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

Good morning. I'm Samik Chatterjee, networking and hardward analyst at JPMorgan. For the next session today, we have the pleasure of hosing Extreme Networks. With us for the fireside chat, we have Ed Meyercord, CEO; we have Stan Kovler from Investor Relations as well. You can see both of them on your screens here. And the way we want to run this is go through the most pertinent investor questions we're getting on Extreme for about 30, 35 minutes. We do want to encourage it you send in your questions as well. You can use the Ask Question button or queue in the -- on the website to send in your questions, and I'll ask it on your behalf. So please feel free to go ahead and do that in relation to any kind of top-of-mind burning questions you have. Ed, Stan, thanks for taking the time to participate at the conference, attend the conference here. Really exciting year for Extreme. The stock is up 66% or so year-to-date. So definitely something is going right. So great to see that. I did want to start you off with talking about one of the verticals that's really doing well, which is the education vertical and the support from the government spending that you're seeing.

I know you've spoken recently about the American Rescue Plan in the U.S., the Digital Pack in Germany, the GIGA Schools program in Japan. So just help us think through the magnitude of each of them, how impactful can each of them individually be? And also timing, when do these spend start to materialize?

Thanks, Samik, and thanks for having us at the conference. Yes, you're right. So what we call SLED, which is state, local government and education spending, is our largest vertical, and it's a healthy part of our business. And we have the benefit of a few trends that are happening. As you mentioned, America Rescue Plan and other funding mechanisms that we have around the world and other geographies and other countries. There is a COVID and what will be a post-COVID stimulus spend that's happening there that we will be the beneficiary of. What's happened is analysts have taken their forecast for the industry, which is normally a 3% to 5% grower, to a 5% to 8% industry growth rate as we're seeing the wave of spending coming into networking infrastructure to support local governments as well as education and schools. So this is something that we are the beneficiary of. What is a longer-term plan in the U.S. is an E-Rate program. We've had a particular success this year where we're up over 30% in terms of E-Rate filings and wins. So that's going to fuel growth. That is a longer-term program. And so this is what's happening from a macro perspective, driving growth at Extreme. In terms of our competitive position, we have the industry-leading cloud, Samik, as you're aware, and as a result of our position of cloud and our end-to-end portfolio, we're winning more and we're taking share. So from that perspective, that drives incremental growth as Extreme is -- when we take share, it has a larger impact on our top line given our relative size in the industry.

Just to follow-up on that, Ed, any way to quantify, when you talked about E-Rate, like the size of the plans in Germany or Japan relative to the size that you have for E-Rate that you participate in more consistently?

So in the U.S., it's a very targeted program. And we mentioned Digital Pack. You mentioned Digital Pack and GIGA Schools. And really, those are the larger programs in Germany and Japan. But all countries have spending plans around education. The most formalized plan is the E-Rate plan that has been in place for a long time. For us, we expect to see an incremental $30 million of revenue in our fiscal '22 coming from the growth of our E-Rate. And in general, the E-Rate spending pool has grown, and then we're taking share predominantly from Cisco in that -- in that environment. So we have a unique value proposition in terms of what we can offer. And now with cloud, we have more differentiation than ever before. And this is -- for us, this is providing us with nice tailwinds.

Got it. Got it. Before we get into the product-level differentiation, let me stick on the SLED vertical for a bit more. You've talked about the E-Rate filings up more than 30%. I think the number you had given on the earnings call was up 35%, if I'm not wrong. You had a similar growth last year as well, but that was helped by Aerohive being included in that portfolio. So as we look at this 35% year-on-year growth, I'm assuming this is all organic. Can you help us think about how much of this is really just improving traction for Aerohive versus other parts of the portfolio?

Yes. So this -- the 35% is organic growth. And then what we've done, we moved very quickly to cloudify our portfolio. So Aerohive was primarily wireless LAN from the cloud. And then what we've done is we've gone end-to-end, and we put our switching portfolio in the cloud. What has been very popular with us is also our Fabric technology, which makes it very easy to segment networking and deploy networks within the environment, and it's also highly secure. So as a result, the combination of our cloud as well as our Fabric technology and the fact that we have universal hardware that has embedded XIQ or cloud licensing is something that is allowing us to take share. It's being very well received in the market. And so from that perspective, that's been a big driver.

And Samik, just to quantify the market share drivers, the overall dollars for E-Rate were up only 13%. So in the context of our 35% growth, that's a pretty big number.

Okay. That's interesting. Let's move to the differentiation here, the cloud-ready portfolio, that's definitely been one of the talking points and one of the share drivers. How should we break down kind of the growth outlook in cloud-ready solutions in the Extreme portfolio? Like what's underlying industry growth? Because it does appear like cloud-ready solutions are growing faster than some of the other traditional applications. And then within that, how is Extreme positioned to either like even gain share within cloud-ready solutions that you're seeing -- that you're probably competing against at this point?

So yes, cloud is the fastest-growing segment in the networking industry. And the projection is for cloud to be a $10 billion market. And what is -- and to grow to become over 50% of the market in the not-so-distant future. And so that's where the strength of our cloud offering, we have the highest quality cloud in the industry, is playing well for us from a competitive standpoint. I talked earlier about our hardware and us putting switching into the cloud. We've consolidated all of our acquisitions and our product road map into what we call universal hardware. And that is from access points all the way into the core of the network. And all of our switches are embedded with XIQ licenses, which means that they come cloud-ready, if you will. And then with what we are offering in terms of all the software, it makes sense for customers to embrace our cloud and to manage from the cloud in terms of our network management, in terms of security, in terms of guest WiFi, in terms of locationing. If we look at all the different components that we're bringing, the value-add services and software that we're putting into that cloud subscription license. If you look at what's happening with the industry, with COVID, we saw the world work from home effectively. And so we saw a more distributed networking environment. And then the more distributed network calls for cloud is an easier way to manage the complexity of networking. And so it's the -- the demand for cloud has never been stronger because of the new edge of the network, which is moving out towards people working from home and what we call the Infinite Edge or the Infinite Enterprise now. And in order to manage that and to eliminate the complexity of managing that network and to deliver a consistent user experience, cloud has never been more important. And so you're seeing this acceleration of cloud. From our standpoint at Extreme, we have with the industry-leading cloud, is enterprise customers are rethinking, return to work, office, school, new health care models, et cetera, cloud becomes more important as part of the networking infrastructure consideration. And with that, people -- more people are considering Extreme today than ever before, and we're moving further through competitive processes, and we're winning more than we ever have.

Got it.

And Samik, at our user conference this week, people will get a chance to hear more about some of the new developments that we have like, for example, our explainable AI that we talk about, which is going to be called Co-Pilot. So lots of new features coming out to extend that differentiation that Ed just talked about.

Got it. Let me follow-up just in terms of clarifying, I think, Ed, you mentioned the $10 billion kind of market opportunity that you see for the cloud. How does that break down between if you have the numbers? How does that break down between wireless access points and switching and -- just to size up the opportunity there? And also, how is the competitive landscape now different? Because when we look at the traditional switching and wireless access players, some of them don't have a cloud-ready solution. So what are you finding in terms of the more kind of smaller competitive landscape that you're now in with the cloud-ready solutions? And who are your usual competitors now relative to what was kind of the traditional market?

Yes. Well, first of all, I'll just start off by saying that we -- yes, we're competing with Cisco and HP, primarily, to a lesser extent, Juniper is investing more in the enterprise market today. And we have significant differentiation relative to the largest competitors as it relates to cloud. And we don't have a conflict in our portfolio. So it's pretty clean sale from our perspective, and the differentiation is real for enterprise customers. Most of the market is still wireless land. So it's the edge of the network that moved to the cloud first. And now what we expect to see in the next wave is to see more and more switching move into the cloud. And it will start edge switching and then moving deeper into the core. I mentioned Fabric technology. We're the first company to put Fabric into the cloud so that you can manage from the core of the network out to the edge, leveraging our Fabric technology and this is another differentiator that we have at Extreme. I think as we look at our 1.6 million connected devices, we continue to see opportunities to grow with the wireless land side of the portfolio, if you will, but we expect to see a significant growth in switching. And so that's where I think in the future, you'll see the uptick for us. And I think you'll see that trend happen in the industry as well. Stan mentioned AI and what that brings. We are coming out with what we call explainable AI. It's kind of the next-generation AI for cloud networks. A lot of the earlier versions from competitors were creating alarm fatigue in the marketplace. And what we're talking about is 99% false alarm free. In other words, you don't need to light up your -- either your cell phone or your network management software with alerts and alarms that are unnecessary. And so we are very focused on true, differentiated services, if you will, to our AI and what we're calling explainable AI that, as Stan mentioned, is available -- will be available with a pilot license starting in the month of June.

Okay. Okay. Before I move further, let me again remind investors, if you have any questions, please feel free to send them in using the Ask A Question queue on the website, and we'll ask it on your behalf. So that's that. Moving on, so Ed, let's -- the next question that I wanted to hit is really about then what does the strategic priority here for the company? How to think about the strategic priority here? In the past, when we look at your history, you've scaled up the business both through organic investments as well as acquisitions over time. And now you're starting to see the benefits of that in terms of market share of the total enterprise market. As we look forward, like how are you thinking of scaling this business further? Is it going to be more of an organic approach from here on? Or with the acquisitions coming good, is there more confidence in pursuing some of the inorganic opportunities that might come through as well?

Yes. Samik, right now, it's an exciting time at Extreme because we're seeing double-digit organic growth. And this is something that we see -- we can see out into the future, this opportunity to grow the business based on the opportunities we have with cloud and the enterprise as well as with 5G. And we remain very focused there. From an M&A perspective, we will be opportunistic. If there is an opportunity that comes up, that appears to be attractive for us, that would be a strategic fit, this is -- we'll consider we'll that as a growth opportunity. And then we're always in the market looking for interesting technology. So if there's a tuck-in, engineering or technology tuck-in, to enhance our portfolio, be that around SD-WAN or the new evolving SASE marketplace, we're very active in the market, evaluating potential opportunities. So I guess, I would say we consider both. Right now, the primary focus is on our organic growth opportunity and taking advantage, again, at this unique double-digit growth opportunity we have.

Okay. Got it. That's helpful. So thinking about then the market share opportunities, I think you outlined clearly in the SLED vertical, you're positioned to gain share with the E-Rate program. Your growth is going to be higher than the industry -- underlying industry. Outside of education, how should I think about customer verticals or even regions, for example, where you're making a bigger push to drive higher share and where will the strongest share gains come from over the next, let's say, 3 to 4 years?

So as far -- from a share perspective, and I'll start off with enterprise, and then we could turn to 5G. From an enterprise perspective, it's -- cloud is really our differentiator. And the fact that, that's the fastest-growing segment in cloud and the fact that we have highest quality, we have the broadest portfolio, we'll have the most advanced AI, this will allow us to take share in our marketplace. If we look at where we play, we talked about SLED, very healthy SLED outlook for the next couple of years for sure. And then if we take share and continue to take share, that creates a long-term growth opportunity for us, SLED. When we look at some of the other verticals where we play, if we look at manufacturing, that has remained healthy and robust. If we look at health care, we saw a dip in health care spend, but we've seen that come back quite a bit. Retail and hospitality was significantly impacted, COVID. We're seeing that come back. We're seeing spending come back in that vertical. Extreme has got a unique position. When we look at our sports and entertainment and venue business, we had a major win with Major League Baseball. And we're shooting our user conference in Fenway as we are deploying with the Boston Red Sox. But we're seeing a significant return to spend in those verticals. And we're seeing geoexpansion outside of the U.S. there. So in all of our verticals, if you go back a year ago, Samik, we were impacted, and we saw headwinds, for sure, in some of these verticals and now we're seeing a return to spending, which is also fueling growth and giving us the confidence and the kinds of numbers that we're forecasting.

Let me just check in here. Yes, I don't see any questions yet. So again, a reminder, if anyone has any questions, please send them in. Let's talk a bit more near term, Ed, here. Clearly, the supply chain constraints are top of mind for investors. Cisco reported last week, and they sounded cautious just on the supply chain constraints as well, including talking about raising prices with their suppliers or giving more pricing power to their suppliers as well. So how is -- let's talk about Extreme first. How is Extreme trying to navigate this situation? What are you hearing in terms of some of these challenges moderating? How soon do they moderate?

Yes. So Samik, the supply chain constraints are real, and we are feeling it. I'd say we are at the peak of the impact at Extreme this quarter. We factored all of this into our guidance. So we have -- in terms of our outlook, we baked into the equation the fact that our product constraints will be twice as much or more than they normally are. And that has to do purely with supply chain. And it also has a negative impact on the gross margin number that we called for the quarter. That being said, I think we're probably in a better position than competitors in the industry, and a lot of that has to do with our relationship with Broadcom. We have a strategic relationship with them. I recently met with Charlie Kawwas, the COO; and Hock Tan, the CEO of Broadcom. One of the things they do for us is they work with us, and they consider us to be a strategic partner more so than the big companies like Cisco or HP, Juniper, et cetera. So -- and because of our size, it's easier for them to work with us, to help us work around shortages. In addition to the chipsets that are inside of our switchings and access points, we also have -- you'll see power supply optics. The -- and many of the other components that are part of our solutions have been constrained. I would say our teams have done a really good job of working with all of our vendors to mitigate this. We see loosening. We have clear visibility to constraints loosening in September, December from here on out. And we think that, for us, the worst is behind us as it relates to the June quarter from a supply chain constraint perspective.

So let me drill down on that a bit further in terms of how much of the constraints is leading to essentially revenue being left on the table versus headwinds on the cost side that you're seeing, either it be the freight cost or higher component prices? And if -- secondly, on the second part of that question, can I ask you to comment on the cost headwind? Is it primarily freight or are suppliers raising prices on you?

So it's a combination. So on the cost side of the equation, what happens is, if suppliers, if they lengthen delivery times, then if you want to bring in the delivery time, then you pay expedite fees. So that's the trend that's happening that everybody is experiencing this expedite fee phenomenon. Also most -- in this quarter, most of our products will be shipped by air, that's more expensive for us. So in the September and December quarters, we'll be able to put more of our product and ship by sea. And that will provide an advantage for us from a gross margin perspective. So yes, that -- from a cost perspective, that's where we've been feeling the impact. We do see that loosening as we go forward into the September and December quarters.

And are you leaving any -- like is it the impression that you're leaving some revenue on the table because you don't have components?

We're leaving -- what's interesting is we're not leaving orders on the table. We're leaving current quarter revenue on the table. So the byproduct of this, Samik, which has been positive for us is the fact that we're building backlog. So when we have product constraints, we have more backlog than we've had. And as a result, that gives us a lot of confidence in terms of our outlook and our ability to forecast the business. And we would expect to see the backlog from product constraints diminish in the September quarter, but they've built up quite a bit in the March and June quarter in terms of our outlook. So it's already factored into our numbers. In an interesting way, it provides us with more confidence in what we're calling in the future in terms of our outlook given that we have the orders.

Got it.

Samik, one of the ways to track that for folks if they want to look at what the impact does on our business is to look at the book-to-bill that we report. So we break out the product book-to-bill, which has been above 1 for a number of quarters now. And so I think that's kind of what Ed was alluding to on that front as far as building up the potential future billings.

Got it. Just staying with some of the near-term drivers here, Ed, I think one of the concerns that we are seeing from investors. Obviously, you've had a great year, you're capitalizing on the demand coming through. One of the concerns that we often hear from investors on this front is how much of the transformation for Extreme, for example, is led by enterprise spending recovering versus underlying strength for the portfolio? How do they get comfortable that this is not just led by the spending recovery versus the portfolio? And how does that -- what does that imply in terms of sustainability of some of this growth? I think if that's essentially what we get from most investors when they're looking at some of these enterprise IT suppliers, including yourself, that's the big concern. So how would you ask investors to think about what's underlying? And what's really traction for the portfolio stand-alone?

Well, I think if you look at -- Samik, it gets back to market share, if you look at relative growth. If you look at our growth in the third quarter, for example, and compare with Cisco, I think our growth was probably 3 or 4x the growth rate of Cisco, for example. So I think on a relative basis, you have the industry that will benefit from health and enterprise spending. And then there's that element -- and then there's also the market share element. And that's where -- when you look at our universal hardware, our time to market. The other element with Broadcom is we're part of the early access program a few years ago, where Extreme may have been 12 or 18 months behind the market in terms of coming out with the latest technology. Today, we're the first. So with early access, we have the latest technology that's right on the front end with the hardware. And then with our solutions and the differentiation, you see it in growth. And with cloud, as I mentioned before, people are reevaluating networks and networking infrastructure today, and more than ever before, people are thinking cloud. And if you're thinking cloud, who would you include in a competitive process? Cisco is very limited and they're cloud with Meraki in terms of, for example, they have no AI machine learning capabilities, just it's the architecture of how their cloud was built. They're not integrated with the portfolio on the enterprise side, if you look at D&A and sort of the traditional enterprise portfolio. So as a result, there's a disconnect, whereas Extreme is end-to-end and streamlined. And so we are providing a very different look and feel for eliminating complexity in the network. And that's really what we're all about, which is how do we simplify the complexity of delivering the networking experience to end users? And this has been our focus, and this is playing really well in the marketplace. And it's keeping us more advanced. As I said before, we're moving further along in the competitive processes, we're winning more of them. So look, if investors -- we get it, we understand those questions. We get them as well. And I think, over time, investors will just see it in the numbers. So we -- we're talking about it today. It's real, it's happening. And then I think over time, you'll just -- you'll see it in our results.

Okay. Before I move on, we have less than 10 minutes here. So again, if you -- if anyone dialed in has any questions, please send them over and we'll ask it on your behalf here. Ed, wanted to talk about the 5G opportunity that you've highlighted. I would kind of -- I would say that nobody really -- as an investor really thought Extreme would be positioned for a 5G leverage here. So maybe just give us some background first on what that opportunity entails? And how do you further expand on that opportunity beyond kind of the initial wins that you've talked about? How do you look at further expanding that revenue opportunity?

Sure. Samik, if I go back, we acquired what we would -- what we call them a data center assets from Brocade. And at the time, we were -- as far as use cases, we were very distributed in terms of how we deploy that technology. And a couple of years ago, we got very focused on what we consider to be a few very large opportunities that are in 5G. And these are -- these have become new opportunities for us. One, with a global telecom equipment and solutions provider for service providers in 5G, which this is a very large opportunity. We are part of the full stack solution for what we would call cloud-native infrastructure services in 5G. And this is -- it's a very, very early stages of deployment. So what -- we are receiving some orders, and I think we have visibility, and we'll talk about that in Q4. It's been pulled in earlier than anticipated. But what's happening as 5G networks are ramping, they're looking at cloud-native infrastructure. And we are part of that solution, and this is part of a very long-term trend where we have visibility to looking out at $100 million plus of run rate revenue from these kinds of opportunities, being part of the 5G infrastructure that's being built out. On the other side, we're part of the packet broker solution at Verizon. This is a next-gen technology with Barefoot, Intel technology as our partner. And this is a very big opportunity. It's a full step ahead of where packet broker technology is today. And as a result, we could bring this to other service providers as well. So 2 new growth factors, largest opportunities -- growth opportunities I've seen since I've been at Extreme, and we're very focused on executing there. And that's with a clear differentiated technology, and this is a long-term growth play on 2 very focused opportunities.

Okay. So let me move to then kind of putting all this together and to your longer-term targets that you outlined at the recent Analyst Day, 5% to 9% top line growth, clearly in the early years that we have visibility into, you seem to be kind of towards the high end of it or at least exceeding it in my model. So how should I think about either sustaining that level or even let's call it, more upside to that broader range of 5% to 9% that we're talking about? The second part of that question, you guided to gross margins improving to 63 to 65 Now keeping some of these supply chain constraints in mind, does that impact longer term the ramp to gross margin even as you look out kind of 3 years?

Yes. So with gross margin, I would say there are 3 things. There's a loosening of supply chain constraints. And so we'll have the benefit there, both in our gross margin in terms of not paying expedite fees as far as that is concerned as well as lower cost of transport. So that would be a benefit for us. The second thing is a mix to universal platform. And as we sell a greater percentage of that universal platform, that comes at higher gross margins as well. So you'll see that mix shift. And then the other thing that you're seeing is this explosion in cloud. And we will see, as we look towards the December quarter, and we've kind of caught up from product growth and the COVID compare quarters, if you will, you're going to see growth in that software subscription line and the services line. So we'll have a higher gross margin as a percentage of revenue from that recurring revenue stream. So those are the drivers of gross margin. As it relates to sustainability of what we're doing, we're at the beginning of a long-term trend toward cloud. And as I mentioned before, Extreme has got the highest quality cloud in the industry. This is going to run for many, many years and is not part of a spending cycle, if you will, that relates to enterprise and stimulus spending around COVID. And then 5G, as I mentioned, this is, again, another long-term secular trend in 5G, and we're well positioned. Within the vendor, there are other opportunities that we have. In both cases, we have growth opportunities beyond where we stand today as far as use cases. So yes, I guess that would be the response as far as do we view this as short term or longer term, we see a longer-term opportunity here just based on our differentiation and our position.

Got it. Ed, given we have less than 1 minute, let me ask you to quickly just comment on the OpEx leverage in the model. Particularly, if I look at OpEx today, it's about 50% of revenue. You're talking about multiple growth drivers, how should we think about balancing spending versus top line growth?

So there's operating leverage in the models. We have a lot of fixed cost in supporting the global customer base that we've got. And so incremental growth and the marginal revenue comes at higher profitability. So as we see growth in the top line, we would expect to see expansion of the operating income, where our operating expense is just -- they're not going to grow as fast as revenue. So from that perspective, there's leverage in the model, which will drive significant earnings growth for the future.

And Samik, when you look at the long-term targets that we gave at the Analyst Day, we said about 46% to 49% OpEx percentage of revenue. We gave a lot of long-term targets. And the thing is that even though all of them collectively are for 3 to 5 years out, there are some that are more under our control than others. And so you'll see us try to get to some of those targets faster than others.

Great. We are close to the end of the session time here. So I want to thank Ed, Stan, both of you to -- for taking the time to participate at the conference. And thank you, everyone, for dialing into this session as well. Thank you.

Thanks, Samik.

Thank you.

Thanks, Samik. Thanks for hosting us.