ServiceSource International, Inc.
Q3 2016 Earnings Call Transcript

Published: 10 Nov 2016

[Operator:]

Good everyone, and welcome to the ServiceSource Third Quarter 2016 Earnings Results Conference Call. This call is being recorded. Erik Bylin from Investor Relations will be opening today's call. Eric, 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 may make projections or forward-looking statements to reflect our views as of today and are based upon 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. We caution you that such statements are just projections and actual events and results may materially differ from what we discussed. 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 these non-GAAP measures, we direct your attention to the 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 Web site. 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 Q3 fiscal 2016 earnings call. I'm joined on the call by Bob Pinkerton, our Chief Financial Officer. Today, I'll provide you a brief summary of our Q3 2016 financial results, share some color on our sales efforts, and the progress we are making in the business, and then turn the call over to Bob who will cover our financials in more detail. We will then open the call for Q&A. For the past couple of quarters I've shared with you my conviction around the market opportunity in front of and the positive momentum we are seeing with our clients. As our third quarter financial results highlight, that momentum is continuing to accelerate, and importantly, is being translated into material improvements in all areas of our P&L. Q3 is the seventh consecutive quarter where our results met or exceed guidance on all metrics, including revenue, gross margin, OpEx, and EBITDA. Looking first to revenue, the top line grew 5% year-over-year to $62.5 million, squarely at the top end of guidance. The growth was also broad-based with revenue growth in each of our reportable geos UPNOWA [ph], EMEA, and APJ. We have now delivered two consecutive quarters of year-over-year growth, and this was also the first time in five years where Q3 revenue grew sequentially over Q2. As we exit the headwinds cause by 2014-2015 churn, add new logos and net ACV, and continue to expand with our install base. We are well positioned to further accelerate our revenue growth rate. Now turning to profitability, Q3 non-GAAP gross margins were 38.3%, a nearly 600 basis point year-over-year improvement. The investments we have made in our revenue as a service platform over the past year, inclusive of our people, process, and technology, are generating early positive ROI even faster than we expected. Our improved profitability and increased success with clients is also a result of the sensational job that Managed Services team has done, improving efficiency and effectiveness in delivering revenue and bookings growth on behalf of our clients. Brian Delaney and his team have changed the culture and energy of our global revenue delivery centers, while installing a framework that simplified the org structure aligning teams around the client and change how we managed engagements. These collective efforts have resulted in year-over-year gross margin improvement for seven quarters in a row. Moving beyond gross margin, we continue to be disciplined stewards of our capital, and where we focus expenses and investment, with non-GAAP operating expenses during the quarter of $21.7 million or 34.7% of revenue, which is the lowest as a percent of revenue in 11 quarters. The combination of strengthening revenue growth and continue expense leverage resulted in Q3 adjusted EBITDA of $4.1 million or 6.6% of revenue. This is the highest level of profitability in seven quarters. On the sales front we continued our progress to achieving 10% ACV growth in 2016. Q3 marked the sixth consecutive quarter of net ACV growth. We closed 13 transactions in the quarter, and we remain within industry norms for churn. Various circumstances caused a handful of new log opportunities to push out past the Q3 cutoff, but I am very pleased to report that we were able to get three of these over the finish line in the first few weeks of October. I continue to be encouraged by the growing robustness of our sales funnel, which has a healthy mix of new logo and expansion opportunities across all of our target sectors and geo. As I near my two-year anniversary with ServiceSource in just a couple of weeks, I reflect back on the dramatic changes our global team has accomplished. In a short timeframe we have refocused the company to me maniacal about our client-centricity and delivering the outcomes and results that move our clients' businesses forward. We have built a great leadership team who have united the organization and reinvigorated the employee base. We expanded our global footprint with two new revenue delivery centers now staffed with more than 300 people. We have returned to the sustainable growth inclusive of an installed base expansion, and expanding our total addressable market with new logo wins and further acceleration in front of us. We have reversed course from a sizable office to four consecutive quarters of positive EBITDA. And we have successfully built our new technology platform to deliver enhanced revenue lifecycle management solutions that will fuel our ability to deliver even better outcomes for our clients, which will accelerate our revenue, gross margin, and EBITDA performance. The over 3000-person strong ServiceSource team is starting to fire on all cylinders, and I am encouraged by the opportunity opening in front of us. Over the past couple of quarters I've been able to spend much of my time on the road talking with clients, prospects, consultants, and other industry experts. Make no mistake, these are challenging times for many sectors and companies as legacy product sales stall or shrink, cloud models disrupt the status quo, and digital transformation pervades the enterprise. Most third-party market research reports show anemic growth or even contraction in the global technology industry. In this growth-constrained environment industry participants are rethinking all aspects of their business from go-to-market strategies, pricing models, customer engagement and support technologies, and internal versus outsourced resources among others. Just a few weeks ago I attended the Technology Services World Conference put on by the Technology Services Industry Association, a leading trade group with over 30,000 executive members from the hardware, software, task, industrial, and life sciences sectors. It was exciting to see executives from hundreds of global companies accepting the challenges and opportunities of growing in the new outcome economy. As I met and talked with these executives it reaffirmed my conviction that ServiceSource is uniquely positioned in the marketplace to help these companies achieve customer success. Customer engagement is now a 24/7/365 endeavor, but to turn customer engagement into true customer success it requires capabilities that are at the core of ServiceSource's DNA, including highly skilled and expertly trained people, proven and proprietary processes and playbooks, big data insight and analytics, and a purpose-built technology stack. Our revenue as a service platform and ROM solution are tailor-made to accelerate with the companies' installed base customers by enabling best-in-class performance on things like adoption and onboarding, expansion, and upsell and cross-sell, and renewals and retention. We are specialists in this space, and have been lowering our clients' customer retention costs for expanding customer lifetime value for 17 years. As the markets we serve are forced to rapidly evolve, our message and value prop continue to resonate even stronger giving me even greater confidence in the path we are on and the potential in front of us. With that I'll now turn the call over to Bob Pinkerton, our Chief Financial Officer. Bob?

[Bob Pinkerton:]

Thank you, Chris. Today I'll share our Q3 2016 financial results, give some color on the drivers of our business and provide guidance for the fourth quarter of 2016. 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. I am please to share that in Q3 we delivered results at or above the high end guidance. Most importantly we increased our revenue growth rate and with that we were able to show the first signs of the leverage we delivered in the P&L. Revenue was up 5% over last year while our cost of revenue was down 4% leading to strong gross margin gains. Even as we delivered higher gross margins, in Q3 we actually had 8% more people than last year in our revenue delivery centers which speaks to the efficiency we are achieving in our new locations. With a slight year-over-year decline in operating expenses we lowered non-GAAP OPEC as a percent of revenue by 2.8%. This all combined to deliver an adjusted EBITDA result above guidance. And with that I will turn to results. Our revenue was $62.5 million, a 5% increase from the prior year and at the high-end guidance. Non-GAAP gross margin was 38.3%, up 590 basis points year-over-year and above guidance as the team continued to drive efficiency by improving processes leveraging our technology platform and driving best-in-class hiring and whole definition. Moving on to operating expense and profitability; our non-GAAP operating expenses came in below guidance for the quarter at $21.7 million, down $600,000 year-over-year and below guidance to largely to lower program and people cost in the quarter. Adjusted EBITDA for the second quarter was $4.1 million, well above the loss of $1.3 million from the prior year and our guidance of negative $2.5 million to positive $500,000. Our non-GAAP net income in the third quarter was $1.3 million or $0.02 per share above our guidance of a loss of $1 million to $2.5 million. Now turning to a brief review of the balance sheet and cash flow metrics, DSOs in Q3 were 78 days, down from 79 days in the second quarter of 2016. Cash flow provided by operations was $1.1 million. CapEx was $6.9 million, which included $3.4 million in capitalized development, resulting in negative free cash flow of $6.1 million after adjusting for foreign exchange. We subsequently ended the quarter with $190.9 million of cash equivalents in investments down $3.2 million from Q2. Turning now to guidance for the fourth quarter of 2016, we expect revenue for Q4 in the range of $68.5 million to $71.5 million, which is growth of 5% to 10% over the same quarter last year. We expect non-GAAP gross margins in the range of 41% to 44% in the fourth quarter compared to 40.8% in the year ago quarter. We are forecasting non-GAAP operating expenses in Q4 of approximately $26 million. The sequential increase of around $4 million over Q3 is due principally to increases in one time investments along with the normal Q4 update for marketing and sales activities in commission. As a result, in Q4, we expect adjusted EBITDA to come in between $4 million and $7 million and a non-GAAP net income in the range of $1 million to $3 million or $0.01 to $0.03 on a per share basis. We assume a basic share count of 86 million shares and a normalized tax rate of 40%. We're expecting free cash flow to come in between negative $1 million and positive $2 million for Q4. Looking at the full year, we began 2016 expecting modest improvement in gross margin and EBITDA because of spend related to the investment we needed to make in the business. While we have been making investments critical to strengthening our execution expanding our value proposition, we are concurrently making great strides in driving efficiency. Because of this, as you can see implicitly our Q4 guidance, we expect to show considerable improvement to gross margin which should be up more than 300 basis point from 2015 and EBITDA, which should be up around $10 million for the last year. And with that, I'll turn it back to Chris.

[Chris Carrington:]

Thank you, Bob, for sharing that positive news. Before we open the call for questions I would also like to share some exciting news that Gary B. Moore has joined the ServiceSource Board of Directors. As we highlighted in yesterdays' 8-K and press release, the Board of Directors unanimously approved the addition of Gary B. Moore as our seventh external director. We could not be more pleased to have someone with Mr. Moore's depth of experience and expertise join us. Most recently, Mr. Moore was President and Chief Operating Officer of Cisco, a networking and collaboration market leader, where he oversaw the marketing operations, human resources, IT services, transformation office, and corporate planning groups. Mr. Moore was Cisco's first Chief Operating Officer, and over his 15-year career at the company revenue grew from $22 billion to more than $49 billion. Previous to Cisco, Mr. Moore was CEO of Netigy, a leading network consulting company that was acquired by ThruPoint. And he had a very successful 26-year career at Electronic Data Systems, including the creation and expansion of its E-solutions global business community, EDS' fastest growing organization with 20,000-plus employees. His leadership, transformation, and growth acceleration experience will be immensely valuable to ServiceSource, and we are thrilled to have him onboard. With that, let's open the call for questions.

[Operator:]

Thank you. [Operator Instructions] Our first question comes from Ed Maguire with CLSA. Your line is open.

[Ed Maguire:]

Hi, good afternoon. I was wondering if you could just talk about the demand profile you're seeing among your customers, where is their business healthy, where are you finding opportunities to shore up [ph] their own challenges? And I'm really referring to your historical mix of traditional on-premise software, you know, hardware networking as well as software as a service companies. Just to follow up on your comment about some of the challenges that your customers are seeing? If you could just elaborate on that that'd be helpful.

[Chris Carrington:]

Ed, thanks for the question, it's Chris here, and good to hear from you again. Yes, I think we're seeing continued growth across many of the segments that we call on, whether it be hardware, software, cloud, healthcare, life sciences, or industrial solutions. But clearly as the market is shifting from on-prem perpetual based licensing models to the cloud and subscription, it's providing us an increased demand for helping our clients a, make that transformation, so more and more we're assisting clients in the cross-sell over to cloud-based subscription services versus their on-prem licenses. And then second, because the cog-based subscriptions tend to be shorter duration than the traditional prem-based models. We're getting more involved in the customer life cycle management, where we're assisting both the end client and or assisting channel partners with onboarding adoption, and increased demand for cross-sell and upsell. So we see it as a real positive for ourselves. And I think my commentary in the opening remarks, not necessarily directed at our clients, to be clear, but really based on some information from some of the industry analysts from the overall technology market, so not necessarily our direct client.

[Ed Maguire:]

Great, and looking at the improvement in gross margins or declining costs, could you elaborate on what -- number one, how sustainable do you think a normalized -- the run rate might be for gross margin? In other words, how much more room do you have to grow those gross margins. And secondly, just if you could provide a little bit more color on the increased investment in the fourth quarter?

[Bob Pinkerton:]

Sure, absolutely, yes. Thanks Ed, this is Bob. There's a couple of things that have been -- that kind of culminated in Q3. I would say that we're continuing to see just ongoing improvement by Brian Delaney, his operating focus, and the team really starting to kind of get up to speed. There's a lot more though, we have to go there. But you've got just improved operational efficiency; we've got new hiring and role definition in the operations of our Managed Services business. We're starting now to see the first signs of some revenue and margin benefit from the technology investments that we're making, but again just first signs. Really we're still very early days in us getting to the point where we can really start seeing the kinds of operational improvements and efficiencies that frankly we're used to seeing in the larger services businesses that we're used to working with. At the end of the day, as we've been vocal, our [indiscernible] 40% gross margins, and Q3 reflected that continued trajectory toward that goal state. As it relates to Q4, as you can see from the guidance, the Q4 expectation is that margins would expand further. That's in large part related to the seasonal uplift that we tend to have in Q4. And when you add that to that the efficiency that we're driving the business, that's what's driving many hundred basis point improvement in gross margin on our Q4 guidance.

[Ed Maguire:]

Great. Thanks a lot. Appreciate it.

[Operator:]

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

[Bob Pinkerton:]

Hi, Tim.

[Operator:]

Tim, if your line is on mute please un-mute it.

[Tim Klasell:]

Can you hear me?

[Bob Pinkerton:]

Yes, we can Tim, go ahead.

[Tim Klasell:]

Okay, good. I just wanted to sort of touch base a little bit on the margin structure. Obviously you guys are marching in the right direction. When you think of your target model, what should we be considering going forward?

[Chris Carrington:]

So when you mean margin structure in the go-forward, I mean, we've been kind of vocal that our goal state is mid 40% gross margin. It's going to be a combination of revenue growth as well as further efficiencies to drive us to that goal state from a gross margin perspective. With respect to EBITDA and operating margin it's going to be getting leverage on the investments that we're making in operating expenses, again with a growing business, and getting where we want to be relative to operational scale. We're making investments in world-class training; we're making investments in technology in large part that happens at the OpEx line. As well as, frankly as we grow, we're going to have higher sales and marketing expenses as we drive that. Does that answer your question?

[Tim Klasell:]

Yes, it does. Can you give us maybe some -- maybe a little bit more specific numbers on what you're thinking particularly in the sales and marketing front?

[Bob Pinkerton:]

Well, yes, I think just to make sure one clarification in the gross margins in the mid-40s, so probably the 44 to 46 range. So just wanted to make sure we clarified that. In the sales and marketing -- are you saying as it relates to a percentage of revenue, a cost as a percentage of revenue or -- I want to make sure…

[Tim Klasell:]

Yes, as a percentage of revenue.

[Bob Pinkerton:]

Great. So as we think about OpEx in total as a percentage of revenue, again in a growing business, we think it's in the mid to high 20% range. And if you disaggregate that we should be able to start getting much better leverage on our sales and marketing engine. Again, we have a global sales and marketing engine right now that as we kind of get to 5% revenue growth this quarter, we're guiding at the high end of 10% next quarter, et cetera, as we kind of continue that engine we expect to drive the sales and marketing percentage of revenue down in the lower double-digit, lower teens, maybe even closer to 10% range. Again, it's going to depend on how our revenue is driving, and then also whatever investments we're making on things like training, and world-class recruiting, et cetera, that happens in the G&A line.

[Chris Carrington:]

And I'd say, Tim, just adding to that, we've been consistent in the fact that when we got here total OpEx expenses were in the low to mid 40s. We've driven that down now pretty consistently to the mid-30s. And we do believe it's something we can get down overall as far as OpEx in the high 20s. So we're still driving towards that within our goal state.

[Bob Pinkerton:]

But with the true goal, as well though to get it to double-digit revenue growth, which is going to require some investment in OpEx, so it's of balancing all that.

[Tim Klasell:]

Perfect. And then as you guys look at 10% you know, going back to double-digit type growth, where is it coming from? And obviously you've got new logos and you've got expansion. Is it a 50-50 mix between the two, or is it more expansion, how should we think about that going forward?

[Chris Carrington:]

To be consistent with what we talked about coming into last year, into this year, and then looking forward, last year as we were, I'll say, landing the plane on evening out our revenue we were seeing most of our new revenue coming in from expansions. I'd say, 90%-plus from expansions. And we talked about in 2016; our expectations would be to be about 80% expansion with 20% new logos. And I'd say we're right around that mark. And then we do see it change, and even further in 2017, where we'll be getting much, much closer to 50-50 between expansions and the logos. So we still have a strong desire to grow with our existing client base, because we've discussed in the past our wallet share of penetration with the opportunity still is around 10%-11%. So we still think that has an ability to double. But we're also excited now about the new logos mentioned last quarter, pretty consistent this quarter, that we have about 25 new logos in our pipeline right now, as I alluded to in my commentary a few minutes ago. We've already closed three new logos this quarter, so that would be 16 logos for the year, and we anticipate more new logos close to this quarter. So, like I said, we'll see a real acceleration from revenue growth from new logos next year.

[Tim Klasell:]

Okay. And then one final housekeeping question. [Indiscernible] 3,000 employees, do you have an exact number? I think at last quarter you were at 3,200. What's the headcount at the firm right now?

[Chris Carrington:]

Yes, I think we're right around that direction. I'd say we're right around…

[Bob Pinkerton:]

Just over 3,000.

[Chris Carrington:]

Yes, just over 3,000. So I don't know that we were 3,200 last quarter. Tim, we'll check on that. I think we were right around 3,000 and maybe we added 100 or 200 in our operations but we were able to drive some efficiencies in our SG&A.

[Tim Klasell:]

Okay, great. Thank you very much.

[Operator:]

[Operator Instructions] Our next question comes from Patrick Walravens with JMP Securities. Your line is open.

[Patrick Walravens:]

Good, thank you. So two years, Chris?

[Chris Carrington:]

Yes, it's flowing by, right. I remember you asking me that years ago, why did I join ServiceSource. Now you know the answer.

[Patrick Walravens:]

I know, yes, time really flies. Well, great, congratulations guys. So, I want to focus on ACV, and I might have missed something here, and if I did then forgive me. So first of all, just how satisfied were -- let's forget the things that closed later, how satisfied were you with the way ACV production was in Q3?

[Chris Carrington:]

Yes, I think being totally transparent, not as happy as I'd like to be. The good news is we had such a strong H1 that with -- Q3 is always kind of the summer hangover time. And so sometimes you have a good Q3, sometimes you have a little bit lighter. I definitely know it's not a trend based on what we've already started off in Q4, and what we believe we'll see the rest of Q4. So but -- I heard someone say the other day, very grateful but never satisfied. So I'm -- outside sales team has done an admirable job this year, it's kept it on track for the full year. But we'll look towards even a bigger Q4.

[Patrick Walravens:]

Okay. And so then the part I might have missed, did you guys reiterate that you're comping -- you're going to get the 10% ACV growth this year?

[Chris Carrington:]

We've repeated that so many times, didn't think we needed to. But we remain on track for that. We absolutely believe we're going to do that, and with a little less than 90 days to go, obviously we're excited about Q4.

[Patrick Walravens:]

Okay, good. And then how should we think -- I mean, should that 10% be the way we should think about next year?

[Chris Carrington:]

Well, I think to be cautious as far as I think next year from a couple of perspectives. One is, first of all, we haven't given 2017 guidance, and we'll give that in February. I think from a revenue perspective, a reminder we've talked about before, that depending on the exact timing and the type of business that comes in, and its ramp time, that will be directional towards next year's revenue. So depending on the exact timing, maybe it's 7%, maybe it's 11%. And then on ACV growth next year, once again, we haven't given guidance, but I would tell you I am very, very optimistic and excited about what I think will be given in February.

[Q –:]

Okay, good. I mean this is not a business that you would expect to decelerate, right?

[Chris Carrington:]

No, I don't think so. I think this is a business that clearly we fixed in '15, business that was kind of detail two halves whereby Q1 we still suffered some of the pains in the past. We are real pleased with four tens and 1% growth in Q2, 5% growth in Q3 and then if you just look at our guidance, they would suggest the growth above that. So we are accelerating our growth towards that 10 digit, or I am sorry excuse me, the 10% growth guidelines were given.

[Patrick Walravens:]

Right. And then last one from me, this is a company that I think of as having the ability to perform well above industry norms. So whenever I hear turn within industry norms, sort of make a mental point to ask, I mean your turn rate should go down, right? I mean do you guys see your retention rate going higher over time?

[Chris Carrington:]

Yes, I think remembering that sometimes, no I don't see it going higher. I think we will stay within that norm of…

[Patrick Walravens:]

I said it the wrong way, I mean improving.

[Chris Carrington:]

Yes, I think we will improve but I think the one thing that's outside of our control, path that we don't have as much control over is sometimes any given segment of the five we cover maybe more challenge than another and it's not that we are losing the business because of performance or because of cost anymore, that was so 2014. It's because they may actually not be having the opportunity themselves rest to go work on. So when that happens we count that as churn, in the full transparency, it does require us to go sell new business, adding to existing clients that are growing or to new logos and as I mentioned previously with Tim, we have really seen acceleration of our logo growth heading and in the '17 we already are having a strong year this year with it.

[Patrick Walravens:]

Awesome, okay. Well, congratulations, and thank you.

[Chris Carrington:]

Thanks, Pat.

[Operator:]

I am showing no further questions, I will now turn the call back to Chris Carrington for closing remarks.

[Chris Carrington:]

Yes, Thanks, Stephanie. Once again really excited to share the positive news of the quarter we just finished up and once again share the excitement for what we believe we will do in Q4 and looking forward to 2017. So, thanks for joining the call with us today and I am sure we will be in touch soon. Thank you.

[Operator:]

Ladies and gentlemen, that does conclude today's conference. You may now disconnect and everyone have a great day.