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Q4 2013 Earnings Call Transcript

Published: 6 Feb 2014

[Operator:]

Good day, ladies and gentlemen, and welcome to the Digital River Fourth Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I'd now like to introduce your host for today's conference, Melissa Fisher, Vice President of Investor Relations. Please go ahead.

[Melissa Fisher:]

Welcome to Digital River's fourth quarter 2013 earnings call. Joining us on the call today are Dave Dobson, our CEO; and Stefan Schulz, our Chief Financial Officer. I'd like to remind you that there may be statements made during the course of this conference call that are not historical facts and are forward-looking in nature. These statements may relate to the company's future growth and financial results and contain the words believe, anticipate, expect, guidance and similar words. These forward-looking statements involve both known and unknown risks, uncertainties and other factors, which may cause actual results to differ materially from expectations. For a detailed review of these risks, please refer to the company's filings with the Securities and Exchange Commission. Also, a webcast of this call will be available in the Investor Relations section of Digital River's corporate website. Now I'll turn the call over to Dave Dobson.

[David C. Dobson:]

That's great. Thanks, Melissa, and thanks to all of you for joining us this afternoon. I'd like to start out today's call by making a few comments on our fourth quarter and full year financial results. Then I'll give a progress update on our strategic transformation and talk about some of our key areas of focus as we move into 2014. Following my opening comments, I'll turn the call over to Stefan, who'll provide more details on the quarter's financial performance. Then we'll open it up to take your questions. I'm very pleased to report we closed the year with solid results. In the fourth quarter, revenue totaled just over $101 million, exceeding our guidance, up 3% year-over-year. And non-GAAP earnings were $0.22 a share, meeting the high end of our guidance range. On a full year basis, revenue topped guidance of $390 million, and non-GAAP earnings were $0.61 per share, which also was at the high end of our guidance range. In the fourth quarter, holiday sales were one of the primary contributors to the solid performance of our Commerce business. In Commerce, we processed just over $2 billion for the trailing 12 months ended December 31, a 4% increase compared to the trailing 12 months ending in September 2013. We believe the strong activity levels we saw among some of our largest Commerce customers reflects the shift in consumer purchasing preferences away from traditional brick-and-mortar retail stores towards digital direct-to-consumer commerce channels. And recent research suggests the pace is picking up. A new study from IBM reported that 27% of global consumers made their most recent purchases online, which was almost double the percentage from the previous year's study. These market forces certainly play in Digital River's favor as more companies follow suit and begin to make investments in building direct online channels, shifts that are driving incremental revenue streams, higher margins and closer relationships with their customers. In the fourth quarter, Payments performed in line with expectations, with revenue growing organically by 29% year-over-year. Gross volume processed by Payments was $28 billion for the trailing 12 months ended December 31 versus $26 billion, an increase of 7% over the dollar volume processed over the trailing 12 months ended in September. Consistent with our comment over the last quarter's earning call, we continue to expect strong revenue growth from this business. We believe these results continue to point to the significant opportunity for Digital River. As we noted during our Investor Day last September, our current Commerce and Payment markets are large and growing. While there's no lack of growth opportunity in front of us, we also understood as we enter 2013 that there were some challenges holding us back. We needed to drive customer loyalty, expand into new markets, improve executions and increase our operational efficiencies. To begin to address these challenges, we made a number of important leadership changes. We realigned our company resources around our core Commerce, Payments and Marketing businesses. We divested some non-core businesses and started to execute the key elements of our strategic transformation. As we outlined last September, our strategic transformation is focused on the following 3 areas

[Stefan B. Schulz:]

Okay. Thank you, Dave, and good afternoon, everyone. As Dave mentioned earlier, our fourth quarter revenue was $101.2 million, an increase of 3% over last year's revenue from continuing operations, which beat the top end of our guidance range of $100.5 million. Please note that we discontinued some of our operations in 2013 and all of the following comparisons with historical periods relate only to our continuing operations. International Commerce revenue in the quarter accounted for about 42% of total revenue, down from 46% last year due to strong U.S. holiday sales this quarter. Moving on to the full year. Revenues in 2013 were $389.7 million, which also exceeded the top end of our guidance range of $389 million and represented 5% growth over 2012 revenue. Within our revenues, Commerce was $84.7 million, down 6% from last year's Commerce revenues of $90.1 million. For the full year of 2013, Commerce ended at $328.1 million, a 5% decrease from 2012. This decline is consistent with our expectations and largely driven by the planned attrition we previously discussed. Our Payments revenue was $16.5 million, an increase of 105% from last year's Payments revenues of $8 million. Excluding LML, Payments grew 29%. For the full year, Payments revenues were $61.5 million, a 147% increase over 2012 and a 50% increase on an organic basis. Now shifting to expenses. Total non-GAAP operating costs and expenses increased $7.1 million in the same quarter of last year, including approximately $4.8 million of expenses related to the LML acquisition. The remaining increase was primarily attributable to $2.5 million in incremental investments related to our technology innovation and transformation initiatives. Approximately $2.4 million related to sales and marketing and general and administrative incentive compensation as the metrics needed to earn these incentives in 2012 were not met, and $1.2 million of additional depreciation, driven primarily by our technology investment. These increases were partially offset by some lower variable costs of $3.9 million. Moving on to earnings. The GAAP net loss for the fourth quarter totaled approximately $43,000, representing roughly 0 earnings per share. Last year, the loss was $5.77 per share in Q4. The GAAP net loss for the full year of 2013 was $18.5 million or $0.58 per share. On a non-GAAP basis, diluted net income for the fourth quarter was $8.3 million or $0.22 per share, which was at the high end of our guidance range. Last year, we earned $0.32 per share in the same period. For the full year, non-GAAP diluted net income was $20 million or $0.61 per share. Non-GAAP EBITDA was $17.1 million for Q4 and $54 million for the full year compared to $19.8 million and $68.8 million in the same periods last year. As in previous quarters, we have included a table at the end of our earnings release which reconciles our GAAP and non-GAAP results. Now turning to cash and cash flow. Our net cash used by operations for 2013 was $15.3 million as compared to cash generated by operations of $38.8 million in 2012. Larger uses of working capital in 2013 combined with lower profits drove the reduction in cash generated from operations. Excluding the impact of working capital changes, our operating cash flow for 2013 was $38.4 million, down from last year's cash flow of $59.8 million. Capital expenditures were $23.3 million in 2013 compared to $22 million last year as we continued the investment in our technical architecture during the course of 2013. As of December 31, 2013, our cash and non-equity investments totaled $641.5 million. This was a decrease of $100 million from the end of last year, and the primary drivers of this change were the use of cash in operations I just referenced, the repurchase of $51.2 million of common stock, as well as our acquisition of LML. Under our current buyback authorization, we repurchased $7.3 million of common stock in Q4 at an average price of $17.86 per share. As of December 31, there was $46 million remaining under the current authorization. Our company cash, which we define as cash and non-equity investments less our client cash, was $533 million. Now moving onto guidance for the full year of 2014 and the first quarter. Our guidance for the full year of 2014 is as follows

[David C. Dobson:]

Thank you, Stefan. So before I move on to Q&A, I want to recap some of the points that you heard on this call. First, we have made good progress on our transformation across many fronts. We invested in optimizing our IT infrastructure, platform and tools to increase capacity, scalability and performance for our customers. We built momentum across our core Commerce, Payments and Marketing businesses, as well as expanded in high potential verticals, such as publishing and branded manufacturing. And finally, we realigned the organization for success. We focused our talent on our key growth markets and welcomed new leadership to our team. Secondly, while we are pleased with the progress we have made in the business, we still have work to do and we're going to be very focused on executing our transformation plan. In 2014, we intend to continue improving our infrastructure and executing our platform modularization strategy while making additional investments in Commerce and Payments. Finally, while we will face some expected headwinds in the first half of the year, we remain confident in our plan, which will continue to drive our execution priorities. We believe the many positive results that we've seen today are early indicators that our transformation is beginning to deliver against our ultimate goal, which is to create added value for our customers and our shareholders. With that, let's move to Q&A. Kate, if you would, please open the lines.

[Operator:]

[Operator Instructions] Our first question comes from the line of Gene Munster with Piper Jaffrey.

[Charles Eugene Munster:]

The retention number, 93% for Commerce. Where should that number be longer term? My first question. The second question is, you talked about the increased spending in 2014 of $8 million in kind of incremental spending. Was there anything about kind of the strategic direction that we outlined at the Analyst Day last fall that has shifted slightly to have caused that increase? And if so, what was that slight shift?

[David C. Dobson:]

Gene, it's Dave. Let me talk-- the first one is pretty easy. We expect over time our retention should be in the mid-90s. So what you're seeing at 93% as we continue to see the tail of some of the retention that was announced a number of quarters ago, as that works its way through, we would like to see our retention in the mid-90s. And you can see Payments is at 100. We'd love to see it stay there. But realistically, mid-90s for Commerce. On your question with regards to 2014 spending, no change in our strategic direction. In fact, what we're seeing is some early signs that some of the new markets that we highlighted at Investor Day, particularly outside of our core software segment, are very real and we're choosing to spend in advance and expanding our presence in Europe and Asia to get to those market opportunities. And then secondly, with our Payments business, we clearly have an opportunity to differentiate in that so we're going to increase our rate of innovation, increase our global footprint for Payments and continue to try to drive that at or above market rates. No changes in the strategic direction at all.

[Charles Eugene Munster:]

Okay. I know that -- and Stefan, you outlined kind of where -- the 3 segments of that increased spending. But is it disproportional to software or to Payments or neither?

[Stefan B. Schulz:]

Yes, it's a fair question. So it's not quite 1/3, 1/3, 1/3. But let's just say, it's almost 1/3 of it will go into our Payments business and then 40% of it goes into our technology platform, particularly around accelerating the rate around our software modularization. And then the balance goes into the expansion of our Commerce footprint in Europe and Asia.

[Operator:]

Our next question comes from Craig Nankervis with First Analysis.

[Craig Nankervis:]

Actually, the first questioner asked a couple of my questions. But your transformation timetable that you said changed with the financial benefits in Q4, can you just spell that out a little bit more? Does that mean you think you're going to be in better shape come Q4 this year than you thought you would be 90 days ago? Or how do I think about the comment that you made on that front?

[David C. Dobson:]

I'm just going to clarify your question, Craig. The comment that was made that I made was that we created close to $20 million of run rate savings in fiscal '13, and so we commented on that. That was the comment about the benefit. I used the term "financial capacity." And we've chosen to invest $8 million of that back into the business. There really hasn't been any change in the transformation timetable that we announced back in September, and that we've communicated in a couple of updates since then. We expect -- we're in the late innings of the significant investments at our core infrastructure. We're starting to see the benefits, I think early indicators of benefits, and our customer retention is stabilizing. But the real work ahead of us is in our software code base. We continue to evolve and invest in the modularization of our platform. I would tell you that the progress on that was relatively slow in 2013 because we've put most of our efforts on infrastructure and stabilizing and preparing for the holiday. But you're going to see in 2014 us really ramping up our software modularization such that we can extend our customer wins and our platform into those markets beyond our core software base. And that's really been our focus and continues to be our focus in 2014 and into 2015.

[Craig Nankervis:]

Okay. And just extending that a little, so this acceleration of your footprint overseas, what have you seen there? You talked about it being very real. What -- do you think is it pent-up demand? Is it a lot of old platforms that are ready for refresh? What's -- can you just give a little more color on what's made you incrementally more excited and compelled to invest there.

[David C. Dobson:]

I'm really glad you asked the question. Because it's something that we saw and certainly I saw firsthand because I traveled around the world and met with many of our customers. Particularly I'll use an example, I spent -- I've now been over 3 times to Asia and particularly in Taiwan, as you know, where we have one of our large development centers. We have the team there introduce me to 3 or 4 customers that are Taiwanese-based branded manufacturers that build products. They do not have the capabilities to market and sell those products in all the countries around the world. They typically use a large network of resellers today. And so as we've launched companies like Johnson Health Care and Thunder Tiger and, hopefully many more to come. We now have Furla in Europe. We're seeing these customers saying, "Digital River, your business model of having entities and capabilities in 150-plus countries around the world is very powerful. Your competitors don't have that." And so that's what -- we saw that. And a lot of our business, Craig, in Europe and Asia, quite honestly, is multinationals, U.S.-based multinationals doing business in Europe and Asia. That's great. But we're saying, we've got an enormous opportunity to get more European and Asian-based customers to expand their presence into North America, into Latin America and into Europe or Asia or vice versa. So that's really what we've seen. And quite frankly, we're seeing more of what we call branded manufacturers that fit into our current platform capabilities that we have today. Now we think we can accelerate that over time, it's a relatively small portion of our revenue. But we're pretty excited about our prospects. And with Tom Peterson joining the team and making some of the changes to the go-to market model, it has certainly increased my confidence that this was a smart investment to make.

[Craig Nankervis:]

Do you feel the competitive dynamics notably different in those geographies versus domestic? I'll say in particular the e-commerce platform players that I'm familiar with, while their approach towards Asia has been modest, although it is changing as China changes. But what do you see on that front?

[David C. Dobson:]

Yes, the short answer is absolutely yes, the competitive dynamics are different. And it's very simple. We have a lot of competitors that can create e-commerce stores, whether it's software, software-as-a-service here in the United States. But trying to expand, if you're a Tier 2 customer, so let's just say, you've got an e-commerce revenue somewhere between $10 million and $1 billion, for you to have entities to do tax, compliance, be the merchant and seller of record, to be able to do payments, there's no one like Digital River that's got the capability to do that. So as you go into countries outside of the U.S., quite frankly, our value proposition is very strong and that's the comment we made it. It's resonating with these Tier 2 customers, particularly this branded manufacturers. So we think we've got a highly differentiated offering, and we're going to invest to extend that into Europe and Asia.

[Craig Nankervis:]

Okay. And then lastly, is there a comment -- maybe this is for Stefan -- are you breaking out Microsoft for the year for us?

[Stefan B. Schulz:]

Yes, we can do that. We do, do that, annually, Craig. And the percentage for the year was 33%.

[Operator:]

Our next question comes from the line of Joshua Reilly with Northland Securities.

[Joshua Reilly:]

This is Josh in for Tim Klasell. Can you tell me, are you seeing more outsourcing of payment processing to Digital River as a result of the recent securities scares in the marketplace, the Target incident and others?

[David C. Dobson:]

Josh, it's Dave. I've got Souheil Badran, who runs our Payments business, here in the room. And I'm going to let him ask that. I don't know if in the last 2 weeks you've seen an increase as a result of that, but what are you seeing, Souheil?

[Souheil Badran:]

Josh, we definitely see our existing clients and more process talk about what our capabilities are, I'd hate to say yes, over the last 2 weeks we've had a shift in brand-new customers. But definitely, it's a topic that as we're talking to them, people are saying, "I don't want to kind of outsource -- I want to be able to outsource your Payments page because you guys are responsible for the security aspect of my Payments data." So it's more of a discussion right now. I would not say, it's more of a true. Maybe it's based what happened in the last few weeks.

[Joshua Reilly:]

Okay. Can you tell me in your pipeline of new customers, what area has been growing the fastest, Consumer Electronics, traditional software, et cetera?

[David C. Dobson:]

Yes, I'll start off with that. And by the way, the other person we've got in the room is Tom Peterson. In fact, Tom, I'll give this to you and then pass it over to Souheil. So what are you seeing in Commerce, Tom, as far as pipeline building? Where is the action happening?

[Thomas E. Peterson:]

Our Commerce business, frankly, I think, the biggest growth that we're seeing right now is in the branded manufacturers space. We've made some investments there to bring our offering to markets in Europe, Asia and the Americas. And candidly, the dependence that we've had historically on the software business, it hasn't declined. It's just not growing as rapidly as branded manufacturing. And as Dave alluded to earlier, we've had some great wins in the gaming industry as well. So I would point to branded manufacturing and gaming as the fastest growth areas of the company right now.

[David C. Dobson:]

Souheil, do you want to add anything from a vertical standpoint to an area where you're seeing growth?

[Souheil Badran:]

We're really seeing serious growth. As Dave mentioned earlier, we've signed over 50 new partners that are leveraging outsource and are taking our solutions to their own verticals. In addition, we continue to see an increase within the gaming vertical and within in-app purchases as well. That seems to be a growing area for us.

[David C. Dobson:]

And Josh, just a comment on both Souheil and Tom, is one of the things we're doing that we had not taken advantage of historically is historically we've run at the time of pre-mid 2013, we had really run Payments almost like a standalone entity. And with Souheil and Tom working arm-in-arm now, we're actually looking at how do we lead as we modularize our offering? How do we lead with Payments in selected verticals and will land the customer in Payments and then over time upsell our entire commerce-as-a-service stack? So that's something that's very early on, but we're starting to guide our marketing and demand generation and targeting to customers to really take advantage of the fact that we have an integrated Payments business inside of Digital River. So I think more to come on that as we go forward.

[Joshua Reilly:]

Okay, great. And then one final question. How do you anticipate churn for the next 6 months and possibly over 2015? Are you seeing any spikes in customer notifications?

[David C. Dobson:]

No. We as we communicated during the call, we are right now seeing a churn or the inverse of customer retention at very low levels, which is very encouraging. So we don't certainly, in the forecast we just provided, we don't see any significant uptake -- or uptick in the churn of our customers, which I think is a really strong indicator for the progress we're making with our investments in technology and our transformation.

[Operator:]

Our next question comes from the line of Phil Winslow with Crédit Suisse.

[Harris Heyer:]

This is Harris Heyer for Phil Winslow. I was hoping you could give us a little bit of an update regarding your progress on re-platforming? Any key milestones you've reached and/or maybe haven't reached and also milestones that you've kind of expect to reach over the next 3 to 6 months?

[David C. Dobson:]

Sure, Harris, I'll start that. And then Stefan, if you want to add anything to it. The first as we commented on, as we set out on this significant investment that we're going to make in our technology core, we really talk about 2 halves

[Harris Heyer:]

Yes, absolutely.

[Operator:]

Our next question comes from the line of Nat Schindler from Bank of America Merrill Lynch.

[Jason Mitchell:]

This is Jason Mitchell here for Nat. I guess I kind of have a follow-up question on that. I think you had said on an earlier call that you anticipated to start releasing some of the modularity of your platform towards the latter half of 2014. How do you see that affecting your customer base? Do you expect most of your customers to remain on your platform or start to pick and choose pieces of your platform as you move along into 2014 and '15?

[David C. Dobson:]

Yes, Jason, pretty consistent with what we've talked about previously is that for some customers, we think, some of our larger customers that they really, as they look at the investments that they're making or the systems they've had, we think we've got an opportunity to continue to work with them and have a significant part of their business as they outsource parts of their e-commerce capability. So think of these Tier 1 customers that, in some cases, they might have their own Payments platform, they might want us to provide merchandising capabilities, or they might want us to provide a content management system. That's really what modularization is doing for our largest customers. For our Tier 2 customers, which is a really core part of our growth going forward, what modularization provides is more around having a very robust API layer that they can start to plug into third-party capabilities that are incremental to the platform and the capabilities that we provide. So we've already started, as far as the way we price and the way we're packaging our offering, just in the fourth quarter we're engaged in probably 3 or 4 opportunities that we would not have been engaged in 1 year ago because of what we're doing around pricing and packaging. But over time, so I'm talking over through the course of '14 and early into '15, I think we'll start to see the benefit more from a product modularization, so going beyond pricing and the way we package our offering to start to sell capabilities that we wouldn't have had the potential for now. It's not so much that the largest customers that we land a new deal, with a module. The best example of that is Payments. We're seeing that already today. So we sell our Payments capability. But what we really think is some of the attrition that you'd seen historically at Digital River was because we were not flexible on the way we packaged and made our offering available. So our expectation is that you might see us and some of our large customers have a lower what we call take rate. So the percent of revenue we get could be lower, but as their e-commerce grows, we think we can manage the dollar volume in an attractive way and our profitability in an attractive way for Digital River.

[Operator:]

And I'm not showing any further questions at this time. I'd like to turn the call back over to Melissa Fisher for closing remarks.

[Melissa Fisher:]

Thank you for participating in today's call. This concludes Digital River's fourth quarter 2013 earnings call.

[Operator:]

Again, ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a good day.