Good morning, and welcome to the Extreme Networks Conference Call. This call is being recorded. With us today from the company is Ed Meyercord, the President and Chief Executive Officer Drew Davies, the Executive Vice President, Finance and Chief Financial Officer and Frank Yoshino, the Vice President of Treasury and Investor Relations. At this time, I would like to turn the call over to Frank. Please go ahead, sir.
Thank you, Takiya, and welcome to today's conference call to discuss Extreme Networks' agreement to acquire the wireless LAN business from Zebra Technologies. 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. The presentations and the recording of this call are copyrighted property of the company and no other recording or reproduction is permitted unless authorized by the company in writing. By now, you have had a chance to review the company's 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 the federal securities laws in relation to the company's acquisition of certain assets of the wireless LAN business from Zebra and the future operating performance and outlook of the company and the combined company as well as other future events and their potential effects on the company and the combined company. 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. For a detailed description of these risks and uncertainties, please refer to our most recent reports on Form 10 ks, 10 Q and 8 ks 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 the call this call, we will be referencing 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 is not possible at this time due to the fact that amortization, stock compensation expense and the impact of the markup of inventory to fair value for purchase accounting can only be determined in connection with the post closing valuation of the assets and other post closing activities of the company. Now I will turn the call over to Extreme's President and CEO, Ed Marckord, for some opening comments.
Thanks, Frank, and good morning, everyone, and thank you for joining us today. This morning, we are pleased to announce that we signed an asset purchase agreement to acquire the $115,000,000 wireless LAN business of Zebra Technologies for $55,000,000 in cash, less deferred revenue of approximately $7,000,000 In a way, it's a bit of a reunion since this is the wireless LAN business that Zebra bought from Motorola Solutions. This is Extreme's original OEM partner for delivering wireless LAN. We began discussions with the executive leadership team at Zebra over a year ago. And in the interim, both of our teams have worked together in a very productive and constructive way to make this happen.
Given that we are assuming wireless LAN customers who will remain Zebra's most important customers for their core products, the quality of the customer's wireless network experience remains Zebra's top priority. With Extreme's number one ranking in customer satisfaction and 100% in sourced technical support, we are well positioned to assume control of the critical wireless networking technology that many blue chip companies rely on to run their businesses every day. We're taking a win win approach with our peers at Zebra to create the best possible outcome for end users, our partners and employees. I'll first take a moment to provide a few highlights and why we think the acquisition is such an attractive opportunity for Extreme. Then I'll ask Drew to provide details about the transaction and address financial considerations.
Finally, we'll open up the line for Q and A. We've also prepared a supplemental slide deck, which is available on our website. Here are some of the highlights. First, this acquisition expands Extreme's presence in one of the fastest growing segments of the networking industry and expands our bench with talented key management and new and experienced wireless industry experts. Wireless LAN is growing at 6.3% a year versus 1% for the industry overall.
Driven by the growth of mobile devices and new demands from the Internet of Things. At closing, Extreme will be the 4th largest player in the overall wireless LAN market and the 3rd largest in our enterprise campus markets and our targeted industry verticals after Cisco and HPE. We'll be adding approximately 260 employees from the original Motorola solutions, pioneers in wireless technology. Wireless will now represent approximately 25% to 30% of our total revenue. 2nd, Zebra has a very strong position in the retail vertical as well as the transportation and logistics industry verticals where they have the number 2 market share in wireless LAN.
This will add over $1,300,000,000 to our target addressable market. Our TAM expands to $9,400,000,000 when we add these verticals to our target customers in education, healthcare, government, manufacturing and hospitality public venue. We will also diversify our high concentration in education and government segments where there is greater margin pressure. You can see some of the new logos will pick up in the slide deck. We're adding a strong base of blue chip customers with the likes of Walmart, CVS, Kroger and TJ Maxx in retail, FedEx, UPS and DHL and transportation logistics.
And in our current verticals like hospitality, we're adding Marriott, Hilton and Sheridan. In manufacturing, we're adding DuPont, Colgate, Honda, Panasonic and Coca Cola, among many others. We're also adding the New York Stock Exchange and the New York City Subway System for those of you based in New York. Many of these global corporations will open up new business opportunities, a hunting license, if you will, for our global sales teams and channel partners. 3rd, with this acquisition, we will significantly expand our product and service technology portfolio with new security capabilities like air defense and industry leading wireless intrusion prevention system, Wi Fi forensics and payment card industry and HIPAA compliance.
We're getting easy to deploy ultrafast installation solutions for retail and a new guest management platform for hospitality and healthcare. We're also buying the managed services team and the recurring revenue stream from that business that will bring us up the value chain with our higher end customers. In the wireless LAN industry, almost all the competitors use radio chipsets from Broadcom and Qualcomm. Most of the differentiation comes from operating system software capabilities and features. In this case, the former Motorola wing operating system has very large scale and multi site deployment capabilities that are well suited to deliver Wi Fi to large retail sites.
So you can think about our network system supporting sites like Kroger grocery stores, each with 50 access points and hundreds of locations. This complements our high density offering of very large deployments of thousands of access points and enterprise campus environments like a hospital, a college campus or an NFL stadium with few sites. We also see upside in our ability to bring what Gartner calls our visionary single pane of glass network management, control and analytics software platform to Zebra's customers. This was a gap in Zebra's portfolio and when we add our portfolio of wired switches, we will be able to offer these customers our expanded end to end wireless and wired networking solutions that will provide these campuses with complete visibility and control across their entire campus networks. Net net, our product portfolios are highly complementary.
We are expanding our wireless LAN capabilities to existing Extreme customers and we significantly expand our ability to sell end to end solutions to Zebra customers. We'll continue to carry forward the technology Zebra integrations and feature sets that will provide us with competitive differentiation. One last point as it relates to our technology, our timing is fortunate because in July, Zebra completed a product refresh of their entire portfolio, including next generation location based technology. So we will have positive sales momentum with these upgrades and we will have more flexibility from a timing perspective in our product roadmap and how we will integrate our technology. Finally, we expect this transaction to be highly accretive.
We expect to close the transaction in mid October, even though there is very little customer overlap in cases where we have common customers, we are the wired switch provider at the access edge or the core of the network, whereas Zebra is the Wi Fi provider, like the largest retailer in Spain, El Corte Ingles. That said, we have assumed a decline in Zebra's revenue as well as 10% revenue dissynergy in our outlook. In addition, we have not assumed improvement in Zebra's gross margin and we will go after that as well. This deal will add to our EPS in fiscal 2017 and we expect the deal to pay for itself with the cash flow from the acquired assets within 8 to 10 quarters. Given that both Extreme and Zebra use Oracle ERP systems and sales force for lead gen and point of sale, our plan is to migrate Zebra systems within 45 days of closing.
For more information on this, I will now turn the call over to Drew to cover transaction details and financial considerations.
Great. Thank you, Ed, and thanks, everyone, for joining the call on short notice. I'd like to talk through some of the financial metrics and integration efforts of the wireless LAN asset we will be acquiring from Zebra. As indicated in our press release, we will pay $55,000,000 for the assets of the wireless LAN business less deferred revenue of approximately $7,000,000 and subject to working capital adjustments. We will finance the transaction with a combination of cash on hand and an increase to our existing credit facility.
The integration efforts and realization of the synergies will be led by both Extreme and Zebra wireless LAN teams. We expect to realize nearly $26,000,000 of annual operating expense reductions with our integrated financial model compared to the business model prior to the acquisition. The structure of the asset purchase allows us to realize most of the operating expense savings on day 1 since we will generally only integrate headcount that will remain with the business longer term. The cost savings will be broadly based across sales, marketing, R and D, G and A and supply chain. The acquired sales and marketing operations will be combined within our regional sales structure with reductions in spending occurring where redundancies exist, while maintaining a strong focus and emphasis on customer support.
In R and D, we have identified opportunities to rationalize overall R and D spending and to merge product roadmaps by leveraging expertise across both teams. Zebra's wireless LAN business has a limited amount of dedicated G and A and almost all will remain with Zebra. Over the next 12 months, we will consolidate and align our manufacturing activities. We expect to rapidly integrate the wireless LAN customer transactions into Extreme's ERP, CRM and supply chain systems. We anticipate that we will be ready to process transactions from the new business shortly after the close of the deal.
The closing of the transaction is contingent upon regulatory approval, which is expected in mid October. We expect this acquisition to be accretive to our full year fiscal 2017 earnings and cash flows. We anticipate the strong cash flows of the business will pay for the net purchase price of the acquisition in roughly 8 to 10 quarters. I would like to highlight that revenue from the wireless LAN business will be impacted in 2 ways in the quarter following the close of the transaction. In our 2nd fiscal quarter ending December 31, 2016, revenue and earnings of the acquired business will be impacted by the date of the closing and by the accounting treatment of the inventory in the Zebra distribution channel.
The inventory in the channel at the time of closing will have already been recognized by Zebra as they recognize revenue on a sell in basis. On the other hand, Extreme recognizes revenue to distributors on a sell through basis, which means we defer revenue when it is shipped to the distributor and recognize the revenue when the distributor ships it to the end customer. Since Zebra has already recognized the revenue from product currently in the channel, we will not be able to begin to recognize revenue from the new business until after the inventory already in the distribution channel at the time of close has shipped to the end customer. In a typical quarter, we expect the new business to add approximately $29,000,000 to $35,000,000 in revenues with fiscal Q2 and Q4 anticipated to be seasonally stronger. As a result of the accounting impact, we anticipate the acquired business will add $14,000,000 to $20,000,000 to our fiscal Q2 revenue.
We expect non GAAP gross margin for the new business to be between 45% 49%, excluding amortization, stock comp expense and the impact of the markup of inventory to fair value for purchase accounting. The incremental non GAAP operating expenses from this new business are expected to be between 12 $1,000,000 $13,500,000 excluding amortization and stock comp expense. Our revenue, non GAAP gross margin and non GAAP operating expense estimates reflect our current expectations for the new business at the time of closing the transaction, and we believe there are opportunities for improvement after we complete the integration. For example, estimates do not include cross selling revenue opportunities from selling our switching and management software products to existing Zebra wireless LAN customers nor do they include implementation of gross margin initiatives we are driving in our existing business. Reconciliation of non GAAP to corresponding GAAP measures is not possible at this time due to the fact that amortization and stock expense can only be determined in connection with the post closing valuation of the assets and other post closing activities of the company.
We are integrating this business into our existing tax structure and do not expect a material change in tax expense. We expect total interest expense to be $1,200,000 each quarter for the remainder of our fiscal year, up from $600,000 currently. We will provide further financial details of the acquired business and its impact on our existing Extreme business during our fiscal Q1 2017 earnings conference call, which is planned for November 1. I would like to close by saying how excited we all are to begin working with the wireless LAN team from Zebra and their outstanding portfolio of products as we aim to build the world's leading provider of end to end wireless and wired networking solutions. And with that, we will now open it up for questions.
Thank And our first question will come from the line of Matt Robison of Wunderlich. Your line is now open.
Hey, thanks for taking this question. This makes a lot of sense. Can you say on as far as ZebraMotorola channels, what their nature is and if there's still some OEM business that you are or are not including in that revenue magnitude?
Yes. Good morning, Matt. Thanks. Appreciate you getting up so early. No, the our OEM business revenue out of Zebra or Motorola at this stage is essentially 0.
So there won't be an impact there. And from a channel perspective, there's not a lot of overlap. Given the fact that we're going into new industry verticals in terms of retail, transportation logistics, Their partner set is very different. So for us, we're actually excited about the opportunity to pick up new partners.
Well, my question was if they still had OEMs, other brands that they were
I'm sorry, I missed that. No, they do not. So it's all all the revenue is with these large customers.
So is no subtracting effect by you being a competitor to their channels?
Correct.
Okay. I'll have some other kind of product specific questions. I hope I can take those offline a little later. Thanks a lot.
Okay, terrific.
Thank you. And next question will come from Mark Kelleher of D. A. Davidson. Your line is now open.
Great. Thanks for taking the question. I want to talk a little bit about possible product overlap. I know 3 years ago when you bought Enteresys, one of the key aspects of that was to replace the Motorola wireless products with Enterasys products. So can you just kind of explain why you're now going back to the Motorola products and what markets and what capabilities do your existing wireless products not address?
Thanks, Mark. Yes, it's a good question. I mean, the motivating factor behind the Extreme and Terasys merger really wasn't about wireless. Wireless was a piece of it. And when you look at the 2 product portfolios, they're actually quite complementary.
As I mentioned earlier, when you Motorola's expertise, you think about these large retail providers, for example, like take a Walmart and they may have 50 access points in hundreds of locations. So their weighing operating system software has a lot of features built in and a capability to handle these very large scale multi location deployments, whereas the old Interisys wireless that we bought is more of this in the high density environment for the enterprise campus and a college university or the NFL stadiums. This is where our operating system and software has been designed. So we're viewing this as complementary. The other thing that's really important is what we are picking up from the deep experience that you get from your Motorola Solutions, Symbol, Air Defense.
From a security perspective, we talked about WIPs. We don't have those capabilities, so that's a significant enhancement. Location based services is important. They have a really slick guest portal. There is a there are a lot of different feature sets that we don't have that will be additive to our portfolio.
We'll be able to take this technology we'll be able to target this in our current verticals and apply and use these tools to build new solutions. And then lastly, the other thing we're doing is picking up their managed services business. We haven't provided this service directly. There's pent up demand with our channel and with customers inside of Extreme for us to be more actively engaged in managing their networks. The Zebra, the old Motorola Solutions, they have this team.
It's a 20 fourseven team that will allow us to do a few things. It provides us with a new revenue stream, a recurring revenue stream. It also puts us closer to these customers. And so in terms of the strength of the customer relationship, it strengthens that and then it also provides us upselling capabilities when we're in the network. So we're picking up a lot of capabilities.
And also on the Zebra side, the sales teams at Zebra have been very focused on selling handheld devices, scanners, handheld printers and the multitude of these kind of handhelds that you'd see in transportation logistics and retail. In our case, we're bringing our software. This could be a weakness in the Zebra portfolio in terms of our extreme management, extreme control and analytics. We haven't been able to offer that. At the same time, we have our hardware as far as access layer and core wired switching capability.
So we bring this to play and we'll be able to provide these customers full end to end wired wireless solutions with our single pane of glass. So within the Zebra sales teams, 90% of their focus has been on these handhelds and the wireless LAN teams have been very restricted in terms of what they've been able to do as far as approaching these customers. So now we're very excited about the opportunity to release our sales teams on this really exciting base of blue chip customers.
Okay. That's very helpful. And just a clarification on the guidance. The inventory sell through issue that's affecting Q2, the December quarter, Do I understand that, that negative effect on earnings that that's going to have, because it will carry all the costs will be made up in Q3 and Q4 to be accretive total? Does that have a look at that?
Yes. We think that so in Q2, we'll get a little less than half of the revenue because of the inventory impact. We'll carry if we close in mid October, we'll carry about 85% of the cost of the quarter. But then we expect that, that inventory will sell through. There's less the 13 weeks in a quarter, there's less inventory in the channel than that.
So we expect that to clear through in that Q1 and then we'll be back to more of a normalized run rate in the in our 3rd fiscal quarter.
Okay, thanks.
Thank you. And our next question will come from Victor Chu of Raymond James. Your line is now open.
Hey, guys. Victor in for Simon. You mentioned the potential for 10% revenue dis synergies earlier. So what verticals are you expecting those in? And what verticals do you overlap with those you're doing
right now?
Victor, I we didn't specify we didn't go bottoms up vertical by vertical to come up with that number. We assume that there would be some revenue decline in the business. And then maybe just for conservatism, we applied a 10% discount for dissynergy. So I think that's really the logic there. At this point, we're not really prepared to get more granular on that.
Okay.
So Zebra's
pro form a gross margin profile seems to be a bit below extremes overall profile right now. And then you mentioned you're expecting to improve that at some point in the future. So are you expecting to get the margins up to the extremes overall corporate gross margin levels? Or is that something that's going to be a more gradual process?
Yes. I mean it's something that we're definitely going to work on and we're going to take a lot of the same initiatives that we're working on with our existing business, mainly pricing and discounting discipline, working on solution selling, selling their APs with our software solutions with extreme management control and analytics. And then working on channel incentives to incent the channel to sell at higher margins. And then we believe that we've got opportunity on the gross on the cost of goods sold side as we consolidate the supply chain. But that's going to it will take time.
In this business, the product gross margins, unlike our current business, the product gross margins are actually higher than the services business. And that's because there's a lot of managed services on the service side, which has a lower gross margin, but it requires a lot less R and D and SG and A. So it's got it still has an
And are you expecting to incur any integration expenses? And if so, when does that get incurred?
So the majority of the integration significantly less in Q3 and maybe a significantly less in Q3 and maybe a very small amount in Q4, but I don't have the granularity on that right now.
And our next question will come from Rohit Chopra of Buckingham Research.
Good morning, Ed and Drew. Three questions for you. What was the total customer count that you're actually getting? I do see the logos in the presentation, but what's the total customer count?
Yes. At this stage, we're not, Roe, we're not prepared to provide the total number. We provided logos, you'll see in the slide deck. There is it is amazing when you look across at the names, even in manufacturing, we're in the manufacturing vertical and we have Intel Corporation and Samsung Electronics and Hitachi and you kind of go on with some of the people we have in manufacturing. And then you look at Colgate, DuPont, Panasonic, Coca Cola Bottling, they have some really large accounts in our verticals as well as the new retail and the transportation logistics that we mentioned.
At this stage of the game, we're not providing that customer.
Okay. And just so you know, the reason I was trying to figure that out is just want to get a sense of the upgrade opportunity, but also the cross selling opportunity with the switching. So maybe we can talk about that at some other point. Okay. Next question is the service versus product, just on an annualized basis.
Do you have that?
Yes. So
the product is about 80% of the revenue and service, which is managed services and maintenance is about 20% of
the business.
Okay. And the last question was, Ed, and I think you'll remember this, but on the Acerus acquisition, it was
a little bit challenging,
I think, and you weren't obviously service to those customers. And I just wanted to know, like, if there's a plan in service to those customers. And I just wanted to know like if there's a plan in place to sort of keep these customers, make sure you guys go them from a service perspective and not just that upgrade opportunity that's out there. And I think you know what I'm talking about with Interisys, right? There were some early challenges, I think.
Absolutely.
And Ro, what I think everyone has to keep in mind is that the Extreme and Terrisys, it was really a merger and Extreme acquired a business that was actually larger than Extreme. Culturally, the companies were very different. And there were a lot of issues and there were a lot of integration issues. There were a lot of technology debates about how the roadmap should be built and where the company should drive its investment in R and D. This is a very clean asset purchase.
I will tell you we have a very clean and clear product and technology roadmap. I mentioned the refresh. We have some time because their technology has just been upgraded. I will also tell you that from a planning perspective, a lot of work has gone into planning on this deal. It was a due diligence phase, it was extensive, integration planning, which has been extensive and very collaborative.
The first time we met with Zebra, they made it clear that their number one priority was their customers. And it's really important, for example, for CVS that their wireless LAN continues to function smoothly. So it gives us comfort in a way in derisking this because we're really going to we don't have an official partnership, but we're taking a partnership approach towards going after these customers with new opportunities. So, yes, we've had over 110 people under the tent on our side. We have very extensive and detailed bottoms up plans.
Now we go into the implementation phase, and we're feeling very confident about the integration. The other comment that I made in my script is that we expect to they're on Oracle and Salesforce. We're on Oracle and Salesforce. So it's really a porting exercise here that we expect to get done in less than 45 days after closing. Very different.
Just to be clear, this is a controller based solution that even on the upgrade side that Zebra had is a controller based solution, right?
That's great. They have a controller based solution. They also have a cloud platform that they're coming out with. And then they also have an AP, a controllerless AP called Wing XPress that they've come out with. Okay.
So, yes.
Thank you. Thanks, Ed.
Okay. Thanks, Rob.
Thank you. And our next question will come from Christian Schwab of Craig Hallum Capital. Your line is now open.
Hey, thanks. Congrats on the deal guys. Ed, can you remind us, I haven't found it yet, but how big was this business when Zebra acquired it in 2014?
Yes, Chris, we're not really going back and it's something I think has to do with apples to apples comparisons and what assets are included or what assets aren't included. I can't give you at this time, I'm not prepared to provide you with historical information about the assets that were the specific asset group that we're acquiring.
Do you believe the specific asset group you're acquiring grow year over year for the last 2 years?
No.
The business has been in somewhat of a decline. Although recently it's stabilized. Historically, because of the size of the customer base and the kinds of customers that you're seeing, there were some really large deals, let's say, like if Walmart decides to upgrade their network, you can imagine the size and scope of that. So these some of these larger transactions had a really significant effect on their revenue. Over the course of the past year, they really haven't had any of these large transactions.
In fact, it's something that we're really excited about because we think there's it's time to refresh and there could be some of these. So most of the revenue that we're acquiring is it's almost recurring in nature of existing customers. And I've given the information in terms of the assumption that we made and information that we provided you, but we're very confident in our ability to stabilize and grow the revenue from this customer base.
And then a follow-up to, I forget what analyst asked the question, but along those same lines, when you figure out or have a number for all of us on the exact number of customers, Can you give us an update on if the mix is the same as when the asset was sold, roughly an eightytwenty mix between the distribution channel and the direct channel or direct sales force, so we can kind of figure out ourselves the cross selling opportunity for switches a little bit better?
Yes. I think we'll be able to get you back. I mean, I don't think you should assume that the channel mix is different, but I think that in terms of what's being driven, the same thing is true in our business. In different regions, we have channel partners that are really driving business. In other regions, like in the Americas, it's more of our direct sales teams that are driving even though we sell through the channel.
So I'm not sure that's the right way to look at it. But I would say that in this case with larger customers, there's a lot more direct involvement. So that's how we look at it. Our plan is starting on today, we have very detailed plans and Zebra is going to be working with us and that's part of the agreement with them to immediately letters are going out, we're mapping accounts to our sales teams, making introductions and that process starts today. So we're going to be going after all these accounts in a direct fashion and working with partners.
Great. I don't have any other questions. Congrats on the deal.
Thanks, Christian. Thank you.
Thank you. And I'm showing no further questions at this time. I would like to turn the call back over to Ed for closing remarks.
Okay. Thank you very much. And again, thanks everybody for joining us. We're really excited about this. In Extreme, we see this as a big opportunity for us.
We're expanding our presence in the fastest growing segment of the networking industry. We're picking up we're expanding our bench and picking up some talented employees with depth in terms of their wireless expertise. We have new growth opportunities now in retail, logistics, expanding our addressable market. And as we've been talking about, we have this amazing base of customers now that we can go after along with our peers at Zebra. Doors are going to open and we're going to come in with a much larger product portfolio and a solution selling approach, which we think is going to be attractive.
If you remember, almost 80% to 85% of our sales come from existing customers. So we now have this a large base of new customers, blue chip customers that we can that are warm that we can go after. And then finally, when we talked about the technology, that's also a very big opportunity for us in terms of the enhancements and what we can bring to our existing customers and new customers. And finally, financially, this is going to be a it's a highly accretive deal for us. We're talking about some of the cash flow metrics.
We're expecting to generate significant cash flow from these assets with a very, very short payback. So anyway, we appreciate everyone getting up early this morning and getting on the call. I was on the phone late last night with the CEO of Zebra when we finally signed all the documents, Anders Gustafsson, he and I have a very good relationship. From the outset, when we had our first dinner, he said his number one priority were the customers and the quality of the customer experience. So I just want everyone to know this is a win win deal.
We're going to be working very closely with them and we look forward to working with Zebra on making this a big success. So thank you very much for your time today and stay tuned.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program and you may now disconnect. Everyone have a great day.