Thomas Dinges - Director, IR William Atkins - CFO and EVP Carl Russo - CEO, President and Director.

Simon Leopold - Raymond James & Associates George Notter - Jefferies Meta Marshall - Morgan Stanley Gregory Mesniaeff - Drexel Hamilton.

Welcome to the Calix First Quarter 2017 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Tom Dinges, Director of Investor Relations. Thank you. Mr. Dinges, you may begin..

Thank you, operator, and good afternoon, everyone. Today, on the call, we have President and CEO, Carl Russo, as well as Executive Vice President and Chief Financial Officer, William Atkins. This conference call will last approximately 60 minutes and will be available for audio replay in the Investor Relations section of the Calix website.

Before we begin, I want to remind you that in this call, we'll 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 today's earnings press release 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. Reconciliation of GAAP to non-GAAP measures is included in our earnings press release and available on our website.

As a reminder, our earnings press release, supplemental financial data, including the recast of the presentation of our historical revenue and cost of revenue for the quarters and full year period for each of 2015 and 2016 and an accompanying earnings release presentation are available in the Investor Relations section of the Calix website.

For the quarter ended April 1, 2017, Calix reported revenues of $117.5 million, a GAAP loss of $0.67 per share and a non-GAAP loss of $0.57 per share. In just a moment, William will take you through the quarter in greater detail, and Carl will conclude with remarks on financial guidance, Calix's growth strategy and market outlook.

This will be followed by questions from analysts. With that, I would now like to turn the call over to Calix Executive Vice President and CFO, William Atkins.

William?.

Thank you, Tom. We last provided you with guidance regarding Q1 on February 14.

And in that guidance, we called for estimated revenues of between $110 million and $114 million; a non-GAAP gross margin of between 30% and 34%; non-GAAP operating expenses in the range of $61 million to $63 million; and non-GAAP EPS of between a loss of $0.57 and $0.49 on a per-share basis.

Relative to that guidance, our actual revenues for the quarter were $117.5 million, above the upper end of our guidance range. Non-GAAP gross margin was 30.1%, at the lower end of our guidance range. Non-GAAP operating expenses came in at $63.1 million, slightly above the upper end of our guidance range.

Non-GAAP EPS was a loss of $0.57 per share, at the lower end of the guidance range.

At the gross margin level, the largest drivers in the first quarter were costs associated with the quarter-end acceleration in activity for turnkey network improvement projects, including CAF II-related projects, as we completed and closed a large number of sites for an existing project and added new projects as we continue to ramp our services business.

These activities resulted in a sharper increase in services revenues, which carry lower margins than our systems product revenues in absolute dollars and as a percentage of revenues.

Systems gross margins were negatively impacted by higher warranty and retrofit costs, inventory write-downs for slower-moving product as well as less favorable shifts in product and regional sales mix.

Operating expenses were slightly higher than our guidance and increased compared to the year ago quarter, driven primarily by continued investments in R&D headcount as well as our acceleration of cost for prototype builds and the use of outside contractors to support new opportunities with both existing and prospective customer.

Getting into a bit more detail. Revenues of $117.5 million for Q1 marked a new first quarter record, representing an increase of $19.1 million or 19.5% year-over-year. This marked the second strongest quarterly year-over-year revenue growth since the third quarter of 2013.

Systems revenues were $91.6 million, representing 80% of total revenues and were essentially flat compared to the year ago period, as we saw some customers shift some of their CAF-related planning for 2017 towards services to start the year.

Services revenues were $25.9 million, representing approximately 20% of total revenues and were up nearly 3x from the year ago period, as we completed activity on one major turnkey network improvement project and continue to ramp other projects.

Within total revenues, domestic revenues were 90.6% of our Q1 revenues, representing an increase of $18.7 million or 21.2% year-over-year. International revenues were 9.4% of our Q1 revenues, representing an increase of $488,000 year-over-year. We had 2 greater than 10% customers during the quarter, representing 55% of revenues.

As I noted earlier, at 30.1%, Q1 non-GAAP gross margin was at the low end of our guidance range and was down from the 48.1% level in Q1 of 2016. Non-GAAP systems gross margins were 38.4% and down from the 49.9% level of 2016.

This decrease was primarily driven by product and regional sales mix as well as by the previously mentioned inventory write-downs on slower-moving inventory and by higher costs associated with warranty and retrofit. Non-GAAP services gross margins were just under 1% and down from the 22.9% level of 2016.

This decrease was primarily driven by higher costs associated with our continued ramp of our professional services business as well as by the higher pace of activities at quarter end, as we completed a significant number of turnkey network improvement sites for a larger project.

In the first quarter, we continued to accelerate the amount of services work, increasing our deployment of additional resources to complete work and substantially closing out the activity in one major project for an important customer, which drove the aforementioned higher costs.

As we noted last quarter, we've implemented a number of process improvements in the services business under the leadership of Greg Billings, who joined as SVP, Services last December.

While there are more optimization efforts underway, sequentially, we saw those improvement efforts start to positively impact our results and services, as non-GAAP services gross margins increased from negative 15% to just under 1%.

Q1 non-GAAP operating expenses at $63.1 million were up $11.5 million from $51.7 million in the same quarter a year ago, which included approximately $3.4 million of Occam litigation expenses.

The year-over-year increase primarily reflects higher headcount in costs associated with a higher use of outside contractors, particularly in research and development in addition to higher costs for additional prototype builds and overall research and development investment targeted at leveraging and promoting newer technologies to secure new, larger customer opportunities.

We continue to make strategic investments in our platform, systems and software as well as in our information technology systems, with these investments focused on a number of opportunities with large operators here in North America as well as on growing our market share amongst small- and medium-sized operators.

Last quarter, I noted that we saw a scope for realigning our cost structure to allow for cost optimization in our traditional systems while increasing our focus in Software Defined Access and on expanding our customer base.

Towards the end of the first quarter, we began a targeted realignment of our operating costs in order to reduce our support costs in more traditional systems and reinvest a portion of those savings to fund additional investment in our growth-focused platform, systems and software.

Based on this plan, we took approximately $699,000 in charges during the first quarter, which were not included in our non-GAAP operating expenses. Turning now to the balance sheet.

We ended the quarter with total cash and marketable securities of $51.5 million or $1.04 on a per-share basis, down from $78.1 million or $1.59 on a per-share basis in Q4 and a decrease of $12.7 million from the year ago quarter.

The primary drivers in the year-over-year decrease in cash were negative operating cash flow in the first quarter of $23.5 million due to our operating loss and reflective of our higher cost of working capital needs for our services organization and investment in research and development.

During the quarter, we also saw a decline in customer prepayment balances as associated projects were completed and revenues recognized. Capital expenditures were $2.5 million in the quarter to support ongoing activity. Receivables DSOs were a healthy 33 days, flat compared to the previous quarter and down 5 days compared to the year ago quarter.

Inventory levels were $46.5 million in Q1, up from Q4's $44.5 million level and up from $41.1 million in the year ago quarter. With revenues rising the strong pace year-on-year, we are pleased by our team's performance in managing inventory levels. Inventory turns were 6.6x in Q1, essentially flat from Q4 and up from 3.9x in the year ago quarter.

At this point, let me hand the call over to Carl.

Carl?.

Thank you, William. And before I continue, I would like to thank William for his service and helping Calix transform. Thank you, again, William. We finished the first quarter with stronger-than-anticipated revenues and earnings within the guidance range we discussed with you back in mid-February.

Our revenue growth accelerated as we completed activity on 1 turnkey network improvement project, and we continue work on others. With that in mind, let me take you through our Q2 guidance. For the second quarter of 2017, we expect revenues to be in the range between $122 million and $126 million, representing growth of 14% to 17% year-over-year.

We are guiding non-GAAP gross margin to a range between 40.5% and 43.5% for Q2. While this is down from last year's Q2 level of 47.5%, it represents a 1,000 basis point improvement sequentially. We expect non-GAAP operating expenses to be in the range of $59 million to $61 million, up from $53 million in the year ago quarter.

The increase in operating expenses compared to the year ago quarter predominantly reflects incremental hiring and R&D costs to support our strategic investments to pursue broader opportunities in the market. To be clear, this guidance does not include the impact from our restructuring plan.

Based on 50 million basic shares, the expectations that I've just finished taking you through result in a guidance range for Q2 of a non-GAAP EPS loss between $0.19 and $0.12 per share. Despite the projected operating loss in Q2, we anticipate positive operating cash flow as working capital velocity should improve relative to Q1.

Looking beyond Q2, we see Calix solutions enabling us to continue our double-digit revenue growth. So far, the year is tracking relative to the expectations we discussed a quarter ago, with accelerated services activity in the first half of the year and our overall revenue following normal seasonal patterns.

In addition, we've accelerated our own activity on opportunities to streamline and optimize our operating costs driving improved operating leverage as revenues rise. As a result, our previous full year 2017 guidance for revenues increasing at least 10% and a lower non-GAAP net loss relative to 2016 remains intact.

As we have discussed, disruption is sweeping over the communications industry. And our innovations and investments have perfectly positioned us to ride this wave. To this end, we have continued to release a stream of innovations to help our customers win in their markets.

Here are just a few, we launched AXOS Sandbox, the world's first Software Defined Access virtual environment. I spoke about this exciting enhancement to the AXOS platform last quarter and customer interest has been significant.

AXOS Sandbox allows service providers to run the actual production version of our AXOS platform independent from the associated systems hardware. This changes the entire process by which our customers design, productize and deploy new services.

We continue to remove the massive burden of custom IT development costs for our customers, that are driven each time they deploy a new technology.

When we ushered in the era of any PHY or any PON service based on our revolutionary AXOS systems family, this enabled our customers to deploy new technologies without the need to reintegrate them into their back-office systems.

We continue to simplify the operating environment for our customers when we introduced the AXOS OFx Connector, which allows AXOS to rapidly integrate into ON.Lab ONOS and CORD environments.

We also launched the AXOS DPx, which unlocks Software Defined Access for cable operators by allowing for a simple plug-and-play solution utilizing a DOCSIS Virtualized Network Function based on a microservices architecture.

These enhancements continue to demonstrate that AXOS is the only true Software Defined Access platform in the marketplace and the innovations extended into our systems offerings as well.

We delivered the world's first and only true symmetrical gigabit over copper solution for MDUs, a key target market for our customers when we delivered cDTA into our bonded G.fast AXOS systems. And the AXOS E9-2 was recognized by the 2017 Lightwave Innovation Award with an almost perfect score from the judges.

The E9-2, which brings state-of-the-art data center technologies to the access edge, was described by a panel of third-party judges as easily expanded and most importantly, limits expansion to fewer edge systems, thereby rendering the access networks future-proof.

These accolades have peaked the interest of our customers and prospects looking to transform their networks into one unified access infrastructure. Finally, our second generation of Calix Cloud role-based analytics have hit the market, with our first deployment of Calix Marketing Cloud beginning last month.

The information that comes from Calix Marketing Cloud enables our customers to target their marketing campaigns, raising the return on investment and ARPU, while at the same time identifying potentially dissatisfied subscribers and meeting their needs, thereby lowering churn. Since our inception, Calix has established a reputation for innovation.

With AXOS and Calix Cloud, our customers are now able to revolutionize their access infrastructure and utterly upend their business models. It is the most exciting time in our history. With that, I would like to open it up for questions.

Operator?.

[Operator Instructions]. Our first question come from the line of Simon Leopold of Raymond James..

Handful of things I want to check on. One is, I appreciate you sending us -- sending out the slides. I'm looking at the segment details, you're breaking up services now on your fifth slide there. And clearly, the first quarter was a big jump from the past pattern in terms of the services contribution.

So I want to make sure I understand, one, what happened in the March quarter? And two, how do we think about this trend going forward? Is it go back to the more normalized level of 2016? Or is this have a longer duration in terms of the services contributions?.

So as you heard William note and I think I reiterated, there was one major turnkey program that was closed out. And when that happens, you get sign off on revenues and therefore, the mix was driven in Q1. And if you have more questions, William will certainly be willing to add color..

Yes..

As you look forward, obviously, we have so many things out now. We're not going to forecast them separately. But I will hearken back to the color that we spoke to before, Simon. We expect services to be a larger percentage of revenue in the first half and tailing off somewhat in the second half. And that's the best way I would characterize it.

I would not necessarily say it would go back to way, way back historical percentages. And the reason I wouldn't say that is because of the set of service offerings that are now being brought to market and developed by Greg Billings and his team.

So we expect services actually to be a significant component of our revenues, albeit probably not as high as it is today..

So that takes me actually to my second question, which was assuming services are still significant in your second quarter, understanding you don't want to forecast all that detail. You have talked about a very significant recovery in the gross margin.

So I'm just trying to make sure I understand what's driving that recovery in gross margin if it isn't the change in mix between products and services?.

It's not going to be mix. What you should expect to see is both segments that were reporting improved from a margin perspective. And that's as much -- as far as I would go..

Okay. And then, you also mentioned your customer concentration this quarter, appreciate you offering that 55% from 2 customers. Historically, you have not had anything quite that high.

So I wondering, if you can give us a little bit more color in terms of was this one customer spiking up or 2 customers being 25-ish percent? Anything you could help us to understand how this compares to your historical trends? And how we should think about a more normalized behavior?.

Yes, Simon, it's William here. What I would say is, we did note that we'd closed out one of our major network turnkey improvement projects. And that coincides with that gross and the customer concentration that you highlighted. And so I would just link those two together.

And just note that therefore a lot of it is driven by that services activity that we've been discussing..

[Operator Instructions]. Our next question comes from the line of George Notter of Jefferies..

I guess, I wanted to also take you on the gross margin discussion. So looking at your systems gross margin, that was quite a bit lower year-on-year. I think you said 34% change versus, I think, 50% a year ago.

How important was the warranty provision and then the inventory write-down in driving that lower gross margin?.

The net of it is that you're going to see systems bounce back up. So pretty important..

Yes, we had a number of what I would describe as one-off factors, not totally driven by inventory write-downs or warranty and retrofit or those where we call them out and therefore, they inherently must be drivers. We also had some one-off contractual sort of systems pricing move through the system that moved through our reporting systems.

And we don't expect that to be repeated. So I would say there are a number of one-off factors that affected systems margins this quarter..

Got it.

Is it fair to say that your systems gross margin would have been up year-on-year or down year-on-year or flat, you ex those one-off items or will it stay there?.

I would say, we'll look forward to chatting at the end of Q2. And I think you'll get a better read on things, George. But you are heading -- directionally your question is in the right direction..

I mean, I guess, I ask because the strategy here, I think, has been to develop more and more value in your products [indiscernible] software systems of course. I think the idea here is just to get more margin and more profitability on the systems side is continue to invest.

I just want to make sure that that's showing up in your financials? And at this point, I can't see it of course..

Yes, so to your point, that's exactly right. When you think about it from a moving part standpoint, you think about new things that are ramping up that might have a different value, older things that might be ramping down at a different value. Trying to tie those things out without having any excess and obsolete, et cetera, et cetera, et cetera.

We're going to go through that transition for a couple of quarters. But inexorably, there's no way we come back by a 1,000 basis points without both sides of that segmentation improving..

Okay.

On the services gross margin side, what you think that the right longer-term gross margin would look like in the services business? I mean it seems there's a lot of volatility here certainly, but, I guess, I just wanted to be sure that business makes sense to you guys to be in longer term that you can drive some component of profitability there for the company?.

Yes, so it really depends upon how this all evolves. If it evolves to a traditional feet on the street driving the vast majority of this, then services will be by some number of points below corporate average gross margins.

If it evolves into a higher software value add then actually you start to -- the services start to track more towards the systems margin and actually go up quite a bit. So it's really a future mix question. And I don't know the answer to it yet. But certainly, we're not intending on staying at the range that we are at for sure..

Our next question comes from the line of Meta Marshall of Morgan Stanley..

Quick question here. If you looked -- I just want to get a sense of over the course of the last year, you certainly focusing a lot on CAF II.

And so kind of is the split between copper business versus fiber business just on the products or on the systems side, like has that meaningfully changed year-over-year to become kind of more copper weighted? And then, the second question was, you noted in the script, the revenue was kind of more weighted towards -- or the spend from your customers is more weighted towards services this quarter.

And do you expect that the product growth rate would kind of go back to be more towards a high single-digit growth rate kind of going forward?.

Yes, let me answer the last one first. It's impossible for us to grow with the rate in front of us without the systems side of the segment growing at a good clip. So hopefully, that answers your second question. On the first, and I think as we discussed before, we don't break things out by a physical layer. We don't tend to think of them that way.

And even less so today, as we now have an operating system that's literally any PHY, so it's physically -- it's independent of the physical layer. I'm sitting annulling your question.

There may be a certainly greater mix of copper driven by some of the longer reach CAF deployments, but I'd have to go dig and need -- and look at it at a different way than we do..

Okay.

Yes, I mean, I'm just trying to get a sense of like there is, obviously, a lot of enthusiasm about fiber builds right now, but it just seems as if like you guys are spending a lot of time -- and your customers are spending a lot of time on kind of CAF II and whether that's distracting from some of their more fiber activity? I guess this is kind of what I'm getting at.

Is it CAF II a distraction from fiber activity currently?.

So we haven't seen that to be sure. We have seen customers doing more copper. That's why I was thinking about your question, because there's funds coming to them that are going to be deployed on a copper basis, because there're 10 megabits, 25 megabits, et cetera. So there's clearly some more of that there.

But by the way from a fiber infrastructure standpoint, they're dragging fiber out to those points..

[Operator Instructions]. Our next question come from the line of Greg Mesniaeff of Drexel Hamilton..

Given the commitments you've obviously made to your major customers recently and the gross margin trends that we have seen, can you give us any sense of any changes in market share that you can report as far as your competitive landscape?.

I don't think there has been anything that's noteworthy. Nothing I would call out positive or negative..

Okay.

Any color on pricing, macro pricing environment?.

Good question, Greg, but no. Neither there actually..

There are no further questions over the audio portion of the conference. I would now like to turn the conference back over to management for closing remarks..

Thank you, Operator. Calix's next quarterly earnings report for our fiscal second quarter ending July 1, 2017 will take place on August 8, 2017 after market close. In addition, management will be participating in investor meetings and conferences during the first quarter.

Information about these future events will be posted on the Events and Presentations page of the Investor Relations section of calix.com. Once again, thank you for your interest in Calix, and thank you for joining us today. Goodbye for now..

This concludes today's conference, and thank you for your participation. You may disconnect your lines at this time. Have a wonderful rest of your day..