Calix - Q3 2023

Transcript

Operator (participant)

Greetings everyone, and welcome to the Calix Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the brief prepared remarks. If anyone should require operator assistance during this 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, Kat, and good morning, everyone. Thank you for joining our Third Quarter 2023 Earnings Call. Today on the call, we have President and CEO, Michael Weening, and Chief Financial Officer, Cory Sindelar. 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 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 third quarter 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. Also 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 third quarter 2023 letter to stockholders. Unless otherwise stated, all financial information referenced in this call will be non-GAAP. 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. In the third quarter of 2023, the Calix team continued our track record of improved financial performance across four measurable objectives that we've outlined for investors. First, deliberate revenue growth continued as we achieved our 10th consecutive quarter of sequential growth while delivering record revenue. Our demand frontier remains strong as broadband service providers, who we call BSPs, continue to recognize that building fiber is not enough, as speed as a go-to-market strategy will not win in the long term. At Connections, our Customer Success and Innovation conference held last week, we focused on how BSPs can transform their business with the Grow Your Community playbook, which is their recipe for success as they take on the legacy and consumer giants.

The playbook clearly lays out how a BSP can leverage the Calix platform and managed services to simplify, which yields the highest margins and the fastest time to market. Excite, which creates the subscriber experiences that yield the highest Net Promoter Scores. And grow for their investors, for their members, if they are a cooperative, and for the communities they serve. Second, gross margin expansion continued with our fifth consecutive quarter of margin growth, while we delivered record gross margin as strategically aligned BSPs continued to expand their use of the Calix platform and managed services to achieve their business and financial goals. Third, we executed disciplined operating expense management following the model outlined in the investor letter, and continued to invest fulsomely to take advantage of the once-in-a-generation growth opportunity ahead.

Fourth, ongoing predictability continued as we met or exceeded the guidance that we laid out for investors in July. In the third quarter, I continued to invest a significant amount of time meeting with customers, prospects, partners, and team members. I have just returned from our most successful Connections ever. Attendance set a new record at almost 3,000 attendees, and the excitement in the room was palpable as Calix is perfectly positioned to be the catalyst for the biggest disruption our industry has ever seen. Our mission and the disruption we are enabling was evidenced on the main stage, which you can see on the videos at calix.com. Tombigbee Fiber shared how their cooperative leveraged the Calix platform and managed services to beat the industry's norm of a new broadband provider requiring seven years to get to cash flow positive.

They achieved cash flow positive in two and began generating seven-figure monthly profits in year three. In addition, they launched Bark in two weeks for employees and subscribers to protect children from cyberbullying and deployed SmartTown to cover nine football fields with a return on investment that was significantly higher than traditional advertising. It is easy to see why their Net Promoter Score is 91. Hunter Communications shared their journey from serving businesses to serving the entire community by leveraging the end-to-end Calix platform and managed services such as SmartHome and SmartBiz. Our platform and managed services have enabled their team to lead their market, with average online reviews of 4.8 out of 5, when competitors are as low as 1.1, exceeding 30% take rates in only 18 months and growing revenue by 300% and EBITDA by 400%.

United Fiber, founded in 1937 as an electric cooperative, shared how by leveraging the unique Calix Broadband Platform and growing managed services portfolio they transformed their economics. The broadband revenue has enabled them to freeze electric rate increases since 2015 and return $9 million to members. They were told it would take 12 years to achieve cash flow positive, and they did it in four. They have continued that success, growing to 32,000 subscribers across 45 communities. Through the quarter, our Broadband Platform continued to enhance our partner ecosystem that enables BSP success. Most notable, we announced a significant expansion of our partnership through a joint roadmap with NISC, the leading OSS/BSS and solution provider to rural broadband and electric cooperatives.

Our ongoing focus on our purpose-driven culture, which is constantly evolving to meet the needs of our team members, customers, and partners, remains a focal point and a key driver on why people want to join Calix. In the investor letter, we highlighted that the industry continues to acknowledge our culture and products through awards, such as the Best Tech Culture from TMC and Calix Marketing Cloud winning a technology award for superior marketing insights and analysis. It remains a great time to be part of the Calix team as we continue to embrace the notion of constant improvement through our better, better, never best mindset. And our leadership team continues to believe that we're just getting started. Before I close, I'll turn it over to Cory to expand on the team's stellar performance in the third quarter. Cory?

Cory Sindelar (CFO)

Thank you, Michael. The Calix team again executed well across the board, and we delivered our tenth consecutive quarter of sequential revenue growth, with record quarterly revenue of $263.8 million. We also saw our fifth consecutive quarter of gross margin expansion, with non-GAAP gross margin of 53.8%, an increase of 100 basis points from last quarter. This improvement in gross margin was due to the continued expansion of our platform and managed services, plus a small product shift to Intelligent Access EDGE from Revenue EDGE, and the sell-through of a lower amount of systems with excessively priced components. I'm also pleased to deliver that we delivered our second consecutive quarter of double-digit free cash flow. As we have said previously, the added benefit of our platform model is a low SKU count and component fungibility between SKUs.

This allows us to better manage our inventory levels and have the right inventory at the right time to meet our customers' demand. During the third quarter, we saw continued improvement in component lead times, and our purchase commitments decreased by $27 million from the second quarter to $227 million. This is down $143 million after peaking a year ago at $370 million. As component lead times continue to normalize, we expect to see further reduction in purchase commitments, an improvement in inventory terms, and a reduction in supplier deposits. These reductions in working capital requirements, combined with sequential revenue growth, expanding gross margin, and disciplined OpEx investment, will result in significantly more free cash flow.

We expect to continue to generate double-digit quarterly free cash flow and more than $100 million of free cash flow in 2024, further enhancing our already pristine balance sheet. Back to you, Michael.

Michael Weening (President and CEO)

Thank you, Cory. With our unique platform and Managed Services model, and a clear ability to innovate at a pace that has never been seen before in this industry, we remain excited about the opportunity ahead for Calix and our strategically aligned VSP customers and partners. They are leveraging our end-to-end partner, platform, clouds, and growing ecosystem of managed services to deliver offerings across residential, business, education, and the communities they serve, growing market share and subscriber satisfaction, thereby delivering high margins and cash flows that are the envy of the industry. Backed by our unique Broadband platform and Managed Services model and unmatched financial strength, we are uniquely positioned ahead of the $10s of billions of stimulus dollars that is expected to positively impact the market over the many years to come. This is a once in a generation opportunity, and we are just getting started.

Jim, let's open the call for questions.

Cory Sindelar (CFO)

Thanks, Michael. Kat, we're ready to open the call for 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 would 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 keys. One moment while we poll for questions, please. Our first question comes from George Notter, from Jefferies. George, please proceed.

George Notter (Managing Director, Equity Research Analyst)

Hi, guys. Thanks very much. I wanted to ask about customer inventories. You know, in the shareholder letter, I think you guys mentioned the Revenue EDGE products were down about 6% sequentially. Can you talk about, you know, how much... I think this is actually the third quarter in a row where you guys have been bleeding down those inventories, but can you talk about how much inventory is left out there? And then... Also, you know, when might you exhaust that customer inventory in terms of your attempts to bleed that down? Thanks.

Cory Sindelar (CFO)

Hey, George. Thanks for the call, for the question. George, this is a function of, of, of lead times, right? So as lead times continue to come in, not only for us and our vendors, but for our customers, they're continuing to, you know, manage down their, their buffers. And we've been seeing this, you know, from the beginning of the pandemic. We've been using the information that we have to help them with those inventory decisions. And so we did all of this while continuing, you know, our sequential growth in a, in a predictable fashion. So we'll just continue to do it. It's hard to say where that'll level out, but, but clearly, you know, they're getting further along with, with managing to an appropriate buffer level, given inside the lead times that we're currently giving them.

George Notter (Managing Director, Equity Research Analyst)

Got it. And then, do you have a sense for how much that inventory might be? Can you talk about it in terms of weeks or months of inventory? What sense do you have for how much is out there?

Cory Sindelar (CFO)

So George, it's a matter of their comfort level of where, where do they level out at? And so I think this is one of those adjusting things that happen over time. You know, coming out of the, the, pandemic-induced supply chain crisis, you know, they clearly had more inventory than that they, they wanted. And as they get more supply certainty, they're going to adjust that down over time. So I can certainly understand why investors are sensitive to this issue, right? Because there's a lots of other companies out there reporting challenges, but nothing has changed in our business. We continue to use the information that we have available to us and manage these buffers and continue to meet their subscriber demand.

George Notter (Managing Director, Equity Research Analyst)

Is it just to follow on that, is it possible to give us a sense for where your lead times are now, you know, in terms of weeks or months, in terms of product deliveries?

Cory Sindelar (CFO)

Yeah. Our stated lead times are between 12 and 14 weeks right now.

George Notter (Managing Director, Equity Research Analyst)

Great. Okay. And then, I guess I can assume from the, you know, the dynamic you guys are seeing, I assume the rate of consumption, obviously, you guys see when customers operationalize products in the network. But I guess the question here, I assume the consumption or, you know, people operationalizing products in the network, I assume that consumption is greater than your revenue run rate right now.

Cory Sindelar (CFO)

The consumption we keep on a weekly basis keeps going up every single week. So that's them growing up their rate of usage, like deployment, faster and faster every single week. And that's a factor of them winning. So as we continue to help those customers win in their markets, and if you watched Connections, you'll see a myriad of customers presenting on stage. And what they talked about was not the legacy mindset of homes passed or the legacy mindset of get to 20% or 25% market share. They all talked about they are going to get to 60, 70, 80% market share and grow. You know, there was one customer who was up on stage that said they're currently at 32,000 subscribers, and their target over the next 18 months was to go to 50,000.

And so those are the factors that we're focused on, not burning down inventory, but actually significantly growing their penetration in their market, their dominance of their markets, and then that will just take care of itself, which is what it's doing, because it goes up every week.

George Notter (Managing Director, Equity Research Analyst)

Great. Thank you very much.

Operator (participant)

Our next question comes from Ryan Koontz, from Needham and Company. Ryan, please proceed.

Ryan Koontz (Managing Director, Senior Analyst)

Good morning, thanks for the question. First of all, housekeeping, did you have any 10% customers in the quarter? And within the, you know, the larger customer sets, the medium and large, you know, how would you explain kind of the spread of customers in there? You obviously have two large customers, one in each segment. Are they still pretty dominant within those segments? So, thank you.

Cory Sindelar (CFO)

Hey, Ryan, thank you. For your first question, no, we did not have any 10% customers inside the quarter, and the attribution of our large and medium-sized customers is consistent with prior quarters. We saw continued strength in each of those customers into the third quarter.

Ryan Koontz (Managing Director, Senior Analyst)

All right. That's super helpful. And as far as, you know, this mix shift we talked about with the, you know, the Intelligent Access, you know, how should investors think about that in terms of that mix shift? Is that primarily inventory driven, and it gives you greater footprint in your customer base as you see a mix shift toward access?

Michael Weening (President and CEO)

Yeah, right. So remember, when we talked, we were here, you know, last quarter, we talked about how we anticipated a shift into the Intelligent Access EDGE as customers finish their seasonal network builds. And obviously, you know, how we're managing our business, that means we're going to have the opportunity there to manage customer buffers on the Revenue EDGE side. So it's exactly, you know, played out the way we thought it would. And as we look forward to the fourth quarter, it's going to kind of reverse back the other way. That seasonality will come back out, and you'll see the Revenue EDGE pick back up relative to Q3 again. As we say, every single quarter, I wouldn't read anything into mix, right? You know, it goes up and down, and it mixes left, right.

You know, it goes up and down based upon customer requirements. There are nothing that you can read into mix that are indicative of the future because of the fact that it's just moving back and forth as we ship more to one customer who needs more of this, and another one needs more of that. You know, one started, you know, one's in a southerly market, and therefore, it can build through the winter, another one can't because they're in Minnesota, so, or in Canada. So, you know, nothing should be read into mix in any way, shape, or form. And then with regards to the inventory issues, why don't you talk about the DSOs?

You know, if there's a question with regards to inventory issues, go look at the DSOs, right, Cory?

Cory Sindelar (CFO)

Yeah, yeah. Correct.

Ryan Koontz (Managing Director, Senior Analyst)

Makes great sense. All right, thank you.

Cory Sindelar (CFO)

Yeah. Thanks, Ryan.

Ryan Koontz (Managing Director, Senior Analyst)

Understood, Michael. Thank you.

Operator (participant)

Our next question comes from Samik Chatterjee from JP Morgan. Samik, please proceed.

Joe Cardoso (VP, Equity Research)

Hey, thanks for the question, guys. This is Joe Cardoso on for Samik. You know, if I look across the platform expansion this quarter, we're seeing a bit of a slowdown on a relative basis when compared to your strong execution prior quarters. I guess, how are you or should we, I guess, be thinking about that? Is it more related to timing, or are you seeing more prudent customer behavior in the current backdrop? Just curious to hear your thoughts on that front. And then maybe if I could just squeeze my second one on the managed services front, that continues to hum along. As you think about your nine offerings, where are you seeing the most traction today? And then as you think about the recent additions in the form of SmartBiz and SmartTown, how have those been tracking? Thanks for the question, guys.

Michael Weening (President and CEO)

Right. So the first one on revenue, you know, there's something that's out in the marketplace and that's the broadband stimulus. And so we've been through many broadband stimulus programs for the last couple of decades. You know, we're a 24-year-old company who is, as I said, on stage, at Connections, founded in the United States. And over those 24 years, we did broadband stimulus, Connect America Fund, Connect America Fund Two, which was a surprise, the Rural Digital Opportunity Fund. And now there's two programs that are key to our customers, and they're in the market. The first one is A-CAM, the Alternative Connect America Cost Model. Say that quickly five times, which is an OpEx subsidy and is around a $20 billion program. And BEAD, which we've all talked about, which is a CapEx incentive that dwarfs all four previous programs, around $42 billion.

Both of these programs have significant fine print, and this is really important because this is what our customers are working through right now. With all the fine print, they're looking through which is right for them because they've been told very clearly that they cannot participate in both. If that's the case, having been through this before, our customers are going through this period of evaluation on how they are going to take advantage of these programs, and this time around, it's much more complex with massively larger dollars in play. As we go through this, we are managing the business on the conservative side, 1%-4% continued sequential growth, as is the case for our platform model for the next few quarters, until we see that government fund flowing.

You know, clearly, there's a tsunami of funds coming into this space in the near future. Look at those two programs, A-CAM at $20 billion, BEAD at $42 billion, and our customers just need to work through that. The good thing is we're right beside them. You know, we've done over 450 consults, which are, you know, how do you engage with investors? How do you understand government funding? How do you participate in that funding? We help our customers do their submissions. We're right beside them, so as fast as it can happen, we will be right there to make it happen. And now, as for the managed services, as I said in my opening remarks, if you watch the Connections sessions online, you'll see the excitement as we rapidly expand our business model.

You know, and across the entire business, we believe platform and managed services growth will continue unabated, like at this massive pace. And so, for us, you know, to your question on SmartTown and SmartBiz, they actually went into production with customers in August. The excitement around SmartBiz products is incredible as our customers look at this as a high-margin opportunity to grow their business. And in most cases, they have no offering for this segment because people are taking enterprise-class products, scaling it down to the SMB, and that just doesn't work. So they look at this as a massive opportunity to grow margin and add value to the small business. And on the SmartTown side, customer after customer after customer is realizing how incredible an opportunity that is to support their community.

The big announcement that we made at Connections is that we made it so as part of their base licensing model, that they can also expand SmartTown and create a secure network for all first responders, which, you know, honestly, I would think that's one of the few things, you know, most people don't applaud on stage. But as soon as I said that, there was a massive round of applause because they care about their communities, and they're super excited. So how am I with regards to growth trajectory? Well, in essence, both of those products became saleable in August, and they're flying.

All I have to do when I was at Connections is say to a customer on SmartBiz, it allows you not to buy this other product, which I will go unnamed, and I could guarantee you'd get a fist bump because they all want to not buy it, they want to buy us. So great trajectory ahead.

Joe Cardoso (VP, Equity Research)

Thank you, Michael. I appreciate all the colors. Thanks, guys.

Michael Weening (President and CEO)

Great question. Thanks.

Operator (participant)

Our next question comes from Michael Genovese, from Rosenblatt Securities. Michael, please proceed.

Michael Genovese (Senior Communications and Cloud Infrastructure Analyst)

Thanks. Good morning. I guess, so can we talk about RPOs, and, you know, maybe what your expectation for, re-acceleration in the year-over-year growth in RPOs, when we could see that, and what would drive that? Would it be, you know, adding more cloud customers or, you know, renewals, of these three-year contracts? Just, you know, comments on RPOs, would be helpful. Thanks.

Michael Weening (President and CEO)

Thanks, Mike. So like we said in the prior calls with RPO, you know, if we go back and look at the last two years and try to analyze those trends, there's not a lot that you can infer from Q1, Q2, and Q3. What you can infer is that your fourth quarter is the strongest quarter. So... and so that's a function of two things, we think. We think that's largely due to the excitement coming off of Connections and the timing of when their fiscal calendars, their budgets are being set, begins with the calendar year. There's a combination of those two things. So if you go back in time, you tend to see a nice big bump in the fourth quarter. We have no reason to believe that won't continue here in this year.

Certainly, after all the level of excitement that we saw at Connections, and we certainly have more things on the truck to sell. So, that's about all we can say about that, Mike.

Michael Genovese (Senior Communications and Cloud Infrastructure Analyst)

Okay. Can you talk a little bit more about, or talk a little bit about the sort of rebranding of the cloud products? I mean, I noticed the names were changed. Was there, is there anything else behind that or just different names?

Michael Weening (President and CEO)

No. No. So what, as we announced on main stage, we announced why we did it. And the reason why we did it is because one of the things that our customers said to us is that Marketing Cloud is too, saying, calling it Marketing Cloud is too limited. And they were right, because Marketing Cloud infers that you're just selling something to somebody, right? When in fact, what we're doing with Marketing Cloud, Marketing Cloud is, as the new name indicates, it's an engagement engine. It's an engagement engine around all interactions, and this is really important as we evolve into more customer journeys. And a customer journey incorporates all the different elements from the, you know, acquiring the customer at the very beginning, to retaining the customer, and then to growing.

Also through that life cycle, through that entire journey or life cycle, ensuring that at all times, you're engaged with them around what's happening. So for example, let's say an excavator knocks out, you know, rips up your fiber because they cut up a line, right? That is where Engagement Cloud will become engaged. It'll send a—It'll actually run as a campaign, send a text message to the customer, and it'll say, "Hey, you know, we're out for 30 minutes because an excavator ripped up the fiber," which happens shockingly a lot, despite all of the signs. And it's all around how do you engage with that customer.

The other part of it, and this is the big shift, is that, one of the things we've been talking with customers, and I'm a huge believer in this, is that when you're doing good things for an end subscriber, doing things and just hoping that they know you do good things, is a really bad strategy. You actually have to constantly remind them. So if Corey was my customer, I would say, "Hey, Corey, this month, you know, we stopped a cyberbullying attack. We saw it with Bark. We stopped this many viruses, this much phishing, all these different things. We, you know, you had these speeds.

You were doing all this kind of stuff." So Cory takes a glance at it, and he goes, "Oh, I never even knew you were doing that for me." So that in the future, if a bad thing happens, consider it that you're making goodwill investments in the bank, and that if a bad thing happens, well, now you're withdrawing from that bank account, but there's a huge balance to draw from, and the customer is less apt to be angry at you return because they've been reminded nonstop for four years that your, their experience has been incredible. So that's the mentality. That last part is really the key element around why we did it and called it Engagement Cloud.

On the Service Cloud, we just moved it from support, which again suggests that it's just a call center supporting scenario, where we really think of it as much more than just support. It's actually everything we're doing around field service, dispatching, but also having the technician do upsell, cross-sell, we're in their home. So it's how do you service the customer end to end, versus just supporting them if they have a one-time problem. So no, the naming was consciously debated over two years with, you know, which is about as painful as going to the dentist. But we finally got to the right name with our customers and internally, and that's what we aligned it to, and, but frankly, it better reflects the future of those clouds.

Michael Genovese (Senior Communications and Cloud Infrastructure Analyst)

Great, that's helpful. I hope you don't mind, I have a couple more questions, hopefully quick. Just-

Michael Weening (President and CEO)

Go ahead.

Michael Genovese (Senior Communications and Cloud Infrastructure Analyst)

Great. So, I mean, could you—I haven't heard any type of reiteration of the, you know, the forward guide for 2024 on this call. So I wanted to ask about, you know, the expectations for growth in 2024.

Cory Sindelar (CFO)

Yeah, Mike, Michael said in his last response that we believe for next year, we're going to manage this business, given the indecision by our customers around government funding, to the lower end of 1%-4% sequential quarterly growth. So we're going to be targeting 1%-4% sequential growth. That's the target for next year. And but the key thing from us is you're going to see, you're going to see sequential growth.

Michael Genovese (Senior Communications and Cloud Infrastructure Analyst)

So sorry, that's the, that's the guidance for each quarter, is 1%-4% sequentially?

Cory Sindelar (CFO)

Yeah, and, and it'll be at the lower end of that range until we see the government funding starting to flow.

Michael Genovese (Senior Communications and Cloud Infrastructure Analyst)

Okay, great. And then last question is, just, you gave us the lead times now. What were they before, COVID and, you know, all the supply chain issues? Were they similar to now, or were they different?

Cory Sindelar (CFO)

No, they were about 16. They, they range between 10 and— no, prior, prior to the pandemic, they ranged between 10 and 16 weeks, depending on the component, like the, the components that were included in it. So you have some simpler chipsets, you have more complex chipsets. So it was in around the range that we're currently in, so about an hour lead time for inventory purchases. And so it, it was, it was a little bit tighter window than that, Mike.

Michael Genovese (Senior Communications and Cloud Infrastructure Analyst)

Okay. Great. Thanks so much.

Operator (participant)

Our next question comes from Tim Savageaux, from Northland Capital Markets. Tim, please proceed.

Tim Savageaux (Managing Director, Senior Research Analyst)

Hi, good morning. Sorry about that.

Cory Sindelar (CFO)

Morning.

Tim Savageaux (Managing Director, Senior Research Analyst)

And I guess I'd ask this question in the context of both Q4 and given your comments there about expectations for next year. You've seen some nice sequential increases in gross margin thus far this year, including in Q3, despite some pretty modest sequential growth, and despite, you know, weakness in Revenue EDGE. And I don't know if that really matters from a mix standpoint, but as you look in Q4, you've got that kind of flattening out a bit. And I wonder, since we're talking about 2024, what sort of gross margin trajectory you might expect to go along with that? So a couple different questions about both Q4 dynamics on gross margin and next year, and to what extent that's impacted by the level of revenue growth. Thanks.

Cory Sindelar (CFO)

Yeah, so the scenario we outlined last quarter is playing out the way we expected. So we saw higher gross margins in the third quarter, driven by continued expansion of our platform and managed services. That shift from Revenue EDGE to Intelligent Access EDGE, as they finished up their network builds. And leading off some of that components that we paid, you know, in the spot market. So we're getting to the end of that. In the fourth quarter, those same dynamics are at work. We're going to see continued adoption of our software and platforms. That will help on the margin line. We'll see a shift backwards, back to Revenue EDGE, away from Intelligent Access EDGE as that seasonality dissipates. And then we're going to see the continued runoff of those excess components.

And so we're gonna be, you know, we obviously took the guidance up a little bit, for the fourth quarter. So those one-time charges will now be behind us in the rearview mirror as we exit the year. That obviously sets us up at a higher base going into 2024. And so for 2024, we're going to reaffirm our long-term target model of 100-200 basis points on a higher base coming out of 2023.

Tim Savageaux (Managing Director, Senior Research Analyst)

Thanks very much.

Cory Sindelar (CFO)

Are you there, Tim? Oh, there we go.

Operator (participant)

Our next question comes from Greg Mesniaeff, from Westpark Capital. Greg, please proceed.

Greg Mesniaeff (Sell-Side Equity Research Analyst)

Thank you. Thank you for taking my question. Given the visibility you have on the fourth quarter and on 2024, and given the shift that we've started to see from the smaller customer base to the mid-size customer base, do you see that trend continuing into the fourth quarter into 2024? And assuming it does, how does that alter the the pricing and the competitive dynamics of your products in the marketplace? Thanks.

Cory Sindelar (CFO)

So it doesn't, and yes, it will continue. Yeah, all, all these disruptions start from small and work their way up to the larger customers, and we've said that for, for many, many years now, and you're going to continue to see that trend. You're going to continue to see the, the medium segment grow. It's going to grow from customers that finally move up into that category from the small. And the ones that are existing there are going to continue to grow and, and we may see some further expansion in, in terms of, other Tier 2s, adopting the model as we move forward.

Michael Weening (President and CEO)

But I want to be really clear from a philosophy point of view, like, really clear. We don't chase revenue. We do not. Our goals as a leadership team on behalf of our investors are to grow margin and drive cash flow, because those are the outcomes that investors value in this market. And it's become really clear between who are the winners and the losers, and the platform market will make our investors a winner. And so what we won't be doing is sacrificing margins to win revenue. That's not what we do. Right from the get-go, everything has been focused on finding strategically aligned broadband service providers who understand the value of our platform and are willing to pay for it, because they make a shed load more money when they use our platform.

And so what's going to happen, and this is already happening, is that those bigger customers are starting to see if they watched main stage and saw United Fiber, Tombigbee Fiber, Allo, all these other companies talking about how they're achieving market shares at north of 60%, NPSs that would make Apple jealous, and huge margins that allow them to be cash flow positive at a third of the time that others take. And so they start to realize that what's the difference between me as a big company and the Calix customer? One thing, they're using our platform, and that platform differentiates them in the market. And so as they start to hurt from our customers bringing them the pain, they'll start to realize that they need to actually align or die. So that's where we're gonna go.

Greg Mesniaeff (Sell-Side Equity Research Analyst)

Thank you for that.

Operator (participant)

Our next question comes from Scott Searle from Roth MKM. Scott, please proceed.

Scott Searle (Managing Director, Senior Research Analyst)

Hey, good morning. Thanks for taking my questions, and nice quarter in a difficult macro backdrop. Hey, Mike, maybe to dive in on some of the managed services side, it seems like there's finally momentum-

Michael Weening (President and CEO)

Sure.

Scott Searle (Managing Director, Senior Research Analyst)

building around some of the potentially larger opportunities, specifically SmartBiz, which has been incubating for a while. Seems to have a lot higher revenue opportunity attached to it, and the recently announced SmartMDU as well, seems like it's pretty intriguing in terms of-

Michael Weening (President and CEO)

Yeah.

Scott Searle (Managing Director, Senior Research Analyst)

The value opportunity guys. I was wondering if you could-

Michael Weening (President and CEO)

Yeah

Scott Searle (Managing Director, Senior Research Analyst)

-provide a little, a little bit more color in terms of how we should think about success within those marketplaces. How does that ramp up, and what does that business model really look like as we get out into mid-2024 in the back half of next year?

Michael Weening (President and CEO)

Well, so SmartBiz has taken off like crazy, and the reason why is because it's, it, you know, our customers were the ones who identified this opportunity. The way that they were dealing with small businesses is they really had went at it in two ways. One, they did nothing other than provide a wireless router and a connection, which is very little value for the small business. Or two, they were taking enterprise-class technologies that are very complex and require an IT organization installing them into the small business, which meant that, first of all, they made no margin. It was like crappy hardware margins for them as a resale of hardware into the baker. But more importantly, when that hardware went down and the baker didn't have an IT organization, it meant significant operating costs because they would have to support it.

So there's been this significant gap in the marketplace, and so we closed it. And, you know, yes, you're right. The momentum around SmartBiz now that it went into production in August, in our 23.3 release, which is the second week of August, it went into production, and every single customer is like super stoked because they're like, "You've just—you've nailed a massive gap in the market." And, you know, we have, as I announced at Connections, a number of small expansions that allow them to do things like cover a marina, covering an RV park, those different things. It's pretty great. And then on an ASP side, yeah, it's significantly higher.

So, you know, that's a great growth opportunity, but the way that we deal with that higher ASP, if you'll remember when we talked to you, is that we think about the opportunity, which is $1-$10 a month, and then we blend that into the $1-$10 because, you know, small businesses in any market are gonna be between 5% and 10% of the subscribers. So that's the first one. On SmartTown, look, SmartTown is like Bark. I would say Bark will have a significant momentum and SmartTown because those are our customers doing the right things for their community, and what they drive is everything else.

Because the customer realizes that we have uniquely positioned them to position their brand up against a legacy giant in a way that no one else is. So for example, with SmartTown, they go and they sit down with the mayor and say, you know, and the superintendent of the schools, and say, "Let's make it so that children can roam around town and have broadband and close the digital divide whenever they do homework.

Oh, by the way, Mr. Mayor or Mrs. Mayor, would you like it so that the first responders who have an iPhone, that you're paying a mobile carrier for a lot of data charges, would you actually like them to be on a secure network and let their laptop be on a secure network so that you can have this opportunity to offload that, reduce your cost, partner with us?" And that builds a great relationship with the community. And I was very blunt on stage. The way a customer described what we're doing with first responders, and the reason why our leadership team instantaneously decided to include that as part of their ongoing subscription charges with us, as opposed to an incremental charge with first responders, is because we do believe that will save lives.

The story the customer said was, in a lot of rural America, there is no 5G cell, so cell phone service, as we know, logically, you know, to install a cell phone tower, whether it's, you know, in a large city or in rural America, costs the same amount, $250,000-$400,000 per tower. Right? And so if you're go putting in a small town of 2,000 or 3,000 people, it's not gonna reach out to that farm.

And so what happens is, you know, the story he told was, we all frequently will have an ambulance or a police officer drive down the street, lose cell phone service, and they're trying to find someone who crashed their motorcycle in a ditch, or they're driving up to a farm for a 911 call to save a life because someone's having a heart attack, and they have no cell phone service. They have to go and grab the landline and phone in... What's going to happen with our customers when they turn this on, is that that police officer looking for that motorcyclist is going to have connectivity as they go through when their cell phone service drops.

When they drive up to that farm that has no cell phone service, they're going to connect securely over that fiber back into the back office, and they're going to be fully connected so that they can save that life. So if you think about the significant magnitude of those changes that we implemented, it represents a huge opportunity for our customers to basically eliminate the big soulless giants who do not care about rural America. Yeah, pretty damn excited.

Scott Searle (Managing Director, Senior Research Analyst)

Maybe to just follow up on my second question, in terms of the outlook, you know, it sounds like you're continuing to reiterate the long-term guidance of 10%-15%, albeit towards the lower end of that range in 2024, where I think consensus expectations are. In combination with improvements on the gross margin of another 100-200 basis points off a higher number in 2023 than originally expected. On top of that, though, I'm hearing you talk more and more about BEAD, whereas historically, I think the company had indicated, "Hey, look, don't get too big on government programs. They're unreliable, the timing can slip, et cetera." But it seems like that's coming more and more into the conversation, more visible now, given where these programs are in terms of deploying the capital.

It sounds like with 450 consults, you guys have a significant exposure on that front. I guess in terms of looking at 2024 and going into 2025, it sounds like we should be looking for an inflection as we get into late 2024, 2025, as you start to get more visibility on the BEAD front, and other programs in terms of subsidies and rollouts. Am I thinking about that the wrong way, or how should we be thinking about that longer-term picture?

Michael Weening (President and CEO)

You, by the way, by the way, you literally took the words out of my mouth. So you're thinking about it exactly right. So we, you know, we're managing the business on the conservative side to 1%-4% sequential growth quarterly quarter-over-quarter. As we work with our customers, as they make that complex decision, do they do A-CAM or BEAD? It's an either/or, and this has led to a lot of conversations. And as you said, there is a tsunami of money coming, and we're deeply embedded with our customers.

As I also stated, we've already done 450 consultations on funding and A-CAM and BEAD, helping our customers understand which is the decision they should make and how do they go after that $65 billion worth of funding, which is, I can't see any other word, but tsunami that's coming down the path. So your statement of seeing an inflection point in the latter part of 2024, early part of 2025, perfectly stated, and that's exactly how you should think. Meanwhile, we will continue to manage through it on a, at a conservative level through 2024 as our customers make those decisions, and off we go.

Scott Searle (Managing Director, Senior Research Analyst)

Great. Thanks so much.

Operator (participant)

This concludes our question and answer session. I would like to turn the floor back over to Jim Fanucchi for closing comments.

Jim Fanucchi (VP of Investor Relations)

Thank you, Kat. Calix leadership will participate in several investor events during the fourth quarter, both in person and virtually. Information about these events, including the dates and times and publicly available webcasts, will be posted on the Events and Presentations page of our website at calix.com. Once again, thank you everyone on this call and webcast for your interest in Calix and for joining us today. This does conclude our conference call. Have a great day.

Operator (participant)

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