ServiceSource International, Inc.
Q4 2018 Earnings Call Transcript

Published: 21 Feb 2019

[Operator:]

Good day, ladies and gentlemen, and welcome to the ServiceSource International Inc. Fourth Quarter and Full Year 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and our instructions will be given at that time. [Operator Instructions]. As a reminder, today's program maybe recorded. And now I would like to introduce you host for today's program Chad Lyne, Senior Vice President of Investor Relations. Please go ahead.

[Chad Lyne:]

Thank you, Jonathan, and good day, everyone. Thank you for joining us, and welcome to ServiceSource’s fourth quarter earnings call to discuss our results for the quarter and full year ended December 31, 2018. As a reminder, a copy of our earnings release has been posted on the Investor Relations section of our website at www.ir.servicesource.com. On the call today is ServiceSource's Chairman and Chief Executive Officer, Gary Moore; and our Executive Vice President and Chief Financial Officer, Rich Walker. Before we begin, I’d like to remind you that during the call, we will make projections or forward-looking statements that involve risks related to future events. All statements made during the call reflect our views as of today and are based upon the information currently available to us. 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, included but not limited to our reports on Form-10K and 10-Q. These documents contain and identify important factors that could cause actual results to materially differ from those contained in our projections and forward-looking statement. And we undertake no duty to revise or update any forward-looking statements. In addition, during the call, we’ll also be discussing certain non-GAAP financial measures and projections, which we believe provide additional information to enhance the understanding of how management assesses the operating performance of the business. You can find the reconciliation of the GAAP and non-GAAP measures in today’s earnings release posted on the IR portion of our website. And with that, I’ll turn the call over to Gary Moore, ServiceSource’s Chairman and CEO.

[Gary Moore:]

Thank you, Chad. Good afternoon, everyone, and thank you for joining us for the ServiceSource’s fourth quarter and full year 2018 earnings call. As many of you know, I was appointed Executive Chairman of ServiceSource in November of 2018 and subsequently assumed the role of CEO on December 4th. In addition to myself, several members of the executive team have joined ServiceSource in the past quarter or two, including Rich Walker in the Chief Financial Officer role, Debbie Dunnam in the Chief Operating Officer role and Denzil Samuels in the Chief Marketing and Growth Officer role. Since coming on board, I have been pleased with how quickly this Group of seasoned professionals has come together to lead a great team of employees worldwide. Throughout the organization I am seeing a shared purpose and urgency to collectively address the various challenges that have held the business back from its potential. At the same time, there is an embracing of new ideas and an increased bias towards action. We are focused on opportunities that can improve our execution and efficiency and enhance our client relationships and advance our financial profile to build durable shareholder value over time. Since taking the CEO role as part of my in-depth strategic review I have focused my time and efforts on three key areas

[Rich Walker:]

Thank you, Gary. I would like to echo Gary's opening comments about the comprehensive strategic review the team has undertaken over the last two months, and the progress that has already been made to move the business forward with decisive action. There are many work streams underway throughout the company as part of our PSEM strategic framework. We believe our successful execution against these work streams and the strategic pillars Gary laid out will improve the foundation upon which we can deliver greater client delight, enable further operational efficiency and ultimately improve the financial profile as we work to build value for all stakeholders. For today's call I plan to cover three things. First, I will run through our fourth quarter 2018 results. Second, I will review our full year 2018 results. And third, I will update you on our go forward guidance framework and provide commentary on the opportunities, risks and assumptions underpinning our 2019 summary outlook and long-term roadmap as we focus on building sustainable shareholder value over a multiyear horizon. First, let me hit the fourth quarter results. Revenue for the quarter was $61.5 million, up $4.3 million or 7.5% sequentially and compared to $66 million in the prior year period. By region, NALA revenue was $36.2 million or approximately 59% of our total, compared to $39.6 million in the fourth quarter last year. EMEA revenue was $16.6 million or approximately 27% of our total compared to $19.3 million in the fourth quarter last year. And APJ revenue was $8.7 million or approximately 14% of revenue, up approximately 22% from $7.1 million in the fourth quarter last year. Moving to margins, in the fourth quarter, non-GAAP gross margin was 35.8%, an improvement of 280 basis points sequentially. This compares to 41.8% in the year ago period due principally to the impact of relatively fixed infrastructure, technology and allocated overhead expense against the lower year-over-year revenue base. Non-GAAP operating expense was flat sequentially at $17.7 million in the fourth quarter with a year-over-year savings of $1.5 million. At the bottom-line we generated adjusted EBITDA of $6.3 million, up from $3.1 million sequentially and compared to $10.3 million in the year ago period. Adjusted EBITDA margins at 10.3% of revenue were up 490 basis points sequentially, compared to a year ago margins of 15.7%. Our non-GAAP net income in the fourth quarter was $3.2 million, or $0.03 on a per share basis compared to $5.1 million or $0.06 per share in the year ago period. Shifting to our full year 2018 results, revenue of $238.3 million was down approximately $790,000, or 0.3% year-over-year. By region in NALA we generated revenue of $143.1 million or 60% of our total compared to $150 million last year. EMEA contributed $60.6 million of revenue or 25% of our total compared to $60.9 million last year. And APJ contributed $34.6 million of revenue or 15% of our total and grew approximately 27% from $27.2 million last year. We ended the year with approximately 3,900 employees, an increase of approximately 650 employees compared to 2017 with more than 90% of the increase due to our continued scaling of operations in Manila, Sofia and Okinawa. Turning to our clients. During the full year 2018, our top 10 clients accounted for approximately 67% of total revenue. Revenue from these 10 clients grew in aggregate 6% year-over-year from 2017. The offset to the strong growth of these 10 accounts when compared to our total revenue trajectory is principally due to the loss of two top 10 accounts that were in the 2017 period, combined with smaller puts and takes from new logo wins, expansions and contractions. Our non-GAAP gross margin was 34.6% for the full year 2018, compared to 37.5% in 2017 as the margin contribution from new wins and expansions was more than offset by the lack of contribution dollars from the lost accounts I referenced. Non-GAAP operating expense for the year was $76 million or 31.9% of revenue compared to $77.6 million or 32.4% of revenue in 2017. Adjusted EBITDA was $14.2 million or 6% of revenue in 2018, compared to $19.9 million or 8.3% of revenue in 2017. Our non-GAAP net income was $4.2 million or $0.05 per share, compared to $7 million or $0.08 per share last year. On the balance sheet and cash flow. DSOs were 79 days, up two days year-over-year, primarily due to the delayed receipt of receivables from three accounts into early January. Cash flow generated by operations during the year was $3.7 million. CapEx was $15.6 million, which included $10.8 million of capitalized software, resulting in free cash flow consumption of $11.9 million. We ended the year with a solid net cash position and liquidity profile with cash, cash equivalents and restricted cash of $27.8 million and no borrowings against our $40 million revolving line of credit. Let me now provide an update in context on how we will approach our shareholder communication and guidance practices for 2019 and beyond. We have had the fortunate opportunity to hear valuable and constructive feedback from many stakeholders, which has informed the approach we will be taking going forward. While our frontline delivery teams operate the business tactically in the 90 day cadence, at a corporate level, we are focused on making investment and resource allocation decisions that we believe are right for the company and our stakeholders over a longer horizon. That said, the specific timing of these investments and decisions may cause quarterly variability that may not appropriately reflect their longer term nature and benefit. As such, we will no longer be providing detailed quarterly financial guidance. Instead we will focus our discussions on our longer-term roadmap and the strategic priorities, important factors and underlying expectations, which inform that roadmap. I will share the targets for our long-term roadmap in a minute. But as you think about 2019, we would expect total revenue to contract approximately 3% to 5% for the full year with improved momentum as we exit the year. Anticipated growth in the installed base and conversion of new sales pipeline will be masked by the impact of churn and contraction events from the second half of last year that create a more difficult year-over-year comparison. Consistent with the pattern in prior years and important factor to be aware of is that nearly 45% of our revenue is up for renewal in 2019. Approximately one-third of which is in the first half of the year and two-thirds of which is in the second half of the year. As you would expect we are already in discussions and negotiations across most of these engagements and we generally have been pleased with the results and outcomes so far in the first quarter of this year. Our ability to successfully renew, extend and expand these engagements as they come up, are important factors in arriving at our full year revenue expectation. This also assumes macroeconomic and geopolitical factors, do not deteriorate from current expectations and that the market for our clients, products and services remains healthy. As you think about profitability, we are reducing and realigning discretionary spend to free up the investment and transformation capital required to successfully execute on our strategic pillars and long-term roadmap. You can expect to see these investments in our cost of revenue, sales and marketing line as we bolster the global account management organization and fund client delight programs. Further, we are making prudent investments in targeted technology and data enablement initiatives where we expect to begin realizing payback three to four quarters out through frontline, rep productivity gains and back office efficiencies. Due to the sequencing of these clients and productivity investments against our revenue trajectory, we would anticipate adjusted EBITDA to be approximately breakeven for the full year. Moving to our long-term roadmap, our targets for the year 2022 assume an 8% to 12% compounded annual growth rate, in line with our publicly traded clients’ forward growth estimates and components of the broader IT industry. Market research firm Gartner estimates that global IT spending reached $3.7 trillion in 2018 with a forecast annual growth rate of 3.1% through 2022. With the broader industry, however, our primary focus continues to be on the software and access to service sectors where analysts forecast growth of 8% and nearly 20%, respectively, over the forecast horizon. On non-GAAP gross margins our 2022 target is 38% to 42% as we model the favorable benefit of moderate annual pricing increases, sustained operational efficiency gains and leveraging against relatively fixed infrastructure costs to be partially offset by the effects of a continued tight labor market. We are targeting adjusted EBITDA margins of 8% to 12% by 2022 as we expect to see returns on our digital transformation investments, driving total non-GAAP OpEx as a percent of revenue below 30%. We are further modeling adjusted EBITDA to free cash flow conversion of approximately 30% to 40%, driven by CapEx spend at less than 5% of revenue and improved working capital cycle and days sales outstanding enabled by the data and invoicing automation investments we are undertaking this year. With that, I'll hand the call back over to Gary.

[Gary Moore:]

Thank you, Rich. In closing, the Board of Directors, myself and the leadership team recognize the work we have put out for us and the challenges we face. We are 100% aligned on the things we need to do and how we need to do them. The time I have spent with our clients in the past couple of months has validated for me that

[Operator:]

[Operator Instructions]. Our first question comes from line of Zach Cummins from B. Riley. Your question please.

[Zach Cummins:]

I guess, first one around this -- I know you are not giving formal guidance anymore, but can you walk me through more or so how you are getting to your full year adjusted EBITDA assumption for 2019?

[Rich Walker:]

Sure, Zach. A couple of parameters, I guess I would first emphasize the amount of vast investment we are targeting in the year. Investment around our technology stack, it enables better data governance, data management, improved invoicing, improved efficiencies on how the organization manages our clients ultimately. We are making investments in the global account management area, improving some of the sales and marketing investment in that area. And it's all pointed out at some of the fundamental issues that we have been wrestling with. One being churn, second being high turnover at our frontline employees and third being the significant operational complexities we have within the business. So a combination of the revenue profile, the investments we're making produced the profile we outlined.

[Zach Cummins:]

And then in terms of, it sounds like you made some changes to kind of your product set and how that's being priced and the appropriate hurdle rates, but it sounds like if there's engagements that aren’t meeting the criteria that you set out that you are beginning to walk away, has that been the case already with some of these client engagements as you’ve come up for renewal here in the first half of 2019?

[Gary Moore:]

Zach, this is Gary. Yes, that is the case. We have taken out a number of customers or clients that we tried either to negotiate with or just realized that they were too small. So not big dollar amounts but just wasn’t profitable business.

[Operator:]

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

[Tim Klasell:]

Yes. Just a few questions. Sort of to follow-on to the previous questions around the renewal of some of your existing clients, how long do you think it will take until you have gone through your customer base and let’s say the majority of the customers that are contracts that don't fit have been rationalized or are sort of out of the operations?

[Gary Moore:]

Yes, Tim, again this is Gary. So I think if you look at our 10-K, we represent that in Q4 we had revenue from 57 clients. Approximately 10 of those will -- either had already we have negotiated and/or their contract was up and they did not renew, and about 40% of those were ones that we chose not to renew. That said, about 45% of our current revenue renews in 2019. About one-third of that is in the first half of the year and two-thirds in the back of the year. I can't tell you specifically, but I would tell you that we are very pleased with the trend that we are seeing relative to the renewals that we've done already. And so, we are not foreseeing a renegotiation on contracts that are performing and in fact we are investing as Rich pointed out to ensure that we get in front of these customers more frequently, sharing the value proposition that we are offering them so that they see the value in what we're doing. The biggest job there I see at ServiceSource is to reduce churn, and we're throwing everything we have at it from executive relationships to the global account management program underneath one of our strongest leaders and filling that team with people that understand global account management and how to provide value to customers. And so, I think our client base is going to respond well to that but I can't tell you how successful we will be relative to increasing our prices based on if we can't change the perception that some of them have that we are just there to do a fairly simple job. Once we get in there and make it look easy, some times the value gets lost on customers.

[Tim Klasell:]

And then as part of that, can you sort of give us maybe a little bit of metrics or flavor for what are the contracts that you really value and you are investing in versus the ones that maybe aren’t so strategic? It only sounds like it sizes part of it but maybe if you can walk us through other characteristics?

[Gary Moore:]

So they are valuable Tim. But I think the size of them, the length of them and certainly the margin profile. Our ability to leverage people, process and technology to deliver versus mostly people it is where we are aiming. Those are contracts that allow us to optimize and improve our margin and enhance our service to those customers. So those are the ones I put at the top of the list. Multi-year contracts is something that is also high on that list. Rich do you want to add anything to that?

[Rich Walker:]

I would Tim, I would say we are also widening the aperture and looking at our delivery centers and what our invested cost of delivery is and making sure as we are interacting with large global accounts that we are optimizing the economics of our delivery model to maximize contribution from those relationships. We are spending a lot of time evaluating that and trying to ensure as we talk about optimizing the delivery. That's an important consideration as well.

[Tim Klasell:]

And then final one here. Obviously you and the Board have been discussing these plans. I know it's hard to give quarter-to-quarter guidance and I'm certainly sympathetic to that. However maybe you can give us without giving exact numbers but the upper management, how are you guys being compensated? What are your goals that the Board has set out for you? Is it revenue growth? Is it profitability? Maybe you can give us an idea of how you guys are being incented?

[Gary Moore:]

Yes, I think without getting too specific about that it’s the things I outlined. The Board right now in the discussions that I've had with the Board center around stabilizing our employees, our client base, making the investments that actually yield the results relative to churn. I would tell you that -- me personally, I've always worried about cash. I think we are in a good position there. So it's about making -- the measurements on me are where are you investing the money, where are you saving money and what kind of results will that yield over the period of time that we have laid out? And I think the Board is very comfortable with that. And we are incented to drive the business to I think a higher level of profitability but also part of that has to grow because we have a fixed cost infrastructure relative to the facilities that we have and relative to a number of other things. So I don’t want to get too specific about the way we are measured in compensation. I think it's fairly public knowledge but I'll just leave let go with that.

[Operator:]

Thank you. This does conclude the question-and-answer session as well as today's program. We thank you for your participation and you may now disconnect. Have a good day.