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NetSuite Inc. (NYSE:N)

Q2 2009 Earnings Call

July 30, 2009 5:00 pm ET

Executives

James McGeever – Chief Financial Officer

Zachary Nelson – Chief Executive Officer

Analysts

[Unidentified Analyst] - Deutsche Bank Securities

Rich Baldry - Canaccord Adams

Michael Huang - ThinkPanmure

[Calvin Wu] - Morgan Stanley

Laura Lederman - William Blair & Company, LLC

Sasa Zorovic - Janney Montgomery

Andrew Shaw - Raymond James

Mark Murphy - Piper Jaffray

Bryan McGrath - Credit Suisse

Tom Roderick - Thomas Weisel Partners

James McGeever

Good evening, everyone, and welcome to NetSuite's second 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 line 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 say the measure is a GAAP number. These non-GAAP measures exclude stock-based compensation expenses, expenses relating to the amortization of intangible assets, and transaction costs relating to acquisitions.

Any non-GAAP outlook we provide has not been reconciled to the comparable GAAP outlook because we cannot readily estimate our future stock-based compensation expenses, which are dependent on our future stock price, and also cannot readily estimate expenses relating to the amortization of intangibles from our recent acquisition.

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 risk, 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 are 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.

In my closing comments at the end of our Q1 conference call I said we were encouraged about new business activity during the remainder of the year based on positive trends in some of our leading indicators, namely lead flow, conversion of leads to prospects, and a greater percentage of our revenue coming from recurring revenue sources. In addition, I felt Q2 would provide insight into how our customers were being impacted by global economic conditions.

Based on the results we will report today, we do indeed have greater insight into how global market conditions will impact NetSuite in the coming quarters and we are generally optimistic about what the trends portend.

On the positive side, new business trends were encouraging. Average selling price and number of customers closed during the quarter both improved over Q1. In addition, the shift to more revenue coming from recurring rather than nonrecurring sources continued in Q2.

In our installed base, however, we saw the impact of turbulent economic conditions on some of our customers. Churn picked up slightly over Q1 and our analysis indicates that was due to continued financial challenges facing some of our customers that came to a head during the quarter.

Taken together, these trends still resulted in an overall positive quarter; in fact, we beat our stated outlook or consensus analysts' opinion on all of our core financial metrics, namely, revenue, profitability and cash flow. Our bottom line results exceeded our stated outlook. We posted non-GAAP net income of $687,000 or $0.01 per share. Our continued strong bottom line performance is especially impressive given the foreign exchange headwinds we faced and the fact that more than $0.02 of profitability was eliminated as we ceased revenue recognition of some fees related to the localization and distribution of our Japanese product during the quarter.

We also generated significant positive cash flow from operations during the quarter. The $1.4 million of cash generated from operations in the quarter was well ahead of our internal plans as well as most analysts' models. As you'll recall from statements at the beginning of the year, our objective was to improve cash flow from operations to breakeven for fiscal year 2009 and given our overachievement on this metric in Q2, we are well on our way to meeting that goal.

On the top line we also delivered results above our stated outlook. Revenue grew 10.3% year-over-year to $40.3 million. More importantly, recurring revenue growth significantly outpaced growth in nonrecurring revenue. Recurring revenue grew 20% year-over-year when factoring in the impact of foreign exchange.

And once again our top line growth when compared with the double-digit negative new license growth for traditional ERP vendors indicates a continued shift in customer demand from on-premise stand-alone accounting packages to NetSuite's cloud-based business applications suite.

Industry data also clearly illustrates the shift from on-premise ERP solutions to NetSuite's on-demand suite of applications. Gartner Group published interesting data on market share and market share growth recently. In their annual report on the ERP software market, NetSuite for the first time cracked the top 10 vendors list for financial management systems market share in North America. Furthermore, in the financial management systems study, NetSuite was the only SAS provider in the top 10 - or the top 25, for that matter. And the Gartner data named NetSuite by far the fastest-growing vendor in the top 10 list.

The market share facts show that NetSuite's lower cost of ownership, faster implementation times and value proposition is resonating in the market. We believe that NetSuite will continue to take share from our competitors. Our leading product functionality is propelling NetSuite ahead of the pure play private competitors and traditional public companies, and our 10-year technology lead in delivering an integrated suite of web-based applications and expertise in cloud computing continue to deliver enormous value to customers around the globe.

Our recent customer wins also tell the tale of NetSuite's momentum. During the quarter we added approximately 270 customers of all sizes across a spectrum of industries, representing nice growth from our Q1 signings. Our OneWorld product had another strong quarter, with an average selling price of approximately $100,000. Sales of our OneWorld product were 31% of new business bookings in the second quarter of 2009. Q2 represents the second-best quarter of OneWorld deals sold, trailing only Q4 of 2008, notable as Q4 is our seasonally strongest quarter.

And the types of companies we are winning continue to reflect the ability of NetSuite to serve large, complex organizations. Earlier this week we announced three of the four most recent tech initial public offerings - SolarWinds, OpenTable, and LogMeIn - chose NetSuite to run key business processes. Today we announced that Jollibee, one of the largest fast food chains in Asia, chose NetSuite OneWorld to manage 35 subsidiary operations in emerging markets, including China and Vietnam. These four examples show the continued momentum of OneWorld and our move up market to support the needs of large, stand-alone companies and to meet the needs of divisions of very large enterprises.

And the selection of NetSuite by these and other companies is just another nail in the coffin of on-premise software companies espousing the complex ERP and SRM operations of large companies won't be trusted to the cloud.

Our continued success in moving up market is driven not just by OneWorld, but also by successful execution in our verticalization strategy and the continued development of our SuiteCloud Ecosystem.

We continue to keep the heat on our would-be competitors with our continued progress in verticalizing our suite. We believe services industries are key to economic growth in developed nations and we have the best product set and industry expertise to meet the needs of this underserved and strategic vertical.

Last year we acquired OpenAir to accelerate our ability to meet the needs of large services-based organizations, and that effort continues to bear fruit, as illustrated earlier in the quarter when it was reported that we won an OpenAir pilot that could grow to 9,000 seats with a global company headquartered in Europe.

Last week we doubled down in the professional services automation market with the acquisition of QuickArrow. With a leading market share position, including more than 80,000 global services users, and the best cloud-based professional services automation software suite in the world, NetSuite by far has the best position to meet the needs of services-based industries around the globe.

And with our vision of the NetSuite Services Resource Planning addition or SRP, we are well on our way to transforming how services business are run and in much the same way we hope to transform that industry as the economics of running manufacturing enterprises was changed in the '90s with the advent of ERP and MRP systems.

In addition to the verticalization we are undertaking within NetSuite, our SuiteCloud Ecosystem strategy is designed to enable third parties to extend our offerings with their vertical expertise. During this quarter we saw some really cool new applications launched on SuiteApp.com, including new taxation management capabilities from Avalara, new business intelligence tools from Good Data, and new CRM extensions from Inside View.

Our SuiteCloud Developer Network continues to grow, with more than 100 Suite apps on SuiteApp.com and more than 1,800 registered developers, up from 1,400 in the prior quarter.

So in closing, we were very pleased with our financial performance and strategic execution during the quarter. Once again, we delivered top line and bottom line results that exceeded our publicly stated outlook, significant cash flow improvements that also exceeded expectations, and continued momentum for our strategic initiatives of moving up market, extending NetSuite as a platform and in the verticalization of our product line.

Now with that, let me turn the call over to our CFO, Jim McGeever.

James McGeever

Thanks, Zach.

As a reminder, today's discussion will be based primarily on non-GAAP financial measures that exclude expenses relating to share-based compensation, the amortization of intangibles and transaction costs relating to acquisitions.

I'm very pleased with our solid financial results in what has been a turbulent economic environment. As Zach mentioned, the second quarter 2009 marked continued improvement within our operating model with the third consecutive quarter of non-GAAP operating income and non-GAAP profitability, which was particularly impressive given the loss of revenue and associated profit from our Japanese distribution rights deal, which I'll discuss later.

I'm also pleased that we were able to post strong new customer acquisitions, improvements in our average selling price, and solid 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 second quarter that ended June 30, 2009.

Total revenue for the quarter was $40.3 million, a year-over-year increase of 10%. As expected, Q2 revenue was down versus the prior quarter due to the reduction of revenue recognized from our Japanese distribution rights agreement that we signed in 2006. As a side note, I want to reinforce that NetSuite continues to sell products and grow our business in Japan, and you should keep your eye out for some significant announcements in the coming weeks relating to our efforts in Japan.

While we did see strong year-over-year growth, Q2 revenue also exceeded our revenue outlook despite the economic slowdown that has been adversely affecting all companies. The annual increase in revenue was fueled in part 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.

Backing out the impact of nonrecurring revenue associated with our Japanese distribution rights agreement, nonrecurring professional services, and the impact of foreign exchange rates, recurring revenue grew 20% year-over-year. This metric has grown each and every quarter since we began reporting this measure as a public company. We continue to focus on recurring revenue growth as this is what we value most.

We added approximately 217 new customers in Q2, an increase from approximately 214 in Q1, and we're particularly pleased we not only acquired more new customers during the quarter but we did so at a higher average selling price.

As I highlighted on the last call, we generally see a sequential increase in average selling prices from Q1 to Q2, but I'm pleased that despite the difficult economy we saw meaningful improvements in average selling price during the quarter. First year ASPs were approximately 34,000, reflecting an increase of 33% over Q1. We believe our higher ASPs are a direct result of the success of our strategy in moving upstream and attracting larger customers. In fact, customers paying us less than $10,000 in the first year annual revenue continues to decrease sequentially as a percent of our total revenue.

As Zach mentioned, our OneWorld product had another strong quarter, with an average selling price of approximately $100,000. Sales of our OneWorld product were 31% of new business bookings in the second quarter of 2009. This represents the second-best quarter of OneWorld deals sold to date, trailing only Q4 of 2008, our seasonally strongest quarter.

Also as Zach mentioned, we were very pleased with the improvements in new customer acquisitions and up sell to our installed base. This improvement was slightly offset by a modest uptick in churn during the quarter. From our analysis, this increase in churn was primarily related to customers in financial distress caused by the current global economic environment. Up sell into our installed base did, however, replace over 100% of this churn, however, not at as high a level as we had historically experienced.

Moving on to revenue by geography, customers located in the U.S. and Canada delivered 81% of revenue, while 19% was delivered from international. Non-GAAP gross margin for the second quarter was 69.4%, down from 71.2% in Q1 of 2009. The reduction in Q2 gross margin was driven by the combination of the reduction in Japanese distribution rights revenue as well as an increase in costs related to foreign exchange movement. Looking ahead for the rest of 2009, we anticipate that our non-GAAP gross margin will be approximately 69% to 70%.

Turning to our non-GAAP operating expenses, product development expense was $5.3 million for the quarter. This represented 13% of revenue, consistent with the prior quarter. For 2009, we expect non-GAAP product development expenses to be roughly 13% to 14% of our revenue, driven by the continued investment in more internationalized versions of NetSuite, OneWorld and new vertical additions, especially now with the addition of QuickArrow in the services space. Product development continues to be a key strategic investment for NetSuite.

Sales and marketing expenses were $16.8 million or 42% of revenue. Sales and marketing expenses were down from Q1 due to lower commissions, reduced payroll and lower marketing expenditures. As planned, we did not make any significant hires during the second quarter within our sales organization. We ended the quarter with 157 quota-carrying sales reps, slightly down from Q1 as a result of churning unproductive reps. We believe that we have sufficient sales capacity to match the opportunity in the current business environment.

G&A expenses were $5.2 million or 13% of revenue. This was down sequentially due to traditional seasonal expenses which we incur during the first calendar quarter of each year. For the remainder of 2009 we expect non-GAAP G&A expense to be approximately 12% to 13% of our revenue.

During the quarter we recorded a net income tax expense of $213,000. This provision was principally related to our international entity. Consistent with what we have outlined to you in prior calls, 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 135% from Q2 of 2008. Non-GAAP operating income was $674,000 during Q2, slightly down from $790,000 in the prior quarter and up from a non-GAAP operating loss of $1.9 million in Q2 of 2008. I'm pleased that our non-GAAP operating profitability was down by only $116,000 from the prior quarter despite the impact of the aforementioned Japanese distribution rights as well as an increase in expenses relating to foreign exchange of $560,000 versus Q1 of 2009.

Q2 marked the third consecutive quarter of non-GAAP profitability. Non-GAAP net income for the second quarter was $687,000 versus a non-GAAP net loss of $900,000 in the year ago quarter. On a non-GAAP basis we reported earnings per share of $0.01 for the second quarter as compared to a loss of $0.01 in Q2 of 2008. Again, excluding the impact of the Japanese distribution rights agreement and the impact of foreign exchange, non-GAAP profitability improved significantly sequentially.

Moving to the balance sheet, we closed the quarter with $116.4 million in cash and cash equivalents. We believe our strong financial position enhances our competitive position in the marketplace. During the quarter we acquired the assets of our Australian distributor for $3.2 million, which is reflected in our cash flow investing line. This asset purchase should not have any significant impact on 2009 revenue.

Short-term deferred revenue excluding deferred revenue associated with our Japanese partnership was essentially flat versus Q1 levels, a decrease of two-tenths of 1%. While new bookings activity was generally healthy during the quarter, the reduction in professional services bookings in favor of increased recurring revenue continues to put pressure on our deferred revenue growth; however, we believe the shift to recurring revenue is a positive trend for the long-term success of the business.

In addition, customer churn was slightly higher than we had anticipated, which also impacted the growth of short-term deferred revenue.

Long-term deferred revenue totaled $5.6 million at the end of Q2, down from $6.2 million in Q1. As we have outlined to you in the past, as we continue to shift away from multi-year to one-year standard contracts, we expect the long-term component of deferred revenue to continue to decline over time.

Cash flow generated from operations for Q2 was $1.4 million, an improvement of $3.6 million from the use of $2.2 million in Q1 of 2009. Cash flow from operations was positively impacted by strong collections during the quarter.

During Q2 days billing outstanding improved over the prior quarter. In addition, during Q2 our overall billing term across all customers was in line with Q1. We're pleased that the proactive measures that we implemented at the beginning of this year continued to stabilize this measure.

Headcount at June 30, 2009 was 962 as compared to 967 at the end of the previous quarter. 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.

Following the close of the quarter, building on the success of last year's OpenAir acquisition, last week we announced the purchase of QuickArrow for $20 million in cash. There will be some nonrecurring integration charges and typical acquisition expenses related to the purchase that will hit in Q3. This transaction should improve NetSuite's financial model by adding scale and leverage within the services vertical.

We valued QuickArrow based on multiples of revenue, cash flow and net income. If you compare these metrics to the price paid for OpenAir, then QuickArrow was valued at a high revenue model, but lower on an earnings and cash flow perspective. Our expectations of revenue for QuickArrow on a stand-alone basis for the next 12 months is that it will be approximately half of the revenue we obtained from OpenAir in their first 12 months post-acquisition.

As we are consolidating the operations of QuickArrow and OpenAir we would expect that a potential upside in terms of revenue will accrue to the combined business and not to QuickArrow on a stand-alone basis. We don't expect that QuickArrow will contribute material amounts of revenue for the remainder of 2009.

From a non-GAAP EPS perspective, we expect the acquisition to be neutral to overall earnings this year but accretive in 2010 to both non-GAAP net income and operating cash flow.

On a GAAP basis we will have an increase in expenses associated with the amortization of intangible assets, the amounts of which will be finalized once we have completed our accounting valuation analysis.

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

For Q3 2009 we anticipate revenues of approximately $41.4 million. This assumes a continued increase in recurring revenue, a reduction in professional services revenue, and a reduction in revenue related to foreign exchange rates from the comparable period in the prior year.

For the third quarter, we expect a non-GAAP net loss of $250,000 to a non-GAAP net profit of $250,000. This equates to non-GAAP EPS of approximately $0.00.

For 2009 we're updating our total revenue outlook to a range of $164 million 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

Thank you, Jim.

So for NetSuite Q2 turned out to be a strong quarter and the results are telling on many fronts.

First, the new business results appear to indicate a strengthening of demand based on less uncertainty in the global economic situation.

Second, the results indicate our team's continued execution on advancing our core strategic initiatives. We saw continued progress surrounding our move to support the needs of larger companies, on our SuiteCloud platform strategy, and on the verticalization of our industry leading business suite.

And finally, the results point to continued market share gains at the expense of our traditional competitors. As cloud computing moves into the mainstream of IT business practices, NetSuite is taking more than its fair share of the demand.

And we are optimistic heading into Q3 and beyond. I want to reinforce the incredible market position we have built over the last 10 years. The vision to create a suite of applications that was delivered from the cloud was scoffed at when we started this company 10 years ago, and as recently as Q2 SAP's CTO told Information Week, quote, "Not only us but the industry doesn't know how to deliver mission-critical business applications yet in the cloud," unquote.

With data points such as the market share data provided by Gartner Group, the go lives at recently IPO'd companies and the hundreds of global organizations like Jollibee choosing NetSuite to run the complex multinational operations and business consolidation functions, it's pretty clear that while SAP and the rest of the industry may not have figured out how to deliver mission-critical applications from the cloud, NetSuite certainly has.

Of course, we're not resting on our laurels or our advantage. As evidenced by our investment last week in QuickArrow and our continued global expansion, we will continue to bring these new and innovative approaches to enable companies to take advantage of the efficiency and coverage ratios of cloud computing.

So with that I will turn it over to the operator for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from [Unidentified Analyst] - Deutsche Bank Securities.

Unidentified Analyst - Deutsche Bank Securities

What are you seeing in the spending environment? Are you seeing customers spending increasingly more than the last quarter? Do you think there's a holdup in budget spending? In particular, are you expending a budget flush in the fourth quarter in your current outlook?

Zachary Nelson

Looking at the new business side of the equation, Q2 was a very solid quarter based on all the metrics we talked about - the average selling price both of conventional NetSuite as well as the OneWorld product, both ASPs rising nicely; the number of new customers signed also increasing. So we certainly saw an uptick in customers' willingness to procure during the quarter, particularly as compared to Q1.

For the rest of the year we sort of look at Q3 basically as a flattish quarter when compared to Q2. You've got all the vagaries of summer and summer holidays that come into play there, so that's how we're modeling that.

And then Q4, Q4's has historically been our strongest quarter, quite frankly typically not related to budget flush from the markets we usually serve but just because of the way the compensation model is structured, perhaps more so. So we are expecting Q4 to show that similar trend that it has historically, to be the strongest quarter of the year.

James McGeever

And the thing I would add to that is I think when we look at the overall economy, we don't think it's getting any worse. We think we've seen some stabilization in terms of how people plan their businesses and plan their application purchases. That's actually relatively positive for us. As long as they see stabilization that changes their buying behavior and allows them to plan their business going forward.

Operator

Your next question comes from Rich Baldry - Canaccord Adams.

Rich Baldry - Canaccord Adams

I'm a little surprised to see the commission line cited as down sequentially when the bookings, number of new customers and the ASPs are up on the strength in the OneWorld. Can you talk about how that happened and then maybe where that would trend forward assuming your trend to increasing new customers continues?

James McGeever

Sure. So we do amortize our commissions of their life of the contract, so what you're seeing in commission expense primarily relates to deals sold in prior years and prior quarters. So if you look at the Q2 commission expense, that change is mostly related to the new business bookings in Q1, which obviously were down from Q4. The other component of commissions being down is that the rates this year that we're paying are slightly less than what we were paying in prior years as well.

So the combination of those two elements mean that commissions are down. It's really not a reflection of anything that we've got booked in Q2.

Rich Baldry - Canaccord Adams

When I look at the geographies and the sequential revenues, America was down much more than international. Is that because of the Japanese version coming off? I actually would have thought that would have come out of the international revenue base. Am I confused on that?

Zachary Nelson

Yes, it's normally factored into those numbers. That revenue split excludes that Japanese revenue. But when we look at the business, how it's trended, actually North America and America on a bookings basis was actually much stronger than international in Q2.

Operator

Your next question comes from Michael Huang - ThinkPanmure.

Michael Huang - ThinkPanmure

First of all, can you talk about your progress in getting large system integrators into the NetSuite Ecosystem? Are you seeing any success in working with the likes of either Accenture or Deloitte. Just curious. I mean, some of the OneWorld activity that you saw in Q2, was any of that influenced by these large integrators or partners and what would you expect to see from a trend standpoint?

Zachary Nelson

I think we are starting to see more interest from the SIs in NetSuite. I won't name any particular names, but we've definitely been having discussions with them, so I think what that indicates is more their willingness and desire to get into this market than us having not talked to them for years.

It's been awhile for them to come to the table because, as you know, my belief is that software as a service radically changes the economics of the services business as well and not necessarily for the better. It's not necessarily for the worse, either; it's just a different strategy.

So I think they've been challenged in trying to determine how their model applies in the new cloud computing world. I think they've come to grips with that and that's why these discussions are beginning.

I think the other thing that you're seeing in the world - and I've been predicting this for a long time - you saw Sage's largest reseller go out of business last quarter. I've been saying forever those traditional mid-market VARs had better figure out how to transition their model to dealing with software service solutions like NetSuite or they would be out of business, and we saw the first big shoe to fall, I believe, with Sage's largest reseller going out of business.

So I do believe there's going to be a fair amount of turmoil in the systems integration market, whether you consider those VARs or larger system integrators. I do believe some of them will make the transition and it's exciting that they're talking to NetSuite about how we can enable them to make that transition. There's going to be a whole class of them that don't make the transition, however.

Michael Huang - ThinkPanmure

And then in terms of the financial planning module that your reps are selling now, I think on behalf of another vendor, how does doing that either impact their productivity or close rates and how does it impact the profitability of bookings?

Zachary Nelson

Well, I'll talk to a few of those elements. Yes, the financial planning module, number one, I think shows the success of the SuiteCloud Ecosystem that we've built. It's a third-party product, really extends NetSuite's core financial functionality with Hyperion-like, if you will, capabilities and they've been developing that product for five years, so it's a very deep, very rich product. As we move up market, our larger companies need a tool like that to do financial planning and, in fact, NetSuite itself uses it, so we're very familiar with the tool.

In terms of our sales cycle, why we brought them into the equation is we are selling to larger companies and this is a product that really extends our functionality so it doesn't make our sales cycle more complex, I guess, is what I'm saying; at the end of the day it actually solves perhaps a problem we were running into before.

And the terms are done in such a way that we certainly make healthy margin on it and can sell it profitability.

James McGeever

One of the other things with that particular product is although there are some new business opportunities, there's a large number of our installed base who could benefit from such a solution and typically the costs of selling into installed base are much lower than the cost of selling to a new business.

So when you factor in those two different models it still ends up being a very profitable model for us.

Michael Huang - ThinkPanmure

And so you guys will be the primary or first line of support for that product?

Zachary Nelson

Yes.

Michael Huang - ThinkPanmure

Just in terms of the SuiteCloud Ecosystem, it's nice to see some of the [inaudible] are onboard already. Do you have any sense at all as you look out over the next couple of years how much revenue could the SuiteCloud Ecosystem be bringing you if you look two or three years out?

Zachary Nelson

You know, I don't think we really have quantified it in that way. We really look at it as a way to extend our footprint both horizontally, as you see with the adaptive planning product, without, quite frankly, investing more money in development, so we get expertise outside the company to extend it horizontally. And then secondly and very importantly is going deeper vertically. And for us our philosophy has always been verticalization of NetSuite is all about domain expertise, less about technology expertise, and you see that in some of these third-party products that are coming on board.

Rootstock we've talked about before as a MRP product that's built on top of NetSuite. These guys, this is the second MRP company they've built. They have deep knowledge and understanding of the customer base and the functionality and, quite frankly, much more so than we do. So we're getting to leverage not just their - they're leveraging our technology platform, which they do not have and would have to spend 10 years building, but we get an equally important aspect of the equation and that is their domain expertise in building, selling and implementing manufacturing suites.

So if you didn't get a chance to see it - I don't know if you saw Bruce Richardson's First Thing Monday report. As you know, Bruce is Chief of Research at AMR, which in the old days stood for Advanced Manufacturing Research, so these guys know manufacturing and he did an amazing write-up, I thought, looking at the Rootstock product and the NetSuite strategy in regards to that. If you haven't seen it, you should definitely take a look at it. So that's really how we're looking at it.

And the third element of the SuiteCloud strategy is verticalization allows us to address the needs of larger companies. So it really is an extension of our capability to move up market and sell and service larger companies.

So in terms of quantifying it in hard dollars, it's something we haven't done, but we've seen the success of it in advancing the strategy and all of that ultimately ends in more customers at a higher average selling price and presumably more profitable delivery.

James McGeever

And certainly these types of solutions allow us to go increase the available market for our product because we can now sell to manufacturing companies, which we couldn't have done so before. So we'll get to sell NetSuite core ERP [inaudible] into a whole new set of companies we never could have sold to before.

Operator

Your next question comes from [Calvin Wu] - Morgan Stanley.

Calvin Wu - Morgan Stanley

If I may follow up on your comments about improving ASP, how do you expect these to trend going forward? Do you expect them to maintain the current level or go up as you migrate up market?

And my second question would be about expenses. You've been focusing on controlling costs. As billings growth stabilizes and improves, should we expect expenses to trail or lead billings over time?

James McGeever

On the ASPs - I'll take that question first - what we've seen historically and it's been a very consistent trend over the last seven years, we've seen ASPs continue to grow, and as we move up market and go deep into verticals and sell to large companies we would expect that ASPs will continue to grow over time. You may see one or two quarter blips because often they can be driven by large deals, but as a general trend we do expect to see consistent growth in our ASPs.

On the expense side, right now the primary initial driver of expenses when you're growing your billings is really your sales team, and we believe we have significant or enough capacity within our existing sales organization to continue to be able to grow the business without having too dramatic of an increase in sales.

Now, a lot of that really is dependent on the rate of growth. So we can handle with just consistent trends or keeping our expenses similar as a percent of revenue to a certain growth rate. Once it goes above that then you do have to hire ahead of time. But we did hire a lot of salespeople in 2008 and they're becoming fully productive and tenured now, which gives them additional sales capacity.

So we wouldn't expect to see a big ramp up in expenses unless the growth rates are so substantial that we're required to do so.

Calvin Wu - Morgan Stanley

So should I interpret that as meaning expenses would probably trail billings in the near term?

James McGeever

I would think so.

Operator

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

Laura Lederman - William Blair & Company, LLC

I was wondering if you could help us understand a little bit about your business, bookings and if you just do the new calculation without taking Japan revenues out with 6% bookings growth, can you help us on what it really is if you isolate out for Japan and changing billing terms year-over-year so you can get a better understanding of what's happening underlying in the business?

James McGeever

Well, if you look at the sequential growth the way you calculate bookings growth by looking at change in deferred, you actually see sequentially this is our best bookings or deferred revenue growth or billings as a proxy for billings that we've had in the last year. So we were very pleased with that.

There have been a couple of other factors and it's not just term that impacted us versus a year ago. One of the other elements - and we've talked about this in the past but we never really talked about the impact it has on deferred revenue - is one of the things that we started doing in the last year is we started transitioning more of our sales towards recurring revenue versus professional services revenue. So what that ultimately means is that we'll essentially discount services before we'll discount recurring.

That ultimately means that you don't get that upfront billing all in the professional services; you essentially get it over the two or three years that you get that catch up. So that has an impact on short-term deferred revenue.

But when we look at sequential growth, this is the best performance that we've had certainly in the last year.

Zachary Nelson

And just to be quick, that's not adjusted for any change in billing term.

James McGeever

That's not adjusted for change in billing term. That's just with the absolute numbers.

Laura Lederman - William Blair & Company, LLC

Shifting gears a little bit to competition, are you seeing any more or any less since [inaudible] so why isn't Microsoft [inaudible] also shifting to business [inaudible] apparently a new [inaudible] of that product is, in theory out. Are you seeing it showing up in sales cycles at all?

James McGeever

On Business by Design, from our data it's basically the single greatest product that you still can't buy, so we don't really see it in any deals.

Our understanding is you're really not going to see a rev that you can actually buy until next year, so that's been - I think they announced they were going to ship it in 2007, so, as predicted, 2010 they may actually get something out that people can actually use. But don't get me started on Business by Design. I don’t want to go too crazy.

So beyond that it's the usual suspects. We don't see a lot of Sage in new business in the U.S.; you do see Sage in the U.K., but not in the U.S. It's pretty much Sage replacement in North America.

So it's the same old suspects. You see Great Plains in the back office. But, again, in the deals where we see them it's only about 10% of our deals, so it is this vast, you know, the unwashed masses of the mid-market that you compete with depending on vertical and customer and customer size and whatnot.

Laura Lederman - William Blair & Company, LLC

If you look at acquisitions, you've been making a few relatively small ones. Can you talk about the uses of cash, future acquisitions versus buybacks versus whatever. And I guess [inaudible] buybacks don't make any sense, but if you'd talk about, I guess [inaudible] make additional acquisitions and would they [inaudible].

Zachary Nelson

Yes, well, I'll tell you. We're very excited about the QuickArrow acquisition. A major reason is how well the OpenAir acquisition went and how well the customers have received the combined NetSuite/OpenAir product. So we had a high degree of confidence in doing that transaction because we know how the business works, we know what the customer profile looks like, we know there's lots of demand in that space, and we know we're executing well. So we were very excited to make the QuickArrow transaction happen.

So I guess if there were opportunities that extended our verticalization strategy, that being our key strategy, we would look at it, but we look long and hard at doing those things before we actually execute them. And, again, QuickArrow was something we knew we understood quite well, so we didn't have much trepidation going down that road.

James McGeever

[Inaudible] buybacks, as you said, just given the sheer ownership structure, it's pretty unlikely that we'd be going into the market doing buybacks.

Operator

Your next question comes from Sasa Zorovic - Janney Montgomery.

Sasa Zorovic - Janney Montgomery

I was wondering if you could provide us some more granularity regarding how the different verticals performed through the quarter if you could.

James McGeever

Overall, generally across the board, there was no one vertical that really stood out. We had a pretty good quarter in technology. We weren't really exposed to the verticals that had significant impact from the economy such as financial services and construction and real estate, so we haven't really seen any huge bounce backs or changes in those particular markets. So most of our strong verticals, which are services-based businesses, have been very strong. Technology had a pretty good quarter and wholesale distribution.

So there's no one vertical that I think really stands out versus any of the others as major growth drivers.

Zachary Nelson

You saw a couple of the go lives this week in some of the news releases, the IPOs that we talked about. We're very strong in software companies and very large software companies. That's really one of our true verticals. We run everything at NetSuite on NetSuite, and we believe we probably have the best application to run a software business, and those are just three other examples of major companies agreeing with us.

Then you see something like Jollibee, which reinforces a number of the points we've been making about divisions of large companies using OneWorld to automate their emerging markets environment, and so that was another strong showing in that particular market segment.

And then finally I think the doubling down in QuickArrow, we've been having great success in the services space and interestingly enough, while Jim said we don't have a ton of exposure to financial services, our exposure has actually been increasing, I believe, over the last six months. We've had some significant wins in financial services companies. I think it's been driven, quite frankly, by their desire to increase efficiency and reduce cost and that's what NetSuite and cloud computing are all about. So we've seen an uptake really in that market segment, interestingly enough, over the last couple of quarters.

Sasa Zorovic - Janney Montgomery

Also could you comment on the progress of the business through the quarter? Did you see sort of as the quarter was progressing the environment sort of improve or was it relatively steady as the quarter went on?

Zachary Nelson

You know, it behaved like a normal pre-Apocalyptic recession quarter. It was sort of 20%, 25%, and then the remainder in the last month actually happened. So the good news about this quarter was when customers said they were going to buy they did buy. They tend to backend load that decision towards the end of the quarter. So it behaved really like a normal quarter should behave.

Operator

Your next question comes from Andrew Shaw - Raymond James

Andrew Shaw - Raymond James

Last quarter you discussed a small uptick in down sell at renewal time. Did you guys see that again this quarter at all?

James McGeever

No, down sell was flat with Q1. We didn't see any change in that.

We did see a slight increase in churn in terms of customers that left, which based on our analysis was based on financial distress. However, up sell within our installed base continued to offset both down sell and churn at a rate greater than 100%. In prior years that rate had been higher, but it's still greater than 100% within the installed base.

Andrew Shaw - Raymond James

And then if I'm not mistaken last quarter you guided to 70% to 71% gross margin for the year. You dropped that slightly this quarter to 69% to 70%. Would you provide any color around just that slight drop?

James McGeever

Sure. Most of that drop is a result of foreign exchange in terms of our forecast. If you look at the quarter-over-quarter change in gross margin, it was attributable to two factors. One was the decline in the recognition from the Japanese distribution rights revenue, which we already knew about and had been factored into our forecast. The other element, about half the change in gross margin in the quarter came as a result of movements in the foreign exchange rates, and so we're factoring those in moving forward.

In fact, if you look at overall expenses in Q2 versus Q1 of '09, there was about an incremental $560,000 worth of expense purely related to movements in foreign exchange rates over the quarter.

Andrew Shaw - Raymond James

And then just lastly on CapEx, that came in a lot lower than in previous quarters. How shall we think about that going forward into the back half and then maybe into 2010?

James McGeever

It does fluctuate a little bit based on timing. I think what you'll see is on CapEx basically the same historical trends moving forward. I wouldn't expect to see any major changes in what our CapEx environment has been historically.

Operator

Your next question comes from Mark Murphy - Piper Jaffray.

Mark Murphy - Piper Jaffray

Zach, could you provide any update on competition versus companies like [Dell Tech] in the services resource planning market?

Zachary Nelson

Yes. I'll be honest with you - we haven't seen much of them yet or they haven't seen much of us yet I guess is the right way to say it.

One of the things we're doing right now with the combination of the OpenAir product line and the NetSuite product line is going to Version 2 of the integration of that product set and that will come out - OpenAir's doing their user group summit in October and so we'll have Version 2, really, of NetSuite SRP at that time, so that will provide deeper and deeper links between the two products and should give us a more tightly integrated product and more tightly integrated story to go into larger services companies.

That said, over the past couple quarters I think we have something probably north of 20 companies running the integrated NetSuite SRP product combining both NetSuite and the OpenAir, NetSuite as the CRM ERP platform and OpenAir as effectively the service delivery facing application that consultants use. I don’t know if we've signed it yet, but I believe this quarter we will sign the largest joint implementation, the joint NetSuite SRP implementation  probably a 500-user deal - for professional services companies. So that's a very exciting data point as we move forward.

Mark Murphy - Piper Jaffray

And then, Jim, I think you commented that the recurring revenue was up 20% in constant cyclical in Q2. Do you have what the comparable number was in Q1? I think you gave a number last quarter and it just wasn't clear to me whether that was as reported or in constant currency.

James McGeever

It was 27%. It was the recurring growth that we reported in Q1.

Mark Murphy - Piper Jaffray

And then finally, the FX impact sequentially to deferred revenue - is that anything you can approximate for us?

James McGeever

It wasn't that significant on the deferred revenue side. As we mentioned, we had a much stronger book into North America versus international, so it didn't have that significant of an impact on deferred revenue; versus a year ago the impact is more significant, but sequentially on deferred revenue itself it wasn't that material.

Mark Murphy - Piper Jaffray

So would you say less than $1 million, maybe half a million, something like that?

James McGeever

Yes, half a million, in that range or less.

Operator

Your next question comes from Bryan McGrath - Credit Suisse.

Bryan McGrath - Credit Suisse

Real quick blocking and tackling, can you review what happened with contract length and payment terms? I think you said bookings were flat - or billings were flat, but I just wanted to make sure I got that right.

And then secondly, with your growing SRP business or product group, from a vertical standpoint do you think you can have more government sales with that product and then, if so, are you seeing that in your pipeline and would you expect any kind of uptick in Q3? It's typically strong government quarter sales.

James McGeever

So on the billing terms and contract length, the contract length was essentially flat and consistent. We typically sell one-year contracts, so our typical contract length is usually 12 or 13 months and we were within that range within that quarter.

In terms of billing terms, so the amount we get to bill on Day 1 when we sign these contracts, that was consistent overall with where it had been in Q1, which was an improvement from Q4.

Zachary Nelson

And on the government market opportunity, yes, we would agree that's going forward an bit opportunity for us, both in the NetSuite product line, in the OpenAir product line and in the combined SRP product line. We already do have a lot of features and functions designed specifically for the vagaries of delivering services in the government market and we have as customers companies that actually do service delivery, consulting, to the government as an entity.

So it's not a big part of the business today; we're looking at investing further in it, so I don't know that you'd expect anything in particular in Q3 as a result of our efforts there, though.

Operator

(Operator Instructions) Your final question comes from Tom Roderick - Thomas Weisel Partners.

Tom Roderick - Thomas Weisel Partners

I'm hearing more of an emphasis here on the recurring revenue portion and I'm wondering if you could give us a sense for how much do you anticipate that that could move your gross margin structure over time and at what point do you think that we should expect to see that moving in a positive direction from a larger proportion of recurring revenues?

James McGeever

Initially it puts pressure on the gross margin line because the services revenue is recognized within the first year of the contract and the recurring you get over multiple years, but you still have all the costs. So as you're getting smaller services revenue you still have all the costs associated with that.

So it does put a bit of pressure on the gross margin line initially, so it will take a year or two before you start to see some of the benefit of that on the gross margin line.

Now there are quite a few trends going on within our services business, especially as we're going to larger customers; you do see more complex rollouts and often you see a low initial subscription and recurring rollout, they do the implementation and then they buy the subscription recurring after essentially the pilot and the implementation's done. So you do see it kind of more staggered.

There's a lot of moving parts in that services organization, but I would expect that'll take a year or two before you start to see leverage on the gross margin line.

Tom Roderick - Thomas Weisel Partners

And just one last question on churn - I apologize if you addressed it earlier - but can you provide any further details with respect to the idea that churn was up a little bit this quarter? Which segments of your market are you seeing it in and to the extent that that's the low end where you have some customers actually going out of business, can you talk about the dollar renewals that you saw in the mid-market and your higher-end customers?

James McGeever

Well, when we look at our churn rate, so if you look at our largest customers, we see very little involuntary churn, so all the churn that we do see - with the larger customers it's involuntary churn; I mean, these are customers who are very happy with NetSuite and if it wasn't for financial distress then they'd still be customers - we continue to see a higher rate of churn in the very smallest customers, as we have historically always seen, and we don't expect that really to change moving forward.

But we do expect within the larger customers that over time our overall churn rate will improve as our base transitions to more of these larger customers which are stickier from a revenue standpoint.

Zachary Nelson

And, again, to the second part of your question, we did replace churn and down sell with up sell, so 100% of that, whatever churned either as a lost customer or as a renewal but for less dollars, that gap was replaced completely by up sell within the installed base.

Operator

That will conclude today's question-and-answer session as well as today's conference call. Thank you all for your participation.

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Source: NetSuite Inc. Q2 2009 Earnings Call Transcript
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