Extreme Networks, Inc. (EXTR) Earnings Call Transcript & Summary

Hello, everyone, and thank you so much for joining us here today. My name is Jim Suva. I'm the IT hardware, tech supply chain and telecom equipment analyst here at Citigroup Investment Research. We're very pleased to bring to you in this large audience right now, Extreme Networks. A few housekeeping items. First, please proceed and have a look at the Investor Relations site on Extreme Networks, where they have safe harbor statements as well as comments that talk about the risks and uncertainties of the company's outlook and business operations. Please have a look at that. In addition to that, there are disclosures that Citigroup Investment Research has that you can please read. And if you're a MiFID II client, please make sure you have that research agreement in place. We do note, press and media are not allowed on this. If you're press or media, please disconnect right now, and we will go through the list of attendees, and if you're press or media, we will exclude you from this call. This is intended for Citigroup institutional investors. Joining me on the call is Rémi Thomas. He's the Chief Financial Officer; as well as Stan Kovler, he's in charge of Investor Relations. So thank you so much for joining us here today.

And maybe to kick things off, Rémi, big picture. Can you talk about the trends you're seeing across your various market verticals and geographies?

Sure. Sure. So we're seeing some recovery from the low level of business that we achieved in our March quarter, so September saw an uptick. It went from $210 million to $215 million, and we're guiding to $225 million, if you take the midpoint of our guidance. So some sequential recovery, I would say, across all geographies and across all verticals, the interesting trend we've seen so far in July and August has been the pickup in what we describe as run rate business. So various networking companies have a different expression to qualify that. But if we typically look at it as anything that's below $50,000, typically coming from our installed base of customers, not really a new project but they might be expanding an office, opening a new branch, and they're going to send us orders for a few switches, a few routers, power cords, fans, and those orders are not flagged in sales force. So they're not necessarily in the pipe. We have seen drying out in the April and May time frame, where a lot of IT operatives and networking guys were kind of on pause, waiting to see what COVID would do to their business and that built pent-up demand, which is now coming back online. Very encouraging trends because, typically, the margins on that type of business is usual. We don't have to bid against anybody else to get that business. It's driven by the installed base. So first comment, we're very happy to see that. Secondly, if you look at the Americas versus international, you see the pace of recovery is about the same and it's really vertical-specific, and I'll go back in that. If I look at the geographies outside of the U.S., we're tracking according to the expectation we had entering the quarter, looking at our fund -- book of business. The only region that we continue to see as trending behind in terms of the pace of recovery is what we call Southern, which includes France, Portugal, Italy and Spain. Those countries are coming out of lockdown but we're not seeing the business that we're hoping to see. Everywhere else, we're seeing a nice recovery. And I would say, specifically, when I look at our biggest region, which we call DACH, which is Germany, Austria, Switzerland, which is critical to us because historically, it's been a big area of business for us. We're enjoying a nice recovery there. Northern Asia, including Korea and Japan, which were hit early by COVID, specifically for Korea, is also enjoying a nice recovery. So that's what we see from a geographic basis. From a vertical standpoint, we've talked about the strength of the education and government vertical, which is slightly more than 35% of our business. Manufacturing is also recovering nicely, and that's -- the pace of the recovery is depending on whether or not the employees are coming back to the factories. Service provider and telco is looking really healthy, both in terms of ongoing business and what we see in the pipe as our customers are rolling out or getting ready for 5G. Retail continues to be weak. And I would say finally, sports venues, which is important for us because we're so dominant in the NFL, a lot of opportunities in the pipe, not much business for now until this -- the fans can come back to the stadium. I'll pause here, Jim, and give you a chance to double-click on any of these verticals, if you wish.

Well, Rémi, what I'd like to do is maybe connect your positive comments and kind of what you're seeing to say some of the other companies who presented today and yesterday and also news, for example, Cisco guiding down, Ciena seeing soft outlook, Keysight's, their orders down. It seems like all of them had a lot more concerning things that what you're talking about. I mean I know you don't work there as CFO, you work for Extreme Networks. But can you maybe help me bridge their commentary versus your optimism?

Yes. So as far as optical transport is concerned, I would have expected that business to do well, given everybody working from home or streamlining videos from Netflix from home. So I would have expected service providers to add capacity in optical transport. We don't play in that market, but the comment from the 1 optical transport vendor that you just mentioned, came to us as a surprise. The mix that we have in the telco space is much more towards wireless. And although we provide high-end switches and routers, they're part of the 5G buildout, that the 1 OEM vendor that we work with and the 1 service provider we work with are doing. So we have no exposure whatsoever to optical transport. I'm surprised by what was announced. But we don't see any of that at all. As far as Cisco is concerned, we announced early that we took a big hit from COVID. Our revenue was supposed to be around $250 million in the March quarter, and we landed at $210 million, and we're recovering and so for them to call a slowdown full month into the pandemic also took us by surprise. I would say that they have exposure to China. They have exposure to India. They have exposure to certain verticals like finance and insurance where we don't play. And so maybe that's why they're calling out the slowdown, but all the verticals or the geographies where we get hit, we saw that impact as early as March and April, and we're not seeing any further deterioration. If anything business is picking up and as I said, the trend is $210 million in March, $215 million in June, we're calling $225 million and we're perfectly on track to achieve that for the September quarter.

As $210 million, $215 million and what were the numbers again, Rémi?

If you think the midpoint of the September guidance for revenue, we call out $220 million to $230 million. So $225 million is the midpoint and we're on track to achieve that.

That's nice. So maybe if you can just help me better understand about how are some of your customers actually using Extreme technologies -- Extreme's technologies, their products during the COVID-19 environment. I mean it's been a long time since I've been to your professional sports arena or a stadium and I just don't know when we're going to go back. So help me understand, I'm just very -- conceptualize the products.

Yes. When you point actually the one vertical that we're have a high exposure to are, then currently not using our products because no fans are in the stadium. I know that there's 1 NFL game where there would be some fans soon and we're hoping there will be more of that, but typically that's one area where there's a change. I would say, with COVID-19, we've seen the emergence of a lot of trends as we didn't see before. So first off, if I look at transportation logistics, every package that FedEx or UPS ships today and they're shipping a lot of them, there's extreme technology behind that. So we have a strong presence in logistics which obviously is an area where they're being kept busy right now. If I look at some of the application around health care, the City of Madrid today basically just deployed our cloud to support testing and telehealth for all of the Madrid area. servers.com, which is a infrastructure as a service hosting platform at the Netherlands, is also using our switches to provide streaming of the football league. So there's many new applications that are emerging as a result of COVID. If I were to sum it up, we're seeing accelerated adoption of the cloud. With all the networking, IT, people having to work remote, the tools that we're providing that it gives them visibility and the ability to manage their network remotely from a public cloud platform, be it AWS, Google Cloud or Azure versus the on-prem solution that we had is turning out to be very convenient. And so the strength in our Q2 bookings for cloud subscription which were up 42% sequentially is reflecting that accelerated adoption in the cloud. We believe that our platform is second to none in terms of the capabilities that it has to offer.

And Rémi, can you maybe shift now and talk a little bit about state and local and education businesses? How are they holding up? I think about I'm still paying taxes at my house, but also I'm not traveling, I'm not staying at hotels, a lot of the money where I stay in a hotel or airplane has an additional tax or tariff or some type of additional tax that goes to help out the municipalities. Can you talk a little bit about that and how you're thinking about or your discussions with the states and municipalities?

Yes. That's a great point. So obviously in the initial phase, we saw plans being introduced by governments. Obviously the Trump administration but if you look at fans, Emmanuel Macron just last Friday announced a new plan to inject liquidity in the economy. So everything that is driven by the Federal or the Central government, there's funding that's being made available. When it cascades get down to states and counties local authorities, their income from you not traveling, Jim, or from local businesses, hair salon and stuff going out of business could potentially be impacted. At this stage, I would say that the state local, and even education business which is driven by Federal funding has been flown well for us. We'll monitor the situation when it comes to local authorities. But we also could argue that even if funding were to be reduced as a result of the COVID crisis, we have an opportunity to take market share at the expense of some of the other vendors. And so right now, this is a big focus area for us and we feel good about that opportunity.

Now as CFO, you're used to having your sales force fly around and meet with customers and things like that. How -- what have been the changes that you had to do, Extreme's ability to generate funnel of business and how the sales cycle is trending?

I would say that we were pleasantly surprised not just when it comes to salespeople. But in general, even if I look at support functions like finance, HR, IS and IT as quickly everybody adapt to the new normal, being able to attend a virtual conference like this one from my home office. So the transition went rather well. We ended up saving a lot of money in terms of travel, where we're spending roughly $3 million or $4 million in a quarter and right now we're spending close to 0. There are certain countries though where the feedback we're getting from our salespeople is that being able to physically meet the customers, bring them to an EVC, shake hands when they sign a PO, that is hurting business a bit. So if I think of France, Italy, Spain, that contact with the customer is missing, and I'm glad that these countries are coming out of lockdown because we'll need to be able to have that face-to-face dialogue. But overall, we've been pleasantly surprised as how quickly our sales teams have adapted in the various markets where they operate and have been able to close deals without physically meeting the customers.

If we take a step and look back on what's happened recently, there's been a lot of mergers and acquisitions by some of your competitors. For example, Cisco bought, I think, what's called a ThousandEyes, Hewlett Packard Enterprise, Silver Peak, if I remember right, and Juniper-Mist. How should we think about what they're doing, their service offerings and kind of the competitive implications from such moves?

Yes. No, I think a lot of the acquisition by our competitors were very smart in terms of the specific technology or customer set that they were acquiring. Some of the valuation, however, looked pretty high. I'm not going to comment on either of this transaction, but those are high multiple and certainly not something that we would consider given our balance sheet and given that we want every acquisition to be earnings enhancing. When I look at our portfolio, we feel pretty good about it. There are some areas such as software-defined wide area network where we've seen our competitors move recently and where our portfolio is probably not where it should be. And so we'd be looking to close the gap, either organically or inorganically, but it certainly wouldn't be the same level of investment. But we're not surprised by these moves. We feel good about our product portfolio, and we might be looking to do some tuck-in acquisitions where we feel we have gaps.

And Jim, I would just add to that -- on that point, when you look at our position in the marketplace with the differentiation we have around fabric, our fabric extends from headquarters out to branch offices. So we have that covered, and we have a lot of new capability that we're adding to our cloud platform. So these moves, as Rémi mentioned, are not surprising, but we feel like we're well prepared or well positioned to offer our customers a lot of different features and functionality that they'd be looking for in the current environment.

Stan, Rémi, I believe on your last earnings call, you made a comment about some go-to-market changes heading into fiscal '21. I think you had a new hire, like Chief Revenue Officer or maybe Chief Marketing Officer or something. Can you -- each of you or one of you talk about the implications of these changes and what we should expect are the key focus and why you had to do some changes?

That's a great question. We're doing many, many things. But if I were to sum it up in the 3 most important things, we now have 2 very strong leaders for the 2 regions that I talked about earlier. It's the Americas and international, and these guys are driving the day-to-day building the funnel for this quarter and next quarter and converting that funnel into a bookings number. Joe Vitalone, who just joined the company 6 weeks ago, is going to be able to be more strategic, relying on them to delivering the number for this quarter, but developing new routes to market, signing up new OEM agreement, business partners, distis and building the pipe this quarter and next, but over the next few quarters by constantly rethinking our go-to-market and our various partnerships. That's item number one. Item number two, we did not have a strong connection between the lead generation coming from marketing, qualifying those leads and then acting upon them to either get a deal won or lost, but at least exploiting these leads. So Joe knows Wes Durow, which they both worked at Mitel a few years back really well, and we're basically making sure that the lead generation engine and how it's exploited by sales is working better than it was. And the third and final item is that we made a big reorg in the Americas about a year ago now with a very strong focus on verticals, and we left out some of the territory coverage. So we rebalanced that out so that no customers in our territories is not called on a regular basis by these. So we have an enhanced territory coverage. And this is true for the Americas and to an extent for international, where we tried to mirror that organization. So many more things, but those are the 3 most important things that we're doing right now to improve our go-to-market.

Okay. And to your financials a little bit, like gross margins. I believe you mentioned improving gross margins. Can you help us understand, is that quarter-over-quarter or year-over-year? And what are the factors that are influencing gross margins?

So it would be quarter-over-quarter. And the idea is that we're currently -- the last quarter, it was 59.4%. We're guiding between 59% and 60%. So take the midpoint, it's 59.5%. And the idea is by Q3 or Q4, we should be above 60%. We haven't provided specific guidance, but that's sort of the time line as we're thinking about it. The improvement is going to be driven by 3 things. The first one is the fact that we're constantly refreshing our product portfolio, and we're soon going to be introducing what we call a universal hardware platform, which is a common set of hardware platforms that will serve all of the pillars that we serve: edge, core, and data center with the same hardware. That's going to drive savings because we'll have better scale with each of the products that we're launching. The second one is the change in the mix. We're currently at 34% recurring revenue, including support and subscription, which typically carries a gross margin in the high 60s to low 70s versus our product, which is in the high 50s. So as we are growing that recurring revenue, you should be expecting the overall company's gross margin to improve. And the third and final one is, we're currently being hit by a significant increase in freight costs. We have 1 main hub in El Paso, Texas, that covers the rest of the world. Every time we have to ship product to distributors in either Europe or Asia, we are using commercial airlines that are charging us about twice the rate that they used to charge us pre-COVID because there's very few flights that are available right now. So that's hurting us temporarily. We expect that to go down over the next 3 quarters as passenger traffic picks up.

Okay. That makes sense. Sticking still on your financials. Can you talk about operating expenses? I believe during coronavirus, normally, you and I and Stan would all be in New York on stage in front of a very busy room. And this year, we're doing this all remotely, my home, your home and Stan's home, respectively. Can you talk about operating expenses? It seems like at some point, they should come back up due to traveling, but how should we think about, as you CFO monitoring cash flow or operating expenses?

Yes. So we took early action, which is, again, why I was surprised by some of the other vendors talking about taking cost reduction 3 weeks ago. Those actions were carried out at the end of March and April. Some of them were temporary in nature. You mentioned travel. There was a total freeze on travel, but we also had pay cuts and not matching 401(k)s, these type of things, specifically in the June quarter because we lost money in our March quarter. And others were more structural in nature. We drove more efficiency in our R&D, our go-to-market, which I mentioned. And so we took some costs out on a more permanent basis. As we enter Q1, the temporary measures that we took have been lifted. In other words, everybody is getting back their full pay. We're allowing some traveling, but it's very limited, and our headcount is now stabilized where we want it to be. So going forward, you should be expecting our operating expense to be between $120 million to $125 million. And the only way it's going to go up is if travel goes back to about $3 million or $4 million a quarter, and I don't see that happening in Q1 nor in Q2. And if the bookings are so strong that we end up paying more commission to our salespeople, which I'd be delighted to do, by the way. But there's no reason why operating expenses should be going up outside of these 2 things. And therefore, we're going to get operating leverage. Every time the revenue goes up by $10 million sequentially, about 60% of that goes into gross profit, and a majority of that 60% grows into the operating profit.