Calix, Inc (CALX) Q2 2023 Earnings Call Transcript

Greetings everyone, and welcome to the Calix Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the brief prepared remarks. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jim Fanucchi, Vice President of Investor Relations. Sir, please go ahead.

Thank you, Rob. And good morning, everyone. Thank you for joining our second quarter 2023 earnings call. Today on the call we have President and CEO, Michael Weening; and Chief Financial Officer, Cory Sindelar. As a reminder, yesterday after the market closed, Calix issued a news release which was furnished on our Form 8-K along with our stockholder letter, which was also posted in the Investor Relations section of the Calix website. Today's conference call will be available for webcast replay in the Investor Relations section of our website. Before I turn the call over to Michael for his opening remarks, I want to remind everyone on this call that we will refer to forward-looking statements, including all statements the company will make about its 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 the second quarter 2023 letter to stockholders and in the 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, in this call, we will discuss both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in the second quarter 2023 letter to stockholders. Unless otherwise stated, all financial information referenced in this call will be non-GAAP. With that, it is my pleasure to turn the call over to Michael. Michael, please go ahead.

Thank you, Jim. In the second quarter of 2023, the Calix team continued our track record of improvement in our financial performance across the four measurable objectives that we have outlined for investors. First, deliberate revenue growth continues, as we achieved our ninth consecutive quarter of growth, while delivering record revenue. Demand remains strong as customers transformed their business and communities by leveraging the Calix platform, managed services, and our customer success teams. Second, gross margin expansion continued with our fourth consecutive quarter of margin growth. Third, we executed disciplined operating expense management, as we invested substantively to take advantage of this once-in-a-generation growth opportunity ahead. And fourth, ongoing predictability continued, as we met or exceeded the guidance that we laid out for investors in April. In the second quarter, I continued to invest a significant amount of time meeting with customers, prospects, partners, and team members. The feedback remains positive, as we continue adding broadband service providers of all sizes that are strategically aligned with Calix. As we noted in our investor letter, these Calix partnered BSPs continue to attract significant private and public investment to grow. They are not seeing the impact of tightening credit markets, unlike the debt-laden legacy providers who are pulling back. For example, last week, we announced that ALLO Communication, who is in an end-to-end partnership with Calix, secured $650 million in sustainable financing, also known as a green bond, to grow. During the second quarter, we also hit a milestone with our 1,000th customer starting their platform journey with Calix, including 16 new strategically aligned BSPs, who chose our platform for the first time to meet their long-term goals. In addition, 20 new cloud customers signed on to deploy one or more of our cloud services, and 15 BSPs launched their first managed services with the support of the Calix team. Last, but certainly not least, our culture continued to embrace the better, better, never best mindset. At all times, our team is constantly asking how we can improve. During our advisory board sessions, our customers and our product, sales, marketing, and customer success teams collaborate on how to supercharge BSP success. Internally, we encourage Calix team members to challenge the norm and continue our journey of nonstop improvement. This approach has built our purpose-driven culture, which contributes to the success of our customers, partners, and team members and is a key driver of why people want to join Calix. We continue to be recognized as one of the best places to work in any industry. In the second quarter, Calix was ranked number one on the top 50 list for most inspiring places to work in North America. In addition, we achieved our third great place to work certification, noting the strength of our remote culture as a driver of customer success and corporate growth. Also, our Chief Product Officer, Shane Eleniak, was named a top 20 CPO worldwide, and we were awarded the number one best place to work in the entire Bay Area. It is a great time to be part of the Calix team as we continue to embrace the notion of constant improvement through our better, better, never best mindset. Before I close, I'll turn it over to Cory to expand on the team's stellar performance in the second quarter. Cory?

Thank you, Michael. The Calix team executed well across the board, and we delivered our ninth consecutive quarter of sequential revenue growth, with record quarterly revenue coming in at $261 million, which was at the high end of our guidance range. We also saw our fourth consecutive quarter of gross margin expansion, with non-GAAP gross margin of 52.8%, at the high end of our guidance range, and an increase of 100 basis points from last quarter. This improvement in gross margin was due to the continued expansion of our platform and managed services, plus a small product shift from revenue edge to intelligent access edge, and easing of the expedite and excess prices paid for components on the secondary market. As we have said consistently, our platform model provides us unique insights, starting with subscriber demand, which gets translated all the way back to the component purchase commitments with our suppliers. During the second quarter, our purchase commitments decreased by $52 million from the first quarter to $254 million. This is down $116 million from a high of $370 million in the third quarter of 2022. This is another advantage of our low SKU count platform model because these components are fungible across multiple product SKUs. Our component inventory on hand and at suppliers combined with our finished goods provides us with the basis to say that we have ended our pandemic-induced supply chain crisis. Our product and supply chain teams now have the time to expand their focus on subscriber demand analysis, supplier optimization, process improvements, and cost reductions. Silicon lead times are still extended but are improving. As they improve, we will be able to normalize our inventory and supplier commitments. Over the next six quarters, we expect to see components at suppliers and on hand decrease and our inventory turns to return to the middle of our long-term financial model of three to four turns. Based on our second quarter performance and the expected sequential increase in third quarter revenue and gross margin, we now believe our annual growth for 2023 will be close to 20% and our annual non-GAAP gross margin expansion will be between 200 and 250 basis points, an increase from the 100 to 200 basis points we had noted previously. With our accelerating gross margin expansion and disciplined OpEx investments, you will see further operating income leverage. When you combine increased operating leverage with our improved supplier commitments and inventory levels, we will be able to generate significantly higher levels of free cash flow and build on our ever-strengthening balance sheet. Back to you, Michael.

Thank you, Cory. In closing, I remain very excited about the growth opportunity ahead for Calix and our strategically aligned customers. They are leveraging our end-to-end platform, cloud, and growing ecosystem of managed services to deliver offerings across residential, business, education, and the communities they serve, growing market share and delivering high margins for years to come. Backed by our unmatched financial strength, growing cash balance, and a pristine balance sheet, we will continue to invest in our business to enable our customers to win at an increasingly faster pace. Jim, let's open the call for questions.

Operator, at this time, please open the call for questions.

And our first question comes from George Notter with Jefferies. Please go ahead with your question.

Hi, guys, thanks very much. I guess I wanted to start by asking about the gross margin improvement. Obviously, the supply chain crunch is easing here. That's terrific. But if I go back and I look at last year, there were points last year where you guys were talking about 300 to 600 basis points of headwind on gross margins because of the supply chain. And I guess I'm wondering, obviously there's been a big build on inventory, you're still consuming that high-priced inventory. But I guess what I'm wondering now is, could you give us an update on that number, how much of a headwind are you still seeing in the gross margin line? And then I have another question also.

Sure, George. Consistent with what we have said in the past, there were three large buckets of costs associated with the pandemic-induced supply chain challenges. The first bucket, and the largest bucket, had to do with price increases. Importantly, those price increases aren't going to roll back. The way that those will get in line is through future product designs, where we go out to negotiate and try to get a better price for the new design wins; they aren't going to roll back prices on the existing designs. So that is still likely to stay with us for some time to come. The second category is around those expedite costs and going out into the spot market, and you're starting to see those things roll off. We will see that trend here for the next couple of quarters as that finishes going through the P&L. And then the third category of costs was all around the logistics and freight costs. As I said before, those all normalized back in the first quarter, meaning that had already gone back to pre-pandemic pricing, but also transit times. So we're making good progress on normalizing where we're at with the supply chain. The only thing that really is still left is the lead times on silicon, and they're improving each quarter. So for me to kind of tell you how much of that translates into still an overhead on our P&L? I don't mind, I'm going to probably quantify it for you already. But you can think that all the logistics costs are already normalized back into P&L, so you've already got the benefit of that. The third, the second category is starting to come back to the P&L and those third are now going to connect it. And I just want to amplify one point, George, which is on the front end, where you talked about new product creation. In this regard, because of our platform model, we are uniquely advantaged because of the fact that when you look at old Calix, it would generally take us to put out certain SKUs anywhere from two to five years, requiring a huge amount of customer integration. With our platform, which is abstracted from all of the underlying appliances that support it, we gain the opportunity to actually quick-turn products. You saw in the investor letter that we actually now got to below 260 SKUs, which is frankly unheard of in the industry and surprised me that the team was able to get there so quickly from, I believe it was 292 last quarter, and that just shows that this ongoing improvement that the team has been driving will yield significant advantages in the future. When you have fungibility across the components, it is wickedly competitive.

Got it, that's helpful. And then the follow-on here was just on the price increase. If I remember correctly, you guys took a price increase back in the springtime of last year. I know your lead times at one point were longer than a year. So I'm assuming that part of the gross margin benefit here is fully biting down into product sales that were repriced higher. Is that part of the narrative here? And then is that fully in the model at this point? Or is there more to go?

So George, that's kind of where it gets convoluted, because there was another price increase on the silicon components put through in January of this year. And that is eating into some of the favorability that we are getting on the PPVs, or the excessive prices. And so that's kind of where they are offsetting each other. When we said at the very beginning of the year, we thought that the supply chain would have a neutral effect on our P&L and that the margin expansion was purely related to software expansion. But we now are seeing the point where the excess-price components are rolling off, and it's giving us a little bit of a bump, as well, as I said that in our letter, we’re getting a little bit of benefit from a product shift going on from revenue edge to intelligent access edge. So that also helped with the quarter to give us a little bit better off margin.

Got it. Okay, great. I'll pass it on. Thanks very much, guys.

Our next question is from the line of Ryan Koontz with Needham & Company. Please proceed with your question.

Thanks for the question. I want to ask about your commentary in the letter on softness in the medium customers. Wonder if you could expand on that, is this mostly U.S. type customers and what sort of downward revisions on build plan in general are you seeing across that segment of customers?

Yes, Ryan, no problem. We consider the most valuable aspect of our business model to be the continuous predictable sequential growth. This year, we're going to grow by about 20% over last year, and we have not changed our long-term financial model of 10% to 15%. As I stated in the prepared remarks, we have unparalleled visibility from subscriber demand all the way back through the component suppliers. This has enabled us to continue our sequential growth throughout the pandemic. As we continue to work with our customers to help them grow their subscriber demand and manage their inventories, you're going to see anomalies from quarter to quarter. For example, in this quarter, you see the continued strength of our small customers, because they have relatively balanced inventories, while seeing a slight decline in shipments to the medium and large customers. And again, this is a result of the unparalleled visibility into the subscriber demand that we have. But the most important point is that the subscriber demand continues to grow every day. That's what we’re seeing in terms of the strength of our entire customer base.

That's great. Looks like it's good on the shift from revenue edge to intelligent access edge. Is this more supply chain driven or kind of traditional build cycle seasonality? I assume you've been expecting this can maybe give some commentary on that shift in revenue?

Yes, as we continue to work with our customers on inventory balancing, they had gotten a bit ahead on the revenue edge side. We're still addressing that, but we're also entering the summer building period, which increases demand for access products. What you're noticing is a bit of inventory adjustment as they prepare for the network builds this summer.

Yes. And Ryan, just like last quarter, when everyone was going, 'what was going on between large and these kinds of things,' what we stated in last quarter, and we will restate again this quarter, and we will state again in Q3 and Q4, is that everything that we do from a shipping point of view is planned. And the reason why is because we're unique in this industry in that we actually work really closely with our customers not only around what their network builders are, but also how fast they build those networks. And then we stand beside them and help them drive subscriber demand. So as we go into Q3 and Q4 in the second half, everything that we're going to be doing is very planned, and there are no surprises. It's actually us deciding as a corporation and as a leadership team what we should ship to whom based upon our partnership with those customers, whether they're small customers, medium, or large.

Super helpful. Thanks for that. Yes, I'll pass it on.

Our next question is from the line of Christian Schwab with Craig-Hallum. Please proceed with your question.

Great, thanks. I just want to follow up on George's question. Since we did pull in some of the gross margin improvements into this calendar year from our original expectations based on the things already described, I'd like to look to next calendar year. Cory, which way are you thinking about highest gross margin improvement year-over-year?

Yes, thanks, Christian. As it relates to next year, we haven't given any guidance for 2024. So I would fall back to our long-term financial model, where we've targeted 100 to 200 basis points on market expansion, and we see that still applying to 2024 as we sit here today.

Okay, great. Is some of the BEAD funding being allocated and utilized? Do you expect to benefit in 2024 from the government stimulus in any way? How should we consider this in terms of impact? I understand we’re not focusing on specific offerings, but do you anticipate this to be a positive influence, or how should we view it?

Yes, great question, Christian. I would say, the way we've been answering that question consistently over the last, I would say four to six quarters remains the same, which is there is already a big bonfire going on, which is our customers are winning in the market; they are taking market share from legacy service providers and growing at a rapid rate. For example, as they shared, ALLO received $650 million through a green bond, which is enabled because of the fact that we have a unique platform that is greener than anything else out there by now 50% to 75%. This means that when these funds come out, they'll also be well positioned to win a significant amount of it, and as it rolls out over the next 10 years, think of it like gas on a bonfire. The bonfire is already enormous, where our customers are taking share. Of course, this will help them move faster and start building out into areas where the economics didn't make sense, but government stimulus will assist them. So for sure, there's a long-term benefit, and it's going to extend over the next 10 years. Cory, any comments?

Yes, so Christian, our current view is that we ought to start seeing some of that late '24 and as we move into '25.

Okay, great, kind of what we're hearing from others. Spectacular. Awesome. Thanks, guys.

Our next question is from the line of Samik Chatterjee with J.P. Morgan. Please proceed with your questions.

Hi. Thank you for taking my question. I have a couple, and maybe for the first one, if I can start with the growth forecast for the full year of roughly 20%, and obviously, these are very strong numbers relative to any companies we can compare you to. But still from a high level, if I can kind of ask you when we look at the 20% relative to a 28% growth or a 26% growth the prior year, I mean, in your mind, what is sort of that big or what is that change really being driven by? Is it the macro? Is it some of the revenue edge sort of pulled forward that you talked about? Like when you think about the big buckets here, in terms of that growth stepping down from 28% to 20%, how are you sort of thinking about what's driving that?

Well, so there are two elements to it. The first I'm going to take the macro discussion head-on. We do not see any macro concerns in any way, shape, or form. I've stated this over and over again; if actually a macro issue did pop up, for example, like a recession, this would be advantageous to our customers, and I can go into depth on why. It's simply because of the fact that if you think about someone who is affluent, for example, does with their disposable income, they would spend a lot of time at the country club. But if their disposable income declined, what are they going to do? They're actually going to hunker down in their house, and what is central to everything they do, whether it's work, play, or education, is broadband. So if there is some macro trend swinging around, actually, we think it's advantageous. But we don't see that. As I said, I was on the road all Q2 and all of Q1, and our customers don't have this concern. With regards to what's going on the growth side, we've, as Cory stated in his remarks, we see us getting closer to 20% for the year. What you're seeing is a shift in our business model, which is we're moving towards a sequentially growing company. What you're going to see is this constant sequential growth; we've already done it for nine quarters in a row. It means that there will be smoothing of our revenue. We expect that to continue through '24 and '25, whereas instead of having the lumpiness that is inherent to the business, that will go away in 2024. We're kind of eliminating the old business model is what I would say. Cory, anything to add on that?

Yes, Samik. I think the decline in revenue growth from say last year at 28% to where we're seeing today at 20% has a lot to do with us. The supply chain-induced inventory challenges, when you have lead times going to 52 weeks, your customers are going to buy inventory to ensure they can complete their builds. As the lead times start coming back in, they just don't need to carry as much inventory. So we're going through this period of time where our customers are adjusting their inventories. And we're really working with them to rebalance them so they have the right materials they need to finish their builds. The great news is they're continuing to grow; they aren't slowing down their builds; they're going as fast as they can in an environment where there are constrained labor and permitting issues, but they are growing every day. Therefore, we will continue to grow every day, and that's why we're very confident about the sequential revenue growth that we talked about.

And thanks for that. Follow up if I can ask you, you mentioned 15 new customers adopting managed services. What are you seeing from those customers in relation to the type of services they're adopting first? More curious to hear how much of that is like a retail type, like Aldo Arlo Secure versus like a SmartTown, which seems to be more of a wholesale offering? And how does that play out in your revenue model as well, in terms of how you monetize that with the BSP customer?

Well, so that's a great question. What we generally see is the initial adoption is to expand beyond managed Wi-Fi, where I'm adding text IQ and experience IQ, getting into virus malware paths, and then they expand out their smart home strategy. Really, when you think about the Arlo and the different components, that's where they actually go to market with a number of them that allow them to finish up the smart home. What they start thinking about is, okay, now I've got the smart home nailed, how do I add SmartBiz and SmartTown, all the different components? A good example would be, we're hearing a lot of customers actually talking about wanting to become an MVNO. An MVNO is a fascinating situation in this market because, in most cases, becoming an MVNO as a broadband provider is just a discount strategy. That's it. Why do you actually bundle your cell phone with a broadband package? It's because you want to discount, unless you're a Calix partner. In the Calix partner scenario, it becomes all about experience and that becomes something that's really interesting and important for them with SmartTown because you can now take those devices that would be roaming on a mobile network, and if you live in rural America, where 5G coverage is basically nonexistent, with a fiber-backed SmartTown with ubiquitous Wi-Fi coverage across the town, that MVNO experience becomes incredible. You're getting great Wi-Fi calling and great speeds to your device regardless of where you are in the town. So I guess it's a long way of saying, and I'll leave the revenue component to Cory, it's a long way of saying there is this maturity continuum that we see our customers marching down, which starts at one service and goes into three, four, and forward. Cory, if you could comment on the revenue implications?

Yes. What I would add to Michael's comments is that it's a portfolio approach. What we're finding is the more items we put into that portfolio, it has the effect of customers wanting to adopt more as they start pulling through more of the items. We saw good traction with our SmartBiz offering in the quarter that came out at the beginning of the year, so we're seeing strong traction there. Likewise, very strong traction with Bark. So those are newer offerings in the marketplace, we're seeing strong attraction. In terms of the value to Calix, as you know, we've talked about it representing a model monetizing on a subscriber basis, and that over the long term, we think we can move somewhere between $1 and $10 per user, per month. These new offerings, albeit, at larger amounts, are going to be applied to and attached to rates that will just help us move that average from $1 closer to the $10 mark.

Yes, when you think about it from a growth perspective, what is the growth? Growth is actually two components: revenue and margin. These will be significant contributors to what Cory is calling out as that 100 to 200 basis points in our long-term model. Those will be significant contributors to it, and you saw some of that strength, not just due to the supply chain this quarter, but because of the strength of our managed services, which have contributed to margin.

Okay, great. Thank you. Thanks for the responses.

Our next question is from the line of Michael Genovese with Rosenblatt Securities. Please proceed with your questions.

Great, thanks a lot. First of all, just as a clarification, can you give us the percentage of current RPOs?

I think it's still around 37%.

Can you tell us more about what RPOs indicate? The sequential growth of RPO in the past few quarters has been somewhat weaker, and there has been a shift towards current RPOs away from long-term ones. Since we don't have a clear understanding of RPOs, can you help us clarify what's happening?

Cory, I think you'd start by explaining what's in RPOs; we've explained it every quarter, right?

Yes, this is a mindset. In any long-term contract that we have with the customer, they're making a commitment to us. That means it’s the clouds; it means some of the managed services where they enter into a minimum commitment. It's our support contracts, maintenance contracts, those kinds of things, anything that has a commitment to it; what's not in there is hardware. Anything on a usage model, so you take something like a brand new service that we bring into the marketplace, one of the things we tried to do is lower the barrier to sale. The easiest way to take a new offering that a customer has no experience with is to offer it on a usage basis. So one, it will take some revenue on it. If not, no problem. What we find over time is that they get comfortable with these new offerings, and what they end up doing is they say alright, now I better understand how I can sell this; what my attach rate is; I'm willing to make a long-term commitment to you. So they come back around and we'll sign a three-year agreement, of course, they're trading this commitment for a better price. So that's what we see there. So in the meantime, the newer services are not in the RPO number because there's more of a usage model. Software licenses are not in the usage model because those are all recognized upfront. Then the third thing is really up to true-ups. A lot of these engagements we are billing on a monthly basis. To the extent that they have more subscribers than they committed to, we're going to recognize that in the period, and that's not in the RPO number. So that's a summary of what's in and not in our RPO number.

Just current some long term?

Yes.

Like what's driving that? The fact that we're getting more for the current RPOs last couple quarters, but not as much growth in long-term?

That's just a matter of timing when contracts come up for renewal, and they're going to continue to work their way over, and the renewals will go back and replenish the duration on it. So I think that's just a timing statement on when contracts are and where they're at. But at the end of the day, understand we're a billion-dollar startup. Inherently, we are still learning. If you look at our trends, you'll see that we grow stronger in some quarters and lower in others, and it's just inherently lumpy. What I can tell you is that we expect our RPO to grow every quarter for the foreseeable future.

Okay, that's very helpful color. And then just my other question, can you explain a little bit more about the green bonds? And I think you guys have part of your business trying to help your customers get funding, whether it's for deeds or other stimulus programs, or now for this green funding. So just give us more background on how that works. $650 million to ALLO is very meaningful. But overall, as you look at your customer base, how significant do you think this kind of funding could be?

Well, so our customers, in the case of a green bond, what we assisted them with is if you look at the platform model and how we help a company like ALLO build a business, it’s through a radically different architecture. In the end, the same architecture is the one that Verizon has deployed, where they would have been very transparent for five years that it drives an 80% reduction in operating costs every month. This comes from the fact that if you build a traditional network, you're buying four or five different boxes to build a network and operate it versus Calix, who has collapsed or consolidated all of those functions and the functions being subscriber-facing provider edge capabilities, the BNG, access aggregation player, and all these different capabilities, all onto a single appliance with our platform on top of it. Logically, going from four or five boxes down to a single system is a massive increase in sustainability. Then you take on top of it that when you think about Wi-Fi 5, you saw all these viruses popping up all over the place, on Wi-Fi 5 systems, because the Wi-Fi 5 wouldn't reach well across a home. So you had to put extenders all over the place, right? With Wi-Fi 6 and the architecture we've built, where we optimize power and all the different capabilities, less than 7% of the homes that we support actually require a second system. You think about that: I can go buy something from Amazon, for example, that has three different boxes that I put around my house. That's three different consumers of power versus a single Calix system that's optimized with our AI engines in our cloud and allows you to run a single system. That's inherently about 70% more power-efficient from a Wi-Fi point of view. So all of these components came together, and then on top of it, because we are so incredibly efficient in how we stop truck rolls to support customers through policy management and all the insights and analytics we provide the service provider, which is unprecedented in the industry and has never been done before at this level. The vast majority of our customers are now stopping things remotely, where a few years ago, they were constantly rolling a truck. In fact, we are in the process of standing up a customer right now. Their biggest negative on their margins every single day is the fact that they didn't have those analytics and insights to drive down truck rolls. So they were operating with their hair on fire, because everybody was running from customer to customer to support them. So that's another green example of how we do it. With regard to pursuing that funding, which was obviously a public market funding, we were absolutely involved in it. In fact, Martha Galley, who has been promoted as EVP of all the ESG work we're doing, is leading this effort with our customers as they go after these types of financial vehicles, or as they put in their funding requests into government, highlighting how this transformative business model completely changes how they do business from an operating cost, environmental impact point of view, and then also that leads to higher margins and great growth. Hope that answers your question.

Thanks a lot, Michael.

Thanks for your question. Great one.

Our next question is from the line of Tim Savage with Northland Capital Markets. Please proceed with your question.

Hey, good morning. And congrats on another strong quarter.

Thanks, Tim.

My question, I'm going to focus back on gross margins because I think that's what kind of jumps off the page in this report. Cory, you mentioned three factors, and I am talking both about the quarter and the outlook, where you're looking for ostensibly 50-plus basis point increases to the back half of the year. You seem to break it down into three factors, which is some element of pricing, the software platform shift? And a third one, is that coming to my mind right now, but I'm sure you're going to remember. I wonder if you can assess, as you look at the quarter and the outlook, how meaningful each of those factors might be? Again, both for the quarter and as you look in the second half? And then I have a follow-up from that.

Sure, sure, Tim. The third one you're talking about was the supply chain, spot market purchases, the excessive pricing, and expedite. I won't break down and quantify it for you, but they are raised in the letter based on size of impact. First and foremost, continued selling of our software and managed services is always our number one priority. That growth in software is unrelenting, it’s continuing every day. So you're going to see that continue. Also in the second quarter, first quarter and into the third quarter, we still think the access business is going to be strong. The third quarter is likely to be strong as they finish up their network builds. Just like you saw a year ago, with a very, very strong access print for Q3 a year ago, we suspect we will see that again here in the third quarter. That's going to help with our margins. Likewise, the third one is the easing of our purchase price commitments. As you know, there's a delayed effect from it. We haven't had a material PPV charge and entered into a new one in 90 days, so consequently, it’s just a matter of time for this commitment that we entered into previously to work its way through the P&L. I think you're going to see that for the next couple of quarters, in addition to the benefit that you saw in the second quarter.

Got it. Possibly somewhat related to that, you made a comment in the letter about at least the strength that you saw in Q1 with your one large carrier customer maintaining that. As we look into the second half, and then you mentioned a kind of a summer build among the smaller BSPs. From a customer mix standpoint, small through large carriers, are you anticipating any major changes there, either in Q3 or Q4? And would that have any impact on the direction of gross margins?

Great, great question, Tim. I don't think you're going to see material movements in the customer segment pieces. That customer that was strong in the first quarter that was strong in the second quarter will be strong again in the third quarter. We know that. And so you've seen even with that strength, our margins are continuing to improve. It can move around a couple of percentage points; that's inherently part of the business with those medium and large customers. But it's not going to move around materially.

You know, Tim, I'm really excited about the margin growth going forward for one simple reason. And that's because we're actually getting to this pivot point in the broadband industry. Think of it like a big freight train coming. That freight train is commoditization. The first stage of broadband that we're in is whether I’m overbuilding a DSL network, or I'm a cable company building myself, or a net new broadband provider. During that network phase, I see technologies working well and allowing me to get between 20% and 30% market share; the average is usually low 20s to get the 20% to 30% market share. In that phase, I'm focused on getting that share, and I'm not necessarily getting it from speed; I'm actually getting a significant component of that initial market share from dissatisfaction with the existing incumbents. The second stage of broadband, which is what we've invested $1.2 billion into and built over 12 years to prepare for, is that speed will become a commodity and not a differentiator, especially because most markets will have two fast broadband providers. If you have two fast broadband providers, you need look no farther than the mobile market to see the decimation of margin when this market share is stuck between mobile carriers. They can't move it unless they throw everything in the kitchen sink and toaster and everything else into it to try to convince customers to come over; there's no differentiation. We built our company to address this next stage, which is: broadband providers on top of a highly efficient network need to differentiate with their subscribers—whether business, education, or consumers—and build a go-to market where they have a really high NPS. So they've got great customer loyalty, and that loyalty drives incremental services, between $2 and $10, whatever it is, to drive into that subscriber. For us, that is the huge opportunity as we go forward on the margin side, where every time they add a new service, our margins go up because those are high-yield services. I’m really excited looking at the second half and especially into 2024. We reach a maturity point where they get their 20% to 30% share, and they say to Calix, okay, now how do I get to 50%? How do I get to 60%? In fact, one service provider I just spoke with two days ago said, I got to 51%. Now I want to figure out how to get to 62% market share, which, in a legacy model, is bluntly unheard of unless you’re a monopoly. So that is where, as we go forward, this big margin shift comes. Our customers work with us through our customer success army, finding micro-segmented markets, marketing, and identifying consumers to buy. We are masters of our own fate because of the fact we will help them drive revenue, which, in turn, helps us succeed.

Great, appreciate it. That bonfire and freight train were two pretty good and insightful metaphors.

Thank you. Have a good one.

Our next question comes from the line of Greg Mesniaeff with WestPark Capital. Please proceed with your questions.

Yes, thank you for taking my question. You referenced headcount increases during the last two quarters; I guess that's been driving up operating expenses to pretty much the top end of your guidance ranges for the last two quarters. In what area was the headcount increase concentrated? Was it R&D, sales and marketing? And my second question is, are you expecting that trend to continue in the second half of this year? How will that impact the OpEx levels? Thanks.

That’s great. I'm going to lead with kind of comment on where we're at with the financial model, and then I'll let Michael talk about where we're making those investments. We're right on our model, and that's good news. We've been on our model now for a couple of quarters. Just to recap, sales and marketing will be between 18% and 20%. In the quarter, we were at 19%. R&D, we seem to be at 29% of gross profit, and we're a little bit above that. G&A, we said we’d be at 7% of revenue, and we’re well below it. When you put it all together, we're right about exactly where we want to be. We've said repeatedly, we're going to continue to invest fulsomely according to our model, and that will continue in the second half of this year. Michael wanted to share where those investments are being made.

I’m going to reiterate this notion that we're investing substantially, an homage to Carl because you love that word. We're at the top levels regarding investment because there are just massive opportunities ahead. We don't see a slowdown; we see our customers growing at a faster rate, and they need our help. There are all kinds of new market opportunities for us to expand into. We're super excited about it. As Cory said, we're a $1 billion startup, and we feel that way—we're just getting started after moving from $400 million to a $1 billion. With regard to where we're investing across the board, we will get scalability on G&A, which we are as we continue to make significant investments in IT systems and all those capabilities. Even then, if I look at our backend regarding how we built out our IT systems leveraging Salesforce, Oracle Financials, and other components, I consider it best of breed and able to leverage that. But then in sales and marketing and everything we’re doing on the product side, you're going to continue to see us move at top pace. One of the great things is that with all the awards that our culture is winning, with all the ways our customers are incredibly inspiring, we use that to attract talent. We talk about the purpose of our customers as they change communities, drive education, and help underprivileged children. All these component parts contribute to how we actually engage talent, which is allowing us to meet our model, where we struggled for a long time. So you will see us investing substantively.

Thank you for that.

Thanks, Greg.

Thank you. Our next question is from the line of Scott Searle with Roth. Please proceed with your questions.

Hey, good morning. Nice quarter. Thanks for taking my questions. Hey, guys, I wanted to go back to the managed services side of the equation. Initially or historically, you talked about a curated offering or suite of around 10 services, but you're moving beyond that. I was wondering if you could give us an update about what's going on in the pipeline. What sort of opportunities are you starting to explore? If we look at 18 months, is there a number of services that you would expect to be offering at that point in time? Coupling in with that—maybe talk about that $1 going to $10—when do you expect to see some of the initial more aggressive customers starting to get to the upper end of that range and beyond it? Then I had a couple of follow-ups.

One of the ways that — the way we actually build our products is that now that the platform is in place, it's a very collaborative process with our customers. We actually run five or six advisory boards at this point. Those advisory boards feature our leadership team, myself, and a number of executives working with CEOs, COOs, and General Managers around what business opportunities are available to them. So we have advisory boards focused on operations, marketing, support, field service, and different insights to identify what we should do with our platform. On the simplify side, we explore new capabilities through automation and different elements that we should add, for instance, managing DNS and end-to-end provisioning to drive margins in the broadband service provider space. On the excite side, which is what are those new managed services, we're considering the two managed services that we've launched recently: SmartTown and SmartBiz. Those actually came from customers—SmartTown came from a customer call—and we’re proud of that. SmartBiz stemmed from about 10 or 15 customers who were pushing us to address a gap in enterprise technology that's delivered to the large customers, which does not scale down to them. Where do we go next? That actually comes down to our collaborations with customers. So looking at SmartBiz, its offerings initially target small businesses like travel agencies or corner stores, offering managed services with elements like wireless backup. These services will be completely managed, contributing to high margins without the need for truck rolls for the service provider. Where does the service provider want us to go? They understand what's possible and see our technology as enabling them to eliminate more expensive offerings like SD-WAN, which is generally purchased but often unnecessary in practice. So is that where we're going? Potentially. Those are the types of conversations we are having, but I can't determine how many services will roll out— it'll really depend on what our customers identify as logical opportunities and whether they can sell those offerings.

That being said, Scott, it's so early days, and just what we've launched will take us a while to get going. We're excited about what we have in the market right now, but we just know that now we've created the platform, more offerings to come, but we should not get too far ahead of ourselves in that regard.

Yes, and on the topic of early adopters, the early adopters are generally those in the advisory boards because they're driving us, saying 'Hey, do this, do this.' We just put out a press release mentioning Tombigbee Fiber and how they're in the process of adopting all of our technologies. They’re launching SmartTown and SmartBiz, so we're excited about their total integration and how they’re differentiated in their competitive market. Those are the types of all-in customers we enjoy learning from, and we take those learnings with our customer success organization and pass them on to others.

Great, that was very helpful. But Mike, I could follow up on SmartBiz and SmartTown specifically. Those seem like they're pretty large, potentially unique opportunities? Are there going to be some of the larger revenue generators once they reach a little bit more maturity? Specifically, I think on SmartTown, you were referring earlier to what you're able to do with MVNO opportunities. But when I think about it, it seems like it's a gateway into smart city and IoT, sensors. Are you seeing that interest as well? How does the model work around that? Do you end up charging per operator per community? Or is that more of a per person model?

Absolutely. SmartBiz has been drawn into very large opportunities that exist within the market because there's a huge underserved segment that needs help. Everyone's trying to take enterprise-class technologies and scale it down, but that doesn't work! Socially, disruption starts with small customers and goes upward. This leads me to believe that the opportunity for our service providers to disrupt this entire market is significant. I certainly see a large growth opportunity there. On SmartTown, we haven't been marketing it very heavily yet, but there’s great interest from various innovators to develop a smart town concept. That's why it's called SmartTown, as it allows us to engage with mayors to boast a full Wi-Fi mesh across the town, linking everything from parking meters to lights and schools. This connectivity is the biggest hurdle towns face, creating opportunities for further integration to generate revenue, positively impacting our bottom line as well. If you want to expand your network, permits are crucial, and working closely with local officials puts us at an advantage as we change the landscape in town.

Great. Got it. I was wondering if I could slip one more in under the line here, but you’re medium agnostic. I've had conversations with various wireless ISPs who are adopting as long as you get a GigaSpire solution. I think that's also true within some fiber deployments as well. I'm wondering if that's a big opportunity for growth for you guys, getting a foot in the door with additional carriers. If I could quickly follow up on deeds as well. I know it's further on the horizon, so I apologize for asking, but it seems like it will be a highly politicized environment. There are some new rules that are cropping up regarding matching funds and capitalizing potential operators, which is directly counterproductive to what DEED is supposed to achieve. It seems like some of your customers are well-positioned on that front with their access to capital. So broadly speaking, are you going to benefit disproportionately from DEED versus other providers because of your customer base and what you can help them achieve from a capital standpoint? Thanks, guys.

Yes, the first question regarding agnostic? The answer is yes. And then, regarding DEED, your point is not just focused on access to capital; about 42% of our customers are not-for-profits and have significant cash flows. We've had one customer who funded a $300 million network entirely with cash flows. Other cooperatives also have significant access to capital. I believe that, regarding DEED, they are uniquely positioned not only from a capital perspective but through a genuine concern for the communities they serve. When faced with legitimizing their previous underfunding of a community, they stand on a solid footing as they’ve continually invested their resources regardless of the government funding situation. By making strong community ties, they can press their case more successfully. I think that goodwill factor and their track record of investment regardless of government support will further bolster their long-term advantage.

Thank you, guys.

Thank you. We've reached the end of the question-and-answer session, and I'll turn the call over to Jim Fanucchi for closing remarks.

Thank you, Rob. Calix leadership will participate in several investor events during the third quarter, both in person and virtually. Information about these events, including dates and times and publicly available webcasts, 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 webcast for your interest in Calix and for joining us today. This concludes our conference call. Have a good day.

You may now disconnect your lines at this time. Thank you for your participation.