Extreme Networks Inc (EXTR) 2016 Q4 法說會逐字稿

Good afternoon and welcome to the Extreme Networks fourth-quarter and fiscal year 2016 earnings results conference call. This call is being recorded.

With us today from the Company is Ed Meyercord, the President and Chief Executive Officer; Drew Davies, the Executive Vice President, Finance and Chief Financial Officer; and Frank Yoshino, the Vice President of Treasury and Investor Relations. At this time I would like to turn the call over to Frank. Please go ahead.

Thank you, Sally, and welcome to Extreme Networks fourth-quarter and fiscal year-end 2016 earnings conference call. This conference call is being broadcast live over the internet and is being recorded on behalf of the Company. 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. I would 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. These forward-looking statements involve a number of risks and uncertainties, which could cause actual results to differ materially from those anticipated by these statements. For a detailed description of these risks and uncertainties please refer to our most recent reports on Form 10-K, Form 10-Q, and 8-K filed with the SEC.

You should not place undue reliance on forward-looking statements which speak only as of today. We undertake no obligation to update these statements after the call.

Throughout this call, the Company we will be referencing both GAAP and non-GAAP financial results. Non-GAAP information should be considered a supplement to and not a substitute for financial statements prepared in accordance with GAAP. Reconciliation of non-GAAP to the corresponding GAAP measures is in our earnings press release issued today. For your convenience, a copy of the release and supporting financial materials are available on the Investor Relations section of the Company's website at extremenetworks.com.

Now, I would like to turn over the call to Extreme's President and CEO, Ed Meyercord, for some opening comments.

Thank you, Frank, and thank you all for joining us this afternoon.

I'm pleased to announce that we closed fiscal 2016 on a strong note. We reported solid fourth-quarter results in line with our guidance at $0.10 per share, despite the macro headwinds affecting the networking industry.

For the fifth consecutive quarter we delivered earnings that met or exceeded our guidance. We drove operating efficiencies that generated significantly higher cash flow and closed out the year with a much stronger balance sheet. One number that underscores our progress turning around Extreme is our full-year net income which was up more than four times our fiscal 2015 number.

This year we elevated our position in the enterprise campus market. We deliver highly competitive, software-driven networking solutions that address campus mobility, BYOD, the Internet of Things, at the edge of the network and private clouds and the rapidly emerging hybrid cloud data center environment.

We deliver multi-vendor, easy to deploy and cost effective software tools that provide complete visibility and control of devices and applications that run on networks. Our wired and wireless end-to-end solutions give us a competitive advantage.

Net/net, our team has executed on our strategy and executing on our operating plan. We're seeing the results of our focus on targeted verticals that make up the $8 billion of our $34 billion industry. We're making concentrated investments to drive our field teams and our partners' success.

We have 2.5 times the number of new products and software releases coming to market this fiscal year. When you combine this with the strength of the pipeline rolled up from our global sales teams, we are confident in forecasting 2% to 4% annual revenue growth for fiscal 2017. And we believe this is a good step toward achieving our long-term target of 10%-plus organic top-line growth.

Now I'd like to dive deeper into some of the factors driving our positive outlook. The first is Extreme's customer intimacy and value proposition that define our brand, the performance of our wired and wireless products' visibility and control through our single pane of glass and our top-ranked, 100% in-sourced customer service. Our existing customers are our strongest reference base and our largest source of revenue.

The second factor is our focus on the midlevel enterprise campus, where we have competitive advantages such as quality, performance, service, and price versus larger players such as Cisco and HP who rely on partners to address customer needs in this market segment. We're the only player solely focused on the midlevel enterprise campus. It's a big opportunity.

Another success factor is how we are selling -- leading with wireless, leading with software, leading with security, policy, access control, and analytics. Our investment in training to lead with wireless and software solutions is clearly paying off. In fiscal 2015, 30% of our teams sold wireless. In fiscal 2016 100% of our SEs were certified and 100% of our AEs sold wireless.

In year-over-year comparisons versus fiscal 2015, wireless sales were up 1% in the first half of the year, up 20% in the second half of the year, and up 29% in Q4. And in fiscal 2016 we more than doubled the volume of solution sales from 5% to 12% year over year. We expect this to contribute to our forecasted increase in gross margins.

In addition, we are building a vertical marketing platform to support sales to enterprise customers in education, government, healthcare, manufacturing, and hospitality public venue, our five target verticals. We've hired industry-expert teams in sales and marketing to expand the scope and scale of our solutions offerings.

We've doubled our investment in lead-generating sales reps. We launched an exciting new channel program that generously rewards new logo wins and best-in-industry incentives. We just rolled out a game-changing app called E-360 at our global sales kickoff meeting last week that stole the show. It's an exciting new interactive way to share content and information with our global field teams.

Finally, we are much more nimble in response to our customers than our larger competitors. We launched our Cloud Management 1.0 within six months last January. We released Cloud 2.0 just a few weeks ago. It is much easier to configure and deploy and has stronger security controls versus our competitors -- so much so, that our field dubbed it a Meraki killer. Where customers with names like UNICEF and Technicolor made on the spot purchases. We expanded our professional services resources and we introduced managed service offerings. And we're offering CPE as a service in a flexible OpEx consumption model.

Now, let me take a few minutes to review some financial highlights. We reported revenue of $140 million in fiscal Q4, our strongest revenue quarter of the past fiscal year. It's up 12% sequentially. The year-over-year decline was projected to unusually high revenue in Q4 2015 that included one of the largest orders in Company history.

In addition, we overcame well publicized macro economic headwinds, including EU uncertainty with Brexit, the coup attempt in Turkey, and impeachment in Brazil. These events weakened local currencies relative to the dollar and in some cases froze spending. We believe we will manage through this, and the softer E-Rate season in our fiscal Q1 and revenue growth will begin to accelerate in the December quarter on a year-over-year basis.

We drove 15% growth in sales productivity last year and we're beginning fiscal 2017 with the same sales headcount. We will add an additional 5% to our direct sales force throughout the year and expect that to contribute 1% to 2% growth, given the six- to nine-month ramp required in our business. We also expect another 1% to 2% growth from sales productivity resulting from solution selling gains, wireless sales, new product introductions, and our marketing platform investment.

Revenue in Q4 was driven by several large wireless- and software-driven solutions deals in all of our targeted industry verticals, especially education and healthcare. The largest sequential growth from Q3 came from our North America, Germany, and West European markets. We also saw growth in APAC and stable results in LatAm as our new leadership teams are showing steady progress.

Here are some examples of recent enterprise campus customer wins. In education, our largest vertical, we won the State of West Virginia K-12 education business, opening 60% of their schools in over 55 counties. We took out Aruba, because the State wanted centralized management and control over each county's system. They needed standard policies to manage student devices in their BYOD environment. And they selected ExtremeAnalytics to provide network usage and performance benchmarking across the State.

We also won Nazareth College in Upstate New York. This was an existing Maru Fortinet wireless customer, with former Enterasys wired switches. They have limited IT resources and were being challenged by the Internet of Things and a barrage of student devices with limited network visibility, a perfect candidate to move to a single network vendor with our ExtremeManagement. Now we have superior network performance, complete network visibility, and control over all devices and applications running on their network.

In healthcare, Charleston Area Medical Center wanted voice-grade applications to run over WiFi in connection with their electronic medical records system upgrade to Cerner. Extreme delivered with voice-grade Wave 2 and our ExtremeManagement control and analytics suite saved them a huge amount of time detecting and locating equipment in connection with their Cerner upgrade.

This was very similar to a story in the UK with Basildon and Thurrock University Hospital in Essex, part of the NHS Trust. They were going through a major change from a paper-based patient administrative system toward a digital healthcare record platform. They needed visibility and control from the patient bedside at the edge, to electronic health records at the core of the network. We replaced HP Aruba with our single-pane-of-glass visibility and control over the entire network end to end.

Basildon and Thurrock joins 35 other NHS Trust hospitals that rely on Extreme Solutions. We have 24% share of the NHS acute care facilities in the UK.

We have similar stories in government, like with our recent win at McCarran International Airport in Las Vegas, where we beat out HP Aruba, and the Foreign Affairs Ministry in Germany that provides networking for all of their embassies worldwide. And the same is true in manufacturing, with wins around the globe.

And in our stadium/public venue vertical we deployed the first Wave 2 WiFi system in an arena in the US, with the Buffalo Sabres, following our success at the Buffalo Bills stadium. With ExtremeAnalytics, team owners and staff can understand user engagement, improve user experience, optimize application performance, and detect malicious application use. This is why Extreme is the leader in this vertical, as evidenced by our exclusive relationship with the NFL.

Back to the P&L. We are improving our gross margins. In Q4 our gross margins came in at 54.8%, which was near the high end of our guidance and a full percentage point above fiscal Q2 and Q3 levels. We will capture higher gross margins by executing on our solutions selling strategy and by driving operating improvements. Most software-driven solutions drive larger deals with higher margins, so growth in solutions sales will impact gross margins in a positive way.

Furthermore, we have adopted changes and implemented several operating initiatives to drive gross margin improvement to over 56% in fiscal Q1 2017. We have established new discounting policies. We changed how we incentivize our [DSTs] and channel partners to better align them with our goals. And we've identified savings in our supply chain. When combined with solution selling, we expect to achieve 60%-plus gross margins over the next two years.

On the expense side, we've been very disciplined with respect to our operating costs. Operating expenses were down $5 million from Q4 of fiscal 2015. And our operating margin came in at 8.6%, the highest since Q1 of fiscal 2014. Now we're operating leaner and more efficiently than ever before.

The strength of our cash flow has become evident on our balance sheet. Cash increased year over year by $18 million, while we brought down payables by $9 million and paid down $11 million of debt.

We were also able to move inventories and improved our turns up to over 5 times during the quarter from 3 times in Q1.

We have a new product lineup that is creating excitement with our sales teams and our partner community. Our EVP of Engineering recently called the ramp in new products coming to market a tidal wave. And we've accelerated our software release cycles.

Here are a few of our new product releases. We have multi-rate core and data center switches from 10 gig to 100 gig port speeds, and multi-rate edge switches for our Wave 2 wireless platforms. Our application-aware Wave 2 APs with built-in port flow technology support three times the number of devices at two times the speed with much higher reliability.

We're coming out with wall-plate APs that support IoT and will create opportunities for us in higher ed, healthcare, and hospitality. In addition, we are bringing lower-cost cost Wave 2 APs for larger-scale, lower-density deployments.

Our 2.0 release of ExtremeCloud, it supports small scale and enterprise environments. It's so easy to use that even I have deployed it in my home. We are the first networking company to offer unified cloud management across wireless and wired environments.

Sales leaders at our kickoff last week said they haven't seen this much excitement in our vision, strategy and technology roadmap in many years or, in some cases, ever. Our teams are confident in our ability to grow top-line growth and growth in gross margins. We have the commitment of the field, visibility in our pipeline, an exciting technology roadmap, and operating plans to make this happen.

At this point, I'm very pleased to introduce Drew Davies, our newly appointed Executive Vice President and Chief Financial Officer.

Drew brings more than 26 years of finance, accounting, IT, and M&A experience to the Company. In addition to his most recent and successful stint at Marvell and Spansion, he started his career with Micron in their contract manufacturing business and had Extreme Networks as a customer.

He has responsibility for IT and has recruited a strong new CIO. Drew will be the primary driver of our gross margin push to over 60%. We are excited to have him on our team and pleased that he has hit the ground running.

And with that, I'll turn the call over to Drew.

Thanks, Ed. Before I get to the numbers, I would like to make a few initial comments. This is my first quarter with Extreme, and I would like to say how happy I am to be joining the Company at this point in its history.

We just completed two weeks of quarterly business reviews and our sales kickoff meeting with teams from around the world. The energy and enthusiasm of the teams, driven by their excitement for new products and services, is immeasurable. And I certainly look forward to our future and the opportunity to contribute to Extreme's success.

We ended fiscal 2016 with a strong year-over-year earnings performance and a much improved balance sheet. With a sharp focus on our target vertical markets and greater concentration of solution sales, combined with firm control of operating expenses, the Company realized year-over-year non-GAAP earnings growth of over 400%.

The balance sheet strengthened throughout the year due to the same financial discipline we used to manage expenses. Year over year cash grew $18 million, while debt decreased over $11 million and inventory reduced by $17 million. I'll talk more about the balance sheet in a moment.

Now let's review the fourth-quarter results, starting with revenue. Q4 GAAP revenue was $139.6 million compared to $124.9 million in Q3 and $149.9 million in Q4 a year ago. Q4 non-GAAP revenue was $141 million compared to $125.3 million in Q3 and $150.6 million in Q4 last year.

The geographical split of revenues were as follows. North America contributed 51% to total revenue; EMEA contributed 37%; APAC contributed 9%; and Latin America contributed 3%.

Product revenue, both GAAP and non-GAAP for Q4 was $106 million compared to $92.7 million in Q3 and $116.3 million in Q4 last year. Q4 GAAP service revenue was $33.6 million compared to $32.2 million in Q3 and $33.5 million in Q4 last year.

Non-GAAP service revenue for Q4 was $34 million compared to $32.6 million in Q3 and $34.3 million in Q4 last year.

Moving on to gross margin and operating expenses, in Q4 GAAP gross margin was 52.1% compared to 50.2% in Q3 and 50.9% in Q4 last year. Non-GAAP gross margin was 54.8% which compares to 53.4% in Q3 and 54.4% in Q4 last year.

The sequential increase in gross margin was mainly due to seasonally stronger revenues in Q4 combined with our focus on inventory management, product mix through adoption of our solution selling approach. For example, 3 of our top 10 sales during the quarter were comprehensive solution sales, which carried higher than our average product margins, validating the strategy. We expect continued improvement in gross margins in Q1 due to tighter controls on discounting and increased solution sales with software content.

Q4 GAAP operating expenses were $73.2 million compared to $71.6 million in Q3 and $89.8 million in Q4 last year. Q4 GAAP operating expenses includes amortization of intangibles of $4.1 million; stock-based compensation charges of $2.4 million; litigation expenses of $200,000; restructuring charges of $1 million related predominantly to the completion of our facilities consolidation following the reduction in force in Q4 2015, plus executive transition charges of $800,000.

Q4 non-GAAP operating expenses were $64.7 million and compare to $61.6 million in Q3 and $69.6 million in Q4 2015. The sequential increase in non-GAAP operating expenses was mainly attributed to higher sales and marketing expenses.

Fourth-quarter GAAP operating loss was $0.5 million compared to a loss of $8.9 million in Q3 and a loss of $13.5 million in Q4 of last year. Fourth-quarter non-GAAP operating income was $12.1 million, or 8.6% of total revenue, compared to $5.4 million, or 4.3% of total revenue, in Q3, and $12.3 million, or 8.2% of total revenue, in Q4 last year.

GAAP net loss for Q4 was $2.3 million, or $0.02 per share, compared to a net loss of $10.8 million, or $0.10 per share. in Q3 and a net loss of $15.7 million, or $0.16 per share, in Q4 last year. Non-GAAP income for the quarter was $10.2 million, or $0.10 per diluted share, and compares to net income of $3.5 million, or $0.03 per diluted share, in Q3 and $10.1 million, or $0.10 per diluted share, in Q4 2015.

On a full-year GAAP basis for fiscal 2016, revenue was $528.4 million. Gross margin was 51.2%. Operating loss was $25.6 million. And EPS was a net loss of $0.31 per share. On a full-year non-GAAP basis for fiscal 2016, revenue was $529.9 million. Gross margin was 54.3%. Operating income was $35.7 million. And EPS was $0.28 per diluted share.

Turning to the balance sheet, Q4 cash and cash equivalents benefited from strong collections, and we ended the quarter with $94.1 million, up $5.8 million from last quarter and up $17.9 million from Q4 of 2015.

In the quarter cash flow from operations was $15.1 million compared to $4.9 million in Q3, $3.9 million in Q4 last year. Free cash flow was $8.9 million compared to $3.6 million in Q3 and $2.3 million in Q4 last year.

Accounts receivables were $81.4 million at the end of Q4, up $18.7 million from last quarter on higher sales and down $11.3 million from Q4 FY15.

DSO increased to 53 days this quarter from 46 days in Q3, and compares to 56 days in Q4 of 2015.

Inventory ended at $41 million, down $11.8 million from last quarter and down $17 million from Q4 FY15. We expect inventory to increase slightly in Q1.

Total debt outstanding at the end of Q4 was $55 million compared to $66.9 million at the end of Q4 2015.

Now let's move to guidance for Q1. Our first fiscal quarter is seasonally slower entering the summer months and coming off a strong year end. Similar to last year, E-Rate is starting off slower due to delays in the application process last quarter. But we expect to see significant improvement in our fiscal Q2.

In consideration of some of the possible impact of the Brexit fallout and political issues in Turkey and Brazil and reports of softening released through networking market channel checks and industry experts, we expect Q1 GAAP revenue to be in the range of $120.6 million to $130.6 million, and non-GAAP revenue in the range of $121 million to $131 million.

As Ed mentioned, for fiscal 2017 we anticipate revenue growth of 2% to 4%, driven by our strategic focus, new products coming to market, and the expectation from our field sales teams that leading with software and solutions will result in the increased average transaction size and better margins.

Q1 gross margin is anticipated to be in the range of 53.5% to 55%, and non-GAAP gross margin is estimated to be in the range of 56.7% to 58.1%. Our anticipated improvement in gross margin is driven by increases in solution sales, tighter controls on discounting, a revised partner incentive program that rewards growth, and operational cost reduction initiatives.

Q1 operating expenses are expected to be in a range of $70 million to $72.5 million on a GAAP basis, and $63.5 million to $66 million on a non-GAAP basis.

Tax expense is expected to be relatively consistent with Q4 levels.

Q1 GAAP net loss is expected to be in the range of $1.5 million to $6.2 million, or a loss of $0.01 to $0.06 per share. Non-GAAP net income is expected to be in the range of $4.3 million to $9 million, or $0.04 to $0.09 per diluted share.

The average shares outstanding are expected to be just over 1.6 million(sic-see press release "106 million") on a GAAP basis and 1.8 million(sic-see press release "108 million") on a non-GAAP basis.

Extreme Networks experienced strong financial growth in FY 2016 and we look forward to continued improvement in 2017.

With that, I will now open the call for questions.

(Operator Instructions) Mark Kelleher; DA Davidson.

Maybe we could start with Europe and Brexit. You had a nice sequential increase there in Europe. What are the early indications? Is there any slowdown anywhere? What are you seeing?

It's interesting. In terms of some of the deals that we saw in Europe, we had a strong quarter. We don't feel like too much business pushed out. Our teams are very confident in their plan and what they've got in terms of the pipeline coming up.

But we do want to be a little bit conservative because of what we know has happened, particularly in the UK, for example, with the exchange rate. We sell in dollars and it's just gotten a lot more expensive to buy our equipment. It's also true for our competitors.

So we want to be somewhat conservative in terms of how we forecast it. We don't have a lot of specific examples of deals being pushed. Our teams are very confident in their pipeline and in their [commits].

All right. And just a quick second question: Is there a way you can size the amount of solution sales that's in your revenue stream, what percent of sales is solution sales?

Yes. So our sales this year, we had 12% of our sales were solution sales. And last year that number was about 5% solution sales. The definition of that is a sale that occurs with our ExtremeManagement software. That also includes hardware. So over a six-month period when a customer purchases, it's a measure of sales based on that criteria.

So we know that we've sold a lot more solutions. We invested a lot in training. So we were very pleased to see the ramp and the adoption of our solution selling. We're working on a reporting methodology that we could use that will be very consistent to help you evaluate solution sales.

We want to look at it on a customer basis instead of a sales basis, the reason being we have customers who are solutions customers, but maybe they purchased -- let's say a hospital adds a new wing and in this case let's say they buy hardware or they want to buy access points in edge switches. So in that case maybe they don't buy software with the sale, but they're a solutions customer.

So we're building the framework so that we can present consistent reporting around solutions. I hope that helps you quantify. Net/net we more than doubled solution sales with that definition.

And the other thing we could say is that our field has gotten a lot more comfortable leading with software and leading with solutions.

Good. That's very helpful. Thank you.

Matt Robison; Wunderlich.

Congratulations on the progress you're making. If you cut it another way and you have access points along with switches, what kind of progress have you gotten in accomplishing that? And can you talk a little bit about Europe? It looks like the rate of decline for Europe year over year is decreasing. Maybe you can give us a little flavor for what you expect to accomplish there.

Sure. Well, it's interesting because EMEA for us is our second-largest region. And despite the macro headwinds that team is probably the most aggressive team in terms of their outlook. We have new leadership in EMEA, a very strong new regional VP who's heading up that territory. And there's a lot of confidence coming out of EMEA.

At the same time, we are aware of research that we've seen as far as channel checks and concern about what's happening at a macro level in terms of purchasing. So we want to -- we have to temper some of the enthusiasm that we have there. So our teams are feeling very confident in their outlook for EMEA and in terms of our judgment we want to put a little bit of caution on some of those numbers.

As far as selling access points and selling our switches, our teams have embraced solution selling. And we're seeing -- and it's really how we're differentiating ourselves in the field at the enterprise campus. A lot of our competitors, in fact most of our competitors, are selling point products into this market. And we're very focused on solutions. And when we sell a solution we're leading with wireless where there's growth in the marketplace, and we're leading with software. So it's a way for us to differentiate ourselves in a large competitive market and our teams have embraced it.

We had a nice increase of wireless sales year on year, 8.3% year-on-year improvement in wireless sales.

That's good to know. And I know it's the cadence for wireless sales, not always at the same time as a switch sale. But it would be interesting to know what percentage of your switch customers are buying wireless from you and vice versa. Probably the former, in fact, maybe more significant than the latter. So maybe in the future that kind of information you can help us with.

Okay.

Simon Leopold; Raymond James.

So just maybe following up on this wireless LAN aspect in the business, I'm hoping we could get a little bit better context to understand where it sits within the results. So understand solution sales will include both access points and switches, but if we can get an idea of the total wireless LAN revenue as a percent?

Yes. In the fourth quarter our wireless LAN was about 10% of revenue. And that's up from where we were a year ago. And as I mentioned, Simon, if we look at our teams in terms of who is selling and who's embracing wireless, we did a ton of training in the beginning of this year. And the field did an amazing job of picking up on it, from an AE perspective as well as from our system engineers in the field where all of them have their certified wireless certification.

And they have embraced wireless and you can see it by the growth in the second half of the year. Most of the training took place in the first part of the year, and then in the second half of the year you see the ramp where literally Q4 over Q4 we were up 29%.

The other thing which is going to be an accelerant, is our cloud management platform. We announced that in January and we rolled it out (inaudible). We just came out with our second version of the cloud management platform that is being embraced by the field. There's a lot of excitement by our teams about how easy it is to demo and the capabilities we have relative to our competitors side by side. But this is a platform that they feel that we can sell. And obviously that's going to be a driver of wireless.

And I presume that the wireless business is margin accretive. And I'm also making the assumption that you expect that that business grows faster in fiscal 2017 than the campus switch business or even services. So what do you think your mix looks like in a year? And how much of this mix shift plays into gross margin changes?

Well, on the wireless side I don't think we've broken out gross margins specifically for wireless. That's something we'll consider that, and looking at that. But I do know that we do expect the growth rate in wireless to accelerate. So, given what we're seeing in terms of the ramp-up going into Q4, we only expect that to continue. It's the highest growth segment of our industry, so it's a natural place to open up new doors in terms of growing our business and attracting new logos.

And then one last one if I might: You referred to the Cloud 2.0 solution as the Meraki killer. That's a pretty bold statement given the size of Cisco's wireless LAN business relative to Extreme's. Can you give us some metrics around what makes your product differentiated, how you're competitive and really substantiates this concept? Thanks.

You know what I'd like to do, Simon, I'd like to invite you and really anyone else on the call to try it out for -- it would take about 10 minutes to run through a side by side. It's so easy to deploy our cloud solution. You literally -- you get an AP and you have to fill out four fields. When you compare it to what you have to do at Meraki, it's a lot more complicated.

And, look, Meraki has been around for a long time. They have a lot more features than we have. But it is a lot more complicated to use. And we have a very elegant and simple-to-use solution that is being very well received in the field. And it's very easy to demo this. In a way we have a favor -- we're in a favorable position from coming to the market a little bit late and being able to start over with a much simpler user interface.

So without being able to get into too much detail on the call here, maybe this is something that we take off line and we'd be happy to take you through and just show you the demos. It's pretty powerful when you see it.

Great. I expect I'll take you up on that. I appreciate it. Thanks for taking the questions.

Alex Henderson; Needham.

So really like to see all the quantification you put into the discussion, but I'm not sure I got all the details. So I wanted to go back and visit a couple of the data points you threw out. I was wondering if we could just start on the discounting, elimination of some of these unnecessary discounts. Where are we on implementing that program? And what do you think the impact is on the top line and on the margin from that?

So we've changed our discounting levels and the thresholds for which special approval is required. We've tightened that up and that has been embraced by the field. That is in place. And that is a primary driver of the gross margin jump that you're going to see in our fiscal Q1.

And we've also implemented policies around older products and raising price and restricting discounts on some of the older products that we'd like to sunset. That would contribute to margins.

And we're looking at our policies around smaller transaction sizes, for example. I --

Just so I could be clear, when you say it's been fully implemented, was it implemented for the full June quarter or was it implemented as the June quarter progressed so the September quarter is the first full quarter of it?

It was implemented July 1st.

Oh, so it's just starting to kick in.

Correct.

All right. And the impact on the top line from that elimination of those discounts, assuming the same level of sales, would be what?

It's hard for us to estimate that. We really have to make a best guess.

Okay. I'll take a guess. Better than our guess.

I think as we looked at the effect of gross margin, we don't have a specific sales offset number for you but we would say that this is going to contribute 1 to 2 points of gross margin.

So there's a potentially 1 to 2 points on the top line as well then?

Of growth or negative impact?

Just elimination of revenue negative impact.

We don't -- we factored that into our top line. All of this, the changes that we've made, have been communicated out to the field and it's all being factored into our revenue targets.

Okay. And then the second piece of it is the headcount in sales. I know you've shifted a lot of people around, but if we look at quota-carrying sales people, what is the change in the staffing level between, say, the end of December and the end of the June quarter?

We're flat. Not a lot of change. We may have increased headcount slightly but year over year we're in the same position as where we were last year in terms of our sales headcount. And we are expecting to build on this, and I mentioned 5% growth. As you're aware it does take time for sales people to ramp and generate revenue. So I'd put six to nine months in there, which is why we said you could add 1 to 2 percentage points of growth from that.

And the other 1 to 2 points of growth will come from increased sales productivity from all the things that we have going on in terms of this marketing platform that we're building in verticals, the lead generation that we're doubling down on for the field, the investment in our verticals, ecosystem partners and the demand creation activities that marketing is doing to facilitate more sales.

In addition, we have a ton of new products coming to market that are going to kick off in the Thanksgiving timeframe in our fiscal Q2. And we're expecting -- and the field is very excited about the new products. So we're also expecting to get wind in our sails from new products that will be coming to market beginning fiscal Q2.

Just coming back to the sales, as I understood it, the June to December timeframe, 15 to December 15, that the sales had seen a fair amount of attrition and was down from the June period to the December period and then you've rebuilt it from the December period. Is that not correct?

So from the end of our fiscal Q2, which is December, sales and marketing both are up about 11 people. So we did have some increase there.

So percentage-wise, what is that?

It's 11 people on --

It's about 5%.

5%, yes.

So 5% since then. I get it.

Yes.

That's what I was looking for. And then, just a technical question. You said your tax rate was going to be flat. I didn't know whether you meant tax dollars or tax rate.

Tax dollars.

Okay. That's all I need. Thank you.

(Operator Instructions) Ryan Flanagan; Buckingham Research.

Nice to see the GM expansion here, particularly given the pricing pressure out there. I did want to ask about deferred revenue. Looks like it was down sequentially and year on year. I was curious to know what's driving that.

And then the second part of my question is: Looking at service revenue, which has kind of been bouncing around, flattish let's call it the last six to eight quarters, I was thinking if the increase in solution sales would maybe drive that a bit higher? What am I missing in that line item? Thanks.

So why don't I take the service revenue question first. Service revenue overall has been negatively affected by this limited lifetime warranty that's been attached to a lot of our hardware that we sell. We're developing new plans that we can attach to the limited lifetime warranty, which is going to help us. It provides an increased level of service in terms of hardware replacement, time intervals, 24/7 service. So these are new plans that we've developed that we're going to roll out.

We've also improved our processes for renewals. And we're taking a renewal process that was out of market and we're putting it back in market, which we think is going to help us.

We've also made new hires to focus on growth. And we're separating service delivery from service sales. The two had been combined. But we've got excellent teams who take care of our customers from a delivery standpoint and we're going to split them from the sales team. They're going to be focused on and fully commissioned on driving services revenue. So these are some of the things that we're going to be putting in place.

I think you're right when you talk about solutions. We're investing in professional services. And this is another area where we're making more investments and we're growing those teams. When we are deploying a solution a lot of our customers would like to buy professional services hours and to help configure and deploy the full solution, the single pane of glass, our control and our analytics. So this is another area of opportunity for growth for us.

And then there was another question about deferred revenue?

Yes, deferred revenue. So as we worked through year-end audit with our auditors we changed the classification of part of our deferred revenue. And there was a re-class of about $2 million from deferred revenue up to other current liabilities.

We also had about $3 million to $4 million of a decrease in deferred revenue as a result of timing between shipment to the end customer and delivery to the distributor.

Okay. Fair enough. And then just one quick E-Rate follow-up. I think the last couple quarters you've talked about a range of $10 million to $20 million and the expectation that the quarter you just printed would come in at the lower end. Is that where you guys ended up?

We ended up a little stronger than we expected in E-Rate because we had some deals come into the quarter. Overall, I think the way you should think about E-Rate is that last year we had projected between $10 million and $20 million a quarter, as you pointed out. That, if you average it out, would put us around $60 million for the year. We came in a little light relative to that number.

Keep in mind that E-Rate is one component. It's a funding mechanism for overall K-12. As we roll forward into next year, we are expecting call it a 10% plus or minus decline in E-Rate revenues in our K-12.

But one of the nice things about E-Rate for us has been it's been an opportunity for us to pick up new logos. And we have a lot of customers. Once we bring on a new customer through the E-Rate program, they will still buy outside of the E-Rate program. So we have a lot of potential orders that are out there that are outside of E-Rate from customers who could potentially make up that shortfall.

So as we're looking at our education business overall in K-12, we see it as being roughly flat, maybe down a bit.

Great. Appreciate the color.

Christian Schwab; Craig-Hallum Capital.

So, Ed, gross margins on a go-forward basis, given some of the changes of less discounting, et cetera, should remain in this 57% plus or minus range? Or is it going to ebb and flow with volume or mix?

Well, I think it will always ebb and flow a bit with volume and mix, but the answer is yes. We're targeting to grow our gross margins from here on out. There are a lot of initiatives under way. And so we're looking at establishing a new base line and building on that base line, Christian.

Okay. Well, that's fabulous. So the OpEx at $63.5 million to $66 million, seems slightly heavy to me. Is this range of OpEx support future growth? In other words it's kind of a run rate to support the 2% to 3% you're looking for this year and then obviously we want to get to double-digit growth, as you outlined in your prepared comments. Is that type of OpEx, ex commission levels or very strong quarters, is that a sustainable level? Or is that something that's going to itch up further?

We expect it to be right in that range here throughout the year, with the exception, like you said, of some ebb and flow based on higher commissions and higher revenue quarters.

Also, we're a little bit heavy this quarter just because we had our sales kickoff meeting this quarter and we're paying for it in Q1.

Great. Well, that's fabulous news on gross margins. Thanks, guys.

Alex Henderson; Needham.

Just following that same line of logic, that's exactly what I was thinking of asking. To the extent that you're now driving a couple of percentage points improvement in gross margin, it seems like the business strategy is to reinvest that primarily in the sales and marketing line. Is that the right way to think about it --

Exactly.

-- with a little bit falling down to the bottom line, but using that incremental investment in sales and marketing to then drive the acceleration in top line?

That's correct, Alex. Overall you know we have our operating income target of moving into double-digit territory. But we're balancing growth and we want to do both. I think the way you're thinking about it is accurate.

So if you had a choice between accelerating the top line an extra couple percent or dropping another percentage point or two to the margin line, you would choose which?

That's a really good question. At this stage of the game, we're driving at both. We think we have to deliver both.

Okay. Great. Thanks.

I am showing no further questions at this time. I would now like to turn the conference back to Ed Meyercord.

Okay, thanks, Sally. We appreciate the questions. We appreciate everyone participating on the call.

This was -- there's a lot of exciting things going on at Extreme. This was a solid quarter for us. We are really excited about all the initiatives that we have going on, everything through our sales organization and our marketing and then with our engineering teams and all the technology and the products that we have that we're bringing to market.

And I will comment that our teams in the field are very confident in their ability to deliver. So there's a lot of excitement. And it gives us confidence in forecasting growth for the year. We feel really good about the strategy we're on and we feel good about our operating plan and we're confident we can make it happen.

So thank you all for participating and have a great day.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.