Good day, ladies and gentlemen. And welcome to the Extreme Networks Q2 Fiscal Year 2017 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce Matt Sandberg, Investor Relations. You may begin.

Thank you, Vicky. And welcome to Extreme Networks second quarter fiscal year 2017 earnings conference call. This conference call is being broadcast live over the Internet and is being recorded on behalf of the company. The recording will be posted on Extreme Networks' website for replay shortly after the conclusion of the call. By now, you've had a chance to review the company's earnings press release. I would like to remind you that during today's call, management will be making forward-looking statements within the meaning of the Safe Harbor provision of Federal Securities laws. These forward-looking statements involve a number of risks and uncertainties, which could cause actual results to differ materially from those anticipated by these statements. For a detailed description of those risks and uncertainties, please refer to our most recent reports on Form 10-K, 10-Q and 8-K filed with the SEC. You should not place undue reliance on forward-looking statements which speaks only as of today. We undertake no obligation to update these statements after this call. Throughout this call, we’ll be referencing both GAAP and non-GAAP financial results. Non-GAAP information should be considered a supplement to and not a substitute for financial statements prepared in accordance with GAAP. Reconciliation of non-GAAP to corresponding GAAP measures is in our earnings press release issued today from the supporting financial materials. For your convenience, a copy of the release and supporting financial materials are available on the Investor Relations section of the company's website, extremenetworks.com. Now, I'll turn the call over to Extreme's President and CEO, Ed Meyercord for his opening comments.

Thank you, Matt, and thank you all for joining us this afternoon. Today we are pleased to announce solid second quarter results that beat our non-GAAP earnings guidance of $0.07 per share by a full $0.05. And we announced the near completion of our business integration initiatives associated with our purchase of Zebra Wireless LAN assets that closed on October 28. Based on fiscal Q2 results and guidance for Q3, this acquisition is already accretive to our EPS. We're also pleased to announce that for the 7th consecutive quarter, our Extreme team has delivered earning that met or exceeded our guidance. We drove significantly higher gross margins up 390 basis points year-over-year and operating efficiencies that generated higher cash flow with non-GAAP operating income of 29% and net income of 40% year-over-year on 6% revenue growth. We delivered these results while our teams were busy integrating our new wireless LAN customers, channel partners, distributors, suppliers and employees into Extreme. We added thousands of high quality customers to our existing targeted industry verticals and hospitality manufacturing and onboarded Marquis account in the retail sector with new logos like Kroger, Walmart, Lowe's and CVS, as well as transportation logistics accounts with FedEx, UPS, DHL. With these new customers we've expanded our presence and our market position one of the fastest growing segments in networking with wireless LAN growing at 6.3% a year versus 1% for the networking industry overall. We're now the third-largest wireless LAN competitor in our target industry verticals with wireless now representing approximately 25% of our total revenue. During the quarter we contracted with 57 new distributors globally and added 100s of new channel partners with a greater focus on wireless LAN. We hired 276 new employees in locations around the world and moved our corporate headquarters into the…

Thanks Ed. First I like to start with a few financial highlights from our second fiscal quarter of 2017 specifically playing out the increase in our gross margin and a strong growth in our earnings compared to the prior year period. Our non-GAAP gross margin improved 120 basis points quarter-over-quarter from 56.3% to 57.5% and improved 390 basis points year-over-year from 53.6%. Our non-GAAP product margin was up 580 basis points year-over-year for Q2. These increases were driven by our heightened focus on discounting approvals, reduce supply chain costs, improved software sales, as well as lower service and logistics costs. In Q2 our non-GAAP operating income margin improved to 9.4% up from 7.2% and 7.8% quarter-over-quarter and year-over-year respectively. The increase was driven by our improvement in gross margin, as well as our ability to leverage and control operating expenses as we layered in the additional revenue from the acquisition of wireless LAN assets from Zebra. Q2 also benefited from a higher level of vacation days taken due to the holidays resulting in a reduction in labor expenses. Please refer to our Q2 presentation on our IR website for details. Now I'd like to move to the second quarter fiscal - second fiscal quarter details starting with revenue. Q2 2017 revenue was $148.1 million compared to $121.6 million in Q1 and $139.3 million in Q2 a year ago. Our revenue increased during the quarter driven by the addition of two months of revenue from the newly acquired wireless LAN business partially offset by the impact of transitioning from selling revenue recognition to sell through in distribution channel for the acquired business. The geographic split of revenues were as follows; North America contributed 50% of total revenue, EMEA contributed 38%, APAC contributed 8%, and Latin America contributed 4%. Product revenue for…

[Operator Instructions] And our first question comes from the line of Matt Robison with Wunderlich. Your line is now open.

Thanks for taking the question. What were the product and service revenues before Zebra?

So we are not breaking out the revenues separately right now between the two. It's starting to blend together as we are starting to have cross-selling so we’re not breaking it out.

Okay. That’s it for me.

And our next question comes from the line of Alex Henderson with Needham. Your line is now open.

Let me try a different slant on that. Relative to your guidance, I assume that there was some expectation for the Zebra - revenues were offset, adjustment of 6 million in the quarter. So was the revenue adjustment more or less than expected there? How should we think about that? And we say has a small impact in the March quarter what we're talking about?

Yes Alex we have the revenue recognition accounting adjustments that was part of the quarter. This quarter we have only two months of the Zebra revenue and so the other thing that I mentioned in my comments is the fact that, we closed this at the very end of October and then we had to sign up all of our distributor and then start shipping product in November and December timeframe which push out some orders in the quarter. The overarching comment - I think Zebra is coming in exactly as we had planned and had modeled and as we go forward we are quite pleased with the integration, we're quite pleased with the opportunities that we're seeing and our assessment is that Zebra is right on track with how we set expectations earlier.

It's really not the question guys. The question is relative to the guide, you said that you are slightly off on the revenues because the adjustment is $6 million, selling was a big part of the difference and the question is, okay if it was $6 million what had you expected to be? Was it supposed to be 3 million or 5 million or how does it vary from what you'd expected?

I think what we're saying is that Zebra ended up being about what we thought. So the headwinds that we had were some - small amount on the Zebra business and then also on the base business as well. And then you had asked about the impact next quarter and we said it would be about $1 million to $3 million impact but that's built into our guidance for next quarter.

So that $1 million to $3 million falls out in the June timeframe?

Yes, it will be an immaterial impact in the June quarter.

Okay. The second question I have for you is on major wave of new products. How long do you think the timeline from the new product launch to positively impacting revenue, is it a launch from here or some in December, some in the current quarter, some even bleeding into the second quarter calendar but it's a three to six months self cycle so it's an - a positive driver for FY 2018 or is it something that we should anticipate contributing to the June quarter.

Alex it will contribute some to the June quarter but the big drivers will be in fiscal 2018.

Okay. And then the margin impact of a full quarter of Zebra, I assume that that's still impacting the gross margin on the downside. How quickly can you mitigate that and push the margins up towards target?

Yes, a lot of the gross margin initiatives that we're working on. We think they are completely applicable to the Zebra business as well. So we're starting to work on the discounting and working on the supply chain and we'll see those start kicking in here in the next couple of quarters for sure but we - a lot of the initiatives that we have will certainly apply to the Zebra business as well.

So clearly with the restructuring you just announced that I was - has always has a positive implication, how do you see that playing out over the course of next two or three quarters in terms of – I think it was $8 million benefit from the restructuring?

Yes, on an annual basis. So yes, I think on a quarterly basis we expect $2 million to $3 million and that - kicks in – we took that action in the first week of January so we get the majority of the benefit for this quarter as well.

Okay. I’ll see the floor thanks.

And our next question comes from the line of Simon Leopold with Raymond James. Your line is now open.

Thank you for taking my questions. I wanted to clarify a couple of things you mentioned in the prepared remarks, towards beginning Ed I think you commented on your position in the wireless LAN market mentioning that Extreme with the Zebra products was now the third-largest but I think there was a footnote to that statement or suspect there was, I’m just trying to square this with some of the market research we look at. You could clarify that?

Yes, Simon that’s for the enterprise market and our targeted verticals. So for example you have Cisco and you have HP Aruba, and those would be number one and number two. And then you would look at Ruckus and you might scratch your head and say why is Extreme higher than Ruckus and the reason is, they are very focused on service provider, and have other market focuses than we do. What we did is we did a lot of work with our analyst team in identifying the market, looking specifically the verticals, working with Gartner and IDC and [indiscernible] to understand that and then to give our best guess as to where we shake out and our competitors shake out. From an overall perspective, we're number three when you add in Zebra Wireless LAN it only strengthens our position.

Great. That answers it. That helps me understand what you were describing and that squares it. So the other comment you made shortly after that was - you mentioned wireless was now 25% of sales and I want to make sure I am catching this or accounting for this correctly in terms of is that 25% of product or are you assuming a certain portion of your services revenue as related to wireless and are you assuming any switching revenue as coupled with wireless is it truly be access point and controller revenue in that 25%.Thanks.

Simon, we don't break out we're modeling the business, we don't model by the different product groups. The 25% would be product and 25% would be service both. And what we're expecting, we're trying to sell both - one of the big opportunities that we have with Zebra and a wireless LAN business that we brought on is the opportunity to sell switching and more complete solutions to some of these really large enterprise customers with distributed networks. So they were selling pure wireless access points controllers et cetera, we now can sell edge switching and then look to even to go deeper into the network for those switching portfolio and then more importantly for us is we’re really driving software so by providing our control, our analytics and our management suite of software which we’re pushing out into wireless access points, we will be able to push policy to the edge to wireless APs et cetera. We are looking at it more as a comprehensive solution to our customer. Does that make sense?

It does, it does and I certainly appreciate how it's going to blend over time, I just want to make sure I put the value - that 25% in context. You didn't mention ERATE on this call, it's been an area of focus in the past with you and I guess some to last year, a couple of quarters ago with a little bit disappointing. If we can get an update of where the ERATE program fits into the business now and your expectations for that as a driver for sales?

Sure. ERATE has been a terrific program for Extreme. Over the years it's bought us a lot of new customers and then we get K-12 customers that we acquired through the ERATE program that we buy outside of the ERATE and we actually see some potential for that and some large orders in the second half of the year where that will come from that. All of that said, this funding cycle has been a disappointment and whereas - what we've heard we've seen announcements from all of our competitors that play in this market and what we see it's 30% to 40% off where was a year ago and the funding has been much slower to come out. So for us our first quarter which is that September quarter was much slower on ERATE. Our ERATE business picked up in Q2 but on a year-over-year basis it was significantly off. There are some orders in our pipeline that are backed up that we're expecting to recover in Q3 and Q4. Normally we would say ERATE would be 10 on a low as much as 20 million in a quarter, we definitely been down at or below the low mark for the first two quarters and we’re expecting it to pick back up in Q3 and Q4.

Great. And one last modeling question if I might. I certainly appreciate the seasonal aspects that move your operating expenses around particularly the spike associated with your June seasonality. So I’m just trying to understand how to think about the normal run rate of expenses post the restructuring given the longer term targets you have for operating margin. So if there's some metrics you can give us to think about pro forma OpEx on a run rate basis post the restructuring efforts.

Yes, I think - we have some fluctuation, we have variable comp that plays in there but I think based on kind of where our run rate revenues are looking, you could kind of model $70 million, $76 million to $80 million to $82 million of OpEx per quarter and we kind of vary by quarters on - the higher revenue quarters we’re going to drive more variable comp.

Great. Thank you very much for taking my questions.

And our next question comes from the line of Mark Kelleher with D.A. Davidson. Your line is now open.

Great. Thanks for taking the question. You had Zebra for three months now, could you just tell me where we are in the integration process? Is that completely integrated? Are we still integrating the R&D team, the sales team, what savings can we still expect going forward?

Sure. Let me take the first shot then I'll give Drew the opportunity to follow up. The Zebra acquisition for us has gone very well and very smoothly. It's probably exceeded our expectations. We think about it on three levels. First of all we'll start-up with the employees. We made offers to Zebra employees and got almost every single employee onboard. This is really a talented crew and they are going to add a lot to our capabilities and in our competitive position in the market and our product development. The second thing we look at is our customers. We're thrilled at the customers that we're bringing over from Zebra and the reception from the customers has been fantastic. So we're - customers and partners alike, we're seeing much bigger opportunities from the likes of Kroger and the likes of Walmart and Macy's et cetera when they are looking at potential refreshes of a nationwide highly distributed network, very large network versus the traditional enterprise customer that we've had. So the reception has been very, very favorable, so that's where we're encouraged by that and excited by that. And then the last piece is we're looking at the business operations and the systems and data migration. We literally - we closed on a Friday and then on that Monday when the Zebra employees logged into Extreme systems we had migrated Oracle data and Salesforce data over the weekend and then within 40 days we migrated nine desperate customer service system into Extreme system. I will say it was a lot of work, it was an amazing effort by people on the Extreme team and people worked a lot of long hours and a lot of weekends to get it all done but at this stage of the game we're largely complete. We're still ironing out there'll be a situation where we're looking for a customer contract and the customer service system et cetera very normal integration kinds of thing but there only a few TSA left over and 90 days in we feel like we're largely complete. Drew, do you want to add anything to that?

Yes, I mean the only thing on the cost side I think you asked if there's still opportunity there. Right now in the beginning we've got two completely different wireless APs supply chain. So there's an opportunity there for us to consolidate those over time and we've got plans to do. There is also just the overall roadmap. We've got - with eight most recently came out with wave 2.802.11 AC platform and we just introduced ours. As we go to the next generation, we’ll have the opportunity to consolidate some of our spending there as well and go on to one platform. So there is still opportunity from a cost standpoint on the integration.

.:

I think we should think about that as noise right now, I'm not sure we can give you a strong signal. We're highlighting win against Ruckus and also highlighting wins against Cisco, Meraki, Aruba. I'm not sure I would point out or single out Ruckus more than any other competitors at this stage.

Okay, thanks.

And our next question comes from the line of Christian Schwab with Craig-Hallum Capital Group. Your line is now open.

Great quarter, guys. So can you remind us what you anticipate the combined company can grow at like a 3 to 5 year CAGR with 25% of your business in wireless and the remaining in switch. What do you think the growth rates should be for those two businesses over the next 3 to 5 years?

Christian it’s a really good question. We look around at the industry and on a consolidated basis we look at Cisco has got to be the ultimate sale letters since they have down at market share. And they are shrinking at HP's been struggling on the network side, as well as - 3% growth when they just came out their earnings report. Most of their growth was in high end data center and cloud service providers and they actually shrank in the enterprise space where we are flying. So, it's a very competitive market and if you look at the enterprise market I think we would say even though we had a wireless LAN business which is the fastest growing segment, overall the market is somewhat flat to maybe up a percentage point or two so the way that we would set our goals is that we should beat the market so that we're going to look at growth rate that's higher than that. We believe we can beat the market because we’re the only player that’s focused solely on the enterprise campus. It’s a very competitive market, the competition is there but we're the only ones there are solely focused on that quality of experience, changing business outcomes, and focusing all the resources in our company on those enterprise customers, end-to-end solutions in our solution portfolio. So I would say the industry is going to be a 1% lower, 1 or 2 that we should be able to beat that.

Okay, great. Given the added month of service, you know why gross margins went down on a sequential basis on a non-GAAP I'm talking about from Q2 to Q3. When we look to the June quarter, obviously we should have better revenue - but is it safe to assume that gross margins will be up on sequential basis?

You know we're looking at it, a lot of it is driven by if - software sales we had a nice increase in software sales this quarter and that that helped our gross margins. We don't have a lot of visibility to that in the Q4 and then if services revenues go up we will but we're not guiding the Q4 yet at this point.

Okay. And then my last question on the 60% type of gross margin objective or goal that you have for your company. How long realistically is that going to take? Is that a one or two years thing or is that kind of a 3 to 5 year type of objective?

Christian, I think it's a one or two. We have – there's a lot of initiatives that we have underway and there is a lot of ways for us to grow our gross margin. So as Drew mentioned if we can grow that service line, we made changes to our service organization. We've hired a lead to drive services revenue. We have a new managed and services business. That alone has got a fixed cost structure so we're driving revenue there, that will contribute to gross margin, I think that’s a big opportunity for us. Drew runs our gross margin SWAT team here inside the company. We have at this stage 20 different initiatives and a lot of it around our discounting policy, pricing policies. I talked about some of the initiatives that we have underway but all across functional teams are very focused on hitting that target. So I think 1 to 2 is a better timeframe.

So I just wanted to make sure I heard that right. We had 20 distinctly different gross margin initiatives to increase gross margin throughout the entire company we have people working on, is that correct?

Yes, there's probably half of dozen that are discount related looking at discounts by stratifying our sales and looking at the size of the deal and having different discounts on the deals overall pushing back on low margin deals. Looking at the discounts that the partner and distribution chain have and the agreement that we have with them and ensuring that we stick with those discounts. So we've got a lot that are based on discounts. We've got a number of supply chain initiatives. We have product lifecycle initiatives and you know there's - like Ed said, there's an extensive list of 20 different things that we're working on and trying to improve.

Okay. And then my last question if I may, Drew what do you think is the current attach rate on the service revenue side?

30% yes of sales.

Okay. So still well below of some of your peers.

Yes it's a huge opportunity for us.

Yes, we've been tackling this opportunity for a number of years here, previous management team attempted to attack it too.

Yes, yes.

So what is a realistic goal and time frame that myself and investors can think about – about that and then can you quantify it to the gross margin level, so let's say we wake up magically one day from now and we have a 40% attach rate, what would be all things else being equal what type of impact would that have on gross margins?

Christian, I'm not sure we're in position to forecast that on the call today. Maybe we will take that back and maybe we can cover it offline. We will say that, we made a structural change inside the company to drive services revenue, we hired a resource who is going to focus entirely on revenue and working with the sales - I'm sorry the service delivery team to drive new services offerings. So this is an area that is right - this is an area that has been out there for a while, we feel more confident now than we have over the past since I've been here that we're really going to go after in target and make a difference. I'm not sure we can build the bottoms-up structure at this time in terms of having a change in services margin and services line that we can ultimately contribute to the gross margin goal.

Okay, that's fair. All right, good quarter. Thanks guys.

And our next question comes from the line of Rohit Chopra with Buckingham Research. Your line is now open.

Thanks very much, hi guys, how are you? I had three questions for you, the first one was on software, you mentioned that couple of times as a key driver of gross margin, any way to give us a growth rate there or percentage of revenue or some type of reference point for software?

It was up 20% quarter-to-quarter, so we had a nice improvement this quarter.

Okay.

The top of small base but it was a good improvement.

The software is still about 5% of our revenue, yes so it's a small.

That's perfect actually. And then I want to come back to the restructuring real quick on the $8 million, what lines is that supposed to hit maybe I missed that. Where are you getting the savings from?

It's primarily going to be in the operating expense lines.

Okay. All right and the last question I had was I just want to come back to the Zebra/Motorola assets, they were known for being a retail focused company, I think in your presentation when you acquired them, one of the key verticals was retail and I just want to get a sense of what you're seeing in that area and you mentioned a few logos Ed but Macy's is in there, Kohl's is in there, CVS is in there, there are some retailers and I think all of us who are sort of in this industry have seen some challenges in the retail big-box area and they're closing some stores, I just want to get a sense of what you're seeing in the Zebra assets as it relates to retail specifically?

Yes, so we have - we've been really pleased with the new customer relationships that we have with the Zebra retail customers and when you start talking about the Walmart's and you start talking about Kroger's and you start talking about these kinds of companies and businesses, they are lot larger than what we've seen in the past and what we I'm not sure, we are in a good position to talk from a historical context about these customers. But what we can say is that we're seeing a lot of opportunities to refresh networks and one of the things that retailers have to do if they have to improve the quality and experience and the quality of their customer engagement and order to bring them into the retail environments. And a big part of that is Wi-Fi and a big part of that is networking, so this is something that we're seeing opportunities with our software beyond just providing Wi-Fi access but looking at other solutions with retail to improve the quality experience not just for the retailer infrastructure but also for retail customers, that would include not just edges but also switches. So that the opportunity we're seeing are a lot larger than the opportunities that we would traditionally see just because of the nature of these large distributing networks but also lot larger than what Zebra would traditionally see because it includes our edge switching portfolio and our software.

Okay, thanks Ed. That really actually does help a little bit. Thank you.

And our next question comes from the line of Matt Robison with Wunderlich. Your line is now open.

Hi thanks for taking the follow-up. Just wondered if the tone of collections changed with the addition of the Zebra customers because no way it's a follow-on to Rohit's question and the other just curious kind of qualitatively, Ed what were the weakest and strongest aspects of the quarter from your perspective?

Yes, you probably saw that big, we talked about the big accounts receivable number, the 117 plus and the collections were very good, we bought the A, accounts receivable that came with the deal was about $19 million and we've collected all but million dollars of that since we have owned the business. Some of it - the lot of it came after the first year, so it's not reflected in that balance of collections but everything has been normal, we expect to be down to our normal DSO levels here within most likely in Q3 but certainly in Q4.

Yes so Matt, the culprits from the pressure that we felt on revenue, I would say the number one issue during the quarter was ERATE and headwinds that we continue to see with the slowdown in ERATE funding during the quarter, it's more than we expected. We also have in our Asia-Pacific region, we changed management and there is an opportunity for us that business has dropped and we see an opportunity to bring that back. But that was another area of weakness, these were offset by very strong performance in our EMEA region. The benefit of the gross margin discounting policies and the enforcement of driving higher gross margins, the benefit of the higher gross margins one of the things we have to do is we have to pass on certain lower margin deals which affects revenue. And so we still see that you will see that effect, we haven’t quantified that for you but it has an effect on revenue and the last thing I would say is that this was a backend loaded quarter and there were from us, we don't report on backlog but we saw an uptick in our backlog based on the timing of deals at the end of the quarter.

Thank you.

And our last question is a follow-up question from Alex Henderson with Needham. Your line is now open.

Yes I was just wondering if you could just help us out with the long-term target model, you talked about getting to 60% gross margins but can you give us some sense of what the other line items might look like to get to the I think the target is 10% operating margins even in your seasonally weakest quarter, should I think comply kind of 11% overall operating margin given you're normally couple of points between the soft quarters and the strong quarters, what would be the mix on R&D and sales marketing at that level if you're at 60?

I think - we think we can do it being close to where we are right now. We can get the gross margin improvement and based on the action that we took in Q1, we're going to be right there at 10% in the - even in the lower quarters. So we're there, so I think if you kind of math the operating expenses in that range that I talked about earlier which should be about $76 million to $82 million depending on low quarter, high quarter we can achieve that 10% operating margin.

I was just wondering what the split is between the R&D and sales marketing in that model, was really the question.

Okay.

I can do the math 60 down to 10, I just don't know what the split is.

So R&D stays around the $25 million a quarter level here for at least the next few quarters. And then the variability would be more in the sales and marketing line item where we variable comp. And we would be ranging from say $42 million to $47 million or $48 million.

All right, thank you.

And then G&A, G&A would be pretty flat.

Great, thanks.

And I'm showing no further questions at this time. I would now like to turn the call back over to management for closing remarks.

Okay. Thank you, operator, and thank you everyone for participating in the call, the strong quarter from our perspective. Again really excited about the wireless LAN asset acquisition, how that's going and the new team we've got, we’re excited about the products we've got coming and the wave is starting, that's going to have a really positive impact on our business and all the initiatives we have around gross margin. This is going to be very strong cash flow quarter here in Q3, so we're excited about the outlook for the second half of our fiscal year. And final plug, I think the team at Extreme has done an excellent job across the Board at executing. Thank you everyone for participating and have a good evening.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a great day.