ServiceSource International, Inc.
Q4 2016 Earnings Call Transcript

Published: 21 Feb 2017

[Operator:]

Good day everyone and welcome to the ServiceSource Fourth Quarter and Fiscal Year 2016 Earnings Results Conference Call. This call is being recorded. Erik Bylin from Investor Relations will be opening today's call. Erik, please go ahead.

[Erik Bylin:]

Thank you for joining us today. 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 will 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 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 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.

[Christopher Carrington:]

Thank you, Erik. Good afternoon and thank you for joining the ServiceSource Q4 and full year 2016 earnings call. I am joined by Bob Pinkerton, our Chief Financial Officer. Today I'll provide you a brief summary of our Q4 and full year 2016 financial results and accomplishments, share some insight into our 2017 outlook, and then discuss where we are in our transformation process. I will then turn the call over to Bob who will cover our Q4 and full year 2016 financials in more detail as well as provide detailed Q1 and full year 2017 guidance. Q4 revenue, non-GAAP gross margin, and adjusted EBITDA results all came in within our guidance range. Revenue grew 5.6% year-over-year to $68.7 million and represented our third quarter in a row of year-over-year growth. Non-GAAP gross margin in the quarter was 42% and was the eighth quarter in a row of increasing year-over-year gross margin. Adjusted EBITDA was $5.7 million or 8.3% of revenues and was the most profitable quarter since Q4 2013. Combined with our results for the first three quarters of 2016 we ended the year with revenue of $252.9 million, non-GAAP gross margin of 38.4% up more than 300 basis points from 2015, and adjusted EBITDA of $12.9 million and $11.5 million improvement from the prior year. Turning to our sales results, in 2016 we grew ACV by 8.2% ending the year with 266.5 million of ACV. While we are disappointed that our few deals did not close as expected which resulted in not achieving 10% ACV growth, we are encouraged by the new ACV momentum coming out of Q4. We closed 29 transactions in the quarter bringing our full year count to 82. Both are all time company records. We placed particular focus on adding new logos in 2016 and by combining a more refined value proposition with expanded capabilities and offering we brought in nine new clients in the fourth quarter and 12 total for the year with wins across all of our target segment. To continue that momentum in 2017 we increased the size of our outside sales team by 20%. However, with a respectable 2016 in the books and despite meeting or exceeding the vast majority of client's expectations we are being confronted with a significant headwind in the new year that will temporarily stall the revenue growth momentum we had been building. Several of our larger clients are experiencing unique marketplace challenges. We have retained these logos but due to the product and revenue challenges they're facing, the ACV we have with these clients will materially contract and impact our revenue for the entirety of 2017. These negative impacts will cause our churn for Q1 to be well above industry norms. I do want to emphasize that we continued to perform well for these clients and our relationship and client satisfaction remained strong. Based on discussions with these clients we believe that with time we will be able to grow these particular relationships again. As we've discussed in previous calls ACV contraction generally tend to have a more immediate hit to revenue and especially when they occur in Q1, have a profound reduction for full year revenue. Conversely new ACV wins and especially new logo wins such as the nine we signed in Q4 2016 can take several quarters to ramp revenue. Our ACV wins in the second half of 2016 were back-end loaded which combined with Q1 2017 contractions will cause 2017 revenue to be particularly muted. We’re expecting 2017 revenue to come in between $248 million and $258 million. Although our 2016 sales results will not translate into the 2017 our team envisioned, we believe the core foundation of the business and value to the marketplace is stronger than ever. We have vastly improved our delivery capabilities and built a strong foundation of trust with our clients over the last two years. This trust has opened the door to conversations with a broader set of differentiated and strategic solutions all of which makes me believe our financial performance will improve and return to its trajectory that is in line to our target model of double-digit revenue growth, gross margins in the mid 40's, EBITDA margins in the mid teens, as well as a business that will turn sustainably cash flow positive. With that I will now turn the call over to Bob Pinkerton our Chief Financial Officer to share greater detail on our results and outlook. Bob?

[Robert Pinkerton:]

Thank you, Chris. Today I will share our Q4 and full year 2016 financial results and provide our outlook for the first quarter and full year of 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. As Chris discussed we have mixed results this year today. But we continue to make great strides optimizing the operations of the business and driving better results for our clients. But we are also increasing profitability. We are experiencing churn in Q1 that significantly dampens our growth expectations in the near-term. This churn is being driven beyond industry norms by several large clients that are experiencing market challenges and is unrelated to ServiceSource performance. The vast majority of this churn is a contraction of business as opposed to termination of a relationship. We believe this is a temporary setback and we still fundamentally believe we are strengthening our value proposition in the marketplace and our target model remains valid. We see the expansions and new client wins in 2016 and the significant progress we're making in improving the operations of the business as strong supporting evidence. And with that I'll turn to Q4 results. Our revenue was $68.7 million, a 5.6% increase from the prior year due to the low end of guidance due to softness across a number of accounts. Non-GAAP gross margin was 42% up 114 basis points year-over-year. Our non-GAAP operating expenses came in below guidance for the quarter at $25 million down 3.7% year-over-year. Adjusted EBITDA for the fourth quarter was $5.7 million well above the $2.3 million from the prior year and in the middle of our guidance $4 million to $7 million. Our non-GAAP net income in the fourth quarter was $1.7 million or $0.02 per share also in the middle of our guidance of $1 million to $3 million. Now turning to a brief review of the balance sheet and cash flow metrics. DSOs in Q4 were 83 days up from 78 days in the third quarter. Cash flow provided by operations was negative $5.2 million. CAPEX was $5.1 million which included $3.3 million of capitalized development resulting in a free cash flow of negative $9.7 million after adjusting for foreign exchange. We subsequently ended the quarter with $185.6 million of cash equivalents in investments down $5.3 million from Q3. Looking back on the full year, our 2016 revenue came in at $252.9 million roughly flat to 2015 due principally to slower than expected ramping of our net new ACV in 2016 along with slight under-performance in Q4. The team continued to drive efficiency into the business and that showed in the P&L. For full year 2016 our gross margins grew over 300 basis points to 38.4%, our operating expenses were down almost 4%, and that led to an over $11 million improvement in adjusted EBITDA. With that I'd like to discuss our outlook for the first quarter and fiscal year 2017. As Chris mentioned we grew ACV by 8.2% in 2016, so we begin 2017 with our ACV at $266.5 million. However, Q1 contractions are having an immediate impact on our fiscal year 2017 expectations and that is reflected in our Q1 and full year guidance. We expect revenue for Q1 in the range of $55 million to $58 million down 3% to 8% from Q1 last year and non-GAAP gross margin in the range of 31% to 34% in the first quarter compared to 34.5% in the year ago quarter. We are forecasting non-GAAP operating expenses in Q1 of approximately $23 million. As a result in Q1 we expected adjusted EBITDA loss of between $1 million to $4 million and a non-GAAP net loss in the range of $1.5 million to $3.5 million or $0.02 to $0.04 on a per share basis. We assume a basic share count of 88 million shares and a normalized tax rate of 40%. We're expecting free cash flow to come in between negative $4 million and negative $7 million for Q1. I'll take a few moments to address our outlook for 2017. As Chris mentioned we expect 2017 revenues to be between $248 million and $258 million. We will continue to invest in our managed services business in 2017 and still expect progress driving efficiency. However, with the top line challenge we expect gross margin to come in between 38% and 40%. We have initiatives underway to expand our offerings to our clients which we expect to result in operating expenses between $92 million and $98 million for the year. These factors will combine to result in an adjusted EBITDA between $11 million and $15 million in 2017. Additionally we expect 2017 CAPEX to be $18 million to $20 million compared to 2016 CAPEX of $26 million as investment in facilities and IT abate. For the full year 2017 we expect free cash flow between negative $8 million and negative $12 million. Let me spend a minute commenting on the cash flow side of our 2017 guidance. With a change in revenue outlook as set forth in our 2017 guidance combined with the need to continue to invest to grow the business as outlined in part by Chris it is unlikely we will become consistently cash flow positive at some point in 2017. Getting to consistently cash flow positive is a key corporate and personal goal for Chris and me and as such we will continue to be maniacally focused on managing the expenses, improving profitability, and driving ROI discipline. And with that I will hand it back to Chris. Chris?

[Christopher Carrington:]

Thank you, Bob. While things like client challenges are outside of our control let me be clear that the entire ServiceSource team is not content to sit back and quietly accept our current 2017 outlook. We've experienced the setback that we will work through but it does not quell my optimism to what ServiceSource will become and I know we have a great team that is best positioned to get us back on track through consistent year-over-year growth. Before we open the call for questions I thought it would be helpful to share with everyone where we are on our multiyear journey and transformation and why my conviction for the business has not abated despite my disappointment with the 2017 guidance. I view our transformation in four phases; refocus, reinvest, revitalize, and reignite. During 2015 our phase one, we dramatically refocused the business. We consolidated two separate businesses into one company by harnessing the strengths of both our managed services and technology platform competencies. We prioritized our investments, our options, and our outcomes around a singular initiative of client centricity ensuring we either met or exceeded client expectations. While improving the outcomes for our clients, we improved the global operating performance of our business. These refocusing efforts in 2015 allowed us to increase adjusted EBITDA by more than $20 million in the face of a $20 million revenue decline. In 2016 we shifted to the second phase of our transformation of reinvesting for the future. First we opened and began client operations in our new Philippines and Bulgaria revenue delivery centers. Today between the two centers we have more than 400 employees and brand new state of the art facilities deployed with our latest technology platform enabling us to attract and retain the best talent in the respective regions. Between the two RDC's we are servicing 20 different clients with an expanded value proposition and have received great feedback from our clients in regards to our performance. As part of our 2016 phase two reinvestment plan, we upgraded our other RDC's and our IT infrastructure. In addition to improving our operations, this was an important step in revitalizing our workforce, attracting and retaining high caliber talent, and fostering growth with both existing and new clients. Importantly these investments have positioned ServiceSource with the capacity to scale more efficiently in the years to come. We also have invested considerable time and energy to ensure we are building a cohesive and resilient culture that is sustainable for years to come. The core of our culture is represented by the acronym grow. Growth beyond expectations, revolutionized revenue, and the outcome and win as a team. Today more than ever we're committed to ensuring growth is a shared expectation throughout outward inflation. By committing to our employees that we wish for them to grow personally, professionally and financially we know that in return they will strive to exceed our clients' expectations by revolutionizing how revenue will grow in the outcome economy. In meeting these expectations of ourselves we will win as a team. Our growth framework embodies the spirit and culture of ServiceSource and will sustain us in good times and through our challenges. In addition to the physical infrastructure expansion and investment in our people and culture we began the digital transformation of our business in 2016. We made considerable progress on migrating to our single global technology suite. We've consolidated from five platforms to three and on our way to a single global sales platform. The integration of our proprietary IP and best of breed tools and applications offered tangible differentiation to clients and prospects. Our new platform introduces automation of manual processes, enhanced knowledge management, a higher quality digital training experience, and improved analytics and business insights for both ourselves and our clients. Our new platform will allow us to leverage future investments and easily integrate new and innovative technologies. Most importantly enables us to expand our solutions well beyond our traditional renewals business. We expect our migration efforts to be completed in 2018 when the last of our legacy platforms will be retired and the resulting benefits of reduced spend and increased operating leverage will be more fully recognized. I am proud of the foundational work we accomplished in phase two which allowed us to re-earn our clients' trust positioning us for our next phase of revitalizing our business. As we move into 2017 and beyond, we are now shifting into the third and fourth phase of our transformation revitalizing how we can drive even greater benefits for our clients and reigniting growth. Although we remain the clear and differentiated market leader in our core renewals business, we are now uniquely positioned as a one stop shop to help clients find, convert, grow, and retain revenues at all points along with our end users customer journey. We are expanding the solutions we offer and the outcomes we deliver such as helping a high growth software company recruit and manage indirect channel partners in Asia. Migrating premise based SMB customers to the latest cloud solution for one of the world's largest technology providers and supporting a market leading SaaS company to achieve better premium to premium conversion through targeted demand gen and up sell campaign. We are now expanding into new solutions to drive revenue for our clients that even 24 months ago our embedded base clients would not have thought to ask us for. It is this seamless transformation of our people, our processes, our places of employment, and our technology platforms that are enabling deeper strategic relationships with our clients. In closing the B2B technology world is changing. No longer is it about buying technology assets whether those are hardware or software or is it a world where end clients wish to sign up for a four year license based agreement. End customers want to buy outcomes through a flexible dynamic business model where if the outcomes and value they're seeking are not achieved in 12 months they will move their business to the next technology service that does. More and more companies are challenged with this transition to a subscription based economy and outcome based pricing business model where ServiceSource has become a trusted partner in the transition. With a global and agile workforce united across a best in class technology platform, speaking 40 languages across 170 countries, we can adapt our B2B offerings and delivery to solve through their unique challenges. ServiceSource is revitalizing our relationship with each client and we believe we can become a more vital partner for our current and future clients. And with a growing and diversifying pipeline across the segments we serve and solutions we sell we are confident we're on the right path to reigniting growth. And with that Chelsea let's please open the call to questions.

[Operator:]

[Operator Instructions]. And our first question comes from the line of Patrick Walravens with JMP Securities. Your line is now open.

[Patrick Walravens:]

Okay, thank you. Chris I'm sure you're disappointed. I guess I have three questions and the first one, I always ask CEO' in this position, so when did you know?

[Christopher Carrington:]

Sure Pat. I'd start out and say for sure we are disappointed and this wasn't the 2017 that we envisioned. So we came through December as you know very optimistic and confident of the business that we were doing at that time. And as Q1 started to evolve over the past 45 days we were hit with a series of changes with certain clients whereby it started to have a significant impact and contractions resulting in turn that was outside our industry norm. So it evolved here in Q1.

[Patrick Walravens:]

Okay, and number two is so contractions, are we talking about the clients reducing the percentage that they pay you for the renewals, is that part of what a contraction is?

[Christopher Carrington:]

Well contractions really are predominantly made up of the opportunity under management that they're able to provide us for our sales teams to work. So in the case of the evolution of this Q1 we have several clients that were facing legacy client, legacy product and service reductions where there is some setting products and so the sales of those products and services aren't going as well as hoped. And so the opportunity given to us is being reduced. And another example, late in January one of our clients filed for bankruptcy, Chapter 11 and while we are optimistic of how we will work through that, that too resulted in a reduction of opportunity.

[Patrick Walravens:]

And then lastly big picture, what would you and I think you're trying to address this but let me just ask it directly, I mean do you have a renewals business with weak renewals, right so what do you say to investors who are going to say I feel like this undermines the investment gains for this business?

[Christopher Carrington:]

Well, I certainly don't agree with that thesis at all. In fact as I alluded to in my opening comments, we're optimistic about the business. We are seeing increases in certain sectors that are in certain cases allowing us more opportunity. Our fastest growing sector which is the cloud subscription business is growing rapidly as compared to our other sectors. We are offering more solutions to the market today than we were a year ago. More around customer success, inside sales opportunities as well as channel management solutions. And so this is a business that offers a lot more today than it did a year ago and candidly is in a far stronger position today than it was two years ago when I arrived or a year ago when we started 2016.

[Patrick Walravens:]

Okay, I guess maybe last one, how much more of this, I don't know if legacy is the right word but if this sort of business that you saw churn in is there, right I mean how much risk do investors have that we're going to see more of this as 2017 goes on?

[Christopher Carrington:]

Yeah, I think that our hardware industry that had faced some of these headwinds in the telecommunications space will be in transition. Now all of them are moving to cloud and SaaS and subscription based offerings and in many cases we're able to make those changes with them and we will be able to grow right along with them. Like our Q4 representative where we signed nine new logos, the vast majority of those logos were in the cloud subscriptions space and I think the investment community knows that that's a growing segment in the marketplace for technology and represents once again the vast majority of our growth going forward.

[Patrick Walravens:]

Okay, thanks for taking my question.

[Christopher Carrington:]

Absolutely Pat, thank you.

[Operator:]

Thank you. And our next question comes from the line of and Ed Maguire with CLSA. Your line is now open.

[Edward Maguire:]

Hi, good afternoon. I was wondering if there were any common threads across the customers that are facing challenges, is it an industry thing or there are secular issues or are they really company specific issues that your clients are facing?

[Christopher Carrington:]

Ed thanks for the question and for listening today. What we've seen across the handful of clients who have experienced this status for really discrete reasons, difference between clients as I just mentioned, one of them is in the telecommunications space and is facing some headwinds as they make their transition from I’ll say premise based solutions to cloud and services based solutions. In another case it was the bankruptcy of one of our large clients that has created some of the turbulence in transition and our opportunity and potential revenue in 2017. And then I'd say in other smaller instances there are different reasons as well and not all say within a singular segment.

[Robert Pinkerton:]

And Ed, this is Bob here. And additionally we have other clients that are in similar businesses that we're growing with. So this is something that we do not see as a factor issue and something really that's more discrete to a couple of the larger clients that we have. And that's really one of the foundational reasons why we still feel that our long-term model is valid and that we are still excited about the future we have coming out at us and view this really as a temporary setback that really pushes kind of our growth trajectory, etc out a couple quarters. Nothing that's really -- it’s nothing systemic.

[Edward Maguire:]

Okay, now you did mention you’ve expanded the field sales pretty significantly I guess by 20%. You know where -- what areas whether it's types of customers or industries or regions are you targeting and where do you see potential upside into your current expectations or I guess potential upside to current guidance in terms of ACV opportunities?

[Christopher Carrington:]

Sure Ed. Well we felt strong enough about the global marketplace that we actually had growth in our sales team within all of the three regions both within the Americas, EMEA, and APJ. So we were able to add all three. If I look at 2016, our faster percentage growth was occurring in Europe and in Asia. But clearly the Americas rep continues to represent a big part of our revenue and a big opportunity for us. As I alluded to on the prior question, the fastest growing segment of the five that we cover hardware, software, cloud, healthcare, life sciences and industrials is the clouds subscription space and so I would say that we've we definitely invested a little bit more in that area because that's where the market is moving.

[Edward Maguire:]

Okay, and regarding the harmonization or I guess some of the common technology platform that you're seeing, you're really finished by 2018. I mean should we look at 2017 as really sort of final phase of investment and retooling in the business and once you're on a common technology platform what type of benefits do you see playing out through the business?

[Christopher Carrington:]

Sure Ed, good pick up on a point there. Yeah, we anticipate this will be a heavy year for our ongoing digital transformation project that really revolves around our platform. In 2016 as we alluded to in many calls before it was really around our physical plant in a sense and infrastructure to create the right working environment for our employees. We had started the digital transformation on the one sales platform but it will be pretty significant here in 2017. We believe we will start to wind that down sometime around mid part of 2018 and we think the benefits are that some of the final components in our solution that move us towards our target model of enabling double-digit top line growth are very importantly the ongoing expansion of our operating margins around gross margin to mid 40's and then contributing to our bottom line profitability of mid teens for EBITDA. So we do think it's an important part of our solution and it will be a busy year around that.

[Edward Maguire:]

Great, thank you.

[Operator:]

Thank you. And I'm not showing any further questions at this time. I would now like to turn the call back to Mr. Chris Carrington, CEO for any closing remarks.

[Christopher Carrington:]

Chelsea, thank you and thanks for everyone's participation today. Clearly not the 2017 we had envisioned. But I remain with the team very committed to the potential the market has for us in the marketplace, if I think about it here in Q1, if it wasn't for the unexpected Q1 contractions that were mostly related to legacy client products and services. In 2016 we sold 19% more ACV than we did in 2015 and we reduced our 2016 churn by 28% as compared with 2015. But as we shared in our opening comments of the contraction in Q1 are significantly higher than industry norms of 5 to 15. I think there's the situation where I think we performed, we did well by our clients, we got a lot right in 2016, and we're set up for a solid 2017.But we had not anticipated a few of our key clients having the headwinds that we did experience. With that we're looking forward to 2017 that's going to provide good results for our clients and for investors. Thanks Chelsea.

[Operator:]

Thank you. Ladies and gentlemen thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone have a great day.