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Executives

Mark Canepa - President & Chief Executive Officer

Karen Rogge - Senior Vice President & Chief Financial Officer

Analysts

Doug Ireland - JMP Securities

Sam - Wedbush Morgan

Extreme Networks Inc. (EXTR) F2Q09 Earnings Call January 28, 2009 5:00 PM ET

Operator

Good afternoon ladies and gentlemen and welcome to the Extreme Network’s 2009 second quarter conference call. At this time all participants are in a listen-only mode. Following today’s presentation, instructions will be given for the question-and-answer session. (Operator Instructions)

On the call today from Extreme Networks are Mark Canepa, President and Chief Executive Officer; and Karen Rogge, Senior Vice President and Chief Financial Officer. As a reminder, this conference is being recorded today, Wednesday, January 28, 2009.

This afternoon Extreme Networks issued a press release announcing the company’s financial results for the second fiscal quarter of 2009. A copy of this release is available at the company’s website at www.extremenetworks.com. This call is being broadcast live over the internet and will be posted on the Extreme Network’s website for a replay shortly after the conclusion of this call.

The company has asked me to remind you that this conference call contains forward-looking statements that involve risks and uncertainties, including statements regarding the company’s expectations, regarding its strategy, growth of customer bandwidth demands, development of new products, customer acceptance of the company’s products, customer spending and economic conditions in the company’s market.

Actual results could differ materially from those projected in the forward-looking statements, as a result of certain risk factors including but not limited to fluctuations and demand for the company’s products and services, the highly competitive business environment for network switching equipment, it’s effectiveness and control expenses, the possibility that the company might experience delays to make development of new technology and products, customer response to it’s new technology and products, the timing of any recovery in the global economy, risks related to pending or future litigation and a dependency on third parties for certain components, and for the manufacturing of the company’s products.

The company undertakes no obligation to update the information on this conference call. More information about potential factors that affect our business and financial results is included in the company’s filings with the Securities and Exchange Commission, including without limitations under the captions, management’s discussion and analysis of financial conditions and results of operations and risk factors which is on the file for Securities and Exchange Commission.

Throughout the conference call the company will reference to both GAAP and non-GAAP financial results. The company has provided a reconciliation table of GAAP to non-GAAP and information in the tables that accompany the press release on its website. Please go to the Investor Relations section of the company’s website at www.extremenetworks.com. In addition all announced results are preliminary and maybe subject to change when the review of the fiscal quarter is concluded and/or a Form 10-Q is filed.

I would now like to turn the call over to Mr. Mark Canepa, President and CEO of Extreme Networks; please go ahead sir.

Mark Canepa

Thank you, Mary and thank you all for joining us today. I would like to cover three points with you: a brief review of the quarter, what we are doing to maintain success in the current financial downturn, and market expansion opportunities we are positioned to capture. I will then turn the call over to Karen for details on the financials.

Revenue for the quarter was $87.5 million, which is down slightly from last quarter. Pro forma earnings were $0.04 per share. Given the severity of what appears to be a still-worsening economic climate in the United States and in most of the world, we are satisfied with these results.

While revenue for the Americas decreased sequentially in year-over-year, revenue outside of the Americas continued to increase, both sequentially and with respect to last year. Our product book-to-bill was slightly above one and we again were able to increase our cash position. Karen will give you the details later on.

Over the next few quarters, we do not expect the US and many of the world economies to show material improvement. We expect it to be difficult for our customers to obtain credit and we expect capital investments and operating budgets to continue to be under significant pressure for the foreseeable future, we plan to manage accordingly. At the same time, our customer’s challenges drive opportunities for us to create solutions, to make the most effective use of our customer’s limited resources.

Furthermore, in the U.S., we are closely monitoring the plans of the new administration intends to pursue to stimulate the economy and are positioning to take advantage of those. We have positioned ourselves for some time, in markets such as health care and education, two industries that seem to be poised to receive significant government investment.

Another market that may receive government attention is broadband deployments by small and mid-sized service providers in rural part of the U.S. While many of the players in the Ethernet segment of the networking industry are distracted in the result of recent mergers or in financial crisis, we are free to focus our energies on finding the right opportunities to serve current and new customers and gain market share during this tight economic period. Specifically, our strategy is to focus our energies in the following three areas.

First, we will focus on local and regional carriers which need to upgrade their legacy infrastructure. We will do so in partnerships with system integrators and for larger projects, with our strategic network equipment provider partners Ericsson and Nokia; second, we will focus on the conversion of data center connectivity to 10 gigabit, especially Top of Rack applications; third, we will focus on campus enterprise applications which need to reduce overall costs through the implementation of a single standard based architecture that covers the core to the wiring closet.

Let me tell you a bit about those opportunities in more detail and why Extreme is well positioned to offer compelling value to our customers. We through consistently about the opportunity in the metro service provider, a $2 billion-plus fast-growing market, we continue to focus in this segment and again this past quarter we generated about 30% of our revenue in the carrier market. Even in an economic downturn the opportunity is compelling.

Triple Play residential services continue to be enhanced. The number of HD channels and the number of video on demand sessions continue to increase, driving the need for more bandwidth. Emerging markets around the world and rural markets in the U.S. still need to build the required infrastructure and are searching for the most cost effective way to accomplish this. I believe that highly scalable Layer 2, technologies is the way to do it.

Therefore, over the past year we’ve built the most scalable and cost effective carrier grade Layer 2 switches in the industry. As an example, our BlackDiamond 20-K family, which we launched last quarter, can deliver up to 80,000 simultaneous, independent HD video streams. In the U.S. alone, there are over 1,000 small to mid-sized service providers delivering business and residential services to their communities.

Most of these service providers still use expensive legacy technologies which are difficult to adapt to the needs of modern video capabilities and need to be upgraded. For larger applications Ericsson and Nokia routinely integrate our technology into sophisticated metro core and wireless backhaul projects around the world.

In addition, we are beginning to hear from some of our customers of their plans to offer direct 10gigabit customer facing interfaces. This trend could drive a significant increase in ports and bandwidth requirements. The economics of Ethernet are such that service providers can continue to scale to higher volumes thereby lowering the overall capital cost per subscriber.

Our Ethernet solutions also bring simplicity, allowing new services to be provisioned faster and more simply, thereby lowering the overall operating expenses for the service provider. I continue to spend a great deal of my time out on the road, talking to new and existing carrier customers about their needs for equipment for their network deployments.

Our customers consistently tell us that the BD 20-K serves as a great platform for their new carrier Triple Play infrastructure requirements. They like the 20K because it is priced to address their current needs and has the capacity to grow as their needs grow down the line. They also like that compared to solutions from larger networking companies, the 20K significantly cheaper to deploy and operate, easier to maintain and support and faster to evolve and enhance. The BlackDiamond 20-K delivers three times the performance at half the price of currently installed solutions.

The strategy to focus on the carrier market is paying off. Heavy Reading noted just a couple weeks ago that our carrier Ethernet switching products gained market share in the third quarter of 2008 and that Extreme is now the number three provider in this important and growing space.

Another particularly attractive opportunity for Extreme lies within the data center. The world economy will continue to present us with significant challenges, even after the current financial crisis is behind us. There are fundamental long-term challenges in energy, the environment and health related development that will be with us for the next generation.

The answers lie in understanding and creating fundamentally new approaches, whether it is the search for new energy sources, technologies to deal with greenhouse gases or the development of new and more powerful medicines, these approaches will all have one thing in common, the need fro massive amounts of computation, data transport and storage.

Companies are responding by building new data centers around the world and provisioning to enable the solutions to these challenges. Extreme is responding with the creation of powerful networking solutions, focused on the transition to 10gigabit. All the new multi-core processors generate massive amounts of data, which needs to be transported.

New servers are being developed with 10gigabit interfaces. 10gigabit networks are needed at the Top of Rack to aggregate these data streams. Extreme enables cost effective, flexible, scalable and standard compliant Ethernet solutions. At Extreme, we’ve understood this trend and have been working on powerful solutions. For example, this past quarter we started shipping the Summit X650 family of 10gigabit fixed configuration switches. The X650 is designed to boost performance and can sustain up to 48 continuous streams of 10gigabit data over either fiber or copper, at a price of less than $1,000 per stream.

Additionally, we are working closely with Intel, a market leader in the space to integrate our network equipment with their IO cards, to provide fully tested, seamless integration for our customers. We also work with server market leader Dell, to integrate our network products into Dell data center server and storage solutions for distribution through Dell’s extensive sales network.

We are also gaining traction in the enterprise, with a refreshed and expanded portfolio of products that now include an expanded line of lower cost products, to complement the higher end. [Inaudible] continue to de-leverage they are looking at their capital expenditures very carefully. Today they want to use their networks to reduce their costs and build efficiencies.

Price and ongoing maintenance costs of the network matter far more in recent times, before the credit meltdown. We have invested resources and now have a full product line in place. From the wiring closet to the core of the enterprise, we offer Layer 2 and Layer 3 solutions, to support the most sophisticated enterprise applications.

Now that I have told you where we are focusing on to gain market share, let me tell you a bit about some of the recent wins that we have enjoyed. We continue to build the expansive distribution network for ENEL SPA, Italy’s largest power company, which serves over 50 million power and gas customers. Extreme, along with our partner Nokia Siemens Networks, assists ENEL in it’s data center and convergence needs, implementing our BlackDiamond 8800 and our Summit X450 switches.

In Russia, Extreme continues to be an integral part of the Moscow network renovation, addressing the installation of new high performance Ethernet networks for government agencies and more than 3,000, K312 schools where next generation Internet applications and convert services are being adopted. We are working with the local service provider MRS to deliver scalable and secure network infrastructure.

During the quarter, VMware relied on Extreme, as the company continues to build its extensive networks including in metro Ethernet ring, in addition to supporting their needs for high performance Ethernet within their development in test laboratories. Within the carrier Ethernet market we continue to build new and extend existing networks.

Italy’s WIND, a progressive carrier continues to leverage our BlackDiamond and Summit switching solutions, to deliver converged Triple Play services and high-speed data services to its subscribers throughout the country. OGERO Telecom based in the Middle East, grew its presence again this quarter with Extreme’s scalable carrier technology. This supports broadband connectivity between localized ISPs, with the goal of expanding the network for the delivery of IP TV services.

So you can see that we continue to make progress and gain customer traction. Of course, the economic downturn will continue to impact many companies and we are certainly not immune, but the fact remains that the need for broadband expansion continues which presents an opportunity for us. Particularly during these lean times, companies are highly focused on costs in ROI. In addition, the areas of government stimulated growth like health care, government and education are all areas we have been concentrating on and are making positive gains.

With that, I’ll turn the call over to Karen for more details on the financials.

Karen Rogge

Our second quarter results reflected the difficult macro-economic climate in the U.S. Despite this backdrop, we managed our operating expenses in the quarter to deliver a profit and increase our cash and investments. Overall, revenue for the quarter was down 2% from the year ago quarter. Pro forma gross margin declined 1.7 percentage points compared to the year ago quarter and cash and investments increased $900,000 from the prior quarter.

Product revenue was $72.6 million, which compares to $77.4 million a year ago. Once again, EMEA revenue grew stronger, increasing 18% from a year ago. Our product book-to-bill ratio was one for the quarter. Service revenue was $15 million and inline with the prior year’s results. We continue to see further progress in our services business. The ratio of enterprise to service provider sales was 71% to 29%, which compares to our historical pattern of 74% and 26% respectively.

The decreased percentage of enterprise sales was primarily due to the lower proportion of sales in the Americas region. Sales of new products introduced to market in the past 24 months were 37% compared to 41% in the prior quarter, primarily due to the maturing of our Summit 450 product family.

We believe this ratio will increase as the recently introduced BlackDiamond 20-K and Summit 650 product lines begin ramping during the coming quarters. The ratio of stackable and modular product sales was 67% and 33% respectively and inline with our historical pattern.

Looking at revenues by geography for the quarter; revenue in North America was $33.4 million which compares to $35.7 million in Q1 and $40.5 million in the year ago quarter. We continue to see a slowing of business in North America, as a result of the ongoing macro-economic downturn in the United States.

Product and services revenue in the region declined 20% and 9% respectively from the year-ago quarter. EMEA continued to grow stronger, with revenues of $42.2 million, up from $41.6 million in Q1 and $35.7 million in the year-ago quarter. This represents the fifth consecutive quarter of growth in the region, primarily driven by an increase in service provider sales in Eastern Europe.

Product sales increased 17% and service revenue increased 27% compared to the year-ago quarter. Revenue in Asia Pacific was $11.9 million, down from $16.3 million in the year ago quarter. Products and services revenue in APAC declined 29% and 14% respectively from the year ago. We believe the company’s growth in Asia is limited primarily by our execution, as opposed to the broader macro-economic climate and we are in the process of rebuilding the management team and partner relationships in the region. We continue to perform well in selected markets, including Korea and India.

Let’s now turn to non-GAAP gross margin results, which exclude the effect of stock-based compensation. As a percent of revenue, total non-GAAP gross margin was 55.8%, down 1.7% points from the year-ago quarter. Product non-GAAP gross margin as a percent of revenue was 56.8%, down 3.2% points from a year ago.

The decrease in product gross margin was primarily driven by the decrease in revenue, product mix and increased distribution costs of $0.5 million, partially offset by a decrease in warranty costs of $0.4 million due to improvements in quality. Service non-GAAP gross margin was 50.7%, an increase of 7 percentage points from the year ago quarter, primarily due to the change in the amortization of our spares inventory of $0.6 million and a decrease in service overhead spending of $0.4 million.

Non-GAAP operating expenses were $46.2 million, which is down $4.2 million from the prior quarter. The decline in operating expenses compared to the first quarter was primarily due to the reduction of $1.8 million in variable compensation, $0.75 million related to the December shutdown and $0.65 million in other expense controls, including the reduction of our contingent work force.

In comparison to the year ago quarter, expenses were down $3.3 million, primarily due to the reduction of variable compensation expense of $4.1 million, decreased R&D project spending of $0.6 million, offset by an increase of $1.2 million in general sales and marketing expenses. Other income was $0.8 million, which primarily includes foreign exchange gains.

Non-GAAP net income was $3.5 million or $0.04 per diluted share, which compares to $5.5 million or $0.05 per diluted share in the year ago quarter. In summary, revenue and gross margins declined from the second fiscal quarter of last year, partially offset by reduced operating costs.

Turning to the balance sheet; at the end of December, cash equivalents and investments increased $900,000 from the September quarter, ending the quarter at $143.5 million. Cash flow used in operations was $2.8 million, primarily due to a decrease in deferred revenue of $6.9 million, increased inventory of $6.6 million, as a result of lower sales than forecasted, offset by a decrease of $9.1 million in accounts receivable.

At the end of the second fiscal quarter, regular employees were 863 and in line with Q1. As a part of our effort to align operating expense with anticipated revenue, we reduced our contingent work force in Q2 by 37 people or 47%.

We are continuing our practice of not providing specific guidance for the coming quarter. Against the backdrop of uncertain macro economic conditions, we are focused on the need for fiscal discipline and executing on the areas we can control, to maximize our profitability and cash flow from operations.

During Q2, we took measures to reduce our work force, executed the December shutdown and reduced discretionary spending levels including travel. Looking forward given the continuing weakness in the worldwide economy and what has historically been a seasonally down quarter in Q3; to further manage our cost structure, we are focused on reducing inventory levels to be in line with our current operating needs, aligning operating expenses with anticipated revenues and ensuring adequate cash flow to protect the business.

Specifically in Q3, we have already announced a one week shutdown for our US operations and reduced executive compensation. While we are tightly managing our expenses, we are continuing to invest strategically in technology, products and partnerships to bring our new solutions to market.

With that, I will now turn the call back over to Mark.

Mark Canepa

Thank you, Karen. This concludes our prepared remarks and we are now ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Samuel Wilson - JMP Securities.

Doug Ireland - JMP Securities

Hello, this is Doug Ireland for Sam Wilson. I was wondering if you have considered a reverse stock split, as your stock is down between $1 and $2?

Mark Canepa

Yes, good question. These are all pieces of the planning process. Those kinds of things, stock buybacks and so on that the Board considers from time-to-time and these are discussions that I and the Board have on a regular basis. For now, we felt that we are in the correct position. If the Board were to arrive at a different conclusion, obviously we would take action.

Doug Ireland - JMP Securities

Do you consider the Dutch tender that you carried out in the quarter successful?

Mark Canepa

Well, certainly the Dutch tender achieved its goal. We wanted to retire a $100 million worth of stock at that point in time and we were able to reduce our outstanding shares by something close to 25%. So from that point of view, it met the needs.

Operator

(Operator Instructions) Your next question comes from Rohit Chopra - Wedbush Morgan.

Sam - Wedbush Morgan

This is actually [Sam] for Rohit Chopra. On the European service provider sales, we asked this question last quarter, but could you give us an update on where we are in the implementation cycle?

Mark Canepa

That’s right, the question was asked last quarter. We have a lot of service providers in various parts of the world and all in different stages of where their life cycles might be. So we don’t have obviously precise data for any one. We believe that they are continuing their implementations and we continue to work with them on an ongoing basis.

Sam - Wedbush Morgan

I mean, but overall generally do you feel like we are still in the beginning phases or we’re mid-cycle?

Mark Canepa

Well, it depends on the particular carrier. I mean, some of them are just beginning deployments. For example, the Moscow government one, we put it under the enterprise category. It’s really very much of a carrier kind of deployment. Those are long ways to go there and some of them are a little further down the line.

You’ve seen that over the last few quarters our Carrier business continues to be pretty healthy. We believe we’ve got good products and not only are we continuing with the deployment of these carriers, but we are continuing to work and find other carriers that over time will begin to begin new deployments.

Sam - Wedbush Morgan

Great and then Karen maybe just a follow-up on service gross margin; there’s a nice bump-up there. Now, how sustainable is that going to be to get to north of 50% gross margins on the services side?

Karen Rogge

Well, we’ve been looking at our service provider business quite some time and we’ve have been talking about that. In looking at that business over the last few quarters, it has stabilized I would say in the low 50’s range.

Sam - Wedbush Morgan

Great and one final question on R&D, that was down; you mentioned last quarter that it probably would be down. It was a little bit more than I was expecting. Is there anything else in that number that’s maybe like one time?

Mark Canepa

R&D bounces around. It was up kind of last time because as I was telling you we were sort of in the final phases two of major problems, the X650 and the BD 20K. We are winding down a little bit of those and we are a bit in a lull and I’m sure there’ll be other programs that are going to be coming along. Now all that said, we are watching our R&D expenses very carefully like all of the other expenses in the company and we continue to focus our resources where they need to be.

Operator

(Operator Instructions) and management, I am showing that there are no further questions. I’ll turn it back to you for closing comments.

Mark Canepa

Well, thank you Mary. Thank you all for joining us this afternoon. I want to thank all of our employees for their dedication and effort, especially during these challenging times. We look forward to speaking with all of you again at our next conference call. Thank you.

Operator

Thank you. Ladies and gentlemen that will conclude today’s teleconference. If you would like to listen to a replay of today’s conference, please dial into 303-590-3000 or 1800-405-2236 and enter the access code of 11124856#. We thank you again for your participation and at this time you may disconnect.

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Source: Extreme Networks Inc. F2Q09 (Qtr End 12/28/08) Earnings Call Transcript
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