Good day, ladies and gentlemen, and welcome to the Extreme Networks' second quarter fiscal year 2018 financial results conference call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question and answer session, and instructions will follow at that time. If anyone should require operator assistance during the call, please press star and zero on your touch-tone telephone. As a reminder, this call may be recorded. I would now like to introduce yours for today's conference, Ms. Jean Young. Ma'am, you may begin.
Thank you, Skyler, and welcome to the Extreme Networks second quarter fiscal 2018 earnings conference call. This conference call is being broadcast live over the internet and is being recorded on behalf of the company. The recording will be posted on Extreme Networks' website for replay shortly after the conclusion of the call. By now, you've had a chance to review the company's earnings press release. I would like to remind you that during today's call, management will be making forward-looking statements within the meaning of the safe harbor provision of federal security laws. These forward-looking statements involve a number of risks and uncertainties, which could cause actual results to differ materially from those anticipated by these statements. These risks include our ability to successfully integrate the recently acquired assets, technologies, and operations from Avaya and Brocade into our business and operations, including, but not limited to, the following risks.
Difficulties we may experience in the retention, assimilation, and successful integration of employees and teams, acquired operations, technologies, and/or products. Unanticipated costs, litigation, or other contingent liabilities associated with the acquisitions that could negatively impact our operating results and financial condition. Adverse effects on existing business relationships with suppliers and customers, and difficulties we may experience in reaching our aspirational goals related to the acquisitions. For a detailed description of risks and uncertainties, please refer to our most recent reports on Form 10-K, 10-Q, and 8-K filed with the SEC. You should not place undue reliance on forward-looking statements, which speak only as of today. We undertake no obligation to update these statements after this call. Throughout this call, we may reference both GAAP and non-GAAP financial metrics. Non-GAAP information should be considered a supplement to and not a substitute for financial statements prepared in accordance with GAAP.
Reconciliation of non-GAAP to corresponding GAAP measures can be found in our earnings press release issued today. For your convenience, a copy of the release and supporting financial materials are available on the investor relations section of the company's website at extremenetworks.com. I will turn the call over to Extreme's President and CEO, Ed Meyercord, for his opening comments.
Thank you, Jean, and thank you all for joining us this afternoon. Welcome to Extreme's Q2 earnings call. Today, we are pleased to announce financial results for fiscal Q2, highlighted by a 48% growth in total revenue and gross margin expansion ahead of plan, which we believe has us on track to exceed our 60% gross margin target and 15% operating income target in our fiscal June quarter. We have taken share to become the number 3 firm in our target enterprise market, with over 30,000 customers and over $1 billion in annualized revenue. Recent acquisitions and our expanded product portfolio to cover the entire enterprise, from the wireless access edge to the cloud, have created a heightened awareness of Extreme in the industry, elevated our brand, and are generating a significantly increased level of new opportunities for us.
We are seeing the pace of digital transformation gain momentum for our enterprise customers across our industry verticals. Mobility and the Internet of Things are driving rapid growth of network devices with new demands for ease of deployment, intelligence, visibility, and security. Today, enterprise data centers are all about cloud services, multi-cloud and hybrid cloud environments, giving Extreme more ways to support our customers with our next-generation technology. These changes in the market are happening at a time when IT budgets are shrinking. The only way to solve for the growth in complexity is to leverage software-driven solutions that automate provisioning of devices at the edge and the deployment of cloud services across multiple platforms. Extreme is well-positioned as the premier alternative to the larger competitors in our market who are less focused and playing in many different market segments like servers, storage, security, and hyper-converged platforms.
We believe we have better and differentiated technology to support our enterprise customers at all places in the network. At the wireless edge, we have a leading dense Wi-Fi and distributed Wi-Fi solutions, and we're the only competitor with unified architecture for both cloud managed and on-premise solutions. We have unique fabric technology that makes it easy to automate the secure campus environments that is complemented by our software that provides complete visibility and control of the enterprise environment. Finally, our portfolio of next-generation cloud data center solutions, complemented with our Workflow Composer, deliver cross-domain automation and agility for enterprise and cloud service providers alike. We're the only networking vendor exclusively focused on delivering end-to-end software-driven networking solutions from the wireless edge to the cloud, and our 100% insourced technical support is also a differentiator with our customers.
Q2 results for fiscal 2018 highlight our progress. We delivered 48% revenue growth, gross margin expansion, and non-GAAP earnings per share of $0.14, marking the 11th consecutive quarter Extreme has met or exceeded our earnings guidance target. Growth in the quarter was driven by the addition of a full quarter of our campus fabric business and a partial quarter of the data center business acquired from Brocade. In our core Extreme portfolio, we see continued strength in wireless and software-driven sales that pull through our fixed switching portfolio, offset by the runoff of modular switching, which is now a much smaller portion of our revenue mix. We're developing more prescriptive solutions for our customers in the field, and our Secure Automated Campus launch has also been well-received. In Q2, we turned away a considerable amount of low-margin business, particularly in the campus market.
Our core Extreme portfolio, which now includes Zebra, grew at 1%, and our core gross margins ran up to 59.9% as a result of pursuing higher-quality business. We were expecting higher distributor inventory in our sales in model that we adopted in July versus sales out accounting. With the acquisitions, we increased the number of distributors threefold and began the process to rationalize and consolidate them. We had to set a target inventory level and overestimated that level, which caused a one-time reduction in our reported sales numbers relative to sales out. Today, we believe we are at the right inventory levels heading into our fiscal Q3 and expect our sales in to be consistent with sales out going forward.
Given the strength of our pipeline and visibility we have for the March quarter, in our $262 million-$272 million revenue guidance, we are projecting higher organic growth in our core Extreme portfolio to our low- to mid-single-digit target. The pipeline is diverse across all of our geos and target verticals and includes significant growth in cross-sell opportunities. We have a large health system in London with six hospitals who have selected our fabric technology and want to replace one of our larger competitors with Extreme. We are a very large cloud service provider in the U.S. that is a household name and likely to be a breakthrough for a new use case for our cloud offerings with SLX technology. These are just a couple of examples of what is in our pipeline.
In the second quarter, we were very successful in our continued efforts to clean up the discounting behavior in the field with the former Avaya portfolio. We pushed back on high discount requests relating to what had historically been bundled unified communication sales or residual deals affected by the bankruptcy process. While this had a one-time effect on revenue during the quarter, it was offset by an 800-basis point sequential improvement in our campus fabric gross margins from Avaya from 48%-56%. We are seeing a very healthy pipeline in our Avaya Campus business being generated by strong demand for our fabric solution. The ease of deployment, the ability to segment networks across the enterprise, and a high level of security at our Layer 2, what we call stealth networking, is driving a healthy pipeline of demand for our solutions.
We expect that business to return to our $200 million annual run rate target in the second half of our fiscal year at the higher run rate gross margin level that we saw in Q2. We are pleased with the health of the data center business acquired from Brocade. We benefited from a partial quarter of revenue that exceeded our expectations. Strength in the SLX, VDX, and MLX switching and routing platforms, along with our automated deployment tools, is driving revenue. There is excitement in the field and with our customers as we build out the use cases with our next-generation SLX combined switching and routing platform. Our validated designs and reference architectures for specific use cases are making it easy to sell and deploy our cloud solutions. When combined with our Workflow Composer and its cross-domain deployment capability, we can support our customers in delivering very agile enterprise cloud solutions.
At our upcoming March quarter, it will be the first full quarter of results with our Extreme Data Center assets. In our revenue guide, we are including data center revenue that is ahead of our $230 million annual revenue target and generating margins in the low 60% range. We completed the migration of Brocade data and IT systems into the Extreme platform as scheduled on January 15th and have good visibility into that business. Net-net, when we combine revenue for the acquired assets of Brocade and Avaya, we're projecting to be slightly better than the $430 million revenue run rate for the acquired assets. With core growth in our core Extreme business, we are comfortable with our revenue outlook of $262 million-$272 million, with continued improvement in gross margin. We are encouraged by the growth of our cross-selling opportunities.
We already book cross-selling revenue in all of our product families, which amounted to approximately $3 million in Q2. Recall that Avaya had differentiated fabric technology, but they didn't have software, our access control management analytics, and they sold Zebra Wireless in an OEM relationship. Extreme has a full suite of software and competitive wireless, but not the fabric. This past quarter, a large German university from Legacy Avaya deployed ExtremeWireless and our Extreme Management Center software. A large retailer in Europe from Legacy Zebra deployed Extreme switching and products from the legacy Avaya portfolio. One of our large manufacturing customers in our APAC region deployed our switching and routing products from former Brocade in their data center. Our pipeline has grown to over $20 million for these kinds of opportunities.
We are three-quarters of the way through Extreme NOW, our world tour to bring our leadership directly to customers in 55 cities in 22 countries. Feedback has been very encouraging, and we've received significant press in local markets. Our customers and partners are usually surprised and encouraged by the depth of our portfolio when our technical teams take everyone through each place in the network. Our initial goal was to attract over 3,000 customers to these global events, and we've blown through that target. Our customer outreach efforts for the new Extreme will culminate with our user conference in April. The benefits of higher-quality solution sales are evident in our second quarter non-GAAP gross margins that jumped 220 basis points year-over-year.
When we add a full quarter of the new Extreme Data Center business, this will bring us very close to our 60% target for the new Extreme in fiscal Q3, and we believe we're on track to achieve the 60% non-GAAP gross margin target in our fiscal Q fourth quarter in June of 2018. Our teams continue to execute well despite the extra time and resources required to integrate and onboard our employees, our customers, and our partners, develop our combined product roadmaps, build out our engineering labs and resources, combine the data and systems that support the business. As I mentioned earlier, we see upside to our combined outlook on both a revenue and cash flow perspective. With that, I'll turn it over to Drew to review our results and guide the detail.
Thanks, Ed. I will get started with a few highlights from our second quarter of fiscal 2018. In Q2, our non-GAAP gross margin increased 220 basis points to 59.4%. We have now increased our non-GAAP gross margin every quarter compared to the same quarter year-over-year since fiscal Q3 of 2016. This is before adjustments made to the prior year's financial statements as a result of our adoption of the new ASC 606 revenue recognition guidance. Our margins benefited from the addition of the acquired data center business starting in November and a strong 800 basis point quarter-over-quarter improvement in the margin for the acquired campus fabric business, as well as continued improvements in our core business from reduced discounting and supply chain cost improvements. Next, I will turn to revenue.
Q2 revenue was $231.1 million compared to $211.7 million in Q1 and $156.4 million in Q2 a year ago. Revenue increased quarter-over-quarter and year-over-year by 9.2% and 48% respectively. Although our Q2 revenue was 2.1% less than the lower end of our previous guidance, during the second quarter, we focused on improving the quality of revenues and gross margins for the campus fabric business, which had an impact on our revenues. We also anticipated better growth driven by a higher level of distributor stocking orders in our Extreme Core business in the quarter that did not occur. The geographic split of revenues was as follows: The Americas contributed 51% to total revenue, EMEA contributed 39%, and APAC contributed 10%. Product revenue for Q2 was $174.8 million, compared to $164.8 million in Q1 and $118.1 million in Q2 last year.
Q2 service revenue was $56.3 million, compared to $46.9 million in Q1 and $38.3 million in Q2 last year. Moving on to gross margin and operating expenses. In Q2, GAAP gross margin was 55.8%, compared to 53.1% in Q1 and 50.9% in Q2 last year. Non-GAAP gross margin was 59.4%, which compares to 56.7% in Q1 and 57.2% in Q2 last year. Q2 GAAP operating expenses were $160.1 million, compared to $107.9 million in Q1 and $82.6 million in Q2 last year. Q2 GAAP operating expense includes amortization of intangibles of $2.7 million, stock-based compensation charges of $6.6 million, a litigation settlement proceed of $0.4 million and acquisition-related expenses of $34.1 million. Q2 non-GAAP operating expenses were $117 million, compared to $97.5 million in Q1 and $71.2 million in Q2 of 2017.
The sequential increase in non-GAAP operating expenses was mainly attributable to the addition of two months of expenses from the Brocade Data Center business. Second quarter GAAP operating loss was $31.1 million compared to operating income of $4.5 million in Q1 and a loss of $3 million in Q2 last year. Second quarter non-GAAP operating income was $20.3 million or 8.8% of total revenue, compared to $22.5 million or 10.6% of total revenue in Q1, and $18.4 million or 11.7% of total revenue in Q2 last year. GAAP net loss for Q2 was $31.9 million or $0.28 per share compared to net income of $4.4 million or $0.04 per diluted share in Q1, and a net loss of $4.2 million or $0.04 per share in Q2 last year.
The GAAP net loss includes the $25 million payment to Broadcom for consent to purchase Brocade's data center business, a $4.9 million gain on the purchase of Brocade's capital finance business, and a $2.5 million tax credit resulting from recent changes in the tax law. The $25 million payment was part of our originally agreed-upon purchase price for the business but was treated as an expense for GAAP purposes. Non-GAAP net income for the quarter was $16.4 million or $0.14 per diluted share in comparison to net income of $18.6 million or $0.16 per share in Q1 and $17.1 million or $0.16 per share in Q2 of 2017. Turning to the balance sheet. Q2 total cash and cash equivalents ended the quarter at $127.1 million, down $25.9 million from the end of last quarter and up $23.3 million from the end of Q2 of FY 2017.
Payment for the data center acquisition and build-up of working capital, mainly for the investment in inventory for the acquired businesses attributed to the decline in cash in Q2. During the quarter, cash flow from operations was an outflow of $4.4 million compared to inflows of $18.6 million in Q1 and $9.7 million in Q2 last year. Free cash flow was an outflow of $10.2 million compared to inflows of $11.2 million in Q1 and $6.7 million in Q2 last year. Accounts receivables were $154.9 million at the end of Q2, up $38.4 million from the end of Q1 on higher sales and up $64.6 million from the end of Q2 of FY 2017 with the addition of the acquired data center and campus fabric businesses. DSO increased by 11 days to 62 days this quarter compared to Q1 and increased compared to 53 days in Q2 of 2017.
Inventory ended at $83.4 million, up $25.3 million from last quarter and up $33.9 million from Q2 of fiscal 2017 with the addition of acquired inventories. Total debt outstanding net of loan fees at the end of Q2 was $183.1 million compared to $97.1 million at the end of Q2 last year. The increase is attributed to the amended term loan for the purchase of the campus fabric and data center acquisitions. Let's move to guidance for Q3. We expect total Q3 revenue to be in the range of $262 million-$272 million. Q3 GAAP gross margin is anticipated to be in the range of 56.1%-58.4%, and non-GAAP gross margin is estimated to be in a range of 58.9%-61.1%.
Our anticipated increase in gross margin in Q3 is driven by a full quarter of the data center business and the benefit of our gross margin initiatives. Q3 operating expense is expected to be in a range of $153.5 million-$156.5 million on a GAAP basis and $130 million-$133 million on a non-GAAP basis. Tax expense is expected to be $1.8 million-$2.6 million, up from previous quarters on higher revenue. We are continuing to evaluate the recently enacted U.S. tax legislation and the impact to our income statement and balance sheet. Pursuant to SEC guidance, we have recorded provisional amounts in our Q2 financial results. For the second quarter, we have estimated that there will be no tax impact relating to the deemed repatriation of previously untaxed foreign earnings based on our ability to utilize existing tax attributes.
The revaluation of our net U.S. deferred tax liabilities at the new lower U.S. tax rate of 21% resulted in an estimated tax benefit of $2.5 million to our second quarter GAAP net income. We have not been a U.S. taxpayer in recent years due to the level of accumulated tax attributes we are carrying forward. We believe changes in the tax laws, including the addition of a new minimum tax on a portion of our foreign earnings, limitations on certain U.S. deductions, and anti-base erosion provisions, will likely cause us to utilize those U.S. operating losses on an accelerated basis, and we will be subject to the full U.S. tax rate in two to three years. Q3 GAAP net income is expected to be in a range of a loss of $1.6 million to $10.4 million, or a loss of $0.01 to $0.09 per share.
Non-GAAP net income is expected to be in a range of $20.4 million to $29.2 million, or $0.17 to $0.24 per diluted share. In Q3, we expect average shares outstanding to be approximately 115 million on a GAAP basis and 120 million on a non-GAAP basis. This concludes our prepared remarks. We will now open it up for questions.
Ladies and gentlemen, if you have a question at this time, please press the star, then the number one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from Paul Silverstein with Cowen and Company. Your line's now open.
Thanks, Ed and Drew, for taking the question. Two or three, if I may. First off, at what revenue level can you guys drive 20-plus % operating margin?
Hey, Paul, it's Ed. I think you're looking at a number that's north of $1.2 billion. If you look at our base assumption and we talk about base Extreme, it's $650 or $430 of acquired revenues, you're looking at $1,080. If you look at organic growth on top of that, the marginal profitability of that organic growth is quite high and will contribute a lot to that operating income. If we tag Q4, we hit our 15% operating income number, based on that level, you'd need another $55 million. It's going to be north of $1.2, unless. That's the ballpark guess for you.
Okay. I appreciate that. Drew, on OpEx, if we look beyond March and, as you look out to the longer-term business, what are you thinking about in terms of OpEx growth on a normalized basis in terms of organic growth?
Yeah. Well, we think as we get into Q3 here, that we can hold our OpEx fairly steady. We will have some increases for sales compensation. We'll have some variability there. We'll have our annual pay increases. We'll have some there. You can see from the midpoint of our guidance here, in the mid $130 range, $133 to $135-ish, and we think we can continue to hold it there with the exception of annual pay increases and some variable sales comp.
Any sense for how much growth the annual pay increases and variable sales comp, what that would drive in terms of growth? If those are the only drivers.
We usually target a 3%-4% pay increase each year, and then the sales can vary $2 million-$4 million. The variable expense could go up $2 million-$4 million per quarter.
All right. One last question from me. If you already provided, my apologies, but did you all give a breakout of the revenue from each of the Avaya and Brocade acquisitions?
The breakout this quarter? We didn't give the exact breakout this quarter.
Are you willing to give that?
What we've put into our guidance is, or into our release is that Avaya was below our expectation. We had an expectation of $50 million there. Avaya was below that. On Brocade, we had said that they would do about 40%-45% of revenues in a typical quarter, so 40%-45% of $57.5 million, which is a fourth of the $230 million that we gave. We thought that they would do about $25 million in a quarter, and they did better than that. Then on the Extreme Zebra piece, we had low, we had single digit, 1% organic growth year-over-year.
All right. Again, my apologies, because I think you actually did say it on the call, but the Avaya weakness was a function of, or the weakness relative to your original expectations, that was a function of what?
Yeah. I'll let Ed chime in, too. Really, we were working hard on improving the quality of that revenue this quarter and turning down deals with really low margins. I think that business was coming out of bankruptcy, there was a lot of really heavy discounting to kind of maintain where they were. I think some of the customers had kind of been conditioned to being able to get very large discounts at low gross margins. We really focused on that business this quarter, and we improved the gross margin by 800 basis points. We went from 48%-56% on that piece of business alone.
The other piece you mentioned, Paul, has to do with disti. We picked up several hundred distributors globally and brought them on board and began the integration and rationalization process with our disti. We had to pick an inventory level. Now that we're sales in versus sales out, we pegged it at an inventory level for what that sales in would be to disti. We wound up below that peg, and a lot of that has to do with how distis buy globally and also their perception of their business with Extreme as we go forward. There was a lack of visibility there and some moving pieces, but we've done a lot of work there. We feel good now about the visibility, the reporting, and the clarity we have about going forward.
We believe we're at a level now where the sales in number is going to be close to the sales out number. It should be in sync there. We have plans with our disties in terms of how they're buying and inventory levels and modified agreements so that we have clarity on both sides of that. That was another element that affected us in Avaya, and then also in Extreme.
Again, my apologies if you already stated this, looking at the revenue stream you were expecting going forward on the Avaya piece, given that you understandably walked away from the low margin business, when you look at that outlook, and I assume that wasn't a one-time, that low margin business, or maybe it does come back if people are willing to pay up. When you look at the revenue stream going forward, given the business you're walking away from, what does that look like relative to your original communications with the investment community?
We're projecting, this is based on pipeline and what we're seeing in the field and the opportunities that are being created in the field, we have much better visibility today. We are expecting a rebound and a rebound at the higher margin level of Avaya. Whether or not we hit the 50 in Q3 or Q4, we're confident that we're going to get there by the end of our fiscal. It's amazing what's going on with their fabric. It's really driving the campus sale, particularly in some of our verticals, like in healthcare, also in education, and in manufacturing. It's been a big driver of demand in our pipeline. We know that some of the partners and some of the customers have been on the sideline there looking for our suite of software.
They want to know that we're committed to the portfolio, they're seeing that. They're seeing that by the Secure Automated Campus release, where we attached Extreme Management and our software suite to the Avaya portfolio. We've gone deeper with more management tools and analytics in the release that's coming out next week. By the end of the quarter, it's going to be fully featured with the entire Avaya portfolio. The feedback that we're getting from partners and customers and evident in the pipeline, we're projecting that to come back in either Q3 or Q4, hit the 50 bogey. That is being more than offset by strength at data center, and the good news as far as the business model is concerned is that data center revenue is a higher margin business and carries higher gross margins.
To the extent that we're offsetting higher Brocade with lower Avaya, net is a positive to the model.
Got it. I've got other questions, out of respect for others on the call, I'll take them offline. I'll pass them on. Thanks, guys.
Okay.
Thanks, Paul.
Our next question comes from Erik Suppiger with JMP Securities. Your line is now open.
Hi, guys. Congratulations on a good quarter. This is actually Michael Bergin for Erik Suppiger today. For revenue, I just want some clarity. Obviously it was a miss, but the miss in the guide up was a function of this sales in versus sales out dynamic combined with the weakness in Avaya that was offset by the strength in the Brocade. Is that a good way of looking at it? Are you guys still on target to hit the $1 billion mark in revenue in fiscal 2018?
Michael, I'll jump in. Drew, you can follow me. Yeah, I think that's a good way to look at it. The other thing to consider is the 800 basis point improvement in gross margin. We did turn away a lot of business, and it was global in many different geos. Some of this has to do with the former deals where they were highly discounted because maybe they were part of a unified communications sale or bundle with the old Avaya, or because it's a legacy pipeline opportunity from when Avaya was going through bankruptcy, these kinds of things. I would say that's more the one-time nature of this. We were very disciplined, and we're reconditioning the field, our field and our partners, in terms of what kind of discounts that we're going to deliver.
We're seeing growth in the pipeline, and we are expecting growth in that business at the higher margin range.
Yeah. To the second half of your question there, based on the midpoint of our guidance and where we think we can come in for Q4, we do still think that we'll be above $1 billion for the full year.
Okay. Just a follow-up on that. It sounds like things are going well, both in the Avaya overall and Brocade. Would you say, given the one-time, I guess, revenue miss, or whatever I call it, for this quarter, what would you say is driving the extra strength in the second half of this year? Would you say it's expecting higher growth in Avaya or Brocade or anything in particular you can point to?
Well, I'll start. We're seeing strength in the Brocade portfolio, the Brocade business. That's been very strong. The adoption of the next-gen data center platform, which is the SLX platform, which is the combined switching and routing platform with the automation tools, cross-domain automation, providing agility for data center. We have a really interesting looking pipeline for that portfolio in the data center side and differentiated technology. On the Avaya side, we think people have been looking. There's an overlap between Avaya and Extreme in terms of having campus portfolios. People have been watching, but it's the things like the release of our next version of our software that now opens up all of the features and capabilities of Extreme Management Center to the Avaya portfolio. It's also on the Extreme side, where we're bringing wireless.
There's a lot of cross-sell deals in the pipeline where you're seeing Avaya customers with ExtremeWireless, which is creating opportunities for growth. Drew, I don't know if you want to add anything to that.
No, just the other thing on Avaya that makes us feel better is the visibility that we have. We've gotten a lot closer to the customers. We've worked with Avaya. We're still on TSA, the transition services agreement, where we're using their systems for one more quarter. We're going to be off their systems at the end of March. We've improved the management of the pipeline and the sales force tool that they use there and the visibility that our sales team has in that tool. We've also improved, or we got all the historical service revenue opportunities. It took us a while to get that, and we've got good visibility to that so that we can go after additional service renewals and target those customers. Just our overall visibility has improved on the Avaya business.
Got it. Thank you for that. One last question, then I'll cede the floor. Would you be able to quantify the missing revenue guidance in terms of the one-time and inventory change for the sales in versus something like the Avaya weakness?
Yeah. Well, we didn't give an exact number on that, but the Avaya piece is the majority of the miss, and the inventory issue, it makes up the balance. It was primarily on the Avaya side.
Okay. Overall, you're feeling very strong about the business given all the factors you listed earlier.
Yep.
Okay.
Yeah, definitely.
Awesome. Well, all right, I'll cede the floor. Thank you very much.
Thank you.
Our next question comes from Alex Henderson with Needham & Company. Your line's now open.
Thanks. How long do you think it'll take you to get the salespeople moving the Avaya products to be on board with the proper discounting structure so that you're not turning away deals and to get the customers who might have been hesitant to buy products when they were in bankruptcy now that you've got the company in-house to step up to the plate and up their product purchases? When do you see the business accelerating, so you start beating numbers within the Avaya footprint?
Alex, this is Ed. We see that happening in real time. We're in the second half of the year. We see it in our pipeline. We expect to be there by the end of our fiscal year. A lot of the discounting that we saw was cleanup. We are calling some of that one time. We think it was. Some of the inventory issues with disti is tied to the Avaya portfolio as well. That gets cleaned up. The thing I'd like to highlight is that the technologies are truly complementary. If you look at what's come in, Avaya has this Fabric technology that is unique. It's Layer 2. It's got differentiated security elements, security features. It's very easy to deploy, segmenting networks in complex enterprise environments.
It has unique capabilities that we didn't have at Extreme. We didn't have this in the campus. The fabric is truly differentiated. There's a lot of interest in the field with that fabric. Remember that Avaya didn't have our software. Well, that's our bread and butter on the Extreme side. This is where we have technology differentiation. We can reference the Gartner reports with a single pane of glass and the visibility and the control and a common database for every device that's running on an enterprise network and all the different network elements. Well, they didn't have that technology. Avaya customers in the field have been looking at this saying, "Wow, this is great technology. How is it going to come together?
Are they protecting my investment?" They're seeing that because we're putting our money where our mouth is in terms of where we're investing. The last piece was wireless. This was another opportunity for margins from us because the resold Zebra Wireless OEM solution was a very low margin for the Avaya business. We have higher quality wireless solutions that are going to come at higher margins that are also tied into the fabric technology and tied into our software. If you look at it from an edge and a campus perspective, the technologies are very complementary. We're expecting what we're seeing in the pipeline is growth. It's growth based on this combined technology roadmap that we've put out there.
A couple of questions, if I could, on the competitive front. Clearly, you guys are now a billion-dollar company. I would assume you're popping up a little bit more on Cisco's radar screen, even though it's probably still low on their hit list. Has there been any competitive response or any change in their behavior in the marketplace as they've pushed on pricing or other variables to keep you out of accounts or to take accounts away from you?
Nothing has really changed there, Alex, from our perspective. I personally have been involved with some meetings where customers have not been thrilled with the packaging of security for a combined package, given the-
Separate question. That was my next one, actually.
Yeah. Well, Cisco's coming at it from the data center or from the core of the network out, and we're looking at the portfolio of security that they're packaging and selling and the way that they're changing the pricing around this. It's creating a lot of expense and a lot of complexity, whereas we're coming at it the opposite way, whereas we're coming at it with simplicity, and we're coming at it with an open framework where we want our customers to continue to use their preferred security vendor, for example, if they like Palo Alto or if they like Fortinet or they like Check Point. Our strategy is all about enabling flexibility for our enterprise customers.
I'm sure that there could be a lot of customers out there that like Cisco's solution, that want to just deal with one vendor, but there's a big piece of the market that is less enamored there, and we actually see that creating opportunities for us, which is why it's important for us to pull our portfolio together with our Secure Automated Campus, we think is a much better solution.
Can you give us any scaling on how much of the opportunity in your pipeline might reflect on people's discontent with the intuitive networking lock-in around security and networking, plus a requirement to move to a licensing model? There's a lot to that. If you look at your pipeline, how big a nut is there? A couple percentage points of opportunity from that or more?
It's really hard for us to call that because we go up against Cisco all the time, and we go up with Aruba, HPE all the time. We see them. Aruba's really coming at it from the other edge. They're really starting wireless and moving their way in. Cisco's moving out to the edge with DNA. They don't have an integrated or unified architecture for cloud-based or on-prem wireless, so they're a little disjointed on the wireless side. It would be a big guess to try to pin it to that.
When you look at that product, the intuitive networking, have you done a teardown? Have you looked at the way the various software elements of the security pieces are integrated into it? I know you've said that Meraki's not integrated in it, any sense of the competitive nature of that product?
I think there are standalone elements of the product that may be compelling. What we've heard, our experts have ripped it apart, our analysis is that there's really nothing new from a switching perspective. There's nothing new coming out. From that perspective, it's older technology. They're bundling in a portfolio of security. The problem is to actually deploy it in an enterprise is really complicated. They want to sell managed services so they can deploy it for you, which starts to get really expensive. All of a sudden, you're putting all of your eggs in one basket in a solution that's very expensive, you're giving up future flexibility. That's the question: do you want to be handcuffed to them going forward? That's where we see ourselves having a big opportunity.
One last question then I'll cede the floor. When you look at the OpEx number, going from March to June, and then back to September, and then back up to December, how much seasonality should we be baking into the newly structured company on the OpEx line between them? Is it a situation where March is generally somewhat lower, June's a little higher, September's a little lower, December is more like June? How do we think about the splay between those seasonal quarters?
Yeah. The June quarter is still going to be our highest quarter. I think it's going to be the highest quarter in terms of revenue, and then the OpEx will kind of follow that with the variable sales OpEx that we have. Typically for us, Q1 would come down. It's going to be a little bit different next year, just because of the seasonality that Avaya and Brocade had. They typically had a fairly busy September. It was September for Avaya, and it was October for the Brocade business, because they had a fair amount of federal business and their year-ends were at that time. We anticipate that September will be a little stronger than it has in the past, and then the December quarter and the March quarter will be more similar to each other for the quarter, so more flat.
Q1 was typically been down and Q2 also, but that changes a little bit with the new business.
Great. Is there a location for finding the non-GAAP R&D sales and marketing and G&A breakout, which I don't think is in the press release or the slide deck?
Yeah, I think we have it. Do we have it in the slide deck? We're checking.
Yeah, I don't see it in the slide deck. I was looking at it. It's broken out at the OpEx line, not at the individual granularity.
Okay. Yeah.
Great. Thanks.
Yeah, we'll get back to you. Thanks.
Our next question comes from Simon Leopold with Raymond James. Your line is now open.
Great, thanks. I just want to follow up on one of the prior questions. Understanding June is typically a peak quarter, it does seem that you've had some revenue maybe slide from December into March. I guess I'm looking for a little bit finer detail on the June prospect. Certainly the highest quarter, but historically you've had a teen sequential growth in your June quarter. Are you still calling for that kind of sequential growth rate in June?
Yeah. You're talking about on revenue or on OpEx?
No, revenue specifically.
Yeah. Yes, we do. We've got a low double-digit growth % from Q4 to Q3, or Q3 to Q4.
Okay. I guess the other thing I was trying to get a better understanding of, in terms of the strength in gross margin in the December quarter. I think there may be two questions here, how much of this was related to mix? I tend to assume that the Wireless LAN access point products are better than average. Just wondering how that plays into the overall gross margin story here.
Wireless LAN now that we're getting on the combined run rate here, Wireless LAN is going to be about 15%-20% of our overall product revenues. It's not as high as the Brocade Data Center gross margin. It's about the same as our switching line of products, which now it's in the mid to high 50s.
Okay, great. Thanks. Given that you generally have had decently high exposure to EMEA, and considering the shift in foreign exchange rates, basically your products seem to be cheaper to European customers buying in dollars, converting from euros. Can you comment on what, if anything, you've seen in terms of ForEx related benefits?
Yeah. I'll chime in here. What we've seen is an overall strengthening in the European economies, and we've seen strength in EMEA in terms of what's a big driver of organic growth for us. We have it in our core market, if you recall, Germany and the DACH region has always been our largest region maybe even skewed more than it should be in terms of the distribution of GDP or economy in EMEA. We're seeing a healthy business there, we're also seeing a recovery in markets like UKI, Benelux, France, Spain, Italy, the Southern Cone markets, Middle East. Across the board, we're seeing nice growth numbers as those economies rebound. I don't think we have a number for you from a ForEx perspective.
Okay, one last one. I don't think you really talked much about specific market verticals, I do recall the strategy pre these acquisitions was to focus on select verticals, not to be everything to every enterprise opportunity. You've had strength, particularly in education, hospitality. Any variances in terms of the vertical behaviors or any shift in this strategy of focusing on select verticals? Thank you.
What we're doing is we're developing use cases, we're looking at use cases that are horizontal, we're going to drop them into our verticals. If you take our Secure Automated Campus, if we look at how that would fall into, for example, manufacturing, it's going to be tweaked a little bit from how it drops down into healthcare or how that drops down into manufacturing. The one thing that did happen to the quarter, our reliance on K-12 , or our exposure to K-12 , which is a market which has been more susceptible to public bidding and more aggressive pricing and margin pressure, that's a vertical that has come down a bit for us. We have lower exposure, that's also been contributing to our higher gross margins.
Great. Thanks for taking my questions.
Okay.
Thank you.
Our next question comes from Christian Schwab with Craig-Hallum Capital. Your line is now open.
Hey, great. I only have one question. What can we grow at now? If we're a billion-dollar business and we're walking away from some Avaya business, which makes perfect sense, what is the targeted growth rate for the three years that you would be targeting as an average CAGR following this June?
We're not putting guidance out that far. Appreciate the question. What we've said is that when we're acquiring these businesses, we sort of laid out the core Extreme to mid- to low-single digit. The companies that have come in, that have been acquired at that $430 million revenue run rate, those we expect to grow and to grow beyond that into the future, and we'll be putting together, as we project, as we go through Q4, our outlook. When you look at the first quarter of projection, we're projecting a healthy organic growth in the core Extreme, which now includes Zebra business. We're projecting sequential growth in the Avaya and the data center business. As it all comes together, we're going to have to figure out how we modify the guide, but we're saying the low- to mid-single digits now, and I think we'll hold there.
Okay. Yeah. We still feel, even with the Avaya just walking away from business, you knew you'd have to walk away from some of that lower margin business, whether other people on the call knew or not. Your top line growth expectations of low- to mid-single digits on the combined company hasn't changed, correct?
Correct.
That's all I got.
Okay.
Our next question comes from Alex Henderson with Needham & Company. Your line is now open.
Yeah, I just wanted to go back to actually, similar to what was just asked. The current quarter that was just reported, can you try to give us a little bit better sense of what was going on with the organic growth? I think you said it was 1% in the quarter at Extreme per se. Is that what-
Extreme Zebra combined.
Yeah, Extreme Zebra combined, right?
Yeah.
Is that what we should be using as the organic growth for the quarter because everything else is non-organic?
Yeah. Well, I think that's-
That's how we were kind of looking at it.
That's how we're looking at it for this quarter, We're expecting that number to go up, take a jump, going into the March quarter.
The increase from the 1% to the low to mid single digit organic growth is driven by the cross-selling predominantly and, to some extent, the opportunities within the install base of where customers might have been reluctant in the past to buy for a variety of reasons?
I mean, at Extreme this quarter, we had issues related to distie. That was part of the distributor issue that I mentioned before. The pushback from a discounting perspective is also happening within the Extreme portfolio.
I'm sorry, I thought the pushback on discounting was predominantly in the Avaya portfolio, which would not be in the EZ piece.
It was in the Avaya portfolio predominantly, we're also getting more stringent on discounting in the core Extreme portfolio. It's a combination of both, Alex. I think with what we're looking at in terms of how the product roadmaps are coming together and the opportunities that we see in the pipeline, we have a good visibility, and we're quite confident in our forecast for the March quarter.
Okay. The mechanics to get to the higher growth is predominantly coming from what is that?
Yeah. What we've said, I think how to think about it is that we are going to be on the $430 of acquired revenue. We're going to be a little bit ahead there, you're going to see a nice step in the organic growth of core Extreme, which core Extreme is the Extreme and Zebra combined business.
Okay. I'll cede the floor. Thanks.
At this time, I'm showing no further questions. I'd like to turn the call back over to Mr. Ed Meyercord for closing remarks.
Okay. Well, we appreciate all the questions. We thank everybody who could join us on the call today. I do want to shout out to all the employees at Extreme. There has been a lot of extra lifting going on as we integrate these businesses while driving the train. We're collectively really looking forward to the putting up March numbers when we have all the assets combined into one, and having our first full quarter as the combined new Extreme. Thank you and have a great evening.
Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day.