Zix Corporation
Q3 2013 Earnings Call Transcript

Published: 23 Oct 2013

[Operator:]

Good day ladies and gentlemen and look into the 2013, Q3 Zix Corporation earnings conference call. My name is Crystal and I will be your operator for today. At this time, all participants are in a listen only mode. (Operator Instructions) I would now like to turn the conference over to your host today, Mr. Geoff Bibby. Please proceed, Sir.

[Geoff Bibby:]

Thank you, Crystal. Good afternoon. As Crystal mentioned my name is Geoff Bibby I'm Vice President of corporate marketing for Zix Corporation. Thank you for joining our 2013, 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, Mike and Rick will answer questions from analysts and institutional investors. Listeners can also summit questions during the call through our Investor Relations mailbox at [e-mail]. Rick and Mike will provide forward-looking statements on matters such as forecast of revenue, earnings, operating margins and cash flow, projections about contracts for business, and comments on trend and commission. The Company undertakes no obligation to publicly operate best 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 committees 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 very pleased to turn the call over to Rick.

[Rick Spurr:]

Thanks, Jeff. Good afternoon, everyone, and welcome to today's call to discuss Zix Corporation third quarter 2013 financial results. I am pleased to report another solid quarter for the Company, including record revenue, and a record high backlog reflecting our continued strong business momentum. Revenue for the third quarter was a record $12.2 million, a slight increase sequentially from record revenue in the preceding quarter, and up 11% from the same quarter last year. It also exceeded our previously stated guidance for the quarter. New first year orders for the third quarter were $2.2 million, which is a slight increase compared to the prior-year quarter if you exclude the one-time catch-up of approximately $417,000 related to Google overages that were included in new first year orders for the third quarter of last year. Let me elaborate. For the third quarter last year, we reported that new first year orders included $417,000 that related to Google user overages during the first and second quarters of last year. Specifically, the number of end-users of 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 included in the third quarter of last year as a one-time catch-up. The third quarter of last year was a first time we reported these overages. As we noted then, we established a process for identifying and reporting this type of overage and had continued to include these in our results going forward. Total orders during the third quarter were $13 million, up 3% from $12.7 million in the same quarter last year. And this past quarter, we grew our backlog to a new record high of $64.2 million versus $57 million in the quarter a year ago. On the bottom line, we achieved GAAP net income of $3.2 million or $0.05 per share on a fully diluted basis. Non-GAAP adjusted net income in the third quarter was $3.7 million or $0.06 per share on a fully diluted basis exceeding our guidance for the quarter. During the third quarter, our business generated $6.2 million in cash flow from operations; a very strong result. Now let me share some more detail regarding the composition of our new first year orders in the third quarter. Our corporate sales team came in at $1.4 million, up 11% over the third quarter of last year. As you know, this team targets small and medium businesses and the government sector and drives our VAR and MSSP partner channel. Our enterprise group achieved $543,000 of new first year orders, up 29% over the third quarter of last year. We are pleased with this growing contribution from large accounts and believe that this growth will continue. Our OEM business represented 12% of our new first year orders this quarter, and this is down compared to last year due partly to the large one-time Google overages reported in 2012, and partly due to the transition to GME 2.0. As we have noted on previous calls, 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 earlier this year. However, there were some implementation issues not related to our technology, but related to Google technology readiness. The Google technology issues were resolved earlier in the year and are behind us. The remaining challenges that we are now in the final stages of being certified as a true Google app as opposed to before when we were sold as a Postini service, albeit often used in conjunction with Google apps. We are confident this will be accomplished after which the Google salesforce will be fully compensated for selling Zix encryption. Also, I should note that we are in the final phase of signing yet another annual extension to our reseller contract with Google, and we are still the only e-mail encryption solution that Google resells. Other OEM related news is that we are seeing continued growing contribution from our OEM relationship with Symantec. In fact, year to date, the first year order contributions from Symantec exceeded the contribution from Google, and we are excited about the Symantec related pipeline of Zix opportunities. As we typically do, I’ll now comment on sales contribution from an industry perspective. Our new first year orders in Q3 broke down as follows

[Mike English:]

Thanks Rick. Good afternoon, everyone. The third quarter was our 19th consecutive quarter of record revenue. We are happy to report that our revenue and adjusted earnings-per-share resulted – results for the quarter exceeded guidance. Beginning with our GAAP results, net income for the third quarter was $3.2 million, compared to $1.9 million for the third quarter of 2012, a 63% increase. Revenue for the third quarter 2013 was $12.2 million, exceeding the top end of our revenue guidance. The third quarter revenue represents an 11% increase over the same period last year. Contributing to revenue this quarter were several significant add-on sales resulting from customers exceeding their license seat quantities. Third quarter revenues from these licensed overage transactions was three to four times higher than our normal quarterly run rate of $50,000 to $100,000. We anticipate returning to a more normal run rate going forward. Our backlog of contracted orders totaled $64.2 million at the end of the third quarter. This was a 13% increase compared to the same period last year. We anticipate approximately 54% of the backlog will be recognized into revenue in the next 12 months. Moving on now to our non-GAAP earnings and non-GAAP expenses. We achieved third quarter adjusted gross profit of $10.4 million, which was 85% of revenues. This compares favorably to $9.2 million or 83% of revenues for the same quarter in 2012. On a sequential basis, it compares favorably to $10 million or 84% of revenues for the second quarter of 2013. In fact, when we look at this in absolute terms, compared to the same period last year, Q3 2013 revenue increased $1.2 million well-adjusted cost of sales increased only $9000. This resulted in part because a significant portion of our cost of sales are fixed due to excess capacity in the Zix data center so cost of sales will grow at a slower pace than revenue. Combined total adjusted R&D and SG&A expenses were $6.6 million in the third quarter of 2013; relatively flat compared to $6.4 million for the third quarter of 2012. Adjusted R&D expenses were $2.3 million in the third quarter of 2013, up $300,000 from the third quarter of 2012 when we were beginning to ramp our R&D investment in products. Adjusted sales and marketing expenses for the third quarter were $3 million, compared to $2.9 million for the third quarter of 2012. Adjusted G&A expenses were $1.3 million compared to $1.6 million for the third quarter of 2012. We anticipate fourth quarter operating expenses to be below the Q1 and Q2 levels, largely due to lower spending on marketing. Obviously, our increased revenue along with modest increases in operating expenses resulting greater profitability. Specifically, adjusted operating profit for the quarter was $3.8 million or 31% of revenues. That compares favorably to $2.8 million or 25% of revenues for the third quarter of 2012. Adjusted EBITDA for the third quarter was $4.2 million to an increase of 35% compared to $3.1 million from the third quarter of 2012. The adjusted EBITDA margin percentage for the quarter was 34.2%. Capital expenditures for the third quarter were $314,000 and depreciation expense was $367,000. Consistent with previous quarters, approximately 70% of depreciation expense was recorded in cost of revenues. The cash balance as of September 30, 2013 was $32.9 million, up $6.6 million sequentially from the second quarter of 2013. Net cash provided by operating activities for the third quarter 2013 were $6.2 million. Adjusted net income for the third quarter was $3.7 million, which compares to $2.7 million for the same period in 2012. Our adjusted net income for fully diluted share of common stock for the quarter was $0.06, exceeding our guidance of $0.05 and comparing favorably to $0.04 for the same period in 2012. Let's now move to guidance for the fourth quarter and full-year. For the fourth quarter of 2013, we project fully diluted non-GAAP adjusted earnings-per-share of $0.05 to $0.06 projected revenue ranging from $11.9 million to $12.3 million. This fourth quarter guidance will yield achievement for the full year at or near the lower end of our previous revenue guidance of $48 million to $50 million. With regard to non-GAAP adjusted earnings-per-share, due to rounding whether we report $0.05 or $0.06 per share in the fourth quarter, we still expect full-year non-GAAP fully diluted adjusted earnings per share of $0.19. We expect to end the year with adjusted EBITDA margin percentage in the high 20s and adjusted operating margin in the mid-20% range. In closing, we are pleased to deliver solid revenue and earnings performance for the third quarter and we look forward to a strong finish to the year. With that, I will turn it back to Rick.

[Rick Spurr:]

Thank you, Mike. And with that we will turn it over to the audience to see if you have any questions. Operator Ladies and gentlemen, (Operator Instructions). Our first question comes from the line of Mike Malouf with Craig-Hallum Capital Group. Please proceed, Sir.

[Mike Malouf:]

Great. Thanks, guys. Thanks for taking my call.

[Rick Spurr:]

Sure. Hi, Mike.

[Mike Malouf:]

Hi. Can we talk a little bit about the base business on the revenue side? You know it looks like things – and I understand that Google is not ramped up yet. But if you look at the new first year orders, they have been – they are pretty steady, yet you can see a declining growth pattern pretty evident in the numbers, and I’m just wondering is there any change with pricing or attrition in the base business, the e-mail encryption business?

[Rick Spurr:]

Let me start by asking – you make the statement that it’s pretty obvious, there is declining results. And that certainly is not our perspective because I don't know exactly what math you're doing to arrive at that. The revenue…

[Mike Malouf:]

I’m showing in 2010, we had 25% growth; in 2011 we had 15%; 2012 we have 14%; and if we come into the midpoint of your guidance we’ll have 10%. We’ll have 12% growth in the end of 2011 going to – going all the way down to what looks like about 3% to 5% growth. So, there’s certainly…

[Rick Spurr:]

What was the very last number? I'm sorry, I missed the last number.

[Mike Malouf:]

The last number was 2% to 3% – 2% to 5% year-over-year growth in revenues.

[Rick Spurr:]

You talking about on a quarterly basis?

[Mike Malouf:]

Based on your year-over-year guidance.

[Rick Spurr:]

On a quarterly basis, not on an annual basis.

[Mike Malouf:]

Correct.

[Rick Spurr:]

Yes. So, annual revenue growth will be 10% to 11%, given the guidance we just issued. We anticipate and expect that our base business will continue to grow at least at those rates. There are no meaningful shifts in pricing or retention rates. Pricing will see some pressure, if we have – continue to have success with enterprise accounts just because they’re much larger deals. And as such, the per unit per user pricing is lower, but that’s offset by the higher number of users, of course, and that’s our perspective. We have said that corporate is up, Enterprise is up, and Symantec is up, where Google is the one piece of the business that is down, and the end result is sales year on year we anticipate will be up from 2012 but won't be up at the kind of rates that we would like to see, but we’ve – that’s not any new news.

[Mike Malouf:]

So, let me make sure I understand it. Here, the 10% to 11% growth in top line, is that on the e-mail encryption or does that include some benefit from the new products?

[Rick Spurr:]

So, that's a good question. So, the 10% to 11% growth is going to be virtually 100% from the e-mail business, because as you know – yes, we’re talking about revenue. And as you know, we did not start to ship any of the new products until April, and the DLP contribution to revenues was de minimis. Mike Malouf – Craig-Hallum Capital Group I'm talking looking forward, and you said that – is the e-mail encryption – does the email encryption have the ability to grow at low-double-digit rates?

[Rick Spurr:]

Yes. We actually think it has. Well, I guess low is a debatable word. We want to just say yes to your answer – to your question.

[Mike Malouf:]

Okay. So you would characterize the fourth quarter of guidance between say 2% to 5% as an anomaly related to the Google slowdown?

[Rick Spurr:]

It’s partially Google. I have not gone back Mike and torn apart Q4 of last year. When you compare three months to three months, there’s all sorts of things that can be occurring – one-time things – and I don't think of the business as last year’s quarter to this year’s quarter. I think of it as last year’s year to date maybe versus this year’s year to date or what we see on an annualized basis. But there is no other explanation other than arguably that Google slowed down.

[Mike Malouf:]

Okay. And then, just a quick question on the new products. Are you – do you have any of those – I think you had mentioned 19 that are in evaluations. Are any of the evaluations large in size or you know larger than maybe 200 or 300? Is it – I mean are there some large enterprises in that group?

[Rick Spurr:]

In that group of 19, I believe the answer is no. They’re in the hundreds. But one of the new contracts that we just signed is quite large, well the customer is quite large., The evaluation, of course, will be with a small subset of those users, so that’s the answer to your question.

[Mike Malouf:]

Okay, great. Thanks. I’ll get back in the queue.

[Rick Spurr:]

Thanks, Mike.

[Operator:]

(Operator Instructions). An our next question comes from the line of Fred Ziegel with Topeka Capital Markets. Please proceed.

[Fred Ziegel:]

Yes. Hi guys.

[Rick Spurr:]

Hey Fred.

[Mike English:]

Hey, Fred

[Fred Ziegel:]

Two questions. Would you expect the ZixOne subscription mix to be predominantly three years?

[Rick Spurr:]

I wouldn't have known how to answer that question a month ago, but of the 11 contracts we have signed, 10 of them are three-year contracts. So, it does appear as if despite the fact that the product is new, at least the evidence to date would suggest people are quite comfortable with longer-term contracts in exchange of course for obviously better pricing.

[Fred Ziegel:]

So should we think about the deferred revenue account as one in which we're going to continue to see some shift from short-term to long-term? And therefore, I noted what Mike said, a lower percentage is coming off the balance sheet in the next 12 months. Is that trend likely to continue?

[Mike English:]

We – Fred, this is Mike. We would agree with that that although it won't be pronounced, we do expect that the trend towards those three year contracts would continue.

[Fred Ziegel:]

Okay. And therefore, a somewhat smaller percentage rolling off the balance sheet? I think last quarter, the number was 56 or 57, and now we're down to 54, right?

[Mike English:]

Yes. That – as you know, Fred, that number gets impacted by what you're describing but also other variables are impacted. But generally speaking, I think you're heading in the right direction. Although, I would guide you on that, the reduction in that number would be relatively slow or go

[Fred Ziegel:]

Yes, okay.

[Rick Spurr:]

We are having much more success in part because of focus, but largely because we’ve been around for so long; getting longer-term contracts. We now in some cases get four-year and five-year contracts. And we find less and less resistance to standard three-year offer. So it’s – you’re spot on. That mix is going to change that percentage that will flow to revenue mix.

[Fred Ziegel:]

Okay. Second question, is an adjusted operating margin in the low 30s the new norm?

[Mike English:]

Hi, Fred. This is Mike again. I’m – I would say no. Certainly, the third quarter was an exceptionally good quarter. We had good revenue increase from the prior quarter. Our costs remain low. We had some very good cost controls and performance in our G&A accounts. These are – and also we pulled back on some of the marketing spend we have been doing. As we expand the business, we expect to invest in key areas, marketing and sales being in those areas and continue to invest in R&D. We are not anticipating to be at that 30% level. Our targets are to be – to get toward that 25% level and grow this business at 20% plus. So, that’s the direction we are heading.

[Fred Ziegel:]

Okay. All right, thanks.

[Operator:]

Our next question comes from the line of Michael Kim with Imperial Capital. Please, proceed, Sir.

[Michael Kim:]

Hi. Good afternoon, Rick. Good afternoon Mike.

[Rick Spurr:]

Hey, Michael.

[Mike English:]

Hi, Michael.

[Michael Kim:]

You know just going back to new first year orders from OEMs, Rick did you sense that once 2.0 is certified that Google sales force reengage is relatively quickly and by first quarter of next year they will be at historical run rate that you have seen a new first year orders?

[Rick Spurr:]

That's what we hope to see. All right. You know I… (CROSSTALKING)

[Michael Kim:]

Or would it take longer – you know do you sense it’ll take longer than that?

[Rick Spurr:]

I don't think there is any way to know. You know is the pent-up – so these are customers that we get the opportunity to call on every day because they our customers. So you know might there be pent-up demand? Yes, past the first. Possibly. Might it take some time for people to get the news and get back in the saddle? Maybe. I wish I could give you a more crisp answer to that. But my answer a minute ago is yes, we hope that will get back on track by the first quarter of next year, certainly. But we don't know that.

[Michael Kim:]

And then in terms of your first year orders from the Enterprise Group, should we expect that to be somewhat lumpy from large accounts? You talked about some opportunities in the pipeline and…

[Rick Spurr:]

Yes.

[Michael Kim:]

Would it be potentially be larger than the corporate group in some quarters?

[Rick Spurr:]

Yes. Good question. I mentioned that Enterprise sales was up 29% quarter on quarter and this is after I said we should not pay attention to three-month periods. And as it turns out, that result does not have any large deals in it. So, some of the large deals come to fruition, you can definitely see some lumpiness. In terms of it being bigger than corporate, that is conceivably could be in a given quarter, but that is not – they will not get to a run rate that exceeds corporate, you know, in the next six months. But corporate is almost three times the size of enterprise right now. But you could have one or more big transactions that would cause it to spike in a given quarter.

[Michael Kim:]

Okay. And then just switching back to ZixOne and new products, out of the 11 new customers and maybe even including the 19 customers that are potential customers that are evaluating it, are any of them already – have already implemented and EM or containerization solution? Is that something that can coexist or would it display some of those alternative old solutions?

[Rick Spurr:]

Yes, yes. Good question. It is all over the map. Some of them are any have competing solutions. Some of them have nothing. Some of them are looking to ZixOne to replace the competing solutions. And some of them are looking to implement it in a coexistence strategy. The predominant response when somebody has are the tried competitive tools is this makes a lot of sense for what turns out in the survey data to be the majority of employees who just want low-cost e-mail calendar and contacts and don't envision using a whole plethora of applications on their mobile device. So, it’s – again, the dominant response is there is a place for both of these in my organization. And fortunately, we think on a seat-by-seat basis we’re going to get the major share. Because most people just don't need all the complexity and flexibility that our competitors purport to provide.

[Michael Kim:]

And out of the 11 new customers for ZixOne, you know can you articulate how many of them are already existing e-mail encryption users and how many users that might encompass? Is a your expectation that once they get comfortable with BYOD the number of users for ZixOne could potentially exceed whatever they’re using now on their e-mail encryption side?

[Rick Spurr:]

Yes. So, if you do the math, I said – and maybe you have are ready done it. We've got about 700 seats of ZixOne now. That is the 11th signed contracts with an average of 60 seats per. Some of those are quite small customers and we just sold them coverage for a whole population. Some of them are larger customer that as you might expect that let me try this with 50 and see how it goes. In terms of a relationship to encryption, that's going to be all over the map. It’s likely going to be more than the encryption across the board in aggregate sense but it will very account by account.

[Michael Kim:]

And the 19 evaluating customers, are those all existing e-mail encryption customers ?

[Rick Spurr:]

No. Again, we are getting the majority of the uptake from our existing client base but we had several situations where we had approached a client, a brand-new prospect or we were all ready engaged with a brand-new prospect and the BYOD and in some cases DLP has changed the picture. Now they are looking at buying all of them or in various phases. It is not all about our install base, but as you can expect, those are the people that we – it’s easiest to reach out to and in terms of timing of adoption, we are likely to see that SKU continue. But it's not pure, it is not all one or the other.

[Michael Kim:]

Great. Well, thank you very much.

[Rick Spurr:]

Thank you, Michael.

[Operator:]

With no other calls – there’s no other questions in the queue. I would like to turn the call back over to Rick Spurr.

[Rick Spurr:]

Okay. Thank you very much. We are proud of the quarter, and hopefully get the one shortcoming out of our way. We’re very confident about our current backlog and current business. And that’s the current base business. And we're really excited to be adding in now and layering in brand-new products and I can say honestly particularly ZixOne that’s – could be a real game changer for us. Thanks for your time and interest. Stay in touch. Thanks everybody.

[Operator:]

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.