Extreme Networks, Inc. (EXTR) Q4 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Extreme Networks Q4 '13 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, John Kurtzweil, Chief Financial Officer. You may now begin.

Thank you, Nicole, and welcome to the Extreme Networks fiscal 2013 fourth quarter conference call. On the call with me today is Chuck Berger, Extreme Networks President and CEO. This conference call is being broadcast live over the Internet and is being recorded on behalf of the company. The recording will be posted on the Extreme Networks' website for replay shortly after the conclusion of the call and will remain there for the next 7 days. 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. By now, you should have had a chance to review today's fourth quarter fiscal 2013 earnings press release. For your convenience, 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 that involve risks and uncertainties, including statements regarding the company's expectations regarding its financial performance, the impact of its restructuring efforts, strategies, growth, 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 the pending or future litigation; and the dependency on other parties for certain components and for the manufacturing of the company's products. The company undertakes no obligation to update information on this call. For more information about potential factors that affect our business and financial results, we suggest you review 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 other non-GAAP information provided by other companies. Non-GAAP information should be considered as 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 and the accompanying press release. Non-GAAP results exclude stock-based compensation, restructuring charges, the gain on the sale of the facilities, a net loss from litigation settlements, certain CEO transition expenses, as well as a cumulative translation adjustment related to the closure of one of our foreign subsidiaries. Before I go into a review of our fiscal Q4 financial results, I will turn the call over to Chuck Berger for some opening comments.

Thanks, John, and thanks, everyone, for joining us today. In addition to announcing the results for our fourth fiscal quarter and full 2013 fiscal year, I have now been with the company for 90 days and would like to share with you with what we will be focused on in the upcoming fiscal year and beyond. First, let's talk about the quarter. After a frankly disappointing Q3, we showed strong sequential quarter-over-quarter revenue growth, reporting revenues of $79.5 million, up 16.5% from the prior quarter and above the high end of our guidance, which was $77 million. At $0.07 non-GAAP EPS, we were also towards the high end of our guidance for earnings. Our balance sheet remains strong as cash and investments reached $205 million and we generated free cash flow of nearly $17 million. We also strengthened the management team significantly. Just yesterday, we announced that Ed Carney joined Extreme Networks as Executive Vice President of Products and Customer Success. Ed brings with him over 3 decades of experience in the networking industry, first with IBM and, more recently, with Cisco. Ed will be managing all of our product development, product planning and services. He will combine our product development organization with the service and support team to ensure that our product innovation is guided by the experiences and input from our large customer base. Ed is very well known and very respected across the networking industry. The fact that he chose Extreme has sent a strong message to the market that people who know this industry and know the technology that drives it are picking Extreme. The Raleigh Press described Ed, a former Army Ranger, as someone who knows only one direction, forward. Allison Amadia also joined the company as General Counsel, bringing with her over 20 years of experience in the high-tech industry, a tremendous energy level and a strong intellect. During the quarter, we also announced a partnership with Lenovo. Lenovo has made a strategic commitment to grow their service business substantially. They're investing heavily in product development, marketing and sales and leveraging their position as the world's largest PC vendor to become a force in the server market. After a year of testing Extreme's networking products, they selected us to be their networking partner. As they grow their market share in the service space, they will be reselling Extreme switches as part of their solution. We received EMC VSPEX certification during the quarter as well. With the EMC VSPEX validation, extreme Networks open fabric network solution, including the Summit X670 10 gigabit ethernet switch, is positioned to deliver industry-leading speed, low latency and virtualization support for cloud networking as part of the EMC VSPEX proven infrastructure. We are only 1 of 3 networking vendors to have received this certification. EMC VSPEX and Lenovo deal provide solid evidence of our progress in becoming a preferred vendor for converged solutions in the data center. They also demonstrate our focus on developing partnerships like the one we have enjoyed with Ericsson for several years to provide leverage beyond what a company of our size can achieve on its own. We also extended our ethernet switching product line with the introduction and first customer shipment of the 430, which has been engineered to allow us to reach a breakthrough price point for the edge of the campus. Finally, we moved into new facilities in San Jose, which continues to be our corporate headquarters and moved into new facilities in Research Triangle Park, where we have focused our R&D efforts along with our facility in Chennai, India. The new facilities provide a fresh face for the company and new energy as we drive the company going forward. I have been at Extreme for 90 days now. It would be presumptive to say that I have all the answers at this point. But it is clear where we need to focus our efforts going forward. First and foremost, we are a products and technology company. We will continue to develop a full range of products for the campus as we grow our presence in the data center. We will upgrade virtually every switch over the next 3 to 9 months, bringing a 100-gig solution to the market in the first half of the calendar year. We have built incredible expertise in leveraging the full capabilities of the fabric and processor chips from our partner, Broadcom. In fact, Broadcom frequently tells us that we push their technology further than any other developer. The focus across the product line will be maximum port density, lowest latency and the least power consumption. We have a tremendous asset in our network operating system, XOS. It is the only OS that spans a complete range of switches from the low-end, level 2-only 430 switch, all the way to the extremely powerful modular BDX8 being deployed in high-performance data centers and IXPs across the globe. We have the designed XOS as a network abstraction layer since its introduction in 2004. We have led the industry in what has become known as software defined networking, or SDM, and we'll continue to do so. We also have developed a number of apps running on XOS and we'll continue with that development in the future. Going forward, we'll place increased emphasis on monetizing our software assets. Today, we largely see and sell XOS as an automatic bundle with a switch rather than a collection of products that can generate added high-margin revenue for the company. As we continue to demonstrate the value proposition of our software technologies, we will also focus on increasing the attach rate for our service products. Our service margins were almost 70% in the fourth quarter, nearly 20% higher than our product margins. The benefits of increased attach and renewal rates are clear. I mentioned our partnerships with Ericsson and Lenovo, as well as our VSPEX certification as key leverage points going forward. Our channel partners should represent another strong leverage point for Extreme. We fulfill over 80% of our demand through our 2-tier channel structure and give them substantial margin. After 90 days, I can tell you we are only realizing a very small percentage of the leverage that channel can provide for us. I can site 2 of many indicators of this. Last quarter, we booked nearly 6,500 orders, many for very small amounts. We dropshipped directly to partners and customers nearly 65% of all orders during the quarter. It's safe to say that there is significant leverage to be gained from better channel management. We have relatively new leadership overseeing that effort in the sales organization and a mandate in the operation team to get better in this area. Finally, we have to significantly improve our demand creation efforts. Our lead generation activity in North America is virtually non-existent and we have none of the infrastructure needed to develop leads and to close business for Extreme. Last week, I flattened the marketing organization, eliminating the CMO position. The key leaders now report directly to me in the marketing organization. It will take some time to fix all of this, as we'll need to implement infrastructure like Eloqua or Marketo for lead nurturing and Salesforce for sales force automation. Based on what I have seen, there is significant opportunity for improved revenue growth as we fix this. To summarize, we had a strong quarter and as we look to the future going forward, we will continue to develop the best hardware and software in the industry. We will focus far more on monetizing our software products. We will work to increase our service attach and renewal rates. We'll work closely with our channel partners to realize the full benefits of their capabilities and we will significantly improve our demand and lead gen programs and infrastructure. Now John will give you a detailed review of the financials for the quarter and the year end.

Thank you, Chuck. I will now provide a review of our fiscal Q4 financials and our financial target for our Q1 of fiscal 2014. Revenues for Q4 fiscal 2013 were $79.5 million, which exceeded our guidance of $73 million to $77 million. Sequentially, revenues were up from Q3 by $11.3 million or 16.5% and down $8.2 million or 9.4% year-over-year. The book-to-bill ratio was slightly over one for the quarter and we entered our first fiscal quarter of 2014 with a healthy backlog. During the quarter, we again experienced key component shortages, which we believe should be resolved in the early September time frame. Overall momentum in North America, Asia-Pacific and Latin America is also improving as we have seen a greater number of deals, as well as decision timelines that are moving back to more industry norms. In addition, we are beginning to see signs of stabilization in our EMEA region, most notably in the Northern region, but we are still concerned with the overall general economic conditions in that region. Product revenues were $64.5 million, an increase of 19.3% or $10.4 million sequentially. Service revenues were $15 million, an increase of 6.4% or $0.9 million, sequentially. America's revenues were $39.4 million and were up 40.7% or $11.4 million from Q3 FY '13. North America was a primary contributor to the increase in revenue as was expected during the time of summer upgrades for our campus products. The June quarter is typically our strongest quarter of the year. EMEA revenues were $26.6 million or down slightly 6.7% or $1.9 million from Q3 FY '13. Southern Europe, including the Middle East were the weakest regions with stronger results in the Eastern Bloc. Asia-Pacific revenues were $13.5 million, up 15.4% or $1.8 million sequentially from Q3 FY '13. We had solid performance in both China and Korea. Overall GAAP and non-GAAP gross margins were 55.3% and slightly above the high end of our target range of 54% to 55%. GAAP operating expenses of $41 million increased by $1 million from Q3 and were above our target range, primarily due to the higher year end sales commissions. Certain CEO transition expenses, which included both cash and stock-based compensation and achieving slightly higher year-end bonus targets. Included in GAAP operating expenses are items that we do not include in our non-GAAP expenses. They were $0.6 million of restructuring charges, $0.9 million of stock-based compensation, $2.1 million of certain CEO transition expenses. Non-GAAP operating expenses of $37.5 million were up $3 million from Q3 and $2 million over our target, related to the previously mentioned year-end bonuses and sales commissions. Non-GAAP R&D was $9.5 million. Non-GAAP sales and marketing was $22 million and non-GAAP G&A was $6 million. Fourth quarter GAAP operating income was $2.9 million and non-GAAP operating income was $6.5 million or 8.2% of revenue. Non-GAAP operating income increased by $2.9 million sequentially. Other income for the quarter was $0.5 million and taxes were essentially flat sequentially for the quarter at $0.3 million and were primarily related to our foreign income. GAAP net income for Q4 was $3.2 million or $0.03 per diluted share versus a net loss of $2.2 million or a $0.02 loss per diluted share in the third fiscal quarter of 2013. Non-GAAP net income for the quarter was $6.7 million or $0.07 per diluted share versus net income of $3.3 million or $0.04 per diluted share in the third quarter of 2013. The non-GAAP results were at the higher end of our target range of $0.04 to $0.08 per diluted share. Turning to the balance sheet. Total cash investments for the quarter ended at $205.6 million, as compared to $189.1 million at the end of the last quarter. Previously, we announced a $75 million share repurchase plan, which covers the next 3 years and we will be reviewing this, at least annually, with the Board of Directors. During the quarter, we repurchased 1 million shares for $3.5 million. Since the program authorization, we have repurchased 4.1 million shares for $14.5 million. It is currently expected that purchases will occur unevenly over the 3-year period approved by the Board of Directors. The repurchase program may be suspended or discontinued at any time. Accounts receivable increased by $4 million sequentially in Q4, with DSO decreasing by 4 days to 54. Inventory increased slightly by $0.5 million to $16.2 million, with days of inventory decreasing by 9 days to 47. This inventory level is too low to respond effectively to our customers' demands and we'll be cautiously increasing this level over the next few quarters. As we look forward to starting our first quarter of fiscal 2014 ending September 30, I want to remind you that this is a seasonally weak quarter for us. We are targeting revenue in a range of $72 million to $77 million with GAAP and non-GAAP gross margins targeted to be 55% to 56%. For both GAAP and non-GAAP, R&D expenses are targeted to be sequentially flat. Sales and marketing expenses are targeted to be flat as sales commissions are targeted to be lower and are offset by expenditures for our Global Sales Conference where we are aligning the team on our strategies and in the Asia-Pacific Customer Advisory Council Meeting, plus increased marketing spend for lead generation and brand awareness. G&A expenses on a GAAP basis are targeted to decrease by approximately $2.1 million and on a non-GAAP basis, they are targeted to be sequentially flat. Restructuring charges are targeted to be $0.3 million. Interest income and other expense are targeted to be approximately $0.2 million, with tax expense targeted to be approximately $0.5 million. GAAP net income is targeted at breakeven to $4 million or breakeven to $0.04 per diluted share. Non-GAAP net income is targeted in a range of $2 million to $6 million or $0.02 to $0.06 per diluted share. The GAAP and non-GAAP net income targets are based on an estimated 95 million diluted weighted average shares. The targeted non-GAAP earnings exclude expenses related to stock-based compensation expense of approximately $1.6 million and restructuring charges of approximately $3 million. We will now open the call for questions. Nicole, you can start the polling. Thank you.

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

As we look to Lenovo relationship, our checks kind of suggest that they're going to have kind of bundled products for distribution kind of in the fall time frame, so call that September. How should we be thinking about -- obviously, it certainly depends upon Lenovo's success, but is there a broad range of which you guys are thinking about as far as the revenue opportunity driven by them over the next few years?

Christian, thanks for your comments and question. Frankly, we're being pretty cautious on how we look at the Lenovo partnership going forward. This is unchartered territory for both of us. I think we will begin to see activity in the fall into winter time frame as they ramp up their business and as they particularly increase their focus on rack-based products as opposed to tower-based products, which they traditionally sell in the SMB marketplace. So there's a number of variables here as Lenovo ramps the business. As they ramp to a higher end than they've typically sold to and then start to attach our networks to those solutions. So we've kept a pretty cautious estimate in our forecast for the upcoming year, but can't be more specific than that at this point.

And then following up on the other strategic partnership announcement with EMC joining Cisco and Brocade, with your switches into their storage platform, is that a sale that potentially will just be a line item for customers to choose which they want? How is the sale of your product into that going to work? Can you just kind of help us understand that?

Sure. We are, as John mentioned at our Worldwide Sales Conference, as we speak, and Lenovo actually presented to our sales team yesterday, and we are the partner they are focused on for networking in the server business between servers and between servers and the outside world. What they do on the storage part of this is yet to be seen, but I think the bulk of what they sell and resell as network solutions will certainly be Extreme Networks' products.

Excellent. And just a couple more questions, if I may. The migration from 1G to 10G is probably still in the early stages and 40G has kind of just begun, and it sounds like you have 100-gig product in the first half of next year. As we exit next fiscal year, is there any broadbrush percentage of product revenue you think will come from 10 gig and above?

We're certainly seeing the 1 gig to 10 gig transition gain momentum. We showed 90% year-over-year growth in our 10 gig revenues and 300% year-over-year growth for the 40 gig. We also saw tremendously at the high end, with the strongest quarter for our BDX8 data center solution. So as that transition is in its very early stages, we expect to see significant growth in that as a percentage of our business, but we haven't given specific guidance on that.

Great, and then last quarter, you guys kind of talked about a record backlog. This year, you've kind of described it as kind of healthy. Obviously, we shipped some of that backlog. Is the dialogue -- this will be my last question, by the way -- is the dialogue regarding backlog something you want to discuss now over these last couple of quarters because we're seeing component shortages, or is that a discussion we should expect in every conference call?

The dialogue regarding backlog is truly driven by the decision that was made in the March quarter, I will emphasize, before I got here, to fairly dramatically reduce inventories. And as demand happily grew it's taking us some time to catch up with that demand and rebuild our inventories, particularly, unfortunately, because lead times with our largest vendor, Broadcom, have extended fairly significantly over the past 90 days, going from roughly 18 weeks to north of 21, 22 weeks. That said, it was one of the first decisions I made when I joined the company to increase our inventory position given that we have very long-lived products. Roughly 80% of our components are common parts and we certainly have a cash position that can afford an investment -- a bigger investment in inventory. We expect by the end -- therefore, we expect that by the end of August, we will have caught up with demand and we'll come into September and the rest of the calendar year in a strong position to fill the demand that's out there.

Our next question comes from the line of Ryan Flanagan with Wedbush.

I had a question on deal sizes. Last quarter, you mentioned you had some $1 million plus-size deals in the pipeline. Were these closed, are they still out there? And just maybe any color you can give, just generally around deal sizes will be appreciated.

We had 2 or 3 deals during the quarter in the 7-figure category. We extended our business with Intel, with Samsung and with a couple other customers. So we're seeing large purchases from our larger customers, both repeat business or expansion business, as well as new business. That said, we still get a significant part of our business in the $10,000, $100,000 range. In fact, we're happily today announcing close to a dozen of those deals as part of our sales conference already in the quarter.

Okay, great, that's helpful, guys. And then I also want to ask about some different verticals, maybe some points of strength and some points of weakness you're seeing out there.

Sure. Particularly in our Data Center business, we have focused heavily on high-performance computing centers, with customers like Abbott Labs and we're now competing for the business with their spinoff Abbott B. Where in a number of ISXs -- IXPs, excuse me, around the country, including Moscow, London and a couple of the Asia-Pacific region. We are sitting here today in the Wynn Hotel of Las Vegas, who is a very large customer in the gaming industry, both here and in Macau, as is the Galaxy. So we've had a strong presence in the casino and gaming industry. Beyond that, it's pretty much across the board.

Got it. And then I also want to ask, on competition, seeing some of the larger networking companies out there competing by bundling. Can you just give some commentary on what you're seeing in the competitive landscape? If any of that type of bundling activity has impacted you guys at all?

To be honest with you, I have not heard that from our sales team. So if it was impacting us, I'm sure I would have. So I would say, at the moment, that has not been a factor in any of the deals that I've been brought in the loop on.

Great, great. That's real helpful. Last one for me is, I want to ask about -- on the guidance there, it looks like revenue is guiding up a little bit, but EPS were about the same. Is there a margin impact we should be looking at on the guidance?

No. In our forward-looking guidance, we have given guidance between 55%, 56% and...

Gross margin.

Gross margin. And as a little bit of a background is that all of our manufacturing, essentially all of it is outsourced to a company called Alpha Networks. And we don't typically see, what you would call, overhead absorption or factory absorption costs from quarter-to-quarter. So the margin is pretty stable, except for pricing or mix.

Our next question comes from the line of Ross Berner with PCO Capital.

Just a quick couple questions. Could you give us a rough estimate or take a stab at guiding to how much revenue got pushed out because of the inventory shortages and just how we could think about that a little bit?

Roughly, it was in the $4 million to $6 million of revenue orders that we know about. Frankly, my greater concern is the resellers who didn't place orders because they knew there wasn't product availability and filled demand with other products because they had their targets to meet for the June quarter and the month of June. So I think there's more business out there to be had once we had inventory than what we actually saw orders on the books for. But physical orders in hand for revenue as opposed to channel stocking orders was in that range.

Okay. And prior to your arrival, Chuck, last year, there's been lots of talk about pricing competition, and given just the falloff in demand, how tough the environment was. Given that you're starting to see demand pick up and you've already got into kind of 55% to 56% gross margins, are you seeing price not be an issue out there? I know what you said in terms of bundling products. But is pricing starting to feel better to you?

Well, this is a competitive marketplace, and I think pricing will always be a factor. And to the question earlier of the 1 gig to 10 gig and 40 and 100 gig transitions eventually, those switches, today, are at a higher price point, reflecting our higher capacity, but we expect we'll see erosion of that going into the future. The price competition has not been so intense as to materially reduce our gross margin. I think we're pretty disciplined at holding our price points and selling the added value that we have in our switches, both from the hardware perspective, as I mentioned, and the incredible characteristics we have there, as well as leveraging XOS as a key differentiator. So I think we will be able to hold margins in the hardware part of our business and I have a strong confidence, over time, in our ability to grow margins by monetizing our software assets better than we do today and increasing our service attach and renewal rates.

Okay. And my last question, Chuck, is the -- you talked kind of earlier on about being consciously optimistic about maintenance and service contracts as a kind of low-hanging revenue growth opportunity in terms of attachment rates and getting that higher. Can you give any more clarity or visibility, as you've come up on your 90th day now, what you're seeing out there in terms of that opportunity?

Well, again, as I mentioned my comments, it's one of the 5 or 6 key areas that we're going to focus on. It's one of the areas that Ed Carney will now manage, and he's got tremendous experience from running several different services organizations over his years at Cisco. So I think we are quickly building a credible capability to increase that. Today, we're at just slightly under 20% of tax rate on service products. And I think an industry standard is more in the upper 20s to low 30s. So that's where we need to be, and I think that will take several quarters to start to move in that direction and get to those kind of levels.

And I'm showing no further questions at this time. I'd like to hand the call back over to Chuck Berger for any closing remarks.

Thanks, everyone, and I appreciate, again, the interest in the company. This is the beginning of a very long path for me. I have been with the company for only 90 days. I will reiterate what I said on the last earnings call where I'd only been with the company 3 days, I think we have unbelievable potential with a very large customer base, with the best technology in the industry, both hardware and software and an incredibly strong financial position to back that up. That said, as I commented in the press release, there's room for far better execution in virtually everything we do. We've started to strengthen the management team towards that end, along with me joining, and we hope to continue to deliver improved results going into the future.

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