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

Welcome, everyone, to Citi's Global Technology Conference. I'm Adrienne Colby, and I'm part of Citi's IT hardware and networking equipment research team. It's my pleasure to introduce our next session with Extreme Networks. Joining us today are Ed Meyercord, President and CEO; and Stan Kovler, VP of Corporate Strategy and Investor Relations. Before we get started, we've got a few quick housekeeping items. There are disclosures associated with this presentation that are available on Citi's conference website. In addition, you can contact us if you need those disclosures, and you can also see Extreme Networks' Investor Relations website. To ask a question during the session, please click on the Ask-a-Question button that you'll see on your upper right side of your screen, and we'll do our best to get to your questions. Thank you, Ed, and Stan for joining us. Let's get started.

I was hoping we could start by talking about how networking is evolving these days as employees shift to more distributed and remote work environments and newer technologies, such as 5G, become more mainstream.

Yes, Adrienne, this environment that we're in has been an accelerant, if you will, to this kind of long-term trend of a more distributed network. And so when we think about students going home and learning from home, we think about remote health care, we think about our carpeted enterprises with people moving and working from home, it's changed. And it's made -- networking, in general, has been somewhat complicated. And then when you take the edge of the network and you move it out to the home or a remote environment, it changes the requirements for networking. And so what it's done is -- what we're seeing is we're seeing enterprise customers take ownership now for their end users wherever they are. So Adrienne, if you're at your home, or you're in the office or if you're traveling, now your enterprise, Citi, wants to take ownership of your experience. And the connected tissue to that is cloud. And at Extreme, you'll hear us talk about the Infinite Enterprise. And what we mean by the Infinite Enterprise is that the edge of the network is no longer that corporate office or the branch office or the health care, it's the end user wherever the end user is. And so now enterprise teams are taking ownership of that -- of the connectivity, where the edge of the network has become much more distributed and much more infinite. And so that's what we mean when we say that that's the long-term secular trend. And it means that enterprises can be more flexible, which they want to be. Workers want more flexibility today. And this dynamic is calling for cloud, and then it's calling for more services to be delivered from the cloud instead of a more traditional networking architecture.

Great. What is the impact of the recently announced acquisition of the Ipanema SD-WAN business? And why did you make this acquisition now? And how should we think about Extreme's integration of this technology?

It fits perfectly with the strategy that I just laid out. If the edge of the network is moving and you want to manage the experience, that's what the SD-WAN technology provides. And with Ipanema, they have a cloud-managed SD-WAN platform. So it means that we can manage the user experience and the quality, application performance, security, all these elements that we can manage now from the cloud, and they've been developing this technology. From our perspective, we've been looking at SD-WAN. We looked at a lot of traditional players, but we were drawn to Ipanema because of this cloud-driven SD-WAN capability, which, for us, will be an accelerant as we are moving very quickly in cloud. I think, Adrienne, as you're aware, we're the fastest-growing networking player in cloud-driven networking. And this is moving -- this trend to the cloud has created the fastest-growing segment of the market. And now it becomes about delivering more capabilities to support our enterprise customers from the cloud. And so that's what Ipanema is about. We're picking up really interesting technology that is accelerant. We're also picking up a highly qualified team with deep domain expertise for us. And then we have the opportunity now, and we'll look to bring the Ipanema solution out to our huge customer base starting in Europe and then bring it back to the U.S. and then Americas and APAC.

We hear a lot of talk about the benefits from government stimulus programs. And I was hoping you could talk about what some of the specific business drivers. I know you've spoken about this a little bit on recent conference calls, but how do you expect those programs to really impact Extreme's business?

Yes. For us, it's more of a near-term catalyst when we're talking about cloud and the Infinite Enterprise, and that's more of a secular trend that will take place over many, many years. As it relates to coming out of COVID and stimulus spending, for us, it creates a near-term catalyst because of government spending. A lot of our business comes with government agencies with -- within education. A lot of these dollars are stimulus dollars for schools, both higher education, universities as well as K-12. This is a big part of our business. So a lot of the government dollars that are going to work are going to work where we have our traditional customer base. So when you look at our verticals, so there's a lot of dollars that are coming into play. We hired a team now that is working with our enterprise customers to help them access government dollars. So we actually have a grant writing team that can work with schools, with hospitals, health care organizations, different government agencies, local governments to be able to tap into funds to help that. So this is in near term. I would describe that as kind of 12 to 24 months of added stimulus spending that would directly affect our business. And that is the near-term -- what I would call a near-term catalyst to the business. And then longer term, it's also helping our position as it relates to us taking share in cloud and this longer-term trend towards more distributed networking.

That's great. So for some of the folks that are a little less familiar with Extreme, can you talk about what some of the other key verticals are in your business? And maybe where you're seeing some of the greatest sort of pent-up potential, if you will, we haven't seen recovery yet post pandemic?

Yes, Adrienne. So we have -- I mentioned government, and we have amazing government business globally. And then education is another large vertical. Again, spending was fairly consistent. The same is true with manufacturing. When we look at some of the other areas where we play, health care is an area where we're seeing a rebound. That's an important vertical for us. With COVID, a lot of elective surgeries -- there were a lot of -- it was, I would say, a slowdown, if you will, in a lot of projects because of COVID. Now we're seeing that come back. Retail is another great example where we're seeing retail and hospitality come back. These are other verticals that we have a percentage of our business. Entertainment is another area. We won Major League Baseball. We have NFL. These are important franchises for us. And stadiums were empty for a while, and now you're seeing people come back to the stadiums. We've had some nice wins on that front, and we're seeing that come back. On the gaming side, we won Wynn Casino and Resort, a huge deal in Las Vegas, but a big marquee customer globally is a great reference account. So these are the areas, if we look at kind of retail, health care, sports and entertainment, hospitality, these are areas where we're seeing this come back. And so for us, during COVID, it was a negative impact, and now it's coming back, so it is providing some more -- it's more of a tailwind for us today.

Great. So maybe if we could talk about sort of a little bit longer term, so maybe on a 3- to 5-year outlook. Can you talk about how things like cloud capabilities and AI and machine learning, like how would you view those as changing networking as we look out? We hear a lot of buzz around AI, machine learning. How do you really think about what those actually mean for Extreme?

I think it's really simple. It's about having intelligence, gleaning intelligence from the network. And if you think about it, Adrienne today, networking has never been more important, right? It's almost like there's like a renaissance of network. Why? Because we realized how important it is to be connected. And there's a lot of intelligence that's built into a network. And so through AI tools, you can glean insights, actionable insights from the network and then by also using AI and insights to solve more complicated problems. So we just -- we all expect the network to work. And then when we have an issue, it's a major issue. And so having the tools and the insights to be able to predict networking issues or events or outages and be able to get in front of that is very valuable to people who are managing networks. To have automation tools to be able to automate and automatically remediate networking issues with minimal human interaction is also very valuable to players that are managing networks. So this idea that you can automate functions, that you have more insights and more intelligence is something that is a big driver. And as we talk about the network moving out and being more distributed, having these tools where the edge of the network you have a lot more connection points become even more important. And so that's what -- we launched our base license, our XIQ license, we call pilot. Like flying a plane. You're driving -- managing the network. We've come out with CoPilot. CoPilot is providing insights for solving. In our case, we call it explainable AI, where we provide a lot of context. We're very careful because network managers get inundated with alarms. We're avoiding alarm fatigue. So we're focusing on very specific use cases where we provide context and we have explainable AI, and then we provide very insights that drive remediation. And so this is -- this came out in June, and we're going to continue to build on the use cases for our AI tool.

That's a great segue into my next question. I was hoping you could talk a little bit about what's driving some of Extreme's share gains in cloud networking? Is it things like this rollout in June? If you could just talk about where you think you're really gaining advantages?

It's really -- it's about our competitive differentiation. And cloud for us has become a real differentiator just in terms of we're moving our entire portfolio into the cloud, so end-to-end management from the cloud. And then we have unique differentiators in terms of how our cloud is architected and cloud native architecture, which speeds and enables the delivery of services, leveraging the latest cloud technologies. So we have kind of an architectural advantage, if you will. So as people are contemplating cloud, that becomes important to them as they think about how easy is it to deliver new services. And our cloud makes it easier than our competitor cloud. So we also provide flexibility. You can run Extreme's cloud within all the different public cloud environments. So it depends on what you choose. We have the most secure cloud in terms of ISO certifications. And then the currency in today's world is really -- in the cloud world is about data. And one of the things that differentiates Extreme is the fact that we're providing customers with unlimited data, so they can capture everything that's going on in their networking environment and then they have access to that data as they go forward. So as they're trying to understand and make sense of what's happening in different patterns and traffic in the network and events that occur in the network, having that data becomes valuable. And so we're differentiated on that front as well. So we have cloud differentiation, technology differentiation that's real. And what's happening is that because we're the second largest cloud and because we're the fastest-growing cloud, because we have the highest quality cloud, as a result, people want to hear from Extreme, more so today than ever before. So as an enterprise, as they are contemplating the future of their network and as they're contemplating cloud, then they want to hear from Extreme today because of our leadership position. And then when they find out about what we've got, it is interesting, people are surprised to learn of all the technology that we've got and all the innovation that's coming out of Extreme really focused on driving and making it easier to deliver this high-quality networking experience. And as they survey the landscape, they're saying, "Wow, this is a really compelling alternative." And we're getting more and more at bats, and our batting average has gone up. We're winning more competitive deals. So that's what's bringing the business velocity to Extreme right now.

And I'm curious and so who are some of the primary competitors that you see out there? And has this changed as you're adding a lot more of this innovation and new capabilities?

Today, we run into the obvious candidates. It's Cisco. They have the 10-ton gorilla with the most market share. We run into them. And Cisco has got an incredible amount of technology. The issue is just how it comes together or how it doesn't come together for customers in their environment. It's complicated, and it's not seamless. Their cloud solution is separate from their core enterprise solution, and it doesn't appear that the 2 portfolios will come together. So if you're an enterprise customer, it gets a little kludgy, and it's complicated and expensive. So that's where we can pick off market share from the likes of Cisco, and we do that regularly. HPE, Aruba is the other competitor that we see the most in the market. There have been some leadership changes there. But again, we go head-to-head with -- these are our 2 largest competitors where we've been taking market share. And then Juniper has made several acquisitions targeting enterprise. And so we begin to see them a bit more.

So is it things like the universal platforms that you think that help to make Extreme so unique in the market?

Yes. It's the universal platform and then it's our cloud and cloud differentiation. And then we've invested a lot to make it easier to do business with Extreme, easier to partner with Extreme from a partner that we sell through the channel. And so what we're -- we talk about effortless. We talk about taking the complexity out of networking and making it easier to delivering this high-quality, high-performance, secure networking experience where the edge is expanding. And that's where we believe we have a leading position. Because it's easier with our solutions, our integrated solutions. It's easier to deliver that networking experience than it is with our competitors. So that's what we're very focused on, and this is how we're winning in a competitive marketplace.

As we're talking about new technology, I think I'd be remiss if I didn't ask about Wi-Fi 6. I'm curious, do you think that there are particular advantages to being the first on the market, for example, for Wi-Fi 6E access points? Or does it not really matter who's first? It just matters who's best?

In our case, because we're first, I think it does matter. I mean it matters at a few levels. It matters because we're out in the marketplace and people who are exploring Wi-Fi 6 and 6E. They're going to reach out to us because we were first to market, right? So if you're exploring kind of the next-gen technologies and there's a vendor that's out there first, it creates more demand for Extreme. And so that -- we've seen that happen. There's been -- we've had a response from our announcement. It's been very positive. And it's also good for our own teams inside of Extreme to know that we're leading. So there's a victory inside of Extreme when we're out there first. And we've got our 6E product in customer environments up and running and working, and we can claim that. So I think it gives us more awareness out in the marketplace. It creates more dialogue, more discussion with Extreme. Net-net, I think it helps us strengthen our position in wireless.

Makes sense. I would also be remiss if I didn't ask you about the current supply chain shortages. Love to hear you just talk about what kind of an impact you feel like you saw from the supply chain shortages in Q4? And what do you have baked in for 1 quarter ahead and maybe even into 2022?

Yes. It's -- Adrienne, it's very real, and I know you're hearing this from all the different companies that are presenting. So yes, I would say it's the worst we've ever seen and that we've ever experienced. We -- in terms of our guidance, when we were calling the quarter, we baked in the effect of constraints. And we've done that throughout the course of last year and as we go forward. For us, this is the tightest quarter, the September quarter. And then we've got visibility and commitments from our supply chain, so that we see loosening beginning in the December quarter for us. I think some of that is unique to Extreme because of the relationship that we've got with Broadcom. They are the supplier of our chipsets, and we have a strategic relationship with them. And they have been working with us to provide us with secure ship dates and quantities that we need. In a way, it's easier for them to support us because of our relative size. And so they've been a valuable strategic partner. It goes beyond just the main chipsets, there are other semiconductors. There are other components that we need in our supply chain. And so our teams have been very tactical, all hands on deck, working the supply chain to get the other components. Once we have the chipsets, all the other pieces come around it. And we -- based on where we are today, this quarter is the tightest, and then we see a loosening starting in December and then in the first half of the calendar year, we've got visibility to things opening up for us.

I'd love to hear your view about how the industry overall comes out of this sort of supply-constrained environment. Do you think that there's going to be a big reckoning and a big snapback? Or how do you see this sort of unwind from here?

I mean we're taking a long-term view. I mean our view is that this will persist for a long time, that these conditions will last. To the extent it snaps back, it's a benefit to us. So we're going to plan for constraints in a really tight market for the next 12, 24 months. That's how we're going to be managing very actively. As I mentioned before, because of our position and where we are in the industry, we do see maybe Extreme loosening a little earlier than our competition just because of where we sit in our competitive position and how our teams have been able to manage. But we are planning for 12, 24 months of a very tight environment.

Okay. We've heard a lot of discussion about companies passing on price increases to their customers. What's Extreme strategy there? And maybe just highlight for investors too, what are some of the drawbacks of raising price?

Well, I mean I think everybody understands that if you have a financial model and you raised price, you can't do anything better to a financial model than raising price. Our reality is that we're responding to our cost and our cost structure. So yes, we're feathering in price increases. We're doing that. We move very quickly to make sure we stay in front of the business that way. And we've become pretty good at doing that. I think if you look back over time with tariffs that we've had to weather and now supply chain constraints, this is something that is kind of part of our business practice. Obviously, what you worry about when you raise price is, what is the competitive landscape? Are competitors raising price? Are we pricing ourselves out of the market? And the reality is we're not. Our competitors are raising price as well. They're forced to do so because of what is happening with the supply chain and what's happening with expedite fees and what's happening with all the logistics around product delivery. The cost increases are real. And in order to recover them, people have to raise price. So we worry about our competitive position in the industry, and we factor that in. We balance things out with how we discount. But at the end of the day, it's an industry phenomenon. And I'd say we're an early mover, and that we're -- I would say we're very aggressive as it relates to us managing this and protecting margin.

Last quarter, you talked about building backlog. And particularly as we head into 2022, I think sometimes this is a concept that investors overlook. And I'm just hoping you could talk a little bit about what the backlog implications are really for the outlook of the company.

So backlog is good and bad. Backlog is bad because you've got pent-up demand, and your customers want product, and lead times are longer than you'd like them to be. But it's good because you have visibility of the business. So in our case, we have better visibility today than we've ever had because of this big backlog. In our case, we don't have double ordering. If you're a K-12 school district in a county, you're not double ordering in network. If you're a government office or if you're an enterprise customer, you're not double booking. So we don't have -- in our backlog, we don't have this phenomenon of people that are doubling or tripling up. I'm just trying to get in front. So it's real. And we have real purchase orders. And we know exactly where the demand is coming from. So from that standpoint, it's a positive when we can unlock backlog. So we're in the process of building backlog unprecedented for us in terms of the amount we have, I would say 4 to 5x. We'll be at the end of September with 4 to 5x a normal backlog amount, and with well over 100 million of backlog. That will get released. And ultimately, that will be good for us because it will release a lot of earnings. It will release a lot of revenue and earnings when that backlog gets released. So yes, it's -- we are constrained. So we're creating longer lead times for customers, which is not good. At the same time, we're building up this backlog, which gives us great visibility to the business and an unlocking of revenue and earnings that will happen. We think it starts to happen in December time frame, but really in the first half of calendar '22.

Great. As we think about the evolution of Extreme, I don't know if you've outlined sort of longer-term margin profiles, if you have a 3-year target. But how should investors be thinking about? What is really the ideal for a company of your size and your scale?

So from a gross margin perspective, we've got this in our investor deck. We say 63%, 65%. We've seen -- we were approaching that range prior to the supply chain issues and constraints. We've taken our guide down as a result of the near-term costs that we're experiencing. But as we move into the -- I would say, into the second half of calendar '22, and really the first half, we'll see loosening as well. We'll have a -- we'll benefit from the loosening of supply chain and those expenses. The other thing that's a big driver for us is that we've made a lot of acquisitions over the year, Adrienne, over the years. We've scaled up. We've made a lot of different acquisitions. And with that, we had a very diverse portfolio. And we've been working to rationalize and streamline that portfolio, and you mentioned the universal hardware. So as we are now consolidating our portfolio and moving to the latest generation -- next-generation chipsets and technologies, this is where we have inherent advantages to our gross margins. So our new products, our universal hardware platforms will make up a much larger percentage of our product revenue, and with that comes higher margins. So we will naturally benefit from higher gross margins there. The other point is that -- and we've acquired Ipanema. This is recurring, high-margin recurring revenue, 70% type gross margin revenue. And then we're going to be investing and adding more services on top. We mentioned CoPilot, other services that we'll be announcing that will come out that are software recurring services. So as we bring on high-margin software -- cloud-delivered software services through the network, we expect to see the percentage of that recurring revenue grow. That margin is higher margin revenue, and that will help us drive and hit the higher end of that gross margin target that we set.

As we get sort of to the end of our session, it would be great if you could just touch on what your priorities are for cash.

So the first thing we're going to do is pay for Ipanema. That should happen very soon. And then we want to look at technology-type tuck-ins or we'll be opportunistic if there's an opportunity that exists. But otherwise, we're looking at using our cash for buying back stock to mitigate the dilution from our equity programs. Ideally, we would run equity neutral as far as our equity programs. Our Board is committed to that. We have room left over in our share buyback program and there's $55 million left over from what has been approved. And then we'll look to that as we turn the corner at the end of the calendar year and look to sop up some of the dilution from the equity programs.

That's great. Well, I would love to close in asking both Ed and Stan. I would love to hear, as you meet with investors, what do you feel are the 1 or 2 points that either investors tend to miss about Extreme? Or something that you'd like to highlight just for investors to really get your message across about Extreme?

Well, I've been doing all the talking. So I got to let Stan have a turn. I mean what I don't think has been appreciated yet, and I think a lot of it has to do with concerns about supply chain and worries about constraints. But our leadership position in cloud has been real. And the fact that the demand, we've never seen higher demand. I think there are people who are thinking that, "Hey, this is just because now we're coming out of COVID, we were down and now we're coming back." But I think it's a longer-term trend. So this infinite enterprise that we talked about where people are going to be more flexible in the future. The edge of the network is moving. Cloud becomes more important. And then delivering more services over cloud, we are really well positioned to lead this trend in the networking industry. So we have a stronger position than we've ever had before. Our teams feel it. It's happening out in the field. I don't think that's really made it into the market yet. And I also think some of the demand that we've experienced has been constrained because it hasn't flown through in our income statement. Stan, what would you say?

Yes. Ed, I would just add that, Adrienne, we're capturing this market in transition, right? And when -- pre-pandemic when we made some of our prior acquisitions, the market for cloud was a lot more smaller and nascent than it is now. Right now, I would say it's becoming more prevalent. Because take a look at the wireless market, for example, about 20%, maybe 25% of the market was related to cloud-based wireless between products and services, right? Now when we look at the market and 45% of the wireless market in the enterprise is products that are cloud-based and services that are cloud-based. And our market share in this new market is 3x what it was in the traditional market. And so we're just very excited by taking this leadership position, becoming a leader from an execution standpoint. And so what we're going through right now, there's a lot of growth left in the market because the industry is continuing to shift and there's going to be continued convergence between networking and cloud and security. And so being a leader in this transition, I think that's what's really exciting for us. And at the same time, our level of execution and how we are doing as a company has never been better. I think the combination of those 2 things is pretty exciting for us. And we're trying to make sure that people understand that combination.

Great. Well, I want to thank Extreme Networks for participating in the conference. Thank you so much, Ed Meyercord and Stan Kovler for joining us today. This will wrap up the session. Thanks so much.

Thanks for having us, Adrienne.