ServiceSource International, Inc.
Q2 2018 Earnings Call Transcript

Published: 7 Aug 2018

[Operator:]

Good day, ladies and gentlemen and thank you standing by. Welcome to the ServiceSource Second Quarter 2018 Earnings Call. [Operator Instructions] We will have a question-and-answer session later and the instructions will be given at that time. And as a remainder, this conference is being recorded. Now it’s my pleasure to turn the call to your host, Chad Lyne with Investor Relations.

[Chad Lyne:]

Thank you, Carman and thank you everyone 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 discussed. 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 this call, we’ll 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 the 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. And with that, I’ll turn the call over to Chris Carrington, ServiceSource’s CEO.

[Chris Carrington:]

Thank you, Chad, and good afternoon everyone. I appreciate you taking the time to join us for ServiceSource’s second quarter 2018 earnings call. On the call with me is Bob Pinkerton, our Chief Financial Officer. ServiceSource had another strong quarter making it the third consecutive quarter in which we exceeded our revenue and EBITDA guidance. Before we jump into the details, I want to share some brief commentary on the state of the business and the progress we're making to position ServiceSource as the go-to-solutions partner to find, convert, grow and retain B2B revenue from our key global brands. Through the first half of 2018, the company's growth exceeded the expectations we laid out for you at the beginning of the year. Our strategic transformation to address and serve the full B2B customer journey with an integrated suite of solutions is gaining steam, which will allow us to capture a large and growing market opportunity. In conversations with clients and prospects alike, we are getting validation that are value proposition and capabilities are addressing a fundamental need as companies are struggling to adapt to new and different customer requirements in a digital and cloud era. After several years of putting the pieces in place to drive consistent execution and sustainable shareholder value creation, we are gratified by our growing momentum and we’ll continue to prudently reinvest revenue and EBITDA outperformance back into growth initiatives. I'm also pleased to share that we delivered on our commitment to fully pay off our $150 million convert at maturity with no dilution to shareholders with $30 million plus of cash on the balance sheet, a new $40 million line of credit and our expectation to be cash flow positive for the year, ServiceSource is now debt free with an excellent liquidity profile. With that as a backdrop, let’s shift to today’s agenda. First I will provide a high level review of the solid financial performance we achieved in Q2, where we delivered another quarter with top and bottom line results that beat expectations. I will then share an update on our execution against the five strategic priorities for 2018, which we believe are key levers for a sustained shareholder value creation over the long-term. Bob will then give a detailed review of our second quarter financial results and our outlook for the third quarter, which positions us well to deliver on our full year commitment. During Q2, we executed well throughout the business to generate positive results and outcomes for our clients, which translated into continued strong top line momentum for ServiceSource. Total revenue came in at $61.1 million beating our guidance. On a year-over-year basis, the 4.9% growth rate in Q2 was an acceleration from the 3.3% year-over-year growth rate in Q1. On the bottom line, we generated non-GAAP adjusted EBITDA of $3.2 million or 5.3% of revenue, both of which exceeded guidance despite the investments we discussed last quarter. As expected, the ramping of new logo wins and some program expansions from prior periods began contributing to our upward revenue trajectory, large new programs often ramp with materially lower initial contribution margins when compared to our more tenured accounts. This dynamic was factored into our margin guidance for the second quarter, but our teams did a great job offsetting some of the expected new program margin inefficiencies by driving enhanced profitability across the existing installed base of clients, allowing our consolidated margin to exceed the initial adjusted EBITDA expectations we provided. Now let me share an update of the status of our five strategic priorities and how our team is performing against them. As a reminder, these priorities are, one, grow both the number of new logos and total sales transaction value by 20% plus. Two, build market leadership and inside sales and customer success solutions. Three, optimize our onshore and offshore delivery mix. Four, prove client value and centricity through multi-year contracts. And five, generate profitable growth which is really an output of executing well on priorities one through four. Across the Board, I'm pleased to report that we are pacing well on these initiatives and gaining traction on multiple fronts. And priority number one, we closed 19 sales transactions in Q2 comprising 16 expansions and 3 new logo wins. Considering the global nature and complexity of many of the opportunities in our pipeline sales performance is rarely linear quarter to quarter. Our teams continue to do a good job winning the right kinds of clients that have the right attributes we are seeking around size, growth, opportunity, margin profile and lifetime value potential. When combined with the tremendous Q1 the first half of 2018 represents a record H1 for the sales team in terms of value closed. With eight great new logos through June and a healthy pipeline of late-stage opportunities in front us we remain confident in our ability to grow the number of new logos and total sales transaction value by 20% plus for the full year. On priority number two, we continue to see traction and momentum for our inside sales and customer success solutions in the marketplace. In fact, over half of our business we closed in Q2 came from these solutions exclusively, including the three new logos and many of our larger expansions. While we have a lot more opportunity for these solutions that we can penetrate in our installed base, I am pleased to see the progress we're making cross-selling these capabilities to our existing clients. As recently as two years ago, the vast majority of our clients were single-threaded with a sole offering of revenue retention and renewals. Today, many of our largest clients have added one or both of our newer solutions to the mix, and our teams are rapidly proving the value of our holistic approach to find, convert, grow and retain more revenue for our clients throughout the entire customer journey. On priority number three, we've shared with your plan to accelerate growth in our lower cost labor markets, namely Manila, Sofia, Kuala Lumpur and Okinawa. On a year-over-year basis for Q2, we grew our employee base in these locations by nearly 50%. We remain on pace to reach our year-end goal of more than 2,000 employees in these sites through a mix of new business wins and load balancing existing work. As you would expect in the near-term, these moves are somewhat margin dilutive given the cost of ramps and overlapping onshore and offshore resources during the interim transition. As we move past the burn-in period, however, these strategic shifts will unable longer term margin accretion, given the different unit economic profiles, while also increasing our flexibility when serving global clients. On priority number four, our client centricity focus continues to pay dividends. The data we manage and the outcomes we deliver on behalf of our clients are inherently complex, but through a variety of internal initiatives, we've become a much simpler and better company to do business with. Our clients are telling us to support and satisfaction surveys and where our Net Promoter Scores have shown marked improvement and by awarding us a greater share of wallet. On this latter point, we grew revenue year-over-year with 8 of our top 10 clients in Q2 with over 60% of our consolidated revenue is now covered under multi-year agreements proving our value is a long-term strategic partner that the world's most recognizable technology brand are proud to aligned with. On the final priority of our profitable growth our results year-to-date inclusive of the race to our full year revenue guidance last quarter highlight a good progression. Revenue for the first half of 2018 was up 4.1% year-over-year while adjusted EBITDA margin in H1 was 4% of revenue or 70 basis points improvement from a year ago period. It is worth noting that this modest margin expansion occurred despite growth investments back into the business. The investments we have already made in our newer solutions, process improvements and operational efficiencies are bearing fruit, as evidenced by our better than expected top line performance and enhanced competitive offering. Our data shows the total addressable market opportunity for integrated solutions suite is enormous and we are still in a very early innings with only a fraction of this TAM currently penetrated. As we continue to make targeted growth investments in the business, our ability to execute against this opportunity set and capture the TAM is increasing. We will continue our strategy and philosophical approach of prudently reinvesting back into the business to drive greater future growth, scale and shareholder value. In summary, I'm pleased with how we have turned the corner from last year. The momentum we are gaining and the way our teams around the world are working in unison to deliver against our current and long-term strategic priorities. Before I turn the call over to Bob, I would also like to take a moment to welcome a new executive to our leadership team. As you saw from our announcement last week, we are thrilled to have attracted Denzil Samuels to join ServiceSource in the role of Chief Marketing and Growth Officer, where he will lead key go to market and growth acceleration activities including worldwide alliances, strategic partnerships, global marketing, branding and communications. Denzil has an incredibly successful career as a Senior Executive and transformational leader at companies like HPE, GE Digital and Salesforce.com. His knowledge of the technology ecosystem, challenges and opportunities is second to none. Companies large and small alike are reshaping their B2B go to market strategies and tactics to thrive in a world of digital disruption, cloud delivery models and subscription and consumption based economics. In this era of change, where companies are increasingly outsourcing their inside sales, customer success, revenue retention functions, Denzil will play a key role ensuring ServiceSource is squarely positioned to own the market. With that, let me turn the call over to Bob Pinkerton our Chief Financial Officer. Bob?

[Bob Pinkerton:]

Thank you, Chris. Today I will share more detail on our Q2, 2018 financial results and provider our outlook for the third quarter and full year 2018. Echoing Chris's comments, we delivered another solid quarter with favorable achievements throughout the business. We were again able to outperform relative to expectations in Q2 and accelerate year-over-year revenue growth from Q1 levels. Our second quarter revenue came in at $61.1 million, a 4.9% from the prior year and beating the midpoint of our guidance range by $1.6 million. We're also pleased with how our results were well-balanced across the client portfolio. We had meaningful revenue contribution from previous new logo wins and expansions that are now live and in various stages of ramping as well as year-over-year revenue progression across a substantial portion of our installed base. Moving on to margins. In Q2 non-GAAP gross margin was 35.6%, an increase of nearly 170 basis points compared to the first quarter of 2018 as we saw some good efficiency gains in our installed base quarter-over-quarter. When compared to the year ago period, as expected gross margins decreased for the quarter due to the J-curve impact of new business ramps and a higher mix of ramping versus tenured accounts in the portfolio. Non-GAAP operating expenses were $20.4 million in the second quarter, up marginally by $200,000 on a sequential basis. At 33.4% of revenue, OpEx was fueled by nearly 110 basis points compared to Q1. Importantly on a year-over-year basis, we held the operating expense flat as a percentage of revenue despite the growth investments we are making, both fixed and variable to support new global program launches and to fuel strategic high ROI initiatives that underpin our target model growth objectives. Moving further down the P&L, we generated adjusted EBITDA of $3.2 million for the second quarter or 5.3% of revenue and above the guidance we provided. And even with the investments we're making you can see the operating leverage in our model where we had $0.67 of every incremental revenue dollar above Q1 flow through to adjusted EBITDA. Our non-GAAP net income in the second quarter was $790,000 or $0.01 on a per share basis compared to $1.5 million or $0.02 per share a year ago. Now turning to a brief review of the balance sheet and cash flow metrics. DSOs were 74 days, a record low for ServiceSource and down 7 days year-over-year. Cash flow generated by operations was $1.8 million, CapEx was $3.8 million, which included $2.8 million in capitalized development resulting in negative free cash flow of $2 million after adjusting for foreign exchange. We ended the quarter with $184.3 million of cash equivalents and investments, down $900,000 from Q1. Subsequent to the quarter end, as Chris mentioned in his opening remarks, we are pleased to report that we paid off our $150 million convertible note at maturity on August 1st. Pro forma for the payoff, at quarter end we had an excess of $30 million of cash and equivalents on the balance sheet which is more than sufficient to support our liquidity needs and growth objectives. To enhance our liquidity and provide additional flexibility, in July we also entered into a $40 million revolving credit facility with attractive terms. With a strong Q1 and Q2 in the books, let me now share our outlook for Q3 and full year 2018. On a full year, given the strength of our first half performance, we are reaffirming the recently raised revenue guidance of $246 million to $249 million provided last quarter. We're also reaffirming full year guidance for the other metrics we shared at the beginning of the year, including gross margins between 36.5% and 37.5%, operating expenses between 32% and 32.5%, EBITDA between $19 million and $22 million, non-GAAP net income between $8 million and $10 million or $0.09 to $0.11 on a per share basis, CapEx between $14 million and $17 million and free cash flow between breakeven and positive $3 million. For Q3, we expect revenue in the range of $60 million to $61 million, which takes into consideration the Q2 to Q3 quarterly seasonality we typically experience. We expect adjusted EBITDA between $3.5 million and $4.5 million and net income between $1 million and $2 million or $0.01 to $0.02 on a per share basis. We assume that basic share count of 91 million shares and a normalized tax rate of 26.5%. Recall from last quarter, we shared our intent to reinvest revenue upside back into the business. While our Q3 adjusted EBITDA guide points to higher margin sequentially compared to Q2, you will see these growth oriented investments are continuing in the third quarter in both the cost of revenue and OpEx lines as we recruit and train new talent, ramp new programs, judiciously expand our sales and marketing efforts and advance our prison technology platform, which is proving to be a key differentiator for us. With the growth returns we've seen year-to-date, we continue to feel good about these targeted investments and the ROIC they will drive in the latter part of this year and into 2019. Despite an increased budget for 2018 growth investments, we're taking a measured and methodical approach to layering these in and are still reaffirming our annual EBITDA guidance as stated earlier. Wrapping up from what Chris and I see, the company continues to get healthier and stronger. We are pleased with the progress we're making on various fronts as we execute systematically against our long-term plan. We would like to thank our employees around the globe for their focus and efforts, our clients for their alignment and partnership with us and our shareholders for their ongoing support as we invest in and build the business. With that, we’ll open it up to questions.

[Operator:]

[Operator Instructions] Our first question comes from Pat Walravens with JMP Securities.

[Pat Walravens:]

Chris, could we start out just sort of at a high level - could we just start out sort of at a high level with - I mean so you guys clearly still pretty good about Q2, but if you look at your transactions year-over-year - I mean last year you did four new and 19. So a little worse, I would say how do we think about that?

[Chris Carrington:]

Good, great question Pat. I don't think the number of transactions necessarily reflects the success of the quarter. In fact as I alluded to in my opening comments there for H1, 2018 it was our best first half of the year in sales ever. So, between Q1, and Q2 aside from the number of transactions, clearly the transactions were bigger individually than they had been in the past. So, sales feels pretty darn strong for the first half of the year.

[Pat Walravens:]

I just - that's fine, but so I mean were they bigger in Q2 or - I mean look it happens or was Q2 a little light versus your expectations?

[Chris Carrington:]

No. I think Q2 is right on track, Q1 was actually bigger than expectation, but I think we have to really look at both the number of transactions the eight new logos we did that we're still on track to hit our 20% plus growth in both the number of new logos, as well as a dollar sold for the full year.

[Pat Walravens:]

And so, where are we now on the sort of inside sales business in terms of how much of the overall business does it represent, I mean ballpark size?

[Chris Carrington:]

As we stated at the beginning of the year, our high growth solutions, which is really inside sales and the customer success was about 10% and we committed to a 50% growth rate for the year and we’re definitely right on track for that. In fact, in the second quarter, more than 50% of our total sales dollars of new deals we sold or expansions were in those high growth solutions of inside sales and customer success. So, it’s come along really good. And so, we’re on track to achieve our ultimate goal of having revenue from inside sales and customer success exceed 15% of the total revenues of the company this year.

[Pat Walravens:]

And then, Bob, two questions for you. So, when I look at the EBITDA guidance for Q3, I mean, even if you credit the beatings in Q2, it’s still lower than I’d model. Is there something besides investments that, that is pressuring an EBITDA number?

[Bob Pinkerton:]

No. I think the key things about Q3 is to again remember that it tends to be the softer quarter during the year and what we’re doing this year is as part of our investing to keep growing the top line of the business, we’re investing in new accounts, ramping new business, ramping inside sales and customer success initiatives, in technology, in our PRISM investments, in BI, in the platforms, as well as sales and marketing and we're reaffirming our full year from an EBITDA perspective in the 19% to 22%, so that’s - we feel good about where we are and the investments we're making.

[Pat Walravens:]

And then last one for me, just sort of optically on the EPS, so we have $0.09 to $0.11 for the year and Q1 was minus one, correct me if I'm wrong, Q1 was minus 1, Q2 is the penny and Q3 is high end your guiding $0.02 so I mean Q4 is like $0.07 to $0.09 which is a little hard to believe, is that really what's going to happen?

[Bob Pinkerton:]

Well, we were $0.06 last year same quarter so and again Q4 tends to be our big quarter. This is a year where we're growing year-over-year and we look at the leverage of the investments that we're making in the business and productivity, and how people are performing and our ability to get a higher return per person here we still feel good about our ability to meet all of the guidance that we set for the full year including EPS.

[Pat Walravens:]

And actually starting, there is one more. Hey Chris, what is the science of selling, and how that has to do with you guys?

[Chris Carrington:]

Yes, as I've talked to you before, Pat, I started my career 30 plus years ago in sales and even certainly back then and has been for a long time sales has been really more of an art form than science. And what we're really trying to do here at ServiceSource especially on an inside sales perspective is turn that art form into science and we're doing that by investing in our PRISM platform such that we can create predictive analytics and propensity miles to buy and propensity miles to churn by being able to demonstrate that to both our clients and our prospects we're able to share with them and show them the higher value we can bring to the table by generating more sales. And literally just a year or two ago, it was just pure brute human force, great selling people and we’ve great people. But now we’re bringing the tools to bear that help them sell smarter.

[Operator:]

Our next question comes from Zach Cummings with B. Riley FBR.

[Zach Cummins:]

So if I heard correctly, were - all three of your new logo wins, were those driven by inside sales?

[Chris Carrington:]

Combination of a inside sales and customer success. But yeah we’re seeing that really being the foundation of our sales going forward as a over 50% of our total sales including both new logos and expansions, we’re represented by inside sales and customer success.

[Zach Cummins:]

Great. And was there an outstanding RFP for any of those engagements?

[Chris Carrington:]

I'm trying to think I don't, for this quarter in particular no, previous quarter yes. And we have definitely working on RFPs in this quarter. As we've talked about before Zach and kind of my 3.5 years here I'm not sure I ever saw an RFP for revenue retention and now we're definitely feeling pull into the market as we're seeing RFPs on you know each and every quarter. But I don't recall a specific RFP in Q2 or at least related to the new logos that was inside sales related, I’ll double check on the expansions.

[Zach Cummins:]

That's really helpful. And now that you've beat your revenue guidance for two quarters in a row, I was just curious, is there -- kind of what are some of the things that you are seeing in the second half of the year that are preventing you from once again raising your full year outlook for the revenue line?

[Chris Carrington:]

Well it is a previous year, we feel like we've beaten three quarters in a row. We actually beat Q4 of last year, started that track record again so into Q1 and Q2. But as we look forward in the second half of the year, we feel really good about you know two beats in a row. We did raise our revenue back after the first quarter. We felt it was the prudent thing to do as we looked into Q3 to just hold our revenue guide for the full-year. But we just see accelerating growth on the inside sales and customer success will be a big contributor into Q4 and into 2019.

[Zach Cummins:]

No, that's really helpful. And now that you have that $40 million credit facility in place, it sounds like you haven't drawn down on that yet. But if you were to draw down on the proceeds from that, what would be kind of your top priorities for putting that cash to use?

[Bob Pinkerton:]

Yes, so Zach this is Bob, thanks. You know listen, we - I think we said in my prepared remarks you know with the closing of the line - with the closing of the pay off the convert, we have more than enough cash to run the business you know as we stand without the line of credit. We were able to access the line of credit from a credit bank on really favorable terms, made sense to do that, you know, right now I think we kind of view it as a backstop. We're not you know looking at using that for any other kind of more corporate finance strategic reasons, so in the near-term we've got lots of opportunity in front of us, long runway in front of us. And you know our key priority is to you know execute on the back half of this year and position us for big growth going on.

[Chris Carrington:]

Well I would just add Bob, to point out again that as we forecast you know breakeven to positive $3 million cash flow we should be in a position where we start accreting to that, cash that's already on the balance sheet. So again I don’t see it happening in the line of credit in anytime soon.

[Operator:]

And our next question is from Tim Klasell with Northland Securities.

[Tim Klasell:]

First question has to do with the customers in your pipeline, you mentioned that the J curve you have with your new projects. If you look at what's in your pipeline, are you seeing a J curve that I don’t know will be deeper or shallower or what should we expect going forward as you do sign new logos? Thank you.

[Chris Carrington:]

I'll take a swing and Bob you can follow-up. First of all really excited Tim about our pipeline. We've got more early stage conversations we would call them Stage 1, but there are conversations that are started by our inside are our only inside sales group are BTRs than we've ever had in history of me being here three and a half years. So, as Bob alluded to earlier we continue to make investments in sales and marketing because with this complete end-to-end solution set now of inside sales customer success and revenue retention we see more opportunity out there than ever. As it relates to selling the new deals and winning those new deals, we continue to learn lessons I mean it's still early days and sale that's those solutions. We think there's increasing ways that we will hopefully, probably in 2019 be able to further mitigate some of the J curves, it’ll never go completely away. But we're getting smarter about this each and every day. And the good news is we factored all of the J curve for our current deals in the pipeline and we’ll close this year in our current year - full year forecast, so we've got that covered.

[Tim Klasell:]

And then on the seasonality side of things, is this something we should be modeling going forward, I mean obviously your customers have typically have backend waited years, obviously that flows through to you. Is there anything changing in the business or on contracts or maybe it won't be so backend waited for you or the way you've structured the contracts or is it just something that we should expect going forward? Thanks.

[Bob Pinkerton:]

This is Bob. As we think about the business, this going forward, we don't see any radical changes in the seasonality we see. Q4 as being the big quarter, we don't see that changing that's the way it is with most of our largest accounts and we see Q3 being relatively a soft quarter. And again, it will depend on certain things that are happening in terms of opportunities we have et cetera. I would do so suspect that as we increase the amount of business that we do in inside sales related, that should allow us to fill in some of the parts of the quarters inside the quarters, months, even in quarters that are softer, so we could potentially see some reduction in the seasonality, but on near-term basis that would not change your assumptions radically.

[Tim Klasell:]

And then one final question of the quarter I guess. FX, obviously that's mostly on your expense lines. What was the effect there?

[Bob Pinkerton:]

So from an FX perspective, the impact to EBITDA was less than $0.5 million. Just to summarize for everyone, a weakening U.S. dollar tends to increase my non-U.S. revenue and expense and is strengthening the USD tends to reduce my non-USD revenue expense, so that's kind of how it impacts us. We use natural hedges, no derivatives and is key know that our guidance reflects our view where currencies are going forward and we continue and that’s being a major impact into our financials.

[Operator:]

Thank you. And I'm not showing any further questions in the queue. I would like to turn the call to Chris Carrington for final remarks.

[Chris Carrington:]

Carman, thank you and thanks to all of our listeners today and participants. I'd just like to close the quarter with a couple of comments that feel really good about. I’ve been here 3.5 years and I think day one the question was, are you going to be able to pay off your convert. That was the question 3.5 years ago. Pleased to say that we always said we would be able to and we did without any dilution to our shareholders. And we're in a nice cash position on our balance sheet, so that's behind us now. I really thankful to our global team and our people for delivering a solid first half 4% growth year-over-year for the entire half, really sets us up nicely for the second half in our full year, and a good solid beat in Q1 and Q2. Record sales in H1 should set us up for late in the second half, as well as leading into 2019. 8 new logos to-date, so we're well on track on hitting our 18 logos for the full year. And just really excited how we are continuing to transform the business with our high growth solutions of inside sales and customer success. With that Carman, we’ll close and thanks again everyone and talk to you soon.

[Operator:]

And ladies and gentlemen, thank you for participating in today’s conference. This concludes the program and you may all disconnect. Have a wonderful day.