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Extreme Networks, Inc. (NASDAQ:EXTR)

F4Q09 Earnings Call

July 30, 2009 5:00 pm ET

Executives

Mark A. Canepa – President, Chief Executive Officer & Director

Robert L. Corey – Chief Financial Officer & Senior Vice President

Analysts

Colby Synesael – Kaufman Brothers

Analyst for Sam Wilson – JMP Securities

Analyst for Rohit Chopra – Wedbush Morgan

Jess Lubert – Brean Murray

Operator

Welcome to the Extreme Networks 2009 fourth 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 Bob Corey, Senior Vice President and Chief Financial Officer.

As a reminder, this conference is being recorded today July 30, 2009. This afternoon Extreme Networks issued a press release announcing the company’s financial results for the fourth fiscal quarter 20009. The conference 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 Extreme Network’s website for 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 the financial performance, strategy, growth of customer bandwidth demand, development of new products, customer acceptance of the company’s products, customer spending and economic positions 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 in demand for the company’s products and services, a highly competitive business environment for network switching equipment, [inaudible] control and expenses, the possibility that the company might experience delays in the development of new technology and products, customer’s response to its new technology and products, the timing of any recovery in the global economy, risks related to pending or future litigation and dependency on third parties for certain components and for the manufacturing of the company’s products.

This 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 & 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 the company’s website. Just 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 view of the fiscal quarter is concluded and/or the 10K is filed. I will now turn the conference over to Mr. Mark Canepa, President and CEO of Extreme Networks.

Mark A. Canepa

Before we proceed to discuss the results of the quarter and of the fiscal year, I wanted to comment on two very important additions to the Extreme Management team. First, I am very pleased to welcome Bob Corey as Extreme’s Chief Financial Officer. Bob has wide ranging experience as CFO of private and public companies. He has been a member of our board of directors for the past five years and has also been the head of the audit committee of the board so comes with deep knowledge of the company’s financial operations. Bob also has an excellent background in investor communication so expect an increase in interaction from Bob and me with all of you.

Second, I’d like to welcome Vish Nandlall as Extreme’s Chief Technology Officer. Vish joins us from Nortel where he was CPO of Nortel’s carrier network division. Vish has over 15 year experience in creating vision and strategy for scalable networks, wireless and carrier voice over IP technologies.

This marks the end of our fiscal year in which we, along with most other technology companies have to adapt quickly yet purposefully to the economic changes that have impacted most of the world’s markets. We developed a strategy and a road map of where to streamline our operations while preserving our long term competitiveness. Consequently, we were able to eliminate almost 15% of our permanent and contingent headcount.

In our manufacturing operations we further strengthened the partnerships and synergies with key suppliers while streamlining our transportation, distribution and logistics systems and continued with aggressive material cost cuts. We made major cost savings improvements in our services business while continuing to deliver excellent service to our customers. We controlled our R&D costs while making the necessary investments to develop and introduce three new product families.

During FY ’09 we brought to market the BlackDiamond 20K focused on cost effective carrier grade Ethernet transport. We brought to market the Summit X650 focused on 10 gigabyte datacenter aggregation and we brought to market the BlackDiamond 8900 focused on 10 gigabyte datacenter core. We continued to build our VAR community to over 700 partners worldwide. We generated positive operating cash flow and earnings for the year while we continued to stay focused on the ongoing goal of the company to deliver great solutions in the carrier, converged enterprise and datacenter markets.

Aside from the slowdown precipitated by the recession, the underlying economic forces driving continued increase in bandwidth demand has not changed. Furthermore, Ethernet continues to be the technology of choice to satisfy this bandwidth need. We don’t expect this to change.

Turning to the quarter, we saw sequential improvement in results reflecting the substantial improvement in North American business while signaling that EMEA continues to weaken. Overall, revenue was up 5% sequentially and revenue from the enterprise business in particular was up 15%. The carrier business was 25%. We had increased this ratio to about 30% the last couple of quarters but the delay in orders on a number of European carriers affected the results this quarter. I believe this is signaling in general enterprise budgets are stabilizing before carriers.

However, overall visibility remains low as the shape of the three geography overall macro environment and the behavior of both enterprise and carrier customers are difficult to model. In a minute, I’ll turn the call over to Bob who will give you a lot more of the details but I want to highlight and comment on a few of the numbers. Revenue for the quarter was $81.3 million driven by increased sales in North America who grew 30% sequentially. Asia Pacific Japan grew as well sequentially and more importantly year-over-year. We have made considerable progress in addressing APJ and are internal execution there has begun to improve.

Careful expense control allowed us to deliver a 50% increase in pro forma operating profit from Q4 last. We were also able to increase our cash position by $7 million. Despite the mixed economy, we added more than 100 new customers during the quarter. This signals that customers are looking for alternatives in this market. The global economy right now is a mixed bag but appears to be stabilizing in certain markets. Overall, we expect it to be at least a few quarters until capital investments and operating expenditures begin to demonstrate meaningful signs of recovery.

One of our primary areas of focus is the carrier market. While our carrier Ethernet business was slower this quarter, we remain confident in its long term strength. The need for increased bandwidth remains, carriers do business with us because our Ethernet transport solutions help them increase their levels of services at a lower cost. We saw increased business during the quarter with India. With Ericsson we helped four service provider customers: United Wireless Private Limited; [Eitchela]; [Bartley] AirTel and BSNL.

In the Middle East with Ericsson we helped Saudi Telecom further the build out of its metro network. Also in the Middle East we worked with our partner Motorola to build the go wireless network for Etihad AtheebTelecom. The network is one of the largest WiMAX implementations in the Middle East. In Europe T-Com of Croatia is a significant customer that continued to work with Nokia Siemens Networks and Extreme to build its next generation network to better deliver both business and residential triple play services. The network is built using Extreme’s carrier class BlackDiamond 20K metro core switching platform.

Another key market for Extreme is the converging enterprise market. This last week we announced a major new strategic alliance with global security leader McAfee Incorporated. The two companies will go to market with a strong portfolio of networking and security solutions that address the needs of enterprises for replay, available and secure networks. The relationship helps our customers choose a network that is complemented with McAfee’s broad world class portfolio of security tools all backed by a global leading brand in security.

IT budgets are still under intense scrutiny creating opportunity to articulate differentiated value for the customer dollar while supporting high performance and global reach with sales, marketing and support. For example, Extreme was selected by Incheon University of Korea for a significant win. Incheon University near Seoul is building an entirely new campus with a higher performance network. Incheon selected Extreme’s portfolio of enterprise Ethernet solutions for the core and edge of the network. The end-to-end network including wireless will ensure consistent, secure and fast connectivity for students and staff alike.

In the US Georgia State University adopted our highly scalable BlackDiamond 8900 series modules to power its datacenter with dense 10 gigabyte connectivity. In the K through 12 segment Extreme continued business with large accounts such as the Buford School District in South Carolina, Rochester Community Schools and the Oakland County Schools of Michigan. In healthcare we experienced a significant win with the Ministry of Health in Trinidad. In Germany, we had a win with the [Reinhardt Meriter Hospital].

In the government market Extreme’s converged Ethernet solutions were selected by Finmeccanica Group as the network of choice for the much publicized G8 Summit held in Italy in Early July. This global gathering of economic and political leaders including President Obama required an integrated networking and communication solution with maximum availability and simple management.

We continue with our focus on providing solutions for the datacenter market. This past quarter we introduced and have begun shipping a new family of products called the BlackDiamond 8900. These chassis based products were specifically designed to provide highly scalable and dense datacenter core connectivity. When coupled with the Summit X650 which we introduced last fall, we now have powerful solutions in place to help our customers transition to state of the art 10 gigabyte Ethernet data centers.

In addition, with the recent release of ExtremeXOS operating system version 12.3, we have added powerful virtualization technology that works in conjunction with VMware and other server virtualization software to automatically virtualize the network. This is yet another capability we have added to our software system to make the network a more integrated and seamless part of datacenter operations. Capabilities like this one in addition to others introduced over the past several quarters enable our customers to build powerful and bandwidth intensive datacenters for cloud computing, video deliver and Web 2.0 applications.

For example, Continental American Insurance Company in South Carolina has deployed our Summit X650 10 gigabyte Ethernet switches as the high performance network backbone of its datacenter giving the company a strong foundation for its high transaction environment. [Metick] of France, an internet based social media site has recently adopted Extreme to drive an extensive website and its growing consumer traffic and Web 2.0 technologies.

Video is a key element of this datacenter growth as it requires higher capacity from Ethernet as well as very strong performance such as low latency and quality of service. For example, Chunghwa Telecom has recently adopted Extreme to power its video-on-demand and multitask digital TV services. This is an example of how carriers utilize the datacenter to further expand their menu of services while meeting the demand for what connected consumers want most.

The drive from one gigabyte to 10 gigabyte is happening rapidly. For example, The Planet is one of the largest datacenter hosting providers globally. They support an expansive footprint of data facilities. The Planet is a recent datacenter win and has adopted Extreme’s Summit X650 in its 10 gigabyte network. Cost effective storage based Ethernet is another driver of the datacenter. We have strengthened our relationship with Dell. In June announced that our Summit X450 family of switches are certified and promoted as a networking companion to Dell’s fast growing line of EqualLogic iSCSI storage solutions. This brings the market a high performance, cost effective Ethernet SAN.

This week we announced a go to market relation with Scale Computing an emerging company focused on storage clustering which offers technology that dramatically reduces the cost of storage networking also leveraging iSCSI. With that, I would like to now turn the call over to Bob who will provide you with additional financial details.

Robert L. Corey

I’m delighted to be part of the management team. As a former member of the board I’ve gotten to know the company well and I’m excited about the organization and the technology. Over the past year and a half I believe we’ve engineered a broad range of solutions that address the opportunity that is emerging in the datacenter, the converged enterprise and the carrier markets. With some signs of stability returning to parts of the market, Extreme is well situation for the growth in demand for our simplicity, scalability and value.

My comments will address our ongoing efforts to align operating expense with the current level of revenue. I will then comment on revenue by geography and customer type, discuss the results of operations and review the balance sheet and cash flow. All of my comments will be addressing non-GAAP operating results unless I state otherwise. Of course, revenue and the number of shares outstanding are GAAP numbers only. Non-GAAP operating results exclude the effect of restructuring charges and stocked-based compensation.

During fiscal 2009, we have been responding to a global economic recession that begin in the United States. We’ve continued to align our operating expense to our current level of revenue. Throughout the year we’ve implemented initiatives to improve efficiencies and lower costs in our supply chain and improve product quality resulting in lower warranty costs and improved customer satisfaction. Further, we’ve reduced headcount both permanent and contractors by almost 14% from the beginning of the year and we’ve used company shutdowns to lower companywide costs.

These initiatives resulted in our reporting operating income for the year of $7 million which is down slightly from the prior year on a decrease in revenue of about 7%. Further, we reported operating income for the fourth quarter of $3 million which is the highest in over five quarters. We reported positive cash flow from operating activities of $8.7 million in the fourth quarter, $4.7 million positive for the full year and ended with over $127 million of cash and investments.

Turning to revenue, total revenue for the fourth quarter was $81.3 million representing more than a 5% sequential increase. We reported increased revenue in both North America and Asia Pacific offset by weakening demand in EMEA. North America revenue was up 30% from the March quarter to over $34 million. This reflects the sense of stability that we’re seeing in North America which Mark referred to earlier in his comments. The weakening demand in EMEA highlighted the effect of the global recession on service providers in that market.

Compared to the March quarter, EMEA sales were down 18% to $32 million. The European markets were among the last to enter the recession and we suspect they will be among the last to recover. Increased demand in Asia Pacific reflected improved execution as a result of the change over in management that we implemented in that region. Compared to the March quarter Asia Pacific revenue increased 25% to $15 million. The total revenue of $81.3 million for the fourth quarter was down 17% year-over-year as a result of the impact of the global economic recession.

Our service business continues to improve and was up 10% in Q4 over Q4 of last year and up more than 8% sequentially making this the first time that our service revenue has comprised 20% of total revenues. Since Mark joined the company in late 2006 we have successfully transitioned the service business from a support function to a source of revenue as we actively engage our customers to protect the value of their network investment.

Perhaps most telling is that even though sales in EMEA declined this quarter, service revenue to the region increased 46% over Q4 last year and 15% sequentially. North America service revenue was flat year-over-year and up 5% sequentially. The differential was largely due to the volume of carrier business we do in EMEA where services area an increasingly important part of the value that we bring to our customers.

Sales of new products introduced in to the market over the last 24 months was 31% of total revenues which is down 35% from the March quarter. We look to ramp our newer products such as BlackDiamond 20K and Summit X650 and believe that this ratio will increase over the course fiscal 2010 as parts of the global economy improve. The ratio of stackable and modular product revenue in the fourth quarter was 66% and 33% respectively which is consistent with our year-to-date trends. The mix of enterprise and carrier orders for the fourth and third quarter was 76% versus 24% and 69% versus 31% respectively. This reflects the increase in enterprise revenue primarily in North America offset by lower demand in EMEA which traditionally has a higher mix of carrier revenue.

Turning to gross margins, the overall fourth quarter gross margin percentage declined to 56.8% as compared to 57.8% in the third quarter. This reflects a decrease in the product gross margin percentage of 2.7% offset by an increase in the service gross margin percentage of 5.7%. Product gross margins declined due to the change in mix and an increase to the inventory reserve recorded in the quarter. The increase to the inventory reserve reduced the product gross margin percentage about 2.2 percentage points in the fourth quarter.

The service gross margin percentage improved 62.5% as compared to 56.8% in the March quarter. Once again, in Q4 service margins remained greater than the historical averages as we continued to deplete the use of previously written off spares inventory, about a $600,000 benefit in the quarter and a higher mix of service contracts. We believe that we will continue to benefit from the previously written off spares inventory for up to two additional quarters based upon utilization.

Overall, operating expense was $43.2 million, a decrease of $11.2 million from Q4 last year and a decline of $948,000 from the March quarter. Compared to Q4 last year, sales and marketing declined $5.1 million to $22.9 million on lower spending for marketing events and cut backs in travel. Research and development was down $2.4 million to $13.3 million as a result of reduction in variable compensation and continued reduction in project materials spending. G&A declined $3.7 million to $7 million even on lower litigation expenses as well as lower professional service fees and variable compensation.

We recorded a restructuring charge of $153,000 during the quarter which was the finalization of severance payments associated with reductions in headcount that were announced in the third quarter. Net income was $2.3 million or $0.03 per diluted share. That compares to net income of $3 million or $0.03 per diluted share in the fourth quarter last year. Total shares used in the fully diluted earnings per share calculation were 88.7 million.

Turning to the balance sheet, cash and investments were $127.4 million an increase of $6.6 million from $120.8 million at the end of the March quarter. Cash flow from operating activities was $8.7 million positive in the fourth quarter and $4.7 million positive for the year. Inventory was $12.4 million at year end representing a decrease of $10.4 million from the third quarter. Our normal investment level in inventories is expected to be between $15 and $17 million going forward and we anticipate returning to that level in Q1.

We ended the quarter with 786 regular employees, down 4% from 816 employees at the end of the March quarter and down 9% from 861 employees at the end of last 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.

Before turning it back over to Mark I wanted to emphasis that we are committed to running the business profitably and generating positive cash flow. With our entire product refresh and investment in R&D we’re focused on building partnerships and aggressively growing share in some of the highest growth Ethernet based sectors. I look forward to getting to know each of our investors in our investor base in generating a productive ongoing dialog with you.

With that, I will turn it back over to Mark.

Mark A. Canepa

Operator, we’re ready to address any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Colby Synesael – Kaufman Brothers.

Colby Synesael – Kaufman Brothers

Just wondering what your customers are saying about the potential impact of the stimulus package as it relates to the spending patterns over the next two or three quarters, whether or not they might be delaying in front of that or when exactly they’ll be getting that funding and could be spending? Then also I was hoping you could talk a little bit about linearity of the quarter and maybe just a little bit of color on what you’re seeing already in July?

Mark A. Canepa

First of all regarding the stimulus spending, it varies greatly by market. Some markets have access to stimulus money and some markets do not. In general probably the ones that I’ve spoken to the most that have access to stimulus money tends to be in the area of healthcare so we’ve talked to a number of our healthcare customers. There are a number of things that are taking place that enables them to create proposals and these proposals can be reviewed by the various governmental bodies. So, my understanding is certainly little of this money has actually flowed but we’ll see how that takes place over time.

Also, there is some stimulus money that is available in the area of the small rural carriers. In the US we’ve had a program in place for a couple of quarters to do that. Again, they’re designing proposals and they’re submitting them for stimulus money. My understanding is relatively little of that stimulus money has flown to at least the customer we’re talking to, to date.

Colby Synesael – Kaufman Brothers

Do you think it’s fair to say that you expect that when money is released that it will impact your business in a material way? Or, is it most likely not something that you’ll see that big of an uptick from?

Mark A. Canepa

Well, we’re going to have to wait and see. Certainly, education, healthcare and US based small carriers are a big focal point of ours and those are the ones, at least in the press, have been reputed to being able to access stimulus money. We’re going to have to see whether it comes quickly enough or whether the recession sort of runs its course on its own prior to the speed at which stimulus money can be made available in fact takes place.

Colby Synesael – Kaufman Brothers

And on the linearity?

Mark A. Canepa

Well, as you know we don’t give guidance of the current quarter and we’re only really three weeks in to it so it’s way too early to tell what’s likely or not likely to happen in Q1. As it pertains to Q4, it was about a pretty normal quarter when we go back and look at it in relationship to the previous Q4s. So, the traditional kind of 25% to 25.50% we were within those kinds of boundaries like we were in the past several years.

Operator

Your next question comes from Analyst for Sam Wilson – JMP Securities.

Analyst for Sam Wilson – JMP Securities

I have a couple of questions, one is about the Nortel auction and how you feel if there is going to be any fallout from that in both the Avaya side and in the competitive environment for carrier Ethernet considering the bidding there hasn’t even started on the metropolitan Ethernet business.

Mark A. Canepa

Yes, certainly Nortel’s business is getting divided up. I’m sure you’ve all seen the Ericsson bid on the metro carrier side which does not contain any of the networking equipment, it’s fundamentally the wireless backhaul part of the business and the enterprise business as it’s been reported in the press is coming under auction here in the near future. Avaya has been reputed to be bidding on that business. It’s going to be an auction and we’re going to have to see how all of this turns out.

Meanwhile, our relationship with Avaya continues to be very strong. Business with the Avaya and Avaya business partner community in fiscal ’09 was up year-over-year which suggests that in spite of the tribulations in the economy, customers who want to buy Avaya based call centers or telephony systems continue to prefer the Extreme brand when it comes to building the underlying network. Beyond that, we’re all going to have to wait to see what happens with this auction over the coming weeks.

Analyst for Sam Wilson – JMP Securities

Do you think there’s any significance to Avaya getting the Nortel networking business as part of getting their voice over IP business?

Mark A. Canepa

Nortel has put them together in to the same sort of group. Obviously, we had a close strategic cooperation, we talked to executives in Avaya on an ongoing basis. I think it doesn’t materially change our relationship with Avaya. Avaya is really strong in building and creating telephony based solutions. They had in previous years internal networking developments and in spite of those, Extreme and Avaya have worked very, very closely together to deliver powerful voice solutions from Avaya and powerful data solutions from Extreme that are closely aligned from both a marketing sales as well as engineering perspective.

Analyst for Sam Wilson – JMP Securities

On the 10 gig Ethernet product set, do you have plans to incorporate fiber channel over Ethernet or do you now incorporate fiber channel over Ethernet?

Mark A. Canepa

Today it’s a non-simple answer, there’s the various competing SCOE standards are still being developed and they’re in the standards committees. Certainly technology is getting developed, silicon is getting developed to support the underlying protocols that govern the transport of fiber channel packets over Ethernet. The primary driver of fiber channel is a lossless environment where Ethernet is primarily a [inaudible] so the underlying hardware technologies are getting developed.

As it pertains to the software, we’re going to be watching it very carefully. We’re going to see how, and if, and when, and in what shape or form the market develops. There are a number of ways in which customers transport data between servers and storage SCOE is just one of them. I mentioned during my remarks iSCSI both in our relationship with Dell and EqualLogic and a number of other partners is also a very fast growing way in which people can very cost effectively transport data between storage and servers.

Obviously NFS and PCPIP are a way to do that and so we’re going to have to monitor the development of the fiber channel over Ethernet market and depending on how it develops we’re going to respond appropriately.

Analyst for Sam Wilson – JMP Securities

But currently you don’t have a plan to license in technologies from a QLogic or Emulex or anything like that?

Mark A. Canepa

Today if you look at QLogic and Emulex they provide basically host based technologies. They provide cards that plug in to servers that are able to generate fiber channel capabilities and they’re reputed to talk about being able to provide fiber channel over Ethernet capability. As this market develops we can participate in it where the market could become sizeable enough to warrant it. Our belief currently is that NFS and iSCSI and some of these other transport mechanisms are going to occupy a large fraction of this market and so we want to basically stay focused on what a lot of our customers tell us. But, we can respond pretty quickly if the market dynamics change.

Analyst for Sam Wilson – JMP Securities

The last question I had was on your carrier Ethernet business are you targeting specific geographies?

Mark A. Canepa

well, we are not targeting per say particular geographies. What we have found is that the technologies and carrier Ethernet that we have been shipping tend to resonate very well with a number of markets in Europe, particularly in Eastern Europe. These tend to be newer markets, therefore they tend to be unencumbered by some of the older transport technologies like SONET, SDH or frame relay or ATM. Consequently, they are far more quickly able to build up Ethernet based solutions for their metro transport mechanism.

That just seems to be a market that has developed more quickly but we believe it’s just a matter of time before sort of the North America market kind of moves in that direction. Certainly, in a number of markets in Asia we’re finding pretty good reception to the new methodology of transporting data over a carrier environment.

Analyst for Sam Wilson – JMP Securities

Is the meltdown in Eastern Europe, should we read the fall in European sales as a macroeconomic only issue or is there something else happening there?

Mark A. Canepa

Obviously we talk to our customers in Eastern Europe or anywhere in Europe on the carrier space and the answers that we’re getting is there is not a strategic change in how they want to deploy their networks. Most of these countries are beginning to roll out things like 100 megabyte services to the consumer. We’re not getting any data to suggest that the consumers are not ready to purchases these kinds of services but it’s like everything else, as their parent companies, many of these Eastern European companies either access capital from Western Europe or they’re owned by Western European companies.

For example T-Com Croatia, which is a company I mentioned on the call here earlier is owned by Deutsche Telekom. So as the parent companies review capital budgets and make kind of global decisions sometimes their Eastern European subsidiaries have to make adjustments in change. So, what we’re seeing we seem to think that it’s basically a financially driven environment dictated by the capital budgets of companies rather than an inherent change in either consumer buying behavior or the companies themselves wanting to change the strategy on how they deliver services.

Analyst for Sam Wilson – JMP Securities

So there is no change in your operations in Europe that’s causing this?

Mark A. Canepa

No, we don’t believe so. We’ve had a good team in place, that team has grown the business year-over-year for many years in Europe. They’re well deployed. We think in general the kind of malaise that North America suffered last year, some of it is beginning to catch up with the European theater and I think that issue goes far beyond Extreme.

Operator

Your next question comes from Analyst for Rohit Chopra – Wedbush Morgan.

Analyst for Rohit Chopra – Wedbush Morgan

I had a couple of questions, Mark last quarter we talked about price competition showing up last quarter with CISCO, is there any change in that this quarter or are we seeing kind of the same pricing environment?

Mark A. Canepa

Nothing material right, it’s a tough business out there. To some extent customers are doing what we’ve always expected customers to do in this kind of environment, a lot of them don’t like either the pricing or discounting policy that their incumbent is providing and there out there searching for alternatives. Once again, we were able to sign up in excess of 100 new customers that had no previously purchased from Extreme. People are out there making decisions about changing vendors if they’re not happy with the incumbent.

So, price does play a roll but not just capital budget, the ability to install a network that’s easier to operate, that costs less to run, that uses less power. Some enterprises rooms are getting filled up with air conditioning they can’t put more of that, the power companies are only willing to supply so much energy, especially in kind of saturated markets. So, there’s a number of variables under this whole sort of cost that drives customers to change vendors and change buying behaviors.

Analyst for Rohit Chopra – Wedbush Morgan

My next question kind of goes back to Avaya, you guys use to give Avaya a percentage of product bookings or total revenue. Can you give us some color on how big Avaya is currently?

Mark A. Canepa

Well, we don’t comment on any one customer, the Avaya business and the Avaya business partner community if you think about there’s a solid fraction, I don’t have off the top of my head exactly how many, of the 700 VARs that we have around the world there’s a meaningful fraction of those partners that are also Avaya voice partners and have been learning on how to be voice and data partners which is why they work very well together. Beyond that, not a lot more information that I can share with you other than those partners are committed, those partners enjoy bringing the two technologies together, they’ve learned how to do it over a number of years, they see the value proposition that going in to a customer and designing a solution that’s got Avaya telephony and Extreme data, the underlying data infrastructure works for the customer, works for the VAR, works for the overall business model.

Analyst for Rohit Chopra – Wedbush Morgan

My next question is, it’s been a busy quarter for you guys, you’ve had a CFO leave and we have a new CFO of Bob, the founder is taking on market development role, we have a new CTO and we have a brand new relationship with McAfee. Are all these changes a sign of a shift or a change in the strategy? If so, what is the strategy going forward?

Mark A. Canepa

Obviously the strategy keeps getting refined and tuned every day. That’s kind of mostly why I come to work is to make sure that we have the very best possible strategy that’s driving all of the investment decisions that the company is making. I would say that within the last quarter just a lot of stuff just happened to happen all at once. The search for the CTO had been going for almost a year or maybe even over a year. I was taking my time to hire the right person, Vish came along from Nortel and I felt he was of a caliber that I really felt good about bringing him in to the company.

Certainly, he comes with a lot of carrier background so you can kind of draw your own conclusions on that but we’ve been talking about spending a lot of time and energy in the carrier business. We developed the BlackDiamond 20K family over the last couple of year so that doesn’t really signal a change in the strategy it sort of just signals a continued priority and commitment to creating a value proposition for certain parts of the carrier market.

Gordon coming on board, as we started to put together the datacenter strategy I felt that having another set of world class neurons in here helping to develop market strategies, go to market, potential ways of approaching this would give the company a significant competitive advantage. They all just kind of sort of happened to coincide but not a signal of any material change in strategy. It’s still a focus on the converged enterprise, the carrier business and the datacenter are where the energy of the company is going.

Analyst for Rohit Chopra – Wedbush Morgan

Is Gordon going to focus on expanding the overall opportunity or is he focused on maybe the partnership side?

Mark A. Canepa

Well obviously I don’t want to go in to a lot of detail about what Gordon may or may not be doing on a day in and day out basis. But, he’s a world class individual who has been around the networking industry for his entire adult life. So, I will utilize Gordon’s skills and capabilities to maximize the success and direction of the company as I see it as we go forward.

Operator

Your next question comes from Jess Lubert – Brean Murray.

Jess Lubert – Brean Murray

I also have a couple of questions, first was book-to-build greater than one?

Robert L. Corey

Book-to-build was just a little under one actually.

Jess Lubert – Brean Murray

It looks like really nice improvement in North America and Asia, can you give us a sense of how sustainable that feels to you? Do you think it was just some catch up spending or are customers feeling a little bit more comfortable in their business and therefore we should expect more normal seasonality at least in those geographies going forward?

Mark A. Canepa

Let’s separate the variables, as it pertains to Asia Pacific Japan, as we look at the results especially the fact that not only were we up sequentially which is something you would expect to see in a normal seasonality pattern, we were up year-over-year. That I believe when I go in to the depth and look at the data by country and so on that in fact Paul Rath when he came on board about a year ago made some changes and we’re beginning to see the results of some of those changes are made.

All else being equal I think our execution in Asia Pacific has improved and I don’t see any reason why that execution shouldn’t be able to continue. Now, that’s all else being equal, we don’t quite completely understand what the macroeconomic factors might or might not be within the Asia Pacific theater. It seems to be a little clearer to define what seems to be happening in the US and what’s happening in Europe. The Asia Pacific Japan is not a monolithically behaving segment. You’ve got places like China and India where it may be slowing down but GDP seems to continue to be increasing, you’ve got places like Japan who’s GDP is in fact suffering significantly and then you’ve got a bunch of other countries that are kind of in between.

So, Asia Pacific I think the execution there is improving. North America we believe that it is kind of a normal environment and nothing unusual took place in Q4. There might have been some deferred spending from Q3 that might have caught up in Q4. If you remember, it kind of happened last year too where the whole industry suffered from an abnormally stringent Q3. But, it’s tough to tell what’s in the mind of the CIOs and CFOs of a lot customers. We’re monitoring it carefully, we’re remaining flexible, we’re working hard on the cost structure and we’re going to watch as the quarter unfolds.

Jess Lubert – Brean Murray

Can you give us a sense of what drove the big inventory draw down? It seems like the sustainable inventory level is below what we’ve historically seen and how should we think about that in regards to future demand?

Robert L. Corey

As you know in Q3 I guess inventory inched up to around $22 million so the company feels that $15 to $17 million range is more of a sustainable inventory for the level of revenue we’re currently enjoying. The inventory came down to a little more than we wanted to, to $12.5 roughly so we’re going to bring it back up to around $15 million.

Jess Lubert – Brean Murray

How should we think of that in regard to demand because just going back over the last several years, historically your inventory levels have been north of $20 million. Should we take that to mean that this is kind of the current run rate going forward? Do you think it steps back up to north of $20 million as the demand environment improves?

Robert L. Corey

No, we’ve had a lot of programs underway in our supply chain to drive efficiencies, etc. for worldwide distribution and assembly relationships, etc. so we were focused on trying to get the inventory turnovers down to something more competitive. It also relates to cash management so the company was very aggressive in managing inventory and the MRP in Q4 and we’re going to bring it back up to around $15 million.

Mark A. Canepa

We have a specific set of activities to fundamentally drive the terms ratio of the company up from where it had been historically. So, it’s an active program within the company. In addition, as our supply, where we manufacture, our product ships around the world, it does give us an opportunity to be much more streamlined with how much inventory we have to keep in order to move the product around the world. It’s all part of a plan to drive it in the right direction.

Jess Lubert – Brean Murray

Deferred revenue appeared to decline a fair amount sequentially while the service revenue improved quarter-over-quarter. Should we expect service revenue to decline in the September quarter? Clearly it was a nice quarter for services, I guess I’m just curious whether or not services will be lumpy or how we should look at the deferred revenue line and what that means for services going forward?

Mark A. Canepa

Certainly, we had a good services quarter and certainly as the data shows, not all of it came from new bookings. Bookings tend to be more or less linear, service contracts get renewed and all of this kind of stuff and revenue recognition of those tend to be a bit more lumpy than the underlying bookings. We had a good ability to turn bookings in to revenue this quarter. Overall, yes over time we think the revenue that was generated in kind of the services part of the business was unusually rich this quarter and it will probably end up being at a more sustainable based on what we’ve done the last several quarters.

Jess Lubert – Brean Murray

Then the decline in product gross margins is this more a function of pricing, is it product mix, or is it due to weakness in service provider, how do we think about that?

Robert L. Corey

It was more of a product mix issue plus the real big issue that impacted product margins we booked a $1.4 million charge increase to the inventory reserves to settle up on consigned inventory we had offsite with a supplier.

Jess Lubert – Brean Murray

Then on the service gross margins, over the next couple or quarters as you work off the spares, can we go higher from current levels, should it be consistent? What’s the sustainable run rate for service margins for our models as that kind of starts to tail off towards the end of the next fiscal year?

Robert L. Corey

That’s a good question. Once we consume all these spare parts inventories we definitely think that the margin is high now because of the benefits we’ve been getting the last couple of quarters. Like I said in my comments, we’ll probably get that benefit maybe Q1, maybe some in Q2 but we think the margins will normalize around 55% going forward after that.

Jess Lubert – Brean Murray

Then operating expenses have now declined sequentially for four consecutive quarters, can they go down further or this on an absolute dollar basis, do you think this is the base and you’ll build from here kind of as revenue improves? I guess have you begun to hire selectively in any areas?

Robert L. Corey

I think the company has been working very hard to align the operating expenses with the revenues we were encountering and the uncertainty in the US and now the world has gone in to a global recession. We will continue to monitor expenses in light of the revenue we encounter.

Mark A. Canepa

In terms of selective hiring, in the fourth quarter we’ve begun to kind of cherry pick at sales people in a number of geographies. We’re being very cautious overall but as the world begins to stabilize and perhaps decide someday it wants to get out of the doldrums, having the right number of feet on the street certainly you kind of want to be there when the customers get in to a buying mode. In [inaudible] environment have been somewhat less tight with the sales organization over the last 60 days or so.

Robert L. Corey

Just one more comment, one of the things we’re trying to do is monitor that expense run rate so we can position the company where when we do start to see an uptick in revenues then we can accelerate the impact to earnings per share.

Jess Lubert – Brean Murray

One last question and I’ll get back in the queue, particularly in regards to your datacenter business, can you provide a little bit more color regarding what you’re seeing there? Has that been an area of strength or weakness and in Europe I guess is that trending with the region or has that seen a trend that’s held up a little bit better than some other areas in that part of the world?

Mark A. Canepa

At one level if capital budgets get cut, projects get delayed and datacenter component kind of gets delayed alongside with it. In general we see maybe whether it’s this quarter of next or the one after that, that in general there’s a propensity right now for people to accelerate datacenter and build more datacenter capabilities. Whether it’s people going in to the business of doing that, providing video services or cloud computing services or those things or enterprises themselves that are finding that by having more compute power they can cut costs somewhere else in the enterprise. Like pharmaceuticals, they do more simulation, they need to do less drug testing by building the molecules themselves or so on.

We see that that is an area that people are finding attractive. That’s one of the reasons why 18 months ago we sort of decided to go focus on it. Transition to 10 gigabyte also seems to be happening. A number of our technology partners are bringing out great new technologies. I think in general it’s a pretty good place to go concentrate.

Operator

I’m showing no further questions at this time. We’ll turn it back to management for any closing remarks.

Mark A. Canepa

I would like to thank all of our employees at this point for their ongoing dedication during fiscal ’09 and I think all of you for joining us this afternoon and look forward to Bob and I to meet with as many of you as possible over the coming weeks and months.

Operator

Ladies and gentlemen this concludes Extreme Networks 2009 fourth quarter conference call. If you’d like to listen to a replay of today’s conference, please dial 1-800-406-7325 or 303-590-3030 with the access code of 4114946. ACT would like to thank you for your participation. You may now disconnect.

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Source: Extreme Networks, Inc. F4Q09 (QTR End 06/28/09) Earnings Call Transcript

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