Extreme Networks, Inc. (EXTR) Q2 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Extreme Networks Q2 2013 Financial Results. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the call over to your host, John Kurtzweil, Chief Financial Officer. Please go ahead.

Thank you, Patrick. Welcome to the Extreme Networks Fiscal 2013 Second Quarter Conference Call. On the call with me today from Extreme Networks is Oscar Rodriguez, President and CEO. This conference call is being broadcast live over the Internet and will be posted on the Extreme Networks' website for a replay shortly after the conclusion of the call and will remain for the next 7 days and is being recorded on behalf of the company. The presentations and the recording of this call are copyrighted property of the company, and no other recording or reproduction is permitted unless authorized by the company in writing. This afternoon, Extreme Networks issued a press release announcing the company's financial results for the second quarter of fiscal 2013. A copy of the release and supporting financial materials are available in the Investor Relations section of the company's website at www.extremenetworks.com. This conference call contains forward-looking statements and involve risks and uncertainties, including statements regarding the company's expectations regarding its financial performance, the impact of its restructuring efforts, strategies, growth of customer demand, development of new products, customer acceptance of the company's products, customer buying patterns and spending patterns and overall trends and economic conditions in the company's markets. Actual results could differ materially from these projected in the forward-looking statements as a result of certain risk factors, including, but not limited to, a challenging macroeconomic environment worldwide; fluctuations in demand for the company's products and services; a highly competitive business environment for network switching equipment; the company's effectiveness in controlling expenses, including the company's cost restructuring efforts; the possibility that the company might experience delays in the development of new technologies and products; customer response to its new technologies and products; the timing of any recovery in the global economy; risks related to pending or future litigation; and the dependency on third parties for certain components and for the manufacturing of the company's products. The company undertakes no obligation to update information on the conference call. More information about potential factors that affect our business and financial results is included in the company's filings with the Securities and Exchange Commission. Throughout the conference call, the company will reference some financial metrics that are derived in accordance with Generally Accepted Accounting Principles, or GAAP, while other metrics are not in accordance with GAAP. This approach is consistent with how management measures the company's results internally. However, non-GAAP results are not in accordance with GAAP and may not be comparable to non-GAAP information provided by other companies. Non-GAAP information should be considered a supplement to, and not a substitute for, financial statements prepared in accordance with GAAP. A reconciliation of the non-GAAP information to the corresponding GAAP measures is in the slide presentation under the Investor Relations tab on our website at www.extremenetworks.com and accompanying our press release. Non-GAAP results exclude stock-based compensation, restructuring charges, the gain on the sale of facilities, a gain from a litigation settlement as well as the cumulative translation adjustment related to the closure of one of our foreign subsidiaries. After a short review of our fiscal Q2 financial results, I would turn the call over to Oscar for an update on the business and our strategies. I will return to provide our financial targets for our fiscal Q3, and then we will open the call for Q&A. Revenue for Q2 fiscal 2013 of $75.6 million was within our revised target range of $75 million to $77 million. Sequentially, it was slightly down from Q1 by $0.5 million and down $7.2 million year-over-year. Product revenue was $60.3 million, a decrease of $0.8 million sequentially; and service revenue was $15.3 million, an increase of $0.3 million sequentially. The Americas revenue was $33.5 million and is down 4.2% from Q1 FY '13. The Americas continued to be our largest region despite customer delays in some North American opportunities. EMEA revenue was $28.7 million and is up 0.6% over Q1 FY '13. We had several key program wins in the region, which Oscar will talk about shortly. It's good to see a small growth in the region compared to declines in prior quarters. Asia-Pacific revenue was $13.4 million and was up sequentially from Q1 FY '13. The new leadership in our Asia-Pacific team has begun to stabilize the region and is beginning to get some traction, yet there's a long way to go. Overall, GAAP and non-GAAP gross margins were 53.9% and 54.2%, respectively; and these were within our revised target range. And they increased from the first fiscal quarter. Both product and service gross margins' percentage increased sequentially, primarily due to better inventory management and an increased focus on cost control. Before I begin to discuss operating expenses, I want to remind you that, in the first quarter, we had completed the sale of our property in Santa Clara, California and recorded a gain of $11.6 million. With that understanding, GAAP operating expenses increased by $18.1 million from Q2 -- in Q2 from Q1 and was within our revised target range. Included in operating expense was $5.2 million of a restructuring charge, $1.4 million of stock-based compensation expense and a favorable litigation settlement of $0.4 million. These 3 items are not included in our non-GAAP operating expenses. R&D of $11 million was up sequentially by $0.4 million, and sales and marketing was flat at $22.1 million. G&A of $6.6 million was up $1.3 million sequentially, primarily due to increased litigation expense and an increase in our bad debt expense related to 1 particular account in China. Non-GAAP operating expense increased in Q2 by $2.2 million sequentially to $38.3 million. Non-GAAP R&D was $10.7 million. Non-GAAP sales and marketing was $21.5 million. And non-GAAP G&A was $6.1 million. Second quarter GAAP operating loss was $3.8 million. And non-GAAP operating income was $2.6 million or 3.5% of revenue. Non-GAAP operating income decreased by $1.6 million sequentially from $4.2 million. Other income and expense for the second quarter of 2013 was positively impacted by $0.3 million related to foreign currency gains. Also, there was a $0.3 million of interest income as well as a negative cumulative translation adjustment of $0.6 million. We exclude the negative cumulative translation adjustment from our non-GAAP financials as it relates to the closure of one of our foreign subsidiaries and does not reflect our ongoing operations. Taxes for the quarter were $0.4 million, primarily related to our foreign income. GAAP loss for Q2 was $4.2 million or a loss of $0.04 per diluted share versus a profit of $12.9 million or $0.14 per diluted share in the first quarter of fiscal 2013 and $4.1 million or $0.04 per diluted share in the first quarter of fiscal 2012. Non-GAAP profit for the quarter was $2.8 million or $0.03 per diluted share versus profit of $3.5 million or $0.04 per diluted in the first fiscal quarter of 2013 and $5.8 million or $0.06 per diluted share in the first quarter of fiscal 2012. These results are within our revised target of $0.02 to $0.03 per diluted share. Turning to the balance sheet. Total cash and investments for the quarter ended at $196.2 million as compared to $202.6 million at the end of last quarter. Previously, we had announced a $75 million share repurchase plan, which represents the initial capital authorization for the next 3 years; and we will be reviewing this, at least annually, by the Board of Directors. During the quarter, we repurchased 1.9 million shares for $6.7 million. Please note that one of the primary goals of the share repurchase plan is targeted to maintain the value of our deferred tax assets. Because of this, it is currently expected that purchases will occur unevenly over the 3-year period. The repurchase program may be suspended or discontinued at any time. Any repurchased shares will be canceled and will not be available for future corporate purposes. Accounts receivable increased to $7.9 million in Q2. And DSO increased by 11 days from Q1, primarily due to receipt of customer orders and delayed shipments later in the quarter than normal. Inventory decreased by $4.9 million to $17.9 million. And DOI decreased by 12 days to 55 days of inventory. At this point, I'll turn the call over to Oscar.

Thank you, John, and I want to thank everyone for joining us on this call. It's always our goal to set and meet what we believe is prudent financial guidance for our investors, and we are pleased to report that we have met our revised guidance for Q2. In the quarter, we continued to experience significant growth in the development of next-generation 10-gig and 40-gig technologies, and we continued to see growing customer acceptance for our new products. We are realigning our cost structure, and we are now focused on driving company performance in Q3. We remain cautiously optimistic that the macroeconomic issues impacting our largest geographic sales regions are beginning to improve, as we enter what is a normally, seasonally lower quarter for the company. Given the current macroeconomic environment and the impact of delayed customer buying decisions, we have taken steps to streamline our operations and further reduce our cost structure. As we discussed on January 3, we are restructuring the company by consolidating several functional groups into our facility in Research Triangle Park, North Carolina. We expect this consolidation to lower costs by reducing both the total numbers of staff needed to run the company and by lowering the cost of the staffing. We also expect these changes to increase our overall productivity, as we add new skills and co-locate complementary functions into this facility. We have already begun to execute on these specific transformative actions, and we expect to complete the majority of these actions in this fiscal year. Once completed, we believe these actions will allow us to preserve the financial and organizational flexibility needed to continue key product investments and drive market awareness and will allow us to focus our sales -- on sales productivity and revenue growth in the coming quarters. Overall, we believe that by acting to further transform our cost structures, we will be better able to position the company to meet our stated goals. While I'm confident that these operational changes position us well in terms of our overall cost structure, I want to reiterate that a key focus is also on driving revenue growth with both our new and existing products. In an environment of increasing competition and uncertainty, in Q2, Extreme Networks continued to gain a strategic footprint in the data center space. Our flagship Open Fabric product, the BlackDiamond x8 switch, gained traction across geographies and market verticals and was deployed or selected by 20 new customers, which is an increase from 10 new customers in the prior quarter. Key new developments along -- among Internet exchange customers included both the E6 Exchange in Germany and the Moscow Internet Exchange in Russia, which is the 5th largest in the world. New wins in the high-performance computing market included the Max Planck Institute in Germany and continued deployments at petroleum companies, such as PetroChina, and an additional project at SINOPEC also in China. This project at Shengli Oil Geophysical, which is SINOPEC's largest oil field, was a replacement of InfiniBand technology by ethernet products and a solid win against major competitors. We also won a key deployment at the National Observatory for Astronomical Research in Japan, which has some of the most advanced observational facilities in the world. This was also the first Extreme Networks deployment of new leading-edge, long-reach, 40-gig optics technology. In the quarter, we also saw several deployments into enterprise data centers. Key wins here included a major software developer in France, a development -- a deployment, excuse me, at Mauser in Germany, NCC Media, Traveler's HealthPartners and Data Holdings, all 3 in the United States. NCC Media, a New York-based media and advertising firm, will deploy the BDX8 at the core of their data center. At Five Rivers in the Midwest, Extreme Networks will be part of a new multi-tenant data center, tying together 7 regional major hospitals, and was a key win against significant top competitors. Data Holdings, a provider for cloud services to casinos and other high-value transaction customers, was a key multi-tenant data center win for our new Extreme BDX products. Also in the quarter, our Open Fabric products were selected for a web scale deployment at a large Internet search provider in Russia. In addition, we also shipped the first BDX products to a major telecommunications network equipment provider partner as a part of their new cloud initiative. Overall, our BDX and Open Fabric products deal pipeline and customer win ratio is strong, and I'm pleased with the momentum we are seeing for these new cloud and data center products. In the education vertical, new wins included Krakow University in Poland and Jawaharlal Nehru University in India. We also saw continued deployments at a major school system in Florida. Beyond education, major campus core wins included NHN, which is the leading search provider in Korea with over 70% market share and 1 of the top 10 portals in the world. The initial stage of their refresh core network and data center leverages the 10-gig capabilities of over 800 of our Summit X460 switches, and we expect future phases of this project to result in additional deployments. In Latin America, at the [indiscernible] in Peru, we met major -- we beat major competitors by offering our wide portfolio of products to provide a 40-gig ready, backbone solution that delivers key resiliency and automation capabilities. In Brazil, we provided the infrastructure for the new court of justice, and we deployed a combined switching and wireless LAN solution. For the University [indiscernible], both for their campus and core data center network, we continued to expand our position. In addition, we also sold a complete 10-gigabit data center and campus upgrade for the Ministry of Communications in Brazil. These last 2 wins were competitive replacements of aging 3Com and Enterasys products, respectively. Beyond Brazil, we saw another key major win at Branx Farmacia [ph], the ministry that controls the part of the Russian-wide health clinic network, where we now have won multiple regions as a part of their network refresh. In the service provider space, we landed a major win at Russia's VimpelCom, the 6th largest mobile operator in the world, and are deploying over 400 of our Summit X670 switches for 10-gig and 40-gigabit metro ethernet aggregation. Korea Telecom deployed the X670 in a similar application, further demonstrating the versatility of the Open Fabric platform. Overall, we continued to experience increased new customer growth in what we consider high-growth emerging markets, such as Korea, Latin America, Eastern Europe and including Russia and CIS. Acceptance by customers of our Open Fabric technology is evidenced by strong high-speed port growth. In a quarter where overall port shipments in the market were estimated to be down, we grew 10-gigabit and 40 gigabit ports by over 15% each quarter-over-quarter, making Q2 Extreme's best quarter ever for these leading interfaces. This reflects a 157% year-on-year growth for 10-gigabit bookings and almost a 300% year-on-year growth for 40 gig. What's notable with this growth is that of our new -- that it is a part of all of our new products, and that new products represent 70% of our revenue at this point, which have become -- and those that have become available over the last 24 months are a key portion of this. This is an increase from 40% of revenue from new products only 1 year ago. The new portfolio includes data center products that we've launched over the past 18 months, such as the BlackDiamond X8 and the Summit X670, as well as campus products like the X440 portfolio for campus and the E4G mobility products. Our campus product line continues to see wide customer acceptance, and the new X440 product line is the linchpin in our refresh campus edge portfolio. This increased customer adoption of our new offerings demonstrates the success of our product innovation and the value of our continuing product investment. Further acknowledging our technical leadership, we continue to garner key industry recognition, and this quarter was no exception. We were recently recognized in the new Forrester Research Wave data center report as one of the strong performers in the data center based on the strength of our both our strategy and our current offerings. Forrester cited that customers looking to keep their data center hardware options open and compatible with multiple virtual machine hypervisors should put Extreme on their shortlist. This speaks to our strength in providing an open-systems approach to integration of server, storage and virtual machine software and in offering customers economic choices in cloud deployments. Beyond this, our flagship, BlackDiamond X8, was acknowledge by the Digital Times in Korea as the 2012 Hit Network Switch and by Enterprise Networking as the Tech Innovator of the Year in 2012. We were also awarded Network Vendor of the Year in 2012 by the technology channel news and media firm, CRN. During the quarter, we expanded our data center technology capabilities by launching the second phase of our Open Fabric architecture. This included expanded cloud 40-gig and new 100-gigabit interfaces for the BlackDiamond X8. With the introduction of the first 100-gigabit products for the BDX family, we are proving its readiness as a key competitive portfolio that is now prepared for the next decade of cloud and data center deployments. These new products offer the flexibility to handle both traditional and SDN data center architectures and are integrated as a part of our SDN portfolio. In the quarter, we also announced a partnership with SDM controller and applications vendor, Big Switch, that included support both for their OpenFlow controller as well as integration with their first set of supported SDN applications. Our announcements demonstrate the continual innovation Extreme brings to the evolving SDN discussion with a key focus on moving customer value discussions from technical architectures and products to the economics of business-impacting solutions. Beyond our accomplishments in technology and innovation, we continue to build up our world-class executive team. Over the past few weeks, Extreme announced several key executive additions. Just after the quarter, we announced the appointment of Shehzad Merchant as our new CTO. Shehzad is one of Extreme Networks' original employees based in Silicon Valley and is -- has been instrumental in developing our data center and SDN strategies. He has provided key innovation leadership to enable our success with our best-of-breed Open Fabric products based on the ExtremeXOS operating system. Gary Garber, our new Vice President of Talent and Culture, is a veteran of several communications companies and brings industry experience from Avaya and Nortel Networks. Joe Novak, our new Vice President of Customer Service, joins us from a long career at Cisco and Nortel and will focus to enhance our customer service and professional services capabilities. And finally, our new CIO, Marykay Wells, who was responsible for global IT strategy and operations, comes to us from similar positions she's held at Tekelec and Nortel and will be focused on helping drive overall systems efficiency and productivity at Extreme. All 3 of these new leaders are based out of our facility in RTP, North Carolina and bring a balance of global experience, industry best practices and new energy to Extreme. In summary, we believe the markets that we serve are strong. Our innovation is providing real value to our customers, and we are executing on the next steps in our strategy. And I believe our strategy is on track. We are focusing our revenue growth, and we are taking the next critical steps to drive customer awareness and focus on product portfolio investments to execute a clear market innovation strategy. We're also working to lower our operating costs and enhance our operational productivity to thereby enable more consistent levels of operating income and free cash flow. I am confident that the work we are doing to deliver award-winning products and drive a lower cost structure will begin to positively change the position of Extreme Networks in the market. As a result, we continue to believe we are well positioned to grow earnings and cash in FY '13 and into FY '14. And now, I'll turn the call back over to John to discuss guidance for the third quarter of fiscal '13.

Thank you, Oscar. We target our third fiscal quarter of 2013 revenue to be in the range of $70 million to $75 million. This is typically a sequentially down quarter, and we have taken into account the macroeconomic weakness being seen in the industry, not only by Extreme Networks, but by our competitors as well. We've also taken the conservative view of Asia-Pacific given Chinese New Year is in this quarter. The restructuring efforts we took last quarter, and also this quarter, have helped us lower our cost structure. Given this, we target our GAAP and non-GAAP gross margins to be 54% to 55%. R&D is targeted to decrease by approximately $1.5 million. Sales and marketing is targeted to decrease by $2 million to $2.5 million. And G&A is targeted to decrease close to $0.5 million. On a GAAP basis, we anticipate an incremental $0.6 million of restructuring charges. GAAP net income is targeted to be between $3 million and $5 million, with non-GAAP net income targeted to be between $4 million to $7 million. GAAP EPS is targeted to be between $0.03 and $0.06 per diluted share, and non-GAAP EPS is targeted between $0.04 and $0.08 per diluted share based on 93.5 million diluted shares. For those of you who are building financial models on the company, we are targeting a quarterly financial model with the goal of achieving non-GAAP gross margin of 56%, plus or minus, and for non-GAAP operating income of 10%, plus or minus, at a revenue level below the $80 million range by the end of fiscal 2013. To help achieve this goal, the company intends to focus on growing its revenue with higher performing and lower-cost products, as well as further realigning its operating cost structure around this set of products. We will now open the call for questions. Patrick, you can start the polling. Thank you.

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

Just a few questions. As you look to visibility, Oscar, this quarter versus last quarter, would you say the visibility is the same, a little bit better or a little bit worse?

I would say, looking at the quarter and the information I've got, the information I have right now is probably about the same level of consistency that I had at this time last quarter. Now with that said, we drove down a lot into our pipelines, et cetera. So I got good confidence in the forecast that we've given at this point. But I would say that it's still a little bit cloudy out there and the customers are still being very careful about how they buy.

Right. Can you quantify your pipeline? You talked about that, in your press release, the pipeline continues to grow. Can you quantify either revenue or percentage improvement quarter-over-quarter?

Yes. The -- so specifically, my comments are around the 10-gig and 40-gig products, which are mostly data center-oriented products. There are some 10-gigabit products that wind up going into campus cores for some of the high performance campuses. But for the most part, it's really data center and deployments or high-performance computing, Internet Exchanges, et cetera. For that, we continue to see the pipeline grow. I'm beginning to see more large customer deals out there, and more large customer deals are being bid into. So -- and a lot of these larger customer deals wind up having a lot of 10-gig and 40-gig technologies along with them. So I'm seeing the pipeline for 10-gig and 40-gig products grow more aggressively than the other parts of our portfolio, which are more 1-gig to 10-gig combinations are more campus oriented. So that's the part that I'm feeling good about. The -- in terms of percentage, I don't know if I can cite a percentage and I don't want to give an announcement of dollar value here but it is growing and better.

Can you quantify the size of the typical deal you're looking at now? And has the size of that deal larger than it was a quarter or 2?

Yes. So for us, the concept of average deal size is beginning to vary a little bit. It's almost becoming [indiscernible] we have these larger customers that we're engaging with include data center cloud types of customers, and those deals have a tendency to be anywhere minimum of $500,000 on up to $1 million, $2 million or several million dollars. So those are important deals for us, and they get a lot of our attention, of course. The other side is the more traditional campus medium-sized campus and medium-sized customers, which could be more on the lines of $350,000 to $500,000 type of deals, right? So I'm beginning to see more of the former. And as a result of more of the former, you can then begin to see the lot more of the bigger technologies, bigger bandwidth technologies at 10 gig and 40 gig. Also, the growth of that jives along with that.

And then, are you ready, prepared to quantify exactly what you're 10-gig and 40-gig product revenue was in the quarter yet?

No, we haven't brought it out yet.

As we look to -- no, you're not going to answer that either. I guess, 2 quick other questions. Given the fact that you expect to be in your 10% non-GAAP operating margin target by June, is that going to be more revenue driven or gross margin driven?

It will be a combination of both. We have -- the cost structures that are going in place are going to help the gross margins but also greater volume, typically -- because typically, Q4 -- our fiscal Q4, the June-ending quarter has the highest volume of the year. That's pretty typical for us over the course of the last dozen years.

And then, my last question, if I may. Can you explain the customer buying decision to move from InfiniBand to ethernet?

Sure. So a lot of customers that are in the high-performance environment are now looking at ethernet as a replacement for InfiniBand. Not everyone has moved immediately. I think there are some early adopter customers that are beginning to look at InfiniBand. I've cited at least one of the InfiniBand retrofits that we did in China. For a large high-performance computing environments and for geophysical research. It's -- part of it is a cost-driven issue and also the fact that InfiniBand interfaces on some of the largest servers today, there's a tendency for them to bring 10-gig interfaces with them. And so, there's no additional cost at the server and no additional cost at the network, if you will. And the fact that Ethernet is also running storage now is very compelling. So with Ethernet able to drive network type storage over iSCSI or other types of technologies, plus the servers having native 10-gig interfaces and 40-gig interfaces, now we have the ability for Ethernet to move into the InfiniBand space. So I think that it's an early market. It's growing, and I think we're going to more InfiniBand replacements by ethernet as the market moves on.

[Operator Instructions] We show no other questions in queue.

Okay. Thank you very much for your time this evening. We appreciate your participating in the call, and look forward to talking to you again at the end of next quarter. Thank you very much.

Ladies and gentlemen, thanks for participating in today's program. This concludes the program. You may all disconnect.