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

I'm going to read some disclosures that you've heard many times. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. We're delighted to have Extreme Networks here today, Kevin Rhodes, CFO. We also have Stan Kovler in the audience. And then myself, I'm Meta Marshall. I cover networking here at Morgan Stanley. So Kevin, thanks so much for being here today.

Good to see you again.

You recently rolled out some impressive targets at your Analyst Day calling for share gains in the market. which we'll dive into in a minute. Can you just kind of refresh everybody here on Extreme's value proposition and kind of the key verticals that you serve?

Sure, sure. Happy to. And by the way, at the Analyst Day, I would say that was a good day for us to roll out for the next several years what we are going to achieve 10% growth on the revenue side, 20% growth on the bottom line side. And we've been executing pretty well, right? 7 quarters in a row of growth as a company. And so that was a meaningful kind of event for us to talk to investors about what we're trying to do. From a market perspective, as you can probably appreciate, we're on the wired and wireless solutions on networking. We combine software that helps with cloud management. It also helps with security. And we do this to enterprise, the campus enterprise. And so our vertical markets that we focus on more of the complex environments that we see. We see venues and stadiums. We see health care facilities, education, hospitality, retailers, manufacturers and the like in government systems as well. We've actually had some recent really good great wins on government entities outside the United States. So I'd say, yes, we've got good momentum going as a company and feeling good about the momentum that we are seeing on the enterprise side. We can talk more about the trends, Wi-Fi 7 enterprise campus refresh over time. But effectively, we are seeing some real good wins in our sales right now.

Got it. you've had a lot to deal with over the last year in terms of tariffs and memory, not so distance we're talking about supply chain issues. What are you seeing in terms of impact to the top and bottom line from kind of tariffs and memory impacts?

Yes, more of an impact on the stock price, right, than it is actually on our ability to execute, to be honest with you. I mean, at the end of the day, we are seeing good, strong demand for enterprise network solutions is what we see. People are getting worried about supply chain and whether they're going to be able to get the equipment that they need to support their customers. I think from our perspective, a lot of companies did not do a refresh post-COVID. And if you didn't do one right after COVID, the reality is your network is likely 5, 6 years old at this point. And so you really are in a point where you need to do a refresh because you've got AI workloads going over your environment. And naturally, that's going to pull more and more requirements for networking resources. And so I think from our perspective, we see an opportunity, a long-term opportunity for us to get ahead of some of these supply chain issues and be able to supply the enterprise customers, the equipment they need.

Got it. And then just in terms of your own availability of memory or how you're seeing kind of that elasticity of demand when you're having to contemplate price increases? Just how are you thinking about that?

Well, so one thing that we are doing, and we saw this early on last summer, we're getting ahead of the DDR4 memory issue. And we've been procuring supply of DDR4 and we've got upwards of 2 years of DDR4 memory. Now I used to not do that. My ODMs used to just buy the DDR4 memory for themselves to be able to supply us. But now we're actually jumping ahead of that, and we've been jumping ahead. So our supply chain teams have done an amazing job of getting ahead of that. And so we would like to get like 3 years worth of DDR4 memory, and we'll use some of our balance sheet to be able to do that. But from our perspective, I think that's a smart and wise investment for us to get ahead of that. The next wave of probably WiFi 8, which is a good 3 years away is really when you're going to make the move over to DDR5. But DDR4 is still going to be around for at least another 3 years on the switching and WiFi access points perspective.

Okay. And then just on elasticity of demand?

Well, when there's scarcity and there's worry about scarcity, I think demand starts to get pulled in a bit. We are communicating out and you talked about price increases as well. We put some price increases like the rest of the industry out in November. I think the industry is considering price increases yet again. We're still waiting -- Cisco tends to lead the price increase train, if you will, from that perspective. And so still waiting to hear what's happening there on their end. But we anticipate another price increase coming through in the next 3 to 4 months would be our thought because of just the cost of DDR4 memory. And you have other components as well, copper, aluminum, other raw materials have gotten more expensive. And so I think from our perspective, the demand for enterprise equipment is still strong. We think it will be elastic from a price sensitivity perspective with all the AI workloads going on right now, and we're actually seeing some customers thinking about doing like basically creating their own data centers in addition to hyperscaler because they want to balance the workloads and where their data sits, especially sensitive data sitting in an environment that's an enterprise data center versus in the hyperscale cloud. And so we can see kind of some shifts happening there as well.

Okay. We're in a very healthy investment cycle for campus kind of currently. Why do you think we're seeing such a healthy refresh? Maybe you mentioned some people didn't during COVID. And we hear this like AI preparedness or AI at the edge. Do you think it is really just pent-up demand? Or we're starting to see some of this kind of preparedness come in?

It is certainly AI preparedness. And I would say you're also going to see more workloads going over the network, right, than we've experienced in the past. So if workloads go up and you've got an older network, let's say, a Wi-Fi 4 or 5 network, you're going to feel the real pain in that world with more and more adoption of AI. And we naturally see adoption of AI being more ubiquitous. And so people are looking at all the different use cases across sales, across product development, et cetera, and that's just going to drive more and more use cases there. So we think that, that is certainly one trend that's there. Naturally, you've got WiFi 7 right now that's in its early innings, and it's starting to get adopted more. And naturally, it's much faster. It's got a 6 gigahertz band on it. And so it's a cleaner spectrum than the 5 or the 2.5. And so we think that the Wi-Fi 7 is going to have another impact around WiFi refreshes, especially on the wireless side of things. I'm trying to think of other catalysts that we're going to experience here. But I mean those data sovereignty, I'd say, is probably the last one on the enterprise side, especially in Europe, we're seeing more and more interest as they're thinking about where their data sits. And if it's in the hyperscale, what sits there. And especially in Europe, like Germany, we actually are building an RDC in Germany, and we've got some government opportunities there that will benefit from that. And so I think from our perspective, that's also a trend that we're hearing is data sovereignty is important, especially in Europe, and that we're trying to meet that. I would remind everybody that we are cloud agnostic. So our cloud management works in all 3 hyperscale environments with GCP and Azure and AWS. And then we also allow for on-prem as well. So Gartner is like, hey, do you realize you guys are the only ones that can do this? And so that's something that we're starting to lean into from a market messaging perspective.

Yes, the kind of that hybrid future. Can you just remind us kind of on the split of the business between kind of edge or campus and data center?

Yes. I mean -- so I'd say the data center opportunity is an opportunity for us. It's smaller. It's less than 10% of our revenue today. Most of what we're doing is on the campus side of things. What we are introducing -- so we have a 400 gigabit per second switch that we are doing for a particular client. We're going to commercialize that 400-gig switch for commercial use. And then we're also working on 800 gigahertz gigabit solution for campus data center later this year and roll that out later this year. Between 100, 400 and 800, you cover almost every enterprise data use case out there. And so we feel good about that.

Got it. You've most certainly been focused on kind of selling the fabric and Platform ONE for a number of years now. Just what kind of differentiation do customers speak about on the product?

Yes. So Platform ONE is the newest, right? We just launched this in July of this year. And we are the only networking provider today that provides an Agentic AI solution for networking. We've got others like Nista or others will talk about AI, but it's more on the AIOps side, and we've got an Agentic solution that will proactively go out and monitor your network. Let's say that you've got -- so I would say that the paradigm is this. Most of the networking experience today is someone has a problem, they create a trouble ticket, it goes to IT. IT is evaluating log files and everything else to find out why that particular person is having a problem. And then they find the problem, it's an access point, they need to firmware upgrade, they go and fix the problem so and so issue is solved. What we're doing on the Agentic AI side, these are service agents that are monitoring and managing and looking at your network. And they are identifying in advance that, that access point has got a firmware need. And so it will come back to you and say, we've identified this issue, human in the loop, do you want us to go and fix that issue proactively? Our person could say, yes, go fix it or no, don't fix it. I want to fix it myself. I want to validate this issue. And then if you choose for it to fix it, it will go and actually fix it for you. They can also -- another use case is say, hey, by the way, we see some activity over here that we don't normally see. Someone's knocking on this door that they shouldn't be, do you want to go and investigate that? So it's got cybersecurity elements to it as well. So we're excited about the Agentic AI that we put into Platform ONE. We see a lot of customer adoption to it. Another, I'll call it, financial benefit of our Platform ONE is that we were selling cloud management. separately from support contracts, separately from like Universal ZTNA, those were all sold separately by my salespeople, all their own sales cycles, et cetera. Now with Platform ONE, it's all one bundled solution. And so with that, I get higher attach rates because of the Agentic AI. People want this solution. We have a higher ASP on it than buying them individually. And then on the back end, where people tend to not renew support contracts later in life with the equipment because why renew it if the equipment is going to be past its life, let's say, it's 5 years old. I'm not going to spend money on that support contract anymore. Well, we're basically bundling it all together. So we're not going to see that drop off in the value on the support contracts. And so from a financial perspective, it's going to drive our recurring revenue. We just saw this last quarter, 25% ARR growth as a SaaS CFO, traditionally, I want that recurring revenue, and I want that recurring revenue to stay sticky. And so from that perspective, I think we're going to get really -- those 3 levers are going to be beneficial to our financial model. And it's high margin. It's high-margin revenue that we retain and that we're able to continue to grow.

Got it. I mean just on that security piece, you have been rolling out kind of more security products around the portfolio. Just are you seeing a combined buyer? Is there a type of buyer who -- or type of customer set who is really embracing kind of that combined network security?

I mean we're seeing a convergence certainly of network security solutions and actually embedding technology or software into the network itself. If you think about the SAT scalers at Cloudflare, over-the-top solutions you wonder how much AI will be able to solve for some of that knocking at the back door point that I made. Like at the end of the day, it's all about proactivity and making sure that all of the different places in your network are secure. And if they are secure, then you should be fine. And it's really being proactive around what is happening within your network. And are people accessing the areas of the network that they should? And are there any actors not supposed to be there? Are they there? I think at the end of the day, what we are seeing is we're seeing that convergence. We're seeing that we are continuing to drive more and more security features within our own networking applications, and you will see a bit of a convergence there over time.

Okay. There's been a lot of M&A in the space. You've had HPE Juniper, you've had Ruckus that's kind of in the remnants within CommScope. Just how have you been able to kind of capitalize on some of these dislocations in the market?

Sure. And so really competitive landscape. You've got the HP-Juniper merger that they've identified, what, $600 million plus, maybe up to $1 billion of cost savings that need to be made over the next several years. We've been the beneficiary, quite frankly, Meta, of some of that. So we picked up the Head of European sales out of Juniper. He just started with us about 3 months ago. He's a rock star. We picked up the Global Head of the Resellers and the Partners, Joe Spencer. He's come over. He's also a rock star. And then we picked up other people across the board. Naturally, sales folks at these others that are coming to join us as well. So we're getting the benefit of just some good talent there. And naturally, those talented individuals also have relationships either with customers or resellers as well. And so there's a bit of a pull-through and a halo effect of some of those folks. What we're hearing from the HP-Juniper perspective is just they haven't really solidified the road map yet and that they haven't really communicated to customers what that road map is going to look like. And I think that's -- and that's just what we're hearing. I don't know whether it's true or not, but it seems like that's been the real delay that is kind of causing any sort of concern with customers and that they don't want to wait to hear what's going to happen. They want to know right now what the road map looks like. And Ruckus, you mentioned Ruckus. I mean, Ruckus and Ubiquity and others at the lower end, I think they might start to feel a little bit more of a pinch on the cost of the DDR4 RAM issue because they operate at the lower level and more price-sensitive markets that it's a higher percentage of the BOM for them as it increases. And so they would have to raise price a lot more in order to cover and maintain margin there. And so we'll see. I mean it's a good company. They've got good vertical markets, et cetera, but time will tell whether that impacts them or not.

Got it. I mean...

We don't compete against them that much.

Yes. I mean you've been focused on kind of key verticals for a while. Does some of this dislocation either make you think about expanding your lens? Or does it just make it much easier to be effective in kind of your key verticals?

Yes. I mean key verticals for sure, but I think the point I made earlier around expanding into the enterprise data center is probably the area where we think that there's more expansion opportunity, more TAM expansion above and beyond what we have today. Today, we tend to kind of sit at core to the edge and not as much in the data center. But once we commercialize this 400-gig switch, I think that, that's going to allow us to really go after a different market.

Okay. Perfect. You've mentioned kind of the flexibility in consumption models with customers and kind of some of the encouraging things you're seeing around the recurring revenue. But just what trends have you seen around what customers are looking to kind of lock into as consumption models?

Yes. We've had some really good success with our consumption models. So we've created an MSP program. That MSP program enables MSPs who want to buy equipment from us, but they're able to flex up and down as customers flex up and down on the amount of licensing that they have and the support contracts that they have up and down on a consumptive basis over time. So if you have 100 customers and 1,000 licenses today, but that drops down to 95 and 50 you don't pay for those 50. Effectively, we flex down with you. Also, if you flex up to 1,050, no problem. You can go up and down over time. That's been a really successful model for us so far, and we've gotten some good benefit there. We also have created this Extreme subscription private offer, which is kind of a different model for enterprise customers who want to buy a large bulk of equipment, but they don't want to buy, but they don't want to spend a lot of money on the CapEx, and they would rather have a license model. But we have the ability to be able to do that where they buy the equipment through our distributor, not from us, at near cost. And then we put a license model in place for them to buy that way. And then the last thing that we're doing right now, Meta, which you might find interesting is that we're doing ENaaS, Extreme Networking as a Service. And so think about it as $20 an access point per month or $100 a month for a switch. And so we are bundling the hardware and the software and the cloud management and the support all together in one monthly, almost rental model, if you will. Now there's going to be a year requirement as a commitment. But beyond that, you can basically just buy and continue to rent, if you will, the equipment on a monthly basis so long you're paying.

Are you seeing enough of that to kind of change how we should think about the P&L or any headwinds, tailwinds?

I think it's just -- this is incremental. So I don't think it's going to cannibalize what I'm doing today. And I think at the end of the day, this is going to drive more and more recurring revenue for us as a company. And so that's what I'm excited about is how can we drive -- how can these new commercial models create new opportunities for the company to expand its TAM and get into new models that enable us to sell more.

Got it. You noted an overhang from professional services on gross margins this last quarter. Just kind of go into detail on just how you would expect to see resolution there?

Sure. I won't apologize for lower margins on deployments. I mean, at the end of the day, we said this last quarter, we see product margins continuing to increase into Q3 and Q4, which is the most important point is that product margins continue to drive and grow. On the support -- on the professional services side, we sold a couple of large deployments, which is good. And the lifetime value of that customer is still very healthy. It's got healthy margin at the product level, heavily margin at the subscription level, but then they're more price sensitive to the actual deployment. And they've asked us to do those deployments because these are specialized. And we don't have a problem with that, but it's like more like 15% margin at that level. It's not going to be systemic or extend likely beyond Q4. So I think from our perspective, we were just highlighting for the Street to understand -- help them understand why margins -- overall mix margins might be a little bit lower in Q3, Q4 because of those lower services margins. But at the end of the day, product margins remain healthy.

Got it. You talked upfront about kind of this 10% revenue growth, 20% EPS growth target. Just is that all -- just what are kind of the key -- if you dissect what are the drivers to get to those targets?

Yes. price increases will actually come in back in November. And now all of a sudden, we're sitting in our March and price increases can actually help that even further. So I mean, I think at the end of the day, we see the demand environment being strong. We see our pipeline building. We see conversion rates going up. We're excited about what the demand environment is going to look like over the next 12, 24 months because of that. I think from our perspective, we're thinking that the market growth rate generally, if you look at some of the 650 Group or others are saying that equipment sales could grow 3%. We think it's going to grow for us 7% to 9% that we talked about last in November. But that subscription and support growth would be more in the low to double digits, 12% to 14%, I think. And so that's going to give us the 10%. I feel pretty confident in our ability to continue to drive that double-digit growth. And we've seen, by the way, I would say, also for the last 7 quarters, growing sequentially each quarter and year-over-year on a double-digit basis. So I see us continuing to be able to do that at that level. And then on the operating leverage perspective, right, we've just done a really good job of managing expenses against the revenue growth rate. And even this last year, we had a 20% growth rate, higher than 20% growth rate on operating income against our revenue growth. And I think we're pretty focused and dedicated towards continuing to have at least twice the revenue growth rate and profitability.

What are those levers kind of on OpEx that you're still able to?

Yes. I mean AI is going to be helpful there, right? I mean instead of hiring more and more engineers, we're using AI to basically add more engineers on a virtual basis. And so I think that we can continue to do that. I'm also deploying an AI sales expert that is helping our SEs and our RFP teams to answer more RFPs. So I can grow my business by churning out 10 more or 15 more RFPs per week because I'm using AI to do that as opposed to just trying to have people do as much as they can. And so I think the efficiencies we'll get through AI is going to enable us to raise and grow our business without having to necessarily add the requisite dollars and people costs to do that.

I mean you mentioned kind of MSPs earlier, but just how are you thinking about kind of different or adjustments you can make to go-to-market to kind of better capture some of these opportunities?

Yes. On the MSPs or others, I mean, the new commercial models, I think, are going to give us that opportunity. When we talk about the competitors, one thing that we didn't talk about on the Cisco side is that they are changing their partner program, and they're changing it to a point system. And the early indications are that, that point system where you get points for selling everything is going to benefit the larger partners. But it may not benefit, I'll call it, the longer tail of resellers that are just network and network only. And so we think that there's more of those resellers that might consider, well, if I'm not going to make as much money there or if I'm concerned about making money, maybe I should consider Extreme as a potential partner as well to kind of diversify myself a little bit more. So we're thinking that, that could be an avenue for us to continue to drive more growth rate there. Again, not having to add a lot of dollars there, just adding more resellers to the base will tend to grow the business more. And we're seeing success. I mean, one of the success stories that we have right now is a Cisco takeaway in Japan. We got the government of Japan, and we're getting all the ministries in Japan as well. Well, that was KDDI and that was NTT East as well. Now that they know who we are, now they know how our technology works, we feel like we can get better leverage with them and better opportunity for them to sell Extreme into that market as well. So it's also going upstream with higher and bigger resellers as well.

Got it. And then just -- I mean, some of that 10% growth that you spoke about versus kind of an industry that's certainly not growing that. Just is the share gain opportunity that you're seeing just adding more products to kind of customers? Or is it just adding more customers kind of faster? I guess, is it coming from expand or land?

Yes, it's a good question. We will continue to grow the business. I think, a, it's keeping the existing customers that we have happy, expanding TAM on the data center side with those customers. So not having that in the past, but having it now will help us expand, adding more resellers and more resellers at scale that give us more opportunity to attract new customers into the fold who we have not had relationships or experience selling into. And so more resellers coming in, more proof of concepts, more opportunities at bats, I call them for us to hit a double single or a triple, we're a home run. At the end of the day, if we get more at bats, it's more opportunities for us to convince other customers that our technology is great and it sits a little bit below Cisco from a price perspective and that we can provide really great networking support and service.

Got it. And then maybe just the last question for you, just on capital allocation priorities or just kind of how you're thinking about the balance sheet.

Yes. I mean, first and foremost, I would say this DDR4 RAM issue is...

That's the #1 priority.

The #1 priority is making sure that we've got that and that we've got plenty of ability to go and land the equipment that our customers need over the next several years. The second thing is buybacks, right? We've been buying back historically, but we are in market right now buying back shares as well. And so we will continue to prioritize buybacks as well. We've got a little bit of debt on the balance sheet, but not much. And so I'd say the third order of magnitude there would be just paying down some of that debt over time.

Okay. All right. Well, Kevin, thanks so much for being here today.

All right. Thank you, Meta.