Zix Corporation Q1 2010 Earnings Call Transcript

May. 1.10 | About: Zix Corporation (ZIXI)

Zix Corporation (NASDAQ:ZIXI)

Q1 2010 Earnings Call Transcript

April 27, 2010 5:00 pm ET

Executives

Peter Wilensky – VP, Corporate Development & Government Affairs

Rick Spurr – CEO, Chairman and COO

Susan Conner – CFO

Analysts

Jonathan Ruykhaver – ThinkEquity

Jeb Terry – Aberdeen Investment

Alex Zukin –ThinkEquity

Operator

Good day, ladies and gentlemen, and welcome to Q1 2010 Zix Corporation earnings conference call. My name is Katrina, and I will be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions)

I would now like to turn the call over to you host for today Peter Wilensky, Vice President of Corporate Development and Government Affairs. Please proceed.

Peter Wilensky

Thank you, Katrina. Good afternoon and thank you for joining Zix Corporation's first quarter 2010 conference call. This call is being recorded and a replay will be available after the call's conclusion from our website or by dialing 188-286-8010 and entering the access code 32652704. This information can also be found at investor.zixcorp.com, which is investor's portion of our website.

Zix Corporation’s Chief Executive Officer, Rick Spurr will begin with an overview of the company and a discussion of our business, followed by a discussion of the Q1 2010 financial results by our Chief Financial Officer, Susan Conner. Mr. Spurr will then provide closing remarks. Afterwards we'll be available to answer questions from analysts and institutional investors, and we'll also be taking questions via e-mail, which can be sent to our Investor Relations mailbox invest@zixcorp.com.

Before we get started, I would like to remind you that some of the our comments on matters such as our forecast of revenues, earnings, transactions, operating margins, and cash flow, contracts, or business, and trend information, which constitute forward-looking statements.

These matters are subject to a number of factors that could cause actual results to differ materially from our expectations. Those factors are described in the risk factors section of the company's most recent filing on our Form 10-K with the SEC. The company undertakes no obligation to publicly update or revise any forward-looking statements.

During the call, we will refer to various non-GAAP financial measures such as adjusted gross profit, adjusted operating expenses, adjusted earnings and adjusted EBITDA. We are provided on our earnings press release issued today and on our website detailed explanations of our non-GAAP financial measures in reconciliations of our adjusting item to the most directly comparable GAAP financial measures.

With that, I'm pleased to turn the call over to Rick Spurr.

Rick Spurr

Thank you, Peter. Good afternoon everyone. Coming of our strong finish to last year, we were excited about the momentum going into 2010, and today I'm pleased to report that we had indeed started off the year on a tremendous note. We exceeded guidance in revenue showing a new overall revenue record for the Company despite the anticipated decline in the e-Prescribing business.

We had another strong quarter in Email Encryption orders exceeding the 2 million mark in new first year orders for the second straight quarter resulting in more than 9 million in total orders. We set several other records including all time highs in gross profit, EBITDA, cash flow from operations and bookings backlog, and of course in Q1, we just recorded the first profitable quarter ever on a GAAP basis in the history of the company.

We are quite proud of this milestone with our soul focus going forward now on Email Encryption. We expect to see sustained strong financial results throughout the year. The e-mail business is firing in all cylinders due to rising demand, fewer competitors and the superiority of our technology.

We think it's a matter of right time, right place for the Company. As we announced earlier this year, we expect 2010 to be ZixCorp's first year of profitability. Susan will provide more details on our financial performance, but I would like to discuss our primary leading indicator, Email Encryption orders.

As I just mentioned, Q1 represented another great quarter in terms of orders for our Email Encryption business. The 2.2 million in new first year orders was second only to the previous quarters 2.4 million, so we feel good about coming of the two best quarters for e-mail orders in the company's history.

I'd like to take a moment to review how we discuss our orders because although we use the term, new first year orders for sometime. There is still some confusion about its meaning based on conversations I've had with investors. We generally discuss our orders in two ways. New first year orders and total orders going forward the discussion of our performance will also focus more on backlog.

Let's first define the term new first year orders, which are a subset of the total orders. A new first year order represents only the first year portion of a new license soap. As most of you know, we generally sell multi-year licenses. In most cases, three years licenses, but for the new first year order measurement we exclude years two and three, and a new first year order must be new business as opposed to repeat renewal business.

New business can be a brand new customer. For instance, a new bank, hospital or government agency or it can be new seat licenses sold into an existing customer. It can also be a new product or service sold to new more existing customers. The key point is it must be new business because we are focusing here on growth.

We use this metric internally for planning purposes as well as measuring and compensating our sales force, and externally in communicating our results to the market because we believe is the best leading indicator of our future revenue growth. By focusing on the first 12 months, we both standardize the results for any mix of contract lengths and provided clear data point for forecasting our per over the ensuing 12 month period, since we recognize revenue rapidly due to our subscription model.

Now I'd like to discuss what's in total orders. Total orders include all new first year orders as just described plus the out years of a multi-year deal. For example, years two and three in the typical three deal and all renewals from our existing customers. When measuring and tracking renewals, we focus on the same number of seat licenses in a just expired contract including any price adjustments to those licenses.

Our backlog, the most complete picture of future growth then represents all of the total orders booked whether new orders or renewals that are committed, but had yet been recognized into revenue. I just want to make sure that terms were clear in everyone's mind as we use them to continue to describe our performance.

While we are obviously thrilled about putting together in the two strongest quarters for first New Year orders in the company's history, we are particularly pleased that this strength represents broad-based demand across all of our vertical sectors. We previously discussed the beneficial impact on our business of the expansion of HIPAA in the HITECH act.

So I will dwell on it here again. While we continue to see strong demand and a good result in absolute dollars from healthcare where or instance, we did convert a 20 hospital account from a competitor in Q1. the percentage of our direct sales from that sector those still a priority of our orders has actually declined over each in the last two quarters, which indicates that our recent success has in fact not been driven just by healthcare.

Our second largest vertical financial services remained strong for us in the sector, a sector which we close several more deals in Q1, and where we now have surpassed 1300 customers including over 1000 banks. In government, we've also had continued success.

We sold a 3,000 seat expansion in the Treasury Department, up sold the conference of state banks supervisors and added 17 state agencies local governments as new customers during the quarter. We now have a total of 58 accounting governance as customers. We are on the top of the 20 state banking regulators.

All of the federal banking regulators and the other federal agency such as the SEC or any of the several accounts within the Treasury Department where we saw unexpected strength in Q1 was in the percentage of orders which came from outside our three core verticals, which accounted for 17% of new first year orders in the quarter.

We believe the drivers for this success outside our primary accounts is a combination, the general increase in overall awareness for the need to protect sensitive information contained in electronic communications, and the impact of state laws requiring the encryption of personal information particularly in the Massachusetts law.

On that point, State of Washington just became the third state to enact an encryption law, which becomes effective this July and other states are considering laws of their own. This is a dynamic period for the Email Encryption market, and I'm pleased with our position in demonstrated ability to capitalize on this demand.

In addition to the strong direct sales effort in the first quarter, we also recorded the best quarter for our channel partners in the history of our company with one of our premier distributors, Google having particular success. Overall, we are excited about what's happening in the channels.

Similar to our direct sales results, we are coming off to our two best quarters in terms of contribution to our orders from the channels. Even we are hearing from our partners that our prospects are increasingly asking for an Email Encryption solution. As the leading short play hosted service, ZixCorp is perfectly positioned to supply our Email Encryption capabilities to meet the demand for this large channel partners.

In March, Symantec another of our premium distributors who is one of the largest and best known software security companies in the world announced the latest edition of their new Brightmail Gateway platform with the Symantec content encryption premium service. This hosted encryption services leverages the message labs infrastructure, for which ZixCorp is one of the key Email Encryption providers, and provides us access to Symantec's global platform.

We are optimistic about our potential with Symantec. Though history has shown us these great opportunities generally do take time to develop. We have the only technology that offers fully transparent secured communications between gateways, and access to the ZixDirectory, the largest community of users in the industry, which now numbers over $20 million and is growing at more than 100,000 new addresses per week all delivered in a Software as a Service or SaaS model.

In fact with Gartner expecting messaging security to be increasingly offered as a service over the next few years. ZixCorp is uniquely positioned to become the dominant Email Encryption service provider with our SaaS architecture, shared directory of users providing viral growth in terms of access to other users in our existing relationships with some of the largest e-mail security companies in the world.

By virtue of our proven track record over the last decade for reliability, security and ease of use, we enjoy a reputation in the market for having superior technology. It is exceptionally to use, and as our customers often tell us just works. We find ourselves at the intersection of two opposing trends driving the development of technology in today's markets.

First, the increased desire to share information, and second the need to protect certain information. On the one hand, the desire for the ability to share information quickly and easily can be seen in everything from the push for electronic health records to the rise of social networking to the desire for real time search. On the other hand, people are more worried than ever about protecting their personal information, a concern which is been reflected in the recent state and federal regulations.

People though necessarily want to block all movement of their information as I just said people do want to share certain information for a variety of purposes. So, the issue is balancing in this two opposing forces by providing control over what information is shared, and what information is protected. When it comes to e-mail, which is still the primary means of electronic communication in business today, and increasingly used for personal purposes as well.

ZixCorp's service allows the customer to define policies for determining what information is protected, and how that information is handled. Our Email Encryption service therefore becomes the mechanism that enables to easy and hard communication of e-mail layered with security that the customer can't control the best of both worlds.

As people realize the value of this key function and demand their service, we have the scalability attributable to direct sales and our channel partners, the distribution to deliver this solution wherever it's needed. That's why I'm so excited about where the company is. I believe we are on track for continued growth and success.

With that I'll turn the call over to our CFO, Susan Conner for more detailed discussion of the first quarter's financial results.

Susan Conner

Thanks, Rick, and good afternoon everyone. I'm also very pleased to report we achieved great results in our key financial metrics, new first year orders, revenue, cash flow from operations, EBITDA and non-GAAP adjusted earnings as well as GAAP net income.

As Rick mentioned in the first quarter, we achieved GAAP profitability for the first time in the company's history with GAAP net income hitting $700,000. Additionally, we've also now recorded improvement in our positive adjusted earnings for three consecutive quarters. Our Email Encryption business achieved new first year orders during the first quarter of $2.2 million almost doubled the amount from the first quarter of 2009.

In addition to growth and new first-year orders, we also continued to maintain a strong renewal rate and the low to mid 90s range for contracts that were up for renewal. Let's now discuss the details of our first quarter financial results beginning with revenue. We achieved company-wide revenues of $8.4 million which exceeded the top end of our previously provided guidance of $8 million to $8.2 million, and which compares to $7.3 for the first quarter of 2009.

Email Encryption revenue was $7.5 million of this amount and e-Prescribing was $900,000. Email Encryption revenue for the first quarter grew $1.2 million, a 20% increase over the comparable 2009 figure. Our OEM channels drove approximately $200,000 of this increase, which was a 54% improvement from the first quarter of last year.

Our direct sales to enterprise in corporate customers drove the remaining growth. These increases were due to the growth inherent in our successful subscription model, where strong new orders were added along with the high level of renewals. E-Prescribing revenue for the first quarter was $900,000 which is down 8% from the first quarter of the last year as expected given our announced plan to exit this business at the end of 2010.

We had approximately $2 million of our customer contract that were up for renewal during the quarter of which we renewed app $1.875million. As we believe backlog provides a more holistic view of the trending of our renewals, we are beginning to shift our focus to this metric as a key measure of the growth and health of the business with renewal rates been an underline component of the backlog.

Looking at company-wide booking backlog, we ended the first quarter at $45.5 million, which is an 18% increase over the booking backlog of $38.4 million at the end of the first quarter of 2009. Total backlog for the first quarter included $44.4 million from the Email Encryption business, which was up 25% from the first quarter of 2009 and $1.1 million from the e-Prescribing business, which of course was down.

On a sequential basis, we measure our Email Encryption momentum on a trailing 12 month or TTM basis. For the first quarter, the TTM backlog for Email Encryption was $39.6 million versus $37.3 in the fourth quarter of 2009, a 6% increase. As a reminder to everyone our end user bookings backlog is comprised of contractual commitments whether they come from new orders or renewal orders that we expect to amortize into revenue in the future as services are performed.

The timing of revenue recognition is affected by both the length of time required to deploy a service and the length of the service contract. We anticipate app 60% of the total backlog been recognized into revenue within the next 12 months. In summary, we are pleased with the high level of demand for our Email Encryption products in the first quarter.

We believe the overall rising demand for Email Encryption and the recognized competitive advantages of our service positioned the company for a strong year. Let's move on to look at our various margins as well as the details on our expenses. We achieve that company wise adjusted growth profit for the first quarter of $6.6 million, 79% of revenue.

This compares to $4.9 million, 68% of revenues for the same quarter of last year, and on a sequential basis that compares to $6.3 million, 77% of revenues for the fourth quarter of 2009. The Email Encryption adjusted gross profit for the first quarter was $6 million, 80% of revenues compared to $5.3 million in the same period last year, 84% of revenue.

The performance was primarily driven by the $1.2 million increase in revenue partially offset by $491,000 increase in allocated expenses. As we've begun to wind down e-Prescribing, the allocation of some of the shared fixed cost previously allocated the e-Prescribing are now shifting to Email Encryption as we've discussed in previous calls driving healthy, but slightly lower margins in the Email Encryption business.

Our e-Prescribing adjusted gross profit was $604,000, 64% of revenues compared to a negative $357,000 or negative 35% of revenues for the same quarter of last year. This improvement in our adjusted gross profit is due primarily to a $1 million reduction in our cost of revenues driven by the wind down of the business. We have lower headcount between periods.

We are not incurring cost to deploy any doctors, and the business is being burdened with lower allocated cost based on lower headcount and the decrease time spent as I just mentioned. With regards to company-wide operating expenses, adjusted R&D and SG&A expenses totaled $5.4 million in the first quarter of 2010 compared with $5.7 million for the same period last year.

R&D expenses were $1.4 million in the first quarter, a decrease of $200,000 while SG&A expenses were $4 million, a decrease of $69,000. The R&D and SG&A expense decreases from 2009 are primarily driven by lower headcount resulting from actions taken to align expenses with the needs of our business mainly in the e-Prescribing segment.

In the first quarter of 2010, we continued R&D investment in our Email Encryption products adding new key features including language localization flexibility and iPhone support.

Our company-wide adjusted operating margins for the first quarter, was $1.3 million, 15% of revenues. This compares to a loss of $754,000 or negative 10% of revenues for the same quarter of last year. Driving towards our mid-20% margin target for the year, our adjusted EBITDA for the first quarter was $1.6 million with an adjusted EBITDA margin of 19%, compared with an adjusted EBITDA of negative $367,000 and adjusted EBITDA margin of negative 5% for the first quarter of 2009.

Our capital expenditures for the first quarter were $379,000. depreciation expense for the quarter was approximately $344,000 and its recorded in the various P&L line items with approximately 70% been recorded in cost of the revenues. We delivered outstanding results in cash flow this quarter.

Cash and cash equivalents were $15.7 million at March 31 2010, compared with $13.3 million to December 31 2009, and $12.2 million at March 31 2009. The significant cash increase in the first quarter was driven by a record result in cash flow from operating activity, which included three primary drivers.

First, our record new first year orders in the fourth quarter of 2009 that were collected during this quarter. Second, the cost savings generated by the wind down of e-Prescribing business and last the receipt of a $925,000 renewal payment from one of our largest customers. We achieved this excellent growth in cash in the first quarter, while at the same time reducing accounts payable by approximately $100,000 in accrued expenses by approximately $900,000 from the fourth quarter of 2009.

We expect cash to continue to grow throughout 2010 as our revenue and earnings increase. Our company-wide adjusted net income for the first quarter was $1.2 million, which compares to $698,000 loss for the same period in 2009. Our adjusted net income per fully diluted shares of common stock for the quarter was $0.02 versus negative $0.01 for the same period in 2009.

Now I'd like to talk about our outlook for the second quarter of 2010. We project our adjusted earnings to continue to increase with our fully diluted adjusting earnings per share rounding to $0.02 per share. Let me make a point so everyone understands why we are not giving a range.

Since we had approximately 65 million shares outstanding on a diluted basis in any given quarter, it takes around $650,000 to drive up earnings per share by another penny. So, although we expect our actual earnings to be higher, it would still round to $0.02. These earnings results are supported by our revenue guidance ranging from $8.4 million to $8.6 million again reflecting continued growth in our Email Encryption business partially offset by the decline in e-Prescribing.

Included in this overall revenue projection are e-Prescribing revenues of $600,000 to $700,000. As announced on January, we expect the e-Prescribing business to be breakeven or slightly positive for the years we winded down. The wind down process is on target and is proceeding as we plan.

In the first quarter, this business generated app $390,000 of adjusted operating income. We anticipated adjusted operating income in the second quarter to be approximately $100,000 decreasing to an operating loss in the subsequent quarters as revenue continues to decline.

Slightly up from our previously announced full-year guidance, we project company-wide 2010 revenues to be between $34.5 million and $36 million of which e-Prescribing revenues would comprise $2.1 million to $2.6 million. For full-year 2010, fully diluted adjusted earnings per share are projected to be between $0.08 and $0.11

This guidance will heal the full-year adjusted EBITDA margin in the mid-20s and an adjusted operating margin of approximately 20%. To close my comments, I will reiterate how gratifying it is to have reported positive GAAP earnings for the first time in Company history.

Our entire management team is highly focused on delivering improved results. We looked forward to continued growth in both revenue and earnings throughout the year. With that, I'll turn it back to Rick. Rick?

Rick Spurr

Thank you, Susan. Yes we are well quite pleased to have recorded the first quarter in profitability in the company's history. Through a combination of the strong underlying fundamentals of the Email Encryption business, a disciplined approach to managing the company and the wind down of the e-Prescribing business, we generated record EBITDA cash flow from operations in profit in Q1, but we are hardly going to rest in our laurels, and it feels like this strong quarter in Q1 is a sign of more to come.

Demand remains strong across all sectors for both our direct sales force and our channel partners. Our growing backlog points to continued strong revenue performance for the company. Our superior highly differentiated technology shares structure of our ZixDirectory and the SaaS model, all are grounds for continued optimism for growth.

The largely fixed nature of our costs and our focus on running an efficient operation needed much of any topline improvement should drop down to our bottom line. I believe ZixCorp has entered a new and exciting phase in its development and I feel very good about our prospects for continued profitable growth and success in the marketplace. Thank you everyone for you intention and interest today. Let's now turn the call over to the operator for any questions.

Question-and-Answer session

Operator

(Operator Instructions) And your first question will come from the line of Jonathan Ruykhaver from ThinkEquity. Please proceed.

Jonathan Ruykhaver – ThinkEquity

Hey, Rick. Hey, Susan. Nice performance.

Rick Spurr

Thanks Jonathan.

Jonathan Ruykhaver – ThinkEquity

I'm just curious on the gross margins for the core encryption business. They were at 80% for the quarter. Can that number go higher as you scale or does volume pricing or some other things come into play to limit expansion from here?

Susan Conner

No, we continue to talk about that gross margin will be nudged upwards and noticed I say nudge because I don't now that it gone expand up 10 percentage points of anything like but it can increase. Now just as a reminder Jonathan as we talked about there are some allocated cost that are being burdened or born by the e-prescribing business this year that will fully comeback and hit the email encryption business next year. So, that will impact the margin a little bit next year that’s about $800,000 for the full year but I do believe that our gross margins will continue to rise slightly in the low 80s moving to the 85% mark.

Jonathan Ruykhaver – ThinkEquity

Okay, good enough. And I guess along those same lines to some extent, the infrastructure capacity you have, what is utilization on that capacity with the 200 million-plus email addresses you currently managing? How many ultimately emails can you get to on that infrastructure without having to spend more on CapEx?

Rick Spurr

So, we have done and continue to do work to allow for scale. Our history has been and our plan is to continue to invest on a very methodical basis as I think you know you between 1 million and 1.4 million a year. Much of which is replacement and upgrades to the existing day center facility and of course that comes with new technology with great and great speeds and capacities. So we do not anticipate it at this point any dramatic uptick or requirement for new investment to accommodate scale at least in the foreseeable future.

Jonathan Ruykhaver – ThinkEquity

Okay, good enough and a question on the competitive environment. What do you see–who do you see when you go after the hosted email encryption market? Who are the specific vendors out there that you compete with directly?

Rick Spurr

Yeah in the hosted space the most meaningful one is Proofpoint who is a private company but of meaningful size now and they provide a mix of solutions but our focus quite keenly on the hosted space because of its growth and the trends that we all see. Cisco as you know is a meaningful competitor of ours but still is selling on premise with I'll call distributed directories and it will turn the old outdated approach. Now by the way Proofpoint does not going back to, Proofpoint does not have a share directory, so they do not have any equivalent of the Zix directory and therefore cannot accommodate transparent delivery. So, that still remains a huge differentiator for us even vis-à-vis Proofpoint.

But some of the other advantages of hosting that they can provide Cisco and the others aren't in the game there.

Jonathan Ruykhaver – ThinkEquity

Rick, can you mention–you mentioned that competitive display thing. Can you say who that competitor was?

Rick Spurr

I don't see any reason why won't, it is why it is right? We replaced PDP in the large hospital setting.

Jonathan Ruykhaver – ThinkEquity

So it was an on premise displacement?

Rick Spurr

Yeah, it was on premise and PDP as got a name and they have been around for a long time and they have got some fairly good static encryption technology but they have not been meaningful competitively to us and in fact are now starting to give us win back opportunities.

Jonathan Ruykhaver – ThinkEquity

Okay. And I guess one final quick question. You mentioned renewals in the low to mid-90% range. When a customer does not renew, what is typically the reason?

Rick Spurr

Should I mention the other numbers yet or?

Susan Conner

Sure.

Rick Spurr

Let me remind everybody while we are on that Jonathan, we have realized over the last six or eight months that we have really done our investors a disservice with way we have reported renewals because we really haven’t been very clear, because most of our contracts are three years in length. We only have about a third of our contracts come up for renewal every year. So, it's not a percentage that should be applied to entire occurring revenue base. It’s a percentage, the loss percentage in this case last quarter we were 93.5, so we lost 6.5% but only of what came up.

The actual, the real absolute recurring revenue that was lost to us was $136 million which is just a little bitty number in light of the $2.2 million in new business that we brought in but to your point more specifically to your question. The loss has come from bankruptcies and consolidation that have caused displacement of one technology or another and that’s a recurring small amount. It also comes from, in some cases, customers cutting back or their usage, where they say "hey, we are licensed for these," are more samples of tough times. I think we are coming out of this but something says I have got 10,000 users licenses and then I really think I am going to cut back and only do five because I got to cut my budget.

Any price pressure that we feel it renewal time is reflected in the renewal number but at the same time any price increases we are able to get net against those and in this most recent quarter we had a net increase overall.

Jonathan Ruykhaver – ThinkEquity

When you say a net increase, because of pricing going up or because of new mailboxes? It's more of a pricing?

Rick Spurr

Yes I wasn't clear. So, we don't in the renewal number we don't take into account anything new, so if we sell new seats to a customer for instances that’s ruining that goes in the new first year order number. That is not counted in the renewal number.

Jonathan Ruykhaver – ThinkEquity

Okay.

Rick Spurr

Okay if we sell a new service to an existing customer that is not counted in the renewal number that is counted in the new first order number. So, all we do is say how many seats did you have last year with how many products, what products and how much did you pay us and then we use that as the denominator to compare the same payment we get for that same set of products in that same customer and that’s how we calculate the percentage.

We do have a factored any price increase or decrease on that same existing base. So, that gives all a good sense of are we maintaining our current base of customers in that revenue and then the news is news as I described. So lastly Jonathan on occasion but quite rarely we will have a displacement where somebody will take us out and put the competitor in but those are like if you have one a quarter that’s kind of a dynamic.

Jonathan Ruykhaver – ThinkEquity

Okay. No, that puts it into perspective. I appreciate that, Rick. But I guess I don't want to take up too much time, but I'll get back into the queue. But just one other final question. There's a company out there called EasyLink Services that recently announced a secure messaging service with hosted encryption. Are you familiar with that company? Are they maybe an OEM partner of yours?

Rick Spurr

Never heard of them.

Jonathan Ruykhaver – ThinkEquity

Okay.

Rick Spurr

Sorry.

Jonathan Ruykhaver – ThinkEquity

Yes, I just–I mean, I just noticed the name of the company recently and hadn't heard of them before and didn't know if they were someone that you were seeing directly. So, maybe it's too early for them in trying to get into this opportunity and so, you're not seeing them. But anyway, thanks, Rick. I'll get off and back into the queue, but nice performance.

Rick Spurr

That’s okay Jonathan, the only thing I will mention about the company you mentioned that we never heard of is that once in a while we will see something coming up and then we will go who are they? These kinds of things have happened before and when we dig into it and we find out that it’s a company that’s actually using an established technology in the market place. So the underlying encryption technology is really a well known competitor who is just then white labeled into somebody's service.

Nobody has – I shouldn't say nobody, I just guess Proofpoint and McAfee recently have real technology that they bought or modified with some solutions but basically it’s the same old set of players that just keep up popping up at difference places because this is the hard stuff to do and people are little late to the market and so they are trying to start from scratch and building something.

Jonathan Ruykhaver – ThinkEquity

Right. Okay, thanks, Rick. Thanks, again, and congrats.

Rick Spurr

All right. Thank you. Any other questions?

Operator

Your next question will come from the line of Jeb Terry from Aberdeen Investment. Please proceed.

Jeb Terry – Aberdeen Investment

Hello Susan and Rick.

Susan Conner

Hi, Jeb.

Jeb Terry – Aberdeen Investment

These are certainly more pleasant times than in years gone by.

Susan Conner

Yes.

Jeb Terry – Aberdeen Investment

Congratulations for the good quarter. To the point of the competition and also – by the way, thanks for the detail on the explanation of recurring revenue and renewals and all of that.

Rick Spurr

Yeah, sure.

Jeb Terry – Aberdeen Investment

The channel partners – one of the things that seems to be bouncing around is issues regarding Google. Are they a competitor or are they a partner? You have the (inaudible) OEM, but then theirs is the things bounce around till it gets free encryptions from Google. Can you help clarify that and also kind of frame how the OEMs fit in this competitive framework that you just talked about?

Rick Spurr

The OEMs fitting in with what Jeb?

Jeb Terry – Aberdeen Investment

The competitive –

Rick Spurr

Yeah I am glad you asked that because the Google we got a couple of questions on the what appeared to be a Google encryption announcement, that is not in anyway shape, or form a competitor. So let's just be clear. Their email encryption solution is Google message encryption and the underlying technology is Zix. We are the only email encryption solution that they offer in the market today. The Google encryption thing that hit the press had to do with the link between the Google users' browser and the Google datacenter and the Sky. It had nothing to do with any outbound user to user email, so the link from the Google browser to the Google service previously defaulted to HTTP and therefore was totally insecure unless of course they had layered on Zix for that one portion of the exchange.

They change that default to HTTPs which is a secured link. All that does though is create a secure pipe between the browser and Google it doesn't do anything to address the content of the email as it reverses the internet to its recipient and so Google continues to sell Zix for the real purpose and the real aim of compliance which is full content encryption from end to end.

Jeb Terry – Aberdeen Investment

Yes.

Rick Spurr

Makes sense?

Jeb Terry – Aberdeen Investment

That does make sense. And–but to that point then and can you elaborate a little more on the success of the channel partners? I think Susan mentioned that this was–

Rick Spurr

In terms of absolute – this is the third increase quarter-on-quarter that we have seen, so third quarter was up from second quarter was it 203?

Susan Conner

That’s right.

Rick Spurr

On an absolute basis, third quarter was up from second, fourth quarter was up from third, first quarter was up from fourth. On a percentage basis they just crossed 20% this quarter of our total new first year orders. So, that’s new milestone too in terms of contribution and one that frankly we have expected and continue to see greater and greater contributions. The channels take a while to get going but as the technology gets refined and more importantly the sales and marketing machine starts to crank up and gain confidence and their references and generally their respect for the vendor goes up the sale multiple and expand.

We are seeing increases from the Symantec channel as well, although as we mentioned Google still surpassing them today. We don't know yet what the impacted the new Symantec right now gateway integration will be. We are hopefully excited but it's too early to tell that was just made generally available about three weeks ago. Although it was announced March it wasn't available to the market place for sales guys to sell until ship about three weeks ago.

Jeb Terry – Aberdeen Investment

Okay. One more question. I know in the first quarter you had the event of HIPAA 2.0 going effective and you had high new orders. Can you address your sales pipeline and the sales cycle as we look forward? I know you mentioned your other verticals are doing well and those are unrelated to that threshold date. How should we think about it just looking forward?

Rick Spurr

I shy away from any quantitative assessment because the only thing that really is meaningful that we never have share and I am unwilling to share is the actual sales forecast. The sales cycle data and the pipeline data is brought with in precision. Sales cycle for instance has to do with when you start the cycle, its at the first time you send the brochure, the first time the guy comes to your location, the first time you get the trial, there is just too many ways to slice and dice that but generally and subjectively the sales people are busier than ever, happier than ever, making more money than ever and as I said it, it feels like that’s going to continue. Sales are never over told or over, but we are happy about where we are and where it feels like the market is going.

Jeb Terry – Aberdeen Investment

Great. Well, thanks very much and congratulations on the quarter.

Rick Spurr

Thanks Jeb for your questions.

Susan Conner

Thanks Jeb.

Operator

(Operator Instructions) And your next question will come from the line of Alex Zukin from ThinkEquity. Please proceed.

Alex Zukin –ThinkEquity

Hey, guys. Great performance. I just had a couple of quick questions. Can you talk about sort of the changing mix within deferred revenues? It seems like your long term deferred revenues went down and sort of shifted more towards the short term deferred.

Susan Conner

A lot of that is being driven from the e-prescribing side of the business. When we would get some of the larger contracts that they would pay for an advance, we would have that money obviously on the balance sheet and defer the revenue, its that's part of it and as well because of our financial position being much stronger today than it has been say two or three years ago.

We are not enticing customers to prepay years two and year three like we have in the past and that’s the other piece of it as well. We are in a much healthier financial position today.

Alex Zukin –ThinkEquity

Got it. And then, on the channel partner side, what's your target for channel partner revenue as a percentage of total as we go forward? Is it 25%, 30%, 50%?

Rick Spurr

Again the revenues are and if I was going to answer I we already answered on revenue because revenue because we are a recurring model. We are getting tons and tons of revenue every year from or tons and tons to us from stuff that was booked back in 2004 and 2005 and of course when the channels weren’t really relevant. So, percentage of revenue although I said they just crossed 20% on new orders, they are nowhere near that on real revenues because we have this underlying base of renewing revenue from customers that we sold through the direct channels over the years.

In terms of the new first year order number that’s one that is the leading indicator, as we indicate we just crossed the 20 for the channels. If you ask me what I think it's going to be on the year I would tell you I can't tell you but we do expect it will be a continuing percentage increase. It's also hugely unpredictable I mean Symantec for instance and Google but Symantec has 5000 sales people and if we get a hit on a particular product and that machine starts to crank up I mean it could be just great. On the other hand we can't project or forecast that or get too excited about it because it develops overtime and you got to kind of click on lot of cylinders before you can start projecting that sort of aggressive explosive growth.

Unfortunately its unpredictable but we are putting all the pieces in place and investing time and talent, energy and technology on maximizing our growth.

Alex Zukin –ThinkEquity

That’s helpful.

Rick Spurr

It's not only is the most scalable piece of the puzzle, I mean sales guys can only sell so much the productivity goes up, productivity can double and sell twice as much. But the right channel with the right mix you could sky is the limit.

Alex Zukin –ThinkEquity

Right. That's helpful. One other thing I want to try to understand is when–so say, for Google apps premier new customer that's paying $50 for their subscription to apps, out of that $50, how many dollars or cents belongs to Zix? What's sort of the revenue contribution or the revenue realization from a partner?

Rick Spurr

Well I am going to avoid the mention of the retail price because that’s their price and various by package and various by contract and all that. We have what we think is very attractive pricing in place with our partners from (inaudible) meaningful margin and yet at the same time is quite profitable for us and looks frankly quite close to what you get on a direct basis almost. And I have said in the past that a good number to think about across all of channels both in direct and direct is around 20 bucks a user a year. Sometimes we have channels in volume you will go lower than that but its –

Alex Zukin –ThinkEquity

And does per user mean per seat?

Rick Spurr

Yes.

Alex Zukin –ThinkEquity

Okay.

Rick Spurr

On the same side, you go to a bank as you say how many guys are sending emails, guys and gals, the guy says a 1000 and you give him a price and the more volume they rely and lower the price and we build a similar tiered structure to the channels and they use that pricing to pay us and then they package their own from that to establish the retail price in their margin.

Alex Zukin –ThinkEquity

Got it.

Rick Spurr

But if we thought the chills are really going to dilute our margins I think we have to be telling you all that as we talk about how they can become a large percentage and right now that’s not the case.

Alex Zukin –ThinkEquity

Okay, great. Thanks guys.

Rick Spurr

Thank you.

Operator

And you have no audio questions at this time and I will now turn the call back to

Peter Wilensky

Rick we do have one email question from an investor. Although you did touch on pricing somewhat when we were talking about renewals, we did get a question specifically on whether we are seeing increasing pricing pressure and pressure to lower our prices in the market?

Rick Spurr

Generally we have not changed our list pricing for three years, we did recently introduce some new pricing for non-strategic verticals but only in conditions where it was a large placement and where the customer was protecting every single person in the account so we have put some framing around it. But we want to make sure we remain competitive as those new verticals to develop. In our core verticals, we have said time, after time after time that Cisco will try to drive the price low. We will try to stay with them to a point but they have a vastly inferior product we believe and its difficult to use and its provided an architecture that we believe is dated and we sell to value and if it gets too low we just walk away and if all the guy wants is to do is check the box then it is what it is.

I think that and I would say by the way and some body really full fledge function encryption, its just the pricing everybody is enjoying the same similar sort of price points and yet we compete but there is no downward pressure like you might see in some commoditized industries or anything of that–even approaching that. I think the proof is in the pudding. The people that wave the flag about I have got the prices really good, these guys have got problems which you see on chat boards and stuff. The proof is in the pudding, which is our margin. If we were feeling real price pressure you would start seeing it in our gross margins and the simple fact is that you are not, the only downward margin impact we had at all is due to this allocation issue that Susan addressed and she informed earlier that had it not been for that, our margins actually would have been up. So I think that’s the key to it and comprehensive to the answer.

Peter Wilensky

Okay. Thanks a lot. You want to drive through the completing remarks?

Rick Spurr

Yes, I just want to say thanks to everybody again. Obviously, we're pleased with our results. We look forward to speaking with more and more of our shareholders and perspective shareholders about this progress. In fact we're heading out over the road over the next few weeks for meetings and if any of you are interested in speaking with us, give us a call and we'll try to accommodate that. We'll also be presenting at the RBC Capital Markets Technology, Media and communications investor conference on June 9th, which is in New York City this year. If anyone in New York City would like to join us there, call us as well and we'll try to hook up and enjoy speaking with you then. So thank you again for your time and attention and continued interest in Zix and we'll just keep driving the boat. Thanks everybody.

Operator

Ladies and gentlemen, that continues today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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