QAD Management Discusses Q2 2014 Results - Earnings Call Transcript

| About: QAD Inc (QADA)


Q2 2014 Earnings Call

August 27, 2013 5:00 pm ET


John Neale - Senior Vice President of Finance and Treasurer

Karl F. Lopker - Chief Executive Officer and Director

Daniel Lender - Chief Financial Officer, Executive Vice President and Secretary

Pamela M. Lopker - Founder, Chairman and President


Matthew Paul - Sidoti & Company, LLC

Mark W. Schappel - The Benchmark Company, LLC, Research Division


Good afternoon, ladies and gentlemen, thank you for standing by. And welcome to the QAD Fiscal 2014 Second Quarter Financial Results Conference Call. [Operator Instructions] As a reminder, today's conference call is being recorded. I would now like to turn the conference call over to your first speaker, John Neale. Please go ahead.

John Neale

Hello, everybody, and welcome to today's call. I'm John Neale, QAD's Senior Vice President and Treasurer. Earlier today, we issued a press release announcing QAD's financial results for the fiscal 2014 second quarter ended July 31, 2013. The press release and associated financial statements are available through the Investor Relations section on our website at Additionally, please be advised that this call is being webcast live on our website.

Before I begin, I need to ensure that everybody on today's call understands that our discussion might contain forward-looking statements that are based on certain expectations and analysis. Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated. QAD takes no obligation to revise or update these forward-looking statements to reflect events or circumstances after the date of this call. For a complete description of these risks and uncertainties, please refer to QAD's 10-K and 10-Q filings with the Securities and Exchange Commission.

Now I'd like to turn the call over to Karl Lopker, QAD's Chief Executive Officer.

Karl F. Lopker

Well, good afternoon, and thank you for joining us to discuss our second quarter results. The phone connection may be a bit uneven since Pam and I are traveling, however, Daniel Lender, Chief Financial Officer, is in Santa Barbara. While we had a good quarter in our core business, which is pretty much on target, but we're most excited our strong On Demand activity, which hasn't yet been reflected in our reported numbers. For the first half of the year, we booked more On Demand business than in the entire previous year. As we've discussed, On Demand bookings generally don't create any revenue in the quarter of the booking, but we do incur sales costs which hurt the bottom line. However, we do believe that our transition to On Demand is critical to our future. Service bookings were again strong due to good license revenue and the On Demand bookings.

Daniel will give you the numbers and I'll discuss the details. Daniel?

Daniel Lender

Thank you, Karl. Total revenue was $65.2 million for the second quarter of fiscal 2014, up 7% from $61 million last year. DynaSys and CEBOS, which we acquired in the last fiscal year, contributed $2.2 million. There was a partial quarter contribution of $1.1 million from the DynaSys for last year's second fiscal quarter.

Foreign currency had a negligible impact on revenue. License revenue grew 25% to $8.6 million, up from $6.9 million for last year's second fiscal quarter. This quarter, we closed 16 deals with license revenue greater than $100,000, of which 6 were greater than $300,000 versus last year, where we closed 11 with license revenue greater than $100,000, of which 2 were greater than $300,000.

Maintenance and other revenue rose to $34.3 million, up from $33.9 million last year and down from $35.2 million last quarter.

Professional services revenue was $17.9 million, an increase from $16.4 million last year. As we mentioned last quarter, due to the nature of large multielement transactions, services revenue tends to fluctuate from the effects of ratable recognition in the achievement of milestones, while costs related to these engagements are expensed as incurred. As a result, we expect to continue to experience some fluctuations in our services margin on a quarterly basis.

Subscription revenue, which includes QAD On Demand, grew 19% to $4.5 million, up from $3.7 million last year. On Demand bookings were very strong for the quarter, with more than 70% coming from North America, which is consistent with historical percentages.

Looking at total revenue by vertical, high tech and industrial represented 34%; automotive, 28%; consumer products and food and beverage, 22%; and life sciences, 16%. By geography, North America represented 43%; EMEA, 33%; Asia Pacific, 18%; and Latin America, 6%.

Gross profit totaled $36.4 million or 56% of total revenue for the second quarter of fiscal '14, compared with $34 million or 56% of total revenue in the same quarter of last year.

Sales and marketing expenses totaled $15.9 million versus $14.7 million during the second quarter of last year. The increase primarily reflected $800,000 of higher commissions and bonuses, mainly driven by higher revenue, including deals not fully recognized in the quarter and new On Demand deals, as well as an additional $400,000 of costs related to DynaSys and CEBOS. As a percentage of revenue, sales and marketing expense totaled 25% and 24% for Q2 FY '14 and Q2 FY '13, respectively.

R&D expense for the second quarter was $10.5 million or 16% of revenue compared with $9.2 million or 15% of revenue for the same quarter last year. DynaSys and CEBOS added $500,000 to this expense category during the second quarter of fiscal '14. Also, this year's second quarter R&D expense included $400,000 less joint development income versus the same quarter last year.

General and administrative expense totaled $8.4 million, the same as in last year's fiscal second quarter. The DynaSys and CEBOS acquisitions added $400,000, which included $300,000 of termination costs to G&A expense in this year's second quarter. As a percent of revenue, G&A expense was 13% for this Q2 compared with 14% last year. This brings total operating expenses to $34.9 million or 54% of revenue for the fiscal 2014 second quarter, compared with $32.4 million or 53% of revenue for the same period a year ago.

Total expense related to DynaSys and CEBOS was $3.4 million for the second quarter of fiscal '14 compared with $1.2 million last year. Equity compensation expense totaled $1.6 million for the second quarter of fiscal '14 versus $1.4 million a year ago.

Operating income amounted to $1.5 million compared with $1.6 million for last year's second fiscal quarter. Other income was $673,000 versus other expense of $258,000 last year. The change reflected income related to fair market value changes of interest rate swaps associated with the mortgage of -- on our headquarters, offset by foreign exchange losses primarily related to the euro. Net income was $1.3 million or $0.08 per diluted Class A share and $0.07 per diluted Class B share. Net income for last year's second quarter was $959,000 or $0.06 per diluted Class A share and $0.05 per diluted Class B share.

Our tax rate for the second quarter fiscal '14 was approximately 42%. For the full year, we expect a tax rate of approximately 40%.

Subsequent to quarter end, QAD became aware of new information in relation to its California Research and Development tax credits. As a result, the company may record a noncash charge to income tax expense of up to $2.6 million in the third quarter of fiscal 2014. The company is in the process of assessing the impact, if any, of this new information, and our guidance this quarter does not include the effect of any potential charge.

For the year-to-date period, cash flow provided by operations increased to $13.1 million from $11.4 million.

I'd like to briefly review our year-to-date results. Revenue rose to $127.1 million, up from $124.7 million for the first 6 months of fiscal '13. The acquisitions contributed $4.3 million in revenue for the first half of fiscal '14 versus $1.1 million for the same period last year. Gross margin was 55% of revenue versus 57% of revenue for the first half of fiscal 2013. Total operating expenses amounted to $70 million or 55% of revenue, compared with $65.5 million or 53% of revenue for the first 6 months of fiscal 2013. The acquisitions contributed $6.8 million to total expense, compared with $1.2 million for the same period last year.

We had breakeven performance for the first half of fiscal 2014. For the same period of last year, net income was $2.8 million or $0.18 per diluted Class A share and $0.15 per diluted Class B share.

Moving on to the balance sheet. We ended the fiscal 2014 second quarter with cash and equivalents of $69.4 million compared with $65 million at the end of fiscal 2013. Accounts receivable equaled $42.7 million, down from $72.6 million at the end of fiscal 2013. The decrease reflects a typical seasonal decline, as well as strong cash collections. Accounts receivable for the second quarter fiscal 2013 was $36.3 million.

Day sales outstanding, using the countback method, was 53 days for the second quarter fiscal 2014 versus 52 days for the second quarter of fiscal 2013. The quality of our receivables remains good.

Our deferred revenue balance was $86 million, which included $70.8 million of deferred maintenance, $6.4 million of deferred subscription, $5.7 million of deferred license and $3.1 million of deferred professional services. At the end of last year's second quarter, our deferred revenue balance was $77.1 million. And at the end of fiscal 2013, our deferred revenue balance was $101.2 million, and the decline from the 2013 year-end reflects normal seasonality.

Our business outlook for the fiscal '14 third quarter calls for total revenue of approximately $65 million on earnings of approximately $0.07 per diluted Class A share and $0.06 per diluted Class B share.

That concludes my remarks. I'll turn the call back to you, Karl.

Karl F. Lopker

Okay. Well, thanks, Daniel. Licenses, maintenance, services and subscription revenue came in roughly on target. And as both Daniel and I pointed out, On Demand bookings were very good in the second quarter. For the first of the year, we signed 21 new customers or divisions for On Demand, about the same number as all of last year.

In reviewing the first half, we see 3 situations where On Demand is making the most sense for our customers. The first is conversions of an existing customer to On Demand, usually at the time of an upgrade, and when new hardware needs to be purchased. This has been about 50% of our On Demand business, and creates the most immediate On Demand revenue stream. These deals also have short sales cycles, as we had 2 deals closed in the quarter that were not in the funnel at the beginning of the quarter.

The second situation is spinoffs, where the acquiring company wants to continue to use QAD applications but does not want to purchase the software and hardware, and instead chooses On Demand. This also creates an almost immediate On Demand revenue stream. These first 2 situations do reduce maintenance somewhat, since maintenance is scheduled -- is included in On Demand subscription billing.

And the third area is completely new divisions and new customers, where On Demand revenue stream comes over 1 to 2 years, as the customer rolls out our application. This is in contrast to a perpetual license transaction, where we receive the revenue immediately, assuming no deferrals, of course. The difference in the timing of these different revenue streams makes revenue and profitability forecasting difficult. Even so, we certainly feel that the transition to On Demand is important for the long run.

The funnel for On Demand continues to be around 25% of our total funnel. However, the total funnel is down around 5% from last year, mainly due to a larger number of On Demand deals that we closed right at the end of the quarter. In the services area, we've been concentrating on getting customers to upgrade their systems, and the strategy continues to work well. Most On Demand conversions also include an upgrade, which drives services revenue.

Our 2 recent acquisitions are performing on target for the first half of the year. DynaSys had a slower quarter than the first quarter due to the French economy, although the first quarter did exceed our expectations. CEBOS had a good quarter with a big license order from Europe, and they're working on a new release of their On Demand quality product. We believe that the economic conditions in manufacturing had a slightly positive effect on our results this past quarter compared to last year, and we're encouraged by the continued positive growth in North America manufacturing and recent positive PMI in the Eurozone in China.

Regional and vertical results were generally in line with recent history, and full-time employee headcount was down about 1% from last year to 1,540, reflecting our constant control on costs. I'd like to turn the call over to Pam for a minute, for a closer look at our On Demand activity. Pam?

Pamela M. Lopker

Great, Karl. Karl, let me know if I'm breaking up at all, because I'm worried a little about my connection here.

Karl F. Lopker

Pam, it's fine now.

Pamela M. Lopker

Am I sounding okay?

Karl F. Lopker


Pamela M. Lopker

Okay, great. Thank you. Today, I'd like to give a bit of color to the type of deals we saw for On Demand in Q2. As Karl mentioned, we are getting a good mix of deals from net new sites and from companies that are currently using QAD On Premise moving to On Demand offering. I'd like to highlight 3 examples of deals in Q2 that have good representations of the opportunities we won.

So first off, a net new win in the U.K. It was a GBP 250 million plastic packaging division of a GBP 2 billion group. The larger group had a SAP strategy, and our key competition was some SAP, which was strongly pushed by corporate. The QAD team used our standard engagement model of a discovery and a vision to understand the business requirement and to gain executive confidence. QAD was able to show strong business process capabilities and a global presence that fit their needs. QAD On Demand was deemed to be less risk, with the ability to budget and control costs. The company has just started their rollout, which will take us from Europe to the U.S., and then to Asia Pacific.

The next customer I'd like to highlight is a U.S.-based luxury jewelry manufacturer. This company has been a QAD customer for the last decade since actually 2002. The company wanted to get out of the IT business so that their IT team could focus on the internal customers needs for business process optimizations. They felt that going to On Demand would be the best way to reduce IT distraction, and they also wanted to stay current on releases but struggled to find the time to upgrade. On Demand solved that problem and freed up their IT people to focus on optimization of business processes.

The last example I want to highlight is the net new customer, which was $100 million contract package manufacturing company for pharmaceutical. The company was running an accounting package and a manual document management procedure to produce packaging materials and instructions. Their customers challenged their ability to do track and trade, as well as trend analysis for deviations from quality standards. They recognized the need for a full ERP, and a system that would grow their business at the anticipated 30% a year that they're currently experiencing. The company selected QAD due to our On Demand offering combined with our validation offering for life science companies, our prescriptive implementation approach and our capabilities in key life science requirements such as product serialization, which is a legal requirement in California starting 2015. The company received strong recommendations from both our customers, as well as competitors that are currently QAD users. There's no real ERP system, very limited IT staff. QAD On Demand made a lot of sense, allowing them to focus from their core business of packaging. After the initial implementation and validation, we expect the phase 2 engagement for a serialization and CEBOS' quality management application. Thank you, Karl. Back to you.

Karl F. Lopker

Okay, great, Pam. As you can tell, we're excited about the prospects for On Demand, and we see activity there picking up. Our challenge is to balance revenue and profitability during the transition to On Demand. On the balance sheet, cash continues to look good, which is important, as our growth in On Demand continues to accelerate.

Now as usual, we'll take questions from the analysts. Operator, can you give the instructions for the questions?

Question-and-Answer Session


[Operator Instructions] We'll first go to the line of Matthew Paul with Sidoti & Company.

Matthew Paul - Sidoti & Company, LLC

In regards to growth in On Demand bookings, do we look at the longer-term gross margin rate back towards 60% where it's traditionally been or maybe a little higher?

Daniel Lender

Matt, it's Daniel. Yes, regarding to our subscription revenues, we do look at about a combined -- or I should say our plan is for a combined 60%-or-so gross margin for that line of business.

Matthew Paul - Sidoti & Company, LLC

Okay. And moving forward to the conversion of your customers. How seamless of a transition is it for a customer to go from the license deal to the subscription deal?

Karl F. Lopker

Pam, do you want to cover that from a customer experience standpoint?

Pamela M. Lopker

Sure, I'll take that. Certainly, a current customer on a fairly current release of QAD, we just do a simple technical upgrade to latest release, and that's very seamless and very fast. It can happen in a few weeks, even a couple of weeks. If it is a net new customer like the first one I mentioned, it's what, a $400 million company, they're global, they've got lots of sites. That roll-out implementation is going to take anywhere from 6 months to 12 months, depending on how fast they want to bring on board all their sites. We have larger customers that are in the 1 billion plus that are in the midst of rollouts, and certainly those rollouts can take 12 to 18 months. So if they're on QAD already, they just do a technical upgrade, and that's quite fast and easy. If they're a net new customer, well, we do try to make that as fast as possible and we have a lot of streamline on-boarding tool. We're still doing a software implementation. I'm trying to think we implemented work day ourselves, and I think it took us almost 14 months to implement that, which I was surprised then, it's just such a niche module. So there is soft -- there is implementation involved in anything that you do.

Matthew Paul - Sidoti & Company, LLC

Okay. And during the implementation, do you need QAD IT personnel on your customers premises at all times?

Pamela M. Lopker

No, no. You wouldn't have IT personnel. You may have services people really looking at implementation. How do you want to do your product, how do you want to sell it to customers, what's the methodology you want to use in manufacturing? So certainly, you want to have IT people. The On Demand system is -- can be initiated in minutes. You just say, new customer, here's the configuration they want, and that all happens in the background quite seamlessly.

Matthew Paul - Sidoti & Company, LLC

Okay. And last question, I'm curious to know what or any of your customers have to comment about keeping them -- keeping their deal as a perpetual license or not interested in switching to subscription. Are they your larger customers or?

Pamela M. Lopker

Well, that's interesting. We actually see kind of a stratification there that small companies which are possibly not QADs typical customer, feel like they can do it cheaper themselves because they haven't really looked at the cost of IT. It might be the engineering managers, the manufacturing manager, whatever, that's handling the system stuff, putting patches on, doing that kind of work, and they don't have a clear understanding of the cost of maintaining their own in-house system, whereas larger companies absolutely know what it cost per user to maintain their internal IT systems, and they're more than happy to give that up. So I would say that we have a good amount, at least a handful of customers that are in the billions, $2 billion range, moving to On Demand. Probably at a very large end, you're not going to see the whole enterprise go there for a while, but you'll see them saying, "Boy, Brazil's too much of a hassle for us, maybe China is too. We don't want to have to do that." So they're more than willing to give up different geographies of their enterprise and also, potentially, different modules. We're seeing -- with AIM, we're seeing customers implementing Enterprise Asset Management On Demand. We also believe there will be marginal demand for things like quality management.


We'll next go to the line of Mark Schappel with Benchmark.

Mark W. Schappel - The Benchmark Company, LLC, Research Division

So Karl, starting with you. On the operating margin front, it looks like the operating margins have kind of in the kind of low to mid-single-digit range here, kind of bouncing around in that range. I was wondering if you just give us what your strategy or plan is for operating margins going forward?

Karl F. Lopker

Well, as On Demand grows, we'd like keep those -- we'd like to keep that positive operating margin. Certainly, we want to feed the On Demand machine, so we're very interested, making sure that's working if we need to pay commissions up front before we get the revenue, we're going to do that. If we need to invest in infrastructure, we're going to do that. But right now, we wouldn't. It's growing at a rate that we believe that we can keep them certainly a positive operating profit.

Matthew Paul - Sidoti & Company, LLC

Okay, and then next question. Last quarter, you noted a slowdown in your business in China, and I was wondering if there's been any kind of change or update with respect to your view in that country.

Karl F. Lopker

Well, the PMI has come back to the positive territory, so that's good. I don't know -- I haven't looked at the numbers from just exactly China to see how they're doing right now, so I couldn't answer that.

Daniel Lender

Yes, China's back to what I would consider more of a normal rate, Mark. I think we did experience a little bit of a slowdown, but I think it's back to a normal run rate.

Mark W. Schappel - The Benchmark Company, LLC, Research Division

Okay, great. And then Pam, I was wondering if you could just speak to a little bit about your new quality control functionality for your life science manufacturers. And also competitively, are you seeing some of the usual suspects in life sciences or do you have a whole new set of competitors there?

Pamela M. Lopker

Life science is an interesting market. Certainly, I think it's one that companies would like to get into. But we did a lot of work up front, making sure that our On Demand capabilities were validatable, if that's a word. So we spent a lot of money getting audited ourselves and going through the same type of procedure that you'd have to go through to get an FDA audit as a life science company. So we have, I think, that's been a strong advantage for us. I don't know the exact number, but life sciences either are #1 or #2 vertical for On Demand, because they look at that as a great addition to be able to have a validatable environment. So I think right now -- and we just invested, as I mentioned, in that first, I think it was, or maybe just the last one, the pharmaceutical packaging company, we're just releasing a big module in what's called serialization. It's oftentimes called pedigree, being able to track down back to the customers' different serial numbers. And not only what's in that serial number, but what's in that serial number. So there is a different serial memory, that's a component of it, and it's becoming a real requirement when there's a recall. So I think we have a good offering in that area. Obviously, there is competitors that will be there, some kind of point solutions maybe like Massive Controls or Pilgrim, Sparta Systems which are more quality control systems in that area. But for an ERP system and an On Demand environment, boy, I'm not thinking there's a ton of competition there, and then certainly we're working with our CEBOS acquisition to have very strong EQMS capabilities in their quality management product to augment the life science areas, surpass the competition in that area. So we felt good about that as being a great niche for us. Probably talked too long, but there you go.

Mark W. Schappel - The Benchmark Company, LLC, Research Division

Okay, great. And then one final question. Daniel, for you. Cash flow from operations in the quarter, I believe you mentioned it for the 6 months, what was it in the quarter?

Daniel Lender

So for the quarter, it was positive, Mark. And hold on a second, let me give you the number. So cash flow from operations for the quarter was $800,000.


And with that, we will turn the conference call back over to management. Please go ahead.

Karl F. Lopker

Okay. Well, thanks, everyone, for your attendance and your questions. And I'll update you again in November with our third quarter results. Goodbye for now.


Ladies and gentlemen, this conference will be available for replay, beginning today, August 27 at 4:00 p.m., and lasting until September 4 at 11:59 p.m. During that time, to access the AT&T Executive Playback Service, please dial 1 (800) 475-6701 and enter the access code 297006. International participants may dial area code (320) 365-3844, use the same access code of 297006. That will conclude your conference call for today. Thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect.

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