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

All right. Great. We can kick things off. I'm Sami Badri with Crédit Suisse. Thank you very much for joining us today. Today, we also have Rémi Thomas, Chief Financial Officer from Extreme Networks and we also have Stan Kovler, the Director of IR, also for Extreme. Thank you both for joining us today. And I think the majority of the conversation will be with Rémi, and Stan will come in when there's a question or anything specific that needs to be referred to. If you have any questions, please feel free to e-mail me directly. You can see the e-mail targeting on the dialogue box or on the website page.

So Remi, thank you very much for joining us, and really to kick things off. I was hoping you could kick it off with the COVID-19 impacts to the business and to the various segments? I know it's been a bit of a bumpy ride in 2020. And I was hoping you could kind of just go through some of the demand, the effects, some of the customer priorities that you've seen and maybe any kind of supply disruption? And then we can kind of kick it off through there, some of the questions.

So as far as COVID is concerned, now that we're sort of 9 months into the crisis, we can look back and kind of break it down into phases. Phase I, which was really from mid-March, I would say, almost until the end of June was the phase of pure shell shock. We saw a sudden and brutal impact to our business. If I look at product bookings specifically, I'd say roughly 30% of that vanish in the month of March. Projects that were in-flight, in verticals that were not too impacted, typically carried on, but new projects were put on hold. What we call our run rate business, which is anything below 50,000, that's typically coming out of the installed base, it's just customers adding a few switches, fans, power cords that dried out. In those verticals that were most impacted by COVID, the only things we got were support contracts that were renewed. And overall, because of the resilience of the ongoing support in subscription, it took out roughly 20% of our top line if I look at pre-COVID versus the March and the June quarter. Phase II, where we started to be able to pull our heads out of the water was the beginning of July where all of a sudden that run rate business started to pick up. There was pent-up demand that was built. The networks continued to be used. People were just accessing them remotely. And so all of a sudden, that run rate business started to come back. And the other thing that was very interesting in Phase II is because the IT people realized they were going to have to manage their networks remotely for a long period of time, they accelerated the adoption of the cloud. So all of a sudden, we saw our subscription business, which is our cloud offer, pick up dramatically in terms of bookings. The big projects, though, we saw a few in governments and education, basically those verticals that were supported by stimulus money, but elsewhere, people were really, really shy. And then as a result of this Phase II, our business picked up. We had a 9% sequential increase in the September quarter versus the March quarter. And Phase III, which really is since the start of October, we saw -- we've seen acceleration of the pickup in run rate business. We've seen big deals starting to come back. We see a number of verticals that have really been severely impacted by COVID like sports venues, all of a sudden, there's deals in the pipe, and the outlook is looking much stronger. So those were the things I would highlight. Are you still there, Sami?

Got it. Got it. When we go into 2021 -- yes, sorry. Yes, Yes. I can hear you. I'm just a little bit of an Internet connection problem.

Okay. Yes, you're delayed somehow.

The majority of the segments that were impacted negatively in 2020, and some of them have already started to see some -- and you've already seen some of the segments start to improve and transition in 2020. When we go into 2021, which parts of your business should see further improvements or even further accelerations of improvements, at least when we get into the midst of the year?

Okay. So the segment that's showing the best resilience right now is state, local and education, we'll call it SLED at Extreme. And that's roughly 40% of our business. A lot of that is boosted by government stimulus money, not just in the U.S. by the way, across the globe, that is currently strong. And unless there's not a new stimulus package put in place, but it seems like there's going to be one in the U.S., and we're seeing some in other countries, we expect that to remain strong. Manufacturing, since workers have been able to go back to the factories, has picked up and we've been enjoying good momentum there and signed a major deal with a large manufacturer. And the call makers, our traditional customers continue to suspend. Retail, Transportation & Logistics is still very mixed. The classic part of retail, which is department stores, I'm not sure it's going to pick up, to be honest with you, because everybody is basically shopping online. For Transportation & Logistics, obviously, because of the online business is doing quite well, we would expect that to continue. And so the 2 verticals that we see ramping up as we hit '21 will be telco service provider because we have now an exposure to 5G. And it would be the sports venue, which I mentioned earlier, because we have won the MLB in addition to NFL. And that business is expected to kick off as we enter calendar 2021.

Got it. Got it. Thank you for unpacking that. You know you made a mention regarding the CARES Act contribution to some of your customers. If you were to think about the level of benefit that the CARES funding actually contributed, how would you size it? Would you say just from like account perspective, did it benefit 15% of your customers, 30% of your customers? Can you just give us an idea of positive kind of lift or attribution from CARES funding?

Well, if I look at education plus government, it's slightly north of 40%. We typically break it down in 3 parts. There's the pure government and then there's K-12, which is mostly driven by e-rates and then this college. But I would say roughly the part that really benefits the CARES Act is probably 20% to 25%. And the other 15% was either private funding for schools or e-rates, but it was a big chunk of our business. That's obviously in the U.S. but elsewhere in the world, it was not CARES act, but they were government program in Germany, France, and a number of countries where we operate.

Got it. Got it. Thank you for clarifying that. I wanted to go back to fiscal 1Q, 2021. And can you just talk about the better-than-expected performance in a little bit more detail then? And more specifically, could you speak to the competitive landscape that's going on in the WLAN market space? Just because the perception probably in 2018 through early 2020 was that market competition was going to intensify, and that was probably going to squeeze essentially most players into the market. But what we have found end up being the case is just an overall large tailwind, and this tailwind has applied to both consumer level routing and all the way into enterprise, obviously, enterprise is a mixed bag. But I think the net kind of takeaway or viewpoint is that we've been positively surprised. So if you can kind of unpack the WLAN market from maybe your perspective and what you're seeing at Extreme. And maybe in the context of that, talk about fiscal 1Q, 2021?

Yes, sure. So overall, and my comment applies to all of Extreme, not just our wireless LAN business. I would say that we have better execution as a company. And this was really tangible in how we delivered on that product roadmap, how we delivered on our sales execution and how we worked hard with our back office capabilities and automation to make it easier for customers to work with us. So we have an overall better execution than we did, say, a few quarters back. As far as specifically, wireless is concerned, this remains competitive, always has been. We've seen customers with -- competitors, sorry, with the recent acquisition that they made become more present. I'm speaking specifically of Juniper and MIS. Huawei is less present now, they're pulling out of the U.K. market, for example, because they are not going to have as good a market share in 5G as they did in 4G. So their presence in enterprise is being affected in those countries where they were not able to secure 5G deals. And we see one competitor right now being more price aggressive over the last couple of months. But that comes and go. Overall, I'd say the competitive nature of the wireless business has not really become more intense or less intense than it was, say, 12 months ago. What we're seeing today for wireless is strength in education, transportation and logistics. However, retail, as I mentioned earlier, sports, entertainment have still not recovered. So my view is that the recovery of wireless is going to be stronger in calendar '21. And in fiscal Q1, if you really think about what drove the performance, it was wired, it was not yet wireless. So the best is yet to come in wireless, in our view.

Got it. Got it. And then shifting gears a little bit to the innovations you've made in user experiences. And I was hoping you could kind of talk about the updates on your go-to-market strategies? And along the lines of that is, how have customers been utilizing the LEAP program during the pandemic?

Okay. So as far as go-to-market, I mentioned, our execution has been stronger, I'd say there's a number of things we did. Number one is the change in sales leadership. So about a year ago, we changed ourselves either for the Americas. And about a quarter and half ago, we changed our CRO, Joe Vitalone joined the company, and the difference that these 2 leaders are making is very visible today. The other thing is we refine -- there have been a sales reorg about a year ago, but we further refined it. And we really built our presence with strategic accounts where there's strategic AEs focusing on these accounts and our coverage of territory. So we're having an overall better coverage of those territories and those strategic accounts. I mentioned the automation tool, one of them, which we introduced is called Channel Self-Service. It enables our business partners to literally place appeal with us, get approval for a certain level of discounts, without having to speak to anybody. It's basically a tool that they enter in our portal, and that is driving velocity in our go-to-market. And finally, we're investing in the digital marketing side of our marketing investments. And I feel like we have a better conversion of leads into qualified leads that potentially can become one opportunities. LEAP, which is our financing program has helped us. We're not the only ones to have it. But obviously, having that program in place for those customers who are looking for financing has been really helpful for them. And so we haven't left any business on the table because of the potential financial issues that our customers would have as a result of the pandemic.

Got it. Got it. Thank you for summarizing those points on execution. This kind of is an interesting segue into the next question set, which is second waves of lockdowns for COVID. So as we see some countries in some regions going to a second broad-based lockdown type of dynamic, how is Extreme seeing the current dynamics play out, at least from a sales force perspective or execution perspective?

Yes. We were concerned about this, and we haven't seen any impact. I would say that the majority of our customers have been working from home for 9 months now, and so they're used to it. And really, with the second wave of lockdown has impacted restaurant owners, hotels, small businesses, hair and nail saloon, but for our customers, it's kind of been business as usual. They're part of this new normal and they have been for a while. In addition to that, I would say that because they couldn't spend money in March, April, May, in that Phase I that I described earlier, they're now looking at their budgets for the whole of calendar '20 and realize that they haven't spent based on their budgets. And this is budget flushing phenomenon that we see, specifically in Europe, specifically in Latin America, which is playing in our favor where they're rushing to spend that money before the end of the year. So, so far, I would say, no impact, if anything, we're seeing that budget flushing really playing the way it does normally at the end of the year.

Got it. Got it. Yes, the budget flush dynamic is a very new dynamic for a lot of analysts to be looking over during a pandemic. I wanted to shift a little bit to larger tech secular trends. And along those lines, 5G, AI, machine learning and Wi-Fi 6 adoption, I guess for Extreme Networks, specifically, could you just elaborate on the 5G opportunities ahead for Extreme? You mentioned a couple of times earlier, but I was hoping if you could kind of give us a bit more of a tangent -- sorry, a bit more of a granular idea on the reference points?

Yes. So typically, the majority of the products that we do are off-the-shelf, and they're basically for the mainstream campus market. Right. Having said that, we have strong relationship with existing customers, one large service provider in the U.S. and one large telco equipment maker in Europe, which were inherited from the Brocade acquisition. So they were mostly in the space of data centers, switches and routers. About 1.5 years ago, we initiated programs with these 2 customers, one on next-gen packet broker for the service provider and one on high-end switches that are embedded in the 5G network of the large telco equipment maker. And basically, we built solutions that can really be embedded in their own solution. We expect that will result in a significant increase in revenue as of the second half of calendar '21. So in other words, we have a bigger exposure to 5G than we did in 4G as a result of those investments. And hopefully, you will see the impact on our revenue in the second half of next year.

Got it. Got it. Does the majority of your projections that you're seeing hinge on a 5G momentum acceleration? Or are they just kind of relatively well banked on at this point from like a position and expectation perspective?

So we're going to have an Analyst Day in February, and we'll be in a position to quantify those impacts. I would say if you look at the first half of calendar 2021, the recovery will be largely driven by the year-over-year comparison with the first half of calendar '20, which was when we got hit by the pandemic. And so it will be a recovery driven, largely by enterprise campus. As you think about the second half, this will be more organic growth and will be driven by the combination of the strength we see in the enterprise space, especially with our cloud technology, combined with the incremental revenue coming from 5G.

Got it. Got it. Okay. Perfect. I wanted to shift gears a little bit. And as you have launched new products like the universal platform, how should investors be thinking about the trend for margins? And just to take a step further is, how should investors be thinking about the timing of the launch and its contribution hitting the top line as well?

So the long term part of it has already happened. So the universal hardware platform is -- for those of you who are not familiar with it, it's a common hardware that we use across the various operating systems that we have. So we have an operating system that came from Extreme, which is called EXOS, one that came from Avaya, one that came from Brocade. And these operating systems have been kept because they respond to different use case, edge, automated campus and data center. Going forward, we couldn't afford to have dedicated hardware for each of these operating systems. So we basically are now having one common hardware across the board capable of supporting the various OSs. So what it does is, to your point, improve gross margin because now we get better scale on this platform, also gives customer the comfort that they're not going to be left behind. Because if you were an ex-Avaya customer, you could worry that your hardware would become obsolete. And now basically, everybody is on the same hardware with the same platform. We just launched the first product, the 5520 over the next 18 to 24 months. The entire portfolio will be renewed with that Gen 3 common hardware that we call the universal platform.

Got it. Got it. I wanted to shift gears a little bit. And I want to talk about Extreme Networks' position and opportunity in SD-WAN. One thing I think that's come in recently to the industry with a lot of questions is Juniper's acquisition of 128 Technologies. So as you see Extreme Networks to position SD-WAN, how would you characterize the competitive landscape, especially during some of these, I want to say, rather differentiated acquisitions or industry consolidations?

Yes. So first off, let me say that Extreme, historically, and still today, is focused on the LAN. So we've never really played in the wide area network market with IP and PLS. And so we consider that for us, currently not having a strong position in SD-WAN, it's a lost opportunity. It really doesn't jeopardize our existing revenue in the LAN the way SD-WAN jeopardized the revenue of the key IP and PLS players like Cisco, Nokia with the TiMetra acquisition or Juniper. Having said that, if you look at our 3 biggest competitors in the LAN, Cisco, HP and now Juniper, all 3 have made acquisition in the SD-WAN space. And so we are aware of that. In addition, I would say that we're seeing a convergence between traditional networking equipments and networking security around SASE. And so that's a secular trend in the industry that we need to address. We typically don't pay the kind of multiples that you've seen for SD-WAN. If you look at the acquisitions we've made, they have to be earnings accretive year 1. So those multiple means that inorganic move is perhaps not very likely. However, we do have organically some solution. Avaya had an SD-WAN solution. Aerohive had an SD-WAN platform. It doesn't scale that well, but there are some things that we could be doing organically with our own R&D to build a position in that space. So stay tuned.

Got it. Got it. I was hoping we could shift over a little bit to capital allocation strategy, and then when we think about the pecking order of things, how do you assess any investments organic or inorganic really? And you can talk about even just other kind of capital allocation features as well.

So the top priority is very simple, is to delever. We haven't talked about cash flow, but it was important that in Phase I we didn't burn any cash flow, in Phase II we generated a tiny bit. And obviously, now, we feel like we're going to start generating $20 million to $25 million in cash flow per quarter, and that's helping us reduce our net debt. So that will be the #1 priority. If there are tuck-in acquisitions that make sense where the multiples are reasonable, and it's part of our overall strategy, we may see some of that. But then we, by definition, given our balance sheet be limited in size. And at this stage, we're not really in a position to do share buyback, but we believe that the stock is very, very cheap. And so hopefully, one day we'll be in a position to start doing share buybacks as well. Number one priority, delever.

Got it. Got it. And then as you mentioned earlier, from an M&A perspective, it needs to be accretive on fiscal year-1, right, following acquisition. Got it.

Which, by the way, was the case for [indiscernible]. It was accretive year-1 even though that year-1 included the pandemic for the second half of it.

Yes. Yes. Someone could say that was phenomenal timing, and best way to put it lightly. The one kind of other question I have is, when you think about the opportunities for Extreme ahead, and you think about elements of the business or dynamics that investors are overlooking, are there a couple of dynamics that you think are completely flying under the radar for investors that have not necessarily been brought up enough in some of your meetings and some of your presentations over the last couple of months?

So I think those investors that are invested in the stock typically know the things that get us really excited. It's just that we need to obviously reach out to new investors that are less familiar with the story. I would say the 3 things that get me excited and get our current shareholders excited is, number one, the accelerated adoption of the cloud and the fact that we have a very strong platform. I mentioned that it was kind of the side effect of COVID. Our trend in terms of bookings or number of devices managed, we're now 1.4 million, that's up from 1.1 million at the end of June. So we're seeing an accelerated adoption. And we have a unique opportunity to leverage the platform that we got from Aerohive. That's the thing that gets me most excited. Number two is this incremental business in 5G and with the next-gen packet broker, which potentially creates a second leg of growth in the second half of calendar '21. And number three is the operating leverage. I mentioned that in Phase 1, the impact of COVID was brutal, we adapted our cost structure extremely quickly, and we've reduced our breakeven point down to $215 million a quarter. So every time you are $10 million, $20 million, $30 million above that number, that creates operating leverage because we don't really need to start spending more in terms of OpEx. So that in turn will help us achieve higher operating margin and to my earlier points about deleveraging free cash flow. And that's the kind of stuff that gets me really excited. And hopefully, some investors will get excited as well.

Got it. Got it. And then thank you for covering those. And then one kind of -- I want to go back to some earlier comments and put them into context is we talked about the M&A mandate. We talked about how things need to be accretive on day 1, and we also talked about Aerohive being accretive on day 1 and that being essentially one of the last major acquisitions. But when you look to the future, what kind of acquisitions are you actually looking for? In terms of type of technologies or type of adjacencies that you already currently have, right? Because I think you kind of checked off...

Yes. Sorry. If you look at what we've done, it's mostly been transformative in nature. So you look back at Enterasys, Zebra, Avaya, Brocade, Aerohive, it basically were companies that were anywhere between $150 million, while Zebra was slightly less, was about $70 million, Aerohive was about $150 million, Avaya and Brocade were about $200 million, Enterasys was $200 million to $250 million. So we were trying to get scale. Right. And then the nuance with Aerohive is that it brought us this cloud platform that we didn't have. Going forward, now we're a $1 billion company, I don't know that there's any company that we could look at to do a transformative deal, it's really about complementing our portfolio and making sure we hit to your point about SD-WAN, the areas of the market that are good opportunities for us.

Got it. Got it. Perfect. Well, Rémi, that's -- we've crossed the majority of my questions. Thank you very much for your time. Thank you, Stan as well, and the rest of the Extreme Networks team. And then we look forward to catching up with you in the very near future.

Thanks for having us. Sami.

Absolutely. Thank you very much. Bye now.