Extreme Networks Inc (EXTR) 2017 Q2 法說會逐字稿

Good day ladies and gentlemen, and welcome to the Extreme Networks Q2 fiscal year 2017 financial results conference call. At this time all participants are in a listen-only mode. (Operator Instructions). This conference is being record. I would like to introduce, Matt Steinberg, Investor Relations. You may begin.

Thank you, Vicky, and welcome to the Extreme Network second quarter fiscal year 2017 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.

By now, you've 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 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 those risks and uncertainties, please refer to our most recent reports on Form 10-K, 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 this call. Throughout this call, we'll 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 corresponding GAAP measures is in our earnings press release issued today in the supporting financial materials. 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 will turn the call over to Extreme's President and CEO, Ed Meyercord, for his opening comments.

Thank you Matt, and thank you all for joining us this afternoon. Today we are pleased to announce solid second quarter results that beat our non-GAAP earnings guidance of $0.07 per share by a full $0.05 and to announce the near completion of our business integration initiatives associated with our purchase of the Zebra Wireless LAN assets that closed on October 28th.

Based on the fiscal Q2 results and guidance for Q3 this acquisition is already accretive to our EPS. We are also pleased to announce that for the seventh consecutive quarter our extreme team has delivered earnings that met or exceeded our guidance. We drove significantly higher gross margins, up 390 basis points year-over-year, and operating efficiencies that generated higher cash flow with non-GAAP operating income of 29% and net income of 40% year-over-year on 6% revenue growth.

We delivered these results while our teams were busy integrating our new wireless LAN customers, channel partners, distributors, suppliers and employees into Extreme. We added thousands of high quality customers into our existing targeting industry verticals and hospitality manufacturing and on-boarded marquee accounts in the retail sector with new logos like Kroger, Walmart, Loews and CVS, as well as transportation logistics accounts with FedEX, UPS, and DHL.

With these new customers we've expanded our presence and our market position in one of the fastest growing segments in networking with wireless LAN growing at 6.3% a year versus 1% for the networking industry overall. We are now the third largest wireless LAN competitor in our targeted industry verticals with wireless now representing approximately 25% of our total revenue. During the quarter, we contracted with 57 new distributors globally and added hundreds of new channel partners with a greater focus on wireless LAN.

We hired 276 new employees in locations around the world and moved our corporate headquarters into the former Zebra offices in south San Jose.

We began shipping our new Wing AP's and wireless controllers in November. We migrated data from Zebra's Oracle and Sales Force systems into Extreme's platform over the weekend immediately following the close and we migrated all customer service information in our systems during the second week of December. With the exception of a few transition service agreements, such as temporary office leases, and engineering software development tools, our business integration is largely complete.

Now we are in a stronger position to take share in our enterprise markets with complete solutions. End to end, high quality, high performance wired to wireless switching from the access point where access layer switch at the edge to the private cloud in the emerging hybrid cloud enterprise data center with a thousand physical servers or less. Our controls, analytics and advanced management suite of software provide network automation, orchestration and security at the edge for all users and devices through granular policy implementation and our wired and wireless infrastructure.

We make it easier to manage and secure enterprise networks with complete visibility and control from hybrid cloud core to the wireless access point. We are the only networking company with a strategy solely focused on delivering what we call network quality of experience to drive better business outcomes for our enterprise customers and we are rated number one in customer service and support in the industry.

No other competitor has 100% in-sourced high touch customer and channel partner support as Extreme. During the Q1 earnings call we talked about the large volume of new products coming to market in the second half of our fiscal year. This wave of new products began in December with our upgraded cloud wireless release that supports white labelled multi tiered managed services for our partners. As well as our new wall plate AP complete with ethernet ports and policy management capability. We also introduced our Aspen single chip set low cost AP for hospitality and retail that could be ceiling or wall plate mounted.

We have families of multi-rate fixed switches coming to market in February with our Tomahawk chip-set based 870 series for the data center and network core along with multi-rate one, two and a half, five and 10-gig multi-rate switches. We announced our street fighter series of value oriented switches that leverage Broadcom FASTPATH's operating system software two weeks ago the national retail federation in New York City.

We can now offer our large customers with massive distributed networks a complete and highly competitive edge solution with street fighter switches paired with the APs pre-packaged with our cloud management agent and our ON-PREM controller based capabilities. Finally, we are planning to launch our layer three fabric feature with our new version of EXSoft that will accompany the release of our 870 series high end switch.

We have had many exciting customer wins that highlight our innovative solutions and the strength of our customer relationships during the quarter and none will be more prominently displayed than our presence this weekend at NRG Stadium, home of the Houston Texans and the NFL Super Bowl LI. For the big game on Sunday, our solution for fans, teams and workers includes Extreme switching, wireless with 1260 total APs, 105 Extreme switches, two high end bonded chassis and 70 miles of cable installed at the stadium.

And, of course, the solution is being driven by our control analytic and advanced management software to provide security at the edge and visibility and control over the entire environment. We are very proud of our growing relationship with 12 NFL teams who use our networking solutions including the addition of the New York jets and the New York Giants this quarter, and 20 NFL stadiums powered by Extreme analytics. To top it off, we won the 29 story brand new Marriott marquee in the heart of Super Bowl city which is the NFL Super Bowl headquarters.

We beat out Ruckus for both of the wins at NRG stadium and the Marriott. Another high profile win, this in the EMEA region, Extreme beat out a Cisco/Meraki cloud solution for the German government. A nice six digit win for our recently enhance the cloud wireless platform. The German IT infrastructure team is a long time customer of Extreme that is building out networking infrastructure to support housing for refugees from western Europe and the Middle East.

Extreme won because the Extreme cloud solution offered better value with high performance, low maintenance, and a flexible cloud management model the customer was looking for. We have many more competitive wins and all of our target verticals and all of our geo's throughout the quarter. Our teams are building momentum in the field with quality customers who are turning to Extreme.

Now, turning back to our Q2 results. Our revenue grew by 6% year-over-year and up 20% sequentially versus Q1 2017 led by new revenue contributions from our wireless LAN business and our seasonally strong fiscal second quarter. We came in at the low end of revenue guidance range due to a few factors. This quarter represents just two months of wireless LAN revenue from Zebra and we had to adjust revenue down for a sell-out versus sell-in revenue accounting by approximately $6 million. This accounting adjustment will have a smaller affect on our March quarter.

Finally, the timing of the wireless LAN acquisition closing affected linearity that caused a back end loaded quarter as we began contracting with distributors beginning in November with most shipments and invoices in December. This pushed out some orders and generated higher than normal backlog in receivables. We posted very strong results in our EMEA region this quarter led by strength in our dock region as well as growth in France, Spain and Italy.

This was offset by softness in the America's as a result of lower E-rate revenue during the quarter consistent with the industry trending at 60% of 70% of last year's volume. In APAC, our new leader is moving aggressively to rebuild our sales management team in that region and we will expect to see a rebound in our fiscal Q4.

Our field teams did an excellent job improving our discount and controls this quarter. This was the leading driver of our strong gross margin performance as we passed on many price competitive lower margin deals. We are very focused on driving increased gross margins and improved profitability. We have multiple initiatives that have been underway for several quarters to make this happen from an operational perspective. We have taken actions on pricing, discounts, end of life products, marketing rebates as well as several distributor and supply chain initiatives.

And from a strategic perspective we drive higher margins when we sell solutions and lead with software and software sales were up this quarter. Our fiscal Q2 is our fifth consecutive quarter of non-GAAP gross margin increases. We were pleased to see 120 basis points sequential improvement and 390 basis point year-over-year increase and our non-GAAP gross margins for the quarter and we remain committed to our long-term objective of driving non-GAAP gross margins to 60% or higher. Our team has been very disciplined in managing our operating expenses.

We came in ahead of our plan and took further steps in the beginning of January to realign the Company's resources to take advantage of new growth opportunities from the recent addition of very large blue chip wireless LAN customers around the globe. These actions will allow us to achieve our double digit operating income margin targets by fiscal Q4.

Consistent with our guidance, the benefit of the actions we have taken with our investment in wireless LAN, our focused and disciplined sales initiatives along with our gross margin improvement and cost controls are evident in our year-over-year results. We are projecting revenue growth in excess of 20%, 300 basis points year-over-year gross margin improvement and more than doubling our operating income and EPS for our fiscal third quarter ending March.

Drew will take you through the details of our balance sheet but I would also like to highlight the expected normalization in receivables and a significant cash flow benefit expected in the March quarter. Given the back-end loaded nature of our December quarter, we expect to grow our cash balances in excess of $20 million and that includes the effect of $7.5 million in anticipated restructuring charges from our business re-alignment disclosed in January.

In closing, I am pleased with the progress that our team is making. We are executing well in our operating plan, highlighted by seven quarters in a row of delivering on our earnings guidance, and we have exciting new growth opportunities that lie ahead with our new wireless LAN customers, innovative new product releases and the traction we are getting with our focused and targeted enterprise customer strategy.

With that, I will turn the call over to Drew to take you through the detailed financial results.

Thanks, Ed. First I would like to start with a few financial highlights from our second fiscal quarter of 2017 specifically pointing out the increase in our gross margin and the strong growth in our earnings compared to the prior year period. Our non-GAAP gross margin improved 120 basis points quarter over quarter from 56.3% to 57.5%. and improved 390 basis points year-over-year from 53.6%.

Our non-GAAP product margin was up 580 basis points year-over-year for Q2. These increases were driven by our heightened focus on discounting approvals, reduced supply chain costs, improved software sales as well as lower service and logistics costs. In Q2, our non-GAAP operating income margin improved to 9.4%, up from 7.2% and 7.8% quarter over quarter and year-over-year respectively.

The increase was driven by our improvement in gross margin as well as our ability to leverage and control operating expenses as we layered in the additional revenue from the acquisition of wireless LAN assets from Zebra. Q2 also benefited from a higher level of vacation days taken due to the holidays resulting in a reduction in labor expenses. Please refer to our Q2 presentation on our IR website for details.

Now, let's move to the second fiscal quarter details starting with revenue. Q2, 2017 revenue was $148.1 million, compared to $121.6 million in Q1, and $139.3 million in Q2 a year ago. Our revenue increased during the quarter driven by the addition of two months of revenue from the newly acquired wireless LAN business, partially offset by the impact of transitioning from sell-in revenue recognition to sell-through in the distribution channel for the acquired business.

The geographic split of revenues were as follows. North America contributed 50% of total revenue. EMEA, 38%, APAC contributed 8%, and Latin America contributed 4%. Product revenue for Q2 was $109.8 million compared to $90.1 million in Q1 and $105.4 million in Q2 last year. Q2 service revenue $38.3 million compared to $32.5 million in Q1 and $34 million in Q2 last year.

Moving on to gross margin and operating expenses. In Q2, gross margin was 50.9%, net GAAP gross margin was 50.9% compared to 53.2% in Q1 and 50.4% in Q2 last year. Non-GAAP gross margin was 57.5% and compares to 56.3% in Q1 and 53.6% in Q2 last year. Our non-GAAP gross margins grew significantly and this included the offsetting impact of blending in the lower margins from the new wireless LAN business.

As previously mentioned, gross margin increases were driven by improve the discounting, reduced supply chain costs, improved software sales as well as lower service and logistics costs. Q2 operating expenses on a GAAP basis were $82.7 million compared to $70 million in Q1, and $75.6 million in Q2 last year. In addition to the ongoing amortization of intangibles, stock compensation expense, Q2 operating expenses includes charges of $11.5 million for integration and restructuring costs related to the acquisition of the wireless LAN business and our exit of certain lease facilities.

Q2 non-GAAP operating expenses were $71.2 million compared to $60.3 million in Q1 and $64.1 million in Q2 of 2016. The increases in both GAAP and non-GAAP operating expenses were mainly attributed to two months of operating expenses from the newly acquired wireless LAN business. Second quarter GAAP operating loss was $7.4 million, compared to a loss of $5.4 million in Q2 last year and compares to a loss of $4.8 million in fiscal Q1 of 2017.

Second quarter non-GAAP operating income improved 29% to $14 million compared to operating income of $10.8 million in Q2 last year and compares to operating income of $8.8 million in fiscal Q1 of 2017. GAAP net loss for Q2 was $8.6 million, or $0.08 per share compared to a net loss of $6.5 million, or $0.06 about per share in Q1 and a net loss of $7.2 million, or $0.07 per share in Q2 last year.

Non-GAAP net income for the quarter was $12.7 million or $0.12 per diluted share compared to net income of $7.1 million or $0.07 per diluted share in Q1, and net income of $9 million or $0.09 per share in Q2 of 2016. Turning to the balance sheet. Q2 cash and cash equivalents ended the quarter at $103.8 million, up $1.5 million from last quarter and up $17.9 million from Q2 in FY16. In the quarter cash flow from operations was $9.7 million, compared to $9.6 million in Q1 and $7.4 million in Q2 last year. Free cash flow was $6.7 million, compared to $7.9 million in Q1 and $6.7 million in Q2 last year. Accounts receivables were $117.8 million at the end of Q2, up $49.6 million from last quarter, and up $44.7 million from Q2 of FY16.

The increases were driven by purchase receivables and higher revenues from the addition of the acquired wireless LAN business as well as an increased percentage of sales in the latter part of the quarter. DSO increased to 73 days this quarter from 51 days in Q1 and increased from 48 days in Q2 of 2016. We expect a significant reduction in accounts receivable in Q3 which will drive strong cash flows.

Inventory ended at $47.4 million, up $4 million from last quarter, and down $9.2 million from Q2 of FY16. Total debt outstanding at the end of Q2 was $98.2 million compared to $51.9 million in Q1, FY17 reflecting the additional amount borrowed to acquire the wireless LAN assets.

Now, let's move on to the guidance for fiscal Q3. We expect Q3 revenue to be in the range of $151 million to $161million representing a 20% to 28% increase compared to Q3 last year.

The transition from sell-out to sell-in revenue recognition to the distributor channel related to the acquired wireless LAN business will have a $1 million to $3 million negative impact on Q3 revenue and is anticipated to be immaterial in the June quarter. Gross margin is anticipated to be in the range of 53.4% to 54.5%, and non-GAAP gross margin is anticipated to be in the range of 55.5% to 56.5%. Our fiscal third quarter is historically a lower revenue quarter.

We expect service revenues to be flat with Q2 of 2017 which will reduce the associated gross margin as we add a full month of service expenses for the acquired wireless LAN assets. Operating expenses are expected to be in the range of $90.3 million to $92.8 million on a GAAP basis, and $74.9 million to $77.5 million on a non-GAAP basis.

The sequential increase represents a full three months of operating expenses from the newly acquired wireless LAN business compared to two months in Q2, higher sales commission on increased sales, and increased labor expense accruals compared to Q2. We expect total interest expense to be $1.1 million each quarter for the remainder of our fiscal year. Tax expense is expected to be flat to Q2 levels. GAAP net loss is expected to be in a range of $7.4 million to $12 million, or a loss of $0.07 to $0.11 per diluted share.

Non-GAAP net income is expected to be in the range of $6.6 million to $11.2 million, or $0.06 to $0.10 per diluted share. The average shares outstanding are expected to be 109.1 million on a GAAP basis and 110.6 million on a non-GAAP basis.

In closing, I would like to provide an update on the systems integration of the wireless LAN business acquired in the quarter. We closed the transaction on October 28 and within three days we had fully integrated the product quote to cash cycle into our existing ARP systems.

By December 9th we completed integrating the services portion of the business as well. On day one, the new employees joining as part of the acquisition were fully integrated into our network and e-mail environment allowing them to work productively. This was a tremendous effort by our integration team that immediately allowed us to realize many of the synergy's from the acquisition.

I will now open it up for questions.

Ladies and gentlemen, (Operator Instructions). Our first question comes from the line of Matt Robinson with Wunderlich. Your line is open.

Thanks for taking the question. What were the product and service revenues before Zebra?

So we are not breaking out the revenues separately right now between the two. It is starting to blend together as we are starting to have cross selling so we are not breaking it out.

Okay. That's it for me.

Our next question comes from the line of Alex Henderson with Needham. Your line is now open.

Let me try a different slant on that. Relative to your guidance, I assume that there was some expectation for the Zebra revenues offset adjustment of $6 million in the quarter. So, was the revenue adjustment more or less than expected? Or how should we think about that? And when you say it has a small impact in the March quarter, what are we talking about?

Drew, I will start off and then pass it to you.

Yes, sure.

Alex, we have the revenue recognition accounting adjustment that was part of the quarter, this quarter we have only two months of Zebra revenue. The other thing I mentioned in my comments is the fact that we closed this at the very end of October and then we had to sign up all of our distributors and then start shipping product in the November and December time frame which pushed out some orders in the quarter.

The over arching comment is that Zebra is coming in exactly as we had planned and had modelled and as we go forward we are quite pleased with the integration. We are quite pleased with the opportunities that we are seeing. And our assessment is that Zebra is right on track with how we set expectations earlier.

That is really not the question, guys. The question is relative to the guide, you said that you were slightly off on the revenues because the adjustment of $6 million sell-in was a big part of the difference. And the question is okay, if it was $6 million, what had you expected it to be? Was it supposed to be $3 million or $5 million or how does it vary from what you had expected?

I think what we are saying is that Zebra ended up being about what we thought. So, the head-winds that we had were a small amount on the Zebra business and then also on the base business as well. And then you had asked about the impact next quarter and we said it would be about a $1 million to $3 million impact but that is built into our guidance for next quarter.

So the one to three falls out in the June time frame?

Yes. It will be an immaterial impact in the June quarter.

Okay. The second question I have for you is on major wave of new products. How long do you think the timeline from the new product launch to positively impacting revenue? Is it a launch from here, some in December, some in the current quarter and some even bleeding into the second quarter calendar, but it's a three to six month sell cycle so it's a positive driver for FY18? Or is it something that we should anticipate contributing to the June quarter?

Alex, it will contribute some to the June quarter. But the big drivers will be in fiscal 2018.

Okay. And then the margin impact of a full quarter of Zebra, I assume that that is still impacting the gross margin on the downside. How quickly can you mitigate that and push the margins up towards target?

A lot of the gross margin initiatives that we are work on, we think they are completely applicable to the Zebra business as well. We are starting to work on the discounting and the supply chain and we'll see those start kicking in here in the next couple quarters, for sure. A lot of the initiatives that we have will certainly apply to the Zebra business as well.

Clearly with the restructuring you just announced that obviously has a positive implication. How do you see that playing out over the course of the next two or three quarters in terms of, I think it was an $8 million benefit from the restructuring, is that right?

Yes, on an annual basis. I think on a quarterly basis we expect $2 million to $3 million and that kicks in, that, we took that action in the first week of January so we get the majority of the benefit for it this quarter as well.

Okay. I'll turn it over, thanks.

Our next question from the line of Simon Leopold, with Raymond James. Your line is open.

Thank you for taking my questions. I wanted to clarify a couple of things you mentioned in the prepared remarks. Toward the beginning, Ed, I will think you commented on your position in the wireless LAN market mentioning that Extreme with the Zebra product was now the third largest but I think there was a footnote to the statement or suspect there was because I'm just trying to square this with some of the market research we look at. Could you clarify that?

That is for the enterprise market in our targeted verticals.

What are you excluding?

For example, if you have Cisco and you have HP Aruba and those would be number one and number two and then you would look at Brocade Ruckus and you might scratch your head and say, "Why is Extreme higher than Ruckus?" The reason is, they are very focused on service provider and have other market focuses than we do. What we did is we did a lot of work with our analysts team in identifying the market, looking specifically at the verticals, working with Gartner and IDC and Del Oro, to understand that and then to give our best guess as to where we shake out and our competitors shake out. From an overall perspective we are number three when you add in Zebra wireless LAN. It only strengthens our position.

Great. That answers it. That helps me understand what you were describing and that squares it. So, the other comment you made shortly after that was you mentioned wireless was now 25% of sales. And I want to make sure I'm catching this or counting for this correctly in terms of is that 25% of product or are you assuming a certain portion of your services revenue as related to wireless? And are you assuming any switching revenue as coupled with wireless, is that truly the access point in controller revenue in that 25%? Thanks.

Simon, we don't break out when we are model the business we don't model by the different product groups. The 25% would be product and 25% would be service both. And what we are expecting, we are trying to sell both. One of the big opportunities that we have with Zebra and the wireless LAN business that we brought on is the opportunity to sell switching and more complete solutions to some of these really large enterprise customers with distributed networks.

So whereas they were selling fewer wireless access point controllers, et cetera, we now can sell etch switching and then look to even go deeper into the network with our switching portfolio. And then more importantly for us is we are really driving software. By providing our control our analytics and our management suite of software, which we are pushing out into wireless access points, we will be able to push policy to the edge through wireless APs, et cetera. We are looking at it more as a comprehensive solution to our customer. If that makes sense?

It does. And I appreciate how it will sort of blend over time. I just want to make sure I put the value, that 25%, in context. You didn't mention E-rate on the call. It has been an area of focus in the past with you. And I guess some last year. A couple of quarters ago it was a little bit disappointing. If we can get an update of where the E-rate program fits into the business now and expectations for it as a driver for sales?

Sure. E-rate has been a terrific program for Extreme over the years. It has brought us a lot of new customers and then we get K-12 customers that we acquired through the E-rate program that will buy outside of E-rate and we actually see some potential for that and some large orders in the second half of the year that will come from that. All of that said, this funding cycle has been a disappointment.

Whereas what we have heard, we have seen announcements from all of our competitors that play in this market and what we see is 30% to 40% off where it was a year ago and the funding has been much slower to come out. So for us, our first quarter which is that September quarter was much slower on E-rate. Our E-rate business picked up in Q2. But on a year-over-year basis it was significantly off. There are some orders in the pipeline backed up that we are expecting to recover in Q3 and Q4. Normally we would say E-rate would be $10 million, on the low side to as much as $20 million in a quarter.

We have definitely been down at or below the low mark for the first two quarters and we're expecting it to pick back up in Q3 and Q4.

Great. And one last modelling question, if I might. I certainly appreciate the seasonal aspects that move your operating expenses around. Particularly the spike associated with your June seasonality. I'm trying to understand how to think about the normal run rate of expenses post the restructuring. Given the longer term targets you have for operating margin. So, if there is a metric you can give us to think about pro-forma Op EX on a run rate basis, post the restructuring effort?

We have some fluctuation, we have variable comp that plays in there. But I think what based on kind of where our run rate revenues are looking. You could kind of model $76 million to maybe say $82 million of Op EX per quarter and it would kind of vary by quarters. On the higher revenue quarters are going to drive more variable cost.

Great. Thank you very much for taking my question.

Your next question comes from the line of Mark Kelleher, with D. A. Davidson. Your line is now open.

You've had Zebra for three months now. Could you just tell me where we are in the integration process? Is it completely integrated? Are we still integrating the R&D teams, the Sales teams? What savings can we still expect going forward?

Sure. Let me take the first shot and then I'll give Drew the opportunity to follow up. The Zebra acquisition, for us, has gone very well and very smoothly. It's probably exceeded our expectations. We think about it on three levels. First of all, we'll start off with the employees. We made offers to Zebra employees and got almost every single employee on board. This is really a talented group and they're going to add a lot to our capabilities and our competitive position in the market and our product development.

The second thing we look at is our customers. We're thrilled with the customers that we're bringing over from Zebra and the reception from the customers has been fantastic. So, customers and partners alike, we're seeing much bigger opportunities from the likes of Kroger and the likes of Walmart and Macy's etc., when they're looking at potential refreshes of a nationwide highly distributed network, very large network. First, is they're a traditional enterprise customer that we've had. So, the reception has been very favorable. We're encouraged by that and excited by that.

And then the last piece is we're looking at the business operations and the systems and data migration. We literally closed on a Friday and then on that Monday when Zebra employees logged into Extreme systems, we had migrated Oracle data and Sales Force data over the weekend. And then within 40 days we migrated 9 desperate customer service systems into Extreme systems.

I will say it was a lot of work. It was an amazing effort by people on the Extreme team. People worked a lot of long hours and a lot of weekends to get it all done. But at this stage of the game we are largely complete. We're still ironing out, there will be a situation where we're looking for a customer contract in the customer service system, etc., very normal integration kinds of things, but there are only a few TSA's left over and at 90 days in we feel like we're largely complete. Drew, do you want to add anything?

Yes. The only thing, on the cost side. You had asked if there is still opportunity there. Right now, in the beginning, we've got two completely different wireless AP supply chains. So there's an opportunity there for us to consolidate those over time. And we've got plans to do that. There's also just the overall road map. We've got (inaudible) most recently came out with their WAVE 2-802.11 AC platform and we just introduced ours. As we go to the next generation we'll have the opportunity to consolidate some of our spending there as well and go onto one platform. So there is still opportunity from a cost standpoint on the integration.

Okay. And the second question. The competitive environment, you mentioned some wins against Ruckus, are you seeing an easier competitive environment against Ruckus while it's sort of in limbo with the Brocade situation? Or is that not an impact?

I think we should think about that as noise right now. I'm not sure we can give you a strong signal. We're highlighting wins against Ruckus and also wins against Cisco, Meraki, Aruba. I'm not sure I would point out our single out Ruckus more than any other competitor at this stage.

Okay. Thanks.

And our next question comes from the line of Christian Schwab with Craig-Hallum Capital Group. Your line is open.

Good quarter guys. Can you remind us what you anticipate the combined Company can grow at? Like a 3-5 year CAGR with 25% of your business is wireless and the remaining in switch what do you think the growth rates should be for those two business over the next 3-5 years?

Christian, it's a really good question. We look around at the industry and on a consolidated basis as we look at Cisco, it's got to be the ultimate (inaudible) since they have (inaudible) market share. And they're shrinking. And HP has been struggling on the networking side. While Juniper shows 3% growth, they just came out with their earnings report. Most of their growth was in high end data center and cloud service providers and they actually shrank in the enterprise space, where we're playing.

So, it's a very competitive market and if you look at the enterprise market I think we would say, even though we have a wireless LAN business which is the fastest growing segment, overall, the market is somewhat flat to maybe up a percentage point or two. So the way that we would set our goals is that we should beat the market.

So that we're going to look at a growth rate that's higher than that, we believe we can beat the market because we're the only player that can focus solely on the enterprise campus. It's a very competitive market. The competition is there. But we're the only one's that are solely focused on that quality of experience. You're changing business outcomes and focusing all of the resources in our Company on those enterprise customers with the end to end solution and our solutions portfolio.

So, I would say, if the industry is going to be a 1% grower, 1% or 2%, we should be able to beat that.

Okay, great. Given the added month of service, you know, wide gross margins went down on a sequential basis, on a non-GAAP I'm talking about from Q2 to Q3. When we look to the June quarter, obviously we should have better revenue with seasonality but is it safe to assume that gross margins will be up on a sequential basis?

We're looking at it. A lot of it is driven by software sales. We had a nice increase in software sales this quarter and that helped our gross margins. We don't have a lot of visibility to that into Q4. And then if Services revenues go up, we will. But we're not guiding to Q4 yet at this point.

Okay. And then my last question, on the 60% type of gross margin objective or goal that you have, for your Company, how long realistically is that going to take? Is that a one or two year thing, or is that kind of a three to five year type of objective?

Christian, I think it's a one or two. There's a lot of initiatives that we have underway and there's a lot of ways for us to grow our gross margins. So, as Drew mentioned, if we can grow that Service line. We have made changes to our Service organization. We've hired a lead to drive Service's revenue. We have a new Management Services business. That alone, it's got a fixed cost structure. So when we're driving revenue there that will contribute to gross margin. I think that's a big opportunity for us.

Drew runs our Gross Margin SWAT team here inside the Company. We have, at this stage, 20 different initiatives. A lot of it around our discounting policy, pricing policy's. I talked about some of the initiatives that we have underway. All of our cross functional teams are very focused on hitting that target. So I think one to two is a better time frame.

I just want to make sure I heard that right. We have 20 distinctly different gross margin initiatives to increase gross margins that throughout the entire Company we have people on, is that correct?

Yes. There's probably half a dozen that are discount related. Looking at discounts by stratifying our sales and looking at the size of a deal and having different discounts on the deals. Overall pushing back on low margin deals. Looking at the discounts that the partner and distribution chain have and the agreement that we have with them and ensuring that we stick with those discounts.

So we've got a lot that are based on discounts. We've got a number of supply chain initiatives. We have product life cycle initiatives. And like Ed said, there's an extensive list of 20 different things that we're working on and trying to improve.

Okay. And then one last question, if I may? Drew, what do you think is the current tax rate on the Service revenue side?

30% of sales.

Okay. So still well below some of your peers.

Yes. It's a huge opportunity for us.

Yes. We've been tackling this opportunity for a number of years here. The previous management team attempted to attack it, too.

Yes, yes.

What are the realistic goal and time frame that myself and investors can think about, about that? And then, can you quantify it to the gross margin levers? So, let's say we wake up magically one day from now and we have a 40% of tax rate. What would be, all things else being equal, what type of impact would that have on gross margins?

Christian, I'm not sure we're in a position to forecast that on a call today. Maybe we'll take that back and we can cover it off line. I will say that we made a structural change inside the Company to drive Services revenue. We hired a resource who is going to focus entirely on revenue and working with the Service Delivery team to drive new Services offerings. So this is an area, you're right, this is an area that has been out there for awhile. We feel more confident now than we have in the past, since I've been here, that we're really going to go after it and attack it and make a difference. I'm not sure we can build a bottom's up structure at this time in terms of having a change in Services margin and Services line that would then ultimately contribute to the gross margin goal.

Okay. That's fair. Alright, good quarter. Thanks guys.

Thank you.

Our next question comes from the line of Rohit Chopra, with Buckingham Research. Your line is now open.

I have three questions for you. The first one is on software. You mentioned that a couple of times as a key driver of gross margins. Any way to give us a growth rate there? Or a percentage of revenue, or some type of reference point for software?

It was of 20% quarter to quarter. We had a nice improvement this quarter.

Okay.

It's off of a small base but it's a good improvement.

Software is still about 5% of our revenue so it's a small part.

That's perfect, actually. And then, I wanted to come back to the restructuring real quick. On the $8 million, what line(s) is that supposed to hit? Maybe I missed that. Where are you getting the savings from?

It's primarily going to be on the Operating Expense line.

Okay. And the last question I had was I just wanted to come back to the Zebra Motorola app that they were known for being a retail focused company and I think in your presentation when you acquired them one of the key verticals was retail and I just want to get a sense of what you're seeing in that area. And you mentioned a few logo adds but Macy's is in there, Kohl's is in there, CVS is in there, there's some retailers and I think all of us who are sort of in this industry are seeing some challenges in the retail big box area and they are closing some stores. I just want to get a sense of what you're seeing in the Zebra asset as it relates to retail specifically.

We have been really pleased with the new customer relationships that we have with the Zebra retail customers. When you start talking about the Walmart's and you start talking about Krogers, and these kinds of company's and businesses, they're a lot larger than what we have seen in the past. And I'm not sure we're in a good position to talk from a historical context about these customers but what we can say is that we're seeing a lot of opportunities to refresh networks.

One of the things that retailers have to do is that they have to improve the quality of experience and the quality of their customer engagement in order to bring them into their retail environment. And a big part of that is wi-fi and a big part of that is networking. So, this is some that that we're seeing opportunities with our software beyond just providing wi-fi access but looking at other solutions of retail to improve the quality of experience not just for the retailer infrastructure but also for retail customers.

That would include not just (inaudible) but also switches. So the opportunities that we are seeing are a lot larger than the opportunities that we would traditionally see just because of the nature of these large distributing networks. But also, a lot larger than what Zebra would traditionally see because it includes our edge switching portfolio and our software.

Okay. Thanks, Ed, that really actually does help a little bit.

Thank you.

And our next question comes from the line of Matt Robinson, with Wunderlich. Your line is now open.

Thanks for taking the follow-up. I was wondering about the tone of collections. Was it changed with the addition of the Zebra customers, I guess just as a way to follow onto Rohit's question. And the other, I'm just curious to kind of qualitatively Ed, what were the weakest and strongest aspects of the quarter from your perspective?

Yes. You probably saw that big, we talked about the big accounts receivable number, the $117 million plus. The collections were very good. We bought the AR that came with the deal was about $19 million and we've collected all but $1 million of that since we've owned the business. A lot of it came after the first of the year so it's not reflected in that balance of collections. But everything has been normal. We expect to be down to our normal DSO levels here within most likely in Q3 but certainly in Q4.

So Matt, the culprits from the pressure that we felt on revenue, I would say the number one issue during the quarter was E-Rates and head-winds that we continued to feel with the slow down in E-Rates funding during the quarter. It was more than we had expected. We also have in our Asia Pacific region we've changed management and there's an opportunity for us. That business has dropped and we see an opportunity to bring that back. That was another area of weakness. These were offset by very strong performance in our EMEA region.

The benefit of the gross margin discounting policy's and the enforcement of driving higher gross margins, the benefit is to higher gross margins. One of the things that we have to do is we have to pass on certain lower margin deals which effects revenue. So you'll see that effect. We haven't quantified that for you but it has an effect on revenue. And the last thing I would say is that this was a back-end loaded quarter and there were, from us, we don't report on back log but we saw an up-tick in our back log based on the timing of deals at the end of the quarter.

Thank you.

And our last question is a follow-up question from Alex Henderson, with Needham. Your line is now open.

I was just wondering if you could help us out with the long term target model. You talked about getting to 60% gross margins. But can you give us some sense of what the other line items might look like to get to the, I think the target is 10% operating margins. Even in your seasonally weakest quarter which would I think imply kind of an 11% overall operating margin given you're normally a couple of points between the soft quarters and the strong quarters. What would be the mix on R&D and Sales and Marketing at that level if you were at 60%?

We think we can do it being close to where we are right now. If we can get the gross margin improvement and based on the action that we took in Q1, we're going to be right there at 10% even in the lower quarters. So, we're there. So I think if you kind of map the operating expenses in that range that I talked about earlier, which would be about $76 million to $82 million, depending on low quarter, high quarter, we can achieve that 10% operating margin.

Right. I'm just wondering what the split is between the R&D and the Sales and Marketing in that model? That was really the question.

Oh, okay.

I can do the math from 60 down to 10 I just don't know what the split is.

Yes. So R&D stays around the $25 million a quarter level here for at least the next few quarters. And then the variability would be more in the Sales and Marketing line item where we have variable comp. And we would be ranging from say $42 million to $47 million or $48 million per quarter.

Alright. Thank you. That's all.

And then G&A would be pretty flat.

Great. Thanks.

And I'm showing no further questions at this time. I would now like to turn the call back over to management for closing remarks.

Okay. Thank you Operator. Thank you, everyone, for participating on the call. It was a strong quarter from our perspective. Again, really excited about the wireless LAN asset acquisition, how that's going and the new team we've got. We're excited about the products we've got coming. The Wave is starting. That's going to have a really positive impact on our business. And all of the initiatives we have around gross margin. This is going to be a very strong cash flow quarter here in Q3. We're excited about the outlook for the second half of our fiscal year. A final plug, I think the team at Extreme has done an excellent job across the board at executing. Thank you, everyone, for participating, and have a good evening.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, you may all disconnect. Everyone, have a great day.