Zix Corporation
Q3 2018 Earnings Call Transcript

Published: 24 Oct 2018

[Operator:]

Good afternoon. Welcome to Zix's Third Quarter 2018 Earnings Conference Call. My name is Carmen, and I will be your operator this afternoon. 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, Carmen. Good afternoon everyone and thank you for joining our third quarter 2018 call. With me today are our CEO, Dave Wagner; and CFO, Dave Rockvam. After the market closed, we issued a press release announcing our results for the third quarter ended September 30, 2018, a copy of which is available in the Investor Relations action of our website, at www.zixcorp.com. Please note that during the course of this call, we will make forward-looking statements regarding future events and the future financial performance of the company. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. It's important to note also that the company undertakes no obligation to update such statements. We caution you to consider risk factors that could cause actual results to differ materially from those in the forward-looking statements contained in today's press release and in this conference call. The risk factor section in our most recent Form 10-K filing and 10-Q with the SEC provides examples of those risks. During the call, we will present both GAAP and Non-GAAP financial measures. Non-GAAP financial measures are not intended to be considered in isolation from, a substitute for, or superior to our GAAP results. We encourage you to consider all measures when analyzing the company's performance. A reconciliation of certain GAAP to non-GAAP measures is included in today's press release, which can be found in the Investor Relations section of our website. Now with that, I would like to turn the call over to David Wagner for his opening remarks. Dave?

[David Wagner:]

Thanks, Geoff. Good afternoon and thank you everyone for joining us today. Q3 represented another major step forward for Zix. We achieved 24% new first year order growth, which combined with our 27% new first-year order growth last quarter, brings us to over 20% growth for the year to date. These are meaningful milestones demonstrating successful execution of the bundling strategy we put in place just 1.5 years ago. We made progress on each of our key initiatives of securing new customers, growing our attach rates and increasing retention as we continue to strengthen our position in the broader e-mail security market. What is particularly driving our business in 2018 is the great success we are having selling ZixProtect into our installed base and increasing ZixEncrypt deployments further into existing accounts. Our customers are demonstrating a preference for bundling encryption and threat production in a highly effective easy-to-use package with outstanding customer service. Once again, our strong orders performance was driven by both our channel and direct sales team across all customer sizes helping us increase revenue by 8%, ACV or annual contract value by 13%, new first year orders by 24% and total orders by 33%. We also continue to see solid improvements in our GAAP earnings, up 29% and adjusted EBITDA, which increased 16% year-over-year. Over the last 1.5 year, we've progressively extended the solid momentum generated by our advanced threat production and unified archiving products, which again, made up more than 25% of our new first year orders for the quarter. We were encouraged that the contribution from new services continues to trend higher as the quarter’s progress. Attaching additional cloud-based e-mail security services to our existing customers is key to our strategy of capturing a larger share of our expanded addressable market. This quarter's results indicate we are making real progress towards realizing that goal. New first year orders are climbing higher, attach rates are improving and retention is stabilizing. We are benefiting from positioning our products to support the direction our customers are heading. Our customers are migrating to the cloud, strengthening their security solutions and consolidating vendors. We're seeing stronger uptake of our new solutions by new customers and that's adding onto our attach rate success with existing customers. In fact, all 5 of our top 5 new customers in the quarter purchased ZixProtect. We expect these positive company and market dynamics to continue. We will be building on this progress by investing further in our cloud-based platform by leveraging our strong customer base through cross-selling and up-sell opportunities and by expanding the momentum of our hosted and bundled solutions for protecting business communications. Now I'll turn the call over to our CFO, Dave Rockvam, to provide more detail on the financials for the quarter. Dave?

[David Rockvam:]

Thank you, Dave, good afternoon, everyone. As Dave mentioned, Q3 was another solid quarter for Zix. Our strong new first year orders of $2.6 million were driven by the solid growth of our hosted offerings and bundles and were up 24% year-over-year. We also experienced another robust quarter with total orders, which were up 33% year-over-year. These orders drove our higher backlog and deferred revenue as we successfully moved customers to longer-term contracts and generated more transactions with our bundles. Our performance for Q3 helped us achieve our 30% adjusted EBITDA margin target, and we generated another quarter of solid cash flow, ending the quarter with $24 million in cash. Altogether, the positive results and execution of our business initiatives enabled us to increase the midpoint of our revenue and GAAP earnings per share guidance for 2018 as well as our non-GAAP adjusted earnings per share guidance for the year. Turning now to our financial numbers in more detail. As I mentioned earlier, our new first-year orders for the quarter increased 24% to $2.6 million compared to $2.1 million in the same quarter last year. The key drivers for this success were the increasing market adoption of our advanced threat protection archiving and hosted e-mail encryption offerings, along with strong cross-sell and upsell activity. In fact, with this quarter's new first year orders, we have a now surpassed 1 million encryption users on our hosted cloud offerings. This is up 142% from when we started this journey Q1 2016. Thus, demonstrating the continued customer momentum we're experiencing with our cloud-based encryption offerings. New first year orders were up 239% year-over-year for ZixProtect and up 108% for ZixArchive, reflecting the continued success we're having in marketing and selling our cloud bundles. Year-to-date, 40% of our new first-year orders were from new customers while 60% were from our installed base. So along with the strong new customer acquisition activity, we're also making solid inroads selling into our installed base because our customers are in increasingly demanded some of the newer solutions we've added to the Zix platform. Also important to note, we didn't have any order that made up more than 10% of the total new first-year orders, demonstrating the balance, consistency and repeatability in our results. Revenue for the third quarter increased 8% to a record $17.9 million from $16.6 million in the same quarter last year. With $17.9 million, we exceeded our revenue guidance for the quarter. I remind you that our revenue base is 100% subscription, giving us good visibility on a quarterly basis and serving as a pillar for our profitable growth business. Our adjusted gross profit for the quarter was $14.2 million or 79.6% of total revenue, which was an improvement on a dollar basis from $13.5 million or 81.1% of total revenue in the third quarter of 2017. Our adjusted gross profit margin percentage for Q3 was down year-over-year. This was primarily due to Erado and the deferred haircut associated with the acquisition subscription revenue. That being said, we were still able to achieve the 80% target for the quarter that we committed to on our last call, and we expect gross margins to remain around this level for the rest of 2018. Our adjusted R&D expenses for the third quarter of 2018 were $2.6 million or 14.7% of total revenue, compared to $2.8 million or 16.7% of total revenue in the third quarter of last year. The year-over-year decrease was primarily due to the capitalization of software associated with new features and functions added to our hosted platforms. In total, the software capitalization was about $400,000, and we expect a similar amount in Q4. Our adjusted selling and marketing expenses for the quarter were $4.8 million or 27% of total revenue compared to $4.6 million or 27.5% of total revenue in Q3 of last year. The increase in selling and marketing expenses was due to the buildout of our lead qualifications team or BDRs to support the company's growth, particularly with our advanced threat protection and archiving solutions. The increase was also partly due to an increase in other quota carrying headcount. As I mentioned on the previous call, some of the increase in selling and marketing expense has been offset by lower commission expenses as a result of our implementation of ASC 606 earlier this year. For the third quarter of 2018, our adjusted general administrative expenses were $2.3 million or 12.8% of total revenue, compared to $2.2 million or 13.5% of total revenue reported in Q3 of last year. On a GAAP basis, we reported net income of $2.5 million or $0.05 per fully diluted share compared to $1.9 million or $0.03 per fully diluted share in Q3 of last year. Our third quarter non-GAAP adjusted net income was $4.7 million or $0.09 per fully diluted share. $0.09 per share exceeded our guidance for the quarter and represents an improvement of $0.02 over the amount we reported in Q3 of last year. And finally, our adjusted EBITDA for Q3 2018 totaled $5.3 million, an increase of 16% compared to the $4.6 million we reported in Q3 of last year. As a percentage of total revenue, adjusted EBITDA for Q3 2018 increased to 29.8% from 27.7% we reported Q3 of last year. Our strong revenue growth for the quarter enabled us to achieve our 30% target that we guided on our prior call. Cash flow from operations for the third quarter of 2018 was up 10% to $7.4 million. At the end of Q3, we had $24 million in cash and no debt, highlighting, once again, our healthy balance sheet and ability to generate strong cash flow. CapEx and other intangibles for the quarter were $973,000, which consisted primarily of normal business capital purchases, internal software development projects and capitalized R&D. We reiterate our CapEx and other intangible forecast for 2018 to be between $2.8 million and $3.4 million, which as a reminder, takes into account other investments to modernize our business systems, integrate our acquisitions and enhance our multi-tenant cloud platform. We continue to expect depreciation and amortization to be approximately $3.4 million for all of 2018. Our backlog, which represents the dollar value of committed contracts was $74 million as of September 30, 2018, which was down 1% from $75 million of the same date last year. This year year-over-year decrease is due to our strategy of reducing the term commitment in 2017 as we rolled out our bundled offering to our customers. The increase in touch points has allowed us to substantially increase our sales to our installed base over the first 3 quarters of last year. In Q3, we did see our backlog increase sequentially for the second quarter in a row, in part, due to the healthy amount of total orders achieved by our sales team. We also achieved the higher term length for our new first-year orders this quarter, up 13% or 2.4 months compared to the same period last year. We believe these results demonstrate that we can drive higher orders in the near-term and also be flexible in accommodating with our customers to earn more repeat business and build our retention over the longer term. Looking at our deferred revenue, we expect to recognize approximate $46.6 million or 63% of our deferred revenue balance as revenue over the next 12 months. At the end of the third quarter, our ACV, or annual contract value, totaled a record $74.9 million, up 13% from Q3 of last year. From an industry perspective, our revenue breakdown was 48% from healthcare; 29% from financial services; 7% from government; and 16% from other verticals, all excluding acquisitions from 2017 and 2018. Now for our fourth quarter and full year 2018 financial guidance. We currently anticipate revenue for the fourth quarter to range between $18 million and $18.2 million. We are also forecasting fully diluted GAAP earnings per share to be between $0.04 and $0.05 and fully diluted non-GAAP adjusted earnings per share to be $0.09, which represents an increase of 8% compared to fully diluted non-GAAP adjusted earnings per share in the fourth quarter of 2017. Given the company's strong performance year-to-date, we are again raising the midpoint of our 2018 revenue guidance. We now expect revenue for the full year to range between $70.0 million and $70.2 million, which represents an increase of 7% compared to revenue in fiscal 2017. As part of our updated guidance, we are also forecasting our fully diluted GAAP earnings per share to be between $0.16 and $0.17 and increasing our fully diluted non-GAAP adjusted earnings per share to be $0.33 for fiscal 2018, which represents an increase of 14% compared to fully diluted non-GAAP earnings per share in fiscal 2017. So, to wrap up my section, Q3 was another strong quarter for Zix, building on the overall momentum we saw in the first half of 2018. We're seeing the evidence that our strategy is working and that we're on the right path to scale the business. We will continue to lead with our growing hosted and bundled offerings, which helps us not only secure additional new customers but also becoming more meaningful part of our existing customer’s data and communication security budget. We are also continue to execute on our profitable growth commitment, generating strong cash flow and allocating capital toward the areas where we see the highest returns. We're encouraged by the position we're in and excited about the opportunities ahead. As we close out a strong year and look to build on this momentum in 2019. This completes my financial summary. For a more detailed analysis of our financial results, please reference our Form 10-Q, which we plan to file by November 8. Dave?

[David Wagner:]

Thank you for the financial overview, Dave. I'll now review our progress as it relates to our main growth drivers and update you on some of our new product capabilities before we open the call for questions. As a reminder, our three growth drivers are

[Operator:]

Thank you. [Operator Instructions] And our first question comes from Michael Malouf with Craig-Hallum. Your line is open.

[Michael Malouf:]

Hey, guys. Congratulations on a great quarter.

[David Wagner:]

Thanks, Mike.

[Michael Malouf:]

I wondered if you can flush out a little bit more on the Erado acquisition. It sounds like that with this launch in Q1 that it could shape up to be a pretty meaningful impact to growth over the next few years. I'm just wondering if you could kind of size of market for us and give us a sense of why your salespeople are so excited?

[David Wagner:]

That's a great question, Mike. So the archiving market, as we look at it, is $800 million to $900 million. The part of the archiving market that's really focused on compliance. Cross channel's a little bit smaller than that but growing faster. The first great opportunity here is the rotation of archiving from on-premise to cloud. Our perception is that the e-mail boxes are the first thing to move and advanced threat protection, attach those mailboxes, has been a leader to the cloud and that archiving is a big opportunity in behind that. The second aspect of the Erado solution that we really like is that multichannel capability, the ability to archive virtually any digital communication channel, and the way that we reformat the data to look like e-mail when the reviewer or the searcher of the in-depth content is using the archive. So those two things are highly differentiated. The attach rates, we think, will be good. Vendors don't compete their archiving as often as the threat protection - when I say vendors I mean customers. So we'll probably be a little bit slower right off, but it's a higher priced offering and we feel really good about the attach opportunity from that acquisition.

[Michael Malouf:]

Okay. Great. And then, if you did mention it I missed it. Can you talk a little bit about international? How's that going for you? And as a look into 2019, what's the opportunity there?

[David Wagner:]

Yes, you didn't miss it, Mike, we didn't break it up because we did not have a real meaningful contribution of international in this quarter. We had a nice win in the quarter ended June. We've got a nice pipeline for the fourth quarter. So we continue to make measured progress with our major investment in international and it's kind of progressing as planned.

[Michael Malouf:]

Okay. And then one final question. As you move into 2019, I know that you gave guidance of gross profit margins to stay around that 80%. But as you get that deferred revenue kind of following off for the acquisition, should we see those go back up a little bit over the next several quarters?

[David Rockvam:]

As you get into 2019, we might see it tick up a little bit. Remember, what we've talked about also in both of those is, on the advanced threat protection and on the archiving, it carries a little bit higher cost of sales. The support and threat analysts for the advanced threat protection and archiving itself carries a little heavier expense from the standpoint of your - actually archiving that data and have to put it into - put it somewhere whether it's on-prem or onto AWS. So there is real expenses. But I think next year, we plan to see that tick up a little bit.

[Michael Malouf:]

Yes. Okay, all right. Because I know back in - if you go back in time, you were always sort of in those low 80s. As high as like in the 84%, but are you taking more like 81%, 82% is where you'll sort of wind up given the change in mix?

[David Rockvam:]

Yes, 83% I think is where we ran all of '16. And then, getting into '17, adding advanced threat protection, it started -- it ticked down. But yes, you're right in that range over the next couple of years that 81% to 82%.

[Michael Malouf:]

Okay. Thanks for taking my questions.

[David Rockvam:]

Thanks, Mike.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from Zack Turcotte with Dougherty. Your line is open.

[Zack Turcotte:]

Hey, guys. Zack on for Catherine. Further, I just want to dive a little bit deeper into the on-prem versus cloud retention discussion. What is actual percentage of on-premise versus cloud customers right now? And what if the difference in ACV between them?

[David Wagner:]

So the ACV number is 16% now that are - have the on-prem appliance. And that's total ACV from customers who have an on-premise hardware appliance.

[Zack Turcotte:]

Okay. Got it. I think you said last quarter like 50% - it was around 50-50 for...

[David Wagner:]

Yes, exactly. And so that 50-50 picks up the virtual appliance customers that gets it closer to the 50-50. And we're focusing as, remember, more on the on-premise hardware ones because that's where, in the past, we have experienced the higher churn, the virtual on-prem appliances, from our churn perspective, are behaving very consistently with prior trends and the overall business.

[Zack Turcotte:]

Got it. And then, just -- I'll just do one on the competitive landscape. Are you still mostly displacing sort of mid-market guys like Barracuda, and taking their share at the bottom end, like the 100 to 1,000 seats? And also, are you seeing anything different in the market with pricing? Is anyone pricing to win?

[David Wagner:]

So we're not seeing any pricing pressure in the market. This quarter, as I mentioned -- or I emphasized, we had our largest ZixProtect win in the history of the company. That one was a displacement of -- I guess I gave kind of sample of Office 365, Sophos and Google. So this quarter, and the new wins that we talked about, we're in that group as opposed to in prior quarters, it's a little more heavily weighted to the targeted cloud-based bundle providers that we more normally see.

[Zack Turcotte:]

Got it. Thanks.

[David Wagner:]

Thanks, Zack.

[Operator:]

Thank you. [Operator Instructions] Next question is from Alex Henderson with Needham. Your line is open.

[Alex Henderson:]

Thanks. So I was looking at the archiving business, and It sounds like you're accelerating that business somewhat. Is there a difference in margins given the cost of archiving versus traditional business? And is that something that will help or hurt your gross margins as we move forward?

[David Rockvam:]

In the near-term, it's hurt the margins a little bit. We have a few capital projects going on in the next couple of quarters that help alleviate some of the kind of AWS cost and bring some of that in house, since we already have our own data center. So there are some things like that that we can do to help bring those margins more in check. But as we scale the business, it's probably in that low 70s already percent gross margin. So I think we can help bring it up over the next year or two as we scale the business to get it towards that 80-plus percent.

[Alex Henderson:]

And I'd like to go back to the percent on-prem versus on cloud. Little confused by the answer in the sense that I think you said last quarter you were 50-50. Is that still the case at this point if we include both hardware and virtual?

[David Wagner:]

That is right. So it'd be still right around 50-50, getting better but still right around 50-50. And then, to just try to be clear again, we break out on-premise deployments into 2 different categories

[Alex Henderson:]

So should I be at all concerned if that 6 25 starts to become such a diminimus number that ultimately, you don't have that much of our customer base to move to the cloud? Or how should I be thinking about it?

[David Wagner:]

No, I wouldn't -- not worried about that at all. Alex, the key thing is, from our perspective, is getting those customers migrated to the cloud. We work very well in a hybrid environment where the mail routes to our cloud, then back to on-prem exchange -- Microsoft exchange to encourage our customers to get migrated to the Zix cloud before they move their office 365 mailbox. And then what you're seeing on that new customer acquisition side that I'm emphasizing is the bundled solution, the combination of our strong e-mail encryption offering with a really effective easy-to-use and deploy threat protection bundle is driving that new customer additions into our cloud platform.

[Alex Henderson:]

So as I read the numbers, and tell me if I'm miss analyzing this, so you have 60% of the new orders coming in from the install base and install base is primarily moving from the hardware to the cloud, and you're up selling them as they do that. Am I misreading that in thinking that the upsell to the hardware customer to the cloud move and the upsell associated with that is not a big part of the selling...

[David Wagner:]

That's right. There is -- unless the customer has a dedicated instance, there is no charge for the deployment method. So we are not making money -- or nominal -- it's nominal in the models that might've made in the movement. The ad-on is coming from additional encryption fee and adding -- at this time, adding threat protection into our existing customer base typically displacing some competition on the threat - compared on the threat protection side.

[Alex Henderson:]

All right. What I was getting at is, it sounds like the sales motion is as somebody decides to get rid of this hardware server in their data center...

[David Wagner:]

No, if that's what you're hearing, I'm miss speaking that's not the motion at all.

[Alex Henderson:]

And you get upsell opportunity at that time, is that not right?

[David Wagner:]

No, that's not the motion at all. The motion is the renewal of their current threat protection vendor to give us an opportunity to displace and attach on the threat protection. And on the encryption side, the motion is the growth in fees, the further extension, as companies improve their security posture, increasing the licensed users.

[Alex Henderson:]

So just for a second if I could. I would think that people would still want to move to even off the virtual piece because virtual still running on appliance and the appliance...

[David Wagner:]

That's right.

[Alex Henderson:]

I mean, whether it's a server or appliances, it's still the same thing functionally. Is there any reason to believe that that virtual piece won't also follow the pattern maybe with a little bit of a lag that the hardware piece is doing?

[David Wagner:]

Yes, so we do think that e-mail boxes are moving to the cloud, the Office 365 and those will move. But the pattern that we're seeing different with the virtual appliances is those customers tend to have more sophisticated IT staff that are better able -- in a better position with the migration comes to do that in a way that continues to include the value of the Zix solution in that migration. But the on-premise tend to be the extra turndown there is from the lack of sophistication of those IT departments at the time they make the migration.

[Alex Henderson:]

That's helps on the clarification, makes a lot of sense. So one more question if I could, can you talk about -- when you talk about customer retention, what retention plus upsell would look like?

[David Wagner:]

That's not something that we'd disclose. Although, you can probably do some math. We're doing really nice job, as you can tell, with 60% of year-to-date new first-year orders from existing customers of pushing that number closer and closer to 100.

[Alex Henderson:]

So if you were to look at two years, where you think the mix will be between cloud and on-prem at this point -- at that point?

[David Wagner:]

Two years, I think, it will base 60/40. It's a little better than 60/40 in the cloud. I mean, we're getting that really strong adoption in the cloud. And again that's just an out of the air kind of number. We've got a great pipeline of larger customer opportunities that are going to stay on-prem for a while longer, so. But I definitely see the trends that we're seeing in the business continue where the cloud is the dominant part of our growth.

[Alex Henderson:]

I look forward to see you in New York next month. Thanks.

[David Wagner:]

Thanks, Alex.

[David Rockvam:]

Great, Alex, and I'll make a clarifying for you as well as Zack. Just to be clear, because of the way we stated, if you add our virtual encryption customers and our hosted encryption customers that would be 79% of our encryption customers, which leaves you the other 22% of on-prem. So that's of when you look at it when you taking out advanced threat protection and taking out archiving and kind of our -- the other product lines; just to provide a little clearing there on that number. So it would be closer to 79% or either virtual or hosted.

[Alex Henderson:]

Okay. Thank you.

[Operator:]

Thank you. Our next question is from this Tim Klasell with Northland Securities. Your line is open.

[Tim Klasell:]

Hey, guys. Just a few questions here. First, your sales the motion, as you go to bundling -- obviously, you guys are having good success there and the deal sizes are increasing. Are you seeing the sales cycles lengthen? If so, maybe give us some color around then. And then are you getting a little bit more back-end weighted in your quarters around your bookings?

[David Wagner:]

So neither of those are happening. In fact, we are getting a little bit faster in our sales cycles as opposed to slower. And I think that comes from a better intersection of other customers want to buy by having our cloud solution more complete and more robust. And no, on the contrary, we've increased the sales management early in 2018, and they're just doing a real nice job of delivering increasing orders month-over-month, each month. And that's part of that, consistency and repeatability that Dave and I are emphasizing in the delivery from the go-to-market team this year.

[Tim Klasell:]

Okay, great. And then you mentioned how your retention rate, particularly with the multi product customers is above 90%. What do you think is your bogey as you get more products? What sort of the best-in-class? What would you like to achieve?

[David Wagner:]

Well, we achieved 93%, 94% at the peak in 2016. We would aspire to get back there. As we look at the bundling market, however, I think there's a little more competition in that space so we're not modeling getting back that aspirational 94% number until we better understand the dynamic in the churn. As I mentioned earlier on the call, the threat protection tends to get competed more off than the archiving or the encryption part of the bundle.

[Tim Klasell:]

Okay, perfect. And then, one final question. With your on-premise customers are getting to -- you're targeting longer terms. What are you doing to encourage the customers, locking in the price for them? Are you giving extra features? What is encourage your customers to take the longer-term contracts? Thank you.

[David Wagner:]

It's a price lock-in is the attractive feature. So the first thing we're offering is incentivize pricing to move to the hosted environment, and if the customer's answer is well, no, no, no, we're really comfortable on-premise where we expect to be, we say, well why don't you do then yourself a favor and go ahead and lock that in. We have not had the discount, but its been more of a lock-in.

[Tim Klasell:]

Okay, perfect. Thank you.

[David Wagner:]

Thank you, Tim.

[Operator:]

Thank you. And Ladies and gentlemen, at this time, this concludes our question-and-answer session. I would like to turn the call back to Mr. Wagner for his closing remarks.

[David Wagner:]

I would just like to thank everybody for joining us this afternoon and I look forward to speaking you all after the end of Q4.

[Operator:]

And thank you for joining us today for Zix's third quarter 2018 earnings call. You may now disconnect.