Extreme Networks, Inc. (EXTR) Q1 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Extreme Networks' Q1 Fiscal Year 2018 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions]. As a reminder, this call is being recorded. I would now like to introduce your host for today’s conference, Brandi Piacente, Investor Relations. You may begin.

Thank you, Heather, and welcome to the Extreme Networks' first quarter fiscal 2018 earnings conference call. 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 Extreme Networks' Web site for replay shortly after the conclusion of the call. By now you've had a chance to review the company's earnings press release. I would like to remind you that during today's call, management will be making forward-looking statements within the meaning of the Safe Harbor Provision of Federal Securities Laws. These forward-looking statements involve a number of risks and uncertainties, which could cause actual results to differ materially from those anticipated by these statements. These risks include our ability to successfully integrate the recently acquired assets, technologies and operations from Avaya and Brocade into our business and operations, including, but not limited to, the following risks; difficulties we may experience in the retention, assimilation and successful integration of employees and teams, acquired operations, technologies and/or products, unanticipated costs, litigation or other contingent liabilities associated with the acquisitions that could negatively impact our operating results and financial condition, adverse effects on existing business relationships with suppliers and customers, and difficulties we may experience in reaching our aspirational goals related to the acquisitions. For a detailed description of risks and uncertainties, please refer to our most recent reports on Form 10-K, 10-Q and 8-K filed with the SEC. You should not place undue reliance on forward-looking statements, which speak only as of today. We undertake no obligation to update these statements after this call. Throughout this call, we may make reference to both GAAP and non-GAAP financial metrics. Non-GAAP information should be considered a supplement to and not a substitute for, financial statements prepared in accordance with GAAP. Reconciliation of non-GAAP to corresponding GAAP measures can be found in our earnings press release issued today. For your convenience, a copy of the release and supporting financial materials are available on the Investor Relations section of the company's Web site at extremenetworks.com. Now, I will turn the call over to Extreme's President and CEO, Ed Meyercord, for his opening comments.

Thank you, Brandi, and thank you all for joining us this afternoon. Welcome to the new Extreme's Q1 earnings call. Today, we are pleased to announce financial results for fiscal Q1 highlighted by 73% growth in total revenue, our second quarter in a row of organic growth within the core Extreme portfolio, excluding acquisitions, and more than doubling our cash flow and earnings. The new Extreme is taking market share with enterprise customers. Our rapid growth to number three in our target market with over 30,000 customers and over 1 billion in annualized revenue has created a heightened awareness of Extreme in the industry elevating our brand and creating an unprecedented level of new opportunities. Our exclusive focus on delivering end-to-end software-driven networking solutions from the wireless edge into the hybrid cloud data center is a differentiator. And our existing and newly acquired customers will also say our number one ranked customer support distinguishes us and they greatly value our 100% in-source technical service. Our strengthening competitive position is evident in our financial results. Q1 results for fiscal '18 highlight customer demand for our networking technology, the success of our solutions go-to-market strategy and the accretive impact of our acquisitions of Extreme WiNG and Avaya's networking assets that we will refer to as the Extreme Campus Fabric. We delivered non-GAAP earnings per share of $0.16, growth of over 100% compared to the first quarter a year ago marking the 10th consecutive quarter Extreme has met or exceeded our earnings guidance. And for the second quarter in a row, we delivered operating income in excess of 10% and positive GAAP earnings highlighting the benefits of our operating leverage with increased scale. In Q1, we achieved our second quarter in a row of organic revenue growth and our core Extreme portfolio driven again by strength in wireless and software-driven sales that include our Extreme Management Center and wired switch portfolio. We will continue to forecast mid to low-single digit organic growth in our core Extreme business on an ongoing basis and overall growth in the 60% to 70% range when you factor in new revenue from Campus Fabric and the assets acquired from Brocade that we will call Extreme data center. We are quite pleased with the focus of our teams. We delivered on our numbers and continue to execute well despite all the extra time and resources required to integrate and onboard our new team members, customers and partners, develop our combined product roadmaps, build out our engineering labs and resources and combine all the data and systems that support the businesses. We’re pleased to report that our acquisitions are performing in line or better than expected. Extreme WiNG has been performing within the 29 million to 35 million revenue range we set with higher than forecast gross margins. We picked up a large base of blue-chip, large enterprise customers in the Fortune 500, particularly in retail, transportation, logistics and hospitality where we see significant cross-selling opportunities with our software and wired portfolio. Going forward, in our quarterly commentary we will consider Extreme WiNG to be part of our core business. This will be the final quarter that we comment on WiNG results independently. The Campus Fabric assets we acquired from Avaya in mid-July also performed in line with our expectations for the quarter. As you may know, with the announcement of our Secure Automated Campus launch, the technology integration of our newly acquired fabric with our wireless, switching and Extreme Management Center software is well ahead of plan. We already booked cross-selling revenue for a large hospitality customer and a large European government account utilizing our new Campus Fabric technology with our wireless and Extreme Management Center software during our first quarter as a combined company. Going forward, we expect the Campus Fabric revenue to be in line with our 200 million annual forecast and expect to drive margin improvement. And finally, with the close of our purchase of the data center assets from Brocade at the end of October, we added an important piece of the puzzle that helps us complete our enterprise networking solutions portfolio. We now have the leading edge solution for the large scale data center needs of the Fortune 500 enterprise customers. This creates even more cross-selling opportunities and expands our addressable market to all enterprise customers. This also opens the door to new service provider relationships who either use our switching and routing platforms with our network automation tools to run their back offices or to offer industry leading data center solutions to their enterprise customers. We’re projecting to be on track with our 230 million revenue target for our new Extreme data center business over the next 12 months. In each of these acquisitions we picked up new customers, partners and employees who are excited to return to a company that’s winning in the market and 100% committed to networking and enterprise environments where our customers are actively building and supporting hybrid clouds environment, managing the on-slot of wireless devices, driving more bandwidth and security requirements, Extreme has the best solutions in all places of the network. We make it easy for enterprise customers to deliver a high quality of experience for their end users. No other competitor has this unified architecture for wired and wireless, dense and distributed, on-prem and cloud-managed networking. Enterprise customers no longer need expensive Cisco trained engineers to recommend lines to perform network functions. They can run much more efficiently and more quickly with our user interface running Extreme Management Center over our simple, secure and intelligent networking fabrics. The acquisitions also strengthened our competitive position in key industry verticals whether it’s a very large healthcare system provider in the U.S. from a buyer, a large WiNG retailer in the UK, a large research institution in Europe from Brocade or a large manufacturer in Germany who uses technologies from all four vendors. Each of our enterprise customers leverages our technology platforms in different ways. They provide valuable industry references as well as proven architectures for us to prescribe to our sales teams when we go to market. Our Extreme Management Center software is the glue with a common data base for all connected devices in the network across the entire enterprise. Now with over 30,000 customers and expanded solutions, growth from cross-selling is a big opportunity. WiNG’s Guest Portal and Location Inc. for retail can be a powerful tool in hospitality and in healthcare. Our Campus Fabric technology which is delivering unmatched ease of deployment, agility, hyper-segmentation and security for hospitals can be applied to all enterprise campuses. Extreme’s stadium analytics can be used to drive better business outcomes in retail, manufacturing, government and education. And our new high-performance data center switching and routing platform with the industry’s easiest to use drag-and-drop network automation tools are creating new opportunities with our large enterprise customers. These are just a few examples. Net-net, we are very competitive in all places in our customer networks with unique software to help our customers deliver better business outcomes across the entire enterprise. Two weeks ago, we were pleased to have third-party support to validate our unique software-driven solutions in differentiated unified architecture. For the fourth consecutive year in a row, Extreme has move up in Gartner's Magic Quadrant for wired and wireless LAN, one of the most relied upon resources for enterprise customers. Of the 16 customers in the Magic Quadrant, we were one of two moving up to the right again putting us much closer to Cisco and HP in a tight group, distance from the rest of the pack. And Gartner's peer insights provide third-party recognition of our number one ranking in customer service for the enterprise. This is the best marketing we have and our teams, partners and customers are leveraging this valuate recognition in the market. At the time of our last earnings call, we had just completed our kickoff meeting with a 1,000 strong of our internal global sales teams and three weeks ago we completed our largest and most successful global partner summit in history with excellent representation from core Extreme, new Avaya and Brocade partners. The feedback has been overwhelmingly positive with the excitement focused on the strength and scope of our new technology portfolio and the growth opportunities that exist with our large high-quality customer base around the world. And finally, last week we kicked off Extreme NOW, our World Tour to bring our leadership directly to customers in 55 cities in 22 countries. We’re expecting to meet with thousands of customers and will culminate with the largest users’ conference in company history in April. The benefit of higher quality solution sales are evident at our fourth quarter non-GAAP gross margins that jumped 40 basis points year-over-year to 56.7%. This is our 10th quarter in a row of delivering year-over-year gross margin expansion and importantly the year-over-year comparisons this quarter includes lower margin revenue from WiNG wireless and Campus Fabric. We see many opportunities to improve our WiNG and Campus Fabric gross margins in the coming quarters. If we adjust gross margins for WiNG and Campus Fabric, Extreme’s core portfolio non-GAAP gross margins for Q4 would be approximately 58.5%. When we add a full quarter of the new Extreme data center business running in the low 60% range, this will bring us very close to our 60% target for the new Extreme in fiscal Q3. We expect to achieve this 60% target in our fiscal fourth quarter in June of '18. Solution selling, when we focus on solving customer issues with our software, is being embraced by our field teams and delivering sticky customers with lower discounts and higher gross margins. We’ve also increased the number of tactical gross margin improvement initiatives for fiscal '18 by leveraging best practices from newly acquired businesses. Changes in discounting policies and procedures, new services’ sales initiatives to drive attach and renewals, supply chain improvements along with new software tools and new partners from our acquisitions and product lifecycle management are major drivers. We also expect to benefit from coming off TSAs. We’re targeting January for our data center business and April for our Campus Fabric business. From an operating expense perspective, we will continue to be disciplined. The benefits of operating leverage with WiNG and Extreme Campus Fabric along with our efficiency initiatives contributed to improved year-over-year operating income to 10.6%, the second time our new team broke the 10% objective we put in place two years ago and the year-over-year increase of 340 basis points. While we expect to realize higher operating margins when our new data center assets are fully reflected in our results, the timing of the closing of Brocade transaction will have a one-time effect of lowering our operating income margins in fiscal Q2. Then, we expect it to increase our operating margins in the quarters that follow. Drew will take you through the effects of Brocade’s October year end, the timing of our close and linearity for the rest of the quarter to provide more detail to our Q2 guidance. Net-net, the addition of our Campus Fabric and data center assets will drive cash flow and earnings accretion toward our targeted 15% operating income margins in fiscal Q4. And with that, I’ll turn it over to Drew to review our results and guidance in detail.

Thanks, Ed. I will get started with a few highlights from our first quarter of fiscal 2018. In Q1, for the second quarter, we are reporting year-over-year organic revenue growth from our business prior to the acquisitions, and we are pleased to report another quarter of GAAP profit as well. Revenue growth came from solution sales from both wired and wireless products. Our fiscal Q1 of '18 marks the 10th consecutive quarter that we have improved our non-GAAP gross margin and non-GAAP operating income compared to the same quarter year-over-year. This is before adjustments made to the prior year’s financial statements as a result of our adoption of the new ASC 606 revenue recognition guidance, which I will discuss in more detail in a moment. Our non-GAAP gross margin improved 40 basis points year-over-year to 56.7% even after the dilutive effect of the acquired WiNG and Avaya Campus Fabric businesses, which we did not have in Q1 last year. In 2018, we will continue to focus on gross margin and initiatives we put in place in 2017 and we will work to drive continued improvement in all of our products and services, including those recently acquired. Now let’s review the first quarter results, starting with revenue. As of the beginning of the first quarter, July 1, we adopted the ASC 606 revenue recognition guidance. Under the new guidance, we will now recognize revenue when we sell or ship product to our distributors and make an estimate for rebates or potential distributor returns at the time of shipment. Previously, we deferred revenue and accrual of rebates and returns when products shipped to distributors. The adoption of 606 did not require adjustments to our Q1 '18 financial statements; however, we retroactively adjusted our income statement and balance sheet for fiscal years 2016 and '17 to reflect those periods under the 606 guidance as required. To be clear, these adjustments mainly reflect revenue recognition at the time the product was shipped to the distributor, the removal of deferred revenue for shipments to distributors and an adjustment to reduce accounts receivable by the estimated rebates and potential returns from distributors. We have included two slides in our earnings presentation showing the adjustments to the prior year’s financial statement. Q1 revenue was 211.7 million compared to 178.9 million in Q4 as adjusted and 122.6 million, as adjusted for Q1 a year ago. The geographical split of our revenues is as follows. The Americas contributed 53% of total revenue; EMEA contributed 38% and APAC contributed 9%. Product revenue for Q1 was 164.8 million compared to 141 million in Q4 and 90.1 million in Q1 last year. Q1 service revenue was 46.9 million compared to 38 million in Q4 and 32.5 million in Q1 last year. Moving on to gross margin and operating expenses. In Q1, GAAP gross margin was 53.1% compared to 57.4% in Q4 and 53.7% in Q1 last year. Non-GAAP gross margin was 56.7% which compares to 57.5% in Q4 and 56.8% in Q1 last year, as adjusted. Q1 GAAP operating expenses were 107.9 million compared to 87 million in Q4 and 69.9 million in Q1 last year. Q1 GAAP operating expense includes amortization of intangibles of 1.6 million, stock-based compensation charges of 4.6 million and acquisition-related expenses of 4.2 million. Q1 non-GAAP operating expenses were 97.5 million and compares to 79.9 million in Q4 and 60.2 million in Q1 of '17. The sequential increase in non-GAAP operating expenses was mainly attributable to the addition of the expense from the Campus Fabric business. First quarter GAAP operating income was 4.5 million compared to operating income of 15.7 million in Q4 and a loss of 4 million in Q1 last year. First quarter non-GAAP operating income was 22.5 million or 10.6% of total revenue compared to 22.9 million or 12.8% of total revenue in Q4 and 9.5 million or 7.8% of total revenue in Q1 last year. GAAP net income for Q1 was 4.4 million or $0.04 per share compared to net income of 13.2 million or $0.12 per share in Q4 and a net loss of 5.7 million or $0.05 per share in Q1 last year. GAAP net income in Q1 this year included a $3.8 million gain from the sale of an equity investment we held in a private company that was acquired. Non-GAAP net income for the quarter was 18.6 million or $0.16 per diluted share and compares to net income of 20.4 million or $0.17 per diluted share in Q4 and 7.8 million or $0.07 per share in Q1 of '17. Turning to the balance sheet. Q1 cash and cash equivalents benefitted from strong collections and we ended the quarter with $153 million, up 22.6 million from the end of last quarter and up 50.7 million from the end of Q1 of '17. During the quarter, cash flow from operations was 18.6 million compared to 15.3 million in Q4 and 9.6 million in Q1 last year. Free cash flow was 11.2 million compared to 12.7 million in Q4 and 7.9 million in Q1 last year. Accounts receivables were 107.6 million at the end of Q1 and up 14.5 million from the end of Q4 on higher sales and 59.6 million from the end of Q1 of '17 with the addition of the acquired WiNG, wireless LAN and Campus Fabric businesses. DSO increased slightly to 51 days this quarter compared to 47 days in Q4 and flat at 51 days in Q1 of '17. Inventory for the quarter ended at 58.1 million, up 10.7 million from last quarter and up 13.4 million from Q1 of fiscal '17. Total debt outstanding at the end of Q1 was 167.6 million compared to 51.9 million at the end of Q1 last year. The increase is attributable to the amended term loan in connection with the Campus Fabric acquisition. Now let’s move to the guidance for Q2. We expect total Q2 revenue to be in the range of $236 million to $246 million. Our second fiscal quarter will include nine weeks of revenue from the data center acquisition. Brocade’s fiscal 2017 ended on October 27th, one month into our fiscal Q2. The data center business has similar linearity to Extreme where a higher percentage of the quarterly revenue occurs in the third month of the fiscal quarter compared to the other two months. Based on that linearity, we expect the revenue contribution for November and December to be roughly 40% to 45% of a full quarter for the data center business. We previously stated we expect the data center business to generate $230 million of revenue per year. Q2 GAAP gross margin is anticipated to be in the range of 52.5% to 54.1% and non-GAAP gross margin is estimated to be in a range of 56.9% to 58.4%. Our anticipated increase in gross margin is driven by the addition of the data center business and the benefit of our gross margin initiatives. Q2 operating expenses are expected to be in the range of 158.9 million to 162.9 million on a GAAP basis and 117.7 million to 121.5 million on a non-GAAP basis. Tax expense is expected to be 2.1 million to 2.6 million, up from previous quarters on higher revenue. Q2 GAAP net loss is expected to be in a range of 35 million to 40.2 million or a loss of $0.31 to a loss of $0.35 per share. Non-GAAP net income is expected to be in the range of 11.7 million to 16.9 million or $0.10 to $0.14 per diluted share. As part of the acquisition of the data center assets, we paid $25 million as a consent fee to Broadcom to allow Extreme to acquire the assets directly from Brocade as previously disclosed. The GAAP net loss estimate above includes the $25 million consent fee as an expense. Our earnings guidance reflects the expectation that we will realize approximately 40% to 45% of the revenue from the data center business in the quarter, as discussed earlier, while incurring roughly 67% of the services cost of sales and operating expenses which are primarily headcount related. We estimate this impact to be between $0.05 and $0.07 earnings per share. To further illustrate this, we’ve included a slide, Slide 16, in our earnings presentation available in the Investor Relations section of our Web site. In the illustration; service, cost of sales and operating expenses are incurred relatively evenly throughout the quarter while more revenue is recognized in the third month of the quarter. This results in lower gross margin and profitability in the first two months of the quarter and a recovery of profitability in the third month. The contribution of the data center business to our Q2 will be indicative of the first two months illustrated in the slide with our quarter ending December 31st. In fiscal Q3, we expect to receive the full benefit of the data center business. In Q2, we expect average shares outstanding to be approximately 114 million on a GAAP basis and 119 million on a non-GAAP basis. This concludes our prepared remarks and we will now open up for questions.

Thank you. [Operator Instructions]. Your first question comes from Simon Leopold with Raymond James. Your line is open.

Hi, guys. This is Victor in for Simon. I just want to make sure I’m doing the math correct here. Of the high end of your December guidance for the $246 million, let’s say, you’re expecting about 23 million of Brocade. Is that correct?

Yes, 23 million to 26 million.

Okay. And the large maturity of that difference from your – the run rate of your target is driven by the fact that the January quarters – it’s heavily loaded in the January quarter, is that right?

Yes, the January month would be their heavier month there. Their year-end was October. And that was their heaviest month and that’s – and then January would be their next quarter end and that would be their heavier month of revenue. As we said, we expect to get about 40% or 45% of the revenues.

Right. But 60%-something of the expenses --

Yes, but we anticipate it to be about two-thirds of the expenses because those are pretty linear. We can control some spending but the majority of the expenses are headcount related and we’ve got those people onboard now.

Okay. So does that imply for the March quarter then that it will be heavy – actually that it will be a little bit higher, I guess, then?

It won’t really be higher. It’s probably going to take a while. We think it will probably slowly happen over a couple of years where the data center business linearity starts to follow our linearity. But just for the March quarter we expect it to be very similar to their past linearity. So we would expect January to be 50% or more of the revenues and then February and March would be less. But net-net, it will be a normal quarter for them.

Okay, great. Let me see here. Just really quickly – I’m sorry, it seems that the ASC 606 adjustment doesn’t have too material of an impact from what I’m looking at --?

It doesn’t on the quarter, so we don’t make any adjustments to the current quarter because – and what you do is you go back and you retroactively restate the previous year 2017 and also '16 and you restate those periods as if you had applied the 606 guidance to those years. So then it changes in the year-over-year compares.

Okay. Are you seeing any slowing from Brocade’s core customer base kind of around the acquisition and is there that dynamic where you have a slowing ahead of the acquisition and then resumption in spending when customers become more confident in the product and thus support buying product?

Hi, Victor. This is Ed. Yes, I think it’s fair to say that there is some business slowdown on the Brocade side during the Broadcom-Brocade uncertainty around that acquisition. And then you could say the same thing is true with Avaya as far as them being in a period of bankruptcy. We’ve seen it but we’re encouraged by the pipeline and the opportunities and we think – the partner conference that we just held, we heard a lot of really good things from long-time partners from both of those companies and we expect to see a rebound in buying activities. The customers and partners will want to wait and see what we’re doing with the product portfolio. We’re clearly communicating that we’re going to continue to invest and protect the customers’ investments in their network. So we’re expecting to see business come back in both companies.

Great. I’ll see you for now. Thank you.

Thank you. [Operator Instructions]. And I am showing no further questions at this time. I’d like to turn the call back over to Ed Meyercord for closing remarks.

Well, thank you. Thank you everyone who could join us on the call today. And I also want to thank all the employees of the new Extreme who are listening in. I want to thank them for a job well done. I’m proud of our team for delivering our 10th consecutive quarter of meeting or beating our earnings guidance and more than doubling our cash flow and earnings while closing and integrating our new Campus Fabric acquisition and mending and closing our data center acquisition. It was a very strong quarter. So thank you all for your participation and have a good evening.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you all may disconnect. Everyone, have a wonderful day.