Zix Corporation
Q2 2010 Earnings Call Transcript

Published: 27 Jul 2010

[Operator:]

Welcome to Q2 2010 Zix Corporation Earnings Call. My name is Jonathan, and I will be your operator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder this conference is being recorded for replay purposes. I would now like to turn the call over to Mr. Geoff Bibby, Vice President of Corporate Marketing. Please proceed sir.

[Geoff Bibby:]

Thank you, Jonathan and thank you for joining our 2010 Q2 conference call. You can find our earnings press release on our investor website at investor.zixcorp.com. The earnings release contains instructions for accessing a recording of this call. Our Chairman and Chief Executive Officer, Rick Spurr will provide an overview of the company's performance in the quarter and then our Chief Financial Officer, Susan Conner will give you details of our financial results. Later in the call Rick and Susan will answer questions from analyst and institutional investors. Listeners can also submit questions during the call to our investor relation's mail box at [e-mail]. Rick and Susan will provide forward-looking statement on matters such as forecast of revenues, earnings, operating margins, and cash flow, projections of our contracts, or business, and comments on trend information. The company undertakes no obligation to publicly update or revise any forward-looking statements. Forward-looking statements are subject to risks that could cause actual results to differ materially from our expectations. The risk factor section of the company's most recent Form 10-K filing with the SEC gives examples of those risks. Rick and Susan will refer to various non-GAAP financial measures such as adjusted gross profit, adjusted operating expenses, adjusted earnings, adjusted net income, adjusted operating margin and adjusted EBITDA. You can find in our earnings press release and on our investor website detailed explanations of our non-GAAP financial measures along with reconciliations of our adjusting items to the most directly comparable GAAP financial measures. Now, I'm pleased to the call over to Rick.

[Rick Spurr:]

Thank you, Jeff. Good afternoon everyone and thanks for joining Zix Corporation's earnings call. In the second quarter of 2010, ZixCorp continued to build on its strong start to the year with yet another solid quarter in its Email Encryption business, which obviously led to a strong performance for the company overall.] In Q2, we set records in total revenue, adjusted EBITDA, adjusted earnings per share and bookings backlog. We had continued success in our Email Encryption orders topping the $2 million mark in new first year orders for the third consecutive quarter, culminating in the best nine months of email orders in the company's history. That sales performance combined with our sustained, high customer retention also generated a record backlog for the company. We are excited about the impressive top-line growth through the first half of this year with revenues running 24% ahead of the first half of 2009. Concern among potential customers about privacy law compliance remains a strong driver for demand. HIPAA compliance is an important factor within healthcare. Banks and credit unions continue to get pressure from their regulators to protect electronic transmissions that contain sensitive information. State laws such as those in Massachusetts, Nevada and most recently Washington State, continue to set new data protection standards and call for action from a variety of sectors, but Email Encryption isn’t just being driven by privacy and law compliance, businesses are concerned about protecting their reputations and their sensitive data. Publicity about data security breaches has certainly put protecting sensitive information on the front door for many companies. These data breaches including some involving unsecured email have highlighted the vulnerability of sensitive information, including when it's in transit. In general, the heightened awareness of these threats and fear of unwanted publicity are causing companies to take proactive steps to secure this information. Healthcare was the largest contributor to our new sales in the second quarter, with 55% of the $2.1 million in new first year orders coming from this sector. Many business associates of health care providers are just beginning to realize that HIPAA data's privacy and security privacy rules apply directly to them. Businesses such as third party administrators, medical transcription and billing companies, lawyers and accountants with access to patient information are being required to demonstrate compliance with HIPAA We saw significant surge in demand from this group in the second quarter the bar keeps getting set higher to protect privacy in healthcare. Earlier this month, the United States Department of Health and Human Services, proposed yet new HIPAA data security and privacy rules that would among other things further expand HIPAA by broadening the definition of a business associate and requiring all business associates to impose new contractual conditions on their subcontractors. These developments continue to drive a need for many more companies involved in healthcare to adopt appropriate data safeguards, such as email encryption. Our strong footprint in healthcare combined with ease of use of our transparent Email Encryption solution when communicating between entities behind our gateways makes ZixCorp a particularly attractive solution for these business associates. So healthcare is our leading industry sector, but our solutions continue to be a demand in several industries. We've build the brand known for reliability, scalability, ease of use and customer service. Companies wants an easy to use email encryption solution that helps to mitigate their data security and privacy risks without adding significant burden for their users. Our customers [obviously will] to having to think about the ZixCorp solution because it "it just works." In fact, we just had a nice reference to our leadership position as an email encryption provider in Gartner's latest Leaders Magic Quadrant on secure email gateways. So, it appears all of our hard work is indeed paying off. Our direct sales force has been particularly productive recently. Of the sales opportunities we tracked we are winning three out of every four deals. That success has led to the best three quarters for new first year orders in the company's history. We're really seeing that companies outside our core verticals are considering using Email Encryption to protect their entire organization, when in the past they were deployed only for part of their company. If that becomes a strong trend it would benefit our average deal size. Plus integrating our solution deeper into customer’s infrastructures would also help us sustain our high customer retention rates. Our sales success extends beyond our direct sales efforts. We continue to see good performance across all of our sales channels. Our OEM relationships made another strong contribution generating a record 22% of our new first year orders in Q2 and a record contribution on an absolute basis as well. We are particularly pleased to see stronger contributions among our most recently signed OEM partners like Webroot, as well as our longer term OEM partners, such as Google and Symantec. In addition, our MSSPs, Managed Security Service Providers and resellers continue to deliver sales for us. In fact, we've seen growing interest from potential new MSSPs and resellers calling us as demand for Email Encryption remain strong. This is obviously another good indicator of the strength in our brand and of our reputation as a leader in the industry. Broader business trends also support our prospects for continued success. First, email remains the primary form of business communication, with the volume of email exceeding phone calls, written communications and text messages combined. There are an estimated 833 million business email users worldwide that send and receive an average of 133 emails per day and the volume of email is expected to continue to grow. Email is also the principal file transportation mechanism in many companies. Osterman Research estimates that 20% to 25% of email contains attachments. Therefore email is expected to stay at the forefront of business communications for the foreseeable future. Second, companies are increasingly moving their applications to cloud computing services. ZixCorp offers Email Encryption in a cloud, using our Software-as-a-Service model. IDC just released a study indicating that SaaS model has become the mainstream for software and services vendors. With SaaS revenues expected to grow five times faster than revenue from traditional package software, IDC predicts that by 2012, 85% of net new software firms coming to the market will be built around SaaS model and delivery. Of course our Email Encryption business has always been built around the SaaS model now being considered the wave of the future. So demand for Email Encryption is rising as the addressable market continues to expand. We offer the market a solution that’s affordable, simple and reliable with outstanding customer service and high customer retention rates. Those factors coupled with our SAS subscription model are key to our recurring revenue stream. This recurring revenue model gives us great visibility into the coming quarter’s performance. We begin each quarter with a large percentage of our revenue already contractually committed. For instance let's look at the record order backlog for email. As of June 30, 2010, we expect to recognize 15.5 million of that backlog into revenue in the second half of this year, which when added to our 2010 revenue to-date, equals over $31 million. Add to this new 2010, revenue from new 2010 sales made between now and year-end, and you can see pretty easily how we expect to achieve our revenue guidance. We also begin to have visibility into 2011, where we already have over $18 million in revenue, scheduled in the backlog at 6/30/2010. With continued success in acquiring new customers, and retaining existing customers, we expect to build on our current financial performance. That highly predictable revenue stream is nice to have in these unusually uncertain economic times. While pundits may worry about a double dip in the economy, we don’t anticipate much of an impact on our performance for the perceivable future. Complimenting the predictability of our revenue stream is the predominately fixed cost, structure of the business, because the vast majority of our costs are fixed, we have significant operating leverage in the company. So as we grow top-line we've also been able to sustain or even grow our various margins. Again, in the current economy, we are pleased to be in the situation we are in and expect to maintain our high performance level. More to the point, as we previously disclosed, we expect 2010 to be in the first year of profitability in the history of this business. Due to strong demand for Email Encryption and our superior technology, we continue to show significant improvement in our Email Encryption business and are on track to meet the high end of our overall financial projections for the year. The wind down of our e-Prescribing business is also progressing well. We worked out appropriate resolutions with all of our major customers in this business and so we protected our brand in the important healthcare vertical. We've managed this process professionally. With that I will invite Susan to discuss the financials for the second quarter. Susan?

[Susan Conner:]

Thanks, Rick, and good afternoon to everyone. It's great to report strong results for the second quarter in our key financial metrics, revenue, GAAP and adjusted net income, EBITDA, cash flow from operations, new first year orders and total bookings backlog. This is a second quarter in a row that we've achieved GAAP profitability, with GAAP net income of $1.5 million. Additionally, we have recorded improvement in our adjusted earnings for four consecutive quarters now. Our Email Encryption business achieved new first year orders during the second quarter of $2.1 million, a 28% increase over the second quarter of 2009. I will now move on to the details of our second quarter financial results, beginning with revenue. We've achieved company wide revenues of $8.9 million which compares to $7.4 million for the second quarter of 2009. Email Encryption revenue was $8.2 million of this amount and e-Prescribing was approximately $700,000. Email Encryption revenue for the second quarter grew $1.8 million, a 28% increase over the comparable 2009 figure. Our OEM partners drove approximately $280,000 of this increase and the total OEM revenue contribution was a 74% improvement from the second quarter a year ago. Our direct sale to enterprise and corporate customers, including to our resellers and MSSPs drove the remaining growth. We continue to see cumulative growth in our subscription model with strong new orders combined with a high level of renewals. Our second quarter revenue also included a catch-up entry of approximately $300,000 for a change in our accounting practice concerning when we commenced revenue recognition after deployment. During the second quarter we implemented an automated method of closing out our service offering deployments. This method shortens the time for reporting deployments and allows us to begin recognizing revenue as soon as the service is implemented. This deferred revenue catch-up is not anticipated to have a material impact on our projected annual revenue for 2010. Under the old method we would have seen the $300,000 in revenues split between Q3 and Q4. It is simply a difference in timing of when this $300,000 of revenues would have been recognized. We will continue to follow this new accounting practice going forward. E-Prescribing revenue for the second quarter was $700,000, which is down 27% from the second quarter of last year as expected, given our announced plan to exit this business at the end of 2010. Looking at our Email Encryption bookings backlog, we ended the second quarter with $45.6 million, which is a 16% increase over the bookings backlog of $39.2 million at the end of the second quarter of 2009. As a reminder to everyone, a bookings backlog is comprised of contractual commitments that we expect to amortize into revenue in the future as services are performed. The timing of revenue recognition is affected by both the length of time required to deploy a service and the length of the service contract. We anticipate approximately 57% of the Email Encryption backlog being recognized into revenue within the next 12 months. Since we are simply running out the e-Prescribing backlog as we recognize the revenue throughout the remainder of the year, I will no longer report this balance going forward. The e-Prescribing backlog at June 30 was $700,000, which we obviously will recognize into revenue during 2010. Let's move on to look at our various margins as well as the details on our expenses. We achieved a company-wide adjusted gross profit for the second quarter of $7.1 million, 79% of revenues. This compares to $5.1 million, 69% of revenues for the same quarter last year and on a sequential basis, it compares to $6.6 million or 79% revenues for the first quarter of 2010. The Email Encryption adjusted gross profit for the second quarter was $6.7 million, 81% of revenues, compared to $5.3 million in the same period last year, 83% of revenue, the Email Encryption gross profit amount was a result of an increase of $1.8 million in revenue and an offsetting $455,000 in increased expenses. The Email Encryption gross margin percentage change as I mentioned before, is occurring due to some of the shared fixed cost previously allocated to e-Prescribing, which are now been shifted to Email-Encryption. Although slightly lower, our Email-Encryption margins are still healthy, and after these costs are fully absorbed by the Email-Encryption business, I expect the Email-Encryption gross margin percentage to improve as we grow revenue. Our e-Prescribing adjusted gross profit was $406,000, 56% of revenues compared to a negative $203,000 or negative 20% of revenues for the same quarter last year. This improvement is due primarily to a $900,000 reduction in our cost of revenues driven by the wind down of the business. We have lower head count between periods, we are not incurring cost to deploy new doctors, and the business is being burdened with lower allocated cost, based on lower head count and decreased time spent on that business segment. With regards to company-wide operating expenses, adjusted R&D and SG&A expenses totaled $4.8 million in the second quarter of 2010, compared to $6.03 million for the same period last year. R&D expenses were $1.3 million in the second quarter a decrease of $400,000 while SG&A expenses were $3.5 million, a decrease of $1.1 million. The R&D and SG&A expense decreases from 2009 are primarily driven by lower headcount, resulting mainly from actions taken in the e-Prescribing segment to align expenses with the needs of our business. In the second quarter of 2010, the ongoing R&D investment in our Email Encryption products included delivery of new versions of both ZixGateway, and ZixPort that provided increased security and supports for multiple languages. We also designed a set of tool to improve the automation level and efficiency of customer provisioning process for our channel partners. This will allow the channels to deploy our services more quickly and we'll be able to begun recognizing revenue sooner. Initially, these tools are being rolled out through our MSSPs and later to all the channel partners. Our company-wide adjusted operating margins for the second quarter was $2.2 million, 25% of revenues, this compares to a loss of $880,000 or negative 12% of revenues for the same quarter of last year. Our adjusted EBITDA for the second quarter was $2.6 million with an adjusted EBITDA margin of 29%, compared with an adjusted EBITDA of negative $472,000 and adjusted EBITDA margin of negative 6% in the second quarter of 2009. Our capital expenditures for the second quarter were $284,000. Depreciation expense for the quarter was approximately $341,000 and it's recorded in the various P&L line items with approximately 76% been recorded in cost to revenues. Cash and cash equivalents were $17.5 million at June 30, 2010, compared with $15.7 million at March 31, 2010, and $12.5 million at June 30th, 2009. We again delivered good results in cash flow from operations this quarter. This cash increase in the second quarter was driven primarily by the continued cost savings generated by the wind down of e-Prescribing business. We achieved this growth in cash in the second quarter, while at the same time holding accounts payable and accrued expenses basically flat with the first quarter. While I’m touching on aspects of the balance sheet, I’d like to also mention that our stockholders equity balance is $1.7 million. This is the first quarter since 2007 in which we now have positive stockholders equity again. Our companywide adjusted net income for the second quarter was $2.2 million, which compares to $835,000 loss for the same period in 2009. Our adjusted net income for fully diluted shares of common stock for the quarter was $0.03 versus negative $0.01 for the same period in 2009. This amount is also up sequentially from the first quarter, where we reported adjusted net income of $1.2 million and $0.02 per fully diluted share. Now I’d like to move to our outlook for the third quarter and full year. We project our adjusted earnings to continue to increase with our adjusted earnings per fully diluted share rounding to $0.03 consistent with last quarter. I’ll explain again why we are not giving an EPS range. With approximately 66 million shares outstanding on a diluted basis in any given quarter it takes around $660,000 to drive up earnings per share by another penny. So, although we expect our actual earnings to be higher it would still round to $0.03. While this is the same adjusted earnings per share we recorded in the second quarter, approximately $300,000 of our results in Q2 were driven by the revenue catch-up I previously discussed. The projected earnings results for Q3 are supported by our revenue guidance ranging from $8.9 million to $9.1 million, again reflecting continued growth in our Email Encryption business, partially offset by the decline in e-Prescribing. Included in this overall revenue projection, are e-Prescribing revenues of $400,000 to $500,000. In Q2 this business generated approximately $304,000 of adjusted operating income and we are now expecting e-Prescribing to be better than breakeven as we had previously projected and to actually generate positive earnings for the year. The wind down is progressing well and there have been minimal technical support issues, which have allowed us to re-purpose some of the e-Prescribing team to support the Email Encryption business when they have time. This is producing a shift in expenses though between the two businesses and will not generate additional earnings at a company level. Narrowing the spread towards the upper end of our previously announced full year guidance, we now project company-wide 2010 revenues to be between $35.2 million and $36 million of which e-Prescribing revenues would comprise $2.3 million to $2.5 million. For full year 2010, adjusted earnings per fully diluted share are projected to be between $0.10 and $0.11 with approximately 67 million fully diluted shares outstanding. This should yield a full year adjusted EBITDA margin in the 26% to 27%, and an adjusted operating margin in the 21% to 23% range. We are very pleased with the results of the second quarter and in closing I would like to mention that we are continuing our focus on getting the story out on the company’s improved fundamentals. Rick will provide a summary at the end of his comments on our upcoming investor activity. We are very exited about sharing with the investment community this update on our year-to-date performance and our updated full year guidance. With that I will turn it back to Rick. Rick?

[Rick Spurr:]

Thanks Susan, ZixCorp, continues to show good growth, and our results in Q2 were impressive. We delivered records in revenue, adjusted EBITDA, adjusted earnings per share and bookings backlog. Demand remained strong for our Email Encryption solutions, which we anticipate will translate into continued success in this business. Even the wind down of our e-Prescribing businesses is performing ahead of our original projections. Our direct sales efforts have been productive. The contribution from our OEM partners continues to grow and we are seeing more interest from potential MSSPs and resellers who are calling us to sell our technology. Our record backlog even during this period of economic uncertainty and high operating leverage, point to continued strong results in 2010. Our recurring revenue model provides a high level of visibility and predictability, which when combined with our performance in the first half of the year, has led to the tightening of range on our guidance for 2010, for the high end of our annual revenue and adjusted earnings projections, as Susan just mentioned. We are progressing well and intend to continue to keep working hard and working smart to deliver results. Thank you for your time and attention today and with that I will turn the call over to the operator for questions.

[Operator:]

(Operator Instructions) Your first question comes from the line of Mike Malouf with Craig-Hallum Capital.

[Mike Malouf:]

I just pretty surprised actually by your win rate at three out of five, certainly impressive. I was wondering if you could talk a little bit about the competitive environment out there and then specifically the relationship with the OEM side. How are they competing out there is well? Thank you.

[Rick Spurr:]

Sure. I should mention this is Mike Malouf of Craig-Hallum who just in the second quarter of this year initiated coverage. So Mike it's great to have you and thanks for your leading question. Actually the competitive win rate is three out of four and again that's measured against those deals that we have visibility. We are sure there are things on that we don’t know about but we do have a lot of eyes, ears and feet on the street and our corporate sales team is calling hundreds and thousands of customers all the time. So we have pretty good visibility. So we are wining three out of four, which is consistent with what we reported last quarter. Underlying that, we do however see that CISCO is strengthening while the other competitors are weakening. So, of the one and four that we are losing, CISCO is getting a larger share of those. We still believe that where we are losing predominantly where Encryption is an interesting thing, something that people want to check the box on, but when they really do an in-depth detail analysis we believe we are winning a vast majority of those. Our partners, we got some great ones and if you look at the Gartner Magic Quadrant for email security solution providers, we are partnered with some of the best. The competition is seeing frankly is each other and they too see CISCO of course with a bundled solution, but I don’t think there is anything markedly different in this [sort of] competition they are facing versus what we see on a direct basis.

[Operator:]

(Operator Instruction). I see no further questions. I would like to hand the call back to Mr. Rick Spurr, Chairman and CEO for any closing remarks.

[Rick Spurr:]

Thank you again for your interest today. We are looking forward to continuing to tell our story and share our results. In the middle of August we plan to visit Minneapolis, Milwaukee and Chicago for industrial meetings. In September we’ll be in New York for the Imperial Capital Annual Global Opportunities Conference. In October, we will be back in New York for Craig-Hallum's Alphas Select List conference. So, please contact us if you would like to speak with us during any of these trips. So until we speak again, until next time, thank you and goodbye.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's call. The presentation has ended. You may now disconnect. Have a good day.