Earnings Call Transcript - EXTR Q1 2023

Operator, Operator

Ladies and gentlemen, thank you for being here and welcome to the Extreme Networks Q1 FY '23 Financial Results Conference Call. I would now like to turn the call over to your host, Stan Kovler. You may begin.

Stanley Kovler, Vice President of Corporate Strategy and Investor Relations

Thank you, Kevin. Welcome to Extreme Networks first quarter in 2023 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. All financial disclosures on this call will be on a non-GAAP basis, unless stated otherwise. 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, 2022, as filed with the SEC. Any forward-looking statements made on this call reflect our analysis as of today and we have no plans or duty to update them as required, except as required by law. Now, I will turn the call over to Extreme’s President and Chief Executive Officer, Ed Meyercord.

Ed Meyercord, President and CEO

Thank you, Stan, and thank you all for joining us this morning. We had a record quarter as demand for cloud-driven networking and for Extreme Solutions has never been stronger. Again, our share gains are evident by double-digit revenue growth, record revenue, and continued growth of backlog which now sits at $555 million. The sequential increase in revenue and margins led to continued improvement in our operating model and we achieved EPS of $0.20 in Q1, up from $0.15 in Q4. We expect these bottom line earnings trends to continue. The combination of our fabric and cloud solutions drive significant differentiation for Extreme. Our fabric technology, deployed in over 7,500 campus networks globally, delivers network automation, hyper-segmentation, and unmatched security. Today, our fabric provides simplicity and ease of use for local area network deployments from the campus core to the wireless edge. In calendar Q1, we're extending our fabric across the wide area network, bringing new features and security to our enhanced SD-WAN solution. With ExtremeCloud IQ, our customers have complete visibility and management of network devices and connected clients throughout the entire enterprise, end-to-end across local and wide area networks. The intelligence and automation tools we bring in our CoPilot license, such as digital twin and AIOps, are game changers. Highlighting the value of our CoPilot solution, one of our customers is on record saying, with CoPilot I'm finding problems in the network that I didn't know existed and now I have readily available solutions that I didn't have without the tool. Both our fabric and cloud solutions stole the show at our oversubscribed sales kickoff event for direct sellers and channel partners where we hosted over 1,000 people in Boston in August. At Extreme, we have a unique focus on finding new ways for our customers to deliver better outcomes, leveraging the most advanced cloud and fabric technologies. During the quarter, 37 customers spent more than $1 million with Extreme. Some of our top wins for the quarter include household names such as the third largest cruise line in the world, where we beat out a large incumbent and we'll be deploying our wired, wireless CloudIQ, and fabric solution, a 4,000-room luxury hotel going up in Las Vegas that will showcase our fabric along with our CloudIQ site engine. The third largest bank in South Korea is deploying our data center switching and fabric to protect sensitive customer information and ensure uninterrupted operations. And the world's third largest energy company based in Europe, a global leader in smart grid technology, added more than 2,000 Extreme access points to our switching solutions and CloudIQ. Our sales productivity continues to run at historically high levels and this will only increase over the next few years given the rightsizing of book-to-bill and the release of backlog. There has never been a better time to be a salesperson at Extreme. And our competitive position has never been stronger. In such a large industry, small share gains have a large impact on Extreme's top line, making us the fastest-growing networking company. Third-party analysts, industry press, and partner community have noticed this, demonstrated by accolades and awards for our solutions and service. For example, this is the fifth year in a row that Extreme was named Gartner's Choice for Wired and Wireless LAN access infrastructure based on peer insights. We achieved subscription bookings growth of 60% and annualized cloud SaaS bookings of close to $190 million exiting Q1. Strong demand for our innovative cloud solutions is also pulling through product sales, and we believe the level of organic subscription growth we're seeing today is sustainable. In addition, the improvement in supply chain and our ability to deliver products, most notably wireless LAN this quarter supported a strong pull-through of software subscription. On the supply chain side, we continue to be laser-focused on tactical execution to meet our customers' needs. Our distributors give us the highest rank in the networking industry for delivering on our commit dates and this is driving demand and has become a source of new customer logos and partners for Extreme. This quarter alone, we qualified an additional 50 component suppliers and reduced our part shortages. Our success in reengineering products has also helped ease constraints. Based on all the actions we've taken with our supply chain over the past year, we now have better visibility and confidence in the ramp of our product deliveries. With a strong outlook for bookings growth and the gradual improvement in supply, we expect to build backlog through the end of the fiscal year. We anticipate neutral book-to-bill or release of backlog in our fiscal Q1 of '24. Once backlog begins to release, it will unlock an accelerated wave of product shipments and revenue growth over multiple quarters. We have complete visibility into our product backlog, the vast majority of which is comprised of orders with current delivery request dates. Our orders are part of essential IT projects that have been carefully designed and planned for customer environments such as stadiums, college campuses, hospitals, and manufacturing facilities. This is why cancellations remain negligible at a fraction of 1%. About half of our backlog consists of the latest-generation universal products that pull through subscription and services. So when our backlog shifts, it will also unleash subscription and maintenance services revenue. Our recently introduced Universal Switch 5720, designed to support products with higher data throughput such as our Wi-Fi 6E access points, will be launching later this year. We also launched new outdoor APs, building on our first-to-market status in Wi-Fi 6E. The transition to universal products continues with nearly 60% of our bookings now on universal platforms for wired and wireless products. Our sales funnel, our AI tools, and our field forecast all point to healthy bookings trends for the next 12 months. This is a combination of Extreme taking market share and the resiliency of cloud-based networking in this environment. I'm excited about the strength and favorable outlook of the networking industry, our growing market share, and gains from larger competitors. Cloud-driven networking has never been more important in our competitive position, with the highest quality cloud in the industry, combined with unique simplicity and security of our Extreme Fabric, has never been more impactful. We're poised for accelerated top line growth and margin increases that will drive unprecedented cash flow and earnings growth in future quarters and years to come. And with that, I'll turn the call over to our CFO, Rémi Thomas.

Rémi Thomas, CFO

Thanks, Ed. Q1 results highlight the strength of execution of our go-to-market and supply chain teams. Our direct sellers and channel partners achieved near record bookings for both products and cloud subscriptions. Our global operations team delivered strong shipments that resulted in record revenue, and we're reaching new milestones for SaaS ARR. At the same time, we improved our margin sequentially and continued to generate strong cash flow. Our first quarter revenue of $297.7 million grew 11% year-over-year and 7% quarter-over-quarter, which was once again above the high end of our expectations entering the quarter. With a product book-to-bill ratio of 1.3 for the quarter, we added $42 million to backlog from the prior quarter. We now have nearly 3 full quarters of product revenue in backlog. Wireless LAN revenue grew sharply on a quarter-over-quarter and year-over-year basis and now accounts for 30% of product revenue due to the loosening supply of access points in the quarter. We grew our SaaS subscription bookings by 60% in Q1, accelerating from the prior quarter's growth rate of 61%. This was fueled by the sequential recovery in our wireless LAN business, which has an extremely high attachment rate of cloud services. Our SaaS ARR grew to $111 million, up from $103 million in Q4 for a growth of 41% year-over-year and 8% quarter-over-quarter. We remain confident in our long-term subscription revenue growth outlook of 35% to 45%. SaaS deferred revenue was $171 million, up 40% year-over-year and 9% quarter-over-quarter. Q1 earnings per share were $0.20 at the high end of our guidance entering the quarter. Revenue on a geographic basis has been impacted by the timing of product shipments to our distributors. With that in mind, the difference in performance between the Americas compared to EMEA and APAC is not a good indicator of demand. Bookings by geography is a better representation of end-user demand. To that point, the Americas reflected the highest growth, up over 20% year-over-year. EMEA grew mid-single digits year-over-year which is a solid performance considering that last year, EMEA had an over 70% growth rate versus the prior year. Finally, APAC bookings also grew mid-single digits, also a good performance considering the strength of last year's bookings. The APAC region was also impacted by currency devaluations which are making our dollar-denominated products more expensive in region, particularly in Japan. Product bookings grew mid- to high single digits from the previous year, with similar performance in our wired and wireless products; campus switching growth outpaced overall product bookings growth for the quarter. From a vertical standpoint, our mix did not change meaningfully during the quarter, with government and education accounting for roughly 40% of the total; manufacturing at about 10%; health care at about 10%; and retail, transportation, and logistics also at about 10%. Services and subscription revenue of $91.4 million in Q1 was up 11% year-over-year. This growth was largely driven by the strength of cloud subscriptions, up 39% year-over-year. Total Q1 recurring revenue, including maintenance, managed services, and subscriptions was at $86.8 million, or 29% of total company revenue on the strength of product revenue. The growth of cloud subscription and service renewals drove the total deferred revenue to $424 million, up 19% from the year-ago quarter and 6% sequentially. Our gross margin came in at 57.6%, up 60 basis points sequentially and down 2.8 percentage points from the year-ago quarter, driven by lower product gross margin. On a sequential basis, the improvement in gross margin is attributed to an improvement in supply chain and freight costs, and offset slightly by changes in the mix of products and services. Services and subscription gross margin of 67.5% grew 3.8 percentage points from the year ago quarter on a higher subscription mix but fell 3.2 percentage points sequentially, driven by higher professional services revenue and slight decline in maintenance. Q1 operating expenses were $135 million, up from $125 million in the year-ago quarter and from $132 million in Q4 '22, reflecting higher R&D expenses and year-over-year increase in sales and marketing to support higher revenue growth. The year-over-year increase in sales and marketing spend relates to the reintroduction of in-person corporate events we hosted in Q1. Total operating expenses as a percentage of revenue overall dropped to 45.4%. All in all, our operating margin was 12.1%, down from 13.8% in the year-ago quarter and up from 9.6% in Q4 of '22. Net debt was reduced by $41 million sequentially to $73.2 million, driven by the strong increase in our EBITDA as well as a reduction in operating working capital, resulting for the most part from strong collections. Our cash conversion cycle dropped by 8 days sequentially and now sits at 19 days. This quarter, we made a principal repayment of $37 million to our Term Loan A, enabling us to reduce our covenant leverage ratio to less than 1.25 and in turn, reduced the carrying interest rate on the loan by 50 basis points. At the current 3-month LIBOR rate, the annual carrying interest rate on our debt will be approximately 5% to 5.5% effective November 9. Now turning to guidance. Our confidence in our outlook is further solidified by $555 million worth of product backlog exiting Q1. For Q2, we expect revenue to be in the range of $299 million to $309 million. Q2 gross margin is anticipated to be in the range of 57.5% to 59.5%. Q2 operating expenses are expected to be in the range of $133 million to $138 million. Q2 earnings are anticipated to be in the range of $28 million to $35 million, or $0.21 to $0.26 per diluted share. We continue to expect that the reduction in expedite and shipping fees, combined with the full impact of our recent pricing actions, will lead to a progressive recovery in gross margin throughout fiscal year '23. So for the year, we expect 10% to 15% revenue growth. For the second half, we expect to cross the 60% gross margin threshold and achieve an operating margin in the mid-teens.

Operator, Operator

Our first question comes from Alex Henderson with Needham. Your line is open.

Alex Henderson, Analyst

Thanks. I’m going to break that a little bit because I wanted to get some clarification on some of the numbers which are just pretty straightforward. Can you give us some guide on the interest line since you obviously have a lot of things moving around in there? And did you say the book-to-bill was 1.3, I’m getting 1.23 when I calculate it.

Ed Meyercord, President and CEO

Product looks to be a little at 1.3, Alex.

Alex Henderson, Analyst

It was 1.3%, okay.

Ed Meyercord, President and CEO

Yes, it was 1.4%. So the average is slightly higher.

Alex Henderson, Analyst

I see, I see. And the interest line?

Ed Meyercord, President and CEO

Hold on, let me just bring that up. It keeps moving with 1-month LIBOR rate. You should assume about $5 million a quarter.

Alex Henderson, Analyst

The LIBOR rate going up 75 basis points this morning impacted you guys or ECB did?

Ed Meyercord, President and CEO

We do the reset on a monthly basis. So today's rate may not necessarily be the one that we'll have after November 9. But currently, it would be 330 plus 125 would be 455 if we use the last 1 month LIBOR reset that we have.

Alex Henderson, Analyst

I have a couple of questions. First, I didn't hear any mention of pricing, and since pricing has increased in the industry, can you discuss your current pricing situation this quarter and your expectations moving forward? Additionally, you mentioned that you believe your backlog will grow by year-end. Are you referring to an increase from the beginning of the fiscal year or from the 555?

Ed Meyercord, President and CEO

Alex, I'll jump in and then, Rémi, you can back me up here. Alex, we expect backlog to increase each quarter throughout the remainder of our fiscal year. So we're expecting increases in December, March, and June.

Alex Henderson, Analyst

Perfect.

Ed Meyercord, President and CEO

As it relates to pricing, we had a very modest and targeted price increase effective October 1. On the bookings side, we did see some pull-ins but it was much more muted than what we had last year. If you recall last year, we had a 12% price increase as of October 1 and that drove significant bookings. Rémi referenced that, over 70% growth in product bookings in EMEA which we were really excited to see that we were able to grow organically on top of that kind of comparable. So in general, we feel like we're in a strong position. Cisco has announced price increases. We remain under their umbrella. And then we've seen our other competitors follow suit. So we like where we are in terms of seeing the price increase in numbers. You'll see the most recent price increase, a small impact this quarter and then a larger impact in the following quarter. Rémi, I don't know if you want to add anything to that.

Rémi Thomas, CFO

I was just going to add that with the exceptions of certain countries where currency devaluations have impacted our ability for our customers to meet their budget, our price increases are holding edge. So we're not having to raise discounts to offset the price increase and so they really translated into an improvement in the overall net selling price of the company.

Alex Henderson, Analyst

So just to be clear, in the quarter, the price benefit was low single digits and you expect it to be what by the fourth quarter or fiscal year?

Ed Meyercord, President and CEO

There was an impact this quarter from the price increase we implemented on April 1. However, we did not experience the effects of the October 1 price increase during the September quarter.

Alex Henderson, Analyst

Clearly. But my point is what was the real impact of price increases in the quarter? Was it a low single digit contribution to your revenue growth or some other number?

Ed Meyercord, President and CEO

Yes, low single digit coming from prior price increases, correct.

Alex Henderson, Analyst

And you expect by the June quarter it will be 5%, 6%, 8%, 1%? What are your expectations for the realization of that when you talk about building backlog through the end of the year and the like?

Ed Meyercord, President and CEO

If discount trends remain unchanged, it would be in the low to mid-single digits.

Alex Henderson, Analyst

Low to mid-single digits. Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Eric Martinuzzi with Lake Street Capital. Your line is open.

Eric Martinuzzi, Analyst

I’m going to assume that's to me. It’s Eric from Lake Street Capital Markets. Just wanted to follow-up on the geographic commentary that you gave. You talked about bookings by geo with the Americas being up 20% and then mid-single digits for EMEA and APAC against a tough comp. Where should we think about that for fiscal year ‘23, given the revenue guide of 10% to 15%. How do you see the bookings growth across geographies for FY ‘23?

Ed Meyercord, President and CEO

Total bookings growth across all geographies and products, services, and subscription is expected to be in the high single digits.

Rémi Thomas, CFO

Okay. And then combined with what's coming off the backlog, that's how we get to the revenue number of business.

Ed Meyercord, President and CEO

I would say, Eric, we expect to grow our backlog throughout the year. Our goal for fiscal year growth is to increase backlog rather than reduce it. I just wanted to clarify that.

Eric Martinuzzi, Analyst

Yes. Regarding the release in gross margins, we're experiencing some relief. You have qualified additional component suppliers, and you have some room on the expedite fee. What I'm really looking for is the main factor driving the expansion of gross margins as we progress from quarter to quarter.

Ed Meyercord, President and CEO

Eric, that would be the reduction in expedite fees based on what we paid to our key suppliers of semiconductors and components as well as the reduction of freight cost, which is still elevated today because most of the products that are produced out of China and Taiwan are shipped by air directly to El Paso, which is our main hub. So the reduction of these two that are currently hurting gross margin is really what's going to drive the improvement over time.

Eric Martinuzzi, Analyst

Got it. Thanks for taking my questions.

Operator, Operator

One moment for our next question. Our next question comes from Paul Silverstein with Cowen. Your line is open.

Paul Silverstein, Analyst

Thank you. I have two questions. First, regarding the macro environment, your commentary suggests things are stable, but I need to inquire. Recently, F5 shared very different insights compared to Juniper. F5 mentioned issues like cancellations, delays, downsizing, and increased budget scrutiny, particularly overseas. Are you experiencing any similar challenges, especially given the foreign exchange and energy price situation in Europe?

Ed Meyercord, President and CEO

Paul, we are closely monitoring the situation and are not observing any issues. We evaluate various factors as we look ahead, focusing on the opportunities in our pipeline, which we review regularly. We also gather feedback from our direct sellers in the field. Additionally, we utilize an AI tool integrated with Salesforce that helps inform our outlook. There are two key aspects to consider. Firstly, the resilience of networking plays a crucial role. One way to combat inflation is through increased productivity, which is driven by advancements in technology and ongoing digital transformation projects, with networking being central to this. We are not witnessing a deprioritization of networking initiatives, and our backlog consists of complex networking systems rather than commodity products. This is why we assert it’s a minimal impact, as we truly do not see significant issues. If enterprise customers are cutting back on spending, they are not reducing their investment in networking but tend to cut other budget items first. Secondly, our relative size is important; we are gaining market share against larger competitors. These small share increases may obscure broader market trends. Our ability to maintain bookings growth, even in challenging markets like EMEA and currency-affected regions in APAC, is evident, and some of this growth comes from market share gains. Moreover, the resilience of these networking initiatives is becoming increasingly strategic for enterprise customers.

Paul Silverstein, Analyst

And I just thought you just pushed through; you’re not even seeing elongated sales cycles.

Ed Meyercord, President and CEO

No, we're not. I would say it's actually the opposite, Paul. If anything, we may see people anticipating lead times and ordering early to establish their position regarding the supply chain. So we're not observing that. In our case, we're asking the questions and staying on top of it. Given everything happening in the world and the news, there is an expectation, and we're quite sensitive to it. What I would say is we're just not seeing it.

Paul Silverstein, Analyst

That raises an important question. I assume the answer is no, but has there been any communication or indication that the supply chain constraints are keeping customers engaged, and that might explain why you and others haven’t experienced any weakness in relation to the macro environment? Again, I assume that's the case for when…

Ed Meyercord, President and CEO

I think it's reasonable to consider that as a factor. For Extreme, the importance of networking initiatives for our enterprise customers is crucial as it supports their digital transformation and productivity efforts, which are integral to their business strategies. We're not observing a decrease in priority for these initiatives. There is a supply chain aspect that you've pointed out, but it goes beyond that. Our narrative is cohesive with our fabric, cloud, and comprehensive enterprise solutions, all of which are gaining recognition in the market. We're encountering more opportunities, partly due to larger competitors providing these avenues because of their fragmented approach to leveraging cloud solutions. They are struggling to create a unified view of their network components across the enterprise and to orchestrate services from a single cloud while securing investments with the latest technology. Currently, we have the strongest story in the marketplace when we combine that with our fabric technology, and it’s resonating well. As a result, we are capturing market share with a distinct narrative, and it seems we're benefitting from the challenges faced by some of our bigger competitors.

Paul Silverstein, Analyst

One last question on this. Ed, correct me if I’m wrong. Historically, when there were downturns, especially significant downturns, the typical customer behavior in that environment had been to stay with the incumbent and not to switch vendors. It was only in better environments when they were more willing by away from whoever their increament was HP, Cisco level. Do I have that right?

Ed Meyercord, President and CEO

I'm not sure I can validate that for you, Paul. What we're seeing in this environment may be the opposite. The supply chain strategies of some larger players are creating opportunities for us, especially among our enterprise customers. There's also a lack of a cohesive solution for customers, making it very expensive for them. In fact, staying with some of the legacy larger vendors is almost riskier due to the absence of a comprehensive end-to-end strategy, particularly regarding the cloud. This situation is generating more opportunities for us rather than fewer, which might differ from what you've seen in previous significant downturns in the market.

Operator, Operator

One moment for our next question. Our next question comes from Mike Genovese with Rosenblatt Securities. Your line is open.

Mike Genovese, Analyst

Great. Thanks. So, guys, really good report. I mean, I don’t see anything not great here except for, I guess, the gross margins you're building up sequentially, the gross margin was in the quarter and the guide were just very slightly less than what we were looking for. And I guess my question is, is that more a function of the supply chain and expedite fees? Or is that more of a function of the mix shift to wireless? And where do we think that’s going to look like in future quarters, particularly in the back half of the year? Do we expect a mix shift away from wireless? Or will that ground for a while?

Ed Meyercord, President and CEO

I would say that the latter because the amount of expedite fees and the freight costs that we paid in the quarter were in line with our expectations. The shift to wireless was more pronounced than we expected entering the quarter, and that's really what drove the difference between the 57.6 that we reported and the 58 that we were getting for at the start of the quarter.

Mike Genovese, Analyst

And do we think the mix will change? I think that happened last quarter too. So is this kind of the two quarter...

Rémi Thomas, CFO

The loosening of the supply chain combined with the historical very high level of backlog for wireless products means that, that the 30%-70%, 30% wireless 70% wired is going to stay for the next few quarters. However, the reason we mentioned in our introductory comments that we feel confident we can cross the 60% gross margin mark is that we now have visibility as to the reduction of expedite fees and freight costs. So although that mix is not going to change, we do see progressive reduction in expedite fees and freight costs that will drive a higher gross margin, especially in the second half when we expected higher volumes of shipments that lead to a better absorption of the fixed costs that are in our cost of goods sold.

Ed Meyercord, President and CEO

Rémi, I can add one other variable here which is if you recall a year ago, we did not have these direct relationships with secondary and tertiary component vendors. And today we do; we meet regularly and we have confidence in what they're delivering because they are delivering on what they say they're going to deliver. And they've given us the commitment of the ramp. When we don't have the direct commitment and we're not getting the shipments, we also have to go out in the secondary markets to find product. And so that also leads to increased prices when we're having to go out and buy components in the secondary market. So as we have and we see the commit from the secondary and tertiary component vendors step up, this is what's giving us the confidence in the forecast. At the same time, it will reduce our reliance on secondary markets where we're paying up, also the expedite fees that Rémi is talking about as well as the freight components.

Mike Genovese, Analyst

Okay. Great. I thought you provided a clear answer regarding Europe, indicating that there is no macro weakness there. However, you did mention some currency-related weaknesses in the Asia Pacific region in your prepared remarks. Is that the macro effect you're experiencing? What do you believe the solution to that is? Is it related to customers' willingness to pay, expectations about currency changes, or is there any consideration for repricing the backlog if the situation worsens? I'd appreciate your thoughts on these matters.

Ed Meyercord, President and CEO

Yes. I would say, Mike, I would say it's less of an issue with backlog. It's more of an issue with new bookings and a timing issue on these important projects. I mean, I'll reiterate that networking projects are underpinning the really important initiatives. And there's not really another alternative for them other than a timing decision. And in that market, I will say we have upgraded our team significantly. We are excited about the team and new channel relationships that we have, more than any other market in the world we have smallest markets there in that market. So the opportunity to take share, small little share bites in that market can help us offset the reticence of certain buyers, particularly in Japan, for example, where they've seen a currency devaluation of 40%. So that's at the high level. Rémi, I don't know if you want to add anything to that.

Rémi Thomas, CFO

No, I just want to say that for deals that we deem to be strategic if the customer is struggling basically to meet their budget, given the currency devaluation, it's a question for us of do we want to leave that deal or go ahead and grab it. And so in certain specific deals that are strategic to us, we're willing to be slightly more aggressive to meet the customers' budget requirements and take the deal up the street.

Mike Genovese, Analyst

Okay. Fantastic. Last question. I know I’m going to ask the same, I guess, numbers that everybody asked. But fiscal ‘24, I guess, where we’re still looking, I just want to confirm, first of all, that we’re still looking for acceleration in the 13% to 17% revenue growth. But I guess we would expect the book-to-bill to be below 1 that year because we're releasing so much backlog but I don’t know if you can see this far out. But kind of sequentially year-over-year, ‘24 orders versus ‘23 orders, do you think that they could be flat to up? Or do you think that they’ll be down? If you can have any view this early on that?

Ed Meyercord, President and CEO

Well, Mike, I'll start by saying that we have a strong focus on our sales funnel, analyzing each opportunity from the ground up by region and involving our regional directors, who are attentive to details at the account executive level. We also conduct separate partner forecasts during our quarterly business reviews with our partners. All of this information comes together to inform our outlook for the next 12 months. We're observing very healthy, organic demand for bookings year-over-year based on our funnel. We anticipate this trend will continue without any current signs of a slowdown. As we prepare for fiscal '24, we expect ongoing growth in demand and bookings, along with a releveling of the book-to-bill ratio. It's important to note that not all of our revenue is being recognized yet since we are still building our backlog this year. Thus, we expect to benefit from the normalization of the book-to-bill ratio in line with current demand levels and the release of backlog, which currently represents three quarters' worth. We believe this backlog will continue to grow. So, as we head into fiscal '21, that's our best estimate at this moment. We do expect to see the book-to-bill ratio drop below 1, but this will significantly contribute to revenue growth.

Rémi Thomas, CFO

And our current working assumption, Mike, is that top line will grow between 15% and 17% next year.

Mike Genovese, Analyst

Great. Well, congratulations on the results and the momentum and keep up the great work.

Ed Meyercord, President and CEO

Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Dave Kang with B. Riley. Your line is open.

Dave Kang, Analyst

Hi, thank you. Good morning. Can you repeat the backlog mix between wired and wireless?

Rémi Thomas, CFO

We have not split the backlog between wired and wireless, Dave. The comment I made, the 30%-70% was for revenue this quarter. And just to give you an idea, a year ago it was 21%-79%. So on a year-over-year basis, there's been a dramatic shift in the wired to wireless revenue ratio. But we're not communicating the split. I did mention that there's a significant amount of backlog for wireless but I didn't give a percentage.

Dave Kang, Analyst

Got it. And then in your presentation I noticed that regarding the verticals, there are no plus and minus signs. Can you kind of go over those key verticals, what you’re seeing and whether it’s a plus or somewhat turning equal or negative?

Rémi Thomas, CFO

Yes, we haven't observed any significant changes in the distribution of total bookings. The primary segments, which include government, education, healthcare, manufacturing, retail, transportation, and logistics, continue to represent a consistent percentage. There was a sequential uptick in our bookings in sports and entertainment, primarily due to a lower performance in Q4, leading to a notable recovery. However, we are not witnessing any major trends. Funding in education and government remains strong, and the healthcare sector is also performing well. Although one might expect a slowdown in manufacturing due to the economic climate, it has remained resilient, with year-over-year bookings in manufacturing showing double-digit growth. Likewise, retail, transportation, and logistics are also experiencing healthy trends, despite potential vulnerabilities to economic changes.

Dave Kang, Analyst

Got it. And then I may have missed this but then did you talk about the supply chain impact on your margins? I think last quarter it was about 600 bps. What was it this quarter?

Rémi Thomas, CFO

So the comment I made about 600 bps is I was comparing the purchase price variance that we pay which really are expedite fees and us going out to the secondary market, as Ed mentioned. And I was adding that with the freight costs and comparing it to fiscal '21. We're not really breaking it down by quarter but just to give you an indication, purchase price variance, which really reflects those expedite fees, have reached an elevated amount of about $15 million per quarter. They're back to $11 million. So there's a $4 million improvement there. As far as freight costs are concerned, they just roughly are expected to improve by $1 million in Q2 versus Q1. So if you think of the improvement that we're seeing today, it's about $5 million overall versus the peak that we reached at one point in time. And then you can divide that $5 million by the revenue this quarter of $297.7 million to get a feel for the improvement that we're seeing in gross margin as a percentage of revenue.

Dave Kang, Analyst

Got it. And my last question is on seasonality. I mean, typically I think in the past, fiscal first quarter is seasonally weak versus the second quarter, and yet you grew about 7% sequentially in the first quarter and you’re only guiding to about 2% sequential growth in second quarter. Just wondering how much of that is conservatism versus is there something else that we are missing?

Rémi Thomas, CFO

And that's purely driven by supply chain. We get weekly reads from my supply chain teams as to what they're able to ship this quarter. The services and subscription revenue, as you can imagine, is largely coming off the balance sheet from deferred revenue that's sitting there, and that 2% sequential growth that we're guiding for is based on these 2 factors. And we don't feel like we've been particularly conservative. We try to be as accurate as possible.

Dave Kang, Analyst

Got it. Thank you.

Operator, Operator

One moment for our next question. Our next question comes from Christian Schwab with Craig-Hallum. Your line is open.

Christian Schwab, Analyst

Congratulations on the excellent results. Rémi, when do you expect the backlog to normalize? I understand there are various components, and although some areas of silicon might be becoming available, others are still constrained. Are we likely to continue with a larger backlog, or do you think it will return to historical levels? Do you believe that might not happen until we have full access to or an oversupply of semiconductor components?

Rémi Thomas, CFO

Christian, I'll let Ed add his thoughts since we are both closely involved in this topic. We believe that fiscal '26 will be when things return to normal. We anticipate our backlog will be between $50 million and $100 million at that time. However, given the current trends in the semiconductor industry, including the addition of new capacity and some major semiconductor manufacturers adjusting their plans, we also expect to see a decline in demand from other industry segments that are significant consumers of chipsets and are currently experiencing slower demand. These combined factors indicate that it will take a while for things to return to normal. Based on our delivery schedules, we estimate that it will take about two fiscal years — with what remains of fiscal '23, followed by fiscal '24 and fiscal '25 — before we might see our backlog drop below $100 million at the beginning of fiscal '26. That's our current outlook.

Christian Schwab, Analyst

Fantastic. No other questions. Thank you.

Operator, Operator

One moment for our next question. Our next question is the follow-up from Alex Henderson with Needham. Your line is open.

Alex Henderson, Analyst

Great. Thanks. So in looking at the mix assumptions through to the fourth quarter and thinking about your gross margins, can you talk a little bit about the impact on gross margins of; one, the fall of expedite fees and costs associated with the procurement. Two, the mix to Universal and the impact that, that has versus your historical products, where I think the margins are quite a bit better. And then third, what kind of improvements you’re getting off of the redesign process? How do we allocate between those various factors, the improvement in margins?

Rémi Thomas, CFO

I'm hesitant to go into that level of detail. However, I believe the combination of the factors you mentioned should lead to an improvement in gross margin for products of about 1 to 1.5 percentage points in Q2 compared to Q1, and then in Q3 compared to Q2. Overall, these three factors together are expected to drive an improvement of approximately 2 percentage points. For Q4 compared to Q1, we are looking at about 1 percentage point. One aspect that hasn't been mentioned is the mix of professional services versus subscriptions and classic services, with classic services referring to maintenance in Q1, which lowered our services gross margin to 67.5% from 70.7% in Q4 of fiscal '22. We anticipate that the services and subscription gross margin will return to 68.5% by Q4 because we will not experience the same level of professional services, which were primarily related to MLB deployment.

Alex Henderson, Analyst

I wanted to ask about the revenue growth rate guidance for FY '23. Can you provide some details on the implied growth in the product line compared to the services line in that guidance assumption?

Rémi Thomas, CFO

Yes. We expect both services and subscriptions to grow at around 11%. In Q2, we anticipate product growth to be closer to 10%, while services and subscriptions will be in the mid- to high single digits. In Q3, we expect growth in services and subscriptions to surpass that of products based on our current delivery plans. By Q4, we anticipate a significant improvement in the supply chain, leading to strong growth in products, while services and subscriptions will also be close to 10% growth.

Alex Henderson, Analyst

That’s very helpful. And then so I guess in as we move out into ‘24, the product would continue to be much higher based off of the fact that you’re getting meaningful improvement in supply availability. Is that the right logic?

Rémi Thomas, CFO

That's correct. And then services and subscription continues to grow at a steady rate of anywhere between 8% and 10% depending on the quarters.

Alex Henderson, Analyst

What are you factoring in, in terms of Broadcom price increases I’ve heard that they’re going to increase pricing in the January timeframe. Does that show up in that quarter? Or does that show up with some delay? How do we think about their price increases?

Rémi Thomas, CFO

We're basically today placing orders with Broadcom a year in advance in order for us to secure the current pricing.

Alex Henderson, Analyst

You would be protected for a considerable amount of time because of that advanced procurement. That's really interesting. I wouldn’t have expected that. The other question…

Rémi Thomas, CFO

The other thing to mention is that in addition to list price and price increases, there are expedite fees. And one of the things that we see happen with Broadcom and some of this has to do with our relationship with them. Some of the price increases will be mitigated by a reduction in expedite fees.

Alex Henderson, Analyst

Right, right. The other question I had is on the decommits comments you made, it sounded like decommits are declining but still happening. Is that accurate? Or have the decommits basically stopped at this point?

Rémi Thomas, CFO

Alex, decommits are a normal aspect of our business. These are isolated incidents. I can assure you that we thoroughly examine each decommit situation, and there is no consistent pattern to them. For instance, a government agency may have a budget they need to use by the end of the year, leading them to reprioritize their spending and possibly cancel an order, which might then carry over into the next year's budget. While you could loosely associate these with supply chain issues, they are primarily isolated occurrences. We are not observing any significant change in these isolated cases, and they continue to represent a small fraction of our overall operations.

Ed Meyercord, President and CEO

Alex, was your question on decommits related to customers or suppliers?

Operator, Operator

His line actually left the queue. So we're going to move on to our last question. Our next question comes from Paul Silverstein with Cowen. Your line is open.

Paul Silverstein, Analyst

And Rémi, I apologize if I missed it but can you give us an update on the Arsen relationship and what you’re seeing with respect to future revenue outlook and current revenue contribution from that product?

Rémi Thomas, CFO

I will actually let Ed comment on that.

Ed Meyercord, President and CEO

Paul, we have a strong relationship with them. We recently met with senior leadership in Stockholm. We are in a very good position with that account. Additionally, C&IS is largely driven by 5G rollouts from carriers, each of which is at a different stage of its lifecycle. We're seeing some of the larger carriers transition from proof of concept to deployment phases. This is exciting for us because we are the sole source vendor for that application, which we expect to roll out over the next five-plus years. We are also exploring other longer-term opportunities with Ericsson, but there are new growth avenues within that account.

Paul Silverstein, Analyst

Ed, on the 5G products in general, because I believe you’ve referenced another relationship previously with a specific carrier. What’s the current revenue run rate from that and what’s the potential going forward?

Ed Meyercord, President and CEO

I don't know what we've disclosed. Rémi, I'll rely on you for information about what we've communicated regarding the service provider. We have two significant relationships that Paul mentioned, along with additional service provider customers that are less strategic but still part of that category. In terms of direct service provider accounts, we see a significant opportunity, not just with sell-to and supporting their 4G and 5G back office but also with carpeted enterprises. We collaborate on stadium deployments as well, and we've recently been approved for their enterprise teams to sell Extreme, meet quota, and earn commissions. Our sellers are actively working alongside their sellers, which represents a new growth opportunity with that account. From the service provider side, we see new opportunities with a Swedish company as well as additional growth potential within a large U.S. carrier.

Rémi Thomas, CFO

Ed, we haven't really communicated but we did mention that both of them were several tens of million dollars in annual bookings. And I can say that the combination of these 2 is between $50 million and $100 million in annual bookings.

Paul Silverstein, Analyst

Okay. Thanks, guys.

Ed Meyercord, President and CEO

Thank you.

Operator, Operator

And I'd like to turn the call back over to Ed for any closing remarks.

Ed Meyercord, President and CEO

Thank you for the great questions. We appreciate everyone's participation in the call and the engagement from analysts and attendees. It was a strong quarter for us at Extreme, and I am proud of the execution from all our teams as well as our partnership with the channel community. We have significant momentum and are gaining market share. Our improved supply chain visibility is enhancing our confidence in our future outlook. It’s a great time to be at Extreme for our employees, partners, customers, and investors. We have upcoming investor conferences with Needham, Raymond James, Oppenheimer, and Cowen, and we encourage participation. We look forward to connecting with everyone and sharing our story in more detail. Thank you, and have a great day.

Operator, Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.