QAD Inc.
Q3 2017 Earnings Call Transcript

Published: 23 Nov 2016

[Operator:]

Welcome to the QAD FY '17 Third Quarter Financial Results Call. [Operator Instructions]. Also as a reminder, today's teleconference is being recorded. At this time I will turn the conference over to your host, Chief Accounting Officer, Ms. Kara Bellamy. Please go ahead.

[Kara Bellamy:]

Hello and welcome to today's call. Before I begin, I need to ensure that everybody on the call 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 net income and non-GAAP earnings per diluted share which are non-GAAP financial measures as defined by SEC Regulation G. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP measures are 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:]

Good afternoon and thank you for joining us to discuss our third quarter results. Pam Lopker, President, and Daniel Lender, Chief Financial Officer join me on the call. Our QAD cloud business continues to roll along with cloud subscription revenue showing a 40% growth rate this quarter. And the fourth quarter is already looking strong due to cloud booking since the election. Given our focus and success in the cloud, our license revenue is again lower than historical levels and we expect this effect to continue going forward. Our services backlog is strong and getting stronger, due to the recent cloud bookings and upgrades. Maintenance revenue remains steady, despite the increase in subscription from the cloud. Daniel will give you the numbers and I will discuss the details. Daniel?

[Daniel Lender:]

Thank you, Karl. Subscription is growing strong at over 40% while overall revenue is holding firm. Total revenue for the third quarter was near the top of our guidance range, driven by subscription revenue that was approximately $500,000 higher than forecast on higher than expected professional services revenue. EPS of $0.08 per Class A share and $0.07 per Class B share exceeded our guidance of breakeven results. During the quarter, our cloud business benefited from the addition of 14 new customers, growth in our existing customer base and revenue from deals we closed at the end of last quarter. GAAP net income was higher than anticipated as a result of improved services margins. Third quarter total revenue was $69.5 million compared with $68 million last year. Currency had a $600,000 negative impact. Comparing to FY '16, on a constant currency basis, total revenue increased $2 million, driven by higher subscription revenue, partially offset by lower license revenue as we continue to see shifts in customer preference to the cloud. Currency also had a $600,000 positive impact on expenses, resulting in no overall foreign exchange impact to net income. Recurring revenue which we define as subscription revenue plus maintenance revenue, makes up approximately 67% of total revenue, up from 62% a year ago and 65% in the second quarter of this year. Customers continue to move to the cloud, meeting our target so far for this year and continuing our transition from a professional software provider to a cloud Company. As a result, license revenue declined from the prior year faster than expected. As we've said in the past, this is a trend we expect to continue and one we believe is positive for QAD over the long term. As normal during these transitions, we continue to expect short term profitability challenges resulting from investments in support of our cloud business growth, as well as sales and operational expenses that are recognized ahead of cloud revenue. I do think it is important to note that we're managing for this transition maintaining our top line revenue and continuing to grow our subscription business at over 30% to a current run rate well over $50 million. Subscription margins were 48%, up from 47% last year and 45% sequentially. The improvement resulted from added revenue catching up with previously added capacity. This year we have not been able to achieve so far our targeted margin improvement, mainly due to adding capacity ahead of growth at a faster rate than originally planned. Although we're making investments to support additional environments for our new customers, where the revenue associated with these customers lags we do continue to expect subscription margins to improve further over time. Our 60% target for subscription margin remains unchanged. License revenue was $4.3 million compared with $6.4 million last year. As noted earlier, our growing cloud business is impacting license revenue levels. During the quarter we closed three license deals greater than $300,000 compared with none last year. However, the total number of licensed deals was higher last year. Maintenance and other revenues totaled $32.6 million, compared with $33.4 million a year ago. On a constant currency basis, maintenance revenue decreased $200,000 year-over-year. We consider these results positive given our ongoing shift toward the cloud. As our customers continue to convert to QAD's cloud-based solutions, we anticipate that maintenance revenue will decrease. Professional services revenue came in at $19 million versus $18.6 million last year and $17.8 million last quarter. The increase was primarily due to professional services related to a large cloud deal we signed last quarter. We were able to significantly improve our professional services backlog during the quarter, as we now have several significant projects underway that should help improve overall utilization. Total revenue by vertical for the third quarter was, automotive at 35%, high-tech and industrial 33%, consumer product and food and beverage 17%, and life sciences 15%. By geography, North America was 48%, EMEA 28%, Asia Pac 17% and Latin America 7%. Gross profit for the FY '17 third quarter totaled $36.5 million or 52% of total revenue versus $37 million or 54% of total revenue last year. Gross profit is impacted by lower license revenue. Sales and Marketing expense was $15.3 million or 22% of total revenue, compared with $15.5 million or 23% of total revenue last year. R&D expense was $10.8 million or 16% of total revenue for the third quarter 2017, compared with $10.2 million or 15% of total revenue last year. The increase related to higher headcount and personnel costs in support of our Channel Islands project. General and administrative expense was $7.9 million or 11% of total revenue versus $7.7 million or 11% of total revenue a year ago. The increase relates to higher bonus expense in the current quarter. Total operating expenses amounted to $34.2 million or 49% of total revenue compared with $33.6 million or 49% of total revenue last year. Equity compensation expense was $1.8 million for the FY '17 period and $1.9 million last year. This brings operating profit to $2.3 million versus $3.5 million for last year's third quarter. Other income was approximately $430,000 compared with other expense of approximately $150,000 in the prior year period. The movement related primarily to a positive change in the fair value of our interest rate swap. Net income totaled $1.5 million or $0.08 per diluted Class A share and $0.07 per diluted Class B share. For last year's third quarter net income totaled $2.6 million or $0.14 per diluted Class A share and $0.12 per diluted Class B share. Our year-to-date tax rate as of October 31 was 63%. For FY '17, we anticipate a tax rate of 65%. Our tax rate is negatively impacted by the shift from license revenue to cloud. As our net income before taxes during this transition is close to breakeven, our discrete tax items not driven by net income, have a significant effect on the rate. Non-GAAP net income which is described in greater detail in today's press release, was $3 million or $0.15 per diluted Class A share and $0.13 per diluted Class B share. For last year's third quarter, non-GAAP net income was $4.4 million or $0.24 per diluted Class A share and $0.20 per diluted Class B share. Covering our year-to-date results briefly, total revenue $204.7 million compared with $208.6 million for the first nine months of FY '16, driven by lower license and services revenue, partially offset by higher cloud revenue. Gross margin was 52% of total revenue compared with 54% in the prior year, primarily as a result of lower services margin and the shift from license to cloud. Subscription margin was 46% of subscription revenue for both periods. Total operating expenses came to $107.5 million versus $106.3 million last year. As a percent of total revenue, total operating expenses were 52% for the current year-to-date period, compared with 51% of total revenue for the prior period. Net loss $281,000 compared with net income of $4.8 million last year. Non-GAAP net income was $4.6 million or $0.24 per Class A share and $0.22 per Class B share, versus $9.6 million or $0.51 per Class A and $0.43 per Class B share. We ended the third quarter with cash and equivalents of $136 million down slightly from $138 million at the end of FY '16, primary as a result of dividend payments. Accounts receivable equal $39.1 million versus $41.2 million last year. Days sales outstanding using the count back method was 50 days for the third quarter versus 60 days one year ago. The quality of our receivables remains healthy. Our deferred revenue balance at October 31 was $74 million, including deferred maintenance, $52.9 million, deferred subscriptions of $17.9 million, deferred professional services of $2.3 million and deferred licenses of $900,000. On a constant currency basis, deferred revenue were $75.2 million at the end of FY '17 third quarter. Currency negatively impacted deferred revenue by $1.2 million. A year ago, our deferred revenue balance was $69.6 million including $54.7 million of deferred maintenance, $12.3 million of deferred subscriptions, $2.1 million of deferred professional services and $500,000 of deferred license. As a reminder, maintenance contracts are generally billed annually, while subscription contracts are billed either annually or quarterly. Our cash flow provided by operations was $5.5 million for the first nine months, compared to $10.2 million for the same period last year. The decrease mainly related to lower net income as a result of the shift from license to the cloud. Moving on to guidance, with an increased sales funnel, but a more pronounced shift from licenses to cloud, we expect fewer license deals to be closed in Q4, but more cloud. So we're lowering our expectations on the top end of revenue as we don't get to recognize those deals as revenue in the quarter. Given the heavy weight of cloud deals versus licenses, we also expected to have significant impact of bonus and commission expenses without the corresponding revenue being recognized in the period. For FY '17 year we anticipate total revenue of $277 million to $279 million, including $51 million to $53 million of subscription revenue. On a long term basis we continue to believe that subscription revenue will grow between 30% to 40%. GAAP earnings per share were approximately $0.04 to $0.08 per diluted Class A share and $0.07 per diluted Class B share and non-GAAP earnings per share of approximately $0.38 to $0.42 per diluted Class A share and $0.31 to $0.35 per diluted Class B share. That concludes my remarks, Karl, back to you.

[Karl Lopker:]

Thanks, Daniel. We continue to be excited about our success in cloud activity. Around half of our new cloud sites continue to come from net new customers, that is new customers or new divisions of existing customers. The rest comes from on premise customers who convert to the cloud, usually while doing an upgrade. Both of these types of bookings generate services revenue and because of the strong bookings, our services backlog has increased significantly for both QAD and our partners. Services utilization which suffered in the first half of the year, has recovered to the level we have targeted due to the cloud bookings and upgrades. Our sales funnel for cloud and licenses is up around 5% from last year at this time with all of the increase coming from the cloud and cloud still accounts for most of the larger deals. We added 14 new cloud sites in the quarter versus nine a year ago and many of these deals have the potential for much larger rollouts over time. Our divisional products also continued to perform well as they have transitioned their business to the cloud. Maintenance revenue was flat in constant currency, despite the effect of cloud conversions and a lower level of license deals. Renewal rates are consistent with past experience, however conversions from on premise to the cloud and the shift of our business as a whole from a licensed vendor to a closed cloud vendor, are putting more pressure on this revenue line going forward. On a regional basis for the quarter, revenue is consistent with past experience. Automotive was our strongest performing vertical overall, as it has been for some time. However, life sciences is still the top vertical for cloud bookings so far this year. Full-time employment employee headcount at 1,720 was up around 5% from last year although personnel expense was flat. The increase was mainly in cloud operations, development and services. Now I'll turn the call over to Pam for a closer look at our cloud activity.

[Pam Lopker:]

Thanks, Karl, good afternoon. As Karl mentioned, we had another good cloud quarter. We had 14 new cloud customers, eight of which were conversions. So a little bit more than our historical 50/50, but overall we're still at that range. All verticals and all regions contributed to the bookings this quarter with Europe region in automotive, followed by life science verticals being the strongest. For a bit of color, we have seen more requirements for complete end-to-end products. Not only complete functionality for our vertical markets, but also for capability reaching outside the enterprise and outside any ERP system. To that end, I would like to highlight a couple wins this quarter. This quarter we received our largest ever cloud EDI contract from a very large global automotive company. As part of our overall cloud offering, we're continuing to see substantial interest in revenue with our cloud EDI offerings. With this offering we provide both partner translation mapping and the data communication services. We support both customer and supplier transactions, as well as banking, financial transactions. Along the same lines, we saw we received this quarter a nice sized order for our Precision division transportation management products from a global company providing material handling and industrial equipment in over 150 countries. Precision provides a full suite for international transportation, trade capabilities, including transportation management, global trade management, trade compliance and package exception handling. I'd also like to mention a bit about our R& D development. This September, we launched our Actionable Insights to early adopters in the cloud. With this product we created the capabilities to have analytics embedded in the ERP database that is updated as the transaction happens. Which eliminates the need to periodically move data over to a standalone database which is never quite up to date. This capability allows analytics to be actionable, allowing the user to drill down right from the KPI to the transaction that created the KPI and provides the ability to modify and create transactions using the full ERP capability and then to see the updated KPI in real time. With our Actionable Insights we include prebuilt action centers by role populated with a broad selection of KPIs. We're already seeing tremendous interest in Actionable Insights and we expect over time it will drive new QAD users, primarily in the executive and management roles that have not traditionally logged on to ERP systems. Really great, great new product there and tremendous interest from our customer base. Back to you, Karl.

[Karl Lopker:]

Thanks, Pam. On the economic side we're still seeing an improved environment. The Brexit issue doesn't seem to have as big an effect on the overall manufacturing economy as we feared and Europe continues to recover, while the U.S. remains in growth mode. We're also watching closely for any effect on the manufacturing economy due to the change in administration in the United States. We believe the biggest unknown effect will be on our global automotive customers, due to the threat of a tariff war which would affect their global supply chains. On the other hand, we've seen a positive effect on our customers who stand to benefit from the national infrastructure rebuilding projects being considered. In any case, we expect to continue to keep up the pace in cloud due to the increased interest in our cloud offerings, both for ERP, as well as our divisional products. As usual, now we will take questions. Operator? Can you give the instructions?

[Operator:]

[Operator Instructions]. Our first question will come from Bhavan Suri with William Blair. Please go ahead.

[Bhavan Suri:]

Congrats, nice job there, especially on the cloud business. And I apologize for the background noise. Just to start off here, as you look at the cloud business, you are seeing some great traction. You sort of talked about the deal size in the pipelines for cloud being the bigger ones. That's been a little bit of change, you typically see the deal size in the cloud being the small ones? Help me understand what's driving that? And you typically said license deals are bigger, the cloud a size smaller -- help me understand how that is playing out and what's driving the change, that’d be great to start off with?

[Karl Lopker:]

Sure, we have both big deals and little deals. So the smaller deals are coming from life sciences customers that are usually coming out of development and starting to market their products. The bigger deals we're talking about are generally coming from the automotive supplier market that happens on a global basis. So we have the two mix of type of deals basically.

[Pam Lopker:]

We've also gotten some very large life science companies, as well, two medical device companies.

[Karl Lopker:]

Right.

[Pam Lopker:]

So it's a good mix.

[Karl Lopker:]

Some of the medical devices are in the $400 million to $500 million range -- maybe a bit larger. But the automotive companies are definitely in the billions.

[Bhavan Suri:]

Pam, you touched a little bit on the new offering and exposing it to your new set of users. Just help us understand a little more, how does that affect the TAMs? If I was to look at the ASP, I look at the net new set of users you talk to, what does that look like from an actual dollar-based opportunity perspective? Any sense would be great?

[Pam Lopker:]

This is all really early, but what we're seeing typically in our customers, we don't have the CEO, CFO a lot of the executive management as users of the ERP. And we've been now taking this opportunity to go out and visit, particularly the CFO, and seeing tremendous interest. So we think we can pick up another set of users. Typically our customers are typically in the 20% of the employees are ERPs, so maybe we'll pick up another 10%. That is hard to say at this point, but what we're very excited about is now getting the eyes of the C-level on our product and of course it better be great.

[Bhavan Suri:]

Just to clarify, before I jump to the next question, you're saying 10%? Not 10% of the 20% which would be 2%, but another 10% incremental employees within the organization that could potentially look at the QAD offering?

[Pam Lopker:]

No, I was actually thinking 10% of the 20%, but it's really early. It’s early days, but just thinking that management of our companies are typically only 10% of the whole population.

[Bhavan Suri:]

2% incremental in terms of users, that's helpful. Thank you. You talked a little bit about Channel Islands. I love to see or hear a little bit more color about what's gaining traction in the Channel Islands? You obviously had some of these sales portion of that available, perhaps some of the finance portions of Channel Islands available. What portions are gaining traction and what you plan to roll out in say the next six to 12 months?

[Pam Lopker:]

Our whole focus has been on the parts of the product that are externally facing and can also benefit from mobile and remote usage. So what we're releasing, what we started releasing in the September time -- not September time, in the March timeframe was the purchasing side. All purchase requisitions, mobile requisition approvals, we released this September, every single report and every single -- what we call browsers, so screen-based inquiries have been released both on the desktop and mobile because basically the same programs work in both environments. So they change their format a bit depending on the size of the device you are using. So the next step we're working on is the field service area, so that's another area that we would like to see in mobile and in the field so we will start seeing more purchasing. We did requisitions now we're doing the purchase order type areas and we'll see more generic approvals for everything as well as the service area are our next steps forward. And then the last area to work on is actually the manufacturing and finance, because those are what we consider back room type functions.

[Bhavan Suri:]

And then one last one maybe for Daniel or Kara, the cloud business feels like it has done a little better, at least than our expectations on the sell side. Obviously you've got your internal expectations, but are there any other investments that need to be made to support the growth there consistently at this 35% to 40%? Or do you think the investments you've made are good enough for the gross margin profile for the cloud business? How should we think about that for the next 12 to 24 months? That would be helpful.

[Daniel Lender:]

We're looking, as I mentioned, Bhavan, we haven't quite made improvements this year that we had originally thought. And we've had to invest a bit heavier in that area in order to support growth. So going forward, for next year I would hope that we would start getting some of the improvements that we've seen in the past in the overall percentage. But likely that it’s not going to go the other way. Likely we should be able to at least maintain, but we will definitely target to improve on those numbers going forward.

[Operator:]

Our next question will come from Richard Davis with Canaccord. Please go ahead.

[Richard Davis:]

I'm going to ask about sales and sales motion and stuff like that. Could you remind me to what extent you have your salespeople specialized by industry so they can stay focused on their spaces and things like that? And the second question is, is there, to reverse it, because people always ask who you are competing against, is there a percentage of deals that you have that have either very little or no competitive bake-off? Because you have a bit of an upgrade cycle here and I'm just trying to kind of get a sense of how big of a gap competitively you have versus the folks that you compete with?

[Karl Lopker:]

Well, in the specialized sales area, yes, we try to specialize our salespeople wherever possible. We have about 70 of them and they are spread all over the world though. Many in different countries. So outside the U.S. they are not as specialized, except maybe in Europe as they might be in the United States; although it's more important to specialize our pre-salespeople. So they really have to get down with the customer's problems and show them how they can be solved so we really are concentrating on the pre-salespeople. As far of the competition is concerned, some of -- when we're selling to our current customers, we don't have much competition. We have to prove to them that we're going to be around a long time and we have been developing product. And that can keep them happy. Although I do know that we have gone into ERP selections with some of our current customers as they choose whether or not to do an upgrade. A lot of our deals are coming, oddly enough, from SAP rollouts that have stalled or failed and people are coming back to us now because they are not seeing the SAP rolling out for years, four or five years, and they want to upgrade QAD. Of course we want to capture them and have them never upgrade. We do have many customers or some customers with an SAP strategy but they keep their QAD divisions running on QAD which of course we like to see, because it does buy us some time to get into the rest of the corporation when they're doing M&A which is a big driver for us also.

[Pam Lopker:]

Also, in the cloud we're always competing against on premise. So when we're doing a cloud conversion, it's always the decision whether -- it's typically with an upgrade. The decision to keep on premise and upgrade or to go to the cloud and upgrade. So there's always that competition of the internal IT organization. But any net new deal or even some upgrades for competing against somebody, whether its the SAP that is typical in the global automotive areas or different people, different spot people from time to time in other areas.

[Richard Davis:]

Well it probably wouldn't be politically correct for you to say it, but I will bet you SAP continues to be a net donator of customers to people like yourself, but we will see.

[Pam Lopker:]

We hope so. At least this year they have been.

[Operator:]

Our next question will come from Mark Schappel with Benchmark. Please go ahead.

[Mark Schappel:]

Daniel, starting with you, I know you haven't provided guidance for FY '18 yet, but is there any reason why your subscription business would not continue to growing in the 30% to 40% range?

[Daniel Lender:]

No. We expect that 34% growth over in the lower term market. And I did mention that in my guidance comments.

[Mark Schappel:]

And then, Karl, in your prepared remarks, you mentioned that your cloud bookings were off to a good start due to the election? I know it's still early here, but have you seen a change in your business since the election?

[Karl Lopker:]

I think we have. I think it's just knowing that there is a decision made by the American public has actually loosened up some of the deals that were waiting to see what was going to happen. I'm not sure that having the election go one way or the other was what did it, but I think just having the reality of knowing was good. So no -- things have gone well since the election, actually and that's only been about, what, 15 days.

[Pam Lopker:]

Some of the bellwether industrial stocks like Caterpillar have done really well too. So I think, was that the election, were they just starting to do well, why are people like that buying now, but then we were off to a great start this quarter.

[Karl Lopker:]

The infrastructure stocks have done really well, so that helps the mindset in our buyers. Some of the oil related stocks which was really hurting us for a couple years now, people who make pumps or pipes, those things that support the oil well business weren't feeling so good. Now they may be feeling a bit better, so we're circling back with them.

[Operator:]

Our next question will come from Michael Morosi with Avondale Partners. Please go ahead.

[Michael Morosi:]

I guess maybe for Daniel, as we look into 2018, what are your expectations around OpEx growth? Headcount was up 5%, total OpEx was somewhat less than that. What should we expect as we look into 2018?

[Daniel Lender:]

We haven't given guidance yet in terms of FY '18. Generally speaking, we've been pretty steady on those areas and they go up or down with revenue. We're being a very technology focused Company, R&D is clearly an area we always like to invest more in. But at this point in time it's a little early to get into any more detail there.

[Michael Morosi:]

That's fair. And then maybe for Pam or Karl, whoever would like to take it. You provided directional guidance around how backlog has evolved, I wonder if you can give any more quantitative indications in terms of, relative to revenue or new customers that you're talking to? Or anything else incremental you can say with respect to how the order book is shaping up as we move into 2018?

[Karl Lopker:]

Are talking mainly about the services side? Or the license and cloud side?

[Michael Morosi:]

More on the cloud side.

[Karl Lopker:]

Our total funnel is up around 5%, all of its coming from the cloud. That means the cloud is probably about 60% of our total funnel. What we're looking at is probably that funnel continuing to increase. I think the economic environment looks reasonably good right now, although there's a lot to see on this new Trump administration. And we could be surprised one way or the other. Although when things change, we see opportunity and we have such a global footprint right now that we can take advantage of opportunity wherever it pops up if we're sharp and smart and on top of it.

[Pam Lopker:]

I think as Daniel said, we still project that we can do 30% to 40% growth next year and our funnel supports that going into next year. So it does look really promising, that as you start getting -- we already had a $50 million plus run rate, so as you start seeing those numbers get so big, it obviously gets a little bit scary. And at some point the growth is going to have to slow down a bit, but it looks good for now.

[Operator:]

Thank you. I will turn the conference back over to the presenters -- actually next question will come from Jeff Captain with Stifel. Please go ahead.

[Jeff Captain:]

Hi, guys thanks for taking the question, just a quick one for Daniel. On EPS guidance, you guys beat your guidance for this quarter but lowered the full-year guide. So just curious if you could give a little more color on this that is tied to the higher sales commissions related to the cloud or your ongoing buildouts in your cloud infrastructure where the higher tax rate that you mentioned?

[Daniel Lender:]

Yes, as I talked earlier, it really -- when we look at our sales funnel going now in Q4, it's increased, it even has a more pronounced shift from licenses towards cloud so there's also that. The revenue should be less or less of a chance of going high there and the greater the shift towards cloud, we get quite a bit more expense in the OpEx line around sales commissions and bonuses. On top of that, as you mentioned, we do have a higher tax rate given the lower net income in total. So I think all those three factors are what is driving that shift.

[Operator:]

Thank you. At this time will turn the conference back over to Mr. Lopker for any closing comments.

[Karl Lopker:]

Okay, well thanks everyone for your attendance and questions and we'll update you again in March, with our fourth quarter results which will be great. Goodbye and thanks for now.

[Operator:]

[Operator Instructions]. That does conclude your conference call for today. We thank you for your participation and using AT&T Executive Teleconference. You may now disconnect.