Earnings Call Transcript - EXTR Q4 2022

Operator, Operator

Good day and thank you for standing by. Welcome to the Extreme Networks Fourth Quarter Fiscal Year 2022 Financial Results. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Stan Kovler, Vice President of Investor Relations and Corporate Strategy. Please go ahead.

Stan Kovler, Vice President of Investor Relations and Corporate Strategy

Thank you, Katherine, and welcome to the Extreme Networks fourth fiscal quarter and year-end 2022 earnings conference call. I'm Stan Kovler, Vice President of Corporate Strategy and Investor Relations. With me today are Extreme Networks President and CEO, Ed Meyercord; and CFO Rémi Thomas. We just distributed a press release and filed an 8-K detailing Extreme Networks financial results for the quarter. For your convenience, a copy of the press release, which includes our GAAP to non-GAAP reconciliations, is available in the Investor Relations section of our website at extremenetworks.com. I would like to remind you that during today's call, our discussion may include forward-looking statements about Extreme's future business, financial and operational results, growth expectations and strategies. We caution you not to put undue reliance on these forward-looking statements as they involve risks and uncertainties that can cause actual results to differ materially from those anticipated by these statements as described in our risk factors in our 10-K report for the period ended June 30, 2021 filed with the SEC. Any forward-looking statements made on this call reflect our analysis as of today. We have no plans or duty to update them, except as required by law. Now, I will turn the call over to Extreme's President and CEO, Ed Meyercord.

Ed Meyercord, President and CEO

Thank you, Stan, and thank you all for joining us this morning. We had a strong quarter and year, and I'm pleased with the progress our teams are making. Our results for fiscal '22 highlight unprecedented demand for Extreme solutions and a very vibrant and healthy market for networking. We reported record bookings growth of 24%. This is a clear indication that we're taking share and winning in the market. And our forward-looking funnel for fiscal '23 is up double digits year-over-year. This is a leading indicator of future bookings growth. The differentiation of our Fabric and Cloud solutions for enterprise customers and our targeted solutions for very large service provider customers, combined with the high performance in our global sales and channel teams, gives us the confidence in our outlook for continued growth in demand. Our technology solutions are critical to infrastructure initiatives, underpinning digital transformation for all of our customers around the world. We believe these important projects will continue to remain a priority, irrespective of the changing macroeconomic environment. For the year, our double-digit revenue growth led to an all-time high revenue of 1.1 billion, yet it was understated by the 400 million of incremental backlog we built during the year. Our total Q4 ending backlog was 530 million, thanks to the current supply chain environment. Despite margin pressures, we were also pleased to generate a record 60 million of free cash flow during the quarter, bringing our net debt to EBITDA below 1. The continued improvement in our operating model allowed us to achieve record non-GAAP EPS of $0.70 per share for the year, up 35% year-over-year. We expect these bottom line earnings growth trends to continue. A record 208 customers spent more than $1 million with Extreme during fiscal '22, up 28% from a year ago. We attribute this success to our strategy of leveraging channel partners as a vehicle for growth in the enterprise market while focusing our direct sellers on larger projects. Our sales productivity is at an all-time high as a result, and we have more teams over quota than any time in our history. There's never been a better time to be an Extreme as demonstrated by our sellers in the field. In addition, our competitive position in the industry has never been stronger. Small share gains have a large impact on Extreme in both financial and industry recognition perspectives. Our distributors, channel partners, and our customers have taken notice of the industry accolades we're receiving for our solutions and service. For the first time, we eclipsed the largest industry player in the Gartner Magic Quadrant, where we are an established leader for four years. And for the fifth year in a row, Extreme was named Gartner's Choice for Wired and Wireless LAN access infrastructure. This recognition carries weight with our target enterprise customers. Our differentiated cloud-based solutions drove subscription bookings growth to 58% and we achieved annualized cloud SaaS bookings of 170 million exiting Q4. Demand for our innovative SaaS solutions is also driving demand for our products, and we believe the level of organic subscription growth we are seeing today is sustainable. Our ARR reached 103 million in Q4, up 47% year-over-year and 8% quarter-over-quarter. We continue to build on our vision of the infinite enterprise with the launch of ExtremeCloud SD-WAN solutions, extending our cloud edge services across wide area networks. These solutions, along with our AIOps development around Digital Twin and Co-Pilot will provide the next wave of growth in our subscription business and support our long-term subscription revenue outlook of 35% to 45%. We received tremendous feedback from our Annual Connect User Conference that we held live for the first time in several years. Associated content sessions were viewed more than 4,000 times over one and a half days. We also showcased our ecosystem of over 100 technology integrations and partnerships on display at the event. Next week, we're oversubscribed for our sales kickoff event for our direct sellers and channel partners where we expect over 1,000 live in Boston. We exceeded our stated goal of generating an incremental 20 million in fiscal '22 sales of our 5G solutions to service providers. We're starting to experience pull-through business, thanks to the significant ramp in next-generation global telco network deployments. And we're working on expanded use cases with our OEM partner for additional cloud native solutions where we are the preferred vendor. Today, our teams are more competent navigating the challenging supply chain environment, thanks to a combination of strategic relationships, new processes and more consistency with secondary and tertiary component suppliers and success in the broker market for components. In addition, our teams have been successful in reengineering products in improved lead times for customers. This allowed us to release nearly 20 million in backlog during the quarter. These efforts were enabled by a number of our cross-functional teams working with our partners and suppliers. We were able to create new products used and certified in record time, our customers recognized this agility and it's creating new business opportunities for us. As we noted during our Investor Day in May, we expect to continue to build backlog for the next several quarters, given our outlook for continued bookings growth and the gradual recovery in supply chain. For the guidance we provided, we expect sequential improvements in our ability to deliver product to customers throughout the full '23. Based on the lead times and commitments, we expect backlog will begin to shrink by Q4 of fiscal '23. We have complete visibility into our product backlog and have received negligible cancellations to date of less than 1% of bookings. Our backlog primarily consists of our latest generation universal products. So when we begin to ship product, we will also see an improvement in subscription and services bookings that are attached to our wired and wireless products. At Extreme, we're focused on finding new ways to enable better outcomes for our customers. This quarter, Extreme helped DM, an Italian grocer with over 100 locations and over 2 billion in annual turnover for next-generation retail experiences for its customers through our ExtremeCloud SD-WAN solutions, lowering costs, simplifying management and providing ease of deployment. At North Carolina A&T, the nation's largest HBCU serving more than 13,000 students, Extreme Fabric solutions are being used to expand the campus network and improve the digital learning experience for students while enhancing security. The re-architecture of the environment was created with the help of our award-winning services team. This quarter, we booked the largest network infrastructure as a service deal in Extreme's history with the U.S. federal customer, a 10 million campus switching deal over five years. We leveraged our Capital Solutions group to deliver a new OpEx-based consumption model for this federal customer. Again, our ability to be flexible with our enterprise customers is an important differentiator for us. In Q4, we continued to expand our universal portfolio with the introduction of the 5720 Universal Switch designed to support data-heavy applications, such as Wi-Fi 6E. We also continued to innovate on best-in-class Wi-Fi 6E and ultra-wideband technologies. Extreme's first-to-market move in Wi-Fi 6E is leading us to win in the market transition. Adoption of 6E wireless will also drive multi-gig switching demand in the future, nearly doubling that Wi-Fi 6E revenue during the quarter sequentially as we've improved our ability to deliver access points to customers. 6E is now over 25% of our wireless ACE revenue. Net-net, I'm incredibly excited to see our team execute at such a high level across the organization, from our product team delivering incredible innovation, from our sales and marketing teams driving demand, our supply chain and operations teams delivering products in a challenging environment, and the cross-functional support from all the other organizations are putting Extreme in a position for unprecedented growth in top line, cash flow, and earnings in future quarters and years to come. With that, I'll turn the call over to our CFO, Rémi Thomas.

Rémi Thomas, CFO

Thanks, Ed. As Ed described, we had solid execution in fiscal '22 with record bookings and backlog generation, double-digit revenue growth, and overall improving margins in spite of the supply chain environment. Strong demand for our portfolio of products, services, and subscriptions drove year-over-year bookings growth of 24% in fiscal '22 and 8% in Q4. With a product book to bill ratio of 1.29 for the year and 1.23 for the quarter, we exited the year with $513 million in backlog, that's more than 400 million year-over-year and close to 90 million sequentially. That's nearly three full quarters of product revenue. We achieved double-digit revenue growth for the year to surpass the $1.1 billion mark. Our fourth quarter revenue of $278.2 million came above the high end of our expectations entering the quarter, reflecting the ability of our supply team to either source more components or qualify alternative ones. We grew our subscription bookings by 58% in fiscal '22 and 51% in Q4. We're making a change to how we report our SaaS ARR. We're now basing it on an annualized view of our quarterly subscription revenue as opposed to the annualized contract value. Historical data can be found on Page 15 of the Q4 earnings deck posted on our website. Based on this methodology, our ARR reached $103 million in Q4, that's 47% year-over-year and 8% quarter-over-quarter. SaaS deferred revenue was $157 million at the end of Q4, up 40% year-over-year and 10% quarter-over-quarter. For the year, we achieved record EPS of $0.77, up from $0.57 a year ago. Q4 non-GAAP earnings per share were $0.15, in line with our expectations entering the quarter. On a geographic basis and looking at revenue, our top-performing region was EMEA, which delivered revenue growth of 23% for the year and 10% from Q4. The Americas grew 3% for the year, but declined in Q4 impacted by fewer stadium deployments this quarter. Finally, although APAC revenue declined slightly for the year, it enjoyed a very strong recovery of 48% in Q4, resulting from improved execution across the board. From a vertical standpoint, and this time looking at total company bookings, the highest year-over-year growth in fiscal '22 came from sports and entertainment, followed by government and healthcare. For Q4 specifically, the highest growth came from government, followed by healthcare and service provider. From a product category standpoint, our wired product bookings grew 28% for the year but were down slightly in Q4, due to very demanding comparisons in the campus segment. Wireless product bookings were 25% for the year and maintained a healthy growth rate of 6% in Q4. Total wired revenue grew at a high single-digit rate for the year but declined in Q4 due to supply chain constraints. Our wireless revenue, on the other hand, grew at a double-digit rate for the year and in the mid-20s for Q4, as we were able to release a meaningful part of our backlog. Services and subscription revenue of $91.1 million in Q4 was up 11% year-over-year, taking the total for the year to 350.6 million, up 13%. This growth was largely driven by the strength of cloud subscriptions for which revenue grew 34% in Q4 and 37% for the year. Total Q4 recurring revenue, including maintenance, managed services, and subscription, rose to 87.3 million or 31% of total company revenue, up from 28% last quarter. For the full year, our recurring revenue was 30% of total. The growth of cloud subscription and service renewals drove the total deferred revenue sitting on our balance sheet to $402 million, up 16% from the year-ago quarter and 8% sequentially. Our non-GAAP gross margin came in at 57%, down 1 percentage point sequentially and 3.5 percentage points year-over-year, driven by lower product gross margin. In addition to high expedite fees and freight costs, our product gross margin was impacted by an unfavorable mix. For the full year, total company gross margin would have been 600 basis points higher if not for these elevated expedite fees and freight costs. On the other end, services and subscription non-GAAP gross margin improved to 70.7% in Q4, up from 64% in the year-ago quarter and 65.1% sequentially driven by high mix of subscription and maintenance and lower professional services revenue based on the timing of certain high-touch stadium deployments. Q4 non-GAAP operating expenses were $132 million, up from $131 million in the year-ago quarter and from $130 million in Q3, reflecting lower R&D expenses, but higher sales and marketing expenses. OpEx as a percentage of revenue was 47.3%. For the full year, operating expenses dropped to 46.1% of revenue at the lower end of the long-term range of 46% to 49% provided at our Analyst Day in early 2021. All-in-all, our operating margin was 9.6% for the quarter and 12.2% for fiscal '22, the highest on record. Net debt was reduced by $35 million sequentially to $114 million as a result of a record operating cash flow of $60 million this quarter. This was driven by strong collections as well as an acceleration in the pace of cash collections. During Q4, we repurchased a total of 2.05 million shares of our common stock for $20 million, with an average price of $9.74 per share. For the full year, we repurchased $45 million worth of stock. We currently have $200 million remaining in our new buyback authorization as of July 1. Now turning to guidance. For Q1, we expect revenue to be in the range of $279 million to $289 million. Q1 non-GAAP gross margin is anticipated to be in the range of 57% to 59%. Q1 non-GAAP operating expenses are expected to be in the range of $130.7 million to $134.2 million. Q1 non-GAAP earnings are anticipated to be in the range of $19.9 million to $26.5 million, or $0.15 to $0.20 per diluted share. We anticipate that the reduction in expedite and shipping fees, combined with the full impact of our recent pricing actions, will lead to a progressive recovering gross margin throughout fiscal year '23 with Q4 expected to be above 60%. For the year, we expect 10% to 15% revenue growth with an operating margin in the 10% to 15% range. With that, I will now turn it over to the operator to begin the question-and-answer session.

Operator, Operator

Thank you. Our first question comes from Alex Henderson with Needham & Company. Your line is open.

Alex Henderson, Analyst

Thank you very much and great job, guys, in a tough environment. I wanted to get a better handle on the bookings in 4Q and the outlook commentary going into the first half of fiscal '23. It sounds like clearly you expect to stay supply constrained through most of the fiscal year. But do you see any improvement in supply in your expectations in the first half of the year? And then second, what's going on in that pipeline as you're looking at that first half outlook? And particularly, if you look at the booking numbers in the fourth quarter, how did that play on geography? And how do you think that looks going into the upcoming quarter, particularly in EMEA? Thanks.

Ed Meyercord, President and CEO

Thanks, Alex. Rémi, why don't you let me jump in and then you can fill in. And so, Alex, you're rightfully pointing out kind of just how we're looking at bookings, which is really our measure of true demand, and then versus revenue and our revenue outlook is really a function of a supply chain and product that we're able to release, given the massive backlog that we built up and the continued strength of bookings. So I'll just start off with supply chain. You've asked about that. What we see is a gradual improvement throughout the year. So think of a step function where we will be stepping our revenue quarter-by-quarter throughout the year based on our outlook of supply chain. And we do have more confidence, as we've mentioned before, strong relationships with the likes of Broadcom where we are not constrained. It's more about secondary and tertiary component vendors where we've established direct relationships, normal processes, and have consistency now in our expectations around delivery. And then some of the creative things that our teams are doing around reengineering, etc., and then more products showing up on the spot market. So our teams, as I mentioned in my comments, are more competent today than they have been in our ability to step function our supply of products to our customers' partners. So what does that mean? That is how we built the revenue forecast for fiscal '23, which is that step function with the sharper improvement in the second half of the fiscal. As it relates to demand, our demand has been strong, as we've talked about it for the year, 24%. For us, that's record-breaking performance. However, the seasonality for bookings is very different. In an environment where people know that there are long lead times when there are pricing actions, like they were last year in response to increased expenses, we had a couple of price raises. And in that case, people wanted to get ahead. So we saw extraordinary bookings growth at the very end of the September quarter last year and of the March quarter as far as bookings. So there was a lot of pull-ins from the other periods. So normally, you would see the peak in June and then slow down in September, peak in December and then slow down in March. In this case, what we saw was an explosion in September last year, a slowdown from that level in December, an explosion in March, and then a slight slowdown. In terms of our internal plans, we hit our internal target, which is why we continue to grow bookings. But relative to where we were in the March quarter with the pricing action, it was different. As we look out at the first half of fiscal '23, we see bookings growth continue. And that is a function of several factors. First of all, we rely on our teams and our bottom-up roll up from direct sellers in the field rolling up geographically. There's a lot of confidence from our field teams and the numbers that they're actually calling, I'd say stronger than in years past. The second thing, we look at that funnel and we run our own metrics and look at the commit levels and the confidence levels with our algorithms and our formulas there, and they're up. As we mentioned, if you look at our funnel year-over-year, we are up over double digits in terms of the opportunities. And over the course of last year with competitiveness at Extreme, our conversion rates from that funnel have improved. So we're more confident about the quality of the funnel and our ability to win. And we still see growth there. Finally, we have an AI tool based on all the CRM activity and looking at the opportunities. That's up. And then our partners, channel partners, and our distributors, they have an outlook and a view and they're calling a number. So when we look at all those different data points, it points to an increase in demand. What I would tell you is that for the first quarter, we definitely expect to be over a book to bill of 1 and that the normal seasonal trends in bookings and comparisons will likely be different because of the pricing actions.

Alex Henderson, Analyst

EMEA?

Ed Meyercord, President and CEO

Rémi, do you want to comment?

Rémi Thomas, CFO

No. I think you gave a very detailed view of it.

Ed Meyercord, President and CEO

Alex, regarding EMEA, we continue to observe strength. I understand this is something you are closely monitoring and are concerned about, but we cannot provide that specific data point. We are not seeing any issues; the strength persists. The question is whether this is due to us gaining market share amid macroeconomic conditions or if our data point represents valid macroeconomic data.

Alex Henderson, Analyst

It's a good result to you either way. Thanks so much for the detail.

Operator, Operator

Thank you. Our next question comes from Mike Genovese with Rosenblatt Securities. Your line is open.

Mike Genovese, Analyst

Thanks very much. Good to be on the call. I guess a little bit of asking that part of the last question a slightly different way, I think you said that by the fourth quarter of the fiscal year you think book to bill will be below 1. And I guess my question there is that more is a function of less confidence in demand when you look that far out or more confidence in the supply chain, allowing you to eat into the backlog and report extraordinary revenue growth in the back half of the year?

Ed Meyercord, President and CEO

Hi, Mike. That's a great question. It's primarily related to the supply chain. As I mentioned, we still see strong demand as we move through the year. However, on the supply chain front, we face limitations, particularly with our Tier 2 and Tier 3 components. We need all of these components to manufacture a switch or an access point. Without them, we are unable to produce or ship our products. Some of our suppliers are bringing their manufacturing capabilities online early in the calendar year, and we have a timeline that provides us with visibility into the availability of our components. Once these components are available, we anticipate an increase in supply, which has currently been a bottleneck for us.

Mike Genovese, Analyst

I need some clarification on the difference between fiscal years and calendar years. When we discuss improvements in every quarter of 2023, are we referring to fiscal or calendar years? Also, could you provide any insights on potential positive developments you may or may not be observing in the actual calendar second half of 2022?

Ed Meyercord, President and CEO

Yes, I believe our comments regarding the fiscal year are applicable to the calendar year as well. For the latter half of 2023, we anticipate a significant increase in product inflow, particularly as we begin to reduce our backlog. What we have been discussing is realigning our revenue to match actual demand, which involves adjusting our book-to-bill ratio. Additionally, we are focused on building our backlog, expecting to accumulate hundreds of millions in relief. This trend will persist and is anticipated to accelerate in the second half of the calendar year.

Mike Genovese, Analyst

Sorry to ask again, but can you provide any insight regarding the gross margin for fiscal Q2, specifically for the December quarter? I understand you typically avoid providing guidance that far out, but how should we consider factors like the supply chain, pricing, and others when thinking about the sequential gross margin leading into December?

Rémi Thomas, CFO

Based on our view of expedite fees of freight costs that are starting to come down as more capacity is being built between Taiwan and Shanghai. In El Paso, where we have a main hub, we feel confident that we can improve the gross margin sequentially by close to 1 percentage point so that we now see ourselves in Q2 at around 59%.

Mike Genovese, Analyst

Great. Well, I have more questions but I think I'll pass it on to be fair to other people. So thank you. Thank you very much.

Rémi Thomas, CFO

You're welcome.

Operator, Operator

Our next question comes from Eric Martinuzzi with Lake Street Capital Markets. Your line is open.

Eric Martinuzzi, Analyst

Yes. I wanted to address the FX impact of the strong dollar. I was actually concerned that you guys might be backing away from the 10% to 15% growth in FY '22 based on the strength of the dollar versus the pound and the euro. Could you address that?

Rémi Thomas, CFO

Sure. There's two aspects, Eric. The first one is the competitiveness of our product. Unless some of our customers are willing to go with Huawei or with Alcatel-Lucent Enterprise, which is a voicemail player, if we're dealing with Juniper, Cisco, HP, Aruba, that has not proven to be a problem. And believe me, I'm asking the questions every Monday on our sales call to our Head of EMEA sales. But so far, customers basically are absorbing the impact of higher product in their local currency, specifically if they're in the Eurozone, because all of our competitors use the dollar as a functional currency with the exception of the two that I mentioned. The second aspect is we have a significant cost base, not so much in terms of R&D, but obviously in sales and marketing with a significant presence in Europe. And as we account for that, it basically has a favorable impact on our OpEx. As a prudent CFO with a very prudent treasurer, we're hedging ourselves against the euro and the Indian rupee to locking some of these rates. So the impact that you'll see on the P&L depends on how smart we've been in terms of hedging, but that second aspect is favorable to the P&L.

Eric Martinuzzi, Analyst

Okay. You mentioned relief in the supply chain for Q4, likely due to the release of the backlog. Is that in line with what you said during the Investor Day in May? I thought you were referring to relief in Q3.

Rémi Thomas, CFO

Go ahead, Ed.

Ed Meyercord, President and CEO

Yes, I was going to say it is consistent. I think not to be confused with how our suppliers begin turning up product and then how that product affects our supply chain. So I think in Norman's commentary, he was talking about suppliers, where we're constrained, turning up and opening up new fabs and then turning up production lines to start releasing products. And so there's an evolution there. That is happening in the first quarter and they're on schedule. That's happening in Q4 and calendar Q1. But then those components have to make it into our supply chain. And so our timetable for that is we're seeing a significant step in our Q4 of those much-needed components that we can then turn around and ship product.

Eric Martinuzzi, Analyst

Okay. So it was really more of an upstream comment and that the P&L impact is just Q4. Okay. Thanks.

Ed Meyercord, President and CEO

I think keep in mind, we are forecasting a significant step in each quarter going forward. So normally there'd be seasonality in the September quarter and revenue we're guiding to a step up in December, a step up in March, a step up in June. So we're seeing this gradual release with some pretty larger steps happening in the March and then especially in the June timeframe.

Eric Martinuzzi, Analyst

Yes, definitely unusual times.

Ed Meyercord, President and CEO

Yes.

Eric Martinuzzi, Analyst

Thanks for taking my questions.

Operator, Operator

Thank you. We have a follow-up from Alex Henderson with Needham & Company. Your line is open.

Alex Henderson, Analyst

Great. A double dip, all right. So I wanted to just clarify on the FX and international sales. So do you have any receivables that you have exposure on relative to the FX that could be impacted by the strong dollar, weak currencies in the international markets, particularly Europe, that are either unhedged or would be impacted by further strength in the dollar?

Rémi Thomas, CFO

The functional currency that we use, without the fees where we basically collect 85% of our receivables happens to be the dollar. So that means that whatever bill was in dollar, they have to come up with the right amounts to meet that bill, so no exposure there.

Alex Henderson, Analyst

In relation to the functional currency internationally, especially in EMEA, what percentage of your revenues is in dollars compared to local currencies? I believe there are some in local currencies. Could you please clarify that percentage since it is such an important factor these days?

Rémi Thomas, CFO

I don't know the exact percentage but I would assume it's 95%, unless we have guaranteed a net price in the local currency which to my knowledge we don't do. We sometimes will guarantee a net price, so some customers are immune from the price increase we've done until the frame agreement we have with them expires. But in any instance, that price is always set in dollars to my knowledge.

Alex Henderson, Analyst

That's higher than I thought it was. So thanks for the clarification. Going back to the environment, it's hard to believe that the Europeans are not seeing some pressure in the pipeline. Can you talk a little bit more about the pipeline relative to Europe? You haven't seen any slowdown or any increase in the number of signatures really, the stretching of lead times, anything on those types of metrics? It seems hard to believe that given the massive hits that that economy is taking that there hasn't been any change at all on conditions?

Ed Meyercord, President and CEO

I would like to add a few points to that, Alex. Firstly, we are closely monitoring the situation, and so far, we haven't observed any significant changes. As I mentioned earlier, this could be indicative of us gaining market share. Our position in the cloud and fabric space, along with the quality of our implementations, is leading to more opportunities for us. This might suggest that the increase in opportunities is a result of our share gains. Additionally, I want to emphasize that networking infrastructure is now more crucial than ever. When considering digital transformation, the network acts as the essential connective element, as does the cloud. These are complex projects that we are not seeing being deprioritized. If there are budget cuts happening, it’s important to note that critically important networking projects are likely to remain a priority. However, as of now, we haven't noticed any changes in that regard.

Alex Henderson, Analyst

That's fabulous. Okay. One more question, except this one on the internal side of things. Have you changed your behavior relative to hiring? What are you seeing in terms of wage inflation? What are you seeing in terms of staffing, churn, any thoughts on those elements to drive OpEx? And when does your annual merit increases, so that we can note them in our model?

Ed Meyercord, President and CEO

So annual merit increases for us are in the second half of the fiscal, so they come into play at January and February timeframe, so in the March quarter. For us, what I will tell you is that our turnover remains unusually low. And I think some of that has to do with our success in the marketplace and the kind of talent that we're attracting right now at Extreme. So from that standpoint, we are out in the market and we are out hiring. We are being very disciplined in our spend, in our investments because real demand is a lot higher in the market and we're driving much higher demand than what we're spending for because revenue is lower. But we've been making some key strategic hires in the channel and in our sales leadership. We're better organized now to support the channel and we see a real channel growth opportunity. And I would say we're hiring. So right now we're in investment mode, but we're constrained because we're governing investment by our revenue. And our revenue is artificially low because it's not a reflection of real demand because of supply chain, if that makes sense.

Alex Henderson, Analyst

So would you then, as supply chain improves, accelerate the hiring to take advantage of your accelerating revenue growth? That sounds like that's the answer to that question.

Ed Meyercord, President and CEO

We would blend our returns to investment in the business and growth that current returns to shareholders.

Alex Henderson, Analyst

I wanted to get a bit more clarity on the embedded backlog in the systems backlog, specifically regarding service and software subscriptions tied to actual shipments. If we consider a scenario where it's $100 million worth of systems, what portion of that in terms of software and services would be included in the deferred revenue for systems? Would it be 25%, 30%, or 50%? How should we think about it?

Rémi Thomas, CFO

I don't know that we have that kind of metric, because in that 100, you have to see what is our campus portfolio as opposed to our wireless portfolio? I could answer that typically the attach rate that we're now seeing around our wireless portfolio for cloud is around 60%. So every time you sell 100 switches, in 60% of the case the customers will take XIQ to manage that. And the dollar amount related to that is a lower number of that which we haven't really disclosed. So I'm not sure we can answer that question, Alex.

Alex Henderson, Analyst

Well, the services should be pretty straightforward, right?

Rémi Thomas, CFO

Services attach about $7. So you sell $100 worth of a switch or access point, you typically get $7. But as far as XIQ is concerned,

Ed Meyercord, President and CEO

We should circle back with you on this one.

Alex Henderson, Analyst

Okay, great. Thank you very much. I'll cede the floor.

Operator, Operator

We have a question from Dave Kang with B. Riley. Your line is open.

Dave Kang, Analyst

Yes. Good morning. Nice quarter. First, on clarification, I think, Rémi, you talked about gross margin would have been 600 bps higher. I'm assuming that was for fiscal fourth quarter.

Rémi Thomas, CFO

No. That was for the full year.

Dave Kang, Analyst

Okay. What was for fiscal fourth quarter? Can I get that number?

Rémi Thomas, CFO

It was about the same.

Dave Kang, Analyst

Got it. And regarding expedite fees, have we reached the peak of that, or when can we expect to see it peak? Gross margin clearly declined by 1 percentage point sequentially, and I assume that contributed to that decline.

Rémi Thomas, CFO

Actually, the expedite fees in freight costs in Q4 versus Q3 and versus what we expected didn't really come as a surprise. What really drove that 1% gross margin impact was a mix. We had a significant stronger quarter for wireless and our gross margin on wireless is lower than for our wired products. To your question about, have we seen the peak? The answer is yes. As we look at the expected what we call PPV, purchase price variance, which is really what we pay in addition to the normal invoices to secure supplies from Broadcom and other vendors, we actually see a slight improvement in Q1 and same for freight costs. I mentioned earlier, that there is now more capacity being added back by commercial airlines between Asia and the United States. And we're basically leveraging that commercial airline capacity to carry our products. So that the bill that we expect to pay this quarter is actually going to be down sequentially, which is why we're suggesting a 1 percentage point improvement sequentially.

Dave Kang, Analyst

Got it. And then sticking with wireless, what is the mix between wired versus wireless for product revenue?

Rémi Thomas, CFO

So this quarter it went back up. It had been depressed because we were delivering more on the wired side. This quarter, we went back up to 28% wireless, 72% wired.

Dave Kang, Analyst

Got it. And then regarding your backlog, I think last quarter you talked about backlog of maybe 500, maybe slightly higher, but clearly you already exceeded that. And you're implying that will continue to go up. So how should we think about the new peak? Are we talking about maybe 600, even higher? And then after peaking, can you maybe talk about the rate of decline? I'm assuming that's going to be more of a fiscal '24?

Rémi Thomas, CFO

Ed, do you want to comment? So I'll go, Dave, and Ed you can feel free to add.

Ed Meyercord, President and CEO

Yes, I wanted to clarify. I wasn't sure about the question of rate of decline.

Dave Kang, Analyst

The backlog decline.

Ed Meyercord, President and CEO

Yes. We anticipate seeing a decline in backlog. Our expectation is to stabilize and gradually reduce it. In Q4, we do not foresee a significant impact, but in the latter half of calendar year 2023, you will start to notice us making more substantial progress in reducing that backlog. This will depend on the availability of components and an increase in volume. Therefore, during the second half of our fiscal year, you can expect an uptick, and throughout fiscal 2024 and likely into fiscal 2025, we aim to right-size our backlog.

Dave Kang, Analyst

Where do you think it will peak, around 600?

Ed Meyercord, President and CEO

I'm not sure we provided guidance on that. However, I believe that's a fairly conservative number. I would consider that a safe estimate based on the strength of our bookings in relation to supply, particularly when looking at the trend over the last several quarters.

Dave Kang, Analyst

Got it. Just a couple more. Can we get the latest update on SD-WAN and Ipanema, how that's progressing?

Ed Meyercord, President and CEO

We recently held our Connect Conference where we announced the launch of ExtremeCloud SD-WAN. Our teams completed the integration of the SD-WAN solution into our cloud ahead of schedule. We will emphasize that we have a single cloud that orchestrates services, making us the only provider in the industry offering cloud management for both campus and wide area networks from a single cloud. This distinction sets us apart as we aim to introduce new WAN edge services that we can manage across our cloud. The sales cycle for this is expected to take 6 to 12 months. Following our launch, we are beginning to see an increase in potential opportunities. I also mentioned that we have a sales kickoff meeting with partners next week, where SD-WAN will be a major focus. Our teams are setting targets for these numbers, and we anticipate considerable growth throughout the year. Therefore, we expect to see a developing sales pipeline and corresponding bookings primarily in the latter half of the year.

Dave Kang, Analyst

Got it. And my last question is on 5G. Clearly, you exceeded 20 million. And then I think before you were expecting 50 million to 100 million. So just wondering if that's the case, still the case for fiscal '23? And then any new customers in the funnel, in the pipeline?

Ed Meyercord, President and CEO

The answer is yes. We are identifying new opportunities with one of our large global telecom suppliers that we have discussed before. They have progressed from zero to over 22 proof of concepts, which are now moving into production. This will lead to a significant increase as major telecom companies begin to implement this cloud-native infrastructure solution, where we are the exclusive vendor for networking tied to major service provider 5G networks around the world. We are witnessing this development in real time, and we are confident in our projections. Additionally, we are involved in the 5G solution and have a significant business opportunity with Verizon, where we are currently undergoing certification. This allows Verizon sellers in the enterprise sector to promote and sell our products, presenting an exciting new opportunity for us. This initiative also extends across our broader portfolio. We are attracting new customers thanks to our efforts with these large service providers. There are specific use cases applicable to other service providers, and we are beginning to see the pipeline grow as we broaden our offering to them, while also noting our investments in this area. We perceive substantial growth opportunities ahead.

Dave Kang, Analyst

Got it. Thank you.

Rémi Thomas, CFO

And Alex, if you're still on the line, we do have an answer to your earlier question. We did some back of the envelope math, but typically when you have $100 worth of backlog that you're not able to deliver between the services and subscription, assuming attach rate for service and assuming different attach rate for subscription, you should assume around 15% of that 500 million of backlog gets released, that's potentially $75 million worth of subscription and services business that can be generated over time.

Operator, Operator

Our next question is a follow up from Mike Genovese with Rosenblatt Securities. Your line is open.

Mike Genovese, Analyst

Great. I haven't gotten any long list of follow ups, but then they're mostly just got asked in the last few questions. So I'm just going to end with, for me, Co-Pilot. I know it's early days, but do you have revenues there yet? What's the pipeline like that looking for? How do you sell that product? And what's customer acceptance like? Thank you?

Ed Meyercord, President and CEO

Yes, Mike, it's a great question. It's something we're really excited about. We talked about the next generation as sort of new growth factors for subscription. And clearly SD-WAN, we've gotten a lot of attention around Digital Twin. And then Co-Pilot with AIOps and automation and some of the operational savings that we're going to bring. The launch is really this upcoming week in Boston. So there's a huge amount of training and enablement and an official launch with our own internal sellers, with marketing programs and incentives, as well as for our partners. So more to come on that. We're very excited about the capability and the differentiation on what that can do. So still early, but stay tuned.

Mike Genovese, Analyst

Okay. I guess if we take very long term, years down the road, and we kind of dimensionalize the Co-Pilot opportunity versus the core XIQ opportunity, like what percentage would it be?

Ed Meyercord, President and CEO

We haven't guided there yet, Mike, but I think that's something that we can come back. And what we do is we look at customers and we look at their software subscriptions spend. So obviously, the core is a pilot license and then you start layering services on top of that. And so we look at, you can call it, it's an additive strategy where we're looking at adding services on top of that pilot. And I think for us to give you a meaningful answer there, we need to do some modeling for you to try to be responsive and understand what you're trying to build in there. I think it's premature for us to give you an answer on the call today.

Rémi Thomas, CFO

Mike, you should think of this as an opportunity for us to improve on that retention rate. So if our gross retention rate is in the high 80s, low 90s, when we go back to the customer and renew, we're typically going to upsell them with this type of product and get an additional few percentage points increase on that retention rate.

Mike Genovese, Analyst

Fantastic. Thank you very much.

Operator, Operator

Thank you. And that's all the time we have for questions. I'd like to turn the call back to management for closing remarks.

Ed Meyercord, President and CEO

Okay. Thank you. Well, we appreciate everyone joining us today. And we appreciate the engagement with the analysts. Great questions. We're very excited as we turn the corner into our fiscal '23. The bookings growth and the demand for Extreme in the market is unprecedented. And I've just say personally, I'm very proud of the team. I know we have a lot of customers, partners, and employees who listen in on the call and I would congratulate everyone on a job well done and tremendous momentum that we've got turning the corner, again across the board from the product teams, the sales and marketing teams, our services teams, supply chain ops teams, and then everyone supporting the efforts at Extreme. We're just in a very unique position for top line growth and cash flow and earnings growth, not just the next couple of features but the next several years. So we're excited about that. Thank you again for joining us and have a great day.

Operator, Operator

This concludes today's conference. Thank you for participating. You may now disconnect.