Extreme Networks, Inc. (NASDAQ:EXTR) Q2 2023 Earnings Call Transcript

Extreme Networks, Inc. (NASDAQ:EXTR) Q2 2023 Earnings Call Transcript January 25, 2023

Operator: Good day, and thank you for standing by. Welcome to the Extreme Networks Second Quarter Fiscal Year ’23 Financial Results. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Stan Kovler, Vice President, Corporate Strategy and Investor Relations. Please go ahead.

Stanley Kovler: Thank you, and welcome to the Extreme Networks fiscal second quarter 2023 earnings conference call. I’m Stan Kovler, Vice President of Corporate Strategy and Investor Relations. With me today are Extreme Networks’ President and CEO, Ed Meyercord; and Interim CFO, Cristina Tate. We just distributed a press release and filed an 8-K detailing Extreme’s financial results for the quarter and also an 8-K detailing our CFO transition. For your convenience, a copy of the press release, which includes our GAAP to non-GAAP reconciliations, our earnings presentation are both available in the Investor Relations section of our website at extremenetworks.com. And I would like to remind you that during today’s call, our discussion may include forward-looking statements about Extreme’s future business, financial and operational results, growth expectations and strategies.

All financial disclosures on this call will be made on a non-GAAP basis, unless stated otherwise. We caution you not to put undue reliance on these forward-looking statements, as they involve risks and uncertainties that can cause actual results to differ materially from those anticipated by these statements, as described in our risk factors in our 10-K report for the period ended June 30, 2022, is filed with the SEC. Any forward-looking statements made on this call reflect our analysis as of today and we have no plans or duty to update them except as required by law. Now, it’s my pleasure to turn the call over to Extreme’s President and CEO, Ed Meyercord.

Ed Meyercord: Thank you, Stan, and thank you all for joining us this morning. We had another record quarter, as demand for cloud-driven networking and for Extreme Solutions remains exceptionally strong with good visibility through fiscal year end ’23, leading us to raise our full year revenue outlook to the high end of our range. Our share gains are evident by a second consecutive quarter of double-digit revenue growth, 17% growth in product revenue, record free cash flow and a sizable backlog. The resiliency of our business combined with a strong execution of our teams and focus on shareholder value continues to position Extreme well for the long-term. The sequential increase in revenue and margins led to continued improvement and our operating model to record levels just shy of 15% operating margin, and we achieved EPS of $0.27 in Q2, up from $0.21 in the year ago quarter.

We expect these bottom line earnings trends to continue. Both our fabric and cloud solutions are driving significant differentiation for Extreme, particularly due to our ability to deliver network automation, hyper-segmentation, unmatched security. Today, our fabric solutions offer a simple way for customers to tie all the components of their network together, and the branch, campus, data center to the cloud. It removes network complexity, speeds deployments and streamlines operations. The transition to universal products has proven successful, with well over 60% of our bookings now on universal platforms for Wired and Wireless Products. We’re on track to achieve this transition by year end calendar ’23 with over 90% coverage of our portfolio with the universal platform.

This calendar quarter, we’ll be announcing a set of unique innovations, involving ExtremeCloud SD-WAN and our widely deployed Extreme Fabric. These capabilities will enable our customers to improve visibility, management, application performance and security at the edge of the network. This further extends our vision of one network, one cloud, one Extreme over the wide area network with a truly differentiated fabric technology. We’re focused on helping our customers find new ways to deliver better outcomes across their organizations. During the quarter, 44 customers spent more than $1 million with Extreme, up from 37 last quarter, is another signal of how Extreme continues to take share and move up market. The top wins for the quarter included a multinational bank in Hong Kong, where we beat two of our largest competitors to modernize the infrastructure for surveillance, digital cornerstone for safety and security.

After using a competitor for many years, Extreme was able to bid on this project and win. A large school district just outside of Houston was looking to streamline management of its network, which sprawls across 92 buildings and support 60,000 students. Our fabric technology will provide full visibility across the network, simplifying and unifying network management, improving security at every site, and automating network configuration and provisioning to significantly reduce time spent on new deployments. A leading NHS Trust Hospital and Cancer Research Center in London upgraded their networks to continue to offer patients the most modern care. New bandwidth heavy applications, telehealth visits and medical devices are crucial for patient monitoring and require a Wi-Fi 6E fast, reliable, low latency network that could be easily managed by Extreme Cloud IQ.

Our competitive position has never been stronger. Given our relative size, even small share gains have a large impact on Extreme’s topline. We remain the fastest-growing company in our space. Third-party analysts, industry press and partner community have taken notice and we received numerous accolades and awards for our solutions and service. For the fifth consecutive year, we were named a leader in the Gartner Magic Quadrant for Wired and Wireless Local Area Network Infrastructure. Our innovation, vision and continued execution with solutions like fabric and digital twin were significant factors in our ranking. Our new customer logo wins contributed a higher percentage of our bookings. About half of our new logo wins are coming, because of fatigue and lack of innovation from some of the largest players in the industry.

We’re taking advantage of these market dislocations and when customers realize, they’ll benefit from interoperability between platforms, simpler licensing structures, productivity from Extreme versus our largest competitor, we’re quick to capitalize on these opportunities to win new business. More customers and partners choose Extreme, because of our ability to offer unlimited end-to-end network that can be managed within a single-cloud platform. Customers also love our universal hardware that offers choice of both cloud-based and on-premise deployments. As product lead times continue to improve, we expect our share gains to accelerate. Last quarter, we strengthened our go-to-market organization by appointing Pete Brant as Senior Vice President of U.S. Sales.

Photo by Taylor Vick on Unsplash

Pete is a proven sales leader focused on taking share and building SaaS organizations coming from leading networking and security companies, such as F5 and Fortinet. We ended Q2 with ARR growth of 29% year-over-year, while SaaS deferred revenue grew at 38% year-over-year. Our innovative cloud solutions are pulling through product sales and we believe the level of organic subscription growth we’re seeing is sustainable. In addition, the improvement in supply chain, our ability to deliver products, most notably Wireless LAN this quarter supported a strong pull-through of software subscription for the next several years. On the supply chain side, our ability to pull in components enabled us to achieve revenue upside, which we believe is sustainable into the second half of the year.

As a result, we are raising our revenue outlook to the high-end of our prior 10% to 15% guidance range. We continue to be laser-focused on tactical execution to meet our customer’s needs. This quarter alone, we qualified an additional 37 component suppliers and significantly reduced our parts shortages. Based on all the actions we’ve taken with our supply chain over the past year, we now have visibility and confidence that the ramp of our product deliveries will continue to improve and reduce lead times. With a strong outlook for bookings growth and the gradual improvement of supply, we expect backlogs to remain relatively stable for the next several quarters. We’re in the beginning stages of an accelerated wave of product shipments and revenue growth over multiple quarters.

The majority of our backlog consists of the latest generation universal products that pull-through subscription and service bookings. So when our backlog shifts, it will also unleash subscription and maintenance services revenues over the next several years. Throughout calendar ’23, we have several universal product innovations coming to market that will drive better outcomes for our customers. In addition to the 5720 switches designed for higher data throughput, such as our Wi-Fi 6E access points will be coming to market with new industrial switches for hardened environments and smart city deployments. New distribution switches to support the higher power over Ethernet and density requirements of Wi-Fi 6E and Wi-Fi 7 in the future. Several new datacenter and core products will also launched throughout the year.

Lastly, I want to welcome our Interim CFO, Cristina Tate to the call. Cristina is a proven and highly respected leader at Extreme, and I expect a smooth transition as we enter this new growth phase. Remi accepted a new opportunity with a privately owned software company and will stay on with us through the middle of next month to oversee the transition. He was a great partner and leader, and has set the company up for success. With that, I will turn the call over to Cristina to cover the financials.

Cristina Tate: Thanks, Ed. Q2 results highlight solid execution by the team, as well as an improvement in the supply chain environment. Our ability to deliver product resulted in record revenue and continued the trend of double-digit revenue growth we have achieved in seven of the last eight quarters. Our SaaS ARR continued to rise. We improved our margins sequentially, and we generated record cash flow, which enabled us to repurchase 2.6 million shares of our common stock. Our second quarter revenue of $318.3 million grew 13% year-over-year and 7% quarter-over-quarter, which was above the high end of our expectations entering the quarter. With a product book-to-bill ratio of 0.9 times for the quarter, our backlog stands at $542 million, equivalent to 2.5 quarters of product revenue.

The slight decrease in backlog primarily reflects accelerated product shipments. Product revenue grew a healthy 17% year-over-year and 8% sequentially, attributable to both campus switching and Wireless LAN, partially offset by a decline in data center. The ongoing loosening of the supply of access points resulted in Wireless LAN revenue accounting for 34% of product revenue, up from 30% in Q1. Subscription bookings grew by 30% year-over-year, in line with the long-term guidance of 25% to 35% growth provided at Investor Day last May. SaaS ARR grew 29% to $115 million, up from $89 million in the year ago quarter. Subscription deferred revenue was up 38% year-over-year and 9% quarter-over-quarter to $187 million. Q2 earnings per share was $0.27 above the high end of our guidance entering the quarter.

Revenue on a geographic basis once again reflects the timing of product shipments to our distributors across the regions. Regarding our bookings performance, recall that we experienced very strong demand in Q1, resulting from pull-ins of deals from Q2, ahead of the list price increases as of October 1. Then during Q2, we saw less of a year-end budget flush than we normally see and it’s a tight supply environment. This resulted in a slight decrease in bookings in Q2. However, for the first half as a whole, bookings grew low-single digits year-over-year. As a reminder, last year in the first half, our bookings grew in the mid-teens year-over-year. From a vertical standpoint, our mix did not changed meaningfully this quarter, with government and education accounting for over 40% of the total, healthcare at a bit over 10%, manufacturing at approximately 10%, and retail, transportation and logistics approaching 10%.

Services and subscription revenue was $94.9 million, up 6% year-over-year. This growth was largely driven by the strength of cloud subscription, up 33% year-over-year. Total Q2 recurring revenue, including maintenance, managed services and subscriptions was at $88 million, or 28% of total company revenue. The growth of cloud subscriptions and maintenance drove the total deferred revenue to $446 million, up 19% from the year ago quarter and 5% sequentially. Our gross margin came in at 58.5%, up 90 basis points sequentially and 30 basis points from the year ago quarter. This was mainly attributable to our product gross margin, which benefited from higher revenue and an improvement in supply chain and distribution costs, partially offset by a change in the product mix with higher contribution from Wireless.

Our services and subscription gross margin was at 67% in Q2, consistent with both the prior year and prior quarter periods. Q2 operating expenses were $139 million, up from $127 million in the year ago quarter and from $135 million in Q1 ’23, reflecting higher R&D investment and sales and marketing expense to support higher revenue growth. Total operating expense as a percentage of revenue was 43.7%, down 1.7 percentage points versus last quarter. All-in-all, our operating margin was 14.9%, the highest level ever achieved, up from 13.1% in the year ago quarter and 12.1% in Q1 ’23. This quarter, we enjoyed record free cash flow of $67.5 million, driven by the strong increase in our EBITDA, as well as a reduction in operating working capital due primarily to strong collections.

Our cash conversion cycle rose five days sequentially to 24 days. This strong cash flow enabled us to complete $50 million worth of share buybacks, while also reducing our net debt by $14 million to $59.5 million. Now turning to guidance. As we enter the second half, our confidence in the revenue outlook is supported by our product backlog of $542 million, our services and subscription deferred revenue balance of $446 million, as well as a product pipeline that is up double-digits year-over-year. We continue to expect that the reduction in expedite fees and shipping costs, combined with the full impact of our recent pricing actions will lead to a continued progressive recovery in gross margin throughout fiscal year ’23. Against this backdrop, we expect for Q3 revenue to be in the range of $315 million to $325 million, gross margin to be in the range of 58% to 60%, operating expenses to be in the range of $140 million to $145 million, and earnings to be in the range of $31.1 million to $38.4 million, or $0.23 to $0.29 per diluted share.

We expect to cross the 60% gross margin threshold in Q4. For full fiscal year ’23, we expect revenue growth towards the high end of our 10% to 15% outlook, with an operating margin in the mid-teens. With that, I will now turn it over to the operator to begin the question-and-answer session.

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Q&A Session

Operator: Thank you. Our first question comes from Alex Henderson with Needham & Company. Your line is open.

Alex Henderson: Great. Thank you very much. I knew there had to be somebody behind Remi doing all the work, so welcome to the call Cristina.

Cristina Tate: Thank you.

Alex Henderson: It could have been just for Remi. I knew it had to be somebody else. I was hoping you could talk a little bit more in-depth about your commentary around backlog. I think you had said that you thought it would be up slightly in the December quarter, but obviously on a lower revenue guide. So it sounds like the overall orders were actually a little bit ahead of forecast or ahead of what would have built a little bit of backlog. But I think you’d also said that the March quarter, you would expect it to be flat to down here and then the June quarter down a little bit more. So the comment about the backlog relatively stable implies somewhat of a change in the rate of backlog usage bookings would have to be or orders would have to be a little bit stronger than what you had suggested, given the higher comments.

So am I reading that correctly that you’re actually a little bit more confident on new orders based off of what you said about the flatness of the backlog going into the June quarter?

Ed Meyercord: Hi, Alex. This is Ed and then Cristina jumps in behind if you want to add another comment, but I think that’s right. So this is, for us, if we look at what happened as Cristina mentioned that, first half of last year we grew 16% in the first quarter and the first half of the year, and then we were up low-single digits in the first half of this year and then a lot of it got pulled-in to the first quarter. But our supply chain teams have done a great job. We talked about all the work that’s going on behind the scenes. So we’re seeing it loosen. So we’ve seen an acceleration of the release of products. And at the end of the day, we want to take care of our customers with some of that older aged backlog that’s out there.

So we took advantage of that. The second half for us, as you know, we see a lot of demand, and we’re really confident and our teams are very confident of that demand. So we have booking strength we see in the second half of the year, and that should hold that backlog — that should hold the backlog very, very stable through the second half of the year.

Alex Henderson: Yeah. Just to be clear, that’s product backlog you’re talking about, right?

Ed Meyercord: That’s correct.

Alex Henderson: So that also results in an increase in your services backlog as a result of the releases of services on those bookings.

Ed Meyercord: It does. I mean, the other thing that’s happened here is that we have and you can see it from a bookings perspective, we talked about universal hardware platforms and those universal hardware platforms typically will have service attach and always subscription attach. So we have a backlog of subscription and services that will be released as we release the product backlog.

Alex Henderson: Second question I have for you is on the inventory side of things. There is certainly a lot of costs that were inflated over the last year as a result of the supply constraints. When I look at your inventory up considerably over the last two years, is there a — some higher priced inventory in there that needs to be worked down before the full leverage of the upside to universal and lower parts costs plays through? How do we think about the improved availability causing that inventory to come down driving up cash flow?