Extreme Networks, Inc. (EXTR) Earnings Call Transcript

Good morning. Paul Silverstein, senior analyst, communications and networking equipment at Cowen. It's my pleasure to have with us today Extreme Networks. We've got CEO, Ed Meyercord and VP of Strategy, Investor Relations, Stan Kovler, and it really is my pleasure to have both in this meeting with us. And I'd like to start out, I think it's going to probably consume in the next 30 minutes.

And I'd like to start out, I think it's going to probably consume in the next 30 minutes. I'll ask you one question. What are you most excited about? Yes. I set for opening up..

I really appreciate you starting it off this way. Paul, I'm excited about what's happening with Extreme right now and the fact that we're winning in the market, demand has never been stronger. Our leadership position in the industry has never been stronger. Gartner just came out with their ranking like peer insights like how is everyone faring in the enterprise space, upper right quadrant, Extreme is all over the place in terms of what our customers are saying about Extreme as the enterprise. We're clearly taking market share from Cisco. I think most of the industry is doing that right now. We're benefiting from a healthy enterprise market, and we're taking share. So what does that mean? It means we have unprecedented growth in our bookings. We're supply chain constrained. So we're hiding, so you can't really see what's happening on the demand side of the equation. But as soon as you build a model and you leverage book-to-bill and you see what's going on and all you have to do is just rightsize book-to-bill to see the demand side of the equation is so strong for Extreme. When you ultimately turn that into a financial statement, we are poised for significant revenue growth, gross margin expansion and unprecedented earnings growth, certainly since I've been involved with the company for 12 years. So there's never been a better time to be at Extreme and we're poised for an unprecedented run and we're excited about it. The team is strong. We have -- we continue to add to our leadership ranks. And people want to work at Extreme. Our attrition is very low. The culture is a great place to work. And so it's a really fun time to be at the company. We're excited about SD-WAN and the expansion of cloud. And what we're going to be able to do at our Analyst Day, we took our subscription numbers up. So we're talking about 35%, 40% sustained growth in subscription, which for us is a very valuable recurring revenue stream, also supporting the expansion of gross margin. So I just return, we're at the Lotte hotel, I just returned from Seoul, found at the Lotte is a customer of Extreme. We haven't upgraded this hotel yet, but a major provider...

Despite to check before you book the hotel.

Major provider in Korea, Samsung's headquarters runs on Extreme. They're obviously the largest company in Korea. They're expanding a lot, Biden was there talking about global expansion projects. They want to work with us. They're meeting with SoftBank in Tokyo, the largest distributor in that market, Zero with Extreme. They want to open up. They're talking big numbers for Extreme. So every -- globally, in all of our geos, in all of our vertical markets, Extreme is in a position where -- our brand awareness is higher than it's been. Our competitive position is stronger than it's ever been. People are taking notice, and we're seeing more opportunities than we've ever had before. And we're closing on a higher percentage of deals and our batting average and our conversion rate is higher than it's ever been before. So we could talk for a half hour about all things...

Maybe I should have asked that you -- but there's -- it's on a serious note. There is a lots of cracks there. And let me start off. You referenced the fact that it's that fast it's been in 12 years. And I would say, argue, objectively. I'm not covering the sector from a long time. Demand -- and demand environment across enterprise and service provider where you've got a new foothold could be a nice meaningful growth driver for you. And in cloud is the best demand environment I saw in [indiscernible] 26 years now.

Yes.

But it is impossible to discern to stand for those who are familiar with Extreme's history. There have been some truths where you had some really nice growth spurts and then it didn't pan out. This seems to be more durable both because of the demand environment because it appears that you are executing better. But is it possible to discern how much of your current success as people try to extrapolate and determine whether they're sustainable? How much of that success is a function of in demand? How much of this is part of execution compared against...

I think I mean. And you know this better than anyone. In our segment of the industry, normally, you see low single-digit growth rates, right? So 3% to 5% is what you would see. I think in this environment, you're probably seeing like an 8% to 10% growth rate. There's also the inflationary impacts of price increases, which is helping on the bookings and revenue lines that you're seeing out there. And our numbers are about twice the industry. So that's how we know we're taking -- that's the confidence that we have in taking share. The largest competitor in this space is struggling a bit in our space. They don't really have a very good story. They have a problem with cloud, and cloud is the fastest-growing segment of our market. So they have a cloud, which is a 15-, 20-year old architecture that hasn't been modernized. We've taken a long time to get there. They have the bulk of their business that they can't move to cloud without a complete rip and replace, which opens the door to competition. And there's a lot of dislocation in the market because of that. And so this is why we're getting more looks. And so we think the market share gains for Extreme are sustainable. In terms of the overall strength in the market, look, if you're a 5%, 6% market share player, the ups and downs of kind of the overall market should have less of an impact on us. So if the market does recede back into the low single-digit bookings growth numbers, we still see extreme outperforming the market largely because we're taking share from the largest player. And there's a lot of interest in the channel. There's dislocation in the channel with that player. And then with end-user customers, we just have a better story. And so that's what we're -- that's why I say we're winning more in the market. So I'd like to say large chromes because we take little points of market share, and it has a bigger impact on Extreme than our top line. So -- in many respects, we're not as squarely in the radar as some of the other competitors. So just we see this sustained bookings growth over the next several years. Now there's a math exercise, a simple math that you can ignore the market and just go through math and say, if we were flat, no growth for the next 3 years. The revenue growth from Extreme would still be unprecedented just because if you look at the right side of book-to-bill, if I'm building $350 million of backlog this year, I'm just not showing it on the revenue line. Normally, in a one-to-one booking environment, your model, you should add $350 million to what's really going on at Extreme today to understand how we're performing.

Well, just to be clear, what you're saying is historically, you and Cisco and Juniper, everybody, at least in is focus, it was all booking ship. It was 90 days you shipped within 90 days...

Yes, within 60 days. Yes. And so now what's happened is the book -- when you're a 1.4 book-to-bill and then you're building up -- so it just means in your revenue, you're just not showing true demand and true performance because you're creating backlog. So then the question turns to supply chain, and it turns to what is your confidence in releasing the backlog. So there's the normalization of book-to-bill, which is powerful because that adds significant growth just to right size to where we are with demand. And then there's the release of this backlog, where this year, we're building over $350 million. We're going to be over $450 million of backlog. Next year, if I build only $150 million. So I'm still not completely rightsized in fiscal 2023, but I released an extra $200 million of product, that's really nice growth -- and then if you start releasing backlog, and that's where I think the model -- because you don't have the operating expense. So there's -- the operating expenses really tied to bookings. So as you start rightsizing and releasing, you don't have the expense. So it's massive operating leverage.

Well, I'm going to get to that. But I think what you're highlighting this is universally true. It's hard to meet [ competitor ] company for which this would not be true in networking. Which is the dramatic increase in backlog is going to sustain growth well into the -- I think the real debate is does that carry over because there's an element of demand that clearly is not, I would argue, true demand in the sense that all customers really large customers are forward order and it's not immune to you. It's pretty universal throughout the industry. But I think the real question is, is it 2 years, 3 years? What's the duration of that extraordinary growth that you and others are looking at. But let me get back to.

Just from an industry perspective, I think we see kind of from where we are today, I'd say another 12, maybe 18 months of strength in demand. This is based on our funnels and opportunities.

With orders exceeding revenue and building backlog.

Yes, I would say our outlook for that is probably another year -- and then we feel like a year from now we can rightsize that...

It's been the question is once in orders we're going to come down below revenue, your book-to-bill, everybody's book-to-bill we see [indiscernible] at some point. I asked in the questions, all right. So how long be on that point, right, that build up a backlog? How long do you take you to drain backlog back down to normal levels and drive...

So we're calling the end of fiscal '25. And so -- and then we look out, and I'm saying, okay, so what is fiscal -- I'm literally looking at fiscal '26 because I'm thinking about, okay, with massive growth and the earnings tsunami, which is coming at Extreme with supply chain, crazy. Then how do we sustain that in '26 and '27. And the reality is it's really the growth in subscription now with this higher performance of recurring revenue, which is very supportive of kind of stabilizing a flat 26% and then continued growth in '27. So -- and all of this is on a very modest product bookings assumption, which is why -- can the modeling exercises so fascinating.

I wonder for the benefit of those, I may not know 2 related questions. One, when you talk about cloud, where you've had a lot of progress and you're doing very nicely. You're specifically if not entirely, you're largely referencing your wireless LAN business, which is not the...

Wired and wireless.

Wired and wireless. But a lot of that [ correction ] is on the wireless side, having a cloud-based AP. And it's not totally isolated because increased lean in more and more enterprises are making a holistic decision. They're not bifurcating treatment except the way we used to. And so there's a time effect. But also the larger point about moving to a subscription model, the moment you or your peers are doing as well. You're having a lot of success in.

Yes. We have a we can make a very compelling argument that we have the highest quality cloud in the industry. From a security standpoint, in terms of the architecture of our cloud in terms of we're going to be announcing. We have our user conference next week, and we're formalizing our AIOps tool, co-pilot, which brings operating efficiency into the network, it brings sort of new insights into the network. And so it's a license that will go on top. -- you're piloting a plan, you have a co-pilot that's helping you along and we're excited about that. Mist is a competitor that's been very good selling their AIOps. We have a very compelling story to compete with them, but the largest competitor doesn't really have that story. So it's really about us taking share from the larger player. And then we also have a very different story in terms of data. And to what -- our selling motion, our narrative in the market is different than everyone else's. We're talking to customers about how are you leveraging data from the network to drive a better business outcome. And you can do it. That's why our Investor Day at Major League Baseball was so important because the COO of Major League Baseball set up here at the other stage and talked about how there are new ways to drive better outcomes, leveraging information from the network. And this is what networking is going through a very different stage where all of a sudden, you have visibility and insights, the network is very smart. We know everyone in this room. We know every device which is running on the network in this room. We know every application running on every device in the room. So if you're running this hotel, you have a lot of intelligence as to what's going on or a stadium or a hospital, et cetera. So we're just unlocking this data for the first time. No one has a more compelling data story than Extreme in the marketplace. And so this is why we've won all the sports leagues. This is why -- that's where we're most advanced in terms of our data analytics. And now we're going to sort of -- we're bringing this into other industries in terms of health care, in terms of manufacturing. One of the largest manufacturing companies in the world is working with us on how do we leverage the network to lower our carbon footprint. Very different discussion around speeds and feeds and kind of different kind of discussion. And that's what cloud brings. And that's where all of a sudden extreme is bringing a different viewpoint. Cisco, we have to talk about them. Meraki can't manage Cisco equipment although Extreme can. So we can literally manage Cisco equipment. So we're winning customers because Cisco can't put their devices in the cloud when Extreme can. So this is the market environment that we're in.

Let me interject and just again for the both of the audience. What Ed's highlighting beyond his argument about what Extreme can do that competitors can or can't do. I'd argue it's a very important network-wide industry-wide phenomenon. It's not just an enterprise and not just from wireless, wireline. There is a large trend about networking becoming -- I would argue, becoming increasingly important, increasingly relevant, and that's relative to concerns, I think, long-standing concerns or pricing concerns among many investors from some of you that networking is being commoditized earlier just the opposite. I have the role in the network, especially to Ed's point, about monetizing data. And again, I can talk to you about broadband access and many different arenas. This is true. And so I'm not here to talk extremes but on objectively, I think what I'm saying is...

The other thing I was going to say, I want Stan chime in here a bit. But with SD-WAN, from the cloud, and you'll hear us talk about sort of like there's one network, end-to-end network from Extreme and then there's one cloud to manage the entire network. So with enterprises becoming more distributed, we have the only SD-WAN solution orchestrated from our one cloud. So with the cloud, you've got to orchestrate the edge of the network, SD-WAN branch environments as well as campus environments, core environments, all from a single cloud. And then you could do this with subscription licenses. So Stan, maybe you want to just highlight the market and kind of how our -- the expansion of our solutions across the wide area network kind of changes in market...

Stan, before you begin. It just -- get us a chance to get us into -- Extreme may need acquisitions of a private company Panama of Panama the paper -- SD-WAN was a part of more what we first wrote about at the very SD-WAN, where at the beginning, I think there were 70 different companies claiming to act. The landscape has rented out dramatically and Panama the most recent one and that thought into the SD-WAN arena. It was what about a year ago, and you guys have obviously done a lot of internal R&D and time products where you want a...

Yes. So thanks. And you talked about the core market for networking being in that low to mid-single-digit growth right? And so if we had stayed in that core market, that's what we would have been -- have access to from a TAM, but I think what's interesting is what we showed at the Analyst Day a couple of weeks ago is that we have expanded our TAM to the point where if you look at the growth rate of what we have access to as a company now is a double-digit TAM growth, because between the access to the SD-WAN market, the additional AIOps services and all these other software elements that we can add and the longer-term things that we're investing in are underlying TAM is accelerating. And that's what's exciting for me is that now we have access to all different areas of growth. And what it translates into from a financial model perspective is that average revenue per account for Extreme can grow, we can grow wallet share. Average revenue per unit can grow because all of a sudden, you're selling the base license to manage the device and you can sell an AIOps license to add other elements and so on and so forth. And so that's really the exciting part for our model and what I was talking about in FY '26. As we go through this cycle of very strong product growth, one of the things that you can knock us for, Paul, is that we're actually not growing our percentage of recurring revenue all that much, right? We said our goal at some point is to get that to 40%. We're going to be in the low to mid-30s because of that upside in the product revenue growth, not because it's not growing itself. So the contribution is there. Once we get through the next couple of years in this investment cycle and all this technology that we're building, that's the next phase of the story so that you have the stickiness of the cloud sort of like the iCloud and the iPhone model where that creates the next phase of demand. And it's been a couple of years since we made the initial Aerohive acquisition. There's going to be a lot of renewals of the subscription that we've had there. So in addition to new licenses, we have the renewals piece. We have the SD-WAN and the new elements that we're selling. It's a very compelling story...

There's a waterfall effect that things what you're highlighting.

Exactly.

Just bear in mind as within a subscription model, those new subscriptions have -- it's a better model. And I think what Stan is highlighting is the benefit as measured by recognized revenue and thereby [ APS ], that's still on to come, but they're good early data points. But speak to that. Let me also -- and I think you touched on it briefly, but I want to give you all the opportunity to speak to the margin portion of the story, which is obviously tied to revenue. It's not to bore from revenue, but it's also tied to the way you're shifting your revenue. And just for a frame reference, you all struggled for many years to get to 60%. And you -- along with everybody else, not Extreme specific, but obviously COVID related, the whole backup in expenses, great logistics, [ ICs centers ] has impacted you just like everybody else. But it seems like you're again, you have a more durable, that there's a real story here, not just a transitory, but it looks like you're driving secular improvement, albeit intercepted to some extent. -- by the current situation, not Extreme specific, let me let you all address the outlook there.

Yes. So everyone is familiar with what's going on in supply chain. And I think every company in our industry has been talking about this. For us, what does it mean? It means that on a gross margin line, we currently have visibility to what is permanent versus what is variable because of the current environment. And so today, we're absorbing approximately 7 gross margin points of incremental expense because of all the expedite fees in terms of incremental payments for component parts because of the transportation and freight charges and all the constraints that we've had -- they really add up. It's a huge number. Now as we -- model going forward, we expect 2 points to blend into permanent cost and then for us to recover 5 points over the course of this modeling period if you look out through fiscal '24, okay? So fiscal '23, fiscal '24, you see the normalization...