Blackbaud Management Discusses Q4 2013 Results - Earnings Call Transcript

| About: Blackbaud, Inc. (BLKB)

Blackbaud (NASDAQ:BLKB)

Q4 2013 Earnings Call

February 13, 2014 8:00 am ET

Executives

Robert Weiner

Anthony W. Boor - Chief Financial Officer, Principal Accounting Officer and Senior Vice President of Finance & Administration

Michael P. Gianoni - Chief Executive Officer, President and Director

Analysts

Tom M. Roderick - Stifel, Nicolaus & Co., Inc., Research Division

Ross MacMillan - Jefferies LLC, Research Division

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Operator

Greetings, and welcome to Blackbaud's Fourth Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Rob Weiner, Director of Investor Relations for Blackbaud. Please go ahead.

Robert Weiner

Good morning, everyone. Thank you for joining us today for Blackbaud's Fourth Quarter and Year-End Conference Call. Today, we will review our fourth quarter and full year financial results for 2013, and provide our goals for 2014.

Joining me on the call today are Mike Gianoni, Blackbaud's new President and CEO; and Tony Boor, Blackbaud's Senior Vice President and CFO. Mike and Tony will make prepared comments and then we will open up the call for your questions.

Please note that our comments today contain forward-looking statements. These statements are made based solely on 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 SEC filings, including our most recent quarterly report on Form 10-Q, our most recent annual report on Form 10-K, all amendments thereto and the risk factors contained therein, as well as our periodic reports under the Securities Act of 1934 for more information on these risks and uncertainties, and on the limitations that apply to our forward-looking statements. Also, please note that a webcast of today's call will be available on the Investor Relations section of our website.

During this call, we will be referring to both GAAP and non-GAAP financial measures. We believe that non-GAAP financial measures are more representative of how we internally measure the business. However, non-GAAP financial measures should not be considered in isolation from, or as a substitution for, GAAP measures. A reconciliation of GAAP and non-GAAP results is available in the press release we issued last night, which is available on our website at www.blackbaud.com.

Over the next month, the Blackbaud team will be participating in a couple of investor-focused events, beginning in early March, meeting with investors in Houston and Dallas. And on March 17, in New York City, presenting and meeting with investors at the Sidoti & Company 18th Annual Emerging Growth Forum.

I'm now pleased to turn the call over to Blackbaud's Senior Vice President and CFO, Tony Boor.

Anthony W. Boor

Thanks, Rob. Good morning, everyone. Thanks for joining us today to review our fourth quarter performance and recap the full year of 2013.

Let's begin the call by welcoming 2 new members to the Blackbaud team. Rob Weiner, from whom you've just heard, recently joined Blackbaud as our Head of Investor Relations. Some members of the investment community now have a resource here at the company to call upon. And I'd also like to welcome Mike Gianoni to the call and to the company. As many of you are aware, Mike is Blackbaud's new President and CEO, who joined us exactly 1 month ago on January 13. Mike will be making some comments a little bit later on during the call. We're pleased to have Mike join the company and I'm looking forward to working with him to accelerate our growth and profitability over the long term. We're already off to a fast start together working to kick off 2014.

Now, let's turn to our fourth quarter performance. We delivered non-GAAP revenue of $134.9 million, an increase of 11.7% over Q4 of 2012. Importantly, 72% of our total revenue was derived from subscriptions and maintenance in the fourth quarter of '13, compared to 69% in the fourth quarter of 2012. The fastest-growing segment of the business continued to be subscription, where we had 23% growth for the full year when you exclude the net to gross accounting presentation change.

With more than 2/3 of our total revenue in the fourth quarter generated from subscriptions and maintenance, we are continuing to make progress in our shift to become a predominantly recurring revenue based company. It's important to note that our organic revenue growth in the fourth quarter was approximately 7%, when you strip out the net to gross change for our Blackbaud Payment Services business. I'll remind you why we changed the presentation of the Blackbaud Payment Services revenue from recognition on a net basis to a gross basis. The regulatory environment has become more complex and our historic third-party payment processor made the decision to exit this business. We now have a new partner, where responsibility for providing end-to-end merchant services over the course of customer transactions has increased. As a result, recognizing revenue on a gross basis is more appropriate when we move forward.

Turning to profitability. Non-GAAP gross margin was 55.7%, which was below last year's fourth quarter, and primarily reflected the change from presenting net to gross accounting for our Payment Services business. Excluding this accounting presentation change, our core gross margin was positively impacted by increased scale of our subscription revenue base, which represented 45% of our total fourth quarter revenue.

Our gross margin would have been 59.5% if presented under the old net method. We generated non-GAAP operating income of $25.1 million, representing the non-GAAP operating margin of 18.6%. The operating margin in the fourth quarter was lower sequentially compared to the third quarter due to operating investments in our go-to-market strategies and product optimization efforts, which, if you'll recall, I spoke about on the third quarter call.

Due to our overperformance in '13, we accelerated some of our planned 2014 operating investments into our 2013 fourth quarter. Additionally, our change in accounting presentation from net to gross recognition in our Payment Services business impacted operating margins by 124 basis points in the fourth quarter. This net to gross change will continue to impact our operating margin in 2014 and beyond. We expect a 90 basis point impact in operating, or EBIT margins, in 2014 as a result of this change, which doesn't affect any economics in the business but does have an optical impact on the P&L. Our non-GAAP diluted earnings per share were $0.32 for the quarter. This performance is 18.2% ahead of last year's fourth quarter.

Now let's look at the balance sheet and cash flow statements. In the fourth quarter, we generated $29.3 million in cash flow from operations, used $5.6 million to pay our quarterly dividend, invested $7.5 million in capital expenditures and capitalized software and used $20.8 million to pay down our debt. We ended the quarter with $152 million of debt, which is down $20.8 million from the third quarter and from $215.5 million at the end of last year, reflecting $62.6 million of net debt reduction in 2013.

Our total deferred revenue balance was $190.6 million, an increase of 3% from 1 year ago. For the full year, we achieved non-GAAP revenue of $504.9 million, representing 11.4% growth, compared to non-GAAP revenue of $453 million in 2012. We generated non-GAAP operating income of $101.3 million, representing a non-GAAP operating margin of 20.1%, and we generated cash flow from operations of $107.2 million in 2013. Earnings per share were up 34.8% for the year. Overall, 2013 was a very solid year.

We are proud of the Blackbaud team who, in 2013, delivered on a business plan that called for the achievement of significant operational and financial initiatives. 2013 brought significant change to our company, a year of challenge and transition.

During the past year, our Board of Directors worked closely with senior management and identified the need to reset operational priorities, product management and development, and the execution of our R&D spend. Specific initiatives were taken during the past year, including the launch of new products while continuing to innovate, develop and optimize our product suite. We transitioned our leadership twice, from Mark to me and now me to Mike. We increased our focus on sales and marketing effectiveness and go-to-market strategies. And near the end of the year, we began a program that we will implement over a specific period of time, where we will heighten our level of operating investments.

Our team embraced the advancement of our business and executed very well on our key initiatives. As we begin '14, we continue to develop and evolve as an organization with a deeper bench of talent, more insightful experience and new leadership. This year, our organization is more forwardly focused than we were 1 year ago. Do we still have work to do? Yes. We do still have some heavy lifting. However, and importantly, this year we're focused on initiatives that are predominately forward-looking, investing for new product innovations and enhancements in our customer solutions, increasing our sales and marketing presence, investing in systems that will increase operating efficiencies, scalability and profitability and accelerating our revenue growth.

In 2014, we're focused on 4 primary objectives. Number one, revenue growth. Our company is positioned to generate long-term sustainable revenue growth. We expect to accelerate revenue growth this year, while we make increased investments in our sales and go-to-market teams and invest in product development and optimization. This year, we are significantly increasing our commitment in these 2 areas to spur organic growth, which is expected to be nearly double our organic growth rate from '13. Furthermore, these investments will position us for accelerating growth in '15 and beyond, but will pose a nominal drag in our 2014 operating margins. We anticipate making more than $8 million of incremental investments, targeted at accelerating revenue growth in 2014.

Number two, product optimization. A key element to our expectation for heightened revenue growth is bringing the right solutions to market for our customers. Our priority is to balance the continued optimization of our product suite with new investments. We're also focused on innovation of SaaS online fundraising and mobile solutions among others, to best serve the exciting application, device and solution shift going on in the marketplace. Our goal is to ensure that Blackbaud remains a clear leader in the non-profit software and solutions market. Our product optimization efforts are focused on most prudently allocating resources to highest growth, most profitable and strategic solutions.

We continue to believe that this is the right strategy for our customers and for Blackbaud, and will enable us to maximize the returns on our R&D investments. We believe this is also the right strategy for our shareholders, as we expect skillful execution of our operating plans that are aligned with this strategy will lead to improve shareholder returns over the long term. We anticipate making approximately $2.5 million of incremental product optimization investments in 2014, compared to the level of investment made in these areas in 2013.

Number three, transformation to a recurring revenue company. Our strategy to optimize our product suite through a period of heightened investment when compared to historical levels, will both strengthen our customer solutions and, as equally important, help to accelerate our continuing transformation from a licensing-based revenue model to a recurring-revenue, SaaS-based model. We have made significant process -- progress transitioning to a predominately recurring-revenue model, which was accelerated through the addition of the Convio assets and now subscriptions and maintenance represent 72% of our total revenue in the fourth quarter of '13.

Further investments in our product suite and new innovation will be focused on continuing this transformation, particularly as we increase our investments in the exciting mobile SaaS, analytics payments and online fund-raising opportunities. We anticipate investing more than $1 million of incremental investments targeted towards furthering our SaaS transition in 2014, compared to the level of investment we made in those areas in 2013.

And finally, number four, increased operating efficiencies. We've been on an enterprise-wide mission to become more efficient in every facet of our business. Our consistent efforts to increase operating efficiencies are marked by investments in systems to automate processes together with improved resource planning and utilization. We have increased our focus on how we invest and spend capital, guided by a much more stringent analysis of return on investment metrics and customer-needs-based evaluation. Our investments in automation systems in 2013 and '14, such as CRM, travel and expense management and others, are expected to bring greater efficiencies and productivity gains in the future.

We also began to increase the level of talent and expertise in many functional areas around the company to improve our effectiveness and strengthen our capabilities. As we look to '14, we anticipate making approximately $5 million of incremental investments in areas targeted to increase our long-term operating efficiencies. We remain confident that our skillful execution of the work required to meet these objectives will speed us to the creation of a business that generates higher returns and increases shareholder value over the long term.

Increased investments we are making to pursue these objectives are expected to modestly reduce non-GAAP operating margins in 2014 by approximately 200 basis points, when compared to 2013's operating margins. We'll offset some of this impact on our operating margins through increased operating efficiencies, so the impact to our P&L will be less than 200 basis points overall. This is a temporary reduction in operating margins to fuel the business for '15 and beyond, where we expect non-GAAP operating margins to return to near the levels of where we landed in 2013 when you exclude the impact of the net to gross accounting presentation change. But we then expect materially higher revenue growth to go along with the return to higher operating margins.

Additionally, and as I mentioned earlier, our change in accounting presentation from the net to gross recognition in our Payment Services business will impact both our gross margin and our operating margin, because we're adding revenue to the top line and adding the same amount of cost of goods sold, resulting in 0 margin dollar change. From an optical standpoint, this is significant, with an expected impact of 300 basis points to our gross margin line and an additional impact of 90 basis points to our operating margins in 2014.

An important distinction about this change is that it does not affect any economics of the business but it does change the optics of our reported P&L in '14. We believe this will be a very important change for investors to understand so that it provides a clearer picture of our underlying performance.

Now, I'd like to discuss a recent and significant change at Blackbaud. Mike Gianoni, our President and CEO. Mike's already offered valuable insight into our business, discussing opportunities to expand our reach and ideas to generate higher returns for our shareholders. While the path to higher returns is visible and achievable, it will take hard work and diligence and require strong leadership throughout the journey. Mike fits that description. And it's quickly become apparent to me why the board chose and our senior leadership team endorsed Mike as our new CEO of Blackbaud.

I'd now like to turn the call over to Mike for some of his initial thoughts about the company, why he fit the board's and the company's criteria and why he chose Blackbaud. I'll come back later to provide a view of our goals for 2014. Now, I'm pleased to turn the call over to Mike Gianoni.

Michael P. Gianoni

Thanks, Tony. Good morning, everyone. I'm very excited to be here today, speaking with members of the investment community, and very excited to be part of Blackbaud here in Charleston. Blackbaud is a great company and I'm feeling welcomed and energized to lead our growth and continued evolution as the leading technology company serving non-profit organizations.

As Tony mentioned, I've been here 1 month, during which time, I have been meeting with, of course, the senior team and many members of the Blackbaud management team at all levels, including some early meetings with clients, and generally immersing myself into the business. I strongly believe that Blackbaud has a very bright future as we continue our migration to a predominately subscription and SaaS-based model. We will continue to optimize our product suite and customer solutions and improve upon our development and innovation capabilities to drive growth and increasing profitability into the future.

Tony and the senior leadership team have been very resourceful to me, helping me to rapidly get up to speed. I have initially focused on the customer-facing elements of the business, while Tony and his team continue to standardize processes to create operating efficiencies on the noncustomer-facing elements of the business. The company is currently on the right track, focusing on the 4 primary initiatives that Tony just discussed. I support these strategies, and I am now focused on what I can do to complement their execution, particularly related to our product suite and customer solutions and our revenue generation activities. I am still in the early stages of learning about the company, just getting my feet wet, so stay tuned and I will update you more fully on the next call.

Now, I'd like to spend a couple of minutes to talk about why Mike. Why did the board chose Mike Gianoni? Why did I choose Blackbaud? My view is that the board and the senior team believed that my background and experience are well aligned to the operating model here at Blackbaud. I believe that is true. I also believe that I have the skill set to take Blackbaud to its next level of evolution and performance. I've been in technology and software businesses my entire career. Beginning in engineering, then working in integration, product management, sales, software development and operations, really wearing many hats until I moved into a general management role many years ago. Seven years ago, I became a Division President of CheckFree, and over last 4 years, as Group President at Fiserv, with responsibilities over several business units. I have touched almost every aspect of this business at some time during my career. And I have a passion for technology-based businesses. So to sum it up, I believe we are a good match, Blackbaud and myself. And my family and I are already settling into our new home and life here in Charleston.

Today, I will be brief and I would like to leave you with a few thoughts before I meet you personally or talk to you again on our first quarterly call. Blackbaud is well-positioned to continue to deliver market-leading customer solutions that best serve the evolving needs and multiple delivery channels used in the NPO marketplace; to increase our competitive advantages through product and service innovation and outstanding customer service; to continue to improve our operating efficiency and increase our profitability; and, to generate growth on our business by delivering a balanced approach of these objectives, guided by a rigorous process to evaluate capital allocation and returns. These are some initial objectives. Others that we are working on will be added or new ones will arise as our team seeks to optimize our performance and increase our long-term value. I am confident as we focus and execute on these objectives. We expect to increase the performance of our business for our customers, team members and business partners, which should drive increasing value and returns for our shareholders. I'll look forward to reporting on our progress.

I will now turn the call back over to Tony to discuss our goals for 2014. Tony?

Anthony W. Boor

Thanks, Mike. We're all excited that you're finally here. It's been almost a year-long journey. Mike's been a strong presence already and I've had fun digging in with him.

Now, let's turn -- let me turn and make a brief comment about our markets and then we'll turn to our financial goals for 2014. We've seen our markets hold fairly steady during the fourth quarter, continuing to see acceleration and giving through online and mobile-giving channels. Going into '14, we expect a similar environment throughout the year as compared to what we experienced in 2013, a low- to mid-single-digit growth environment with a continuing mix shift towards online and mobile giving. Our product optimization efforts and investments are focused on -- both on taking advantage of these evolving delivery channels and ensuring that we continue to deliver market-leading solutions and customer service.

I'd like to finish by turning to our goals for '14. Historically, our business performs fairly predictably over the course of the four quarters during any given year. We will be adopting a more detailed, deeper dive strategic planning process this year here at the company as we look forward to 2015 and beyond. As part of that process, we will be expanding our enterprise-wide planning over a longer horizon. We are seeking to increase our effectiveness and matching investments in products, services and new opportunities more closely with returns, which is expected to refine and speed up our capital allocation process and, thereby, increase the profitability of our business over the long term. We are now adopting a process to provide our financial goals on an annual basis to better align with our operating plans and match how we plan our investments. We manage our business with a view towards more than this quarter and next, seeking to drive annual progress and achievements. Our financial goals will now better mirror how we plan, and Rob can make sure assumptions on a quarterly basis are reasonable.

For 2014, we expect our non-GAAP revenue to be in a range of $535 million to $550 million. Non-GAAP operating income, or EBIT, a range of $92 million to $98 million, resulting in non-GAAP earnings per share of $1.16 to $1.24. We also expect to generate approximately $100 million of cash flow from operations, with our free cash flow remaining relatively flat compared to 2013's free cash flow. We define free cash flow as cash available after capital expenditures and capitalized software costs.

While the level of profitability is lower than our recent trajectory in 2013, our goals include the full effect of the operating investments I noted earlier, which represents more than $17 million of incremental spend over the levels invested during 2013. And our goals include the effects of the net to gross accounting change, which reduces gross margins by 300 basis points and operating margins by 90 basis points, respectively, with no economic or business impact. Also included is an $11 million negative swing in estimated cash taxes for 2014.

More than half our revenue growth in '14 will be generated organically, with the remaining balance reflected as a result of the accounting change related to the payments business. This implies an organic revenue growth rate expectation in 2014 of mid-single digits, which is almost double that of 2013.

From a profitability perspective, our goals at the midpoint result in an anticipated non-GAAP EBIT margin for the full year of 17.5%. This expectation reflects both the 90-basis point impact of the net to gross accounting change and more than 200 basis point impact of the $17 million of investments we're making this year, which are partially offset by increased operating efficiencies.

Many of the investments will occur in 2014. It will be offset by increased revenue or by decreased operating costs in '15 and beyond. We are making investments in systems and their related implementation costs, which are duplicative costs in year 1. We're building greater scale and effectiveness in our sales and marketing functions. Those investments will remain in '15, but will be offset by higher revenue growth rates and we are investing heavily in our product suite.

As a result of these combined investments, we expect to gain leverage and profitability in '15 and beyond. In 2015, we expect non-GAAP operating margins to return to near the levels of where we landed in '13 when you exclude the impact of the net to gross accounting change. In 2016 and beyond, we expect greater leverage on these investments, enabling further increases in revenue growth and profitability. As many of you are aware, it takes time to implement systems, to optimize those system and the resulting cost leverage to bake in with employees and into the P&L.

2013 was a strong year from a profitability perspective. We successfully controlled our spending while we simultaneously made numerous infrastructure and product improvements. In '14, we'll be balancing between investments for accelerated long-term revenue growth and continuing to streamline our cost structure. We believe that these investments will position Blackbaud to accelerate our growth in '14 over '13 levels. In fact, we will nearly double our rate of organic growth in 2014 when compared to 2013.

We will also carryover the benefit of these investments with accelerating revenue growth in '15 and beyond, along with higher profitability. Most notably, our free cash flow will be approximately flat in 2014 after CapEx and capitalized software costs, compared to approximately $87 million in 2013. In 2013, we were a low single-digit taxpayer. We're expected to be a mid-teens cash taxpayer in 2014, along with our incremental investment increase of $17 million. If you combine these moving parts together, our cash expenses will increase significantly year-over-year, while free cash flow is expected to remain essentially flat. That is some nice leverage in our model.

In summary, we expect to generate strong free cash flow despite our incremental investments and increase in taxes. That strong cash flow results from a high quality earnings stream and contributes to a stable return to shareholders in the form of cash, dividends, and creates strong foundation for increasing enterprise value for our shareholders over the long term.

With that, Mike, Rob and I are happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Tom Roderick with Stifel.

Tom M. Roderick - Stifel, Nicolaus & Co., Inc., Research Division

I want to -- I apologize, I'm going to ask you to go back and just give some more numbers again here regarding the net to gross accounting change. But I want to make sure I have it right, particularly as it relates for the fourth quarter and then as it relates for your margin expectations for this coming year. So to summarize what we've got going on here is, revenues get a lift by anywhere from, say, $5 million to $10 million per quarter, it's what it seems like. Gross profits don't necessarily follow, so the margin hit here, it sounds like it's somewhere in the ballpark of a couple hundred basis points. Can we start with question one, how much was the revenue impact to the fourth quarter? And then question number two, when you think about your guidance for the year, how much is the actual impact to gross and operating margins for the full year?

Anthony W. Boor

Tom, Tony. I want to clarify one thing real quick, if I could, Tom, before I get to your answers. My team passed me a note that I may have misspoken in my prepared remarks. In the remarks, they think I stated that our Q4 organic growth when you strip out the net to gross impact of the payments business, was 7%. I should have stated that our Q4 organic growth when you strip out the net to gross impact of the payments business, was 4.7%. So I just wanted to clarify. So Tom, good question, because I know we've got this accounting treatment change that's creating a bit of noise in the numbers. I'll start with the Q4. Q4 impact -- when we had done the Q3 call, we had expected about a $5 million impact. We had better performance in the payments business in Q4 than we had anticipated. As a result, we actually exceeded that $5 million impact for the quarter. We would have been -- if you net out the accounting treatment change, we would have been closer to the bottom side of our midpoint of guidance from a revenue perspective. So we did overperform by a couple of million dollars on the payments business and then that, coupled with the net to gross, resulted in our overperformance compared to our revenue guidance for the quarter. On a given quarter, Tom. I think we have to take into account seasonality, as well as the various pieces of our payments business. I don't know that I'd go as far as to say -- to anticipate the impact being $10 million per quarter. For 2014, as part of our guidance, I would estimate somewhere on a full year impact of the net to gross to be $25 million to $30 million. So that's full year difference between net to gross for 2014. So you'll have -- if you're closer to $5 million in some of those quarters and higher in the highly seasonal quarters, you'll get to that range of $25 million to $30 million. From a margin impact, speak to Q4 first, margin impact in Q4 on operating margins was 124 basis points. So it had a bit more impact than we would expect for '14. I think we would have been -- if you net out this accounting change for Q4, we would've been close to 20%, just under a 20% operating margin. For 2014, we would expect about a -- I think, you said 200 basis points, Tom, if I wrote that down properly on gross margins. We expected to be more like a 300 basis point impact on gross margin. And for 2014, we're estimating about 90 basis point, as I stated in my prepared comments, impact on operating margins. That has, again, no economic impact, just optical on the P&L. So you have the same amount of revenue gross up as you do gross up in cost of goods, thus the gross margin impact and then it just changes the percentages on the face of the P&L, but the actual dollar impact should be neutral.

Tom M. Roderick - Stifel, Nicolaus & Co., Inc., Research Division

Okay. So when we look at the actual operating investments you're looking to make this year, the net change associated with your guidance today is really -- there isn't one from an operating expense standpoint. It's just -- what we're looking at here is an optical impact of this gross margin shift?

Anthony W. Boor

So if you look at the guidance, I think the midpoint somewhere in about -- is it 17.5%, I think, the guidance on operating margins, Tom. I'd take the 17.5%, add back 90 basis points, so we're going to be something just north of 18 points on an operating margin. That is the amount that we're pulling back because of the $17 million worth of incremental year-over-year investments we're making in sales and marketing, customer success, as we spoke about. Quite a bit of back office infrastructure with a single CRM across the entirety of the business, and travel and entertainment systems, additional product, rationalization, optimization, decisions and, obviously, on top of that, from a revenue kind of drag, we still have the continued shift towards subscription.

Tom M. Roderick - Stifel, Nicolaus & Co., Inc., Research Division

Great. Let me follow up with a fundamental question here. Which is, I can't help but notice that you're giving index and Chronicle Philanthropy and other indexes that we've seen showed a pretty big uptick in non-profit giving last year, which certainly makes sense given the returns in the stock market. How does this alter or impact or encourage you to think about the fundamentals possibly improving in your end markets as you look at this year?

Anthony W. Boor

Well, I think, as giving improves, obviously, we would expect that to result, hopefully, over a period of time. There'll obviously be some lag there, but we would hope that, that bodes well for us and for our growth in the future. I think the other key theme, as you're well aware of, is the shift to online giving with all of the tools and solutions we offer, and speaking of the payments business earlier, and helping them also manage all of those online transactions through our payments solutions, should provide good upside for us in the future. We're optimistic. And I think the difficulty in '14, as we know, is going to be a transition year, we're working through the product rationalization efforts while, at the same time, trying to make some big innovative improvements and move to SaaS and subscriptions because you're going to get the ebbs and the flows and the ying and the yang, both hitting us in '14. But we do feel really good about the long-term outlook for the company. And these positive trends in the market certainly bode well for that future growth, accelerated growth.

Tom M. Roderick - Stifel, Nicolaus & Co., Inc., Research Division

Great, last quick one for me. You've talked in the past about making investments to upgrade the product portfolio to SaaS, particularly on the Raiser's Edge side. Is that still a realistic goal for 2014?

Anthony W. Boor

I don't think that we're ready to make a specific comment, as you can appreciate that's a significant release of information to the market on what we're doing. We are making investments certainly in our -- and not just Raiser's Edge but in our Edge product suite, continuing to move that forward. And we're making, as I think as we spoke last quarter -- maybe the quarter before, incremental increased investments in those Edge products. I think, today, we're just not at a point we're willing to state a specific date, but we are moving and migrating that product forward and making innovations in those Edge products.

Tom M. Roderick - Stifel, Nicolaus & Co., Inc., Research Division

Welcome aboard, Mike.

Michael P. Gianoni

Hey, thank you, Tom.

Operator

Our next question comes from the line of Ross MacMillan with Jefferies.

Ross MacMillan - Jefferies LLC, Research Division

My welcome to Mike and Rob as well.

Michael P. Gianoni

Thank you.

Ross MacMillan - Jefferies LLC, Research Division

Maybe just starting with the $25 million to $30 million impact in 2014 from the change from net to gross. Tony, can you just help us with the seasonality on that? It was obviously a bigger number than you expected in Q4. What are the sort of peak quarters in the year for the Merchant Services?

Anthony W. Boor

Sure, Ross. And Q4 was a little bit of an anomaly. We did quite a bit better, obviously, than what we expect in Q4 on that one. From a normal seasonal impact, I would expect Q2 and Q3 to be highest quarters throughout the year. Q1, obviously, falls off dramatically from what we'd normally have. This year was a little bit different. So I think we're going to have to watch this one and see if the trend changes at all on us from a seasonality perspective. And then I think the other thing that could impact us, and it's really difficult to tell at this point, is the continued shift to online and how much of that opportunity we are able to garner, could cause our seasonality to look a little bit out of whack with normal seasonality, right, that incremental growth and pick up in that business. So I think that's something we'll have to watch throughout the year. I do think that the payments business is a great opportunity for us, a very good business and one that I expect will continue to grow at a good pace over the coming years.

Michael P. Gianoni

Hey, Ross, it's Mike. Mobile is a big move for us, as well. We've got a mobile payments platform. We think we're going to get a nice long run with that platform. Also, we recently released a charitable giving report that has some of the market trends. And online grew 13.5%. But online is still only pretty small, it's only about 6.5% of all giving. We're positioned well for both, sort of, traditional and online. So we think we'll get some long run, sort of, uptick in that. And to Tony's point, we think payments is a really good opportunity for us.

Ross MacMillan - Jefferies LLC, Research Division

But just so I'm clear. The Merchant Services business, as we do this net to gross, it's effectively offsetting. So we have equal revenue uplift and gross uplift. But is it -- at the EBIT line, is it a very profitable business? I'm just trying to conceptualize that payment business as it grows within the mix.

Anthony W. Boor

So, obviously, as we shift to gross, if you're looking at it as a percentage, it's going to drop down on us substantially from where it was. So about a 90 basis point impact on our total company, to give you an idea. On a net basis, obviously, it was much higher margins because we were recording effectively that there was really no cost of goods, in that case. So it was almost 100% margin business. And so it would be lower margin, Ross, than what you would expect to see in the software business or a subscription normal.

Ross MacMillan - Jefferies LLC, Research Division

Okay, that's helpful. So when I look at the underlying gross margins x the shift for Merchant Services in Q4, I think gross margins were up. By my calculations around 50 bps for both Q4 and fiscal '13. I guess, a, is that right; and then, b, what is your -- what is embedded x the impact from the gross up in 2014 for the underlying gross margin?

Anthony W. Boor

So I think you're relatively close on the gross margin. When you net out the impact, we did have a bit of improvement. The continued shift to subscription is helping in the gross margin line. We continue to make good progress on the services margin. Although in Q4, and for the full year, that one's the one we talked about before when you have some seasonality and folks go away for the holidays, et cetera, it gets a little harder to get the chargeable hours in on the services business. So Q4 and Q1 typically will drop off as a result of not having quite the variable -- variability in the headcount that you would like to see. But overall, Joe has made great progress since closing Convio. On the full year, I'd remind you, on the services margins, look at that one -- is that Convio was running the business largely at about a breakeven services margin. So it's hard to see the improvement the team's made because this was a full year impact of Convio in '13 where we only had 8 months in the prior year. When I think about next year -- at this point, Ross, I apologize, the only thing I can tell you is we expect about a 300 basis points impact on gross margins as a result of the change, but we're not really giving any other guidance to this point at that level of granularity that I can provide.

Ross MacMillan - Jefferies LLC, Research Division

Okay. Maybe just a couple other questions related to the free cash flow commentary, it's obviously impacted by investments and the higher cash tax rate. So 2 questions. One is, what do you expect CapEx, including capitalized software, to do in 2014 versus 2013? And then as cash taxes move from single digit to mid-teens in 2015, how should we be thinking about cash taxes, maybe as we move forward? Because, historically, Blackbaud's had a number of ways to shelter cash taxes. I'm wondering if we're getting to a point where most of those are exhausted and we should think about a different cash tax rate.

Anthony W. Boor

That's a very good question, Ross -- or questions. So the free cash flow, remember we said we would be relatively flat, this is kind of where we're expecting to be right now or anticipate being compared to '13, which obviously, was a very good free cash flow generation year for us. That estimate includes the $17 million of incremental investment and we estimate $11 million to $12 million of incremental cash taxes in that number. So very solid free cash flow performance from the underlying business when you consider that $28 million drag on free cash flow. The CapEx for 2014, we do anticipate to be slightly less. We had long-yielding facility moves and reconstruction last year. So I think we're currently estimating maybe somewhere in the range of $3 million to $7 million less of CapEx in '14 than what we had in '13. As a result of not having as many facility transactions to deal with. Cash taxes, very good question. We've run at a very low cash tax rate because of the NOLs and various tax credits that we've had. In 2014, we anticipate burning through the large majority of those NOLs and large tax credits as a result of just the improved profitability we've had over last couple of years. So we'd expect to move into a mid-teens cash tax rate in '14. And then in '15 and beyond, because the NOLs and credits will largely gone other than the kind of annual recurring one, we'd expect to actually be at something that's higher than our normal effective rate. So we'd expect we could be upwards towards that 40%, possibly even a little higher than that rate for cash taxes in '15 and beyond as a result of some nondeductible amortization associated with the Convio acquisition. That said, as we look out, we also think that there's some opportunities, obviously, as we increase revenue growth and start to gain leverage over time. We expect we may get a bit of a dip in '15 from a free cash flow perspective because of that cash tax increase. But then I would expect to see some rebound in that, pretty quickly, in '16, '17, '18, as we the accelerated revenue growth and leverage offset that incremental tax impact.

Ross MacMillan - Jefferies LLC, Research Division

That's great, really helpful color. Very last one, just on the organic growth comment. There is a compounding effect as you increase the amount of recurring revenue that should inherently drive higher organic growth. But what are the other things that you point to which could start to help you accelerate underlying organic growth in '14?

Michael P. Gianoni

So -- hey, this is Mike. One thing I'll bring us back to is the opportunity I think we have in mobile and payments. So as we continue to expand our presence across our core platform base and in the market, that will help accelerate organic growth and recurring revenue as well, and we think there is a great upside with those platforms.

Anthony W. Boor

And I think, Ross, to your point on the compounding, we've got that kind of Catch-22 right now. As we continue to shift to subscription, we've got a great recurring revenue base. I think that the plus and the minus on the subscription is the subscription offers seems to be much more palatable to the customer base, right? It's easier for them to acquire the solutions when they're renting it versus buying and implementing on prem. And so we've seen good adoption there. I'd expect to continue to see accelerated growth in subscription. That, unfortunately, in the first couple of years, as you're well aware of, as you commented on, is going to be a bit of a drag on us because of the ratable recognition compared to software recognition treatment. I do think that -- it's great talking to Mike. We've had a lot of great discussions just in the first few weeks he's been here. And I think the innovation and the things that we're talking about doing from a product perspective, some of the things we started 1 year ago from a strategic perspective with the product portfolio. Those things are going to have a positive impact on us as well. I think the key is that we've got to get through a bit of the drag that we have from the conversion to subscription from on-prem software offers, here and over the next -- it's typically the first 1 to 2 years, that by the time you get to that third or fourth year, you start to getting that positive impact. So we're hopeful that by the time we start getting into that latter '15 and then into '16, '17, we start seeing that very positive impact of that shift being largely complete

Operator

[Operator Instructions] Our next question comes from the line of Sterling Auty with JPMorgan.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

I'm wondering, Tony, in terms of -- you gave us a lot of detail around the full year guidance, but nothing here for March. Going forward, are you just going to stick to the full year guidance only? Or is there going to be some color for the quarter as well?

Anthony W. Boor

Yes, Sterling. At this point, Mike coming on board and Rob and myself and we've all -- really trying to implement better planning processes and better strategic planning for us as a company, and we really have pushed towards looking at things over a longer-term perspective. We're doing our planning on an annual or longer basis, making sure we're getting the right kind of returns and not focus nearly so much on this quarter or next. And so, we're trying to align our -- setting our goals to the market guidance, per se, more along the lines of what we're doing internally. And so, Rob would certainly be happy to help you. There's pretty good consistency. You've been around and followed us long enough, you have pretty good sense of how the seasonality works out. And Rob would be happy to work with you guys to make sure you're on track as far as expectations. But at this point, were going to -- our proposal, our plan is to stick to just annual.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Okay. And then, I'm curious about the strategy and the $8 million of incremental investment in sales and marketing, the timing of that investment relative to the product optimization and the investments there. I thought there was some thought around focusing on the product portion first and then coming in with a little bit more aggressive sales and marketing spend. Why the change there in terms of the timing?

Anthony W. Boor

I'm not sure, Sterling, that we were on -- that you are on the same page on the planned timing of that. If you recall, last quarter is where we spoke about these incremental investments that we were strategically looking at. On the sales and marketing -- 2 big pieces on the sales and marketing side, one was an increase in actual sales force, market sales force. And that was, if you recall, we spoke -- as we've done some analysis, we believe we have some gaps in coverage where we had to have an opportunity to drive increased sale with the existing product set. And so that's just a coverage issue. I think as we went to the Convio acquisition and integration and all of that work that we did, realigning territories, et cetera, that we've now had time to go back and look at that. And we think we've got some opportunity to add some actual direct sales heads and get good cap ratios and an adequate return on those investments. And so we actually started the ramp up of those investments in Q4. Actually, those have already begun, and that's part of why the Q4 margin was off a little bit and profitability was off a bit. The other investments on the sales and marketing side we're making really are also less of a product-specific focus, there were on customer success and retention. As the model -- if you'll recall, we spoke, the model is shifting more and more to subscription, retention rates become even that much more important to us. We're in the 90 -- mid-90 range on our maintenance retention. Subscription, we're in the high 80s, low 90s, depending on the product. And so we're really looking to drive an incremental 1 or 2 points on each of our products from a retention perspective and reduce that churn. And so I think, product investments will help with that as well. Don't get me wrong, but we felt that both of those were investments we could start making today with the existing product and solutions set, and get a good return on those investments. The problem is, as you know, we've got to hire the salespeople or the customer success teams. We've got to train those folks. They've got to go out and either make the sale, which fill their pipeline and close the deal, and it's probably going to be a substitution deal which there's going to be ratable recognitions. So you're going to get very little revenue in '14. We'll start seeing the benefit of that in '15, certainly in '16 and '17. And on the customer success side, I hate to ramble, but on the success side, you're going to see improved retention which won't show up in revenue until late this year and going into next year.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

All right, that makes sense. And then in terms of the operating margin comment, I just want to make sure that I understand, in terms of, you made the comment about, not only kind of, 17.5% at the midpoint for 2014, but where the bounce back in 2015 should get to -- you made a comment relative to 2013. Was the idea that 2015 should get back to the kind of 18.6% level that you finished 2013 with? What's the level that you're expecting to elevate back to once you get beyond 2014?

Anthony W. Boor

Yes, there's still a lot -- that's a good question. There's still a lot of moving parts and there'll be 2 major impacts. So maybe -- to your comment, yes, we started with the 17.5%, there's 90 basis point kind of anticipated impact of the net to gross, so that we'll take us back up into the 18s for 2014. What we're expecting to happen, starting in 2015, is a lot of the redundant and duplicate costs, obviously, will go away. So we've got consultive expenses for implementing these systems, like our CRM across the company. We've got the cost up the old licenses and subscriptions along with the cost of the new ones because you're not off the old platforms yet. So those duplicated software costs or rental subscriptions would go away as well. So we'll see a pickup in OpEx where we won't have those duplicate costs. So that'll be immediate once we get them implemented and the contracts fall off. The second piece would be what I was just speaking to you about on the sales and marketing and customer success side. We expect to start seeing an increase in revenue growth rate, which will not make those expenses stand out, right, you'll have revenue to offset against those expenses or reduced churn to offset those customer success expenses. So it's too early to give a specific. But what we currently would anticipate is that we get back to a full year kind of 2013 performance when you adjust for the net to gross change. So you need to contemplate that impact on a full year basis. So if you're looking at '13's performance, keep in mind it only has one quarter of that impact in it. So I would look at the kind of full year performance, which I think was 20 -- just over 20% on the operating margin line for the full year. You need to net that down for what the net to gross impact would be on a full basis -- full year basis. But I don't have the exact number in front of me. But that's roughly where we hope to get back to. And we can -- we'll feel better giving you some better flavor on that as we progress through the year. Some of these projects are significant investments and they're not a 1- or 2-quarter implementation timeframe. So we'll see how they progress. How quickly we start to get some optimization in our cost structure, et cetera. And how we start to see traction in revenue and sales efforts. So we'll continue to update you on those throughout the year.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Okay. And maybe if Rob could come back to us with that 2013 full year instead of just the 1 quarter hit, that would be hugely helpful. Last question would be, Mike made the comment that we're sort of looking at the growth opportunities there in front of you, you mentioned mobile and payments as 2 of the growth areas. We talked about mobile. But in terms of payments, there was the commentary that was if payments count at a margin that's lower than traditional subscription and definitely lower than license. Are there moves to actually make on the margin front in the payment part of the business?

Anthony W. Boor

So, Sterling, maybe I could take that one from Mike just on the margin piece and he can talk to anything he'd like to on the growth opportunity side. The difficulty on the payment side is just the accounting treatment, Sterling. So we just -- give an example with dollars, to put it in perspective. We will charge a customer -- just say, if they had a $100 transaction, we charge them $3, for example. We would pay $1.50 in fees to third-party processors and other people involved in those transactions, and we would keep $1.50. Those aren't the actual numbers, but to give you an idea. So the difficulty there is to see a significant increase or decrease in margin is effectively not going to happen. It's just the math of, historically, we would have recorded only the $1.50 that we made. We have very little cost of goods in that transaction, per se, outside of the software solutions, et cetera. In this case, with the accounting change, it's just mathematical. Now, we're going to record the $3, $1.50 of cost with the same $1.50 of profit. So our profitability doesn't change, it's all optical on the face of the P&L. The economics of the business is still very, very positive. I can't tell you -- the regulatory folks and accounting team may come back at some point and say, "You should treat this net again." So I don't want to get caught up in the percentages on the P&L because the economics are very good in that business. Very strong cash flow generating business, good strong traction and stickiness in that business. Once you start providing those services for the customers, they get a lot of value out of it. So I think the difficulty is it really is a mathematical and an accounting -- GAAP-accounting issue, not an underlying issue with the business.

Michael P. Gianoni

It's a -- this is Mike, Sterling. It's a presentation change. We like the margins in the business quite a bit and we very much like the revenue upside in the payments business.

Operator

Ladies and gentlemen, we've come to the end of our Q&A session. I'd like to turn the floor back over to management for closing comments.

Michael P. Gianoni

Thank you, operator. Thank you, everyone, for questions and for participating today. I look forward to meeting you into our next call. Thanks, have a good day.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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