Calix, Inc. (CALX) Earnings Call Transcript & Summary

Hi. I'm Samik Chatterjee, the networking equipment and hardware analyst at JPMorgan. Welcome to the closing show of day 3 at the conference. So we did finally get here. Thanks for staying and tuning in for the conference for over the last 3 -- last 2 days, I guess. But thanks for staying tuned. We have the pleasure of hosting Calix for this session. As you can see on your screen, we have Carl Russo, the Chief Executive Officer; as well as Cory Sindelar, who's the Chief Financial Officer of the company. And what I want to do is go through a set of questions that I have and get Carl's and Cory's views on that. But if you, in the audience have any questions, please feel free to send them over, and I'll ask it on your behalf. I think what you need to do is use the Ask a Question button on the website, and that would get the questions. Obviously, if that doesn't work, just shoot me an e-mail and that will work as well. So Carl, Cory, thanks for taking the time.

I do want to get into some of your specific platforms, which I know you give a lot of color around and a lot of numbers around. But first, just the industry backdrop here. At the end of the day, there is the alignment of what the cable equipment, cable companies are spending, and what they're spending on different equipment or appliances as well as software. So definitely want to get a barometer check here. How has the cable spending environment been? Our checks are indicating that they are up this year low single A to mid-single A. But what are you seeing on the ground? Is the environment better than what you had last year or the last few years to understand that?

Well, let me start by broadening that and saying, keep in mind that with our platforms that are abstracted off of the hardware, we now are uniquely able to address service providers of all types. So whether they're cable providers or wireline providers, wireless providers, wireless Internet service providers or WISPS, municipalities, electric co-ops, small telephone cooperatives, anyone that's providing Internet service to a device-enabled subscriber connecting them to content and applications in the cloud is a customer. So I'm going to take your question and broaden it into what are we seeing across the entire space. We are seeing capital flow into the space. We've actually, for those of you who have followed us, we spoke some 3 years ago about starting to see capital formation in the service provider space to actually invest in building new service providers. We refer to them as greenfields, where literally, it's a start-up service provider. So we are actually seeing robust capital investment in the space across all of our categories of customers.

Okay. That's good. The other industry-wide topic that I wanted to hit, every company's highlighted this, obviously, is the supply chain issue that we're seeing industry-wide at this point. I know you gave an update on the earnings call. I wanted to see, one, have things improved since then? Or things have gone the other way? What's your general sense in terms of kind of the timing between your reporting earnings and now how have -- which way is the industry headed on that front? And also want to understand what is the nature of the headwind that you're seeing? What products are impacted? What components are really kind of impacted at this point?

Well, look, the great news is we see robust investment in the space, and we see robust demand. I don't worry about supplying it, who cares if we can actually ship it? All right. I'm just kidding. Cory, do you want to take the folks through what we've seen, what the work is? Cory and our President and Chief Operating Officer, who's not with us today because he may actually soldering up components as we speak, deal with this every day with their teams. So Cory, do you want to spend a few minutes and help folks understand where we've come from, where we are and how we see the future?

Sure. You bet. This challenge around supply disruption just didn't start yesterday. We've been working at it for over a year. It started really with the COVID shutdown in China. At the same time, we've seen demand take off. We grew 27% last year. So you take supply challenges plus a robust demand in equation, and we've been kind of behind the 8-ball. We've been chasing it for over a year. What's different for us, because we made a lot of progress as we went through 2020, is the fact that we had a silicon provider change their lead time from 32 weeks out to 50 weeks. And that happened at the beginning of the year. So all of a sudden, you're ordering complex silicon for Q2 delivery -- Q3 delivery and now they're saying, we'll start delivering to you in Q1 '22. So that obviously leaves a gap, a plug that we have to go chase and fill. We've been at it. And I would say since our last earnings call, we've made improvement on that. It's by no means solved. We're also seeing a broader set of products in terms of shortages in order to do our builds. But those are components that can be easily substituted, qualified, think of memories and optics, those kinds of things. So it is absolutely -- continues to be a very challenging environment, but we are making progress each day in terms of addressing that gap, and that gap largely will affect us Q3, Q4 and probably into Q1 as well, all due to complex silicon being pushed out to 50-week lead times.

Thanks, Cory.

So follow-up there, and we've been hearing this from all the companies we've talked to at the conference. And since I've been asking all the companies, I do want to get this question across as well. What we're hearing is a lot of the silicon suppliers are raising prices in the form of expedite fees, which is you can get the supply if you want in 30 weeks instead of the 50 week when you pay an expedite fees. So what are you seeing on that front? How much of a headwind is that on the gross margin line for you?

Yes. I would be careful about the expedite from 50 to 30, but expedite fees are really an issue. And Cory, why don't you go through a little bit of maybe some anecdotes as well to help folks understand what we're seeing and what we're doing about it from a commitment standpoint?

Yes. So there's a couple of things. We're seeing just straight up price increases, right, on a number of our components. So that will come through as negative PPDs. But yes, we are also having sometimes an opportunity to be able to expedite basically the change your place in line, if you will. That will largely lead to us probably putting more material on planes as we approach the second half of the year. Obviously, the supply is going to be coming in late relative to the demand. And so while we made a lot of progress here in the first quarter, you've seen our inventory grow up to $72 million. Our goal is to keep inventory between 3 and 4 turns, so made a lot of good progress. But as we start looking at the back half, we're probably going to see margins impacted pretty significantly, 100 -- a couple of hundred basis points is probably as we look into expedite fees, increased prices airfreighting along those lines.

So moving on to the Calix platforms that I think has been the discussion point for you for a while. Actually, before I do, again, as a reminder to investors, if you have a question, please send that in and I can ask it on your behalf. So Carl, I've spoken to you in the past, and I know you keep your cards close to your chest rated to the numbers around the platforms. But I think what you've said more recently is that the platform revenues could exceed half of revenue exiting the year, half of product revenue is in yield. So firstly, given the supply backdrop, what we're seeing, does that change any of that expectation?

So let me just make sure that we have our definitions. So when we -- internally, we refer to this as Blue Ocean and Red Ocean businesses. In essence, our Calix 1.0 Communications System company, which was a box ship revenue sort of company, and then obviously, the new platform company, which is an all-software platform systems, so there's a hardware resource underneath it on the operating systems and services, that's the platform business. The revenue mix between those 2, obviously, used to be 100% and 0%. And then as the new company started to grow, it's continued to become a larger and larger percentage of the business. Its growth is now driving the growth of the top line of the business. So it's gotten large enough to where it's actually not only driving margins up, but also starting to drive revenues up. We do expect that just reach a crossover point between the new business and the old 50% crossover sometime this year, and I won't move away from that. I think that's what's going to occur in some particular quarter, whether it's Q3 or Q4. I don't believe it will be Q2. That having been said, then your question is more specifically around have the silicon issues affected that in a disproportionate way. And the answer is the silicon issues have really affected us across the business. They're not as mix sensitive in any one space because in some cases, like in the new businesses, you might have newer silicon that's under more demand from other customers. But in our older business, you have some silicon that's actually on older processes that the silicon vendors may be looking to trim back. So to be blunt, the silicon issues show up across the board. What enables us to be very well positioned in the marketplace with this is the fact that our platforms have enabled us to concentrate our hardware down to very few SKUs. So if you look back in our history, we used to have over 3,000 SKUs. There are many communications companies that have 5,000, 10,000, 15,000, 20,000 SKUs. Today, we have about 350 SKUs, which enables Cory and Michael and their teams to concentrate our energies and our balance sheet resources on a much narrower set. And so it gives us that much more ability to fight that component fight and do so in a way that allows us to continue to drive margins higher, all the while we're in this headwind on costs. It's pretty cool.

Got it. Helpful. So a follow-up on that, Carl, is now this Red Ocean business, how fast is this legacy business moderating? What's the usual piece of decline? And as customers came back and added capacity during 2020, did you see an uplift in terms of just the business -- regulation business kind of getting more of a buck up during that period of time?

Great question. So let me start with the last 1 first. In fact, when you see a surge in demand across networks, people will add capacity with whatever system they're currently deploying. So the answer is yes, we saw an uplift for our platform business and for our legacy business. That said, as you think through the attenuation of the old business, the older business will roll off proportionate to the life cycles of those products. So in the service provider networks that we've helped build over many years, our products can be in the network for 5, 7, 10, 15, 20 years. So our C7, which we brought to market in 2002, is going to end of sale at the end of this year. You may notice on your calendar that, that's almost 20 years. So what's the point in me be sharing that with you? They don't decay as fast as you might think on the network side. On the premises side, well, those typically have life cycles of 3 to 5 years, and so we expect that swap over to happen faster. And that's what we are seeing this year. We're starting to see that occur. And that's a bigger component of the 50-50 mix I was talking about earlier because that business that's declining in our past is not going to some other vendor. Those folks are coming over onto our new platforms. And we believe all of our customers will come with us on this journey, but some will go quickly, as they did 4 years ago or 3 years ago. Some, it may be another 4 or 5 or 6 years from now before they do. So does that help?

Yes. No, definitely. So let's move to discussing the platform businesses, the Blue Ocean business as such, EXOS, AXOS, Cloud, the 3, what innings are we in each of them in terms of adoption? Any way you've quantified the addressable market for each of them?

Well, the addressable market, the way we think about it, because all of our platforms, software platforms are charged based upon the number of subscribers on them, is basically the number of subscribers in the world times whatever the charge per month is. So it's a -- TAM math is sort of like, it's a really big number. When you narrow it up and you think about where we are, I've said at all jointly times, we're in the first inning or second inning, here's what's very interesting and for me personally, very exciting. If you think about our model going forward, it's very much a land and expand model. We land new customers and then we expand with them. A new customer of ours can join with Calix Cloud, and not deploy EXOS or AXOS. They can deploy EXOS GigaSpire on the premises side and not deploy AXOS for Calix Cloud. They can deploy AXOS the network like Verizon does, for example, and not deploy the Cloud or EXOS. The reason I take you through that is our customers can join us in any area or multiple areas, and then we expand with them. And then we have applications on top of that and suites and other partnerships where the value of the model just continues to expand. Why is this exciting? Because every day I come to work and chat with customers, I realize that the opportunity is actually bigger. Watching our customers that have deployed the most with us, they're killing it in the market. They are just crushing their competitors. I realize the opportunity is bigger than I thought, and we're actually even earlier to it than I thought. So oddly, I -- actually, the innings are going backwards. I think we're earlier and earlier to what is a much larger opportunity than even I understood and I've been leading the company. It's really exciting, especially for the team here.

Carl, between the 3 though, I understand you're in early innings in -- across those 3, but if you had to then relatively compare the 3, how would you compare where you are in terms of them relatively? Or any color on relative growth between those 3?

So let's take AXOS, where we've been chugging further down the path. We've been in the market longer, but here's what's interesting. It also has a much longer life cycle. And so oddly enough, even though we've been pursuing AXOS and more and more customers are uptaking it, because it's such a longer life cycle, it actually feels like early inning. With EXOS, we've been in the market in a much shorter period of time. But by the way, 3- to 5-year life cycles for those products, it's a steeper ramp, but it feels early. And with Calix Cloud, we're just scratching the surface, and we have many customers now up on our clouds. But again, look, I would be quibbling if I said maybe first inning and not second inning or another, but they're not materially different. They really each have their own ramps in front of them. And we haven't even started talking about the components that sit on top of those operating systems in the form of modules over on AXOS or the applications and suites on top of the subscriber edge. So our Revenue EDGE platforms are still early days.

So when we went through, I think it was the Analyst Day when you are maybe -- yes, at the Analyst Day that you gave the target of 5% to 10% revenue growth, and it's quite a broad range. But what I wanted to see is if you can help investors think about how you're building up to it. Because given the disclosure, I'm not sure how investors should think about it on a bottom stop basis. How do they get to that range? What drives you to the bottom end? What drives to the high end of it?

Yes. So we gave that range, and I'll let Cory -- Cory, if you wouldn't mind, spend a moment on the whole model. So maybe we should take a moment and just let everybody know the whole model that we laid out back in March, and then I'll come back and answer your question. Is that fair, Samik? So Cory, can you take everybody through the model that we laid out? Again, this is 2 days before we closed the company down because of the pandemic. So fire away, Cory.

Yes. At the Analyst Day, we set revenue at 5% to 10% growth per annum covering, call it, '21, '22, '23. Mind you, this is when we had just pivoted to kind of a growth where we were stopped declining and started anticipating revenue growth. And so we felt comfortable establishing that as our benchmark. Last year, obviously, we grew at 27%. This year, we've kind of guided to 15% or better depending on the supply constraints so that's kind of how we laid out the revenue. On the margin side, we said we would grow between 100 and 200 basis points per annum over the same time horizons. We've been doing much better than in recent years. This year, with the supply headwinds, we said that the 100 to 200 basis points would be challenging. After our first quarter performance, we said we feel better about getting to that same threshold. And we'll see how the second half folds out to see whether we can do it. A lot of hard work yet to do there. On the sales and marketing side, you're looking at 18 -- 16% to 18% of revenue, R&D at 30% of product to gross profit, and G&A at 9% of revenue.

And so when you look at that, to your point, Samik, we've outperformed in a number of those areas. And pretty clearly, we're getting more comfortable with demand. And look, it's a model that we set as we were making the turn for the next 3 years. We're now a year and a quarter later or thereabouts getting there. And we're getting more run time in the model. We make -- if we see an ability to change the model, we will, but there's no news to report yet. So clearly, we've outperformed the model; stay tuned.

Okay. I think I know the answer here, which is going to be that you don't disclose this, but I wanted to clarify. So when you think about the 5% to 10%, you didn't disclose what's embedded in there for the Red Ocean business versus the Blue Ocean business.

Well, let me make sure I disclosed in where?

When you arrive at the 5% to 10% revenue growth guide on [indiscernible]...

Oh, sorry, sorry, sorry. No, we don't break that out. And anyway, I just want to make sure I understood what you were saying. So no, we do not.

So just moving forward in terms of the margin profile then. I think just, obviously, I see the local model rate of the corporate average margins and how you expect them to expand. How should I think about if I take stand-alone some of the platforms today, the new platforms, what the stand-alone margin looks like? What's the margin differential to some of the legacy products that you have?

So let me let Cory address the layers of the software platform business that we have, and then I'll come back and talk to you about the systems, legacy new, et cetera. Is that fair, Cory?

Yes, you bet.

Fire away.

So from an operating standpoint, the operating system, it's 100 points of margin, right? And the way we are selling that, again, the licenses are completely disconnected from the hardware and it's all based on number of subscribers. So in that case, customer will come in and buy x number of licenses. On the anniversary date, we're coming in and doing true-ups. And so as they add subscribers, we're going -- we're seeing follow-on license sales. There's also a maintenance component to that, that is reoccurring. On the Cloud business, we are usually booking a 3-year deal. There's usually a ramp involved, right? It's all based on customer adoption, again, of the clouds. So you'll see that -- again, those are minimums. They're actually issues to exceed that on the anniversary date, where there is a true-up involved. That's completely ratable. So it's a 3-year deal, built 1 year in advance. The margins on that is above corporate average, but it's still undersized. We still need to scale them up. So we are nowhere near where a typical SaaS company is in terms of margins on our clouds. Next, you can move up to, we have the suites. The suites are high 80, 90 points of margin. There's some IP that we pay on that doesn't make it 100% margin. But the suites are billed monthly based on usage. And so reoccurring nature of it. And the last one is kind of our partner models, we have partners that come in and use the platforms to sell their goods and services, in which case, we act as an agent in that structure, 100% gross margin. And again, those would be monthly billings. So again, a reoccurring component that's at 100 points.

When you compare that to a legacy box company, which Calix [ one day ] there was, you know from looking at the communications space that you have box companies that are in the low 30s to sort of low 40s gross margins, and that's roughly where it sits on the box side, we would not be wildly dissimilar from that. On the hardware side of the new business, it's a little bit better because of the value of the software actually pulls it up, but it's still a system, it's still a box. Is that helpful?

Yes. No, good. So staying with the discussion in terms of margins, but now starting to focus on operating margins. What I found very interesting as you outline your long term model. And when you outline the OpEx, you largely outlined them in terms of fixed percentage of revenues. And that made me wonder, how should I think about the operating leverage in the model? Because as you scale revenues, I would expect some of those ranges to start to moderate. So how are you thinking about OpEx increases related to revenue growth?

Yes. So let's go down that, and let me frame it up, and then I'm going to let Cory speak with you as well. To be clear, we expect gross margins to expand. So obviously, if OpEx simply stayed flat as a percentage of revenue, we would see operating income expansion once we get to model. Remember, we are currently underrunning our model, and we intend to fully and fulsomely invest in our model. As we scale, you'll notice that R&D is not tied to revenue. R&D in our model is 30% of product gross profit, and that is a formula that comes out of my head for -- from 100 years of doing this, which R&D should never be tied to revenue because it shouldn't be driving revenue. We should be driving differentiated value, which manifests itself in your margin percentage times your revenue. The more valuable it is, the more you would want to invest in R&D. And when you vary too much from that number I just gave you, you're either overspending or you're under-investing. So you will see us be pretty relentlessly focused on that number. So as margins expand, it would go up as a percentage of revenue. But at 30% of the gross margin -- gross profit expansion, obviously, 70% of it would go to the bottom line, and you can see that leverage. On sales and marketing, it's 16% to 18% for the foreseeable future, but that comes out of the mix model that we have internally. And so if anything, you'll see that slowly drift up as software becomes more and more of the content. Obviously, if you go look at software businesses, you'll see that sales and marketing runs at a higher percentage of revenue than they do in other businesses. I don't think I'm telling anyone here any secret. In many software businesses, sales and marketing is more than the gross profit of the company, which is, by the way, not where we are. And then last but not least is G&A, and we've been working hard on that to make forward-looking investments. And Cory, why don't you take that and help people understand what's going on, where we're coming from and where we might be going?

Yes. So as we started the conversation, we had a revenue outlook of 5% to 10% revenue growth, and we've obviously far exceeded that. So when we set the target at 9% for G&A, revenue is growing way faster than we anticipated. Therefore, it's hard for us to keep up with those level of investments. We certainly have because, again, at the beginning of last year, we implemented our Oracle Cloud and really all our other automation projects and investments we want to do were literally put on hold while we made that change. And so since we've kind of stabilized the Oracle platform mid-last year, we've turned on the spigot. So there's lots of investments and projects we want to go do. We're expensing them. We're not capitalizing those. And so therefore, at the end of the day, as we continue to scale up the business and grow the business, we want to do so without adding a commensurate amount of headcount, and that's coming through these automation projects. So for the foreseeable future, we will continue to add to G&A in these projects. But if revenue continues to overperform, it will be hard for us to maintain that 9% of G&A. [ 9% to 10% ] for G&A.

So you expect it to go down over time. From a transactional efficiency, G&A investments don't just manifest themselves as G&A returns; they simplify the entire business is what Cory were alluding to there. And I would draw your attention to a couple of things. We have roughly half the number of people per revenue as most anyone else in the space. We run a very headcount lean high talent team, and core and central to that is having the transactional efficiency ahead of that. As we continue to move towards software, that's a whole different transactional engine than a hardware company. So a lot of work going on there. Secondly, if you look at the operating metrics of the company and you want to understand what kind of a company we are internally, they'll look at our balance sheet metrics. And I would challenge anyone on this call to find me a company anywhere near our space that has the balance sheet metrics that we do and a clean, simple, easy to read balance sheet as we do. We believe very much in running a clean shop internally because it simplifies energy and allows us to focus on growing our opportunity in the market. Samik, all yours.

Great. Thanks for that. So let me -- I think I have 3 or 4 more questions to get through. But again, just a last call here, if any investors have a question, please feel free to send that over. Just changing gears here, Carl, a couple of areas. One, just the amount of U.S. investment in broadband, either take out of, for example, or Biden's infrastructure plan, how are you thinking about those? Like, one, there is always a promise of spending. The second part being, does it really come through? So how are you thinking about those opportunities at this point?

So RDOF is what the current discussion is. And obviously, RDOF was a $20 billion fund, and its first cut, they deployed $9 billion of it, which has yet to be awarded, but it's close. We think of all government investments in infrastructure as being -- as having the following 3 attributes. The first is they take longer than you think to get started. The second is they take longer than you think to be deployed. So it takes them a lot longer to build out, deadlines get moved. And the third one is they're typically larger than you think. In other words, over the course of the deployment, there's more dollars that get deployed. Where am I going with this? Well, here's where I'm going. As Calix 1.0, we would pursue broadband stimulus or CAF I or CAF II because you would get the box revenue, the system revenue out of that deal. The rest would go to infrastructure, fiber, routes, et cetera. But in our old model, we would, in essence, ship them the box and then the revenue would stop. In our new model, when we build the network infrastructure, that's just the start of the revenue because you now start to layer the platform recurring revenue on top of it. And so oddly, stimulus in our own model or in any communications company actually oftentimes is a pull-forward. It pulls forward revenue, and then there's a trough after it because it's revenue -- it's investments that customers would have made 2 and 3 and 5 years from now that they're accelerating forward. And you actually create a concomitant air pocket. With our model, it actually lifts the entire stage upon which we are playing. And so we saw this with the pandemic. Unfortunately, a pandemic, which has obviously been bad for the world, for certain segments has been good. And what happened with us is it actually wasn't a pull-forward. It was an uplift of our entire model. And so it will be with these dollars. How many dollars? Well, if you look at all the programs in North America alone, federal, state, province, region, et cetera, there's $352 billion of programs being talked about. They're not all going to pass. But if you simply look at one aspect, which is the infrastructure deal that's in front of Congress today, if an infrastructure bill is to be passed, you now know the bid and ask on the broadband part of it. The ask by the Biden administration was $100 billion for infrastructure for Internet. The bid back from the Republicans in the Senate was $65 billion. So guess what? There's probably going to be an infrastructure bill pass, and it's probably going to be somewhere between $65 billion and $100 billion of broadband infrastructure. 10% to 12% of that will make it to companies like us. And we obviously feel we are very well positioned to benefit from that, not only because we have an enormous footprint in North America, not only because we have a direct selling organization in North America to everyone, big and small, but we also have breakthrough platforms that if a customer gets an opportunity to build a new infrastructure, that's a great time to talk to them about building a new business model on top of it to become a company that can excite their subscribers and grow their value. So that's how we think about it.

In the time we have remaining, Carl, let's talk about the same but focus on the international markets. Like, I think today, you derive a majority of your revenues from the domestic market. There are some...

Very much so.

Yes. So I think there are similar programs. When I look at the U.K., there's like Project Gigabit and there are similar programs in EU as well on the same lines of what RDOF's and Biden's infrastructure plan is really trying to achieve.

They're on the same line, they're not the same size. Even relative to their population. And when we look internationally, look, we think internationally long term, and we've been doing well, is going to be a significant growth opportunity for us. Here is the challenge. We have so much growth in front of us at a very low-risk in North America that our first and foremost investments are in North America. So it's not that we are sitting here saying, we're North America only or we're North America right now. We just have to make sure that we've fully invested in the North American opportunity while we're looking at what we need to do internationally, but it will come later. So that's the best way I can answer your question.

Yes. I think we're close to the session time here. So let's wrap it up here. Carl, Cory, thanks for taking the time for participating at the conference, for doing this fireside chat. And great to have you here, and great to get the opportunity to talk to you.

Looking forward to many more, Samik. Thanks for the invite.

Thank you very much.

Thank you, everyone, who dialed in. Thank you.

Thanks, folks.