Zix Corporation
Q1 2021 Earnings Call Transcript

Published: 6 May 2021

[Operator:]

Good afternoon. Welcome to Zix first quarter 2021 earnings conference call. My name is Howard and I will be your operator today. Joining us today for today's presentation are the company's President and CEO, David Wagner, CFO, David Rockvam and Chief Marketing Officer, Geoff Bibby. Following their remarks, we will open the call for your questions. I would like to remind everyone that this call will be recorded and made available for replay via a link in Investor Relations section of the company's website. Now I would like to turn the call over to Geoff Bibby. Sir, please proceed.

[Geoff Bibby:]

Thank you operator. Good afternoon everyone and thank you for joining our first quarter 2021 earnings conference call. On the call today, we have our CEO, Dave Wagner and our CFO, Dave Rockvam. After the market close today, we issued a press release announcing our results for the first quarter ended March 31, 2021, a copy of which is available in the Investor Relations section of our website at www.zix.com.

[Dave Wagner:]

Thanks Geoff. Good afternoon and thank you everyone for joining us today. In the first quarter, we delivered consistent overall results, reflecting our continuing commitment to drive profitable growth. We delivered 14% growth in revenue and ARR in Q1, along with an 18% increase in adjusted EBITDA dollars and solid cash flow from operations of $10.7 million in the quarter, which is more than double the amount we generated in Q1 of last year.

[Dave Rockvam:]

Thank you Dave and good afternoon everyone. The first quarter of 2021 marked another period of consistent profitable growth, increased year-over-year adjusted EBITDA dollars and strong cash flow generation. Looking at the numbers in more detail. At the end of Q1, our ARR totaled $243.6 million, up 14% from Q1 of last year. Our cloud-based ARR grew 20% over Q1 of last year and comprises 88% of our total ARR or a record $214.3 million. New customers added in the quarter totaled roughly 3,900. For the first quarter, our net dollar retention was 98% which represents our renewals plus new sales into the installed base divided by the renewals that were available at the beginning of the quarter. Both new customers and net dollar retention were slightly lower than the last two quarters as we felt some impact from the COVID induced SMB slowdown in January and February. This slight slowdown is right in line with the dip in the December, January and February NFIB Small Business Optimism Index which dropped from 104.7 in November to 95 in January. The index did come back up to 98.2 in March, in line with our business performance. We have yet to see the April number but we were pleased to see a rebound in both new customers and net dollar retention in both March and April for Zix. Dave will provide more color in the context of our growth pillars, but we continue to be encouraged by our ability to grow ARR at a double digit rate and maintain solid retention rates.

[Dave Wagner:]

Thanks Dave. Our financial results underscore the growing role Zix is playing in empowering businesses of all sizes with technology to drive cloud adoption, facilitate digital transformation and protect communications. As we noted on our last call, 2021 will be a year transformation for Zix. Our transformation plan is built on the same three growth pillars. New partner and customer acquisition, partner and customer add-ons and retention. I will take a few minutes now to provide updates in each of these areas. Beginning first with new partner and customer acquisition. In Q1, we added about 3,900 new customers, of which approximately 89% were added by our MSP partners, which was up slightly from 88% last quarter. Some key MSP partner wins in the quarter included a new U.K.-based MSP who once consolidated Office 365, cloud backup and advanced threat to a single trusted provider with superior support. We had another win with a U.K.-based MSP who recognized the value of being a Zix partner and the benefits of consolidating a cloud backup and Office 365 with security auditing into one provider. They have already moved nearly 1,000 seats on to our cloud backup solution and we have an opportunity to sell more to this partner as this relationship continues to grow. Three of our top five new partner wins included cloud backup in the quarter. All five of our top new partner wins were international with three in U.K. and two in Germany, the latter being a major focus for us this year. While we are just getting started with our expansion into Germany, our early traction is encouraging and validates our investment thesis. Broadly speaking, vendor consolidation by partners is a growing trend and Zix's MSP partners are realizing tremendous value from our broad portfolio of products focused on their most critical security and compliance needs. On the value-added reseller and direct side of the business, our top five wins in the quarter included four in healthcare and one in finance. Turning to our second growth pillar, which is sales to existing partners and customers. A key source of growth driver is sales to existing customers through partners. In the first quarter, sales to existing customers through MSPs accounted for 44% of the MRR increase in the quarter, which compares to 46% last quarter. As Dave mentioned, we saw a decline in sales to existing customers in Q1 from what we experienced in Q3 and Q4. The good news is that the sales to existing customers began to recover in mid-March and April sales to existing customers were the strongest month for the such orders since we have owned AppRiver. Our interpretation of this modest slowdown in Q1 is that it was a result of the COVID surge we saw in late winter and that the March, April recovery bodes well for our outlook. In terms of our top five add-ons through our VAR and direct sales team, three were in healthcare and two were in banking. The largest was a meaningful six-figure add-on for an encryption-only customer. We also secured a meaningful add-on with a financial institution who licensed Zix products, including cloud backup. Moving to our third growth pillar, increasing retention. Total company net dollar retention was down slightly to 98% in Q1 from 100% both last quarter and in Q1 last year. Gross retention at the company level remained over 90%, consistent with historical trends. Our net dollar retention was impacted in the quarter due to lower sales to existing customers as discussed earlier and also due to churn and Microsoft Hosted Exchange or HEX. The rotation from HEX to Office 365 accelerated in Q1 for two reasons. First, it appears that more cloud email migrations were planned for early 2021 than normal. So we saw a seasonal work from home induced acceleration. And second, the program we instituted earlier this year to proactively market our HEX to Office 365 migration capabilities probably accelerated migrations as well. To be clear, the rotation to the cloud remains a point in our favor and we are leaning into it. Our cloud retention rates remain very strong and our overall net dollar retention in April was back over 100%, driven predominantly by the strongest months for AppRiver since we acquired the business in 2019. Our increased topline guidance for the year reflects all of these factors. Our acquisition of CloudAlly was very well timed and has performed exceedingly well since joining Zix last November. In fact, CloudAlly's ARR has hit record levels each of the last three months and they recently secured their largest deal in company history, which was a six-figure ARR win. Cloud data backup is playing an increasingly critical role within a secure modern workplace and we have a leading solution to address that growing need. We are seeing strong attach rates and adoption of cloud backup by our partners. In summary, we believe Zix is well positioned. Our cloud momentum has us on track to realize our goals for 2021 including delivering $56 million in adjusted EBITDA while also setting us up for more success as we continue to focus on profitably growing the company to $500 million of ARR by 2025. That concludes our prepared remarks. Operator, we are ready to open the call for questions. Operator?

[Operator:]

. Our first question or comment comes from the line of Nehal Chokshi from Northland Capital. Your line is open.

[Nehal Chokshi:]

Thank you. And congrats on the upside in the quarter and the $3 million guidance increase at midpoint, that's fantastic. Just to be clear, I know you said there is a lot of the different drivers there. But simplistically, AppRiver versus core offering which one was the bigger driver here?

[Dave Wagner:]

You are talking about at the whole company level, that's really primarily how we looked at it, Nehal, Those trends that we talked were real consistent across all parts of the business. Really good momentum, especially later in the quarter and here in April and kind of across all parts of the business, just a little bit of SMB draw down in January, February period.

[Nehal Chokshi:]

Okay. Go ahead.

[Dave Wagner:]

The other thing that we call out was the hosted exchange, which was just a little dip for us. And when you think back, it makes a lot of sense that cloud rotation that happened in 2020, lot of customers were waiting to year-end to make that change and we further incented that change. So that was the one other thing that was just kind of a different business trend than the rest of the business. So those are the ones we highlighted, Nehal.

[Nehal Chokshi:]

I see. Okay. But what do you think is behind the acceleration in the month of March? Is it easier comps? Or is there something more fundamental going on there?

[Dave Wagner:]

That's why we use those NFIB stats. So we just feel like it was really a market thing. I don't know what other SMB players are at. But we really thought it was just really tightly correlated to market. April, as you know, was a superstrong month in the SMB segment of the economy. We certainly saw that.

[Nehal Chokshi:]

Got you. Okay. And great to hear about the great success that you are having with CloudAlly. Do you think that has anything with the news items of accelerating ransomware across the cyber security universe that's driving that? Or do you think there is something else that's driving that?

[Dave Wagner:]

No. I think I you are exactly right. The ransomware and recognizing the value of the cloud data workload is that's what we talked. First part of COVID is just rotation, work from home which did drive a lot more cloud adoption. And that's why we also think it was really well timed. We were close our partners through that period and close to our customers in recognizing that's where they would be going next as they come out to this new hybrid workplace with a lot of cloud data workloads. So we think it's still really early for backing those up. We are seeing great success, continued the number one workload is, of course, Office 365. But sales force really right behind that is the second biggest cloud data we are backing up.

[Nehal Chokshi:]

I see. Okay. And my final question is that, it's great to see that you are guiding, I don't know if you are guiding, but targeting $500 million in ARR by calendar 2025. If I see that on a five-year basis, that gets a 16% CAGR. So you did have a slight acceleration in this most recent quarter. Is it fair to assume that you are expecting continued acceleration to this subscription rate by the end this year?

[Dave Wagner:]

Yes. So obviously, we are very pleased with the acceleration that we are seeing. When we talked about the $500 million, we were leaving a little bit room for inorganic work as well. So at 15% where we are today, there is $30 million of acquired ARR that would get us to the $500 million. So that's exactly how we are looking at it. Building momentum, continuing to look for tuck-in technology that can further accelerate that rate and accelerated through it.

[Nehal Chokshi:]

Okay. Great. Thank you.

[Dave Wagner:]

Thank you Nehal.

[Operator:]

Thank you. Our next question or comment comes from the line of Nick Mattiacci from Craig-Hallum. Your line is open.

[Nick Mattiacci:]

Hi guys. This is Nick Mattiacci, on for Chad Bennett. Thanks for taking our question. So have you guys started to migrate legacy customers on to Secure Cloud? Are you seeing customers use this as an opportunity to add additional products? And then just overall, do you see the number of services per mailbox continue to tick up? How should we think about having on impact on net retention and gross margin?

[Dave Wagner:]

Okay. I will take the first part of the question and let Dave come back in on the attach rates and the gross margin dollars. So we are seeing an acceleration of the migrations to secure cloud. As you know, Nick, we finished up with that work late 2020 to get all of the best features of, what we will advanced email encryption into Secure Cloud. So that's the migration point for our customers. That coupled with just the cloud rotation, to give you kind of a sense of how that's accelerated. A year ago, we touch these customers all the time and a year ago it was about 20% wanting to move to the cloud in the next 12 months. We have 60% of the customers we touched year-to-date moving to the cloud either now or within the next quarter or two. So we timed well to have that capability ready, timed well in order to enhance that cross-sell. And then the other big migration cohort happening now that's going really well is that over 2,000 SMB hosted customers are moving across with great success as well. So that program is moving are really well. Thanks for checking in, Nick. And I will let Dave kind of hit the cross-sell.

[Dave Rockvam:]

Yes. On the attach, it's going well. We always want more. We are looking at that growing a couple hundred basis points, couple hundred tenths of points every quarter. So we were 1.31 in total. We would like to see that get close to 1.4 towards the end of the year. So we are working towards that with the team as far as we look at cross-sell. Getting the U.K. team, continuing to focus on the additional products that they now have to sell, especially when you look at the CloudAlly add-on. That brings a lot of opportunity for cross-sell. Launching in Germany this month. We are really excited about that and the teams we have been able to bring on there to get the cross-sell going in Germany as well. So we got that. And then the gross margin dollars. We look for gross margin dollars increasing in the next couple of quarters. As Dave said, we had that significant HEX to Office 365 rotation this quarter, early in the quarter, which was great because we retained a lot of those customers. It flattened the gross margin a little bit in January, February on the dollar side but with what we are seeing in March and April, we are looking for that to pull back up in the second quarter. So we would expect to see gross margin dollars increasing. A big part of why we can maintain that $56 million of EBITDA for year-end.

[Nick Mattiacci:]

Got it. Thank you. And then a year ago, now we are talking about customers downgrading to lower price Office 365 SKUs. I was just wondering if kind of saw any similar impact in the quarter over that that you are talking about SMB?

[Dave Wagner:]

Yes. That's a very good reminder. And it was different that time. It was not, the churn was super solid. We did not see that price sensitivity. It' just a slowdown in the addition of seats in the installed base. That was a good questions. It was not due to skewing down like we did last March.

[Nick Mattiacci:]

Okay. Got it. Thank you.

[Dave Wagner:]

It was a great question.

[Operator:]

. Nehal Chokshi from Northland Capital. Your line is open.

[Nehal Chokshi:]

Thanks. So just to be clear, the reason why the gross margin declined this quarter was because the acceleration to cloud migration, acceleration of cloud from basically hosted exchange to the cloud hosted. Is that correct?

[Dave Wagner:]

That's right. Yes, that's right. It's the Office 365 carries a little bit lower gross margin for us. So as that the rotation happened, it brought the gross margin dollars down. I think it was down $100,000 quarter-to-quarter. But we have saw that got off a little bit in March and April. So we are looking at that to grow in Q2 and the subsequent quarters.

[Nehal Chokshi:]

Right. And can you explain why that's a long term positive?

[Dave Wagner:]

So the long term positive, Nehal, I think it is a very clear positioning of Secure Cloud as a platform for MSP partners to consolidate these services. So the higher margin HEX we have known for a long, long time but that's not the future. The future is the cloud solutions for productivity, security and compliance that we provide including Office 365. So that's the growth area we are leaning into and that profit flow from HEX is one that we are managing transition.

[Nehal Chokshi:]

I am sorry. When you HEX, can you just explain what that means basically?

[Dave Wagner:]

I am sorry. hosted exchange and we call it HEX. It's H-E-X. My accent is coming through, sorry. H-E-X, HEX.

[Nehal Chokshi:]

Got you. Okay. And so this gives you the clear position to move customers to Secure Cloud and therefore attach additional services and I think they get some additional data, at least on the what the trials were which is the route towards adding the additional services. Can you run through that data in terms of how that's proceeded from last quarter to this quarter and maybe over the past few quarters as well?

[Dave Wagner:]

I will take a cut at that. We didn't have it in the script. So the trials are tightly correlated, obviously, with the net seat adds. And so trials were off a little bit as we described in the net seat numbers in that December is always a low trials month because IT folks take the time off. So it was the January, February, trials were down. March saw a really nice increase, which led to the best April since we have had AppRiver. So that's kind of the trial rotation window. And it's just a month. It precedes the seat adds by a month.

[Nehal Chokshi:]

Okay. So then what other metrics that give you confidence that you will be able to attach additional services as customers migrate from hosted exchange to cloud based subscription?

[Dave Wagner:]

Okay. Good. So thank you for that clarification. So going back to the package that we put together for our SMB clients into our installed base, not our partner's installed base, the direct portion of our installed base, we have been marketing a package to them that moves them to what we think is the best offer, which is the Office 365 productivity suite plus advanced threat plus archive and encryption, if they are a compliance-oriented buyer and on that cloud backup. So stacking together at least three services with that migration offer. And we have done more hosted exchange or on-prem exchange to Office 365 migrations, probably than any company in North America. We are over 19,000 migrations. We are really good experts at that. And so that's a real strong capability that we have that these customers in migration value.

[Nehal Chokshi:]

Okay. All right. And then there is also this on-premise email exchange, HEX? Do you think that's also been a driver of the accelerated migrations that you are seeing?

[Dave Wagner:]

So I actually think, well I know, that we do a fantastic job on behalf of our partners and our customers operating the hosted exchange servers. We have a team that's been doing that for a long time and really, really best-in-class. We collaborated really closely with Microsoft on that. Our partners and customers, our partners in particular, were really complimentary of the work we did, the communication we offered. And the SMB customers tended not to be as aware of what was going on. So we think it's more of an opportunity for us with that capability we have for some of the mid-market buyers who haven't yet moved to be there is a really good option. But I think what you are alluding to, Nehal, is that the on-premise exchange servers that are still in existence, those are going to get a really, really hard look for upgrade this year, which I think will help contribute to further acceleration as an expert in making those migrations happen. We will have the slight offset that we have talked about. We have our own hosted exchange customers that we are working to migrate as well. But the partner side of that is holding in quite well. And so anyway, it's a balance with the overall, we think, the net positive because we do some of these migrations.

[Nehal Chokshi:]

Got you. Okay. And then finally, for Dave Rockvam. You did say that you have confidence that gross profit dollars will increase Q-over-Q into the second quarter. Can you review the reasons on why that is?

[Dave Rockvam:]

Yes. It has to do with the March and April sales that we saw. So we had the Office 365 really bump up with the hosted exchange in January and February. We continue to see the growth of Office 365 into March and April for sure .And we saw gross margin dollars there. But then we also continue to see growth in the IP products. And that's where we are seeing the gross margin dollar increase. So we are pleased with the March and April numbers that we have seen. Now that we are May 5, we have confidence we will grow gross margin dollars this quarter and in the coming quarters.

[Nehal Chokshi:]

Great. Thank you very much.

[Dave Wagner:]

Thank you Nehal.

[Dave Rockvam:]

Thank you Nehal.

[Operator:]

Thank you. I am showing no additional questions in the queue at this time. I would like to turn the conference back over to Mr. Wagner for any closing remarks.

[Dave Wagner:]

Well, thank you, Howard and thank you, everyone, for joining Zix first-quarter earnings call. We look forward to speaking to you again in early August with our Q2 results. And I hope you all have a great evening.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Thank you. Everyone, have a wonderful day.