Extreme Networks - Q3 2023

Transcript

Operator (participant)

Good day, welcome to the Extreme Networks Q3 Fiscal Year 2023 financial results call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star one one on your telephone. You will hear an automated message advising that your hand is raised. To withdraw your question, press star one one again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker, Mr. Stan Kovler. Please go ahead.

Stan Kovler (VP of Corporate Strategy and Investor Relations)

Thank you, operator. Good morning, everybody. Welcome to the Extreme Networks' third fiscal quarter 2023 earnings conference call. Thank you all for your patience. We were experiencing some technical issues with the webcast that have been resolved now. Everyone is able to join. I lead investor relations and the corporate strategy. With me today are Extreme Networks President and CEO, Ed Meyercord, and Interim CFO, Cristina Tate. We just distributed a press release and filed an 8-K detailing Extreme Networks' financial results for the quarter. Earlier this week, filed an 8-K announcing our new CFO. For your convenience, a copy of the press release, which includes our GAAP to non-GAAP reconciliations, is available in the investor relations section of our website at extremenetworks.com, along with our presentation, which should be up right now. There's a link.

I would like to remind you that during today's call, our discussion may include forward-looking statements about Extreme's future business, financial, and operational results, growth expectations, and strategies. Our financial disclosures on this call will be made on a non-GAAP basis, unless stated otherwise. We caution you not to put undue reliance on these forward-looking statements as they involve risks and uncertainties that can cause actual results to differ materially from those anticipated by these statements, as described by our risk factors in our 10-K report for the period ended June 30, 2022, filed with the SEC. Any forward-looking statements made on this call reflect our analysis as of today, and we have no plans or duty to update them except as required by law. I will turn the call over to Extreme's President and CEO, Ed Meyercord.

Ed Meyercord (President and CEO)

Thank you, Stan, and thank you all for joining us this morning. Extreme delivered another quarter of record results driven by solid execution of our teams. Our top-line performance was highlighted by improvements in our supply chain that drove 16% total revenue growth and 22% product revenue growth on a year-over-year basis. We achieved double-digit growth in eight of the past nine quarters. Our operating margin and EBITDA also achieved quarterly records in Q3. Product orders grew 6% sequentially, and orders from new customers grew 20% during this timeframe. This is the second consecutive quarter where new logos are playing a substantial role in our growth. We believe demand trends will continue as customers recognize the simplicity of our One Network, One Cloud solutions relative to the complexity and total cost of ownership of our largest competitors.

Although our Q3 bookings typically decline sequentially in the March quarter, we in fact grew from December, reflecting strong demand. With our funnel of opportunities remaining robust, we expect more normal seasonality and higher sequential growth in Q4. We expect total revenue growth to accelerate to over 20% from the prior year based on improved product availability. We're reiterating our long-term growth outlook in the mid-teens through fiscal 2025 based on confidence in our ability to take market share, given the size of our market, where small share gains have a big impact on our growth rate. For the first time, Extreme's non-GAAP operating margin surpassed the 15% mark, and we achieved EPS of $0.29 in Q3, up from $0.27 in Q2 and from $0.21 in the year ago quarter.

We expect these bottom line earnings trends to continue and for earnings to grow faster than revenues over the long term, given increasing gross margins and operating leverage. Demand is being driven by the execution of our field teams, our strategic partners, and the competitive differentiation of our solutions. We're the only networking vendor that has flexible universal hardware and combines cloud choice with best-in-class automation, the most widely deployed Fabric, and the industry's simplest licensing model. Our end-to-end solutions operationalized from One Cloud makes it easy to manage the entire enterprise network. We offer visibility, access control, security, machine learning, and AI across wired, wireless, and SD-WAN infrastructure via a single cloud. The evidence of our success can be seen in marquee new logo and large global deals with brands such as Kroger, Cedar Fair, Boingo, Ahold, and others.

We're gaining share across our key verticals driven by our competitive differentiation. For example, in E-Rate, we grew faster than the market. We gained share, most notably against our largest competitors. During the quarter, bookings from customers who spent more than $1 million with Extreme were the highest in our history. Given the strength of our solutions and our elevated profile with strategic partners, we're being invited to compete for larger projects. We're winning more. We expect these trends to continue. Some top wins for the quarter included Kroger, one of the largest U.S. grocers with 2,800 stores across the country. This deployment will become the world's largest cloud-managed network, with more than 110,000 access points managed via ExtremeCloud. With Wi-Fi 6E, Kroger will benefit from faster speeds, lower latency, and more security across its entire network.

Our technology will help Kroger drive energy savings, improve the shopper experience, streamline operations, and drive business transformation initiatives to create their store of the future. Our success in retail also extended into Europe, where Ahold Albert Heijn, a global supermarket chain with stores across 10 countries, serving 60 million shoppers a week, chose Extreme for its cloud-driven wireless deployment and our CoPilot AI ML insights available on Extreme Cloud. In the Middle East, we won one of the largest healthcare providers in Saudi Arabia. Extreme and a partner deployed a secure end-to-end fabric-enabled network at 2 new hospitals. The new state-of-the-art facilities will rely on Extreme to support and secure a wide range of new digital services.

Cedar Fair, owner and operator of 15 amusement parks, 5 hotels across North America, selected Extreme to deploy Wi-Fi 6E ready networks across its properties to provide high-speed connectivity and bandwidth for operational needs like digital signage, cashless payments, and guest device connectivity. Catawba College in North Carolina will leverage machine learning and AI featured in CoPilot to proactively detect network anomalies, improve network performance, reduce time-consuming tasks for the IT team, and streamline operations. Catawba will also offer Extreme Academy as part of its computer science curriculum. In the venue space, we had continued success with sports franchises and won Amica Mutual Pavilion in Rhode Island and Prudential Center in New Jersey, home of the New Jersey Devils. This quarter, we were able to bring our lead times down faster than expected in Q3, putting us in a healthier position.

The actions we have taken with our supply chain over the past year give us greater visibility and confidence that the consistently quarter ramp-up of our product deliveries and revenue will continue. We expect our backlog will normalize to a range of $75 million-$100 million in our Q1 fiscal 2025. Our exposure to the fastest-growing areas of the networking market, our share gains, and expanding go-to-market partnerships provide ample growth opportunities to drive double-digit bookings growth. We will also expand our subscription business to our entire hardware portfolio in fiscal 2024. We are forecasting market share gains with large targeted partners, leveraging the strength of our existing integrated solutions in our core market verticals, and have new partnerships with Comcast and new go-to-market motions with Verizon, for example.

Additionally, since we established a more strategic relationship with one particularly large US-based reseller, our E-Rate awards grew 100% year-over-year, with total bids submitted on behalf of Extreme by this reseller up 50% despite softness in the market. We will build on this and these other relationships as we enter fiscal 2024. As we look forward to the next quarter, I'm excited about our incoming CFO, Kevin Rhodes, who starts on May 30th and brings a wealth of experience from several successful SaaS companies. Kevin has a great track record of delivering operational and financial excellence with a clear focus on shareholder value. Last quarter, I asked Cristina Tate to step into the role of interim CFO, and she has executed flawlessly. Thank you, Cristina.

I will look forward to her partnership, continuing with Kevin to drive our financial strategy and take Extreme to the next level. With that, I will turn the call over to Cristina.

Cristina Tate (Interim CFO)

Thanks, Ed. Q3 financial results reflect record revenue, operating margin, and EBITDA, driven by increased product availability. We were also able to pay down $25 million in debt and repurchase $25 million worth of our shares, leaving net debt at just $34 million. The strong execution of our teams drove 29% growth in new SaaS bookings, and our SaaS ARR continued to rise. We are confident in our Q4 and FY 2023 outlooks and reiterate our commitment to mid-teens long-term growth through fiscal year 2025. Our third quarter revenue of $332.5 million grew 16% year-over-year and 4% quarter-over-quarter, exceeding the high end of our expectations entering the quarter.

Product revenue accelerated to 22% growth year-over-year and 8% sequentially, attributable to both campus switching and wireless LAN, partially offset by a decline in data center. New subscription bookings grew by 29% year-over-year. SaaS ARR grew 22% year-over-year to $117 million, up from $96 million in the year ago quarter. Subscription deferred revenue was up 39% year-over-year to $199 million. Revenue on a geographic basis once again reflects the timing of product shipments to our distributors across the regions. Regarding our bookings performance, as Ed mentioned, product bookings grew 6% sequentially, and we continue to expect sequential bookings growth into Q4 as well. The supply chain environment is improving significantly and lead times are coming down faster than we expected.

During Q3, our direct customer order backlog did remain flat. With product shipment lead times coming down, our distributors are adjusting their stocking orders to align with delivery timing. At the end of Q3, our backlog represented five times our expected normalized level. We continue to expect the normalized level of backlog to be in the range of $75 million-$100 million by Q1 fiscal year 2025. Distributor backlog is releasing at an accelerated pace, our scenario-based planning gives us confidence to reiterate our long-term guidance of mid-teens revenue growth and gross margin in the range of 64%-66% through fiscal 2025. From a vertical standpoint, our largest vertical remains government and education at over 35% of total bookings this quarter. The large wins in the retail sector increased the retail, transportation, and logistics vertical mix to 15% of bookings.

Manufacturing remained around 10%, while sports and entertainment grew to slightly less than 10% of bookings. Services and subscription revenue was $91.4 million, up 5% year-over-year. This growth was largely driven by the strength of cloud subscription revenue, up 30% year-over-year. Total Q3 recurring revenue, including maintenance, managed services, and subscriptions, was at $87 million or 26% of total company revenue. The growth of cloud subscriptions and maintenance drove the total deferred revenue to $464 million, up 25% from the year ago quarter and 4% sequentially. Our gross margin came in at 59.1%, up 60 basis points sequentially and 110 basis points from the year ago quarter. This was attributable to improvements in both our product gross margin and services gross margin.

Product gross margin benefited from higher revenue and an improvement in supply chain and distribution costs, as well as product mix. Our services and subscription gross margin was at 67.3% in Q3, up 30 basis points from the prior quarter and 2.2 percentage points from last year due to lower managed services and RMA costs based on better product quality. Q3 operating expenses were $144 million, up from $130 million in the year ago quarter and from $139 million in Q2 '23, reflecting higher R&D investment and sales and marketing expenses to support higher revenue growth.

Total operating expense as a percentage of revenue was 43.4%, down 30 basis points versus last quarter and down 2.1 percentage points compared to last year as we continue to drive operating leverage in the business. The combination of strong revenue growth, gross margin expansion, and operating leverage contributed to achieving a record operating margin of 15.6%, up from 12.5% in the year ago quarter and from 14.9% in Q2. Q3 earnings per share were $0.29 at the high end of our guidance entering the quarter. This quarter, we generated free cash flow of $45.8 million, driven by record EBITDA as well as a sequential two-day improvement in our cash conversion cycle to 22 days. Turning to guidance.

We remain confident in the revenue outlook for Q4 as supported by our strong funnel of opportunities, our product backlog, and our services and subscription deferred revenue balance. As products get delivered to customers and networks are installed, this should drive subscription and services bookings and billings that in many cases have been deferred or delayed until products are delivered to match service terms. We continue to expect that the reduction in expedite fees and shipping costs, combined with the full impact of our recent pricing actions, will lead to a continued recovery in gross margin in Q4 and into fiscal year 2024.

Against this backdrop, we expect for Q4 revenue to be in the range of $340 million-$350 million, gross margin to be in the range of 59%-61%, operating margin to be in the range of 15.5%-17.3%, and earnings to be in the range of $0.28-$0.34 per diluted share. For full fiscal year 2023, we expect revenue growth of 16% at the midpoint with an operating margin of around 15%. With that, I will now turn it over to the operator to begin the question and answer session.

Operator (participant)

Thank you. As a reminder to ask a question, please press star 1 1 on your telephone and wait for your name to be announced. To withdraw your question, please press star 1 1 again. One moment while we compile the Q&A roster. Our first question will come from the line of Mike Genovese with Rosenblatt Securities. Your line is open.

Mike Genovese (Managing Director and Senior Research Analyst)

Great. Thanks so much. I guess I have to ask, you know, about the distributor backlog change, if you could give us more color on that? I guess from the numbers you guys gave, I'm calculating that.

Backlog maybe went down about $100 million quarter-over-quarter. You know, I guess one question is all of that gonna be in revenue, you know, this quarter, next quarter, the quarter after? Did some of that actually sort of, you know, quote-unquote, go away?

Ed Meyercord (President and CEO)

Yeah. Mike, let me jump in, and then Cristina, feel free to follow. Yeah, there's a distributor, a component of backlog, and then there's the customer order component. As we said, the customer order component of backlog did not change during the quarter. The distributor ordering is driven by lead times, and lead times came in faster than we expected this quarter, which, you know, that occurrence is good news because it means that the market is getting healthier, and we're able to deliver products to customers sooner. At the same time, it means that our distributors will adjust their orders accordingly.

The early ordering that we had experienced earlier would effectively go away, and older orders would be adjusted effectively and modified to the shorter lead time. You know, what we're doing is we're trying to focus people, Mike, on our revenue outlook, and we're confirming the mid-teens revenue growth through our fiscal 2025, and with a new target point of $75 million-$100 million in ending backlog. We think that distributors going forward are going to have. They'll keep more orders on us, and they'll have more inventory on hand so they don't get caught the way they got caught this last cycle.

you know, what we want people to do is focus on that $75 million-$100 million, that would be a landing point for backlog. Focus on, you know, what we're calling is gonna be this mid-teens revenue growth rate through fiscal 2025. Cristina, I don't know if you wanna add anything to that.

Cristina Tate (Interim CFO)

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

Mike Genovese (Managing Director and Senior Research Analyst)

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

Ed Meyercord (President and CEO)

Well, Mike, I think you hit on all three. One is, you know, we are playing. First of all, we're playing in, you know, we mentioned, and I think Cristina reviewed our verticals and how we're doing in terms of, you know, our government accounts internationally and state and local governments and education, which remains strong. Retail was particularly strong for us this quarter. Obviously, when you get huge wins like Kroger, that has an effect on mix. Manufacturing remains strong. Overall, you know, enterprise spending and networking has been pretty resilient. I think when you do market checks with some of the larger distributors and some of the resellers out there, I think they'll tell you that networking is probably one of the more resilient categories.

The other one is, obviously, you know, we're taking share, and we're taking share in terms of our batting average and winning competitive processes, Kroger being a great example. We also mentioned in E-Rate win where we have, you know, a very large channel reseller, you know, very well known out in the market, that's doubling down on Extreme. You know, they grew their E-Rate bid with Extreme by 100% and then, you know, we won, you know, a 50% more. Even in an E-Rate market that was considered to be somewhat soft this year, you know, with that channel partner, we saw 50% growth. We have opportunities to grow with our partners.

As I mentioned, our funnel looks, you know, very healthy, and our batting average continues to hold up. We're performing well because of competitive differentiation. I think overall, you know, where we play in the enterprise market is pretty resilient.

Mike Genovese (Managing Director and Senior Research Analyst)

Okay, perfect. If I could just do one final quick follow-up. I mean, should we just assume that, you know, in the future that we won't see the backlog and the book-to-bill in the quarterly presentation? Is that, you know, a change going forward?

Ed Meyercord (President and CEO)

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

Mike Genovese (Managing Director and Senior Research Analyst)

Okay, thanks a lot. Congratulations on the great outlook.

Ed Meyercord (President and CEO)

Thanks, Mike.

Operator (participant)

Thank you. One moment for our next question. That will come from the line of Alex Henderson with Needham. Your line is open.

Alex Henderson (Managing Director and Senior Research Analyst)

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

Ed Meyercord (President and CEO)

Yeah, at a high level, Alex, you know, we're shipping out a lot more product. We're expecting our product shipments to increase. I think you'll expect to see that build as we're building inventory to support shipments of more product. Let me have Cristina jump in.

Cristina Tate (Interim CFO)

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

Alex Henderson (Managing Director and Senior Research Analyst)

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

Cristina Tate (Interim CFO)

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

Alex Henderson (Managing Director and Senior Research Analyst)

Well, I mean, it's not cannibalizing, but it's not being recognized in the current period. It's being deferred into future periods because of the mechanics of SaaS. Whereas normally if you sold the product, the same amount of product that you sign in a SaaS subscription, you would get more upfront and less in the future periods. Almost by definition, since... I mean, if you sign something on March 31st, you get no revenues in the quarter.

Cristina Tate (Interim CFO)

Oh, right.

Alex Henderson (Managing Director and Senior Research Analyst)

Whereas if it was purchased, you would have the entire revenue. Clearly it has to reduce the recognition of revenue.

Cristina Tate (Interim CFO)

Sure. As the mix of our revenue shifts to more recurring revenue such as SaaS and subscription, absolutely that is going to happen because we book the contract. It may be a single year contract or a multi-year contract, but we recognize that revenue over time. Yes, as our overall mix shifts, that phenomenon will be definitely there. I thought you were saying that it was actually reducing some other part of our business and that's not the case. Yeah.

Alex Henderson (Managing Director and Senior Research Analyst)

Just the recognition timing of it.

Cristina Tate (Interim CFO)

Yes. Agreed.

Alex Henderson (Managing Director and Senior Research Analyst)

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

Cristina Tate (Interim CFO)

Um, I don't-

Ed Meyercord (President and CEO)

I don't know if we have that answer for you.

Cristina Tate (Interim CFO)

Yeah. I don't have that answer.

Ed Meyercord (President and CEO)

Yeah.

Alex Henderson (Managing Director and Senior Research Analyst)

Okay. No problem. No problem.

Ed Meyercord (President and CEO)

I think maybe we can take it offline and come back and dig in a little deeper. I mean, one of the things that Cristina mentioned earlier is that, you know, because of backlog, you know, we do have a lot of subscription, as well as service and maintenance tied up in that backlog. As that releases, you know, we are expecting to see an acceleration in that growth rate.

The other thing that I mentioned is that, you know, we're doing a lot of work so that, we can effectively sell subscriptions, on all of our hardware, which we don't have today, and that will also create a really nice growth wave, in addition to some of the other, the packaging and the services that we're putting together with some of our partners.

Alex Henderson (Managing Director and Senior Research Analyst)

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

Cristina Tate (Interim CFO)

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

Alex Henderson (Managing Director and Senior Research Analyst)

400-500 basis points.

Cristina Tate (Interim CFO)

Mm-hmm.

Alex Henderson (Managing Director and Senior Research Analyst)

of margin that's caught up in those two variables.

Cristina Tate (Interim CFO)

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

Alex Henderson (Managing Director and Senior Research Analyst)

Great. Thank you so much.

Cristina Tate (Interim CFO)

Mm-hmm.

Ed Meyercord (President and CEO)

Thanks, Alex.

Alex Henderson (Managing Director and Senior Research Analyst)

Thanks, Alex.

Operator (participant)

Thank you. One moment for our next question. That will come from the line of Dave Kang with B. Riley. Your line is open.

Dave Kang (Senior Research Analyst)

Hi. Thank you. Good morning. My first question is regarding gross margins. You provided 60% for fiscal fourth quarter, and then you're guiding to 65% for fiscal 2025. For fiscal 2024, should we think of gross margin sort of like is it gonna be like a linear ramp from fourth quarter to fiscal 2025?

Cristina Tate (Interim CFO)

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

Dave Kang (Senior Research Analyst)

Got it. On universal platform, can you give us an update? When should we expect that, you know, full 100% universal?

Ed Meyercord (President and CEO)

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

Dave Kang (Senior Research Analyst)

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

Ed Meyercord (President and CEO)

Well, it's helpful. I'd say, you know, it's part of our solution. You know, if you recall, universal hardware is the most flexible hardware in the market in the enterprise space because you can run different personalities. When you combine that universal hardware with management and the features of our cloud and the cloud choice we bring, then you combine that with our unique fabric technology, we're able to build solutions in the market that are differentiated. You know, end-to-end, you know, wired wireless across the wireless LAN in terms of our SD-WAN solution. It creates a lot of flexibility, it provides simplicity, and it provides choice. Yeah, that's absolutely a contributor on the demand side.

When we look at this linear growth and our gross margin, you know, we factored in the adoption of universal platforms into that equation. Cristina, I don't know if you want to add anything to that from a gross margin perspective?

Cristina Tate (Interim CFO)

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

Dave Kang (Senior Research Analyst)

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

Cristina Tate (Interim CFO)

Yes. We're confirming our long-term guidance. Yep.

Dave Kang (Senior Research Analyst)

Okay. Thank you.

Cristina Tate (Interim CFO)

Mm-hmm.

Operator (participant)

Thank you. Ladies and gentlemen, due to time restraints, we ask that you please limit yourself to one question and one follow-up question. One moment for our next question. That will come from the line of Paul Silverstein with Cowen. Your line is open.

Paul Silverstein (Managing Director and Senior Research Analyst)

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

Ed Meyercord (President and CEO)

Well, Paul, we had an incredibly large number of million-dollar-plus deals in education, I'd say that. You know, we are in that vertical, we are doing very well with the channel and partner community. I gave an E-Rate example where, you know, even in a kind of a soft E-Rate climate, we have partner adoption, which is driving up, you know, our share in that market. You know, we also have big wins this quarter, for example, Palm Beach County Schools, $6 and a half million dollar win. You know, we're getting into larger deals, we're winning more larger deals. I think the channel community is realizing that they can get out and win with Extreme, quite frankly, we have a differentiated solution.

What's interesting is that because of our success and some of the even larger wins in the retail verticals and then sports verticals, it was actually down. The math, normally we talk about 40% state, local government education, and in this quarter, it was down to 35%. We ticked up to 15% in retail. The other verticals kinda held in there. It, you know, it remains strong and from our standpoint, we are seeing larger opportunities. We're winning larger opportunities, and that's part of the share gain story, which is why, you know, we talk about large crumbs and the opportunity for us to take small share points and it has a big impact on our bookings and overall our long-term revenue target.

Paul Silverstein (Managing Director and Senior Research Analyst)

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

Ed Meyercord (President and CEO)

That's correct. That's a correct statement.

Paul Silverstein (Managing Director and Senior Research Analyst)

Okay.

Ed Meyercord (President and CEO)

The other point I'm trying to make is that there's partner penetration. I mean, one of the things that we talked about, you know, we have, you know, Comcast is a new partner of Extreme. A pretty large company. They do a lot of business. You know, we won, you know, Cedar Fair, a $8 million plus deal with a new relationship with a partner like Comcast. Verizon, we're now certified in Verizon's portfolio, and we're working directly with their enterprise sellers. This is new, so we're opening up, and this is another large channel partner, and they're excited about our solution in bringing Extreme to market. With some of these larger partners now, we have what are new growth opportunities with the same portfolio of product.

You know, from that standpoint, it is broad-based. We will see enterprise, overall enterprise growth, and then we would expect to see this growth happen, really littered across all of our verticals.

Paul Silverstein (Managing Director and Senior Research Analyst)

All right. I appreciate it. Thank you.

Operator (participant)

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

Eric Martinuzzi (Senior Research Analyst and Founding Partner)

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

Ed Meyercord (President and CEO)

Well, thanks for the question, Eric. A lot of what we're doing is investing, you know, in our existing platforms and developing, you know, the completion of our universal platforms, you know, further development of our wireless platforms, and we're investing a lot, obviously, in cloud and the kinds of features that we can orchestrate over cloud. Historically, we've had a NAC product, which is effectively, you know, access control and security in the network. We, you know, we are cloudifying that solution, and we'll be adding that into our offerings. The other thing that we're doing is we're packaging our complete solutions for new channel partners to provide managed services. In our space, managed services are on the rise, but it's commercially really complicated.

You hear us talk about simplicity. We're bringing simplicity to a market that's complicated, and we think we have a real differentiator with our managed services solutions portfolio. This is taking effectively, the existing products and our cloud and services that we have, that we're developing, and packaging it in a very simple licensing framework that's generated a lot of interest in the marketplace. This is an area where we expect to take share, and effectively what we're doing is, you know, we'll be supporting a managed service. Yeah, that will be coming out at Connect. Finally, Edge Cloud. You know, there's a lot of conversation about Edge Cloud. There will be a reveal at Connect, where because of the way we're developing our platform, and it's really around cloud choice.

No, no enterprise customer, or supplier in the networking industry, is able to offer the kind of choice that we can provide. Choice has to do with public cloud versus, you know, private cloud versus what goes to data center versus kind of what stays on campus. We are gonna be able to provide more flexibility than anyone as companies are wrestling with this. We'll also there'll be a reveal around Extreme EdgeCloud, and where data resides in enterprise networks that I think will be, you know, further differentiation for Extreme. These are areas that we're investing in, and quite frankly, there's a lot of interest in the market, particularly with large partners for these kinds of solutions.

Greg Mesniaeff (Equity Research Analyst)

Got it. Look forward to the news.

Operator (participant)

Thank you. One moment for our next question. That will come from the line of Greg Mesniaeff with WestPark Capital. Your line is open.

Greg Mesniaeff (Equity Research Analyst)

Thank you. Ed, could you hear me?

Ed Meyercord (President and CEO)

I can hear you, Greg.

Greg Mesniaeff (Equity Research Analyst)

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

Ed Meyercord (President and CEO)

Thanks for the question. Security in our industry is pretty complicated, and there's a lot of different layers. People make the analogy of the layers of the onion to describe all the different elements. You know, one of the big differentiators that we have on our solution set today is our Fabric and our Fabric technology that has inherent security built in. The idea that we could extend that security out across the wide area network with our SD-WAN solution is truly unique in the marketplace and brings a level of security that's just inherent in the network.

One of the things that we can do with that is effectively provide inherent security as opposed to an over-the-top solution, which brings a lot of simplicity again, and likely savings. Remember, we also have AirDefense, which is one of the leading Wi-Fi security solutions that's out in the marketplace. Obviously, this is something that's critical in winning something like a Kroger or these distributed networks. And that also is an element of our offer. And I referenced earlier network access control, and policy and identity management around, you know, who is accessing the network and access security. And we are taking what is a very mature and proven technology, and we're cloudifying this.

Once again, we will have an access control, security element that will be inherent and built into the network, which will be differentiated. It will, we will be in a position to compete and we think attract a lot of interest by simplifying these security elements into a single solution, within a single license that we believe will be disruptive in the marketplace.

Greg Mesniaeff (Equity Research Analyst)

Great. Thank you for that.

Operator (participant)

Thank you. One moment for our next question. That will come from the line of Christian Schwab with Craig-Hallum. Your line is open.

Christian Schwab (Managing Partner and Senior Research Analyst)

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

Ed Meyercord (President and CEO)

Thanks, Christian, for the question. You know, what we said is it's, you know, that, that overall backlog is about 5x. Obviously, distributor behavior is a little more tied to lead times, and lead times came down faster. We're expecting them to come down. We really don't wanna get into sort of dissecting backlog. Really what we wanna do is reinforce our outlook of revenue growth. We're doing that out through our fiscal 2025, which is out there. We, we bake that into our revenue guide, and that's where we're trying to focus everyone.

Christian Schwab (Managing Partner and Senior Research Analyst)

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

Ed Meyercord (President and CEO)

Yeah, yeah. I mean, look, we have to factor in the industry. We're obviously factoring a backlog runoff. We're also looking at share gains. You know, I would say the overall industry, we see this kind of, you know, mid-single digit growth in the overall industry. When you look at the release of backlog, as I mentioned before, we're expecting our distributors to have more on order with us in the future than they did in the past. If we go back to pre-supply chain issues, it was very much a just-in-time model, and that obviously put a lot of risk on their business. This is where we landed at that $75 million-$100 million number.

In your model, you should think about $75 million-$100 million of backlog is kind of the ending point in our Q1 fiscal 2025. That's where we see that. We have share gains. I know earlier in your report, you mentioned, you know, a large reseller that, you know, the outlook was down. You know, in our case, you know, with those kinds of resellers, because of their size, small share points create big opportunities. You know, we mentioned one of those resellers where literally in kind of a soft E-Rate market, you know, we're up 50%.

These are the kinds of things that we can do at Extreme because of our relative size, and, you know, it gives us, you know, a growth advantage, if you will. Some of these other larger partners I mentioned, you know, when you open up a Comcast, when you open up a Verizon, when you open up some of these larger managed services partners, we open up the door, it for, you know, growth opportunities where quite frankly, we haven't played. The growth opportunities are quite large. A point of market share is over 20% growth on top of the market. It doesn't take a lot of share gains for Extreme, you know, to outgrow the market and then for us to get to that mid-teens number.

Christian Schwab (Managing Partner and Senior Research Analyst)

Okay. That's a great answer. Thanks, Ed. Thanks.

Ed Meyercord (President and CEO)

Yeah. Thanks, Christian.

Operator (participant)

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

Ed Meyercord (President and CEO)

Thanks, Cherie. Thanks everyone for joining the call. Obviously, we're excited about the quarter and the performance. We had a lot of records. I wanna shout out to the Extreme employees, our partner community, everyone that they join in on these calls because we have a lot of momentum right now, and we say there's never been a better time to be at Extreme. The competitive differentiation is there and it's fun to be winning in the marketplace. Shout out to those teams, and then also investors for your continued participation and interest in the company.

You know, we're holding on to a very strong guide in terms of top line growth and margin expansion, both at the gross margin line and then operating leverage down at the bottom line. You know, we appreciate your interest in Extreme, and we're quite confident about, you know, the quarters to come. Thanks everyone, and have a great day.

Operator (participant)

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