Calix, Inc. (CALX) Q2 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Calix Q2 2017 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] As a reminder, this conference is being recorded. It is now my pleasure to turn the call over to your host, Mr. Tom Dinges. Thank you. You may begin.

Thank you, Rob, and good afternoon, everyone. Today, on the call, we have President and CEO, Carl Russo, as well as Interim Chief Financial Officer, Cory Sindelar. This conference call 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’ll refer to forward-looking statements, which include all statements we make about our future financial and operating performance, growth strategy and market outlook. 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 annual and quarterly 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 and available on our website. 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 July 1, 2017, Calix reported revenues of $126.1 million, a GAAP loss of $0.38 per share and a non-GAAP loss of $0.30 per share. In just a moment, Carl will start with brief remarks regarding the quarter, Cory will then take you through the quarter in greater detail as well as our financial guidance for Q3 and the full year 2017. Carl will then conclude with remarks and Calix’s strategy and growth outlook. This will be followed by questions from analysts. With that, I would now like to turn the call over to Calix President and CEO, Carl Russo. Carl?

Thank you, Tom. First, I would like to welcome Cory as our Interim CFO. Cory joined us two months ago and has been extremely valuable and helping us continue to improve our processes as we begin to capitalize on the exciting opportunities ahead of us. Cory, your hard work with the team is appreciated, as we continue our search for a full time CFO. We finished the second quarter with stronger than anticipated revenue. Overall investments in broadband access continued this quarter, as evidenced by a return to growth in our product business and our continued growth in services. However, earnings were below our guidance range. As the quarter progressed and our services team was implementing process improvements, the team experienced higher costs to complete previously awarded projects to meet customer and site requirements. These higher costs were related to projects closed out in Q2 and additional projects expected to close out throughout the remainder of 2017. Projects initiated after these improvements are expected to benefit throughout. However, we still have a significant backlog of projects that began well before these changes and are therefore cost burdened. I would like Cory expand on this in his remarks. We saw a number of key Calix product innovations launched this quarter, which I will discuss in more detail in a few minutes. However, I wanted to reiterate that underlying all is AXOS. As we’ve been saying for some time, Calix is transforming from a wireline access systems company to a communications software systems and services company. This transition has been driven by relentless innovation in our award-winning AXOS platform and our Calix cloud offerings. Calix customer adoption of our AXOS platform continues to grow, having achieved double-digit growth in customer adoption, every quarter since its introduction. I will come back and discuss the market in more detail. And let me now turn the call over to Cory to walk you through the quarter.

Thank you, Carl. We last provided you with guidance regarding Q2 on May 9th, and in that guidance we called for revenue to be between a $122 million and $126 million, a non-GAAP gross margin of between 40.5% and 43.5%, non-GAAP operating expenses in a range of $59 million to $61 million and a non-GAAP net loss per share between $0.12 and $0.19. Relative to that guidance, our actual revenue for the second quarter was a $126.1 million, just above the upper end of our guidance range. Non-GAAP gross margin was 34.5%, below our guidance range. Non-GAAP operating expenses came in at $58.5 million, lower than our guidance range. And our non-GAAP net loss per share was $0.30, below our guidance range. The shortfall relative to our guidance was driven by higher costs than previously estimated associated with a large number of previously awarded CAF II projects. Specifically through site assessments as part of our implementation of process improvements, we’re seeing higher than estimated levels of remaining work on these previously awarded sites, as well as incremental rework costs to complete project sites to customer and site specifications. Although we continue to drive process improvements in our services business, our costs remain higher for these previously awarded sites, which had commenced prior to our optimization efforts. Operating expenses came in under guidance, as we tightened our expenditures for personnel, travel and marketing. Getting into a bit more detail revenue of $126.1 million for Q2 marks a new second quarter record, representing an increase of $18.7 million or 17% year-over-year. This marks the third consecutive quarter of strong double-digit revenue growth. Product revenue was a $107.3 million, representing 85% of total revenue and was up 7% compared to the year ago period, driven by strong international sales. Service revenue was $18.8 million, representing approximately 15% of total revenue and was up nearly a 158% from the year-ago period, as we completed activity on one major turnkey network improvement project and continued activity on other previously awarded projects which are large CAF II related. Within total revenue, domestic revenue was 86% for our second quarter revenue, representing an increase of $8.9 million or 9% year-over-year. International revenue was 14% of our second quarter revenue, representing an increase of $9.7 million or a 117% year-over-year. We had one customer that was greater than 10% of revenue during the quarter. Our Q2 non-GAAP gross margin of 34.5% decreased from 47.5% in Q2 of 2016 but increased from the 30.1% reported last quarter. Non-GAAP product gross margin was 45.8%, down from the 49.5% reported in the year ago period, but better than the 38.4% reported last quarter. Compared to the year-ago quarter, this decrease was primarily driven by shifts in product and regional sales mix; and compared to the prior quarter, the increase was primarily to shifts in product regional sales mix and to a lesser extent improvements in other cost of revenue of which the largest component was a lower provision for excess and obsolete inventory. Non-GAAP service gross margin was a negative 30%, down from a positive 19% as compared to last year and down from a positive 1% last quarter. Compared to both the year-ago quarter and the previous quarter, the decrease was primarily driven by the deployment of additional resources and the incurrence of additional costs related to CAF II projects started in 2016 that were completed during the quarter, as well as the write down of deferred costs for deferred CAF projects to be completed in future quarters. While our optimization efforts for our services business are progressing, we have more work to do. Based on the progress made to-date, we currently expect that the large majority of the older CAF II projects will be completed by the end of the third quarter. Furthermore, we are seeing evidence that the new process improvements and delivery methodologies are working as new projects started under the leadership of Greg Billings are tracking to completion at positive gross margin. Our Q2 non-GAAP operating expenses of $58.5 million were up $8.3 million from $50.2 million in the same quarter a year ago when excluding approximately $2.8 million of Occam litigation related expenses. The year-over-year increase primarily reflects higher level of investments in research and development through increased headcount, use of outside contractors and additional prototype builds as we develop new technologies and target new, larger customer opportunities. We will continue to make strategic investments in our platform products and software, targeted toward a number of opportunities with large operators here in North America as well as growing our market share among small and medium-sized operators. We are also making investments in our core IT infrastructure to automate and build more scalable foundation to meet the growing demands of our business. Last quarter, we announced a targeted realignment of our investment strategy to reduce operating expenses related to more of our traditional products and reinvest a portion of those savings in our growth-focused platform, products and software. Based on this plan, we incurred restructuring charges of nearly $1 million during the second quarter. Over time, we expect the level of our investment R&D to moderate as we continue to invest in sales and marketing. Turning now to the balance sheet. We ended the quarter with cash and investments of $50.2 million or $1 per share, down slightly from the $51.5 million or $1.04 per share at the end of the first quarter of 2017 and a decrease of $14 million from the year-ago period. The primary drivers in the year-over-year decrease in cash were negative operating cash flows over the past 12 months, predominantly due to our net operating losses as well as capital expenditures to support future growth opportunities, partially offset by improved working capital velocity. Operating cash flow for Q2 was a positive $2 million, as working capital efficiency continued to improve and more than offset the net operating loss we reported this quarter. Capital expenditures to support ongoing activity in the quarter were $2.6 million. Accounts receivable DSO were healthy 39 days, compared to 50 days in the previous quarter and 42 days in the year ago quarter. Inventory was $39.6 million in Q2, compared to $46.5 million in the previous quarter and $40.8 million in the year ago quarter. With revenue continuing to rise, our team’s performance has been excellent at managing inventory levels. Inventory turns were 6.9 times in Q2, compared to 6.3 times in Q1 and 4.7 times in the year-ago quarter. To support our growth, we replaced our existing credit agreement with a new $30 million revolving line of credit with Silicon Valley Bank. This line of credit was structured with limited balance sheet-oriented financial covenants to allow us access to this facility. Now, let me take you through the details of our third quarter guidance. For the third quarter of 2017, we expect revenue to be in the range between $126 million and $130 million, representing 4% to 7% year-over-year growth, as our customers continue to invest in their access networks. This reflects not only continued investments in broadband access by our customers but also reflects the impact from the completion of a major turnkey network improvement project in Q2 2017, which was a material component of our year-ago revenue. We expect non-GAAP gross margin to be in a range of 36% to 39% for Q3; this is down from last year’s Q3 level of 45%, as we expect these cost pressures in our service businesses to continue into the third quarter. These losses are anticipated to be partially offset by continued improvement in our product gross margin. We expect non-GAAP operating expenses to be in the range of $59 million to $61 million, up from $52.8 million in the year-ago quarter, after excluding the recovery from the Occam litigation. The increase in operating expenses compared to the year-ago quarter predominantly reflect incremental hiring and R&D expenses. It also includes an estimate for SaaS implementation expenses for our internal systems of approximately $800,000. To be clear, we do not expect a significant benefit from our restructuring plan in the third quarter, but we continue to move forward with our plan to realign and optimize our operating expenses. Based on our estimate of just over 50 million weighted average shares outstanding, the expectations that I’ve just taken you through, result in a guidance range for Q3 of a non-GAAP net loss per share of between $0.21 and $0.27. With the projected operating loss in the third quarter and increased working capital needs, we anticipate negative operating cash flow for Q3. Looking beyond Q3, we continue to see Calix solutions enabling us to grow our revenue at or above 10% for the full year. So far, the year is tracking relative to our expectations with a return to year-on-year growth in products and accelerated growth in services. With our reported operating loss for the first half of this year and our guidance for an operating loss for Q3, we now expect our non-GAAP net loss for 2017 to be greater than that for 2016. Despite this short-term profit setback, we remain committed to our long-term model. As a reminder, our long-term model drives to a 10% or better operating margin as annual revenue exceeds $600 million. At this point, let me turn the call back over to Carl.

Thank you, Cory. As we have discussed, disruption is sweeping over the communications industry and our innovations and investments have positioned us to ride this wave and help our customers win. For our customers and prospects, this network transformation is the means to accelerate time to market, lower their costs and raise the value to their subscribers. In just the last quarter, we have brought the following innovations to market: AXOS Routing Protocol Module which brings Layer 3 functionality to the access infrastructure, allowing our customers to greatly simplify their operations; NG-PON2 Channel Bonding which allows for up to 40 gigabits per second symmetrical to be delivered to a subscriber over a single PON; AXOS 10 gigabit per second EPON, demonstrating that our anyPON architecture which brought this functionality to AXOS in record time; AXOS Subscriber Management Module which brings subscriber management functions to the access infrastructure, thereby dramatically simplifying our customers operations; AXOS E7-2, the first example of AXOS coming to the E7-2 with NG-PON2 and XGS-PON options; and Calix Support Cloud, which revolutionizes the way in which a service provider can deploy their customer support functions. These innovations taken in sum, represent a manifold increase in our addressable markets. Calix ASOS innovations also spurred industry first achievements during the quarter that have shown a new path for transformation to the industry. In May, Calix teamed with partner Radisys to demonstrate and deliver the first deployment-ready residential CORD platform at the Light Reading Big Communications event. Calix currently has CORD trials under way with multiple tier 1 global service providers and is one of the core companies leading the way leveraging this initiative to enable service providers to accelerate new service introduction while maintaining the highest quality of experience for their subscribers. In June, Calix became the first vendor to achieve Gfast end-to-end solutions interoperability certification from the Broadband Forum. Both of these are clear demonstrations of the power of AXOS to accelerate the speed of innovation at Calix and accelerate innovation across the industry ecosystem. This accelerated rate of innovation is being recognized by the industry. In mid May, Light Reading awarded the AXOS E3-2 Intelligent PON Node as a winner in the Light Reading Annual Leading Lights Award by winning best cable product. This follows last year’s winner AXOS which was a Light Reading winner for the Most Innovative SDN Product Strategy. In addition to our AXOS driven innovations, we’ve been extremely active after launching our second generation cloud-based SaaS offering Calix Cloud which provides purpose built analytics and insights that allow our customers to transform their marketing and customer service organizations. In April, we launched Calix Marketing Cloud, a service that uses behavioral analytics to drive actionable insights, allowing marketing professionals and service providers to revolutionize the efficiency, effectiveness and return on investment of their marketing campaigns. As an example, our first customer on Calix Marketing Cloud has accelerated the pace of their social interaction 500-fold by leveraging the powerful behavioral analytics available in our Marketing Cloud to drive more targeted customer campaigns. This was followed in June by the launch of Calix Support Cloud a service that reinvents connected home support and subscriber experience management through breakthrough diagnostics and automated issue resolution, simplifications that deliver problem resolutions up to 90% faster than traditional support methods. These two new services take our traditional cloud offerings to a whole new level and are rapidly gaining traction beyond our over 400 existing compass cloud customers. To help with our transformation, we have added to our Board of Directors Kira Makagon, an experienced product innovator, joined our Board in July. As the Executive Vice President of Innovation at RingCentral, a cloud-based unified communications company, Kira’s experience directly relates to our future. And as such, we are pleased to welcome her to our Board. Last and perhaps most importantly, we have discussed how our platform-based rate of innovation is allowing Calix to dramatically expand our addressable markets and capitalize on the large opportunity in front of us. To that end, we now have a signed letter of agreement with a large North American tier 1 to begin the first year trials and initial deployments of the AXOS E9-2. This deployment is NG-PON2 based and includes our routing protocol and subscriber management modules. This is the ultimate in unified access infrastructure and the realization of our long held vision, the error of one network that connects the device-enabled subscribers to the content and applications in the cloud. With that, I would like to open up the call for questions. Rob?

[Operator Instructions] Our first question comes from Meta Marshall with Morgan Stanley. Please proceed with your question.

First off, you just ended with noting progress with the tier 1 or having kind of order. I guess, is that progress, is that still in the trialing stage and it’s just kind of the next phase of a trialing stage, or do you think that that is a significant milestone? And the second question I had is just in relation to your tier 3 customers and what you are seeing with investment patterns there. Because I guess, just wondering, is the shortfall really tier 1s and tier 2s are continuing to invest in higher speed networks and tier 3s are lagging investment or just trying to get a sense of where you see investment being slower, at the tier 1s or tier 3s?

So, first of all, it’s a significant milestone, to directly answer your first question. And I would leave it at that, Meta. As far as the tier 3s are concerned, these things ebb and flow, depending upon what’s going on. There have been different things talked about, I think in other earnings calls about different areas of spending slowdowns. As far as the tier 3s are concerned, we see the business continuing to grow and it’s been strong. So, actually, the tier 3s, as we talked about last year, when they were still waiting to get through the CAF II, we felt that lag. But as we stated last year, we expected that to go away, and it has. So, does that answer your question?

Yes, I guess I’m just trying to -- like your guidance would imply kind of a significant -- or a potential deceleration in the second half and part of that is due to these -- anniversarying some other service contracts. I’m just trying to get a sense of where - what customer set is causing perhaps -- not investing as fast as you would have expected or is that just lumpiness? I guess, I’m just trying to get at where that weakness is coming from.

So, I think it varies by space. I think more publicly held wireline customers would be a little slower at this time than the tier 3s would be.

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

I guess my question is how much tolerance for pain -- more pain can you endure as far as the negative gross margins that you recently incurred in the services business? I mean, my -- the way I see it as, you got maybe another quarter or two of this and then onto greener pastures. Is that a fair statement?

Well, that’s a statement, then you had a question. So, on a personal note, my tolerance probably withered a little while ago to be blunt, but I own it, so we’ll leave it at that. I think you heard Cory in his remarks highlight a couple of things. So, let me frame it up, if you don’t mind, Greg, and then I’ll answer your question directly. First and foremost, number one are -- and the reason we separated out product and services, so people could see them. Our product business is doing exactly what we wanted it do, and performed well in the quarter. If that were not the case, then obviously tolerance becomes a whole different thing. So, we’ve identified that services was the area that we had challenges and we’ve been working on it. So, in fact, those risks came to the floor. A couple of things that I would highlight there that you heard Cory mention. One, a very important fact is that projects that have begun after Greg Billings and after the systems improvements that we started to make, are now tracking in positive gross margins. So, that’s obviously a big step when you talk about how much pain because it is negative, that’s unbearable almost. The second piece is, to your point about another couple of quarters, all of these things relate to projects that were in flight before Greg got here, which means you’re really dealing with 2016 CAF programs, which by the way have to be done by the end of this year. So, we know what the case is bounded in the next two quarters. And I believe if you listen to Cory’s remarks, he also spoke to the fact that we believe largely it’ll be done in Q3. So, does that answer your question in detail or would you like me to add some more color?

No. that’s a pretty good high level overview. I appreciate it. That’s kind of what I was thinking. Thank you.

[Operator Instructions] Our next question comes from George Notter with Jefferies. Please proceed with your question.

I guess, I’m curious about why intuitively do projects that start after Greg Billings joined and you granted your systems improvement, why do those projects all of a sudden get positive margins whereas the projects you’ve been working on do not, is there something -- just walk me through the change there please?

Yes, there’s a set of changes. Cory, do you want to go through some of those?

Happy to do so, Carl. So, over the past six months with Greg coming on board, there’s just a litany of things that he’s worked on from better vendor management to the way resources are allocated to restructuring fee arrangements with vendors, defining rules and responsibilities and so forth. All of those process improvements are not fully coming to bear in the period as projects that had already been started had accumulated costs on them.

But that specifically to -- George, to your point, it’s a boatload of improvements, George.

Any reason why those improvements can’t be applied to the projects that are currently in process?

They are. The problem is they were in process, and you just have to think of them as what percentage of the process was completed and how many steps were completed And by the way, the yield of those steps and then in the middle of Q2, Cory I think you’re going to discuss for example, site audits and things of that nature. So, you’re some percentage done and the improvements are only allowed on the remaining percentage, and you may even be in clean-up mode on some of those sites.

Got it, okay.

Unfortunately, they are what they are which is what we’ve talked about before. And as we dig deeper and get better at our processes, fundamentally what’s happening is, is we’re getting a much granular understanding and our arms around it. At the same time, we’re at this long enough now to have started projects after a lot of these improvements were made, and we’re getting a much better read on where those margins are coming out. And so, that’s what gives us the fortitude to frankly go plow through this, if you get my drift.

Why, what gives you the confidence that projects that are started now or even recently, would be profitable in terms of gross margin? Is there something else that you can share with us or anything intuitively that’s changed there? I guess, my presumption is that you thought -- you just put up a negative 30% gross margin, right, my presumption is that when you started those projects, you thought you were going to make money on those deals also.

There’s a difference between thought and steps in the process, right. So, these things are managed step by step. Cory, do you want to go into a little more detail?

Sure. So, if you kind of go back and recap a little bit, in the first quarter a lot of the time and effort was spent concluding a major network improvement project for a different customer. Our Q2 then turned around start being more focused on a CAF related work. And as part of one those process improvements, we decided to start evolving [ph] some site surveys and site assessments.

And hold that thought for one second. George, keep in mind that these projects that we’re talking about, have hundreds or thousands of sites underneath them, each of which is individually started and tracked, so that may go part of the way to answering your question. Do you follow what I’m saying?

I’m sorry. So, you’re realizing there’s more sites than…

Not realizing, simply -- no you asked the question of how do you know. Well, these are site by site by site by site, and they’re being started and completed every day. And so, there are some that were started afterwards and were -- on their way to being completed; that are clearly a whole different margins than the ones that were before that, because you’re tracking that way.

We have a whole set of projects that hundreds of projects that are nearing completion, and with those projects in completion, they started later after Greg has been on board and they’re tracking to a positive margin. So, these aren’t just recently kicked off, they’re fairly far along; it gives us the confidence that those new projects with the process improvements that we’ve had are yielding a positive gross margin.

Got it, okay. And then you mentioned that there’s a bulge in CAF II projects right now that need to finish up by year-end. Is it fair to say that the mixture of your services business then would step down next year?

So, yes, I would be careful about a bulge. There is a remaining set of projects that were in flight from 2016. Having said that, as you know, CAF in the price cap carriers is a six-year program. CAF that’s just starting in the tier 3s is a 10-year program. So, I have said before that I anticipate services being in the teens somewhere. I am not sure what changes that over the long haul. In any given quarter, it may change, but I don’t know that that’s going to change, which is why obviously we are very focused on getting this business to produce the revenue and the margin that we expected to produce.

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

Carl, when do you see gross margins returning the double-digit levels again?

I’m not sure you meant that gross margins to double digit levels or …

Sorry. When do you see service gross margins returning to double-digit levels?

So, we don’t forecast the business separately. And the way I would answer your question is I don’t believe you will see that before year-end. So, let me give you the inverse of your question because we have got to clear out those other items. And then, after that, I think you’ll have to wait until next quarter’s guidance to start to almost impute it because you can sort of impute it based upon percentage mix and what the blended gross margin is. So, look, over the course of 2018, we certainly believe this business is a positive gross margin business. If you do look at businesses that are well run in this space, they are in the 30s. We have a world class leader and Greg Billings that’s leading the organization, Cory’s rolled up his sleeves on the finance side, and I think we are making great progress. But I would be low to give you any particular target at this point in time.

So, sometime in calendar 2018 seems reasonable though?

Certainly, we intend it to be positive. I don’t know that I would put any finer point on it. How about if I said it doesn’t seem unreasonable, how is that for a double negative?

Yes. I’m just curious if you wanted to take ownership. You guys have been awful at predicting your business. So, I was just curious if you want to take a stab at it. Your large tier 1 design win that you talked about, could you -- if that trial moves on besides the trial stage, are you able to bracket what that could mean as far as a revenue opportunity and the gross margin that it would represent for that, is that possible at this time?

Again, obviously, we would never forecast gross margins on any individual opportunity. There are two reasons why we made the statement we made in this call. Number one, this customer can and we believe will become a greater than 10% customer, there is no question in our minds about that. The second reason is because NG-PON2 as a technology at the physical layer is the ideal physical layer technology for a unified access infrastructure, i.e. one single access network that runs everything over top of it. Residential business, consumer, small and medium business, large business, wireless, 5G, doesn’t matter, one infrastructure. And the ability to go and build one access infrastructure puts our customers in a position to have the broadest service offering over the lowest cost per bit per mile and that is a fearsome shift in business models for our customers. And so that’s the second reason why we chose to talk about it. First is, again, this will grow into something larger than a 10% customer as we execute and the second is NG-PON2.

[Operator Instructions] Our next question comes from Steve -- we have reached the end. Excuse me. [Operator Instructions] Ladies and gentlemen, we’ve reached the end of our question-and-answer session. I’d like to turn the floor back to Tom Dinges for closing remarks.

Calix’s next quarterly earnings report for fiscal third quarter ending September 30, 2017 will take place on November 7, 2017 after market close. In addition, management will be participating in investor meetings and conferences during the third quarter. Information about these future investor events will be posted on 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. Good bye for now.

This concludes today’s conference. You may disconnect your lines at this time and we thank you for your participation.