Cornerstone OnDemand, Inc.
Q3 2017 Earnings Call Transcript

Published: 9 Nov 2017

[Operator:]

Good day, ladies and gentlemen, and welcome to Cornerstone OnDemand's Third 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.

[Alexandra Geller:]

Good afternoon, everyone, and welcome to Cornerstone OnDemand's third 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 September 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 future financial and operating performance, including our GAAP and non-GAAP guidance, business strategy, demand for our solutions, product development, client satisfaction and retention, market or business growth, investment activity in our business, visibility into our business model and results, the reduction of (01

[Adam Miller:]

Thanks, Alex, and thank you to everyone for joining us today. We have a lot of news to share. I would like to start by updating you on the results of the strategic review process recently undertaken by our board of directors. Several months ago, our board of directors retained Goldman Sachs and Centerview Partners to conduct a fulsome evaluation of the company's strategic alternatives. The board established an independent committee to oversee this process and review all available options. During this process, we received both solicited and unsolicited interest in Cornerstone. Over the course of several months, the board had more than a dozen independent committee meetings, plus seven full board meetings and conducted a thorough evaluation of proposals. At the conclusion of that process, taking into account ongoing feedback we've received from some of our largest shareholders, the board determined that the optimal way to maximize shareholder value is to execute a plan to transform our operations and support that plan with a capital infusion and new strategic partnerships. The plan provides a renewed focus on recurring or subscription based revenue growth and will drive cost reductions to accelerate the growth of our operating margins and free cash flow. We believe this plan will allow us to achieve the rule of 40 by 2020. We have entered into an agreement with Silver Lake, one of the world's leading technology private equity investors and LinkedIn, under which Silver Lake and LinkedIn will invest $300 million in Cornerstone in the form of convertible senior notes. We believe the investment by Silver Lake and LinkedIn not only endorses our plan, it accelerates it. Silver Lake has extensive experience supporting both growth and margin expansion initiatives, and we believe their advice and support will help speed our transformation into a high-margin growth software company. We will use a portion of the investment to fund a share repurchase program of up to $100 million of our common stock. This investment is a strong vote of confidence on our long-term strategy and future growth potential, and it will enable Cornerstone to return cash to those shareholders who want to monetize their investment in the near-term, while preserving our ability to fund growth opportunities and increase shareholder value in the years ahead. We will also use a portion of this investment to retire our existing convertible debt. In connection with the investment, we plan to expand our board of directors and appoint Joe Osnoss, Managing Director of Silver Lake, to our board immediately upon the closing of the transaction, which is expected to occur by the end of the year. Now, let's talk more specifically about the strategic plan that Silver Lake and LinkedIn is endorsing with their investment. Over the past two years, Cornerstone has grown recurring revenue by over 40% and net income margins by nearly 1,000 basis points. Today, we're committing to a plan which we expect allows us to achieve the rule of 40 by 2020 with a combination of revenue growth and margin expansion. Our strategic plan has three pillars. First, we are driving renewed focus on recurring revenue growth. Second, we are executing on a plan to rapidly grow operating margins and free cash flow. And third, we are leveraging our leadership position in global learning to aggressively enter the e-learning content market. Regarding our renewed focus on recurring revenue, we're taking multiple actions to drive growth. As Brian mentioned on past calls, the percentage of new sales that include substantial non-recurring services has grown dramatically higher in recent years. The increase in non-recurring service revenue has been the unfortunate side effect of the success we've had selling up-market to many of the world's largest organizations. Simply put, clients with hundreds of thousands of employees demand significant upfront services to deploy our software to their offices around the globe. In contrast to our subscription software, these services are non-recurring and the roll-off at completion of a project has a dampening effect on our overall revenue growth. Until now, we have required that all implementation services be contracted by us, and then we subcontract the work to our implementation partners as needed. Beginning next year, we will do what almost all other software companies have done at our scale, instead of subcontracting services, we will allow our partners to directly paper or contract delivery and implementation services with our clients. We believe this will strengthen our partner ecosystem and encourage even more referral business to us. We will continue to maintain our global services organization, but we believe by embracing our diverse and well-established partner network, we will be able to shift the sales mix towards more recurring revenue, which in turn will drive improved growth rates and higher margins. It is important to note that our large enterprise delivery business is the least profitable part of our global operations. As a result, a gradual reduction in revenues in this business is not expected to have an adverse impact on operating margins. To support this plan, beginning in 2018, we plan to change our commission plans to get our reps 100% focused on recurring revenue. We also plan to convert some of our non-recurring technical services to recurring offerings, such as the conversion of certain one-time integration services to subscription based connectors. With regard to our anticipated improvements in operating margin, the strategic plan calls for a continuation and expansion of the margin improvement program we began last year. We are focused on driving efficiencies in several categories, specifically customer acquisition costs and overall G&A, while still preserving the corporate culture that we believe has been key to our success. To be clear, the changes we're making are not simply one-time cost cutting, rather we are making a fundamental change in the way we think about and manage our business. Our plan has five key margin improvement initiatives. First, while we have made great strides in reducing our sales and marketing expense as a percent of revenue over the past two years, we believe further optimization is necessary. We are now looking at customer acquisition costs based solely on new annual recurring revenue versus based on total sales, and this has highlighted additional opportunities for us to save in this area. As a result, we expect the annual improvement in sales and marketing as a percent of revenue to be even greater next year than it's been over the last two years. Second, we see clear opportunities to drive additional cost reductions through our ongoing strategic sourcing initiatives. We expect to achieve significant savings in the areas of benefits and travel, primarily driven through more rigorous procurement without a reduction in service quality for our employees. Third, the shift away from certain delivery services allows us to move away from our least profitable business line to more profitable business. Our consulting partners will be able to deliver these services on their paper, which is their preference. Fourth, we believe we have further margin improvement available through our automation process improvement initiatives that are part of our operational excellence program, including those related to order-to-cash automation and level zero support. Fifth, we expect a reduction in third-party fees related to contractors, consultants and systems as we further simplify our internal business processes. Even with these margin improvement initiatives, it is important to note that we expect to continue to invest in R&D to drive innovation and further increase our competitive advantage. The third pillar of our strategic plan is to extend our leadership position in the global learning market by growing content sales of our new regional and industry-based content subscriptions. We intend to leverage our position as the largest distributor of global online training with hundreds of millions of course registrations each year to provide our clients with a Netflix-like experience, serving up some of the best content available. After recently showcasing our new Cornerstone Content Anytime offering, coupled with our new Cornerstone Learning Experience platform at multiple HR technology conferences in the last month, we believe there is significant demand for a modern, subscription-based content offering in today's evolving workplace. We've already entered into agreements with multiple content providers to create compelling subscription offerings. Over time, we expect to curate multiple subscription offerings to satisfy the specific content needs of our clients across various verticals and geographies. As a result, we expect that our entire global sales force will have the opportunity to attach content to their new and existing learning deals, which we believe will drive incremental annual recurring revenue. With more than 2,600 clients currently using our learning suite today, we believe this can be a material driver of long-term recurring revenue growth. Furthermore, we believe that the addition of specialized content subscriptions enables Cornerstone to provide our clients with a holistic solution to meet their learning and development needs, which further differentiates Cornerstone as a leader in corporate learning. All of these initiatives are coming at a good time. The momentum in our business is palpable. Over the last few months, we've seen the reversal of downward trends in our go-to-market efforts. I am very pleased to report that we significantly exceeded our expectations in several areas in the third quarter. Third quarter billings eclipsed our expectations and reached a record $132 million, representing record reported growth of 23% and constant currency growth of 18%. In addition, third quarter revenue came in above the high end of our guidance range at a record $122 million, representing reported and constant currency growth of 13%. We continued to see improvements in profitability with approximately $7 million in net income. We have now achieved three consecutive quarters of profitability. In the third quarter, we expanded our organically grown client base to more than 3,100 enterprise and mid-market organizations from all over the world. New client additions include Samsung, Nikon Corporation, Austria's second largest bank, Brenntag AG in Germany, Merlin Entertainments in the UK, Wind Tre in Italy, Manitou Group in France, a Fortune 200 financial institution, Goodman Manufacturing Company, Home Depot Mexico, the U.S. Defense Acquisition University, the largest YMCA cohort in the world, and the City of Riverside, California, among many more. Today, our client base includes global leaders in virtually every vertical, which has enabled us to build one of the largest subscriber bases of any software provider in the world. In Q3, we continued to grow our user base, adding more than 1 million net users, amounting to a total user base of more than 33 million subscribers. Additionally, I am proud to report that last month Cornerstone was named a Strategic Leader in the Fosway 9-Grid for Integrated Talent Management for the third consecutive year, moving us into their top spot in talent, well ahead of the competition. We were also recognized as a Core Challenger in their 9-Grid for Cloud HCM, advancing from last year's position as the Potential Challenger. As a premier HR industry analyst in Europe, this recognition by Fosway is a testament to our leadership position in talent management around the globe. Following two quarters of notable wins in the U.S. public sector, we saw continued strength in this segment in Q3. We added new client logos at the state and local level with several municipalities and expanded our federal footprint with the addition of the Defense Acquisition University, the premier corporate learning university for the Defense Acquisition workforce. Within our install base, we saw considerable up-sells with the U.S. Postal Service signing their second task order in Q3, as well as the Securities and Exchange Commission adding the recruiting suite. After years of little to no movement within the federal vertical, we're pleased by the volume and magnitude of the wins we've seen in 2017. We believe we have reached an inflection point within the federal government and our growing roster of referenceable accounts will allow us to continue to penetrate this largely greenfield segment. Shifting gears to the international markets, the Asia Pacific region had its second best quarter ever. The team won a landmark deal with Samsung in South Korea, which is our first client in South Korea. Also, the Japanese business continued to build momentum in Q3, with new client wins including Nikon Corporation, MST Insurance and OUTSOURCING Inc. As I've mentioned on previous calls, we believe Japan represents a substantial market opportunity and that it would become a top five market for Cornerstone over time. Another strong performer for the quarter was our European business, which added its largest number of new client logos ever. This was driven by a comeback in the UK, as well as the continued adoption of the Cornerstone HR product among European businesses. The third quarter saw the largest volume of Cornerstone HR wins in the company's history, more than doubling the number of year-to-date Cornerstone HR wins among new European clients when compared to the first nine months of 2016. We believe Cornerstone HR will continue to drive growth within our existing client base, as well as new client wins in the European region. So, overall, we're very pleased with our performance in Q3 and we are encouraged by what this means for our outlook. With that, I'd like to turn it over to Brian to discuss our third quarter financial performance and our outlook in more detail.

[Brian L. Swartz:]

Thanks, Adam, and good afternoon, everyone. Needless to say, I'm a big supporter of the plan Adam just outlined, and I have extensive experience in managing business transformations, capital structures and operational improvement initiatives. Before I begin with the quarterly financial review, I'd like to highlight the expected near-term financial impacts of our go-forward plan that Adam just discussed. The plan has two impacts. The first is on revenue. Once we better understand the impacts of our go-forward services strategy, we'll have clear insight into 2018 revenue trends and we'll communicate that detail with you as soon as possible in the coming months. With that said, we do not expect the go-forward services strategy to impact subscription revenue. Assuming continued strong market demand as well as current GAAP revenue recognition standards, we expect our subscription revenue in 2018 to grow in the low to mid teens. The second impact is on margins. Irrespective of our go-forward services strategy and based on our operational efficiency plans, we are raising our previously communicated 2018 operating margin target of 10% to a range of 11% to 13%, which at the midpoint doubles our expected rate of profitability from 2017. Now, on to the financial summary for the quarter. In the third quarter, billings came in at a $132 million, which represents a year-over-year increase of 23% on a reported basis and 18% on a constant currency basis, an acceleration from 12% and 6%, respectively, in Q2. About half of the billings beat was due to continued strong performance in the U.S. public sector, and the balance was the result of solid performance in EMEA and favorable currency. It's important to note that the strong performance in the U.S. public sector was in part due to a follow-on order from the U.S. Postal Service for about $6 million. This order was for all software and is primarily – and has been classified primarily as long-term deferred revenue as the contractual terms push most of the revenue recognition for this order beyond the next 12 months. Moving on to revenue, in the third quarter, revenue exceeded the high end of our guidance range by nearly $2 million, coming in at $122 million, a year-over-year increase of 13% on a reported and constant currency basis. The split between subscription and services revenue was 83% and 17%, respectively. Through the first nine months of the year, services revenue has been lower than historical averages due to the timing of service delivery, which is often dictated by clients. Consistent with my comments on the last call, we expect the mix of software to services to be more services-heavy in Q4 as we have historically experienced that many of our large enterprise clients finalize projects before year-end. A few other key Q3 metrics, the size of our client base increased to 3,146 as of September 30, representing 70 net new client additions during the quarter, and we added 1.4 million net users during the quarter, bringing our user base to more than 33.5 million users. Finally, we added 27 net new employees, bringing us to 1,960 employees at the end of the quarter, which represents a 10% increase over the prior year. Our gross margin was 73% in the third quarter, up 130 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 continued to demonstrate improved efficiency in sales and marketing expense. Sales and marketing expense reached a record low of 43% of revenue in Q3. To give you some perspective, just two years ago, in Q3 of 2015, sales and marketing expense was 53% of revenue or 1,000 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 commission plan changes we made in early 2016. Looking towards 2018, as part of the margin improvement program that Adam outlined, we plan to continue to improve our sales efficiency by further reducing our customer acquisition costs. As a result of these efforts, we expect the annual improvement in sales and marketing expense as a percentage of revenue to be even greater next year than it's been over the last two years. Continuing down the P&L, R&D expense was 11% of revenue or 200 basis points more than the prior year, principally due to 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 costs of $4 million, was $18 million or 15% of revenue. Our G&A was roughly in line with the prior year at 13% of revenue. We expect to see incremental G&A savings as our operational excellence initiatives are fully implemented. Overall, this resulted in an operating margin of 6% for the quarter, in line with our expectations. Driven in part by our continued focus on controlling operating expenses, net income for the quarter was $7.3 million or $0.12 per diluted share, compared to net income of $6.9 million in the prior year. Please note, this is the first time we've achieved three consecutive quarters of profit. It also marks three consecutive quarters of year-over-year improvements in profitability. As a reminder, for EPS purposes, our weighted average diluted share count of approximately 58 million increases to approximately 63 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, improved year-over-year by more than $6 million to $14 million in the third quarter, representing a free cash flow margin of 12%. Now, let's turn to the balance sheet. We continue to maintain a well-capitalized balance sheet. As of September 30th, our total cash and investment balance was approximately $347 million. Additionally, as of September 30th, we had $246 million in carrying value of debt. As Adam discussed, we have entered into an agreement with Silver Lake and LinkedIn to purchase $300 million of convertible senior notes at 98% of par that pay interest at 5.75% per annum and are due in July of 2021. The notes have a conversion price of $42 per share. We expect to complete the sale by the end of the year, subject to customary closing conditions. We intend to use the proceeds from the notes to pay off our existing convertible debt, fund a share repurchase program, and other general corporate purposes. With regard to the share repurchase program, our board of directors has authorized a $100 million share repurchase program. The program is expected to be executed over the next two years, but it is not specific as to when or how many shares will be purchased. Our deferred revenue balance was $273 million as of September 30th, compared to $235 million in the prior year, representing a year-over-year increase of 16%. 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 rate of 1.32 to 1, up from 1.31 on our last earnings call. We are tightening our full year 2017 revenue guidance range of $477 million to $487 million to a range of $479 million to $487 million. At the midpoint of $483 million, this represents 14% growth and 16% constant currency growth over the 2016 revenue of $423 million. Our full year guidance implies fourth quarter revenue of $129 million to $137 million. At the midpoint, this represents 22% growth or 20% constant currency growth year-over-year. It's worth noting that our Q4 revenue guidance assumes subscription revenue will grow at about the same rate or perhaps slightly faster on a year-over-year basis than it did in Q3. Therefore, and consistent with last quarter, we are still expecting a significant increase year-over-year in services revenue in Q4. We believe this increase is achievable based on our conversations with clients as well as further supported by Cornerstone Realize, our new delivery methodology, which has driven and we expect will continue to drive faster and more efficient implementations. Also, please note a large majority of Q4 services revenue is expected to come from our backlog of services requested by existing clients as compared to services related to new Q4 client wins. Despite this increase in service revenue, we do not expect our Q4 gross margin to be adversely impacted. Regarding billings, we are maintaining our full year 2017 billings expectations of low to mid teens year-over-year growth. With respect to profitability, we're very pleased with the performance year-to-date and believe we're on track to maintain our previously communicated guidance for a full year operating margin of approximately 6%. I want to highlight one item in our full year operating margin guidance related to the wider than typical revenue range in Q4. This 6% operating margin guidance assumes we deliver the middle of the revenue range. As I just mentioned, the wider than typical range is due to the potential variability in the delivery of service revenue in Q4. To the extent we are at the lower or the higher end of the range, we would expect that variance to generally flow to the bottom line on a dollar for dollar basis. We believe the 6% target is the best estimate as of today, but I did want to point out this nuance in our financial outlook. We are also reaffirming our free cash flow margin target for the full year of 6% to 7%. And as I mentioned earlier, as it pertains to 2018, I'd like to highlight two items. The first is on revenue. Once we better understand the impacts of our go-forward services strategy, we'll have clear insight into 2018 revenue trends and we'll communicate that detail with you as soon as possible in the coming months. With that said, we do not expect the go-forward services strategy to impact subscription revenue. Assuming continued strong market demand as well as current GAAP revenue recognition standards, we expect our subscription revenue in 2018 to grow in the low to mid teens. The second is on margins. Irrespective of our go-forward services strategy and based on our operational efficiency plans, we are raising our previously communicated 2018 operating margin target of 10% to a range of 11% to 13%, which at the midpoint doubles our expected rate of profitability from 2017. With respect to long-term margin targets, as Adam mentioned, we expect to achieve the rule of 40 by 2020. As a reminder, we define the rule of 40 as the sum of annual revenue growth and free cash flow margin. Finally, I'd like to announce that we plan to attend several upcoming investor conferences this quarter, including the UBS Technology Conference, the Needham & Company SaaS Event, the Credit Suisse Technology Conference and the Wells Fargo Tech Summit. We also plan to host an Investor and Analyst Day in the first quarter of 2018. With that, I'll turn it back to Adam.

[Adam Miller:]

Thanks, Brian, and thank you to everyone who joined us today. Given our strong market opportunity, our new strategic partnerships and our commitment to the strategic plan we've outlined today, I'm confident we'll be able to achieve even greater profitable growth and enhance shareholder value in the years to come. As always, I especially want to thank our global team for all of their great work to help more than 33 million people around the world to realize their potential. We will now take your questions.

[Operator:]

Certainly. Our first question comes from the line of Michael Nemeroff from Credit Suisse. Your question, please? Michael Nemeroff - Credit Suisse Securities (USA) LLC Hey, guys. Thanks for taking my questions. I've actually got a couple. Nice job on Q3, by the way. The first one is, I know the plan is to repay the old convert, I'm just looking at the structure of the terms on the old one, the old one had a much lower coupon than the one that you're floating currently. So, I'm curious why you would be paying that down? And then the other question is around the services revenue and where you expect as a percentage of total revenue that to be in 2018. I know you don't want to give the guidance for the actual revenue amount, but would it be 5%, do you expect it to go to zero next year? And then also as it relates to moving the services off of your paper and on to partners, do you think that this is going to have an impact on slowing down the contracting process? Do you think that this could be – could add weeks or months which could push out billings into the next quarter? Just thanks – those questions. Thanks very much.

[Brian L. Swartz:]

Yeah. Sure, Michael; it's Brian. Nice to hear from you and welcome everyone. So let me try to answer your first two questions and I think Adam will take the third. So with respect to the financing transaction by Silver Lake and LinkedIn, I think we view this more – this is not just a financing transaction, right, we view this as – they both bring a lot more value to the table than purely capital. Obviously, Silver Lake is the most successful technology private equity investor out there and LinkedIn is LinkedIn, and is clearly the leading professional networking social media site out there which really will help us – has lots of intellectual property around jobseekers and employees which is obviously beneficial to our business. So we view it a lot more – it's a lot more than just capital, right, it's strategic partners that are bringing a lot to the table, both money, institutional knowledge, experience in transformations, and extensive experience just helping companies transform exactly what it is we're doing. So that's number one. Number two, with respect to services and the services revenue for next year, so we will comment a lot more on our Q4 call about specifically 2018 and beyond. What we tried to do or what I tried to do on this call was just give you a perspective specifically on subscription revenue which as you know we've been disclosing now for a while. We do not expect subscription revenue to be impacted adversely from our go-forward changes to our services strategy. We think as partners paper more services obviously we will generate less services revenue, but because of the nature of that service line, we do not expect it to impact the bottom line or profitability at all and that's why we provided the 11% to 13% operating margin guidance for next year. So, when we have our Analyst Day in Q1, we'll be prepared to kind of walk through a lot of this. We're going through our budgeting process like every other company right now in Q4 that will finalize the numbers for next year and be able to provide a lot more transparency and clarity not just to 2018, but beyond.

[Adam Miller:]

And Michael, with regards... Michael Nemeroff - Credit Suisse Securities (USA) LLC Brian, that's helpful. But with all due respect, we do have estimates for 2018 and they include a regular or normal amount of services revenue. Leaving it out there, you're creating this overhang that we have to lower our estimates when you give us until next quarter, so if you could maybe just tell us what the mix you expect or what kind of a decline in services revenue do you expect that would be helpful.

[Brian L. Swartz:]

Yeah, Michael, it's not that I don't want to tell you, the truth is we are operationalizing plans now to know exactly how that will phase out. So, we do somewhere between $80 million and $90 million of services revenue. Over the course of 2018, we'll have a backlog at the end of the year that will burn off into revenue next year. We're obviously going to continue to do services and delivery internally, but our partners will start to paper some of those opportunities. It will really be a function of how quickly the new opportunities are – some of those new opportunities are papered by our partners. So, I understand, I want to be as helpful as I can. I can only be as helpful with the best information that I have. And I think the key here is to focus on subscription revenue. We can make some – you're welcome to – and you will make some conclusions about what will happen with services revenue, but the key is subscription revenue, the key is growing recurring revenue and ARR, which is again we'll start talking about, I think, a lot more going forward.

[Operator:]

Thank you. Our next question comes from the line of Patrick Walravens from JMP Securities. Your question, please?

[Pat D. Walravens:]

Oh! Great. Thank you. So, Adam, I guess, it would be really helpful if you could explain to us sort of big picture here what is going on strategically in the industry that is driving this? And I'll just throw in two other little tidbits that maybe you can comment on in your answer. One is, Dreamforce is underway here and Benioff has been talking a surprising amount about trailheads and trailblazers in fact saying that, nothing is more important than the trailblazers. And then secondly, why is it LinkedIn as opposed to Microsoft that's making the investment, I suspect that fits in there somewhere? So love to hear your thoughts.

[Adam Miller:]

Yeah. So if you just take it at the macro level, what we're doing is becoming more and more front and center in the minds of CEOs around the world. Technology is moving very quickly; jobs are being transformed by the day, by the minute; and the skills that people need to do those jobs are changing very, very quickly at this point. If you just think generally about any job you can think of today, 5 years or 10 years from now, that job is going to be dramatically different because of technology and the skills you need to do that new job probably are not skills that you have today. And so training becomes incredibly important in that world. And so what we're doing as the leader in learning is becoming more and more important, and we recognize that both with regard to the size of deals that we're closing these days, the types of clients that we're able to access, the geographical distribution of the deals that we do today, all point to this idea that this is a global phenomenon, this is not one group or one industry or one region, this is the whole world, every industry. And so it's not surprising that more and more people are talking about talent management, that more and more companies are trying to enter into talent management, that are talking about learning and development as an important part of whatever it is they do. Benioff obviously talking about it with regard to sales enablement and how you train salespeople. And so all of those things point to the TAM opportunity that we have today as the number one player in that space. And so we think there's an enormous opportunity here and we think we need to double down on our efforts to do it the right way, which means we have to be focused on recurring revenue, not non-recurring revenue. It means we have to be focused on the holistic solution, which means not just the learning platform, but also the learning experience and the learning content. And it means we need the right partners to help us get there, and do it in a profitable way, and so that's where Silver Lake comes in, that's where LinkedIn comes in. As you know, LinkedIn is part of Microsoft, and LinkedIn is the one that is closer to us. We've had relationship with LinkedIn for a long time. There are many, many areas of collaboration between the two companies. We both work in the recruiting space. We both now work in the learning space, and we wanted to deepen that relationship, and that's exactly what's happening.

[Pat D. Walravens:]

Okay. Good. 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, thanks for taking my question. Kind of two part question, but very related on the strategic review is, Adam, first of all, content, you emphasized content many a times in your pre-scripted remarks and I've written on content in the space I think three times in the last month in terms of how important it's going to be moving forward. I guess, why the focus on that, how does that change your selling strategy? How does that set you up competitively? But then secondly to that, regarding your comp plans that you mentioned, how does that impact your comp plans? Because my guess is your comp plans are changing relative to professional services that probably won't be a part of the deal, but how does content kind of enter that equation?

[Adam Miller:]

Yeah. So, content's always been part of the story for us. In fact, when I first started the company, it was focused on content, not software, and then we quickly learned that the clients were really focused on the software piece. But if you look at what's happened with Netflix, you look at other players in that space, you notice that they start with a platform, they develop their distribution capability and then they support that effort with more and more content. That's exactly what's happening here. Last year, we delivered hundreds of millions of course registrations, hundreds of millions of hours of training and that translates to a big opportunity for us as the number one distributor of training content in the corporate world to start to monetize that in a better way. And we're doing that really for two different reasons. One is it's a very obvious revenue stream for us with minimal incremental cost. If you think about it, yes, there is the licensing cost for the content or the revenue share, but beyond that, if you think about it from an operating perspective, minimal costs, same salespeople, same buyer, same process, same infrastructure and we're already delivering this content. So, we're just delivering it without getting paid for it. Now, we intend to get paid for it. The second piece of the puzzle is modernizing the entire approach to content. So, most content today is still sold the way music used to be sold, right. You used to buy the album, then you bought the song, now you buy the subscription. We are introducing the subscription. So we're giving people the opportunity to buy content specialized for their industry, specialized for their geography in a subscription model that gives us recurring revenue, that grows our recurring revenue, it actually helps our margins and it gives our salespeople something else to sell in their bag, which obviously helps with their commissions and with their quota attainment.

[Scott Berg:]

Got it. Thanks for taking my question.

[Adam Miller:]

Thank you.

[Brian L. Swartz:]

Thanks.

[Operator:]

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

[Pinjalim Bora:]

Hi, this is Pinjalim sitting in for Mark. Thanks for taking my question, and congrats on a good quarter. Was just wondering about, I mean, I guess you're not giving us any guidance on the revenue side for 2018, total revenue, but is there any way to think about the head count growth for 2018? I think last time you said that 2017 will lag 2016's 11% and seems like year-to-date it's about 8%; 2018, what should we expect for head count growth, will that essentially lag the 2017 growth number? And second part to that question is, you talked about the pro forma operating margin increase in 2018, it's good to see. Is there inherent expansion – or dramatic expansion in gross margin as well built in because of the changes in the mix?

[Brian L. Swartz:]

Yeah. So let me try to answer both of those. With respect to the details of 2018, similar to my comments earlier, we're obviously finalizing all of our 2018 budgets now. So with respect to specific head count growth numbers, we'll be able to provide a lot more clarity on that, but here's what I will tell you. We are committed to the 11% to 13% margin improvement, and as a result of that, you would draw the conclusion that head count clearly is going to grow at a lower rate certainly than it did this year, because obviously with us losing some portion of the revenue next year, at what rate we lose some of the revenue – the services revenue, we are committed to that 11% to 13% margin expansion, which at the midpoint is double what it was this year. So again, you can – hopefully that helps you kind of think through kind of growth and cost structures in general, including head count. And then the second part of your question, I'm sorry, could you repeat it again?

[Pinjalim Bora:]

The gross margin for 2018, I mean, is there an inherent dramatic expansion in the gross margin because of the change in mix shift that you might be expecting?

[Brian L. Swartz:]

Yeah. So over time, the answer is, yes, and it gets to Michael's question a little bit earlier, how quickly do you do that? We obviously are taking a portion of our business, our services business and over time we're still in the services business, we're still in the delivery business, but our partners will start to paper some of that. In the future, as we comp that or lap it, annualize it basically, there will be an inherent improvement in operating margins of the business, which we think is very, very positive and over the course of the next 12 months to 24 months, as that happens, you will see that manifest itself in the numbers.

[Pinjalim Bora:]

Thank you.

[Operator:]

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

[Alex J. Zukin:]

Hey, guys, thanks for taking my question. Two quick ones from me. First, does the infusion of capital change or influence your M&A strategy in the short term, would you consider going deeper into core HR, payroll? And separately maybe for Adam, you mentioned a number of really interesting deals in APAC and EMEA, but could you also comment on your performance domestically ex-federal and maybe also comment on the competitive environment there? And the reason I ask that is you're guiding to basically flat to potentially accelerated subscription revenue growth next year, and the years after that to get to the rule of 40. What gives you the confidence to kind of come out with that?

[Adam Miller:]

Yeah, so on the first question with regard to M&A, the answer is no, no major shift in our overall strategy. With regard to the overall performance of the sales team, obviously we have multiple sales teams, different geographies, different industries, that have different rates of performance in any given period of time, whether we're looking at a particular year or a particular quarter. But we are feeling pretty good overall about the business, we've seen very good demand. We've seen an uptick almost in every area of the business with regard to pipelines and forecasts. And we feel like we are through the trail of the – the trough of the business. Specifically, if you look at groups like our strategic sales team or the large enterprise sales group, they did have a weak first half of the year, we expect them to have a much stronger second half of the year.

[Operator:]

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

[Samad Samana:]

Hi, thanks for taking my questions. Adam, I guess this is a multi-part around the content side. I'm curious if, as part of this deal, LinkedIn will consider using Cornerstone as their core learning platform? You often see this with tech partnerships or investments where one company or the other uses the other's product. And I guess as also derivative to that, is this more about taking Lynda.com content and using Cornerstone's large installed base as the distribution mechanism or is there a special pricing that they're going to give you on that content to sell back into your base? Maybe just some color on how the strategic partnership with LinkedIn will contribute to this? Thank you.

[Adam Miller:]

Yeah. So, with regard to the client question, LinkedIn and Microsoft are both clients of Cornerstone and we are clients of both Microsoft and LinkedIn. So, we already have been having a mutual client relationship. We also had already been partners. So, we are a very large .NET shop. We use .NET across our entire stack. We also already work closely with LinkedIn in a number of different areas. We are looking at ways to deepen that relationship. We both have APIs, we both have integration points, we both have relevant data that would be relevant to each other. So, there are many opportunities for collaboration and this is something that will be developed over time.

[Operator:]

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

[Justin A. Furby:]

Thanks, guys. Multi-part question – I'll join the theme. Adam, you've mentioned that – different sort of unsolicited and solicited offers that came in, can you sort of walk through why those were rejected and this was favored over those? And then I guess the second part to that is the strategic sales team, I think you mentioned a weak first half of the year. Can you comment on Q3 specifically and what you're seeing so far in Q4? And I guess I just wonder as you look out over the next couple of years, what the concern is around the competitive landscape getting tougher with folks like SumTotal and Saba and Workday? Thanks.

[Brian L. Swartz:]

Hi, Justin, it's Brian. Let me handle the first part of that question, and just Adam obviously commented on this in his remarks. But just with respect to the whole process, I want to reiterate that the whole process we ran over the last several months was a very fulsome process. It was obviously overseen by our board. There was an independent committee that did that. We had two of the top banks out there that assisted us, who participated in all the dozens and dozens of meetings we had throughout that process. There was a variety of kind of solicited and unsolicited interest. And at the end of the day, the board evaluated all that and made the decisions that they made. We're not commenting on any of the nature of any type of proposal or nature of offers that we might have gotten or not gotten. So, we're not commenting any more specifically on that, but you should rest assured it was a very fulsome process that was managed at the board level. So with that, I'll let Adam answer the second question.

[Adam Miller:]

Yeah. And with regard to strategic accounts, I've said this many times in the past. These are binary and they typically happen at the end of the year. So, while the team does have an annual number and theoretically that number gets spread out over the course of the year, the reality is these deals tend to come in in the fourth quarter, and so the same is likely to be true this year.

[Justin A. Furby:]

Got it. Thanks.

[Adam Miller:]

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. I wanted to follow-up on the comments around improving customer acquisition costs. It seems like that's key to the pretty significant margin expansion that you're guiding to for next year. I guess what is the – what are the specific things that you think you can do to improve sales efficiency? And I guess, how much of the plan around improving sales and marketing as a percentage of revenue is related to reducing the size of that group or slowing the growth of it significantly? Thank you.

[Adam Miller:]

So the primary focus we have now is on recurring revenue growth. And so, the best way to drive better CAC ratios is to move the shift, the mix between recurring and non-recurring sales almost entirely to recurring and that allows for much better productivity of the reps and much better CAC ratios. We're doing this through a number of different approaches, including changes in the commission arrangements with the salespeople, all of which will allow for better focus on recurring revenue. This also is supported by the idea that partners on the services side that are bringing us deals and helping us in that sale process will be able to paper their own deals. And that again helps with the mix between software and services, it helps shift to more recurring revenue and helps improve the CAC ratios. At the same time, we're looking at a number of different approaches to cost containment, and we are going to provide more details about our cost containment plans at the Analyst Day next quarter.

[Jesse Hulsing:]

Thanks, Adam.

[Operator:]

Thank you. And 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 further remarks.

[Adam Miller:]

Thank you all for participating and we look forward to seeing you at the upcoming conferences. 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.