Zix Corporation
Q1 2013 Earnings Call Transcript

Published: 24 Apr 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to the First Quarter Zix Corporation Earnings Conference Call. My name is Ayesha and I will be your coordinator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session at the end of this conference. (Operator Instructions) I would now like to turn the conference over to your host for today, Mr. Geoff Bibby. You may proceed sir.

[Geoff Bibby:]

Thank you, Ayesha. I am Vice President of Corporate Marketing for Zix Corporation. Thank you for joining our 2013 Q1 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 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 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?

[Rick Spurr:]

Thank you, Geoff. Good afternoon, everyone, and welcome to today's call to discuss Zix Corporation' first quarter 2013 financial results. I am pleased to report another solid quarter for the company where we continued to build on our strong business momentum despite typical first quarter weaknesses in sales due to seasonality. New first year orders were $2.1 million, up 22% from $1.7 million in the first quarter of last year, using a 12 month rolling comparison specifically April 2012 through March of 2013 compared to April 2011 through March 2012, our new first year order growth is 28%. We achieved a record high $13.9 million in total orders during the first quarter up 53% from $9.1 million in the same quarter last year and our backlog hit a new record of $60 million at quarter end. Revenue for the first quarter was $11.8 million, up 14% from the same quarter last year and at the mid range of our guidance for Q1. On the bottom line, we achieved GAAP net income of $600,000 or $0.01 per share on a fully diluted basis. Non-GAAP adjusted net income in the first quarter was $2.1 million or $0.03 per share on a fully diluted basis meeting our guidance for the quarter. During the first quarter, our business generated $1.1 million in cash flow from operations. Now let me provide some more detail on the composition of our new first year orders in the first quarter, which includes a very strong performance from our corporate team and the best performance in the last two years from our enterprise group. Our corporate sales team new first year orders were up 34% over the first quarter of last year. As you know this team targets small and medium businesses and the government sector and drivers our bar and MSSP partner channel. This solid growth is being driven by a number of factors. One, we are seeing strong evidence of an increasing trend in competitive replacements, particularly replacements of competing solutions from Ironport, McAfee, Voltage and Barracuda. Two, with the substantial increase in new channel partners that we've added over the last couple of years, we are seeing increased channel activity and partner initiated activity and three the hi-tech final rule, which we talked about last quarter is resulting in increased demand. Our Enterprise group had its best new first year order performance in over two years, more than two times greater than the first quarter of last year. We see these positive results as validation of our strategic initiatives to one target to growing enterprise space without rich programs aimed at raising awareness and visibility of Zix. And two, to continue to innovate and deliver product enhancements, many of which are targeted explicitly at the enterprise space. Our OEM business represented 15% of our new first year orders this quarter. These OEM results would have been much better had they not been impacted by the product transition that occurred in Q1 with our largest partner Google. As you know, our email encryption technology is sold through Google and is called Google Message Encryption or GME. Google commissioned Zix to develop GME 2.O to more tightly integrate with Google Apps. We completed GME 2.O in Q1 and shifted as planned fully tested and quality assured, but the required Google software changes to effect the completion of the project were delayed resulting in a stoppage of orders during the quarter. We believe this technical issue has now been resolved; however, as you can imagine the stoppage created some disruption with the Google sales force, which now must reengage. We believe this will not have a long term impact on our sales through Google, but it did affect Google related sales in Q1 and is likely to have some impact on Q2. So $2.1 million new first year orders for the quarter, we grew over 20% year-on-year, but would have done even better if the transition to GME 2.0 had gone smoothly. As we typically do, I’ll now comment on sales contribution from an industry sector perspective. Our new first year orders in Q1 broke down as follows. Healthcare was 48%, followed by finance at 28%, government at 7% and other was 17%. So healthcare in Q1 at 48% is up from last year, where healthcare for the year as a whole was 42%. We think this is largely due to the final rule mentioned previously. In summary we are pleased with our new first year order results and are optimistic about the increasing traction we are seeing for email encryption business, particularly in the high-end enterprise space. Let me comment on our ongoing marketing initiatives. We continue to leverage the investments we made late last year to take our marketing capabilities to a new level and to continually increase awareness, consideration, preference and leads for Zix products and services, to in turn increase our sales efficiency and productivity. As a result of continued upgrades to our ZixGateway installed base. We are now sending more than 1 million messages per week that include our “blue bar”, that’s over 50 million a year. You will recall that the blue bar says “this message was sent securely by ZixCorp” and there is an actively link to our website. The landing page asked if the Zix salesperson should contact them. The same landing page is use for inquiries coming from our thousands of portals. We now have inbound inquiries running at rate of 30 per day, requesting Zix salesperson contact them. We don’t know yet what percentage of those contacts will result in qualified leads but we are certainly excited about these potential opportunities. Now let’s turn to our new products, our ZixDLP solution launched in March as planned and is now in general availability. ZixDLP is our single application email DLP solution designed to help both new and existing ZixCorp customers address the number one data leakage problem in their organization, email. We are off to a good start, having closed eight sales of our DLP solution even prior to launch, at the end of March and the sales team are very excited to have another tightly integrated product in the suite. Our initial emphasis is selling ZixDLP add-ons into our current customer base. We offer brand new email encryption customers the option to include ZixDLP or new DLP customers the option to include Zix email encryption, and in either case deliver the combination in a tightly integrated packaged solution. ZixDLP is also available as a standalone solution that could easily integrate with most email systems and competitive email encryption solutions. Pricing for ZixDLP is on a subscription basis per seat license, just like our email encryption service. And we continue to expect it to be priced at about one-third of the cost of our typical email encryption seat license. The pending introduction of our new, bring your own device or BYOD solution, code name [Brooklyn] remains on track for marketing launch this quarter and product general availability in Q3. We have begun implementations with 10 early stage beta customers and we are beginning to present our solution to analysts and selected prospects. We are very excited about the timing and the introduction of this product, and the validation we are receiving from very knowledgeable industry sources about our approach. [Brooklyn] solves the BOYD problem of potential corporate data exposure and loss by holding and managing corporate email and attachments in a single secure location in the cloud, through patent pending highly efficient protocols, we provide high-speed excess to those corporate emails through personal smartphones and tablets. This contrast would virtually all other competing solutions that take for granted the fact that the Apple and Google platforms save corporate email on the device and these competitors attempt to resolve the resulting data security problem with encryption and device management techniques, such as containerization, our full mobile device management. So we are introducing a significant paradigm shift by never allowing the corporate data to reside on the phone in the first place. This way the data is easy to secure in one protected place and employees aren’t forced to accept corporate software on their phone. We believe that when employees owned their own devices they don’t want it manage by their employer. We believe our unique solution will have greater end-user and corporate IT acceptance, and provide stronger security than solutions in the market today. We have never been more optimistic and confident in our outlook both for our existing business and in light of our new products. With respect to our existing email encryption business, our pipeline is a strong as ever. We see exceptional strength with high-end accounts, one very significant one, working its way to the sales process in conjunction with our partners Symantec and several others through our direct sales teams. To strengthen our ability to capitalize on these opportunities, we budgeted for additional sales resources. Specifically, our enterprise sales team is now fully staffed with eight account executives compared to between five and six last year. Additionally, we recently added a new Vice President of Enterprise Sales, who is focused solely on this market. We have also added two individuals to our Corporate Sales Group, which adds the sixth team consisting of a sales professional, partnered with the channel representative. Before I conclude, I want to call attention to a very important metric, our backlog. We have achieved a record highs $60 million in backlog at the end of March. This is most of you know represents contractually committed business, orders that we've gotten and still not been recognized into revenue. 56% of this backlog or $33 million will flow through revenue in the next 12 months. This characteristic in our business model leads to exceptional visibility into future revenue streams. To summarize, we are very excited about our progress and the strong business momentum we are generating. Now I’ll turn the call over to Mike English our CFO to discuss our first quarter financial results in more detail and after that we'll take questions. Mike?

[Mike English:]

Thanks Rick. Good afternoon, everyone. We achieved very good results in the first quarter 2013 in our key financial metrics, including revenue, adjusted earnings and backlog. GAAP net income was $567,000, compared to $2.4 million for the first quarter of 2012. A lower net income reflects the impact of our previously announced investments in new products and additional investments in sales and marketing. Also, Q1 2013 reflects the impact of $1.1 million of litigation expense. I’m pleased to announce that we reached the settlement in our patent infringement lawsuit that we brought against Echoworks. Combination of this litigation along with the recently announced our post-settlement should significantly reduce our litigation expense. Although the terms are confidential, neither of these settlement matters as material. We achieved record revenues of $11.8 million, which compares to $10.3 million for the first quarter of 2012. This met the midpoint of our guidance range of $11.7 million to $11.9 million. First quarter revenue growth was $1.5 million, a 14% increase over the comparable 2012 figure. Revenue from our OEM partners was 12% of the total revenues for the quarter. First quarter-ending backlog was $59.6 million, which is a 14% increase compared to the. $52.3 million backlog at the end of our first quarter 2012. We anticipate approximately 56% of the backlog that will be recognized into revenue in the next 12 months. We achieved first quarter adjusted gross profit of $9.9 million, 84% of revenues. This compares to $8.5 million, 82% of revenues for the same quarter of 2012. On a sequential basis, it compares to $9.7 million or 83% of revenues for the fourth quarter of 2012. With regard to operating expenses, adjusted R&D and SG&A expenses totaled $7.7 million in the first quarter of 2013 compared to $5.5 million for the first quarter of 2012. Adjusted R&D expenses were $2.5 million in the first quarter of 2013, up $1.1 million from the first quarter of 2012, reflecting a continuation of our increased level of investment in new product development announced in July of last year. Adjusted sales and marketing expenses for the first quarter were $3.5 million compared to $2.5 million for the first quarter of 2012. Adjusted G&A expenses for the first quarter were $1.7 million compared to $1.5 million for the first quarter of 2012. The increase in sales and marketing expenses was driven primarily by additional investments in sales headcount, sales tools and advertising. A significant piece of the non-headcount marketing expense is front-end loaded due to the Brooklyn launch and plans to build demand and awareness in the first part of the year. Adjusted operating margin for the first quarter was $2.1 million, 18% of revenues compared to $3 million or 29% of revenues for the first quarter of 2012. Our adjusted EBITDA for the first quarter was $2.5 million compared to $3.3 million in the first quarter of 2012. The adjusted EBITDA margin percent for the quarter was 21.6%. Capital expenditures for the first quarter were $250,000 and depreciation expense for the quarter was approximately $355,000. Approximately 70% of the depreciation expense was recorded in cost of revenues. We continue to maintain a strong balance sheet with no debt. We ended the first quarter with $24.2 million in cash, up $1.2 million from the fourth quarter of 2012. Our cash flow from operations was $1.1 million for the quarter. We continue to use cash to fund additional investments in R&D and sales and marketing as well as expenses related to the recently settled litigation. Adjusted net income for the first quarter was $2.1 million, which compares with $2.9 million for the same period in 2012. Our adjusted net income per fully diluted share of common stock for the quarter was $0.03 versus $0.04 for the same period in 2012. Let’s now move to guidance. For the second quarter of 2013, we project our fully diluted non-GAAP adjusted earnings per share to be $0.03 to $0.04 on projected revenue guidance, ranging from $11.5 million to $11.7 million. We expect the second quarter 2013 revenue to be very slightly below the preceding quarter. Although rare, we occasionally see minimal sequential quarter drops in revenue. We reaffirm our full-year guidance with projected 2013 revenues to be between $48 million and $50 million. I want to remind everyone that our new products will contribute relatively little revenue in 2013, due primarily to our subscription revenue model, which spreads revenue ratably over the subscription period, and the fact that our new Brooklyn product won't begin shipping until the third quarter of this year. We expect meaningful revenue impact from the two new products, ZixDLP and Brooklyn will begin in 2014. Getting back to full-year guidance, we continue to project fully diluted non-GAAP adjusted earnings per share to be between $0.19 and $0.20. This guidance will yield an adjusted EBITDA margin in the high 20s and adjusted operating margin in the mid-20% range. In closing, we are pleased with the first quarter results against our key financial metrics. Our financial results remain strong. And we are well-positioned for the future. We look forward to continued strong performance in the second quarter. With that, I'll turn it back to Rick.

[Rick Spurr:]

And with that, let’s turn it to the audience for questions.

[Operator:]

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

[Mike Malouf:]

Hi guys. Thanks for taking my question.

[Rick Spurr:]

Certainly, Mike.

[Mike English:]

Hey Mike.

[Mike Malouf:]

A couple of questions, first of all, on the Google changeover, how much lingering effect are we going to have in the second quarter? I guess, maybe when did Google get their work done. And have you seen their sales team start to get back on track here, that were at the end of April?

[Rick Spurr:]

So the resolution, the technical resolution has just been recent. And it’s difficult to predict the rate at which they’ll come back. And that’s why we were stated what we did. And last, some impact on Q2, we don't know how much.

[Mike Malouf:]

Okay. All right. And then with regards to the guidance for next quarter, I think Mike you had pointed out that it's rare that you're down year-over-year because your subscription model. So you sort of think you add new layer on the new orders on top of the old existing run rate. So when I look back, it actually was 2008 since the last time you had it down sequential quarter. And so, can you talk a little bit about what is causing that at least in the near-term. Is it is all Google or is it something else?

[Mike English:]

Yeah, it’s not all Google. It certainly has a lot to do because you’re looking at a quarterly period. So you got to see some ups and down. Usually they're masked and you can’t see them because we do have a sequential increase. But we do -- we do see from time to time due to the timing of new orders, the timing of deployments and non-recurring revenue items that pop up, that occasionally revenue recognition in quarterly periods can fluctuate slightly and give us skew to the quarterly results. But certainly, the amount that's being exposed to just a couple hundred thousand, 100,000 or 200,000, we don't -- we really can't give you much of a trend or any further background on what's causing that to happen. It’s relatively minor.

[Mike Malouf:]

Okay. Great. And then just one follow-up question. To the litigation that you had that really impacted the cash flow in the fourth quarter and the first quarter and obviously that's behind us with the litigation settled. But should we expect any, even if it's sort of I guess nonmaterial or just slight, was there any impact on say gross margins with regards to any kind of royalty, or with regards to cash flow in the second quarter and say maybe a one-time payment that we should be looking for? Thanks.

[Rick Spurr:]

Mike, as you know in both of the settlements, the terms are confidential. I’m not trying to hide behind that. It’s just a fact that we made an agreement with the parties that the specific terms would be kept in confidence. But I think Mike said it very clearly. We’ve all settled long we see again that these settlements neither one of them are material so. But that’s how we can say about it for now.

[Mike Malouf:]

Okay. Thanks. I will get back in the queue.

[Rick Spurr:]

Thank you.

[Operator:]

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

[Noel Atkinson:]

Hi, guys.

[Rick Spurr:]

Hi, Noel.

[Noel Atkinson:]

Following up on Mike’s comment there, can I ask you differently, you have had what looks like a record gross margin in the quarter after sort of -- it looked like it picked up meaningfully from what you achieved in 2012? Do you guys believe that there is further room to run in your gross margin going forward as you add new products and as you had scale with your ZixMail product?

[Rick Spurr:]

Yeah. So the big question is the new products. We don’t expect, when you look at our guidance for the year, we don't expect this to move more than slightly. So the uptick, the 84, it really depends on the timing. You can move this thing very literally. The cost of sales went up minimally from last year. We don't expect that to move very much. So we look at that as almost a fixed cost. So that margin should, if it does move it will move only slightly. We don't expect any big ups or downs in the gross margin percent.

[Noel Atkinson:]

Okay. And then switching over to DLPs, you mentioned eight sales prior to the launch. Can you give us some sense of the size of the sales in number of seats in aggregate?

[Rick Spurr:]

They were all in the corporate sales group. So, which were the smaller customers, I mean small, we are talking customer sales that are in the 200 to 1000 ranges and the sales team is pitching DLP with every deal. I mean, it is part of the standard integrated sales presentation. Obviously, we're not seeing 100% adoption and we can’t really tell you what we think of that. We don't know when adoption will be until we get a little more history behind us. But those worked cases where somebody just took a couple seats. Those were cases where people took meaningful number of DLP licenses to complement their e-mail encryption sale.

[Noel Atkinson:]

Okay. And how did this translate in terms of getting these in these pre-launch orders, how did that relate to sort of in total number of seats that were in your beta for example. Is there an opportunity to really go after those beta customers and get some meaningful early sales?

[Rick Spurr:]

The bigger opportunity, Noel, is just standard everyday sales to not only the base but to new customers. So the beta customers were ones that get us anywhere near as excited. It’s just having the product to launch across the entire base.

[Noel Atkinson:]

Okay. All right. Thank you.

[Rick Spurr:]

Thank you.

[Operator:]

Your next question comes from the line of Fred Ziegel. You may proceed.

[Fred Ziegel:]

Hi, guys.

[Rick Spurr:]

Hello, Fred.

[Fred Ziegel:]

Mike, you commented on sales and marketing expenses relative to the BYOD project to be front end loaded. Do I take that to mean, we should expect sales and marketing expenses to be lower in the second half of the year than the first?

[Mike English:]

That's correct, Fred. That’s talking about the front-end being first six months.

[Fred Ziegel:]

Okay. So first and second quarter.

[Mike English:]

Yeah.

[Fred Ziegel:]

Okay. And then the decline from there. On the BYOD product, maybe it’s a little early but I'll ask anyway. Any general thoughts about pricing element?

[Rick Spurr:]

Yeah. Pricing will be higher than our current product -- our current e-mail encryption product. Our current pricing element with that pricing, our revenue per seat license is still averaging $23 per user per year for our standard e-mail encryption offering that excludes any uplift we may get from a DLP license. When comparing to the standard e-mail encryption seat license currently running at $23 per user per year, I have to be cautious. We think it could be 52% to 100% higher than that on a per seat basis. But we obviously have to get out and close some deals at negotiable prices in real deals before we know any answer. But in looking at the competitive space and bouncing our thoughts about pricing off of the analysts it does appears it can command a higher price.

[Fred Ziegel:]

If I think about the BYOD product relative to the DLP product, in the DLP product you can sell that into your installed base into new customers with a combination of e-mail plus DLPs. You can sell it standalone in the third-party opportunities. Is that the way we should think about BYOD from an addressable market perspective?

[Rick Spurr:]

I think -- so first of all, BYOD will be a separate product. It won’t be integrated with the existing products. It will fall under a very neat elegant umbrella, positioning around e-mail data protection. It will be -- could be sold to any and everybody that has corporate e-mail, which is everybody. So, there's no limitations on where that can be sold. Now, logically, where we have existing relationships, of course will be easy for us to show up and tell the story. And if they are in the market, we would hope to get an audience. But we know of a lot of the BYOD interests that is outside of our existing customer base. If you think about the BYOD opportunity, the broad addressable market is every e-mail user. I guess in an extreme sense in the world, but let’s stick with the U.S. where we know those number are 120 million email users and so the question is of those 120 email users, over the next three to five years, how many of them will actually need to protect, use their personal devices for protection of corporate email. And then the second question of course would be what’s our market share against that? So if adoption rates are exceedingly high, let’s just pretend 80%, I just picked a number, that would be a four times -- four times the number of seats and then we said the price could be 50% to 100% higher. So based upon the assumptions you make, it could be a much, much larger addressable market.

[Fred Ziegel:]

Yes, is there anything you think you need to do in terms of broadening or looking for new channel partners, specifically for the BYOD stuff.

[Rick Spurr:]

I wouldn’t use the word, need Fred, but there certainly is an opportunity to partner with new partners as well as existing partners. Our distribution strategy for Brooklyn would be hit the ground initially with direct sales, which is only logical, get some established references shortly thereafter launched with bars and then we think logically if and only if you get a reasonable base of referenceable customers will you get real meaningful interest from really, really big guys to distribute this who typically want to see a base of happy, proven customer satisfaction. I am not saying that when that occurs, I wouldn’t anticipate we will launch with some big distribution partners this year, but certainly we are beginning those conversations.

[Fred Ziegel:]

Okay. Thanks.

[Rick Spurr:]

Thank you.

[Operator:]

There are no further questions in the queue at this time. I would now like to turn the call over to Mr. Spurr for any closing remarks.

[Rick Spurr:]

My closing remarks are just as we said in the script, we are excited as ever about both our current business as well as our new products and we are really pleased that you all joined us today and I am sure we'll have further dialogue. Thanks so much.

[Operator:]

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