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NetSuite Inc. (NYSE:N)

Q4 2009 Earnings Call

February 4, 2009 5:00 pm ET

Executives

Zachary Nelson – President, Chief Executive Officer

James McGeever – Chief Financial Officer

Analysts

Laura Lederman – William Blair

Bryan McGrath – Credit Suisse

David Hilal – FBR Capital Markets

Brendan Barnicle – Pacific Crest Securities

Thomas Ernst – Deutsche Bank

Michael Huang – Thinkequity

Sasa Zoravic – Janney Montgomery Scott

Operator

Welcome to today’s NetSuite fourth quarter fiscal year 2009 conference. At this time I would like to turn the conference over to Jim McGeever, Chief Financial Officer.

James McGeever

Good afternoon everyone and welcome to NetSuite’s fourth quarter and 2009 year end 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’ll 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 the call we will be referring to both GAAP and non-GAAP financial measures. The GAAP reconciliation to our non-GAAP information is provided in the press release and on our website. All of the non revenue financial measures we will discuss today are non-GAAP unless we state the measure is a GAAP number. These non-GAAP measures exclude stock based compensation expenses, expense relating to the amortization of intangible assets and the transaction costs relating to acquisitions.

Any non-GAAP outlook we provide has not be reconciled with the comparable GAAP outlook because among other things, we cannot reliably estimate our future stock based compensation expenses which are dependent on our future stock price.

Some of the information discussed during this call including any financial outlook we provide may constitute forward-looking statements within the meanings of U.S. Federal Security laws. These statements are subject to risks, uncertainties and assumptions and are based on financial 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 forward-looking statements are summarized in the release that we issued today. They are also described in detail in 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 these 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 and thank you all for joining us today. While 2009 started in the worst of times for our customers and the global economy, we closed the year at least relative to where the year began in the best of times.

In a year that saw most of our ERP competitor sales decline, NetSuite took market share and achieved record results on the top line, bottom line and in operating cash flow. In many ways, the challenges the industry faced in 2009 made NetSuite a much stronger company as we head into 2010 and beyond.

2009 was a very painful year for traditional providers of on premise software and their struggles allowed us to put a great deal of distance between us and them. As well, 2009 showed us definitively that our efforts to move up market, to drive customer satisfaction and to verticalize our products were the right focus areas.

The impact of our competitor’s struggles, customers growing preference for Cloud based solutions and our excellent execution against our strategic initiatives are reflected in the results we are presenting today.

Q4 marked another record quarter with revenue growing to $43 million, exceeding our earlier stated outlook. For the year, total revenue reached $166.5 million, growth of more than 9% when compared to FY 2008. And more importantly, recurring revenue grew by 16% in 2009 when compared to 2008.

FY 2009 also proved to be a watershed year as we proved the profitability of our model. We recorded a non-GAAP operating profit and non-GAAP net income for each and every quarter of 2009.

In what I think is fair to call a phenomenal performance, non-GAAP net income improved 233% for the year, improving to a gain of $3.3 million as compared to the $2.5 million non-GAAP net loss in 2008. This represents a swing in our non-GAAP earnings per share of $0.09 year over year.

In Q4, our non-GAAP net income grew to $1.3 million representing a $991,000 improvement over Q3 ’09 and an improvement of $805,000 over the same quarter last year.

In addition, in 2009 we focused on operating cash flow as a key metric for the company. For the year, we far exceeded our stated target of operating cash flow breakeven by delivering $4.8 million of operating cash flow, and in Q4 we recorded our highest ever quarterly cash flow from operations, generating $3.5 million of cash.

These solid financial results were driven in part by excellent execution on the strategic initiatives we laid out at the beginning of the year. In particular, during 2009 we focused on enabling larger companies to enjoy the benefits of Cloud computing and our integrated suite of applications, and those efforts paid off for NetSuite and for our new customers.

On the sales front, we grew billings, calculated by most analysts as the change in deferred revenue plus revenue, by 18% over Q4 in 2008, our fastest billings growth rate in more than a year. Sequentially, billings grew 8% over Q3.

Q4’s billing growth was driven not only by our highest quarterly number of new customers added during 2009, but also our focus on adding the right types of customers. During Q4 we added approximately 295 new customers, the most in any quarter for the year.

Importantly, we set a record for average selling price per new customer, reaching approximately $38,000. For the quarter, our average selling price per customer increased over 10% versus Q4 of 2008 which was our previous quarterly high water mark.

Partially driving this ASP growth was NetSuite One World. One World continues to attract companies with multi-national subsidiaries and those companies tend to be larger and more complex than our traditional customers. In Q4 ’09, One World new business bookings was the highest of any quarter in the year. In fact, we have customers using NetSuite and NetSuite One World today to manage their operations in more than 100 countries around the globe.

This shift to larger company is very positive for our business model. Given the economic headwinds facing most companies, particularly smaller businesses, we closed the year with roughly the same number of total customers that we started the year with.

However, the number of paid subscribers actually grew by more than 30% during the year. In fact, the majority of customers that did not renew were at the very low end of our business where the impact of the economic shock waves of 2009 were felt most acutely.

As you recall, customers paying us less than $10,000 per year comprised less than 8% of our revenue. However, they make up roughly 40% of our customer count and they churn on average at a higher rate than our larger customers. The economic conditions of 2009 increased the rate at which these very small customers went out of business.

So in short, the customers that we lost came from the low revenue end of our customer base and these small customers are being replaced by customers that are more stable, and deliver higher revenue to NetSuite. We view this replacement cycle as good for the long term health of our business.

I mentioned already how our strategy of focusing on larger companies positively impacts the growth of subscribers this year. This increase of subscriber base is also due to increased usage of our system within a company as well as increased usage outside a company’s firewall where access is permitted to partners, vendors and customers.

For example, at the end of 2009 we measured a total of more than 1.5 million unique log in’s across our servers, indicating the increased usage of NetSuite and NetSuite as a platform.

So any way you look at the business by record financial metrics on the top line, the bottom line and cash flow, or by record customer metrics such as average selling price, growth in subscriber base and use of NetSuite as a platform, 2009 was a good year, especially in the face of a horrid economy.

As Cloud computing becomes the dominant way customers wish to procure and to use business applications, NetSuite’s market position is strong. Against the traditional mid market on premise ERP providers, NetSuite took share in 2009 and we think our market share will continue to grow as more and more customers turn to Cloud for their next generation business solutions.

As we look to the future competitive environment, we think the battle for ERP based suites in the mid market will ultimately come down to three providers; NetSuite, SAP and Microsoft. SAP struggles to create a product that competes with NetSuite have been well chronicled. It is now 2010 and by SAP’s own estimates, they should have been doing $1 billion in business from their Business by Design product by now.

However, they are still mired in a seemingly endless alpha release, unable to deliver the product beyond a hand full of users. In Q4 of 2009, the first shoot out comparing NetSuite and SAP Business by Design was held at the Sapien’s conference in Boston and NetSuite won the battle handily in a comparison of several cross departmental business processes.

Meanwhile, Microsoft’s efforts in the business of delivering sophisticated, on-demand ERP applications has largely been ignored and probably for good reason. They don’t appear to have a strategy to bring Windows centered products such as their Great Plains product line into the era of Cloud computing.

Lately, sensing the growing impatience of such a strategy in their customer base and their reseller base, they have begun talking about how customers can buy hosted versions of Great Plains. This hosted model appears to be the same archaic ASP model that failed so miserably during the dot com bubble.

We don’t believe that a product like Great Plains that was literally released before Microsoft even released the first version of their internet browser will work well over the internet. Given Microsoft’s apparent lack of even a strategy to deliver core web native business application suites over the Cloud, we expect that it won’t be long before customers and portions of their sales channel leave Microsoft for solutions like NetSuite.

Microsoft’s strategy or more accurately, lack of a strategy, will be as big of a story in 2010 as was SAP’s struggles with Business by Design between 2007 and now.

I think our announcement with Hein Partners today, one of the top 60 accounting firms in the U.S., is a harbinger of how software delivery models are changing driven by the shift to Cloud computing from the client server paradigm favored by Microsoft.

We are very excited to announce our joint partnership with Hein to provide public and private companies with a range of customized accounting and regulatory compliance solutions powered by NetSuite. Of particular note is that Hein’s professional consultants will deliver vertically focused solutions built on NetSuite and our Suite Cloud environment.

This partnership is a great example of how new approaches to delivering applications are emerging with new forms of Cloud based business applications like NetSuite. I have often said that the third party delivery model for NetSuite will ultimately be different from the third party delivery model that developed around an application like Microsoft Great Plains that was extremely hard to customize and required massive amounts of on-premise support.

Hein is just one example of many new and interesting partnerships you will see emerging around NetSuite during 2010. So the future indeed does look very bright for NetSuite. Our financial performance in the worst economic conditions in 70 years is a testament to our management and the correct bets we have made on the direction of the software market.

Our integrative suite approach to Cloud computing is a disruptive technology that has been hard for our on-premise and Cloud based competition to match. Our delivery model has gone from being a novelty in the customer’s minds to the primary way they wish to consume business applications, and our 10 year investment in creating the sales, services, and support models to deliver complex business applications via the Cloud give us enormous advantage in meeting the needs of customers around the globe.

Following Jim’s detailed remarks on our financials, I’ll close by sharing some of the initiatives we are putting in place in 2010 to further our market leadership and continue to bring the value of Cloud computing to companies around the world.

Now here’s Jim McGeever, our CFO.

James McGeever

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

I’m very pleased with our record financial results as well as the encouraging trends in a number of our key metrics. As Zach mentioned, the fourth quarter of 2009 marked a continued improvement of our operating model with a fifth consecutive quarter of non-GAAP operating income and non-GAAP profitability. In fact, Q4 also marked a record in our quarterly non-GAAP net income.

In the context of many of our on-premise ERP competitor’s shrinking revenue in 2009 we are very pleased with our top line performance. While the top line results were good, we were even more excited by the improvements in our bottom line an operating cash flow.

On the bottom line, results were exceptional and I’d like to spend some time discussing how I believe they once again demonstrate the strong earnings leverage in our SAS business model.

First, we improved non-GAAP operating income year over year by $8.2 million, a 163% improvement from 2008. We went from a non-GAAP operating loss of $5 million in 2008 to a non-GAAP operating income of $3.2 million in 2009. On a per share basis, this represents an operating income improvement of $0.13 year over year.

However, when you exclude the impact of the Japanese distribution rights to our revenue which ended in Q1, 2009 this improvement was even greater. Excluding the Japanese distribution rights revenue, our operating income actually improved by $12 million or $0.20 of operating income per share.

Our goal which we have previously stated during and after our IPO was that we intended to improve our bottom line by 200 basis points each year while maintaining strong revenue growth. So we were extremely pleased to have exceeded this goal in 2009.

We were equally excited by our operating cash flow improvement. 2009 was the first year that we gave an outlook for operating cash flow which was to be breakeven from operating cash flow for the year. We were able to achieve this goal early and in fact, Q4 2009 represented our highest ever level of cash flow from operations.

We improved cash flow from operations year over year by $13.7 million, 163% improvement over 2008. We went from cash used by operations of $9 million in 2008 to cash generated from operations of $4.8 million.

In summary, our strong revenue non-GAAP profitability and cash flow growth in the face of some of the worst economic headwinds in 70 years reinforced our belief that our Cloud based business model is not only the right model for our customers but also for NetSuite and its investors.

Driving these positives in the business model was our continued focus on moving up market and our focus across the company including sales, services and development on targeting key vertical markets. We posted strong new customer acquisitions and delivered continued increases in average selling prices.

In Q4 2009 we added the highest number of new customers in the year of approximately 295, an increase from approximately 218 I Q3 2009. We achieved an all time high in average selling price for new customers. During the fourth quarter we recorded approximately $38,000 per new customer. We believe this is directly the result of the success of our up market strategy taking hold.

Now let me turn to our financial statements for the fourth quarter and year end ended December 31, 2009. Total revenue for the year was a record $166.5 million, a year over year increase of over 9%. Total revenue for the fourth quarter was $43 million, an increase of 4% over the fourth quarter of 2008 and an increase of 3% over the prior quarter.

Importantly, recurring revenue continues to grow at a faster rate and for the year recurring revenue grew by 16% over 2008. As we have stated before, we continue to focus on recurring revenue growth as this is what we value most.

Quarterly recurring revenue grew 11% over Q4 of 2008 which is an improvement of the year over year growth rate in Q3 2008 of 9%. However, during Q4, non recurring revenue declined by 24% year over year and declined by 4% versus the prior quarter. As we have discussed in the past, non recurring revenue declined primarily as a result of the Japanese distribution rights agreement which ended in Q1 2009 as well as our focus on recurring revenue versus non recurring revenue.

We also continue to be encouraged by increased demand from our install base for additional features and modules as compared to earlier in 2009. During Q4, up sell bookings to the install base grew by 14% over Q3. This growth in up sell in the install base is an indication that our customers businesses are showing signs of improvement which we believe given the nature of our install base bodes well for the economy and the demand environment overall.

As Zach mentioned, our One World product had another strong quarter as we added more new One World customers than any quarter in the company’s history. One World continued to make a significant contribution to our new business bookings during the quarter and Q4 2009 One World new business bookings were the highest in all of 2009.

In addition, One World fees grew above the prior quarter and Q4 recorded the highest quarterly ASP’s for One World during 2009.

As Zach mentioned, while NetSuite was not immune to the challenging economic backdrop faced by most companies in 2009, we were also encouraged that we were able to replace non renewing customers on the very low end in terms of customer size with the addition of larger customers.

We believe that these larger customers offer us higher potential revenue and earnings and an additional level of stability over the long term which in turn improves the quality of our customer base and revenue visibility.

Q4 2009 also showed improvements in customer retention over the prior quarter, a trend that we have focused on continuing into 2010.

Moving on to revenue by geography, in 2009 customers located in the U.S. and Canada delivered 81% of revenue while 19% of it was delivered from international.

Non-GAAP gross margin for the fourth quarter was 68.8% up from 68.5% in Q3 of 2009. The increase in Q4 gross margin was driven primarily by improved margins in our services and support organization, offset by the impact of foreign exchange.

Our gross margin percentage is fairly sensitive to movement in foreign exchange rates as a substantial portion of our customer revenues are denominated in currencies other than the U.S. dollar.

Turning to our non-GAAP operating expenses; product development expense was $5.5 million for the quarter or 12.8% of revenue. Product development was slightly down from the prior quarter as a result of seasonally low payroll benefits which is typical in the fourth quarter.

For 2010 we expect product development expense to be roughly 13% to 14% of our revenue driven by continued investment in verticals and our One World product. Sales and marketing expenses were $17.5 million or 48.6% of revenue. Sales and marketing expenses were consistent with Q3 levels.

As planned, we didn’t make any significant hires during the fourth quarter within our sales organization. However, as we look forward we plan to increase hiring within our sales organization in the early part of 2010.

G&A expenses were $5.3 million or 12.4% of revenue. This was relatively flat to the prior quarter. Looking into 2010 we expect G&A expense to be roughly 12% to 13% of our revenue. We may have higher G&A expenses in the first half of the year as we work and implement new software recognition policies relating to EITF 0801.

During the fourth quarter we recorded an income tax benefit of $2,000 principally related to our international entities. Consistent with what we’ve outlined in prior calls for tax purposes, we expect our net operating losses to offset any domestic earnings for the foreseeable future.

Non-GAAP net income for the fourth quarter was $1.3 million versus a non-GAAP net income of $534,000 in the year ago period. On a non-GAAP basis, we reported earnings per share of $0.02 for the fourth quarter as compared to $0.01 per share in Q4 of 2008.

Moving to the balance sheet, we closed the quarter with $96.4 million in cash and cash equivalents with minimal debt. Short term deferred revenue was $67 million, an increase of 6% over Q3. This increase in short term deferred revenue was the largest sequential increase in over two years.

Long term deferred revenue totaled $5.7 million at the end of Q4, down from $6 million at the end of Q3. As outline in the past and as we continue to shift away from multi-year to one year contracts, we expect the long term component of deferred revenue to continue to decline over time.

Primarily as a result of strong sales, at the end of Q4 the calculated billings amount which is typically defined as the change in deferred revenue plus revenue was $46.2 million, an increase of 8% quarter over quarter and 18% year over year.

As I mentioned earlier, cash flow from operations was ahead of plan. This was driven by strong collections and a reduction in our days billings outstanding. During Q4, days billing outstanding improved over the prior quarter and represented an 18% improvement over the quarter ended December 31, 2008. In addition, during Q4, our billing term across all customers showed some slight improvement over Q3.

Head count at December 31, 2009 was 968 as compared to 975 at the end of the previous quarter.

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

For Q1, 2010 we anticipate revenues of approximately $43 million to $44 million. For the first quarter we expect a non-GAAP net income of $400,000 to $700,000. This equate to non-GAAP EPS of approximately $0.01 per share.

For 2010 we anticipate revenues of approximately $180 million to $185 million. For the year we expect non-GAAP EPS of approximately $0.06 to $0.08 per share.

It’s important to note that this outlook incorporates a number of assumptions I’d like to share with you. In Q4 2009, we had a very strong bookings growth. However, some of those bookings won’t turn into revenue until the later part of this year.

Our revenue recognition policy generally allows us to start recognizing revenue at the start of the contract. However, when we are dealing with more complex implementations, we delay revenue recognition until we have completed those complex elements.

In Q4 2009 there were significantly more deals subjected to this treatment than in prior quarters. As you’ve seen in the past year, as we’ve moved up market, we’ve seen more deals subject to this treatment and expect this trend will continue.

Another factor impacting or 2010 outlook is that we are planning on being an early adaptor of EITF 0801. This will change how we split and when we recognize recurring and non recurring revenue. One expected impact of this change is that all services revenue will be recognized as we complete implementations as opposed to our current standard practice of recognizing services revenue over the life of the contract.

We expect this change will reduce services revenue in the early part of 2010 but should ultimately in 2011 and beyond be a net positive to services revenue.

In addition to the impact of EITF0801, our 2010 outlook assumes improving recurring revenue growth to the mid teens. Following the adoption of the EITF0801 we’ll be able to break out recurring versus non recurring revenue on our income statements which will give you much greater visibility into the trends in our underlying business.

And finally, I will put 2010 on the bottom line incorporates not only the impact of the revenue recognition dynamic that I just stated, but more importantly, also includes our planned investments for growth which Zach will highlight in his closing remarks.

That said, this outlook on the bottom line assumes our operating income for 2010 will grow by a very healthy 70% year over year. In terms of cash flow, our goal is to increase cash flow from operations for 2010 by 75% to approximately $80.5 million. We expect 2010 capital expenditures to be roughly in line with 2009.

That concludes my prepared remarks. With that, I will turn the cal back to Zach.

Zachary Nelson

Thank you Jim. While 2009 was challenging, NetSuite ended the year on a high note. Part of our success during the year was certainly attributable to the fact that the market continues to move in the direction of the course we charted a decade ago.

As we thought it would, the cost pressures facing companies in 2009 drove companies to aggressively consider Cloud computing. In 2009 it became clear that Cloud computing and integrated business applications are the future of software.

But our success in 2009 also had to be with the focused execution of our 1,000 employees around the globe in 2009. We focused on growing the top line and we delivered. We focused on the bottom line and cash flow, and we delivered.

Strategically, we focused on pressing our advantage with NetSuite One World and in the verticalization of our Suite and both of those efforts drove NetSuite’s success and improved our customer’s ability to compete more effectively in an internet based economy.

And you can see the results of this focus in the changing profile of our customer base. Today we announced our largest in terms of users, SAP migration to date. RedBuilt LLC, a leading innovator and supplier of engineered wood products migrated to a full NetSuite roll out in only 90 days and saved hundreds of thousands of dollars.

This is another great example of how much time and money NetSuite saves our customers not to mention the enormous productivity benefits that NetSuite’s modern, Cloud based integrative suite of applications brings to these organizations.

In 2010 we are continuing to focus our efforts to move up market driven by our One World and our verticalization initiatives. We will also be investing in some key areas to further our market leadership.

In our sales organization we will add to and shift resources from the low end of the market to the mid and upper ends of the market. We are also reorganization our organizations, namely sales, services and development around going deeper in the core industries where we have seen NetSuite flourish.

As you know, much of our company is already organized around our key verticals and the changes we are making continue our investments in this regard. We will increase the number of resources working with our worldwide customers to ensure broad adoption of NetSuite through their organization.

While many think of NetSuite primarily as and ERP suite, the true differentiation of NetSuite is that it is a suite of cross departmental applications used to automate business processes across an entire enterprise and most of our customers do use Net Suite for their ERP, CRM and e-commerce needs.

Investing in resources to work with customers post implementation not only improves the stickiness of our application, it also helps customers streamline their business and operate more efficiently as they eliminate redundant applications in favor of NetSuite and of course such efforts also enhance our already strong up sell revenue.

And finally, I think this is the year the channel will finally bite the bullet and begin to transition their business model from selling archaic on-premise software to selling Cloud based suites. If traditional mid market VAR’s don’t change to meet the demand for Cloud computing solutions, they will go out of business. We saw the first signs of this with Sage’s largest reseller in the U.S. going out of business in 2009.

Given traditional vendors, especially Microsoft in the U.S. and Sage in the U.K., inability to provide partners and customers with a true Cloud computing solution for complex, ERP based business applications, we think we will see a sea shift in the channel to NetSuite.

I believe we have one of the best channel programs in the world and during 2010 it will even get better.

In closing, NetSuite is one of the best positioned software companies in the industry. Our balance sheet and financial performance are sound. We have built a global organization to take advantage of the disruptive shift to Cloud computing and our 10 year head start in delivering complex, on-demand business applications bodes well for us in 2010 as more companies move their core business applications from 1990’s style client server offerings to NetSuite solutions that have Cloud computing at their core.

So with that, we will now open the lines for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Laura Lederman – William Blair.

Laura Lederman – William Blair

I want to understand the increased investment in ’10 because it looks like earnings is going to be relatively flat year over year and so is it mainly hiring a lot more sales people, or where is that investment going?

Zachary Nelson

As I outlined at the end of the presentation, there is a bit of investment going in the sales front. There is also a shifting of resource as I said on the sales front from a focus in the low end of the marketplace, moving those resources to the higher end of the marketplace. So that’s one element.

Another important addition of head count is what I mentioned towards the end of my remarks, in terms of investing resources to work with our customers post implementation so really, on the account management front. We increased that organization or put more emphasis on that organization in 2009, but we’re actually going to increase the size of that organization in 2010.

You could roughly say an account manger today probably manages 100 net customers. This year we’re looking at having a much lower ratio of NetSuite account management to NetSuite customers, something about 40 or 45 customers to a given account manager.

So we’re putting a lot more resource on the install base again to push this notion of giving expanded use of NetSuite throughout an organization, helping our customers understand how they can use the suite or elements of the suite that they aren’t using today to streamline their business process.

So it’s proven successful in the past and we’re doubling down on it going forward.

James McGeever

One other point I’d add to that is if you actually look at our operating income, our operating income at that level of outlook is going to grow by about 70%. The outlook you’ll see at the mid point of the range is actually on the net income line, is growing about 40%.

So there’s a fairly cycle shift in the other income and expense line; that’s mostly related to our expectations of low interest income just as rates have come down, but also we do have some minority shareholder interest in our Japanese entity. We’ve been repurchasing those to own 100% of it. That legal entity is not profitable on a stand alone basis so in the past some of those losses have been taken out through the other income line and that won’t be the case in 2010.

Laura Lederman – William Blair

I appreciate that because I didn’t hear your guidance for operating income. I know you said something but I couldn’t understand it. Most of the time I read through your accent because it’s lovely, but I missed it this time, so that’s very helpful.

Can you talk a little bit about the pipe entering Q1 in terms of the sales in Q4 were so strong, we always worry that it might have impacted the ability to selling in Q1 and Q2, so could you talk about the health of the pipeline where you’re entering the first quarter.

Zachary Nelson

I think we can take a bit of a look historically. Q4 is always our strongest quarter. It was last year and we exited last year with a fairly strong Q4 and then of course Q1 happened which was, Q1 is always seasonally down, but Q1 was down pretty substantially for everyone around the globe.

I think as you look at this transition from Q4 to Q1 we’re feeling certainly much better about the pipeline than we were last year. I don’t think on any level we feel like everything got emptied out of the pipe moving into Q1, but so here we are in Q1. We’ll see how it all closes, but the pipeline and the visibility of the pipeline seems pretty solid.

Laura Lederman – William Blair

If you look at the billings ratio, I think you said it improved a little bit. It was about seven months last year in Q4. Can you give us a feel for why it was relatively flat year over year?

James McGeever

It’s actually down year over year. It improved sequentially from Q3 slightly, not very meaningful it didn’t really impact the billing calculations. But it’s actually down from over a year ago.

Operator

Your next question comes from Bryan McGrath – Credit Suisse.

Bryan McGrath – Credit Suisse

I guess you’re staring out with a new partner, Hein. I’m not familiar with them. What verticals do they specialize in?

Zachary Nelson

They’re one of the top 60 accounting firms in the U.S. so they’re a large mid market accounting firm. So I think the notion of verticalization is almost as much related to what NetSuite’s strategy around verticalization is as it is to Hein’s.

Our whole suite Cloud environment and what we’re doing with our platform strategy is about verticalizing the suite and I think if you look at what we’re doing with Hein, it’s really two things. One is leveraging their expertise on compliance and all of those elements to bring that value on top of NetSuite to their customers.

And secondly, I think the other thing that we’re going to work with them to do is bring our expertise in how to verticalize the application to the markets they’re serving today. So I think both companies are super excited about the opportunity.

We’ve been in discussions with lots of fairly large mid market CPA firms and accounting firms and Hein certainly appears to be the most aggressive in terms of shifting their model and helping their clients shift their businesses to Cloud computing infrastructure.

So I think how we go to market in the verticals we go to market will evolve over time, but it think it’s a pretty substantial relationship that we’ve put together with them.

Bryan McGrath – Credit Suisse

You mentioned a couple of time you think the channel is really going to come alive in 2010 but you didn’t mention anything specific that you’re doing. Is that a reflection of more announcements like Hein coming? Do you have anything else you can share with us along those lines?

Zachary Nelson

I truly believe we have one of the best channel programs in place today. We give our channel partners recurring revenue. On average if you sell a deal you get 30 points in year one and you get 30 points every time that customer renews. Very few companies do that in the Cloud computing world.

So number one I think we have a great program. I think what’s going to happen and to the point of are we going to change our program, yes. We have some shock and awe aspects of the program that we’re going to bring to market. That’s all I’m going to say. We’re going to make this program basically an offer the channel can not refuse in Q1. So you can keep your eyes out for that.

But more importantly the reason we’re doing it now and the reason we’re doubling down now is I believe the channel has resisted moving to Cloud computing quite frankly because they built their businesses around things like Great Plains and around Sage.

But what’s happening and this is what I predicted is Cloud computing demand has grown and these guys have to extend their business model. And it’s as big a transition for them to extend their business model to Cloud computing as it is for a traditional software company selling license to change their model to Cloud computing. It’s a complete sea change.

So I think the customer demand profile is changing and that quite frankly is what’s going to drive the channel to start to embrace NetSuite more than it has to date. That said, we do about 20% of our billings through channel partners today, so we have a fairly healthy piece of the business there, but I think this is the year that will begin to grow.

It’s been 20% for as long as I can remember as a percentage of our billings. I think this year, my hope is, that the demand in the market will force it to grow at a faster rate.

Operator

Your next question comes from David Hilal – FBR Capital Markets.

David Hilal – FBR Capital Markets

In the past we’ve gotten more data from you at year end so I was hoping to do that this time around and specifically ASP’s for One World. Historically you’ve always said about 100,000 and on this call you did say you show an increase. I want to understand the magnitude of the increase. And then you also talked about a record number of new customers. Of the 300 total new customers I was hoping to understand roughly what percent of that was One World folks.

Zachary Nelson

The numbers on One World stayed relatively the same. The ASP was above $100 K again so that was strong. The portion of bookings stayed roughly the same which has been running at about 30% of new business bookings, so that stayed the same in terms of bookings, not necessarily in terms of customer accounts.

In terms of customer count it was the highest number of customers that we sold One World to so that was really a nice piece of the business. So the metrics are all I think very solid on One World. We’re very excited about it. And then you look at the customers that are going live on the product, it’s even more exciting. So that’s a bit more color on the One World dynamics.

David Hilal – FBR Capital Markets

Let me ask you on the renewal business, or just really the ongoing relationship with customers, are you seeing them come in and buying seats? Are they adding more seats? Are they adding more functionality or is the usage kind of running flattish and things are still kind of status quo.

Zachary Nelson

Up sell continues to be very strong, not speaking about any particular segment, seats are suites, but in general I think it was our strongest. Up sell tends to offset customers that don’t renew and customers that renew for less. So typically you’ll see 100% replacement of revenue that doesn’t renew by up sell. And that again happened in Q4. In fact it was our largest over replacement of churn and down sell that we see in the year. So the up sell remains solid.

The other thing that I’d say about up sell is as we move up market, we talked a little bit about how our subscriber base grew about 30% during the year. The number of companies, the number of seats they’re buying on first go live is also starting to go up as well. So I think as you look at selling to larger companies over time larger companies will tend to also buy more during the up sell phase, at least we believe that to be the case.

So they buy more at the beginning and they buy more as time goes on. So I think up sell will continue to be strong as we move up market. That’s another factor that I think is positive for the dynamics of the up sell portion. It’s also positive for the flip side of that is the larger companies don’t churn at nearly the rate.

They renew at a much higher rate than somebody paying us less than $10,000 a year where you see lots of different dynamics at that end of the marketplace. So the up market piece is really positive for both ends of the install base dynamics.

David Hilal – FBR Capital Markets

On the EITF change, the way we understand it and obviously applies to the service component of rev and how that’s recognized. I would have thought that would help boost near term revenue because rather than recognizing something over the 12 month subscription agreement, you’re taking it in the first three months when the work is completed. So I would have thought it would help near term rev. And also can you tell us what percent of total rev is the service consulting fees because that’s a part of the part that’s affected and that would help us understand the magnitude of the impact of this change.

James McGeever

Let me start by saying this is all new territory not only for us but the industry as a whole and we’re still working on finalizing our estimated selling prices and third party evidence and we hope to finish that shortly.

What the new rules do is they talk about how you split the bookings between the elements of your revenue between services and subscription. So once you’ve done the split, now you have to determine how you’re going to recognize each of those elements.

So today with services, we recognize our services over the life of the contract. As we move forward to break our service and start recognizing them independent of the subscription, what it looks like we’re going to be ending up with in terms of the revenue recognition methods of those services business, is we’ll be on we call a completed contract basis.

So we won’t recognize our services revenue until the customer has actually gone live. And there are some reasons for that. It’s fairly technical in terms of historically what we’ve done in estimating the number of hours to complete a job.

As we work through the process and get a better history of estimating those hours, then we can move to another method which is called semi-completion. If we were on semi-completion from the start, then the impact would be exactly as you said. However because we’re looking to be on a completed contract basis, what will end up happening is deals under the old rules will continue to amortize as over the life of the contract on the balance sheet.

The new deals under the new rules we won’t recognize any revenue of those until those customers go live. So you’ve essential got a shift out by the average implementation time that services revenue. So the impact will be to push it out in the first couple of quarters and then you’ll start to see a pick up which you’ll really begin to see take full effect in 2011.

So that’s the difference in how we’re accounting for services revenue primarily accounts for that. Services revenue is a whole has been approximately mid teens for us, but one of the good things going forward with the adoption of the ITAF0801 is we’ll be able to break out our recurring and non recurring revenue on our income statement so you’ll be able to see those dynamics exactly.

Operator

Your next question comes from Brendan Barnicle – Pacific Crest Securities.

Brendan Barnicle – Pacific Crest Securities

On the Hein partnership can you talk a little bit about how long it takes to ramp and when you might see revenue coming from that partnership? Is it two quarters or a year? What should we expect?

Zachary Nelson

Going back to my general philosophy, I believe there are going to be new distribution models and new distribution partnerships to deliver Cloud based solutions to the marketplace. I’d love to literally be able to predict which channel is going to take off and which time frame, but this is really unchartered territory for most everyone.

The channel is doing and channel partners are doing very little revenue around Cloud based computer solutions other than delivering some services against them. So for example, the BT relationship we announced last year, I put many of the same caveats around that and now you’re starting to see us get some traction around BT as they sell NetSuite with their BT business organization into the marketplace.

Having that same traction, that traction was about a year or so. They were pretty committed and they still are very committed to delivering SAS type solutions and Cloud solutions to their customers.

So Hein, I think we’re both very excited about it. We’re putting a lot of marketing resource behind it and sale resource behind it. It has executive commitment on both fronts. That’s key to making these relationships work. So it think it’s some time before you see deals begin to come in, something like six months to 12 months.

You’ve got to start somewhere and it’s going to happen. As I said, we’ve worked this issue for as long as I’ve been here, so we are very well positioned I think to take advantage of when it does spike.

Brendan Barnicle – Pacific Crest Securities

On One World, obviously it’s a big cost savings for your customers and how much of sales of One World is a function of market awareness, people calling requesting proposals versus NetSuite pushing the product into the marketplace right now.

Zachary Nelson

It’s a bit of both. And I believe we introduced it in April, probably 18 months ago and so I still think we’re at the beginning of the cycle. We certainly have built up a very large base relatively speaking of customers using One World. That’s a very important part of selling enterprise software is having that referral base because Jolly B is very happy with it, they tell everybody else about it and then suddenly you’ve got a bunch of fast food companies using it.

So I think we’re still at the very early stages of One World but you can see just the numbers that we report and the continued growth and the use of that product that we are starting to see that organic fly wheel begin to turn. But again, I think we’re at the very early stages of One World.

On the company side we continue to devote resources to extending the product both on the development side as well as extending the resources at the high end of the marketplace and at the high end of our sales food chain to bringing that product to market. So I think we’re just at the beginning of this cycle.

Operator

Your next question comes from Thomas Ernst – Deutsche Bank.

Thomas Ernst – Deutsche Bank

I want to follow up on that question because it’s consistent with the progression of up market and the fact that your ASP’s have doubled from two years ago. How far up market do you go today and what do you see as your sweet spot where you do have that referral base.

Zachary Nelson

How far we go up market in enterprise applications typically has some relationship to what industry that company is in. So again, that’s why we’re focusing a lot of resources on verticalizing our company across the industries that we do well in because we can build the product to deal with the broader issues facing larger companies in those industries. So I think you have to look at it in that light.

You look at it from the software vertical for example, selling to other software companies, we have a number of publicly traded software companies running on NetSuite and One World today. So as you begin to start to hit vertical areas you begin to go to larger and larger companies.

If you look at the, an interesting deal to look at in relation to that was the RedBuilt deal that was announced today. Interesting enough they are manufacturing and distribution company, a manufacturer of wood products. We have traditionally not been that strong in the manufacturing sector.

However, you saw us over the last year extend our suite Cloud environment. We have a variety of third parties now building manufacturing extensions right on our data model. So now suddenly you can address the needs of a complex manufacturer like RedBuilt very efficiently.

In the past manufacturing would have been a market where we would have played it at the lower end of the market. With those third party add ones we can begin to move up in the marketplace. So that’s really a bit of color on why we focus on verticals. Number one, it streamlines our sales process because we speak the language of the customer.

It streamlines our service process because our services team implements just those types of customers all day long, and thirdly, it allows us to reach larger companies in those industries because we can focus our development resources on building the complex feature set they need to deal with larger, more complex business processes.

Thomas Ernst – Deutsche Bank

From a forward basis when you look at your investment to expand the account manager and the account manager capabilities and the product themselves, how is that spread across the different verticals that you’re in today? Is it more software? Is it more technology or is it spread equally across software, wholesale distribution etc.

Zachary Nelson

It’s spread in relationship to the revenue in each of those verticals so we’ve taken a look at our verticals. As I said we’ve been organizing these verticals for three or four years now so we have fairly good understanding of the customer base there and so what we’re doing is we’re decreasing the ratio of accounts to account managers so that we can spend more time with each account. That’s the simplest way to put it. So that’s the investment that’s happening there from an install base perspective.

Operator

Your next question comes from Michael Huang – Thinkequity.

Michael Huang – Thinkequity

In terms of One World SRP, I was wondering whether or not that contributed to bookings performance and how is the pipeline or activity building around that compelling product?

Zachary Nelson

SRP is doing great. We probably have 50 joint customers now that combine NetSuite and Open Air product. Those customers are, some of them are small, some of them are medium and some of them are large. So it’s really spread across all spectrums of the market there.

The great thing about this company and why we do well in services business and why we double down our investment there with the acquisition of Open Air is that services businesses are incredibly complex to run.

Even a small services business can be incredibly complex to run, so eliminating complexity by having a unified system to address the vagaries of not just tracking time but billing time, resource management, skills tracking, all of those issues that are really important to services companies really shows the whole power of NetSuite in addressing a complex business process whether you’re a small company or whether you’re a large company.

Now the NetSuite One World SRP product is really targeted are large multi-national services organizations and we’re doing some great work there in terms of addressing the complexity of multi subsidiary management, project management across subsidiaries, on and on, very complex business issues that have to do with combining the power of multi subsidiary management that you find in One World with the project and resource management that you find in our solutions set addressing how you manage service delivery people.

So we’re going to continue to invest. That’s one of the key verticals that we’re investing in and doubling down in certainly in 2010.

Michael Huang – Thinkequity

So is it 50 One World SRP customers that you have or is it something less than that now and when you look at the ramp of One World SRP versus what you saw for One World would you expect a similar one or would you expect it quicker than what you’ve seen.

Zachary Nelson

That’s all of the SRP, services resource planning customers that we have, effectively joint NetSuite and Open Air implementations. That said, one of the changes we’re making this year is to create a sales force that sells both NetSuite and Open Air.

So I think what you’ll see happen, they were separate sales forces last year. So when we combine those sales teams and have common sales management that’s driving the combined solution versus two sales organizations driving the combined solution, I think you’ll see uptick of the NetSuite SRP product increase in the coming year.

Michael Huang – Thinkequity

On customer acquisition, obviously a strong Q4, I wanted to find out some of the drivers behind that. How much would you attribute to better sales execution or a better selling environment or some Q4 flush? Could you talk about what drove that and how does that trend over the next several quarters given that we hope to see a more favorable spending environment.

Zachary Nelson

I think if you look at the year as a whole Q1 and Q2 were not the most enjoyable quarters of my career but you definitely saw a turn around relative to those in Q3 and Q4 so the selling environment definitely improved as the year went on. You can look at some of the acceleration of the bookings and those things as evidence of that.

The other thing that happened I think during the year was just this mad rush, and I think an understanding of the benefits of Cloud computing can bring to companies. A lot of that was driven by the fact that people view it as a cost cutting measure, but at the end of the day, what they’ve seen from Cloud computing is it’s faster, it’s cheaper and it’s better.

And while cheaper may have been the most important thing in their mind in ’09, the faster and the better didn’t escape their glance. So I think that also played a very important role.

And lastly, I think in our particular space, the ERP driven suite space, I think the fact that SAP was out there talking about how important it is to buy a suite of applications delivered on demand is starting to help our business because they don’t really, they can’t really sell you that today. In fact I don’t think they will sell you that today, but that’s all NetSuite sells all day long.

So the fact that they’re investing their resources and their clout behind our message certainly helped us during the year and I think will help us in 2010.

James McGeever

One final point in terms of execution, Q4 actually represented the highest level of sales productivity we’ve ever had so it was very strong from an execution standpoint.

Michael Huang – Thinkequity

If you were to drill into the major product areas within the suite, so e-commerce and accounting are there any areas that are outperforming others or trending in any particular direction and as you look at allocating R&D across these buckets through 2010 is there any particular area that’s getting the lion’s share of the love?

Zachary Nelson

As I said in my comments, we market to a variety of pains that customers have but at the end of the day, 95% of the customers that come in buy the suite. They buy the application with the thought of running multiple departments on it. So of that 95% that buy the suite, 100% will implement ERP effectively and then 70% implement CRM in all of its forms, sales management, order management or e-commerce aspects of the product.

So a large, large portion a large majority of our customers are buying the suite and using the cross department capabilities and the cross departmental functionality that the suite promises.

Operator

Your next question comes from Sasa Zoravic – Janney Montgomery Scott.

Sasa Zoravic – Janney Montgomery Scott

Similar question to the last one, namely when you are talking about sort of focusing on reducing the number of clients that an account manager serves and adding more sales people, how do you really allocate or plan to allocate those against verticals. Will all the verticals in which you’re strong be benefiting equally or are there some that you’re prioritizing over others for 2010.

Zachary Nelson

I’d say it’s basically everyone will be benefiting equally. Again, it’s a matrix of how big of a customer in any given vertical and how many customers do you have in that given vertical, and then you assign those accounts to reps in ratios that you want to maintain at a low level so that you can have good interaction with your customers and not be torn between calling this customer versus that customer. That’s really what it’s about.

So if you look at our software companies using NetSuite, the software verticals tend to be larger than companies using NetSuite at wholesale distribution. That’s because software companies tend to be larger. Wholesalers and distributors tend to be smaller by definition. So perhaps an account manager in software may be managing 10 very large accounts where an account manager in wholesale distribution may be managing 40 relatively medium sized accounts.

So we’ve gone through a fairly detailed analysis on how to allocate that but nobody is getting any less love in any one vertical when compared to another.

Sasa Zoravic – Janney Montgomery Scott

So for 2010 probably at the end of the year it would also be fair to say that each of the verticals likely would be representing just about the same amount of revenue? There are no specific verticals where you want to grow faster than the others?

Zachary Nelson

Not necessarily. Historically wholesale distribution has been our largest vertical but they tend to be smaller companies. Services is definitely up there now given our success with NetSuite SRP.

James McGeever

I would say there’s a couple of areas which I think you’ll see probably stronger growth in some of our verticals. One is software. The new revenue recognition rules EITF0801 I think is going to be a driver business, not just software companies but a lot of technology companies and service based businesses will have to adopt that in 2011 and so we think that’s going to be a driver of business.

Within manufacturing this is really a new vertical for us in terms of having a fully fledged integrated MRP system and that’s really a vertical we’ll put a lot of effort behind this year so we expect to see stronger growth in that.

And the final one really I expect to see relatively stronger growth is within the services vertical just with the success of the Open Air and NetSuite integrated product, and as we saw One World SRP and combine those sales forces.

So those are the three I think will probably show relatively stronger growth versus some of the others.

Sasa Zoravic – Janney Montgomery Scott

When you mentioned the split 81 versus 19 domestic versus international was it the fourth quarter or for the full year?

James McGeever

That was for the fourth quarter.

Sasa Zoravic – Janney Montgomery Scott

So if that’s the case then domestic and international growth have kind of been on par with one another through the past several quarters. Would you expect that to be the case also going forward?

James McGeever

You may begin to see a pick up. The areas that got hit the hardest during 2009 during the recession was actually Amir. We’ve seen those guys come back. The rest of the world, Asia and Australia where we had other significant revenue have been relatively strong and actually relatively stronger than the U.S.

So it really was Amir that was bringing it down so if Amir comes back on line with the trends that have existed, then international could grow slightly stronger.

Sasa Zoravic – Janney Montgomery Scott

Regarding acquisitions, how do you look at acquisitions in this kind of market environment? Any plans there that you might want to be sharing with us?

Zachary Nelson

The acquisitions we’ve done to extend our NetSuite resources planning product have gone I’d say very well for the company and very well for our customers. So I think as we look at our strategy, the place we look at potentially acquiring companies is in extending that verticalization strategy.

When we acquired Open Air what that allowed us to do was we acquired a product that had been in development 10 years really just targeting the needs of services oriented businesses. So we got 10 years of domain expertise, 10 years of development and that pulled us up into the higher end of the marketplace.

So while we don’t really have anything burning right now, those are the kinds of things that we look for, are acquisitions that can extend our functionality in the verticals that we serve today.

Operator

There are no further questions at this time. I will turn the call back over to NetSuite’s CEO, Mr. Zach Nelson.

Zachary Nelson

Thank you all very much for joining us today. We really look forward as a company to what we’re going to achieve in 2010 and we’ll certainly keep you updated on our plans as we go forward. Thank you very much.

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Source: NetSuite Inc. Q4 2009 Earnings Call Transcript
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