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NetSuite Inc. (NYSE:N)

Q1 2009 Earnings Call

May 4, 2009 5:00 pm ET

Executives

James McGeever – Chief Financial Officer

Zachary Nelson – Chief Executive Officer

Analysts

Adam Holt - Morgan Stanley

Brendan Barnicle - Pacific Crest Securities

Tom Roderick - Thomas Weisel Partners

Mark Murphy - Piper Jaffray

Bryan McGrath - Credit Suisse

Laura Lederman - William Blair & Company, LLC

Michael Huang - ThinkPanmure

Greg McDowell - JMP Securities

Michael Nemeroff - Wedbush Morgan Securities Inc.

Terry Tillman - Raymond James

Operator

Good day and welcome to the NetSuite first quarter 2009 financial results conference call. Today's call is being recorded.

At this time I would like to turn the conference over to Jim McGeever, Chief Financial Officer of NetSuite. Please go ahead, sir.

Jim McGeever

Thank you. Good afternoon, everyone, and welcome to NetSuite's first quarter 2009 financial results conference call. By now you should have received a copy of our press release issued today after the market closed and furnished on Form 8-K to the SEC.

Joining me on the call today is Zach Nelson, our Chief Executive Officer. Zach and I will begin with prepared remarks and then we will open up the lines for questions.

As a reminder, today's call is being recorded and a replay will be available following the conclusion of the call. To access the press release and the financial details please access our Investor Relations website at www.NetSuite.com/Investors.

During this call we will be referring to both GAAP and non-GAAP financial measures. The GAAP reconciliation to our non-GAAP information is provided in the press release and on our website. All of the non-revenue financial measures we will discuss today are non-GAAP unless we state that the measure is a GAAP number. These non-GAAP measures exclude share-based compensation expenses and the amortization of intangible assets. Any non-GAAP outlook we provide has not been reconciled to the comparable GAAP outlook because we cannot readily estimate the impact of our future stock price and our future share-based compensation expenses.

Some of the information discussed during this call, including any financial outlook we provide, may constitute forward-looking statements within the meaning of the U.S. federal securities laws. These statements are subject to risks, uncertainties and assumptions and are based upon information available as of today. We disclaim any obligation to update any forward-looking statements.

The risks and uncertainties that would cause our results to differ materially from those expressed or implied by any such forward-looking statements are summarized in the press release we issued earlier today. They're also described in detail in the reports that we file from time to time with the SEC, including our most recent 10-K filing, which I encourage you to read. All of those filings are available in the Investor Relations section of our website.

With that, I will now turn the call over to Zach.

Zachary Nelson

Thank you, Jim.

Combining the facts that Q1 is our seasonally slowest quarter with the continued uncertainty in the global economy, we were cautious as we moved into Q1. Today as we report our Q1 2009 numbers we are pleased with the results we are presenting to you.

We delivered results that met or exceeded our state outlook and we also believe our results indicate that we continue to take market share and execute on our strategic initiatives of moving up market and extending the NetSuite platform. Our bottom line result exceeded out stated outlook, nearly doubling our record non-GAAP profitability we reported in Q4. We posted a non-GAAP net income of $1 million or $0.02 per share.

These results are especially impressive given the turbulent macroeconomic environment and Q1's seasonal increase in expenses due to items such as annual audit fees and resetting of payroll taxes. In addition, headcount was essentially flat from Q4, so this improvement was not the result of reducing our work force but rather represents excellent fiscal management across the entire organization.

We also improved cash flow in Q1. As you will recall from our Q4 '08 earnings call, our objective for this calendar year was to improve cash flow to breakeven for FY 2009. Our focus paid off during the first quarter, where we posted strong sequential improvement in cash flow from operations, with a positive $3.1 million improvement over Q4 of 2008.

On the top line we delivered results within our target range, with revenue growing 22% year-over-year to $41.6 million. And on another positive note, recurring revenue increased at a faster rate and was 29% year-over-year. If you recall from our Q4 call, we said we were going to focus on enhancing recurring revenue at the expense of nonrecurring revenue like professional services, and that indeed happened during the quarter.

It's useful to view this 22% year-over-year top line growth in light of the comparable growth rates of legacy providers of mid-market ERP suites. By comparison, traditional ERP vendors such as SAP, Epicor, Lawson, Deltek, and Sage experienced year-over-year total revenue growth ranging from a positive 1.9% to double-digit negative growth. In terms of new license revenue growth, all of those competitor vendors declined by more than 20% year-over-year.

These comparisons reveal that NetSuite's low cost of ownership, faster implementation times and value proposition is resonating with the market. We believe that NetSuite will continue to take market share from our competitors. Our leading product functionality is propelling NetSuite ahead of the pure play private competitors as well, and our 10-year technology lead in delivering an integrated suite of web-based applications and our expertise in cloud computing continued to deliver enormous value to customers around the globe. So in terms of revenue, profitability and cash flow, we met or exceeded our plans.

On the short-term deferred revenue front, like most of our SAS peers, we saw the impact of the macroeconomic headwinds during the quarter. That said, short-term deferred revenue did grow year-over-year. Whereas bookings were not as strong as we would have liked, we are seeing some encouraging business trends that I'll talk about in my closing remarks.

We added 240 customers during the quarter. Certainly this new customer count also shows the impact of the macroeconomic environment; however, as our customers do get larger over time, we may see a smaller count than our historic averages as we move forward. And we did add large customers during the quarter, showing that our strategic initiative to move up market continues the momentum we experienced last year.

Our recent announced deployment at Suntech Power provides insight into the power of our solution and the multiple opportunities for NetSuite in larger companies. Suntech Power Holdings, as many of you know, is the world's leading solar energy company and producer of solar panels. The company is headquartered in China, where the corporate parent runs on a traditional on-premise ERP system. However, its U.S. subsidiary, Suntech America, chose to run its core ERP, CRM and ecommerce processes on NetSuite. This is another great example of a division of a large enterprise running its subs on NetSuite while maintaining the corporate investment in legacy ERP systems.

Our NetSuite OneWorld product continues to drive our market push. On the eve of the one-year anniversary of its launch, NetSuite OneWorld remains, we believe, the first and only on-demand system to deliver real-time subsidiary management and business consolidation capabilities to midsized companies and divisions of large enterprises for accounting, ERP, CRM and ecommerce operations. All of this capability comes at a fraction of the cost of traditional on-premise solutions. NetSuite OneWorld continues to gain popularity not only in North America but also in Europe and Asia-Pacific as well.

NetSuite OneWorld has blossomed to become an important contributor to NetSuite. The enthusiasm in our customer and prospect base, as well as the growth in our pipeline, gives us confidence that our up-market strategy will continue to meet with success as we move further into 2009.

Our second strategic area of focus has been in fostering the NetSuite ecosystem. Unlike other cloud-based development environments, our NS VOS environment is targeted to allow partners and independent software vendors or ISVs to extend NetSuite by developing industry specific versions of our application suite. The key differentiation for NS VOS and for NetSuite from other platforms is that these third parties and ISVs are embedding our accounting, our CRM and our ecommerce into their applications.

During the quarter we launched the SuiteCloud Developer Ecosystem, a comprehensive offering of on-demand products, development tools and developer services designed to help customers and commercial software developers alike take advantage of the significant economic benefits of cloud computing. SuiteCloud enables customers who run their core business operations in the cloud and software developers to target new markets quickly with newly created mission-critical applications built on top of the mature proven business process management capabilities and functionality of NetSuite.

An important aspect of SuiteCloud is the SuiteCloud Developer Network, a comprehensive program that helps accelerate the development of rich business-oriented applications and SuiteApp.com, NetSuite's new online marketplace for ISV-developed applications which provide the mechanism for developers to distribute and for customers to find these valuable third-party applications for their NetSuite environments.

And we've already begun to see some interesting initial SuiteCloud applications roll out. Introduced this week was a new MRP application from Rootstock Software. Rootstock Software is a pure play software service provider of on-demand manufacturing software for discrete manufacturers. Just last week they announced the new beta release of Rootstock MRP from NetSuite, a complete end-to-end solution for discrete manufacturing and the first pure SAS MRP system built and delivered via NetSuite's SuiteCloud computing platform. Rootstock MRP for NetSuite tightly couples key manufacturing processes such as materials management, shop floor management and engineering change control with general business functions such as financial management, order processing, sales automation and customer service.

Our SuiteCloud Ecosystem also saw a series of connectors introduced that enable NetSuite to be used in conjunction with other applications. As larger companies begin to standardize on NetSuite, the availability of such products and services become more important.

For example, SuiteCloud Connect for Salesforce.com incorporates a series of partner integration applications that connect the latest versions of both NetSuite and Salesforce.com. These applications were built by independent software developers who were also charter members of NetSuite's SuiteCloud Developer Network and include Boomi, Cast Iron Systems, Celigo, and Pervasive Software. These new applications deliver to larger companies an integrated lead to cash process, deep customer visibility for sales, and the elimination of manual processes across business units.

In closing, as we've seen across the entire software industry and most other business sectors, Q1 was a challenging quarter. While NetSuite and our customers are not immune to these global economic forces, we were very happy to deliver bottom line results that exceeded our publicly stated outlook, top line growth that fell within our target range, cash flow improvements as promised, as well as driving continued momentum for our strategic initiatives of moving up market and extending NetSuite as a platform.

So with that let me turn it over to our CFO, Jim McGeever.

Jim McGeever

Thanks, Zach. As a reminder, today's discussion will be based primarily on non-GAAP financial measures. They exclude stock-based compensation expense and the amortization of intangibles.

As Zach mentioned, the first quarter of 2009 marked continued enhancement to our best financial performance on both the top and bottom line with the second consecutive quarter of non-GAAP operating income and non-GAAP profitability. We also showed improvement in cash flow from operations as we work towards our objective of reaching breakeven cash flow from operations for the year.

Now let me turn to our financial statements for the first quarter that ended March 31, 2009.

Total revenue for the quarter was a record $41.6 million, a year-over-year increase of 22%. The annual increase in revenue was driven by the success of our strategy to move up market over the past year, which resulted in the acquisition of larger customers with a larger average selling price than our smaller customers. In addition, given the change in foreign exchange rates, our revenues were also negatively impacted by over $750,000 compared to the same period last year.

While we did see strong year-over-year growth, Q1 revenue was at the low end of our guided range. We were affected by the broad economic slowdown that's been adversely affecting all companies. For example, some of our customers elected to renew for lesser amounts. Churn rates over the past few quarters did not fluctuate significantly in Q1. Importantly, when we looked at our larger customers we saw no voluntary churn during Q1.

During the quarter upsell to our installed base continued to be strong, largely offsetting lost revenue from customers who did not renew. We added approximately 240 new customers in Q1. We believe that this metric was impacted by both the typical Q1 seasonality and the difficult economic environment. Notably, while the new customer adds were smaller than in Q4 '08, we continue to see progress in selling to larger-size customers. The percentage of customers paying over 10,000 a year grew over Q4 of '08 with the fastest-growing segment being those customers that pay over $100,000 per year. During Q1 the NetSuite OneWorld product had another strong quarter, representing 27% of new business bookings and an increasing percentage of our pipeline.

In terms of pricing, over the past several years the first calendar quarter generally exhibits reduced ASPs versus the fourth quarter. This was also the case in Q1, when ASPs trended down versus Q4 '08. We also believe that the current economic environment contributes to our reduced ASPs during the quarter, but historically we've seen ASPs rebound in Q2 and beyond. Importantly, recurring revenue - what we value most - grew 29% year-over-year.

Moving on to revenue by geography, customers located in the U.S. and Canada delivered 81% of revenue, while 19% was delivered from our international region. We continue to believe that international markets provide us with opportunities to expand our business and we plan to continue to invest in this growth area.

During Q1 we recognized $1.5 million of revenue related to our distribution rights of our localized Japanese products. As a reminder, this distribution agreement comes to an end during Q2 and our recognition of this level of revenue will cease.

Non-GAAP gross margin for the first quarter was 71.2%, which was an improvement over fourth quarter's gross margin of 71%. This was principally the result of our ability to leverage investments made last year in our service and support organization. Looking ahead we anticipate that gross margins will remain approximately at the 70% to 71% level.

Turning to our non-GAAP operating expenses, product development expense was $5.4 million for the quarter. This represented 13% of revenue, consistent with the prior quarter. For 2009 we expect product development expense to be roughly 13% to 14% of our revenues, driven by the continued investment in more internationalized versions of NetSuite and the NetSuite OneWorld product. Product development continues to be a key strategic investment for NetSuite.

Sales and marketing was $17.6 million or 42% of revenue. Sales and marketing was down from Q4 due to reduced payroll, lower marketing expenditures and lower commissions. As planned, we didn't make any significant hires during the first quarter within our sales organization. We ended the quarter with 161 quota-carrying sales reps, slightly down from Q4 as a result of churning unproductive reps. However, during the quarter we did increase the number of corporate-designated sales reps assigned to larger-sized customers. We continue to monitor the effectiveness of our sales infrastructure and we'll adapt in real-time to opportunities as they present themselves.

G&A was $5.8 million or 14% of revenue. The sequential increase reflected additional expense related to our annual order and legal fees, which tend to be higher in the first quarter. For 2009 we expect G&A expense to be approximately 12% to 13% of our revenue.

During the quarter we recorded a net income tax expense of $201,000. This provision was principally related to our international entities. For tax purposes we expect our net operating losses to offset any domestic earnings for the foreseeable future.

Now to discuss our profitability. On a non-GAAP basis we improved our operating income by over 540% from the prior quarter. Non-GAAP operating income was $790,000 during Q1 as compared to $123,000 in Q4 2008 and an operating loss of $1.7 million in Q1 of 2008. Non-GAAP net income for the first quarter was $1 million versus a non-GAAP net loss of $420,000 in the year ago quarter, an improvement of 340% or 3% of current quarter revenue. As a result, on a non-GAAP basis we're reporting earnings per share of $0.02 for the first quarter as compared to a loss of $0.01 in Q1 of 2008. Our solid bottom line performance was attributable to general cost controls across the organization.

Moving to the balance sheet, we closed the quarter with $119.6 million in cash and cash equivalents. We believe our strong financial position enhances our competitive position in the marketplace, particularly with respect to smaller competitors.

Accounts receivable for the quarter ended at $25.5 million, down from $26.7 million at the end of the fourth quarter of 2008. Q1 traditionally shows a step down in receivables due to seasonality.

As we have noted to you in the past, given our revenue recognition model and the flow of deferred revenue we do not use traditional DSO calculations as an internal metric but manage to days billing outstanding. During Q1 days billing outstanding improved slightly over the prior quarter. During Q1 the average billing term for new customers was approximately six months, a slight improvement from the five months in Q4 2008. We are pleased that the proactive measures that we implemented last quarter are taking effect on this measure.

Short-term deferred revenue totaled $63.6 million at the end of Q1, down from $67.7 million in Q4 2008. Excluding deferred revenue associated with our Japanese partnership, co-owned deferred revenue was $62.6 million. As a reminder, we've included a reconciliation of our deferred revenue on our website.

As Zach mentioned, NetSuite historically exhibits lighter bookings during the first calendar quarter and Q1 of 2009 was no exception. That said, as most analysts define bookings as a change in deferred revenue plus recognized revenue, we grew substantially faster than our traditional ERP rivals. However, we did not meet our own expectations for new business in Q1, which we believe was driven primarily by the overall economy. As Zach will discuss later on the call, we are seeing positive data points regarding new business activity.

Long-term deferred revenue totaled $6.2 million at the end of the first quarter, down from $7.2 million in Q4 of '08. As we continue to shift away from multi-year to one-year contracts within our customer contracts we expect the long-term deferred revenue balance to continue to decline.

Cash flow used in operations for Q1 was $2.2 million, an improvement of $3.1 million from the $5.3 million in Q4 of 2008. Cash flow used in operations was affected by improvement in billing terms and strong collections during the quarter. We were able to accomplish this while also reducing days payables outstanding. We believe that this keeps us on track to achieve our previously stated goal to reach breakeven cash flow from operations for 2009.

Headcount at March 31, 2009 was 967 as compared to 971 at the end of December 31, 2008. As we discussed on our last call, looking forward we intend to take a cautious approach on hiring and will only invest in certain functional areas as we see opportunities present themselves. As such we expect headcount to continue to grow at a measured pace in the near term.

Now I would like to move on to our forward-looking financial outlook, which is covered by our cautionary language outlined at the state of the call and based on assumptions which are subject to change over time.

For Q2 2009 we anticipate revenues of approximately $40 million. This assumes a reduction in revenue related to our Japanese agreement of approximately $1.5 million and a reduction in service revenue. However, we do expect recurring revenue in Q2 to grow sequentially.

As a remainder, we have been recognizing $1.5 million of revenue each quarter related to distribution rights of our localized Japanese product. This distribution agreement comes to an end during Q2 and our recognition of this level of revenue will cease. There is no cost associated with this revenue and as a result this loss of revenue will directly reduce our non-GAAP income as well in Q2. For the remainder of 2009 our non-GAAP income would be approximately $0.07 higher if not for the ending of this revenue stream.

For the second quarter we expect a non-GAAP net loss of $500,000 to breakeven. This equates to non-GAAP EPS of approximately negative $0.01 to zero.

Moving to 2009 outlook, whereas we haven't previously given 2009 revenue outlook, with Q1 behind us we feel that we can now provide a revenue range. For 2009 we anticipate revenues in the range of $162 to $168 million. In addition, we are reiterating our outlook for non-GAAP EPS to be between $0.04 to $0.06 for the year.

We look forward to continuing improvements in our recurring growth and non-GAAP bottom line profitability in 2009.

This concludes my prepared remarks. With that, I will turn the call back to Zach.

Zachary Nelson

Thanks, Jim.

In closing, while Q1 was difficult and Q1 has the largest impact on revenue for the year, we are feeling the glass is more than half full. During Q1 we began to see strength in some of our leading indicators. Our lead flow grew year-over-year. More granularly, during Q1, leads from companies with more than 500 employees grew over 14% sequentially and over 50% from the year ago quarter, indicating increasing interest in NetSuite solutions from larger enterprises. And in Q1 our conversion ratio of leads to prospects improved over Q4 of 2008. The month of March, in fact, had the greatest number of prospects generated in over a year.

In terms of our composition of revenue, our focus on growing recurring revenue rather than non-recurring revenue such as professional services also exhibited solid performance. Our non-GAAP profitability is showing substantial improvement over the prior year. In 2008 we lost $0.04 a share on a non-GAAP basis and in 2009 our outlook calls for a positive $0.04 to $0.06. This swing alone is impressive, but when you factor in the bottom line impact of the non-recurring Japanese distribution rights Jim mentioned, you would have seen a year-over-year improvement in non-GAAP earnings per share of $0.16.

And finally, our market position is among the strongest in the software industry. Our profitability, balance sheet and experience give customers confidence in our ability to meet their needs. Our 10-year focus on building the product and the organization to deliver an integrated suite of web-based applications is unmatched by any competitor. Our suite approach helps companies save money and the breadth of our application allows us to serve multiple segments of the mid market while providing us several and multiple opportunities for future upsell into our customer base. These leading indicators give us encouragement for new business activity as we look ahead.

Now with that I'd like to open the phone lines, Operator, for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Adam Holt - Morgan Stanley.

Adam Holt - Morgan Stanley

My first question is about, Zach, to touch on some of the comments you made at the end there. It sounds like some of the leading indicators in your business started to improve towards the end of the quarter. Could you talk a little bit about, number one, sort of what the assumptions are underpinning the Q2 guidance with respect to the macro? And then I guess the other question would be outside of the leading indicators did you actually start to see some of the in-quarter indicators get a little bit better maybe at the end of March?

Zachary Nelson

Yes, I think certainly the in-quarter indicators. March finished fairly strongly and we also, going beyond in-quarter into this quarter, April was quite - I guess we'd call it quite strong. So those two data points definitely helped in terms of the outlook for the year.

In terms of the Q2 forecast, Q1, of course, impacts the revenue that we're going to see in Q2 and so the bookings were not quite what we wanted them to be there, so that's being factored in. The loss of the Japanese revenue also comes into play in Q2. But April, I think, both in terms of the business that was closed as well as in terms of some of these other indicators - lead flow and, more importantly, conversion to prospect - have me feeling pretty confident.

Now of course the big question always is conversion of prospect to customer and of course that's been really the challenge since the economic downturn happened was that conversion. And that conversion rate has bounced a little bit, you know, depending on the quarter. Q3 of last year was really rough. Q4, we had a very good close to the year. And then we stepped into Q1.

Now Q1 is typically seasonally down for us, so some of this was expected, some of the change from Q4, but it was certainly greater than we expected and I think that was probably due to the macroeconomic climate as well as customers beginning to look at their environment as they retrenched for the coming year and perhaps slowing down their purchase cycles as they tried to get visibility into what was going on in their markets in much the same way that we were trying to get visibility into what was going on in our market in the first quarter.

Adam Holt - Morgan Stanley

And if I could just ask one follow up on the deal terms, I know you've done a lot of things internally to try and focus people on extending the terms and you saw some improvement there. Should we be thinking about six months as the steady state level going forward or would you expect to see terms continue to increase throughout the year?

Jim McGeever

No, I think we'll expect about six months to be where we'll be for the rest of the year. When we gave a target for being breakeven on an operating basis for 2009, we essentially assumed that six months was where we'd like to get back to, so we're very pleased that in Q1 we were able to get it back to the target and our goal is to try to keep it there for the rest of the year.

Operator

(Operator Instructions) Brendan Barnicle - Pacific Crest Securities.

Brendan Barnicle - Pacific Crest Securities

Zach, I wanted to follow up on the move up market you guys have been making, steady progress there, but we didn't see it in ASPs. I would have thought with the [inaudible] customers we might have seen ASPs increase a bit. Can you reconcile the ASP decline with the move up market?

Zachary Nelson

Yes, I think it's pretty straightforward. While we have this recurring revenue model and a subscription revenue model, the new business model behaves, for better or for worse, very much like a traditional software new business model. And so in that model at the end of the year you close a bunch of deals, you close a bunch of bigger deals because everybody's on that sort of buying cycle, and then Q1 starts again and you're basically starting anew.

And so I think typically we and almost all companies will see fewer large deals early in the year and more large deals later in the year as people move through their purchasing cycles. And so I think that was just sort of standard behavior for a new business software model.

Jim McGeever

And traditionally historically Q1 ASPs have been lower than Q4. We've seen that for several years. And if you look at the drop from Q1 of '09 from Q4 of '08 and compare it to the prior year period, it wasn't that substantially different. I mean, it was roughly in line with the same trend that we've seen in prior years.

So we certainly don't view it as an unusual blip. It was higher than it was a year ago period, so it still shows up positive trend.

Zachary Nelson

Just to be really clear about that, the ASP did grow year-over-year. It did decline Q4 '08 to Q1 '09. I think it declined roughly by 27%.

Jim McGeever

It declined by 27% versus Q4 and in the prior year period it declined by 22%, so not that substantially a different trend.

Zachary Nelson

So it grew year-over-year. It declined as expected. It declined a little more than expected probably due to macroeconomic considerations.

Brendan Barnicle - Pacific Crest Securities

But what could you point us to in terms of metrics that kind of reinforce the thesis about moving up market.

Zachary Nelson

Well, you know, we continue to book a good deal of business with NetSuite OneWorld. Certainly the pipeline has growth with NetSuite OneWorld again. We're seeing great demand for the product in the new business pipeline. I sit in on our large deal customer sell and we're discussing a lot more deals than we ever have before, so the pipeline is definitely growing, interest is growing. And I think you'll see that, you know, given macroeconomic conditions sort of remain constant, you'll see that play out through the remainder of the year and as always our ASPs will go up from here as they have every year prior to this.

Brendan Barnicle - Pacific Crest Securities

What about new customers additions? Will that make the transition upward again or will, given that we've got bigger customers, is that going to stay around these levels for the remainder of the year.

Zachary Nelson

You know, I think the answer to that really remains unknown. I think you look at software companies that sell to larger companies and typically their new customer adds, I have to believe, are less because they're selling to larger companies. So I think that may happen to us, I think you may see us sell to fewer larger companies. That said, we still have a great solution for small and midsized businesses as well. So my hope is it's incremental; there's a possibility that selling to larger companies may take more resources and may come at the cost of some of those smaller companies, so I don't have a really good answer for it today. I think we're just going to have to see how the year plays out.

Brendan Barnicle - Pacific Crest Securities

And, Jim, as we think about how the cash flow may play out for the remainder of the year, what sort of trend there? Would you expect it to sort of do a lineal decline or are we going to see some sort of seasonality to that?

Jim McGeever

Basically in terms of the modeling we'd expect Q2 to be somewhat negative on the operating line and then to see a rebound in the second half of the year to get back to our target of being breakeven for the year as a whole.

Operator

Your next question comes from Tom Roderick - Thomas Weisel Partners.

Tom Roderick - Thomas Weisel Partners

So it sounds much like everyone else is experiencing out there, that the demand environment is pretty tough but you're doing a nice job on cost control. The earnings number came in, it sounds like, better than you expected. Have you made any changes since the close of the quarter, so I guess just in the last month and change, have you made any changes to reduce headcount, particularly on the sales side, and do you see room for a any further movements to contain costs in that arena?

Zachary Nelson

Yes, on the sales headcount we haven't done anything particularly to control costs per se in headcount reduction. We've done the normal churn of unproductive headcount, people not on quota and not on plan, etc., so that's been more the driver versus a cost reduction aspect to the business.

In terms of your preamble, I think it is an accurate assessment to say we're seeing a lot of what everyone else is seeing out there, but I would add to that, you know, we added 240 customers during this quarter. Can you find another ERP software provider in the world that added 240 new customers in the quarter? I think that's very hard to do.

And so even in that environment of difficulty, I think we're performing incredibly well and I'm very excited about those sorts of numbers. Even though they're a bit off our historical, we're in a very difficult market segment that a lot of other SAS companies and that's an incredible of new customers to add, I think, in this environment.

Tom Roderick - Thomas Weisel Partners

And, Zach, could you just clarify, that 240 new customers, is that a gross number or a net new customer number on the quarter?

Zachary Nelson

Yes, that's a gross number.

Tom Roderick - Thomas Weisel Partners

The last question here for you, Jim, just in terms of that recurring revenue number. So you've got that up to 29%. Can you just remind us what the number was a year ago this quarter and then what it was for all of 2008?

Jim McGeever

For a year ago that number would have been close to 40%, so we've seen a decline in that but not that substantial a decline. I don't actually have the annual number in front of me; I can get that to you.

Operator

Your next question comes from Mark Murphy - Piper Jaffray.

Mark Murphy - Piper Jaffray

I believe that last quarter you commented that the Q4 bookings were up 20% sequentially and I just want to clarify how should that be rolling through the P&L into Q1? I mean, the Q4 bookings up 20% sequentially, but the Q1 revenue is up less than 1% sequentially. Jim, could you just walk us through maybe what are some of the underlying abnormal factors that are influencing that?

Jim McGeever

Sure. There were a number of factors. Foreign exchange obviously continues to be a factor. Obviously, we have a fairly high percentage of our revenue is from international and, with relatively short billing terms, as we re-invoice those customers we pick up the impact of that foreign exchange pretty quickly.

The other element is one thing that's happening in our business - our actual services revenue, our revenue from professional services actually declined in the quarter versus Q4. One of the reasons for that is we made a change awhile ago that we'd basically focus on the recurring elements and we discount our services revenue before we'll discount any recurring, so that's also had an impact. That was actually down in absolute dollars and that's the first time that's actually happened. It's been falling in terms of its growth rate relative to recurring, but this was the first time we'd seen an absolute decrease.

The next factor is we did, as I mentioned on the call, did see a small uptick in downsells, so these are customers who, when they renew, are renewing for a smaller number of seats or for a lower price. And that's something that we continue to monitor. I mean, certainly in our mind the churn numbers have been quite strong in terms of losing customers, so it's better off if you keep the customer even if they buy less and then in the following year you have an opportunity as things rebound to sell them again.

So those are really primarily the factors that went into the Q1 numbers.

Mark Murphy - Piper Jaffray

And then, Jim, just as a follow up on that, with the professional services declining sequentially and a lower part of the mix year-over-year and assuming that that's the very low gross margin piece of the business, how are we ending up with gross margins that are essentially flat sequentially and year-over-year? Could you kind of walk us through what's going on on the gross margin line?

Jim McGeever

Sure. So we did make a very substantial investment in services and support in 2008 and we are beginning to leverage that; we did see improvement. If you look over the last three or four quarters you will see some improvement on our gross margin line. I think if you look back to Q2 of last year, we were at 69% but essentially flat year-over-year, but that was because in Q1 of 2008 we hadn't ramped the services and support people to the extent that we had in the rest of the year, so if you actually went through the quarters, we did 71.2% a year ago, then 69.5%, 68.8%, 71%, 71.2%. So you've seen us actually leverage some of that investment within the quarter.

In terms of the actual services, we're actually seeing a reduction in the rate per hour that we're getting on services because as I mentioned we are discounting services more before we'll discount the recurring element. So whereas previously we had essentially run services at breakeven, that's not always the case now; in fact, they were in a loss position in the quarter because we are still delivering the hours and the actual hours we're delivering to implement customers - and as we sell to larger customers - there're actually still increasing.

Zachary Nelson

So effectively in some cases we'd rather take the discount in services than in recurring to keep the recurring high. That said, we will still deliver the services required to get that customer live. So it's increasing the amount of recurring revenue, it's decreasing the amount of services revenue, but in some cases it is not decreasing the amount of services work or the services people required.

Mark Murphy - Piper Jaffray

And then just one final one. On OpenAir, can you talk about some of the successes that you're having recently with OpenAir and then is that still at a quarterly run rate now that would be over $1 million in revenue?

Zachary Nelson

Well, OpenAir continues to charge ahead, really on all fronts. On the product side we're making great progress both in integrating NetSuite and OpenAir. We have this version of the combined product called NetSuite SRP - Services Resource Planning. We're going to have new versions of that coming out in the year. That's going to take us into the upper end of that market very aggressively with a complete suite, so you'll see us competing much more with guys like Deltek in that environment. And we're very excited in that segment; we think Deltek is very vulnerable and certainly their results sort of indicate their vulnerability on that segment, so we're really excited about what's happening there.

As you may remember from last call, we brought in new management there, Jeff Honeycomb. We've increased the sales organization. And so we continue to see great progress there with customers and larger customers typically than you might see in the traditional NetSuite sales cycle, so that continues to move very well.

Jim McGeever

And we've never actually broken out the revenue certainly from OpenAir; it's still too small for us to do that. But the one thing that's a little bit different with the OpenAir business versus the core NetSuite business is most of the deals that they sign, certainly all their large ones, go onto a delayed revenue recognition. We don't start recognizing the revenue on those deals - it's fairly common that you won't get any revenue on a deal they sign for the first six months. We're working through some of the issues associated with that and making some changes to policy and practices to change that, but right now we don't pick as much revenue growth as you would compared to the bookings relative to NetSuite.

Operator

Your next question comes from Bryan McGrath - Credit Suisse.

Bryan McGrath - Credit Suisse

Circling back on the customers that renew for a smaller amount, is that primarily limited to the smaller end customers, the guys that you historically kind of segmented out that pay you around $10,000 or less, or is there any kind of further way you can segment that for us?

Jim McGeever

No, it's not really limited to the smallest customers. It is primarily seats. You know, if you look at this company that has downsized their headcount then they're just going to need less seats when they come to the renewal.

One of the great things with our model, however, is we do get more revenue for modules and suite fees than we do from users, so we do have some protection from that because it's quite hard to drop either the suite or modules; once you're using that functionality it's fairly hard to drop it. And the other thing that's been great is upsell has just continued to be very strong, one of the strongest parts of our business.

Zachary Nelson

I would just comment on the upsell component as well. In the same way that it's, you know, in this environment it's amazing to find a couple hundred companies to replace their ERP system with a suite like NetSuite where, as Jim mentioned, we are also continuing to see strong upsell into these customers as well. So even while the broader economy has lots of issues, you will find - and certainly our customer base is a great example of a place to find - growth because oftentimes when these companies first came to us they were in the hot segments, the growing segments of the market in the first place. And so the upsell aspect of the business this quarter was also very strong.

Bryan McGrath - Credit Suisse

You went and talked a little bit about April saying the environment improved and I just wanted to follow up. Was that in lead generation or an improvement in lead generation or did you see actually more deals actually get done in April or March/April timeframe?

Zachary Nelson

Well, I think, as I commented, the lead flow certainly in the quarter was up year-over-year and conversion to prospect was also up, so I think it's indicative that perhaps more of those prospects are converting into sales as well.

I also think as a psychology thing - again, my belief and I'm not a doctor or an economist, so this is just my own belief - is people took Q1 really to assess what was going to happen through the rest of the year and that's why I think you saw throughout the SAS industry a level of slowness that wasn't necessarily anticipated because I think customers were just really assessing the world. And I think they've emerged now from Q1 and emerged from that assessment perhaps a little more confident than they entered Q1. So I think some of that's coming into play as well.

Jim McGeever

And certainly looking at April compared to January, April was certainly stronger than January, significantly so. So we certainly have had a better start to the quarter than we did in Q1.

Zachary Nelson

I think maybe just to add to that as well, of course, part of the seasonality that you will see in a Q1 is due to just normal internal organizational issues of handing out new quotas and new territories and all those things, so I think some of those things, obviously, have had time to solidify and people are settled in their chairs and their territories and so they get more productive as time goes on.

Operator

Your next question comes from Laura Lederman - William Blair & Company, LLC.

Laura Lederman - William Blair & Company, LLC

When customers renew and you are seeing a downsell, if you will, is there pressure on pricing or is it really pretty much only seats or is there some pricing impact, too, beyond seats?

Jim McGeever

Well, we're starting to see some customers asking for reduction in prices. Generally that's not been the major factor, though. The major factor has been a reduction in just seats, not in modules or suites. As I said, it's much harder to downgrade functionality, but the primary impact has been on the seat count.

Laura Lederman - William Blair & Company, LLC

And is it CRM seats or accounting seats or what type of seats?

Jim McGeever

Well, typically if you look at an organization using the suite there'll be less users in the back office, but more revenue per seat because of the functionality based sale and there's more users in the front office. But if you had 50 salespeople last year and you have 40 salespeople today, then you buy 40 seats. You don't have seats sitting around in this model.

Laura Lederman - William Blair & Company, LLC

And looking at the commentary that the pipeline is improved from where it was in Q1, obviously Q4 you closed a lot of big deals that were in the pipe. Are you now starting to see big deals come back in the pipe or is it kind of medium-sized one or some nice $100,000-type deals in the pipe as well, so just kind of just a little bit of color on the makeup of the pipe.

Zachary Nelson

Yes, you know, the good news is, of course, NetSuite spans this whole broad mid-market segment, so you see small, medium and large in there. I guess speaking just where the deals would naturally fall, we have shifted more of our selling resources to selling larger-sized deals, so I think it's fair to assume that more pipe has shifted up market, if you will, than certainly from down market.

Now, again, for us, you know, up market could be a 50-user deal. We can get $50,000 a year from 50 users, so you have to sort of put on a little different set of thoughts around NetSuite when we're talking about up market than, perhaps, SAP when they're talking about up market or down market, in their particular case.

But that said, I think you look at deals like Suntech Power and the others that we'll announce and these are substantial companies, especially the divisions of large companies, are very substantial organizations, hundreds of millions of dollars in revenue, and we're certainly starting to see more and more of those deals. We're starting to see billion dollar companies begin to look at NetSuite as well, and those are deals that we've been discussing in my own staff meeting and you certainly see a lot more of those guys recently, particularly as we continue to show more success in how you can run divisions of large companies on something like NetSuite versus a very expensive traditional enterprise ERP product. We've definitely seen an increase in the pipeline of those large and very large deals.

Laura Lederman - William Blair & Company, LLC

Last quarter you gave us sort of a calculated year-over-year bookings number which took duration into account. I think it was 19. Can you give us a comparable number for this quarter in terms of the bookings growth on an adjusted basis?

Jim McGeever

Yes. I mean, that's kind of an exact - because there was a pretty dramatic shift in the billing term last quarter; it went down from 7 to 5. We really felt we needed to give you that to kind of show you where the numbers were at. It's not a number we really plan on giving out on a quarterly basis. If you look at the calculated [inaudible] while looking at the change in deferred revenue and [inaudible] deferred, deferred basically grew by about 12% year-over-year.

But that's also negatively impacted by foreign exchange, certainly because of when international customers renew we're going to invoice them for less. And then also compared to a year ago when our billings number was at 9 months for new customers and there was a 6 for Q1 of '09, that's also had an impact as well.

Operator

Your next question comes from Michael Huang - ThinkPanmure.

Michael Huang - ThinkPanmure

First of all, in terms of your assumptions around the revenue guidance for the year, does the top end assume that conversion rates and new business activity improves notably in Q2 or does it assume consistent trends with what you saw primarily through Q1?

Jim McGeever

It's primarily assuming consistent trends. One of the things that we did do after seeing what happened in Q1, certainly a lot higher downsell than we would have expected, we certainly updated our assumptions for the rest of the year on that particular metric. But all the other trends are fairly consistent. We're not assuming things get better on any major metrics for us to hit those targets.

Michael Huang - ThinkPanmure

So for the lower end of the guidance it actually implies some degradation of the business?

Jim McGeever

Yes. And obviously in this environment you have to be somewhat cautious. I mean, it's hard, still, to be too optimistic, but we're really taking it one quarter at a time and seeing what's coming out of the business and really thinking through what that means to our business as we see the results present themselves.

Michael Huang - ThinkPanmure

My last question is on an unrelated note. Can you comment on the integration that you announced with Salesforce.com through some partner integrations? Is that helping you gain traction in the Salesforce base and are you actually going after more point solution deals now because perhaps it's easier to sell in this environment versus suite ones?

Zachary Nelson

You know, again, I think it really depends on the type of company and the size of company you're talking about. In larger companies it's not just Salesforce but many of the companies that we integrate with have SAP. So as you start to look at NetSuite and larger companies and divisions of larger companies, the notion of integrating with other applications because more important.

At the end of the day in the lower end of the market companies still want the one system to run the business and that's still a beautiful, beautiful thing. At the upper end of the market maybe it's two systems, maybe it's three systems. It's about system reduction, not necessarily everything being driven out of NetSuite. And so when you look at SuiteCloud Connect for Salesforce or SuiteCloud Connect for SAP and those types of applications, it's really about enabling companies to get the benefit of a suite approach like NetSuite, but having it plug into one or two other applications that for whatever reason - they've spent $100 million on it or they've got usage, people are used to using it that way, whatever that reason is - they can now feel comfortable in bringing the power of NetSuite to that environment.

Jim McGeever

And certainly it doesn't mean that in these larger divisions or divisions of large corporations that they won't use a full suite, but frequently they are taking a more staggered approach to it.

Michael Huang - ThinkPanmure

So then with respect to the larger accounts, are you starting to see some better activity within the Salesforce base or the SAP base?

Zachary Nelson

Certainly in the SAP base because of the OneWorld functionality and capabilities there. I would say that's safe to say. Just a large enterprise ERP space using NetSuite divisionally is something that we continue to see traction in.

Salesforce base, we've always sold to a lot of Salesforce customers. We probably have hundreds of companies already that use NetSuite and Salesforce, so I don't necessarily that you see a huge sea change there. This was just more of, I think, a clear communication that this is an option for larger companies should they choose to go this way.

Operator

Your next question comes from Greg McDowell - JMP Securities.

Greg McDowell - JMP Securities

In light of the fact that bookings weren't quite where you wanted them to be, can you just touch on any changes you've made in the sales structure maybe in terms of number of reps going after the SMB space versus the enterprise space and maybe talk a little bit about reps by vertical?

Zachary Nelson

Yes, we really haven't changed anything certainly other than what we did at the beginning of the year in terms of putting territories and verticals in place.

As we've indicated really over the last six months or so, we've definitely moved away from deals that are below $10,000 in revenue. That's something that we've done for quite awhile, moving resources literally out of that really small business segment. As you know, much of our research shows that that's the base that churns most frequently and doesn't really ever grow and that was the reason you would initially sell to them is you expect them to get larger over time and they tend to not get larger over time in that segment, sort of the never growing, never profitable business. So that shift was made some time ago.

The other thing that we've probably done this year that's slightly different than last year was continued verticalization of our sales force not just in North America but around the world, so we've taken that approach to selling to companies vertically or by industry, really, is a more appropriate way to say it, around the world.

So, you know, I don't think there's been a huge change in terms of resources. We've been historically moving resources up market, sell to larger companies, and we continue to invest in a vertical structure in the sales organization around the world.

The other thing, I guess, that you'd see change over time during this year is as more of these third-party products get built in the SuiteCloud environment you'll see more joint selling of NetSuite with some of these partners. So, for example, if Rootstock introduced the beta of their MRP products, you would see us probably going to market with them in manufacturing sales. In the quarter you also saw us create a multi-channel retail management system that combines NetSuite with another SuiteCloud-developed product that manages point of sale. So that might be something you'd look for in the sales process, is how do we bring these truly verticalized solutions that a third party has built on top of NetSuite to market.

Operator

Your next question comes from Michael Nemeroff - Wedbush Morgan Securities Inc..

Michael Nemeroff - Wedbush Morgan Securities Inc.

As the number of larger customers grows, could you maybe disclose the actual absolute number of customers that are paying more than $100,000 and if not if you could maybe give us what the average customer size is so we can track the progress of selling into the larger customers?

Jim McGeever

We've never broken out that particular number. In terms of our recurring revenues, they're now approaching a third of our revenue and they're suddenly the fastest-growing segment of our business when we look at the buckets by company size.

In terms of the average company size, it's still primarily these companies who pay us more than $100,000 a year. It's still primarily within the 100 to 1,000 employees range. I don't actually have the average number of employees of those companies.

Michael Nemeroff - Wedbush Morgan Securities Inc.

And then building on a previous question, could you tell us - last quarter was around half the customers opted for shorter payment terms; obviously it got a little bit better this quarter - could you give us the percentage of customers that were looking for shorter payment terms this quarter as well?

Jim McGeever

Well, we did see an improvement in our overall billing term, so we did go for new customers from 5 in Q4 to 6 in Q1. So even though I think a lot of customers still ask for that, I think once we talk them through the economics of the model and they look at their comparisons they realize we're still substantially cheaper on a cash basis.

I wouldn't really put a number on the percent of customers asking. I mean, I think probably all customers ask; it's just really a question of how you manage that in the sales cycle.

Michael Nemeroff - Wedbush Morgan Securities Inc.

Recently you just announced a product to more tightly integrate with SAP and Oracle. I know it's still young, but how has the traction been with that initially?

Zachary Nelson

Well, you know, it is still young and it really is product and services. As you can imagine when you get into these complex ERP environments, no standard product is really going to solve all the problems, right? They've done funky customizations to their corporate enterprise system, so there's a good deal of services that go along with it.

So the development of these things was really the outgrowth of our work with some of our existing customers that have those types of deployments, you know, the [inaudible] of the world running on SAP and we're tying into them or other companies running on Oracle.

So it's still early, but certainly in the prospect discussions that I've been involved with since then, people, at the end of the day, they know they've invested $100 million in these systems. They're going to be there. How do you tie in a modern system like NetSuite so you can make a division more productive while maintaining that investment and providing good information to the corporate users. And so the fact that we're focused on it and the fact that we've done it for other customers makes the new prospects feel very comfortable we're going to be able to solve that problem for them.

Michael Nemeroff - Wedbush Morgan Securities Inc.

You mentioned in your prepared remarks that you increased the number of corporate sales reps. Could you tell us what the breakdown is and how many new corporate sales reps you did increase and what your expectations are for the year?

Zachary Nelson

I don't really have those numbers right at my fingertips, so maybe in the next call we'll share some information on how we structured the sales force and moved resources up market.

Operator

Your next question comes from Terry Tillman - Raymond James.

Terry Tillman - Raymond James

First, as it relates to you guys having more traction with some of these larger companies - 1,000, 2,000 plus employees and larger seat counts - are you still going to try to somehow keep services muted or will you just discount more aggressively, then, to keep that as low as a percent of revenue? Because to me it would seem like it's a natural kind of correlation if you're having more success moving up market with OneWorld, wouldn't there be a natural lift in your services business because you'll have to do some services work?

Zachary Nelson

Well, I would say it's fair to say there's always some amount of services work to be done in an ERP implementation. You rightly surmise that the more complex the implementation, the more complex the services and the larger the bill that gets associated with that. So all those points are true.

That said, as we've always stated with NetSuite, our view is to keep the recurring revenue high, number one, and number two, provide very high-quality services that gets that customer up and running quickly and efficiently and happily so that when it's time to renew that recurring revenue actually happens.

So on balance we believe services are very important. We believe delivering quality services are very important. We just don't believe that making tons of money on it is very important. Making tons of money on the recurring is very important. So our focus has been and will continue to be to try to shift revenue, if you will, from services to recurring whenever we can.

So that could be potentially discount, that could be potentially eating our own dog food and this concept of what I call services software, turning those one-off services that we do for a customer into reusable services that we can sell to other customers like that company.

And so part of what we've done - again, to improve efficiency of service delivery - is to verticalize our services team so that the group doing wholesale distribution implementations only does wholesale distribution implementations. So they can do it more quickly, more effectively, and they can re-use customizations from past implementations for those customers.

So I don't want you to get the impression that we're just giving services work away. We're doing this very smart. I think we're creating the next generation services delivery model in this way. And we're doing it in such a way that hopefully enhances our recurring revenue, which is basically what all of you guys are betting on.

Terry Tillman - Raymond James

And then just, Jim, as it relates to - there was a bogey or an objective you gave out when you all first went public for a couple quarters talking about on a long-term basis the idea was about 250 basis points, if I'm not mistaken, will be the annual net margin expansion. I'm not asking for '10 guidance, but is there anything that's structurally changed in terms of you all's balance of growth with profitability or would that kind of still hold as a long-term target each year?

Jim McGeever

Well, certainly that number is really driven off the revenue growth rate and, as you've seen in the last year or last couple of quarters as well as this quarter, we've actually improved that at a much faster rate than that number. I think there is something of an offset between revenue growth rate and profitability growth rate. It is a little bit easier to grow the bottom line when you're not growing at hyper growth rates. We haven't given 2010 guidance and probably won't until the end of this year, but I don't think it's unreasonable that a lower - a modeled lower growth rate that you might see a slight improvement on that bottom line growth rate.

Operator

And that is all the time that we have for questions. At this time I would like to turn the conference back over to Mr. McGeever for any additional or closing remarks.

Jim McGeever

Well, thank you very much for joining us all today and we look forward to speaking to you all in the near future.

Operator

And that does conclude today's conference call. We thank you for your participation.

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Source: NetSuite Inc. Q1 2009 Earnings Call Transcript
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