Calix, Inc Q3 FY2021 Earnings Call

Greetings, and welcome to the Calix Third Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Operator Instructions: As a reminder, this conference is being recorded. I’d now like to turn the conference 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 third quarter 2021 earnings call. Today on the call, we have Chairman and CEO, Carl Russo; Chief Financial Officer, Cory Sindelar; and President and Chief Operating Officer, Michael Weening. 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 I turn the call over to Carl for his brief opening remarks, I 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 third quarter 2021 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. 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.

Thanks, Tom. Bookings in the quarter continued to be led by the emerging growth of our all-platform offerings. Demand continued to broaden as we added 38 new customers to our already diverse base of broadband service providers of all types and sizes. The exceptional growth we have achieved over the last two years speaks to the power of our platforms, systems and services. Fresh off our Connections conference, it is clear our customers are putting our platforms to work as many stood on stage and shared their stories of success with their peers. In short, our all-platform customers are taking share in their markets as they build the next generation of broadband service providers. We are excited to help them win. While we are clearly positioned in front of a multi-year secular growth opportunity, it is also clear that the short-term supply challenges will persist for longer than we anticipated a year or a quarter ago. We now expect the supply challenges to persist through the entirety of 2022. While our supply chain team again performed well in the third quarter, their struggle will continue for the next four or five quarters. That said, we are up for the challenge. We have a high performing team that continues to attract outstanding talent from many industries supported by a strong balance sheet, leveraging a focused product strategy. We are excited every day to help our customers simplify their businesses, excite their subscribers and grow their value. With that, let’s open the call for questions.

Thank you. At this time, we’ll be conducting a question-and-answer session. Operator Instructions.

Thanks. Good morning. First off, I was hoping that Carl, you or Cory could quantify the magnitude of the supply chain impact on both revenue and especially on margins. And the related question would be, I appreciate that there are different factors that likely contribute to your exposure and the exposure of your peers. I was hoping maybe you could provide some insight on why it appears that the impact was so much less for you than it was for some peers who pre-announced larger impacts.

Okay. Fair enough. So let me first address the margin issue, because as you may remember, we’ve said prior that the margin impacts were greater than one point of margin and less than five points of margin. Cory, you may want to give slightly different color or an update to that as these things get harder.

Yes. So I would update that by saying certainly inside of the quarter, things have gotten harder across the board. We’ve seen lead times pushed out. We’ve seen price increases, transit times increase, and freight costs increase both air and ocean. So it’s definitely a very challenging environment. Inside the third quarter, we saw an impact greater than 200 basis points and less than 500 basis points to gross margin. It’s clearly an impact to margins.

On the revenue side, Paul, a couple of observations. From a revenue standpoint, we continue to work with our customers. As you know, we have a direct engagement model. We obviously had great attendance at Connections; we had some 1,500 customers there. The customers were very engaged, and the planning between us and our customers helps us lay out what we’re after from a revenue standpoint, which is frankly to make sure that they are meeting their subscriber demand. Right now, we know that they’re meeting their subscriber demand and that’s what we’re focused on. So from a revenue impact perspective, we could ship more to their warehouses, but right now, we know that we’re meeting their subscriber demand. As for the factors that differentiated us, I think you’ve seen the discipline of our culture and our execution processes. As we’ve spoken about before, our platforms, because of their fully abstracted model, have allowed us to narrow and focus our SKU count. Our teams are managing roughly 300 SKUs, whereas six years ago we had around 3,200 SKUs. There’s been a lot of work to drive our platforms not only through our customers but to take advantage of the benefits inside the company. We have a very talented supply chain team with a strong balance sheet, focused on those 300 SKUs. So I think that’s the biggest difference. Does that help?

Yes, it does. Follow-up if I may, Carl, in terms of visibility, I trust it’s very strong. Any incremental insight you would offer?

Again, coming off of Connections, we have strong visibility. I don’t know that it’s stronger or less than it was a week or a quarter ago. I would merely amplify what we’ve said to date, which is the partnerships that we have with our customers. The direct engagement model means our customers are definitely working with us to plan this out and that makes all of this a lot easier to try and figure out.

Carl, historically I think your formulation was that a growing and already meaningful number of your customers were giving you forward visibility well beyond the typical 90-day book and ship window. Has that now become almost all customers? Is it a meaningfully greater number than it was 90 days ago or 180 days ago?

Yes, it just continues to grow.

Thank you. Our next question comes from the line of George Notter with Jefferies. Please proceed with your question.

Hi, guys. Thanks very much. My interest stems from the shareholder letter around large customers. I think you said you had one 10% customer during the quarter. I saw the international performance was quite strong. I’m wondering if maybe that was an international customer, but any insight you can give us into that customer and what’s driving that strength and why you had such strong shipments into that customer in the quarter would be great.

I think we said in the letter that a customer exceeded the 10% threshold in the quarter, but it was largely an accident of the supply chain timing. That customer had a shipment that went to them in the third quarter that they received in the third quarter, and they had a shipment that we intended for the second quarter that didn’t arrive in the second quarter but arrived in the third quarter. So they ended up just above the 10% threshold. What that should indicate is that it wasn’t one of our large or medium customers based on the numbers in the histogram and the letter. What it does indicate is there’s a lot of strength in smaller customers, and some smaller customers—especially Greenfield customers—can drive quite a bit of revenue. Going forward, unless we believe a customer will be a 10% customer for the year as it shows up in a 10-K, we’re not going to identify them.

Got it. Okay. And then just to expand on that, obviously your large customers were weaker again. I assume some of that you can attribute to the situation at Lumen, obviously selling off a portion of the assets as a strategic divestiture. Maybe you can just talk about the outlook there. Historically Lumen has been your largest customer. Any insights there would be great.

I think it’s the same as it was 90 days ago when they announced the spinoff of their Eastern assets to a group led by Apollo. We said that may open up opportunities with that group, and the capital going into Lumen might open up opportunities. There’s no change in a strategy from Lumen that we’re aware of and certainly nothing announced.

Great. Okay. I’ll pass it on. Thanks guys.

Thank you. Our next question comes from the line of Michael Genovese with WestPark Capital. Please proceed with your question.

Great. Thanks. I guess Carl, you made comments about the supply chain in 2022. I want to, without undue prompting, talk about your current view on revenue growth, the gross margin and OpEx levels for 2022?

Yes. Well, before I go there, I want to make a little more comment on the supply chain, because clearly what we’re saying is we don’t see this abating in the second half. We think this is going to be with us and we’re just going to have to execute with excellence, plan with our customers and go accordingly. Michael, you and your team led a fantastic Connections. One aspect that isn’t well known from the Connections standpoint is that not only do we have customers there, but we have partners and suppliers there. Michael, maybe you have some observations you want to share from the supplier side.

Thanks, Carl. I had the opportunity to meet with many of our suppliers. While different media outlets continue to forecast when the supply shortage will end, it’s very clear that this is not going away in the short-term. Whether it’s COVID outbreaks slowing a factory, delays in Los Angeles, or weather impacts, the disruptions continue to have an impact. It was the discussion point at the supplier summit. Most suppliers believe this is a 2022 issue and some believe that we could see this seep into 2023.

Yes. That’s what we’re seeing. They were very forthright in that room saying this won't normalize in 2022. On the revenue side, the margin side and the OpEx side, as you know, we have a model and we’re not moving off of that. Cory, maybe categorically you could walk down revenue, margin and OpEx and give color on that for 2022.

Yes. As a refresher, our revenue model is 5% to 10% per annum. We did provide a little more color inside the letter, which says that we expect to be towards the high end of that range. On the margin side, we’ve guided to 100 to 200 basis points of expansion. I would say today there’s a lot of uncertainty as we look to 2022. We certainly don’t have full line of sight to it, but we’re not changing our view of that margin expansion target. If you look at OpEx, we’re going to continue to invest as our model calls for. R&D will be about 30% of gross profit, sales and marketing will be 16% to 18% of revenue and we’ll be looking to drive towards the high end of that 18%. G&A we expect to continue to trend down modestly and we think we’ll be about a point less than where we are under the model. Historically our G&A model is roughly 9%, but we’re closer to 8% today largely due to increased revenue growth over the last couple of years, which accelerated that denominator effect.

And just to add, we’re committed to invest according to the model for a very simple reason: we see an extraordinary secular opportunity ahead of us.

Right. Well, I want to follow-up on that point. When I look at the projected rate of OpEx spending and then you talk about this extraordinary opportunity, and I also look at the revenue growth in the last couple of years, frankly it looks like the OpEx plan is running ahead of a 5% to 10% revenue growth company or even a 10% revenue growth company. So there seems to be a disconnect. Am I thinking about that the wrong way? It seems like your investment plan implies you think you’re going to grow faster than 10%. Am I thinking about that the wrong way?

Well, yes, you are thinking about it the wrong way if I may be forthright. But part of your question is correct. You have to go back a year and a half or two years ago when we were very sensitive about OpEx growth during the onset of the pandemic. As we got more comfortable with our growth rate and our ability to manage through the pandemic, we let ourselves go back to our model. The reason the OpEx rate appears to be outgrowing revenue is because we’re behind our OpEx model by a substantial amount, and so we are growing OpEx to ultimately get back to that rate. We’ve also said that we have grown our employee base on average about 5% a quarter for the last few quarters. If we didn’t see the opportunity in front of us that would justify that employee growth, we wouldn’t be growing. So on one hand we clearly feel we are in front of significant secular growth and we are going to go capture that demand. On the other hand, we’re trying to figure out how to supply it. The short-term supply issues are transitory compared to the long-term secular opportunity.

I just want to ask one more question. Connections seemed like a great event and there were a lot of important announcements. Can you help focus us on what the most important announcements from Connections were?

Wait a minute. That’s not Michael barking, is it? Just kidding. Look, Connections was fantastic. Michael, why don’t you give some color on customer meetings and weave in the product announcements and what you saw there?

From a product announcement point of view, the most important thing was that all of our product announcements were correlated to customer needs. This was a key message because at this next step with our platform we have the opportunity to innovate in any direction, and the last thing we want to do is innovate based solely on our own beliefs. We want to focus on innovation based on what our customers need and where they view us adding the most value in driving their success to capture this long-term opportunity. If I were to stack rank the most important announcements, the first would be our end-to-end solution model, which we call One Plus One Equals Four. That’s our ability to tie the Intelligent Access Edge with the Revenue Edge using Calix Cloud, giving the capability to drive new services. This is something we’ve pursued for 11 years to get to this point, allowing us to create new services and drive automations that have not been seen before in this industry. The second significant innovation is the launch of Calix Marketing Cloud Professional Edition. That brings demographics into real-time behavioral analytics. This capability used to be the purview of big companies—Tier 1s and Tier 2s who can put 200 or 300 data scientists on a floor. We have democratized that data so even the smallest broadband service provider can now be as effective as an Amazon or Google or a Tier 1 that has hundreds of data scientists. It is the holy grail of marketing and allows them to drive very efficient marketing campaigns. The third is what we’re doing with community Wi-Fi: we launched My Community IQ. My Community IQ gives a broadband provider the ability to provide ubiquitous Wi-Fi roaming in their communities. The benefit, which I discussed with Brad, CEO of ALLO, is that it allows providers to partner very closely with municipalities. If you’re a fiber provider building into a town, your most important partner is the municipality, which controls right-of-way and other elements. This gives providers the capability to provide ubiquitous Wi-Fi across town and allow residents to roam, which can improve public safety communications like police, fire and ambulance access, reduce data costs, and help address eRate requirements and programs to provide underserved children with access to broadband. This is a great opportunity for our service providers who are community-centered to make meaningful impact. Those are the top three announcements among many others. We’re really excited about them.

And that’s just the top three of many announcements. As you know, we’ve released products on a roughly 90-day cadence, so the rate of innovation at Calix is accelerating. Any other questions?

No, that’s it for now. Thanks so much. I apologize for my voice. Thank you.

Thank you. Our next question comes from the line of Chris Howe with Barrington Research. Please proceed with your question.

Good morning, Carl. You talked about the supply chain issues lasting through the entirety of 2022, some of which may bleed into 2023. To be direct with my question, how do you foresee the underlying gross margin potential of the business—given you mentioned greater than 200 basis points of impact—affecting Q3 margin? If you were to average that through 2022 on a quarterly run rate basis, that would point to 2023 margin improvement potential beyond what your target model would suggest. Relatedly, you commented previously that all-platform offerings, systems and software represented greater than 50% of bookings. I assume this trend will continue and as we get into 2023, from a revenue and margin perspective, the comparisons will make things look better. Is the best yet to come as the disruption abates?

So, Chris, the directional levers you’re speaking to are correct. The underlying model that is driving gross margin expansion will unfortunately be dramatically muted by the headwind of the supply chain. Those headwinds are going to continue through 2022. As Cory said, more than 200 basis points and less than 500 basis points from what we can see. You also heard Cory say that 100 to 200 basis points of improvement is the longer-term target. If you project forward to a future point when demand and supply are harmonized worldwide and those headwinds abate, you will see rapid improvement in our gross margins as the cost of inventory flows into the business and things normalize. No question about it. The thesis that 2023 could look better is reasonable, but I would be cautious about calling out any specific timeframe because it’s still quite cloudy.

That makes perfect sense. Thank you. I didn’t want to lose sight of some support in the quarter from federal and state government areas. With these government support programs ongoing, what kind of benefit do you anticipate in the Q4 guide? How should we think about the level of benefit in these areas?

It’s still nominal in our numbers. As we said before, ARPA funds have actually been coming out faster than RDOF awards, which happened earlier. RDOF is moving more slowly. ARPA funds are flowing, and then further out you have the bipartisan infrastructure bill, which has significant broadband funding; you wouldn’t see those funds until 2023 or possibly 2024. So there are continued government funding tailwinds, but they’re not driving our model and they weren’t the driver of the customer excitement we saw at Connections. Our customers are winning and investing irrespective of government funding.

Got it. Perfect. One last quick one if I may: I wanted to ask a question about the operations cloud, the third cloud solution. You signed up your first customers in this area. Can you share some color around that and how to think about the opportunity related to this solution?

What you’re speaking to is Operations Cloud, which is our third cloud offering. Michael, why don’t you add some color on that?

Sure. Going back to One Plus One Equals Four, and the product announcements, Operations Cloud is core and central to that. Our first two clouds are Marketing Cloud and Support Cloud. The third, Operations Cloud, ties the Revenue Edge with the Intelligent Access Edge and automates operations to remove bottlenecks and drive low cost per bit-mile network operations. This allows even the smallest broadband service provider to compete and win on efficiency. Operations Cloud is about automating everything: moving into AI, neural networks and massive workflows that we create for broadband service providers, which they can roll out within their operations to be much more successful and efficient.

Thanks, Chris.

Thank you. Our next question comes from the line of Ryan Koontz with Needham and Company. Please proceed with your question.

Thanks for the question. With regards to the gross margin decline from the supply chain, can you discuss your ability to increase and pass along pricing to your customers and kind of where you are in that process?

I’ll be direct. We could potentially pass along pricing, but we remain committed to not doing that broadly. We believe the right long-term decision is to help our customers win and grow market share without having them worry about us raising prices. Customers have repeatedly told us they value our partnership, and at Connections they reiterated how much that matters. If we were purely a box-only company we might take a different approach, but we’re not just shipping hardware—the device and the system are the beginning of a revenue stream for the platforms. It makes much more sense to us to continue to absorb these supply chain headwinds when necessary and focus on long-term partnerships. You can see evidence in the market: some companies have shown different revenue and margin dynamics and raised prices; our decision is to maintain partnership and not broadly pass through these costs.

That’s helpful, Carl. Thanks a lot. In the past you’ve given perspective on the mix of bookings for your platform products. Can you give some qualitative insights there?

Qualitatively, last quarter we said we passed the 50/50 bookings mark for our all-platform systems and services. Once that happened, I couldn’t imagine it going backwards, and so far it has only accelerated. I would absolutely expect—coming off of Connections—that trend continued to accelerate into the fourth quarter as well.

Helpful. One last question on Marketing Cloud: is that purely a software product or are there services tied to it? How should we think about Marketing Cloud and how it drives through your model?

Marketing Cloud Professional Edition is the holy grail of marketing: it brings demographics together with behavioral analytics. That allows customers to produce better churn models, drive acquisition strategy, and guide network engineering on where to build fiber to maximize propensity to buy. With regards to services, Marketing Cloud is a partnership. Our customer success team includes data scientists and marketing experts who engage with customers to build targeted campaigns based on micro-segmentation from Marketing Cloud. We also announced a partnership with a creative ad partner that produces ads our service providers can brand quickly via a web tool, essentially a video branding product to launch ads in their markets. Those assets are available on Calix.com. We’ve created a large library of content—over 3,300 pieces of content for providers to leverage including social posts and over 200 videos, including DIY-style “how-to” videos and support videos that providers can brand and put on their websites. Finally, we announced the Marketing Academy, which brings together top marketers to create a focused broadband marketing curriculum and certification. If you’re a small service provider who wants to up your marketing game, you can go through the academy and learn best practices for broadband social marketing, YouTube, Facebook and other channels. Think of it as marketing certification for broadband marketers.

What you heard from Michael is that we are here to help simplify their business, excite their subscribers, and grow their value. Most importantly, Marketing Cloud helps grow their brand presence, and that showed up in many of the results our service providers reported at Connections.

Sure. Thanks. Lots of questions.

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

Hi, good morning. You kind of said you weren’t seeing much in the way of revenue impact and seemed to be shipping to customer demand. Do you have any backlog or book-to-build metrics that you can share to give us a sense of overall demand trends in the quarter? Thanks.

There’s nothing that we would share on backlog or book-to-bill or anything of that nature other than to say that we had strong bookings in the quarter. We’ll continue to execute the business.

Okay. Thanks.

Ladies and gentlemen, this concludes our question-and-answer session. I’ll turn the floor back to Mr. Dinges for any final comments.

Thank you, operator. Calix leadership will participate in a number of investor conferences and meetings during the fourth quarter of 2021. Information about these events, including dates and times for public webcasts and management interviews, 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 for joining us today.