ServiceSource International, Inc.
Q1 2017 Earnings Call Transcript

Published: 9 May 2017

[Operator:]

Good day everyone and welcome to the ServiceSource First Quarter Fiscal Year 2017 Earnings Results Conference Call. This call is being recorded. Erik Bylin from Investor Relations will open today’s call. Erik, please go ahead.

[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 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 overtime. 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 will also be discussing certain non-GAAP financial results and projections. 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 press release, posted on the Investor Relations portion of the ServiceSource website. And with that, I’ll turn the call over to Chris Carrington, ServiceSource’s CEO.

[Chris Carrington:]

Thank you, Erik. Good afternoon and thank you for joining the ServiceSource Q1 fiscal 2017 earnings call. I am joined on the call by Bob Pinkerton, our Chief Financial Officer. Today I’ll provide brief summary of our Q1 2017 financial results and full year guidance, and then speak in greater detail to our go forward operating model, which we believe will materially accelerate our path to our target financial model. I will also provide additional insights to the markets we serve, which we promise from our last call and close on updates to our new sales activities. I’ll then turn the call over to Bob who will cover our financials in more detail, and then we will open the call for Q&A. Q1 revenue non-GAAP gross margin and adjusted EBITDA results all came in within our guidance range. Revenue was $56.7 million, non-GAAP gross margin was 32.3% and adjusted EBITDA came in at negative $940,000. When we provided our initial full year 2017 guidance on our February 21 earnings call, we were in the middle of a very fluid and dynamic environment as we attempted to forecast the magnitude and timing impacts of the discrete Q1 churn events or more appropriately climate contractions that were significantly above our operating norms over the past two years. As a remainder of Q1 evolved, we completed an even deeper analysis of the full year ripple effect from those events as well as longer-than-expected new ACV ramps coming out of Q4 2016. Contractions hit the P&L swiftly while new signings and ACV often take several quarters to ramp and increasingly we are seeing larger deals and new logos take longer to reach for ACV revenue. Bob will provide greater detail in a moment, but with the benefit of a little more time it has become clear that this compounding effect will have a greater revenue headwind than originally anticipated. In light of the slower start to the year than we initially expected we are lowering our annual revenue guidance to $238 million to $243 million. The events of Q1 do not quell my optimism about the opportunity that lies in front of us. We’re taking multiple actions to reset the course for the long-term. Beyond the topline, we believe our operating discipline will allow us to deliver more than 25% increase to our full year EBITDA compared to prior guidance. This increase reflects the increasing ROI we are seeing from the investments made over the last 18 months in our people, process and platform, which have positioned us to reduce our historical run rate expense level. This plan removes legacy costs carried over from our previous operating model and further enhances our overall operating leverage. As a result of taking action in Q2, we expect ServiceSource will become sustainably cash flow positive in Q4 of 2017 leading to a significantly strengthened margin profile and balance sheet to address the convert maturing in August of 2018 and with appropriate liquidity to support the Company’s trajectory to return to growth next year. Under our go forward operating model ServiceSource is positioned to be more competitive and how we deliver outcomes for our clients by simplifying the customer engagement model and providing us with even greater flexibility in how we price and where we can deliver solutions. Our 3,000 plus employees working from nine revenue delivery centers speaking more than 35 languages, launching every new client on our next-gen revenue platform provide the global solutions to the entire technology-enabled marketplace. Speaking of the marketplace we serve, we have promised to share additional insights into our customer base and the sectors we are pursuing. By Gartner’s latest estimates, the global IT market is forecast to grow 2.6% CAGR through 2021. In the midst of that growth, the market is also undergoing profound changes. Technology convergence is causing traditional lines to blur. Products that were previously hardware centric now derive much of their value from the software that runs on them. Software solutions are rapidly evolving from premise-based installations to hosted or cloud applications and increasingly come with the subscription model. And the value of medical device and diagnostic equipment and industrial equipment is no longer in the underlying physical asset but in that asset’s connectedness through the Internet of things and the data and telemetry that the asset generates. We placed squarely within each of these sectors with approximately 57% of our revenue supporting cloud and software solutions, 35% supporting hardware and 8% supporting medical devices and industrial IOT. More important than the mix, however, is the fact that we are at the intersection of each sector’s respective transformation. In the midst of their digital transformation, our clients turn to us to help them retain their highly profitable customers through our core renewals and retention capabilities while also helping them unlock, new recurring revenue streams through our customer success, inside sales, channel account management and sales enablement solutions. Supported by a differentiated technology stack and operationalized by thousands of sourcers around the world, we consistently demonstrate that we are able to deliver the outcomes that matter more effectively and efficiently than any internal client teams or other third parties can. We are seeing these forces play out on the sales front where I remain encouraged by both the level of activity and the scope of opportunities our teams are engaged on across both new logos and expansion. In Q1, we closed the 11 transaction including a new logo win within a leading provider of interoperable video communication through the cloud. We’re also excited about $3.5 million expansion that started last year as a new logo proof of concept. This is a great example of how a new client relationship can start small in year one and then, as our value proposition proves out, can grow into something much bigger in the years that follow. We believe we will experience additional expansions with many of the new logos signed since the beginning of 2016. Q2 is off to a great start as well with our second new logo win of the year, a cyber security solutions company that signed a 3.5-year agreement valued more than $12.4 million a year of new ACV. This deal is the largest new logo signed in the past four years. With our pipeline up almost 30% compared to last year, we are beginning to see a trend of much larger initial contracts as well as larger expansions than we experienced over the past two years. Companies are entrusting us with bigger opportunities and larger swath of customer base, and our proposition is being solidified as the go to resource and market leader for performance based outsourced customer success and revenue growth solutions for the outcome economy. In summary, we’ve made a tremendous amount of progress throughout the business in the past two years, yet we’re squarely focused on accelerating the pace of transformation, creating a leaner, faster, more efficient organization that delivers outcomes to the marketplace that can’t be found anywhere else. Our go forward operating model will not only make us a healthier company in 2017, but we now expect to be cash flow positive in Q4 of this year. With this new go forward operating model, combined with the $20 million of annualized and fully realized benefit of the actions we’re taking in Q2. We believe we will greatly accelerate our path to our target P&L of gross margins in the mid-40s and EBITDA margins in the mid-teens. We expect to simultaneously improve our operational effectiveness and ability to deliver results for our clients, be increasingly competitive and winning new business and unlock resources to pursue a merchant opportunities and future innovation. With that, I will now turn the call over to Bob Pinkerton, our Chief Financial Officer to showed greater detail on our financial results and outlook. Bob?

[Bob Pinkerton:]

Thank you, Chris. Today, I will share our Q1 2017 financial results, discuss the operational changes in our business and provides result and guidance for the second quarter and full year 2017. 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 a greater understanding of the impact of the Q1 churn in a slow start to 2017, we are lowering our revenue guidance for the year. As Chris discussed, in response to the lowered revenue expectations, and enable by the efficiencies we’ve gained through investments over the last two years, we have made considerable operational changes to the business that will improve our strong execution while driving $20 million in annualized savings. With this new outlook for 2017, we expect to become free cash flow positive by the fourth quarter of this year and be well positioned to address the convertible note we have coming due in 2018. And with that I’ll turn to results. Revenue was $56.7 million a decrease of 5% from the prior year, as revenue was largely impacted by churn that occurred in that quarter. Gross margin was 32.3%, down 2.2 percentage points year-over-year and largely due to lower revenue. Our operating expenses came in at $21.2 million down 3.7% or $800,000 year-over-year due to continued discipline around controlling expenses. Adjusted EBITDA for the quarter was a loss of $940,000 below the profit of $250,000 from the prior year. Our net loss in the first quarter was $1.6 million or a loss of $0.02 per share compared to a $0.01 loss a year ago. Now turning to a brief review of the balance sheet and cash flow metrics. DSOs in Q1 were 84 days up from 83 days in the fourth quarter of 2016. Cash flow provided by operations was $7.4 million due to a strong positive movement in working capital, the majority of which came from a decrease in accounts receivable. CapEx was $4.4 million, which included $3.5 million in capitalized development, resulting in positive free cash flow of $2.8 million after adjusting for foreign exchange. We subsequently ended the quarter with $189 million of cash equivalents in investments up $3.5 million from Q4. And now, I would like to take a moment to speak to the changes we’ve undertaken in designing our go forward operating model. On our last earnings call, we shared a mid-quarter update on abnormally high churn in the form of contractions that was occurring in Q1 and principally driven by a couple of large clients. In a highly fluid situation, we relied on our mid-quarter forecast of Q1 churn to generate our revenue outlook for 2017. While our final churn number for Q1 was in line with our mid-quarter forecast, the full year revenue impact of that Q1 churn do not solidify until early Q2. Additionally, in annualizing our 2017 revenue trajectory, we are seeing larger deals and new logo wins take longer to ramp to full ACV expected revenue. These factors are having a material impact on our 2017 revenue expectations. As a result, we determined it was prudent to recast expectations for – of revenue for the year, which I will address momentarily. While we continue to have optimism about the size of the market opportunity in front of us, we had taken decisive actions to align our costs with the updated revenue expectations. The scope, scale and timing of these actions reflect our understanding of what drives value for ServiceSource clients, shareholders and employees based on the last two-plus years we’ve spent running the business. We are strategically realigning activities and resources in a way that will tighten our relationship with our clients, strengthen our opportunity to grow and do that in a way that generates free cash flow. It is important to note that the results of investments we’ve been making over the last two-plus years in operational insight and effectiveness have been instrumental in allowing us to take these meaningful actions now. We expect to [indiscernible] heavily impact our financial results in a small way in Q2 and ramp throughout H2 2017 to reach an annualized $20 million of savings by the first quarter of 2018. Understand that we take our responsibility as operational leaders of ServiceSource very seriously, and the actions we are taking this quarter and this year reflect our proactive approach to maximizing ServiceSource’s potential for all stakeholders. Going forward, as we drive increased performance, revenue and insight for our customers, we expect to have a level of profit and cash flow that increases our ability to invest in high-ROI opportunities, while maximizing our options related to addressing the convertible note that is due in the third quarter of next year. With that, I’ll now turn to guidance for the second quarter of 2017 We expect revenue for Q2 in the range of $55.5 million to $58.5 million. We expect gross margins in the range of 32% to 35% in the second quarter. We are forecasting operating expenses in Q2 of approximately $19.5 million to $20.5 million. As a result, in Q2, we expect adjusted EBITDA between breakeven and $2 million and a net income between a loss of $1 million and a profit of $500,000 or negative $0.01 to positive $0.01 on a per share basis. We assume a basic share count of 88.5 million shares and normalized tax rate of 40%. We are expecting free cash flow to come in between negative $5 million and negative $7 million for Q2, exclusive of the impact of any restructuring charge. I will now address how the cost savings will impact our full year guidance. Given our reevaluation of how Q1 churn and longer ramp times for new logos will impact our full year, we now expect revenue to come in between $238 million and $243 million. We expect gross margin to come in between 36.5% and 38.5%, OpEx between $80 million and $84 million for the year, which should result in an adjusted EBITDA between $15 million and $18 million for 2017. Additionally, we now expect 2017 CapEx to come in between $16 million and $18 million, an improvement of approximately $2 million from our prior guidance. For the full year 2017, we expect free cash flow between negative $2 million and positive $2 million, exclusive of the impact of any restructuring charge. But importantly, we now expect to be sustainably free cash flow positive by fourth quarter 2017. Now let me address ACV. We began to 2017 with $266.5 million in ACV. While we experienced larger-than-industry-norm churn in Q1, we did close new business in Q1. And given the health of our new business pipeline, we expect to close meaningful new business in excess of churn over the rest of this year. Based on a deep diligence of our pipeline and expected levels of churn, even with the larger Q1 churn, we expect to finish 2017 with an ACV balance of between $267 million and $275 million. This ACV balance may seem at odds with the revenue guidance we gave above. As you know, we are very strict in maintaining a consistent and rigorous definition of ACV. New ACV is counted when business is won. The revenue from that win generally takes a couple quarters to reach its ACV expected value. In addition, we are also now seeing logos – new logos and larger deals take longer to ramp to their ACV expected revenue levels due to the complexity and breadth of these engagements. Conversely, when we recognize churn in the existing base of business, it tends to impact revenues very quickly, and this is particularly true of contractions like we experienced in Q1. These factors are combining to set ServiceSource on a lower trajectory for 2017 than originally expected this year. While we had strong signings to close 2016, much of the ACV was added in the last months of the year in 2016, which will severely limit its contribution to revenue in 2017. In contrast, Q1 churn started impacting revenue immediately. These factors combine to create the difference between the ACV forecast and the revenue forecast for the year. So while our revenue outlook is challenged in the near-term, we are confident we have built a solid foundation for ServiceSource, both operationally and financially, and look forward to the opportunity to leverage that foundation moving forward. We are capitalizing on our investments in new technologies and resources to deliver performance, efficiency and intelligence unmatched in our history. Leveraging our investments, we have taken important measures to significantly reduce costs and increase profitability while designing an organization that is tightly attuned to our clients. Our pipeline is growing, and our execution against that pipeline is improving. And with that, I’ll open it up for questions.

[Operator:]

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

[Pat Walravens:]

Oh good and thanks. So Chris, what would you say, just sort of in plain English for people, that you learned since you talked to us last about all this?

[Chris Carrington:]

Hey Pat, thanks for the question. Well, it’s always a learning experience every quarter. But I would say that what’s critical for us is to get better insights as we sign these new deals at the speed in which they’ll ramp. We’ve learned some of the complexities of as we focused on new logos and global deals versus, I’ll say, regional deals. There’s definitely some additional challenges to getting the deals kicked off and started. But I’d say on the positive side, what we’ve learned is that our value proposition is still resonating in the market. Our pipeline is getting stronger. I’m more energized about Q2 than probably any quarter I’ve had in front of us before. And I think we have a good opportunity in front of us.

[Pat Walravens:]

Okay. And so are you going to be able to figure this out?

[Chris Carrington:]

Pat, I believe we can. It’s been two years into it, and we had seven, eight great quarters in a row there. We’ve had a couple of quarters here that are challenged on the revenue front. We owe it to our investors, our employees to fix that and get on the sustainable track record there. But we are continuing to make improvements in our operating model as it relates to our operating leverage and to our bottom line profitability. But I think we’ll be much more reflected in quarters to come and pleased to say that we’re in a position to address our convert in 2018 and move forward.

[Pat Walravens:]

Okay, that’s a perfect transition. So Bob, my question for you. I think we’re going to need a little more detail about the convert. So can just talk about – just walk people through how much you owe, how much you have, how you’re planning on paying it off, what the options are? And also, is there an issue as it becomes current?

[Bob Pinkerton:]

Sure. Well, let me – thanks, Pat. I’ll start with the last part of your question. We do not believe we have an issue if it becomes current. There have been no issues with clients et cetera or others, too, when they – if – when that convert that’s due in August of 2018, which is $115 million, comes current. As everyone, I think, know, we’re sitting on about $189 million of cash. And when you combine that with the actions we’re taking in this go forward model and the cost savings that we expect in addition to the cash piece, sustainably cash flow positive and have many options as it relates to our refinancing that convert with a variety of different instruments.

[Pat Walravens:]

Okay, all right. Thank you, guys.

[Bob Pinkerton:]

Thanks, Pat.

[Operator:]

[Operator Instructions] Our next question comes from Tim Klasell with Northland Securities.

[Tim Klasell:]

Yes. Hi, guys. Just a quick question. What – and I’m sorry, I got disconnected. So you may have already answered this. But the longer time for ACV – for the new contracts to turn to revenues, what’s changed there? You have some history there, so I would think that you would have had some pretty good understanding to be able to estimate how long that takes. But clearly, something must have changed. So maybe you can walk us through what’s different about the new contracts or what’s different around customer activity to help understand that longer route.

[Chris Carrington:]

Yes, Tim, it’s Chris. Thanks for the question. If we think back over the recent history, the past two years, in 2015, clearly we were focused on expansions with our current clients. A lot of experience with that and the pace at which that revenue is able to ramp up and coming to the P&L. In 2016, we continued the expansions, but we started signing new logos. Signed 12 last year in total, nine of those specifically in Q4 of 2016, which is the largest number of new logos we signed in a single quarter. What was also different about those new logos is they’re starting to represent larger deals than proof of concepts, although we had a few of those, but larger deals. And those larger deals are more reflective of global-type deals where you’re launching at one time in all three regions, in the Americas, in EMEA and in APJ. And we found that there’s little – greater coordination record with our clients as it relates to getting those off the ground quickly. You’re ingesting a whole lot data, which takes a little time to set up. And so the ramp to revenue on those new logos that are globalized is taking a longer time.

[Tim Klasell:]

Okay. Okay, great. And then as far as the cost reduction, rightsizing the business, where are those coming from? Are there specific types of technology or offerings that you think are just redundant anymore, where demand has slipped? Maybe you can walk us through there, so where the $20 million is coming from.

[Bob Pinkerton:]

Sure. Yes, Tim, absolutely, this is Bob. It’s not as – it’s not that at all. This is investments that we’ve made over the last couple years that have allowed us to reduce costs in a variety of parts of the business and have no impact to our clients. When we look at the cost reductions, it’s – and you’ll see in an 8-K that has been released that we’ve got – there was a restructuring charge of about – anywhere from $4.5 million to $5 million. A $1 million or so of that is going to be noncash impairment and then about $3 million of that is related to employee severance. So you’re going to see that that’s – that relationship of savings, whether it’s people or non-people, is kind of reflected there. As it relates to the $20 million of savings, it’s – you’re going to see – some of it is in CapEx, and we’ve been clear on that in my script. And then the remaining part of that savings will be in cost of revenues and OpEx. I will highlight that, that $20 million is an annualized number, and that when we look at the impacts in 2017, we expect to have about 7/12 of that impact this year is what you should see in 2017 in the EBITDA guide that we gave.

[Tim Klasell:]

All right. Good, enough. Thank you.

[Operator:]

And I’m not showing any further questions at this time. I’d like to turn the call back over to our host for closing remarks.

[Chris Carrington:]

Kevin, thank you. And thanks to everyone listening today. I want to just thank all of our employees once again for their hard work in Q1 and the results that we’ve delivered. We’re all looking forward to Q2 and the rest of the year in front of us, and we look forward to speaking to many of you on the phone in the days and weeks to come. Thanks, and everyone have a great day.

[Operator:]

Ladies and gentlemen, this does conclude today’s presentation. You may now disconnect. And have a wonderful day.