Extreme Networks - Earnings Call - Q3 2018

Transcript

Speaker 0

Good day, ladies and gentlemen, and welcome to the Extreme Networks Q3 FY twenty eighteen Financial Results Conference Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time. As a reminder, this conference may be recorded. I would now like to introduce your host for today's conference, Stan Clover, Senior Director, Investor Relations and Finance.

Sir, you may begin.

Speaker 1

Thank you, Mani, and welcome to the Extreme Networks third quarter fiscal twenty eighteen earnings conference call. This conference call is being broadcast live over the Internet and is being recorded on behalf of the company. The recording will be posted on Extreme Networks' website for replay shortly after the conclusion of the call. By now, you've had a chance to review the company's earnings press release. I would like to remind you that during today's call, management will be making forward looking statements within the meaning of the Safe Harbor provision of federal securities laws.

These forward looking statements involve a number of risks and uncertainties, which could cause actual results to differ materially from those anticipated by these statements. These risks include possible adjustments in tax calculations arising from further assessment of the impact of the recent changes to U. S. Tax laws and our ability to successfully integrate the acquired assets, technologies and operations from Avaya and Brocade into our business and operations, including but not limited to the following risks difficulties we may experience in the retention, assimilation and successful integration of employees and teams, sales functions, acquired operations, technologies and or products unanticipated costs, litigation or other contingent liabilities associated with the acquisition that could negatively impact our operating results and financial condition, adverse effects on existing business relationships with suppliers and customers and difficulties we may experience in reaching our aspirational goals related to these acquisitions. For a detailed description of risks and uncertainties, please refer to our most recent reports on Form 10 ks, 10 Q, eight ks filed with the SEC.

You should not place undue reliance on forward looking statements, which speak only as of today. We undertake no obligation to update these statements after this call. Throughout this call, we may reference both GAAP and non GAAP financial metrics. Non GAAP information should be considered a supplement substitute for financial statements prepared in advance in accordance with GAAP. Reconciliation of non GAAP to corresponding GAAP measures can be found in our earnings press release issued today.

For your convenience, a copy of the release and supporting financial materials are available on the Investor Relations section of the company's website at extremenetworks.com. Now I will turn the

Speaker 2

call over to Extreme's President and CEO, Ed Meyercord, for his opening comments. Thank you, Stan, and thank you all for joining us this afternoon. Welcome to Extreme's Q3 earnings call. Today, we announced Q3 results highlighted by 76% growth in total revenue year over year. A few key successes.

we were pleased with our consecutive quarter of organic growth within the core Extreme portfolio, excluding acquisitions. Core Extreme experienced 8% year over year organic growth on strength in our wireless business, particularly in North America. Avaya experienced strong sequential growth of 10% as we continue to focus on disciplined go to market and success in cross selling the Layer two fabric, particularly in Europe. quarter over quarter improvement in sales during a typically seasonally weak quarter for us. However, in our full quarter with Brocade, our data center revenue was impacted by two primary factors, a $5,000,000 purchase accounting adjustment with Brocade and discounts built into the pipeline we acquired on a few deals.

We also built backlog of $7,000,000 during the quarter. We started Q3 with three separate versions of Salesforce, two versions of Oracle and one version of SAP. Now the entire business runs on one Extreme system, one instance of Salesforce and all our bookings are in one Oracle system. Entering Q3, we said we had better visibility and that it would take some time to transition. But now heading into Q4, we believe we have complete visibility of our business from a systems perspective.

And for our consecutive systems migration, we booked, shipped and billed orders on the day of the cutover with excellent performance by our IT and business integration teams. Beyond organic growth of 8% core Extreme year over year, the acquired Avaya revenue also grew 10% sequentially to $44,000,000 while Brocade's first full quarter revenue totaled $53,000,000.58000000 adjustment. All in, our acquired run rate remains in line with our two thirty million dollars guidance. Our non GAAP gross margin came in at 57.9%, affected by a few large Brocade deals early in the quarter. Although we were targeting to reach our long term goal of 60% gross margins and 15% operating income by Q4 twenty eighteen, we now expect to achieve them in fiscal twenty nineteen.

Our Q3 results for fiscal 'eighteen highlight our progress despite some integration challenges we worked through during the quarter. We delivered $0.16 of non GAAP earnings just below our guidance range. Our Extreme Connect user conference in Phoenix, Arizona in late April attracted a large audience of customers and partners that are now Extreme certified insider community members. Attendees at Connect received technical training across all of Extreme's solutions, along with dedicated training for key verticals such as education, retail and hospitality. Feedback continues to be very encouraging, and we've received very favorable press.

Our customers and partners are usually surprised and encouraged by the depth of our new portfolio when our technical teams take everyone through each place in the network. With the IT systems integration of our acquisitions behind us, we are taking a unified approach in our new go to market focus centered around the Smart Edge, Automated Campus and Agile Data Centers. We bring together applications, services and support for our customers that truly highlights our end to end networking focus. Our customers across our target verticals continue to embrace digital transformation and consider Extreme as a partner on this journey. At the beginning of Q4, we rolled out a unified branding message to our employees and partners focused on software driven solutions.

These solutions, driven by the agile, adaptive and secure infrastructure and a variety of software applications deliver intelligence across Smart Automated Campus and Agile Data Center solutions. Our customers are telling us their businesses demand that they shift from managing the network to managing the business. Smart Edge supports campus, distributed and cloud wireless architectures for unprecedented choice and adapts to diverse technical requirements. Our customers can manage Smart Edge from Extreme Cloud as a service and from our Smart Edge management application on prem or private cloud, allowing multiple consumption models. You'll be hearing a lot about Smart Edge this summer and fall as we introduce a broad range of products, including 802.11ax wireless and extended edge switching products.

Our secure Automated Campus launch continues to make headway in the marketplace as campus upgrades are a key priority for a significant number of our customers. Automated Campus redefines networking to match the expectations of a digital business. Designed for agile, simple and intelligent networking, this policy based fabric enabled architecture is unrivaled in its simplicity and manageability. Our customers tell us that on average, automated campus makes adds and changes 11x faster than prior generations. We continue to enhance automated campus solution.

Our whole campus portfolio is already supported in XMC. And by summer, we will have Extreme Analytics support across the portfolio as well. In this era of cloud networking, agility at the speed of business is critical for maintaining competitive advantage. Extreme's agile data center solution is optimized to help enterprises and cloud organizations meet these challenges. Our agile data center solution is built programmable switching and routing platforms, providing pervasive network visibility and cross domain network lifecycle automation.

In April of this year, we introduced OptiScale for Internet routing, which enables customers to easily utilize the programmability built into the platforms. We continue to enhance OptiScale to include other use cases and features. Our end markets are undergoing tremendous change that is happening at a time when IT budgets have been under pressure. However, recent CIO surveys show budgets are actually improving in calendar twenty eighteen relative to their 2017 views. This gives us confidence in the demand environment as we refresh and homogenize our product portfolio under one extreme.

Campus upgrades are an essential priority for a significant portion of our customers with a key focus on using more software solutions. The only way to solve for this growth and complexity is to leverage software driven solutions that automate provisioning of devices at the edge and the deployment of cloud services across multiple platforms. Extreme is well positioned as the premier alternative to the larger competitors in our market who are less focused and playing in many different market segments like servers, storage, security and hyper converged platforms. In our core Extreme portfolio, we see continued strength in wireless and software driven sales that pull through our fixed switching portfolio, offset by the runoff of modular switching, which is now a much smaller portion of our revenue mix. We are developing more prescriptive solutions for our customers in the field.

Our secure automated campus launch continues to make headway in the marketplace. Having completed the systems migration from the Avaya TSA agreement early in Q4, we are unencumbered to grow into our run rate for this business and expect sequential growth in our Avaya business once again in the June. We entered the March with a pipeline of cross selling deals of $20,000,000 up from $8,000,000 in December, of which we recognized $2,500,000 in the December. During the March, we recognized $10,500,000 in cross sell revenue and grew our June cross selling pipeline to $38,000,000 with particular strength in both The U. S.

And EMEA. I want to highlight a few examples of what these opportunities were. a large university healthcare center implemented our complete hardware and software solutions suite deploying Extreme wireless, analytics and switches to create unique and engaging user experiences for their patients, physicians and staff. in the hospitality vertical, we expanded our engagement with existing customers beyond analytics and deployed ExoS switches and Extreme's management center solution for new applications. We also deepened our relationships with several key Fortune 50 customers and became even more strategic to their network edge and core efforts.

Combining Avaya's differentiated fabric technology with Extreme's full suite of software and competitive wireless continues to yield dividends from a cross selling perspective. We are now rebuilding our pipeline of business in our Avaya campus business, which is being generated by strong demand for our fabric solution. The ease of deployment, the ability to segment networks across the enterprise and the high level of security in our Layer two fabric is driving a healthy pipeline and demand for our solutions. We continue to target a $200,000,000 annual run rate in Q4 and growth in fiscal twenty nineteen at a higher gross margin level than what we saw in Q3. While there is excitement in the field about our data center business, as we build out the use cases with our next generation SLX combined switching and routing platform, we were impacted by residual challenges in Brocade's pipeline that we are now rebuilding.

Our VDX and MLX switching and routing platforms, along with our automated deployment tools, are driving revenue and customer engagements. We continue to make progress with customers such as The U. S. Government agency that deployed our VDX solution. The key components to their continued business is unbeatable support in addition to high performing products from an uptime and thermal efficiency perspective.

We are introducing extreme validated designs across the entire portfolio, bringing true solution bundles of hardware and software to our enterprise and cloud service customers. On the data center side, our validated designs and reference architectures for specific use cases are making it easier to sell and deploy our cloud solutions and are being embraced by our customers. When combined with our workflow composer and its cross domain deployment capability, we can support our customers in delivering very agile enterprise cloud solutions. A few lower margin Brocade deals early in the quarter impacted our gross margin by about 100 basis points. As we continue to impart our discipline on our acquired businesses, we expect gross margins to reach our long term 60% target in early fiscal year twenty nineteen.

Our third quarter non GAAP gross margins grew 70 basis points year over year. As we look out into the June, we project Q4 revenue to improve to a range of $277,000,000 to $287,000,000 The improved visibility into our business should allow us to rebuild the pipeline across all our geos and target verticals and include significant growth in cross sell opportunities into fiscal twenty nineteen. One focus point I wanted to reiterate heading into June is on our data center business. We expect data center revenue to remain at our $230,000,000 annual revenue target adjusted for purchase accounting and generate gross margins in the low 60% range going forward. We continue to work with our teams to build out Brocade's pipeline following a period when this business was going through a sales process, and we remain confident in the business.

Net net, taking our second half fiscal twenty eighteen run rate yields $1,080,000,000 of revenue on an annualized basis. Our recently acquired assets, Brocade and Avaya, are on a $430,000,000 run rate that we expect to grow 3% to 5% in fiscal twenty nineteen. Our core Extreme business exits fiscal twenty eighteen on a $650,000,000 run rate, and we expect this business to maintain a similar growth rate into next year. Our teams continue to execute well despite the extra time and resources required to integrate and onboard our employees, customers and partners, develop our combined product roadmaps, build out our engineering labs and resources, move our new employees into our facilities and combine the data and systems that support the businesses. With all our acquisitions now under one roof, we expect improved execution and 3% to 5% normalized annual revenue growth heading into fiscal twenty nineteen that we continue to believe is appropriate for our combined businesses on a like for like basis.

With that, I'd like to turn it over to Drew to review our results and guidance in detail.

Speaker 3

Thanks, Ed. Let's get started with a few highlights from our third quarter of fiscal twenty eighteen. In Q3, we had our full quarter of the combined revenues of our recent acquisitions. And as a result, our revenue grew $113,000,000 or 76% year over year and $31,000,000 or 13% from the previous quarter. Also, I'm pleased to report organic revenue growth in the pre acquisition Extreme business of 83% year over year and quarter over quarter.

Our non GAAP gross margin increased 70 basis points in Q3 from fiscal twenty seventeen to 57.9%. This makes eight consecutive quarters we have now increased our non GAAP gross margin compared to the same quarter year over year. Quarter over quarter from Q2, our gross margin declined from 59.4% to 57.9%. Next, turning to revenue. Q3 revenue was $262,000,000 compared to $231,100,000 in Q2 and $149,200,000 in Q3 a year ago.

Revenue increased quarter over quarter and year over year by $30,900,000 and $112,800,000 respectively. I would also like to note that we did not recognize $5,100,000 of service revenues in Q3 and $3,400,000 last quarter from our campus fabric and data center acquisitions as a result of purchase accounting adjustments. The geographical split of revenues was as follows: The Americas contributed 55% to total revenue, EMEA contributed 36, APAC contributed 9%. The order of our top five verticals in Q3 was education, communications, government, manufacturing and healthcare compared to government, education, manufacturing, communications and retail in fiscal Q2 of twenty eighteen. Product revenue for Q3 was $203,500,000 compared to $174,800,000 in Q2 and $111,300,000 in Q3 last year.

Q3 service revenue was $58,500,000 compared to $56,300,000 in Q2 and $37,900,000 in Q3 last year. Moving on to gross margin and operating expenses. In Q3, GAAP gross margin was 54.6% compared to 55.8% in Q2 and 55.5% in Q3 last year. Non GAAP gross margin was 57.9, which compares to 59.4% in Q2 and 57% in Q3 last year. Q3 GAAP operating expenses were $151,200,000 compared to $160,100,000 in Q2 and eighty five point four million dollars in Q3 last year.

Q3 GAAP operating expense includes amortization of intangibles of $2,100,000 stock based compensation charges of 7,300,000.0 litigation settlement expense of $200,000 restructuring charges of $4,900,000 and acquisition related expenses of $9,300,000 We had stock compensation expenses of $700,000 in cost of goods sold, dollars 2,400,000.0 in R and D, dollars 2,800,000.0 in sales and marketing and $2,200,000 in G and A. Q3 non GAAP operating expenses were $127,400,000 compared to $117,000,000 in Q2 and $70,800,000 in Q3 of twenty seventeen. The sequential increase in non GAAP operating expenses was mainly attributable to the addition of one month of expenses from the Brocade data center business. Third quarter GAAP operating loss was $8,200,000 compared to an operating loss of $31,100,000 in Q2 and a loss of $2,600,000 in Q3 last year. non GAAP operating income was $24,400,000 or 9.3% of total revenue compared to $20,300,000 or 8.8% of total revenue in Q2 and $14,600,000 or 9.8% of total revenue in Q3 last year.

GAAP net loss for Q3 was $13,600,000 or $0.12 per share compared to a net loss of $31,900,000 or $0.28 per share in Q2 and a net loss of $5,000,000 or $05 per share in Q3 last year. Non GAAP net income for the quarter was $19,000,000 or $0.16 per diluted share and compares to net income of 16,400,000.0 or $0.14 per diluted share in Q2 and $12,200,000 or $0.11 per share in Q3 of 'seventeen. Turning to the balance sheet. Q3 total cash and cash equivalents ended the quarter at $103,000,000 down $24,000,000 from the end of last quarter and down $14,000,000 from the end of Q3 and fiscal 'seventeen. Our cash balance declined in Q2 and Q3 due to acquisition and integration related spending for CapEx, mainly for facilities and IT systems and infrastructure, transition services, IT integration consulting, restructuring and other spending that we do not expect to incur beyond Q4.

For illustration, we've included Slide 10 in our earnings release presentation posted on the Investor Relations section of our website to show these payments compared to what we view as our typical capital spending. During the quarter, cash flow from operations was an outflow of $16,000,000 compared to an outflow of $4,000,000 in Q2 and an inflow of $25,000,000 in Q3 last year. Free cash flow was an outflow of $25,000,000 compared to an outflow of $41,000,000 in Q2 and an inflow of $22,000,000 in Q3 last year. Accounts receivables were $188,000,000 at the end of Q3, up $34,000,000 from the end of Q2 on higher sales and up $116,000,000 from the end of Q3 of fiscal 'seventeen with the addition of the acquired data center and campus fabric businesses. DSO increased by three days to sixty five days this

DSO Our DSO for the last three quarters has been impacted by the transition services agreements from the Campus Fabric and data center acquisitions. Under these TSAs, Avaya and Brocade collected accounts receivable on behalf of Extreme over the standard customer payment terms, typically thirty to forty five days, and then remitted the collections after forty five days. This temporarily built additional days into our collection cycle, inflating our DSO. The impact of the TSA on our DSO will end in our fiscal Q4. Inventory ended at $78,000,000 down $6,000,000 from last quarter and up $28,000,000 from Q3 of 'seventeen with the addition of the acquired inventories.

Total debt outstanding net of loan fees at the end of Q3 was $179,000,000 compared to $95,000,000 at the end of Q3 last year. The increase is attributed to the amended term loan for the campus fabric and data center acquisitions. On May 1, we closed a new term loan and revolving line of credit that repaid our outstanding debt. The outstanding amount of the new term loan is $190,000,000 and there is $10,000,000 outstanding on the revolver out of a total available of 40,000,000 The interest rate on the new term loan will initially be 100 basis points less than the rate on the previous term loan. This will result in approximately $200,000 less interest expense in Q4 and $500,000 in Q1 of fiscal 'nineteen, the full quarter that the loan will be outstanding.

Now let's move the on to the guidance for Q4. We expect total Q4 revenue to be in the range of $277,000,000 to $287,000,000 Q4 GAAP gross margin is anticipated to be in the range of 56% to 58.1%, and non GAAP gross margin is estimated to be in the range of 58% to 60%. Q4 operating expenses are expected to be in a range of $148,600,000 to $152,200,000 on a GAAP basis and $136,500,000 to $139,500,000 on a non GAAP basis. Tax expense is expected to be $2,000,000 to $2,400,000 in Q3 and Q4, up from the previous quarters due to higher revenue and increased activity in our foreign jurisdictions. We are continuing to evaluate the recently enacted U.

S. Tax legislation and the impact to our income statement and balance sheet. And pursuant to the SEC guidance, we have recorded provisional amounts in our Q3 year to date financial results. We have not been a tax a U. S.

Taxpayer in recent years due to the level of accumulated tax attributes we are carrying forward. We believe changes in the tax laws, including the addition of a new minimum tax on a portion of our foreign earnings, limitations on certain U. S. Deductions and anti base erosion provisions will likely cause us to utilize those U. S.

Operating losses on an accelerated basis and we will be subject to the full U. S. Tax rate in two to three years. Q4 GAAP net income is expected to be in a range of 1,500,000.0 to $9,600,000 or $01 to $08 per share. Non GAAP net income is expected to be in a range of $19,200,000 to $27,900,000 or $0.16 to $0.23 per diluted share.

In Q4, we expect average shares outstanding to be approximately 121,500,000.0 shares outstanding. This concludes our prepared remarks. We will now open the call up for questions.

Speaker 0

You. And our question comes from Erik Suppiger with JMP Securities. Your line is now open.

Speaker 4

Yeah, thanks for taking the question. off, can you just clarify on the Brocade revenue or restatement? Was that a surprise to you during the quarter or was that already factored into your guidance? And then I've got a

Speaker 3

Yeah, sorry, Eric. Yeah, so part of it was we had a $1,000,000 adjustment that we had to make during the quarter. And then the other part is the deferred revenue that you lose when you have an acquisition and that accounted for about 4,000,000 of the $5,000,000

Speaker 4

Were both of those or one of those already assumed in

Speaker 3

Yes. We had assumed the $4,000,000 in our guidance, but the $1,000,000 was a surprise.

Speaker 4

Okay. And then secondly, how were your Brocade sales to Brocade Campus customers during the quarter? And similarly, how was your Avaya sales to Avaya wireless customers in the quarter?

Speaker 2

Yes, Eric, let me take that. We have several initiatives underway and we have a pipeline of ICX customers, the campus customers from Bocade. But at this point, we don't have a sales number to comment on for the call. But we are building up quite a pipeline there. So it's taking it takes a little bit of time, but we do see opportunities there.

On the Avaya side, that's really been a big driver of the cross sell. We talked about the pipeline growth and commented that the growth in pipeline being driven largely by Avaya, campus, fabric, wireless, the opportunity for us to sell Extreme wireless into the fabric customers and then also the fabric technology that we're selling along with Extreme technology. And this is happening across our geos in Europe and The U. S. But we talked about the fact that we went into the December, we had a pipeline of $8,000,000 and then it grew to $20,000,000 and now it's grown to $38,000,000 and a lot of that is driven by wireless.

Speaker 4

Very good. Thank you.

Speaker 0

Thank you. This concludes today's Q and A session. I would now like to turn the call back over to Ed Mayercord for closing remarks.

Speaker 2

Okay. Thank you, Amani. Appreciate that. And thank you, everybody, who could join us on the call today. And I want to thank all the Extreme employees who are listening in.

We are looking forward to improving our execution in the pipeline in the June, which is going to set us up for a strong fiscal 'nineteen. We hope to speak to you. We have a Craig Hallum Conference on May 30 coming up as well as at the Cowen Company Technology, Media and Telecom Conference on May 31. So we thank you for your participation, and we'll catch up with you next quarter. Thank you.

Speaker 0

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

Speaker 2

great day.