AudioCodes Ltd.
Q3 2023 Earnings Call Transcript

Published: 2 Nov 2023

[Operator:]

Greetings. Welcome to AudioCodes Third Quarter 2023 Earnings Conference Call. [Operator Instructions] I will now turn the conference over to your host, Mr. Roger Chuchen, VP of Investor Relations at AudioCodes.

[Roger Chuchen:]

Hosting the call today are Shabtai Adlersberg, President and Chief Executive Officer; and Niran Baruch, Vice President of Finance and Chief Financial Officer. Before we begin, I'd like to remind you that the information provided during this call may contain forward-looking statements relating to AudioCodes business outlook, future economic performance, product introductions, plans and objectives related thereto, and statements concerning assumptions made or expectations to any future events, conditions, performance or other matters are forward-looking statements as the term is defined under U.S. Federal Securities Law. Forward-looking statements are subject to various risks and uncertainties and other factors that could cause actual results to differ materially from those stated in such statements. These risks, uncertainties and factors include, but are not limited to, the effect of global economic conditions in general and conditions in AudioCodes' industry and target markets, in particular, shifts in supply and demand, market acceptance of new products and the demand for existing products; the impact of competitive products and pricing on AudioCodes and its customers, products and markets; timely product and technology development, upgrades and the ability to manage changes in market conditions as needed, possible need for additional financing, the ability to satisfy confidence in the company's loan agreements, possible disruptions from acquisitions, the ability of AudioCodes to successfully integrate the products and operations of acquired companies into AudioCodes business; possible adverse impact of the COVID-19 pandemic on our business and results of operations. The effects of the current terrorists attacks by Hamas and the warrent hostilities between Israel Hamas and Israel Hezbollah as well as the possibility that this could develop into a broader regional conflict involving Israel with other parties may affect our operations and may limit our ability to produce and sell our solutions. Any disruption in our operations by the obligations of our personnel to perform military service as a result of current or future military actions involving Israel and other factors detailed in AudioCodes' filings with the U.S. Securities and Exchange Commission. AudioCodes assumes no obligation to update this information. In addition, during the call, AudioCodes will refer to non-GAAP net income and net income per share. AudioCodes has provided a full reconciliation of the non-GAAP net income and net income per share to its net income and net income per share according to GAAP in the press release that is posted on its website. Before I turn the call over to management, I'd like to remind everyone that this call is being recorded. An archived webcast will be made available on the Investor Relations section of the company's website at the conclusion of the call. With all that said, I would like to turn the call over to Shabtai.

[Shabtai Adlersberg:]

I would like to welcome all to our third quarter 2023 conference call. With me this morning is Niran Baruch, Chief Financial Officer and Vice President of Finance of AudioCodes. Niran will start off by presenting a financial overview of the quarter. I will then review the business highlights and summary for the quarter and discuss trends and developments in our business and industry. We will then turn it into the Q&A session. Niran.

[Niran Baruch:]

Before I start my formal remarks, I would like to remind everyone that in conjunction with our earnings release this morning, we will post shortly on our Investor Relations website and earnings supplemental deck. On today's call, we will be referring to both GAAP and non-GAAP financial results. The earnings press release that we issued earlier this morning contains a reconciliation of the supplemental non-GAAP financial information that I will be discussing on this call. Non-GAAP net income exclude share-based compensation expenses, amortization expenses related to intangible assets, expenses related to deferred payment in connection with the acquisition of Callverso, other income related to a payment made by the landlord of AudioCodes Inc., a subsidiary of the company in connection with the termination of lease agreement for its offices in New Jersey, financial income related to exchange rate differences in connection with revaluation of assets and liability in non-dollar-denominated currencies. Noncash deferred expenses or income and noncash lease expense, which is required to be recorded during the quarter even though this is a free-rent period under the lease for the company new headquarters. To provide investors with a more accurate view of our current operating performance, we are adjusting lease expenses in our non-GAAP presentation. We calculate the non-GAAP adjustment by subtracting the noncash lease expenses during the quarter for our new offices, which are currently under construction from our total lease expense. The exclusion of these noncash lease expenses reflect the fact that we are not required to pay rent with respect to the new office during the quarter, and we are not yet occupying the new offices. After this adjustment, lease expenses in the non-GAAP presentation for the quarter will be equal to the lease expense for our current occupied office. In the future, our non-GAAP presentation will reflect an upward adjustment for lease expenses over the life of the lease for the amount of lease expenses excluded in our non-GAAP presentation during the free rent period. We will be comparing our third quarter 2023 results to the prior quarter as we believe it provides a better gauge of our financial performance. Revenues for the third quarter were $61.6 million, an increase of 2.6% over the $60 million reported in the second quarter. Services revenues for the third quarter were $30.6 million, accounting for 49.6% of total revenues. The amount of deferred revenues as of September 30, 2023, was $77.8 million compared to $77.7 million as of June 30, 2023. Revenues by geographical region for the quarter were split as follows

[Shabtai Adlersberg:]

I'm pleased to report solid third quarter 2023 results against a difficult macro backdrop with ongoing strength in our core enterprise business overall, partially offset by softness in our noncore service provider segment. We continue to perform well in our enterprise business, now reaching a record 90% of company revenues. Within enterprise, our UCaaS business continued to perform well, with Microsoft business up 13% year-over-year. Microsoft Teams business grew 20% year-over-year. LiveTeams annual recurring revenues grew north of 50% year-over-year, ending the quarter at $43 million, we expect Teams Live annual recurring revenue to grow approximately 50% in 2023 as planned earlier in the year. Customer Experience business grew 13% year-over-year, and conversational AI business bookings grew over 50% year-over-year. Importantly, leading indicators such as stable amount of newly created opportunities remains robust and new business bookings had grown substantially above 2022, giving us increasing conviction about our business prospects for the rest of 2023 and into 2024. As referenced earlier, our noncore service provider segment remains challenged, down about 50% year-over-year. This is primarily attributable to customers adjusting CapEx plans, delayed projects and tightened inventory investment amid the challenging macro environment. Important to note, however, that we have won several new projects with leading service provider that can provide incremental revenue contribution in 2024. Now the positive development in the third quarter is the continued evolution in our conversational AI space merges a key growth engine for the next years. Our investment in the conversational AI product innovation are paying off and have successfully positioned our UCaaS and CX segments for faster sustainable top line growth. Conversational AI bookings grew over 50% year-over-year. Since our announcement of the Microsoft Teams certification of Voca CIC in July 2023, our lightweight AI-first Team CCaaS platform, we have seen a step-up in customers' interest and engagement. The success with our CCaaS offering is having a pull-through effect on our -- on the rest of our conversational AI portfolio, in particular, in our generative AI-powered recording services. We are stepping up our efforts in the cognitive services space with key investments in speech to text and generative AI and LLM technologies. In that regard, we believe that we own a unique advantage in maintaining a very comprehensive knowledge in several key vital technologies, which are really vital to create efficient systems. We own technologies such as telephony, VoIP networking and a variety of cognitive services technologies. Integrating these technologies with the vast experience we have in delivering full end-to-end solution and services creates for us clear unique advantage and capability to emerge a strong player in the emerging voice AI space. As an example to the advantage we have developed with our conversational AI in the UCaas space, we are now seeing rising interest and progress made with our meeting insights, workflow productivity application for meetings in the enterprise space. Coupling meeting insights with the line of devices we have developed for the meeting rooms position, position us with a unique leading solution for the emerging meeting space. A few more notable developments in the third quarter are the following. We saw professional and managed services continue to evolve at a meaningful pace. Services accounted for 49.6% of revenues and grew 13.8% year-over-year compared to mere 2.4% in the previous quarter with an acceleration in growth rate primarily related to timing of professional services completion. What has fueled our ongoing momentum in services is primarily our live subscription business, which ended the third quarter at $43 million annual recurring revenues, up from $40 million last quarter. Additionally, we ended the quarter with total contract value for our live subscription, growing close to 10%, up from over $120 million in second quarter and providing us with an increasing level of revenue visibility. We expect strong momentum in live services to continue for the balance of 2023 and beyond and reiterate our annual recurring revenue target of $46 million to $50 million by the end of this year. A few more notable developments in the third quarter are the following. We see a shift in our product mix to software and services. Noncore hardware-related product percentage of our revenues are now down to around 20%, contributing to increase in gross margin in our revenue. Noncore hardware relates to business lines such as the service provider CPE, IP phones and technology legacy. As we continue to add new value-add voice software application and services, we expect hardware-related percentage in our product mix to decrease below 20% and to contribute to the continued increase in gross margin in the coming years. Another major trend in our sales operation is the shift from CapEx selling to recurring revenue sales, a trend that will affect our long-term financial model and relating mainly to both the top line and the bottom line results. On the top line or at the revenue line, we expect annual revenue growth to moderate to the range of 6% to 12% compared to the previous years, our annual growth rate was -- range was between 10% and 13%. This decline is a direct result of moving to recurring revenue, where recognition is spread over 36 to 60 months rather than recognizing in a single quarter. However, the bright side of it is that on the earnings side, this trend contributes to key results

[Operator:]

We will now be conducting our question-and-answer session. [Operator Instructions] Your first question is coming from Ryan MacWilliams of Barclays.

[Ryan MacWilliams:]

Do you think products like Microsoft Co-Pilot for enterprise could drive more enterprise customers to put their communications following Microsoft Teams and then in turn utilize your solutions at AudioCodes to help them do that for things like voice?

[Shabtai Adlersberg:]

Yes, that is the play. I believe just as Microsoft thinks that moving from one telephone solution partner, like in the past, could be Cisco, Avaya and anyone else into Teams, it will be really desirable mainly if on top of Teams, you can provide higher value applications. This is indeed what Co-pilot provides, and this is indeed what we're trying to do with our value, voice of the application. Voca CIC is a contact center in our IVR on top of Teams phone. Same goes for Meeting Insights, same goes for smarter. Yes, I definitely believe that with Co-Pilot becoming useful and contributing to gaining more insight into the phone system and voice interaction resulting from it? Yes, that will definitely help in the future to the growth of Microsoft Teams phone.

[Ryan MacWilliams:]

You guys have a pretty strong exposures in terms of facing up against the macro with federal customers and large enterprises and the time to Microsoft are things that I think have been a little more resilient at least so far during this earnings season. As you talk to some of your largest customers or potential customers, what are they saying right now about next year? Do they think they can grow next year? Or are they still -- because they're on better footing, being more enterprise, more comfortable continuing with large enterprise deployments. Just want to hear how they're thinking about their budgets and their place in the macro at this point.

[Shabtai Adlersberg:]

Yes. I'm less in a direct touch. Quite frankly, we're deeply looking to make 2023 successful. Have not yet. I mean, we're entering our planning phase normally in November and December. We can though judged by their actions and from what we can see, I think definitely Microsoft Teams is an essential platform for collaborating, both on-prem and remotely. I think it is really do exactly what we just answered on the previous questions, they will simply look to enhance their productivity. Definitely, generative AI will be there to drive more voice-based software applications. We have not seen a decline. I'm not aware of a substantial uptake. We see the business continuing developing. Microsoft should grow for us this year around 10-ish, 10%, 12%, and we expect to see that next year. I think that the increasing maturity and more value from applications will definitely help drive usage of the system. No decrease

[Operator:]

Your next question is coming from Greg Burns of Sidoti & Company.

[Gregory Burns:]

I appreciate the improved momentum or execution you had quarter-over-quarter. Can you just remind us what is the primary drivers of the year-over-year decline, particularly around, I guess, on the product side of the business. Can you just give us a little bit more color on the primary drivers of the year-over-year decline and I guess the outlook for getting back to revenue growth?

[Shabtai Adlersberg:]

Yes, it has to do primarily with the split of our business between enterprise and service provider. Yes, we can see and definitely in the third quarter, we've seen that more than before, Enterprise business is well on its growth, and we have not seen -- except for a slight decrease in the first quarter in Microsoft. The rest of the year, we see growth. The other side of the business, which is service provider really suffers badly. To give you some rough numbers, looking on the overall 2023, take one line, the service provider CPE. We reached about $40 million level of revenue last year. This year, we do not expect more than $30 million. The major decrease in product value comes from product used by service provider, namely gateways and service provider and MSBR. Also, there was an issue of inventories of IP phones, which due to high interest rates drove partners to hold less inventories. However, let me give you one perspective that we have not mentioned so far about, say the decline in gateways and MSBR, as the world moves from PSN to IP increasingly, I would tell you that in our longer-term plans, we assumed that in the next three to five years, we will see a decline in sales of other products, mainly gateways and MSBR but that was primarily based on the fact that the process would be linear. Unfortunately, due to the global crisis in 2023, -- this process has accelerated. I believe that we have seen the majority of that decline occurring already in the first three quarters of 2023. Basically, I think what we should have want through the next three to five years, substantial part of it we went through in 2023. That's what drove our product decline. Also IP phones. I think I mentioned the high cost of inventory, but we're seeing come back. One area that we have not touched and mentioned just briefly is the MTR in the meeting rooms. We do expect we have invested heavily in the last two years to prep it. We believe that we will start to see the benefit of it already in 2024. This is a huge market. We know there was a big push by Microsoft into the MTR space in 2022, which subsidized a bit because of the inflation, the high inflation and interest rates, which affect hardware cost. Hopefully, if we see that changing somewhere mid '24 or towards the end of the year, I believe that already in '25, we will see a big ramp-up in that. We will then probably go up in products.

[Gregory Burns:]

You mentioned, I guess, the hardware mix on the noncore piece, and I guess you just discussed some of that. In the core on the enterprise side, what's the mix of hardware versus software on that part of the business, particularly around SBCs?

[Shabtai Adlersberg:]

Yes. The good news on that, as we see is a major line for us, the annual level of revenues for SBCs give or take about $120 million. Now we constantly move more to software. Many new SBCs solution are cloud-based. Even more than that, while in small branch offices, you need to use some hardware, we know in the process of moving from proprietary designed hardware that we engaged with in the past. We're now moving into using software that's embedded in service, we purchase from other parties. All in all, majority of our SBC is going to become software-based. That's a trend. Therefore, the very high gross margin that we will enjoy.

[Operator:]

Your next question is coming from Ryan Koontz of Needham & Company.

[Ryan Koontz:]

I wanted to see if you could unpack the gross margin strength, the nice job you did there. You talked about product mix and software and services. Is the shift to subscription and software the key driver there on gross margins? Or is there more to understand if you could help us unpack that?

[Niran Baruch:]

No, it's mainly related to the improvement in our service revenues, which is now about 50% of total revenues and also relates to more software as part of the product and high gross margin product, as Shabtai mentioned, the SBC was very strong this quarter, and it's in a better gross margin than the other products, such as the MSBR and IP phones. It mainly relates to the product mix.

[Ryan Koontz:]

With regards to the software services revenue at 50%, is there further upside in margins in that business as you continue to scale? Or do you feel like you really achieved your goals there within that mix and that margin?

[Niran Baruch:]

No, if you look at the supplemental deck that we published with our results on our website, you will see that our long-term target for gross margin is 65% to 68%. There is more room for improvement in gross margin.

[Ryan Koontz:]

On the AI products and your strategy around pricing and maybe your cost advantages you have from bringing that technology in-house considering the different commercial strategies out there on one side, you've got Microsoft Co-pilot charging a very hefty premium for their capabilities. You've got Zoom who's essentially giving it away. What's your approach to your AI feature set with regards to cost and price? Then how do your costs compared to maybe others that are depending on outsourced, using outsourced models?

[Shabtai Adlersberg:]

I'll tell you, usually, when you go to market, you want to penetrate the market, cost is less important. You drive with let's call it quick and dirty, using many cloud-based services that may cost a bit. Once you become successful and cost becomes an issue, I think you need to include in your strategy, the ability to move to solution, including generative AI solution that will owned by itself. There's a huge first running forward an industry that provides a lot of open source solutions for generative AI in our plans for the future. We definitely would like to decrease cost based on our solution developed internally. I would also add that due to the issue of security, you'll find many large corporation enterprises and entities, government entities, et cetera, that are forbidden from using a cloud solution. Therefore, mastering those technologies and bringing them into your development team and potentially developing on-prem solution will result both in, obviously, security, but then with substantially lower cost. One needs to navigate among all those options and find out the one that's best suitable for him.

[Operator:]

Your next question is coming from Samad Samana from Jefferies.

[Samad Samana:]

You guys talked about how leading indicators robust and new business bookings have grown substantially over the last year. Maybe double-clicking and asking another way. You talked about last quarter how bookings experienced a measurable improvement over Q1. In terms of an update on that, how do bookings track over the course of Q3? How did that compare to Q1 and Q2? Follow-up, can you rank order and speak to the products and offerings that are driving that bookings and pipeline activity and maybe the products and offerings that have been maybe a little less successful and potentially a headwind to that activity?

[Shabtai Adlersberg:]

In our conversational AI, I would split the discussion into two. We have currently two lines, which are already up and running and generating revenues and profits but are, I would say, mildly in scope of -- and those are the SmartTAP and Voice.AI connect. We do have a major focus and emphasis on two fast developing business lines in this conversational AI. Those would be Voca CIC, a CCaaS platform for Teams. Second one is the Meeting Insight platform for enterprise voice interaction processing. We definitely see maturities driving the evolution of this, obviously, the need in the market. Booking is growing definitely due to the fact that there is increased need in the market for this type of solution. We glad to be among the front runners who can provide it.

[Samad Samana:]

I want to ask Ryan's question in maybe a different way. How should we think about the sustainability of gross margins over the next, call it, a handful of quarters? Should we expect a lot of quarter-over-quarter variability? Or should we expect that the product mix will be generally similar or potentially improving compared to the Q3, the quarter you just reported in subsequent quarters.

[Shabtai Adlersberg:]

We haven't done yet a detailed analysis, but I'll tell you that basically, I think we've seen some of the worst in the hardware side of the business, mainly the service provider, the CP and the zones. We do not expect those lines to grow. Therefore, the hardware part of the mix will not affect gross margins. We see growth coming from software and services related business, mainly in Microsoft Teams phone in customer experience and conversational AI, all our majority which is software. I do expect gradual growth going forward. In our long-term financial model, we basically target the range of 65 to 68 or even I would dare to say that in two, three years from today, will reach to 70. We will not see big change in the trend. I think we would see a gradual increase towards the 68 and thereafter. That's what we plan.

[Operator:]

[Operator Instructions] That appears to be the end of the question-and-answer session. I'm going to hand back over to the management for any closing remarks.

[Shabtai Adlersberg:]

I would like to thank everyone who attended our conference call today. On the heels of good third quarter and solid pipeline this quarter, fourth quarter, we have high confidence in our ability to successfully expand our business this year and in coming years. We look forward to your participation in our next quarterly conference call. Thank you all. Have a nice day.

[Operator:]

Thank you very much. This does conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.