Extreme Networks Inc (EXTR) 2014 Q2 法說會逐字稿

Good day ladies and gentleman, and welcome to the Extreme Networks second-quarter FY14 financial results conference call. As a reminder this call is being recorded. I would now like to introduce your host for today's conference, John Kurtzweil, CFO. Please go ahead sir.

Thank you Nova. Welcome to the Extreme Networks second-quarter of FY14 conference call. On the call with me today is Chuck Berger Extreme Networks President and CEO. This conference call is being broadcast live over the internet and is being recorded on behalf of the Company. The recording is -- will be posted on Extreme Networks website for replay shortly after the conclusion of the call and will remain there for the next seven days. The presentations and the recording of this call are copyrighted property of the Company and no other recording or reproductions permitted unless authorized by the Company in writing.

By now you have had a chance to review today's earnings press release, for your convenience a copy of the release and supporting financial materials are available in the Investor Relations section of the Company's website at www.Extremenetworks.com. This conference call contains forward looking statements that involve risks and uncertainties including statements regarding the Company's expectations regarding its financial performance, the impact of the Enterasys Networks acquisition, strategies, growth of customer demand, development of new products, customer acceptance of the Company's products, customer buying patterns and spending patterns, and overall trends and economic conditions in the Company's market.

Actual results could differ materially than those projected in the forward looking statements as a result of certain risk factors including but not limited to: a challenging macroeconomic environment worldwide, fluctuations in demand for Company's products and services, a highly competitive business environment for network switching equipment, the Company's effectiveness in controlling expenses, the possibility that the Company might experience delays in the development of new technologies and products, customer response to its new technology and products, the timing of any recovery in the global economy, risks related to pending or future litigation, the dependency on other parties for certain components and for the manufacturing of the Company's products, and our ability to receive the anticipated benefits of the acquisition of Enterasys.

The Company undertakes no obligation to update information on the conference call. For more information about potential factors that affect our business and financial results we suggest you review the Company's filings with the Securities and Exchange Commission. Throughout the conference call the Company will reference some financial metrics that are driving in accordance with generally accepted accounting principles or GAAP, all other metrics are not in accordance with GAAP. This approach is consistent with how Management measures the Company's results internally; however, non-GAAP results are not in accordance with GAAP and may not be comparable to non-GAAP information provided by other companies.

Non-GAAP information should be considered a supplement to and not a substitute for financial statements prepared in accordance with GAAP. A reconciliation of the non-GAAP information to the corresponding GAAP measures is in the slide presentation under the Investor Relations tab on our website and the accompanying our press release. Non-GAAP results exclude stock base compensation, acquisition and integration costs, restructuring charges, amortization of intangibles, purchase accounting adjustments, litigation settlements, and the gain on the sale of facilities.

Before we go into a review of our fiscal Q2 financial results, I will turn the call over to Chuck Berger for some opening comments.

Thanks, John, and thanks to everyone on the call for joining us at this early hour. It continues to be a very exciting time at Extreme Networks we announced the completion of the Enterasys acquisition just before our last earning call on November 4 and today we announce our first quarter as a combined company. John will give the details but today we are reporting non-GAAP revenues of $148.3 million and earnings per share of $0.14.

Both revenues and EPS were within the guidance ranges we gave for the quarter. We are pleased with these results as they represent our third straight quarter of delivering on our guidance, something Extreme was not known for in the past. As significant, we delivered these numbers in the first quarter after closing the acquisition. That we were able to forecast our financial performance accurately is one of the many examples of how the integration of the two companies has gone to date. Overall we have found few surprises since closing the acquisition reflecting how well Chris Crowell now our Chief Operating Officer and his team managed Enterasys for the past six years. Additionally if you add the $11 million in revenues Enterasys booked in October, prior to the acquisition, combined revenues for the Company were flat year-over-year.

To this point we have not seen significant evidence of revenue to synergies and we are positioning ourselves for revenue growth in the future. During the quarter, we shipped the Summit 770 our newest Top of Rack data center switch. The 770 brings a new level of performance to the data center with unmatched 10 and 40 gig port density. Its advanced scale ability, program ability, and robust software make it the perfect solution for companies dealing with the challenges of big data and cloud based computing. Our first 100 gig switch is in beta with a number of IXP customers and doing very well. We expect a fourth fiscal quarter launch for general availability of that product.

We are growing faster than the market in our data center products; however, it's still a small part of our revenue. We plan to increase the focus on the data center to drive revenue growth in the future. In mid-January, Extreme and the National Football League announced that Extreme had been selected as the Wi-FI analytics provider for NFL and Super Bowl XLVIII. Just yesterday we launched our new analytics product Purview. Purview is now deployed at the stadiums for the New England Patriots, the Philadelphia Eagles, the Detroit Lions and MetLife Stadium, home of the New York Jets, New York Giants and last Sunday's Super Bowl.

Please visit our web site to see data gathered by the NFL during Sunday's game using purview. We literally had this data out only 48 hours after the game was completed. Purview builds on our core flow to ASIC technology and our net site network management suite to provide unprecedented visibility into the application activity on an enterprise network. Purview integrates with any vendor's network infrastructure, wired or wireless in providing insight into usage and performance of applications at any point in the network, from the wireless edge to the deep core of the data center. With open API's Purview can integrate with any third party application as well as either a data feed or as an actionable control point.

The NFL is focused on improving the fan experience at its stadium and Purview provides them with the data and analytics to do that and more. The NFL announcement and the launch of Purview will be followed by 802.11 AC products early in the fiscal quarter. We experienced double-digit growth in our wireless revenues during the quarter; however it's still relatively small part of our overall business. With Purview, the NFL announcement, the upcoming AC release, and an increased focus on our wireless product line, we expect significant growth in our wireless revenues in the future.

In October, Extreme hosted its annual Global Partner Conference. Attendance was more than double last year's event. One of the principle reasons was the Legacy Xtreme reseller's interest in our new wireless product line. In January we had over 200 of our system engineers from around the world in the bay area for product training, data center and wireless were two of the main focus areas.

Finally yesterday we launched the new Extreme brand and state of the art website. I encourage you to visit our web site at www.Extremenetworks.com. The brand speaks volumes for the bold and exciting future we see for Extreme. The comments from our customers and analysts featured on the website are indicative that our technology and our customer first strategy is winning in the marketplace. We changed the game for Extreme Networks and the ethernet switching market in our second fiscal quarter with the acquisition of Enterasys. We have already entered the new calendar year with tremendous momentum including a partnership with the NFL, the Purview launch and our new brand and state of the art web site.

John will be giving guidance from March quarter that shows year-over-year revenue growth within the range for the first time in a long time for Extreme. It's indeed a very exciting time at Extreme and we believe there is much more to come. Now John will give you the financial details from the quarter.

Thank you, Chuck. I will now provide a review of our fiscal Q2 financials and our financial targets for our Q3 of FY14. GAAP revenues for Q2 FY14 were $146.6 million and non-GAAP revenues were $148.3 million which is at the low end of our guidance of $145 million to $160 million. The difference between the two is related to purchase price accounting on deferred service revenue and will be with us for the next several quarters. As a reminder from our last call when we provided guidance, we noted that there would be three months of Extreme product line revenue and expenses for only two months of Enterasys product line revenue and expenses.

I will now provide you the revenue splits, and this will be the last time we are able to split out the two product line as there is already some cross selling occurring which would skew the forward numbers and make them meaningless to draw any conclusions from. Legacy Extreme Networks $76.5 million, which was a $1 million or 1.3% growth year-over-year and a $0.6 million or 0.8% growth sequentially. Legacy Enterasys Networks non-GAAP revenue was $71.8 million. The revenue for the month of October that was not recorded in consolidation was $11.4 million.

If you add in October, the non-GAAP revenue would have been $83.2 million which was a decline of $0.7 million or 0.9% year-over-year and a decline of $5 million or 5.7% sequentially and we have found that the December quarter is a seasonally weaker quarter for that line of business. As you can see, we are essentially flat on a year-over-year basis. Combined product revenues were $119.1 million and combined service revenues were $29.2 million.

We look at the overall market; North America is a tough market right now. Latin America has line of sight to continuing growth in the spring. Asia-Pacific is in line with weaker expectations and EMEA was surprisingly strong especially the Eastern region. America's non-GAAP revenues were $71.9 million or 49% of revenue. The Legacy Enterasys revenues in the Americas was greater than Legacy Extreme revenues and gives us a greater presence in the region. When compared to last quarter, the Legacy Extreme revenues were 42% of revenue. During the quarter we saw North America as a weakest region, and in particular the central part of the country. As we mentioned last quarter, we believe this is due to decisions to delay capital spending at year end.

EMEA's non-GAAP revenues were $61.3 million or 41% of our revenue. The Legacy and Enterasys revenues in EMEA were greater than the Legacy Extreme revenues and also gives us a greater presence in the region. When compared to last quarter, the Legacy Extreme revenues were 40% of our combined revenues. Southern Europe, the Middle East, and Africa were the weakest regions with strong results in the Eastern region where several large infrastructure projects broke loose during the quarter.

Asia-Pacific non-GAAP revenues were $15.1 million or 10% of our revenue. The Legacy Extreme revenues in Asia-Pacific were greater than the Legacy Enterasys revenues which give us the opportunity to reach deeper into that region. When compared to last quarter, the Legacy Extreme revenues were 18% of our revenue. We have solid performance in both Korea and Taiwan.

Overall GAAP and non-GAAP gross margins were 47.6% and 56.4% respectively and above the high end of the target non-GAAP range of 54% to 56%. This non-GAAP improvement came from a richer product mix, supply chain cost reductions, and slightly higher service to product mix. The cost items that are included in GAAP and not in non-GAAP are stock based compensation of $0.2 million, the step up to fair value for acquired inventory of $9.2 million, and the amortization of intangibles of $2.7 million. GAAP operating expenses were $83.6 million and non-GAAP operating expenses were $67.5 million.

The items included in GAAP and not including non-GAAP are as follows: stock based compensation of $3.2 million, acquisition and integration related expenses of $8.7 million, amortization of intangibles of $3.8 million, and restructuring charges of $0.4 million. Non-GAAP R&D was $18 million. Non-GAAP sales and marketing was $39.4 million and non-GAAP G&A was $10.1 million. First quarter GAAP operating income was a loss of $13.8 million which includes items mentioned above and non-GAAP operating income was $16.3 or 11% of revenue.

Other expense for the quarter of $1.3 million included approximately $0.5 million of interest expense on our debt and the balance was primarily related to foreign currency translation losses. Taxes were $0.9 million which is as we expected and is primarily related to foreign income. GAAP net loss for Q2 was $16 million and $0.17 per basic share. Non-GAAP net income for the quarter was $14 million or $0.14 per diluted share and the results were in our targeted range of $0.14 to $0.16 per diluted share.

Turning to the balance sheet, total cash and investments for the quarter ended at $112 million as compared to $199.4 million at the end of last quarter. During the quarter, we closed on our $125 million credit facility of which we drew down $100 million as part of the funding for the $180 million net of cash purchase of Enterasys Networks. As it relates to the credit facility, the balance outstanding at the end of December was $99.2 million and we were in compliance with all covenants. Accounts receivable increased to $94.3 million and non-GAAP DSO of 58. This is an increase of 11 days from the prior quarter. Inventory increased to $62.9 million with non-GAAP days of inventory at 88. This is a decrease of 11 days from the prior quarter. These balance increases were planned as part of the Enterasys acquisition.

I will now move on to providing guidance for our third fiscal quarter. This will be the first time we have a full quarter of the Legacy Extreme and Legacy Enterasys combined into one entity. As we have already started the integration process and some cross selling we will not be providing product line splits as we operate in a single segment. We are targeting GAAP revenue in a range of $138 million to $153 million with non-GAAP revenue of $140 million to $155 million. The difference is related to purchase price accounting on deferred service revenue and will be with us for the next several quarters. As note, when we look at the third fiscal quarter of 2013, and if the companies were combined, the revenue was $139.5 million at that point. Our guidance is flat to up 11% year-over-year.

GAAP gross margin is targeted to be 50% to 52%. Non-GAAP gross margin is targeted to be 55% to 57%. The three key deltas between the GAAP to non-GAAP gross margin are purchase price accounting on deferred service revenue of approximately $2 million. The purchase price accounting step up value of inventory estimated at $2 million and this will be the last quarter this will be an impact on the Company. The amortization of intangibles is estimated at $4 million and stock based compensation of $0.5 million. When we look at the third fiscal quarter of 2013, and if the companies were combined, the non-GAAP gross margin at that point was approximately 55.6%.

GAAP operating expenses are expected to be in a range of $88 million to $94 million. Similar to revenue, this will be the first quarter where we will have a full quarter of the Legacy Extreme and Legacy Enterasys combined into one entity. The GAAP expenses include the following items which are not included in our non-GAAP expenses: stock based compensation is targeted at $5.8, amortization of acquired intangibles targeted at $5.7 million.

On a non-GAAP basis, we see expenses increasing to between $75 million to $81 million. With R&D targeted to come in between $24 million and $25.5 million. Sales and marketing targeted to come in between $42 million and $43.5 million, and G&A targeted to come in between $9.5 and $10 million. Interest expense and other is targeted to be approximately $0.7 million. This includes the interest expense related to the debt incurred in relation to the acquisition. The all-in interest rate on the debt is approximately 3%. The tax expense is targeted to be approximately the same as last quarter at $0.9 million.

GAAP net income is targeted at a loss of $15 million to $20 million or $0.15 to $0.21 per share. Non-GAAP net income is targeted in a range of $0.5 million to $6 million or $0.01 to $0.06 per diluted share. The GAAP and non-GAAP net income targets are based on estimated $96 million, plus or minus, and $99 million, plus or minus, average shares respectively. Targeted non-GAAP earnings exclude expenses related to stock based compensation expense of $6.3 million.

The amortization of acquired intangibles of $9.7 million. Acquisition and integration expenses of $1.5 million. Step up value to fair value, acquired inventory of $2 million and the purchase accounting value related to the deferred service revenue of $2 million. When we look at the third fiscal quarter of 2013, and if the companies have been combined, the non-GAAP EPS would have been $0.01. At this point we are similar at the low end of the revenue guidance and expect to provide positive growth in earnings as our revenue increases.

Moving on to a bit more detail regarding the acquisition and expected synergies, we see cross selling already beginning, scale of the Company that will lead to reduced material costs that will show up in the P&L beginning in the fourth fiscal quarter, a reduction in operating expenses that will begin to show up in sales in the third fiscal quarter, marketing in the fourth fiscal quarter, and G&A in FY15. When we have fully integrated the two teams, we target to reduce combined material costs and operating expenses between $30 million to $40 million. The timing of synergies will begin to be seen in the financials in a small way this coming quarter and will hit full stride 12 months to 15 months from now.

At this point, this brings a close to our prepared remarks and we will open the call for questions. Nova, will you please start the polling?

Thank you.

(Operator Instructions)

Our first question is from the line of Mark Kelleher. Your line is open.

Great. Thanks for taking the question.

Just to pick up where your commentary left off there on the synergies, you talked about reduced material cost in Q4 and you also mentioned that you had supply chain cost reductions that were helping in the current quarter. So, could you talk about how that plays out and maybe talk a little bit more about what the limitations are on reducing the operating costs quicker?

Thanks.

Okay. On the COGS, where we are seeing the benefit is from the inventory. We have to roll all the inventory through that was on the balance sheet at the end of December for the quarter. As you saw 88 it days, so it's basically a quarter's worth of inventory.

We are seeing good cost reduction on the material side. We have been able to open up the bills and materials for both product lines, and where we have common parts we are able to get the lower price on both. So, we are seeing real good progress on that side, as well as incremental volume on our chip sets with Broadcom and the manufacturing costs with Alpha. So, we are seeing good efforts there.

We are also, now that the peak season finished on shipping, we are starting negotiations on freight, and we also starting some consolidation efforts in terms of our warehousing. So, that all takes a little bit of time. We saw a little bit last, or this quarter in terms of some of the prices that will roll through, but the big impact will really start to show up in the June quarter.

I will pass it to Chuck for the operating expenses.

Just to add to John's comment, remember we are integrating here two $300 million plus companies that had dissimilar business models on the supply chain side, as well as two different ERP systems. Legacy Extreme was on Oracle; we had just upgraded to Oracle 12. If you remember back a couple calls. And Legacy Enterasys was on SAP.

We expect to have that integration complete late summer early fall, but as anyone that has gone through that can tell you, it's a fairly monumental task. On our parts and logistic side, we are going to go from 95 total parts depots around the world to a number roughly equal to half of that.

So, we put it in place plans in relatively short order given, that we only closed this transaction three months ago to realize these benefits that as John points out it just takes a little more time. On the operating expense side, we are making progress, but we are being very mindful of commitments we've made to our customers not to disturb the product road map of either of the companies until we are ready to combine the product lines under a unified operating system, which as we've said from the beginning would be a 18 to 24 month effort. And we are also being very mindful not to disturb our ability to create and deliver on our revenue guidance.

So, we have started to make significant cuts, particularly in removing duplicative and very expensive senior management in the sales organization. We've got a similar move already in the marketing organization. I think you will see more of those synergies in this quarter and certainly next.

Okay. Just as a quick follow-up on the integration efforts. Can you tell us where you stand with the sales effort, getting each side to cross sell. Is that still in the early stages? How is that going?

I would say it's still in the early stages, although as I mentioned, there is a tremendous interest in the wireless product that we purchased as part of the acquisition of Enterasys, and we are putting a lot of focus on that, as I mentioned in the past, along with our data center business to drive revenue growth as we come out of FY14 at the end of June.

So, we are just starting to integrate the sales teams and generate cross selling opportunities across the product line, but I would say we are ahead of the curve, particularly on wireless right now.

Okay, great. Thanks.

Our next question comes from the line of Christian Schwab of Craig-Hallum Capital. Your line is open.

Great thank you.

As we look, I know we are only going one quarter at a time here, but as we look to the June quarter, it appears that their business experience is the same seasonality, seasonal strength as your business does. Would we expect that to be replicated again this year?

Hi, Christian, yes. Both have a significant concentration in the education market, which has their fiscal year on June 30th. In addition to that, it's the end of now the combined companies' fiscal year, which tend to drive sales performance towards quota accelerators and making their year-end number and club attendance and things like that. We would expect to see that now for the combined company, yes.

Great. On the $30 million to $40 million in cost synergies in, -- that we've outlined full stride 12 to 15 months from now, does that mean we wait three to four quarters for meaningful OpEx reductions, or does that mean 12 to 15 months from now we are well on our way to proof points of that $30 million to $40 million.

Remember the $30 million to $40 million contains two items; it contains the rationalization of our manufacturing network and our logistics network, which is a significant part of that. That should start to hit as we come into the first and second quarter of next fiscal year with some of it happening in the fourth quarter this year as John mentioned.

On the OpEx side we will see a little bit of it in this current quarter and that will ramp up each quarter over the next two to three or four quarters. The last place that we will see synergies is in R&D, for the reasons I have just mentioned.

Great. And then on a go forward basis, should we assume taxes remain at a similar levels as the last few quarters, or do you see any material changes in taxes as we go throughout time here.

I don't see much, because we are solely going to use the NOLs in the US. I would -- for your models I would plan $900,000 to a $1 million on a quarterly basis.

Excellent. No other questions. Thank you.

Our next question is from the line of Rohit Chopra of Wedbush Securities. Your line is open.

Thanks very much. A couple of questions, John, maybe I will start with North America.

You indicated it was tough. Some of the other companies who have reported indicated that they were seeing a pretty decent budget flush, and I think one of your large competitors actually had a good quarter in switching.

I just wanted to get a sense of what you saw in North America that made it tough. Was it more competition, or was it something in the sales force where you are making adjustments. And on the second question if you could talk a little bit about where you are with Lenovo today, and if there have been any discussions post what they are doing with IBM?

Yes let me grab that Ro, I think we are seeing in North America, it's a combination of things. We are seeing a tough market with delays in CapEx decisions. As John mentioned, we particularly saw that in the central region. I think for this, to keep this in perspective is, we have been in the middle of a turnaround of both our sales and marketing efforts at Legacy Extreme, and that was probably most pronounced -- the need for that was probably most pronounced in our North American organization.

And where our lack of demand generation, where the pretty significant headcount reductions we took back in November and February a year ago, over a year ago, are now having some impact on our revenue going forward. So, we saw tough market conditions, but we also saw the results of some of the issues in our sales and demand creation engine that I have been talking about almost literally since joining the company.

We see that getting dramatically better with a couple of things, the combination of the sales forces under the leadership of our now head of North American sales John Fabiaschi, who came from Enterasys with strong performance there. We should by the end of the quarter be integrated on to a unified automated marketing system as part of the launch of the new web site that I talked about, as well as have Enterasys line and sales force integrated on salesforce.com.

I think you will start to see improved performance there. But mostly what you are seeing there is tough market conditions, but also some self imposed issues that we have been working on and talking about for some time.

On Lenovo, frankly we are extremely excited about the prospects for Lenovo with their recent announcement of the acquisition of IBM's server business. This takes them from a 2% global market share player to a 14% global market share player, and we continue to be their only networking partner, and we will be now included in a price list shared by 1200 more sales people they are getting as part of the acquisition, assuming it stays on track and closes in 6 to 9 months and we just see this as tremendously positive.

That said, I would remind everybody that we have been saying that the ramp on this prior to this acquisition was going to be delivered, but slow and that we would not see results, significant results in this fiscal year, but at a fairly steep ramp once we left the fiscal year, and this just only makes that that much better in my opinion.

Can I ask a quick follow-up just on some other partners? We did talk about Aviat and some others, so just give us an update there and then maybe, John, if you just could talk about MSN and Siemens and their contribution in the quarter, were they total greater than 10%?

So, we really have four key partners, Lenovo and Ericsson, and you've seen Ericsson in the past be a 10% revenue contributor to the Extreme as a standalone company revenues. We continue to see strong performance from Ericsson and we have new opportunities at Ericsson that we can't talk about yet, but we think will make that relationship significantly larger, quite a bit larger than it has been in the past. Those will again kick in as we come into the next fiscal year.

Aviat is a small microwave backhaul vendor we are just starting to see a ramp in business with them. It will be, as I've said in the past, single digit millions. It will also absorb our router products, the E4G which we will get good marches on, because a lot of that has been inventoried for some time.

Again we just are starting to see the ramp in the SGI business, given the size of their business overall, again as we've said I think that's going to a be a single digit million per quarter opportunity as it ramps up. The two large ones are really Ericsson and Lenovo going forward.

Then Rohit to answer your question on that was directed towards Siemens, they've changed the name of their company. It's now called Unified. To be honest, the revenues out of there were are actually a little bit disappointing. They are not a 10% customer. They not even a 10% customer of the Legacy Enterasys.

They are going through a restructuring themselves. There is a little bit of chaos in their organization. But we do expect going forward for them to be a solid partner with us.

Their greatest contribution to Enterasys' revenue was in the EMEA region and the Latin American region despite the fairly significant downturn with now Unified, formerly SEN. Both of those regions were on target for the quarter. What we are seeing is them -- we are being able to take business that they would have picked up as a reseller and find other resellers to absorb that volume.

Okay.

Sir, this ends the Q & A session. I would like to turn the call back to Chuck Berger for closing remarks.

Thanks, everybody for joining us in this very early hour and on a snowy and icy New York City where we will be spending our day. I suspect many of you are as well.

As I said at the end of my comments, this is an extremely exciting time for us. We have an enormous amount of momentum as we've showed in the last couple of days with the Purview launch and rebranding of the company, and we look forward to next quarter's results and moving towards the guidance ranges that we gave you. Thanks.

Ladies and gentlemen, thank you for participating in today's program. This concludes the program. You may all disconnect.