ServiceSource International, Inc.
Q1 2018 Earnings Call Transcript

Published: 5 May 2018

[Operator:]

Good day, everyone, and welcome to the ServiceSource First Quarter Fiscal Year 2018 Earnings Results Conference Call. This call is being recorded. Erik Bylin from Investor Relations will be opening today's call. Erik, please go ahead, sir.

[Erik Bylin:]

Thank you for joining us. Before we begin, I'd like to remind you that during the course of this webcast and call, we make projections or forward-looking statements that involve risks related to future events. We caution you that such statements are just projections and actual events and results may materially differ from what we discuss. All statements made during the course of this webcast and call reflect our views as of today and are based upon the information currently available to us. This information will likely change over time. By discussing our current perception of our market and the future performance of our company and our solutions with you today, we are not undertaking an obligation to provide future updates. All projections and forward-looking statements should be considered in conjunction with the cautionary statements in the earnings press release and the risk factors included in our SEC filings. Please refer to the documents we have filed with the SEC. These documents contain and identify important factors that could cause actual results to materially differ from those contained in our projections and forward-looking statements. During the course of of this call, we will also be discussing certain non-GAAP financial results and projections. Unless otherwise stated, financial measures discussed in today's remarks are non-GAAP and exclude restructuring charges and onetime gains from sale of an investment. For all of these non-GAAP measures, we direct your attention to a reconciliation between the GAAP and non-GAAP measures, which can be found in today's earnings release posted on the Investor Relations portion of the website. I would like to touch on the transition to the new accounting standard, ASC 606 regarding revenue recognition. As we shared last quarter, we expect the effect of the new standard to be immaterial and, as such, do not expect to restate prior results. We have provided a description of how we expect the standard will affect us in the slides that accompany the webcast, which should be considered forward-looking information subject to the above cautionary statements. And with that, I'll turn the call over to Chris Carrington, ServiceSource's CEO.

[Chris Carrington:]

Thank you, Erik, and good afternoon, everyone. I appreciate you taking the time to join us for ServiceSource's first quarter 2018 earnings call. On the call with me is Bob Pinkerton, our Chief Financial Officer. I'm proud to share that the positive momentum discussed on our fourth quarter call has continued into 2018 and, by many measures, is accelerating. In early February, I said I believe ServiceSource had reached an inflection point where the internal progress and advances we had been making for the better part of 18 months would become more evident in our financials. Our Q1 P&L results provide the first clear marker of that inflection as I'm proud to share that we returned to year-over-year revenue growth a full quarter ahead of plan. We beat all four of our guidance metrics and continued to successfully execute against the five strategic priorities for 2018 discussed in our last call. As a result of the operating and financial momentum, a strong foundation has been laid for us to raise the revenue guidance for the full year. On the topline, Q1 2018 revenue of $58.6 million was up 3.3% versus Q1 2017. This year-over-year growth occurred despite the tough 2017 comparisons that we referenced in our last call. So a real credit to our teams around the world for delivering a great outcome. Encouragingly, the upside relative to our guidance was broad based with favorable performance and executions across regions and clients. On the margin side, we expanded our non-GAAP gross margins 159 basis points and reduced OpEx $1 million year-over-year to drive a $2.5 million improvement in adjusted EBITDA from negative $900,000 last year to positive $1.6 million this year. Given the strong first quarter results, combined with robust market demand fundamentals and improved execution internally, we are raising our full year revenue guidance from a range of $243 million to $246 million to $246 million to $249 million. The Q1 outperformance will also allow us to thoughtfully reinvest some of the upside back into key strategic growth initiatives through the balance of the year. Bob will discuss the numbers in more detail, so let me switch gears to update you on the progress across the five strategic priorities I laid out on our last call. Priority number one is on the sales and marketing front with a goal to grow our new logo count and the value of our closed sales wins by least 20% compared to 2017. I am pleased to report that we are off to a great start here as our outside sales team turned in the best Q1 in the history of the company. Our messaging and value proposition are clearly resonating in the marketplace, evidenced by solid momentum on transaction count and new logo metrics that are key leading indicators for future growth. We closed 23 transactions in Q1, more than double the count from the same period last year. And we won five new logos in Q1, another company record for the first quarter. These new logos are great, new brands that we are proud to align with, and each of them are also large organizations with over $1 billion of revenue, providing ample Greenfield opportunity for us to expand with them in the future. Complementing the 5 new logos, one in the first quarter, were 18 expansions with existing clients. Several of these recent wins are large, global implementations that present meaningful revenue opportunities at scale. By way of example, we are in the process of scaling 100 new hires in seven locations around the world for one expansion. Another global expansion is with one of the five largest cloud companies in the world where ServiceSource is not only displacing the incumbent but has also been tasked with a faster on-boarding time frame. In general, the complexity and size of large client ramps creates a near-term margin impact due to the required upfront investments before any revenue is generated. As we discussed on the last call, result of these large global implementations will be a more pronounced J-curve effect on profitability. However, we expect the first half expenses tied to implementing the record Q1 business wins will be followed by expanding margins as targeted revenue run rates are achieved later this year and into 2019. Overall, the strong sales execution for the fourth quarter continued into Q1 '18, which sets the stage for accelerating growth in the second half of 2018 and into 2019. Priority number two relates to our solution mix and our commitment to own the emerging growth markets of inside sales and customer success. These high-growth solutions accounted for more than one third of our sales wins in Q1 2018, and there was particularly notable traction with companies that have cloud and subscription based business models. We are increasingly seeing these companies accelerate their investments in acquisition, expansion and retention activities, which our solutions squarely address. There are fundamental macro drivers at work here that are opening up a massive market opportunity, and ServiceSource is quickly emerging as the premier outsourced solution for leading global brands. To win in the cloud subscription area, companies are rapidly transforming their B2B go-to-market models, shifting aggressively away from field sales to inside sales, migrating from the indirect channel to the direct customer relationships and reallocating investments to scale customer success practices and teams. These shifts are opening up what we believe to be one of the last great frontiers for outsourcing, that of B2B revenue generation and retention. We estimate this market represents $260 billion of total global spend, of which approximately $2 billion or less than 1% is currently outsourced. We expect this market will advance on a similar outsourcing trajectory that many other sectors already have. Whether it's IT outsourcing, F&A outsourcing or CRM/BPO, they all reached the tipping point where 25% or more of spend has now been outsourced. We see similar parallels and catalysts with our clients and prospects, which we believe will cause the $2 billion of currently outsourced spend to grow thirtyfold over the coming years. This total addressable market expansion will provide a massive opportunity to ServiceSource to not only win new clients but to also expand within our existing clients, which includes many of the most successful companies in the world. Given the size of the opportunity that we see, the accelerating traction we are getting and the long-term potential it presents for ServiceSource, our intent is to invest more aggressively to capture the growth. Our goal will be to maintain the cost discipline we have demonstrated over the years while targeting growth-focused investments to deliver faster topline progression well into the future. We believe reinvesting revenue upside back into key growth initiatives will result in greater long-term value for ServiceSource and all of its stakeholders. Moving to priority number three, our geographic footprint and offshore/onshore load balancing. Earlier in Q1, we announced capacity expansions in Philippines and Bulgaria to address the growth we are seeing, in addition, to opening a new location in Okinawa to support the growth of our Japanese business. These expansions are proceeding well, putting us on pace to meet our year-end 2018 objectives. Our onshore teams are also benefiting from recent new business wins, and it's great to see the energy and excitement in these centers as they recruit, onboard and train top-tier talent to support our return to year-over-year growth. On the topic of talent, we will continue to focus on investing in our people. Globally, there's a broad trend of labor markets tightening. Like most global businesses, we are also seeing upward pressure on wages and competition to attract skilled, young professionals given the cities and demographics in which we operate. To date, we have demonstrated effectiveness at providing the appropriate compensation and benefits to attract and retain a world-class workforce while also driving efficiency and productivity to offset wage pressures. While ServiceSource is not immune from marginal wage pressure, we remain committed to attracting, retaining and investing in the best human capital. Priority number four is our sustained focus on client centricity and success; but more specifically, our emphasis on demonstrating long-term partnership value through multiyear contracts. I am pleased to share that in Q1, we signed another one of our largest clients to a multiyear relationships. So we now have three of our top five clients on multiyears. In the most recent example, not only we did we turn an annual contract into a two year extension worth nearly $45 million over the contract term, but we also broadened the scope of the relationship with the software client by taking full ownership for a larger segment of their customer base and adding our inside sales and customer success solutions to the mix. It's a great testament to the consistently high performance our teams are driving and the value we are creating for this client. In another great expansion example, we significantly broadened the relationship with a long-term cybersecurity client who has been with ServiceSource for over 12 years. Our team's day-to-day execution and clear client focus recently earned us the right to take on a lot more. In a Q1 multiyear expansion that will roughly double the size of our partnership, we migrated the client to our PRISM platform, moved up their customer stack to handle larger enterprise accounts, secured a much larger opportunity set and added up-sells, cross-sells and customer success health checks to a historically renewal-centric mandate. Our teams have done an amazing job ramping this expansion globally. And given the results we continue to deliver, I fully expect this to be a top five revenue client as we exit 2018. In a third expansion example for the quarter, we signed a multiyear extension and expansion with a global market leader in cloud and on-site business communications and collaboration solutions. ServiceSource has been a valuable partner to this client for six plus years, during which we had played a central role in driving high-margin software and service revenue for the company as they accelerate their migration to the cloud. This latest agreement extends our relationship with the client through 2020 and expands the opportunity under management we have with them by 40%. With these and other multiyear extensions, we are progressing well toward our goal of having more than two-thirds of our business on multiyear engagements by year-end, providing much better long-term revenue visibility and predictability than we have had in the past. Rounding out the five strategic priorities for number five, we commit to profitable growth in 2018 with an initial expectation to return to year-over-year revenue growth in Q2 of this year. As you heard in my opening comments, we are really proud of the fact that we returned to year-over-year revenue growth one full quarter earlier than expected. Across the board, we came out of the gate strong in Q1. New business ramps performed well, and we also saw year-over-year growth across the majority of our installed base clients, driven by a combination of expanded scope and new engagements as well as performance uplift on many accounts. The net result is that this year marks the first time since 2014 with Q1 year-over-year revenue growth. While we are only one quarter through 2018, the first quarter outperformance, combined with our upwardly revised revenue outlook for the year, demonstrates our conviction that the business is on the right path. This conviction is supported by strong underlying demand drivers in a large and growing market where we are best positioned to capture the opportunity. Before concluding, I want to publicly acknowledge and say thank you to Brian Delaney, our COO, who announced today that he will be retiring from ServiceSource at the end of Q2. Three years ago, I was fortunate to lure Brian out of early retirement to join ServiceSource. Throughout his career, he built a reputation as a high-impact executive, and he brought that same action and results orientation to ServiceSource. To say Brian has clearly left his mark on the company is an understatement. During his time with us, he built a global team and cultivated leaders who have fundamentally transformed the company. Under his direction, we opened and rapidly expanded our presence in the Philippines and Bulgaria to realign our cost structure and unlock additional growth opportunities. His organization rebuilt our tech stack and added new innovations that have improved the productivity of our teams while bringing operational science and business insights to our clients. The client success teams under his leadership have returned us on a path to growth and with our client-centricity initiatives resulting in higher NPS scores and expansions across the installed base. Perhaps most importantly, however, Brian has groomed the next generation of leaders at ServiceSource who will continue to build on the momentum we have established. Speaking on behalf of our board and the entire ServiceSource family, we wish Brian well in his retirement. With that, let me turn the call over to Bob, our Chief Financial Officer, who will share greater detail on our Q1 2018 results and our outlook for Q2 and full year 2018. Bob?

[Bob Pinkerton:]

Thank you, Chris. Today, I will share our Q1 2018 financial results and some color on the drivers behind those results, then provide our outlook for the second quarter along with an update to the full year. As a reminder, we have posted a presentation on the company website with the details of our guidance along with the GAAP-to-non-GAAP reconciliation of that guidance. With our Q1 results, ServiceSource successfully crossed through the inflection point that Chris spoke about in our early February call as we achieved year-over-year revenue growth one quarter earlier than anticipated. Our teams exceeded expectations by delivering revenue of $58.6 million, up 3.3% from the prior year and just over $4 million above the midpoint of our guidance. In terms of bucketing this overachievement, approximately one third was due to our teams' strong performance and execution across a wide range of accounts. We saw the first signs of this in Q4 and repeated in Q1, and we are encouraged and believe the momentum can carry forward through the year. The second third of the Q1 revenue uplift was due to a continued healthy demand environment for several of our larger clients' products and services. While this provided a positive revenue tailwind in Q1, we are taking a prudent approach. And given global macro volatility, we are not incorporating the robust demand environment experienced by our clients into our guidance for the remainder of 2018. The final contributing factor to the Q1 revenue exceeding expectations is due to tailing-off revenue as we exited the relationship with a former bankrupt client. Our teams delivered amazing results through the last day of the quarter as we wound down this relationship, providing an unforeseen onetime revenue benefit in Q1. Moving on to margins. As Chris mentioned, the first quarter was the best sales Q1 in the history of the company. The expanding number of global customer ramps and implementations requires meaningful investments in areas like recruiting, training, capacity expansion, management support and our proprietary PRISM technology platform and data capabilities. While these growth investments are expected to generate strong returns as programs and revenues scale, the upfront costs initially produced a J-curve margin. That said, in Q1, we continue to improve our operational efficiency in excess of the J-curve costs, which resulted in a non-GAAP gross margin of 33.9%, an increase of 159 basis points compared to last year. Our operating expenses came in at $20.2 million, down 4.7% year-over-year. The lower spend off of our higher revenue performance resulted in meaningful leverage as we generated adjusted EBITDA for the first quarter of $1.6 million, which was $2.1 million above the midpoint of our guidance and a $2.5 million improvement year-over-year. Our net loss in the first quarter was $550,000 or $0.01 on a per-share basis compared to a loss of $1.6 million or $0.02 per share a year ago. Now turning to a brief review of the balance sheet and cash flow metrics. DSOs in Q1 were 76 days, down from 77 days in the fourth quarter of 2017 and down 8 days year-over-year. Cash flow generated by operations was $600,000. CapEx was $3.5 million, which included $2.7 million in capitalized development, resulting in negative free cash flow of $2.8 million after adjusting for foreign exchange. We subsequently ended the quarter with $185.2 million of cash, equivalents and investments, down $3.4 million from Q4. With the strong start to the year, we remain on track to pay off the convert balance of $150 million in August while maintaining sufficient cash in the balance sheet to operate the business and invest in our most promising growth opportunities. Let me now provide our outlook for Q2 2018. We expect revenues for Q2 in the range of $58.5 million to $60.5 million. We expect adjusted EBITDA of between $1.5 million and $3 million and net income between negative $1 million and positive $1 million or negative $0.01 to positive $0.01 on a per-share basis. We assume a basic share count of 91 million shares and a normalized tax rate of 26.5%. With that, I would now like to share the update to our outlook for the full year of 2018. We have started 2018 with better topline performance than contemplated in our February guidance. As discussed earlier, the strong Q1 performance was aided by the tailing-off revenue with a former bankrupt client as well as a robust macro demand environment for our clients. Thinking about the cadence for growth for the remainder of the year, Q2 guidance implies 2.1% year-over-year revenue growth at the midpoint, and we expect growth will continue to accelerate in the back half of the year, reaching mid-single digits in Q4. In consideration of these factors, we are raising our revenue guidance range to $246 million to $249 million for the year. We are also reaffirming our annual guidance for gross margins between 36.5% and 37.5%, operating expenses between 32% and 32.5%, EBITDA between $19 million and $22 million and non-GAAP net income between $8 million and $10 million or $0.09 to $0.11 on a per-share basis. We continue to expect 2018 CapEx to be between $14 million and $17 million and reaffirm our expectation to generate full year 2018 free cash flow between breakeven and positive $3 million. With that, we'll open up to questions.

[Operator:]

[Operator Instructions] Our first question comes from the line of Zach Cummins of B. Riley. Your line is now open.

[Zach Cummins:]

So just starting off from there, it sounds like you were able to actually extend one of your top five clients to a multiyear arrangement. And it sounds like it's still one of your goals to really approach the kind of -- try to get the rest of that top 10 signed under multiyear arrangements. Can you talk about some of the progress you've made with some of the other top 10 clients and kind of where they're at in that contracting phase?

[Chris Carrington:]

Yes, absolutely. So to date, we now have six of our top 10 under multiyear contracts. And as I stated last quarter in, I believe, the open call, our goal was to get eight of the top 10 by the end of the year. So we are in discussions and negotiations with two other top 10 clients that we believe will have multiyear by the end of this year.

[Zach Cummins:]

Great. And then you also had a really strong start to the year in terms of new logo wins, five to start the year. Puts you well on track to your goals that you stated. But how are you feeling kind of about your pipeline of opportunities for the rest of the year? Did any of these deals -- did they pull forward and close earlier than you were expecting? Anything along those lines? Or do you still feel pretty good about the pipeline going forward?

[Chris Carrington:]

No, absolutely feel good about the pipeline. It's robust and it continues to grow. We're doing a better job of driving new logos into the pipeline. So our new logo pipeline is as big as it's been since I've been here. So we're excited about that. And we're also starting to see a lot of expansion opportunities with our installed base clients because of our new solutions and inside sales and customer success.

[Zach Cummins:]

Great. And then last question for me. It sounds like you want to invest a lot of this upside that you got in Q1 back into the business. Can you delve a little more into it and provide a little more color about kind of the specific areas that you want to invest in for the rest of this year?

[Bob Pinkerton:]

Sure, Zach, absolutely. This is Bob. Well, what you'll -- you're seeing in our Q2 guidance in particular is a portion -- a big portion of that investment is with several – two large ramps that we're dealing with right now, with two very, very large existing clients. And they're big opportunities for us to grow with them. We're very excited about it. So you'll see much of that in "investment" happening in the cost of revenues line as we're ramping those accounts. Additionally, you'll see investment that we're making in the sales and marketing team to continue the upward trajectory on our pipeline and our revenue growth as well as in our technology stack because that, again, continues to be a big differentiator for us.

[Operator:]

Our next question comes from the line of Pat Walravens of JMP Securities. Your line is now open.

[Pat Walravens:]

Nice to see the inflection. Chris, so you mentioned on the big cloud company that you displaced an incumbent. I didn't really realize there were incumbents. So who are you competing against out there? And who are the types of people you might be replacing?

[Chris Carrington:]

Right. So Pat, as you know with our business as it relates to revenue retention, we haven't historically had anyone of significance from a competition standpoint other than -- and I don't ever like saying we complete against our clients because we don't; we're an extension of their team. But as we've moved more and more into these high-growth solutions of inside sales and customer success, we are starting to see new competitors, no one of huge scale. In fact, probably the largest inside sales competitor might be a little over $100 million in size. But we're seeing a few of those companies, and in this case, we were able to take business right away from them. And I think as we had entered this new space and really, through our marketing efforts, promoted our capabilities here, we're starting see RFPs, which we've seen in revenue retention. We're seeing it at inside sales. And inside sales, like I said, all those smaller companies had a fair amount of work outsourced, and so we're able to go now and compete against companies and beat them out to get new clients and new revenue.

[Pat Walravens:]

Okay, that's interesting. And then I'm curious what could go wrong around the wage pressures? So why did you feel it's important to call out the wage pressure now?

[Chris Carrington:]

Yes, I think that based on a lot of the reports we read from the markets that we employ people in around the world, what we've really noted through ourselves is the declining unemployment rate. And I think out of the 10 markets or 11 markets we're in now, I believe one was as low as about 2% and the highest might have been about 6% unemployment. And if you look for tech, I'll say, capable people, it's probably even tighter than that. So I would say that as we're in this expansion phase, we're starting to see some pressure on compensation plans that we have to address. And what I'm pleased about is thus far and, we believe, for the rest of the year, we can address this through increased productivity gains and staying ahead of those wage pressures. And we're also starting to see some pricing power, where we're able to now increase prices not only on revenue retention but also with inside sales. And so we can also offset those wage pressures. But we felt it was important to at least share that with our investors, that as a company that greater than 70% of our expense is human capital, it is something we'll have to deal with in 2018.

[Pat Walravens:]

Okay, great. And then last one for me. And I know you're not going to want to be too specific because you're certainly not guiding to it yet, but how should we think about 2019?

[Bob Pinkerton:]

Yes, Pat, great question. We're excited about what's happening in 2018 right now, and we think it's setting us up well for this year. We're busy executing on this year. We're excited about what the future holds. And right now, I think that the thoughts that we've got for '19 are consistent with where everyone else's kind of view is.

[Chris Carrington:]

Yes, and I think it gives us a chance, Pat, from a revenue standpoint now that we've been able to finally beat and raise to come back to the investors in August and share a little bit greater insight into 2019.

[Operator:]

Our next question comes from the line of Tim Klasell of Northland Securities. Your line is open.

[Tim Klasell:]

Congrats on the turn as well. My question has to do with the multiyear contracts. As you're getting deeper into them and you're signing them, are you seeing any changes in the margin structure? A little bit J-curve. I don't know, it might be a little bit deeper up front with a bigger return out years. Or how should we think about the profitability of a customers as they begin to sign those multiyear contracts? Then I have one follow-up.

[Bob Pinkerton:]

Sure, Tim, yes. And I think this came up last call when we talked about the two big clients that we went to multiyear with and like the questions were do we give up a lot for that. And in actuality, we're -- we -- on those deals, we saw actually price increase on one of the accounts. And as we think about the relationship that Chris mentioned on this call, there we -- no concessions at all. It was just about us doing more for that client and growing the relationship. So we -- the margin structure is consistent with our current target market on deals.

[Timothy Klasell:]

And then sort of a follow-on to the prior question around wage pressure. As you begin to move sort of up the stack, carrying it with capabilities and your sales force, are you having to recruit to a higher skill level with your employees? How should we think about that going forward?

[Chris Carrington:]

Tim, great question. I've commented over the years that part of our expertise in our sales -- inside sales teams has really been somewhat of a process sale where we kind of start at point A and going -- we go to point C in a revenue retention play. As we move more and more into inside sales specifically, it's more of a product sale. So in that sense, we are starting to see ourselves hire engineers. As we're responsible for selling product, we hire -- add engineers to our teams so that as we're talking with clients, we can configure complex integrations of different products together. And this is one of the reasons why we do charge more for inside sales-type motions. But I do think the complexion of our workforce will continue to change in the coming year or two as we do add more technical engineers to our team.

[Operator:]

And at this time, I'd like to turn the call back over to management for any closing remarks.

[Chris Carrington:]

Latif, thank you for that. Well, we'll wrap up the call. Look, I'm very pleased. It took three years to get the point where Bob and I could join a call and give those words of beat and raise from a revenue perspective. And so we're really pleased with the first quarter. We're really excited about the rest of the year and the expansions that we're seeing with existing clients and the new logos. So we look forward to talking to all of you in coming days and weeks and the rest of the year. Thanks, everyone.

[Operator:]

Thank you, sir. And thank you, ladies and gentlemen. This concludes today's conference. You may disconnect your lines. Have a wonderful day.