Cornerstone OnDemand, Inc.
Q2 2017 Earnings Call Transcript

Published: 4 Aug 2017

[Operator:]

Good day, ladies and gentlemen, and welcome to Cornerstone OnDemand's Second Quarter 2017 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. And now, I'll turn the call over to Alexandra Geller, Manager of Investor Relations for Cornerstone OnDemand. Please begin.

[Alexandra Geller:]

Good afternoon, everyone, and welcome to Cornerstone OnDemand's second quarter 2017 earnings conference call. As always, today's call will begin with Adam Miller, Chief Executive Officer, who will provide a brief overview of our performance; and then Brian Swartz, Chief Financial Officer, will review some key financial results for the quarter which ended on June 30, 2017. Later, we will conduct a question-and-answer session. By now, you should have received a copy of our press release, which was released after the market closed today and was furnished with the SEC on Form 8-K. You can also access the press release and related investor materials, including detailed financials, on our Investor Relations website. As a reminder, today's call is being recorded and a replay will be made available following the conclusion of the call. Our discussion will include forward-looking statements, including, but not limited to, statements regarding our business strategy, demand for our products, certain projected financial results and operating metrics, product development, client satisfaction and retention, client attrition rate, market or business growth, our revenue run rate, investment activity in our business, visibility into our business model and results, the effect of capitalized development costs, spending on R&D, professional services and other aspects of our business, our appraisal of our competitors and their products, and our ability to compete effectively. Forward-looking statements involve risks, uncertainties and assumptions. If any of the risks or uncertainties materialize or any of the assumptions prove incorrect, actual results could differ materially from those expressed in or implied by the forward-looking statements we make. These risks, uncertainties, assumptions, as well as other information on potential factors that could affect our financial results are included in today's press release and the Risk Factors section of our most recent Form 10-K and subsequent periodic filings with the SEC. During the call, we will be referring to both GAAP and non-GAAP financial measures. All financial figures discussed today are non-GAAP, unless we state that the measure is a GAAP number. The reconciliation of our GAAP to non-GAAP information is provided in the press release and on our website. With that, I will turn the call over to Adam.

[Adam Miller:]

Thanks, Alex, and thank you to everyone for joining us today. I would like to start with some good news. In the second quarter, Cornerstone won what we expect will become the largest contract in the history of the company. The U.S. Postal Service plans to deploy the full Cornerstone human capital platform to over 600,000 employees. The agreement we signed authorizes but, like most federal deals, doesn't guarantee the U.S. Postal Service to purchase software and services for Cornerstone Recruiting, Learning, Performance and HR over a 10-year period inclusive of all options. For the second quarter, billings exceeded our expectations and reached a record $119 million, representing reported growth of 12% and constant currency growth of 6%. In addition, we continue to see improvements in profitability with approximately $1 million in net income, marking the first time in which we achieved two consecutive quarters of profitability. As both Brian and I will speak to later in this call, we believe there is considerable opportunity for continued margin improvement in the coming years. In the second quarter, we grew our client base organically to more than 3,000 enterprise and mid-market organizations from all over the world. New client additions include the University of Georgia, Aerojet Rocketdyne, Birlasoft India, Banco de España, the Federal Communications Commission, Sopra Steria Group, University Hospitals Health System, the Chinese division of Asia Pulp & Paper, the Austin Independent School District, a $10 billion North American tire manufacturer, Mobivia Groupe in France, a leading telecom service provider in Hong Kong, Grupo Bafar in Mexico and many more. In Q2, we continue to grow our user base, adding more than 1 million net subscribers. This amounts to a total user base of more than 32 million subscribers, representing one of the largest subscriber bases of any software provider in the world. This summer, given the challenges we had in Europe last year post Brexit, I chose to take an extended business trip to Europe. I was able to see firsthand how Cornerstone HR was resonating with our clients and prospects alike. The challenge with many European multinationals is that because they were built by acquisition, they run on a very decentralized basis with several HRIS systems in place. The prospect of ripping out and replacing their many HR administration systems is daunting, expensive and often politically untenable. Yet their need to centrally report on their employee data and their desire to enable a modern approach to employee self-service is real. The same time, they're strategically focused on taking a world-class approach to managing their talent. Cornerstone HR provides the solution. I am pleased to report that Cornerstone HR is seeing strong success in Europe. More than one-third of our new second quarter wins in Europe included the Cornerstone HR Suite. As we had hoped, the introduction of this product has moved us beyond stand-alone talent management into the broader market for human capital management and, as a result, it has increased our total addressable market. As we've discussed on recent calls, Cornerstone HR is not our only recent major product initiative. At our Convergence Client Conference in June, we introduced two new analytics offerings; Cornerstone Engage and Cornerstone Benchmark. Engage strengthens our Performance Suite by enabling organizations to measure key employee engagement factors through pulse surveys to uncover real-time critical employee insights and make positive organizational change. Benchmark supports our HR Suite and leverages Cornerstone's global workforce data to identify and compare key HR and talent metrics against internal teams and industry peers. But unquestionably, the biggest product announcement at Convergence was the introduction of our learning experience platform. As you know, we started in the learning space. And today, Cornerstone has become the thought leader in the space with one of the largest learning distribution platforms in the world. Last year, we managed over 350 million training registrations. We have helped our clients build a culture of learning and development and supported them in the rapid evolution of learning from online training to blended learning to social learning. Today, we are seeing yet another major transformation in workplace learning that's being driven by two forces. The first is a rapid pace of technological change, which is affecting every industry on the planet. Because of technology, almost every job is changing. And lifelong learning is no longer optional. In this world, the onus of career development shifts in part from the company to the employee. The second is taken from the consumer world where standards for the consumption of media have changed. Netflix has become the prototypical interface for the consumption of video. And Spotify has done the same for audio. As a result, today's adult learners who are consuming training media typically in the form of video expect a similar consumer-like experience. Cornerstone's learning experience platform will provide our users with a fully consumerized experience, similar to Netflix and Spotify, to streamline the search and discovery of training for personal and career development. It leverages machine learning to fully personalize the experience for each learner. And because it was built on top of the world's leading learning management system, our users have a unified experience for both elective and mandatory or compliance training. For those of you that watched my keynote at Convergence, you heard Josh Bersin, the Principal and Founder of Bersin by Deloitte, and arguably the most respected analyst in the learning industry, state that, quote, Cornerstone is the only vendor that has built a learning experience platform on top of the learning management system. And he believes that our learning experience platform is, quote, the most significant thing Cornerstone has ever done as a company. As we have continued to build out our product offerings and have refined our pricing and packaging, we have created an even more compelling value proposition for our clients. As a result, we are seeing more first-time clients purchasing multiple suites upfront. In Q2, the number of unified talent management deals, including Recruiting, Learning and Performance for new clients more than doubled from the previous quarter and nearly tripled relative to a year ago. Within our installed base, we also continue to round out client suites with significant cross-sells around the globe. To name a few, the largest IT-enabled services provider in India with more than 70,000 employees started out with the Learning Suite. And in Q2, they selected the Cornerstone Performance Suite to replace their existing SAP performance product. They first became a client in December 2016. And despite their short tenure, they have already seen substantial business benefits within the Learning Suite and are very excited to unify both Learning and Performance. In France, our client SUEZ, a global expert in water and waste management became a client in September 2016 when they purchased the HR and Performance Suites for one of their business units. Since then, they've expanded their Cornerstone footprint twice. And as of June of this year, their products encompass our full HCM platform across all SUEZ business units, representing nearly 80,000 employees. SUEZ chose Cornerstone for the organic nature of our platform, our unified approach to talent management, our modern user interface and the flexibility of our solution. And back in the States, one of the largest car rental companies in the U.S. more than doubled their population of Learning users in Q2 to nearly 60,000 employees. They initially rolled out Learning for compliance training in 2014 to all corporate management levels, but still had disparate processes amongst employee populations. This expansion within the Learning Suite enables global oversight of training across all full-time employees. I'd like to wrap up with a summary of our longer-term goals. From a top-line perspective, our goal is to achieve $1 billion in revenue. Given the breadth of our platform, the enormous size of our total addressable market and our substantial global distribution, we believe we can achieve that goal through continued execution of our existing business without the need to enter new markets or the need to develop new product categories. Of course, we will continue to innovate to sustain our leading position in learning and talent management. We also need to maintain our industry-leading retention rates, and we will continue to focus on client success. And while our Q2 top-line results exceeded expectations, we are not satisfied with our current growth rates and are focused on improving execution globally. At the same time, we will continue to drive margin improvement. We have made significant strides in profitability and, once again achieved profitability in Q2. While our operational excellence initiatives have already demonstrated strong progress, we believe they will continue to drive margin improvement into the future. From strategic sourcing operations, to sales productivity programs, to our program accelerate delivery initiative, we've seen positive early results and we expect that significantly more benefit will be realized over the next several quarters. With that, I'd like to turn it over to Brian to discuss our financial performance in more detail.

[Brian L. Swartz:]

Thanks, Adam, and good afternoon, everyone. As Adam highlighted, we are pleased with our performance in Q2 relative to our expectations. Before I begin with our financial overview, I am proud to report that last week, Gartner, the world's leading technology research and advisory company, issued a report on us because Cornerstone, quote, out-executed many of its peers to become a leading talent management suite software provider. The report further stated that, quote, because Cornerstone had outperformed most of its original peer group in business and strategy execution, we believe business unit leaders of other SaaS vendors can learn from Cornerstone OnDemand actions to accelerate their own companies' growth ambitions, end quote. We believe this type of third-party analysis validates our leading position in the marketplace. And now, on to the financial summary. In the second quarter, billings came in at $119 million, which represents a year-over-year increase of 12% on a reported basis and 6% on a constant currency basis. We exceeded our billings expectation due to our strong performance in the U.S. public sector, EMEA, as well as favorable currency. We have forecasted solid public sector activity in Q3, but pulled in a significant portion of that business into Q2. The win with the U.S. Postal Service, which Adam discussed, is expected to be the largest deal in the company's history. The contract is an ID/IQ or Indefinite Delivery/Indefinite Quantity contract. It is dependent on the receipt of task orders from the Postal Service, the first of which was executed this June. I would also like to point out that as I've stated on past calls, due largely to our success at the top end of the market, which requires more services and less success in the U.S. mid-market in recent years, we have continued to experience a higher percentage of new sales as services. Moving on to revenue. In the second quarter, revenue was slightly above the midpoint of our guidance range coming in at $117 million, a year-over-year increase of 9% or 13% on a constant currency basis. The split between subscription and services revenue was approximately 83% and 17%. Our services revenue was down in the first half of 2017 due to the timing of service delivery, which is often determined by the clients. We expect this trend to reverse in the second half of the year because, in our experience, clients attempt to finalize projects before year-end. A few other key Q2 metrics. The size of our client base increased to 3,076 clients as of June 30, representing 78 net client additions during the quarter. And we added 1.1 million net users during the quarter, bringing our user base to more than 32 million users. Finally, we added 74 net new employees, bringing us to 1,933 employees at the end of the quarter, which represents a 12% increase over the prior year and 4% sequentially. Our gross margin was 73% in the second quarter, up 300 basis points from the prior year. This improvement is largely a result of a higher percentage of subscription revenue. With respect to operating expenses for the quarter, we continue to demonstrate improved efficiency in sales and marketing expense. Sales and marketing expense was 47% of revenue, down 80 basis points year-over-year. To give you some perspective, just two years ago, in Q2 of 2015, sales and marketing was 56% of revenue or 900 basis points higher than it is today. This improvement continue to be largely driven by the optimization of our sales head count across various teams as well as the impact of the commission plan changes we made in early 2016. Given our trends on new sales over the last 18 months, we recognize that our trends on sales efficiency or CAC have not moved in the right direction. We are focused on this metric and expected to improve over time. R&D expense was 11% of revenue or 120 basis points more than the prior year, principally as a result of our increased investment in new head count to support our product development initiatives. I'd like to point out that R&D expense, including capitalized software development cost of $6 million, was roughly $18 million or 15% of revenue. G&A expense was 14% of revenue or 170 basis points more than the prior year, primarily due to continued investment in our operational excellence initiatives, which we expect to result in significant savings when fully implemented. Overall, this resulted in an operating margin of 1.1% for the quarter, which represents an improvement of 100 basis points from our operating margin of 0.1% in the prior year. Driven in part by our continued focus on controlling operating expenses, net income for the quarter was $1 million or $0.02 per diluted share compared to a net loss of $0.1 million in the prior year. Please note this is the first time we have achieved two consecutive quarters of profit, which highlights our commitment to continued improvements in profitability. As a reminder, for EPS purposes, our weighted average diluted share count of approximately 57 million increases to approximately 62 million in quarters in which we report a profit. With regard to cash flow, free cash flow, which we define as operating cash flow less capitalized software and capital expenditures, was negative $5 million in the second quarter. Now, let's turn to our balance sheet. We continue to maintain a well-capitalized balance sheet. As of June 30, our total cash and investments balance was approximately $329 million. Additionally, as of June 30, we had $243 million in carrying value of long-term debt. You will notice that in our June 30, 2017 balance sheet, we have classified our outstanding convertible note as a current liability. We are currently evaluating various alternatives related to retiring the convertible note and we'll update you as we move forward. Our deferred revenue balance was $263 million as of June 30 compared to $236 million in the prior year, representing a year-over-year increase of 11%. Now, let's discuss our 2017 outlook, which has been developed using the best information we have as of today. Please note that all guidance assumes a U.S. dollar to British pound exchange ratio of $1.31 to £1, up from $1.28 on our last earnings call. We are maintaining our full year 2017 revenue guidance range of $477 million to $487 million. At the midpoint of $482 million, this represents approximately 14% growth and 16% constant currency growth over the 2016 revenue of $423 million. If the British pound were to change by 5%, the approximate impact on our full year revenue would be about $4 million. For the third quarter of 2017, we currently expect revenue between $117 million to $120 million. At the midpoint, this represents 10% growth on a reported and constant currency basis. You will note that given our Q3 revenue guide, we are expecting a significant year-over-year increase in Q4 revenue. This increase is driven by our expectation that a large percentage of our services revenue, which has been trending less than historical averages in the first half of 2017, will be delivered in Q4. These services include the new U.S. public sector wins as well as other recent large deals. Furthermore, the Q4 revenue increase is supported by our expectation that Cornerstone Realize, also known as program accelerate, our new delivery methodology, will begin to have a greater impact later this year. Regarding billings, we are maintaining our full year 2017 expectation of growth in the low to mid-teens. We expect third quarter billings on an absolute dollar basis to be similar to Q2 and believe our pipelines will support the expected growth in the second half of the year, particularly Q4. With respect to profitability, we are very pleased with our performance through the first half of the year and expect to be profitable in each of the two remaining quarters of 2017. We expect our Q3 margin profile to be similar to the third quarter of 2016 and are maintaining our previously communicated guidance for full year operating margin of approximately 6%. We are also reaffirming our free cash flow margin for the full year 2017 of 6% to 7%, with Q3 margins similar to 2016. And finally, with respect to the long-term margin targets, we remain committed to achieving an operating margin of at least 10% by 2018 (24

[Adam Miller:]

Thanks, Brian, and thank you to everyone joining us today. As always, I especially want to thank our global team for all of their great work to help more than 32 million people around the world to realize their potential. We will now take your questions.

[Operator:]

Our first question comes from the line of Michael Nemeroff from Credit Suisse. Your question please.

[Michael Nemeroff:]

Thanks for taking my questions. Adam – I've got one for Adam and then one follow-up for Brian, please. Before Concur was acquired, they built a very large federal government business, as everybody knows. And this win with the USPS, that's a great new piece of business. But everybody knows that there are several other very large federal agencies with tens of millions of employees. Are there other large federal agencies that you're in discussions with currently? And if so, how far into the sales cycles are you?

[Adam Miller:]

Yeah. So, there are 14 cabinet-level civilian agencies. We have several of them now. And there are many more to go. So, we're in discussions with many of the cabinet-level agencies on the civilian side. We also have been working on penetrating more business on the DOD side of the equation, which are also very large organizations, but managed completely separately from the civilian side of the government. So, the answer is there is more business to come. Also, noteworthy is that the business we've already gotten, in particular, the U.S. Census Bureau and the U.S. Postal Service, will grow significantly over time. They start out as relatively small deals and are authorized to become very large deals over time as they get deployed to the full population.

[Michael Nemeroff:]

That's helpful. Thanks. And then for Brian, the operating expenses this quarter came in markedly above what I think myself and the Street was modeling, particularly the – actually, all of the OpEx lines. Was there anything that impacted those lines? Was there a bit of hiring that you did in advance of some new business that you expect to get that drove the EBIT a little bit short of expectations?

[Brian L. Swartz:]

Yeah. So, there was some – hi, Michael. Good question. So, there was some accelerated hiring that we did so our hiring plan for the year, if you recall, we said we expected it to be in line, if not slightly above last year's growth level, which I have to check the exact number, but I believe it was 11%. But in general, there was some of that that took place in Q2, not at any specific project or anything else, but just in general. We also had just some timing of marketing spend where we had some opportunities to capture high-quality leads to drive pipeline growth. We accelerated some of that into Q2 as well. So, there definitely was some from timing related. The other thing is just to remind everyone, and this is consistent year-over-year, but seasonal in nature, is our Convergence Event obviously takes place in Q2. And so, there are some incremental costs associated with that.

[Michael Nemeroff:]

Okay. And then lastly, on the guidance for Q3, a little bit below what the Street was expecting. Is there any change in your confidence and how you've been giving the guidance for Q3 and also for the full year?

[Brian L. Swartz:]

No. I mean, the full year guidance is, obviously, consistent with the last call, and our Q3 guide is very consistent in the way we've done in the past. I will note, as I said in my comments, obviously, the Q4 number in the revenue increase is tied to the delivery of services, where we expect that to happen today. We sold some very large accounts like Census and U.S. Postal Service and others, and we expect the delivery of those services to take place in Q4. But outside of that, there's nothing different or unusual the way we did the forecast or the guidance.

[Michael Nemeroff:]

Okay. Thanks. nice job on the quarter, guys.

[Adam Miller:]

Thank you.

[Brian L. Swartz:]

Thank you.

[Operator:]

Thank you. Our next question comes in the line of Alex Zukin from Piper Jaffray. Your question please.

[Alex J. Zukin:]

Hey, guys. Thanks for taking my questions. So, I wanted to ask about the Postal Service deal. I guess, is there any way to get a sense for the proportion of that deal that gets – maybe this – any sense for size or contract value total or annual, and the proportion of how that deal will, over time, come into the P&L? And how that also underlines maybe some of your confidence around the guides for the full year?

[Adam Miller:]

Sure. So this is an IDIQ agreement, so it means Indefinite Delivery/Indefinite Quantity. It is a five-year deal with options for another five years. So, it's effectively a 10-year deal. And the way these work is much like a purchase order, where you get authorization to spend up to X amount. In this case, that total ceiling amount is a nine-figure amount. And that can be spent over the course of the 10 years through a series of, what they call, task orders that specifically order certain products and services. We've gotten an initial task order, but it is extremely small relative to the total opportunity here. And we expect, over time, the software to be in the mid-eight figures over time, if not higher.

[Alex J. Zukin:]

Perfect. And then, maybe just a follow-up, with respect to any changes that you've seen in terms of dollar attrition and maybe commenting on just the pricing and competitive environment in the quarter?

[Adam Miller:]

Yeah. So, obviously, we don't give guidance on attrition. We don't give that number until the end of the year, because it's very difficult to forecast that number until the end of the year. But we have, historically, been at 95%. So, 5% attrition on a gross basis, on a dollar-weighted gross basis. And we expect to be in that same range as we have been over the years. We are not seeing anything unusual from the competitive landscape. We obviously continue to compete predominantly with SAP, but in addition are still competing with Oracle, Workday and many upstarts, especially in the mid-market as well as some of the payroll providers. From a pricing perspective, I just want to clarify this, because I think there was some confusion here. We did not lower our prices. What we did is we changed our price list to match reality. We had a price list that was aspirational and required significant discounting by the reps. It led to confusion in the field. We wanted to simplify our operations. And so, we set the price list to match market reality and where the deals were ending up in any case. So, what we really did that's different is change the packaging of our products. We moved from over two dozen different products to four product suites. That obviously, simplifies our messaging, it simplifies our communication, both internally and externally. And it created competitive differentiation, all of which has helped on the sales front.

[Alex J. Zukin:]

Perfect. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Scott Berg from Needham. Your question please.

[Scott Berg:]

Hi, Adam and Brian. Congrats on a good quarter. I wanted to dig into the Cornerstone HR product a little bit. It has come up in a lot of my checks in the quarter. And Adam, your comment about it impacting a third of the deals – European deals in the quarter I found interesting. Can you give us maybe a sense on what you're seeing in terms of, I don't know, size of those deals or pricing versus expectations maybe 6 months or 12 months ago, and maybe what we can see out of that product here over the next 6 months to 12 months? Thank you.

[Adam Miller:]

Yeah. So, as you know, we don't speak specifically about pricing. That varies based on the location, competitive environment and size of the deal. But what I will tell you is the penetration has been much higher than we expected. We thought it was going to be a much slower ramp. We knew as we announced previously that we were focused predominantly on Europe, and that's where we're seeing all the traction. And probably, what's most noteworthy about the Cornerstone HR deals is that a quarter of all of the deals that we did in Europe in Q2 were full platform deals. Meaning, we sold all four product suites, Recruiting, Learning, Performance and HR, to a quarter of the deals. And that obviously is directly related to our thesis behind Cornerstone HR, which is, if you're using us for full talent management, it doesn't take much for you to also use us for HR administration. So, we become the central provider you're going to focus your people business on. And as a result, the ASP for those deals is substantially higher than for a typical deal.

[Operator:]

Thank you. Our next question comes from the line of Mark Murphy from JPMorgan. Your question please.

[Mark R. Murphy:]

Yes. Thank you. So, Adam, I wanted to ask you relative to the U.S. Postal Service deal. If we try to understand for historical precedent, can you remind me, I think you had some type of a historical structure with a $20 million Treasury deal back somewhere around 2012. And I think I've just lost track of what happened with that. And did you end up billing all $20 million from that transaction?

[Adam Miller:]

Yes, we did. So, that got fully billed over time. And in fact, that deal was renewed this year.

[Mark R. Murphy:]

Okay. That's good to hear. And then, Brian, so I wanted to ask you when you look at the Q2 revenue results and then the Q3 revenue guidance, what is it that's impacting that, just considering, I think, there should be an incremental FX tailwind from the pound. So, what is counteracting that incremental currency tailwind in the last 90 days?

[Brian L. Swartz:]

Yeah, I know. I mean, listen, there's a variety of things, obviously, that go into the full year guide. We've left intentionally the full year revenue guide with a range of $10 million. We did have very slight favorable FX, it went from $1.28 on our last call to $1.31 now. Obviously, that's a bit of a tailwind. There's a slight tailwind in the timing of the billings. We obviously had a very strong Q2 billings where we pulled in much of the business from Q3 happened in Q2 that we otherwise would have thought that it was a small tailwind there. There's also a lot of – those are some of the puts and then there's some takes on the service delivery side, you can see our trend in services revenue year-over-year for the last couple of quarters has been down. A lot – that is really dictated by the client, as I talked about in the script. Most of the time, we expect much of that to be delivered in Q4, as many of the clients – some of our larger clients, in particular, want to get stuff done by the end of the year. So, it's really just our best estimation right now of how it will just unfold for the next five months and two quarters. Obviously, it could be a little bit different, but that's basically our best view now. We've intentionally left the full year revenue guide at the full $10 million, because there is some level of uncertainty there. I'm giving you our best view as we have it today.

[Mark R. Murphy:]

Okay. So, last question I wanted to ask, I believe you stated you that pulled in a significant portion of the Q3 performance in Q2, or something along those lines. Are you referring to the U.S. Postal Service transaction? And is that a reference to – I think, the billings guidance is $10 million or $11 million below consensus on Q3. So, is that the dynamic that you're referring to there? Is it just a little bit loading of the linearity across the quarter through this year?

[Adam Miller:]

Yeah, that's exactly right. It's not limited to the Postal Service deal. It was specifically our public sector business, which, as you know, Mark, is predominantly happening in prior years in Q3. That's the end of the fiscal year for the government, is the September 30 year. So, we typically see that business doing its best in the third quarter of each year. This year, obviously, they did extremely well in the first half of the year. And we are just adjusting the timing of our expectations. So, there's nothing significant happening here. We just assume that the business that we brought in from the public sector, which we expected to come in Q3 that came in Q2, is not going to also happen in Q3. And that's why you see us keeping the year flat.

[Mark R. Murphy:]

Okay. Got it. Yeah. Thank you very much for taking my questions.

[Adam Miller:]

Thank you.

[Brian L. Swartz:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Jesse Hulsing from Goldman Sachs. Your question please.

[Jesse Hulsing:]

Yeah. Thank you. Adam, a question I've got a lot recently is, I guess, what's the three-year plan or five-year plan or outlook for Cornerstone and what's the model as an independent company that you can follow? I guess, I'm wondering what your thoughts are on that. Is there someone that's come before you that you look at and say, we can be this type of business and this type of profile? And I guess, how do you think about that as it relates to driving longer-term shareholder value? Thank you.

[Adam Miller:]

Yeah, you have to remember that Steve Singh was on our board and Concur went through a period where, I think, their share price hit almost $2 a share or $3 a share. The market cap was significantly down. And obviously, that company was sold to SAP for over $9 billion. So, I think there is clearly opportunity to ride out some of the challenges we've had, particularly over the last couple of years, as we move towards the Rule of 40. At the same time, me and the board are always looking at strategic alternatives. So, we keep an open mind and really are laser focused on maximizing shareholder value.

[Jesse Hulsing:]

Thanks, Adam.

[Brian L. Swartz:]

Jesse, it's Brian. One thing I would like to add to that. I obviously speak to a lot of the investors and the analysts. And I know there is a desire for more, whether it's one – two, three, four, five, I'd call, it mid-term guidance, whether that's financial, operational or both. And so we recognize that's a desire for everyone. And perhaps, in the future, we'll do that. I don't want to promise anything in the future, but we recognize that that's a question that many, many of our investors have. We think it's a reasonable question. It's hopefully something we can give a little more color on in the future.

[Jesse Hulsing:]

Thank you both.

[Operator:]

Thank you. Our next question comes from the line of Brad Sills from Bank of America. Your question please.

[Bradley Sills:]

Hey, guys. Thanks for taking my question. Just wanted to ask for a little bit of color on the HR deals that you mentioned. Are those primarily, as you've kind of talked about in the past, deals where big companies have multiple – mixed environments of core HR systems and trying to kind of glue them together for a separate application, or are you starting to see potential displacements in the core HR category itself?

[Adam Miller:]

So, some of these deals are competitive. Some of them were more blue ocean. But effectively, what we see in Europe, and the primary use case that we see in EMEA are multinational corporations, some of them, quite large, that have been built via acquisition, with each acquisition may inherit a new HR administration system, a new payroll system, or a new HRIS. And over time, they end up with a very decentralized organization with no ability to report on or manage data centrally. And we solve that problem, of course, on HR. So, we do not require them to rip out and replace all of the existing systems. Rather, we sit on top of their existing systems, enabling things like employee and manager self-service, centralized reporting, benchmarking, predictive and prescriptive analytics, workforce planning and, of course, all the talent management functions.

[Bradley Sills:]

Got you. Great. Thanks. And then Adam, as you look forward to that $1 billion long-term target on revenue, where do you see the most potential for expansion in the mix of the business across the different suites? Where would you expect to see the most incremental contribution as you get to that across Recruiting, and Performance, and HR, the other three primary suites?

[Adam Miller:]

Yes. So, I would say, our biggest short-term opportunity is in Recruiting. We have about 21% penetration in Recruiting. And we have over 50% penetration of Learning and Performance. And so, we think there's a very clear opportunity to get Recruiting up to that 40% to 50% penetration range. At the same time, we think there's a long-term opportunity for Cornerstone HR. So, that's maybe further out. But all along the way, there is clearly continued significant opportunity within Learning. So even though we're the dominant player and we have 85% penetration of Learning in the installed base, we still believe there is much opportunity to further up-sell Learning, both to our existing clients and, of course, to other companies that are out there that are not currently using Cornerstone.

[Bradley Sills:]

Great. Thanks, Adam.

[Adam Miller:]

Thank you.

[Operator:]

Our next question comes from the line of Patrick Walravens from JPM Securities (sic) [JMP Securities]. Your question, please.

[Natasha Asar:]

Hi. This is actually Natasha on for Pat. Thanks for taking my question. Could you please tell us a little bit about your plans to improve sales efficiency?

[Adam Miller:]

Yeah. So, we're doing a number of different things around sales efficiency. So, the one we've talked about quite a bit is, obviously, reallocating sales head count to the highest-performing teams. We have done that. We will continue to do that. It's already had a meaningful impact on our sales and marketing expense, and we think we'll continue to improve over time. The second is what we've done with our commission plans, which still have a tail benefit, which will apply both this year and next year. And the third is more training of our salespeople. Obviously, we are a learning company and believe significantly in employee development. We think there's much more we could do around training our teams, particularly as we move into more verticals, more geographies and extend our product offerings. And lastly, just more rigor in managing the teams themselves, so better daily management of the sales organization to ensure performance and appropriate talent management of those teams.

[Natasha Asar:]

Okay. Great. Thank you.

[Adam Miller:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Samad Samana from Stephens. Your question please.

[Samad Samana:]

Hi there. Thanks for taking my questions and apologize if I ask something that's already been asked. We're juggling multiple calls. I'm curious when you think about the core HR product, we've heard some positive things about it and the role it plays for customers that maybe don't want to move off of their legacy payroll provider, but that Cornerstone can fill a space for them. It's like an ADP or ULTI doesn't provide great talent. Can you tell us how much of that's factoring into the success of the product early on?

[Adam Miller:]

I mean, honestly, the biggest use case right now is not that use case. We think that's a long-term opportunity, particularly in the U. S. Right now, we are very focused on the European opportunity, which predominantly is a situation where multinational has multiple systems and needs a way to centrally manage the data. We help them manage that data across disparate systems, across disparate geographies to centrally report, centrally managed data and run the organization.

[Samad Samana:]

Great. And then maybe one follow-up for Brian. We saw that you mentioned the progress towards getting the company's organizational structure in a healthy place. I'm curious maybe what inning of that you think we're in? And thanks again for taking my questions. I really appreciate it.

[Brian L. Swartz:]

Yeah, Samad, just when you refer to organizational structure, just be clear, you're just talking about operational excellence and profitability or something else?

[Samad Samana:]

Yes, yes. Like some of the changes that the company has talked about over the last, call it, year since you've joined in terms of improving the operational excellence. Maybe how far along are we on that process?

[Brian L. Swartz:]

Yeah. I mean, listen, I think we're early on in that process. I mean, it's – I think our trends on profitability have been great. I think we've exceeded most expectations even internally. I'd say, overall, if it was a nine-inning ballgame, we're like in the second inning of that. I mean there's a lot of things that we could do different and optimize, and we're having those conversations daily, and not just the way we do things, but the way we buy things. We've talked a lot about strategic sourcing which we've seen a lot of opportunity in, and I think there's even a lot more opportunity. So, again, things don't happen overnight, but I think there's still a lot more opportunity on that path.

[Operator:]

Thank you. Our next question comes from the line of Justin Furby from William Blair. Your question please.

[Justin A. Furby:]

Thanks, guys. I guess, Adam, for you maybe, I was just wondering if you could talk about the growth in the Enterprise Learning market for you guys and what you're seeing. I ask it just because it does seem like federal was soft for sometime, it seems like it's coming back, at least, a little bit the last few quarters. And you're calling out some success in core HR and other areas. So, I'm wondering what that means for the Enterprise Learning business, just given the change in your growth trajectory over the last couple of years. Thanks.

[Adam Miller:]

Yeah. So, I think the Enterprise Learning business is going through a renaissance right now. And it's driven by what I talked about earlier in my remarks, which is the concept of learning experience. That's driven really by the way we now consume media how we watch video on Netflix, or Hulu, or Amazon Prime, how we consume audio on Spotify or Pandora, or some of the other services, all of which are changing our expectations around how we search for things, how we discover things, how personalized an experience is for us. And the same thing applies to corporate learning. If you think about a millennial entering the workforce who has grown up on things like YouTube, and TED Talks, and Spotify and Netflix, you would assume that they would expect to have a similar experience in their career development. And that's exactly what we're witnessing happening right now. We're trying to get to the forefront of that. We are, as Bersin said, really on the cutting edge of what's possible here, taking not only our extensive experience at learning management and managing push training, which the company is pushing to the employee, but also innovating with learning experience to allow for pull training, which is the employee electing certain content or certain training; and then using the incredible data we've amassed over the years to allow for machine learning-based personalization at a level beyond what anybody else is capable of doing. And that creates, I think, a really nice, renewed long-term opportunity for us in Enterprise Learning.

[Justin A. Furby:]

And so, if I can follow up, so you guys have been very good on the push training side of it. If we go more towards pulling, what does that mean for some of the newer vendors? Workday, and I think even Oracle, is trying to build it around more of a social. Does that change the competitive dynamics, do you think, over time? Thanks.

[Adam Miller:]

Yeah. So, I mean, I think people have tried to go where we're not. We're obviously very dominant in the enterprise compliance learning space. So, us moving into the somewhat blue ocean of learning experience allows us to be not only the dominant player in compliance training, but in training overall, both pushed and pulled content. And that, I think, creates another long tail opportunity for us that didn't exist two years ago.

[Justin A. Furby:]

Got it. Thanks very much.

[Adam Miller:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of from Siti Panigrahi from Wells Fargo. Your question, please.

[Siti Panigrahi:]

Hi, guys. Just wanted to follow up on that sales performance question earlier. Last quarter, you talked about Gene Gainey joining as Head of Enterprise Sales. Just wondering any sort of changes or any strategy he has put together, any changes on that side? And then as a follow-up, you guys talked about the sales quota capacity going up with tenure. How is the quota attainment trending so far?

[Brian L. Swartz:]

Yeah. So, Siti, it's Brian. Let me handle the second one. So, in terms of head count, the way we've talked about this and the trends have basically stayed the same, we are growing overall capacity of quota. And that's being done not necessarily by growing head count, but actually with tenure being up kind of across the board. So, if you take – head count is roughly flat, it's a little bit up, a little bit down, but the tenure of our reps is up, which means their quotas individually are up on average and, therefore, quota capacity is up overall. So, that combined with better and improved sales execution, some of which Adam talked about in his prior comment, we believe, will drive or allow us, enable us to continue to grow both this year and in the future years. So, that's how we're thinking about it in terms of optimizing the sales force.

[Adam Miller:]

And just on that point, a new rep ramps into their quota, a rep that's been around for a while, starts the year out at full quota. That's why you have incremental quota capacity. In terms of the team, we are doing in Enterprise what we're really trying to do across the board, around the globe, which is better monitoring of continuous sales productivity. And that starts with the pipeline and the initial calling, lead qualification, cold calling, all the way down to how we negotiate and close the deal. And really, looking at every single step of the process and going, in some cases, back to the basics to ensure that we have the right people doing the right things, and we are equipping our salespeople as best as possible to be effective.

[Siti Panigrahi:]

Thanks. And in terms of geography, could you give some color in terms of like where – how is the Europe and Asia Pacific doing?

[Adam Miller:]

Yeah. So, Europe has had a really strong comeback, as I mentioned before. The one interesting part of Europe is that we have not seen a comeback yet in the UK. So since Europe is doing well overall, it actually means that we're doing quite well in Continental Europe despite the fact that we have not seen a full recovery in the UK post Brexit. We continue to perform in other parts of the world. Places like Mexico and Asia continue to do quite well. And we still think there's long-term opportunity in places like Brazil and China with a real emphasis for us, as I've talked about on previous calls, in Japan.

[Siti Panigrahi:]

It's great. Thank you.

[Adam Miller:]

Thank you.

[Operator:]

Thank you. Our final question comes from the line of Corey Greendale from First Analysis. Your question please.

[Corey Greendale:]

Good afternoon. Thank you for taking my question. So, one real quick one for Brian and then one for Adam. Brian, I just want to clarify your comment about the Q4 services revenue. I think you said something like the majority of services revenue in Q4. I just want to make sure I understand sort of what you're suggesting a little more specifically for services revenue in Q4.

[Brian L. Swartz:]

Yeah. No, Corey, let me make sure it's clear. So, we obviously provided full year revenue guidance and a Q3 guide, so you can, by definition, do the math to figure out what the implied Q4 guide would be. And that growth in revenue in Q4 is much higher that it has been in the first three quarters. All I was saying – all I was trying to say or what I intended to say was that that growth in revenue is driven – our expectation is that growth in revenue will be driven by a strong delivery of services in that quarter. So, that's the only point I was trying to make. The growth year-over-year in revenue in Q4 is being driven by the delivery of services.

[Corey Greendale:]

Got it. Thank you. And then the other question is that you're still getting leverage on the sales and marketing line, not as much as in recent past quarter. So, my question is how much of that is being driven by marketing versus sales? And to the extent that you're increasing or modifying marketing, what are you seeing in the front end of the funnel as far as the effects of that?

[Adam Miller:]

Yeah. So, some of the impact of the marketing spend in the first half of the year and on things like our Convergence Client Conference impacted the improvements in sales and marketing overall. So, those are one-time costs that will not reappear in the second half of the year. So, we expect some continued improvement. And like I said, all of the moves that we are making around sales productivity, we expect to continue to improve sales and marketing as a percent of revenue.

[Brian L. Swartz:]

Yeah. And Corey, just to add to that. One of the things that put little pressure on the improvement, it was about 1 point improvement year-over-year in Q2, which obviously is less than we've seen in the last few quarters, is the fact that we did, as I mentioned in my remarks, pull forward some marketing spend. So, just on a year-over-year seasonal basis, there's more in Q2 than there usually is. Again, I don't want to quantify that. But in general, if you look at the trend it smooths out over time.

[Corey Greendale:]

And could you – just the back end of the question, Adam, just thinking about potentially accelerated sales growth, what you're seeing in the front end, just sort of lead flow and how that might translate to greater revenue growth ahead?

[Adam Miller:]

Yeah. So, as Brian mentioned, we have a higher-tenured team now. So, we have good stability in the sales force. We have good pipelines for the remainder of the year and going into next year. And we are feeling good about our capability in the second half of the year.

[Corey Greendale:]

Great. Thanks very much.

[Operator:]

Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Adam Miller for any closing comments.

[Adam Miller:]

Thank you all for your participation, and we look forward to speaking to you all soon. Thank you.

[Operator:]

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.