Extreme Networks, Inc.
Q3 2015 Earnings Call Transcript

Published: 7 May 2015

[Operator:]

Good day, everyone, and welcome to the Extreme Networks Third Quarter 2015 Earning Results Conference Call. This call is being recorded. With us today from the company is Ed Meyercord, the President and Chief Executive Officer; Ken Arola, the Chief Financial Officer; Norman Rice, the Executive Vice President of Global Marketing and Corporate Development; and Frank Yoshino, 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, Amanda, and welcome to Extreme Networks' Third Quarter Fiscal Year 2015 Earnings Call. Earlier today, we announced our third quarter results and outlook for the fourth quarter. A copy of the company's earnings release and supporting financial materials are available in the Investor Relations sections of our website. This conference call is being recorded and will also be posted on our website shortly after the conclusion of the call. I would like to remind you that during today's call, management will be making forward-looking statements regarding our business, financial outlook, strategy, future operating results and overall future outlook. Actual results may differ materially from those anticipated by these statements. These statements apply as of today and we undertake no obligation to update these statements after this call. For a detailed description of risks and uncertainties that could cause actual results to differ materially from the forward-looking statements, please refer to our most recent 10-K or 10-Q, in addition to our earnings release furnished with our 8-K filed with the SEC today. Throughout the conference call, the company will reference some financial metrics that are derived in accordance with GAAP, while other metrics are in accordance with -- not in accordance with GAAP. Non-GAAP information should be considered a supplement to and not a substitute for financial statements prepared in accordance with GAAP. Reconciliation of the non-GAAP information to corresponding GAAP measures can be found in our earnings press release issued today. Now I will turn the call over to Extreme's President and CEO, Ed Meyercord, for some opening comments.

[Edward B. Meyercord:]

Thanks, Frank. It's great to be here with all of you. It's been a busy 2.5 weeks since I came on board, and I can confidently say that I'm more optimistically today than I was first approached to step in as CEO. I will address 4 items in my prepared remarks before turning the call over to our CFO, Ken. First, I'll provide color on our leadership changes and the reorganization of our customer-facing departments. Second, I'll comment on our new strategic plan that's under development. Third, I will give operating highlights for Q3. And finally, I'll spend some time on our U.S. K-12 business and in particular, E-Rate. Starting with leadership, our board approached me with a desire to accelerate change at Extreme with a greater sense of urgency. Our focus will be on 2 success factors

[Kenneth B. Arola:]

Thanks, Ed. Let's review the third quarter results, starting with revenue. Q3 GAAP revenue was $119.6 million compared to $147.2 million in Q2 and $141.8 million a year ago. Q3 non-GAAP revenue was $120.4 million, down 19% compared to $148 million in Q2 and compares to $143.7 million in Q3 last year. GAAP and non-GAAP product revenue was $86.5 million compared to $112.5 million in Q2 and a $109.9 million in Q3 of last year. GAAP service revenue was $33.1 million compared to $34.7 million in Q2 and $31.9 million last year. Non-GAAP service revenue for Q3 was $33.8 million compared to $35.8 million in Q2 and $33.8 million in Q3 of last year. On a sequential basis, all geographies were down quarter-over-quarter. The geographical split of revenues is as follows

[Operator:]

[Operator Instructions] Our first question comes from Mark Kelleher with D.A. Davidson.

[Mark Kelleher:]

First, I want to start with the cash management strategy that you're looking at. You paid down some debt. You supported the loss with the quarter. What's the expectation going forward? What level of cash are you comfortable with? And where do you think that will get down to?

[Kenneth B. Arola:]

Yes, Mark, this is Ken. We're really focused on our cash collections as well as managing the overall working capital at the company here. Certainly working capital has dropped off a bit over the past couple of quarters, but our focus is continue to work with our customers, keep collections down to a reasonable level of days sales outstanding. And we think over time, we'll start building that cash position, as we focus the business in relation to our strategy.

[Mark Kelleher:]

But would this be the lowest point of cash at 74 [ph]?

[Kenneth B. Arola:]

I wouldn't want to say that specifically, but we think we have opportunities to improve our position over time.

[Mark Kelleher:]

All right. And how about an update on Lenovo. You didn't mention that. Is that still a few quarters out?

[Edward B. Meyercord:]

Yes. Mark, this is Ed. One of the things that I looked at when I came in was taking a deeper dive into Lenovo. And there's a lot of changes happening in that organization. We've got a very good relationship at the corporate level with the Lenovo folks, but the deals right now are happening out in the field. But it's just a question of whether or not we're collaborating in the field to get deals done with them, which -- it's hard to step on a throttle when that's the situation. So I don't have much visibility into that. At this stage, I have zero visibility into Lenovo. So as far as where that is or how you're building that as a model, I'd be uncomfortable giving you a forecast for Lenovo.

[Operator:]

Our next question comes from Matt Robison with Wunderlich.

[Matthew S. Robison:]

Yes, I've got a follow-up on that one. I did notice the discussion of Eileen's role on Lenovo was conspicuous and absent. So is that a situation you're just going to wait for it to stabilize before you include it in the focus along with the others that were mentioned there? And while I'm on, I'm interested to know if you could comment a little bit on the degree which you're able to capture the deals that slipped out the quarter and give us some flavor for the contribution of wireless and data center.

[Edward B. Meyercord:]

Sure. So let me address Lenovo and deals that slipped out of the quarter. In terms of data -- Norman, I don't know if you can pick up the data center, wireless question. Yes, as far as Lenovo is concerned, we -- Eileen has got excellent relationships. And I would say across the board, she's very well connected in the industry. And Lenovo is on my list to go meet with them. There has been a lot of things happening at that company and that's something that's going to be happening in the near future. And I'll get a better feel for it to see how we may able to align our interests and work together to generate a predictable business. But that, I'm not in a position to comment on this time. As far as deals that slipped, my view on that is that is that deals slip every quarter. And unless we're willing to take up our guidance for deals that slip, I'd prefer the team to stop talking about deals that slip. We either make our numbers or we don't make our numbers. So in this case, I don't think we made our numbers and I'm not in a position to comment on whether they'll slip and fall into this quarter or will there be deals in Q4 that slip and fall into Q1, which I suspect there will be. So I think it's a policy -- I think we're going to stop talking about deals slipping.

[Norman J. Rice:]

So in terms of your question -- this is Norman Rice speaking. In terms of your question with regards to wireless and data center, their contributions continue to be consistent. Wireless in the 10% to 15% range, continue to -- that business continues to evolve as well as of our contributions from data center being in the 20% to 25% range for the overall product revenue for the quarter.

[Matthew S. Robison:]

You're -- for me, I lost the kind of the punchline on the wireless percentage. I didn't hear. The call dropped for a second.

[Norman J. Rice:]

Sure. It's 10% to 15% of the product revenue for the quarter.

[Matthew S. Robison:]

Okay. And I'll just comment that I think it makes a lot of sense, the discussion about the deals slipping out, like you described it. And we'll wait until we hear more about Eileen's role to focus on Lenovo it sounds like.

[Operator:]

Our next question comes from Alex Henderson with Needham & Company.

[Alexander B. Henderson:]

I was just wondering if you could give us the R&D, sales and marketing and G&A in a non-GAAP format, since I don't believe they're in the press release that way.

[Kenneth B. Arola:]

Yes, they are not. We actually don't disclose that outside the company. We actually just disclose the total operating expenses. But from an R&D perspective, I'll give you some rough ranges, Alex. R&D is running in kind of the low 90s, right around $90-ish million or so a quarter, give or take a little. Sales and marketing's been running around -- I'm sorry, that was an annual number, I just gave you. On the quarter, our R&D been running around $22 million, $23 million a quarter. Sales and marketing, around $40 million, $42 million a quarter; and G&A, around $8 million to $9 million a quarter.

[Alexander B. Henderson:]

And is there a reason why you don't provide the -- a breakout going forward of those numbers? You've done it in the past. That's been -- most people do forecast an income statement based on non-GAAP format all the way down. It's kind of hard to...

[Kenneth B. Arola:]

It's certainly something we can provide going forward, Alex. I don't really have a specific issue with it.

[Alexander B. Henderson:]

Okay. Second question, your data center business percentages really haven't changed much. You were expecting the -- I believe that there was expectation that the BlackDiamond, particularly the 100-gigabit line card and the Summit 770 (sic) [Summit X770] would improve some demand conditions out of that segment. Have you seen any traction with those new products?

[Norman J. Rice:]

Yes. I mean, our -- this is Norman Rice speaking. In the data center, what you're seeing is contributions from products that are -- that have come out just as you had mentioned. So the composition of the products that's in the marketplace today is different from those in the marketplace previously. So overall, the data center business continues to be something that's a strong foundation for our company. And typically, we look to sell solutions to our customers that reach to our entire portfolio, whether it's driven through the data center or it's driven through other areas, such as the access layer.

[Alexander B. Henderson:]

Okay. Second, the $90 million number you cited on the call relative to E-Rate, how is that compared to prior periods when you had E-Rate kicking in, in a. And b, is that something that you would expect to be spread out over multiple quarters? I assume that's not all falling in the September quarter. So how do we think about that? A little bit better clarification might be helpful so people don't...

[Edward B. Meyercord:]

Yes, Alex, so I can comment on that. It's probably more than a double of what we've had in the past. The issue is trying to figure out how much of the business would we have gotten without E-Rate funding. In other words, it's a funding mechanism and schools that apply to the program can get a discount. They can get up to 85% discount based on need. And so would those schools have fallen into our budget or would we have sold them anyway? And that's a question -- that's part of the reason why we're not giving guidance right now, because we need to dig a little deeper on that. Timing wise, what -- they start writing letters in waves. And in the beginning of June, we think we'll see the first letter that will come out, the first wave of letters. And the SEC is committed to sending out all the letters in -- through September 1. So by September 1, we'll know where we stand in terms of projects that are going to be funded, deals that were either displaced or incremental. And we'll also have a better feel for how they're going to roll out, because those dollars get spent from that September 1 all the way through September 1 of 2016.

[Alexander B. Henderson:]

Right. And can you remind me what the base of non-E-Rate spending into that -- or revenues from that, that 1 through 12 environment is?

[Kenneth B. Arola:]

Yes. Alex, this past year, we've got virtually no E-Rate business related to that -- the funding mechanism since it wasn't there. Prior years, I believe in 2014, we did something like mid-single digits, $4 million, $5 million, something like that. And in the prior year, we did something like around $20 million of E-Rate business.

[Alexander B. Henderson:]

Yes. No, that's not what I was asking. I was asking what the base was for non-E-Rate-related sales into that vertical. So it's how much you -- you said that the E-Rate could cannibalize your existing business. What's the scale of the existing business on a quarterly basis going into the E-Rate funding window?

[Edward B. Meyercord:]

So typically, it's in the single digits, most, call it, low single digit per quarter in terms of overall business, and the E-Rate creates an acceleration of that. It's been a growing and robust part of the business for a long time. And with no E-Rate funding over the past 2 years, a lot of organizations have chosen not to pursue -- or it created a headwind in that space. Now that these programs are back in place, we see the pent-up demand and that's why you see this larger-than-normal $90 million kind of aggregation of that funding mechanism.

[Alexander B. Henderson:]

So it's kind of reasonable to say, excluding E-Rate, it's a $20 million kind of a year business, and with E-Rate, it could be $80 million or $90 million, something of that sort.

[Kenneth B. Arola:]

I'd say slightly lower than that, but that's accurate.

[Operator:]

Our next question comes from Simon Leopold with Raymond James.

[Victor Chiu:]

This is Victor Chiu in for Simon Leopold. Previously, you mentioned hitting -- attempting to hit double-digit growth by the December quarter. I mean, is it safe to say at this point, you're not targeting that anymore? And if that's the case, kind of what's a more realistic target now for the December quarter? Where do you see growth kind of by the end of the year?

[Edward B. Meyercord:]

Yes. I think we need to wait. The team is working on a plan. And we're going to be back out to you in about 30 days with a plan and it reflects the new vision and customer strategy and operating plan for the company. And I think it's going to be a better time for us to address that.

[Victor Chiu:]

Okay. You also mentioned a more focused effort on prioritizing the software and services. Can you just give us some color around your plans around that and what that looks like?

[Edward B. Meyercord:]

Again, I want to hold on that, because we have a team of people that are working very hard on that. And rather than give you bits and pieces of it piecemeal, I rather wait and come out with a strategy when we've got it all baked together, along with a -- the financial plan that we can give you guidance on.

[Victor Chiu:]

Well, then I guess, I just -- I guess the last thing I'll ask about is an update on maybe the competitive environment then, whether you're still seeing discounting impacting results. And how does that impact the guidance? And then going forward, I guess, how does that impact what you're looking for?

[Kenneth B. Arola:]

Yes, Victor, this is Ken. Yes, we still see the environment out there as competitive. We saw it more so in the Asia Pacific region this past quarter with discounting occurring, more heavily with Cisco, Huawei and others. But it is something we see every quarter in the business, and we probably will -- with where the dollar is in relation to the euro, certainly, either deals are getting slowed down, because they're going back and trying to make decisions, are they going to move forward or there may be more discounting come into play there as well.

[Operator:]

[Operator Instructions] Our next question comes from Christian Schwab with Craig-Hallum Capital.

[Christian David Schwab:]

Great. Ed, you've been through -- you've been here for many years. Now you're in charge. But so when we put Enterasys and Extreme together in 2014, we had a company doing about $624 million in revenue. And this year, we're going to go down at the midpoint to $535 million in revenue. What is the ultimate size of this business before we attempt to go at growth? Is this a $500 million business? Is this a $600 million business? What do you think it is?

[Edward B. Meyercord:]

Well, this is something that I'm going to tell you within the next 30 days. I mean, look, if I go back to the Enterasys acquisition with Extreme, if you look at it on paper, you'd say that wasn't a very good deal. I think we had -- there's no doubt, there were some execution issues. And it was harder for the teams to put the companies together than anticipated. That said, the combination of the 2 companies has been beneficial on many fronts from a product perspective, adding the wireless business to the portfolio, adding software network analytics is -- enhances our product capability and our competitive positioning. Really good people, and the combination of the 2 companies, we're left with very strong talent in engineering organizations, as well as sales, marketing and across the board. Finally, there's a lot of customer relationships that we picked up that are valuable. I -- as I said before, I'm a lot more excited today than I was when I first agreed to step into this role, based on my interactions with the new executive team that we put together, their leadership and how strong, as a team, it is. And then, all the people that I've met

[Christian David Schwab:]

Should we assume that the business is eventually going to be structured to whatever size you believe this business is, when you tell us in the next 30 days to make a reasonable rate of return to the bottom line?

[Edward B. Meyercord:]

Yes. We see a business that can grow. And we see a business that will generate cash flow in the near term. I don't want to get too specific on guidance. It's really not fair to my team, because people are working very hard and we have top down a new vision for this company. We have a new strategy. We have a bottoms-up operating plan that's being worked on. And for me to start tossing out numbers here, it's not fair to the team that's doing all work. And so I wish I had it for you right now. But I've been here for 2.5 weeks and people are working really hard on this. And what I am confident in is our ability to grow the business and our ability to generate cash in this business very quickly.

[Operator:]

We have a follow-up question from Alex Henderson with Needham & Company.

[Alexander B. Henderson:]

Couple of questions. First one, so to the extent that you're realigning the strategy, I know you do have some pretty good software, but does that require some reinvestment and increased spending to bring forward a number of products that would bulk up that software-oriented platform that you're working with? And conversely, should we anticipate offsetting restructuring in cost cutting to pare out anything that you're planning on lowering the emphasis on?

[Edward B. Meyercord:]

Yes. So it's a function of us aligning our resources. We've got very strong wireless resources in our Engineering department. We have strong software resources in terms of network management, network analytics. We have an SDN team that's very impressive, doing really good work. And so it's really a function of us getting our engineering resources into alignment with our go-to-market strategy with sales and marketing. And it's a little bit different when I talked about the old model, where we would invest dollars in building a new box that is going to be faster and more efficient, et cetera, that we're going to push onto the market. Instead what we're finding is that the market today is more solutions oriented. And that's how we're looking at combining all the elements, hardware and software into a combined solutions offering that we'll sell directly. We'll sell through our channel partners, where we have a lot of opportunities, and it's a function of aligning our internal resources around that. And you'll hear a lot more about that in 30 days' time.

[Alexander B. Henderson:]

So second question, nobody seems to ever mention the bulk of your business, which is the campus business. Can you give us some indication of how that business is looking? Whether the spending in campus is declining at an accelerating rate or flat? Or how do we think about it relative to corporations that are realigning towards more and more cloud-oriented architectures?

[Edward B. Meyercord:]

No, that campus and enterprise is still right in the heart of our strategy. And those customers -- our existing customers are incredibly important to us, and our R&D investment is going to be aimed at our existing customers as well as our new customers. Our existing customers are looking more at solutions as well. When we're selling in the marketplace, we need to have wired and wireless solutions for a campus. And we need to have network analytics, and we need to have network management tools, and we have to have the flexibility to allow enterprises to add new services and for us to sell flexible solution where they can add new services. And it's a bit of a different focus. It's a bit of a different orientation. But where we're going is right in line with our existing customers as well as where the market's going as far as new customers. Because we're a smaller company relative to a lot of larger companies in the networking space, we think we're going to be able to move very quickly, with this team and with this company, to get in front of it.

[Alexander B. Henderson:]

So again the question was, are you still seeing a decline in the overall campus market?

[Edward B. Meyercord:]

Well, look, in the market, I guess, it depends on how you define the market. I don't know, Norman, you want to take a shot at that?

[Norman J. Rice:]

Sure. So the overall campus market continues -- it's a very big and robust market, as you're aware. It continues a transition that's going on in that marketplace from -- as thick [ph] switching becomes much more a part of the DNA of that particular segment. That said, we're in line with what we're seeing in the market in terms of the gradual and slow transition from that core space, and it's moving more towards access spend. And in some instance, in the mid-market enterprise, the cloud is being leveraged in very different ways. And so we see the spend and the shift in spend happening more on the access in the customers that we serve.

[Alexander B. Henderson:]

Again, I mean, it seems to me that the question is, is the enterprise shifting money away from campus to private cloud and to public cloud services against a budget that's barely increasing. So are we seeing spending shifting away from campus, is the question. I mean, I understand there's spending shifts within the campus, but are we not seeing a move away from the campus environment in terms of priority of spending?

[Norman J. Rice:]

Yes, I think where you're seeing a majority of the cloud shift is towards the data center. That's where most -- a majority of that is happening. Campus switching is really transitioning, as I had mentioned before, more towards access mobility, those types of things, the data centers where you would see a majority of cloud. Now we participate in those areas whether it's through our partners or through our technology relationships, so that we can help the customers regardless of what their interest is, to better serve what they need.

[Alexander B. Henderson:]

Okay. One last question and then I'll let you get on with things. The company, Ericsson, hasn't really been brought up much. Can you talk about whether you're seeing any improvement in the relationship with Ericsson? Or do you have any expectation of that providing growth in the future quarters here?

[Edward B. Meyercord:]

Well, so we have a relationship with Ericsson. It's a very long-standing relationship. It's been very positive. I mentioned Eileen Brooker on the call, who's -- she has been front and center there. I don't have specific opportunities to share with you at this time, but in addition to our solution being part of a service provider solution at an OEM relationship with them, we are looking at a handful of other opportunities. And based on the long history and some common backgrounds with the team there, we think there could be some opportunities to work with them. Our product vision is, we have certain attributes and elements to our product vision where we think we can contribute to what they're trying to do.

[Operator:]

I'm showing no further questions. I would like to turn the call back to Ed Meyercord for closing remarks.

[Edward B. Meyercord:]

Thank you very much. Well, look, I -- this is my first call as the CEO of Extreme Networks. I'm very proud to be part of this new team here. And as I said before, I'm impressed with the people here and with how quickly things are coming together in terms of us putting together a new plan. And I'm looking forward to getting to know you in the analyst community and the investor community as we head out and share our new plan over the coming 30-plus days. So thank you for your time. We appreciate it and look forward to working with you.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great...