Zix Corporation
Q3 2016 Earnings Call Transcript

Published: 26 Oct 2016

[Operator:]

Good day ladies and gentlemen and welcome to Zix's Corporation Q3 2016 Earnings Conference Call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference Mr. Geoff Bibby, Vice President of Marketing. Sir, you may begin.

[Geoff Bibby:]

Thank you, operator. Good afternoon, everyone and thank you for joining our third quarter conference call. With me today is our CEO, Dave Wagner and our CFO, Dave Rockvam. After the market closed, we issued a press release announcing our results for the third quarter ended September 30, 2016, a copy of which is available in the Investor Relations section of our Web site 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 statement. 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 Factors section of most recent Form 10-K filing with the SEC provides examples of those risks. During the call, we’ll present both GAAP and non-GAAP financial measures. Non-GAAP financial measures are not intended to be considered in isolation from of 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 Web site. Now, I would like to turn the call over to our CEO, Dave Wagner. Dave?

[Dave Wagner:]

Thanks Geoff. Good afternoon and thank you everyone for joining us today. Our financial performance for the third quarter was strong in terms of revenue, earnings and renewal, but lower than we would have liked for new first year orders. Record revenue of $15.3 million and adjusted earnings per share of $0.07 were both higher than our guidance. Total orders of $16.5 million were up 13% year-over-year driven by strong renewal rate resulting in record backlog of $81.6 million and $60.2 million of annual contract value, which is up 9% year-over-year. Those of you who have followed the company for a while know that new first year orders is a volatile metric for us and the third quarters can be particularly challenging. That having been said, our new first year orders of $1.9 million in Q3 were on the low-end of our normal range and lower than we would have liked for two reasons. First, new first year orders from our OEM partners lagged expectations and were down significantly year-over-year. Our OEM partners contributed only 10% or approximately $200,000 of new first year orders for the quarter, which was down from 23% of new first year orders or approximately $600,000 in Q3 of last year. In Q3 2015, Google booked a large state government contract, which explains why their contribution is down for Q3 on a year-over-year basis. And regarding Cisco, in the second half of last year, we worked with them on an end of life migration of the Iron Port Encryption Appliance Solution to migrate their customers to our Zix Encryption Appliance or ZEA. This migration drove an uptick in orders during the second half of 2015 that is not repeating in the second half of 2016. For these reasons, a year-over-year comparison of our OEM new first year orders doesn't present the full picture. Nonetheless, we realized that there is certainly room to improve on our OEM orders something on which I will elaborate later in the call. Second, September was lighter than expected as we had deals slip from the quarter into Q4. I want to emphasize though that we didn't experience any order losses but rather slipped due to timing and we are well on track to close these deals. So in summary, what we are seeing is continued strength in our core market leading, email encryption product through our direct, VAR and MSP channels offset by a transition in our OEM partner relationships. We are also making investments to strengthen our core products and customer relationships as we build for the future. Despite the new first year order shortfall, we remain extremely confident in the business and in our ability to continue delivering profitable growth for our shareholders. I'd now like to turn the call over to our CFO, Dave Rockvam, who will provide a more detailed financial report and an update to our guidance. Following Dave’s commentary, I will return to provide more detail about our operational highlights and outlook particularly as it relates to our seven growth pillars.

[Dave Rockvam:]

Thank you, Dave, and good afternoon everyone. As Dave mentioned, we had strong results across many of key metrics in the quarter. Even though our new first year orders came in lower than we expected, our subscription model continued to show solid growth driven by strong retention and our ability to sell more licenses and additional products to our existing base of customers. The combination of these results led to record revenue and backlog in the quarter. Revenue for the third quarter increased 9% to $15.3 million from $14 million in the same quarter last year. As Dave alluded to earlier, Q3 revenue not only exceeded our revenue guidance range of $15 million to $15.1 million but also represented the highest level of quarterly revenue for the company's history. The increase was driven by the addition of recurring revenue from new customer contracts and strong revenue retention. Revenue for the first nine months of 2016 increased 10% to $44.6 million from $40.4 million in the same period last year. This increase is in line with our current growth projections. Turning to expense side of our income statement, we ask that you see today's full earnings release, which is posted on our Web site for further details including a reconciliation of the GAAP to non-GAAP results which exclude non-cash tax expense, non-cash stock-based compensation expense, executive severance expense and expenses related to litigation. Our adjusted gross profit for the quarter was $12.7 million or 83% of total revenue; this was an improvement from $11.6 million or 82.9% total revenue in the third quarter of 2015. Adjusted gross profit for the nine month period was $36.9 million or 82.8% of total revenue. This was an improvement from $33.5 million or 82.8% of total revenue in the same period a year ago. The increase in adjusted gross profit for both the quarter and nine month period was primarily due to higher subscription revenue. Our adjusted R&D expenses were $2.6 million or 16.7% of total revenue compared to $2 million or 14.2% of total revenue in the third quarter of last year. The increase in adjusted R&D expenses was due to two reasons, first, we invested and continued to invest in our core email encryption market to build on our number one market share position. And second, we reclassified our documentation team during the quarter to now be part of our R&D expense rather than our marketing expenses. Our adjusted selling and marketing expenses for the quarter were $4.5 million or 29.7% of total revenue compared to $4 million or 28.9% reported in Q3 of last year. The increase in adjusted selling and marketing expenses for the quarter was primarily due to investments we are making to strengthen our brand and increasing our product marketing team and to enhance our professional sales capabilities so that we can accelerate our growth. For the third quarter of 2016, our adjusted general and administrative expenses were $1.9 million or 12.7% of total revenue compared to $1.7 million or 12.5% of total revenue reported in Q3 of last year. The increase over last year was mainly due to some increased consulting in IT project work in the quarter. Regarding income taxes, we expect to continue reporting non-cash income tax expense consistent with the amount for last year resulting in an effective GAAP tax rate of approximately 37%. This expense is largely non-cash due to our NOLs. We expect the cash component of our taxes to remain in line with prior quarters. Our third quarter, non-GAAP adjusted earnings were $3.6 million or $0.07 per fully diluted share, $0.07 per share was higher than our guidance for the period and equal to the amount we reported in Q3 of last year. For the first nine months of 2016, non-GAAP adjusted earnings were $10.3 million or $0.19 per fully diluted share, $0.19 per share was 31% higher than the amount we reported in the same period a year ago. On a GAAP basis, we recorded a net income for the third quarter of $1.8 million or $0.03 per fully diluted share and for the nine month period GAAP net income totaled $3.9 million or $0.07 per diluted share. And finally, our adjusted EBITDA for Q3 2016 was $4.3 million, which was slightly down from Q3 last year. As a percentage of total revenue, adjusted EBITDA declined from 32.3% to 28.1%. However, for the first nine months of 2016, adjusted EBITDA increased by 19% to $12.3 million from $10.4 million in the same period a year ago. As a percentage of total revenue, adjusted EBITDA increased from 25.6% to 27.7%. Even though, we have surpassed our adjusted EBITDA margin target of 25% for the last three quarters, we will be making additional investments in sales and marketing to set the stage for continued growth in 2017. As a result, we expect this percentage to move closer to our 25% target in the fourth quarter. Cash flow from operations for the third quarter of 2016 was $5.7 million, our highest level of this year. We continued to maintain a strong balance sheet with $24.8 million in cash and no debt, $24.8 million is above Q3 of last year. We are pleased with our continued ability to generate cash and that we have been able to rebuild the cash balance upon completing two buybacks over the last six quarters for a total of $30 million. CapEx for the quarter was $500,000 and is planned to be approximately $2.4 million for the full year 2016. Our backlog which represents the dollar value of committed contracts was a record $81.6 million as of September 30, 2016, which is up $7.4 million or 10% compared to the same date last year. Of this record amount, we expect to recognize approximately $45.9 million or 56% as revenue over the next 12 months. At the end of the third quarter, our ACV or annual contract value totaled a record $60.2 million up 9% from Q3 of last year. From an industry perspective, the breakdown of ACV was 51% from healthcare, 27% from financial services, 7% from government and 15% from other verticals. Now breaking down ACV by product, ZixOne, our bring your own device security product accounted for $1.1 million of our total ACV and was up 17% year-over-year. ZixQuarantine and ZixInsight, our data loss prevention products accounted for $1.3 million of ACV, which was up 51% from Q3 of last year. And finally, Zix Email Encryption, our flagship product accounted for $57.8 million of total ACV, which was up 8% from Q3 of last year. Now shifting gears to our financial outlook for the fourth quarter ending December 31. We currently anticipate revenue to range between $15.5 million and $15.6 million representing an increase of 8% to 9% compared to Q4 of last year. We are forecasting fully diluted GAAP earnings per share to between $0.02 and $0.03 and non-GAAP adjusted earnings per fully diluted share to be $0.06. For the full year ending December 31, based on our year-to-date results and pipeline of business, we anticipate revenue to range between $60.1 million and $60.2 million. This would represent an increase of 10% compared to revenue in 2015. We forecast fully diluted GAAP earnings per share to be between $0.09 and $0.10. And we increased our forecast of non-GAAP adjusted earnings per fully diluted share by a $0.01 to now be $0.25 representing a 19% increase from fiscal 2015. 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 3. Before I turn it over to Dave, I would just like to add that it has been a very busy first four months for me here at Zix. I found that the key reasons that made me join this company are well intact and only beginning to reveal some of the great opportunities in front of us. We are the industry leader in encrypted email. We have a strong business and financial model built for growth. And we have a dedicated team that is focused on an execution strategy to continue to realize the company's mantra of profitable growth. Dave?

[Dave Wagner:]

Thanks for the overview Dave. Starting at the top, revenue grew to its highest level ever of $15.3 million, up 9% and over the high-end of our guidance. Our renewals were also encouraging, strong renewals in Q3 resulted in $16.5 million of total orders and a 13% increase over Q3 2015. So, we had yet another quarter of exceeding our 90% core renewal rate target. Not only did our direct sales team produced strong renewals for the quarter, for the [same details] [ph] our OEM partners contributed as well. Altogether, these efforts increased our backlogs to record level of $81.6 million. Yet, as we talked about last quarter, we believe it's important to connect some of these successes and challenges of the quarter to what the leadership tam and I are doing to execute on our longer term objectives. We define these objectives to our seven growth pillars and I will now spend a few moments talking about our progress along each of these pillars. Our first pillar is securing new customers to our direct and indirect sales force. We measure additions to our subscribe base at the metric new first year orders. For the third quarter 33% of our new first year orders were delivered through our direct sales efforts, 55% through borrowers and MSVs, 10% through our OEM partners and 3% from web sales. I would like to highlight two new first year orders that were won last quarter by the enterprise sales team, which serves companies with more than 1000 employees. The first was a large city government, which purchased 5000 users of our Zix gateway solution in the third quarter. They selected Zix primarily for our superior and user experience and the enhanced security provided by the Zix encrypted network. But, they were also attracted by the end-to-end encryption passport or integrated Zix mail product for a subset for their users. Due to fiscal budget considerations, these was only a two months order, so it is expected to be extended in the fourth quarter and it is anticipated to grow to 30,000 users over time as they roll out to all departments. A second major win was a medical service provider with offices and affiliates all over the country. This customer solicited proposals from multiple vendors before finally choosing Zix. Again, for the superior end-user experience, but also we have the most flexible deployment options including multiple branded portals and custom policies that we were able to offer seamlessly through our cloud based Zix Port service. These and many other new customer wins continue to highlight the strength of our industry leading email encryption service. So, I mentioned in my opening remarks, while new first year orders for the Q3 were lower than we would have liked, our core direct bar and MSV partners are largely on track. From our results, it's clear that we experienced some short-term challenges in the third quarter and executing on our second pillar, which is to accelerate our growth through our key OEM partners Google and Cisco. Regarding Google, they continue to place orders through their small and medium business team in a very consistent with prior year based levels. Regarding Cisco, we are transitioning from ZEA to selling ZZT. And as had mentioned on our last call, the pipeline with Cisco was growing but at a slower pace than both parties would like. Third quarter was another slow quarter exacerbated by sales territory changes as Cisco began the new fiscal year. On the Zix side, what we can control is implementing a more targeted go-to-market alignment to focus our resources are more specific enterprise sales cycles. Our strategy is to get closer to a more select group of Cisco customers to help boost Cisco's contribution to Zix. Moving on to our third and fourth pillars, which involve expanding our installed base by increasing the number of seats our customer purchase and by up selling more of our products to increase average revenue per user. An example of such a customer expansion in the third quarter was with a large national home healthcare network that originally purchased ZixAccess. ZixAccess is ideal for customers that receive many encrypted emails through ZixPort because it allows customers to transparently decrypt and reply only to the sender. After using ZixAccess for three years, they came to more clearly see the value of the full Zix solutions and moved up to a full hosted Zix Gateway solution in the third quarter. This growth within a customer base is where we see the greatest potential of immediate impact to new first year orders and we are diligently working to optimize our sales team and our product suite to execute these pillars. Moving to the fifth growth pillar, we talked earlier about how we successfully maintained more than 90% of our renewals in the third quarter, which is an increase of 300 basis points over the same period a year ago. In addition to our renewals from our core business, we are working with our OEM partners for improvement on their renewals. Increasing customer satisfaction and reducing churn is the primary purpose of pillar five and we are enjoying success in this area. We intend to build upon this early success with even more focus. Our sixth pillar is to invest in our core email encryption solutions. As we mentioned in our last call, we brought on a new VP of Product Management and Strategy to focus on our roadmap and longer term product portfolio strategy. In the third quarter, we added two additional senior people to the product management team and together with the leadership team, they have done a great job gathering customer feedback and realigning our core roadmap. In Q3, we saw the release of enhancements to our hosted email encryption solution including ZixPort. The new ZixPort release expands single sign-on capability using credentials for both Google and Microsoft services, offering recipients a more convenient experience and enabling two-factor authentication without additional hassle. The new product release also empowers customers to expand email encryption to senders outside the organization such as contractors, strategic partners, agents and board members. These features meet the needs of many customers in healthcare, financial services and title organization facing complaints requirements that extend beyond their organization's infrastructure and offer Zix solid add-on license opportunities within our existing base. And finally, our seventh and last pillar relates to exploring adjacent English speaking international market that present us with attractive opportunities to drive profitable growth. During the quarter, we announced that we partnered with LAWtrust, a security solutions provider in South Africa to address that market at a very opportune time with respect to its new regulatory requirement. Under South Africa's Protection of Personal Information Act or POPI, minimum requirements were established for the processing of personal information of South African citizens. While portions of POPI went into effect in 2014, regulators were just appointed in September 2016 to enforce POPI, which includes substantial fines and even imprisonment. Our partnership with LAWtrust will enable South African organization to easily protect personal information and email and meet regulatory obligation, presenting us with an opportunity to expand our market leading position beyond the United States and become an email encryption provider of choice for the South African market. We are excited by how fast we are able to respond to this opportunity and we look forward it to be a nice extension of our business as we continue to explore other international market, where we see potential to add to Zix's long-term growth. Overall, we are encouraged both by our quarterly and year-to-date results. More importantly, we believe we are on track to achieve our financial guidance for the year and we are in a solid position to deliver a high level of profitable growth moving forward. This is certainly not a signal to relax. We are actively working to improve our OEM go-to-market processes and the team is aggressively working to capitalize on Q4 opportunities. However, it's reassuring to know that our core business continues to perform well and that the progress we are making on our seven pillars is both increasing and meaningful. Now, with that, we are ready to open the call for your questions. Operator?

[Operator:]

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

[Mike Malouf:]

Great. Thanks guys for taking my questions.

[Dave Wagner:]

Sure thing, good to talk to you Mike.

[Mike Malouf:]

Yes. I guess the first thing, if we could just delve just a little bit more deeper into the Cisco relationship and obviously, we have been waiting for that to get some traction. And as you look into the pipeline and into next year, how do you see that maturing, I kind of thought maybe last quarter we were starting to get some of that traction with that one large client that you highlighted on the call last time. Can you give us a little bit more color on that?

[Dave Wagner:]

Well, I can and as I have been saying, it's unfortunate that the pipeline is coming through the orders slower than both parties would like. What we are doing as I said is focusing on the very specific larger enterprise accounts with our resource to do more side-by-side selling. Cisco as you know has a great large set of product offerings. So, they have literally 100 security offerings alone, so getting the right message to the right people through the right Cisco people to the right customer has proven more challenging than we thought. And that's why we are targeting in the resources more carefully to mask the selling motion.

[Mike Malouf:]

Okay. And as you look at the opportunity, do you still think its large as it was, or perhaps maybe it's not quite as large, can you give us a sense of just how you look at the opportunity now and has that changed?

[Dave Wagner:]

The opportunity is still large. The time is clearly longer and I think it's going to take -- clearly, we are going to take more work than we thought a year ago and that's what we are focused on getting done in the next couple of quarters.

[Mike Malouf:]

Okay. And then, it's great to see your success on the renewal, that's very impressive. I'm just wondering if you could talk a little bit about pricing and how that has changed, you haven't been that long but what kind of trends do you see on the pricing side on the renewals?

[Dave Wagner:]

So, on the renewal side, we continue to get a very even offset between price increases that we are able to push through the base, offset by some aggressive procurement people. But that offset has been no negative increase in the pricing on renewal.

[Mike Malouf:]

Okay, great. Thanks a lot for taking my questions.

[Dave Wagner:]

Great. Thank you, Mike.

[Operator:]

Thank you. Our next question comes from Joe Maxa from Dougherty & Company. Your line is open.

[Joe Maxa:]

Thank you. I was wondering if you could quantify or give us maybe some more color on the deal that –slipped from Q3 to Q4; were those one year in nature or those multi-years and maybe for some type of value you can give us or range?

[Dave Wagner:]

I don't know I can give a value. The OEM as I mentioned was – at 10% of our total orders was disappointing. On the corporate and enterprise side, there were handful of deals on each side. On the corporate side, which tend to be -- these were customers under 100 end users, so these deals tend to be in $15,000 to $65,000 per year range. Those -- the one that slipped there have largely been completed in October. On the enterprise side, there is a big customers' with longer sales cycle and one that slipped out, we are tracking well to this quarter. A very specific example would be that large city government there – you know ended up being a two-month instead of what normally would be a full year, just the way that organization’s budgeting cycle went, they made full big decisions just they could only execute two months of a fiscal year, flipped over. So, but that would be another example of one that -- we would expect to be coming -- in the coming weeks.

[Joe Maxa:]

Next question would be regarding the new first year orders versus total orders, is that an indication of just longer mid three-year contracts versus one-year in general or you seeing that trend that way or is this more of a one-time event do you think?

[Dave Wagner:]

In terms of our total average contract length that's been pretty sticky between 30 and 31 months, so we still primarily do three year agreements, but we are totally open to one-year agreements when that fits that customers preference. But that's been a relative 50 percentage. Really, what you are seeing in those -- in the total orders, it has to do, first, with our great renewal rate and, second, the timing of when the renewals come up, so we had a large pot of renewals available to renew that drove the orders and we executed on a really strong percentage of those renewals this quarter.

[Joe Maxa:]

Okay. And if you wouldn't mind going back over, you reclassified some expenses from sales and marketing into R&D?

[Dave Rockvam:]

Yes. There was about three or four people in the selling and marketing line items that has been in there for a long time and really just belong in more R&D, the documentation team. So, they are reclassified just to get them better aligned with the team and budgets going forward.

[Dave Wagner:]

That's just maybe [$200,000]…

[Dave Rockvam:]

[Inaudible] quarter adjustments.

[Joe Maxa:]

Okay. That's all I had. Thank you.

[Dave Wagner:]

Okay. Thanks Joe.

[Operator:]

Thank you. Our next question comes from Michael Kim from Imperial Capital. Your line is open.

[Michael Kim:]

Hi, good afternoon guys. Just following up on the city government win, what's the expected timeframe to roll out over the 30,000 total users. Do you think there is --within the budget cycle a plan to accomplish that over the next 12 months or maybe a little bit longer timeframe than that?

[Dave Wagner:]

I would guess a little bit longer - city government ,in my experience, takes a little longer. They did a very comprehensive bake-off of multiple solutions and we are very, very pleased to get that win for the reasons I mentioned and our time to deployment with the customer is hours, not week, so we will -- I didn't check if they are actually up [inaudible] today, but they are probably up [inaudible] today. And then, the tempo which they introduce it to new users, it will be based on their business plan and budget priorities, but I would expect they bought enough for the first full fiscal year.

[Michael Kim:]

Got it. On the OEM channel, as you think about your partnership with Google, do you see that sort of returning to maybe higher levels or maybe historical levels or if you think something has changed in that reseller base that -- maybe put a little less emphasis on the game solution?

[Dave Wagner:]

Well, I think what I like about the Google partnership, their competition with Office365, encryption is a piece that they need and so we get positioned within those cycles at a base rate that we like. We are going to -- we are focusing on that relationship for ways that we can enhance and improve it which would be our goal. We are making really good progress, still early but good progress on the renewals and gain those renewal processes in place. And doing some of the things that we do for our direct customers hoping to get that level of touch and service to our customers to increase satisfaction. We think those things combined with some product work will keep us in a strong and strengthening position at Google. And the big, the 230,000 state deal those are the big and lumpy and the opportunities to get those -- they come up when they come up, it's not something that we depend on in our -- forecasting them.

[Michael Kim:]

Got it. And then, lastly, talked a little bit about ramping up some of your sales and marketing growth investments. Do you envision putting that to work and expanding the direct sales force, your field organization or building out the Insight sales and part of what the reason I asked that is, if I have my numbers right, Warren, MS, P-Channel are pretty similar Q2, Q3, curious if Insight sales could become a larger component?

[Dave Wagner:]

Yes. That's what we are going to call it as customer relationship management as we focus on pillars three and four and we focus on customers as fast and make sure that our customers are being communicated with in a best-in-class way and they are getting maximum value from solution. That's when we are going to make those investments. So we have 14,300 customers. The top 1000 make up a very meaningful, half of our revenue comes from the top 1000 customers and those are the ones we want to make sure getting a world-class service relationship and really aware of the features -- the ZixPort features that I talked about in the call. These are meaningful value adds that get built into the solution. It allow us to be provided to more and more users and so we want to take advantage of the work we are doing to our core email encryption product and make sure our customers are super aware of that and informed about what we are doing and have the opportunity to get value from our Zix solution as many places as possible in the organization.

[Michael Kim:]

Great. And then, if I could just get one more in here, with regards to the ZixQuarantine and Insight, are you seeing a higher catch with the existing customers, higher take rate and/or are you also seeing kind of new customers embrace encryption and DLP at the same time?

[Dave Wagner:]

We are seeing -- when we talk to our customers but the context where nature of our product whether it's the Lexicon built into the gateway and the extended or the extended ZixQuarantine Insight functionality is really important how they look at it as a provider of our protection. They are always looking at, but not always, but the vast majority of the time they are looking at Lexicon, the ZixInsight and Quarantine add-on. We saw a pretty similar quarter to last quarter, we see that being positioned, I know we are positioning it more and more on new sales and existing customers; I talk to the sales people and talk to existing customers. Really it's been the value of Insight mails have more insight into the email flow in the -- the information they are able to get about the organization through that product. So, work done get about it.

[Michael Kim:]

Very good. Thank you very much.

[Dave Wagner:]

All right. Thanks Michael.

[Operator:]

Thank you. And ladies and gentlemen, this does conclude our question-and-answer session for today's conference. I would now like to turn the conference back over to Dave Wagner for any closing remarks.

[Dave Wagner:]

Well, I just like to thank everybody for your time today on the call and for your interest in Zix Corporation. Thank you very much. Good evening.

[Operator:]

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