Calix's Management Presents at the Goldman Sachs US Emerging/SMID Cap Growth Conference (Transcript)

Nov.14.13 | About: Calix, Inc. (CALX)

Calix Inc. (NYSE:CALX)

Goldman Sachs US Emerging/SMID Cap Growth Conference

November 14, 2013 10:40 a.m. ET

Executives

Michael Ashby – EVP & CFO

Simona Jankowski

Good morning everyone. My name is Simona Jankowski. I’m the contact analyst at Goldman and it's my pleasure today to welcome Michael Ashby, the CFO of Calix. Thanks Michael for joining us. And I think we will get started here is -- then I will turn it over to Michael for some very quick slides to give you all brief overview of Calix and then we will dig into some Q&A and I’ll leave some time for questions at the end as well.

Michael Ashby

Okay. Thank you very much. -- by taking me through fairly quick presentation, I’ll go through fairly quickly and so Calix was founded in 1999. We are the leader in advanced broadband access for the – [with no presentation so.

Simona Jankowski

Can we –

Michael Ashby

Sorry about that. I am not sure we are back on track or not. Okay. I guess we are reloading the presentation. There must have been some error on that. I apologize for that. Let's go back again. So let's try and get through this fairly quickly.] So what is driving the business, the access business is the explosion of video traffic. So it is an all video world and this is a new statistic that comes out of our own database actually which is 62% of North American IP traffic is streamed video upcoming from NetFlix, YouTube, Amazon.com, Hulu, and various other sources. So it's a very large percentage which is driving an increase in the bandwidth requirement that goes up with the access network.

Another item which is also important in driving increased demand for streamed video is the Chromecast which some of you may have or may know about. It's a $35 dongle that came out from Google, that you stick in to the back of your HDMI TV and that allows you then to run NetFlix and YouTube directly onto your TV screen which again is [some] coming off your subscriber device. Again all pushing towards more use of bandwidth and more need for the access network to be more robust.

Other examples of that which are coming out actually just this month, Xbox 1 and PS4, both of which allow for high definition and ultra high definition and streaming video again over to your TV or your subscriber device. So these are all items which are beginning to increase the demand for bandwidth. Calix’ situation is we focus strictly on access, that’s all we do. And access is everything between the cloud which is where the contents and application are stored and the subscriber and the device. And the access network is how you get that data between the subscriber and the cloud and back again.

Our view of the network is a very simple one. It is that the access network is one network in the future. It is all IP, it is via Ethernet. It's all fiber with wireless at the end that’s the view we had for some time. It hasn’t changed. People say why doesn’t wireless take away for your network, wireless in fact is a part of the network. Wireless traffic goes over the same access network at different points in the network. If it's a large cell tower, it might have a separate fiber running out to back to another part of the data center or another part of the access network and small cells connect directly to the closest point of the access network and obviously I believe is at the last 30 meters or less is Wi-Fi and so all of that traffic again the explosion of wireless traffic requires a more robust access network.

So it is a world which is connected. It is always connected. Subscriber devices are there permanently. They are on the whole time whether you haven’t turned off or not, polling and so the emerging role of access is both necessary, strategic and very valued.

Calix has a leadership in fiber access. We support the transmission networks. We believe strongly that the networks of the future are fiber and as you can see here we have 520 customers in North America compared to 239 for all other vendors combined. Over 15 years of real world, fiber deployments and we have a purpose built solutions and a breadth of portfolio.

What is very interesting is what's happening at the present moment which is the confluence of trends leading to an acceleration of gigabit services. The FCC has called for gigabit services in all 50 states by 2015 and as of today, we have 17 of those which are announced and either been in the process of being built or in some cases already built. Those have been driven by the FCC, have been driven by the FTTH, they have been driven by competition from cable. They have been driven by catalyst such as the Gig University initiative, such as Google Fiber which is of course well known in Kansas City and now probably Utah and then announced Austin, Texas. Then the gigabit squad initiative and then sample of some of Calix customers who have also been rolling out gigabit networks. We see this as something which is a trend that is going to accelerate as time goes on. Recent industry gigabit residential announcement, these are not necessarily Calix customers. These are recent announcements and you can see there is quite a wide variety of them and every week there are more announcements of gigabyte residential networks being coming out.

Just last week, there was an announcement from Fierce Telecom about Los Angeles, the city of Los Angeles, which is putting out an RFP and as you can see at the bottom it says it would require fiber to be run to every residence, every business and every government entity within the city limits of Los Angeles and once you get a large city like Los Angeles beginning to push this. I think we are beginning to see this take off.

So the joy of gigabit broadband this is the picture from CenturyLink presentation using the speed test. And they have another picture in the presentation as well which shows the small business where they have rolled out gigabit services where everyone is smiling and in fact taking pictures with the smartphone of the speed test because they can see that there is a gigabit service coming across. So it is quite an experience in something which really [Indiscernible]. You can see them all taking pictures of it because it's such an impressive thing. I mean they are excited to have.

So what is gigabit? Well, it's important to understand that there is a very big difference between the speed that can be achieved through copper or through cable and gigabyte fiber. And this chart gives you some indication of that. At the bottom, you have the copper technologies and from ADSL and VDSL, VDSL 2 with vectoring and bonding and DOCSIS 3.0 and as you can see that is a long way from being able to match what an all-fiber gigabit fiber network can do.

Now obviously we understand that not everyone is going to move to gigabit fiber network immediately as they are in fact going to transition slowly over time and so one example here is the 700 series GE ONTs which are upgradeable to residential gateway and ONT normally require home router but through a downloadable software we can actually do away with the home router completely and allow the service provider to in fact control the network directly by using software that we have called Consumer Connect and be able to do maintenance and repair and troubleshooting on the network from the data center. And that’s all available through a software upgrade.

In addition to that, there are different revenues available for our customers to rollout and we have design systems that allow them to have the lowest OpEx and the lowest CapEx. Examples of that are auto detect in our ONTs which today we are still the only company that does which allows the ONT to detect if it’s BPON, GPON or AE or 10-gig PON and automatically then upgrade itself without having to change the hardware. All of that is obviously considerably advantageous to our customers. Again, going further forward, there are a lot of different products that we’ve introduced over the last few quarters. We have industry leading vectoring solutions. VDSL 2 vectoring and bonding supported today. We deliver superior services over copper because we recognize that copper networks are going to transform and the key is to have the copper loop length getting shorter and shorter and then be able to take fiber as deep into the neighborhood as you can and we have a series of products that allows us to do that and the top ones look like IP/DSLAMs, but in fact, can be run, can be put into rings or data chain or point-to-point that is sealed or hardened. They can be mounted on a wall, pole, pedestal or cabinet. So allowing service providers to be innovative in the way they build their networks.

From a global point of view, we have started over the last couple of years to begin to invest globally when we acquired Occam we acquired some customers overseas. From that we have started to build our own customer base and you can see from here that we now have a pretty large footprint internationally through our relationships with Ericsson and through our own infrastructure that we put into place and value added resources put into place.

And in the first quarter of 2014, we will introduce an interface of our operating systems or product with Ericsson operating systems and a series of global T-series ONTs which would allow us to go after more of these markets in going forward.

Just to give you a quick view of our financial results in the long-term model. We are from a revenue point of view, 2012 is a little disappointing, but we have bounced back and have grown significantly during the first three quarters and we expect at the end of the year at about 18% growth rate for the year over 2012. Our gross margins have gone from the low 40s and mid 40s in 2012 up to the high 40s now and that continues to go up and the target is to get to the low 50% range.

Operating expenses we have done a better job at controlling this recently. I am beginning to see that percentage go down and as we grow the top line, we should see that go down eventually to the low 30% range which will allow us to have operating income in the high teens or low 20%.

This is a chart which I think you will not see from many telecom companies. Our gross margin over the last few years and you can see the gross margin growth has continued and as I said before, we expect it to get up to the 50% level in the quite near future.

And that really is a brief sort of explanation of the company. Hopefully that was interesting and with that we will move to Q&A session.

Question-and-Answer Session

Simona Jankowski

Okay. Thanks Michael that was very helpful. Let me just maybe start out by looking into next year. What would you say would be the top three growth drivers for your business?

Michael Ashby

Our growth in 2014 and 2015 is coming from a number of areas –let me take you through the business. We are growing in the largest customer CenturyLink as you know we weren’t able to sell into the quest side of that until December 2012, so effectively 2013. And we are very pleased with the progress they are making there. We expect that to continue for the next two to three years that we can continue to grow that business. We are also growing the business in some of our cable customers in North America where we sell GPON networks to cable companies or business services and we are seeing cable have a greater interest in GPON for business services and also for residential. So we expect that to be an area of growth for us going forward. In the Tier-2s, there is a mixed environment. Where some Tier-2s are investing more heavily than others and we expect that to be probably a low single digit growth rate going forward. The Tier-3s is somewhat similar and that there are some stronger Tier-3s who are investing heavily and moving more rapidly towards future networks and there are others who have weaker balance sheets and poorer cash flows who are not as investing as heavily. So the mix of that again is probably low single digit growth.

And then there is the international where we have grown the business in 2012 our international was approximately 7% of the business. We expect this year to be between 11% and 12%. So that’s a pretty good growth. That growth has come from our installed base in the Caribbean and Canada as well as going up to Tier-2 accounts in different international countries and signing up value added resellers where we had a lot of success added lot of new customers; small orders but new customers. And then starting in 2014 onward we hope to be able to take advantage of the Ericsson relationship to go after tier ones internationally.

Simona Jankowski

Okay that’s very helpful, a couple of follow-ups on that. First on the Ericsson piece and you touched on that in your prepared remarks as well as having some kind of new interface capability in Q1 that will allow you to better leverage that channel. Can you go into that in a little more detail?

Michael Ashby

Sure. When we announced the deal with Ericsson there was two parts to it. One was to as we bought GPON OLT to resell back through Ericsson which are the time we felt was going to be reasonably significant revenues and as you know that proved to be disappointing and as revenues are actually being quite small. But the real jewel of the relationship was this reseller agreement and in order to be able to take advantage of that and go after the install base that Ericsson already has internationally. We need to be able to interface our products with the Ericsson operating systems.

And that was something that was as you worked on all year, it will be available in the middle of the first quarter of 2014 that’s not late that was always the timetable. And together with that we are introducing some global ONTs which in the combination of those two will allow us then to go after the Ericsson tier one customers, and so for the last year we have been working with Ericsson to identify those customers, we have actually visiting those customers. We actually have some trials this month of the products that will be out in Q1 with some of those customers. And you know and our goal is to try and make those successful in 2014 and then grow that subsequently.

Simona Jankowski

Yes. Can you help us size that opportunity? How big is that installed base and also should we think about this business as yours to lose? In words are these customers if all goes well very likely to want to upgrade with Calix given the Ericsson relationship or are they fully opening this up to RSPS that will completely open to bidding to third party access vendors as well?

Michael Ashby

Okay let me answer that in several different ways, first of all, they are more likely to go with us because of the relation with Ericsson then if we are stand alone, so that’s good news. But having said that Ericsson when they sold the business they told all of their customers that they were getting out of the access business and most of this customers either did last time buys all started to look at other vendors and so in most cases the customers are in fact talking to other people as well. And we are competing against the likes of Huawei and Alcatel Lucent together with Ericsson. So in all cases I think it’s competitive. So there is no guarantee that they are going to go with Ericsson- Calix, but because of Ericsson’s strong relationship with a lot of them obviously we feel that there is a good opportunity because we bring state of the art access products that Ericsson didn’t have then we are obviously hopeful that we will be able to break into some of those accounts. But what we need to do over the next year or two is we need to get two or three of those international tier one accounts and if we can do that, that gives us a very solid base from which to grow the business from.

The reality is we need this release to come out in Q1. We need the relationship with Ericsson to be successful. It’s important for us to develop that relationship, and we have been working on it for some time to come. And when I say Tier-1s internationally, we are not really going after the PTTs in Western Europe. We are going after the Tier-1’s in more of the developing countries as opposed to developed countries, and the reason for that is that they tend to be more open to new technologies. They tend not to have such a large installed base that they want to protect; and so in developing countries, we are talking with countries in Eastern Europe for instance, countries in Middle East, Africa, and South America. And examples of potential customers might be, you know Rostelecom and MGTS in Russia; Turk Telecom, Kazakh Telecom, and the whole host of others. Some of whom we are already working with and others that we will work more closely with Ericsson once we have the products available.

Simona Jankowski

Okay, now that’s very helpful. And historically, your go to market in the United States was a direct sales force. How does that differ when we think about some of these opportunities internationally? Do you still have a Calix sales person that goes hand in hand with an Ericsson sales person or can you explain that a little better?

Michael Ashby

Yes. The international approach is somewhat different. We have signed value-added resellers in different countries, and then we have the relationship with Ericsson. In all cases, we work closely with them, so we do what we call high touch selling so it is not direct selling, but it is high touch meaning that we do have people who call all those customers directly. We do not have a customer where that we have not visited were not present. . So in the case of Ericsson, yes certainly we do call on those customers either on our own or together with Ericsson.

Simona Jankowski

Okay. So as I look at the drivers you outlined for your 2013 growth, one thing I didn’t hear you say is the Tier-1 customers in the U.S. or North America. And of course you have talked in the past about calling on those accounts, and they have always been kind of part of your longer term plan. Where do we stand on those as we look into next year or beyond?

Michael Ashby

They are still part of the longer-term plan. We are calling on both AT&T and Verizon and have been for some time now. We have, I think it’s fair to say, good relations with both of them. They know us. We know them. I think that it is our goal to get those as customers eventually. How long that takes is difficult to say, it is a long-term process. As you probably know, AT&T has a third provider or two of the main vendors for access, Alcatel Lucent and Ericsson, and Ericsson has a relationship with Adtran for AT&T which is still in place and remains in place. So, that one is a little bit more difficult to break into, but Verizon doesn’t have any such relationship, and so we are calling on both of them, and we do expect eventually to have both of them as customers. How quickly that happens is really – it's really difficult to say. It depends on the opportunity. It depends on the niche that becomes available to us.

It is unlikely that we are going to go after larger RFPs with either of them. It is more likely that we will find a place where our technology fits, but they can try it and test it and see if it works and then grow from there.

Simona Jankowski

Okay. Got you. And it sounds like it's not quite part of the 2014 plan at the moment, but in the longer term.

Michael Ashby

I am really not expecting anything from those in 2014, that would be a nice upside if it happens.

Simona Jankowski

Okay. Fair enough. Obviously, there has been a lot of talk about gigabit service and fiber-to-the-home, fiber-to-the-premise, and you highlighted that in your slides as well. At the same time though, you just issued fairly disappointing guidance this last quarter as you looked out into the fourth quarter, and when we look at the CapEx numbers by Tier-2 carriers in the U.S., a lot of which were your customers, they are down this year and they look to be down into next year as well. How do you reconcile those two trends?

Michael Ashby

Well let's just talk briefly about the fourth quarter. Fourth quarter what we are seeing is that we actually expect to have a good fourth quarter. It's going to be up between 7% to 13% over the prior year, so it is still a good fourth quarter but slightly less than we had anticipated because we are not seeing this end–of-year budget spending that we normally see, and the reasons for that are a little not that easy to ascertain. We think some of it is due to the fact that customers are looking at how they are going to build things in 2014 and don’t want to buy stocking parts for equipment that they may not need in 2014, but on the other hand there are a number of other companies in other parts of our industry who have announced the same thing, so presumably there are other reasons going on there. So it is as if there is less end-of-year budget spending taking place this year. We don’t see that affecting our activity levels. We don’t see it – we don’t see any change in the project plans that we look at for 2014, so we don’t believe it's going to have any impact in 2014 at the moment. It seems like it's just simply sort of a cut back in year-end budget spend at the end of this year.

So as we look forward, we see a lot of activity. We see – we have just finished our user group which had an increase in attendance of over 20% from the prior year, which is very good. We seem to have very satisfied customers, all of whom – a lot of whom are taking about launching more fiber projects in 2014. A lot of them have either already made that decision, others in the process of making that decision are looking at it. So, we see a lot of activity. The Tier-2’s are rather mixed. The two largest, Windstream and Frontier, basically are spending less cutting CapEx. Their balance sheets are not very strong. And so Frontier, for example has certainly done less upgrading to fiber in 2013 than we had expected, and I think they are cutting back CapEx in general, that’s not just in fiber, but overall.

So we are still, we still see Frontier as a good customer, but we don’t see them growing very much in the future, in the near future at least. Windstream is concentrating on business services, and we have been less present in the business service in Windstream and more on the residential side. So, Windstream still remains a good customer, but we don’t see them being a strong growth customer for us either. But when you look at some of the other Tier-2’s such as TDS, FairPoint, Cincinnati Bell Telephone, and some of the other larger Tier-2’s, quite a number of those are moving very rapidly towards building more fiber networks and increasing their CapEx, so we see it as a mixed environment. There are a number of customers that are expanding CapEx or they are moving a greater portion of that towards fiber which benefits us. And then there are some who are doing the opposite, who are trying to preserve the life of copper as long as they can, and that’s why I say I think we see it as a low-single digit growth area of the business over the next year or two.

Simona Jankowski

Okay. One of the questions we get from investors is just trying to understand Calix’s exposure to copper versus fiber. Is that something you have looked at internally that you can quantify in terms of your revenue split?

Michael Ashby

I can't give you actual numbers for that, but the vast majority of the revenue is still copper, and we believe strongly that copper networks need to transform to fiber. The question is how quickly does that happen. So there are still a lot of ADSL networks in place that still needs upgrade to VDSL 2. We obviously have products that allow them to do that, and then we also have products that allow them to move from VDSL 2 to add copper paired bonding and to add vectoring all the time pushing fiber deeper into the network.

As you saw from the gigabit chart, the technologies in copper, the speed drops off dramatically with distance, so you have to move fiber deeper and deeper into the network. In our view, eventually you have to move fiber all the way to the home, and what we are seeing in terms of gigabit networks being rolled out, we think it's just the start of that process. It obviously has a long way to go. How quick it happens really depends on success of some of these pilots. So CenturyLink’s pilot in Omaha, they announced a few weeks ago they were considering to be a success so far, and so they announced they are going to build Las Vegas next. When you have cities like Los Angeles looking at RFPs to build gigabit networks, we think there is a potential for that to pick up speed and move rapidly, but the vast majority of networks today are still copper, and they will slowly transform towards more fiber into the network.

Simona Jankowski

There is somewhat more recent technology on the copper side or DSL called vectoring, which you eluded to as well, and effectively what that allows folks to do is just put a new piece of equipment that allows them to use the existing copper plant and substantially increase speeds close to 100 megs. Is that a significant piece of business as you look into next year for Calix or do you think that most of your opportunities for growth will be on the fiber side?

Michael Ashby

No. it's both. I think vectoring is -- we support vectoring, we have done for some time. We have a number of customers that have installed vectoring. Vectoring is a noise cancelling technology, so it doesn’t actually increase the speed, it reduces the noise which allows you to use more of the bandwidth, so it's a good technology. It's a fairly complex technology. We don’t believe that it is in the end, the long term answer. It is an interim solution, and there are a number of customers who are interested in doing that, so it's an important part of our strategy as customers transform. I guess it's fair to say we would like to see customers move more rapidly towards all fiber networks, but realistically that is not going to happen. They are going to move from ADSL to VDSL 2, and then they are going to incorporate bonding and vectoring, and if you can bond and add vectoring, then you can get to approximately 100 megabit per second to the home, which is a reasonable speed. Having said that, it is our belief that 100 megabits per second is in fact not going to be fast enough, and rapidly that is going to actually become slow.

Simona Jankowski

Another topic I wanted to ask you about is the Connect America Fund, which is a new fund that the FCC has basically put forth to help some of the Tier 2, Tier 3 carriers fund broadband expansion initiatives, and a number of your customers have applied and received these types of funds. How do you think this plays out for Calix? Is that a source of incremental CapEx for some of your customers into next year or do you think it's just another source of funding, and it really doesn’t add more substitutes of source of CapEx for them?

Michael Ashby

We see it as another source of funding. We do not believe it increases the CapEx, and we would be happy to be surprised by that and see if it does – if it can become incremental, but most of that, I think you are talking primarily about the 485 million that was handed out, which has gone to Tier-1 and Tier-2 carriers, and most of them have accepted it and said that they’re going to match it dollar for dollar, but we believe that it is going to be used as a means of funding of capital projects. It is not necessarily going to be adding incremental CapEx or incremental projects.

Simona Jankowski

Okay. And on the Tier 3 space, which is still the majority of your revenues, you had this dynamic there in the last year or so really looking back to 2012 when a lot of those customers had fallen off pretty dramatically, and some of that was related to uncertainty about how some of this funding was going to be administered. And then in the course of this year, it sounded like at least in the second quarter a lot of that customer base came back and normalized pretty nicely and perhaps took a step back a bit in Q3. Can you just recap for us where we stand in that process? Has that customer base in aggregate returned to normal levels for you guys or is there still a little bit more to go?

Michael Ashby

No, it hasn’t returned to completely normal levels, and again I think what's happening in that customer base is the same thing as we have seen in the Tier-2’s. Those customers who have stronger balance sheets, better cash flows are increasing CapEx and investing fairly heavily. Those that have the weaker balance sheets and weaker cash flows are really looking at what are they going to do looking at the strategy. We have seen a lot of consolidation taking place, and we think that will continue. And so, we think it is at the point where over the next year or two, that customer base is changing as the more aggressive of those start to build out in their competitors’ territories or even start to take over their competitors, and so it is changing the environment over the next couple of years.

Simona Jankowski

Okay. With only a couple of minutes left, I want to see if there are any quick questions in the audience. And if not, I did want to ask a question on margins. You showed that nice looking chart with a very upward trajectory on margins. How does that change and how do you manage it as you expand more aggressively internationally where first of all you have to go partially through a channel and then secondly you see some more price aggressive competitors like Alcatel and Huawei?

Michael Ashby

That’s a good question. We – the good news for us is that internationally we are selling only the E-series products other than [Indiscernible] on the BLM. The new products are all E-series which have higher gross margins for us, and what we have said is that we expect that gross margin growth to continue to the low 50% over a period of time. There may be quarters where it dips slightly and then goes back up, and we have also said that we are prepared in certain situations to take low margins if we need to gain one of these large international customers, but we do not think that over any period of time or any full quarter that’s going to have any negative impact on me, on the growth in gross margin. So we think we can absorb that. You may see a dip in one quarter and then back up the next quarter. As I said, we are prepared to be aggressive from time to time if necessary within regions to try and gain one of these customers because once you become installed in those customers, then you have the opportunity to be able to increase that margin over time. So that’s really the strategy that we have.

Simona Jankowski

Sure. Makes sense, thank you Michael. I really appreciate you joining us.

Michael Ashby

Thank you very much for inviting us. Thank you.

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