Calix - Q1 2023

Transcript

Operator (participant)

Greetings and welcome everyone to the Calix Q1 2023 earnings conference call. At this time, all participants are on a listen-only mode. A question-and-answer session will follow the brief prepared remarks. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jim Fanucchi, Vice President of Investor Relations. Sir, please go ahead.

Jim Fanucchi (VP of Investor Relations)

Thank you, Paul. Good morning, everyone. Thank you for joining our Q1 2023 earnings call. Today on the call, we have President and CEO, Michael Weening, Chief Financial Officer, Cory Sindelar, and Chairman, Carl Russo. As a reminder, yesterday after the market closed, Calix issued a news release, which was furnished on a Form 8-K, along with our stockholder letter, which was also posted in the Investor Relations section of the Calix website. Today's conference call will be available for webcast replay in the Investor Relations section of our website. Before I turn the call over to Michael for his opening remarks, I want to remind everyone on this call, we will refer to forward-looking statements, including all statements the company will make about its future financial and operating performance, growth strategy, and market outlook.

Actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause actual results and trends to differ materially are set forth in the Q1 of 2023 letter to stockholders and in the annual and quarterly reports filed with the SEC. Calix assumes no obligation to update any forward-looking statements which speak only as of their respective dates. In this conference call, we will discuss both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in the Q1 2023 letter to stockholders. Unless otherwise stated, all numbers referenced in this call will be non-GAAP measures. With that, it is my pleasure to turn the call over to Michael. Michael, please go ahead.

Michael Weening (President and CEO)

Thank you, Jim. As the Calix evolution continues, I want to start this call by sharing my view on why Calix is performing in a very different manner than the market in general. Three consecutive years of greater than 25% growth. As Cory will share, raising annual guidance for 2023. nine consecutive quarters of sequential growth. Three consecutive quarters of gross margin expansion as supply headwinds abate. Zero debt and a pristine balance sheet, which will see cash grow at an accelerated rate. These are clear indicators the Calix team is executing our strategy in a predictable and disciplined manner. More importantly, it is making it clear that Calix is alone in a new market. This new market is made up of broadband service providers who are building consolidated networks and efficient end-to-end operations that yield incredible margins.

This new market has BSPs leveraging data and insights from our platform and clouds to build an entirely new business model where they are the center of the home, the center of business, and the center of the community through the power of our managed services that grow revenue and customer satisfaction to record levels. BSPs continued to add subscribers and grow their business in Q1 through the power of the Calix platform, clouds, and managed services. The land and expand nature of our business was on full display in Q1 as we landed 11 new BSPs and expanded platform adoption as 38 BSPs adopted one or both of the Revenue EDGE and the Intelligent Access EDGE. This brings the total number of BSPs deploying our platforms to 988.

In Q1, 21 BSPs adopted one or more of our clouds, bringing the total number of cloud customers to 865. Perhaps the most important evidence that this is a new market is the growth of BSPs deploying one or more of our eight managed services. In the Q1, 41 BSPs began differentiating their offerings by launching one or more of our managed services. This is the fastest pace in the last five quarters and brings the total number of BSPs with managed services to 334. On that note, I'll now hand it to Cory to expand on the Calix team's performance in Q1. Cory.

Jim Fanucchi (VP of Investor Relations)

Thank you, Michael. Calix team executed well across the board as we delivered our ninth consecutive quarter of sequential revenue growth, with record quarterly revenue coming in at $250 million, which was modestly above the high end of our guidance range. As we have said before, we believe our supply chain will normalize over the course of 2023, and so it did. Vendors, for the most part, are meeting their delivery commitments, and we are starting to see lead times shorten. Consequently, this allowed us to continue to reduce our purchase commitments to $306 million, which were down $335 million from year-end. We expect our free cash flow to improve significantly as we invest less in inventory.

The improving supply chain has also allowed us to reduce our lead times to customers and to work with them to shrink their inventories as well. The consequence of this work was a sequential reduction in our Revenue EDGE system shipments within our small customer segment. At the same time, our large and medium-sized customer segments increased. Specifically, we saw strength from a large platform customer and continued shipments to a recently acquired medium customer, which contributed to the Intelligent Access EDGE record revenue in the Q1. In sum, our platform model provides us with a view of end subscriber demand, which enables us to work with our BSP customers to optimize their inventories. This enables us to perform in a predictable manner and forecast what we expect will be our 10th consecutive quarter of sequential growth.

Based on our Q1 revenue overperformance and the expected sequential increase in our Q2 revenue, we currently believe our annual growth for 2023 will be between 15% and 20%. Back to you, Michael.

Michael Weening (President and CEO)

Thank you, Corey. In closing, I will call your attention to two additional data points that further amplify that Calix is on a mission in a new market. First is the talent that we are attracting to our team. Industry leaders like John Durocher, who joined from Salesforce as the Chief Customer Officer, are joining because they are inspired by our purpose-driven culture, which is enabling even the smallest broadband service provider to simplify their business, excite their subscribers, and grow their value for their members, their investors, and the communities they serve. Second is the fact that Calix was recognized by Comparably as the number 1 best place to work in the Bay Area.

Our sales, marketing, engineering, and HR teams were ranked top 20 globally because our team members are inspired every single day to help our BSP customers transform the communities they serve by empowering families, students, and local businesses to thrive. More than ever, I'm excited about the future of Calix. As Cory Sindelar stated, we raised 2023 revenue guidance as we continue to execute in a disciplined and predictable fashion, supported by an enviable balance sheet. I would like to thank our amazing customers for their partnership, as it is their ideas that are delivered every 91 days when we update our ever-expanding platform, clouds, and managed services. I would also like to thank our partners and Calix team members for their continued support and dedication as we execute on this once in a generation opportunity. Jim, let's open the call for questions.

Jim Fanucchi (VP of Investor Relations)

Operator, let's move to the Q&A.

Operator (participant)

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment please while we poll for questions. Thank you. Our first question is from Christian Schwab with Craig-Hallum. Please proceed with your question.

Christian Schwab (Senior Research Analyst)

Great. Good morning, guys. Well, I guess first of all, you know, congrats that macroeconomic uncertainty hasn't significantly affected your customers' spending patterns like your peers. Congrats on the continued business transformation and a different value proposition. With that.

Jim Fanucchi (VP of Investor Relations)

Thanks, Christian.

Christian Schwab (Senior Research Analyst)

Yeah, you're welcome. With that, Cory, would we expect, you know, continued sequential revenue growth, you know, throughout the remainder of the calendar year from June?

Jim Fanucchi (VP of Investor Relations)

The simple answer is yes. I would mute your expectations, obviously with the macro environment, that outlook in the second half of the year is murky. Our expectation is that yes, we'll continue to grow, but at a very small pace.

Christian Schwab (Senior Research Analyst)

Right.

Michael Weening (President and CEO)

I'm just gonna add one thing to that. I would add one thing to that, Christian, is you saw in the investor letter, Cory clearly called that out. We've always said this is one of the transitions that we have gone because we are on a new mission in a new market. Part of that is moving away from that legacy model, which is highly cyclical, and it's moving into a sequential business.

Christian Schwab (Senior Research Analyst)

Great. And then can you give us a little bit of clarity on the large customer activity? You know, your revenue in the March quarter, you know, was, you know, the largest, you know, for greater than 2.5 million subs in years. Is this the beginning potentially of an inflection point? I ask that because, you know, we kind of saw the beginning of the inflection point in the medium, you know, base customers and, you know, over the last, you know, two years that went from, you know, a $35 million business to a $52 million business to, you know, almost a $105 million.

I know, you know, I know the story has always been, you know, we'll start with the small guys and then the medium guys will figure it out, and then the large guys would figure it out. Is everything going, you know, as planned, should we assume?

Jim Fanucchi (VP of Investor Relations)

Yes. Yeah. Christian, you know, thank you for, you know, highlighting what we've been saying. This is one of those things where technology adoption start with small customers and work your way to large. In terms of what you've seen in the Q1 relative to our large customers, it was, you know, the increase was with that one customer. They were an existing customer. And I think it's just kind of a, you know, lumpy, you know, delivery schedule associated with a large customer. I don't think it's an inflection point where you should just expect continued growth from that one customer.

Cory Sindelar (CFO)

Okay. That's fair. I know we started the year, you know, or, you know, started the year previously at kind of like a 10%-15% growth rate. Now we're moving it up to, you know, a 15%-20% growth rate. If we even get modest sequential growth from June, you know, we're, you know, almost at that 20% range. What, you know, was it just conservatism, you know, given the macroeconomic environment, you know, that the expectations have been exceeded, or have you been positively surprised somewhere?

Jim Fanucchi (VP of Investor Relations)

You know, as we said last quarter, you know, our view of the annual growth rate was a combination of not so much demand, but more of our view of supply chain. We saw that improve within the quarter. You know, we built a little bit more inventory. You know, we worked through some issues. Consequently we were able to overperform in the Q1 by a little bit to give a little bit more confidence on where we're at with Q2. I think at this point, you know, as the supply chain is expected to continue to normalize over 2023, you know, the concern becomes the demand equation in the back half of the year. We're just taking a conservative view of what that might entail.

That being said, you know, demand continues to be strong.

Cory Sindelar (CFO)

Great. Then my last question. You know, our objective of growing gross margins 100-200 basis points a year, you know, given, you know, given, you know, that lead times are finally short, becoming, you know, normalizing, for lack of a better word, you know. Does that give you? Should we be more encouraged that maybe we can start operating to the higher end of that 100-200 basis point range as the mix continues to improve and the supply chain costs, not only the cost of the chips procured, but the expedite fees in some cases to get them, you know, as we get into 2024 and 2025, or should we just, you know, stick to the 100 to 200?

Jim Fanucchi (VP of Investor Relations)

Yeah, Christian, I think you're going to want to stay within the range that we provided of 100-200 basis for the year. You can see we're tracking along that line. Each of the last couple quarters, we've increased by about a quarter point. I think that rate will continue through the quarter. I don't think we're at a point where you're starting to see costs come down precipitously, where you would see a faster than that rate, expansion of gross margins. It's still early days. We're still normalizing. We feel better about it, but it's not at a point where I think you get to an accelerated pace.

Cory Sindelar (CFO)

Okay, great. No other questions. Thanks again.

Operator (participant)

Thank you. Our next question is from George Notter with Jefferies. Please proceed with your question.

George Notter (Analyst)

Hi, guys. Thanks very much. I wanted to ask about, you know, the software play here. You know, I noticed that RPOs were up about $7 million sequentially, which is one of the smaller sequential growth numbers you guys have put up in a while. You know, obviously it captures just a portion of your software business. I get that. Conversely, you know, the customer adds look really good, as you guys pointed out in the monologue and in the shareholder letter. I guess I'm just trying to better understand how you feel about the progress you're making in software at this point and, you know, in this quarter, in Q1, you know, specifically. Thanks.

Jim Fanucchi (VP of Investor Relations)

Hey, George. Thanks for the question. We feel good about it. If you were to go back to the Q3, we had a similar, you know, lower growth sequentially, and everybody was alarmed by that lower increase. Then fourth quarter came along, and we blew past that number, and everybody was like, "Oh, is this another inflection point?" We've consistently said contract signings are lumpy, and they go up and down. I mean, we anticipate RPO to increase sequentially going forward, but the rate at which it increases will vary from quarter to quarter.

Cory Sindelar (CFO)

You know, I'll add in. Look, you know, I spent all of Q1 on the road. All except for two weeks, I was with customers and conferences and CEOs and talking about their business and what's coming with them. In fact, I was with one customer, well, actually not a customer, someone who in essence has refused to talk to us for 25 years. With some of the things that are going on in the macroeconomic level, in fact, in, that's been their only source of funding for their business. When they heard me speak at a conference, we got into a conversation around how do you actually build out a different business model that allows you to attract a radically different type of investment? You know whether it's private equity or family investors or whatever it is.

If you're just selling a dumb pipe, that's really hard because your margins need level, but are low. If you're partnering with significantly higher from an operations point of view, but you also have all these incremental ways to monetize that subscriber and grow revenue for the long time, term. What does that mean? That means that when you get that investment, it's gonna be to you all these kind of things. You know, while RPO is one element of it, I would turn you heavily towards, you know, 38 customers, you know, adopting one or more of our platforms, 41 people starting on the managed services journey.

You know, we continue to see, and I would say that if anything, you know, this whole dumb box mindset is actually really gonna go to the side as customers get about it.

George Notter (Analyst)

Hey, just to follow up on that. You know, if I look at the differential between managed services adoption, just in terms of numbers of customers and Calix Cloud, you know, obviously, there's still a really, really big gap there and, you know, and I get it's a land and expand strategy. Maybe talk about, you know, why can't you get those guys kinda ramping faster? Is it just inertia? Is it, you know, some other sort of technology piece that I don't appreciate? Maybe just kinda talk through that gap.

Michael Weening (President and CEO)

No, George, that's a great question. You know, if I was to actually walk through the continuum of moving from being a legacy provider to entering this new market and becoming a broad business in the community, you know, it's a journey, right? If you've, you know, been in business for 25 years, the only thing you're used to is you're a construction company. You actually operate a network, as long as you exist, you get customers, speed is the only thing that you ever talk about. You're now moving into a scenario where, first of all, you're re-engineering your network and collapsing everything so you can get 80% higher margins. You're saying, "Okay, well, I have to change my call center.

I have to make it so that when I'm doing an install, they're not just going and installing a Wi-Fi router. They're actually talking to the customer, educating them on how to use the app. Then my installers, I'm converting them into upsell people, right? If Cory's my installer, he's gonna say, "Let's get them an app. By the way, do you have children? Would you like to, you know, do parental controls?" All those kind of things. It's a completely different market, a completely different mindset. I would say if you think about that journey, we're the ones taking it on, taking them on that journey.

That's why, you know, it's really exciting that John Durocher joined the team to lead our customer success army and where, you know, dumb box companies don't have success teams because it's helping them create an entirely new business model. That's what our success teams do, and that's why we continue to invest in it. I wouldn't, you know, be concerned in any way, shape, or form other than this is the beginning. This is something we've been saying on every one of these calls for ages, right? You look at managed services and even that number at 334, I would... You know, you should be pushing on us saying, you know, "What about underneath of that?" Because there's eight managed services today. We've announced 11. There's massive expansion even inside of that, right?

There's all these different ways to grow. Look, if we can put up these kind of numbers and project higher for 2023 with this early stage of where we are in this new market, you should be very excited about the future. Thanks, George.

Operator (participant)

Thank you. Our next question is from Ryan Koontz with Needham & Company. Please proceed with your question.

Ryan Koontz (Managing Director and Senior Equity Research Analyst)

Good morning. Thanks for the question and great execution on the quarter, obviously. Regarding the small and medium kinda customer set down market, and as you think about that driving growth through the rest of this year, wonder if you could reflect on, you know, your conservatism around growth there. Specifically, you know, are you seeing impacts from labor in these downmarket areas or in, you know, how are the kinda subsidy trends working their way through the processes from RDOF and the ARPA funds, which we've seen a lot of announcements of late? Thank you.

Michael Weening (President and CEO)

Sure. Sure. You know, I'll proactively ask funding because someone's gonna frigging ask that question. You know, look, there's tons of investment that's coming into the market, family funds investing in these incredible businesses. You know, KKR recently purchased one in the Texas area. You see everybody coming into it. Berkshire is now in here. There's lots of funding. The government funding is, as we've said, consistently slow. In the end, it'll take 10 years, a lot longer than we anticipated, in the end, it'll also trickle what's coming through and all the debates that are going on, right? With regards to deployment, you know, we can get into the whole immigration thing, the job market's still strong.

To your point on hiring people, yeah, I was with a customer the other day, and they literally, at any point in time, have 1,100 open jobs. 1,100. If you look at the job ads in the U.S. market, like I believe last month was 330, and then the month before was 600, and then the month before was hundreds of thousands. The job market is really strong. There is no recession. You know, they have to hire good people, they have to train them, and they have to bring them forward. By the way, if you're looking for a job, they're paying $70,000 for someone who splice fiber, like out of school. There's lots of opportunity. Yeah, those are, you know, normal headwinds, but they're positive headwinds because the economy is so strong.

Ryan Koontz (Managing Director and Senior Equity Research Analyst)

That's great. That's great, Michael. Thank you. In terms of the product mix there, it sounds like it was a great quarter for access sales. That's great to hear that footprint going out. I assume the kinda softer, Revenue EDGE is mostly from, you know, customers, reducing their kinda inventory holdings around, you know, customer prem type hardware. Is that correct?

Michael Weening (President and CEO)

Yeah, Ryan. Like my prepared remarks said, with the normalization of the supply chain, we started seeing the lead times pull in. That consequently allowed us to reduce our lead times to customers. We've been working with our customers to help reduce their inventory levels, right? That they can become more capital efficient, so they can start taking down their inventory levels, and that's what you're seeing. Not obviously concerned about it. Obviously, by our Q2 guidance that we gave, obviously we're seeing another up sequential quarter.

Jim Fanucchi (VP of Investor Relations)

There's obviously no air pocket behind this, you know, reduction in supply chain or a reduction in premise systems shipped.

Michael Weening (President and CEO)

I'll just add one comment, and that's that, you know, again, back to this whole concept that we're in a new market, and we are a different company, and everyone needs to start thinking about it. We understand exactly their deployment rates. We understand everything they're doing. We know how much inventory they have, and therefore the key word that you heard from Cory was actually working with and manage. In no way, shape, or form is anything a surprise to us because we generally are now seeing if they're having a problem beforehand, and that's what our customer success army is for. They pop in, and they say, "Hey," you know, we go, we say, "What? Your deployments are slowing.

What's going on?" "Oh, it's because I can't get my permits fast enough," or, "I'm struggling." We subsequently go on top of that and we look at, for example, every time they install a new router, we're saying, "What is your attach rate on CommandIQ," which is our mobile app. "Are you ensuring every one of your customers is getting the mobile app?" That becomes an early seed to driving upsells with managed services. It's not just about the hardware and everything else, it's also about making sure they have a really strong business in the long term and win against the legacy providers.

Ryan Koontz (Managing Director and Senior Equity Research Analyst)

Super helpful, Michael. Just a quick question, a quick follow-up on on RPO. Cory, was there any. I didn't quite see the release of the numbers of current versus total RPO in the letter. Was there any mix shift at all in current versus total RPO in the quarter?

Jim Fanucchi (VP of Investor Relations)

No, Ryan.

Ryan Koontz (Managing Director and Senior Equity Research Analyst)

Okay.

Jim Fanucchi (VP of Investor Relations)

Nothing substantial.

Ryan Koontz (Managing Director and Senior Equity Research Analyst)

Got it. That's all I had. Thanks.

Michael Weening (President and CEO)

Thanks, Ryan.

Operator (participant)

Thank you. Our next question is from Fahad Najam with Loop Capital. Please proceed with your question.

Fahad Najam (Managing Director and Senior Equity Research Analyst)

Hey, good morning. Thank you for taking my question. Cory, Michael, let me start with, I'm trying to model a little bit differently given your shift in how you disclose numbers. The way I'm thinking about is average revenue per BSP. If I look at it, I see a trend starting 3Q, a ramp in or I guess growth in average revenue per broadband subscriber service provider. One, as you head into the second half of this year, how should that normalize? One, I guess, what was that catalyst event that started in 3Q 2022 that really expanded your average revenue half of this year as it normalizes against the top comp?

Jim Fanucchi (VP of Investor Relations)

Hey, Fahad, I guess I'm not exactly following your line of questioning. maybe we can explore that.

Fahad Najam (Managing Director and Senior Equity Research Analyst)

Basically, I take your revenue, and I divide that by total broadband service providers that you disclose, and I see a trend of average revenue per BSP. I see that the average revenue per BSP is growing considerably over like the starting second half of 2022. Is there anything that is, I guess driving that, step function improvement?

Michael Weening (President and CEO)

What you're trying to do, we're not reading anything into it. For example, you know, our definition of a small service provider is from zero subscribers to 250,000 subscribers, right? If actually a really good executing Calix customer, their market share is about 60%, so they have significantly more homes passed. If they're actually early stages of their deployment, those 250,000 subscribers could only be 25% market share on a broader, you know, goal, right? As you go and use that logic, I think there's a flaw to it. The other part of it is the company. There are all kinds of ways you can parse this. I just don't know if that's the right thing.

Cory would like to take that question offline and explore it to see if there's, if we can understand more how you're thinking about it. With regards to our business, you know, large customers, small customers, again, small customer can be a $300 million, you know, business. There's all kinds of variables in there, and it's lumpy and all the different elements. I would say no, but Cory will take it offline with you.

Fahad Najam (Managing Director and Senior Equity Research Analyst)

Got it. Appreciate that. If I was going through the proxy filings, and I noticed that you're $3 billion, which gives you significant visibility. Can you just maybe talk about the momentum in orders? Certainly-

Michael Weening (President and CEO)

No, we don't talk. Thanks, Fahad. We don't talk about bookings.

Fahad Najam (Managing Director and Senior Equity Research Analyst)

All right. I'll pass it on. Thank you.

Michael Weening (President and CEO)

Demand is strong.

Operator (participant)

Thank you. Our next question is from Tim Savageaux with Northland Capital Markets. Please proceed with your question.

Tim Savageaux (Managing Director and Senior Research Analyst)

Good morning and congrats on the quarter. Hopefully you do. Okay. You saw, you know, a nice increase in cash in the quarter, and I know we've been talking to you guys previously, and I think Cory mentioned some purchase commitments coming down. You know, do you still anticipate there to be a significant positive impact on cash flow from both obviously ongoing operations but this kind of balance sheet impact? Kind of maybe review how that, how that works and what your expectations are, and then any comments on, you know, capital allocation, you know, given the strength in CapEx?

Jim Fanucchi (VP of Investor Relations)

Thanks, Tim. Yes, over the course of last year, we used a lot of our cash from operations to buy inventory. Now as we are getting to a plateau, you can see that the rate at which we're investing in inventory is slowing into additional free cash flow. We are expecting as we progress through 2023, an increase, a significant increase relative to where we've been of more cash. Over time, we'd expect our inventory to normalize and start coming back to where we were pre-pandemic. That'll then free up additional cash. That's still a ways away. We need lead times to come, you know, come back in, kind of where they were, and then that'll make that trend happen.

In terms of capital allocation, you know, it's a process that we have that we look at every quarter. As we think about our cash, you know, there's an opportunity cost with the use of our cash. Our decision to allocate capital kind of relates to its opportunity costs. Cash that is, could be used to operate a growing business comes at a very high opportunity cost. Cash for strategic investments would come then at a high opportunity cost. Cash beyond those categories would be at a lower opportunity cost. In other words, you know, the price at which we're willing, you know, to buy shares goes up, you know, as we accumulate more cash.

Tim Savageaux (Managing Director and Senior Research Analyst)

Great. Just to follow. Yeah, I'm sorry about that. Any updated quantification on, you know, I think you talked about before, I don't know, tens of millions coming off the balance sheet. You know, as we sit here, any updates on that, or are we still in the same range in terms of?

Jim Fanucchi (VP of Investor Relations)

Yeah.

Tim Savageaux (Managing Director and Senior Research Analyst)

free cash?

Jim Fanucchi (VP of Investor Relations)

Yeah, Tim, I expect we'll start seeing double, well, you know, double-digit cash generation.

Tim Savageaux (Managing Director and Senior Research Analyst)

Months.

Jim Fanucchi (VP of Investor Relations)

Double-digit millions, yes.

Tim Savageaux (Managing Director and Senior Research Analyst)

Okay. Thanks very much.

Operator (participant)

Thank you. Our next question is from Greg Mesniaeff with WestPark Capital. Please proceed with your question.

Greg Mesniaeff (Equity Research Analyst)

Yes, thank you, and congrats on the print. Last couple of quarters, your OpEx levels were running a little hot, I thought. I was wondering, as we look beyond the guidance you gave for the June quarter, what should we kinda be modeling as far as OpEx levels? Do you foresee continued investment in sales and marketing, or do you second half of the year? Thanks.

Jim Fanucchi (VP of Investor Relations)

Yes, thank you. I would give you the same counsel that I would give you every quarter, which is that we're gonna continue to invest according to our target financial model. We haven't deviated from that. You can see in the quarter that we were, you know, a little bit higher on the engineering side, a little bit less than the G&A. For the most part, you know, we're executing very predictably, and to our model. As we continue to grow the top line, there will be incremental investments up into, I guess the word we like to say is we're gonna invest fulsomely to our target financial model. Specifically, every area will grow according to the model.

Michael Weening (President and CEO)

Yeah, I'll add onto that. Look, we're in a new market. It's the beginning of that new market. It's a once in a generation opportunity. In fact, you know, new markets don't happen in not once a generation. Investing to our model fulsomely is actually the team doing their job as leaders and making sure that we drive organic growth in this new market and succeed. We predicted for everybody to ensure we can take advantage of this opportunity.

Jim Fanucchi (VP of Investor Relations)

One last thought on that, on this point. First, I will highlight in the fourth quarter, we have our ConneXions user group event. Obviously, sales and marketing will tick up by, you know, an incremental % in the fourth quarter.

Greg Mesniaeff (Equity Research Analyst)

Got it. Thank you for that. Just to quickly recap, you had mentioned earlier in a, in answering a question that regarding the broadband stimulus roadmap, that you're basically it's taking longer but should be bigger at the end of the day. Is that right?

Jim Fanucchi (VP of Investor Relations)

Correct.

Greg Mesniaeff (Equity Research Analyst)

Thank you.

Jim Fanucchi (VP of Investor Relations)

Thank you.

Michael Weening (President and CEO)

Thank you.

Operator (participant)

Thank you. Our next question is from Mike Genovese with Rosenblatt Securities. Please proceed with your question.

Mike Genovese (Managing Director and Senior Research Analyst)

Great. You know, there was a little bit of upside in the Q1, a little bit of upside in the Q2 outlook. I, I'm assuming that with the mix shift to infrastructure, that's probably a, or, you know, mix shift to Intelligent Access EDGE, that's probably a function of supply chain. I wanted to check with you, the business model, the mix shift to software, cloud recurring revenue, driving the gross margin. I mean, how do you think about that for the 1st half of 2023?

Jim Fanucchi (VP of Investor Relations)

You're exactly right, Mike Genovese. It's both those things, right? It's the continued adoption of our software that's obviously giving us a margin uplift, as well as from a product shift. I expect that that'll continue to normalize, meaning I think we'll go back to, you know, more prime shipments in the, in the back half of the year. I think it's just delivery of their systems. You've seen this in the past. You know, when we had a customer a year wanted to get all their equipment out into the warehouse at the end of the year. It's just a normal process with large customers, but it can be lumpy on how we get that.

Mike Genovese (Managing Director and Senior Research Analyst)

I just to be clear, a mix shift to Revenue EDGE in the future should have more positive gross margin implications. I mean, more kind of more powerful than we're seeing, you know, currently. Is that correct?

Michael Weening (President and CEO)

For sure, when you're looking at the managed services and anything that attaches on top of it. For sure. That's the greatest portion of the recurring revenue comes on-prem systems.

Mike Genovese (Managing Director and Senior Research Analyst)

Great. You know, finally, I mean, a lot of good questions were asked on the conference call already, numbers in the quarter, you know, falling to 11. You know, do you think that there's a macro reason for fewer, new customers? Obviously the expand part of the model is working really, really well. As we look to the rest of the year on the land part, should we think about, you know, this lower number being the new normal? Do you think that we could go back to what we saw last year or the year before?

Michael Weening (President and CEO)

Yeah, it is a good question. Remember, in that number, there's two component parts to that. The first is it could be an existing service provider who's actually never signed, right? It could be someone actually starting a broadband service provider, which is something that we've seen a lot of over the last couple of years. Clearly, with the rise in interest rates, that has made the hurdle for someone to acquire capital to start a brand new company harder. We noticed that's happening in the market for sure.

What's interesting, though, is that the ones who did get capitalized, our analysis is that they're getting a lot more capital than we anticipated, and they're going to be more successful over the long term because they built into their business model this significantly higher margin model affiliated with Calix and everything that we're doing from a platform and managed services point of view. Their investors are saying, "Hey, let's go big." You know, what will it be long term? We'll see.

Mike Genovese (Managing Director and Senior Research Analyst)

Right. actually, you know, my very last question is, I just wanted to check, is Carl in the room? Is he on the call?

Michael Weening (President and CEO)

He is. In the corner.

Mike Genovese (Managing Director and Senior Research Analyst)

Working in the corner.

Michael Weening (President and CEO)

Yeah. Yeah.

Mike Genovese (Managing Director and Senior Research Analyst)

He's doing his best to not speak, Mike, but I do appreciate the shout out. Okay. Well, great. congratulations on the...

Operator (participant)

Thank you. Our next question is from Scott Searle with Roth MKM. Please proceed with your question.

Scott Searle (Managing Director and Senior Research Analyst)

Hey. Good morning. Nice job on the quarter. Thanks for taking my questions.

Michael Weening (President and CEO)

Thanks, Scott.

Scott Searle (Managing Director and Senior Research Analyst)

Maybe for starters, could you just talk a little bit about linearity in the quarter? You know, what you've seen, through the Q1 and kind of early parts of the Q2 here. Also on the small customer front, taking a little bit of a pause, seems like it's a managed inventory reduction on your part. Are we through that? Do we start to see a sequential increase back within the small customer base into the June quarter and beyond? I had a couple of follow-ups.

Michael Weening (President and CEO)

Sure. Let's start off with your linearity question. Linearity was good in the quarter. I mean, you can see that in the fact that the DSO are down. So that was a very positive trend, and it has continued. As it relates to the second part of your question, Scott, it was really not the revenue.

Scott Searle (Managing Director and Senior Research Analyst)

Small, small customers.

Michael Weening (President and CEO)

Oh.

Scott Searle (Managing Director and Senior Research Analyst)

You know, in terms of absorption.

Michael Weening (President and CEO)

Yeah. It, it likely continues into the Q2, but obviously it's something we're not very much worried about because you're showing quarter-on-quarter. There's gonna be a little bit of that as we continue to normalize the business management.

Scott Searle (Managing Director and Senior Research Analyst)

Gotcha. If I could, you know, Mike, from a high level, when you're in discussions with your current customers right now, how are they thinking about their build out plans in terms of footprint expansion versus harvesting within the existing footprint as we kind of look at, you know, the second half of this year and maybe early thoughts on 2024? Then also in terms of the Revenue EDGE side of the equation, how should we be thinking about you give numbers in terms of how many customers have adopted 1 service or more? But I'm wondering if there are some other metrics or idea that you could help us see into in terms of penetration of multiple services, target on that front from customers and the velocity on that front.

I know we get an RPO number, but if there are some other metrics we could think about.

Michael Weening (President and CEO)

Right. First of all, the customers now they're thinking about their business. I would actually say they're, you know, every single one of them is thinking in both ways, right? Unless they're a legacy provider, and you're seeing that from some of the big ones, who with interest, you know, we see this all the time with large public legacy service providers. As interest rates increase, they're actually pulling back on CapEx because their margins are declining, and this is a way for them to fund it. They slow down, and our customers are seeing this as an incremental opportunity, right? Hey, they were gonna go build out this town, now they're gonna do it even faster.

They still have access to capital because, again, their business as a whole is radically higher margins, therefore, they can actually get all the capital that they need. They're a service provider in recently, and what they did was they shared out their spreadsheet, and we went through 10 different markets that they're looking at towns. They had profiled out who the competitors were, and a number of those places were legacies, and they were saying, "Let's build a joint plan to actually attack those legacy providers and take share, and where should we stack rank?" We helped them identify who we thought. Which goes back to the whole customer success discussion. The whole point of our business model is that, you know, land and expand. That, you know, permeates over to the customer's business model.

If all they ever did was they would sell the pipe, and that's it. I would hope that I would monetize. Generally, that means that over time, they're under pressure because someone else throws a cheap price, whatever it is. Now, their whole business model is I land in the home or the business, I'm selling all these incremental services. I expand my margin and my revenue inside that account, but I also make it wickedly sticky so that if somebody comes and throws, you know, a legacy provider who is only speed throws in some cheap price, the customer is gonna say, "No, I've got all these things. Consider that cheaper price because the service is so incredible. By the way, my NPS is 75." You know, these customers are incredibly loyal.

That grow is absolutely front of mind, and that, I guess, comes to the core of what we're doing in this new market. It is a new market with a new business model, and we're teaching these customers how to transform their businesses and disrupt the legacy companies. With regards to your question on incremental metrics, you know, beyond RPO, we consider that competitive. No, you can just assume that again, we have a growing customer success army that spends every single day helping our customers use best practices and insights and understanding what works and what doesn't, segmenting data, all these different elements to grow their business. So.

Scott Searle (Managing Director and Senior Research Analyst)

Hey, Mike, maybe just to quickly follow up in terms of your commentary of the changing landscape and enabling the epiphany ongoing here, that it's driving more conversations with them on that front or is that something that takes longer?

Michael Weening (President and CEO)

No. Well, I'd say it's your normal product adoption curve. You always start with the, you know, innovators who are those thought leaders. You follow up as the market matures. You know, if you look at our press releases, what are you seeing in those press releases? Story after story after story of customer success and what's possible and what kind of NPS they're driving, what margin levels they're driving, all these different things. As we go through a normal product adoption curve, you're gonna continue to see more and more growth. Even somebody who is a legacy provider who has never thought that way has thought at some point, everybody's gonna have a different realization and say, "Oh my gosh, the whole market's changed.

It's a new business model, there's this once in a generation opportunity for me to grow my business in all kinds of different ways. Clearly the only person that. I wouldn't say it's like a, you know, everyone has different epiphanies at different times, we're moving up into the right, that's just gonna continue. You know, that's our why we have our press releases, to educate.

Scott Searle (Managing Director and Senior Research Analyst)

Mike, lastly, if I could, on the managed services front, I think you're up to eight now that have officially been launched, but I was wondering if you could talk a little bit about the pipeline, you know, the level of interest and kind of what you guys are wading through there, if there are any targets that we should be thinking about. Maybe quickly, like an update on things like SmartBiz and SmartTown. Thanks.

Michael Weening (President and CEO)

Well, it's starting to explore managed services and again, it's, you know, what's the pipeline? It depends on the customer, right? I was with one CEO, you know, last week and he has an incredible go-to-market. He's got all his go plans in place. He's really focused on operational efficiency and customer satisfaction as his first go-to-market with a clear recognition that as he lands, then he will be able to expand in those existing markets over time. You know, what's the uptake on these services? It really depends on the customer and where they are in their market needs. Someone who's very mature is adopting, I would say, more managed services to differentiate. Somebody who's just building out is gonna be in a different mindset.

With regards to all the managed services, look, they're unique. This is a new market. We have a new business model. What we've done with SmartBiz and SmartTown, they've never been done before, and they're super exciting. You know, our customers, if they're deciding, "Hey, you know what? It's not the right time for me today. Maybe it's 6 months, maybe it's one year from now," everybody's talking about it. That's what we do.

Scott Searle (Managing Director and Senior Research Analyst)

Great. Thanks so much. Nice job on the quarter.

Michael Weening (President and CEO)

Thanks.

Operator (participant)

Thanks, guys.

Scott Searle (Managing Director and Senior Research Analyst)

Thank you.

Operator (participant)

There are no further questions at this time. I would like to hand the floor back over to Jim Fanucchi for any closing comments.

Michael Weening (President and CEO)

Thank you, Paul. Calix leadership will participate in several investor events during the Q2. Information about these events, including dates and times and publicly available webcasts, will be posted on the Events and Presentations page of the Investor Relations section of our website. Once again, thank you to everyone on this call and webcast for your interest in Calix and for joining us today. That concludes our conference call. Have a great day.

Operator (participant)

Goodbye.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.