Zix Corporation
Q2 2012 Earnings Call Transcript

Published: 25 Jul 2012

[Operator:]

Good day ladies and gentlemen and welcome to the second quarter 2012 Zix Corporation's earning conference call. My name is Kim and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will conduct the question-and-answer session at the end of today's conference. (Operator instructions) I would now like to turn the call over to your host for today, Mr. Geoff Bibby. Please proceed.

[Geoff Bibby:]

Thank you Kim. Good afternoon. As Kim mentioned, my name is Geoff Bibby. I am Vice President of Corporate Marketing for Zix Corporation. Thank you for joining our 2012 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. Then our CFO, Mike English, will give you details of our financial results. Later in the call they will answer questions from analysts and institutional investors. Listeners can also submit questions during the call to our investor relations mailbox at [e-mail]. Rick and Mike will provide forward-looking statements on matters such as forecast of revenues, earnings, operating margins and cash flow, projections of our contracts or business, new products 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 factors section of the company's most recent Form 10-K filing with the SEC gives examples of those risks. Rick and Mike will refer to various non-GAAP financial measures, such as adjusted gross profit, adjusted operating expenses, adjusted earnings 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 am very pleased to turn the call over to Rick.

[Rick Spurr:]

Thanks Geoff. Good afternoon everyone and thank you for joining us today. I am pleased to announce that during the second quarter, we delivered the best financial results in our company's history. These results included strong new first year orders, which reached a record $2.5 million, up 46% sequentially from 1.7 million in the preceding quarter and up 22% from 2 million in the second quarter of last year. While our second quarter tends to be our strongest, we believe this significant increase in orders goes beyond seasonal trends and reflects the broad based increase in demand for email encryption. We are seeing more inbound enquiries, up 66% over last year. More activity from prospects buying email encryption for the first time and more opportunities to replace outdated or weak competitive solutions. The strong new order results in Q2 also reflects our increased number of mid-market channel partners which we grew by 80% over the last 18 months. We now have 191 combined managed security service providers and value added resellers compared to 106 at the end of 2010. This increased command also highlights what we talked about over the past few quarters that buyers have become better educated and are now more discriminating when it comes to selecting an email encryption solution. They now understand the robust capabilities and ease of use design features that are required for success and are demanding a more sophisticated solution like Zix Corp. prospective customers are starting to make buying decisions based on the feature set, quality and effectiveness of the solution they intend to implement including automatic policy based encryption, ease of use through transparency, strong analytics and reporting capabilities and best in class mobility support. This trend has and will continue to benefit Zix because of the quality and maturity of our solutions. We’ve been focused on this market segment for more than 10 years. We are far away the leader in the market and continue to enhance the feature set, reliability, ease of use and the overall effectiveness of our solution. Let's get back to the Q2 numbers. From a top lying perspective, we recorded revenue of $10.3 million which was up 9.7% when compared to the $9.4 million we reported in the second quarter of last year. We also had record total bookings for the second quarter, a $13.6 million up 50% sequentially from $9.1 million in the preceding quarter and up 8.6% from $12.5 million in the second quarter of last year. Our record backlog at the end of second quarter of 2012 is very strong at $55.5 million up 6% both sequentially and year-over-year. We recorded our 10th consecutive quarter of GAAP profitability achieving GAAP net income of $2.6 million. On a fully diluted share basis, GAAP profitability was $0.04 per share. We also exceeded our non-GAAP adjusted net income guidance for the quarter, achieving non-GAAP adjusted net income of $3.1 million, up 12.8% over the $2.7 million reported in the second quarter of last year. Non-GAAP net income for the second quarter on a fully diluted per share basis was $0.05 per share exceeding our guidance of $0.04 per share. Our business continued to generate cash during the quarter with approximately $5 million in cash flow from operations, an increase of $2.5 million year-over-year. We ended the quarter with a cash balance of $18.8 million, an increase of $800,000 from last quarter, taking into account $4 million worth of share repurchases that we completed during the quarter. Our healthy balance sheet and strong cash flow gives us multiple options to increase value to our shareholders. Let's look more closely at the composition of the new first year orders this past quarter. Our small and medium business segment had the best performance ever. Not only did they set a record, but their performance was 80% higher than any quarter for over a year. Our enterprise sales were good but we think they can be even better and it's important to note that our strong performance in the quarter was not the result of one or two big deals. In fact, the largest sale this quarter was just under $90,000 on an annualized basis. In Q1, our OEM channels set a new record and against that backdrop Q2 was disappointing. We think this could be due in part to the fact that two of our OEM partners, Symantec and M86, were dealing with organizational changes in the second quarter. M86 was acquired by Trustwave. And in Symantec's case, they implemented a major sales reorganization in April. Going forward, we continue to be optimistic regarding the OEM channel partners and are particularly encouraged by a renewed focus from Symantec. If we look at the Q2 new first year orders by vertical, there are no surprises. The healthcare and finance verticals continued to lead the way at 43% and 31% respectively. I am pleased to report that we now have over 1,500 hospitals which means that Zix is being used by one in every five hospitals in the United States. We also surpassed the 1,800 mark for financial institutions and now provide email encryption services to one out of every five banks in the United States and we recorded solid growth from our non-core verticals as well. This market we call "other" is made up of all companies not classified as finance, insurance, healthcare or government. In 2011, the new first year order contribution from other, was 17%. Through the first half of 2012, it's up to 21%. We think this reflects stronger overall demand for email encryption and a broader reach through our channel partners. Not new to us this quarter but in general, customers in this other category include U.S. Steel, Bed, Bath & Beyond, Starbucks and Costco. As the number one provider of email encryption in the marketplace today and the clear technology leader, we believe Zix has a distinct advantage with a better educated set of buyers we are seeing today. Our recent strategic investments in our platform have produced a superior product offering that significantly separates us from our competition. In the last 18 months alone, we've added Zix Mobility, new high end features including two factor authentication and message recall. We incorporated ToS in the best method of delivery to give customers increased transparent delivery of encrypted email and to do it in a way that's significantly superior in terms of security and control. And now, with our new Zixgateway 4.4 release just announced, we are delivering the industry's best-in-class reporting capability. We will continue to invest in our technology and we remain focused on expanding our leadership position and driving increased market share in this growing market. Our opportunities for growth are twofold. One, to capture more than our fair share of growth in the marketplace and two, to displace competition and that second growth opportunity is starting to play out. It was especially gratifying to record more competitive win backs in this most recent quarter than ever before. In fact, we had twice the number of competitive win backs than any previous quarter and yet, we think we are just seeing the tip of the iceberg in terms of competitive replacement at the high-end of the market. So in summary, the email encryption business, we just completed the best quarter in our history in terms of new sales and total sales. We said that we expected 2012 to be strong and now we've seen the first signs of that in the numbers. Other than typical Q2 seasonality, we didn’t see anything exceptional that caused a spike in the numbers and so we remain confident as we move through Q3 and beyond. Now let's turn from the excitement in our core market of email encryption to some exciting new markets where we are investing to further accelerate our growth and expand our addressable markets. We are making two new investments that will result in new offerings for us in 2013. Let me explain those two new investments and put them in to context of our total R&D spending plans. As noted in previous conference calls, we increased our planned investment in R&D in 2012 to roughly $6 million, up approximately $1 million compared to 2011. This investment has already enabled us to deliver additional significant capabilities to our core, email encryption solution as I mentioned earlier. Now, in addition to the R&D increase announced as we entered 2012, we have decided to make an additional $1.8 million investment this year to begin the development of two new products. This decision will further increase our R&D investment in 2012 by another $1.8 million all being spent in the second half of the year. Our new R&D investments address two separate exciting opportunities. Smaller of these two investments which represents approximately 25% of our increased R&D spending is designed to accelerate the delivery of an email data loss prevention capability. This category of products is referred to in the industry as DLP. our email DLP product will be tightly integrated with our current email encryption offered and will be sold as an add-on to our existing customer base as an optional add-on to new sales or as an independent standalone solution. DLP solutions are designed to prevent the loss of sensitive corporate information whether that information is IP, intellectual property, trade secret data, sensitive legal documents or other confidential information. These solutions stand corporate data, exiting the firm using complex filters to prevent the leakage of sensitive data. It's a product that we are very comfortable adding since we already have the sophisticated filtering technology that is at the core of DLP solutions. We have the industry's most (inaudible) and precise email filters that we've been using and refining for years to identify data in email that needs to be encrypted. We are simply using those same filters to identify data in email that needs to be blocked or in some cases, quarantined. This new product will offer blocking, a quarantine capability, rural space access to that quarantined information and additional reporting. This email-only DLP solution will solve corporation's biggest data leakage problem, email. Independent survey data from the Ponemon Institute, tells us that 70% of customers believe that email is their largest source of data leakage. We intend to address this problem with an easy to use and affordable offering, not available into market today. Today, most solutions in this category are quite large, quite complex and expensive. This new product will allow us to tap into a new market, the DLP market and it will give us an opportunity to further accelerate our growth. Gartner estimates the total worldwide market for DLP in 2012 to be over $500 million and growing at 20% per year. The second investment we're making will address a very large opportunity that exists due to the massive disruptive advent of easy to use mobile technology, mostly notably the iPhone and Android mobile devices. Although these new technologies offer obvious ease of use, functionality and convenience, at the same time, they introduce huge security concerns, potential loss of corporate data, possible unauthorized access to corporate systems and a possible attack vector from malware. Corporations when will accommodate their executives and employees to one user personal devices for business, but now they must address these resulted security concerns. This phenomena is often referred to as BYOD, bring your own device. And is upsetting the security and stability that the old Blackberry construct provided for mobile corporate communication. The result is the emergence of a new market known as mobile device management. Gartner also estimates the total worldwide market for mobile device management in 2012 to be over 500 million and growing at 20% per year. These new offerings, email, DLP and our new mobile device management product, both address large emerging markets and dovetail nicely with the Zix Corp assets. Our leading edge technology and technology team, our strong security brand, our mature direct and indirect channels to market and our ability to develop and deliver exceedingly high quality trusted security solutions into the corporate space. Our plan is to begin delivering our new DLP product in early 2013 and our new mobile device management product addressing the BYOD opportunity in the middle of 2013. These new R&D investments will of course impact our near term earnings and accordingly we are updating our guidance for 2012 for adjusted EPS to $0.16 to $0.17 per share. The plan of course is that these new products will provide even more opportunity to significantly improve our sales growth in 2013 and beyond. And now, let me turn the call over to Mike English, our CFO to discuss our second quarter financial results in more detail and then we'll be happy to take your questions. Michael?

[Mike English:]

Thanks Rick and good afternoon everyone. We achieved excellent results in our key financial metrics including revenue, net income, adjusted net income and adjusted EBITDA in the second quarter of 2012. We reported revenues of $10.3 million for the second quarter which compares to 9.4 million for the second quarter of 2011. This was within our guidance range of $10.3 to $10.5 million. GAAP net income was $2.6 million, essentially flat with the same quarter last year. On an adjusted basis, non-GAAP net income for Q2, 2012 was $3.1 million compared to $2.7 million for the same period last year. Second quarter revenue grew $900,000, a 9.7% increase over the comparable 2011 figure. Our OEM partners drove approximately $220,000 of the revenue increase for the quarter, a 21% improvement from the second quarter a year ago. Our direct sales to enterprise and corporate customers including through our resellers and managed security service providers drove the remaining growth. We ended the second quarter with bookings backlog of $55.5 million which is a 6% increase over the $52.6 million backlog at the end of second quarter 2011 and 6% above the Q1, 2012 ending backlog. We anticipate approximately 58% of the backlog to be recognized into revenue in the next 12 months. Let's move on to look at our various margins as well as the details in our expenses. We achieved second quarter adjusted gross profit of $8.6 million, 83% of revenues. This compares to 7.7 million, 82% of revenues for the same quarter in 2011. On a sequential basis, it compares to $8.5 million or 82% of revenues for the first quarter of 2012. Adjusted R&D expenses were $1.4 million in the second quarter of 2012 up $200,000 from the second quarter of 2011. Adjusted SG&A expenses for the second quarter were $4 million compared to $3.7 million for the second quarter of 2011. The increase in SG&A was split approximately evenly between selling and marketing and G&A expenses. One of the factors in selling and marketing was higher sales commissions. Adjusted operating margin for the second quarter was $3.1 million. 30% of revenues compared to 2.7 million or 29% of revenues for the second quarter of 2011. Our adjusted EBITDA for the second quarter was $3.5 million compared to 3 million in the second quarter of 2011. And the adjusted EBITDA margin percent for the second quarter was 33.5%. capital expenditures for the second quarter were $394,000 and depreciation expense was $326,000. Approximately 70% of the depreciation expense was recorded in cost of revenues. We ended the quarter with $18.8 million in cash, a sequential increase of $800,000. The net increase was driven by a record $4.9 million of cash from operations that more than offset a $4 million repurchase of our common stock. We repurchased 1.4 million shares during the second quarter at an average price of $2.87. this brought the total shares repurchased for the year to 3.1 million. The repurchase was part of the $15 million share repurchase program announced in November 2011. As of June 30th, 2012, there were 62.7 million diluted shares outstanding compared to 67.3 million diluted shares at the end of 2011. As I just noted, operating cash flow for the quarter was $4.9 million up 2.5 million in the same period last year. The year-over-year increase resulted primarily from the growth inherent in our subscription model and the resultant timing of cash collections from our customers. Adjusted net income for the second quarter was $3.1 million which compares to $2.7 million for the same period in 2011. Our adjusted net income for fully diluted share of common stock for the quarter was $0.05 versus $0.04 from the same period in 2011, a year-over-year per share increase of 23%. Let's now move to guidance for 2012. For the third quarter of 2012, taking into account our new R&D investment, we project our fully diluted non-GAAP adjusted earnings per share to be $0.04 on projected revenue guidance ranging from 10.8 million to $11 million. For the full year, we now expect revenue up $42 to $43 million. This represents a tightening of our revenue guidance towards the high end of our previous forecast. As a result of the planned increased investment in R&D that Rick discussed, we now project our fully diluted non-GAAP adjusted earnings per share to be $0.16 to $0.17 versus our previous guidance of $0.19 to $0.20. In closing, we are pleased with our second quarter results and look forward to continued strong performance throughout 2012. With that, I'll turn it back to Rick.

[Rick Spurr:]

Thanks Mike. And now let's turn it back to our operator Kim and begin the Q&A.

[Operator:]

(Operator Instructions). Your first question comes from the line of Mike Malouf of Craig-Hallum and Capital Group. Please proceed.

[Mike Malouf:]

A question on the new products and the new spend. As we look out into 2013, I'm trying to get a sense of just where you think the revenue impact or what the revenue impact could be. Obviously we spend $1.8 million in the back half of this year you had some sort of expectations of what kind of return on that money that the shareholders could get for that. So I'm just trying to get a sense how impactful could this be to your growth rate? Thanks.

[Rick Spurr:]

Sure. Well, first of all, currently we expect that our financial model will be the same, that isn’t cast in concrete, but we expect it will be the same in terms of 100% subscription with revenue recognized ratably as we provide the service. And as such, we expect that these products will boost sales next year but will have a lesser impact on revenue in 2013. Of course, then, for subsequent years, we'll continue to see sales growth we expect and then we'll start seeing revenue impacts from of course prior sales. We obviously aren't forecasting what those increases in sales and revenue will be at this time. These are both very significant markets and we look at opportunities for growth all the time and have for years and the fact that we decided to go forward, I think is a statement that these have passed some severe tests we run on, on fit and viability and our ability to be in a leadership position and our margins and such. So we're quite serious about these and we expect it will allow us to accelerate our growth but we're not in a position to give exact numbers of course or even approximate numbers at this point.

[Mike Malouf:]

So an increase of 900,000 a quarter in spend, are you expecting that to sort of be the new level of R&D spend going forward, or is this sort of a one time bubble (inaudible) that goes back down to that sort of that that 1.5 million or that $6 million a year. I'm just trying to get a sense, now we had $8 million a year, or are we 8.5 or 9 or 10? Where are we with R&D sort of looking out, that'd be helpful.

[Rick Spurr:]

Yes, understood Mike. So first of all the math’s simple. We're at 7-8 this year and you come out of the fourth quarter with a higher run rate. So let me see that, the 1.5 plus minus 2.4, so your run rate of 2.4, so you’ve run rate of approaching 10 million. Now we can make a decision as we cast our budget for 2013 to pull that back, to leave it flat or increase it but we expect success for these products and we're going to continue to flush out feature set of those products and grow our position to market. So, I'm not forecasting what 2013 will be in terms of an R&D spend but just trying to give you a little color on that.

[Mike Malouf:]

And just a last question, with regards to the mobile device management side, what -- obviously a pretty big market at 500 million right now. Who are the competitors that you're going after specifically. I mean who are you targeting to compete against in this market, right now? Thanks.

[Rick Spurr:]

Yes, it’s a good question, Mike. There is a number of competitors as you'll typically see in an emerging market like this. Most of those, all of those in the leader box, the Gartner leader box are relatively smaller companies. Just to throw out a few names, there is a company called AirMobile, there is a company called Good Technology to name a couple. There's one called MobileIron. And some of the larger companies are just starting to look at this opportunity and put some solutions forward, but they don’t appear to being crowned (inaudible) crowned the leader by a long shot.

[Operator:]

Your next question comes from the line of Noel Atkinson with LOM. Please proceed.

[Noel Atkinson:]

Can you talk a little bit about what Google's contribution to the new orders were in the quarter?

[Rick Spurr:]

Well, we usually don't break that down. I guess I'll just say that Google has for many, many quarters running been the major source of OEM business and that hasn’t changed. But I mentioned that the overall OEM contribution was down but there wasn’t any marked change in terms of the mix from the various vendors.

[Noel Atkinson:]

Can you talk a little bit about expectation for your litigation cost in the third quarter. Do you expect it to remain similar to what it's been running at?

[Mike English:]

This quarter we are at about 180,000. Prior we were at about 160,000. We would expect that it's going to remain in a range similar to that but expect that it will go up in the second half.

[Noel Atkinson:]

Go out meaningfully or just a little bit?

[Mike English:]

I don't think meaningfully, no.

[Noel Atkinson:]

And then my last question is, could you talk a little bit about the competitive landscape for the encryption over the last few months.

[Rick Spurr:]

Sure. Not any meaningful changes. I guess there was one new piece of information that could bode well for us in the case of change in the future, but Cisco announced they are no longer selling their high end encryption solution and they put a notice in the marketplace that, like I said, they quit selling and they are going to drop support for their product in the 2014-2015 timeframe. So customers will have a little runway but it's obviously a signal that they are going to quit investing and most customers see that as a red flag to do something different. We don't know the rate at which that will play out but that high-end encryption appliance is being used by a number of large corporations. So that's good. In terms of the quarter that just passed, overall email activity is up. So if you look at a number of deals, the competition, they got more deals too collectively. We might have had some little hangers on straight away [ph] but they were not being held to begin with. And the major competitors Tru Point and Cisco for instance continue to sell products, but I would rate it as is as good if not better than it's ever been. But in terms of people coming in and people going out, other than that one Cisco product change, we haven't seen any different.

[Operator:]

(Operator Instructions).

[Rick Spurr:]

Okay, I am going to assume there are no further questions.

[Operator:]

And no further questions at this time sir.

[Rick Spurr:]

That's great. Thank you Kim. Okay, so we'll close this up. Thank you everybody. We are very proud to have set six new records for Zix Corporation this quarter. We hit all-time highs in new sales, total bookings, revenue, backlog, cash generation and adjusted earnings per share and we're very excited about our new investments in DLP and mobile device management. I look forward to visiting with investors throughout the quarter and into our next quarterly update. Thank you again.

[Operator:]

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a good day.