Good day, ladies and gentlemen. Welcome to the Extreme Networks second quarter fiscal year 2019 financial results call. At this time, all participants are in listen only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require assistance during the conference, please press star then zero to speak with an operator. As a reminder, this call is being recorded. I would now like to turn the call over to Stan Kovler. You may begin.
Thank you, operator. Welcome to the Extreme Networks second quarter fiscal 2019 earnings conference call. I am Stan Kovler, Executive Director of Investor Relations. With me today are Extreme Networks President and CEO, Ed Meyercord, CFO, Rémi Thomas, and VP of Finance, Matt Cleaver. We just distributed a press release and filed an 8-K detailing Extreme Networks' second quarter fiscal 2019 financial results. For your convenience, a copy of the press release, which includes our GAAP to non-GAAP reconciliations and our fiscal 2019 Q2 financial results presentation and CFO commentary, are both 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 Networks' future business and financial results, products, operations, pricing, and digital transformation initiatives.
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 reports filed with the SEC. For 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.
Thank you, Stan. Thank you all for joining us this morning. Welcome to our fiscal Q2 earnings call. Today, we announced Q2 results that were better than expected, highlighted by 9% year-over-year and 5% quarter-over-quarter growth in total revenue to $252.7 million and non-GAAP earnings of $0.13 per share. Our gross margin was the highest in three quarters. We repurchased $15 million worth of our shares during the quarter. From a bookings perspective, we grew year-over-year and quarter-over-quarter across all our solutions pillars and in all our key industry verticals. We continue to win large deals as customers embrace a broader set of our solutions. During the quarter, we had 18 deals over $1 million representing software, products and services across our solutions pillars.
We're growing our total pipeline of large opportunities globally, our total cross-sell pipeline for the next four quarters grew sequentially once again. I recently came back from meetings with our teams in Asia, where growth has been driven by larger deal sizes and software-driven solution selling. APJC revenue grew 13% year-over-year and 28% quarter-over-quarter. In the EMEA region, from a competitive standpoint, we believe our story and our product portfolio are resonating well with European customers. European governments are also placing greater scrutiny on the security concerns around Huawei products, which is creating an opportunity for us in the marketplace. We are a trusted provider to many European customers, and our secure Automated Campus products and various software applications are resonating well in this context.
As a result, our revenue in EMEA grew 26% year-over-year and 22% quarter-over-quarter in fiscal Q2, our pipeline continues to build. In the Americas, we saw a nice rebound in our service provider vertical and continued growth in our healthcare, transportation, logistics, and higher ed verticals. Overall, the revenue for Americas was negatively impacted by distributor consolidation and softness in the K-12 market. We made key hires to enhance our service provider team and new leadership in our federal team that will strengthen our coverage model for these key verticals. Both in our data center business and our Automated Campus grew sequentially slightly ahead of expectations. Our sales teams continue to lead with differentiated software for applications such as management, control, and analytics that can manage both Extreme and third-party networking products. Growth in software and cloud-based applications accelerated in the quarter.
We posted another quarter of record service bookings with improvement in our attach rate and growing contribution of multi-year agreements. We increased our overall services backlog, that bodes well for service revenue growth in the future. Our team has done an excellent job of mitigating the risks of the trade uncertainty between the U.S. and China. In response to the 10% tariff increase in September, which affects most of our hardware products, we implemented price increases on November 1st. As we previously announced, we moved aggressively to move manufacturing to Taiwan and expect 80% of our products that ship into the U.S. to be exempt from this tariff at the end of March. In addition, we benefited from approximately $5 million of forward customer buying during the quarter that came in from Q3. Last week, we launched our first 802.11ax or Wi-Fi 6 products.
Customer momentum is building as we have a unique set of high-density Wi-Fi customers who are looking forward to this and additional solutions that we expect to launch throughout calendar 2019. We are also the first to market with machine learning capabilities on our APs for RF management and artificial intelligence tools that will allow customers to auto-tune their networks without human intervention. Software programmable radios, upgraded security, and integration with our full software suite of analytics, location, and guest, augmented by our AirDefense wireless intrusion prevention system, creates a truly differentiated and first-to-market solution for customers ranging from stadiums to enterprises. We already have pre-orders for our Wi-Fi 6 products that will be generally available in April.
In November, we launched new Agile Data Center products as we expected, covering the solutions such as border routing, Layer 2 Exchange, data center interconnect, and full XMC management integration for a single pane of glass visibility. Looking ahead for the rest of calendar 2019, we have a multitude of new products coming to market that we believe will drive growth in revenue and margin from our expanded and upgraded product and software portfolio. We are very excited to share many of our new innovations at our Extreme Connect conference in May. This quarter, we had several exciting wins. A division of a large European auto manufacturer had a requirement for a secure networking solution with future-proof technical capabilities in their assembly plants. The customer implemented our Fabric Connect solutions based on features, security, support, and differentiated technology, despite a much lower competitive bid from Huawei.
The city of Memphis, Tennessee, is using our Automated Campus and XMC management and analytics software as the basis of its smart city implementation for surveillance and digital transformation of the city and its infrastructure. Memphis valued the ease of use of our solution and the hyper-segmentation features it offers to create distinct networks for its community center, public safety, and transportation departments. We built on our strength in the sports and entertainment space with wins at MetLife Stadium, home of the Jets and Giants, University of Pittsburgh Athletics, and the Chicago Cubs, among others, with our Smart OmniEdge portfolio with strong attach rates of our mobility, analytics, control, and cloud software. Our momentum in this vertical continues to build globally as our teams in EMEA and Asia are winning with our differentiated solutions and strong customer references like the NFL.
The launch of Wi-Fi 6 products will only accelerate this trend. In the higher education space, the University of Central Arkansas required a strong, secure network infrastructure to fully support its plans for its Arkansas Coding Academy and to achieve their goal of being a technology-first university. UCA selected our Automated Campus solutions, including Fabric Connect and ExtremeCloud Appliance, to implement a complete networking solution for their campus of 124 buildings for over 11,000 students. Extreme management control and analytics software have streamlined network management for UCA IT team, substantially reducing the potential for human errors. Industry analysts are telling us they are recommending Extreme to their clients based on our software, support, and ease of use. Our differentiation means our true single pane of glass visibility and control software that our largest competitors simply can't replicate.
In November, Extreme was named Gartner Peer Insights Customers Choice for wired and wireless LAN and data center, highlighting our number one position in customer service. Our investment in sales enablement and digital transformation is making it easier for our customers and partners to do business with us. We continue to execute on this plan to modernize our go-to-market infrastructure and drive sales productivity. This quarter, we have improved demand, supply, and inventory planning for the entire product portfolio. We started to roll out new automation tools to our field to improve time to market for quotes and pricing. We upgraded a number of our internal systems, ranging from finance to HR. Looking ahead, we expect fiscal Q3 revenue to be consistent with fiscal Q2, despite a seasonally weak March quarter and the $5 million of forward buying from Q3 that came into Q2.
We expect revenue to be in the range of $247 million-$257 million, and gross margins to be consistent with Q2. Our gross margin outlook assumes approximately 1% negative impact from transitioning our manufacturing to Taiwan. The resulting expected EPS outlook is in the $0.06-$0.13 range. Given some macro concerns investors have about a slowdown in the Chinese economy, I do want to point out that our exposure to China is quite limited at less than 1% of our revenue. Given our vertical customer exposure, I also don't believe many of our largest customers have passed through exposure to China, such as higher ed, healthcare, retail, government, and manufacturing. Our balance among verticals and geos allows us to diversify our risk, as we are not overly reliant on region or vertical, as evidenced by the strength of our international business this quarter.
With that, I will turn the call over to our new CFO, Rémi Thomas.
Thanks, Ed. As Ed noted, our revenues of $252.7 million grew 9% year-over-year. 5% quarter-over-quarter and exceeded the high end of our guidance. Earnings per share of $0.13 was also at the high end of our guidance range. EPS benefited from similar gross margin with fiscal Q1, but better operating leverage. Our product revenue of $189.6 million grew 8% year-over-year and 7% quarter-over-quarter. This also reflects the distributor consolidation actions and data center business outlook we previously noted. To that end, we reduced the number of distributors by another 10% in Q2, and will continue to execute on our consolidation plans as previously outlined. Our services revenue of $63.1 million were 12% year-over-year and 2% quarter-over-quarter.
Attach rates and renewals continued to improve during the quarter, and we're seeing increased traction with multi-year offerings under Premier Services we rolled out last quarter. During the quarter, the Americas contributed 45% to total revenue, EMEA 44%, and APAC closed out the remaining 11%. EMEA remain our fastest-growing market, where we see customers embracing our differentiated product portfolio very effectively. Globally, government was once again our top-performing vertical for the third consecutive quarter. This includes both state, local, and federal governments, both in the U.S. and internationally. The next largest verticals were education, manufacturing, service provider, and healthcare to finish out the top five. Non-GAAP gross margin was 58.2% compared to 59.4% in the year-ago quarter, and up slightly from 58% in Q1.
Our gross margin was the highest in the last three quarters, despite headwinds from higher component costs and tariffs that more than offset the price actions we took in our portfolio on November 1st. We estimate that tariffs had a negative impact of approximately one percentage point to total gross margin in Q2. Our non-GAAP product gross margin of 57% compares to 59.4% in the year-ago quarter and 56.8% in Q1. Q2 non-GAAP operating expenses of $126.6 million were up from $117 million in the year-ago quarter and from $125.3 million in Q1, increasing at a slower rate than revenue. The sequential increase in non-GAAP operating expense was mainly due to the higher R&D spending as we continue to focus on new product developments and product introductions.
On a year-over-year basis, the increase in our operating expenses resulted primarily from the first-time consolidation of the acquired data center assets over the full quarter. As a result, operating margin of 8% compares to 8.8% in the year-ago quarter and 5.8% in Q1. Free cash flow of $23.6 million compared to use of cash of $10.3 million in the year-ago quarter. Year to date, we generated $15 million in free cash flow compared to less than $1 million in the first half of 2018, which is driven by improved collections and working capital.
We expect continued strong cash flow generation into the second half of our fiscal year, even as we continue to make capital investments in our own digital transformation. Our total cash and cash equivalent balance at the end of September was $140.6 million. Sorry, end of December, up slightly from $140.2 million at the end of September.
We repurchased $15 million worth of our stock at an average price of $6.33 a share. DSO of 53 days, down 16 days year-over-year and 10 days quarter-over-quarter. The substantial year-over-year decrease reflects our shift away from the TSA we were on for the period that immediately followed the acquisitions of the Fabric Connect and data center businesses last year. On a sequential basis, the strong linearity I referenced in our earnings release is what drove DSO lower. We also made significant progress in growing our deferred revenues to $186 million from $152.4 million in the year-ago quarter and $183.6 million in Q1 on growth of service bookings, including multiyear renewal offerings and higher software attach rates. Now, turning to guidance.
I want to remind investors that this outlook factors in the $5 million worth of forward buying from customers Ed mentioned that we would have expected for Q3. With that in mind, we expect total Q3 revenue to be in the range of $247 million- $257 million. Q3 GAAP gross margin is anticipated to be in the range of 55.2%- 57.3%, and non-GAAP gross margin in the range of 57.5%- 59.5%. We estimate that tariffs will continue to have up to a negative 100 basis point impact on our overall gross margin for Q3 2019. Overall, we expect our pricing actions will be neutral to accretive related to the slightly lower gross margin outlook we provided. Q3 operating expenses are expected to be in the range of $139.7 million- $143 million on a GAAP basis-
$129.9 million-$ 133.2 million on a non-GAAP basis. The sequential increase in OpEx is primarily related to payroll and variable compensation costs. Q3 GAAP earnings is expected to be in the range of a net loss of $8.3 million to a net income of $0.7 million, or a loss of $0.07 to a net income of $0.01 a share. Non-GAAP net income is expected to be in the range of $7.2 million-$14.9 million, or $0.06-$0.13 per diluted share. In Q3, we expect average shares outstanding to be approximately 117.1 million on a GAAP basis and 119.6 million on a non-GAAP basis, excluding the impact of any shares we may repurchase. With that, I would like to now turn it over to the operator and begin the question and answer session.
Ladies and gentlemen, if you'd like to ask a question, please press star then one. If your question has been answered, and you'd like to remove yourself from the queue, you may press the pound key. Once again, to ask a question, please press star then one. Our first question comes from Alex Henderson of Needham. Your line is open.
Hey, guys. There was a couple of pieces that you talked about in the prepared remarks that seem like they're somewhat countervailing. You said on the one hand that in the most recent quarter, you added 1% impact from the tariffs, but then you said in the upcoming quarter, you're expecting to have 80% of that production move to Taiwan, which should fall out. As I look past the current quarter into the June quarter, do I take 80% of the hit from the tariffs plus the 1% hit from the manufacturing move, so I'm improving by 180 basis points? Is that the right way to think about that?
Hey, Alex. Yeah, this is Ed. I think the way to think about it is that we still have the impact of the tariffs. Obviously, we're going to have that in the March quarter. We also have the benefit of the price increase in the March quarter. We are experiencing incremental costs of the manufacturing shifts, and that's going to happen at the end of March. We're not going to have the benefit of the shift of supply chain and products coming from Taiwan versus China until Q4. That's when we would expect to receive that benefit. We're guiding that if the midpoint is a 58.5% gross margin range, we think there's a point attributed to that. You can add that point. We have other benefits occurring in Q4, and our expectation is to guide over 60% in our fourth quarter.
Just to reiterate what I had said before. If I take the currency, excuse me, the tariff impact 1%, which persists into the March quarter, I lose 80% of that because you'll have production moved. In the June quarter, that falls out, right?
That's right. That falls out.
In addition to that, I'm absorbing 1% impact to cost of goods sold for the move. That falls out.
That's correct. There is an offsetting item, which is the fact that costs in Taiwan are more expensive than costs in China. Overall, we're expecting a 5.5% increase in our cost for products coming in from Taiwan. When you consider that will provide some offset. Keep in mind, there will be 20% of our products that will still come from China, and we'll be phasing those out through the September timeframe. We have to be ready to react to what happens with the Trump administration and negotiations with the Chinese government over tariffs and what happens. We're ready to respond. Fortunately, now our team is nimble. We're practiced in this because we've just been through the exercise. Depending on what comes out, we'll react and either react with more pricing initiatives or not, depending on what happens.
We wanted to mitigate the risk of China altogether by shifting to Taiwan. The shift to Taiwan, even though we have a 5%, 5.5% incremental cost on the products, that's obviously less than the 10% cost we have with the tariffs coming from products in China.
Understand. The second question I wanted to ask you is on the pricing initiative. It's my understanding you put it in November 1st, it wasn't immediately effective on all products at that point. There was a portion of your business that was grandfathered as a result of deals that were in the pipeline. I guess the question is, what percentage of the price increase actually shows up in the December quarter versus how much of an increase will it represent to pricing in the full March quarter? 1% or 2% out of the 7% total?
Well, Alex, I guess what I would say is that's really the point. It's that timing differential of September 24, 10% tariff effective immediately. We have to provide 30 days notice. November 1st, our pricing takes effect. Meanwhile, we had great linearity in the quarter where normally we have a small percentage of our orders that would come in in that first month, and we had close to 40% of orders in that first month. It was a bit lopsided, and that timing differential is what caused that margin headwind during the quarter.
I understand on the margin side. I think I've got that calibrated. What I'm trying to figure out is on the revenue side. Obviously, if you had a 7% price increase, you had, what, 1% or 2% of that actually accrue in the December quarter, and then another 5% sequentially? Is that the right mechanics?
I think you could think about it that way, but I think you also have to realize that we put 7% in the U.S., we put 5% rest of world. Given the fact that it's roughly 50/50, I guess you could average that out and say 6%. I think you have to consider the discounting behaviors in the field. When we raised price rest of world, there was some confusion as to why are we raising price rest of world when the tariffs only affect the U.S. We needed to recover years and years of component cost increase on our products, and we decided to do it all at the same time. Discounting behavior has to be managed, and that's deal by deal. As you know, all of our deals have discount authorizations.
The other thing that we have is we have frame contracts, let's just say roughly 15% of our revenue, where they have long-term pricing contracts where we can't adjust price. That's also somewhat of a limiting factor. I guess what I'm saying is that there's a lot of different variables that enter into the equation, and we have to manage that. We also have to take care of customers, where we may have been negotiating a deal for a long time and the price lands outside of the pricing window and they want a higher discount. Those we view as more near-term pressures. Over the long term, we expect our discounting to return to normal levels, and that's really where we're going to see the benefit. We really expect to see that pop in Q4.
Okay. One more question, if I could. The distribution consolidation, obviously there was an impact to that during the period. Where were you? I think you were at 250, supposed to be down to 200 by the end of the year. If I remember correctly, 150 distributors or VARs by the June quarter. Where are you on that, and what was the impact of that?
Yeah, we beat that at the end of the year. We were down to 180. The impact of that, it affects the book to bill ratio. It was heavier in this quarter in the United States. At this point, we're feeling like we're pretty close to complete. If you look at our top 10 distributors, that's roughly 85% of the products that flow through distribution. At this stage of the game, we feel like our teams have done a really good job of that, and we're almost at the finish line.
You do sell-in recognition of revenue, and you said you were going to be bringing down inventories at the discontinued players. Did that have an impact on your sales?
Yes. That had an impact on our sales, certainly for the second quarter where the bookings number would be higher than the revenue number that we report. That was the case.
Can you quantify it?
We haven't provided quantification to that, Alex, and a lot of that is just because of there are a lot of different moving pieces globally with all of those distributors, and I guess we don't really want to get caught up in the minutia of diving into all of the different components. Book to bill in the second quarter was definitely over one.
Okay. I will cede the floor. Thank you.
Okay. Thanks.
Our next question comes from Mark Kelleher of D.A. Davidson. Your line is open.
Great. Thanks for taking the questions. Before we get too far away from gross margins, I wanted to go back to that a little bit. Can you just talk about the impact of different product categories, the product mix within gross margin? There was an issue a couple quarters ago with some Brocade, some core switch headwinds to gross margin. Can you just talk about where we stand on that?
We're really pleased at what we're seeing in the gross margins of the acquired portfolios. If you look at the data center a year ago, I think you'll recall when we first brought on the SLX assets from Brocade, there was heavy discounting in the field and gross margins were a lot less than we had anticipated. We're really pleased to see the recovery of gross margin there. I mentioned in my comments that we've come out and we've updated our Agile Data Center products. We came out with border routers. We've seen success with Layer 2 Exchange, data center Interconnect. We're at the early stages of migrating these customers to our new SLX platform. There's still somewhat of a drag there from the older product portfolio.
As we move to the new SLX platform and we build out the use cases for SLX, we're going to see continued margin improvement along those product lines. The same with Avaya Fabric and their campus solution. That has been a bright spot. I know we're not technically reporting on Avaya as an entity, and we're looking more as our campus fabric, but that business is now up over our acquisition expectations from a quarterly revenue run rate, and those margins are up a full 10 percentage points. From that standpoint, that's really a driver of the cross-sell pipeline. On that side, we're feeling very good as well. The improved margins on the acquisitions and really the improved margins across the product portfolio is what's going to take us to the 60% gross margin in Q4.
Okay. That's helpful. You mentioned that the K-12 was still a headwind over on the wireless side. Is that a big headwind? How's the wireless doing? There's some thought that we might be approaching a refresh cycle on those K-12.
Yeah, the wireless is up, and interestingly for us, education for us as a vertical was up overall because of the strength in higher education. The K-12 vertical for us is sensitive to E-Rate, and as you may recall, last year was a rather weak E-Rate spending cycle. This year, we're expecting the opposite, a stronger E-Rate cycle, and we'll find out at the end of March how we do with the next round. The weakness in K-12 is still largely a result of that funding cycle that goes back to last March. We are expecting that to pick up. Wireless as a percentage of our total portfolio, is approaching 20% of our total product sales. Wireless is doing very well. As you pointed out, we do have a lot of customers.
When you think about stadium and you think about healthcare, these are very dense Wi-Fi environments, and we have a lot of these customers that are going to be ripe for Wi-Fi 6, where you have significant density benefits. We have pre-orders for that product line, maybe a little cannibalization from the existing Wi-Fi lines. As we look out at Q3, we are not going to be able to ship any of the AX products. Despite bookings and pipeline that we see today, we can't put that in our Q3 revenue forecast because those products will likely ship in the April timeframe and land in Q4.
Last question, then I'll cede the floor. You mentioned Huawei. You were doing well against Huawei in Europe. How much of an impact is that? Is that a one-quarter thing, or do you think that's something that's going to help you for several quarters?
It's hard to tell. Obviously, the Huawei, most of the news that you've seen has been around 5G and is less involved with the enterprise. I talked about a win that we had against Huawei with a large auto manufacturer. A lot of that had to do with our fabric and security, and Huawei was still very much in the hunt with that customer, but it was really our software and the security and segmentation capabilities of our fabric that allowed us to win, that the manufacturer was adamant and fought procurement that wanted to go with a lower Huawei price. So Huawei is still very much alive in the enterprise space. We do think that there is some trickle-down, and we don't know exactly how this is going to play out, but we know that people are starting to think about it.
For us, it creates an opportunity if we are in a competitive situation just to point that out to customers when they're considering their choice of networking vendor.
Okay, great.
I can't really quantify it for you, Mark.
All right. Thanks.
Thank you.
Our next question comes from Christian Schwab of Craig-Hallum. Your line is open.
Great. Thanks for taking my call. I just want to follow up on E-Rate and your comments there on education. The number of Form 470s for category 2 are back off the charts again, something we haven't seen since fiscal year 2015, in part because all of those schools who took money in fiscal year 2015, as you know, can finally come back after taking three fiscal years off and get it again for funding. At the same time that we're transitioning to Wi-Fi 6. In that year, you guys won almost $100 million worth of business. I'm surprised that you're not more optimistic about what you're seeing as far as the initial bidding requests that have already come out, which should accelerate further over the next 90 days. Are you guys not as strongly positioned as far as a sales force initiative there? I'm slightly confused.
Hey, Christian. No, I wouldn't say that, and we should not have left that impression if we did. As you know, and you're pointing out, this is the last year of the current E-Rate funding cycle, and there are a lot of dollars left. As you point out, there are a lot of people who can come back. When we're talking about guidance, we're obviously talking about Q3, and we'll find out in Q3, but we don't expect a revenue impact in Q3, but we are expecting quite a revenue impact in Q4. If anything, we are probably better positioned than we've ever been to take advantage of E-Rate with a focused vertical team. This is something that we're very much in the hunt, and we're very much going to be involved. Our business has become a lot more diversified across the board.
E-Rate makes up a smaller portion of the overall business, and the E-Rate weakness now is really a result of the weaker season last year. To your point, I think it's a good comment, is that we are expecting a much bigger E-Rate cycle this year. Our teams are in place, very busy, very active. This is going to be March news for us, and it will affect our Q4 and our Q1 coming up.
Right. Then last time in fiscal year 2015, you didn't have as broad and maybe as a competitive Wi-Fi access point technology as you do this cycle, and benefited more across the board on your switch platform. As you look to this, and securing wins, and the team is working, do you think that your opportunity is more broad-based and the opportunity to win both switch opportunities as well as wireless access points?
Yes, I would say that. The other thing I would mention is we also didn't have a cloud platform. As you know, cloud management is becoming more popular, particularly in K-12 in distributed environments. We have a unique offering as it relates to our single pane of glass and managing both an on-prem solution as well as a cloud-managed solution for a remote site with that single pane of glass that our competitors don't have. We think there's a feature there that's pretty powerful and differentiating for Extreme when we're out in the market. As you know, that the E-Rate dollars aren't applied to software, so that software is a differentiating item. That's where we're working to lead with our customers to focus on that software and spec Extreme and their RFPs.
Great. I don't have any other questions. Thank you.
Thanks, Christian.
Once again, if you'd like to ask a question, please press star then one. Our next question comes from Paul Silverstein of Cowen. Your line is open.
Thanks. First off, just some clarification on wireless LAN. Ed, you said it's approaching 20% of total product revenue. That would make it about $50 million if I did the math right, this quarter. Can you give us what was wireless LAN last quarter and the year ago quarter?
I'm going to say a year ago quarter is probably closer to 15%. Last quarter is probably going to be 18%. Again, that's not a precise number, and I think when we get off line, we can follow up with the exact number. I'm giving you a range which is more or less accurate.
All right. I know you mentioned K-12 is small, can you quantify how small?
Well, K-12 for us, is part of the education vertical. Given the growth that we've had in higher education, K-12 for us is smaller than higher Ed. It historically has been much higher than higher ed. It depends on that E-Rate funding cycle. Overall, if we look at E-Rate exposure for the second quarter, and really, if I have data from a bookings perspective, it's going to be like 3% of revenue, more or less, in that ballpark.
Got it. All right. Let me move on. The pretty broad spread in the guidance, especially on the EPS line, to what extent does that reflect you being appropriately conservative? To what extent does that reflect limited visibility at this point in the quarter, which I assume is not the case? I know it's early, but given your comments about the various strengths, what accounts for that pretty broad range? What are the key variables, levers?
I'm going to add a couple of high-level points, and then I'll let Rémi chime in if he wants to kind of supplement the answer. First of all, we did pull in $5 million forward buying healthcare accounts. Other people that knew they were going to be buying Extreme in Q3 took advantage of lower pricing, and we've quantified that at about $5 million. If we pull that out of Q2 and put it into Q3, obviously that makes a change. We still would've beaten this quarter without the $5 million, but that would've taken the number up quite a bit for Q3.
If we look at our operating expense structure every year, the calendar year, we automatically have an increase in operating expenses because we restart the clock on different payroll taxes, and we have other OpEx expenses that are seasonal that just reset and start in Q1 that create higher OpEx. Kind of right out of the chute there, if you're just doing the comparative number, you're looking at a revenue headwind, and then you're also looking at a seasonal operating expense increase that'll have that effect. The other comment I'll make is, we talked about the 1% headwind as it related to the manufacturing shift. Obviously, that's a one-timer, but it does mitigate the risk of China for us.
It's the right thing for us to do, but there's a near-term impact of that shift. Obviously, we have a new CFO, and I'm going to let him chime in on the call and add some commentary. This is the second quarter in a row that we've met or exceeded guidance. We obviously want to continue on that path and on that trend. We set our guidance with that in mind, and we want to make sure that we have a high degree of confidence of hitting those numbers, and that's how we set guidance. I'll let Rémi chime in if you want to add anything.
Before Rémi chimes in, I just want to make sure I understood your comments correctly. Everything you cited sounds to me like while the OpEx apparently reset in calendar Q1, I assume you guys know or should have a pretty good feel for what that reset is. The $5 million pull-in you've identified, it's not a mystery, apparently. The things you identified, I'm not trying to be argumentative, but I'm just pointing out those are things you have visibility into. I'm trying to understand what accounts, other than you being appropriately conservative, and that's fine if that's what it is, but what are the variables that you don't have such good visibility into that accounts for that degree of spread?
The one item that I didn't mention is seasonality, and as you know historically, there's been a fairly significant falloff from the December quarter into March, and then a step up from March into June. I would say that's the piece where we don't have as much of the visibility as to what is that natural falloff. Now, what I will say is that we have done a lot of work on our pipeline and on enabling our field and on enforcing the field in terms of the tools that we're using and building a more accurate forecast for our pipeline of opportunities. I would say that our confidence in that pipeline of opportunities this year versus last year is significantly different.
That said, we do have seasonality in the business that we've had historically, and obviously we're missing the $5 million we're still calling a flat number, and we're calling a flat number and assuming that we're going to outpace and outgrow that seasonality.
If I can just add, we spent quite a bit of time as a team preparing that guidance, we really looked at three drivers. Obviously, Ed mentioned the revenue based on the pipe that we see, we have a range, which as you see is pretty wide. We spent a lot of time on the gross margin drivers, the positive aspect as well as being mentioned that we have to the impact of tariffs. We spent quite a bit of time on the operating expenses. The math, when you have a range of $10 million for revenue, as much as two percentage points on gross margin, and let's call it $5 million for operating expense. When you multiply the three, you end up with the range that you see on the EPS.
One is just math applied to three drivers with wide range. The second one, which we haven't mentioned in our initial response, is on the operating expenses. We note your point fine well what the impact of merit is going to be on compensation. We do, as a company, hire a number of people every quarter, based on how quickly the recs will be filled and people will come on board, that will have an impact on our operating expenses. That's something to keep in mind to understand why revenue times gross margin times a range in OpEx result in this range for EPS.
All right. I get the math. I understand that concept. Let me ask you just one last question on this. On gross margin in particular, what are the variables that account for that two percentage point spread? What would drive it to the high end? What would cause it to be on the low end?
There's really, I would say five factors to keep in mind. On the positive, you've got the list price, which this quarter is going to be effective for the full quarter. We're counting also on higher expected rate of acceptance in two regions that kind of offset the initial list price increase in Q2 by providing higher discounts, which was EMEA and APAC. One factor that's going to kick in this quarter is every year we renegotiate in procurement with our suppliers, and the benefit of that, given the timing of negotiations, typically comes into Q3. Those are the two positive things that would drive gross margin up. The negative ones, one that Ed mentioned, is the one-time manufacturing shift to Taiwan from China. That's the 5.5% impact that we're getting compared to the cost of manufacturing in China.
We don't expect to receive the financial benefit of the move to Taiwan from the low cost of production until Q4 when that production fully ramps up. Another aspect that we haven't mentioned is that we had a very strong quarter in EMEA last quarter, we don't expect EMEA to be as strong this quarter. From a geo mix, EMEA tends to be a region where we generate higher gross margin. There's obviously others, but those are the five that I would isolate as you build your model.
All right. It sounds like only two or three of those are true variables, because you have a pretty good fix about the 5.5% manufacturing and the timing. That's not a variable that I wouldn't think would factor into that two-point spread. Again, not trying to be argumentative, just trying to understand.
Well, there's two pieces. There's the run rate, once manufacturing is running in Taiwan, and we have the increased cost going forward. There's also one-time expenses which will be expensed in the quarter for setting up and resetting manufacturing, if you will, in Taiwan. There's a one-time effect that we're expecting to be a negative impact this quarter, and then we'll have the positive effect in Q4 of having Taiwan manufacture goods that are exempt from the 10% tariff, but come at a 5% higher expense.
All right. I'll take the rest of those offline. Let me ask you one last question, though, if I may. I thought I heard you say that you have higher component costs. I'm not sure if that was particular to the quarter or if it was a more generic statement, but I'm hoping you give more insight on that. I get the fact that it's more expensive to manufacture in Taiwan. I assume that purely reflects labor, or mostly reflects labor costs. Is there something else going on from a component cost perspective? I recognize we've had shortages, certain component shortages. Are those having an adverse impact on costs, and is that something you expect to continue? What's going on there?
Paul, that's more of a legacy issue. I would say over the past several years, we've seen things like memory and then different component costs because we're in the process of refreshing a big piece of our product portfolio. There are a lot of products that are in our portfolio that are older. The prices for components have gone up over time. Historically, we've never raised price. We haven't raised list price on our products. As we contemplated the increase in the U.S., we decided that we should raise price globally, and we should take into account the component price increases that have literally happened over the last few years. It's more of a decision to raise price, and if we're going to do it, let's do this all at once.
We'll reset the U.S. and the rest of the world at separate rates, but to recover what's happened over the past few years. I think going forward, what you'll see us do is have a regular price increase strategy, where we will raise price on a more regular basis. It's consistent-
All right. Let me ask you, I'm sorry. Was there more?
Well, I just said it's consistent with what our competitors do. It's just something that we haven't done.
Got it.
I look at that as an opportunity for us.
Got it. One last question. My apologies, I want to return to what's going on in the U.S. region. You cited the consolidation of your distribution channel, and there was one other factor you mentioned for the weakness. Can you give more insight? Let me ask you the question this way. On a normalized basis, what would U.S. growth look like? Alternatively, more importantly, what are you expecting in terms of U.S. growth once you've completed the consolidation?
What I can tell you is that from a bookings perspective, obviously when we're saying that this quarter, particularly in the Americas, you have a book-to-bill ratio higher than one. We're going to expect that to level out over time, that if we look at bookings as a leading indicator, obviously our revenue is sales in. We're encouraged by what we're seeing from a bookings perspective. Christian chimed in and he talked about what's going on with E-rate. E-rate has been a drag on our numbers this year because of the weak E-rate season last year. This year should be a different story, as we talked about. Rather than being a drag, it should flip to being a contributor and a growth driver. I think that's going to help out the Americas quite a bit.
We're really encouraged, Paul, by what we saw across our targeted verticals, because in each of our verticals, education overall grew despite the weakness in K-12 because of our strength in higher ed. Government grew, healthcare grew, manufacturing grew, retail grew, transportation logistics grew. All the areas where we're focusing, and in addition to the horizontal solution, delivering vertical solutions and targeting our field, we're seeing growth. That's true in the Americas as well.
Ed, you mentioned that E-Rate exposure was 3% of the quarter. What was it a year ago?
A year ago, it would've been twice that.
In fact, in the envelope, it looks like your E-Rate business went from $13 million, $14 million a year ago to $8-ish million in Q5. It was about a $5 million, $6 million delta, $5 million delta. Is that the math?
You're doing good math, Paul.
I've got an averages on my desk. All right, I'll pass it on. Thanks, guys.
Okay, thanks.
Our next question is a follow-up from Alex Henderson of Needham. Your line is open.
Great, thanks. A couple of things I wanted to talk about. First one, you threw off a lot of cash. You bought back $15 million in stock. You have put on some debt associated with these acquisitions. Can you talk about your bias to, say you pull $20 million in cash flow a quarter, how should we think about the split between working down debt versus share repurchases with that available cash flow.
Yeah. From a capital allocation policy perspective, under our bank facility, we're allowed to buy down $35 million a year. We spent $15 million in the second quarter. We have for the last six months, it means we have $20 million to spend. We look to be opportunistic and to take advantage of that. We will balance that with M&A, potential M&A opportunities, and keeping powder dry there. For the most part, we look at our stock as being undervalued, and we're going to continue to look at share repurchases through the second half of the year.
Just to be clear, is that a fiscal year or a calendar year that we're talking about?
Fiscal year.
Okay. You have another $20 million, some odd, $25 million, or $20 million available between now and the end of June.
We-
You reset to having another $35 each year?
Yes, it does. We have another $20 million, and if you look at our cash, we have $183 million of debt, $140 million of cash, so net debt of $43 million today. We're generating positive cash flow. It's something that we're going to consider. I'm not at liberty to comment on exactly what our intentions are at this point, but I'd say we're predisposed towards buying in stock because we believe it's accretive.
Yep. The mechanics help. Thanks. Second question. You increase price. There's obviously price elasticity in any product. What do you think the net impact of the price increases is to the revenues? If it's a 6% price increase, did it trim volume growth at all? Did it trim it 1%, 2%? Or do you think it was immaterial?
I would say that it was a net neutral in the second quarter, and we believe that it should get incrementally positive over the next quarter, although we do have the cost offset. I guess that's more from a margin perspective. We see the full benefit coming in Q4, Alex.
Right. Let me just say it again. As we think about it for multi-quarter period, do you think that there is some negative impact to volumes as a result of the price increases?
I would say it's less about volumes, and I'd say it's more about discounting.
Well, I mean, the net pricing adjustment, I assume, is going up. Does that have an impact on volumes or not?
We don't see it. In the U.S., everyone is expecting a price increase because everyone's very familiar with what's going on with the tariffs. It doesn't have an effect on 15% of our customers who have frame agreements or contractual pricing over a longer term. We can't move price on those customers. The answer to your question is, yes, we do. We do see a benefit of that. We see traction in having benefit on the price increase without affecting volume in the fourth quarter.
You think that...
This is based on what we see in our current pipeline.
You'd said several times that you've had significant improvement in your pipeline. I assume that some of that's in the wireless piece because you've called that out. I assume some of that's in E-Rate because you've called that out. Are you also seeing it in the data center piece, and what's going on with the service provider acceptance of the new feature set that they were requesting in the fourth quarter calendar that you were supposed to introduce in the fourth quarter? What's the timeline for the acceptance of those feature adjustments?
Well, this quarter we saw, as I mentioned, a strong rebound in service provider, and we've been hiring, and we're excited about the team that we're building in that space, and we're excited about some of the customer opportunities, larger customer opportunities that we have in service provider. Whereas that was a challenge for us, when we look at the second half of fiscal 2018, we see a rebound, and I would say that from a feature perspective, we are in a much stronger position as we look at the first half of calendar 2019.
If I look at the current quarter numbers, you've got a guidance that is down year-over-year, roughly at the midpoint, flat to down a little bit maybe. As I get into the June quarter with a full acquisition in hand, with all of the impacts falling out, with the price benefits accruing, the service provider kicking in, E-Rate kicking in, the wireless kicking in. Should we be looking at a meaningful growth rate in that period, or are we just getting back to the flat, with the fiscal 2018 quarter? I know you don't want to give guidance more than one quarter out, but could you just give us some sense of direction? Should we be thinking about it as up, down, flat?
I would have two things I would say. One is, I really think you have to adjust our guidance, Alex, for the $5 million. We had $5 million come in, but you take that out, we still had a strong quarter this quarter. It's really in terms of how we were guiding and how we're setting expectations, our expectation is that $5 million would've been in Q3. When you adjust that, it is flat to slightly up and you're getting closer to last year's number.
It's slightly down, right?
We haven't changed the full year guidance here. We are expecting a very strong Q4. I can't really comment on trying to provide an exact number.
Could you explain why the numbers are actually flat to down given the acquisition closing timing?
Well, if you remember, we reset. At the end of June, we reset the data center business, and we made the decision to consolidate our distributors. Overall, we saw business volumes down quite a bit. We are starting at a lower point. Even though we may be growing sequentially, we're getting back to where we were, and we're getting back to where we were in a much stronger position.
Right. Well, that's exactly what I was trying to get at. You have two variables here, which are obviously critically important for the reason why you're absorbing in the March and June quarter, the distribution consolidation and the data center realignment. Sounds like given the strength of the SLX product line launch in the December quarter, and the feature adds that the customers were waiting for, that there's a amount of time from the time that feature gets done to the time that they accept it and say, "Hey, this looks good. I'll accept it." When do we get back to a normalized data center number, and is that business growing off of that base, or is it flat?
Well, we reset the data center expectations for $160 million-$170 million run rate. That business has stabilized, and that business is growing. We're back to growth in that part of the portfolio, and we expect that to continue. If I look at fiscal 2018 being, granted, it wasn't a full quarter in terms of what we had as far as the acquisitions, but approximately $980 million of revenue, and now we're over $1 billion. As we pivot and go into fiscal 2020, we will be projecting growth across the entire portfolio. That's where we see this, and that's why I make the comment about a much stronger foundation from where we're starting.
I think you'd been talking about the distributors being a $10 million-$15 million hit per quarter, until it stabilized. It sounds like you're ahead of trajectory on that. Should we still be thinking about a $5 million-$10 million hit from that in the March and June quarters?
Yeah, at this point, Alex, I would say we're almost done. I would say the numbers are probably a little bit smaller in terms of what the effect would be in the quarters in the second half of the year.
Great. Those fall out, that would suggest in the back half of the fiscal 2019 or fiscal 2020 period, when you get into the first half of their fiscal 2020, that you should be seeing better results in September, December versus to traditional seasonality. Is that correct?
Absolutely.
Okay, great. That's what I needed. Thank you.
Okay.
Thanks Ed.
Thank you.
There are no further questions. I'd like to turn the call back over to Ed Meyercord for any closing remarks.
Okay. Well, I'd like to thank everybody for joining us today, and all the Extreme employees who are listening in for a job well done. The progress is visible. We're looking forward to sharing a more detailed outlook about our portfolio, our long-term vision, business model, et cetera, at the investor day that we're having at the Nasdaq Exchange in New York on February 13th. I would encourage everyone to please consider attending. I think it's going to give you a great look at the progress that we're making and why we're excited about the second half of this year.
We're also having a user conference in May, and I would ask people to look at that as well. It's pretty exciting in terms of what we're coming out with in terms of our vision across the entire enterprise portfolio and the three solutions pillars. Thank you all for participating, and have a great day.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.