Zix Corporation
Q2 2013 Earnings Call Transcript

Published: 24 Jul 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to the second quarter 2013 Zix earnings conference call. My name is Philip and I will be your operator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions). As a reminder this conference is being recorded for replay purposes. Please proceed, sir.

[Geoff Bibby:]

Thank you, Philip. Good afternoon, everyone. My name is Geoff Bibby and I'm Vice President of Corporate Marketing for Zix Corporation. I would like to thank you for joining our 2013 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, we 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 about contracts or business and comments on new products and 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 very pleased to turn the call over to Rick Spurr. Rick?

[Rick Spurr:]

Thank you, Geoff. Good afternoon everyone and welcome to today's call to discuss Zix Corporation's second quarter 2013 financial results. I am pleased to report another solid quarter for the company, including record revenue, record total orders and a record high backlog, reflecting our continued strong business momentum. New first year orders were $2.4 million, up 17% sequentially from $2.1 million in the preceding quarter and ranks the second quarter of 2013, number three in terms of historical highs in the company's history. Only the second quarter of last year and the third quarter of last year were slightly higher at $2.5 million and $2.6 million respectively. We achieved a record $15.6 million in total orders during the second quarter, up 14% from $13.6 million in the same quarter last year and up 12% from the first quarter of this year when we set our previous total order record of $13.9 million. And this past quarter, we grew our backlog to a new record high of $63.4 million. This exceptionally strong total order achievement resulting in exceptional growth to our backlog was the result of strong sequential new first year order growth, strong renewals and to some extent longer-term contracts. Revenue for the first quarter was $11.8 million, a slight increase sequentially from record revenue in the preceding quarter and up 15% from the same quarter last year. It also exceeded our previously stated guidance for the quarter. On the bottom line we achieved GAAP net income of $1.9 million or $.03 per share on a fully diluted basis. Non-GAAP adjusted net income in the second quarter was $2.5 million or $0.04 per share on a fully diluted basis, exceeding the high end of our guidance range for the quarter. During the second quarter our business generated $2.5 million in cash flow from operations. Now let me share some more detail regarding the composition of our new first year orders in the second quarter. Our corporate sales team recorded the second best quarter ever, achieving new first year orders of $1.5 million. As you know, this team target small and medium businesses in the government sector and they drive our VAR and MSSP partner channel. They closed an enterprise wide agreement, resulting in a significant expansion in one of our prominent federal banking regulator accounts and continue to capitalize on the increasing trend in competitive replacements. Our enterprise group sales were above average, but we think they can be even better going forward. A highlight includes the signing of a large agreement with one of our large nationally known insurance and financial services customers that markedly expanded their number of seat licenses. Our competitive replacements were up 80% in the first half of this year, compared to the first half of 2012. Our leadership is evident as we continue to displace competition across the board. Nine different competitors were displaced in many accounts, some multiple times, with Cisco replacements topping the list and we continue to see a boost in demand resulting from the approaching compliance date of the HIPAA/HITECH final rule on September 23. Our OEM business represented just under 15% of our new first year orders this quarter. As anticipated, these OEM results reflect continued impact of the product transition with our largest partner, Google. As we noted on our last call, our email encryption technology is sold through Google and is called Google Message Encryption or GME. Google commissioned Zix to develop GME 2.0 which we completed on schedule and shipped as planned. However, required Google software changes to effect completion of the project were delayed affecting results in the first half of this year. This technical issue has been resolved. However, we expect to see a continued challenging environment with Google in Q3 as they continue to reengage their sales force from the disruption created by this transition. However, as an offsetting factor in the OEM category, we are pleased to note that we are seeing growing contribution from our relationship with Symantec. Q2 was up and the outlook from Symantec looks even stronger for Q3. As we typically do, I will now comment on sales contribution from an industry perspective. Our new first year orders in Q2 broke down as follows. Healthcare was 38%, followed by finance at 32%, government at 9% and other was 18%. Healthcare on an absolute basis was 3% lower in Q2 versus a very strong quarter in Q1, and overall activity and demand in healthcare continues to be very strong aided by the pending HITECH September deadline. Our Q2 results in every other sector, finance, government and other, were up in terms of absolute contribution. In fact Q2 of 2013, the contribution from finance was the best in the last 18 months. Government also would have been the highest contribution in the last 18 months if we had closed a government deal in our pipeline at the end of June. Instead, we closed this deal in July and are happy to announce the addition of the City and County of San Francisco. This adds close to 15,000 new users in this highly visible marketplace. In summary, we are pleased with our new first year order results and are optimistic about the continued traction we are seeing for email encryption business in all sectors. Let me provide an update 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 are excited with the momentum we are building with our campaigns to increase awareness, consideration, preference and leads for Zix products and services and to in turn increase our sales efficiency and productivity. We are now sending more than 1.3 million blue bars per week which is more than 65 million a year. As you may recall these highlighted blue bar notifications are at the top of the message and they say “this message was sent securely by Zix Corporation”. The blue bar also includes an active link to our website with a landing page that asks if a Zix sales person should contact them. We're now receiving 20 to 30 inbound inquiries per week where a prospect is requesting that a Zix sales person contact them. In Q2, we added another person to our team to keep up with these potential leads. In addition, we continue with our mailing campaigns, webinars, nurture campaigns and other initiatives that underscore our new positioning as an email data protection company. Now with three primary high profile products that address email data protection, email encryption and DLP for emails that are exiting the corporation on to the public internet and our new Zix 1 for protecting internal email, we have more than tripled our addressable market. Now let me comment on our new products. 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. While it has only been three months since launch, we have doubled the number of DLP customers since our last call and now have sold approximately 5,400 licensed seats. Although the current feature set is satisfactory for many of our prospects, early feedback from the marketplace has given us valuable input to begin the development of an enhanced version 2, which incorporates a richer set of controls for the treatment of quarantined emails. This new version is planned for release in Q1 of 2014. During the quarter, we formally announced our new bring your own device, or BYOD solution, which we call ZixOne. And we are very excited about the potential of this new solution and the acceptance that we are seeing already. We now have nearly 30 customers in our beta program with extremely positive feedback. To provide some further color here's a quote from one of those customers. “The new update worked wonders, emails open quicker using the app than our normal email-connect, documents open much, much faster and to be honest your calendar works better than the phone's natural one.” Earlier this month we released another version of our beta product that contains the full package of functionality for the general release. So we are on-track for our planned September shipment of our commercial ZixOne product. As many of you know ZixOne is the first BYOD mobile email application to solve the problem of protecting corporate data in email, while at the same time allowing employees to maintain privacy and control of their personal devices. ZixOne solves the BYOD problem of potential corporate data exposure and loss by holding and managing corporate email and attachments in a single secure location in the cloud. This contrasts with virtually all other competing solutions that distribute corporate email and data to untold numbers of mobile devices. And then attempt to solve the data security problem that results with encryption and device management techniques, such as containerization, our full mobile device management, MDM. The unique architecture of ZixOne represents a significant paradigm shift by never allowing the corporate data to reside on the phone in the first place, providing a higher level of security and much greater ease of use, which in turn translates into greater employee acceptance. Additionally, ZixOne can be used from any Apple or Android device with a download of the app and proper credentials, as such it can also serve to complement existing solutions, by enabling broader employee mobile access to the most frequently used applications, email, calendar and contacts. ZixOne provides easy, convenient and efficient access to business tools that ultimately make employees more productive while protecting corporate data. In addition, ZixOne is simple and easy to implement. It takes only about 30 minutes to setup a company of any size by connecting ZixOne servers with the company's email exchange servers and then less than a minute for employees to download the app. There is no learning curve or training process, because email is already the largest and most well known application in the world. From a sales standpoint, you can tell this story in less than 60 seconds. In essence, the elevator pitch is the sales pitch. During the quarter we added a dedicated ZixOne specialist as an overlay to our sales force, both corporate and enterprise. We see a substantial opportunity with ZixOne and our strategic marketing emphasis is on aggressively building momentum through trial activity with a broad array of companies, to plant the seeds that will position Zix for significant sales growth in 2014. In conclusion, we remain very optimistic and confident about our outlook both for our existing business and with our new products, which leverage our proven capacities and offer significant cross-selling opportunities that more than triple our total addressable market. Our pipeline of existing email encryption business is as strong as ever and ZixDLP and Zix 1 should allow us to take ZixCorp to a new level in 2014 and beyond. As we stated before one of our primary goals is to accelerate growth in our top line in excess of 20% and the introduction of our two new products certainly make that achievable. Now I'll turn the call over to Mike our CFO to discuss our first quarter financial results in more detail and after that as always we'll take questions, Mike.

[Mike English:]

Thanks, Rick. Good afternoon, everyone. As Rick mentioned we are happy to report the second quarter revenue and adjusted earnings per share both exceeded guidance. Additionally, backlog reached a record level the result of record total orders. Beginning with our GAAP results, net income for the second quarter was $1.9 million compared to $2.6 million for the second quarter of 2012. As I discussed in last quarter's call, the lower year-over-year net income reflects the expected impact of our previously announced investments in new products, sales and marketing. Turning to revenue, we achieved record revenues of $11.8 million, exceeding our revenue guidance of $11.5 million to $11.7 million and posting our 18th consecutive quarterly revenue increase. The second quarter revenue represents a 14% increase over the same period last year. Our backlog of contracted orders totaled $63.4 million at the end of the second quarter. This is a 14% increase compared to the same period last year. We anticipate approximately 55% of the backlog will be recognized into revenue in the next 12 months. Moving on now to our non-GAAP earnings and expense metrics, we achieved second quarter adjusted gross profit of $10 million which was 84% of revenues. This compares to $8.6 million and 83% of revenues for the same quarter in 2012. On a sequential basis, it compares to $9.9 million or 84% of revenues for the first quarter of 2013. With regard to operating expenses, adjusted R&D and SG&A expenses totaled $7.5 million in the second quarter of 2013 compared to $5.4 million for the second quarter of 2012. As mentioned, the year-over-year increase in expenses resulted primarily from planned investments in new product development, marketing and sales. Adjusted R&D expenses were $2.4 million in the second quarter of 2013, up $1 million from the second quarter of 2012. Adjusted sales and marketing expenses for the second quarter were $3.5 million compared to $2.4 million for the second quarter of 2012 and adjusted G&A expenses were $1.6 million compared to $1.5 million for the second 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 a non-headcount marketing expense is front-end loaded due to the ZixOne launch and the first half marketing campaigns designed to build awareness and demand. Adjusted operating profit for the second quarter was $2.5 million, 21% of revenues compared to $3.1 million or 30% of revenues for the second quarter of 2012. Our adjusted EBITDA for the second quarter was $2.6 million compared to $3.5 million in the second quarter of 2012. The adjusted EBITDA margin percent for the quarter was 24.5%. Capital expenditures for the second quarter was $698,000 which brings our first half capital spending to $948,000 which is approximately $150,000 above our typical run rate. This additional $150,000 in capital spending is from second quarter spending on computer equipment in anticipation of ZixOne volume. Going forward we expect capital requirements and gross margins in our ZixOne product to be similar to our existing email encryption product. Depreciation expense for the second quarter of 2013 was approximately $356,000. 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 second quarter with $26.3 million in cash, up $2.1 million from the first quarter of 2013. Our cash flow from operations was $2.5 million for the quarter. Adjusted net income for the second quarter was $2.5 million which compares with $3.1 million for the same period in 2012. Our adjusted net income per fully diluted share of common stock for the quarter was $0.04, exceeding guidance of $0.03 and compared to $0.05 for the same period in 2012. Let's now move to guidance. For the third quarter of 2013, we project our fully diluted non-GAAP adjusted earnings per share to be $0.05 on projected revenue guidance ranging from $11.9 million to $12.1 million. We reaffirm our full year guidance with projected 2013 revenues to be between $48 million and $50 million. We expect our new products will contribute relatively little revenue in 2013 due to our subscription model which spreads revenue ratably over the subscription period, and the fact that our new ZixOne product won't begin shipping until the end of the third quarter of this year. We expect meaningful revenue impact from the two new products, ZixDLP and ZixOne 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 percent in the high 20s and adjusted operating margin in the mid-20% range. In closing, we are pleased that we exceeded our second quarter revenue and earnings guidance and we look forward to continued strong performance in the third quarter. With that, I'll turn it back to Rick.

[Rick Spurr:]

Thank you Mike, it's great. Let's turn this over to questions.

[Operator:]

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

[Mike Malouf:]

A question for you, when we -- when you look at the transcript from last quarter, you talked about high end accounts doing pretty well, specifically I think you had mentioned the last quarter that Symantec was helping you with a significant large account. Did that come true on this quarter?

[Rick Spurr:]

It has not Mike and that particular opportunity is in the holding pattern. If it closes it will be an upside surprise to our current projections.

[Mike Malouf:]

So that wasn't the San Francisco win that you mentioned earlier?

[Rick Spurr:]

No, it was a totally different opportunity.

[Mike Malouf:]

And then moving to the new products, you mentioned that the DLP version is going to head into 2.0; does that increase your R&D over and above what you are expecting or is that going to be in line with what you had?

[Rick Spurr:]

That R&D is baked into our run rate, Mike.

[Mike Malouf:]

And then, is the acceptance of the DLP a little bit below what you had expected because of some of the enhancements that you need to do?

[Rick Spurr:]

Well, let's turn that around it's pretty clear to us now that had we had these additional control features in that we would have had even greater acceleration than we have already seen. They are not huge, like I said some of the customers are fine with it, but a lot of the customers say, hey, if you could just give me the ability to do this or that, that would make my workflow more efficient and the delay for them to wait for months or so is not a big deal to them.

[Mike Malouf:]

And then you had mentioned you have 30 beta customers using the ZixOne, can you give us a sense of how many users that encompasses?

[Rick Spurr:]

A relatively small number of users so because it's a beta product the customer is of course hesitant to certainly spread it around in a broad based way but it's enough users that we're getting very good input in terms of features and functions and concerns that they might have, actually it's really not, we haven't heard too many concerns, is the real answer. But we are getting input some of which is encouraging and positive.

[Mike Malouf:]

Great. And then just one last question, with regards to Google, you said that that's on track now, how long do you think it will take the sales force to be reengaged on that?

[Rick Spurr:]

We don't know. We know what they're telling us but we're being cautious because we don't control any of this. So we hope we’ll be out of the woods this year but I'm holding, or not holding my breath I guess. I did look at the impact of this Google thing. I think it's probably getting a little more air time than it deserves. Our fall off in licensed revenue when we exclude the overages which is a totally separate thing has been about a 150K, so we're talking a lot about, not that 150K is meaningful but it's the size of one good sized deal. And so we hope we're on track to get that back and go beyond it but we're not ready to project the timeframe yet. By the way, to be clear, they can and are placing orders. So this isn't like there's no order flow, it's just that we know it can be a lot better.

[Mike Malouf:]

Got it. Great, thanks for the help, I appreciate it.

[Rick Spurr:]

Thank you, Mike, for those questions.

[Operator:]

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

[Noel Atkinson:]

I was wondering also for the ZixOne beta, if you could talk about some of the size of the companies that are participating in the beta?

[Rick Spurr:]

There are no gargantuan, Fortune 1000 companies but there are some decent sized, you know, medium sized companies as well as some smaller companies, but again we're doing our own machine driven scalability testing and such. So we don't, we're not expecting the betas to give us input on scalability. We're expecting the betas to give us input on functionality.

[Noel Atkinson:]

Okay, and then also on ZixOne. We see it as that product may be helping you guys to get in to the non-regulated companies that maybe have not quite done the uptick yet for the email encryption and do you guys plan to offer a bundle of ZixOne plus the other two to new customers?

[Rick Spurr:]

We are and some of those are actually being packaged up now to satisfy some [inbound] [ph] inquiries. So it will roll out as individual products or in bundles as whatever suits best for the customers' requirements.

[Noel Atkinson:]

Okay, great, thanks.

[Rick Spurr:]

Sure.

[Operator:]

(Operator Instructions) And your next question comes from the line of Fred Ziegel from Topeka Capital Markets. Please proceed.

[Fred Ziegel:]

Hi guys.

[Rick Spurr:]

Hey, Fred.

[Fred Ziegel:]

A couple of question, one on the HITECH Act from your vantage point, I know deadline kind of slipped, what's your sense of how that’s going particularly the, I guess as they have drawn in the business associates to the whole mix, what's your perspective on that and do you think this is something that, I mean what, September is not very far away, are we going to see some huge scramble, or are we going to see people asking for more time, how do you think it sorts out over the next few…?

[Rick Spurr:]

Sure. First of all there is definitely – it’s definitely a factor in the marketplace and the sales people will tell us that loudly and crisply, it is not a tsunami, but it's increased activity and more efficiency in the sales cycle. In terms of the timing, we only have a little bit of history to give us guidance on this. But history suggest that there will be for a segment of the population a drive to be compliant let’s say by the end of third quarter, the big question of course is what, how big is that segment, is it 20% of people who haven't done anything or 80% of people that haven't done anything. And I think it's probably closer to 20 than it is 80, because our experience is that people just find excuses to let this drag out a bit. Now there's both good news and bad news, we're not going to see any super spike in Q3, I don't believe, underwriting super spike, we do have wind in our sails. But I think we're going to see demand from this healthcare sector in this legislation for several quarters.

[Fred Ziegel:]

Okay. And then just generally speaking whether it's the HITECH Act, whether it's all this brouhaha in Washington, with the NSA, is it your sense that encryption in general is the awareness and perhaps the interest is on the rise or are we still primarily driven by the more heavily regulated financial and healthcare?

[Rick Spurr:]

I think it's on the rise and I think it's on the rise across the board. All, as I said in the script, all of our sectors are up, government at the federal level government at now the state and local level. Finance is as high as it's ever been. So I think just a general awareness about digital security and very specifically email security is increasing the priority on this topic. That's what we sense.

[Fred Ziegel:]

Okay. Thanks.

[Rick Spurr:]

Thank you.

[Operator:]

Your next question comes from the line of Michael Kim from Zix. Please proceed.

[Michael Kim:]

Good afternoon, guys. Michael Kim from Imperial Capital.

[Rick Spurr:]

We knew where you are from Michael.

[Michael Kim:]

Rick, Mike, just going back to beta for ZixOne, as you’ve gotten some positive early feedback, do you guys have a better sense of the price discovery, if you think that the premium relative to email encryption pricing still in that 50% to 100% range or have you honed that down in a little bit narrow range to that?

[Rick Spurr:]

We haven't changed our pricing, and our pricing reflects at the midpoint about double our email encryption street price. But we also acknowledge and understand that this is an adolescent market and we are frankly shocked by the prices that our competitors are charging and it's hard to believe that won't start to come down. How we respond to it, we're going to let the market tell us.

[Michael Kim:]

And the competitive pricing is that even above 2X that email encryption pricing?

[Rick Spurr:]

Yes, so there is only one competitor, a company called [AirWatch] [ph] that is at or below our pricing, and the others are all substantially above ours. That has to do, Michael, largely with the fact that they're charging by device and we've come to the market with really not a new approach, it's an approach that's more common which is just the price per user. So when a company employee is enabled with ZixOne for one price they can use a multitude of devices, they can have a tablet at home and they can have as many smartphones as they choose to have at all, had access with a set of credentials across all those devices. The competition is actually putting software on these devices instead of trying to charge for these various versions of software that we have on these different mobile devices and that's we just don't think acceptable in the marketplace.

[Michael Kim:]

And just to clarify do you think ZixOne is something that's mutually exclusive if you know say organizations already are planning to deploy an MDM or a containerization solution?

[Rick Spurr:]

I think what you are asking is do we think that it's one or the other, and the answer is no. The more and more we get engaged, the more we think we see where even people who have a competing solution are attracted to our product as a complementary option for a broader set of their employees. So the idea would be we bought this competition of yours, but it is sort of heavy and hard, but you know it's in place and it services, I'm making these numbers up, but 20% of our population, but you guys, this thing is really simple and can provide email calendar contact access for a much broader spot on the population. And by the way a single user could have both. A single user could use their one of these competing solutions for whatever applications they are enabled for and might choose to use ZixOne as well, say, for 24 hour access while they are on vacation or night or anywhere in the car, we're just much more flexible.

[Michael Kim:]

Rick, you briefly touched on this in your prepared remarks, but can you maybe expand on the go-to-market strategy for ZixOne and what do think the sales cycle could look like and are you seeing maybe better opportunity on Greenfield or is it really just mining the installed base and going back to customers who know you?

[Rick Spurr:]

It's really all the above. We're seeing opportunities from customers that don't have any. This is their first exposure to Zix. We're seeing opportunity in brand new sales to introduce that product. And so the strategy more broadly is to just maximize the number of placements, not try to be all things to all people and get the entire user population out of the box, but just give them an opportunity to try it and touch it and feel it, realize how easy, simple and robust it is and let that grow. So in 2013, it's a seeding strategy.

[Michael Kim:]

And just given the proliferation of this whole BYOD trend and is it reasonable to assume that the number of users in an organization is potentially much higher for ZixOne than what you've seen traditionally in for email encryption?

[Rick Spurr:]

Yes. So, I mean, ZixOne is we believe will be a much more broad-based and widely adopted solution in companies that make that choice.

[Michael Kim:]

Great, well pricing and hopefully higher penetration.

[Rick Spurr:]

Yeah, all sounds good.

[Operator:]

Ladies and gentlemen, this will conclude the question-and-answer portion of today's conference. I would now like to turn the conference back over to Rick Spurr for closing remarks.

[Rick Spurr:]

Simple closing remarks, we're going to get back to Q3 which is very exciting for us and we were glad that you were all able to join us today. Thanks.

[Operator:]

And ladies and gentlemen, that concludes today's conference. Thank you for your participation and you may now disconnect. Have a wonderful day.