ServiceSource International, Inc.
Q3 2015 Earnings Call Transcript

Published: 6 Nov 2015

[Operator:]

Good day, everyone, and welcome to the ServiceSource Third Quarter 2015 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. 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 that reflect our views as of today and are based upon the information currently available to us. This information will likely change over time. By discussing our current perception of our market and the future performance of our company and our solutions with you today, we are not undertaking an obligation to provide future updates. We caution you that such statements are just projections and actual events and results may materially differ from what we discuss. 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. Please note that we reference non-GAAP revenue, which excludes the impact of the haircut to deferred revenue from our acquisition of Scout Analytics, as required by purchase accounting. The remainder of our non-GAAP metrics do not include non-cash expenses related to stock-based compensation, the amortization of internally developed software, amortization of intangibles acquired from our acquisition of Scout Analytics, acquisition-related costs and non-cash interest expense related to the issuance of convertible notes. 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:]

Erik, thank you. Good afternoon and thank you for joining the ServiceSource Q3 fiscal 2015 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 2015 financial results, share some updates on 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. I’m pleased to share that Q3 2015 was yet another solid quarter as we came in at the high end of our revenue guidance at $59.5 million. We continued to expand our gross profit margin, which improved 5.2 percentage points to 32.4% of revenues as compared to 27.2% in Q3 of 2014. Our trend and discipline around expense management continued as reflected by the Q3 year-over-year operating expense reduction of 18.4%. Hitting our revenue guidance, expanding our gross profit margin and reducing our operating expenses led to a significant $6.1 million to our Q3 adjusted EBITDA year-over-year. At the beginning of the year, we announced our intent to focus on five key initiatives that would get us through the 2015 turnaround

[Robert Pinkerton:]

Thank you, Chris. Today, I will share our Q3 2015 financial results, give some color on the drivers of our business, and provide guidance for the fourth quarter of 2015. 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. In Q3, our revenue came in at the high end of guidance and we were able to control cost in both cost of revenue and operating expenses. This led to better than expected profitability and a significant improvement year-over-year. As Chris mentioned, we continued to deliver churn results consistent with historic norms. Now, turning to results, our non-GAAP revenue was $59.5 million, a decrease of 8.5% from the prior year. Non-GAAP gross margin was 32.4%, up 5.2 percentage points year-over-year. I’ll now turn to our business segment review, starting with Managed Services. Q3 non-GAAP revenue for Managed Services was $53.3 million, down 5.9% year-over-year. Non-GAAP gross margin for Managed Services was 29%, up 4.5 percentage points from a year ago as a result of disciplined management of our Managed Services operations and increased efficiencies. For Cloud and Business Intelligence, Q3 non-GAAP revenue was $6.2 million, down $2.2 million from last year, but above our guidance due to implementation fees related to a recent expansion with a large customer using Renew and professional services related to adding new Renew functionality. Non-GAAP gross margin for Cloud and Business Intelligence was 60.7%, up 15.4 percentage points from a year ago as a result of lower support and operational costs, offset by lower revenue. Moving on to operating expense and profitability, our non-GAAP operating costs came in below guidance for the quarter at $22.3 million, down 18.4% or $5 million from last year’s Q3 OpEx of $27.3 million, due principally to continued operational discipline. Adjusted EBITDA for the third quarter was negative $1.3 million, better than the negative $7.4 million in the prior year and our guidance of a loss of $5 million to $8 million. Our non-GAAP net loss in the third quarter was $2.1 million, or a loss of $0.02 per share, better than the $0.08 loss a year ago. This quarter’s result reflect that we continue to make progress in the turnaround of the company, particularly from an expense management perspective. As will be the case in future quarters, this quarter we were highly selective in how we invested the company’s resources with the goal of maximizing ROI for ServiceSource and performance for our clients. We saw improved results both in cost of revenues and operating expenses. The energy, commitment, and, frankly, ownership of the ServiceSource team is driving client success at the same time we improved operations has been impressive. That said, while we’re managing costs, we’re also making important investments aimed at driving expanded service and technology for clients, as well as increase revenue and profitability for ServiceSource. The investment in our Philippines center is more recent and important example. Looking forward, we expect to increase our investment in our clients and the business, always driven by a strong ROI discipline. Now, turning to a brief review of the balance sheet and cash flow metrics, DSOs in Q3 were 85 days, up from 84 days in the second quarter of 2015. Cash flow used in operations was $3 million. CapEx was $3.2 million, which included $2.1 million in capitalized development, resulting in negative free cash flow of $5.8 million after adjusting for foreign exchange. With respect to our stock buyback program, we repurchased [158,900] shares for a total spend of $651,000, not including commissions, equating to an average price of $4.10 per share. We subsequently ended the quarter with $210.6 million of cash, equivalents and investments, down $3.6 million from Q2. Turning now to guidance for the fourth quarter of 2015, we expect consolidated non-GAAP revenue for Q4 in the range of $61 million to $64 million. We expect consolidated non-GAAP gross margins in the range of 34% to 37% in the fourth quarter, compared to 37.8% in the year-ago quarter. We are forecasting non-GAAP operating expenses in Q4 of between $26 million and $27 million. The sequential increase in operating expenses is due [roughly equal parts] to normal seasonality in our sales and marketing expenses and one-time investments to accelerate the turnaround such as developing the Philippines center. As a result, in Q4, we expect adjusted EBITDA loss in the range of $1 million to $4 million and a non-GAAP net loss in the range of $1 million to $3 million, or a loss of $0.02 to $0.04 per share. We assume a basic share count of 86 million shares and normalized tax rate of 40%. In our business segments, we expect Managed Services revenue of $56.5 million to $59 million, reflecting a decrease of 12% to 15% year-over-year. For Cloud and Business Intelligence, we expect revenue of $4.5 million to $5 million, down 39% to 45% year-over-year. We are expecting free cash flow to come in at negative $7 million to negative $10 million for Q4. And with that, I’ll open it up for questions.

[Operator:]

[Operator Instructions] First question comes from Ed Maguire from CLSA.

[Edward Maguire:]

I wanted to ask about the investments in the Philippines, what has prompted that? I know, if I understand you guys, you had a presence in Singapore, but is this really – what’s driving that? Is it – are there cost advantages, do you have customers that are going to better served by a local presence and what geographies are you looking to service from the Philippines?

[Christopher Carrington:]

We’re in Singapore, we’re also in Kuala Lumpur where we do much of our back office today. And the Philippines provides a 7/24 solution. So today in Singapore or KL the markets don’t really support the 7/24 solution. And when we think about back office operations, our ability to [indiscernible] enablement 7/24 can really speed the sale cycle back to our clients. So that’s the new level of service that they’re excited about and a new service level looking forward to. The Philippines market obviously has been evolving marketplace for Managed Services for a decade now and it’s truly access to labor pool that’s very talented and can provide English-based skills worldwide for us. So it provides a lot of new opportunities for us and most importantly it prepares us for the new growth that we’re starting to see in our pipeline and new deals that we’ll be selling in 2016.

[Edward Maguire:]

You had made reference to how a number of your customers are seeing this transition from products to subscription businesses and I think that if you look across the technology landscape, it’s a recurring theme. What role can you play in helping customers manage this? And the reason I ask is that as you see this transition, I mean, it’s a very different role for ServiceSource, for you guys that traditionally been able to capture a lot of unrealized value from renewals that weren’t successfully being executed, but now as you move to a different model, you move from being [indiscernible] again and that’s a different mindset. So I appreciate your thoughts on that.

[Christopher Carrington:]

The good news and I think why a number of current customers and prospects are turning to us is we’ve actually been working in what we call the revenue lifecycle management field for about four, five years now if I think of several of our clients, probably about a half dozen that we’re providing a variety of services who are early adopters of the shift from prem-based solutions to cloud based subscription world. And within that, what certainly adopters realized and more and more large software-based companies removing the cloud are realizing is that the renewal event isn’t as much guaranteed or certain if you’re not doing a right set of activities across the roadmap of that revenue lifecycle. What I mean by that is if I once sold you $1 million of software in day one, you’re essentially locked in for five years, whether you use the product or not, whether you like it or not. And in today’s subscription based world, the buyer has much greater flexibility. And so if they’re not properly onboarded, which are services that we’re providing say like activation assurance, making sure that people actually digitally turning on their software licenses, whether they’re not adopting the software correctly, or if you’re missing out on those opportunities to cross-sell/up-sell, the renewal event becomes at risk. And so we’re going backwards sin that lifecycle more and more for many of our clients to support them in onboarding, adoption and cross-sell/up-sell based activities. And we’re using, once again, our technology that helps us with the analytics of understanding who to call within that revenue lifecycle, because they have a million customers, they can’t call every one of them. But if you can understand customers that are, say, not using your product very heavily through usage based analytics, our revenue analytics product, then you can know you should call them because they’re at churn risk early, whereas if you see a client or a customer using the product extensively, they’re a great call to make that you can cross-sell or up-sell them on other features or capabilities or other modules. And so it’s really that intelligence that we bring to the revenue lifecycle that positions us as a great partner to our customers.

[Edward Maguire:]

And one final question which is that the 4Q guidance for the Business Intelligence and analytics is still down pretty significantly year-over-year. And I think there was an expectation certainly well before you joined that that could be a much larger part of the business, I mean, what were you seeing for the BI and cloud, has it become – did it have more of a cannibalistic effect or was it more difficult to sell within the context of the overall Managed Services business or now you’re just finding that customers just prefer the traditional Managed Services opportunity and the analytics is much more value-add when it’s utilized within the framework of your traditional business?

[Christopher Carrington:]

Ed, we’re really seeing the market evolve, right, and as we take more and more to the marketplace not just either our cloud and business intelligence solution or just a pure-play managed service, but more of a technology-enabled solution, we’re seeing that the role that analytics really goes across that lifecycle. And so in many cases, we can use our own technology within the Managed Services arena to provide that overall solution in that insight and business analytics for our clients. And so once again, going back more than a year, we were kind of separated where we had a cloud and business intelligence selling direct to the market and we were just selling a pure-play managed service. And we’ve really taken these two capabilities, combined them together to create an overall tech-enabled solution for the marketplace. And so we still do see, by the way, opportunities to sell our software on a standalone basis. In fact, three of our 12 deals in the quarter were included to this cloud and business intelligence and then several deals were a combination of both and then other deals were just a pure Managed Services play. So we’re really seeing it evolving and we’re excluding ourselves from opportunities by not really merging our capabilities to create one singular tech-enabled solution offering to the market.

[Operator:]

Our next question comes from Pat Walravens from JMP Group.

[Patrick Walravens:]

My first question would be what did attrition do in the quarter? Did it tick up, tick down, stayed flat?

[Christopher Carrington:]

Our customer attrition or churn really stayed within historic norms. We talked about that stat back in February when we experienced really an abnormal churn rate back at the end of 2014. And since then, both in Q1, Q2 and Q3, it really stayed in that 5% to 15% industry norm of churn. And so once again in Q3, we were within that range.

[Patrick Walravens:]

And then I heard you mention growth in 2016 in your remarks, so how you think investors should think about what you guys can do in 2016 in terms of growth in margins?

[Christopher Carrington:]

I’d say first on the top line, as I said in my opening comments, as we’ve started to complete the financial turnaround of our business and we start moving more towards even bottom line profitability, we’re really able now to focus on the top line and expand the offerings that we take to the marketplace. And I think that’s starting to show up. Our beginning period of the quarter, of our sales pipeline is larger than it’s been in years, so that’s positioning us well for growth in 2016. Our deal sizes are increasing in size for three sequential quarters in a row, so that’s positioning us well for top line growth in 2016. Much like I alluded to the comments back in Q1, when I talked about hiring a new Chief Customer Officer and Chief Sales Officer, we’re really pleased with what Greg has accomplished since April. He has rebuilt the sales leadership team, he’s got us refocused and refined, he’s driving profit to us much more, he’s also enabled our account management teams to be much more involved in the pursuit of growth oriented business. And so a lot of things are starting to come together that really give me the confidence 2016 will be a year of top line revenue growth.

[Patrick Walravens:]

On the margin front, how should we think about it?

[Christopher Carrington:]

As we suggested in 2015 and as we’ve demonstrated even in this past quarter as well as across the entire year, we’ve been expanding our gross margins as we’ve been making investments. So I would suggest you that our gross margin improvement over the last three quarters has been even greater than what you see in the line, because that line includes investments that we’re making at the same time. We’re making those investments such that we can return gross profit margins to their historic norms, north of 40% which we’ve seen historically. And we believe we’re on the continued path to do that through the course of 2016. And in any given quarter, if we accelerate investments like we’re doing here in the Philippines more than the savings we create in any given quarter, there might be still a little choppiness, but much like we’ve demonstrated in 2015, we believe 2016 will be another year of improving gross margins. You add that for the controlled discipline we’ve put in around our operating expenses, we think operating expenses will continue to decline as a percent of overall revenue as we start growing the top line. And therefore, the bottom line will continue to improve.

[Robert Pinkerton:]

If I could also step in and just recognize that we’re playing this for the long haul and we’re going to make investments and continue to do that. So while we’re improving margins, there is a significant focus for us as the management team to make sure that we’re investing for long-term growth of profitability.

[Patrick Walravens:]

And then last one from me, in general, a remarkable job turning around this business. Is there anything, Chris, in Q3 that you would have liked to have seen be better?

[Christopher Carrington:]

We actually – I mean, we are set up well for Q4 because candidly a couple of deals – you always like to get them done within the quarter and a couple of deals slipped, so we would have had a even better sales quarter, new ACD quarter, but that fell actually in Q4. So we’re excited about that. Candidly, I’m just pleased overall. As I think about the chemistry, the new executive leadership team and how we’ve all come together and started to work together well, the amount of time we’re spending in the field with our employees, with our customers, with our prospects, I think about two meetings I’ve just had with current customers, one was on a net new piece of business and we walked in and it’s probably about $1 million piece of expansion, and by the time we walked out, it looks like it’s going to be a $4 million to $5 million piece of expansion. And I would tell you that type of conversation wasn’t even available to us nine months ago. I was in another meeting here just recently with a client, we were doing a quarterly business review, and we had had yet another very successful quarter for the client. And at the end of the meeting, the response was, you know, I’ve been thinking about it at all meetings, but I need to introduce you to a friend of mine over another company because they could use ServiceSource as a partner as well. So now we’re getting references from our clients. So I’m not sure there is anything in Q3 that didn’t meet my expectations, considering the entirely new management team and the amount of change we’ve been putting in place. I’m pretty pleased with our performance.

[Operator:]

Our next question comes from Tim Klasell from Northland Securities.

[Tim Klasell:]

Just a real quick question. As you expand into the Philippines, just a housekeeping thing, what’s the FX on your operating expenses exposure? How should we start thinking about that, if there is a wild swing between the currencies?

[Robert Pinkerton:]

As you know, we have offices all around the world now. So we manage FX with a strong discipline, adding Philippines people and business there is not going to significantly change, which you’ll see from an FX perspective in our P&L or balance sheet. Frankly, for a company of our size and what we do, the FX impact is very modest. So we don’t see that as having any significant change to our financials at all.

[Tim Klasell:]

As we think of the analytics business and the core services side, in your pipeline, how many of your deals do you see include both? And maybe you can give us a little bit of color on what we should be thinking about for 2016.

[Christopher Carrington:]

We’re actually seeing an increasing number of deals that include both, because especially as I referred to earlier around revenue lifecycle management, 15 customers moving from prem-based solutions to cloud-based solutions [indiscernible] customers and prospects who were born in the cloud, more and more there is a greater dependency for analytics based capabilities such that you can identify usage patterns, identify adoption pattern, identify churn risk within the quarter or along the course of the year. So you can once again truly help the client. So as I think about it, especially in Q4, almost all of our deals are partnered now with our technology and whether they’re either embedded in the overall service tech-enabled solution that we provide or there is a licensing component of that, we’re seeing more and more of our deals include both aspects of our business.

[Operator:]

I’m showing no one else in queue at this time. I’d like to hand the conference back over to management for closing remarks.

[Christopher Carrington:]

Great. Thank you very much. It was a great quarter, really pleased with how we finished out. But I’d be remiss if I didn’t think through this and share that how proud I am of our new leadership team and the 2,800 employees of ServiceSource around the world for having really just a great first nine months of 2015. During the course of these nine months in our turnaround, we’ve expanded gross margin by 3.8 percentage points, we’ve reduced operating expenses by 22.2%, we’ve improved EBITDA by $22.8 million, year-over-year improvement. Our sales pipeline is increasing. We had our third quarter in a row of sequential improvement to sales. And even more than the great financial story, I’m really impressed with our efforts and our energy focused on our culture of customer centricity. And I think what we’ve accomplished in 2015 to date and we’ll do in Q4 really sets us up nicely for 2016 to focus on top line revenue growth. So looking forward to what’s ahead of us. And I thank everyone for their time and attention and interest in ServiceSource and we’ll talk to you again soon.

[Operator:]

Ladies and gentlemen, thank you for participating in today’s conference. This concludes our program. You may all disconnect and have a wonderful day.