Extreme Networks Inc (EXTR) 2010 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen and welcome to the Extreme Networks 2010 second quarter conference call.

At this time, all participants are in a listen-only mode.

Following today's presentation, instructions will be given for the question-and-answer session.

On the call today from Extreme Networks are Bob Corey, CFO and acting President and CEO, Helmut Wilke, Senior Vice President of Worldwide Sales, Frank Blohm, Vice President of Worldwide Operations and Chief Quality Officer.

As a reminder this conference is being recorded today, February 1, 2010.

This afternoon, Extreme Networks issued a press release announcing the Company's financial results for the second fiscal quarter of 2010.

A copy of this release and a slide presentation of supporting financial materials are available in the Investor Relations section of the Company's website at www.extremenetworks.com.

This call is being broadcast live over the Internet and will be posted on the Extreme Networks website for a replay shortly after the conclusion of this call.

The Company has asked me to remind you that this conference call contains forward-looking statements that involve risks and uncertainties, including statements regarding the Company's expectations regarding its financial performance, strategy, growth of customer bandwidth demands, development of new products, customer acceptance of the Company's products, customer spending and economic conditions in the Company's market.

Actual results could differ materially from those projected in the forward-looking statements.

As a result of certain risk factors, including, but not limited to fluctuations in the demand for Company's products and services, supply chain constraints and the ability of third-parties to manufacture the Company's products and components thereof.

A highly competitive business environment for network switching equipment, its effectiveness in controlling the expenses, the possibility that the Company might experience delays in the development of new technology and products, customer response to its new technology and products, the timing of any recovery in the global economy, and risks related to pending or potential future litigation.

The Company undertakes no obligation to update the information on this conference call.

More information about potential factors that affect our business and financial results is included in the Company's filings with the Securities and Exchange Commission.

Throughout the conference call, the Company will reference both GAAP and non-GAAP financial results.

The Company has provided a reconciliation table of GAAP to non-GAAP and information tables that accompany the press release on its website.

Please go to the Investor Relations section of the Company's website at www.extremenetworks.com.

In addition to all announced results are preliminary and may be subject to change when the review of the financial quarter is concluded and/or a Form 10-Q is filed.

I would now like to turn the call over to Mr Bob Corey, CFO and Acting President and CEO of Extreme Networks.

Thank you, operator.

Welcome to the Extreme Networks Q2 fiscal 2010 earnings conference call.

As the operator said, I'm joined today by Helmut Wilke, our Senior VP of Worldwide Sales and Frank Blohm, our VP of Worldwide Operations and Chief Quality Officer.

I will begin with some brief comments on the quarter, followed by some more comments by Helmut and Frank regarding our performance in the quarter.

Then I will summarize and provide guidance for our fiscal Q3.

We will then open for a Q&A.

Our goal is to provide more time for Q&A, and less time reading our scripts Additionally, we posted a slide presentation on our website at extremenetworks.com, under Investor Relations that I hope you will find useful.

I want to take a minute and share our vision and mission with you.

Our vision simply stated is we see a fully connected world enabled by ethernet everywhere.

This is more true today than it was when the Company was founded, and ethernet was the genesis of Extreme Networks.

Our mission is that we are dedicated to the delivery of high performance, innovative products and superior services to ensure the success of our customers and partners.

With these guiding principles, we are focused on our strategy, that is of growing revenue, gaining market share, while continually improving our operational execution.

During the quarter, we simplified and streamlined our organization to allow us to compete more effectively.

The reorganization was affected and completed in the first month of Q2, resulting in a reduction of head count of about 8%.

During the quarter, we worked to resolve the supply chain constraints that negatively impacted us in Q1.

Frank will comment further on the progress here.

In December, we launched our vision for the next generation data center, at the Gartner Data Center Conference.

In that vision, we provide a clear road map for the enterprise, hosting and colocation service providers, to migrate from a physical, to a virtual and then cloud-based architecture.

Our vision is unique in that it does not force a certain technology or operating methodology on our customers.

In January, in support of our vision, we announced the latest additions to our data center product portfolio, the Black Diamond 8900 XL Modules, and the Summit X480 Stackable Switch family, both of which are expected to be available in Q3.

As a reminder, all of my comments will be non-GAAP, except for revenue and the number of common shares.

There is a reconciliation from non-GAAP to GAAP financial results in the slide presentation under investor relations on the website that I mentioned previously.

Before I go any further, I want to thank every employee in our organization for their dedicated effort and commitment which contributed directly to our performance in Q2.

During Q2, we dramatically improved our operational execution, and reported $79.4 million of net revenue, representing a 27% sequential increase in product revenue.

Helmut will comment on sales performance later on.

Our gross margin percentage expanded to 58%, and was the highest in the history of the Company.

Operating income was $4.3 million or 5.4% of revenue and was the strongest quarterly performance in over three years.

Cash flow was $4 million positive, allowing us to exit the quarter with about $135 million of cash and investments and, of course, no debt.

Deferred revenue on the balance sheet increased by over $5 million sequentially, and is up about 20% from year end while DSOs and accounts receivables improved to 46 days from 50 days in Q1.

Inventory remained in the $16 million range with consistent turnover of about eight times.

With, that I would like to introduce Helmut Wilke, our Senior VP of Worldwide Sales.

Thank you, Bob.

Let me provide you with some color and comment on the sales performance in Q2 and let me start with the geographic perspective.

It was a quarter where we saw good sales momentum around the world.

We had a particularly strong performance in Asia Pacific, where we are starting to benefit from the management changes we put in place last year.

Revenue in Q2 was up more than 24% over Q1 and 18% year-over-year with strong new customer business, and traction in China and Japan, in addition to our traditional areas, Korea and India.

Europe, EMEA, continued its strong performance in the enterprise space where we saw some softness in our eastern European service provider business.

Our customers are still in the process of deploying the equipment purchased in the previous quarters.

The US economy has still not fully recovered, but we saw growth over our Q1 business with an increase in pipeline and deal size.

We remain fully invested in the US market place and will be ready to respond to an improved demand situation.

Next, let's talk about customers and where we went.

Across the globe, we have won more than 100 new customers, representing around 20% of our business.

Of those 100 plus new customers, 29 were over $100,000 and represent a number that keeps trending up for us.

Some of the more notable new customer wins this quarter were one of the largest banks in India, a major ship builder in Korea, the facilities securities in Saudi Arabia, several universities and institutions of higher education around the world.

As recently announced, in the US we won the Baltimore School District with 200 facilities and 82,000 students.

In addition, we are happy that a long standing customer of ours, Wynn Resorts, selected Extreme for the new tower and expansion in Macau.

The business came from a broad range of vertical markets with a continued strength in education and service providers.

But why do they buy from us?

We are the innovators.

We offer such features as the Axis Operating System, which results in ease of use and flexibility of network management, network performance, and just overall favorable cost of ownership with product and service quality being important factors as well.

Our improved margin performance is a testament to the strength of our product portfolio and the overall value propositions that we bring to our customers.

The competitive landscape remains tough, particularly in the US.

The downturn has just made every vendor push harder for business, resulting in a higher noise level and a very competitive climate.

Continue to see the high level of interest among enterprises to investigate alternatives and more cost efficient solutions to the market leader.

We see this increased competition as benefiting us, as we continue to expand our partnerships and grow our customer base with our unique pure play value proposition.

Our focus and investments and our strategic partnership keep paying off.

Our business with Ericsson has grown quarter over quarter, as well as year over year.

This will remain an area of investment for us.

To summarize, overall, a good quarter.

We are looking forward to being able to retain the sales momentum into Q3 and beyond.

With that said, I would like to hand over to Frank Blohm, our VP of Operations and Chief Quality Officer for an update on the supply situation.

Thank you, Helmut.

In my opinion, 2009 was one of the most challenging years for those of us in supply chain management and the networking industry.

Forecast reductions by many companies, including Extreme, caused suppliers to react and drastically cut their output and supply.

Lead times increased substantially and in some cases more than doubled from the suppliers which caused lead time increases by Extreme and many of its competitors.

Since then, we made significant investment in our supply chain and inventory levels, which helped us bring lead times almost in line with historical levels and obtained the greatly improved results in Q2.

We expect to see -- I'm sorry, we expect to continue seeing tight availability of key components from our suppliers through the first half of calendar year 2010, but believe the actions we have taken have resolved the short-term constraints and position us well to meet future demand at close to historical lead times in the next few quarters.

As we look into the future, we are implementing a project to more closely align the distribution locations of our finished goods with our manufacturing locations to reduce freight, cost and improve customer lead time.

Our current timing is to complete this project in our fiscal 2011.

We have also implemented a program to more aggressively manage the costs associated with our service spares inventory.

We are partnering with leading logistic management companies to leverage their cost efficiencies and geographic presence.

From a product quality standpoint, over the last two quarters, we have improved key hardware and software quality metrics which contributed to the improved margins and our lower operating cost.

In addition, we believe we will see continued improved quality as a result of the restructuring we announced last quarter, which brought engineering into a unified functional organization.

I now turn the call over to Bob.

Okay, great.

Well, thank you, Frank, thank you, Helmut.

I am going to make some summary comments.

We executed well in Q2 and we see signs of improved sales momentum around the world.

While the US economy improved well in calendar year Q4, with a GDP growth rate of 5.7% there is still a question if it's fully recovered and if the recovery is sustainable.

On the other hand we have been seeing particularly strong performance in Asia PAC and EMEA's enterprise business has been showing signs of strength.

The competitive landscape continues to change and evolve while remaining strong, particularly in the US.

We see that benefiting Extreme as an opportunity to expand our partnerships and grow our customer base by providing high performance, innovative products and superior services to ensure our customer and partners success.

I will now turn to guidance for Q3.

Over the past two years, we have experienced seasonally about a 12% sequential decline in revenue in Q3.

However, as a result of signs of an improving macro economic climate, the increased sales momentum, and increase in our backlog and deferred revenue, we are not anticipating historical sequential decrease in revenue for Q3, but rather we anticipate net revenue to be between $77 million and $79 million for the quarter.

Further, we anticipate the gross margin percentage being between 57% to 58%, and operating income of $3.0 million to $3.5 million resulting in earnings per share of $0.03 to $0.04 per share.

We believe the economic recovery that appears to be underway will be uneven across geographies.

And as I said last quarter, we will continue to closely manage our operating expense while selectably investing for revenue growth to accelerate earnings and cash flow and gain market share.

We remain committed to making our customers and partners successful and creating value for our stockholders.

With that, I am happy to open it up for questions.

Operator?

(Operator Instructions) And we'll go first to Samuel Wilson with JMP Securities.

Good afternoon, gentlemen.

I have about four questions here.

I will just ask them one at a time.

Okay.

First, for the December quarter, can you give us a sense, how much revenue was recognized in the December quarter, was actually really booked and originally expected to be delivered in the September quarter when you pre-announced the downside but it ended up being shipped in December because of the supply chain.

I'm trying to get a sense for organic market demand versus catch up revenue.

Great question.

If you recall, we had about $5 million of increase to the backlog, et cetera, coming out of Q1 into Q2.

So if you normalize Q2, that's about a 12% sequential increase in product revenues for Q2 coming out of Q1.

Okay.

Second is, can you just talk a little bit about -- you saw some nice swings in gross margins, but in both directions, service drops, product margins up.

Can you talk about what was influencing those factors and should we expect bigger swings here in the future, or are gross margins stabilizing by category down a little bit?

Yes, let me talk about the service margin first.

If you recall, we forecasted a decline in service margins in Q2, and that was because through Q1, we had completely utilized the previously written off spares inventory that the prior three quarters had received a benefit from by using those, right?

So the service margins have popped up over 60 something percent, I think in Q3, Q4, and Q1, sequentially, but we had utilized all of that previously written off spares inventory and we forecasted a decrease in the service margin in Q2.

So, in fact, the service margin came right in around the areas where we were expecting it to come in in Q2.

We do expect the service margins to normalize going forward, in around the 55% to 57% range.

Okay?

The product revenue -- I'm sorry, the product margin -- it was benefited this quarter, one by mix in products that contributed stronger gross margins.

Number two, by a stabilization in the warranty cost and improved quality that Frank had talked about, et cetera.

And lastly, the E&O, the excess and obsolete inventory reserve charges in Q2 were down from what they were in Q1.

So we would anticipate that those margins in the product line are going to stay stabilized and we think over time trend up for some of the reasons that Frank outlined in the distribution and manufacturing areas.

Fantastic.

Okay.

Last question for you.

Can you talk a little bit about pricing pressure and competitive environment and then specifically can you throw in sort of your two cents on what hp3com combined means specifically for Extreme?

How much are you seeing in pro curve?

How much do you see in 3com.

Does the two combined change the dynamics?

So pricing pressures in the December quarter and then hp3com specifically.

Yes, Helmut Wilke, let me talk about the pricing pressure.

The market is competitive, particularly in the US, with every player here, it's a bit less competitive overseas, frankly and we benefit certainly that about two-third of our business comes if geographies outside of the US, and we have a strong business space there and not all the competitors are playing there.

We don't see that much of a margin pressure.

We are aggressive on deals where we need to be, but typically in a sales cycle, customers appreciate the features that we have, the quality of the product, the functionality, and we are typically able to differentiate ourselves enough from other vendors who just, let's say, with the more basic feature set tried to sell more aggressively on price.

So as you can see from the margin situation, the revenue situation, we are holding our space in the market above those vendors quite well.

And hp3com and what that means --

Yes, we don't see them that much yet.

There's usual confusion in the market.

What does it mean?

What does it mean for resellers who are now either selling one or the other.

That's consolidation of cause in the reseller channel.

So we certainly use that irritation that there is in a transition period to win partners over to move to us as the alternative.

So we will see how it all pans out.

Right now we don't see that much of an effect yet, other than what I just described.

Got it.

Thank you so much, gentlemen.

Thank you.

We'll take our next question come from Steve Salberta with Boenning & Scattergood.

Hi.

Hi, Steve.

Can you give us a little bit more detail in the North American business?

I would have expected it to be up a little bit more.

Can you talk about just what you are seeing in the pipeline, backlog, that sort of thing and seasonality in North America?

Yes.

The US still has to recover fully, I would say.

My previous answer pointed out how strong we are overseas.

The US is still a lot more competitive with a lot more players here.

We see some recovery in the school business, erate funding seems to be coming through.

That has stabilized a bit.

We still don't see very much defensive spending going up.

We had hoped that would be a bit stronger, but that hasn't quite materialized that.

So our strong strength remains in the enterprise business.

The deal sizes I would say will go up.

Customers are cautious and buying in smaller chunks.

Even winning projects doesn't mean that $1 million orders are placed right away, they deploy over time.

We see this particularly in the US.

The nervousness about the overall economy shows more through in the US than any other area.

Yes, yes, hi, Steve, it's Bob.

We are watching the US economy very closely and we are obviously watching the pipelines, et cetera.

We are going to be ready as we see expanding pipelines, et cetera to make the appropriate investments to make sure we stay ahead of the recovery and the US economy.

Okay.

Did I hear you right, Bob, when you were giving the part on guidance, say that part of what gives you comfort in better seasonality is that backlog is up again in the quarter?

That's correct.

How would that apply to your different regions?

Is backlog up in the North American market?

I think the back log was pretty well stabilized in North America, I would say the book to bill was maybe a smidgey over one.

We certainly had strength in Asia Pac and those pipelines continue to expand, and EMEA on the enterprise side of the business, we are starting to see that actual part of the market over there strengthen and show some positive trends.

Okay.

Last quarter, you talked about China mobile being a partner or if you actually got revenue from them last quarter.

Did that drive strength for you this quarter?

Yes, that continues to be a partner, as you probably know, worldwide, we partner with Ericsson.

Ericsson builds infrastructure projects around the world.

A lot of them being in India, Africa and the Middle East and increasingly in China.

One of their customers is China Mobile and we manage now by having a much stronger team on the ground in China to engage a lot better with Ericsson and their end customers in China which resulted in a very nice uptick in business with Ericsson to China Mobile and we saw that starting about half a year ago and that continued last quarter and that looks quite promising.

Okay.

And inventory, fairly flat sequentially, but you are confident that you've resolved the issues.

Is it mix?

Do you feel comfortable that you can get more inventory if you need to?

Yes, this is Frank.

Yes, we work very closely with our manufacturing partners and our key component manufacturers and believe we have enough inventory secured given any mix variation that could come into play this quarter.

Would do you expect that to go up again in March?

We were flat Q1 to Q2 and we expect to remain about flat, eight turns a year.

And my last question is with respect to your -- your target margin, 11% operating margin.

I think in the past, you've said near term, or something to that effect.

Can you give us a time frame and just go through -- it looks like sales and marketing is where you need to see the most leverage to get there, which kind of -- according to my calculations indicates not a lot of incremental dollars of investment.

How do you get there?

What sort of things are you doing to take that step and timing of it?

Yes, I think what we are doing is we are clearly focused on trying to drive revenue growth.

So if you look at the 11% operating income target in our model, I expect it's going to take us probably around $90 million on a quarterly basis to break through the double digit and get to the 11%.

We're continuing to review and expand our sales channels where appropriate, and we are going to selectively invest in additional sales teams on a global basis, where we see revenue growth opportunities.

So we are focused on trying to grow the revenue and most specifically gain market share.

So we are -- we are highly committed to driving through the double digit operating income percentage contribution and, like I said, I think roughly $90 million will get us there on a quarterly basis.

And we are continuing to see how we drive that revenue line.

Okay.

Can you tell us how much of the $2.5 million that you took out of the model, how much benefit you got in the quarter from that?

Yes, we got roughly almost two-thirds of the benefit.

Thank you.

We affected the reduction for us right at about the end of October.

Okay.

Thank you.

Okay, thank you, Steve.

And we'll go next to Douglas Whitman with Whitman Capital.

Thank you for great quarter, guys and achievement.

Thank you, Doug.

Talk a little bit about the cash balance.

It's now about two-thirds of the overall market capitalization and you also grew cash sequentially about $5 million, so congratulations on that.

But now that you stabilized the Company and outgrowing the industry, maybe you could talk about given the low valuation, what the thoughts are on buyback and whether that's back on the table.

Yes, well, Doug we did a dutch auction buyback, I think in September of 2008, where the Company took about $100 million of our available cash and bought back, I can't remember the number of shares off the top of my head.

So we did a Dutch auction.

We did that.

The Company has been focused on, like you suggested, stabilizing the business and how do we grow revenues.

So we think remaining cash flow positive is an important metric for the Company.

We are aimed at deploying that cash to see how we can expand channels, shore up partner arrangements and opportunities organically drive the business, and we want to assume a reasonably aggressive posture trying to gain market shares.

So there are no short-term considerations for additional buyback right now.

Can you talk a little bit about -- on the inventory, you're relatively flat on the inventory and you were early kind of to have this problem and get in the ordering process, but what -- as you are giving that guidance on the first quarter and thank you for the good expectations, but how much of a concern is components at this point in time for first quarter?

This is Frank.

So, again, I think we have done a lot of investing over the last 90 to 120 days in our inventory and in our supply chain.

So right now we see minimal impacts.

Again, the industry is still tight.

So we will probably have one off issues that we will work with, but we believe that we have enough materials to cure, to manage through any risks or mix issues we may have for the quarter.

And then one of the things you have also been investing on is the future and so can you talk a little bit about -- or is there kind of a date that we should be looking for for some of the new product stuff that you are working on?

Yes, we certainly have a road map in the Company, both for hardware and software product,s, and imminently, you are looking at some upgrades and product releases on improving the software performance of the products for XOS, our operating system.

In January, we just announced, like I said in the call and the comments earlier, there's a couple of product releases to support our data center vision and thrust there.

So you are going to continue to hear more about new products coming to market.

And how much -- I know you gave long-term margin guide, how much is [nucrutional] operating improvement that you plan to have on manufacturing?

Yes, I think the margin forecast in the model is -- let's see if I can double check it and see if I can get it here.

We are saying the gross margin is 57% and 59%.

So we just posted 58%.

So we're clearly square in the middle of that financial model.

We're going to continue to drive, like Frank outlined, efficiencies and cost reductions and savings just economies in operations, et cetera.

Quality will also play a large role in driving the gross margin as we go forward.

Now, obviously it's a competitive world, so we are going to continue to drive those costs and those efficiencies and respond to a competitive environment.

Okay.

That sounds like it gives you some leeway to work with then.

Yes.

Thank you.

Thank you, Doug.

All right.

Cheers.

(Operator Instructions) We'll go next to Rohit Chopra with Wedbush Securities.

How are you doing, Bob?

Hi, I'm good.

How you doing?

Good.

I just want to ask you a few questions and maybe you could update us first on the CEO search.

I wanted to see if you were imminently ready to hire somebody.

Well, as you know, there's a CEO search.

It's underway by the board and the feedback I'm getting, the updates are there's been great progress made on that.

We've got a grouping of very qualified candidates, and the board is culling down the number of candidates.

So I can't give you an exact date as to when we may have a new CEO on board, but the board is making great progress on this and like I said, we have good quality candidates and I suspect in the next few months, we'll certainly have maybe something to announce.

Could you also provide an update on Motorola?

Were they (Inaudible) the product announcement that I think was made the last quarter, is there anything coming of that yet?

Maybe I take this Helmut.

We announced that we take the Motorola wireless product line and sell it was a WAN product and that started to sell last quarter.

We are in the ramp up phase.

We are pleased with that.

The product seems to be really good, the acceptance by [myself and the organization] is great.

The corporation with Motorola is really promising.

So we are actually enthusiastic to this and this should contribute to the revenue stream going forward and continue to see -- expect the ramp up really this quarter.

And then Helmut, while you are right there, I wanted to ask you question.

When you were speaking, you indicated that, I think you were talking about the 100 new customers and you saw strength in education and service provider and then in the slides it looks like, if I'm right, service provider was actually down as a percentage of sale.

I want to reconcile that your comments with the slides indicating that service provider is actually down.

Yes, good catch.

You are absolutely right.

Overall 20% to 30% of all business comes from service provider and it also been like this over this period.

So we continue to think of this as one of our verticals.

We are strong and we have customers who like our architecture and buy products from us.

They are very important vertical for us.

At the same time, I commented on this.

Yes, last quarter we were a bit light.

We sold a little less than our usual percentage in the service provider space in Q2.

That was my specific comment.

We expect to be seasonal.

This was partly the Eastern European economy was hitting us, as well as the particularly strong sales we had a few quarters before and we still see customers going production with a gear that they have and put it into the network.

That's why we saw that little less than normal performance in the service provider space, but it continues to be a key vertical for us.

I only had two other questions.

I just wanted to get a sense, with Ericsson, are you working with any US carriers on upgrading the backhaul in the US?

I can't comment on specific deals we are working with them.

Yes, this is Bob, Rohit.

We have some discussions underway with some carriers that will give us some OEM opportunities in the service provider -- I'm sorry, the wireless backhaul area.

They are not fully finalized yet.

We are engaged in those and we are looking forward to making an announcement when they are finalized.

And my last question because I don't want to take anything away from what you have done because I think there has been a lot of changes and they have all been very positive in the last few quarters and clearly the environment is improving as well.

But I want to come back to one of Sam's questions which I think is important.

You talked a little bit about competition, and I just want to get your sense, Bob, on how Juniper is able to get from zero to $74 million in revenue in the switching area within eight quarters and revenues at Extreme -- I mean, they are improving.

I don't want to take anything away from you.

What are they doing right and what needs to continue to happen at Extreme?

Well, they are certainly doing a respectable job with their new product line.

There is no question about it.

They have a customer base that they can go after.

They have a customer base with their security products and they can sell into those, which gave them a start to leverage on their other product lines and we'll see how well they will be able to do what they have been doing last couple of quarters.

We are very confident in our product line.

The main target for us is and remains the big, big pie which is Cisco, and so the more customers we can convince that there's an alternative and a very powerful feature set, that gives them low operating costs and a better product.

And take the jump to one of the smaller windows, the better it is.

So we continue to say focused on that really big size of the market.

Yes, plus, Rohit, it's Bob.

With the reorganization we accomplished last quarter, if you recall, one of the main thrusts of that was to allow us to compete more effectively in the market place.

So clearly the whole Company is focused on growing revenue and gaining market share.

So we restructured the business to give us the flexibility to be more aggressive in the market and you will continue to see us be more aggressive in the market and grow revenue.

Thanks, Bob.

Thanks, Helmut.

Okay, cheers.

Thank you.

At this time, there are no further questions.

I would like to turn the conference back over to Mr Bob Corey for any closing or additional remarks.

Okay.

Great.

Well, I just want to thank everybody for calling in.

We're excited about our opportunities here at Extreme Networks and we look forward to reporting the results of Q3 to you in April of this spring.

Thank you very much.

Cheers.

That concludes today's conference.

We thank you for your participation.