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PROS Holdings Inc. (PRO)

Q2 2009 Earnings Call Transcript

August 6, 2009 4:30 pm ET

Executives

Charlie Murphy – EVP and CFO

Bert Winemiller – Chairman, President and CEO

Analysts

John Difucci – JPMorgan

Tom Roderick – Thomas Weisel Partners

Nabil Elsheshai – Pacific Crest Securities Inc.

David Heinz – Needham & Company

Horatio [ph] – Jefferies & Company

Nandan Amladi – Deutsche Bank

Ashok Ramji – Lamoreaux Capital Management

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2009 PROS Holdings, Inc. earnings conference call. My name is Arica and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions)

I would now like to turn the presentation over to your host for today’s call Mr. Charlie Murphy, Chief Financial Officer. Please proceed.

Charlie Murphy

Thank you, operator. Good afternoon everyone and thank you for joining us today for the PROS Holdings, financial results conference call for the second quarter of 2009. I am Charlie Murphy, the Company’s Executive Vice President and Chief Financial Officer.

Joining me on today’s call is Bert Winemiller, PROS' Chairman and Chief Executive Officer. Today’s conference call, Bert will provide a commentary on the highlights for the second quarter of 2009 and then I will provide a review of the financial results and our outlook before we open up the call to questions.

Before beginning, we must caution you that today’s remarks in this discussion, including statements made during the question-and-answer session contain forward-looking statements. These statements are subject to numerous important factors, risks and uncertainties, which could cause actual results to differ from the results implied by these or other forward-looking statements.

Also these statements are based solely on the present information and are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Please refer to our prospectus, Form 10-K, and other filings with the SEC in the risk factors contained therein.

Also, please note that a replay of today’s webcast will be available in the Investor Relations section of our website.

I would also like to point out that the Company’s use of non-GAAP financial measures is explained in today’s earnings press release, and a full reconciliation between each non-GAAP measure, and the corresponding GAAP measure is provided in the tables accompanying the press release, filed earlier today, and can also be found on our website in the Investor Relations section.

With that, I will turn the call over to Bert.

Bert Winemiller

Thank you, Charlie, and thanks to those of you listening to our call this afternoon. We are pleased with our financial performance in the second quarter of 2009, as revenue of $17.3 million was above the mid-point of our revenue guidance, and we exceeded the high-end of our EPS guidance for the quarter.

Non-GAAP operating income was $3.5 million, 20% of revenue for the second quarter of 2009. Non-GAAP earnings came in at $2.5 million, or $0.10 per diluted share, exceeding our guidance. We believe this was a solid performance given the current economic environment.

PROS is a global company with revenue diversified across geography and our target industries. Second quarter 2009 revenue that came from outside of the United States was 59%, and second quarter license and implementation revenue that came from our target industries of manufacturing, distribution, and services was 57%.

We believe this diversification of multiple dimensions provides us with a competitive advantage and the pricing of margin optimization market, and benefits us especially in difficult economic environment.

It is also important to recognize that the pricing optimization market, where we hold a leadership position, is still in its early stage, and that our customers tell us that the ROI benefits they receive by implementing our pricing optimization software, are important in a challenging down market, when demand is unpredictable, and costs are volatile.

We remain focused on our strategic goals of delivering significant value to our customers, early in our implementations, and provide an increasing return on investment over time, while focusing on lowest total cost of ownership.

We have reduced our discretionary spending and overall non-GAAP expenses from $14.9 million in the fourth quarter of 2008 to $13.9 million in the second quarter of 2009, while still investing in people, product, and processes to drive our science and product innovation and to increase our competitive advantage.

R&D, as a percentage of revenue remains high at 25%. We are also planning to continue our focus on sales and marketing to position us to take advantage of the large market opportunity as the economy improves.

PROS proven track record, proven processes, and proven solutions are the keys to our long-term success, and drive our high level of customer satisfaction.

Now, let me address the current economic conditions, and provide some insight into our business, and how it is being impacted. We have said previously, during these difficult economic times, CEOs, CFOs, and COOs who are the ultimate decision makers, for pricing software, have been focusing on reducing cost.

This focus on reducing cost and tight control over IT spending, has resulted in a downward trend in our revenue, which continued in the second quarter, and we expect will continue in the third quarter.

However, we do expect the fourth quarter revenue to improve. While the macro economy continues to be challenging and forecasting for the longer-term remains difficult, bookings have improved.

Sales activity continues to be very good, with increasing participation by prospects at our sales events and webcast. We believe interest and pro science based pricing and margin optimization software continues to increase. Companies that have been pushing of the decision to move forward with innovative pricing solutions seem to be freeing up spending, or innovative high return on investment initiatives.

Although sales cycles continue to be long, at this time, we believe there is enough of an improvement in our near-term bookings, to expect fourth quarter revenue to be slightly up from the third quarter.

In the second quarter, contracts were signed with new or existing customers and four of our target markets. New prospects continue to be identified and our maintenance renewal rate remains strong in the best-in-class mid-90% range.

We believe the market for pricing and optimization software is in the innovator early stage and that PROS is in the center of this shift to science-based pricing from spread sheets, and current destructive pricing practices.

According to a July 2009 Gartner report, hype cycle for CRM marketing applications 2009, the market for pricing optimization software for B2B companies is earning increasing recognition.

Gartner stated that overall market penetration is still in the low single digits. The report identified the characteristics of companies that would benefit from our pricing and margin optimization software.

Gartner said, “Consider price optimization and management software, if you are Fortune 2000 firm, or an organization with more than $500 million in revenue, and industries with complex pricing requirements that involve one or more of the following issues.

Large numbers of customers segments with different price points, large volumes of product stock, keeping units with varying price points, large numbers of products with short product life cycles, inconsistent deal margins, flexible discounting bands, multiple volume based pricing agreements, complex price bundling practices, high price sensitivity to market conditions, including competition and market index.

PROS believes that there are thousands of companies that meet the criteria identified by Gartner and as a result, there is multi-billion dollar market opportunity for PROS. Gartner also stated and I quote, “This market differs from most other application segments because it offers strategic benefits and helping organizations grow revenue and margins, as well as operational efficiencies."

Companies implement PROS pricing and margin optimization software as a strategic innovation in our risk mitigation initiative, as they face unpredictable demand and volatile cause in this economy.

We believe that with our market leadership position PROS will be the pricing partner that mainstream customers turn to, as market adoption increases, and companies focus on setting, and executing optimal pricing strategies.

With respect to marketing efforts and the pricing of margin optimization software space, we continue to see strong levels of interest in our software products, as is evidenced by our well attentive education webinars.

These webinars highlight the power of pricing analytics, execution, and optimization, the roadmap to pricing excellence, and lowest total cost of ownership. With respect to PROS thought leadership, we are an active member and sponsor of two well respected professional organizations, dedicated to pricing.

We are a pricing technology expert member of both, the Professional Pricing Society, PPS and the European Pricing Platform, EPP. We have also had great attendance at our new regional pricing leadership summits. We've had six regional events year-to-date, with total prospect attendance up more than 25%, over the prospect attendance at our annual event last year.

We expect this pattern to continue as we host regional events in Asia, Europe, and the United Kingdom, as well as several more cities in the United States. As I mentioned on our last earnings call, PROS has unique strength for managing in the challenging economy.

First, PROS has proven management experience during the past challenging economic environment, PROS was able to maintain its track records of profitability, and positive cash flow.

Second, PROS has a strong balance sheet, with 53.7 million in cash and no debt. This helped PROS standout positively in one of the most important criteria, in current sales situations, which is vendor viability, and puts us in a unique position to continue to invest prudently, to increase our relative competitive position.

Third, PROS has an attractive business model that is based on a high return on investment value proposition for customers, by providing pricing and margin improvement with a fast time to value and lowest total cost of ownership.

Another component of our business model is the PROS revenue visibility, which is based on our percentage of completion, revenue recognition model, which helps with cost expense management, and resource planning.

And the last component of our business model is the fact that PROS has a diversified revenue mix across industries and geographies. On management strengths, the fourth component is PROS employees’ experience and expertise in pricing that is unequal, and PROS best-in-class products and services are exemplified by our high maintenance renewal rates.

And lastly, our fifth unique strength, we believe PROS has a superior product strategy, which supports our strategic goals of shortest time-to-value, highest return on investment, lowest total cost of ownership, and this is the cornerstone of this strategy as the PROS pricing solution suite, common code platform, a single integrated database, and PROS configuration capabilities.

On the customer front, a recent example that demonstrates why forward thinking innovative companies choose PROS to be their pricing partner, is that one of the nation's largest providers of industrial supplies and equipments, recently selected PROS for an enterprise-wide deployment of PROS optimization software suite, across their 96 branch network, after an extensive review of all pricing software tools.

This customer has 500,000 products, 350,000 customers, and has over 4 million transactions per year, consistent with the Gartner profile, for companies that can benefit from pricing optimization software.

This new customer stated that they selected PROS for our demonstrated speed and success of implementations, our inability to provide high return on investment in just 30 days, our strong financial viability, our high-performance software platform that facilitates multiple upgrades per year, and our high level of ongoing investment in pricing software R&D.

The deployment includes, PROS scientific analytics price optimizer, deal optimizer products, as well as PROS scientific segmentation and optimized price guidance. Another customer just completed Phase 1 of a multi-phase implementation of PROS pricing software.

This customer is a very large energy company, and the project was on time under budget and delivered 200% of the budgeted return on investment.

In summary, we are pleased to have met our guidance for the second quarter, 2009 given the macro economic situation; this achievement is the result of the hard work of over 350 personnel or smart dedicated people doing great things to bring writing excellence, and high value to our customers.

We expect our business trends to stabilize in the second half of 2009. We have an experienced management team that we believe is focused on the right strategies. We think, we are well-positioned, and will continue to invest appropriately to capitalize on what we believe is a fantastic long-term market opportunity.

We are being prudent about our spending in this economy. With a strong balance sheet we are in a unique position to invest in our products, processes, and sales and marketing to improve our relative competitive position in the pricing and margin optimization market.

We have great people, products, and processes and we are going to manage through this time very appropriately. At this time, I'm very pleased to announce that one of our executive officers has been promoted.

Andres Reiner, formerly Senior Vice President of Product Development, has been promoted to Executive Vice President in-charge of all product and marketing activities for the Company.

Andres has been with the Company for 10 years and been in an increasing responsible and high-value positions throughout his career and been a very high-value member of our executive team, and we congratulate Andres.

Now let me turn the call over to Charlie, so that he can provide you with a review of our financial results, and our outlook for the third quarter of 2009.

Charlie Murphy

Thanks, Bert. PROS had a solid quarter. I will begin with a review of our statement of operations for the quarter, which ended June 30. Then I will provide some commentary on the balance sheet and cash flow, before providing you with financial guidance for the third quarter of 2009.

I'll be discussing the statement of operations information on a non-GAAP basis. Our earnings press release includes a full GAAP to non-GAAP reconciliation, which can be found in our website in the Investor Relations section.

As Bert indicated, we are pleased with our performance in the second quarter, with revenue above the midpoint of our guided range at 17.3 million, operating income at 20%, another quarter of positive cash flow, and our balance sheet with cash at $53.7 million, again, no bank debt and a solid working capital position.

Also EPS of $0.10 exceeded the high-end of the range provided, which was $0.08 to $0.09. In accordance with our revenue recognition policy, PROS does not recognize any revenue of contract signing.

License and implementation fees are bundled together and the revenue, generally recognized on a percentage of completion basis over the implementation period. It can be variability and licensed implementation revenue from quarter-to-quarter.

As we saw the seasonality of rather the implementation if it is needed, the network products being deployed, the contract size and the timing of when and implementation starts or finishes.

Revenue of $17.3 million in the second quarter was down 7% year-over-year and was above the midpoint of our guided range. Within revenue, license, and implementation revenue was down year-over-year, while maintenance revenue was up year-over-year. Let me provide some additional color on this.

Maintenance revenue increased 17% from the second quarter of 2008, which was due to implementations that have been completed that are now in maintenance. Also, we are pleased that our maintenance renewal rate continues in the best-in-class mid-90% range.

License and implementation revenue decreased 16% year-over-year. Although sales activities remains strong, the global macro-economy is having an impact on our license implementation revenues, as it has lengthened sales cycles, and increased scrutiny on purchasing decisions.

In addition, the current mix of business contributed to the decline in license and implementation revenue. Our revenue continues to be diversified geographically, and spread over our five target political markets.

For the quarter international revenue was approximately 59% and as in the past approximately 90% of our airline revenue continues to be from outside the United States. During the second quarter, we did of a small gain of foreign exchange of approximately $0.1 million.

On a non-GAAP basis, gross profit was $12.6 million in the second quarter, resulting in gross margins of 73%, compared to gross margins of 75.8% in the second quarter of 2008.

License implementation margins of 68.5%, decreased by nearly 6 percentage points, and maintenance margins of 81% increased by over one percentage point, over the second quarter of 2008.

License and implementation gross margins may vary from period-to-period, depending on the factors, included in the amount of implementation services required to deploy our products, relative to the total contracted price in mix of business.

Also, we have not significantly changed our implementation cost in 2009, while our revenue has decreased impacting on gross margins. As we have previously communicated, we have not had any layoffs, as we believe it is wiser to retain our trained personnel, including our professional services personnel, and take advantage of the market opportunity that we believe is ahead for us.

Based on our anticipated cost of license implementation services in our third-quarter revenue guidance, we do not expect a significant change in our license implementation gross margins in Q3, as compared to Q2.

Going forward, we would expect license implementation margins would improve when the license implementation revenue increases. Implementation efficiencies are continuing, which should help margins.

Non-GAAP research and development expenses, in the second quarter were $4.3 million, and decreased approximately 500,000 or 10.5% in the second quarter of 2008. We are maintaining our research and development staffing levels.

However, in the global economic environment, we have taken actions to closely manage all operating expenses, and we are able to reduce non-personal related spending by approximately $200,000 over last year.

In addition, we reassigned certain research and development personnel to assess with short-term implementation activities, which reduced R&D expense in the quarter. Research and development expenses continue in the mid-20% range during the quarter, as we continue to invest in product development.

Non-GAAP selling general and administrative expenses for the second quarter were 4.8 million or 28% of revenue, and decrease 5% in the second quarter of 2008. The decrease was in general and administrative expenses, mostly professional fees, partially offset by an increase in sales personnel costs.

Non-GAAP operating income, which exceeded the high-end of our guidance was $3.5 million or 20% of revenue in the second quarter, compared to $4.2 million or 23% of revenue in 2008.

As a result of actions to closely manage operating expenses, total expenses continued to decrease and were down approximately 3% or $400,000 from the first quarter of 2009.

Interest income was approximately $50,000 for the quarter, a decrease of approximately $250,000 in the second quarter of 2008. Lower interest income resulted from lower interest rates on higher average cash balances and lower EPS by approximately $0.01 in the second quarter of 2009, over the same period in 2008.

Our effective tax rate was approximately 28% for the second quarter of 2009, compared to approximately 36% in 2008, largely due to the timing of the reinstatement of the research and experimentation tax credits.

In October 2008, Congress reinstated the research and experimentation tax credit for 2008, and extended the credit through the end of 2009. The second quarter of 2008 did not reflect the benefit of the credits, until the legislation was passed in the fourth quarter of 2008.

Non-GAAP net income for the second quarter of 2009 was $2.5 million for $0.10, at a 28% tax rate per diluted share – with diluted shares of $26.5 million and exceeded the high end of our guidance.

The second quarter of 2008, non-GAAP net income was $2.9 million or $0.11 per diluted share, with diluted shares of $26.5 million, and a 36% tax rate. The previous information has been based on our non-GAAP operating results, because we believe that excluding certain non-cash items, such as non-cash equity-based compensation, provides you the best indicator of the health of your all business.

This is how we measure the success of the business internally. That said, we appreciate that investors also need to analyze our results on a GAAP basis. So, we have provided the reconciliation of GAAP results and the non-GAAP results as part of the earnings release.

GAAP income from operations was $2.1 million in the second quarter of 2009, compared to $3.2 million from the second quarter of 2008. Approximately, 400,000 of the decrease was from higher stock-based compensation expense in 2009.

Net income in the quarter was $1.5 million or $0.06 per diluted share compared with $2.2 million or $0.08 per diluted share in the second quarter of 2008.

Moving to our balance sheet, cash and equivalents were $53.7 million for the second quarter of 2009, compared to 52 million for the first quarter of 2009. Our operating cash flow in the second quarter of 2009 was approximately $2 million.

Trade accounts receivable, days sales outstanding were approximately 64 days, which is slightly lower than our Q1 days sales outstanding. Cash flow and accounts receivable balances can vary in the quarter, based on among other things, the timing of collections, and invoicing of milestone billings under our contracts. At the cash flow, the payment of accruals, all of which may vary from quarter-to-quarter.

Total deferred revenue at the end of the second quarter was $18.9 million, a decrease of approximately $200,000 from the end of the first quarter. As with accounts receivable and cash flow, deferred revenue can fluctuate from quarter-to-quarter, depending on the timing of contractual milestone billings. Because deferred revenue is not tied to total contract value, we do not believe it is a meaningful forward indicator.

Headcount at the end of the second quarter was 389, compared to 385 at the end of March. Our headcount has increased modestly, we have slowed headcount growth as compared to 2008 in response to the uncertain market conditions and we continue to monitor expenses carefully.

Now, let me turn to our guidance for the third quarter of 2009. As Bert has mentioned, the macro economy continues to be challenging and forecasting for the longer-term remains difficult.

For the third quarter, PROS anticipates total revenue in the range of $16.1 million to $16.5 million. We are projecting on GAAP operating income of $2 million to $2.4 million, and we're anticipating non-GAAP diluted earnings per share of $0.06 to $0.07, based on an estimated weighted average of 26.5 million diluted shares outstanding, and the estimated effective tax rate used is 28%.

The Company is projecting GAAP income from operations of $500,000 to $900,000, and diluted earnings per share of $0.02 to $0.03. Non-GAAP operating income and net income for the third quarter, excludes estimated FAS 123R stock option expense of approximately $1.5 million.

The third quarter guidance is based on our current expectation, which assumes no meaningful improvements in the macro environment. Although bookings are the most important component driving revenue, historically, revenue for PROS has not been solely impacted by current year bookings.

Revenue is also primarily impacted by four areas; first, the duration of implementations, particularly those that exceed one year. Second, growth and maintenance revenue, resulting from completed implementations, which has been an ongoing trend. Third, enhanced efficiencies in implementation processes that we have seen with the shortening of some implementations, well customer delays have lengthened other implementations. And four, to a lesser extent cost of living increases for maintenance services, which we continue to see as maintenance agreements are renewed.

It is the layering effect of current year bookings for more than one year, the time duration of our implementations and maintenance growth that has traditionally given PROS good revenue visibility, based on our percentage of completion revenue recognition model.

We ended the second quarter of 2009, with 53.7 million of cash, working capital of 63.5 million, excluding deferred revenue and no bank debt. While there was no assurance that past performance can be continued, our experienced management team, the financial strength of the Company, and our revenue recognition model is particularly helpful during such periods.

In summary, given the current economy environment, we continue to be pleased to have met our expectations in the second quarter, and our very strong financial position is continuing into 2009.

We will face additional challenges in the remainder of 2009. However, as Bert mentioned, we expect our business trends to stabilize in the second half of 2009. From what we see today, bookings, which lead revenue are showing sufficient signs of improvement to expect fourth-quarter revenue to be slightly up from the third quarter.

We believe, we are in a very strong competitive position, given among our other strengths, our strong financial position. With the continued growing awareness of the benefits of high ROI pricing optimization software, we remain confident that PROS has an attractive long-term growth opportunity, and we believe we have positioned the Company, to take advantage of that opportunity.

With that let me turn the call back to the operator, so we can take your questions.

Question-and- Answer Session

Operator

(Operator instructions) Our first question comes from the line of John Difucci with JPMorgan. Please proceed.

John Difucci – JPMorgan

Thank you. Hi Bert and Charlie.

Bert Winemiller

Hi, John.

John Difucci – JPMorgan

Could you help us out here a little bit, and I know we have had similar conversations, but you have given us a lot of information here, it does sound conflicting in some cases, you are saying that you expect fourth quarter revenue, actually the third quarter guidance is for an accelerating decline in revenue, realizing there is a lot of things and I appreciate going through what effects that, but even if fourth is up sequentially slightly, you could still see another increase in the declining rate year-over-year in revenue? At the same time, you are also saying that bookings and sales activity have improved, so if you can just – realize that you guys obviously have a lot more visibility into the accounting here than we can have, but can you help us out a little bit here to see if, are things getting less bad or are they getting a little better?

Bert Winemiller

Bad or a little better? Well obviously, we have had decreasing revenue for a number of quarters here. And we think that is a direct reflection of the marketplace CEOs and CFOs been under tremendous pressure, and having to cut cost, and basically freezing expenditures for investments, especially capital expenditures, and we have seen that.

At the same time, and I would say that we are seeing that being less bad, at the same time, what we are seeing is, an increasing awareness and a education in the market of the value of pricing.

And that is a reason we specifically mentioned, the Gartner report. And there is other venerable observers of our space that think that, you know as budgets, free-up and as companies entertain, innovative investments that one of the first investments they are to consider, is pricing optimization software. That said, everything that is going on in our space right now, is really payrolls in the big future market opportunity that we have.

And our assessment of the profile or the kind of companies that can use our software and achieve a high return on investment, has been validated by the Gartner report, and if you take that profile and you apply it to the target industry, the manufacturing distribution, and services that are our targets, big BTB transaction, dynamic pricing, negotiated deals, list pricing, contract optimization, you know the people that have complex pricing problems to solve, and you look at that profile, and the thousands of companies that are in those target markets.

We think with the low penetration today and low single-digit percentage that the recent activity and awareness levels, and validation by Gartner says that this really is going to be a substantial market someday, and the better news for us is that the indicators are that that at some point out in the future this is going to move from an innovator to a mainstream to a must-have application and that is why, we have comforted with this validation because we are investing, and we are continuing to manage the company for the strategic opportunity.

And that is why, we haven't had and any layoffs, we have maintained our R&D investment, we continue focused on total customer satisfaction, we have had some incredible implementation successes, you can see that in the increase in maintenance that kicks in, you know when we put our software into production.

So, even though things are tough they are less bad in the short-term, but we think the recent validation indicates that things are better in terms of the confidence level that this market someday, we don't know when that is going to happen, but someday it is going to be a big market and that PROS are to focus on doing the right things to be positioned to capitalize on that market.

John Difucci – JPMorgan

Thanks, Bert, and I think your results sort of show – you guys are certainly controlling the things you can control, and just trying to get a feel for the things you probably can't control much, and that is really the top line here. I guess Charlie, I think Bert had mentioned that bookings have improved, can you tell us, just qualitatively anyway, has the duration of those bookings has that extended out a bit, or has it gotten longer, and can you give us any color on that?

Charlie Murphy

Yes, we can. Excluding subscription, like there was a subscription contract that was close, which has a long duration. Excluding that the durations are, I would say, normal duration for our projects. So, no real change their John, as far as the duration.

And as mentioned of close, it is still big market opportunity ahead of us. I am pleased that the economy is showing certainly signs of improvement. We do see some signs that Q4's revenue, likely should be better than the Q3 revenues, we feel good about that.

Obviously, we don’t feel good about having a quarter – the third quarter with a revenue decline, but we do see some improvement in the fourth quarter, so that is helpful, and we have continued to maintain control of our spending to the extent we believe that we should be taking a discretionary spending of the Company.

We still haven't, as you know, our head count hasn’t gone down; in fact it has gone up by a handful of people in the quarter. So, we are investing in the areas that we believe we need to invest in to really take advantage of the opportunity.

And at least there may be a little (inaudible) on the fourth quarter, we can't go beyond that because it is still too early relative to the economy, and when the cycles will pick back up again for a company with an ASP the size of PROS.

John Difucci – JPMorgan

Okay, thanks. And if I might, just one last question, Charlie you mentioned, one thing revenue is affected by as cost are moving increases for maintenance, are you able to actually get to the cast of living increase for maintenance today?

Charlie Murphy

The answer is, it is very, very modest that is why I said even to a lesser extent, which is at the change from the past, because inflation is very low, cost of living increases are not contributing much at all to maintenance. It is primarily new implementations finishing and maintenance starting.

John Difucci – JPMorgan

Were you able to release old price?

Charlie Murphy

Yes, but the exception is we commented previously, I think on the fourth quarter call and the first quarter call, now this call, within primarily one segment of our business, we have had, some request, what they call hardship and it is in the travel and transportation space.

And similar to what happened in 2001, after September 11, we have made some minor adjustments, minor changes in maintenance renewal cost, that will get – will go back to the original renewal rate, once we get past this period of economic stress.

John Difucci – JPMorgan

Okay thanks, thanks a lot guys.

Charlie Murphy

Thank you.

Bert Winemiller

Thank you, John.

Operator

Our next question comes from the line of Tom Roderick with Thomas Weisel Partners, Please proceed.

Tom Roderick – Thomas Weisel Partners

Hi, Bert, Hi, Charlie; good afternoon.

Bert Winemiller

Hi, Tom.

Tom Roderick – Thomas Weisel Partners

I just wanted to see if you can add a little bit of commentary around the comment that bookings did improve this quarter, I know it has been a case in the last several quarters that it has been tough getting senior executives sign off on these deals, so it sounds like that finally came to fruition, but can you comment, you know, is this the situation were bookings are getting better, simply because some of the deals that have been out there, you know in the pipeline for several quarters, are finally closing or is there a real pickup in new deal activity and do you see that extending to a healthier pipeline, as you look in the back half of the year?

Charlie Murphy

We would say that for the most part, the bookings increase has come from situations that we are in our pipeline that got delayed, you know, if you go back to the October financial industry meltdown, then large companies in the fourth quarter, the first quarter, and partially in the second quarter have basically, the level of uncertainty was so high and they were facing lots of cost-cutting that even good proposals that were sitting on the desk just didn't get any visibility or any attention.

So, a lot of the bookings is, is really delayed bookings that were in the pipeline. Now, at the same time I would say, the sales activity levels that we are seeing at the seminars and on our webinars is a lot of new name attendees, now that isn't going to turn in, you know we have long sales cycles.

So, these new name attendees that are showing up in our sales and marketing activities, we find that particularly comforting. Now, obviously they are suspects not prospects today, but the fact that they are showing up and showing up at increasing numbers at much higher then we saw last year, you know before the financial meltdown in the fall, we find that very encouraging.

But we know there is long sales cycles, we know the approval processes, you know the deals we signed had to go through more scrutiny, more approval processes, you know then they certainly back in 2007, early 2008, so the buying process has changed and we are being very responsive to that and trying to take advantage of every opportunity that presents itself, but the bookings levels at this point in time, just give us confidence that we can make a qualitative statement that revenue in the fourth quarter will be slightly above the third-quarter.

Tom Roderick – Thomas Weisel Partners

Perfect and maybe just building on that, I know it is too early to think about 2010 as a whole, but the trend to reverse this sequential decline in revenues that we have seen for several quarters now, you're looking for that to reverse itself in Q4.

So, is that something that we can think about is being a multi-quarter trend, where we start seeing quarter-on-quarter sequential improvements into next year, is it too early to make that statement at this point, how much confidence do you have that the bookings you have are kind of a sustainable trend that can drive upward revenue for future quarters, beyond just next quarter?

Charlie Murphy

Yes, we are seeing positive metrics right now, we're seeing positive trends right now, but I would say it is too early to project beyond the comments we have made about the fourth quarter.

Tom Roderick – Thomas Weisel Partners

Okay, thanks, guys; I appreciate it.

Charlie Murphy

Thank you, Tom.

Operator

Our next question comes from the line of Nabil Elsheshai with Pacific Crest Securities. Please proceed.

Nabil Elsheshai – Pacific Crest Securities Inc.

Hi guys how are you?

Charlie Murphy

Oh great Nabil.

Nabil Elsheshai – Pacific Crest Securities Inc.

I was wondering, if you could comment – is it safe to assume that you expect license implementation consulting also to be up sequentially Q4 from Q3 based on what you're seeing in bookings?

Charlie Murphy

I would comment on it. Yes, I think the slight increase is expected to come from the (inaudible) Nabil.

Nabil Elsheshai – Pacific Crest Securities Inc.

Okay. And I guess just a follow-up on the last question, I mean I would presume then based on the bookings you are seeing that basically means new projects are starting at least an equal rate to the ones that are completing, or something to that effect, and given the length of your typical implementation, I guess I don't know why that sequential improvement wouldn't contend you to fall, as pointed out in my last question?

Charlie Murphy

That is a very, very good point. The PROS model should be go down slow and come up slow that should be the model. It is a good point; we are just not in a position to comment on anything beyond the slight increase in Q4 at this time.

Nabil Elsheshai – Pacific Crest Securities Inc.

Okay. And then on the competitive front, any updates and win rates I guess given the criteria of viability have you seen the improved win rates given that your key competitors are private companies at this point?

Bert Winemiller

I don't think we have seen any material change. I think, earlier in the year, you and others speculated that some of the French players in a tough economy, you know would either go way or become less significant. So, I would say the smaller French players that is exactly, what has happened, but the major competition that we face day-in and day-out, you know that is the same competitive landscape, and that really hasn't changed.

Nabil Elsheshai – Pacific Crest Securities Inc.

Okay. And then within your new target verticals, are there any areas of strength, I think one of the things that stood out in the enterprise phase is the manufacturing, is going to struggle in an enterprise spend, you may have different dynamics, but is there any particular verticals that stand out for the improving bookings.

Bert Winemiller

Yes, you know, what we have always said in the past, which is true is that because this is a nation market and because it is still early stage innovator, there are still few deals that you can't really discern an early adoption rate, in one industry that is significantly different than the others.

We did close deals in manufacturing and distribution, which are the big markets that are out in front of us, but it is really, you know we are all statisticians here, you know that we can't get statistical significance on adoption either at the industry level or in the sub-industry level at this time.

Nabil Elsheshai – Pacific Crest Securities Inc.

Okay, great, thank you very much.

Bert Winemiller

Thank you, Nabil.

Operator

Our next question comes from the line of David Heinz with Needham & Company. Please proceed.

David Heinz – Needham & Company

Hi, guys. We talked about in the past a little bit and I guess it seems like a good idea to get people started with a less expensive or a more modular deployment of your software, how effective has it been in terms of at least getting beachhead wins in the customers?

Charlie Murphy

You know, it is really interesting, I think we mentioned in the past that we believed and we even said it on the IPO road show that people would look for a lower price point, and potentially just put in scientific analytics without, you know signing a contract for the entire suite. And I got to tell you it is a trend, we expect it with a tough economy that that might happen, but even though there has been a few instances of that you know it isn't, it is not prevalent. It hasn't really taken over.

David Heinz – Needham & Company

Okay.

Charlie Murphy

So, it is like the delayed bookings question, I mean once people recognize the power of pricing, they recognize that they get incredible value and find a negative pocket margin products and customers in 30 days, using scientific analytics and plug the profit leaks, the very next question is, well how are we going to get optimized price guidance, you know for our contracts, and are negotiated deals into our sales force.

So, we just had an incredible set of successes in terms of implementation in the first half of 2009, but it just moves right from one phase and even if they signed a contract for everything, and they say well let's just put in one first or let's have a limited scope deployment, you know, as soon as they see the success of that, I got to tell you, they are off to the races, and they put pressure on us to accelerate the implementation of the other models.

So, I think, you will look at the pricing problems that they have to solve, which was profiled very effectively by the Gartner report and then you say, well how many of those problems do you have and do you want to just carve out one particular area, and you know just do that with no real plan for future phases, these big companies once they get it, you know there may be a phased implementation, but it is not a commitment only to do one product in the short-term, we just haven't seen it.

David Heinz – Needham & Company

Got it. And then, I guess one on the bookings backlog side of things, it is obviously difficult in getting the large deals across the finish line. The enterprise sales people with whom we have spoken have said that they are basically getting the sales process complete except for the purchase orders, so that when budget authorization frees up, the sales cycle might be, you know days instead of weeks or months.

So, I guess my three-part question will be, one, are your sales people doing this? Two, to what extent might we see snap back quarters of bookings growth, you know to fill pent-up demand for your software? And then I guess, lastly can you draw analogy scenario with the experiences you guys had in the airline industry earlier in the decade?

Charlie Murphy

Okay. The first one is, hope it is not a strategy, so we don't believe in, you know accounting on deals that are signed, and we take them through us as rigorous process, and we are not trying to tee everything up, you know if we have a customer and they believe in the value and they want to go ahead, you know, we take it all the way to contract signing and start the product launch process, and we have done some product – project launches recently.

The other thing is the airline industry went from the innovator stage to the mainstream stage to the must-have stage over a period of eight years and this market really started to move in 2006, very late 2005, now the economy has slowed it down. There is no question about it.

So, when you look at the adoption what you would say is, we are tracking to the airline industry adoption, but we definitely have slowed down moving from innovator to mainstream, as a result of this challenging economy.

David Heinz – Needham & Company

Got it. That is helpful color. Thanks.

Charlie Murphy

Thank you.

Operator

Our next question comes from the line of Ross MacMillan with Jefferies & Company. Please proceed.

Horatio – Jefferies & Company

Hi. This is for Horatio [ph] for Ross. I wanted to ask about the license gross margin, it's been trending down and I understand the reasons for that, but this quarter it was down significantly more than even you have seen in other quarters. I am wondering if there was something that caught you by surprise or is it – and should I think of that in terms of just your comp – your customers telling you the majority of the impact there is in one of your slow in the implementation process?

Charlie Murphy

I would say the primary contributing factor to the decline in the ’09 margins is that as we said in each quarter, we have not had any layoffs, we have retained all of our personnel and we expect it as we communicate in the guidance for the second quarter that revenue would be down.

I think most of us would expect it to be down the (inaudible), not the maintenance side and that has what happened. So, it is primarily – the primary reason is that we have retained our headcount because we still believe that the opportunity is there, we want to keep our trained staff, keep them with us, so we haven't brought to headcount down in our cost of services areas.

That is the single biggest contributor to that. Second, we did have a few of our resources on this – primarily in our science side that we didn't move over the implementations to help assess with some implementation efforts in the second quarter. We have that every quarter, but a little more of that in the second quarter of this year in the second quarter of last year, we expect that the decrease in the third quarter, that is one of the reasons it gave me confidence in saying, we would expect the ’09 margins to be about the same in Q3 as they were in Q2, even though we a guidance out there for lower revenue levels. Is that helpful?

Horatio – Jefferies & Company

Yes that is. So, it sounds like this is, the gross margin is a little bit more controllable with the people you're bringing over in the headcount and it is not just something customers decision to slow down and maybe a little less controlled going forward?

Charlie Murphy

Yes in the second quarter there really were no meaningful decisions to slow down. Projects always slow down a little bit, some projects accelerate a little bit, we really didn't have anything unusual in the second quarter compared to a typical quarter, unlike in the fourth quarter of last year where we did see say a customer did postpone the implementation and another customer delayed. We did not have that in the second quarter.

Horatio – Jefferies & Company

Okay and just a housekeeping question, you've had a 28%, I guess tax rate here for two quarters in the non-GAAP side, I was just wondering if we can model that going forward or should we continue to look at it as sort of 30%?

Charlie Murphy

I would say given the outlook, now, of course we have given the guidance for lower profits in the third quarter – 28% should be a good rate.

Horatio – Jefferies & Company

Okay, thank you.

Charlie Murphy

It would have gone up to 30, if we go in the other way because at some point R&E credits would be less than the growth in the Company's pretax income. The growth R&E credits will be less than the growth in the Company's pretax income and we would start moving up towards the 30%. Right now, 28% should be a good number to use.

Horatio – Jefferies & Company

Thanks.

Charlie Murphy

Thank you.

Operator

Our next question comes from the line of Nandan Amladi with Deutsche Bank. Please proceed.

Nandan Amladi – Deutsche Bank

Good afternoon, thanks for taking my question. You talked about the Gartner report were it – obviously it tells you what you already knew that there is a big market out there, are you making any changes to your go-to-market strategy in terms of perhaps expanded channels, reasonable partners, and things like that to take advantage of the eventual recovery in the economy?

Bert Winemiller

I would say we, you know we are always exploring opportunities to form partnerships, you know there isn't anything substantive to report at this time, but as we look on our strategic plan, which is all about scalability as we move from the innovator phase to the mainstream to the must have apt.

Obviously, we have got a number of implementations, where we are working with third-party system integrators and consultants, in the implementation of our software, we are also looking at how to automate, how labor in the implementation process.

So, absolutely we are thinking of scalability, and our ability to deliver software products with the implementation labor content being less and a significant portion of that labor content being done by third parties or the customers. So, it is absolutely part of our long-term strategy.

Nandan Amladi – Deutsche Bank

Okay and then related question, you continue to have roughly 25% in sales and marketing, what – where is that spending being focused?

Bert Winemiller

Well, what we have done in the past is we have, our sales teams that are part of the territory sales group solutions, and then we complement that with some of her senior leadership and professional services that really are involved with very successful total customer satisfaction deployments.

They can bring industry expertise into a sale situation. So, the combination of all those people is really similar but at the higher scope level. In other, words we haven't changed our strategy in terms of our industries, we haven't changed our strategy in terms of our approach to going to market, we are using the seminars, we are using webinars, but we are just doing more now than say we were doing a year ago.

Nandan Amladi – Deutsche Bank

Okay. Thank you.

Bert Winemiller

You're welcome.

Operator

Next question comes from the line of Philip Lamoreaux from Lamoreaux Capital Management. Please proceed.

Ashok Ramji – Lamoreaux Capital Management

Hi, Bert, hi Charlie; this is Ashok for Phil. My question is mainly about your non-target verticals, the airline's and hotel and cruise, in previous discussions you have talked about the international airlines being stronger than the domestic US counterparts. And if got the number right, I think Charlie you said 90% of airline revenue in Q2 came from outside the U.S.

So, my question is, are maintenance renewal rates for the airline's, verticals, also in the mid-90s, are the international airlines still faring well, relatively speaking, any color you could provide here and with regards to hotel and cruise, and comparing contrasts to what you saw in 2001 would be helpful? Thank you.

Charlie Murphy

Absolutely. First of all, it is 97% of airline revenues outside the United States, was predominantly international airline base. Renewal rates continue to be very, very strong in airline, they have historically been very strong. Airlines generally do not walk away from renewing, what they did, we did have some requests going back to September of 2001, with a travel and transportation industry was severely impacted. We did have some requests, that it could be a reduction in the amount of the maintenance that they pay for a period of time, and then the maintenance can be stored to the original amount.

We started commenting on this in the fourth quarter call, and that has continued, fourth quarter, first quarter, second quarter of this year. Now within the travel and transportation industry, there have been some requests for our reduction in the amount of the maintenance, but not redoing. They are renewing, renewal rates still phenomenally. It is a question of, there is a request for reduction, these companies have been with us for years and years and years, these very long-term partners. We are very receptive to providing some modest amount of support during this period of time and they will be with us for years to come. Does that answer the question?

Ashok Ramji – Lamoreaux Capital Management

Sure does. And also you are seeing that as well with hotel and cruise, is that all locked in?

Charlie Murphy

I would say, (inaudible) it was predominantly isolated to the airline industry.

Ashok Ramji – Lamoreaux Capital Management

Okay. Great, thank you very much.

Bert Winemiller

Thanks, Ashok.

Operator

There are no further questions at this time; I will now turn the call back over to Bert Winemiller for closing remarks.

Bert Winemiller

Thank you, operator. In closing, we are pleased with our second quarter 2009 results and we believe we have the expertise and resources to continue to deliver innovative high return on investment products to our customers, and as a result we intend to extend our leadership position in the pricing and margin optimization markets.

We plan to continue investing appropriately to capitalize on what we believe is a fantastic long-term market opportunity. So, thank you very much, we appreciate you taking your valuable time to listen to the call and we hope to see you soon. Operator?

Operator

Thank you for your participation at today's conference. This concludes the presentation, everyone have a great day.

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Source: PROS Holdings Inc. Q2 2009 Earnings Call Transcript
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