Calix, Inc. (CALX) Q3 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Calix Third Quarter 2017 Earnings Conference Call. My name is Matt and I will be your conference operator today. At this time, all participants are in a listen-only mode. And interactive question-and-answer session will follow formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Tom Dinges. Thank you. You may begin.

Thank you, Matt, and good afternoon, everyone. Today, on the call, we have President and CEO, Carl Russo, as well as 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 will 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 on the Investor Relations section of the Calix website. For the quarter ended September 30, 2017, Calix reported revenues of $128 million, a GAAP loss of $0.34 per share and a non-GAAP loss of $0.28 per share. In just a moment, Cory will take you through the quarter in greater detail as well as provide our financial guidance for Q4, Carl will then conclude with remarks on Calix 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 CFO, Cory Sindelar. Cory.

Thank you, Tom. We last provided you with guidance regarding Q3 on August 8th and in that guidance we called for revenue to be between $126 million and $130 million. In non-GAAP gross margin of between 36% and 39%, non-GAAP operating expenses in a range of $59 million to $61 million and a non-GAAP net loss per share between $0.21 and $0.27. Relative to that guidance, our actual revenue for the third quarter was $128.8 million above the midpoint of our guidance range. Non-GAAP gross margin was 34.8% 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 $0.28, a $0.01 lower our guidance range. Getting into a bit more detail, revenue of a 128.8 million for Q3 marks a new third quarter record representing an increase of 6% year-over-year; this marks the seventh consecutive quarter of year-over-year revenue growth. Product revenue was a $106.4 million representing 83% of total revenue and was down 7% compared to the year ago period. Despite continued traction with our AXOS and Calix Cloud product offerings, product revenue was lower as a result of major turnkey network improvement project which was still ongoing in the year ago quarter that subsequently completed this year; creating a challenging comparison for this quarter. Service revenue was $22.4 million representing 17% of total revenue and was up over 200% from the year ago period as we accelerated the completion of our large number of previously awarded CAF II sites. Domestic revenue was 91% of our third quarter revenue, and increased 5% year-over-year. International revenue was 9% of our third quarter revenue and increased 20% year-over-year. And we had one customer that was greater than 10% in the quarter. Our Q3 non-GAAP gross margin of 34.8% decreased from the 45% in the year ago quarter, but slightly increased from the 34.5% reported last quarter. Non-GAAP product gross margin was 48% marking a five quarter high and increased from the 47.6% reported in the year ago period as well as the 45.8% reported last quarter. Compared to the year ago quarter and the prior quarter the principle drivers of the increased product gross margin were product and regional sales mix as we continue to see strong traction with our AXOS and Calix Cloud products. Non-GAAP service gross margin was a negative 28%, down from a positive 3% in the year ago quarter, but an improvement from the negative 30% reported last quarter. Compared to the year ago quarter the decrease was primarily driven by the deployment of additional resources and the incurrence of additional costs related to older CAF II projects that we completed during the quarter, including a write down of differed cost of 2.6 million. Compared to the prior quarter, the increase was primarily driven by process improvements and greater efficiency in closing out a larger number of sites than expected since our last earnings call. As we discussed last quarter the team has now closed out a vast majority of these previously awarded sites. While our optimization efforts for our service business continues to progress, we have more work to do. Based on the progress made to-date we continue to see evidence that the new process improvements and delivery methodologies are working, as new projects started under the leadership of Greg Billings have completed or continue to track at positive gross margin. Our Q3 non-GAAP operating expenses of 58.5 million were up $5.7 million from the 52.8 million in the same quarter a year ago, excluding the Occam litigation settlement proceeds of approximately $4.5 million. The year-over-year increase primarily reflects a higher level of investment in research and development through increased headcount and the increased use of outside contractors. 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 among small and medium-size operators. In addition, the increase in operating expenses reflect a $1.2 million investment in moving our IT infrastructure to the cloud. The investment in our IT infrastructure builds a more scalable foundation allows us to automate the growing demands of our business. As compared to last quarter our operating expenses were flat even with the incremental IT investment demonstrating the leverage that our AXOS operating platform provides, as we rapidly develop product enhancements on one unified platform as well as our decision to moderate investments as we move forward. Turning now to the balance sheet. We ended the quarter with total cash and investments of $70.8 million up from the $50.2 million at the end of the second quarter of 2017 and an increase of $9.5 million from the year ago period. The primary drivers in the year-over-year increase in cash were borrowings under the line of credit and improved working capital velocity partially offset by negative operating cash flow over the past 12 months, predominantly due to our net operating losses as well as capital expenditures to support future growth opportunities. Operating cash flow for Q3 was a negative $7.2 million as working capital efficiency continue to improve, but could not completely offset the net operating loss this quarter. Capital expenditures in the quarter were $2.1 million. Accounts Receivable DSOs were 31 days compared to 39 days in the previous quarter and 43 days in the year ago quarter. Inventory levels marked a multiyear low of $36.3 million in Q3, compared to $39.6 million in the previous quarter, and $40.2 million in the year ago quarter. With total revenue increasing our team's performance has been excellent at managing inventory levels. Inventory turns were eight times in Q3, compared to 6.9 times in the prior quarter and 5.7 times in the year ago quarter. Now, let me take you through the details of our fourth quarter guidance. For the fourth quarter of 2017, we expect revenue to be in the range between $140 million to $145 million, representing growth of 6% to 10% year-over-year. This reflects continued investments in broadband access of our customers as well as the initial shipments of the AXOS E9-2. We expect non-GAAP gross margin to be in a range of 36.5% to 38.5%, down from the 40.4% reported in the year ago quarter reflecting the higher mix of service revenue compared to the year ago period. Importantly based on the remaining 2017 CAF II sites to be closed out this year and the continued implementation of process improvements, on new projects, we anticipate service gross margin to be near breakeven in the quarter. We expect non-GAAP operating expenses to be in the range of $59 million to $61 million, flat to down from the $60.7 million in the year ago quarter. It also includes an estimate for SaaS implementation expenses for our internal systems of approximately $1 million as well as our normal seasonal increases related to costs for our ConneXions Conference and year-end sales commission accelerators. The decrease in operating expenses compared to the year ago quarter predominantly reflects lower investment levels for prototypes as well as the positive benefit as we leverage our AXOS platform by accelerating product development at lower incremental costs and reduced timeframes. Based on our estimate of 50.7 million weighted average shares outstanding, the expectations that I have taken you through results in a guidance range for Q4 of a non-GAAP net loss per share of between $0.10 and $0.15. With the projected operating loss in Q4 and increased working capital needs on higher revenue level, we anticipate negative operating cash flow for Q4. With three quarters reported and the guidance for the fourth quarter I just walked you through, we can now update our full year 2017 expectations. We now expect revenue to increase between 12% and 13% year-over-year, which would mark our second consecutive year of double-digit revenue growth. Importantly we remain committed to our long-term model. As a reminder, our long-term model drives to a 10% or better operating margin and annual revenue achieves $600 million. At this point, let me turn the call over to Carl.

Thank you, Cory. Before I begin to discuss the quarter as many of you are aware Calix is based in Sonoma County which along with a number of other areas throughout California recently endured a series of devastating fires. Although the fires did not disrupt our operations, the tragic losses sustained by employees and their families and friends have been met with the tremendous outpouring of support. Many of you have been kind enough to enquire, and please rest assured we are doing everything possible to support our employees through this as they look to rebuild after this tragic event. As Cory just reviewed our financial performance in the third quarter was solid and there were many additional examples of our continued transformation to a cloud software platform systems and services company. In the third quarter we saw our Calix Cloud bookings ramped quickly albeit from small base. Cloud bookings increased quarter-over-quarter as total contract value for our new Calix marketing cloud and Calix support cloud remain significantly higher than our first generation of cloud products. We are now seeing objective evidence that these powerful cloud solutions are helping our customers transform their business models. Our customers are now able to raise their revenues, increase customer satisfaction, lower churn and decrease their operating expenses all by applying the insight that our cloud analytics deliver. Our customers’ ability to own the subscriber experience was dramatically enhanced when we launched the industry's first mesh-enhanced Carrier Class Wi-Fi solution. This new addition to our GigaFamily of products is off to a rapid ramp, with nearly 200 customers placing orders prior to general availability. Based on this initial strong demand, we expect great things in the immediate future and we have now delivered AXOS into all of our E series systems. The E9 E7 E5 E3 all have a AXOS available, to speed our customers transformation to an always-on [DVOP] (Ph) environment. Our next generation of service offerings grew as well and most importantly we believe we have turned the corner on our deployment services cost structure. We expect that our services margin in Q4 will reflect this improvement. And in Q3 we announced we announced the addition of Kathy Crusco to our Board of Directors, a seasoned finance and operation executive with these software and systems experience. We look forward to Kathy’s guidance as we continue to focus on our financial execution. Continuing on to Q4 we just left the Calix ConneXions show and it was the biggest and best yet, not only because of the product and service offerings I just covered, but because we launched EXOS, the Experience OS, architected to bring an AXOS level of performance to the subscriber edge. EXOS is built for a future where boundless complexity at the subscriber edge can be managed and monetized by the service provider all while offering their subscribers a sensational experience. Judging by the interest expressed to ConneXions, EXOS stands to be our fastest-growing platform yet. EXOS combined with AXOS and Calix Cloud march the beginning of Calix as a software platform company. AXOS and EXOS are revolutionary software platforms, fully abstracted and stapled open and standards-based that allow our customers to move at their DVOP speed from their data centers to their subscribers across the entire active infrastructure. These platforms are unique and combined with Calix Cloud will continue to help our customers transform their business models. Over time, you will continue to see us use our platform based agility to enter new markets thereby significantly increasing our TAM as these innovations are customer segment and network technology agnostic. For example last month Calix enabled an electric cooperative to be the first to deploy NG-PON2 with the Calix AXOS E7-2 system; just two weeks ago, Calix software defined 10 gig EPON was awarded the best MSO Solution by BTR Diamond Technology review in the FTTH/Optical Access Platform category. Calix Software Defined 10 gig EPON gives cable operators limitless possibility on which to build their next generation of software designed multi-technology cable networks. This marks the second major award for the Calix AXOS E3-2 intelligent access nodes in just the past six months. And we continue to drive innovation, in Gfast with broadband trends recognized in Calix as the top vendor in four out of five categories in its 2017 Global Service Provider survey of Gfast deployment strategy. Calix ranked first in product performance, product roadmap, service and support, while also tie-in for the top spot in deployment experience. Finally, initial shipments of the AXOS E9-2 will begin this quarter to a number of customers large and small. As a reminder these deployments include RPM and SMM, our Routing Protocol and Subscriber Management Modules. Looking to the future enhanced innovation delivered on decreased research and development investments is the promise of an all platform company and so it shall be in this coming quarter and beyond. Increasing services margin driven by alignment with our all platform product strategy which also be on display this coming quarter and beyond. Helping our customers build more valuable businesses by delivering an unrivaled subscriber experience will remain our focus as we expand into new markets and become Calix, the Cloud Software Platform Systems and Services Company. With that, I would like to open up the call for questions. Operator?

Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] And our first question is from Christian Schwab from Craig-Hallum. Please go ahead.

Hey congratulations. So, as we look forward Carl can you give us an idea of what we should expect for a gross margin range in 2018, does it get to double-digits positive or how should we be thinking about the beginning of the trajectory of this improvement with breakeven in Q4?

So, you are talking specifically about service margins?

Correct.

So, I didn't say breakeven, but Cory did and I will support him in it, I'm just kidding. So, look we intend to get the brackets off of services margins in Q4 and that's been a clear goal of ours since we figured out what we are doing here. As we look into next year, obviously we expect it to go into positive margins and we have often spoken about a range of 30 to 40 points being the normal services margin range for a reasonably well run business and we think that's obtainable over the course of 2018.

Wow, okay, congratulations on that. The last few years we have had kind of growth outperformance versus your peers I would call it a double-digit top-line growth. Is that type of you know not putting you on the spot for 2018 but over a multi-year timeframe would you given the new product announcements and the strong uptake that you talked about and customers already placing orders, would you expect that type of growth trajectory on a multiyear timeframe to continue?

Yes.

Excellent and then my last question and I will let somebody else hop in here. As some of these more expensive service contracts that might have been truly done on under previous management, is there an opportunity for the absolute OpEx or in particular may be R&D costs to not go up in 2018 or to possibly go down with less outside contract work?

I want to separate two things there and I want to cover the services margin piece one more time, because obviously services margins is separate from R&D and I think you meant to be separate right?

Yes, I did.

Yes. So as you look at services margins just to put a fine point on it, I think you said an exclamatory wow, let me see if I can help you understand some moving pieces under that. We are definitely improving how we go about doing our deployment services. But deployment services are the lowest margin offering in the services portfolio. There is two things going on here with services going forward. One is that we are increasing our mix of higher value services as you go into more cloud and AXOS and EXOS. They are more on the order of consulting services and we actually expect a decreasing percentage of services going forward to be deployment services so there is two things that have that come together to elicit your wow. Does that makes sense?

Yes, no, thank you for that clarity.

Okay and then on the R&D piece, look we have made a very straightforward statement that when we got our platforms in place we felt that our R&D would for a period of time actually go down as an absolute number and obviously go down as a percentage of revenue and so you are saying that in the commitment for Q4 in OpEx, you will see R&D go down. And we expect it to continue to glide slope down until we start to look more like what we want in our model going forward. And by the way, you should see no slowing of innovation, because we are now able to do things very quickly on AXOS, EXOS and Calix Cloud.

Fabulous. Thank you, no other questions. Thank you.

Thanks Christian.

[Operator Instructions] And our next question is from Greg Mesniaeff from Drexel Hamilton. Please go ahead.

Yes, thank you. Carl I noticed your international sales were up in relative terms more than previously year-over-year. Can we expect to see a greater contribution from overseas customers going forward, and if so how does that impact your mix of product versus services cost of goods sold?

Okay, so let me address the first piece and I will stay consistent with what we have seen before. Post Michael Weening joining us and really rethinking our sales and marketing approach mix et cetera, I think we have been clear that we expect international to grow, but not at a rate faster than the rest of the business is growing. So as a mix, I don't know that you are going to see any appreciable shift in mix for a period of time; it may be up a little bit or down a little bit in any given quarter, but I think that's roughly what you are going to see. So, that's the first piece. The second piece is to be blunt, we are doing better business in international, so we are making better choices about where we go and where we do not go, so that has a favorable impact on margins. From a services standpoint, pretty clearly deployment services is not a big part of international, but the attach services are. So overall, we believe we should have an improving margin opportunity in international when you blend products and services.

Thank you for that.

You are welcome. Other questions.

[Operator Instructions] Our next question comes from Meta Marshall from Morgan Stanley. Please go ahead.

Thanks guys. You guys have mentioned kind of deployment services being less a piece of the services mix in 2018, I just want to get a sense of should we think of these contract as drive around CAF deadlines and when is the next CAF deployment deadline we should think of where there might be another spike kind of in deployment services or do the contracts extend that long? And then just implied in kind of the Q4 gross margin guidance the services is breakeven, that would imply that services is pretty significant portion of Q4, and so just kind of wanted to get a sense of is that just a full completion of those Q4 contracts or these initial kind of CAF contracts and we should think of services as a smaller portion of the mix in 2018? Thanks.

So, Meta those are comprehensive questions and let me see at my age I can remember them. So, let's start and look at where we are going as a business, and thinking through the deployment services and speaking to the CAF part first. We have said all along that deployment services are something that we want to make sure we can do for our customers, but we are also very happy to have an ecosystem of partners that do it as well, and we actually have a mix today. I expect that mix to continue into the future and perhaps maybe even tilt a little bit more towards third-parties than us doing the deployment services. As for CAF, CAF will remain unabated, because as you know it's a six year and a 10 year program, six years, in the price CAF carriers, and 10 years starting next year in the rate of return carriers, the CAF portion in the rate of return carriers is referred as ACAM, and we have actually been very positive on that now being in place and allowing that portion of the market to go forward and not have uncertainty so they can invest. So we see both of those proceeding at pace, what you are seeing from us a little bit more of the mix of us doing deployment services versus working with third-parties that are doing it. So, did I answer the first part of your question?

Yes. No I mean I guess that answers it, but I just want to get a sense of through the current services contracts kind of expand through the entire CAF lifecycle and we might see some deflationary impact kind of as we had another CAF deadline in years to come or does these just kind of an extent to the original 40% in the first couple of years deadline.

Yes, there is sort of 20%, 20%, 20% and then on the 10 ones 10%, 10% it's a different sort of thing. So they are linear in the way they are done. So you shouldn't read anything into that. Does that help.

Yes. I mean I guess just were the initial contracts for the entire life of CAF or just for kind of these deadline?

Oh no, no when you take the CAF fund you take the CAF fund for their lifecycles. They were bid out.

But your contract, so services…

Okay our contracts are handed out pretty much on an annual basis. Sorry, I didn’t understand what you are asking. Does that help?

Yes. No that helps. And then I guess the second part of that was just..

And the fourth quarter.

Yes, the fourth quarter.

Look we are not going to forecast the business on product and services. We took a little bit of risk this quarter just to simply say we intend to get rid of the brackets and services because for us we think that’s a very important thing for us to go achieve and we think it's an important thing to communicate to our shareholders. But I will give you a little inkling in the Q4, we are taking on shipments that will probably have an effect on product gross margins that will bring product gross margins down a little bit while services gross margins are coming up, because we are adding some new customers in Q4. How is that?

Great, okay thank you.

You are welcome Meta.

[Operator Instructions] And our next question comes from George Notter from Jefferies. Please go ahead.

Hey guys thanks very much. I guess I wanted to go back to the services discussion. As you think about getting back to breakeven services gross margin Q4 or better, what is the formula in there? I realize you guys are improving the processes achieved to attack these kind of projects and that’s a big piece of this, but you are also raising prices with customers as well or is this again more just about execution?

Yes. So George to continue on the theme that you and I talked about before, there is many more variables than just a single dimension. So when you say pricing, actually you and I spoke about this before, its not so much pricing and frankly it is getting this definition around what is in the contract, what is in scope and what is out. And we are doing a much better job of planning these together with our customers. Planning out what is in scope, what is out of scope, who has responsibility for what. The price may turn out to be the same price, the difference is, its far better defined, but we end up not ending up with a price for something that didn’t have boundaries around it. So that's been going on since Greg has been here okay. Now the second part of that is since Greg has been here, it takes many months, quarters potentially more than a year for some of these programs to flow through. So what you are seeing is the tale of those deals being closed off from a year ago and two years ago. Combined with what Cory outlined earlier, which is we have run rate pieces now that since Greg has been here that are in the positive gross margin, and its just a mix shift from things we have that are underwater and things that are do you guess what positive gross margins.

Got it, okay and then just to expand on that if you think about - obviously the initiative here I think is to your due services works that's attached directly to product sales from Calix, if you look at your customers, that I realize that some of the bigger guys like Windstream and CenturyLink really drove you to pursue to the services space. But when do you think you hit kind of a full penetration in a sense on that activity, is there a limit this quarter next quarter year from now when you kind of maxed out in the amount of services work that your customers want you to do for them and that and therefore you hit a limit in terms of how big this business can be and how much it can affect the margins, talk about how deeply penetrated that is?

Yes. Penetration is an interesting word there, so let me see if I can bracket it a couple of different ways. In the way I think you are asking the question, penetration is actually in our rear view mirror. I think you are going to see the mix of our services continue to shift north bound on value while the math of services decreases as a percentage of our total revenue. I think our revenues for services will still be as I have said inside of our company in the teens by the way 19 being a teen as I have remarked inside the company, 11 teen is a teen, so somewhere in between 11% and 19% but I suspect it's going to start to move towards the lower end of that range, and as deployment services makes up less of the mix and engineering and consulting services increases. Training services all sorts of things that are tied to cloud deployments and other things, its just a very different type of service. So the way you are asking me the question from a penetration standpoint, I think the answer is, it's already happened.

Got it, okay and then just to be clear, so, another way of saying this I think is to say that in dollar terms the amount of deployment services revenue has peaked and will go down going forward is that fair to say?

I believe so, and I believe so for a couple of reasons, it's continued to work - our ecosystem partners, across all of our customers, we have a pretty clear view into the CAF II and ACAM requirements from our customers and so yes I believe you will see it as a percentage of mix of services go down and therefore as a percentage of mix of total revenues go down. All the while we are actually getting better at doing it, but nonetheless even if we get great at doing it, it's a 30 point margin sort of thing, if you are really good at deployment services. If you add that into the services than you can figure out how you get to a mix. So, am I giving you too many numbers or does that makes sense?

Yes. No that makes sense. And just to be - sorry to delever this, but just to be clear in dollar terms it has peaked and will decline, just not talking about mix now but just dollar terms?

Yes that we I think we can say for this - from what we can see that's true.

Great, and then that's a function of what, it's a function of you guys just I guess sort of pushing more business off onto this ecosystem of outsourced contract engineering firms or is that more a byproduct, there is just less business to do in the marketplace among the set of customers?

The CAF here is still moving along and so you can read it as the former, it's an ecosystem approach.

Got it. Okay, fair enough. Thanks very much guys, I appreciate it.

George thank you.

[Operator Instructions] And our next question is from Christian Schwab from Craig-Hallum. Please go ahead.

I just had a quick follow-up, Carl when you talk about adding new customers in Q4, are any of those customers Tier-1 customers?

I will just say we are adding a lot of customers from small to large and yes some of them might be large.

Great. Thank you.

Thanks Christian.

[Operator Instructions] And there are no further questions I would like to turn the floor back over to Mr. Dinges for any closing comments.

Thank you Matt. Calix’s next quarterly earnings report for fiscal fourth quarter ending December 31, 2017 will take place on February 13, after market close. In addition, management will participating in Investor Meetings and conferences during the fourth quarter, information about this future investor events, we post on the events and presentations page investor relations section of calyx.com. Once again thank you for your interest in Calix and thank you for joining us today. Goodbye for now.

This concludes today’s teleconference. Thank you again for your participation. You may disconnect your lines at this time.