Good day and welcome to the Extreme Networks Q3 Fiscal Year 2023 Financial Results Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions]. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker, Mr. Stan Kovler. Please go ahead.

Thank you, operator. And good morning, everybody. Welcome to the Extreme Networks third fiscal quarter 2023 earnings conference call. Thank you all for your patience. We were experiencing some technical issues with the webcast that have been resolved now. So, everyone is able to join. I lead investor relations and corporate strategy. With me today are Extreme Networks' President and CEO, Ed Meyercord, and Interim CFO, Cristina Tate. We just distributed a press release and filed an 8-K detailing Extreme Networks' financial results for the quarter and earlier this week filed an 8-K announcing our new CFO. For your convenience, a copy of the press release, which includes our GAAP to non-GAAP reconciliations, is available in the Investor Relations section of our website at extremenetworks.com along with our presentation, which should be up right now. There's a link. I would like to remind you that, during today's call, our discussion may include forward-looking statements about Extreme's future business, financial and operational results, growth expectations and strategies. Our financial disclosures on this call will be made on a non-GAAP basis, unless stated otherwise. We caution you not to put undue reliance on these forward-looking statements as they involve risks and uncertainties that can cause actual results to differ materially from those anticipated by these statements, as described by our risk factors in our 10-K report for the period ended June 30, 2022 filed with the SEC. Any forward-looking statements made on this call reflect our analysis as of today and we have no plans or duty to update them except as required by law. Now, I will turn the call over to Extreme's President and CEO, Ed Meyercord.

Thank you, Stan. And thank you all for joining us this morning. Extreme delivered another quarter of record results, driven by solid execution of our teams. Our top line performance was highlighted by improvements in our supply chain that drove 16% total revenue growth and 22% product revenue growth on a year-over-year basis. We achieved double-digit growth in eight of the past nine quarters. Our operating margin and EBITDA also achieved quarterly records in Q3. Product orders grew 6% sequentially and orders from new customers grew 20% during this timeframe. This is the second consecutive quarter where new logos are playing a substantial role in our growth. We believe demand trends will continue as customers recognize the simplicity of our one network, one cloud solutions relative to the complexity and total cost of ownership of our largest competitors. Although our Q3 bookings typically declined sequentially in the March quarter, we in fact grew from December, reflecting strong demand. With our funnel of opportunities remaining robust, we expect more normal seasonality and higher sequential growth in Q4. We expect total revenue growth to accelerate to over 20% from the prior year based on improved product availability. And we're reiterating our long-term growth outlook in the mid-teens through fiscal 2025 based on confidence in our ability to take market share, given the size of our market, where small share gains have a big impact on our growth rate. For the first time, Extreme's non-GAAP operating margin surpassed the 15% mark, and we achieved EPS of $0.29 cents in Q3, up from $0.27 in Q2 and from $0.21 in the year ago quarter. We expect these bottom line earnings trends to continue and for earnings to grow faster than revenues over the long term, given increasing gross margins and operating leverage. Demand is…

Thanks, Ed. Q3 financial results reflect record revenue, operating margin and EBITDA, driven by increased product availability. We were also able to pay down $25 million in debt and repurchase $25 million worth of our shares, leaving net debt at just $34 million. The strong execution of our teams drove 29% growth in new SaaS bookings and our SaaS ARR continued to rise. We are confident in our Q4 and FY 2023 outlook and reiterate our commitment to mid-teens long term growth through fiscal year 2025. Our third quarter revenue of $332.5 million grew 16% year-over-year and 4% quarter-over-quarter, exceeding the high end of our expectations entering the quarter. Product revenue accelerated to 22% growth year-over-year and 8% sequentially, attributable to both campus switching and wireless LAN, partially offset by a decline in data center. New subscription bookings grew by 29% year-over-year. SaaS ARR grew 22% year-over-year to $117 million, up from $96 million in the year-ago quarter. Subscription deferred revenue was up 39% year-over-year to $199 million. Revenue on a geographic basis once again reflects the timing of product shipments to our distributors across the regions. Regarding our bookings performance, as Ed mentioned, product bookings grew 6% sequentially, and we continue to expect sequential bookings growth into Q4 as well. The supply chain environment is improving significantly and lead times are coming down faster than we expected. During Q3, our direct customer order backlog did remain flat. With product shipment lead times coming down, our distributors are adjusting their stocking orders to align with delivery timing. At the end of Q3, our backlog represented 5 times our expected normalized level. We continue to expect the normalized level of backlog to be in the range of $75 million to $100 million by Q1 fiscal year 2025. Although distributor backlog is…

[Operator Instructions]. Our first question will come from the line of Mike Genovese with Rosenblatt Securities.

I guess I have to ask you about the just the distributor backlog change, if you could give us more color on that. I guess from the numbers you guys gave on calculating that, backlog maybe went down about $100 million quarter-over-quarter? And I guess one question is, is all of that is going to be in revenue this quarter, next quarter, the quarter after or can some of that actually sort of "go away."

Mike, let me jump in. And then Cristina feel free to follow. There's a distributor component of backlog and then there's the customer order component. And as we said, the customer order component of backlog did not change during the quarter. But the distributor ordering is driven by lead times and lead times came in faster than we expected this quarter, which that occurrence is good news because it means that the market is getting healthier and we're able to deliver products to customers sooner. At the same time, it means that our distributors will adjust their orders accordingly. And the early ordering that we had experienced earlier would effectively go away and older orders would be adjusted effectively and modified to the shorter lead time. So, what we're doing is we're trying to focus people, Mike, on our revenue outlook and we're confirming the mid-teens revenue growth through our fiscal 2025 and with a new target point of $75 million to $100 million in ending backlog. We think that distributors going forward are going to have – they'll keep more orders on us and they'll have more inventory on hand, so they don't get caught the way they got caught this last cycle. So what we want people to do is focus on that $75 million to 100 million and then that would be a landing point for backlog, and then focus on what we're calling is going to be this mid-teens revenue growth rate through fiscal 2025. Cristina, I don't know if you want to add anything to that.

I would just add that, as we went through this constrained supply chain environment, the days the distributors were on order with us was elevated. And as lead times come down, as Ed mentioned, the whole environment is getting normalized, and so the distributor orders and the backlog is coming to that normalized level of $75 million to $100 million. And we expect that to get to that level at around Q1 2025. And as Ed said, our scenario based planning gives us commitment and confidence in the guidance that we gave.

Clearly, when I do look at the growth rate for this year and what you're projecting for the next couple of years, we don't see anything sort of macro negative here. And so, I was wondering if you believe that's more of a function of healthy trends in the verticals that you play in and it'd be great if you could sort of go through some of those verticals and sort of rank what you're seeing. Or is it a function of share gains? Or how do you see your success as what's the main driver there?

Mike, I think you hit on all three. First of all, we're playing in – we mentioned and I think Cristina reviewed our verticals and how we're doing in terms of our government accounts internationally and state and local governments in education. Retail was particularly strong for us this quarter. Obviously, when you get huge wins like Kroger, that has an effect on mix. Manufacturing remains strong. Overall, enterprise spending and networking has been pretty resilient. And I think when you do market checks with some of the larger distributors and some of the resellers out there, I think they'll tell you that networking is probably one of the more resilient categories. The other one is, obviously, we're taking share, and we're taking share in terms of our batting average and winning competitive processes, Kroger being a great example. And then also, we also mentioned an E-Rate win where we have a very large channel reseller, very well-known out in the market, that's doubling down on Extreme. So they grew their E-Rate bids with Extreme by 100%. And then we won a 50% more. So, even in a E-Rate market that was considered to be somewhat soft this year, with that channel partner we saw 50% growth. So we have opportunities to grow with our partners. As I mentioned, our funnel looks very healthy and our batting average continues to hold up. We're performing well because of competitive differentiation. And I think, overall, where we play in the enterprise market is pretty resilient.

If I just do one final, quick follow-up. Should we just assume that in the future that we won't see the backlog and the book-to-bill in the quarterly presentation? So is that a change going forward?

Yeah, I think what we'll do is we'll let you know how we're trending towards that end goal.

Congratulations on a great outlook.

One moment for our next question. And that will come from the line of Alex Henderson with Needham.

Obviously, a very nice quarter, a nice print. The only thing that surprised me was that inventory actually went up. I was expecting, as supply improves, that inventory might go down and create additional cash flow. Obviously, you had excellent cash flow in the quarter, but inventory went up. Can you give us a sense of the timing of when you expect inventory to start to normalize and come back in and when that cash generation will occur?

At a high level, Alex, we're shipping out a lot more product and we're expecting our product shipments to increase. So, I think you'll expect to see that build is, is we're building inventory to support shipments of more product. But let me have Cristina jump in.

Inventory was actually unnaturally low during the supply chain constrained environment. And so, the fact that our inventory is increasing is another sign that the supply chain environment is improving, raw material is flowing, finished goods. We're building our finished goods to be able to ship out. So there is an element of timing to this as well. But we do actually expect inventory to keep going up for the next few quarters as the product flows and then we'll get to normalized level. I'll just say, just reiterate again that the levels we were seeing were not natural and we're getting to a more normalized level of inventory internally as well.

Looking at the subscription business, the SaaS particularly, the mechanics of a high growth in SaaS subscription generally creates a reduction in realized revenue in the period that those contracts happen. If that had been a direct product order instead of a SaaS order, obviously, you would have ended up with higher revenues on the upfront sales instead of just the small portion of the SaaS subscription. So can you give us a sense of what the reduction in the contribution to growth is as a result of the high rate of success in your SaaS business?

We're not seeing a high level of cannibalization. So, we had a very – I would call pretty low upfront software business that has been trending down over time, but it was not significant or material. And so, the subscription growth is not cannibalizing from that or from our product sales.

Well, it's not cannibalizing, but it's not being recognized in the current period. It's being deferred into future periods because of the mechanics of SaaS. Whereas normally, if you sold the product, the same amount of product that you sign in a SaaS subscription, you would get more upfront and less in the future periods. So almost by definition, if you signed something on March 31, you get no revenues in the quarter, whereas if it was purchased, you would have the entire revenue. So clearly, it has to reduce the recognition of revenue.

Sure. As the mix of our revenue shifts to more recurring revenue, such as SaaS and subscription, absolutely, that is going to happen because we booked the contract, it may be a single year contract or a multi-year contract, but we recognize that revenue over time. So, yes, as our overall mix shifts, that phenomenon will be definitely there. I thought you were saying that it was actually reducing some other part of our business.

The recognition timing of it.

Yes, agree.

If it had been straight product sales, how much additional revenue growth would have been in the quarter?

I don't know if we have that answer.

Yeah, I don't have that answer.

Maybe we can take it offline and come back and dig in a little deeper. One of the things that Cristina mentioned earlier is that, because of backlog, we do have a lot of subscription, as well as service and maintenance tied up in that backlog. And then as that releases, we are expecting to see an acceleration in that growth rate. The other thing that I mentioned is that we're doing a lot of work, so that we can effectively sell subscriptions on all of our hardware, which we don't have today. And that that will also create a really nice growth wave in addition to some of the other – the packaging and the services that we're putting together with some of our partners.

One last question. The universal product is making progress. I'm assuming that that's increasing as a percentage of revenues. There's gross margin benefit as that increases as a percentage of shipped product. And you additionally have a lot of supply chain costs that you've been absorbing as a result of inflated the logistics and parts costs. When we exit this year, how much is left of that cost to normalize in 2024/2025?

Our expectation for gross margin, we're reiterating our long term guidance of 64% to 66% by the end of FY 2025. So that gives you a sense of how much left. We're at 59.1% in Q3, we're guiding a midpoint of 60% in Q4, and then we expect to see that step improvement to the 64% to 66% range by the end of FY 2025.

So 400 basis points to 500 basis points of margin that's caught up in those two variables.

Both in supply chain costs as well as improvement in gross margin as well as the mix, seeing the subscription, higher margin subscription revenue, and our mix will also contribute to that margin expansion.

One moment for our next question. And that will come from the line of Dave Kang with B. Riley.

My first question is regarding gross margins. So, you've provided 60% for fiscal fourth quarter and then you're guiding to 65% for fiscal 2025. For fiscal 2024, should we think about gross margin sort of like – is it going to be like a linear ramp from fourth quarter to fiscal 2025?

Exactly. Similar to what we communicated last quarter. No change in that guidance that we expect to see about a half a point to a point of improvement each quarter sequentially as we head through FY 2024.

On your universal platform, can you give us an update? When should we expect full 100% universal?

We will be completing the build out of our universal platform over the course of this year. So we're excited about that. And then the adoption of our universal platforms has been incredibly high. So we would expect 90% by the end of the year. It's been our most popular seller in terms of the adoption. So the universal platforms have been our most successful product releases. The other thing I'll say is that the quality of universal has been significantly higher than any other product we've had in our history. So as it relates to operational support, it's been a very popular product.

If I remember correctly, I believe you mentioned something about expecting an uptake once that happens. Can you kind of quantify the situation? So I guess you're talking about next year? So should we expect some kind of a new uptick in orders or demand because of that?

Well, it's helpful. I'd say it's part of our solution. If you recall, universal hardware is the most flexible hardware in the market in the enterprise space because you can run different personalities when you combine that universal hardware with management and the features of our cloud and the cloud choice we bring. And then you combine that with our unique fabric technology, we're able to build solutions in the market that are better differentiated end-to-end, wired, wireless, across the wireless LAN in terms of our SD-WAN solution. So it creates a lot of flexibility. It provides simplicity and it provides choice. And yeah, that's absolutely a contributor on the demand side. When we look at this linear growth in our gross margin, we factored in the adoption of universal platforms into that equation. Cristina, I don't know if you want to add anything to that from a gross margin perspective.

No, just reiterate what you said. It's built into our outlook.

My last question is, should we still expect subscription revenue CAGR to be 35% to 45%?

Yes, we're confirming our long term guidance. Yep.

One moment for our next question. And that will come from the line of Paul Silverstein with Cowen.

It sounds like the demand you're describing is broad based. But I've got to ask, how much of the strength is specific to education and government? It sounds like that was extremely strong from your comments.

Paul, we had an incredibly large number of million dollar plus deals in education. And I'd say that, in that vertical, we are doing very well with the channel and partner community. I gave an E-Rate example where, even in a kind of a soft E-Rate climate, we have partner adoption, which is driving up our share in that market. We also have big wins this quarter, for example, Palm Beach County Schools, $6.5 million win. We're getting into the larger deals and we're winning more larger deals, and I think the channel community is realizing that they can get out and win with Extreme, quite frankly, we have a differentiated solution. What's interesting is that because of our success and some of the even larger wins in the retail verticals and then sports verticals, it was actually down. The math, normally, we talk about 40%, state/local government education, and in this quarter, it was down to 35%. We ticked up to 15% in retail. The other verticals kind of held in there. So it remains strong. And from our standpoint, we are seeing larger opportunities. We're winning larger opportunities. And that's part of the share gains story, which is why we talk about large crumbs and the opportunity for us to take small share points and it has a big impact on our bookings and, overall, our long term revenue target.

Just to be clear, the question I'm trying to get at, just to be clear, the strength you're describing is broad based. When you look at your order book, your funnel, your revenue, that's not primarily or exclusively about that public sector and education vertical that's been 35% to 40% of revenue. It's throughout your customer base. I just want to make sure…

That's correct. That's a correct statement. And the other point I'm trying to make is that there's partner penetration. One of the things that we talked about, we have Comcast as a new partner of Extreme, pretty large company, they do a lot of business. We won Cedar Fair, $8 million plus deal with a new relationship with a partner like Comcast. Verizon, we're now certified in Verizon's portfolio, and we're working directly with their enterprise sellers. Well, this is new. So we're opening up. And this is another large channel partner, and they're excited about our solution and bringing Extreme to market. So with some of these larger partners now, we have what are new growth opportunities with the same portfolio product. So from that standpoint, it is broad based. We will see overall enterprise growth. And then we would expect to see this growth happen really littered across all of our verticals.

One moment for our next question. That will come from the line of Eric Martinuzzi with Lake Street Capital.

Yeah, understand the R&D spending is up. I know you guys have Extreme Connect coming up here in a couple of weeks, just where are we pointing those R&D dollars at? Are these kind of evolutionary enhancements to the existing products? Or can we see some expansion in the breadth of where you're headed with the product portfolio?

A lot of what we're doing is investing in our existing platforms and developing the completion of our universal platforms, further development of our wireless platforms, and we're investing a lot obviously in cloud and the kinds of features that we can orchestrate over cloud. Historically, we've had a NAC product, which is effectively access control and security in the network. We're cloudifying that solution, and we'll be adding that into our offerings. The other thing that we're doing is we're packaging our complete solutions for new channel partners to provide managed services. In our space, managed services are on the rise, but it's commercially really complicated. And you hear us talk about simplicity, we're bringing simplicity to a market that's complicated. And we think we have a real differentiator with our managed services solutions portfolio. And this is taking effectively the existing products and our cloud and services that we have that we're developing and packaging it in a very simple licensing framework that's generated a lot of interest in the marketplace. So, this is an area where we expect to take share. And effectively, what we're doing is we'll be supporting a managed service. So, yeah, that will be coming out at Connect. And then finally, edge cloud, there's a lot of conversation about edge cloud. There will be a reveal at Connect, where, because of the way we're developing our platform, and it's really around cloud choice. No enterprise customer or supplier in the networking industry is able to offer the kind of choice that we can provide and choice has to do with public cloud versus private cloud versus what goes to data center versus kind of what stays on campus. We're going to be able to provide more flexibility than anyone as companies are wrestling with this. And so, there will be a reveal around Extreme edge cloud and where data resides in enterprise networks that I think will be further differentiation for Extreme. So these are areas that we're investing in. And quite frankly, there's a lot of interest in the market, particularly with large partners for these kinds of solutions.

One moment for our next question. That will come from the line of Greg Mesniaeff with West Park Capital.

I have a question for you regarding your network security offerings. As you continue to move upstream into subscription-based, cloud-based services, what kind of next gen network security products – or services, rather, are you going to be offering? And in doing so, can you sort of deliberately encroach on the turf of some of the network security vendors that you're working with right now?

Security in our industry is pretty complicated. There's a lot of different layers. People make the analogy of the layers of the onion to describe all the different elements. One of the big differentiators that we have in our solution set today is our fabric and our fabric technology that has inherent security built in, and then the idea that we can extend that security out across the wide area network with our SD-WAN solution is truly unique in the marketplace and brings a level of security that's just inherent in the network. So one of the things that we can do with that is effectively provide inherent security as opposed to an over the top solution, which brings a lot of simplicity again, and likely savings. Remember, we also have air defense, which is one of the leading Wi-Fi security solutions that's out in the marketplace. Obviously, this is something that's critical and winning something like a Kroger or these distributed networks. And that also is an element of our offer. And I referenced earlier, network access control and policy and identity management around who is accessing the network and access security. And we are taking what is very mature and proven technology and we're cloudifying this. And once again, we will have an access control security element that will be inherent and built into the network which will be differentiated. So we will be in a position to compete and we think attract a lot of interest by simplifying these security elements into a single solution within a single license that we believe will be disruptive in the marketplace.

One moment for our next question. And that will come from the line of Christian Schwab with Craig-Hallum.

As we look at the backlog which we discussed looked to be down roughly $100 million due to adjustments in distributor orders, can you tell us what percentage of the backlog that's left is deferred revenue customer orders or distributors still?

What we've said it's that the overall backlog is about 5x. Obviously, distributor behavior is a little more tied to lead times, and lead times came down faster. We're expecting them to come down. So we really don't want to get into sort of dissecting backlog. Really what we want to do is reinforce our outlook of revenue growth. And we're doing that out through our fiscal 2025, which is out there. And so, we baked that into our revenue guide. And that's where we're trying to focus everyone.

What you guys are doing then, I guess my second question is, you look at your scenario based planning over the next two-and-a-half, three years, what do you expect the industry growth rate for the verticals you serve to be growing at, how much market share gain are you assuming in that growth rate over that timeframe? And then what percentage is your catch-up orders from backlog that couldn't be shipped during COVID? Is that how you guys look at it or maybe you could explain…?

We have to factor in the industry. We're obviously factoring a backlog run-off. And then we're also looking at share gains. So I would say the overall industry, we see this kind of mid-single digit growth in the overall industry. When you look at the release of backlog, as I mentioned before, we're expecting our distributors to have more on order with us in the future than they did in the past because if we go back to pre-supply chain issues, it was very much a just-in-time model. And that, obviously, put a lot of risk on their business. So this is where we landed at that $75 million to $100 million number. So in your model, you should think about $75 million to $100 million of backlog as kind of the ending point in our Q1 fiscal 2025. So that's where we see that. And then, we have share gains. I know earlier in your report, you mentioned a large reseller that the outlook was down. In our case, with those kinds of resellers, because of their size, small share points create big opportunities. And we mentioned one of those resellers where literally in kind of a soft E-Rate market, we're up 50%. So these are the kinds of things that we can do at Extreme because of our relative size. And it gives us a growth advantage, if you will. Some of these other larger partners I mentioned, when you open up a Comcast, when you open up a Verizon, when you open up some of these larger managed services partners, we open up the door for growth opportunities where, quite frankly, we haven't played and the growth opportunities are quite large. So, a point of market share is over 20% growth on top of the market. So it doesn't take a lot of share gains for Extreme to outgrow the market and then for us to get to that that mid-teens number.

Thank you. And I'm showing no further questions in the queue at this time. I would now like to turn the call back over to Extreme Networks CEO, Mr. Ed Meyercord.

Thanks, Sherrie. And thanks, everyone, for joining the call. Obviously, we're excited about the quarter and the performance. We had a lot of records. I want to shout out to the Extreme employees, our partner community, everyone that joined in on these calls because we have a lot of momentum right now. And we say there's never been a better time to be at Extreme. The competitive differentiation is there and it's fun to be winning in the marketplace. So shout out to those teams. And then also investors for your continued participation and interest in the company. We're holding on to a very strong guide in terms of top line growth and margin expansion, both with the gross margin line and then operating leverage down in the bottom line. So, we appreciate your interest in Extreme and we're quite confident about the quarters to come. So thanks, everyone. And have a great day.

Thank you all for participating. This concludes today's program. You may now disconnect.