Zix Corporation
Q3 2012 Earnings Call Transcript

Published: 24 Oct 2012

[Operator:]

Good day, ladies and gentlemen, and welcome to the third quarter 2012 Zix Corporation earnings conference call. (Operator Instructions) I would now like to turn the conference over to your host for today, Mr. Geoff Bibby, Vice President of Corporate Marketing.

[Geoffrey Bibby:]

Thank you for joining our 2012 Q3 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 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 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 pleased to turn the call over to Rick.

[Richard Spurr:]

Thanks Geoff. Good afternoon, everyone, and thank you for joining us today. I'm excited to announce another strong quarter for the company, adding to the record results we delivered last quarter and continuing to build momentum. New first year orders for the third quarter reached $2.6 million, up 58% over the third quarter of last year. This includes a one-time catch up of approximately $300,000, which I'll explain in a minute. But even with that taken out, using $2.3 million, we're still up 41% year-over-year. We achieved strong total bookings during the third quarter of $12.7 million, up 31% from $9.7 million in the third quarter of last year. On the topline we recorded record revenue of $11 million, delivering on the high-end of our guidance. This quarterly revenue is up 15% over the $9.6 million we reported in the third quarter of last year, and our backlog is now a record high, $57 million. Now, let me go back to new first year orders and explain the one-time catch up I referred to earlier. Included in this quarter was approximately $300,000 of new first year orders that relate to OEM user overages during the first and second quarters of this year. Specifically the number of end-users of the Google message encryption service was over and above the number actually licensed by Zix. These end-user overages in 2012 were reported to us by Google and calculated this quarter, which warranted the one-time catch up. Now that we've established a process for identifying and reporting this type of overage, we'll continue to include these in our results going forward. Because of this one-time catch up going back to January, a better way to look at our new first year orders is for the first nine months of 2012 as compared to the same period last year. This for you reconciles and accurately reflects year-to-date new first year orders. For the first nine months of 2012, our new first year orders totaled $6.8 million, which represents an impressive growth rate of 31% over new first year orders and $5.2 million for the first nine months of 2011. Obviously, we're very excited to see the significant increase, which we think reflects the demand that is building in the marketplace. We believe the second consecutive quarter of strong financial results reflects a continued broad-based increase in the overall demand for email encryption and increased overall customer preference for Zix as the premier brand associated with ease of use and exceptional quality. As we've noted before, buyers have become increasingly educated and discriminating about email encryption. They understand what robust capabilities and ease of use designed features are required, and they are demanding a more sophisticated solution like ZixCorp. In fact, these trends were further validated in a new survey that we commissioned with the Ponemon Group during the quarter, which directly focused on the email encryption market. I will go into great detail, but among the more important findings, the survey indicated that 50% of the companies represented are either looking to replace their existing email encryption solutions or add email encryption, if they don't have it, in the next two years. This also further substantiates what Gartner has been saying, which is that over the next contract cycle for email security products, 65% of customers will be making decisions largely based on email encryption. In addition, when the survey asked, what vendors are you going to consider for email encryption, 40% of the respondents said Zix, which is an impressive third place ranking behind only McAfee at 51% and Symantec at 45%. And the fourth place mentioned was Google at 39%, which we all know is also Zix, and that Zix is the only email encryption capability that Google sells. So together, Zix and Google are clearly top of mind, when it comes to email encryption. So in terms of overall demand in the market, in addition to our two back-to-back quarters of record sales, we have the Gartner perspective on demand, we have the Ponemon survey results I just reviewed, and I can tell you that our own sales activity and inbound enquiries are at an all-time high. Let's go back to the numbers again. On the bottomline, we delivered our 11th consecutive quarter of GAAP profitability, achieving GAAP net income of $1.9 million. On a fully diluted share basis, GAAP profitability was $0.03 per share. We achieved non-GAAP adjusted net income of $2.7 million, down approximately $100,000 from the $2.8 million in the third quarter of last year. The decrease is due to the increased spending for commissions, of course due to our higher sales and increased marketing and R&D spending. Non-GAAP adjusted net income for the third quarter expressed on a fully diluted per share basis was $0.04 per share, achieving our guidance. Our business continued to generate cash during the quarter, with $4.6 million in cash flow from operations. We ended the quarter with a cash balance of $23 million, an increase of $4.2 million from last quarter. This strong cash flow and our healthy balance sheet further reduces risk in our business and increases our options for continued growth. Now, let me provide some more detail on the composition of our new first year orders in the third quarter. The total OEM channel contribution was $784,000 of which approximately $300,000 is as I mentioned a one-time catch up for earlier in the year. Excluding this benefit, $784,000 minus this $300,000, results in a contribution of $484,000, which is a very good quarter for OEM, up 72% from the third quarter last year. For the year, the results were up 35%. Our corporate sales team came in at $1.2 million, up 40% over the third quarter of last year. This team goes after small and medium business in the government sector and drives our VAR and MSSP partner channel. For the year, their results are up 53%. One major driver for this corporate team success has been our strategy to grow the partner channel. We now have through September, 237 active VARs and managed security service partners. Active and that they are actually selling our services. They are not just names on a list. This active partner number is up 225%, since the end of 2010. The enterprise group came in at $548,000 during the quarter, which is up 23% compared to the third quarter of last year. Although, this is a solid quarter for the enterprise team, we still believe there is some significant upside and look forward to see even stronger results moving forward. From an industry vertical perspective, our new first year orders broke down as follows

[Michael English:]

Thank, Rick. Good afternoon, everyone. We achieved excellent results in our key financial metrics, including revenue, net income, adjusted net income and adjusted EBITDA in the third quarter of 2012. We reported record revenues of $11 million for the third quarter which compares to $9.6 million for the third quarter of 2011. This was at the top end of our guidance range of $10.8 to $11 million. GAAP net income was $1.9 million, down from $2.6 million for the same quarter last year. This decrease was driven by previously announced increases in R&D and marketing expenses, and higher sales commissions resulting from higher sales. Also we incurred approximately $350,000 legal cost related to litigation. On an adjusted basis, non-GAAP net income for Q3, 2012 was $2.7 million compared to $2.8 million for the same period last year. The third quarter of this year represents the 13th consecutive quarter of positive non-GAAP net income. Third quarter revenue grew $1.5 million, a 15% increase over the comparable 2011 figure. Our OEM partners drove approximately $600,000 of the revenue increase for the quarter, a 53% improvement from the third quarter a year ago. Included in the OEM revenue for the quarter was approximately $300,000 of true-up for Google customer usage during the first two quarters of the year. This additional usage was not reported previously due to ongoing efforts to clarify reporting and contract terms that were resolved in the third quarter. On a year-to-date basis 2012 revenue from our OEM partners was up 36% over the same period last year. The third quarter ending backlog was $57 million, which is an 8% increase compared to the $52.6 million backlog at the end of the third quarter 2011 and 3% above the Q2 2012 ending backlog. We anticipate approximately 57% of the backlog to be recognized into revenue in the next 12 months. We achieved third quarter adjusted gross profit of $9.2 million, 83% of revenues. This compares to $7.8 million, 82% of revenues for the same quarter in 2011. On a sequential basis it compares to $8.6 million or 83% of revenues in the second quarter of 2012. Adjusted R&D expenses were $2 million in the third quarter of 2012, up $700,000 from the third quarter of 2011, reflecting the increase cost associated with our R&D new product spending. Adjusted SG&A expenses for the third quarter were $4.4 million compared to $3.6 million for the third quarter of 2011. The increase in SG&A was driven primarily by higher commissions in sales and additional investments in market. Adjusted operating margin for the third quarter was 25% compared to 30% for the third quarter of 2011. Adjusted EBITDA for the third quarter was $3.1 million compared to $3.2 million in the third quarter of 2011. The adjusted EBITDA margin percent for the third quarter was 28.2%. Capital expenditures for the third quarter were $427,000 and depreciation expense was $329,000. Approximately 70% of the depreciation expense was recorded in cost of revenues. We continue to have a strong balance sheet with an old debt and strong cash generation. We ended the quarter with $23 million in cash, a sequential increase of $4.2 million. The net increase was driven by $4.6 million of cash from operations. Adjusted net income for the third quarter was $2.7 million which compares to $2.8 million for the same period in 2011. Our adjusted net income per fully diluted share of common stock for the quarter was $0.04 versus $0.04 from the same period in 2011. Let's now move to guidance for 2012. For the fourth quarter of 2012, taking into account our new R&D investment, we project our fully diluted non-GAAP adjusted earnings per share to be $0.03 on projected revenue guidance of $11.2 million to $11.5 million. This fourth quarter guidance should yield achievement for the full year at or near the high end of our previous revenue guidance of $42 million to $43 million. We now expect non-GAAP adjusted earnings per share of $0.17 for the full year, which is the high end of our previous guidance. In closing, we are very pleased with our third quarter results and look forward to continued strong performance as we close out 2012. With that, I'll turn it back to Rick.

[Richard Spurr:]

Thank you, Mike. Now let's take some questions.

[Operator:]

(Operator instruction) Your first question today comes from the line of Mike Malouf of Craig-Hallum.

[Michael Malouf:]

Can we talk a little bit about R&D now? I think on the last quarter you said it was going to be $1.8 million for the back half, and we were up about $700,000. So do we have a make up coming in the fourth quarter of up to that $1.8 million or are we just running a little bit behind, just takes a while to ramp?

[Michael English:]

I think there will be a ramp-up in the fourth quarter Mike. Some of the spending when we had a partial quarter in the third quarter, it's going to get a full load in the fourth quarter all three months. So you're going to see that go up in the fourth quarter.

[Michael Malouf:]

So will it actually capture that whole $1.8 million for the year's sale?

[Michael English:]

Hard to say, but we're not going to change that at this point.

[Richard Spurr:]

We're certainly not going to exceed it.

[Michael English:]

Yes, we wouldn't exceed it, Mike.

[Michael Malouf:]

And I was thinking about what you said about the ramp in the VAR system that you have. Can you talk a little bit about how long it takes to ramp a typical a VAR? And I can imagine that you probably have still lot of training and ramping up of this channel and you've really kind of I think capitalized this really next year and into 2014, is that right?

[Richard Spurr:]

So the 225% increase is a function of additions we made throughout 2011, and continue to make throughout 2012. So we continue to grow the overall partner channel. In terms of a ramp at a given partner level, it's going to take 120 days to six months for them to start turning opportunities into real sales. And then once they have one success, and they find out what it's like to sell the product, they'll find out how happy the customer is, then that bolsters their confidence and enthusiasm to continue to grow sales. And that happen sometimes as salesmen-by-salesmen basis. So if partners have two to 15 sales guys and one of them goes out, makes a sale and that gives confidence then to the other, who then start to ramp up. So over time it does ramp and to get a partner from zero to where you want them to be, I'm sure it could take a year-and-a-half. But we got so many of them in hop or that we're already starting to see some very meaningful contributions.

[Michael Malouf:]

Just based on the ramp in new first year orders and the ramp in VARs, it sounds like those guys in Burlington are really doing a great job. So that's good to hear.

[Richard Spurr:]

Yes. They are doing a wonderful job. And the overall contribution from our indirect channels for those new guys and of course, the more season partners as well as the Google, Symantec OEM channels are now represent in this past quarter around 60% of our sales. So it's growing quite nicely. And of course it's a profitable method-to-market, because we're not having to invest and commensurate arms-legs on the direct side.

[Michael Malouf:]

One final question for you, in September of 2011 and if you that quarter going out four quarters into June 2012, those four quarters, you were around 30% on an non-GAAP operating margin basis and with the last quarters announcement that R&D spend would go up about 7% off of the run rate that you're on. It looks like that 30% is going to go down into that low 20s for a while. And my question is where do you think that the model shakes out overtime? Or can we get back up to those historical levels of profitability or is the long-term target just much lower than it was? I guess implying that maybe the R&D was just too low at that time.

[Michael English:]

Mike, the increase in the R&D spending, obviously, will have an impact on the 4Q operating margin. As the sales, of course I can't predict what will happen in the next year, but assuming sales follow trending that we're used to then those percentages obviously will go down. So I'm not sure if I'm answering your question. We do expect that as a percent of sales, the R&D percent will go up for a short period and then will level off and start going down. Is that what you're asking?

[Michael Malouf:]

Well, I guess I'm asking as do you think ZixCorp will ever see 30% operating margins again on an adjusted basis?

[Richard Spurr:]

So this year we've given to the extent we give guidance, we have an IR deck pro forma P&L and we show operating margin this year after the new R&D spend. It brings you between 24% and 26% on the year. So at the beginning of the year, we were running at 30-ish as you pointed out. With the new R&D spend, it came down if you take the midpoint about five points. We think 25% operating margins are pretty healthy, and it puts us at very, very high maybe number one in terms of operating margin in the SaaS company. So we are proud of that number. And in terms of could we get it to 30%? Honestly, if somebody said that's the most important thing in the world, you got to get it to 30%. We could do it very, very quickly. But I think the market taught us over the last year, so that we really got to grow business and put emphasis on the top line. And if that means sacrificing a little bit of margins, in this case the five points I referenced. Then we think the markets are going to reward us for that. And that's our answer. Could we get back to 30%? Yes, we could. Will we get back to 30%? I don't know, let's see.

[Operator:]

(Operator Instructions) Your next question comes from the line of Noel Atkinson with LOM.

[Noel Atkinson:]

I was wondering if you could talk about whether there is any positive seasonality in Q4, usually for new first year orders.

[Richard Spurr:]

Q4 is usually a good quarter. It's not as in many businesses consistently our best quarter, it is not. The seasonality question is difficult, because in our company there really hasn't been any pattern that's noticeable. The only pattern that's starting to show up is that 1Q is usually a little weak, but last year Q4 was $1.9 million in new first year orders. Our highest quarter last year was Q2 of $2 million. So it was up there. It wasn't our best quarter but almost made it. This is not a capital acquisition. And so people that are doing a capital flush at the end of the year, which is sometimes occurs that money doesn't come our way. They buy it when they're ready to buy it. And till the end of year people get anxious to meet the goals that they've set for themselves to have certain solutions in place. So you're kind of bolstered by that, but there is no consistent pattern.

[Noel Atkinson:]

And could you talk a little bit about the demand that you see in the enterprise channel? Are you seeing sale cycles to sort of a dissimilar level or are you seeing any push out or lengthening?

[Richard Spurr:]

I don't think we see any change in the cycles, but sale cycles are really more company dependent. Obviously, there is some average somewhere, but really big companies take a long, long time. And sometimes they go through R&P processes and all of those things, really longing sale cycles. But generally we're seeing in the enterprise space, we're seeing a great deal of activity. It seems to be activity that substantiates the forward looking survey data we quoted, and we're excited about it. But the large end of the market always takes, I think, a little bit longer to turn into contracts and ink than the lower end.

[Noel Atkinson:]

And sort of following on that comment are you seeing increased amount of interest at the enterprise level from the other category, the non-mandated users?

[Richard Spurr:]

I quoted in this call here that are others now up to 20%. That's a very healthy number. And that's the fastest growing segment if you can call that a segment of our business. And that's coming primarily from the third party distribution that we put in place. So the market just generally, email encryptions now better understood, very well understood as compared to what it was a couple of years ago. And it really is a cross industry phenomena. And I assume it did show that as well, even in other sectors, entertainment, hospitality, once that you wouldn't guess. The numbers are pretty much the same. They really not going to replace what they have, because they want to get more up to date, have a functional capability or they want to buy something, but in fact they don't have anything at all, but with 237 partners and plus Google, plus Symantec we're getting eyes and ears and feet on the on the street that help us harvest that opportunity.

[Noel Atkinson:]

And then just one last quick question, so following on to Mike's comment about R&D, for SG&A do you expect to see similar levels of spending Q4 or is there anything such as litigation that maybe will come back, turn back down again in Q4 that you think?

[Michael English:]

So the selling and marketing piece of the SG&A that I talked about earlier, we expected that will continue. On the litigation piece said, we don't expect that to drop off in Q4. I don't have anything specific that would cause that to drop off at this point.

[Operator:]

Ladies and gentlemen, this does conclude the question-and-answer portion of today's event. I'd like to turn the call back over to management for some closing remarks.

[Richard Spurr:]

Okay, great. Our closing remarks that we're happy that you could join us today. We're obviously thrilled about the quarter and going forward. I'm going to be at the SRA Conference next week in San Francisco. If any of you happen to be there, please stop by and see me. Thanks everybody. Have great day.

[Operator:]

Ladies and gentlemen, thank you so much for your participation today. This does conclude our presentation. And you may now disconnect. Have a great day.