Calix, Inc Q2 FY2020 Earnings Call

Greetings, and welcome to the Calix Second Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the call over to your host Mr. Tom Dinges, Director of Investor Relations for Calix. Thank you. You may begin.

Thank you, operator, and good morning, everyone. Thank you for joining our Second Quarter 2020 Earnings Conference Call. Today on the call, we have President and CEO, Carl Russo; as well as Chief Financial Officer, Cory Sindelar. As a reminder, yesterday after the close of market, we released our letter to stockholders in an 8-K filing, as well as on the Investor Relations section of the Calix website. This conference call will be available for audio replay in the Investor Relations section of the Calix website. Before we continue, we want to remind you that in this call, we refer to forward-looking statements, which include all statements we make about our future financial and operating performance, growth strategy and market outlook, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause actual results and trends to differ materially are set forth in our second quarter 2020 letter to stockholders, and in our annual and quarterly reports filed with the SEC. Calix assumes no obligation to update any forward-looking statements, which speak only as of their respective dates. Also on this conference call, we will discuss both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our letter to stockholders. Unless otherwise stated on this call, we will reference non-GAAP measures. With that, let me turn the call over to Carl. Carl?

Thank you, Tom. As the COVID-19 pandemic continues, it is clear our mission to connect everyone and everything is more vital than ever. The second quarter reinforced our view that the pandemic has accelerated the secular forces moving through the communications industry, while also creating additional demand resulting from the expansion of capacity to meet immediate subscriber needs. These two effects combined to drive strong bookings in the second quarter. However, the pandemic has continued to challenge the component supply chain. Fortunately, the Calix supply chain team outperformed in the quarter and enabled us to deliver results well above the high end of our guidance. For Calix, it appears the future is sooner. As a result, we have undertaken a targeted restructuring of the business. Ironically, the pandemic has allowed us to re-imagine our business as it might be three years from now. And thus, we have decided to embrace a full work-from-anywhere culture. This impacts our facilities requirement, and as of the end of the second quarter, we have reduced our overall real estate footprint. Furthermore, as our customers are accelerating their transformation, we are further focusing our product offerings on our all-platform future. These changes are reflected in the charge we took to our GAAP earnings in the quarter. There is a growing class of service providers building new business models on top of the unified access infrastructure. These service providers deliver superior subscriber experience, and do so at the lowest cost. They are aggressive in growing their subscriber base and they are attracting capital. Our all-platform offerings speak loudest when the service provider is the aggressor and we are focused on helping them win. Even with customer travel virtually eliminated we still added 18 new customers in the second quarter. This along with our strong guidance for the third quarter is confirmation of the opportunity ahead. With that, let us open the call for questions. Melissa?

Thank you. At this time, we will be conducting a question-and-answer session. Our first question comes from the line of George Notter with Jefferies. Please proceed with your question.

Hi, guys. Thanks very much. And I guess, a lot of my questions were answered already just through the release from last night and the shareholder letter. But I wanted to ask about gross margins, particularly systems gross margins. If I look at systems revenue, it was roughly equivalent to what you guys printed a couple of quarters ago in the December quarter. Yet gross margins for systems were three points higher. Certainly, I understand the product mix and customer mix are helping you. But I'm wondering if you can give us some more color around that. Is that Calix Cloud? Is it anything else that might be going on there? And then also did you guys get impacted by additional supply chain or expedite costs because of the pandemic? Is that in that systems gross margin also? Thanks.

George, first of all, I will pass on your compliment to Tom Dinges for the stockholder letter being comprehensive and answering lots of your questions. So thanks for that compliment. Now directly to your question on gross margins. As you know, we have said for a long time that as the all-platform business accelerates, we expect gross margins to expand. But we have also said that we expect gross margins on any particular quarter to be noisy even though the long-term trend is clear. In this quarter, we saw the benefit actually of a little bit of upward noise. So we had better mix and a number of factors that were just in our favor. We've also seen, as I discussed in my opening comments, a pull-forward of capacity during the pandemic versus what percentage of what we are doing is an uplift of our strategy. Customers are using this as an opportunity to transform themselves quicker. A minority of it is that transformation but it's a meaningful minority. Those factors combined are just further down the path. So adding the quarterly noise and I think you get to where we are. To your question on expedite fees, actually yes, they are included in gross margin and we are still challenged with expedite fees and spot charges on components. Cory, do you want to add some color on that?

Yes. I would just say that we're seeing a fair amount of disruptions in the supply chain. We're out there looking for component inventory. Sometimes we're buying that on the spot market, which is usually higher than our standard cost. And then expedite fees—we're continuing to air freight material into the United States in order to meet customer demand. We're continuing to see that trend into the third quarter for sure. So we continue to work the supply chain aggressively in response to component shortages where we see them.

And just real quickly George, combining Cory's comments is also obviously what gives us the guidance for Q3, right?

Got it. Okay. Any sense for how big that supply chain impact was in the quarter? I'm trying to look at your systems gross margins and try to normalize for some of that stuff.

George, that's something we haven't broken out. We don't report that separately. We certainly could quantify it, but I'm not going to give you much help on that piece.

Got it. And then you talked about the work-from-home benefit in the quarter. Could you give us any sense for how much benefit that might have been on the top-line? I know it's probably not an easy question to answer, but any color you could give us there would be great. Thanks a lot, guys.

When you say on the top-line, are you referring to revenue? I want to break it up into two different things. The pandemic drives a number of behaviors in our customers. There's a significant portion of the beat that relates to that for sure. It's broken up into the majority being pull-forwards on capacity. The minority is that we actually saw an acceleration of our all-platform model. I don't know how to quantify it more than to say that it's the majority of the beat.

Okay. Thank you.

Thank you. Our next question comes from the line of Paul Silverstein with Cowen. Please proceed with your questions.

Thanks. I'll try asking the question although I suspect I already know the answer. Carl, on Access, EXOS, Cloud and Edge, beyond what you had in the shareholder letter, can you give us any sense for where they are as a percentage of total revenue collectively? I know they're still small and early albeit ramping aggressively.

No differently than we've characterized before, Paul. It's greater than 10% and less than 50%. That's where we would keep it today.

Okay. It was greater than 10% also last quarter. Presumably it's that much greater as a percentage given the numbers that you discussed in the shareholder letter?

Correct. It's continuing to grow at an aggressive pace.

With respect to your larger customers, while they have become the minority of revenue—not much over 20%—it looks like they've also returned to growth. Not only has the risk been moderated, but it looks like they're now also contributing to the larger growth profile. Any thoughts you could share with us in terms of what's going on at CenturyLink, and also with those Tier 2 customers that are still 5%, 6%, 7% of revenue?

If you look at large, medium and small, all are growing now. It would appear that we are through the many quarters of headwinds and everybody is now starting to grow at their own rate. CenturyLink, my comments would not change from where they have been in the past, which is we expect CenturyLink to be roughly flat year-over-year. Their business is moving forward on plan. Everyone else is basically chugging along on plan. One quarter might be up a little bit, one quarter might be down. But there's no new news there, Paul.

All right. And finally is there anything of a one-off nature either in the quarter or that you would anticipate in this quarter and coming quarters?

I can't think of any one-offs from my perspective. Cory?

I think of a couple in the OpEx area. The overperformance in the second quarter has led to a higher level of incentive compensation in Q2 compared to Q1 or what we would expect going forward. Also, as you comb through the 10-Q you'll see that we took a bad debt write-off in the second quarter for one international customer. It was a reasonable size and we called it out in the filing. I wouldn't expect that to happen again.

Cory, on the overcompensation or the better-than-expected compensation, I assume if you had another similarly strong quarter in Q3 and Q4, we would see the same phenomenon?

Not to the same extent. The Q2 target was lower, so there's a greater percentage overperformance. Our expectation for Q3 is larger. It will be harder to overperform to the same degree.

Carl, if I may let me ask you one last question. I know it may sound like speculation about the future, but RDOF—there's been a lot of press and a lot of actions in Congress most recently with the two different bills in the House and the Senate proposing acceleration. Any thoughts you can share? Any incremental insight that you have on the timing?

Speculating about the future is fun. Let's spend a moment on RDOF. The Rural Digital Opportunity Fund is currently in full flight. Bids are going in and awards will be made. But on the current course and speed, the funds won't be distributed until the third quarter of next year. There are discussions on Capitol Hill about potentially accelerating this program. If those discussions bear fruit, you may see some of those funds being let earlier next year or even pulled into late this year. However, for us as a platform and systems provider, we probably wouldn't see an effect until the second quarter of next year. So it might change the revenue impact for us by two quarters, but it would be very speculative to say that that's going to pass Congress. There are other infrastructure investments that might come on top of RDOF, along with various states' investments. Under the general heading, we believe there will be a lot of infrastructure investment in broadband. The timing of those things and the magnitude is spread out across the next decade.

I apologize for one more question. It's not just federal but also states. Can you give us any flavor for the types of programs and magnitude?

There are lots of state programs. That would be a much longer conversation because we'd have to go through them, but they're in the tens of millions and potentially $100 million. So they're modest compared to RDOF, but they occur in various states quite frequently and actually fly below the radar.

I assume as with U.S. federal, there's been some pickup in those programs to some extent with all the focus on the bigger part?

As I was saying, I was thinking about the history and how much pickup there has been. Let me take a rain-check on that and do a little homework. I don't know if there's been a material pickup. They've sort of always been there, but there may have been. I'll come back to you.

All right. I'll pass it on. Thank you.

Thank you. Our next question comes from the line of Christian Schwab with Craig-Hallum Capital Group. Please proceed with your question.

Hey, congratulations guys on a great quarter and a good outlook. I only have one quick follow-up question regarding CenturyLink. I just want to make sure I heard you correctly that you would expect them to be flat year-over-year, potentially in 2020 versus 2019 given the very strong start that they've had in the first half. But are you suggesting that in aggregate, September and December will be less than the first half of the year, is that still your current plan? Is that correct?

Well they've been roughly a 15% customer in both quarters, and they're running a couple of million dollars ahead of that flat number. So it's going to sort of be the same, Christian. Trying to parse it any closer would be getting down to detail that we don't have a view into.

Great. And then can you highlight for us in particular what components need to be expedited that are super tight for you today?

They run the gamut from silicon to optics to small components and chiplets. It's all over the place. I wish it was a narrow set.

But it's a broad-based set of stuff—that's fair?

It is, and it's slowly improving. But so is our demand. We have another quarter of the supply chain team burning the candle at both ends.

Fabulous. Congrats again. No other questions. Thank you.

Thank you. Our next question comes from the line of Tim Savageaux with Northland Capital Markets. Please proceed with your questions.

Good morning. And I'll add my congratulations on some very strong results. I have two questions: one on margins and one on the top line. I'll start with the gross margin question. I want to focus on incremental gross margins, which seemed to tell an interesting story on a year-over-year basis. Both your results and guidance incremental gross margins look to be in the 70s or maybe even greater. What should we take from that with regard to the status of the company's software platform transition and what the eventual business model of Calix 2.0 might look like? Then I'll follow up.

First, one thing I take away is that you're good with a calculator. Secondly, we've spoken in the past about the very long-term potential that this model could resolve itself into gross margins in the 60s. That gives you a sense for how we're thinking directionally. Keep in mind that our platforms are hardware independent and fully abstracted operating systems. While that sets us up to potentially have an all-software future, we believe for the foreseeable future we will still provide systems for many of our customers, because there's not a stable white-box market to provide the hardware independent from the software. Over time, we think we'll continue to see the model move in that direction. You are directionally on the right track with your incremental margin calculation, but I would dissuade you from taking that number and driving it into the near-term model.

Right. Just in terms of direction, a healthy metric. Switching to the top line, you mentioned 17% growth among smaller carriers, although you did see some weakness internationally in the quarter. It looks like U.S. small carrier or rural broadband growth may have been in the mid-20s which is significant. You've already addressed the pull-in dynamic. Are there any other issues driving such above-trend U.S. rural broadband growth if indeed I'm getting that calculation right? And can you talk about what's happening internationally, especially in the context of CityFibre potentially ramping later on? Thanks.

International is a smaller portion of our business, which is quite lumpy and moves around, so there's no firm conclusions to draw. On your other calculations, the pull-forward is the largest percentage of what we're seeing in overperformance, but there's a minority that is clearly an uplift of the model. One of the things you have to consider is how much of the pull-forward from 2021 continues versus not, and that's what we're trying to get our arms around over the next couple of quarters. We're focused on the minority of outperformance representing a strategic uplift where customers are using the pandemic as an opportunity to accelerate their transformations. We're helping our customers transform their business models, and to the extent more of them choose to do so sooner, that's the biggest strategic driver of our business and what would feed the incremental margin calculation in the future. I trust that makes sense.

It does. Congrats once again. Thanks very much.

Thank you. Our next question comes from the line of Fahad Najam with Cowen and Company. Please proceed with your question.

Thanks for taking my question. Carl, your comments about your supply chain outperforming—does that suggest you've gauged market share against competitors? Can you elaborate on what you mean by the supply chain outperforming? What do you think the issue is that the broader supply chain is facing that your supply chain outperformed?

Very simple: our supply chain outperformed our expectations going into the quarter. When we set expectations for Q2 last quarter, we did so as a balance of demand and supply. Ordinarily you're setting it more based upon demand without supply being a particular constraint. They simply outperformed our expectations going into the quarter. As for market share per se, given the all-platform focus of the business, we don't see competitors for that business in the same way, so we don't think of it in terms of market share. We simply don't frame it that way.

Got it. Appreciate it. In response to Tim's question, you alluded to still trying to grapple with how much of a pull-forward you're experiencing. But wouldn't it be fair to say the current climate is probably the best case scenario—people are at home, demand for bandwidth is high, service providers were caught flat-footed, and as they add capacity there's strong demand? Maybe this is the best environment you could think of and from here it normalizes as capacity gets added. Wouldn't you say this is probably the best environment you can have?

No, I wouldn't say it's the best environment we could ever have. I can imagine better scenarios, but this is certainly a very good one. This is why we emphasize that the capacity upgrades represent a pull-forward. The model uplift is what we are focused on. The work-from-home dynamic is causing service providers to ask how to deliver services without rolling trucks and how to satisfy subscribers in new ways. Those questions cause them to look more at our all-platform offerings and accelerate uptake. That's the most lasting and significant shift in the business, and that's what we're focused on.

I appreciate the answers. I'll pass it along.

Thank you. Ladies and gentlemen, this concludes our time allowed for questions. I'll turn the floor back to Mr. Dinges for any final comments.

Thank you, Operator. Calix's management will be participating in three virtual investor conferences during the third quarter of 2020. Information about these future investor events will be posted on the events and presentations page of the Investor Relations section of calix.com. Once again, thank you to everyone on this call and on the webcast for your interest in Calix. And thank you for joining us today. This concludes our conference call. Goodbye for now.

Thank you. This concludes today's conference call. You may disconnect your lines at this time. Thank you for your participation.