Zix Corporation
Q2 2020 Earnings Call Transcript

Published: 5 Aug 2020

[Operator:]

Good afternoon. Welcome to Zix Second Quarter 2020 Earnings Conference Call. My name is Michelle, and I'll be your operator today. Joining us for today's presentation are the company's President and CEO, David Wagner; CFO, David Rockvam; and Vice President of Marketing, 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 link in the Investor Relations section of the company's website. Now I would like to turn the call over to Geoff Bibby. Sir, please proceed.

[Geoffrey Bibby:]

Thank you, operator. Good afternoon, everyone, and thank you for joining our second quarter 2020 earnings conference call. On the call today, we have our CEO, Dave Wagner; and our CFO, Dave Rockvam. After the market closed today, we issued a press release announcing our results for the second quarter ended June 30, 2020, a copy of which is available in the Investor Relations section of our website at www.zixcorp.com.

[David Wagner:]

Thanks, Geoff. Good afternoon, and thank you, everyone, for joining us today. In the second quarter, we continued to drive profitable growth, and I'm proud to report that in these volatile times, we exceeded all of our financial objectives for the quarter. The abrupt and dramatic shift to remote work during Q2 enabled us to support our customers and partners more assertively than ever before. Under the strain of the global pandemic, we are becoming an even more essential component of our customers' work lives, further supporting the resiliency of our operating model and the importance of our secure cloud platform to provide comprehensive digital security and compliance solutions for businesses of all sizes.

[David Rockvam:]

Thank you, Dave, and good afternoon, everyone. Echoing Dave's remarks, during the second quarter, we delivered on our financial guidance as well as our commitment to consistently generating profitable adjusted EBITDA growth on an absolute basis, both of which have us on strong footing as we head into the back half of the year. Now let's talk about our numbers in more detail. At the end of the second quarter, our ARR totaled $215.9 million up 11% from Q2 of last year. Our continued growth in ARR continues to be driven by our customers' move to the secure modern workplace, which puts a heavy emphasis on cloud adoption. We are pleased that our cloud-based ARR grew 20% over Q2 of last year and now comprises 84% of total ARR. New customers in the quarter totaled 4,500, up 3% from Q2 of last year. For the second quarter, we had just over 96% net dollar retention, which represents our renewals plus new sales into the installed base divided by the renewals that were available at the beginning of the quarter. As expected, the 96% is down from our prior run rate of just over 100% last quarter. And Dave will touch on this later on today's call. We are pleased that in this unprecedented environment, we were able to grow our ARR at a double-digit rate and maintain good retention rates with our customers, which we believe demonstrates the mission-critical role that our solutions fill with our customers.

[David Wagner:]

Thanks, Dave. I will now review our execution of strategy in the context of our 3 primary growth drivers. Our first growth driver is new customer acquisition. We had some noteworthy wins in the quarter on both the Zix and AppRiver sides of the business. First, on the direct far side, our top 5 wins in the quarter were in a diverse set of industries, including 2 in health care, 1 in legal, 1 in construction and 1 in manufacturing. Two of our top 5 wins included archiving, and both of these wins included data migration-as-a-service, which has proven to be a game changer for new customers. Our largest new customer win in Q2 was a 6-figure deal in construction that included productivity, encryption and advanced threat protection. This customer is looking for a proven advanced threat solution following a malware attack they experienced in March that took their network down for a week. Another major win in Q2 was with a health care provider that was attracted to Zix because of our phenomenal customer support. We again averaged 3 products per new customer in our top 5 new customer wins. On the MSP side, we added 60 net new transacting partners in Q2, which was up from the 55 we added in Q1 and brings our total to over 4,450 at quarter end. In Q2, we added approximately 160 net new customers per week, bringing our total customer count on the legacy AppRiver side of the business to more than 73,000. Late in Q2, we began seeing increasing sales momentum, both on the direct and indirect side of our business and across our full suite of products. In June, we achieved a monthly record of 4,300 trials, exceeding the prior record of just under 4,200 trials established in February. The record trials were driven primarily by continuing increases in encryption, archive and advanced threat protection by our MSP partners. We also launched our new enhanced advanced threat product localized for the U.K. market in June, which also contributed to the increased IP trial activity. IP trials in June were 28% of total trials. In terms of overall business trends across our large partner base, we've seen a substantial stabilization since the March, April time frame. If you recall from our Q2 earnings call in May, we reported that in April, we were seeing an uptick of approximately 20% in new customers, a slight increase in churn and a real drop-off in additional business from existing customers. As we move through Q2, both the new customer increase and the increase in churn moderated and more importantly, the business to existing customers began to recover. In total, for the second quarter, business to existing customers was off almost 50% from Q2 2019. However, by the time we hit June and now July, the net increase in business to existing customers has largely recovered to pre-COVID levels. We remain guarded in our view of the macro environment, but we are pleased with the opportunities we are seeing to help our customers and partners work remotely and digitally transform their businesses and the resulting recovery we are seeing in June and July. That overall backdrop is a good segue to our second growth driver, which is sales to existing customers. In Q2, 4 of the top 5 add-ons through our bar and direct sales teams were in health care and one was in government. All 5 were encryption-only add-ons. Cross-selling into the base remains a focus, and we would have loved to have more success in the top accounts. But the fact that we're seeing strong upsell in our core encryption business is a healthy sign. The average contract term of the top 5 add-ons was approximately 20 months, consistent with prior periods, which we also think is a healthy sign. On the MSP side, sales to existing customers accounted for only 22% of the MRR increase in the quarter. This compares to 44% in Q2 2019. As we previewed on our May call, we experienced a deceleration of orders from existing customers in March and April. As we hope, though, our flexible, consumption-based, month-to-month billing model allowed our partners and customers to recover quickly. For the month of July, 48% of our increase in MRR was from existing customers. In the existing customer base, we are also seeing a continued migration from hosted exchange to Office 365, driven by work-from-home demands that are better served in the cloud and by Microsoft's customer incentive for Teams adoption. We've always anticipated this migration, but COVID and work from home has accelerated it. Moving to our third growth driver, increasing retention. Our total company net dollar retention was 96% in Q2 compared to 100% in the prior quarter. This is primarily due to reduced sales to existing customers that I just reviewed. In addition, we lost a meaningful OEM encryption customer that was moderate in terms of ARR, but very large in terms of number of seats. Churn is up modestly in both hosted exchange and our on-premise encryption business as COVID has clearly accelerated trends towards the cloud and secure remote work. We are encouraged that for the month of July, total company net retention was back over 100%. The successful launch of Secure Cloud and the positive initial acceptance by our customer base makes us even more enthusiastic about our long-term growth prospects. Before closing, I would like to highlight an accomplishment that the Board, the leadership team and I are really proud of. Building upon our foundation of values and our focus on compliance, in the past 12 months, we have doubled down on Environmental, Societal and Governance programs, or ESG. During Q2, Zix received a prime status rating and corporate ESG performance from ISS. This recognition speaks to the quality of the framework we have established for ESG best practices that guides our decision-making on a daily basis. We are proud of this rating that places us in the top decile of publicly traded companies with respect to ESG, which we think bodes well for all of our stakeholders as we continue to grow. Looking forward, we are encouraged by our progress in Q2 and the initial positive indicators in July. The uptick we're experiencing in customer engagement and overall business development activities has ignited our team's energy and enthusiasm, providing momentum as we continue into the third quarter. However, we remain cognizant of the challenges in the macro environment. Some of our smaller customers are struggling, and our health care system is dealing with unprecedented challenges. We are excited by the opportunities we have to help these customers successfully transition to the cloud and digitally transform their businesses. Our results in Q2 and July demonstrate that we are now in a much more planful state than we feared back in April. We are also encouraged by our strong financial foundation. We are generating significant free cash flow, we are reiterating our strong adjusted EBITDA outlook for the year, and we have over $30 million of cash and available credit facilities. Further, our Secure Cloud strategy is right on. Digital transformation is continuing to accelerate, and we are well positioned to capitalize on the remote work trends as evidenced by our continued efficient rate of new customer acquisition. Together with our partners, we provide the solutions and resources businesses need to be effective in this environment, helping them achieve a secure, modern workplace. We remain confident in our ability to deliver on our vision of becoming the leading provider of cloud email security, productivity and compliance for businesses of all sizes. That concludes our prepared remarks. Operator, we're ready to open the call for questions.

[Operator:]

. Now our first question will come from Chad Bennett of Craig-Hallum.

[Chad Bennett:]

So yes, I mean, interesting qualitative and quantitative commentary on the rebound into June and then the first month of July. I guess, are you -- I mean, the net expansion, it sounds like, is now back over 100%. It seems like the adoption of Secure Cloud has been phenomenal to this point. Is it too early -- I don't want to get over our SKUs, but too early to think about whether it's existing or net new add-ons where you talked about the attach rates of 1.5 to 1. 1, I think, where we can actually see reacceleration, so to speak, in kind of those -- some of the metrics that we look at? Obviously, we're in a unique environment, I know, but it just seems like things are back to normal a lot quicker than anybody would have thought.

[David Wagner:]

Yes. Thanks for those comments. We are really pleased with Secure Cloud. We are really pleased with the recovery as we had talked about in April, the monthly nature of our billing had things draw down relatively quickly, and then they have rebounded quickly. And that's exactly what we're seeing. That trial activity that we've talked about, the June records, that's really being driven by the advanced threat solution, the archive and the encryption. So we're leaning in, we're seeing really good new customer adoption, the new channel partners out of net 60 up from that 55. So our trends are good. The environment is not great, but our trends are good, and the team is really digging into drive those attach metrics, Chad.

[Chad Bennett:]

And then maybe one follow-up, just on your commentary on the churn you saw in the quarter. I think you talked about kind of on-prem encryption churn and then maybe kind of the exchange-hosted churn. I guess, can you give any type of insight, again, maybe it's a mute point because we're back to normal, but kind of the percentage of the business today that, that represents or kind of what the risk is there?

[David Wagner:]

Okay, great. I'll let Dave give the numbers. But the really good news is we're positioned well on the cloud side. So our -- even though the net churn was down from 100% to 96%, the customer and revenue churn was tens of basis points, not hundreds, changed in the quarter. And so what we're seeing is customers are staying with us, but they're shifting technology platforms from those on-prem environments to the cloud environment. In the case of the encryption rotation, it's kind of a price margin-neutral equation in the terms of the Hex to Office 365, the price is relatively constant, but the margins get impacted. So those are trends that we've been aware of in the business. What happened with COVID is IT people don't want to go in and mess with servers. And so they're really looking to us to take that -- us and our partners to take that out of the equation and move fully to the cloud. So that's the rotation that we're capitalizing on.

[David Rockvam:]

Yes. And what -- the numbers kind of look like we said 84% of our business is coming from cloud-based businesses now. So if you look at -- that would mean the other key part of that would be our total defense product line, which is our consumer base, which is $7.5 million to $8 million. So you get outside of that, there's probably 15% to 20% that we need to rotate through from either on-prem or hosted exchange to our cloud. And not all -- those won't be losses, right? Those will be lots of opportunities for us to move them under our cloud. So over time, we think we can move well over 50% of those to our cloud, if not more, with the Secure Cloud launch.

[Operator:]

Our next question will come from Andrew King of Colliers Security.

[Andrew King:]

So looking at the customers being on board to secure cloud versus legacy, can you give us a little bit of an idea of why that 42% is choosing legacy versus Secure Cloud? And is it more of the feature functionality or what's going on there?

[David Wagner:]

Yes. A lot of that has to do with the timing, Andrews, so our Secure Cloud launched officially in mid-April. So there were customer sales cycles in place in the second quarter where we weren't able to bring all of the new customers on Secure Cloud. Dave shared the July number just to show the momentum that we're getting as the sales cycles are transitioned over and then we'll expect for the long time to still bring some customers into our dedicated zones, particularly large customers. Some of them want to keep their mail flow in a very dedicated way. But the very vast majority of our customers, as Dave indicated, are coming directly on Secure Cloud now.

[David Rockvam:]

Yes. And if you pulled it back even a little bit further, yes, exactly what Dave said, it was timing a lot in that part. And even in that 87%, we're allowing for -- we have tiny, tiny Zix male type of customers that come on that aren't going to be a Secure Cloud-type customer that get caught up in those numbers. So we're more in the -- if you were to take some of those small ones out, you get up into the 90s pretty quickly. And then as we continue to build the feature functionality on the core products on the Secure Cloud and get full feature parity there, we'll get into the high 90s across. And it'll just be, as Dave said, a few of those, maybe older customers that are staying on on-prem or customers that come on to us on-prem for some reason that may not go on to Secure Cloud. So we expect that number to continue to climb and be a pretty high percent by the end of the year.

[Andrew King:]

Great. And then could you dive in a little bit on to the impact of COVID on the conversion on the trials?

[David Wagner:]

Yes. Really in terms of conversions, we continue to perform right at the prior conversion rates, the Zix IP continues to improve as more and more of the partners are exposed to the Zix IP, that continues to converge. So the trial conversions are real strong. Again, that March, April and into May was tough. And then June and July, we've seen the trial activity, obviously, picking up through the record that we talked about in the month of June.

[Operator:]

Our next question will come from Nehal Chokshi of Northland Capital.

[Nehal Chokshi:]

Yes. Nice to the results come in above guidance and the tightening of range a little bit to the higher end. So that's great. So I want to stick on to the 96% -- net dollar expansion to 96% and as some of you guys mentioned, it's somewhat mute given that it's gone back up, but I still want to double-click here. You did mention another factor we was the loss of a large OEM customer. Can you give a little more details about that OEM customer? And why was that lost? And how much of an impact did it play in that downtick?

[David Wagner:]

Yes. So it was -- because it was through an OEM, the price per user was very low. So it was not a -- it was below 6 figures, I guess, ARR account, but had quite a number of users on it. It was through an OEM and that -- when we implement product or we sell products, our implementation rate is 99.98%. We always get it implemented. One of our OEM partners was not nearly that good about getting implementations done. And so -- and we were the OEM. We weren't the person to -- outfront making that happen. So it was a 3-year renewal that didn't get renewed with our OEM partner.

[Nehal Chokshi:]

Okay. Great. And what do you think is driving this net increase to existing customers recovering to pre-COVID levels? That seems a bit odd given that the macro remains pretty tough.

[David Wagner:]

Yes. I think we're -- two things. On the decline, because we're rebilling and because we're around e-mail box, even though we have lots of small business customers. These are knowledge workers, not hospitality and health care worker. And so where we had is a contraction, we didn't lose customers, we lost users at the customer. And that then allowed us to recover more quickly. And then we're seeing the work -- remote work, even smaller businesses are all getting set to be worked from home. And so we're bringing on our MSP partners, especially are bringing on new accounts because we offer the Office 365 and secure modern workplaces that they need to be effective. So it is not easy out there. But we think we're in the right position. And clearly, the June, July rebound, we feel good about.

[Operator:]

. Our next question will come from Daniel Ives of Wedbush.

[Daniel Ives:]

So maybe just follow-up on the other question. In terms of June, July and just trajectory, is there anything different that you guys are doing from marketing campaigns, attacking the customer and -- or it's just a natural rebound in terms of what you believe as you've seen the last few months?

[David Wagner:]

I think it's a natural rebound from where we're positioned. I would like to give credit to the sales leadership and the sales team. They've really gotten focused or -- and especially since COVID, they've just really gotten focused and are executing well. Trial activity is a part of how they're measured and paid, and they've really focused and done a nice job with them. And I think it also goes to Secure Cloud and actually give the product team lots of credit, too. We launched that Secure Cloud product. We spent all year working on it, and we're delivering what the partners asked us to deliver. And so the enhancements to the advanced threat product are really causing the uptick, the localization in Europe causing an uptick as we continue to follow-on delivery throughout the summer, we've really introduced a lot of value for our -- especially for our MSP partners. At this point, we expect to continue to capitalize that as we head in -- through the summer and into the fall.

[Daniel Ives:]

Okay, great. Now in terms of the cost structure, obviously, there's just lower T&E and interest in a number of things, just given the environment, how are you thinking about that going forward in terms of maybe things that are temporary versus more longer term sustainable?

[David Wagner:]

Yes. So you remember that we made a meaningful expense reduction at or around our last earnings call, and we think that was the right size for the right time and that's showing through in the bottom line and driving the profitable growth. We're just really pleased by the effectiveness of the remote work. We'll be continuing to look at little things down the road, office leases as they come up. I don't think travel will spring back, but when it's safe and if -- we won't do it until it's safe, but when it's safe, partner conferences are a really good way to engage with new prospects. We'll be out there when it's time, but we don't see that time being this calendar year.

[Operator:]

At this time, this concludes our question-and-answer session. I'd now like to turn the call back over to management for closing remarks.

[David Wagner:]

Well, thank you all for your time and attention on our Q2 earnings call, and we look forward to speaking with you again in 90 days.

[Operator:]

Thank you for joining us today for Zix Second Quarter 2020 Earnings Call. You may now disconnect.