QAD Inc.
Q2 2018 Earnings Call Transcript

Published: 25 Aug 2017

[Operator:]

Welcome to QAD Fiscal 2018 Second Quarter Financial Results Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Ms. Kara Bellamy. Please go ahead.

[Kara Bellamy:]

Hello, and welcome to today's call. Before we begin, I need to ensure that everybody understands that our discussion may contain forward-looking statements that are based on certain expectations and analyses. Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. QAD undertakes no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date of this call. For a complete description of these risks and uncertainties, please refer to QAD's 10-K and 10-Q filings with the Securities and Exchange Commission. Please also note that during this call, we will be discussing non-GAAP pretax income, which is a non-GAAP financial measure as defined by SEC Regulation G. A reconciliation of this non-GAAP financial measure to the most directly comparable GAAP measure is included in today's press release, which is posted on the company's website. Now I would like to turn the call over to Karl Lopker, QAD's Chief Executive Officer.

[Karl Lopker:]

Well, good afternoon, and thank you for joining us to discuss our second quarter results. Pam Lopker, President; and Daniel Lender, Chief Financial Officer, joined me on the call. Overall, we had a solid second quarter. Subscription revenue growth rate picked up a bit, and license revenue did well. In addition, services revenue continued to grow, although services margin suffered a bit due to aggressive hiring and subcontracting to meet demand. And maintenance was down slightly. Daniel will give the numbers, then I'll discuss the details. Daniel?

[Daniel Lender:]

Thank you, Karl. We delivered solid results in the second quarter, posting revenue of $76 million, which exceeded guidance by $3 million and increased 9% in constant currency from $70 million last year. The revenue achievement was driven by higher-than-anticipated subscription and license revenue on the positive currency impact to our foreign revenue compared to the prior quarter. Maintenance and services revenue were generally in line with expectations, but the level of subcontractor use in our professional services business was higher than planned. Non-GAAP pretax income of $2.5 million exceeded guidance by $800,000. The U.S. dollar devalued against many currencies in the quarter. As a result, compared to prior quarter, revenue was favorably impacted by $1.2 million, but that was offset by a negative impact to expenses of $1 million. So on a net basis, the impact to profitability was small. Subscription revenue grew 41% to $17.4 million, up from $12.3 million last year, representing 23% of total revenue. During the quarter, we recognized approximately $0.5 million of previously deferred subscription revenue that is not recurring going forward. We are pleased to report our subscription margins improved to 57% from 45% a year ago, resulting from ongoing economies of scale and operational efficiencies, and includes a 1% benefit from the nonrecurring subscription revenue I mentioned earlier. We are starting to see the benefits of our efficiency programs in the cloud operations through our improved margin and expect margins of 53% to 55% for the fiscal year, which is ahead of plan. We're continuing our investment in future cloud growth, which could result in quarterly margin fluctuations, but we stand by our 60% long-term target. Maintenance and other revenue was $32 million versus $33.3 million last year. The decline was primarily the result of prior conversions to the cloud, and we expect this trend to continue. Recurring revenue, which combines subscription and maintenance revenue, was 65% of total revenue for the quarter. License revenue grew to $6.7 million, up from $6.4 million last year. As we noted during our last call, given our focus on driving new customer business to the cloud, growth and license revenue is being driven by the expansion of our existing perpetual customer base. Professional services was $19.8 million compared with $17.8 million last year. Demand for professional services continues to be driven by cloud implementations and existing customer upgrades and should remain strong throughout the year. You'll recall that we started sub hiring programs for the services organization last quarter that resulted in 45 additional personnel in Q2. Compared to this time last year, our professional services organization has 60 additional employees. During the quarter, our margins were negatively impacted by these new hires because they are not immediately billable, in addition to increased use of subcontractors to meet customer demand. We expect margins will continue to be impacted until these hires are fully utilized, which we expect to gradually occur through the remainder of this year. Total revenue by vertical for the second quarter was, automotive, 38%; high tech and industrial, 32%; consumer products and food and beverage, 15%; and life sciences, 15%. By geography, the breakdown was, North America, 47%; EMEA, 29%; Asia Pacific, 17%; and Latin America, 7%. Gross margin in Q2 was $39.3 million versus $37 million last year. As a percentage of total revenue, gross margin was 52% for the fiscal 2018 period and 53% last year. The decline in margins is due mainly to decline in services margin and overall revenue mix. Sales and marketing expense totaled $17.7 million or 24% of total revenue compared with $17.3 million or 25% of total revenue a year ago. R&D expense totaled $11.7 million for the 2018 second quarter compared to $11.1 million last year. The increase resulted from higher personnel expense mainly due to 26 additional headcount supporting our investment in the Channel Islands initiative. As a percentage of total revenue, R&D expense was 15% for the fiscal 2018 quarter and 16% last year. General and administrative expenses were $9.2 million versus $8.5 million last year, with the increase primarily relating to higher stock compensation and professional fees. As a percentage of total revenue, G&A expense was 12% in both periods. Total operating expenses were $38.7 million or 51% of total revenue compared with $37 million or 53% of total revenue last year. Equity compensation expense was $2.5 million for the fiscal 2018 second quarter and $2.1 million last year. Operating income of $0.5 million, improving from about breakeven last year. During the FY '18 second quarter, we recorded $1.2 million of other expense related primarily to unrealized foreign currency losses compared with other income of $433,000 for fiscal 2017 period. The U.S. dollar depreciated against most other currencies in the quarter, most notably the euro. As a result, our pretax loss totaled $329,000 versus pretax income of $393,000 last year. Non-GAAP pretax income was $2.5 million compared with $3 million last year. Income tax expense was $832,000 for the second quarter and reflects actual tax expense in the quarter versus a benefit of $575,000 last year, which applied an estimated annual tax rate. As a reminder, because we expect our results to be close to breakeven for the year, we are recording taxes each quarter based on the actual tax expense on a nonapplying and estimated annual tax rate. GAAP net loss was $1.2 million or $0.06 per Class A and $0.05 per Class B share. For last year's second quarter, net income was $968,000 or $0.05 per diluted Class A and $0.04 per diluted Class B share. For the year-to-date period, total revenue grew to $147.3 million from $135.2 million, driven by gains in subscription, services, and license revenue. Subscription revenue increased 38% to $32.8 million from $23.8 million in the year-ago period. Gross margin was 51% of total revenue compared with 52% in the prior year 6-month period. Subscription margin was 52% of subscription revenue for the FY '18 period and 46% for the FY '17 period. Total operating expenses came to $76.6 million versus $73.3 million for the first 6 months of last year. And as a percent of total revenue, total operating expense were 52% for the current year-to-date period compared to 54% last year. Our pretax loss was $2.3 million versus $3.5 million a year ago. Non-GAAP pretax income was $2.7 million compared to $1.1 million. Our GAAP net loss was $3.7 million or $0.20 per Class A and $0.17 per Class B share compared with a net loss of $1.8 million or $0.10 per Class A and $0.08 per Class B share last year. We ended the second quarter with over $149 million in cash and equivalents, up from $145 million at the end of fiscal 2017. Accounts receivable was $42.4 million, down from $45.5 million a year ago. And day sales outstanding using the countback method was 51 days for the fiscal second quarter versus 54 days a year ago, and the quality of our receivables remained healthy. Our deferred revenue balance at July 31 was $89.7 million, including $63 million of deferred maintenance, $22.8 million of deferred subscription, $2.7 million of deferred professional services and $1.2 million of deferred licenses. A year ago, our deferred revenue balance was $85.3 million, including $65 million of deferred maintenance, $17.2 million of deferred subscriptions, $1.8 million of deferred professional services and $1.3 million of deferred licenses. A quarterly reminder, our maintenance contracts are billed annually, while subscription contracts can be billed either annually or quarterly. Our cash flow provided by operations was $7.6 million for the first half of 2018 compared with $2 million for the same period last year, primarily as a result of strong cash collections. I'll end my remarks with the guidance. For fiscal '18, we're raising our guidance for total revenue to $292 million to $296 million, including $68 million to $70 million of subscription revenue. The increase is driven mainly by higher professional services and licenses, and we're maintaining our prior guidance on subscription revenue for the year. A GAAP pretax loss of $1 million to pretax income of $1 million and non-GAAP pretax income of $8 million to $11 million. For the third quarter fiscal '18, total revenue of $73 million to $75 million, including $17.4 million of subscription revenue. Given the lower-than-average mix of conversions in the quarter, subscription revenue growth is being impacted negatively for Q3 as new customers ramp up their user counts over time, but as mentioned earlier, we are maintaining our yearly guidance. GAAP pretax income of approximately breakeven and non-GAAP pretax income of $2.1 million to $2.8 million. With that, I'll turn the call back to you, Karl.

[Karl Lopker:]

Great. Thanks, Daniel. Our cloud bookings continue to come in steadily, with 1/3 due to conversions from on-premise and the remainder from new customers or new users. We expect that conversions will return to half of cloud bookings in the remainder of the year. We added 11 new cloud customers during Q2. Our license revenue was similar to last quarter and came mainly from new users and new modules to existing customers. New hiring in services put pressure on our services margin but will put us in a better position to meet demand for upgrades and rollouts. We're not expecting to add a significant number of services people in the last half of the year. Our sales funnel for cloud and licenses is up slightly from last year at this time, and cloud still accounts for 60% of the funnel. As I mentioned before, maintenance revenue was down slightly due to the effect of cloud conversions. We continue to see renewal rates consistent with past experience. However, conversions from on-premise to the cloud will continue to affect overall maintenance revenue. On a regional basis for the quarter, overall revenue was consistent with past experience. However, licenses were somewhat stronger in North America due to a single large order. Automotive continues to be our strongest performing vertical for the quarter. Full-time employee headcount at 1,830 was up around 6% from last year. The increase was mainly in development and services, as Daniel mentioned. Now I'll turn the call over to Pam for a closer look at our QAD cloud and development activity.

[Pamela Lopker:]

Great. Thanks, Karl. In Q2, as Karl mentioned, we had 11 new cloud bookings, including 3 conversions and 8 net new customers, representing all verticals and all regions. I'd like to highlight one particular deal. It went to a $20 billion-plus consumer product global appliance company. It is not a company where QAD, until, now had any presence. They were looking for a quality management product that would be available globally and in the cloud. They had determined that advanced product quality planning techniques, known as APQP, and used extensively in many manufacturing industries represented best practices that they wanted to adopt. We competed against a long list of 8 different solutions, something I typically don't like to do where we had no presence in that company and had no inside track, but we did it. We competed against 8 different solutions and won based on our deep knowledge and experience in APQP, our proven global cloud support and the capability and usability of our quality product suite. They particularly liked our new HTML5 usability. Their primary ERP vendor, which is SAP, was viewed as too heavy and difficult to implement and wasn't even on the long list. This quarter deal represents the start of what we hope to become a long and growing relationship with this company. I also want to mention that our Channel Islands web user interface and our enterprise platform will move to limited availability at the end of September. Moving to limited availability will open up availability for customers in North America, Western Europe and Asia for customers with under 500 users. So a big step getting this huge development to market, a very important development for us. The Channel Islands web user interface provides ability to run our software on different devices both desktop and mobile, leverage the inherent security of our application across the Internet and provides many key features such as attachments, activity feeds, KPIs, dashboards and all in an HTML5 user interface. The enterprise platform allows our customers to extend their existing application as well as create brand-new applications, all in the same environment and leveraging all the aspects that Channel Islands brings to the user experience. And it extends and it creates these applications in a way that are embedded in data and, therefore, can be moved forward as new releases and new capabilities are available in our product. So very important capabilities in the cloud environment to keep people moving forward on current releases, but allowing them to have extensions that are important to the personality and requirements of their companies. So that's it for me, Karl. Back to you.

[Karl Lopker:]

Okay. Thanks. Well, the manufacturing economy continues to roll along nicely, and we expect to continue to keep up the pace in the cloud that we experienced last year. And as usual, now we'll take questions live. Operator, can you give the instructions?

[Operator:]

[Operator Instructions]. Our first question comes from the line of Bhavan Suri with William Blair.

[Bhavanmit Suri:]

I guess my first question is this, you obviously had really good cloud numbers and cloud wins. But sort of Q3 looks a little lighter on that number, and you sort of talked about the new customers versus existing and that pipeline has shifted from 50-50 to where it is. Is there anything specific you're seeing with existing customers? Is there a geography or a vertical or something where there is push back? Because I figured, with Channel Islands, sort of the release where you have functionality of the cloud will help people move over, but it seems to have sort of tapered a little bit. So maybe Pam or Karl, help me think through that a little bit. So let's get a little more color there.

[Pamela Lopker:]

No, personally, I think it's just a timing issue. We have quite a few conversions and very large conversions in the funnel. So I think it's more yin and yang than it is a trend, and I would expect by the end of the year that we will still have that 50-50 conversion in net new.

[Bhavanmit Suri:]

Got it. And then maybe turning over to the biotech market. I'll jump into the large wins sort of outside your course maybe for a second. But in the biotech market, which is kind of a space you own, Pam, you guys bought a great product and quality space. But there's a company called Veeva up there that's doing a bunch of quality management, the QMS offering in that space, too. Do you run into them? How does that competitive environment play out? And are you seeing traction with your quality management solution in that space or is the quality solution really being sold into the automotive space?

[Pamela Lopker:]

Yes. Our quality product is sold throughout our verticals in all spaces. And I think it's quite a bit different than Veeva. I think that they're really focused on the extended CRM phase. I know we've looked at them a few years ago just for competitive information, but maybe it's time for us to take a look at them again. But I have not heard of competing with them. So that's interesting.

[Bhavanmit Suri:]

Got it. They just announced something outside of life sciences, but they have a quality management solution, it'd be interesting to get your thoughts. And then, obviously, you moved outside of some of the core verticals, especially this recent win, I guess, SAP. And you've now seen 3 or 4 quarters of large SAP displacement. When you look at the pipeline, is that something you're seeing on a regular basis? Or is it sort of very lumpy or are we going to sort of start seeing this sort of increase? Just some color on how you think about SAP where sort of these larger [indiscernible] 20 sites North America or 40 sites globally orders go, how are you sort of thinking through that and what does the pipeline look like for that?

[Pamela Lopker:]

Well, obviously, they're a very large company, and we're nibbling away at it here and there. Certainly, they don't seem to be the threat that they used to be. I no longer feel that companies are saying, "Wow, we need to get to SAP." And even if they've made that commitment to go to SAP, they are rethinking it in different areas and different aspects. And I think that the success of Salesforce really reflects that. Salesforce just said, "Hey, you have SAP, but obviously, you're probably not very happy with the CRM product or you're never going to get there in your lifetime, so you ought to use ours in the cloud." And that basically was representative of the large company deal that we got this quarter. "Yes, we have SAP. We have it pretty well implemented. Do we want to buy more from them? No."

[Operator:]

[Operator Instructions]. We have a question from the line of Matthew Galinko with Sidoti.

[Matthew Galinko:]

I was hoping you could maybe talk a little bit more about what the sales cycle was for the large competitive deal you highlighted this quarter.

[Pamela Lopker:]

I can talk a little bit to it. It was around a 6-month sales cycle and obviously started off with a long list of competitors and just the standard presentation, references, negotiations. So it was a 6-month deal. So it was about an average deal for that kind of product, but one that, originally, I said I'm not sure we should compete in. We have no relationship with this company. We know none of the players. We know none of the management. Does it really make sense when they have a big SAP footprint. But as it turned out, it made a lot of sense.

[Matthew Galinko:]

Got it. Appreciate that. And maybe as a follow-up, given what you learned going through that competitive displacement part, you didn't have a toehold, I guess, previously. Does that change your thinking of the sorts of deals that you go after going forward or do you think that you'll become a little bit more aggressive in putting yourself on that position where you think you'll be able to ultimately displace the incumbent?

[Pamela Lopker:]

Yes, I definitely think so. I do believe that really helps us understand what the landscape is out there and things are changing. And for us, change is good, and I think we are well positioned to win new business.

[Matthew Galinko:]

Got it. All right. One last one. Just on visibility into the license revenue stream at this point. I mean, I'd imagine, it's somewhat difficult to predict. But you have had a few quarters of kind of reversal in the trend of that revenue line. So I'm just curious, I understand long term that the conversion should somewhat diminish that, but does it kind of meter compared to the trend that it's been on or do we go back to the same pace as the conversions pick up again?

[Pamela Lopker:]

Karl, I think maybe you wanted to take that one.

[Karl Lopker:]

Yes. I think license revenue was more dependent upon the general manufacturing economy. When that's going well, our customers hire people, and then they need more licenses to run their businesses. They also feel a lot more comfortable about buying additional software. So I think it might be not necessarily independent from conversions because the conversions go to the cloud but dependent more on the total economy.

[Operator:]

And we have no further questions. So I would like to turn the conference back to Mr. Karl Lopker.

[Karl Lopker:]

Well, thank you, everyone, for your attendance and questions. And we'll contact you again in November with our third quarter results. Bye for now.

[Operator:]

Thank you. Ladies and gentlemen, this concludes our conference for today, and thank you for using AT&T Executive Teleconference services. You may now disconnect.