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Greetings, and welcome to the Calix Second Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the call over to your host Mr. Tom Dinges, Director of Investor Relations for Calix. Thank you. You may begin.
Thank you, operator, and good morning, everyone. Thank you for joining our Second Quarter 2020 Earnings Conference Call. Today on the call, we have President and CEO, Carl Russo; as well as Chief Financial Officer, Cory Sindelar.
As a reminder, yesterday after the close of market, we released our letter to stockholders in an 8-K filing, as well as on the Investor Relations section of the Calix website. This conference call will be available for audio replay in the Investor Relations section of the Calix website.
Before we continue, we want to remind you that in this call, we refer to forward-looking statements, which include all statements we make about our future financial and operating performance, growth strategy and market outlook, and actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause actual results and trends to differ materially are set forth in our second quarter 2020 letter to stockholders, and in our annual and quarterly reports filed with the SEC.
Calix assumes no obligation to update any forward-looking statements, which speak only as of their respective dates. Also on this conference call, we will discuss both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our letter to stockholders. Unless otherwise stated on this call, we will reference non-GAAP measures.
With that, let me turn the call over to Carl. Carl?
Thank you, Tom. As the COVID-19 pandemic continues, it is clear our mission to connect everyone and everything is more vital than ever. The second quarter reinforced our view that the pandemic has accelerated the secular forces moving through the communications industry, while also creating additional demand resulting from the expansion of capacity to meet immediate subscriber needs. These two effects combined to drive strong bookings in the second quarter.
However, the pandemic has continued to challenge the component supply chain. Fortunately, the Calix supply chain team outperformed in the quarter and enabled us to deliver results well above the high end of our guidance.
For Calix, it appears the future is sooner. As a result, we have undertaken a targeted restructuring of the business. Ironically, the pandemic has allowed us to re-imagine our business as it might be three years from now. And thus, we have decided to embrace a full work-from-anywhere culture. This impacts our facilities requirement, and as of the end of the second quarter, we have reduced our overall real estate footprint.
Furthermore, as our customers are accelerating their transformation, we are further focusing our product offerings on our all-platform future. These changes are reflected in the charge we took to our GAAP earnings in the quarter. There is a growing class of service providers building new business models on top of the unified access infrastructure. These service providers deliver superior subscriber experience, and do so at the lowest cost. They are aggressive in growing their subscriber base and they are attracting capital.
Our all platform offerings speak loudest when the service provider is the aggressor and we are focused on helping them win. Even with customer travel virtually eliminated we still added 18 new customers in the second quarter. This along with our strong guidance for the third quarter is confirmation of the opportunity ahead.
With that, let us open the call for questions. Melissa?
Thank you. At this time, we will be conducting a question-and-answer session [Operator Instructions] Our first question comes from the line of George Notter with Jefferies. Please proceed with your question.
Hi, guys. Thanks very much. And I guess, a lot of my questions were answered already just through the release from last night and the shareholder letter. But I wanted to ask about gross margins, particularly, systems gross margins. And if I look at systems revenue, it was roughly equivalent to what you guys printed a couple of quarters ago in the December quarter.
And yet gross margins for systems were three points higher. Certainly, I understand the product mix and customer mix are helping you. But I'm wondering if you can give us some more color around that. Is that Calix Cloud? Is it anything else that might be going on there? And then also did you guys get impacted by additional supply chain or expedite costs because of the pandemic? Is that in that systems gross margin also? Thanks.
George, first of all, I will pass on your compliment to Tom Dinges in the stockholder letter for being comprehensive and answering lots of your questions. So thanks for that complement.
And now directly to your question on gross margins. As you know, we have said for a long time that as the all platform business accelerates, we expect gross margins to expand. But we have also said that we expect gross margins on any particular quarter to be noisy even though the long-term trend is clear.
In this quarter, we saw the benefit actually of a little bit of sort of, upward noise. So we had better mix. A number of factors that were just in our favor. But we've also seen -- in my opening comments, I talked about sort of the pull-forward of capacity during the pandemic versus what percentage of what we are doing is an uplift of our strategy. So customers actually using this as an opportunity to transform themselves quicker.
And the minority of it is that transformation but it's a good minority. So those factors combined are just further down the path. So adding the quarterly noise and I think you get to where we are.
To your question on expedite fees actually yes, they are included in gross margin and we are still challenged with expedite fees and spot charges on components. Cory do you want to add some color on that?
Yes. I mean, I would just say that we're seeing a fair amount of prohibitions in the supply chain. So we are out there looking for component inventory. Sometimes we're buying that on the spot market that's usually higher than our standard cost. And then expedite fees right? We're continuing to air freight material into the United States in order to meet the customer demand. And we're continuing to see that trend into the third quarter for sure. So we continue to work the supply chain aggressively in response to component shortages from where we see them.
And part of it -- and just real quickly George the combination of Cory's comments in mind are also obviously what gives us the guidance for Q3, right?
Got it. Okay. Any sense for how big that supply chain impact was in the quarter? I guess, I'm just trying to look at your systems gross margins and try to normalize for some of that stuff?
Yes, George that's something we haven't broken out. We don't report that on it separately. We certainly could quantify it. But I'm not going to give you much help on that piece.
Got it. And then you talked about the work-from-home benefit in the quarter. Could you give us any sense for how much benefit that might have been on the top-line? I know it's probably not an easy question to answer, but any color you could give us there would be great. Thanks a lot, guys.
When you say on the top-line so what we saw from a revenue standpoint?
Correct.
Yes. I want to break it up into two different things. Again, the pandemic drives a number of behaviors in our customers. And so there's a significant portion of the beat that relates to that for sure. And it's broken up into the majority of it was pull forwards on capacity. The minority we actually saw an acceleration of our all platform model. So I don't know how to quantify it more than just to say let's just say that it's the majority of the beat.
Okay. Thank you.
Thanks, George.
Thank you. Our next question comes from the line of Paul Silverstein with Cowen. Please proceed with your questions.
Thanks. I'll try asking the question although I suspect I already know the answer. Carl on Access EXOS Cloud and Edge beyond what you had in the shareholder letter can you give us any sense for what the -- I know they're still small and early albeit ramping aggressively. But can you give us any sense for where they are as a percentage of total revenue collectively?
No differently than we've characterized before Paul. So you do know the answer. It's -- we've said it's greater than 10% and less than 50%. And that's where we would keep it today.
Okay. It was greater than 10% also last quarter. Presumably it's that much greater as a percentage given the numbers that you discussed in the shareholder letter?
Correct. It's continuing to grow at an aggressive pace.
Okay. With respect to your larger customers while they have become the minority of revenue not much over 20% it looks like they've also returned to growth. And not only has the risk been moderated, but it looks like they're now also contributing to the larger growth profile. Any thoughts you could share with us in terms of what's going on at CenturyLink number one. But also with those Tier two customers that are still 5%, 6%, 7% of revenue?
Yes. Actually let me broaden your comments because if you look at large, medium and small all are growing now. And so it would appear that we are through the dread many quarters of headwinds and everybody is now starting to grow at their own rate.
CenturyLink my comments would not change from where they have been in the past, which is we expect CenturyLink to be roughly flat year-over-year. And their business is moving forward on plan. Everyone else is basically in those sets, sort of, chugging along on plan. One quarter might be up a little bit one quarter might be down. But there's no new news there Paul.
All right. And finally is there anything of a one-off nature either in the quarter or that you would anticipate in this quarter and coming quarters?
I can't think of any one-offs from my perspective. Cory, you?
I think of a couple in the OpEx area. The overperformance in the second quarter has led to a higher level of incentive compensation in Q2 comparing to Q1 or what we would expect it to be going forward. And we also -- as you comb through the 10-Q you'll see that we took a bad debt write-off in the second quarter for one international customer. And so that was reasonable size enough so that we called it out in the Q. I wouldn't expect that to happen again.
Cory on the overcompensation or the better-than-expected compensation. I assume if you had another similarly strong quarter in Q3 and Q4, we would see the same phenomenon?
Not true, but not to the same extent. So if you were looking at kind of where the targets were set a Q2 target was lower. So there's a greater percentage over performance. Our expectation for Q3 is larger. It will be harder to overperform to the same degree.
All right. Carl if I may let me ask you one last question. I know it may sound like speculate about the future, but RDOF, there's been a lot of press, a lot of actions in Congress most recently with the two different bills in the house and the senate proposing acceleration. Any thoughts you can share? Any incremental insight that you have on the timing?
Speculating about the future is fun. So let's spend a moment on RDOF. As we've discussed the Rural Digital Opportunity Fund is currently in full flight. There are bids going in. There will be awards being made. But current course and speed on RDOF, the funds won't be distributed until third quarter of next year.
There is discussions going on on Capital Hill about potentially accelerating this program. If those discussions bear fruit, you may see some of those funds being let earlier next year maybe even pulled into late this year. However, if that occurs for us being a platform and systems provider, we probably wouldn't see an effect until second quarter of next year. So it might change the revenue impact for us by two quarters, but it still would be very speculative to say that that's going to pass Congress.
Just as we've talked for about other infrastructure investments that might be coming on top of RDOF, along with various states' investments. So under the general heading of, we believe there will be a lot of infrastructure investment in broadband, I think you and I would agree. The timing of those things and the magnitude is spread out frankly all over the next decade.
So -- I apologize to you and everybody else on the call for one more question. On the -- you brought up an important point, which is it's not just federal, but also states. Can you give us any flavor for the types of the programs and magnitude?
There's lots of state programs. That would be a much longer conversation, because we'd have to sort of go through them. But they're in the tens of millions and potentially $100 million. So they're modest compared to RDOF, but these go on in various states quite frequently and actually is fly below the radar.
I assume as with U.S. Federal, there's been some pickup in those programs to some extent with all the focus on the bigger part?
Yes. As I was saying that I was thinking about over history how much pickup there's been. Let me defer that and do a little homework. I don't know if there's been a material pickup. They've sort of always been there, but there may have been Paul. So I'm going to take a rain-check on that one and come back to you.
All right. I’ll pass it on. Thank you.
Thank you, Paul.
Thank you. [Operator Instructions] Our next question comes from the line of Christian Schwab with Craig-Hallum Capital Group. Please proceed with your question.
Hey, congratulations guys on a great quarter and a good outlook. I only have one quick follow-up question regarding CenturyLink. I just want to make sure, I heard you correctly that you would expect them to be flat year-over-year, potentially in 2020 versus 2019 given the very strong start that they've had in the first half. But are you suggesting that in aggregate, September and December will be less than the first half of the year, is still your current plan. Is that correct?
Well they've been a 15% customer I think in both quarters. And with that they're running a couple of million dollars ahead of that flat number. So it's not going to be -- it's going to sort of be the same Christian. And I think to try and parse it any closer would really be getting down to detail that we don't have a view into.
Great. And then I guess one last question. Can you highlight for us in particular what components need to be expedited that are super tight for you today?
They run the gamut from silicon to optics to small components and chiclets. It's all over the place. I wish it was a narrow set.
But it's a broad-based set of stuff is -- I guess is what you're saying. Is that fair?
It is and it's slowly improving. But so is our demand. And so we have another quarter of supply chain team burning the candle at both ends.
Fabulous. Congrats again. No other questions. Thank you.
Thanks for the congratulations. Appreciate it.
Thank you. Our next question comes from the line of Tim Savageaux with Northland Capital Markets. Please proceed with your questions.
Good morning. And I'll add my congratulations on some very strong results. I think I have two questions. One on margins, one on the top line. I'll start with the gross margin question. And what I want to focus on is incremental gross margins, which seemed to tell a fairly interesting story if you look at I guess on a year-over-year basis. Both your results and guidance incremental gross margins look to be in the 70s I guess or close or maybe even greater than that. And I wonder what we should take from that with regard to that being an indicator of the kind of status of the company's software platform transition and what the eventual business model of Calix 2.0 might look like? And then I'll follow-up.
So first of all one thing that I take away is that you're good with a calculator. So that would be my first comment. Secondly, we've spoken in the past about long, long, long-term that this model could resolve itself in the 60s. So I think directionally that gives you a sense for how we're thinking about it. Keep in mind that our platforms as you know are hardware independent, as they are fully abstracted operating systems. But while that sets us up to potentially have an all software future, we believe for the foreseeable future, we will always be providing systems for many of our customers, because there's really not a stable white box market to provide the hardware independent from the software.
So over time, we think we'll continue to see the model more. You are directionally on the right track with your incremental margin calculation. But I would dissuade you from taking that number and starting to drive it into the model in the near term.
Right. Yeah. No problem there. But just in terms of direction I think a pretty healthy looking metric. Switching to the top line, you'd mentioned, I think 17% growth among smaller carriers. Although, you did see some weakness internationally in the quarter, I wonder, if you might make a comment on that. And in that context, it looks like U.S. small carrier or rural broadband growth if we can say that might have been in the mid-20s which is pretty significant there. And you've kind of already addressed this to some degree to the extent that growth rate in the company's overall growth rate is well above your long-term targets at this point. I imagine there is – you might point to a pull-in dynamic that would drive that short-term outperformance. But are there any other issues that are driving such above trend U.S. rural broadband growth if indeed I'm getting that calculation right? And if you can talk to what's happening internationally especially in the context of CityFibre potentially ramping later on? Thanks.
Yeah. So let's go to international first, which is as you know international is a smaller portion of our business, which is quite lumpy and it always just moves around. So there's no conclusions to draw there. On your other calculations, I will directly point to the pull forward being the largest percentage of what we're seeing in over performance. But there's a minority that is clearly an uplift of the model. And so one of the things that you sort of have to noodle is the pull forward nature from 2021, and how much of that continues versus not and that's what we are looking to get our arms around as we go through these next couple of quarters. But what we're focused on is the minority of the outperformance representing an uplift as in a strategic uplift of our model where customers are genuinely looking at the pandemic as an opportunity to accelerate their transformations.
I think you could understand that we are obviously involved in helping our customers transform their business models. And to the extent that more of them choose to do so sooner, because of the pandemic that's the biggest strategic driver of our business. And ultimately, what would feed the incremental margin calculation that you did in the future. I trust that makes sense.
It does. Congrats once again. Thanks very much.
Tim, thanks very much, appreciate it.
Thank you. [Operator Instructions] Our next question comes from the line of Fahad Najam with Cowen and Company. Please proceed with your question.
Thanks for taking my question. Carl, your comments about your supply chain outperforming does that suggest that you think that you've gauged market share against competitors? And can you just elaborate on what do you mean by the supply chain outperforming? What do you think is the issue that the other broader supply chain that you think your supply chain outperformed?
Very simple. They outperformed our expectations going into the quarter. When we set the expectations for Q2 last quarter, we did so as a balance of demand and supply. Ordinarily, you're setting it more based upon demand without supply being a particular constraint. And they simply outperformed our expectations going into the quarter.
As for market share per se, given the all platform focus of the business, we don't see any competitors for that business, so we don't think of it in terms of market share. So I would simply not answer that question. This is not how we think.
Got it. Appreciate it. And in your response to Tim's question, you alluded to the fact that you're still trying to grapple with, how much of a pull forward you're experiencing right now. But wouldn't it be fair to say that the current climate is probably the best thing that could ever happen. And it's probably the best case scenario.
We're all stuck at our home. We're kind of limited in our mobility. And service providers are a bit mostly caught flat-footed. And so the gap between demand for bandwidth and their ability to provide that capacity is quite huge right now. But as they add capacity there seems to be certainly indicative of your results, there seem to be adding that capacity.
So maybe this is like the best case scenario, this is the best demand scenario that you could think of. And then from here on it just essentially kind of normalizes and goes down and declines as capacity gets added. Wouldn't you say that this is probably the best environment that you can ever have?
No I wouldn't say it's the best environment, we could ever have. I have an imagination that could allow me to come up with better scenarios. But this is certainly a very good one. However, this is why we take the time to say, the capacity upgrades and we're trying to parse that, represent more of a pull forward.
It's the model uplift that we're focused on. And so what's actually very good for us is not the temporary pull forwards. What's very good for us is that, that work from home is causing a lot of our service providers to actually say, wait a minute.
We have to figure out how to deliver our services without rolling trucks. We have to figure out a way to satisfy our subscribers in a way that we haven't in the past. And those types of questions cause them to start to look at our all platform offerings and accelerate the uptake of those. That's what is the most lasting and telling shift in the business. And that's what we're focused on.
I appreciate the answers. I'll pass it along.
Thanks, Fahad.
Thank you. Ladies and gentlemen, this concludes our time allowed for questions. I'll turn the floor back to Mr. Dinges, for any final comments.
Thank you, Operator. Calix's management will be participating in three virtual investor conferences during the third quarter of 2020. Information about these future investor events will be posted on the events and presentations page of the Investor Relations section of calix.com.
Once again, thank you to everyone on this call and on the webcast, for your interest in Calix. And thank you for joining us today. This concludes our conference call. Goodbye for now.
Thank you. This concludes today's conference call. You may disconnect your lines at this time. Thank you for your participation.