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Zix Corporation (NASDAQ:ZIXI)

Q2 2009 Earnings Call

July 28, 2009 5:00 pm ET

Executives

Richard Spurr - Chief Executive Officer

Susan Conner - Chief Financial Officer

Peter Wilensky - Vice President of Investor Relations

Analysts

No questions.

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2009 Zix Corporation earnings conference call. My name is Janada and I will be your coordinator for today. (Operator's instruction) I would now like to turn the call over to your host for today's call, Mr. Peter Wilensky, Vice President of Corporate Development and Government Affairs. Please proceed, sir.

Peter Wilensky

Thank you, Janada. Good afternoon and thank you for joining Zix Corporation’s second quarter conference call. As the operator mentioned, this call is being recorded and a replay will be available after the call's conclusion from our website or by dialing 1-888-286-8010 and entering the access code 36658027. This information can also be found at investor.zixcorp.com, which is the investors' portion of our website.

Zix Corporation's Chief Executive Officer, Rick Spurr, will begin with an overview of the company and discussion of our businesses followed by a discussion of the Q2 2009 financial results by our Chief Financial Officer, Susan Conner. Mr. Spurr will then provide closing remarks.

Afterwards, we will be available to answer questions from analysts and institutional investors and we will also be taking questions via email, which can be sent to our Investor Relations mailbox, invest@zixcorp.com.

Before we begin, I would like to read a paragraph regarding any forward-looking statements that may be made during this call. This conference call may include certain forward-looking statements that are based on the current beliefs of, assumptions made by, or information currently available to ZixCorp's management team.

Forward-looking statements may include words such as believe, estimate, expect, go, may, will, could, should or other similar expression. ZixCorp's actual results, performance, prospects or opportunities in 2009 and beyond could differ materially from those expressed in or implied by these statements.

Information concerning risk factors that could allow actual results to differ materially from those expressed in or implied by these forward-looking statements is contained in ZixCorp's filings with the Securities and Exchange Commission, as well as in ZixCorp's earnings press release issued earlier today. Except as required by Federal Securities Regulation, ZixCorp undertakes no obligation to publicly update or revise any forward-looking statement for any reason after the date of this call.

With that, I would like to turn the call over to Rick Spurr.

Richard Spurr

Thank you, Peter. Good afternoon, everyone, and thank you for joining today’s call.

This is a dynamic time in both of the markets in which we currently participate, email encryption and electronic prescribing.

Against this backdrop of activity in the underlying markets, we have one business, email encryption, which is doing quite well financially and we’re optimistic with regard to continued growth. You’ll hear about our recent results in email encryption and the drivers for growth in a minute, but first let me address what’s new as of 2Q 2009 with respect to e-Prescribing.

We believe that real time decision support at the point of care is essential to modernizing the U.S. healthcare system and e-Prescribing is the most logical first step to achieving this evolution, particularly in small practices; however, we now think that the time required and risk associated with continued investment in this strategy and in this business segment as it is currently configured is too great. Therefore, we retained Allen & Co. to assist us in reviewing strategic alternatives for this business. Because this review is currently underway, I’m not prepared to discuss potential outcomes in any detail at this point, but I will say that we are open to looking at any and all options to maximize the value of this business asset. Ranging from ongoing involvement in the industry through some kind of partnership or joint venture where we capitalize on our core competency to host prescription processing to completing exiting this business through a divestiture.

Our goal is to reconfigure this company to reduce or eliminate the investment in the e-Prescribing business and allow us to unleash the true value of the email encryption business.

I also want to briefly comment on the large payer contract that we had previously indicated we were pursuing. Although we had been negotiating a deal with a national payer that could have almost doubled the number of active users, we decided it was appropriate to terminate those discussions in light of this strategic review.

In the meantime while are conducting our strategic review, we continue to execute on our existing contracts and provide high quality service to our customer.

In the second quarter, we deployed 325 new prescribers and processed over 2.5 million scripts in the quarter, an increase of about 19% over the second quarter of last year. Most of that increase was due to higher average scripts per active prescriber this year, an indication that prescribers continue to utilize our technology in the course of delivering care to their patients.

Now let me turn to email encryption. The email business continues to drive the performance of the company and we believe it should do so at an accelerated rate given the opportunities that now present themselves. Our investments, expertise, dedication, and perseverance in this industry has us well positioned to take advantage of these new opportunities. That include a new, more aggressive regulatory landscape, access to overseas markets through our partners, a heightened awareness of the need for privacy when using email, and a fewer number of credible competitors.

In the second quarter, growth in the email revenue more than offset the decline in e-Prescribing revenue to produce another revenue high quarter for the company. Record total orders, record total backlog, strong margins, and positive cash flow are all great signs for this business. Focusing specifically on new first year orders, we have the second best result in the company’s history at 1.7 million. Think about that. The second best quarter in the company’s history during what is the worst economy in my lifetime.

We believe that’s not just good execution, but it’s clear evidence of growing demand. So what’s driving this demand? We think several things. One driver is new Health Insurance Portability and Accountability Act or HIPA legislation. The best quarter in our history was the second quarter of 2005 when the HIPA security rule went into effect. Now, we think HIPA again appears to be a major driver in our most recent quarter’s strong orders result. As most of you probably know, the high tech act in the stimulus package passed earlier this year contained a significant expansion of HIPA, which we refer to as HIPA 2.0.

Although the changes to the laws were extensive, the major impact can be categorized into three areas. Number one, extension of the applicability in the law to all business associates. A term defined in the law that relates to entities that provide services to covered entities, also a term defined in the law to include entities like hospitals and insurance companies that were the focus of the original HIPA legislation.

Number two, increased enforcement and punishment with fines for violations, now up to $1.5 million dollars. And three, instituting new breach notification requirements, including an obligation to notify HHS and in the case of larger breaches, the general media.

It is interesting to note that these breach notification requirements only pertains to disclosure of unsecured information. So the disclosure of information that has been encrypted using our service, for instance, would not trigger this notification requirement. One hint the expert recently called these breach notification rules, the most significant change to HIPA since the legislation was first enacted in the 1990’s.

Let me summarize for those not familiar with our history with this healthcare regulation. HIPA 1.0 was good to us, but it was viewed as a tiger without teeth. We expect now severe fines and expected increase in enforcement of HIPA 2.0 to motivate those that sat on the fence the first time around. For instance, our most recent webinairs, including one on HIPA 2.0, had more than twice as many attendees as any before.

We expect to see a new set of buyers of email encryption capabilities, namely those business associates, and we’re confident in our leadership position as the email encryption supplier for the United States healthcare system.

While healthcare was certainly a major component in the strong new first year order result last quarter, keep in mind that while some penalties have been implemented already, additional breach notification requirements become effective this year. In most of the rest of the new HIPA provisions don’t even go into effect until next February. So we’re optimistic that demand for our service in the healthcare sector should remain strong over the next several quarters.

Now let’s turn to another demand driver. It is clear the pendulum has swung in the regulatory environment under the new administration toward much more stringent oversight and enforcement.

We believe this is having a profound impact on the financial services industry. We have found that banks and other financial institutions are much more focused on audits and other compliance issues than before.

An unexpected but perhaps not surprising side effect has been a change in attitude at the regulated entities with respect to compliance, where people at these institutions are showing a great deal more deference to the regulators in an unwillingness to push the envelope in these matters.

So the second quarter, our increased sales were not only due to renewed emphasis for privacy and healthcare, but also the renewed emphasis on regulatory matters in the financial services sector.

Our sales to financial institutions in the second quarter, on top of our already very impressive customer base, has us in a position where we now boast over 1,000 financial institutions as customers, including over 800 banks and over 200 credit unions and credit associations. These 1,000 institutions do not even count all of the FFIEC regulators and state banking regulators that we have as customers. Given that there are over 18,000 financial institutions in the United States and our impressive leadership in this sector, we believe we are well positioned for continued growth.

These aren’t the only drivers for demand in email encryption. For instance, several state laws such as those in Massachusetts and Nevada and others under consideration will for the first time ever also require the use of encryption when transmitting sensitive citizen information, such as numbers for Social Security, drivers licenses, or credit cards. This regulation applies to organizations of all sizes and extends beyond just the states’ borders to communication with any party transmitting sensitive information regarding the states’ citizens.

In light of all the optimism around the demand for email encryption, I’d like to comment on the renewal rate in the second quarter. As we reported, the 86% renewal rate was below our historical rate of approximately 95%.

The causes of the non-renewal generally fell into two categories. Number one, pressure to reduce costs due to the impacts of the downturn in the economy and the resulted belt tightening. And two, a formidable competitor in Cisco with a bundled approach to anti-spam, anti-virus, and email encryption. In the first category, the economy has put unusual pressure on IT budgets in the first and second quarter of 2009. In these cases, our customers cut back on either the number of users or services they purchased.

In the second quarter, Cisco was able to convince some of our customers that they not only could save money on their email encryption, but could also achieve efficiencies by consolidating their security services, anti-spam, anti-virus, and email encryption with a single vendor.

Our position has been that we don’t really get into a pricing war putting undue pressure on our margins. Not just with these few renewals, but across the board with our service offering and therefore we’ve decided to compete on our differentiated value-added service. Even against Cisco, our Zix directory and our software as a service architecture are unique.

When customers are considering a bundled approach versus our best-of-breed solution, we are working to bring in some of our partners to compete head-to-head to retain those customers. The bottom line is at this point we don’t see this level of renewal as a trend in the longer term and the impact of a 14% loss for one quarter were about $450,000 in annual revenue. It is meaningful, but not that bad considering that in the same quarter we added $1.7 million of new revenue for a net increase of $1.2 million in new annual revenue.

We will stay focused on protecting in monitoring the effects of the economy while at the same time continuing to add new customers in this new energized market space.

Earlier I spoke about some of the regulatory dynamics that drive my continued enthusiasm for email encryption. Another cause for a bright outlook in this business is our continued success in signing up new partners. I view our momentum with partners as yet another validation of the fact that the Zix Corp brand has been established as the leading email encryption brand in the industry.

We continue to broaden our partner brace with the recent announcement of our latest partnership with Marshall 86, a secure web gateway and email security provider with over 20,000 business customers. We’re continuing to strengthen the relationships with our existing partners, such as Google, Symantec Message Labs, Secureworks, Code Green Networks, and the new partner we announced last quarter, Webroot. Most of these partners have come to us recently to tell us they’ve also seen a significant increase in the number of customers specifically requesting email encryption and obviously they’re happy to have established a relationship with us.

In addition, many of these companies have significant operations overseas and are the basis of our strategy for international expansion. Of course, they too are feeling the impact of the economy as is everyone, but I believe this group of partners will continue to contribute to our sales and should be the key to our ability to take our sales to the next level.

With that, let me turn the call over to our CFO, Susan Conner, to discuss the financials from the quarter. Susan.

Susan Conner

Thanks, Rick and good afternoon everyone. First, and as I highlighted last quarter, let me start with a few comments about our reporting of both GAAP and non-GAAP or adjusted financial measure.

We report our financial results in accordance with US Generally Accepted Accounting Principles or GAAP; however, we believe certain non-GAAP financial measures used in managing the operations of our business can also provide users of our financial information with additional meaningful comparisons between current results and results in prior operating periods. I will always refer to these non-GAAP measures as adjusted amounts.

Each of these non-GAAP measures excludes non-cash, stock base compensation cost, as required under FAZ123R, any non-cash adjustments to our provision for income taxes, and certain non-recurring items which have occurred in the current reporting periods or which may occur in future reporting periods.

We use these non-GAAP financial measures in making financial operating and planning decisions and believe the reporting of these measures can assist the users of our financial information in evaluating our performance. We have an will also include with our press release a reconciliation of our GAAP to non-GAAP measures. In addition, we posted this reconciliation to our company website.

Let me now move to the second quarter financial results beginning with revenue. We achieved company-wide revenues for the second quarter of $7.4 million, which was within our previously provided guidance of $7.3 million to $7.6 million, which compares to $7 million for the second quarter last year. This revenue was made up of $6.4 million for email encryption and $1 million from e-Prescribing.

Email encryption revenue increased $700,000 dollars, representing a 13% increase over the comparable 2008 figure. The increase consisted of $500,00 for non-OEM customers and $200,000 from our OEM channels. As a side note, our OEM channel revenue doubled over the second quarter of last year.

These increases were due to the growth inherent in our successful subscription model with steady additions to the prescriber base coupled with a high rate of renewing and existing customers.

The renewal rate for the second quarter was 86%, lower than historical ranges from 93-95%. Rick just provided the details behind this, so I won’t repeat them here. I will comment by saying in spite of this quarter’s renewal result, we believe our renewal rate remains solid and future renewal performance will realign itself to our historical renewal range of 93-95%.

e-Prescribing revenue for the second quarter was $1 million, which compares to $1.3 million for the second quarter last year. The $300,000 decrease primarily resulted from two things. First, an approximate $160,000 dollar decline in the transaction or usage base fees, primarily because of the second quarter of 2008 as we have indicated in past quarterly calls. We reached the ceiling or the cap on the transaction or usage base fees allowed under a single healthcare payer customer contract.

Secondly, an approximately $170,0000 dollar decrease in deployment related revenues as the rate of new deployments during the proceeding four quarters ending June 30, 2009 of approximately 1,010 had declined from a level of 1,250 for the preceding four quarters ending June 30, 2008.

Looking ahead, we expect our quarterly e-Prescribing revenues to remain relatively flat for the remainder of the year.

We ended the second quarter with a company-wide bookings backlog of $41.4 million, which is a 12% increase over the bookings backlog of $37 million for the second quarter of 2008. We anticipate approximately 60% of the total backlog being recognized into revenue within the next 12 months.

In summary, we continue to be pleased with the year-over-year growth in revenues for email encryption, even through these tough economic times.

Before I move on to our adjusted gross profit results and details on our expenses, I’ll remind you that my following comments are based on adjusted numbers. During the quarter, we had a reduction in force primarily involving our e-Prescribing business and a part of our ongoing strategy to match headcount requirements to current business needs.

As Rick mentioned earlier, we announced our engagement of Allen & Co. to assist in a review of strategic alternatives for our e-Prescribing business. I will comment further on the headcount reductions as a part of my review of operating expenses.

Additionally, I refer you to our reconciliation of GAAP to non-GAAP financial measures tables, which is reported in both today’s press release and on our company website for additional insight to these adjustments.

We achieved an overall company-wide adjusted gross profit for the second quarter of $5.1 million or 69% of revenues. This compares to $4.5 million or 65% of revenues for the same quarter last year.

The email encryption adjusted gross profit for the second quarter was $5.3 million or 83% of revenue compared to $4.6 million or 82% for the same period last year.

The improvement was primarily due to a $700,000 dollar increase in revenue while cost remains flat. As we have indicated in the past, these improvements are a natural result of our subscription business model, continued new net new business for new sales and renewals, and a relatively fixed cost structure.

As we discussed in detail last quarter, our cost structure remains relatively fixed, because of our scalability which is driven by our focus on automating certain services, product simplification, remote deployment, and the application of more efficient and lower cost technologies.

Our e-Prescribing adjusted loss was negative at $200,000 or 20% of revenues compared to a negative $137,000 dollars or 11% of revenues for the same quarter last year. This increase in our adjusted gross loss is due primarily to the $300,000 reduction of revenues as reported earlier, partially offset by a $200,000 dollar reduction in our cost to revenues due to lower costs between periods resulting from lower deployments.

With regards to operating expenses, adjusted R&D and SG&A expenses totaled $6 million in the second quarter of 2009 compared to $5.5 million for the same period last year. The $500,00 increase consists of $400,000 dollars for R&D expenses and $100,000 dollars for SG&A expenses.

R&D increased first due to our investment and additional resources for the purposes of further adapting our service for international customers.

Second, due to resources for enhancing the platform for our OEM customers in the email encryption and third, for ongoing workflow improvements and certification requirements for e-Prescribing.

Also included in the increased expenses between periods is the fact that in 2008, we incurred R&D costs totaling $140,000 for development work on an e-Prescribing customer contract, involving the creation of a new service offering, which was deferred in that period for the purpose of matching the revenue over the contract subsequent subscription period.

SG&A expenses increased in 2009, primarily due to higher expenses for outside service providers.

With regard to our company-wide adjusted operating loss performance and resulting from the financial highlights I just mentioned, the second quarter’s adjusted operating loss was $900,000 dollars, compared to a $1 million dollar loss for the same period in 2008.

We continue to focus on the weakened economy and how the company’s performance is being or could be impacted to ensure we deliver continued financial performance. Specifically, we strive to manage our headcount to meet the needs of the business, which is tied to our belief that headcount can only be supported if the business need is there.

With respect to our e-Prescribing business, we match our headcount needs to a combination of new payer sponsor contract signings and the resulting numbers of new prescribers to be deployed, which as we have indicated in this call and earlier quarterly calls, have been down from historical activity levels.

As a result, we did initiate a plan in the second quarter to reduce our workforce by nine positions, primarily involving the e-Prescribing line of business and impacting cost of revenue, R&D, and SG&A expenses.

We have further taken actions in the third quarter to eliminate 12 additional positions impacting both cost of revenue and SG&A expenses.

We expect these reductions to be completed by the end of August. Severance cost associated with these eliminated positions are excluded from the adjusted net loss, due to their non-recurring nature.

Our capital expenditures for the second quarter were $371,000. Depreciation expense for the quarter is approximately $329,000 dollars and is recorded in the various P&L line items with the majority or 75% of it being recorded in cost of revenues.

Turning to cash flow, cash, and cash equivalents at June 30, 2009 were $12.5 million compared with $12.2 million at March 31 and $13.2 million at December 31, 2008.

We had anticipated our cash position to return to the year end level by the end of this quarter, but our progress was slowed due primarily to lower than anticipated collections for the email encryption business.

Additionally in this quarter, we made one-time cash payments totaling about $200,000 for severance and outside professional services.

Relative to the lower than anticipated collections, we have now seen for the past two quarters some impact on cash collections due to the slow economy with customers stretching out to some extent their payments. Nonetheless, I believe this decline in cash is temporary in nature and will be offset with new business or further cost reductions or a combination of both later in the year.

Additionally, I’d like to reiterate that our goal is to end 2009 with at least as much cash as we ended 2008 with and we will continue to manage the company’s overall cash to break even or positive cash flow.

Our company-wide adjusted net loss for the quarter was $835,000, which compares to $716,000 dollars loss for the same period in 2008.

As I mentioned earlier, operating income actually improved year-over-year. So this decline in adjusted earnings is a result of a drop in other income, primarily due to the decline in interest rates this year compared to last year.

Our adjusted net loss per share for the quarter was $0.01 for common stock and that matches the adjusted net loss per share for the same period in 2008.

I’ll close with our financial outlook where we project our adjusted basic earnings per share to the third quarter of 2009 to be between $0 and $0.01 per share, which if achieved will be our first quarter in the history of our company to achieve positive adjusted earning.

These results were supported by our revenue guidance ranging from $7.5 million to $7.8 million, again reflecting continued growth in email, but flatness in e-Prescribing due to lower deployment as discussed earlier.

We expect deployments to be between 200 and 250 for the quarter. We also expect certain operating expense reductions to contribute to this projected performance level.

We remain committed not only to continuing to find new growth strategies for our email business, but also to improving our overall company performance. To that end, we announced earlier that we are reviewing strategic alternatives for our e-Prescribing service and that we continue with business as usual in e-Prescribing with respect to executing our existing contracts in providing services to our customers.

Also indicative of our improving performance, I’ll mention that the company rejoined the Russell 3000 index when the index was reconstituted on June 26 this year.

With that, I’ll turn it back to Rick. Rick?

Richard Spurr

Thank you, Susan.

In our email encryption business, we have a track record of growth with strong margins and positive cash flow and as we’ve discussed today, demand appear to be healthy as well. New and changing laws as well as a stricter regulatory environment, all combine to make this a good time to offer a secure and proven compliance service like ours. Add in our established leadership position in this industry, our recognized brand, unique architecture with a shared directory of encryption keys hosted in the cloud, and strong partner relationships with some of the best known IT companies in the world, and you can see why we’re optimistic about this business.

As always, I want to thank our employees for their continued dedication, our partners and customers for their business, and our shareholders for their continued support.

And now let’s turn the call back to the operator for any questions. Thank you.

Question-and-Answer Session

Operator

(Operator's instruction) At this time, there are no questions in the queue. I would now like to turn the call over to Rick Spurr for any closing remarks.

Rick Spurr

Thanks, everybody, for joining. I think you can tell we’re optimistic and excited about where we are and look forward to continuing to report even better results moving forward throughout the balance of 2009. Thanks again.

Operator

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

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