stadium business had slight growth. Healthcare was a grower this past quarter. But, overall, let’s say the E-Rate slowdown was the culprit.

[Matt Robison:]

Dropped pretty significantly?

[Ed Meyercord:]

Yeah and I would say for us it’s pushed.

[Matt Robison:]

Okay. Why do you think that happened?

[Ed Meyercord:]

We commented on this earlier. It’s just – it’s timing. It’s the timing of the FCC letters. We can’t predict that. So, we’re at the mercy each week to watch and see what’s getting funded. We know where we’ve won and we’re at the mercy of these funding letters.

[Matt Robison:]

Well, let’s talk about APAC.

[Ed Meyercord:]

Oh, APAC, I thought you said E-Rate.

[Matt Robison:]

No, sorry.

[Ed Meyercord:]

APAC is a smaller region for us. We’re really excited about the new leader, our VP, who has come in, who has got a very clear plan to turnaround performance. And we’re also excited about the team that we’re picking up from Zebra that’s already onboard. In fact our Head of Sales is in China as we speak, just had some fantastic meetings. I’m very excited about the new leadership that we’re bringing in, in addition to our regional leadership, and the opportunities that we have with the Zebra customers. So, yeah, we’re expecting to see that market turnaround.

[Matt Robison:]

Okay. So, we can just think it maybe a bit disrupted from the change in leadership and stay tuned, is that the message?

[Ed Meyercord:]

Yes.

[Matt Robison:]

Okay. I’ll listen to the rest of the crowd. Thanks.

[Operator:]

I’m showing no further questions at this time. I would now like to turn the conference back to Ed Meyercord.

[Ed Meyercord:]

Well, we’d like to thank everybody for your time and participation on the call. And then, yeah, our team at Extreme welcoming the new Zebra employees into the fold. We’re very focused on executing our strategy on a tactical level and delivering results as well as on a strategic level. And we’re very excited about the new growth opportunities that lie ahead. And with that, I think, we’ll close the call and look forward to seeing maybe some of you – we’re presenting at the Needham Conference tomorrow. There maybe we’ll see some of you there. Thanks again for your participation in the call. Have a good evening.

[Operator:]

Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation and have a wonderful day. You may all disconnect.