Extreme Networks, Inc. — Form 10-Q Summary
Reporting period: Fiscal second quarter and six months ended December 31, 2017. Fiscal 2018 is the year ending June 30, 2018. Comparative 2016 results are presented as adjusted for the company’s retrospective adoption of ASC 606.
Business context and reporting period
Extreme Networks sells software-driven wired and wireless networking equipment and related services to enterprise customers worldwide, primarily through distributors, resellers, and its field sales organization. Results include acquired businesses from their respective closing dates: Zebra WLAN (acquired in October 2016), Avaya Campus Fabric (July 2017), Brocade Data Center (October 2017), and a capital financing business (December 2017).
Key financial metrics
Amounts are in millions of dollars, except per-share data and percentages.
| Metric | Three months ended Dec. 31, 2017 | Three months ended Dec. 31, 2016 | Six months ended Dec. 31, 2017 | Six months ended Dec. 31, 2016 |
|---|---|---|---|---|
| Revenue | $231.1 | $156.4 | $442.8 | $279.0 |
| Gross profit | $129.0 | $79.7 | $241.4 | $145.5 |
| Gross margin | 55.8% | 50.9% | 54.5% | 52.2% |
| Operating loss | $(31.1) | $(3.0) | $(26.6) | $(7.0) |
| Net loss | $(31.9) | $(4.2) | $(27.5) | $(10.0) |
| Diluted net loss per share | $(0.28) | $(0.04) | $(0.24) | $(0.09) |
- Quarterly product revenue was $174.9 million, up 48.1%; service revenue was $56.3 million, up 46.8%. For the six months, product and service revenue rose 63.2% and 45.7%, respectively.
- Management attributed revenue growth mainly to the acquisitions, alongside low-single-digit organic product growth. Acquired service contracts also contributed to service revenue growth.
- Quarterly product gross margin rose to 55.1% from 47.0%, while service gross margin declined to 57.9% from 63.2%. The company cited favorable manufacturing costs and acquisition-related revenue for product margin improvement; increased acquired technology amortization and warranty charges were offsets.
- Operating expenses increased to $160.1 million from $82.6 million in the quarter, including $34.1 million of acquisition and integration costs. These costs included a $25.0 million consent fee paid to terminate a prior agreement to acquire the Brocade business from Broadcom. A $4.9 million bargain-purchase gain from the capital financing acquisition partly offset acquisition costs.
- Six-month operating cash flow was $14.2 million, compared with $19.3 million. Investing cash use was $106.0 million, including $97.6 million for acquisitions and $13.3 million of capital expenditures. Financing provided $88.3 million, primarily reflecting $100.0 million of term-loan borrowings.
- Cash and cash equivalents were $127.1 million at December 31, 2017, with $1.1 million of marketable securities; combined liquidity was $128.2 million, versus $130.5 million at June 30. Working capital was $43.9 million, down from $85.6 million.
- Gross debt outstanding was approximately $185.0 million; the balance-sheet carrying amount, net of unamortized issuance costs, was $183.1 million. Revolver availability was $48.8 million, with $1.2 million of letters of credit outstanding. The company reported compliance with its credit-facility covenants.
Material changes versus the prior comparable period
- Reported revenue increased sharply, but management said acquisitions accounted for most of the growth; the company described organic product growth as low single digit.
- Gross margin improved, particularly for products, but operating and net losses widened substantially as operating expenses and acquisition-related charges rose.
- Debt increased from $92.7 million at June 30 to approximately $185.0 million at December 31, primarily to fund acquisitions. Cash declined modestly.
- Receivables rose to $154.9 million from $93.1 million and inventory to $83.4 million from $47.4 million. The filing attributes much of the balance-sheet expansion to acquired businesses.
- ASC 606 adoption changed distributor revenue recognition from generally sell-through to sell-in when control transfers, and the company restated comparative periods. The filing’s prior-period figures are labeled “as adjusted.”
Outlook, commentary, risks, contingencies, and unusual items
- Liquidity outlook: Management said cash, operating cash flows, and revolver availability should fund principal cash needs for at least the next 12 months. The filing gives no specific revenue or earnings guidance.
- Subsequent restructuring: On January 31, 2018, the company approved a workforce reduction to align resources following acquisitions. It expected approximately $4.0 million of charges and $7.0–$9.0 million in annualized savings; actual timing and costs could vary.
- Acquisition obligations: The Brocade Data Center deal includes $20.0 million of deferred payments over 20 quarters and contingent earn-outs tied to profits. The capital financing acquisition also includes contingent consideration. Acquisition purchase-price allocations remained preliminary and may be revised.
- Commitments: At December 31, the company had $145.3 million of non-cancelable inventory purchase commitments, $19.0 million of software and support purchase commitments, and $104.0 million of operating lease obligations. Total contractual cash obligations were $546.8 million.
- Tax: The Tax Cuts and Jobs Act generated a $2.5 million tax benefit in the quarter from remeasurement of a deferred tax liability. Tax accounting remained provisional in certain respects; management expected possible incremental U.S. tax from GILTI and BEAT beginning in fiscal 2019. A full valuation allowance applied to specified deferred tax assets.
- Legal and other contingencies: The company disputed a Brazilian tax assessment; the court decision, if final, would require approximately $5.1 million, and the company appealed. Securities and shareholder derivative litigation remained pending, as did a patent-infringement suit; the filing generally could not estimate possible losses. The company reported $19.0 million of unrecognized tax benefits.
- Key operating risks: The filing highlights acquisition integration and realization of expected benefits, competition and pricing pressure, demand variability, dependence on distributors and third-party manufacturers, component supply constraints, product quality and interoperability, foreign-exchange exposure, litigation, and debt covenant restrictions. Westcon and Tech Data each represented at least 10% of quarterly revenue; together they accounted for 45% of receivables at period end.
Most important facts for investors to verify
- How much of reported growth is sustainable organic growth versus acquired revenue, and whether the acquisitions improve profitability after integration.
- The path to operating profitability after elevated acquisition costs, and the extent to which the announced workforce reduction delivers its expected savings.
- Debt repayment capacity, variable-rate interest exposure, covenant headroom, and cash needs given the sizeable inventory commitments and acquisition-related payments.
- Acquired-business purchase accounting, contingent consideration assumptions, and the final cost and integration profile of the acquisitions.
- Receivables collection and distributor concentration, especially the large shares attributable to Westcon and Tech Data.
- Resolution and potential financial impact of the Brazilian tax matter, securities litigation, patent litigation, and provisional tax-law accounting.