Calix, Inc. (CALX) Q3 2016 Earnings Report, Transcript and Summary

Greetings and welcome to the Calix Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only-mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] I would now like to turn the conference over to your host, Mr. Tom Dinges, Director of Investor Relations. Thank you, Mr. Dinges. You may begin.

Thank you, Tim, and good afternoon everyone. Today on the call, we have President and CEO, Carl Russo; as well as the Executive Vice President and Chief Financial Officer, William Atkins. This conference call will last approximately 60 minutes and will be available for audio replay in the Investor Relations section of the Calix website. Before we begin, I want to remind you that in this call, we refer to forward-looking statements, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause actual results and trends to differ materially are set forth in today’s earnings press release and in our Quarterly and Annual Reports filed with the SEC. Calix assumes no obligation to update any forward-looking statements, which speak only as of their respective dates. Also on this conference call, we will discuss both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our earnings press release. Unless otherwise noted, all numbers referenced in today’s conference call are non-GAAP. As a reminder, our earnings press release, supplemental financial data, and an accompanying earnings release presentation are available in the Investor Relations section of the Calix website. For the quarter ended September 24, 2016, Calix reported revenues of $121 million, and a non-GAAP profit of $0.12 per share. In just a moment, William will take you through the quarter in greater detail, and Carl will conclude with his thoughts on Calix’s strategy and market outlook. This will be followed by questions from analysts. With that, I would now like to turn the call over to Calix’s Executive Vice President and Chief Financial Officer, William Atkins. William?

Thank you, Tom. We last provided you with guidance regarding Q3 on August 2 and in that guidance we called for revenue of between $115 million and $119 million, a gross margin of between 45.5% and 46.5%. Operating expenses in the range of $48.5 million to $49.5 million and net income per share of between $0.08 and $0.12, including approximately $4.5 million of Occam litigation settlement gain recorded as a reduction to operating expenses or a loss of minus $0.01 to income of positive $0.03 per share if Occam litigation expense in settlement gain had been excluded. Relative to that guidance, our actual revenues for the quarter were $121.2 million and non-GAAP EPS was $0.12 per share including Occam litigation expense in settlement gain, or a profit of $0.03 per share excluding the Occam litigation settlement gain, with revenues above the upper end of guidance and non-GAAP EPS at the upper end of our guidance range. Gross margin was 45% and operating expenses came in at $48.3 million, which includes that $4.5 million in Occam litigation settlement gain or $0.09 per share recorded as a reduction to operating expense. At the gross margin level, the largest drivers were costs associated with the continued ramp of turnkey network improvement projects and increased activities with CAF II projects as well as product and regional sales mix. Operating expense included continued investments in R&D to support growth initiatives. Our aggregate balance of cash and marketable securities was down sequentially at $61.3 million from $64.2 million in the prior quarter, primarily due to operating cash usage including cash outlays related to turnkey network improvement projects and capital expenditures of $2.2 million. Getting into a bit more detail, our $121.2 million in revenues for the quarter marks a new quarterly record, representing an increase of $8.9 million or 8% year-over-year, and demonstrating strong top-line growth sequentially. This is the third consecutive quarter when we have shown 8% or better year-over-year growth. At 7.8% of our Q3 revenues, international revenue was $9.4 million, down $5.1 million in absolute dollars or down 35% from $14.5 million or 12.9% of revenues in the year ago quarter. For the third consecutive quarter, two customers represented 10% or greater of our quarterly revenues, primarily the result of our focus on increasing our market share of larger accounts. As I noted earlier at 45% Q3 gross margin was just below our guidance range. This gross margin in Q3 2016 was down from the 49.3% level in Q3 of 2015. With this decrease driven in large part by costs associated with our ramp of turnkey network improvement projects as well as less favorable and customer mix – product and customer mix relative to the prior quarter. Q3 operating expenses of $48.3 million were up $1.1 million from $47.2 million in the same quarter a year ago. With this year-over-year increase primarily reflecting additions in head count, particularly in research and development offset by the $4.5 million Occam litigation settlement gain. Excluding the impact of the Occam litigation settlement, Q3 operating expenses were $52.8 million with the equivalent, non-litigation impacted operating expense figure for last year being $46.6 million. We continue to make strategic investments in R&D for our platform, systems and software as we focus on a number of opportunities with large customers both domestic and international as well as an opportunity to enhance our market share amongst small and medium-sized operators on a global basis. At this stage of the year, it’s worth pausing to review how Calix performed over the first nine months of 2016 relative to the same period last year. The first nine months 2016 revenues increased by $24.5 million to $327 million, or up 8% from last year’s $302.5 million level. This marks our strongest first nine month revenue growth since 2013. Gross margins came in at 46.7% for the first nine months versus last year’s first nine month number of 49.8%. Inclusive of Occam litigation expense and settlement, operating expenses increased by $10.4 million to $153 million or 46.8% of revenues versus last year’s first nine month level of $142.6 million or 47.2% of revenues. After deducting the net Occam litigation expenses of $1.7 million in 2016 and $2.4 million in 2015, the first nine month operating expense figure would have increased by $11.2 million to $151.3 million or 46.3% of revenues from last year’s $140.2 million level, also 46.3% of revenues. First nine month 2016 non-GAAP EPS was breakeven or $0.00 per share versus last year’s first nine month non-GAAP EPS of $0.15 per share. Excluding the Occam litigation expense in settlement, first nine month 2016 non-GAAP EPS was $0.03 per share versus last year’s first nine month EPS of $0.20 per share. Turning now to the balance sheet, as noted earlier, we ended the quarter with total cash and marketable securities of $61.3 million, down from $64.2 million in Q2 and a decrease of $32.5 million from the year ago quarter. The primary driver in the year-over-year decrease in cash was the share repurchase program that we completed in Q1 2016. Receivables DSOs were a healthy 37 days, up one day compared to the previous quarter and flat compared to the year ago quarter. The overall quality of our receivables and our collections performance remained strong. Inventory levels decreased to $40.2 million in Q3, down from Q2 $40.8 million level and down from $43.8 million in the year-ago quarter. With revenues rising at a strong pace both year-on-year and sequentially, we are pleased by our team’s performance in managing working capital. Inventory turns increased to 5.7 times in Q3 from 4.5 times in Q2 and also up from 4.6 times in the year-ago quarter. Now, let me turn to guidance for the fourth quarter of 2016. We expect revenues to be in a range of between $127 million and $131 million with a midpoint of $129 million, up 23% from the $105 million for Q4 2015. At the midpoint of guidance, full-year 2016 revenues would increase by just under 12% year-over-year. Our guidance for revenues in the fourth quarter reflects our anticipation of an accelerated pace of activity for several turnkey network improvement projects to meet customer demands. This accelerated project related activity is an addition to our expectations for another quarter of solid year-over-year growth in our systems and software. We are guiding gross margin to a range of between 44.5% and 45.5% for Q4, down from last year’s Q4 level of 46.5%. With this decline relative to the year-ago quarter, largely driven by the continued ramp of turnkey network improvement projects and the commensurate increase of related professional services revenues as a percent of total revenues. As services generally carry lower margins relative to systems, we will see some pressure on gross margins in the December quarter as our mix shifts. In terms of operating expenses, we expect operating expenses to be in the range of $58.5 million and $59.5 million, up from $50.6 million in the year ago quarter, which included approximately $850,000 of Occam litigation expenses. On a sequential basis, operating expenses for Q4 included a number of seasonal factors such as costs associated with our annual User Group Conference in Los Vegas, year-end commission accelerators and the impact associated with aligning our fiscal quarters to a calendar year-end. Historically, these costs have increased our Q4 operating expenses relative to Q3 by $1 million to more than $4 million. Our expectation is that cost associated with these seasonal factors will increase at or above the upper end of the historical range. Given higher revenues and previous additions to head count, while investments that support our growth in strategic initiatives will comprise the remainder of the sequential increase. Compared to the year ago quarter and allowing for the seasonality effect that I’ve just described, the increase predominantly reflects, incremental hiring in R&D cost to support our growth and our strategic investments. Based on 49.1 million basic shares, the expectations that I just finished taking you through result in a guidance range for Q4 of a net loss of $0.04 to breakeven on a per share basis. With the higher pace of revenue growth, our increased investments in R&D and working capital absorption related to our turnkey network improvement projects, we also anticipate negative operating cash flow in Q4. Before turning it over to Carl, I want to give you some insights into our expectations for revenues and gross margins for the first part of 2017. We continue to see a strong pace of activity across our customer base, amid an elevated level of investments in their access networks. As our customers increase these investments with limited internal resources, we’re seeing increased demand by our customers for turnkey services. We see this demand shifting our overall revenue mix towards a higher level of services in the early part of 2017. As a large number of sites associated with one major project near-completion, and other projects begin to ramp in the December quarter. These additional projects will be in the early stages of their ramp phase, and although, they may not impact revenues early in 2017 to the same extent that you see reflected in our guidance for Q4 in 2016, you could see this mix-shift continuing to dampen our gross margins into 2017. In total, we see the demand for turnkey services as reflective of an overall robust level of activity with our customers increasingly turning to key suppliers as they increase investments in their access networks to provide a better customer experience. At this point, let me hand the call over to Carl. Carl.

Thank you, William. I’ll begin this quarter as I did last quarter by reiterating our goal, predictable, profitable growth. Q3 was another solid quarter of progress for Calix with revenues increasing 8% compared to the year-ago period. Growth this quarter was broad-based, and as I said last quarter, growth remains our number one focus. Our guidance for Q4 reflects our continued focus on growth as we expect another quarter of solid growth driven by increased systems and service upgrade investments by our customers. The latter reflects the desire of our customers amid tightening internal resources. So relying more heavily on partners like Calix to provide a broader array of aligned professional services as we’ve noted for over a year now, our professional services team has ramped to meet customer needs and we are seeing improvements on the productivity front. However, this shift will pressure our margins in the near-term. Looking to 2017 and beyond, the rate of change in our industry is increasing and our opportunity to bring disruptive economics to the access infrastructure is enormous. Our view has always been driven by the pursuit of one converged network, built on a software defined access foundation and elevated by a cloud service offering. It is now clear that customer readiness for this change is here and our opportunity is directly ahead. To capture this opportunity and drive our growth, we’ve noted that from time to time, we’ll have to push on the OpEx levers to achieve our goals and in Q4 we’ll continue doing just that. To be clear, these investments are generating solid returns. Here’s just a few examples. In late September, we launched the AXOS E3-2 Intelligent Access Node, while the E3-2 incorporates Layer 3 functionality and is ideally suited for the needs of the cable MSO market. It is clear that it will be deployed by service providers of all types. This is because it extends the reach of PON up to a 140 kilometers and allows our customers to dramatically reduce facilities and speeds the deployment of new ARPU raising, churn-reducing services taking full advantage of the fast, Always On and simple nature of AXOS, the E3-2 upends the economics of traditional access deployment models. At our User Group last week, about over 1,800 attendees came to hear the latest from Calix. We launched the AXOS E9-2 Intelligent Edge System. The E9-2 accelerates service provider transition to NG-PON2, removes the constraints of traditional systems and enhances the Access Edge. With the E9-2, we would collapse access, aggregation and service edge functions including a router – routing and subscriber management into a single system that resides at the access edge of the data center. While taking full advantage of data center technologies, the E9-2’s intelligent design also allows it to be deployed in existing central offices and headends. Last quarter, I spoke to you about our Compass Cloud and its ability to allow our customers to target their infrastructure investment for maximum return, all while reducing the operating expense of delivering winning services. Well, early last month, we surpassed the 400-customer mark with Compass Cloud just after five years after its launch. However, innovation is always on at Calix, and we believed we had to step it up a notch for our customers to transform into the next-generation of winning communication service providers. So we’ve taken Compass a step further. And last week at the Calix user group, we launched our next-generation of subscription services. It’s called the Calix Cloud, and it unleashes the power of data for our customers through a set of rare-based services for network data analytics and subscriber experience assurance. It encompasses five unique subscriptions. One each for planning, operations, support, marketing and the subscriber. The combination of Calix Cloud Services and AXOS systems is so revolutionary that a new service provider beginning business today could build a business model the likes of which the industry has never seen. However, the vast majority of our customers and prospects don’t have the luxury of no legacy infrastructure. And that’s where the power of our architecture becomes clear. All of our Calix Cloud Services and AXOS systems can be deployed into existing legacy infrastructure and begin delivering all these benefits today. That’s why when we say it is truly revolutionary. We capitalize the E, because it would just as easily deployed in an evolutionary fashion. To learn about the full impact of these revolutionary offerings, I would encourage all of you to visit www.calix.com. And with that, I’ll open the call for questions. Tim?

At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Simon Leopold of Raymond James. Please proceed with your question.

Great. Thank you for taking my question. A couple of things I wanted to see if we could get a little bit more insight on, and I know, this first one is probably a bit of a challenging question, but you did enter the trial, the lab trials with Verizon, that you talked about I think last quarter with a press release at least, just want to see if you can give us any indication on how that’s going? What the timeline might be for getting additional updates on the status? And if there is any insight you can give us in terms of the – the impact this has on your operating expenses I know Tier 1 trials can be expensive to support?

Simon, thanks for the question. So it’s a good challenging question, let me directly answer your question by saying, there is no news that we will – we’ll report at this time other than the following. We had not made it clear what the system was that was going to Verizon. With our announcement prior to the User Group of the E92 intelligent access system, I think it’s now clear what that system would be, and so the E92 bring-in all of the functions that are required along with NG-PON2 is in fact the system that’s being used, beyond that, there is no news to report at this time.

Any indication of a timeline you can give us or the impact on your OpEx in the – even in the near-term?

So, thanks for reminding me I apologize, on the OpEx piece I mean, pretty clearly William messaged to the OpEx forecast and I mentioned that there is some pushing on the OpEx levers to go achieve what we want to achieve. I think it would be wise to assume that some percentage of that investment is related to trials and things of that nature like this, beyond that I wouldn’t go.

Okay. And then the other bucket of opportunity is the – the CAF II funds from the rate of return carriers, could you help us, give us an update of where that opportunity stands?

So, all of that is now rotating into time horizons for 2017. And it’s clear now from obviously coming from the user group where many of those carriers might have participated that those things are moving forward. I think as I’d mentioned before, it’s my view that this is likely – this particular portion is likely to start to look more incremental than substituted. And I think that will be the case from what I have seen over the last two weeks.

Great. That’s very encouraging. Thanks for taking my questions.

Simon, appreciate it.

[Operator Instructions] Our next question comes from the line of Greg Mesniaeff of Drexel Hamilton. Please proceed with your question.

Yes, thank you. I have a question on gross margins on the guidance that you gave. Is it fair to assume that some of the guidance you gave on the gross margins for the fourth quarter factors in some attempts to lower cost of goods sold on products to perhaps offset any lower, or rather any higher costs associated with the shift towards service and support that you’re referring to?

So, Greg, as you might imagine, we have a pretty consistent cost reduction effort that goes on related to COGS. I think as William alluded to and I think I reiterated, the rotation towards a greater percentage of revenue albeit still small, on service deployments has a downward pressure, irrespective of the efforts that we put in on COGS.

Okay. But is it fair to assume that there is an ongoing effort to reduce product COGS to at least, may be partially offset or offset the higher COGS associated with the service revenues?

Well, the – it would be hard to do something unusual. So, I guess what I’m trying to make sure I’m being clear is we continually go after reducing COGS and there is no discontinuous effort that will go on because of that. William do you want to add?

Just want to weigh in Greg and I understand why you’re phrasing the question. What I would say is that – is not through shall we say a tactical response to the increased amount of service revenues going through our P&L causing us to focus on reducing costs for our systems rather it is an ongoing effort. You recall that we had an Investor Day roughly six months ago where we took people through our long-term model, a model we’re still committed to at 50% plus gross margins and that assumes that a lot of building blocks, that Carl specifically referred to, in terms of AXOS and moving to, this sort of single architecture will definitely drive operating and cost efficiencies through our system. So, we continue to do that anyway. It’s not and I know you’re phrasing that way, but I want to be sure that you and other people on this call understand...

No. That’s very helpful. That’s very helpful.

...not reactive.

Okay. That’s – and then just as a quick follow up, can you tell us who the two greater than 10% customers are?

That we do not do. No, we don’t disclose that.

Okay. Fair enough. Thank you.

Thanks, Greg.

Our next question comes from the line of George Notter of Jefferies. Please proceed with your question.

Hi, guys. Thanks a lot. I guess I wanted to just step back and kind of better understand the longer-term outlook on gross margin. I think you said, 50% is that a longer-term goal, but I guess I want to understand how the trajectory looks in driving back towards that kind of a number. Obviously from the commentary, we’re looking at your some lower gross margin assumptions. It sounds like the first few quarters of the year, next year at least, and kind of help me understand why the mix would swing back such that you guys can get to a 50% gross margin number?

Sure. I’ll tackle next few quarters aspect of your question, and then I’ll pass the baton on to Carl for the longer-term outlook. In terms of I think as we’ve highlighted and in fact we’ve given you a small window into what early 2017 might look like. We’re specifically calling for services as an increasing portion of our margins over that period of time – of our revenues over that period of time. And therefore, given the fact that services are traditionally a lower-margin business than the systems business, you’re going to see some downward pressure on gross margins as we execute on those projects. But that doesn’t again take away from what we’re doing in the underlying systems business, and for the business overall. Carl, do you want to address that?

I mean in the longer-term, if you looked at the business from a, basically a products and a services standpoint, our products business platforms, Calix Cloud, AXOS, and the systems business together is going to continue to go up in margins over time as the differentiable value of this goes up over time, Calix Cloud, AXOS and the leverage that we get from it. On the services side, we’re building a services business, and as such you can think about what long-term professional services businesses look like. And as we get towards that model from a professional services standpoint, then our long-term model is I think well within reach. But obviously, we’re going after building that professional services business, and we lag the long-term model for professional services.

Got it. Okay. I guess I asked the question because – I guess, my inclination here is to think that the services mix stays elevated for some time, your customers are trying to move more and more of that unionized labor of the payrolls and ask you to do more of the installation work. I would imagine that that doesn’t necessarily flip back in terms of their – your desires. And so, I would imagine the mix on services will be elevated for some time. I guess, is what you’re trying to tell me that there is a significant gross margin improvement in services ahead of us, or is it just the product side grows so fast ultimately that you can overcome that increased services mix, I guess, I’m just trying to understand sort of the logic here?

Well, I think so – let me address it in a couple of different ways, and then I’ll ask William to share his thoughts as well. So, first and foremost, professional services as we’ve discussed, we think of it in an aligned fashion. So, we’re not interested in going out and doing generalized professional services turf stuff on other peoples, systems, software et cetera. That’s just not anything we can lend any value add to. So everything that we do is related to Calix, products platforms, service offerings, systems et cetera. With that in mind, we believe there’s lots of opportunities all over the professional services spectrum, to help our customers transform their networks, their business models et cetera. So long-term, we believe an aligned services organization is a very good thing strategically for us to help our customers win. That being said, we are entering this business and we do believe over time obviously, we’re going to get more and more efficient at it and yes, the margins are going to go up. But I also would say that I believe our products – our product margins will go up over time as well, but it’s not one needs to go up wildly just to take care of the other. William, please feel free.

Yeah. I mean, I’d just like, just echo Carl, looking out beyond the next few quarters. You’re going to see as we hit our stride with professional services, essentially a slackening of the negative impact on the overall margin posed by introducing what is inherently a lower margin line of business, right. So, inherently that lower margin becomes a little bit less lower, if you know what I mean. So, there is that and then on the product side, I think, we’re making great strides in terms of enhancing margins on the product side as well. So, those two move together to pull our overall corporate margins up, again once you look out beyond the next few quarters.

Got it. And the one last question I had, I guess, extends off the prior question. So, you mentioned, CAF II, there were some news flow in the last two weeks. Obviously, I think, that’s the ruling around the rate of return carrier, but can you just kind of walk us through exactly what – what came out and how specifically it impacts your business, thanks?

I’m not sure, I would go any deeper than the following that in essence, the rules are now set. Everybody knows what they’re going to go do and we expect funds to be deployed across 2017.

Got it. Okay. Great. Thank you.

Right. Is there something else that you’re looking for? I mean, today is specifically is the day that everybody is making their elections on which way they’re heading. So, this program is rolling.

I guess, I was just wondering, what happened in the last two weeks, you referenced that in a prior question?

Oh! I’m sorry. So in the last two weeks, I’ve been – so we had our User Group, and there were hundreds of customers there, and so there is nothing like being amongst hundreds of customers, you will have these conversations, and not only listen to the fact but the mood if that makes sense.

Got it. Okay. Fair enough. I get it. Thank you so much.

No. I’m sorry, George. I missed your question. Thanks, George.

[Operator Instructions] Our next question comes from the line of Paul Silverstein of Cowen & Company. Please proceed with your question. Paul, your line is open. Please, proceed with your question. Please double check to see if your line is on mute. Paul, please respond as you’re not asking the question at this time. Our next question comes from the line of Simon Leopold of Raymond James, which is a follow-up question.

Great. Just a quick follow-up. Given that it’s the end of the fiscal year, I was hoping you could give us the 10% customers for 2016 the detail identities et cetera?

No, actually William, we neared on that ones, Simon, we’ll give just the...

I think it was on the quarter, I’m looking for the full year, which you, I expect will disclose in your 10-K filing? I think, you promised to do that?

I won’t do that, Simon, but what I will do is I can give you a sort of sneak preview what’s going to be coming up in our 10-Q in terms of customer concentration if that is helpful?

Sure.

Okay.

Sure.

I mean for the three months, we’re looking at 37% for the current quarter versus 27% same quarter last year, for nine-month year-to-date we’re looking at 34% relative to 26% year-to-date last year. So, I hope that helps you in your modeling.

It does. Thank you. Thanks a lot for the follow up.

Yup thanks, Simon.

[Operator Instructions] At this time, we have no further questions over the audio portion of the conference. I will now like to turn the conference back over to Tom Dinges for closing remarks.

Thank you, Tim. Our next quarterly earnings report for the year ended December 31, 2016 will take place on February 14, 2017 after market close. In addition, management will be participating a number of investor meetings and conferences during the fourth quarter. Information about these future investor events will be posted on the events and presentations page of the investor relations section of calix.com. Once again, thank you for your interest in Calix and thank you for joining us today. Goodbye for now.

This conclude today’s conference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful rest of your day.