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

Welcome, everybody. I hope everybody got some sugar for the session or some caffeine as we drift into the afternoon of day 1. For everybody, I'm Meta Marshall. I cover the networking space here at Morgan Stanley. We're delighted to have Extreme Networks and Kevin Rhodes, CFO of Extreme Networks here with us. I'm going to start with a brief disclosure, and then we'll get into more exciting conversations. For important disclosures, please see the Morgan Stanley research website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative.

Kevin, very timely to have you here, I think. There's been a lot of inventory digestion and macro pressure impacting the networking market that's been putting pressure on your business and much of the networking space. Can you just give us an overview of when these challenges begin and how they progress over time or how the makeup of those headwinds have progressed?

Sure. I mean it's primarily COVID-induced, right? So during the period of COVID, you had a lack of supply because a lot of the manufacturing has shut down. You had all of these people who are getting in line to get their orders eventually. The question was when would that occur? So that created a lot of backlog, backlog opportunity and a lot of orders and people were getting in line just to get those orders. Then all of a sudden, we started to see supply chain coming back online. Supply chain started to come in a little bit faster than we realized. And so we thought that supply would kind of come in over time, and the reality is it kind of came in a lot at a failed swoop. And so we were basically getting those orders out into through distribution and to the resellers to install over a period of time, and that's where you saw a lot more, I'll call it, revenue outpacing demand from a bookings perspective because even though you had general normal bookings in a given quarter, you were able to revenue off the backlog over time. So a lot of the industry saw a real growth area for a period of time. And then all sudden, the backlog started to come down because those orders were fulfilled and now book-to-bill became one. And so -- what we are trying to do now is all kind of managed through this channel digestion or this digestion of all this inventory that's coming through right now. And so with all those orders from the backlog coming through, you've got all that inventory coming through and not enough, if you will, installers to actually install all the inventory. And so there's really a pinch point, if you will, of how to get that inventory out into the marketplace. And then the overall macroeconomic environment has not been as good as it was a year or even 1.5 years ago as you saw post COVID, like a lot of people coming back online, you saw more orders coming there. And so now we end up being with higher interest rates, a little bit more of a macro challenge in the market, which has reduced the amount of inventory or reduce the amount of demand that there is in the marketplace that's created this disconnect.

Okay. That's helpful. So I mean, how do you judge just when to expect recovery from the current digestion period may be separate from kind of macro?

So we've gotten very focused around looking at our pipeline, looking at the pipeline of opportunities that we have. For instance, we felt like it was important for us as a company to get through the channel digestion issue, especially at the disti level in the third quarter. And that would lead to us getting back to a more normalized backlog as well as just the inventory in the fourth quarter. And then as we think about the next 2 to 3 quarters out that we think that demand will start to come back sometime later this year, second half, but probably more beyond September, like September, October get through the summer months and we should see more normalized inventory levels in Q4 and then demand coming back in the September quarter.

Okay. And are there specific customer types that you kind of expect to recover sooner rather than later or certain product types that you expect to come back sooner versus later.

Yes. I mean what we -- the -- we definitely have strength in certain vertical markets and in certain regions of the world. So maybe I'll talk about both from a regional perspective, where we've had strength, for instance, has been some of the weaker areas like Germany, we have real strength there and have a good market share there, but that's been fairly weak, and they've been in technical recession. Same thing with England, same thing with Japan, all 3 of those regions are pretty strong for us, but yet those have been weak from a macroeconomic perspective. When we see those start to come back, we think that we will generate a lot of market share in those particular regions of the world. From a product set, we actually do quite well in switching. We do quite well on wireless. We think that our campus fabric is a differentiated fabric and our cloud management software is agnostic. We can run our cloud management software in AWS, Azure, GCP or your own hybrid cloud. And so we see the differentiation from a product perspective, being the combined network solution that we have enables enterprises to use our technology in a different way than you can get with the IP fabrics that tend to exist within the industry.

Okay. And just you mentioned kind of the inventory digestion, but just how are you judging how much inventory is in the channel to digest?

So we have good visibility. So I call it the 80-20 rule. About 80% of our revenue comes from 20% of our distribution partners. So we've got some larger partners that are in that world. And so from our perspective, we have real-time visibility into their inventory levels as they get orders in. They're fulfilling those orders. Those orders are fulfilled, either 100% through what they have on hand or they may have partial orders, partial inventory on hand and they may need us to supply the other in order to fulfill the total order. But I would say, in general, we have very good visibility into what distribution has our hands. And then there's the other 20% that is more like we -- either it's a phone call or it's weekly reporting that we have with them. But again, they're much smaller, longer tail of our distribution network.

Okay. That's helpful. And so just as we get past this macro disruption or kind of period of digestion. Just what are you expecting from growth there? And what gives you confidence that, that comes in kind of that fiscal '25 period?

Yes. I mean, part of it is just -- so it's -- obviously, there's disruption in our marketplace right now, and there's a lot of fear uncertainty doubt as to -- at the end customer level where they should be buying and what is going to -- what the world is going to look like in 6 months or 12 months from now with HP and Juniper merging together, CommScope having their challenges and Ruckus being underneath the CommScope name. There's a number of different industry players out there right now that a lot of people and customers are just worried about where they're going to go and buy from. It creates an opportunity for us. And so that opportunity is really when people were inflection at an inflection point of where am I going to buy my next networking gear from it creates an opportunity for us. The other thing I'd say for Extreme Networks is we're getting introduced into more million-dollar opportunities than we ever have before. And so these large multimillion dollar opportunities and we're knocking some down when there's like an RFP process. And there's 4 of us in that process, including Cisco, Juniper, HP and us. We -- I'll cite Kroger is a good example, very competitive win on our port 2,400 stores, and that was all a technology purchase and the technology buy from their perspective. And so we are purpose built for the enterprise, and that's where we're seeing a real well benefit from them.

Okay. Perfect. So I think for a lot of people, kind of the strength that we saw coming out of the pandemic on campus spending made sense. There was hybrid work. We're investing in return to office. Is return to work still a tailwind? Or what do you see driving kind of continued investment that you're seeing on the camp.

Yes, I mean, return to work is certainly part of it, like we call that the carpeted enterprise right. So we still see that. I would say that the higher demand is going to be one WiFi 7. It's got 4 to 5x the amount of speed that you have in WiFi 5 or 6. And so that will create an opportunity for all of us in the future. We also see just in general, more and more proliferation of devices online. And even AI, right, even if you've got machine learning models or launched language models that are happening in the data center, it still has to make its way back out to the end user of that information. And so that's making its way through the network effectively. And so we think about our network and what we do is we're the heart and the vascular system of the enterprise, delivering oxygen to the enterprise. And so that vast array of network that we have is basically delivering all that good information that they need in order to do their business. And so that for us is really where we see proliferation of devices, more AI happening and going over the Internet and then just more just analytics as well driving that world.

Okay. You alluded to it earlier, but the HPE and Juniper acquisition has been top of mind for investors, just given what happens to the competitive dynamics of the market. Just how do you think it can change the competitive environment? And what have you been hearing from customers or kind of channel partners?

I think the biggest question or the biggest concern is uncertainty. It's the fear, uncertainty and doubt around what's this mean for me in the future for those resellers for those employees, $450 million of announced synergies that have to occur in order for that deal to be a successful one, where is that going to come from? That's got to come from cuts employees where are those going to come from? No one knows. And then the road map, just what's the road map look like? Does Aruba survive, dismiss survive. I think the management team is coming along with it. So who's making those decisions? Is HP making the decisions, or Aruba making those decisions, I think no one knows. And so I think resellers are worried, especially at the low end. Are they going to be there or lost in the HP Enterprise. I think the employees are worried because they know they have got cuts coming, and then we've got resellers -- I'm sorry, we've got end customers who are worried about what's the road map going to look like and what's this mean for them.

Have you heard anything similar from -- I mean, just the CommScope Enterprise just given kind of what the stress I've been on the...

Yes. I mean comps, I mean, obviously, they've got their own challenges with debt and the debt is massive and just a really difficult quarter most recently. And so Ruckus is a good little business that's sitting within CommScope, but the reality is it's got the mothership, if you will, challenges on the debt side of things. And so we don't see them that often. We know that they play for the most part in the E-Rate K-12 space, and they also play in the hospitality space. But that's all I can really comment there.

Yes. Okay. You've been very disciplined over the past few years kind of since you've done a lot of this roll up around the verticals that you target. Just how does that change? Or how does your view of that strategy change given the consolidation that we are seeing? And does that create any kind of new opportunity.

On the vertical markets side?

Yes.

So we're strong on the SLED side, about 40% of our revenue comes from state, local and education. I think about education as kind of the K-12, but also the higher education side of things where we play very well. All of those kind of end markets within SLED are really great for us because we love environments where there's a lot of change occurring like I said at the outset, like a lot of our competitors kind of sit in the data center. And it's static kind of IP fabric that they use, and that's what they tend to use in general. Ours is a very dynamic campus fabric that effectively is really purpose-built for companies or institutions or whatnot that constantly change. They have lots of people coming in, coming out, and they have a lot of change. Things like this room, it might be -- carry 2 access points initially. But if everybody were on video right now, you need 3 more access points in the room to make it all work. Well, ours can self-provision within 2 minutes, and you can have all 5 access points up and running their solutions. You probably need a site network engineer to come in that's going to take an hour to go get it provisioned, command line interfaces and the like. And so that's what we think is a real differentiator for us is that real -- that campus fabric.

But not expanding those kind of verticals despite kind of...

No, I mean, SLED one retail is another manufacturing or another that we've actually competed very well and hospitality is another that we're making really good inroads on. Those are all the very clear industries that we think that we can compete very well in and where we are.

And then just given you guys do compete with in education, I know maybe a little more skewed to higher education. But E-rate cycles always get brought up. Is that something that you think can kind of help midway through this year?

Yes. I mean we even talked about this in terms of our Q4, like guidance that we gave out. We gave netly Q3 guidance, but also Q4 just to kind of bridge where we thought we were going to come out post Q3 with a digestion issue kind of behind us on the disti side. We have more quotes and more pipeline this year than we had last year. We're in the fourth year on a 5-year cycle. But we've got a lot of quotes that are outstanding on E-Rate. And we think that given the HP Juniper merger, given where Ruckus is within CommScope's challenges, like all of that, we think this could be a good E-Rate season for us, again, for people in the audience, that's K-through-12 purchasing in a government program that's basically sponsors network infrastructure upgrades.

Got it. You've talked a lot about kind of managed services as a channel. Just how do you see the managed service provider opportunity developing? And just how can you differentiate within that channel?

So this is an area that we are starting to lean into. So managed service providers. So typically, when we sell, we sell in a CapEx model. And so people, when they buy our hardware, they're buying it 100%, and they're buying it themselves. Where we see and we do that through resellers, where we see an opportunity is to enable managed service providers, that is they are the ones who are buying the equipment and they're installing it with their customers, typically smaller customers who they will manage the entire IT infrastructure, the closet, the networking, the desktop support operations, et cetera, for that company. And what we are doing is we're building a consumptive billing model for those MSPs. So not only can they buy the hardware from us, but also they pay on a usage basis on what their licensing is, they're licensing and naturally, they have direct line support with us as well. And we're basically signing up 25 this year, 25 next year, the year after. We think each one of these new resellers that we don't have today will be a new vector of growth for us. And we think that we can get $2 million to $5 million per reseller at scale. And so that's an interesting opportunity for us to really drive more market share and new market share that we've never had before.

Okay. Got it. You mentioned on your past earnings call that you expect to begin shipping WiFi 7 and then we get into Q3 and beginning to ramp into Q4, kind of alluded to that earlier. Can you just talk about the demand you're seeing for WiFi 7 and just what are you hearing from customers just in terms of like how you can expect to model this ramp?

Sure, sure. I mean -- so some people, for instance, Ruckus went WiFi 5 to WiFi 7. They skip 6. And so -- and then we see like one of -- like HP, Juniper or Cisco none of them will come out with WiFi 7 right now. It is 4 to 5x faster than WiFi 6. And so there is a marked difference in what WiFi 7 is going to give from a speech perspective and going back to AI, going back to how many more devices are coming online with the network and people are using the network to get more and more data on what people were doing within their network or I think about an example of a stadium like a Gillette Stadium and Boston, where I'm from, right? They're not only tracking what websites you go to, but also where you are in the stadium as well. And they're using that information to make the experience for that customer even better. If you sat in line for 10 minutes to get a beer or to get snacks, they're trying to figure out, well, how do we make that experience better for the end consumer. So all of that data is being used, and that's where there's an upgrade cycle coming from many customers. Yes, some customers went to WiFi 6 and so they may that need to upgrade for a period of time, but there's a whole swath of customers that are at WiFi 5 that in the next 2, 3 years, we'll be interested in getting to WiFi 7, and it's like I said, 4 to 5x faster. So we think that, that will be a real natural opportunity for us to upgrade those customers.

Okay. You're very generous in saying or making the customer experience better versus just trying to sell them more beer and have...

They would like to do that, too.

Yes. All right. So you recently had some changes with your go-to-market. You've appointed a new COO. Just what has changed in terms of your focus on go-to-market strategy and just how you're looking at growth going forward?

Yes. There's actually really 2 changes that have happened here recently. So not only did we take our COO and can convert them into a Chief Commercial Officer. So now we own both the sales side as well as the supply chain and delivery of revenue for the company is named Norman Rice. He's been with the company for 6 years now and he's outstanding. I really like working with Norman. So Norman is thinking about the go-to-market slightly differently than we used to think about the go to market in the past. So let me just say that. And then the other part is that we just hired Monica Kumar and Monica is our new CMO. So really 2 pillars on the go-to-market side, we're a new CCO and then a new CMO coming and coming online and really then pairing themselves with the CTO to make sure that we've got a triumvirate of people that are really looking at the go-to-market in a different way. A few things that we are doing. First and foremost, stratifying our opportunities in a different way and going to market in a different way with them. So under $50,000 deals. Those deals, we have a different process for going after those deals. Those tend to be primarily a reseller focused and have the reseller focusing on those deals. And as we go up to $1 million plus deals, there's a continuum here of reseller only, all the way up to extreme only and in the middle, kind of a hybrid approach of us and the reseller are trying to sell those opportunities. But we're going to spend our time more conservatively on $500,000 to $10 million plus deals in our sales force and have our sales force really focused on those larger deals as they spend their time, which we think is a good use of their time as opposed to spending their time on smaller deals and just every deal that's in the pipeline. And then on the account-based marketing side of things, but just the marketing side in general, different, if you will, motions for the marketing as well. So a $10 million deal has a very different marketing motion to it than a $250,000 deal with an existing customer. So making sure that we've got all the marketing messages and all the marketing collateral, if you will, behind that and making sure that we've got white papers and we've got webinars, and we've got all those things that need to get a $10 million deal through the cycle.

Okay. Maybe circling back. We spent a lot of time talking about kind of campus demand and WiFi. We have said as much time talking about data center, which I know is kind of a smaller portion of the business. But just any different trends you would point out on data center versus kind of campus.

I mean the -- we don't have a lot of data center business. So I would say, from our perspective, we are very enterprise-focused. And while data center is good, and while we have an IP fabric as well that can work within the data center, we have not focused necessarily on switching that would drive the hyperscalers and that sort of thing. So I would say, for us, we're just being very focused on the enterprise and feel like that is the area where we will compete the best. And while we might have to give up some opportunity in data centers, while we still -- people can still buy our hardware for their own data center, we're not trying to like outfit AWS as your [indiscernible].

Yes. But just any different trends with enterprise and just in terms of how either -- how macro is impacting data center versus campus for enterprises? Or is it the same?

Yes. I mean obviously, AI right now is impacting data center a bit where people are starting to buy more and beef up their data centers to manage the large language algorithms and models that they have there. So data center clearly with Arista and others that play in that world are doing fairly well. But from our perspective, that's where we see the pull-through coming through is the end user of that is going to get that through the network.

Perfect. Subscription growth has been a big portion of the growth story over the past couple of years. Who is that customer that is most interested in that sale? And sometimes we hear noise in the marketplace around competitive pushback around those who aren't selling subscriptions, saying customers don't like it, but how much of that is competitive.

A, we think we've got great subscription software. We think our cloud management software is really good, too. We're going to add more and more features over time. And we believe we are very much leaning into that strategy as a company. As a matter of fact, my background SaaS CFO, primarily. And as I think about this business and my role here as a CFO is really to SaaSify this business a lot more. And so we will continue to lean in there. The MSP business that we have is going to be 100% attached. We are moving our company to hardware sales with 100% attached. We're bundling software and subscription together starting in July, and that's going to be 100% attached. And then we've got a great new motion happening within the service provider space that is 100% subscription. And so we think that is an area we will continue to lean into, we've had really enjoyed great growth out of that part of the business, and we'll continue to see that in the future. But we will continue to add more and more features over time that just enure to the benefit of our customers who are on those subscriptions, and they don't have to pay more for that than we've already paid into it.

Do you ever get any pushback or kind of competitive pushback from having a kind of subscription piece to your sales?

The customers who use our subscription cloud management love it. They can't think about not having it. And as we add more security features to it, like Zero Trust network access, and we start building security features within the network, we think that, that is what's going to carry us in the future with our customers that they will -- they don't know what they want until they see it, will apple adage. And that's our view is like we will deliver to them all of the features that they think they don't know that they need today, but they will realize tomorrow, they absolutely need them.

Okay. Perfect. You've had 60%-plus gross margin for the past 3 quarters despite inventory digestion, macro weakness, pressuring the top line. What were the main drivers in the strength on the gross margins? And how sustainable are those going forward?

Yes. I mean there's probably 2 vectors of growth there on the gross margin side. One, just we've improved our product gross margins over time because the cost of material has come down over time. And we were able to generate some price increases with that. But as costs have come down, we've not necessarily had to reverse some of those price increases that we've experienced over time. So we are seeing a better benefit from product. Shipping is cheaper than it was before and no longer paying $0.50 for this crew like I had at one point when you just couldn't find any crews anywhere, et cetera. So clearly, some of that supply chain is eased and that we've helped and got benefit out of that. The other vector is just a subscription. And our subscription and support, both of those elements are at a higher overall margin than our products. And so as we sell more of that, we will see even higher subscription overall margin from the subscription and support margins just being a larger mix.

Okay. Perfect. Your long-term operating margin target is 23% to 25%. Just can you talk about how you plan on improving operating margins over time? And just how you're optimizing kind of your offering?

Yes. I mean I can't talk about it now in Q3 because we're not going to have a lot of operating margin. But when I think back to Q4, when we were at 18%, I know how we can get there as a company. And we have strong visibility that we can get back to that 18% where we already were and then move to 20% and then the 23% to 25% in the future. Part of that is going to be all these -- the MSP market maturing for us this extreme subscription private offer that matures over time for us, that is 100% subscription. And then with this cloud attach that we have at 100% too, that's going to drive more margin for us in the business. So we're going to continue to sell products, but we're also going to get 100% attached from that. And that, I'll call it the future hardware sale that we have is going to be a richer, better margin in the future than it is even today.

Okay. Perfect. Before I ask any more questions, any questions from the audience?

So you saw Cisco go through Meraki and how they had to manage kind of the 2 platforms at the same time. You're now seeing HPE and Juniper doing the same time. What's the -- how do you see those parallels in terms of your ability to capture any impact from those? That's question number one. Question number two is, has there really been any real success with this subscription model? I mean I don't see it in Juniper's model. I don't see it in Cisco's model where it's like, okay, well, we'll charge you for operations. And if you look at whether Juniper's Aster, they don't break it out or you look at Mist, they don't break it out. You look at Cisco's DNA Center, they don't break it out. Management teams tend to say good things when things are good. So I guess those are my 2 questions. Number one, do you see the parallels between the Juniper acquisition and the opportunities there as you saw with Cisco Meraki? And then number two is, what evidence do you have that customers will actually pay for operation software.

Okay. Sure. Sure. On the first side, like I can't speak for why Cisco did not integrate Meraki and Catalyst well together. They've owned Meraki for over, what, 9 years, 10 years at this point. Hard to understand why they didn't integrate those. HP and Juniper obviously to be determined whether those can be elegantly integrated together. What I can tell you is that Extreme has done 5 or 6 acquisitions over the last 5 to 6 years. And we have absolutely integrated all those companies together and all those platforms together and I call it part of our DNA. I mean, our CEO, Ed Meyercord; and our CTO, Nabil Bukhari, have very much focused on making sure that we have one universal hardware platform and not only can our cloud management software see our own technology, but believe it or not, we can actually see into our competitors' technology better in some cases and they can see their own technology.

There the opportunities the same with these instructions. Do you see this. Can you replicate some of the share needs that you do from Meraki acquisition with this Juniper [indiscernible].

Yes. I mean we -- so the question is just like will this create an opportunity for us? And I think the answer is yes. I think that we will create an opportunity for us as we think about the disruption in the marketplace of people. I mean, number one, we already see it today on the Cisco side, that we have won opportunities because of the disruption between Catalyst, DNA and Meraki and they don't work together. We've won deals in that world. Obviously, we're hoping that we will win deals because of the road map issues and how HP and Juniper will have to come together, and they'll have to align that technology, but that creates fun in the marketplace around what is going to be the road map for them. On your second question, which was, remind me again, operations software and just how sticky it is. Yes, I mean we -- I mean, look at our 39% year-over-year growth. Apparently, we're doing something right on people buying our operations software and the cloud management software that we have, and we get high renewals in that regard. So what we are doing is we're adding more and more features to that, like a typical software company. And so if you just have cloud management software, and it sits there on its own and never changes. I think that's the problem that you would see in face with some of the other cloud management softwares that are out there, that we're thinking about our cloud management software as an ecosystem, not only that we will add more features to over time that we can actually integrate our software with other software out there that people will use security software is a good example and that, that would create more value in the overall subscription. So we think that, that is a big market opportunity for us to go after, and we do believe between AI ops being embedded within our cloud software, we have this thing called digital twin, where you can go and create a virtual network. All of those are things that people to test exactly, all those are things that people really love about our software and how our cloud management software works. So hopefully, we will continue to be successful as we are today.

[indiscernible].

No, it's absolutely something we are thinking about right now, adding security as part of it, for instance, ZTNA, Zero Trust Network Access is something we've already added into the cloud management software today. We did it in December.

Okay. Maybe as we wrap up with the last final question, just how are you thinking about capital allocation from here?

Yes. We've been buying shares for a while. I'd say we bought $25 million a quarter for probably the last 5 or 6 quarters as a company. We will continue to buy shares on pausing a little bit in Q3 here just to get through this channel digestion and purchase of inventory ourselves. But I think back -- I think forward into the next quarter in Q4 and beyond, we will continue to be buying shares. For sure.

And then obviously, you guys have been acquisitive in the past. Just what is your appetite for M&A? You've largely pursued a roll-up strategy, but there's obviously a lot of interesting adjacencies, whether security software otherwise.

Security software, certainly areas that we would look at. There are other opportunities out there. I would say that we are pragmatic that we are looking for things that are accretive. And if it's any interest to it, we're not going to be afraid to do even hard deals like we've done deals out of bankruptcy before it. So we know how to do deals. We know how to integrate them well. You should be rest assured that if we do a deal, it is something that we can integrate well that we have all of the DNA to be able to do that. But that being said, we have nothing like on the near horizon that we're really looking to try and pull the trigger on right now.

Okay. Any last say for questions? All right. Perfect. Kevin, thank you so much for being here today.

Thank you. Thanks for having me.