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Extreme Networks, Inc. (NASDAQ:EXTR)

F3Q09 (Qtr End 3/29/09) Earnings Call

April 23, 2009 5:00 PM ET

Executives

Mark Canepa - President and Chief Executive Officer

Karen Rogge - Senior Vice President and Chief Financial Officer

Operator

Good afternoon ladies and gentlemen and welcome to the Extreme Networks 2009 Third 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.

On the call today, the 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, April 23, 2009.

This afternoon, Extreme Networks issued a press release announcing the company's financial results for the third fiscal quarter of 2009. A copy of this release is available at the company's website at www.extremenetworks.com. This call is being broadcasted live over the Internet and will be posted on the Extreme Networks' 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 financial performances, strategy, growth of customer bandwidth, demands, development of new products, customer acceptance of the company products, customer spending and economic conditions in the company market.

Actual results could differ materially from these projects in the forward-looking statements. As a result of this certain risk factors including, but are not limited to fluctuations in demand for the company's products and services. A highly competitive business environment for network switching equipment; its effectiveness in controlling expenses, the possibility that the company might experience delays in the development of new technology and products; customer response to its 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 could affect our business and financial results is included in the company's filings with the Securities and Exchange Commission, including, without limitation, under the captions: Management's Discussion and Analysis of Financial Condition and Results of Operations, and Risk Factors, which are on file with Securities and Exchange Commission.

Throughout the conference call, the company will reference both the GAAP and non-GAAP financial results. The company has provided a reconciliation table for the GAAP to non-GAAP and information on the tables that accompanying the press release on the 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 may be subject to change when the review of the fiscal quarter is concluded and our Form 10-Q is filed.

I'd no like to turn the conference over to Mr. Mark Canepa, President and CEO of Extreme Networks. Please go ahead sir.

Mark Canepa

Thank you, Patty and thank you all for joining us today. Revenue for the quarter was $77.2 million, down 6% from the quarter last year. Pro-forma EPS was $0.01 per share. I am pleased with the cost cutting effort we put in place and our ability to retain pro-forma profitability in a very tough economic market. While book-to-bill was below one and while we were cash flow negative for the quarter primarily due to timing of payables and receivables, we were able to maintain constant inventory levels despite a drop in demand for the quarter.

Our business this past quarter was slow to start and was more back-end loaded than normal, with linearity weighted even more than usual towards the last few weeks of the quarter. Karen will go into further detail on the financials in a few moments.

The slowdown that started in the U.S. last summer has spread to other economies across the globe and we would expect that could be at least a few quarters until capital investments and operating expenditures begin to recover. To add more color to do what we have seen in our geographies compared to Q3 last year, the enterprise business saw a significant drop in North America consistent with the depth of the U.S. enterprise slowdown. The enterprise business was roughly flat in EMEA and was up in Asia Pacific.

The Service Provider business was very strong in North America and up significantly from last year, reflective of our focus on the carrier market. The developing business with any key strategic partners more than offset the macroeconomic slowdown. In EMEA and APAC, we saw a slowdown in the SP business consistent with the trend of lower carrier spending.

While we wait for signs of a recovery, we continue to make progress. For the quarter, we added more than 100 new customers to Extreme. Even in tough economic times, thoughtful customers clearly see the value proposition that Extreme Networks, our products and our capabilities offer to them. We help lower their capital expenditures, control operating costs and let them deliver new services more quickly; a great combination for cost conscious customers who need to do more with less.

Despite the recession's impact on overall levels of business, we continue to demonstrate progress in the service provider markets in our chosen enterprise verticals and in the data center.

The carrier Ethernet market represents an increasing part of our business and now generates more than 30% of our revenue. Our primary focus has been Tier-Two and Tier-Three players which are less dependent on large legacy networks and are more likely to gravitate towards best-of-breed equipment providers to gain a competitive advantage.

Extreme products are also being deployed into Tier-One carriers through deployment by our strategic partners. We currently enjoy the number three market position in the carrier switch market according to analyst firm and phonetics research report for the fourth quarter of calendar year 2008.

The need for increased bandwidth remains constant for all carriers, in a good economy as well as in difficult times. Customers come to us because we help them drive their profitability by delivering increased services over our common Ethernet transport infrastructure.

Now more than ever, the particular needs of the small and mid-sized carriers play to our strength. We're helping carriers win by demonstrating their highly scalable Ethernet transport solutions provide the best value for delivering Ethernet services to businesses, Triple Play aggregation for residences and Ethernet mobile backhaul solutions. For example, P2 in Slovenia is able to provide Triple Play services to residential customers materially less expensively compared to the incumbent based on the efficiencies and reliabilities of our product.

With our expensive product refresh over the last year, we believe we have the most scalable and cost effective carrier grade Ethernet switches in the industry, which I believe will enable us to gain market share in the service provider market.

This quarter, we began production of the BlackDiamond 20K family of products with shipments to four carriers and evaluations begun in it more. In connection with the availability of the BD 20K, this past quarter we have launched an initiative to focus on the segments of the carrier market that gave us the small to mid-sized markets and provide a range of residential and business services, as well as wholesale wireless backhaul.

They need powerful, scalable, yet easy to deploy solutions. For example, Vernon Telephone Cooperative of Wisconsin is seeking high performance and value for its network to support services including voice, IPTV and Internet. They selected the new BlackDiamond 20K switch for performance, reliability and lower costs.

In Europe, we continued our business with a number of carriers such as T-Com Croatia, Wilhelm.tel of Germany and WIND of Italy. Each of these leverages Extreme to build resilient, scalable networks that support a mix of residential and business services.

In Asia, we've seen traction with carriers through our relationships with Nokia Siemens Networks and Ericsson for both Triple Play networks and wireless backhaul. The converged campus enterprise market has been a large and traditional market for Extreme. Customers in this market continue to deploy new applications which drive more requirements in their networking infrastructure.

Customers need networking equipment which can scale and be flexible to support their needs while being cost effective. This is more than ever true now that most enterprise IT budgets are under extreme constraints. Our customers recognize that we simply provide better value for their implementations, especially in the markets we've chosen to serve.

Education has been one of our key vertical areas of focus. We continue to do very well with K-312 (ph) schools, colleges and universities, all of which are making better use of converged communication, the Internet and wireless mobility to improve the experience across their campuses. We believe we're gaining market share by focusing on our current customers and adding new ones. For example, we believe we've increased our revenue in the U.S. education market by 25% over last 24 months.

Specifically during the quarter, we finished building a converged network for Boulder Valley School District of Colorado. Extreme was also selected by the Farmington Public School District in Minnesota, where Extreme has replaced the Cisco network.

Government both in the U.S. and abroad has also been an area of growing strength for us. This segment tends to demonstrate more consistent spending in times of economic distress and is an area that has been identified as a recipient of significant stimulus spending. As evidence of this growth, during the recent quarter we helped a number of states including Nebraska, Oklahoma and North Dakota. We've built converged networks for local municipalities including the cities of Memphis and Beverly Hills.

Finally, within the U.S. Military, we continued our business with the U.S. Army and Marines. Outside the U.S., we had significant government wins in Korea with the Seoul Government and in various local governments in India.

Last month the Summit X650 Switch was named the infrastructure product of the year by the UK's leading network magazine Network Computing. The award is a testament to our attention to converge Ethernet technology and our continued innovation in the market.

The data center is another area of focus for us. Customers are building data centers with ever increasing computational and storage capabilities and are estimated to purchase about $5 billion of Ethernet networking equipment on an annual basis.

Data centers require large amounts of networking bandwidth and similarly to what is happening with carriers, the demands are expected to grow rapidly driven by virtualization, server consolidation and the expanding a ray of applications brought on by Web2.0 and Cloud Computing.

There is a very real need for more and faster band within the data center, which is quickly driving the push from 1 gigabyte to 10 gigabyte Ethernet. Simultaneously, we predict the push to drive down costs and consolidate it into fewer data centers by leveraging 10 gigabyte. With our latest products, partnerships and focus, we are at the forefront of this progressive evolution.

For example in December, we began shipping the Summit X650 a fully stackable 10 gigabyte switch which was designed specifically with the data center in mind. Just like the Summit X450 mentioned previously, the X650 also received Network Computing's annual award, being named the Data Center Product of the Year. Extreme was selected by the publication's thousands of readers for having a standout solution in the emerging data center market.

Customer such as video gamers, government and research organizations and hosting companies are evaluating and purchasing the Summit X650 to meet the needs of their bandwidth intensive applications in data center environment. Continuing on the successes of the Summit X650 top-of-Rack platform, we announced the Summit X650-24t Copper, the first 10 gigabyte Ethernet switch introduced to reach the portion of the market that works with standard Ethernet copper cabling.

While nearly all of the latest 10 gig solutions being pushed into the marketplace are designed for fiber only, we recognized that in reality, many existing data centers will continue to rely extensively on standard copper cabling as they migrate from 1 gigabit to 10 gigabits. We are unique in offering our data center customers a cost effective and realistic migration to 10 gigabit while giving the choice of copper or fiber 10 gigabit networks.

To summarize, we believe that our overall results for the quarter are a reflection of the current global economic environment. Nevertheless, we continue to make progress and are optimistic that we can gain additional market share in our particular verticals. We compete by providing superior value and offering innovative solutions tailored to fit the needs of our individual customers. At the same time, we're focused on managing our business to its positive earnings and cash flow from operations.

I am now going to turn the call over to Karen. Karen?

Karen Rogge

Thanks Mark. Revenues declined this quarter as a result of the global macroeconomic downturn. In light of these conditions, we took expenses out of the business, increased gross margins and we're profitable on a pro-forma basis. Revenue for the quarter was $77.2 million, which is down 6% from a year ago quarter. Product revenue was $62 million, down 15% from Q2 and 8% from a year ago quarter. While the steepest decline was in the Americas, the economic downturn appears to have spread across the globe to each of the geographies we serve.

Our service business continues to show further signs of improvement and it was up both year-over-year and on a sequential basis as our customers looked to ask to help them project the value for their network investment.

For the quarter, services revenue was $15.2 million, up 4% from a year ago and slightly up from Q2. The ratio of enterprise to service provider sales for the quarter was 69% and 31% respectively and inline with historical averages. Sales of new products introduced into the market in the past 24 months, was 35% down slightly from the prior quarter, primarily due to the maturing of our Summit 450 and 250 product families. As we ramp our newer products, such as the BlackDiamond 20K and Summit 650, we believe this ratio will increase over the coming year. The ratio of stackable and modular product sales was 60% and 40% respectively, which is in line with our historical pattern.

Looking at revenues by geography for the quarter, revenues in North America was $26.9 million, which declined 13% from a year ago and 19% from Q2 as the extent of the recession in the U.S. appeared to deepen. At the start of Q3, customers were reluctant to commit to purchase decisions. Even as the quarter moved on, the sales process was more prolonged than usual as customers were trying to gauge the extent and duration of the recession's impact on their own business. Product revenue in North America declined 18% from the prior year and service revenue in the region was down 3%.

Revenues in EMEA increased slightly from a year ago quarter. Product sales in EMEA declined 3% from the prior quarter and our services business grew 35% primarily due to the growth of maintenance renewals and professional services.

Asia Pacific revenues declined 8% from a year ago and were flat with Q2. Compared to the year ago quarter, APAC product and services revenue declined 6% and 24% respectively.

Turning to our non-GAAP gross margins, which excluded the effect of stock-based compensation and restructuring. As a percent of revenue, pro-forma gross margin was 57.8% inline with the year ago quarter. Product gross margins declined 1.9 percentage points year-over-year as a result of competitive pricing and changes in product mix.

On a sequential basis compared to the second quarter of fiscal 2009, product gross margins improved 1.2 percentage points as a result of lower distribution costs and strong expense controls, offset by lower volume.

Service margin of 56.8% of revenue increased significantly from the year ago quarter, up 10% primarily due to the use of fully reserved inventory of $0.8 million, lower repair cost of $0.6 million due to improved quality and $300,000 due to increased revenue.

On a sequential basis compared to the second quarter of fiscal 2009, service gross margins improved 6.1 percentage points primarily due to the use of fully reserved inventory of $800,000. We anticipate the favorable affect of fully reserved inventory usage to continue over the next several quarters.

Non-GAAP operating expenses were $4.4 million a decrease of $4.2 million from a year ago quarter and a decline of $2.1 million from Q2. Compared to the year ago quarter sales and marketing was down 4% to $23.9 million primarily due to lower commissions and decreased sales and reduced spending for marketing events and travel.

R&D was down 11% to $13.5 million as a result of a reduction in variable compensation in reduced project material spending. G&A declined 20% to $6.7 million on lower litigation expenses as well as lower professional services fees and variable compensation.

During the quarter, we announced plans to reduce employee head count by approximately 6%. As a result of these actions, we have recorded a restructuring charge of $2.1 million consisting 2.6 million for severance, asset impairment, and facility charges partially offset by $0.5 million of additional sublease income related to our prior restructuring charges.

Non-GAAP net income was $1.2 million or $0.01 per diluted share excluding the affect of stock-based compensation and restructuring expense compared to net income of $1.1 million or $0.01 per diluted share on a year ago quarter excluding stock-based compensation.

Turning to the balance sheet; Cash and investments were $120.8 million a decrease of $22.7 million sequentially primarily due to the timing of trade accounts payable and accrued liabilities payments which varied throughout the year.

In general, the fluctuation in cash flow from operations is primarily driven by the timing of shipments over the quarter and payments on inventory purchases. Revenue for the quarter was down sequentially and shipments were more back-end loaded than the historical pattern resulted in lower accounts receivable collections in the quarter. While inventory was flat quarter-over-quarter, payments for inventory purchases in prior quarters on deferred payment terms negatively impacted cash flow this quarter.

Net, for the fiscal year, cash used in operations was $4 million.

We ended the quarter with 817 regular employees down 47 from Q2 as a result of cost reduction actions. Our total workforce, which includes both employees and contractors has declined over 100 people or 11% from the beginning of the fiscal year. We continue our practice of not providing specific guidance for the coming quarter; macroeconomic conditions remain uncertain and we are focused on the need for fiscal discipline and executing in the areas that we can control.

In summary; revenues for the quarter were down primarily as a result of the global macroeconomic climate. During the quarter, we reduced expenses, increased gross margins, and delivered profitable pro-forma earnings.

Looking forward, given the continued weakness in the worldwide economy, we are focused on reducing inventory levels to be inline with our current operating needs, aligning operating expenses with anticipated revenues and managing the business to be cash flow positive. We are tightly managing our expenses; while we're tightly managing our expenses, we are continuing to advance strategically in technology, products, and partnerships to bring our new solutions to market.

With that, I'll now turn it back over to Mark.

Mark Canepa

Thank you, Karen. And this concludes our prepared remarks, and we're now ready to take your questions. Patty?

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). And our first question comes from the line of Rohit Chopra from Wedbush Morgan Securities. Please go ahead.

Unidentified Analyst

Hi Karen, hi Mark. This is Sanjit (ph) for Rohit Chopra.

Mark Canepa

Hi, how are you doing?

Unidentified Analyst

Very good thanks. Let's talk first about Europe and what's going on there. I think Eastern Telco was an area of strength. And can just may be maybe talk about what the dynamics for Eastern European service providers?

Mark Canepa

Sure. Well Eastern Europe is not at monolithic block and certainly, as you know with the capital flow is flowing from Eastern Europe to west -- back into Western Europe. There is certainly some pressure on the Eastern European companies in general to raise sufficient capital.

However, our current incumbence are continuing with their network deployments. I spoke about of T-Com Croatia for example, they were one of the recipients of the BlackDiamond 20K product and so we are actually very excited about augmenting their network deployment.

I personally went and visited exaggerate (ph) Croatia Telecom just last month and had a very positive meeting with them. So, a number of them are continuing our business, for example in Russia, there's a lot of deployments even that are taking place there. So, in our base, obviously people are careful, but we see continuation of the business. That said, we're being cautious and we know that even our customers aren't totally immune from the overall environment. And so, we continue to watch this thing carefully and see how the situation in Eastern Europe develops.

Unidentified Analyst

Got it. A couple of more questions. I think in your prepared remarks, you talked about may be some pricing pressure or intensifying competitive environment.

Mark Canepa

Yeah.

Unidentified Analyst

Well -- is that coming from larger players or there is more with smaller guys?

Mark Canepa

Well, if you look at any particular deal, most of the time there is not a smaller player that's competing against us. The competition is really would be with Cisco. And so it's a function of the dynamics of -- is there an account that there are big deal for Cisco to want it to save it or not and things of that nature.

But in general, we see the customers themselves are -- their budgets are being cut, and they're much more careful and so in general, you have to look at the overall environment that's taking place out there and how we need to respond to it. Certainly, we're out there with competitive products and we want to be successful with our customers and so where necessary, we get aggressive to win the business.

Unidentified Analyst

Got it. And then Karen may be you could walk us through the improvement in gross margins sequentially, that was nice to see. Can you just may be walk us through may be the sustainability of that on the services side? And then may be talk about the uptick on the product gross margins sequentially as well?

Karen Rogge

Okay. We'll start first about the services gross margin. We just see improved services gross margins this quarter driven by two factors, once more longer term and the other shorter term. As I mentioned, we're seeing the benefits long term for the reduced repair cost due to our improvements in product quality. And then shorter term, we are seeing an improvement due to our ability to utilize previously expensed inventory.

And based on business circumstances in prior periods, we expensed the portion of our inventory that we can now utilize. We have remaining 1.6 billion of previously expensed inventories that we intend to utilize over the next few quarters based on customer needs. So we can expect to see that over the next several quarters as well.

In terms of the product gross margin, we have good product gross margin on a sequential basis especially in light of the lower revenue sequentially. And on the products standing in house (ph) the 1.2% point improvement in gross margins was basically driven by a lower distribution cost in the quarter and our strong expense controls that were somewhat little bit offset by the way we're going.

Does that answer your questions?

Unidentified Analyst

Absolutely Karen, thank you. And my last question, I know you guys were not going to talk about guidance. But you did say the quarter was heavily back-end loaded. Now given the first couple of weeks of April, is there -- do you see things may be not getting worse or are things kind of leveled off and may be you can talk about the first couple of...

Mark Canepa

It's way too early to tell, right? I mean we -- it's too early to tell.

Unidentified Analyst

Fair enough.

Operator

Thank you. (Operator Instructions).

Mark Canepa

Okay. If there are no further questions, thank you Patty...

Operator

Thank you, sir.

Mark Canepa

Thank you Patty for driving the conversation today. Thank you all for joining us this afternoon. I want to thank all of our employees for their ongoing dedication and effort during these challenging times. We look forward to speaking with all of you again at our next conference call. Thank you.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.

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