Extreme Networks Inc (EXTR) 2015 Q4 法說會逐字稿

Good day everyone, and welcome to the Extreme Networks fourth quarter fiscal 2015 earnings results conference call. This call is being recorded. With us today from the Company is Ed Meyercord, the President and Chief Executive Officer, Ken Arola, the Chief Financial Officer, and Frank Yoshino, the Vice President of Treasury and Investor Relations. At this time I'd like to turn the call over to Frank. Please go ahead, sir.

Thank you Kevin. Welcome to Extreme Networks fourth quarter fiscal year 2015 earnings conference call. This call is being broadcast live over the Internet, is being recorded on behalf of the Company. Should you wish not to be recorded, please do not ask questions during the Q&A. The recording will be posted on Extreme Networks' website for replay shortly after the conclusion of the call. The presentations and the recording of this call are copyrighted property of the Company, and no other recording or reproduction is permitted unless authorized by the Company in writing. By now, you have had a chance to review the Company's earnings press release. For your convenience, a copy of the release and supporting financial materials are available on the Investor Relations section of the Company's website on ExtremeNetworks.com.

I'd like to remind you that during today's call management will be making forward-looking statements within the meaning of the Safe Harbor Provision of the Federal Securities Laws regarding business and financial outlook. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after the call. For a detailed description of these risks and uncertainties, please refer to our most recent report on Form 10-K filed with the SEC, as well as our most recent Form 10-Q filed with the SEC, in addition to our earnings release posted a few minutes ago on our website.

Throughout the conference call the company will reference some financial metrics that are derived in accordance with Generally Accepted Accounting Principles, or GAAP, while 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. Reconciliation of the non-GAAP information to corresponding GAAP measures is in our earnings press release issued today. In preparing non-GAAP information, the Company has excluded where applicable the impact of acquisition to integration costs, purchase accounting adjustments, amortization of acquired intangibles, and share based compensation. Now I'll turn the call over to Extreme President's and CEO, Ed Meyercord, for some opening comments.

Thanks Frank, and good morning everyone. Thank you for joining us on our call to discuss what turned out to be a very strong fourth quarter for Extreme. I will kick off with commentary on the quarter, talk about our solutions strategy, and our business outlook, then Ken will go through the numbers, and we'll open it up for Q&A. Let me start by saying how pleased I am with the solid execution by our leadership team, and all of the employees at Extreme, especially in light of the quick and decisive actions we took to streamline our organization in the middle of the quarter. We reduced our headcount by approximately 20%, generating $40 million in savings on an annualized basis.

Despite the distraction and expense of a significant force reduction, we grew our cash balance, and saw a strong rebound across our primary customer markets, and all geographies with the exception of Latin America. After a disappointing Q3, our Extreme team responded without missing a beat, with impressive growth in the US and Canada, led by strong sales in the education market, where we booked one of the largest deals in Company history, and the entertainment venue market, where we continue to grow our customer base, including the Ralph Williams Stadium, home of the Buffalo Bills. We now have over half of the NFL teams as customers. We also saw a nice recovery in our EMEA and APAC regions, driven by higher education and government spending. However, customers in these regions continue to experience purchasing constraints, due to a strong dollar in addition to the typical headwinds of pricing pressures and competition.

At Extreme, we have a clear vision of the networking industry and our competitive landscape. We believe that software will drive networking decisions in the future. Our customers want flexible operating systems, easy to use management tools, access control for Edge devices, and gateways to private and public cloud and network analytics. We have the software and we want to be a leader in software-driven networking solutions. This is why our go to market strategy is to sell solutions bundles, and this is why 90% of our engineering resources are currently developing software. Right now we are very focused on the tactical execution of this strategy. The good news for Extreme and our customers is that we have all of the component piece parts in our product portfolio, highly competitive wired and wireless networking hardware, along with our operating system, network management, access control, and analytic software.

We have more to offer our customers than traditional point product vendors, and a basis for a more productive dialogue around using customer networks as a strategic asset, in a gateway to cloud services in our target customer industries. The competitiveness of our product portfolio should strengthen when we add cloud managed networking capability along with our wave two wireless access points in calendar Q4, our fiscal Q2. The other advantage for us is that Extreme already has showcased accounts in our target customer markets in all geographies, who purchased and are using our software-driven networking solutions. So we have case studies and prototypes in education, entertainment, healthcare, and more around the globe. This means we are planning a very tactical game right now, focusing on making it easier for our sales teams to go to market, to sell our hardware and software networking components in a solution set, and making it easier for our worldwide sales teams to attack all customer markets in their respective geographies.

To date, the response to our new strategy from all of our market checks, customers, partners, employees, and industry analysts, has been overwhelmingly positive. We are entering fiscal 2016 on solid footing, with the completion of the realignment of our strategy, and a leaner expense structure. We've restructured sales to be more effective at the bottom of the pyramid, accounts of less than $65,000 are now handled by a revamped inside sales team. At the top of the pyramid we cover our large global strategic accounts and OEM partners with highly specialized and dedicated teams. This frees up our direct and channel sales teams to focus on our solution selling to targeted customer and targeted industries.

And while we focus on all of the tactical initiatives to make it easier for our sales teams to make this happen, we expect to benefit over at least the next 24 months from four tangible growth initiatives. First, E-Rate, there were over 90 million in E-Rate filings tied to Extreme, we began to see some early deployments in Q4, and expect the remaining backlog potentially positively impact fiscal 2016. In addition, we anticipate greater sales force participation, as well as greater wireless penetration in next year's program that will run through 2017. That said, we know that a certain portion of the funding requests will fall out due to incomplete or incorrect applications. In addition, only a fraction of the requests funded so far, we continue to lack the visibility to provide more detail around the timing and the total impact to our business in fiscal 2016.

Second is channel alignment. We've made tremendous progress with our channel partners and distributors. As we streamline our partners and push more business through higher value partners, they in turn are willing to contractually commit to deliver new revenue to Extreme. Our team has been very successful signing what we call our give to get contracts to deliver new revenue. We expect these to begin to take hold in our fiscal Q3. We believe this will have meaningful upside potential, but again, the timing and hard dollars are difficult for us to forecast at this time.

Third, Wi-Fi, AC wave two, we are on track to deliver new products for the wave two upgrade cycle. Our solutions-based approach is a great fit for wave two as customers will be looking to purchase both wired and wireless solutions, to take advantage of the increased bandwidth and performance. We intend to roll out our access points in calendar Q4 in time for the E-Rate selling season, and plan to follow this with new 2.5 gig and 5 gig access layer switches, when the chip sets become available in calendar Q1. We will expect to see sales from wave two begin to take hold in fiscal Q4 and our calendar Q2.

Lastly, we view our high touch customer service model as a competitive advantage. Most of our competitors outsource this function to third parties. Historically we have not properly incentivized sales nor inside service to sell service plans. As a result, we have several tactical opportunities to grow our service revenue from new sales, and from our existing base and service customers who are not on plan. As far as guidance, as many of you will remember, although Q1 is projected to be down sequentially, it is within our normal seasonality range, with the summer quarter typically getting off to a slower start with the 4th of July holiday, and Europe seeing a seasonally slower quarter.

Having said that, we do enter the quarter with a healthy backlog, and we know that we will have an E-Rate left despite the lack of visibility at this time. On a personal note, after being at the Company for 3.5 months, my confidence in Extreme continues to grow, and it's driven on three fronts. First, the quality of the products and our engineering, we know our products and solutions are high-performance and well engineered, especially when sophisticated technology companies like Intel, Microsoft, Oracle, Samsung, Ericsson, and many more, are actively buying Extreme gear. Two, the quality of customer relationships. Customers rely on our high touch customer service model. Customers like Galaxy Entertainment Group, the largest casino retail and hospitality venue in the world, or the NFL, or Volkswagen. I could go on and on with the logos. They value our relationships, product quality, and our service levels.

And finally, our people. Extreme has a high caliber team of professionals. They want to win, and the proof of our team's execution capability is evident in what was accomplished in Q4. I know this team is hyper focused on execution of all of the tactical initiatives that we have in place, to make our solutions portfolio easier to sell and easier to use, while taking advantage of E-Rate, the give to get relationships, the upcoming wave two replacement cycle, and wireless and our services opportunity. So with that, I'll turn it over to Ken for numbers.

Thanks Ed. Let's review the fourth quarter results, starting with revenue. Q4 GAAP revenue was $149.9 million, compared to $119.6 million in quarter three, and $155.3 million a year ago. Q4 non-GAAP revenue was $150.6 million, up 25% compared to $120.4 million in quarter three, and compares to $156.9 million in Q4 of last year. GAAP and non-GAAP product revenue was $116.3 million, up 34% compared to $86.5 million in quarter three, and $121.8 million in Q4 of last year. GAAP service revenue was $33.5 million, compared to $33.1 million in quarter three, and $33.5 million last year. Non-GAAP service revenue for quarter four was $34.3 million, compared to $33.8 million in quarter three, and $35.1 million in Q4 last year.

As mentioned, on a sequential basis, all geographies were up quarter over quarter except Latin America. With the geographical split of revenue as follows. North America revenues were 50% of total revenue, compared to 44% in quarter three, EMEA revenues were 37% of total revenue, compared to 40% in quarter three. Asia-Pacific revenues were 10% of total revenue, compared to 11% in quarter three. And Latin America revenues were 3% of total revenue, compared to 5% in quarter three.

Now moving on to gross margin and operating expenses. In Q4 GAAP gross margin was 50.9%, compared to 48.3% in quarter three, and 53.4% in Q4 of last year. Non-GAAP gross margin was 54.4%, and compares to 52.6% in quarter three, and 56.9% in Q4 last year. Sequentially gross margin benefited from the increase in revenues. Additionally, in Q3, we incurred significant E-node charges for legacy wireless products. Q4 GAAP operating expenses were $89.8 million, compared to $79 million in quarter three, and $96.4 million in Q4 of last year. Q4 non-GAAP operating expenses were $69.6 million, and compares to $68.9 million in quarter three, and $78.1 million in Q4 2014. Q4 GAAP operating expenses include restructuring charges of $9.8 million, and executive transition costs of approximately $2 million.

Additionally, the GAAP and non-GAAP sequential increase in operating expense was driven by higher sales commissions through the increased revenue, offset by a partial expense benefit realized in the quarter from the restructuring action taken in late May. Fourth quarter GAAP operating loss was $13.5 million, compared to a loss of $21.3 million in quarter three, and a loss of $13.4 million in Q4 of last year. Fourth quarter non-GAAP operating income was $12.3 million, compared to an operating loss of $5.6 million in quarter three, and an operating income of $11.2 million in Q4 last year. GAAP net loss for quarter four was $15.7 million, or $0.16 per share, compared to a net loss of $23.5 million, or $0.24 per share in quarter three, and a net loss of $16.2 million, or $0.17 per share in quarter four of last year. Non-GAAP net income for the quarter was $10.1 million, or $0.10 per diluted share, and compares to a net loss of $7.8 million, or $0.08 per share in quarter three, and net income of $8.5 million, or $0.09 per diluted share in Q4 2014.

On a full year GAAP basis for fiscal 2015, revenue was $552.9 million. Gross margin was 50.6%. Operating loss was $63 million. And EPS was a net loss of $0.72 per share. On a full year non-GAAP basis for fiscal 2015, revenues were $556 million, gross margin was 54.3%, operating income was $14.5 million, and earnings per share was $0.06 per diluted share. Now turning to the balance sheet, Q4 total cash, cash equivalents, short-term investments and marketable securities were $76.2 million, compared to $75.6 million at the end of last quarter. Ending Q4 with cash up following weaker revenue in Q3 was a substantial achievement, driven by our focus on managing the supply chain, coupled with effective channel management and timely collections.

In the quarter cash flow from operations was $3.9 million compared to cash flow used in operations of $8 million in quarter three, and cash flow from operations of $3.8 million a year ago. For the full year, our cash flow from operations was $37.4 million, up from cash flow used in operations of $26.8 million last fiscal year. Accounts Receivable were $92.7 million at the end of quarter four, up $14 million from last quarter as a result of higher revenues, with DSOs decreased to 56 days this quarter from 59 in quarter three. Inventory ended at $58 million, down $8.8 million from last quarter. This decrease was driven by higher revenues and focused supply chain management. Total debt outstanding at the end of quarter four was $66.9 million. During the quarter we amended our debt agreement to exclude restructuring and executive transition costs from the covenant calculations. We were in compliance with all bank debt covenants at the end of the quarter.

Now let's move on to guidance for quarter one. On a sequential basis, our fiscal Q1 is generally a down quarter, and we anticipate we will experience a similar theme this Q1. Offset somewhat by a favorable impact from E-Rate funded deals. With that, we expect Q1 GAAP revenue to be in a range of $119.6 million to $129.6 million, and non-GAAP revenue to be in a range of $120 million to $130 million. Gross margin is expected to be comparable to Q4, with GAAP gross margin anticipated to be in a range of 49.5% to 51%, and non-GAAP gross margin anticipated to be in a range of 54% to 55%. Operating expenses are expected to be in a range of $72.5 million to $75 million on a GAAP basis, and $62.5 million to $65 million on a non-GAAP basis. This range of operating expense reflects approximately 90% of the cost savings from the restructuring actions taken in late May. We expect to realize the full benefit in the December quarter.

Tax expense is expected to be consistent with the Q4 levels. GAAP net loss is expected to be in a range of $10.5 million to $15 million, or a negative $0.11 to $0.15 per share, with non-GAAP net income expected to be in a range of $750,000 to $5 million, or $0.01 per share to $0.05 per share. The average shares outstanding are expected to be 102 million on a GAAP basis, and 104 million shares on a non-GAAP basis. Now I'll open the call to questions.

(Operator Instructions). Our first question comes from Mark Kelleher with DA Davidson.

Great. Thanks for your taking the questions. Congratulations on a nice turnaround there. 20% headcount reduction in the quarter, can you give us some insight into where those, what functions those people were in that you let go?

Sure. If you look at the overall cost savings, Mark, that we indicated was going to be $40 million annually, and most of that is coming out of head count, some out of expenses, but again predominantly headcount, if I take that $40 million, about 10% comes out of cost of goods sold with manufacturing operations and services, about 20% comes out of R&D, sales and marketing is close to 60% of the reduction, and G&A about 12% to 13% of the reduction. So that's how that $40 million annually breaks out.

Mark, I would add one point, Mark, is that we didn't touch service. Our high touch service is very important to us and our customers. And we felt that was an area that we needed to leave intact. And so I should make it a point that wasn't touched.

Okay. And you mentioned a large deal in education. Were there any 10% customers in the quarter?

No, there were no 10% customers, but it was a very significant deal, the biggest one the Company's had. High single digits, I think.

Okay. And then my last question is just on the general strategy of your bundling. You've gone out to your customers and your sales force has been out there. Is this being generally well received, does this look like it's going to work?

It's being very well received. Our customers, in making networking decisions, are really starting to look towards software, and it's more about how are they managing the network, how are they managing access on and off the network as far as devices, how are they managing access to applications, how are they evaluating users on the network, and application usage and application performance. So what we're seeing is that the market is moving more and more towards software, and the fact that we have the software elements in our offering, we think is a big advantage. And so I think it creates an opportunity for our sales force to have a higher quality dialogue and discussion with our customers, and it's more strategic, and when we get a sale, in addition to the software, it will pull along the hardware elements as far as wired switches and wireless infrastructure.

Okay. Great. Thanks.

Our next question comes from Matt Robison with Wunderlich.

Thanks for taking the question. Ed, can you give me a little sense of what gives you the confidence that E-Rate is going to be another strong contributor in fiscal 2017, and can you give us a little color on education, and K through 12 I guess particularly, as a contributor to sales, and if there was any prior categories that were particularly helpful for the good execution you demonstrated?

Okay. Let me start off with E-Rate and fiscal 2017. A couple of data points. Only 25% of our North American sales force participated in the E-Rate program, and obviously with the success we've had this past year, we're expecting a much greater participation rate and greater coverage throughout the country. So from that standpoint, we'll have more people on it. The other thing that was interesting is that most of our E-Rate sales were wired switches. And we've been focusing on wireless and building out our wireless solutions platform. We will be prepared for AC wave two, which will come out in Q4. We're going to hit that right at a peak E-Rate selling season, and then we'll have the access layer switch in calendar Q1, so that as E-Rate dealings get funded, we'll be there for wave two, which we think is going to be a big selling point as it relates to E-Rate. So I would say the combination of adding wireless to our solutions portfolio, and increasing the participation rate of our sales force in the program, in terms of schools gives us confidence that we should see this continue and have a very strong fiscal 2017 with E-Rate.

So you don't have any particular insights into government commitments, and how firm they are?

No, we don't have any particular color on that. But our understanding is that this is a program that's going to run again through fiscal, that will run through our fiscal 2017, into calendar 2016.

And so on the mix questions and then you touched a little bit on the context of E-Rate on the strength of the wired switching, maybe a little bit more color on if there's any details on the products that helped your execution? And before I yield the floor, also, just great to hear that you're on track with timely wave two activity.

Okay. Great, as far as the products, and he will in Q4 there really wasn't much of a mix change. I would say that the product mix across our portfolio was very consistent with previous quarters. We did see a dip in wireless in our fiscal Q3, and so we saw wireless rebound and come back. We are expecting to see a lot more wireless in the future, and the adoption of our solutions-based strategy, it was going to take some time to kick in, and we really didn't see that in our fourth quarter. So I would just say mix was very consistent. The other question that you asked as it relates to K through 12 schools, obviously E-Rate is helping that customer group. And so we're expecting that to continue to be an important part of our sales efforts this year and through next year.

Thanks.

Our next question comes from Alex Henderson with Needham.

Thanks. I was hoping you could go through a couple of things with me. First, you have $90 million worth of E-Rate indicated. Can you talk about what portion of that is cannibalizing, business you would have had otherwise to help us get a gauge of what the incremental nut is? And then second, can you talk a little bit about the timeline for that disposition of those revenues? Will most of that $90 million lend by the end of fiscal 2016?

So a couple things here. This is Ken, Alex. If you think about the $90 million of E-Rate funding that we've been named on as Ed alluded to on the call, there will be some fallout on that with application process, et cetera. So it will be something less than that. We've kind of sized it internally but it's a range, a pretty wide range here and it's early in the process, I think, with only about 20% roughly of overall funding being made so far, I think all companies, ourselves included as well as some of our competitors, are being a little bit cautious on what we think the number is going to be for the year, because it's so early. But with that said, I mean, timing for us, we saw some of it in quarter four, as Ed mentioned. We'll certainly see some of it in quarter one. And that will probably more significantly as we move beyond quarter one, as funds start getting released.

If you think about our K through 12 business, I believe this is off the top of my head, and I might have to refine it a bit, about roughly about $40 million to $45 million of our business last year was K through 12 business, so the question for us as we're thinking about this is how much of that E-Rate cannibalized that K through 12 business of last year, and how much of it is incremental. So if you take $90 million of deals, and you waterfall that down and pick a number, $50 million, $60 million of E-Rate business that we could potentially see, and these are rough numbers here, how much is that going to cannibalize what we currently have, versus what we've done in the past, and that's something we've been trying to size ourselves. It's really tough. But how much of that $40 million goes away and gets replaced by E-Rate is the question we are asking ourselves internally. That's not a perfect answer but hopefully that gives you the size of what we are thinking about.

So would it be reasonable to think that if your net E-Rate out of the $90 million is $50 million to $60 million, that it could be $10 million or $15 million worth of cannibalization in that?

I think that's a possibility, $15 million to $20 million possibly.

Okay. That's helpful. Thank you. Can you talk a little bit about the data center business, what's going on with it? You've launched a couple products over the last 18 months into that space. You've got some initiatives to push it. Is it still fairly flat? Have you started to see any pickup? That is an area that theoretically should have growth.

Yes, we are seeing, I would say that sales have been consistent with data center. I don't think, as far as in terms of our mix, if we break out data center, enterprise, wireless, our mix has been very steady and very consistent. So we're not seeing an uplift in either one of those. As we go forward, and we're talking about solution selling, that kind of categorization becomes more difficult, because if we have a customer that's buying, they're buying pick switches that they could use as a top of rack switch in a data center, they could use in a distribution closet, distribution point in the network, they could use, so they have wireless/wired infrastructure, they're using a data center and they are an enterprise, then the question is how do we look at that segment, how do we look at that customer. So as we go forward, we're going to start looking more and more at our customers, and driving customer revenue, as opposed to the traditional segmentation of the market.

If I answered that, Alex, one of the things that we've been lacking in our product portfolio is supporting DX LAN, so that's on the road map to be delivered before the calendar year end here, so with that, I think that opens up the door for different conversations, with customers like Ericsson and others.

How would you characterize the pricing environment in wireless, as well as in switching space at this juncture? Any change in the competitive dynamics?

No, we're not seeing any change in the competitive dynamic.

Okay. And then if I were to look at the guidance that you gave for the September quarter, kind of essentially a flat year-over-year number, is that the right way to be thinking about the full year, or should we be expecting the solution-based selling to actually get to turn up on a year-over-year growth basis over the course of the year?

Before I answer the question, one of the things to just keep in mind, Alex, is the seasonality of our business, typically Q1 is a down quarter, Q3 is a down quarter, as Ed alluded to with some of the give to gets that we're looking at could start kicking in in Q3, a little bit difficult to size right now. But I think we'll see that typical kind of seasonality in the business. And then with solutions selling, I think we are at the forefront to that, I think that will start moving in the right direction. How much that impacts this fiscal year's revenues versus next fiscal year's revenue I think is a big question right now.

Just to rephrase the question, so the September quarter is kind of at flat year-over-year number, that takes into account the seasonality. Should we be expecting flattish revenues for the year? Is that reasonable to think? Or can you get growth this year, or are we still looking at some erosion and contraction on a full year basis?

Yes, Alex, let me say that internally we're driving the Company for growth. Obviously that's what we're driving for. And we have what we would perceive to be a lot of low hanging fruit, in terms of tactical initiatives across the board, and then we have some favorable air cover from E-Rate, the realignment of our distribution and our partner channels. And then as far as the solutions selling piece, there are a lot of tactical initiatives inside the Company that make it easier for our sales teams to position and sell, which is a big opportunity, and also a lot of our salespeople have been concentrated on single verticals in their geographies, and so the other thing that we're doing is expanding the customer markets that they're going after. So if we have a sales team that's gone after education, we want to make it easier for them to go after healthcare or manufacturing or government accounts. So there's both the expansion of our product portfolio that we're driving with many initiatives, and then it's also the expansion of the customer markets that we want to cover in our specific geographies. And it's a tactical game for us right now. We have all of the products. It's just a question of making it easier to sell and position, there's training, there's new incentives that have been put in place. There's a lot happening inside the Company to drive this. At this stage of the game, we're not at a point where we can give concrete metrics as to exactly how it's going to play out. So maybe we're being a little gun-shy in terms of how we want to guide that.

Okay. One last question and I'll cede the floor. The guidance for the September quarter, historically you guys have had strong June quarters and often beaten in June quarters, but then promptly miss September quarters. Have you taken a highly conservative approach to this September quarter, to make sure that you properly adjusted for that potential seasonal challenge that you have every September quarter? I mean, should we consider this to be a conservative expectation, and built into this guide?

I'll make a comment and then I'll let Ken make a comment. One of the things that I wanted to do when I first came to the Company is to position Extreme to win, and by winning, winning means beating. And we did that. And we have a quarter on the board where we won. And everyone here is very well aware of the fact that points doesn't mean much, but that we need to have two points to make a line, and then we have three points and we have a trend, so what we've been very focused on doing is setting expectations where we position this Company to win. And that's how we're guiding.

Yes, if I add to that, Alex, I guess I'd use the word prudent in thinking about our revenue trajectory for Q1 here. Looking back, again going back to seasonality in the business Q4 to Q1, capturing that here, understanding exchange rates and how it impacts customers' buying decisions, especially in Europe where it slows down their buying decisions, in the decrease of their budgets that they have available to them, so we've taken all of that into account. The impact that we expect to see from E-Rate, all of those kind of things built into what we're looking at our range of $120 million to $130 million, so I guess I'd sum it up again as prudent in thinking about that range.

Thank you very much. I appreciate the prudent guide and the commentary around it.

Okay. Thanks, Alex.

Our next question comes from Simon Leopold of Raymond James.

Great. Thanks for taking my question. So first off, strong upside to this June result. I'd like to understand your thinking in terms of the fact you did not have a positive pre-announcement when you seemingly could have. So just a little bit of thought about that, why you chose not to make a positive pre-announcement on this quarter?

The answer there is pretty simple we're trying to get out of the pre-announcement business. Pre-announcements create too much volatility. I know that's my view. And it's not just me, it's the whole team over here. And I guess we probably could have if wanted to come out with a pre-announcement, but there was no legal requirement on our end. And given the fact that there wasn't a legal requirement, given the fact that we want to get out of the drama of pre-announcements and excess disclosure, we're trying to get back to business as usual, and as I said earlier, we want to win. And we want to keep it simple, and eliminate some of the drama around Extreme, and the resulting volatility in the stock.

So if we think about the upside in this quarter, clearly some of it surprised you versus your initial forecast. What would you categorize as the biggest surprises versus your original forecast for sales for the quarter?

Yes, so I would say some of the early activity around E-rate, we mentioned a large high single-digit account win that we had that came in. Again, this is a solutions sell. But that was something that came in earlier than anticipated, and had an impact. But other than that, we saw a rebound across the board. And we mentioned Latin America, there was the strong results offset, it was a difficult quarter for us in Lat Am, and we have opportunities for that to come back and we're rehiring there, and that was part of our restructuring. So there are a lot of, as in every quarter, there's always moving pieces, there's puts and takes. I think there's really only one item to point to other than kind of normal puts and takes coming out of the business, which would be the strength of that early E-Rate business that we saw coming in, mitigated by the offset of unusual weakness in Latin America.

And the degree of upside to gross margin was, let's say, more modest than revenue or earnings, which were way ahead of expectations. So not a lot of leverage in gross margins here. Is this reflective of mix issues or something else? Can you help us understand what gross margins didn't get more leverage in this June quarter?

So if you think about the product versus services, product we saw a reasonably night uplift in overall gross margins from that perspective. If Q3 we had some excess and obsolete reserves we took against legacy product, and then so in quarter four the revenue trajectory, the increase in revenues and lower amounts of E&O improved gross margins on product. On the service side of the business, it had an impact, a negative impact on gross margins temporarily for the fourth quarter and that was because we were in the process of restocking service depots around the world, and we had additional logistics and freight costs in doing that for the quarter, so that dropped our service margins a bit in quarter four. And as we move into now in quarter one, I'd anticipate our margins on products to be relatively consistent depending on this trend that continues to on in the marketplace, and then service margins come back a bit, now that we've got most of that depot stocking completed.

Great. That's helpful. And you've alluded to a couple of elements that should affect the December quarter, the fourth calendar quarter, particularly some of the E-Rate and wireless LAN cycles, and I'm just wondering, should we be thinking about December as a quarter where you probably will do better than your historic seasonality? How should we kind of think about that, at least directionally and relative to seasonal patterns?

Well, yes, we wish we had more visibility and we could give you more visibility on E-Rate, but we just don't. So how that lands this quarter and then the following quarter, it's hard for us to guide you on that. As far as the next wave, as far as the replacement cycle in wave two, we don't expect that to affect revenue greatly in the December quarter. That's going to be more in the second half of the year, and probably most likely in the fourth quarter where we'll see meaningful revenue associated with the access points, as well as the access layer switches which will come out in the first quarter. The other piece that we haven't touched on, talking about services but we believe we have real service opportunities when we benchmark ourselves against the industry, and look at attach rates on the sale side, when we look at accounts that are calling in for service regularly that aren't being billed for service, we know we have an opportunity there. And obviously the marginal profitability of adding those customers, having higher attach rates is something that will be beneficial to the gross margin, but also should generate some incremental revenue for us.

That's helpful.

Okay.

One last one. Are you able to quantify at all what the effect was on a year-over-year comparison, in terms of the foreign exchange impact? Is that something you can quantify?

It's a little bit difficult to quantify, actually, Simon. Most of our business in Europe in particular is done in US dollars, so from an FX point of view, there's less of an impact there. What it really does is slow down the purchasing cycles of customers in Europe, as their budgets are more constrained now. With that said, it's difficult to understand how much they've pulled back on purchasing because of the FX rates. We do know it has an impact, though. But it's hard to size.

Great. Appreciate you taking my questions.

Thanks, Simon.

Our next question comes from Christian Schwab with Craig-Hallum Capital Group.

Congratulations guys on a fabulous quarter. On your service attachment rate, we kind of at least we have in our previous notes probably about a 30% service attachment rate currently. What do you think over the next two years that can improve to? What is the internal goal?

Well, what we hear about the industry is that a service attach rate in the industry is probably closer to the 60%, 70% range, so then the question is, how do we drive that, and a lot of it is tactical. One of the things that we weren't doing is, for example retiring quota with service plans. Our sales teams obviously are going to be a lot more motivated to sell service if it's retiring quota, and also adding incentives for that. So if we look at 60% to 70% as an industry number, and if historically we've been kind of in that mid 20% to 30% range --

Low 20s, 20%, 25%.

Yes, that range, then you could see a pretty good opportunity on a go-forward basis, and also if you look back and say, what about those base of customers that you missed, and that's the other opportunity, for us to go back and charge those customers who are using our service, but we haven't been billing for that. So these are part of the, there's a ton of tactical activity happening inside the company and we're driving a very, very clear focus on execution around, really around all of these initiatives that we're talking about.

As you realigned your management team around you, as far as a CTO and services and sales and marketing, I'm sure all four performed well for you in this outperformance, but do you think a big part of that was finally having one marketing team inside the Company versus various companies working at all kinds of different directions, and some of the customer confusion that we had picked up previously in our checks around Enterasys support, et cetera, it certainly seems if there is no longer any confusion there. Is that fair?

Yes, I think that's fair. I mean I stepped off the Board and one of the questions I always had on the Board was, it seemed if both companies, Enterasys and Extreme have been very high quality engineering departments, and very focused on engineering, and I think with hiring decisions that have been made over the year, I'm not sure it was carefully thought out exactly where different functional departments landed, but we wound up with service reporting to engineering. We wound up with product line marketing reporting to engineering. And there are a lot of potential conflicts of interest with that kind of a structure. And to me it seemed very clear that to create a customer facing, customer focused organization, you've got to pull those functions out. And so we created a layer where we have worldwide sales and services, one department very focused, so you have one group effectively that's touching our partners and our customers, and then right next to that we have a separate marketing department that is acting like a funnel, where you're taking many points of customer communications, and then funneling that down into the engineering department to streamline our product road map to be very focused with our product road map.

So I think we're just getting going with this but I think it's going to provide a lot more clarity. Also going to help us drive sales. And I think the feedback to engineering is going to be of much higher quality, because it's coming from a unified customer front with sales and services. And the consolidation of the marketing groups together where we have one marketing voice, one consistent message, I think it's going to make a big deal. And it's part of making our Company a customer-focused company, which ultimately will help Extreme.

Great. I think previously you had somewhere near in the channel, over 2,000 different partners, but 10% of them driving 90% of the revenue. So some of this channel opportunity realignment that you've talked to in greater focus, can you just walk us through, it seems like that might be one of your biggest opportunities of your four growth drivers?

Well, I think if you look at our partners, it was very much of a grab, it is a long tail grab, and so you're right in pointing out that 10% of our partners generate 90% of the revenue. And then there this really long tail of partners that are out there. We hired, we brought in Bob Gault to run channels for us, and he had run a big business at Cisco, doing this. He has brought in a team of A level players that really understand this market well. And when they got to Extreme, again, it's a low-hanging fruit situation where they say, oh my gosh, there's all of these opportunities to streamline and consolidate how we're going to market with our partners and our distributors. And they have been very active and very successful in the early stages here.

And it enhances our partner relationships with our most important partners, it gives us focus and it gives us opportunity, as we mentioned before, a lot of these partners are willing to sign contracts with us committing to delivering us revenue. So to the extent that we push revenue their way, in turn they'll commit to bringing us new revenue. And that creates yet another growth opportunity for us, the timing of which again, we don't know how to project that. We don't want to give metrics where you build that into a model. We want to see how this plays out. But we do know that the relationships are strong, and that the numbers could be material down the road, but we expect these things to kick in Q3, which would be nice, during our seasonally weak quarter, and in Q4.

Great. No other questions. Thank you.

Thanks, Christian.

Thanks, Christian.

Our next question comes from Rohit Chopra with Buckingham Research.

I had a couple questions and a clarification, if you don't mind. Ed, as the focus continues to be on software, I think you mentioned most of your resources are now focused on software, when do you expect maybe gross margin to start moving beyond the mid 50s, and start to tick up a little bit as that solution sale and the focus on software starts to kick in? That's the first question. The second one was on the Latin America transition, I think you're going from direct to indirect. I want to when, or how long that actually takes, to get through that transition when Latin America may become a driver again. And the last, it's really just a clarification, and it's for Ken. On excess and obsolete, how much did that actually benefit gross margin?

Just real quickly, I would say that benefited gross margin a couple points on a quarter-over-quarter basis.

Thank you.

Yes, so in reverse order, as far as LATAM, we're projecting a stable first quarter, as it relates to Q4 to Q1 sequential growth or activity, with some potential upside. There are a couple of large deals down there, where we have opportunities. We put Latin America under the leadership of our North America team. We have very strong leadership in North America. The execution in Q4 was very strong for North America, where the North America sales grew year-over-year outright. And the leadership team is excited, and we're in active dialogue as far as replacing leadership down in Latin America, and we think there are a lot of opportunities given our historical presence there, as well as the caliber of the people that we can bring on, and their knowledge of our product portfolio. As far as the gross margin, I think it is hard, this is another area where it's hard for us to project this. The software for us is a very small percentage of our revenue today, and we are in, one of our tactical items is around pricing, and how are we pricing these services. You're right, as we sell more software in the bundle, we should see higher margins, and that's how we're building our pricing, but at this stage, I would say it's almost too early for us to tell you, to give you an answer on that. I would say if we're successful in adding service revenue, then that service revenue is going to be a margin driver, because of the marginal profitability. We already have all of the expense; it's just a question of billing and getting the revenue for it, so the marginal profitability will be extremely high, and could be a contributor to higher gross margins.

I appreciate it. Thanks very much and good luck.

Thanks.

Our next question comes from Matt Robison of Wunderlich.

Thanks for the follow-up. On this give to get concept with distribution, just maybe help understand the deferred revenue of portions for distributor revenue, and if that's been on a pretty significant sequential upward trend, and it's pretty big year-over-year growth in that, is there any linkage there? Can you talk a little bit about how that might grow your business channels?

There's not a specific linkage on deferrals of revenue with give to get. The deferrals revenue depend on the revenue that you're getting, of course, if you want to make a linkage, that is what it is. If we're doing a give to get with a distributor, and we give them, push X amount of business towards them and we get something back in return for that, that incremental revenue will have the associated deferrals with it, but no different than any normal business we would have. There are no deferrals that you get directly from a give to get.

So this is just reflecting a greater portion of your revenue going indirect versus direct?

Correct, or else going to other customers or distributors that you consolidate.

Thanks.

I'm not showing any further questions at this time. I'd like to turn the call back over to our host.

Okay. Well, I'll just make a closing comment to say that it was obviously a very strong quarter for us. It did come in better than we expected. And I'll just reiterate the fact that inside of Extreme, we are extremely tactical right now, and very, very focused on what we perceive to be a lot of opportunities. We realize we're not giving specific guidance, and it's going to be difficult to plug in the models, exactly how to build the revenue case here, but as we go forward, we're going to be looking more and more at customers, and how the customers relate to solutions, and the confidence of our team, and my confidence comes from all of the opportunities that we see around tactical execution, which will drive improvements in how we run the business. So we appreciate your participation in the call, all the great questions, and we'll look forward to circling back at the end of Q1.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.